WORKING CAPITAL

MANAGEMENT

PREPARED BY:-
PRIYANKA GOHIL
In business two types of financial management is
made.

(1) Long-term financial management

(2) Short-term financial management
 ASSETS

FIXED ASSETS CURRENT ASSETS

TANGIBLE (land, INTANGIBLE

Building, plant) (goodwill, Patent)
 FIXED ASSETS are those assets which are permanent
in nature and are held to be used in creating income and
wealth. They are not ordinarily for sale.
 CURRENT ASSETS are those assets which can be
easily liquidated and encashed at a short notice usually
within a year. Ex. Debtors, short-term investments,
cash and bank balances etc.
 LIABILITIES are economic obligation that legally
binds a company to settle a debt.
 Long term liabilities are those which are repayable over
a period greater than the accounting period.
Ex. Debentures, term loans etc.
 Short- term liabilities or current liabilities have to be
paid within the accounting period.
Ex. Creditors, bills payable, outstanding expenses etc.
Constituents/components of current assets and current liabilities:-
PART A: CURRENT ASSETS
 Inventories

-Raw materials and components

-work-in-process
-Finished Goods
-others
 Trade Debtors

 Short term loans and Advances

 Cash and Bank Balances

 Short-term Investments

 Bills Receivables
PART B: CURRENT LIABILITIES
 Sundry creditors

 Trade Advances

 Borrowings (short-term)

-Commercial Banks
-Others
 Tax Provision

 Outstanding expenses

 Bills Payable
WORKING CAPITAL
 Working capital is defined as the excess of current
assets over current liabilities.
 Working capital is also known as circulating capital,
fluctuating capital and revolving capital. The magnitude
and composition keep on changing continuously in the
course of business.
CONCEPTS OF WORKING CAPITAL
GROSS WORKING CAPITAL:-
Gross working capital is the total of all current assets.

NET WORKING CAPITAL:_

Net working capital is the difference between current
assets and current liabilities.
OBJECTIVE OF WORKING CAPITAL
MANAGEMENT

 The basic objective of working capital management is to

maintain the smooth functioning of the normal business
operations of a firm.
 A trade-off between liquidity and profitability is required
for the smooth running of the company.
OPERATING CYCLE
Operating cycle include three phases:
 Acquisition of resources- procuring raw materials,
labour, fuel, etc.
 Manufacture of the product- conversion of raw material
into inventory.
 Sale of the product- conversion of sales into cash or
credit in which case the firm has accounts receivable.
 The length of the operating cycle is the sum
total of:
 Raw Material storage period
 Conversion period
 Finished goods storage period
 Average collection period
This total is referred to as Gross operating cycle. From
this, the firm has to make payables which are the
Average Payment Period. Subtracting payables deferrals
from GOC, we get Net operating cycle or the cash
conversion cycle.
 ACCOUNTS
CASH
RECEIVABLES

FINISHED RAWMATERIAL
GOODS INVENTORY

WORK-IN-
PROCESS
PERMANENT AND TEMPORARY WORKING
CAPITAL
PERMANENT WORKING CAPITAL
 Permanent working capital represents the assets required on
continuing basis over the entire year, will generally be
financed from long-term debt and equity.
 Tandon committee has referred to this type of working
capital as “Core Current Assets”. Core Current Assets are
those required by the firm to ensure the continuity of
operations which represents the minimum levels of various
items of current assets viz. stock of raw materials, stock of
work-in-process, stock of finished goods, debtors balances,
cash and bank etc. This minimum level is called the
permanent or fixed working capital.
TEMPORARY WORKING CAPITAL:-
 The firm’s working capital requirements fluctuate
depending upon the cyclicality and seasonality of
product demands. This is referred to as the variable or
fluctuating or temporary working capital.
 A firm will finance its seasonal and current fluctuations
in business operations through short term debt
financing.
 EX. In peak seasons, more raw materials to be
purchased, more manufacturing expenses to be incurred,
more funds will be locked in debtors balances etc. In
such times excess requirement of working capital would
be financed from short-term financing sources.
DETERMINANTS OF WORKING CAPITAL
NATURE OF BUSINESS:-
 Working capital requirements are basically influenced by the nature of business.
 If we look at the Balance sheet of any trading organisation, we find major part of
the resources are deployed on current assets, particularly stock-in-trade. Trading
organisation invest little on fixed assets and are have a large stock of finished
goods, accounts receivable (arising out of credit sales) and accounts payables (due
to credit purchases).
 Whereas in case of a transport organisation major part of funds would be locked up
in fixed assets like motor vehicles, spares and work shed etc. and the working
capital component would be negligible.
 The service organisations or public utilities need lesser working capital than trading
and financial organisations
 On an average, the percentage of current assets to total assets are found to be lowest
in hotels, restaurants and travel agents’ offices (10%-20%) while it is in the range of
20%-30% in electricity generation companies and railways and they are in the range
of 80%-90% in trading companies.
GROWTH AND DIVERSIFICATION OF BUSINESS
 Growth and diversification of business call for larger
volume of working fund. The need for increased
working capital does not follow the growth of business
operations but precedes it. Working capital need is in
fact assessed in advance in reference to the business
plan.
NATURE OF RAW MATERIAL USED

