Short Questions Answers
1. What do you understand by working capital cash flow cycle? How do you measure it? How can it be shortened?
Firm’s liquidity has two major aspects: ongoing liquidity and protective liquidity. Ongoing liquidity refers to the inflow and outflows of cash through the firm as the product acquisition, production, sales, payment and collection takes place over time. Protective liquidity refers to the ability to adjust rapidly to unforeseen cash demands and to have backup means available to raise cash. The firm’s ongoing liquidity is a function of its working capital cash flow cycle or cash conversion cycle. As raw materials are purchased, the firm’s current liabilities increase through accounts payable. Subsequently, the firm pays for these purchases. During the same time, the raw materials are converted into finished goods through the production process. After getting the finished goods inventory they can be sold either for cash or in credit. In later case, receivables are created. Finally, the accounts receivable are collected, resulting in cash. Ongoing liquidity is influenced by all aspects of the cash cycle, since increase in purchases, inventory, or receivables will decrease liquidity. ongoing liquidity. decrease in any of the three will increase
One important model to look at the working capital cash flow cycle is to analyze a firm’s cash conversion cycle (CCC). This represents the net time intervals in days between actual cash expenditure of the firm and the ultimate recovery of cash. The cash conversion cycle model focuses on the length of time between when the company makes payments and when it receives cash inflows. It is calculated as:
CCC = Operating Cycle – Payable Deferral Period
A firm’s operating cycle has two components: Inventory conversion period and receivables collection period.
Inventory conversion period (ICP) refers to the length of time required for converting raw materials into finished goods and then into sales. It is calculated as:
ICP= Inventory/sales per day
Receivable collection period (RCP), also called days sales outstanding or average collection period, is the average length of time required to collect accounts receivable after credit sales have taken place. It is calculated as:
RCP = Receivables/Credit sales per day
Payables deferral period (PDP) is defined as the average length of time between purchase of materials and labor and the payment of cash for them. It is calculated as:
PDP = Payables/Credit purchase per day
Having determined all these three components, the cash conversion cycle (CCC) is given by:
CCC = ICP + RCP -PDP
The calculation of cash conversion cycle is meaningful in a sense that it represents the average length of time that the firm must hold investment in working capital. This discussion explores one important point that the level of working capital investment depends on the length of the cash conversion cycle. If the firm is able to shorten its cash conversion cycle, the working capital requirement also could be reduced. However, the length of cash conversion cycle is positively related with inventory conversion period and receivable collection period, whereas it is negatively related with payables deferral period. Therefore the cash conversion cycle of a firm could be shortened by reducing inventory conversion period resulting from quick sales of finished goods, by reducing receivables collection period resulting from speeding up collection and by increasing the length of payables deferral period resulting from slowing down the payments. However in doing so the finance manager must look into the impact of these changes into comparative cost benefits associated with the firm.
2. Why is working capital management important for the financial health of the firm? Explain inventory conversion period, receivables conversion period and payables deferral period.
Working capital management is concerned with managing a firm’s current assets and current liabilities to maintain a proper trade-off between profitability and liquidity. The working capital management is important for the financial health of the firm due to the following reason:
- It requires significant managerial consideration: For most manufacturing concerns, the current assets represent a significant part of total assets. This size and volatility of current assets make working capital management a major managerial concern. Financial managers spend much of their time in day-to-day interna! operation of the firm, which revolves around working capital management.
- It is helpful to maintaining desired scale of operation: The relationship between growth in sales and working capital used is direct and close. So far as the firm is more concerned about maximizing sales revenue it must involve in working capital management. For example, as sales increase, firms must increase inventory and accounts payable to meet the increasing sales requirement. The increased level of sales again generates a higher level of accounts receivable. So working capital must be managed as firms increase or decrease their scale of operations and sales.
- It assists in maintaining continuous cash flow: Working capital management is also important from the viewpoint of maintaining continuous cash flow. A good working capital management reflects in terms of adequate level of accounts receivable, inventory and cash flow in and out of the firm. A firm doing better in working capital management can maintain control over its accounts receivable and inventory and ensure the regular flow of cash.
- It is more significant to small firms: Working capital management is particularly significant for smaller firms, since they carry a higher percentage of current assets and current liabilities. The survival of these firms largely depends on the effective working capital management. Due to their limited approach to the long-term capital market, they have to rely heavily on short-term borrowing, trade credit and so on. Effective working capital management provides a cushion of protection to the short-term lenders so that smaller firms can function well and survive for a long term.
