WORKING CAPITAL MANAGEMEN

Definition of Working Capital

" Working capital is an excess of current assets over current liabilities. In other words, The amount of current assets which is more than current liabilities is known as Working Capital. If current liabilities are nil then, working capital will equal to current assets. Working capital shows strength of business in short period of time . If a company have some amount in the form of working capital , it means Company have liquid assets, with this money company can face every crises position in market. " Formula of Calculating Working Capital Working Capital = Current Assets - Current Liabilities Current Assets Current assets are those assets which can be converted into cash within One year or less then one year . In current assets, we includes cash, bank, debtors, bill receivables, prepaid expenses, outstanding incomes . Current Liabilities Current Liabilities are those liabilities which can be paid to respective parties within one year or less than one year at their maturity. In current liabilities, we includes creditors, outstanding bills, bank overdraft, bills payable and short term loans, outstanding expenses, advance incomes . Other names of Working Capital Some Professional accountants know working capital as operating capital, operating liquidity, positive working capital. Important things about Working Capital 1. Working Capital can be negative. At that time, We add one word " deficiency" in the back of working capital . It means if Current Liabilities are more than current assets, it is known as working capital deficiency or inverse working capital or negative working capital.

2. Working capital can be easily adjusted, if Accounts manager knows different techniques of managing working capital . He can try to get short term loan or he can increase working capital by proper management of inventory and outstanding incomes and debtors . 3. Working capital can also change by Changing in Cash Conversion period. Cash conversion period is a period in which company changes current assets into cash or bank. 4. Working capital can also positive by increasing growth rate of company. If company does not invest more money and increase profit, the same amount will increase in the cash position of company and with cash company can increase their working capital position. Importance of Working Capital Some time, If creditors demands their money from company, at this time company's high working capital saves company from this situation . You know that selling of current assets are easy in small period of time but Company can not sell their fixed assets with in small period of time. So, If Company have sufficient working capital , Company can easily pay off the creditors and create his reputation in market . But If a company have zero working capital and then company can not pay creditors in emergency time and either company becomes bankrupt or takes loan at higher rate of Interest . In both condition , it is very dangerous and always Company's Account Manager tries to keep some amount of working capital for creating goodwill in market . Positive working capital enables also to pay day to day expenses like wages, salaries, overheads and other operating expenses. Because sufficient working capital can not only pay maturity liabilities but also outstanding liabilities without any more delay. One of advantages of positive working capital that Company can do every risky work without any tension of self security. Introduction of Working Capital Management

Working capital management is the device of finance. It is related to manage of current assets and current liabilities. After learning working capital management, commerce students can use this tool for fund flow analysis. Working capital is very significant for paying day to day expenses and long term liabilities.

Meaning and Concept of Working Capital and its management Working capital is that part of companys capital which is used for purchasing raw material and
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involve in sundry debtors. We all know that current assets are very important for proper working of fixed assets. Suppose, if you have invested your money to purchase machines of company and if you have not any more money to buy raw material, then your machinery will no use for any production without raw material. From this example, you can understand that working capital is very useful for operating any business organization. We can also take one more liquid item of current assets that is cash. If you have not cash in hand, then you can not pay for different expenses of company, and at that time, your many business works may delay for not paying certain expenses. If we define working capital in very simple form, then we can say that working capital is the excess of current assets over current liabilities.

Types of Working Capital 1. Gross working capital Total or gross working capital is that working capital which is used for all the current assets. Total value of current assets will equal to gross working capital. 2. Net Working Capital Net working capital is the excess of current assets over current liabilities. Net Working Capital = Total Current Assets Total Current Liabilities This amount shows that if we deduct total current liabilities from total current assets, then balance amount can be used for repayment of long term debts at any time. 3. Permanent Working Capital Permanent working capital is that amount of capital which must be in cash or current assets for continuing the activities of business. 4. Temporary Working Capital Sometime, it may possible that we have to pay fixed liabilities, at that time we need working capital which is more than permanent working capital, then this excess amount will be temporary working capital. In normal working of business, we dont need such capital. In working capital management, we analyze following three points Ist Point What is the need for working capital? After study the nature of production, we can estimate the need for working capital. If company produces products at large scale and continues producing goods, then company needs high
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amount of working capital. 2nd Point What is optimum level of Working capital in business? Have you achieved the optimum level of working capital which has invested in current assets? Because high amount of working capital will decrease the return on investment and low amount of working capital will increase the risk of business. So, it is very important decision to get optimum level of working capital where both profitability and risk will be balanced. For achieving optimum level of working capital, finance manager should also study the factors which affects the requirement of working capital and different elements of current assets. If he will manage cash, debtor and inventory, then working capital will automatically optimize. 3rd Point What are main Working capital policies of businesses? Policies are the guidelines which are helpful to direct business. Finance manager can also make working capital policies. 1st Working capital policy Liquidity policy Under this policy, finance manager will increase the amount of liquidity for reducing the risk of business. If business has high volume of cash and bank balance, then business can easily pays his dues at maturity. But finance manger should not forget that the excess cash will not produce and earning and return on investment will decrease. So liquidity policy should be optimized. 2nd Working Capital Policy Profitability policy Under this policy, finance manger will keep low amount of cash in business and try to invest maximum amount of cash and bank balance. It will sure that profit of business will increase due to increasing of investment in proper way but risk of business will also increase because liquidity of business will decrease and it can create bankruptcy position of business. So, profitability policy should make after seeing liquidity policy and after this both policies will helpful for proper management of working capital. Operating cycle and cash cycle are two important components of working capital management.

Together they determine the efficiency of a firm regarding working capital management. While the operating cycle is the time period from inventory purchase until the receipt of cash, the cash cycle is the time period from when cash is paid out, to when cash is received. Operating cycle refers to the delay between the buying of raw materials and the receipt of cash from sales proceeds. In other words, operating cycle refers to the number of days taken for the conversion of cash to inventory through the conversion of accounts receivable to cash. It indicates towards the time period for which cash is engaged in inventory and accounts receivable. If an operating cycle is long, then there is lower accessibility to cash for satisfying liabilities for the short term. Operating cycle takes into consideration the following elements: accounts payable, cash, accounts receivable, and inventory replacement. The following formula is used for calculating operating cycle:

Operating cycle = age of inventory + collection period Here,

Age of Inventory (in days) = Inventory/ (Cost of Sales/365) = 365/Inventory Turnover

Collection Period (in days) = Receivables/ (Sales/365) = 365/Receivables Turnover

Cash cycle is also termed as net operating cycle, asset conversion cycle, working capital cycle or cash conversion cycle. Cash cycle is implemented in the financial assessment of a commercial enterprise. The more the figure is increased, the higher is the period for which the cash of a commercial entity is engaged in commercial activities and is inaccessible for other functions, for instance investments.

The cash cycle is interpreted as the number of days between the payment for inputs and getting cash by sales of commodities manufactured from that input. The fundamental formula that is applied for the calculation of cash conversion cycleis as follows:
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Cash cycle = (Average Stockholding Period) + (Average Receivables Processing Period) - (Average Payables Processing Period)

Here

Average Receivables Processing Period (in days) = Accounts Receivable/Average Daily Credit

Sales Average Stockholding Period (in days) = Closing Stock/Average Daily Purchases Average Payable Processing Period (in days) = Accounts Payable/Average Daily Credit Purchases

A short cash cycle reflects sound management of working capital. On the other hand, a long cash cycle denotes that capital is occupied when the commercial entity is expecting its clients to make payments.

There is always a probability that a commercial enterprise can face negative cash conversion cycle, in which case they are getting payments from the clients before any payment is made to the suppliers. Instances of such business entities are commonly those companies, which apply JIT or Just in Time techniques, for example Dell, as well as commercial enterprises, which purchase on terms and conditions of longer duration credits and perform sales against cash, for instance Tesco.

The more the manufacturing procedure is extended, the higher the amount of cash should be kept engaged in inventories by the company. Likewise, the more time is taken for the clients for the purpose of bill payment, the more is the accounts receivable amount. From another viewpoint, if a company is able to detain the payment for its internal inputs, it can decrease the amount of money required. Put differently, the net working capital is diminished by accounts payable. Thus, Operating cycle and cash cycle determine the efficiency of a firm regarding working capital management.

Operating cycle of a business Background to the operating cycle of a business The operating cycle of a business is also known as the "Cash Operating Cycle", the "Cash to Cash Cycle", the "Cash Conversion Cycle" or simply the "Cash Cycle". Business conducts a stream of value-adding activities designed to satisfy customer needs. The key components of this value-adding stream include management's decision making and actions, the equipment and assets that transform raw materials into the finished products and a ready access to cash. Cash is a critical support factor in the value-adding process of businesses. If it is unavailable at critical times then the other factors of production cannot operate and the sustainability of the business is threatened. Cash can be locked-up in assets like inventory and accounts receivables (debtors). This cash cannot be invested in activities that may further enhance the value-adding stream. Excessive amounts of cash lock-up in these assets becomes unproductive and therefore a waste of valuable resources.

Business decision makers wish to monitor the amount of cash that is locked up and out of reach because it impacts on the working capital requirements of the business. The metric that has been developed to do this is the called the Operating Cycle ratio of the business. The Operating Cycle ratio is a metric that expresses the length of time, in days, that it takes for a business to convert resource inputs into cash flows. The Operating Cycle incorporates the amount of time that is needed to sell inventory, the amount of time that is needed to collect account receivables and the length of time the business takes to pay its bills, without incurring penalties.

