Q .

Importance of Working Capital

Working capital is the life blood and nerve centre of a business. Just as circulation
of blood is essential in the human body for marinating life, working capital is very
essential to maintain the smooth running of a business. No business can run
successfully without an adequate amount of working capital.

The main advantages of maintaining adequate amount of working capital are as

follows:

1. Solvency of the business: Adequate working capital helps in maintaining

solvency of the business by providing uninterrupted flow of production.

2. Goodwill: Sufficient working capital enables a business concern to make

prompt payments and hence helps in creating and maintaining goodwill.

3. Easy Loans: A concern having adequate working capital, high solvency and
good credit standing can arrange loans from banks and other on easy and
favourable terms.

4. Cash discounts: Adequate working capital also enables a concern to avail cash
discounts on the purchases and hence it reduces costs.

5. Regular supply of raw materials: Sufficient working capital ensures regular

supply of raw materials and continuous production.

6. Regular payment of salaries, wages and other day-to-day commitments: A

company which has ample working capital can make regular payment of salaries,
wages and other day-to-day commitments which raises the morale of its
employees, increases their efficiency, reduces wastages and costs and enhances
production and profits.

7. Exploitation of favourable market condition: Only concern with adequate

working capital can exploit favourable market conditions such as purchasing its
requirements in bulk when the prices are lower and by holding its inventories for
higher prices.
8. Ability to face crisis: Adequate working capital enables a concern to face
business crisis in emergencies such as depression because during such periods,
generally, there is much pressure on working capital.

9. Quick and regular return on investments: Every investor wants a quick and
regular return on his investments. Sufficiency of working capital enables a
concern to pay quick and regular dividends to its investors as there may not be
much pressure to plough back profits. This gains the confidence of its investors
and creates a favourable market to raise additional funds ion the future.

10. High morale: Adequacy of working capital creates an environment of security,

confidence, and high morale and creates overall efficiency in a business.

Q .Factors Affecting Working Capital Requirements

The working capital requirement of a concern depends upon a large numbers of

factors such as nature and size of business, the character of their operations, the
length of production cycles, the rate of stock turnover and the state of economic
situation. It is not possible to rank them because all such factors of different
importance and the influence of individual factors changes for a firm overtime.
However the following are important factors generally influencing the working
capital requirement:

1. Nature or Character of Business: The working capital requirement of a firm

basically depends upon the nature of this business. Public utility undertakings like
electricity water supply and railways need very limited working capital because
they offer cash sales only and supply services, not products and as such no funds
are tied up in inventories and receivables. Generally speaking it may be said that
public utility undertakings require small amount of working capital, trading and
financial firms require relatively very large amount, whereas manufacturing
undertakings require sizable working capital between these two extremes.
2. Size of Business/Scale of Operations: The working capital requirement of a
concern is directly influenced by the size of its business which may be measured
in terms of scale of operations.

3. Production Policy: In certain industries the demand is subject to wide

fluctuations due to seasonal variations. The requirements of working capital in
such cases depend upon the production policy.

4. Manufacturing Process/Length of Production Cycle: In manufacturing business

the requirement of working capital increases in direct proportion of length of
manufacturing process. Longer the process period of manufacture, larger is the
amount of working capital required.

5. Seasonal Variation: In certain industries raw material is not available through

out the year. They have to buy raw materials in bulk during the season to ensure
and uninterrupted flow and process them during the entire year.

6. Rate of Stock Turnover: There is a high degree of inverse co-relationship

between the quantum of working capital; and the velocity or speed with which
the sales are affected. A firm having a high rate of stock turnover will need lower
amount of working capital as compared to affirm, having a low rate of turnover.

7. Credit Policy: The credit policy of a concern in its dealing with debtors and
creditors influence considerably the requirement of working capital. A concern
that purchases its requirement on credit and sell its products/services on cash
require lesser amount of working capital.

8. Business Cycle: Business cycle refers to alternate expansion and contraction in

general business activity. In a period of boom i.e., when the business is
prosperous, there is a need of larger amount of working capital due to increase in
sales, rise in prices, optimistic expansion of business contracts sales decline,
difficulties are faced in collection from debtors and firms may have a large
amount of working capital lying idle.

9. Rate of Growth of Business: The working capital requirement of a concern

increase with the growth and expansion of its business activities. Although it is
difficulties to determine the relationship between the growth in the volume of
business and the growth in the working capital of a business, yet it may be
concluded that of normal rate of expansion in the volume of business, we may
have retained profits to provide for more working capital but in fast growth in
concern, we shall require larger amount of working capital.

