Liquidity

Decisions
 Liquidity and
Liquidity Management

Liquidity is the ability of

Liquidity management is
the company to satisfy its
the ability of the company
short-term obligations
to generate cash when and
using assets that are
where needed.
readily converted into cash.
 Liquidity
Management

Pulls on liquidity are

Drags on liquidity are forces that decisions that result in paying
delay the collection of cash, such cash too soon, such as paying
as slow payments by customers trade credit early or a bank
and obsolete inventory. increasing a line of credit.
Sources of
liquidity
• Primary sources of liquidity
• Ready cash balances (cash and cash
equivalents)
• Short-term funds (short-term
financing, such as trade credit and
bank loans)
• Cash flow management (for example,
getting customers’ payments
deposited quickly)
• Secondary sources of liquidity
• Selling assets
• Issue of debentures
Working Capital Management

• The management of the short-term investment and financing of a

company.
• The amount of Capital that a Business has available to meet the day-to-
day cash requirements of its operations.
• The difference between resources in cash or readily convertible into
cash (Current Assets) and organizational commitments for which cash
will soon be required (Current Liabilities).

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 Basis on Concept Basis of time or Need
Classificatio
n of
Working Gross Working
Capital
Net Working
Capital
Permanent
Working Capital
Temporary
Working Capital

Capital
Seasonal Special
Concepts of • Gross Working Capital Concept
• Total of Current Assets
Working • Net Working Capital Concept
Capital • The difference between current assets
and current liabilities
• Zero Working Capital Concept
• (Inventory + Receivables) - Payables
Permanent working capital

The hard-core working capital.

Minimum level of investment in the current

assets that is always carried by the business
to carry out minimum level of its activities.
Temporary
working capital
• Part of working capital, which is required
by a business over and above permanent
working capital.
• Variable working capital.
Normal Firm Growth Firm
Importance of Working Capital
Regular Supply of Raw Materials

Full Utilization of Fixed Assets

Cash Discount

Increase in Credit Rating

Exploitation of Favorable Market conditions

Facility in Obtaining Bank Loans

Increase in Efficiency of Management

 Adverse
effect on Idle Funds
profitability

Disadvantage
of Excessive Unnecessary
Working Purchases
Capital

Leads to Defective
overall Credit
inefficiency Policy
Disadvantage of Inadequate Working Capital

Difficulty in Availability of Raw-Material

Full Utilization of Fixed Assets not Possible

Difficulty in the Maintenance of Machinery

Decrease in Credit Rating

Non Utilization of Favorable Opportunities

Decrease in Sales

Difficulty in the Distribution of Dividends

Decrease in the Efficiency of Management

Operating Cycle

Receivables Cash

Finished Raw-
goods Material

Work-in-
process
Operating Cycle
Receivables Cash If the length of
the operating
cycle is long, firm
require high
Finished Raw- working capital,
goods Material
if it is short, firm
requires low
Work-in- working capital.
process
 Market and
demand Cash
conditions

Nature of Determinants Inventory

Business of Working
Capital (JIT & EOQ)
(Restaurant)

Debtors
Short-term
(appropri
financing
ate credit
options
policy)
 Percentage of Sales Method

Methods of Cash Forecasting Method

Estimating
Working Operating Cycle Method

Capital
Requiremen Projected Balance Sheet Method

t Regression Analysis Method

Percentage Working capital is calculated based

of Sales on the previous year assuming that

there is a stable relationship
between sales and working capital.
Method
 Example – 1
The following information has been provided by a company for the year ended 31-03-2020.

Liabilities ₹ Assets ₹
Equity Share Capital 200000 Fixed Assets 300000
8% Debentures 100000 Inventories 100000
Reserves and Surplus 50000 Sundry Debtors 70000
Long-term loans 50000 Cash and Bank 10000
Sundry Creditors 80000
480000 480000

Sales for the year ended 31-03-2020 amounted to ₹1000000 and it is estimated that the same will amount to
₹1200000 for the year 2020-21.
You are required to estimate working capital requirement for the year 2020-21 assuming a linear relationship
between sales and working capital.
Example – 2
The following information has been provided by ABC company for the year ended 31-03-2020.

Particulars ₹ Additional Info.