3. What is working capital? What factors may a firm consider in financing working capital needed?
Every firm requires investing current assets along with the fixed component of assets. Working capital generally refers to the capital required to satisfy day-to-day requirements of the firm to pay for wages, salaries, and other operating expenses. Working capital is defined in two ways: gross working capital and net working capital. Gross working capital refers to the gross amount invested into current assets. It is represented by the firm’s total investment in current assets. On the other hand, net working capital refers to the excess of current assets over current liabilities. In other words, it is that part of current assets, which is financed by long term funds. Here current assets refer to all those assets such as cash, marketable securities, accounts receivable, inventories and short-term investment that are convertible into cash within a year. On the other hand, current liabilities represent the obligations such as creditors, accruals, accounts payable, notes payable, short term loan, which are to be paid within a year. The gross and net concepts of working capital are not contradictory rather they are used as a supplementary to each other. The gross concept emphasizes the level of investment associated with total current assets. It explores that a firm should hold neither excessive nor deficit investment in current assets. On the other hand, the net concept of working capital is concerned with determining the financing pattern of these current assets. The working capital requirement for a firm is influenced by a larger number of factors. They are as follows:
- Nature and size of business: The nature and size of business affects the working capital. If a firm is involved in the trading or financial sector, it requires very less investment in fixed assets than manufacturing. Thus the working capital requirement for such firms is relatively larger. Similarly a firm in the public utility sector requires a considerable amount of fixed outlay so that their working capital requirement is relatively small. Similarly, for a larger firm it is more common to maintain larger working capital.
- Cash conversion cycle: Cash conversion cycle represents the length of period lag between the time cash outflow occurs in the form of purchase and investment in inventories and receivables and the time cash inflows realize in the form of cash sales or collection of credit sales. Longer the cash conversion cycle will be the working capital requirement.
- Seasonal fluctuation: Most firms have seasonal nature of business. For such firms, the working capital need is relatively larger during the peak season because of the increase in temporary working capital over and above the permanent working capital.
- Production Policy: If a firm adopts steady production policy, the investment in inventories will build up during off seasons, as a result of which the working capital need of the firm increases.
- Credit policy: A firm’s credit policy also affects the working capital requirement. A firm may apply a relatively liberal or strict credit policy. If the firm has liberal credit policy it will go on extending credit to a large number of customers, which results in an increase in investment in receivables thus causing the level of working capital to increase.
- Terms of purchase: If the term of credit purchase is relatively longer, the firm will have a larger spontaneous source of financing in the firm of accounts payable, which results in decline in working capital need.
- Growth and expansion: If a firm is growing in terms of its size and operations, it needs to expand its operating capacity. Because of this expansion, the firm has to maintain additional investment in working capital in terms of additional inventories, raw materials, work-in-progress, finished goods, receivables, and pay salaries and wages to additional manpower.
- Access to money market: The level of working capital to be maintained by a firm is also determined by capacity of the firm to borrow on short notice. If the firm has a good approach with bank and finance companies, it can raise short term loans at very short notice so that working capital requirement is reduced.
4. What do you understand about the cash conversion cycle?
Firm’s liquidity has two major aspects: ongoing liquidity and protective liquidity. Ongoing liquidity refers to the inflow and outflows of cash through the firm as the product acquisition, production, sales, payment and collection takes place over time. Protective liquidity refers to the ability to adjust rapidly to unforeseen cash demands and to have backup means available to raise cash. The firm’s ongoing liquidity is a function of its working capital cash flow cycle or cash conversion cycle. As raw materials are purchased, the firm’s current liabilities increase through accounts payable. Subsequently, the firm pays for these purchases. During the same time, the raw materials are converted into finished goods through the production process. After getting the finished goods inventory they can be sold either for cash or in credit. In later cases, receivables are created. Finally, the accounts receivable are collected, resulting in cash. Ongoing liquidity is influenced by all aspects of the cash cycle, since increase in purchases, inventory, or receivables will decrease liquidity. A decrease in any of the three will increase ongoing liquidity.
One important model to look at the working capital cash flow cycle is to analyze a firm’s cash conversion cycle (CCC). This represents the net time intervals in days between actual cash expenditure of the firm and the ultimate recovery of cash. The cash conversion cycle model focuses on the length of time between when the company makes payments and when it receives cash inflows. It is calculated as:
CCC = Operating Cycle – Payable Deferral Period
5. Factors affecting working capital
The working capital requirement for a firm is influenced by a larger number of factors. They are as follows:
- Nature and size of business: A firm involved in the trading or financial sector, it requires very less investment in fixed assets thus the working capital requirement is relatively larger. Similarly, for a larger firm it is more common to maintain larger working capital.
