9)WCM NEW DOC (1) (PROJECT)

INTRODUCTION
Conceptof working capital
There are two concepts of working capital:
1. Gross working capital
It refers to the firm’s investment in total current assets or circulating assets.
2. Networking capital (defined in two ways)
(i) It is the excess of current assets over current liabilities.
(ii) It is that portion of a firm’s current assets which is financed by long-term
funds.
NEED FOR WORKING CAPITAL:-
The basic objective of financial management is to maximize shareholders
wealth. This is possible only when the company earns sufficient profit. The amount
of such profit largely depends upon the magnitude of sales.
However, sales do not convert into cash instantaneously. There is always time gap
between the sale of goods and receipt of cash.
Working capital is required for this period in order to sustain the sales activity.
OPERATING CYCLE:-
Types of working capital:-
Can be divided into two categories on the basis of time: -
Cash
Raw
materials
Accounts
Receivable
Finished goods
Work-in-
progress

1. Permanent working capital
2. Temporary or Variable working capital
1. PERMANENTWORKING CAPITAL:-
This refers to that minimum amount of investment in all current assets which
is required at all times to carry out minimum level of business activities. It
represents the current assets required on a continuing basis over the entire year.
The following are the characteristics of this type of working capital:-
1. Amount of permanent working capital remains in the business in one form
or another. This is particularly important from the point of view of
financing. The suppliers of such working capital should not expect its return
during the lifetime of the firm.
2. It also grows with the size of the business.
Permanent working capital is permanently needed for the business and therefore it
should be financed out of long-term funds.
This is the reason why the current ratio has to be substantially more than ‘1’.
2. TEMPORARYOR VARIABLE WORKING CAPITAL:-
The amount of such working capital keeps on fluctuating from time to time
on the basis of business activities.
In other words, it represents additional current assets required at different times
during the operating year.

Temporary
Amount of working permanent
Capital (Rs.)
Time
Temporary
Amount of working permanent
Capital (Rs.)
Time
REASONS FOR ADEQUATE WORKING CAPITAL: -
A firm must have adequate working capital, i.e., as much as needed by the
firm.
It should neither have excessive nor inadequate. Both situations are
dangerous. Excessive working capital means the firm has idle funds, which earn no
profit for the firm. Inadequate working capital means the firm does not have

sufficient funds for running its operations, which ultimately results in production
interruptions, and lowering down the profitability.
It will be interesting to understand the relation between working capital, risk
and return. In a manufacturing concern, it is generally accepted that higher levels
of working capital decrease the risk and decrease the profitability too.
While lower levels of working capital increase the risk but have the potentiality of
increasing the profitability also.
This principle is based on the following assumptions: -
(i) There is direct relationship between risk and profitability --- higher is the risk,
higher is the profitability, while lower is the risk, lower is the profitability.
(ii) Current assets are less profitable than fixed assets.
(iii) Short-term funds are less expensive than long-term funds.
MANAGEMENT OF WORKING CAPITAL:-
Working capital refers to all aspects of the administration of both current
assets and current liabilities.
In other words, working capital management is concerned with the problems that
arise in attempting to manage the current assets, the current liabilities and the
interrelationships that exist between them.
Moreover, different components of working capital are to be properly
balanced in such a way that during one complete production or trade cycle the cash
should be available for purchase of fresh material and for running the business
including operating expenses, after realization of sale proceeds of earlier cycle
without any hurdles.
In the absenceof such situation, the financial position in respectof the firm’s
liquidity may not be satisfactory in spite of satisfactory liquidity ratio.
Working capital management policy has a great effect on firm’s profitability,
liquidity and its structural health.
A finance manager should therefore, chalk out appropriate working capital
management policies in respect of each of the components of working capital so as

to ensure higher profitability, properliquidity and sound structural health of the
organization.
In order to achieve this objective the finance manager has to perform basically
following two functions: -
1) Estimating the amount of working capital.
2) Sources from which these funds have to be raised.
ESTIMATING WORKING CAPITAL REQUIREMENTS: -
In order to determine the amount of working capital needed by a firm, a
number of factors viz. productionpolicies, nature of business, length of
manufacturing process,rapidity of turnover, seasonalfluctuations, etc. are to be
considered by the finance manager.
TECHNIQUES FOR ASSESSMENT OF WORKING CAPITAL REQUIREMENTS: -
1. ESTIMATION OF COMPONENTS OF WORKING CAPITAL METHOD: -
Since working capital is the excess of current assets over current liabilities,
an assessment of the working capital requirements can be made by estimating the
amounts of different constituents of working capital e.g., inventories, accounts
receivable, cash, accounts payable, etc.
2. PERCENT OF SALES APPROACH:-
This is a traditional and simple method of estimating working capital
requirements.
According to this method, on the basis of past experience between sales
and working capital requirements, a ratio can be determined for estimating the
working capital requirements in future.
3. OPERATING CYCLE APPROACH: -
According to this approach, the requirements of working capital depend
upon the operating cycle of the business.

