Management of Working Capital

M.B.A Third Semester

 Caution
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propose and basic understand on the subject. This study

material will be cover majority part of the syllabus. There

may be some portion (topic) which may be not coved or

covered in short. Despite every effort are taken to present the

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they will be corrected. This study material is provided to you

only as an additional support on the subject.

All students are advised to attend regular class room classes

in the college and use standard reference books on the subject

available in the college library for the examinations

preparation.

-Subject Faculty

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 Subject Code: MSMSR/MBA/307 (F)

MANAGEMENT OF WORKING CAPITALS

Learning Objectives

 The objective of the course is to acquaint the students with various theoretical and
practical concepts relating to Management of Working capital.

MODULE I: Meaning of Working Capital, Overview of Working Capital Management, Levels of

Working Capital Investments, Optimal Level of Working Capital Investment, Working Capital Strategies,
Profitability versus Risk Trade-off for Alternative Financing Strategies, Approaches of Working Capital
Financing, Concept of Operating Cycle, Calculation of Working Capital

MODULE II: Meaning of Receivables Management, Determination of Appropriate Receivable Policy,

Marginal Analysis, Evaluation of Credit Proposal, Credit Analysis and Credit Decision, Heuristic
Approach, Discriminate Analysis, Sequential Decision Analysis.

MODULE III: Meaning of Cash Management, Motives for Holding Cash, Factors determining Cash
Balance, Collection System, Disbursement Tools, and Investment in Marketable Securities; determining
the optimum level of Cash, Baumol Model, Beranek Model, Miller-Orr Model, Stone Model, and
Optimization Model.

MODULE IV: Financial Forecasting, Forecasting Collection from Accounts Receivable, Forecasting
Daily Cash Flow, Cash Balance Uncertainty, Hedging Cash Balance Uncertainty, Meaning of Inventory
Management, Cost of Holding, Cost of Placing order, Inventory Control Models, Inventory Control
Devices, Inventory Management and Valuation, Inventory Management and Cash Flow Timeline

MODULE V: Meaning of Payables Management, Trade Credit, Terms of Purchase, Stretching of

Accounts Payable, Disbursement of Float Management, Other Accruals, Bank Credit – Basic Principles
and Practices, Methods of Assessment and Appraisal, Financing Working Capital Gap, Short-Term
Financing Sources, Working Capital Control and Banking Policy Integrating Working Capital and Capital
Investment Process.

Text Books/ Reference Books:

1. Bhattacharya, Working Capital Management—Strategies and Techniques, 2nd ed., ISBN: 978-81-
203-3636-0, PHI.
2. P Gopalakrishnan: Inventory and Working Capital Management, Macmillan Publishers India
3. N.P. Agarwal; B.K. Mishra: Working Capital Management, RBSA Publishers
4. Bhattacharya Hrishikes (2008): Working Capital Management: Strategies and Techniques, PHI
Learning Private Limited
5. N.K. Jain: Working Capital Management, A.P.H. Publishing Corporations

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 Reference Books
1. D.R. Mehta, Working Capital Management, Prentice-Hall Inc., 1974.
2. K.V. Smith, Management of Working Capital, McGraw-Hill, New York.
3. Khan and Jain, Financial Management, Tata McGraw-Hill.
4. Pandey, Financial Management, Vikas Annex. 54.J.3 -MBA - Finance - SDE Page 20 of 23.
5. Prasanna Chandra, Financial Management, Theory and Practice, Tata McGraw-Hill.
6. V.K. Bhalla, Working Capital Management – Text and Cases, Sixth Edition, Anmol
Publications.

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 Index
Chapter No Chapter Page No
1. MODULE I 6
2. MODULE II 10
3. MODULE III 7
4. MODULE IV 8
5. MODULE V 9

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MODULE I: Meaning of Working Capital, Overview of Working Capital Management, Levels of
Working Capital Investments, Optimal Level of Working Capital Investment, Working Capital Strategies,
Profitability versus Risk Trade-off for Alternative Financing Strategies, Approaches of Working Capital
Financing, Concept of Operating Cycle, Calculation of Working Capital

Introduction:
Working capital is the life blood and nerve centre of a business. Just as circulation of blood is
essential in the human body for maintaining life, working capital is very essential to maintain the
smooth running of a business. No business can run successfully without an adequate amount of
working capital.
Working capital refers to that part of firm’s capital which is required for financing short term or
current (revolving) assets such as cash, marketable securities, debtors, and inventories. In other
words working capital is the amount of funds necessary to cover the cost of operating the
enterprise.
Meaning:
Working capital means the funds (i.e.; capital) available and used for day to day operations (i.e.;
working) of an enterprise. It consists broadly of that portion of assets of a business which are
used in or related to its current operations. It refers to funds which are used during an accounting
period to generate a current income of a type which is consistent with major purpose of a firm
existence.
Objectives of working capital:
Every business needs some amount of working capital. It is needed for following purposes:

1. For the purchase of raw materials, components and spares.

2. To pay wages and salaries.
3. To incur day to day expenses and overhead costs such as fuel, power, and office expenses
etc.
4. To provide credit facilities to customers etc.
Importance of Working Capital:
a. Cash discount: Adequate working capital also enables a concern to avail cash discounts
on the purchases and hence it reduces costs.
b. Solvency: Adequate working capital helps in maintaining solvency of the business by
providing uninterrupted flow of production.
c. Liquidity: Adequate working capital enables a concern to face business crisis in
emergencies such as depression because during such periods, generally, there is much
pressure on working capital.
d. Profitability increased: Every investor wants a quick and regular return on his
investments. Sufficiency of working capital enables a concern to pay quick and regular
dividends to its investors as there may not be much pressure to plough back profits. This

