Subject: Business Finance - 1

Chapter 8: Working capital management

Chapter No. 8 – Working Capital Management

Contents
♦ Gross and net working capital
♦ Components of working capital
♦ Objectives of working capital management
♦ Operating cycle and turn over
♦ Factors influencing working capital including working capital policy of
the business enterprise
♦ Estimation of working capital and sources of working capital
♦ Brief visit to recommendations of various committees affecting working
capital resources from banks
♦ Cash management
♦ Inventory management
♦ Receivables management
♦ Numerical exercises on:
Estimation of working capital
Cash flow statements
EOQ model and
Receivables management

At the end of the chapter the student will be able to:

♦ Calculate operating cycle in days and value
♦ Estimate the different components of current assets and arrive at
required working capital assistance from external sources
♦ Prepare cash flow statement after understanding the difference
between cash budgeting and cash flow statement
♦ Apply Inventory control techniques like EOQ, ABC analysis, movement
analysis to materials
♦ Appreciate that control of work in process is a technical subject and
control of finished goods is a factor of stocking policy and the nature of
industry
♦ Calculate the inventory carrying costs and receivable carrying costs and
♦ Map the process of bills discounted with banks and compare bills
discounted with factoring of receivables

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What is working capital?

Capital in any business is split into long-term capital and working capital. Working capital is
used for day-to-day operations of the business enterprise and hence the name. It does not
mean that the other capital namely the long-term capital does not work. Working capital has
got two connotations – gross working capital and net working capital.
Gross working capital = Sum total of current assets
Net working capital = Difference between gross working capital and current liabilities.

What are working capital assets? Are there other names for these terms?
Gross working capital is also known as short-term assets or current assets
Current liabilities that finance working capital are also known as short-term liabilities or
working capital liabilities

Current assets are:

Cash
Bank balances
Inventory of materials, work-in-progress, finished goods, components and consumables
Inland short-term receivables
Loans and advances given including advance tax paid
Pre paid expenses
Accrued income
Investments that can be converted into cash

Current liabilities are:

Short-term bank borrowing like overdraft, cash credit, bills discounted and export
finance
Creditors outstanding for materials, components, consumables etc.
Other short-term loans and advances for working capital like Commercial paper, fixed
deposits accepted from public for less than 12 months, inter-corporate deposits etc.
Outstanding expenses or provision for expenses, tax and dividend payable etc.

Objectives of working capital management

Having seen the components of working capital – both assets and liabilities, let us understand
the objectives of working capital management through following examples.

Example no. 1
ABC Enterprises on an average require Rs. 20 lacs in cash (not physical cash but in ready to
draw facility like current account or overdraft account) but have Rs. 30 lacs on an average on a
conservative basis. At the end of the accounting period, the management is upset that its
estimated profits do not materialise although the sales and other parameters are as per the
estimates. What could be one of the reasons for reduced profits?
Obviously excess cash that they are carrying. The excess cash of Rs. 10 lacs suffers what is
known as “opportunity cost”. In this case, it is loss of interest on cash credit or overdraft

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facility. Thus the objective of cash management is to minimise the cost of idle cash but at the
same time not run the risk of little liquidity.

Similar to this is the entire objective of working capital management –

♦ Manage all the components of working capital in an efficient manner so that

♦ We do not run out of cash or materials;
♦ We are able to cut down process time;

♦ Hold optimum level of finished goods and

♦ Collect money from debtors without carrying receivables longer than necessary.
In short manage all the components efficiently. Hence working capital management
has the following components:
♦ Cash management
♦ Inventory management
♦ Creditors management
♦ Bank finance management
♦ Receivables management
♦ Short-term excess liquidity management by investment in short-term securities

Why should current assets be greater in value than current liabilities?

Current assets include receivables that include profit. Further inventory excepting materials,
components that are bought out and consumables would be valued after value addition. For
example, work in progress and finished goods would be higher in value than the materials that
have gone into them; whereas the current liabilities would be at cost and hence less in value
than the value of current assets. Further the value of current assets is always expected to be
higher than the value of current liabilities as the difference represents the net liquidity
available in the business enterprise.
In other words, let us say that current liabilities for a firm are Rs. 100 lacs and the current
assets are Rs. 80 lacs. This means that the net working capital is negative and that the
enterprise does not have any liquidity. This is a very dangerous situation. An examination of
the current assets as above would reveal that all the current assets are not the same in the
context of convertibility into cash. While some of them like inventory of materials,
components, work-in-progress cannot be converted into cash immediately; the debtors
outstanding (unless it happens to be bad debts) could be converted into cash with a little more
ease.
Thus can we differentiate between some current assets and others in the context of liquidity?
Yes. Those assets that can be converted into cash without difficulty are known as “liquid
assets”. They are:
♦ Cash on hand
♦ Receivables (conventional thinking whereas in reality, there could be some percentage of
debtors that cannot be converted into cash easily)
♦ Investments that can be converted into cash immediately like investment in limited
companies whose shares are listed on stock exchanges
♦ Bank balances like current account etc.
Current assets to current liabilities relationship is known as “current ratio”. Current ratio
should always be greater than 1:1

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What is the nature of working capital assets?

