Unit – 1 seasons.

It includes the minimum level of current assets, which is

necessary over the whole period.
Working Capital Policy
Permanent Working Capital = Minimum Level of Current Assets
b. Temporary Working Capital: It is also known as seasonal or
Concept variable working capital. It represents the additional working capital
over permanent working capital which holds during peak seasons. It
There are two major concept of working capital i.e. gross concept
is desirable to finance temporary working capital by using short term
and net concept. According to gross concept, working capital refers to
financing like trade credit, short term bank loan etc.
the firm’s investment in current assets i.e. cash, MKT securities,
inventory, receivables etc. This concept –lays emphasis on optimum Temporary Working Capital = current assets of given period-
investment in current assets and financing of these current assets. permanent working capital.

According to net concept, working capital refers to the excess of Importance of Working Capital
current assets over current liabilities. In other works, net working capital The importance of having a sufficient amount of working capital
refers to the current assets which are financed by long term fund. Net are as follows:
working capital may be positive or negative. This concept lays emphasis
1. Security and confidence: Adequacy of working capital creates a
on the liquidity position of the firm and permanent sources of fund to
feeling of security and confidence among customers, creditors and
finance working capital.
business associates. Adequacy of working creates an environment of
Working capital management deals with the administration of certainty, security and confidence. Vendors workers, creditors are
current assets and current liabilities. It is concerned with the problems sure that their bills, wages and salary are paid.
arise to manage current assets and current liabilities.
2. To maintain solvency and continuing production: To maintain
Types of Working Capital the solvency of business and continue production, it is essential that
There are two types of working capital sufficient amount of funds to be available to purchase raw materials,
pay the wages and salaries, bills, and meet the other administrative
a. Permanent Working Capital: Permanent working capital is that
expenses.
level of current assets which is acquired by the firm for the normal
business operations. In other words, permanent working capital is 3. Creation of Sound Goodwill: The sufficient investment in working
that level of current assets which the firm holds even during the slack capital promotes the business payment that will results creation of

1
 credit image and will establish credit for the future or seasonal 1. Inventory Conversion Period (ICP):
operations. It may be defined as the length of time required to convert raw
4. Easy Availability of Cash: Advantage may be taken of cash materials into finished goods and then to sale those goods. It can be
discounts in the purchase of raw materials or merchandise, resulting calculated as follows:
in a saving in interest charges on the amount of working capital 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
a. ICP = = ⋯ 𝑑𝑎𝑦𝑠.
employed. 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
5. Steady work for the employees and efficiency in production: A b. ICP = × 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
continuous supply of raw materials and production means steady
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
work for employees which raises their morale increases their Or = × 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
efficiency, lowers costs and creates goodwill in community. 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
Or =
6. Easy loan from the banks: Banks are also favorable inclined in 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦

granting loans if the business is adequately finance in the first place 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
c. ICP = × 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝑨𝒏𝒏𝒖𝒂𝒍 𝒔𝒂𝒍𝒆𝒔
and has good credit standing and trade reputation.
2. Receivable Conversion Period (RCP)
7. Facility of off-season purchasing: Having adequate working
capital can take advantage of purchasing in off seasons periods, It may be defined as the length of time required to convert the
resulting in substantial saving where storage cost are not prohibitive. firms receivable into cash. In otherworld, it is the length of tie
8. Quick and Steady Return to Investors: In case of insufficiency of between credit sales and payment received from credit sales. It is also
working capital, the profits are to be retained in the business, but in called DSO, ACP, debtors collection period.
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
the case of adequacy working capital dividends and other payments a. RCP = = ⋯ 𝑑𝑎𝑦𝑠.
𝑑𝑒𝑏𝑡𝑜𝑟𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 /𝑎𝑐𝑐𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
are paid to the shareholders timely.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
b. RCP = × 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
Cash Conversion Cycle/Working Capital Cash flow Cycle 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠

𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
Working capital cash flow cycle or cash conversion cycle is the Or = × 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑙𝑎 𝑒𝑠
length of time between paying for raw material purchased and receiving
𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
cash from the sale of finished goods. It measures the length of time the Or = 𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦
fund will be tied up in working capital. It involves the following three
events:

2
3. Payable Deferral Period (Pdp) i. Inventory conversion period can reduced by processing and
selling goods more quickly.
It may be defined as the length of time between the purchse of
materials and labour and the payment of cash for them. It can be ii. Receivable conversion period can reduced by speeding up
calculated as follows: collections.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 iii. Payable deferral period can increased by slowing down the firms
i. Pdp = × 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
payment. However, in doing so, the financial manager must look
𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
Or = × 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟 into the impact of these charges into comparative cost and benefit
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠 𝑠𝑜𝑙𝑑
to the firm.
𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
Or = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑠𝑜𝑙𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦 Cash Conversion Cycle = ICP + RCP – Pdp = ……..days.
𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 Or = Operating Cycle – Pdp = …….days.
ii. Pdp = × 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐 𝑕𝑎𝑠𝑒𝑠

𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
Cash Requirement for Working Capital
Or, = 𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐 𝑕𝑎𝑠𝑒 𝑝𝑒𝑟 𝑑𝑎𝑦
As a financial manager you will be interested in figuring out how
4. Operating Cycle much cash you should arrange to meet the working capital needs of your
firm. The requirement of cash is based on the cash conversion cycle
It is the sum of inventory conversion period and receivable
longer csh conversion cycle increases the requirement of cash whereas,
conversion period. It may be define as the length of time between
shorter the cash conversion cycle reduced the requirements of cash. Thus
receiving inventory from suppliers and collecting cash from
the level of working capital depends on the length of cash conversion
customers.
cycle.
Operating Cycle = ICP + RCP = …..days.
W.C finance/Requirement of Cash/Negotiate financing needs
5. Cash Conversion Cycle
= CCC × W.C per day
Cash conversion cycle particularly represents the average
= CCC × Cost of goods sold per day
length of time that the firm must hold investment in working capital.
It measures the length of time the fund will be tied up in working = CCC × investment in operating cycle per day
capital. Working capital per day = Production unit per day × production cost per
Cash conversion cycle can be reduced by reducing inventory unit
conversion period and receiving conversion period and increasing Cost of goods sold /annual sales
Working turnover =
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑓𝑖𝑛𝑎𝑛𝑎𝑐𝑒
payable deferral period.
3
Determination of Working Capital Step – 3 Estimation of Net Working Capital

CCC determines the length of time for which fund is tied up in Estimated Net working capital
working capital working capital finance determined the amount of A. Current Assets Amount
working capital. But in this section, we discuss the computation of Raw material ×××
working capital. The calculation of working capital is based on the Working progress ×××
Finished goods ×××
holding period, production and sales unit during the year. For the Account receivable ×××
calculation of net working capital, following steps are followed. Estimated Cash Balance ×××
Total investment in current assets ×××
Step – 1. Estimation of Current assets B. Current Liabilities
i. Raw Material Accounts payable ×××
Wages ×××
𝐵𝑃𝑈×𝑅𝑎𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 Total Current Liabilities ×××
= × 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑕𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 C. Net working capital (CA – CL) ×××
𝑤𝑒𝑒𝑘 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
Add: provision against and contingencies ×××
Estimated net working capital ×××
ii. Work In Progress
𝐵𝑃𝑈 ×𝑊𝐼𝑃 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝐴𝑣𝑒𝑟𝑎𝑣𝑒 𝑕𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑟𝑖𝑜𝑑 Alternative Current Asset Financing Policies
= ×
𝑊𝑒𝑒𝑘𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟 𝑜𝑓 𝑊𝐼𝑃
Most businesses experience seasonal or cyclical fluctuations.
iii. Finished goods Business must build up current assets when the economy is strong, but
𝐴𝑣𝑒𝑟𝑎𝑣𝑒 𝑕𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑟𝑖𝑜𝑑 they then sell off inventories and reduce receivables when the economy
𝐵𝑃𝑈 ×𝑃𝑅𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
= ×
𝑊𝑒𝑒𝑘𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟 𝑜𝑓 𝑊𝐼𝑃 slacks off. Still, current assets rarely drop to zero. The company holds
minimum level of current asset at any time even business runs at the low
iv. Account Receivable
point of cycle; when sales increase during the upswing, current asset
𝐵𝑢𝑑𝑔𝑒𝑡 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑢𝑛𝑖𝑡 ×𝑐𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 must be increased and these additional current assets are defined as
= ×
𝑤𝑒𝑒𝑘𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
temporary current assets. The manner in which the permanent and
Step – 2. Estimation of Current Liabilities temporary current assets are financed is called the firm’s current asset
𝐵𝑃𝑈 ×𝑅𝑀 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 financing policy.
i. Account Receivable = × 𝐴𝑃𝑃
𝑊𝑒𝑒𝑘𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

