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Table of contents

1. Objective behind the project
2. About the organization
3. Financial statements and cash flow analysis
- Meaning
- Relationship b/w financial statements
4. Cash flow management
- Cash cycle
- Importance of cash management for business
- Cash conversion period
- Credit policy
5. Cash budget
- Inflow and outflow of cash
- Projecting operating expenses
- Projecting cost of goods sold
- Projecting major purchases
- Projecting for debt payments
- Putting the projections together
- Cash-flow surpluses and shortages
6. Cash flow statement
- The Importance of Cash Management
- Cash vs. Cash Flow
- Components of cash flow
7. Funding a Business
- Sources of finance
- Funding Options
- Types of analysis
- Financial Ratios
8. Financial analysis

- Goals and drawbacks
- The interpretation of company accounts
9. Performance analysis of the company
- Framework for linking financial business objectives
- Liquidity ratios
- Profitability analysis ratios
- Activity analysis ratios
- Capital structure analysis ratios
- Capital market analysis ratios
10. Working capital
- Nature and Importance of working capital
- Working capital cycle
- The Management of Working Capital
- Approaches to Working Capital Management
- Working Capital Analysis
- Factors influencing working capital
- Consequences of under and over assessment of working capital
- Financing Working Capital
- How is working capital reflected in balance sheet
- Working capital ratios
11. Inventory
- Why hold Inventory
- The cost of Inventory
- Opposing Views of Inventory
- Why We Want to Hold Inventories?
- Why We Do Not Want to Hold Inventories?
- Independent Demand and Dependent Demand Inventory Systems
- Inventory Costs
- Behavior of EOQ Systems Successful inventory management
12. Basic financial tools and terms

 Identify ways a financial statement impacts my company.
 Demonstrate how different financial instruments impact financial statements.
 Identify the characteristics of the statement of cash flows.
 List ways a company's financial statements can impact the value of its stock.
 Calculate a company’s profitability ratios.
 Calculate a company's liquidity ratios.
 Ways to manage the finances to achieve the strategic goals of the institution
 To increase profitability
 To reach self-sufficiency/breakeven point.
 To increase efficiency especially reducing the cost per client
 Find the optimum level of each different operational expense including the cost of
 To manage the costs of human resources as part of overall human resource
 How to manage liquidity—i.e., how to keep solvent at the same time as disbursing the
maximum number of loans, setting a target level of liquidity.
 What is the best financing structure, i.e., how much debt including from commercial
sources and how much capital do you need?
 What should the asset structure be?
 How to manage the fixed assets, i.e., the depreciation policy, how to finance them, are
they insured, are they safe?
 How to undertake trend analysis and to compare actual performance against planned

Analysis of the company/organization

Founded in 1958 by Sh SL Minda, the Minda Group today is one of the leading
manufacturer of automobile components with a turnover of Rs. 3,690 million and
employs 3,000 people India-wide.
The group is a major supplier to OEM's both in India and overseas. The group companies
are accredited with quality and environment certification and have collaborations and
strategic alliances with international manufacturers.
The Group manufactures different lines of automobile parts:



For over four decades, MINDA has been a major presence in India's automobile industry.
These forty-five years have been interspersed by a number of technological innovations
that have gone on to become industry standards. .
For assimilating the latest technologies, Minda has entered into strategic alliances and
technical collaborations with leading international companies. This has provided Minda

with the cutting edge in product design and technology to meet strict international quality
The Groups' companies are accredited with QS 9000 and ISO-14001 certification from
TUV, GERMANY. We are one of India's leading manufacturers of Security systems,
Wiring harnesses, Couplers & Terminals and Instrument Clusters catering to all major
two & four wheeler vehicles manufacturer in India.
The products are well accepted worldwide both with O.E.M's and the after market.
Minda is a major supplier to General Motors India, Ford, Telco, Maruti (Suzuki),
Mercedez Benz, Daewoo, Fiat, Mahindras, Hero Motors, Kinetic Engg., Piaggio,
Peugeot, Royal Enfield, Escorts, LML (Piaggio), TVS-Suzuki, Bajaj (Kawasaki), Kinetic
Honda, Honda Scooters, etc.
Organization & Management
To ensure product specialization and optimization of capacity the manufacturing is
managed between the Ashok Minda and NK Minda groups. This also encourages
synergies in manufacturing and product development.
Sales Growth 2,472


Rs. Million





01-02 02-03 03-04 04-05 05 -06 06-07 07-08

Export Sales

Value Engineering
Design Capability
Process Improvement


Focus Area

 On time

 First Time Righ t

Financial Statements and Cash Flow Analysis
Financial statements provide information about the financial activities and position of a
firm. Financial analysis is an aspect of the overall business finance function that involves
examining historical data to gain information about the current and future financial health
of a company. Financial analysis can be applied in a wide variety of situations to give
business managers the information they need to make critical decisions. Finance is the
language of business. Goals are set and performance is measured in financial terms.
Plants are built, equipment ordered, and new projects undertaken based on clear
investment return criteria. Financial analysis is required in every such case.

The finance function in business organizations involves evaluating economic trends,
setting financial policy, and creating long-range plans for business activities. It also
involves applying a system of internal controls for the handling of cash, the recognition
of sales, the disbursement of expenses, the valuation of inventory, and the approval of
capital expenditures. In addition, the finance function reports on these internal control
systems through the preparation of financial statements, such as income statements,
balance sheets, and cash flow statements.

Finally, finance involves analyzing the data contained in financial statements in order to
provide valuable information for management decisions.

Documents Used in Financial Analysis

 Balance sheet
 Profit & Loss statement
 Funds flow statement
 Cash flow statement

The two main sources of data for financial analysis are a company's balance sheet and
income statement. The balance sheet outlines the financial and physical resources that a
company has available for business activities in the future. It is important to note,
however, that the balance sheet only lists these resources, and makes no judgment about

how well they will be used by management. For this reason, the balance sheet is more
useful in analyzing a company's current financial position than its expected performance.

The main elements of the balance sheet are assets and liabilities. Assets generally include
both current assets (cash or equivalents that will be converted to cash within one year,
such as accounts receivable, inventory, and prepaid expenses) and non-current assets
(assets that are held for more than one year and are used in running the business,
including fixed assets like property, plant, and equipment; long-term investments; and
intangible assets like patents, copyrights, and goodwill). Both the total amount of assets
and the makeup of asset accounts are of interest to financial analysts.

Using company accounts
The wealth of information can be obtained from company accounts. The information can
provide a valuable insight into our customers and their business: their trading
performance, creditworthiness, financial health and even their expansion plans for the
future. Much of this is simply stated in the notes or can be gleaned from the written
reports from the chairman, chief executive and finance director. Further insight can be
gleaned from a straightforward analysis of the figures from the Profit and Loss, Balance
Sheet and Cash Flow reports.

Cash-flow management
In its simplest form cash flow is the movement of money in and out of your business.
Cash flow is the life-blood of all growing businesses and is the primary indicator of
business health. The effect of cash flow is real, immediate and, if mismanaged, totally
unforgiving. Cash needs to be monitored, protected, controlled and put to work. There are
four principles regarding cash management:
• First, cash is not given. It is not the passive, inevitable outcome of your business
endeavours. It does not arrive in your bank account willingly. Rather it has to be tracked,
chased and captured. You need to control the process and there is always scope for
• Second, cash management is as much an integral part of your business cycle as, for
example, making and shipping widgets or preparing and providing detailed consultancy

• Third, you need information. For example, you need immediate access to information
 your customers’ credit worthiness
 your customers’ current track record on payments
 outstanding receipts
 your suppliers’ payment terms
 short-term cash demands
 short-term surpluses
 investment options
 current debt capacity
 longer-term projections
• Fourth, be masterful
Professional cash management in business is not, unfortunately, always the norm. You
will find, therefore, that the cash management process has a double benefit: it can help
you to avoid the debilitating downside of cash crises and, in addition, grant you a
commercial edge in all your transactions.

Cash flow can be described as a cycle: business uses cash to acquire resources.
The resources are put to work and goods and services produced. These are then sold to
customers, funds are collected and deposited and so the cycle repeats. But what is
crucially important is to actively manage and control these cash inflows and outflows. It
is the timing of these money flows which can be vital to the success, or otherwise, of our
business. It must be emphasized that profits are not the same as the cash flow. It is
possible to project a healthy profit for the year and yet face a significant and costly
monetary squeeze at various points during the year, such that may worry whether
company can survive.
Inflows are the movement of money into the business. Inflows are most likely from the:
• Receipt of monies from the sale of goods/services to customers
• Receipt of monies on customer accounts outstanding

• Proceeds from a bank loan
• Interest received on investments
• Investment by shareholders in the company
Outflows are the movement of money out of the business. Outflows are most likely from:
• Purchasing finished goods for re-sale
• Purchasing raw materials and other components needed for the manufacturing of the
final product
• Paying salaries and wages and other operating expenses
• Purchasing fixed assets
• Paying principal and interest on loans
• Paying taxes

Cash Budget
Cash budget basically incorporates estimates of future inflows and outflows of cash over
a projected short period of time which may usually be a year, a half or a quarter year.
Effective cash management is facilitated if the cash budget is further broken down into
month, week or even on daily basis.
There are two components of cash budget
(i) Cash inflows and
(ii) Cash outflows.
The main sources for these flows are given hereunder:
Cash Inflows
(a) Cash sales
(b) Cash received from debtors
(c) Cash received from loans, deposits, etc.
(d) Cash receipt of other revenue income
(e) Cash received from sale of investments or assets.
Cash Outflows
(a) Cash purchases
(b) Cash payment to creditors

(c) Cash payment for other revenue expenditure
(d) Cash payment for assets creation
(e) Cash payment for withdrawals, taxes
(f) Repayment of loans, etc.
A suggestive format for ‘Cash Budget’
Particulars Month
January February March

Estimated cash inflows
I. Total cash inflows
Estimates cash outflows
II. Total cash outflows
III. Opening cash balance
IV. Add/deduct surplus/deficit
during the month (I – II )
V. Closing cash balance (III – IV)
VI. Minimum level of cash balance
VII. Estimated excess or shortfall of
cash (V – VI)

Cash-flow management is vital to the health of our business.
Hopefully, each time through the cycle, a little more money is put back into the business
than that flows out. But not necessarily, and if we don’t carefully monitor our cash flow
and take corrective action when necessary, our business may find itself sinking into
trouble. Cash outflows and inflows seldom seem to occur together. More often than not,

cash inflows seem to lag behind our cash outflows, leaving our business short. This
money shortage is our cash-flow gap. Managing cash flow allow us to narrow or
completely close our cash-flow gap and we do this by examining the different items that
affect the cash flow of our business as listed above.
Answer the following questions:
• How much cash does business have?
• How much cash does business generate?
• How much cash does my business need in order to operate?
• When is it needed?
• How do my income and expenses affect my capacity to expand my business?
If we can answer these questions, we can start to plot our cash-flow profile and
importantly if we can plan a response in accordance with these answers, we are then
starting to manage our cash flow.
Advantages of managing cash flow
The advantages are
• We should know where our cash is tied up
• We can spot potential bottlenecks and act to reduce their impact
• We can plan ahead
• We can reduce dependence on bankers and save interest charges
• We can identify surpluses which can be invested to earn interest
• We are in control of your business and can make informed decisions for future
development and expansion

Cash conversion period
The cash conversion period measures the amount of time it takes to convert product or
service into cash inflows. There are three key components:
1. The inventory conversion period – The time taken to transform raw materials into a
state where they are ready to fulfill customers’ requirements. This is important for both
manufacturing and service industries. A manufacturer will have funds tied up in physical
stocks while service organizations will have funds tied up in work-in-progress that has
not been invoiced to the customer.

2. The receivables conversion period – The time taken to convert sales into cash inflows.
3. The payable deferrable period – The time between purchase/usage of inputs e.g.
materials, labour, etc. to payment.
The net period of (1+2)-3 gives the cash conversion period (or working capital cycle).
The trick is to minimize (1) and (2) and maximize (3), but it is essential to consider the
overall needs of the business.
The chart below is an illustration of the typical receivables conversion period for many
businesses. The flow chart represents each event in the receivables conversion period.
Completing each event takes a certain amount of time. The total time taken is the
receivables conversion period. Shortening the receivables conversion period is an
important step in accelerating our cash inflows.

Accelerating cash inflows
Accelerating cash inflows will improve our overall cash flow. The quicker we can collect
cash, the faster we can spend it in pursuit of further profit. Accelerating our cash inflows
involves streamlining all the elements of the cash conversion period:
• The customer’s decision to buy
• The ordering procedure
• Credit decisions

• Fulfillment, shipping and handling
• Invoicing the customer
• The collection period
• Payment and deposit of funds

Customer purchase decision and ordering
Without a customer, there will be no cash inflow to manage. Make sure that business is
advertising effectively and making it easy for the customer to place an order. Use of
accessible, up-to-date catalogues, displays, price lists, proposals or quotations to keep our
customer informed. Provide ways to bypass the postal service. Accept orders over the
Internet, by telephone, or via fax. Make the ordering process quick, precise and easy.

Credit policy
Company’s credit policy is important. It should not be arrived at by default. It should be a
Board decision and should determine such items as company’s credit criteria, the credit
rating agency to be used, the person responsible for obtaining that credit rating, the
company’s standard payment terms, the procedure for authorizing any exemption and the
requirements for regular reporting. The policy should be written down and kept up to date
with supplements as necessary concerning any changes to the creditworthiness of specific
customers, any warnings or notes of current poor experience. The policy should be
disseminated to all sales staff, the financial controller and the Board.