- Cash conversion cycle: Longer the cash conversion cycle higher will be the working capital requirement.
- Seasonal fluctuation: The working capital need is relatively larger during the peak season because of increase in temporary working capital.
- Production Policy: A firm with steady production policy requires building up inventories during off seasons and thus working capital needs of the firm increases.
- Credit policy: A firm that has liberal credit policy extends credit to a large number of customers. It results in an increase in investment in receivables thus causing the level of working capital to increase.
- Terms of purchase: A firm with a longer term of credit purchase will have a larger spontaneous source of financing in the form of accounts payable. It results in. decline in working capital need.
- Growth and expansion: A firm growing and expanding in size and operations needs to maintain additional working capital to finance additional inventories. receivables, salaries and wages.
- Access to money market: A firm with a good approach to bank and finance companies can raise short term loans at very short notice so that working capital requirement is reduced.
Numerical Problems
Nepal Sugar Corporation has an inventory conversion period of 75 days, a receivables conversion period of 38 days, and a payables deferral period of 30 days.
a. What is the length of the firm’s cash conversion cycle?
b. If the corporation’s annual sales are Rs 3,375,000 and all sales are on credit, what is the firm’s investment in accounts receivable?
c. How many times per year does the company turn over its inventory?
SOLUTION
We have,
Inventory conversion period (ICP) = 75 days
Receivables collection period (RCP) = 38 days;
Payables deferred period (PDP) = 30 days;
The length of cash conversion cycle:
a. CCC = ICP+ RCP – PDP = 75 days + 38 days -30 days = 83 days
b. Calculation of investment in accounts receivable:
We have,
Annual credit sales = Rs 3,375,000
Thus, Receivables = RCP x Credit sales / 360
= 38 x Rs 3,375,000 / 360
= Rs 356,250
c. Inventory turnover:
ITOR = Days in year /ICP
=360 / 75 = 4.8 times
The company turns over its inventory 4.8 times during the year.
The National Corporation turned over its inventory 4 times during the year, and its DSO was 30 days. The corporation’s payables deferred period is 40 days. Calculate the cash conversion cycle. If the inventory turnover can be raised to 6 times, what would be the cash conversion cycle?
SOLUTION
We have,
Inventory turnover = 4 times
DSO = 30 days
The Bagmati Corporation trying to determine the effect of its inventory turnover ratio and days sales outstanding (DSO) on its cash flow cycle. The corporation’s 1999 sales (all on credit) were Rs. 150,000, and it earned a net profit of 6 percent, or Rs. 9,000. It turned over its inventory 6 times during the year, and its DSO was 36 days. The firm had fixed assets totalling Rs. 40,000. The corporation’s payables deferred period is 40 days. Calculate the cash conversion cycle. If the inventory turnover can be raised to 8 times, what would be the cash conversion cycle?
Nepal Sugar Corporation has an inventory conversion period of 75 days; a receivable turnover is 9 times, and payable deferral period of 30 days.
a. What is the length of the cash conversion cycle?
b. If Corporation’s annual sales are Rs. 3,300,000 and 90% of sales are on credit, what is the corporation’s investment in accounts receivable? c. How many times per year does the corporation turnover its inventory?
SOLUTION
Red Horse Battery Corporation is a leading producer of all kinds of batteries. Corporation turns out 1600 automobile batteries a day at a cost of Rs. 3,500 per battery for materials and labour. It takes the corporation 24 days to convert raw materials into a battery. Corporation allows its customers 40 days in which to pay for the batteries, and the corporation generally pays its suppliers in 30 days.
Assume 360 days a year.
a. What is the corporation’s cash conversion cycle?
b. If Corporation always produces and sells 1600 batteries a day, what amount of working capital must be financed?
c. If the corporation could sell all the produced batteries at a price of Rs. 4,000 per battery, what is the working capital turnover?
SOLUTION
We have,
Production = 1,600 units
Cost per unit = Rs 3,500
Inventory conversion period (ICP)= 24 days
Receivable collection period (RCP) = 40 days
Payable deferral period (PDP) = 30 days
a. The cash conversion cycle:
CCC = ICP RCP – PDP = 24+ 40-30 = 34 days
b. The working capital financing need:
Working capital = Production per day x Cost per unit x CCC
= 1,600 x Rs 3,500 x 34 = Rs 190,400,000
c. Calculation of Working capital turnover
We have.
