FINANCIAL MANAGEMENT / UNIT-4

INTRODUCTION TO working Capital4. Introduction to working capital: Concepts and characteristics of working capital, Factors determining the working capital. Estimation of working capital requirements. Current Assets Management: Management of current assets Cash, Receivables and Inventory. Cash budget, Credit terms Financing current assets. 4.1. Introduction to working capital116

4.1.1. Meaning of working capital116

4.1.2. Definitions 116

4.1.3. Concepts of Working Capital117

4.1.4. Classification of Working Capital118

4.1.5. Types of Working Capital119

4.1.6. Needs of Working Capital120

4.1.7. Working Capital Position/ Balanced Working Capital Position121

4.1.8. Factors determining working capital requirements121

4.1.9. Computation or estimation of working capital122

4.1.10. Working capital management policy124

4.1.11. Nature of Working Capital125

4.1.12. Characteristics of working capital125

4.1.13. Estimation of working capital126

4.1.14. ADEQUATE WORKING CAPITAL131

4.1.15. Importance/Need/Advantage of Adequate Working Capital132

4.1.16. EXCESSIVE AND INADEQUATE WORKING CAPITAL133

4.1.17. Disadvantage of Excessive Working Capital133

4.1.18. Disadvantage of Inadequate Working Capital133

4.1.19. DETERMINANTS OF WORKING CAPITAL134

4.1.20. Estimation of Working capital requirements1374.2. Sources of working capital1444.3. Current assets management146

4.3.1.Cash Management146

4.3.2. Meaning and definition of cash146

4.3.3. The Concept of Cash Management146

4.3.4. Motives for Holding Cash147

4.3.3. Cash Management Techniques147

4.3.5. Objectives of cash management147

4.3.6. Cash Management Models149

4.3.7. Significance of Cash Management149

4.3.8. Objectives of cash management150

4.3.9.Principles of Cash Management151

4.3.10.Cash Management Models152

4.4. Inventory Management158

4.4.1. Meaning and Definition of Inventory158

4.4.2. Types/Classification of Inventory158

4.4.3. Meaning of Inventory management159

4.4.4. Motives of Inventory Management159

4.4.5. Techniques of Inventory Management160

4.4.6. BENEFITS OR ADVANTAGES OF HOLDING

INVENTORY165

4.4.7. DISADVANTAGES OF HOLDING INVENTORY1664.5. Introduction to Receivables 168

4.5.1. Meaning of Receivables168

4.5.2. RECEIVABLE MANAGEMENT168

4.5.3. Factors Considering the Receivable Size169

4.5.4. Significance and Purpose of Receivable Management170

4.5.5. Characteristics of Receivables170

4.5.6. Objectives of Receivables1714.1. INTRODUCTION TO WORKING CAPITALWorking capital management is also one of the important parts of the financial management. It is concerned with short-term finance of the business concern which is a closely related trade between profitability and liquidity. Efficient working capital management leads to improve the operating performance of the business concern and it helps to meet the short-term liquidity. Hence, study of working capital management is not only an important part of financial management but also is overall management of the business concern.

Working capital is described as the capital which is not fixed but the more common uses of the working capital is to consider it as the difference between the book value of current assets and current liabilities.

4.1.1. MEANING OF WORKING CAPITALCapital of the concern may be divided into two major headings.

Fixed capital means that capital, which is used for long-term investment of the business concern. For example, purchase of permanent assets. Normally it consists of non-recurring in nature.

Working Capital is another part of the capital which is needed for meeting day to day requirement of the business concern. For example, payment to creditors, salary paid to workers, purchase of raw materials etc., normally it consists of recurring in nature. It can be easily converted into cash. Hence, it is also known as short-term capital.

Working Capital is the amount of Capital that a Business has available to meet the day-to-day cash requirements of its operations.

Working Capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities) .It refers to the amount of Current Assets that exceeds Current Liabilities (i.e. CA - CL) Working Capital refers to that part of the firms Capital, which is required for Financing Short-Term or Current Assets such as Cash, Marketable Securities, Debtors and Inventories.

4.1.2. DefinitionsAccording to the definition of Mead, Baker and Malott, Working Capital means Current Assets.

According to the definition of J.S.Mill, The sum of the current asset is the working capital of a business.

According to the definition of Weston and Brigham, Working Capital refers to a firms investment in short-term assets, cash, short-term securities, accounts receivables and inventories.

According to the definition of Bonneville, Any acquisition of funds which increases the current assets, increase working capital also for they are one and the same.

According to the definition of Shubin, Working Capital is the amount of funds necessary to cover the cost of operating the enterprises.

According to the definition of Gerestenberg, Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, for example, from cash to inventories, inventories to receivables, receivables to cash.

Working Capital is also known as Revolving or Circulating Capital or Short-Term Capital.

4.1.3. CONCEPT OF WORKING CAPITALWorking capital can be classified or understood with the help of the following two important concepts.

1. Gross Working CapitalGross Working Capital is the general concept which determines the working capital concept. Thus, the gross working capital is the capital invested in total current assets of the business concern.

Gross Working Capital is simply called as the total current assets of the concern.

2. Net Working CapitalNet Working Capital is the specific concept, which, considers both current assets and current liability of the concern.

Net Working Capital is the excess of current assets over the current liability of the concern during a particular period.

If the current assets exceed the current liabilities it is said to be positive working capital; it is reverse, it is said to be Negative working capital.

Definitions Favoring Net Working Capital Concept:-

According to C.W.Gestenbergh "It has ordinarily been defined as the excess of current assets over current liabilities".

According to Lawrence. J. Gitmen The most common definition of net working capital is the difference of firm's current assets and current liabilities".

4.1.4. Classification of Working Capital

(1) On the Basis of Concept: -

(i) Gross Working Capital

(ii) Net Working Capital

(2) On the Basis of time or Need:-

(i) Permanent Working Capital

(ii) Temporary Working Capital

II. On the basis of time or need

(1) Permanent or Fixed Working Capital:-

The need for working capital fluctuates from time to time. However, to carry on day-to-day operations of the business without any obstacles, a certain minimum level of raw materials, work-in-progress, finished goods and cash must be maintained on a continuous basis. The amount needed to maintain current assets on this minimum level is called permanent or regular working capital.

The amount involved as permanent working capital has to be meet from long-term sources of finance, e.g.

(i) Capital

(ii) Debentures

(iii) Long-term loans. (2) Temporary or Variable or Fluctuating Working Capital:-Depending upon the changes in production and sales, the need for working capital, over and above the permanent level of working capital is called temporary, fluctuating or variable working capital. It may be two types:-(a)Seasonal-Due to seasonal changes, level of business activities is higher than normal during some months of year and therefore additional working capital will be required along with the permanent working capital. It is so because during peak season, demand rises and more stock is to be maintained to meet the demand.

(b) Special- Additional doses of working capital may be required to face cut throat competition in the market or other contingencies like strikes, lock outs, theft etc.

4.1.5. TYPES OF WORKING CAPITALWorking Capital may be classified into three important types on the basis of time.

1. Permanent Working CapitalIt is also known as Fixed Working Capital. It is the capital; the business concern must maintain certain amount of capital at minimum level at all times. The level of Permanent Capital depends upon the nature of the business. Permanent or Fixed Working Capital will not change irrespective of time or volume of sales.

2. Temporary Working CapitalIt is also known as variable working capital. It is the amount of capital which is required to meet the Seasonal demands and some special purposes. It can be further classified into Seasonal Working Capital and Special Working Capital.

The capital required to meet the seasonal needs of the business concern is called as Seasonal Working Capital. The capital required to meet the special exigencies such as launching of extensive marketing campaigns for conducting research, etc.

Seasonal Working Capital:

Seasonal working capital is that temporary increase in working capital which is caused due to some relevant season for the business. It is applicable to businesses having impact of seasons for example, manufacturer of sweaters for whom relevant season is the winters. Normally, their working capital requirement would increase in that season due to higher sales in that period and then go down as collection from debtors is more than sales.

Special Working Capital:

Special working capital is that rise in temporary working capital which occurs due to a special event which otherwise normally does not take place. It has no basis to forecast and has rare occurrence normally. For example, country where Olympic Games are held, all the business require extra working capital due to sudden rise in business activity.

3. Semi Variable Working CapitalCertain amount of Working Capital is in the field level up to a certain stage and after that it will increase depending upon the change of sales or time.

4.1.6. NEEDS OF WORKING CAPITALWorking Capital is an essential part of the business concern. Every business concern must maintain certain amount of Working Capital for their day-to-day requirements and meet the short-term obligations.

