CHAPTER 4: MANAGING CURRENT ASSETS

Introduction
Capital required for a business can be classified under two main categories viz., Fixed Capital,
and Working Capital. Every business needs funds for two purposes-for its establishment and to
carry out its day-to-day operations. Long-term funds are required to create production facilities
through purchase of fixed assets such as plant and machinery, land, building, furniture, etc.
Investments in these assets represent that part of firm’s capital which is blocked on a permanent
or fixed base and is called fixed capital. Funds are also needed for short-term purposes for the
purchase of raw materials, payment of wages and other day-to-day expenses, etc. These funds
are known as working capital. In simple words, working 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. Further funds invested in current assets keep revolving fast
and are being constantly converted into cash and this cash flows out again in exchange for other
current assets. Hence, it is also known as revolving or circulating capital or short-term capital.

Although working capital linked to a short term financing there are much disagreement among
various financial authorities (Financiers, accountants, businessmen and economists) as to the
exact meaning of the term working capital here are some mentioned;
 According to the definition of Mead, Baker and Malott, “Working Capital means Current
Assets”.
 According to the definition of J.S.Mill, “The sum of the current asset is the working
capital of a business”.
 According to the definition of Weston and Brigham, “Working Capital refers to a firm’s
investment in short-term assets, cash, short-term securities, accounts receivables and
inventories”.
 According to the definition of Bonneville, “Any acquisition of funds which increases the
current assets, increase working capital also for they are one and the same”.
 According to the definition of Shubin, “Working Capital is the amount of funds necessary
to cover the cost of operating the enterprises”.
The concept of Working Capital
There are two concepts of working capital:
A. Balance Sheet Concept
B. Operating Cycle or Circular Flow Concept
A. Balance Sheet Concept: - There are two interpretations of working capital under the
balance sheet concept.
 Gross Working Capital
 Net Working Capital
In the broad sense, the term working capital refers to the gross workings capital and represents
the amount of funds invested in current assets. Thus, the gross working capital is the capital
invested in total current assets of the enterprise. Current assets are those assets which in the
ordinary course of business can be converted into cash within a short period of normally one
accounting year. Examples of current assets are Cash in hand and bank balances, bills

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receivables, debtors (less provision for bad debts), short –term loans and advances, inventories of
stocks, temporary investments of surplus funds, prepaid expenses and accrued Incomes.

In narrow sense, the term working capital refers to the net working capital. Net working capital
is the excess of current assets over current liabilities, or say:
Net Working Capital = Current Assets-Current liabilities.
Net working capital may be positive or negative. When the current assets exceed the current
liability the working capital is positive and the negative working capital results when the current
liabilities are more than the current assets. Current Liabilities are those liabilities which are
intended to be paid in the ordinary course of business within a short period of normally one
accounting year out of the current assets or the income of the business. Examples of current
liabilities are bills payable, accounts Payable, accrued expenses, Short-term loans, advances and
deposits, dividends payable, bank overdraft, and provision for taxation, if it does not amount to
appropriation of profits.
B. Operating Cycle or circular Flow Concept
The circular flow concept of working capital is based upon the operating or working capital cycle
of a firm. The cycle starts with the purchase of raw material and other resources and ends with the
realization of cash from the sale of finished goods. It involves purchase of raw material and
stores, its conversion in to sock of finished goods through work-in-progress with progressive
increments of labor and service costs, conversion of finished stock into sales, debtors and
receivables and ultimately realization of cash and this cycle continues again from cash to purchase
of raw material and so on. The speed/time duration required to complete one cycle determines the
requirements of working capital-longer the period of cycle, larger is the requirement of working
capital. The gross operating cycle of a firm is equal to the length of the inventories and
receivables conversion period

Permanent and variable working capital

Working capital may be classified in two ways: one on the basis of concept and the other on the
basis of time. On the basis of concept, working capital is classified as gross working capital and
net working capital as discussed earlier. This classification is important from the point of view of
the financial manager. On the basis of time, working capital may be classified as:
 Permanent or fixed working capital; and
 Temporary or variable working capital
A. Permanent or fixed working capital
Permanent or fixed working capital is the minimum amount of investment in all current assets
which is required at all times to carry out minimum level of business activities. In other words, it
represents the current assets required on a continuing basis over the entire year. For example,
every firm has to maintain a minimum level of raw materials, work-in-process, finished goods
and cash balance. However, even though it does not change with time and volume of sales, the
requirements of permanent working capital increase the business grows due to the increase in
current assets.

The permanent working capital can further be classified as regular working capital and reserve
working capital required ensuring circulation of current assets from cash to inventories, from

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inventories to receivable and from receivables to cash and so on. Reserve working capital is the
excess amount over the requirement for regular working capital which may be provided for
contingencies that may arise at unstated periods such as strikes, rise in prices, depression, etc.

Figure 2.1 Permanent working capital

A. Temporary or variable working capital

Temporary or variable working capital is the amount of working capital which is required to
meet the seasonal demands and some special exigencies. In other words, it represents additional
current assets required at different times during the operating year.
Variable working capital can be further classified as seasonal working capital and special
working capital. Most of the enterprises have to provide additional working capital to meet the
seasonal and special needs. The capital required to meet the seasonal needs of the enterprise is
called seasonal working capital. Special Working capital is that part of working capital which is
required to meet special exigencies such as launching of extensive marketing campaigns for
conducting research, etc.

Notice that Temporary working capital differs from permanent working capital in the sense that
it is required for short periods and cannot be permanently employed gainfully in the business.
Permanent working capital is stable or fixed over time while the temporary or variable working
capital fluctuates. Furthermore, permanent working capital is also increasing with the passage of
time due to expansion of business but even then it does not fluctuate as variable working capital
which sometimes increases and sometimes decreases.

Figure 2.2 Temporary working capital

4.4: Determinants of Working Capital Management

Working Capital management depends upon various factors. There are no set of rules or formula
to determine the Working Capital needs of the business concern. The following are the major
factors which are determining the Working Capital requirements.

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1) Nature of business: Working Capital of the business concerns largely depend upon the
nature of the business. If the business concerns follow rigid credit policy and sell goods only
for cash, they can maintain lesser amount of Working Capital. A transport company
maintains lesser amount of Working Capital while a construction company maintains larger
amount of Working Capital.
2) Production cycle: Amount of Working Capital depends upon the length of the production
cycle. If the production cycle length is small, they need to maintain lesser amount of
Working Capital. If it is not, they have to maintain large amount of Working Capital.
3) Business cycle: Business fluctuations lead to cyclical and seasonal changes in the business
condition and it will affect the requirements of the Working Capital. In the booming
conditions, the Working Capital requirement is larger and in the depression condition,
requirement of Working Capital will reduce. Better business results lead to increase the
Working Capital requirements.
4) Production policy: It is also one of the factors which affect the Working Capital requirement
of the business concern. If the company maintains the current production policy, there is a
need of regular Working Capital. If the production policy of the company depends upon the
situation or conditions, Working Capital requirement will depend upon the conditions laid
down by the company.
5) Credit policy: Credit policy of sales and purchase also affect the Working Capital
requirements of the business concern. If the company maintains liberal credit policy to
collect the payments from its customers, they have to maintain more Working Capital. If the
company pays the dues on the last date it will create the cash maintenance in hand and bank.
6) Growth and expansion: During the growth and expansion of the business concern,
Working Capital requirements are higher, because it needs some additional Working Capital
and incurs some extra expenses at the initial stages.
7) Availability of raw materials: Major parts of the Working Capital requirements are largely
depend on the availability of raw materials. Raw materials are the basic components of the
production process. If the raw material is not readily available, it leads to production
stoppage. So, the concern must maintain adequate raw material; for that purpose, they have
to spend some amount of Working Capital.
8) Earning capacity: If the business concern consists of high level of earning capacity, they
can generate more Working Capital, with the help of cash from operation. Earning capacity is
also one of the factors which determine the Working Capital requirements of the business
concern.
Working capital management has the following objectives.
a) It helps to maximize the value of a firm by focusing on maximizing the returns from the
working capital investment in relation to its cost.
b) It helps to minimize, in the long run the cost of working capital employed by identifying
least cost sources of finance.

c) It helps to control the flow of funds within the organization so that the firm can meet its
financial obligation and run its operation smoothly.
4Alternative Current asset Investment Policies

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There are three alternative policies regarding the total amount of current assets carried.
Essentially, these policies differ in that different amounts of current assets are carried to support
any given level of sales. It is illustrated in figure 5.1 below
Current asset
40
30 Relaxed
Moderate
20 Restricted