Having calculated the Operating Cycle for their business, management are able to compare this result with previous periods, industry benchmarks and key competitors to identify potential unproductive cash resources. The Operating cycle will vary from business to business and is dependent on the nature of the business, the type of inventory carried and the credit terms of the business. For example, a takeaway food businesses will have an operating cycle of less than 14 days while construction firms may have an operating cycle of over 12 months. Such is the nature of these industries.
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Define the Operating Cycle of a business The Operating Cycle of a business is the length of time between the cash outflow on purchased material and cash inflow from the sale of goods. The Operating Cycle determines the amount of working capital that a business requires to operate on a day-to-day basis. The shorter the Operating Cycle the lower the amount of working capital required for the business and the greater opportunity for investments in other value-adding activities. The Operating Cycle for a manufacturing based business can involve many stages, namely: 1. Purchase - the receipt of raw materials from suppliers on account. 2. Conversion - the conversion of these raw materials into finished goods 3. Inventory - the holding and storage of raw materials, Work-In-Progress (WIP) and Finished Goods. 4. Payment - the payment of the supplier's account for the raw materials received earlier. 5. Sale - the sale of finished goods to customers on account 6. Collection - the collection of money from these customers in payment of their account Note: A retail business does not need to the conversion phase, it purchases finished goods and so does not have a raw materials and WIP inventory.

The operating cycle

Calculation of Operating Cycle: The relevant financial information for Xavier Limited for the year ended 2005 is given : Sales -500 Cost of goods sold -360 Inventory -60 and 64 Accounts receivable 80 and 88 Accounts payable 40 and 46 What is the length of the operating cycle? The cash cycle? Assume 365 days to a year. Solution: Operating Cycle= Inventory Period + Accounts Receivables Period Inventory Period: Average inventory Annual cost of goods sold / 365 = (60+64) / 2 360 / 365 = 62.86 days Accounts receivables period: Average accounts receivable Annual Sales / 365 = (80+88) / 2 500 / 365 = 61.32 days. WORKING CAPITAL POLICY For a firm, it can exercise a few options/policies when considering the risk return aspect when managing its working capital.
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The following describe the different policies: Working Capital Policy Now what is working capital policy? The working capital policy is basically about how much working capital the company should maintain. Should they go in for a zero-risk arrangement, or can they try a bit of daredevilry in their working capital management? Here are the different working capital policies, their advantages and disadvantages. Matching Working Capital Policy Simple and straightforward, this working capital policy works in an arrangement where the current assets of the business are used perfectly to match the current liabilities. It is a medium risk proposition and requires a good amount of attention. For example, if the creditor is due to be paid 8 months from today, the company will ensure that there is cash to pay the creditor 8 months hence. Today the company may or may not keep the cash on hand. Sounds risky? Yes. Then why would companies opt for this working capital policy? Because, by keeping as little cash, as they can, unemployed and sitting in the banks. They can reinvest it in purchasing more goods, more machinery, which will increase production and, should the sales go according to plan, so will the profit. Hence keeping low levels of working capital means that you can employ your funds more productively elsewhere. Aggressive Working Capital Policy High risk, and often high return, the aggressive working capital policy sees the company keep a really low amount of current assets. The idea here is very simple. Collect payments on time, leaving no debtors and invest that amount in the business. And pay the creditors as late as possible. This means that the business uses very little of its own cash, paying the creditors as late as it possibly can. It is a high risk arrangement though, because, should your creditor come asking for money, and for some reason, you don't have enough money to pay them off, you might end up having to sell a costly asset to pay off your debt to them. Conservative Working Capital Policy And if this above eventuality seems unpalatable to you, perhaps you would be better off opting for the conservative working capital policy. In this policy, you not only match the current assets and the current liabilities, but you also keep a little safety net just in case of any uncertainty. Undoubtedly, this is the lowest risk working capital policy, but it reduces the money used in increasing the production.

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So this was all about which working capital policy to choose. As you can see, working capital policy really depends on your business and risk appetite. (1) MATCHING OR HEDGING APPROACH/POLICY This approach or policy is a moderate policy that matches assets and liabilities to maturities. Basically, a firm uses long term sources to finance fixed assets and permanent current assets and short term financing to finance temporary current assets Simple illustration: A fixed asset/equipment which is expected to provide cash flow for 8 years should be financed by say 8 years long-term debts Assuming a firm needs to have additional inventories for 2 months, it will then sought short term 2 months bank credit to match it. (2) CONSERVATIVE APPROACH/POLICY

Conservative because the firm prefers to have more cash on hands Fixed and part of current assets are financed by long-term or permanent funds As permanent or long-term sources are more expensive, this leads to lower risk lower return Having excess cash at off-peak period hence the need to invest the idle or excess cash to earn returns. (3) AGGRESSIVE APROACH/POLICY The firm want to take high risk where short term funds are used to a very high degree to finance current and even fixed assets.

WORKING CAPITAL CALCULATION

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Working capital is the difference between the current assets or the short term assets that a company holds and the current liabilities or the short term liabilities, which the company has to dispose of. Thus, working capital actually depicts the financial health of the company in a short period. It shows whether a company has enough finances or assets to take care of any short term liabilities that may arise. Calculation of the working capital is done after calculating both the current assets and the current liabilities. In order to understand how to calculate working capital, it is very important to know what all is included while arriving at the current assets and the current liabilities figure. So, let us learn how is working capital calculated, by looking at the current assets and the current liabilities first. Read more on financial management.

How to Calculate Working Capital: Current Assets and Current Liabilities

Assets of a company are of two types, i.e., long term assets and short term assets. Short term assets, also known as current assets, are those which will be either used or sold within one operating cycle, usually one year. Current assets are calculated as the sum total of the cash or cash equivalents, current inventory, accounts receivable as well as marketable securities.

Liabilities of a company are of two types, i.e., long term liabilities and short term liabilities. Short term liabilities, also known as current liabilities are those, debts, obligations and liabilities of a business which have to be settled within one operating cycle, usually one year. Current liabilities are calculated as the sum total of the accrued expenses, accounts payable, part of the long term debt which is accounted as current and notes payable.

How to Calculate Working Capital: Procedure

Working Capital = Current Assets (Cash + Current Inventory + Accounts Receivable + Marketable Securities) (Accrued Expenses + Accounts Payable + Current Debt)

How to Calculate Working Capital: Example

Lets calculate working capital by taking example of a company named YXM Ltd. YXM has cash
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worth $200,000, $20,000 in account receivable, $100000 in securities, and $40,000 in inventory. The same company has $80,000 in accounts payable, $40,000 in current debt and $30,000 in accrued expenses. How will its working capital be calculated?

Current Assets of YXM Ltd. = $200,000 + $20,000 + $100,000 + $40,000 = $360,000

Current Liabilities of YXM Ltd. = $80,000 + $40,000 + $30,000 = $150,000

Thus, Working Capital of YXM Ltd. = $360,000 - $150,000 = $210,000

Suppose, the working capital of YXM Ltd in the previous year is $200,000. Then for change in working capital calculation, working capital of the previous year is subtracted from the working capital of the current year. For YXM Ltd, change in working capital will be $210,000 - $200,000 = $10,000. PROJECTION OF WORKING CAPITAL REQUIREMENTS: DETERMINED LEVEL OF ACTIVITY ESTIMATE RAW MATERIAL COST ESTIMATE LABOUR & OVERHEADS COST WORK-IN- PROGRESS PERIOD FINISHING GOODS PERIOD SUNDRY DEBTORS PERIOD CASH/BANK BALANCE SUNDRY CREDITORS CREDITORS FOR EXPENSES SAFETY MARGIN

FACTORS AFFECTING/DETERMINING WORKING CAPITAL REQUIREMENTS

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NATURE OF BUSINESS PRODUCTION POLICIES PRODUCTION PROCESS SIZE OF PRODUCTION UNIT CONDITION/TERMS OF PURCHASE TURNOVER OF INVENTORIES TURNOVER OF CIRCULATING CAPITAL/WORKING SEASONAL VARIATIONS DIVIDEND POLICIES BUSINESS CYCLE INFLATION CHANGE IN TECHNOLOGY OTHER FACTORS 1. Nature and size of business: The WC requirement of a firm is closely related to the nature of the business. We can say that trading and financial firms have very less investment in fixed assets but require a large sum of money to be invested in WC. On the other hand Retail stores, for example, have to carry large stock of variety of goods little investment in the fixed assets. Also a firm with a large scale of operations will obviously require more WC than the smaller firm. 2. Manufacturing cycle: It starts with the purchase and use of raw materials and completes with the production of finished goods. Longer the manufacturing cycle larger will be the WC requirement; this is seen mostly in the industrial products. 3. Business fluctuation: When there is an upward swing in the economy, sales will increase also the firms investment in inventories and book debts will also increase, thus it will increase the WC requirement of the firm and vice-versa. 4. Production policy: To maintain an efficient level of production the firms may resort to normal production even during the slack season. This will lead to excess production and hence the funds will be blocked in form of inventories for a long time, hence provisions should be made accordingly. Since the cost and risk of maintaining a constant production is high during the slack season some firms may resort to producing various products to solve their capital problems. If
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& SALES

