WORKING CAPITAL

MANAGEMENT

1
 OUTLINE

• Characteristics of Current Assets

• Factors Influencing Working Capital Requirements

• Level of Current Assets

• Current Assets Financing Policy

• Profit Criterion for Current Assets

• Operating Cycle Analysis

• Cash Requirement for Working Capital

2
Concept of WC
•Balance sheet concept
•Operating cycle concept

Balance sheet concept- two concepts

1. Gross CA
2. Net working capital or net CA
•Net working capital = Current assets (-) Current liabilities
ICAI has endorsed net CA view while suggesting vertical form of B/S

•B/s concept of WC is not meaning full except as indication of firm’s

current solvency in paying creditors
•When firm speaks of shortage of WC, it implies scarcity of cash resources

Management of current assets involves management of various items of

working capital cycle
Cash RM WIP FG Receivables Cash

Operating cycle concept

3
 CHARACTERISTICS OF CURRENT ASSETS
• Short life span
• Swift transformation into other asset forms

Current Assets Cycle

Finished
goods

Accounts Work-in-
receivable process
Wages, salaries,
factory overheads
Raw materials

Cash Suppliers

4
 Working capital
Current assets
Inventories
•Raw materials & components
•Work-in-process
•Finished goods
•Others
Trade debtors
Loans & debtors
Cash & bank balance

Current liabilities
Sundry creditors
Trade advances
Borrowings (short term)
•Commercial banks
•Others
5
 FACTORS INFLUENCING WORKING
CAPITAL REQUIREMENTS

• Nature of Business

• Seasonality of Operations

• Production Policy

• Market Conditions

• Conditions of Supply
6
 Proportions of Current Assets and Fixed Assets
Current Assets Fixed Industries
(%) Assets (T)

10–20 80–90 Hotels and Restaurants

20–30 70–80 Electricity Generation and

Distribution
30–40 60–70 Aluminium, Shipping

40–50 50–60 Iron and Steel, Basic

Industrial Chemicals
50–60 40–50 Tea Plantation
60–70 30–40 Cotton Textiles, Sugar

70–80 20–30 Edible Oils, Tobacco

80–90 10–20 Trading, Construction
7
Carrying Costs and Shortage Costs

8
 WORKING CAPITAL POLICY

Two important issues in working capital policy are:

• What should be the level of investment in current

assets?

• What mix of long-term and short-term financing should

the firm employ to support current assets?

9
 LEVEL OF CURRENT ASSETS
Flexible Restrictive
(Conservative) (Aggressive)
Policy Policy
Liquidity High Low
Inventories Large Small
Debtors High Low

A flexible policy results in fewer production stoppages, ensures

quicker deliveries to customers, and stimulates sales .. but
HIGHER INVESTMENT IN CURRENT ASSETS

A restrictive policy leads to more production stoppages, delayed

deliveries to customers, and lost sales … but
LOWER INVESTMENT IN CURRENT ASSETS
10
CAPITAL REQUIREMENTS
AND THEIR FINANCING
Fluctuating current
asset requirement

Capital
requirements
A

C Permanent current
asset-requirement

Fixed asset
requirement

Time
11
 CURRENT ASSETS FINANCING POLICY
Strategy A
•Long term financing for meeting fixed assets and peak working capital
requirements
•When working capital requirement is less than peak level, surplus is invested in
liquid assets ( cash and marketable securities)
•Increased liquidity at cost of profitability
Strategy B
•Long term financing for meeting fixed assets, permanent working capital and a
portion of fluctuating working capital requirements
•During seasonal upswings short-term financing is used
•During seasonal downswings, surplus is invested in liquid assets
•Less liquidity as compared to Strategy A but results in more profitability
Strategy C
•This is based on matching principle
•Fixed assets and permanent current assets should be supported by long-term
sources of finance whereas fluctuating current assets must be supported by short-
term sources of finance.
•Best option with required liquidity and increased profitability

12
 PROFIT CRITERION FOR
WORKING CAPITAL

• Investment in current assets is easily reversible.

• For reversible investments, the criterion of net profit per

period (which here means residual income) is equivalent

to the criterion of net present value

For working of above see next slide

13
 P = the initial investment in a current asset,
r = the rate of return earned on it,
k= the cost of capital.

The residual income per year = Pr –Pk

Pr = return for the year
Pk = cost of funds for the year

NPV, assuming investment in current asset continues for n years

= –P + Pr (PVIFAk,n) + P(PVIFk,n) (1)

PVIFAk,n = {(1+k)n –1} / (1+k)n k (2)

and PVIFk,n = [1/(1+k)n ] (3)

Putting values from (2) & (3) in (1)

NPV = –P + Pr [{(1+k)n –1}/{k(1+k)n}] + P[1/(1+k)n]
= [Pr – Pk) [{(1+k)n –1}/{k(1+k)n] (4)

Thus criterion of residual income per period may be substituted for the
criterion of net present value in analysing working capital decisions.

