Prof.

John Pradeep Kumar

Kristu Jayanti College
Bengaluru
 Meaning and importance of cash
management
 Motives for holding cash
 Cash budget
 Cost associated with inventories
 Inventory Management techniques
 Stock levels
 Cost associated with maintaining receivables
 Credit policy variables

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 Cash management is one of the key areas of
working capital management as cash is both the
beginning and the end of working capital cycle
[cash – inventory – receivables – cash]
 Shortage of cash will disrupt the firm’s
manufacturing process while excess cash will
remain idle without any contribution towards
profit.
 Effective management of cash involves an
effort to minimise idle cash without impairing
liquidity of the firm.
 It implies a proper balancing between the two
conflicting objectives of the liquidity and
profitability.

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 The cash requirement of working capital is
calculated by estimating the cash cost of various
current assets required by the firm and
deducting the spontaneous current liabilities
from the cash cost of current assets.

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 Narrow sense : it is used broadly to cover
currency and generally accepted equivalents
of cash, such as cheques, demand drafts
(DD), and demand deposits (savings
accounts) in banks.
 Broad sense: cash also includes near-cash
assets, such as marketable securities (money
market instruments) and time deposits
(bank certificate of deposit) in banks.

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 There are four primary motives for
maintaining cash balances:
1. Transaction motive
2. Precautionary motive
3. Speculative motive
4. Compensating motive

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 Transaction motive is a motive for holding
cash/near cash to meet routine cash
requirements to finance the transactions in
the normal course of business.
 Example: cash payments have to be made for
purchases, wages, operating expenses,
financial chargers like interest, taxes,
dividends, and so on.
 Such motive refers to the holding of cash to
meet anticipated obligations whose timing is
not perfectly synchronised with cash
receipts.

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 Precautionary motive is a motive for holding
cash/near-cash as a cushion to meet unexpected
contingencies/demand for cash.
 The unexpected cash needs at short notice may be the
result of:
a) Floods, strikes and failure of important customers;
b) Bills may be presented for settlement earlier than
expected;
c) Unexpected slow down in collection of accounts
receivable;
d) Cancellation of some order for goods as the
customer is not satisfied; and
e) Sharp increase in cost of raw materials.
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 Speculative motive is a motive for holding
cash/near-cash to quickly take advantage of
opportunities typically outside the normal course
of business. (Exploit profitable opportunities)
 This motive helps to take advantage of:
i. An opportunity to purchase raw materials at a
reduced price on payment of immediate cash;
ii. A chance to speculate on interest rate
movements by buying securities when interest
rates are expected to decline;
iii. Delay purchases of raw materials on the
anticipation of decline in prices; and
iv. Make purchase at favourable prices.
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 Compensating motive is a motive for holding
cash/near-cash to compensate banks for
providing certain services or loans.
 Banks provides a variety of services to business
firms, such as clearance of cheque, supply of
credit information, transfer of funds, and so on,
for a commission or fee, for others they seek
indirect compensation.
 Usually clients are required to maintain a
minimum balance of cash at the bank.

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 Since this balance cannot be utilised by the
firms for transaction purposes, the banks
themselves can use the amount to earn a return.
 Such balances are ‘compensating balances’.
 Compensating balances are also required by
some loan agreements between a bank and its
customers.
 This is presumably to ‘compensate’ the bank for
a rise in the interest rate during the period when
the loan will be pending.

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 The compensating cash balances can take
either of two forms:
(i) an absolute minimum, say Rs. 5 lakh, below
which the actual bank balance will never
fall;
(ii) a minimum average balance, say, Rs. 5 lakh
over the month.
o The first alternative is more restrictive (firms
viewpoint – dead money).

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 The two most important motives are the
transactions motive and the compensation
motive.
 Business firms normally do not speculate and
need not have speculative balances.
 The requirement of precautionary balances
can be met out of short-term borrowings.

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 Cash budget is a statement of the inflows
and outflows of cash that is used to estimate
its short-term requirements.
 The principal method of cash budgeting is
the receipts and disbursements method.
 Under this method, the cash forecast
shows the timing and magnitude of cash
receipts and disbursements over the
forecast period.
Note: Preparation of cash budget (already
covered in Accounting for Managers–II)

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 The term inventory refers to the stockpile of
the products a firm is offering for sale and the
components that make up the product.
 The assets which firms store as inventory in
anticipation of need are:
i. Raw materials;
ii. Work-in-process (semi-finished goods) and
iii. Finished goods.