 The nature of raw materials also influences the quantum of

inventory.
 For example: if the raw material is based on the agricultural
produce, the seasonality of production affects the raw
material requirements. Consequently, the percentage of raw
material inventory to total current assets will be very high.
 Some companies may depend on raw materials to be
imported or which may have to be procured from other
places. these companies will therefore hold large quantities
or raw materials so that there are no production hold-ups.
 SALES AND DEMAND
CONDITIONS/BUSINESS CYCLE

 This is another factor which determines the need level.

Barring exceptional cased, there are variations in the
demand for goods/services handled by any organisation.
Economic boom or recession etc., have their influence on
the transactions and consequently on the quantum of
working capital required
 Companies which are growing will have large quantities of
finished good inventory. Sales depend on the demand
conditions which vary depending on the seasonality and
cyclicality of product demand.
 The upswing in the economy, that is, during boom phase, sales rise rapidly
bringing in new accounts receivables. An increase in sales will also
necessitate additional investment in fixed assets aiding production
activities. This will in turn lead to an increases in creditors and accounts
payable. Thus a boom phase has an all-round effect of steady production,
high sales, increased accounts receivables and payables. On the other hand,
 During a slack period, there is depression everywhere. A company with
seasonal sales may follow a policy of steady production and utilize its
production resources to the fullest extent possible. This policy can lead to
accumulation of inventories during off season and disposal during peak
periods.
ACCESSIBILITY TO CREDIT
 Creditworthiness is the precondition for assured
accessibility to credit. Accessibility in banks
depends on the flow of credit i.e. the level of
working capital.
PROCESSING TECHNOLOGY
 The manufacturing cycle comprises the purchase and
use of raw materials and production of finished goods.
 Longer the manufacturing cycle, larger is the firm’s
requirement of working capital. This will also lead to an
extended manufacturing time span and larger tie-up of
funds in inventory. In case the raw material has to go
through several stages during the production process,
the work-in-progress inventory is likely to be higher
than any other item of current assets.
PRODUCTION POLICY
 The quantity of working capital is also determined by the
production policy in force.
 The seasonality of goods demanded and availability
affects the finished goods inventory. A firm can have two
options- either they confine to production only if demand
is there or raw materials are available or they can follow a
steady production policy throughout the year.
 The former is called variable production policy
throughout the year. The former is called variable
production policy and has serious drawbacks like non-
availability of skilled workforce to execute the orders in
time or lack of physical facilities availability like power,
transportation and infrastructure at the right time, etc.
 Following a steady production policy is a better alternative.
 For example, a manufacturer of ceiling fans may maintain a
steady production throughout the year, rather than intensify
the production activity during the peak business season.
Such a production policy may dampen the fluctuations in
working capital requirements.
 But the shortcoming here is that each product has a shelf-life
after which it is not saleable in market. Steps should be
therefore be taken to dispose them off quickly or otherwise
the firm runs into possibilities of they become outdated or
deteriorating in quality which again is a drain on company’s
profits.
CREDIT POLICY
 Credit policy of the business organisation includes to
whom, when and to what extent credit may be allowed.
Amount of money locked up in account receivables has
its impact on working capital.
 The credit terms to be granted to customers depend on
the industry norms. If the industry standard is 50 days
and the firm restricts its credit terms to 25 days, it works
heavily on the company’s sales. On the other hand if the
company follows the industry standard and grants credit
of 50 days, extra efforts are to be put in towards
collection.
 Credit sales result in higher book debts. Higher book debts
mean more working capital. In contrast, if liberal credit
terms are available from suppliers, the working capital
requirement is less.
 In order to ensure that unnecessary funds are not tied up in
debtors, the firm should follow a rationalized credit policy
based on the credit standing of customers and other relevant
factors.
MANUFACTURING CYCLE
 Time span required for conversion of raw materials into
finished goods is a block period. The period in reality
extends a little before and after the work-in-progress.
This cycle determines the need of working capital.
OPERATIONAL EFFICIENCY
 The optimum utilization of resources at minimum costs.
Investment in working capital will be low if a firm
controls its operating costs and utilizes its assets in the
most optimum way.
 Better utilization of resources improves profitability and
helps in reducing the pressure on working capital.
SUPPLY SITUATION
 In easy and stable supply situation, no contingency plan
is necessary and precautionary steps in inventory
investment can be avoided.
 But in case of supply uncertainties, lead time may be
longer necessitating larger basic inventory, higher
carrying cost and working capital need for the purpose.
No aggressive approach can gain foothold in such
situation.
ENVIRONMENT FACTORS
 Political stability in its wake brings in stability in
money market and trading world. Things mostly go
smooth. Risk ventures are possible with enhanced
need for working capital finance. Similarly,
availability of local infrastructural facilities-road,
transport, storage and market etc., influence
business and working capital need as well.
MARKET CONDITION
 The degree of competition prevailing in the market place
has an important bearing on working capital needs. When
competition is keen, a larger inventory of finished goods is
required to promptly serve customers who may not be
inclined to wait because other manufacturers are ready to
meet their needs.
 If the market is strong and competition weak, a firm can
manage with a smaller inventory of finished goods because
customers can be served with some delay. Further, in such a
situation the firm can insist on cash payment and avoid
lock-up of funds in accounts receivable-it can even ask for
advance payment, partial or total.
 ESTIMATION OF WORKING
CAPITAL