𝐵𝑃𝑈 ×𝐿𝑎𝑏𝑜𝑢𝑟 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

ii. Accrued Wages = × 𝐴𝑃𝑃 𝑜𝑓 𝑤𝑎𝑔𝑒𝑠
𝑊𝑒𝑒𝑘𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

4
1. Maturity Matching or Self Liquidity Approach: Under this policy, Rupees

firm uses average level of STF and LTD under this approach PCA
Short-term non - spontaneous debt financing
are financed by LT F and temporary CA are finance by and STF.
According to this policy, maturities of current assets and liabilities
are matched. This strategy minimizes the risk that the firm will be
Long-term, debt plus equity plus spontaneous
unable to pay off its maturing obligations. PCA current liabilities

Rupees

Short-term non –spontaneous debt

financing o 1 2 3 4 5 6 7 8
TCA Time Period

3. Conservative Approach
Long-term debt plus equity plus
PCA spontaneous debt financing Under this policy firm uses more long term debt and less short term debt
for financing current assets. The firms finance its all permanent currents
FA
and some part of temporary current assets with long term financing. Only
some parts of temporary current assets are financed from short term debt.
o
1 2 3 4 5 6 7 8 Thus firm will have surplus fund during off season, which is invested in
Time Period marketable securities. This policy is a very safe and conservative as a result
of its earning will below.
2. Aggressive Approach: Under this policy, the firm uses more
Rupees
short-term debt and less long-term debt for financing of current Short-term financing requirements
assets. The firm finance its some permanent currents and all
temporary currents assets by short term financing. The firm also
financed the some part of fixed assets with short term credit, this
would be a highly aggressive, extremely non conservative
Long-term debt plus equity plus
position, and the firm would be very much. Subject to dangers spontaneous current liabilities
from rising intrest rates as well as to loan renewal problems.
However, short term debt is often cheaper than long term debt,
and some firms are willing to sacrifice safety for the chance of
higher profits. o
1 2 3 4 5 6 7 8
Time Period
5
 Balance Sheet

Conservative Matching aggressive

Fixed Assets ×××
Current Assets ×××
Total Assets ×××
Short Term Debt ×××
Long term debt ×××
Common equity ×××
Total liabilities and equity ×××

Income Statement

Conservative Moderate aggressive

EBIT ×××
Less: Interest ×××
EBT ×××
Less: Tax ×××
Net Income ×××

𝑁𝐸
ROE = × 100 = ⋯%
𝐶𝑜𝑚𝑚𝑢𝑛𝑖𝑡𝑦 𝑒𝑞𝑢𝑖𝑡𝑡𝑦

𝑁𝐼
ROA = × 100%
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

𝑆𝑎𝑙𝑒𝑠
Total assets turnover = = ⋯ 𝑡𝑖𝑚𝑒𝑠.
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

6
 Unit – 2 Sources/Types of Short-Term Financing
There are various sources of short-term financing. These sources can be
Short-Term Financial Management classified into two major types

STF

Concept
Unsecured Secured STF
Short-term financing refers to all those liabilities or debt STF

obligations which are payable in less than a year. It includes all the Spontaneous Non Inventory Receivable
current liabilities. It is used to finance the current assets such as cash, Spontaneous Financing Financing

marketing securities, inventory etc. A variety of short-term credits are

 Accruals Bank Loan  Floating lien loan  Receivable pledging
available to a firm. A financial manager should be more careful in  Deferred income  Transaction loan  Chattel mortgage loan  Receivable factoring
 Trade credit  Line of credit  Trust receipt loan
taking decision about short term financing because some are cost free,  Revolving Credit  Terminal warehouse
some are least costly, some are costly. Money Market Credit receipt loan
 Commercial Paper

Advantages/merits of Short-Term Financing

i. Cost (Lower interest rate, some are cost free) Unsecured Short-Term Financing

ii. Speed (It requires short time) i. Accruals

iii. Flexibility (Obtain or repaid for at any time) Accruals are popularly known as outstanding expenses such as
accrued wage, taxes, salary, interest expenses etc. It represents the
iv. Restriction
liabilities for the services provided to the firm but payment has not
v. Collateral (May not require collateral) been made. Thus, it is considered as an important sources of short-
Disadvantages/Demerits of Short-Term Financing term financing. It is spontaneous interest free sources of financings.
Accruals tend to expand with the scope of the operation. As sales
i. High risk
increase, labour costs
 Bankers usually increase and with them, accrued
acceptance
ii. Limited use of fund
wages increase. As profits increase, accrued taxes increase.
iii. Fluctuation in interest
iv. Limited amount of financing

7
Advantages received, advance interest received etc. Therefore, they constitute
sources of Short-Term Financing.
 Cost free sources of financing.
iii. Trade credit/Accounts Payable
 Funds can be raised internally without going out from the
company. When a company purchase goods or services from supplier or for
other firms on a basis for, cash is paid some days after the purchase,
Disadvantages
then this payable amount is known as Trade Credit.
 Less fund can be generated.
It is also known as accounts payable. Trade Credit is also a
 Funds can be generated for very short period. spontaneous short term sources of financing because the buyer does
 The postpone payment of wage increases the absenteeism, or not have to pay for goods on delivery and they have to pay after a
reduced efficiency and consequently increases the cost specified period. Trade credit becomes a built in source of financing
that varies with the production cycle.
A company can change the frequency of wage payments and thereby
affect the amount of financing. The longer the pay period, the a. Credit Term
greater the amount of accrued wage financing. Credit term refers to the condition of sale goods on credit, which
Amount of Payroll per pay day = pay period × daily wages = Rs. specifies the length of time over which credit is extended to a
……… customer and the discount if any given for early payment.

𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑝𝑎𝑦𝑟𝑜𝑙𝑙 𝑝𝑒𝑟 𝑝𝑎𝑦 𝑑𝑎𝑦 For Example:

Average accruals = = 𝑅𝑠 … … … ….
2

Annual payroll expenses = payroll expenses per pay day × No. of Discount rate
3
pay day in a year Credit terms net 30 Credit Period
10
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑤𝑎𝑔𝑒𝑠 Discount period
= 𝑅𝑠. −
𝑁𝑜. 𝑜𝑓 𝑝𝑎𝑦 𝑑𝑎𝑦𝑠
Advantages:
ii. Deferred Income
 It is a flexible source of financing.
Deferred income represents funds received by the firm for goods
and service, which it has agreed to supply in future. These receipts  Readily available.
increase the firms liquidity in the form of cash like advance rent

8
  It does not require any formal negotiation. (No need to sign Effective annual interest rate of not taking discount (EAR)
the note) 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎𝑦𝑒𝑎𝑟
𝐷𝑅 𝐶𝑃−𝐷𝑃
 Relatively easy to obtain. 𝐸𝐴𝑅 = 1 + − 1 = ⋯%
100 − 𝐷𝑅
 It does not need any collateral. iv. Short Term Loans
Disadvantages Business frequently need funds for short period to finance current
 Forgoing of discount offered by the suppliers. assets. In such a case, they may request a bank for a loan for short
period then this is called a short term fbank loan. It is shown in
 Cost of cash discount lost. balance sheet as a notes payable. It is an unsecured, non
 Inability to pay credit decreases the credit worthiness and spontaneous interest carrying and negotiated financing. The debt
credit rating. loans itself is evidenced formally by promissory note signed by the
borrower, showing the time and amount of payment and the interest
 Excessive use of trade credit threatens finance position.
to be paid.
b. Cost of Trade Credit
Features of Bank Loan
 If cash discount is not offered, and pay on due date then there is
a. Maturity: The bank loans have short maturity. The maturity is less
no cost of trade credit.
than one year.
 IF cash discount is offered and takes discount then there is also
b. Compensative Balance: Bank demands certain percentages of loan
no cost of trade credit
to deposit on loan account.
 If a cash discount is offered but not taken, there is a definite
c. Promissory Note: The loan agreement is executed by signing a
opportunity cost and it is calculated as follows
note, which specifies that. The term and condition of loan like
Annual percentage cost/Approximate annual interest cost (APC) methods for interest and principal payment time period etc.
of forgoing cash discount
Types of Bank Loans
𝐷𝑅 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐴𝑃𝐶 = 100−𝐷𝑅 × 𝐶𝑃−𝐷𝑃
× 100 = ⋯ % The unsecured short-term bank loan may be extended under a line of
𝐷𝑖𝑠𝑐𝑜𝑛𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟 credit, under a revolving credit agreement or on a transaction basis.
OR = 𝐼𝑛𝑣𝑜𝑖𝑐𝑒 × × 100 = ⋯ %
𝑝𝑟𝑖𝑐𝑒 −𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝐶𝑃−𝐷𝑃

