Working Capital Management: Discussion Points

WORKING CAPITAL
CHAPTER
MANAGEMENT
6 Discussion Points
Introduction to Working Capital Management
Determinants of Working Capital
Financing Current Assets
Cash Management
Cash Management Techniques
Cash Management Models
Receivable Management
Inventory management
Objectives of Inventory Management
Techniques of Inventory Management
INTRODUCTION TO WORKING CAPITAL MANAGEMENT
 Management of working capital is an important part of

financial manager.
 The main objective of the working capital management is
managing the current asset and current liabilities
effectively and maintaining adequate amount of both
current assets and current liabilities.
Meaning of Working Capital
 There are two concepts of working capital – gross and net
(i) Gross Working Capital – refers to the firm’s investment
in current assets.
…INTRODUCTION TO… CONT’D
(ii) Net Working Capital – refers to the difference between

current assets and current liabilities.
 Net working capital can be positive or negative. A positive
net working capital will arise when current assets exceed
current liabilities. A negative net working capital occurs
when current liabilities are in excess of current assets.
 The gross working capital concept focuses attention on
two aspects of current assets management: (a) how to
optimize investment in current assets, and (b) how should
current assets be financed?
…INTRODUCTION TO… CONT’D
 The consideration of the level of investment in current

assets should avoid two danger points – excessive
and inadequate investments in current assets.
 Investment in current assets should be just adequate,
not more or not less, to the needs of the business firm.
Excessive investments in current assets should be

avoided because it impairs the firm’s profitability, as idle
investment earns nothing. Inversely, insufficient amount of
working capital can threaten solvency of the firm
because of its inability to meet its current obligations.
…INTRODUCTION TO… …Cont’d
CONT’D
 It should be recognized that the working capital

needs of the firm may be fluctuating with changing
business activity. This may cause excess or
shortage of working capital frequently. The
management should be prompt to initiate an
action and correct imbalances.
CONT’D
 Whenever there is excess investments in current assets that

may not be needed in the normal course of business, it should
be invested in the appropriate investment vehicle to produce
earnings.
 Inversely, whenever a need for working capital funds arises
due to the increasing level of business activity or for any other
reason, financing arrangement should be made quickly.
 Thus, the financial manager should have a knowledge of the
sources of working capital funds as well as investment
avenues where idle funds may be temporarily invested.
CONT’D
Current assets should be sufficiently in excess of

current liabilities to constitute a margin or
cushion for maturing obligations within the
ordinary operating cycle of a business.
In order to protect their interests, short-term

creditors always like a company to maintain current
assets at a higher level than current liabilities. It is a
conventional rule to maintain the level of current
assets twice the level of current liabilities.
CONT’D
However, the quality of current assets should be considered

in determining the level of current assets vis-à-vis current
liabilities.
A weak liquidity position poses a threat to the solvency of the
company and makes it unsafe and unsound.
A negative working capital means a negative liquidity,
and may prove to be harmful for the company’s
reputation.
Excessive liquidity is also bad. It may be due to
mismanagement of current assets. Hence, timely
action must be taken by management to improve and
correct the imbalances in the liquidity position of the
firm.
CONT’D
 Working Capital Policy – refers to the firm’s basic policies

regarding (i)target levels for each categories of current asset,
and (ii) how current assets are to be financed.
 Working Capital Management is an act of planning,
organizing and controlling the components of working capital
like cash, short-term investments, receivables, inventories,
payables, overdrafts and short-term loans.
 Working capital management is concerned with the problems
that arise in attempting to manage the current assets, current
liabilities and the interrelationship that exist between them.
CONT’D
Balanced Working Capital Position