Methods for Estimating Working Capital

Requirements,
There are three methods for estimating the working
capital requirements of a firm:
(1) Percentage of sales method
(2) Regression analysis method
(3) Operating cycle method
Method 1: Percentage of sales
method
It is a traditional and simple method of determining
the level of working capital and its components. In
this method, working capital is determined on the
basis of past experience. If, over the years, the
relationship between sales and working capital is
found to be stable, then this relationship may be
taken as a base for determining the working capital
for future.
Ex.The Balance sheet of Bhaskar Ltd. as on 31st March, 2003.

Liabilities Rs. Assets Rs.

Share capital 10,00,000 Land & 3,00,000
Building
Reserve & 8,00,000 Plant & 10,00,000
Surplus Machinery
Term Loans 8,00,000 Inventories 10,00,000
Sundry 6,00,000 Receivables 11,00,000
Creditors
Provision for 3,00,000 Cash and 1,00,000
taxation Bank
35,00,000 35,00,000
The company’ turnover for 2002-2003 was Rs. 60
lakhs. It anticipates a sales turnover of Rs. 90
lakhs in 2003-2004. Estimate the working capital
requirement for 2003-2004.
Item % of sales (Based on 2002-2003 (Actual) 2003-
2002-2003 figures) Rs. 2004(Estimates) Rs.

Sales 100 60,00,000 90,00,000

Current Assets
Inventories 16.67 10,00,000 15,00,000
Receivables 18.33 11,00,000 16,50,000
Cash and Bank 1.67 1,00,000 1,50,000
Total (A) 36.67 22,00,000 33,00,000
Current Liabilities
Sundry creditors 10.00 6,00,000 9,00,000
Provision for 5.00 3,00,000 4,50,000
taxation
Total (B) 15 9,00,000 13,50,000
Working Capital 21.67 13,00,000 19,50,000
(A)-(B)
Method 2: Regression Analysis
Method
It is a useful statistical technique applied for
forecasting working capital requirements. It helps
in making working capital requirement projections
after establishing the average relationship between
sales and working capital and its various
components in the past years. The method of least
squares is used in this regard.
The relationship between Sales (X) and Working
capital (Y) is given by the equation:
Y= a + bx
The value of ‘a’ and ‘b’ are obtained by the
solution of simultaneous linear equations given
below:
Σ y= na + b Σx
Σxy= a Σx+bΣx2
where
a= Fixed Component
b= Variable component
x= Sales
Y= Inventory
n= Number of observations
Ex. The sales and current assets figures (Rs. in Lakhs) for
Dinesh Ltd. for a period of five years are given below:

Year Sales Current Assets

1999 320 220

2000 440 270

2001 520 315

2002 570 435

2003 690 450

Estimate the working capital requirement for the
year 2007, if the anticipated sales is Rs. 870 lakhs.
Year Sales (X) Current XY X2
Assets (Y)