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1. ORDERING OR ACQUISITION COSTS
 It is the fixed cost of placing and receiving an
inventory order
 Ordering costs are costs involved in:
a) Preparing a purchase order or requisition form.
b) Receiving, inspecting, and recording the goods
received to ensure both quantity and quality.
 The acquisition costs are inversely related to
the size of inventory: they decline with the
level of inventory.
 Ordering Cost can be minimised by placing
fewer orders for a larger amount.

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2. CARRYING COSTS
 Carrying costs are the variable costs per unit
of holding an item in inventory for a specified
time period.
 The cost of holding inventory may be divided
into two categories:
a) Those that arise due to the storing of
inventory (insurance, utilities, pilferage,
service costs, such as labour for handling
inventory, clerical and accounting costs).
b) The opportunity cost of funds (if funds were
not locked up in inventory, they would have
earned a return).
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 The carrying costs and the inventory size are
positively related and move in the same
direction.
 Total cost is the sum of the ordering costs
and carrying costs of inventory.
Total Cost = OC + CC

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I. ABC analysis
II. Economic order quantity (EOQ)
III. Order point problem
IV. Two-bin technique
V. VED classification
VI. HML classification
VII. SDE
VIII. FSN
IX. Order cycling system
X. Just in time (JIT)
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 Inventory control tool that categories
inventory into three groups –A, B, and C, in
descending order of importance of control.
 Categorisation of inventory
 Category No. of Items (%) Item value (%)
A 15 70
B 30 20
C 55 10
TOTAL 100 100

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A firm has 7 different items in its inventory.
The average number of each of these items
held, along with their units costs, is listed
below. The firm wishes to introduce an ABC
inventory system. Suggest a breakdown of
the items into A, B, and C classifications.
Item numbers Average number of Average cost per
units in inventory unit (Rs.)
1 20,000 60.80
2 10,000 102.40
3 32,000 11.00
4 28,000 10.28
5 60,000 3.40
6 30,000 3.00
7 20,000 1.3

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 Per Cent of Per Cent of
Item Units Unit Cost Total Cost
Total Total

1 20,000 10 60.8 1216000 38.00

15 70
2 10,000 5 102.4 1024000 32.00

3 32,000 16 11 352000 11.00

30 20
4 28,000 14 10.28 287840 9.00

5 60,000 30 3.4 204000 6.38

6 30,000 15 55 3 90000 2.81 10

7 20,000 10 1.3 26000 0.81

Total 2,00,000 100 3199840 100.00

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 EOQ is the inventory management technique
for determining optimum order quantity
which is the one that minimises the total of
its order and carrying costs.
 EOQ = √2AB/C
 A = annual usage of inventory (units)
 B = buying cost per order
 C= carrying cost per unit
 C = C * i (i = carrying cost (%) c = cost per
unit)

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A firm’s inventory planning period is one
year. Its inventory requirement for this
period is 1,600 units. Assume that its
acquisition costs are Rs. 50 per order. The
carrying costs are expected to be Re.1 per
unit per year for an item. Find out the EOQ.
 Solution: EOQ = √2AB/C
= √2*1,600*50/1
= 400 units

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 EOQ provides answer to the question: how
much inventory should be ordered in one lot?
 Another important question pertaining to
efficient inventory management is: when
should the order to procure inventory be
placed?
 This aspect of inventory management is
covered under the reorder point problem.
 “Reorder point is the level of inventory
when fresh order should be placed with the
suppliers for procuring additional inventory
equal to the economic order quantity”.

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 According to this technique, stock of each item is
separated into two bins or groups.
 First bin contains stock, just enough to last from
the date a new order is placed until it is received in
inventory.
 The second bin contains stock, which is enough to
meet current demand over the period of
replenishment.
 First stock is issued when the first bin stock is
completed, then an order for replenishment is
placed, and the stock in the second is utilised until
the ordered material is received.
 Generally, this method is used to control ‘C’
category inventories.

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 According to this classification inventories
are grouped based on the effect on
production.
 Inventories are grouped into three groups-
Vital, Essential and Desirable (not so
essential) inventories.
 It is specially used for classification of spare
parts.
 ‘V’ category item are stocked high and
category ‘D’ items are maintained at
minimum level.
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VI. HML Classification : It classifies materials into
three groups – High (H), Medium (M) and Low (L)
in descending order of unit value.
 This classification is useful for keeping control
over consumption at department levels, for
deciding the frequency of physical verification
and for controlling purchases.

VII. SDE classification: it is based on availability of

inventory. Here ‘S’ refers to ‘scarce’, ‘D’ refers
to ‘difficult’ and ‘E’ refers to ‘easy’.

VIII. FSN classification: it is based on movement of

inventory from stores. FSN stands for fast moving
(F), slow moving (S) and non-moving (N).