Fixed Assets a. It is estimated that sales will increase by 25% next year
b. Max. amount of OD that can be availed will be only
Land and Buildings 1250000
₹600000
Plant and Machinery 750000 c. There will be no increase in the liability for tax due to
Current Assets increase in sales
Stock 2000000 d. Period of credit allowed to customers and stock
turnover will remain unchanged
Debtors 750000
e. Period of credit allowed by creditors and that for bills
Cash and Bank 500000 payable will remain the same
Less: Current Liabilities f. There will be no increase in the amount of cash and
Creditors 850000 bank balance
Bank OD 550000
Compute the additional working capital required by the
Bills Payable 400000 company for the year ending 31-03-2021.
Cash Forecasting Method

Working capital is estimated

based on the forecasting of
cash receipts and payments
during a future period.
Example – 3
XYZ Ltd., is to start production on 1st Jan 2020. The prime cost of a unit is expected to be ₹40 out of which ₹16 is
for materials and ₹24 for labor. In addition, variable expenses per unit are expected to be ₹8 and fixed expenses
per month ₹30000. Payment for materials is to be made in the month following the purchases. One-third of
sales will be for cash and the rest credit for settlement in the following month. Expenses are payable in the
month in which they are incurred. The selling price is fixed at ₹80 per unit.
The number of units manufactured and sold are expected to be as under.

Particulars Units
January 900
February 1200
March 1800
April 2100
May 2100
June 2400

Draw up a statement showing requirement of working capital from month to month.

Operating Cycle Method

Operating Cycle starts with

purchase of raw-materials and
ends with realization of cash
from the sale of finished
goods.
Estimation
of Working
Capital ESTIMATION OF ESTIMATION OF
CURRENT ASSETS CURRENT LIABILITIES
 Raw-material Inventory

Work-in-progress Inventory
Estimation of Finished Goods Inventory
Current Assets
Debtors

Cash or Bank Balances

Raw-material Inventory
Work-in-progress Inventory

Average WIP Period

Budgeted Production (in Units) x Cost of WIP per unit x ---------------------------------
365 days
Finished Goods Inventory

Budgeted Production (in Units) x Cost of Production per unit x

Average Finished Goods Holding Period

----------------------------------------------------
365 days
Debtors

Budgeted Credit Sales (in Units) x Cost of Sales per unit x

Average Debtors Collection Period

----------------------------------------------------
365 days
Estimation of Current Liabilities
• Direct Wages
• Overheads
Direct Wages

Budgeted production (in Units) x Direct labour Cost per unit x

Average Lag in payment of wages

----------------------------------------------------
365 days
Overheads

Budgeted Production (in Units) x Overhead Cost per unit x

Average Lag in payment of overheads

----------------------------------------------------
365 days
Operating Cycle Method
Working Capital Required

= Cost of goods sold x (operating cycle / 360 days) + Desired

Cash Balance
 Details of ABC Ltd. for the year 2020-21, are
given below.

Cost of goods sold – ₹50,00,000

Operating cycle – 75 days
Example – 4 Minimum desired level of cash balance – 10% of
cost of goods sold

You are required to calculate the expected

working capital requirement by assuming 360
days in a year.
Projected Balance
Sheet Method
 Prepare an estimate of working capital
requirement from the following information of
Example – 5 a trading concern.
a. Project annual sales – 100000 units
b. Selling price - ₹8 per unit
c. % of net profit on sales – 25%
d. Average credit period allowed to customers – 8 weeks
e. Average credit period allowed by suppliers – 4 weeks
f. Average stock holding in terms of sales requirement –
12 weeks
g. Allow 10% for contingencies.
 Example – 6
From the following details you are required to make an assessment of the amount of
working capital required of AB ltd.
Particulars Average Period of Credit Estimate for the First Year
Purchase of material 6 weeks 2600000
Wages 1 ½ weeks 1950000
Overheads:
Rent 6 months 100000
Salaries 1 month 800000
Other OH 2 months 750000
Sales (Cash) - 200000
Sales (Credit) 2 months 6000000
Average amount of stock and - 400000
WIP
Average amount of undrawn - 300000
profit

