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Financial Management Unit 2 Management of Working Capital
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Management of Working Capital
FINANCIAL MANAGEMENT
| VERY SHORT TYPES QUESTION & ANSWERS |
A. State whether each of the following statements is True and False:
1. There is a time gap between cash inflows and cash outflows.
Ans: True.
2. Look box system is a method for accelerating cash outflows.
Ans: False.
3. Bank float refers to the time taken by bank in collecting cheques.
Ans: True.
4. Cash management is a trade off between the cost of carrying cash and the need of maintaining liquidity.
Ans: True.
5. A firm should always keep a large balance of cash so as to meet the contingencies.
Ans: False.
6. Receivables constitutes a significant portion of fixed assets.
Ans: False.
7. The volume of sales is influenced by credit policy of a firm.
Ans: True.
8. Factoring is a form of financing receivable.
Ans: True.
9. Average size of receivable = Estimated Annual sales Average collection period.
Ans: True.
10. Trade off between profitability and cost of maintaining receivables is important for effective receivables management.
Ans: True.
11. Inventory management is essential because investment in stock are high.
Ans: True.
12. The time required to process and execute an order is called lead time.
Ans: True.
13. Re-order level is the quantity of materials which must be kept in stock.
Ans: False.
14. ABC analyses is used to manage spare parts etc.
Ans: False.
15. Ordering costs are the cost of purchasing materials.
Ans: True.
16. Longer the process period of manufacture larger is the amount of working capital required.
Ans: True.
17. The fixed proportion of working capital should be generally financed from the fixed capital sources.
Ans: True.
B. Fill up the blanks:
1. The excess of current assets over the current liabilities can be expected as_____.
Ans: Net current assets/Net working control.
2. _______ is amount of money required to get into business.
Ans: Float.
3. ________ working is the minimum amount of current assets needed to conduct a business even during the dullest season of the year.
Ans: Permanent.
4. Cash working capital is calculated from the ________ account.
Ans: Profit and Loss.
5. When current liabilities exceed current assets, there is ________ working capital.
Ans: Negative.
6. The need for_______ capital varies with changes in the volume of business.
Ans: Working.
7. The two methods of estimated working capital requirement are______ and _____.
Ans: Conventional, operating cycle.
8. A company in interested in _____operating cycle.
Ans: Reducing.
9. If working Capital is varying relative to sales, the amount of ______ that a firm assumes is also varied and the opportunity for gain or loss is ______.
Ans: Risk, Increased.
10. ________ commercial banks cater to the working capital requirement of business.
Ans: True.
11. The famous committees appointed for examining credit limit for commercial banks in respect of the working capital requirements are _________, and ______.
Ans: V.T. Dehajia committed, Prakash Tandon committee, K.B. chore committee.
12. Net working Capital is the excess of ______ over ______ .
Ans: Current Assets, Current Liability.
13. Working capital is also know as ______or _______ Capital.
Ans: Revolving.
SHORT TYPE QUESTIONS & ANSWERS
1. What do you mean by working capital? Mention fine sources of working capital.
Ans: Working capital, also known as net working capital (NWC), is the difference between a company’s current assets, such as cash, accounts receivable/customers’ unpaid bills, and inventories of raw materials and finished goods- and its current liabilities, such as accounts payable and debts. It’s a commonly used measurement to gauge the short-term health of an organization.
The working capital are:
(i) Issue of shares.
(ii) Issue of debenture.
(iii) Retuned profits.
(iv) Sole of Fixed Assets.
(v) Security from Employees and from the customers.
2. Mention various classes of working capital. Mention five importance of working capital.
Ans: On the basis of concept, working capital may be:
(i) Gross working capital.
(ii) Net working capital.
On the basis of periodically of Requirement it may be:
(i) Permanent of fixed working capital.
(ii) Variable working capital.
The importance of working capital are:
(i) Business can avail the advantages of cash discreet by available of working capital.
(ii) It creates a feeling of security and confidence.
(iii) It helps in maintaining the solvency of the business.
(iv) A firm can raise funds from the market, purchase goods on credit and borrow short term funds from banks.
(v) It make easy to distribute dividend.
3. Mention various types of inventories. Give five objectives of inventory management.
Ans: The various types of inventories are:
(i) Raw Materials.
(ii) Work-in- progress.
(iii) Consumables.
(iv) Finish goods.
(v) Spares.
The five objectives of inventory management are:
(i) To ensure continuous supply of materials.
(ii) To avoid both over- stocking and under stocking of inventory.
(iii) To maintain investments in inventories at the optimum level.
(iv) To keep material cost under control so that they contribute in reducing cost of production and overall costs.
(v) To eliminate duplication an ordering or replenishing stocks.
4. What is inventory management control?
Ans: Inventory control is concerned with the acquisition, storage, handling and uses of inventories so as to ensure the availability of inventory whenever needed, providing sufficient protection for contingencies, maximising economy and minimising wastages and losses.
L.R. Harvard observes that “the proper control and management of inventory not only solves the acute problems of liquidity but also increases annual profits and causes substantial reduction in the working capital of a firm.”
5. What do you mean by cash funds? What are the motives for holding cash?
Ans: Cash is the most liquid asset that a firm owns. It includes money and instruments like cheque, money orders, or bank drafts which banks normally accept for deposit and immediately credit to the depositor’s account. Sometimes, near cash items, such as marketable securities, bank time deposits are also included in cash. The basic characteristic of near cash assets is that they can be easily converted into cash.
Keynes defined liquidity preference as depending upon:
(i) The transaction motive.
(ii) The precautionary motive.
(iii) The speculative motive.
(i) Transaction motive: The business concerns require a certain amount of cash to carry out their day to day transactions. The amount of cash depends on the nature of business. The amount of cash held also depends on the regularity of receipts and disbursements. Business concerns that have highly predictable inflows and outflows of funds can hold relatively less cash than firms that have irregular cash flows.
(ii) Precautionary motive: A firm is required to keep cash for meeting various contingencies. It is also related to the nature and level of business activity. Precautionary balances are those which are set aside because cash inflows and outflows are not synchronized.
(iii) The speculative motive: According to Keynes, the object of the speculative motive is “Securing a profit from knowing better than the market what the future will bring forth”. The speculative balances are sensitive to interest rate and are usually held in the form of interest bearing securities.
6. Define Trade credit.
Ans: Trade credit is a business-to-business agreement in which a customer can purchase goods without paying cash up front, and paying the supplier at a later scheduled date. Usually, businesses that operate with trade credits will give buyers 30, 60, or 90 days to pay, with the transaction recorded through an invoice.
Trade credit can be thought of as a type of 0% financing, increasing a company’s assets while deferring payment for a specified value of goods or services to some time in the future and requiring no interest to be paid in relation to the repayment period.
LONG TYPE QUESTIONS & ANSWERS
1. Discuss the various sources of working capital?
Ans: Various Sources of Working Capital. Sources of working capital are many. There are both external and internal sources. The external sources are both short-term and long-term. Trade credit, commercial banks, finance companies, indigenous bankers, public deposits, advances from customers, accrual accounts, loans and advances from directors and group companies etc. are external short-term sources. Companies can also issue debentures and invite public deposits for working capital which are external long term sources. Equity funds may also be used for working capital.