Annual sales = Selling price x Sales units per day x Days in a year
= Rs 4,000 x 1,600x 360 = Rs 2,304,000,000
Thus,
Working capital turnover = Working capital /Sale
=Rs 2,304,000,000/ Rs 190,400,000
= 12.10 times
- 2064 Q.No. 8
New Nepal Corporation is a leading producer of automobile batteries, New Nepal turns out 1,500 batteries a day at a cost of Rs. 6 per battery for materials and labor. It takes the firm 22 days to convert raw material into a battery. New Nepal allows its customers 40 days in which to pay for the batteries, and the firm generally pays its suppliers in 30 days.
a. What is the length of the New Nepal cash conversion cycle?
b. If New Nepal always produces and sells 1,500 batteries a day, what amount of working capital must it finance?
c. By what amount could New Nepal reduce its working capital financing needs if it was able to stretch its payables deferral period to 35 days?
SOLUTION
We have,
Production =1,500 units
Cost per unit = Rs 6
Inventory conversion period (ICP) = 22 days
Receivable collection period (RCP) = 40 days
Payable deferral period (PDP) = 30 days
a. The cash conversion cycle:
CCC = ICP + RCP – PDP = 22 +40-30 = 32 days
b. The working capital financing need:
Working capital = Production per day Cost per unit x CCC
= 1,500 × Rs 6 x 32 = Rs 288,000
c. If PDP can be stretched to 35 days, the reduction in working capital is given by:
CCC = 22 +40-35 = 27 days
Working capital = Production per day Cost per unit x CCC
= 1,500 x Rs.6 x 27 = Rs 243,000
Thus,
Reduction in working capital = Rs 288,000 – Rs 243,000 = Rs 45,000
The Import Corporation is trying to determine the effect of its inventory turnover ratio and days sales outstanding (DSO) on its cash flow cycle. The corporation’s 2004 sales (all on credit) were Rs.180,000, and it earned a net profit of 6 percent. The cost of goods sold equals 85 percent of sales. Inventory was turned over 8 times during the year, and DSO was 36 days. The corporation had fixed assets totaling Rs. 40,000. Corporation’s payable deferral period is 30 days.
a. Determine cash conversion cycle.
b. Calculate total assets turnover ratio.
c. Calculate return on assets (ROA) assuming holding of cash and marketable securities is negligible.
ABC Company has an inventory turnover of 2.4 times, receivables collection period of 75 days and payable deferred period of 60 days. Assume 360 days.
(i) What is the length of the cash conversion cycle?
(ii). If the company’s annual sales is Rs. 6.75 million and 80% of sales are on credit, what is the firm’s investment in receivables?
(iii) What is the level of inventory of ABC Company?
SOLUTION
1. How should a firm manage its inventories?
Inventory constitutes one of the important items of current assets, which permits the production and sale process of a firm to operate smoothly. Inventories involve significant investment of funds. In this sense, inventory is an investment that the firm ties up its money in, thereby forgoing certain other opportunities of investment. As the firm goes on investing more and more in inventories, the cost of funds being tied up will increase. Therefore inventory management is proved to be a significant part of a firm’s financial management function.
So far as it is concerned with financial management, investment in inventories must be minimized to the extent it is unnecessary. Here, inventory management of a firm attempts to meet two basic and conflicting requirements: maintaining adequate size of inventory for smooth flow of production and selling activities; minimizing investment in inventory to enhance firm’s profitability. This requires that inventory should not be excess than requirement and at the same time it should not be less than requirement, rather it should just be optimum. Excessive investment in inventories results in more cost of funds being tied up so that reduces the profitability, inventories may be misused, lost, damaged and holds cost in terms of large space and others. At the same time, insufficient investment in inventories creates stock-out problems, obstruction in production and selling of goods. So that firm may lose the customers as they shift to the competitors. Maintaining optimum level of investment in inventories is the basic aim of inventory management.
To manage the inventory effectively and efficiently, a firm can use several techniques of inventory management. For example, the economic order quantity (E00) technique enables the firm to reduce inventory cost by making an optimal size of stock of inventory. Reorder point (ROP) technique suggests when a reorder of inventory has to be made. Applying these techniques can meet the above mentioned purpose of inventory management.
