FINANCIAL MANAGEMENT

Unit 4

What is Working Capital Management?

Working capital management is defined as the relationship between a

company’s short-term assets and commitments. It tries to ensure that a
company’s day-to-day operational expenses can be met while simultaneously
investing its resources in the most profitable way possible. Management of
working capital is mainly about making sure that a business has enough cash
flow to pay its short-term debts and cover its short-term running costs. The
current assets minus the current bills of a business make up its working capital.
Anything that can be easily turned into cash within a year is considered a
current asset. These are the company’s assets that can be quickly sold. Cash,
accounts due, inventory, and short-term investments are all examples of current
assets. Current liabilities are debts that are due within the next 12 months.
Some examples are accruals for operational expenses and current parts of
payments on long-term debt.

Objectives of Working Capital Management

Working capital management is all about making sure that a company can meet
its short-term financial responsibilities, keeping operations running smoothly,
and increasing the value of shares. These are the main goals of managing
working capital,
1. Liquidity Management: One is liquidity management, which means making
sure the company has enough cash on hand to pay its short-term debts as they
come due. To do this, you need to have enough cash on hand and assets that can
be quickly turned into cash to cover your present debts.
2. Optimal Utilisation of Resources: Try to find a balance between keeping
enough working cash on hand and not having too many assets that aren’t being
used. The goal of this purpose is to make the best use of money by avoiding the
needless holding costs that come with having too much inventory or accounts
receivable.
3. Risk Management: Reduce the risks that come with working capital, like
credit risk in accounts payable and inventory going out of date. Strategies for
finding, evaluating, and lowering risks that could affect cash are part of good
working capital management.
4. Maximizing Profitability: As long as liquidity is maintained, working
capital management tries to maximise profitability by keeping the cost of
hanging onto extra working capital as low as possible. This includes managing
inventory well, negotiating good credit terms, and finding the best ways to
collect on accounts outstanding.
5. Effective Cash Flow Management: Make sure you manage cash flows well
so that you have a steady flow of cash coming in and going out. This means
making accurate predictions about how much cash you will need, collecting
receivables quickly, and managing payables wisely.

Why is Working Capital Management Important?

Managing a business’s working capital is important for its general financial

health and the smooth running of its operations. Here are some reasons why itis
important to stay on top of your working capital,
1. Liquidity and Solvency: A business should have enough cash on hand to
meet its short-term obligations if it manages its working capital well. This helps
avoid financial trouble and improves stability.
2. Operational Efficiency: Good working capital management makes day-to-
day operations run more smoothly by making sure the company has the money
it needs to do things like buy raw materials, pay employees, and cover extra
costs.
3. Ideal Use of Resources: A business can get the most out of its assets and
avoid extra costs by keeping its working capital as low as possible. This is
because too much working capital can get stuck in things like inventory,
accounts payable, and other things.
4. Lowering Costs: Good handling of working capital can lead to lower costs.
For instance, lowering the amount of inventory you keep on hand can lower
your holding costs, and negotiating good payment terms with suppliers can get
you discounts and other saves.
5. Managing your Cash Flow: Managing your working capital is important for
keeping your cash flow healthy. It makes sure that a company has enough cash
on hand to pay its short-term debts, which lowers the chance that it will fail.
6. Lowering Interest Costs: If a business manages its working capital well, it
can depend less on borrowing money from outside sources. This can then lead
to lower costs for interest and funding.
7. Risk Mitigation: Good control of accounts receivable lowers the risk of bad
debts by making sure that payments are made on time. Keeping track of
inventory levels also lowers the chance of items going out of date and being
written off.
8. Relationships with Suppliers and Buyers: Keeping your working capital
in good shape can help you have good relationships with both suppliers and
buyers. Suppliers may give better terms to customers who can pay them, and
customers like service that they can count on.
9. Flexibility and Adaptability: A company with well-managed working
capital can respond quickly to changes in the market, take advantage of
business possibilities, and deal with economic uncertainty.
10. Investor Confidence: Good control of working capital shows investors that
a business is well-run and responsible with its money. It can make investors
more confident and improve a business’s standing in the financial markets.
TYPES OF WORKING CAPITAL
According to the needs of business, the working capital may be classified into
following two basis:
1) On the basis of periodicity
2) On the basis of concept

On the basis of periodicity: The requirements of working capital are

continuous. More working capital is required in a particular season or the peck
period of business activity. On the basis of periodicity working capital can be
divided under two categories as under:
1. Permanent working capital
2. Variable working capital

(a) Permanent working capital: This type of working capital is known as

Fixed Working Capital. Permanent working capital means the part of working
capital which is permanently locked up in the current assets to carry out the
business smoothly. The minimum amount of current assets which is required to
conduct the business smoothly during the year is called permanent working
capital.
For example, investments required to maintain the minimum stock of raw
materials or to cash balance. The amount of permanent working capital depends
upon the size and growth of company. Fixed working capital can further be
divided into two categories as under:

1. Regular Working capital: Minimum amount of working capital required to

keep the primary circulation. Some amount of cash is necessary for the payment
of wages, salaries etc.
2. Reserve Margin Working capital: Additional working capital may also be
required for contingencies that may arise any time. The reserve working capital
is the excess of capital over the needs of the regular working capital is kept
aside as reserve for contingencies, such as strike, business depression etc.

(b) Variable or Temporary Working Capital: The term variable working

capital refers that the level of working capital is temporary and fluctuating.
Variable working capital may change from one assets to another and changes
with the increase or decrease in the volume of business. The variable working
capital may also be subdivided into following two sub-groups.
1. Seasonal Variable Working capital: Seasonal working capital is the
additional amount which is required during the active business seasons of the
year. Raw materials like raw-cotton or jute or sugarcane are purchased in
particular season. The industry has to borrow funds for short period. It is
particularly suited to a business of a seasonal nature. In short, seasonal working
capital is required to meet the seasonal liquidity of the business.
2. Special variable working capital: Additional working capital may also be
needed to provide additional current assets to meet the unexpected events or
special operations such as extensive marketing campaigns or carrying of special
job etc.

2) On the basis of concept: on the basis of concept working capital is divided

into two categories as under:
(A) Gross Working Capital: Gross working capital refers to total investment
in current assets. The current assets employed in business give the idea about
the utilization of working capital and idea about the economic position of the
company. Gross working capital concepts is popular and acceptable concept in
the field of finance.
(B) Net Working Capital: Net working capital means current assets minus
current liabilities. The difference between current assets and current liabilities
is called the net working capital. If the net working capital is positive, business
is able to meet its current liabilities. Net working capital concept provides the
measurement for determining the creditworthiness of company.

Components of Working Capital Management

When it comes to managing working capital, some balance sheet accounts are
of greater significance than others. When looking at working capital, it’s
common to compare all current assets to current liabilities. However, there are
some accounts that are more important to keep an eye on.
1. Cash: Cash flow and cash needs are the most important parts of managing
working capital. This means keeping an eye on the company’s cash flow by
estimating how much it will need, planning how it will spend and earn, and
making sure that the company has sufficient cash to pay its bills. Every account
should be looked at because cash is always a present asset. But businesses
should be aware of payments that are limited or have time limits.
2. Receivables: Companies need to be aware of their receives in order to
handle their capital. In the short run, while they wait for credit sales to be
completed, this is very important. This includes overseeing the company’s credit
policies, keeping an eye on how much customers pay, and making recovery
methods better. It doesn’t matter if a company makes a sale if it can’t get paid
for it.
3. Accounts Payable: Companies can use payables as a tool to better handle
their working capital because they often have more control over this area. A
business may not be able to control some parts of its working capital
management, like selling goods or collecting debts. However, it usually has
control over how it pays its suppliers, the terms of its credit, and when it spends
cash.
4. Inventory: When companies handle their working capital, they first look at
their inventory because it may be the riskiest part of the process. When a
company wants to turn its goods into cash, it has to go to the market and rely
on what customers want. If this can’t be done on time, the company might have
to keep short-term resources that can’t be used right away. The company may
also be able to quickly sell the stock, but only if the prices are slashed by a lot.

Factors Determining Working Capital

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The working capital requirements of an enterprise depend on a variety of

factors. These factors affect different enterprises differently and vary from time
to time.

These factors are:

1. Nature of Business:

The working capital requirements of a firm is basically influenced by the nature

of business undertaken by it. The ratio of current assets to total assets of a firm
measures the requirements of working capital of various firms. The need for
working capital is depend on operating cycle period i.e., shorter the operating
cycle period, smaller the working capital requirements, larger the operating
cycle period, larger the working capital requirements.

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E.g. Public utilities, hotels, restaurants etc. need small working capital
requirements. Trading firms’ financial firms, Construction Companies
Manufacturing firms etc. need larger working capital requirements.

2. Size of Business:

The size of a business firm affects the working capital requirements. The size
indicates the scale of operation. Larger the scale of operation larger will be the
working capital requirements. Smaller the scale of operation, smaller will be the
working capital requirements.

3. Manufacturing Cycle:

Manufacturing cycle is the time gap between the purchase of raw materials and
the production of finished goods. Shorter the manufacturing cycle, smaller will
be the working capital requirements and larger the manufacturing cycle, larger
will be the working capital requirements.
e.g., a distillery needs larger working capital whereas a bakery requires smaller
working capital.

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4. Business Cycle:

The working capital requirements depend upon the supply and demand for the
goods and services produced. The demand for the products will be expected
well in advance and working capital requirements decided accordingly.

5. Firm’s Credit Policy:

The credit policy of the firm influences the requirement of working capital and
it is based on credit allowed to the debtors and credit allowed by the creditors.

6. Operating Efficiency of the Firm:

The efficiency of the business operation improves the pace of the cash cycle,
thereby strengthens the working capital turnover.

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7. Profit Margin and Dividend Policy:

A higher the net profit margin reduces the working capital requirements
because it contributes towards working capital resources. Again, the policy of
the management towards dividend strengthens the base for working capital
requirements. If more will be the retained earnings there will be more cash
available for working capital necessity of a firm.

8. Expansion and Growth of Business:

If the company goes for growth and expansion of business, it will require more
working capital in terms of sales and fixed assets. Increasing sales require more
working capital in the form of more stock of raw materials, inventory of work-
in- progress and finished goods.

9. Suppliers’ Credit:

The purchasing policy of the business decides the working capital necessity. If
the purchases on a cash basis only, more working capital required. If the
purchases on credit basis, the period of credit allowed by the creditor decides
the size of working capital requirements.

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10. Loans and Credit Facilities Available:

The working capital requirements of the firm depends upon access to the money
market. The firms with readily available credit from banks and from other
financial institutions at liberal terms, will be able to manage with less working
capital.

11. Taxation Policy:

The industries which will be required to pay heavy taxes to the Government
need larger working capital.

12. Level of Automation:

By adopting higher level of technology in the industry reduces employees,

hence lesser working capital is needed. The industries which are more labour
intensive require more working capital.

Main Sources of Working Capital – Sources of Regular Working Capital

and Seasonal Working Capital (With Flow Chart)
A large scale organisation can procure finance for its working capital
requirements from the various sources.

The following flow chart illustrates the various sources of working

capital:

I) Sources of Regular Working Capital

1. Issue of shares:

It is the most important source of long term regular working capital. As far as
possible the company should procure maximum amount of working capital by
issue of shares. It creates no burden on the fixed charges on the assets of the
company. Moreover the company is not under obligation to return the capital.

2. Issue of debenture:
Long term regular working capital can also be procured by issue of debentures
or bonds. But it should be remembered that the method be resorted to only for
satisfying permanent working capital requirements, and not the seasonal needs.

It creates a burden on the fixed charges on the assets and the company is under
the obligation to return the capital to its investors. Considering these difficulties
it is better to rely more on the issue of shares than issue of debentures.

3. Retained profits:

It is considered as a sound practice to finance the fixed and working capital

requirements from the retained profits of an existing unit. It is the cheaper and
most convenient method of securing capital by an enterprise. It creates no
charge on future profits of the company.

II) Sources of Seasonal Working Capital

1. Indigenous bankers:

Prior to establishment of banking companies on modern lines the shroffs, money

lenders and other country bankers had control over the financial activities. With
the development of banks indigenous bankers, confine their activities to giving
loans for personal consumption and trading purposes. In certain cases, cottage
and small scale industries obtain short term credit from indigenous bankers.

2. Commercial banks:

Commercial banks are the most important source of short term funds to
industrial enterprises. The greater part of the working capital is supplied by
them through direct advance in the shape of loans, overdraft or cash credits and
through the discount of commercial papers.

After nationalisation of commercial banks in India in 1969, more short term

finance was made available to small and cottage industries.

3. Public deposits:

Variable or seasonal working capital requirements of the business enterprise,

can also be met by accepting the deposits from the public. Public deposits are
accepted by industrial and commercial enterprises from 6 months to 5 years,
Established companies can get ready response from the public to place their
surplus in deposits accounts.

It is the simple method of raising short term finance. It should, however, be

remembered that it is not a very dependable source of finance because there is
always the risk of withdrawals during the “Rainy Day”.

4. Ploughing back of company profits:

Ploughing back of profits refers to the process of using the part of net profit for
financing the business operations of the company. The most suitable method of
financing for an existing and well established company is the policy of retaining
a portion of net earnings.
5. Specialised finance corporations:

Although funds can be procured from special finance corporations Eg. :

Industrial Financial Corporations. State Finance Corporations, Industrial
Development Ranks etc.; yet this source should not be used for supplying the
variable or seasonal working capital. These institutions are important sources of
long term and medium term finance.

Risk and Returns: Concept of Risk and Returns

After investing money in a project a firm wants to get some outcomes from the
project. The outcomes or the benefits that the investment generates are called
returns. Wealth maximization approach is based on the concept of future value
of expected cash flows from a prospective project.

So cash flows are nothing but the earnings generated by the project that we
refer to as returns. Since fixture is uncertain, so returns are associated with
some degree of uncertainty. In other words there will be some variability in
generating cash flows, which we call as risk. In this article we discuss the
concepts of risk and returns as well as the relationship between them.

Concept of Risk:

A person making an investment expects to get some returns from the

investment in the future. However, as future is uncertain, the future expected
returns too are uncertain. It is the uncertainty associated with the returns from
an investment that introduces a risk into a project. The expected return is the
uncertain future return that a firm expects to get from its project. The realized
return, on the contrary, is the certain return that a firm has actually earned.
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The realized return from the project may not correspond to the expected return.
This possibility of variation of the actual return from the expected return is
termed as risk. Risk is the variability in the expected return from a project. In
other words, it is the degree of deviation from expected return. Risk is
associated with the possibility that realized returns will be less than the returns
that were expected. So, when realizations correspond to expectations exactly,
there would be no risk.

i. Elements of Risk:

Various components cause the variability in expected returns, which are known
as elements of risk. There are broadly two groups of elements classified as
systematic risk and unsystematic risk.

Systematic Risk:

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Business organizations are part of society that is dynamic. Various changes

occur in a society like economic, political and social systems that have influence
on the performance of companies and thereby on their expected returns. These
changes affect all organizations to varying degrees. Hence the impact of these
changes is system-wide and the portion of total variability in returns caused by
such across the board factors is referred to as systematic risk. These risks are
further subdivided into interest rate risk, market risk, and purchasing power
risk.
Unsystematic Risk:

The returns of a company may vary due to certain factors that affect only that
company. Examples of such factors are raw material scarcity, labour strike,
management inefficiency, etc. When the variability in returns occurs due to such
firm-specific factors it is known as unsystematic risk. This risk is unique or
peculiar to a specific organization and affects it in addition to the systematic
risk. These risks are subdivided into business risk and financial risk.

ii. Measurement of Risk:

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Quantification of risk is known as measurement of risk.

Two approaches are followed in measurement of risk:

(i) Mean-variance approach, and

(ii) Correlation or regression approach.

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Mean-variance approach is used to measure the total risk, i.e. sum of systematic
and unsystematic risks. Under this approach the variance and standard
deviation measure the extent of variability of possible returns from the expected
return and is calculated as:

Where, Xi = Possible return,

P = Probability of return, and

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n = Number of possible returns.

Correlation or regression method is used to measure the systematic risk.

Systematic risk is expressed by β and is calculated by the following formula:

Where, rim = Correlation coefficient between the returns of stock i and the
return of the market index,

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σm = Standard deviation of returns of the market index, and

σi = Standard deviation of returns of stock i.

Using regression method we may measure the systematic risk.

The form of the regression equation is as follows:

Where, n = Number of items,

Y = Mean value of the company’s return,

X = Mean value of return of the market index,

α = Estimated return of the security when the market is stationary, and

β = Change in the return of the individual security in response to unit change in

the return of the market index.
Concept of Return:

Return can be defined as the actual income from a project as well as

appreciation in the value of capital. Thus there are two components in return—
the basic component or the periodic cash flows from the investment, either in
the form of interest or dividends; and the change in the price of the asset, com-
monly called as the capital gain or loss.

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The term yield is often used in connection to return, which refers to the income
component in relation to some price for the asset. The total return of an asset
for the holding period relates to all the cash flows received by an investor
during any designated time period to the amount of money invested in the asset.

It is measured as:

Total Return = Cash payments received + Price change in assets over the
period /Purchase price of the asset. In connection with return we use two terms
—realized return and expected or predicted return. Realized return is the
return that was earned by the firm, so it is historic. Expected or predicted
return is the return the firm anticipates to earn from an asset over some future
period.

Working Capital Investment Policies (Explained With Diagram)

Working capital financing policy basically deals with the sources and the
amount of working capital that a company should maintain.
A firm is not only concerned about the amount of current assets but also about
the proportions of short-term and long-term sources for financing the current
assets. There are several working capital investment policies a firm may adopt
after taking into account the variability of its cash inflows and outflows and the
level of risk.

1. Hedging Policy:

One of the policies by which a firm finances its working capital needs is the
hedging policy, also known as matching policy. This policy works in an
arrangement where the current assets of the business are used perfectly to
match the current liabilities.

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As per this approach, fixed and permanent current assets are financed through
long-term sources and fluctuating current assets are financed through short-
term sources.

This policy is a medium risk proposition and requires a good amount of

attention. For example, if a bank loan is due to be paid after six months, the
company will ensure that sufficient amount of cash will be available to repay the
loan on the date of maturity even though it may or may not currently have
sufficient cash.

In case of a growth firm, the amount of fixed assets and permanent current
asset go on increasing with the passage of time but the volume of fluctuating
current assets change with the change in production level. In Figure 8.1, Line A
and Line B is upward slopped indicating that they go on increasing with the
passage of time and as per hedging principle they are financed through long-
term sources like equity and long-term debt.

Fluctuating current assets, which are shown by the curved Line C, should be
financed through short term sources.

2. Conservative Policy:

As the name suggests, this policy tries to avoid the risk involved in financing of
current assets. Here, relatively high proportions of long-term sources are to be
used for financing current assets. The firm not only matches the current assets
with current liabilities but also keeps some excess amount to meet any
uncertainty.

This is the lowest risk working capital policy and fails to ensure optimum utiliza-
tion of funds. Hence it cuts down the expected returns of the shareholders. This
policy is illustrated in Figure 8.2. Line A denotes the fixed assets and Line B
denotes the permanent working capital, which is financed through long-term
sources. Certain portion of fluctuating current assets, which is shown by dashed
Line C, is also financed by long-term sources. Under this policy some part of
fluctuating current assets is financed through short-term sources.

3. Aggressive Policy:

Aggressive working capital financing policy is a risky policy that requires

maximum amount of investment in current assets. Fluctuating as well as
permanent current assets under this policy will be financed through short-term
debt. In this policy debt is collected on time and payments to the creditors are
made as late as possible.

This policy has been illustrated in Figure 8.3. According to this approach long-
term sources are used to finance the fixed assets, which are shown by Line A;
but a portion of permanent current assets, shown by the dotted Line B, is also
financed through long-term sources. The remaining part of permanent current
assets, depicted by Line C, and the entire amount of fluctuating current assets,
shown by the curved Line D, are financed by short-term debt.

4. Highly Aggressive Policy:

This is a highly risky policy for financing the working capital. As per this policy,
even some part of fixed assets is financed through short-term sources. Excessive
reliance on short-term sources makes this policy highly risky.

This policy has been illustrated in Figure 8.4. A major proportion of fixed assets
as shown by dotted Line A are financed through long-term sources and the
remaining part of the fixed assets are financed by short-term sources—shown by
Line B. Short-term sources are also used for financing permanent current assets
—Line C; as well as fluctuating current assets as shown by the curved Line D.

OPERATING CYCLE

Working operating cycle or operating cycle indicates the time period elapsed
between the deployment of cash into business and recovery of cash from
business. For manufacturing firm, the cash is being used to purchase raw
material stock. The payments are being made to suppliers. Labour and
overheads are added to raw material and finished goods are manufactured. The
finished goods are then sold on credit to debtors. Debtors made cash payment.
In this manner, the cash invested at the beginning of the cycle comes back to
business with added value. In service firms, the operating cycle is shorter as
manufacturing stages are absent. There is no finished stock in service sector.

The working capital requirement depends to a great extent on 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 realisation". The series of activities that are carried out in a
manufacturing concern beginning from procurement of raw materials to
realisation of sales revenue from sale of finished goods is a time consuming
process. In a trading firm, the activities begin from procurement of salable
goods to realisation of cash from debtors is the time taken to complete the
trading cycle. The time taken from the beginning activity till the time taken to
complete the last activity is termed as the 'Operating Cycle.