CAPITAL

they do not, then they require high WC. 5. Firms Credit Policy: If the firm has a liberal credit policy its funds will remain blocked for a long time in form of debtors and vice-versa. Normally industrial goods manufacturing will have a liberal credit policy, whereas dealers of consumer goods will a tight credit policy. 6. Availability of Credit: If the firm gets credit on liberal terms it will require less WC since it can always pay its creditors later and vice-versa. 7. Growth and Expansion Activities: It is difficult precisely to determine the relationship between volume of sales and need for WC. The need for WC does not follow the growth but precedes it. Hence, if the firm is planning to increase its business activities, it needs to plan its WC requirements during the growth period. 8. Conditions of Supply of Raw Material: If the supply of RM is scarce the firm may need to stock it in advance and hence need more WC and vice-versa. 9. Profit Margin and Profit Appropriation: A high net profit margin contributes towards the WC pool. Also, tax liability is unavoidable and hence provision for its payment must be made in the WC plan, otherwise it may impose a strain on the WC. Also if the firms policy is to retain the profits it will increase their WC, and if they decide to pay their dividends it will weaken their WC position, as the cash will flow out. However this can be avoided by declaring bonus shares out of past profits. This will help the firm to maintain a good image and also not part with the money immediately, thus not affecting the WC position. 10.Depreciation policy of the firm, through its effect on tax liability and retained earning, has an influence on the WC. The firm may charge a high rate of depreciation, which will reduce the tax payable and also retain more cash, as the cash does not flow out. If the dividend policy is linked with net profits, the firm can pay fewer dividends by providing more depreciation. Thus depreciation is an indirect way of retaining profits and preserving the firms WC position.

Cash management The Basic objective in Cash management is to keep the investment in cash as low as possible, while still operating the firm's activities efficiently and effectively.
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There are 3 steps involving cash management 1. 2. 3. Determining the appropriate target cash balance Collecting and disbursing cash efficiently Investing excess cash in marketable securities

What is exactly is cash? Financial Managers include short-term marketable securities, "cash equivalents" T-Bills, CDs and repurchase agreements (Net working capital)....as such this is much more interesting, but given that the cash as money also has to be examined (however briefly) we will also look at the Economic definition includes currency, checking account deposits, and undeposited checks Why hold cash? Introduction Cash is the most liquid asset. It is the most important for the daily operation of the firm. Efficient Management of the cash is very crucial for solvency of the firm. Hence, it is considered as life flood of business organization. MOTIVES FOR HOLDING CASH There are 3 important motives for holding cash: TRANSACTION MOTIVES Business organization needs cash for conducting business transaction. The collection of cash is not perfectly matched with payments of cash. Hence some cash balance is required to be maintained. PRECAUTIONARY MOTIVE There may be uncertainties regarding receipt of cash and payment of cash. In order to protect against such uncertainties, it is necessary to maintain some cash balance.

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SPECULATIVE MOTIVE Business organization would like to tap business opportunities arising from fluctuations from commodity prices, shares prices, foreign exchange rates etc. A firm which has sufficient cash can exploit opportunities. Determining the Target Cash Balance In order to determine the target cash balance the firm must do cost-benefit analysis of holding cash. The target cash balance involves trade off between the opportunity costs of holding too much cash and the trading costs of holding too little\ Managing the collection and disbursement of cash Float: is the difference between bank cash and book cash, represents the net effect of checks in the process of collection. Float management involves controlling the collection and disbursement of cash, the objective in cash collection is to reduce the lag between time customer pays and the time checks clear., the objective of cash disbursement is to slow down payments, increase time when checks are written, and received; in other words collect early, pay late. Types of Float 1. 2. 3. Mail Float- when checks are trapped in the postal system In-House Processing Float- time it takes for the receiver to process the check for deposit Availability Float- time is takes for the check to clear in the bank

Accelerating Collection 1. Lockbox: special post office box set up to intercept accounts receivable payments 2.Concentration banking: checks are deposited into local bank, by sales office, surplus funds are
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transferred from the deposit bank, to the concentration bank, bank clearing time is reduced because most customer's checks are drawn on local bank rather than the concentration bank. 3. Wire transfers: electronic transfer over computer Delaying Disbursement how to...(note I am not suggesting you do these, as some are stretching the rules a bit) 1. 2. 3. 4. 5. Write Check on distant bank Hold payment for several days after postmarked in office Call supplier to verify statement accuracy for large amounts Mail from distant post office Mail from post office that requires a great deal of handling

6. Playing "games" with Disbursement Float, Zero Balance Accounts, Drafts- these are all other ways to delay the disbursement of funds, cash managers must be careful because if they are drawing on uncollected funds many ethical and legal questions will be raised... Investing Idle Cash--you do not want to have cash just sitting there! Money market is the market for short term financial assets. Sweep accounts- this is when the bank will take all excess $$ at the end of the business day and will invest it for a firm Firms may have temporary cash surpluses for the following reasons 1. 2. 3. To help finance seasonal for cyclical activity To help finance planned expenditures To provide for unanticipated contingencies

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Baumol model of cash management

Baumol model of cash management helps in determining a firm's optimum cash balance under certainty. It is extensively used and highly useful for the purpose of cash management. As per the model, cash and inventory management problems are one and the same.

William J. Baumol developed a model (The transactions Demand for Cash: An Inventory Theoretic Approach) which is usually used in Inventory management & cash management. Baumol model of cash management trades off between opportunity cost or carrying cost or holding cost & the transaction cost. As such firm attempts to minimize the sum of the holding cash & the cost of converting marketable securities to cash.

Relevance At present many companies make an effort to reduce the costs incurred by owning cash. They also strive to spend less money on changing marketable securities to cash. The Baumol model of cash management is useful in this regard.

Use of Baumol Model The Baumol model enables companies to find out their desirable level of cash balance under certainty. The Baumol model of cash management theory relies on the trade off between the liquidity provided by holding money (the ability to carry out transactions) and the interest foregone by holding one's assets in the form of non-interest bearing money. The key variables of the demand for money are then the nominal interest rate, the level of real income which corresponds to the amount of desired transactions and to a fixed cost of transferring one's wealth between liquid money and interest bearing assets.

Assumptions There are certain assumptions or ideas that are critical with respect to the Baumol model of cash management:

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The particular company should be able to change the securities that they own into cash, keeping the cost of transaction the same. Under normal circumstances, all such deals have variable costs and fixed costs. The company is capable of predicting its cash necessities. They should be able to do this with a level of certainty. The company should also get a fixed amount of money. They should be getting this money at regular intervals. The company is aware of the opportunity cost required for holding cash. It should stay the same for a considerable length of time. The company should be making its cash payments at a consistent rate over a certain period of time. In other words, the rate of cash outflow should be regular. Equational Representations in Baumol Model of Cash Management: Holding Cost = k(C/2) Transaction Cost = c(T/C) Total Cost = k(C/2) + c(T/C) Where T is the total fund requirement, C is the cash balance, k is the opportunity cost & c is the cost per transaction.

Limitations of the Baumol model: 1.It does not allow cash flows to fluctuate. 2. Overdraft is not considered. 3. There are uncertainties in the pattern of future cash flows.

Miller and Orr Model of Cash Management

The Miller and Orr model of cash management is one of the various cash management models in operation. It is an important cash management model as well. It helps the present day companies to manage their cash while taking into consideration the fluctuations in daily cash flow.

Description of the Miller and Orr Model of Cash Management

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As per the Miller and Orr model of cash management the companies let their cash balance move within two limits - the upper limit and the lower limit. The companies buy or sell the marketable securities only if the cash balance is equal to any one of these.

When the cash balances of a company touches the upper limit it purchases a certain number of salable securities that helps them to come back to the desired level. If the cash balance of the company reaches the lower level then the company trades its salable securities and gathers enough cash to fix the problem.

It is normally assumed in such cases that the average value of the distribution of net cash flows is zero. It is also understood that the distribution of net cash flows has a standard deviation. The Miller and Orr model of cash management also assumes that distribution of cash flows is normal.

Application of Miller and Orr Model of Cash Management

The Miller and Orr model of cash management is widely used by most business entities. However, in order for it applied properly the financial managers need to make sure that the following procedures are followed: Finding out the approximate prices at which the salable securities could be sold or bought Deciding the minimum possible levels of desired cash balance Checking the rate of interest Calculating the SD (Standard Deviation) of regular cash flows

Cash Budget

What Does Cash Budget Mean? An estimation of the cash inflows and outflows for a business or individual for a specific period
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of time. Cash budgets are often used to assess whether the entity has sufficient cash to fulfill regular operations and/or whether too much cash is being left in unproductive capacities. A cash budget is extremely important, especially for small businesses, because it allows a company to determine how much credit it can extend to customers before it begins to have liquidity problems.

For individuals, creating a cash budget is a good method for determining where their cash is regularly being spent. This awareness can be beneficial because knowing the value of certain expenditures can yield opportunities for additional savings by cutting unnecessary costs.