9
i. Line of Credit ii. Revolving Credit Agreement
A line of credit is an agreement between a bank and its customer. It is a legal commitment by a bank to extend credit up to the
Specifying the maximum amount of unsecured credit, the bank will maximum amount. Since, the bank guarantees the availability of
permit the firm to use for a specified time. Usually, credit lines are funds to the borrower regardless of the scarcity of money. There are
established for a 1-year period and are subject to 1-year renewals. two types of cost associated with revolving credit agreement.
The bank does not have a legal commitment to supply the funds Interest is charged on average used amount and commitment fee
when the firm request them, but banks tend to feel morally obligated charged on average unused amount.
to provide the loan up to agreed amount Advantages:
Banks regard borrowing under lines of credit as seasonal or  It provides guaranteed fund and the bank is obligated to provide
temporary financing; they may required that the borrower be out of the fund.
bank debt at some time during the year so the borrower will be
 It provides flexibility of borrowing within a maximum limit.
required to clean up (pay off) bank debt for a period of time during
Disadvantages:
the year.
 The commitment fee should be paid on unused funds.
Advantages
Cost of Revolving Credit Agreement/Cost of Line of Credit
 Firm does not have to renegotiate fwith the bank every time
Total cost in Rs. = Interest Cost + Commitment fee
funds are required.
= Rs………….
 It can obtain funds on a short notice with little or no additional
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑐𝑜𝑚𝑖𝑡𝑚𝑒𝑛𝑡 𝑓𝑒𝑒 365
justification. 𝐴𝑃𝑅 = × × 100
𝑁𝑒𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑢𝑠𝑒𝑑 𝑁𝑜. 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑓𝑢𝑛𝑑 𝑢𝑠𝑒𝑑
 Firm can plan for its future short-term financing requirements = ……..%
without having anticipated exactly.
iii. Transaction Loan/Single Payment Notes
Disadvantages:
Borrowing under a line of credit or under a revolving credit
 It does not legally commit the bank to making loans to the firm. arrangement is no appropriate when the firm needs short-term funds
 The bank can refuse to lend an additional amount in case of the for only one purpose and for a specified time period then they
scarcity of money. borrow through transaction loan. Transaction loan is a type of short-
term loan under which a borrower agrees to repay principle and

10
 𝑚
interest in a single payment at specified maturity. It is also known as 𝐴𝑃𝑅
𝐸𝐴𝑅 = 1 + −1 = ⋯%
single payment loans. 𝑚

Methods for Computing Interest Rates iii. Add on Installment Loan

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
There are three ways for calculating the interest cost APR/Approximate Annual Rate = × 100 = ⋯ %
𝑙𝑜𝑎𝑛 /2

i. Simple Interest/Regular/Collect Basis Calculate of EAR

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐴𝑚𝑜𝑢𝑛𝑡 Step -1 Calculate Total Payable Amount
𝐴𝑃𝑅 = × 100
𝑁𝑒𝑡 𝐴𝑚𝑜𝑢𝑛𝑡 𝑈𝑠𝑒𝑑 Total payable amount = principle + interest = Rs…
𝑚
𝐴𝑃𝑅 Step -2 Calculate the Amount of Installment
𝐸𝐴𝑅 = 1 + −1 = ⋯%
𝑚 𝑇𝑜𝑡𝑎𝑙 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑎𝑚𝑜𝑢𝑛𝑡
𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛𝑡 = = 𝑅𝑠 ….
Where, 𝑁𝑜. 𝑜𝑓 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛𝑡

Net amount used = Face value of loan-CB Step – 3 Find Out The True Factor
𝐿𝑜𝑎𝑛
m= No. of interest compounding periods 𝑇𝑟𝑢𝑒 𝐹𝑎𝑐𝑡𝑜𝑟 = =×××
𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛𝑡
APR=Annual percentage rate/cost Step-4 Locate the PVIFA table in the period equal to no. of
ii. Discount Interest Loan installments and the factor value lies between ……% and
…..% and their corresponding factor value are:
Discount loan require that interest to be paid in advance. If the loan
is taken on a discount basis, the borrower actually receives less than True factor = ×××
the face amount of the loan and this increases the loan and this Factor at LR = ×××
increases the loan’s effective cost. Factor of HR = ×××
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 Step-5 By Interpolation Method
𝐴𝑃𝑅 = × 100 = ⋯ %
𝑁𝑒𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑅𝑎𝑡𝑒 = 𝐿𝑅 +
𝐹𝑎𝑐𝑡𝑜𝑟 𝑎𝑡 𝐿𝑅−𝑇𝑟𝑢𝑒 𝐹𝑎𝑐𝑡𝑜𝑟
𝐻𝑅 − 𝐿𝑅 = ⋯ %
𝐹𝑎𝑐𝑡𝑜𝑟 𝑎𝑡 𝐿𝑅−𝐹𝑎𝑐𝑡𝑜𝑟 𝑎𝑡 𝐻𝑅
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
= × 100 = ⋯ % APR = PER×m
𝐿𝑜𝑎𝑛 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝐶𝐵
% 𝐼𝑅 EAR = (1+PER)m -1 =….%
𝐴𝑃𝑅 = × 100 = ⋯ %
100 − % 𝐼𝑅 − %𝐶𝐵

11
Alternate Method 𝑁𝑒𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑
Step-3: Calculate the PVIFA factor = 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛 𝑡
Step 1 to 3 – Same
Step-4: Referring the PVIFA table in the period equal to the no. of
Step-4: installments factor lies between …..% and …..%
Referring to the PVIFA table in the period equal to the no. of Try at %
installment and factor lies between …….% and ……%. Then
PV = Installment × PVIFA, i, n
calculate one higher PV of loan and another lower PV amount
of loan. When

Try at = ………% n = No. of installment period

PV = Installment × PVIFA,i,n Step-5: Calculate period rate

= ………. 𝑃𝑉𝑙𝑅 − 𝑁𝑒𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑

𝑃𝐸𝑅 = 𝐿𝑅 + 𝐻𝑅 − 𝐿𝑅
𝑃𝑉𝐿𝑅 − 𝑃𝑉𝐻𝑅
When, n = No. of installment period
=………%
Step-5: By Interpolation Method
APR = PER×m = ……………%
𝑃𝑉𝐿𝑅 − 𝐿𝑜𝑎𝑛
𝑃𝐸𝑅 = 𝐿𝑅 + 𝐻𝑅 − 𝐿𝑅 𝐸𝐴𝑅 = (1 + 𝑃𝐸𝑅)𝑚 − 1 … … %
𝑃𝑉𝐿𝑅−𝑃𝑉𝐻𝑅
= …….% Money Market Instrument

APR = PER×m = …………% i. Commercial Paper

EAR = (1+PER)m - 1 = ……..% Commercial paper is an emergency sources of short-term financing.