A brief discussion of each source is attempted below:
(i) Trade Credit: Trade credit is a short term credit facility extended by suppliers of raw materials and other suppliers. It is a common source. It is an important source. Trade credit is an informal and readily available credit facility.Trade Credit is a business-to-business agreement in which a credit limit is offered to the borrower (buyer) by a supplier who let the borrower buy now and pay later. Trade Credit is used whenever an entrepreneur is receiving equipment, machinery, material, and other business-related products and not paying back cash instantly but paying later on or before the scheduled date.
(ii) Commercial Banks: Short-term sources of working capital are generally short term loans from banks and NBFCs. There are different options for raising short-term capital, including short-term loans, overdrafts, etc. from commercial banks, invoice discounting, accrual accounts, etc. They provide loan in the following form:
(a) Straight loans are given with or without security. A onetime lump-sum payment is made, while repayments may be periodical or one time.
(b) Cash credit is an arrangement by which the customers (business concerns) are given borrowing facility upto certain limit, the limit being subjected to examination and revision year after year. Interest is charged on actual borrowings, though a commitment charge for utilization may be charged.
(c) Hypothecation advance is granted on the hypothecation of stock or other asset. It is a secured loan. The borrower can deal with the goods.
(d) Pledge loans are made against physical deposit of security in the bank’s custody. Here the borrower cannot deal with the goods until the loan is settled.
(e) Overdraft facility is given to current account holding customers to overdraw the account upto certain limit. It is a very common form of extending working capital assistance.
(f) Bill financing by purchasing or discounting bills of exchange is another common form of financing. Here, the seller of goods on credit draws a bill on the buyer and the latter accepts the same. The bill is discounted per cash will the banker. This is a popular form.
(iii) Finance Companies: A company whose business and primary function is to make loans to individuals, while not receiving deposits like a bank.Finance companies abound in the country. About 50000 companies exist at present. They provide services almost similar to banks, though not they are banks. They provide need based loans and sometimes arrange loans from others for customers. Interest rate is higher.
(iv) Indigenous Bankers: Indigenous banking system provides financial support to the local traders and merchants for their domestic trading, transportation, and other related expenses. Indigenous bankers also abound and provide financial assistance to small business and trades. They change exorbitant rates of interest by very much understanding.
(v) Public Deposits: Public deposits are unsecured, long term debt instrument. They have a slightly higher rate of interest when compared to that of interest rates of banks. They are usually issued to meet the working capital needs of the company. The RBI is regulating deposit taking by these companies in order to protect the depositors. Quantity restriction is placed at 25% of paid up capital + free services for deposits solicited from public is prescribed for non-banking manufacturing concerns. The rate of interest ceiling is also fixed.
(vi) Advances from Customers: These advances provide an important source of “no-cost” working capital financing. Of course, the company incurs an obligation to provide the goods or services to the customer in the future, which is usually recognized as a deferred revenue liability on its balance sheet. Where sellers* market prevail advances from customers may be insisted. In certain cases to ensure performance of contract in advance may be insisted.
(vii) Accrual Accounts: Accrual accounts are simply outstanding dues to workers, suppliers of overhead service requirements and the like. accruals address short-term timing differences that, at the transaction level, typically resolve within a year. Long-term accruals address timing differences that can take many years to resolve. Outstanding wages, taxes due, dividend provision, etc. are accrual accounts providing working capital finance for short period on a regular basis.
(viii) Loans: A Working Capital Loan is one that is availed of to fund the day-to-day operations of a business, ranging from payment of employees’ wages to covering accounts payable.Loans from directors, loans from group companies etc. constitute another source of working capital. Cash rich companies lend to liquidity crunch companies of the group.
(ix) Commercial Papers: Commercial papers can be used to raise funds. It is a promissory note carrying the undertaking to repay the amount on or after a particular date. Commercial paper is typically issued by companies to raise funds to meet their short-term financial obligations. This can include using the funds for working capital, refinancing debt, funding capital expenditures, and meeting other financial commitments. Normally it is an unsecured means of borrowing and the companies are allowed to issue commercial papers as per the regulations issued by SEBI and Company’s Act.
(x) Debentures and Equity Fund: Debentures and equity fund can be issued to finance working capital so that the permanent working capital can be matchingly financed through long term funds.A debenture is a type of long-term business debt not secured by any collateral. It is a funding option for companies with solid finances that want to avoid issuing shares and diluting their equity.
2. Explain the need and importance of working capital. Discuss the various sources of working capital?
Ans: Importance or Advantages of working capital can be discussed under the following points:
(i) Cash Discount: If proper cash balance is maintained the business can avail the advantages of cash discount by paying cash for the purchase of raw materials and merchandise. It will result in reducing the cost of production.
(ii) It creates a feeling of security and confidence: The proprietor or officials or management of a concern are quite carefree, if they have proper working capital arrangements because they need not worry for the payment of business expenditure or creditors. Adequate working capital creates a souse of security, confidence and loyalty not only throughout the business it self but also among its customers, creditors and business associates.
(iii) Must for maintaining solvency and continuing production: In order to maintain the solvency of the business, it is but essential that sufficient amount of funds be available to make all the payments in the as and when they are due. Without ample working capital, productions, will suffer particularly in this era of cut throat competition, and a business can never flourish in the absence of adequate working capital.
(iv) Sound Goodwill and Debit Capacity: It is common experience of all product businessmen that promptness of payment in business creates goodwill and increases the debt capacity of the business creates goodwill and increases the debt capacity of the business. A firm can raise funds from the market, purchase goods on credit and borrow short term funds from the market, purchase goods on credit and borrowers are confident that they will get their due interest and payment of principal in time.
(v) Easy Loan from the Banks: An adequate working capital i.e. excess of current assets over current liabilities helps the company to borrow unsecured loans from the bank because the excess provides a good security to the unsecured loans, banks far our in granting seasonal loans, if business has a good credit standing and trade reputation.
(vi) Distribution of Dividend: If company is short of working capital, it cannot distribute the good dividend to it shareholders in spite of sufficient profits. Profits are to be retained in the business to make up the deficiency of working capital. On the contrary, if working capital is sufficient, ample dividend can be declared and distributed. It increases the market value of shares.
(vii) Exploitation of Good Opportunities: In case of adequacy of capital in a concern, good opportunities can be exploited e.g. company may make off season purchases resulting in substantial servings as it can fetch big supply orders resulting in good profits.
(viii) Meeting unseen Contingencies: Depression short up the demand of working capital because stock piling of goods become necessary, certain other unseen contingencies e.g. financial crisis due to heavy losses, business oscillations etc. can easily be overcome, if company maintains adequate working capital.
(ix) It increases fixed Assists Efficiency: Adequate working capital increases the efficiency of the fixed assets of the business because of its proper maintenance. Without working capital, fixed assets are like a gun which can not shoot as here are no cartridges. It is therefore said, the fate of large scale investment in fixed capital is often determined by a retiring small amount of current assets.
(x) High Morale: The provision of adequate workings capital improve the morale of the executives because they have an environment of certainty, security and confidence which is a great psychological factor in improving the overall efficiency of the business and of the person who is it the help of affairs in the company.