For example, without setting a cash budget, spending a dollar a day on a cup of coffee seems fairly unimpressive. However, upon setting a cash budget to account for regular annual cash expenditures, this seemingly small daily expenditure comes out to an annual total of $365, which may be better spent on other things. If you frequently visit specialty coffee shops, your annual expenditure will be substantially more. Cash budget is an important tool in the hands of financial management for the planning and control of the working capital to ensure the solvency of the firm.

The importance of cash budget may be summarised as follow:-

(1) Helpful in Planning. Cash budget helps planning for the most efficient use of cash. It points out cash surplus, or deficiency at selected point of time and enables the management to arrange for the deficiency before time or to plan for investing the surplus money as profitable as possible without any threat to the liquidity.

(2) Forecasting the Future needs. Cash budget forecasts the future needs of funds, its time and the amount well in advance. It, thus, helps planning for raising the funds through the most profitable sources at reasonable terms and costs.

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(3) Maintenance of Ample cash Balance. Cash is the basis of liquidity of the enterprise. Cash budget helps in maintaining the liquidity. It suggests adequate cash balance for expected requirements and a fair margin for the contingencies.

(4) Controlling Cash Expenditure. Cash budget acts as a controlling device. The expenses of various departments in the firm can best be controlled so as not to exceed the budgeted limit.

(5) Evaluation of Performance. Cash budget acts as a standard for evaluating the financial performance.

(6) Testing the Influence of proposed Expansion Programme. Cash budget forecasts the inflows from a proposed expansion or investment programme and testify its impact on cash position.

(7) Sound Dividend Policy. Cash budget plans for cash dividend to shareholders, consistent with the liquid position of the firm. It helps in following a sound consistent dividend policy.

(8) Basis of Long-term Planning and Co-ordination. Cash budget helps in co-ordinating the various finance functions, such as sales, credit, investment, working capital etc. it is an important basis of long term financial planning and helpful in the study of long term financing with respect to probable amount, timing, forms of security and methods of repayment.

Methods of Preparing Cash Budget There are three usual methods of preparing cash budget as follows-

(1) Receipts and Payments Method (2) Adjusted Profit and Loss Method or Adjusted Earnings Method or Cash Flow Method.

(3) Balance-Sheet Method.

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The above methods of preparing cash budget represent different approaches. Receipts and Payments Method It is the most simple and popular method of preparing cash budget. The method is most commonly used in forecasting the sort term cash position.

It is just like receipts and payment method in technique. It shows yearly cash position with proper breakups by quarters and months. For the purpose of preparing cash budget under this method, cash informations are collected from other budgets such as sales budget, salary and wages budget, overhead budgets, material budget etc.

Under this method cash budget is divided into two parts. One part shows the timing and the amount of cash receipts and other part shows the timing and the amount of cash disbursements. Cash receipts and cash disbursements are estimated as under:-

(a) Cash receipts arising form Operations. It includes advances form customers, estimated cash receipts from sales, debtors and collection of bills receivables. In estimating the amount of cash sales, cash-discount policy of the firm should be taken into account. Forecasting the receipts from credit sales, i.e., receipts from customers, B/R etc. Credit policy, terms of sales, position of customers, customers of the trade, an time lag between sale and collection should be considered.

(b) Non-operating Cash Receipts. It includes revenue receipts of non-operating nature and includes receipts from interest, dividend, rent, commission, royalty, sale of scrap, refund of tax etc.

(ii) Estimation of Cash Disbursements. The amount of cash disbursement can be estimated from the following items:-

(a) disbursement for operations Such as disbursements for cash purchases, wages and overheads,

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payment to creditors, bonus and other remunerations such as gratuities, pensions etc. and advances to suppliers. Terms of purchases, discounts receivable and time lag between the time of purchase and payment are taken into consideration.

(b) Disbursement for non-operating functions. It includes financial expenses on non operative functions such as interest, rent, dividend, donations, income tax and other taxes etc.

(c) Disbursement for capital transactions. Such as expenditure for expansion, payment of loans and overdrafts, redemption of debentures and preference capital etc.

In preparing cash budget, total budgeted cash receipts re added to the opening balance of cash and then the total budgeted disbursements are deducted therefrom to know the closing balance of cash. If opening cash balance and estimated total cash receipts are much larger than the estimated payments, there will be cash balance at close and management should take the necessary steps, to invest surplus funds for short period. On the other hand, if there is cash shortage, the manage mt must plan the borrowings for short period to manage the deficiency. Adjusted profit and Loss Method The method is suitable for preparing the long term estimates of cash inflows and outflows. It is also called cash-flow statement.

Under this method, profit and loss account is adjusted to know the cash estimates. This method is useful in budgetary control technique.

Under this method, closing cash balance can be known by adding profits for the period to the opening cash balance because the theory is based on the elementary assumption that profits of a business are equal to cash. Thus if we assume that there are no credit transactions, capital transactions, accruals, provisions, stock fluctuations, or appropriations of profit, the balance of profit as shown by the profit and loss account should b equal to the cash balance in the case
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book. However, such a situation will never exist in actual practice, the assumption needs adjustments. In preparing the cash forecasts, one proceeds with the budgeted profit for the period and then adjusts this figure by the items mentioned below-

Items to be Added-

(i) All non-cash items shown in the debit side of profit and loss account should be added to the budgeted profit because these items do not involve any cash outflows-depreciation, deferred revenue expenditure, writing off of intangible assets, prepaid expenses etc.

(ii) Changes in working capital which results in inflow of cash balances such as increase in closing stock, debtors and decrease in sundry creditors and other liabilities, redemption of preference shares and debentures, payment of dividend, purchase capital assets, investment etc. RECEIVABLES MANAGEMENT INTRODUCTION: A sound managerial control requires proper management of liquid assets and inventory. These assets are a part of the business. An efficient use of financial resources is necessary to avoid financial distress. Receivables result from credit sales. a concern is required to allow credit sales in order to expand its sales volume . it is not always possible to sell goods on cash basis only . Sometimes, other concerns in that line might have established a practice of selling goods on credit basis. Under these circumstances, it is not possible to avoid credit sales without adversely affecting sales. The increase in sales is also essential to increase profitability. After a certain level of sales the increase in sales will not proportionately increase production costs. The increase in sales will bring in more profits

Thus, receivables constitute a significant portion of current assets of a firm. But, for investment in receivables, a firm. Affirm has to incur certain costs. Further, there is a risk of bad debts also. it is, therefore, very necessary to have a proper control and management of receivables .

MEANING OF RECEIVABLES:

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Receivables represent amounts owed to the firm as a result of sales of sale of goods or services in the ordinary course of business. These are claims of the firm against its customers and form part of its current assets. Receivables are also known as accounts receivables, trade receivables, customer receivables or book debts. The receivables are carried for the customers. The period of credit and extent of receivables depends upon the credit policy followed by the firm. The purpose of maintaining or investing in receivables is to meet competition, and to increase the sales and profits.

COSTS OF MAINTAINING RECEIVABLES: The allowing of credit to customers means giving of funds for the customers use. The concern incurs the following cost on maintaining receivables:

1. COST OF FINANCING RECEIVABLES: When goods and services are provided on credit then concerns capital is allowed to be used by the customers. The receivables are financed from the funds supplied by shareholders for long term financing and through retained earnings. The concern incurs some cost for collecting funds which finance receivables. 2. COST OF COLLECTION: A proper collection of receivables is essential for receivables management; the customers who do not pay the money during a stipulated credit period are sent remainders for early payments. Some persons may have to be sent for collecting these amounts. In some cases legal recourse may have to be taken for collecting receivables. All these costs are known as collection costs which a concern is efficient collection machinery but one cannot altogether rule out this cost. 3. BAD DEBTS: Some customers may fail to pay the amounts due towards them. The amounts which the customers fail to pay are known as bad debts. Though a concern may be able to reduce bad debts through efficient collection machinery but one cannot altogether rule out this cost.

FACTORS INFLUENCING THE SIZE OF RECEIVABLES: Besides sales, a number of other factors also influence the size of receivables. The following factors directly and indirectly affect the size of receivables.

1. SIZE OF CREDIT SALES: the volume of credit sales is the first factor which increases s or decreases the size of receivables. if a concern sells only on cash basis , as in the case of Bata shoe company , then there will be no receivables . the higher the part of credit sales out of total sales, figures of receivables will also be no more or vice versa .

