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SIGNIFICANCE OF WORKING CAPITAL

+ne will hardly find an operating business firm which does not require some amount of

woring capital. Even a fully equipped manufacturing firm is sure to collapse without #a$

an adequate supply of raw materials to process, #b$ cash to meet the wage bill, #c$ the

capacity to wait for the maret for its finished products, and #d$ the ability to grant credit

to its customers. imilarly, a commercial enterprise is virtually good for nothing without

merchandise to sell. &oring capital, thus, is the life-blood of a business. !s a matter of

fact, any organization, whether profit-oriented or otherwise, will not be able to carry on

day-to-day activities without adequate woring capital.

Operating Cycle

%he time between purchase of inventory items #raw material or merchandise$ and their

conversion into cash is nown as operating cycle or woring capital cycle. %he

successive events which are typically involved in an operating cycle are depicted in

Figure *. ! perusal of the operating( cycle would reveal that the funds invested in

operations are re-cycled bac into cash. %he cycle, of course, taes some time to

complete. %he longer the period of this conversion the longer is the operating cycle. !

standard operating cycle may be for any time period but does not generally exceed a

financial year. +bviously, the shorter the operating cycle, the larger will be the turnover

of funds invested for various purposes. %he channels of the investment are called

current assets. ometimes the available funds may be in excess of the needs for

investment in these assets, eg., inventory, receivables and minimum essential cash

balance. !ny surplus may be invested in government securities rather than being

retained as idle cash balance.


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yield earnings over and above the interest costs. 2ogic then demands that the

aggregate of current assets should be taen to mean the woring capital.

3. Management is more concerned with the total current assets as they constitute

the total funds available for operating purposes than with the sources from which

the funds come.

4. !n increase in the overall investment in the enterprise also brings about an

increase in the woring capital.

Net Wor"ing Capital

%he net woring capital refers to the difference between current assets and current

liabilities. 'urrent liabilities are those claims of outsiders which are expected to mature

for payment within an accounting year and include creditors( dues, bills payable, ban

overdraft and outstanding expenses. et woring capital can be positive or negative. !

positive net woring capital will arise when current assets exceed current liabilities. !

negative net woring capital occurs when current liabilities are in excess of current

assets.

Kin# o! Wor"ing Capital

+rdinarily, woring capital is classified into two categories)

Fixed, 5egular or 1ermanent &oring 'apital6 and 7ariable, Fluctuating, easonal,

%emporary or pecial &oring 'apital.Fi$e# Wor"ing Capital

%he need for current assets is associated with the operating cycle is a continuous

process. !s such, the need for current assets is felt constantly. %he magnitude of

investment in current assets however may not always be the same. %he need for

investment in current assets may increase or decrease over a period of time according

to the level of production.

Fl%ct%ating Wor"ing Capital


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8epending upon the changes in production and sales, the need for woring capital, over

and above the permanent woring capital, will fluctuate. %he need for woring capital

may also vary on account of seasonal changes or abnormal or unanticipated conditions.

For example, a rise in the price level may lead to an increase in the amount of funds

invested in stoc of raw materials as well as finished goods.

Figures ** and *** give an idea about fixed and fluctuating woring capital.

!ig%re II& !i$e# 'or"ing capital re(aining contant o)er ti(e

*t is shown in Figure ** that fixed woring capital is stable overtime, while variable

&oring capital is fluctuating9sometimes increasing and sometimes decreasing. %he

permanent woring capital line, however, may not always be horizontal. For a growing

firm, permanent woring capital may also eep on increasing over time as has been

shown in Figure ***.

:oth these inds of woring capital9permanent and temporary9are required to

facilitate production and sales through the operating cycle, but temporary woring


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capital is arranged by the firm to meet liquidity requirements that are expected to be

temporary.

Co(ponent o! Wor"ing Capital

*t is already noted that woring capital has two components) 'urrent assets and 'urrent

liabilities. 'urrent assets comprise several items. %he typical items are)

'ash to meet expenses as and when they occur.!ccounts receivables or sundry trade debtors.*nventory of raw materials, stores, supplies and spares, wor-in-process, and finished

goods.!dvance payments towards expenses or purchases, and other short-term advances,

which are recoverable.

%emporary investment of surplus funds which could be converted into cash whenever

needed.!part from these, the need for funds to finance the current assets may be met from

supply of goods on credit, and deferment, on account of custom, usage or arrangement,

of payment for expenses. %he remaining part of the need for woring capital may be

met from short-term borrowing from financiers lie bans. %hese items arc collectively

called current liabilities. %ypical items of current liabilities are)

oods purchased on creditExpenses incurred in the course of the business of the organization #eg., wages or

salaries, rent, electricity bills, interest etc.$ which are not yet paid for.%emporary or short-term borrowings from bans, financial institutions or other parties.

!dvances received from parties against goods to be sold or delivered, or as short-

term deposits.+ther current liabilities such as tax and dividends payable.

I(portance o! Wor"ing Capital Manage(ent

:ecause of its close relationship with day-to-day operations of a business, a study of

woring capital and its management is of ma;or importance to internal, as well as

external analysts. *t is being increasingly realised that inadequacy or mismanagement of

woring capital is the leading cause of business failures. &e must not lose sight of the

fact that management of woring capital is an integral part of the overall Financial


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Management and, ultimately, of the overall corporate management. &oring capital

management thus throws a challenge and should be a welcome opportunity for a

finance manager who is ready to play a pivotal role in his organization.

! firm may have to face the following adverse consequences from inadequate woring

capital)

0. rowth may be stunted. *t may become difficult for the firm to undertae

profitable pro;ects due to non-availability of funds.

3. *mplementation of operating plans may become difficult and consequently the

firm(s profit goals may not be achieved.

4. +perating inefficiencies may creep in due to difficulties in meeting even day-to-

day commitments.

. %he firm loses its reputation when it is not in a position to honour its short-term

obligations. !s a result, the firm is liely to face tight credit terms.

+n the other hand, excessive woring capital may pose the following dangers)

0. Excess of woring capital may result in unnecessary accumulation of inventories,

increasing the chances of inventory mishandling, waste, and theft.

3. *t may provide an undue incentive for adopting too liberal a credit policy and

slacening of collection of receivables, causing a higher incidence of bad debts.

%his has an adverse effect on profits.

4. Excessive woring capital may mae management complacent, leading

eventually to managerial inefficiency.


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means a larger tie-up of funds in inventories. !ny delay at any stage of manufacturing

process will result in accumulation of wor-in-process and will enhance the requirement

of woring capital. ?ou may have observed that firms maing heavy machinery or other

such products, involving long manufacturing cycle, attempt to minimise their investment

in inventories #and thereby in woring capital$ by seeing advance or periodic payments

from customers.

+%ine Fl%ct%ation

easonal and cyclical fluctuations in demand for a product affect the woring capital

requirement considerably, especially temporary woring capital requirements of the firm.

!n upward swing in the economy leads to increased sales, resulting in an increase in

the firm(s investment in inventory and receivables or boo debts. +n the other hand, a

decline in the economy may register a fall in sales and, consequently, a fall in the levels

of stocs and boo debts.

Pro#%ction Policy

*f a firm follows steady production policy, even when the demand is seasonal, inventory

will accumulate during off-season periods and there will be higher inventory costs and

riss. *f the costs and riss of maintaining a constant production schedule are high, the

firm may adopt the policy of varying its production schedule in accordance with the

changes in demand. Firms whose physical facilities can be utilised for manufacturing a

variety of products can have the advantage of diversified activities.

T%rno)er o! Circ%lating Capital

%he speed with which the operating cycle completes its round raw materials finished

product accounts receivables cash plays a decisive role in influencing the woring

capital needs.

Cre#it Ter(


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%he credit policy of the firm affects the size of woring capital by influencing the level of

boo debts. %hough the credit terms granted to customers in a large measure depend

upon the norms and practices of the industry or trade to which the firm belongs, yet it

may endeavour to shape its credit policy within such constrains. ! long collection period

will generally mean tying of larger funds in boo debts. lave collection procedures may

even increase the chances of bad debts.

Gro't, an# E$panion Acti)itie

!s a company grows, logically, larger amount of woring capital will be needed, %hough

it is difficult to state any firm rules regarding the relationship between growth in the

volume-of a firm(s business and its woring capital needs.

