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A firm needs fixed capital as well as working capital for its operations while the fixed capital
is invested in fixed assets and the working capital is in the form of current assets. The
management of current assets differs from fixed assets in the following three ways: -
ë. First is managing fixed assets time is very important factor in fixed assets but significant in
current assets.

Secondly the large holdings of current assets strengthen the firm¶s liquidity positions but
also reduce the overall profitability.
3. Third, level of fixed as well as current assets depends upon expected sales, but it is only
current assets, which can be adjusted with sales fluctuation in short run.

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apital required for a business can be classified under two main categories
è? Fixed capital
è? ÷orking capital
Every business needs funds for two purposes ± for its establishment and to carry out its day to
day operations. Long terms funds are required to create production facilities through the
purchase of fixed assets such as plant and machinery, land, etc. Investments in these assets
represent that part of firm¶s capital, which is blocked on a permanent or fixed basis and is
called fixed capital.
÷orking capital refers to that part of the firm¶s capital, which is required for financing short
term or current assets such as cash, marketable securities, debtors and inventories. Funds,
thus, invested in current assets keep revolving fast and constantly being converted into cash
and these cash flows out again in exchange for other current assets. Hence it is also known as
revolving or circulating capital or short term capital.



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There are two basic interpretations of working concept
? [alance sheet concept
? „perating cycle concept
 CONCEPTOFORKINGCAPITAL


[alance „perating
sheet cycle

Net Gross
working working
apital capital

 
    : There are two types of working capital under this concept

ë
? Gr

 rkii: Itrefers to firm¶s investments in current assets. Thus 

Gross working capital includes the total current assets.
2.? N   rki i   It refers to difference between current assets and current
liabilities i.e.
N÷ = current assets - current liabilities
It can be negative or positive. The positive net working capital will arise when current assets
exceed current liabilities. A negative net working capital occurs when current liabilities
exceed current assets.
O ri       A company operating cycle typically consists of 3 primary
activities: purchasing resources, producing the product and distributing the product.
„perating cycle is the time duration to convert sales, after the conversion of resources into
inventories into cash. It involves three phases.
1. Acquisition of resources
2. Manufacture of product
3. Sale of the product either for cash or on credit.

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curchase cay for Sale of product on ‘eceive

‘esource resources credit cash
s

Inventory conversion period ‘eceivable conversion period

cayable deferred period ash conversion period

„perating cycle

The length of the operating cycle of a firm is the sum of:

? Inventory conversion period

? ‘eceivables conversion period
? cayable deferred period
? cash conversion period

C

ifii  f rkii

The working capital can be classified into ways:

? on the basis of concept
? on the basis of time
? on the basis of concept it is classified into two i.e. G÷ and N÷
? „n the basis of time it is classified into permanent and fixed working capital and
temporary or working capital.

? ?  it is the minimum amount, which is to insure effective

utilization of fixed facilities and for maintaining the circulation of current assets. There is
always a minimum level of current assets, which is continuously required by the enterprise to
carry out its normal business operation. This minimum level of working capital is known as
permanent working capital as this capital is permanently blocked in the form of current
assets.

?? temporary working capital is amount of working capital, which

is required to meet the seasonal demands and some special exigencies. The temporary
working capital can be further classified as seasonal working capital. Most of enterprise has
to provide additional working capital to meet the seasonal and special needs
.
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÷orking capital polices of a firm have a great effect on its profitability, liquidity and
structural health of the organization. In this context ÷orking capital management is three
dimensional in nature.
*? mimension I is concerned with the formulation of the policies with regard to profitability,
risk and liquidity.
*? mimension II is concerned with the decisions about the composition and level of current
assets.
*? mimension III is concerned with the decisions about the composition and level of current
liabilities.

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The need of working capital arises due to time gap between production and realization of
cash from sales. There is an operating cycle involved in the sales and realization of cash.
There are time gaps in the purchase of materials and production; production and sales; and
sales and realization of cash. Thus working capital is needed for the following purpose:

è? For the purchase of raw material, components and spare.

è? To pay wages and salaries
è? To incur day to day expenses and overhead costs such as fuel, power and office
expenses, etc.
è? To meet the selling cost as packing advertising etc.
è? To provide credit facilities to the costumers.
è? To maintain the inventories of the raw material, work in progress, stores and spares
and finished goods.

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The most appropriate method of calculating working capital needs of a firm is the concept of
operating cycle. Following are the other three approaches which can be applied to estimate
working capital needs.
1)? urrent assets holding period: To estimate working capital requirements on the basis
of average holding period of current assets and relating them to cost based on the company¶s
experience in the previous year.
2)? ‘atio to sales: To estimate working capital requirements as a ratio of sales on the
assumption that current assets change with sales.
3)? ‘atio of fixed assets: some times working capital may be estimated as the percentage
of fixed assets.

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÷orking capital is the life, blood and nerve of a business. Just as circulation of blood is
essential in human body for maintaining life, working capital is very essential to maintain the
smooth running of the business. No business can run successfully without an adequate
amount of working capital. The main advantages of an adequate amount of working capital
are,
1.? Solvency of [usiness ± an adequate solvency of business working capital helps in
maintaining solvency of business by providing an uninterrupted flow of production
2.? Goodwill ± sufficient working capital enables a business concern to make prompt
payments and hence helps and maintaining and creating goodwill.
3.? ‘egular supply of raw materials ± sufficient working capital ensures a regular supply
of raw materials and continuous production.
4.? ‘egular payment of salaries , wages and others day to day commitments- a company
which has an ample working capital can make regular payment of salaries , wages and others
day to day commitments which raise the morale of its employees , increases their efficiency ,
reduces wastage¶s and costs and enhances production and profits¶.
5.? Ability to face crisis- adequate working capital enables a concern to face business
crisis in emergencies such as depression because during such periods, generally, there is
much pressure on working capital.
6.? Quick and regular return on investment- every investor wants a quick and regular
return on his investments. sufficiency of working capital enables a concern to pay quick and
regular dividends to its investors, as there may not be much pressure to plough back profits .,
this gains the confidence of its investors and creates a favorable market to raise additional
funds in the future .
Every business concern should have an adequate working capital to run its operations. it
should have either redundant or excess working capital nor inadequate nor shortage of
working capital . both excess as well as short working capital positions are bad for any
business . however , out of the two, it is the inadequacy of working capital , which is more
dangerous of point of view of the firm
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The two constituents of working capital are as follows:
? urrent assets
? urrent liabilities

  These are the assets, which can be converted onto cash with in an

accounting year or are held for short period of time.