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 gains the confidence of its investors and creates a favourable market to raise additional
funds in the future.
e. High morale: Adequacy of working capital creates an environment of security,
Danger of Inadequate Working Capital
When working capital is inadequate, a firm faces the following problems
1. It may not be able to take advantages of cash discount.
2. It cannot buy its requirements in bulk and unable to utilize the production facilities fully.
3. It may not be able to take advantage of profitable business opportunities.
4. It may fail to pay its dividend because of non-availability of funds.
5. Its low liquidity may lead to low profitability. In the same way, low profitability results
in low liquidity.
6. Short-term liabilities cannot be paid because of inadequate working capital. This leads to
borrow funds at exorbitant rates of interest.
7. Credit-worthiness of the firm may be damaged because of lack of liquidity. Thus, it will
lose its reputation. Thereby, a firm may not be able to get credit facilities.
8. Low liquidity position may lead to liquidation of firm. When a firm is unable to meet its
debts at maturity, there is an unsound position.
Danger of Excessive Working Capital
When there is too much working capital, it is also dangerous. Excessive working capital raises
the following problems:
1. A firm may be tempted to over trade and lose heavily.
2. The situation may lead to unnecessary purchases and accumulation of inventories. This
causes more chances of theft, waste, losses etc.
3. There a rise an imbalance between liquidity and profitability.
4. Excessive working capital means funds are idle. When funds are idle, no profit is earned.
When it is so, the rate of return on its investment goes down.
5. The situation leads to greater production which may not have matching demand.
6. The excess of working capital may lead to carelessness about cost of production.
Advantages of working capital:
a. It helps the business concern in maintaining the goodwill.
b. It can arrange loans from banks and others on easy and favorable terms.
c. It enables a concern to face business crisis in emergencies such as depression.
d. It creates an environment of security, confidence, and overall efficiency in a business.

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 e. It helps in maintaining solvency of the business.
Disadvantages of working capital:
a. Rate of return on investments also fall with the shortage of working capital.
b. Excess working capital may result into over all inefficiency in organization.
c. Excess working capital means idle funds which earn no profits.
d. Inadequate working capital cannot pay its short term liabilities in time. Confidence and
high morale and creates overall efficiency in a business.
Types of Working Capital:
Working capital may be classified in two ways i.e. (i) on the basis of balance sheet concept, and
(ii) en the basis of time. On the basis of balance sheet 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 Requirement (time),
working capital may be classified as—(i) Permanent or Regular Working Capital; and (ii)
Variable or Temporary Working

1. On the basis of concept

a. Gross working capital:
b. Net working capital:
2. On the basis of Requirement
a. Permanent or Regular Working Capital: It refers to that minimum amount of
investment in all current assets which is required at all times to carry out
minimum level of business activities.
b. Temporary or Variable or Seasonal: The amount of such working capital
keeps on fluctuating from time to time on the basis of business activities.
Operating Cycle: accounting receivable finished Goods WIP RAW material cash
Sources of Working capital:
The working capital requirements should be met both from short term as well as long term
sources of funds. Financing of working capital through short term sources of funds has the
benefits of lower cost and establishing close relationship with banks. Financing of working
capital through long term sources provides the benefits of reduces risk and increases liquidity

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Factors that determine working capital:
The working capital requirements of a concern depend upon a large number of factors such as:
1. Size of business: The working capital requirements of an enterprise are basically related
to the conduct of the business. Public utility undertakings like Electricity, Water Supply,
Railways etc. need very limited working capital because they offer cash sales only and
supply services, not products, and as such no funds are tied up in inventories and
receivables. But, at the same time, trading firms require large amounts in current assets -
inventories, receivables, cash etc. - but have to invest fewer amounts in fixed assets. The
manufacturing concerns require sizable working capital along with fixed investments as
they have to build up inventories. Again, manufacturing concerns face problems of slow
turnovers of inventories and receivables, and invest large amounts in working capital.
2. Nature of character of business: Credit terms granted by the concerns to its customers
as well as credit terms granted by its suppliers also affect the working capital. If the credit
terms of purchases are more favourable and those of sales less liberal, less cash will be
invested in inventory. With more favourable credit terms, working capital requirements
can be reduced. The ratio of cash and credit sales or purchases will also affect the level of
working capital. A firm that purchases its requirements on credit and sells its product on
cash, requires less amount of working capital. At the same time, a firm buying its
requirements for cash and allowing credit to its customers, shall need huge amount of
working capital. This is because funds are tied up in Debtors or Bills Receivables.
3. Seasonal variations working capital cycle: The quantum of working capital needed is
influenced by the length of manufacturing cycle. Manufacturing process always involves
a time- lag between the time when raw materials are fed into the production line and
finished products are finally turned out by it. The length of the period of manufacture in
turn depends on the nature of product as well as production technology used by a
concern. An utmost care should be taken to shorten the period of cycle in order to
minimise the working capital requirements.
4. Operating efficiency: If the inventory turnover is high, the working capital requirements
will be low. With a better inventory control, a firm is able to reduce its working capital
requirements. When a firm has to carry on a large slow moving stock, it needs a larger
working capital as against another whose turnover is rapid. A firm should determine the
minimum level of stock which it will have to maintain throughout the period of its
operation.
5. Business Cycle: Cyclical changes in the economy also influence quantum of working
capital. In a period of boom i.e. when the business is prosperous, there is a need for larger
amount of working capital due to increase in sales, rise in price etc. During the period of
depression also a heavy amount of working capital is needed due to the inventories being
locked unsold and book debt uncollected.
6. Changes in Technology: Changes in technology may lead to improvements in
processing of raw materials, savings in wastage, greater productivity, more speedy
production. All these improvements may enable the firm to reduce investments in
inventory. Thus changes in technology affect the requirements for working capital. If the
firm decides to go for automation, this would reduce the requirements for working