 The firm should maintain a sound working capital position. It
should have adequate working capital to run its business
operations.
 Both excessive as well as inadequate working capital
positions are dangerous from the firm’s point of view.
 Excessive working capital means idle funds which earn no
profits for the firm. Paucity of working capital not only
impairs the firm’s profitability but also results in production
interruptions and inefficiencies.
CONT’D
۩Some of the dangers of maintaining excessive working

capital are:
a) It results in unnecessary accumulation of inventories.
Thus, chances of inventory waste, theft and losses
increase.
b) It is an indication of defective credit policy and slack
collection period. Consequently, higher incidence of bad
debts results, which adversely affects profits.
c) Excessive working capital makes management satisfied
which degenerates into managerial inefficiency.
CONT’D
۩Some of the Effects of inadequate working capital are:

a) It stagnates growth. It becomes difficult for the firm to
undertake profitable projects for non-availability of working capital
funds
b) It becomes difficult to implement operating plans and
achieve the firm’s profit target.
c) Operating inefficiencies creep in when it becomes difficult even
to meet day-to-day commitments.
d) Paucity of working capital funds render the firm unable to
avail attractive credit opportunities,
e) The firm loses its reputation when it is not in a position to
honor its short-term obligations. As a result, the firm faces tight
credit terms.
CONT’D
 An enlightened management
should, therefore, maintain the
right amount of working capital
on a continuous basis. Only
then a proper functioning of
business operations will be
ensured.
 Sound financial and statistical
techniques, supported by
judgment, should be used to
predict the quantum of working
capital needed at different time
period.
Determinants of Working Capital…Cont’d
 There are no set rules or 1) Nature of Business

formula to determine the Working capital requirements
working capital needs of of a firm are basically
firms. influenced by the nature of its
 A large number of factors, business.
For example, trading and
each having a different
importance, influence financial firms have a very
working capital needs of small investment in fixed
firms. assets, but require a large sum
of money to be invested in
 Some of these factors are
working capital.
described below:
Determinants of Working …Cont’d
Capital
 Retail stores must carry large stocks of a variety of goods to
satisfy varied and continuous demands for their customers.
 In contrast, public utilities have a very limited need for
working capital and have to invest abundantly in fixed
Assets.
2) Sales and Demand Conditions
The working capital needs of a firm are related to its sales
A growing firm may need to invest funds in fixed
assets in order to sustain its growing production and
sales. This will, in turn, increase investments in
current assets to support the inflated scale of
operations.
Determinants of Working Capital
…Cont’d
3) Technology and Manufacturing Cycle

 The manufacturing cycle (or the inventory conversion
cycle) comprises of the purchase and use of raw
materials and the production of finished goods.
Longer the manufacturing cycle, larger will be the firm’s

working capital requirements. For example, the
manufacturing cycle in the case of a boiler, depending on
its size, may range between six to twenty-four months.
Inversely, the manufacturing cycle of products such as
detergent powder, soaps, chocolate, etc. may be a few
hours.
 An extended manufacturing
time span means a larger tie-
up of funds in inventories.
Thus, if there are alternative
technologies of manufacturing
a product, the technological
process with the shortest
manufacturing cycle may be
chosen.
 A high collection period will mean tie-up of large funds

in receivables. Loose collection procedures can increase
the chance of bad debts.
 In order to ensure unnecessary funds are not tied-up in
receivables, the firm should follow a rationalized
credit policy based on the credit standing of customers
and other relevant factors.
4) Availability of Credit
 A firm which can get bank credit easily on favorable
conditions, will operate with less working capital
than a firm without such a facility.
Determinants of Working…Cont’d
Capital
5) Credit Policy
The credit policy of the firm affects the working
capital by influencing the level of debtors.
A liberal credit policy, without rating the credit-

worthiness of customers, will be detrimental to
the firm and will create a problem of collecting
funds later on.
Determinants of Working…Cont’d
Capital
6) Operating Efficiency
 The firm may keep its investment in working capital
at lower level if it is efficient in controlling operating
costs and utilizing current assets.
 The use of working capital is improved and pace of
cash conversion cycle is accelerated with operating
efficiency.
7) Price Level Changes
 Generally, rising price levels will require a firm to
maintain higher amount of working capital.
Financing Current Assets
…Cont’d
 A firm can adopt different financing policies vis-a-vis current

assets. Three types of financing may be distinguished:
(1) Long-term financing – The sources of long-term
financing include:
♠ ordinary share capital,
♠ preference share capital,
♠ debentures,
♠ long-term borrowings from financial firms and
♠ reserves and surplus (retained earnings).
Financing Current …Cont’d
Assets
(2) Short-term financing – The short-term financing is

obtained for a period less than one year. It can be obtained
from banks and other suppliers of short-term finance in
the money market. Short-term finances include working
capital funds from banks, public deposits, commercial
paper, factoring of receivables, etc.
…Cont’d
Financing Current Assets
(3) Spontaneous financing –