14
 OPERATING CYCLE AND CASH CYCLE
Order placed Stock arrives Goods sold Cash received

Inventory period Accounts

receivable period

Accounts
payable period

Firm receives Cash paid for

invoice materials

Operating cycle

Cash cycle
Average inventory
Inventory period =
Average COGS / 365

Average accounts receivable

Accounts receivable period =
Annual sales / 365

Average accounts payable

Average payable period = 15
Average COGS / 365
 ILLUSTRATION
Financial Information for Horizon Limited
Balance Sheet Data
Profit and Loss Beginning of End of
Account Data 20X0 20X0
Sales 800 Inventory 96 102
Cost of goods 720 Accounts receivable 86 90
Sold Accounts payable 56 60

(96 + 102) / 2
Inventory period = = 50.1 days
720 / 365

16
 (86 + 90) / 2
Accounts receivable period = = 40.2 days
800 / 365

(56 + 60) / 2
Accounts payable period = = 29.4 days
720 / 365
 
Operating cycle = 50.1 + 40.2 = 90.3 days
Inventory Accounts
period receivable
period

Cash cycle = 90.3 - 29.4 = 60.9 days

Operating Accounts
cycle payable period

17
 CASH REQUIREMENT FOR
WORKING CAPITAL

Step 1 : Estimate the cash cost of various current assets

required by the firm.

Step 2 : Deduct the spontaneous current liabilities from

the cash cost of current assets

18
Step 1 : Estimate cash cost of various current assets required by the firm.
The cash cost of a current asset is:
•Value of the current asset
•Profit element, if any, included in the value

To illustrate, suppose the value of sundry debtors (receivables) is shown to be

Rs 10 million on the balance sheet. If the profit margin is 25 percent and the
depreciation element in the cost of goods sold corresponding to sundry debtors
is Rs 0.5 million, the cash cost of sundry debtors is obtained as follows:
Value in the balance sheet Rs 10.0 million
Profit margin Rs 2.5 million
Cost of goods sold Rs 7.5 million
Depreciation element Rs 0.5 million
Cash cost of sundry debtors Rs 7.0 million

Step 2 : Deduct spontaneous current liabilities from cash cost of current

assets
A portion of the cash cost of current assets is supported by trade credit and
accruals of wages and expenses, which may be referred to as spontaneous
current liabilities. The balance left after such deduction has to be arranged from
other sources 19
Max Limited sells goods at a profit margin of 25 %, counting depreciation
as part of the cost of manufacture.

Its annual figures are as follows:

Max Limited keeps two months' stock of raw materials and
one month's stock of finished goods.
It wants to maintain a cash balance of Rs 5 million.
Estimate the requirement of working capital on cash cost basis, assuming
a 10 % safety margin.
Ignore work-in-process.
 Sales (Two months credit is given) Rs 240 million
 Material cost (Suppliers give three 72
months credit)
 Wages (Wages are paid one month in 48
arrears)
 Manufacturing expenses outstanding at 4
the end of the year (Cash expenses are
paid one month in arrears)
 Administrative and sales expenses 30
(These are paid as incurred)
20
Requirement of working capital on cash cost basis is worked out below:
A: Current Assets
Item Calculation Amount
Debtors (Total cash cost / 12) 2 = (198  2)/12 33.00
Raw Material stock (Material cost / 12) 2 = (72  2)/12 12.00
Finished goods stock (Cash manufacturing cost / 12)  1 = (168/12) 14.0
Cash balance A predetermined amount 5
A: Current Assets 64.0

B. Current Liabilities
Item Calculation Amount
Sundry Creditors (Material cost / 12) 3 = (72  3)/12 18
Manufacturing expenses One month’s cash manufacturing 4
outstanding expenses
Wages outstanding (Cash manufacturing cost / 12)  1 = 4
(168/12)
B: Current Liabilities 26.0
Working capital (A–B) 38.0
Add 10 % safety margin 3.8
Working capital required 41.8 21
 Rs in million
1
.
Sales 240
Less: Gross profit (25%) 60
Total manufacturing cost 180
Less: (Materials + Wages) = (72+48) 120
Manufacturing expenses 60
2
.
Cash manufacturing expenses (Rs 4 million  12) 48
3
.
Depreciation: (1–(2) 12
4
.
Total cash cost
Total manufacturing cost 180
Less: Depreciation 12
Cash manufacturing cost 168
Add Administration and selling expenses 30