(xi) Increased Production Efficiency: A continuous supply of raw Immaterial, research programmers, innovation and technical developments and expansion programmers can successfully be carried out if adequate working capital is maintained in the business. It will increase the production efficiency, which will in turn, increase the efficiency and morale of employees and lowers costs and creates image the community.
The sources of working capital may be classified into two categories such as:
(a) Source of long term working capital.
(b) Sources of short term working capital.
(a) Sources of long term working capital: Following are the various sources of long term working capital.
(i) Issue of shares: It is the most important source of long term regular working capital out of the proceeds of issue of shares. It creates no burden or the fixed charge on the craning assets of the company. Moreover, the company is not under obligation to return the capital.
(ii) Issue of debenture: Regular working capital can also be procured by issue of debenture or bonds. The cost of capital is lower in the case. By issuing debentures company may trade on equity by issuing debenture if there is no stability in the earning of the firm because they create charges on the earnings assets of the company. Management should make a choice in procuring funds either by issue of shares of by issue of debentures depending upon the various other factors.
(iii) Retained Profits: Accumulated large profits is also considered to be a good source of financing long term working capital requirements. It is the best and the cheapest source of finance. It creates no charge on future profits. A part of earned profits are ploughed back by the firms in meeting the working capital requirement. Retained profits may be represented by various uncommitted reserve and sophists or specific reserves created out of profits.
(iv) Sole of fixed assets: If there is any idle fixed asset in the firm, it’ can be sold out and the proceeds may be utilized for financing the working.
(v) Security from Employees and from customs: Certain companies require a security deposit from their employees before giving them employment under the terms of service. contracts. Similarly public utility concerns e.g. electricity distributing companies or cooking gas supply companies require security deposits from their registered customers. Such security deposits are not refundable during the period the employee is in service of the firm or customer is registered with it. The amount of advances thus can be utilized by the company in meeting its long term working capital needs.
(vi) Term Loans: Mid term and long term loans for a period above 3 years provide important sources of working capital. Such term loans can borrowed from the special financial institutions such as the Industrial Development Bank of India, the Industrial Finance corporation, the life Insurance Corporation and Commercial Banks etc.
Sources of short term working capital:
There are two types of sources of short term working capital:
(i) Internal Sources.
(ii) Eternal Sources.
(i) Internal Sources: Following are the main internal sources of short term working capital.
(a) Depreciation Funds: Depreciation funds created but of profits of the company provide a good source of working capital provided they are not invested in or represented by an assets.
(b) Provision for Taxation: There remains a time lag between making the provision for any payment of taxation. A company may utilize such provision during the intermittent period temporarily.
(c) Accrued Expenses: The company sometimes postpone the payment of certain expenditure due on the date of finalization of the accounts. These accorded (due but not paid) expenses also constitute an important source of working capital.
(ii) Internal sources: Following are the external sources:
(a) Normal Trade credit: Trade, creditors provide short term finance to the company by selling the goods, inventories and equipments of the basis of deferred payment. It becomes a very common source of short term finance and normally every concern use this source as a normal trade practice.
(b) Credit Papers: Under this category bills payable note are included. The acceptor of a bill of exchange gets time in making the payment for loan. It is like a credit extended to him by the creditor against his acceptance. The drawer of a bill of exchange or payable of promissory note may also get finance from his banker by discounting these documents to meet short term requirements. Accommodation bill is also an important source of short term finance.
(c) Bank credit: The greater part of the working capital is supplied by commercial banks to their customers through direct advanced in the shape of loans, cash credit or overdraft and through discounting the credit papers e.g. B/R, P/N etc.
(d) Customers credit: Advances may also be obtained from customers against the contracts entered into by the enterprise. Such advances are generally asked for, by the companies manufacturing large plants and machineries involving longer time in completing the process of manufacture e.g. ship building industries. The amount can be used for purchasing raw materials paying wages and so an.
(e) Public Deposits: Most of the companies in recent years depend on this source to meet their working capital requirements. It had been most common in cotton textile mills in Bombay and Ahmeda dad but how almost every public limited company raises finances from this source ranging from 6 months to there years to meet working capital needs under the companies (Acceptance of Deposits) rules, a company is authorized to raise funds equal to 25 per cent of paid up capital and free reserves by this source.
(f) Loans from Managing Director or Directors: Some times directors or managing directors of the company provide loans to the company at a very negligible rate of interest or at no rate of interest.
(g) Government Assistance: Central and state governments of the country provide short term finances to industries or businesses by allowing them tax concessions, sectioning direct loans or grants to industries or a class of industries to assist their production programmes etc.
3. Discuss the various method of determining or analysis working capital.
Ans: The analysis of working capital can be made either through:
(i) ratio analysis.
(ii) fund flow analysis, or
(iii) budgeting analysis.
(i) Ratio Analysis: The ratio analysis of working capital helps the management in checking upon the efficiency with which the working capital is being used in the business. For this purpose, different ratios are calculated to serve different purposes.
Ratio analysis (a) Behaviours of ratios over a period of years to determine trends in the business and (b) companying ratios for one concern with those of other concerns in the same line of business. In such compassions, due allowance must be given for differences in the character of enterprise and for special accounting practices and policies followed by each undertaking.
The most important ratios for determining the trend in the business over a period of years are as follows.
(a) Turnover of working capital Ratio: This ratio measures the rate of working capital utilization and is calculated as follows:
Turnover of working capital Ratio = Net Sates/ Net working capital.
This ratio shows how many times the working capital turns over in trending transactions. If it has an increasing trend over previous years, it shows that the working capital is how being used very efficiently or in other words, working capital is working harder than it worked in the past. On the other hand, if there is decreasing ratio, One can reasonably follow, that the company is used working capital less economically or not so efficiently as it should have been. It indicates relative in efficiency of the management. Every business has to work out its own normal level of variations and its own upper and lower limits of ratio which produce a reasonable combination of profitability and safety in the management of working capital.
(b) Current Ratio: Current ratio is the ratio between current assets and current liabilities of a business.
It is worked out as under:
Current Rate = Current Assets/ Current liabilites.
Current ratio measures the ability of the company to pay off its short term debts I, e, Current liabilities. It reveals how efficiently a firm can meet the sudden demand, if it at all arises, to pay off all its short-term creditors. It is, therefore, advisable that short term assets should be large enough to meet the sudden demands with some margin taking into consideration the liquidity of assets. The ratio is very useful for bankers and creditors while advancing loans to the company. The ratio is not of much use to the growing concerns.
(c) Acid Test Ratio: It is also called quick— ratio, It is determined by dividing quick assets i.e., assets which are most easily convertible into cash, by current liabilities. It is a better test of financial strength than the current ratio as it gives no consideration to inventory which cannot be sold at fair prices immediately.
This ratio Lays more emphasis on immediate conversion of assets into cash. A quick ratio of 1:1 is us really considered favourable. The higher the quick ratio, the better the financial position.
(d) Cash Ratio: The relationship of current assets and cash balance in called cash ratio. It may be determined by dividing the total current assets by total cash. The ratio shows availability of cash to meet the day to day requirements in relation to the total current assets. Past experience may show the trend of relationship of cash with current assets. If ratio is higher than the average, it shows that funds are lying idle contributing nothing to the business. It should be reduced to the average needs of the business.