Working Capital is needed for the following purposes.

1. Purchase of raw materials and spares: The basic part of manufacturing process is, raw materials. It should purchase frequently according to the needs of the business concern. Hence, every business concern maintains certain amount as Working Capital to purchase raw materials, components, spares, etc. 2. Payment of wages and salary: The next part of Working Capital is payment of wages and salaries to labour and employees. Periodical payment facilities make employees perfect in their work. So a business concern maintains adequate the amount of working capital to make the payment of wages and salaries. 3. Day-to-day expenses: A business concern has to meet various expenditures regarding the operations at daily basis like fuel, power, office expenses, etc. 4. Provide credit obligations: A business concern responsible to provide credit facilities to the customer and meet the short-term obligation. So the concern must provide adequate Working Capital. 4.1.7. Working Capital Position/ Balanced Working Capital Position.A business concern must maintain a sound Working Capital position to improve the efficiency of business operation and efficient management of finance. Both excessive and inadequate Working Capital lead to some problems in the business concern.

A. Causes and effects of excessive working capital.

(i) Excessive Working Capital leads to unnecessary accumulation of raw materials, components and spares.

(ii) Excessive Working Capital results in locking up of excess Working Capital.

(iii) It creates bad debts, reduces collection periods, etc.

(iv) It leads to reduce the profits.

B. Causes and effects of inadequate working capital

(i) Inadequate working capital cannot buy its requirements in bulk order.

(ii) It becomes difficult to implement operating plans and activate the firms profit target.

(iii) It becomes impossible to utilize efficiently the fixed assets.

(iv) The rate of return on investments also falls with the shortage of Working Capital.

(v) It reduces the overall operation of the business.

4.1.8. FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

Working Capital requirements depends upon various factors. There are no set of rules or formula to determine the Working Capital needs of the business concern. The following are the major factors which are determining the Working Capital requirements.

1. Nature of business: Working Capital of the business concerns largely depend upon the nature of the business. If the business concerns follow rigid credit policy and sell goods only for cash, they can maintain lesser amount of Working Capital. A transport company maintains lesser amount of Working Capital while a construction company maintains larger amount of Working Capital. 2. Production cycle: Amount of Working Capital depends upon the length of the production cycle. If the production cycle length is small, they need to maintain lesser amount of Working Capital. If it is not, they have to maintain large amount of Working Capital. 3. Business cycle: Business fluctuations lead to cyclical and seasonal changes in the business condition and it will affect the requirements of the Working Capital. In the booming conditions, the Working Capital requirement is larger and in the depression condition, requirement of Working Capital will reduce. Better business results lead to increase the Working Capital requirements. 4. Production policy: It is also one of the factors which affects the Working Capital requirement of the business concern. If the company maintains the continues production policy, there is a need of regular Working Capital. If the production policy of the company depends upon the situation or conditions, Working Capital requirement will depend upon the conditions laid down by the company. 5. Credit policy: Credit policy of sales and purchase also affect the Working Capital requirements of the business concern. If the company maintains liberal credit policy to collect the payments from its customers, they have to maintain more Working Capital. If the company pays the dues on the last date it will create the cash maintenance in hand and bank. 6. Growth and expansion: During the growth and expansion of the business concern, Working Capital requirements are higher, because it needs some additional Working Capital and incurs some extra expenses at the initial stages. 7. Availability of raw materials: Major parts of the Working Capital requirements are largely depend on the availability of raw materials. Raw materials are the basic components of the production process. If the raw material is not readily available, it leads to production stoppage. So, the concern must maintain adequate raw material; for that purpose, they have to spend some amount of Working Capital. 8. Earning capacity: If the business concern consists of high level of earning capacity, they can generate more Working Capital, with the help of cash from operation. Earning capacity is also one of the factors which determines the Working Capital requirements of the business concern. 4.1.9. COMPUTATION (OR ESTIMATION) OF WORKING CAPITALWorking Capital requirement depends upon number of factors, which are already discussed in the previous parts. Now the discussion is on how to calculate the Working Capital needs of the business concern. It may also depend upon various factors but some of the common methods are used to estimate the Working Capital.A. Estimation of components of working capital method

Working capital consists of various current assets and current liabilities. Hence, we have to estimate how much current assets as inventories required and how much cash required to meet the short term obligations.

Finance Manager first estimates the assets and required Working Capital for a particular period. B. Percent of sales method

Based on the past experience between Sales and Working Capital requirements, a ratio can be determined for estimating the Working Capital requirement in future. It is the simple and tradition method to estimate the Working Capital requirements. Under this method, first we have to find out the sales to Working Capital ratio and based on that we have to estimate Working Capital requirements. This method also expresses the relationship between the Sales and Working Capital. C. Operating cycle

Working Capital requirements depend upon the operating cycle of the business. The operating cycle begins with the acquisition of raw material and ends with the collection of receivables. Operating cycle consists of the following important stages:

1. Raw Material and Storage Stage, (R)

2. Work in Process Stage, (W)

3. Finished Goods Stage, (F)

4. Debtors Collection Stage, (D) 5. Creditors Payment Period Stage. (C)

Each component of the operating cycle can be calculated by the following formula:

4.1.10. WORKING CAPITAL MANAGEMENT POLICYWorking Capital Management formulates policies to manage and handle efficiently; for that purpose, the management established three policies based on the relationship between Sales and Working Capital.

1. Conservative Working Capital Policy.

2. Moderate Working Capital Policy.

3. Aggressive Working Capital Policy.

1. Conservative working capital policy: Conservative Working Capital Policy refers to minimize risk by maintaining a higher level of Working Capital. This type of Working Capital Policy is suitable to meet the seasonal fluctuation of the manufacturing operation. 2. Moderate working capital policy: Moderate Working Capital Policy refers to the moderate level of Working Capital maintenance according to moderate level of sales. It means one percent of change in Working Capital that is Working Capital is equal to sales. 3. Aggressive working capital policy: Aggressive Working Capital Policy is one of the high risky and profitability policies which maintain low level of Aggressive Working Capital against the high level of sales, in the business concern during a particular period.

Working Capital Policies4.1.11. Nature of Working Capital:

The nature of working capital is as discussed below:i. It is used for purchase of raw materials, payment of wages and expenses.

ii. It changes form constantly to keep the wheels of business moving.

iii. Working capital enhances liquidity, solvency, creditworthiness and reputation of the enterprise.

iv. It generates the elements of cost namely: Materials, wages and expenses.

v. It enables the enterprise to avail the cash discount facilities offered by its suppliers.

vi. It helps improve the morale of business executives and their efficiency reaches at the highest climax.

vii. It facilitates expansion programmes of the enterprise and helps in maintaining operational efficiency of fixed assets.

4.1.12. Characteristics of working capital

The following are the important characteristics of working capital;

1. Short Life: Current assets have very short life so it is difficult to manage. The components of working capital change their shape quickly which requires efficient management and timely decisions. The life may extend from one hour to one year. Management has to spend a lot of its time on working capital because these assets often change and require continuous control and supervision.

2. Nearness to Cash: All the components of working capital are more liquid and near to cash, marketable securities may be sold and converted into cash at any time. Receivable almost takes a time from one month to two months to convert into cash. Inventory may convert into cash from one day to nearly one year. Cash is already the most liquid assets. The liquidity of working capital needs much time and supervision.

3. Lack of Synchronization: In other important characteristic of working capital is the lack of synchronization among its components. All the parts of working capital do not occur at the same time. So there is a lack of synchronization.

4. High rate of Change: The shape of working capital components change more quickly which requires timely and quick decision from the management. It may be profitable for the firm to purchase securities at the time of low price and sell them when the price arises.

5. Financing from all Sources: Working capital requires financing from all sources. More fluctuating working capital may be financial with short-term sources, while the permanent working may be financed with intermediate and long term sources. Both variable and permanent types of working capital are also financed with internal sources.

6. Risk and return Trade off: Another characteristic of working capital is that it has a direct impact on the profitability and risk of the firm. If many funds are invested in working capital to avoid technical insolvency and to meet the material shortages, the return on investment will be low. On the other hand if adequate liquidity is not maintained the firm is likely to face but the return will be maximum.

7. Interchange of Current Assets: All the components of working capital interchange during the life time of the firm. Sometimes, they change into permanent nature and some time transferred into liquid nature frequent interchange needs proper attention of the management to maintain a balance between the permanent and fluctuating working capital.