The operating cycle begins with the acquisition of raw materials and ends
with the collection of receivables
It may be broadly classified into the following four stages viz.
1. Raw materials and stores storage stage.
2. Work-in-progress stage.
3. Finished goods inventory stage.
4. Receivables collection stage.
The duration of the operating cycle for the purposeof estimating working
capital requirements is equivalent to the sum of the durations of each of these
stages less the credit period allowed by the suppliers of the firm.
Symbolically the duration of the working capital cycle can be put as follows: -
O=R+W+F+D-C
Where,
O=Duration of operating cycle;
R=Raw materials and stores storage period;
W=Work-in-progress period;
F=Finished stock storage period;
D=Debtors collection period;
C=Creditors payment period.
Each of the components of the operating cycle can be calculated as
follows:-
R= Average stock of raw materials and stores
Average raw materials and stores consumptions per day
W=Average work-in-progress inventory
Average cost of production per day
D=Average book debts

Average credit sales per day
C=Average trade creditors
Average credit purchases per day
After computing the period of one operating cycle, the total number of
operating cycles that can be computed during a year can be computed by dividing
365 days with number of operating days in a cycle. The total expenditure in the
year when year when divided by the number of operating cycles in a year will give
the average amount of the working capital requirement.
SOURCES OF WORKING CAPITAL :-
The working capital requirements should be met both from short-term as
well long-term sources of funds. It will be appropriate to meet at least 2/3rd (if not
the whole) of the permanent working capital requirements from long-term sources
and only for the period needed.
The financing of working capital through short-term sources of funds
has the benefits of lower costand establishing close relationship with the banks.
Financing of working capital from long-term resources provides the following
benefits:
(i) It reduces risk, since the need to repay loans at frequent intervals is
eliminated.
(ii) It increases liquidity since the firm has not to worry about the payment of
these funds in the near future.
APPROACHES FOR DETERMININGTHE FINANCING MIX:-
There are three basic approaches for determining the working capital financing
mix.
(i) THE HEDGING APPRAOCH:-
According to this approach, the maturity of sourceof funds should match the
nature of assets to be financed.
The approachis, therefore, termed as “Matching approach”.
It divides requirements of total working capital funds into two categories.

a) Permanent working capital, i.e., funds required for purchase of core
current assets. Suchfunds do not vary over time.
b) Temporary or seasonal working capital, i.e., funds which fluctuate over
time.
The permanent working capital requirements should be financed by long-
term funds while the seasonal working capital requirements should be
financed out of short-term funds.
(ii) THE CONSERVATIVE APPROACH: -
According to this approachall requirements of funds should be met from
long-term sources.
The short-term sources should be used only for emergency requirements.
The conservative approachis less risky, but more costly as compared to the
hedging approach.
In other words conservative approachis “low profit-low risk” (or high cost,
high net working capital) while hedging approachresults in high profit-high risk
(or low cost, low net working capital).
(iii) TRADE-OFF BETWEEN HEDGING AND CONSERVATIVE
APPROACH: -
The hedging and conservative approaches are both on two extremes.
Neither of them can therefore help in efficient working capital management. A
trade-off between these two can give satisfactory results. The level of such trade-
off will differ from case to case depending upon perception of the risk by the
persons involved in financial decision-making. However, one way of determining
the level of trade-off is by finding the average of the minimum and the maximum
requirements of working capital during a period. The average working capital so
obtained may be financed by long-term funds and the balance by short-term funds.

Managementof different components of working capital
Working capital management involves management of different components
of working capital suchas cash, inventories, accounts receivable, creditors, etc
*MANAGEMENTOF CASH
It is the duty of the finance manager to provide adequate cash to all
segments of the organization. He also has to ensure that no funds are blocked in
idle cash since this will involve costin terms of interest to the business. A sound
cash management scheme, therefore, maintains the balance between the twin
objectives of liquidity and cost.
Meaning of cash
The term “cash”with reference to cash management is used in two senses.
In a narrower sense it includes coins, currency notes, cheques, bank drafts held by
a firm with it and the demand deposits held by it in banks.
In a broader sense it also includes “near-cash assets” such as, marketable securities
and time deposits with banks. Such securities or deposits can immediately be sold
or converted into cash if the circumstances require. The term cash management is
generally used for management of both cash and near-cash assets.
Motives for holding cash
A distinguishing feature of cash as an asset, irrespective of the firm in which
it is held, is that it does not earn any substantial return for the business. In spite of
this fact cash is held by the firm with following motives.
1. Transactionmotive
A firm enters into a variety of business transactions resulting in both inflows
and outflows. In order to meet the business obligation in such a situation, it is
necessary to maintain adequate cash balance. Thus, cash balance is kept by the
firms with the motive of meeting routine business payments.
2. Precautionarymotive
A firm keeps cash balance to meet unexpected cashneeds arising out of
unexpected contingencies such as floods, strikes, presentment of bills for payment
earlier than the expected date, unexpected slowing down of collection of accounts
receivable, sharp increase in prices of raw materials, etc. The more is the