Total cash cost 198

22
Requirement of working capital on cash cost basis is worked out below:
A: Current Assets
Item Calculation Amount
Debtors (Total cash cost / 12) 2 = (198  2)/12 33.00
Raw Material stock (Material cost / 12) 2 = (72  2)/12 12.00
Finished goods stock (Cash manufacturing cost / 12)  1 = (168/12) 14.0
Cash balance A predetermined amount 5
A: Current Assets 64.0

B. Current Liabilities
Item Calculation Amount
Sundry Creditors (Material cost / 12) 3 = (72  3)/12 18
Manufacturing expenses One month’s cash manufacturing 4
outstanding expenses
Wages outstanding (Cash manufacturing cost / 12)  1 = 4
(168/12)
B: Current Liabilities 26.0
Working capital (A–B) 38.0
Add 10 % safety margin 3.8
Working capital required 41.8 23
 SUMMING UP
• Current assets have a short life span and are swiftly
transformed into other asset forms.
• The working capital needs of a firm are influenced by
numerous factors : nature of business, seasonality of
operations, production policy, market conditions, and
supply conditions.
• Determining the optimal level of current assets involves
a tradeoff between carrying costs and shortage costs.
• According to the matching principle, the maturity of the
sources of finance should match the maturity of assets
being financed. 24
• The operating cycle of a firm begins with the acquisition
of raw materials and ends with the collection of
receivables.
• The cash requirement of working capital is calculated by
estimating the cash cost of various current assets
required by the firm and deducting the spontaneous
current liabilities from the cash cost of current assets.

25
CASH AND LIQUIDITY
MANAGEMENT

26
 OUTLINE

• Motives for Holding Cash

• Cash Budgeting
• Long-term Cash Forecasting
• Reports for Control
• Cash Collection and Disbursement
• Optimal Cash Balance
• Investment of Surplus Funds
• Cash Management Models
27
 MOTIVES FOR HOLDING CASH

Three possible motives for holding cash :

• Transaction motive

• Precautionary motive

• Speculative motive

28
 CASH BUDGET
The principal method of cash budgeting is the receipts and disbursements method.
Under this method, the cash forecast shows the timing and magnitude of cash
receipts and disbursements over the forecast period.
Illustration
The following information about Beta Company is given:
• The estimated sales for the period January 20X1 through June 20X1 are as
follows: Rs.100,000 a month from January through March and Rs.120,000 a
month from April through June.
• The sales for November and December of the previous year have been
Rs.100,000 each.
• Cash and credit sales are expected to be 20 percent and 80 percent respectively.
• The receivables from credit sales are expected to be collected as follows: 50
percent after one month and the balance 50 percent after two months.
• Other anticipated receipts are: Rs.5,000 from the sale of a machine in March
and
29
Rs.2000 interest on securities in June.
 CASH BUDGETING

January February March April May June

1. Sales 100,000 100,000 100,000 120,000 120,000 120,000
2. Credit sales 80,000 80,000 80,000 96,000 96,000 96,000
3. Collection of
accounts
receivables 80,000 80,000 80,000 80,000 88,000 96,000
4. Cash sales 20,000 20,000 20,000 24,000 24,000 24,000
5. Receipt from
machine sale 5,000
6. Interest 2,000
Total cash
receipts 100,000 100,000 105,000 104,000 112,000 122,000
(3+4+5+6)