10
0 50 100 150 Sales
Figure 5.1
Policy Current assets to support sales of 100
Relaxed Birr 30
Moderate 23
Restricted
A. Relaxed current asset investment( fat cat) policy
Where relatively large amounts of cash, marketable securities, and inventories are carried and
where sales are stimulated by the use of a credit policy that provides liberal financing to
customers and a corresponding high level of receivables.
B. Restricted current asset investment (lean and mean) Policy
With this policy, the holdings of cash, securities, inventories, and receivables are minimized.
C. Moderate current asset investment policy.
The moderate current asset investment policy is between the two extremes.
Under conditions of certainty- when sales, costs, lead times, payment periods are known for
sure- all firms would hold only minimal levels of current assets. Any larger amounts would
increase the need for working capital financing without a corresponding increase in profits, while
any smaller holdings would involve late payments to labor and suppliers and lost sales due to
inventory shortages and an overly restrictive credit policy.
With a restricted current asset investment policy, the firm would hold minimal of safety stocks
for cash and inventories, and it would have a tight credit policy even though this meant running
the risk of losing sales. A restricted, lean and mean current asset investment policy generally
provides the highest expected return on investment, but it entails the greatest risk, while the

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 reverse is true under a relaxed policy. The moderate policy falls in between the two extremes in
terms of risk and expected return.
CASH MANAGEMENT
The basic objective in cash management is to keep the investment in cash as low as possible
while still keeping the firm operating efficiently and effectively (i.e., is reducing the idle cash
amount). This goal usually reduces to the dictum (motto) “collect early and pay late”.
Accordingly, we discuss ways of accelerating collections and managing disbursements.
Nature of Cash
 Cash is the blood life and most liquid asset (it is easily handled, usable, transferable, etc) of an
organization
 All purchases and payments are made through cash
 Cash by itself like other asset doesn’t produce goods and services
 At any point of time, a firm has to have cash
 At any point of time, receipts and payments can’t be synchronizing
 Cash is sensitive to changes in working capital
 A decrease in account receivable will increase cash position
 The determination of cash flow for a particular period is dependent upon working capital.
 Short term liquidity position of a firm is dependent on the amount of cash
 Loss due to shortage of cash can’t quantified easily
 Holding excess cash is a costly affairs ( it is an idle cash with opportunity cost)
The cash operating cycle is the length of time, which elapses between a business paying for its raw
materials and the business’s customers paying for the goods made from the raw materials. It equals the
debtor’s collection period plus the length of time for which stocks are held, less the creditors payment
period.
The operating cycle is represented by the following sequences of events.
1. Purchase of material inputs
2. Conversion of raw materials into w/p
3. Conversion of w/p into finished goods
4. Sale of finished goods, Account receivable
5. Conversion of account receivable into cash
Motives for Holding Cash
John Maynard Keynes, in his great work the “General theory of employment, interest and money”,
identified three reasons why liquidity is important the speculative motive, the precautionary motive and
the transaction motive.
Transaction motive: - cash is needed to satisfy the transaction motive, the need to have cash on hand to
pay bills. Transactions related needs come from the normal disbursement and collection activities of the
firm. The disbursement of cash includes the payment of wages and salaries, trade debts, taxes and
dividends.
Precautionary motive (contingency needs)- is the need for a safety supply to act as a financial reserve

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-To maintain a safety cushion or buffer to meet unexpected cash needs. The more predictable the
inflows and out flows of cash for a firm, the less cash that needs to be held for precautionary needs.
Ready borrowing power to meet emergency cash drains also reduces the need for this type of cash
balance
Speculative motive (opportunity needs) – is the need to hold cash in order to be able to take advantage
of, for example, bargain purchases that might arise, attractive interest rates, and (in the case of
international firms) favorable exchange rate fluctuations.
- To take advantage of temporary opportunities, such as a sudden decline in the price of raw material.
It is important to point out that not all of the firm’s needs for cash call for holding cash balances
exclusively. Indeed, a portion of these needs may be met by holding marketable securities- cash
equivalent assets. For the most part, firms don’t hold cash for the purpose of speculation. Consequently,
we concentrate only on the transactions and precautionary motives of the firm, with these needs being
met with balances held both in cash and in marketable securities.
When a firm holds cash in excess of some necessary minimum, it incurs an opportunity cost. The
opportunity cost of excess cash (held in currency and bank deposits) is the interest income that could be
earned in the next best use, such as an investment in marketable securities.
Compensating Motive:
 Is a motive for holding cash/near-cash to compensate banks for providing certain services or
loans
 Clients are supposed to maintain a minimum balance of cash at the bank which they cannot use
themselves.
An organization has to maintain a minimum cash balance to meet cash requirements.
Advantages of Holding Adequate Cash
In addition to the motives just discussed, sound working capital management requires that an ample
supply of cash be maintained for several reasons.
 It prevents insolvency or bankruptcy
 It helps in fostering good relationship with creditors and suppliers.
 To take available trade discounts
 It leads to a strong credit ratings. A strong credit rating enables the firm both to purchase
goods from suppliers on favorable terms and to maintain an ample line of low-cost credit
with its bank
 It is useful to take advantage of favorable business opportunities, such as special offer from
suppliers or the chance to acquire another firm.
 To meet unexpected expenditure with the minimum strain, like strikes, fires or competitors
marketing campaigns, and to weather seasonal and cyclical downturns.
Objectives of Cash Management
The basic objectives of cash management are two, these are: -
1. To meet the cash disbursement need (payment schedule)
2. To minimize funds committed to cash balance (Minimization of Idle cash).
These two objectives are conflicting and mutually contradictory and it is the task of cash
management to reconcile them.
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 1. Meeting the payment schedule- in the normal course firms have to make payment of cash on a
continuous and regular basis to supplier of goods, employees and so on. At the same time there is a
constant inflows of cash through collection from debtors and cash sales. And cash is therefore as
Bolton S.C. puts it “oil to lubricate the ever turning wheals of business, without it the process of
grinds to stop”.
A basic objective of cash management is to meet the payment schedule i.e., to have sufficient cash
to meet the cash disbursement needs of the firm. Keeping large cash balances however implies a
high cost. Sufficient and not excessive cash can well realize the advantages of prompt payment of
cash.
2. Minimizing funds committed to cash balance
High level of cash balance has the advantages of prompt payment but has high costs. A low level of
cash may result in not keeping up payment schedule but has low cost.
Excessive cash balance reduces profitability as well as lower cash leads to insolvency. As excess
cash or shortage has its own costs, an optimal cash balance would have to be arrived. This optimal
cash balance has to be arrived at after taking into consideration of the future cash inflows and out
flows. Using cash budget can derive an optimal cash balance.
Cash Management Strategies
The cash budget as a management tools would throw light on the net cash position of a firm. After
knowing the cash position, the management should work out the basic strategy to be employed to
manage its cash.
The broad cash management strategies are essentially related to the cash turnover process i.e., the cash
cycle together with the cash turnover.

A
A B C D E F G H I
A = Material order F= Customers mails payment
B = Material received G= Payment received
C= Payment to supplier H= Check deposited
D= Check clearance I= Fund collected
E= Goods sold
In cash management strategies we are concerned with the time periods involved in stages B, C, D and F,
G, H & I. A firm has no control over the time involved between stages A and B. The lag between D and
E is determined by production process and inventory policies. The lag between E and F is determined by
the credit terms and payment policy of the customers.
Cash cycle – refers to the time taken from the time cash is paid to purchase raw materials till the time it
is received from customers.
 Keeping the cash cycle so short is utmost important
Cash turnover – means the number of times firm’s cash is used during each year
Minimum operating cash- the higher cash turnover, the less cash the firm requires. Therefore, the firm
should try to maximize the cash turnover but it must maintain a minimum amount of operating cash
balances so that it doesn’t run out of cash