Thus operating cycle consists of the following activities.

a. Procurement of raw material,

b. Process of conversion, from raw material to WIP to FG,

c. Transportation of FG to warehouses and distributors,

d. Sale of finished goods (either for cash or credit),

e. Collection of cash from debtors arising out of credit sales.

The above listed activities involved in creation of operating cycle are graphically
presented in figure 12.1 as shown below.
Determinants of Operating Cycle

The length of working capital operating cycle is an indicator of the efficiency of

working capital management. The amount of working capital requirement
depends upon the length of operating cycle. We have two concepts here:

● Gross Operating Cycle

● Net Operating Cycle

The length/ duration of operating cycle depend upon inventory conversion

period (ICP) and receivable conversion period (RCP). Gross operating cycle is
the total of inventory conversion period and the receivable (Debtors) conversion
period.
Gross Operating Cycle = Inventory Conversion Period + Receivable
Conversion Period

GOC=ICP+RCP

Inventory Conversion Period (ICP): inventory conversion period refer to the

time taken for conversion of raw material into finished goods. In a
manufacturing unit ICP is combination of three conversion cycles; namely raw
material conversion period (RMCP), work-in-progress conversion period (WPCP)
and finished goods conversion period (FGCP).

IPC= RMCP+WPCP + FGCP

Raw material conversion period (RMCP) is the time taken for the storage of
raw materials in the stores up to the time they are issued for production.

RMCP=(Average Raw Material Stock/Total Raw Material Consumption)

× 365

Work-in-progress conversion period (WPCP) refer to the time taken for the
raw material to remain in the production process till they take the form of
finished goods.

WPCP=(Average work-in-progress/Total Cost of Production) × 365

Finished goods conversion period is the period taken by the finished goods
to get converted into a sales transaction; that is the time they remains in
warehouse unsold.

FGCP=(Average Finished Goods/Total Cost of Production) × 365

Receivable Conversion Period (RCP): it is the time required to convert the

credit sales into realisation of cash. It is known as the 'Debtors Conversion
Period'. It is time period between the credit sale transaction and receiving
payment against it. When RCP is added to ICP the total time period is termed as
'Gross Operating Cycle' (GOC) or total operating cycle period (TOCP).

RCP=(Average Receivables/Total Credit Sales)× 365

Deferral Period (DP)

Deferral period or the creditors deferred payment period is the average time
taken by the firm in paying its suppliers/ creditors. It is calculated as follows:

DP=(Average Creditors/Total Credit Purchases) X 365

When the deferral period is deducted from the total operating cycle period, the
net balance is known as 'net operating cycle' (NOC).

Net Operating Cycle (NOC)

Net operating cycle is the difference between the gross operating cycle and the
deferral period.

Net operating cycle = Gross Operating Cycle - Deferral Period

It is summarised as follows:

Net Operating cycle (NOC) = RMCP+ WPCP+ FGCP + RCP - DP

Or

Net Operating cycle (NOC) = TOCP - DP = (RMCP + WPCP + FGCP + RCP) -

DP

Inventory conversion period (ICP) = RMCP + WPCP + FGCP

Gross operating cycle = RMCP+ WPCP + FGCP + RCP

Gross operating cycle period (GOCP) = ICP+ RCP

Net Operating cycle (NOC) = GOCP or TOCP - DP

Various conversion periods are summarised as follows:

RMCP=(Average RAw Material Stock/Total Raw Material Consumption) x 365

WPCP=(Average work-in-progress/Total Cost of Production) x 365

FGCP=(Average Finished Goods/Total Cost of Production)× 365

RCP=(Average Recievables/Total Credit Sales)x 365

DP=(Average Creditors/Total Credit Purchases) X 365

Points to be noted:

1. 'Average' value means the average of opening balance and closing

balance of the respective variable. However if only closing balance is
available, then just the closing balance can be taken as average value.
2. 365 represent the number of days in a year. In certain case it is
mentioned that 360 days should be considered in a year; changes should
be made likewise.
3. Total figure in the denominator represent the total value of that variable
in that particular year.
4. In case of RMCP, WPCP, and FGCP the denominator is calculated on cost-
basis (excluding the profit margin).

Graphical presentation of operating cycle in terms of various conversion periods

explained above is done in figure 12.2as follows:
NEED FOR MAINTAINING ADEQUATE LEVEL OF WORKING CAPITAL

Adequate level of working capital should be maintained for smooth day-to-day

operations of a business concern. Inadequate working capital can prove very
hazardous for the liquidity position of the company and therefore the need for
management of working capital should never be underestimated. Every
business must maintain the required level of working capital to avoid adverse
effects on sale and profitability. Adequate working capital does not mean
maintaining higher level of working capital than required. Excessive working
capital is also equally dangerous as inadequate working capital.

Excessive working capital may result in:

(i)Unnecessary blockage of funds in inventories.

(ii) High level of inventories may lead to losses due to damage, theft, spoilage,
wastage etc.

(iii) Delay in collection of receivables will result in liberal credit policies, which
may not be suitable in all market/ business conditions.
(iv) Mismanagement of capital, resulting in higher cost of capital and loss of
profit.

(v)Shows mismanagement of finance and adverse performance of the

management.

(vi)Loss of interest on funds blocked in gross working capital.

Inadequate working capital may result in:

(i) Stoppage/interruptions in production, leading to losses.

(ii)Under utilisation of fixed assets, may lead to under utilisation of installed

capacity.

(iii)Hampers the growth of the firm.

(iv)The firm may lose an opportunity of optimum utilisation of production

capacity.

(v) If liabilities are not met on time, the firm's goodwill will be damaged.
Looking at the adverse effects of excessive working capital and inadequate
working capital, it becomes necessary to manage the firm's current assets and
its liquidity position in such a way as to help maintain an adequate level of
working capital. Thus the management must make efforts to maintain and
manage the appropriate level of working capital for which a well-defined
working capital management policy must be designed.

Working capital should be managed by developing an internal mechanism will

take care of maintaining the optimum levels of individual component of working
capital and will also take care of its financing. For better control on working
capital, we need to manage the current assets as well as the firm's liquidity.

Management of Current Assets

The requirement of working capital in manufacturing firm is different from the

The working capital needs of a firm are generally dependent on the nature of
business. requirement of working capital by a service firm. Also a
manufacturing capital has to invest huge funds in plant & machinery and also in
raw material inventories, but a service fund mainly invest in human capital than
in other capital assets. Irrespective of these differences, all types of firm try to
manage their current assets and current liabilities of meeting the liquidity
requirements on time. Thus the discussion of managing the current assets
becomes necessary.

Managing of current assets has always being challenging for firms. The
aggregate of current assets is termed as 'gross working capital'. The term GWC
is used to address issues relating to current assets and management of current
assets. Important issues relating to gross working capital are:

● What is the optimal level of current assets a company should maintain?

 ● What should be the ideal mode of financing the current assets?

To seek answer to the first question, management should try to maintain

balance between the excessive and inadequate current assets. Excessive
current assets will increase the investment in current assets, which will
increase the cost of capital. Inadequacy of current assets will result in failure to
meet commitments. Thus both the situations are non-desirable. The choice of
funding is also an important issue to address. Current assets are generally
funded from internal sources of finance, however sometimes the external funds
are used to finance the gross working capital. To appropriately finance the
working capital, we need to understand the two different types of need for
working capital.

TYPES OF WORKING CAPITAL NEEDS

Analysing the need for working capital is one of the important aspects of
working capital management. For this purpose the working capital is estimated
foe two different types of needs: permanent need of working capital and
temporary need for working capital. due to existence of the operating cycle,
working capital is needed in the business. As the operating cycle is a continuous
process, the need for working capital is also continuous and regular in nature.
However the need and the amount of working capital will fluctuate from time to
time and therefore on the basis of need the working capital is divided into the
following two types:

Permanent Working Capital: Every firm has to maintain a minimum level of

current assets in form of inventories, cash etc. Permanent working capital is the
minimum level of required current assets. It is permanent in the same way as
the fixed assets are Depending upon the level of activity, the need for working
capital over the permanent level will fluctuate. For example: in case of peak
level sales extra inventory of raw materials is maintained which will demand
additional working capital requirement up and above the permanent level of
working capital level. On the other hand in period of slack season the level of
inventory (raw material. WIP, finished goods) will fall.

Fluctuating/Variable Working Capital: Variable working capital is the extra

working capital that is needed to support the changes in the business activity.
Variable or temporary working capital requirement arises only when there is
increase in the sales volume. Every firm should maintain a level of liquidity to
finance the variable working capital requirement. However, if the need is
beyond the limits of internal financing, then the funds can be raised by external
sources.

Both the types of working capital: permanent and temporary are necessary to
maintain smooth production and sales activities. Permanent working capital
level once determined may not require regular management and attention. But
that is not the case of temporary working capital. Permanent working capital
usually remains constant over a period of time or may increase with increase in
level of activity of the company due to additions to production capacity.

The difference between permanent and temporary working capital can

be shown in the following Figures 8.2 and 8.3.
The above figure depicts the permanent working capital that is stable over a
period, whereas temporary working capital shows ups and down – sometimes
working capital requirement has increased or decreased. The above Figure 8.2
will hold good to those firms where there is no development and having
seasonal fluctuations.

But for the growing firms Figure 8.3 will be suitable.

Over a long period permanent working capital also changes with the additional
funds, required for expansion programmes.

Permanent working capital may either remain constant over the period of time
or may increase with time. Figure represents temporary and permanent
working capital, where permanent working capital remains constant and thus it
is represented as a straight line parallel to time. When the permanent working
capital will increase over the period of time the graphical presentation of
increasing permanent working capital will be done as shown in the following
[Link] the permanent working capital line will slope upwards as
compared to time.
FINANCING OF CURRENT ASSETS

Decision of financing the working capital is yet another important decision of

financial management. There are various sources: long term/short term which
can be used to finance the current assets. The firm has to explore the available
options for investments in current assets, and choose a cost effective option
amongst the available alternatives. The permanent working capital can be
financed in advance as the need of it is predetermined. The temporary working
capital can also be predicted but the time period for arrangement of funds may
be limited. The different sources to finance the current assets may be listed as
follows:

a) Long-Term Sources: Long term sources are those sources which provide
funds for a relative longer period. Under this category the main sources are the
share capital, retained earnings, debentures/ bonds and long term borrowings.
Each source carries its cost, and they can be procured from the capital market.

b) Short-term Sources: These are the sources that provide funds for a short
period generally up to one year. Bank credit, commercial papers, public
deposits, etc. are few examples of short term sources of finance. The procedure
for procuring short term finance is not tedious and these funds are readily
available.

c) Funds from normal Business Transactions: In course of the normal

business, there are many transactions that create funds. For example: credit
purchases of credit allowed by suppliers of raw material and expenses creditors
delay the payments to be made. This preserves the cash balance for a period
equaling the credit period, which can be utilised for other business activities.

As discussed earlier,

Gross Working Capital = Current Assets less Current Liabilities and

Net Working capital = Current Assets less Current Liabilities;

In other words the excess of current assets over current liabilities is net
working capital. This also mean that part of the current assets are financed by
the current assets and only that portion of the current assets not financed by
current liabilities is to be arranged for. Thus the net working capital is to be
managed by the finance manager by either employing the internal sources or
external sources. The working capital requirement can be financed by either
any one or by combinations of all the above mentioned sources. It depends upon
the cost and availability of the finance.

Permanent working capital and temporary working capital both can be

predetermined and needs to be managed & financed. The difference between
permanent working capital and temporary working capital is that the financing
for permanent working capital is like financing the fixed assets, because the
investment in permanent working capital is for long term in nature. For long
term financing equity capital or debt capital are resorted to. The firm may
either choose equity or debt or combination of both to finance its permanent
working capital. A part of permanent working capital is financed by current
liabilities and the balance is to be financed by equity-debt combination. The
temporary working capital is to be financed by pre-arranged short term sources
like bank credit. There are different approaches to arrive at the mix of various
sources of finance.

WORKING CAPITAL: ESTIMATION

For smooth operation of the business, the firm must estimate and calculate its
need for working capital requirement. The need for working capital can be
either permanent or temporary.

The bifurcation of need for working capital into permanent need and temporary
need will help the firm to decide the source of financing the working capital.
Capital can be financed by long term sources as well by the short term source of
capital. There are different methods to estimate and calculate the future need of
working capital. Some of the important methods are discussed below.

1. Working capital as a percentage of Net Sales: the need for working

capital is based on the sales of the firm and therefore under this approach, the
working capital is estimated and calculated on the basis of the net sales of the
firm. As the estimation of working is done in advance, the expected sales for the
particular time period are taken into consideration. Under this method the
working capital is estimated as the percentage of net sales. Therefore higher
the sales greater will be the need for working capital. as, working capital is the
difference between current assets and current liabilities; working capital is
estimated in the following manner:

1. step 1- estimate total current assets (CA) as percentage of total sales;

2. step 2-estimate total current liabilities (CL) as percentage of total sales
 3. Difference between estimated CA (step 1) and estimated CL (step 2) is
the estimated Working Capital.

2. Working capital as a percentage of Total Assets or Fixed Assets: under

this approach of estimating the working capital, total assets or fixed assets are
considered. A firm can set a relationship in terms of percentage between: (i) the
total current assets (gross working capital) or the working capital (current
assets- current liabilities) and (ii) the fixed assets of the company. This
percentage can be used in the future for estimation of working capital
requirement for the coming period of time.

For example if a firm is holding total assets of Rs. 15,00,000 and its current
assets are 3,00,000. In the coming year the total assets are estimated to
increase by 10%. Here the current assets of the company are 20% of its total
assets; thus the company is maintaining 20% of total assets as its gross working
capital. The estimated working capital for the coming year will be: expected
total assets Rs. 16,50,000 × 20% = Rs. 3,30,000.

3. Working capital based on Operating Cycle: under this approach the

estimation of working capital is done on the basis of element wise requirement
of working capital. There are various elements of current assets and current
liabilities. A summary of the requirement of each element is prepared to find out
the total requirement of working capital for a certain period of time. This
summary can also be prepared from different time periods at the same time, say
for a period of 3 months or for 6 months etc. The estimation of working capital
requirement for different elements of working capital is explained as follows:
1. Cash and bank balance: a minimum cash balance is maintained by
every firm, to meet its daily requirement of cash. The firm has to meet
petty expenses, and sometimes make cash purchases and therefore the
firm has to maintain the minimum cash balance. The cash balance is an
unproductive current asset but it provides liquidity to the firm. Therefore
it is maintained at the minimum possible level.

2. Raw material: every firm has to maintain a certain level of inventory of

raw materials, loose tools, consumables, spares etc. to ensure smooth
production operation. The level of inventory to be maintained will depend
upon factors like level of production, consumption rate of raw material,
number of processes, processing time, etc. Time lag in procurement of
raw material is also a decisive factor for investment of funds in raw
material. The higher the requirement, the greater will be the need for
working capital.
3. Work-in-progress: usually in manufacturing industries, the raw material
goes through several processes before it is converted into final product.
Each process may be time consuming and thus the final product may take
a time period of few hours to few days to complete. The WIP of a
company is made up of raw material plus labour plus overhead cost that
has gone into the production process up to that point of time. The capital
in WIP remains blocked until the finished product is sold and money is
realised.
4. Finished Goods: there is substantial amount of capital locked in goods
which are stocked in warehouse and are unsold. A manufacturing firm
has to store finished goods before they reach the retailers through the
distribution channel; same is the case of trading firms. Trading firms also
stock goods before they are sold. This increases the need for working
capital. As the finished goods at valued at a mark-up price, i.e. the sales
 price; the cost of finished goods is considered while the working capital
need is estimated.
5. Debtors/receivables: receivables are the funds blocked in credit sales.
Sales which are made on credit basis, amounts to the debtors of the
company. Payment from debtors is received in some future period and up
to that time the capital remains blocked in receivables. Debtors and bills
payable are together termed as receivables. For example if a company
sells goods of which the cost of production is Rs. 10,00,000 on credit
basis and allows a credit period of 15 days, then the working capital
blocked in debtors will amount to Rs 10,00,000/0.5= Rs 5,00,000.
6. Creditors for purchases: firm makes purchases of raw materials on
credit basis. Suppliers of raw material often offer credit period, in other
words a time lag in payment for raw materials. This is the credit the firm
is getting and therefore this reduces the working capital requirement of
the firm.
7. Creditors for wages and expenses: the payment of wages is usually
done at the end of the month. Also expenses are paid with some time lag.
Usually firm make payment of expenses like wages, salaries, expenses,
overhead charges etc. after a certain time period. Not all expenses are
paid on cash basis. Thus there is a time lag of one month in payment of
wages. This time lag that a firm enjoys in payment of wages and
expenses reduces the requirement of working capital in a firm.

The components of current assets increase the requirement of working

capital whereas the creditors for raw materials, wages and expenses
reduce the need for working capital. Estimation of working capital
requirement based on the components of operating cycle is done in the
following manner.

Top 5 Techniques of Forecasting Working Capital – Operating

Cycle, Estimation of Current Assets and Current Liabilities and
 Profit and Loss Adjustment Method of Working Capital (with
Formula)

The following are the techniques or methods may be used in forecasting

working capital for any future period:

1) Operating cycle method.

2) Estimating current assets and current liabilities method.

3) Profit and loss adjustment method.

Technique # 1) Operating Cycle Method:

Under this method working capital is determined by dividing total operating

cost by the number of operating cycles during the year.

Total operating expenses includes all expenses on raw materials. Labour and
overheads, while estimating operating expenses, non-cash items like
depreciation is excluded. Because depreciation is non-operating expenses.
Number of operating cycles is calculated dividing 365 days of the year by the
duration of operating cycles.

The duration of operating cycle is the number of days involved in the various
stages of the operating cycle i.e., cash – raw materials -finished goods – debtors
– cash as reduced by the credit period allowed by the creditors.

Technique # 2) Assessment of Working Capital or Estimation of

Current Assets and Current Liabilities:

It is the oldest and traditional method of estimating working capital

requirements.

According to this method the working capital is the excess of current assets
over the current liabilities. Thus its requirements can easily be forecasted by
making the estimates of the amount of each component of current assets and
current liabilities.

The procedures for estimating the components is as follows:

i) Stock of raw materials.

ii) Stock of work-in-progress.

iii) Stock of finished goods.

iv) Sundry debtors.

v) Cash and Bank Balance.

vi) Sundry Creditors.

vii) Outstanding expenses.

i) Stock of Raw Materials:

An industrial unit needs to maintain a certain stock of raw materials to ensure

uninterrupted production. Stocking is necessary because of uncertainty of
availability. Time lags between the placing of the order and actual delivery,
sudden increase in demand etc.

Inadequate stocking could lend to being out of stock which would result in
stoppage of production, inability to meet delivery schedules, cancellation of
orders etc.

In short – For continuous and smooth production, raw materials are to be kept
in the store.

The average amount of such stock of raw materials would depend on the
quantity of raw materials required for production during a particular period as
well as upon the average time taken in obtaining fresh delivery.
ii) Stock of Work-In-Progress:

It includes raw materials, wages and overheads. In order to determine the stock
of work-in-progress, we must find out the time period for which the inputs will
be in the process of production. This is also known as conversion period.

Note:

a) When wages and overheads acquire even during the period production is in
process, then only half of the wages and overheads for that period shall be
taken for determining the cost of work-in-progress.

b) When it is mentioned that raw materials are in process, the cost of work- in-
progress will consist of any raw materials.

iii) Stock of Finished Goods:

The stocking of finished goods would depend on expected sales, seasonal nature
of sales delivery schedules, length of the manufacturing process, expected
sports in demand, and the like. Finished goods represent both materials cost
and conversion charges.

Finished goods are to be kept in determining the amount to be locked cap in

finished goods stock

iv) Sundry Debtors:

It is computed based on credit sales, period of credit allowed or time lag in

collecting the payments
Debtors may be calculated either at sales value or at cost.

Sales Value – In this case the amount of credit sales is taken into account.

At Cost – In this case the cost of credit sales is taken into account.

Note:

a) Calculation of cost of sales:

ii) While Calculating Debtors following points considered:

a) If sales value is given but profit is not given in such cases debtors should be
calculated on the basis of sales values.

b) If sales value and profit are given, in such cases deduct the profit from sales.
We will get cost of sales. So debtors should be calculated on cost of sales.

Formula for Debtors Based on Sales Value:

v) Cash and Bank balances

vi) Creditors:
It is estimated on the basis of credit purchases and the time day in payments to
creditors or credit period allowed by suppliers of raw materials.

Creditors = Units of raw materials purchased on credit x Rate per unit x Credit
Period

vii) Outstanding expenses such as wages, Salaries, overheads etc.

Technique # 3) Profit and Loss Adjustment Method:

Under this method profit is calculated on the basis of transactions. Afterwards

working capital is determined by making necessary adjustments for cash inflow
and outflow in the profit.

Format:
 Risk and return

Risk: Meaning, Types and Measurement (with Formulas)

Meaning
The business dictionary defines risk as exposure to the possibility of loss, injury,
or other adverse or unwelcome circumstance, i.e., a chance or situation
involving such a possibility. Risk is the probability or possibility of having a
negative outcome due to certain sudden events.

The variation of the actual outcome from the expected outcome is defined as
risk. In simple terms, risk is the volatility in actual outcome. It is a sudden
occurrence of some unexpected or unplanned events resulting in reduction of
earnings or huge financial losses.

