Dr.P.S.

Ravindra
Professor of Management
UNIT-V
WORKING CAPITAL & WORKING CAPITAL MANAGEMENT
In financial management, two important decisions are very vital and crucial. They are
decision regarding fixed assets/fixed capital and decision regarding working capital/current
assets. Both are important and a firm always analyzes their effect to final impact upon
profitability and risk.
Capital

Fixed Capital Working Capital

Fixed capital is required for establishment of a business, whereas working capital is
required to utilize fixed assets. Working capital plays a key role in a business enterprise just as
the role of heart in the human body. It acts as grease to run the wheels of fixed assets. Its
effective provision can ensure the success of a business while its inefficient management can
lead not only to loss but also to the ultimate downfall of what otherwise might be considered as a
promising concern. In other words, the efficiency of a business enterprise depends largely on its
ability to manage its working capital. Working Capital, therefore, is one of the important facet
of a firm’s overall Financial Management.
MEANING OF WORKING CAPITAL
Working Capital refers to short-term funds that are needed for meeting day to day
requirement of the business concern. For example, payment to creditors, salary paid to workers,
purchase of raw materials etc., normally it consists of recurring in nature. It can be easily
converted into cash. Hence, it is also known as short-term capital.
Definitions
According to the definition of Mead, Baker and Malott, “Working Capital means
Current Assets”.
According to the definition of J.S.Mill, “The sum of the current asset is the working
capital of a business”.
According to the definition of Weston and Brigham, “Working Capital refers to a
firm’s investment in short-term assets, cash, short-term securities, accounts receivables and
inventories”.
IMPORTANCE OF WORKING CAPITAL:
Working capital is the life blood and nerve center of business. Working capital is very
essential to maintain smooth running of a business. No business can run successfully without an
adequate amount of working capital. The main advantages or importance of working capital are
as follows:
1. Strengthen The Solvency:
Working capital helps to operate the business smoothly without any financial problem for
making the payment of short-term liabilities. Purchase of raw materials and payment of salary,
wages and overhead can be made without any delay. Adequate working capital helps in
maintaining solvency of the business by providing uninterrupted flow of production.
2. Enhance Goodwill:
Sufficient working capital enables a business concern to make prompt payments and
hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current
liabilities and operating expenses are paid on time.
 Dr.P.S.Ravindra
Professor of Management
3. Easy Obtaining Loan:
A firm having adequate working capital, high solvency and good credit rating can arrange
loans from banks and financial institutions in easy and favorable terms.
4. Regular Supply of Raw Material:
Quick payment of credit purchase of raw materials ensures the regular supply of raw
materials fro suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply
of raw materials and continuous production.
5. Smooth Business Operation:
Working capital is really a life blood of any business organization which maintains the
firm in well condition. Any day to day financial requirement can be met without any shortage of
fund. All expenses and current liabilities are paid on time.
6. Ability to Face Crisis:
Adequate working capital enables a firm to face business crisis in emergencies such as
depression.
CONCEPT OF WORKING CAPITAL:
Working capital can be classified or understood with the help of the following two important
Concepts
Gross Working Capital:
Gross Working Capital is the general concept which determines the working capital concept.
Thus, the gross working capital is the capital invested in total current assets of the business
concern.
Gross Working Capital is simply called as the total current assets of the concern.
Gross Working Capital = Current Assets
Net Working Capital:
Net Working Capital is the specific concept, which, considers both current assets and
current liability of the concern.
Net Working Capital is the excess of current assets over the current liability of the
concern during a particular period.
If the current assets exceed the current liabilities it is said to be positive working capital; it is
reverse, it is said to be Negative working capital.
Net Working Capital = Current Assets – Current Liabilities
COMPONENT OF WORKING CAPITAL:
Working capital constitutes various current assets and current liabilities. This can be
illustrated by the following chart.
Working Capital

Current Assets Current Liabilities

Cash in Hand Bills Payable

Current Assets Current Liability Sundry Creditors
Cash at Bank Outstanding Expenses
Bills Receivable Bank Overdraft
Sundry Debtors Dividend Payable
Short-term Loans Advances Provision for Tax
Inventories
Prepaid Expenses
Accrued Income
 Dr.P.S.Ravindra
Professor of Management
NEEDS OF WORKING CAPITAL
Working Capital is an essential part of the business concern. Every business concern
must maintain certain amount of Working Capital for their day-to-day requirements and meet the
short-term obligations.
Working Capital is needed for the following purposes.
1. Purchase of raw materials and spares:
The basic part of manufacturing process is, raw materials. It should purchase frequently
according to the needs of the business concern. Hence, every business concern maintains certain
amount as Working Capital to purchase raw materials, components, spares, etc.
2. Payment of wages and salary:
The next part of Working Capital is payment of wages and salaries to labour and
employees. Periodical payment facilities make employees perfect in their work. So a business
concern maintains adequate the amount of working capital to make the payment of wages and
salaries.
3. Day-to-day expenses:
A business concern has to meet various expenditures regarding the operations at daily
basis like fuel, power, office expenses, etc.
4. Provide credit obligations:
A business concern responsible to provide credit facilities to the customer and meet the
short-term obligation. So the concern must provide adequate Working Capital.
TYPES OF WORKING CAPITAL:
Working Capital may be classified into three important types on the basis of time.
Permanent Working Capital
It is also known as Fixed Working Capital. It is the capital; the business concern must
maintain certain amount of capital at minimum level at all times. The level of Permanent Capital
depends upon the nature of the business. Permanent or Fixed Working Capital will not change
irrespective of time or volume of sales.