(e) Ratio of current Liabilities to tangible Net Worth: The ratio is worked out by dividing the current liabilities by tangible wealth. The ratio is helpful in finding out how much capital has been contributed by the short term creditors and how much by the owners. Higher ratio means greater risks to short term creditors.
(ii) Funds Flow Analysis of Working capital: Funds flow analysis is the study of the sources of funds and their application in the business. The analysis shows how the funds in the business have been procured and how they have been employed. By the use of this method, changes in the working capital between the two dates can be very easily analyzed by studding the changes in each type of current assets and current liabilities as the sources from which working capital has been obtained.
A more thorough analysis of current assets and current liabilities can be made by incorporating certain items from the income statement. A detailed study of Fund – flow technique has been given in chapter II.
(iii) Budgeting Analysis: Efficient working capital management is concerned with the careful measurement of future requirements and the formulation of plans to meet them for this purpose a working capital budget as a part of total budgeting process, is prepared stating the future long term and short term working capital needs and the sources to finance them. The objective of working capital budget is to secure the proper utilization of the investment. At the end of the period budgeted figures and the actual figures can be compared and studied using different ratios and standards. The investment utilization can be studied by the rate of turnover as measured against sales or cost of goods sold through scatter charts.
4. What is Inventory Management? Discuss its various objectives. Describe the various factors influencing inventory.
Ans: Inventories are the stocks of the product of a company and component thereof that make up the product. The different form in which inventories exist are – raw materials, Work-in-process and finished goods. Raw materials are those inputs that are converted into finished product through the manufacturing process. Work in progress inventories are semi- finished products. That require move work before they are ready for sale. Finished goods inventories are those which are completely manufactured products and are ready for sale Raw materials and semi finished goods inventories facilitate production while finished goods inventories are required for smooth marketing operations. Thus inventories serve as a link between the production and the consumption of goods.
The objectives of inventory management may be discussed under two heads:
(a) Operating objectives and.
(b) financial objectives as follows.
(a) Operating objectives:
(i) Availability of Materials: The first and the fore most objective of inventory management is to make all types of materials available at all times whenever they are needed by the production departments so that the production may not be help up for want of materials. It is therefore Sable to maintain a minimum quantity of all types of materials to move on the production on schedule
(ii) Minimizing the wastage: Inventory control is essential to minimize the wastage at all levels i.e. during its storage in the godowns or at work in the factory. Normal wastage, in other words uncontrollable wastage, should only be permitted. Any abnormal but controllable wastage, should only be permitted. Any abnormal but controllable wastage, should only be permitted. Any abnormal but controllable wastage should strictly be controlled. Wastage of materials by leakage, theft, embezzlement and spoilage due to rust, dust or dirt should be avoided.
(iii) Promotion of manufacturing Efficiency: The manufacturing efficiency of the enterprise increases if right types of raw materials is made available to the production department at the right time. It reduces wastage and cost of production and improves the morale of workers.
(iv) Better service to customers: In order to meet the demand of the customers, it is the responsibility of the concern to produce sufficient stock of finished goods to execute the orders received. It means, a flow of production should be maintained.
(v) Control of Production Level: The concern may decide to increase or decrease the production level in favourable time and the inventory may be controlled accordingly. But in odd times, when raw materials are in short supply. Proper control of inventory helps in creating and maintaining buffer stock to meet any eventuality. Production, Variations can also be avoided through proper control of inventories.
(vi) Optimal Level of Inventories: Proper control of inventories help management to procure materials in time in order to run the plan efficiently. It thus, helps in the maintaining the optimum level of inventories keeping in view the operational requirements. It also avoids the out of stock danger.
(b) Financial Objectives:
(i) Economy in Purchasing: Proper inventory control brings certain advantages and economics in Purchasing the raw materials. Management makes every attempt to purchase the raw materials in bulk quantity and to take advantage of favourable market conditions.
(ii) Optimum Investment and efficient use of capital Use of capital: The prime objective of inventory control from financial point of view is to have an optimum level of investment in inventories. There should neither be any deficiency of stock of raw materials so as to hold up the production process nor should there be any excessive investment in inventories so as to block the capital that could be used in an efficient manner otherwise. It is, therefore, the responsibility of financial management to set up the maximum and minimum levels of stocks to avoid deficiency or surplus stock positions.
(iii) Reasonable Price: Management should ensure the supply of raw materials at a reasonably Low Price but with out sacrificing the quality of it. It helps in controlling the cost of production and the quality of finished goods in order of maximize the profits of the concern.
(iv) Minimizing Costs: Minimizing inventory costs such as handling ordering and carrying costs, etc., is one of the main objectives of inventory management. Financial management should help controlling the inventory costs in a way that reduces the cost per unit of inventory. Inventory costs are the part of total cost of production hence cost of production can also be minimized by controlling the inventory costs.
Factor influencing the decision of investment in inventories can be divided into two parts:
(a) General factors. and
(b) Specific factors.
(a) General Factors: These factors include considerations common to the management of all types of assets fixed or current. Such factors are, type and nature of business, anticipated volume of sales, operation level, price level variations, availability of funds and the attitude of the management.
(b) Specific factors: Such factors are those which influence the decision of investment in inventories. These include:
(i) Seasonal Nature of Raw Material and Demand of Finished Goods: If certain raw material is available during a particular season, but its consumption continues throughout the year in the firm, the investment in such raw material shall naturally be heavier to store the stock in order to streamline the production throughout the year. This is true in agro-based industries like sages etc. Similarly seasonal industries purchase raw material in the season and there fore, their investment in raw material increases in that particular season. Conversely, where demand for goods is uneven, shall or seasonal, the management will have to store the finished goods inventory till the demand season approaches for timely execution of orders and therefore will follow longer production runs and more even and efficient production scheduling. It will require higher investment in inventories in off season.
(ii) Length and Technical Nature of the Production Process: If Production process is such that takes much time in its completion, the investment in inventories shall be Larger such as ship-building industry. Moreover if production process is of technical nature, even then it requires heavy investment in inventories.
(iii) Style factor in the End Product: The style factor of end product or nature of finished goods determines the size of investment in inventories. The durability and perish ability of the finished product are such important factors.
(iv) Terms of Purchase: If supply of raw material is available on favourable terms i.e.. long credit conditions of supply, concession or rebate available on favourable terms i.e.. long credit, conditions of supply, concession or rebate available etc., the management may have larger investment in inventories in order to avail of the opportunity of favourable terms. But, here, the management must consider the cost and benefit effect of ordering raw materials is available only on cash terms, the management will dare not to invest heavy amount in inventories.
(v) Supply conditions: Certainty and regularity in supply of raw material are also important factors in determining the size of investment from the view point of operating continuity. Suppose, if the source of material is outside the country and a ban on imports is feared or supply may be disturbed due to weather, a great stock of inventory will be needed to avoid the risk of being out of stock. If, on the other hand, the company relies upon the supplier for regular and speedy supply of raw material, it may carry a very small stock of that raw material.
(vi) Time Factor: Time is also an important factor in determining the size of inventory and affects the inventory management in a number of ways:
(a) Bad time i.e.. time lag between intending and availability of raw material.
