FYBBA

Semester II
Fundamentals of Financial Management
Dr. Swati Modi
Prof Minouti Jani

UNIT I

Introduction

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.

Financial management is management of finances of an organisation in order to achieve its

objectives.

Financial management involves acquisition and management of financial resources for

organization to maximise the value of stockholder’s claims.

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting).

Investment in current assets are also a part of investment decisions called as working
capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources
which will depend upon decision on type of source, period of financing, cost of
financing and the returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net
profit distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will
depend upon expansion and diversification plans of the enterprise.

Traditional approach is the initial stage of financial management, which was followed, in the
early part of during the year 1920 to 1950. This approach is based on the past experience and
the traditionally accepted methods. Main part of the traditional approach is rising of funds for
the business concern.

Traditional approach consists of the following important area:-

Arrangement of funds from lending body.

Arrangement of funds through various financial instruments.

Finding out the various sources of funds.

The traditional approach to the scope of financial management refers to its subject matter in
the academic literature in the initial stages of its evolution as a separate branch of study.
According to this approach, the scope of financial management is confined to the raising of
funds. Hence, the scope of finance was treated by the traditional approach in the narrow sense
of procurement of funds by corporate enterprise to meet their financial needs.
Since the main emphasis of finance function at that period was on the procurement of funds,
the subject was called corporation finance till the mid-1950's and covered discussion on the
financial instruments, institutions and practices through which funds are obtained.
Further, as the problem of raising funds is more intensely felt at certain episodic events such
as merger, liquidation, consolidation, re organisation and so on. These are the broad features
of the subject matter of corporation finance, which has no concern with the decisions of
allocating firm's funds.
But the scope of finance function in the traditional approach has now been discarded as it
suffers from serious criticisms. Again, the limitations of this approach fall into the following
categories.

The emphasis in the traditional approach is on the procurement of funds by the corporate
enterprises, which was woven around the viewpoint of the suppliers of funds such as
investors, financial institutions, investment bankers, etc. i.e. outsiders.
It implies that the traditional approach was the outsider-looking-in approach. Another
limitation was that internal financial decision-making was completely ignored in this
approach.

The second criticism levelled against this traditional approach was that the scope of
financial management was confined only to the episodic events such as mergers, acquisitions,
reorganizations, consolation, etc. The scope of finance function in this approach was confined
to a description of these infrequent happenings in the life of an enterprise. Thus, it places over
emphasis on the topics of securities and its markets, without paying any attention on the day
to day financial aspects.
Another serious lacuna in the traditional approach was that the focus was on the long-term
financial problems thus ignoring the importance of the working capital management. Thus,
this approach has failed to consider the routine managerial problems relating to finance of the
firm.

During the initial stages of development, financial management was dominated by the
traditional approach as is evident from the finance books of early days. The tradi-tional
approach was found in the first manifestation by Green's book written in 1897, Meades on
Corporation Finance, in 1910; Doing's on Corporate Promotion and Reorganisation, in 1914,
etc.
As stated earlier, in this traditional approach all these writings emphasized the finan-cial
problems from the outsiders' point of view instead of looking into the problems from
managements, point of view.
It over emphasized long-term financing lacked in analytical content and placed heavy
emphasis on descriptive material. Thus, the traditional approach omits the discussion on the
important aspects like cost of the capital, optimum capital structure, valuation of firm, etc. In
the absence of these crucial aspects in the finance function, the traditional approach implied a
very narrow scope of financial management.
The modern or new approach provides a solution to all these aspects of financial
management.

Modern Approach

After the 1950's, a number of economic and environmental factors, such as the technological
innovations, industrialization, intense competition, interference of government, growth of
population, necessitated efficient and effective utilisation of financial resources. In this
context, the optimum allocation of the firm's resources is the order of the day to the
management. Then the emphasis shifted from episodic financing to the managerial financial
problems, from raising of funds to efficient and effective use of funds. Thus, the broader view
of the modern approach of the finance function is the wise use of funds. Since the financial
decisions have a great impact on all other business activities, the financial manager should be
concerned about deter-mining the size and nature of the technology, setting the direction and
growth of the business, shaping the profitability, amount of risk taking, selecting the asset
mix, determination of optimum capital structure, etc. The new approach is thus an analyti-cal
way of viewing the financial problems of a firm. According to the new approach, the
financial management is concerned with the solution of the major areas relating to the
financial operations of a firm, viz., investment, and financing and dividend decisions. The
modern financial manager has to take financial decisions in the most rational way. These
decisions have to be made in such a way that the funds of the firm are used optimally. These
decisions are referred to as managerial finance functions since they require special care with
extraordinary administrative ability, management skills and decision - making techniques,
etc.
The modern approach of financial Management can be divided into four major decisions as
function of finance:

- The investment decision

- The financial decision
- The dividend policy decision
- The funds requirement decision

INVESTMENTDECISIONS

This is concerned with the allocation of capital. It has to show the funds can be invested in
assets which would yield benefit in future. This is a decision based on risk and uncertainty.
Finance Manager has to evaluate the investment in relation to their expected results and risk
to determine whether the investment is feasible or not.
FINANCIALDECISIONS

This decision is concerned with the mobilization of finance for investment. The Finance
Manager has to take the decisions regarding the acquisition of finance. Whether entire capital
required should be raised in the form of equity capital or the amount should be borrowed
totally or a balance should be struck between equity and borrowed capital has to be decided.
Even the timing of acquisition of capital should also be perfectly made.

DIVIDENDDECISION

The dividend decision involves the determination of the percentage of profit earned by the
enterprise which is paid to the shareholders. The dividend payout ratio must be evaluated in
the light of the objective of maximizing shareholder’s wealth. Thus, the dividend decision has
become a vital aspect of financial decision.

CURRENT ASSETS MANAGEMENT

The Finance Manager should also manage the current assets to have liquidity in the business.
Investment of funds in current assets reduces the profitability of the firm. However the
finance manager should also equally look after the current financial needs of the firm to
maintain optimum production. While investing in current assets, he should see that proper
trade off is maintained between the profitability and liquidity.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.

The objectives can be classified into two broad categories

Profit maximisation

Wealth maximisation

Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional
and narrow approach, which aims at, maximizes the profit of the concern. Profit
maximization consists of the following important features.

1. Profit maximization is also called as cashing per share maximization. It leads to

maximize the business operation for profit maximization.

2. Ultimate aim of the business concern is earning profit, hence, it considers all the
possible ways to increase the profitability of the concern.

3. Profit is the parameter of measuring the efficiency of the business concern.

So it shows the entire position of the business concern.

4. Profit maximization objectives help to reduce the risk of the business.

Favourable Arguments for Profit Maximization

The following important points are in support of the profit maximization objectives of the
business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also.

Unfavourable Arguments for Profit Maximization

The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair
trade practice, etc.
(iii) Profit maximization objectives leads to inequalities among the sake holders such
as customers, suppliers, public shareholders, etc.

Drawbacks of Profit Maximization

Profit maximization objective consists of certain drawback also:
(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates
some unnecessary opinion regarding earning habits of the business concern.
(ii) It ignores the time value of money: Profit maximization does not consider the
time value of money or the net present value of the cash inflow. It leads certain
differences between the actual cash inflow and net present cash flow during a
particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the business
concern. Risks may be internal or external which will affect the overall operation
of the business concern.

Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations
and improvements in the field of the business concern. The term wealth means shareholder
wealth or the wealth of the persons those who are involved in the business concern.
Wealth maximization is also known as value maximization or net present worth
maximization. This objective is an universally accepted concept in the field of business.
Favourable Arguments for Wealth Maximization
(i) Wealth maximization is superior to the profit maximization because the main aim
of the business concern under this concept is to improve the value or wealth of
the shareholders.
(ii) Wealth maximization considers the comparison of the value to cost associated with
the business concern. Total value detected from the total cost incurred for the
business operation. It provides extract value of the business concern.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.

Unfavourable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea of the business concern but it may
not be suitable to present day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect
name of the profit maximization.
(iii) Wealth maximization creates ownership-management controversy.
(iv) Management alone enjoy certain benefits.
(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.
(vi) Wealth maximization can be activated only with the help of the profitable position
of the business concern.

Key points

Wealth maximization objective is a widely recognised criterion with which the performance a
business enterprise is evaluated. The word wealth refers to the net present worth of the firm.
Therefore, wealth maximisation is also stated as net present worth.

Net present worth is difference between gross present worth and the amount of capital
investment required to achieve the benefits.

Gross present worth represents the present value of expected cash benefits discounted at a
rate, which reflects their certainty or uncertainty

Thus, wealth maximisation objective as decisional criterion suggests that any financial action,
which creates wealth or which, has a net present value above zero is desirable one and should
be accepted and that which does not satisfy this test should be rejected.

The wealth maximisation objective when used as decisional criterion serves as a very useful
guideline in taking investment decisions.

This is because the concept of, wealth is very clear. It represents present value of the benefits
minus the cost of the investment. The concept of cash flow is more precise in connotation
than that of accounting profit. Thus, measuring benefit in terms of cash flows generated
avoids ambiguity.

The wealth maximisation objective considers time value of money. It recognises that cash
benefits emerging from a project in different years are not identical in value. This is why
annual cash benefits of a project are discounted at a discount rate to calculate total value of
these cash benefits.

At the same time, it also gives due weight age to risk factor by making necessary adjustments
in the discount rate. Thus, cash benefits of a project with higher risk exposure is discounted at
a higher discount rate (cost of capital), while lower discount rate applied to discount expected
cash benefits of a less risky project. In this way, discount rate used to determine present value
of future streams of cash earning reflects both the time and risk. .

Conclusion:

In view of the above reasons, wealth maximisation objective is considered superior to profit
maximisation objective. It may be noted here that value maximisation objective is simply the
extension of profit maximisation to real life situations. Where the time period is short and
magnitude of uncertainty is not great, value maximisation and profit maximisation amount
almost the same thing

A myopic person or business is mostly concerned about short term benefits. A short term
horizon can fulfill objective of earning profit but may not help in creating wealth. It is
because wealth creation needs a longer term horizon Therefore, financial
management emphasizes on wealth maximization rather than profit maximization

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs
and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has
many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period
of financing.

4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
 6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current
liabilities, maintainance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through
many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

FINANCE FUNCTION IN THE ORGANISATION-

Finance function is one important part of business organization, which involves the
permanent, and continuous process of the business concern. Finance is one of the interrelated
functions which deal with personal function, marketing function, production function and
research and development activities of the business concern. At present, every business
concern concentrates more on the field of finance because, it is a very emerging part on
which profitability of business depends. Deciding the proper financial function is the
essential and ultimate goal of the business organization. As a wrong financial decision may
create disaster for any good business.

Following are important finance functions-

1. Forecasting Financial Requirements

It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to
acquire fixed assets and forecast the amount needed to meet the working capital requirements
in future.

2. Procurement of finance

After deciding the financial requirement, the next step is to concentrate how the finance is to
be procured and where it will be available. It is also highly critical in nature. In this decision
various financing options are analysed. which includes equity shares, debentures, preference
shares and loan financing etc.

3. Investment Decision
The next step is to select best investment alternatives and consider the reasonable and stable
return from the investment. For such decisions capital budgeting techniques are used to
determine the effective utilization of investment. The finance manager must concentrate to
principles of safety, liquidity and profitability while investing capital.

4. Cash Management or working capital decisions

Present days liquidity plays a major role in the area of finance because proper cash
management and receivable management is not only essential for effective utilization of cash
but it also helps to meet the short-term liquidity position of the concern.

Interrelation with Other Departments

Finance manager deals with various functional departments such as marketing, production,
personel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization.

From above functions it is evident that finance function has obtained the status of a science
and an art. As finance function has far reaching significance in overall management process,
structural organization for further function becomes an outcome of an important organization
problem. The ultimate responsibility of carrying out the finance function lies with the top
management. However, organization of finance function differs from company to company
depending on various factors like size of organization, location etc.. In many organizations
one can note different layers among the finance executives such as Assistant Manager
(Finance), Deputy Manager (Finance) and General Manager (Finance). The designations
given to the executives are different. They are
 Financial Planning
Manager
Treasurer
Cash / Credit/
Capital Expense
manager
Vice
CFO
President
Tax/ Cost
Accounting Manager

Controller Corporate/ Financial

Accounting Manager

Chief Finance Officer (CFO)

Vice-President (Finance)
Financial Controller
General Manager (Finance)
Finance Officers

Finance, being an important portfolio, the finance functions is entrusted to top management.
The Board of Directors, who are at the helm of affairs, normally constitutes a ‘Finance
Committee’ to review and formulate financial policies. Two more officers, namely
‘treasurer’ and ‘controller’ – may be appointed under the direct supervision of CFO to assist
him/her. In larger companies with modern management, there may be Vice-President or
Director of finance, usually with both controller and treasurer.

