Theories and

UNIT 8 THEORIES AND APPROACHES Approaches

Objectives
The objectives of this unit are:
• To provide you an understanding as to the policy making in the area
of working capital management.
• To examine the different approaches to working capital management.
• To highlight the impact of different choices of investment and financing on
working capital policy.

Structure
8.1 Introduction
8.2 Creation of Value through Working Capital Management
8.3 Approaches to Working Capital Investment
8.4 Approach to Financing Working Capital
8.5 Effect of Choice of Financing on ROI
8.6 Summary
8.7 Key Words
8.8 Self-Assessment Questions
8.9 Further Readings

8.1 INTRODUCTION
In the previous two Blocks, we have discussed about the concept of
Working Capital and various methods for determining working capital
requirements and the management of various components. The present block
focuses on the theoretical issues governing the determination and also the
practices followed by banks and other financial institutions. This is
expected to help the student come closer to the reality. There has been little
difficulty in segregating the issues under this block into individual units due
to their overlapping content. Therefore, an attempt has been made in this
unit to cover all those issues that could not be covered under the earlier
Blocks, yet focusing on the theme of the present Block. As you could
observe from the structure of the lesson presented above, enough care has
been taken to include only pertinent matters in the discussion that follows.
Major concentration has been on the following:
a) What is the objective function in taking working capital decisions?
b) How to create value through working capital?
c) Is there any scope to lay down time-tested principles of working
capital policy?
d) How do risk-return relationships operate in the area of working capital
decision making?
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Financing of
Working Capital
8.2 CREATION OF VALUE THROUGH
WORKING CAPITAL MANAGEMENT
Creation of value has been said to be the objective of a company. In the
realm of finance it turns out to be the function of firm’s investment,
financing and dividend decisions. In addition to long term investment
decisions, companies face many decisions involving investment in current
assets. Quite often, maximisation of profits is regarded as the proper
objective of the firm. but it is not as inclusive as that of maximising
shareholders’ value. A right kind of approach to decisions of investment
and financing of working capital can contribute to the achievement of the
objective function.

Value maximisation is considered consistent with the interests of various

groups that interact with the business. Take for instance shareholders;
businesses can often do what individuals cannot do on their own. Business
houses pool up resources and engage in mass production, which is beyond
the capacity of an individual as shareholder. Perpetual succession ensures
enough confidence to a creditor. The point of view of society is well taken
care of, since there is a realisation on the company that it cannot pursue
profit maximisation as a goal. A framework is thus created for analysing the
financial decisions from the standpoint of maximising value.

Be that as it may, how should one proceed to create value through working
capital management. The answer is: invest in an asset, if its net present
value is positive. The fact is that the basic principles of long term asset
investment decisions should apply equally well to short term asset
investment decisions. Therefore, it is useful to examine this criterion more
closely in terms of current asset investment decisions.
The general formula for finding net present value of a project is:
A1 A2 A3 An
NPV = 1 2 3 ...... n C
1 K 1 K 1 K 1 K

Where A1 to An represent annual cash inflows on an after tax basis. ‘K’ is the
discount factor, which is generally taken as the cost of capital. ‘C’
represents the initial outflow.

This equation can be used to decide the choice of investment in current

assets taking into account their shorter life span. Accepting one year life
as standard to categorise assets into fixed and current, NPV has to be
calculated for each year. For this purpose, the above equation can be
modified as follows to elicit NPV.
A1 A2 A3 An
NPV = ......... C
K K K K

Like the decisions in capital budgeting, the problem remains as that of

determination of risk and thus the appropriate discount rate to apply.