it refers to the automatic
sources of short-term funds
arising in the normal course
of a business. Trade credit
and outstanding expenses
are examples of spontaneous
financing. The firm is
expected to utilize this
sources of finances to the
fullest extent.
Cash Management …Cont’d
 Business concerns needs cash to make payments for

acquisition of resources and services for the normal
conduct of business.
 Cash is one of the important and key parts of the current
assets.
 Cash is the money which a business concern can disburse
immediately without any restriction.
 The term cash includes coins, currency, checks held by the
business and bank balance.
 Cash management involves

 identifying sources of cash flows,
 identifying various avenues to invest surplus cash
effectively, and
 being prepared to meet any cash contingencies.
A Cash crises can be pre-empted by preparing a cash budget.
This involves short-term cash forecasting (weekly, monthly,
and annually) to help manage daily cash; and long-term
(annual, 3 – 5 years) cash flow projections to develop the
necessary capital strategy to meet business needs.
Motives for Holding Cash

1. Transaction Motive
 It is a motive for holding cash or near cash to meet routine cash
requirements to finance transaction in the normal course of
business.
 Cash is needed to make purchases of raw materials, pay expenses,
taxes, dividends etc.
2. Precautionary Motive
 It is the motive for holding cash or near cash as a cushion to meet
unexpected contingencies.
 Cash is needed to meet the unexpected situation like, floods, strikes etc.
3. Speculative Motive
 It is the motive for holding cash to quickly take advantage of
opportunities typically outside the normal course of business.
 Certain amount of cash is needed to meet an opportunity to purchase
raw materials at a reduced price or make purchase at favorable prices.
 This is to tap profits from opportunities arising from fluctuations in
commodity prices, security prices, interest rates, etc.
4. Compensating Motive
 It is a motive for holding cash to compensate banks for
providing certain services or loans.
 Banks provide variety of services to the business concern, such
as clearance of check, transfer of funds etc.
Cash Management Techniques

 To minimize the firm’s financing requirements; financial
managers use two techniques viz., (1) speedy cash collections
and (2) slowing disbursements.
Speedy Cash Collections
 A business must concentrate in the field of speedy cash
collections from customers. For the purpose, the firm should
prepare systematic plan and refined techniques.
 Customers are encouraged to pay their bills as quickly as
possible without delay.
(1) Some of the Speedy Cash Collection techniques

applied by the firm are as below:
(a) Prompt payment by customers
 A business should encourage the customer to pay
promptly with the help of offering discounts, special
offer etc.
 It helps to reduce delaying payment of customers
and the firm can avoid delays from the customers.
(b) Early Conversion of Payments into Cash

 A business should take careful action regarding the quick
conversion of the payment into cash.
(c) Concentration Banking
 It is a collection procedure in which payments are made to
regionally dispersed collection centers, and deposited
in local banks for quick clearing.
 It is a system of decentralized billing and multiple
collection points.
 This system has the advantage of placing collection
centers close to the customers thereby reducing mail float.
Other mechanisms
(2) Slowing Disbursement

 An effective cash management is not only in the part
of speedy collection of its cash and receivables but
also it should concentrate to slowing their
disbursement of cash to the customers or suppliers.
Slowing disbursement of cash does not mean

delaying the payment or avoiding the payment.
…Cash Management
…Cont’d
 Slowing disbursement of cash is possible with the help of the

following methods:
(1) Avoiding the Early Payment of Cash
 The firm should pay its payable only on the last day of
the payment.
 If the firm avoids early payment of cash, the firm can
retain the cash with it and that can be used for other
purposes.
…Cash Management
…Cont’d
(2) Centralized Disbursement System

 Decentralized collection system will provide the
speedy cash collections.
 Centralized disbursement of cash system takes time
for collection from our accounts as well as we can pay
on the date.
Cash Management Models

 Cash management models analyze methods which
provide certain framework as to how cash
management is conducted in the firm.
 Cash management models are the development of
the theoretical concepts into analytical approaches
with the mathematical applications.
 There are two cash management models which are
very popular in the field of finance.
(1) Baumol Model