Amount of Working Permanent Working Capital

Capital

Time
Sources of financing Permanent or Fixed Working Capital:
(i) Shares:
The most important source for the permanent or long-term Working Capital is the issue
of equity, preference and deferred shares.
(ii) Debentures:
Another important source for raising the permanent Working Capital is the issue of
debentures, which means a debt where the debenture holder is considered as the creditor of the
company.
(iii) Retained Earnings:
Otherwise called ploughing back of profits. It means the reinvestment by the company’s
surplus earnings in its business.
 Dr.P.S.Ravindra
Professor of Management
(iv) Loans from Financial Institutions:
Financial institutions such as Commercial banks, Life Insurance Corporation of India,
Industrial Finance Corporation of India, State Finance Corporation, Industrial Development
Bank of India, etc., also provide term loans for Working Capital needs.
(v)Public Deposits (Fixed):
These deposits are fixed in nature and are accepted by a business enterprise directly from
the public.
Temporary Working Capital:
It is also known as variable working capital. It is the amount of capital which is required
to meet the Seasonal demands and some special purposes. It can be further classified into
Seasonal Working Capital and Special Working Capital.
The capital required to meet the seasonal needs of the business concern is called as
seasonal Working Capital. The capital required to meet the special exigencies such as launching
of extensive marketing campaigns for conducting research, etc.

Amount of Working Temporary

Capital Working Capital

Fixed
Working Capital

Time
FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS:
Working Capital requirements depends upon various factors. There are no set of rules or
formula to determine the Working Capital needs of the business concern. The following are the
major factors which are determining the Working Capital requirements.
1. Nature of business:
Working Capital of the business concerns largely depend upon the nature of the business.
If the business concerns follow rigid credit policy and sell goods only for cash, they can maintain
lesser amount of Working Capital. A transport company maintains lesser amount of Working
Capital while a construction company maintains larger amount of Working Capital.
2. Production cycle:
Amount of Working Capital depends upon the length of the production cycle. If the
production cycle length is small, they need to maintain lesser amount of Working Capital. If it is
not, they have to maintain large amount of Working Capital.
3. Business cycle:
Business fluctuations lead to cyclical and seasonal changes in the business condition and
it will affect the requirements of the Working Capital. In the booming conditions, the Working
Capital requirement is larger and in the depression condition, requirement of Working Capital
will reduce. Better business results lead to increase the Working Capital requirements.
4. Production policy:
It is also one of the factors which affect the Working Capital requirement of the business
concern. If the company maintains the continues production policy, there is a need of regular
Working Capital. If the production policy of the company depends upon the situation or
 Dr.P.S.Ravindra
Professor of Management
conditions, Working Capital requirement will depend upon the conditions laid down by the
company.
5. Credit policy:
Credit policy of sales and purchase also affect the Working Capital requirements of the
business concern. If the company maintains liberal credit policy to collect the payments from its
customers, they have to maintain more Working Capital. If the company pays the dues on the last
date it will create the cash maintenance in hand and bank.
6. Growth and expansion:
During the growth and expansion of the business concern, Working Capital requirements
are higher, because it needs some additional Working Capital and incurs some extra expenses at
the initial stages.
7. Availability of raw materials:
Major part of the Working Capital requirements are largely depend on the availability of
raw materials. Raw materials are the basic components of the production process. If the raw
material is not readily available, it leads to production stoppage. So, the concern must maintain
adequate raw material; for that purpose, they have to spend some amount of Working Capital.
8. Earning capacity:
If the business concern consists of high level of earning capacity, they can generate more
Working Capital, with the help of cash from operation. Earning capacity is also one of the factors
which determine the Working Capital requirements of the business concern.
9. Seasonal Operations:
It is not always possible to shift the burden of production and sale to slack period. For
example, in case of sugar mill more working capital will be needed at the time of crop and
manufacturing.
10. Credit Availability:
If credit facility is available from banks and suppliers on favourable terms and conditions,
less working capital will be needed. If such facilities are not available more working capital will
be needed to avoid risk.
11. Price level change:
With the increase in price level more and more working capital will be needed for the
same magnitude of current assets. The effect of rising prices will be different for different
enterprises.
12. Circulation of working capital:
Less working capital will be needed with the increase in circulation of working capital
and vice-versa. Circulation means time required to complete one cycle i.e. from cash to material,
from material to work-in-progress, form work-in-progress to finished goods, from finished goods
to accounts receivable and from accounts receivable to cash.
13. Volume of sale:
This is directly indicated with working capital requirement, with the increase in sales
more working capital is needed for finished goods and debtors, its vice versa
is also true.
14. Liquidity and profitability:
There is a negative relationship between liquidity and profitability. When working capital
in relation to sales is increased it will reduce risk and profitability on one side and will increase
liquidity on the other side.
15. Management ability:
Proper co-ordination in production and distribution of goods may reduce the requirement
of working capital, as minimum funds will be invested in absolute inventory, non-recoverable
debts, etc.
 Dr.P.S.Ravindra
Professor of Management
16. External Environment:
With development of financial institutions, means of communication, transport facility,
etc., needs of working capital is reduced because it can be available as and when needed.
OPERATING CYCLE:
The Working Capital requirement of a firm depends, to a great extent upon the operating
cycle of the firm. The operating cycle may be defined as the time duration starting from the
procurement of goods or raw materials and ending with the sales realization. The length and
nature of the operating cycle may differ from one firm to another depending upon the size and
nature of the firm.
In a trading concern, there is a series of activities starting from procurement of goods and
ending with the realization of sales revenue (at the time of sale itself in case of cash sales and at
the time of debtors realization in case of credit sales). Similarly, in case of manufacturing
concern, this series starts from procurement of raw materials and ending with the sale realization
of finish goods (after going through the different stages of production). In the both cases,
however, there is a time gap between the happening of the first event and the happening of the
last event. This time gap is called the operating cycle.
Thus, the operating cycle of a firm consists of the time required for the completion of the
chronological sequence of some or all of the following:
i) Procurement of raw materials and services
ii) Conversion of raw materials into work-in-progress
iii) Conversion of work-in-progress into finish goods
iv) Sale of finished goods (Cash or Credit)
v) Conversion of receivables into cash

Debtors

Sales
Cash

Finished
Raw goods
Materials Work-in-
Progress

Operating Cycle of Manufacturing Firm

Duration of Operating Cycle:

The duration of the operating cycle is equal to the sum of the duration of each of these
stages less the credit period allowed by the suppliers of the firm. In symbols,
O=R+W+F+D–C
Where,
O = Duration of Operating cycle
Raw Material and Storage Stage, (R)
Work in Process Stage, (W)
Finished Goods Stage, (F)
Debtors Collection Stage, (D)
Creditors Payment Period Stage. (C)
 Dr.P.S.Ravindra
Professor of Management
The components of the operating cycle may be calculated as follows:
Average stock of raw materials and stores
R=
Average raw material and stores consumption per day

Average Work – in – Progress Inventory

W=
Average Cost of Production per day

Average Finished Stock Inventory

F=
Average Cost of Goods Sold per day

Average Book Debts

D=
Average Credit Sales per day

Average Trade Creditors

C=
Average Credit Purchases per day

PRINCIPLES OF WORKING CAPITAL FINANCE:

The Financial Manager must keep in mind the following principles of Working Capital
Finance.
1. Principle of Risk Variation:
Risk variation refers to an ability of a firm to maintain sufficient Current Assets to pay
for its obligations. If Working Capital varied in relation to sales, the amount of risk that a firm
assumes is also varied and the opportunity for gain or loss is increased. It means that there is a
definite relationship between the degree of risk and the rate of return.
2. Principle of Equity Position:
The amount of Working Capital invested in each component should be adequately
justified by a firm’s equity position. Every paise contributed in the Working Capital must
contribute the Net Working Capital of the firm.
3. Principle of Cost of Capital:
It emphasizes the different sources of finance and each source has a different cost of
capital. The cost of capital moves inversely with risk. As such additional risk capital results in
the decline in the cost of capital.
4. Principle of Maturity of Payments:
A firm should make every attempt to relate maturities of payments to its flow of internally
created funds. The failure to meet such a match of generation to outside demand would
accentuate the risk.
COMPUTATION (OR ESTIMATION) OF WORKING CAPITAL
Working Capital requirement depends upon number of factors, which are already
discussed in the previous parts. Now the discussion is on how to calculate the Working Capital
needs of the business concern.
No business can be successfully run without an adequate amount of Working Capital. An
estimate of Working Capital Requirement should be made in advance, in order to procure
adequate Working Capital and thereby avoid shortage of it. A large number of factors have to be
considered in estimation, viz., cost of material and operating cycle. The following criteria can be
adopted in its estimation.
 Dr.P.S.Ravindra
Professor of Management
a)Working Capital as a percentage of net sales.
b)Working Capital as a percentage of total assets or fixed assets.
c) Working Capital estimation based on operating cycle.
a) Working Capital as a percentage of Net Sales:
This method is based on the fact that the Working Capital for any business is directly
related and linked to sale volume of the business. The assumption here is that the higher the sales
level; the greater would be the need for Working Capital. As such the Working Capital is solely
dependent on sales forecast, which is expressed as a percentage of expected sales for a particular
period. The steps involved in the estimation of Working Capital are: an estimate of total Current
Assets as percentage of estimated net sales; an estimate of Current Liabilities as percentage of
estimated net sales. The difference between the two represents the Net Working Capital under
this method
b) Working Capital as a percentage of total assets or fixed assets:
Under this method, estimation of Working Capital is based on the fact that the total assets
of the firm consist of fixed assets and Current Assets. The estimation of Working Capital is also
determined as a percentage of fixed assets, even though fixed assets determination is a capital
budgeting decision. But the efficient and optimal way of using the fixed assets solely depends
upon the availability of Working Capital, which in turn makes the Working Capital Requirement
resorting to a percentage of total fixed assets.
c) Working Capital estimation based on operating cycle:
Under this method the Working Capital is estimated on the basis of operating cycle as the
length varies from one industry to another. The components used for calculation of the operating
cycle are Current Assets and Current Liabilities. Current Assets here means cash and bank
balance, inventory and receivables. Current Liabilities represents creditors for purchases and
expenses.
The working capital estimation as per the method of operating cycle, is the most
systematic and logical approach. In this case, the working capital estimation is made on the basis
of analysis of each and every component of the working capital individually. The work sheet for
estimation of working capital requirements under the operation cycle method may be presented
as follows:
Estimation of Working Capital Requirement
(A) Current Assets: Amount Amount
Cash-in-Hand ×××
Inventories:
(i) Stock of Raw materials ×××
(ii) Work-in-Progress:
Material ×××
Wages ×××
Overheads ×××
(iii) Stock of finished goods ××× ×××
Debtors ×××
Total Current Assets/Gross WC ×××
(B) Current Liabilities:
Creditors for Raw materials ×××
Creditors for wages ×××
Creditors for overheads ×××
Total Current Liabilities ×××
(C) Working Capital [A-B] ×××
Add: Safety Margin ×××
Net Working Capital ×××
 Dr.P.S.Ravindra
Professor of Management