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2. CREDIT POLICIES: A firm with conservative credit policy will have a low size of receivables while a firm with liberal credit policy will be increasing this figure. The vigor with which the concern collects the receivables will remain under control. In case receivables remain outstanding for a longer period, there is always a possibility of bad debts. 3. TERMS OF TRADE: the size of receivables also depends upon terms of trade. The period of credit allowed and rates of discount given are linked with the receivables. If credit period allowed is more than receivables will also be more. Sometimes trade policies of competitors have to be followed otherwise it becomes difficult to expand the sales. The trade terms once cannot be changed without adversely affecting sales opportunities. 4. EXPANSION PLANS: when a concern wants to expands its activities, it will have to enter new markets. To attract customers, it will give incentives in the form of credit facilities. The periods of credit can be reduced when the firm is able to get permanent customers. In the early stages of expansion more credit becomes essential and size of receivables will be more. 5. RELATION WITH PROFITS: the credit policy is followed with a view to increase sales. When sales increase beyond a certain level the additional costs incurred are less than the increase in revenues. It will be beneficial to increase to increase sales beyond a point because it will bring more profits. The increase in profits will be followed by an increase in the size of receivables or viceversa. 6. CREDIT COLLECTION EFFORTS: the collection of credit should be streamlined. The customer should be sent periodical remainders if they fail to pay in time. On the other hand, if adequate attention is not paid towards credit collection then the concern can land itself in a serious financial problem. Efficient credit collection machinery will reduce the size of receivables. If these efforts are slower then outstanding amounts will be more. 7. HABITS OF CUSTOMERS: the paying habits of customers also have a bearing on the size of receivables the customers may be in the habit of delaying payments even though they are financially sound. The concern should remain in touch with such customers and should make them realize the urgency of their needs. FORECASTING THE RECEIVABLES: A concern should be clear about its credit policies how much will be the size of receivables on the basis of present policies? This is an important estimation which wills the concern in planning its working capital. Though it is not possible to forecast exact receivables in the future but some estimation is possible on the basis of past experience, present credit policies and policies perused by other concerns. The following factors will help in forecasting receivables. 1. CREDIT PERIOD ALLOWED: Aging of receivables is helpful in forecasting .the longer amounts remain due, the higher will be the size of receivables .the increase in receivables will result in more profits as well as higher costs too. The collection expenses and bad debts will also be more. if credit period is less than the size of receivables will also be less

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2. EFFECT OF COST OF GOODS SOLD: Sometimes an increase in sales results in decrease in cost of goods sold. If this is so then sales should be increased to that extent where costs are low. The increase in sales will also increase the amount of receivables. The estimate for sales will enable the estimation of receivables too. This can be explained with the help of an example; supposing cost of sales is 60% of the total sales when sales are rs20lacs. If sales are increased to rs25lacs the cost of sales goes down to 55% of sales .the concern should raise its sales to rs25 lacks so that it may be able to earn more profits .the increase in sales may increase the cost of sale to the same old percentage. Under these circumstances it will not be wise to increase sales beyond rs25lacs .the receivables will be forecasted when sales figures are estimates. 3. FORECASTING EXPENSES: the receivables are associated with a number of expenses .these expenses are administrative expenses on collection of amounts, cost of funds tied down in receivables, bad debts, etc. at the same time the increase in receivables will bring in more profits by increasing sales .if the costs of receivables are more than the increase in income, for the credit sales should not be allowed. On the other hand, if revenue earned by the increase in sales is more than the costs of receivables, then sales should be expanded. 4. FORECASTING AVERAGE COLLECTION PERIOD AND DISCOUNTS: the credit collection policies will spell out the time allowed for making payments and the time allowed for availing discounts. If the average collection period is more than the size of receivables will be more . average collection period is calculated as follows: AVERAGECOLLECTIONPERIOD=TRADEDEBTORS*NO.OFWORKINGDAYS/NE TSALES. The concern should try to keep average collection period under control .the number of customers availing discounts should also be determined. if 30% of the customers are not availing discount facility, it means the payments by 30% customers are over due. Average collection period and discount allowed will also be help full in forecasting the size of receivables. 5. AVERAGE SIZE OF RECEIVABLES: The determination of average size of receivables will also be helpful in forecasting receivables. Average size of receivables is calculated as: AVERAGE SIZE RECEIVABLES=ESTIMATED ANNUAL SALES *AVERAGE COLLECTION PERIOD

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MEANING AND OBJECTIVES OF RECEIVABLES MANAGEMENT: Receivables management is the process of making decisions relating to investment to trade debtors. We have already stated that certain investment in receivables is necessary to increase and profits of a firm. But at the same time investment in this asset involves cost consideration also. Further, there is always a risk of bad debts too. Thus, the objectives of receivables management a sound decision as records investments in debts. In the words of BOLTON, S.E., the objective of receivables management is to promote sales and profits until that pint is reached where the return on investment in further funding of receivables is less than the cost of funds raised to finance that additional credit. DIMENSIONS OF RECEIVABLES MANAGEMENT: Receivables management involves the careful consideration of the following aspects: 1. forming of credit policy 2. executing the credit policy 3. formulating and executing collection policy FORMING OF CREDIT POLICY: For efficient management of receivables, a concern must adopt a credit policy. A credit policy is related to decisions such as credit standards, length of credit period, cash discount and discount period, etc. QUALITY OF TRADE ACCOUNTS OR CREDIT STANDARDS: the volume of sales will be influenced by the credit policy of a concern. By liberalizing credit policy the volume of sales can be increased resulting into increased profits. The increased volume of sales is associated with certain risks too. It will result in the clerical work of maintaining the additional accou7nts and collecting of information about the credit worthiness of customers. There may be more bad debt losses due to extension of credit to less worthy customers. These customers may also take more time than normally allowed in making the payments resulting into tying up of additional capital in receivables. On the other hand, extended credit to only credit worthy customers will save costs like bad debt losses, collection costs, investigation costs, etc. the restriction of credit to such customers only will certainly reduce sales volume, thus resulting in reduced profits. A finance manager has to match the increased revenue with additional costs. The credit should be liberalized only to the level where incremental revenue matches the additional costs. The quality of trade accounts should be decided so that credit facilities are extended only up to that level. The optimum level of investment in receivables should be where there is a tradeoff between the costs and profitability. The increased investment in receivables also adversely affects liquidity of a firm. On the other hand, a tight credit policy increases the liquidity of the

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firm. Thus, optimum level of investment in receivables is achieved at a point where there is a tradeoff between cost, profitability and liquidity as depicted below:

LENGTH OF CREDIT PERIOD: credit terms of length of credit period means the period allowed to the customers for making the payment. The customers paying well in time may also be allowed certain cash discount. There is no binding on fixing the terms of credit. A concern fixes its own terms of credit depending upon its customers and the volume of sales. The customs of industry act as constraints on credit terms of individual concerns. The competitive pressure from other firms compels to follow similar credit terms, otherwise customers may feel inclined to purchase from a firm which allows more days for paying credit purchases. Some times more credit time is allowed to increase sales to existing customers and also to attract new customers. The length of credit period and quantum of discount allowed determine the magnitude of investment in receivables.

A firm may allow liberal credit terms to increase the volume of sales. The lengthening of this period will mean blocking of more money in receivables which could have been invested somewhere else to earn income. There may be an increase in debt collection costs and bad debt losses too. If the earnings from additional sales by lengthening credit periods are more than the additional costs then the credit terms should be liberalized. A Finance manager should determine the period where additional revenue equates the additional costs and should not extend credit beyond this period as the increase in cost will be more than the increase in revenue.

CASH DISCOUNT: Cash discount is allowed to expedite the collection of receivables. The funds tied up in receivables are released. The concern will be able to use the additional funds received from expedited collections due to cash discounts. Then discount allowed it involves cost. The financial manager should compare the earnings resulting from released finds and the cost of discount. The discount should be allowed only if its cost is less than the earnings from additional funds. If the funds cant be profitably employed then discount should not be allowed.

DISCOUNT PERIOD: the collection of receivables is influenced by the period allowed for availing the discount. The additional period allowed for this facility may prompt some more customers to avail discount and make payments. This will mean additional funds released from receivables which may be alternatively used. At the same time the extending of discount period will result in late collection of funds because those who were getting discount and making payments as per earlier schedule will also delay their payments. For example, if the firm
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allowing cash discount for payments within 7 days now extended into payments within 15 days. There may be more customers availing discount and paying early but there will be those also who were paying earlier with in 7days will now pay in 15days. It will increase collection period of the concern. Hence, this decision involves matching of the effect on collection period with the increased cost associated with additional customers availing the discount.

EXECUTING CREDIT POLICY: After formulating the credit policy, its proper execution is important. The evaluation of credit applications and finding of the credit worthiness of customers should be under taken.

COLLECTIING CREDIT INFORMATION: the first step in implementing credit policy will be to gather credit information about the customers. The information should be adequate enough so that proper analysis about the financial position of the customers is possible. This type of investigation can be undertaken only up to a certain limit because it will involve cost. The cost incurred in collecting the information and the benefit firm reduced bad debt losses will be compared. The credit information will certainly help in improving the quality of receivables but the cost of collecting information should not increase the reduction of bad debts losses. The sources from which credit information will be available should be ascertained. . the information may be available from financial statements, credit rating agencies, reports from banks, firms records etc. financial reports of the customers for a number of years will be help full in determining the financial position and profitability position. The balance sheets will help in finding out the short and long term position of the concern. The income statements will show the profitability position of the concerns the income figures will help in finding out whether it is sufficient to enable the payment of receivables or other business liabilities or not. The liquidity position and currents assets movement will help in finding out the current financial position. A proper analysis of financial statements will be helpful in determining the credit worthiness of customers. There are credit rating agencies which can supply information about various concerns. These agencies regularly collect information about business units from various sources and keep this information up to date. The interpreted information can be had from these agencies. These agencies supply this information to their subscribers on regular basis through circulars, periodicals etc. The information is kept confidence and may be used when required. Such agencies are not available in India at present but countries like America have so many agencies in this field. Credit information may be available with banks too. The banks have credit department to analyze the financial position of a customer. The bank in which one has its accounts can be helpful in supplying this information. If the customer is at a different place then the bank can
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collect this information through its branch at that place and bank may even request the other banks for information about customers having accounts with them. The credit limits allowed, frequency of amounts deposited, etc. may be helpful to know about the customers.