Although used synonymously, risk is a bit different from uncertainty. In case of

risk, probabilities of the occurrence of an event can be predicted based on the
past available facts, figures and information for the purpose of decision making,
but in case of uncertainty the occurrence of an event cannot be predicted, due
to unavailability of facts, figures and information.

Uncertainty varies from zero (0) to infinity (). Risk is better than uncertainty. Risk lies somewhere between certainty an

Types of Risk:

[Link] are systematic risks?

Systematic risks are inherent risks that exist in the stock market. They’re also
called “non-diversifiable risks” or “market risks” since they impact the entire
asset class.

Non-diversifiable means that an organization can’t control, minimize, or avoid

systematic risks. These risks are typically due to external factors like ongoing
geopolitical situations, monetary policies, and natural disasters. For example,
the COVID-19 pandemic was a systematic risk because it impacted the entire
stock market.

Types of systematic risks

Consider a few types of systematic risks:

● Interest rate risk. Interest rate risk results from a change in the market
interest rate. It mainly impacts fixed-income securities like bond prices
and asset-backed securities. The yield on these securities is inversely
related to the interest rate. As interest rates go up, investors find it more
attractive to pull their money out of fixed-income securities.‍
● Market risk. Market risk results from the general tendency of investors
to behave as per the market. For example, investors avoid investing in
even the best-performing companies during a financial crisis. ‍
● Purchasing power risk. Also called inflation risk, purchasing power risk
results from the decline in the purchasing power of money due to
inflation. For example, if inflation is 5% per year, you’d need $10.50 to
buy the pack of pens next year that cost $10 today.
The Federal Reserve's aggressive interest rate hikes since March 2022 led to a
significant decline in bond prices, as higher rates reduce the present value of
future bond payments. This is an example of interest rate risk and its impact on
bond markets.

Market risk was starkly demonstrated during the COVID-19 pandemic, when
the U.S. saw one of the biggest stock market crashes in history. Major stock
indices plummeted in early 2020 due to widespread investor panic. Inflation risk
became particularly evident in 2022-2023, as the U.S. experienced inflation
rates of over 8%, significantly eroding consumers' purchasing power.

These real-world scenarios highlight how systematic risks can affect entire
markets and economies, impacting a wide range of investments simultaneously.

[Link] are unsystematic risks?

Unsystematic risks, also known as “nonsystematic risks,” “specific risks,”
“diversifiable risks,” or “residual risks,” are unique to a specific company or
industry. These risks arise due to various internal and external factors that
affect only the particular organization but not the entire market.

Some examples of unsystematic risk include labor unrest at a factory, regulatory

changes, and shortages of raw materials.

Unlike systematic risks, an organization can control, minimize, and possibly

even avoid unsystematic risks.

Total risk = Systematic risk (nondiversifiable or unavoidable)+

Unsystematic risk (diversifiable or avoidable)

Types of unsystematic risks

Unsystematic risks occur as two types:

● Business risk. Business risk includes the internal factors that affect a
company’s revenue and performance. Business risks can also result from
company-specific external factors, such as the government banning a raw
material that a company uses.
● Financial risk. Financial risk relates to a company’s debt and equity. If a
company takes on too much debt, its debt-to-equity ratio may suffer. A
negative debt-to-equity ratio indicates that a company might be on the
verge of bankruptcy.
One example of business risk is a major product recall. In 2022, Abbott
Laboratories faced a significant business risk when it had to recall several
batches of its infant formula due to contamination concerns. This led to a
temporary shutdown of its Michigan plant, causing a nationwide shortage of
baby formula in the U.S. and significantly impacting the company's revenue and
reputation.

A prime example of financial risk is debt overload. WeWork, the co-working

space company, has faced severe financial risk due to its high debt levels and
unsustainable business model. In 2022, the company's debt-to-equity ratio was
negative, indicating more liabilities than assets. This led to a significant drop in
its stock price and eventual bankruptcy filing in November 2023.

The 6 main differences between systematic vs. unsystematic risk

This table is helpful in illustrating the key differences between systematic and
unsystematic risks.

Let’s explain each of the above points:

 ● Impact. Systematic risks can potentially affect the entire industry and
the overall economy, whereas unsystematic risks generally affect an
organization. Systematic risks are non-diversifiable, whereas
unsystematic risks are diversifiable.
● Nature. Systematic risks are unavoidable and uncontrollable, whereas
unsystematic risks are avoidable and controllable.
● Factors. Systematic risks result from external factors that occur at a
macroeconomic level, which is why they’re unavoidable and
uncontrollable. In contrast, unsystematic risks result from internal
factors occurring within an organization or externally but in a closely
related manner to the organization. They’re linked to microeconomic
factors and are avoidable and controllable.
● Protection. The effects of systematic risk can be mitigated through
proper asset allocation, whereas mitigating unsystematic risk relies on
portfolio diversification.
● Avoidability. Systematic risks can’t be avoided; however, unsystematic
risks can be mitigated or avoided.
● Types. Systematic risks include interest, inflation, purchasing power, and
market risk, whereas unsystematic risks are financial and business-
specific risks.

Measurement of Risk:
There are various methods of measuring risk.

The following will provide an overview of the different methods

available:

1. Sensitivity Analysis:

It is a method of risk estimation based on the decision model. Under this

approach, the probable impact of risk arising due to change in the data set is
tried to be assessed on the decision model. It measures the sensitivity of the
data set used for decision making, i.e., trying to assess the changes in expected
values or outcomes of a decision model due to change in the data set.

Analysing the sensitivity of the data set which is very vital for decision making
ensures better decision making of the management of a firm. So this technique
does not measure risk in quantitative terms but rather in qualitative terms by
stating the impact on the final decisions due to sudden variations in those
factors affecting decision making.

2. Probability Distribution and Expected Values:

Probability is the chance of occurrence of an event. Probability distribution not

only takes into account the possible or expected return from each alternative
but also considers the uncertainty associated with each of the alternatives.
Probability can be objective or subjective.
Objective probability is based on a large number of observations under
independent and identical situations, whereas subjective probability is totally
based on individual judgement or decision and not based on a large number of
identical and independent observations.

3. Standard Deviation:

Standard Deviation is an absolute measure of dispersion. Dispersion is variation

of the actual value from the central value or mean. Standard Deviation
measures the deviation of actual return from the expected return in absolute
terms. It is the positive square root of the mean of the squares of the deviations
of the variables from their arithmetic mean. It is denoted by sigma (σ).

High Standard Deviation indicates higher dispersion, i.e., higher amount of risk,
whereas low Standard Deviation reveals lower dispersion, i.e. lower amount of
risk.

Standard deviation is expressed by the following formulae:

Standard Deviation is not a reliable measure of risk; this measure suffers from
the limitation that in case of a project involving different Cash Outflows and
different expected returns or mean values, this measurement of risk has the
high chance of giving misleading results. So it is not suitable for comparison.

Coefficient of Variation:

Coefficient of variation is a relative measure of risk. It is expressed as –

This is measured as Standard Deviation as percentage of mean. This method is

also not a reliable measure of risk but it helps in comparison in case of projects
having different Cash Outflows and different expected returns. Higher
coefficient of variation reveals higher degree of risk and vice versa.

4. Decision Tree Analysis:

In this method, the decision tree is drawn to explain the full set of probable
events and alternatives that may arise under a given situation. Each course of
action is represented by a branch which further has subsidiary branches which
represents the probable alternative course of actions and events in future.

In case of an Investment Decision, this Decision Tree Analysis method is usually

followed, where the Investment Decision is portrayed by a tree along with
branches which represents the future probable events.
5. Capital Asset Pricing Model:

Capital Asset Pricing Model (CAPM) measures the expected return on equity. In
this method, the return on equity has two components—one is the risk-free rate
of return and another is the risk premium.

Risk-free rate of return is the assured return especially on the government or

the gilt-edged securities. Risk premium is the additional or extra return for
investing in a particular risky security.

Risk premium component comprises average return on the market portfolio and
the beta factor which represents the risk of a particular security. Beta measures
sensitivity of an investment in respect to the market.

It is measured as follows:

Beta value (β) > 1, represents high-risk security, beta value (β) < 1 represents
low-risk securities and beta (β) = 1 represents neutral, i.e., neither high risk nor
low risk.

6. Alpha:

It is also another measure of risk, where risk is measured relative to the market
risk or the benchmark index.

7. R squared (R2):

This measure is expressed as a percentage (%) of a particular investment’s or

security’s movement in terms of the movement of the benchmark index.

8. Sharpe Ratio:

This ratio is calculated to determine whether the return arising from an

investment is due to rational Investment Decision or the reward for taking
excess or high risk.

Methods of Risk Management

Risk is inherent in business and hence there is no escape from the risk for a
businessman. However, he may face this problem with greater confidence if he
adopts a scientific approach by dealing with risk. Risk management may,
therefore, be defined as adoption of a scientific approach to the problem dealing
with risk faced by a business firm or an individual.

Broadly, there are five methods in general for risk management:

i) Avoidance of Risk
A business firm can avoid risk by not accepting any assignment or any
transaction which involves any type of risk whatsoever. This will naturally mean
a very low volume of business activities and losing of too many profitable
activities.

ii) Prevention of Risk

In case of this method, the business avoids risk by taking appropriate steps for
prevention of business risk or avoiding loss, such steps include adaptation of
safety programmes, employment of night security guard, arranging for medical
care, disposal of waste material etc.

iii) Retention of Risk

In the case of this method, the organization voluntarily accepts the risk since
either the risk is insignificant or its acceptance will be cheaper as compared to
avoiding it.

iv) Transfer of Risk

In case of this method, risk is transferred to some other person or organization.

In other words, under this method, a person who is subject to risk may induce
another person to assume the risk. Some of the techniques used for transfer of
risk are hedging, sub-contracting, getting surety bonds, entering into indemnity
contracts etc.

v) Insurance

This is done by creating a common fund out of the contribution (known as

premium) from several persons who are equally exposed to the same loss. Fund
so created is used for compensating the persons who might have suffered
financial loss on account of the risks insured against.

Return: Meaning and Measurement (with Formulas)

Return is simply, the Cash Inflows arising from an investment. Return arising
from an investment has two components, one the periodic return called the
dividend or interest on the principal sum invested and another the difference
between the price at the time of investment, i.e., purchase price and the ending,
i.e., the selling price.

Periodic return may be received in different ways such as – annually, bi-

annually, quarterly, etc. From a business point of view return is the reward of a
business for carrying out its operation and undertaking risk involved in such
operations. From an investor’s point of view, the perception of return varies
from investor to investor.

Some may opt for high returns on a short-term basis, whereas others may like
to invest in long-term growth funds. Again, some may like to invest in the
security of a company with sustainable growth in sales and earnings over the
years, whereas some may invest in the security of a company based on its high
return on net worth.

Measurement of Return:
Some of the commonly used techniques of return measurement are as
follows:

1. Return on Investment (ROI):

ROI is the profit earned by a company in relation to the amount of capital

invested. It is the measure which indicates the overall financial performance of
a company. Return on Investment as a measure of return was first developed by
DuPont Company in USA in the year 1919.

It is expressed as follows:

High ROI, indicates higher return whereas low ROI represents low return. This
ratio has certain advantages such as it measures the Operating Profit of a firm,
helps in understanding the profit earning capacity of a firm, indicates efficiency
of assets utilisation, helps in taking long-term Investment Decision but at the
same time suffers from some limitations such as – unsuitable for short-term
Investment Decisions, perception of profit varies, etc.

2. Internal Rate of Return (IRR):

It is that rate of return at which Present Value of Cash Inflow is just equal to the
Present Value of the Cash Outflow, i.e., the initial cost of investment, which
means at IRR, the Net Present Value, i.e., Present Value of Cash Inflow—Present
Value of Cash Outflow is just equal to zero. It is also known as the opportunity
Cost of Capital.

Internal Rate of Return is calculated as:

Under this method, an Investment Decision is taken based on criteria for a

single project as r (rate of return) > K (Cost of Capital), accept the project; r
(rate of return) < K (Cost of Capital), reject the project; and r (rate of return) =
K (Cost of Capital), firm is indifferent.
In case of mutually exclusive projects, the project with higher IRR is to be
selected. This method as an Investment Decision measure has certain
advantages such as – it considers the Time Value of Money factor, Cash Inflows
are taken in total for estimated life, easy to understand, does not takes into
account the Cost of Capital in its calculation, etc., whereas at the same time it
suffers from various limitations such as – involving very complex calculation,
difficulty in decision making in case of mutually exclusive project, ignores the
concept of Cost of Capital or the required rate of return, etc.

3. Weighted Average Cost of Capital:

Cost of Capital is the minimum or the required rate of return to be earned on a

project to retain the investors. Weighted average Cost of Capital is calculated as
the Cost of Capital of individual sources multiplied by the respective weights
and their sum divided by the total of their weights.

4. Weighted Average Return Method:

Under this method, similarly, the returns from different projects are calculated
and that figures are multiplied by their respective weights. Finally, the sum of
the product is divided from the total of their weights. The potential income from
a particular investment varies from one investment to another. This potential
income from different investments is called the weight of an investment. Such
potentialities may be high, low or moderate.

5. Profit Method:

This is a simple method of return estimation. In this method, profit that is

calculated by deducting the amount of purchase from the sales amount is taken
to be the return.

6. Cash Flow Method:

Under this method, Cash Outflows are deducted from the Cash Inflows of a
project. Only cash items are considered. The difference between Cash Inflows
and Cash Outflows is known as the return from a project.

7. Income Method:

Under this method, return is the income which is the excess of total revenue
over and above the total expense. There are different types of income such as –
income before interest and tax, income before tax and after tax, etc.

8. Ratio Analysis Method:

Ratio depicts the relationship between two variables in the financial statements.
For example, if we calculate the gross profit ratio as (Gross Profit / Sales) x 100,
it measures the return by deducting the cost of goods sold from the sales figure,
i.e., gross profit—measuring it as a percentage of sales.
Again if we take return on capital employed, it is the net earnings of a firm as
percentage of the capital employed, or all these are the commonly used
measures of return.

Return or Income

The prime objective of making investment in any security is either to yield

income on that investment in form of dividend/ interest or appreciation in the
investment value. Return is the motivating force and the principal reward in the
investment. An appreciation in the investment can also be considered as capital
gain on investment. A rate of return on investment provides a basis of
comparison among given alternative investment opportunities. There are two
types of returns are, commonly, discussed under investment management, first,
realised return and second, expected return. The realized return is the actual
outcome on investment, on the other hand expected return is the probable
return on investment over future period. The expected return is calculated for
both purposes i.e., annual return, as well as capital growth in investment over a
given future period.

The term yield is often used in connection with return. Yield refers to the
income component in relation to the price paid for a security, as well as change
in price of the investment (at the time of selling such security) in relation to the
price at which it was bought. In order to compute total return, one has to
consider probable decrease or increase in the principal amount of investment
along with annual income on such investment, thus,

Total Return = Income + Change in Price of Investment (+/-)

 Risk-Return relationship

In the CAPM, the expected return on an asset varies directly with its systematic
risk and the risk premium of market portfolio which is a reward depending on
the level of risk free return and return on the market portfolio. In other words,
the risk premium for an asset or portfolio is a function of its beta i.e. the risk
premium added to the risk free rate is directly proportion to beta. Thus the
three basic elements required to apply CAPM model are: risk free rate, risk
premium on market portfolio and beta.

Risk free rate- The rate of return available on an assets like T- bills, money
market funds or bank deposits is taken as the proxy for risk free rate as such
assets have very low or virtually negligible default risk and interest rate risk.
However under inflationary conditions, they are risk less in nominal terms only.
In fact, real return (nominal return inflation rate) may become zero, even
negative when inflation wakes up.

Risk premium on market portfolio- The risk premium on market portfolio is

the difference between the expected return on the market portfolio and the risk
free rate of the return. The CAPM holds that in equilibrium the market portfolio
is the unanimously desirable risky portfolio. It contains all securities in
proportion to their market value. In the efficient portfolio, which enables
neither lending and borrowing, the risk premium on the market portfolio is
proportional to its risk and the degree of risk aversion of the average investor.

Beta- Beta measures the risk (Volatility) of an individual security relative to

market portfolio. Accordingly, beta is the co variance of the security’s return
with the market portfolio’s return, divided by the variance of market portfolio.
The co-variance of two securities is the product of their correlation coefficient
and respected standard deviation. The covariance of the market portfolio with
itself is the variance of the portfolio. Thus the beta of the market portfolio is
one. This classifies all other market portfolios and securities in the two risky
classes. Securities with beta less than one are called defensive security.
Security with beta greater than one is called aggressive security. Risk free
security has a beta equal to zero.

Securities provide returns in the form of dividends or interests and it also

provides a return at the time of sale in the form of capital gain. These securities
have to be valued at different points of time. The returns at a particular point of
time are required to be calculated by discounting the returns at an appropriate
discount rate, which depends upon the individual’s own perception of risk. The
discount rate which is also called the required rate of return show the risk of
the cash flows. It would also help to determine the value of the asset. The
higher the discount rate greater will be the risk level. Thus the value of an asset
therefore varies according to the risk perception and estimation of each
individual. The required rate of return can be calculated with the help of the
following formula-
K= If+Rp
Where K= required rate of return
If= risk free rate
Rp= Risk premium
The risk free rate remains the same irrespective of any increase or decrease of
risk level. The risk premium which indicates the compensation for taking the
risk increases with increase in risk and decreases with decreasing risk. Thus the
required rate of return comprises of the risk free rate, the risk perception and
risk premium.

Cash Management

Cash is the medium of exchange on the common purchasing power and which is
the most important component of working capital.

It includes coins, currency and cheques held by the firm and the balances in its
bank accounts.

Sometimes, near-cash items are also included. Cash is the basic input required
to keep the firm running on a continuous basis. At the same time it is the
ultimate output expected to be realised by selling goods and services. A firm
should hold sufficient cash, neither more, nor less.

Excessive cash remains idle which simply increases the cost without
contributing anything towards the profitability of the firm, and in the opposite
case, trading and/or manufacturing operation will be disrupted. Not only that, it
largely upholds, under given condition, the quantum of other ingredients of
working capital, viz., inventories and debtors, that may be needed for a given
scale and type of inventories and debtors, that may be needed for a given scale
and type of operation.

Cash is, no doubt, a most important asset and that is why a firm wants to get
hold of it in the shortest time possible. In the absence of sufficient quantity of
cash at the proper time, payment of bills, including dividend and others may not
be made.

It is interesting to note that cash management involves three factors:

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(i) Ascertainment of a minimum cash balance;

(ii) Proper arrangement to be made for collection and payment of cash in such a
way that minimum balance can be maintained; and

(iii) Surplus cash to be invested to temporary investments or to be invested in

fixed assets.

Similarly, cash is not productive directly like other assets, viz., it is sterile. For
example, fixed assets are acquired for the purpose of earning revenue. Accounts
receivables are generated by granting credit to customers, etc.

Apart from the fact that it is the most liquid current asset, cash is the common
denominator to which all current assets can be reduced because the other
major current asset, viz., receivables, inventories, etc. get converted eventually
into cash.

It is the significance of cash management which is the key area of working

capital management. Cash management is important since it is very difficult to
estimate correctly the inflow of cash. Practically, it is not easy to make a proper
synchronisation of inflows and outflows of cash.

Meaning:

A Cash Flow Statement is a statement which is prepared by acquiring Cash

from different sources and the application of the same for different payments
throughout the year.

It is prepared from analysis of cash transactions, or it converts the financial

transactions prepared under accrual basis to cash basis.

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The information about the amount of resources provided by operational

activities or net income after the adjustment of certain other charges can also
be obtained from it. The changes in Cash—both at the beginning and at the end
—can also be known with the help of this statement and that is why it is called
Cash Flow Statement.

Objectives of Cash Flow Statement:

The primary objective of cash flow statement is to supply the necessary

information relating to generation of cash to the users of financial statement. It
also highlights the future or prospective cash positions i.e. cash or cash
equivalent. The inflows and outflows of cash can be represented with the help of
this statement.

However, the main objectives of cash flow statement are:

(a) Measurement of Cash:

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Inflows of cash and outflows of cash can be measured annually which arise from
operating activities, investing activities and financial activities.

(b) Generating inflow of Cash:

Timing and certainty of generating the inflow of cash can be known which
directly helps the management to take financing decisions in future.

(c) Classification of activities:

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All the activities are classified into operating activities, investing activities and
financial activities which help a firm to analyse and interpret its various inflows
and outflows of cash.

(d) Prediction of future:

A cash flow statement, no doubt, forecasts the future cash flows which helps the
management to take various financing decisions since synchronisation of cash is
possible.

(e) Assessing liquidity and solvency position:

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Both the inflows and outflows of cash and cash equivalent can be known, and as
such, liquidity and solvency position of a firm can also be maintained as timing
and certainty of cash generation is known i.e. it helps to assess the ability of a
firm to generate cash.
(f) Evaluation of future cash flows:

Whether the cash flow from operating activities are quite sufficient in future to
meet the various payments e.g. payment of expense/debts/dividends/taxes.