Customer credit worthiness
Credit checks for new customers and reviews for existing customers are important.
Checking credit references, obtaining credit reports and chasing references will cost time
and resources. Start credit decision-making process when first meeting with new
prospective customers or clients. If necessary, consider allowing small orders to get
underway quickly with a small start limit for new accounts. This may be a reasonable
level of risk and may ensure that new business is not lost. With existing customers or
clients, it is best to anticipate a request for an increase in their credit limit whenever

possible. This can be accomplished by monitoring customers’ current credit limits and
payment performance and comparing them with your expected levels of future business.
Ask yourself:
• Do you methodically check the financial standing of all new customers before executing
the first order?
• Do you periodically review the financial standing of existing customers?
• Do you undertake a full recheck of the financial standing of existing customers whose
purchases have recently shown a substantial increase?
• Do you use the telephone when checking trade references? Suppliers will often tell you
over the telephone what they would not put in writing
• Do you recognize that salesmen are by nature optimists? Use other sources of
information before increasing/establishing credit for customers
• Is there one person in your firm who is ultimately responsible for supervising credit and
for ensuring the prompt collection of monies due and who is accountable if the credit
position gets out of hand?
• Are you clear in your own mind as to how you assess credit risks and how you impose
normal limits – both in terms of total indebtedness for each customer’s account and also
in terms of payment period?
• Do you make your credit terms very clear? In a sales negotiation it is professional, not
anti-selling, to be upfront about terms for payment. On an ‘Account Application Form’
include a paragraph for the buyer to sign, agreeing to comply with your stated payment
terms and conditions of sale. On a ‘welcome letter’ restate the terms and conditions. On
an ‘Order Acknowledgement’ again stress your payment terms and conditions of sale. On
‘Invoices and Statements’ show the payment terms boldly on the front. On invoices also
show the due date e.g. ‘payment terms: X days from invoice date – payment to reach us
by (date)’
To save time and resources use the 80/20 rule to identify the few accounts that buy most
of your sales; that is, list accounts in descending order of value and give the top 80 per
cent a full credit check and review; undertake only brief checks on smaller ones. Review
the check on specific smaller accounts if monitoring starts to reveal a poor payment
performance. A full credit report on a limited company will cost in the region of from a

rating agency. Credit agencies should give you full customer details, financial results,
payment experience of other suppliers, county court judgements, registered lending and a
recommended credit rating. This information can be received online. Use an agency with
a complete database and a fast response. The reference agency will also provide a
rating/score i.e. 80/100 would indicate a safe risk, 60/100 is not so safe, 20/100 would
probably indicate that the company is either unlikely to survive or may be a new start-up
with little capital (or both). The agency will provide a full description to accompany the
score. If our customer is a sole trader or a partnership we can still obtain information in
the same way as we would with a limited company.

Cash-flow budget
The cash-flow budget projects your business cash inflows and outflows over a certain
period of time. A typical cash-flow budget predicts cash inflows and outflows on a
month-to-month, weekly or daily basis. The cash-flow budget can help predict your
business’s cash-flow gaps – periods when cash outflows exceed cash inflows when
combined with your cash reserves. This will allow us to take steps to ensure that the gaps
are closed, or at least narrowed, to avoid expensive, uncontrolled overdrafts. These steps
might include lowering our investment in accounts receivable or inventory, increasing or
advancing receipts, or looking to outside sources of cash, such as a short-term loan, to fill
the cash-flow gaps. If we want to apply for a loan, we need to create a cash-flow budget
that extends for several years into the future, as part of the application process. But for
our business needs, a six-month cash-flow budget is probably about right. It predicts
future events early enough for you to take some corrective action and yet may minimize
the amount of uncertainty involved in the budget preparation.
Preparing a cash-flow budget involves:
• preparing a sales forecast
• projecting our anticipated cash inflows
• projecting our anticipated cash outflows
• putting the projections together for our cash-flow bottom line
• identifying surpluses and the opportunity to place short-term money on deposit to earn

• identifying deficits and the need to accelerate cash flows or borrow short-term money
• identifying longer-term surpluses to fund expansion and development
• identifying longer-term needs for funds, either from banks or shareholders

Cash inflows
Forecasting our sales is key to projecting our cash receipts. Any forecast will include
some uncertainty and will be subject to many variables: the economy, competitive
influences, demand, etc. It will also include other sources of revenue such as investment
income, but sales are the primary source. If our business only accepts cash sales, then our
projected cash receipts will equal the amount of sales predicted in the sales forecast.
Projecting cash receipts is a little more involved if the business extends credit to its
customers. In this case, we must take into account the collection period for our accounts
Accounts receivable
Accounts receivable can be looked upon as an investment. That is, the money tied up in
accounts receivable is not available for paying invoices, repaying loans, or expanding our
business. If credit is normally extended to our customers, the payment of accounts
receivable is likely to be the most important source of cash inflows. At worst, unpaid
accounts receivable will leave our business without the cash to pay its own bills. More
commonly, late-paying or slow-paying customers will create cash shortages, causing our
business to be late in covering its own payment obligations, spoiling its reputation and
upsetting its suppliers. The payoff from an investment in accounts receivable does not
occur until your customers pay our invoices. The following analysis tools can be used to
help determine the effect our business’s accounts receivable is having on our cash flow:
• Average collection period measurement
• Accounts receivable to sales ratio
• Accounts receivable ageing schedule
Average collection period
The average collection period measures the length of time it takes to turn our average
sales into cash. A longer average collection period represents a higher investment in
accounts receivable and less cash available to cover cash outflows such as for purchases

and expenses. Reducing our average collection period will reduce our investment in
accounts receivable and improve our cash flow. The average collection period in days is
calculated by dividing our present accounts receivable balance by average daily sales:
Average collection period = current accounts receivable balance / average daily sales
where average daily sales = annual sales /365

The ageing schedule can be used to identify the customers that are extending the payment
time. If the bulk of the overdue amount in receivables is attributable to one customer,
then steps can be taken to see that this customer’s account is collected promptly. Overdue
amounts attributable to a number of customers may signal that our business needs to
tighten its general credit policy towards new and existing customers. The ageing schedule
also identifies any recent changes in the accounts making up our total accounts receivable
balance. If the makeup of accounts receivable changes, when compared to the previous
month, we should spot the change rapidly. Is the change the result of a change in sales,
your credit policy, or is it caused by a billing problem? What effect will this change in
accounts receivable have on next month’s cash inflows? The accounts receivable ageing
schedule can sound an early warning and help us protect our business from cash-flow

Cash outflows
Projecting cash outflows for our cash-flow budget involves projecting expenses and costs
over a period of time. An accounts payable ageing schedule helps to determine our cash
outflows for certain expenses in the near future – 30 to 60 days. This will give us a good
estimate of the cash outflows necessary to pay our accounts payable on time. The cash
outflows for every business can be classified into one of four possible categories:
• Costs of goods sold
• Operating expenses
• Major purchases
• Debt payments
By classifying business expenses, it will help us to ensure that all our outflows are readily

Accounts payable ageing schedule
The accounts payable ageing schedule is a useful tool for analysing the makeup of our
accounts payable balance. Looking at the schedule allows us to spot problems in the
management of payables early enough to protect our business from any major trade credit
problems. The accounts payable ageing schedule can help us determine how well we are
(or are not) paying our invoices. While it is good cash-flow management to delay
payment until the invoice due date, take care not to rely too heavily on our trade credit
and stretch our goodwill with suppliers. Paying bills late can indicate that we are not
managing our cash flow the way a successful business should.
An accounts payable ageing report looks almost like an accounts receivable ageing
schedule. However, instead of showing the amounts our customers owe to us, the
payables ageing schedule is used for listing the amounts we owe to our various suppliers
– a breakdown by supplier of the total amount on our accounts payable balance. Most
businesses prepare an accounts payable ageing schedule at the end of each month. A
typical accounts payable ageing schedule consists of six columns,the number of columns,
however, can be adjusted to meet your reporting needs. For instance, we might prefer
listing the outstanding amounts in 15-day intervals rather than 30-day intervals. We
should take into account suppliers’ terms of trade – to which we already have agreed.
For example, if G.R.H. Unlimited was an important supplier for Technical Office
Supplies Ltd, then the past due amounts listed for G.R.H. Unlimited should be paid in
order to protect the trade credit established. The schedule can also be used to help
manage and improve your business’s cash flow.

Projecting operating expenses
Expenses tend to come under four headings:
o debt payments,
o cost of goods sold,
o asset purchases and
o operating expenses.

Operating expenses include payroll and payroll taxes, utilities, rent, insurance and repairs
and maintenance. Operating expenses can be fixed or variable. Rent, for example, is
fairly fixed, being the same amount each month. However, payroll or utilities may vary in
line with our sales projections and have a seasonal aspect.

Projecting cost of goods sold
Outflows for the cost of goods sold, i.e. purchases of materials, will be in line with the
sales projection after allowing for our production cycle, changes in the level of inventory
and our payment terms.

Projecting major purchases
Purchasing new assets for the company tend to occur when the business is expanding, or
improving its cash-flow position, or the result of machinery needing to be replaced. Cash
outflow in this area is generally large and irregular. Examples of fixed asset expenditure
would be on new company cars, computers, vans and machinery.

Projecting for debt payments
Projecting for debt payments is the easiest category to predict when preparing the cash-
flow budget. Mortgage payments and lease hire payments will follow the schedule agreed
with the lender. Only payment against an overdraft, for example, will be variable by

Putting the projections together
The completed cash-flow budget combines the following information on a monthly,
weekly or even daily basis:
• Opening cash balance
plus Projected cash inflows
• Cash sales
• Accounts receivable
• Investment interest
less Projected cash outflows

• Operating expenses
• Purchases
• Capital investment
• Debt payment
• cash-flow bottom line (the closing cash balance)
The closing cash balance for the first period becomes the second period’s opening cash
balance. The second period’s closing balance is determined by combining the opening
balance with the second period’s anticipated cash inflows and cash outflows. The closing
balance for the second period then becomes the third month’s opening cash balance and
so on until the last period of the cash-flow budget is completed.
A positive cash-flow bottom line indicates your business has a cash surplus at the end of
the period. We can plan to place money on short-term deposit to earn interest, or fund
capital investment for longer-term expansion and development. A negative cash-flow
bottom line indicates that our business has a cash-flow gap. If a cash-flow gap is
predicted early enough, we can take cash-flow management steps to ensure that our cash-
flow gap is closed, or at least narrowed in order to protect our business for the future.
These steps might include:
• increasing sales
• Increasing margins, i.e. maximize the difference between costs and prices by cutting
costs and/or raising selling price. However, care must be taken not to compromise on
quality or to lose customers because our prices are too high
• Preventing leakage from the cycle. We have already mentioned the importance of
managing debtors, but we also need to control stocks effectively to avoid theft,
deterioration, etc.
• Increasing our anticipated cash inflows from accounts receivable collections
• Decreasing our anticipated cash outflows by cutting back on inventory purchases or
cutting certain operating expenses
• Postponing a major purchase
• Rolling over a debt repayment
• Looking to outside sources of cash, such as a short-term loan

Cash-flow surpluses and shortages
• First, we can put the surplus to work by placing the surplus on short-term deposit,
either overnight or on term deposit with a bank or with a proprietary money fund, to earn
interest until we are ready to put the money to other uses
• Second, we can use the money to fund capital investment for development and
expansion in line with our longer-term corporate plan
• Third, if the funds truly are surplus to current and future requirements, then we can pay
out money to stakeholders
• Finally, we can advance payments to creditors and by so doing enhance our credit
credentials for the future. Similarly, we can pay down debt to improve our balance sheet
gearing ratio and make the payment profile for future principal and interest payments
more manageable.
If we choose this route, then there are considerations of whether there is a premium to be
paid for early repayment and whether it restricts our future flexibility unduly.

Sources of finance
If there is a requirement for additional funds, either to meet short-term shortages or for
longer-term development, there are several sources of new funds that can be considered.
These are outlined, in brief, below.
First, we will have an overdraft facility with our relationship bank. We should negotiate
with the bank to agree acceptable limits to the facility and agree competitive interest
rates. We’ll be paying a premium over the base rate; haggle the premium.
Second, establish a short-term borrowing facility with the bank whereby, at short notice,
you can draw down a specific amount to be repaid in a specified number of days. The
limits to the facility, the repayment periods and the interest rates will be negotiated with
the bank. The interest on a short-term facility may be more favourable than for an
Third, as a natural extension of the two sources above, establish a revolving credit
facility with the bank. The facility will enable us to make withdrawals at short notice. It

will also enable us to make unscheduled repayments whenever we have a cash surplus:
the saving on interest owed may outweigh the interest that could have been earned from a
separate investment.
Fourth, for longer-term needs, we can raise fixed-term finance from the bank or other
institutions. The finance can be loan debt or bond issue and can be general company debt
or project specific. The interest rate can be fixed or variable. Although we want to
maintain a good relationship with our bank, there are now many competing sources of
sound finance in the market, especially since the de-mutualisation of many of the
building societies. It is simply good business to take the time to establish fresh links to
some of these.
Beyond that we can raise further equity, either from a private placing of shares or a
public offering. This is an important source of funds and can be essential if the debt-
equity ratio is to be maintained at acceptable levels. It requires consideration of the time,
effort and cost required for set-up. Finally, an excellent and sometimes overlooked,
source of finance is factoring, which we turn to in some detail below.

