Working capital management (1)

WORKING CAPITAL MANAGEMENT
(FINANCE)

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UNIT – I

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Q. Explain Working Capital. What do you mean by Gross Working Capital and Net
Working Capital?
Ans. Introduction:- Working capital plays the same role in the business as the role of heart
in the human body. Just like heart gets blood and circulates the same in the body, in the

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same way in working capital, funds are generated and then circulated in the business. As
and when this circulation stops the business becomes lifeless. Thus, prudent management
of Working capital is necessary for the success of a business.
Meaning of Working Capital:-Working capital management is an important aspect of
financial management. In business, money is required for fixed assets and working capital.
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Fixed assets include land and building, plant and machinery, furniture and fittings etc. Fixed
assets are acquired to be retained in the business for a long period and yield returns over the
life of such assets. The main objective of working capital management is to determine the
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optimum amount of working capital required. Generally, management of working capital
means management of current assets.
Concepts of Working Capital:-There are two concepts of working capital-
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(1) Gross Working Capital Concept
(2) Net Working Capital Concept.
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(1) Gross working capital: Gross working capital; refers to firm's investment in current
assets. Current assets are the assets which can be converted into cash within an
accounting year and include cash, short-term securities, debtors, bill receivables and
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stock. According to this concept, working capital means Gross working Capital which
is the total of all current assets of a business. It can be represented by the following
equation:

Gross Working Capital = Total Current Assets

Definitions favouring this concept are:-
According to Mead, Mallot and Field : "Working Capital means total of Current Assets".

According to Bonneville and Dewey
"Any acquisition of funds which increases the current assets increases working capital, for
they are one and the same".
Arguments in favour of Gross Working Capital Concept:- Persons acknowledging the

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total of current assets as working capital give the following arguments in their favour:-
(i) Just as fixed assets are considered as the symbol of fixed capital, current assets must

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also be considered as symbol of working capital.
(ii) Any acquisition of funds increases the working capital. This statement proves true

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according to this concept whereas it does not hold true according to the second
concept.
(iii) Most of the managers plan their business operations according to the current assets
concept because these are the assets used in day-to-day business operations.

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(2) Net Working Capital Concept: Net working capital refers to the difference between
current assets and current liabilities. Current liabilities are those claims of outsiders
which are expected to mature for payment within an accounting year and include
creditors, bills payables, and outstanding expenses. Net working capital can be
positive or negative. A positive net working capital will arise when current assets
exceed current liabilities. A negative Net working capital occurs when current liabilities
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are in excess of current assets.

Net Working Capital = Current Assets - Current Liabilities
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Definitions Favouring Net Working Capital Concept:-
According to C.W.Gestenbergh
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"It has ordinarily been defined as the excess of current assets over current liabilities".
According to Lawrence. J. Gitmen
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" The most common definition of net working capital is the difference of firm's current assets
and current liabilities".
Arguments in Favour of Net Working Capital Concept:-
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(i) This concept gives the true information about the liquidity of a concern. According to
first concept, the working capital appears to be increased merely by taking a short-
term loan whereas in the second concept working capital remains unchanged by
doing so. Thus, the second concept looks more logical.
(ii) Excess of current assets over current liabilities will indicate whether or not the concern
will be able to meet its current liabilities when they fall due. First concept does not
disclose this fact.

(iii) It is on the basis of this concept that the short-term lenders, bankers etc. calculate the
safety margin regarding the timely payment of their debt.
(iv) Excess of current assets over current liabilities will determine whether or not the
concern will be able to face the depression or any other contingent need of the

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business.
(v) According to this concept a comparison can be made between the financial position of

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two firms whose current assets are equal.
As discussed, net working capital is the excess of current assets over current
liabilities. There are three conditions:-

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(i) When Current assets are equal to current liabilities, then working capital will be
zero.
(ii) When current assets are more than current liabilities, then working capital will be
positive.
(iii)
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When current assets are less than current liabilities, then working capital will be

Current Assets:- Current assets mean those assets which are converted into cash
within a short period of time not exceeding one year e.g. Cash, Bank balance, Debtors,
Bills Receivables, Stock, Accrued Income etc.
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Current Liabilities:- Current liabilities means those liabilities which have to be paid
within a short period of time in no case exceeding one year, e.g. Creditors, Bills
payable, Outstanding Expenses, Shot-term loans etc.
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Q. What is the need of Working Capital?
Ans. Meaning of Working Capital:- Working capital management is an important aspect
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of financial management. In business, money is required for fixed assets and working
capital. Fixed assets include land and building, plant and machinery, furniture and fittings
etc. Fixed assets are acquired to be retained in the business for a long period and yield
returns over the life of such assets. The main objective of working capital management is to
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determine the optimum amount of working capital required. Generally, management of
working capital means management of current assets.
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NEED FOR WORKING CAPITAL: Along with the fixed capital almost every Small-Scale
industries requires working capital though the extent of working capital requirement differs in
different businesses. Working capital is needed for running the day-to-day business
activities. When a business is started, working capital is needed for purchasing raw
materials. The raw material is then converted into finished goods by incurring some
additional cost on it. Now goods are sold. Sales do not convert into cash instantly because
there is invariably some credit sales. Thus, there exists a time lag between sales of goods
and receipts of cash. During this period, expenses are to be incurred for continuing the
business operations. For this purpose working capital is needed. Therefore, sufficient

working capital is needed which shall be involved from the purchase of raw materials to the
realization of cash. The time period which is required to convert raw materials into finished
goods and then into cash is known as operating cycle or cash cycle. The need for working
capital can also be explained with the help of operating cycle. Operating cycle of a
manufacturing concern involves five phases:

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ØConversion of cash into raw material

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ØConversion of raw material into work-in-progress
ØConversion of work-in-progress into finished goods

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ØConversion of finished goods into debtors by credit sales
ØConversion of debtors into cash by realising cash from them.
Operating Cycle: Thus the operating cycle starts from cash, finishes at cash and then again
restarts from cash. Need for working capital depends upon period of operating cycle.
Greater the period, more will be the need for working capital. Period of operating cycle in a

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manufacturing concern is greater than period of operating cycle in a trading concern
because in trading units cash is directly converted into finished goods.

Cash
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Debtors and Bills Receivables Raw Materials
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Finished Goods Work-in-Progress
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Diagram: Operating Cycle

Working capital in a business is needed because of operating cycle. But the need for
working capital does not come to an end after the cycle if completed. Since the operating
cycle is a continuous process, there remains a need for continuous supply of working
capital. However, the amount of working capital required is not constant throughout the year,
but keeps fluctuating. On the basis of this concept, working capital is classified into two
types:-

(1) Permanent Working Capital:- The need for working capital fluctuates from time to
time. However, to carry on day-to-day operations of the business without any
obstacles, a certain minimum level of raw materials, work-in-progress, finished goofs
and cash must be maintained on a continuous basis. The amount needed to maintain
current assets on this minimum level is called permanent or regular working capital.

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The amount involved as permanent working capital has to be met from long-term
sources of finance, e.g.