Working capital assets are distinct in their characteristic feature from the long-term fixed
assets. Current assets turn over from one from into another and this characteristic trait of
current assets is known as “turn over”. This term is mistaken to mean the value of sales or
operating income in a given period. There should be no doubt in the readers’ minds about the
linkage between the current assets turning over and the value of sales revenue in a given
period. The sales are due to the “turnover” of current assets. This is unlike the fixed assets
that provide the platform for the activity but do not turnover by changing form. The time taken
for cash to be converted back to cash is known as “Operating Cycle” or “Working Capital
Cycle”. Let us examine the following diagrammatic representation to understand this.
Cash Materials

Work in progress or semi-finished goods

Sales
Finished goods
The above cycle is known as “operating cycle” or “working capital cycle”. This can be
expressed in value as well as in number of days.

Example no. 2
Cash to materials = 10 days = “procurement time” or “lead time”
Material to finished goods = 21 days = process time or production time through work-in-
progress stage
Finished goods to sales = 10 days = stocking time
Sales to cash = 30 days = Average collection period (ACP) or this can be nil (in most of the
companies, this would be existent and very rarely this would be “zero”)
The operating cycle in number of days would simply be the sum total of all the components of
the cycle = 71 days.
Suppose there is credit on purchases, what would be its impact on the above?
To the extent credit is available on purchases, the cycle would shorten as due to availability of
material on credit, there would be no lead-time or procurement time or usual procurement
time would reduce to that extent. If we take 10 days as credit period given by suppliers on the
purchases, the operating cycle would be 71 days (-) 10 days = 61 days.

What is the use of this operating cycle?

The cycle indicates the operating efficiency of the enterprise. The higher the number the
better the efficiency. Let us study the following example for understanding this.

Example no. 3
Let us compare two business enterprises with differing operating cycles in number of days.
Unit 1 = 60 days Turnover = 6 times; 360/60 (for sake of convenience the year is taken to
consist of 360 days instead of 365 days)
Unit 2 = 90 days Turnover = 4 times; 360/90

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It is obvious that the turnover of unit 1 is more efficient. This is also referred to as “operating
efficiency index” Formula for operating efficiency index = number of days in a year/no. of days
per working capital cycle.
It should be borne in mind in the above example that the two units under comparison should
be from the same industry and have comparable scale of operations.
Operating cycle in practice
Although we have seen in Example no. 1 how one determines the number of days in a cycle, in
practice the cash portion is neglected and instead credit on purchases is considered. Let us
see the following example to understand this.

Example no. 4
Item in the current assets Number of days Value
of item (Rupees in lacs)
Materials 45 230
Work in progress 21 200
Finished goods 15 180
Receivables or debtors 30 500
Creditors outstanding or credit on 15 76
Purchases
Then the operating cycle in number of days = 45 + 21 + 15 + 30 – 15 = 96 days
Operating cycle in value = 230 + 200 + 180 + 500 – 76 = Rs. 1034 lacs

Is there any difference between operating cycle in value and operating

cycle in terms of funds invested?
Yes. In the above case, the value of operating cycle is Rs. 1034 lacs. However this is not the
same as the amount of funds invested in operating cycle. The difference is the profit on
outstanding debtors. Let us assume that the profit margin is 10%. Hence in the above
example, the profit on Rs. 500 lacs works out to be Rs. 50 lacs. This is return on investment
and not a part of investment. Hence to determine how much of funds have been invested
in current assets, we will have to deduct this amount. After deducting Rs. 50 lacs, the resultant
figure is Rs.984 lacs.
Thus in the given example, the investment in operating cycle is Rs. 984 lacs and the value of
one operating cycle is Rs.1034 lacs.

How is working capital financed in practice?