Meaning of Controller and Treasurer

The terms ‘controller’ and ‘treasurer’ are in more used in USA. And not so popular in Indian
corporate sector. Practically, the controller / financial controller in India carry out the
functions of a Chief Accountant or Finance Officer of an organization.

Financial controller who has been a person of executive rank does not control the finance,
but monitors whether funds so obtained are properly utilized. So his role is to monitor proper
utilization of funds.
Thus, Functions of controller are mainly related to accounting and control, they are as
follows.

-financial accounting

-internal audit

-taxation

-management accounting and control

- budgeting ,planning and control

- economic appraisal etc

While function of the treasurer of an organization is to raise funds and manage funds. The
treasures functions include forecasting the financial requirements, administering the flow of
cash, managing credit, flotation of securities, maintaining relations with financial institutions
and protecting funds and securities.
The controller’s functions include providing information to formulate accounting and costing
policies, preparation of financial reports, direction of internal auditing, budgeting, inventory
control payment of taxes, etc. According to Prof. I.M. Pandey, while the controller’s
functions concentrate the asset side of the balance sheet, the treasurer’s functions relate to the
liability side. It can be said that treasurer forecast financial requirements and procures funds
for the same while controller monitors its better utilization that means investment decisions.
Executive and Finance functions

These executive functions of financial management (FM) are explained below.

1. Estimating capital requirements : The company must estimate its capital

requirements (needs) very carefully. This must be done at the promotion stage. The
company must estimate its fixed capital needs and working capital need. If not, the
company will become over-capitalized or under-capitalized.

2. Determining capital structure : Capital structure is the ratio between owned capital
and borrowed capital. There must be a balance between owned capital and borrowed
capital. If the company has too much owned capital, then the shareholders will get
fewer dividends. Whereas, if the company has too much of borrowed capital, it has to
pay a lot of interest. It also has to repay the borrowed capital after some time. So the
finance managers must prepare a balanced capital structure.

3. Estimating cash flow : Cash flow refers to the cash which comes in and the cash
which goes out of the business. The cash comes in mostly from sales. The cash goes
out for business expenses. So, the finance manager must estimate the future sales of
the business. This is called Salesforecasting. He also has to estimate the future
business expenses.

4. Investment Decisions : The business gets cash, mainly from sales. It also gets cash
from other sources. It gets long-term cash from equity shares, debentures, term loans
from financial institutions, etc. It gets short-term loans from banks, fixed deposits,
dealer deposits, etc. The finance manager must invest the cash properly. Long-term
cash must be used for purchasing fixed assets. Short-term cash must be used as a
working capital.
 5. Allocation of surplus : Surplus means profits earned by the company. When the
company has a surplus, it has three options, viz.,

1. It can pay dividend to shareholders.

2. It can save the surplus. That is, it can have retained earnings.

3. It can give bonus to the employees.

6. Deciding additional finance : Sometimes, a company needs additional finance for

modernization, expansion, diversification, etc. The finance manager has to decide on
following questions.

1. When the additional finance will be needed?

2. For how long will this finance be needed?

3. From which sources to collect this finance?

4. How to repay this finance?

Additional finance can be collected from shares, debentures, loans from financial institutions,
fixed deposits from public, etc.

7. Negotiating for additional finance : The finance manager has to negotiate for
additional finance. That is, he has to speak to many bank managers. He has to
persuade and convince them to give loans to his company. There are two types of
loans, viz., short-term loans and long-term loans. It is easy to get short-term loans
from banks. However, it is very difficult to get long-term loans.

8. Checking the financial performance : The finance manager has to check the
financial performance of the company. This is a very important finance function. It
must be done regularly. This will improve the financial performance of the company.
Investors will invest their money in the company only if the financial performance is
good. The finance manager must compare the financial performance of the company
with the established standards. He must find ways for improving the financial
performance of the company.

The routine functions are also called as Incidental Functions.

Routine functions are clerical functions. They help to perform the Executive functions of
financial management.

The six routine functions of financial management are listed below.

Finance and other functions

As an integral part of the overall management, financial management is not a totally independent
area. It draws heavily on related disciplines and areas of study namely economics, accounting,
production, marketing and quantitative methods. Even though these disciplines are inter
-related, there are key differences among them. Some of the relationships are being discussed below:

Financial Management and Accounting:

The relationship between financial management and accounting are closely related to the extent that
accounting is an important input in financial decision making. In other words, accounting is a
necessary input into the financial management function.

Financial accounting generates information relating to operations of the organisation. The outcome of
accounting is the financial statements such as balance sheet, income statement, and the statement of
changes in financial position. The information contained in these statements and reports helps the
financial managers in gauging the past performance and future directions of the organisation. Though
financial management and accounting are closely related, still they differ in the treatment of funds and
also with regards to decision making. Some of the differences are:-

Treatment of Funds

In accounting, the measurement of funds is based on the accrual principle i.e. revenue is recognised
at the point of sale and not when collected and expenses are recognised when they are incurred
rather than when actually paid. The accrual based accounting data do not reflect fully the financial
conditions of the organisation. An organisation which has earned profit (sales less expenses) may
said to be profitable in the accounting sense but it may not be able to meet its current obligations due
to shortage of liquidity as a result of say, uncollectible receivables.
Such an organisation will not survive regardless of its levels of profits. Whereas, the treatment of
funds, in financial management is based on cash flows. The revenues are recognised only when cash
is actually received (i.e. cash inflow) and expenses are recognised on actual
payment (i.e. cash outflow). This is so because the finance manager is concerned with maintaining
solvency of the organisation by providing the cash flows necessary to satisfy its obligations and
acquiring and financing the assets needed to achieve the goals of the organisation. Thus, cash flow
based returns help financial managers to avoid insolvency and achieve desired financial goals.

Decision – making

The purpose of accounting is to collect and present financial data on the past, present and future
operations of the organization. The financial manager uses these data for financial decision making. It
is not that the financial managers cannot collect data or accountants cannot make
decisions. But the chief focus of an accountant is to collect data and present the data while the
financial manager’s primary responsibility relates to financial planning, controlling and decision
making. Thus, in a way it can be stated that financial management begins where accounting
ends.

Financial Management and Other Related Disciplines:

For its day to day decision making process, financial management also draws on other related
disciplines such as marketing, production and
quantitative methods apart from accounting. For instance, financial managers should consider the
impact of new product development and promotion plans made in marketing area since their plans will
require capital outlays and have an impact on the
projected cash flows. Likewise, changes in the production process may require capital
expenditures which the financial managers must evaluate and finance. Finally, the tools and
techniques of analysis developed in the quantitative methods discipline are helpful in
analyzing complex financial management problems.

The above figure depicts the relationship between financial management and supportive disciplines.
The marketing, production and quantitative methods are, thus, only indirectly related to day to day
decision making by financial managers and are supportive in nature while accounting is the primary
discipline on which the financial manager draws considerably. Even economics can also be
considered as one of the major disciplines which help the financial manager to gain knowledge of
what goes on in the world outside the business.

CAPITALISATION

The term capitalisation, or the valuation of the capital, includes the capital stock and debt. According
to another view it is a word ordinarily used to refer to the sum of the outstanding stocks and funded
obligations which may represent wholly fictitious values.

The ordinary meaning of capitalisation in the computation appraisal or estimation of present value.
This ‘valuation’ concept underlies the definitions of capitalisation and the emphasis is placed upon the
amount of capital. But the term capitalisation has on thrown its previous concept.
Originally, it was used in the sense of ‘valuation’ and ‘amount’ but qualitative connotation now usually
accompanies the quantitative expression. The term capitalisation is now taken as being synonymous
with capital structure or financial plan.

The study of capitalisation involves an analysis of three aspects:

i) amount of capital

ii) composition or form of capital

iii) changes in capitalisation.

Capitalisation may be of 3 types. They are over capitalisation, under capitalisation and fair
capitalisation. Among these three over capitalisation is likely to be of frequent occurrence and
practical interest.

Over Capitalisation:

Many have confused the term ‘over-capitalisation’ with abundance of capital and ‘under-capitalisation’
with shortage of capital. It becomes necessary to discuss these terms in detail. An enterprise
becomes over-capitalised when its earning capacity does not justify the amount of capitalisation.

Over-capitalisation has nothing to do with redundance of capital in an enterprise. On the other hand,
there is a greater possibility that the over-capitalised concern will be short of capital. The abstract
reasoning can be explained by applying certain objective tests. These tests require the comparison
between the different values of the equity shares in a corporation. When we speak in terms of over-
capitalisation we always have the interest of equity holders in mind.

There are various standards of valuing corporation or its equity shares:

Par value:

It is not the face value of a share at which it is normally issued, i.e., at premium nor at discount, it is
static and not affected by business oscillations. Thus it fails to reflect the various business changes.

Market Value:

It is determined by factors of demand and supply in a stock market. It is dependent on a number of

considerations, affecting demand as well as supply side.

Book Value:

It is calculated by dividing the aggregate of the proprietary items – like share capital, surplus and
proprietary reserves – by the number of outstanding shares.

Real Value:

It is found out by dividing the capitalised value of earnings by the number of outstanding shares.
Before the earnings are capitalised, they should be calculated on an average basis. It may be pointed
out at this place that longer the period cover by the study, the more representative the average will be
the period should normally cover all the phase of business cycle, i.e., good, bad, and indifferent years.
Some authors compare the par value of the share with the market value and if par value is greater
than the market value they regard it as a sign of over-capitalisation.

Par value > Market value

The comparison of book and real values of shares is a better test in the sense that the book value
gives an idea about the company’s past career i.e., how it had fared during the last few years, and its
strength is determined by its reserves and surplus.

Real value is a study of the working of company in the light of the earning capacity in the particular
line of business. It takes into account not only the previous earnings or earning capacity of a concern
but relates the earnings to the general earning capacity of other units of the same nature. It is a
scientific and logical test.

Book Value = Real Value (Fair capitalisation)

Book Value > Real Value (Over-capitalisation)

Book Value < Real Value (Under capitalisation)

Causes of over-capitalization:

The following are the cases for over-capitalisation:

i) Promotion with inflated asset:

The promotion of a company may entail the conversion of a partnership firm or a private company into
a public limited company and the transfer of assets may be at inflated prices which do not bear any
relation to the earning capacity of the concern. Under these circumstances, the book value of the
corporation will be more than its real value.

ii) The incurring of high establishment or promotion expenses (ex: good will, patent rights) is a potent
cause of over-capitalisation. If the earnings later on do not justify the amount of capital employed, the
company will be over-capitalised.

iii) Inflationary conditions:

Boom is a significant factor for making the business enterprises over-capitalised. The newly started
concern during the boom period is likely to be capitalised at a high figure because of the rise in
general price level and payment of high prices for the property assembled. These newly floated
concerns as well as the reorganised and expanded ones find themselves over-capitalised after the
boom conditions subside.

iv) Shortage of capital:

The shortage of capital is also a contributory factor of over-capitalisation, the inadequacy of capital
may be due to faulty drafting of the financial plan. Thus a major part of the earnings will not be
available for the shareholders which will bring down the real value of the shares.

v) Defective depreciation policy:

It is not uncommon to find that many concerns are over-capitalised due to insufficient provision for
depreciation/replacement or obsolescence of assets. The efficiency of the company is adversely
affected and it is reflected in its reduced profit yielding capacity.

vi) Liberal Dividend Policy:

If corporations follow liberal dividend policy by neglecting essential provisions, they discover
themselves to be overcapitalized after a few years when book value of their shares will be higher than
the real value?
vii) Taxation Policy:

Over-capitalisation of an enterprise may also be caused due to excessive taxation by the Government
and also their basis of calculation may leave the corporations with meagre funds.

Effects of over capitalisation: Over-capitalisation affects the company, the shareholders and the
society as a whole. The confidence of Investors in an over-capitalised company is injured on account
of its reduced earning capacity and the market price of the shares which falls consequently. The
credit-standing of a corporation is relatively poor.

Consequently, the credit-standing of a corporation is relatively poor. Consequently, the company may
be forced to incur unwieldy debts and bear the heavy loss of its goodwill In a subsequent
reorganization. The Shareholders bear the brunt of over capitalization doubly. Not only is their capital
depreciated but the income is also uncertain and mostly irregular. Their holdings have little value as
collateral security.

An over-capitalised company tries to increase the prices and reduce the quality of products, and as a
result such a company may liquidate. In that case the creditors and the Labourers will be affected.
Thus it leads to the misapplication and wastage of the resources of society.

Under-Capitalisation:

Generally, under-capitalisation is regarded equivalent to the inadequacy of capital but it should be

considered as the reverse of over-capitalisation i.e. it is a condition when the real value of the
corporation is more than the book value.