possibility of such contingencies more is the cashkept by the firm for meeting
them.
3. Speculative motive
A firm also keeps cash balance to take advantage of unexpected
opportunities, typically outside the normal courseof the business. Such motive is,
therefore, of purely a speculative nature.
For example,
A firm may like to take advantage of an opportunity of purchasing raw
materials at the reduced price on payment of immediate cashor delay purchase of
raw materials in anticipation of decline in prices.
4. Compensationmotive
Banks provide certain services to their clients free of charge. They,
therefore, usually require clients to keep minimum cash balance with them, which
help them to earn interest and thus compensate them for the free services so
provided.
Business firms normally do not enter into speculative activities and, therefore,
out of the four motives of holding cash balances, the two most important motives
are the compensation motive.
Objectives of cashmanagement
There are two basic objectives of cash management:
1. To meet the cash disbursement needs as per the payment schedule;
2. To minimize the amount locked up as cash balances.
1.Meeting cashdisbursements
The first basic objective of cash management is to meet the payments
Schedule. In other words, the firm should have sufficient cash to meet the various
requirements of the firm at different periods of times. The business has to make
payment for purchase of raw materials, wages, taxes, purchases of plant, etc. The
business activity may come to a grinding halt if the payment schedule is not
maintained. Cash has, therefore, been aptly described as the “oil to lubricate the
ever-turning wheels of the business, without it the process grinds to a stop.”
2.minimizing funds lockedup as cashbalances
The second basic objective of cashmanagement is to minimize the amount
locked up as cash balances. In the process ofminimizing the cash balances, the
finance manager is confronted with two conflicting aspects. A higher cash balance

ensures properpayment with all its advantages. But this will result in a large
balance of cash remaining idle. Low level of cashbalance may result in failure of
the firm to meet the payment schedule.
The finance manager should, therefore, try to have an optimum amount of
cash balance keeping the above facts in view.
Cashmanagement - - - - - basic problems
Cash management involves the following four basic problems:
1. Controlling levels of cash;
2. Controlling inflows of cash;
3. Controlling outflows of cash;
4. Optimum investment of surplus cash.
1. Controlling levels of cash
One of the basic objectives of cash management is to minimize the level of
cash balance with the firm. This objective is sought to be achieved by means of the
following: -
(i) Preparing cashbudget:
Cash budget or cash forecasting is the most significant device for planning
and controlling the use of cash. It involves a projection of future cash receipts and
cash disbursements of the firm over various intervals of time. It reveals to the
finance manager the timings and amount of expected cash inflows and outflows
over a period studied. With this information, he is better able to determine the
future cash needs of the firm, plan for the financing of these needs and exercise
control over the cash and liquidity of the firm.
Thus in case a cash budget is properly prepared it correctly reveals the timings and
size of net cash flows as well as the periods during which the excess cash may be
available for temporary investment. In a small company, the preparation of cash
budget or a cash forecastdoes not involve much of complications and, therefore,
relatively a minor job. However, in caseof big companies, it is almost a full time
job handled by a senior person, namely, the budget controller or the treasurer.
(ii) Providing for unpredictable discrepancies:
Cash budget predicts discrepancies between cash inflows and outflows on
the basis of normal business activities. It does not take into account discrepancies
between cash inflows and cash outflows on account of unforeseen circumstances
such as strikes, short-term recession, floods, etc. a certain minimum amount of
cash balance has, therefore, to be kept for meeting such unforeseen contingencies.

Such amount is fixed on the basis of past experience and some intuition regarding
the future.
(iii) Considerationof short costs:
The term short costrefers to the costincurred as a result of shortage of cash.
Such costs may take any of the following forms:
(a) The failure of the firm to meet its obligations in time may result in legal
action by the firm’s creditors against the firm. This costis in terms of fall in
the firm’s reputation besides financial costs incurred in defending the suit;
(b)Borrowing may have to be resorted to at high rate of interest. The firm may
also be required to pay penalties, etc., to banks for not meeting the
obligations in time.
(iv) Availability of other sources offunds:
A firm can avoid holding unnecessary large balance of cash for
contingencies in caseit has adequate arrangements with its bankers for borrowing
money in times of emergencies. Forsuch arrangements the firm has to pay a
slightly higher rate of interest than that on a long-term debt. But considerable
saving in interest costs will be effected because such interest will have to be paid
only for shorter period.
2. Controlling inflows of cash
Having prepared the cash budget, the finance manager should also ensure
that there is no significant deviation between the projected cash inflows and the
projected cash outflows. This requires controlling of both inflows as well as
outflows of cash.
Speedier collection of cashcan be made possible by adoption of the following
techniques, which have been found to be quite useful and effective.
(i) ConcentrationBanking:
Concentration banking is a system of decentralizing collections of accounts
receivables in case of large firms having their business spread over a large area.
According to this system, a large number of collection centers are established by
the firm in different areas selected on geographical basis. The firm opens its bank
accounts in local banks of different areas where it has its collection centers. The
collection centers are required to collect cheques from their customers and deposits
them in the local bank account. Instructions are given to the local collection centers

to transfer funds over a certain limit daily telegraphically to the bank at the head
office. This facilitates fast movements of funds.
The company’s treasurer on the basis of the daily report received from the
head office bank about the collected funds can use them for disbursement
according to needs.
This system of concentration banking results in the following advantages:
(a) The mailing time is reduced since the collection centers themselves collect
cheques from the customers and immediately deposit them in local bank
accounts. Moreover, when the local collection centre’s are also used to
prepare and send bills to the customers in their areas, the mailing time in
sending bills to the customer is also reduced;
(b)The time required to collect cheques is also reduced since the cheques
deposited in the local bank accounts are usually drawn on banks in that area.
This helps in quicker collection of cash.
(ii) Lock-box system:
Lock-boxsystem is a further step in speeding up collection of cash. In case
of concentration banking cheques are received by collection centre’s who, after
processing, deposit them in the local bank accounts. Thus, there is time gap
between actual receipt of cheques by a collection centre and its actual depositing in
the local bank account.
Lock-boxsystem has been devised to eliminate delay on accountof this
time gap.
According to this system, the firm hires a post-officebox and instructs its
customers to mail their remittances to the box. The firm’s local bank is given the
authority to pick the remittances directly from the post-officebox. The bank picks
up the mail several times a day and deposits the cheques in the firm’s account.
Standing instructions are given to the local bank to transfer funds to the head office
bank when they exceed a particular limit.
The Lock-Box system offers the following advantages:
(a) All remittances are handled by the banks even prior to their de3posits with
them at a very low cost;
(b)The cheques are deposited immediately upon receipt of remittances and the
collecting process starts much earlier than that under the system of
concentration banking.

