Chapter 2

Working capital
management
 Introduction

Working Capital Management: Defined

• Working capital management is the administration and
control of current assets, current liabilities and the
relationship between them.
• Specifically it involves the determination of:
 The level of investment in each type of current assets
and consequently the level of total current asset
investment.
 The specific sources of financing of working capital and
their proportions
 Working capital management has the following objectives.

1. It helps to maximize the value of a firm by focusing

on maximizing the returns from the working
capital investment in relation to its cost.
2. It helps to minimize, in the long run the cost of
working capital employed by identifying least cost
sources of finance.
3. It helps to control the flow of funds within the
organization so that the firm can meet its financial
obligation and run its operation smoothly
 Working capital management is important for a number of reasons

• First through a proper working capital management a firm

can avoid liquidity crisis that results in financial
embarrassment to its creditors.

• Second, in many manufacturing and merchandising firms

current assets constitute relatively large proportion of total
assets. This by itself justifies the close attention and
management of working' capital.

• Third, working capital involves firm's day-to-day transactions

and occupies most of the time of finance personnel.
• Working capital: firm’s investments in current assets.
• Net working capital: current assets minus current
liabilities.
Components of Working Capital
1. current asset: cash, marketable securities,
accounts receivable and inventory.
2. Current liabilities: accounts payable, banks loans
and notes payable; and portion of long term debt
(due in one year).
• 1. Permanent Working Capital
• There is always a minimum level of current assets, which is
continuously required by the enterprise to carry out its
normal business operations.
 For example, every manufacturing firm has to maintain a
minimum level of raw materials, work-in-process, finished
goods and cash balance.
 This minimum level of current assets is called permanent
working capital or permanent current assets as this part of
working capital is permanently blocked in current assets.
 2. Variable /Temporary working capital
 Temporary working capital or temporary current assets,
on the other hand, are the investment in current assets
that varies with seasonal requirements.
 It is the amount of working capital, which is required to
meet the seasonal demands and some special
unforeseen events.
 Temporary working capital differs from permanent
working capital in the sense that it is required for short
periods and cannot be permanently employed in the
business.
 Working Capital Investment policy

Investment in current assets has a lower return than

in fixed assets. Current assets have lower risks
(dangers) too.

Therefore, although large investment in current assets

signifies low risk the profitability of this investment is
low as compared to profitability of investment in fixed
assets at the same time.
A business has to strike the right balance between its
investment in current assets and that in fixed assets.
 Cont’d….
Under these assumptions, the actual level of current
assets within the firm will depend upon the firm’s
evaluation of the risk-profitability tradeoffs. Because of
the following reasons:
 increasing the proportion of current assets to fixed assets
lowers the profitability of assets (rate of return on assets)
but decreases risk (or increase the liquidity position of a
firm to meet unexpected future funds requirement)
 decreasing the proportion of current assets to fixed
assets increases profitability of assets but it increases the
risk (or reduces the liquidity position of a firm to meet
unexpected future funds requirement).
• There are three alternative working capital
investment policies. These include
conservative, Maturity Matching Financing
Policy/Strategy and aggressive working
capital investment polices.
 1. Maturity Matching Financing Policy/Strategy

A strategy (policy) to match asset and liability maturities

Short term sources are used to finance the temporary

current assets.
The permanent current asset and fixed assets are
financed with long term sources
The strategy is to match expected funds inflows with
expected fund out flows.
• Purchase terms = 2/10, n/30
• Sales terms = 2/10, n/30
 2. Conservative Stratrgy(policy)
 Suggest that estimated working capital is financed by long
term funds and if there is an emergency you can use short
term funds
 Much of the assets requirement is financed with long term
sources
 Excess of funds during off-peak season are invested in short
term securities or will be applied for the repayment of
short term obligations.
 Under conservative working capital investment policy
the company holds a relatively large proportion of its
total assets in the form of current assets
 3. Aggressive strategy (policy)

o Financing the temporary and part of the permanent

current assets with short term sources (borrowing).