The major components of current assets include
? inventories
? cash and bank balance
? accounts receivables
? loans and advances
? short term investment
urrent Assets include the following entities:

*? #$?%?#$? &'(#)?
ash and ash Equivalents include all the money that the firm has in its bank accounts,
certificates of deposits, money market funds and savings deposits. They represent the most
liquid form of assets and this money can be made available to a business immediately.
Having a decent amount of ash and ash Equivalents on hand not only helps the firm to pay
dividends and fulfill other obligations, but also can come to a firm¶s rescue in bad times.
„n the other hand, having too much cash on the balance sheet is not a good sign as that may
mean the company is allowing the cash to sit idle, rather than investing it in useful return-
generating activities. Also, having too much cash may also mean that some of it may actually
be borrowed money, for which the amount of debt must always be seen carefully in tandem.

*? $?
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Short Term Investments are investments that a firm can sell at a short notice to generate cash.
These investments are not as liquid as ash and ash Equivalents, but nevertheless provide
added cushion in times of need. These investments are employed by the company when it has
so much cash on hand that it invests in higher return (higher interest rate than savings account
in banks) generating instruments like short term bonds (maturity less than 1 year).
 *? ()?
Inventory includes primarily 3 types of items:
1. ‘aw Materials Inventory:
They include the raw materials and components which will be used in manufacturing the
finished goods.
2. ÷ork-In-crocess Inventory (÷Ic):
÷Ic includes the materials and components that are in the process of transformation into the
finished goods. This is the stage in between the ‘aw Materials and Finished Goods.
3. Finished Goods Inventory:
These are goods ready for sale to the customers
The following are the basic reasons for keeping inventory:
Time: The supply chain will always have some time lags (called lead time) from supplier to
user at every stage and hence it is necessary to maintain certain amount of inventory to utilize
in this lead time
Uncertainty: [usiness environment is always filled with uncertainties in demand and supply
and hence maintaining certain amount of inventory is necessary to have a buffer during
uncertain times.
Economies of Scale: [ulk buying, movement and bulk storing always brings with itself the
important benefit if Economies of Scale and thus a certain minimum amount of inventory is
maintained to realize this benefit.

Inventory Management is all about determining and managing the size and placement of
stocked goods in such a way that there is never a condition of stock-out and also the costs
associated with handling and storage of inventory is minimized to the maximum possible
extent.
It is a must to have just the optimum amount of inventory and not in excess because
inventory, as such, is a dead asset and the capital is unnecessarily tied up in stock until the
goods are sold and the proceeds are received from the customers. This capital may have been
invested in useful, productive activities.
Also, having excess inventory always has the risk attached to it in the sense that inventory
may become obsolete and hence the costs incurred in producing the inventory goes in waste,
resulting in losses to the firm.
 *? '#?(*#)?
Accounts ‘eceivables is the money that is owed to the firm by the entities outside the
company called the debtors of the firm. This money is due within 1 year. In most business
firms, when a good is sold to a customer, an invoice is generated and mailed electronically to
the customer, who must pay the amount due within an established or negotiated time frame
called the µreditor cayment Terms¶.
ommon cayment Terms are Net 30, Net 45, Net 60 etc which mean that payment is due 30
days, 45 days, 60 days respectively from the date of the invoice. It could be any other time
frame as negotiated between the firm and customer. It is also a practice to give discounts on
the invoice amount to customers as an incentive for earlier payment than the maximum
allotted credit period. For example, 2% 10, Net 30 would mean that the customer can avail a
2% discount on the invoice amount if the payment is made within 10 days from the invoice
date, whereas the maximum credit period given for full payment is 30 days.
Generally, grace period of 10-20 days is given by firms after the due date for receiving
payments from customers, with decisions dictated by industry standards, corporate policy,
and financial condition of client.
As all the customer debts or receivables are unlikely to be collected successfully, firms may
provide an allowance for bad debt which is subtracted from total accounts receivable. This
subtracted amount represents the ‘eceivables onsidered Good. ÷hen account receivable are
not paid in due course of time, some firms turn them to third party collection agencies who
attempt to recover the dues via renegotiating payment terms, legal action etc.

*? %? +##)?
crepaid expenses represent certain assets, usually of an intangible nature, whose usefulness
will expire in the near future. An example is an insurance policy. A business pays for
insurance protection in advance. Its right to this protection is an asset ± an economic resource
that will provide future benefits. Since this right will expire within a short period of time, it is
a current asset. The amount on the balance sheet is the amount of the unexpired cost of the
future benefit.
Similarly, a firm may pay its rents, taxes, salaries, utility bills etc in advance and these would
be pooled together and put under crepaid Expenses.
crepaid Expenses are a very small part of the balance sheet and relatively unimportant for
analysis purposes.
   There are short term debates and obligations due to outside parties.

The major components of current liabilities includes

? trade credit
? bank loans overdrafts and cash
? short term loans from FI
? tax payment due
urrent Liabilities include the following entities:
*? '#? *)?
It is the exact opposite of Accounts ‘eceivables. It is the amount which the firm owes to its
creditors within a period of 1 year. This happens as the firm also pays for a product (generally
raw materials for a manufacturing firm) some days after it receives them. That is, the firm is
essentially a customer of some supplier and hence asks for credit terms just as it provides for
its customers.
It is one of the largest urrent Liabilities of the firm as buying raw materials is the most
significant activity for being able to produce the finished goods.
The big and powerful companies try and get really favorable credit terms from its suppliers
so that they effectively pay for the raw materials after they sell their finished goods and
receive the payment from their customers. This, though is a rare thing, only possible for very
big and highly reputed and powerful companies.