The following are the causes for under-capitalization:

1. Underestimation of earnings:

Sometimes while drafting the financial plan, the earnings are anticipated at a lower figure and the
capitalisation may be based on that estimate; if the earnings prove to be higher the concern shall
become under-capitalised.

2. Unforeseeable increase in earnings:

Many corporations started during depression find themselves to be under-capitalised in the period of
recovery or boom due to unforeseeable increase in earnings.

3. Conservative dividend policy:

By following conservative dividend policy some corporations create adequate reserves for
depreciation, renewals and replacements and plough back the earnings which increase the real value
of the shares of those corporations.

4. High efficiency maintained:

By adopting ‘latest techniques of production many companies improve their efficiency. The profits
being dependent on the efficiency of the concern will increase and, accordingly, the real value of the
corporation may exceed its ‘book value’.

Effects of under-capitalisation:

The following are the effects of under-capitalisation:

1. Causes wide fluctuations in the market value of shares.

2. Provoke the management to create secret reserves.

3. Employees demand high share in the increased prosperity of the company.

Definition of Financial Planning

Financial Planning is the process of estimating the capital required and determining it’s competition. It
is the process of framing financial policies in relation to procurement, investment and administration of
funds of an enterprise.

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:

a. Determining capital requirements- This will depend upon factors like cost of current and
fixed assets, promotional expenses and long- range planning. Capital requirements have to
be looked with both aspects: short- term and long- term requirements.
b. Determining capital structure- The capital structure is the composition of capital, i.e., the
relative kind and proportion of capital required in the business. This includes decisions of
debt- equity ratio- both short-term and long- term.
c. Framing financial policies with regards to cash control, lending, borrowings, etc.
d. A finance manager ensures that the scarce financial resources are maximally utilized in
the best possible manner at least cost in order to get maximum returns on investment.

FINANCIAL PLANNING PROCESS

Six Steps in the Financial Planning Process

The following steps make up the financial planning:

1. Establishing and defining the client-planner relationship - The financial planner explains
or documents the services to be provided and defines his or her responsibilities along with the
responsibilities of the client. The planner explains how he or she will be paid and by whom.
The planner and client should agree on how long the relationship will last and on how
decisions will be made.
2. Gathering client data and determining goals and expectations - The financial planner
asks about the client's financial situation, personal and financial goals and attitude about risk.
The planner gathers all necessary documents at this stage before giving advice.
3. Analyzing and evaluating the client's financial status - The financial planner analyzes
client information to assess his or her current situation and determine what must be done to
achieve the client's goals. Depending on the services requested, this assessment could
include analyzing the client's assets, liabilities and cash flow, current insurance coverage,
investments or tax strategies.
4. Developing and presenting the financial planning recommendations and/or alternatives
- The financial planner offers financial planning recommendations that address the client's
goals, based on the information the client provided. The planner reviews the
recommendations with the client to allow the client to make informed decisions. The planner
listens to client concerns and revises recommendations as appropriate.
5. Implementing the financial planning recommendations - The financial planner and client
agree on how recommendations will be carried out. The planner may carry out the
recommendations for the client or serve as a "coach, " coordinating the process with the client
and other professionals such as attorneys or stockbrokers.
6. Monitoring the financial planning recommendations - The client and financial planner
agree upon who will monitor the client's progress toward goals. If the planner is involved, he
or she should report to the client periodically to review the situation and adjust
recommendations as needed.
Unit II

MANAGEMENT OF WORKING CAPITAL

Meaning and concepts of working capital

WCM is concerned with the problems that arise in managing the current assets, current
liabilities and the interrelationships between them.

Its operational goal is to manage the CA and CL in such a way that a satisfactory level of
NWC is maintained.

WC is the capital which a firm requires on a day to day basis to manage its business.

The interaction between current assets and current liabilities is the main theme of the theory
of working management.

There are two concepts of working capital: Gross and net.

The term Gross working capital also referred to as working capital, means the total current
assets.

The term NWC is the difference between CA and CL and the other definition is that portion
of current assets which is financed with long term funds.

The task of the financial manager in managing WC efficiently is to ensure sufficient liquidity
in the operations of the enterprise. The liquidity of a business firm is measured by its ability
to satisfy the short term obligations as they become due. The three basic measures of a firms
overall liquidity are the current ratio , the Acid test Ratio and the NWC.

The NWC helps in comparing the liquidity of the same firm over time.

Efficient working capital management requires that firms should operate with some amount
of NWC, the exact amount varying from firm to firm and also depending on various factors.

The theoretical justification for the use of NWC to measure liquidity is based on the
assumption that the greater the margin by which the current assets cover the short term
obligations, the more is the ability to pay obligations when they become due for payment.

When companies work with positive working capital their approach is conservative and if
they work with negative working capital their approach is aggressive.

Working Capital may be classified in two ways

a) Concept based working capital

b) Time based working capital

Concepts of working capital

1. Gross Working Capital: It refers to the firm’s investment in total current or

circulating assets.

2. Net Working Capital: The term “Net Working Capital” has been defined in two
different ways:

i. It is the excess of current assets over current liabilities. This is, as a matter of fact, the
most commonly accepted definition. Some people define it as only the difference
between current assets and current liabilities. The former seems to be a better definition
as compared to the latter. ii. It is that portion of a firm’s current assets which is
financed by long-term funds.

3. Permanent Working Capital: This refers to that minimum amount of investment in

all current assets which is required at all times to carry out minimum level of business
activities.

In other words, it represents the current assets required on a continuing basis over the
entire year.

Tandon Committee has referred to this type of working capital as “Core current
assets”.

The following are the characteristics of this type of working capital:

 1. Amount of permanent working capital remains in the business in one
form or another. This is particularly important from the point of view of
financing. The suppliers of such working capital should not expect its
return during the life-time of the firm.
2. Working Capital Concept based and Time based
3. Gross Working Capital
4. Net Working Capital
5. Negative Working Capital
6. Permanent or Fixed Working Capital
7. Temporary or Variable Working Capital
8. Seasonal Working Capital
9. Special Working Capital
10. Regular Working Capital

Types of Working capital.

Permanent Working capital or fixed working capital

Temporary working capital or fluctuating or variable working capital

Permanent working capital is a certain minimum level of working capital on a continuous and
uninterrupted basis.

It is the minimum capital which the company requires through out the year. Any amount over
and above the permanent level of working capital is temporary, fluctuating or variable
working capital. The permanent is fairly constant while the temporary is fluctuating
increasing or decreasing in accordance with seasonal demands. In the case of an expanding
firm, the permanent working capital line may not be horizontal. This is because the demand
for permanent current assets might be increasing or decreasing to support a rising level of
activity.

Both kind of WC are necessary to facilitate the sale process through the operating cycle.
Temporary WC is created to meet liquidity requirements that are of a purely transient nature.

Temporary Working Capital:

The amount of such working capital keeps on fluctuating from time to time on the basis of
business activities. In other words, it represents additional current assets required at different
times during the operating year. For example, extra inventory has to be maintained to support
sales during peak sales period. Similarly, receivable also increase and must be financed
during period of high sales. On the other hand investment in inventories, receivables, etc.,
will decrease in periods of depression.

Suppliers of temporary working capital can expect its return during off season when it is not
required by the firm.
Hence, temporary working capital is generally financed from short term sources of finance
such as bank credit.
DETERMINANTS OF WORKING CAPITAL:

The factors influencing the working capital decisions of a firm may be classified as two
groups,such as internal factors and external factors. The internal factors includes, nature of
business size of business, firm’s product policy, credit policy, dividend policy, and access to
money and capital markets, growth and expansion of business etc.

The external factors include business fluctuations, changes in the technology, infrastructural
facilities, import policy and the taxation policy etc. These factors are discussed in brief in the
following lines.

I. Internal Factors

1. Nature and size of the business

The working capital requirements of a firm are basically influenced by the nature and size of
the business. Size may be measured in terms of the scale of operations. A firm with larger
scale of operations will need more working capital than a small firm. Similarly, the nature of
the business - influence the working capital decisions. Trading and financial firms have less
investment in fixed assets. But require a large sum of money to be invested in working
capital. Retail stores, business units require larger amount of working capital, where as,
public utilities need less working capital and more funds to invest in fixed assets.

2. Firm’s production policy

The firm’s production policy (manufacturing cycle) is an important factor to decide the
working capital requirement of a firm. The production cycle starts with the purchase and use
of raw material and completes with the production of finished goods. On the other hand
production policy is uniform production policy or seasonal production policy etc., also
influences the working capital decisions. Larger the manufacturing cycle and uniform
production policy –larger will be the requirement of working capital. The working capital
requirement will be higher with varying production schedules in accordance with the
changing demand.

3. Firm’s credit policy

The credit policy of a firm influences credit policy of working capital. A firm following
liberal credit policy to all customers require funds. On the other hand, the firm adopting strict
credit policy and grant credit facilities to few potential customers will require less amount of
working capital.

4. Availability of credit

The working capital requirements of a firm are also affected by credit terms granted by its
suppliers – i.e. creditors. A firm will need less working capital if liberal credit terms are
available to it. Similarly, the availability of credit from banks also influences the working
capital needs of the firm. A firm, which can get bank credit easily on favorable conditions
will be operated with less working capital than a firm without such a facility.

5. Growth and expansion of business

Working capital requirement of a business firm tend to increase in correspondence with

growth in sales volume and fixed assets. A growing firm may need funds to invest in fixed
assets in order to sustain its growing production and sales. This will, in turn, increase
investment in current assets to support increased scale of operations. Thus, a growing firm
needs additional funds continuously.

6. Profit margin and dividend policy

The magnitude of working capital in a firm is dependent upon its profit margin and dividend
policy. A high net profit margin contributes towards the working capital pool.To the extent
the net profit has been earned in cash, it becomes a source of working capital. Thisdepends
upon the dividend policy of the firm. Distribution of high proportion of profits in the form of
cash dividends results in a drain on cash resources and thus reduces company’s working
capital to that extent. The working capital position of the firm is strengthened if the
management follows conservative dividend policy and vice versa.

7. Operating efficiency of the firm

Operating efficiency means the optimum utilisation of a firm’s resources at minimum cost. If
a firm successfully controls operating cost, it will be able to improve net profit margin which,
will, in turn, release greater funds for working capital purposes.

II. External Factors

1. Business fluctuations

Most firms experience fluctuations in demand for their products and services. These business
variations affect the working capital requirements. When there is an upward swing in the
economy, sales will increase, correspondingly, the firm’s investment in inventories and book
debts will also increase. Under boom, additional investment in fixed assets may be made by
some firms to increase their productive capacity. This act of the firm will require additional
funds. On the other hand when, there is a decline in economy, sales will come down and
consequently the conditions, the firm try to reduce their short-term borrowings. Similarly the
seasonal fluctuations may also affect the requirement of working capital of a firm.

2. Changes in the technology

The technological changes and developments in the area of production can have immediate
effects on the need for working capital. If the firm wish to install a new machine in the
placeof old system, the new system can utilise less expensive raw materials, the inventory
needsmay be reduced there by working capital needs.

3. Import policy

Import policy of the Government may also effect the levels of working capital of a firm
sincethey have to arrange funds for importing goods at specified times.

4. Infrastructural facilities

The firms may require additional funds to maintain the levels of inventory and other
currentassets, when there is good infrastructural facilities in the company like, transportation
andcommunications.

5. Taxation policy

The tax policies of the Government will influence the working capital decisions. If the

Government follow regressive taxation policy, i.e. imposing heavy tax burdens on
businessfirms, they are left with very little profits for distribution and retentionpurpose.
Consequentlythe firm has to borrow additional funds to meet their increased workingcapital
needs. Whenthere is a liberalised tax policy, the pressure on working capital requirement is
minimised.

Thus the working capital requirements of a firm is influenced by the internal and
externalfactors.

WORKING CAPITAL FINANCING:

Accruals

The major accrual items are wages and taxes. These are simply what the firm owes to its
employees and to the government.

Trade Credit

Trade credit represents the credit extended by the supplier of goods and services. It is a

spontaneous source of finance in the sense that it arises in the normal transactions of the firm
without specific negotiations, provided the firm is considered creditworthy by its supplier. It
is an important source of finance representing 25% to 50% of short-term financing.

Working capital advance by commercial banks

Working capital advance by commercial banks represents the most important source for
financing current assets.

Forms of Bank Finance: Working capital advance is provided by commercial banks in three
primary ways:

(i) cash credits / overdrafts, (ii) loans, and (iii) purchase / discount of bills.