o The remaining assets are financed with long term sources

o Under this policy, the company holds a relatively small
proportion of its total assets in the form of current assets.
o This policy yields a higher expected profitability and a
higher risk in contrast to conservative policy.
o The firm may be unable to meet its short-term obligations
when due from its current assets.
Factors Affecting Working Capital Requirements (Determinants of Working Capital)

• There are no set rules or formulae to determine

the working capital requirements of firms.
• Therefore, an analysis of relevant factors should
be made in order to determine total investment
in working capital. These factors affect different
firm differently.
• Factors that determine working capital
requirement of the firm include:
 1. Nature of Business
• Working capital requirements of a firm are basically influenced
by the nature of its business.
 Public utilities have a very limited need for working capital and
have to invest abundantly in fixed assets. This is because they
may have only cash sales and supply services, not products.
 Thus, no funds will be tied up in debtors and stock (inventories)
 Trading and financial firms have a very small investment in fixed
assets, but require a large sum of money to be invested in
working capital.
 WC is high because they have to stock a variety of goods.
 Manufacturing -WC requirement fall between the two extreme
requirements of trading firms and public utilities.
 2. Production (manufacturing) cycle (and technology)

• The manufacturing cycle (or the inventory conversion

cycle) comprises of the purchase and use of raw materials
and the production of finished goods.
• It covers the time span from procurement till the time it
becomes finished goods.
• Longer the manufacturing cycles, larger will be the firm’s
working capital requirements.
• E.g. Sugar Factory Vs Beer Factory
 3. Production policy
• A strategy of constant production may be maintained in order
to resolve the working capital problems arising due to seasonal
changes in the demand for the firm’s product.
• A steady production policy will cause inventories to
accumulate during the off-season periods and the firm
will be exposed to greater inventory costs and risks.
• Thus, if costs and risks of maintaining a constant
production schedule are high, the firm may adopt a
variable production policy, varying its production
schedules in accordance with changing demand.
 4. Credit Policy
• The credit policy of a firm in its dealings with debtors
and creditors influences considerably the
requirements of working capital investment.
• A firm that purchases on credit and sells its
products/services on cash requires lesser amount of
working capital investment.
• On the other hand, a firm buying its requirements for
cash and allowing credit to its customers shall need
larger amount of working capital investment as very
huge amount of funds are bound to be tied up in
accounts receivable.
 5. Business cycle
• During the period of boom, production is more and
WC is high.
• During a period of recession, production decline, the
requirement of WC is low.
6. Marketing policy of the firm (Market and
demand conditions)
 Skimming the cream-pricing strategy that a firm should
adopt, i.e., taking the most important thing from the
market.
 It is possible when there is no close substitute
(Competition) to the market.
 The production is less, you sell less then you will get
higher amount of profit by using a small amount of WC
– Market penetration: - By making the price , sale ,
profit , you will have to produce more so working
capital will be more.
 7. Growth and expansion
• More fixed assets and more working capital
 Product diversification
 Expanding existing product line
 New business line.
 8.Availability of Credit from suppliers
• The working capital requirements of a firm are also
affected by credit terms granted by it suppliers.

• A firm will needless working capital if liberal credit

terms are available to it from suppliers.

• In the absence of suppliers credit, the firm either has to

hold cash or borrow from bank (which is interest
bearing).
 9. Profit level

 The net profit is the source of working capital to the

extent that it has been earned in cash.