It is assumed that all expenses and incomes were made at even rate for the year.
Example - 7
XYZ Ltd sells its product on a gross profit of 20% of sales. The following information is extracted
from it’s annul accounts for the year ending 31 Dec. 2020.
• Sales (at 3 months credit) 40,00,000
• Raw material 12,00,000
• Wages (15 days in arrears) 9,60,000
• Manufacturing and general expenses (one month in arrear) 12,00,000
• Admn. Expenses (one month in arrear) 4,80,000
• Sales promotion expenses (Payable half yearly in advance) 2,00,000
The company enjoys one month’s credit from the suppliers of raw material and maintains two
months stock of raw material, and one and half month of finished goods. Cash balance is
maintained at ₹1,00,000 as a precautionary balance. Assuming 10% margin, find out the working
capital requirement of XYZ Ltd.
Regression Analysis Method

• Its estimates the WC based on statistical technique by predicting the unknown

value of a dependent variable from the known value of an independent variable.
• It establishes the relationship between sales and WC.
y = a + bx
• y = Working capital (dependent variable)
• a = Intercept of the least variable
• b = Slope of the regression line
• x = Sales (independent variable)
• For determining the values ‘a’ and ‘b’ two normal equations are used which
can be solved simultaneously.
• ⅀y = na + b⅀x
• ⅀xy = a⅀x + b⅀x2
Example – 8
The sales and working capital figures of Suresh Ltd. For a period of 5 years are
given as follows.

Year Sales (₹ In Lakhs) Working Capital (₹ In Lakhs)

2015-16 60 12
2016-17 80 15
2017-18 120 20
2018-19 130 21
2019-20 160 23

You are required to forecast the working capital requirements of the company for
the year 2020-21 taking the estimated sales of ₹200 lakhs by using Regression
Analysis Method.
 Operating Cycle

Gross Operating Cycle = RMCP + WIPCP + FGCP + RCP

RMCP = Raw Material Conversion Period
WIPCP = Work-in-process Conversion Period
FGCP = Finished Goods Conversion Period
RCP = Receivables Conversion Period

Net Operating Cycle = Gross Operating Period – Payable Deferral Period

The period of time a firm takes to pay back their

suppliers or creditors for their material purchases.
Formulas

Length of Raw-Material Period = Avg. Stock of Raw-material/Raw-material consumption per day

Length of Work-in-progress Period = Avg. Stock of WIP/Total cost of production per day

Length of Finished goods Period = Avg. Stock of Finished Goods / Total cost of goods sold per day

Period of Credit allowed to Debtors = Avg. total of Debtors outstanding /Sales per day
 From the following information extracted from the books of
ABC Ltd., compute the operating cycle in days.
Period Covered – 365 days
Average period of credit allowed by suppliers – 16 days
Average total of debtors outstanding – ₹480
Raw-material consumption – ₹4400
Total production cost – ₹10000

Example – 9 Total cost of goods sold for the year – ₹10500

Sales – ₹16000
Value of average stock maintained:
Raw-materials – 320
Work-in-progress – 350
Finished Goods – 260
Cash and Marketable Securities
Management
Cash Management
• Cash is the money which a business concern can disburse
immediately without any restriction.
• Management of cash consists of cash inflow and outflows, cash flow
within the concern and cash balance held by the concern etc.
Cash Motives
• Transaction motive
• Precautionary motive
• Speculative motive
• Compensating motive
• to compensate banks for providing certain services or loans
Cash Management Techniques
• Speedy Cash Collections
• Prompt Payment by Customers
• Early Conversion of Payments into Cash
• Concentration Banking
• Slowing Disbursement
• Avoiding the early payment of cash
• Centralised disbursement system
Cash Management Models
• Baumol model
• to determine the minimum cost amount of cash conversion and the lost
opportunity cost.
• Miller-Orr model
• to determine the optimum cash balance level which minimises the cost of
management of cash.
• Orgler’s model
• Integration of cash management with production and other aspects of the
business concern. Multiple linear programming is used to determine the
optimal cash management.
Receivable Management
Receivable Management
• 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.
• Objective
• 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.
Example-10

ABC Ltd. decides to liberalise credit to increase its sales. The liberalized
credit policy will bring additional sales of ₹300000. The variable costs
will be 60% of sales and there will be 10% risk for non-payment and 5%
collection costs. Will the company benefit from the new credit policy?
Example – 11
From the following information, calculate average collection period.
Total Sales - ₹100000
Cash Sales - ₹20000
Sales Returns - ₹7000
Debtors at the end of the year - ₹11000
Bills Receivables - ₹4000
Creditors - ₹15000
Inventory Management
Tools and Techniques