1999 320 220 70,400 1,02,400

2000 440 270 1,18,800 1,93,600

2001 520 315 1,63,800 2,70,400

2002 570 435 2,47,950 3,24,900

2003 690 450 3,10,500 4,76,100

N=5 Σx=2540 Σy=1690 Σxy=9,11,4 Σx2=13,67,

50 400
Σ y= na + b Σx
1690=5a+2540 b ___ (1)
Σxy= a Σx+bΣx2
9,11,450=2540a+13,67,400 b ___ (2)
Solving equations (1) and (2), we get
a= -12.52
b= 0.69
The relationship between sales and current assets
can now be expressed as follows:
Y= a + bx
Where x= Sales
Y= Current assets
Y= -12.52 + 0.69X
When sales = Rs. 870 lakhs
Working Capital Y= -12.52 + (0.69) (870)

= -12.52+ 600.3
=Rs. 587.78 lakhs
Method 3: Operating Cycle Method- The
following methods are used in operating
cycle approach:
ESTIMATION OF CURREENT ASSETS:
 Raw material Inventory: The investment in raw material
inventory is estimated as:
(Budgeted production (units)* cost of raw material per unit*
Average inventory holding period (months or days)/(12
months or 365 days)
 Work-in-progress Inventory : ((Budgeted production
(units)*Estimated WIP cost per unit*Average time span of
WIP inventory months or (days) )/12 months or 365 days)
 Finished Goods inventory: (Budgeted production
units)* cost of goods produced per unit excluding
depreciation*finished goods holding period (months
or days )/(12 months or 365 days)
 Debtors: (Budgeted credit sales (units)* cost of sales
per unit excluding depreciation * finished goods
holding period (months or days)/12 months or 365
days)
 Cash and Bank balances: Apart from the wc needs for
financing inventories and debtors, firms should also
have some minimum cash balances with them. This
amount will depend on the firm’s attitude towards risk,
access to borrowing sources, past experience
ESTIMATION OF CURRENT LIABILITIES:
 Trade Creditors: (Budgeted yearly production
(units)*raw material cost per unit* credit period allowed
by creditors (months or days)/(12 months/365 days)
 Direct wages: (Budgeted yearly production units)
*Direct labour cost per unit* Average time-lag in
payment of wages months or days))/12 months /365
days
 Overheads: (Budgeted yearly production (units)
overhead cost per unit* Average time-lag in payment of
overheads (months or days)/12 months/365 days)
Ex.The Board of Directors of Ruby Ltd. requests you to prepare a statement
showing the working capital requirements forecast for a level of activity
of 1,56,000 units of production. The following information is available for
your calculation.

(Rs. per unit)

Raw Materials 90

Direct Labour 40

Overheads 75

205

Profit 60

Selling price per unit 265

1) Raw materials are in stock on average one month
2) Materials are in process, on average 2 weeks
3) Finished goods are in stock, on average one month
4) Credit allowed by suppliers – one month
5) Time lag in payment from debtors- 2 months
6) Lag in payment of wages-1.5 weeks
7) Lag in payment of overheads- one month
20% of the output is sold against cash. Cash in hand
and at Bank is expected to be Rs. 60,000. It is to be
assumed 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.
 Working notes
1) Raw Material =1,56,000/52* 4 weeks *Rs. 90 = Rs. 10,80,000

2) Work-in-progress = 1,56,000/52* 2 = 6,000 units

(Rs.)
Raw materials (6000@Rs. 90) 5,40,000

Wages (6,000@ Rs. 40*.0.5) 1,20,000

Overheads (6,000@ Rs. 75* 0.5) 2,25,000
Total 8,85,000
3)Finished goods =1,56,000/52*4*205 =24,60,000

4)Debtors = 1,56,000/52 *8*205*80/100

=39,36,000
5)Creditors =1,56,000/52*4*90 =10,80,000
6)Wages =1,56,000/52*1.5*40=1,80,000
7)Expenses =1,56,000/52*4**75 =9,00,000
Current Assets

Cash in hand and cash at Bank 60,000

Stock in Hand:

Raw Material 10,80,000

Work-in-process 8,85,000

Finished goods 24,60,000 44,25,000

Sundry Debtors 39,36,000
(A) 84,21,000
Current Liabilities

Sundry Creditors 10,80,000

Wages payable 1,80,000
Expenses Payable 9,00,000
(B) 21,60,000
Net Working capital employed 62,61,000
CASH MANAGEMENT
CASH MANAGEMENT CYCLE