Example no. 5
Working capital assets = Rs. 200 lacs = Gross working capital
Current liabilities like creditors, outstanding expenses = Rs. 40 lacs
Net working capital = Total current assets (-) Total current liabilities = funds from medium and
long-term = Rs. 60 lacs
Bank finance = Rs. 200 lacs (-) Rs. 40 lacs (-) Rs. 60 lacs = Rs. 100 lacs
Thus current assets in practice are financed by:
♦ Medium and long-term permanent finance called “net working capital”

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♦ Current liabilities other than bank borrowing due to the market position of the enterprise
♦ Finance by commercial banks like cash credit, overdraft and bills discounted

In a business enterprise that is showing continuous incremental sales, what

will be the impact on its working capital requirement?
Example no. 6
Let us say that the working capital requirement for 2001-2002 was Rs. 100 lacs for a sale of
Rs. 300 lacs
Let us assume that the sales are estimated to increase by 30% during 2002-2003. Then it is
very likely that the working capital requirement (i.e., gross working capital) would increase by
30% to Rs. 130 lacs. Under very few circumstances wherein the holding period of materials is
less or process time is less etc. the working capital increase will be less than proportionate to
increase in sales. At times this could be more than proportionate to the increase in sales due
to change in Average Collection Period (average credit period on sales) or circumstances
forcing the unit to hold inventory for a longer time than in the previous year.
Thus very rarely the working capital requirement of a business enterprise gets reduced in
future. So long as the business enterprise is working, the working capital requirement would
only increase. Along with increase in gross working capital, the net working capital would also
increase proportionately. In case this does not happen the current ratio is likely to reduce. We
will examine this example to understand this.

Example no. 7 (Rupees in lacs)

Parameter Year 1 Year 2
Sales 10 13
Gross working capital 2.5 3.25
Net working capital 0.8 0.9 (increase less
than
30%)
Current liabilities other than bank finance 0.50 0.65
(increase 30% -
proportionate)
Eligible bank finance 1.2 1.7
Current ratio 1.47 1.38

Thus the current ratio gets impaired when the incremental sales do not get proportionate
increase in net working capital. There are two more alternatives that could push up the bank
borrowing in the year 2. They are:
Current liabilities other than bank finance reducing or increasing less than proportionately to
incremental sales
Both current liabilities other than bank finance and net working capital are estimated to
increase less than proportionately
The banks financing current assets would be reluctant to accede to the borrower’s request of
reduction in net working capital that affects the current ratio. From the above it is very clear
that any business enterprise has certain minimum working capital at all times. This is called
the “core working capital”. Invariably this is financed by net working capital and rarely by
current liabilities. Thus in most of the business enterprises, core working capital = net working

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capital = permanent working capital = medium and long-term investment in current assets
that only goes on increasing with growth and not reduce.

Are there factors that influence working capital requirement of a business

enterprise?
1. The type of activity that the business enterprise is carrying on:
♦ Manufacturing = maximum investment in current assets
♦ Trading = no investment in material but investment only in finished goods and no
requirement of cash for conversion of materials into finished goods
♦ Service industry = no investment in material or finished goods and hence least
investment in current assets
2. The kind of product that the manufacturing enterprise produces:
♦ Capital goods = requirement of funds especially work-in-process will be high
♦ FMCG = requirement of funds especially in finished goods will be high but overall
inventory held will be less than in the case of capital goods manufacturer
♦ Manufacturer of components or intermediaries = requirement will be in between the
capital goods manufacturer and FMCG
3. Dependence upon imports for materials or components or spares or consumables:

♦ If it is high the lead time 1 will be high and accordingly the amount invested in materials
or components or spares or consumables as the case may be will be high
4. Whether the operations are seasonal or not?
♦ For example a sugarcane crushing industry is a seasonal industry – the material of
sugar cane is not available throughout the year. Hence whenever available stocking in
large quantities is necessary. The same thing is true of a manufacturer producing
edibles that are dependent upon availability of the required agricultural products in the
market.
5. What is the policy of the management towards current assets?
♦ Is it conservative? If it is the management is risk-averse and tends to carry higher
inventory of materials and cash on hand at least. The current ratio tends to be high
with higher dependence on medium and long-term sources for financing current assets
rather than short-term liabilities
♦ If it is aggressive, it is risk taking and tends to carry less inventory of materials and
cash on hand. The current ratio tends to be low with higher dependence on short-term
liabilities for financing current assets
♦ If it moderate, it is between conservative and aggressive and hence investment in
materials and cash on hand is moderate. The current ratio would also be moderate
with balanced dependence on medium and long-term liabilities on one hand and short-
term liabilities on the other hand to finance current assets.
6. The degree of process automation in the industry
♦ If it is more = less investment in work in progress or semi finished goods
♦ If it is less = more investment in work in progress or semi finished goods
7. Government policy in the country