(g) Supply necessary information to the users:

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A cash flow statement supplies various information relating to inflows

and outflows of cash to the users of accounting information in the
following ways:

(i) To assess the ability of a firm to pay its obligations as soon as it becomes due;

(ii) To analyse and interpret the various transactions for future courses of
action;

(iii) To see the cash generation ability of a firm;

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(iv) To ascertain the cash and cash equivalent at the end of the period.

(h) Helps the management to ascertain cash planning:

No doubt, a cash flow statement helps the management to prepare its cash
planning for the future and thereby avoid any unnecessary trouble.

Features of Cash Flow Statement:

The significant features are:

1. Dynamic in Character:
 ● The Cash Flow Statement is dynamic as it tracks the flow of cash in and
out of a business over a specific period, from the beginning to the end of
that period. It reflects how cash is being invested, utilized, and
generated.

2. Periodical Statement:

● This statement is prepared for a specific period, such as a month, quarter,

or year, making it a periodical statement. It provides insights into cash
flows over that defined timeframe.

3. Non-Adherence to Matching Principle:

● Unlike the Income Statement, the Cash Flow Statement does not follow
the matching principle (which matches revenues with expenses). Instead,
it records actual cash transactions, regardless of when the revenue or
expense is recognized.

4. Focus on Cash from Operations:

● A key aspect of the Cash Flow Statement is that it helps in calculating

cash flows from operational activities, which are critical for
understanding a company's ability to generate cash from its core
business operations.

5. Exhibits Changes in Financial Position:

● The statement shows changes in the financial position by categorizing

cash flows into three main activities: operating, investing, and financing.
This categorization allows analysts to draw conclusions about the
company’s liquidity, solvency, and overall financial health.

These features make the Cash Flow Statement a crucial tool for financial
analysis, providing a clear picture of how cash is generated and used within a
business.
Utility or Importance of Cash Flow Analysis:

Cash Flow Statement is particularly useful in short-term planning. In order to

meet the various obligations, a firm needs sufficient amount of cash (e.g.
payment for expenses, purchase of fixed assets, payments for dividend and
taxes etc.).

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It helps the financial manager to make a cash flow projection for immediate
future taking the data, relating to cash from the past records. As such, it
becomes easy for him to know the cash position which may either result in a
surplus or a deficit one. However, Cash Flow Statement is an important
financial tool for the management to make an estimate relating to cash for the
near future.

(a) Helps to make Cash Forecast:

Cash Flow Statement, no doubt, helps the management to make a cash forecast
for the near future. A projected Cash Flow Statement helps the management
about the cash position which is the basis for all operations and, thus, the
management sees light relating to cash position, viz. how much cash is needed
for a specific purpose, sources of internal and external issues etc.

(b) Helps the Internal Management:

It helps the internal management to determine the financial policy to be

adopted in future since it supplies information relating to funds, e.g. taking
decision about the replacement of fixed assets or repayment of long-term
liabilities etc.

(c) Reveal the Cash Position:

It is a significant pointer about the movement of cash, i.e. whether there is any
increase in cash or decrease in cash and the reasons thereof which helps the
management. Moreover, it explains the reasons for a small cash balance even
though there is sufficient profit or vice versa.
Besides, the management can compare the original forecast with the actual one
in order to understand the trend of movement of cash and the variation
therefore.

(d) Reveals the result of Cash Planning:

How far and to what extent the cash planning becomes successful, is revealed
by the analysis of Cash Flow Statement. The same is possible by making a
comparison between the projected Cash Flow Statement/Cash Budget and the
actual one, and the measures to be taken accordingly.

Classification of Cash Flows:

According to AS-3 (Revised), the cash flow statement should report cash flows
during the period classified by operating, investing and financing activities.

Thus, cash flows are classified into three main categories:

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1. Cash flows from operating activities.

2. Cash flows from investing activities.

3. Cash flows from financing activities.

1. Cash Flows from Operating Activities:

Operating activities are the principal revenue-producing activities of the

enterprise and other activities that are not investing or financing activities. The
amount of cash flows arising from operating activities is a key indicator of the
extent to which the operations of the enterprise have generated sufficient cash
flows to maintain the operating capability of the enterprise, pay dividends,
repay loans, and make new investments without recourse to external sources of
financing. Information about the specific components of historical operating
cash flows is useful, in conjunction with other information, in forecasting future
operating cash flows.
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Cash flows from operating activities are primarily derived from the principal
revenue-producing activities of the enterprise. Therefore, they generally result
from the transactions and other events that enter into the determination of net
profit or loss.

Examples of cash flows from operating activities are:

(a) Cash receipts from the sale of goods and the rendering of services;

(b) Cash receipts from royalties, fees, commissions, and other revenue;

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(c) Cash payments to suppliers of goods and services;

(d) Cash payments to and on behalf of employees;

(e) Cash receipts and cash payments of an insurance enterprise for premiums
and claims, annuities and other policy benefits;

(f) Cash payments or refunds of income taxes unless they can be specifically
identified with financing and investing activities; and

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(g) Cash receipts and payments relating to futures contracts, forward contracts,
option contracts, and swap contracts when the contracts are held for dealing or
trading purposes.
Some transactions, such as the sale of an item of plant, may give rise to a gain
or loss which is included in the determination of net profit or loss. However, the
cash flows relating to such transactions are cash flows from investing activities.

2. Cash Flows from Investing Activities:

Investing activities are the acquisition and disposal of long-term assets and
other investments not included in cash equivalents. The separate disclosure of
cash flows arising from investing activities is important because the cash flows
represent the extent to which expenditures have been made for resources
intended to generate future income and cash flows.

Examples of cash flows arising from investing activities are:

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(a) Cash payments to acquire fixed assets (including intangibles). These

payments include those relating to capitalized research & development costs
and self constructed fixed assets;

(b) Cash receipts from disposal of fixed assets (including intangibles);

(c) Cash payments to acquire shares, warrants, or debt instruments of other

enterprises and interests in joint ventures (other than payments for those
instruments considered to be cash equivalents and those held for dealing or
trading purposes);

(d) Cash receipts from disposal of shares, warrants, or debt instruments of

other enterprises and interests in joint venture (other than receipts from those
instruments considered to be cash equivalents1 and those held for dealing or
trading purposes);

(e) Cash advances and loans made to third parties (other than advances and
loans made by a financial enterprise);
(f) Cash receipts from the repayment of advances and loans made to third
parties (other than advances and loans of a financial enterprise);

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(g) Cash payments for futures contracts, forward contracts, option contracts,
and swap contracts except when the contracts are held for dealing or trading
purposes, or the payments are classified as financing activities; and

(h) Cash receipts from futures contracts, forward contracts, option contracts,
and swap contracts except when the contracts are held for dealing or trading
purposes, or the receipts are classified as financing activities.

3. Cash Flows from Financing Activities:

Financing activities are activities that result in changes in the size and
composition of the owners’ capital (including preference share capita! in the
case of a company) and borrowings of the enterprise. The separate disclosure of
cash flows arising from financing activities is important because .it is useful in
predicting claims on future cash flows by providers of funds (both capital and
borrowings) to the enterprise.

Examples of cash flows arising from financing activities are:

(a) Cash proceeds from issuing shares or other similar instruments:

(b) Cash proceeds from issuing debentures, loans, notes, bonds, and other
short-or long-term borrowings; and

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(c) Cash repayments of amounts borrowed such as redemption of debentures,

bonds, preference shares.
What is Cash Management?

Cash management refers to managing a business’s cash flow to make sure that
it has enough funds to function in its daily operations. It suggests the utilisation
of cash to ensure maximum liquidity and profitability. Cash management is
concerned with monitoring, analyzing, and managing cash inflows, outflows,
and cash balances held by the firm at a certain point by financing the deficit or
investing surplus cash. Management of cash is an essential component of
overall working capital management since cash is the most liquid type of
current asset. It is a key factor in the financial stability of an organisation.

Geeky Takeaways:

● Cash management, also known as treasury management, is a process

that involves determining and managing the cash flow which is

● In cash management, the word cash not only includes money in the
form of currency but also includes liquid assets like marketable
securities and time deposits.

● It aims to ensure that a company’s funds are not idle and are being
used efficiently to maintain a sound cash flow position.

● The cash flow statement is the main element of corporate cash flow.

Objectives of Cash Management

The primary goal of cash management is to maintain adequate liquidity in a firm

to meet its day-to-day obligations while utilising surplus cash to give rise to
returns. Other objectives of cash management are discussed below,
1. Meeting Obligations: Cash management needs to be done in the right
manner by a business to meet its short-term and long-term obligations.
2. Instigate Investment: Cash management encourages investing the surplus
cash in the right place and in the correct proportion to make efficient use of the
funds of the company.
3. Optimizing Cash Holding: The finance manager must decide the optimal
cash holding to avoid any excess or deficit. It means determining the
appropriate amount of cash needed to be kept in the business to meet the
contingency needs.
4. Avoiding Insolvency: It aims at reducing the risk of insolvency which may
arise due to lack of liquid assets or not making a profit out of surplus funds.
5. Proper Planning: Cash management involves anticipating when the
organization may need additional funds or when excess cash may be available
and also helps in planning the capital expenditure.
6. Handling Unorganized Costs: Cash surplus becomes a lifesaver where the
condition of unforeseen expenditure occurs. Effective management of cash
helps the business to cope with these situations.

Importance of Cash Management

1. Liquid Asset: Cash is the lifeblood of any business as it is needed to acquire

resources, make transactions, pay off debts, etc. A business will not generate
profit if the cash is held idle and on the other hand, if there is a cash deficit then
it may cause an irreplaceable loss to the business. Therefore, proper
management of cash flow is essential to have a profitable business.
2. Adequacy of Funds: The availability of cash is necessary for purchasing
assets, making investments, reducing liabilities, etc. A business needs to make
sure that there are adequate funds to meet its current obligations and make
proper reserves to meet any future contingencies.
3. Working Capital: As cash is the most liquid asset, it has a major role in
working capital management. Hence, the business needs to manage cash in a
way that maintains the liquidity position without affecting profitability.
4. Reducing Risk: With accurate forecasting and making cash reserves
accordingly, a business can overcome unforeseen circumstances. It helps in
assessing and reducing the risks related to cash and implements internal
controls to safeguard cash assets.
5. Planning: It involves anticipating when the organization may need
additional funds or when excess cash may be available. Proper planning makes
the entity ready to face challenges and unwanted situations.
6. Relations with Stakeholders: This strengthens the relationships between
the company and its stakeholders and leads to more favourable terms. A
business can enhance its credibility by timely payment of bills, and salaries, and
by performing other financial obligations

Functions of Cash Management

Cash management plays an important role in managing the finances of

businesses or individuals. As discussed above, this involves accumulating,
managing, and disbursing cash to create liquidity in the business and boost
profitability. The main functions of cash management are,
1. Liquidity Management: Liquidity means the amount of cash and cash
equivalents held by a company for its day-to-day operations and smooth
working. Cash management ensures that there is enough cash in hand to meet
daily operational needs. It also balances the need for liquidity with the
opportunity cost of holding idle cash.
2. Receivable Management: Cash management plays the function of faster
recovery of receivables to avoid a cash crunch and to maintain liquid cash. If
the average time for recovery is shorter, the organization will have enough cash
in hand to pay off its debts.
3. Investments: It is important to invest the surplus cash in hand wisely. The
company needs to look for various short-term investment alternatives to utilize
surplus funds. Management helps in investing with maximum returns without
compromising the liquidity of the business.
4. Compliance: Effective cash management shall fulfill all the compliance with
regulatory requirements related to cash handling and reporting. It keeps us
informed about changes in financial regulations that may impact cash
management practices.
5. Risk Management: Businesses need to monitor their system timely to avoid
the risk of bankruptcy. Cash management assesses and reduces the risk related
to cash and forms internal controls to safeguard cash assets.

How does Cash Management Work?

Cash management involves effective planning to maintain adequate cash flow

and liquid assets in the company. Strategic planning contains the following,
1. Cash Forecasting: Budgeting and Forecasting are parts of cash
management strategy. Based on the forecasting, the company maintains a
budget for future expenses and daily operations. The company assesses various
sources of cash inflows and expenditures.
2. Lowering Costs: It is the key aspect of cash management. To increase the
profit margin and conserve cash, a company needs to identify unnecessary
expenses and try to lower them.
3. Bank Relations: Making good relations with banks and other financial
institutions, helps businesses negotiate for various banking services, interest
rates, granting loans, and have the most favourable terms.
4. Cash Reserve: A business needs to make proper cash reserves by setting
aside money to meet any future contingencies. A cash reserve can be in the
form of a general reserve or free reserve. During excess reserve, the company
may decide to declare an interim dividend, which positively affects the goodwill
of the company.
5. Monitoring and Adjustment: Regular monitoring and adjusting the cash
flow will help the business adapt to changes quickly and foresee the expenses
and various ways of generating the funds.

Examples of Cash Management

1. Efficient Invoicing: A business can implement efficient invoicing processes
by using automated payment reminders to ensure timely collection from
customers and offering discounts for early payments.
2. Budgeting: It means proper planning for expenditure. Making a detailed
cash budget that sets out the planned structure for cash inflows and outflows
can help the business allocate resources effectively and avoid unnecessary
expenditures. It also encourages the growth of the business at a constant rate.
3. Working Capital: It is necessary to efficiently manage the working capital
by optimizing inventory, shortening the receivables, and negotiating favourable
terms with creditors to improve the overall cash flow of the business.
4. Cash Reserve: A business needs to make proper cash reserves by setting
aside money to meet any future contingencies. A cash reserve can be in the
form of a general reserve or free reserve. During excess reserve, a company
may decide to declare an interim dividend, which positively affects the goodwill
of the company.

Types of Cash Management

1. Cash Flow from Operating Activities: Operating activity means the

functions that are carried out by a business daily. The operating cash flow is
represented by the cash flow statement of the company which shows how much
money is being generated from regular business activities over a certain period.
In simple words, it shows the cash flow from its core business activity and does
not include revenue from investments and long-term expenditures.
2. Free Cash Flow to Equity: It reveals the company’s financial health and its
capacity to meet its obligations to equity shareholders. It represents the cash
that is available to be distributed to its equity shareholders. The cash can be
distributed to the shareholders in the form of an interim dividend or final
dividend.
3. Free Cash Flow to the Firm: It is the amount of cash derived from the
operations of the company that is calculated after allowing depreciation and
paying off the taxes. It is also essential in assessing the company’s financial
state and capacity to meet its obligations. This form is used in financial
modeling and valuation.
4. Net Change in Cash: It represents the difference or ‘Net Change’ between
two accounting periods. It depicts the overall increase or decrease in the
company’s cash and cash equivalents during a period.

Cash Management Strategies

1. Cash Sweep Accounts: Using cash sweep accounts to automatically

transfer excess funds to interest-earning accounts maximizes returns on idle
cash. A sweep account is a bank account that transfers funds that fall short of a
certain threshold or surpass it, into a higher interest-earning investment option,
at the end of a day.
2. Employee Training and Awareness: To foster a culture of cost-
consciousness and cash responsibility within the organization, training and
educating employees on the importance of cash management and their role in
optimizing cash flow becomes necessary. Training of the personnel will improve
efficiency and funds of the company can be utilised in a better manner.
3. Centralized Cash Management: This includes consolidation of funds into a
master account for efficient management. Centralizing the cash system will
have better control and visibility over cash positions. It will also help to keep
track of funds in a better manner.
4. Technology Integration: Leveraging technology for electronic payments,
online banking, and cash management systems will save time and introduce
ease of doing business. It encourages automation of various tasks that helps
companies to become more efficient with their resources.
5. Short-term Investments: Short-term investments are those which can be
easily converted into cash. These are also known as cash equivalents. Investing
in short-term instruments helps in generating funds which helps in maintaining
liquidity and cash reserve.

What does Working Capital Include?

Working capital means capital available with the company to meet its current
and short-term obligations and to run daily operations. The difference between
the current assets and current liabilities of the company is working capital. It
includes the following:
1. Current Assets: Current assets are those assets that are highly liquidable.
Current assets include the following,

● Bills Receivables: Money owed to the company by customers for

goods or services delivered on credit.

● Short-Term Investments: Investments that can be quickly converted

to cash within one year.

● Prepaid Expenses: Payments that are made in advance for goods or

services that are to be received in the future are prepaid expenses.

● Cash and Cash Equivalents: Money in the form of physical currency,

cash at the bank, and highly liquid investments with a short maturity
period.

2. Current Liabilities: Current liabilities are short-term financial debts that a

company needs to pay within one year. Current liabilities include:

● Accounts Payable: Amounts owed by the company to suppliers and

vendors for goods or services received on credit.
 ● Short-Term Debt: Debt obligations with a maturity period of one year
or less.

● Accrued Liabilities: Expenses that have been incurred but not yet
paid, such as accrued wages or utilities.

Benefits of Cash Management

1. Capital Management: As discussed earlier, cash is the most liquid asset,

therefore, it has a major role in the working capital management of the
company. It involves forecasting the need and amount of funds required for
maintaining smooth operations and maximising profitability.
2. Adequate Funds: The business needs to ensure that there are adequate
funds to meet current obligations and proper reserves to meet future
contingencies. Proper availability of funds is necessary to carry out daily
activities and reduce liabilities.
3. Liquidity Management: Cash management ensures that there is enough
cash in hand to meet daily operational needs. Accurate cash flow data can give
a better understanding of liquidity risks associated with the business. Cash
management also balances the need for liquidity with the opportunity cost of
holding idle cash.
4. Risk Management: Businesses need to monitor their system timely to avoid
the risk of bankruptcy. With accurate forecasting and making cash reserves
accordingly, a business can overcome unforeseen circumstances. Cash
management assesses and lowers the risk related to cash and implements
internal controls to safeguard cash assets.
5. Cash Reserve: Maintaining sufficient cash reserve can save a firm from
unforeseen expenses and contingencies. Entities can also use their cash reserve
to expand their business or declare dividends which will enhance their goodwill
in the market.
6. Cost Saving: Proper management of cash flow saves costs by avoiding late
fees, penalties, and interest expenses. With the standardization and automation
of cash management processes, businesses can save a significant number of
hours for their finance team which can be used in other work.
7. Strategic Investments: It ensures strategic planning for the investment of
funds which contributes to the long-term growth of business.

Limitations of Cash Management

1. Opportunity Cost of Holding Cash: Holding excess cash for precautionary

reasons incurs an opportunity cost, as funds could potentially be invested to
generate returns. Striking the right balance between liquidity and investment
opportunities is challenging.
2. Interest Rates and Inflation Impact: Fluctuations in interest rates and
inflation can affect the returns on short-term investments and the real value of
cash over time. Low-interest-rate environments may limit the earnings potential
on idle cash.
3. Economic Uncertainty: Economic uncertainties can impact the
predictability of cash flows and make it challenging to plan for cash needs
accurately. It may affect the cash management strategies.
4. Seasonal Variations and Business Cycles: Businesses with seasonal
variations may experience uneven cash flows throughout the year. It can be
complex to accommodate the cash management strategies with these
fluctuations.
5. Credit Policy Impact: Offering loose credit terms to customers may result
in delayed receivables, affecting the cash conversion cycle and leading to cash
flow challenges.
6. Market Fluctuations: Economic fluctuations and unfavourable market
conditions may impact the value of the investments made by the company.
These uncertain conditions can affect the liquidity of the company and its
capacity to meet contingencies.
7. Technology: Relying heavily on technology becomes risky as it exposes the
entities to various downfalls of technology such as cyber threats, hacking of
data, or technology failures.

How to Improve Cash Management?

There are many ways through which we can improve cash management. Some
of them are discussed below:
1. Accurate Cash Flow Forecasting: Making accurate cash flow forecasts by
regularly updating financial models and by using market trends, business
intelligence, and forecasting tools or software.
2. Explore Short-Term Investments: Businesses should identify suitable
short-term investment opportunities for engaging surplus cash. Firms can also
use money market instruments, certificates of deposit, or other low-risk
investments to earn additional returns.
3. Effective Communication with Stakeholders: Maintaining open
communication with customers, suppliers, and financial institutions helps
negotiate payment terms and conditions when necessary.
4. Working Capital Optimization: Evaluation and optimization of working
capital by balancing current assets and liabilities can help in improving cash
management. It will minimize the time between paying for inventory and
receiving cash from sales.
[Link] Cash Reserve: Cash reserve ensures liquidity in the business and
acts as a lifesaver in case of unforeseen circumstances.
Factors Determining Level of Cash
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Factors Determining Cash Needs and Level of Cash:

The factors affecting or determining the cash requirements of a

business are as follows:

(1) Timing of Cash Flows:

The need for maintaining cash balance arises because cash inflows and cash
outflows take place at different times. If cash inflows perfectly match cash
outflows, i.e., if they take place at same time, there would be no need for
keeping cash balance. Need for keeping cash balance arises when cash outflows
exceed cash inflows. Therefore, the need for cash can be determined by
forecasting cash inflows and cash outflows. Forecast is done through a cash
budget.

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(2) Cash Shortage Costs:

Cash budget would reveal the quantum as well as periods of cash shortages.
Every shortage of cash involves a cost depending upon the quantum and
duration of shortfall. Costs incurred as a result of shortfall of cash are called
cash shortage costs.

Examples of cash shortage costs are:

(i) Transaction cost relating to raising cash to tide over the shortage such as
brokerage etc. for sale of marketable securities.

(ii) Borrowing costs like interest etc. for borrowing to cover the shortage,

(iii) Penal interest charged by banks due to shortfall in compensating or

minimum balances in the bank.