188
Sometimes, practitioners tend to use net profit criterion to decide the Theories and
Approaches
investment in current assets; which they consider is a simple modification of
the concept of NPV as shown below:

r
Net profit per period = Annuity = NPV n
1 1 r

Example 8.1
There is an investment proposal involving Rs.5000 initial investment and
generating Rs.500 per year, so long as we keep the investment intact. The
NPV in this case depends on the discount rate and time period assumed.
We may also calculate an annuity that has a present value equal to the NPV
of above investment using the above equation. Assuming that the discount
rate is 8%. Net profit per period will be Rs.100. See the following
derivation:

r
Net profit per period = Annuity = NPV n
1 1 r

500 500 5000 r

5000 n n n
1 r 1 r 1 r 1 1 r

n
1 1 r r
500 n
r 1 1 r

n r
= – 5000 5000 1 r n
1 1 r

1 1 r
n 1
But r
n
r 1 1 r

r
So Net Profit = 500 – 5000 [1– (1+ r )–n ] n
1 1 r

= 500 – 5000 (r)

= 500 – 5000 (8%)
= 500 – 400 = 100

The Rs. 400 is the annual capital cost of Rs.5,000 investment at an 8 per
cent rate of interest, and the annual net profit of Rs. 100 does not depend
on when the investment is reversed. The result is that we can use net
profit per period as a criterion for choosing among alternative reversible
investments. The investment with the highest value of net profit per period
is also the investment with the highest net present value, regardless of
when the investment is reversed. Investments with positive NPVs will have
positive net profits, investments with zero NPVs will have zero net profits,
and investments with negative NPVs will have negative net profit. Thus, 189
Financing of net profit per period instead of NPV, can be used as a decision criterion
Working Capital
for working capital management.

While the above sounds logical theoretically, in practice, firms are choosing
innovative approaches to create value through current assets management.
For instance, firms are very active in commodity markets to buy raw
materials while they are in full supply. They are not minding the size and cost
of investment in this asset. More so, firms are also adopting risk management
techniques like options, hedging, etc. Like any usual trader in the stock
market, they are watchful of the trends in both stock and commodity markets.
Similarly, idle cash is now intelligently invested in various markets such as
Money Market, Mutual Funds and finally equities. Gone are the days when
companies used to focus on their core activities of operations; they are now
exploring ways to maximize value through every means. Mergers, takeovers
and acquisitions are the best examples of utilizing surplus cash and every
cash-rich firm got benefitted by these choices.

Many current asset decisions, particularly inventory decisions, can be

made on the basis of minimising cost. There also, instead of minimising
the net present value of costs. One may minimise total annual cost where
the annual capital cost of the investment is the discount rate times the
amount invested. In sum the current assets may be treated as reversible
and investment policies may be selected that maximise net profit or
minimise total cost per period. The choice between the profit or cost
criterion will of course depend on the particular problem being analysed.

8.3 APPROACHES TO WORKING CAPITAL

INVESTMENT
Every business enterprise needs to pay particular attention towards the
planning and control of working capital. Different approaches have been
suggested for this purpose. Of them, let us focus our attention on the
following two approaches:
i) Walker’s approach
ii) Trade off approach

8.3.1 Walker’s Approach

Early in 1964 Ernest W. Walker has developed a four-part theory of
working capital. He has laid down that a firm’s profitability is determined
in part by the way its working capital is managed. When the working
capital is varied relative to sales without a corresponding change in
production, the profit position is affected.
If the flow of funds created by the movement of working capital is
interrupted, the turnover of working capital is decreased, as is the rate of
return on investment. In this regard, Walker has laid down the following
four principles with respect to working capital investment.

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First principle: This is concerned with the relation between the levels of Theories and
Approaches
working capital and sales. His principle is that: if working capital is varied
relative to sales, the amount of risk that a firm assumes is also varied and
the opportunity for gain or loss is increased. This implies that a definite
relation exists between the degree of risk that management assumes and
the rate of return. The more the risk that a firm assumes, the greater is
the opportunity for gain or loss. Consider the following data:

Table 8 .1: XYZ Manufacturing Company

1 2 3
Level of working capital (Rs.) 50,000.00 90,000.00 1,20,000.00
Fixed capital (Rs.) 10,000.00 10,000.00 10,000.00
Liabilities 30,000.00 30,000.00 30,000.00
Net Worth 30,000.00 70,000.00 1,00,000.00
Sales 1,00,000.00 1,00,000.00 1,00,000.00
Fixed Capital Turnover 10.00 10.00 10.00
Working Capital Turnover 2.00 1.1 0.8333
Total Capital Turnover 1.66 1.00 0.761
Earnings (as Percent of Sales) 10.00 10.00 10.00
Rate of Return (Percent) 16.60 10.00 7.60