3.controlover cashflows
An effective control over cash outflows or disbursements also helps a firm in
conserving cashand reducing financial requirements. However, there is a basic
difference between the underlying objective of exercising control over cash
inflows and cash outflows. In case of the former, the objective is the maximum
acceleration of collections while in the caseof latter; it is to slow down the
disbursements as much as possible. The combination of fast collections and slow
disbursements will result in maximum availability of funds.
A firm can advantageously control outflows of cash if the following
considerations are kept in view:
(i) Centralized system of disbursement should be followed as compared
to decentralized system in case of collections. All payments should
be made from a single controlaccount. This will result in delay in
presentment of cheques for payment by parties who are away from
the place of controlaccount.
(ii) Payments should be made on the due dates, neither before nor after.
The firm should neither lose cash discount nor its prestige on
account of delay in payments. In other words, the firm should pay
within the terms offered by the suppliers.
(iii) The firm may use the technique of “playing float” for maximizing
the availability of funds. The term float refers to the period taken
from one stage to another in the cash collection process.
It can be of the following types: -
(i) Billing float:
It refers to the time interval between the making of a
formal invoice by the seller for the goods sold and mailing the invoice
to the purchaser;
(ii) Capital float:
It refers to the time, which elapses between receiving of the
cheque by the postoffice or other messenger from the buyer till it is
actually delivered to the seller.
(iii) Cheque processing float:

It refers to the time required for the seller to sort, record
and depositthe cheque after it has been received by him.
(iv) Bank processing float:
This refers to the time period which elapses between
deposit of the cheque with the banker and final credit of funds by the
banker to the seller’s account.
4.investing surplus cash
(i) Determination of the amount of surplus cash;
(ii) Determination of the channels of investments.
(i) Determining of surplus cash
Surplus cash is the cashin excess of the firm’s normal cashrequirements.
While determining the amount of surplus cash, the finance manager has to take
into accountthe minimum cash balance that the firm must keep to avoid risk or
costof running out of funds. Such minimum level may be termed a “safety level of
cash”.
Determining safety level for cash
The finance manager determines the safety level of cash separately both for
normal periods and peak periods.
In both the cases, he has to decide about the following two basic factors:
(a) Desired days of cash:
It means the number of days for which cashbalance should be sufficient to
cover payments.
(b) Average daily cash outflows:
This means the average amount of disbursements, which will have to be
made daily.
The “desired days of cash” and “average daily cashoutflows” are separately
determined for normal and peak periods. Having determined them, safety level of
cash can be calculated as follows:
During normal periods:

Safety level of cash= Desired days of cash x average daily cash outflows
During peak periods:
Safety level of cash= Desired days of cash at the busiest period x
Average of highest daily cash outflows.
(ii) Determining of channels of investments
The finance manager can determine the amount of surplus cash, by
comparing the actual amount of cash available with the safety or minimum level of
cash. Such surplus may be either of a temporary or a permanent nature.
Temporary cashsurplus consists of funds, which are available for
investment on a short-term basis (maximum 6 months), since they are required
to meet regular obligations such as those of taxes, dividends, etc.
Permanent cashsurplus consists of funds, which are kept by the firm to avail of
some unforeseen profitable opportunity of expansion or acquisition of some asset.
Such funds are, therefore, available for investment for a period ranging from six
months to a year.
Criteria for investment
In most of the companies there are usually no written instructions for
investing the surplus cash. It is left to the discretion and judgment; he usually takes
into consideration the following factors:
(i) Security:
This can be ensured by investing money in securities whose price
remains more or less stable.
(ii) Liquidity:
This can be ensured by investing money in short-term securities including
short-term fixed deposits with bank.
(iii) Yield:
Most corporatemanagers give less emphasis to yield as compared to
security and liquidity of investment. They, therefore, prefer short-term government

securities for investing surplus cash. However, some corporatemanagers follow
aggressive investment policies, which maximize the yield on their investments.
(iv) Maturity:
Surplus cash is available not for an indefinite period. Hence, it will be
advisable to select securities according to their maturities keeping in view the
period for which surplus cash is available. If such selection is done carefully, the
finance manager can maximize the yield as well as maintain the liquidity of
investments.
Cash management models
Several types of cash management models have been recently designed to help in
determining optimum cash balance. These models are interesting and are beginning
to be used in practice.
Two of such models are given below:
1. Baumol model: -
This model was suggested by William J Baumol. It is similar to one used for
determination of economic order quantity.
According to this model, optimum cash level is that level of cash where the
carrying costs and transactions costs are the minimum.
Carrying costs
This refers to the costof holding cash, namely, the interest foregone on
marketable securities. They may also be termed as opportunity costof keeping
cash balance.
Transaction costs
This refers to the costinvolved in getting the marketable securities converted
into cash. This happens when the firm falls short of cash and to sell the securities
resulting in clerical, brokerage, registration and other costs.
There is an inverse relationship between the two costs. When one increases,
the other decreases, the other decreases. Hence, optimum cash level will be at that
point where these two costs are equal.
The formula for determining optimum cash balance can be put as
follows:

C= 2U x P
S
Where,
C = Optimum cash balance
U = Annual (or monthly) cash disbursements
P = Fixed costs per transaction
S = Opportunity cost of one rupee p.a. (p.m)
2. Miller-Orr Model
Baumol model is not suitable in those circumstances when the
demand for cash is not steady and cannot be known in advance.
Miller-Orr model helps in determining the optimum level of cash
in such circumstances. It deals with cash management problem under the
assumption of stochastic or random cash flows by laying down control
limits for cash balances. These limits consist of an upper limit (h), lower
limit (o) and return point (z). When cash balance reaches the upper limit,
a transfer of cash equal to “h-z” is affected to marketable securities.
When it touches the lower limit, a transfer equal to “z-o” from
marketable securities to cash is made. No transaction between cash to
marketable securities and marketable securities to cash is made during
the period when the cash balance stays between the high and low limits.
The model is illustrated in the form of the following chart:

Upper control limit
H
Cash balance
Z Return point
O lower control limit
Time
The above chart shows that when cash balances reaches the upper limit, an
account equal to “h-z” is invested in the marketable securities and cash balance
comes down to “z” level. When cash balance touches the lower limit marketable
securities of the value of “z-o” are sold and the cash balance again goes up to ‘z’
level.
The upper limit and lower limit are set on the basis of opportunity costof
holding cash; degree of likely fluctuation in cash balances and the fixed costs
associated with securities transactions.
*MANAGEMENT OF INVENTORIES
Inventories are good held for eventual sale by a firm. Inventories are thus
one of the major elements, which help the firm in obtaining the desired level of
sales.

Kinds of inventories
Inventories can be classified into three categories.
(i) Raw materials:
These are goods, which have not yet been committed to productionin a
manufacturing firm. They may consistof basic raw materials or finished
components.
(ii) Work-in-progress:
This includes those materials, which have been committed to production
process buthave not yet been completed.
(iii) Finished goods:
These are completed products awaiting sale. They are the final output of the
production process in a manufacturing firm. In case of wholesalers and retailers,
they are generally referred to as merchandise inventory.
The levels of the above three kinds of inventories differ depending upon the nature
of the business.
Benefits of holding inventories
Holding of inventories helps a firm in separating the process of purchasing,
producing and selling. In case a firm does not hold sufficient stock of raw
materials, finished goods, etc., the purchasing would take place only when the firm
receives the order from a customer. It may result in delay in executing the order
because of difficulties in obtaining/ procuring raw materials, finished goods, etc.
thus inventories provide cushion so that the purchasing, productionand sales
functions can proceed at optimum speed.
The specific benefits of holding inventories can be put as follows:
(i) Avoiding losses of sales
If a firm maintains adequate inventories it can avoid losses on account of
losing the customers for non-supply of goods in time.

(ii) Reducing ordering cost
The variable costassociated with individual orders, e.g., typing, checking,
approving and mailing the order, etc., can be reduced if a firm places a few large
orders than numerous small orders.
(iii) Achieving efficient production runs
Maintenance of large inventories helps a firm in reducing the set-up cost
associated with each production run.
Risks and costs associated with inventories
Holding of inventories exposes the firm to a number of risks and costs. Risk
of holding inventories can be put as follows:
(i) Price decline
This may be due to increase in the market supply of the product,
introduction of a new competitive product, price cutting by the competitors, etc.
(ii) Product deterioration
This may due to holding a productfor too long a period or improper storage
conditions.
(iii) Obsolescence
This may be due to change in customers taste, new production technique,
improvements in the productdesign, specifications, etc.
The costs ofholding inventories are as follows:
(i) Materials cost
This includes the cost of purchasing the goods, transportation and handling
charges less any discount allowed by the supplier of the goods.
(ii) Ordering cost
This includes the variable cost associated with placing an order for the
goods. The fewer the orders, the lower will be the ordering costs for the firm.
(iii) Carrying cost
This includes the expenses for storing the goods. It comprises storage costs,
insurance costs, spoilage costs, cost of funds tied up in inventories, etc.

Management of inventory
Inventories often constitute a major element of the total working capital and
hence it has been correctly observed, “Good inventory management is good
financial management”.
Inventory management covers a large number of issues including fixation of
minimum and maximum levels; determining the size of the inventory to be carried;
deciding about the issue price policy; setting up receipt and inspection procedure;
determining the economic order quantity; providing proper storage facilities,
keeping check on obsolescence and setting up effective information system with
regard to the inventories.
However, management inventories involve two basic problems:
(i) Maintaining a sufficiently large size of inventory for efficient and
smooth production and sales operations;
(ii) Maintaining a minimum investment in inventories to minimize
the direct-indirect costs associated with holding inventories to
maximize the profitability.
Inventories should neither be excessive nor inadequate. If inventories are
kept at a high level, higher interest and storage costs would be incurred. On the
other hand, a low level of inventories may result in frequent interruption in the
production schedule resulting in underutilization of capacity and lower sales.
The objective of inventory management is, therefore, to determine and
maintain the optimum level of investment in inventories, which help in achieving
the following objectives:
(i) Ensuring a continuous supply of materials to production
department facilitating uninterrupted production.
(ii) Maintaining sufficient stock of raw material in periods of short
supply.