 Higher profit margins would improve the prospects of

generating more internal funds there by contributing
to the working capital needs.
 10. Level of taxes
 The first appropriation of profit is tax.
 Taxes may be payable in advance depending on previous
profit.
 If tax liability is increased, working capital requirement will
be high.
 Tax evasion: cheating income tax amount. Concealment of
income is tax evasion illegal action
 Tax avoidance: making use of income tax provision for
reducing tax liability.
 11. Dividend policy
– Dividend policy
• Cash dividend
• Stock dividend
• No dividend

12. Deprecation policy

There is no payment for depreciation, so no cash is
needed for this purpose
– It has an indirect effect
 12. Price level changes
 During period of inflation to maintain the same level of
requirement additional investment is needed.
 The situation has an effect only at initial position because
the company also sells the product at high amount. In this
case WC increase drastically

13. Operating Efficiency

 The operating efficiency of the firm related to the
optimum utilization of resources at minimum costs.
 The firm will be effectively contributing in keeping the
working capital investment at a lower level if it is efficient
in controlling operation costs and utilizing current assets.
Working capital policy: refers to the firm’s basic policies
regarding
1) Target levels for each category of current assets and
2) How current assets will be financed.
Working capital management: involves the administration
of current assets and current liabilities.
The three tasks of working capital management
– speeding up receipts of cash
– delaying payments of cash, and
– investing excess cash
• These three tasks should be done in a manner to
maximize shareholders wealth ,considering time value of
money in to account.
• Current asset Investment Policies
• Relaxed current asset investment( fat cat) policy
– large amounts of cash, marketable securities, and inventories
are carried and where sales are stimulated by the use of a credit
policy that provides liberal financing to customers and a
corresponding high level of receivables.
• Restricted current asset investment (lean and mean) Policy
– Holdings of cash, securities, inventories, and receivables are
minimized.
•  Moderate current asset investment policy.
– Between the two extremes.
Relaxed

Moderate

Restricted
 Operating Cycle:

• The operating cycle begins when the firm receives the raw
materials it purchased and ends when the firm collects cash
payments on its credit sales. Two measures—days’ sales
outstanding and days’ sales in inventory—help determine
the operating cycle.
•  Days’ sales in inventory(DSI) shows how long the firm keeps
its inventory before selling it. It is the ratio of the inventory
balance to the daily cost of goods sold. The quicker a firm
can move out its raw materials as finished goods, the shorter
the duration when the firm holds it inventory, and the more
efficient it is in managing its inventory.
365 days 365 days
Days' sales in inventory  DSI  
Inventory turnover Cost of goods sold / Inventory
• Days’ sales outstanding (DSO) estimates how long it takes on
average for the firm to collect its outstanding accounts receivable
balance. This ratio is also called the average collection period
(ACP).
• An efficient firm with good working capital management should
have a low average collection period compared to its industry.
365 days 365 days
Days' sales outstand.  DSO  
Accounts receivable turnover Net credit sales / Accounts receivable

• The operating cycle is calculated by summing the days’ sales

outstanding and the days’ sales in inventory.

• Operating cycle = DSO+ DSI

 Cash Conversion Cycle:
• The cash conversion cycle is related to the operating
cycle, but it does not start until the firm actually pays
for its inventory.
• The cash conversion cycle is the length of time between
the cash outflow for materials and the cash inflow from
sales.
• To measure the cash conversion cycle, we need another
measure called the day’s payables outstanding.
• Days’ payable outstanding (DPO) shows how long a firm
takes to pay off its suppliers for the cost of inventory.

365 days 365 days

Days' payables outstand.  DPO  
Accounts payable turnover Cost of goods sold / Accounts payable
• The cash conversion cycle is then calculated by
summing the days’ sales outstanding and the
days’ sales in inventory and subtracting the
days’ payables outstanding.
• The formula is
Cash Conversion Cycle  DSO  DSI  DPO
• Calculating the Operating and Cash Conversion
Cycles (example):
Item Beginning Ending Average