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 capital. If the firm adopts a labour-intensive process, the requirements for working capital
will be larger. The shorter the manufacturing processes due to use of improved
technology, the lower the requirements for working capital. The working capital
requirements of a concern increase with the growth and expansion of its business
activities. A fast growing concern need larger amount of working capital.
7. Seasonal Variation: The inventory of raw materials, spares and stores depends on the
conditions of supply. If the supply is prompt and adequate the firm can manage with
small inventory. However, if the supply is unpredictable and scant then the firm, to
ensure continuity of production, would have to acquire stocks as and when they are
available and carry larger inventory on an average. A similar policy may have to be
followed when the raw material is available only seasonally and production operations
are carried out round the year.
8. Market Conditions: The degree of competition prevailing in the market place has an
important bearing on working capital needs. When competition is keen, a larger inventory
of finished goods is required to promptly serve customers who may not be inclined to
wait because other manufacturers are ready to meet their needs. Further, generous credit
terms may have to be offered to attract customers in a highly competitive market. Thus,
working capital needs tend to be high because of greater investment in finished goods
inventory and accounts receivable.
9. Seasonality of Operation: Firms which have marked seasonality in their operations
usually have highly fluctuating working requirements. To illustrate, consider a firm
manufacturing ceiling fans. The sale of ceiling fans reaches a peak during the summer
months and drops sharply during the winter period. The working need of such a firm is
likely to increase considerably in summer months and decrease significantly during the
winter period. On the other hand, a firm manufacturing a product lamp, which have fairly
even sales round the year, tends to have stable working capital needs.
10. Working Capital Cycle: “The production or manufacturing cycle” refers to the time
involved in the manufacture of goods. It covers the time span between the procurement of
raw materials and the completion of manufacturing process, i.e. leading to finished
products. In a manufacturing concern, the working capital cycle starts with the purchase
of raw materials and ends with the realization of cash from the sale of finished products.
Generally the working capital cycle involves purchase of raw materials and stores, its
conversion into stocks of finished goods through work-in-progress with progressive
increment of labour and service costs, conversion of finished goods into sales, debtors,
receivables and ultimately realization of cash. This cycle is repeated again and again.
11. Dividend Policy: Dividend policy has a dominant influence on the working capital
position of an enterprise. If a conservative dividend policy is followed by the
management, the need for working capital can be met with the retained earnings. When
once dividend is declared and the same has to be paid in cash, it consequently drains off
large amounts from the pool of working capital.
12. Depreciation Policy: Depreciation charges do not involve any cash outflow.
Depreciation affects the tax liability and retention of profits. It is allowable expenditure in
calculating net profits. Higher depreciation will mean lower disposable profits and
therefore, a smaller dividend payment. Thus cash will be preserved.

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 The level of working capital is determined by a wide variety of factors which are partly
internal to the firm and partly external to it. Efficient working capital management requires
efficient planning and a constant review of the needs for an appropriate working capital
strategy.
Concept of Working Capital
Working capital typically means the firm’s holdings of current, or short-term, assets such as
cash, receivables, inventory, and marketable securities. Working capital refers to that part of
firm’s capital which is required for financing short-term or current assets such as cash,
marketable securities, debtors, and inventories. In other words working capital is the amount of
funds necessary to cover the cost of operating the enterprise.
Working capital means the funds (i.e.; capital) available and used for day-to-day operations (i.e.;
working) of an enterprise. It consists broadly of that portion of assets of a business which are
used in or related to its current operations. It refers to funds which are used during an accounting
period to generate a current income of a type which is consistent with major purpose of a firm
existence.
Working Capital is the money used to make goods and attract sales. The less Working Capital
used to attract sales, the higher is likely to be the return on investment. Working Capital
management is about the commercial and financial aspects of Inventory, credit, purchasing,
marketing, and royalty and investment policy. The higher the profit margin, the lower is likely to
be the level of Working Capital tied up in creating and selling titles. The faster that we create and
sell the books the higher is likely to be the return on investment. Thus, when we have been using.
Calculation of Working Capital
There are two possible interpretations of working capital concept:
1. Balance Sheet Concept
2. Operating Cycle Concept
It goes without saying that the pattern of management will be very largely influenced by the
approach taken in defining it. Therefore the two concepts are discussed separately in a nutshell.

