CHAPTER - II

MANAGEMENT OF WORKING CAPITAL

a) Introduction

b) Objectives of Management 0f Working

Capital.

c) Elements of Working Capital Management.

d) Working Capital Management -
A Survey And Synthesis.

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 o°

CHAP T E R II

MANAGEMENT OF WORKING CAPITAL 8

A s Introduction

B s Objectives of the Management of Working Capital.

C s Elements of Working Capital Management.

0 8 Working Capital Management - Survey and Synthesis.

A s INTRODUCTION s

The basic aims of management of working capital are

to speed up the rate of turnover to reduce the ideal periods

of excess current assets and ensure availability of adequate

funds to meet commitments on purchase, and other recurring

payments and to minimise the costs of raising working

capital.

It is the fundamental responsibility of management

to guide the circulation of working capital in suitable

proportion through the production mechanism. It is

an art of managing assets in such a way that there is

a smooth flow from one state to another over the normal

period. If there is no smooth circular of assets there

would be shortage of some current assets and over­

abundance of others. Management must seek to offset

the cash drawn by so planning the circulation of current

assets as th#/ generate sufficient cash in the process to

purchase the raw materials, to continue the cycle and to

pay all the expenses incidential to business operations.
 24

There must be efficient regulation of purchases, production,

stocks, credit and collection for proper management of

working capital.

The prime object of management is to make profit

whether or not this is accomplished in most businesses

depends largely on the manner in which their working capital

is managed. Working capital management usually is

considered to involve the administration of current assets

of a firm viz; cash inventory.

ft; OBJECTIVES OF THE MANAGEMENT OF WORKING CAPITAL :

The objects of working capital management are two fold.

(1) • Maintenance of Working Capital.

(2) Availability of ample funds at the time of need.

As a matter of fact a business cannot survive in the

absence of a satisfactory ratio between its current

assets and current liabilities. Further, its ability

to proper will be largely determined by the composition

of the current assets pool. Management is setting

policies with respect to general operations, purchasing,

financing and must work within limitations set by the

working capital position.

(3) Importance of the Management of Working Capital.

There are number of aspects of working capital management

that make it an important topic for study. They are

as follows

(i) There is a positive correlatioh between the sales of

 the firm and its current assets. Therefore in order to

increase sales a corresponding increase in current assets

is required. Here too, proper administration of it becomes

significant.

(ii) Near about 5096 to 7056 capital of a firm invests in its

current assets. In capital budgeting plans we have seen the t

there is only 3056 to 5096 investment is made in fixed assets.

(iii) Fixed assets can be often acquired even on lease,

there is no alternative for current assets. There is no

way of avoiding an investment in inventory and ih receivables.

(iv) Working Capital needs are generally financed through

outside sources so a continuous care is necessary to utilise

them in the best way. Surveys indicate that the largest part

of financial manager's time is devoted to the management of

current liabilities and assets, that is, working capital

management•

(v) Working Capital Management is particularly important

for small firms because a small firm has relatively limited

access to the long term capital markets. Therefore it must

necessarily rely heavily on trade credit and short term Bank

loans, which are current liabilities.

Management must take the following steps to ensure

balanced proportion of capital consistent with the objectives

of liquidity and profitability.

(1) Sales budgets is prepared to estimate the volume

and value of expected sales and the amount of cash likely

to be realised on sales during the budget period with

reference to the average credit terms granted and the

 26
incidence of direct cash sales.

(2) Inventory budget indicates the potential increases

and decreases in the stock of goods to be held during the

budget period. The raw materials budget shows the estimated

volume and produce the budgeted targets of output. Labour

budget shows the direct cost of labour essential to carry

out the production programme.

(3) Advertising and selling expenses budget gives an idea

of expenses to be increased to fulfil the sales target.

(4) General expenses budget refers to all administrative

costs of several departments,

(5) Cash budget is an important tool of working capital

management. It is an estimate at future, receipts and

disbursement of cash at particular intervals. It shows as

the following s-

(a) Estimates of cash expected to be received during

the period from sales and other sources.