Inventory $200,000 $300,000 $250,000

Accounts Receivable 160,000 200,000 180,000

Accounts Payable 75,000 100,000 87,500

• Net sales (all credit sales) = $1,150,000

• Cost of goods sold = COGS = $820,000
• Days’ sales in inventory:
• Inventory turnover = COGS / Average inventory =
$820,000 / $250,000 = 3.28 times
• Days’ sales in inventory = 365 / 3.28 = 111.28 days
Days’ sales outstanding:
• Accounts receivable turnover = Credit sales /
Average accounts receivable = $1,150,000 /
$180,000 = 6.389 times
• Days’ sales outstanding = 365 / 6.389 = 57.13 days
• Operating cycle = DSO + DSI = 57.13 + 111.28 =
168.41 days
• Days’ payables outstanding:
• Accounts payable turnover = COGS / Average
accounts payable = $820,000 / $87,500 = 9.37
times
• Days’ payables outstanding = 365 / 9.37 =
38.95 days
• Cash conversion cycle = DSO + DSI – DPO =
57.13 + 111.28 – 38.95 = 129.46 days
 Chapter three

Cash and Marketable Security

Management
 Cash and marketable security management

• Cash is the ready currency to which all liquid assets

can be reduced
• Marketable securities are short term, interest-
earning, money market instruments that are used
by the firm to obtain a return on temporarily idle
funds.
• Cash and marketable securities are held by firms to
reduce the risk of technical in solvency by providing
a pool of liquid resources for use in making planned
as well as unexpected outlays.
 Motives for holding cash and near cash balances

• There are three motives for holding cash and near cash (marketable
securities) balances :
• Transaction motive: A firm maintains cash balances to satisfy the transaction
motive, which is to make planned payments for items such as materials and
wages.

• Safety motive: Balances held to satisfy the safety motive are invested in
highly liquid marketable securities that can be immediately transferred from
securities to cash.
• Such securities protect the firm against being unable to satisfy unexpected
demands for cash.

• Speculative motive: This is a motive of holding cash or near to be able to

quickly take advantage of unexpected opportunities that may arise.
• Speculative motive is the least common of the three motives.
 CASH MANAGEMENT

• The basic objective in cash management is to

keep the investment in cash as low as possible
while still keeping the firm operating efficiently
and effectively (i.e., is reducing the idle cash
amount).

• This goal usually reduces to the dictum (motto)

“collect early and pay late”.
 OBJECTIVES OF CASH MANAGEMENT

• The basic objectives of cash management are two,

these are:
To meet the cash disbursement need (payment
schedule)

To minimize funds committed to cash balance

(Minimization of Idle cash).
• These two objectives are conflicting and mutually
contradictory and it is the task of cash management
to reconcile them.
 1. Meeting the payment schedule

 In the normal course firms have to make payment of cash on a

continuous and regular basis to supplier of goods, employees
and so on. At the same time there is a constant inflows of cash
through collection from debtors and cash sales.
 Cash is “oil to lubricate the ever turning wheals of business,
without it the process of grinds to stop”.
 A basic objective of cash management is to meet the payment
schedule i.e., to have sufficient cash to meet the cash
disbursement needs of the firm. Keeping large cash balances
however implies a high cost. Sufficient and not excessive cash
can well realize the advantages of prompt payment of cash.
 2. Minimizing funds committed to cash balance

 High level of cash balance has the advantages of

prompt payment but has high costs.

 A low level of cash may result in not keeping up

payment schedule but has low cost.

 Excessive cash balance reduces profitability as well as

lower cash leads to insolvency. As excess cash or
shortage has its own costs, an optimal cash balance
would have to be arrived.
 CASH MANAGEMENT STRATEGIES

• The broad cash management strategies are

essentially related to the cash turnover process i.e.,
the cash cycle together with the cash turnover. 
 