It is a short-term unsecured, negotiable debt obligations and issued
by both of financial and non-financial companies for raising funds
Discounted Installment Loan from money markets. It has a maturity of a few days to maximum of
Step-1: Net Amount Received = Loan-Interest 270 days. Commercial paper is usually unsecured, only highly
creditworthy companies are able to take advantage from this
Step-2: Calculate installment on loan
financing. Commercial paper represents cheap and flexible sources
𝐿𝑜𝑎𝑛 𝑡𝑜𝑡𝑎𝑙 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 of funds especially for highly rated borrowers. For investor, it is an
𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛𝑡 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛𝑡

12
 attractive short-term investment opportunity compared to a time ii. Bankers Acceptance
deposit with a bank.
This is an instrument widely used in money market to finance
Advantages domestics well as international trade. In a typical international trade
transaction, the seller (exporter) draws a "time draft"(Like post-
 It allows the companies to meet their short-term financing needs
dated check) on the buyer's (Importer's bank. On completing the
at lower rates than bank loans.
shipment the exporter hands over the shipping document and the
 It does not require a specific security. letter of credit issued by the importer's bank to its bank.
 No compensative balance is required. The exporter's bank presents the draft to the importer's bank, which
 It enables the firm to meet large amount of credit needs. stamps it as "accepted." A banker's acceptance is created. It is
easily traded in money market because it is backed by the credit of
Disadvantages
the bank. The exporter company may discount the banker's
 It is not advantageous for low credit ranking companies acceptance in the money market before maturity or hold it till
 It is less reliable sources of credit than bank loan. maturity.
Example
 There is no extension of maturity, it must be paid on due date.
Letter of Credit
Cost of Commercial Paper
A letter of credit issued by bank simply says that if company does
Total Rupees Cost = Interest + Placement Cost
not pay its obligation by a certain time, the bank will make
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
Annual Percentage Cost (APC) = × × 100 payment.
𝑁𝑒𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑢𝑠𝑒𝑑 𝑛

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑃𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟 First: Buyer Company place an order of purchase along with LC.
= × × 100
𝑁𝑒𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑢𝑠𝑒𝑑 𝑛
Second: Seller company approaches its banks to draw time draft
After tax cost = APC (1-T) along with LC and shipping document.
Where, Third: Buyer bank receives the time draft and stamps it as
Placement Cost = Issue cost or Floatation cost or Transaction fee or "accepted". Then it is now a "banker acceptance.'
commitment fee
n = No. of days funds used.

13
Factors affecting the Interest Rate a. Floating liens Loan/Blanket:
 Personal negotiation (lender and borrower) Under floating lien arrangement, borrower may pledge inventory
 Credit worthiness of the borrower "In general" without specifying the kind of inventory involved.
 Money market condition (demand and supply) Lender receives a general claim on all of the inventory, this may
 Balance maintained in the bank account include present and future inventory. It simply acts as additional
 Cost of funds protection to the loan. It does not play a major role in deciding
 Prime rate whether loan is to be granted. In this case, loan granted will be
less. Lenders cannot exercising tight control over the collateral
 Size of loan
(Inventory).
Secured Short - Term Financing
Firm prefer to borrow loan from unsecured credit but many firms cannot  Sometimes floating lien is made to cover both receivable
obtain credit on an unsecured basis because they are new and unpoven and inventories.
or firms credit ratings are not sufficiently high. In that situation, to make  Lenders, generally, advance less than, 50% of book value
a loan, a lender (bank) requires security (collateral). Thus a secured loan of the average inventory.
is a loan for which a lender rquires collateral (security) that will reduce Lien: Right to retain possession of a property until debt is
their risk of loss. Secured loans are the following types. paid off.
i. Inventory financing b. Chattel Mortgage Agreement/Loan
ii. Receivable Financing Here, the inventory are identified specifically b serial number or
I. Inventory Financing by some other means. Borrower holds title to the goods and the
Inventory financing is the important sources of short-term secured lender has a lien on inventory. Borrower has to obtained the
credit from financial institutions. Inventories represent a reasonably consent from the lender to sell the goods. Because of the
liquid asset and are therefore suitable as security for leans. Loan is rigorous identification requirements, chattel mortgage are
provided as a certain percentage o inventory value. The amount of illsuited for inventory with rapid turnover and it is suited for
loan that can be obtained depends on marketability and portability capital goods or assets.
(durability) of the inventory. In making a loan secured with
c. Trust Receipt loan/Floor Planning
inventories, the lender can either allow the borrower to hold the
A trust receipt loan is secured by specific and easily identified
collateral or require that it be held by a third party. There are several
collateral (inventory) that remains in the control or physical
methods of obtaining loans by inventory financing. They are:

14
 possession of the borrower. Under this, borrower holds in trust collateral, against which lender advance the loan. The field
to the lender for the inventory and the sale proceeds of warehouse company has sole access to this area and is supposed
inventories. Thus this type of lending agreement is known as to maintain strict control over it.
Trust Receipt Loan or Floor Planning. This type of loan is used  Sometimes field warehouse co. many appoint watchman.
by manufacturers of automobiles, equipment dealer, automobile  The field warehouse arrangement is useful means of
dealer, and dealer of consumer durable goods. financing then it is desirable either because of the expense.
 Commission is charged on face value  Because of inconvenience,
 Generally, interest is charged on advance. (If no any  It is not possible to take inventories to terminal or public
information available) warehouse co.
d. Terminal/Public Warehouse Receipt Loan:
 It is appropriate when a borrower must wake frequent use of
A firm obtain this type of loan by storing inventories with
inventory.
terminal or public warehouse company. Once the goods are
stored, the public warehousing company will issue the receipt  Risk of fraud.
and will be pledged as collateral with the bank, against which a Calculation of Total Cost of Public Warehouse Receipt Loan
loan cann be made to the borrower. Under such an arrangement,
Servicing Cost ×××
the warehouse can release the collateral to borrower only when
Warehousing Cost ×××
authorised to do so by the lender. Consequently, lender is able to
Efficiency Cost ×××
maintain strict control over the collateral and will release
Other Cost (extra payable or reduction in cost) ×××
collateral only when the borrower pays a portion of the loan. For
Less: any reduction cost ×××
protection, the lender usually requires the borrower to take out
Total/Net Cost ×××
an insurance policy with a loss payable clause in favor of the
lender.
II. Receivable Financing
e. Field Warehouse Receipt Loan Account receivable financing is another type of secured short-term
Under field warehouse receipt loan, goods are stored in financing under this financing account receivable are used as a
borrowers' own premises. The field warehouse co. sets off collateral. They are believed to be one of the liquid assets of the firm
designated storage area for the goods to be pledged as collateral. and make security for a loan. There are two arrangements;
The field warehouse co will issue the receipt as evidence of

15
 A. Assignment of Receivable/Pledging Account Receivable: Advantages
Account receivables are one of the most liquid assets of the firm.  Very flexible type of loan
They make good security for a loan. Under pledging  No. cleanup of funds
arrangement the borrower simply pledges account receivable as  No compensative balance requirement
collateral for a loan obtained from a bank.
Disadvantages
 Generally a lender advance between 50% to 80% of their
Calculation of Cost Receivable Loan
face value.
𝑆𝑎𝑙𝑒𝑠
a. Amount of Receivables = 𝑅𝑒𝑒𝑖𝑣𝑎𝑏𝑙𝑒
 Limit of advance amount depends on the quality of the 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜

receivable. b. Average duration of receivable/Average collection period (ACP)

 Higher the quality greater would be the amount of loan and 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
ACP = = 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 = … 𝑑𝑎𝑦𝑠
𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜
vice-versa.
c. Calculation of Net amount received/Net proceeds
 Lender may reject certain receivable whose credit rating are
low. Average receivable outstanding ×××
Less: Reserve ×××
 Once the pledging agreement has been established, the firm
Less: Interest charge ×××
periodically send the lender a group of invoices along with
Total/Net Amount ×××
the loan request and this process continued.