*? '%?,#?%? )?
This section represents the money that the firm owes to its employees as salary and bonus
that it has not yet paid.

*? $?
? *?%?'??
? *)?
These are sometimes called as Notes cayable. They are the most important section under
urrent Liabilities and represent the payments on a firm¶s bank loans due in the next 12
months. The loans may be of short term expiring within the next 12 months or the current
portion of the long term debt.
÷hen a firm¶s sum of cash, short term investments and accounts receivables is still less than
Notes cayable, then it is a serious cause of concern. Unless the firm can turn its inventory and
quickly convert it into cash, this can be a serious financial weakness.
 *?
+#? *)?
Taxes cayable shows the amount that the firm owes government agencies for taxes. It is
shown separately from other obligations both because of its size and because the amount
owed may not be precisely known as of the date of the balance sheet.

*? %?('#)?
meferred ‘evenues represent the liability that arises because the firm has received advance
payment for a service it as agreed to render in future. An example is unearned subscription
revenues which represent magazine subscription payments received in advance, for which the
publishing company agrees to deliver issues to deliver issues of its magazine during some
future period.

APPROACHESTOFINANCECURRENTASSETS

The approaches followed by a company may be referred to as:

1.? Matching approach

2.? onservative approach
3.? Aggressive approach

1)? ºir : under this approach long term financing will be used to finance
fixed assets and permanent current assets and short term finance for temporary or variable
current assets. More can be understood from following graph.
 Temporary
current assets
Short term financing

Long term financing

assets cermanent currentassets

Fixedassets
Time

2. C 
rviv  r : Under this policy a firm is said to be conservative when it
depends more on long-term funds for financing needs. Under a conservative approach a firm
finances its permanent assets and also a part of current assets with long term financing.

Temporary current assets

Short term financing

Long term financing

Assets cermanent current assets

Fixed assets

Time



 Ar

iv  Ar : A firm may be aggressive in financing its assets. An aggressive

policy is said to be followed to by the firm when it uses more short-term financing than
matching plan. Under an aggressive policy, the firm finances a part of its permanent current
assets with short term financing. Some extremely aggressive firm may even finance a part of
their fixed assets with short term financing. This can be more understood by the following
figure.

Temporary current assets

Short term financing

Long term financing

assets cermanent currentassets

Fixedassets

Time

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iz  f
i

.
÷orking capital requirement of a firm are basically influenced by nature of its business.
Trading and financial firms have a very small investment in fixed assets, but require a large
sum of money to be invested in working capital. In contrast, public utilities have a very
limited need of working capital because they provide services on cash basis. Hence no funds
will be tied up in debtors and stocks. ÷orking capital needs of most manufacturing concerns
fall between two extremes.
The size of business also has an important impact on its working capital needs. Size may be
measured in terms of scale of operations. A big firm will need more working capital than a
small firm will.

ºfri 
The manufacturing cycle comprises of purchase and use of raw materials and the production
of finished goods. Longer the manufacturing cycle, larger will be the firm¶s working capital
requirements.

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The working capital needs of a firm increases as the sale grows. It is difficult to precisely
determine the relationship between the volume of sales and working capital needs. As sales
grow, the firm needs to invest more in inventories and debtors. These needs become very
frequent and fast when
Sales grow continuously.


Pri  v  

Generally, rising prices will require a firm to maintain higher amount of working capital.
However, companies, which can immediately revise their product prices with rising price
levels, will not face a severe working capital problem. Effect of rising prices will be different
for different companies. Some will face no working capital problem, while working capital
problems of other may be aggravated


O ri ffii  rf rm 
The operating efficiency of a firm relates to the optimum utilization of resources at minimum
cost. [etter utilization of resources improves profitability and thus helps in releasing the
pressure on working capital. Firms differ in their capacity to generate profit from business
operations. Some firms enjoy a dominant position due to quality product or good marketing
management or monopoly in the market and earn a high profit margin and vice-versa can be
there. A high net profit margin contributes towards working capital pool.


ºrk  ii 

The degree of competition prevailing in the market place has an important bearing on
working capital needs. ÷hen competition is keen, a large inventory of finished goods is
required to promptly meet the needs of customers. Also lenient terms of credit are to be given
to attract the customers.


Pr i  i

In certain industries the demand is subject to wide fluctuations due to seasonal variations.
The requirements of working capital, in such cases, depend upon the production policy. The
production could be kept either steady by accumulating inventories during slack periods with
a view to meet high demand during the peak season or the production could be curtailed
during the slack season and increased during peak season. If the policy is to keep production
steady by accumulating inventories it will require higher working capital.

m
R  f
 kr v r
There is a high degree of inverse co-relationship between the quantum of working capital and
the velocity or speed with which the sales are affected. A firm having a high rate of stock
turnover will need lower amount of working capital as compared to a firm having a low rate
of turnover. For example, in case of precious stone dealers, the turnover is very low. They
have to maintain a large variety of stocks and the movement of stock is very slow. Thus, the
working capital requirements of such a dealer shall be higher than that of provision store.


Cr i i
The credit policy of a concern in its dealings with debtors and creditors influence
considerably the requirements of working capital. A concern that purchases its requirements
on credit and sells its products/ services on cash requires lesser amount of working capital.
„n the other hand, a concern buying its requirements for cash and allowing credit to its
customers, shall need larger amount of working capital as very huge amount of funds are
bound to be tied up in debtors.