(b) Estimated payments of cash on various items purchases

payments of salaries etc.

(c) Estimated cash balance at the end of the periods.

(d) The difference between estimated cash balance and

the cash that may be actually required as per different

budget estimates.

Cash budget predicts whether additional cash should be

repaid £o plug the gaps between the expected inflow and

 expected outflow. It also projects when additional funds

are to be borrowed and for how long borrowed funds would

be needed. It indicates as to when amount borrowed can be

repaid out of cash receipts etc.

gi ELEMENTS OF WORKING CAPITAL MANAGEMENT :

There are three elements of working capital management.

(1) Management of Cash.

(2) Management of Receivables,

(3) Management of Inventory.

(1) MANAGEMENT OF CASH s

Maintaining the liquidity or solvency is the main

task before the financial manager. Availability of cash

in sufficient amount and at proper time to meet the need

is the essence of financial management. Cash is medium of

exchange to purchase goods and services and to disburse

the liabilities. It indicates cash in hand, cash at Bank

and short term investment.

THE OBJECTS OF HOLDING CASH :

1) To avoid Technical Insolvency s

Technical insolvency refers to the conditions when the

firm has sufficient fixed and current assets but failing to

discharge the liabilities on due date. It is one of the

most important factor leading the firm towards the domain

insolvency or otherwise effecting the im#age of the

organisation and telling on the moral and motivation of

employees or human factor.
2) To meet unpredicatable needs s

To meet unpredicetable needs in future cannot be

master minded because the conditions are always changing

and nothing in this world is permanent.

3) To avoid Specific Gains s-

'present value of money is greater than the future value

is an accepted principle. For this reason business men give

certain monetory mode in cash. It may be in the form of

cash discount. Sometimes we can purchase the services at

low market price for the simple reason that payment is being

made in cash. Therefore a businessman maintains cash

reserve to avoid specific monetory and non-monetory gains.

FACTORS DETERMINING LEVEL OF CASH s

Maintenance of optimum level of cash is the main problem

around which the financial managers do the exercise of cash

management. Level of cash holdings differs from industry to

industry, organisation to organisation but the factors can

be summerised as follows

1) Credit Policy s
Credit policy refers to the management policy in regards

to allowing credit sales. Credit policy is very critical

problem. If credit policy is liberal, cash level will be

lower and vice-versa.

2) Distribution Channel :

Distribution channel refers to the number of middlemen

in the process of distribution of service or product.

If the distribution channel is long and the credit policy ^*

liberal, the level of cash may be higher. If goods or

services are sold through departmental store or chain

store the cash holding will differ substantially.

3) Nature of the Produce s

Nature of the goods off service produced by an

organisation to a great extent exercises influence on

cash reserve.

4) Size And Area of Operation s

Area of operation refers to the time period taken

by the raw material to become finished product. In case

of long production cycle the level of cash holding is

likely to be hi$i and vice-versa.

(2) MANAGEMENT OF RECEIVABLES s

The capital invested in receivables is exactly the

same with that invested in other assets, that a cost is

associated with the investment so the financial executive

will have to pay due consideration to receivables

management also.

The problem of receivables management is basically a

problem of balancing profitability and liquidity. Credit

terms are a sales attraction and so the longer the time

a company allow its customers to pay, the greater the sales

and the possible profits.

The level of investment in account receivabi^ depeMfP

!*tr. L'S '• -a^ j

upon two types of factors.

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1) General Factors t

These are the factors which are common to all firms.

They include all types of assets,the type and nature of
business, anticipated volume of sales, sales operations,
price level variations, availability of funds and attitude
of management etc.

2) Specific Factors :

The main determinates of the level of receivables

are as follows :-

(a) The Volume of Credit Sales s

The most important vairbale affecting the level of

the receivables is investment in the volume of the credit
sales. As sales increase receivables expand and vice-versa.

(b) Term of Sales s

The firm sells only for cash on delivery in order to afcoid

thinii% its funds in receivables and risking bad-debts losses.
This item will altogether disappear from the balance sheet of
the firm.