In addition to these forms of direct finance, commercials banks help their customers in
obtaining credit from other sources through the letter of credit arrangement.

i. Cash Credit / Overdrafts: Under a cash credit or overdraft arrangement, a pre-determined

limit for borrowing is specified by the bank. The borrower can draw as often as
requiredprovided the out standings do not exceed the cash credit / overdraft limit.

ii. Loans: These are advances of fixed amounts which are credited to the current account
ofthe borrower or released to him in cash. The borrower is charged with interest on theentire
loan amount, irrespective of how much he draws.

iii. Purchase / Discount of Bills: A bill arises out of a trade transaction. The seller of

goods draws the bill on the purchaser. The bill may be either clean or documentary

(a documentary bill is supported by a document of title to gods like a railwayreceipt or a bill

of lading) and may be payable on demand or after a usance period

which does not exceed 90 days. On acceptance of the bill by the purchaser, the
seller offers it to the bank for discount / purchase. When the bank discounts /

purchases the bill it releases the funds to the seller. The bank presents the bill to

the purchaser (the acceptor of the bill) on the due date and gets its payment.

iv. Letter of Credit: A letter of credit is an arrangement whereby a bank helps its

customer to obtain credit from its (customer’s) suppliers. When a bank opens a

letter of credit in favour of its customer for some specific purchases, the bank

undertakes the responsibility to honour the obligation of its customer, should the

customer fail to do so.

Public Deposits

Many firms, large and small, have solicited unsecured deposits from the public in recent
years,mainly to finance their working capital requirements.

Inter-corporate Deposits

A deposit made by one company with another, normally for a period up to six months,
isreferred to as an inter-corporate deposit. Such deposits are usually of three types.

a. Call Deposits: In theory, a call deposit is withdrawable by the lender on giving a

day’s notice. In practice, however, the lender has to wait for at least three days.

The interest rate on such deposits may be around 10 percent per annum.

b. Three-months Deposits: More popular in practice, these deposits are taken by

borrowers to tide over a short-term cash inadequacy that may be caused by one or

more of the following factors: disruption in production, excessive imports of raw

material, tax payment, delay in collection, dividend payment, and unplanned capital

expenditure. The interest rate on such deposits is around 12 percent per annum.

c. Six-months Deposits: Normally, lending companies do not extend deposits beyond

this time frame. Such deposits, usually made with first-class borrowers, carry and

interest rate of around 15 percent per annum.

Short-term loans from financial institutions

The Life Insurance Corporation of India and the General Insurance Corporation of India
provideshort-term loans to manufacturing companies with an excellent track record.

Rights debentures for working capital

Public limited companies can issue “Rights” debentures to their shareholders with the
objectof augmenting the long-term resources of the company for working capital
requirements.

Commercial paper

Commercial paper represents short-term unsecured promissory notes issued by firms

whichenjoy a fairly high credit rating. Generally, large firms with considerable financial
strengthare able to issue commercial paper. The important features of commercial paper are
as follows:

i. The maturity period of commercial paper usually ranges from 90 days to 360 days.

ii. Commercial paper is sold at a discount from its face value and redeemed at its face

value. Hence the implicit interest rate is a function of the size of the discount and

the period of maturity.

iii. Commercial paper is either directly placed with investors who intend holding it

till its maturity. Hence there is no well developed secondary market for commercial

paper.

Factoring

Factoring, as a fund based financial service, provides resources to finance receivables as

wellas facilitates the collection of receivables. It is another method of raising short-term
financethrough account receivable credit offered by commercial banks and factors. A
commercialbank may provide finance by discounting the bills or invoices of its customers.
Thus, a firmgets immediate payment for sales made on credit. A factor is a financial
institution whichoffers services relating to management and financing of debts arising out of
credit sales.

Factoring is becoming popular all over the world on account of various services offered by
theinstitutions engaged in it. Factors render services varying from bill discounting facilities
offeredby commercial banks to a total take over of administration of credit sales including
maintenanceof sales ledger, collection of accounts receivables, credit control and protection
from bad debts,provision of finance and rendering of advisory services to their clients.
Factoring, may be ona recourse basis, where the risk of bad debts is borne by the client, or on
a non-recourse basis,where the risk of credit is borne by the factor.

It is of two sources of financing:

i) Short –term

ii) Long – term

Short-term financing refers to borrowing funds or raising credit for a maximum of 1

yearperiod i.e., the debt is payable within a year at the most. Whereas, the Long – term
financingrefers to the borrowing of funds or raising credit for one year or more. The finance
managerhas to mix funds from these two sources optimally to ensure profitability and
liquidity. Themixing of finances from long-term and short term should be such that the firm
should not faceeither short of funds or idle funds. Thus, the financing of working capital
should not result ineither idle or shortage of cash funds.

Policy is a guideline in taking decisions of business. In working capital financing, the

managerhas to take a decision of mixing the two components i.e., long term component of
debt andshort term component of debt. The policies for financing or working capital are
divided intothree categories.

Firstly, conservative financing policy in which the manager depends moreon long term
funds.

Secondly, aggressive financing policy in which the manager dependsmore on short term
funds,

and third, are is a moderate policy which suggests that the managerdepends moderately on
both long tem and short-term funds while financing. These policies

are shown diagrammatically here under.

Working Capital Policies

Matching Approach

The question arising here is how to mix both short term and long term funds while
financingrequired working capital. The guiding approach is known as ‘matching approach’. It
suggeststhat if the need is short term purpose, raise short – term loan or credit and if the need
is for along term, one should raise long term loan or credit. Thus, maturity period of the loan
is to bematched with the purpose and for how long. This is called matching approach. This
matchesthe maturity period of the loan with the period for how long working capital requires.
Thefollowing diagram shows the graphic presentation of the matching approach.

Aggressive Working Capital

An aggressive working capital policy is one in which you try to squeeze by with a minimal
investment in current assets coupled with an extensive use of short-term credit. Your goal is
to put as much money to work as possible to decrease the time needed to produce products,
turn over inventory or deliver services. Speeding up your business cycle grows your sales and
revenues. You keep little money on hand, cut slow-moving inventory and unnecessary
supplies to the bone and stretch out your bill payments for as long as possible. The one
payment you cannot delay is interest -- your creditors can sue you, force you into bankruptcy
and liquidate your assets. You would also want to avoid missing tax payments.

Conservative Working Capital

Companies in volatile or seasonal industries such as tourism, farming or construction might

adopt conservative working capital policies to buffer against risk. If you employ a
conservative working capital policy, there’s plenty of cash in the bank, your warehouses are
full of inventory and your payables are all up to date. Employees need not turn in their old
pencils before they are allowed to have new ones. If you compute the working capital ratio --
current assets divided by current liabilities -- a conservative policy might yield a ratio above
2.0. That is, you have more than $2 in current assets for every dollar of short-term liabilities.
Conservatively managed working capital will help lower your risks of short-term cash
shortages but might hurt your long-term profitability, because excess cash doesn’t earn much
of a return.

Risk

Your risk of default and bankruptcy increases as you adopt more aggressive working capital
policies. For example, a sudden emergency can leave you unable to make a bond interest
payment. Tight inventories can lead to shortages and lost sales. Vendors might balk at
extending your further credit if you stretch out payments beyond 90 days. Investors might be
less willing to buy your bonds and may force you to offer higher interest rates on newly
issued long-term debt. The major risk of a conservative working capital policy is the
opportunity costs of “lazy” assets that you could put to work. A conservative policy lowers
your sales efficiency -- sales revenue divided by working capital -- that can dissuade potential
investors.

Return

An aggressive working capital policy can produce a higher return on assets, as measured by
indicators such as gross income divided by working capital. However, while your indicators
might rise, your absolute amount of gross income might fall. For example, as you tighten
inventory, your sales and accounts receivable might swoon because you could run short of
product. Inventory shortages might result in lower revenue and collections as competitors
with well-stocked inventories steal your customers. A conservative policy might mean that
some of your working capital is not working. This is like leaving money on the table -- you
might have used the excess assets more productively to increase your return on assets. The
optimal policy is one in which you allocate only the amount of working capital necessary to
simultaneously maximize your revenues and minimize your risks.

Concept of operating cycle:

Operating cycle implies the continuing flow from cash to suppliers, to inventory to accounts
receivable and back into cash. In other words, the term cash cycle refers to the length of time
necessary to complete the following cycle of events:

Conversion of cash into inventory

Conversion of inventory into receivables

Conversion of receivables into cash

The operating cycle is a continuous process. If it were possible to complete the sequences
instantaneously, there would be no need for current assets but since it is not possible the firm
is forced to have current assets. Since cash inflows and outflows do not match, firms have to
necessarily keep cash or invest in short term liquid securities so that they will be in a position
to meet obligations when they become due. An adequate level of WC is absolutely necessary
for smooth sales activity which in turn enhance the owners wealth.

The shorter the cycle the better it is.The operating cycle ,thus creates the need for current
assets. However the need does not come to an end after the cycle is completed

The Operating Cycle Defined

From the time you spend money necessary to acquire inventory to the time you get the money
back from customers is called the operating cycle.
The ability of leaders to understand and manage the company's operating cycle is one of the
most important predictors of long-term business viability. Few things will put companies out
of business quicker than spending cash faster than you collect it.
The operating cycle measure how well you manage your cash.
Before you can produce a product or service, you need to have the right materials and the
right resources (equipment, people, etc.). Acquiring these resources and materials cost
money, so you've spent cash before you've produced or sold anything.
The total of inventory holding period and a receivable collection period of a firm is the
operating cycle time of that firm.
Operating cycle and cash operating cycle are used interchangeably but it’s a
misconception. They are different by a small margin but that makes a big difference.

Cash Operating Cycle and its Importance

Like working capital, operating cycle can also be gross operating cycle (operating cycle) and
net operating cycle (cash operating cycle).

Cash operating cycle is gross operating cycle less creditor’s collection period. It is the time
period for which the working capital is required.

Operating cycle is extremely important because business is all about the running the
operating cycle smoothly. If it is running smoothly, almost everything will be smooth. If any
part of the operating cycle is stuck, the whole business gets disturbed.

For a manager to effectively manage the business, he should have a deep understanding of his
business cycle and potential threats and risks to it. Proactively, he should have ways and
means to mitigate those threats and risks.
In our example, operating cycle is 80 days. The entrepreneur should always focus to reduce it
as more as possible and that will ensure better utilization of their fixed assets. In turn, they
will gain the higher return on their investment.
On the other hand, cash operating cycle is the base for working capital estimations.

The net operating cycle, also called the cash conversion cycle, is the number of days it takes
a company to generate revenues with assets.

The net operating cycle involves determining how long it takes to create inventory, sell
inventory and collect on invoices to customers. For example, let's say Company XYZ makes
widgets, which typically sit in the warehouse for 10 days. Let's also assume that it typically
takes 15 days to collect on the sale of each widget, and that it takes 14 days to pay invoices to
Company XYZ's vendors. Using the formula above, Company XYZ's net operating cycle is:

Net Operating Cycle = 10 + 15 + -14 = 11 days

This means that Company XYZ generates cash from its assets within 11 days.

WHY IT MATTERS:

The net operating cycle is a measure of how long an investment is locked up in production
before turning into cash.

Changes in net operating cycle can be very telling. For example, when companies take a long
time to collect on outstanding bills, or they overproduce and fill up the warehouse because
they can't figure out what sells, their net operating cycles lengthen. For small businesses
especially, long net operating cycles can be the difference between profit and bankruptcy.
After all, companies can only pay for things with cash, not profits. In turn, the net operating
cycle is a measure of managerial competency as well as operational efficiency.

It is important to note that different industries have different capital requirements and
standards, and determining whether a company has a long or short net operating cycle should
be made within that context.

A normal operating cycle includes the purchase or manufacture of inventory with credit
purchases (accounts payable), the sale of inventory with credit sales (accounts receivable)
and the payment of cash to suppliers and customers. It is a measure of the time taken to
complete the purchase, sell the inventory and collect the cash. The perpetual inventory
system keeps a running account of the available inventory. The periodic system of inventory
measures inventory levels at periodic intervals. The gross operating cycle calculation does
not take creditor deferral periods into account.

Estimate of Working Capital Requirements

“Working Capital is the life blood and controlling nerve centre of a business.” No
business can be successfully run without an adequate amount of working capital. To
avoid the shortage of working capital at once, an estimate of working capital requirements
should be made in advance so that arrangements can be made to procure adequate
working capital. But estimation of working capital requirements is not an easy task and
large numbers of factors have to be considered before starting this exercise. There are
different approaches available to estimate the working capital requirements of a firm
which are as follows:
(1) Working Capital as a Percentage of Net Sales: This approach to estimate the
working capital requirement is based on the fact that the working capital for any firm is
directly related to the sales volume of that firm. So, the working capital requirement is
expressed as a percentage of expected sales for a particular period. This approach is based on
the assumption that higher the sales level, the greater would be the need for working capital.
There are three steps involved in the estimation of working capital.
a) To estimate total current assets as a % of estimated net sales.
b) To estimate current liabilities as a % of estimated net sales, and
c) The difference between the two above, is the net working capital as a % of net sales.
(2) Working Capital as a Percentage of Total Assets or Fixed Asset: This approach
of estimation of working capital requirement is based on the fact that the total assets of the
firm are consisting of fixed assets and current assets. On the basis of past experience, a
relationship between (i) total current assets i.e., gross working capital; or net working capital
i.e. Current assets – Current liabilities; and (ii) total fixed assets or total assets of the firm is
established. The estimation of working capital therefore, depends upon the estimation of
fixed capital which depends upon the capital budgeting decisions.
 Both the above approaches to the estimation of working capital requirement are
simple in approach but difficult in calculation.
(3) Working Capital based on Operating Cycle: In this approach, the working capital
estimate depends upon the operating cycle of the firm. A detailed analysis is made for each
component of working capital and estimation is made for each of these components. The
different components of working capital may be enumerable as follows:
Current Assets Current Liabilities
Cash and Bank Balance Creditors for Purchases
Inventory of Raw Material Creditors for Expenses
Inventory of Work-in-Progress
Inventory of Finished Goods
For manufacturing organisation, the following factors have to be taken into consideration
while making an estimate of working capital requirements.