Q .WORKING CAPITAL MANAGEMENT OBJECTIVES

Maintaining the working capital operating cycle and its smooth operation is vital
for a business to function. The operating cycle or lifecycle of a business goes from
the acquisition of the raw material to the seamless production and delivery of the
end products. This is one of the main objectives of working capital management.
Keeping the cost of capital to a minimum is also an important objective that
working capital management strives to achieve. The cost of capital is what is
spent on maintaining the working capital. It is imperative that the cost of
maintaining healthy working capital are carefully monitored, negotiated and
managed.
The other main objective is to maximize ROI or return on current asset
investments.the return on current asset investments. The ROI on currently
invested assets should be more than the weighted average cost of the capital.
This ensures wealth maximization.

Disadvantages of Excessive and Inadequate Working Capital 

Disadvantages of Redundant or Excessive Working Capital:
1. Excessive Working Capital means idle funds which earn no profits for the
business and hence the business cannot earn a proper rate of return on its
investments.

2. When there is a redundant working capital, it may lead to unnecessary

purchasing and accumulation of inventories causing more chances of theft, waste
and losses.
3. Excessive working capital implies excessive debtors and defective credit policy
which may cause higher incidence of bad debts.

4. It may result into overall inefficiency in the organisation.

5. When there is excessive working capital, relations with banks and other
financial institutions may not be maintained.

6. Due to low rate of return on investments, the value of shares may also fall.

7. The redundant working capital gives rise to speculative transactions.

Disadvantages or Dangers of Inadequate Working Capital:

1. A concern which has inadequate working capital cannot pay its short-term
liabilities in time. Thus, it will lose its reputation and shall not be able to get good
credit facilities.

2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.

3. It becomes difficult for the firm to exploit favourable market conditions and
undertake profitable projects due to lack of working capital.

4. The firm cannot pay day-to-day expenses of its operations and it creates
inefficiencies, increases costs and reduces the profits of the business.

5. It becomes impossible to utilize efficiently the fixed assets due to non-

availability of liquid funds.

6. The rate of return on investments also falls with the shortage of working
capital.
Cash Management

Definition: Cash Management refers to the collection, handling, control

and investment of the organizational cash and cash equivalents, to ensure
optimum utilization of the firm’s liquid resources. Money is the lifeline of
the business, and therefore it is essential to maintain a sound cash flow position
in the organization.

Receivables Cash Management

Any amount which the company has earned however not yet received, i.e. its
outstanding and is expected to be received in future, is known as receivables.

An organization must manage its receivables to maintain the surplus cash inflow.
It helps the firm to fulfil its immediate cash requirements.

The cash receivables must be planned in such a way that the organization can
realise its debts quickly and should allow a short credit period to the debtors.

Payables Cash Management

The payables refer to the payment which is unpaid by the organization and is to
be paid off shortly.

The organization should plan its cash outflow in such a manner that it can acquire
an extended credit period from the creditors.

This helps the firm to retain its cash resources for a longer duration to meet the
short term requirements and sudden expenses. Even the organization can invest
this cash in a profitable opportunity for that particular credit period to generate
additional income.

Content: Cash Management

1. Objectives
2. Models

 Baumol’s EOQ Model

 Miller – Orr’ Model
. Functions
 . Strategies
. Techniques
. Limitations

Objectives of Cash Management

Why do we need to manage cash flow in the organization? What is the use of cash
management in the business?

Following purposes of cash management will resolve the above queries:

 Fulfil Working Capital Requirement: The organization needs to maintain

ample liquid cash to meet its routine expenses which possible only through
effective cash management.
 Planning Capital Expenditure: It helps in planning the capital expenditure
and determining the ratio of debt and equity to acquire finance for this
purpose.
 Handling Unorganized Costs: There are times when the company
encounters unexpected circumstances like the breakdown of machinery.
These are unforeseen expenses to cope up with; cash surplus is a lifesaver in
such conditions.
 Initiates Investment: The other aim of cash management is to invest the
idle funds in the right opportunity and the correct proportion.
 Better Utilization of Funds: It ensures the optimum utilization of the
available funds by creating a proper balance between the cash in hand and
investment.
  Avoiding Insolvency: If the business does not plan for efficient cash
management, the situation of insolvency may arise. It is either due to lack of
liquid cash or not making a profit out of the money available.

Cash Management Models

Cash management requires a practical approach and a strong base to determine

the requirement of cash by the organization to meet its daily expenses. For this
purpose, some models were designed to determine the level of money on
different parameters.

The two most important models are discussed in detail below:

Let us now elaborate on each of these models:

The Baumol’s EOQ Model

Based on the Economic Order Quantity (EOQ), in the year 1952, William J. Baumol
gave the Baumol’s EOQ model, which influences the cash management of the
company.

This model emphasizes on maintaining the optimum cash balance in a year to

meet the business expenses on the one hand and grab the profitable investment
opportunities on the other side.

The following formula of the Baumol’s EOQ Model determines the level of cash
which is to be maintained by the organization:
 Where,
‘C’ is the optimum cash balance;
‘F’ is the fixed transaction cost;
‘T’ is the total cash requirement for that period;
‘i’ is the rate of interest during the period

The Miller – Orr’ Model

According to Merton H. Miller and Daniel Orr, Baumol’s model only determines
the cash withdrawal; however, cash is the most uncertain element of the
business.