Write Short Notes on
Economic order quantity
Economic order quantity (EOQ) refers to the order size of inventory at which total inventory costs remain at the minimum. EOQ is one of the most commonly used tools for determining the optimal order quantity for an item of inventory. It takes into consideration the carrying and ordering costs of inventory and determines the order quantity that minimizes total inventory costs. Carrying cost is the cost per unit of holding an item of inventory for a specified time period. Carrying cost includes cost of storage, insurance, and taxes; cost of deterioration and obsolescence; opportunity cost of tying up funds in inventory and so on. As the level of inventory holding increases, the carrying costs also increase. Ordering cost includes the fixed clerical costs of placing and receiving an order. They are the cost of writing a purchase order; cost of processing the paperwork; cost of receiving an order and checking it against the invoice; cost of running a purchasing department; personnel and telephone costs, and the cost of preparing specifications. Ordering costs change in direct proportion to the change in number of orders placed. If inventories are ordered more frequently, it involves more ordering costs.
Thus, ordering and carrying cost oppositely react to each other in response to the order quantity. Due to this fact, EOS is determined at the order size where these two costs are equal, producing the minimum total cost of inventory. It is determined as follows:
EOQ = Square Root(2AO/C)
Where, A refers to the annual requirement of inventory, O is the ordering cost per order, and C is the inventory carrying cost per unit per year.
Reorder point.
In real life situations, it is not possible to get the replenishment of inventory as immediately as required. The basic problem associated with the inventory management is to determine when a reorder should be placed. EOQ solves the problem of how much to order. Once an order is placed it will sometimes take to receive the delivery as per order placed. Thus, a reorder has to be placed in advance before previous inventories are completely used. Hence, a reorder level refers to the level of inventory at which a reorder should be placed to receive the inventory at the time when previous stocks exactly finish. It is worked out as follows:
ROP (Lead time x Average usage) + Safety stock =
The time consumed between placing an order and receiving as per the order is known as lead-time. Similarly, the demand for products may fluctuate from time to time, causing change in average consumption and at the same time actual lead time may be different from what has been expected. If such a condition occurs, the firm may face stock-out problems. To be safe from the possibilities of stock-out due to increased average consumption and delayed lead-time, firms should maintain safety stock.
Long Questions Answers
1. What do you understand by working capital cash flow cycle? How do you measure it? How can it be shortened?
Firm’s liquidity has two major aspects: ongoing liquidity and protective liquidity. Ongoing liquidity refers to the inflow and outflows of cash through the firm as the product acquisition, production, sales, payment and collection takes place over time. Protective liquidity refers to the ability to adjust rapidly to unforeseen cash demands and to have backup means available to raise cash. The firm’s ongoing liquidity is a function of its working capital cash flow cycle or cash conversion cycle. As raw materials are purchased, the firm’s current liabilities increase through accounts payable. Subsequently, the firm pays for these purchases. During the same time, the raw materials are converted into finished goods through the production process. After getting the finished goods inventory they can be sold either for cash or in credit. In later cases, receivables are created. Finally, the accounts receivable are collected, resulting in cash. Ongoing liquidity is influenced by all aspects of the cash cycle, since increase in purchases, inventory, or receivables will decrease liquidity. ongoing liquidity. decrease in any of the three will increase
One important model to look at the working capital cash flow cycle is to analyze a firm’s cash conversion cycle (CCC). This represents the net time intervals in days between actual cash expenditure of the firm and the ultimate recovery of cash. The cash conversion cycle model focuses on the length of time between when the company makes payments and when it receives cash inflows. It is calculated as:
CCC = Operating Cycle – Payable Deferral Period
A firm’s operating cycle has two components: Inventory conversion period and receivables collection period.
Inventory conversion period (ICP) refers to the length of time required for converting raw materials into finished goods and then into sales. It is calculated as:
ICP= Inventory/sales per day
Receivable collection period (RCP), also called days sales outstanding or average collection period, is the average length of time required to collect accounts receivable after credit sales have taken place. It is calculated as:
RCP = Receivables/Credit sales per day
Payables deferral period (PDP) is defined as the average length of time between purchase of materials and labor and the payment of cash for them. It is calculated as:
PDP = Payables/Credit purchase per day
Having determined all these three components, the cash conversion cycle (CCC) is given by:
CCC = ICP + RCP -PDP
The calculation of cash conversion cycle is meaningful in a sense that it represents the average length of time that the firm must hold investment in working capital. This discussion explores one important point that the level of working capital investment depends on the length of the cash conversion cycle. If the firm is able to shorten its cash conversion cycle, the working capital requirement also could be reduced. However, the length of cash conversion cycle is positively related with inventory conversion period and receivable collection period, whereas it is negatively related with payables deferral period. Therefore the cash conversion cycle of a firm could be shortened by reducing inventory conversion period resulting from quick sales of finished goods, by reducing receivables collection period resulting from speeding up collection and by increasing the length of payables deferral period resulting from slowing down the payments. However in doing so the finance manager must look into the impact of these changes into comparative cost benefits associated with the firm.