Factors Requiring Consideration While Estimating Working Capital

1. Total costs incurred on material, wages and overheads

2. The length of time for which raw material are to remain in stores before they are issued
for production.

3. The length of production cycle or work in process i.e. the time taken for conversion of
raw material into finished goods.

4. The length of sales cycle during which finished goods are to be kept waiting for sales.

5. The average period of credit allowed to customers.

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

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

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

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

From the total amount blocked in current assets estimated on the basis of the first
seven items given above, the total of the current liabilities i.e. the last two item, is deducted to
find out the requirements of working capital. In case of purely trading concern, points 1,2,3
would not arise but all other factors from points 4 to 9 are to be taken into consideration. In
order to provide for contingencies, some extras amount generally calculated as a fixed
percentage of the working capital may be added as margin of safety.
Suggested Proforma for estimation of working capital requirements under operating
cycle is given below:

Estimation of Working Capital Requirements

 I. Current Assets: Amount Amount Amount

Minimum Cash Balance ****

Inventories:

Raw Materials ****

Work-in-Progress ****

Finished Goods **** ****

Receivables

Debtors ****

Bills **** ****

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

II. Current Liabilities : Amount Amount

Creditors for purchases ****

Creditors for Wages ****

Creditors for Overheads ****

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

Excess of CA over CL ****

+ Safety Margin ****

Net Working Capital ****

Illustration 1: XYZ Ltd. has obtained the following data concerning the average working
capital cycle for other companies in the same industry :

Raw material stock turnover 20 Days

Credit received 40 Days

Work-in-Progress Turnover 15 Days

Finished goods stock turnover 40 Days

Debtors' collection period 60 Days

 95 Days

Using the following data, calculate the current working capital cycle for XYZ Ltd. And
briefly comment on it.

(Rs. in '000)

Sales 3,000

Cost of Production 2,100

Purchase 600

Average raw material stock 80

Average work-in-progress 85

Average finished goods stock 180

Average creditors 90

Average debtors 350

Solution: Operating cycle of XYZ Ltd.

1. Raw material

= 49 Days

2. Work-in-progress

= 15 Days

3. Finished Goods

= 31 Days

4. Debtors
 = 43 Days

5. Creditors

= 55 Days

Net Operating Cycle = 49 days + 15 days + 31 days + 43 days – 55 days

= 138 Days – 55 Days = 83 Days

Comment : For XYZ Ltd., the working capital cycle is below the industry average, including
a lower investment in net current assets. However, the following points should be noted about
the individual elements of working capital.

a) The stock of raw materials is considerably higher than average. So there is a need for
stock control procedure to be reviewed.

b) The value of creditors is also above average; this indicates that XYZ Ltd. is delaying
the payment of creditors beyond the credit period. Although this is an additional source of
finance, it may result in a higher cost of raw materials or loss of goodwill among the
suppliers.

c) The finished goods stock is below average. This may be due to a high demand for the
firm's goods or to efficient stock control. A low finished goods stock can, however, reduce
sales since it can cause delivery delays.

d) Debts are collected more quickly than average. The company might have employed
good credit control procedure or offer cash discounts for early payments.

Illustration 2: From the following data, compute the duration of operating cycle for each of
the two years and comment on the increase/decrease:

Year 1 Year 2

Stock:

Raw materials 20,000 27,000

Work-in-progress 14,000 18,000

Finished goods 21,000 24,000

Purchases 96,000 1,35,000

 Cost of goods sold 1,40,000 1,80,000

Sales 1,60,000 2,00,000

Debtors 32,000 50,000

Creditors 16,000 18,000

Assume 350 Days per year for computational purposes

Solution:

a) Calculation of Operating Cycle

Year 1 Year 2

1. Raw Material Stock 20/96 x 360 = 75 Days 27/135 x 360 = 72 Days

(Average Raw Material/Total Purchase x 360)

2. Creditors period 16/96 x 360 = 60 days 18/135 x 360 = 48 days

(Average Creditor/Total Purchase) x 360

3. Work-in-progress 14/140 x 360 = 36 days 18/180 x 360 = 36 days

(Average Work-in-progress/Total cost of goods sold) x 360

4. Finished goods 21/140 x 360 = 54 days 24/180 x 360 = 48 days

(Average Finished goods/Total cost of goods sold) x 360

5. Debtors 32/160 x 360 = 72 days 50/200 x 360 = 90 days

(Average Debtors/Total Sales) x 360

Net operating cycle 177 days 198 days

This is an increase in length of operating cycle by 21 days i.e., 12% increase approximately.
Reasons for increase are as follows:

Debtors taking longer time to pay (90-72) 18 days

Creditors receiving payment earlier (60-48) 12 days

30 days

-- Finished goods turnover lowered (54-48) 6 days

--Raw material stock turnover lowered (75-72) 3 days

Increase in Operating Cycle 21 days

Illustration 3: A proforma cost sheet of a company provides the following particulars:

Elements of Cost

Material 40%

Direct Labour 20%

Overheads 20%

The following further particulars are available:

(a) It is proposed to maintain a level of activity of 2,00,000 units.

(b) Selling price is Rs.12/- per unit.

(c) Raw materials are expected to remain in stores for an average period of one month.

(d) Materials will be in process, on averages half a month.

(e) Finished goods are required to be in stock for an average period of one month.

(f) Credit allowed to debtors is two months.

(g) Creditor allowed by suppliers is one month.

You may assume that sales and production follow a consistent pattern.

You are required to prepare a statement of working capital requirements, a forecast

Profit and Loss Account and Balance Sheet of the company assuming that:

Rs.

Share Capital 15,00,000

8% Debentures 2,00,000

Fixed Assets 13,00,000

Solution:

Statement of Working Capital

Current Assets: Rs. Rs.

Stock of Raw Materials (1 month)

80,000

Work in progress (1/2 month):

40,000

Materials

20,000

Labour

20,000 80,000

Overheads

Stock of Finished Goods (1 month)

80,000

Materials

40,000

Labour

40,000

Overheads

1,60,000

Debtors (2 months)

at cost

Material 1,60,000

Labour 80,000

Overheads 80,000 3,20,000

6,40,000

Less: Current Liabilities:

Creditors (1 month) for raw materials

80,000

Net Working Capital Required: 5,60,000

(Note: Sales = 2,00,000 X 12 = Rs.24,00,000)

Forecast Profit and Loss Account

For the year ended….

Rs. Rs.

To Materials 9,60,000 By Cost of good old 19,20,000

To Wages 4,80,000

To Overheads 4,80,000

19,20,000 19,20,000

To Cost of goods sold 19,20,000 By Sales 24,00,000

To Gross profit c/d 4,80,000

24,00,000 24,00,000

To Interest on Debentures 16,000 By Gross Profit b/d 4,80,000

To Net Profit 4,64,000

4,80,000 4,80,000

Forecast Balance Sheet

as at……

Liabilities Rs. Assets Rs.

Share Capital 15,00,000 Fixed Assets 13,00,000

8% Debentures 2,00,000 Stocks:

Net Profit 4,64,000 Raw Materials 80,000

Creditors 80,000 Work-in-Progress 80,000

Finished Goods 1,60,000

Debtors 4,00,000

Cash & Bank Balance

(Balancing figure) 2,24,000

22,44,000 22,44,000

Working Notes:

(a) Profits have been ignored while preparing working capital requirements for the
following reasons:

(i) Profits may or may not be used for working capital.

(ii) Even if profits have to be used for working capital, they have to be reduced by
the amount of income tax, dividends, etc.

(b) Interest on debentures has been assumed to have been paid.

Illustration 4: A proforma cost sheet of a company provides the following particulars:

Elements of Cost Amount per unit

Rs.
Raw Material 80
Direct Labour 30
Overheads 60

Total Cost 170

Profit 30

Selling Price 200

The following further particulars are available:

Raw materials are in stock on an average for one month. Materials are in process on
an average for half a month. Finished goods are in stock on an average for one month. Credit
allowed by suppliers is one month. Credit allowed to customers is two months. Lag in
payment of wages is 1½ weeks. Lag in payment of overhead expenses is one month. One-
fourth of the output is sold against cash. Cash in hand and at bank is expected to be
Rs.25,000.
You are required to prepare a statement showing the working capital needed to
finance a level of activity of 1,04,000 units of production.
You may assume that production is carried on evenly throughout the year, wages and
overheads accrue similarly and a time period of 4 weeks is equivalent to a month.

Solution:

Statement Showing the Working Capital Needed

Current Assets Rs.

Minimum cash balance 25,000

(i) Stock of raw materials (4 weeks)

1,60,000 x 4 6,40,000

Rs.

(ii) Work-in-Process (2 weeks):

Raw materials 1,60,000 x 2 3,20,000

Direct Labour 60,000 x 2 1,20,000

Overheads 1,20,000 x 2 2,40,000 6,80,000

(iii) Stock of Finished goods (4 weeks):

Raw Materials 1,60,000 x 4 6,40,000

Direct Labour 60,000 x 4 2,40,000

Overheads 1,20,000 x 4 4,80,000 13,60,000

(iv) Sundry Debtors (8 weeks):

Raw materials 1,60,000 x 3/4 x 8 9,60,000

Direct Labour 60,000 x 3/4 x 8 3,60,000

Overheads 1,20,000 x 3/4 x 8 7,20,000 20,40,000

47,45,000

Less Current Liabilities:

 (i) Sundry Creditors (4 weeks)

1,60,000 x 4 6,40,000

90,000

(ii) Wages outstanding (1-1/2 weeks): 60,000 x

(iii) Lag in payment of overheads (4 weeks)

1,20,000 x 4 4,80,000 12,10,000

Net Working Capital Needed 35,35,000

Working Notes:
(i) It has been assumed that a time period of 4 weeks is equivalent to one month.
(ii) It has been assumed that direct labour and overheads are in process, on average, half
a month.
(iii) Profit has been ignored and debtors have been taken at cost.
(iv) Weekly calculations have been made as follows:
(a) Weekly average of raw materials = 1,04,000 x 80/52 = 1,60,000
(b) Weekly labour cost = 1,04,000 x 30/52 = 60,000
(c) Weekly Overheads = 1,04,000 x 60/52 = 1,20,000

From the following information you are required to estimate the net working capital:

Cost per unit

Rs.

Raw Materials 400

Direct labour 150

Overheads (excluding depreciation) 300

Total Cost 850

Additional Information: 30

Selling-Price Rs.1,000 per unit

 Output 52,000 units per annum

Raw Material in stock average 4 weeks

Work-in-process:

(assume 50% completion stage with

full material consumption) average 2 weeks

Finished goods in stock average 4 weeks

Credit allowed by suppliers average 4 weeks

Credit allowed to debtors average 8 weeks

Cash at bank is expected to be Rs.50,000

Assume that production is sustained at an even pace during the 52 weeks of the year. All
sales are on credit basis. State any other assumption that you might have made while
computing.

Solution :

Statement Showing Net Working Capital Requirements

Current Assets : Rs.

Minimum cash balance 50,000

Stock of Raw Materials (4 weeks)

52,000 x 400 x (4/52) 16,00,000

Stock of work-in-progress (2 weeks)

8,00,000

Raw material 52,000 x 400 x

Direct labour (50% completion)

1,50,000

52,000 x 150 x

Overheads (50% completion)

3,00,000 12,50,000

52,000 x 300 x
Stock of Finished goods (4 weeks)

34,00,000

52,000 x 850 x

Amount blocked in Debtors at cost (8 weeks)

68,00,000

52,000 x 850 x

Total Current Assets 1,31,00,000

Less: Current Liabilities:

Creditors for raw materials (4 weeks)

16,00,000

52,00,000 x 400 x

Net Working Capital Required 1,15,00,000

Illustration 6: Texas Manufacturing Company Ltd. is to start production on 1st January,

1995. The prime cost of a unit is expected to be Rs.40 out of which Rs.16 is for materials
and Rs.24 for labour. In addition, variable expenses per unit are expected to be Rs.8 and fixed
expenses per month Rs.30,000. Payment for materials is to be made in the month following
the purchases. One-third of sales will be for cash and the rest on credit for settlement in the
following month. Expenses are payable in the month in which they are incurred. The selling
price is fixed at Rs.80 per unit. The number of units manufactured and sold are expected to be
as under:

January 900

February 1,200

March 1,800

April 2,100

May 2,100

June 2,400

Draw up a statement showing requirements of working capital from month to month,

ignoring the question of stocks.
Solution:

Statement Showing Requirement of Working Capital

January February March April Rs. May Rs. June Rs.