 
 
 
 
 
MANAGING CASH COLLECTION AND DISBURSEMENT

• Float: Difference between bank cash balance

and book cash balance
• Float= Firm’s bank balance- firm’s book
balance
Float: Difference between bank cash balance and book
cash balance
Float= Firm’s bank balance- firm’s book balance

Disbursement float Collection float

• Checks written by firm • Checks received by the
• Decreased in book cash firm
but no immediate • Increase in book cash
change in bank balance but no immediate
change in bank balance
Net float= disbursement float + collection float

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

A. Speeding up collections
Concentration banking: a collection procedure in which payments are made
to regionally dispersed collection centers, then deposited in local banks
for quick clearing.
• Reduces collection float by shortening mail and clearing float.
Lockboxes: a collection procedure in which payers send their payments to a
nearby post office box that is emptied by the firm’s bank several times
daily; the bank deposits the payment checks in the firm’s account.
Reduces collection float by shortening processing float as well as mail and
clearing float.
Direct send: a collection procedure in which the payee presents payment
checks directly to the banks on which they are drawn, thus reducing
clearing float.
Preauthorized checks
Wire transfer.
 B. S-L-O-W-I-N-G D-O-W-N DISBURSMENTS

• Form the firm’s point of view, disbursement float

is desirable, so the goal in managing
disbursement float is to slow down
disbursements as much as possible.

• To do this, the firm may develop strategies to

increase mail float, processing float and
availability float on the checks it writes.
 DETERMINING THE TARGET CASH BALANCE

 The target cash balance involves a trade-off between

the opportunity costs of holding too much cash (the
carrying costs) and the costs of holding too little (the
shortage costs, also called adjustment costs).
 The nature of these costs depends on the firm’s
working capital policy.
• Cash holding
 Benefit- liquidity
 Cost- interest for gone
Estimating cash balances
• If levels of cash are too high, the profitability of the firm will be
lower than if more optimal balance were maintained.
• Firms can use either subjective approaches or quantitative
models to determine appropriate transactional cash balances.

1. Subjective approaches
2. Quantitative models
Two quantitative models:
• Baumol(BAT) model and
• The Miller-Orr model.
 Baumol(BAT) model
A model that provides for cost efficient transactional cash
balances.
Assumes that the demand for cash can be predicted with
certainty and determines the economic conversion quantity
(ECQ/C*).
 It treats cash as inventory item whose future demand for
settling transactions can be predicted with certainty.
helps in determining a firm’s optimum cash balance under
certainty.
A portfolio of marketable securities acts as a reservoir for
replenishing transactional cash balances.
• The firm manages this cash inventory 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). The economic conversion
quantity (ECQ), the cost minimizing quantity in which to
convert marketable securities to cash is
 
ECQ = 2 x Cost per Conversion x demand for cash
Opportunity cost (in decimal form)
  
 
Conversion cost: includes the fixed cost of placing and
receiving an order for cash in the amount ECQ.
• It includes the cost of communicating the necessary
information to transfer funds to the cash account, associated
paper work costs, and the cost of any follow up action.
• The conversion cost is stated as birr per conversion.
Opportunity cost: is the interest earnings per birr given up
during a specified time period as a result of holding funds in a
non-interest earning cash account rather than having them
invested in interest earning marketable securities.
Total cost: is the sum of the total conversion and total
opportunity costs.
• Total conversion =cost per conversion *number of
conversions per period.
• The number of conversions per period
= the period’s cash demand
economic conversion quantity (ECQ).
• The total birr opportunity cost
opportunity cost (in decimal form) *average cash balance.
• The average cash balance is found by dividing ECQ by 2.
The total cost equation is
Total cost = Transaction cost + Holding cost
=(Cost per conversion x number of conversions)+ [Opportunity
cost (in decimal form) x average cash balance]
Example:- The management of Alem Sport, a small distributor of
sporting goods, anticipates birr 1,500,000 in 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 or return,
Compute
1. Economic conversion quantity (ECQ)
2. Number of conversions
3. Average cash balance
4. Total cost
Assumptions that are made in the model
1. The firm is able to forecast its cash requirements with
certainty and receive a specific amount at regular intervals.
2. The firm’s cash payments occur uniformly over a period of
time i.e. a steady rate of cash outflows.
3. The opportunity cost of holding cash is known and does not
change over time. Cash holdings incur an opportunity cost in
the form of opportunity foregone.
4. The firm will incur the same transaction cost whenever it
converts securities to cash.
Limitations of the Baumol model:
1. It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.
2. MILLER- ORR MODEL
• A model that provides for cost efficient transactional cash balances
• 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.
• Return point: the value for the return point depends on:
• Conversion costs