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O rf r

ertain other factors such as management ability, irregularities of supply, import supply,
asset structure, banking facilities, seasonal variations etc. also influence the requirements of
working capital.
-?
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There are some important ratios which are generally used to analyze the working capital
management of a firm. They are as follows:

U‘‘ENT ‘ATI„

CURRENTRATIOCURRENTASSETS/CURRENT
LIAILITIES

The urrent ‘atio is the most commonly used of all balance sheet ratios. It is a measure not
only of the firm¶s liquidity but also of the margin of safety that management maintains in
order to allow for the inevitable unevenness in the flow of funds through the current asset and
current liability accounts. If this flow was absolutely smooth and uniform (so that, for
example, money coming in from customers each day exactly equaled that day¶s maturing
obligations), the requirements for such a safety margin would be small. Since a company
rarely can count on such an even flow, it needs a supply of liquid funds to be assured of being
able to pay its bills when they come due. The current ratio indicates the size of this buffer.

In interpreting the current ratio, consideration of the proportion of various types of current
assets is important. Even if 2 firms have the same current ratio, a firm having a high
percentage of current assets in the form of monetary assets is more liquid than one with a
high percentage in inventory. Also, the nature of the business must be considered. For
example, a manufacturer that makes high-fashion clothes needs a relatively high current ratio,
since there is high risk involved in both this firm¶s accounts receivable and inventory. „n the
other hand, a metals distributor may safely have a lower current ratio than the clothing
manufacturers since the distributors primary current asset would be inventories of steel,
copper, and aluminum shapes, which do not become obsolete and whose prices may be
increasing because of inflation.

AIm-TEST ‘ATI„

ACIDTESTRATIOºONETARYCURRENTASSETS/CURRENT
LIAILITIES

Some of the current assets are monetary assets. A ratio that focuses on the relationship of
monetary current assets to current liabilities is called the acid-test ratio or quick ratio. Quick
current assets are those current assets that are also monetary assets; they therefore exclude
inventories and prepaid expenses.

This ratio gives a better idea of the liquidity as this ratio includes only the ratios which are
liquid and can be readily used to fulfill the obligations of the current liabilities.

‘EEIVA[LES TU‘N„VE‘ ‘ATI„

RECEIVALESTURNOVERRATIOCREDIT
SALES/RECEIVALES

This is another important ratio to analyze the firm¶s receivables as a function of its sales on
credit. This ratio tells us how many times the receivables are turned over in the year. If the
credit sales figure is not available separately, then the Total Sales figure is taken as the
numerator for calculating the ratio.

A more useful measure to analyze the receivables is to calculate this ratio in terms of number
of days known as mays¶ ‘eceivables or ollection ceriod.
 DAYS¶RECEIVALES/RECEIVALES
TURNOVERRATIO

This figure can be used to see how many days worth of sales are represented in accounts
receivables. This result is also called the average ollection ceriod for the receivables.

The ollection ceriod can be related roughly to the credit terms offered by the firm. A rule of
thumb is that the collection period should not exceed 1.33 times the regular payment period :
that is, if the firm¶s typical terms call for payment in 30 days, it is said that the average
collection period should not exceed 40 days. Like all rules of thumb, this one has great many
exceptions. hanges in the ratio indicate changes in firm¶s credit policy or changes in its
ability to collect its receivables.

As with other ratios, comparisons should be made with the collection period of other firms in
the same industry and also with a firm¶s own ratio for previous years. For example, in
industries with excess capacity, looser credit policies are sometimes used as a competitive
marketing tool, thus increasing the days¶ receivables. If a firm¶s collection period is
significantly larger than its competitors, this suggests inadequate collection procedures.

INVENT„‘ TU‘N„VE‘ ‘ATI„

INVENTORYTURNOVERRATIOCOSTOFGOODS
SOLD/INVENTORY

It is the most commonly used ratio for analyzing the size of the inventory. Suppose if the cost
of goods sold for a year is ‘s 10,00,000 and inventory is ‘s 2,50,000, then the inventory
turnover is 4 times. This is equivalent to saying that the inventory turns over once every 3
months.

Some companies calculate this ratio on the basis of the ending inventory, others on the basis
of the average inventory. The average may be simply one-half the sum of beginning and
ending inventories for the year, or it may be an average of monthly inventory levels. The end-
of-period basis is more representative of the current state of the inventory if the volume is
expected to continue at previous levels. The average basis is a better reflection of events that
occurred during the period because it measures the amount of inventory that supported the
sales activity of that period.

Inventory turnover varies greatly with the nature of the business. It should be high for a store
that sells fresh produce: otherwise spoilage is likely to be a problem. A supermarket may
have an inventory turnover close to 50, a petroleum refinery 20. „n the other hand, a
jewellery store with a wide collection of expensive and unusual items may not turn its
inventory as often as once a year. And most art galleries have a turnover lower than 1.

„ne must also consider the seasonality of sales. For example, college bookstores have high
inventory before start of each new term, with lower inventories in between. In such entities,
an annual calculation of inventory has little meaning, and inventory measured at various
seasonal high and low points is of more significance.

Inventory turnover indicates the velocity with which the merchandise moves through a
business. Turnover may fall either because of inventory buildup in anticipation of increased
sales or because sales volume has declined, leaving excess merchandise on hand. The first is
a favorable: event, the second is unfavorable. The turnover number itself doesn¶t include
which is the cause.

Again, the same relationship can be expressed as the number of days¶ inventory on hand.

DAYS¶INVENTORY/INVENTORYTURNOVER
RATIO
[oth inventory turnover and days¶ inventory calculations are affected by the firm¶s inventory
costing method. [ecause, relative to FIF„, the LIF„ method results in lower reported
inventory value on the balance sheet and higher cost of goods sold, a firm using LIF„ will
have a higher indicated inventory turnover ratio and a lower indicated number of days¶
inventory than if it were using FIF„. Such differences must be taken into account when
comparing ratios for different entities. „ne way this problem is resolved is to convert the
LIF„ data to their FIF„ equivalent and use the adjusted data to compare the ratios.

cA A[LES TU‘N„VE‘ ‘ATI„

PAYALESTURNOVERRATIOCREDIT
PURCHASES/PAYALES

This ratio tells us the rate at which the firm pays off its accounts payable to its suppliers. This
is calculated by dividing the credit purchases by the payables. If figure for credit purchases is
not available, then figure for total purchases is taken for calculation and if purchases figure is
not available, then ost of Goods Sold is taken as the figure for calculating the ratio.