30
 CASH BUDGETING
Relevant information for cash payments
 Beta Company plans to purchase materials worth Rs.40,000 in January and
February and materials worth Rs.48,000 each month from March through
June. Payments will be made a month after the purchase
 A payment of Rs.40000 will be made in January for purchases in the previous
December
 Miscellaneous cash purchases of Rs.2000 per month are planned from January
through June
 Wage payments will be Rs.15000 per month, January through June
 Payments for manufacturing expenses will be Rs.20,000 per month and for
general administrative expenses will be Rs.10,000 per month, January through
June
 Dividend payment of Rs.20,000 and a tax payment of Rs.20,000 are planned for
June
 A machine will be bought in cash for Rs. 50,000 in March
31
 CASH BUDGETING
January February March April May June
1. Material
purchases 40,000 40,000 48,000 48,000 48,000 48,000
2. Credit material
purchases 40,000 40,000 48,000 48,000 48,000 48,000
3. Payment of 40,000 40,000 40,000 48,000 48,000 48,000
accounts
payable
4. Miscellaneous 2,000 2,000 2,000 2,000 2,000 2,000
cash purchases
5. Wages 15,000 15,000 15,000 15,000 15,000 15,000
6. Manufacturing
exp. 20,000 20,000 20,000 20,000 20,000 20,000
7. General admn.
expense 10,000 10,000 10,000 10,000 10,000 10,000
8. Dividend - - - - - 20,000
9. Tax - - - - - 20,000
10. Capital - - 50,000 - - -
expenditure
Total payments 87,000 87,000 137,000 95,000 95,000 135,000
(3+4+5+6+7+8+9+10)
32
 CASH BUDGETING
Assuming that the cash balance on 1st January is Rs.22,000 and the minimum cash balance
required by the firm is Rs.20,000, the summary cash forecast is given below.
January February March April May June
1. Opening cash
balance Rs.22,000
2. Receipts 100,000 100,000 105,000 104,000 112,000 122,000
3. Payments 87,000 87,000 137,000 95,000 95,000 135,000
4. Net cash flow (2 –3) 13,000 13,000 (32,000) 9,000 17,000 (13,000)
5. Cumulative net
cash flow 13,000 26,000 (6,000) 3,000 20,000 7,000
6. Opening cash
balance +
Cumulative net flow (1 + 5) 35,000 48,000 16,000 25,000 42,000 29,000
7. Minimum cash balance
required 20,000 20,000 20,000 20,000 20,000 20,000
8. Surplus or deficit in 15,000 28,000 (4,000) 5,000 22,000 9,000
relation to the minimum
cash balance required
(6 – 7)
33
 LONG-TERM CASH FORECASTING
Adjusted net income method is generally used for long-term cash
forecasting.
20 X 0 20 X 1 20 X 2 20 X 3 20 X 4
Source
Net income after taxes
Non-cash charges
(Depreciation, amortisation,
etc.)
Increase in borrowings
Sale of equity shares
Miscellaneous
Uses
Capital expenditures
Increase in current assets
Repayment of borrowings
Dividend payment
Miscellaneous
Surplus/ Deficit
Opening cash balance
Closing cash balance
34
 REPORTS FOR CONTROL

• Daily Cash Report

Opening balance
Receipts
Payments
Closing balance
• Daily Treasury Report
Changes in cash, Marketable security, Debtors and
creditors
• Monthly Cash Report
Actual cash receipts and payments
Actuals compared with budgeted figures and variances
calculated 35
 FLOAT

• The cash balance shown by a firm on its books is called

the book, or ledger balance whereas the balance shown
in its bank account is called the available, or collected,
balance. The difference between the available balance
and the ledger balance is referred to as float.

36
 CASH COLLECTION AND DISBURSEMENT
Float = Firm’s available balance (-) Firm’s book balance
• Disbursement float –Created by Cheques issued by firm
= Firm’s available balance – Firm's book balance
= Rs 40 lacs – Rs 30 lacs ( as cheque of Rs 10 lac issued to a
party and not presented by party and debited by bank)
•Collection float – Lead by cheques received by firm
= Rs 50 lac ( – ) Rs 65 lac
= (–) Rs 15 lac ( cheque received and but so far not credited to It
•Net float = disbursement float + collection float.
Positive net float implies that available balance > book balance and
vice-versa
•Since what matters is the available balance, as a financial manager
you should try to maximise the net float. Thus it means that you
should strive to speed up collections and delay disbursements. 37
Speeding Up Collections
The collection time comprises following
•Customer mails cheque
Mailing time
•Company receives cheque
Processing
•Company deposits cheque
Availability delay
•Cash available

To speed up collection firms use the following

•Customers advised to send cheques to local lock boxes
•Customers advised to send cheques to local offices i.e
concentration banking
• Electronic transfer of funds
Delaying Payments
•Make payment when due and not early
•Centralise payments
•Arrange with suppliers to match payments with receipts
• 38
 OPTIMAL CASH BALANCE

Total costs

Opportunity cost

Costs

•
Transaction cost

C* Cash balance

39
 INVESTMENT OF SURPLUS FUNDS
It may be useful to divide a firm’s short-term investment portfolio into three
segments:
• Ready cash segment
• To augument cash resources of co to meet unanticipated operational needs
• This segment needs to be highly liquid
• Controllable cash segment
•To meet known outflows like taxes, dividend, interest payments, repayment
of borrowings etc
•Investment in this segment must match in size and maturity with known
outflows
• Free cash segment
•Besides the above which represents surplus funds with co which has been
invested in short term instruments to generate income without much concern
for liquidity or maturity