Assignment Procedure/Pledging Procedure:

d. Total annual cost = Interest Cost + Fee
Non-notification basis versus notification basis
𝑇𝑜𝑡𝑎𝑙 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑠𝑡
e. 𝐴𝑃𝐶 = × 100 = … %
𝑁𝑒𝑡 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠
Under the non-notification basis customers of the firm are not notified
that their accounts have been pledged to the lender. The firm is not 𝐴𝑃𝐶 𝑚
f. Effective Interest Rate (EAR) = 1 + − 1 = …%
𝑚
going to inform his customer that their receivable have been credited.
B. Factoring Receivable
Under the notification basis, the customer is notified their account have
been pledged and so remit payment directly to the lender. This Factoring means selling the receivable to a factor. A factor is a
arrangement is safer from the point of view of the lender. financial institution of a professional that purchase the account
receivables of the firm then the receivables are factored or sold

16
 then title (ownership) of receivable is transferred to the factor b. Average duration of receivables (ACP)
and the receivables no longer appears on the firm' balance sheet.
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
Factoring Receivable is normally done on a notification basis 𝐴𝐶𝑃 = = … 𝑑𝑎𝑦𝑠
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜
and non-recourse basis. This means the factor receives payment
c. Net amount received/Net Proceeds
directly from the customer and he also agrees to accept all credit
risks, if purchased account receivable turnout to be uncollectible,
Average receivable outstanding ×××
the factor must absorbs the loss.
Less: Reserve for disputes ×××
 Factoring is governed by factoring agreement. Less: Commission ×××
 Agreement is generally made for one year with automatic Less: Interest Charge ×××
provision for renewal. Total/Net Amount Received ×××

 For cancellation, prior notice is registered.

d. Total Annual Rupee Cost
 For bearing risk and servicing receivable, factor will charge
Interest ×××
commission.
Add: Commission ×××
 Commission charge depends upon quality and size of Less: Saving from credit expenses ×××
receivable. Less: Saving from bad debt losses ×××
 Factoring cost includes commission and interest (charge on Total Annual Cost ×××
advance).
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡
 Factoring commissions are payments to the factor for the e. Annual Percentage Cost (APC)= × 100 = ⋯ %
𝑁𝑒𝑡 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠
administration costs, cost of credit, checking and collection 𝐴𝑃𝐶 𝑚
f. Effective Interest Rate (EAR) = 1 + − 1 = …%
𝑚
as well as for the risk (only, in case of recourse system).
 Factoring commission is charged on receivables lending.

 Other additional charge is changed on face value of loan.

Calculation of Cost of Factoring

𝑆𝑎𝑙𝑒𝑠
a. Amount of Receivables = 𝑅𝑒𝑐𝑒𝑖𝑣𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜

17
 Unit – 3 If a firm able to reduce its inventory significantly with no adverse effect
on sales, by using a better inventory control process then they saved
Inventory Management more of amount in interest and storage costs would increase earnings
much greater than expected during the same period.

Cost Influencing the Size of Inventory:

Controlling Investment in Inventory
There are two types of cost associated with inventory
Inventories represent a significant investment for many firms. management carrying cost and ordering costs. Both of these costs vary
Because the cost of money used to buy inventory (i.e. purchase price of with the changes in levels of inventory. Carrying costs increase with
raw materials) and carrying cost of inventory (i.e. storage, insurance and inventory levels whereas ordering cost decline with inventory levels. The
obsolesce cost etc) occupies the significant proportion of current assets. basic goal of inventory management is to minimize the sum of these two
Average investment in inventories is about 25% to 30%. Despite the size costs.
of a firm’s investment in inventories, the financial manager of a firm will
i. Carrying Costs: Carrying cost is the cost of holding inventory.
not normally have primary control over inventory management. Instead.
Carrying costs are normally assumed to be directly proportional to
Other functional areas such as purchasing, production, marketing will
inventory levels. Total carrying cost increases when order size
usually share decision making authority regarding inventory with
increases and it decreases when order size decreases.
financial manager. So, financial management will have indirect control
on investment in inventory. With these high costs, holding excessive When carrying cost per unit decreases then order size increases and
inventories literally can destruction of a company, decrease in vice versa.
profitability. On the other hand, shortage of inventory can lead to Determination of Carrying Costs
production interruptions, to lost sales, to lost customers, and at last to
Total carrying cost (TCC) = Average inventory×Carrying cost per
lost business so shortage can be just a harmful as excess. Thus inventory
unit
management concerned with optimum investment in inventory. and
𝑄
inventory management give focuses on four basic issues: = × 𝐶 = 𝑅𝑠 … … ….
2

i. How much inventory to hold? When safety stock is given

ii. How many units should be ordered or produced at given time. 𝑄
= + (𝑠𝑎𝑓𝑒𝑡𝑦 𝑠𝑡𝑜𝑐𝑘) × 𝐶 = 𝑅𝑠 … … ….
iii. At what point should be ordered or when to place new ordered? 2

iv. Can Changes in the cost of inventory be hedged?

18
ii. Ordering Costs: Ordering cost is the cost of placing and receiving Inspecting the numbers, we find that cost-minimizing quantity is very.
orders. It is also called setup cost or repurchase cost. It is normally The cost minimizing quantity is about 2500 units.
assumed to be fined. Total ordering cost increases when order size
Economic Order Quantity Model (EOQ)
decreases and it decreases when order size increases. When ordering
Economic order quantity determine how much should be order each time
cost per order increases then order size decreases and vice versa
in order to total cost will be minimum. It may be defined as that level of
Determination of Total ordering cost (TOC) inventory order size where total cost associated with inventory
TOC = No. of orders×Fixed cost per order management is minimum. Total cost is the total of ordering cost and
𝐴 carrying cost. It is also known as optimal inventory level. The cost is not
=𝑄×𝑜
necessarily for choosing the optimal inventory. The other factors should
where, be considered while designing inventory policy (dealing with optimal
order quantity) are quantity discount, inflation, seasonal demand etc.
A = Annual Consumption
There are three methods for determining EOQ.
O = Ordering cost per order/fixed cost per order
1. Formula Method
C = Carrying cost per unit
2𝐴𝑂
a. EOQ = × … … . . 𝑢𝑛𝑖𝑡𝑠
𝐶
Q = Order Size
𝐴 𝐴
The total costs associated with holding inventory are the sum of b. Optimum no of order = 𝑂𝑟
𝐸𝑂𝑄 𝑂𝑟𝑑𝑒𝑟 𝑆𝑖𝑧𝑒

the carrying costs and ordering costs. Our goal is to find the cost of c. Total cost of EOQ = TOC + TCC
ordered quantity, that minimizes this cost to see how we might go about 𝐴 𝐸𝑂𝑄
this, we can calculate total costs for different order size. = ×𝑂+ ×𝐶
𝐸𝑂𝑄 2

For example, ABC Corporation, had carrying costs Rs. 0.75 per d. Total Inventory Cost at EOQ Level
unit and ordering cost Rs. 50 per order and total unit sale of 46800 units. 𝐴 𝐸𝑂𝑄
= ×𝑂+ + 𝑆𝑎𝑓𝑒𝑡𝑦 𝑠𝑡𝑜𝑐𝑘) × 𝐶
𝐸𝑂𝑄 2
Orders Rs. Carrying Cost Ordering Cost Total Cost
(Q) (Q/2×C) (A/Q×O) e. Total inventory Cost with Purchase Price
500 187.5 4680 4867.5
𝐴 𝐸𝑂𝑄
1000 375 2340 2715 = ×𝑂+ + 𝑆𝑎𝑓𝑒𝑡𝑦 𝑆𝑡𝑜𝑐𝑘 × 𝐶 + 𝐴 × 𝑃
𝐸𝑂𝑄 2
1500 562.5 1560 2122.5
2000 750 1170 1920 f. Length of Inventory Cycle/Order Frequencey
2500 937.5 936 1873.5
3000 1125 780 1905 𝐸𝑂𝑄
Order Frequency =
3500 1312.5 6686 1981.1 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑑𝑎𝑦 𝑜𝑟 𝑤𝑒𝑒𝑘

19
 2. Tabulation Method/Trial and Error Method 1200
TCC
Under this method, total cost for different alternative order size 1000
are calculated. The order size having minimum total cost is EOQ.
800 TIC
Following steps are considered while determining EOQ.
600
Determination of EOQ
400
Order Size (A/No. of order 250 500 1000 2000 13000
TOC
No. of order = (A/order size) 200