(c) Stability of Sales :

If the business is of seasonal character, its credit

sales in a particular season will be large. Simultaneously
there will be a large volume of receivables also.

(d) Credit And Collection Policy s

The policies and practices of the firm in determining

which customers are to be granted credit also determine it.
 31

(3) MANAGEMENT OF INVENTORY :

Inventories constitute the principal item in the

working capital of the majority of trading and industrial

companies. In inventory the stores of raw material,

stock of finished goods, work in progress and other

accessories are included. To maintain the continuity

in the operations of business enterprise, a minimum

stock of inventory is required.

The term inventory management is used in two ways

viz; Unit Control and Value Control. Production and

purchase official use this word in terms of unit control

where as in accounting, this word is used in terms of

value control•

OBJECTIVES :

(1) There should be a continuous availability of all

types of material in the factories, so that the production

may not be held up for want of any materials.

(2) Sufficient stock of finished goods must be maintained

to match reasonably demand of the customers for prompt

execution of their orders.

(3) While purchasing materials, it should ensure that

it is purchased at a reasonably low price and is of

good quality.

(4) The basic aim of inventory control is the optimum

level of investment in inventories.

 32
13*.WORKING CAPITAL MANAGEMENT : A SURVEY AND SYNTHESIS;

To cope with the fast-changing situations, the manager

of the future will have to understand how organisations manage

their resources. Of particular importance is the area of

working capital management which includes short-term investment

and financial decisions of the firm. As it is already stated,

•Working Capital* usually refers to the firm*s total current

assets also called the gross working capital. (Net Working

Capital * refers to the difference between the current assets

and the current liabilities. Working Capital Management

deals with the management of the problem areas in the use

of current assets and current liabilities, and their inter-

1
relationships. M.H.R. Abd El-Motaal relates working capital

to current assets, in place of the traditional current assets,

current liabilities ratio, working capital ratio, therefore,

is expressed as ;-

Current Ratio

If current assets are twice the value of current

liabilities, then the working capital ratio becomes half

of 50%. The emphasis is on what is left out of current

assets after current liabilities have been disposed of.

Motaal points out that this ratio claims of current creditors

and provides them in the meantime with a margin of safety and

is a better guide to *the extent of liquidity of the working

capital *.

1. M.H.B. Abd El-Motaal, - Accounting Research, Oct. 1958.

 0
3O
COMPONENTS OF WORKING CAPITAL s

The main components of working capital are cash,

marketable securitiesjaccounts^. receivables, inventories,

trade credits and loans from banks etc.

1) Cash :

Cash is one of the most liquid and important components

of working capital, Holding cash involves cost in the sense

that the worth of cash held, after a year will be less than

the value of cash as on today. During inflationary situations

as exist now, the cost of holding includes the deterioration

in the value of cash due to inflation. Cash, therefore,

results in enhanced liquidity, but lower profitability.

Despite the cost involved it is necessary to hold cash

because it facilitates the attainment of the following

motives s-

i) Transactions Motive s Cash balances are necessary

for the operation of any business. Payments have to be made

to conduct the day-to-day work and the cash balances associated

with these payments and collections are known as transactions

balance.

ii) Precautionary Motive : To account for risk and

uncertainty involved ih the cash inflows and outflows of

any firm some cash balances are kept in reserve. These are

precautionary balances, used in the case of random, unforseen

fluctuations. The more the uncertainty, the larger will be

this balance• These are normally held as highly liquid

marketable securities. This serves the purpose of a cash

balance, while providing an income through the interest

received.
iii) Speculative Motives The speculative motives for

cash is to take advantage of certain opportunities that

might arise. As in the case of precautionary balances,

firms are more likely to draw on the reserve borrowing

power and marketable securities, than to actually hold cash.

iv) ioapehsation s- Cash held to compensate banks for

providing loans and services. This constitutes a compensating

balance.

CAffl MANAGEMENT;

Although cash is required for the motives mentioned

above there is a strong reason for not holding excess balances.