It can be seen from the data that the return on investment has increased
from 7.6 percent to 16.6 per cent when working capital fell from Rs.
1,20,000 to Rs.50,000. Moreover, it is believed that while the potential gain
resulting from each decrease in working capital is greater in the beginning
than potential loss, exactly opposite occurs, if the management continues to
decrease working capital (see-Figure 8 .1).

Fig. 8.1: Working Capital Relative to Sales

Gain
Rate of Raturn
0
Loss

Decreasing Level of Working Capital per Unit of Sales

191
Financing of It is also presumed that by analysing correctly the factors determining the
Working Capital
amount of the various components of working capital as well as
predictions of the state of the economy, management can determine the
ideal level of working capital that will equilibrate its rate of return with its
ability to assume risk. However, since most managers do not know what
the future holds, they tend to maintain an investment in working capital
that exceeds the ideal level. It is this excess that concerns us, since the
size of the investment determines a firm’s rate of return on investment.

Second principle: Capital should be invested in each component of

working capital as long as the equity position of the firm increases. This
principle is based on the concept that each rupee invested in fixed or
working capital should contribute to the net worth of the firm.

Third principle: The type of capital used to finance working capital

directly affects the amount of risk that a firm assumes as well as the
opportunity for gain or loss and cost of capital. It is indisputable that
different types of capital possess varying degrees of risk. Investors relate the
price for which they are willing to sell their capital to this risk. They may
charge less for debt than equity, since debt capital possesses less risk. Thus
risk is related to the return. Higher risk may imply a higher return too.
Unlike rate of return, cost of capital moves inversely with risk. As
additional risk capital is employed by management, cost of capital declines.
This relationship prevails until the firm’s optimum capital structure is
achieved.
Fourth principle: The greater the disparity between the maturities of a
firm’s short-term debt instruments and its flow of internally generated
funds, the greater the risk and vice-versa. This principle is based on the
analogy that the use of debt is recommended and the amount to be used
is determined by the level of risk, management wishes to assume. It should
be noted that risk is not only associated with the amount of debt used
relative to equity, it is also related to the nature of the contracts negotiated
by the borrower. Some of the more important characteristics of debt
contracts directly affecting a firm’s operation are restrictive clauses of
the contracts and dates of maturity.
Lenders of short-term funds are particularly conscious of this problem, and
in an effort to protect themselves by reducing the risk associated with
improper maturity dates, they are requiring firms to produce documents
depicting cash flows. These documents when properly prepared, not only
show the level of loans necessary to support sales but also indicate when
the loans can be repaid. In other words, lenders realize that a firm’s ability
to repay short-term loans is directly related to cash flow and not to
earnings, and therefore, a firm should make every effort to the maturities
to its flow of internally generated funds.

8.3.2 Trade off Approach

It is evident from the study of Walker’s principles that working capital
decisions involve a trade-off between risk and return. The same is sought
192 to be further examined in this section.
All decisions of the financial manager are assumed to be geared to Theories and
Approaches
maximisation of shareholders wealth, and working capital decisions are no
exception. Accordingly, risk-return trade-off characterises each of the
working capital decision. There are two types of risks inherent in working
capital management, namely, liquidity risk and opportunity loss risk.
Liquidity risk is the non-availability of cash to pay a liability that falls due.
Even though it may happen only on certain days, it can cause, not only a
loss of reputation but also make the work condition unfavourable for
getting the best terms on transaction with the trade creditors. The other risk
involved in working capital management is the risk of opportunity loss i.e.
risk of having too little inventory to maintain production and sales, or the
risk of not granting adequate credit for realising the achievable level of
sales. In other words, it is the risk of not being able to produce more or
sell more or both, and therefore, not being able to earn the potential profit,
because there are not enough funds to support higher inventory and book
debts. Thus, it would not be out of place to mention that it is only theoretical
that the current assets could all take zero values. Indeed, it is neither
practicable nor advisable. In practice, all current assets take positive values,
because firms seek to reduce working capital risks.