WORKING CAPITAL MANAGEMENT

Working Capital is considered as the lifeblood and nerve centre of any business. In the
present day modern industrial world the term Working Capital refers to the short term funds
required for financing the entire duration of the operating cycle of a business known as
“Accounting Year”. It is a trading capital not retained in the business in a particular form for
more than a year. This is used for carrying out the routine or regular business operations
consisting of purchase of raw materials, payment of direct and indirect expenses, carrying out
production, investment in stock, etc. In short it represents the fund by which the day-to-day
business is carried on.
Management of Working Capital is also an important part of financial manager. The main
objective of the Working Capital Management is managing the Current Asset and Current
Liabilities effectively and maintaining adequate amount of both Current Asset and Current
Liabilities. Simply it is called Administration of Current Asset and Current Liabilities of the
business concern.
Management of key components of working capital like cash, inventories and receivables
assumes paramount importance due to the fact the major potion of working capital gets blocked
in these assets.
Meaning of Working Capital Management:
Working capital management is an act of planning, organizing and controlling the
components of working capital like cash, bank balance inventory, receivables, payables,
overdraft and short-term loans.
The management of current assets, current liabilities and inter-relationship between them
is termed as working capital management. “Working capital management is concerned with
problems that arise in attempting to manage the current assets, the current liabilities and the
inter-relationship that exist between them.” In practice, “There is usually a distinction made
between the investment decisions concerning current assets and the financing of working
capital.” From the above, the following two aspects of working capital management emerges:
(1) To determine the magnitude of current assets or “level of working capital” and
(2) To determine the mode of financing or “hedging decisions.”
Definition
According to Smith K.V, “Working capital management is concerned with the problems
that arise in attempting to manage the current asset, current liabilities and the interrelationship
that exist between them”.
SIGNIFICANCE OF WORKING CAPITAL MANAGEMENT
Funds are needed in every business for carrying on day-to-day operations. Working
capital funds are regarded as the life blood of a business firm. A firm can exist and survive
without making profit but cannot survive without working capital funds. If a firm is not earning
profit it may be termed as ‘sick’, but, not having working capital may cause its bankruptcy
working capital in order to survive. The alternatives are not pleasant. Bankruptcy is one
alternative. Being acquired on unfavourable term as another. Thus, each firm must decide how to
balance the amount of working capital it holds, against the risk of failure.”
Working capital has acquired a great significance and sound position in the recent past
for the twin objects of profitability and liquidity. In period of rising capital costs and scare funds,
the working capital is one of the most important areas requiring management review. It is rightly
observed that, “Constant management review is required to maintain appropriate levels in the
various working capital accounts.” Mainly the success of a concern depends upon proper
management of working capital so “working capital management has been looked upon as the
driving seat of financial manager.”
It consumes a great deal of time to increase profitability as well as to maintain proper
liquidity at minimum risk. There are many aspects of working capital management which make
 Dr.P.S.Ravindra
Professor of Management
it an important function of the finance manager. In fact we need to know when to look for
working capital funds, how to use them and how measure, plan and control them.
A study of working capital management is very important foe internal and external
experts. Sales expansion, dividend declaration, plants expansion, new product line, increase in
salaries and wages, rising price level, etc., put added strain on working capital maintenance.
Failure of any enterprise is undoubtedly due to poor management and absence of management
skill.
Importance of working capital management stems from two reasons, viz., (i) A
substantial portion of total investment is invested in current assets, and (ii) level of current assets
and current liabilities will change quickly with the variation in sales. Though fixed assets
investment and long-tem borrowing will also response to the changes in sales, but its response
will be weak.
STRUCTURE OF WORKING CAPITAL MANAGEMENT:
The study of structure of Working Capital Management is the study of the elements of
current assets viz. inventory, cash and bank balances, receivable, and other liquid resources like
short-term or temporary investments. Current liabilities usually comprise bank borrowings, trade
credits, assessed tax and unpaid dividends or any other such things. The following points
mention relating to various elements of working capital deserves:
Structure of Working Capital
Management

Inventory Cash Receivables

Management Management Management

A. INVENTORY MANAGEMENT
Inventory management is concerned with the determination of the optimal level of
investment for each component for each component of inventory and the inventory as a whole,
the efficient use of the components and the operation of an effective control and review
mechanism. The management of inventory requires careful planning so that both the excess and
the scarcity of inventory in relation to the operational requirement of an undertaking may be
avoided. Therefore, it is essential to have a sufficient level of investment in inventories.
Inventory management helps to manage stock in such a manner that there are no
excessive and inadequate levels of inventories and a sufficient inventory is maintained for the
smooth production and sales operation. Inventory includes the following things:
(a) Raw Material:
Raw materials form a major input into the organization. They are required to carry out
production activities uninterruptedly. The quantity or raw materials required will be determined
by the rate of consumption and the time required for replenishing the supplies. The factors like
the availability of raw materials and government regulations, etc too affect the stock of raw
materials.
(b) Work-in-Progress:
The work-in-progress is that state of stocks which are in between raw materials and
finished goods. The raw materials enter the process of manufacture but they are yet to attain a
final shape of finished goods. The quantum of work-in-progress depends upon the time taken in
the manufacturing process. The greater the time taken in manufacturing, the more will be the
amount of work in progress.
 Dr.P.S.Ravindra
Professor of Management