1
Lead time is the time gap between placing the order for materials and its receipt at the factory

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♦ If it allows freely imports just as it is at present in India, imported materials will be

higher in the inventory with consequent higher holding and higher requirement of
working capital funds
8. Who the customers are for the industry?
♦ If the unit supplies more to Government agencies = more outstanding debtors and
hence higher requirement of working capital
9. Whether the unit is in a buyer’s position or seller’s position as a supplier and as a
customer?
♦ If the unit is in the buyer’s position as a supplier = more outstanding debtors due to
higher ACP
♦ If the unit is in the buyer’s position as a customer = longer credit on purchases and
less requirement of working capital
♦ Contrary would be true for the opposite position, i.e., unit is in seller’s position as a
supplier and seller’s position as a customer.
10. The market acceptance for the unit – the credit rating given by suppliers, banks etc. The
better the rating the better the terms of supply or lower the cost of borrowed funds and
hence the requirement of working capital funds would alter
11. Availability of bank finance – freely and on easy terms:
♦ If it is so the enterprise tends to stock more and draw more finance from banks; if it
converse, it will be less bank finance. The same goes for rates of interest on working
capital finance charged by the banks. If it is less – dependence on bank finance would
increase; if it is converse, it would reduce
12. Market conditions and availability of alternative instruments of finance like commercial
paper etc.
♦ Increasingly commercial paper is being adopted as reliable means of short-term
finance. The rates are very competitive. They depend upon the credit rating of the
commercial paper floated by the company. If more and more such instruments of
short-term finance are available, dependence upon bank finance will reduce and one’s
own investment in current assets in the form of net working capital will reduce.
13. Easy availability of materials, components and consumables in the local markets:
♦ If they are freely available then there is no need to stock it and the unit can adopt
what is known as “Just In Time (JIT). Their investment in inventory of materials,
components and consumables would be less

Estimation of working capital requirement for a business enterprise

Factors considered are:
1. What is the desired level of stocks for materials, consumables, components and spares
that the unit should have to ensure that it does not run the risk of suspension of
operations?
2. What is the credit policy on sales? Or Average Collection Period (ACP)
3. What is the period of credit available on purchases?
4. What is the expected increase in production/sales and accordingly what is the expected
increase in stocks etc.?
5. What is the policy of stocking of finished goods?
6. Is the product more customized or standard?

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7. What is the lead-time for materials and dispatch of finished goods – location of the factory
– is it in a backward area or a developed area nearer to the market?
Based on the above factors, the unit estimates the gross working capital and then the level of
net working capital that it is required to bring in as a % of gross working capital. It also
estimates the level of current liabilities other than bank finance that could be available to it
without any difficulty. The balance is the bank finance. Please refer to previous examples for
understanding this.

Are there banking norms for giving bank finance?

Yes. The controlling central banking authority in India namely the Reserve Bank of India (RBI)
through various committees that it had constituted over a period of time, has evolved certain
lending norms for banks for working capital. These have been captured in the following
paragraph in its essence.
1. By and large the banks at present are free to evolve their own norms including the current
ratio and permissible levels of inventory and receivables etc.
2. Tandon Committee had suggested levels of inventory and receivables in the late 1970s
and these have been modified from time to time. These are only recommendations and not
binding on the banks. The levels of inventory and receivables depend upon the industry.
There are more than 25 to 30 industries covered by the modified norms that have evolved
over a period of time. As per this the parameters for holding are:
a. Materials, consumables, stores/spares and bought out components = Average
daily consumption x number of days permitted
b. Work-in-progress or semi-finished goods = Average daily cost of production x
number of days permitted
c. Finished goods = Average daily cost of goods sold x number of days permitted
d. Receivables = Average daily credit sales x number of days permitted
Cost of goods sold = Sales (-) finance expenses (-) direct marketing expenses (-) profit
Cost of production = Direct and indirect production costs (excludes administrative
costs, marketing and finance costs as well as profits)
2. Bill finance – both seller’s bills and purchaser’s bills should be encouraged more in
comparison with funding through overdraft/cash credit. The rate of interest should be at
least 1% less than for overdraft/cash credit facility.
3. Bulk of the finance for borrowers having working capital limits of Rs. 10 crores and above,
the funding should be through loan facility rather than cash credit/overdraft. The amount
of loan should be 85% and cash credit/overdraft cannot be more than 15%
4. Banks can evolve their own lending norms
5. Export finance should be given priority
6. Banks should have statements from the borrower for post-sanction monitoring on a
continuous basis
7. Banks should have credit rating of their borrowers done on a regular basis so as to give
benefit or increase the rates or maintain at the current level the rates of interest on
working capital finances.
The banks by and large lend evolving their own lending norms including minimum current
ratio, extent of finance, minimum credit rating required, prime security, additional security
(collateral security), rate of interest depending upon the credit rating given to the borrower,
preference to bill finance and export finance etc.