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 Cash turn over = Number of days in a year
Cash cycle
 High turnover is desirable since it reduces firm’s average cash balance and holding costs.
 Minimum cash balance = Total annual outlay
Cash turn over
The operational implication of the minimum cash requirement is that if the firm has an operating
minimum cash balance it would be able to meet its obligation when they become due. But the minimum
operating cash involves cost in terms of the earning forgone from investing it temporarily (i.e.,
opportunity cost). Also the firm will have to pay a cost for this amount.
Cash cycle= ACP + Manufacturing time – creditors pmt period
The cash management strategies are intended to minimize the operating cash balance requirements.
 The basic strategies that can be employed are:
A. Stretching (Extending) payments of accounts payable
B. Efficient inventory production management
 Increasing the raw material turnover by using more efficient inventory control techniques
Example: JIT- its reduces the idle investment
 Decreasing the production cycle through better production planning, scheduling and control
techniques. It will lead to an increase in WIP turn over
 Increasing finished goods turnover though better for casting of demand and better planning
of production
C. Speedy collection of account receivable
 Credit terms- reducing the credit period
 Credit standards- increase the standards to reduce credit customers
 Collection policy- centralized and decentralized collection
D. Combined cash management strategies
Each one of the above strategies if effected results in saving. Supposing if all the strategies are effected
simultaneously then it is called combined cash management strategies.
 Efficient cash management implies minimum idle cash balances consistent with the need to
pay bills when they become due.
The three basic strategies related to accounts payable, inventory and accounts receivable leads to a
reduction in the cash balance but they imply certain problems to the management.
1. If the accounts payable postponed too long, the credit standing of the firm may be
adversely affected (Signify poor financial position)
2. A low level of inventory may result in stoppage of production or not enough finished
goods stock to meet the demand (Result in out of stock)
3. Restrictive credit terms, credit standards and collection policy may jeopardize (Lower sales).
These implications will constantly kept in view while working out cash management strategies.
Example:
Over the past year, X company’s accounts receivable have averaged 80 day sales and inventories have
averaged 60 days. The company has paid its creditors, on average, 25 days after receiving the bill.
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Production is evenly spread over the year and the company expects to spend birr 18 million during the
year for materials and supplies
1. Compute the following
Cash cycle
Cash turnover
Minimum cash balance
2. What is the birr cost of tying up the fund if the company’s opportunity cost is 20%?
Solution
1. a. Cash cycle = 80 + (60-25) = 115 days
b. Cash turnover = 365/115 = 3.18 times
c. Minimum cash balance = 18,000,000 = birr 5,750,799
3.13
2. Birr cost = 5,750,799 x 0.2 = birr 1,150,160
Managing Cash Collection and Disbursement
Float: Difference between bank cash balance and book cash balance
Float= Firm’s bank balance- firm’s book balance
Float

Disbursement float Collection float

 Checks received by the firm

 Checks written by firm  Increase in book cash but no
 Decreased in book cash but no immediate immediate change in bank
change in bank balance balance

Net float= disbursement float + collection float

Example:
Disbursement float
XYZ co. currently has birr 1,000,000 on deposit with its bank. The book balance also shows birr
1,000,000. Assume that XYZ co. Purchased materials and make payments by writing a check for birr
100,000
 The book balance is immediately adjusted to $ 900,000 when the check is issued.
 The bank balance will not decrease until the check is presented to XYZ’s bank by the
supplier or his bank.
Disbursement float = Bank balance – book balance
= 1,000,000 – 900,000 = 100,000
Collection float
Consider the same example above, but instead of payment, the firm receives a check from a customer
for $ 200,000 and deposits the check at its bank.
Book balance is adjusted immediately to $ 1,200,000

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Bank balance will not increase immediately until XYZ’s bank present the check to the customer’s bank
and received the amount
Collection float = Bank balance - book balance
= 1,000,000 – 1,200,000 = -200,000
Net float = 100,000- 200,000 =- 100,000
Float result an opportunity cost because the cash is not available for use during the time checks are tied
up in the collection process.

FLOAT MANAGEMENT
It involves controlling the collection and disbursement of cash. The objective in cash collection is to
speed up collections and reduce the lag between the time customers pay their bills and the time the cash
becomes available. The objective in cash disbursement is to control payments and minimize the firm’s
costs associated with making payments.
Total collection or disbursement times can be broken down into three parts mailing time, processing
delay, and availability delay.
1. Mailing time is the part of the collection and disbarment process during which
checks are trapped in the postal system
2.Processing delay is the time it takes the receiver or the check to process the
payment and deposit it in a bank for collection
3. Availability delay refers to the time required to clear a check through the bankingsystem.
Speeding up collections involves reducing one or more or these components. Slowing up disbursement
involves increasing one of them. We will describe some procedures for managing collection and
disbursement times later.
The various collection and disbursement method that a firm employ to improve its cash management
efficiency constitutes two sides of the same coin. They exercise a joint impact on the overall efficiency
of cash management. The general idea is that the firm will benefit by “speeding up” cash receipts and
“s-l-o-w-i-n-g d-o-w-n” cash payouts. The firm wants to speed up the collection of accounts receivable
so that it can have the use of money sooner. Conversely, it want to pay accounts payable as late as is
consistent with maintaining the firm’s credit standing with suppliers so that it can make use of the
money it already has. Today, most companies of reasonable size use sophisticated techniques to speed
up collections and tightly control disbursements.

There are a specific techniques and process for speedy collection of receivable and slowing
disbursements.
A. Speedy cash collections
In managing cash efficiently the cash inflow process can be accelerated through systematic planning and
refined techniques. In the first place the customer should en courage to pay as quickly as possible
secondly the payment from customers should be converted into cash without any delay.
1. Prompt payment by customer- one way to insure prompt payment by customer is prompt billing.

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Customers have different payment habits. Some pay their bills on the discount date or the final date (or
later), while others pay immediately up on receipt of an invoice. In any event, accelerated preparation
and mailing of invoices will result in faster payment because of the earlier invoice receipt and resulting
earlier discount and due dates.
2. Early conversion of payment into cash- once the customers makes the payment by writing a check
in favor of the firm the collection can be expedited (speed up) by prompt encashment of the check
An important aspect of cash management is the reduction of deposit float. This is possible if a firm
adapts decentralized collection. The principal methods of decentralized collections are:
1. Lock box system
2. Concentration banking
i. Lock Box System
The single most important tool for accelerating the collection of remittances is the lock box. A company
rents a local post office box and authorizes its bank to pick up remittances in the box. Customers are
billed with instructions to mail their remittances to the lock box.
In the typical lock box system, the local bank collects the lock box checks from the post office several
times a day. The bank deposits the checks directly to the firm’s account. Details of the operation are
recorded (in some computer usable form) and sent to the firm.
A lock box system reduces mailing time because checks are received at a nearby post office instead of at
corporate head quarters. Lock box also reduce the processing time because the corporation doesn’t have
to open the envelopes and deposit checks for collection. In all, a bank lock box should enable a firm to
get its receipts processed, deposited and cleared faster than if it were to receive checks at its head
quarters and deliver them itself to the bank for deposit and clearing.
ii. Concentration Banking
The firm that uses a lock box net work as well as the one having numerous sales out lets which receive
funds over the counter have something in common. Both firms will find themselves with deposit
balances at a number of regional banks. Each firm may find it advantageous to move part, or all, of these
deposits to one central location, which is known as a concentration bank. This is the process of cash
concentration. Cash concentration is the movement of cash from lock box or field banks into the firm’s
central cash pool residing in a concentration bank.
 Improves control over inflows and out flows of corporate cash. The idea is to put all of your eggs
(or in this case, cash) into one basket and them to watch the basket.
 Reduces idle balances- that is keeps deposit balances at regional banks on higher than necessary to
meet transaction needs. Any excess funds would be moved to the concentration bank.
 Allows for more effective investments. Pooling excess balances provides the larger cash amounts
needed for some of the higher yielding, short-term investment opportunities that require a larger
minimum purchase.
Other approaches to cash collection exist. One that is becoming more common is the preauthorized
payment arrangement. With this arrangement; the payment amounts and payment dates are fixed in
advance. When the agreed-up on date arrives, the amount is automatically transferred from the
customer’s bank account to the firm’s bank account, which sharply reduces or even eliminates collection

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delays. The same approach is used by firms that have on-line terminals, meaning that when a sale is
rung up, the money is immediately transferred to the firm’s accounts.
B. S-L-O-W-I-N-G D-O-W-N DISBURSMENTS
Form the firm’s point of view, disbursement float is desirable, so the goal in managing disbursement
float is to slow down disbursements as much as possible. To do this, the firm may develop strategies to
increase mail float, processing float and availability float on the checks it writes. Beyond this, firms
have developed procedures for minimizing cash held for payment purposes.
a. Increasing disbursement float
As we have seen, float in terms of slowing down payments comes from the time involved in mail
delivery, check processing and collection of funds.
Disbursement float can be increased by writing a check on a geographically distant bank.
 Mailing checks from remote post office is another way for firms to slow down disbursements.
Tactics for maximizing disbursement float are debatable on both ethical and economic grounds.
 Payment terms very frequently offer a substantial discount for early payment. The discount is
usually much larger than any possible savings from “playing the float game”
 Suppliers are not likely to be fooled by attempts to slow down disbursements. The negative
relations with suppliers can be costly.
In broader terms, intentionally delaying payments by taking advantage of mailing times or
unsophisticated suppliers may amount to avoiding paying bills when they are due, an unethical business
procedure.
b. Controlling disbursements
We have seen that maximizing disbursement float is probably poor business practice. However, a firm
will still wish to tie up as little cash as possible in disbursements. Firms have therefore developed
systems for efficiently managing the disbursement process. The general idea in such systems is to have
no more than the minimum amount necessary to pay bills on deposit in the bank.
I) Zero-balance accounts: -
With this system, the firm, in cooperation with its bank, maintains a master account and a set of sub
accounts when a check written on one of the sub accounts must be paid the necessary funds are
transferred in from the master account.
The key is that the total amount of cash held as a buffer is smaller under the zero balance arrangement
which frees up cash to be used elsewhere.
ii) Controlled disbursement accounts: -
With a controlled disbursement account system almost all payments that must be made in a given day
are known in the morning. The bank informs the firm of the total and the firm transfers (usually by wire)
the amount needed.