As a matter of fact, there are many studies carried out to establish the link
between the profitability (return) and the investment in various components
of working capital (risk factors). In an interesting study conducted by Majid
Imdad Akash and others (2011) examined the risk-return relationships with
the empirical evidence drawn from Textile Sector of Pakistan. The authors
started with a hypothesis that working capital management has effect on
profitability and there exist a tradeoff between risk and return. Through this
study, they found that there existed significant relationship between
profitability and average college period in a negative manner. However, the
study proved that there was positive relationship between profitability and
other variables like: (a) average collection period, (b) inventory turnover in
days, (c) sales, (d) debt to total assets. The regression results of the study had
clearly indicated the strong relationship between profitability and the
important variables of working capital.

In another study, Daniel Kaman and Amos Ayuo (2014) investigated the
relationship between working capital management and organizational
performance among a sample of 13 manufacturing firms in Kenya through
both quantitative and qualitative dimensions found that the working capital
management is negatively correlated with Return on Assets (ROA) and
Return on Equity (ROE), indicating the “R’ values of -0.148 and -0.231
respectively. Likewise, many studies conducted in this area, have clearly
established the fact that there existed a clear tradeoff between the risk and
return.

The risk-return trade-off involved in managing the firm’s liquidity via

investing in marketable securities is illustrated in the following example.
Firms A and B are identical in every respect but one. Firm B has invested
Rs. 5,000 in marketable securities which has been financed with equity. That
is, the firm sold equity shares and raised Rs.5,000.00. The balance sheets
and net incomes of the two firms are shown in Table 8.2. Note that Firm A 193
Financing of has a current ratio of 2.5 (reflecting net working capital of Rs. 15,000)
Working Capital
and earns a 10 percent return on its total assets. Firm B, with its larger
investment in marketable securities has a current ratio of 3 and has net
working capital of Rs. 20,000. Since the marketable securities earn a return
of only 9 percent before taxes (4.5 percent after taxes with a 50 percent
tax rate). Firm B earns only 9.7 percent on its total investment. Thus,
investing in current assets and in particular in marketable securities, does
have a favourable effect on firms liquidity but it also has an unfavourable
effect on the firm's rate of return earned on invested funds. The risk-return
trade-off involved in holding more cash and marketable securities, therefore,
is one of added liquidity versus reduced profitability.

Table 8.2 : The Effects of Investing in Current Assets on Liquidity and

Profitability

Balance Sheets A (Rs.) B (Rs.)

Cash 500 500
Marketable securities 5,000
Accounts receivable 9,500 9,500
Inventories 15,000 15,000
Current assets 25,000 30,000
Net fixed assets 50,000 50,000
Total 75,000 80,000
Current liabilities 10,000 10,000
Long-term debt 15,000 15,000
Capital Equity 50,000 55,000
Total 75,000 80,000
Net Income 7,500 7,725*

Current ratio (Current assets/Current liabilities)

25, 000 30,000
2.5 times 3.0 times
10, 000 10, 000

Net working capital 15,000 20,000

(Current assets – Current liabilities)

Return on total assets (net income/total assets)

7,500 7, 725
10% 9.7%
75, 000 80,000
*During the year Firm B held Rs.5,000 in marketable securities, which earned a 9
percent return or Rs.450 for the year. After paying taxes at a rate of 50 percent, the
firm netted a Rs.225 return on this investment.