A possible solution to short-term cash-flow problems is factoring. Factoring involves
‘selling’ our accounts receivable to a factoring company at a discount. That is, getting
cash immediately for our sales with a cut being taken by the factoring company.
Factoring contracts all have the following elements in common:
• Advance rate – The advance rate is the percentage of accounts receivable that
companies will advance to us. Some companies will advance us the full 100 per cent up
front. Others will advance say, 70 per cent and then will pay us the balance once the
receivables are collected. The typical range is 60 per cent to 90 per cent of our account
• Discount rate – The discount rate is the fee charged by the factoring company for the
financing. The typical range is 1 per cent to 7 per cent of our accounts receivable,
depending on the accounts receivable payment terms
• Recourse vs. non-recourse – In a non-recourse agreement, the factoring company bears
the burden of collecting the accounts receivable. In a recourse agreement, the small

business owner bears the burden of bad debts (in other words, if they are uncollectible,
they will be charged back to us). Obviously for a small business owner, the non-recourse
agreement is preferred, although the rates we’ll get will not be as good as with a recourse
agreement. The terms will vary from one factoring company to another. Always shop
around before we make a decision. That said, the terms and rates offered to us will
depend upon our credit (or debtor) worthiness. Small businesses with higher sales
volumes or with what are viewed as stronger account debtors get better rates than those
with small sales volumes or more questionable account debtors. Smaller the business, the
worse the terms. Before we commit to factoring, we must approach our bank first for a
loan using the accounts receivables as collateral. Bank fees will typically be much lower
than factoring fees and we should definitely pursue that option if it is available to us.

The Importance of Cash Management
Understanding the basic concepts of cash flow will help to plan for the unforeseen
eventualities that nearly every business faces.

Cash vs. Cash Flow
Cash is ready money in the bank or in the business. It is not inventory, it is not accounts
receivable (what we owe), and it is not property. These can potentially be converted to
cash, but can't be used to pay suppliers, rent, or employees.

Profit growth does not necessarily mean more cash on hand. Profit is the amount of
money we expect to make over a given period of time, while cash is what we must have
on hand to keep our business running. Over time, a company's profits are of little value if
they are not accompanied by positive net cash flow. We can't spend profit; we can only
spend cash.

Cash flow refers to the movement of cash into and out of a business. Watching the cash
inflows and outflows is one of the most pressing management tasks for any business. The
outflow of cash includes those checks we write each month to pay salaries, suppliers, and
creditors. The inflow includes the cash we receive from customers, lenders, and investors.

Positive Cash Flow
If its cash inflow exceeds the outflow, a company has a positive cash flow. A positive
cash flow is a good sign of financial health, but is by no means the only one.

Negative Cash Flow
If its cash outflow exceeds the inflow, a company has a negative cash flow. Reasons for
negative cash flow include too much or obsolete inventory and poor collections on
accounts receivable (what your customers owe you). If the company can't borrow
additional cash at this point, it may be in serious trouble.

Components of cash flow
A "Cash Flow Statement" shows the sources and uses of cash and is typically divided
into three components:

Operating Cash Flow: - Operating cash flow, often referred to as working capital, is the
cash flow generated from internal operations. It comes from sales of the product or
service of your business, and because it is generated internally, it is under your control.

Investing Cash Flow: - Investing cash flow is generated internally from non-operating
activities. This includes investments in plant and equipment or other fixed assets,
nonrecurring gains or losses, or other sources and uses of cash outside of normal

Financing Cash Flow :- Financing cash flow is the cash to and from external sources,
such as lenders, investors and shareholders. A new loan, the repayment of a loan, the
issuance of stock, and the payment of dividend are some of the activities that would be
included in this section of the cash flow statement.

Cash Flow Statement
A cash flow statement shows where an institution’s cash is coming from and how it is
being used over a period of time.

A cash flow statement classifies the cash flows into operating, investing and financing
 Operating activities: services provided (income-earning activities).
 Investing activities: expenditures that have been made for resources intended to
generate future income and cash flows.
 Financing activities: resources obtained from and resources returned to the owners,
resources obtained through borrowings (short-term or long-term) as well as donor
Can use either
 The direct method, by which major classes of gross cash receipts and gross cash
payments are shown to arrive at net cash flow (recommended by IAS)
 The indirect method, works back from net profit or loss, adding or deducting noncash
transactions, deferrals or accruals of past or future operating cash receipts or
payments, and items of income or expense associated with investing or financing cash
flows to arrive at net cash flow.
Taken together, the ratios in the framework provide a perspective on the financial health
of the lending/savings, and other operations of the institution. No one ratio tells it all.
There are no values for any specific ratio that is necessarily correct. It is the trend in these
ratios which is critically important. Ratios must be analyzed together, and ratios tell you
more when consistently tracked over a period of time. Frequent measurement can help
identify problems which need to be solved before they fundamentally threaten the MFI,
thus enabling correction. Trend analysis also helps moderate the influence of seasonality
or exceptional factors. Different levels of users will require a set of different indicators
and analysis. They might be summarized as follows:
o Operations staff needs portfolio quality, efficiency ratios, outreach, and branch level
o Senior management needs institution-level portfolio quality, efficiency profitability,
liquidity, and leverage.
o Regulators need capital adequacy and liquidity.
o Donors/investors need institution-level portfolio quality, leverage and profitability.

In addition to analyzing past trends, ratios, in conjunction with policy decisions, are
helpful when preparing financial projections.

Cash vs. Working Capital
So far, we have discussed funds in terms of cash only. A broader and more useful way of
looking at the availability of funds involves the concept of working capital. How does
your company create income? If you manufacture a product, you use funds to purchase
inventory, produce goods with that inventory, convert those goods into accounts
receivable by selling them, and convert accounts receivable into cash when you take
payment. If you are a merchandising firm, the process is basically the same, although you

probably purchase finished goods instead of producing them. Each of the components in
this process is a current asset, such as an asset that you can convert into cash in a
relatively short period (usually, but not always, one year) as a result of your normal
business operations. Inventory and accounts receivable, for example, are not as liquid as
cash, but your business expects to convert both to cash before too long. Current
liabilities, on the other hand, are obligations that you must meet during the same
relatively short time period that defines your current assets. Notes payable, accounts
payable, and salaries are examples of current liabilities. The accrual basis more
accurately estimates income.

Funding a Business
Before making a choice of how we intend to fund the business, there are a few key
factors that need to be taken into consideration. Take a look at what they are as a starting
guide and some of the funding options available for start-ups and growing enterprises.
Factors to Consider
 At what stage is our business right now? How risky is our business proposition?
 Prioritize our funding needs: Do we require short-term or long term financing?
 How much funds do we intend to raise?
 How would the funds be utilized? What is the money used for – Is it for operational
needs or for capital outlay (for assets like machinery, equipment)?

 How long do we think the money can last? We need to work out some cash flow
 Do we need the entire required amount at one go or can it be raised in stages over a
period of time?
 What type of financing form would we be willing to consider –borrowing, which
means we need to plan how and when we can pay it back or selling a certain
percentage of the business ownership to an interested and willing investor?

Funding Options
Choosing the right financing is critical to a business. Sources of funding can be broadly
categorized into two types:
Debt-financing – Typically refers to borrowing or taking a loan from an external party
(the lender). Bank loan is a common example. This means that we borrow or owe the
money and we agree to pay it back over a period of time. Normally, debt-financing tends
to be interest bearing loans. Whether or not we succeed in your business, we will still
need to repay the amount.
Bank borrowings alone may not be suitable or sufficient for all companies. A mixture of
both debt and equity are considered good.
Equity Financing – This form of financing refers to selling a portion of your company to
interested investors in exchange for cash capital. The investors will then have a stake or
ownership of your company, and therefore becomes a shareholder. As investors, they are
looking for capital returns over a period of time and as an entrepreneur, you would need
to be able to succinctly convince investors of your growth and revenue potential.

Types of analysis
In trend analysis, ratios are compared over time, typically years. Year-to-year
comparisons can highlight trends and point up the need for action. Trend analysis works
best with three to five years of ratios.
Another type of ratio analysis, cross-sectional analysis, compares the ratios of two or
more companies in similar lines of business. One of the most popular forms of cross-

sectional analysis compares a company's ratios to industry averages. These averages are
developed by statistical services and trade associations and are updated annually.
Financial ratios can also give mixed signals about a company's financial health and can
vary significantly among companies, industries, and over time. Other factors should also
be considered such as a company's products, management, competitors and vision for the
By computing the financial ratios, we can also detect certain relationships between the
different types of information. It gives us a quick indication of the firm's performance in
the areas of liquidity, profitability, capital structure as well as the financial position and
potential risk involved.

The interpretation of company accounts-ratio analysis
Why ratios: Ratios are the means of presenting information, in the form of a ratio or
percentage, which enables a comparison to be made between one significant figure and
another. Often the same ratios of like firms are used to compare the performance of one
firm with another. A "one off" ratio is often useless - trends need to be established by
company ratios over a number of years.
 The great volume of statistics made available in the annual accounts of companies
must be simplified in some way. Present and potential investors can therefore quickly
assess whether the company is a good investment or not.
 Financial ratio analysis is helpful in assessing an organisation's internal strengths and
weaknesses. Potential suppliers will, for example, want to judge credit worthiness.
 Ratios by themselves provide no information; they simply indicate by exceptions
where further study may improve company performance. Management can compare
current performance with previous periods and competing companies.

Which areas are used for analysis
Four key areas are generally used for analysis:
 Profitability
 Liquidity
 Leverage (capital structure)

 Activity or management effectiveness (efficiency).

a) Profitability
In most organisations profits are limited by the cost of production and by the
marketability of the product. Therefore, "profit maximisation" entails the most efficient
allocation of resources by management and "profitability ratios" when compared to others
in the industry will indicate how well management has performed this task.
Key questions to be identified in profitability analysis include:
 Does the company make a profit?
 Is the profit reasonable in relation to the capital employed in the business?
 Are the profits adequate to meet the returns required by the providers of capital, for
the maintenance of the business and to provide for growth?
 How are sales and trading profit split among the major activities?
 To what extent are changes due to price change?
 To what extent does volume change?
 Does inter-company transfer pricing policy distort the analysis?
 Has the appropriate proportion of profit been taken in tax charged?
 What deferred taxation policy is being followed?
 Has the share of profit (or loss) attributable to minority interests in subsidiaries
changed? If so, is it clear why?
 Are profits and losses on sales of fixed assets:
-treated as adjustments of depreciation charges?
-disclosed separately "above the line" in the profit and loss account?
-treated as "below the line" items in the profit and loss account?
-transferred directly to reserves?
 What has been included in Extraordinary Items?
 Should any of these items be regarded as part of the ordinary business of the
 Do any items tend to recur year after year?

 Is it clear which items have been transferred directly to reserves without going
through the profit and loss account?
 Is such treatment appropriate in each case?

b) Liquidity
"Liquidity measures" are based on the notion that a business cannot operate if it is unable
to pay its bills. A sufficient amount of cash and other short-term assets must be available
when needed. On the other hand, because most short term assets do not produce any
return, a strong liquidity position will be damaging to profits. Therefore, management
must try to keep the firm's liquidity as low as possible whilst ensuring that short term
obligations will be met. This means that industries with stable and predictable conditions
will generally require smaller current ratios than will more volatile industries.
Key questions to be identified in liquidity analysis include:
 Has the business sufficient liquid resource to meet immediate demands from
 Has the business sufficient resources to meet the requirements of creditors due for
payment in the next 12 months i.e. creditors payable within one year?
 Has the business sufficient resource to meet the demands of its fixed asset
replacement programme and its commitments to providers of long-term capital falling
due for repayment in say, the next five years?

c) Leverage
"Leverage ratios" show how a company's operations are financed. Too much equity in a
firm often means the management is not taking advantage of the leverage available with
long-term debt. On the other hand, outside financing will become more expensive as the
debt-to-equity ratio increases. Thus, the leverage of an organisation has to be considered
with respect both to its profitability and the volatility of the industry.
Key questions to be identified in leverage analysis include:
 What sort of capital has the company issued?
 Who owns the capital?
 What is the cost of capital in terms of interest or dividend?

 What proportions of the capital have a financed return (gearing or leverage)?
 Is the mix of capital optimum for the company?
 Is further capital available if required?
 Is total capital employed analysed among different classes of business?
 If so, can return on capital be calculated for each class?
 Has issued Ordinary share capital increased during the period?
 If so, why? E.g. Rights issue? Bonus (scrip) issue? Acquisition?
 Are “per share” figures calculated using appropriately weighted numbers of shares?
 Are prior years' figures comparable?
 What individual items have caused significant movements on Reserves?
 Do any of them really belong in the profit and loss account?
 Is any long term debt convertible into ordinary shares?
 On what terms?
 Is any long term debt repayable within a short period?
 If so, should it be treated as a current liability?
 Are there significant borrowings in foreign currencies?
 Are they matched by foreign assets?
 How are exchange losses and gains thereon treated?
 Is there any preference capital?
 Is short term borrowing included in capital employed? Should it be?
 Is the treatment of pensions appropriate? Is information revealed?
 Would capitalising leases significantly affect long term debt and gearing ratios?

d) Activity
"Activity ratios" are used to measure the productivity and efficiency of a firm. When
compared to the industry average, the fixed-asset turnover ratio, for example, will show
how well the company is using its productive capacity. Similarly, the inventory turnover
ratio will indicate whether the company used too much inventory in generating sales and
whether the company may be carrying obsolete inventory.