Cash management

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Objective – to minimize holding of cash that is at once liquid and unproductive. Conventional
authors have written about various cash management models like Miller-Orr model etc.
However in practice these models are seldom used. The control over cash is more through
cash flow statement or in some cases cash budgeting. This is similar to funds flow statement.
All cash inflow items and cash outflow items are listed out with due bifurcation as shown in the
Annexure to the chapter. Cash budgeting could also be for estimates of income and expenses
whereas cash flow statement is essentially for monitoring available cash at the end of the
period vis-à-vis the actual requirement. On review, this enables to take a suitable decision to
reduce the average requirement of cash or increase it as the case may be.
There could be three alternative positions in respect of cash in an enterprise as under:

Example no. 8 (Rupees in lacs)

Parameter Alternative 1 Alternative 2 Alternative 3
Opening balance 5 5 5
Cash receipts during the period 105 105 105
Cash outgo during the period 100 107 115
Cash surplus during the period 5 (2) (10)
Overall cash position at the end
Of the period 10 3 (5)
In the first, the cash position is surplus during the month getting added to the opening balance
of cash
In the second, the cash position is deficit during the month reducing the opening balance of
cash. The unit is required to draw cash to the extent of average desired holding from bank
overdraft or cash credit.
It is the third one that is alarming or should be sounding warning signal to the business
enterprise. If the trend continues the unit would face liquidity crunch sooner or later – more
chances for “sooner” rather than “later”.
The student should understand that any short-term excess can be invested in short-term
securities provided cost benefit analysis has been done and return on investment in short-term
security is more than the overdraft interest. This is unlikely to be nowadays. If the short-term
surplus represents the profit of the organisation that partially can be committed to investment
in the medium to long-term, this can be done without fear of liquidity problems in future.

What is cash float and what is its impact on cash management?

Cash float has impact on available liquidity in the system. The word “float” means that the
money is in transit, belonging to the customer of the business enterprise or to the bank in case
of drafts purchased and sent outstation. Let us examine the following example.
Example no. 9
A company has outstanding cheques deposited in its current account to the extent of Rs. 13
lacs at any given time. Simultaneously it has Rs. 4 lacs cheques issued by it in favour of its
suppliers outstation but not yet debited to its account. On an average it purchases Rs. 2 lacs
drafts in favour of suppliers towards advance or settlement of bills. What is the average float
outstanding? Is it in its favour? What is the cost of it?
Average float outstanding = Rs. 13 lacs + Rs. 2 lacs (-) Rs. 4 lacs = Rs. 11 lacs
Float is against it as the money to be credited to its account or debited in advance is higher
than the money to be debited

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The cost of outstanding float is the rate of interest on cash credit/overdraft for the entire year
on the average.

How to minimize float against us?

There are a number of cash management products that the present banking system offers that
cash management is not such a serious problem as it used to be. Advanced techniques of cash
management are beyond the scope of this book. Cash management is closely related to
receivable management. Decentralized cash collection system in a business enterprise
having branch networking throughout the country, Electronic Funds Transfer facility etc. have
reduced the criticality of cash management to the business enterprise.

Inventory management
What do you mean by "inventory management"?
In simple terms, it means effective management of all the components of inventory in a
business enterprise with the objective of and resulting in -
Optimum utilization of resources - this will be possible only if the unit carries neither too much
nor too little inventory. There should be just sufficient investment in the inventory so as to
maximize the number of times the inventory turns over in one accounting period and
simultaneously the unit's production or selling is not hampered for want of inventory. This
means striking a balance between carrying larger inventory than necessary (conservative
inventory or working capital policy - too much of "elbow" room) and high risk of stoppage of
activity for want of inventory (aggressive inventory or working capital policy or the practice of
over trading - too little "elbow" room).
Please refer to example above on “operating efficiency”.
Who takes more risk? - A person holding higher inventory or less inventory?
Assuming that the person holding too much inventory has the right mix of inventory that is
needed for his business, carries less risk of stoppage of production or selling but ends up
paying higher cost in carrying higher inventory. On the other hand, the person carrying less
inventory incurs less cost in carrying inventory but runs the risk of stoppage of production of
selling for want of resources. He is perhaps rewarded with higher sales revenue and profits for
the higher risk that he takes, provided that his operations are not hampered for want of
resources. Thus inventory management as a subject offers a classic proof for one of the two
popular maxims in Finance, namely "Risk" and "Return" go together.

What are the specific objectives of inventory management then?

♦ To minimize investment in inventory and to ensure maximum turnover of the inventory
in an accounting period
♦ To ensure stocking of relevant materials in adequate quantities and to ensure that
unwanted or slow-moving/non-moving items do not pile up
♦ To minimize the inventory carrying costs in business - both ordering and carrying costs
♦ To eliminate waste/delay in the process of manufacturing at all stages so as to reduce
inventory pile-up
♦ To ensure adequate/timely supply of finished goods to the market through proper
distribution
Other components of inventory namely work-in-progress and finished goods are not discussed
here, as they require different kind of handling.

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What are the costs associated with inventory?