Activity 8.1
i) Give points of distinction between the Walker's Approach and Trade
off Approach.
…………………………………………………………………………….
…………………………………………………………………………….
194
 ……………………………………………………………………………. Theories and
Approaches
…………………………………………………………………………….
…………………………………………………………………………….

ii) What do you think are the possible ways by which Value Maximisation
would be possible through Current Assets Management
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

8.4 APPROACH TO FINANCING WORKING

CAPITAL
Financing the firm’s working capital requirements has been shown to involve
simultaneous and inter-related decisions regarding the firm’s investment in
current assets. Fortunately, there exists a principle, which can be used as a
guide to firm’s working capital financing decisions. This is the hedging
principle or matching principle.
Simply speaking, the hedging principle involves matching the cash flow
generating characteristics of an asset with the maturity of the source of
financing used to finance its acquisition. For example, a seasonal expansion
in inventories, according to the hedging principle, should be financed with a
short-term loan or current liability. The rationale underlying the rule is
straight forward. Funds are needed for a limited period of time, and when
that time has passed, the cash needed to repay the loan will be generated
by the sale of the extra inventory items. Obtaining the needed funds from a
long-term source (longer than one year) would mean that the firm would
still have the funds after the inventories (they helped finance) have been
sold. In this case the firm would have “excess” liquidity, which they either
hold in cash or invest in low yielding marketable securities until the
seasonal increase in inventories occurs again and the funds are needed.
This would result in an over-all lowering of firms profits, as we saw
earlier in the example presented in Table 8 .2.

Let us take another example in which a firm purchases a new packing

machine, which is expected to produce cash saving to the firm by
eliminating the need for two labourers and, consequently their salaries.
This amounts to an annual savings of Rs.20,000. While the new machine
costs Rs. 1,00,000 to install and will last 10 years. If the firm chooses to
finance this asset with a one-year loan, then it will not be able to repay
the loan from the cash flow generated by the asset. Hence, in accordance
with the hedging principle, the firm should finance the asset with a source
of financing that more nearly matches the expected life and cash flow
generating characteristics of the asset. In this case a 7 to 10-year loan
would be more appropriate than a one-year loan. 195
Financing of To put it very succinctly the hedging principle states that the firm’s assets
Working Capital
not financed by spontaneous sources should be financed in accordance
with the rule: permanent assets (including permanent working capital
needs) financed with long- term sources and temporary assets (viz.
fluctuating working capital need) with short-term sources of finance towards
the liquidity risk.
We may graphically illustrate the hedging principle as depicted in Figure 8.2A

Figure: 8.2A: Hedging Financing strategy

Note that permanent asset needs are matched exactly with spontaneous plus long-term
sources of financing while temporary current assets are financed with short-term sources
of financing.

This may be termed as hedging financing strategy. In practice we may

come across certain modifications of this strict hedging strategy. Figure
8 .2B and 8.2Cdepict two modifications.

Figure 8.2B: Conservative financing strategy: Long term financing exceeds permanent assets

Shaded area represents the firm’s use of long-term plus spontaneous financing in excess
of the firm’s permanent asset financing needs.

196
 Theories and
Approaches

Figure 8.2 C: Aggressive Financing strategy: Permanent Reliance on Short Term

Financing

Shaded area reflects the firm’s continuous use of short-term financing to support its
permanent asset needs.

In Figure 8.2 B the firm follows a more cautious plan, whereby long-term
sources of financing exceed permanent assets in trough period such that
excess cash is available (which must be invested in marketable securities).
Note that the firm actually has excess liquidity during the low ebb of its
asset cycle and thus faces a lower risk of being caught short of cash than a
firm that follows the pure hedging approach. However, the firm also
increases its investment in relatively low-yielding assets such that its return
on investment is diminished.

In contrast, Figure 8.2 C depicts a firm that continually finances a part of its
permanent asset needs with short term funds and thus follows a more
aggressive strategy in managing its working capital. It can be seen that even
when its investment in asset needs is lowest the firm must still rely on
short-term financing. Such a firm would be subjected to increased risks of
cash shortfall, in that it must depend on a continual rollover or
replacement of its short-term debt with more short-term debt. The benefit
derived from following such a policy relates to the possible savings
resulting from the use of lower-cost short-term debt as opposed to long-
term debt.