Operating E!!iciency

+perating efficiency means optimum utilisation of resources. %he firm can minimise its

need for woring capital by efficiently controlling its operating costs. &ith increased

operating efficiency application use of woring capital is improved

Price Le)el C,ange

enerally, rising price level requires a higher investment in woring capital. *ncreasing

prices for the same levels of current assets need enhanced investment. "owever, firms

which can immediately revise prices of their products upwards may not face a severe

woring capital problem in periods of rising price levels. %he effects of increasing price

level may, however, be felt differently by different firms.


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Ot,er Factor

%here are some other factors which affect the determination of the need for woring

capital. ! high net profit margin contributes towards the woring capital. %he net profit is

a source of woring capital to the extent it has been earned. %he cash inflow can be

calculated by ad;usting non-cash items such as depreciation. +utstanding expenses,

losses written off, etc. from the net profit.

Approac,e to Managing Wor"ing Capital

%wo approaches are generally followed for the management of woring carpet #i$ the

conventional approach and #ii$ the operating cycle approach.

T,e Con)entional Approac,

%his approach implies managing the individual components of woring capital #ii$ the

inventory, receivables, payables, etc. efficiently and economically so that there are

neither idle funds nor paucity of funds. %echniques have been evolved for the

management of each of these components.

T,e Operating Cycle Approac,

%his approach views woring capital as a function of the volume of operating expenses.

@nder this approach the woring capital is determined by the duration of the operating

cycle and the operating expenses needed for completing the cycle. %he duration of the

operating cycle is the number of days involved in the various stages, commencing with

acquisition of raw materials to the realisation of proceeds from debtors. %he credit

period allowed by creditors will have to be set off in the process.

T-E FOLLOWING INDICES CAN +E USED FOR MEASURING T-E EFFICIENC. IN

MANAGING WORKING CAPITAL/

C%rrent Ratio 0CR1

'5 A'urrent !ssetsB'urrent 2iabilities


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*t indicates the ability of a company to manage the current affairs of business. *t is

useful to study the trend of woring capital over a period of time.

%hough the current ratio of 3)0 is considered ideal, this may have to be modified

depending on the peculiar conditions prevailing in a particular trade or industry. *t is not

only the quantum of current ratio that is important but also its quality. i.e., extent to

which assets and liabilities are really current.

2%ic" Ratio 02R1

C5A2iquid !ssetsB'urrent 2iabilities

2iquid assets mean current assets minus those which are not quicly realisable.

*nventory and sticy debts are generally treated as non-quic assets.

%he relationship of 0)0 between quic assets and current liabilities is considered ideal,

but, lie current ratio, it also varies from industry to industry, depending on the peculiar

conditions of a particular industry.

Ca, to C%rrent Aet

*f cash alone is a ma;or item of current assets then it may be a good indicator of the

profitability of the organization, as cash by itself does not earn any profit, the proportion

should usually be ept low.

Sale to Ca, Ratio

ales to 'ash 5atioAalesB!verage cash balance during the period.

'ash should be turned over as many times as possible, in order to achieve maximum

sales with minimum cash on hand.

A)erage Collection Perio#

#8ebtorsB'redit ales$ D 4>=

%his ratio explains how many days of credit a company is allowing to its customers to

settle their bills.

A)erage Pay(ent Perio#


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!verage payment periodA#'reditorsB'redit purchases$ x 4>=

*t indicates how many days of credit is being en;oyed by the company from its suppliers.

In)entory T%rno)er Ratio 0ITR1

*%5AalesB!verage *nventory

*t shows how many times inventory has turned over to achieve the sales. *nventory

should be maintained at a level which balances production facilities and sales needs.

Wor"ing Capital to Sale

@sually expressed in terms of percentage, it signifies that for any amount of sales a

relative amount of woring capital is needed. *f any increase in sales is contemplated it

has to be seen that woring capital is adequate. %herefore, this ratio helps management

in maintaining woring capital which is adequate for the planned growth in sales.

Wor"ing Capital to Net Wort,

%his ratio shows the relationship between woring capital and the funds belonging to the

owners. &hen this ratio is not carefully watched, it may lead to)

a$ +ver trading when the conditions are in the upswing. *ts symptoms being #*$ "igh

*nventory %urnover 5atio #ii$ 2ow 'urrent 5atio6 or

b$ @ndertrading when the conditions of maret are not good. *ts ma;or symptoms are)

i$ 2ow *nventory %urnover 5atio

ii$ "igh 'urrent 5atio.

Efficient woring capital management should, therefore, avoid both over-trading and

under-trading.

So%rce o! Wor"ing Capital

ources of woring capital are many. %here are both external or internal sources. %he

external sources are both short-term and long-term. %rade credit, commercial bans,

finance companies, indigenous baners, public deposits, advances from customers,

accrual accounts, loans and advances from directors are external short-term sources.


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'ompanies can also issue debentures and invite public deposits for woring capital

which are external long-term sources. Equity funds may also be used for woring

capital.

Tra#e cre#it

%rade credit is a short-term credit facility extended by suppliers of raw materials and

other suppliers. *t is a common source. *t is an important source. Either open account

credit or acceptance credit may be adopted. *n the former as per business custom credit

is extended to the buyer. %he buyer is not giving any debt instrument as such.

Co((ercial 3an" are the next important source of woring capital finance.

'ommercial baning system in the country is broad based and fairly developed. traight

loans, cash credits, hypothecation loans, pledge loans, overdrafts and bill purchase and

discounting are the principal forms of woring capital finance provided by commercial

bans.

Finance co(panie in t,e co%ntry !bout = companies exist at present. %hey

provide services almost similar to bans. %hey provide need-based loans and

sometimes arrange loans from others for customers. *nterest rate is higher. :ut timely

assistance may be obtained.

In#igeno% 3an"eralso provide financial assistance to small business and trades.

%hey charge exorbitant rates of interest by very much understanding.

P%3lic #epoitare unsecured deposits raised by businesses for periods exceeding a

year but not more than 4 years by manufacturing concerns and not more than = years

by non-baning finance companies.

A#)ance !ro( c%to(erare normally demanded by producers of costly goods at

the time of accepting orders for supply of goods. 'ontractors might also demand

advance from customers. &here sellers maret prevails, advances from customers may


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be insisted. *n certain cases, to ensure performance of contract an advance may be

insisted.

Accr%al acco%nt are simply outstanding suppliers of overhead service requirements.

Loan !ro( #irector, loans from group companies etc. constitute another source of

woring capital. 'ash rich companies lend to liquidity companies under liquidity crunch.

Co((ercial paper are usance promissory notes negotiable by endorsement and

delivery. ince 0 '1s came into existence. %here are restrictive conditions as to the

issue of commercial paper. '1s are privately placed after 5:*(s approval with any firm,

incorporated or not, any ban or financial institution. :ig and sound companies

generally float '1s.

De3ent%re an# e4%ity !%n# can be issued to finance woring capital so that the

permanent woring capital can be matchingly financed through long term funds.


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ACCOUNTS RECEI5A+LES MANAGEMENT

Intro#%ction

&hen the finished goods are sold on credit, the entire sales #both on cash and credit

bases$ are recorded as sales in the profit and loss account. :ut, while the cash sales

get represented in terms of cash in hand or in ban or some assets purchased on cash

basis, etc, the credit sales are reflected in the value of sundry debtors #8s$ #as

referred to in *ndia$,are also nown as %rade 8ebtors #%8s$. !ccounts 5eceivable

#!5s$, :ills 5eceivable #:5s$ on the assets side of the balance sheet. %his is what

happens in the boos of the seller. :ut, in the boos of the buyer, the purchases made

on credit basis are accounted for as sundry creditors #'s$ also nown as %rade

'reditors #%'s$, !ccounts 1ayables #!1s$ and :ills 1ayable #:1s$.

Further, with a view to fully understand and appreciate the high need for effective

monitoring and follow-up of sundry debtors, it may be very pertinent to mention here

that generally speaing, after the company(s investment in plant and machinery, and

stocs of inventory #mostly in that order$, the sundry debtors constitute the third largest

and most important item of assets of the company.

%herefore, the imperative need of effective monitoring and control of all the items of

undry 8ebtors assume a highly important and strategic position in the area of

'orporate Financial Management.