(b) Time lag between purchase of raw material and the commencement of process.
(c) Time required in production process. and
(d) Average time required for sale of product.
These all exercise their impact on investment in inventories. The longer the time, the larger would be the investment in inventories to maintains the flow of production.
(vii) Price Level Variation: If a price rise is expected in the near future, the investment in raw material will be greater in a bid to keep the cost of product minimum. On the other hand, if price level is expected to go down, there will be a tendency to purchase the goods in the open market as and when it is needed.
(viii) Loans Facilities: Generally raw materials are purchased on credit. Moreover banks advance credit to the firm against their stock of inventories. If the cost of carrying stock and the cost of availability of funds is cheaper than the interest payable to the bank, the investment in inventories will be higher.
(ix) Management Policies: The management policies have significant influence on the investment in work-in-process inventory mainly in process goods industry. For example, a firm manufacturing durable goods, an important decision area may be the extent to which the components or sub-assembly items should be produced in longer runs or in short runs close to the time, they are needed for assembly, if management decided production in longer runs, the investment in semi-finished inventories shall be higher. But, if management decides to produce the goods close to the time, they are demanded, the production may be increased to cope with the demand by running the factory in two or there shifts or may initiate actions that speed production. This decision will require less investment in inventories.
(x) Other factors: Other factors like industry wide strike threats, propose control of raw material, rationing or revision of excise duty rates, price control of finished stock etc., also affect the investment decision in inventories.
5. What do you mean by working capital? Discuss its types?
Ans: The capital required for a business is of two types. These are fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like building, land, machinery, furniture etc. Fixed capital is invested for long period, therefore it is known as long-term capital. Similarly, the capital, which is needed for investing in current assets, is called working capital. The capital which is needed for the regular operation of business is called working capital. Working capital is also called circulating capital or revolving capital or short-term capital.
Working Capital Definitions, In the words of John. J Harpton “Working capital may be defined as all the short term assets used in daily operation”.
According to “Hoagland”, “WorkingCapital is descriptive of that capital which is not fixed. But, the more common use of Working Capital is to consider it as the difference between the book value of the current assets and the current liabilities.
From the above definitions, Working Capital means the excess of Current Assets over Current Liabilities. Working Capital is the amount of net Current Assets. It is the investments made by a business organisation in short term Current Assets like Cash, Debtors, Bills receivable etc.
Working Capital Types: Some portion of working capital is fixed natured and some portion fluctuates for some time. In the view point working capital classified in to 2 classes,
(i) Fixed or permanent working capital: The fund, which is required to produce a certain amount of goods or services at a certain period of time, is called fixed working capital. The minimum amount of cash money, A/R, which is kept to operate the business is called fixed working capital.
(ii) Variable working capital: When extra working capital is required then an addition to fixed working capital due to seasonal causes or increased production or sales, this working capital is variable working capital. So, the working capital which fluctuates with keeping the relation between production & Sales is variable working capital.
6. What is meant by cash planning and control? Explain the main tools of cash planning and control.
Ans. Cash planning is a technique to plan for and control the use of cash. It involves formulation of sound cash management policies, procedures and practices. Cash planning induces cash control as well. Cash control involves proper implementation of policies and procedures regarding inflow and outflow of cash. It includes short term investment plans when cash is surplus and borrowing programmes during the days of cash deficit.
Tools of cash planning and control can be divided into two groups:
(a) Tools of cash planning.
(b) Tools of cash control.
(a) Tools of cash planning: These include methods which establish the future cash level in a firm.
They are:
(i) Net cash forecast.
(ii) Cash budget.
(iii) Working capital position.
(i) Net cash forecast: Forecast of net cash means forecast of cash inflows and cash outflows for a given period.
There are two methods of forecasting cash position:
(a) cash flow method which plots out estimated receipts and payments and.
(b) adjusted earning method.
(ii) Cash Budget: It is a systematic forecast of cash requirements i.e. forecast of cash flows and outflows and thus shows the probable surplus of or deficiency of cash. In forecasting the cash flow, policies regarding other functions such as sales, production, marketing, personnel etc. are taken into consideration.
(iii) Forecasting as overall working capital position: Forecast of the overall working capital position is also an important tool of cash planning. Working capital analysis forecasts the value of current assets and current liabilities to know the cash position of the business.
(b) Tools of cash control: Proper cash control is possible only when there is a person responsible for planning and controlling the cash. Business exigencies and government policies should also be taken into account while planning the control of cash. Following tools are generally used to control the cash position.
(i) Cash budget report: Cash budget report is a prepared as a supplement to cash budget. It presents a comparison between actual and budgeted cash receipts and payments locating the points of deviations, if any. The management may find out the reasons for deviations and take necessary action to remove them.
(ii) Inflow and outflow of cash: In order to check the diminution in cash position, a cash flow statement is prepared. It helps controlling inflows and outflows of cash.
(iii) Ratio analysis: Various cash ratios are used to explain the efficiency or inefficiency of cash management. These ratios are current ratios, quick or acid test ratio, receivable turnover ratio, inventory turnover ratio and cash position ratio etc.
7. Explain the various technique of inventory control.
Ans: The following techniques may be used to control the size of inventory in a manufacturing concern.
(i) Fixing the Maximum Minimum.
(ii) Limits of Inventory: In order to have a proper check on the investment in inventory, it is necessary to fix the minimum and the maximum limits of inventory so that there should be no overstocking of material nor storage of raw materials. In fixing the levels of inventories, the following two factors should be borne in mind.
(a) Time lag between intending and receiving of the raw materials i.e. lead time.
(b) Rate of consumption during lead time.
Under this system, an order of sufficient size is placed when a minimum point in inventory is reached, to bring the inventory to the maximum point. Past experience help the fixing of minimum and maximum points in inventories.
(iii) Re-ordering Level or ordering Level: It is appoint where orders for fresh supplies of materials are placed with the suppliers. The point is fixed some where in between the maximum and minimum point in such a way that the quantity available between the minimum level and this point is sufficient to meet the requirements of production upon the time fresh supplies are received.
Recording level: Minimum level + (Time in acquiring the materials ×rate of consumption).
In fixing the ordering level, a danger level is also considered. It is a level at which normal issues of material are stopped or made at specific instructions of purchase officer. Purchase officer at this point makes the efforts to get the material available within an earliest possible time. This level is below the minimum level of stock.
(iv) Economic order Quantity (EOQ), EOQ in an important factor in controlling the inventory. It is a quantity of inventory which can reasonably be ordered economically at a time. It is also known as ‘Standard Order, Quantity, “Economic Lot Size, or Economical Ordering Quantity”. In determining this point ordering costs and carrying costs are taken into consideration. Ordering costs are basically the cost of getting. An item of inventory and it includes cost of storage facilities, property insurance, loss of value through physical deterioration, Cost of obsolescence. Either of these two costs affects the profits of the firm adversely and management tries to balance these two costs. The balancing or reconciliation point is know as Economic order quantity.
The quantity may be calculated with the help of the following formula:
Here, A = Annual Quantity used (in units).
S = Cost of placing an order (fixed cost).
CH = Cost of holding one unit for one year.
Economic order Quantity may be well understood in the following example – Suppose, the annual the demand for the product is 5000 units, the ordering cost is Rs. 20 per unit and the holding cost is Rs 5/ per unit per annum.