Most firms will not exclusively follow any one of the three strategies outlined
above in determining their reliance on short-term credit. Instead, a firm will
at times find itself overly reliant on long term financing and thus holding
excess cash and at other times it may have to rely on short-term financing
throughout an entire operating cycle. The hedging principle does, however;
provide an important guide regarding the appropriate use of short-term credit
for working capital financing.

Going by the trends in the interest rate structure prevailing in the money and
capital markets, the distinction between short-term and long-term finance
seems rarely relevant. Take for instance, the State Bank of India offers 5.20
per cent on a Fixed Deposits of 1-2 years (as on 30-04-2022); whereas it
offers just 5.40 per cent on a deposit made for the duration between 5 and 10
years. See how thin the margin between short-term and long-term finance.
197
Financing of Same is true in case of many other banks; excepting the fact that private
Working Capital
banks offering little higher rates over PSBs. Whereas the yield on
Government Securities per year stood at 6.779 per cent over the period
between May 1996 and January 2019; as per the data compiled by Census
and Economic Information Center. And whereas, Money Market instruments
like Treasury Bills are yielding 4.41 per cent on an average (2021-22 data),
Long-term Government Bonds (of 5 – 10 years) also are yielding about 4.81
per cent. These examples clearly indicate that the divergence between short
and long has become very thin and fading.

8.5 EFFECT OF CHOICE OF FINANCING ON

ROI
It would be now pertinent to examine the impact of the choice of financing on,
return on investment. Consider the following Data in Table-8.3

Table 8 .3: Effect of choice of financing on ROI

Balance Sheet Firm X Firm Y

Rs. Rs.
Current Assets 40,000 40,000
Fixed Assets 80,000 80,000
Total Assets 1,20,000 1,20,000
Accounts payable 10,000 10,000
Bank credit (10%) 0 30,000
Current liabilities 10,000 40,000
Long Term Debt (16%) 30,000 0
Equity 80,000 80,000
Total Liabilities 1,20,000 1,20,000

Income Statement Firm X Firm Y

Net operating Income (EBIT) 64,800 64,800
Less Interest 4,800 3,000
Taxable Income 60,000 61,800
Taxes @ 50% 30,000 30,900
PAT (Net Income) 30,000 30,900
Measures of Liquidity
(a) Current Ratio 4:1 1:1
(b) Net working capital 30,000 0
Measures of profitability
(a) ROl 37.5% 38.6%
(b) EPS Rs 3.00 Rs 3.09

198
It is evident from the data contained in Table 8.3 that the Firm (X) using Theories and
Approaches
long term debt has a current ratio of 4 times and Rs.30,000 in net working
capital, whereas Firm Y’s current ratio is only 1 time, which represents
zero net working capital. Because of lower interest rates on short-term debt
(bank credit in this case) Firm ‘Y’ was able to earn a ROI of 38.6
percent compared to that of ‘X’, which could earn only 37.5 percent. Thus
a firm can reduce its risk of illiquidity through the use of long term debt
at the expense of a reduction of its return on investment funds. Once again
we see that the risk-return trade-off involves an increased risk of illiquidity
versus increased profitability.

8.6 SUMMARY
It has been noted in this unit that value is created by virtue of investment
in both fixed and current assets. It is also found that the same criterion of
selection of projects used for fixed investment holds good for investments
in working capital; though the inter-related nature of current assets and
current liabilities makes the job of managing working capital difficult. To
attain this objective function, different approaches have been suggested. The
early contribution of Walker is found to be of immense use in this regard.
The principles laid down by him need to be tested in practice and
deviations to be examined. It is further highlighted that working capital
decisions involve trade-off between risk and return. This operates within the
investment and financing areas. Different approaches have been examined
in this unit with suitable examples to highlight the impact of the variables
on the working capital decision-making. Against these theoretical
foundations, the students are expected to compare the practices followed in
their organisations and enrich the existing knowledge base.