Balance Sheet Concept

There are two interpretations of working capital under the balance sheet concept. It is
represented by the excess of current assets over current liabilities and is the amount normally
available to finance current operations. But, sometimes working capital is also used as a
synonym for gross or total current assets. In that case, the excess of current assets over current
liabilities is called the net working capital or net current assets. Economists like Mead, Malott,
Baket and Field support the latter view of working capital. They feel that current assets should be
considered as working capital as the whole of it helps to earn profits; and the management is
more concerned with the total current assets as they constitute the total funds available for
operational purposes. On the other hand, economists like Lincoln and Salvers uphold the former
view. They argue that

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 1. In the long run what matters is the surplus of current asserts over current liabilities;
2. It is this concept which helps creditors and investors to judge the financial soundness of
the enterprise;
3. What can always be relied upon to meet the contingencies, is the excess of current assets
Notes over the current liabilities since this amount is not to be returned; and
4. This definition helps to find out the correct financial position of companies having the
same amount of current assets.
Institute of Chartered Accountants of India, while suggesting a vertical form of balance sheet,
also endorsed the former view of working capital when it described net current assets as the
difference between current assets and current liabilities.
The conventional definition of working capital in terms of the difference between the current
assets and the current liabilities is somewhat confusing. Working capital is really what a part of
long-term finance is locked in and used for supporting current activities. Consequently, the larger
the amount of working capital so derived, greater the proportion of long-term capital sources
siphoned off to short-term activities. It is about tight working capital situation, the logic of the
above definition would perhaps indicate diversion to bring in cash, under the conventional
method, working capital would evidently remain unchanged. Liquidation of debtors and
inventory into cash would also keep the level of working capital unchanged. A relatively large
amount of working capital according to this definition may produce a false sense of security at a
time when cash resources may be negligible, or when these may be provided increasingly by
long-term fund sources in the absence of adequate profits. Again, under the conventional
method, cash enters into the computation of working capital. But it may have been more
appropriate to exclude cash from such calculations because one compares cash requirements with
current assets less current liabilities. The implication of this in conventional working capital
computations is that during the financial period current assets get converted into cash which,
after paying off the current liabilities, can be used to meet other operational expenses. The
paradox, however, is that such current assets as are relied upon to yield cash must themselves to
be supported by long-term funds until are converted into cash.
At least, three points seem to emerge from the above. First, the balance sheet definition of
working capital is perhaps not so meaningful, except as an indication of the firm’s current
solvency in repaying its creditors. Secondly, when firms speak of shortage of working capital,
they in fact possible imply scarcity of cash resources. Thirdly, in fund flow analysis an increase
in working capital, as conventionally defined, represents employment or application of funds.
Operating Cycle Concept
A company’s operating cycle typically consists of three primary activities; purchasing resources,
producing the product, and distributing (selling) the product. These activities create funds flows
that are both unsynchronized because cash disbursements usually take place before cash receipts.
They are uncertain because future sales and costs, which generate the respective receipts and
disbursements, cannot be forecasted with complete accuracy. If the firm is to maintain a cash
balance to pay the bills as they come due. In addition, the company must invest in inventories to

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fill customer orders promptly. And, finally, the company invests in accounts receivable to extend
credit to its customers.
Operating cycle = Inventory conversion period + Receivables conversion period

The inventory conversion period is the length of time required to produce and sell the product. It
is defined as follows:
Average inventory
Inventory conversion period = Cost of sales
⁄365

The payables deferral period is the length of time the firm is able to defer payment on its various
resource purchases (for example, materials, wages, and taxes). Equation is used to calculate the
payables deferral period:
Accounts payable + Salaries,benefits &𝑃𝑎𝑦𝑟𝑜𝑙𝑙 𝑡𝑎𝑥𝑒𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
Payables deferral period = (Cost of sales + Selling,generaAdministrative expensel &
⁄365

Finally, the cash conversion cycle represents the net time interval between the collection of cash
receipts from product sales and the cash payments for the company’s various resource purchases.
It is calculated as follows:

Cash conversion cycle = Operating cycle – Payable deferral period

Cash Conversion Cycle

The most liquid asset is cash in hand and cash at bank. The time required to complete the
following cycle of events in case of a manufacturing firm is called the cash conversion cycle or
the operating cycle:
1. Conversion of cash into raw materials
2. Conversion of raw materials into work in process
3. Conversion of work in process into finished goods
4. Conversion of finished goods into debtors and bills receivables through sales Notes
5. Conversion of debtors and bills receivables into cash
The cash conversion cycle shows the time interval over which additional no spontaneous sources
of working capital financing must be obtained to carry out the firm’s activities. An increase in
the length of the operating cycle, without a corresponding increase in the payables deferral
period, lengthens the cash conversion cycle and creates further working capital financing needs
for the company.
Operating cycle in case of a trading firm consists of the following events:
1. Cash into inventories
2. Inventories into accounts receivable
3. Accounts receivable into cash
Operating Cycle Concept

This is a new concept of working capital which is becoming popular day-by-day. According to
this concept, “working capital is represented by the excess current assets over current liabilities
identifying the relatively liquid position the total enterprise capital which constitutes a margin for

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meeting obligations within the operating cycle of the business. “ ln other words, working capital
is the amount required in different forms at successive stages of operation during the net
operating cycle period of an enterprise.