Rs. Rs. Rs.

Payments:

Materials - 14,400 19,200 28,800 33,600 33,600

Wages 21,600 28,800 43,200 50,400 50,400 57,600

Fixed Expenses 30,000 30,000 30,000 30,000 30,000 30,000

Variable Expenses 7,200 9,600 14,400 16,800 16,800 19,200

58,800 82,800 1,06,800 1,26,000 1,30,800 1,40,400

Receipts:

Cash Sales 24,000 32,000 48,000 56,000 56,000 64,000

Debtors - 48,000 64,000 96,000 1,12,000 1,12,000

24,000 80,000 1,12,000 1,52,000 1,68,000 1,76,000

Working Capital 34,800 2,800 - - - -

Required Payments-
Receipts)

Surplus - - 5,200 26,000 37,200 35,600

Cumulative 34,800 37,600 32,400 6,400 - -

Requirements of
Working Capital

Surplus Working Capital - - - - 30,800 66,400

Working Notes:

(i) As payment for material is made in the month following the purchase, there is no
payment for material in January. In February, material payment is calculated as 900 x 16 =
Rs.14,400 and in the same manner for other months.
(ii) Cash sales are calculated as:

For January 900 x 80 x 1/3 = Rs.24,000 and in the same manner for other months.

(iii) Receipts from debtors are calculated as:

For Jan. – Nil because cash from debtors is collected in the month following the sales.

For Feb. – 900 x 80 x 2/3 = Rs.48,000

For March – 12002 x 80 x 2/3 = Rs.64,000, and so on.

SOLUTION
Unit III

MANAGEMENT OF CASH
Motives for holding cash
Cash Management:-
• Is the maintaining of liquidity of a firm to minimize the risk of insolvency. ( An
insolvent company is one where it is unable to meet its maturing liabilities on time
because it has inadequate liquidity to meet its debt obligation)
• Cash Management is also about the proper balancing of keeping cash without letting
it idling around.
• Remember that profit is not equating to cash flow. A highly profitable company might
collapse if without adequate cash flow due to the tying up of company’s funds with
the accounts receivable and worsen by the needs to make regular payments like
wages, rent & utilities, taxes

Motives/Reasons of Holding Cash:

Three(3) motives advocated by British economist, John Maynard Keynes namely for:
• Transaction motive
Precautionary motive and
• Speculative motive

Transaction motive:
Transaction Motive:
Requirement of cash to meet day to day needs is known as transaction motive. For example:
On day to day basis the company is required to make regular payments like purchases,
salaries/wages, taxes, interest, dividends etc. for which company will hold the cash.
Similarly, company receives cash from its sale operations. However, sometimes receipts of
the cash and the cash payments do not match with each other; in such situations the company
should have enough cash to honour the commitments whenever they are due. So transaction
motive is all about
• Maintaining cash for the purpose of meeting cash needs arising in the ordinary course
of doing business.
• Includes regular payments like wages, utilities, acquisition of fixed assets and
inventories
• Note that the amount of cash needed for transaction requirements depends on the
nature of business and varies from industry to industry.
Precautionary motive:
Precautionary Motive: Holding up of cash balance in order to take care of contingencies
and unforeseen circumstances is known as precautionary motive. In addition to requirement
of cash for regular transactions, the company may require the cash for such purposes which
cannot be estimated or foreseen. For example: Sudden decline in the collection from the
customers or sharp increase in the prices of raw materials may put the company in such a
situation where they need additional funds to deal with such situation without affecting its
regular business. So it deals with
• Maintaining of cash balance as buffer for UNEXPECTED needs that may arise.
• Either holding in cash or marketable securities that can be liquidated easily

Speculative motive:

Speculative Motive: Holding up of some reserve in the form of cash to take the benefit of
some specific nature of favourable market conditions is known speculative motive. For
example: If the company presumes that in near future prices of raw material is going to be
low, then it will preserve that cash for future purchase of raw material. In another case if
interest rates are expected to increase then the company will purchase securities from the
reserved cash.
• Holding cash for potential profit making situation like purchasing raw materials in
bulk in anticipation of a fall in price

Objectives of cash Management

Cash management is a broad term that refers to the collection, concentration, and
disbursement of cash. It encompasses a company's level of liquidity, its management of cash
balance, and its short-term investment strategies. In some ways, managing cash flow is the
most important job of business managers. If at any time a company fails to pay an obligation
when it is due because of the lack of cash, the company is insolvent. Insolvency is the
primary reason firms go bankrupt. Obviously, the prospect of such a dire consequence should
compel companies to manage their cash with care. Moreover, efficient cash management
means more than just preventing bankruptcy. It improves the profitability and reduces the risk
to which the firm is exposed.
Objectives
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 relation’s with suppliers.

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.
Meeting payments schedule: In the normal course of functioning, a firm has to make various
payments by cash to its employees, suppliers and infrastructure bills. Firms will also receive
cash through sales of its products and collection of receivables. Both of these do not occur
simultaneously. The basic objective of cash management is therefore to meet the payment
schedule on time. Timely payments will help the firm to maintain its creditworthiness in the
market and to foster cordial relationships with creditors and suppliers. Creditors give cash
discount if payments are made in time and the firm can avail this discount as well.
Trade credit does not involve explicit interest charges, but there is an implicit cost involved.
If the credit term is for example, 2/10, net 30; it means the company will get a cash discount
of 2% for a payment made within 10 days, or else the entire payment is to be made within 30
days. Since the net amount is due within 30 days, not availing discount means paying an extra
2% for the 20-day period. The other advantage of meeting the payments on time is that it
prevents bankruptcy that arises out of the firm’s inability to honour its commitments.

Minimising funds held in the form of cash balances: Trying to achieve the second objective is
very difficult. A high level of cash balance will help the firm to meet its first objective, but
keeping excess reserves is also not desirable as funds in its original form is idle cash and a
non-earning asset. It is not profitable for firms to maintain huge balances. Seasonal industries
are classic examples of mismatches between inflows and outflows. The efficiency of cash
management can be augmented by controlling a few important factors:
• Prompt billing and mailing: There is a time lag between the dispatch of goods and
preparation of invoice. Reduction of this gap will bring in early remittances.
• Collection of cheques and remittances of cash: Generally, we find a delay in the receipt of
cheques and their deposits in banks. The delay can be reduced by speeding up the process of
collecting and depositing cash or other instruments from customers.
• Float: The concept of ‘float’ helps firms to a certain extent in cash management. Float
arises because of the practice of banks not crediting the firm’s account in its books when a
cheque is deposited by it and not debiting the firm’s account in its books when a cheque is
issued by it, until the cheque is cleared and cash is realised or paid respectively. Whenever
cheques are deposited in the bank, credit balance increases in the firm’s books but not in
bank’s books until the cheque is cleared and money is realised. This refers to ‘collection
float’, that is, the amount of cheques deposited into a bank and clearance awaited. Likewise
the firm may take benefit of ‘payment float’.
Net float = Payment float – Collection float

Conclusion
In order to ensure you meet the objectives of an effective cash management policy, the
financial manager must ensure that the company meets the payment schedule and also
minimize idle funds committed to cash balances.

Cash is one of the most important aspects of a business. Lack of cash could and would
probably lead to financial problems hence it is vital for a company to have a financial
manager who is responsible for managing its cash to ensure it has enough to pay off creditors
whilst also making profit from possible investment schemes with its idle cash.

Cash Budget
A cash budget is a budget or plan of expected cash receipts and disbursements during the
period. These cash inflows and outflows include revenues collected, expenses paid, and loans
receipts and payments. In other words, a cash budget is an estimated projection of the
company's cash position in the future.

Cash budget is an estimation of the cash inflows and outflows for a business or individual for
a specific period of time. Cash budgets are often used to assess whether the entity has
sufficient cash to fulfill regular operations and/or whether too much cash is being left in
unproductive capacities.

cash budget is extremely important, especially for small businesses, because it allows a
company to determine how much credit it can extend to customers before it begins to
have liquidity problems.

For individuals, creating a cash budget is a good method for determining where their cash is
regularly being spent. This awareness can be beneficial because knowing the value of certain
expenditures can yield opportunities for additional savings by cutting unnecessary costs.

For example, without setting a cash budget, spending a dollar a day on a cup of coffee seems
fairly unimpressive. However, upon setting a cash budget to account for regular annual cash
expenditures, this seemingly small daily expenditure comes out to an annual total of $365,
which may be better spent on other things. If you frequently visit specialty coffee shops, your
annual expenditure will be substantially more.

A cash budget is a budget or plan of expected cash receipts and disbursements during the
period. These cash inflows and outflows include revenues collected, expenses paid, and loans
receipts and payments. In other words, a cash budget is an estimated projection of the
company's cash position in the future.

Management usually develops the cash budget after the sales, purchases, and capital
expenditures budgets are already made. These budgets need to be made before the cash
budget in order to accurately estimate how cash will be affected during the period. For
example, management needs to know a sales estimate before it can predict how much cash
will be collected during the period.

Management uses the cash budget to manage the cash flows of a company. In other words,
management must make sure the company has enough cash to pay its bills when they come
due. For instance, payroll must be paid every two weeks and utilities must be paid every
month. The cash budget allows management to predict short falls in the company's cash
balance and correct the problems before payments are due.

Likewise, the cash budget allows management to forecast large amounts of cash. Having
large amounts of cash sitting idle in bank accounts is not ideal for companies. At the very
least, this money should be invested to earn a reasonable amount of interest. In most cases,
excess cash is better used to expand and develop new operations than sit idle in company
accounts. The cash budget allows management to predict cash levels and adjust them as
needed.

CASH BUDGET NUMERICALS

Problem

From the following forecasts of income and expenditure, prepare a cash budget for the
months Jan. to April 2011.

Sales Purchase Manufacturing Administrative Selling

Months Wages
(Credit) (Credit) expenses expenses expenses
2010
30000 15000 3000 1150 1060 500
Nov.
Dec. 35000 20000 3200 1225 1040 550

2011
25000 15000 2500 990 1100 600
Jan.

Feb. 30000 20000 3000 1050 1150 620

March 35000 22500 2400 1100 1220 570

April 40000 25000 2600 1200 1180 710

Additional information in follows :

1. The customers are allowed a credit period of two months.

2. A dividend of $ 10000 in payable April.

3. Capital expenditure which has to be incurred : 15th Jan. $ 5000, we will buy a plant and in
march, we will buy a building on loan and its payment will be done with in monthly
installments of $ 2000 each.

4. The creditor are allowing a credit of 2 months.

5. Wages are paid on the 1st of the next months.

6. Lag in payment of other expenses is one month.

7. Balance of cash in hand on 1st Jan. 2011 is $ 15000.

Solution

Problem

) Saurashtra Co. Ltd. wishes to arrange overdraft facilities with its bankers from the period
August to October 2010 when it will be manufacturing mostly for stock. Prepare a cash
budget for the above period from the following data given below:

Month Sales (Rs) Purchases Wages(Rs) MFG Exp Office Selling

(Rs) (Rs) Exp(Rs) Exp(Rs)

June 1,80,000 1,24,800 12,000 3,000 2,000 2000

July 1,92,000 1,44,000 14,000 4,000 1,000 4,000

August 1,08,000 2,43,000 11,000 3,000 1,500 2,000

September 1,74,000 2,46,000 12,000 4,500 2,000 5,000

October 1,26,000 2,68,000 15,000 5,000 2,500 4,000

November 1,40,000 2,80,000 17,000 5,500 3,000 4,500

December 1,60,000 3,00,000 18,000 6,000 3,000 5,000

Additional Information: (a) Cash on hand 1‐08‐2010 Rs.25,000.

(b) 50% of credit sales are realized in the month following the sale and the remaining 50% in
the second month following. Creditors are paid in the month following the month of
purchase.

(c) Lag in payment of manufacturing expenses half month.

(d) Lag in payment of other expenses one month.

Problem

S. K. Brothers wish to approach the bankers for temporary overdraft facility for the period
from
October 2010 to December 2010. During the period of this period of these three months, the
firm
will be manufacturing mostly for stock. You are required to prepare a cash budget for the
above
period.