(c) Consumables:
These are the materials which are needed to smoothen the process of production. These
materials do not directly enter production but they act as catalysts, etc. Consumables may be
classified according to their consumption and criticality. Generally, consumable stores do not
create any supply problem and form a small part of production cost. There can be instances
where these materials may account for much value than the raw materials. The fuel oil may form
a substantial part of cost.
(d) Finished goods:
These are the goods which are ready for the consumers. The stock of finished goods
provides a buffer between production and market. The purpose of maintaining inventory is to
ensure proper supply of goods to customers. In some concerns the production is undertaken on
order basis, in these concerns there will not be a need for finished goods. The need for finished
goods inventory will be more when production is undertaken in general without waiting for
specified order.
(e) Spares:
Spares also form a part of inventory. The consumption patters of raw materials,
consumables, finished goods are different from that of spares. The stocking policies of spares
are different from industry to industry. Some industries like transport will require more spares
than the other concerns. The costly spare parts like engines, maintenance spares etc. are not
discarded after use, rather they are kept in ready position for further use. All decisions about
spares are based on the financial cost of inventory on such spares and the costs that may arise
due to their non-availability.
MOTIVES OF INVENTORY MANAGEMENT:
The question of managing inventories arises when the concern holds inventories. Holding
up of inventories involves tying up of the concern’s funds and carrying costs. If it is expensive to
hold inventories, why do concerns hold inventories?
There are three motives for holding inventories.
1) Transaction Motive:
The Company may be required to hold the inventory in order to facilitate the smooth and
uninterrupted production and sale operations. It may not be possible for the company to procure
the raw material whenever necessary. There may be a time lag between the demand for the
material and its supply. Hence it is needed to hold the raw material inventory. Similarly it may
not be possible to produce the goods immediately after they are demanded by the customers.
Hence it is needed to hold the finished goods inventory. They need to hold work in progress may
arise due to production cycle.
2) Precaution Motive:
In addition to the requirement to hold the inventory for routine transactions, the company
may like hold them to guard against risk of unpredictable changes in demand and supply forces.
Eg. The supply of raw material may get delayed due to factors like strike, transport, disruption,
short supply, lengthy processes involved in import of raw material etc. hence the company
should maintain sufficient level of inventory to take care of such situations. Similarly, the
demand for finished goods may suddenly increases (especially in case of seasonal type of
products) and if the company is unable to supply them, it may mean gain of competition. Hence,
company will like to maintain sufficient supply of finished goods.
3) Speculative Motive:
The Company may like to purchase and stock the inventory in the quantity which is more
than needed for production and sales purpose. This may be with the intention to get advantage in
term of quantity discounts connected with bulk purchasing or anticipating price rise.
 Dr.P.S.Ravindra
Professor of Management
OBJECTIVES OF INVENTORY MANAGEMENT
Inventory occupies 30–80% of the total current assets of the business concern. It is also
very essential part not only in the field of Financial Management but also it is closely associated
with production management. Hence, in any working capital decision regarding the inventories,
it will affect both financial and production function of the concern. Hence, efficient management
of inventories is an essential part of any kind of manufacturing process concern. Inventory
Management has become very significant process of management in the present day of
manufacturing industry. The basic managerial objectives of inventory management are
(a) To avoid over investment or under investment in inventories and
(b) To provide right quantity of materials in right quality at proper time and at proper value.
The objectives of Inventory Management are discussed under two heads, i.e.
(A) Operating Objectives
(1) Availability of materials:
The first and the foremost objective of inventory management is to make all types of
materials available at all times when ever they needed by the production departments so that the
production may not be held up for want of materials.
(2) Minimizing the wastage:
Inventory management has to minimize the wastage at all levels i.e., during its storage in
the warehouses or at work in the factory. Normal wastage, in other words uncontrollable
wastage, should only be permitted. Any abnormal but controllable wastage should strictly be
controlled. Wastage of materials by leakage, theft, embezzlement and spoilage due to rust, dust
or dirt should be avoided.
(3) Promotion of manufacturing efficiency:
The manufacturing efficiency of the enterprise increases if right types of raw material are made
available to production department at the right time. It reduces wastage and cost of production
and improves the morale of workers.
(4) Better Service to Customers:
In order to meet the demand of the customers, it is the responsibility of inventory
management to produce sufficient stock of finished goods to execute the orders received from
customers. An uninterrupted flow of production is to be maintained.
(5) Control of Production Level:
Inventory Management have to decide to increase or decrease production level in right
time so that inventory is controlled accordingly. But in odd times, when raw materials are in
short supply, proper control of inventory helps in creating and maintaining buffer stock to meet
any eventuality.
(6) Optimum Level of Inventories:
Proper control of inventories helps management to procure materials in right time in
order to run the plant efficiently. Maintaining the optimum level of inventories keeping in view
the operational requirements avoids the out of stock danger.
(B) Financial Objectives
(1) Economy in Purchasing:
Proper inventory management system brings certain advantages and economies in
purchasing the raw materials. Management makes every attempt to purchase raw materials in
bulk quantity and to take advantage of favorable market conditions.
(2) Optimum Investment and Efficient Use of Capital:
The primary objective of Inventory Management, from financial point of view, is to have
an optimum level of investment in inventories. Inventory Management has to ensure neither any
deficiency of stock of materials nor any excessive investment in inventories so as to block the
capital, which could be used in an efficient manner.
 Dr.P.S.Ravindra
Professor of Management
(3) Reasonable Prices:
Inventory Management has to ensure the supply of raw materials at a reasonably low
price, but without sacrificing the quality. It helps to reduction of cost of production and
improvement in quality of finished goods in order to maximize the profits of organization.
(4) Minimizing Costs:
Minimizing inventory costs such as handling, ordering and carrying costs, etc is one of
the main objective of Inventory Management. It helps reduction of inventory costs in a way that
reduces the cost per unit of inventory and thereby reduction of total cost of production.
COSTS OF HOLDING INVENTORY:
The purpose of inventory management is to minimize the cost of inventory without impairing the
efficient flow of production and sales activities. Inventory decisions are affected by the cost of
ordering inventory and the cost of carrying inventory as well as by the costs of not having
enough inventories in hand. Below are common types of inventory cost that are not incurred in
relation to the actual cost of the inventory itself:
1. Ordering Cost:
Ordering cost is simply the total of expenses incurred in placing an order.
in the economic order quantity model, this is the cost of preparing a purchase order and the cost
of receiving the goods ordered.. used in calculating order quantities, the costs that increase as the
number of orders placed increases. it includes costs related to the clerical work of preparing,
releasing, monitoring, and receiving orders, the physical handling of goods, inspections, and
setup costs, as applicable. This cost is also called acquisition cost, inventory costs.
2. Carrying Costs:
It refers to all costs associated with carrying or holding inventory. The cost of carrying
inventory is used to help companies determine how much profit can be made on current
inventory. The cost is what a business will incur over a certain period of time, to hold and store
its inventory. The carrying cost of inventory is often described as a percentage of the inventory
value. This percentage can include taxes, employee costs, depreciation, insurance, and the cost of
insuring and replacing items. There are four main components to the carrying cost of inventory;
capital cost, storage space cost, inventory service cost, and inventory risk cost.
TOOLS AND TECHNIQUE OF INVENTORY CONTROL:
Inventory management consists of effective control and administration of inventories.
Inventory controls refers to a system which ensures supply of required quantity and quality of
inventories at the required time and at the same time prevent unnecessary investment in
inventories. It needs the following important techniques.
Techniques based on Order Quantity:
Order quantity of inventories can be determined with the help of the following
techniques:
1. Stock Level
Stock level is the level of stock which is maintained by the business concern at all times.
Therefore, the business concern must maintain optimum level of stock to smooth running of the
business process. Different level of stock can be determined based on the volume of the stock.
Re-order Level
Re-ordering level is fixed between minimum level and maximum level. Re-order level is
the level when the business concern makes fresh order at this level.
Re-order level=Maximum consumption × Maximum Re-order period.