8. Seasonal and Cyclical Influence: The activity of the firm does not remain the same for the whole period. It fluctuates due to face great demand in spring and autumn, while low demand in other seasons. The changing economy also influences the operations. These changes affect only the current assets and have little or no effect on other assets. The changes must be faced and dealt carefully.

4.1.13. ESTIMATION OF WORKING CAPITAL

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

Components of working capitalEstimation of working capital is based on the assumption that production and sales occur on a continuous basis and all costs occur accordingly.

Estimation of Current AssetsCurrent assets are estimated based on the following assumptions:

Average investment in raw material is estimated

Average investment in work-in-progress inventory is estimated

Average investment in finished goods inventory is estimated

Average investment in receivables (both in debtors and bills receivables) is estimated based on credit policy that the firm wishes to pursue

Based on the firms attitude towards risk, past experience and nature of business, firms decide on the policy of maintaining the minimum cash balances

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

Estimation of current liabilitiesTrade creditors: The average amount of financing available to the firm is estimated based on the production budget, raw material consumption and the credit period enjoyed from suppliers.

Direct wages: Estimation is made on total wages, to be paid on average basis, based on production budget, direct labour cost per unit and average time-lag in payment of wages.

Overheads: Estimation on an average basis of the outstanding amount to be paid to the creditors for overhead is estimated based on production budget, overhead cost per unit and average time-lag in payment of overhead

Solved ProblemA pro-forma cost sheet of a company provides the following details as shown in table 11.2.

Pro-forma sheetRaw material52.00

Direct labour19.50

Overheads39.00

Total cost110.50

Profit19.50

Selling price130.00

The following additional information is also available:

Average raw material in stock: One month

Average materials in process: Half a month

Credit allowed by Suppliers: One month

Credit allowed to debtors: Two months

Time lag in payment of wages: one and a half weeks

Time lag in payment of overheads: one month

One-fourth of sales on cash basis

Cash balance expected to be maintained is Rs.1,20,000

You are required to prepare a statement showing the working capital required to finance a level of activity of 70,000 units of output. You may assume that production is carried on evenly through-out the year and wages and overheads occur similarly. Assume 360 days in a year.

SolutionEstimation of Working Capital

a. Investment in inventory

f. Total Current Liabilities = 568750.00

Net working Capital (D F) = 1788958.33

Solved ProblemThe following annual figures are regarding the sales and production of the company XYZ ltd.

Annual figures of XYZ ltdSales (at two months credit)Rs. 36,00,000

Materials consumed (suppliers extend two months credit)Rs. 9,00,000

Wages paid (monthly in arrears)Rs. 7,20,000

Manufacturing expenses outstanding at the end of theRs. 80,000

year(cash expenses are paid one month in arrears)

Total administrative expenses paid, as aboveRs. 2,40,000

Sales promotion expenses, paid quarterly in advanceRs.1,20,000

The company sells its products on gross profit of 25% counting depreciation as part of the cost stock each of raw materials and finished goods, and a cash balance of Rs.100 000.

Assume a 20 percent safety margin. Calculate the working capital requirements of the company on cash cost basis.

SolutionThe computation of manufacturing expenses is as shown below

Computation of manufacturing expensesSalesRs.36,00,000

Less: gross profit at 25%Rs.9,00,000

Total manufacturing costRs.27,00,000

Less: materialsRs.9,00,000

Less: wagesRs.7,20,000

Manufacturing expensesRs.10,80,000

Cash manufacturing expensesRs.9,60,000

DepreciationTotal manufacturing expenses Cash manufacturing expenses

10,80,000 9,60,000 = Rs.1,20,000

The total cash cost is determined and shown in the following table

Total cash costTotal manufacturing costRs.27,00,000

Less: depreciationRs.1,20,000

Cash manufacturing costRs.25,80,000

Total manufacturing expensesRs.2,40,000

Sales promotion expensesRs.1,20,000

Total cash costRs.29,40,000

Statement of working capital required:

Current assets:

Raw Materials stock

Finished goods stock

Cash manufacturing cost

2580 000 x = 215000DebtorsTotal cash cost of sales x 2 /12 = 2940000 x 2 / 12 = 490000

Sales promotion expenses = 120000 x 1/4= 30,000

Cash required = 100000

Total Assets = 910000

Current LiabilitiesSundry Creditors

Wages outstanding = 720000 x 1/12 = 60000

Manufacturing expenses outstanding = 80000

Total administrative expenses:

Outstanding = 240000 / 12 =20000

Total current Liabilities = 310000

Working Capital (A B) = 600000

Add 20% safety margin = 120000

Working Capital required = 720000

4.1.14. ADEQUATE WORKING CAPITAL:

The firm should maintain a sound working capital position. It should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous from firm's point of view. Excessive working capital means holding costs and idle funds which earn no profit for the firm. Paucity of working capital not only impairs the firm's profitability but also results in production interruptions and inefficiencies and sales disruption

4.1.15. Importance/Need/Advantage of Adequate Working Capital:

(1) Availability of Raw Materials Regularly:-

Adequacy of working capital makes it possible for a firm to pay the suppliers of raw materials on time. As a result it will continue to receive regular supplies of raw materials and thus there will be no disruption in production process.

(2) Full Utilization of Fixed Assets:-

Adequacy of working capital makes it possible for a firm to utilize its fixed assets fully and continuously. For example, if there is inadequate stock of raw material, the machines will not be utilized in full and their productivity will be reduced.

(3) Cash Discount:-

A firm having the adequate working capital can avail the cash discount by purchasing the goods for cash or by making the payment before the due date.

(4) Increase in Credit Rating:-

Paying its short-term obligations in time leads to a strong credit rating which enables the firm to purchase goods on credit on favorable terms and to maintain its line of credit with banks etc. it facilities the taking of loan in case of need.

5) Exploitation of Favorable Market conditions:-

Whenever there are chances of increase in prices of raw materials, the firm can purchase sufficient quantity if it has adequate of working capital. Similarly, if a firm receives a bulk order for the supply of goods it can take advantage of such opportunity if it has sufficient working capital.

(6) Facility in Obtaining Bank Loans:-

Banks do not hesitate to advance even the unsecured loan to a firm which has the sufficient working capital. This is because the excess of current assets over current liabilities itself is a good security.

(7) Increase in Efficiency of Management:-

Adequacy of working capital has a favorable psychological effect on the managers. This is because no obstacle arises in the day-to-day business operations. Creditors, wages and all other expenses are paid on time and hence it keeps the morale of managers high.(8) Ability to face crisis:-

Adequate working capital enables a concern to face business crisis in emergencies such as depression. Generally in these periods there is much pressure on working capital.

(9) Solvency of the business:-

Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.

(10) Good will

Sufficient working capital enables a business concern to male prompt payments and hence helps in creating and maintaining good will.

4.1.16. EXCESSIVE AND INADEQUATE WORKING CAPITAL:

A business enterprise should maintain adequate working capital according to the needs of its business operations. The amount of working capital should neither be excessive nor inadequate. If the working capital is in excess if its requirements it means idle funds adding to the cost of capital but which earn nom profits for the firm. On the contrary, if the working capital is short of its requirements, it will result in production interruptions and reduction of sales and, in turn, will affect the profitability of the business adversely.

4.1.17. Disadvantage of Excessive Working Capital:-

(1) Excessive Inventory:-

Excessive working capital results in unnecessary accumulation of large inventory. It increases the chances of misuse, waste, theft etc.

(2) Excessive Debtors:-

Excessive working capital will results in liberal credit policy which, in turn, will results in higher amount tied up in debtors and higher incidence of bad debts.

(3) Adverse Effect on Profitability:-

Excessive working capital means idle funds in the business which adds to the cost of capital but earns no profits for the firm. Hence it has a bad effect on profitability of the firm.

(4) Inefficiency of Management:-

Management becomes careless due to excessive resources at their command. It results in laxity of control on expenses and cash resources.

4.1.18. Disadvantage of Inadequate Working Capital:

(1) Difficulty in Availability of Raw-Material:-

Adequacy of working capital results in non-payment of creditors on time. As a result the credit purchase of goods on favorable terms becomes increasingly difficult. Also, the firm cannot avail the cash discount.

(2) Full Utilization of Fixed Assets not Possible:

Due to the frequent interruption in the supply of raw materials and paucity of stock, the firm cannot make full utilization of its machines etc.

(3) Difficulty in the Maintenance of Machinery:

Due to the inadequacy of working capital, machines are not cared and maintained properly which results in the closure of production on many occasions.(4) Decrease in Credit Rating:

Because of inadequacy of working capital, firm is unable to pay its short-term obligations on time. It decays the firm's relations with its bankers and it becomes difficult for the firm to borrow in case of need.