• 50% of credit sales are realized in the month following the sales and remaining
50% in the second following.
• Creditors are paid in the month following the month of purchase
• Estimated cash as on 1‐10‐2010 is Rs.50,000.
Solution

Problem
TATA Co. Ltd. is to start production on 1st January 2011.
The prime cost of a unit is expected to be Rs. 40 (Rs. 16 per materials and Rs. 24 for labour).
In addition, variable expenses per unit are expected to be Rs. 8 and fixed expenses per month
Rs. 30,000.
 Payment for materials is to be made in the month following the purchase. One‐third of sales
will be for cash and the rest on credit for settlement in the following month. Expenses are
payable in the month in which theyare incurred.
The selling price is fixed at Rs. 80 per unit.
The number of units to be produced and sold is expected to be:
January 900; February 1200; March 1800; April 2000; May 2,100 June 2400
Draw a Cash Budget indicating cash requirements from month to month.

Solution
Problem
Problem

Additional Information:
(i) 10% of the purchases and 20% of sales are for cash.
(ii) The average collection period of the company is ½ month and the credit purchases are
paid
regularly after one month.
(iii) Wages are paid half monthly and the rent of Rs. 500 included in expenses is paid
monthly and
other expenses are paid after one month lag.
(iv) Cash balance on April 1,2012 may be assumed to be Rs.15,000

Solution
Unit IV

Inventory Management

• Meaning and Components

There are three basic and most important current assets namely Cash, Receivables and
Inventory whose management is very vital for managers. This unit covers Receivables and
Inventory as main topics.
The term Inventory is originated from French word ‘Inventaire’ which implies a list of things
found. American Institute of Accountants define the term Inventory as the aggregate of those
items of tangible personal property which (a) are held for sale in ordinary course of business
(b) are in the process of production for such sales, or (c) are to be currently consumed in the
production of goods or services to be available for sale. The various forms in which
inventories exist in a manufacturing company and those components are:
(i) Raw Material
(ii) Work in progress
(iii) Finished goods
(iv) Stores and spares
Raw Materials are those goods which have been purchased and stored for future productions.
These are the goods which have not yet been committed to production at all.

Raw materials are those inputs that are converted into finished goods through manufacturing
process. These form a major input for manufacturing a product. In other words, they are very
much needed for uninterrupted production.
Work in progress is that stage of stocks that are between raw materials and finished
goods.WIP inventories are semi finished products. They represent products that need to
undergo some other process to become finished goods.
These are the goods which have been committed to production but the finished goods have
not yet been produced.

Finished products are those products which are ready for sale. The stock of finished goods
provides a buffer between production and market. These are the goods after production
process is complete. Say, these are final products of the production process ready for sale. In
case of a wholesaler or retailer, inventories are generally referred to as ‘merchandise
inventory’.

Stores and spares inventory are those purchased and stored for the purpose of maintenance of
machinery.
Some firms also maintain a fourth kind of inventory, namely, supplies. Examples of supplies
are office and plant cleaning materials, oil, fuel, light bulbs and the like. These items are
necessary for production process. In practice, these supplies form a small part of total
inventory involving small investment. Therefore, a highly sophisticated technique of
inventory management is not needed for these.

The size of above mentioned three types of inventories to be maintained will vary from one
business firm to another depending upon the varying nature of their businesses. For example,
while a manufacturing firm will have all three types of inventories, a retailer or a wholesaler
business, due to its distinct nature of business, will have only finished goods as its
inventories. In case of them, there will be, therefore, no inventories of raw materials as well
as work-in- progress.

Inventory management is a science primarily about specifying the shape and percentage of
stocked goods. It is required at different locations within a facility or within many locations
of a supply network to precede the regular and planned course of production and stock of
materials. It is the sum of total of those activities necessary for the acquisition, storage
disposal or use of materials.
If business planning can be perfect, a firm may succeed in attaining the ‘Zero Inventory’
norm which the Japanese management seems to suggest is not unrealistic.

• Inventory Management Motives

Managing inventories involve block of funds and inventory holding costs. Maintenance of
inventory is expensive, then why to hold them? There are generally three motives for holding
inventories in an enterprise:

1. Transaction Motive
2. Precautionary Motive
3. Speculative Motive

1. Transaction Motive:
According to this motive, an enterprise maintains inventories to avoid bottlenecks in its
production and sales. By maintaining inventories; the business ensures that production is not
interrupted for want of raw material, on the one hand, and sales also are not affected on
account of non-availability of finished goods, on the other. It facilitates the uninterrupted
production and delivery of order at given time.

2. Precautionary Motive:
Inventories are also held with a motive to have a cushion against unpredicted business. There
may be a sudden and unexpected spurt in demand for finished goods at times. Similarly, there
may be unforeseen slump in the supply of raw materials at some time. In both the cases, a
prudent business would surely like to have some cushion to guard against the risk of such
unpredictable changes.

3. Speculative Motive:
An enterprise may also hold inventories to take the advantages of price fluctuations. Suppose,
if the prices of raw materials are to increase rather steeply, the enterprise would like to hold
more inventories than required at lower prices.
 • Objectives of Inventory Management:

There are two main objectives of inventory management: (1) Operational and (2) Financial.
The operational objective is to maintain sufficient inventory, to meet demand for product by
efficiently organizing the firm’s production and sales operation. The financial view is to
minimize the inefficient inventory and reduce inventory carrying costs.

Making Adequate Availability of Inventories:

The main objective of inventory management is to ensure the availability of inventories as
per requirements all the times. This is because both shortage and surplus of inventories prove
costly to the organization. In case of shortage of availability in inventories, the manufacturing
wheel comes to a grinding halt. The consequence is either less production or no production.

The either case results in less sale to less revenue to less profit or more loss. On the other
hand, surplus in inventories means lying inventories idle for some time implying cash
blocked in inventories. Speaking alternatively, this also means that had the organization
invested money blocked in inventories invested elsewhere in the business, it would have
earned a certain return to the organization. Not only that, it would have also reduced the
carrying cost of inventories and, in turn, increased profits to that extent.

Minimising Costs and Investments in Inventories:

Closely related to the above objective is to minimize both costs as well as volume of
investment in inventories in the organization. This is achieved mainly by ensuring required
volume of inventories in the organization all the times.

This benefits organization mainly in two ways. One, cash is not blocked in idle inventories
which can be invested elsewhere to earn some return. Second, it will reduce the carrying
costs which, in turn, will increase profits. In lump sum, inventory management, if done
properly, can bring down costs and increase the revenue of a firm.

Other objectives of inventory management are explained as under:-

1. To ensure that the supply of raw material & finished goods will remain continuous so that
production process is not halted and demands of customers are duly met.

2. To minimize carrying cost of inventory.

3. To keep investment in inventory at optimum level.

4. To reduce the losses of theft, obsolescence & wastage etc.

5. To make arrangement for sale of slow moving items.

6. To minimize inventory ordering costs.

• Benefits of Holding Inventory

 • Costs of Holding Inventories:
However, holding inventories is not an unmixed blessing. In other words, it is not that
everything is good with holding inventories. It is said that every noble acquisition is attended
with risks; he who fears to encounter the one must not expect to obtain the other. This is true
of inventories also. There are certain costs also associated with holding inventories. Hence, it
is necessary for a firm to take these costs into consideration while planning for inventories.

These are broadly classified into three categories:

1. Material Costs:
These include costs which are associated with placing of orders to purchase raw materials and
components. Clerical and administrative salaries, rent for the space occupied, postage,
telegrams, bills, stationery, etc. are the examples of ordering costs. The more the orders, the
more will be the ordering costs and vice versa.

2. Carrying Costs:
These costs are associated with carrying or maintaining inventories. The following are certain
examples:

i. Storage costs (depreciations, insurance, maintenance of building, utility and

janitorial services)

ii. Insurance of inventory against theft and fire

iii. Obsolescence cost and deterioration

iv. Serving costs (labor for handling inventory, clerical)

v. Capital costs (expenses in raising funds and interest on capital)

vi. Taxes

These also include opportunity costs. This means had the money blocked in inventories been
invested elsewhere in the business, it would have earned a certain return. Hence, the loss of
such return may be considered as an ‘opportunity cost’. The carrying costs of inventory size
are positively related and move in the same direction. If inventory increases then carrying
costs increases.

Ordering costs: These are those cost that are associated with the acquisition of materials. In
other words, the cost that are spent in placing an order till the receipt of raw material. They
include the following:

i. Cost of requisitioning the items

ii. Cost of preparation of purchase order (drafting, typing, postage, dispatch etc)

iii. Cost of sending reminders to get the dispatch of items expedited

iv. Cost of transportation of goods

 v. Cost of the unloading of the items or goods

vi. Cost of receiving and verifying the goods.

Ordering cost are fixed per order placed irrespective of the amount of the order but ordering
cost increases in proportion to the number of orders placed.

Shortage costs:

Shortage cost are those cost costs that arise due to stock out or either shortage of raw
materials or finished goods. Shortage of inventories of raw materials has an impact on the
firm in the following ways:

✓ The firm may have to pay somewhat higher price, connected with immediate cash
procurements.

✓ The firm may have to compulsorily resort the some different production schedules
which may not be efficient and economical.

While stock of finished goods- may result in the dissatisfaction of the customers.

• Dangers of excessive and inadequate inventory:

Management of optimum level of inventory investment is the prime objective of inventory
management. Inadequate or excess investment in inventories is not healthy for any firm. In
other words, a firm should avoid inadequate or excess investment in inventory.
Excessive inventory means the firm has idle funds which earn no profits for the firm. In
addition, excessive inventory incurs extra handling and holding costs. Inadequate inventory
means the firm does not have sufficient raw materials for production. This also means
insufficient ample goods to sell for merchandising companies. Inventory management will be
more complicated as moderate inflation and seasonality get involved.
I. Dangers of excessive inventories
- Block of funds in inventories: cannot be used for any purpose since they have been locked in
inventory and they involve an opportunity costs
-Increases carrying costs, which include the cost of storage and capital cost. Interest on
capital liked up in inventories; insurance, handling, recording, inspection, obsolescence, and
taxes. These cost reduces the firm’s profits.
-Carrying excessive inventory over a long period leads to the loss of liquidity. It may not be
possible to sell the inventories in time without loss.
-Physical deterioration of inventory while in storage can take place. In case of certain goods
or raw materials deterioration occurs with the passage of time or it may be due to
mishandling and improper storage facilities.
-Mishandling of inventories due to excess purchases or storage which leads to theft and
waste.
II. Dangers of inadequate inventory:
Under investment in inventory is also not healthy one. It has some negative consequences,
they are:
-Inadequate raw materials and WIP inventories will disturb the production.
-When the firm is not able to produce goods without interruption then it leads to inadequate
storage of finished goods. If finished goods are not sufficient to meet customers demand then
the customers may shift to the competitors which may be a loss to the company
Motives for Holding Inventories:
Why do firms hold inventories while it is expensive to hold inventories? The reply to this
question is the motives behind holding inventories in an enterprise.

Benefits and Costs of Holding Inventories:

Holding inventories bears certain advantages for the enterprise.

The important advantages but not confined to the following only are as follows:
1. Avoiding Losses of Sales:
By holding inventories, a firm can avoid sales losses on account of non-supply of goods at
times demanded by its customers.

2. Reducing Ordering Costs:

Ordering costs, i.e., the costs associated with individual orders such as typing, approving,
mailing, etc. can be reduced, to a great extent, if the firm places large orders rather than
several small orders.

3. Achieving Efficient Production Run:

Holding sufficient inventories also ensures efficient production run. In other words, supply of
sufficient inventories protects against shortage of raw materials that may at times interrupt
production operation.

It ensures an adequate supply of materials and stores, minimizes stockouts and shortages and
avoids costly interruptions in operations.

Keeps down investment in inventories; inventory carrying cost and obsolescence losses to the
minimum.

Facilitates purchasing economies through the measurement of requirements on the basis of

recorded experience.

Estimates duplication in ordering stocks by centralizing the stocks.

Provides a check against the loss of materials through careless or pilferage.

-------------------------------------------

• Inventory Management techniques

The financial manager should aim at an optimum level of inventory on the basics of the trade-
off between cost and benefit to maximize the owner’s wealth. Many sophisticated
mathematical techniques are available to handle inventory management problems. Two of
them have been discussed below:
I. ABC analysis:
In order to exercise effective control over materials, A.B.C. (Always Better Control) method
is of immense use and is widely used technique to identify various items of inventory. It
means firm should not keep same degree of control on all items of inventory. It is based on
Pareto’s Law. It is also known as ‘Selective Value Approach’.

Under this method materials are classified into three categories in accordance with their
respective values. Group ‘A’ constitutes costly items which may be only 10 to 20% of the
total items but account for about 50% of the total value of the stores.