CASH
COLLECTION
BUSINESS
OPERATIONS

DEFICIT BORROW
SURPLUS INVEST

INFORMATION AND
CONTROL
CASH
PAYMENTS
Cash management is concerned with,
(a) management of cash flows into and out of the firm,
(b) cash management within the firm and
(c) management of cash balances held by the firm deficit
financing or investing surplus cash.
Classification of cashflows
 Operational cash flows derive from normal trading
operations, in other words cash receipts from sales,
payment for supplies, perhaps interest charges, too.
 Priority cash flows are payments for non-trading cash
payments that must be made to keep the company
afloat, and have priority over other non-operational
payments. These priority items are all cash outflows.
They include interest payments and tax payments.
 Discretionary cash flows are cash payments or receipts
that do not have to be made. Discretionary cash
payments could be deferred if necessary and some
discretionary income could be earned if required. They
include the following:
 (i) Discretionary outflows: Capital expenditures,
payments for acquisitions, the purchase of financial
investments, payout of ordinary dividend and preference
dividend. Some might be more urgent than others.
 (ii) Discretionary inflows: The sale of fixed assets, the
sale of subsidiaries and the sale of financial
investments.
 Financial cash flows arise from variations in long-term
capital. Financial inflows include cash from the issue of
shares, or from new loans. Financial outflows include
the repayment of a long-term loan
 The firm should evolve strategies to manage cash in the
best possible way. These can be broadly summarized as:
 Cash planning: Cash flows should be appropriately
planned to avoid excessive or shortage of cash. Cash
budgets can be prepared to aid this activity.
 Managing cash flows: The flow of cash should be
properly managed. Steps to speed up cash collection
and inflows should be implemented while cash outflows
should be slowed down.
 Optimum cash level: The firm should decide on the
appropriate level of cash balance. Balance should be
struck between excess cash and cash deficient stage.
 Investing surplus cash: The surplus cash should be
properly invested to earn profits. Many investment
avenues to invest surplus cash are available in the
market such as, bank short term deposits, T-Bills, inter
corporate lending etc.
 MOTIVES OF HOLDING CASH
 There are four motives of holding cash. They are:

1) Transaction motive:
 This refers to a firm holding cash to meet its routine
expenses which are incurred in the ordinary course of
business.
 A firm will need finances to meet a plethora of
payments like wages, salaries, rent, selling expenses,
taxes, interests, etc.
 For transaction motive, a firm may invest its cash in
marketable securities. Generally they purchase such
securities whose maturity will coincide with payment
obligations.
2) Precautionary motive:
 This refers to the need to hold cash to meet some
exigencies which cannot be foreseen.
 The money held to meet such unforeseen fluctuations in
cash flows are called precautionary balances.
 Generally, such cash balances are invested in highly
liquid and low risk marketable securities.
3)Speculative motive:
 This relates to holding cash to take advantage of
unexpected changes in business scenario which are not
normal in the usual course of firm’s dealings.
 It may also result in investing in profit-backed
opportunities as the firm comes across.
4) Compensating motive:
 This is yet another motive to hold cash to compensate
banks for providing certain services and loans. Banks
provide a variety of services like cheque collection,
transfer of funds through DD, MT, etc.
Objective of cash Management:
1)Meeting payments schedule:
Ex. If the credit terms are say, 5\10, net 30.
2) Minimize funds committed to cash balances:
 Factors for efficient cash management
 1)Prompt billing and mailing
 2) collection of cheques and remittances of cash
The Baumol model is based on the following
assumptions:
The firm is able to forecast its cash requirements in
an accurate way.
The firm’s pay-outs are uniform over a period of
time.
The opportunity cost of holding cash is known and
does not change with time.
The firm will incur the same transaction cost for all
conversion of securities into cash.
A company will sell securities and realized cash
and this is used to make payments.
As the cash balance comes down and reaches a
point, the Finance Manager replenishes its cash
balance by selling marketable securities available
with it and this pattern continues
C

C
A
S
H
B
A
L.

C/2 AVERAGE

0 T1 T2 T3
TIME
Optimal Cash Balance via Baumol Model
50000000 1002 504 339.3333333 258 210

Z* √ [2cT/k]
C*=
Total Costs

Holding Costs:

Transaction Costs

C*
The Miller - Orr Model

 The Miller-Orr Model provides a formula for

determining the optimum cash balance (Z), the
point at which to sell securities to raise cash
(lower limit L) and when to invest excess cash by
buying securities and lowering cash holdings
(upper limit H).
 The Miller - Orr Model
Dollars in the Cash Account

Upper Limit Buy Securities

H

L
Lower Limit Sell Securities

Days of the Month

Methods of preparing cash budget:
(A) Receipts and Payments Method
(B) Adjusted Earnings Method
(C) Balance sheet Method
(D) Working capital differential method
 Cash Budget
for three months from 1st Jan., 2007 to 31st March 2007.