 It is a model that provides for
→cost efficient transactional balances,
→assumes that the demand for cash can be predicted
with certainty, and
→determines the optimal conversion size.
 That is, the optimum amount of cash that should be
transferred from marketable securities to cash each
time a conversion is made.
 This model assumes that the firm’s cash inflows and
outflows are known with certainty.
 A portfolio of marketable securities acts as a reservoir

for replenishing transactional cash balances.
 The firm manages this cash on the basis of the cost
of converting marketable securities into cash (the
conversion cost) and the cost of holding cash rather
than marketable securities (opportunity cost).
 Opportunity cost is the interest earnings per birr
given up during a specified time period as a result of
holding funds in cash account instead of investing
them in marketable securities.
 Thus, the firm incurs a holding cost for maintaining
the cash balance.
Cash Management
Opportunity cost - can be calculated with the help of the following

formula;
i= where,
i = interest rate earned
C/2 = Average cash balance
Conversion Cost (transaction cost) – is a cost incurred by the
firm while converting its marketable securities into cash. It is
stated as birr per conversion.
 The total conversion cost per period can be calculated with

the help of the following formula:
t=
where,
T = Total transaction cash needs for the period
b = Cost per conversion
C = Value of marketable securities
 Optimal cash conversion can be calculated with the help

of the following formula;
C=
where,
C = optimal conversion amount
b = cost of conversion into cash per lot or transaction
T = projected cash requirement
i = interest rate earned
Cash Management
 The objective of the Baumol model is to determine the

economic conversion quantity (ECQ) of cash that minimizes
total cost.
 Cash transfer that are larger than or smaller than ECQ result in
higher total cost.
 The optimum cash balance (C) or the economic conversion
quantity (ECQ), is the cost minimizing quantity of cash to be
converted from marketable securities to cash.
 The optimum cash balance, C is obtained when the total cost
is minimum.
Example:
 The management of ABC Company, a small distributor of
sporting goods, anticipates Birr 1,500,000 cash outlays
(demand) during the coming year. A recent study
indicates that it costs Birr 30 to convert marketable
securities to cash. The marketable securities portfolio
currently earns an 8 percent annual rate of return.
Required: Compute
(1) the optimum cash conversion balance (C) or the Economic conversion
quantity (ECQ)?
(2) the number of conversion during the year to replenish the account
(3) The average cash balance
(4) The total cost
Solution: (1) C=
C=
C=
C = Birr 33, 541

(2) The number of conversions during the year to replenish

the account:
= T/C
= 1,500,000/33,541
= 45
(3) The average cash balance:
= C/2
= Birr 33,541/2
= Birr 16, 770.50
(4) The total cost of managing the cash:

= i(Average cash balance) + (cost per conversion x
no. of conversions)
= i(C/2) + c(T/C)
= 0.08 (Birr 16,770.50) + (Birr 30 x 45)
= Birr 2692.00
Exercise/Assignment
 Continuing with the above illustration, determine the amount
of conversion cost, opportunity cost and total cost, assuming
that, based on the rule of thumb, the firm set the conversion
amount at:
(a) Birr 40,000
(b) Birr 30,000
(c) Which costs increase and decrease as the cash balance rises
above the optimum cash balance? Consider case (a) for
example.
(d) Which costs increase and decrease as the cash balance falls
below the optimum cash balance? Consider case (b) for
example.
Cash Management
(2) Miller–Orr Model

 Most firms don’t use their cash flows uniformly and also
cannot predict their daily cash inflows and outflows. The
Miller–Orr Model helps them by allowing daily cash flow
variation.
 The objective of this model is to determine the optimum cash
balance level which minimizes the cost of management of
cash.
 Under this model, the firm allows the cash balance to
fluctuate between the upper control limit and the lower
control limit, making a purchase and sale of marketable
securities only when one of these limits is reached.
Cash Management
 This is the method that provides for cost efficient

transactional cash balances. It assumes uncertain cash flows
and determines an upper limit (i.e., the maximum amount)
and return point for cash balances.
 The return point represents the level at which the cash
balance is set, either when cash is converted to marketable
securities or vice versa.
 Cash balances are allowed to fluctuate between the upper
limit and a zero balance.
Cash Management
 The value of the return point depends on:

(1) conversion costs
(2) the daily opportunity cost of funds, and
(3) the variance of daily cash flows.
 The variance is estimated by using daily net cash flows
(inflows minus outflows for the day).
Return point =
Cash Management
Upper limit: the upper limit for the cash balance is

three times the return point.
When the cash balance reaches the upper limit, an amount equal
to the upper limit minus the return point is converted to
marketable securities.
Cash Converted to Marketable Securities = Upper Limit – Return Point
When the cash balance falls to zero, the amount converted from
marketable securities to cash is the amount represented by the
return point.
Marketable Securities Converted to Cash = Return Point – Zero Balance

Cash Management
•
Cash Management
•
Cash Management
Note: The Miller–Orr Model is more realistic as it allows
variations in cash balance within the lower and upper limits.
The lower limit can be set according to the firm’s liquidity
requirement.
EXERCISE
• Assume Compass Corp. has fixed costs of selling securities of
Br. 800, standard deviation of daily net cash flows is Br. 5,000,
and the interest rate on marketable securities is 8%. The lower
cash balance is Br. 5,000. Calculate their target or optimal
cash balance (return-cash point) and upper limit.
Receivable Management
 The term receivables is defined as debt owed to the concern by
customers arising from sale of goods or services in the
ordinary course of business.
 Receivables are also one of the major parts of current assets of
the business concerns.
 It arises only due to credit sales to customers, hence, it is also
known as Accounts Receivables or Bills Receivables.
 Most credit sales are made on open account, without any
formal acknowledgement of debt obligation through a
financial instrument.
 Management of accounts receivable is defined as the process

of making decision resulting to the investment of funds in
these assets which will result in maximizing the overall return
on the investment of the firm.
Credit Terms
 Credit terms are specifications of the conditions under which
the firm extends credit to its customers.
 The credit terms consists of two parts: the credit period and
any cash discount terms offered.
 Account receivables represent the extension of credit by the

firm to its customers. The extension of credit to customers by
most manufacturers is a cost of doing business.
 By keeping its money tied-up in accounts receivable, the firm
loses the time value of the money and runs the risk of non-
payment by its customers. In return for incurring these costs,
the firm can be competitive, attract and retain customers, and
improve and maintain sales and profits.
Factors Determining the Receivable Size

 Receivables size of the business concern depends upon
various factors. Some of the important factors are described
below:
a) Sales Level
 Sales level is one of the important factors which determines
the size of receivable of the firm.
 If the firm wants to increase the sales level, it has to liberalize
its credit policy and terms and conditions.
 When the firm maintains more sales, there will be a
possibility of large size of receivable.
b) Credit Policy
 Credit policy is the determination of credit standards and
analysis.
 It may vary from firm to firm or even sometimes product to
product in the same industry.
 Liberal credit policy leads to increase the sales volume and
also increases the size of receivable.
 Stringent credit policy reduces the size of the receivables.
c) Credit Terms
 Credit terms specify the repayment terms required of credit
receivables, depend upon the credit terms, size of the
receivables may increase or decrease. Hence, credit term is
one of the factors which affects the size of the receivable.
d) Credit Period
 It is the time for which trade credit is extended to customers
in the case of credit sales.
 Normally, it is expressed in terms of “Net days”.
e) Cash Discount
 Cash discount is the incentive to the customers to make early
payment of the due date.
 A special discount will be provided to the customer for his/her
payment before the due date.
f) Management of Receivable
 It is also one of the factors which affects the size of receivable
in the firm.
 When the management involves systematic approaches to the
receivable, the firm can reduce the size of receivable.
Benefits of Extending Trade Credit

 The firm grants trade credit because it expects the investment
in receivables to be profitable.
 The immediate impact of granting trade credit is in the firm’s
sales level; and the motivation for investment in receivables
may be oriented toward either sales expansion or sales
retention.
 Sales expansion refers to granting more trade credit (i) to
increase sales to existing customers and/or (ii) to attract new
customers.
 The second motivation, sales retention, refers to granting

trade credit to protect the firm’s sales from competition. For
example, if a competitor offers customers better credit terms,
the firm may choose to match these terms in an effort to
protect its sales.
Costs of Extending Trade Credit

