UNIT V

Working Capital
 MEANING AND CONCEPT OF WORKING
InCAPITAL
accounting term working capital is the difference between
current assets and current liabilities. If we break down the
components of working capital we will found working capital as
follows
Working Capital = Current Assets – Current Liabilities
Current Assets:
 It is expected to be realized within twelve months after the
reporting period;
 It is non- restricted cash or cash equivalent.
Current Liabilities:
 It is expected to be settled within twelve months after the
reporting period
 SIGNIFICANCE OF WORKING CAPITAL
 Importance of Adequate Working Capital
Management of working capital is an essential task of the finance
manager. He has to ensure that the amount of working capital
available is neither too large nor too small for its requirements.
 A large amount of working capital would mean that the company
has idle funds. Since funds have a cost, the company has to pay
huge amount as interest on such funds.
 If the firm has inadequate working capital, such firm runs the risk
of insolvency. Paucity of working capital may lead to a situation
where the firm may not be able to meet its liabilities.
 Some of the factors which need to be considered while planning for
working capital requirement are:-
 Cash – Identify the cash balance which allows for the business to meet
day- to-day expenses, but reduces cash holding costs.
 Inventory – Identify the level of inventory which allows for
uninterrupted production but reduces the investment in raw materials
and hence increases cash flow
 Receivables – Identify the appropriate credit policy, i.e., credit
terms which will attract customers, such that any impact on cash flows
and the cash conversion cycle will be offset by increased revenue and
hence Return on Capital (or vice versa).
 Short-term Financing Options – Inventory is ideally financed by
credit granted by the supplier; dependent on the cash conversion cycle,
it may however, be necessary to utilize a bank loan (or overdraft), or to
“convert debtors to cash” through “factoring” in order to finance
working capital requirements.
 Market and Demand Conditions - For e.g. if an item’s demand far
exceeds its production, the working capital requirement would be
less as investment in finished goods inventory would be very less.
 Technology and Manufacturing Policies - For e.g. in some
businesses the demand for goods is seasonal, in that case a
business may follow a policy for steady production through out over
the whole year or instead may choose policy of production only
during the demand season.
 Operating Efficiency – A company can reduce the working capital
requirement by eliminating waste, improving coordination etc.
 Price Level Changes – For e.g. rising prices necessitate the
use of more funds for maintaining an existing level of activity. For
the same level of current assets, higher cash outlays are required.
Therefore, the effect of rising prices is that a higher amount of
working capital is required.
 MANAGEMENT OF WORKING
CAPITAL
Working capital is required for smooth functioning of the business of
an entity as lack of this may interrupt the ordinary activities. Hence,
the working capital needs adequate attention and efficient
management. When we talk about the management it involves 3 Es
i.e. Economy, Efficiency and Effectiveness and all these three are
required for the working capital management.
 Inventory Management
 Meaning and Definition of Inventory
 In dictionary meaning of inventory is a “detailed list of goods,
furniture etc.” Many understand the word inventory, as a stock of
goods, but the generally accepted meaning of the word ‘goods’ in
the accounting language, is the stock of finished goods only. In a
manufacturing organization, however, in addition to the stock of
finished goods, there will be stock of partly finished goods, raw
materials and stores. The collective name of these entire items is
‘inventory’.
 The term ‘inventory’ refers to the stockpile of production a firm is
offering for sale and the components that make up the
production.
 Types of Inventories:
 The management of inventory starts from the identification of
suppliers passes through various stages and finally reaches the
consumer. The various forms of Inventory in which it exists are 3
types. They are:
 i) Raw material: these are the basic materials that are converted
into finished products ready for consumption, which can be stored for
future production.
 ii) Work- in- process: this is the stage at which further process is
required to reach the final stage of production.
 iii) Finished goods: this is the stage of the products which are
ready for dispatch for consumption.
 Apart from these three levels of inventories, there is one more form
of inventory, i.e., stores and spares, which is usually a marginal
portion of the total inventory.
 Management of
Inventories
 Meaning and concept
 The maintenance of inventory means blocking of funds and so it involves the interest and
opportunity cost to the firm. The inventory cost is not only interest on stocks but also cost
of store building for storage, insurance and obsolesce and movement of inputs from place
of storage to the factory where the materials have to be finally used to convert them into
finished goods.
 Inventory management is the most significant part of the working capital management in
majority of the business organizations, since inventories constitute on an average about 60
percent of the total current assets. The success of any industry depends upon the effective
utilization of its inventory. The inventory manager is expected to ensure right inventory at
right time with right quality from a right place at right price in order to minimize the cost of
manufacturing of products or services. The most difficult area to the management of a firm
is the management of inventory. A firm neglecting the management of inventories will be
jeopardizing its long-run profitability and may fail ultimately. For any organization, it is
possible to reduce its level of inventories to a considerable extent without any adverse
effect on the production and sales, by using the simple inventory management techniques.