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(i) Capital
(ii) Debentures

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(iii) Long-term loans.
(2) Temporary or Variable Working Capital:- Any amount over and above the
permanent level of working capital is called temporary, fluctuating or variable working
capital. Due to seasonal changes, level of business activities is higher than normal
during some months of year and therefore additional working capital will be required

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alongwith the permanent working capital. It is so because during peak season,
demand rises and more stock is to be maintained to meet the demand.Both types of
working capital is necessary to run the business smoothly. The distinction between
permanent and temporary working capital is illustrated in the following diagram:-
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SHOWING PERMANENT AND TEMPORARY WORKING CAPITAL:
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Time
SHOWING PERMANENT AND TEMPORARY WORKING CAPIRAL IN A GROWING
CONCERN:

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Q.
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What is the meaning of Working Capital? Explain the factors affecting the
working capital requirements of a business.
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working capital means management of current assets
DETERMINANTS OF WORKING CAPITAL: A firm should have neither too much nor too
little working capital. A large number of factors, each has a different importance, influencing
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working capital needs of firms. The importance of factors also changes for a firm over time.
Therefore, an analysis of relevant factors should be made in order to determine total
investment in working capital. The following is the description of factors which generally
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influence the working capital requirements. The working capital requirement is determined
by a large number of factors but, in general, the following factors influence the working
capital needs of an enterprise:
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(1) Nature of Business :- Working capital requirements of an enterprise are largely
influenced by the nature of its business. For instance, public utilities such as railways,
transport, water, electricity etc. have a very limited need for working capital because
they have invested fairly large amounts in fixed assets. Their working capital need is
minimal because they get immediate payment for their services and do not have to
maintain big inventories. On the other extreme are the trading and financial
enterprises which have to invest fewer amounts in fixed assets and a large amount in
working capital. This is so because the nature of their business is such that they have

to maintain a sufficient amount of cash, inventories and debtors. Working capital
needs of most of the manufacturing enterprises fall between these two extremes, that
is, between public utilities and trading concerns.
(2) Size of Business:- Larger the size of the business enterprise, greater would be the

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need for working capital. The size of a business may be measured in terms of scale of
its business operations.

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(3) Growth and Expansion:- As a business enterprise grows, it is logical to expect that a
larger amount of working capital will be required. Growing industries require more
working capital than those that are static.

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(4) Production cycle:- Production cycle means the time-span between the purchase of
raw materials and its conversion into finished goods. The longer the production cycle,
the larger will be the need for working capital because the funds will be tied up for a
longer period in work in process. If the production cycle is small, the need for working
capital will also be small.
(5)
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Business Fluctuations:- Business fluctuations may be in the direction of boom and
depression. During boom period the firm will have to operate at full capacity to meet
the increased demand which in turn, leads to increase in the level of inventories and
book debts. Hence, the need for working capital in boom conditions is bound to
increase. The depression phase of business fluctuations has exactly an opposite
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effect on the level of working capital requirement.
(6) Production Policy:- The need for working capital is also determined by production
policy. The demand for certain products (such as woolen garments) is seasonal. Two
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types of production policies may be adopted for such products. Firstly, the goods may
be produced in the months of demand and secondly, the goods may be produces
throughout the year. If the second alternative is adopted, the stock of finished goods
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will accumulate progressively upto the season of demand which requires an
increasing amount of working capital that remains tied up in the stock of finished goods
for some months.
(7) Credit Policy Relating to Sales:- If a firm adopts liberal credit policy in respect of
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sales, the amount tied up in debtors will also be higher. Obviously, higher book debts
mean more working capital. On the other hand, if the firm follows tight credit policy, the
magnitude of working capital will decrease.
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(8) Credit Policy Relating to Purchase:- If a firm purchases more goods on credit, the
requirement for working capital will be less. In other words, if liberal credit terms are
available from the suppliers of goods (i.e., creditors), the requirement for working
capital will be reduced and vice versa.
(9) Availability of Raw Material:- If the raw material required by the firm is available
easily on a continuous basis, there will be no need to keep a large inventory of such
materials and hence the requirement of working capital will be less. On the other hand,

if the supply of raw material is irregular, the firm will be compelled to keep an excessive
inventory of such raw materials which will result in high level of working capital. Also,
some raw materials are available only during a particular season such as oil seeds,
cotton, etc. They would have to be necessarily purchased in that season and have to
be kept in stock for a period when supplies are lean. This will require more working

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capital.
(10) Availability of Credit from Banks:- If a firm can get easy bank facility in case of need,

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it will operate with less working capital. On the other hand, if such facility is not
available, it will have to keep large amount of working capital.

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(11) Volume of Profit:- The net profit is a source of working capital to the extent it has been
earned in cash. Higher net profit would generate more internal funds thereby
contributing the working capital pool.
(12) Level of Taxes:- Full amount of cash profit is not available for working capital purpose.
Taxes have to be paid out of profits. Higher the amount of taxes less will be the profits
available for working capital.
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(13) Dividend Policy:- Dividend policy is a significant element in determining the level of
working capital in an enterprise. The payment of dividend reduces the cash and,
thereby, affects the working capital to that extent. On the contrary, if the company does
not pay dividend but retains the profits, more would be the contribution of profits
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towards capital pool.
(14) Depreciation Policy:- Although depreciation does not result in outflow of cash, it
affects the working capital indirectly. In the first place, since depreciation is allowable
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expenditure in calculating net profits, it affects the tax liability. In the second place,
higher depreciation also means lower disposable profits and, in turn, a lower dividend
payment. Thus, outgo of cash is restricted to that extent.
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(15) Price Level Changes:- Changes in price level also affect the working capital
requirements. If the price level is rising, more funds will be required to maintain the
existing level of production. Same level of current assets will need increased
investment when prices are increasing. However, companies that can immediately
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revise their product prices with rising price levels will not face a severe working capital
problem. Thus, it is possible that some companies may not be affected by rising prices
while others may be badly hit.
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(16) Efficiency of Management:- Efficiency of management is also a significant factor to
determine the level of working capital. Management can reduce the need for working
capital by the efficient utilization of resources. It can accelerate the pace of cash cycle
and thereby use the same amount working capital again and again very quickly.
Q. Define Working Capital and give its classification.
Ans. Introduction:- Working capital plays the same role in the business as the role of heart
in the human body. Just like heart gets blood and circulates the same in the body, in the

same way in working capital, funds are generated and then circulated in the business. As
and when this circulation stops the business becomes lifeless. Thus, prudent management
of Working capital is necessary for the success of a business.
Meaning of Working Capital:-

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Working capital management is an important aspect of financial management. In business,
money is required for fixed assets and working capital. Fixed assets include land and

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building, plant and machinery, furniture and fittings etc. Fixed assets are acquired to be
retained in the business for a long period and yield returns over the life of such assets. The
main objective of working capital management is to determine the optimum amount of

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working capital required. Generally, management of working capital means management of
current assets.
Classification of Working Capital:-
Working Capital can be classified in two ways, firstly, on the basis of concept, and secondly,
on the basis of its need.
(1)
(i) Gross Working Capital
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On the Basis of Concept: On this basis working capital may be of two types:

(ii) Net Working Capital
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(2) On the Basis of Need:- On this basis also working capital may be of two types:
(i) Permanent Working Capital
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(ii) Temporary Working Capital.
Q. Define Working Capital. Briefly explain the techniques used in making working
capital forecast or Estimating Working Capital Requirements
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working capital means management of current assets.
WORKING CAPITAL FORECASTING TECHNIQUES OR COMPUTATION OF
WORKING CAPITAL:
A number of methods are used to determine working capital needs of a business. The
important among them are:
(1) Operating Cycle Method:- Operating cycle is the time span the firm requires in the
purchase of raw materials, conversion of raw materials into work in progress and

finished goods, conversion of finished goods into sales and in collecting cash from
debtors. Larger the time span of operating cycle, larger the investment in current
assets. Hence, time period of each stage of operating cycle is estimated and then
working capital needed in each stage is computed on the basis of cost of each item.