 In general, trade credit involves about five types of costs.
These are:
i) Production, selling, and administrative costs
ii) Cash discounts
iii) Bad debt losses
iv) Taxes
v) Opportunity cost.
Inventory Management
 Inventories constitute the most significant part of current
assets of the business concern. They are also essential for the
smooth running of the business concern.
 A proper planning of raw material, handling, storing and
recording is to be considered as a part of inventory
management.
 Inventory management means, management of raw materials
and related items.
 Inventory management also involves what to purchase, how
to purchase, how much to purchase, from where to purchase,
where to store and when to use for production etc.
Kinds of Inventories
 Inventories can be classified into five major categories:
A. Raw Materials Inventory – goods not committed to production.
B. Work-In Process Inventory – committed in the production process
but not yet completed.
C. Consumables – materials needed to smooth running of the manufacturing process.

D. Finished Goods Inventory – are the final output of the production process.
E. Spares – include small spares and parts.
Objectives of Inventory Management

 Inventory occupy 30 – 80% of the total current assets of the
business concern.
 It is also very essential part not only in the field of Financial
Management but also it is closely associated with production
management. Hence, in any working capital decision
regarding the inventories, it will affect both financial and
production functions of the concern. Hence, efficient
management of inventories is an essential part of any kind of
manufacturing process.
 The major objectives of inventory management are as follows:

1) to efficient and smooth production process.
2) to maintain optimum inventory to maximize the profitability.
3) to meet the seasonal demand of the product.
4) to avoid price increase in future.
5) to ensure the level and site of inventories required.
6) to plan when to purchase and where to purchase.
7) to avoid both over stock and under stock of inventory.
Techniques of Inventory Management

 Inventory management consists of effective control and
administration of inventories.
 Inventory control refers to a system which ensures supply of
required quantity and quality of inventories at the required
time and at the same time prevent unnecessary investment in
inventories.
 Inventory management techniques may be classified into
various types:
A. Techniques based on Order Quantity of Inventories
Order quantity of inventories can be determined with the
help of the following techniques:
Stock level:
 Stock level is the level of stock maintained by the business
concern at all times. Thus, the business concern should
maintain optimum level of stock to smooth running of the
business process.
Minimum Level:
 The business concern must maintain minimum level of stock
at all times. If the stocks are less than the minimum level,
then the work will stop due to shortage of materials.
Re-order Level:
 Re-ordering level is fixed between minimum level and
maximum level.
 Re-order level is the level when the business concern makes
fresh order at this level.
Re-order level = Max. Consumption x Max. Re-order period
Maximum Level:
 It is the maximum limit of the quantity of inventories, the
business concern must maintain. If the quantity exceeds
maximum level limit then it will be overstocking.
Maximum level = Re-order level + Re-order quantity – (Min.
consumption x Min. delivery period)
Danger Level:
 It is the level below the minimum level.
 it leads to stoppage of the production process.
Danger level = Average consumption x Max. Re-order period for
emergency purchase.
Average Stock Level:
 It is calculated as,
Average Stock level = Min. stock level + ½ of re-order quantity max.
level
Lead Time:
 Lead time is the time normally taken in receiving delivery
after placing orders with suppliers.
 The time taken in processing the order and then executing it
is known as lead time.
Safety Stock:
 Safety stock implies extra inventories that can be drawn
down when actual lead time and/or usage rates are greater
than expected.
 Safety stocks are determined by opportunity cost and carrying
cost of inventories.
 If the business concern maintain low level of safety stock, it will
lead to larger opportunity cost and the larger quantity of
safety stock involves higher carrying costs.
Illustration:
From the following information calculate, (1) Re-order level (2)
Maximum level (3) Minimum level (4) Average level.
Normal usage: 100 units per week
Maximum usage: 150 units per week
Minimum level: 50 units per week
Re-order quantity (EOQ) 500 units
Log in time: 5 to 7 weeks
Solution:
(1) Re-order Level:
= Max. consumption x Max. re-order period
= 150 x 7 =
= 1050 units
(2) Maximum Level:

= Re-order level + Re-order quantity – (Min. consumption x Min.
delivery period)
= 1050 + 500 – (50 x 5)
= 1300 units
•
Economic Order Quantity (EOQ):