Particulars January February March Rs.

Rs. Rs.
Opening cash balance
Add: Cash receipts:

(1) Cash sales

(2) Collection from debtors

(3) Receipts from bills receivable

(4) Interest and Dividend

(5) Sale of fixed asset

(6) Receipts from loan,

(7) Debentures etc.
(8) Receipts from shares issued

(9) Others

Total Receipts (a)

Less: Cash Payments:

(1) Cash purchase

(2) Payment of creditors

(3) Wages and salaries
(4) Administrative expenses

(5)Selling expenses

(6) Purchase of Fixed Asset

(7)Repayment of loan

(8) Payment of taxes

Total Payments(b)

Closing Cash Balance (a-b)

Ex. 1 From the following data prepare cash Budget for the period from 1st July to 31st
December 2007 when the opening cash balance is expected to be Rs.. 50,000
Month Sales Purchases Wages Factory Administrativ Selling expenses
expenses e expenses

May 2,00,000 90,000 18,000 12,000 7,000 8,000

June 1,80,000 95,000 20,,000 14,000 8,000 9,000

July 2,10,000 94,000 19,000 10,000 7,000 8,000

Aug. 1,70,000 94,000 15,000 13,000 5,000 8,500

Sept. 1,75,000 85,000 22,000 14,500 6,500 8,600

Oct. 2,20,000 72,000 18,.000 11,000 7,200 9,300

Nov. 2,,12,000 75,000 21,000 9,500 7,500 7,800

Dec. 2,,50,000 65,000 20,000 10,000 7,400 6,500

Additional Information
 Machinery to be purchased for Rs. 60,000 in July will
be payable on delivery.
 Credit period allowed by suppliers is 1 month and the
same credit period is allowed to customers.
 Wages are paid after one week, while Factory,
Administrative and selling expenses are paid after one
month in which they are incurred.
 A sales commission of 2.5% on sales is paid two
months after sales.
 Machinery to be purchased in August for Rs. 1,80,000
is payabless in equal instalments in September and
october.
Ex. 2 Modern Company wishes to arrange overdraft facilities with its bankers during the period April to June 2007 when it
will be manufacturing mostly for stock. Prepare a cash budget for the above period from the following data indicating the
extent of bank overdraft facilities the company will require at the end of each month.

Month Sales Rs. Purchases Rs. Wages Exp. Mfg. Exp.. Office Exp. Selling Rs.
Rs. Rs. Rs.

Feb. 1,80,000 1,24,800 12,000 3,000 2,000 2,000

March 1,92,000 1,44,000 14,000 4,000 1,000 4,000

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

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

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

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

Aug. 1,60,000 300,000 18,000 6,000 3,000 5,000

 Cash on hand as on 1-4-2000 (estimated) Rs.
25,000.
 50% of credit sales are realised in the month
following the sale and the remaining 50% in the
second month. Creditors are paid in the month
following the month purchase.
 Lag in payment of manufacturing expenses ½
month.
 Lag in payment of other expenses 1 month.
Example 3:
 Make out cash budget for October to December from
the following information
(1) Cash and Bank Balance on 1-10-2007 Rs. 10,000
(2) Sales- Actual and Budgeted:
June Rs.30,000 (Actual)
July Rs.32,500 (Actual)
Aug. Rs.35,000 (Actual)
Sept. Rs.37,500 (Estimated)
Oct. Rs.40,000 (Estimated)
Nov. Rs.41,000 (Estimated)
Dec. Rs.44,500 (Estimated)
(3) Purchase – Actual and Budgeted figures
are:
June Rs.18,000 (Actual)
July Rs.20,000 (Actual)
August Rs.24,000 (Actual)
Sept. Rs.22,500 (Estimated)
Oct. Rs.24,000 (Estimated)
Nov. Rs.20,000 (Estimated)
Dec. Rs.25,000 (Estimated)
(4) Wages and other expenses- Actual and
Budgeted:
Wages Expenses
August Rs.24,000 (Actual) 7,500 2,500
Sept. Rs.22,500 (Actual) 7,500 3,000
Oct. Rs.24,000 (Estimated) 9,000 3,000
Nov. Rs.20,000 (Estimated) 9,000 4,000
Dec. Rs.25,000 (Estimated) 10,000 4,000
(5) Special:
Advance Payment of Income Tax Rs.2,500 in November
Purchase of plant of Rs.5,000 on October
(6) Rent Payable
(7) 10% of Purchases and Sales are on cash terms.
(8) Time lag:
Credit sales 2 months
Credit Purchases 1 month
Wages ½ month
Expenses 1/4 month
Inventory Management
Definition of Inventory
Inventories are stock of the product a
company is manufacturing for sale
and components that make up the
product.
Water Tank Analogy for Inventory