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A disbursement account to which the firm transfers an amount that is sufficient to cover demands for
payment.
Determining the Target Cash Balance
The target cash balance involves a trade-off between the opportunity costs of holding too much cash (the
carrying costs) and the costs of holding too little (the shortage costs, also called adjustment costs). The
nature of these costs depends on the firm’s working capital policy.
 Cash holding
Benefit- liquidity
Cost- interest for gone
If a firm tries to keep its cash holding too low, it will find itself running out of cash more often than is
desirable, and thus selling marketable securities (and perhaps later buying marketable securities to
replace those sold) more frequently than would be the case if the cash balance were higher. Thus trading
costs will be high when the cash balance is small. These costs will fall as the cash balance becomes
larger.
In contrast, the opportunity costs of holding cash are very low if the firm holds very little cash. These
costs increase as the cash holdings rise because the firm is giving up more and more in interest that
could have been earned.

Cost of holding cash ($)

Total cost of holding cash

Opportunity cost

Trading cost

Size of cash balance (c)

Optimal size of cash
balance

Trading costs are increased when the firm must sell securities to establish a cash balance. Opportunity
costs are increased when there is a cash balance because there is no return on cash
1. The Bat Model
The Baumol-Allais-Tobin (BAT) model is a classic means of analyzing our cash management problem.
It is a straight forward model and, more generally, current asset management

14
Implicitly, we assume that the net cash out flow is the same every day and that it is known with
certainty. These two assumptions make the model easy to handle.
Because transactions costs (for-example, the brokerage costs of selling marketable securities) must be
incurred whenever cash is replenished, establishing large initial balances will lower the trading costs
connected with cash management. However, the larger the average cash balance, the greater the
opportunity cost (the return that could have been earned on marketable securities)
To determine the optimal strategy, a company needs to know the following things.
F= The fixed cost of making a securities trade to replenish cash
T= The total amount of new cash needed for transactions purpose over the
relevant planning period, say, one year
R= The opportunity cost of holding cash. This is the interest rate on marketable
securities.
C= Amount of cash raised by selling securities or borrowing, evenly spaced.
The opportunity costs: - To determine the opportunity costs of holding cash, we have to find out how
much interest is forgone. A company has, on average, C/2 in cash. This amount could be earning interest
at rate R. So the total dollar opportunity costs of cash balances are equal to the average cash balance
multiplied by the interest rate.
Opportunity cost= (C/2) x R
The trading costs: - To determine the total trading costs for the year, we need to know how many times
a company will have to sell marketable securities during the year. It is determined by T/C. It costs F
dollars each time; so trading costs are given by
Trading costs= (T/C) x F
The total cost: - Now that we have the opportunity costs and the trading costs, we can calculate the total
cost by adding them together
Total cost= opportunity cost + Trading costs
= (C/2) x R + (T/C) x F
As the figure is drawn, the optimal size of the cash balance, C*, occurs right where the two lines cross.
At this point, the opportunity costs and the trading costs are exactly equal. So at C*, we must have that:
-

Opportunity costs = Trading costs

(C*/2) x R = (T/C*) xF
C*XC* = (2T xF)
R
2
C* = (2T x F)
R

15
 C* = √2T x F
R
The BAT model is possibly the simplest and most stripped-down sensible model for determining the
optimal cash position. Its chief weakness is that it assumes steady, certain cash out flows
Example: - ABC co. has cash out flows of $100 per day, seven days a week. The interest rate is 5
percent, and the fixed cost of replenishing cash balances is $10 per transaction. What is the optimal cash
balance? What is the total cost? T= 365 x days x 100 = $ 36,500

C* = (2T x F) = (2x36,500 x 10) = $ 14.6 million

R 0.05
= $ 3,821
The average cash balance (C*/2) is $ 3,821/2 = $ 1,911, so the opportunity cost is $ 1,911 x 0.05 = $ 96.
Because a company needs $ 100 per day, the $ 3,821 balance will last $3,821/100 = 38.21 days the firm
needs to re supply the account 365/38.21 = 9.6 times per year, so the trading (order) cost is $ 96. The
total cost is $192.
The Miller-Orr Model: A More General Approach
It is a cash management system designed to deal with cash inflows and out flows that fluctuate
randomly from day to day. With this model, we again concentrate on the cash balance, but, in contrast to
the situation with BAT model, we assume that this balance fluctuates up and down randomly and that
the average change is zero
Cash

U*

U* is the upper Cash

balance
control limit

L is the lower
C*
control limit

The target cash

L
balance is C*
Time
X Y
The basic idea: The figure shows how the system works. It operates in terms of an upper limit to the
amount of upper limit to the amount of cash (U*) and a lower limit (L), and a target cash balance (C*).
The firm allows its cash balance to wander around between the lower and upper limits. As long as the
cash balance is somewhere between U* and L, nothing happens.
When the cash balance reaches the upper limit (U*), such as it does at point X, the firm moves U*-C*
dollars out of the account and into marketable securities. This action moves the cash balance down to
16
C*. In the same way, if the cash balance falls to the lower limit (L), as it does at point Y, the firm will
sell C*-L worth of securities and deposit the cash in account. This action takes the cash balance up to C*
Using the model:- To get started, management should set the lower limit (L). This limit essentially
defines a safety stock; so where it is set depends on how much risk of cash shortfall the firm is willing to
tolerate. Alternatively, the minimum might just equal a required compensating balance.
As with the BAT model, the optimal cash balance depends on trading costs and opportunity costs. Once
again, the cost per transaction of buying and selling marketable securities, F, is assumed to be fixed.
Also, the opportunity cost of holding cash is R, the interest rate per period on marketable securities.
The only extra piece of information needed is 2 , the variance of the net cash flow per period. For our
purposes, the period can be anything, a day or a week, for example, as long as the interest rate and the
variance are based on the same length of time.
Given L, which is set by the firm Miller and Orr show that the cash balance target C*, and the upper
limit, U*, that minimize the total costs of holding cash are:
C* = L+ (3/4 x F x 2 /R) 1/3
U* = 3 x C* - 2XL
Also, the average cash balance in the Miller- Orr model is :
Average cash balance = (4 x C* -L)
3
For example, suppose F= $ 10, the interest rate is 1 percent per month, and the standard deviation of the
monthly net cash flow is $ 200. The variance of the monthly net cash flow is:
2 = $ 2002 = $40,000
We assume a minimum cash balance of L= $ 100. We can calculate the cash balance target, C*, as:
C* = L + (3/4 x F x 2/R) 1/3
= 100+ (3/4 x 10 x 40,000)
= 100+ 30,000,000 (1/3)
= $ 411
The upper limit, U* , is thus:
U* = 3 x C* - 2 XL
= 3 x $411 –2x100
= $ 1,033
Finally, the average cash balance will be:
Average cash balance = (4 x C* -L)
= (4 x $ 411 – 100)
3
= $ 515

17
 Implications of the BAT and Miller Orr models
Our two cash management models differ in complexity but they have some similar implications. In both
cases, all other things being equal, we see that.
1. The greater the interest rate, the lower is the target cash balance
2. The greater the order cost, the higher is the target balance
These implications are both fairly obvious. The advantage of the Miller-Orr model is that it improves
our understanding of the problem of cash management by considering the effect of uncertainty as
measured by the variation in net cash inflows.
The Miller-Orr model shows that the greater the uncertainty is (the higher 2 is), the greater is the
difference between the target balance and the minimum balance. Similarly, the greater the uncertainty is,
the higher is the upper limit and the higher is the average cash balance. These statements all make
intuitive sense. For example, the greater the variability is, the greater is the chance that the balance will
drop below the minimum. We thus keep a higher balance to guard against this happening.
Investing idle cash
If a firm has a temporary cash surplus, it can invest in short term securities. The market for short-term
financial assets is called the money market. The maturity of short-term financial assets that trade in the
money market is one year or less.
Firms have temporary cash surplus for various reasons. Two of most important are the financing of
seasonal or cyclical activities of the firm and the financing of planned or possible expenditures.
Seasonal or cyclical activities:- Some firms have predictable cash flow pattern. They have surplus cash
flows during part of the year and deficit cash flows the rest of the year. Such firm’s may buy marketable
securities when surplus cash flows occur and sell marketable securities when deficits occur. Of course,
bank loans are another short-term financing device.
Planned or possible expenditures: firms frequently accumulate temporary investments in marketable
securities to provide the cash for a plant construction program, dividend payment, or other large
expenditure. Thus firms may issue bonds and stocks before the cash is needed, investing the proceeds in
short-term marketable securities and then selling the securities to finance the expenditures. Also firms
may face the possibility of having to make a large cash outlay. An obvious example would involve the
possibility of losing a large lawsuit. Firms may build up cash surplus against such a contingency.
Selecting Investment Opportunities
A firm can invest its, excess cash in many types of securities or short-term investment opportunities. As
the firm invests its temporary cash balance, its primary criterion in selecting a security or investment
opportunities will be its quickest convertibility into cash, when the need for cash arises. Besides this, the
firm would also be interested in the fact that when it sells the security or liquidates investment, it, at
least gets the amount of cash equal to investment out lay. Thus, in choosing among alternative
investment, the firm should examine three basic features of security safety, maturity and marketability.