Cre#it Policy

&hile formulating credit policies, we should vary the quantum and period of credit,

party-wise. For this purpose, we may broadly classify our parties #customers, clilentele$

under four different categories, on the basis of their integrity and ability #both intention

and strength$ to pay in full and in due time. !ccordingly, these may be classified as

under)


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Category Degree o! Ri"

! o ris

: 2ittle ris

' ome ris

8 "igh ris

:ut, such an exercise should not be taen as ;ust a onetime exercise. uch

classifications must, instead, be reviewed periodically, and revised upward or

downward, as the case may be. %hat is, if the performance of a particular party in

category ! seems to be declining, in terms of promptness in payment, it could well be

brought down from 'ategory ! to say, 'ategory :. !nd, similarly, based upon the past

performance, as per the company(s records, if some perceptible improvement is

observed in some category :, or even category ' parties, these could as well be

promoted to 'ategory ! and : respectively, as the case be.

Step an# Strategie

Step 6

Pro(pt #epatc, o! goo# an# in)oice/

%he very first step towards effective supervision and follow-up of sundry debtors is that

the goods must be despatched promptly, as also the relative invoice. :ecause, the 0=th

day or >th, whatever, can be counted only after the day one begins, i.e., when the

goods invoice have been despatched. %hus, a slight delay of even a day or two delays

the payment of the sundry debtors at least by so many day#s$.

Step 7

Correct an# %na(3ig%o% in)oicing/

*t is of crucial importance that the order number, particulars #quality and quantity$ of

goods, and such other details are incorporated in the invoice correctly, so as to facilitate

the buyer company to connect the matter appropriately. !ny error in these particulars,


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howsoever all, may result in a significant financial loss, sometimes, due to the avoidable

correspondence and the resultant delay in payment.

Step 8

A)oi# #ip%te/

Extra care and due precaution must be taen by and at all times, in despatching the

goods of the agreed quality only, #not even a shade less or more$, so that may eep all

the possible disputes avoided, ways.

Step 9

Stan#ar# 0printe#1 in)oice por!or(a 'it, a tear:o!! portion)

&ith a view to ensuring that all the relevant particulars have been incorporated in the

invoice, #of course, meticulously and correctly$, it would augur well if the company taes

care to evolve an all - comprehensive proforma of its invoices, such that no relevant

particulars may be lost sight of. :esides, with a view to ensuring that the invoice, along

with the relative bill of exchange and such other documents, have been duly received by

the party, an acnowledgement slip could also be provided as a tear off portion of the

relative forwarding letter itself, wherein all the relevant particulars details of the various

documents, etc., as also the full and correct postal address of the seller company, are

computer-printed at the appropriate place. %his way, the buyer company, at the

receiving end, would have to ;ust put its rubber stamp #not even signature$ on the

acnowledgement slip, and to slip the #acnowledgement$ slip in the window envelop

and post it. !nd, that is it. ! specimen proforma of the suggested forwarding letter along

with the tear off portion containing the acnowledgement slip, is placed in !nnexure =.0

at the end of the 'hapter.

&hen the efforts of typing acnowledgement letter are involved, mostly the buyer

companies are found to be adopting the easiest course of action. %hat is, they ;ust do

not send any acnowledgement, whatsoever.


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Step ;

Entrie in t,e 0i1 Mater Regiter 0all co(pre,eni)e1 an# 0ii1 Le#ger Acco%nt

0party:'ie1/

&ith a view to exercising effective control on all the &oring 'apital Management sales

effected, on a day-to-day basis, the companies may maintain a Master 5egister6

wherein all the particulars of all the sales effected on a particular day may be entered, in

serial order.

A General Pattern o! Follo':%p Mea%re

! general pattern of follow-up of sundry debtors are discussed hereafter, followed by

some special strategies to be evolved for some special and specific cases, desiring

special attention and specific treatment.

%he idea behind having different sections or registers #or different folios in the

computer$ is that the actual due date can easily be calculated from the date of sale, as

the same section B file will have the same due date for the same date of sale. %hat is, in

a section B file of 4 days credit period, the due date will be 4 days after the date of

sale and so on.

Step 6

:y way of a general follow-up, usually a wee before the due date of payment, a routine

type of computer printed reminder could be sent.

Step 7

Further, if the bill does not appear to have been paid even after a wee or a fortnight, of

the stipulated due date, a second reminder may be sent with a slightly firm language

used, and a copy thereof may be endorsed to the ales +fficerBales 5epresentative

for necessary follow-up action.


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Step 8

*f, even such reminder does not evoe the desired results, a third strict reminder may

have to be sent, with a copy thereof endorsed to the ales +fficerBales Manager

concerned, to personally follow-up the matter with the party concerned, during their

immediately next visit to the area, so as to obtain the payment, at the earliest. !nd, in

the mean time, the goods despatch section may be instructed to suspend the supply of

goods to such party , till further fuctions, so as to avoid the situation of accumulation of

some huge over- amounts.

Step 9

!nd, if even such strict and firm dealings do not bestir #activate$ the parties, legal

notice#s$ may have to be served on some of them, ;ust as test cases, so that they #and

even other buyers$ may not get an impression that they may go scot free so easily.

Step ;

imilarly, in some cases, ;ust by way of setting an example, and creating some sense of

fear, even civil suits may be filed, though not with the intention of bringing it to its logical

conclusion, but only as a demonstration of strong will that mean business.

For(%lation o! Cre#it Policy

'redit policies need to be formulated by the top management, of course, in consultation

with the lower levels of management, as they are expected to have the real feel and

first-hand experience and information about the maret trends as also about the traders

and the competitors.

Ca, Dico%nt

'ash discount is a very common mechanism of effecting and encouraging speedy

payments but of course, at a price. %herefore, before taing a decision about the period

and quantum of giving cash discount, we must first try to understand and appreciate the


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quantum of credit riss involved, which differ from case to case, one must guard against

some usual types of errors of ;udgement that may tae place sometimes.

%hey are)

#i$ Either a class ! category of customer may be classified as category : or even '.

#i$ +r vice versa, i.e., a category : #or even category '$ customer may be erroneously

classified as ! category one.

!nd, both these errors may prove a little costly in that either a good business may be

lost, #and the financial gains therewith$, or the company may accumulate some more

bad debts, eating into its profitability.

uch errors may tae place but only in some cases, and not in general, provided due

care is taen at the time of the evaluation of the credit-worthiness of the parties. *n such

cases, the periodical review of the payment pattern of the respective parties may be

helpful in reclassification of some parties, and thereby rectifying the error, if any,

hopefully well in time.

Type o! Cre#it Policy

8ifferent dimensions of the credit policy may vary in different degrees and shades. *t

may be categorised under three broad types)

0i1 Li3eral Cre#it Policy/! credit policy may be termed as liberal wherein some other

concessions and facilities are granted to the buyers, with the expectation that this way

the sales may pic up, and thereby, the cost of extra concessions granted can well be

taen care of, by the additional yield, resulting from the extra sales achieved therewith.

:ut then, such liberalization may as well lead to some additional quantum of bad debts,

related with the extra sales effected, as also the resultant higher blocage of funds in

sundry debtors, and a higher cost of collection, too. %herefore, all such inter-related

facts and factors must be duly considered while taing a decision regarding adoption

and execution of a specific credit policy, most suited under the given circumstances.


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0ii1 Strict Cre#it Policy/ @nder such credit policy, as against the liberal one, the

minimum possible concessions and relaxations are granted to the customers. !nd, as a

result thereof, the sales may get somewhat adversely affected. :ut, at the same time,

the ris of bad debts may as well be minirnized, and so will be the extent of blocage of

funds in sundry debtors and the collection efforts and expenses, too. %hus, the decision

should be based on the trade-off position of the positive and negative factors.

0iii1 Me#i%( 0Mo#erate1 Cre#it Policy/uch credit policy adopts the middle of the

road approach whereby a balance is tried to be struc in such a way that both the

quantum of additional sales and the resultant ris of bad debts may be ept at the

optimal levels, i.e., neither too high nor too low, but in about ;ust the right measure.

Para(eter o! Cre#it Policy

%he various dimensions on the basis of which a company may be said to be adopting a

rather liberal, strict or medium #moderate$ credit policy may broadly be classified under

four different parameters. %hey are)

#i$ tandard of credit,

#ii$ 1eriod of credit,

#iii$ 'ash discount, and

#iv$ Effective monitoring and follow-up Ji.e., 'ollection EffortsK.