 EOQ refers to the level of inventory at which the total cost of
inventory comprising ordering cost and carrying cost.
 Determining an optimum level involves two types of cost such
as ordering cost and carrying cost.
 The EOQ is that inventory level that minimizes the total
ordering and carrying costs.
Total Costs:
 The carrying cost of inventory is the carrying cost per unit
times the average number of units of inventory, or CQ/2.
 The total number of orders for a period of time is simply the
total usage (in units) of an item of inventory for that period,
S, divided by Q. Consequently, total ordering costs are
represented by the ordering cost per order times the
number of orders, or SO/Q. Total inventory costs, then, are
the carrying costs plus ordering costs, or
 We see from Equation that the higher the order quantity, Q,

the higher the carrying costs but the lower the total ordering
costs. The lower the order quantity, the lower the carrying
costs but the higher the total ordering costs. We are
concerned with the trade-off between the economies of
increased order size and the added cost of carrying
additional inventory.
•
Fig: Economic Order Quantity Relationship
Minimum
Total Cost
X
Order Size (Q)
Illustration of EOQ:
 To illustrate its use, suppose that usage of an inventory item is
2,000 units during a 100-day period, ordering costs are Birr
100 an order, and the carrying costs are Birr 10 per unit per
100 days. The optimal economic order quantity, then, is
•
 With an order quantity of 200 units, the firm would order

(2,000/200), or 10 times, during the period under
consideration, or every 10 days.
 We see from the Equation that Q* varies directly with total
usage, S, and order cost, 0, and inversely with the carrying
cost, C. The relationship is dampened by the square root sign
in both cases. As usage increases, the optimal order size and
the average level of inventory increase by a lesser percentage.
In other words, economies of scale are possible.

Working Capital Management: Discussion Points

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Working Capital Management: Discussion Points

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WORKING CAPITAL

 Management of working capital is an important part of

(ii) Net Working Capital – refers to the difference between

 The consideration of the level of investment in current

Excessive investments in current assets should be

 It should be recognized that the working capital

 Whenever there is excess investments in current assets that

Current assets should be sufficiently in excess of

In order to protect their interests, short-term

However, the quality of current assets should be considered

 Working Capital Policy – refers to the firm’s basic policies

Balanced Working Capital Position

۩Some of the dangers of maintaining excessive working

۩Some of the Effects of inadequate working capital are:

 There are no set rules or 1) Nature of Business

3) Technology and Manufacturing Cycle

Longer the manufacturing cycle, larger will be the firm’s

 A high collection period will mean tie-up of large funds

A liberal credit policy, without rating the credit-

 A firm can adopt different financing policies vis-a-vis current

(2) Short-term financing – The short-term financing is

(3) Spontaneous financing –

 Business concerns needs cash to make payments for

 Cash management involves

Motives for Holding Cash

Cash Management Techniques

(1) Some of the Speedy Cash Collection techniques

(b) Early Conversion of Payments into Cash

(2) Slowing Disbursement

Slowing disbursement of cash does not mean

 Slowing disbursement of cash is possible with the help of the

(2) Centralized Disbursement System

Cash Management Models

(1) Baumol Model

 A portfolio of marketable securities acts as a reservoir

Opportunity cost - can be calculated with the help of the following

 The total conversion cost per period can be calculated with

 Optimal cash conversion can be calculated with the help

 The objective of the Baumol model is to determine the

C = Birr 33, 541

(2) The number of conversions during the year to replenish

(4) The total cost of managing the cash:

(2) Miller–Orr Model

 This is the method that provides for cost efficient

 The value of the return point depends on:

Upper limit: the upper limit for the cash balance is

Cash Converted to Marketable Securities = Upper Limit – Return Point

Marketable Securities Converted to Cash = Return Point – Zero Balance

 Management of accounts receivable is defined as the process

 Account receivables represent the extension of credit by the

Factors Determining the Receivable Size

Benefits of Extending Trade Credit

 The second motivation, sales retention, refers to granting

Costs of Extending Trade Credit

C. Consumables – materials needed to smooth running of the manufacturing process.

Objectives of Inventory Management

 The major objectives of inventory management are as follows:

Techniques of Inventory Management

(2) Maximum Level:

Economic Order Quantity (EOQ):

 We see from Equation that the higher the order quantity, Q,

Fig: Economic Order Quantity Relationship

 With an order quantity of 200 units, the firm would order