Average inventory = (Order

size/2) o 100 200 300 400 500
Carrying cost (AI×C)
Ordering Cost (No. of order×O) Total Inventory Cost at Quantity Discount Offer
Total Cost
Sometimes, supplier may offer quantity discount for order at
large quantity. The quantity discount offer lower the unit price. Decrease
3. Graphic Method in unit price also decreases carrying cost per unit if carrying cost is given
Under this method, EOQ is determined with the help of graphical in percentage of purchase price.
representation of cost versus units. for example. Step – 1 To calculate total cost of EOQ
A = 800 units 𝐴 𝐸𝑂𝑄
Cost of EOQ = 𝐸𝑂𝑄 × 𝑂 + ×𝐶
2
O = Rs. 100 per order
Step – 2 To calculat4e total cost at discount offer order size.
C = Rs. 4 Per unit
𝐴 𝑄
Total inventory cost = × 𝑂 + 2 × 𝐶 − 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑐𝑜𝑠𝑡
2𝐴𝑂 2×800×100 𝑄
EOQ = 𝐶
= 4
= 200 𝑢𝑛𝑖𝑡𝑠
𝐴 𝑄
= × 𝑂 + 2 × 𝐶 − 𝐴 × 𝑃 × % 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
𝐴 800 𝑄
TOC = 𝐸𝑂𝑄
×𝑜 = 200
× 100 = 400
𝐴 𝑄
𝐸𝑂𝑄 200
= × 𝑂 + 2 × 𝐶 − 𝐴 × 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
𝑄
TCC = 2
×𝑐 = 2
× 4 = 400
Decision: If total inventory cost at discount offer ordersize is less than
TC = 400+400 = 800
total cost at EOQ then offer should be accepted.

20
Carrying Cost = P(1 - % discount) × %Carrying Cost 1. Lead Time
= Rs. ……… The time taken in receiving orders from suppliers is known as lead
time. It is also known as delivery time or procurement time.
Inventory Policy with Lead Time
We have assumed that inventory can be ordered and received 2. Goods in Transit
without delay. Usually there is a time lapse between placement of a Sometimes a new order must be placed before receiving the previous
purchase order and receipt of the inventory or in the time it takes to order. In this situation there will be some goods in transit. Goods in
manufacture an item after an order is placed. The length of time between transit exist when normal lead time is larger than the order frequency.
the placement of an order for an inventory item and when the item is
Calculation of GIT
received in inventory is called lead time. The lead time required to
𝐸𝑂𝑄
received delivery of inventory once an order is placed is usually subject Step – 1 Order frequency = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
to some variation. Owing to these fluctuation, it is not feasible usually to 𝐿𝑒𝑎𝑑 𝑡𝑖𝑚𝑒
Step – 2 No. of order in transit = 𝑂𝑟𝑑𝑒𝑟 −1
allow expected inventory to fall to zero before a new order is anticipated. 𝑓𝑟𝑒𝑞𝑢𝑒𝑛𝑐𝑦

Thus knowing the safety stock and reorder point is necessary Step – 3 GIT = No. of order×EOQ
Re-Order Level/Re-Order Point 3. Safety Stock
It may be defined as the level of inventory at which fresh order Safety stock is kept for avoiding loss of sales due to shortage of
should be placed in order to acquire additional materials. Re-order level inventory either because of increase in sales rate or because of
determines when to place new order. Re-order level prevent the increase in lead time.
withdrawal of safety stock. The re-order level depends an average
a. Safety Stock = lead time for safety stock × average consumption
consumption, average lead time, and safety stock.
in units
ROL = Safety stock in units+(Average consumption ×Average lead time)
b. Cost of Safety Stock = Safety stock in units × carrying cost per
– GIT
unit
ROL = (Maximum consumption × Maximum lead time) – GIT
4. Maximum Stock Level
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
Average consumption = 𝑃𝑒𝑟𝑖𝑜𝑑𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟 = Safety stock + EOQ

5. Average Stock level

𝐸𝑂𝑄
= 𝑆𝑎𝑓𝑒𝑡 𝑠𝑡𝑜𝑐𝑘 + 2

21
Inventory Control Systems
Inventory management requires the establishment of an inventory
control system. The purpose of inventory control system is the avoidance
of over investment or under investment in inventory and to provide right
quantity at right time to production department when it wanted.
consequently total cost is minimized. The inventory control system are

i. Just in Time (JIT ) System

A system of inventory control in which a manufacturer coordinates
production with suppliers so that raw materials or components arrive
just as they are needed in the production price. This system required
close coordination between the parties using JIT procedures has led
to an overall reduction of inventory throughout the production
distribution system, and to a general improvement in economic
effiency.

ii. ABC Analysis

The ABC analysis is a simple approach to inventory management
in which the basic idea is to divide inventory in to three or more groups.
The firm should classify inventories to identify as to which items should
receive the most effort of the firm in controlling. The underlying rational
that is a small portion of inventory in terms of quantity management
represent a large portion in terms of inventory value. The firm should
pay maximum attention only to those items whose value is highest.

In this approach, the high value items are classified as ‘A’ items
and would be under the highest control by management. The ‘C’ items
represent relatively least value and would be under simple control. The
‘B’ items fall in between these two categories.

22
 Unit – 4 i. Credit Standard: Credit standard are criteria which determines
which customers will be provided credit standard and to what extent.
Receivables Management Loose credit standard increases sales as well as profit and sales and
credit related cost. Tight credit standard decreases sales as well as
profit on sales and also decreases credit related cost.
Credit and Collection Policies
To qualify for credit, five factors are evaluated to determine the
When a firm sell goods and services than it can demand cash or strength and credit worthiness of a customer's – character, capacity,
it can extend credit to customers. When firm grant credit to its capital, collateral and creditors.
customers. Grating credit is making an investment in a customer and
ii. Credit Period: Credit period is the length of time between credit
investment tied to the sale of a product or service.
sales and payment received from such sales. Increasing the credit
Why do firms grant credit? Not all do, but the practice it period stimulates sales as well as profit on sales and also increases
extremely common. The obvious reason is that offering credit is a way the credit related cost. Tightening the credit period decreases sales
of stimulating sales. But there is a cost to carrying the receivables, as as well as profit on sales and also decreases the credit related cost.
well as the chance of that customer will not pay. Thus credit policy iii. Cash Discount and Collection Effort: Firm generally offer cash
decision involves a tradeoff between the benefits of increased sales and discounts to customers to make early payments. This will have the
the cost of granting credit. effect of reducing the amount of credit being offered and the firm
We must emphasize that the credit and collection policies of one must trade of this against the cost of discount.
firm are not independent with other firms. If product and capital markets Discount are offered is to speed up the collection of receivables. To
are reasonably competitive, the credit and collection practices of one the extent that a cash discount encourages customers to pay early, it
company will be influenced by what other companies are doings. Such will shorten the receivables period and, all other things being equal,
practices are related to the pricing of the product or service and must be reduce the firm’s investment in receivables and also the bad debt
viewed as part of the overall competitive process. if a firm decides to losses.
grant credit to its customers then it must establish procedures for credit
Evaluation of Credit and Collection Policies
and collecting. In particular, the firm will have to deal with the
following components of credit policy. We see that the credit and collection policies of a firm involve
several decisions: (i) The quality of account accepted (ii) Credit period
i. Credit standards
(3) Cash discount (4) Collection expenditure. In each case, the decision
ii. Credit period
should involve a comparison of possible gains from a change in policy
iii. Cash discount and collection effort

23
and the cost of charge. Optimal credit and collection policies would be b. Bad Debt Losses
these that resulted in the marginal gains equaling the marginal costs. Bad debt losses = Annual credit sales × % Bad debt losses
To maximize profits arising from credit and collection policies, c. Cash discount Cost
the firm should vary these policies jointly until it achieves an optimal = Annual credit sales (1 - % bad debt loss) × % of discount taker
solution. That solution will determine the best combination of credit customer × discount ratio
standards, credit period, cash discount policy, special terms, and level of d. Collection Costs
collection expenditures. Sensitivity analysis might be used to judge the It includes administrative cost, credit department cost etc.
impact of a change in policies on profits. Once functional relationship Where,
have been specified for the relationship between a particular policy and i. DSO/ACP = % of discount taker customer × discount period ×
marginal sales, average collection period and bad debt losses then the % of non discount taker customer × ,,,,,,,,,,
policy can be varied from one extreme to other, holding constant other ii. DSO
factors. 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
= 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛 𝑜𝑣𝑒𝑟
This variation gives insight into the impact of a changes in
𝐴𝑣𝑒𝑎𝑟𝑔𝑒 𝑟𝑒𝑐𝑒𝑖𝑏𝑙𝑒𝑠
policy on profits. = × 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠

Step – 1. Credit Related Cost Step - 2 Analying The Proposed Charge In Credit Policy
There are four primary costs related with account receivables. Income Statement
for the year ended
a. Cost of Carrying Receivables/Financing Cost
Particulars Present Policy Proposed Policy
i. Average Account Receivable Credit sales ××× ×××
Less: Cash discount ××× ×××
= credit sales per day × day’ sales outstanding Net Sales ××× ×××
Less: Cost of Production
ii. Investment in Account Receivable Variable Cost ××× ×××
Fired Cost ××× ×××
= Average account receivable × variable cost ratio Profit before credit rerelated cost ××× ×××
Less: Crredit related cost ××× ×××
iii. Cost of Carrying Receivables
Cost of carrying receivables ××× ×××
= Investment in account receivable × K Bad debt losses ××× ×××
Collection costs ××× ×××
= Average receivables × variable cost ratio × K Profit before tax ××× ×××
Less: Taxes ××× ×××
= Credit sales per day × DSO × VC ratio × K NPAT ××× ×××
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
= × 𝐷𝑆𝑂 × 𝑉𝐶 𝑟𝑎𝑡𝑖𝑜 × 𝐾
𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟 Incremental NPAT = Proposed profit – Present profit

24
Evaluating the Credit Applicant be extended. A study of applicants for extending credit includes
the study of four ‘C’s of credit: Character, collateral, capital and
Having established the term of sale to be offered the firm must evaluate
capacity.
individual credit applicants and consider the possibilities of a bad debt
or slow payment. The evaluation procedure involves the following 2. Credit Analysis: Moving collected credit information, a company
steps: must make a credit analysis of the applicant and determine if the
company falls above or below the minimum quality standard. The
1. Sources of Information: A number of sources that supply credit
analyst will be particularly interested in the applicant’s liquidity and
information to the firm. The firm extending credit may have to be
ability to pay bills on time. In addition to, analyst consider the
satisfied with a limited amount of information on which to base a
character and strength of the company.
decision. The credit analyst may use one or more of the following
sources of information. a. Credit Scoring: A statistical technique is used to judge the
credit score for a credit applicant. An applicant is judged to be a
a. Financial Statement: At the time of the prospective sale, the
good or a bad credit risk.
seller may request a financial statement. It is helpful to obtain
interim statement in addition to yearend figures. b. Sequential Investigation Process: The amount of information
collected should be determined in relation to the expected profit
b. Credit Rating and Reports: In addition to financial statements,
from an order and the cost of investigation.
credit ranges are available from various mercantile agencies. It
provides information about credit worthiness, brief history or of 3. Credit Decision: Once the credit analyst has marshaled the
a company, and its principal officers, nature of business, certain necessary evidence and has analyzed it, a decision must be reached
financial information and a trade check of suppliers. on the disposition of the account. In an initial sale, the first decision
to be made is whether or not to ship the goods and extend credit. If
c. Bank Checking: Another source of information for the firm is a
repeat sales are likely, the company will probably want to establish
credit check through a bank. Many banks have large credit
procedures so that it does not have to evaluate the extension of
departments that under take credit checks as a service for their
credit each time an order is received.
customers.

d. Trade Checking: Credit information is frequently exchanged

among companies selling to the same customer. A company can
ask other suppliers about their experiences with an account.
e. The Company’s Own Experience: An experience of credit
department are very useful to the company to whom credit may
25
 Unit – 5 i. Transaction Motive: Transaction motive refers to the holding of
cash to meet routine cash requirements such as purchase of raw
Cash Management material, payment for labour, salary, rent etc. In other, words, the
cash balances associated with routine payments and collections are
known as transaction motive.
Function of Cash Management ii. Precautionary Motive: Precautionary motive refers to the holding
Cash management is concerned with the following functions: of cash to maintain safety cushion and buffer to meet unexpected
cash needs. The precautionary motive is the need to hold cash to
i. Cash Planning: One of the importance functions of cash
meet any contingencies in future. Like greater fluctuation in cash
management is to make cash planning. It is a technique to plan and
flows, seasonal effects, strikes, fire, unpredictable increase in price
control of cash. It protects the financial condition of the firm by
of raw material etc.
developing a projected cash statement from a forecast of expected
can inflows or outflows for a given period. iii. Speculative Motive: The speculative motive refers to the holding of
cash to take advantage of temporary investment opportunities such
ii. Cash Flow Management: Cash management provides the basis of
as bargain purchases, cheapest offers from suppliers, advertising
cash flow management it utilizes the best collection and payment
offers.
procedures.
iv. Compensative Balance: A firm should also holds cash to meet the
iii. Optimum Cash Level: Cash management maintains the optimum
compensative balance requirement demanded by commercial banks
cash level so that it can eliminate cash deficit and overcome the
for providing services. If refers to the holding of cash to compensate
excess lifting of cash left in the firm.
bank for providing loan and services.
iv. Investing Surplus Cash: Another important function of cash
management is to make decision on surplus cash. The surplus cash Cash Management Techniques
balances should be properly invested to earn profits. The various collection and disbursements methods by which a
To place surplus cash in proper institutions and in the proper forms. like firm can improve its cash management efficiency constitute two sides of
bank deposit, marketable securities, inter operate lendiy etc. the same coin. They exercise a joint impact on the overall efficiency of
cash management. The idea is to collect account receivable as soon as
Motive for holding cash possible, but pay accounts payable as late as is consistent with
The firm holds cash for the following reasons: maintaining the firm's credit standing with suppliers.

26
Managing Collection Net Float = Disbursement float - Collection float

1. Accelaration of Collections: It simply means reducing the delay Float Management

between the time customers pay their bills and the time the checks Float management involves controlling the collection and
are collected and became usable fends for the firm. Acclamation of disbursement of cash. The objective in cash collection is to speed up
collections means to collect receivable as soon as possible. A collections and reduce the lag between the time customers pay their bills
number of method are designed to speed up this collection process and the time the cash becomes available. The objective in cash
by doing one or all of the following disbursement is to control payments and minimize the firm's costs
a. Speed the mailing time of payments from customers to the firm. associated with making payments.

b. Reduce the time during which payments, received by the firm Total collection or disbursement times can be broken down into three
remain uncollected funds. parts:

c. Speed the movement of funds to disbursement banks. i. Mailing Time: It is the part of the collection and disbursement
process during which checks are trapped in the postal system.
2. Float: The cash balance that a firm shows on its books is called the
firm's book or ledger balance. The balance shown in its bank ii. Processing Time: It is the time it takes the receiver of a check to
account as available to spend is called its available or collected process the payment and deposit it in a bank for collection.
balance. The difference between the available balance and the ledger iii. Clearing Time: It refers to the time required to clear a check
balance, called the float. through the banking system.
a. Disbursement Float: Checks written by a firm generate Measurement of Float
disbursement float causing a decrease in the firm's book balance
a. Disbursement of Float: The number of days between the issue of
but not change in its available balance.
cheque by the firm and payment made by the bank is called
Disbursement float = Available balance - firms book or ledger disbursement delay. The amount of cheques tied up during this
balance. period is called disbursement float longer disbursement float reduces
b. Collection Float: Checks received by the firm create collection the requirement of cash balance.
float. Collection float increases book balance but does not Disbursement Delay = Mailing time + Processing time + Clearing time.
immediately charge available balances. Disbursement Float/Cash tied up = disbursement delay × amount of
cheque issues/writes per day
Collection Float = Firm ledger balance - Bank's ledger balance.
Opportunity Cost = Cash tied up × % opportunity cost

27
 Cash Released = Increase in disbursement delay × average cheques writes concentration bank. The basic purpose of concentration banking
per day system is to reduce mailing, processing and collection time.
Annual Saving = cash released × % opportunity cost. Local
b. Collection Float: No. of days taken for the collection of payments Bank

when customers mail to the firm, is called collection float in days or

Local Local
collection delay. The amount of cheques tied up during this period is Bank Bank
called collection float. Shorter collection float reduces the HO
requirement of cash balance.
Collection Delay = Mailing + processing + Clearing time
Local Local
Collection Float = Collection delay × Amount of Cheque Bank
Bank
received/Collect per day