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(iv) Costs due to deterioration of credit rating like shortage in the supply of raw-
material, less favourable terms offered by suppliers and so on.

(v) Loss of cash discount because of non-payment in time due to shortage of

cash.

Cash shortage costs should also be considered along with cash shortage itself in
determining cash needs.

(3) Cash Excess Costs:

If a firm keeps cash balance in excess of its requirements, it will miss
opportunities to invest it elsewhere. As a result it will lose interest which it
would otherwise have earned by investing excess cash elsewhere. This factor
should also be considered in determining the level of cash and therefore the
level of cash should not be determined in excess.

(4) Cash Management Costs:

Cash management also involves some costs such as salary, clerical expenses etc.
of cash management staff. Cash need should be determined after considering
this factor also.

(5) Uncertainty:

Cash flows can never be predicted with complete accuracy and there is always
some uncertainty in their forecast such as unexpected delay in collection from
debtors. Firm must always keep some additional cash to meet these
uncertainties.

(6) Firm’s Capacity to Borrow in Emergent Situations:

If a firm is able to borrow quickly in case of emergency, it can keep a low level
of cash. Firm’s ability to borrow depends on many factors such as its credit
standing, relation with the banks and so on.

(7) Attitude of Management:

The attitude of management towards liquidity and profitability affects the level
of cash. If the management attaches more significance to liquidity than
profitability, the level of cash will be high. On the contrary, if it gives more
importance to profitability instead of liquidity, the level of cash will be low.

(8) Efficiency of Management:

If the management can accelerate the collection of cash from customers and
slow down the disbursement of cash, it can keep a low level of cash.

Nature of Cash:

For some persons, cash means only money in the form of currency (cash in
hand). For other persons, cash means both cash in hand and cash at bank. Some
even include near cash assets in it. They take marketable securities too as part
of cash.

These are the securities which can easily be converted into cash. These
viewpoints reflect the degree of freedom of the persons using the cash. Whether
a person’s wants to use it immediately or can wait for a time to use it depends
upon the needs of the concerned person.

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Cash itself does not produce goods or services. It is used as a medium to

acquire other assets. It is the other assets which are used in manufacturing
goods or providing services. The idle cash can be deposited in bank to earn
interest.

A business has to keep required cash for meeting various needs. The assets
acquired by cash again help the business in producing cash. The goods
manufactured or services produced are sold to acquire cash. A firm will have to
maintain a critical level of cash. If at a time it does not have sufficient cash with
it, it will have to borrow from the market for reaching the required level.

There remains a gap between cash inflows and cash outflows. Sometimes cash
receipts are more than the payments or it may be vice-versa at another time. A
financial manager tries to synchronize the cash inflows and cash outflows. But
this situation is seldom found in the real world. Perfect synchronization of
receipts and payments of cash is only an ideal situation.

Motives for Holding Cash:

The firm’s needs for cash may be attributed to the following needs: Transactions
motive, Precautionary motive and Speculative motive. Some people are of the
view that a business requires cash only for the first two motives while others
feel that speculative motive also remains.

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These motives are discussed as follows:

1. Transaction Motive:
A firm needs cash for making transactions in the day to day operations. The
cash is needed to make purchases, pay expenses, taxes, dividend, etc. The cash
needs arise due to the fact that there is no complete synchronization between
cash receipts and payments. Sometimes cash receipts exceed cash payments or
vice-versa.

The transaction needs of cash can be anticipated because the expected

payments in near future can be estimated. The receipts in future may also be
anticipated but the things do not happen as desired. If more cash is needed for
payments than receipts, it may be raised through bank overdraft.

On the other hand if there are more cash receipts than payments, it may be
spent on marketable securities. The maturity of securities may be adjusted to
the payments in future such as interest payment, dividend payment, etc.

2. Precautionary Motive:

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A firm is required to keep cash for meeting various contingencies. Though cash
inflows and cash outflows are anticipated but there may be variations in these
estimates. For example, a debtor who was to pay after 7 days may inform of his
inability to pay; on the other hand a supplier who used to give credit for 15 days
may not have the stock to supply or he may not be in a position to give credit at
present.

In these situations cash receipts will be less than expected and cash payments
will be more as purchases may have to be made for cash instead of credit. Such
contingencies often arise in a business. A firm should keep some cash for such
contingencies or it should be in a position to raise finances at a short period.

The cash maintained for contingency needs is not productive or it remains ideal.
However, such cash may be invested in short-period or low-risk marketable
securities which may provide cash as and when necessary.
3. Speculative Motive:

The speculative motive relates to holding of cash for investing in profitable

opportunities as and when they arise. Such opportunities do not come in a
regular manner. These opportunities cannot be scientifically predicted but only
conjectures can be made about their occurrence.

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For example, the prices of shares and securities may be low at a time with an
expectation that these will go up shortly. The prices of raw materials may fall
temporarily and a firm may like to make purchases at these prices.

Such opportunities can be availed of if a firm has cash balance with it. These
transactions are speculative because prices may not move in a direction in
which we suppose them to move. The primary motive of a firm is not to indulge
in speculative transactions but such investments may be made at times.

4. Compensative motive: the motive to hold cash balance to compensate a

certain facility is termed as 'compensative motive'. For example to avail current
bank account facility, the account holder needs to hold certain minimum cash
balance. The required minimum cash balance may vary from bank to bank, and
is kept as a permanent balance in that account. Thus to avail the benefits of a
current account in a commercial bank, the company will have to maintain the
needed minimum cash balance.

5. Other motives: there are various other purposes for which a firm needs to
maintain cash balance. Certain amount of cash is always maintained in the
business to meet payment obligations and petty requirements arising from daily
business operations. Various other motives can be listed as follows:

1. to meet operational activities,

2. maintain goodwill by prompt and timely payments,
3. to maintain liquidity reserve,
4. to take advantages of long term and short term investment opportunities,
5. to reap advantage of unexpected one time business opportunity.

CASH MANAGEMENT
Cash is required by a firm to meet its transaction and precautionary needs. It is
also required to take advantage of the speculative opportunities coming its way.
Firms need cash to make payments for acquiring resources and services for the
routine business operations. Also certain balance of cash is maintained to meet
any emergency situation.

Looking at the importance of maintaining an optimum cash balance, it is evident

that a involves managing the in and out flows of cash, many the flow of cash,
managing the company should plan for its cash requirements. Planning and
management of cash cash flow within the firm and financing for deficit and/or
investing the surplus of cash, thus managing the cash balance at a point of time.

Reasons for Cash Surplus:

1. Excess net profits earned during the financial year;

2. Actual operating expenses are low;

3. Control and reduction of capital expenditure or actual capital expenditure

less than the budgeted expenditure;

4. Less investments during the period due to lack of profitable investment

opportunities;

5. Sale of assets during the year;

6. New loans raised;

7. Fresh capital raised from issue of shares & debentures to finance new
projects; 8. Low pay-out and high retention of profits.

Reasons for Cash flow problem:

1. If the company trades over its capacity it may face cash flow problems.
Overtrading increases the cash outflow and creates shortage of cash.

2. If the working capital of the company is not managed efficiently, cash flow
problems will appear. Faulty collection policies, extended credit period to
debtors & curtailed credit period of creditors, unbudgeted capital expenditure,
misuse of funds, wrong estimation of need for working capital will lead to cash
flow problems in a firm.

3. If the firm is a 'growing firm' it will need more funds for its development
projects. This will create the cash flow problem.

4. In the net profits earned are less than anticipated or if the firm incurs losses;
the cash flow problems will arise.

5. If the rate of inflation in the economy is higher than accounted for, the
company may face cash flow problems. More cash will be needed to meet the
budgeted expenditure and on the other hand the cash inflows will reduce.
6. If the company has incurred heavy capital expenditure or non-recurring
expense which were not anticipated, the cash flow problems may arise. Excess
payment of cash will increase the cash outflow with no excess cash inflow to
This will lead to short term cash flow problems for the firm. cover the gap. 7.
Variances in the budgeted and actual estimations will lead to cash flow
problems. Variance is the difference between the budgeted figure and actual
figures of revenue & expenditure. Variance can be either favourable or
unfavourable. However, both favourable and unfavourable variance will lead to
cash flow problem.

Effects of Cash Deficits

Shortage of cash will lead to decisions which are sub-optimal in nature. If the
company is facing shortage of cash, it will not be in position to choose the best
financial investment alternatives that are available. The company will end up in
making sub-optimal decision that is probably cost effective. Shortage of cash
will thus lead to sub-optimal investment decision and also sub-optimal financing
decisions. Sub-optimal Investment Decisions: due to shortage of cash, a
company may take decision to discontinue profitable product or division, or it
may not be able to take up a profitable investment project, or may select less
profitable options, etc. Such decisions will be termed as sub-optimal. Failure to
maintain adequate level of working capital will also be a result of
mismanagement and shortage of cash.

Sub-optimal Financing Decisions: these decisions would include taking fresh

loans at a very high rate of interest, or granting of overdraft facility secured
with the guarantees from directors, restrictions on raising of additional finance,
restriction on payments towards director's fees, non-payment of dividends, etc.

MANAGING CASH COLLECTION AND DISBURSEMENTS

Cash Budget' is prepared to summarise the firms expected cash inflow and cash
outflow over the projected time period. It is helpful in determining the timing
and magnitude of expected cash flows and cash balance over the projected
period. Cash budgets are based on the cash forecast that are done on the short
term and long term basis. After preparation of the Cash Budget, the finance
manager has to ensure that the actual cash flows are in tune with the projected
cash flows. The deviation between the actual cash flow and the budgeted cash
flow should not be significant. If the deviations are found to be significant the
finance manager will have to improve the cash management system. To ensure
an efficient cash management system, the finance manager will have to install
proper control system on the cash collection and cash disbursements. An
efficient cash management system will try to:

(i)Accelerate cash collection;

(ii) Decelerate the cash disbursement as much as possible.

Accelerate the Cash Collections

In order to manage cash efficiently, the process of cash inflows can be
accelerated. The firm should significantly plan and design effective techniques
that will speed-up the cash collection of accounts receivables. For this purpose,
the customers should be encouraged to pay as quickly as possible offering cash
discounts. The payment from customers should be converted in to cash without
any delay. In technical terms, the finance manager should manage the 'float'
efficiently to speed-up collections. Cash collections can be accelerated by taking
the following measure:

1. Invoice processing time should be shortened. Delay in processing the

invoice will delay in receiving the payments. The time taken by the firm to
process the orders will increase the collection period. Therefore to
accelerate the cash collection, the firm should have efficient accounting
system to ensure quick preparation and dispatch of invoices.
2. Another way to accelerate the cash collections is to reduce the time lag
between the time when payment is collected from the customers and the
same gets credited in the firms accounts. The time taken between
collection of payments from customers and availability of funds for the
firm should be managed efficiently so as to accelerate the cash
collections.

Float

'Float' is defined as the balance shown in the company/individual's books of

accounts and the balance shown by the bank records. Management of float is
significant as it affects the length of cash cycle. Float is created by the following
delays:

(a) Billing Float: it is created by the time taken between the points of credit
sale to the time taken to mail the invoice.

(b) Postal/ Mailing float: this is created due the mailing time taken by the
post office/ courier services to deliver the cheque from the customers to the
company. This is the transit time, which should be reduced as far as possible by
employing efficient mailing services.

(c) Cheque Processing Float: the time which is taken in deposition of the
cheque in the respective bank account once it is received from the customers.
The company has to make accounting entries before the cheque is presented in
the bank for clearance. Thus cheque processing float is created by the time
taken from receiving the cheque up to the time it is deposited in the bank.

(d) Cheque Clearing/ Bank Float: it takes some time for the cheque to clear
after it is presented in the bank for clearance. The cheque passes through the
bank clearance system before the amount is transferred and credited in the
company's account. The float created due to the clearing delay is known as
clearing/bank float.

It is important to note at this point, that with modernisation of businesses,

intensive use of information technology and internet services is done by modern
corporate houses. This reduces the total float. In the present times E-mail
services are intensively used to mail the bills to the customers, this reduces the
billing float. Also with improvement and innovation in banking services, the
cheque clearing float is reduced to a very large extent. Postal float and cheque
processing float can almost be totally avoided with new innovative banking
payment systems like National Electronic Fund Transfer (NEFT) and Real Time
Gross Settlement (RTGS); internet banking services and online transfer of
money.

Types of Float

Float can be categorised into:

(a) Deposit Float: the amount of cheques received by the company from the
customers but not yet presented for clearance is termed as 'deposit float'. The
greater the company's deposit float, the longer is the time taken to convert the
cheques into cash. If the cheques take longer time to clear, the deposit float will
increase, thus the cash realisation will be slower. The company should try to
improve the collection mechanism so as to reduce the deposit float and have
speedy cash conversion.

(b) Disbursement Float: the amount of cheques which the company has
issued to their creditors, but not yet deposited by them for collection creates a
float. Thus the company's bank account is not debited by the amount of cheques
issued and the float created by this is called the disbursement float.

(c) Net Float: if the disbursement float is greater than the deposit float we get
a positive 'net float'. Net float is the difference between the balance shown by
the company's cheque book and the books of the bank.

Process of Ascertainment of Total Float

1. Dispatch of goods (creation of billing Loan)

2. BIR/ Invoice sent to customer (creation of Bill mailing Boot)
3. Receipt of Bill invoice by the customer (Credit period float)
4. Customer malls the cheque on due date (Cheque mailing float)
5. Company received the cheque (cheque Processing Float)
6. Company deposits the cheque into Bank (Cheque Clearing Float)
7. Amount crested Into Bank Account

Here's how these stages can be broken down:

1. Ascertainment of Total Float:

● Total Float is the sum of all individual floats (time delays) that occur
from the moment goods are dispatched to the time the payment is
credited to the company's bank account.

2. Dispatch of Goods (Creation of Billing Float):

● When goods are dispatched to the customer, the billing process begins.
This creates a Billing Float, which is the time between the dispatch of
goods and the creation of an invoice.

3. BIR/Invoice Sent to Customer (Creation of Invoice Mailing Float):

 ● After the invoice is generated, it is sent to the customer. The Invoice
Mailing Float refers to the time taken for the invoice to reach the
customer.

4. Receipt of Bill/Invoice by the Customer (Credit Period Float):

● Upon receiving the invoice, the customer is given a credit period to make
the payment. The Credit Period Float is the duration between the
receipt of the invoice and the due date for payment.

5. Customer Mails the Cheque on Due Date (Cheque Mailing Float):

● The customer mails the payment (usually by cheque) on or before the due
date. The Cheque Mailing Float is the time it takes for the cheque to
reach the company after being mailed.

6. Company Receives the Cheque (Cheque Processing Float):

● Once the company receives the cheque, it needs to process it. The
Cheque Processing Float is the time between receiving the cheque and
depositing it in the bank.

7. Company Deposits the Cheque into the Bank (Cheque Clearing Float):

● After depositing the cheque, it goes through the banking system for
clearance. The Cheque Clearing Float is the time it takes for the
cheque to clear and the funds to be available in the company's bank
account.

8. Amount Credited into Bank:

● Finally, the amount is credited into the company's bank account,

completing the cash flow cycle.

Total Float Calculation:

● The Total Float is the cumulative time delay from the dispatch of goods
to the final crediting of the payment into the bank. Managing and
minimizing these floats is crucial for maintaining good cash flow and
liquidity in a business.

It depicts the entire process of credit sales to collection of amount and crediting
it to bank account, and in the process it explains the creation of various floats.
'Deposit float' or 'collection float' as explained earlier, is he amount of cheques
received from the customers but not yet deposited in the firm's account. Transit
time and processing time together add up to the time lag resulting in creation of
'float'. Mailing time is the time taken by the cheque in transit. Processing time
is the time taken by the firm in processing the cheques (including the time
taken by banks and inter-bank system to clear the cheques).

Illustration 1
X Ltd. has Rs. 12,00,000 balance available in its bank account as well as this is
the balance reflected in the ledger. X Ltd receives a cheque of Rs 5,00,000 that
it records in its books and deposits it in the bank account. It will take 2 days for
the cheque to clear and for the funds to get credited. Find the amount of
deposit float today.

Solution 1:

Because a cheque of Rs. 5,00,000 is deposited for collection, X Ltd book balance
will increase by Rs. 5,00,000 and the new balance will be Rs. 17,00,000;
whereas the bank balance is still Rs. 12,00,000.

Thus, Deposit Float = Balance in bank account - Balance reflected in the books

=12,00,000 - 17,00,000 = Rs.5,00,000

There is a negative float of Rs. 5,00,000.

Illustration 2

X Ltd. issues cheques of Rs. 30,000 per day and receives cheques of Rs. 20,000
per day. The payment float is 7 days while the receipts float is 2 days on an
average. Find out different floats for the firm.

Solution 2:

Calculation of floats is done as follows:

Disbursement Float = Amount No of days = 30,000 × 7 = Rs 2,10,000

Collection Float =

Amount No of days = 20,000 × 2 = Rs. 40,000

Net Float = Disbursement Float - Collection Float = 2,10,000 - 40,000 = Rs.

1,70,000

Illustration 3

Shoan Ltd. issue cheque of 5000 per day and receive a cheque of 4000 per day.
The payment float is 7 days while the receipt float is 2 days on an average. Find
out different floats for the firm.

Solution 3:

Different floats for the months are as follows:

Disbursement = Amount x no of days

= 5000 × 7 = 35,000
Collection floated = amount x no of days

=4000 x 28,000

Net float = Disbursement floated - Collection floated

=35,000-8000 = 27,000

The firm's net book balance is 27,000 less than the actual balance available in
the bank.

Management of Float

An efficient collection system will try to reduce the time lag and thus reduce the
deposit float. There are various techniques to overcome the problem of
management of float. They are explained as follows:

(a) Decentralized Collection/ Concentration Banking System: this is one

of the traditional methods to accelerate the cash collections. Firm which is
operating from multiple geographical locations will decentralize its payment
collection system, to reduce the collection float. In concentration banking,
cheques are collected by the collection centers and deposited in the local bank
account after processing so that the mailing float is reduced. The basic objective
behind decentralized collection is to reduce the mailing time between the points
where the customer makes the payment up to the time the funds are available
for the use of the firm. A company which is widely spread geographically will
open multiple bank accounts at locations where it has its major branches as
'payment collection center', instead of having only one centrally located
collection center which is usually the company's head office. The selection of
branches is usually done on the basis of business transited at that branch; i.e.
the volume of sales and the volume of disbursements done. This system is
known as 'Concentration Banking' in the USA. Under this system, the various
collection centers will collect the payment from its customers and then transfer
the funds above some predetermined minimum amount to a central or
'concentration bank account' each day. A concentration bank account is the
main bank account of the company from which major payments are done.
Decentralization collection system is thus an effective way to reduce the
collection float. To maintain a decentralized collection system the company will
have to incur some extra charges. This system should be adopted only when the
savings in cost is greater than the operation and maintenance cost of
decentralized collection.

(b) Lock-box System: another traditional method for speeding up collections is

the Lock-box system. This is the alternative method for concentration banking,
where the cheques are collected by the local branches and deposited in the
local bank account after processing. This reduces the mailing float but still
there remain the processing float. Lock-box system eliminates the processing
float as well. Under this system, firm hires a post office box under the control of
a bank at important collection centers. The customers are provided with this
post box number and are directed to remit their payments to the lock-box. The
to open the lock-box and collect the local bank is authorised
remittances/cheques received from the customers. Normally the bank will
incoming cheques) and deposit the same in the company's account. The bank
open the lock-box multiple times a day (depending upon the volume of prepares
a list of cheques deposited in the bank along with another enclosure (proof of
cheques deposited). Thus the collection of cheques under this system is
decentralized, and the collected amount is then transferred to a central account
of the company. The significant difference between the two methods is that
under concentration banking the cheques are collected at various collection
centers and then deposited in the bank account whereas in the lock- box system
the customers send the cheques directly to the post office box.

(c) Electronic Fund Transfer: with the growth in use of computers and
information technology, banks are providing innovative services like electronic
clearing facilities and electronic fund transfers. Transfer of money from one
account to another via internet is easy and superfast; within seconds money is
transferred. Companies distribute dividends to multiple shareholders accounts
with help of electronic transfer. Also payment of taxes, payment to creditors and
other payments are done by electronic transfer systems. Even when the
payments are done by cheques, inter-bank transfers and clearing is done with
the help of computers which reduces the float to a great extent. When the funds
are transferred by electronic fund transfer system the question of float and its
management does not arise. Thus money is no longer blocked in 'float'. Real
Time Gross Settlement (RTGS) and National Electronic Fund Transfer (NEFT)
are the system by which funds can be spontaneous transferred.

Decelerating Disbursements/ Controlling Disbursements

Disbursement is deferred payment that helps to conserve and retain cash

balance in the firm. Firms have to make payments towards various items of
expenses. Expenses like salaries & wages cannot be deferred, but
disbursements arising from trade credit can be deferred to the extent they do
not damage the goodwill of the company. Trade credits are considered to be the
spontaneous source of short term funds. Deferred disbursement to creditors
includes:

1. Maximum use of trade credit available;

2. Using a disbursement float.

Delaying the payments will result in retaining the cash balance with the firm.
However the firm should be cautious while doing so. Delaying the payment
beyond the credit limit will result in hampering the company's image. Also, the
suppliers may 'add-on' cost to cover the delay loss or may supply low quality
goods. If the image of the company is hampered it may find it difficult to raise
credit in future. Disbursement should be deferred only as per the credit norms
of the industry. On the other hand, this does not mean that the company should
make premature payments unless attractive cash discounts are offered.