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Following factors should be taken into consideration while forecasting working capital
requirement on the basis of operating cycle method:

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Øof raw materials, wages and overheads.
Cost
Ø during which raw material remains in store before it is issued for
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production purpose.
Ø of Production cycle.
Period
Ø during which finished goods is stored before sale.
Period
Ø of credit allowed to debtors and period of credit allowed by suppliers.
Period

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Ø lag in payment of wages and overheads.
Time
Minimum cash balance required to be maintained.
A certain percentage for contingencies may also be added to the above estimates to
determine the working capital requirement.
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On the basis of operating cycle, the working capital can be forecasted in the following way:
STATEMENT SHOWING WORKING CAPITAL REQUIREMENT
Current Assets:
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Ø of Raw-Materials:
Stock
Average Inventory holding period
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Cost of yearly consumption (weeks/months)
Of raw material x ----------------------------------------------- = --------
52 weeks / 12 months
Ø in Progress:
Work
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Average time span of work in process
Cost of yearly consumption (weeks/months)
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Of raw material x ----------------------------------------------------------
52 weeks/ 12 months

50 (weeks/months)
+ Yearly wages x --------- x --------------------------------------------------------
100 52 weeks/ 12 months

+ Yearly manufacturing and administrative overheads (excluding dep.)

50 (weeks/ months)
x -------- x ----------------------------------------------------- = ---------
100 52 weeks/ 12 months

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Note: While calculating work in process it will be assumed that full Unit of raw material is

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required in the beginning of the process Whereas wages and overhead expenses accrue
evenly throughout the production cycle. Hence, raw material cost is taken at 100% and
wages and overheads are taken at 50% on an average basis.

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Ø of Finished Goods:
Stock
Cost of goods produced (i.e., yearly cost of raw materials +Wages + manufacturing &
administrative overheads(excluding depreciation)

ØDebtors:
(weeks / months
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Average finished goods holding period

x ------------------------------------------------
52 weeks/ 12 months
= ----------
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Working Capital tied up in debtors should be estimated on the basis of cost of sales
(excluding depreciation):
Average debt collection period
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Cost of goods produces (weeks / months)
(i.e., raw materials + wages x ----------------------------------- = ---------
+ manufacturing, administrative 52 weeks/ 12 months
& selling overhead)
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Ø and Bank Balance:
Cash
(i.e., minimum cash balance required to be maintained = --------
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Less: Current Liabilities
(the working capital are lower to the extent such requirements are met through current
liabilities)
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Ø Creditors:
Trade
Credit period allowed by creditors
Cost of yearly consumption (weeks/ months)
Of raw material x -------------------------------------------------- = --------
52 weeks/ 12 months

ØWages:
Average time lag in payment of wages
(weeks/ months)
Yearly wages x ------------------------------------------------------- = ----------
52 weeks/ 12 months

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Note: If wages are paid at the end of each month, the average time lag in the payment of
wages will approximate to half-a- month. This is so, Because 1st day's wages are paid on the

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30th day of the month, extending credit for 29 days, the 2nd days wages are, again, paid on
the 30th, extending credit for 28 days, and so on. Thus, average time lag will approximate to

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half a month.
ØOverheads:
Average time lag in payment of overheads
Yearly Overheads(other (weeks/ months)
Than Depreciation) x -------------------------------------------------- = ----------

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52 weeks/12 months
Working Capital (Current Assets - Current Liabilities)
Add: Provision for Contingencies
______
----------
----------
________
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Estimated Working Capital Requirement ----------
________
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(2) Forecasting of Current Assets and Current Liabilities Method:- According to this
method, an estimate is made of forthcoming period's current assets and current
liabilities on the basis of factors like past experience, credit policy, stock policy and
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payment policy of the previous years. First of all, such estimate is made for each
current asset on the basis of each month and then monthly requirements are
converted into yearly requirement of current assets. The estimated amount of current
liabilities is deducted from this amount in order to estimate the requirement of working
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capital. A certain percentage for contingencies may also be added to this amount.
(3) Cash Forecasting Method:- Under this method, an estimate is made of cash receipts
and payments for the next period. Estimated cash receipts are added to the amount of
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working capital which exists at the beginning of the year and estimated cash payments
are deducted from this amount. The difference will be the amount of working capital.
(4) Percentage of Sales Method:- Under this method, certain key ratios based on past
year's information are established. These ratios can be ratio of sales to raw material
stock, ratio of sales to semi-finished goods stock, ratio of sales to finished goods stock,
ratio of sales to debtors, ratio of sales to cash balance etc. After this, sales for the next
year will be estimated and the requirement of working capital will be determined on the
basis of these ratios.

(5) Projected Balance Sheet Method:- Under this method, an estimate is made of
assets and liabilities for a future date and a projected balance sheet is prepared for
that future date. The difference in current assets and current liabilities shown in
projected balance sheet will be the amount of working capital.

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Q. What are the advantage of Adequate working capital?
Ans. ADEQUATE WORKING CAPITAL: The firm should maintain a sound working capital

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position. It should have adequate working capital to run its business operations. Both
excessive as well as inadequate working capital positions are dangerous from firm's point of
view. Excessive working capital means holding costs and idle funds which earn no profit for

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the firm. Paucity of working capital not only impairs the firm's profitability but also results in
production interruptions and inefficiencies and sales disruption
Advantage of Adequate Working Capital:
(1) Availability of Raw Materials Regularly:- Adequacy of working capital makes it

(2)
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possible for a firm to pay the suppliers of raw materials on time. As a result it will
continue to receive regular supplies of raw materials and thus there will be no
disruption in production process.
Full Utilization of Fixed Assets:- Adequacy of working capital makes it possible for a
firm to utilize its fixed assets fully and continuously. For example, if there is inadequate
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stock of raw material, the machines will not be utilized in full and their productivity will
be reduced.
(3) Cash Discount :- A firm having the adequate working capital can avail the cash
discount by purchasing the goods for cash or by making the payment before the due
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date.
(4) Increase in Credit Rating :- Paying its short-term obligations in time leads to a strong
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credit rating which enables the firm to purchase goods on credit on favourable terms
and to maintain its line of credit with banks etc. it facilities the taking of loan in case of
need.
(5) Advantages of Favourable Business Opportunities:- Whenever there are
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chances of increase in prices of raw materials, the firm can purchase sufficient
quantity if it has adequate of working capital. Similarly, if a firm receives a bulk order for
the supply of goods it can take advantage of such opportunity if it has sufficient
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working capital.
(6) Facility in Obtaining Bank Loans:- Banks do not hesitate to advance even the
unsecured loan to a firm which has the sufficient working capital. This is because the
excess of current assets over current liabilities itself is a good security.
(7) Increase in Efficiency of Management:- Adequacy of working capital has a
favourable psychological effect on the managers. This is because no obstacle arises
in the day-to-day business operations. Creditors, wages and all other expenses are
paid on time and hence it keeps the morale of managers high.