Opportunity Cost = Collection float × % opportunity Cost i. Time Saved by CBS

Cash Released = Reduction in collection delay × Average collection = Collection float under centralized system - collection flotation under

per day CBS

Annual Saving = Cash released × % opportunity cost ii. Reduction in Cash Balance

c. Net Float: The difference between disbursement float and = Time saved × Average collection per day

collection float is called net float. Positive net float reduces the iii. Annual saving (benefit)
need for cash balance but negative net float increases the cash = Reduction cash balance × % opportunity cost.
balance requirements. iv. Annual cost = Annual system cost + Annual transfer cost
Net Float in days = Disbursement delay - Collection delay = Annual system cost + (Per transfer cost × No. of local bank ×

Net Float in Rs. = Disbursement float - Collection float working days in a year.
4. Lock Box System: A lock box system is one of the oldest and most
3. Concentration Banking/Decentralized Collection System:
widely used cash management techniques. The term lock box refers
Concentration banking is a system of operating through a number of
to the post office box to which customers are sent their payments
collection center instead of single collection center centralized at
rather than to the firm's headquarters. It is used to shortain the
firm's head office. The concentration banking system helps pull up
collection period by avoiding processing float. But it has cost so it is
funds from different collection center (local bank) to the
initiated when saving exceeds over cost.

28
Control of Disbursements i. Wire transfer
ii. Electronic depositing transfer checks (DTC).
Control of disbursement means to slow down the disbursement as much
as possible. Effective control of disbursements can also result in more A DTC is not negotiable, unsigned document, which is used by a
availability of cash significant techniques and systems for improving the bank to transfer funds one bank to another. With electronic DTC,
cash disbursement includes the following. arrangement for the movement of funds, an electronic check image is
processed through an automatic clearinghouse. DTC also can be
1. Payable Through Draft: A means for delaying disbursements is
physically transported.
the use of payable through drafts. Unlike an ordinary check, the
draft is not payable on demand of presenter. When it is presented to The transfer of funds is made by telephone line or the
the issue's bank for collection, the bank must present it to the issuer clearinghouse interbank payment system, is called wire transfer.
for acceptance. A depositary transfer check is less expenses but more time
2. Payables Centralization: Payable centralization is a strategy of consuming where as wire transfers quickest transfer mechanism but it is
disbursement control. It is a strategy in which the payment is made more expensive. There is no time delay in wire transfer.
from central location. Thus it increases the mailing and processing ∆𝐶
time and help to control disbursement. a. Breakeven Treansfer size (S) = 𝐼.∆𝑇

3. Zero Balance Account: ZBA is a type of checking account with a b. Total cost of each transfer mechanism
balance equal to zero. The firm deposits money to cover cheques = Transfer cost + opportunity cost
drawn on the account only as they are presented for payment each = Transfer cost+( transfer size×transfer time×daily interest rate)
day. The purpose is to eliminate non-earning cash balances. Where,
4. Controlled Disbursement Account: CDA is a type of checking S = Break even transfer size above which wire transfer is
account in which funds are deposited only if checks are presented profitable
for payment under this system, the opening bank gives information I = Daily interest rate
on the day the cheques are presented and the firm will have enough
∆C = Incremental cost/different in cost between wire transfer and
time to deposit funds in the account to make payment against those
DTC.
cheques.
∆T = Difference in transfer time in days
Transfer Mechanism / Cash Transfer Tool
Selection of Transfer Mechanism
Transfer mechanism is a system for moving funds from
The Choice of transfer mechanism generally depends upon cost
collecting banks to concentration banks. There are two principal
and benefits. When benefits exceeds over cost mechanism is selected.
methods
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However other factors might also influence the selection decision such C* = Optimal cash balance/Target cash balance/ Amount of
as convenient of source, time delay, reliability, flexibility durability etc. Marketing securities converted in to cash per order..
Cash Management Models T = Total cash usage/Total demand for cash.
There are various models for determining optimal cash balance B = Fixed cost of transaction/transaction cost in the
and marketable securities. They are as follows Purchase or sale of marketing securities.
i. Baumol Model/(Inventory Model) I = Interest rate on marketable securities/opportunity cost
Baurmol model is an economic model that determines the optimal = Conversion cost + Opportunity cost
cash balance by using EOQ concepts of inventory management. It b. Total Cost = Transaction cost + Interest cost
determine optimal cash under the condition of certainty. The = Conversion + Opportunity Cost
purpose of this model is to determine the cost associated with 𝑇 𝐶∗
optimal cash balance. It involves two types of cost. = 𝐶∗ × 𝑏 + ×𝑖
2
𝐶∗
a. Conversion Cost/Fixed cost of transaction (b) c. Average cash balance = 2
+ 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑐𝑎𝑠ℎ 𝑏𝑎𝑙𝑎𝑛𝑐𝑒

It is the cost of the transaction in the purchase or sale of 𝑇

d. No. of Transaction = 𝐶 ∗
marketable securities. It is the cost of transferring marketable
𝐶∗
securities into cash or cash into marketable securities. e. Cash Cycle = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛

b. Opportunity Cost/Interest Rate (i) ii. Miller - Orr Model/Stochastic Model

The carrying cost of holding cash is considered to be the It is applied to determine the optimal cash balance in the situation
opportunity costs that would otherwise be earned if invested into when cash balances randomly fluctuate and not known in advance.
marketable securities. It is the cost of opportunity lost or interest This model assumes that cash flows are uncertain therefore setting a
foregone on marketable securities. control limit for cash balance and cash balances fluctuate within the
To considering above cost, the minimum cost size of limit. If cash reaches to upper limit then convert cash into
cash can be calculated as follows marketable securities and if it approaches to lower limit than sell
marketable securities to realize required cash balances.
2𝑏𝑇
a. 𝐶 ∗ = 𝑖
1
3 3𝑏𝜎 2 3𝜎 2 3
a. 𝑍 = +𝐿 = +𝐿
4 𝑖/360 4𝑖/360
Where,
Where

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 Z = Optimal point of cash to return / Target cash balance. cash flows and cash control. The cash budget is used for planning and
b = Fixed cost of transactions 𝜎 2 = Variance of daily net controlling the cash.
Cash Budget
cash flows
For the period of ……..
i = interest rate on marketing securities Particulars Jan Feb March
Opening cash balance ×××
L= Lower limit or minimum balance. Add: Cash inflows
Cash sales ×××
b. Upper limit of cash balance (h) = 3z-2L = Rs…….. Collection from debtors ×××
ℎ+𝑍 Income received ×××
c. Average cash balance = = 𝑅𝑠 … .. Issue of share and debenture ×××
3
Sale of fixed assets ×××
d. Lower Limit is set by management Total Cash Inflows (A) ×××
Less: Cash Outflows
Buying Strategy Cash purchase ×××
Payment to creditors ×××
When the cash balance reaches the upper limit then the amount equal to
Payment for tax ×××
the upper limit minus the return point is converted into marketable Payment for expenses ×××
securities. Payment for dividend ×××
Sinking fund payment ×××
Cash converted into MKT = h-Z = Rs.……. Interest payment ×××
Lease payment ×××
Selling Strategy Miscellaneous expenses ×××
Purchase of fixed assets ×××
When the cash balance falls to lower limit, then the amount represented Redemption of depreciation ×××
by return point minus lower limit is converted into cash from marketing. (B) Total Cash outflows ×××
Surplus (deficit) ×××
Marketable securities converted into cash = Z-L Borrowing ×××
Repayment ×××
Cash Budget Ending cash balance ×××
Cash budget is the estimated of future cash inflows and outflows for a
Or,
specified time period. It serves as a most important techniques of
planning and controlling the cash flows. The essence of preparing cash Net Cash flow (A-B) ×××
budget is to determine whether there is surplus or deficit of cash at a Add: Opening cash balance ×××
Ending cash balance ×××
given time period. The purpose of cash budget is to plan firms future Less: Minimum cash balance ×××
Amount of surplus or deficit ×××

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