(5) Non Utilization of Favorable Opportunities:

For example, a firm cannot purchase sufficient quantity of raw materials in case of sudden decrease in the prices. Similarly, if the firm receives a big order, it cannot execute it due to shortage of working capital.

(6) Decrease in Sales:

Due to the shortage of working capital, the firm cannot keep sufficient stock of finished goods. It results in the decrease in sales. Also, the firm will be forced to restrict its credit sales. This will further reduce the sales.

(7) Difficulty in the Distribution of Dividends:

Because of paucity of cash resources, firm will not be able to pay the dividend to its shareholders.

(8) Decrease in the Efficiency of Management:

It will become increasingly difficult for the management to pay its creditors on time and pay its day-to-day expenses. It will also be difficult to pay the wages regularly which will have an adverse effect on the morale of managers.

4.1.19. DETERMINANTS OF WORKING CAPITAL:

A firm should have neither too much nor too little working capital. A large number of factors, each has a different importance, influencing working capital needs of firms. The importance of factors also changes for a firm over time. Therefore, an analysis of relevant factors should be made in order to determine total investment in working capital. The following is the description of factors which generally influence the working capital requirements. The working capital requirement is determined by a large number of factors but, in general, the following factors influence the working capital needs of an enterprise:

(1) Nature of Business:-

Working capital requirements of an enterprise are largely influenced by the nature of its business. For instance, public utilities such as railways, transport, water, electricity etc. have a very limited need for working capital because they have invested fairly large amounts in fixed assets. Their working capital need is minimal because they get immediate payment for their services and do not have to maintain big inventories. On the other extreme are the trading and financial enterprises which have to invest fewer amounts in fixed assets and a large amount in working capital. This is so because the nature of their business is such that they have to maintain a sufficient amount of cash, inventories and debtors. Working capital needs of most of the manufacturing enterprises fall between these two extremes, that is, between public utilities and trading concerns.(2) Size of Business:-

Larger the size of the business enterprise, greater would be the need for working capital. The size of a business may be measured in terms of scale of its business operations.

(3) Growth and Expansion:-

As a business enterprise grows, it is logical to expect that a larger amount of working capital will be required. Growing industries require more working capital than those that are static.

(4) Production cycle:-

Production cycle means the time-span between the purchase of raw materials and its conversion into finished goods. The longer the production cycle, the larger will be the need for working capital because the funds will be tied up for a longer period in work in process. If the production cycle is small, the need for working capital will also be small.

(5) Business Fluctuations:-

Business fluctuations may be in the direction of boom and depression. During boom period the firm will have to operate at full capacity to meet the increased demand which in turn, leads to increase in the level of inventories and book debts. Hence, the need for working capital in boom conditions is bound to increase. The depression phase of business fluctuations has exactly an opposite effect on the level of working capital requirement.

(6) Production Policy:-

The need for working capital is also determined by production policy. The demand for certain products (such as woolen garments) is seasonal. Two types of production policies may be adopted for such products. Firstly, the goods may be produced in the months of demand and secondly, the goods may be produces throughout the year. If the second alternative is adopted, the stock of finished goods will accumulate progressively up to the season of demand which requires an increasing amount of working capital that remains tied up in the stock of finished goods for some months.

(7) Credit Policy Relating to Sales:-

If a firm adopts liberal credit policy in respect of sales, the amount tied up in debtors will also be higher. Obviously, higher book debts mean more working capital. On the other hand, if the firm follows tight credit policy, the magnitude of working capital will decrease

(8) Credit Policy Relating to Purchase:-

If a firm purchases more goods on credit, the requirement for working capital will be less. In other words, if liberal credit terms are available from the suppliers of goods (i.e., creditors), the requirement for working capital will be reduced and vice versa.

(9) Availability of Raw Material:-

If the raw material required by the firm is available easily on a continuous basis, there will be no need to keep a large inventory of such materials and hence the requirement of working capital will be less. On the other hand, if the supply of raw material is irregular, the firm will be compelled to keep an excessive inventory of such raw materials which will result in high level of working capital. Also, some raw materials are available only during a particular season such as oil seeds, cotton, etc. They would have to be necessarily purchased in that season and have to be kept in stock for a period when supplies are lean. This will require more working capital.

(10) Availability of Credit from Banks:-

If a firm can get easy bank facility in case of need, it will operate with less working capital. On the other hand, if such facility is not available, it will have to keep large amount of working capital.

(11) Volume of Profit:-

The net profit is a source of working capital to the extent it has been earned in cash. Higher net profit would generate more internal funds thereby contributing the working capital pool.

(12) Level of Taxes:-

Full amount of cash profit is not available for working capital purpose. Taxes have to be paid out of profits. Higher the amount of taxes less will be the profits for working capital.

(13) Dividend Policy:-

Dividend policy is a significant element in determining the level of working capital in an enterprise. The payment of dividend reduces the cash and thereby, affects the working capital to that extent. On the contrary, if the company does not pay dividend but retains the profits, more would be the contribution of profits towards capital pool.

(14) Depreciation Policy:-

Although depreciation does not result in outflow of cash, it affects the working capital indirectly. In the first place, since depreciation is allowable expenditure in calculating net profits, it affects the tax liability. In the second place, higher depreciation also means lower disposable profits and, in turn, a lower dividend payment. Thus, outgo of cash is restricted to that extent.

(15) Price Level Changes:-

Changes in price level also affect the working capital requirements. If the price level is rising, more funds will be required to maintain the existing level of production. Same level of current assets will need increased investment when prices are increasing. However, companies that can immediately their product prices with rising price levels will not face a severe working capital problem. Thus, it is possible that some companies may not be affected by rising prices while others may be badly hit.

(16) Efficiency of Management:-

Efficiency of management is also a significant factor to determine the level of working capital. Management can reduce the need for working capital by the efficient utilization of resources. It can accelerate the pace of cash cycle and thereby use the same amount working capital again and again very quickly.

4.1.20. Estimation of Working capital requirements:

In estimating working capital needs, different people adopt different approaches. Some experts suggest that the working capital should be greater than the minimum requirements of the firm. The management should feel safety. It would be able to meet its obligations even in adverse circumstances. However, the excessive capital may lead to waste and inefficiency. There are various methods which have been applied in practice for the estimation of working capital requirements of a firm. Lets discuss some of them in brief.

1. Forecasting of Current Assets and Current Liabilities Method:- According to this method, an estimate is made of forthcoming period's current assets and current liabilities on the basis of factors like past experience, credit policy, stock policy and payment policy of the previous years. First of all, such estimate is made for each current asset on the basis of each month and then monthly requirements are converted into yearly requirement of current assets. The estimated amount of current liabilities is deducted from this amount in order to estimate the requirement of working capital. A certain percentage for contingencies may also be added to this amount.

2. Cash Forecasting Method:- Under this method, an estimate is made of cash receipts and payments for the next period. Estimated cash receipts are added to the amount of working capital which exists at the beginning of the year and estimated cash payments are deducted from this amount. The difference will be the amount of working capital.

3. Percentage of Sales Method:- Under this method, certain key ratios based on past year's information are established. These ratios can be ratio of sales to raw material stock, ratio of sales to semi-finished goods stock, ratio of sales to finished goods stock, ratio of sales to debtors, ratio of sales to cash balance etc. After this, sales for the next year will be estimated and the requirement of working capital will be determined on the basis of these ratios.

4. Projected Balance Sheet Method:- Under this method, an estimate is made of assets and liabilities for a future date and a projected balance sheet is prepared for that future date. The difference in current assets and current liabilities shown in projected balance sheet will be the amount of working capital.

5. Operating Cycle Approach - Estimation of Working Capital Requirements

Efficient working capital management is one which ensures continuous flow without any interruptions/holdups at any of the stages referred to above and involves as for as possible a rapid completion of the revolutions. In other words, when raw materials remain in store pending issue for production for a less duration, when raw materials get converted into WIP in short duration, when WIP is converted into finished goods in short duration, when finished goods remain in dept pending sales for a short while only, and when cash realizations out of sales are made quickly and finally when payment to creditors is made slowly, the operating cycle would be smaller and consequently the working capital will also be reasonable.