There may be times when the organization will have surplus cash, thus
discouraging withdrawals; instead, it may require to make investments.
Therefore, the company needs to decide the return point or the level of money to
be maintained, instead of determining the withdrawal amount.

This model emphasizes on withdrawing the cash only if the available fund is
below the return point of money whereas investing the surplus amount exceeding
this level.

Given below is the graphical representation of this model:

Where,
‘Z’ is the spread of cash;
‘UL’ is the upper limit or maximum level
‘LL’ is the lower limit or the minimum level
‘RP’ is the Return Point of cash

We can see that the above graph indicates a lower limit which is the minimum
cash a business requires to function. Adding up the spread of cash (Z) to this
lower limit gives us the return point or the average cash requirement.

However, the company should not invest the sum until it reaches the upper limit
to ensure maximum return on investment. This upper limit is derived by adding
the lower limit to the three times of spread (Z). The movement of cash is
generally seen across the lower limit and the upper limit.

Let us now discuss the formula of the Miller – Orr’ model to find out the return
point of cash and the spread across the minimum level and the maximum level:

Where,
‘Return Point’ is the point at which money is to be invested or withdrawn;
‘Minimum Level’ is the minimum cash required for business sustainability;
‘Z’ is the spread across the minimum level and the maximum level;
‘T’ is the transaction cost per transfer;
‘V’ is the variance of daily cash flow per annum;
‘i’ is the daily interest rate

Functions of Cash Management

Cash management is required by all kinds of organizations irrespective of their

size, type and location. Following are the multiple managerial functions related to
cash management:
  Investing Idle Cash: The company needs to look for various short term
investment alternatives to utilize surplus funds.
 Controlling Cash Flows: Restricting the cash outflow and accelerating the
cash inflow is an essential function of the business.
 Planning of Cash: Cash management is all about planning and decision
making in terms of maintaining sufficient cash in hand and making wise
investments.
 Managing Cash Flows: Maintaining the proper flow of cash in the
organization through cost-cutting and profit generation from investments is
necessary to attain a positive cash flow.
 Optimizing Cash Level: The organization should continuously function to
maintain the required level of liquidity and cash for business operations.

Cash Management Strategies

Cash management involves decision making at every step. It is not an immediate

solution but a strategical approach to financial problems. Following are the
strategies of cash management:
Business Line of Credit: The organization should opt for a business line of credit at
an initial stage to meet the urgent cash requirements and unexpected expenses.

Money Market Fund: While carrying on a business, the surplus fund should be
invested in the money market funds. These are readily convertible into cash
whenever required and yield a considerable profit over the period.

Lockbox Account: This facility provided by the banks enable the companies to get
their payments mailed to its post office box. This lockbox is managed by the banks
to avoid manual deposit of cash regularly.

Sweep Account: The organizations should avail the facility of sweep accounts
which is a mix of savings and fixed deposit account. Thus, the minimum balance of
the savings account is automatically maintained, and the excess sum is
transferred to the fixed deposit account.

Cash Deposits (CDs): If the company has a sound financial position and can
predict the expenses well along with availing of a lengthy period, it can invest the
surplus cash in the cash deposits. These CDs yield good interest, but early
withdrawals are liable to penalties.

Cash Flow Management Techniques

Managing cash flow is a contemplative process and requires a lot of analytical

thinking. The various techniques or tools used by the managers to practice cash
flow management are as follows:
  Accelerating Collection of Accounts Receivable: One of the best ways to
improve cash inflow and increase liquid cash by collecting the debts and
dues from the debtors readily.
 Stretching of Accounts Payable: On the other hand, the company should
try to extend the payment of dues by acquiring an extended credit period
from the creditors.
 Cost Cutting: The company must look for the ways of reducing its operating
cost to main a good cash flow in the business and improve profitability.
 Regular Cash Flow Monitoring: Keeping an eye on the cash inflow and
outflow, prioritizing the expenses and reducing the debts to be recovered,
makes the organization’s financial position sound.
 Wisely Using Banking Services: The services such as a business line of
credit, cash deposits, lockbox account and sweep account should be used
efficiently and intelligently.
 Upgrading with Technology: Digitalization makes it convenient for the
organizations to maintain the financial database and spreadsheets to be
assessed from anywhere anytime.

Limitations of Cash Management

Cash management is an inevitable part of business organizations. However, it has

a few shortcomings which make it unsuitable for small organizations; these are as
follows:
Cash management is a very time consuming and skilful activity which is required
to be performed regularly.

As it requires financial expertise, the company may need to hire consultants or

other experts to perform the task by paying administrative and consultation
charges.

Small business entities which are managed solely, face problems such as lack of

skills, knowledge, time and risk-taking ability to practice cash management.