Key questions to be identified in activity analysis are:
 Does management control the costs of the business well?
 Which costs, if any, have changed significantly, thus reducing or improving apparent
 Does management control the investment in assets well?
 Are fixed assets sufficient for the current level of activity? Are they replaced on a
regular basis and adequately maintained?
 Are the stock levels adequate for the level of activity, or excessive?
 Are debts collected promptly?
 Are creditors paid within a reasonable period of time?
 Are surplus cash resources invested to increase overall returns?
 How variable are the profits before interest and tax?
 How many times can the interest be paid from the available profit?
 How many times can the existing dividend be paid from the available profit?

e) Other
Other questions can be asked in interpreting final accounts. These may relate to long-term
trends in the business or to fixed assets, e.g.
Long-term trends in the business
 Are profits increasing or decreasing?
 Is the size of the business growing faster or slower than inflation?
 How has past growth been financed?
 Are the levels of stocks, debtors and creditors consistent with the long-term growth
of the business?
 Are dividends increasing?
 Have any radical changes occurred in the past, giving rise to major changes in the
Fixed assets
 When fixed assets are shown "at historical cost":

-How old are they? What is their estimated current value?
-How would revaluation affect the depreciation charge?
Where fixed assets are shown "at valuation":
-When was the valuation made, and on what basis?
-How have values changed since that date?
-Might the assets be more valuable if used for other purposes?
 What method of depreciation is used for valuation?
 What asset lives are used? Are different lives used for Current Cost Accounting?
 Has adequate provision been made for technological obsolescence?
 Are any assets leased? What is their value?
 How much are the annual rentals? How long is the commitment?
 Is goodwill:
-Shown as an asset?
-Written off against reserves?
-Being amortised by charges against profit?
 How does the book value of goodwill compare with the estimated surplus of the
current value of fixed assets over their net book value?
 Has the status of any investments changed during the period? Subsidiaries?
Associated companies? Trade investments? Non-consolidated subsidiaries?
 Are investments in associated companies shown by the "cost" method or by the
"equity" method?
 What is the difference between cost and market value of quoted investments? Is
market value used if it is lower than cost? Are there any long-term debtors? How have
they been treated in the balance sheet?

Financial analysis refers to an assessment of the viability, stability and profitability of a
business, sub-business or project. It is performed by professionals who prepare reports
using ratios that make use of information taken from financial statements and other

reports. These reports are usually presented to top management as one of their basis in
making business decisions. Based on these reports, management may:
 Continue or discontinue its main operation or part of its business;
 Make or purchase certain materials in the manufacture of its product;
 Acquire or rent/lease certain machineries and equipments in the production of its
 Issue stocks or negotiate for a bank loan to increase its working capital.
 Other decisions that allow management to make an informed selection on various
alternatives in the conduct of its business.

Financial analysts often assess the firm's:
1. Profitability- its ability to earn income and sustain growth in both short-term and
long-term. A company's degree of profitability is usually based on the income statement,
which reports on the company's results of operations;
2. Solvency- its ability to pay its obligation to debtors and other third parties in the long-
3. Liquidity- its ability to maintain positive cash flow, while satisfying immediate
Both 2 and 3 are based on the company's balance sheet, which indicates the financial
condition of a business as of a given point in time.
4. Stability- the firm's ability to remain in business in the long run, without having to
sustain significant losses in the conduct of its business. Assessing a company's stability
requires the use of both the income statement and the balance sheet, as well as other
financial and non-financial indicators.

Financial ratios face several theoretical challenges:
• They say little about the firm's prospects in an absolute sense. Their insights about
relative performance require a reference point from other time periods or similar

• One ratio holds little meaning. As indicators, ratios can be logically interpreted in at
least two ways. One can partially overcome this problem by combining several
related ratios to paint a more comprehensive picture of the firm's performance.
• Seasonal factors may prevent year-end values from being representative. A ratio's
values may be distorted as account balances change from the beginning to the end of
an accounting period. Use average values for such accounts whenever possible.
• Financial ratios are no more objective than the accounting methods employed.
Changes in accounting policies or choices can yield drastically different ratio values.
• They fail to account for exogenous factors like investor behavior that are not based
upon economic fundamentals of the firm or the general economy.

Financial Ratios
What they mean ?
In assessing the significance of various financial data, managers often use ratio analysis,
the process of determining and evaluating financial ratios. Financial ratios allow a
business owner to analyze and assess the firm's financial performance and position over a
period of time.

A financial ratio indicates a relationship between a company's activities. For example,
the ratio between the company's current assets and current liabilities or between its
accounts receivable and its annual sales.

The basic source for these ratios is the company's financial statements that contain figures
on assets, liabilities, profits, and losses. Ratios are only meaningful when compared with
other information. Since they are often compared with industry data, ratios help to
understand their company’s performance relative to that of competitors and are often
used to trace performance over time.

Ratio analysis can reveal much about a company and its operations. However, there are
several points to keep in mind about ratios.
• First, a ratio is just one number divided by another. Financial ratios are only "flags"
indicating areas of strength or weakness. One or even several ratios might be

misleading, but when combined with other knowledge of a company's management
and economic circumstances, ratio analysis can tell much about a corporation.
• Second, there is no single correct value for a ratio. The observation that the value of a
particular ratio is too high, too low, or just right depends on the perspective of the
analyst and on the company's competitive strategy.
• Third, a financial ratio is meaningful only when it is compared with some standard,
such as an industry trend, ratio trend, a ratio trend for the specific company being
analyzed, or a stated management objective.

"Measuring the liquidity, leverage, and profitability of a company is not a matter of how
many dollars in assets, liabilities, and equity it has, but of the proportions in which such
items occur in relation to one another. We analyze a company, therefore, by looking at
ratios rather than just dollar amounts." Financial ratios are determined by dividing one
number by another, and are usually expressed as a percentage. They enable business
owners to examine the relationships between seemingly unrelated items and thus gain
useful information for decision-making. "They are simple to calculate, easy to use, and
provide a wealth of information that cannot be gotten anywhere else," Gill noted. But, he
added, "Ratios are aids to judgment and cannot take the place of experience. They will
not replace good management, but they will make a good manager better. They help to
pinpoint areas that need investigation and assist in developing an operating strategy for
the future."
Virtually any financial statistics can be compared using a ratio. Determining which ratios
to compute depends on the type of business, the age of the business, the point in the
business cycle, and any specific information sought. For example, if a small business
depends on a large number of fixed assets, ratios that measure how efficiently these
assets are being used may be the most significant.
There are a few general ratios that can be very useful in an overall financial analysis. For
assessing company's liquidity, we use the current, quick, and liquidity ratios. The current
ratio can be defined as Current Assets / Current Liabilities. It measures the ability of an
entity to pay its near-term obligations. Though the ideal current ratio depends to some

extent on the type of business, a general rule of thumb is that it should be at least 2:1. A
lower current ratio means that the company may not be able to pay its bills on time, while
a higher ratio means that the company has money in cash or safe investments that could
be put to better use in the business.
The quick ratio, also known as the "acid test," can be defined as Quick Assets (cash,
marketable securities, and receivables) / Current Liabilities. This ratio provides a stricter
definition of the company's ability to make payments on current obligations. Ideally, this
ratio should be 1:1. If it is higher, the company may keep too much cash on hand or have
a poor collection program for accounts receivable. If it is lower, it may indicate that the
company relies too heavily on inventory to meet its obligations. The liquidity ratio, also
known as the cash ratio, can be defined as Cash / Current Liabilities. This measure
eliminates all current assets except cash from the calculation of liquidity. Ideally, the
ratio should be approximately .40:1.
To measure a company's leverage, recommend using the debt/equity ratio. Defined as
Debt / Owners' Equity, this ratio indicates the relative mix of the company's investor-
supplied capital. A company is generally considered safer if it has a low debt to equity
ratio—that is, a higher proportion of owner-supplied capital—though a very low ratio can
indicate excessive caution. In general, debt should be between 50 and 80 percent of
Finally, to measure a company's level of profitability, recommend using the return on
equity (ROE) ratio, which can be defined as Net Income / Owners' Equity. This ratio
indicates how well the company is utilizing its equity investment. ROE is considered to
be one of the best indicators of profitability. It is also a good figure to compare against
competitors or an industry average. Experts suggest that companies usually need at least
10-14 percent ROE in order to fund future growth. If this ratio is too low, it can indicate
poor management performance or a highly conservative business approach. On the other
hand, a high ROE can mean that management is doing a good job, or that the firm is
In conclusion, financial analysis can be an important tool for small business owners and
managers to measure their progress toward reaching company goals, as well as toward
competing with larger companies within an industry. When performed regularly over

time, financial analysis can also help small businesses recognize and adapt to trends
affecting their operations. It is also important for small business owners to understand
and use financial analysis because it provides one of the main measures of a company's
success from the perspective of bankers, investors, and outside analysts.

Framework for linking financial business objectives
There are many different ratios and models used today to analyze companies. The most
common is the price earnings (P/E) ratio. It is published daily with the transactions of
the New York Stock Exchange, American Stock Exchange, and NASDAQ. These
quotations show not only the most recent price but also the highest and lowest price paid
for the stock during the previous fifty-two weeks, the annual dividend, the dividend yield,
the price/earnings ratio, the day's trading volume, high and low prices for the day, and the
changes from the previous day's closing price.The price to earnings (P/E) ratio is
calculated by dividing the current market price per share by current earnings per
share. It represents a multiplier applied to current earnings to determine the value of a
share of the stock in the market. The price-earnings ratio is influenced by the earnings
and sales growth of the company, the risk (or volatility in performance), the debt-equity
structure of the company, the dividend policy, the quality of management, and a number
of other factors. A company's P/E ratio should be compared to those of other companies
in the same industry.

Other ratios useful in analyzing a company's balance sheet and income statement are as
Liquidity ratios help to analyze a company's ability to meet short-term financial
 Current ratio :- Ability to pay current debts
= Current Assets
Current Liabilities
Current ratio measures the ability of the firm to pay its short-term debts obligations
(current liabilities) from its current assets when payment is due. Current assets are those

items owned by the firm with the intention to generate profits or other assets that can be
converted to cash within one year. The higher the ratio, the more liquid the company is.
 Quick Ratio /Acid-test ratio = Quick Assets
Current Liabilities
Quick Assets = Current Assets – Inventories
Ability to convert current assets to cash for the purpose of meeting current liabilities.
Called the acid-test -- is a crucial test of the firm's liquidity

 Net Working Capital Ratio = Net Working Capital
Total Assets
Net Working Capital = Current Assets - Current Liabilities
It measures the flow of cash in the company.

 Return on Assets (ROA) = Net Income
Average Total Assets
Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2
Overall effectiveness to generate profits from total investment in assets.
 Return on Equity (ROE) = Net Income
Average Stockholders' Equity

OR = ------------------
Total equity
Average Stockholders' Equity = (Beginning Stockholders' Equity + Ending Stockholders'
Equity) / 2
 Net Profit Ratio = Net profit ratio on the other hand measures the net profitability of
business in relation to revenues. The higher the net profit, it indicates how effective
the company is at managing costs and converting revenue to actual profit=
Net Profit after Tax / Sales Revenue
This measures the profitability of a business or the operating ratio, which reflects what is
left from sales revenue after taking into account the costs of goods sold.
 Gross profit margin or profit margin on sales: Profitability of a company's sales after
the cost of sales has been deducted.

Sales – cost of goods sold

Asset Management ratios help analyze how quickly a company's resources can be
converted to cash or sales

 Assets Turnover Ratio = Sales
Average Total Assets
Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2
 Accounts Receivable Turnover Ratio = Sales
Average Accounts Receivable
Average Accounts Receivable= (Beginning Accounts Receivable + Ending Accounts
Receivable) / 2
 Inventory Turnover Ratio = Cost of Goods Sold
Average Inventories
Average Inventories = (Beginning Inventories + Ending Inventories) / 2

g) Average collection period: Serves as a basis for determining how rapidly a company's
credit accounts are being collected =
Accounts receivable
Average daily credit sales
h) Fixed asset turnover: Extent to which company is utilizing existing property, plant, and
equipment to generate sales. = Sales / fixed assets

Debt Management ratios helps to analyze the degree and effect of a company's use of
borrowed funds (debt) to finance its operations.
 Debt to Equity Ratio = Total Liabilities
Total Stockholders' Equity
 Interest Coverage Ratio = Income Before Interest and Income Tax Expenses
Interest Expense

Income Before Interest and Income Tax Expenses = Income Before Income Taxes +
Interest Expense

 Price Earnings (PE) Ratio = Market Price of Common Stock Per Share
Earnings Per Share

 Market to Book Ratio = Market Price of Common Stock Per Share
Book Value of Equity Per Common Share
Book Value of Equity Per Common Share = Book Value of Equity for Common Stock /
Number of Common Shares
 Dividend Yield = Annual Dividends Per Common Share
Market Price of Common Stock Per Share
 Dividend Payout Ratio = Cash Dividends
Net Income
 Earnings per share = Net Profit after Tax / Number of shares issued
This is a measure of how much profits have been made for each share issues. Thus, it
also measures the profitability for equity investors. This would potentially impact the
market price of the share, especially for a public listed company.

The term working capital refers to the amount of capital which is readily available to an
organization. The best way to look at current assets and current liabilities is by combining
them into something called Working Capital. That is, working capital is the difference
between resources in cash or readily convertible into cash (Current Assets) and
organizational commitments for which cash will soon be required (Current Liabilities).
Working capital is basically an expression of how much in liquid assets the company
currently has to build its business, fund its growth, and produce shareholder value. If a
company has ample positive working capital, then it is in good shape, with plenty of cash

on hand to pay for everything it might need to buy. If a company has negative working
capital, then its current liabilities are actually greater than their current assets, so the
company lacks the ability to spend with the same aggressive nature as a working capital
positive peer. All other things being equal, a company with positive working capital will
always outperform a company with negative working capital.
Working capital is the absolute lifeblood of a company. About 99% of the reason that the
company probably came public in the first place had to do with getting working capital
for whatever reasons -- building the business, funding acquisitions or developing new
products. Anything good that comes from a company springs out of working capital. If a
company runs out of working capital and still has bills to pay and products to develop, it
has big problems.
Current Assets are resources which are in cash or will soon be converted into cash in "the
ordinary course of business"
Current Liabilities are commitments which will soon require cash settlement in "the
ordinary course of business".