• The daily opportunity cost of funds, and

• The variance of daily net cash flows.
 The formula for determining the return point is

 Return point= 3 x Conversion cost x Variance of daily net cash flows

3 4 x daily opportunity cost (in decimal form)

 Upper limit: the upper limit for the cash balance is three times the return point.
 Cash balance reaches the upper limit: 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
Marketable securities converted to cash = return point – zero balance
 Cash Balance falls to zero: when the cash balance falls to zero, the amount
converted from marketable securities to cash is the amount represented by the
return point.  
• Example, continuing with the prior example, it
costs Alem sport birr 30 to convert marketable
securities to cash, or vice versa; the firm’s
marketable securities portfolio earns an 8
percent annual return, which is 0.0222 percent
daily( 8%/360 days). The variance of Alem
sport’s daily net cash flows is estimated to be
birr 27,000.
 Chapter Four

Receivable Management
• Receivables arise when goods or services of a
firm are sold on credit basis.
• IMPORTANCE OF RECEIVABLES
 Sales growth
 Increase in profit
 Capability to face competition
 Receivable Management
• Receivable management involves decisions
concerning the extension of credit to
customers, protection of the investment in
receivables, achievement of timely collections
and maintenance of appropriate records.
• credit policy: which includes determining
credit selection, credit standards, and credit
terms
• collection policy: A firm’s credit selection
activity involves deciding whether to extend
credit to a customer and how much credit to
extend. Appropriate sources of credit
information and methods of credit analysis
must be developed.
 FUNCTIONS OF RECEIVABLES MANAGEMENT

• Formulation of credit policy

• Evaluation of credit policy
• Implementation of credit policy
• Administration and control of credit policy
The five C’s of Credit
Character: the applicant’s record of meeting past obligations- financial,
contractual, and moral.
 Past payment history as well as any pending or resolved legal judgments
against the applicant would be used to evaluate its character.
Capacity: the applicant’s ability to repay the requested credit.
 Financial statement analysis with particular emphasis on liquidity and debt
ratio is typically used to assess the applicant’s capacity.
Capital: the financial strength of the applicant as reflected by its ownership
position.
Collateral: the amount of assets the applicant has available for use in securing
the credit
Conditions: the current economic and business climate as well as any unique
circumstances affecting either party to the credit transaction.
Analysis of general economic and business conditions, as well as special
circumstances that may affect the applicant or firm is performed to assess
conditions.
 Collection Policy

Collection Policy is the set of procedures for

collecting accounts receivable when they are
due.
• Types of collection techniques
• Letters
• Telephone calls
• Personal visits
• Using collection agencies
• Legal action
 Chapter Five

Inventory Management
 Inventory Management
Techniques for managing inventory
• ABC system
• Economic order quantity (EOQ) model
• Reorder point
• Material requirement planning (MRP) system
and
• Just-in-time (JIT) system
 ABC system
• The ABC analysis concentrates on important items and is
also known as control by importance and exception (CIE).
• The following steps are involved in implementing the
ABC analysis:
 Classify the items of inventories, determining the expected use in units and
the price per unit for each item.
 Determine the total value of each item by multiplying the expected units by
its units price
 Rank the items in accordance with the total value, giving first rank to the
item with highest total value and so on.
 Compute the ratios (percentage) of number of units of each item to total
units of all items and the ratio of total value of each item to total value of
all items.
 Combine items based on their relative value to form three categories: -A, B
and C.
 Economic Order Quantity (EOQ)
• sophisticated tools for determining the optimal order quantity for an item
of inventory
• Excluding the actual cost of the merchandise, the costs associated with
inventory can be divided into three broad groups: order costs, carrying
costs, and total costs.
Order costs: it includes the fixed clerical costs of placing and
receiving an order-
– the cost of writing a purchase order,
– processing the resulting paperwork, and
– receiving an order and checking it against the invoice.
• Order costs are normally stated as birr per order.
Order cost = O x S/Q Where, O is order cost per order
S is usage in units per period
• Q is order quantity in units
 Carrying costs are the variable costs per unit of holding an item in
inventory for a specified time period.
These costs are typically stated as birr per unit per period.
Carrying cost includes storage costs, insurance costs, the cost of
deterioration and obsolescence, and most important, the
opportunity, or financial, cost of tying up funds in inventory.
 Carrying cost = C x Q/2 Where, C is carrying cost per unit per period
Q is order quantity in units