This ratio tells us how many times a year a firm pays its average payable amount. For
example, if a firm purchases worth ‘s 8,00,000 in the year and its payables account is at ‘s
2,00,000, then it means that the payables turnover ratio is 4 times or the payables are being
turned over once 3 months.

This can be expressed in number of days¶ payables as well as follows:

DAYS¶PAYALES/PAYALESTURNOVER
RATIO
A lesser value for mays¶ cayables would mean that the firm is paying its suppliers quickly.
Infact, the value would depend on the credit terms being offered by the supplier. If the firm
has such a reputation that it can demand very favorable credit terms from its suppliers, then it
will have a higher value for mays¶ cayables and hence this value must be analyzed in
conjunction with the credit terms offered by the suppliers.

It must be seen that the value for mays¶ cayables must not exceed the average credit period
offered by the suppliers by a certain amount. As long as that is maintained by the firm, it is
always better for the firm to have a greater value for mays¶ cayables as it gets more days to
pay off its suppliers and it has a great reputation in the market so that it can demand favorable
credit terms.

SOºEIºPORTANTCONCEPTSFORANALYSIS

As we know, ÷orking apital is the difference between the urrent Assets and urrent
Liabilities and is expressed as an absolute amount. Now, this number as a stand-alone has
little or no relevance to the liquidity of the firm, as it is generally believed. Infact, this is the
most commonly reported figure in balance sheets too. [ut, the amount of working capital
throws very little light on the quality if firm¶s liquidity position.

Another misconception people have is that the urrent ‘atio and Quick ‘atio can give all the
information about a firm¶s liquidity position. In reality, these analytical tools are not able to
convey the actual evaluative information about a firm¶s liquidity that an investor would want
to know.

The reason for this is that the urrent ‘atio is actually based on the liquidation of all the
firm¶s urrent Assets to meet all its urrent Liabilities, which is very unlikely to occur in
reality. The most important thing is the time which it takes to convert a firm¶s working
capital assets into cash to pay its current obligations and that is what is the key to assessing
the liquidity position of the firm.
÷e can understand the weakness of using urrent ‘atio as the lone metric to assessing the
liquidity position of the firm with the following example:

Liquidity Measures ompany A ompany [

urrent Assets ‘s 10,00,000 ‘s 5,00,000

urrent Liabilities ‘s 5,00,000 ‘s 5,00,000
÷orking apital ‘s 5,00,000 ‘s 0
urrent ‘atio 2:1 1:1

Now at first look, it may seem that ompany A is the clear winner in liquidity assessment as
it has great margin of safety of current assets over current liabilities, has a good current ratio
and a working capital of ‘s 5,00,000. In comparison, ompany [ has no margin of safety at
all, a current ratio of 1 and no working capital.

Now suppose, both companies¶ current liabilities have an average payment period of 30 days.
ompany A needs 180 days to collect its receivables and its inventory turnover is just once a
year. In comparison, ompany [¶s customers pay in cash, and its inventory turns over every
15 days. Now in such a condition, ompany A is very illiquid and would not be able to
operate properly. This is because its bills are coming faster than its generation of cash. And
these bills have to paid by cash, and not by working capital. [ut, ompany [ is much more
liquid as it has very fast cash conversion.

CASHCONVERSIONCYCLE:
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ash onversion ycle is the more appropriate way to assess the liquidity position of a
company and also for comparing 2 or more companies in this respect. This is because this
takes into account the investment quality of the 2 critical assets i.e ‘eceivables and
Inventory. This tells us the time it takes to convert these 2 assets into cash, which is what
creates real liquidity.
ash onversion ycle is basically the duration of time a firm takes to convert the activities
which require cash back into cash returns. It is calculates as follows:

CASHCONVERSIONCYCLEDAYS¶INVENTORYDAYS¶
RECEIVALESDAYS¶PAYALES

This cycle is very important as it represents the actual number of days a firm¶s cash is tied up
in operations. It is also a powerful tool to assess how well a firm is managing its working
capital. The lower the value for ash onversion ycle, the better it is for the company. If
this value is showing an increasing trend for a firm, then it is a warning sign that working
capital management is not up to the mark.

An increase in the amount of time receivables are outstanding uses up cash, a decrease
provides cash. Similarly, an increase in the value of mays¶ Inventory uses cash, a decrease
provides cash. Also, increase in the value of mays¶ cayables provides cash, a decrease uses
up cash.

NEGATIVECASHCONVERSIONCYCLE

It may also happen that a firm has a negative ash onversion ycle. This can happen when
a firm is able to sell its inventory and collect its receivables even before it pays to its
suppliers. This is possible only for very big companies and very powerful reputed ones who
can demand such credit terms from suppliers and can ask their customers to pay quickly.

A negative ash onversion ycle is very difficult to achieve but nonetheless some big
companies like ÷al-Mart have made this possible and operate always with negative ash
onversion ycles.

A company which can achieve this will never face a liquidity crunch as it always has enough
money coming in from sales, before its liabilities become due.

Hence, we can see that proper management of the ash onversion ycle has a great impact
on a firm¶s liquidity and cash flow and profitability. It also determines whether a firm
requires any lending facility or not, or whether it can fulfill its obligations on time.
NEGATIVEORKINGCAPITAL

Hearing this first, it may seem that a firm which has negative working capital is in trouble
and may not be able to meet it liabilities on time. ÷ell, this is not always true.

Infact, a Negative ÷orking apital may be a good thing for a business which has a high
Inventory turnover and which does business mostly on cash basis. Such businesses need very
little working capital. This is because they can turn their inventory, receive money so quickly
that they can put this money back into producing more inventory to increase sales. Since the
cash is generated so quickly, the firm can easily stockpile their proceeds from sale for a short
time if a financial crisis does occur. Hence, there is no real need to have large amount of
working capital.