Working capital cycle and various components of working capital
Any business we start with cash is converted into various kinds of current assets during
production process and finally it is converted back to cash once the goods are sold and
money paid by customers. It is therefore obvious that in this entire process a cycle is
involved wherein we start with cash and end at cash. This cycle is called “working capital
cycle”. This cycle is shown below:

The above picture reflects the working capital cycle in most elementary fashion. In
business, however, generally, there are many more components of working capital. In
order to understand them more closely, a detailed list of various items of working capital
cycle is being given below.
Current assets
Inventory - raw material
-work in progress
-finished goods
Receivables (debtors)
Loans and advances - Export incentives receivable
- Interest recoverable on bills discounting
- Advances given to suppliers
- Prepaid expenses
- Claims recoverable
- Security deposits given
- Loans given to staff and workers
- Advance tax paid
Cash & bank balances - Balances in current accounts
- Money kept in fixed deposit receipts
- Short term advances given to other corporates.

Current liabilities
- bank borrowings
- sundry creditors
- provision for gratuity an dividend
- ILC/FLC payable
- Interest accrued but not due
- Term loans installments falling due within one year
- Provision for income tax
- Sales tax payable
- Provision for expenses.

A firm is required to maintain a balance between liquidity and profitability while
conducting its day to day operations. Liquidity is a precondition to ensure that firms are
able to meet its short-term obligations and its continued flow can be guaranteed from a
profitable venture. The importance of cash as an indicator of continuing financial health
should not be surprising in view of its crucial role within the business. This requires that
business must be run both efficiently and profitably. In the process, an asset-liability
mismatch may occur which may increase firm’s profitability in the short run but at a risk
of its insolvency. On the other hand, too much focus on liquidity will be at the expense of
profitability Thus, as the manager of a business entity we are into a dilemma of achieving
desired tradeoff between liquidity and profitability in order to maximize the value of a
Every business needs investment to procure fixed assets, which remain in use for a longer
period. Money invested in these assets is called ‘Long term Funds’ or ‘Fixed Capital’.
Business also needs funds for short-term purposes to finance current operations.
Investment in short term assets like cash, inventories, debtors etc., is called ‘Short-term
Funds’ or ‘Working Capital’. The ‘Working Capital’ can be categorized, as funds needed
for carrying out day-to-day operations of the business smoothly. The management of the
working capital is equally important as the management of long-term financial
investment. Every running business needs working capital. Even a business which is fully
equipped with all types of fixed assets required is bound to collapse without

(i) Adequate supply of raw materials for processing;
(ii) Cash to pay for wages, power and other costs;
(iii) Creating a stock of finished goods to feed the market demand regularly; and,
(iv) The ability to grant credit to its customers.
All these require working capital. Working capital is thus like the lifeblood of a business.
The business will not be able to carry on day-to-day activities without the availability of
adequate working capital. Working capital cycle involves conversions and rotation of
various constituents/ components of the working capital. Initially ‘cash’ is converted into
raw materials. Subsequently, with the usage of fixed assets resulting in value additions,
the raw materials get converted into work in process and then into finished goods. When
sold on credit, the finished goods assume the form of debtors who give the business cash
on due date. Thus ‘cash’ assumes its original form again at the end of one such working
capital cycle but in the course it passes through various other forms of current assets too.
This is how various components of current assets keep on changing their forms due to
value addition. As a result,

they rotate and business operations continue. Thus, the working capital cycle involves
rotation of various constituents of the working capital.
Current Assets

The first major component of the balance sheet is Current Assets, which are assets that a
company has at its disposal that can be easily converted into cash within one operating
cycle. An operating cycle is the time that it takes to sell a product and collect cash from
the sale. It can last anywhere from 60 to 180 days. Current assets are important because it
is from current assets that a company funds its ongoing, day-to-day operations. If there is
a shortfall in current assets, then the company is going to have to dig around to find some
other form of short-term funding, which normally results in interest payments or dilution
of shareholder value through the issuance of more shares of stock. There are five main
kinds of current assets -- Cash & Equivalents, Short- and Long-Term Investments,
Accounts Receivable, Inventories and Prepaid Expenses.

Cash & Equivalents are assets that are money in the bank, literally cold, hard cash or
something equivalent, like bearer bonds, money market funds. Cash and equivalents are
completely liquid assets, and thus should get special respect from shareholders. This is
the money that a company could immediately mail to you in the form of a fat dividend if
it had nothing better to do with it. This is the money that the company could use to buy
back stock, and thus enhance the value of the shares that you own.

Short-Term Investments are a step above cash and equivalents. These normally come into
play when a company has so much cash on hand that it can afford to tie some of it up in
bonds with durations of less than one year. This money cannot be immediately liquefied
without some effort, but it does earn a higher return than cash by itself. It is cash and
investments that give shares immediate value and could be distributed to shareholders
with minimal effort.

Accounts Receivable, normally abbreviated as A/R, is the money that is currently owed
to a company by its customers. The reason why the customers owe money is that the
product has been delivered but has not been paid for yet. Companies routinely buy goods
and services from other companies using credit. Although typically A/R is almost always
turned into cash within a short amount of time, there are instances where a company will
be forced to take a write-off for bad accounts receivable if it has given credit to someone

who cannot or will not pay. This is why you will see something called allowance for bad
debt in parentheses beside the accounts receivable number.
The allowance for bad debt is the money set aside to cover the potential for bad
customers, based on the kind of receivables problems the company may or may not have
had in the past. However, even given this allowance, sometimes a company will be
forced to take a write-down for accounts receivable or convert a portion of it into a loan if
a big customer gets in real trouble. Looking at the growth in accounts receivable relative
to the growth in revenues is important -- if receivables are up more than revenues, you
know that a lot of the sales for that particular quarter have not been paid for yet.

Inventories are the components and finished products that a company has currently
stockpiled to sell to customers. Not all companies have inventories, particularly if they
are involved in advertising, consulting, services or information industries. For those that
do, however, inventories are extremely important. Inventories should be viewed
somewhat skeptically by investors as an asset. First, because of various accounting
systems like FIFO (first in, first out) and LIFO (last in, first out) as well as real
liquidation compared to accounting value, the value of inventories is often overstated on
the balance sheet. Second, inventories tie up capital. Money that it is sitting in inventories
cannot be used to sell it. Companies that have inventories growing faster than revenues or
that are unable to move their inventories fast enough are sometimes disasters waiting to

Finally, Prepaid Expenses are expenditures that the company has already paid to its
suppliers. This can be a lump sum given to an advertising agency or a credit for some bad
merchandise issued by a supplier. Although this is not liquid in the sense that the
company does not have it in the bank, having bills already paid is a definite plus. It
means that these bills will not have to be paid in the future, and more of the revenues for
that particular quarter will flow to the bottom line and become liquid assets.

Fixed Assets
Fixed assets are long-term assets.

-Tangible fixed assets are physical assets like plant.
-Intangible fixed assets are the firm’s rights and claims, such as patents, copyrights,
goodwill etc.
-Gross block represent all tangible assets at acquisition costs.
-Net block is gross block net of depreciation.
The balance sheet also includes two categories of liabilities, current liabilities (debts that
will come due within one year, such as accounts payable, short-term loans, and taxes) and
long-term debts (debts that are due more than one year from the date of the statement).
Liabilities are important to financial analysts because businesses have same obligation to
pay their bills regularly as individuals, while business income tends to be less certain.
Long-term liabilities are less important to analysts, since they lack the urgency of short-
term debts, though their presence does indicate that a company is strong enough to be
allowed to borrow money.

Current Liabilities
Current Liabilities are what a company currently owes to its suppliers and creditors.
These are short-term debts that normally require that the company convert some of its
current assets into cash in order to pay them off. These are all bills that are due in less
than a year. As well as simply being a bill that needs to be paid, liabilities are also a
source of assets. Any money that a company pulls out of its line of credit or gains the use
of because it pushes out its accounts payable is an asset that can be used to grow the
business. There are five main categories of current liabilities: Accounts Payable, Accrued
Expenses, Income Tax Payable, Short-Term Notes Payable and Portion of Long-Term
Debt Payable.

Accounts Payable is the money that the company currently owes to its suppliers, its
partners and its employees. Basically, these are the basic costs of doing business that a
company, for whatever reason, has not paid off yet. One company's accounts payable is
another company's accounts receivable, which is why both terms are similarly structured.
A company has the power to push out some of its accounts payable, which often produces
a short-term increase in earnings and current assets.

Accrued Expenses are bills that the company has racked up that it has not yet paid. These
are normally marketing and distribution expenses that are billed on a set schedule and
have not yet come due. A specific type of accrued expense is Income Tax Payable. This
is the income tax a company accrues over the year that it does not have to pay yet
according to various federal, state and local tax schedules. Although subject to
withholding, there are some taxes that simply are not accrued by the government over the
course of the quarter or the year and instead are paid in lump sums whenever the bill is

Short-Term Notes Payable is the amount that a company has drawn off from its line of
credit from a bank or other financial institution that needs to be repaid within the next 12
months. The company also might have a portion of its Long-Term Debt come due with
the year, which is why this gets counted as a current liability even though it is called
long-term debt.

Long-Term Notes Payable or Long-Term Liabilities are loans that are not due for more
than a year. These are normally loans from banks or other financial institutions that are
secured by various assets on the balance sheet, such as inventories. Most companies will
tell you in a footnote to this item when this debt is due and what interest rate the company
is paying.
The balance sheet also commonly includes stock-holders' equity accounts, which detail
the permanent capital of the business. The total equity usually consists of two parts: the
money that has been invested by shareholders, and the money that has been retained from
profits and reinvested in the business. In general, the more equity that is held by a
business, the better the ability of the business to borrow additional funds.

Stockholders or Shareholder's Equity is composed of Capital Stock and Retained
Earnings. Frankly, this is more than a little bit confusing and does not always add all that
much value to the analysis. Capital stock is the par value of the stock issued that is
recorded purely for accounting purposes and has no real relevance to the actual value of

the company's stock. Capital in Excess of Stock is another weird accounting convention
that is pretty difficult to explain. Essentially, it is any additional cash that a company gets
from issuing stock in excess of par value under certain financial conventions.

Retained earnings is another accounting convention that basically takes the money that a
company has earned, less any earnings that are paid out to shareholders in the form of
dividends and stock buybacks, and records this on the company's books. Retained
earnings simply measures the amount of capital a company has generated and is best used
to determine what sorts of returns on capital a company has produced. If you add together
capital stock and retained earnings, you get shareholder's equity -- the amount of equity
that shareholders currently have in the company.

Debt & Equity
The remainder of the balance sheet is taken up by a hodge-podge of items that are not
current, meaning that they are either assets that cannot be easily turned into cash or
liabilities that will not come due for more than a year. Specifically, there are five main
categories -- Total Assets, Long-Term Notes Payable, Stockholder's/Shareholder's
Equity, Capital Stock and Retained Earnings.

Total Assets are assets that are not liquid, but that are kept on a company's books for
accounting purposes. The main component is plants, property and equipment and
encompasses any land, buildings, vehicles and equipment that a company has bought in
order to operate its business. Much of this is actually subject to an accounting convention
called depreciation for tax purposes, meaning that the stated value of the total assets and
the actual value or price paid might be very different.
In contrast to the balance sheet, the income statement provides information about a
company's performance over a certain period of time. Although it does not reveal much
about the company's current financial condition, it does provide indications of its future
viability. The main elements of the income statement are revenues earned, expenses
incurred, and net profit or loss. Revenues consist mainly of sales, though financial
analysts may also note the inclusion of royalties, interest, and extraordinary items.

Likewise, operating expenses usually consist primarily of the cost of goods sold, but can
also include some unusual items. Net income is the "bottom line" of the income
statement. This figure is the main indicator of a company's accomplishments over the
statement period.

Income Statement
An income statement reports the organization’s financial performance over a specified
period of time. It summarizes all revenue earned and expenses incurred during a specified
accounting period. An institution prepares an income statement so that it can determine it
net profit or loss (the difference between revenue and expenses).

Refers to money earned by an organization for goods sold and services rendered during
an accounting period, including
• Interest earned on loans to clients
• Fees earned on loans to clients
• Interest earned on deposits with a bank, etc

Represent costs incurred for goods and services used in the process of earning revenue.
Direct expenses for an MFI include
• Financial costs,
• Administrative expenses, and
• Loan loss provisions.