A& Stan#ar# o! Cre#it

%he main and most important question that may arise, while arriving at the credit policy

decision, is what standard could be considered as the most appropriate and optimal

one, with a view to accepting or re;ecting a customer for credit sales. "ere, the

company has a variety of choices, of offering credit sales, ranging from /none( to /all(

and to Gsome onlyG. %he first two options, obviously, do not seem to be right, as these

may either adversely affect the volume and value of the sales, or else may run the high

ris of the quantum of bad debts. %hus, both these steps are generally not advisable


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#iii$ %he credit period offered by various companies differs to a very great extent,

ranging from day to > days or even days. For example, a company, which is

privileged to be in the seller(s maret, may not give a single day(s credit, i.e., may insist

on cash down payments, while the companies lie 1remier Motors or 8aewoo Motors

may offer a much longer credit period, to boost up the sales. Further, while some of the

companies, manufacturing consumer products #with the exception of textile and

garment manufacturing companies$ may give nil or a limited credit period, other

companies may have to give a much longer credit period, to be able to sell their

products.

#iv$ :esides, the practice of offering cash discount #with a view to ensuring early

payments$ does not seem to be very popular in *ndian business scenario.

0+1 Ae(ent o! Cre#it:Wort,ine o! C%to(er

0. %here does not seem to be any systematic and scientific study made, by using

different tools and techhiques, to determine the creditworthiness or financial

strength and stability of the customers - both present and prospective. *n fact, the

financial position of the present customers should also be reviewed and revised

on a regular basis, based upon out) own experiences of their past performance

and dealings with us. :ut this seldom seems to have been resorted to, in most of

the companies.

3. o serious and sincere effort seems to have been made to meticulously analyse

the balance sheet and profit and loss account of the companies, with a view to

maing a realistic assessment and appraisal of their financial position. *t has

hardly been observed that some companies have ased for some brea-ups of

certain items #say, of inventories or bad debts$, to see through the elements of

window dressing, if any.


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4. 1rospective customers are required to give, at least, two or three references, but

no serious attempt seems to have been made by most of the companies to verify

the position from such references.


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Factoring

Factoring is a unique financial innovation. *t is both a financial as well as a management

support to a client. *t is a method of converting a non-productive, inactive asset #i.e.,

hoo debts$ into a productive asset #viz., cash$ by selling boo debts #receivables$ to a

company that specialises in their collection and administration.( For a number of

companies, cash may become a scarce resource if it taes a long time to receive

payment for goods and services supplied by them. uch a current asset in the balance

sheet is, in fact, illiquid and serves no business purpose6 it is much better to sell that

asset for cash which can be immediately employed in the business. ! GfactoN( maes

the conversion of receivables into cash possible.

%he term factor has its origin in the 2atin word /facere(, meaning to mae or do, or to get

things done. +riginally, factors acted as selling agents. %hey facilitated the flow of

merchandise from the manufacturers to customers. %he functions of a factor included

finding out customers for the manufacturer(s products, stoc his goods, sell them and

finally collect sales proceeds and remit them to the manufacturer. %hus, the function of

factors in olden days included stocing, mareting and distribution as well as

administration and financing of credit. %he modem factor has specialized in credit

collection and financial services, leaving the mareting and distribution functions to the

manufacturer.

Factoring Ser)ice

&hile purchase of boo debts is fundamental to the functioning of factoring, the factor

provides the following three basic services to clients)

0. ales ledger administration and credit management.

3. 'redit collection and protection against default and bad-debt losses.

4. Financial accommodation against the assigned boo debts.


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Cre#it a#(initration

! factor provides full credit administration services to his clients. "e helps and advises

them from the stage of deciding credit extension to customers to the final stage of boo

debt collection. %he factor maintains an account for all customers of all items owing to

them, so that collections could be made on due date or before. "e helps clients to

decide whether or not and how much credits to extend to customers. "e provides

clients with information about maret trends, competition and customers and helps them

to determine the credit worthiness of customers. "e maes a systematic analysis of the

information regarding credit for its proper monitoring and management. "e prepares a

number of reports regarding credit and collection, and supplies them to clients for their

perusal and action.

Cre#it collection an# protection

&hen individual boo debts become due from the customer, the factor undertaes all

collection activity that is necessary. "e also provides full or partial protection against

bad debts. :ecause of his dealings with the variety of customers and defaults with

different paying habits, he is better position to develop appropriate strategy to guard

against possible defaults.

Financial aitance

+ften factors provide financial assistance to the client by extending advance cash

against boo debts. 'ustomers of GclientsG become debtors of a factor and have to pay

to him directly in order to settle their obligations. Factoring thus involves an outright

purchase of debts, allowing full credit protection against any bad debts and providing

financial accommodation against the firm(s boo debts. *n the @..!., the maximum

advance a factor provides is equal to the amount of factored receivables less the sum of

#i$ the factoring commission, #ii$ interest on advance, and #iii$ reserve that the factor


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discounting is a method of financing. "owever, it falls short of factoring in many

respects. Factoring is of bills discounting plus much more. :ills discounting has the

following limitations in comparison with factoring)

:ills discounting is a sort of borrowing while factoring is the efficient and specialized

management of boo debts along with enhancement of the client(s liquidity.%he client has to undertae the collection of boo debts. :ill discounting is always

/with recourse, and as such the client is not protected from bad debts.:ills discounting is not a convenient method for companies having large number of

buyers with small amounts since it is quite inconvenient to draw a large number of

bills.Type o! Factoring

%he factoring facilities available worldwide can be broadly classified into four main

groups

0. Full service non-recourse #old line$

3. Full service recourse factoring

4. :ulBagency factoring


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COMPONENTS OF IN5ENTORIES

%he term /inventory( comprises three components. %hey are)

0. 5aw materials #also consumable stores and spares$,

3. &or-in-process #also nown as stoc-in-process, process$, and

4. Finished goods.

2et us now discuss all these three items, one by one.

0. 5aw Materials are those basic inputs, which are used to manufacture the finished

products.

3. &or-in-process, however, is the intermediary stage that comes after the stage

of raw materials, but ;ust before the stage of finished goods.

4. %he finished goods, in turn, comprise the end products, that is, the goods at their

final stage of production, ready for sale in the maret.

upposing, a company is in the business of production of breads. *n this case, the

wheat flour, baing powder, etc., would comprise the raw materials. !nd, when the flour

is put in the relative moulds, which in turn, are placed in the furnace, this stage is nown

as the wor-in-process stage. !nd, when the bread is fully baed and is ready for sale,

of course, after being wrapped in the pacing paper, it comprises the finished goods of

the company.

*t may be noted that in the case of manufacturing companies, inventory comprises raw

materials, wor-in-process and finished goods, while in the case of trading concerns or

trade merchants or retail traders, the inventory comprises only the finished goods. %hus,

while all the three components, as aforesaid, comprise the items of inventory for the

manufacturing concerns, only the finished goods, lie the breads alone, comprise the

inventory for a retail trader, selling breads.

"ere, it may be pertinent to mention that the tas of inventory management and control

is the ;oint responsibility of the purchase department, materials department, production


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department and mareting department. Further, while the policy pertaining to the raw

materials is to be formulated by the purchase department, in coordination with the

materials and production departments, the policy in regard to the inventory of finished

goods is to be formulated by the production department in coordination with the

mareting department. %he policy in regard to the wor-in-process, however, is finalised

by the production department alone.

!nd, as we have already seen earlier, eeping in view the vital importance of inventory

management and control, in financial terms, the role of finance manager can be said to

be the central coordinating role, among all the aforesaid four different departments, with

a view to ensuring that the inventory management and control are being exercised

effectively at the various stages and departments, on the desired lines. "ere, the main

responsibility of the finance manager comprises apprising the non-finance executives so

as to, at least, understand the basis of the mechanism and its overall implication in

regard to the control of various items of inventory, as these have direct effect on the

financial gains of the company. %hat is why it is said that the management of inventory,

and for that matter, the management of woring capital as a whole, is not the

responsibility of the finance manager alone, but also of the purchase department,

materials department, production department, and mareting department.

Proce In)entorie

%hese inventories comprise the various items of raw materials, lying at the various

stages of production, till these reach the final stage, to become the finished goods.

upposing, a company is manufacturing iron nails, and its basic raw material is iron

rods. *n the drawing machine, these rods may be drawn total time required for

completing all the involved processes #stretched$ and, thus, these may become thinner

and thinner in three to four processes, when these may come to the required diameter.