There should be neither too little nor too much investment in working capital. Efficient handling of the operating cycle would make possible the above. Note, what is suggested is optimization, and not minimization of current assets and maximization of current liabilities. That will affect your liquidity and your profitability. Too little means more illiquid, but more profitability, but not more absolute profits. We want both high profitability and high profits. Too much current liability means illiquid but more profitability as it is assumed short-term funds are less expensive for they can be redeemed the moment you dont need thus saving interest. The reverse is true with too little current liability. Actually the business has to trade-off between risk and return. If it wants less risk it has to carry more current assets and less current liability. This will lead to lower profits. Low risk means low profits. If the business takes more risk, ie., it carries less working capital, it might make more profits. There is no guarantee however that higher level of risk yields higher profits.

In terms of operating cycle concept, too long an operating cycle gives more liquidity but only low returns and vice versa. The optimum operating cycle has to be worked out taking into account the costs and benefits and levels of risk and levels of return for varying lengths of operating cycle.

As a first step, we have to compute the operating cycle as follows:

i) Inventory period: Number of days consumption in stock = I M/36

Where I Average inventory during the year

M = Materials consumed during the year

ii) Work-in-process: Number of days of work-in-process = W K/365 Where W = Average work-in-process during the year

K = Cost of work-in-process i.e., Material + Labour + Factory overheads.

iii) Finished products inventory period = G F/365

Where G = Average finished products inventory during the year F= Cost of finished goods sold during the year

iv) Average collection period of Debtors = D S/365

Where D = Average Debtors balances during the year S = Credit sales during the year

v) Credit period allowed by Suppliers = C P/365

Where C = Average creditors balances during the year

P = credit purchases during the year

vi) Minimum cash balance to be kept daily.

Formula: O.C. = M + W + F + D C

Note : It is also known as working capital cycle. Operating cycle is the total time gap between the purchase of raw material and the receipt from Debtors.

The calculation of net working capital may also be shown as follows ; Working Capital = Current Assets Current Liabilities =(Raw Materials Stock + Work-in-progress Stock + Finished Goods Stock + Debtors + Cash Balance) (Creditors +Outstanding Wages + Outstanding Overheads).

Where,

Raw Materials = Cost (Average) of Materials in Stock

Work-in-progress Stock = Cost of Materials + Wages +Overhead of Work-in-progress. Finished Goods Stock = Cost of Materials + Wages +Overhead of Finished Goods. Creditors for Material = Cost of Average Outstanding Creditors.

Creditors for Wages = Averages Wages Outstanding. Creditors for Overhead = Average Overheads Outstanding. Thus,

Working Capital = Cost of Materials in Stores, in Work-in-progress, in Finished Goods and in Debtors.

Less : Creditors for Materials

Plus : Wages in Work-in-progress, in Finished Goods and in Debtors.

Less :Creditors for Wages

Plus : Overheads in Work-in-progress, in Finished Goods and in Debtors.

Less : Creditors for Overheads.

The work sheet for estimation of working capital requirements under the operating cycle method may be presented as follows:

ESTIMATION OF WORKING CAPITAL REQUIREMENTSI Current Assets:AmountAmountAmount

Minimum Cash Balance****

Inventories :

Raw Materials****

Work-in-progress****

Finished Goods********

Receivables :

Debtors****

Bills *******

Gross Working Capital (CA)********

II Current Liabilities :

Creditors for Purchases****

Creditors for Wages ****

Creditors for Overheads********

Total Current Liabilities (CL)********

Excess of CA over CL****

+ Safety Margin****

Net Working Capital****

The following points are also worth noting while estimating the working capital requirement:

1. Depreciation: An important point worth noting while estimating the working capital requirement is the depreciation on fixed assets. The depreciation on the fixed assets, which are used in the production process or other activities, is not considered in working capital estimation. The depreciation is a non-cash expense and there is no funds locked up in depreciation as such and therefore, it is ignored. Depreciation is neither included in valuation of work-in-progress nor in Finished goods. The working capital calculated by ignoring depreciation is known as cash basis working capital. In case, depreciation is included in working capital calculations, such estimate is known as total basis Working capital.

2. Safety Margin: Sometimes, a firm may also like to have a safety margin of working capital in order to meet any contingency. The safety margin may be expressed as a % of total current assets or total current liabilities or net working capital. The safety margin, if required, is incorporated in the working capital estimates to find out the net working capital required for the firm. There is no hard and fast rule about the quantum of safety margin and depends upon the nature and characteristics of the firm as well as of its current assets and current liabilities

Working Capital = Cost of Goods Sold (Estimated) * (No. of Days of Operating Cycle / 365 Days) + Bank and Cash Balance.

If the cost of goods sold (estimated) is $35 million and operating cycle is of 75 days and bank balance required is 1.25 million. Therefore, Working Capital = 35 * 75/365 + 1.25 = $8.44 Million.

In this method, each component can also be calculated. It means bifurcation of $8.44 million can be done in inventory, cash, accounts receivable, accounts payable etc.

Example.1Hi-tech Ltd. plans to sell 30,000 units next year. The expected cost of goods sold is as follows:

Rs. (Per Unit)

Raw material100

Manufacturing expenses30

Selling, administration and financial expenses20

Selling price200

The duration at various stages of the operating cycle is expected to be as follows :

Raw material stage2 months

Work-in-progress stage1 month

Finished stage1/2 month

Debtors stage1 month

Assuming the monthly sales level of 2,500 units, estimate the gross working capital requirement. Desired cash balance is 5% of the gross working capital requirement, and working- progress in 25% complete with respect to manufacturing expenses.

Solution:

Statement of Working Capital Requirement

1. Current Assets:Amt. (Rs.Amt. (Rs.)

Stock of Raw Material (2,5002100)5,00,000

Work-in-progress:

Raw Materials (2,500100)2,50,000

Manufacturing Expenses 25% of (2,50030)18,7502,68,750

Finished Goods:

Raw Materials (2,500100)1,25,000

Manufacturing Expenses (2,50030)37,5001,62,500

Debtors (2,500150)3,75,000

13,06,250

Cash Balance (13,06,2505/95)68,750

Working Capital Requirement13,75,000

Note: Selling, administration andfinancial expenses have not been included in valuation of closing

stock.

Example.2Calculate the amount of working capital requirement for SRCC Lt d. from the following

information:

. (Per Unit)

Raw materials160

Direct labour60

Overheads120

Total cost34 0

Profit60

Selling price400

Raw materials are held 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 and credit allowed to debtors is two months. Time lag in payment of wages is 1 weeks. Time lag in payment of overhead expenses is one month. One fourth of the sales are made on cash basis.

Cash in hand and at the bank is expected to be Rs. 50,000; and expected level of production Cash in hand and at the bank is expected to be Rs. 50,000; and expected level of production amounts to 1,04,000 units for a year of 52 weeks.

You may assume that production is carried on evenly throughout the year and a time period of four weeks is equivalent to a month.

Solution :Statement of Working Capital Requirement1. Current Assets :Amt. (Rs.)Amt. (Rs.)

Cash Balance50,000

Stock of Raw Materials (2,0001604)12,80,000

Work-in-progress :

Raw Materials (2,0001602)6,40,000

Labour and Overheads (2,0001802)50%3,60,00010,00,000

Finished Goods (2,0003404)27,20,000

Debtors (2,00075%3408)40,80,000

Total Current Assets91,30,000

2. Current Liabilities :

Creditors (2,000Rs. 1604)12,80,000

Creditors for Wages (2,000Rs. 601)1,80,000

Creditors for Overheads (2,000Rs. 1204)9,60,000

Total Current Liabilities24,20,000

Net Working Capital (CACL)67,10,000

Example.3JBC Ltd. sells goods on a gross profit of 25%. Depreciation is considered as a part of cost of production. The following are the annual figures given to you :

Sales (2 months credit)Rs. 18,00,000

Materials consumed (1 months credit)4,50,000

Wages paid (1 month lag in payment)3,60,000

Cash manufacturing expenses (1 month lag in payment)4,80,000

Administrative expenses (1 month lag in payment)1,20,000

Sales promotion expenses (paid quarterly in advance)60,000

The company keeps one months stock each of raw materials and finished goods. It also keeps Rs. 1,00,000 in cash. You are required to estimate the working capital requirements of the company on cash cost basis, assuming 15% safety margin.

Solution:Statement of Working Capital Requirement1. Current Assets :Amt. (Rs.)