Cash is a non-earning asset. The asset turnover is lowered to

the extent cash is held thereby reducing the rate of return on

net worth. Hence, a proper and judicious cash management is

of utmost importance in any business.

Cash budget is the most important tool in cash management.

It depicts the organisations projected cash inflows and

outflows over a period of time. Statistical procedures are

available to help to improve cash flow forecasts and the

better forecasts, the lower the minimum cash balance.

Mathematical models are available to aid management in

1
arriving at an ‘optimal* cash balance.

1. Stephen H. Archer - A Model for the Determination of Firm

Cash Balance; Journal of Financial And Quantitative
Analysis; Vol. 1 BO. 1, March 1966, PP. 1-11.
 35

Due to necessary delays, considerable time is often

vested in the process. The time required ror clearance

may be result of the distance between the payer*s and

the payee's banks. To reduce mail and clearing delays,

a lockbox system can be used. A lock box can be located

in a post office in the customer's area. Customers send

payments to the postal box in their city. The bank picks

up the cheques, have them cleared and remit by wire to

the firm's account. Similarly, slowing down disbursements

accomplishes the same task by keeping cash on hand for

longer periods.

Using float is another method of prudent cash management.

Float is the difference between the balance shown in a firm's

books and the balance on the Bank's books. By having an

efficient collection and clearing process, the firm can

have a negative balance on its records, and a positive

balance on the bank books. The main draw back is that to

make heavy use of float, the firm must be able to forecast

its positive and negative clearing accurately.

Baumol applied the BOQ (Economic Order Quantity)

model to the cash management problem. Just as order costs

and carrying costs are prevalent in the typical inventory

problem, there are similar costs in the cash management

model. Qfcder costs include clearical and brokerage costs.

Holding costs are in terms of the interest foregone when

cash is held.

1• William J. Baumol. The Transactions Demand for Cash :

An Inventory Theoretic Approach s Quarterly Journal of
'Economics,.hE, Rov..19527W.“3^5-556.
 These costs can be expressed as
Total cost (TC) - (T+i(C/2)) ...(2.1)
Where *b* is the fixed cost of transaction.
•T* is the total demand for cash during the time period
*i* is the interest rate on marketable securities.
*6* is the Cash Balance.

The optimal level of *C* i.e. - C *

is obtained when the derivative of equation (2.1) with
respect to *C* is set equal to zero.

Beranek (1963) has also developed a model for optimal

allocation of funds between the cash balance and marketable
securities. He includes a probability distribution for
expected cash flows. Cash discounts and loss of credit
ratings are accounted for by means of a cost function.
This model emphasises the cost arising from cash shortages,
whereas, Baumol's drawbacks could be overcome in a model
that incorporates both the possibilities of borrowing and
holding liquid assets.

MARKETABLE SECURITIESs

Though marketable securities provide a much lower

yield than the firm's operating assets, they serve two useful
functions. First, they act as a substitute for cash,

1. It is assumed that the firm sets out with *C* rupees in

cash and when this amount is expanded, *C* rupees of
marketable securities are sold.
2. William Baranek, Analysis for Financial Decisions:
Home-Wood - Irwin, 1963, PP. 345-387.
 38

and second, are used as temporary investments, where

these securities are held ih lieu of cash balance, they

act as a substitute for transactional or precautionary

balances. Normally, these are not used as speculative

balances, but only as a guard against possible shortage

of bank credit.

Marketable securities (as temporary investments) may

be held - (i) for seasonal or cyclical operations;

(ii) to meet known financial requirements-construction of

an additional plant; and (iii) immediately after the sale

of long-term securities.

Three basic strategies exist regarding the holding

of marketable securities.

Strategy 'A* has a low current ratio. Therefore, it

is risky. Difficulties may arise in borrowing funds or

repaying loans on the other hand; this will lead to a

relatively high expected rate of return.

Strategy *B’ is conservative. There is virtually no

it

risk, but the returns are lower.

Strategy *C* affords a compromise between the level of

risk involved and the returns available.