%hen, these thinner n rods will be cut into pieces of the required length of the nails. !nd


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then, while one end may be made pointed, the other end may be flattened to become

the head of the nail. !nd, after all these required processes are completed in full, the

stocs of finished goods are ready for transportation #movement$ to the godown#s$ or to

the company(s sales outlets.

%hus, as the production process involves several stages of production, the aggregate

quantum and value of the raw materials, lying at the different stages of production, all

taen together, comprise the stocs of process inventory.

!nd, thus, if the entire process #from the raw material stage till the stage immediately

preceding the finished goods stage$ taes say, ten days, and the average production of

the item is 0 units per day, the average quantity of such process inventories would

be equal to)

!verage stocs-in-process, multiplied by the time days required to complete all the

processes, i.e., 0 x 0 days A 0, units.

Mo)e(ent In)entorie

Movement inventories are usually referred to the inventories of finished goods, to be

transferred from the factory to the company(s godowns, warehouses, or sales depots.

%hus, if the average daily sales at the company(s sales depot are 3= units and the

transit time #for transporting the finished goods from the factory to the sales depots$ is

0 days, the average movement inventories, as per the aforesaid formula, would be)

3= units x 0 days A 3= units, or

3= units x 5s. =B- x 0 days A 5s. 03,=B-

Organi*ation In)entorie

+rganization inventories, on the other hand, comprise the items of raw materials and

finished goods stored and stoced in the company(s godowns, to be supplied to the

factory or to the sales depots, as and when they would requisition for the required


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number, weight, volume, etc., of the specific items of raw materials and finished goods,

respectively.

"ere, it may be mentioned that the moment the stocs of raw materials and finished

goods are issued from the company(s godown#s$, these items are excluded from the

organisation inventories and these, in turn, are included in the &oring 'apital process

inventories #though these raw materials may actually be put into the production process

a little later$, or in the movement inventories #even if the stocs of the finished goods

may be lying in the company(s show-rooms, unsold$.

ow, a natural question, that may arise, could be that if the inventory carrying cost is so

huge and material to affect the profitability of the company, favourably or unfavourably,

why should the companies, at all, have organization inventories, too, inaddition to the

process inventories and movement inventories. !nd, the answer, too, is very simple and

logical. %hat is, to mae the decision-maing process of planning #of purchases of raw

materials and level of stocing of various items of finished goods$ and scheduling of

successive operations of production, even more free and flexible. %his also facilitates

bifurcation of the functions of purchase of raw materials and production plan into two

separate departments, to be managed by the respective experts in each department.

%hus, while the production department may ;ust give its production schedule to the

purchase department, it would be the sole responsibility of the purchase department to

decide about the quantum of such purchases and the stocists to purchase them from.

%hat is, if the stocs sometimes are available at a cheaper price during the harvesting

seasons of the respective agricultural products, etc., the purchase department may

even purchase the materials in much larger quantity than required by the production

department #;ust for a fortnight or a month$. 8ecision could as well be taen by the

purchase department whether to go in for such purchases to avail of the bul discount,

or to avail of the cash discount, etc., whenever offered. imilarly, the purchase


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department may mae purchases for a wee only locally, to meet the immediate

demands of production, if, by that time, bul purchases may be made available at a

much cheaper rate. imilarly, in an inflationary condition, the purchase people may

exercise their prudence and expertise to mae the purchases of a larger quantity than

required, if such purchases are going to be sufficiently cheaper today, taing into

account the quantum of inflation, etc. %hat is, it would augur well if the purchase people

could as well now the fundamentals of cost-benefit analysis, to be made in this regard,

as also as to what factors should be taen into consideration #lie time-value of money,

rate of inflation and the total inventory carrying costs, etc.$.

%his much about the rationale behind eeping the organisation inventory of stocs of

raw materials, and delining the purchase functions and the production functions.

ow, let us discuss about the rationale behind eeping organization inventories of

finished goods. *t is a well nown fact that, in order to have some edge over the

competitors, companies have to eep some items in ready stoc so as to be able to

supply these to the customers from the shelf, at least to meet their immediate

requirements, and the balance to be supplied in a wee(s time or so. %his is important

because eeping huge numbers of items in ready stoc is fraught with grave riss of

obsolescence, expiry of shelf life, etc. Further, by virtue of having some organisation

inventory of finished foods, the companies are able to delin the production schedule

from mareting activities.

%hus, we can very well appreciate that by delining the purchase activities and

production activities, as also production activities from mareting activities, companies

may be able to optimise their profitability, by enabling the experts different departments,

to plan things in such a way that the profitability of the company could be optimized and

each departmental experts can concentrate on their respective wor, of course, eeping


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the overall interests and requirements if the other departments, too, in the fore front,

inasmuch as all the departments inter-dependent with each other.

!t this stage, it may be quite pertinent to examine the rationale behind eeping the in-

process inventory, too, #though these do not constitute a part of organization inventory,

as such$.

2et us, at the very outset, clarify that though the in-process inventory refers to wor-in-

process inventory only, it is different from the process or movement inventory,

discussed earlier, even though a part of the wor-in-process inventory may represent

process or movement inventory, too.

ow, as regards the rationale behind eeping the in-process inventory, it may be

mentioned here that it provides some flexibility and latitude in the scheduling of

production, so as to ensure efficient production schedule and higher capacity utilisation

of plant and machinery. Further, in case there is no stoc of in-process inventory, some

bottlenecs may be caused sometime somewhere in the production process, which may

ultimately result in delay in production and non utilisation of the installed capacity at the

optimum possible level. %hese factors, naturally, will culminate in adversely affecting the

financial gains of the company.

Econo(ic Or#er 2%antity 0EO21

*n regard to the management of inventories #specially the inventories of raw materials$

two primary questions naturally arise. %hey are)

#a$ +rder size, i.e., what should be the ideal size of the orderN

#b$ +rder 2evel, i.e., at what level of the stocs should the next order be placedN

:ut, before deliberating to find out the answers to the above questions, let us first try to

understand the distinguishing features of the three types of costs involved in the

management of inventories)

#i$ +rdering costs,


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#ii$ #*nventory$ carrying costs, and

#iii$ hortage costs.

2et us now discuss these costs, in detail, one by one.

%hese include the expenses in respect of the following items)

#i$ 'ost of requisitioning items#s$

6&Or#ering Cot

+rdering costs pertain to placing an order for the purchase of certain items of raw.

%hese include the expenses in respect of the following items)

#i$ 'ost of requisitioning the items#s$

#ii$ 'ost of preparation of purchase order #i.e. drafting, typing, despatch, postage, etc$

#iii$ 'ost of sending reminders to get the dispatch of the items#s$ expedited

#iv$ 'ost of transportation of goods

#v$ 'ost of receiving and verifying the goods

#vi$ 'ost of unloading of the item#s$ of goods

#vii$ torage and stacing charges, etc.

"owever, in case of items manufactured in-house #i.e., by the same company$, the

ordering costs would comprise the following costs)

#i$ 5equisitioning cost

#ii$ et-up cost

#iii$ 'ost of receiving and verifying the items

#iv$ 'ost of placing and arrangingBstacing of the items in the store, etc.

7& Carrying Cot 0o! in)entorie1

*nventory carrying costs include the expenses incurred on the following items)

#i$ 'apital cost #i.e., interest on capital loced up in inventories$

#ii$ torage cost

#iii$ 'ost of insurance #fire and theft insurance of stocs$


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#iv$ +bsolescence cost

#v$ %axes, etc.

*t may, however, be mentioned here that the carrying costs usually constitute around 3=

per cent of the value of inventories held.

8& S,ortage Cot 0or cot o! toc" o%t1

hortage costs or costs of stoc out are such costs which the company would incur in

case of shortage of certain items of raw materials required for production, or the

shortage of certain items of finished goods to meet the immediate demands of the

customers.

hortage of inventories of raw materials may affect the company in one or more of the

following ways)

#i$ %he company may have to pay somewhat higher price, connected with immediate

#crash$ procurements.

#ii$ %he company may have to compulsorily resort to some different production

schedules, which may not be as efficient and economical.

toc out of finished goods, however, may result in the dissatisfaction of the customers

and the resultant loss of sales.

*t, however, is relatively very difficult to actually measure the shortage cost when it

results due to the failure to meet the demands of the customers instantaneously, out of

the existing stocs. %his is so because such costs may have ramifications, both in the

short-term as also in the long term. :esides, these costs are somewhat intangible in

nature, and consequently difficult to assess quantitatively.