Thus to conclude, accelerating cash collection and controlling disbursement will

result in efficient managing the cash balance. It is complicated as the cash flows
cannot be estimated accurately therefore utmost care must be taken in
managing the net float.

Cash Budget
A cash budget is also referred to as a cash flow forecast. It is a method of
predicting the amount of funds and the time when they would be required by an
organisation. In simple words, its basic idea is to predict when and in what
quantity the receipts of cash would come into the firm and when and in what
quantity the payments in cash would be made.

A cash budget is a forecast of anticipated cash receipts and disbursements. The

essential distinction between cash budget and other budgets is that, in the
former, all the estimates are based on the dates when it is expected that cash
would be received or paid. The other budgets, however, are prepared on what is
commonly known as the accruals basis.

The cash budget shows the net effect on cash resources of all the expected
transactions of a company during the budget period. The amount of cash a
company has made available determines its ability to take advantage of trade
discounts, meet obligations falling due, etc. It also projects cash deficiencies
and excesses, thereby indicating the need for either borrowing or investing.

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Because these matters are vital to the communication of a company’s operating

success, the cash budget is one of the most important tools in the budgetary kit.

Cash budget is an estimation of the cash inflows and outflows for a business or
individual for a specific period of time. Cash budgets are often used to assess
whether the entity has sufficient cash to fulfill regular operations and/or
whether too much cash is being left in unproductive capacities.

The cash budget consists of two main areas, which are Sources of Cash and
Uses of Cash. The Sources of Cash section contains the beginning cash balance,
as well as cash receipts from cash sales, accounts receivable collections, and
the sale of assets.
The Uses of Cash section contains all planned cash expenditures, which comes
from the direct materials budget, direct labor budget, manufacturing overhead
budget, and selling and administrative expense budget. It may also contain
items for fixed asset purchases and dividends to shareholders.

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If there are any unusually large cash balances indicated in the cash budget,
these balances are dealt with in the financing budget, where suitable
investments are indicated for them. Similarly, if there are any negative balances
in the cash budget, the financing budget indicates the timing and amount of any
debt or equity needed to offset these balances.

Cash balances may fluctuate considerably within a single accounting period,

thereby masking cash shortfalls that can put a company in serious jeopardy. To
spot these issues, it is quite common to create and maintain cash forecasts on a
weekly basis.

Though these short-term budgets are reasonably accurate for perhaps a month,
the precision of forecasting declines rapidly thereafter, so many companies then
switch to budgeting on a monthly basis. In essence, a weekly cash budget
begins to lose its relevance after one month, and is largely inaccurate after two
months.

The cash budget has its roots in the statement of cash flows in the sense that it
tracks projected cash inflows and outflows as opposed to actual inflows and
outflows.

Importances of Cash Budget

The importance of a cash budget in a firm lies in its ability to provide crucial
insights into the company’s financial health and ensure the smooth operation of
business activities. Here’s a breakdown of why a cash budget is vital:
 1. Maintaining Financial Balance: A cash budget helps avoid imbalances
in the firm’s financial structure, which can reduce output and
profitability. For marginal firms, this imbalance can be disastrous,
potentially leading to a loss of credit standing and difficulty in meeting
obligations.
2. Optimizing Cash Usage: It helps the finance manager identify periods
of cash surplus or deficit. Holding excess cash without utilizing it can
lead to a decline in profits, while a cash deficit can harm the company’s
ability to meet obligations. The cash budget allows for the efficient
allocation of cash, ensuring high liquidity without sacrificing profitability.
3. Guiding Financial Planning: The cash budget indicates the timing and
amount of cash requirements, assisting finance managers in deciding the
best sources of funds. For instance, short-term needs might be met with
bank loans, while long-term needs could involve issuing stocks or bonds.
4. Reducing Financing Costs: Proper cash planning can inspire
confidence among lenders, leading to more favorable loan terms.
Conversely, poor planning might result in higher interest rates and
restrictive loan conditions.
5. Supporting Dividend Policy: A cash budget ensures that the company
has enough cash to pay dividends, even when earnings are high but cash
is tied up in credit sales or other obligations. It helps the finance manager
make informed dividend decisions based on the firm’s cash position.
6. Enhancing Cash Control: The cash budget acts as a control mechanism
by setting limits on cash expenditures and allowing the finance manager
to compare actual cash flows with budgeted amounts. This comparison
helps identify deviations, understand their causes, and take corrective
action.

Limitations of Cash Budget:

● Estimation Errors: Inaccuracies in the budgets that feed into the cash
budget can lead to incorrect cash flow predictions, necessitating regular
reviews and adjustments.
● Lack of Time Segmentation: The cash budget might not specify when
within a month cash flows occur, leading to potential cash shortfalls. For
 instance, a company could plan to invest in short-term securities in April
but might run out of cash by April 10, leaving it unable to meet
obligations like payroll.
● Need for Multiple Budgets: Depending on the firm’s cash position, it
may be necessary to prepare multiple cash budgets, such as weekly
forecasts for the short term and monthly or long-term forecasts. This
underscores the importance of close administration of the budget to
ensure financial stability.

Top 3 Elements of Cash Budgets – Selection of Time Period, Operating

Cash Flows and Financial Cash Flows

Elements of Cash Budgets:

The elements which form part of the cash budget are cash items only and the
noncash items such as depreciation shall be excluded. The cash receipts and
payments can be divided into two categories—revenue and capital nature.

Some other elements of cash budget are:

1. Selection of Time Period:

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Refers to determining the duration for which the cash inflow and outflow would
be recorded. Cash budgeting can be done for any duration of period, such as
three months or six months.

In an organization, all the business transactions in a given period of time are

recorded properly to predict the flow of cash in the future. The process of
selecting the time period is also known as the planning horizon, as it helps in
projecting the receipt and payment of cash in future.

2. Operating Cash Flows:

Refers to the cash used in various operational activities. All the operating
expenses are recorded under the heading cash outflow; whereas, all the
operating incomes arc recorded under cash inflow.

The operating expenses include the wages and rent paid, purchase of raw
material, and production cost. The operative income includes the account
receivable and sales of products.

3. Financial Cash Flows:

Refers to the cash flows, which are generated by the financial activities of an
organization. An example of financial activity is the investment in short-term
financing instruments. The returns received on investments are cash inflows;
whereas, the amount of money invested is cash outflows.

Top Steps in Cash Budget

The steps involved in preparing a cash budget are essential for ensuring that a
company can manage its cash flows effectively. Here's a structured approach:

1. Determine the Beginning Cash Balance

● Start with the entity’s cash balance at the beginning of the period. This
balance is usually the closing cash balance from the previous period and
represents the amount of cash left over.

2. Estimate Cash Receipts

● Add all expected cash receipts for the period. This includes:
○ Revenue Transactions: Cash sales, collections from accounts
receivable, and any other income like interest or dividends.
○ Asset Transactions: Proceeds from the sale of assets.
○ Financing Transactions: Loans received, issuance of stocks, etc.

3. Estimate Cash Payments

● Subtract all expected cash payments for the period. This includes:
 ○ Expense Transactions: Payments for wages, rent, utilities, and
other operating expenses.
○ Asset Acquisition Transactions: Purchases of equipment,
inventory, or other assets.
○ Liability and Owner Equity Transactions: Repayment of loans,
dividends paid to shareholders, and taxes.

4. Calculate the Expected Cash Balance

●
Use the formula: Beginning Cash Balance+Expected ReceiptsExpected Payments=Expected Cash Balance at t

● This calculation provides an estimate of the cash balance at the end of

the budget period.

5. Compare Expected Cash Balance to Budgeted Cash Balance

● Excess Cash: If the expected cash balance exceeds the budgeted cash
balance, the company has a surplus. The company can consider investing
this excess cash in marketable securities or other investment
opportunities.
● Deficit Cash: If the expected cash balance is lower than the budgeted
cash balance, the company is facing a deficit. In this case, the company
may need to seek additional financing, such as a loan or line of credit, to
cover the shortfall.

6. Review and Adjust

● Regularly review the cash budget against actual performance to identify

any discrepancies. Adjustments may be needed if actual cash flows differ
significantly from the budgeted amounts.

By following these steps, companies can better manage their cash flow,
ensuring that they have sufficient funds to meet their obligations and make
informed decisions about investments and financing.
6 Important Utility of Cash Budget

Utility of Cash Budget are as follows:

1. a) It indicates the effect on the cash position of seasonal requirements,

large inventories, unusual receipts and slowness in collecting bills
receivable.
2. b) It indicates cash requirements for a plant or equipment expansion
programme.
3. c) It points to the need for additional funds from external sources such as
bank loans, issue of securities.
4. d) It indicates the availability of cash for taking advantage of discounts
offered.
5. e) It helps in planning redemption of preference shares or redeemable
debentures, payments of pension etc.
6. f) It shows the availability of excess funds for short or long term
investments.

Methods of Preparing Cash Budget

A cash budget can be prepared under any of the following methods:

(i) Receipts and Payments Method

This is the most simple and popular method of preparing a cash budget. This
method is useful for preparing a short term cash budget. Under this method, all
expected cash receipts and payments of the budget period are considered for
preparing the cash budget. Accruals and adjustments are ignored while
preparing the cash budget by this method.

The cash budget starts with the opening cash in hand and at the bank. All
expected cash receipts from various sources such as cash sales, cash collected
from debtors, dividends, interest on bonds, proceeds from sale of assets, bank
loans, etc., are added to the opening balance of cash.

Items of expected cash payments such as cash purchases, payment to creditors,

payment of expenses, dividends, tax and purchase of fixed assets, etc. whether
on capital or revenue accounts, are deducted.
The excess of cash receipts (including opening balance) over cash payments
represents closing cash balance at the end of the period and the excess of cash
payments over cash receipts would indicate the overdraft requirements.

(ii) Adjusted Profit and Loss Method

This method is usually followed in preparing long term cash budgets and it
provides lesser details than the receipts and payments method. Under this
method, a profit and loss account is used as a basis for making the cash
forecast. This method is based on the analogy that profit made during the
period should increase the cash balance.

While preparing the usual profit and loss account, many items which do not
involve cash outlay such as depreciation, transfer to reserves, fictitious assets
written off, goodwill written off etc. are subtracted from gross profit.

But the amount so subtracted from profit remains in the business. To arrive at
the cash balance available at the closing date, these items are added back to the
net profit.

(iii) Balance Sheet Method

This method is also useful for preparing long term cash budgets. Under this
method, a budgeted balance sheet is prepared for a certain future period
showing all liabilities and assets except cash and bank balances. The cash or
bank balance is arrived at as the balancing figure of the two sides of the
balance sheet.

If the liabilities side is more than the assets side, the excess is taken as closing
cash on hand or at the bank. If the assets side is heavier than the liabilities side,
the difference is considered as overdraft.

The main defect of this method is that it ignores the items of income and
expenditure. The second defect is that the exact cash position will be known
only when the balance sheet is prepared at the end of the year.
Determining Period For Which Cash Budget Is To Be Prepared

The first task in the preparation of a cash budget is to decide the period for
which cash budget is to be prepared. It is advisable to take neither a very long
nor a very short period. In case the period chosen is very long, it is likely to
affect the accuracy of the cash budget.

This is due to the fact that the elements of the cash budget are basically
estimated figures and estimation is likely to get affected with time.

For example, one can make a fairly precise estimate of the events likely to
happen in the next three months but one can’t make good estimates of the
events which are to happen after one year.

Therefore, the size of the period shall not be very long. On the other hand, if the
period is very small, again it is likely to affect the accuracy of the net cash
position at the end of various sub-periods of the cash budget.

For example, if the goods are sold on credit basis for which 50% of the payment
is to be received in the third month from the month of sale and the period of
cash budget is taken for two months only, the receipt of the funds would not be
reflected and thus it would present inaccurate picture of the cash budget.
 Optimal cash balance

Optimal cash balance is the amount of cash that minimizes the total costs of
holding and managing cash for your business. Holding cash involves an
opportunity cost, which is the return you could have earned by investing your
cash in other assets. Managing cash involves transaction costs, which are the
fees and expenses you incur when you convert your cash into other assets or
vice versa. The optimal cash balance is the point where these two costs are
equal.

Cash Management Model # 1. William J. Baumol’s Model:

William J. Baumol developed a model (The Transactions Demand for Cash: An
Inventory Theoretic Approach) which is usually used in inventory management
but has its application in determining the optimal cash balance also. Baumol
found similarities between inventory management and cash management.

As Economic Order Quantity (EOQ) in inventory management involves tradeoff

between carrying costs and ordering cost, the optimal cash balance is the
tradeoff between opportunity cost or cost of borrowing or holding cash and the
transaction cost (i.e. the cost of converting marketable securities into cash etc.)
The optimal cash balance is reached at a point where the total cost is the
minimum. The figure below shows the optimum cash balance.

Baumol’s Model For Determination of Cash Balance-

Assumptions of the model

● The requirement for cash for a given period is known.

● The Requirement of cash is distributed evenly throughout the period.
 ● Selling of securities can be done immediately (There is no delay in
placing and receiving orders).
● There are two distinguishable costs associated with cash holding:
opportunity cost and transaction cost.
● The cost per transaction is constant regardless of the size of the
transaction.
● The opportunity is a fixed percentage of the average value of cash
holding.

Baumol’s Model For Cash Balance-

In the above figure T1,T2,T3 represents different time periods. The firm should
maintain the optimum cash balance as computed by the model. When the cash
is utilised the firm should take necessary steps to raise the balance to its
desired level. C/2 depicts the average balance of cash maintained over the
entire time period under consideration.

Limitations of the model

Baumol's model suffers from the following assumptions:

1. The cash flows are assumed to be uniform over the period of time. In
practical situation, the cash flows of the firm fluctuate and are not uniformly
distributed.
2. The assumption that the firm can accurately predict its cash outflows and
inflows seems unrealistic.

3. The opportunity cost (interest on marketable securities is assumed to be

constant, which is an unrealistic assumption. The rate of interest on securities
fluctuates with the market conditions.

4. Transaction cost usually depends on the maturity period of the security and
also on the type of security in which cash is invested. Thus the transaction cost
will keep changing and assuming a constant transaction cost for each
transaction is an unrealistic assumption.

Illustration 1:

The annual cash requirement of A Ltd. is Rs 10 lakhs. The company has

marketable securities in lot sizes of Rs 50,000, Rs 1, 00,000, Rs 2, 00,000, Rs 2,
50,000 and Rs 5, 00,000. Cost of conversion of marketable securities per lot is
Rs 1,000. The company can earn 5% annual yield on its securities. You are
required to prepare a table indicating which lot size will have to be sold by the
company. Also show that the economic lot size can be obtained by the Baumol
Model.
Cash Management Model # 2. Miller and Orr Model:

Firms are not in position to accurately predict their cash inflows and cash
outflows. This result into ununiformed cash flows during the period. One of the
major limitations of the Baumol's model is that it does not allow the cash flow to
fluctuate. The Moller-Ormmodel overcomes these limitations of the Baumol's
model. Miller and Orr model (1966) assumes that the cash flows of the firm
fluctuate and that different amount of cash payments are made at different
point of time. Thus the cash flows are random. This model suggest control limits
which sets control points for time and size of transfer between the 'cash
account' and 'investment account'. Three limits are predetermines: the upper
limit, the lower limit and return level. Money is transferred from cash account
to investment account and vice-a-versa, whenever actual cash balance goes
beyond the upper and lower limit.

The model specifies the following three limits:

1. Upper Control Limit (U): this is the maximum limit of holding cash.
Beyond this limit cash should not be carried.
2. Lower Control Limit (L): this is the minimum limit of holding cash.
Beyond this level the cash balance should not fall.
3. Return Point (R): this is return level for cash balance. The cash balance
may be increased or decreased to adjust to the 'normal' or 'return' limit.
As per Figure, two control limits of cash balance are maintained: the upper limit
and the lower limit. The cash balance should not go beyond the upper limit and
should not fall below the lower limit. The cash balance should move within
these set limits. If the cash balance reaches the upper limit the firm should
invest the excess cash in marketable securities to bring down the balance. If the
cash balance falls below the lower limit, the firm should sell some of its
marketable securities so as to raise the cash balance. Thus the firm should try
and maintain the cash balance upto the limit that is computed by the model.
Management of cash balance by this model is quite simple as shown in the
figure.

The Miller-Orr model will work as follows:

(a) When the cash balance increases and reaches the upper limit, securities are
purchased to the extent of difference between the upper limit and the return
point. Thus the purchase of securities will be of Rs. (U-R).

(b) Thus after the purchase the balance gets adjusted to return point (R).

(c) When the cash balance reaches the lower limit (L), securities are sold and
cash realised, to the extent of difference between the return level and the lower
limit. Thus securities sold will be of Rs. (R-L).
(d) After the securities are sold and cash is realised, the cash balance will get
adjusted to return point (R).

Assumptions of Miller-Orr model:

(1) The basic assumption of this model is that there is no particular pattern of
cash flows over time. The cash flows are random; i.e. different amount of ca
flows at different point of time.

(2) The optimal value of (U) and (R) depends upon the opportunity cost as well
as on the degree of likely fluctuations in cash balance.

Miller-Orr model can be used under conditions of uncertainty and random cash
flows. It basically advocates management of cash balance by setting the control
limits of holding the cash. it easily determines the amount of cash to be invested
or disinvested in the marketable securities to adjust the balance to the return
point. The lower limit (L) of maintaining the cash balance can be set by the
company as per their requirement. What should be the upper limit? The span of
lower limit and the upper limit depends upon the following factors:

1. The transaction cost (T);

2. The variance between the daily cash flows (V);
3. And the interest rate on investment (i).

The formula for determining the span denoted by Z is computed with the help of
the following formula:

The spread between the upper and lower cash balance limits (called z)
can be computed using Miller-Orr model as below:

Variance of Cash Flows = (Standard deviation)2 or (s)2:

Interpretation:

a. The upper limit (U) and the lower limit (L) will be far from each other when
the span (Z) will be larger. This reflects that either the transaction cost is higher
or the cash flows show higher fluctuations.

b. The upper limit (U) and the lower limit (L) will be near to each other when
the Span (Z) will be smaller. This means that the interest rate on the securities
has increased. The limits will come closer with increase in the interest.

c. Thus it is clear that Z is inversely related to the interest rate.

Illustration 2:

A company has a policy of maintaining a minimum cash balance of Rs 1, 00,000.

The standard deviation in daily cash balances is Rs 10,000. The interest rate on
a daily basis is 0.01%. The transaction cost for each sale or purchase of
securities is Rs 50. Compute the upper control limit and the return point as per
the Miller-Orr model.
Illustration 3:

A firm having an annual opportunity cost of 15 per cent is contemplating

installation of a lock box system at an annual cost of Rs 3, 00,000. The system is
expected to reduce mailing time by 4 days and reduce cheque clearing time by
3 days. If the firm collects Rs 4, 00,000 per day, would you recommend the
system?

Thus, it is recommended that the proposed lock box system should be installed.

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Illustration 4:

Beta Ltd. has an annual turnover of Rs 84 crores and the same is spread evenly
over each of the 50 weeks of the working year. However, the pattern within
each week is that the daily rate of receipts on Mondays and Tuesdays is twice
that experienced on the other three days of the week.
The cost of banking per day is estimated at Rs 2,500. It is suggested that
banking should be done daily or twice a week Tuesdays and Fridays as
compared to the current practice of banking only on Fridays. Beta Ltd. always
operates on bank overdraft and the current rate of interest is 15% per annum.

This interest charge is applied by the bank on a simple daily basis. Ignoring
taxation, advise Beta Ltd. the best course of banking. For your exercise, use 360
days a year for computational purposes.
 Inventory management

What is Inventory?

The term inventory includes both the manufactured products that are available
for sale and the raw materials utilized in the manufacturing process. Inventory
is among the most valuable assets possessed by a business, as inventory
turnover is one of the principal contributors to revenue generation and,
consequently, shareholder returns. Inventory is classified as a current asset on
the balance sheet of the company. Raw materials, finished goods, and work-in-
progress constitute the three categories of inventory.

Types of Inventory/Components of Inventory

There are four types of inventory, raw materials, work-in-progress (WIP),

finished items, and maintenance, repair, and overhaul (MRO).
1. Raw Material: Raw materials are all of the materials that your organization
uses to manufacture finished goods. Raw materials can be purchased from any
external supplier or can be produced within the organization. There are two
types of raw materials, direct and indirect. Direct raw materials are those that
are used directly in the final product. These materials are easy to measure and
account for on an individual or batch basis. Indirect raw materials are those
that are not part of the completed product but are used during the
manufacturing process. Indirect raw materials are more difficult to identify and
account for since they are not tied to specific batches or units. However, these
are necessary for the manufacturing process.
2. Work-in-Progress (WIP): Work-in-progress inventory refers to the
inventory the production of which has started but is not completed yet. Work-in-
progess inventory needs to go through more stages of production in order to get
converted into final goods. It may include both direct and indirect raw
materials; the only thing to remember is that the product is not finished and is
still in development.
3. Finished Goods: Your finished goods inventory includes all items that are
ready to sell. Of course, depending on the manner of operation you choose, this
may include slightly different steps. If you employ a make-to-order technique,
the finished product is already produced and ready for shipment to clients. If
you employ the make-to-stock workflow, the inventory must be stored in a
warehouse until an order arrives. In either case, your finished goods inventory
should be quite simple to account for and track.
4. Maintenance, Repair, and Operations (MRO): As the name suggests,
maintenance, repair, and operations (MRO) inventory is essential for keeping
your manufacturing running. MRO inventory is only available for consumption
and cannot be purchased by customers.