Cash-in-hand1,00,000

Debtors (cost of sales i.e. 14,70,0002/12)2,45,000

Prepaid Sales Promotion expenses15,000

Inventories :

Raw Materials (4,50,000/12)37,500

Finished goods (12,90,000/12)1,07,500

Total current assets5,05,000

2. Current Liabilities :

Sundry creditors (4,50,000/12)37,500

Outstanding Manufacturing exp. (4,80,000/12)40,000

Outstanding Administrative exp. (1,20,000/12)10,000

Outstanding Wages (3,60,000/12)30,000

Total current liabilities1,17,500

Excess of CA and CL3,87,500

+ 15% for contingencies58,125

Working capital required4,45,625

Working Notes :

1. Cost StructureRs.

Sales18,00,000

Gross profit 25% on sales4,50,000

Cost of production13,50,000

Cost of materialsRs. 4,50,000

Wages3,60,0008,10,000

Manufacturing expenses (Total)5,40,000

Cash Manufacturing expenses4,80,000

Therefore, Depreciation60,000

2. Total cash cost :

Cost of production13,50,000

Depreciation60,000

+ Administrative expenses1,20,000

+ Sales promotion expenses60,000

Total Cash Cost14,70,000

4.2. SOURCES OF WORKING CAPITALWorking Capital requirement can be normalized from short-term and long-term sources. Each source will have both merits and limitations up to certain extract. Uses of Working Capital may be differing from stage to stage.

WORKING CAPITAL AND BANKING COMMITTEEBanking finance to working capital requirements is a very important part of the business concern. Banks provide finance to business concerns to meet the requirements. To regulate and control bank finance, RBI constitutes committees. These committees submit reports with findings and recommendations to formulate the finance policy of the banks. The major committee and the recommendations are as follows:

CommitteeYearMajor Recommendations

DEHEJIA1969Appraisal of credit applications received by banks for granting loan.

TANDON1975Banks must carry out the realize appraisal for granting loan Fixation

of norms for bank lending to industry.

CHORE1980No bifurcation of cash credit accounts separate limits for peak

level and non peak level requirements.

MARATHE1984Second method of lending to industry, introduction of fast track

concept.

KANNAN1997Regular conduct with the borrowers, periodical monitoring the credit

disposition.

4.3. Current assets management

Current asset management is the handling of the current assets of a company. Any assets that a company or business has that is the equivalent of cash or can be liquidated into cash in the period of a year is considered a current asset. Typically, current assets are the inventory a company has, as well as the accounts receivables and any short-term investments it has in place.

The main principle in current asset management is to keep the proper flow of income and liability in balance. Managing current assets also takes into account the long-term investments of a company, but short-term assets, another name for current assets, is important in determining the liquidity of a company. The measure of liquidity is really the measure of how well and how fast a company can pay off its debts.

Calculating the current ratio is key in figuring out the proper balance for current asset management. The current ratio is the companys current assets divided by its current liabilities. Current liabilities are defined as what a business needs to pay off in a specific cycle of time, either a financial year or a cycle of time particular to a business, whichever is longer.

4.3.1. CASH MANAGEMENT

Business concern needs cash to make payments for acquisition of resources and services for the normal conduct of business. Cash is one of the important and key parts of the current assets.

Cash is the money which a business concern can disburse immediately without any restriction. The term cash includes coins, currency, cheques held by the business concern and balance in its bank accounts. Management of cash consists of cash inflow and outflows, cash flow within the concern and cash balance held by the concern etc.

4.3.2. Meaning and definition of cash:

1. Cash may be in any form of currency, like banknotes and coins, which have a legal acceptance and recognition in the market.

2. The acceptance of cash by its user indicates that it has a trading value when tendered for purchase of goods and services.

3. Cash is one of the current assets in a business. It is needed all times to keep the business on going. A business concern to keep the sufficient fund to meet its obligations.

"Cash is money in form of banknotes and coins that are issued by the government of a country under the administration and control of its finance ministry or department of finance."

4.3.3. The Concept of Cash Management

Cash, like the blood stream in the human body, gives vitality and strength to business enterprises.

Though, cash holds the smallest portion of total current assets. However, cash is both the beginning and end of working capital cycle cash, inventories, receivables and cash. It is the cash, which keeps the business going. Hence, every enterprise has to hold necessary cash for its existence. Moreover, steady and healthy circulation of cash throughout the entire business operations is the basis of business solvency.

In the words of R.R. Bari, Maintenance of surplus cash by a company unless there are special reasons for doing so, is regarded as a bad sigh of cash management.Cash may be interpreted under two concepts. In narrow sense, cash is very important business asset, but although coin and paper currency can be inspected and handled, the major part of the cash of most enterprises is in the form of bank checking accounts, which represent claims to money rather than tangible property. While in broader sense, cash consists of legal tender, cheques, bank drafts, money orders and demand deposits in banks. In general, nothing should be considered unrestricted cash unless it is available to the management for disbursement of any nature. Thus, from the above quotations we may conclude that in narrow sense cash means cash in hand and at bank but in wider sense, it is the deposit in banks, currency, cheques, bank draft etc. in addition to cash in hand and at bank.

4.3.4. Motives for Holding Cash1. Transaction motive

It is a motive for holding cash or near cash to meet routine cash requirements to finance transaction in the normal course of business. Cash is needed to make purchases of raw materials, pay expenses, taxes, dividends etc.

2. Precautionary motive

It is the motive for holding cash or near cash as a cushion to meet unexpected contingencies. Cash is needed to meet the unexpected situation like, floods strikes etc.

3. Speculative motive

It is the motive for holding cash to quickly take advantage of opportunities typically outside the normal course of business. Certain amount of cash is needed to meet an opportunity to purchase raw materials at a reduced price or make purchase at favorable prices.

4. Compensating motive

It is a motive for holding cash to compensate banks for providing certain services or loans. Banks provide variety of services to the business concern, such as clearance of cheque, transfer of funds etc.

4.3.5. Cash Management TechniquesManaging cash flow constitutes two important parts:

A. Speedy Cash Collections.

B. Slowing Disbursements.

A. Speedy Cash CollectionsBusiness concern must concentrate in the field of Speedy Cash Collections from customers. For that, the concern prepares systematic plan and refined techniques. These techniques aim at, the customer who should be encouraged to pay as quickly as possible and the payment from customer without delay. Speedy Cash Collection business concern applies some of the important techniques as follows:

1. Prompt Payment by CustomersBusiness concern should encourage the customer to pay promptly with the help of offering discounts, special offer etc. It helps to reduce the delaying payment of customers and the firm can avoid delays from the customers. The firms may use some of the techniques for prompt payments like billing devices, self address cover with stamp etc.

2. Early Conversion of Payments into CashBusiness concern should take careful action regarding the quick conversion of the payment into cash. For this purpose, the firms may use some of the techniques like postal float, processing float, bank float and deposit float.

3. Concentration BankingIt is a collection procedure in which payments are made to regionally dispersed collection centers, and deposited in local banks for quick clearing. It is a system of decentralized billing and multiple collection points.

4.Lock Box SystemIt is a collection procedure in which payers send their payment or cheques to a nearby post box that is cleared by the firms bank. Several times that the bank deposit the cheque in the firms account. Under the lock box system, business concerns hire a post office lock box at important collection centers where the customers remit payments. The local banks are authorized to open the box and pick up the remittances received from the customers. As a result, there is some extra savings in mailing time compared to concentration bank.

B. Slowing DisbursementAn effective cash management is not only in the part of speedy collection of its cash and receivables but also it should concentrate to slowing their disbursement of cash to the customers or suppliers. Slowing disbursement of cash is not the meaning of delaying the payment or avoiding the payment. Slowing disbursement of cash is possible with the help of the following methods:

1. Avoiding the early payment of cash The firm should pay its payable only on the last day of the payment. If the firm avoids early payment of cash, the firm can retain the cash with it and that can be used for other purpose.

2. Centralised disbursement system Decentralized collection system will provide the speedy cash collections. Hence centralized disbursement of cash system takes time for collection from our accounts as well as we can pay on the date. 4.3.6. Cash Management

The term cash management refers to the management of cash resource in such a way that generally accepted business objectives could be achieved. In this context, the objectives of a firm can be unified as bringing about consistency between maximum possible profitability and liquidity of a firm.

Cash management may be defined as the ability of a management in recognizing the problems related with cash which may come across in future course of action, finding appropriate solution to curb such problems if they arise, and finally delegating these solutions to the competent authority for carrying them out. The choice between liquidity and profitability creates a state of confusion. It is cash management that can provide solution to this dilemma. Cash management may be regarded as an art that assists in establishing equilibrium between liquidity and profitability to ensure undisturbed functioning of a firm towards attaining its business objectives.