Another consideration to be kept in view is the choice

of securities, which is influenced by the following risks :

i) Default Risk : The risk that the person will be

unable to make interest payments, or to repay the principal

amount on schedule.
ii) Interest rate Risk : The price of long-term bonds are more 39
sensitive to shifts in interest rates than prices of short-term

securities.
iii) Liquidity (or Marketability) Risk : An asset that can be sold

at short notice near the market price is highly liquid, and therefore,

desirable from the firm’s point of view.

ACCOUNTS RECEIVABLE s

Though accounts receivables are vital investmints for any

business organisation, little analytical work has been done on

them to determine the credit policies. Maintaining accounts

receivables has its cost implications in that the firm’s monetary

resources get tied up. This is more significant in an inflationary,

because of the depreciation in the value of the money. Basically,

this is a two-step account. When goods are shipped, inventories are

reduced and an accounts receivable is created, when cash level

increases. Accounts receivables are, therefore, a function of the

volume of credit sales and the average length of time between

sales and collections,

The investment in accounts receivables is affected by

1
a set of controllable factors, namely the firm’s credit policy
such as - (i) credit standards, or the maximum risk of acceptable

credit accounts; (ii) credit period; (iii) discounts given for

early payment; and (iv) firm’s collection policy as measured by

its regidity or laxity.

1. J.P. Waston and Eugene F. Grigham, Managerial Finances

V. Edition the Dryden Press, H ins a le, biinois, 19*75
PP. 159-166.
 40
Determination of the optimal credit standards involves

comparing the marginal costs of credit to the marginal profits

on the increased sales. If credit standards are high, there

will be no bad debt losses. Sales, however, will decline.

Unless expenses for follow-up action and bad debts losses

are high having accounts receivable outstanding may prove to be

profitable. Once a credit policy has been established, the

firm’s operations should be continuously monitored to achieve

the desired results. One such technique has been presented

A
by Lewellen and Johnson where the a ccounts receivable from

different periods are separated, preventing overlap.

An analytical model for analysing decisions in the area

2
of a ccounts receivable has been developed by ’Haskel Benishay* .

The control mechanism provided is statistical in nature-any

deviation results in diagnosis and subsequent remedial action.

Like the models for cash management, this work also

deals with only one component of working capital and is,

therefore of limited use in practice.

INVENTORY MANAGEMENT :

Inventories represent a substantial amount of a firm’s

current assets. Proper management of inventories is necessary

1• Wilbur G. Lewellen and Robert W. Johnson : Better Way to

Monitor Accounts Receivable: Harvard Business Review.
May-June,' 1 , f# ."TOT-16? I
2. Haskel Benishay, Managerial Control of Accounts Receivable;
Journal of *ccouniing Research, tfol. 3 lio. i (Spring - 1965)
PP. 114-132.
 41
so that this investment does not become too large, as it would

result in blocked capital which could be put to productive use

elsewhere. On the other hand, having too small an inventory

could result in loss of sales or loss of customer goodwill.

An optimum level of inventory should, therefore, be maintained.

■%
The first step is to determine which costs rise or

decline as an inventory build* up. As increased quantities

are purchased, the carrying costs increase whereas the costs of

shortage will |>e disregarded and incorporated in the safety

2
stocks. Quantity discounts should not be considered.

The total inventory cost is given by :

T » (C) (P) (A) + F (S/«A) + (V) (S)

Where
C = the percentage carrying cost.

P * Price per unit.

A * average consumption (=0/2)

F = total fixed cost/order.

S = total dumber of units ordered during the year.