Inventory management can be stated as the products and supplies that a

company keeps with the ultimate intention of reselling, producing, or using
them. The discipline of inventory management is mostly concerned with
defining the location and form of stored products. In this article, we will
understand the workings of inventory management, the purpose of inventory
management, and more.

What is Inventory Management?

Inventory management is the process of placing orders, keeping inventory,

utilizing it, and selling it for a business. This includes the processing, storage,
and handling of finished items, raw materials, and components. There are
several types of inventory management, each with pros and cons, depending on
the needs of a business. Safety stock should always be the top priority in
inventory management to guarantee that there is additional stock on hand in
case the business is unable to restock those things.

Objectives of Inventory Management

The objectives of inventory management may be viewed in two they are
operational and financial The operational objective is to maintain sufficient
inventory, to meet demands for product by efficiently organising the firm’s
production and sales operations and financial view is to minimise inefficient
inventory and reduce inventory carrying costs.

These two conflicting objectives of inventory management can also be

expressed in terms of costs and benefits associated with inventory. The firm
should maintain investments in inventory implies that maintaining an inventory
involves cost, such that smaller the inventory, lower the carrying cost and vice
versa. But inventory facilitates (benefits) the smooth functioning of the
production.

An effective inventory management should:

1. Ensure continuous supply of raw materials: This ensures that

production is not interrupted due to shortages, helping to meet deadlines
and maintain efficiency.
2. Maintain sufficient stocks during shortages and price changes:
Anticipating market changes and having a buffer stock helps in times of
scarcity and prevents overpaying for materials when prices rise.
 3. Maintain finished goods inventory for smooth sales and service:
Keeping the right amount of finished products ensures you can meet
customer demand without delay, which is vital for customer satisfaction.
4. Minimize carrying costs and time: By reducing storage time and
carrying excess stock, companies can reduce warehousing costs,
spoilage, and depreciation.
5. Control investment in inventories: Maintaining an optimum level of
stock ensures that capital is not unnecessarily tied up in excess inventory,
allowing funds to be used more efficiently elsewhere.
6. Others (centralized purchasing, cost control, and planning):
Centralization avoids duplication, reduces costs, ensures consistent
quality at good prices, and provides valuable data for planning.

Therefore, management of inventory needs careful and accurate planning so as

to avoid both excess and inadequate inventory in relation to the operational
requirement of a firm. To achieve higher operational efficiency and profitability
of a firm, it is very essential to reduce the amount of capital locked up in
inventories.

This will not only help in achieving higher return on investment by minimising
tied-up working capital, but will also improve the liquidity position of the
enterprise.

8 Main Types of Inventory Management – Raw Material, Work-in-

Process, Finished Goods, Flabby Inventory, Profit-making Inventory,
Safety Inventory and More…
Types of inventory management are explained below:

1. Raw Material:
To hold stocks of raw material, an organisation deploys its primary production
sections or processes to obtain raw materials from manufacturers and stockists.

2. Work-in-Process:
The holding of both raw materials and stocks of finished goods is generally a
planned activity. In process stocks, however, they are likely to exist in any
manufacturing organisation, whether they are planned for or not.

3. Finished Goods:
The stock of finished goods provides a buffer between customer and demand
and manufacturer’s supplies.

4. Flabby Inventory:
It comprises finished goods, raw materials and stores held because of poor
working capital management and inefficient distribution.

5. Profit-making Inventory:
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It represents stocks of raw materials and finished goods held for realising stock
profit.
6. Safety Inventory:
It provides for failures in supplies, unexpected spurt in demand, etc., although
there may be an insurance cover.

7. Normal Inventory:
It is based on a production plan, lead time of supplies and economic ordering
levels. Normal inventories fluctuate primarily with change in the production
plan. Normal inventory also includes a reasonable factor of safety.

8. Excessive Inventory:
Even an efficient management may be compelled to build up excessive
inventory for reasons beyond its control, as in the case of strategic import or as
a measure of government price support of a commodity.

Prakash Tandon Committee in their “Report of the Study Group to frame

guidelines for follow-up of Bank Credit” observed that ‘flabby’ inventory should
not be permitted, and ‘profit-making’ inventory ought to be positively
discouraged. A good management brings down safety inventory as much as
periodical statistical checks may justify.

Excess inventory is a luxury which the banker does not encourage. If the normal
inventory is to be further analysed, one is fluctuating and the other steady. In
the steady part also, there is ‘core’ which is fixed representing the absolute
minimum level of raw materials, process stock, finished goods and stores which
are in the pipeline and ensure continuity of production.

These funds invested in core inventories are, therefore, blocked, on a long-term

basis due to technological and business considerations like the investment in
fixed assets.

Risk Associated with Inventory

The risk in inventory management signifies the chance that inventories cannot
be turned over into cash through normal sale without a loss.

These risks are due to following three factors:

1) Price decline

The main risk in inventory investment is that the market value of inventory may
fall below what the firm paid for it, hereby causing inventory losses. It may
result from an increase in the market supply of products, introduction of a new
competitive product and price reduction by competitors.

2) Product deterioration

It may result due to holding a product too long or it may occur when inventories
are held under improper conditions of light, heat, humidity and pressure.

3) Obsolescence
Obsolescence means out of date or out of fashion. This risk arises due to the
change in consumer tastes, this can be due to new production techniques,
improvement in the product design, specifications etc.

7. Purposes of Holding Inventories

The following are the main purposes or motives for holding inventories:

1) Transaction Motive

The first and the most important purpose of holding inventory to meet the day
to day requirement of sales, production process, customer demand etc. This
facilitates continuous production and timely execution of sales orders.

2) The Precautionary Motive

Firms keep the balance of inventory to meet some unforeseen circumstances

like strike, natural calamities or any other reasons. This necessitates the
holding of inventories for meeting the unpredictable changes in demand and
supplies of materials.

3) The Speculative Motive

Firms keep some inventory in order to capitalize an opportunity to make profits,

e. g. sufficient level of finished goods may help the firm to earn extra profit in
case of unexpected shortage in the market.

8. Costs Associated with Inventory/COMPONENTS OF COST OF

INVENTORY
Every firm maintains some stock of material depending upon the individual
requirement of the firm. The benefits of holding inventory, no doubt there are
some costs also associated with inventory.

Inventory cost is made up of three different components. They are explained

asfollows:

Ordering cost: Ordering cost is the cost of placing a separate order multiplied
by the number of separate orders placed in that period. These are the cost
associated with acquiring inventory purchased from external sources or with
production within the firm. Ordering cost relates to cost attached to purchasing
activity like:

● Costs of information, procession on inventory status.

● Cost of preparing of purchase requisition and purchase order.
● Cost of getting quotations, meetings & negotiations, cost of reviewing
and placing an order.
● Cost of receiving goods which include transportation cost, checking,
quality inspection, recording and documentation.
● Cost of storing the goods.
● Additional cost of small quantity orders.
● If the goods are manufactured internally, setup and tooling cost is also
included.
Carrying cost: Cost incurred for possessing and holding the inventory is known
as carrying cost. These costs are the cost from the time when the inventory is
stored up tothe time they are issue for production. Carrying cost includes:

● Cost of storage like lighting-g, rent, heating, refrigeration, air-

conditioning etc.
● Cost of capital blocked in inventories.
● Employees cost, equipment maintenance cost, running cost of the store,
handling cost of material.
● Rates, taxes and insurance cost.
● Stock taking cost, cost of perpetual inventory system, security cost etc.
● Loss due to pilferage, obsolescence, pilferage and damage.
● Cost of audit of store.

Stock-out cost: the cost associated with a situation of running out of stock is
the 'stock-out' cost. These costs are difficult to calculate, as the ill effects of
stoppage of production cannot be predicted accurately. The effect of
interruptions in production may lead to (i) loss of sales and (ii) delay in
delivering customer orders. To overcome the delay of orders, company will have
to resort to overtimes, emergency purchase (usually at high cost), higher cost
delivery, concessions, etc. these cost include:

● Lost sales and lost profits due to stock outs.

● Loss of future sales, due to bad reputation.
● Loss of goodwill and loyal customers.
● Stoppage of production may spoil the WIP, cost of spoilage of material
inputs.
● Additional cost of emergency purchase.

Carrying a high level of inventory will result in high carrying cost, which will
reduce the value of the firm. Carrying a low level of inventory will increase the
ordering cost of the firm, again reducing the profits. Stock-out is often very
expensive. Thus inventory management suggests:

● Maintaining sufficient stock of raw materials and consumable to ensure

continuous supply and smooth uninterrupted production.
● Maintaining enough stock of finished goods to ensure meeting the
salestargets.
● Minimizing the total annual cost of inventories.

9. Factors Affecting Level of Inventory

There is no hard and fast rule regarding the level of inventory to be kept
by the firms, this is affected by several factors; the important among
them are as under:

1) Nature of Business:
Most important determinant of the level of inventory is the nature of the
business. A manufacturing firm will have a high level of inventory as compared
to the trading firm.

2) Nature of Product:

If the product is perishable the level of inventory should be kept low due to the
chances of rotting, on the other hand durable products can be kept easily with
less probability of loss. The firms dealing in seasonal products have to hold
large stock of finished goods during peak season to meet the demand.

3) Financial Position:

A firm which is financially sound may buy material in bulk and hold them for
future use. While a firm having shortage of funds cannot maintain a large stock
level.

4) Length of Manufacturing Cycle:

Length of Manufacturing cycle and the requirement of working capital are

directly related with each other. Manufacturing cycle is the time lag between
the conversions of raw material into finished goods. The longer the time
required for inventory to convert in finished goods the greater the requirement
of inventory.

5) Rate of Inventory Turnover:

The rate of inventory turnover is the time period within which inventory
completes the cycle of production and sales affects the level of inventory. When
the turnover rate is high, investment in inventories tends to be low and vice-
versa.

6) Inventory Cost:

There are some costs associated with the inventory like ordering cost and
holding cost. This cost also affects the level of inventory, because a firm
normally determines the inventory level on the basis of economic order quantity
and these costs affect the economic order quantities.

Reasons to Keep Inventory – To Protect Against the Time Lag, To Protect

Against Uncertainty, Economies of Scale and More…

Tracking and securing inventory is a major role that needs to be performed in

any enterprise. This is equally valid in case of both unfinished as well as
finished goods.

Following are the reasons to keep Inventory:

1. To Protect Against the Time Lag:

The time lags present in the supply chain, from supplier to user at every stage,
requires that you maintain certain amounts of inventory to use in this “lead
time.”

2. To Protect Against Uncertainty:

Inventories are maintained as buffers to meet uncertainties in demand supply

and movements of goods. So, inventory is helpful in protecting against
shortages of stock.

3. Economies of Scale:

Ideal condition of “one unit at a time at a place where a user needs it, when he
needs it” principle tends to incur lots of costs in terms of logistics. So bulk
buying, movement and storing brings in economies of scale, thus inventory.

4. Hedge against Price Change:

To provide a hedge against upward price changes in materials (e.g., inflation)

and to take advantage of discounts available through buying in large quantities.

5. To Minimize Warehouse Costs:

If you know what things are in your warehouse; then pick/pack/ship processes
are significantly more efficient and your warehouse staffs don’t need to be
running around hunting for the last unit since you know that it sold yesterday
and was shipped. This means that you can process more orders in the same
amount of time with the same staff. Accurate stock levels can help you to reduce
cost.

6. Minimize Theft and Losses:

If a company manages accurate stock levels, then the company can identify
theft quickly, company may also discover that company losing stock to damage,
loss or some other cause that company had not be aware of.
Process of Inventory Management and Control
The planning of the control of inventory can be divided into two phases,
inventory management and inventory control.

Inventory management accomplishes the first phase, consisting of-

1. Inventory Management:

(a) Optimum Inventory Levels:

But this is not the only factor that must be considered by inventory
management when determining inventory levels. The planning for the actual
production of the product may involve problems of leveling production that is
producing at a constant rate even though sales may fluctuate.

(b) Degree to Control:

This Inventory management must decide just how much control is needed to
accomplish the objective. The least control – as evidenced by systems, records,
and personnel- that is required to perform the function efficiently is the best
control. This problem of the degree of control can be approached from the
viewpoint of quantity, location and time.

(c) Just-in-Time Concept:

JIT can be implemented with manufacturing work-in- process or with material

purchased from outside vendors. One truck transportation company obtains
much of its business by catering to companies that must deliver parts to other
companies “just in time”.

2. Inventory Control:

The inventory control group puts the plans of inventory management into
operation. These plans are seldom complete in every detail. The day-to-day
planning required to meet production requirements – the second phase of
planning for inventory control -is the responsibility of this group.

11. Dangers of Excessive Inventory

Risks and Costs of Excessive Inventory:

(i) Excessive Carrying Costs

The carrying costs such as storage costs, holding costs, insurance expenses etc.
also increase in proportion of inventory. Excessive inventory results in
unnecessary tie-up of the firm’s fund and loss of profit due to high carrying
costs.

(ii) Risk of Loss of Liquidity

Excessive inventory also increases risk of loss of liquidity. If excessive funds are
invested in inventories, it may not be possible to sell inventories at full value
whenever funds are required.

(iii) Risk of Price Decline

The price decline in the market may cause finished goods to be sold at low
prices. In case of excess inventory, the risk of loss due to price decline is more.

(iv) Risk of Deterioration of Goods

Normally, there is always deterioration of some goods with the passage of time
and due to improper storage facilities. Risk of deterioration of goods is more in
case of excessive inventory because inventory remains in stores for a longer
period.

(v) Risk of Obsolescence

Goods may become obsolete due to change in technique, change in design, and
change in consumer’s choice etc. Obsolete goods have to be sold at lower
prices. Risk of loss due to obsolescence is more in case of excessive inventory.

12. Dangers of Inadequate Inventory

(i) Risk of Break-down in Manufacturing Process

In case of inadequate inventory of raw-material, there is always a risk of break-

down in the manufacturing process due to lack of raw-material supply.
Therefore, the firm will not be able to utilise its manufacturing capacity in full.
It also increases cost of manufacturing per unit because fixed costs of
manufacturing do not reduce even if there are frequent interruptions in
production.

(ii) Risk of not Meeting Demand of Customers

In case of inadequate inventory of finished goods, demand of customers may not

be met and they may shift to competitors. It will result in permanent loss to the
firm.

Techniques of Inventory Management

There are many techniques of inventory management.

[Link] Model:

[Link] of inventory levels

[Link] A.B.C. (Always Better Control)

[Link] Analysis
[Link] Analysis

[Link] Analysis:

[Link] Model:

EOQ model is used to calculate optimal lot size of inventory. Excess inventory
and shortage of inventory, both are dangerous. Therefore a firm must maintain
optimal inventory.

The following diagram depicts the impact of holding large and small in-
ventory quantity levels:

Economic Order Quantity (EOQ) Model:

Economic Order Quantity, also known as EOQ, is a widely used inventory

management technique that helps organizations determine the optimal level of
order quantity for a particular item, which minimizes the total inventory costs.
The primary goal of EOQ is to provide a balance between the costs associated
with ordering and holding inventory efficiently. EOQ is useful for businesses in
order to reduce costs and keep adequate stock levels in order to meet customer
demand while minimizing all the related costs associated with holding excess
inventory. EOQ is a valuable tool for optimizing inventory management, but it is
based on simplifying assumptions that may only hold in some situations.

How does Economic Order Quantity Work?

Economic Order Quantity (EOQ) is an inventory management system that

works by helping the organization determine the optimal order quantity
for a particular item, inventory, or raw material. EOQ helps in balancing
the costs associated with ordering and holding inventory to minimize the
costs for the organization.
Here’s how EOQ works in practical terms,
1. Units Consumed During the Year (A): The organization has to determine
the annual demand for the product. This is the anticipated quantity of the
product that the business is expected to use or sell in a year.
2. Ordering Costs (O): The organization has to determine and calculate the
cost incurred each time an order is placed. The major chunks of costs include
administrative, transportation, and other incidental costs related to the
inventory or raw material procurement process.
3. Holding Costs or Carrying Cost (C): The organization has to determine
the annual holding cost per unit of inventory. This includes all incidental costs
like warehousing, insurance, security, and the opportunity cost of tying up
capital in inventory.
4. Unit Cost: The organization should know the cost of each unit of inventory.
Once all the factors are analyzed, EOQ will help out the organization by
providing the optimum level of inventory or raw material that shall be ordered,
where both the carrying and ordering costs of inventory shall be the lowest.

Why is Economic Order Quantity Important?

1. Improved Order Fulfillment: When a business is in need of a certain item

or inventory to procure an order, an optimal level of EOQ ensures the product is
on hand, which in turn helps the organization get the order out on time and
cater to customer needs. This helps to enrich the customer experience and lead
to increased sales.
2. Less Overordering: An accurate forecast about an organization’s total
consumption and when the organization will be in need of it helps the
management avoid overordering and deploying too much working capital in
inventory.
3. Less Waste: More optimized order schedules help an organization cut down
on obsolete inventory, particularly for businesses that are engaged in holding
perishable inventories, as it can result in dead stock and waste.
4. Lower Storage Costs: When the ordering matches the actual demand of the
organization, it helps to process the optimal level of inventory to store, avoiding
related costs like utility, security, insurance, and other related costs.
5. Quantity Discounts: When an organization properly plans and times the
inventory or raw material, it allows the organization to take advantage of the
best bulk orders or quantity discounts offered by the suppliers.

EOQ is based on the following assumptions:

i. The annual inventory requirement (D) is known with certainty and is constant.

ii. Ordering cost per order (B) and carrying cost per unit (C) per annum are
known with certainty and constant over the year.
iii. There is uniform consumption of inventory throughout the year.

iv. There is no time lag between the placement of an order and getting its
supply. Hence there is instant replenishment of inventory.

v. There are only two costs associated with inventory i.e. ordering cost and
carrying cost.

As per the figure ordering cost reduces with increase in order quantity,whereas
the carrying cost increases with the order quantity. The total cost show higher
cost when less units are ordered. Cost becomes economical when the optimum
quantity is ordered and stored. However purchases above the limits tend to
increase the cost.

(i) Calculation of EOQ (or Economic Lot Size):

Given the above assumptions, the EOQ level of inventory which leads to
minimum total inventory costs is calculated using the following formula –

Where,

D – Annual usage or requirement of inventory

B – buying cost per order

C- carrying cost per unit p.a.

(ii) Total ordering cost = No. Of orders X Ordering cost per order

No. Of orders = Annual usage or requirement of inventory / Lot size

(iii) Total carrying cost = Average inventory X Carrying cost per unit p.a.

Average inventory = Lot size / 2

(iv) Total cost of Inventory = Total ordering cost + Total carrying costIt must be
noted that when lot size is EOQ, total cost of inventory is minimum. Further, at
EOQ, total ordering cost and total carrying cost will be equal. Any other lot size
will have higher total cost of inventory.

Example of Economic Order Quantity

Example 1:
Calculate the EOQ from the available particulars,

● Consumption of material per annum: 10,000kg

● Cost of making an order: ₹25

● Cost of raw material per kg: ₹5

● Storage cost: 10% on average inventory

Solution:
D = Unit Consumed = 10,000
S = Ordering Cost = ₹25
H = Inventory Carrying Cost= 10% of 5 = ₹0.5

Here, the EOQ = 1000 Kg, which represent the optimum size of an order where
the carrying cost and ordering cost will be minimum.
Example 2:
Compute EOQ, when a retail store sells 20,000 units of a certain product
annually. The cost to place and process each order is $50, and the holding cost
per unit per year is $2.
Solution:
D = 20,000 units (annual demand for the product)
S = $50 (ordering cost per order)
H = $2 (holding cost per unit per year)

What Economic Order Quantity Can Tell You?

1. Ideal Order Size: Economic order quantity tells organizations the ideal
order size for every raw material and inventory they should buy. This helps the
management to deploy only the required funds in inventory and avoid situation
of over deployment of working capital.
2. Demand Assumption: The EOQ formula makes the assumption that the
annual demand for a product is relatively flat. Management has to carefully
ascertain the demand of the product carefully along with the demand
fluctuations.
3. Optimal Level of Quantity: EOQ provides an organization with the desired
optimal quantity level of inventory and raw materials. This optimal level of
quantity which should be ordered which minimizes the ordering cost and
storage cost.
4. Helps in New Business: If an organization is in a growing business, the
management has to adopt the changing variables carefully to outline an optimal
EOQ. EOQ may be ideal for calculating the order size, as the numbers could
change frequently. Once an organization has calculated EOQ, they should know
the optimal number of orders per year and the ideal order size.
5. Calculation of Other Market Matrices: Organizations may also adapt the
EOQ model to factor in pricing discounts, backorders, defective items, and
more, which helps the management in carrying out price negotiations and plan
for effective inventory management.
6. Supply Chain: EOQ also helps the organization craft a flawless supply chain
for the business. Crafting a supply chain helps the management to efficiently
handle and manage the inventory in the most efficient manner with reduced
cost and quality control.