Total cost is defined as the sum of the order and carrying costs.
Total cost is important in the EOQ model, since the model’s
objective is to determine the order quantity that minimizes it.  
Total cost = (O x S/Q) + (C x Q/2)
 
The stated objective of the EOQ model is to find the
order quantity that minimizes the firm’s total
inventory cost.
The economic order quantity can be found with the
following formula.  

EOQ = 2xSxO
C
Example, Assume that XXX Company, a manufacturer of
electronic test equipment, uses 1,600 units of an item
annually. Its order cost is birr 50 per order, and carrying
cost is birr 1 per unit per year..
Reorder Point
• Once the firm has calculated its economic order
quantity, it must determine when to place orders.
• A reorder point is required that considers the lead time
needed to place and receive orders.
Reorder point = lead time in days x daily usage
For example, if a firm knows that it requires 10 days to place and
receive an order, and if it uses five units of inventory daily, the
reorder point would be 50 units ( 10 days x 5 units per day).
Thus as soon as the firm’s inventory level reaches 50 units, an
order will be placed for an amount equal to the economic order
quantity.
MRP (Material Resource Planning)system
 It is a system to determine what to order, when to order, and
what priorities to assign to ordering materials.
Just in time (JIT) system
 It is inventory management system that minimizes inventory
investment by having material inputs arrive at exactly the time
they are needed for production.
 Ideally, the firm would have only work in process inventory
 a JIT system uses no, or very little, safety stocks
 Extensive coordination must exist between the firm, its
suppliers, and shipping companies to ensure that material inputs
arrive on time.
 Exercise
 1. Namtig industries forecasts cash outlay of birr 1.8 million for its next
fiscal year. To minimize investment in the cash account, management
intends to apply the Baumol model. A financial analyst for the company
has estimated the conversion cost of converting marketable securities to
cash to be birr 45 per conversion transaction and the annual opportunity
cost of holding cash instead of marketable securities to be 8 percent.
 Calculate the optimal amount of cash to transfer from marketable
securities to cash (i.e the ECQ). What will be the average cash balance?
 How many transactions will be required for the year?
 Calculate the total cost resulting from use of the ECQ calculated in A.
 If management makes 12 equal conversions ( i.e one per month), what
will be 1) the total conversion cost, 2) the total opportunity cost, and 3)
the total cost.
 
 Financing Current Assets
Alternative Current asset Financing Policies
– Maturity Matching or “Self-liquidating approach.
The maturity approach calls for matching asset
and liability maturities.
 Aggressive approach
An aggressive strategy results in a relatively aggressive firm which
finances all of its fixed assets with long term capital but part of its
permanent current assets with short term, non-spontaneous
credit. In this strategy the firm financing at least is seasonal needs,
and possibly some of its permanent needs, with short term funds.
The balance is financed with long term funds
Conservative approach
The most conservative financing strategy should be to finance all
projected funds requirements with long term funds and use short
term financing in the event of an emergency or an unexpected
outflow of funds. It is difficult to imagine how this strategy could
actually be implemented, since the use of short term financing
tools, such as accounts payable and accruals, is virtually
unavoidable.