Inventory Level
Supply Rate

Inventory Level

Demand Rate
Types of Inventories
Raw materials & purchased parts
-Raw material are those basic inputs that are
converted into finished product through the
manufacturing process. Raw materials inventories
are those units which have been purchased and
stored for future production.
Work-in-Process
-WIPs inventories are semi-manufactured products.
They represent products that need more work
before they become finished product for sale.
Finished goods
-Finished goods inventories are those
completely manufactured products which are
ready for sale.
Types of Inventories (Cont’d)

Replacement parts, tools, & supplies

Goods-in-transit to warehouses or
customers
Types of Inventory

Work in
process

Vendors Raw Work in Finished Customer

Materials process goods
Work in
process
 Two Forms of Demand
 Dependent
 Demand for items used to produce
final products
 Tires stored at a Goodyear plant are
an example of a dependent demand
item
 Independent
 Demand for items used by external
customers
 Cars, appliances, computers, and
houses are examples of independent
demand inventory
Independent vs. Dependent Demand

Independent Demand
(finished goods and spare parts)

A Dependent Demand
(components)

B(4) C(2)

D(2) E(1) D(3) F(2)

Reasons To Hold Inventory

 Meet variations in customer demand:

 Meet unexpected demand
 Smooth seasonal or cyclical demand
 Pricing related:
 Temporary price discounts
 Take advantage of quantity discount
 Reducing ordering costs and time
 Reduce risk of production shortages
Reasons To NOT Hold Inventory

 Material costs
 Ordering costs

 Carrying costs

 Cost of fund tied up in inventory

 Cost of running out of goods

 Inventory covers up problems

Inventory Hides Problems

Bad
Design
Lengthy Poor
Setups Quality
Machine
Inefficient Unreliable
Breakdown
Layout Supplier
To Expose Problems:
Reduce Inventory Levels

Bad
Design
Lengthy Poor
Setups Quality
Machine
Inefficient Unreliable
Breakdown
Layout Supplier
Remove Sources of Problems and
Repeat the Process

Poor
Quality

Lengthy
Setups

Bad
Machine
Design Inefficient Unreliable
Breakdown
Layout Supplier
Inventory Counting Systems
 Periodic System
Physical count of items made at periodic
intervals
 Perpetual Inventory System
System that keeps track
of removals from inventory
continuously, thus
monitoring
current levels of
each item
Inventory Counting Systems (Cont’d)
 Two-Bin System - Two containers of
inventory; reorder when the first is empty
 Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached

214800 232087768
INVENTORY MANAGEMET TECHNIQUES
1) ABC Classification System

Classifying inventory according to some

measure of importance and allocating
control efforts accordingly.
A - very important
B - mod. important
C - least important High
A
Annual
$ value B
of items

Low C
Few Many
Number of Items
 ABC Classification
 Class A
 5 – 15 % of units
 70 – 80 % of value
 Class B
 30 % of units
 15 % of value
 Class C
 50 – 60 % of units
 5 – 10 % of value
ABC Classification: Example
PART UNIT COST ANNUAL USAGE
1 $ 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120
 TOTAL % OF TOTAL % OF TOTAL
PART PART
VALUE UNIT
VALUECOSTQUANTITY
ANNUAL USAGE
% CUMMULATIVE
9 1
$30,600 $ 60
35.9 6.0 90 6.0
8 16,000
2 18.7
350 5.0 40 11.0
2 14,000 16.4 4.0 15.0
3 30 130
1 5,400 6.3 9.0 24.0
4 4
4,800 5.680 6.0 60 30.0
3 5
3,900 4.630 10.0 100 40.0
6 6
3,600 4.220 18.0 180 58.0
5 3,000
7 3.510 13.0 170 71.0
10 2,400 2.8 12.0 83.0
8 320 50
7 1,700 2.0 17.0 100.0
9 510 60
$85,400
10 20 120
 % OF TOTAL % OF TOTAL
CLASS ITEMS VALUE QUANTITY