Minimum Level
The business concern must maintain minimum level of stock at all times. If the stocks are
less than the minimum level, then the work will stop due to shortage of material.
Re-order level – (Normal consumption × Normal delivery period)
 Dr.P.S.Ravindra
Professor of Management
Maximum Level
It is the maximum limit of the quantity of inventories, the business concern must
maintain. If the quantity exceeds maximum level limit then it will be overstocking.
Maximum level = Re-order level + Re-order quantity – (Minimum Consumption ×
Minimum delivery period)
Danger Level
It is the level below the minimum level. It leads to stoppage of the production process.
Danger level=Average consumption × Maximum re-order period for emergency purchase.
Average Stock Level
It is calculated such as,
Average stock level= Minimum stock level + ½ of re-order quantity
Lead Time
Lead time is the time normally taken in receiving delivery after placing orders with
suppliers. The time taken in processing the order and then executing it is known as lead time.
2. Determination of Safety Stock
Safety stock implies extra inventories that can be drawn down when actual lead time and/
or usage rates are greater than expected. Safety stocks are determined by opportunity cost and
carrying cost of inventories. If the business concerns maintain low level of safety stock, it will
lead to larger opportunity cost and the larger quantity of safety stock involves higher carrying
costs.
3. Economic Order Quantity (EOQ)
EOQ refers to 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. EOQ can be calculated with the help of the mathematical formula:

EOQ = √2AO/C
Where,
A = Annual usage of inventories (units)
O = Buying cost per order
C = Carrying cost per unit
B. CASH MANAGEMENT:
The term cash management refers to the management of cash resource in such a way that
generally accepted business objectives could be achieved. In this context, the objectives of a firm
can be unified as bringing about consistency between maximum possible profitability and
liquidity of a firm. Cash management may be defined as the ability of a management in
recognizing the problems related with cash which may come across in future course of action,
finding appropriate solution to curb such problems if they arise, and finally delegating these
solutions to the competent authority for carrying them out The choice between liquidity and
profitability creates a state of confusion. It is cash management that can provide solution to this
dilemma. Cash management may be regarded as an art that assists in establishing equilibrium
between liquidity and profitability to ensure undisturbed functioning of a firm towards attaining
its li business objectives.
Cash itself is not capable of generating any sort of income on its own. It rather is the
prime requirement of income generating sources and functions. Thus, a firm should go for
minimum possible balance of cash, yet maintaining its adequacy for the obvious reason of firm's
solvency. Cash management deals with maintaining sufficient quantity of cash in such a way that
the quantity denotes the lowest adequate cash figure to meet business obligations. Cash
management involves managing cash flows (into and out of the firm), within the firm and the
cash balances held by a concern at a point of time. The words 'managing cash and the cash
 Dr.P.S.Ravindra
Professor of Management
balances' as specified above does not mean optimization of cash and near cash items but also
point towards providing a protective shield to the business obligations. "Cash management is
concerned with minimizing unproductive cash balances, investing temporarily excess cash
advantageously and to make the best possible arrangement for meeting planned and unexpected
demands on the firms' cash."

MOTIVES FOR HOLDING CASH:

1. Transaction motive
It is a motive for holding cash or near cash to meet routine cash requirements to finance
transaction in the normal course of business. Cash is needed to make purchases of raw materials,
pay expenses, taxes, dividends etc.
2. Precautionary motive
It is the motive for holding cash or near cash as a cushion to meet unexpected contingencies.
Cash is needed to meet the unexpected situation like, floods strikes etc.
3. Speculative motive
It is the motive for holding cash to quickly take advantage of opportunities typically outside the
normal course of business. Certain amount of cash is needed to meet an opportunity to purchase
raw materials at a reduced price or make purchase at favorable prices.
4. Compensating motive
It is a motive for holding cash to compensate banks for providing certain services or loans.
Banks provide variety of services to the business concern, such as clearance of cheque, transfer
of funds etc.
GENERAL PRINCIPLES OF CASH MANAGEMENT:
Harry Gross has suggested certain general principles of cash management that, essentially
add efficiency to cash management. These principles reflecting cause and effect relationship
having universal applications give a scientific outlook to the subject of cash management. While,
the application of these principles in accordance with the changing conditions and business
environment requiring high degree of skill and tact which places cash management in the
category of art. Thus, we can say that cash management like any other subject of management is
both science and art for it has well-established principles capable of being skillfully modified as
per the requirements. The principles of management are follows:
1. Determinable Variations of Cash Needs
A reasonable portion of funds, in the form of cash is required to be kept aside to
overcome the period anticipated as the period of cash deficit. This period may either be short and
temporary or last for a longer duration of time. Normal and regular payment cf cash leads to
small reductions in the cash balance at periodic intervals. Making this payment to different
employees on different days of a week can equalize these reductions. Another technique for
balancing the level of cash is to schedule i cash disbursements to creditors during that period
when accounts receivables collected amounts to a large sum but without putting the goodwill at
stake.
2. Contingency Cash Requirement
There may arise certain instances, which fall beyond the forecast of the management.
These constitute unforeseen calamities, which are too difficult to be provided for in the normal
course of the business. Such contingencies always demand for special cash requirements that was
not estimated and provided for in the cash budget. Rejections of wholesale product, large amount
of bad debts, strikes, lockouts etc. are a few among these contingencies. Only a prior experience
and investigation of other similar companies prove helpful as a customary practice. A practical
procedure is to protect the business from such calamities like bad-debt losses, fire etc. by way of
insurance coverage.
 Dr.P.S.Ravindra
Professor of Management
3. Availability of External Cash
Another factor that is of great importance to the cash management is the availability of
funds from outside sources. There resources aid in providing credit facility to the firm, which
materialized the firm's objectives of holding minimum cash balance. As such if a firm succeeds
in acquiring sufficient funds from external sources like banks or private financers, shareholders,
government agencies etc., the need for maintaining cash reserves diminishes.
CASH MANAGEMENT – PLANNING ASPECTS
In order to maintain an optimum cash balance, what is required is (i) a complete and
accurate forecast of net cash flows over the planning horizon and (ii) perfect synchronization of
cash receipts and disbursements. Thus, implementation of an efficient cash management system
starts with the preparation of a plan of firm’s operations for a period in future. This plan will
help in preparation of a statement of receipts and disbursements expected at different point of
time of that period. It will enable the management to pin point the timing of excessive cash or
shortage of cash. This will also help to find out whether there is any expected surplus cash still
unutilized or shortage of cash which is yet to be arranged for. In order to take care of all these
considerations, the firm should prepare a cash budget. A cash budget is a summary of movement
of cash during a particular period.
Receipts and Payments Method of Cash Budget:
Cash budget, under this method, is a statement projecting the cash inflows and outflows
(receipts and disbursements) of the firm over various interim periods of the budget period. For
each period, the expected inflows are put against the expected outflows to find out if there is
going to be any surplus or deficiency in a particular period.
Pro-forma Cash Budget (Monthly Basis)
Particulars Month 1 Month2 Month3
Opening cash balance xxx xxx xxx
Cash Inflows:
Cash sales xxx xxx xxx
Collection from debtors xxx xxx xxx
Received dividends xxx xxx xxx
Sale of fixed assts xxx xxx xxx
Issue of shares/debentures xxx xxx xxx
Other cash payments xxx xxx xxx