(8) Meeting Unseen Contingencies :- Adequacy of working capital enables a company
to meet the unseen contingencies successfully.
Q. What are the disadvantage of excessive and inadequate working capital?
Ans. EXCESSIVE AND INADEQUATE WORKING CAPITAL: A business enterprise

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should maintain adequate working capital according to the needs of its business operations.
The amount of working capital should neither be excessive nor inadequate. If the working

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capital is in excess if its requirements it means idle funds adding to the cost of capital but
which earn nom profits for the firm. On the contrary, if the working capital is short of its
requirements, it will result in production interruptions and reduction of sales and, in turn, will

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affect the profitability of the business adversely.
Disadvantage of Excessive Working Capital:-
(1) Excessive Inventory:- Excessive working capital results in unnecessary
accumulation of large inventory. It increases the chances of misuse, waste, theft etc.
(2)
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Excessive Debtors:-Excessive working capital will results in liberal credit policy
which, in turn, will results in higher amount tied up in debtors and higher incidence of
bad debts.
(3) Adverse Effect on Profitability:-Excessive working capital means idle funds in the
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business which adds to the cost of capital but earns no profits for the firm. Hence it has
a bad effect on profitability of the firm.
(4) Inefficiency of Management:-Management becomes careless due to excessive
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resources at their command. It results in laxity of control on expenses and cash
resources.
Disadvantage of Inadequate Working Capital:
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(1) Difficulty in Availability of Raw-Material:- Adequacy of working capital results in
non-payment of creditors on time. As a result the credit purchase of goods on
favourable terms becomes increasingly difficult. Also, the firm cannot avail the cash
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discount.
(2) Full Utilization of Fixed Assets not Possible: Due to the frequent interruption in the
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supply of raw materials and paucity of stock, the firm cannot make full utilization of its
machines etc.
(3) Difficulty in the Maintenance of Machinery: Due to the inadequacy of working
capital, machines are not cared and maintained properly which results in the closure of
production on many occasions.
(4) Decrease in Credit Rating: Because of inadequacy of working capital, firm is unable
to pay its short-term obligations on time. It decays the firm's relations with its bankers
and it becomes difficult for the firm to borrow in case of need.

(5) Non Utilization of Favourable Opportunities: For example, a firm cannot purchase
sufficient quantity of raw materials in case of sudden decrease in the prices. Similarly,
if the firm receives a big order, it cannot execute it due to shortage of working capital.
(6) Decrease in Sales: Due to the shortage of working capital, the firm cannot keep

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sufficient stock of finished goods. It results in the decrease in sales. Also, the firm will
be forced to restrict its credit sales. This will further reduce the sales.

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(7) Difficulty in the Distribution of Dividends: Because of paucity of cash resources,
firm will not be able to pay the dividend to its shareholders.

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(8) Decrease in the Efficiency of Management: It will become increasingly difficult for
the management to pay its creditors on time and pay its day-to-day expenses. It will
also be difficult to pay the wages regularly which will have an adverse effect on the
morale of managers.
Q. Discuss the methods of analysis of working capital?

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Ans. Working capital position of an enterprise is analysed by various internal and external
parties. External parties include bankers, creditors, financial institutions etc. The objective of
these parties in analyzing the working capital is to assess the liquidity of the business, i.e. to
know whether the firm will have sufficient current assets and cash to pay their debts when
they fall due. Method to analyse the working capital are:-
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1. Schedule of Changes in Working Capital: With the help of this schedule increase or
decrease in various current assets and current liabilities can be ascertained. This
schedule considers only current assets and current liabilities, at the beginning and at
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the end of the year. This schedule shows either increase or decrease in working
capital. Following rules are followed while preparing a schedule of changes in working
capital.
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ØAn increase in current assets results in increase in working Capital.
ØA decrease in current assets results in decrease in working capital.
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ØAn increase in current liabilities results in decrease in working capital.
ØA decrease in current liabilities results in increase in working capital.
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(2) Ratio Analysis : A ratio is simply one number expressed in terms of another. It found
by dividing one number into the other. Working capital can be analysed with the help of
various ratios mentioned below:
(A) Liquidity Ratios:-
ØCurrent Ratio:- This ratio explains the relationship between current and current
liabilities of a business. The formula for calculating the ratio is:

Current Assets
Current Ratio = ---------------------------------
Current Liabilities
Ø Ratio:- Liquid ratio explains the relationship between liquid assets and
Liquid
current liabilities of a business. The formula for calculating the ratio is:

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Liquid Assets

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Liquid Ratio = -----------------------------
Current Liabilities
Cash + Bank + Marketable Securities

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ØAbsolute Liquid Ratio = -------------------------------------------------------
Current Liabilities
(B) Activity Ratios:-
ØInventory Turnover Ratio:

Ø
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Inventory Turnover Ratio = --------------------------------------------
Average Stock
Debtors Turnover Ratio:- This ratio indicates the relationship between credit sales
and average debtors during the year. The formula for calculating the ratio:
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Net Credit Sales
Debtors Turnover Ratio = -----------------------------------------
Average Debtors + Average B/R
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ØCreditors Turnover Ratio:- This ratio indicates the relationship between credit
purchases and average creditors during the year. The formula for calculating the ratio
is:
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Net Credit Purchases
Creditors Turnover Ratio = -----------------------------------------------------
Average Creditors + Average B/P
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ØWorking Capital Turnover Ratio:- This ratio indicates the relationship between cost
of goods sold and working capital. The formula for calculating the ratio is :
Cost of Goods Sold
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Working Capital Turnover Ratio = ------------------------------------------
Working Capital
(3) Fund Flow Statement:- This statement reveals the sources from which funds were
obtained and the uses to which funds were applied. In other words, this statement
discloses what the main sources of funds were and how these funds were utilized
during the year. With the help of this statement the basic reasons for increase or
decrease in working capital can be analysed. The term 'fund' does not mean 'cash'. It
is generally used to denote the difference between current assets and current

liabilities. In other words, the term 'fund' stands for 'net working capital'. Thus, a fund
flow statement indicates the causes of changes in the working capital of a company
during the year.
(4) Cash Flow Statement:- A cash-flow statement is a statement showing and outflows

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of cash during a particular period. In other words, it is a summary of sources and
applications of cash during a particular span of time. It analyses the reason for

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changes in balance of cash between the two balance sheet dates. The term 'cash'
here stands for cash and cash equivalents. A cash-flow statement can be for the past
or can be projected for a future period.