A 9, 8, 2 71.0 15.0
B 1, 4, 3 16.5 25.0
C 6, 5, 10, 7 12.5 60.0
2) ECONOMIC ORDER QUANTITY (E0Q)

 EOQ refers to the optimal order size that will result

in the lowest ordering and carrying costs for an
item of inventory based on its expected usage.
 EOQ is defined as that level of inventory order that
minimizes the total cost associated with the
inventory management.
 It is that level one unit beyond which is additional
cost to the firm and one unit below may hamper
production process.
The model is based on the
following assumptions;
 Constant or uniform demand
 Constant unit price

 Constant carrying costs

 Constant ordering costs

RE-ORDER POINT
 The reorder point is that inventory level at which an
order should be placed to replenish the inventory.
 To determine the reorder point under certainty, we
should know:
(a) lead time: Lead time is the time normally taken
in replenishing inventory after the order has
been placed.
(b) Average usage
(c) Economic order quantity
Reorder point= Lead*Average usage
 EOQ Inventory Order Cycle
Order qty, Q
Inventory
Level

ave = Q/2

Reorder point, R

0 Lead Lead Time

time time
As Q increases, average Order Order Order Order
inventory level increases, but
number of orders placed Placed Received Placed Received
decreases
 Re-order point= Average usage*Lead time
Pricing of Inventory
 Firstin first out (FIFO)
 Last in first out (LIFO)

 Weighted average method

 Standard price method

 Replacement or current price methods

RECEIVABLE
MANAGEMENT
 Trade credit arise when a firm sells its
products or services on credit and does not receive
cash immediately.
 Trade credit creates accounts receivable or
trade debtors (also referred as book debts) that the
firm is expected to collect in the near future.
 A study has recently concluded that
receivables constitute a third of that receivables
constitute a third of a firm’s current assets.
Objectives
The main objective of having receivables in the
current assets is to promote and encourage sales
which will lead to increase profits.
Costs Associated with Maintaining
Receivables
1) CAPITAL COST:
 A firm offering goods on credit can surely expect
higher sales but some of the firm’s resources remain
blocked in them as there is a time lag between a credit
sale and cash receipt from customers.
 To the extent the moneys are blocked in its books
debts, the firm has to arrange additional funds to meet
its obligations for payments to its suppliers,
employees, etc.
2) COLLECTION COST:
 These are the costs incurred in collecting
receivables.
 They are administrative in nature and these costs
include - additional expenses on the creation and
maintenance of staff, stationery, postage, registers
etc.
3) DELINQUENCY COST:
 This cost arises out of the failure of customers to
meet their obligations when payment on credit sales
becomes due after the expiry of credit period.
 Additional costs in the form of reminders, legal
charges etc. will be incurred.
4) DEFAULT COST:
The firm may not be able to recover its dues
because of its customers’ inability to pay off their
debts.
5) CREDIT POLICY
 The credit policy of a company can be regarded as a
trade off between increased credit sales leading to highe
profits and the cost of having large cash locked up in
receivables.
 The percentage of credit sales to total sales is mostly
influenced by the nature of business and industry norms
 The term credit policy is used to refer to the
combination of three decision variables:
a. Credit standards
b. Credit terms
c. Collection efforts
6) CREDIT STANDARD:
 Credit standards are the criteria which a firm
follows in selecting customers for the purpose of
credit extension.
 The quantitative basis for setting credit
standards are credit rating, references, average
payment period and ratio analysis.
 Professional credit rating agencies help may be
sought to rate a customer’s creditworthiness. After
rating, the customers are rated as ‘excellent’, ‘very
good’, ‘good’, ‘average’, ‘poor’, etc.
 Credit standard can be of two types
(a) Tight credit standard
(b) Loose credit standard
7) CREDIT PERIOD:
 This refers to the time given to customers to pay for
their purchase.
 It is generally expressed in days like 15 days or 30
days.
 Generally, firms give a discount if payments are
made within a said period.
8) CASH DISCOUNTS:
 A cash discount is a reduction in payment offered
to customers to induce them to repay credit obligations
within a specified period of time, which will be less
than the normal credit period.
 It is usually expressed as a percentage of sales. Cash
discount terms indicate the rate of discount and the
period for which it is available.
 In practice, credit terms would include:
(a) the rate of cash discount
(b) the cash discount period
(c) the net credit period- 2/10, net credit 30
 9) COLLECTION PROGRAM:
 The success of a collection program will be
dependent on the collection policy.
 The collection program consists of the
following:
• Monitoring receivables
• Informing customers about the due date for
payment
• Initiating legal action to overdue customers
after sending repeated notices.