Cash itself is not capable of generating any sort of income on its own. It rather is the prime requirement of income generating sources and functions. Thus, a firm should go for minimum possible balance of cash, yet maintaining its adequacy for the obvious reason of firms solvency. Cash management deals with maintaining sufficient quantity of cash in such a way that the quantity denotes the lowest adequate cash figure to meet business obligations. Cash management involves managing cash flows (into and out of the firm), within the firm and the cash balances held by a concern at a point of time. The words, managing cash and the cash balances as specified above does not mean optimization of cash and near cash items but also point towards providing a protective shield to the business obligations. Cash management is concerned with minimizing unproductive cash balances, investing temporarily excess cash advantageously and to make the best possible arrangement for meeting planned and unexpected demands on the firms cash.

4.3.7. Significance of Cash Management

Cash is one of the most important components of current assets. Every firm should have adequate cash, neither more nor less. Inadequate cash will lead to production interruptions, while excessive cash remains idle and will impair profitability. Hence, the firm need for cash management. The cash management assumes significance for the following reasons.

1. Cash planning: Cash is the most important as well as the least unproductive of all current assets. Though, it is necessary to meet the firms obligations, yet idle cash earns nothing. Therefore, it is essential to have sound cash planning neither excess nor inadequate.

2. Management of cash flows: This is another important aspect of cash management. Synchronization between cash inflows and cash outflows rarely happens. Sometimes, the cash inflows will be more than outflows because of receipts from debtors, and cash sales in huge amounts. At other times, cash outflows exceed inflows due to payment of taxes, interest and dividends etc. Hence, the cash flows should be managed for better cash management.

3. Maintaining optimum cash balance: Every firm should maintain optimum cash balance. The management should also consider the factors determining and influencing the cash balances at various point of time. The cost of excess cash and danger of inadequate cash should be matched to determine the optimum level of cash balances.

4. Investment of excess cash: The firm has to invest the excess or idle funds in short term securities or investments to earn profits as idle funds earn nothing. This is one of the important aspects of management of cash. Thus, the aim of cash management is to maintain adequate cash balances at one hand and to use excess cash in some profitable way on the other hand.

:4.3.8. Objectives of cash management

(1) To make Payment According to Payment Schedule:- Firm needs cash to meet its routine expenses including wages, salary, taxes etc.Following are main advantages of adequate cash:-

a)To prevent firm from being insolvent.

b) The relation of firm with bank does not deteriorate.

c) Contingencies can be met easily.

d) It helps firm to maintain good relations with suppliers.

(2) To minimise Cash Balance:- The second objective of cash management is to minimise cash balance. Excessive amount of cash balance helps in quicker payments, but excessive cash may remain unused & reduces profitability of business. Contrarily, when cash available with firm is less, firm is unable to pay its liabilities in time. Therefore optimum level of cash should be maintained.1. Meeting cash disbursements: The first basic objective of cash management is to meet the payments Schedule. In other words, the firm should have sufficient cash to meet the various requirements of the firm at different periods of times. The business has to make payment for purchase of raw materials, wages, taxes, purchases of plant, etc. The business activity may come to a grinding halt if the payment schedule is not maintained. Cash has, therefore, been aptly described as the oil to lubricate the ever-turning wheels of the business, without it the process grinds to a stop.

2. Minimizing funds locked up as cash balances: The second basic objective of cash management is to minimize the amount locked up as cash balances. In the process of minimizing the cash balances, the finance manager is confronted with two conflicting aspects. A higher cash balance ensures proper payment with all its advantages. But this will result in a large balance of cash remaining idle. Low level of cash balance may result in failure of the firm to meet the payment schedule.

The finance manager should, therefore, try to have an optimum amount of cash balance keeping the above facts in view.

4.3.9. Principles of Cash Management

Harry Gross has suggested certain general principles of cash management that, essentially add efficiency to cash management. These principles reflecting cause and effect relationship having universal applications give a scientific outlook to the subject of cash management. While, the application of these principles in accordance with the changing conditions and business environment requiring high degree of skill and tact which places cash management in the category of art. Thus, we can say that cash management like any other subject of management is both science and art for it has well-established principles capable of being skill fully modified as per the requirements. The principles of management are follows as;

1. Determinable Variations of Cash Needs: A reasonable portion of funds, in the form of cash is required to be kept aside to overcome the period anticipated as the period of cash deficit. This period may either be short and temporary or last for a longer duration of time. Normal and regular payment of cash leads to small reductions in the cash balance at periodic intervals. Making this payment to different employees on different days of a week can equalize these reductions. Another technique for balancing the level of cash is to schedule cash disbursements to creditors during that period when accounts receivables collected amounts to a large sum but without putting the goodwill at stake.

2. Contingency Cash Requirement: There may arise certain instances, which fall beyond the forecast of the management. These constitute unforeseen calamities, which are too difficult to be provided for in the normal course of the business. Such contingencies always demand for special cash requirements that was not estimated and provided for in the cash budget. Rejections of wholesale product, large amount of bad debts, strikes, lockouts etc. are a few among these contingencies. Only a prior experience and investigation of other similar companies prove helpful as a customary practice. A practical procedure is to protect the business from such calamities like bad-debt losses, fire etc. by way of insurance coverage.

3. Availability of External Cash: Another factor that is of great importance to the cash management is the availability of funds from outside sources. There resources aid in providing credit facility to the firm, which materialized the firms objectives of holding minimum cash balance. As such if a firm succeeds in acquiring sufficient funds from external sources like banks or private financiers, shareholders, government agencies etc., the need for maintaining cash reserves diminishes.

4. Maximizing Cash Receipts: Every financial manager has aims at making the best possible use of cash receipts. Again, cash receipts if tackled prudently results in minimizing cash requirements of a concern. For this purpose, the comparative cost of granting cash discount to customer and the policy of charging interest expense for borrowing must be evaluated on continuous basis to determine the futility of either of the alternative or both of them during that particular period for maximizing cash receipts. Yet, the under mentioned techniques proved helpful in this context:

a) Concentration Banking: Under this system, a company establishes banking centers for collection of cash in different areas. Thereby, the company instructs its customers of adjoining areas to send their payments to those centers. The collection amount is then deposited with the local bank by these centers as early as possible. Whereby, the collected funds are transferred to the companys central bank accounts operated by the head office.

b) Local Box System: Under this system, a company rents out the local post offices boxes of different cities and the customers are asked to\forward their remittances to it. These remittances are picked by the authorized lock bank from these boxes to be transferred to the companys central bank operated by the head office.

c) Reviewing Credit Procedures: It aids in determining the impact of slow payers and debtors on cash. The accounts of slow paying customers should be reviewed to determine the volume of cash tied up. Besides this, evaluation of credit policy must also be conducted for introducing essential amendments. As a matter of fact, too strict a credit policy involves rejections of sales. Thus, curtailing the cash inflow. On the other hand, too lenient, a credit policy would increase the number of slow payments and bad debts again decreasing the cash inflows.

d) Minimizing Credit Period: Shortening the terms allowed to the customers would definitely accelerate the cash inflow side-by-side revising the discount offered would prevent the customers from using the credit for financing their own operations profitably.

e) Others: Introducing various procedures for special handling of large to very large remittances or foreign remittances such as, persona! pick up of large sum of cash using airmail, special delivery and similar techniques to accelerate such collections.

5. Minimizing Cash Disbursements: The motive of minimizing cash payments is the ultimate benefit derived from maximizing cash receipts. Cash disbursement can be brought under control by preventing fraudulent practices, serving time draft to creditors of large sum, making staggered payments to creditors and for payrolls etc.

6. Maximizing Cash Utilization: Although a surplus of cash is a luxury, yet money is costly. Moreover, proper and optimum utilization of cash always makes way for achievement of the motive of maximizing cash receipts and minimizing cash payments. At times, a concern finds itself with funds in excess of its requirement, which lay idle without bringing any return to it. At the same time, the concern finds it unwise to dispose it, as the concern shall soon need it. In such conditions, efforts should be made in investing these funds in some interest bearing securities.

4.3.10. Cash Management Models

Cash management models analyse methods which provide certain framework as to how the cash management is conducted in the firm. Cash management models are the development of the theoretical concepts into analytical approaches with the mathematical applications. There are three cash management models which are very popular in the field of finance.

1. Baumol modelThe basic objective of the Baumol model is to determine the minimum cost amount of cash conversion and the lost opportunity cost.

It is a model that provides for cost efficient transactional balances and assumes that the demand for cash can be predicated with certainty and determines the optimal conversion size.