Ordering costs: Carriage inward
Insurance inward
Salaries of purchase department
Communication cost
Stationery cost
Other administration costs
Demurrage charges

Carrying costs: Salaries of material department

Storage costs including rent, depreciation on fixed assets
Administrative costs of the department
Insurance on stocks
Interest on working capital blocked in inventory including return on
margin money provided by the owners

As mentioned earlier, one of the objectives of inventory management is to minimize the total
costs associated with it, namely ordering costs and carrying costs. The underlying principle
that should be kept in mind while discussing this is that ordering cost and carrying cost are
inversely related to each other. Suppose the ordering cost increases because of more number
of times the order is repeated, a direct consequence would be reduction in inventory held
(average value of inventory held) and hence carrying cost would be less. Conversely if the
number of orders is less, this means that the average value of inventory held is higher with the
consequence of higher inventory carrying costs.
Average inventory could be the average of opening and closing stocks or wherever this
information is not available, this could be half of the size of inventory per order.
Are there tools for effective inventory management?
Yes. The tool depends upon the type of inventory, namely materials, work-in-progress or
finished goods. Let us examine the tools for managing materials.

Tool No. 1: Economic order quantity (EOQ)

This refers to that quantity per order, which ensures that the total of ordering and carrying
costs is the minimum. Above this quantity per order, the ordering costs reduce while carrying
costs increase and below this quantity per order, the converse effect is felt.

The formula is 2xAxO

C
Wherein, A = Annual requirement of a particular
material in units or numbers or
kgs.
O = ordering cost per order
And C = carrying cost per unit or as a % of per unit cost

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Assumptions:
The demand is estimable and it is uniform throughout the period without any seasonal
variation.
The ordering costs do not depend upon the size of the order; they are the same for all orders.
The carrying cost can be determined per unit either in terms of % of the unit's value or in
actual numbers, wherein the total carrying costs in a year is divided by the actual inventory
carried (expressed in number of units)

Tool No. 2 - ABC analysis

Each management has its own way of classifying the items into A, B or C. One of the ways
usually adopted in this behalf is based on the experience that 10% - 15% of the items in
inventory account for 60% to 65% of consumption in value - "A" class items
"B" class - 20% to 25% of the items in inventory accounting for 20% to 25% of the
consumption in value
"C" class - 60% to 65% of the items in inventory accounting for 10% to 15% of the
consumption in value.
Based on this, items of regular consumption ("A" class items) would be ordered regularly and
other items would be progressively less stocked or ordered when you go "B" and then to "C"
items.

Tool No. 3 - Movement analysis

Inventory items are bifurcated into fast moving, moderate moving, slow moving or non-moving
as the case may be. The parameter for this bifurcation depends exclusively on the experience
of the management or materials department in this behalf. This bifurcation leads to better
inventory management by not ordering items in the category of slow moving or non-moving
and reducing the stocks of moderately moving items. Further efforts will also be on to
eliminate non-moving items even at reduced prices so that future inventory carrying costs
would be less.
There are other tools in material management like JIT (Just In Time technique), XYZ analysis
etc.

Receivables management:
Receivables form the bulk of the current assets in most of the business today, as business
firms generally sell goods or services on credit and it takes a little time for the receivables to
realise. Hence “receivables management” forms an important part of working capital
management, as it involves the following:
1. Company’s cash flow very much depends on the timely realisation of receivables, so much
so that the cash inflow assumed in the cash flow statement turns out to be reliable;
2. With any delay in realisation of bills, the likelihood of bad debts increases automatically
and
3. There is a cost associated with the bills or book-debts in the form of following costs:
♦ Receivable carrying cost in the form of interest on bank borrowing against the
receivables as well as on the margin brought in by the promoters;
♦ Administrative costs associated with the maintenance of receivables;

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♦ Costs relating to recovery of receivables and

♦ Defaulting cost due to bad debts.
Hence “receivables management” assumes significance in the context of overall efficient
working capital management.

Steps involved in “receivables management” or “monitoring receivables”:

1. Selective extension of credit to customers instead of uniform credit “across the board” to
all the customers. In fact, there should be a well designed “credit policy” in a company,
which lays down the parameters for “credit decision” on sales. In fact, the company
should have its own credit rating system of all its customers and details of these have
been discussed under “credit evaluation” elsewhere in the note.
2. Availing the services of “Consignment agents” who would take the responsibility of
collection of receivables for payment of a suitable commission. In fact, all the companies
who do not enjoy their own network of sales force or branch offices are effectively
controlling their receivables through this. Of late the consignment agents have started
acting as “factoring service agents” called “factors” who extend collection of receivables
service besides the service of financing.
3. Try to raise bill of exchange on the customers especially for bills with credit period and
route the documents through the banks, so that there is a control over the customers due
to their acceptance on the bill of exchange. Acceptance means commitment to payment
on due dates. Even in the case of bills not involving any credit period, i.e., “sight bills” or
“demand bills”, it should be customary to despatch documents through banks so that
better control can be exercised on the “receivables”.
4. Try and obtain “Advance money” against bank guarantees so that the outstanding comes
down automatically, besides improving the liquidity available with the company.
5. Try for early release of payment by offering “cash discount”. Any decision of this kind
should take into consideration both the cost saved due to interest on bank borrowing and
margin money on one hand and the increase in cost due to the discount. For example, let
us say that the interest on bank borrowing and margin money is 15% p.a. The present
credit period is 30 days and you desire to have immediate payment by offering 1.5% cash
discount. The decision should be taken after comparing the saving of interest due to
immediate payment with the amount of cash discount. At 15% p.a., the interest burden
per month is 1.25%, as against the additional cost of 1.5% cash discount. Hence, cash
discount is costlier.
Note: Here, the matter has been considered only from “finance point of view” and not from
the “liquidity” point of view. All credit decisions are influenced to a great extent by
consideration of “liquidity” also.
6. Proper bifurcation of receivables of the company into different credit periods for which
they have been outstanding from the respective dates of invoices like the following. This is
more from the point of view of control and easy review rather than anything else:
Receivables up to 30 days;
Receivables between 31 days and 60 days;
Receivables between 61 days and 90 days;
Receivables between 91 days and 180 days;
Receivables above 180 days up to 1 year;
Receivables between 1 year and 2 years and so on.
7. Proper and timely follow up with the customers whose bills are outstanding, both by
distant communication as well as personal visits to find out whether the delay is due to any
dissatisfaction of the customer with the quality of the goods and/or services or the after
sales service rendered by the company. This should be done regularly by ensuring that

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the marketing and sales personnel are provided with the statement of outstanding
receivables every month so that the matter can be followed up with the customers during
their periodic visit to them.
8. Once any customer’s profile is available as regards his outstanding bills, any further order
from the same customer should not be processed by the marketing department for
sending it on to the production department for manufacturing, especially in case the
outstanding position of receivables is not satisfactory. Thus at the very first stage, i.e.,
even production of goods for customers who are defaulting would be avoided.
Now let us examine the importance of “Credit policy”.
The credit policy of a company is kind of trade-off between increased credit sales and
increased profits for the company and the cost of having higher amount invested for a longer
period besides the risk of bad debts. The decision to extend credit at all, where there is none
or to increase the credit period for higher sales should weigh the additional benefit of profit
from the increase in sales against the increase in the cost with additional investment that too
for a longer period. This is illustrated in the following examples:

Example No. 10
Existing sale - Rs.20lacs
No credit on sales at present
Proposed selective credit for certain customers – 45 days
Increase in sales due to this – 2.4lacs per year
Earnings before interest to sales – 20%
Cost of funds – 15% both from the bank and on margin
What is the additional profit from the increased sales, in case the earnings before interest and
the cost of funds is maintained, based on the assumption that on the increased sales, the bad
debts is 10%.

Usually, it is advisable to do all calculations on annual basis for proper

understanding and comparison, although in the instant case, it is being done only
on additional sales.
Additional revenue before interest due to increase in sales:
Rs.2.4lacs X 20% = Rs.48,000/-
Additional investment in receivables for the credit period of 45 days, ignoring the profit margin
of 20% before interest.
(80% of 2.4 lacs/365) X 45 days = Rs.23,670/-
Interest at 15% on this = Rs.3,551/-
Loss due to bad debts = Rs.24,000/-
Total cost = Rs.51,221/-

Additional net earnings = 48,000/- (-) 51,221/- = Loss of Rs. 3,221/-

Hence the decision to extend credit only on new sales is not correct.

Example No. 11
Existing sales: Rs.18lacs

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Current credit period: 30days

Earnings before Interest and Tax 25%
Cost of funds: 18%p.a.
Contemplated increase in sales: Rs.2lacs
Contemplated increase in credit period for entire sales: 15 days
Loss due to bad debts due to new sales: 5%
Should the company go in for increased credit period?