2. Why is working capital management important for the financial health of the firm? Explain inventory conversion period, receivables conversion period and payables deferral period.
Working capital management is concerned with managing a firm’s current assets and current liabilities to maintain a proper trade-off between profitability and liquidity. The working capital management is important for the financial health of the firm due to the following reason:
- It requires significant managerial consideration: For most manufacturing concerns, the current assets represent a significant part of total assets. This size and volatility of current assets make working capital management a major managerial concern. Financial managers spend much of their time in day-to-day interna! operation of the firm, which revolves around working capital management.
- It is helpful to maintaining desired scale of operation: The relationship between growth in sales and working capital used is direct and close. So far as the firm is more concerned about maximizing sales revenue it must involve in working capital management. For example, as sales increase, firms must increase inventory and accounts payable to meet the increasing sales requirement. The increased level of sales again generates a higher level of accounts receivable. So working capital must be managed as firms increase or decrease their scale of operations and sales.
- It assists in maintaining continuous cash flow: Working capital management is also important from the viewpoint of maintaining continuous cash flow. A good working capital management reflects in terms of adequate level of accounts receivable, inventory and cash flow in and out of the firm. A firm doing better in working capital management can maintain control over its accounts receivable and inventory and ensure the regular flow of cash.
- It is more significant to small firms: Working capital management is particularly significant for smaller firms, since they carry a higher percentage of current assets and current liabilities. The survival of these firms largely depends on the effective working capital management. Due to their limited approach to the long-term capital market, they have to rely heavily on short-term borrowing, trade credit and so on. Effective working capital management provides a cushion of protection to the short-term lenders so that smaller firms can function well and survive for a long term.
3. What is working capital? What factors may a firm consider in financing working capital needed? [20]
Every firm requires investing current assets along with the fixed component of assets. Working capital generally refers to the capital required to satisfy day-to-day requirements of the firm to pay for wages, salaries, and other operating expenses. Working capital is defined in two ways: gross working capital and net working capital. Gross working capital refers to the gross amount invested into current assets. It is represented by the firm’s total investment in current assets. On the other hand, net working capital refers to the excess of current assets over current liabilities. In other words, it is that part of current assets, which is financed by long term funds. Here current assets refer to all those assets such as cash, marketable securities, accounts receivable, inventories and short-term investment that are convertible into cash within a year. On the other hand, current liabilities represent the obligations such as creditors, accruals, accounts payable, notes payable, short term loan, which are to be paid within a year. The gross and net concepts of working capital are not contradictory rather they are used as a supplementary to each other. The gross concept emphasizes the level of investment associated with total current assets. It explores that a firm should hold neither excessive nor deficit investment in current assets. On the other hand, the net concept of working capital is concerned with determining the financing pattern of these current assets. The working capital requirement for a firm is influenced by a larger number of factors. They are as follows:
- Nature and size of business: The nature and size of business affects the working capital. If a firm is involved in the trading or financial sector, it requires very less investment in fixed assets than manufacturing. Thus the working capital requirement for such firms is relatively larger. Similarly a firm in the public utility sector requires a considerable amount of fixed outlay so that their working capital requirement is relatively small. Similarly, for a larger firm it is more common to maintain larger working capital.
- Cash conversion cycle: Cash conversion cycle represents the length of period lag between the time cash outflow occurs in the form of purchase and investment in inventories and receivables and the time cash inflows realize in the form of cash sales or collection of credit sales. Longer the cash conversion cycle will be the working capital requirement.
- Seasonal fluctuation: Most firms have seasonal nature of business. For such firms, the working capital need is relatively larger during the peak season because of the increase in temporary working capital over and above the permanent working capital.
- Production Policy: If a firm adopts steady production policy, the investment in inventories will build up during off seasons, as a result of which the working capital need of the firm increases.