Matching Costs and Revenues
Revenue should be matched with whatever expenses or assets produce that revenue. This
notion leads inevitably to the accrual method of accounting. If we obtain the annual
registration for a truck in January and use that truck to deliver products to our customers
for 12 months, we have paid for an item in January that helps us produce revenue all year
long. If we record the entire amount of the expense in January, we overstate our costs and

understate our profitability for that month. We also understate our costs and overstate our
profitability for the remaining 11 months.
Largely for this reason, the accrual method evolved. Using the accrual method, we would
accrue 1/12th of the expense of the truck registration during each month of the year.
Doing so enables us to measure expenses against our revenues more accurately
throughout the year. Similarly, suppose that we sell a product to a customer on a credit
basis. We might receive periodic payments for the product over several months, or we
might receive payment in a lump sum sometime after the sale. Again, if we wait to record
that income until we have received full payment, we will misestimate our profit until the
customer finishes paying us.
Some very small businesses—primarily sole proprietorships—use an alternative to
accrual, called the cash method of accounting. They find it more convenient to record
expenses and revenues when the transaction took place. In very small businesses, the
additional accuracy of the accrual method might not be worth the effort. An accrual basis
is more complicated than a cash basis and requires more effort to maintain, but it is often
a more accurate method for reporting purposes. The main distinction between the two
methods is that if we distribute the recording of revenues and expenses over the full time
period when we earned and made use of them, we are using the accrual method. If we
record their totals during the time period that we received or made payment, we are using
the cash method.
The cash basis understates income when costs are not associated with revenue that they
help generate. Suppose that a person starts a new firm, Marble Designs, in January. At
the end of the first month of operations, she has made 10,000 Rs. in sales and paid
various operating expenses: her salary, the office lease, phone costs, office supplies, and
a computer. She was able to save 20% of the cost of office supplies by making a bulk
purchase that she estimates will last the entire year. Recording all of these as expenses
during the current period results in net income for the month of 1,554 Rs.
Using the accrual method, Marble Designs records 1/12th of the cost of the office
supplies during January. This is a reasonable decision because they are expected to last a
full year. It also records 1/36th of the cost of the computer as depreciation. The
assumption is that the computer’s useful life is three years and that its eventual salvage or

residual value will be zero. The net income for January is now 5,283Rs.which is 3.4
times the net income recorded under the cash basis.
The net income of 5,283Rs. is a much more realistic estimate for January than 1,554Rs.
Both the office supplies and the computer will contribute to the creation of revenue for
much longer than one month. In contrast, the benefits of the salary, lease, and phone
expenses pertain to that month only, so it is appropriate to record the entire expense for
January. But this analysis says nothing about how much cash Marble Designs has in the
bank. Suppose that the company must pay off a major loan in the near future. The income
statement does not necessarily show whether Marble Designs will likely be able to make
that payment.

Nature and Importance of working capital
Working capital management (WCM) is of particular importance to the small business.
With limited access to the long-term capital markets, these firms tend to rely more
heavily on owner financing, trade credit and short-term bank loans to finance their
needed investment in cash, accounts receivable and inventory. The success factors or
impediments that contribute to success or failure are categorized as internal and external
factors. The factors categorized as external include financing (such as the availability of
attractive financing), economic conditions, competition, government regulations,
technology and environmental factors. While the internal factors are managerial skills,
workforce, accounting systems and financial management practices.
The working capital meets the short-term financial requirements of a business enterprise.
It is a trading capital, not retained in the business in a particular form for longer than a
year. The money invested in it changes form and substance during the normal course of
business operations. The need for maintaining an adequate working capital can hardly be
questioned. Just as circulation of blood is very necessary in the human body to maintain
life, the flow of funds is very necessary to maintain business. If it becomes weak, the
business can hardly prosper and survive. The success of a firm depends ultimately, on its
ability to generate cash receipts in excess of disbursements. The cash flow problems of
many small businesses are exacerbated by poor financial management and in particular
the lack of planning cash requirements.

The Management of Working Capital
The management of working capital is important for the financial health of businesses of
all sizes. The amounts invested in working capital are often high in proportion to the total
assets employed and so it is vital that these amounts are used in an efficient and effective
way. Given that many small businesses suffer from undercapitalization, the importance of
exercising tight control over working capital investment is difficult to overstate. A firm
can be very profitable, but if this is not translated into cash from operations within the
same operating cycle, the firm would need to borrow to support its continued working
capital needs. Thus, the twin objectives of profitability and liquidity must be
synchronized and one should not impinge on the other for long. Investments in current
assets are inevitable to ensure delivery of goods or services to the ultimate customers and
a proper management of same should give the desired impact on either profitability or
liquidity. If resources are blocked at the different stage of the supply chain, this will
prolong the cash operating cycle. Although this might increase profitability (due to
increase sales), it may also adversely affect the profitability if the costs tied up in working
capital exceed the benefits of holding more inventory and/or granting more trade credit to
customers. Another component of working capital is accounts payable, but it is different
in the sense that it does not consume resources; instead it is often used as a short term
source of finance. Thus it helps firms to reduce its cash operating cycle, but it has an
implicit cost where discount is offered for early settlement of invoices. We have already
seen in the preceding paragraphs that every business requires an optimum level of net
working capital. Both the situations when either it is on higher side than required or it is
on a lower side the required are not desirable. It is therefore necessary that the business
has necessary checks and balances to ensure that optimum
Level of net working capital is maintained. The best and simplest method of ensuring this
is that the norms for all kinds of current assets and current liabilities are fixed at
beginning of the year and month after month these norms are compared with actuals so as
to ensure that either the actuals are falling within the norms or norms themselves are
changed in case required. It is also necessary in view of the fact that the money invested

in working capital has some cost attached to it. It will always therefore be prudent policy
to ensure that net working capital is falling within the agreed norms.
At this point it will be necessary to understand that some of the current assets and
liabilities are fixed in nature in the same they do not co-relate directly to production and
sales of the company like pre-paid expenses, dividend proposed, supplier advances and so
on. In contrast there are current assets and liabilities which have direct co relation with
the production and sales that is too easy that is too say that the amount of such assets and
liabilities keep on varying in relation to the increase/decrease in sales and production
figures. The glaring example of such assets and liabilities are debtors, discount provision,
export incentives recoverable, inventories, usance liabilities etc. in order to ensure that
these assets and liabilities are falling within the norm, we therefore, have to set different
kinds of norms.

In Minda at the beginning of every year we make a budget wherein while projecting the
balance sheet, various items of current assets and liabilities are projected. A detailed
calculation is done to fix up the current assets and liabilities required per unit of output in
case of those assets and liabilities which tend to vary with production and sales. Norms
are fixed for other assets and liabilities based on past experience. Every month thereafter
the comparison of budget Vs actual is drawn. The variation is two i.e. budgeted Vs actual
is discussed thoroughly in the meeting and all major items are covered. To rectify any
adverse variances action plans are chalked out and responsibilities are fixed for various
departments and sections. With this effective tool we would be able to keep the working
capital by and large within control thereby keeping our finances cost within the budget.
Another effective instrument of monitoring net working capital is cash flow. Every
month, as we all know, we are making a 3 monthly rolling plan based on which a 3
monthly cash flow is prepared. At the time of making these short term projections we
ensure that the planned current assets and liabilities remain with the agreed norms and
variations, if any, are either explained or it is ensured that after discussions they fall
within the agreed norms.

Approaches to Working Capital Management
The objective of working capital management is to maintain the optimum balance of each
of the working capital components. This includes making sure that funds are held as cash
in bank deposits for as long as and in the largest amounts possible, thereby maximizing
the interest earned. However, such cash may more appropriately be "invested" in other
assets or in reducing other liabilities.

Working capital management takes place on two levels:
o Ratio analysis can be used to monitor overall trends in working capital and to identify
areas requiring closer management.
o The individual components of working capital can be effectively managed by using
various techniques and strategies.

When considering these techniques and strategies, departments need to recognize that
each department has a unique mix of working capital components. The emphasis that
needs to be placed on each component varies according to department. For example,
some departments have significant inventory levels; others have little if any inventory.

Furthermore, working capital management is not an end in itself. It is an integral part of
the department's overall management. The needs of efficient working capital
management must be considered in relation to other aspects of the department's financial
and non-financial performance. While managing the working capital, two characteristics
of current assets should be kept in mind viz.
(i) Short life span, and
(ii) Swift transformation into other form of current asset.
Each constituent of current asset has comparatively very short life span. Investment
remains in a particular form of current asset for a short period. The life span of current
assets depends upon the time required in the activities of procurement; production, sales
and collection and degree of synchronization among them. A very short life span of
current assets results into swift transformation into other form of current assets for a
running business. These characteristics have certain implications:

i. Decision regarding management of the working capital has to be taken frequently and
on a repeat basis.
ii. The various components of the working capital are closely related and mismanagement
of any one component adversely affects the other components too.
iii. The difference between the present value and the book value of profit is not

Working Capital Analysis
The major components of gross working capital include stocks (raw materials, work-in-
progress and finished goods), debtors, cash and bank balances. The composition of
working capital depends on a multiple of factors, such as operating level, level of
operational efficiency, inventory policies, book debt policies, technology used and nature
of the industry. While inter- industry variation is expected to be high, the degree of
variation is expected to be low for firms within the industry.

Working capital needs of a business influenced by numerous factors.
The important ones are discussed in brief as given below:
i. Nature of Enterprise
The nature and the working capital requirements of an enterprise are interlinked. While a
manufacturing industry has a long cycle of operation of the working capital, the same
would be short in an enterprise involved in providing services. The amount required also
varies as per the nature; an enterprise involved in production would require more working
capital than a service sector enterprise.
ii. Manufacturing/Production Policy
Each enterprise in the manufacturing sector has its own production policy, some follow
the policy of uniform production even if the demand varies from time to time, and others
may follow the principle of 'demand-based production' in which production is based on
the demand during that particular phase of time. Accordingly, the working capital
requirements vary for both of them.
iii. Operations

The requirement of working capital fluctuates for seasonal business. The working capital
needs of such businesses may increase considerably during the busy season and decrease
during the slack season. Ice creams and cold drinks have a great demand during summers,
while in winters the sales are negligible.
iv. Market Condition
If there is high competition in the chosen product category, then one shall need to offer
sops like credit, immediate delivery of goods etc. for which the working capital
requirement will be high. Otherwise, if there is no competition or less competition in the
market then the working capital requirements will be low.
v. Availability of Raw Material
If raw material is readily available then one need not maintain a large stock of the same,
thereby reducing the working capital investment in raw material stock. On the other hand,
if raw material is not readily available then a large inventory/stock needs to be
maintained, thereby calling for substantial investment in the same.
vi. Growth and Expansion
Growth and expansion in the volume of business results in enhancement of the working
capital requirement. As business grows and expands, it needs a larger amount of working
capital. Normally, the need for increased working capital funds precedes growth in
business activities.
vii. Price Level Changes
Generally, rising price level requires a higher investment in the working capital. With
increasing prices, the same level of current assets needs enhanced investment.
viii. Manufacturing Cycle
The manufacturing cycle starts with the purchase of raw material and is completed with
the production of finished goods. If the manufacturing cycle involves a longer period, the
need for working capital would be more. At times, business needs to estimate the
requirement of working capital in advance for proper control and management. The
factors discussed above influence the quantum of working capital in the business.
The assessment of working capital requirement is made keeping these factors in view.
Each constituent of working capital retains its form for a certain period and that holding
period is determined by the factors discussed above. So for correct assessment of the

working capital requirement, the duration at various stages of the working capital cycle is
estimated. Thereafter, proper value is assigned to the respective current assets, depending
on its level of completion. The basis for assigning value to each component is given

Components of working capital Basis of valuation
i Stock of raw material Purchase cost of raw materials
ii Stock of work in process At cost or market value whichever is lower
iii Stock of finished goods Cost of sales
iv Debtors Cost of sales or sales value
v Cash Working expenses

Each constituent of the working capital is valued on the basis of valuation enumerated
above for the holding period estimated. The total of all such valuation becomes the total
estimated working capital requirement. We know that working capital has a very close
relationship with day-to-day operations of a business. Negligence in proper assessment of
the working capital, therefore, can affect the day-to-day operations severely. It may lead
to cash crisis and ultimately to liquidation. An inaccurate assessment of the working
capital may cause either under-assessment or over-assessment of the working capital and
both of them are dangerous.

Consequences of under assessment of working capital
o Growth may be stunted. It may become difficult for the enterprise to undertake
profitable projects due to non-availability of working capital.
o Implementation of operating plans may become difficult and consequently the profit
goals may not be achieved.
o Cash crisis may emerge due to paucity of working funds.
o Optimum capacity utilization of fixed assets may not be achieved due to non-
availability of the working capital.
o The business may fail to honour its commitment in time, thereby adversely affecting
its credibility. This situation may lead to business closure.

o The business may be compelled to buy raw materials on credit and sell finished goods
on cash. In the process it may end up with increasing cost of purchases and reducing
selling prices by offering discounts. Both these situations would affect profitability
o Non-availability of stocks due to non-availability of funds may result in production
o While underassessment of working capital has disastrous implications on business,
over assessment of working capital also has its own dangers.

Consequences of over assessment of working capital
o Excess of working capital may result in unnecessary accumulation of inventories.
o It may lead to offer too liberal credit terms to buyers and very poor recovery system
and cash management.
o It may make management complacent leading to its inefficiency.
o Over-investment in working capital makes capital less productive and may reduce
return on investment.
Working capital is very essential for success of a business and, therefore, needs efficient
management and control. Each of the components of the working capital needs proper
management to optimize profit.

Financing Working Capital
Now let us understand the means to finance the working capital. Working capital or
current assets are those assets, which unlike fixed assets change their forms rapidly. Due
to this nature, they need to be financed through short-term funds. Short-term funds are
also called current liabilities. The following are the major sources of raising short-term
i. Supplier’s Credit
At times, business gets raw material on credit from the suppliers. The cost of raw
material is paid after some time, i.e. upon completion of the credit period. Thus, without
having an outflow of cash the business is in a position to use raw material and continue
the activities. The credit given by the suppliers of raw materials is for a short period and

is considered current liabilities. These funds should be used for creating current assets
like stock of raw material, work in process, finished goods, etc.
ii. Bank Loan for Working Capital
This is a major source for raising short-term funds. Banks extend loans to businesses to
help them create necessary current assets so as to achieve the required business level. The
loans are available for creating the following current assets:
o Stock of Raw Materials
o Stock of Work in Process
o Stock of Finished Goods
o Debtors
Banks give short-term loans against these assets, keeping some security margin. The
advances given by banks against current assets are short-term in nature and banks have
the right to ask for immediate repayment if they consider doing so. Thus bank loans for
creation of current assets are also current liabilities.
iii. Promoter’s Fund
It is advisable to finance a portion of current assets from the promoter’s funds. They are
long-term funds and, therefore do not require immediate repayment. These funds increase
the liquidity of the business.