In case of old customers, businesss own records may help to know their credit worthiness. The frequency of payments, cash discounts availed, interest paid on overdue payments etc. May help to form an opinion about the quality of credit. The sales men of the business may also be asked to collect information about the customers.

CREDIT ANALYIS: After gathering the required information, the fianc manager should analyze it to find out the credit worthiness of potential customers and also to see whether they satisfy the standards of the concern or not. The credit analysis will determine the degree of risk associated with the account, the capacity of the customer to borrow and his ability and willingness to pay.

CREDIT DECISION: After analyzing the credit worthiness of the customer, the finance manager has to take a decision whether the credit is to extended and is yes then up to what level. He will match the credit worthiness of the customer with credit standards of the company. If customers credit worthiness is above the credit standards then there is no problem in taking decision. It is only in the marginal places that such decisions are difficult to be made. In such cases the benefit of extending the credit should be compared to the likely bad debt losses and then a decision on should be taken. In case the customers are below the companys credit standards then they should not be out rightly refused. Rather they should be offered some alternative facilities. A customer may be offered to pay on delivery of goods, invoices may be sent through bank and released after collecting dues or some third party guarantee may be insisted. Such a course may help in retaining the customers at present and their dealings may help in reviewing their requests at a later date.

FINANCING INVESTMENTS IN RECEIVABLES AND FACTORING: Accounts receivables block a part of working capital. Efforts should be made that funds are not tied up in receivables for longer periods. The fianc manager should make efforts to get receivables financed so that working capital needs are met in time.

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The banks allow rising of loans against security of receivables. Generally banks supply between 60 to 80 percent of the amount of receivables as loans against their security. The quality of receivables will determine the amount of loan. The banks will accept receivables of dependable parties only. Another method of getting funds against receivable s is their outright sale to the bank. The bank will credit the amount to the party after deducting discount and will collect the money from the customers later. Here too, the bank will insist on quality receivables only. Besides banks, there may be other agencies which can buy receivables and pay cash for them. They facility is known as factoring. The factor will purchase only the accounts acceptable to him and may refuse purchase in certain cases. The factoring may be with or without recourse. If it is without recourse then any bad debt loss is taken up by the factor but if it is with recourse then bad debts losses will be recovered from the seller. The factor may suggest the customers for whom he will extend this facility. The factoring service varies from bill discounting facilities offered by commercial banks to a total takeover of administration of the sales ledger and credit control functions.

FORMULATING AND EXECUTING COLLECTION POLICY The collection of amounts due to the customers is very important. The concern should devise procedures to be followed when accounts become due after the expiry of credit period. The collection policy is termed as strict and lenient. A strict policy of collection will involve more efforts on collection. Such a policy has both plus and negative effects. This policy will enable early collection of dues and will reduce bad debt losses. The money collected will be used for other purposes and the profits of the concern will go up. On the other hand a rigorous collection policy will involve increased collections costs. It may also reduce the volume the volume of sales. Some customers may not appreciate the efforts of the concern and may shift to another concern thus causing reduced sales and profits. A lenient policy may increase the debt collection period and more bad debt losses. A customer not clearing the dues for long may not repeat his order because will have to earlier dues first, thus causing loss of customers. The collection policy should weigh various aspects associated with it, the gains and losses of such policy and its effect on the finances of the concern.

The collection policy should also devise the steps to be followed in collecting overdue amounts. The objective is to collect the dues and not to annoy the customer. The steps should be like a) b) c) d) e) sending a remainder for payments Personal request through telephone etc. personal visits to the customers taking help of collecting agencies and lastly Taking legal action.
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The last step should be taken only after exhausting all other means because it will have a bad impact on relation with customers. The genuine problems of customers should never be ignored while making collections. The aim should be to make collections and keep amiable relations with customers.

The collection of book debts can be monitored with the use of average collection period and aging schedule. The actual average collection period may be compared with the stated collection period to evaluate the efficiency of collection so that necessary corrective action can be taken if the need be. The aging schedule further high lightings the debtors according to the age or length of time of the outstanding debtors. The following table presents the aging schedule of a firm.

Factoring and receivables management A factor is a financial institution which offers services relating to management and financing of debts erasing out of credit sales. Factoring may broadly be defined as the relationship, created by an agreement, between seller of goods/services and the financial institution called a factor, where by the later purchases the receivables of the former and also controls and administers the receivables of the former. Factoring is becoming popular all the over the world on account of various services offered by the institutions engaged in it. Factor renders services varying from bill discounting facilities offered by commercial banks to total takeover of administration of credit sales including maintaining of sales ledger, collection of accounts receivables, credit control, and prediction from bank debts, provision of finance and the rendering of advisories offices to their clients. Thus factoring is a tool of receivables management employed to release of funds tied up in credit extended to customers and solve the problems relating to collections, delays and defaults of the receivables.

The mechanism of factoring The mechanism of the factoring is summed of the below: 1. An agreement is entered into between the selling firm and the factor firm. The agreement provides the basis and the scope of the understanding reached between the two for rendering factor services 2. The sales documents should contain the instruction to make payments directly to the factor who is assigned the job of collection of receivables 3. When the payment is received by the factor, the account of the selling firm is created by the factor after the deducting its fees, charges, interest etc as agreed

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4. The factor may provide advance finance to the selling firm if he conditions of the agreement so require. The mechanism of factoring has been shown in the following figure Functions of the factor Factors render a number of services to the selling firms. Some of the important services rendered or functions performed by the factor are as below. 1. 2. 3. 4. 5. 6. 7. 8. Bill discounting facilities Administration of the credit sales Maintenance of clean ledger Collection of accounts receivables Credit control Protection from bad debts Provision of finance Rendering advisory services.

BENEFITS OF FACTORING: A firm that enters into factoring agreement is benefited in a number of ways as it is relieved from the problem of collection management and it can concentrate on other important business activities.

Some important benefits are out lined under: a. It ensures definite patterns of cash inflows from the credit sales. b. It serves as a source of short term finance. c. It ensures better management of receivables as factor firm is specialized agency for the same. d. It enables the selling firms to transfer the risk of non payments, defaults or bad debts to the factoring firms in case of non recourse factoring. e. It saves I cost as well as space as it is a substitute for in-house collection department. f. In provides better opportunities for working capital management. g. The selling firm is also benefited by advisory services rendered by a factor. TYPES OF FACTORING: A number of factoring arrangements are possible depending upon the agreement reached between the selling firm and the factor. However, following are some of the important types of factoring arrangements:

A. RECOURSE AND RECOURSE FACTORING: In a recourse factoring arrangement, the factor has recourse to the client (selling firm) if the receivables purchased turn out to be bad, i.e., the risk of bad debts is to be done by the client and the factor does not assume the risk of bad debts is to be borne by the client and the factor does not assume
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the risk of default associated with receivables. The difference between recourse and non recourse factoring is mainly on account of risk factor. Whereas, in case of non recourse factoring, the risk or loss on account of nonpayment by the customers of the client is to be borne by the factor and he cannot claim this amount from the selling firm. Since the factor bears the risk of nonpayment, commission or fees charged for the services in case of non _recourse factoring is higher than under the recourse factoring. The additional fee charged by the factor for bearing the risk of bad debts/non payment on maturity is called Del credere commission. B. ADVANCE AND MATURITY FACTORING: under advance factoring arrangement, certain percentage of receivables is paid in advance to the client, the balance being paid on the guaranteed payment date. But in case of maturity factoring, no advance is paid to the client and the payment is made to the client only on collection of receivables or the guaranteed payment date as may be agreed between the parties. Thus, maturity factoring consists of the sale of accounts receivables to a factor with no payment advance funds at the time of sale. C. CONVENTIONAL OR FULL FACTORING: In conventional or full factoring, the factor performs almost all the services of factoring including non_ recourse and advance factoring. It is also known as old line factoring. D. DOMESTIC AND EXPORT FACTORING: The basic difference between the domestic and export factoring is on account of the number of parties involved. In domestic factoring three parties are involved, namely, the selling firm (client), the factor and customer of the client (buyer). In contrast, four parties are involved in case of export or cross border factoring. Namely, the exporter (selling firm or client), the importer or the customer, the export factor and the import factor. Since, two factors are in involved in the export factoring; it is also called two factor system of factoring. E. FORFAITING: The term forfeiting is similar to export factoring. It is a form of financing of export receivables. Forfeiting in essence means the forfeiting of the right to future payments through discounting future cash flows. Thus the difference between the forfeiting and factoring is that forfaiting provides hundred percent finance in advance against receivables where as in factoring only certain (usually 75 to 85) % of receivables is available as advance finance. Moreover, forfeiting is purely financing arrangement whereas, factoring also includes other services such as administration of credit sales, collection of receivables, maintenance of sales ledger, etc. INVENTORY MANAGEMENT

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MEANING AND NATURE OF INVENTORY: The dictionary meaning of inventory is stock of goods, or a list of goods. The word Inventory is understood differently by various authors. In accounting language it may mean stock of finished goods only. In a manufacturing concern, it may include raw materials. Work in process and stores, etc.,. to understand the exact meaning of the word inventory we may study it from the usage side or from the side of point of entry in the operations. Inventory includes the following things: Raw Materials: Raw material from a major input into the organization. They are required to carry out production activities uninterruptedly. The quantity of raw materials required will be determined by the rate of consumption and the time required for replenishing the supplies. The factors like the availability of raw materials and government regulations, etc. too affect the stock of raw materials. Work-in-Process: The work in process is that stage of stocks which are in between raw materials and finished goods. The raw materials enter the process of manufacture but they are yet to attain a final shape of finished goods. The quantum of work in process depends upon the time taken in the manufacturing process. The greater the time taken in manufacturing, the more will be the amount of work in progress. Consumables: These are the materials which are needed to smoothen the process of production. These materials do not directly enter production but they act as catalysts, etc. Consumables may be classified according to their consumption and criticality. Generally, consumable stores do not create any supply problem and from a small part of production cost. There can be instances where these materials may account for much value than the raw materials. The fuel oil may from a substantial part of cost. Finished goods: These are the goods which are ready which are ready for the consumers. The stock of finished goods provides a buffer between production and market. The purpose of maintaining inventory is to ensure proper supply of goods to customers. In some concerns the production is undertaken on order basis, in these concerns there will not be need for finished

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goods. The need for finished goods inventory will be more when production is undertaken in general without waiting for specific orders.