Additional earnings before interest and tax due to increase in sales:

2lacs x 25% = Rs.50,000/-
Additional investment in receivables:
1. Additional investment on existing sales, considering the cost at 80%:
15 days x 18lacs/365 x 75% = 55,500/- (rounded off)
2. Additional investment due to new sales:
45 days x 2lacs/365 x 75% = 18,500/- (rounded off)
Total additional investment = Rs.74,000/-
Additional cost at 18% on the above = 74,000/- x 20% = 14,800/-
Cost of bad debt on new additional sales at 5% = 10,000/-
Total additional cost = Rs.24.800/-
Net benefit = Additional earning (-) additional cost as above = 50,000 (-) 24,800/- = 25,200/-.
Hence the credit decision is welcome.
Similar examples could be given even for cash discount in case there is reduction in the overall
credit period due to cash discount with or without resultant increase in sales.
Factors considered before altering credit decision and/or for credit rating
customers:
Utility of the customers to the company, in terms of existing turnover, expected increase in
turnover due to the altered credit period, efforts in promoting new products, helping in
achieving the yearly targets by agreeing to dumping and past track record regarding credit
discipline.
Instruments available for credit rating and credit evaluation:
1. Bank credit reports
2. Reports in the market
3. Credit reports from independent market or credit agencies, especially in the case of
international customers
4. Customers’ published accounts in the case of limited companies.

Questions for practice and reinforcement of learning along with numerical

exercises
1. Discuss at least 4 important factors that determine the quantum of working capital
required for any business with examples.

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2. From the following, determine the operating cycle in number of days and value,
investment per cycle from our side, total current assets, total current liabilities and eligible
bank finance at current ratio of 2:1. (Rupees in lacs)
♦ Raw materials - imported - annual consumption 18 - holding 45 days
♦ Raw materials - indigenous - annual consumption 24 - holding 20 days
♦ Packing materials - annual consumption 4.2 - holding 30 days
♦ Consumable stores and spares - annual consumption 360 - holding 60 days
♦ Work-in-progress - annual cost of production 63 - holding 21 days
♦ Finished goods - annual cost of goods sold 72 - holding 15 days
♦ Inland short-term receivables - gross sales 127.20 - outstanding 2 months
♦ Other current assets - 10% of total current assets
♦ Other current liabilities - 10% of total current liabilities
3. At present you are selling Rs. 2 lacs per month.
♦ The credit period on sales is 30 days.
♦ The % of bad debts is 0.5%.
♦ The bank finance is 70% of outstanding receivables and rate of interest is 15%
p.a.
♦ Your investment should earn 25% (pre-tax).
♦ Your profit margin on sales is 15% - EBIT
♦ You want to double the sales per month. The marketing department
recommends an increase of 20 days in the credit period, as the demand for your
products is quite good. The bank is willing to give you incremental credit on the
same terms as at present. However the percentage of bad debts could go up to
1.5%. on total sales including the additional sales. Your management also wants to
earn 25% (pre-tax) on its additional investment. No change in the EBIT to sales
margin.
♦ Find out the feasibility of the proposal received from the marketing
department. Show all the steps. Do not skip any step.

4. Your company is at present doing Rs.12 lacs sales a year. The credit period is 30 days for
all customers. You draw bank finance to the extent of 70% and the balance is the margin.
Rate of interest is 14% p.a. and the management is expecting a return of 20% on its
investment. The % of EBIT to sales is 18%. You want to expand your market and the
marketing department advises you to increase the credit period by another 30 days. The
promised increase in sales is 20%. There is no incidence of bad debts on new sales as well
as old sales. Examine the issue and advise the management suitably as to whether they
should accept the recommendation and go ahead with increasing the credit period
5. From the following determine the operating cycle in days, value of operating cycle,
investment in current assets and eligible bank borrowing.
Raw materials: 30 days – 10 lacs
Packing materials: 30 days – 3 lacs
Consumable stores and spares: 60 days – 2 lacs
Work-in-progress: 15 days – 7.5 lacs
Finished goods: 30 days - 20 lacs
Receivables: 45 days – Annual sales being Rs.31.20 lacs

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Creditors at 20 days of purchases

Profit margin – 15% on sales
Current ratio – 2:1
There are no other current liabilities
6. From the following find out the EOQ
Annual demand – 1200 units
Cost per order – Rs.150/-
Carrying cost of inventory per unit 12% of the value of Rs.15/- per unit.
The supplier is willing to give quantity discount of 5% (reduction in Rs.15/- per unit)
provided you increase the quantum per order by 25%. If the carrying cost remains the
same in value (not in %) and the annual demand is not changed what is the revised EOQ?
Compare the total costs in both the cases (excluding the cost of material) and advise as to
whether we should go in for quantity discount?
7. From the following construct a cash flow statement in the proper format and offer your
comments if any (all figures in lacs of rupees)
Sales receipts – 10
Disposal of investment – 2.5
Purchase of fixed assets – 9.5
Sale of goods on credit – 8
Long-term loans received – 8
Repayment of loans – 5
Fresh capital brought in by owners - 5
Creditors payment – 4.5
Operating expenses for the period – 3.8
Cash purchases of components, spares etc.– 3
Other income for the period – 1.5
Opening balance for the period – 1.5
Purchase of materials on credit – 4

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