Total Cash Available (A) xxx xxx xxx

Cash Outflows:
Cash purchase xxx xxx xxx
Payment to creditor xxx xxx xxx
Wages &other expanses xxx xxx xxx
Payment of bonus to workers xxx xxx xxx
Payment of dividend to share holders xxx xxx xxx
Purchase of fixed assets xxx xxx xxx
Payment of income tax xxx xxx xxx
Other cash payments xxx xxx xxx

Total Payments (B) xxx xxx xxx

Closing cash balance (A-B) xxx xxx xxx

 Dr.P.S.Ravindra
Professor of Management

A cash budget is an estimate of cash receipts and cash payments prepared for each month.
In this budget all expected payments, revenue as well as capital and all receipts, revenue and
capital are taken into consideration. The main purpose of cash budget is to predict the receipts
and payments in cash so that the firm will be able to find out the cash balance at the end of the
budget period. This will help the firm to know whether there will be surplus cash or deficit at the
end of the budget period. It will help them to plan for either investing the surplus or raise
necessary amount to finance the deficit. Cash Budget is prepared in various ways, but the most
popular form of the same is by the method of Receipt and Payment method.
C) RECEIVABLE MANAGEMENT
Management of trade credit is commonly known as Management of Receivables.
Receivables are one of the three primary components of working capital, the other being
inventory and cash, the other being inventory and cash. Receivables occupy second important
place after inventories and thereby constitute a substantial portion of current assets in several
firms. The capital invested in receivables is almost of the same amount as that invested in cash
and inventories. Receivables thus, form about one third of current assets in India. Trade credit is
an important market tool. As, it acts like a bridge for mobilization of goods from production to
distribution stages in the field of marketing. Receivables provide protection to sales from
competitions. It acts no less than a magnet in attracting potential customers to buy the product at
terms and conditions favourable to them as well as to the firm. Receivables management
demands due consideration not financial executive not only because cost and risk are associated
with this investment but also for the reason that each rupee can contribute to firm's net worth.
FACTORS CONSIDERING THE SIZE RECEIVABLES:
The size of receivables is determined by a number of factors for receivables being a
major component of current assets. As most of them varies from business the business in
accordance with the nature and type of business. Therefore, to discuss all of them would prove
irrelevant and time consuming. Some main and common factors determining the level of
receivable are presented by way of diagram in figure given below and are discuses below:
Receivables size of the business concern depends upon various factors. Some of the
important factors are as follows:
(i) Stability of Sales:
Stability of sales refers to the elements of continuity and consistency in the sales. In
other words the seasonal nature of sales violates the continuity of sales in between the year. So,
the sale of such a business in a particular season would be large needing a large a size of
receivables. Similarly, if a firm supplies goods on installment basis it will require a large
investment in receivables.
(ii) Terms of Sale:
A firm may affect its sales either on cash basis or on credit basis. As a matter of fact
credit is the soul of a business. It also leads to higher profit level through expansion of sales. The
higher the volume of sales made on credit, the higher will be the volume of receivables and vice-
versa.
(iii) The Volume of Credit Sales It plays the most important role in determination of the level
of receivables. As the terms of trade remains more or less similar to most of the industries. So, a
firm dealing with a high level of sales will have large volume of receivables. Credit Policy A
firm practicing lenient or relatively liberal credit policy its size of receivables will be
comparatively large than the firm with more rigid or signet credit policy. It is because of two
prominent reasons: -

A lenient credit policy leads to greater defaults in payments by financially weak
customers resulting in bigger volume of receivables.
 Dr.P.S.Ravindra
Professor of Management