- Credit policy: A firm’s credit policy also affects the working capital requirement. A firm may apply a relatively liberal or strict credit policy. If the firm has liberal credit policy it will go on extending credit to a large number of customers, which results in an increase in investment in receivables thus causing the level of working capital to increase.
- Terms of purchase: If the term of credit purchase is relatively longer, the firm will have a larger spontaneous source of financing in the firm of accounts payable, which results in decline in working capital need.
- Growth and expansion: If a firm is growing in terms of its size and operations, it needs to expand its operating capacity. Because of this expansion, the firm has to maintain additional investment in working capital in terms of additional inventories, raw materials, work-in-progress, finished goods, receivables, and pay salaries and wages to additional manpower.
- Access to money market: The level of working capital to be maintained by a firm is also determined by capacity of the firm to borrow on short notice. If the firm has a good approach with bank and finance companies, it can raise short term loans at very short notice so that working capital requirement is reduced.
4. What do you understand about inventory management? How do you exercise control over inventories?
Inventory constitutes one of the important items of current assets, which permits the production and sale process of a firm to operate smoothly. Inventories involve significant investment of funds. In this sense, inventory is an investment that the firm ties up its money in, thereby forgoing certain other opportunities of investment. As the firm goes on investing more and more in inventories, the cost of funds being tied up will increase. Therefore inventory management is proved to be a significant part of a firm’s financial management function. So far as it is concerned with financial management, investment in inventories must be minimized to the extent it is unnecessary. Here, inventory management of a firm attempts to meet two basic and conflicting requirements: maintaining adequate size of inventory for smooth flow of production and selling activities; minimizing investment in inventory to enhance firm’s profitability. This requires that inventory should not be excess than requirement and at the same time it should not be less than requirement, rather it should just be optimum. Excessive investment in inventories results in more cost of funds being tied up so that reduces the profitability, inventories may be misused, lost, damaged and holds cost in terms of large space and others. At the same time, insufficient investment in inventories creates stock-out problems, obstruction in production and selling of goods. So that firm may lose the customers as they shift to the competitors. Maintaining optimum level of investment in inventories is the basic aim of inventory management.
To maintain the proper size of investment in inventory, the firm should use a proper inventory control system. An efficient inventory control system minimizes the misuse, losses and damages, and maintains cost of inventory at a reasonable level. facilitates smooth production and sales operation and helps in maintaining the optimal size of investment in inventories. The following inventory control system has close relationship to the determinants of inventory size
ABC system: As inventories from one category to another differ in their value and significance to the firm, it is not desirable to maintain the same degree of control upon all types of inventories. The firm should be careful enough to maintain the best and effective control on those inventories, which have the highest value. ABC system allows selective control on inventories. It classifies all the inventories into three categories – A, B, and C on the basis of their values. Category ‘A’ consists of those items, which have a very high percent of investment value and Category ‘C’ includes those, which have nominal value. The firm should direct most of its inventory control efforts to the items included in category ‘A’. Inventories in category ‘B’ require less attention than those in ‘A’ but more than those in ‘C’.
Just-in-time (JIT) system: JIT is a system of inventory control in which a manufacturer coordinates production with suppliers so that raw materials of components arrive just as they are needed in the production process. This system helps to minimize carrying the cost of inventory.
Red-line method: Under this system a red line is drawn around the inside of the bin used for stocking inventories. This red line represents the re-order point of inventories. A reorder is placed, when the level of inventories reaches down to the red line drawn in the bin.
Two bin system: Under two bins system, inventories are stocked in two separate bins. When the stocks in one bin are completely used, the firm places a reorder to fill the bin and inventories are drawn for use from the second bin.
Computerized system: Larger firms design a specific computer programming to count the stock of inventories. It is a system in which a computer is used to determine the reorder point and to adjust inventory balances. The computer starts with the level of inventory counted in memory. When inventories are drawn the computer records them and the balance of inventories is revised. Once the balance reaches the reorder point, a re-order is automatically placed. After the receipt of reordered quantity, the balance of inventory in record increases.
Budgetary control system: Under this system, budgeted level of inventory usage is determined in advance. The actual usage of inventories is compared against budgeted consumption to identify the favorable and unfavorable variances of inventory usage.
6. What do you understand about inventory management? Discuss the determinants of inventories and its relationship to inventory control systems.