The EOQ shall be.
(v) Two – Bin System: Under this system, all inventory items are grouped under two categories. In the first group, a sufficient supply is kept to meet the current requirements over a designated period of time. In the second group or bin, a safety stock is maintained to meet the requirement of inventory at times when stock in the first bin is exhausted and reordering occurs.
(vi) Order cycling system: In this system, review of each item of inventory is made from time to time depending upon the criticality of the item to have the predetermined level of inventory. Critical items may require a short review cycles and on the other hand, lower cost non- critical item may require longer review cycles. At catch review date, a required quantity of inventory is ordered to bring it to the predetermined level.
(vii) Statistical Inventory Control System: Statistical models are used by some firms to find out their widely sped distribution system with the help of computers etc. It helps the management in taking the inventory management decisions. But this system is valid only if the sufficient information for cost comparison is available and the data has accurately been compiled otherwise it is very difficult to find out the alternatives.
(viii) A, B, C Analysis System: Under this system, a value item analysis is prepared where there are many items in the inventory. It attempts to relate how the inventory value is concentrated among the individual items. Under this system, all items in the inventory are grouped into three categories – A B and C. A being the most important and C the least important. The classification is made on value, usage rate and the criticality of item. After classification as AB or C, they are ranked by their value. We can thus, find as to what percentage of items is held and for what percentage of value.
(ix) Budgetary control system: Under this system, inventory budgets are prepared and then compared with the actual consumption figures. Trough budgets, inventory consumption and levels are coordinated with the expected usage. It serves the purpose of controlling cash and debtors position. The inventory budget is a plan for investing funds in stock at regular intervals via raw materials, work-in-progress and finished stocks.
8. What do you mean by working capital? What are the different types of working capital?
Ans: Working capital is also referred to as circulating capital because it keeps on moving in a circular direction.
In the words of Shubin, “Working capital is the amount of funds necessary to cover the cost of operating the enterprise.”
According to Gerstenberg “Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, as for example, from cash to inventories, inventories to receivables, receivable into cash”.
Working capital can be classified on the following two basis:
(i) On the basis of concept: Working capital can be classified as gross working capital and net working capital.
(a) Gross working capital: It is the capital invested in total current assets of the enterprise.
Total of all current assets = Gross working capital.
(b) Net working capital: Net working capital is the excess of current assets over current liabilities.
Current assets – current liabilities = net working capital.
(ii) On the basis of necessities or time: Working capital can be classified as follows:
(a) Permanent or fixed working capital: Permanent working capital represents the assets required on continuing basis over the entire year.
This is permanently needed for the business and therefore it should be financed out of long-term funds.
The permanent working capital can again be sub– divided into:
(i) Regular working capital: It is the minimum amount of liquid capital required to keep up the circulation of capital from cash to inventories, inventories to receivables and back to cash again.
(ii) Reserve working capital: It is the excess capital over the needs of regular working capital that should be kept in reserve for contingencies that may arise at any time. This contingencies include rise in prices, business depreciation, strikes etc.
(b) Temporary or variable working capital: Variable working capital changes with the increase or decrease in the volume of business. It may also be subdivided into two:
(i) Seasonal variable working capital: The working capital required to meet the seasonal liquidity of the business is seasonal variable working capital. In many lines of business like tea, sugar etc. operations are highly seasonal and as a result, working capital requirement vary greatly during the year.
(ii) Special variable working capital: It is that part of the variable working capital which is required for financing special operations such as extensive marketing campaign experiments with products etc.
9. Discuss the determinants of working capital.
Or
Discuss the factors affecting the requirements of working capital.
Ans. The working capital requirements of a concern depend upon a large number of factors.
The following are important factors generally influencing the working capital requirements:
(i) Nature and size of business: The working capital requirements highly influence the nature and size of business. Trading and financial firm do not need much to invest in fixed assets, but require a large sum of money to be invested in working capital. On the other hand public utilities have to invest larger sums in fixed assets but their working capital requirements are nominal because they have cash sales only and supply services, not product. The manufacturing firm also require sizeable working capital along with fixed investments. Similarly size may be estimated in scale of operation. A firm with larger operational scale will require more working capital than a smaller firm.
(ii) Manufacturing cycle: In manufacturing business, the requirements of working capital increase in direct proportion to length of manufacturing process. Longer the process period of manufacture, larger is the amount of working capital required.
(iii) Business cycle fluctuations: Business cycle refers to alternate expansion and contraction in general business activity. In a period of boom i.e. when the business is prosperous, there is a need for larger amount of working capital due to increase in sales, rise in prices, etc. But in the times of depression i.e. when there is a down swing of the cycle, the business contracts, sales decline so the firm require less amount of working capital.
(iv) Seasonal operations: It is not always possible to shift the burden of production and sale to slack period. For example, in the case of sugar mill, more working capital will be required at the time of crop and manufacturing.
(v) Availability of credit: The working capital requirements of a firm also depend upon the credit granted to the firm by its creditors. A firm will need less working capital if liberal credit terms are available to it. Similarly, a firm which can get bank credit easily on favourable terms, will operate with less working capital than a firm without such facility.
(vi) Management’s ability: Proper coordination in production and distribution of goods may reduce the requirement of working capital as minimum funds will be invested in absolute inventory, non-recoverable debts etc.
(vii) Growth and expansion activities: The working capital requirements of a concern increase with the growth and expansion of its business activities. Although, it is difficult to determine the relationship between the growth in the volume of business and the growth in the working capital of a business, yet it may be concluded that for normal rate of expansion in the volume of business, we may have retained profits to provide for more working capital but in fast growing concerns, we shall require larger amount of working capital.
(viii) Price level changes: As price increases more working capital will be required for the same magnitude of current assets. The need of working capital may further increase due to growth resulting from price level change.
(ix) External environment: With the development of financial institutions, means of communication, transport facility etc. the need of working capital is reduced because it can be available as and when required.
(x) Other factors: Certain other factors such as operating efficiency, credit policy, earning capacity and dividend policy, import policy, asset structure, liquidity and profitability, volume of sales etc. also influence the requirements of working capital.
10. Discuss the Importance of adequate working capital?
Ans: Adequate working capital Importance. Working Capital means excess of current assets over current liabilities. Such Working Capital is required to smooth conduct of business activities. It is as important as blood to body. An organisation’s profitability depends on the quantum of Working Capital available to it. Adequate Working Capital is a source of energy to any business organisation. It is the life blood of an organisation.
The following points will highlight the need of adequate working capital:
(a) Enables a company to meet its obligations: Working capital helps to operate the business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay.Adequate working capital enables a company to meet its immediate financial obligations, including paying suppliers, salaries, and utility bills. This liquidity management is vital for business continuity
(b) Enhance Goodwill: The company that meets the needs of its working capital without any difficulty earns a good reputation in the labour and capital markets. Goodwill is enhanced because all current liabilities and operating expenses are paid on time.
(c) Facilitates obtaining Credit from banks without any difficulty: A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms.
(d) Regular Supply of Raw Material: Quick payment of credit purchase of raw materials ensures the regular supply of raw materials for suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production. If a company has working capital, it can easily get raw materials from suppliers. This is a good situation for any company because, if everything goes well, it is able to bring in regular supplies of raw materials and, thereby, reduce its production costs.