A lenient credit policy encourages the financially sound customers to delay payments
again resulting in the increase in the size of receivables.
(iv) Terms of Sale:
The period for which credit is granted to a customer duly brings about increase or
decrease in receivables. The shorter the credit period, the lesser is the amount of receivables. As
short term credit ties the funds for a short period only. Therefore, a company does not require
holding unnecessary investment by way of receivables.
(v) Cash Discount:
Cash discount on one hand attracts the customers for payments before the lapse of credit
period. As a tempting offer of lesser payments is proposed to the customer in this system, if a
customer succeeds in paying within the stipulated period. On the other hand reduces the working
capital requirements of the concern. Thus, decreasing the receivables management.
(vi) Collection Policy:
The policy, practice and procedure adopted by a business enterprise in granting credit,
deciding as to the amount of credit and the procedure selected for the collection of the same also
greatly influence the level of receivables of a concern. The more lenient or liberal to credit and
collection policies the more receivables are required for the purpose of investment.
(vii) Collection Collected:
If an enterprise is efficient enough in encasing the payment attached to the receivables
within the stipulated period granted to the customer. Then, it will opt for keeping the level of
receivables low. Whereas, enterprise experiencing undue delay in collection of payments will
always have to maintain large receivables.
(viii) Bills Discounting and Endorsement:
If the firm opts for discounting its bills, with the bank or endorsing the bills to the third
party, for meeting its obligations. In such circumstances, it would lower the level of receivables
required in conducting business.
(ix) Quality of Customer:
If a company deals specifically with financially sound and credit worthy customers then
it would definitely receive all the payments in due time. As a result the firm can comfortably do
with a lesser amount of receivables than in case where a company deals with customers having
financially weaker position.
OBJECTIVES OF RECEIVABLE/CREDIT MANAGEMENT:
A brief inference of objectives of management of receivables may be given as under: -
i. To attain not maximum possible but optimum volume of sales.
ii. To exercise control over the cost of credit and maintain it on a minimum possible level.
iii. To keep investments at an optimum level in the form or receivables.
iv. To plan and maintain a short average collection period.
ASPECTS OF RECEIVABLE MANAGEMENT:
The primary objective of management or receivables should not be limited to expansion
of sales but should involve maximization of overall returns on investment. So, receivables
management should not be confined to mere collection or receivables within the shortest possible
period but is required to focus due attention to the benefit-cost trade-off relating to numerous
receivables management.
The trade-off on receivables can be applied to find out whether to liberalize the credit
terms or not. More liberal credit terms may be expected to generate higher sales revenue and
higher profits; but the chances of bad debts will also increase and there will be a decrease in
liquidity of the firm. If the net benefit expected from liberalizing the credit terms is positive, the
firm may offer such terms, otherwise not. On the other hand, a stringent credit policy reduces
the profitability but may increase the liquidity of the firm. Thus, a firm should try to frame its
credit policy in such a way as to attain the best possible combination of profitability and
 Dr.P.S.Ravindra
Professor of Management
liquidity. So, the receivable management must be attempted by adopting a systematic approach
and considering the following aspects of receivable Management.
A. The Credit Policy
B. The Credit Evaluation
C. The Credit Control
A. CREDIT POLICY:
The discharge of the credit function in a firm embraces a number of activities for which
the policies have to be clearly laid down. Such a step will ensure consistency in credit decisions
and actions. A credit policy thus, establishes guidelines that govern grant or reject credit to a
customer, what should be the level of credit granted to a customer etc. A credit policy can be said
to have a direct effect on the volume of investment a company desires to make in receivables.
The reality, it is rather a different task to establish an optimum credit policy as the best
combination of variables of credit policy is quite difficult to obtain. The important variables of
credit policy should be identified before establishing an optimum credit policy.
B. THE CREDIT EVALUATION:
After establishing credit standards a firm must establish a credit evaluation process to
determine to whom the credit can be extended. In judging the credit worthiness of the applicant,
the factors to be considered by the firm are of three C’s (1) Character (2) Capacity (3) Collateral.
Character refers to willingness to pay, capacity refers to ability to pay and collateral represents
the security offered by the firm in the form of mortgages.
Establishing of credit evaluation process involves two stages (1) Obtaining Credit
Information (2) Analysis of Credit Information.
Credit information of a firm will be obtained through audited reports, financial
statements, bank references and trade references.
Analysis of credit information can be done by financial ratios and by firm’s experience
because analysis of credit information includes evaluation of both qualitative and quantitative
aspects of the credit receiver. The credit granting decision can also be made using decision tree
analysis.
C. THE CREDIT CONTROL
Control or receivables largely depends upon the system of credit control practiced by a
business enterprise. It becomes a part of organization obligation to obtain full and relevant
information complete in all respect before deciding upon the right customer for the right amount
of credit grant. Whenever an order is placed by an applicant financial position and credit
worthiness becomes essential. Only after ensuring the degree of safety an order should be
accepted and delivered. A firm is expected to prepare sales invoice and credit notes as early as
possible; side by side it should also ensure that they are dispatched at specified regular intervals
for effective control of receivables. It is always considered good on the part of rim it is keep as
separate ledger for the accounts of based and doubtful debtors. Such segregation not only helps
in easy assessment of the position of bad and doubtful debtors in relation to the total debtor's
position. A considerable amount of reduction in debtors can be achieved by offering cash
discount to the customers.
Even in case of export sales, segregation of credit sales into separate ledger adds
effectiveness to control of receivables. Sometimes large contracts, payable by installments,
involve credit for several years. The price fixed in these cases should be sufficiently high not
only to cover export credit insurance, but also to cover a satisfactory rate of interest on the
diminishing balances of debt expected to the outstanding during the credit period.
Average Collection Period:
It is the time taken by customers bearing credit obligation in materializing payment. It is
represented in terms of the number of days, for which the credit sales remains outstanding. A
longer collection period always enlarges the investment in receivables.
 Dr.P.S.Ravindra
Professor of Management
Accounts receivable at time ‘t’
ACP = Average daily Sales
According to this method accounts receivable are deemed to be in control if the ACP is
equal to or less than a certain norm. If the value of ACP exceed the specified norm, collections
are considered to be slow.
If the company had made cash sales as well as credit sales, we would have concentrated
on credit sales only, and calculate average daily credit sales. The widely used index of the
efficiency of credit and collections is the collection period of number of day’s sales outstanding
in receivable. The receivable turnover is simply ACP/360 days.
Thus if receivable turnover is six times a year, the collection period is necessarily 60
days.