*t has also been observed that some of the companies, with a view to reducing total

ordering costs, prefer to order larger quantities. :ut, this way the level of inventory

becomes higher, and thereby the inventory carrying costs also go up. Further, if the


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company decides to carry a safety stoc of inventory so as to mitigate or reduce the

stoc out costs, or shortage costs, its carrying costs, in turn, would go up further.

%hus, with a view to eeping the total costs, pertaining to management of inventory, at

the minimum level, we may have to arrive at the optimal level where the total costs, i.e.,

total ordering costs plus total inventory carrying costs, are minimal. %o achieve this end

result, we may have to wor out the Economic +rder Cuantity #E+C$.

+aic Econo(ic Or#er 2%antity 0EO21 Mo#el

!t the very outset, it is to clarify here that we are going to discuss only the basic E+C

model, one of the simplest inventory models. %here are, in fact, a large number of other

inventory models, depending upon various variables and assumptions.

A%(ption o! t,e +aic EO2 Mo#el

*t may further be clarified here that the basic E+C model is based on various

assumptions, which are given hereunder)

0. %he estimate of usage #demand or consumption$ of the item of inventory for a

given period #usually one year$ is nown accurately.

3. %he usage #demand or consumption of the various items of inventory$ is equal

#even$, throughout the period.

4. %here is no lead time involved. %hat is, the item of inventory can be supplied

immediately on the receipt of the order itself6 there being virtually no time lag

between placing of an order and the receipt of the goods. 'onsequently, there is

no lielihood of stoc out, at any stage. %herefore, the shortage cost #or stoc out

cost$ is not being taen into account, as if it is nil.


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>. !nd, finally, that the inventory carrying cost is a fixed percentage of the average

value of inventory.

Eo4 For(%la ) Trial an# Error Met,o#

*t may be observed that the E+C can be ascertained in two distinct ways)

#i$ :y trial and error method #discussed immediately hereafter$, and

#ii$ :y use of a definite formula #discussed thereafter$.

Trial an# Error Met,o#

2et us understand the Gtrial and errorG method with the help of an illustrative example.

Econo(ic Or#er 2%antity 0EO21 an# Opti(%( Or#er 2%antity 0OO21

%he standard E+C analysis is based on the assumption that no discount is given,

howsoever large the order size be. :ut, in most of the cases, some discount is given by

way of an incentive to the buyers to order for a larger quantity so as to avail of some

bul discount. %hus, we should try to modify the standard E+C formula so as to find out

the E+C as also to assess whether it would be economical to avail of the bul discount

or not.

Econo(ic Or#er 2%antity 0EO21an# In!lation

%he E+C analysis presumes that the cost price per unit is constant. %his implies that

the incidence of inflation has not been taen into account. *n order to account for

inflation, what we have to do is, to first substract the rate of inflation from ' #the annual

inventory carrying cost, expressed as a percentage$ and apply the standard E+C

formula with this simple modification only.

:ut, you may as, and rightly so, that why at all do we substract the rate of inflation from

'N %he reason is simple enough. *n an inflationary condition, the purchase price of

inventory will also go up and this will, to some extent, offset the inventory carrying cost.

Co(ponent o! In)entory Carrying Cot

*nventory carrying costs comprise various items, some of which are given hereunder)


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0i1 Storage Cot

%hat is, the rental payable will be proportionately higher as more space would be

required to store higher level of inventory.

0ii1 -an#ling C,arge

%hat is, when higher stocs will be stored, handling charges lie unloading and stacing

charges, at the time of receipt of the goods, etc., involving man power, may also go up.

0iii1 In%rance Pre(i%(

imilarly, the amount of insurance premium payable, for fire insurance, theft insurance,

flood and such other natural calamity insurance, etc., will also be higher.

0i)1 Watage

*t has generally been observed that if more than sufficient stocs of inventory are

stored, there is a usual tendency to consume more than what is actually required,

resulting in extra avoidable wastages.

%o bring home the point, let us tae a common place example. upposing there is a

huge stoc of medical bills proforma, these may, at times, be used even as paper

plates, etc. :ut, if these proforma were in short supply, people may tae care not to

waste a single form.

0)1 Da(age an# Deterioration

*n the event of storing more than required level of stocs of raw materials and finished

goods, there is every chance that the goods may deteriorate in quality, lie the

whiteness of papers gets diminished #it turns yellowish$ with the passage of time. ome

chemicals or medicines also have limited shelf-life, where after these may turn useless.

tocs of cement, in rainy season, are fraught with grave ris of turning into stones,

and, thus, becoming useless.


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:ut, as seen earlier, the standard E+C model presumes as if there is no lead-time

involved. !nd thus, the order can well be placed when the inventory level comes to

zero. :ut, the factual position is otherwise. %herefore, we should decidedly tae into

account the lead-time, too, while computing E+C. %his can well be done by introducing

a slight modification in the standard E+C analysis to arrive at a realistic ordering point,

so as to tae care of the lead time involved and thereby to mitigate the ris of shortage

of stocs, involving stoc out costs.

Or#er Point

%his can well be done by ensuring that the order is placed when sufficient balance of

stoc is still left to tae care of the lead-time. :ut, for doing so accurately, we may have

to now the rate of usage of materials as also the lead-time, exactly and in definite

terms. *n that case the ordering level would simply be as under)

2ead time #in number of days for procurement$ multiplied by average usage per day. i.e.

+rder 1oint A 2ead time #in days$ x 8aily @sage.

Sa!ety Stoc"

:ut then, in actual practice, one can neither estimate the lead time nor the daily usage

so accurately and exactly. &e can, at best, mae some reasonable estimates. :ut, in

that case, the possibility of some error, howsoever small, can hardly be eliminated

completely.

!nd, therefore, we should, to be on the safer side, tae into account the element of such

uncertainty, too. !ccordingly, we should always eep some safety stoc with us to meet

such eventualities.

!nd, as such, the order point should be computed by adding the quantum of sufficient

safety stocs, too.

%hus, the order point can well be computed as)

E+C O Hlead time #in days$ x daily usageI O safety stoc


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:ut, how to compute the safety stocN *n fact, it is a managerial decision and, therefore,

it largely depends upon the inventory policy as also the organisational culture of the

company. *t may, accordingly, be high or low, or even medium.

%his, however, does not mean that we should try to cut it too fine, either. +therwise, a

lot of the valuable time of the Materials Manager and the 1urchase 8epartment would

get wasted in the fire-fighting operations in procuring the materials, in the nic of time,

and incur the avoidable expenses relating to such crash purchases.

%he best policy, in regard to eeping the safety stoc, would ideally be - neither Gtoo

muchG, nor Gtoo littleG, but G;ust rightG. :ut, it is easy said than done. "owever, the

considered opinion that, by some trial and error method, we may be able to arrive at a

nearly optimal level of safety stocs, in due course of time.

Ot,er 5aria3le Factor A!!ecting EO2

*n finding out the E+C or order level or safety stoc, etc., we have, in the preceding

pages, made certain assumptions that some other factors do not vary, though in the real

world they do. %herefore, it would always be prudent enough to consider the following

variable factors, too, while taing a particular decision. %hey are)

6& Retriction I(poe# 3y t,e Reer)e +an" o! In#ia 0R+I1 an# t,e Go)ern(ent/

%he 5eserve :an of *ndia #5:*$, and the overnment of *ndia, with a view to arresting

inflation or steep rise in the prices of certain essential commodities, lie food grains

#rice, wheat, maize, etc.$, onion, etc., may resort to some changes in their elective

'redit 'ontrol 1olicies, instructing the bans to retain higher percentage as margin on

the stocs advanced against, as also by fixing some ceiling on the maximum amount

that could be advanced against the security of some commodities specified, to a single

borrower, as also to fix a lower ceiling on the holding of such stocs by a single party,

so as to restrict hoarding, and consequently the steep rise in the price. uch statutory

restrictions exercise limitation on the companies in formulating their inventory policy.


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7& E$pecte# Scarcity/*n case certain material is expected to be in short supply in the

near future, it would be a prudent policy to stoc a larger quantity of such material so as

to avoid the stoc-out ris, as far as possible.

8& Fl%ct%ating Price/ometimes the price of certain commodity is expected to rise or

fall, in the near future. !nd, accordingly, the stocs of inventory of such items should be

ept flexible, and ad;usted accordingly, i.e., retaining higher or lower levels of such

inventory, respectively.