Limitations of Economic Order Quantity

1. Poor Data: EOQ is based on the accuracy and reliability of the data; this is
also one of the biggest challenges in determining EOQ. Manual or, for that
matter, automated data that is inaccurate may lead to inaccurate calculations.
2. Outdated Systems: Old and outdated systems may have incomplete data
and may lead to missing out on potential savings by EOQ. An effective inventory
management system, or ERP, can solve this problem by reconciling inventory
and analyzing demand trends.
3. Business Growth: The EOQ formula is ideal for businesses that have
consistent inventory needs. In a fast-growing business, relying on EOQ can lead
to inventory shortages as it is unable to project surge orders.
4. Inventory Shortages: If an organization relies on this method, it often
generates smaller quantities of inventory and raw materials. If the management
is too conservative with the calculations, they could wind up under-ordering.
5. Seasonal Needs: The seasonality factor can make EOQ more challenging.
This is because there could be major changes in customer demand throughout
the year, and the EOQ has to be carefully calculated by including the demand
trends as well; otherwise, the result might not be effective.

3. Inventory Turnover Ratio:

Inventory can also be managed by using accounting ratios like Inventory

Turnover Ratio. Inventory ratio establishes relationship between average
inventory and cost of inventory consumed or sold during the particular period.

This is calculated with the help of the following formula:

Cost of Good Consumed or Sold during the year/Average Inventory during the
year.

A comparison of current year’s inventory ratio with those of previous

years will unfold the following points relating to inventories:

Fast-Moving Items:
This is indicated by a high inventory ratio. This also means that such items of
inventory enjoy high demand. Obviously, in order to have smooth production,
adequate inventories of these items should be maintained. Otherwise, both
production and sales will be adversely affected through uninterrupted supply of
these items.

Slow-Moving Items:

That some items are slowly moving is indicated by a low turnover ratio. These
items are, therefore, needed to be maintained at a minimum level.

Dormant or Obsolete Items:

These refer to items having no demand. These should be disposed of as early as

possible to curb further losses caused by them.

[Link] of inventory levels

Stock Level: Type # 1. Minimum Level:

This represents the quantity which must be maintained in hand at all times. If
stocks are less than the minimum level, then the work will stop due to shortage
of materials.

Following factors are taken into account while deciding minimum stock
level:

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(i) Lead Time:

A purchasing firm requires some time to process the order and time is also
required by the supplier/vendor to execute the order. The time taken in
processing the order and then executing it is known as lead time. It is essential
to maintain some inventory during this period to meet production requirements.
(ii) Rate of Consumption:

It is the average consumption of materials items in the industry. The rate of

consumption will be decided on the basis of past experience and production
plans.

(iii) Nature of Material:

The nature of material also affects the minimum level. If a material is required
only against special orders of the customer then minimum stock will not be
required for such materials. Wheldon has given the following formula for
calculating minimum stock level:

Minimum stock Level = Re-ordering Level – (Normal Consumption x

Normal Reorder Period)

or

Minimum stock level = Reorder level - (Average or Normal Usage x

Average Lead Time)

The safety stock level is computed as follows:

Safety Stock = (Maximum Usagex Maximum Lead time) - (Average

Usage Average Lead Time)

(iv) Re-ordering Level:

When the quantity of materials reaches a certain level then fresh order is sent
to procure materials again. The order is sent before the materials reach
minimum stock level.
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Reordering level is fixed between minimum level and maximum level. The rate
of consumption, number of days required to replenish the stocks, and maximum
quantity of materials required on any day are taken into consideration while
fixing reordering level.

Re-ordering level is fixed with following formula:

Reordering Level = Maximum Consumption Rate x Maximum Reorder

period.

Stock Level: Type # 2. Maximum Level:

It is the quantity of materials beyond which a firm should not exceed its stocks.
If the quantity exceeds maximum level limit then it will be termed as
overstocking. A firm avoids overstocking because it will result in high material
costs. Overstocking will lead to the requirement of more capital, more space for
storing the materials, and more charges of losses from obsolescence.

Maximum stock level will depend upon the following factors:

1. The availability of capital for the purchase of materials in the firm.

2. The maximum requirements of materials at any point of time.

3. The availability of space for storing the materials as inventory.

4. The rate of consumption of materials during lead time.

5. The cost of maintaining the stores.

6. The possibility of fluctuations in prices of various materials.

7. The nature of materials. If the materials are perishable in nature, then they
cannot be stored for long periods.
8. Availability of materials. If the materials are available only during seasons
then they will have to be stored for the future period.

9. Restrictions imposed by the government. Sometimes, government fixes the

maximum quantity of materials which a concern can store. The limit fixed by the
government will become the deciding factor and maximum level cannot be fixed
more than that limit.

10. The possibility of changes in fashions will also affect the maximum level.

Wheldon has suggested the following formula for calculating maximum

stock level:

Maximum Stock Level = Reordering Level + Reordering Quantity –

(Minimum Consumption x Minimum Reordering period)

or

Maximum Stock Level = Reorder Level +EOQ - (Minimum Usage x

Minimum Lead Time)

Stock Level: Type # 3. Danger Level:

It is the level below which stocks should not fall in any case. If danger level
approaches then immediate steps should taken to replenish the stocks even if
more cost is incurred in arranging the materials. Danger level can be
determined with the following formula:

Danger Level = Average Consumption x Maximum reorder period for

emergency purchases.

Stock Level: Type # 4. Average Stock Level:

It is the average of Minimum level and the maximum level. It is computed as

follows:

Average Stock Level = (Minimum Stock Level + Maximum Stock Level)/2

Or,

Average Stock Level=Minimum Stock Level + 1⁄2 (Reorder Level)

Example1:

calculate minimum stock level, maximum stock level and re-ordering

level:

(i) Maximum Consumption = 200 units per day

(ii) Minimum Consumption = 120 units per day

(ii) Normal Consumption =160 units per day

(iv) Reorder period = 10-15 days

(v) Reorder quantity = 1,600 units

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(vi) Normal reorder period = 10 days.

Solution:

Reordering Level = Maximum Consumption x Maximum Reorder period

= 200 units X 15 = 3,000 units Minimum Stock Value = Reordering Level –

(Normal Consumption x Nominal Reordering Period)

= 3,000 – (160 X 10) = 3,000 – 1,600 = 1,400 units

Maximum Stock Level = Reordering Level + Reorder Quantity – (Minimum

Consumption x Reorder period) = 3,000 + 1,600 – (120 X 10) = 3,000 + 1,600 –
1,200 = 2,400 units.
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The three other factors must also be explained very carefully.

Example2:

Given: Lead time- 15 days; monthly consumption- 1350 units; Find reorder
level.

Solution:

Monthly consumption = 1350 units;

Average usage = 1350/30 = 45 units per day

Reorder Level = Lead Time × maximum usage = 15 x 45= 675 units

Example 3

The following data relate to particular stock item. Calculate stock level.

Normal usage 120 per day

Minimum usage 50 per day

Maximum usage 140 per day

Lead time 25-30 days

 EOQ previously calculated 4,000

Solution:

Reorder Level = Maximum Lead Time x Maximum Usage

=140×30=4,200 units

Minimum stock level = Reorder level - (Average or Normal Usage x Average

Lead Time)

=4,200-(120 x 27.5)

=4,200-3300=900 units

Maximum Stock Level = Reorder Level +EOQ - (Minimum Usage x Minimum

LeadTime)

4,200 +4,000-(140 × 25)= 8,200 - 3,500 = 4,700

Fixation of Stock Levels: Formulas and Calculations

Read this article to learn about the formulas and calculations for fixation of
stock levels.

Formulas:

(i) Maximum Level of Stock = (Reorder Level + Reorder Quantity) – (Minimum

rate of consumption x Minimum reorder period)
Maximum Level may be alternatively fixed as Safety Stock + Reorder Quantity
or EOQ.

(ii) Minimum level of stock = Reorder level – (Average rate of consumption x

Average reorder period)

(iii) Safety Stock = (Annual Demand/365) x (Maximum Reorder Period – Average

Reorder Period)

(iv) Reorder level or Ordering level = Maximum rate of consumption ×

Maximum reorder period. Alternatively, it will be = safety stock + lead time
consumption

[lead time consumption will be = (Annual consumption -s- 360) × lead time]

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(v) Danger level = It is slightly below the minimum level. It is a level at which
special efforts should be made to obtain supplies of materials, i.e.

Minimum rate of consumption × Emergency delivery time

(vi) Average Stock level = (Maximum stock level + Minimum stock level) x 14 or
Minimum Stock level + 14 Reorder Quantity.
Obviously, the Reordering level is below the Maximum level, and Minimum level
is below the Reordering level and the Danger level is below the Minimum level.
Safety Stock is above minimum level.

Important Elements:

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In above calculations, the following elements are important:

(a) Consumption Rate:

It is consumption or use of material per day (or per week) by production

department. These rates will be maximum and minimum, the simple average of
maximum and minimum rates is average consumption rate per day or per Week.

(b) Reorder Period:

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It is period between materials ordered and materials received. The average

reorder period is simple average of maximum and minimum reorder periods.

(c) Reorder Quantity:

At the time of purchase of material, one of the important problems to be faced is
how much quantity of a particular materials to be purchased at a time. If
purchases are made frequently in small quantities it will result in loss of trade
discounts and economies in purchasing. On the other hand if purchases are
made in large quantities it will lead to over stocking and cost of storage will be
high. The ordering quantity should be economic and reasonable by all aspects.
It should be Economic Order Quantity (EOQ). The calculation of EOQ has been
discussed later on.

Illustration 1: [Fixation of stock levels]:

Two components A and B are used as follows:

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Normal usage 50 units per week each

Minimum usage 25 units per week each

Maximum usage 75 units per week each

Reorder Quantity A 300 units; B 500 units

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Reorder Period A 4 to 6 weeks, B 2 to 4 weeks

Calculate for each components:

(a) Reorder level,

(b) Minimum Level,

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(c) Maximum level,

(d) Average Stock Level.

Solution:

(a) Reorder Level = Maximum Rate of Consumption x Maximum Reorder Period.

A = 75 x 6 = 450 units

B = 75 x 4 = 300 units

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(b) Minimum Level = Reorder Level – (Average Rate of consumption x Average
Reorder Period)

A = 450 – (50 – 5) = 200 units

B = 300 – (50 x 3) = 150 units

(c) Maximum Stock Level

= (Reorder Level + Reorder Quantity) – (Minimum Consumption Rate x

Minimum Reorder Period)

A = (450 + 300) – (25 x 4) = 650 units

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B = (300 + 500) – (25 x 2) = 750 units

(d) Average Stock Level = (Maximum Stock Level + Minimum Stock Level)/2

A = (650 + 200)/2 = 425 units

B = (750 + 150)/2 = 450 units

Average Stock Level can also be calculated by the formula.

Minimum Stock Level + ½ of Reorder Quantity

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A = 200 + ½ x 300 = 350 units

B = 150 + ½ x 500 = 400 units

Illustration 2:

If the minimum stock level and average stock level of raw material A are 4,000
and 9000 units respectively, find out its reorder quantity.

Solution:

Average stock level = Minimum stock level + ½ of Reorder Quantity

9000 = 4000 + of Reorder Quantity

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½ Reorder Quantity = 9000 – 4000 = 5000

Reorder Quantity = 10,000 units

[Link] A.B.C. (Always Better Control) Method of Inventory Control (with

statistics and figure)

For selective inventory control, three classes of materials and not more than
that have been found to be convenient. This is known in general as the ABC
Classification. The alphabets A, B & C stand for the three different classes and
it is popularly known as Always Better Control.

ABC analysis is a basic analytical management tool. The greatest effort for the
greatest results is ultimate yield of such analysis of materials. There are areas
in material management which need selective control such as inventory,
criticality of items, obsolete stocks, purchasing order, receipt of materials,
inspection, store-keeping and verification of bills.

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The annual consumption analysis on the basis of money value indicates that
about 10 percent of the high value items account for a substantial portion of
about 75 percent of the total consumption value. There are vital “A” basis; 70
percent of the total number of items are trivial ; there are bottom items
accounting for 10 percent of the consumption value, and termed as “C” items.
In between ‘A’ and ‘C’ items—between top and bottom—the items are known as
‘B’ category items.

When items are, numerous, to give attention to all the items is next i to
impossible. The pointed and concentrated attention focused on the materials
according to their relative importance, pays large dividend to the organization
as a whole by securing economies and efficiency.
It is through ABC analysis, some authorities believe, that clerical costs are
reduced. ABC analysis helps better planning and improved inventory turnover is
assured. Preferential treatment to vital items through concentrated alienation
under the ABC system of analysis of inventory is the panacea for the cure of a
number of ills plaguing an organisation.

Steps in ABC analysis:

The steps involved in ABC analysis are as follows:

(а) Calculate the annual usage value of each item by multiplying the number
used with the price of the item.

(b) Arrange the items in descending order according to the usage value.

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(c) Compute percentage of total usage value for each item.

(d) Find out the average inventory of each item by dividing the usage value with
2 and number of orders.

The ABC analysis can be shown on a graph too. For this purpose the cumulative
percentages of the number of items are shown on X-axis and percentage of
values on F-axis. Where the plotted curve takes a sharp turn a point is marked.
Each such point indicates one category of items. For example, in Fig. 6.1 point P
on the curve indicates 20% of item; with 60% usage value. This category can be
called A. Point Q shows 30% items with 20% usage value. This category is B.
Point R reflects 50% items with 20% usage value which is category C.

What are the benefits of ABC analysis?

Let’s look at three ways ABC analysis can improve your business’ bottom line:

1. More accurate demand forecasting

Using ABC analysis, inventory planners can predict the demand for specific
products and manage their inventory accordingly. This insight minimizes
carrying costs for obsolete items, thus improving your supply chain
management.

2. Better control of high-value inventory

The success of many businesses hinges on A-class inventory. ABC analysis

enables you to identify those items in real-time, monitor demand for them, and
ensure they’re never out of stock. By channeling your resources towards high-
priority inventory, you can rest assured you’re putting the odds of success in
your favor.
3. Strategic pricing

ABC analysis can optimize your pricing strategy for products that bring the
most value to your business. Once you understand which products are in high
demand, you can increase their price, which can significantly impact profits.

What are the shortcomings of ABC analysis?

While ABC analysis is an essential tool for many businesses, there are a couple
of drawbacks to be aware of:

Regular oversight required

To get the full benefits of ABC analysis, you must analyze inventory regularly to
ensure A-inventory still consists of high-priority items. Otherwise, you risk
squandering resources on lower-value items. Data collection and analysis can
put a strain on businesses that don’t have proper accounting software.

Lacks precision

An ABC analysis can overvalue frequently purchased items that get people in
the door over luxury goods with a lower purchase frequency but higher profit
margin. ABC analysis can also miss swings in demand for seasonal items or new
items that haven’t accrued much sales volume data.

Challenges in Using ABC Analysis

Most common challenges while using ABC Analysis are as follows:

Difficult to Implement:
The process requires detailed data on the items being analyzed, and it can be
time-consuming to gather and analyze the data. Additionally, it can be difficult
to determine which items should be classified as “A”, “B”, or “C”.

Doesn’t Consider Demand Patterns:

This means that items may be classified as “A” even if they do not have high
demand. This can lead to inefficient inventory management and missed sales
opportunities.

Seasonal Demand:
One of the main limitations of ABC Analysis is that it does not take into account
seasonal demand. This means that items may be classified as “A” even if they
only have high demand during certain times of the year. This can lead to
inefficient inventory management and missed sales opportunities.

Lead Times:
This means that items may be classified as “A” even if they have long lead times.
This can lead to inefficient inventory management and missed sales
opportunities.

Example:

A company manufactures a line of ten items. Their usage and unit cost are
shown in the following Table below along with the annual rupee usage. The
latter is obtained by multiplying the unit usage by the unit cost.

(a) Calculate the annual rupee usage for each item.

(b) List the items according to their annual rupee usage.

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(c) Calculate the cumulative annual rupee usage and the cumulative percent of
items.

(d) Group items into an A, B, C classification.

Answer, (a) Calculate the annual rupee usage for each item.

Answer. b, c and d

The percentage of value and the percentage of items can be shown as in Fig. 5.4
(see next page).

Control Based on ABC Classification:

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Using the ABC approach, there are two general rules to follow:
1. Have a large number of low-value items:

C items represent about 50% of the items but account for only about 5% of the
total inventory value. Carrying extra stock of C items adds little to the total
value of the inventory. C items are really only important if there is a shortage of
one of them when they become extremely important so a supply should always
be on hand. For example, order a year’s supply at a time and carry plenty of
safety stock. That way there is only once a year when a stock-out is even
possible.

2. Use the money and control effort saved to reduce the inventory of
high-value items:

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A items represent about 20% of the items and account for about 80% of the
value. They are extremely important. So they need the maximum control and
the most frequent review.

Different controls used with different classifications might be the following:

A Items: highest priority:

Tight control including complete accurate records, regular and frequent review
by management, frequent review of demand forecasts and close follow-up and
expediting to reduce lead time.

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B Items: medium priority:

Normal controls with good records, regular attention and normal processing.

C items: lowest priority:

Simplest possible controls make sure there are plenty. Simple or no records,
perhaps use a two-bin system or periodic review system. Order large quantities
and carry safety stock.

Need for Prioritizing Inventory

A items:

In the ABC model of inventory control, items categorized under A are goods that

register the highest value in terms of annual consumption. It is interesting to

note that the top 70 to 80 percent of the yearly consumption value of the

company comes from only about 10 to 20 percent of the total inventory items.

Hence, it is crucial to prioritize these items.

B items:
These are items that have a medium consumption value. These amount to about

30 percent of the total inventory in a company which accounts for about 15 to

20 percent of annual consumption value.

C items:

The items placed in this category have the lowest consumption value and

account for less than 5 percent of the annual consumption value that comes

from about 50 percent of the total inventory items.

Note: The annual consumption value is calculated by the formula: (Annual

demand) × (item cost per unit)

[Link] Analysis

VED stands for vital, essential and desirable. This analysis relates to the
classification of maintenance spare parts and denotes the essentiality of
stocking spares.
The spares are split into three categories in order of importance. From the
view-points of functional utility, the effects of non-availability at the time of
requirement or the operation, process, production, plant or equipment and the
urgency of replacement in case of breakdown.

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Some spares are so important that their non-availability renders the equipment
or a number of equipment in a process line completely inoperative, or even
causes extreme damage to plant, equipment or human life.

On the other hand some spares are non-functional, serving relatively

unimportant purposes and their replacement can be postponed or alternative
methods of repair found. All these factors will have direct effects on the stocks
of spares to be maintained.

Therefore, it is necessary to classify the spares in the following

categories:

V:

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Vital items which render the equipment or the whole line operation in a process
totally and immediately inoperative or unsafe; and if these items go out of stock
or are not readily available, there is loss of production for the whole period.

E:

Essential items which reduce the equipment’s performance but do not render it
inoperative or unsafe; non-availability of these items may result in temporary
loss of production or dislocation of production work; replacement can be
delayed without affecting the equipment’s performance seriously; temporary
repairs are sometimes possible.
D:

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Desirable items which are mostly non-functional and do not affect the
performance of the equipment.

As the common saying goes “Vital Few — trivial many”, the number of vital
spares in a plant or a particular equipment will only be a few while most of the
spares will fall in ‘the desirable and essential’ category.

However, the decision regarding the stock of spares to be maintained will

depend not only on how critical the spares are from the functional point of view
(VED analysis) but also on the annual consumption (user) cost of spares (ABC —
analysis) and, therefore, for control of spare parts both VED and ABC analyses
are to be combined.

[Link] Analysis

The FSN Analysis is based on the rate of issue or rate of usage of spare parts
and the alphabets F S and N stands for Fast Moving, Slow Moving and Non
Moving items. The FSN classification system categorizes the items based on
how frequently the parts are issued and how frequently they are used.

Usual classification of Items at Inventory can be classified based on the

following criteria-

Fast Moving – Items which are frequently issued from inventory which are
more than once for a specific time period

Slow Moving – Items which are less frequently issued which might be once in a
specific time period
Non-Moving – Items which are not issued from the inventory at all in a specific
time period The FSN classification system is extremely helpful in distributing
spare parts which are kept near the dispensing are having items which belong
to the fast-moving category. The items which fall into the non-moving category
can be discontinued if the further scope of use is not expected. As companies in
production for a longer period have a specific percentage of non-moving spare
parts which are usually disposed at regular intervals. Selling the spare parts or
reusing the same can be again in the capital which can be used for other uses.

Dead Stock- Meaning stocks which is neither useful for the current production
nor has any future requirements. When the dead stock keep lying unused in the
store space and also increase the carrying cost. Thus, as soon the dead stock
items are recognised, they should be disposed-off.

[Link] Analysis:

The criterion for this analysis is the availability of the materials in the market.
In industrial situations where certain materials are scarce (specially in a
developing country like India) this analysis is very useful and gives proper
guideline for deciding the inventory policies.

The characteristics of the three categories – SD and E – are:

S:

Refers to scarce items, items which are in short supply. Usually these are raw
materials, spare parts and imported items.

D:
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Stands for difficult items, items which are not readily available in local markets
and have to be procured from faraway places, or items for which there are a
limited number of suppliers; or items for which quality suppliers are difficult to
get.

E:

Refer to items which are easily available in the local markets.