Total conversion cost per period can be calculated with the help of the following formula:

where,

T = Total transaction cash needs for the period

b = Cost per conversion

C = Value of marketable securities

Opportunity cost can be calculated with the help of the following formula;

I=C/2

where,

i = interest rate earned

C/2 = Average cash balance

Optimal cash conversion can be calculated with the help of the following formula;

where,

C = Optimal conversion amount

b = Cost of conversion into cash per lot or transaction

T = Projected cash requirement

i = interest rate earned

2. Miller-Orr model

This model was suggested by Miller Orr. This model is to determine the optimum cash balance level which minimizes the cost of management of cash. Miller-Orr Model can be calculated with the help of the following formula;

where,

C = Total cost of cash management b = fixed cost per conversion

E(M) = expected average daily cash balance E (N) = expected number of conversion

t = Number of days in the period

i = lost opportunity cost

3. Orglers modelOrglers model provides for integration of cash management with production and other aspects of the business concern. Multiple linear programming is used to determine the optimal cash management.

Orglers model is formulated, based on the set of objectives of the firm and specifying the set of constrains of the firm.

Illustration on Cash Management

1. XYZ Company wishes to arrange overdraft facilities with its bankers during the period April to June of a particular year, when it will be manufacturing mostly for stock. Prepare a cash budget for the above period from the following data, indicating the extent of the bank facilities the company will require at the end of the each month.Month Sales (RS)Production (RS)Wages (RS)

February 1,80,0001,24,00012,000

March1,92,0001,44,00014,000

April1,08,0002,43,00011,000

May1,74,0002,46,00010,000

June 1,26,0002,68,00015,000

50% of the credit sales realized in the month following the sales realized in the month following; creditors are paid in the following month of purchase.

Cash at Bank on 1st April (estimated) is Rs. 25,000.

Solution: Cash budget for the period 01.04---- to 30.06-------

Particulars April May June

Opening balance25,00056,000,(47,000)

Receipts:

Collection from debtors1,86,0001,50,0001,41,000

Total receipts 2,22,0002,06,00094,000

Payments:

Creditors (purchases)1,44,0002,43,0002,46,000

Wages 11,00010,00015,000

Total payment(B)1,55,0002,53,0002,61,000

Closing balance(A-B)56,000(47,000)1,67,000

Workings:

1. Calculation of collection from Debtors:

Collection Total

Month Previous months credit salesPrior to previous months credit salesTotal

April50%*1,92,000=96,00050%*1,80,000=90,0001,86,000

May50%*1,08,000=54,00050%*1,92,000=96,0001,50,000

June 50%*1,74,000=87,00050%*1,08,000=54,0001,41,000

2. M/S Smart tech Limited has instructed you to prepare cash budget for October to

December from the following particulars:

1. Cash and Bank balance as on 1st October-Rs.20, 000.

2. Actual and budgeted sales; purchases, wages and other expenses:-Months Sales Purchases Wages Expenses (RS)

June60,000(actual)36,000(actual)--

July65,000(actual)40,000(actual)--

August70,000(actual)48,000(actual)15,000(actual)5,000(actual)

September75,000(actual)45,000(actual)15,000(actual)6,000(actual)

October80,000 budgeted48,000 budgeted18,000 budgeted6,000 budgeted

November82,000 budgeted40,000 budgeted18,000 budgeted8,000 budgeted

December 89,000 budgeted50,000 budgeted20,000 budgeted8,000 budgeted

3. Special points

i. Advance income tax Rs. 5000 on November.

ii. Plant Rs.8, 000 in October.

4. Rs.3000 Rent payable in advance.

5. 10% of purchases and sales are on cash terms.

Trade creditors are paid in the following month after purchases while collections from debtors are made two months after from, the date of sales.

Solution:

Cash budget for the period 01.10-----to 31.12-------

Particulars October November December

Opening balance20,00013,40010,600

Receipts:

Cash sales8,0008,2008,900

Collection from debtors63,00067,50072,000

Total receipts(A)91,00089,10091,500

Payments:

Cash purchases4,8004,0005,000

Creditors(purchases)40,50043,20036,000

Wages 18,00018,00020,000

Expenses6,0008,0008,000

Rent payble in advances300300300

Advance income tax-5,000-

Plant8,000--

Total payment(B)77,6007850069,300

Closing balance(A-B)13,40010,60022,200

Workings:

1. Calculation of cash and credit sales

Particulars July Aug Sep Oct Nov Dec

Total sales 65,00070,00075,00080,00082,00089,000

Less cash sales(of month sales)65,0007,0007,5008,0008,2008,900

Credit sales58,50063,00067,50072,50073,8008,000

1. Calculation of collection from debtors:

Month Collection made two months after from the plate salesTotal

OctSales of the month aug(working 1)36,000

NovSales of the month aug(working 1)67,500

Dec Sales of the month aug(working 1)72,000

4.4. Inventory Management:

Inventory or stock refers to the goods and materials include that a business holds for the ultimate purpose of resale.

Inventory can be defined in many ways with respect to different perspectives. Following selected statements will help you to get a broad understanding of its concept.

In general, the simple definition of inventory can be stated as follows.

Inventory means the stock of goods available or held for sale in the ordinary course of business.

In a business sense, the inventory can be defined as under.

Inventory includes raw-materials stored in a warehouse, work-in-progress in production, and finished goods available for sale.

Inventory is that stock of goods, which have a demand and supply in the market and can be easily realized in cash.

4.4.1. Meaning and Definition of Inventory:

An inventory is a stock of goods maintained for the purpose of future production or sales. In broad sense, the term inventory refers to all materials, parts, supplies, tools, in-process or finished products recorded in the books by an organisation and kept in its stocks, warehouse or plant for some period of time. It is a list or schedule of materials held on behalf of an enterprise. The quantity and value of every item is also mentioned in such list.

According to R.L. Ackoff and M.W. Sasieni, Inventory consists of usable but idle resources. The resources may be of any type; for example, men, materials, machines or money. When the resources involved are materials or goods in any stage of completion, inventory is referred to as stock.

In a nutshell, the term inventory may be defined as the stock of goods, commodities or other economic resources that are stored or reserved at any given period for future production or for meeting future demand.

4.4.2. Types/Classification of Inventory:

The term inventory may be classified into two types namely: 1. Direct Inventories:

Direct inventories are those inventories that play a major role in the production and constitute a vital part of finished goods. These inventories can be easily assigned to specific physical units. Direct inventories may be categorised into four groups.

(i) Raw materials:Raw materials are the physical resources to be used in the manufacture of finished products. They include materials that are in their natural or raw form. For example, cotton in the case of textile mill, sugarcane in the case of sugar factory, oil seeds in the case of an oil mill etc. The chief objective of keeping raw material is to ensure uninterrupted production in the event of delays in delivery and also to enjoy the economies of large scale buying.

(ii) Semi-finished Goods:Semi-finished goods are those materials which are not cent per cent (100%) complete in all respects i.e., some processing still remains to be done before the product can be sold. For example, a person who is engaged in the manufacture of furniture, may purchase unpolished furniture from market and sell it after polishing the same.

(iii) Finished Goods:Finished goods are complete products that are ready for sale or distribution. For instance, in case of a hosiery factory, sweaters, shawls etc. are finished products.

(iv) Spare Parts:

Spare parts means duplicate parts of a machine. Usually, almost all the industrial concerns maintain spare parts of various machines which they use for manufacture. This will enable them to ensure smooth running of machines which in turn provide for uninterrupted production.

2. Indirect Inventories:

Indirect inventories include those items which are necessary for manufacturing but do not become component of the finished goods. They normally include petrol, maintenance materials, office materials, grease, oil lubricants etc. These inventories are used for ancillary purposes to the business and cannot be assigned to specific, physical units. These inventories may be used in the factory, the office or the selling and distribution divisions.

Inventory management:

4.4.3. Meaning of Inventory management

Inventory management is a very important function that determines the health of the supply chain as well as the impacts the financial health of the balance sheet. Every organization constantly strives to maintain optimum inventory to be able to meet its requirements and avoid over or under inventory that can impact the financial figures.

Inventory is always dynamic. Inventory management requires constant and careful evaluation of external and internal factors and control through planning and review. Most of the organizations have a separate department or job function called inventory planners who continuously monitor, control and review inventory and interface with production, procurement and finance departments.

Inventory management is the supervision of non-capitalized assets (inventory) and stock items.

4.4.4. Motives of Inventory Management

Managing inventories involves lack of funds and inventory holding costs. Maintenance of inventories is expensive, then why should firms hold inventories. There are three general motives:

i. The transaction motive:

The company may be required to hold the inventories in order to facilitate the smooth and uninterrupted product