This reduction of inventory volume carries a positive impact on the profitability of the
organization.
 Objectives of Inventory Management
 The objectives of the inventory management are to ensure
maximum and uninterrupted production with minimum
investment in inventory. Thus, the efficient inventory
management results the following advantages:
 i) ensure continuous production;
 ii) anticipate price changes and take advantage of it
 iii) control investment and keep inventory at optimum level;
 iv) maintain sales operations and delivery commitments.
 v) increase operational efficiency and production levels
 vi) economy in purchasing
Need for Inventory
 Continuous production:
Production without halt will be possible by holding enough inventories.
Otherwise, firm has to incur heavy costs for keeping the machine idle.
 Continuous supply market:
Proper inventory management will ensure finished goods without
interruption and customer satisfaction could be possible.
 No stock - out problem:
Shortage of inventories often cause stock - out problem, thereby
consumers shift to competitors.
 Cost saving:
Enough inventories will ensure continuous production, in the absence
of which cost of production will be high.
Costs of Inventory
There are various kinds of costs involved in inventory management policies.
 Ordering costs:
Costs incurred in placing order with suppliers of raw materials, consumables and other
inputs are called ordering costs. These costs include stationary, requisitioning, mailing
expenses, telephone bills, correspondence charges, typing, salaries, dispatching,
inspection, checking, travel, follow up costs, etc. Larger the order size lower the cost per
unit. Thus, ordering costs can be minimized by placing order for bigger quantity.
 Carrying costs:
Warehousing, insurance, wastage, loss due to theft, deterioration, obsolescence etc., are
called inventory carrying costs. These costs are more as the level of stock is higher. These
costs are also known as holding costs.
 Stock-out costs:
Normally, whenever customers place order, the suppliers should be ready to dispatch the
items. At times, the items when not readily available, the suppliers make the customers to
wait. But customers (with out waiting) will go to competitors for the supplies immediately.
Thus, the regular supplier looses the profit which he would have got. This is known as
opportunity cost or lost sales cost

 Storage costs:
Costs pertaining to warehousing of goods or inventory are generally called
as storage costs. Example: rent, lighting, interest, insurance, checking,
etc.
 Obsolescence cost:
When goods are stored more quantity than demand for it, the quality
deteriorates and models will become outdated. At times, they have to be
sold at heavy discounts since the quality of goods is poor and design or
model is outdated. This loss is called as obsolescence costs.
 Set up costs:
Normally production is made regularly an item for few days / weeks.
Wherever, order is placed for different items; the producer changes the
regular processing and shift to new process to make it suitable to new
order placed. Thus, when processing is shifted, the firm incurs costs of
design, loss of clerical time consumption of, components and spares, etc.
All these constitute set up costs.
 Cash Management
 INTRODUCTION
 Cash management is one of the key areas of working capital management. Cash is
the most liquid current assets. Cash is the common denominator to which all current
assets can be reduced because the other major liquid assets, i.e. receivable and
inventory get eventually converted into cash.
 This underlines the importance of cash management. The term "Cash" with reference
to management of cash is used in two ways. In a narrow sense cash refers to coins,
currency, cheques, drafts and deposits in banks. The broader view of cash includes
near cash assets such as marketable securities and time deposits in banks.
 The reason why these near cash assets are included in cash is that they can readily
be converted into cash. Usually, excess cash is invested in marketable securities as it
contributes to profitability. Cash is one of the most important components of current
assets. Every firm should have adequate cash, neither more nor less. Inadequate
cash will lead to production interruptions, while excessive cash remains idle and will
impair profitability. Hence, the need for cash management. The cash management
assumes significance for the following reasons.
 SIGNIFICANCE OF CASH MANAGEMENT
 1. Cash planning - Cash is the most important as well as the least unproductive of all
current assets. Though, it is necessary to meet the firm's obligations, yet idle cash earns
nothing. Therefore, it is essential to have a sound cash planning neither excess nor
inadequate.
 2. Management of cash flows - This is another important aspect of cash management.
Synchronisation between cash inflows and cash outflows rarely happens. Sometimes, the
cash inflows will be more than outflows because of receipts from debtors, and cash sales in
huge amounts. At other times, cash outflows exceed inflows due to payment of taxes,
interest and dividends etc. Hence, the cash flows should be managed for better cash
management.
 3. Maintaining optimum cash balance - Every firm should maintain optimum cash
balance. The management should also consider the factors determining and influencing
the cash balances at various point of time. The cost of excess cash and danger of
inadequate cash should be matched to determine the optimum level of cash balances.
 4. Investment of excess cash - The firm has to invest the excess or idle funds in short
term securities or investments to earn profits as idle funds earn nothing. This is one of the
important aspects of management of cash. Thus, the aim of cash management is to
maintain adequate cash balances at one hand and to use excess cash in some profitable
way on the other hand.