(e) Smooth Business Operation: Working capital is really a life blood of any business organization which maintains the firm in well condition. Efficient working capital management helps maintain smooth operations and can also help to improve the company’s earnings and profitability. Management of working capital includes inventory management and management of accounts receivables and accounts payables.
(f) Ability to Face Crisis: Adequate working capital enables a firm to face business crisis in emergencies such as depression because during such periods there is much pressure on working capital.
(g) Discount of purchase: Adequate working capital also enables a concern to avail cash discounts on the purchase and hence reduces costs.
(h) High morale: Adequacy of working capital creates an environment of security, confidence, high morale and creates overall efficiency in a business. Every business concern should have adequate working capital to run its business operations.
(i) Exploit favourable market conditions: Only concerns with adequate working capital can exploit favourable market conditions such as purchasing raw materials in bulk when prices are lower and by holding inventories for higher prices.
(j) Quick and regular payments of dividends: Investors wants quick and regular payment of dividend on their investments. Dividends are typically paid on a quarterly basis, though some pay annually, and a small few pay monthly. Companies that pay dividends are usually more stable and established, not those still in the rapid growth phase of their life cycles.Sufficient working capital enables a company to pay regular dividend to its investors.
11. Discuss the advantages and disadvantages of cash management. Discuss the functions of cash management.
Ans: The advantages of cash management are many few of them are discussed below:
(i) Helpful during recession: Cash management helps the firm to stand strongly at times of recession. It provides an inventory of the financial reserves which are available in the event of a recession.
(ii) Integrated planning and procedures: Cash is needed to conduct various activities of a concern, hence cash management is an integral part of planning and procedure.
(iii) Solvency of the firm: Cash is vital for maintaining solvency of the firm. This is possible only when the firm is able to pay its debts as when they fall due, both immediately and in the foreseeable future.
(iv) Life blood of business: Cash is like the blood stream in a living body, so it is very much the life blood of a business. It must be kept circulating round the arteries of a business because if the circulation gets clogged sickness and death may ensure as they do when a clot is formed in an artery.
(v) Survival of business: The first priority of any business is survival and this can be assured only when a firm has sufficient cash to manage its day to day transactions effectively and for this cash management is very necessary.
(vi) Optimum working capital: An efficient cash management through a relevant and timely cash budget may enable a concern to achieve optimum working capital and ease the strains of cash shortage facilitating temporary investment of cash and providing funds for normal growth and expansion.
(vii) More efficiency with less cash resources: With the help of effective system of cash management balance can be maintained between cash inflows and cash outflows which results in successful operation of business transactions with minimum cash balance.
(viii) Sound debt policy: Effective cash management helps in raising loans when the business is making progress at low rate of interest on the other hand the shareholders enjoy the policy of trading on equity.
Disadvantages of cash management:
(i) Uncertain future: When a firm is unable to forecast its future activities and plans, cash management is useless rather it creates hinderance in the development and progress of the firm.
(ii) Other factors than recession: Cash budget is able to forecast future inflation or deflation but is unable to study the changes in customer’s taste, technology, politics, which affect the future of a concern.
(iii) Cost of holding cash: Cost of holding cash implies to the profit that could have been earned had the funds been put to another use.
(iv) Financial distress: Financial distress is a matter of degree while the declaration of the bankruptcy is an indication of this distress in an extreme form. It occurs when a concern’s cash flow fall below expectation.
The firm should develop some strategies for cash management in order to resolve the uncertainty about cash flow prediction and lack of coordination between receipts and payments. The firm should involve strategies regarding the following four functions of cash management:
(a) Cash planning: Cash inflows and outflows should be properly planned to project cash surplus or deficit for each of the planning period. It is a technique to plan for and control the use of cash. The period and frequency of cash planning generally depends upon the size of firm and policy of management. Cash budget is the most significant device to plan for and control the cash receipts and payments. Cash forecasts are needed to prepare cash budget. Cash forecasting may be done on a short term or long term basis.
(b) Managing the cash flow: Cash management will be successful only if cash collections are accelerated and cash disbursements as far as possible, are delayed. A firm can reduce its requirements of cash balances, if it can speed up its collections. Cash collection can be accelerated by reducing the gap between the time a customer pay his bill and the time the cheque is collected and funds become available for use. Within this time gap, the delay is caused by the mailing time. The amount of cheques sent by customers but not yet collected is called deposit float. The greater will be the deposit float, the longer is the time taken in converting cheques into usable funds.
There are mainly two techniques which can be used to save mailing and processing time; decentralized collections and lock box system.
(i) Decentralized collection: A decentralised collection procedure, called concentration banking, is a system of operating through a number of collection centres in place of a single collection centre centralised at the firm’s head office. In this system the concern will have a large number of bank accounts operated in the areas where the firm has branches.
(ii) Lock box system: Another technique of reducing collection time is “Lock box system”. In a lock box system, the firm establishes a number of collection centres, considering customer’s locations and volume of remittances. At each centre, the firm hires a post office box and instructs its customers to mail their remittances to the box.
(c) Optimum cash level: The management should be watchful enough while taking this decision as it also affects the profitability of a firm. If the firm maintains a small cash balance, its liquidity becomes weak and suffers from a paucity of cash to make payments. Vice-versa, if the firm maintains a higher level of cash balance, it will have a sound liquidity position but forgo the opportunities to earn interest. Thus the firm should maintain an optimum cash balance.
(d) Investing idle cash: The idle cash kept for the purpose of safety should be properly and profitably invested. The firm should decide about the division of cash balances between marketable securities and bank deposits. There is a close relationship between cash and marketable securities and bank deposits. Therefore the investment in marketable securities and bank deposits should be properly managed. Excess cash should normally be invested in such marketable securities which can be conveniently and promptly converted into cash.
12. Explain the Methods of estimating working capital requirement. Discuss the general principles of working capital Management.
Ans: The following methods are used to calculate the amount of working capital requirement in a business:
(i) Percentage of Sales Method: This method of estimating working capital requirements is based on the assumption that the level of working capital for any firm is directly related to its sales value. If past experience indicates a stable relationship between the amount of sales and working capital, then this basis may be used to determine the requirements of working capital for future period.
Thus, if sales for the year 2007 amounted to Rs 30,00,000 and working capital required was Rs 6,00,000; the requirement of working capital for the year 2008 on an estimated sales of Rs 40,00,000 shall be Rs 8,00,000; i.e. 20% of Rs 40,00,000.
The individual items of current assets and current liabilities can also be estimated on the basis of the past experience as a percentage of sales. This method is simple to understand and easy to operate but it cannot be applied in all cases because the direct relationship between sales and working capital may not be established.
(ii) Regression Analysis Method (Average Relationship between Sales and Working Capital): This method of forecasting working capital requirements is based upon the statistical technique of estimating or predicting the unknown value of a dependent variable from the known value of an independent variable. It is the measure of the average relationship between two or more variables, i.e., sales and working capital, in terms of the original units of the data.