A greater degree of control is exercised to preserve these items. Group ‘B’ consists of items
which constitutes 20 to 30% of the store items and represent about 30% of the total value of
stores.

A reasonable degree of care may be taken in order to control these items. In the last category
i.e. group ‘Q’ about 70 to 80% of the items is covered costing about 20% of the total value.
This can be referred to as residuary category. A routine type of care may be taken in the case
of third category.

If this method is applied with care, it ensures considerable reduction in the storage expenses
and it is also greatly helpful in preserving costly items.

Category No of items Item value

(%) (%)

A 15 70

B 30 20

C 55 10

Total 100 100

The above table indicates that only 15% of items may count for 70% of the total value (A
category items) on which greater attention is required, where as 55% of items may account
for 10% of total value of inventory (C category items) will be paid less attention. The
remaining 30% of inventory control for 20% of total value of inventory (B category items)
will be paid reasonable attention as this category lies between other two. (Diagram in class)
II. Economic Order Quantity (E.O.Q.):
One of the most important problems faced by the purchasing department is how much to
order at a time. Purchasing in large quantities involve lesser purchasing cost. But cost of
carrying them tends to be higher. Likewise if purchases are made in smaller quantities,
holding costs are lower while purchasing costs tend to be higher. Hence, the most economic
buying quantity or the optimum quantity should be determined by the purchase department
by considering the factors such as cost of ordering, holding or carrying. To this problem the
answer is Economic Order Quantity (EOQ).

The Economic Order Quantity may be defined as that level of inventory at which the total
cost of inventory comprising acquisition/ordering/set-up costs and carrying costs is minimal.
Assumptions of this model are:

- Demand for the product is constant and uniform throughout the period

- Lead time (time for ordering to receipt) is constant.

- Price per unit of product is constant

- Inventory holding cost is based on average inventory

- Ordering costs are constant

- All demand for the product will be satisfied (no back orders are allowed)

This can be calculated by the following two formulas:

Q = √2AO/C

Where,

Q stands for quantity per order;

A stands for annual requirements of an item in terms of rupees;

O stands for cost of buying/ordering an item in rupees; and

C stand for carrying cost per unit per year in rupees.

OR

Q = √2AO/CC

Where,

Q stands for quantity per order;

A stands for annual requirements of an item in terms of rupees;

O stands for cost of buying/ordering an item in rupees; and

CC stand for annual carrying cost per unit in rupees which is calculated. (Price per unit x
carrying cost per unit in percentage)
Illustration 1: A firm’s inventory planning period is of one year. Its inventory requirement
for this period is 1600 units. Assume that its acquisition (buying) cost are ₹ 50 per order. The
carrying order are expected to be ₹ 1 per unit. Calculate Economic Order Quantity.

Solution: A= 1600 units; O= ₹ 50, C= ₹ 1

EOQ= √2 x 1600 x 50 / 1

= √160000

= 400 units.

Hence it can be said that the carrying and ordering costs taken together are the lowest for the
order size of 400 units. Thus it is economic order quantity.

Illustration 2: the following details are available in respect of a firm. Determine EOQ.

Annual requirement of inventory: 40,000 units

Cost per unit (other than carrying and ordering costs): ₹ 16

Carrying costs will be 15% per year

Cost of placing an order: ₹ 480 per order

Solution:

EOQ = √2 x 40000 x 480 / 16 x 0.15

= √38400000 / 2.4

= √16000000

= 4000 units

Illustration 3: The annual demand for an item is 3200 units. The unit cost is Rs 6 and
inventory carrying charges 25% p.a. If the cost of one procurement is Rs 150. Determine: (a)
EOQ (b) No of orders per year (c) time between two consecutive orders.

Solution:

(a) EOQ = √2 x 3200 x 150 / 6 x 0.25

= √6, 40,000

= 800 units

(b) No of orders = 3200 units / 800 units

 = 4 orders in a year

(c) Time between two consecutive years = 12 months / 4 orders = 3 months

Illustration 4: Following information relating to a raw material is available:

Annual demand: 2400 units

Unit price = ₹ 2.40

Ordering cost per order = ₹ 4

Carrying cost = 12%

Lead time= half-month

Calculate EOQ and total inventory cost of that particular item.

Solution:

EOQ = √2 x 2400 x 4 / 2.40 x 0.12

= 258 units

Total cost of inventory: ₹

Cost of inventory (2400 x 2.40) 5760

Ordering cost (2400/ 258 x 4) 37

Carrying cost (258 x 2.4 x 0.12 x ½) 37

Total cost of inventory 5834

Illustration 5: A firm purchase 2000 units of a particular item per year at an unit cost of Rs
20. The ordering cost is Rs 50 per order and carrying costs are 25%. Determine EOQ and the
minimum total cost including purchase cost.

If a 3% discount is offered by the supplier for purchases in lots of 1000 or more should the
firm accept the offer?

Solution:

(a) EOQ: √2 x 2000 x 50 / 20 x 0.25

= 200 units

(b) Total cost:

Cost of inventory: (2000 x 20) 40000

Ordering cost: (2000/200 x 50) 500

Carrying cost: (200 x 5 x ½) 500

Total 41000

(c) If the order size is of 1000 units

Cost of inventory 40000

Ordering cost: (2000/1000 x 50) 100

Carrying cost: (1000 x 5 x ½) 2500

Total cost 42600

Less: discount (42600 x 0.03) 1278

Total cost after discount 41322

So, the firm must accept the offer.

Sums:

1. Good Luck Company estimates its carrying costs at 15% and its ordering costs is Rs 9
per unit. The estimated annual requirement is 38000 units at a price of Rs 4 per unit.
What is the most economical number of units to order and how often will an order
needs to be placed? (Ans: EOQ- 1068)

2. The P K company has been buying a given item in lots of 1200 units which is a six
months’ supply, the cost per unit is Rs 12, order cost is Rs 8 per order and the
carrying cost is 25%. You are required to calculate the savings per year by buying in
economical lot quantities.

3. The following information relating to inventory in WTS ltd is made available to you.
Annual demand: 480 units, Price per unit: ₹4, Carrying cost: 40 paisa per unit, Cost
per order: ₹ 5 per order. Determine (i) EOQ (ii) No of orders per year (iii) Time
between two consecutive orders.

4. A firm purchase 96000 kgs of a particular item per year at a unit cost of Rs 20 per kg.
The ordering cost is Rs 1000 per order and carrying costs are 15%. Determine EOQ
and the minimum total cost including purchase cost.

Should the company accept an offer of 2% discount by the supplier, if he wants to

supply the annual requirement in 4 equal quarterly instalments?
RECEIVABLE MANAGEMENT

The term receivable is defined as “debt owed to the concern by customers arising from sale of
goods or services in the ordinary course of business.” Receivables are also one of the major
parts of the current assets of the business concerns. It arises only due to credit sales to
customers, hence, it is also known as Account Receivables or Bills Receivables.

Management of account receivable is defined as the process of making decision resulting to

the investment of funds in these assets which will result in maximizing the overall return on
the investment of the firm.

The objective of receivable management is to promote sales and profit until that point is
reached where the return on investment in further funding receivables is less than the cost of
funds raised to finance that additional credit.

• Costs in Receivables Management

Management of accounts receivables is not cost free. The costs associated with the extension
of credit and accounts receivables are identified as follows:
A. Collection Cost
B. Capital Cost
C. Administrative Cost
D. Default Cost
Collection Cost
This cost incurred in collecting the receivables from the customers to whom credit sales have
been made. It may include staff salaries, records, stationery, and expenses involved in
collecting information about prospective customers.

Capital Cost
This is the cost on the use of additional capital to support credit sales which alternatively
could have been employed elsewhere. It could be financed by shareholders fund or from short
term borrowings.

Administrative Cost
This is an additional administrative cost for maintaining account receivable in the form of
salaries to the staff kept for maintaining accounting records relating to customers, cost of
investigation etc.

Default Cost
Default costs are the over dues that cannot be recovered. Business concern may not be able to
recover the over dues because of the inability of the customers. They are referred as Bad
debts and have to be written off because they cannot be collected.

• Benefits of receivables management

- Increased Sales: Providing goods or services on credit expands sales by retaining old
customers and attraction of prospective customers.
- Market share increases: when the firm is able to retain old customers and attract new
customers automatically market share will be increased to the extent of new sales.
- Increase in profits: increased sales lead to increase in profit because it needs to produce
more products with a given fixed cost and sale of products with a given sales network, in both
the cases, cost per unit comes down and profit will be increased.

• Credit Policy Variables

Receivables size of the business concern depends upon various factors. Some of the
important
Factors are as follows:

1. Sales Level
Sales level is one of the important factors which determines the size of receivable of the firm.
If the firm wants to increase the sales level, they have to liberalize their credit policy and
terms and conditions. When the firms maintain more sales, there will be a possibility of large
size of receivable.

2. Credit Policy
Credit policy is the determination of credit standards and analysis. It may vary from firm to
firm or even some times product to product in the same industry. Liberal credit policy leads
to increase the sales volume and also increases the size of receivable. Stringent credit policy
reduces the size of the receivable.

3. Credit Terms
Credit terms specify the repayment terms required of credit receivables, depend upon the
credit terms, size of the receivables may increase or decrease. Hence, credit term is one of the
factors which affects the size of receivable.

4. Credit Period
It is the time for which trade credit is extended to customer in the case of credit sales.
Normally it is expressed in terms of ‘Net days’.

5. Cash Discount
Cash discount is the incentive to the customers to make early payment of the due date. A
special discount will be provided to the customer for his payment before the due date.

6. Management of Receivable
It is also one of the factors which affects the size of receivable in the firm. When the
management involves systematic approaches to the receivable, the firm can reduce the size of
receivable.

• Types of Credit Policies

A firm’s credit policy comprises its credit standards, credit period, cash discounts and
collection procedures. The credit policy may be lenient or stringent (tight). Basically there are
three types of credit policies:

1 .TIGHT OR RESTRICTIVE
2. LIBERAL OR NON RESTRICTIVE
3. MODERATE

1. TIGHT OR RESTRICTIVE POLICY-

Firms following this policy are very selective in extending credit. They sell on credit, only to
those customers who had proved credit worthiness and are financially sound.

Advantages of Tight of Restrictive Credit Policy:

✓ Minimize cost.
✓ Minimize chances of bad debts.
✓ Higher sales in long run.
✓ Higher profit in long run.
✓ Do not pose the serious problem of liquidity.

Disadvantages of Tight or Restrictive Credit Policy:

✓ Restrict Sales.
✓ Restrict Profit Margin.

2. LIBERAL OR NON RESTRICTIVE POLICY-

A liberal credit policy means your company extends favorable terms to buyers who make
purchases on accounts or through short-term financing. Offering discounts for early payments
or allowing lengthy repayment periods with no penalty are examples of liberal credit terms.
Having a liberal policy may attract new customers and more business, but it can also impact
your cash flow.

Following are major outcomes of liberal policy-

Attract Customers

Liberal credit policies make it easier for customers to buy from you, which increases your
customer base and revenue. When customers want to purchase products or supplies, but don't
have cash, you either offer them access to credit or miss out on the business opportunity. The
lower your rates, and the longer you give your credit buyers to repay the debt, the more
advantageous it is for them to purchase from you as opposed to competitors.

More Sales

Buyers are also more likely to purchase larger quantities more often when you have favorable
credit. It makes more sense for your consumers or business buyers to stock up on products if
they like your current prices and credit terms, and believe prices will go higher. Plus, if your
terms are much more favorable than those offered by competitors, you may capture business
in other product or service categories over time as buyers shift away from previous providers.

Poor Cash Flow

A potential disadvantage is that liberal credit policies often lead to lower turnover ratios on
your accounts receivable. This means that the typical time frame between a purchase and
payment is longer than with more aggressive credit practices. Delays in cash collection from
account holders reduces your near-term cash flow. This limits your ability to invest money in
new equipment and inventory, or to pay off debt and expenses. In fact, when you sell
products or supplies on account, you send inventory out of your business without increasing
cash. Until you collect cash, you don't have the resources to replenish your inventory or to
pay bills. If you are a service provider, such as a doctor or graphic artist, you invest time and
resources in delivering your services, but have to wait on the cash.

Bad Debt

The worst-case scenario with liberal credit is bad debt. The more lenient you are with
debtors, the higher the ratio of those who will take advantage of you. At some point, you have
to write off uncollected debt as bad debt. In addition to not collecting the cash, you also have
lost the inventory or work time performing service, and you lower your revenue at the time
you write off the bad debt.

3. Moderate Policy: Moderate policy is a balance between the two policies i.e. restricted and
relaxed. It assumes characteristics of the both the policies. To strike a balance, moderate
policy assumes risk which is lower than restricted and higher than conservative. In
profitability front also, it lies between the two.

The biggest benefit of this policy is that it has reasonable assurance of smooth operation of
working operating capital cycle with moderate profitability.