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(FINANCE)

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UNIT – II

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Q. What do you mean by Cash? What are the motives of holding cash?
Ans. Cash:- For the purpose of cash management, the term cash not only includes coins,
currency, notes, cheques, bank drafts, demand deposits with banks but also the 'near-cash
assets' like marketable securities and time deposits with banks because they can be readily

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converted into cash. For the purpose of cash management, near-cash assets are also
included under cash because surplus cash is required to be invested in near-cash assets for
the time being.
Motives of Holding Cash: - In every business assets are kept because they generate profit.
But cash is an asset which does not generate any profit itself, yet in every business sufficient
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cash balance is maintained. There are four primary motives or causes for maintaining cash
balances:
(1) Transaction Motive: - A number of transactions take place in every business. Some
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transactions result in cash outflow such as payment for purchases, wages, operating
expenses, financial charges like interest, taxes, dividends etc. Similarly, some
transactions result in cash inflow such as receipt from sales, receipt from investment,
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other incomes etc. But the cash outflows and inflows do not perfectly match with each
other. At times, inflows exceed outflows while, at other times outflows exceed inflows.
To meet the shortage of cash in situation when cash outflows exceed cash inflows, the
business must have an adequate cash balance.
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(2) Precautionary Motive: - In every business, some cash balance is kept as a
precautionary measure to meet any unexpected contingency. These contingencies
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may contingencies may include the following:
(i) Floods, strikes and failure of important customers.
(ii) Unexpected slow down in collection from debtors.
(iii) Cancellation of orders by customers.
(iv) Sharp increase in cost of Raw-materials.
(v) Increase in operating costs etc.

(3) Speculative Motive: - In business, some cash is kept in reserve to take advantage of
profitable opportunities which may arise from time to time. These opportunities are:
(i) Opportunity to purchase raw material at low prices on payment of immediate
cash.

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(ii) Opportunity to purchase other assets for the business when their prices are low.
(iii) Opportunity to purchase other Assets for the business when their prices are low.

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(4) Compensative Motive: - Banks provide a number of services to the business such as
clearance of cheques, supply of credit information about other customers, transfer of

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fund and so on. Bank charge commission or fee for some of these services. For other
services, banks do not charge any commission or fee they require indirect
compensation. For this purpose, bank requires the client to maintain a minimum
balance in their accounts in the bank. The clients cannot use this bank balance &
banks compensate the cost of providing free services by using this amount to earn a
return. Therefore, cash is also kept at the bank to compensate for free services by

Q.
banks to the business.
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Explain how to manage the Cash flows?
Ans. The term cash management also includes prompt collection and efficient
disbursement of cash. If cash is collected promptly and liabilities are paid in time, the
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optimum cash balance requirements in the business also reduces. The task of managing the
cash flow is two fold. It includes:
(A) Accelerating cash collections
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(B) Slowing disbursements
(A) Accelerating cash collection : The customer should be encouraged to pay as
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quickly as possible and their payments should be converted in to cash without any
delay. Customer can be encouraged to pay quickly. If the customer makes the
payment by cheques or draft, the cheques & draft should be encashed promptly.
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The main objective of cash management is to reduce these time gaps so far as
possible. There are certain techniques to reduce this time gaps:
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(1) Establishment of collection centre or concentration banking: - Under this
technique, large firms which have large number of branches at different places,
select some of these branches for receiving payments from customers. These
branches are called "collection centre". The firms also open its accounts in the
local banks of collection centers. Customers are advised to send their cheques
to their nearest collection centre. The collection centers deposit these cheques
in the firm's local bank a/c. All the collection over a predetermined level is
transferred daily to bank where the head office is situated. Head office can use
these funds for disbursements.

(2) Lock- box System: - Under this technique also, large firms select some
branches as collection centers for receiving payments from the customers &
open account in local banks of collection centers. Under this technique, firms
also hire a post office lock-box at important collection centers. Customers are
advised to send their cheques or draft to the post office lock- box. The local

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banks of the firm are authorized to open the post office lock - box and collect the
cheques received from the customers. The local banks withdraw the cheques

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from a lock box several times a day and deposit them in firm's accounts. Local
banks, then, send a deposit slip to the collection center along with list of payment
received from customers, on the basis of which, the collection center makes a

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record of all the receipts in its books.
(B) Slowing disbursements:- Payment should be made as late as possible without
damaging the goodwill and credit rating of the firm. It should, however take an
advantages of the cash discount available on prompt payment. There are certain
techniques to slow the disbursement:
1.

2.
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Avoidance of early payments: - One way to slow disbursements is to avoid
early payments. The firm should not be made before or after due date.
Centralized Disbursement: - Another way to slow down disbursements is to
make all the payments by the head office from the centralized account. This
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system increase the time gap between remittances are made locally by the
branches, it will take lesser time to reach the creditors by post.
3. Float: - Float is a very important way of slowing down the disbursements. Float
is the amount of money tied up in cheques that have been issued to creditors but
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which have not been presented in bank for payment. There is always some gap
between the issue of cheques by firm & presentation it to bank by the creditors
bank for payments due to transit & processing delays by the creditors.
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Therefore, a firm can send cheques to its creditors although it does not have
adequate balance at its bank at the time of issuance of the cheques. Meanwhile,
funds can be arranged to make payment when the cheques are presented for
payment after a few days. To make use of the floats, the firm may issue a cheque
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on the banks far away from the creditor's bank. In order to take advantage of the
float it is necessary to analyse the time-gap in issue of cheques and their
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presentation in the bank for payment.
4. Accruals: - Another way to slow down disbursement is accruals. Certain kind of
expenses such as wages, rent etc. should be paid after the period when actual
services have been rendered.
Q. Explain Investment in Marketable Securities.
Ans. Marketable Securities:- Marketable Securities are those securities which can be
converted into cash in a short period of time., typically a few days. The basic characteristics

of marketable securities affect the degree of their marketability/liquidity. To be liquid, a
security must have two basic characteristics: a ready market and safety of principal. Only
those securities that can be easily converted into cash without any reduction in the principal
amount qualify for short term investments.

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Investment in Marketable Securities:- We describe below briefly the more prominent
marketable securities available for investment. These are :-

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(1) Commercial Papers: - These are short-term unsecured securities issued by highly
creditworthy large companies. Commercial papers are regulated by the RBI and the
main features of commercial papers are:-

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(i) Only those companies are allowed to issue commercial papers which have a net
worth of Rs. 10 crore or more.
(ii) The minimum size of an issue is Rs. 25 lac and the size of each commercial
paper should not be less than Rs. 5 Lac.
(iii)
Advantage:-
(i)
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They can be issued for periods ranging between 15 days and one year.

It is a cheaper source of short-term finance as compared to bank credit.
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(ii) It is a useful source of finance during period of tight bank credit.
Limitations:-
(ii) It can be used only by large and financially sound companies.
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(iii) Commercial papers cannot be redeemed before maturity date even if the
issuing firm has surplus funds.
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(iv) Maturity fate of commercial papers cannot be extended even is the issuing firm
is facing financial difficulties.
2) Treasury Bills:- There are obligations of the government. They are sold on a discount
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basis. The investor does not receive actual interest payment. The return is the
difference between the purchase price and the par value of the bill.
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The treasury bills are issued only in bearer form. They are purchased, therefore,
without the investors name upon them. This attributes makes them easily transferable
from one investor to another.
3) Units of Mutual Fund:- The units of mutual funds offer a reasonably convenient
alternative avenue for investing surplus liquidity as
(i) There is a very active secondary market for them.
(ii) The income from u8niots is tax-exempt up to a specified amount.