40
 CRITERIA FOR EVALUATING
INVESTMENT OPTIONS

• Safety

• Liquidity

• Yield

• Maturity

41
 INVESTMENT OPTIONS
• Fixed deposits with banks
• Treasury bills
• Mutual fund schemes
• Money market schemes
• Commercial paper
• Certificates of deposit
• Inter-corporate deposits

42
 Strategies for managing surplus cash
•Do nothing – enhances liquidity at expense of profits
•Make adhoc investments – makes some contribution but not
optimal contribution
•Ride the Yield Curve – Buy long term securities if interest expected
to fall and vice versa
•Evidence suggests futile to do better than average
•Develop Guidelines reflecting view of mgt towards risk and return
like
•Do-not speculate on interest changes
•Hold marketable securities till maturity
•Do-not put more than a % in particular types of securities
•Minimize transaction costs

43
 Strategies for managing surplus cash (contd)
•Utilize control limits
•Some models define upper and lower limits and when cash reaches upper limit it
advocates that a certain amount should be invested in marketable securities and when
cash reaches lower limit a certain amount of marketable securities should be liquidated
• Models do not specify which securities to be bought or sold
•Manage with a portfolio objective
•Define the efficient frontier i.e a portfolio where there is no alternative with
• same expected return and a lower standard deviation, or
•same stan­dard deviation and a higher expected return, or
•higher expected return and a lower standard deviation.
•Select optimal portfolio which enables investor to achieve highest attainable level of
utility
• Portfolio theory does not provide guidance how funds should be switched from cash
account to marketable securities
•Follow a mechanical procedure
• Use models that provide rules for switching funds between cash account and marketable
securities
•Success of use of model depends on how well the behavior of cash flow of firm conforms
to assumptions of model
44
•In practice mechanical procedures are of limited use
 SUMMING UP
• There are three possible motives for holding cash, viz., transaction
motive, precautionary motive, and speculative motive.
• The principal method of short-term cash forecasting is the receipts
and payment method.
• The method generally used for long-term forecasting is the adjusted
income method.
• To enhance the efficiency of cash management collections and
disbursements must be properly monitored.
• A variety of options are there for investing surplus funds available
for short periods.
• William Baumol has proposed a model which applies the EOQ
concept to determine the cash conversion size.
• Expanding on the Baumol model, Miller and Orr consider a
stochastic generating process for periodic changes in cash balance.
45
CREDIT MANAGEMENT

46
 OUTLINE

• Terms of Payment

• Credit Policy Variables

• Credit Evaluation

• Credit Granting Decision

• Control of Accounts Receivable

• Credit Management in India

47
 TERMS OF PAYMENT
• Cash Terms
• Open Account i.e credit sales
•Credit period
•Cash discount
•Billing
• Consignment
• Bill of Exchange
• Letter of Credit

48
 CREDIT POLICY VARIABLES

The important dimensions of a firm’s credit policy are:

• Credit standards

• Credit period

• Cash discount

• Collection effort

49
 CREDIT STANDARDS

Liberal Stiff

• Sales Higher Lower

• Bad debt loss Higher Lower

• Investment Larger Smaller

in receivables

• Collection costs Higher Lower

50
IMPACT ON RESIDUAL INCOME
OF RELAXATION

RI = [S(1 – V) - Sbn] (1 – t ) – k  I

where RI = change in residual income

S = increase in sales
V = ratio of variable costs to sales
bn = bad debt loss ratio on new sales
t = corporate tax rate
I = increase in receivables investment
k = Post tax cost of capital

51
 EXAMPLE
Pioneer Limited is considering relaxing credit standards.
S ( change in sales)= Rs.15 lacs
bn = bad debt loss ratio on new sales = 0.10,
V = ratio of variable costs to sales = 0.80
ACP = Average collection period =40 days,
k = Post tax cost of capital =0.10
t = corporate tax rate =0.4
RI = [15 (1 – 0.80) – 15x 0.10] (1 – 0.4)
15
– 0.10 x x 40 x 0.80
360
= Rs.76,666

52
 CREDIT PERIOD

Longer Shorter

• Sales Higher Lower

• Investment in Larger Smaller

receivables

• Bad debts Higher Lower

53
IMPACT ON RESIDUAL
INCOME OF LONGER CREDIT PERIOD

RI = [S(1 – V) - Sbn] (1 – t ) – k  I

54
 INCREASE IN RECEIVABLES
INVESTMENT

S0 S
I = (ACPn – ACP0) + V (ACPn)
360 360

where: I = increase in receivables investment

ACPn = new average collection period (after lengthening
the credit period)
ACP0 = old average collection period
V = ratio of variable cost to sales
S = increase in sales
55
 EXAMPLE