18
Safety: usually, a firm would be interested in receiving as high a return on its investment as is possible.
But the higher return yielding securities or investment alternatives is relatively more risky. The firm
would invest in very safe securities, as the cash balance invested in them is needed in near feature. Thus,
the firm would tend to invest in the highest yielding marketable securities subject to the constraint that
the securities have acceptable level of risk. The risk referred here is the default risk. The default risk
means the possibility of default in the payment of interest or principal on time and in the amount
promised.
Maturity: It refers to the time period over which interest and principal are to be made.
 Long term security – more fluctuation in interest rate
- More risky
 Short term security
 For safety reasons it is preferred by the firm for the purpose of investing
excess cash.
Marketability: It refers to convenience and speed with which a security or an investment can be
converted into cash. The two important aspects of marketability are price and time.
Types of short-term investment opportunities
 Treasury bills
 Commercial papers
 Certificate of deposits
 Bank deposits
 Inter-corporate deposits
 Money market mutual funds
MANAGING INVENTORY
Inventories are goods held for eventual sale by a firm. They are thus one of the major elements
that help the firm in obtaining the desired level of sales.
Inventory is needed as supplies for operations, raw materials and work-in-progress for
production, and finished goods for sale. Inventory does not earn interest, and is costly to store,
order, insure, protect, and be without (stock-out costs), so inventory should be held so as to hold
enough to operate, but not too much. Stock-out costs are the hardest to measure since it is
uncertain how many customers are lost as a result of being turned away for lack of products in
inventory.
Inventory management thus consists of deciding on the appropriate level of inventory to hold.
Too less or too much inventory is harmful for any concern because it will increase the
overall inventory cost. Let us now discuss the need for carrying inventory and the nature of
inventory management.
Nature of Inventories

19
Inventories as you know are stock of the product a company is manufacturing for sale and
components that make up the product. Various forms in which inventories exist in a
manufacturing company are raw materials, work-in-process and finished goods.
Raw materials are those basic inputs that are converted into finished product through the
manufacturing process. Thus, raw materials inventories are those units, which have been
purchased and stored for future production.
Work-in-process inventories are semi-manufactured products. They represent products
that need more work before they become finished products for sale.
Finished goods inventories are those completely manufactured products, which are ready
for sale. Stocks of raw materials and work-in-process facilitate production, while stock of
finished goods is required for smooth marketing operations. Thus, inventories serve as a
link between the production and consumption of goods.
The levels of three kinds of inventories for a firm depend on the nature of its business. A
manufacturing firm will have substantially high levels of all three kinds of inventories, while a
retail or wholesale firm will have a very high level of finished goods inventories and no raw
material and work-in-process inventories. Within manufacturing firms, there will be differences.
Large heavy engineering companies produce long production cycle products; therefore, they
carry large inventories. On the other hand, inventories of consumer Product Company will not be
large because of short production cycle and fast turnover.
A fourth kind of inventory, supplies (or stores and spares), is also maintained by firms.
Supplies include office and plant cleaning materials like soap, brooms, oil, fuel, light bulbs etc.
These materials do not directly enter production, but are necessary for duction process. Usually,
these supplies are small part of the total inventory and do not involve significant investment.
Therefore, a sophisticated system of inventory control may not be maintained for them
Now the question that arises is, why at all do we need to hold inventory?
The question of managing inventories arises only when the company holds inventories.
Maintaining inventories involves tying up of the company's funds and incurrence of storage and
handling costs.
If it is expensive to maintain inventories, have you ever wondered why companies hold
inventories.
There are three general motives for holding inventories:
 Transactions motive emphasizes the need to maintain inventories to facilitate smooth
production and sales operations. For uninterrupted and proper running of any firm, it is
necessary to have an appropriate level of inventory.
 Precautionary motive necessitates holding of inventories to guard against the risk of
unpredictable changes in demand and supply forces and other factors

20
  Speculative motive influences the decision to increase or reduce inventory levels to take
advantage of price fluctuations.
A company should maintain adequate stock of materials for a continuous supply to the factory
for an uninterrupted production. It is not possible for a company to procure raw materials
whenever it is needed. A time lag exists between demand for materials and its supply. In
addition, there exists uncertainty in procuring raw materials in time on many occasions. The
procurement of materials may be delayed because of such factors as strike, transport disruption
or short supply. Therefore, the firm should maintain sufficient stock of raw materials at a given
time to streamline production. The firm may purchase large quantities of raw materials than
needed for the desired production and sales levels to obtain quantity discounts of bulk
purchasing. At times, the firm would like to accumulate raw materials in anticipation of price
rise.
Work-in-process inventory builds up because of the production cycle. Production cycle is the
time span between introduction of raw material into production and emergence of finished
product at the completion of production cycle. Until production cycle completes, stock of work-
in-process has to be maintained. Efficient firms constantly try to make production cycle smaller
by improving their production techniques.
Stock of finished goods has to be held because production and sales are not instantaneous. A
firm cannot produce immediately when customers demand goods.
Therefore, to supply finished goods on a regular basis, their stock has to be maintained.
Stock of finished goods has also to be maintained for sudden demands from customer. In case
the firm's sales are seasonal in nature, substantial finished goods inventories should be kept to
meet the peak demand. Failure to supply products to customers, when demanded, would mean
loss of the firm's sales to competitor. The level of finished goods inventories would depend upon
the coordination between sales and production as well as on production time.
Objectives of Inventory Management
No activity is undertaken without some aim/objective. Let’s now come to the objectives of
inventory management. In the context of inventory management, the firm is faced with the
problem of meeting two conflicting needs:
 To maintain a large size of inventory for efficient and smooth production and sales
operations,
 To maintain a minimum investment in inventories to maximize profitability because idle
blocking of funds earn nothing
As we discussed earlier, both excessive and inadequate inventories are not desirable.
These are two danger points within which the firm should operate. The objective of inventory
management should be to determine and maintain optimum level of inventory investment. The

21
optimum level of inventory will lie between the two danger points of excessive and inadequate
inventories.
Firms should always avoid a situation of over investment or under-investment in inventories. The
major dangers of over investment are:
(a) Unnecessary tie-up of the firm's funds and loss of profit,
(b) Excessive carrying costs, and
(c) Risk of liquidity
The excessive level of inventories consumes funds of the firm, which cannot be used for any
other purpose, and thus, it involves an opportunity cost. The carrying costs, such as the costs of
storage, handling, insurance, recording and inspection, also increase in proportion to the volume
of inventory. These costs will impair the firm's profitability. Further, you have to understand that
excessive inventories carried for long-period increase chances of loss of liquidity. It may not be
possible to sell inventories in time and at full value. Raw materials are generally difficult to sell
as the holding period increases. There are exceptional circumstances where it may pay to the
company to hold stocks of raw materials. This is possible under conditions of inflation and
scarcity. Work-in-process is far more difficult to sell. Similarly, difficulties may be faced to
dispose off finished goods inventories as time lengthens. The downward shifts in market and the
seasonal factors may cause finished goods to be sold at low prices.
Another danger of carrying excessive inventory is the physical deterioration of inventories
while in storage. Such loss is, as you know a complicated issue for any business. Goods or raw
materials deterioration occurs with the passage of time, or it may be due to mishandling and
improper storage facilities. These factors are within the control of management; unnecessary
investment in inventories can, thus, be cut down maintaining an inadequate level of inventories is
also dangerous.
The consequences of underinvestment in inventories are:
(a) Production hold-ups and
(b) Failure to meet delivery commitments. Inadequate raw materials and work-in-process
inventories will result in frequent production interruptions.
Similarly, if finished goods inventories are not sufficient to meet the demand of customers
regularly, they may shift to competitors, which will amount to a permanent loss to the firm. The
aim of inventory management, thus, should be to avoid excessive and inadequate levels of
inventories and to maintain sufficient inventory for the smooth production and sales operations.
Efforts should be made to place an order at the right time with the right source to acquire the
right quantity at the right price and quality.
As you can gather from our discussion, inventory management to be effective should:
 Ensure a continuous supply of raw materials to facilitate uninterrupted production,

22
  Maintain sufficient stocks of raw materials in periods of short supply and anticipate price
changes,
 Maintain sufficient finished goods inventory for smooth sales operation, and efficient
customer service,
 Minimize the carrying cost and time, and
 Control investment in inventories and keep it at an optimum level.