Selecting a proper Determination of

Determination of Determination of
system of ordering Economic Order ABC Analysis
Stock Levels Safety Stocks
for inventory Quantity (EOQ)

Classification and
Inventory Turnover Aging Schedule of Preparation of
VED Analysis Codification of
Ratio Inventories Inventory Reports
Inventories

Perpetual
Lead Time JIT Control System
Inventory System
Determination of Stock Levels
• Minimum Level
• Re-order level – (Normal consumption x Normal Re-order period)
• Re-Order Level
• Maximum Consumption x Maximum Re-order period
• Maximum Level
• Reorder level + Re-ordering quantity – (Minimum Consumption x Min. Re-
ordering period)
• Danger Level
• Average Consumption x Minimum re-order period for emergency purchase
• Average Stock Level
• Minimum Stock Level + ½ of re-order quantity
Example – 12
From the following information, calculate minimum stock
level, maximum stock level and re-ordering level.
• Maximum Consumption 200 units per day
• Minimum Consumption 150 units per day
• Normal Consumption 160 units per day
• Re-order period 10-15 days
• Re-order quantity 1600 units
• Normal re-order period 12 days
Example – 13
From the following information calculate
(1) Re-order level
(2) Maximum level
(3) Minimum level
(4) Average level
Normal usage: 100 units per week
Maximum usage: 150 units per week
Minimum usage: 50 units per week
Re-order quantity (EOQ) 500: units
Log in time: 5 to 7 weeks
 Economic Order Quantity (EOQ)
• The level of inventory at which the total cost of inventory comprising
ordering cost and carrying cost.
• Determining an optimum level involves two types of cost such as
ordering cost and carrying cost.
• The EOQ is that inventory level that minimizes the total of ordering of
carrying cost.
Formula
Example - 14
A firm buys casting equipment from outside suppliers @₹30 per unit.
Total annual needs are 800 units. You have with you following further
data:

a) Annual return on investment, 10%

b) Rent, insurance, taxes per unit per year, ₹1
c) Cost of placing an order, ₹100
d) How will you determine the economic order quantity?
Solution
Annual consumption (A) = 800 units
Ordering cost (B) = ₹100.
Annual consumption = 800 unit x ₹30 per unit = ₹24,000
Total interest cost = 10% of 24000 = ₹2400
Interest cost per unit = 2400 / 800 = ₹3
Inventory Carrying cost (C) = Interest cost + Rent, insurance, Taxes cost = 3 + 1 = ₹4 per unit

EOQ = = 200 Units

Example - 15
The annual demand for a product is 6400 units. The unit cost is ₹6 and
inventory carrying cost per unit per annum is 25% of the average
inventory cost. If the cost of procurement is ₹75, determine:
a) Economic Order Quantity
b) Number of order per annum
c) Time between two consecutive orders
Practice Problems
Example – 1
Prepare an estimate of working capital requirement from the following
information of a trading concern.
a. Project annual sales 100000 units
b. Selling price ₹8 per unit
c. % of net profit on sales 25%
d. Average credit period allowed to customers 8 weeks
e. Average credit period allowed by suppliers 4 weeks
f. Average stock holding in terms of sales requirement 12 weeks
g. Allow 10% for contingencies.
Solution
Example – 2
Solution
Example – 3

Note: Selling, administration and financial expenses have not been included in valuation of closing stock.
Solution
Example-4 (Receivable Management)

A Company’s collection period pattern is as follows:

• 10% of sales in the same month
• 20% of sales in the second month
• 40% of sales in the third month
• 30% of sales in the fourth month
The sales of the company for the first three quarters of the year are as follows:
Month Quarter – 1 Quarter – 2 Quarter – 3
Jan 15000 7500 22500
Feb 15000 15000 15000
Third 15000 22500 7500

Working days 90 90 90

You are required to calculate the average age of receivables and comment upon the results.
Solution
Sources
• http://www.universityofcalicut.info/SDE/VISem_BBA_working_capital
_mgmnt.pdf