4) Bill Discounting:- Surplus funds may be invested to purchase/discount bills. Bills of
exchange are drawn by seller on the buyer for the value of goods delivered to him.
During the pendency of bill, if the seller is in need of funds, he may get it discounted.
On maturity, the bill should be presented to the drawee for payment.

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5) Money Market Mutual Funds/Liquid Funds:- These are professionally managed
portfolios of marketable securities. They provide instant liquidity. Due to high liquidity,

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competitive yields and low transactions, these funds have achieved significant growth
in size and popularity in recent years.
6) Certificates of Deposit (CDs):- These are marketable receipts for funds that have

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been deposited in a bank for a fixed period of time. The deposited funds earn a fixed
rate of interest. The CDs are offered by banks on a basis different from treasury bills,
that is , they are not sold at a discount. Rather , when the certificates mature, the owner
receives the full amount deposited plus the earned interest.
Selection Criteria:- A major decision confronting the financial managers involves the

(i)
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determination of the mix of cash and marketable securities. These consideration
include evaluation of:
Financial/Default Risk:- It refers to the uncertainty of expected returns from a
security attributable to possible changes in the financial capacity of the security-
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issuer to make future payments to the security-owner. If the chance of default on
the terms of the investment is high (low), then the financial risk is said to be high
(low).
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(ii) Interest Rate Risk:- The uncertainty that is associated with the expected
returns from a financial instrument attributable to changes in interest rate is
known as interest rate risk.
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(iii) Taxability:- Another factor affecting observed difference in market yields is the
difference impact of taxes.
(iv) Liquidity:- With reference to marketable securities portfolio, liquidity refers to
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the ability to transform a security into a cash.
Q. Write a short note on Cash System.
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Ans. Cash System:- The cash system of a firm is the mechanism that provides the linkage
between cash flows. It includes
(i) Collection System:- The external element of the cash system include a collection
system for getting cash into the firm.
(ii) Disbursement System:- Disbursement systems means for paying the suppliers.

Deposit Disbursemen
Bank 1 Bbank 1

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Concentration
Bank

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Deposit Disbursement
Bank 2 Bank 2

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What are the types of collection system?
Ans. Types of Collection System:-
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1. Over-the-Counter Collections:- The first specialized collection system that we
describe been over the counter collection system, where the payment is received in a
face-to-face meeting with the customer. Most retail businesses receive at least some
of their payments on an over-the-counter basis. Since payments are not mailed, an
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over the counter system does not contain mail float. The cash flow timeline for an over-
the-counter system is shown:-
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Customer Deposit Availability
Delivers made at granted
Payment local bank
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Processing delay Availability delay
Processing float Availability float

Collection float

Components of a collection system for over the counter receipts

Customers

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Filed Unit

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Local Deposit Central Information
Bank System

2. Mailed Payments Collection System:- For many companies, payments, almost

(i)
(ii)
Mail Float
Processing Float
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cheques are mailed by the customer in response to an invoice. A mailed payments
system contains all three components of collection float:
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(iii) Availability Float.
Components of a Mailed Payments Collection System

Customer Customer Customer Customer Customer
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Group 1 Group 2 Group 3 Group 4 Group 5
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Collection Collection
Center A Center A
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Deposit Deposit
Bank X Bank Y

Central Information
System

Q. Explain Baumol Model of Cash Management.
And. Baumol Model:- Baumol model is a device of cash management which is used to
determine optimum cash balance. Optimum cash balance is determined by establishing a
balance between liquidity and profitability. Higher liquidity or higher cash balance means

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excessive cash is kept in business which results in loss of interest which can be earned by
investing this excessive cash in marketable securities. On the contrary, lower liquidity or a

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very low cash balance means no idle cash and interest is being earned by investing the
excess cash into securities. But in this case also, additional costs are incurred such as
brokerage of converting securities into cash, accounting costs of securities, cost of

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registration of securities etc.
Therefore two types of costs are involved in keeping cash balance in a business-
(i) Opportunity Cost
(ii) Transaction Cost

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When cash balance increases, opportunity cost increases but transaction cost decreases.
On the other hand, when cash balance is less, opportunity cost decreases but transaction
cost increases.
Optimum cash balance is that level of cash at which the opportunity cost and transaction
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cost becomes equal. In other words, total cost of keeping cash balance will be minimum if
both of its component namely opportunity cost and transaction cost are equal.
Assumptions :- The Baumol Model is based on the following assumptions:-
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1. The cash needs of the firm are known with certainty
2. The cash disbursements of the firm occurs uniformly over a period of time and is
known with certainty
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3. The opportunity cost of holding cash is known and it remains constant.
4. The transaction cost of converting securities into cash is known and remains constant.
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Baumol model is in the form of following formula:-
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2U X P
C = _____________ = Rs. 10,000
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Where
C = Optimum Cash Balance
U= Cash disbursement of a year (or month)

P= Fixed cost per transaction
S= Opportunity cost of one rupee p.a. (per month)
Example:-

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Monthly cash requirements according to cash budget Rs. 50,000
Fixed cost per transaction Rs. 10

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Interest Rate 12% p.a.
Calculate optimum cash balance

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Solution:-
2 X 50,000 X 10
C = ________________ = Rs. 10,000
.01

Q.
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Therefore, optimum cash balance= Rs. 10,000
What are the objectives of Cash Management?
Ans. Cash Management:- Cash management includes maintaining optimum cash
balance and efficient collection and disbursement of cash. Accordingly, the main objectives
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of cash management are:-
(i) To maintain optimum Cash Balance:- The main objectives of cash management is
to determine the optimum cash balance required in the business and to maintain the
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cash balance at that level.
(ii) To keep the optimum Cash balance Requirement at Minimum level:- The second
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main objectives of cash management is to minimize the optimum cash balance
requirement because cash is a non-earning asset.
Q. Explain Miller and Orr Model of Cash Management .
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Ans. Introduction:- Baumol's model is based on the basic assumption that the size and
timing if cash flows are known with certainty. This usually does not happen in practice. The
cash flows of a firm are neither uniform nor certain. The Miller and Orr model overcomes the
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shortcomings of Baumol model.
The Miller and Orr model provides two control limits:-
1. Upper Control Limit
2. Lower Control Limit along with a Return point.
This model can be explained with the help of the following diagram:-

Curve represents Cash Balance
Upper Control Limit

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Purchase of Marketable Securities
Return Point

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Sale of Marketable Securities

Lower Control Limit

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When the cash balance touches the upper control limit, marketable securities are
purchased. In the same manner when the cash balance touches lower control limit, the firm
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sell the marketable securities. The spread between the upper and lower cash balance limits
(Called R) can be computed using Miller-Orr Model as below:-
1/3
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3 Transaction Cost X Variance of Cash Flows
R = ------- X --------------------------------------------------------------
4 Interest Rate
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Upper Control Limit= 3 R + lower control limit
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Optimal Return Point = R+L
L= Lower control limit
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2
Variance of Cash Flows = (Standard deviation)
Example:- A company has a policy of maintaining a minimum cash balance of Rs. 100000.
The standard deviation in daily cash balance is Rs.50,000. The interest rate on a daily basis
is 0.02 %. The transaction cost for each sale or purchase of securities is Rs. 45. Compute the
upper control limit and the return point as per the Miller -Orr Model.
Spread between the upper and lower cash balance (Z)