Until now, we have discussed the need & nature of inventory management. Let’s move on to
discuss the various techniques of inventory management.
Inventory Management Techniques
As we have already discussed that, every management technique should be in consonance with
the shareholders, wealth maximization principle. To achieve this, the firm should determine the
optimum level of inventory.
Efficiently controlled inventories make the firm flexible. Inefficient inventory control results in
unbalanced inventory and inflexibility-the firm may sometimes run out of stock and sometimes
may pile up unnecessary stocks. This increases the level of investment and makes the firm
unprofitable.
To manage inventories efficiency, we should seek answers to the following two questions:
 How much should be ordered?
 When should it be ordered?
The first question, how much to order, relates to the problem of determining economic order
quantity (EOQ), and is answered with an analysis of costs of maintaining certain level of
inventories. The second question, when to order, arises because of uncertainty and is a problem
of determining the re-order point.
Techniques for managing inventory
Techniques that are commonly used in managing inventory are:
1. Economic order quantity (EOQ) model
2. ABC system
3. Reorder point
4. Material requirement planning (MRP) system and
5. Just-in-time (JIT) system
Economic Order Quantity (EOQ)
You have already studied EOQ while doing Inventory Valuation in the previous semester.
Let us have a quick review of the same.
One of the major inventory management problems to be resolved is how much inventory should
be added when inventory is replenished.

23
1. If the firm is buying raw materials, it has to decide lots in which it has to be purchased on
replenishment.
2. If the firm is planning a production run, the issue is how much production to schedule (or
how much to make).
These problems are called order quantity problems, and the task of the firm is to determine the
optimum or economic order quantity (or economic lot size).
Determining an optimum inventory level involves two types of costs:
(a) Ordering costs and
(b) Carrying costs.
The economic order quantity is that inventory level, which minimizes the total of ordering and
carrying costs.
Ordering Costs
Let’s see if you remember what ordering costs are?
The term ordering costs is used in case of raw materials (or supplies) and includes the entire
costs of acquiring raw materials. They include costs incurred in the following activities:
requisitioning, purchase ordering, transporting, receiving, inspecting and storing (store
placement).
Ordering costs increase in proportion to the number of orders placed.
The clerical and staff costs, however, do not vary in proportion to the number of orders placed,
and one view is that so long as they are committed costs, they need not be reckoned in
computing ordering cost. Alternatively, it may be argued that as the number of orders increases,
the clerical and staff costs tend to increase. If the number of orders are drastically reduced, the
clerical and staff force released now can be used in other departments. Thus, these costs may be
included in the ordering costs. It is more appropriate to include clerical and staff costs on a pro
rata basis. Ordering costs increase with the number of orders; thus the more frequently inventory
is acquired, the higher the firm's ordering costs. On the other hand, if the firm maintains large
inventory levels, there will be few orders placed and ordering costs will be relatively small.
Thus, ordering costs decrease with increasing size of inventory.
Carrying Costs
Do you have any idea what carrying costs are?
Costs incurred for maintaining a given level of inventory are called carrying costs. They
include storage, insurance, taxes, deterioration and obsolescence. The storage costs comprise
cost of storage space (warehousing cost), stores handling costs and clerical and staff service costs
(administrative costs) incurred in recording and providing special facilities such as fencing, lines,
racks etc.

24
Ordering and Carrying Costs
Let’s take a quick look at the various cost items that come under ordering and carrying costs
respectively.
Ordering Costs
 Requisitioning
 Order placing
 Transportation
 Receiving, inspecting and storing
 Clerical and staff
Carrying Costs
 Warehousing
 Handling
 Clerical and staff
 Insurance
 Deterioration and obsolescence
Carrying costs vary with inventory size. This behavior is contrary to that of ordering costs,
which decline with increase in inventory size. The economic size of inventory would thus
depend on trade-off between carrying costs and ordering costs.

FORMULA: EOQ = √2AO

C

Where, A = annual demand

O = ordering cost per order
C = carrying cost per unit
Let’s take an example so that you understand it better.
Example:
Your firm buys casting equipment from outside suppliers @Br.30/unit. Total annual needs are
800 units. You have with you following further data:
Annual return on investment, 10%
Rent, insurance, taxes per unit per year, Br.1
Cost of placing an order, Br.100
How will you determine the economic order quantity?
Re-Order Point:
We have now solved the problem of “how much to order” by determining the economic order
quantity, we have yet to seek the answer to the second problem, “when to order”.
This is a problem of determining the re-order point. Let’s see what re-order point is?

25
The re-order point is that inventory level at which an order should be placed to replenish the
inventory.
To determine the re-order point under certainty, we should know:
(a) Lead time,
(b) Average usage, and
(c) Economic orders quantity.
Under such a situation, re-order point is simply that inventory level which will be maintained for
consumption during the lead-time. That is:

Reorder Point = Lead Time in Days * Daily Usage

Lead-time
It is the time normally taken in replenishing inventory after the order has been placed. By
certainty we mean that usage and lead-time do not fluctuate.
Safety stock
The demand for material may fluctuate from day to day or from week to week. Similarly, the
actual delivery time may be different from the normal lead-time. If the actual usage increases or
the delivery of inventory is delayed, the firm can face a problem of stock-out, which can prove to
be costly for the firm. Therefore, in order to guard against the stock-out, the firm may maintain a
safety-stock-some minimum or buffer inventory as cushion against expected increased usage
and/or delay in delivery time.
Selective Inventory Control: ABC Analysis
Usually a firm has to maintain several types of inventories. It is not desirable to keep the same
degree of control on all the items. The firm should pay maximum attention to those items whose
value is the highest. The firm, therefore, should classify inventories to identify which items
should receive the most effort in controlling. The firm should be selective in its approach to
control investment in various types of inventories. This analytical approach is called the ABC
analysis and tends to measure the significance of each item of inventories in terms of its value.
The high-value items are classified as 'A items' and would be under the tightest control.
'C items' represent relatively least value and would be under simple control. 'B items' fall in
between these two categories and require reasonable attention of management.
The ABC analysis concentrates on important items and is also known as control by importance
and exception (CIE). As the items are classified in the importance of their relative value, this
approach is also known as proportional value analysis (PVA). C items could be controlled by
using unsophisticated procedures such as a red ling method, in which a reorder is placed when

26
enough inventory has been removed from a bin containing the inventory item to expose a red line
that has been drawn around the inside of the bin.
The following steps are involved in implementing the ABC analysis:
1. Classify the items of inventories, determining the expected use in units and the price per
unit for each item.
2. Determine the total value of each item by multiplying the expected units by its units price
3. Rank the items in accordance with the total value, giving first rank to the item with
highest total value and so on.
4. Compute the ratios (percentage) of number of units of each item to total units of all items
and the ratio of total value of each item to total value of all items.
5. Combine items based on their relative value to form three categories: -A, B and C.
Let us understand this with the help of an example.
Example
A firm has seven different items in its inventory. The average number of each of these items
held, along with their unit costs, is listed below. The firm wishes to introduce an ABC inventory
system. Suggest a breakdown of the items into A, B & C classifications.

Item Number Average No Units in Inventory Average Cost Per Unit

1 2,0000 Br 60.80
2 10,000 102.4
3 32,000 11.00
4 28,000 10.28
5 60,000 3.4
6 30,000 3.00
7 20,000 1.30

Materials Requirement Planning (MRP) System

You have seen in the previous discussions almost about the inventory management. Now let’s
come to a new area that is materials requirement planning (MRP) system to determine what to
order, when to order, and what priorities to assign to ordering materials. Many companies are
taking up this process now a day. MRP uses EOQ concepts to determine how much to order.
Using a computer, it simulates each product's bill of materials structure, inventory status, and
manufacturing process. The bill of materials structure simply refers to every pan or material that
goes into making the finished product. Based on the time it takes for a product that is in process
to move through the various production stages and the lead-time required to get materials, the
MRP system determines when orders should be placed for the various items on the bill of
materials.

27
The advantage of the MRP system is that it forces the firm to more thought- fully consider its
inventory needs and plan accordingly. The objective is to lower the firm's inventory investment
without impairing production. If the firm's opportunity cost of capital for investments of equal
risk is 15 percent, every Br.1.00 of investment released from inventory increases before-tax
profits by Br.15.