How is working capital reflected in balance sheet
As we are aware, every balance sheet has 2 sides namely assets and liabilities. The assets
again can be bifurcated into fixed assets and current assets and similarly liabilities into
fixed and current liabilities. At the inception of any business, the promoters bring in some
money of their own and the rest they borrow from various banks and financial
institutions. These, as we are already aware, are called fixed liabilities of the business.
This money is invested both in current and fixed assets. Further besides fixed liabilities
some of the current assets are financed by current liabilities also. The pictorial
presentation of all these assets and liabilities is given below in a very simple form:
Balance sheet as on

Fixed liabilities Fixed assets
- shareholders fund - plant & machinery
- long term loans - factory/non-factory buildings
- unsecured loans - furniture & fixture
- motor vehicles
- office equipments

Current liabilities Current assets
- sundry creditors -Inventories - raw materials
- bank borrowings - finished goods
- provision for dividend, gratuity etc. - WIP
- spares
- receivables
- loans & advances
- cash & bank balances

Why is it necessary to invest in working capital?
Let us presume a situation where business has just been started. Let us further presume
that a portion of money raised by promoters is available for buying raw material, spares,
for making day to day payments, is lying in bank. This is first item of current assets.
Since the supplier of raw material will take some lead time to manufacture the goods and
there is some lead time involved in transporting the goods to our factory, as a logical step,
it becomes necessary to buy raw material for those many days which are equivalent to
supplier’s manufacturing and transporting time. Raw material inventory therefore
becomes the second item of current assets. As this material will be sent on processing

line, it will get distributed to various stages of production and some quantity will always
remain blocked at all processes of production in semi finished form. This is called work
in progress. Once the raw material has various stages of process it is converted into
finished goods. Since some time is required to transport the finished goods to customer
and he also buys them in lots depending upon his selling capacity, some quantity of
finished goods therefore will always be required to be maintained at plant. Once the gods
are sold, they are either bring in cash or they are converted in debtors. They are converted
in debtors, the money will be arise only after the credit period given to customers is over.
It is therefore, be appreciated that ideally speaking although a businessman, would not
like to invest any money in current assets, it is necessary to do so as there is some time
gap between the purchase of raw material and realization of money from customers after
sale of finished goods.

Working capital ratios
Since the money invested in current assets is blocked money, it is considered as some
kind of necessary evil which is required to run the business. The management, therefore,
always aims at optimizing the money required to be invested in net working capital. In
order to optimize, however, it is necessary to know the correct requirement of net
working capital. One of the best methods of calculating the adequacy or inadequacy of
net working capital in business is by calculating the various working capital ratios. These
ratios help in determining the working capital position of business in a very rational
manner. The most important working capital ratios are explained below:-
a) Current ratio
The current ratio measures the ratio of current assets to current liabilities. The formula is:
Current ratio = current assets/current liabilities
= inventories + debtors + loans&advances + cash&bank balances
Bank borrowings + other current liabilities + term loans installments falling in due
next one year.
The current ratio of a business measures its short term inventory i.e. its ability to meet
short term obligations. As a measure of short term financial liquidity, it indicates the
rupees of current assets available form each rupee of current liability. The higher the

current ratio the larger the amount of rupees available per rupee of current liability and
greater the safety of funds of short term creditors. An increase in the ratio of current
assets to total assets will lead to a decline in profitability because current assets are
assumed to be less profitable than fixed assets. A second effect of the increase in the ratio
will be that the risk of technical insolvency would also decrease because the increase in
current assets, assuming no change in current liabilities will decrease NWC. Similarly a
decrease in the ratio of current assets to total assets will result in an increase in
profitability as well as risk. The increase in profitability will be due to the corresponding
increase in fixed assets which are likely to generate higher returns. Since the current
assets decreases without a corresponding reduction in liabilities, the amount of NWC will
decrease, thereby increasing risk.
Effect of changes in current assets of company minda
Initial value value after value after
increase (+) decrease (-)
(1) (2) (3) (4)
Ratio of current to total assets ------ ------- ------
Profits on total assets ------- ------- -------
Net working capital ------ ------- -------
Normally a current ratio of 2:1 is considered very good. Banks however, consider a
current ratio of 1.33:1 as reasonable. Form the above discussion although it might seem
that higher the current ratio, the better it is, it may not be really true. This is because an
unreasonably higher current ratio indicates higher amount of money invested in current
assets than desired. An organization therefore has to always maintain a reasonable current
ratio i.e. a current ratio which is neither higher nor low.
b) Acid test or quick ratio.
Not all current assets can be realized in similar time. In other words of all the current
assets some can be realized immediately if required while some other will take some
more time to realize. Therefore in order to know the immediate current solvency of the
business, another ratio is sometimes used which is called acid test / quick ratio. The
formula for calculating this ratio is almost same except the exclusion of some current
assets which are not very liquid in nature like inventories and other current assets like
loans and advances. The formula is:-

Acid test or quick ratio = debtors + cash & bank balances + short term marketable
Current liabilities.
c) Inventory turnover ratio
Another way of examining the liquidity of a firm is to determine how quickly certain
current assets are converted into cash. The turnover ratios actually check the other
extreme side of current ratio i.e. it checks that money invested in various current assets
like inventory is not more than desired. The higher the ratio, the better it is. The formula
for calculating inventory turnover ratio is:
Inventory turnover ratio = cost of goods sold
Average inventory
The money so saved can be invested in some other better uses. The inventory turnover
ratio therefore helps a business in ensuring that it is not carrying nay excess inventory.
Similarly to judge whether we are investing reasonable amount of money in
debtors and whether we are getting reasonable credit from our creditors, following two
ratios are used:
• Debtors turnover ratio = net credit sales
Average debtors
• Creditors turnover ratio = net credit purchases
Average creditors
All of us in our day to day life in office are dealing with one or the other current assets or
current liabilities. This essentially means that every one of us is touching the working
capital cycle of business in one way or the other.

Given below are some examples of how people working in different sections of finance
deptt. Effect the working capital cycle:
a) A person who is handling banking has to make that no money is kept in current
accounts of banks as it is totally idle money. Similarly he has to make sure that if
there is some surplus money available, it is properly invested in some short term

b) A person handling suppliers payments has to make sure that advances given to
suppliers are squared off in time. Further suppliers are being paid for their dues in
time i.e. neither too early nor too late.
c) A person involved in sales accounting has to make sure that money which is
recoverable from is recoverable on due date. Further in case of bills negotiated under
L/C the money is paid by L/C opening banks on the due date.
d) A person working in journal accounting section has to make sure that money is not
blocked in unawarded current assets like security deposits if possible. Any advances
given to staff and workers are being recovered on time etc.
e) Similarly a person working in exports has to make sure that export incentives are
realized on time and a person working in imports has to make sure that claims of
overseas suppliers are settled on time or minimum balances of clearing agents are
In all the above examples it can be appreciated that operating person has to make sure
that some item of current assets is converted in cash or its equivalent within agreed time
frame or a liability is paid on time. If this is not done, it will disturb the working capital
cycle, leading to liquidity crisis and may even pose a question mark on the very survival
of business in short run.

Assessment of working capital needs by bank
One of the major sources of financing current assets is bank borrowings. The banks, in
general meet the requirement of working capital. However in certain cases, they also
meet the long term requirements of the company. The mechanism of assessing the
working capital requirements of the company is governed by the methods prescribed by
RBI from time to time. Earlier before this system was introduced different banks had
different system of assessing the working capital needs of the borrower. However, after
nationalization of banks, RBI appointed various committees like tandon committee,
chorea committee to point out various methods of assessing working capital needs of the
borrower. Over a period of time 3 months of lending time have been evolved. They are
called Ist IInd and IIIrd method of lending. In our context and in case of all those clients,

whose borrowings are more than 1 crores the most prevalent method is IInd method of
lending. It’ll therefore be appropriate to discuss this method in detail.
In this method lending, a business estimate the requirement of various current assets.
From these gross current assets, the estimated current liabilities (other than bank
borrowing ) are then reduced. This is called net working capital. From this figure a
margin of 25% of gross current assets is further reduced. The rational of reducing this
25% of current assets is that the promoter of business also has to participate in the
financing of gross current assets to the extent of 25%. The balancing figure is financed by
the bank in the shape of bank borrowings. However, the banks also stipulate a condition
that in case the business has funds in view of their desired contribution of 25% of gross
current assets, than the bank borrowing which is also called maximum permissible bank
finance (MPBF) is reduced to that extent. The calculation of MPBF is explained below
with the help of an illustration:
MPBF calculation
Rs. Lacs
Project current assets -----
Less: current liabilities (including term liability falling -----
Due within 1 year but excluding bank borrowing) -----
Working capital gap ------
Less: 25% of current assets (margin) ------
Maximum permissible bank finance (MPBF) ------

It is necessary to note here that norms for various assets and liabilities are agreed to by
the bank and the borrower based on past experience of the borrower and the norms
prevalent in the industry in which borrower operates.

Monitoring the utilization of credit facilities given by banks
In order to ensure that the credit given by the bank is properly utilized, various
information is taken by the banks from their borrowers from time to time during the year.
This information can be divided into the following:-
i) CMA form (annual renewal of limits)

ii) QIS form-I(projections for next quarter as against projections)
iii) QIS form-II( actuals for the quarter)
iv) QIS form-III (actuals for the last six months and projection for the next few
v) Drawing power statement

CMA (credit monitoring arrangement)
After having established limits initially the banks do an annual review of the limits
wherein the projections for next 2 years are given and the limits are accordingly
reassessed. For this purpose the borrower has to fill up CMA forms (there are about 7-8
forms) giving details of profitability projections, balance sheet projections and detailed
projections of current assets and liabilities.

Although the limits are established every year, in order to asses the actual requirement,
banks have a system of working quarterly information from borrower. This is done with
the help of QIS form-I wherein the projections of key items of current assets and
liabilities are given before the beginning of every quarter. The date for submission of this
form is one week before the beginning of the quarter.

This form gives the actual figures as against the figures projected in form-I after the end
of the quarter. The last date for filling this form is within 45days after the end of the

This form gives details of actual profitability and balance sheet figures for last six
months. This also provides the estimates in similar format for next six months. Last date
for filing form-III is within 60 days from the end of six months.

D.P statement

The banks although sanction the working capital limits based on the working capital
requirements of the borrower at the beginning of the year, it actually gives credit based
on the security possessed by the customers on a month to month basis. The security
actually is in the shape of actual current assets like inventories, debtors etc. held by the
borrower reduced for current liabilities like creditors, ILC, FLC payable etc. The rational
behind this exercise is that in case there is a problem with the borrower, the actual current
assets held by the client’s can be sold/realized in the market as bank has first charge over
these assets. Needless to say that while giving credit on monthly basis the bank applies
certain margin on these current assets in order to account for any shrinkage which may
occur at the time of actual realization of the assets.

Objective of Working Capital Management
Liquidity vs. profitability
The basic objective of working capital is to provide adequate support for the smooth
functioning of the normal business operations of a company. The question then arises as
to the determination of the quantum of investment in working capital that can be regarded
as ‘adequate’. The quantum of investment in current assets has to be made in manner that
it not only meets the needs of the forecasted sales but also provides a built in cushion in
the form of safety stocks to meet unforeseen contingencies arising out of factors such as
delays in arrival of raw materials, sudden spurts in sales demand etc. a company
following a conservative approach is subjected to a lower degree of risk than the one
following an aggressive approach. In the former situation the high amount of investment
in current assets imparts greater liquidity to the company than under the latter situation
wherin the quantum of investment in current assets is less. The aspect considers
exclusively the liquidity dimension of working capital.
Once we recognized the fact that the total amount of financial issues at disposal of
company is limited and these resources can be put to alternative uses, the larger the
amount of investment in current assets, the smaller will be the amount available for
investment in other profitable avenues at hand with the company. A conservative attitude
in respect of investment in current assets leaves less amount for other investment than an
aggressive approach does. Since current assets will be more for a given level of sales

forecast under the conservative approach, the turnover of current assets will be less than
what they would they be under the aggressive approach. Even if we assume the same
level of sales revenue, operating profit before interest and tax and net (operating) fixed
assets, the company following a conservative policy will have a low percentage of
operating profitability compared to its counterpart following an aggressive approach.

Cash vs. Working Capital
So far, we have discussed funds in terms of cash only. A broader and more useful way of
looking at the availability of funds involves the concept of working capital. How does
your company create income? If you manufacture a product, you use funds to purchase
inventory, produce goods with that inventory, convert those goods into accounts
receivable by selling them, and convert accounts receivable into cash when you take
payment. If you are a merchandising firm, the process is basically the same, although you
probably purchase finished goods instead of producing them. Each of the components in
this process is a current asset, such as an asset that you can convert into cash in a
relatively short period (usually, but not always, one year) as a result of your normal
business operations. Inventory and accounts receivable, for example, are not as liquid as
cash, but your business expects to convert both to cash before too long. Current
liabilities, on the other hand, are obligations that you must meet during the same
relatively short time period that defines your current assets. Notes payable, accounts
payable, and salaries are examples of current liabilities. The accrual basis more
accurately estimates income.