Inventory constitutes one of the important items of current assets, which permits the production and sale process of a firm to operate smoothly. Inventories involve significant investment of funds. In this sense, inventory is an investment that the firm ties up its money in, thereby forging certain other opportunities of investment. As the firm goes on investing more and more in inventories, the cost of funds being tied up will increase. Therefore inventory management is proved to be a significant part of a firm’s financial management function. So far as it is concerned with financial management, investment in inventories must be minimized to the extent it is unnecessary. Here, inventory management of a firm attempts to meet two basic and conflicting requirements: maintaining adequate size of inventory for smooth flow of production and selling activities; minimizing investment in inventory to enhance firm’s profitability. This requires that inventory should not be excess than requirement and at the same time it should not be less than requirement, rather it should just be optimum. Excessive investment in inventories results in more cost of funds being tied up so that reduces the profitability, inventories may be misused, lost, damaged and holds cost in terms of large space and others. At the same time, insufficient investment in inventories creates stock-out problems, obstruction in production and selling of goods. So that firm may lose the customers as they shift to the competitors. Maintaining optimum level of investment in inventories is the basic aim of inventory management. The determinants of the size of investment in inventories are as follows:
- Level of safety stock: If a firm has to maintain a high level of safety stock because of the relatively larger degree of uncertainty associated with production and sales, the size of investment in inventories is also larger.
- Carrying costs: If the cost of holding inventories in stock is relatively lower, the firm keeps larger stocks of inventories.
- Economy in purchase: If the firm is likely to receive certain benefits in the form of cash discount for purchase made currently, the size of investment in inventories is also likely to be larger because of larger quantity purchase. is likely to rise in near future, the
- Possibility of price rise: If the price of materials firm makes larger quantity purchases at present.
- Possibility of rise in demand: If the firm has anticipated the increased demand of its products in future, it maintains larger socks of inventories at present.
- Cost and availability of funds: If the cost of funds to be invested in inventories is relatively cheaper and they are conveniently available at present, the firm makes larger purchases of inventories.
- Length of production cycle: If the length of production cycle is relatively longer, the firm has to maintain investment in work-in-process inventories for a longer duration of time, which increases the size of investment in inventories.
- Availability of materials: If certain kinds of materials are only available in a particular season only, the firm has to increase the investment in inventories to keep the larger stocks in the season.
- Nature of business: If the firm deals with the business of perishable products, the size of investment in inventories becomes lower.
- Size of the firm: For a firm with relatively larger size and wide market coverage, the investment in inventories is larger. To maintain the proper size of investment in inventory, the firm should use a proper inventory control system. An efficient inventory control system minimizes the misuse, losses and damages, maintains cost of inventory at reasonable level, facilitates smooth production and sales operation and helps in maintaining the optimal size of investment in inventories. The following inventory control system has close relationship to the determinants of inventory size
ABC system: As inventories from one category to another differ in their value and significance to the firm, it is not desirable to maintain the same degree of control upon all types of inventories. The firm should be careful enough to maintain the best and effective control on those inventories, which have the highest value. The ABC system allows selective control on inventories. It classifies all the inventories into three categories A, B, and C on the basis of their values. Category ‘A’ consists of – those items, which have a very high percent of investment value and Category ‘C’ includes those, which have nominal value. The firm should direct most of its inventory control efforts to the items included in category A. Inventories in category ‘B’ require less attention than those in ‘A’ but more than those in ‘C’.
Just-in-time (JIT) system: JIT is a system of inventory control in which a manufacturer coordinates production with suppliers so that raw materials of components arrive just as they are needed in the production process. This system helps to minimize carrying the cost of inventory.
Red-line method: Under this system a red line is drawn around the inside of the bin used for stocking, inventories. This red line represents the re-order point of inventories. A reorder is placed, when the level of inventories reaches down to the red line drawn in the bin.
Two bin system: Under two bins system, inventories are stocked in two separate bins. When the stocks in one bin are completely used, the firm places a reorder to fill the bin and inventories are drawn for use from the second bin.
Computerized system: Larger firms design a specific computer programming to count the stock of inventories. It is a system in which a computer is used to determine the reorder point and to adjust inventory balances. The computer starts with the level of inventory counted in memory. When inventories are drawn the computer records them and the balance of inventories is revised. Once the balance reaches the reorder point, a re-order is automatically placed. After the receipt of reordered quantity, the balance of inventory in record increases.
Budgetary control system: Under this system, budgeted level of inventory usage is determined in advance. The actual usage of inventories is compared against budgeted consumption to identify the favorable and unfavorable variances of inventory usage.