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IX. Order cycling system: in this system,
periodic reviews are made of each item of
inventory and orders are placed to restore
stock to a prescribed supply level.

X. Just-in-time (JIT): No inventories are held

at any stage of production and the exact
requirement is bought in each and every
successive stage of production at the right
time.

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 The different levels are:
1. Minimum level
2. Re-order level
3. Maximum level
4. Average stock level
5. Danger level

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1. Minimum level : is that level that must be
maintained always for smooth flow production.
 Minimum stock level = Re-order level –[Normal
usage * Avg. delivery time]

2. Re-order level : the level of inventory at which

an order should be placed. It lies between
minimum stock level and maximum stock level.
 Re-order level = Maximum Usage * Maximum
Delivery Time
 (Re-order point = Lead time (in days) * Avg.
daily usage)
 Lead time is the number of days required to
receive the inventory from the date of placing
order.
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 Reorder point deals with the specific time in
which you should place an order with your
supplier.
 Reorder level is the specific quantity that
you should have on hand when your order is
placed.

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 Safety stock: prediction of average daily
usage and lead-time is difficult.
 Re-order level = {Lead time (in days) * Avg.
daily usage} + Safety stock

3. Maximum level: is that level of stock

beyond which a firm should not maintain
the stock.
 Maximum stock level = Re-order level + Re-
order Quantity – (Minimum Usage *
Minimum Delivery Time)

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4. Average stock level = Minimum level +
[Reorder Quantity ÷ 2]

5. Danger stock level: is that level of

material beyond which materials should not
fall in any situation.

 Danger level = Average Usage * Minimum

Delivery Time [for emergency purchase]

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Q. 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 units per week
 Re-order quantity – 600 units
 Solution :

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 The term receivables is defined as “debt owed
to the firm by customers arising from sale of
goods or services in the ordinary course of
business”.
 The objective of receivables management is ‘to
promote sales and profits until that point is
reached where the return on investment in
further funding receivables is less than the cost
of funds raised to finance that additional credit
(i.e. cost of capital)’.
 Until Return on funding receivables < Ko

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 Collection cost: is the administrative cost
incurred in collecting receivables.
 Capital cost: is the cost on the use of additional
capital to support credit sales which
alternatively could have been employed
elsewhere.
 Delinquency cost: is the cost arising out of
failure of customers to pay on due date.
(reminders, other collection efforts, legal
charges, etc.)
 Default cost: are the over dues that cannot be
recovered. (treated as bad debts, which cannot
be realised)

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 The credit policy of a firm provides
framework to determine (a) whether or not
to extend credit to customer and (b) how
much credit to extend?
 Credit policy is the determination of credit
standards and credit analysis.

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 Credit standards refers to the minimum criteria
adopted by a firm for the purpose of short listing
its customers for extension of credit during a
period of time.
 Credit rating, credit reference, average
payments periods a quantitative basis for
establishing and enforcing credit standards.
 The nature of credit standard followed by a firm
can be directly linked to changes in sales and
receivables.
 Liberal credit standard or strict credit standards

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 The credit standards covers
i) the collection cost,
ii) the average collection period/cost of
investment in account receivables,
iii) level of bad debt losses, and
iv) level of sales.

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 Credit analysis involves obtaining credit
information and evaluation of credit
applicants.
 Two basic steps are involved in the credit
investigation process:
a) Obtaining credit information
b) Analysis of credit information

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 Internal :
 usually firms require their customers to fill
various forms and documents giving details
about financial operations.
 The firm need to furnish trade references
with whom the firms can have contacts to
judge the suitability of the customer for
credit.

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 External :
 In India, the external sources of credit
information are not as developed as in the
industrially advanced countries of the world.
 Depending upon the availability, the
following external sources may be employed
to collect information.
1. Published financial statements
2. Bank references
3. Trade references
4. Credit bureau reports

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1. Experian Credit Information Company of
India Private Ltd.
2. TransUnion CIBIL or simply known as CIBIL
was formerly known as Credit Information
Bureau (India) Limited.
3. Highmark Credit Information Services
4. Equifax

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1. Quantitative:
 Prepare an Aging Schedule of the accounts
payable of the applicant as well as
calculate the average age of the accounts
payable.
 Ratio analysis of the liquidity, profitability
and debt capacity of the applicant.
 These ratios should be compared with the
industry average.

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2. Qualitative:
 The subjective judgment would cover
aspects relating to the quality of
management.
 The references from other suppliers, bank
references and specialist bureau reports
would form the basis for the conclusions to
be drawn.

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