(iii) Cash Forecasting Method: This method of estimating working capital requirements involves forecasting of cash receipts and disbursements during a future period of time. Cash forecast will include all possible sources from which cash will be received and the channels in which payments are to be made so that a consolidated cash position is determined. This method is similar to the preparation of a cash budget. The excess of receipts over payments represents surplus of cash and the excess of payments over receipts causes deficit of cash or the amount of working capital required.
(iv) Operating Cycle Method: This method of estimating working capital requirements is based upon the operating cycle concept of working capital. The cycle starts with the purchase of raw material and other resources and ends with the realization of cash from the sale of finished goods. It involves purchase of raw materials and stores, its conversion into stock of finished goods through work-in-process with progressive increment of labour and service costs, conversion of finished stock into sales, debtors and receivables, realization of cash and this cycle continues again from cash to purchase of raw material and so on. The speed/time duration required to complete one cycle determines the requirement of working capital – longer the period of cycle, larger is the requirement of working capital and vice-versa. For proper computation of working capital under this method, a detailed analysis is made for each individual component of working capital.
The following are the general principles of a sound working capital management policy:
(i) Principle of risk variation: Risk refers to the inability of a firm to meet its obligations as and when they become due for payment. Larger investment in current assets with less dependence on short-term borrowings increases liquidity, reduces dependence on short-term borrowings increases liquidity, reduces risk and thereby decreases the opportunity for gain or loss. On the other hand less investment in current assets with greater dependence on short-term borrowings increases risk, reduces liquidity and increases profitability. In other words, there is a definite inverse relationship between the degree of risk and profitability.
(ii) Principle of cost of capital: The various sources of raising working capital finance have different cost of capital and the degree of risk involved. Generally, higher the risk lower is the cost and lower the risk higher is the cost. A sound working capital management should always try to achieve a proper balance between these two.
(iii) Principle of equity position: This principle is concerned with planning the total investment in current assets. According to this principle, the amount of working capital invested in each component should be adequately justified by a firm’s equity position. Every rupee invested in the current assets should contribute to the net worth of the firm.
(iv) Principle of maturity of payment: According to this principle a firm should make every effort to relate maturities of payment to its flow of internally generated funds. There should be least disparity between the maturities of short term debt and flow of funds because greater risk is generated with greater disparity. A margin of safety should however be provided for any short term payments.
13. What is receivables? Discuss the objectives or benefits of maintaining receivables. What are the costs associated with receivables?
Ans: Receivables represent the claims of a firm against its customers and are carried to the assets side of the balance sheet under titles such as account receivables, trade receivables, customer receivables or book debts. The objective of such facility is to allow the customers a reasonable period of time in which they can pay for the goods purchased by them.
Hampton John J. defined receivables as “Receivables are assets accounts, representing amount owned to the firm as a result of the sale of goods or services in the ordinary course of business.”
The main objectives of maintaining receivables are as follows:
(i) Expansion of sales: Customers who are not willing to buy goods on cash basis have to be encouraged with the offer of credit terms. In the absence of such an offer, a firm may not be able to sell the goods at a desired level. Receivables enable it to push it sales effectively in the market.
(ii) Increase in profits: If the level of sales increases, the profit will also increase. This is ordinarily so because the marginal contribution affected by an increase in sales higher than the additional costs associated with such an increase.
(iii) Maintain liquidity: The concept of operating cycle explains that receivables are one step ahead of inventories so, it facilitates to maintain liquidity in the business because it can be easily converted into cash, whenever required.
The maintenance of receivables involves tying up of funds, the main costs associated with receivables are as follows:
(i) Collection cost: These are administrative costs incurred in collecting the receivables from the customers. These include additional expenses on creation and maintenance of a credit department with staff, accounting records, stationery, postage and other related costs.
(ii) Capital cost: The time gap between the date of credit sale and the date of final payment necessitates investment in receivables. Meanwhile, the firm has to arrange additional funds to meet his own obligations. The capital which is used to support credit sales could have been profitably employed elsewhere and therefore it constitutes a part of the cost of extending credit.
(iii) Delinquency cost: This cost arises out of the failure of the customers to meet their obligations when they fall due after the expiry of the period of credit. Such costs are delinquency costs.
The various components of this cost are:
(a) Blocking up of funds for an extended period.
(b) Cost associated with steps that have to be initiated to collect the overdues, such as reminders and other collection efforts. and
(c) Legal expenses if necessary and so on.
(iv) Default cost: There are always some customers from whom money cannot be recovered due to certain reasons, such debts are treated as bad debts and which have to be written off as they cannot be recovered. Such costs are known as default costs associated with receivables.
14. Write short notes on.
(i) Capital gearing.
Ans: The term capital gearing refers to the ratio of debt a company has relative to equities. Capital gearing represents the financial risk of a company. It is also referred to as financial gearing or financial leverage. A company is said to have a high capital gearing if the company has a large debts as compared to its equity. For example, if a company is said to have a capital gearing of 3.0, it means that the company has debt thrice as much as its equity.
Capital gearing means taking decisions regarding the proportion of various types of securities in capital structure. Every company aims at maintaining proper proportion between various types of securities in capital structure so as to reduce its cost of capital. It can be also described as the ratio between the ordinary share capital and fixed interest bearing securities. If the ratio of equity is less than the sum of debt capital and preference shares then the situation is said to be high gearing. Again, if the ratio of equity is more than the sum of debt capital and preference share then the situation is said to be low gearing. Capital gearing ratio is calculated by dividing the sum of equity shares and retained earnings by the sum of debt and preference shares.
(ii) Working capital management and its significance.
Ans: The capital required for a business is of two types. These are fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like building, land, machinery, furniture etc. Fixed capital is invested for long period, therefore it is known as long-term capital. Similarly, the capital, which is needed for investing in current assets, is called working capital. The capital which is needed for the regular operation of business is called working capital. Working capital is also called circulating capital or revolving capital or short-term capital.
Working capital management ensures the best utilisation of a business’s current assets and liabilities for the company’s effective operation. The main aim of managing working capital is to monitor a company’s assets and liabilities to maintain adequate cash flow.
Working is needed for the following purposes or significance of working capital:
(a) To purchase ram materials and spare parts.
(b) To pay day to day operating expenses such as salaries, wages, rent, electricity bill etc.
(c) To avail credit facilities from the supplier on bulk purchase.
(d) To provide credit facility to the customers.
(e) To maintain adequate stock of raw materials, work-in-progress, spares and finished stock.
(f) To meet the selling costs such as advertising, packaging, discounts and rebate to the customers etc.
(iii) Financial forecasting and planning.
Ans: Financial forecasting is the process of using past financial data and current market trends to make educated assumptions for future periods. It is an important part of the business planning process and helps inform decision-making.
Effective forecasting relies on pairing quantitative insight with creative evaluation. Taking what you know and what you believe could happen near term, you can plan for what comes next. Forecasting is the basis of every financial decision your company will make in a given time period. Strong financial forecasting practices tend to lead to better financial outcomes, more stable cash flow, and better access to the credit and investment that can help your business grow.
Forecasting also serves as an important barometer for the overall health of your financial organization. As the fiscal year progresses, having well-documented forecasting can illustrate the effectiveness of current revenue-generating strategies, contextualize current performance, evaluate the market’s effect on your financials, and help identify and correct areas of misalignment.