The actual amount of working capital required in a firm depends upon the length of net operating cycle
and the operating expenses needed for the period. The duration or time required to complete the sequence
of events right from purchase of raw materials/goods for cash to the realization of sales in cash is called
the operating cycle or working capital cycle. In every business firm the working capital at the
commencement happens to be in the form of cash. Raw material is purchased with this cash. Through
production process, raw material is converted into finished goods which result in debtors or hills
receivable through credit sale. In due course of time, debtors or bills receivable are realized into cash
which is again invested into raw materials. In this way the operating cycle, as shown on next page goes on
regularly. During this cycle, the capital is converted from one form to another such as Cash—> Raw
Material —> Finished Goods —> Debtors. Or Bills Receivable —> Cash. On account of this, it is also
called circulating capital.

The net duration of operating cycle is calculated by adding the number of days involved in the different
stages of operation commencing from purchase of raw materials and ending with collection of sale
proceeds from debtors after adjusting the number of days’ credit allowed by suppliers.

For example: if in a firm, the material storage period is 27 days, conversion period is 18 days; finished
goods storage period is 27 days and debtors collection and creditors payment periods are 36 and 17 days
respectively, then operating cycle period will be 91(27 + 18 + 27 + 36 - 17) days. This period is affected
by traditions and policies of the firm, technical and commercial features and environmental factors etc. as
it may be more or less due to these factors. The speed with which working capital completes one cycle
determines the requirements of working capital. The lesser the period of operating cycle, the smaller is the
requirement of working capital. For instance, in the aforesaid example, the operating cycle whose period
is 91 days will be repeated four times (365 - 91) in a year. Now, if total operating expenses of the firm for
the year are assumed to be Rs. 5 lakhs, it will require Rs. 1,25,000 (5,00,000 /4) as working capital
according to this concept.

This concept is more appropriate than traditional or balance sheet concept of working capital, where the
funds required for carrying on the operational activities are treated as working capital. According to this
concept, the necessary liquid funds required by a firm for production, administration and selling can be
determined for the whole year. If cash working capital requirements are known in advance, then non-cash
current assets may be better managed. Not only this, hut the operating cycle concept of working capital is

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also helpful in controlling the material and finished goods storage, conversion process and cash collection
policies of the management. That is why; this concept is applied by the finance manager as an important
tool in projecting working capital requirements of an enterprise.

Measurement of Operating Cycle:

Strictly speaking, the volume of working capital depends upon the length of working capital
cycle. So, it is important to measure working capital cycle for management of working capital.
The financial statements i.e., Profit and Loss Account and Balance Sheet, can guide us to
measure working capital cycle.
Management of working capital:

A firm must have adequate working capital, i.e.; as much as needed the firm. It should be neither
excessive nor inadequate. Both situations are dangerous. Excessive working capital means the firm has
idle funds which earn no profits for the firm. Inadequate working capital means the firm does not have
sufficient funds for running its operations. It will be interesting to understand the relationship between
working capital, risk and return. The basic objective of working capital management is to manage firms
current assets and current liabilities in such a way that the satisfactory level of working capital is
maintained, i.e.; neither inadequate nor excessive. Working capital sometimes is referred to as
“circulating capital”. Operating cycle can be said to be t the heart of the need for working capital. The
flow begins with conversion of cash into raw materials which are, in turn transformed into work-in-
progress and then to finished goods. With the sale finished goods turn into accounts receivable,
presuming goods are sold as credit. Collection of receivables brings back the cycle to cash.
The company has been effective in carrying working capital cycle with low working capital limits. It may
also be observed that the PBT in absolute terms has been increasing as a year to year basis as could be
seen from the above table although profit percentage turnover may be lower but in absolute terms it is
increasing. In order to further increase profit margins, SSL can increase their margins by extending credit
to good customers and also by paying the creditors in advance to get better rates.

Optimal Level of Working Capital Investment

The optimal level of working capital investment is the level expected to maximize shareholder
wealth. It is a function of several factors, including the variability of sales and cash flows and the
degree of operating and financial leverage employed by the firm. Therefore no single working
capital investment policy is necessarily optimal for all firms
Proportions of Short-term Financing Notes
Not only a firm have to be concerned about the level of current assets; it also has to determine
the proportions of short-and long-term debt to use in financing use in these assets. The decision
also involves trade-offs between profitability and risk. Sources of debt financing are classified
according to their maturities. Specifically, they can be categorized as being either short-term or
long-term, with short-term sources having maturities of one year or less and long-term sources
having maturities of greater than one year
Cost of Short-term versus Long-term Debt
Historically long-term interest rates normally exceeds short-term rate because of the reduce
flexibility of long-term borrowing relative to short-term borrowing. In fact, the effective cost of
long-term debt, even went short-term interest rates are equal to or greater than long-term rates.