(iii) Maintaining sufficient stock of finished goods for smooth sales
operations.
(iv) Minimizing the carrying costs.
(v) Keeping investment in inventories at the optimum level.
Techniques of inventory management
Effective inventory requires an effective control over inventories.
Inventory control refers to a system which ensures supply of required quantity and
quality of inventories at the required time and the same time prevent unnecessary
investment in inventories.
The techniques of inventory control/ management are as follows:
1. Determination of Economic Order Quantity (EOQ)
Determination of the quantity for which the order should be placed is one of
the important problems concerned with efficient inventory management. Economic
Order Quantity refers to the size of the order, which gives maximum economy in
purchasing any item of raw material or finished product. It is fixed mainly taking
into account the following costs.
(i) Ordering costs:
It is the cost of placing an order and securing the supplies. It
varies from time to time depending upon the number of orders placed and
the number of items ordered. The more frequently the orders are placed, and
fewer the quantities purchased on each order, the greater will be the ordering
costs and vice versa.
(ii) Inventory carrying cost:
It is the cost of keeping items in stock. It includes interest on
investment, obsolescence losses, store-keeping cost, insurance premium, etc.
The larger the value of inventory, the higher will be the inventory carrying
cost and vice versa.
The former cost may be referred as the “cost of acquiring” whiles the latter
as the “cost of holding” inventory. The cost of acquiring decreases while the cost
of holding increases with every increase in the quantity of purchase lot. A balance

is, therefore, struck between the two opposing factors and the economic ordering
quantity is determined at a level for which aggregate of two costs is the minimum.
Formula:
Q = 2U x P
S
Where,
Q = Economic Ordering Quantity
U = Quantity (units) purchased in a year (month)
P = Cost of placing an order
S = Annual (monthly) cost of storage of one unit.
2. Determination of optimum production quantity
The EOQ model can be extended to production runs to determine the
optimum production quantity.
The two costs involved in this process are:
(i) Set up costs;
(ii) Inventory carrying cost.
The set up costis of the nature of fixed costand is to be incurred at the time of
commencement of each production run. Larger the size of the production run,
lower will be the set-up costper unit.
However, the carrying costwill increase with increase in the size of the
production run.
Thus, there is an inverse relationship between the set-up costand inventory
carrying cost. The optimum production size is at that level where the total of the
set-up costand the inventory carrying costis the minimum.
In other words, at this level the two costs will be equal.
The formula for EOQ can also be used for determining the optimum
production quantity as given below:
E = 2U x P

S
Where
E = Optimum production quantity
U = Annual (monthly) output
P = Set-up costfor each production run
S = Costof carrying inventory per annum (per month)
MANAGEMENT OF ACCOUNTS RECEIVABLES
Accounts receivables (also properly termed as receivables) constitute a
significant portion of the total currents assets of the business next after inventories.
They are direct consequences of “trade credit” which has become an essential
marketing tool in modern business.
When a firm sells goods for cash, payments are received immediately and,
therefore, no receivables are credited. However, when a firm sells goods or
services on credit, the payments are postponed to future dates and receivables are
created. Usually, the credit sales are made on open account, which means that, no,
formal acknowledgements of debt obligations are taken from the buyers. The only
documents evidencing the same are a purchase order, shipping invoice or even a
billing statement. The policy of open account sales facilities business transactions
and reduces to a great extent the paper work required in connection with credit
sales.
Meaning of receivables
Receivables are assets accounts representing amounts owed to the firm as a
result of sale of goods / services in the ordinary course of business.
They, therefore, represent the claims of a firm against its customers and are
carried to the “assets side” of the balance sheet under titles such as accounts
receivables, customer receivables or book debts. They are, as stated earlier, the
result of extension of credit facility to then customers a reasonable period of time
in which they can pay for the goods purchased by them.
Purpose of receivables
Accounts receivables are created because of credited sales. Hence the
purposeof receivables is directly connected with the objectives of making credited
sales.

The objectives of credited sales are as follows:
(i) Achieving growth in sales:
If a firm sells goods on credit, it will generally be in a position to sell more
goods than if it insisted on immediate cash payments. This is because many
customers are either not prepared or not in a position to pay cash when they
purchase the goods. The firm can sell goods to such customers, in case it resorts to
credit sales.
(ii) Increasing profits:
Increase in sales results in higher profits for the firm not only becauseof
increase in the volume of sales but also becauseof the firm charging a higher
margin of profit on credit sales as compared to cash sales.
(iii) Meeting competition:
A firm may have to resort to granting of credit facilities to its customers
because of similar facilities being granted by the competing firms to avoid the loss
of sales from customers who would buy elsewhere if they did not receive the
expected output.
The overall objective of committing funds to accounts receivables is to
generate a large flow of operating revenue and hence profit than what would be
achieved in the absenceof no such commitment.
Costs ofmaintaining receivables
The costs with respectto maintenance of receivables can be identified as
follows:
1. Capitalcosts:
Maintenance of accounts receivables results in blocking of the firm’s
financial resources in them. This is because there is a time lag between the sale of
goods to customers and the payments by them. The firm has; therefore, to arrange
for additional funds to meet its own obligations, such as payment to employees,
suppliers of raw materials, etc., while waiting for payments from its customers.
Additional funds may either be raised from outside or out of profits retained in the
business. In both the cases, the firm incurs a cost. In the former case, the firm has
to pay interest to the outsider while in the latter case; there is an opportunity costto
the firm, i.e., the money which the firm could have earned otherwise by investing
the funds elsewhere.