Spares: Spares also from a part of inventory. The consumption pattern of raw materials, consumables, finished goods are different from that of spares. The stocking policies of spares are different from industry to industry. Some industries like transports will be require more spares than the other concerns. The costly spare parts like engines, maintenance spares etc. are not discarded after use, rather they are kept in ready position for further use. All decisions about spares are based on the financial cost of inventory on such spares and the costs that may arise due to their non availability. PURPOSE/BENEFITS OF HOLDING INVENTORIES Although holding inventories involves blocking of firms funds and the costs of storage and handling, every business enterprise has to maintain a certain level of inventories to facilitate uninterrupted production and smooth running of business. In the absence of inventories a firm will have to make purchases as soon as it receives orders. It will mean loss of time and delays in execution of orders which sometimes may cause loss of customers and business. A firm also needs to maintain inventories to reduce ordering costs and avail quantity discounts, etc. Generally speaking, there are three main purposes or motives of holding inventories: i) The Transaction Motive which facilitates continuous production and timely execution of sales orders. ii) The Precautionary Motive which necessitates the holding of inventories for meeting the unpredictable changes in demand and supplies of materials. iii) The Speculative Motive which includes keeping inventories for taking advantage of price fluctuations, saving in re ordering costs and quantity discounts, etc.

RISK AND COSTS OF HOLDING INVENTORIES

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The holding of inventories involves blocking of a firms funds and incurrence of capital and other costs. It also exposes the firm to certain risks. The various costs and risks involved in holding inventories are as below: i) Capital costs: Maintaining of inventories results in blocking of the firms financial resources. The firm has, therefore, to arrange for additional funds to meet the cost of inventories. The funds may be arranged from own resources or from outsiders. But in both the cases, the firm incurs a cost. In the former case, there is an opportunity cost of investment while in the later case; the firm has to pay interest to the outsiders. ii) Storage and Handling Costs: Holding of inventories also involves costs of storage as well as handling of materials. The storage costs include the rental of the godown, insurance charges etc. iii) Risk of Price Decline: There is always a risk of reduction in the prices of inventories by the suppliers in holding inventories. This may be due to increased market supplies, competition or general depression in the market. iv) Risk of Obsolescence. The inventories may become obsolete due to improved technology, changes in requirements, change in customers tastes, etc. v) Risk of Deteriorations in Quality. The quality of the materials may also deteriorate while the inventories are kept in stores. INVENTORY MANAGEMENT The investment in inventory is very high in most of the undertakings engaged in manufacturing whole sale and retail trade. The amount of investment is sometimes more in inventory than in other assets. In India, a study of 29 major industries has revealed that the average cost of materials is 64 paise and the cost of labour and overheads is 36paise in a rupee. In industries like sugar, the raw materials cost is as high as 68.75 percent of the total cost. About 90 percent of working capital is invested in inventories. It is necessary for every management to give proper attention to inventory management. A proper planning of purchasing, handling, storing and accounting should form a part of inventory management. An efficient system of inventory management will determine (a) what to purchase (b) how much to purchase (c) from where to purchase (d) where to store etc.

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There are conflicting interests of different departmental heads over the issue of inventory. The finance manager will try to invest less in inventory because for him it is an idle investment, whereas production manager will emphasize to acquire more and more inventory as he does not want any interruption in production due to shortage of inventory. The purpose of inventory management is to keep the stocks in such a way neither there is over stocking nor under stocking. The over stocking will meaning a reduction of liquidity and starving of other production process; under stocking, on other hand, will results in stoppage of work. The investments in inventory should be kept in reasonable limits. OBJECTIVES OF INVENTORY MANAGEMENT The main objectives of inventory management are operational and financial. The operational objectives mean that the materials and spares should be available in sufficient quantity so that work is not disrupted for want of inventory. The financial objectives means that investments in inventories should not remain idle and minimum working capital should be locked in it. The following are the objectives of inventory management: 1) To ensure continuous supply of materials, spares and finished goods so that production should not suffer at any time and the customers demand should also be met. 2) To avoid both over stocking and under stocking of inventory. 3) To maintain investments in inventories at the optimum level as required by the operational and sales activities. 4) To keep material cost under control so that they contribute in reducing cost of production and overall costs. 5) To eliminate duplication in ordering or replenishing stocks. This is possible with the help of centralizing purchases. 6) To minimize losses through deterioration, pilferage, wastage, and damages. 7) To design proper organization for inventory management. A clear cut accountability should be fixed at various levels of the organization. 8) To ensure perpetual inventory control so that materials shown in stock legers should be actually lying in the stores.

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9) To ensure right quality goods at reasonable prices. Suitable quality standards will ensure proper quality of stocks. The price analysis, the cost analysis and value analysis will ensure payment of proper prices. 10) To facilitate furnishing of data for short term and long term planning and control of inventory.

TOOLS AND TECHNIQUES OF INVENTORY MANAGEMENT Effective Inventory management requires an effective control system for inventories. A proper inventory control not only helps in solving the acute problem of liquidity but also increases profits and causes substantial reduction in the working capital of the concern. The following are the important tools and techniques of inventory management and control: 1. Determination of Stock Levels 2. Determination of Safety Stocks 3. Selecting a proper system of ordering for inventory. 4. Determination of Economic Order Quantity. 5. A.B.C. Analysis 6. VED Analysis 7. Inventory Turnover Ratios 8. Aging Schedule of Inventories 9. Classification and Codification of Inventories 10. Preparation of Inventory Reports 11. Lead time 12. Prepetual Inventory System 13. JIT Control System. 1. Determination of Stock Levels: Carrying of too much and too little of inventories is detrimental of the firm. If the inventory level is too little, the firm will face frequent stock outs involving heavy ordering cost and if the inventory level is too high it will be unnecessary tie up of capital. Therefore, an efficient inventory management requires that a firm should maintain an optimum an optimum level of inventory where inventory costs are the minimum and at the same time
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there is no stock out which may result in loss of sale or stoppage of production. Various stock levels are discuses as such. a) Minimum level. This represents the quantity which must be maintained in hand at al times. If stocks are les than the minimum level then the work will stop due to shortage of materials. Following factors are taken into account while fixing minimum stock level. Lead time. A purchasing firm requires some time to process the order and time is also required by the supplying firm to execute the order. The time taken in processing the order and then executing it is known as lead time. It is essential to maintain some inventory during this period. Rate of Consumption. It is the average consumption of materials in the factory. The rate consumption will be decided on the basis of past experience and production plans. Nature of Material. The nature of material also affects the minimum level. If a material is required only against special orders of the customer then minimum stock will not be required for such materials. Minimum stock level can be calculated with the help of following formula:

Minimum Stock Level = Re-Ordering level (Normal consumption*Normal re order period) Re-Ordering level = Max consumption X Max Re-Order period

Max Stock Level = Re-ordering level+Re-Ordering Quantity - (Min consumption * Min Re-Ordering Period) Danger Level = Avg. consumption*Max. re-ordering period for emergency purchases Economic Order Quantity (EOQ): A decision about how much to order has great significance in inventory management. The quantity to be purchased should neither be small nor big because costs of
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buying and carrying materials are very high. Economic order quantity is the size of the lot to be purchased which is economically viable. This is the quantity of materials which can be purchased at minimum costs. Generally, economic order quantity is the point at which inventory carrying costs are equal to order costs. In determining economic order quantity it is assumed that cost of managing inventory is made up solely of two parts i.e., ordering costs and carrying costs. (A) Ordering Costs. There are the costs which are associated with the purchasing or ordering of materials. These costs include: 1) Costs of staff posted for ordering of goods. A purchase order is processed and then placed with suppliers. The labour spent on this process is included in ordering costs. 2) Expenses incurred on transportation of good purchased. 3) Inspection costs of incoming materials. 4) Cost of stationery, typing, postage, telephone charges, etc.