Just-In-Time (JIT) System:

As you must have guessed from the name, under this system materials arrive exactly at the time
they are needed for production.
The just-in-time (JIT) system is used to minimize inventory investment. The philosophy is that
materials should arrive at exactly the time they are needed for production. Ideally, the firm
would have only work-in-process inventory. Because its objective is to minimize inventory
investment, a JIT system uses no, or very little, safety stocks. Extensive coordination must exist
between the firm, its suppliers, and shipping companies to ensure that material inputs arrive on
time.
Failure of materials to arrive on time results in a shutdown of the production line until the
materials arrive. Likewise, a JIT system requires high-quality parts from supplier. When
quality problems arise, production must be stopped until the problems are resolved.
The goal of the JIT system is manufacturing efficiency. It uses inventory as a tool for attaining
efficiency by emphasizing quality in terms of both the materials used and their timely delivery.
When JIT is working properly, it forces process inefficiencies to surface and be resolved. A JIT
system requires cooperation among all parties involved in the process-suppliers, shipping
companies, and the firm's employees.
RECEIVABLES MANAGEMENT
Meaning of Receivables
Receivables arise when goods or services of a firm are sold on credit basis. According to
Hampton “Receivables are asset accounts representing amount owed to the firm as the result of
the sale of goods or services in the ordinary course of business.”
Van Horne “Account receivables represent the extension of open account credit by one firm to
another firm and to individuals.” As proceeds of credit sales are collected, receivables are
reduced.
Transactions leading to the occurrence of receivable include:
i) Credit sales of goods and services

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 - Account receivable (Trade receivables)
- Notes receivables
- Installment receivables
ii) Loans advanced to individuals and other entities
- Loan receivable
- Notes receivable
- Advance to affiliates
- Advance to employees
iii) Leasing property to others
- Lease contract receivables
iv) Other revenue transactions
- Interest receivables
- Dividend receivables
- Rent receivables
- Commissions receivables etc…..
v) Claims in insurance, tax, litigations, etc…
- Claims receivables
- Tax refund receivables
- Damage claims receivables
Receivable management involves decisions concerning the extension of credit to customers,
protection of the investment in receivables, achievement of timely collections and maintenance
of appropriate records. These tasks are accomplished through the establishment of sound credit
policies. Credit policies involve the duties and responsibilities of the credit manager, general
guidelines as to the credit terms, collections and write-off procedures, etc… The policies are
usually specified in writing as part of the firm’s internal control procedures.
ImportanceoOf Receivables
A) Sales growth: - Credit sales are a powerful stimulant for increasing sales. Especially during
the period of inflation accompanied by recession and stagnation in the industry. In such
situation many customers may not have sufficient cash for cash purchases. If a firm doesn’t
sale on credit it will have fewer customers and decline in sales. Hence, receivable help
growth of sales.
B) Increase in profit: - Increase in profitability by striking a balance between the cost of
extending credit and the gains from sales expansion. The decision to extend credit to
customers involves consideration of the profit to be gained from the sale against the cost of
granting credit (time value of money, collection cost and risk & loss.)
C) Capability to face competition: - If competitors sale on credit, the firm will be able to face
the competition only by selling on credit. The firm should adopt similar credit policies with
its competitors to retain customers.
D) Protection of Company’s Liquidity: - Slow collection procedures and efforts lead to rapid
deterioration in the company’s cash position.

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Factors Influencing the Size of Receivables
The amount and the level of receivables is affected by
 Influence of economic condition and
 Credit policy of the firm
The common influences of economic condition are cyclical and seasonal variances. Credit
policies include credit standards, credit terms, default risk (risk of bad debt), collection policies
and procedures of collection of the receivables.
Symbolically
R = f (Cs, Ct, CR, CPP , SC)
R – Level of receivables
Cs – Amount and size of credit
Ct – Credit term (discount period, & credit period)
Cr – Credit risk (credit standing of individual customers who purchase on credit)
Cpp - Collection policies and procedures
Sc – Seasonal fluctuation in business
Influence of economic condition on amount of receivables by and large beyond the control of a
single firm particularly in the short period but credit policy can be managed to a significant
effect.
Objectives of Receivable Management
The main objectives of receivables management are to maximize profit. As a general rule a firm
should extend credit facilities as long as the profitability of sales generated is greater than the
increase in cost of maintaining accounts receivable.
Additional Profit = (USP – UVC) x no. of additional units sold
In the above it is assumed that additional sales due to attractive credit policy can be effected
without increasing fixed cost. However, if fixed costs are incurred for selling such fixed costs
will also have to be deducted. Such credit policy is normally formulated to utilize existing
capacity and for short period of time.
Functions of Receivables Management
1. Formulation of credit policy
2. Evaluation of credit policy
3. Implementation of credit policy
4. Administration and control of credit policy
1. Formulation of credit policy
This function if concerned with the decision making about the three credit terms namely cash
discount, credit period and cash discount period. It considers
 Change in credit period
 Change in discount rate

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  Change in discount period
While credit terms are relatively fixed because of customers usage and practice of firms in an
industry, a particular firm may have some scope of decision making for credit terms i.e. firms are
likely to have freedom of choice but to a limited extent.
The following effects of the credit terms are to be considered when formulating credit policies
 Cash discount affects
 Cost of capital
 Average collection period
 The demand, i.e., sales
 Credit period affect
 The sales
 Average collection period
 Bad debts losses.
Seasonal dating means extension of credit period during the period of slack sales or off-season.
When a firm sales to customers allowing them to pay in the later part of the season it is called
seasonal dating. For example, a firm may sale in April to June and gets payment in July.
Delinquent Account: - are those accounts, which are due but unpaid. The important factor is
that there should be some policy for such accounts. The policy may relate to two actions
1. Eliminating such customers account (treating as bad debts) and
2. Charging such customers additional interest, which may be equal to the firm’s cost of capital
for the period of delinquency and forcing them to make payment.
Exercise-1: Problem on length of the credit period that affects the profit
The following data are available to the financial manager of a firm for evaluating the credit
policy for different credit period.
Cost of capital -------------------- 12% per annum
Sales, 10 units at birr 170 per unit
Fixed and variable cost is birr 153 per unit
Recent credit period 90 days
Proposed credit period under consideration
A – No credit period, B-30 days, C – 180 days, D – 270 days, E – 330 days , F – 360 days
Show the impact of different credit period on profits.
Solution
30 days 180 days 270 days 330 days 360 days
Cash sales
Sales 1,700 1,700 1,700 1,700 1,700 1,700
Cost (FC +VC) 1,530 1,530 1,530 1,530 1,530 1,530

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Interest at 12% - 17 102 153 187 204
Total Cost 1,530 1,547 1,632 1,683 1,717 1,734
Profit (loss) 170 153 68 17 (17) (34)
As the credit period increases the profit decreases. The break-even point will be 300 days credit
period.
Break-even = 1,700 x 0.12 x 10/12 = 170
Interest income (opportunity cost) or interest expense + cost (FC + VC) = 170 + 1530 = 1,700
The finance manager should evaluate the impact of credit policies on cost of capital.
Exercise-2: Cash discounts and profits
A firm’s cost of capital is 10% of sales per month. Its credit terms are 2/10, n /30. The firm’s
sales at birr 15 per unit and cost is birr 13.50 per unit what is the impact on profit?
a. When discount is taken by customers
b. When discount is not taken by customers
Solution
A. When discount is taken B. When discount is not taken
Sale ---------------------- 15 Sale ----------------- 15
Cash discount 2%-------0.3 Cost ----------------- 13.50
Cash received ---------- 14.70 1.50
Cost --------------------- 13.50 Interest (opportunity cost)
Profit ------------------- 1.20 15 x 0.01 x 20------- (3)
Profit (loss) ----------- (1.50)
2. Evaluation of Credit Policy
There are two important concerns (Trade-offs) in a credit policy.
 Investment in receivables (funds blocked in receivables)
 Increase in sales
Investment in receivables may involve additional bad debt expenses from delinquent account.
Increased in sales may result in additional profit. So the additional profit will have to be
compared with additional expenses on cost of capital, bad debts etc.
Example: In order to increase sales from the present annual sales of Br 240,000 AMASSA
Chemical Company is considering a more liberal credit policy. At present the average collection
period of credit sales of the firm is 30 days. It is expected that
A. If collection period is lengthened by 15 days sales will increases by 10,000 birr
B. If collection period is lengthened by 30 days sales will increase by 15,000 birr
C. Investment in receivables:
Plan A = birr 20,000
Plan B = birr 31,250