2. Administrative costs:
The firm has to incur additional administrative costs for maintaining
accounts receivable in the form of salaries to the staff kept for maintaining
accounting records relating to customers, costof conducting investigation
regarding potential credit customers to determine their creditworthiness, etc.
3. Collectioncosts:
The firm has to incur costs for collecting the payments from its credit
customers. Sometimes, additional steps may have to be taken to recover money
from defaulting customers.
4. Defaulting costs:
Sometimes after making all serious efforts to collect money from defaulting
customers, the firm may not be able to recover the over dues because of the of the
inability of the customers. Such debts are treated as bad debts and have to be
written off since they cannot be realized.
Factors affecting the size of receivables
The size of the receivable is determined by a number of factors.
Some of the important factors are as follows:
(1) Level of sales:
This is the most important factor in determining the size of accounts
receivable. Generally in the same industry, a firm having a large volume of sales
will be having a larger level of receivables as compared to a firm with a small
volume of sales.
Sales level can also be used for forecasting change in accounts receivable.
(2) Credited policies:
The term credit policy refers to those decision variables that influence the
amount of trade credit, i.e., the investment in receivables. These variables include
the quantity of trade accounts to be accepted, the length of the credit period to be
extended, the cash discount to be given and any special terms to be offered
depending upon particular circumstances of the firm and the customer. A firm’s
credit policy, as a matter of fact, determines the amount of risk the firm is willing
to undertake in its sales activities. If a firm has a lenient or a relatively liberal
credit policy, it will experience a higher level of receivables as compared to a firm
with a more rigid or stringent credit policy.

This is because of two reasons:
(i) A lenient credit policy encourages even the financially
strong customers to make delays in payments resulting in
increasing the size of the accounts receivables;
(ii) Lenient credit policy will result in greater defaults in
payments by financially weak customers thus resulting in
increasing the size of receivables.
(3) Terms of trade:
The size of the receivables is also affected by terms of trade (or credit terms)
offered by the firm.
The two important components of the credit terms are:
(i) Credit period;
(ii) Cash discount.
(i) Credit period:
The term credit period refers to the time duration for which credit is
extended to the customers. It is generally expressed in terms of “net days”.
For example,
If a firm’s credit terms are “net 15”, it means the customers are expected to
pay within 15 days from the date of credit sale.
(ii) Cash discount:
Most firms offer cash discount to their customers for encouraging them to
pay their dues before the expiry of the credit period. The terms of the cash
discounts indicate the rate of discount as well as the period for which the discount
has been offered.
MANAGEMENT OF ACCOUNTS PAYABLE
Management of accounts payable is as much important as management of
accounts receivable. There is a basic difference between the approaches to be
adopted by the finance manager in the two cases. Whereas the underlying objective
in case of accounts receivable is to maximize the acceleration of the collection
process, the objective in case of accounts payable is to slow down the payments
process as much as possible. But it should be noted that the delay in payment of
accounts payable may result in saving of some interest costs but it can prove very
costly to the firm in the form of loss credit in the market.

The finance manager has, therefore, to ensure that the payments after
obtaining the bestcredit terms possible.
Overtrading and under trading
The concepts ofovertrading and under trading are intimately connected with
the net working capable position of the business. To be more precise they are
connected with the cash position of the business.
OVERTRADING:
Overtrading means an attempt to maintain or expand scale of operations of
the business with insufficient cash resources. Normally, concerns having
overtrading have a high turnover ratio and a low current ratio. In a situation like
this, the company is not in a position to maintain properstocks of materials,
finished goods, etc., and has to depend on the mercy of the suppliers to supply
them goods at the right time. It may also not be able to extend credit to its
customers, besides making delay in payment to the creditors. Overtrading has been
amply described as “over blowing the balloon”. This may, therefore, prove to be
dangerous to the business since disproportionate increase in the operations of the
business without adequate resources may bring its sudden collapse.
Causes ofovertrading
The following may be the causes of over-trading:
(i) Depletion of working capital:
Depletion of working capital ultimately results in depletion of cash
resources. Cash resources of the company may get depleted by premature
repayment of long-term loans, excessive drawings, dividend payments, purchase of
fixed assets and excessive net trading losses, etc.
(ii) Faulty financial policy:
Faulty financial policy can result in shortage of cash and overtrading in
several ways:
(a) Using working capital for purchase of fixed assets.
(b)Attempting to expand the volume of the business without raising the
necessary resources, etc.