Sometimes, such businesses can generate cash so quickly that they do not even mind having a
negative working capital. Some of the best examples of such companies are Amazon.com and
÷al-Mart. This is because the customers pay upfront and so quickly and hence the products
are sold and delivered to customers before the company pays for them to suppliers.

Hence, we can see that negative working capital can actually be a sign of managerial
efficiency in a business with a high inventory turnover and low accounts receivables. In other
situations, a negative working capital may be a danger sign, possibly a potential sign of
bankruptcy and serious financial difficulty.

Therefore, one must carefully observe and analyze the ratios and working capital before
jumping to any conclusion. Generally, a company with negative ash onversion ycle will
have a negative ÷orking apital, which infact is a good thing. For companies with a positive
ash onversion ycle, a negative working capital may be a dangerous signal and a potential
warning.

ORKINGCAPITALLINEOFCREDIT

÷orking apital Line of redit is a very useful tool to finance your working capital
requirements. ÷orking apital Line of redit is basically a loan from a bank wherein a Line
of redit is determined by the bank which is the maximum amount of funds available from
the bank and can be used when needed by the firm for the working capital needs.
It is different from a normal loan in the sense that interest is charged only on the outstanding
balance, rather than the entire limit. For example, if the Line of redit to a firm is ‘s
10,00,000, then the firm can take out the required funds up to maximum outstanding amount
of ‘s 10,00,000 whenever it needs it and the Interest will only be charged on the outstanding
amount on a monthly basis.

For calculating the monthly interest liability, the balance (debit or credit) is taken at the close
of every day of the month and the average outstanding amount is calculated for the month on
which the interest is charged and added to the outstanding amount at the close of month. This
now becomes the opening outstanding balance of the next month.

A firm only needs to pay the interest liability at the end of each month within the period of 90
days, after which the account becomes a Non-cerforming Asset. The crincipal amount can be
carried forward to the coming months.

÷orking apital Line of redit is given against the security of Inventory and ‘eceivables,
the 2 major items of the urrent Assets. [ut, since a bank can not realize the same value for
these assets in case of default as the firm, it assigns a margin for each of these entities to get
to the actual realizable value of these assets. At the end of each month, account of the firm¶s
current assets is obtained by the bank, which it uses to calculate the mrawing cower of the
firm for the next month, by adjusting the amounts by the margin percentage. mrawing cower
is the maximum amount the firm can withdraw for the next month. If the mrawing cower is
less than the Line of redit, then this becomes the effective Line of redit for the next month.
If the mrawing cower is more than the Line of redit, then Line of redit remains the
maximum amount the firm can withdraw.

The Line of redit is renewed every year depending on the growth and financial condition
and requirements of the company.

Now, this ÷orking apital Line of redit account effectively becomes a rolling, never
ending account for the firm, with the outstanding amount being carried forward for next year
and so on. „nly the interest liability has to be fulfilled by the firm to prevent the account
from becoming a Non-cerforming Asset.
This Line of redit can serve as an important tool for immediate liquidity requirement which
cannot be financed by the current assets at that particular moment of time.

The outstanding balance in this account keeps changing as and when the firm takes out
money, and puts in money into this account whenever it desires and depending on its
requirement and realization of its assets.

c 

 
  
‘eceivable management refers to the decisions a business makes regarding it overall credit
and collection politics and the evaluation of individual credit applicants. ‘eceivable
management proves. For a firm, both, an asset and a problems and assets because of the
promise of a future cash flow and a problem because of the need to obtain financing while
waiting for the future cash flow.

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ompanies in practice feel the necessity of granting credit for several reasons:
1.? ompetition: Generally the higher the degree of competition, the more credit granted
by a firm. However, there are exceptions such as firms in the electronics industry in
India.
2.? ompanies [argaining cower: if a company has higher bargaining power, it makes
grant less or no credit. The company has high bargaining power in case of strong
product, monopoly, power, brand, image strong financial position.
3.? [uyer¶s ‘equirements : in a no. of business sectors buyer¶s are not able to operate
without extended credit
4.? [uyer¶s Status: large buyer¶s demand easy credit terms because of bulk purchases and
higher bargaining power some companies follow a policy of not giving much credit to
small retailers because it is very difficult to collect dues from them.
5.? ‘elationship with mealers: companies some time extend credit to dealers to build long
term relationship with them or to reward them for their loyalty.
6.? Marketing Tool: credit is used as marketing tool, particularly when a new product is
launched or when a company wants to push its weak product.
 V.? Industry cractice: small companies have been found guided by industry practice or
nor more than the large companies. Some time companies continue giving credit
because of past practice rather than industry practice
8.? Transit delay: this is forced reason for extended credit in case of a number of
companies in India. Most companies have evolved system to minimize the impact of
such delay. Some of them take the help of banks to control cash plans in such
situations.
RECEIVALEºANAGEºENTINFºGIL
In this unit, there is no receivable management, as all the sales are controlled and the head
office situated at Faridabad receives payments. To boostup the sales, the company pays an
attractive cash discount to its customers for early payments so that the credit collection period
is decreased. The credit worthiness of the customer is compared with the credit standards of
the company. It takes into account the promptness of the customer to pay. For giving credit to
new customer, the financial position of the customer is investigated. The frequency of
payment and cash discount availed helps in forming an opinion about the customer.
‘eceivable management involves the careful consideration of the following aspects:

*? Forming the credit policy

*? Executing the credit policy
*? ollection efforts

ë
FORºINGCREDITPOLICY
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
etc.

!? Cr i
r
 redit standards are the criteria, which a firm follows in selecting
customers for the purpose of credit extension. The volume of sales will be influenced by the
credit policy of a concern. [y liberalizing credit policy, the volume of sales can be increased
resulting into increased profits.
!?L  f r i  ri  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 length of credit period. A concern
fixes its own terms of credit depending upon its customers and the volume of sales.
 !? C
i
  ash discount is allowed to expedite the collection of 1receivables. 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 discount.


EXECUTINGCREDITPOLICY
After formulating the credit policy, its proper execution is very important. The evaluation of
credit applications and finding out the credit worthiness of customers should be undertaken.