Zenith Limited is considering extending its credit period

from 30 to 60 days.
S = Rs.50 million, S = Rs.5 million, V = 0.85,
bn = 0.08, k = 0.10, t = 0.40

RI = [5,000,000 x 0.15 – 5,000,000 x 0.08] (0.6)

50,000,000 5,000,000
– 0.10 (60 – 30) x + 0.85 x 60 x 360
360

= [750,000 – 400,000] (0.6) – 0.10 [4,166,667 + 708,333]

= – 277,500
56
 LIBERALISING THE CASH
DISCOUNT POLICY

RI = [S(1 – V) - DIS] (1 – t ) + k  I

DIS = increase in discount cost

57
DECREASING THE RIGOUR
OF COLLECTION PROGRAMME

RI = [S(1 – V) - BD] (1 – t ) – k  I

BD = increase in bed debt

58
 ERRORS IN CREDIT EVALUATION

In assessing credit risks, two types of errors occur :

Type I error A good customer is misclassified as a

poor credit risk

Type II error A bad customer is misclassified as a good

credit risk

59
 TRADITIONAL CREDIT ANALYSIS
Five Cs of Credit

Character : The willingness of the customer to honour his obligations

Capacity : The operating cash flows of the customer

Capital : The financial reserves of the customer

Collateral : The security offered by the customer

Conditions : The general economic conditions that affect the customer

To get information on above following may be used:

Financial statements of firms
Bank references
Experience of firm
60
 NUMERICAL CREDIT RATING INDEX

Factor Factor Rating Factor

weight 5 4 3 2 1 score

Past payment 0.30  1.20

Net profit margin 0.20  0.80
Current ratio 0.20  0.60
Debt-equity ratio 0.10  0.40
Return on equity 0.20  1.00

Rating index 4.00

61
 CONTROL OF ACCOUNTS
RECEIVABLES

• Days’ Sales Outstanding

= Accounts receivable / average daily sales

• Ageing Schedule
= Age group (in days) % of receivables

• Collection Matrix

62
 COLLECTION MATRIX

Percentage of Receivables January February March April May June

Collected During the Sales Sales Sales Sales Sales Sales

Month of sales 13 14 15 12 10 9
First following month 42 35 40 40 36 35
Second following month 33 40 21 24 26 26
Third following month 12 11 24 19 24 25
Fourth following month - - - 5 4 5

63
 SUMMING UP
• The important dimensions of a firm’s credit policy are : credit
standards, credit period, cash discount, and collection effort
• In general, liberal credit standards tend to push sales up by
attracting more customers. However, this is accompanied by a
higher incidence of bad debt loss, a larger investment in
receivables, and a higher cost of collection. Stiff credit standards
have opposite effects.
• Broad approaches are used for credit evaluation are traditional
credit analysis and numerical credit scoring.
• The traditional approach to credit analysis calls for assessing a
prospective customer in terms of the five Cs of credit, viz.
character, capacity, capital, collateral, and conditions.
• Three methods are commonly employed for monitoring accounts
receivable : days’ sales outstanding, ageing schedule, and
collection matrix.
64
INVENTORY MANAGEMENT

65
 OUTLINE

• Need for inventories

• Order quantity – EOQ model

• Order point

• Pricing of raw materials and valuation of stocks

• Monitoring and control of inventories

• Criteria for judging the inventory system

• Inventory management in practice

66
 NEED FOR INVENTORIES

• ‘Process or movement’ inventories are required because

it takes time to complete a process/operation and to

move products from one stage to another.

• Organisation inventories are maintained to widen the

latitude in planning and scheduling successive

operations.

67
BEHAVIOUR OF INVENTORY
RELATED COSTS

Costs
Total costs

Carrying costs

Ordering costs
Quantity ordered

68
 ORDER QUANTITY – EOQ MODEL

Total cost of ordering and carrying of inventory =

TC = (U/Q)× F + (Q/2) × P × C

Total cost is minimized when

2FU
Q=
PC
Q = economic order quantity
F = cost per order
U = annual usage/demand
F = cost per order
C = percent carrying cost
P = price per unit
69
 ORDER POINT

• If the usage rate of materials and the lead time for

procurement are known with certainty, then the
ordering level would simply be:

Lead time in days

x Average daily usage
for procurement

• When the usage rate and lead time are likely to vary, the
reorder level should be:

Normal consumption + Safety stock

70
 Other Factors considered in practice

Anticipated scarcity

Expected price change

Obsolescence risk

Government restrictions

Marketing considerations

71
 PRICING OF RAW MATERIALS

The important methods of pricing inventories used in

production are:

FIFO (First in First Out) Method The material which is

issued first is priced on the basis of the cost of material
received earliest, so on and so forth.