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With long-term debt, a firm incurs the interest expense even during times went it has no
immediate need for the funds, such as during seasonal or cyclical downturns. With short-term
debt, in
contrast, the firm can avoid the interest costs on unneeded funds by playing of (or not renewing)
the debt. Therefore, the long-term debt generally is higher than the cost of short-term debt

Risk of Long-term versus Short-term Debt

Borrowing companies have different attitudes toward the relative risk of long-term versus short-
term debt then lenders. Whereas lenders normally feel that risk increases with maturity,
borrowers feel that there is more risk associated with short-term debt. The reasons for this are
twofold.
First, there is always the chance that a firm will not be able to refund its short-term debt. When a
firm’s debt matures, it either pays off the debt as part of a debt reduction program or arranges
new financing. At the time of maturity, however, the firm could faced with financial problems
resulting from such events as strikes, natural disasters, or recessions that cause sales and cash
inflows to decline. Under these circumstances the firm may find it very difficult or even
impossible to obtain the needed funds. This could lead to operating and financial difficulties.
Second, short-term interest rates tend to fluctuate more over time than long-term interest rates As
a result; a firm’s interest expenses and expected earnings after interest and taxes are subject to
more variation (risk) over time with short-term debt than with long-term debt.
Working Capital Management
Working capital is rightly an adjunct of fixed capital investment. It is a financial lubricant which
keeps business operations going. It is the life-blood of a firm. Cash, accounts receivable and
inventory are the important components of working capital, which is rotating in its nature. Cash
is the central reservoir of a firm and ensures liquidity. Accounts receivables and inventory form
the principal utility of production and sales; they also represent liquid funds in the ultimate
analysis. The financial manager should weigh the advantage of customer trade credit, such as
increase in volume of sales, against limitations of costs and risks involved therein. He should
match inventory trends with level of sales. The uncertainties of inventory planning should be
dealt with in a rational manner. There are several costs and risks which are related to inventory
management. The risks are there when inventory is inadequate or in excess of requirements. The
former may hold up production, while the latter would result in an unjustified locking up of
funds and increase the cost of capital. Inventory management entails decisions about the timing
and size of purchases purely on a cost basis. The financial manager should determine the
economic order quantities after considering the relationships of different cost elements involved
in purchases. Firms cannot avoid making investments in inventory because production and
deliveries involve time lags and discontinuities. Moreover, the demand for sales may vary
substantially. In the circumstances, safety levels of stocks should be maintained. Inventory
management thus includes purchases management and material management as well as financial
management. Its close association with financial management primarily arises out of the fact that
it is a simple cash asset.
Meaning of Working Capital Management -The management of current assets, current liabilities
and inter-relationship between them is termed as working capital management. “Working capital
management is concerned with problems that arise in attempting to manage the current assets,

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the current liabilities and the inter-relationship that exist between them.” In practice, “There is
usually a distinction made between the investment decisions concerning current assets and the
financing of working capital.”
From the above, the following two aspects of working capital management emerge:
a. To determine the magnitude of current assets or “level of working capital” and
b. To determine the mode of financing or “hedging decisions.”
Significance of Working Capital Management
Funds are needed in every business for carrying on day- to-day operations. Working capital
funds are regarded as the life blood of a business firm. A firm can exist and survive without
making profit but cannot survive without working capital funds. If a firm is not earning profit it
may be termed as ‘sick’, but, not having working capital may cause its bankruptcy working
capital in order to survive. The alternatives are not pleasant. Bankruptcy is one alternative. Being
acquired on unfavorable term as another. Thus, each firm must decide how to balance the
amount of working capital it holds, against the risk of failure.”
Working capital has acquired a great significance and sound position in the recent past for the
twin objects of profitability and liquidity. In period of rising capital costs and scare funds, the
working capital is one of the most important areas requiring management review. It is rightly
observed that, “Constant management review is required to maintain appropriate levels in the
various working capital accounts.” Mainly the success of a concern depends upon proper
management of working capital so “working capital management has been looked upon as the
driving seat of financial manager.”
It consumes a great deal of time to increase profitability as well as to maintain proper liquidity at
minimum risk. There are many aspects of working capital management which make it an
important function of the finance manager. In fact we need to know when to look for working
capital funds, how to use them and how measure, plan and control them. A study of working
capital management is very important foe internal and external experts. Sales expansion,
dividend declaration, plants expansion, new product line, increase in salaries and wages, rising
price level, etc., put added strain on working capital maintenance. Failure of any enterprise is
undoubtedly due to poor management and absence of management skill.
Importance of working capital management stems from two reasons, viz.,
 A substantial portion of total investment is invested in current assets, and
 level of current assets and current liabilities will change quickly with the variation in
sales.
Though fixed assets investment and long term borrowing will also response to the changes in
sales, but its response will be weak.
Optimal Size of Current Assets
As we have discussed in the earlier paragraphs, current assets and their size depends upon
several factors. Arriving appropriate size of current assets such as cash, raw materials, finished
goods and debtors is a challenge to the financial manager of a firm. It happens sometimes excess
or shortage. We have also discussed in the fore-gone paragraphs about the evils of excess
working capital and inadequate working capital. Very few firms arrive optimum level of working

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capital by their sheer experience and scientific approach. The ratio of current assets to fixed
assets helps in measuring the performance of working capital management. The higher the ratio,
conservative the firm is in maintaining its current assets and lowers the ratio, aggressive the firm
is in maintaining its current assets. So every firm should balance their level of current assets and
make it optimum.
Liquidity vs. Profitability
Any exercise in working capital management will influence either liquidity or profitability. The
working capital management is a razor edge exercise for financial manager of an enterprise. In
this context the financial manager has to take several decisions of routine and non-routine such
as:
Sufficient cash balance to be maintained;
a. To raise long term or short term loans decide the rate of interest and the time of
repayment;
b. Decide the purchase policy to buy or not to buy materials;
c. To determine the economic order quantity for inputs,
d. To fix the price at which to buy the inputs if any;
e. To sell for credit or not and terms of credit;
f. To decide the terms of purchase;
g. To decide the credit period and extent of credit;
In all these aspects the financial manager has to take decisions carefully so that the firm’s twin
objectives such as profitability and solvency are not affected.
Trade Off Between Liquidity and Profitability
If a firm maintains huge amount of current assets its profitability will be affected though it
protects liquidity. If a firm maintains low current assets, its liquidity is of course weak but the
firm’s profitability will be high

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MODULE II: Meaning of Receivables Management, Determination of Appropriate Receivable Policy,
Marginal Analysis, Evaluation of Credit Proposal, Credit Analysis and Credit Decision, Heuristic
Approach, Discriminate Analysis, Sequential Decision Analysis.