3 Transaction Cost X Variance of Cash Flows
R = ------ X --------------------------------------------------------------
4 Interest Rate
2

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3 45 X (50000)

R
R = -------- X --------------------------------
4 .0002

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R = Rs. 75,000
Upper Control Limits =3 X 75,000 +1,00,000 = 3,25,000
Return Point = 1,00,000 + 75,000. = 175000

occur:
Day
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Assume that the firm's starting balance was Rs. 1,50,000 and the following cash flows

Net Cash Flow
1 -25,000
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2 -75,000
3 + 1,00,000
4 -25,000
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5 + 1,25,000
• At the end of day 1, the cash balance would be Rs. 1,25,000 since this is
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between the control limits, no action would be taken.
• A the end of day 2, however the cash balance would be reduced to Rs.
50,000 of the firm did nothing since this is below the lower control limit the
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would disinvest sufficient securities to get back the return point.
Q. Explain the Stone Model of Cash Management.
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Ans. Stone Model of Cash Management:- Like the Miller-Orr model, the Stone model
takes a control-limits approach; when cash balance fall outside the control limits, the firm is
signaled to do something. But in the Stone Model, the signal does not automatically result in
an investment or disinvestment" the recommended action depends on management's
estimates of future cash flows : that is, the model signals an evaluation by management
rather than an action. To do this, the stone model uses two sets of control limits; the inner
control limits (UCL1 and LCL1) and the outer control limits (UCL2 and LCL2).

UCL2
UCL1

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Return Point
Cash

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Balance

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LCL1
LCL2

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Explanation:- The transactions are same as those in Miller Orr Model. Investments are
made sufficient to bring the cash balance back to the return point if the upper control limit is
exceeded: corresponding disinvestment are made if the lower control limit is exceeded.
For Example:- It is assumed that beginning balance was Rs. 1,50,000, the upper control
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limit was Rs. 3,25,000, the return point was Rs. 1,75,000, the lower control limit was Rs.
1,00,000. The cash flows doe the first five days were:-
Day Net Cash Flow
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1 -25,000
2 -75,000
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3 + 1,00,000
4 -25,000
5 +1,25,000
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Let us assume that inner control limits are set Rs. 20,000 inside the outer control limits ( at
Rs. 3,05,000 and Rs. 1,20,000) and the firm looks ahead tat the next two days cash flows. At
the end of day 1, the cash balance is 1,25,000 (1,50,000-25,000), but since the outer control
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limits have not breached, no evaluation is made. At the end of the day 2, however, the cash
balance has been reduced to Rs. 50,000. At this point, the firms total the next two days cash
flows. Let us assume that forecast is correct; the total obtained is Rs.. 75,000 (1,00,000-
25,000) as the expected future cash flow, Adding this to the current balance of Rs. 50,000
gives an expected balance of Rs. 1,25,000. Since the expected cash balance is within the
inner control limits, no transaction is made. There are no investments or disinvestments over
the five-day period of the example (recall the Miller-Orr model required one investment and
one disinvestment).

(FINANCE)

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UNIT – III

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Q. Define Inventory Management. What are the objectives of Inventory
Management?
Ans. Inventory Management:- The term inventory refers to stock of goods kept for sale by
the firm. Inventory of finished goods should be maintained at sufficient high level so that the

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demand of customers may be fully satisfied. Similarly, inventory of raw-materials should
also be sufficient so that manufacturing process can be run smoothly. In case of inadequate
inventory of raw materials, there is always a risk of being out-of-stock. Therefore, the major
responsibility of inventory management is to determine the sufficient level of inventory
required in the business.
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On the other hand, since inventory is a major asset and it involves a lot of funds, inventory
level should not be excessive. Excessive inventory increases costs because extra funds are
involved in it.
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Thus, both inadequate and excessive quantity of inventory is undesirable in the business.
Inventory management should maintain the inventory at sufficient level so that it is neither
excessive nor short of requirement. Thus, the term inventory management includes two
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conflicting tasks:
(a) To maintain a sufficient large size of inventory to meet the demand of finished goods
and to meet the demand of raw materials by production department.
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(b) To keep the investment in inventories at minimum level by efficiently organizing the
purchase and sale operations.
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Objectives of Inventory management:
(1) To ensure continuous supply of raw materials so that production should not suffer at
any time.
(2) To maintain sufficient inventory of raw materials in periods of short supply.
(3) To maintain sufficient inventory of finished goods so that the demands of customers
are duly met.

(4) To minimize the carrying cost of inventory namely cost of godown, insurance
expenses, cost of funds involved in inventory etc.
(5) To control investment in inventory and keep it at an optimum level.
(6) To avoid both over-stocking and under-stocking of inventory.

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(7) To minimize losses through wastages and damages.

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(8) To facilitates furnishing of data for short-term and long-term planning and control of
inventory.

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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) An efficient system of inventory management will determine:-
(a) What to purchase
(b)
(c)
(d)
How much to purchase
From where to purchase
Where to store, etc.
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Q. Define Inventory. What are the benefits and costs of holding inventory?
Ans. Inventory:- Every enterprise needs inventory for smooth running of its activities. The
term inventory refers to stock of goods kept for sale by the firm.
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Kinds of Inventories:-
(A) In Trading Concern.
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(B) In Manufacturing Concern.
(A) In Trading Concern:- In case of trading concerns, it includes only finished goods.
(B) Manufacturing Concern:- In case of manufacturing concern, inventory may include:-
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(i) Inventory of Raw Materials:- Raw Material form a major input into the
organisation. The inventory of raw materials contains the items which are to be
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converted into finished goods through the manufacturing process. The quantity
of raw materials required will be determined by the rate of consumption. The
factors like the availability of raw materials and government regulations, etc. too
affect the stock of raw materials.
(ii) Inventory of Work-in-progress:- The work-in-progress 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.

(iii) Consumables:- These are the materials which are needed to smoothen the
process of production e.g. fuel oil, coal.
(iv) Inventory of Finished Goods:- These are the goods which are ready for the
consumers. In other words, inventory of finished goods represents completed

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items which are available for sale.
(v) Spares:- Spares also form a part of inventory. Spares include those items which

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are not converted into finished goods but are needed to run the manufacturing
process smoothly. The costly spare parts like engines, maintenance spares etc.
are not discarded after use, rather they are kept in ready position for further use.