9& Ri" o! O3olecence/'ertain items of raw materials may become obsolete with

the passage of time. For example, ;ute pacing has since been replaced by polythene

matting in the carpet industries. %he ris of obsolescence may be even higher and

costlier in the cases of the finished goods, in the modern age of technological

advancements and stiff global competition. uch stocs should naturally be ept at the

minimal possible level.

"ere, it may be emphasised that even if the policy of meeting the customers( demand

immediately is taen to be the company(s mareting strategy, instead of having a huge

ready stocs of such finished goods, it would augur well if only a percentage of the

maret requirements could be ept in the ready stoc, to be supplied to the customers

immediately, and the balance quantity could be produced on an emergency basis and

supplied in a wee(s time or so. %his way, the company may meet the competitive

challenges, as also avoid the ris of obsolescence.

A+CANAL.SIS 0OR 5ED ANAL.SIS1

!:' analysis is a very effective and useful tool for monitoring and control of inventories.

!s you must have observed, generally speaing, a very small percentage of the total

number of items of inventory #say 0$ may account for a much larger percentage #say

>=$ in terms of value. !s against this, in cases of certain other items of inventory, a

very large percentage of the total number of items of inventory #say P$ may account


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for a much smaller percentage #say 0$ in terms of their total value. !nd, liewise, a

medium percentage of some items #say 3$ may account for a medium percentage

#say 3=$ in terms of their total value. %hese are classified as category !, : and '

respectively. !:' analysis is also referred to as 7E8 #7ital, Essential and 8esirable$

analysis.

&e may put the aforesaid statements in a tabular form as under)

%he main #or even sole$ purpose of classifying the inventories into these three

categories, !, :, and ', is to vary the pressure and intensity of control, in terms of the

value of the items of inventory.

%o put it differently, while the entire stocs #say 0$, of the items in category G!G must

be very closely monitored and controlled, the monitoring and control of say, 0 of the

items of category G'G, could be considered enough to serve the purpose. !nd, in the

case of G:G category of items, the monitoring and control of say 3= of the item alone

may be taen as sufficient.

Categori*ation o! Ite( !or A3c Analyi

ow, let us see how do we usually proceed to classify the various items of inventories

into the three categories viz., !, :, and '. %he procedure involves the following steps, in

a sequential order)

Step 6

5an all the items of inventory, in a descending order, based upon their annual usage

value, and serially number them, from * to n.


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Step 7

5ecord the totals of annual consumption values of all the items separately and store

them as a percentage of the total value of consumption.

Step 8

a$ +bserve the percentage column and find out the cut off point where the difference

between the two successive percentages is rather significant and mared.

b$ !t the same time, please do bear in mind that the cut off point so arrived at,

comprises a reasonable number of items of inventory, too.

Step 9

&e may finalise the classification of the items of inventory into !, :, and ' categories,

giving the number of units of inventory and their values in percentage terms, under all

the three categories, with the laid down principles and ob;ectives of the !:' analysis

#or 7E8 analysis$, in the desired manner.

+aic EO2 Mo#el

*t is based on the following assumptions)

#i$ %he quantum of the usual annual usage of the items of inventories is nown, in

accurate term.

#ii$ %he usage is usually uniform throughout the year.

#ii$ %he lead-time #i.e, time gap between ordering and receiving$ is *2.

#iv$ %herefore, there is no ris of stoc-out, either. %hat is, the stoc-out cost is *2.

#v$ %hus, only two costs are involved)

#a$ +rdering 'ost, and

#b$ *nventory 'arrying 'ost.

#vi$ Further,

#a$ +rdering 'ost is uniform, irrespective of the order size, and


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#b$ %he *nventory 'arrying 'ost is a fixed percentage of the average value of

*nventories.

EO2 For(%la )& Trial an# Error Met,o#/

%rial and Error Method is a very cumbersome and time-consuming process. %he

formula, however, maes the procedure rather simple enough.

In Practice/

%here is no single Economic +rder 1oint #E+1$. %here is, instead, an Economic +rder

5ange #E+5$.

EO2 5& >>> 0Opti(al Or#er 2%antity1/

H%hat is, when bul #quantity$ discount is availableI.

#a$ &hen the quantity discount is available at a lower level than the E+C, then E+C

itself will be the , too.

#b$ :ut, if it is higher than E+C, will be the E+C or the quantity eligible for bul

discount, depending upon which one of these two will be beneficial Hi.e., when the

resultant difference will be a positive #Ove$ figureI.

A Ne' Cl%e to EO2/

%hat is, after finding out the E+C in terms of the nearest integer figure, we should find

out the number of orders. !nd, this again, should be converted into the nearest integer

number. :ased on this figure as the number of orders, we should calculate the E+C,

which will be the E+C in real terms. :esides, we should bear in mind the concepts of

E+1 and E+5, too, at this stage.

Co(ponent o! In)entory Carrying Cot/

#i$ torage 'ost


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#ii$ "andling 'harges

#iii$ *nsurance 'harges

#iv$ &astages

#v$ 8amageB8eterioration

#vi$ %echnical +bsolescence, :locage of funds and cost of capital, and opportunity cost

connected therewith.

A#)antage o! -ig, In)entory/

#a$ "igh tocs of 5aw Materials

#i$ :ul purchase at cheaper rate with quantity discount. H:etter, if bul annual purchase

is ordered, but the delivery and payments are to be made in phases, to the mutual

advantages of both the parties. *t is an optimal strategy$.

#ii$ easonal purchases, being cheaper and sure.

#iii$ o toc-out cost and ris.

#iv$ *n inflationary economy, it may be gainful.

#v$ avings of ordering cost and the connected hazels of loading and unloading, etc.

031 -ig, Stoc" o! Fini,e# Goo#/

#i$ *t may facilitate instant delivery, out of the shelf, and, thus, to have an edge over the

competitors. H:ut, better to have only a small ready stoc and the rest to be produced

on receipt of the order, on priority basisI.

#ii$ %hus, the Golden MeanG is the most basic management mantra, pertaining to the

management of inventory, too.

6;& Lea# Ti(e

*t represents the time lag between placement of order and the actual receipt of goods.

%his could as well be taen into account by modifying the E+C formula, ;ust slightly.


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6?& Or#er Point

%hus, as a prudent manager, we should place the next order well in advance, at the

point in time, when there is some stoc left, being sufficient enough to tae care of the

lead time.

6@& Sa!ety Stoc"

!nd, it would be a better business sense to have some safety stoc, too, so as to tae

care of some possible fluctuations in both #i$ the lead-time, and accordingly6 #ii$ the

order point.

%hus, +rder 1oint will be A E+C O H2ead-time #in days$ x 8aily @sageI O afety toc.

Estimating and ascertaining the safety stoc is a managerial ;udgement9 decision Q

discretion. :ut, the safety stoc should not be too high, nor too low. *t should be

sufficient enough, ;ust about right.

CAS- MANAGEMENT

INTRODUCTION

*n the previous unit, various issues regarding management of woring capital were

discussed. *t was explained that current assets form an important aspect of woring

capital management. *n fact, each current asset requires a detailed treatment to

understand the issues related to the need and method of its management. *n this unit

we shall discuss the planning and managing of cash. 'ash to business is lie blood

stream in human body. 'ash denotes the liquidity of a business enterprise and plays an

important role in nurturing and improving the profitability of an organization. *t is,

therefore, essential to mae a proper estimate of the cash needs and plan for it so as to

avoid technical or legal insolvency. "ence, effective management ensuring adequate

cash is necessary. %he cash available with the organization should neither be short nor

too excessive.


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W,y i Ca, Nee#e#=

%he demand for liquid assets lie cash, whether by individuals or firms, is normally

attributed to three behavioral motives, viz., the transaction motive, the precautionary

motive and the speculative motive.

%he transaction motive for holding cash is helpful in the conduct of everyday ordinary

business such as maing of purchases and sales. %he amount of cash needed,

however, differs from business to business and from firm to firm depending on the

frequency of cash transactions. 5etail trade, for example, requires a higher ratio of cash

to sales and of cash to total assets. Firms having seasonal business will need greater

amount of cash during the season.

%he precautionary motive is concerned with predictability of cash inflows and outflows.