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 Plan C = birr 42,500
The finance manager has estimated that with 15 days increase bad debt losses will be 3% and 30
days increase bad debt losses will be 6%. The present bad debt loss is 1%.
The firm has the following cost pattern at present and the same will be the pattern in the coming
year.
Price per unit --------------- birr 100
VC per unit --------------------- birr 60
Average cost per unit --------- 0.80
Cost of capital (RRR) --------- 20%
Working days in a year -------- 360 days
Which of the credit policies should be pursued?
Solution
Present (30 days) Policy A Policy B
45 days 60 days
Sales 240,000 250,000 255,000
Profit 48,000 50,000 51,000
Bad debts 2,400 7,500 15,300
(*) 45,600 42,500 35,700
Inv’t in receivables 20,000 31,250 42,500
RRR (CoC@20%) (**) 4000 6,250 8,500
Profit (* -**) 41,600 36,250 27,200
Therefore, it is advisable to maintain the current credit policy.
3. Implementation of Credit Policy
After formulation and evaluation of credit policy the most suitable policy is adopted and use. The
use of a credit policy is implementation of that credit policy. Implementation of credit policy
involves the following two functions.
A. Evaluation of credit applicant (credit analysis) and
B. Financing of the investment in receivables
A. Evaluation of credit applicant: - this function is concerned with assessment of the customers
for selling to them on credit. The assessment of customer is made keeping in due the possible
bad debt risk and possible delay in getting payment. If a customer is financially week and no
payment is anticipated then the customer has significant bad debt risk and the same to that
customer should be avoided.
Similarly potentially late or difficult customer may be given small amount credit. Sale to such
customers should be in small quantity involving small payment. If it is possible to have price
discrimination, goods and services may be sold to such customers at higher prices or on stricter
credit terms.

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Request for supply of goods/services on credit generally come from customers. Such customers
provide information and trade references to support their credit worthiness but such information
mayn’t be adequate and such credit references mayn’t reveal much needed information. It is
therefore desirable to collect and analyze detailed financial and non-financial information. The
major sources of information are trade references, bank references, credit agencies, personal
interviews and marketing executive’s contracts.
A firm’s credit selection activity involves deciding whether to extend credit to a customer and
how much credit to extend. Appropriate sources of credit information and methods of credit
analysis must be developed.
The five C’s of Credit
A firm’s credit analysts often use the five C’s of credit to focus their analysis on the key
dimensions of an applicant’s creditworthiness.
1. Character: the applicant’s record of meeting past obligations- financial, contractual, and
moral. Past payment history as well as any pending or resolved legal judgments against
the applicant would be used to evaluate its character.
2. Capacity: the applicant’s ability to repay the requested credit. Financial statement
analysis with particular emphasis on liquidity and debt ratio is typically used to assess the
applicant’s capacity.
3. Capital: the financial strength of the applicant as reflected by its ownership position.
Analysis of the applicant’s debt relative to equity and its profitability ratios are frequently
used to assess its capital.
4. Collateral: the amount of assets the applicant has available for use in securing the credit.
The larger the amount of available assets, the greater the chance that a firm will recover
its funds if the applicant defaults. A review of the applicant’s balance sheet, asset value
appraisals, and any legal claims filed against the applicant’s assets can be used to
evaluate its collateral.
5. Conditions: the current economic and business climate as well as any unique
circumstances affecting either party to the credit transaction. For example, if the firm has
excess inventory of the item the applicant wishes to purchase on credit, the firm may be
willing to sell on more favorable terms or to less creditworthy applicants. Analysis of
general economic and business conditions, as well as special circumstances that may
affect the applicant or firm is performed to assess conditions.
B. Financing investment in receivables: - When the payment is received from debtors the
amount of receivable is reduced and funds are available for working capital purposes. If debtors
settled their dues, taking short period credits the amount of receivables will be very much less in
relation to the sales volume. A firm should try to minimize the amount of receivables, but such
an effort shouldn’t adversely affect sales and profit. One of objectives of minimizing the
investment in receivables is to reduce the need for arranging additional fund for working capital

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purposes. Generally large amount of receivables cost paucity of liquid resources for persuading
current operations. Quick collection of dues reduces the average amount of investment in
receivables. Quick collection is an action for financing the investment in receivables.
Receivables, billing current asset are generally financed by short term sources. The principal
source is short term borrowing from banks.
An important factor, which significantly affects the financing of investment in receivables, is
inflation. During the inflationary periods a firm decide incurring normal cost of maintaining
receivables, also loses some part of the money i.e., the firm receipts money having less value
than at the time of sales. For example, if a firm sales goods at the value of 100,000 birr, if the
rate of inflation is 20% per annum and if the credit period extends to one year, the real value of
the money the firm receives will be only 80,000.
The finance manager should pay special attention to slow moving accounts and take steps to
collect the amount blocked up. A higher rate of discount may be offered as incentive to induce
the slow paying customer. Another step could be charging an additional interest as a hedge
against inflation.
4. Administration and Control of Credit Policy
The central purpose of administration and control is to insure that the credit policy lay down and
adopted are being followed. The function of administration and control of accounts receivable
includes the following: -
A. Formulating and implementing collection policies and collection procedures
B. Developing and adopting a management information system for account receivables.
A: Formulating and implementing collection policies and procedure:
It is important to know that “The overall collection of the firm is determined by the combination
of collection procedures it adopts, i.e., the collection policy”. Collection policy should aim at:
I. Reducing the proportion of bad debt losses
II. Shortening the average collection period

Adoption of a collection policy depends upon the trade-off between costs and benefits. A cost is
equal to expenditure on collection. Benefits equal to reduction in bad debt losses and reduction in
receivables.
As long as the benefits exceed the costs of adoption of a collection policy it should be presumed.
Example: A firm wants to evaluate the two collection policy B and C against the present policy
A
A B C
Collection expense 58,000 74,000 100,000
Average collection period 30 days 24 15
Bad debt losses (% age) 1.5 1 0.5

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The present sale amount is Br. 2,400,000 it is estimated that the sales volume will not change
with any of the three collection policies. The required rate of return on investment is 20 % before
taxes.
Solution
sales Sales
Average receivables = Turnoverofreceivable = day sin yearACP
2 , 400 ,000
360
A= 30 = 200,000
2 , 400 ,000
360
B= 24 = 160,000
2 , 400 ,000
360
C= 15 = 100,000
Bad debts
A = 2,400,000 x 0.015 = 36,000
B = 2,400,000 x 0.01 = 24,000
C= 2,400,000 x 0.005 = 12,000
Evaluation of policies
A B C
1) Average receivables 200,000 160,000 100,000
2) Reduction in receivables - 40,000 100,000
A: return on reduction of
receivables (20%) - 8,000 20,000
3). Bad debt losses 36,000 24,000 12,000
B. Reduction in bad debt losses - 12,000 24,000
C. Opportunity saving (additional benefit) 20,000 44,000
(A + B)
D. Additional collection expense 16,000 42,000
Net benefit (C – D) 4000 2,000

1. Additional benefit exceed additional cost on both policy B and C

2. However the additional net benefit in policy B is more than in policy C. Therefore policy
B should be selected.
Note that it is assumed in the above problem that the sales aren’t affected by change in credit
policy but it mayn’t be true in practice. If collection policy is made streakiest some of the
customers are likely irritated. Irritated customer may reduce their purchases. Hence change in
sales should also be considered.
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Collection procedures refer to the action which is taken up when customer delay the payments.
This actions may includes
1.Letters to remind the customers
2. Telephone calls
3.Personal visit by firm’s collection personnel
4.Legal notices to the customers
5.Deputing outside collection agency that collect dues on behalf of the firm and charges
fees for its services.
A. Management Information System for Receivables
A firm should have adequate information system for administration and control of investment in
accounts receivable. Following are some of the consequences of not having adequate
information.
1. Overdue account may be neglected
2. A customer may get credit facilities for large amount than the amount fixed for him.
To have a proper control for the above, a firm should prepare and analysis the following
important information records
1. Summary analysis of selected ratios
2. Age profile of outstanding accounts
1. Summary analysis of selected ratio
The main control ratios are receivable turnover ratio and average collection period. These ratios
should be compared with previous period. Standard may be set and actual figures of this ratios
should be compared.
Example – If a standard credit days is 40 days. If the actual is 60 days there is warning signal for
investigation.
2. Age profile of outstanding accounts
This is prepared in statement form as follows.
Period No. of Amount % of total Analysis as
(no. of days) accounts (Birr) no. of accounts % of total amount
0-30 300 100,000 55.5 50
31-40 100 40,000 18.5 20
41-50 80 25,000 14.8 12.5
51-60 30 20,000 5.6 10
61-70 20 10,000 3.7 5
71-80 10 5,000 1.9 2.5
540 200,000 100% 100%
With this analysis of age profile of account receivable management can take actions about the
receivables, which are outstanding beyond the average credit period or beyond the standard
credit period.

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