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Benefits of Holding Inventories:-
(1) Timing of Demand and Supply:- Need to hold inventory of raw materials arises
because it is not possible for a firm to procure raw materials whenever it is needed. If
the firm is assured of supply of raw material without delay, at the rate it is used in it's
manufacturing process, it need not to hold stock of raw materials. But in actual

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practice, a time lag exists between demand of raw materials in manufacturing process
and its supply. Supply of raw material to the firm mat also be delayed because of such
factors as strike, transport problems, short supply etc. Therefore, the firm should
maintain adequate inventory of raw material to run its manufacturing process
regularly. Similarly, need to hold inventory of finished goods arises because the rate
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of manufacturing and the rate of sale do not match. A firm cannot manufacture the
goods immediately on demand by customers.
(2) Quantity Discounts:- Raw materials are required as and when production process is
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run. But instead of procuring raw materials in small quantities at the time of each
production run, firm may purchase large quantities of raw material in advance to obtain
quantity discounts of bulk purchasing. This results in a significant saving in costs.
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(3) Anticipation of Price Rise:- Anticipation of price rise may also necessitate
purchasing and holding of raw material inventories.
(4) Reducing Ordering Cost:- These cost include the cost of preparing purchase orders,
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transporting cost, receiving costs, inspecting costs etc. These cost increase in
proportion to number of order placed. Therefore, a firm may purchase raw materials in
excess of its immediate needs by placing one bulk order to reduce the ordering costs.
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This also results in accumulation of raw material inventory.
Cost of Holding Inventories:
The holding of inventories involves blocking of a firm's funds. The various risks and
costs in holding inventories are as below:
(1) Capital Costs:- Maintaining of inventories results in blocking of the firm's
financial resources. The firm has, therefore, to arrange additional funds to meet
the cost of inventories. The funds may be arranged from own resources or from

outsiders. But in both 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 outsiders.
(2) Storage and Handling Costs:- Holding of inventories also involves costs on

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storage as well as handling of materials. The storage costs includes:
(i) Rent of the Godown

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(ii) Insurance charges etc.
(3) Risk of Price Decline:- There is always a risk of reduction in the prices of

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inventories by the suppliers on holding inventories. This may be due to
increased market supplies, competition or general depression in the market.
(4) Risk of Obsolescence:- The inventories may become obsolete due to
improved technology, change in requirements, change in customer's tastes, etc.

Q.
(5)
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Risk Deterioration in Quality:- The quality of the materials may also
deteriorate while the inventories are kept in stores.
What are the methods for Valuation of Inventories?
Ans. Valuation of Inventories:- The value of materials has a direct bearing on the income
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of a concern, so it is necessary that a method of pricing materials should be such that it gives
a realistic value of stocks. The traditional method of valuing materials 'Cost price or market
price whichever is less' is no longer the only method.
The following methods for pricing materials issues are generally used:-
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(1) First in First Out Method (Known as FIFO Method)
(2) Last in First Out Method (Known as LIFO Method).
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(3) Average Price Method.
(4) Base Stock Method.
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(5) Standard Price Method.
(6) Market Price Method.
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(1) First in First Out (FIFO) Method:- In first in first out method the materials received
first are issue first. The materials are issued in chronological order. The recently
received materials remain in stock. Whenever a requisition for material issue is
presented to the store-keeper he will use the price of the first and then of second and
third lot, etc.
For Example:- A manufacturer has the following record of purchases of a condenser,
which he uses while manufacturing radio sets:

Date Quantity (Units) Price per unit
Dec. 4 900 5.00
Dec. 10 400 5.50

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Dec. 11 300 5.50

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Dec. 19 200 6.00
Dec. 28 800 4.75`

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Total 2,600

1600 units were issued during the month of December. Find the value of closing stock
assuming FIFO Method.
Solution:-

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The closing stock is 1,000 units and would consists of-
800 units received on 28th December; and
200 units received on 19th December as per FIFO
The value of 800 units @ Rs. 4.75 3,800
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Total 5,000
(2) Last in First Out (LIFO) Method:- In last in first out method the last received
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materials are issued first and ending inventory consists of earlier acquired materials.
This method is also known as replacement cost method because the latest purchased
goods will correspond to the current market prices except that goods were not
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purchased much earlier. The inventories will be valued at oldest lot on hand and these
values will be quite different from current invoice prices.
For Example:- A manufacturer has the following record of purchases of a condenser,
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which he uses while manufacturing radio sets:
Date Quantity (Units) Price per unit
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Dec. 4 900 5.00
Dec. 10 400 5.50
Dec. 11 300 5.50
Dec. 19 200 6.00
Dec. 28 800 4.75`
Total 2,600

1600 units were issued during the month of December. Find the value of closing stock
by applying LIFO Method.
Solution:-
The closing stock is 1,000 units and would consists of-

S
100 units received on 10th December; and

R
900 units received on 4th December as per FIFO
The value of 100 units @ Rs. 5.50 550

TE
Total 5,050
(3) Average Cost Method:- In average cost method of pricing all materials in stock are so
mixed that price based on all lots is formed. Average cost may be of two types:
(a)
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Simple Average Cost: In this method the prices of all lots in stock are averaged
and the materials are issued on that average price. For example, three lots of
materials are in stock and the prices per unit these lots are Rs.2, Rs.3, Rs.4 of
first, second and third lots respectively; then the average price will be:
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2+3+4
Average Price= ---------------- = Rs. 3
3
Though this is a simple method of pricing materials but particularly this method does not give
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good results. The total cost is not observed in this method. The following example will
explain this point:
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10,000 units were purchased @ Rs. 2 per unit
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The total cost of materials will be:
10,000 X 2 = 20,000
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15,000 X 3 = 45,000
20,000 X 4 = 80,000
Total Cost = 1, 45,000
The simple average price issue in this case is Rs. 3 and total amount will become 1,35,000
(45,000X3). The under absorbed amount in this case will be Rs. 10,000. Because of this
weighted average method is preferred.

(b) Weighted Average Method:- In this method the total cost of all the materials is
divided by the total number of items in stock. The price calculated in this way will be
used for issue of materials. Taking the earlier example the weighed average price will
be:

S
10000 X 2 + 15000 X 3 + 20000 X 4
Weighted Average Price= ----------------------------------------------------
10000+ 15000+ 20000

R
1, 45,000

TE
= ------------------------ = Rs. 3.22
45,000
(4) Base Stock Method:- In this method some quantity of materials is assumed to be
necessary for keeping the concern going. The quantity is not issued unless otherwise
there is an emergency. This material which is not issued as is kept in stock as a base

(5)
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stock. This method is not an independent method. It is used alongwith some other
methods such as FIFO, LIFO, Average Price Method, etc. After maintaining the base
quantity in stock, the issues are priced at one of the methods mentioned above.
Standard Price Method:- The issue price of materials is predetermined or estimated
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in this method. The standard price is based on market conditions, usage rate, storage
facilities, etc. The materials are priced at standard price irrespective of price paid for
various purchase.
For Example:- The Standard price of raw material is fixed at Rs. 5 per unit. Two lots of
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materials of 10000 units and 12,000 units were purchased at Rs. 4.90 and Rs. 5.25 per
unit. Every issue of material will be priced at Rs. 5 per unit, without taking into
consideration the prices at which these were purchased.
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(6) Market Price Method:- In this method the price charged to production are not costs
incurred on the materials but latest market prices. It reflects the latest price charged to
production. This method is not generally used because of a number of difficulties. It
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becomes difficult to select the market price because price prevails in different markets.
Q. What are the various tools and techniques of Inventory Management?
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Ans. 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 problems of liquidity but also increases profits and causes
substantial reduction in the working capital of the concern. The following the important tools
and techniques of inventory management and control:
1. Re-order point.
2. Economic Order Quantity (EOQ)

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