8.7 KEY WORDS

Aggressive financing Strategy: A portion of permanent assets financed
with short-term sources.
Conservative financing strategy: A portion of the temporary assets
financed with long term sources.
Hedging principle: The firm’s assets not financed by spontaneous sources
should be financed in accordance with the rule: permanent assets financed
with long-term sources and temporary assets with short-term sources.
Reversible investment: An investment, the cash flow related to which
could be readily reversed.
Spontaneous finance: Credit, which arises in direct conjunction with the
day-to-day operations of the firm.
Creation of value: The process of maximising the market price of the
company’s common stock. This occurs when the finance manager does
something that shareholder cannot do for themselves.
Net present value: The difference between the present value of inflows
generated by a project minus the initial investment made in that project.
199
Financing of
Working Capital
8.8 SELF-ASSESSMENT QUESTIONS
1) Distinguish between Fixed asset management and current asset
management.
2) How is value created through working capital management?
3) ‘Merely increasing the level of investment in current assets does not
reduce the working capital risks of a firm’ - comment.
4) ‘Working capital, like other financial management decisions involves
risk-return trade-off: yet the same is unique’. Elaborate with suitable
examples.
5) Examine with suitable examples the principles of Walker.
6) Illustrate, using hypothetical data, the risks-return trade-off involved in
current asset investment and financing decisions.
7) Distinguish matching, conservative and aggressive working capital
financing strategies. Under the present capital and money market
conditions, which of these would you recommend to a consumer durable
manufacturing firm? Why? List out your assumptions, if any.
8) The balance sheet of the Cooptex Manufacturing Company is presented
below for the year ended December 31, 2021.
Cooptex Manufacturing Co.
Balance sheet as on Dec. 31, 2021
Current Liabilities Rs 30,000 Net Fixed Assets Rs 50,000
Long-Term Liabilities Rs 20,000 Current Assets:
Equity Capital Rs 50,000 Cash 5,000
Inventories 25,000
Accounts Receivable 20,000 Rs 50,000
1,00,000 1,00,000

During 2003 the firm earned net income after taxes of Rs. 10,000 based
on net sales of Rs.2,00,000.
a) Calculate Cooptex current ratio, net working capital and return on total
assets ratio (net income/total assets) using the above information.
b) The General Manager (Finance) of Cooptex is considering a Plan for
enhancing the firm’s liquidity. The plan involves raising Rs.l0,000 by
issuing equity shares and investing in marketable securities that will
earn 10 percent before taxes and 5 per cent after taxes. Calculate
Cooptex’s current ratio, net working capital and return on total assets
after the plan has been implemented.
(Hint: Net Income will now become Rs 10,000 plus .05 times Rs. 10,000
or Rs 1,05,000)
c) In what manner will the plan proposed in part (b) affect the firm’s
liquidity and profitability? Explain.
9) The manager of farm supply store is evaluating two alternative levels of
investment in sand inventory. A & B. The relevant data for the two
alternatives are shown below:
200
 A B Theories and
Approaches
Average Monthly Investment Rs. 2000 Rs. 4000
Monthly Cash Revenues Rs. 1200 Rs. 1600
Monthly Cash Costs Rs. 400 Rs. 780

The discount rate for the investment is 1 per cent per month. The Income Tax
rate is 40 per cent. In six month’s time, inventories of this item will be
reduced to zero. The Manager expects to realize the amount invested at that
time.
a) Calculate the monthly net profit for the two alternatives.
b) Calculate the net present value for the two alternatives.
c) Which alternative is better? Does it matter whether net profit per month
or net present value is used to decide on the alternative?
Answers:
9 (a): A= Rs. 444 B= Rs. 438
9 (b): A=Rs.2661 B= Rs. 2627

8.9 FURTHER READINGS

1) Hrishikes Bhattacharya, Working Capital Management, Strategies and
Techniques, Prentice Hall.

2) Gup Benton E., Principles of Financial Management, John Wiley &

Sons, New York.
3) Walker, Ernest W., Essentials of Financial Management, Prentice Hall.

4) Weston, Fred J. & Brigham, E.F., Managerial Finance, The Dryden

Oress, Illinois.

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