!? C  i r i if rmi  The first step in implementing credit policy will be to
gather credit information about customers. This information should be adequate enough so
that proper analysis about the financial position of the customers is possible. The information
may be available from financial statements, credit rating agencies; report from banks, firm¶s
records etc.
!?Cr i 
i
 After gathering the required information, one 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. This is done by keeping three basic ³c´ factors: character,
capacity and collateral. The credit analysis will determine the degree of risk associated with
the amount, the capacity of the customer to borrow and his ability and willingness to pay.
!? Cr i  i
i  After analyzing the credit worthiness of the customer, the finance
manager has to take a decision whether the credit is to be extended and if yes, then up to what
level. He will match the credit worthiness of the customer with the credit standards of the
company. If customer¶s credit worthiness is above the credit standards then credit is granted
otherwise not.


COLLECTIONEFFORTS
Every firm should follow a well-laid down collection policy that may be lenient or strict, and
procedure to collect dues from its customers. ÷hen the normal credit period granted to a
customer is over, and he has not made the payment, the firm should send a polite letter to him
reminding that the account is overdue. If the customer does not respond, the firm may send
progressively strong-worded letters. If receivables still remain uncollected, telephone,
telegram and personal visit of the firm¶s representative may follow letters. If the payment is
still not made, the firm may initiate a legal action against the customer.
In this unit, there is no receivable management, as all the sales are controlled and the head
office situated at Faridabad receives payments. To boost up the sales, the company pays an
attractive cash discount to its customers for early payments so that the credit collection period
is decreased. The credit worthiness of the customer is compared with the credit standards of
the company. It takes into account the promptness of the customer to pay. For giving credit to
new customer, the financial position of the customer is investigated. The frequency of
payment and cash discount availed helps in forming an opinion about the customer.


!  

Inventory management is concerned with keeping enough product on hand to avoid running
out while at the same time maintaining a small enough inventory balance to allow for a
reasonable return on investment to the financial health of the corporation: being out of stock
can force customers to turn to competitors or result in a loss of sales. Exclusive inventory on
the other hand , results in more Inventory carrying cast , including the cost of the capital tied
up in Inventory warehouse fees , insurance etc. therefore management has to see that
Inventory is neither too low to affect production process and nor too high to increase the cost
.


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Inventories are stock of the product a company is manufacturing for sale and components that
make up the product. The various forms in which inventories exists are:

1.R m ri
are the basic inputs that are converted into finished into finished product
through the manufacturing process. These are purchased and stored for future production.
2. rki r r

a unit of input passes through various stages in manufacturing process

before being converted into finished product. This represents product that need more work
before being converted into finished product.

Fii
 r s are the completely manufactured products which are ready for sale. It
separates production from selling.
 

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Economists have established three motives for holding Inventory.
1.? Tr
i 
 m iv  emphasis the need to maintain Inventory to facilitate smooth
production and sales operations.

2.? Pr i rr

This motive provide a cushion in case of actual level of activity
is different from than anticipated i.e. in case of unpredictable changes in demand and supply
and other forces.

3.? S iv m iv influences the decision to increase or reduce inventory levels to take
advantage of raw material inflationary times in one form of speculative behavior.

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The main objectives of inventory management are operational and financial. The 
objective means that the materials and spares should be available in sufficient quantity so that
work is not disrupted for want of inventory. The  objective means that investments
should not remain idle and minimum working capital should be locked in it.
The following are the objectives of inventory management:
*? To ensure continuous supply of materials spares and finished goods so that production
should not suffer at any time and the customer¶s demand should also be met.
*? To avoid both over- stocking and under-stocking of inventory.
*? To maintain investments in inventories at the optimum level as required by the
operational and sales activities.
*? To keep material cost under control so that they contribute in reducing cost of production
and overall costs.
*? To eliminate duplication in ordering or replenishing stocks. This is possible with the help
of centralizing purchases.
*? To minimize losses through deterioration, pilferage, wastage and damages.
*? To design proper organization for inventory management. A clear-cut accountability
should be fixed at various levels of the organization.
*? To facilitate furnishing of data for short-term and long- term planning and control of
inventory.

 

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There are two main techniques of inventory holding:
1.? Economic order quantity.
2.? Graphic solution.
? E  mi r r "i: „ne of the major Economic order quantity management
problems is how much inventory should be ordered when inventory is replenished. If
the firm is buying raw material, it has to decide lots in which it has to be purchased on
each repleshnishment. The task of the firm is to determine the optimal or economic
order quantity determining an optimal inventory level involves two types of costs.
(a) „rdering cost
(b) arrying cost

A!Or ri 
: Every time an order is placed for stock replenishment certain cost are
involved. Under this cost for ordering the material are included. This cost included.
1. caper work cost, typing and dispatching an order.
2. Follow-up cost the follow-up required to ensure timely supply includes the travel.
3. ost involved in receiving order inspection checking and handling to store.
4. Any set up cost of it charged by the supplier.
5. The salaries and wages to the purchase department.

!Crri C
: arrying cost includes all the cost of holding item in inventory for a
given period of time components of this cost include the following:
1. Storage and handling cost.
2.„bsolescence and deterioration cost.
3.Insurance
 4.Taxes
5.The cost of funds invested in inventories.
Economics order quantity may be calculated as follow:
E„Q = 2dco
c
m = total annual demand
o = ordering cost
c = carrying cost
Total cost = o + c
Number of orders per year = m
Q
? Gri m  : the economic order quantity can also be found graphically. At
economic order quantity total cost and ordering cost are equal at this point. in the
following figures carrying cost and ordering costs are plotted on axis and order
size is plotted on X axis
    ºiimm
T 

  Y 
       T 

     


 C


     Crri


     
      Or ri


   O#Or r
iz X 

÷e note that carrying cost increase as the order size increases because on an average, a larger
inventory will be maintained. Similarly ordering cost will decrease in order size because if
order is big and there will be less ordering cost. Q is the point of economic order quantity and
at this point total cost will be minimum and carrying cost and ordering cost will be equal.