Weighted Average Cost Method Material issued are

priced at the weighted average cost of materials in stocks

72
 TREATMENT OF FIXED MANUFACTURING COSTS

Direct Costing Fixed manufacturing overhead costs are

treated as period costs and not product costs. Hence, they
are not reflected in inventory valuation and charged directly to
income statement.

Absorption Costing Fixed manufacturing costs are treated

as product (or inventoriable) costs. Hence valuation of inventory
reflects an allocated share of fixed manufacturing overhead costs

Valuation of WIP and FG under Direct costing is lower and higher

in absorbtion costing

When inventory level increases, reported profit under direct costing

is lower than under absorption costing

73
MONITORING AND CONTROL OF INVENTORIES

ABC Analysis
Just-in -Time Inventory Control

CRITERIA FOR JUGGING INVENTORY SYSTEM

Comprehensibility
Adoptability
Timeliness

74
 (ABC ANALYSIS )
GRAPH OF CUMULATIVE PERCENTAGE OF ITEMS AND CUMULATIVE
PERCENTAGE OF USAGE
Cumulative usage of
items (percentage)

100

80

60

40

20 A B C
Cumulative
25 40 60 80 100 percentage of items

75
 JUST-IN-TIME (JIT) INVENTORY CONTROL

• The JIT control system implies that the firm should

maintain a minimal level of inventory and rely on
suppliers to provide parts and components ‘just-in-time’
to meet its assembly requirements.

• This may be contrasted with the traditional inventory

management system which calls for maintaining a
healthy level of safety stock to provide a reasonable
protection against uncertainties of consumption and
supply – the traditional system may be referred to as a
“just-in-case” system.

76
PROGRAMME OF INVENTORY
MONITORING AND CONTROL
• Exercise of vigilance against imbalances of raw materials and
work-in-process which tends to limit the utility of stocks.
• Vigorous efforts to expedite completion of unfinished production
jobs to get them into saleable condition.
• Active disposal of goods that are surplus, obsolete, or unusable.
• Shortening of the production cycle.
• Change in design to maximise the use of standard parts and
components which are available off-the-shelf.
• Strict adherence to production schedules.
• Special pricing to dispose of unusually slow-moving items.
• Evening out of seasonal sales fluctuations to the extent possible.
77
 INVENTORY MANAGEMENT IN INDIA

• The most commonly used tools of inventory management

in India are ABC analysis, FSN (fast moving, slow
moving, and nonmoving analysis), and inventory
turnover analysis.
• Inventory levels are high on following pretexts
Purchase Executive penalized for stock outs
Lengthy procedure for imports
It pays to hold inventory due to inflation
Lack of standardization leads to large variety of stores
• Inventory management can be improved by effective
computerisation, review of classifications, improved coordination,
development of long-term relationships, and disposal of
obsolete/surplus inventories, and adoption of challenging norms.
78
 SUMMING UP
• Inventories represent a very significant proportion of total assets.
• A distinction may be drawn between ‘process or movement’
inventories and ‘organisation’ inventories.
• According to EOQ model, the optimal order quantity is:
2 FU
Q=
PC
• The reorder point may be determined by the following formula:
Reorder Point = S (L) +  S R(L)
• FIFO method and weighted average cost method are commonly used
for pricing inventories.
• ABC analysis advocates a selective approach to inventory control.
• The most commonly used tools of inventory management in India
are: ABC analysis, FSN analysis and inventory turnover analysis.
79
WORKING CAPITAL FINANCING

80
 OUTLINE
• Accruals
• Trade credit
• Working capital advance by commercial banks
• Regulation of bank finance
• Public deposits
• Inter-corporate deposits
• Short-term loans from financial institutions
• Rights debentures for working capital
• Commercial paper
• Factoring
81
 ACCRUALS

• The major accrual items are wages and provisions.

• Accruals vary with the level of activity of the firm.

• While accruals are a welcome source of financing, they

are typically not amenable to control by management.