V = variable cost per unit ordered.

fCQ3 = / 2PS/CP

1 Costs of Inventory : A Carrying Cost - (i) Cost of

blockedcapital (ii) Shortage Cost; (iii) Depreciation
(iv) insurance, B Shortage cost - (i) loss of sales;
(ii) loss of customer goodwill. C - Order Cost - (i) Cost
of placing order; (ii) shipping/handling cost.
2 Archur Savder, Principles of Inventory Management
Financial lxecufIve7Tpri7~W^---- ----- -----

3 Proof s T = (C) (P) (Q/2) + F (S/Q) +(V) (S) 19.1^2

o PS/Q2 - 0
Or CP/2 = MB/Qd Q /“2FS7SF----

3701 ttffi. RS!*"':.~ USHAr

A
 42
It can be observed from the formula that the higher

the processing or ordering cost, the less frequent should be the

orders placed. Similarly the higher the cost of carrying

inventory, the more frequent should the stoks be ordered•

If neither the demand for the lead time is deterministic

a safety stock has to be added. Khoury illustrates that the

optimal level of safety stock is that which minimises the

expected cost while variation is within prescribed limits.

CURREMT LIABILITIES:

There are three major sources of short-term financing

trade credit, bank loans, and commercial paper. ISdeally,

one could synchronize cash inflows and payment schedule of

debts. But owing to uncertainty, this becomes improbable•

Maturity of a debt, then, becomes the most important feature

of short-term financing.

The maturity of a debt will depend on how much risk

management is prepared to take. The longer the maturity

schedule of debt, the less will be the risk involved in making

payments, both interest and principal. However, the longer

the maturity the more expensive the debt will prove. The

trade-off between risk and profitability, therefore, becomes

the major consideration.

gOMPONENTS OF SHORT TERM FINANCING :

Trade credit or accounts payable is the major source of

short term financing. The credit terms explain the terms of sale,

1• N.T. Khoury, The optimal level of safety stocks in Management

of Working Capital WTET'Or'Smith; West Publishing" Co.'l'§7k,
 43
and there are four factors which influence the time for which

credit is given;

i) Economic nature of the product ; Goods with a high

sales turnover have a short credit terms, because the buyer

resells the goods rapidly, and pays the supplier.

ii) Seller circumstances : Financially weak sellers

use short credit terms because of the need to generate cash.

iii) Buyer Circumstances : Financially strong retailers,

in general, receive longer credit terms.

iv) Cash Discounts : Discounts in cash are offered as

incentive to make payments within a specified period. The

length of credit may be influenced by the size of discounts

offered.

The issue of trade credit has specifi® advantages over other

means of short-term financing. The major advantage is that it is

conveniently available. Negotiation is necessary in the case of

other types of short-term financing. The terms of the loan have

to be decided and restrictions may be imposed. Besides, there

is a lead time before the loan may be granted. In addition, small

firms can make use of trade credit though they may have difficulty

in obtaining loans elsewhere.

Haley and Higgins have formulated a model for optimal

payment time for trade credit in conduction with the optimal

order quantity for inventory.

Charles W. Haley and Robert C. Higgins Inventory Control

Theory and Tj ement Science.
ToIV 20 No. W. 464-471.
 44
Short term bank loans are another means of short-term

financing. They are useful in building up inventories to account

for seasonal changes. This kind of loan is formalized by a

promissory note showing the time, the amount of payment and the

interest to he paid. Unsecured short-term loans may be obtained

under a line of credit, or revolving credit agreement, or on

a transaction basis.

Large companies may use commercial paper as a means of

a short-term financing. This consists of unsecured short-term

2
promissory notes sold in the market. The main advantage of

commercial paper is that it is cheaper than a bank loan.

Inconvenience is also avoided in maintaining links with a number

of financial institutions, each requiring a compensating balance.

A major drawback is that a debtor in temporary difficulty or

a financially weak firm, cannot use this form of funding.

MANAGEMENT OF WORKING CAPITAL s

The method of aggregate guidelines is the most commonly

used approach in the management of working capital. The amount

of short term borrowing is determined by

b a1* + A1-(1^)17 = E1 4- L1)

1• James C. Ven Horne, Financial Management And Policy. Fourth Ed.

Prentice Hall Inc. Englewood Cliffs, N.J. 1977 PP 446-449.
2. Commercial paper is normally sold to other business firms
Insurance Companies, Banks.
3 The first bra eketed term presents next asset requirements.
Where
Current assets (not including marketable securities)

Fixed Assets.

* Current Liabilities (not including short term

bank borrowings).

= Equities.