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Material can be classified in the following ways.
 1.? 



: Under this classification, material is classified into three
categories.
A = the most valued items
[ = medium valued items
 = less valued items

2.?  



 is similar to A[ classification but in this case instead of
value of item unit value of the items is considered.
H = high valued
M = medium valued items
L = low valued items

3.?   



: Under this items are classified according to their
criticality to production process. This application is applicable largely to spare parts.
V = vital items
E = essential items
m = desirable

4.? 



 :under this items are classified according to their
movements
F = Fast moving items
S = Slow moving items
N = Non moving items or dead items

5.?  



: It depends upon the availability of the material.
S = Scare items
m = difficult available items
F = easy to obtain items
6.




 this classification is also depends upon the availability of the
material
G = government control
„ = „rdinary available
L = locally available
F = foreign sources







 raw material specially agriculture inputs are generally classified
as
S =seasonal items
„S = off seasonal items

  

ash is the important current asset for the operations of the business. ash is the lifeblood of
a business firm; it is needed to acquire supplies, resources, equipment, and other assets used
in generating the product and services provided by the firm. ash is the medium of exchange
which allows management to carry on the various activities of the business firm from day to
day. As long as the firm has the cash to meet these obligations, financial failure is
improbable. ÷ithout cash, or at least access to it, bankruptcy becomes a grim possibility.
Such is the emerging view of modern corporate cash management. Near cash items like
marketable securities are also included in cash. The modern day business comprises new
numerous units spread over vast geographical areas. It is the duty of finance manager to
provide adequate cash to each of the units. The firm should keep sufficient cash, neither more
nor less, to meet various needs. ash shortage will disrupt the firm¶s manufacturing
operations while excessive cash will simply remain idle without contributing anything
towards the firm¶s profitability...

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ash flows are very important parts of the business operation of firms. ash planning is
technique to plan and control the use of cash. A projected cash flow statement may be
prepared based on the present business operations and anticipated future activities. The cash
inflows from various sources may be anticipated and cash outflows will determine the
possible uses of cash. ash planning is a technique to plan and control the use of cash. It
protects financial condition of the firm by developing a projected ash Statement from a
forecast of expected cash inflows and outflows for a given period. ash plans are very crucial
in developing the overall operating plans of the firm.
ash planning may be done on daily, weekly or monthly basis. The period and frequency of
cash planning generally depends upon the size of the firm and philosophy of the
management. Large firms prepare daily and weekly forecasts. Medium size firm usually
prepare formal cash forecast because of the non formal forecast because of the non ±
availability of information and small firms prepare cash projections, it is done on monthly
basis. As a firm grows and business operations becomes complex, cash planning becomes
inevitable for its continuing success.

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A cash budget is the most important device to further control receipts and payments of cash.
The short-term forecasts can be made with the help of cash flow projections. Financial
manager will make estimates of likely receipts in the near future and the expected
disbursements in that period. Though it is not possible to make exact forecasts even than
estimates of cash flows will enable the planners to make arrangement for cash needs. „ne
should keep in mind the sources from where he will meet short-term needs. He should also
plan for productive use of surplus cash for short periods. The long-term cash forecasts are
also essential for proper cash planning. Long term forecast indicate company¶s future
financial needs for working capital, capital projects etc. In other words:
A cash budget is an estimate of cash receipts and disbursements of cash during a future
period of the time. It is a device to plan and control the use of cash. The cash budget
pinpoints the period when there is likely to be excess or shortage of cash. Thus, a firm by
preparing a cash budget can plan the use of excess cash and make arrangements for the
necessary cash as and when required.
The cash receipts from various sources are anticipated. The estimated cash collections for
sales, debts, bills receivables, interests, dividends and other incomes and sale of investments
and other assets will be taken into account. The amounts to be spent on purchase of materials,
payments to creditors and meeting various other revenue and capital expenditure needs
should be considered. ash forecasts will include all possible sources from cash will be
received and the channels in which payments are to be made so that a consolidated cash
position is determined.
The cash budget should be co-ordinate with other activities of the business. The functional
budgets may be adjusted according to the cash budget. The available funds should be
fruitfully used and the concern should not suffer for want of funds.
 
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ash management is concerned with the managing of:

(1) ash flows into and out of the firm.
(2) ash flows within the firm.
(3) ash balances held by the firm at a point of time by financing deficit or investing surplus
cash.
It can be represented by the cash management cycle.

[usiness ash
operations ollections
meficit [orrow
Surplus Invest

 Information and ash

ontrol cayments


Sales generate cash which has to be disbursed out. The surplus cash has to be invested while
deficit has to be borrowed cash management seeks to accomplish this cycle at a minimum
cost. At the same time, it also seeks to achieve liquidity and control.
The management of cash is also important because it is difficult to predict cash flows
accurately, particularly the inflows and there is no perfect coincidence between the inflows
and outflows of cash. muring some periods cash outflow exceeds cash inflow. The main aim
of the cash management is to manage its cash balance at minimum profitable investment
opportunities


In order to resolve the uncertainty about cash flow prediction and lack of synchronization
between cash receipts and payments the firm should develop appropriate strategies for cash
management. The firm should evolve strategies regarding the following four facets of cash
flow.
(1) ?  : cash inflows and outflows should be planned to project cash surplus or
deficit for each period of the planning period. ash budget should be prepared for this
purpose.
(2)   ???!: the flow of cash should be properly managed. The cash inflows
should be accelerated while, as far as possible, the cash outflows should be decelerated.
(3"??##?? $: the firm should decide about theappropriate level of cash balances.
The cost of excess cash and danger of cash deficiency should be matched to determine the
optimum level of cash balances.
(4) $ ? ? : the surplus cash balances should be properly invested to each
profit. The firm should decide about the division of such cash balances between alternative
short-term investment opportunities such as bank deposits, marketable securities or inter
corporate lending.

The ideal cash management system will depend on the firm¶s product, organization structure,
competition, cultures and options available. The task is complex and decision taken can affect
important areas of firm.