These costs are also known as buying costs and will be arise only when some purchases are made. When materials are manufactured in the concern then these costs will be known as set up costs. These costs will include costs of setting up machinery for manufacturing materials, time taken up in setting, cost of tools etc. The ordering costs are totaled up for the year and then divided by the number of orders placed each year. The planning commission of India has estimated these costs between Rs.10/- to Rs.20/- per order. (B) Carrying Costs: These are the costs for holding the inventories. These costs will not be incurred if inventories are not carried. These costs include: 1. The cost of capital invested in inventories. An interest will be paid on the amount of capital locked up in inventories. 2. Cost of storage which could have been used for other purposes.,

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3. The loss of materials due to deterioration and obsolescence. The materials may deteriorate with passage of time. The loss of obsolescence arises when the materials in stock are not usable because of change in process or product. 4. Insurance Cost 5. Cost of spoilage in handling of materials. The planning commission of India had estimated these costs between 15percent to 20percentof total costs. The longer the materials kept in stocks, the costlier it becomes by 20percent every year. The ordering and carrying costs have a reverse relationship. The ordering cost goes up with the increase in number of orders placed. On other hand, carrying costs go down per unit with the increase in number of units, purchased and stored. It can be shown in the diagram given on the next page:

The ordering and carrying costs of materials being high, an effort should be made to minimize these costs. The quantity to be ordered should be large so that economy may be made
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in transport costs and discounts may also be earned. On the other hand, storing facilities, capital to be locked up, insurance costs should also be taken into account. Assumptions of EOQ. While calculating EOQ the following assumptions are made. 1. The supply of goods is satisfactory. The goods can be purchased whenever these are needed. 2. The quantity to be purchased by the concern is certain. 3. The prices of goods are stable. It results to stable carrying costs. When above mentioned conditions are satisfied, economic order quantity can be calculated with the help of the following formula:

EOQ = Where A= Annual consumption in rupees S= Cost of placing an order I= Inventory carrying costs of one unit A-B-C Analysis: The materials are divided into a number of categories for adopting a selective approach for material control. It is generally seen that in manufacturing concern, a small percentage of items contribute a large percentage of value of consumption and a large percentage of items of materials contribute a small percentage of value. Under A-B-C analysis, the materials are divided into three categories viz., A, B, C. Past experience has shown that almost 10percent of the items contribute 70percent of value of consumption and this category is called A category. About 20percent of the items contribute about 20percent of value of consumption and this is known as B category. Category C covers about 70percent of items of materials which contribute only 10percent of value of consumption. There may be some variation in different organizations and an adjustment can be made made in these percentages.

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A-B-C analysis helps to concentrate more efforts on category A since greatest monetary advantage will come by controlling these items. An attention should be paid in estimating requirements, purchasing, maintaining safety stocks and properly storing of A category materials. These items are kept under a constant review so that a substantial material cost may be controlled. The control of C items may be relaxed and these stocks may be purchased for the year. A little more attention should be given towards B category items and their purchase should be undertaken or half - yearly interviews.

VED Analysis The VED analysis is used generally for spare parts. The requirements and urgency of spare parts in different from that of materials. A-B-C analysis may not be properly used for spare parts. The demand for spares depends upon the performance of the plant and machinery. Spare parts are classified as Vital(V), Essential(E), and Desirable(D). the vital spares are a must for running the concern smoothly and these must be storedx adequately. The non availability of vital spares will cause havoc in the concern. The E type of spares are also necessary but their stocks may be kept at low figures. The stocking of D type of spares may be avoided at times. If the lead time of these spares can be avoided. Just In Time (JIT) Inventory Control System Just in time philosophy, which aims at eliminating waste from every aspect of manufacturing and its related activities, was first developed in Japan. Toyota introduced this technique in 1950s in Japan, however, U.S companies started using this technique in 1980s. the term JIT refers to a management tool that helps to produce only the needed quantities at the needed time. According to the official terminology of C.I.M.A., JIT is a technique for the organization of workflows, to allow rapid, high quality, flexible production whilst minimizing manufacturing work and stock level. There are brodly two aspects of JIT (I) (II) just in time production, and just in time purchasing
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Schonberger define, JIT as, to produce and deliver finished goods just in time to be sold, sub-assemblies just in time to be assembled into finished goods, fabricates parts just in time to go into sub assemblies and purchased materials just in time to be transformed into fabricated parts. Just in time inventory control system involves the purchase of materials in such a way that delivery of purchased material is assured just before their use or demand. The philosophy of JIT control system implies that the firm should maintain a minimum (zero level) of inventory and rely on suppliers to provide materials just in time to meet the requirements. The traditional inventory control system, on the other hand, requires maintaining a healthy level of safety stock to provide protection against uncertainities of production and supplies. Objectives of JIT The ultimate goal of JIT is to reduce wastage and enhance productivity. The important objectives of JIT include: 1. Minimum/zero inventory and its associated costs. 2. Elimination of non value added activities and all wastes. 3. Minimum batch/lot size. 4. Zero breakdowns and continuous flow of production. 5. Ensure timely delivery schedules both inside and outside the firm. 6. Manufacturing the right product at right time.

Features of JIT The main features of JIT inventory control system are as follows: 1. It emphasizes that firms following traditional inventory control system overestimate ordering cost and underestimate carrying costs associated with holding of inventories. 2. It advocates maintaining good relations with suppliers so as to enable purchases of right quantity of materials at right time. 3. It involves frequent production/order runs because of smaller batch/lot sizes. 4. It requires reduction in set up time as well as processing time.

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5. The major focus of JIT approach is to purchase or produce in response to need rather than as per the plans and forecasts. Advantages of JIT inventory Control System The following are the major advantages of Just In Time inventory control system: 1. The right quantities of materials are purchased or produced at the right time. 2. Investment inventory is reduced. 3. Wastes are eliminated. 4. Carrying or holding cost of inventory is also reduced because of reduced inventory. 5. Reduction in costs of quality such as inspection, costs of delayed delivery, early delivery, processing documents etc. resulting into overall reduction in cost.

VED Analysis

Represents classification of items based on their criticality Classifies items into 3 groups called Vital, Essential & Desirable -Vital category consists of those items for want of which production would come to a halt. - Essential group includes items whose stockouts costs is very high. - Desirable group consists of items which do not cause any immediate loss of production.

An item may be vital for a number of reasons:

If the non availability of the item can cause serious production losses.

Lead time for procurement is very large

It is a non standard item & it is custom made.

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The sources of supply is only one & is located far off from the buyers plant

Steps Identify the factors to be considered for VED Analysis

Assign points/weightages to the factors according to their importance to the company

Divide each factor into 3 categories & allocate points to each category

Prepare categorisation plan

Evaluate items one by one against each factor & assign points to the item

Place the V,E &D categories depending upon the points scored by them

S-D-E Analysis

It is based on problems of procurement like:

Non availability

Scarcity

Longer lead time

Geographical location of suppliers

Reliability of suppliers It is classified in 3 categories called Scarce, Difficult & Easy.

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The information is used to decide purchasing strategies. Scarce classification comprises items which are short in supply, imported or cannalised through government agencies. Difficult classification includes those items which are available indigenously but are not easy to procure. Easy classification covers those items which are readily available.

S-D-E Analysis is employed by the purchase department:

To decide on the method of buying: Eg: Forward buying method for some of the items in the Scarce group; Scheduled buying & contract buying for Easy group To fix responsibility of buyers: Eg: Senior buyers may be given responsibility of S & D groups while E group may be handled by junior buyers or directly by the storekeeper.

G-NG-LF/GOLF Analysis

Its like S-D-E Analysis

It is based on nature of suppliers which determine quality, lead time, terms of payment, continuity or otherwise of supply & administrative work involved.

The analysis classifies the items into 4 groups G-NG-L & F. G group covers items procured from government. Transactions with this category of suppliers involve long lead time & payments in advance or against delivery.

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NG or O in (GOLF) group covers items procured from non-government. Transactions with this category of suppliers involve moderate delivery time & availability of credit usually in the range of 30-60 days. L group contains items bought from local suppliers. The items bought from these suppliers are cash purchased or purchased on blanket orders. F group contains those items which are purchased from foreign suppliers. The transactions with such suppliers: involve a lot of administrative work necessitate search of foreign suppliers require opening letter of credit require making of arrangement for shipping & port clearance

S-O-S Analysis Its based on seasonality of items. It classifies items into 2 groups S (seasonal) & OS (Off Seasonal) The analysis identifies items which are:

Seasonal & are available only for a limited period of time eg raw mangoes, etc. Such items are procured to last the full year.

Seasonal but are available throughout the year. Their prices are lower in the harvest season.

Non seasonal items whose quantity is decided on different considerations

M-N-G Analysis

This analysis is based on stock turnover rate & it classifies the items into M (Moving items), N (Non-moving items) & G (Ghost items).

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M (Moving items) are items consumed from time to time.

N (Non-moving items) are items not consumed in the last year.

G (Ghost items) are those items which had nil balance, both in the beginning & at the end of the financial year. All pending/open purchase orders (if any) of such items should be cancelled.

F-S-N Analysis

F-S-N Analysis is based on consumption figures of the items.

It is classified into 3 groups: F (Fast moving), S (Slow moving) & N (Non-moving)

To conduct these analysis, the last date of receipt or the last date of issue whichever is later is taken into account.

The period, is usually in terms of number of months that has elapsed since the last movement record.

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