(iii) Over-expansion:
In national emergencies like war, natural calamities, etc., a firm may be
required to producegoods on a larger scale. Government may pressurize the
manufacturers to increase the volume of productionwithout providing for adequate
finances. Such pressureresults in over-expansion of the business ignoring the
elementary rules of sound finance.
(iv) Inflation and rising prices:
Inflation and rising prices make renewals and replacements of assets costlier.
The wages and material costs also rise. The manufacturer, therefore, needs more
money even to maintain the existing level of activity.
(v) Excessive taxation:
Heavy taxes result in depletion of cash resources at a scale higher than what
is justified.
The cash position is further strained on account of efforts of the company to
maintain reasonable dividend rates for their shareholders.
Consequencesofovertrading
The consequences ofover-trading can be summarized as follows:
(i) Difficulty in paying wagesand taxes:
This is one of the most dangerous consequences ofovertrading. Non-
payments of wages in time create a feeling of uncertainty, insecurity and
dissatisfaction in all ranks of the labour. Non-payments of taxes in time may result
in bringing down the reputation of the company considerably in the business and
government circles.
(ii) Costly purchases:
The company has to pay more for its purchases on accountof its inability to
have properbargaining, bulk buying and selecting propersourceof supplying
quality materials.
(iii) Reductionin sales:
The company may have to suffer in terms of sales becausethe pressure for
cash requirements may force it to offer liberal cash discounts to debtors for prompt
payments, as well as selling goods at throwaway prices.
(iv) Difficulties in making payments:

The shortage of cash will force the company to persuade its creditors to
extend credit facilities to it. Worry, anxiety and fear will be the management’s
constant companions.
(v) Obsolete plant and machinery:
Shortage of cash will force the company to delay even the necessary repairs
and renewals. Inefficient working, unavoidable breakdowns will have an adverse
effect both on volume of production and rate of profit.
Symptoms and remedies for overtrading
The situation of overtrading should be remedied at the earliest possible
opportunity, i.e., as soon as its first symptoms are visible.
The symptoms can be put as follows:
(a) A higher increase in the amount of creditors as compared to debtors. This is
because of firms inability to pay its creditors in time and exercising of
undue pressure on debtors for payments;
(b)Increased bank borrowing with corresponding increase in inventories;
(c)Purchase of fixed assets out of short-term funds;
(d)A fall in the working capital turnover (working capital/sales) ratio.
(e) A low current ratio and high turnover ratio.
The cure for overtrading is easier to prescribe but difficult to follow. The cure is
simple-reduce the business or increase finance. Both are difficult. However,
arrangement of more finance is better. If this is not possible, the only advisable
course left will be to sell the business as a going concern.
UNDERTRADING:
It is the reverse of overtrading. It means improper and underutilization of
funds lying at the disposal of the undertaking. In such a situation the level of
trading is low as compared to the capital employed in the business. It results in
increase in the size of inventories, book debts and cash balances. Under trading is a
matter of fact an aspect of overcapitalization. The basic cause of under trading is,
therefore, underutilization of the firm’s resources. Such underutilization may be
due any one or more of the following causes:
 Conservative policies followed by the management;

 Non-availability or shortage of basic facilities necessary for
production such as, raw materials, power, labour, etc;
 General depression in the market resulting in fall in the demand of
company’s products;
The symptoms of under trading are the following:
(i) A very high current ratio;
(ii) Low turnover ratios;
(iii) An increase in working capital turnover (working capital/ sales)
ratio.
Consequences of under trading
The following are the consequences of under trading:
(i) The profits of the firm show a declining trend resulting in a lower return on
capital employed (ROI) in the business.
(ii) The value of the shares of the company on the stock exchange starts
falling on account of lower profitability;
(iii) There is loss to the reputation of the firm on account of lower profitability
and creation of impression in the minds of investors that the management is
inefficient.
Remedies for under trading
The condition of under trading is set in because of underutilization of the
firm’s resources. The situation can, therefore, be remedied by the management by
adopting a more dynamic and result-oriented approach. The firm may go for
diversification and undertaking new profitable jobs, projects, etc., resulting in a
better and efficient utilization of the firm’s resources.
FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS
The working capital needs of affirm are influenced by numerous factors.
The important ones are:
Nature of business-Theworking capital requirement of a firm is closely related to
the nature of its business. A service firm, like an electricity undertaking which has short
operating cycle, which sells predominantly on cash basis, has a modest working capital
requirement. On the other hand, a manufacturing concern like a machine tools unit,
which has a long operating cycle and which sells largely on credit, has a very
substantial working capital requirement.

Seasonalityof operations
Firms which have marked seasonality in their operations usually have highly
fluctuating working capital requirements. To illustrate, consider a firm
manufacturing ceiling fans. The sale of ceiling fans reaches a peak during the
summer months and drops sharply during the winter period.
Production policy
A firm marked by pronounced seasonal fluctuation in its sales pursues a
production policy, which may reduce the sharp variations in working capital
requirements.
Marketconditions
The degree of competition prevailing in the market place has an important
bearing on working capital needs. When competition is keen, a larger inventory of
finished goods is required to promptly serve customers who may not be inclined to
wait because other manufacturers are ready to meet there needs.
Conditions of supply
The inventory of raw materials, spares, and stores depends on the conditions
of supply. If the supply is promptand adequate, the firm can manage with small
inventory.
CONCLUSION:-
The study on capital management conducted in to analyze the financial
position of the company. The company’s financial position is analyzed by using
the tool of annual reports.
The financial status of Kansu Group of Companies
is good. In the last year the inventory turnover has increased, this is good sign for
the company. The company’s liquidity position is very good with regard to the
investments in current assets there are adequate funds invested in it. Care should be
taken by the company not to make further investment in current assets, as it would
block the funds, which could otherwise be effectively utilized for some productive
purpose. On the whole, the company is moving forward with excellent
management.

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