Introduction
Receivables mean the book debts or debtors and these arise, if the goods are sold on credit.
Debtors form about 30% of current assets in India. Debt involves an element of risk and bad
debts also. Hence, it calls for careful analysis and proper management. The goal of receivables
management is to maximize the value of the firm by achieving a tradeoff between risk and
profitability. For this purpose, a finance manager has:
a. To obtain optimum (non-maximum) value of sales;
b. To control the cost of receivables, cost of collection, administrative expenses, bad debts
and opportunity cost of funds blocked in the receivables.
c. To maintain the debtors at minimum according to the credit policy offered to customers.
d. To offer cash discounts suitably depending on the cost of receivables, bank rate of
interest and opportunity cost of funds blocked in the receivables.
Factors Affecting the Size of Receivables
The size of accounts receivable is determined by a number of factors. Some of the important
factors are as follows
1. Level of sales - This is the most important factor in determining the size of accounts
receivable. Generally in the same industry, a firm having a large volume of sales will be having a
larger level of receivables as compared to a firm with a small volume of sales. Sales level can
also be used for forecasting change in accounts receivable. For example, if a firm predicts that
there will be an increase of 20% in its credit sales for the next period, it can be expected that
there will also be a 20% increase in the level of receivables.
2. Credit policies - The term credit policy refers to those decision variables that influence the
amount of trade credit, i.e., the investment in receivables. These variables include the quantity of
trade accounts to be accepted, the length of the credit period to be extended, the cash discount to
be given and any special terms to be offered depending upon particular circumstances of the firm
and the customer. A firm’s credit policy, as a matter of fact, determines the amount of risk the
firm is willing to undertake in its sales activities. If a firm has a lenient or a relatively liberal
credit policy, it will experience a higher level of receivables as compared to a firm with a more
rigid or stringent credit policy. This is because of the two reasons:
a. A lenient credit policy encourages even the financially strong customers to make delays
in payment resulting in increasing the size of the accounts receivables.
b. Lenient credit policy will result in greater defaults in payments by financially weak
customers thus resulting in increasing the size of receivables.
3. Terms of trade - The size of the receivables is also affected by terms of trade (or credit terms)
offered by the firm. The two important components of the credit terms are:
a. Credit period and
b. Cash discount.

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Credit Period
The term credit period refers to the time duration for which credit is extended to the customers. It
is generally expressed in terms of “Net days”. For example, if a firm’s credit terms are “Net 30”,
it means the customers are expected to pay within 30 (Thirty) days from the date of credit sale.
Cash Discount
Most firms offer cash discount to their customers for encouraging them to pay their dues before
the expiry of the credit period. The terms of cash discount indicate the rate of discount as well as
the period for which the discount has been offered. For example, if the terms of cash discount are
changed from “Net 30” to “2/10 Net 30”, it means the credit period is of 30 days but in case
customer pays in 10 days, he would get 2% discount on the amount due by him. Of course,
allowing cash discount results in a loss to the firm because of recovery of fewer amounts than
what is due from the customer but it reduces the volume of receivables and puts extra funds at
the disposal of the firm for alternative profitable investment. The amount of loss thus suffered is,
therefore, compensated by the income otherwise earned by the firm.
Optimum Size of Receivables
The optimum investment in receivables will be at a level where there is a trade-off between costs
and profitability. When the firm resorts to a liberal credit policy, the profitability of the firm
increases on account of higher sales. However, such a policy results in increased investment in
receivables, increased chances of bad debts and more collection costs. The total investment in
receivables increases and, thus, the problem of liquidity is created. On the other hand, a stringent
credit policy reduces the profitability but increases the liquidity of the firm. Thus, optimum
credit policy occurs at a point where there is a “Trade-off” between liquidity and profitability.
Determinants of Credit Policy
The following are the aspects of credit policy:
1. Level of credit sales required to optimize the profit.
2. Credit period i.e. duration of credit, whether it may be 15 days or 30 or 45 days etc.
3. Cash discount, discount period and seasonal offers.
4. Credit standard of a customer: 5 C’s of credit :
a. Character of the customer i.e. willingness to pay.
b. Capacity/ ability to pay.
c. Capital/ financial resources of a customer.
d. Conditions / special conditions for extension of credit to doubtful customers and
prevailing economic and market conditions and;
e. Collateral security.
5. Profits.
6. Market and economic conditions.
7. Collection policy.
8. Paying habits of customers.
9. Billing efficiency, record-keeping etc.
10. Grant of credit / size and age of receivables.