Particulars April May June July

"Inventory" is one of the more visible and tangible aspects of doing business. Raw
materials, goods in process and finished goods all represent various forms of inventory.
Each type represents money tied up until the inventory leaves the company as purchased
products. Likewise, merchandise stocks in a retail store contribute to profits only when
their sale puts money into the cash register.
Inventory refers to stocks of anything necessary to do business. These stocks represent a
large portion of the business investment and must be well managed in order to maximize
profits. In fact, many small businesses cannot absorb the types of losses arising from poor
inventory management. Unless inventories are controlled, they are unreliable, inefficient
and costly.
The term inventory refers to the stockpile Inventory is the set of items that an
organization holds for later use by the organization. An inventory system is a set of
policies that monitors and controls inventory. It determines how much of each item
should be kept, when low items should be replenished, and how many items should be
ordered or made when replenishment is needed.
Basic types of inventory
o Independent demand: - items are those items that we sell to customers.
o Dependent demand: - items are those items whose demand is determined by other
items. Demand for a car translates into demand for four tires, one engine, one
transmission, and so on. The items used in the production of that car (the independent
demand item) are the dependent demand items.
o Supplies. :- are items such as copier paper, cleaning materials, and pens that are not
used directly in the production of independent demand items

Why hold Inventory?

1. To decouple work centers;
2. To meet variations in demand;
3. To allow flexible production schedules;
4. As a safeguard against variations in delivery time; and
5. To get a lower price.

The cost of Inventory
o Holding costs;
o Setup costs;
o Ordering costs; and
o Shortage costs.

Opposing Views of Inventory
o Why we want to hold inventories
o Why we donot want to hold inventories.

Why We Want to Hold Inventories?
o Improve customer service
o Reduce certain costs such as
-ordering costs
-stockout costs
-acquisition costs
-start-up quality costs
o Contribute to the efficient and effective operation of the production system.
o Finished Goods
 Essential in produce-to-stock positioning strategies
 Necessary in level aggregate capacity plans
 Products can be displayed to customers
o Work-in-Process
 Necessary in process-focused production

 May reduce material-handling & production costs
o Raw Material
 Suppliers may produce/ship materials in batches
 Quantity discounts and freight/handling and savings

Why We Do Not Want to Hold Inventories?
o Certain costs increase such as
• carrying costs
• cost of customer responsiveness
• cost of coordinating production
• reduced-capacity costs
• large-lot quality cost
• cost of production problems.

Two Fundamental Inventory Decisions
o How much to order of each material when orders are placed with either outside
suppliers or production departments within organizations
o When to place the orders.

Independent Demand Inventory Systems
o Demand for an item carried in inventory is independent of the demand for any other
item in inventory
o Finished goods inventory is an example
o Demands are estimated from forecasts and/or customer orders

Dependent Demand Inventory Systems
o Items whose demand depends on the demands for other items
o For example, the demand for raw materials and components can be calculated from
the demand for finished goods

o The systems used to manage these inventories (Chapter 15) are different from those
used to manage independent demand items

Inventory Costs
Costs associated with ordering too much (represented by carrying costs) and Costs
associated with ordering too little (represented by ordering costs). These costs are
opposing costs, i.e., as one increases the other decreases .The sum of the two costs is the
total stocking cost (TSC) When plotted against order quantity, the TSC decreases to a
minimum cost and then increases. This cost behavior is the basis for how much to order
and this is known as the economic order quantity (EOQ).

Behavior of EOQ Systems
As demand for the inventoried item occurs, the inventory level drops. When the
inventory level drops to a critical point, the order point, the ordering process is triggered.
The amount ordered each time an order is placed is fixed or constant. When the ordered
quantity is received, the inventory level increases. An application of this type system is
the two-bin system. A perpetual inventory accounting system is usually associated with
this type of system

Why use inventories?
1. Inventories smooth out time gap between demand and supply.
2. Holding inventory may contribute to lower production costs.
3. Inventories provide a way of “storing” labor (make more now free up labor later).
4. inventory can provide quick customer service(convenience).

EOQ assumptions
o single product with a constant and known demand rate.
o Goods arrive the same day they are ordered.
o No shortages allowed : we must reorder when inventory reaches zero.

Successful inventory management

Successful inventory management involves balancing the costs of inventory with the
benefits of inventory. Many small business owners fail to appreciate fully the true costs
of carrying inventory, which include not only direct costs of storage, insurance and taxes,
but also the cost of money tied up in inventory. This fine line between keeping too much
inventory and not enough is not the manager's only concern. Others include:
• Maintaining a wide assortment of stock -- but not spreading the rapidly moving ones
too thin;
• Increasing inventory turnover -- but not sacrificing the service level;
• Keeping stock low -- but not sacrificing service or performance.
• Obtaining lower prices by making volume purchases -- but not ending up with slow-
moving inventory; and
• Having an adequate inventory on hand -- but not getting caught with obsolete items.
The degree of success in addressing these concerns is easier to gauge for some than for
others. For example, computing the inventory turnover ratio is a simple measure of
managerial performance. This value gives a rough guideline by which managers can set
goals and evaluate performance, but it must be realized that the turnover rate varies with
the function of inventory, the type of business and how the ratio is calculated (whether on
sales or cost of goods sold). Average inventory turnover ratios for individual industries
can be obtained from trade associations.

The purchasing plan
One of the most important aspects of inventory control is to have the items in stock at the
moment they are needed. This includes going into the market to buy the goods early
enough to ensure delivery at the proper time. Thus, buying requires advance planning to
determine inventory needs for each time period and then making the commitments
without procrastination. For retailers, planning ahead is very crucial. Since they offer new
items for sale months before the actual calendar date for the beginning of the new season,
it is imperative that buying plans be formulated early enough to allow for intelligent
buying without any last minute panic purchases. The main reason for this early offering
for sale of new items is that the retailer regards the calendar date for the beginning of the
new season as the merchandise date for the end of the old season. For example, many

retailers view March 21 as the end of the spring season, June 21 as the end of summer
and December 21 as the end of winter. Part of your purchasing plan must include
accounting for the depletion of the inventory. Before a decision can be made as to the
level of inventory to order, you must determine how long the inventory you have in stock
will last. For instance, a retail firm must formulate a plan to ensure the sale of the greatest
number of units. Likewise, a manufacturing business must formulate a plan to ensure
enough inventory is on hand for production of a finished product.

In summary, the purchasing plan details:
• When commitments should be placed;
• When the first delivery should be received;
• When the inventory should be peaked;
• When reorders should no longer be placed; and
• When the item should no longer be in stock.
Well planned purchases affect the price, delivery and availability of products for sale.

Controlling inventory
To maintain an in-stock position of wanted items and to dispose of unwanted items, it is
necessary to establish adequate controls over inventory on order and inventory in stock.
There are several proven methods for inventory control. They are listed below, from
simplest to most complex.
• Visual control enables the manager to examine the inventory visually to determine if
additional inventory is required. In very small businesses where this method is used,
records may not be needed at all or only for slow moving or expensive items.
Tickler control enables the manager to physically count a small portion of the inventory
each day so that each segment of the inventory is counted every so many days on a
regular basis.
• Click sheet control enables the manager to record the item as it is used on a sheet of
paper. Such information is then used for reorder purposes.
• Stub control (used by retailers) enables the manager to retain a portion of the price
ticket when the item is sold. The manager can then use the stub to record the item that

was sold. As a business grows, it may find a need for a more sophisticated and
technical form of inventory control. Today, the use of computer systems to control
inventory is far more feasible for small business than ever before, both through the
widespread existence of computer service organizations and the decreasing cost of
small-sized computers. Often the justification for such a computer-based system is
enhanced by the fact that company accounting and billing procedures can also be
handled on the computer.
• Point-of-sale terminals relay information on each item used or sold. The manager
receives information printouts at regular intervals for review and action.
• Off-line point-of-sale terminals relay information directly to the supplier's computer
who uses the information to ship additional items automatically to the buyer/inventory
The final method for inventory control is done by an outside agency. A manufacturer's
representative visits the large retailer on a scheduled basis, takes the stock count and
writes the reorder. Unwanted merchandise is removed from stock and returned to the
manufacturer through a predetermined, authorized procedure. A principal goal for many
of the methods described above is to determine the minimum possible annual cost of
ordering and stocking each item. Two major control values are used: 1) the order
quantity, that is, the size and frequency of orders; and 2) the reorder point, that is, the
minimum stock level at which additional quantities are ordered. The Economic Order
Quantity (EOQ) formula is one widely used method of computing the minimum annual
cost for ordering and stocking each item. The EOQ computation takes into account the
cost of placing an order, the annual sales rate, the unit cost, and the cost of carrying

Developments in inventory management
In recent years, two approaches have had a major impact on inventory management:
Material Requirements Planning (MRP) and Just-In-Time (JIT and Kanban). Their
application is primarily within manufacturing but suppliers might find new requirements
placed on them and sometimes buyers of manufactured items will experience a difference
in delivery.

Material requirements planning is basically an information system in which sales are
converted directly into loads on the facility by sub-unit and time period. Materials are
scheduled more closely, thereby reducing inventories, and delivery times become shorter
and more predictable. Its primary use is with products composed of many components.
MRP systems are practical for smaller firms. The computer system is only one part of the
total project which is usually long-term, taking one to three years to develop.
Just-in-time inventory management is an approach which works to eliminate inventories
rather than optimize them. The inventory of raw materials and work-in-process falls to
that needed in a single day. This is accomplished by reducing set-up times and lead times
so that small lots may be ordered. Suppliers may have to make several deliveries a day or
move close to the user plants to support this plan.

Tips for better inventory management
At time of delivery
• Verify count -- Make sure you are receiving as many cartons as are listed on the
delivery receipt.
• Carefully examine each carton for visible damage -- If damage is visible, note it on the
delivery receipt and have the driver sign your copy.
• After delivery, immediately open all cartons and inspect for merchandise damage.
When damage is discovered
Retain damaged items -- All damaged materials must be held at the point received.
Call carrier to report damage and request inspection.
Confirm call in writing--This is not mandatory but it is one way to protect yourself.

• Carrier inspection of damaged items. Have all damaged items in the receiving area --
Make certain the damaged items have not moved from the receiving area prior to
inspection by carrier.
• After carrier/inspector prepares damage report, carefully read before signing.

Special tips for manufacturers

If you are in the business of bidding, specifications play a very important role. In writing
specifications, the following elements should be considered.
• Do not request features or quality that are not necessary for the items' intended use.
• Include full descriptions of any testing to be performed.
• Include procedures for adding optional items.
• Describe the quality of the items in clear terms.
The following actions can help save money when you are stocking inventory:
• Substitution of less costly materials without impairing required quality;
• !Improvement in quality or changes in specifications that would lead to savings in
process time or other operating savings;
• Developing new sources of supply;
• Greater use of bulk shipments;
• Quantity savings due to large volume, through consideration of economic order
• A reduction in unit prices due to negotiations;
• Initiating make-or-buy studies;
• Application of new purchasing techniques;
• Using competition along with price, service and delivery when making the purchase
selection decision.

Glossary of Financial Terms along with Definition
A certificate of debt issued to raise funds. Bonds typically pay a fixed rate of interest and
are repayable at a fixed date.
Capital Budgeting
The process of managing capital assets and planning future expenditure on capital assets.
Capital Investments
Funds invested by a business in its capital assets that are anticipated to be used before
being replaced. Capital investments are generally significant business expenses, requiring
long-term planning and financing.
Current Assets
A balance sheet item, current assets are those items owned by the firm with the intention
to generate profits or other assets that can be converted to cash within one year. It
includes cash, account receivables, inventory, cash equivalents and other cash
Convertible Loans
A loan with a provision allowing it to be converted to equity within a specific time frame.
Convertible Preference Shares

Preference equity shares issued by a business that include a provision allowing them to be
converted to ordinary equity shares after a specific time frame.
Creditors or Accounts Payable
Suppliers the company owes money to, usually for services or goods supplied.
Creditors' Turnover Rate
A short-term liquidity measure used to quantify the rate at which a business pays off its
Debt Financing Debtors or Accounts Receivable
The money that you borrow to finance a business. Customers who owe the company
money, usually for services or goods supplied.
Debtors' Turnnover Rate
A short-term liquidity measure used to quantify the rate at which a business receives
payment from customers.
Default Risk or Risk of Default
The risk of loss due to non-payment by the borrower.
The earnings before interest, taxes, depreciation and amortization. It is the net cash
inflow from operating activities, before working capital requirements are taken into
A measure of operating performance. It is calculated by dividing EBITDA by sales and is
usually expressed as a percentage.
Equity Financing
The issuance of ordinary shares to raise money for a business.
Selling the interest in the accounts receivable or invoices to a financial institution at a
small discount. It is sometimes called "accounts receivable financing". Factoring helps a
company speeds up its cash flow so that it can more readily pay its current obligations
and grow.
Fixed Assets

Fixed assets are those long-term tangible assets that the business has acquired for use to
earn income over more than one year. These assets normally must have a useful life over
a few years and not expected to be converted to cash in the current financial year.
Examples include, factory, warehouse, equipment, fixtures and etc.
Initial Public Offering (IPO)
The sale of a company's shares to the public on a stock exchange for the first time.
Interest Coverage Ratio
An indication of the ability of a business to cover interest expenses with its income. It is
calculated by dividing income before interest and taxes by interest paid.
Letter of Credit
A written undertaking by a bank, given to a seller at the request and on the instruction of
the buyer, to pay up, at sight or at a future date, up to a stated sum of money within a
prescribed time limit.
Trust Receipt
A financing facility for imports where a bank makes an advance to the buyer to settle an
import sight bill. The advance is generally for a certain period. On the due date, the buyer
is required to settle the bill with interest at an agreed rate.
Profit Margin
A measure of a company's profitability. It is calculated by dividing net profit by sales and
is usually expressed as a percentage.
Return on Equity (ROE)
A measure of the return on each dollar of shareholder investment. It is calculated by
dividing net profit by equity and is usually expressed as a percentage.
Stock Turnover
A measure of inventory performance to show how fast stock is converted from purchases
to sales. It is calculated by dividing stock level by cost of sales x 365 days
Term Loan
A loan for a fixed period of more than one year and repayable by regular installments.