82
 TRADE CREDIT
• Trade credit represents the credit extended by the
suppliers of goods and services. It is a spontaneous
source of finance.
• The confidence of suppliers is the key to securing trade
credit.
• The cost of trade credit is:

Discount % 360
x
100 – Discount % Credit period – Discount period

83
 WORKING CAPITAL ADVANCE BY
COMMERCIAL BANKS
• Application and processing
• Sanction, terms and conditions
• Forms of bank finance
• Cash credits/Overdrafts
• Loans
• Purchase/Discount of Bills
• Letter of credit
• Security
• Hypothecation
• Pledge
• Margin amount
84
MAXIMUM PERMISSIBLE
BANK FINANCE (MPBF)

Tandon Committee had suggested three methods for

determining the MPBF
Method 1 : MPBF = 0.75 (CA – CL)
Method 2 : MPBF = 0.75 (CA) – CL
Method 3 : MPBF = 0.75 (CA – CCA) – CL
CA = current assets
CL = non-banking current liabilities
CCA = core current assets
85
 PUBLIC DEPOSITS

• These are unsecured deposits from the public.

• Public deposits cannot exceed 25 percent of share capital

and free reserves.

86
 INTER-CORPORATE DEPOSITS

• A deposit made by one company with another, normally

for a period up to six months is referred to as an inter-
corporate deposit.

• Inter-corporate deposits are typically unsecured.

• Inter-corporate deposits are usually of three types: call

deposits, three-month deposits, and six-month deposits.

87
SHORT-TERM LOANS
FROM FINANCIAL INSTITUTIONS

• Insurance companies provide short-term loans to

manufacturing companies with an excellent track record.

• Such loans are unsecured and given for a period of 1

year, renewable for two consecutive years.

• A company, to be eligible for such loans, should satisfy

certain conditions relating to dividend payment, debt-
equity ratio, current ratio, and interest cover ratio.

88
RIGHTS DEBENTURES
FOR WORKING CAPITAL

• A company can issue “rights” debentures to its shareholders

to augment the long-term source for working capital

requirements

• The key guidelines applicable to “rights” debentures relate to

the quantum of such issues and the debt : equity ratio

89
 COMMERCIAL PAPER
• Commercial paper represents short-term unsecured
promissory notes issued by firms which enjoy a fairly
high credit rating.

• Commercial paper is either directly placed with

investors or sold through dealers

• The effective pre-tax cost of commercial paper is:

Face value – Net amount realised 360

Net amount realised Maturity period
90
 FACTORING

A factor is a financial institution which offers

services relating to management and financing of
debt arising from credit sales.

91
 ADVANCES IN INVENTORY
MANAGEMENT

• Materials requirements planning

• Just-in-time system

• Electronic data interchange and bar coding

92
 MATERIALS REQUIREMENTS PLANNING

Materials requirements planning (MRP) is essentially a

computerised planning and control system for the effective
management of production and inventory in a manufacturing
environment. The objective of the MRP system is to order just the
right parts in the right quantity at the right time.

An MRP system is driven by the master schedule which

specifies the “end items” or output of the production function. The
master schedule is “exploded” into purchase orders for raw
materials and shop orders for scheduling the factory. In the process
of parts explosion, adjustments have to be made for parts which are
already on hand.
93
 JUST-IN-TIME (JIT) SYSTEM

Unlike conventional systems where inventory is treated as

an asset, the JIT system views inventory as the “root of all
evil”. In traditional organisations a high level of inventory
is held to cover up the problem areas related to quality,
vendor delivery, machine breakdowns.etc. The JIT
approach is the opposite. The inventory level is lowered to
expose the real organizational problems and attempts are
made to solve the problems at their points of incipience.

94
 ELECTRONIC DATA INTERCHANGE
The EDI is a direct computer-to-computer exchange of
information normally provided on standard business
documents such as purchase orders, invoices, etc. With
such a direct communication linkage with a supplier, a
buyer can obtain price quotes, determine availability of
items in a supplier’s stock, transmit a purchase order,
obtain follow-up information, provide the supplier
information about changes in purchase requirements
caused by schedule revisions, obtain service information,
and send letters and memos – all instantly. Without the
EDI, such business transactions depend on the exchange of
paper documents.

95
 BAR CODING
Bar coding identifies products using machine-readable codes.
The bar code technology allows faster and more accurate data
entry, better document tracking, and reduced inventory cost.
Bar codes are printed patterns of lines, spaces, and numerals
we see on packaged goods. Bar codes are useful to the
manufacturer, as they are to the retailer. The purpose is to
keep an accurate, current count of inventory items as they
move past a scanner. With the help of bar coding, companies
have decreased inventory investment by 10 to 15 percent,
reduced clerical errors to almost zero, and increased the ability
to give accurate inventory counts and product information to
concerned managers.
96