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Optimum Credit Policy
A firm should establish receivables policies after carefully considering both benefits and costs of
different policies. These policies relate to:
a. Credit Standards,
b. Credit Terms, and
c. Collection Procedures.
Each of these has been explained below:
Credit standards - The term credit standards represent the basic criteria for extension of credit
to customers. The levels of sales and receivables are likely to be high if the credit standards are
relatively loose, as compared to a situation when they are relatively tight. The firm’s credit
standards are generally determined by the five “C’s”. Character, Capacity, Capital, Collateral and
Conditions. Character denotes the integrity of the customer, i.e. his willingness to pay for the
goods purchased. Capacity denotes his ability to manage the business. Capital denotes his
financial soundness. Collateral refers to the assets which the customer can offer by way of
security. Conditions refer to the impact of general economic trends on the firm or to special
developments in certain areas of economy that may affect the customer’s ability to meet his
obligations.
Information about the five C’s can be collected both from internal as well as external sources.
internal sources include the firm’s previous experience with the customer supplemented by its
own well developed information system. External resources include customer’s references, trade
associations and credit rating organizations such as Don & Brad Street Inc. of USA. This
Organization has more than hundred years experience in the field of credit reporting. It publishes
a reference book six times a year containing information about important business firms region
wise. It also supplies credit reports about different firms on request.
An individual firm can translate its credit information into risk classes or groups according to the
probability of loss associated with each class. On the basis of this information, the firm can
decide whether it will be advisable for it to extend credit to a particular class of customers.
Credit terms - It refers to the terms under which a firm sells goods on credit to its customers.
As stated earlier, the two components of the credit terms are
o Credit Period and
o Cash Discount.
The approach to be adopted by the firm in respect of each of these components is discussed
below:
1. Credit period: Extending the credit period stimulates sales but increases the cost on
account of more tying up of funds in receivables. Similarly, shortening the credit period
reduces the profit on account of reduced sales, but also reduces the cost of tying up of
funds in receivables. Determining the optimal credit period, therefore, involves locating
the period where the marginal profits on increased sales are exactly offset by the cost of
carrying the higher amount of accounts receivable.
2. Cash discount: The effect of allowing cash discount can also be analyzed on the same
pattern as that of the credit period. Attractive cash discount terms reduce the average

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 collection period resulting in reduced investment in accounts receivable. Thus, there is a
saving in capital costs. On the other hand, cash discount itself is a loss to the firm.
Optimal discount is established at the point where the cost and benefit are exactly
offsetting.
3. Collection procedures - A stringent collection procedure is expensive for the firm
because of high out-of-pocket costs and loss of goodwill of the firm among its customers.
However, it minimizes the loss on account of bad debts as well as increases savings in
terms of lower capital costs on account of reduction in the size of receivables. A balance
has therefore to be stuck between the costs and benefits of different collection procedures
or policies.
Credit Evaluation of Customer
Credit evaluation of the customer involves the following 5 stages
a. Gathering credit information of the customer through:
 financial statements of a firm,
 bank references,
 references from Trade and Chamber of Commerce,
 reports of credit rating agencies,
 credit bureau reports,
 firm’s own records (Past experience),
 Their sources such as trade journals, Income-tax returns, wealth tax returns,
sales tax returns, Court cases, Gazette notifications etc.
b. Credit analysis - After gathering the above information about the customer, the
creditworthiness of the applicant is to be analyzed by a detailed study of 5 C’s of credit as
mentioned above.
c. Credit decision - After the credit analysis, the next step is the decision to extend the credit
facility to potential customer. If the analysis of the applicant is not upto the standard, he
may be offered cash on delivery (COD) terms even by extending trade discount, if
necessary, instead of rejecting the credit to the customer.
d. Credit limit - If the decision is to extend the credit facility to the potential customer, a
limit may be prescribed by the financial manager, say, Rs. 25,000 or Rs. 1,00,000 or so,
depending upon the credit analysis and credit-worthiness of the customer.
e. Collection procedure - A suitable and clear-cut collection procedure is to be established
by a firm and the same is to be intimated to every customer while granting credit facility.
Cash discounts may also be offered for the early payment of dues. This facilitates faster
recovery.
Two approaches can be followed for credit investigation:
 Traditional Approach
 Statistical Approach
Traditional approach relates to analysis of five "C"s of credit - Capital, Character, Collateral,
Capacity and Condition, which have discussed earlier.
The traditional approach suffers from drawbacks like that it is not easy to judge these five "CWs.
There is no consistency in analysis or no link to shareholders' wealth maximisation.
Modern approach consists of
a. Heuristic approach,
b. Discriminate analysis,
c. Sequential decision analysis.

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According to Heuristic or Rating Index approach, the factors to be considered are credit
requirements, pay habits, year of business, profit turnover, and qualitative factor (i.e., discretion
of the manager). Each factor is given n weight. Then contribution of each factor to credit limits
is expressed as percentage of net worth. Discriminate analysis is computer based technique. It
considers current ratio and return on net worth ratio. These ratios are plotted on a graph. A line
is drawn between the plotted points dividing them in equal parts;
Sequential decision analysis follows three steps
o Consulting credit files, i.e. past payment record
o Examining credit agency rating, i.e., internal analysis.
o Interchange of bank report, i.e., external credit analysis

MODULE III: Meaning of Cash Management, Motives for Holding Cash, Factors determining Cash
Balance, Collection System, Disbursement Tools, and Investment in Marketable Securities; determining
the optimum level of Cash, Baumol Model, Beranek Model, Miller-Orr Model, Stone Model, and
Optimization Model.

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