L-j * Long Term Liabilities.

When net assets requirements exceed the fixed

liabilities, short term bank borrowing is required. Alternately,

marketable relation between risk and the securities should be

procured. Walker attempted to show the relation between risk

and the type of working capital by using generalized guidelines.

Though such policies are theoretically sound, they are of

little use in practice.

Vernon Smith* and Vickers'*

3 have
2 considered working

capital as a constraint set for the objective of minimising

cost, or maximising the value of the firm, Vickers related the

not working capital to the output *Q* by the equation:

A1 - 1-, - 9(Q)

Which represented the total money capital constraint.

The limitation, here is that working capital is considered

• a single variable, rather than a number of interacting

components on both sides of the balance sheet.

1• E.M. Walker, Toward a Theory of Working Capital, Engg.

Economist ( Winder" , ~PP.
2. V.L. Smith - Investment and Production
Cambridge Massachusetts Harvard University Press, 1961•
3. D. Vickers, The Theory Of the Firm - Production, Capital
and Finance, few York, Mcgraw Hill Book Co. Inc., 1968.
 46
A third approach in dealing with working capital is that

of cost balancing. This is a typical minimization problem for

with any current asset a^ and where Oj &2.are costs associated

with different levels of a^• The problem then is -

Minimise (^(a^) + C2(a^) + ...»Cn(ai)

The limitation is that only a single current asset is

dealt with at a time i.e. in isolation.

The account for uncertainties, the probability model has

been considered. This includes random fluctuations that might

exist within the variables. Risk and uncertainty considerations

result in an alteration of the objective function-one now talks

of expected costs and expected profits. Beranek, in analysing

credit pQlicy, gives emphasis to the shortage cost (Cost of

borrowing). The chief disadvantage is that the model does not

consider the possibility of liquidating investment to meet cash

requirements.

Working Capital can be managed by the partfolio theory

which takes cȤnizance of both the uncertainty and the

2
interrelationships among the variables. Friedland suggested

that the portfolio theory could be used once the inter-relationships

between current asset accounts was obtained. This theory has

1. For receivable C-(a.) might represent profits when credit policy

is relaxed and gales and receivables increases C2 (a..) for
inventory C-jCa1' be ordering cost; C2(a-j) *could be
inventory holding cost, C3 (a-| ) could be shortage cost (lost
sales case).
2. S. Friedland, The Economics of Corporate Finance. Englewood
Cliffs, New Jersey,.Prentice Hail'inc. 1966.
•?
 47
been found to have little use in practice because each asset

cannot be independently controlled. ■s

An approach frequently used in dealing with working

capital is mathematical programming, because a large number of

variables can be simultaneously dealt with. Robichek, Teichrow,

and Jones developed a linear programming model for short term

financing. This took into account other working capital accounts

which was its chief advantage. However, as with all LP Problems,

only a single objective function (minimising costs) could be

considered.

Financial simulation is the last known method of analyzing

the management of working capital. It permits the handling of

multiple goals, and also takes care of the inherent uncertainty

2
of future sales. Leraer explained how simulation could help

determine the amount of cash, liquidity of bank line needed to

meet future uncertainties. Further, the effect of changes in

receivable or payable policy could be ascertained. Also, the

activities having the greatest influence on cash balances can

be determined, thereby providing f6cus on certain important

3
activities which have the largest impact. Van Horne presented

a probabilistic method to evaluate the level of liquid assets

1. A.A. Robichek, D. Teichrow; and J.M. Jones, Optimal Short

term Financing Decisions; Management Science (Sept.65} f£.1.36.
2. E.M. Lerner,
Review, Vol.
Simulating a Cash Budget; California Management
'ytb'-g'PPT^-SS.-----
3. James C. Van Horne s A Risk Return Analysis of a Firm's
Working Capital Position,The feconomist, Vol. 14 Mo. 2
(Winter 69) PP 71-88.
 41

and the maturity composition of the debt of the firm.

The trade off between profitability and risk can be
determined once the opportunity cost of a change in
liquidly assets and maturity of the debt is known.