"igher the predictability of cash, lower is the amount needed against emergencies or

contingencies. %his motive for holding cash is also influenced by the ability of the firm to

obtain additional cash on short notice through short-term borrowings. ! minimum

reservoir of cash must always be ept in hand to meet the unexpected payments and

other contingencies.

%he speculative motive for holding cash is concerned with availing the opportunities

arising from unexpected developments, e.g. an abnormal increase in prices. "owever,

eeping additional cash for speculative purpose is not common in business.

Deter(ining Opti(al Ca, +alance

"olding of excessive cash is a non-profitable proposition, as idle cash does not earn

any income. imilarly shortage of cash may deprive the business unit of availing the

benefits of cash discounts, and of taing advantage of other favorable opportunities. *t

may even lead to loss of credit-worthiness on account of default in paying liabilities

when the same becomes due. "ence, every organization, irrespective of its size and

nature, has to determine the appropriate or optimum cash balance that it would need.


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! firm(s cash balance, generally, may not be constant overtime. *t would therefore be

worthwhile to investigate the maximum, minimum and average cash needs over a

designated period of time.

?ou are aware that cash is needed for various transactions of the organization.

Maintenance of a cash balance however has an opportunity cost in the following ways)

a$ 'ash can be invested in acquiring assets such as inventory, or for purchasing

securities. +pportunities for such investments may be lost if a certain minimum cash

balance is held.

b$ "olding of cash means that it cannot be used to offset financial riss from the short-

term debts.

c$ Excessive reliance on internally generated liquidity can isolate the firm from the short-

term financial maret.

ow the Finance Manager should understand the benefits and the opportunity costs for

holding cash. %hereafter, he must proceed to wor out a model for determining the

optimal amount of cash. First of all, 'ritical minimum cash balance should be conceived

below which the firm would incur definite and measurable costs. !part from ris

aversion, the existence of the minimum balance is ;ustified by institutional requirements

such as credit ratings, checing accounts and lines of credit.

%he violation of maintaining a minimum cash balance will create shortage costs, which

will be determined by the actions of creditors on account of postponing their payments

or non-availing of cash discounts.

!t any point of time a firm(s #ending$ cash balance can be represented as follows)

Ending balanceA:eginning :alance O 5eceipts 9 8isbursements

*f receipts and disbursements are equal for any unit of time, no problem is involved.

+rdinarily, however, receipts may be more than disbursements or vice versa. "ence,


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the ending balance will eep on fluctuating. *n actual practice, receipts and

disbursements do vary, particularly in case of firms having seasonal activities.

uppose, the receipts and disbursements are not synchronized but the variation is

predictable, then the main problem will be that of minimizing total costs.

Ca, Manage(ent

'ash, being a sensitive asset, has to be regulated according to needs. !ny deficits #or

inadequacies$ should be rectified and any excess amount be gainfully invested. 'ash

management involves two main questions

0. "ow should the collection and disbursement of cash balances be managedN

3. "ow should the appropriate cash balance be determined, and how should any

temporary idle cash be invested in interest earning assetsN

Managing Collection an# Di3%re(ent

T,e Ca, Cycle

*n order to deal with the problem of cash management, we must have an idea about the

flow of cash through a firm(s account. %he entire process of this cash flow is nown as

'ash 'ycle. %his has been illustrated in Figures *** and *7. 'ash is used to purchase

materials from which goods are produced. 1roduction of these goods involves use of

funds for paying wages and meeting other expenses. oods produced are sold either

on cash or credit. *n the latter case the pending bills are received at a later date. %he

firm thus receives cash immediately or later for the goods sold by it. %he cycle continues

repeating itself.


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be more when there are several centers. 'oncentration of collections at one place will

thus permit the firm to store its cash more efficiently.

%he time lag between the dispatch of cheque by the customer and its credit to our

account with the ban should be reduced. ome firms with large collection transactions

introduce loc box system. *n this system the post boxes are hired at different centers

where cashBcheques can be dropped in. %he local baner can daily collect the same

from the locers. %he collecting ban is paid service charges. *n order to minimize time

front bans may be ased to devise methods for speeding up the collection of cash.

Reco)ering D%e

!fter sale of goods on credit, either on account of convention or for promoting sales,

receivables are created. *t may however be useful to reduce the amount bloced in

receivables by seeing to it that they do not become overdue accounts. *ncentive in the

form of discounts for early payment may be given. More important than anything else, is

a constant follow-up action for the recovery of dues. %his will improve position of cash

balance.

Controlling Di3%re(ent

eedless to assert that speeding up of collections helps conversion of receivables into

cash and thus reduces the financing requirements of the firm. imilar ind of benefit can

be derived by delaying disbursements. %rade credit is a costless source of funds for it

allows us to pay the creditors only after the period of credit agreed upon. %he dues can

be withheld till the last date. %his will reduce the requirement for holding large cash

balances. ome firms may lie to tae advantage of cheque boo float which is the time

gap between the date of issue of a cheque and the actual date when it is presented for

payment directly or through the ban.


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In)et(ent o! I#le Ca, +alance

%wo other important aspects in cash management are how to determine appropriate

cash balance and how to invest temporarily idle cash in interest earning assets or

securities. %he first part relating to the theory of determining appropriate cash balance

has already been discussed earlier. ow we shall discuss the investment of idle cash

balances on temporary basis. 'ash by itself yields no income. *f we now that some

cash will be in excess of our need for a short period of time, we must invest it for

earning income without depriving ourselves of the benefit of liquidity of funds. &hile

doing this, we must weigh the advantages of carrying extra cash #i.e. more than the

normal requirement$ and the disadvantages of not carrying it. %he carrying of extra cash

may be necessitated due to its requirement in future, whether predictable or

unpredictable. %he experience indicates that cash flows cannot be predicted with

complete accuracy. 'ompetition, technological changes, unexpected failure of products,

stries and variations in economic conditions mae it difficult to predict cash needs

accurately.

In)et(ent Criteria

&hen it is realized that the excess cash will remain idle, it should be invested in such a

way that it would generate income and at the same time ensure quic re-conversion of

investment in cash. &hile choosing the channels for investment of any idle cash

balance for a short period, it should be seen that #i$ the investment is free from default

ris, that is, the ris involved due to the possibility of default in timely payment of interest

and repayment of principal amount6 #ii$ the investment shall mature in a short span of

time6 and #iii$ the investment has adequate maretability. Maretability refers to the ease

with which an asset can be converted bac into cash. Maretability has two dimensions

price and time-which are inter-related. *f an asset can be sold quicly in large amounts

at a price determinable in advance, the asset will be regarded as highly maretable and


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highly liquid. %he assets, which largely satisfy the aforesaid criteria, are) overnment

ecurities, :aners( !cceptances and 'ommercial 1aper.

Ca, +%#geting

1lanning cash and controlling its use are very important tass. *f the future cash flows

are not properly anticipated, it is liely that idle cash balances may be created which

may result in unnecessary losses. *t may also result in cash deficits and consequent

problems. %he Finance Manager should therefore, plan the cash needs and uses. 'ash

budget is a useful device for this purpose.

'ash budget basically incorporates estimates of future inflows and outflows of cash

over a pro;ected short period of time which may usually be a year, a quarter or a half-

year. Effective cash management is facilitated if the cash budget is further broen down

into monthly, weely or even daily basis.

Preparing a Ca, +%#get

%here are two components of a cash budget9cash inflows and cash outflows. *n both

these components there are two types of flows, viz. operating cash flows and financial

cash flows. ome common elements of each are as follows)

'ash *nflows - #a$ +perating) cash sales, receivable collections. #b$ Financial) interest

receipts, sale of maretable securities, issue of new securities.

'ash +utflows -#a$ +perating) wage payments, payments of bills and accounts payable,

and capital expenditure #b$ Financial) dividend payments, interest payments,

redemption of securities, loan repayments, purchase of maretable securities and tax

payments.

Sale Wor" S,eet

ales bring in a ma;or part of cash inflows. !ll sales may not be against cash6 credit

sales are quite common. Each business establishment has its own credit policy for

promoting sales. Even when care is taen to ensure that credit sales do not exceed the


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permitted percentage of total sales and that debtors do not default in paying bills in time,

it is a common experience that the total amount of sales is recovered over a period of

time.

-A5E .OU UNDERSTOOD=

0. 8iscuss the concept of woring capital. !re the gross and net concepts of

woring capital exclusiveN Explain.

3. 8istinguish between fixed and fluctuating woring capitals. &hat is the

si

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