Final Project Working Cap MGT

-Working Capital Management
Introduction to Working Capital Management
Working capital management is a significant in financial management due to the fact that it
plays a vital role in keeping the wheel of business enterprises running. Working capital
management is concerned with short term financial decision. Shortage of funds for working
capital has caused many businesses to fail and in many cases, as retarded their growth.
Lack of efficient and effective utilization of working capital leads to low rate of return on
capital employed or even compels to sustain losses. The lead for skill working capital
management has thus become greater in recent years. A firm invests a part of its
permananent capital in fixed asset and keeping part of it for working capital i.e. for meeting a
day to day requirement. The management of working capital is no less important than the
management of long term financial investment. Sufficient liquidity is necessary and must be
achieve and maintain to provided funds and pay of the obligation as they arises or mature.
Each organization is faced with its own limits on the production capacity and technologies it
can employ there are fixed as well as variable costs associated with production goods. In
other words, the markets in which real firm operated are not perfectly competitive.
These real world facts introduce problems and require the necessity of
working capital. The most important areas in the day to day management of the firm, is the
management of working capital. Working capital management is the functional area of
finance that covers all the current accounts of the firm. It is concerned with management of
the level of individual current assets as well as the management of total working capital.
Working capital management involves the relationship between a firm's short-term assets
and its short-term liabilities. The goal of working capital management is to ensure that a firm
is able to continue its operations and that it has sufficient ability to satisfy both maturing
short-term debt and upcoming operational expenses. The management of working capital
involves managing inventories, accounts receivable and payable, and cash.
For example, an organization may be faced with an uncertainty regarding availability

of sufficient quantity of crucial inputs in future at reasonable price. This may necessitate the
holding of inventory ie., current assets. Similarly an organization may be faced with an
uncertainty regarding the level of its future cash inflows and insufficient amount of cash may
incur substantial costs. This may necessitate the holding of a reserve of short – term
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marketable securities, again a short term capital asset. The unpredictable and uncertain
global market plays a vital role in working capital. Though the globalization of economy and
free trading of products envisages the continuous availability of products but how much its
cost effective and quality based varies concern to concerns.
Working capital refers to the funds invested in current assets, ie., investment in
stocks, sundry debtors, cash and other current assets. Current assets are essential to use
fixed assets profitably. The term current assets refers to those assets which in the ordinary
course of business can be converted into cash within one year without undergoing diminish
in value and without disrupting the operations of the firm. The current assets are cash,
marketable securities, accounts receivable and inventory. Current liabilities are those which
are to be paid within a year out of the current assets or earnings of the concern. The current
liabilities are accounts payable, bills payable, bank overdraft and outstanding expenses.
The financial manager plays a vital role in management of working capital. The
financial management of any business organization involves the three following vital
functions:
1. Management of Long Term Assets
2. Management of Long Term Capital
3. Management of Short Term Assets and Liabilities
In most of the organizations the first & second one which refers to Capital Budgeting and
Capital Structure respectively will be maintained and cope up with organization growth. The
third one which refers to Working Capital Management requires more skills for sustaining
and steady growth rate for any organization.
The working capital management includes decisions

i. How much stock/inventory to be hold
ii. How much cash/bank balance should be maintained
iii. How much the firm should provide credit to its customers
iv. How much the firm should enjoy credit from its suppliers
v. What should be the composition of current assets
vi. What should be the composition of current liabilities
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Impact of inflation on Working Capital Management
One of the objectives of working capital management is to determine and maintain the
optimum level of investment in current assets for increase of return on capital employed.
While determination of working capital requirement, moderate inflation rate can be ignored,
but higher rate of inflation will be consider otherwise, wrong setting of working capital level
will hamper the smooth flow of working and profitability of the concern. When the inflation
rate is high, it will have its direct impact on the requirement of the working capital as
explained below:
• Inflation will cause to show the turnover figure at higher level even if there is no
increase in the quantity of the sales. The higher the sales means the higher levels of
balanced in receivables
• Inflation will result in increase of raw materials prices and hike in payment of
expenses and as a result, increase in balance of trade creditors and creditors for
expenses.
• Increase in the value of closing stocks result in showing the higher profits but without
its realization into cash causing the firm to pay higher tax, dividend and bonus. This
will lead the firm in serious problem of funds shortage and firm may unable to meet
its short term and long term obligations.
• Increase in investment in current assets means the increase in the requirement of

working capital without corresponding increase in sales or profitability of the firm.
Keeping in view of the above, the finance manager should be very careful about the impact
of the inflation in assessment of the working capital requirement and its management.
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What is Working Capital?
In simple words working capital is the excess of current Assets over current liabilities.
Working capital has ordinarily been defined as the excess of current assets over current
liabilities. Working capital is the heart of the business. If it is weak business cannot proper
and survives. Sit is therefore said the fate of large scale investment in fixed assets is often
determined by a relatively small amount of current assets. As the working capital is
important to the company is important to keep adequate working capital with the company.
Cash is the lifeline of company. If this lifeline deteriorates so des the companies ability to
fund operation, reinvest do meet capital requirements and payment. Understanding
Company’s cash flow health is essential to making investment decision. A good way to judge
a company’s cash flow prospects is to look at its working capital management. The company
must have adequate working capital as much as needed by the company. It should neither
be excessive or nor inadequate.
Excessive working capital cuisses for idle funds laying with the firm without earning any
profit, where as inadequate working capital shows the company doesn’t have sufficient
funds for financing its daily needs working capital management involves study of the
relationship between firm’s current assets and current liabilities. The goal of working capital
management is to ensure that a firm is able to continue its operation. And that is has
sufficient ability to satisfy both maturing short term debt and upcoming operational
expenses. The better a company managers its working capital, the less the company needs
to borrow. Even companies with cash surpluses need to manage working capital to ensure
those surpluses are invested in ways that will generate suitable returns for investors.
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Types of working capital
On the basis of concept On the basis of time
Gross Net Working Temporary

Working Permanent
Capital Working Working
Capital Capital
Capital
Gross working capital

This thought says that total investment in current assets is the working capital of the
company. This concept does not consider current liabilities at all.
Reasons given for the concept:
1) When we consider fixed capital as the amount invested in fixed assets. Then the
amount invested in current assets should be considered as working capital.
2) Current asset whatever my be the sources of acquisition, are used in activities

related to day to day operations and their forms keep on changing. Therefore they
should be considered as working capital.
*Gross Working capital = Total Current Assets

Net working capital
It is narrow concept of working capital and according to this, current assets minus current
liabilities forms working capital. The excess of current assets over current liabilities is called
as working capital. This concept lays emphasis on qualitative aspect which indicates the
liquidity position of the concern/enterprise
*Net Working Capital = Current assets – Current Liabilities
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Fixed or Permanent Working Capital

The volume of investment in current assets changes over a period of time. But always there
is minimum level of current assets that must be kept in order to carry on the business. This
is the irreducible minimum amount needed for maintaining the operating cycle. It is the
investment in current assets which is permanently locked up in the business, and therefore
known as permanent working capital.
Variable or Temporary Working Capital

It is the volume of working capital which is needed over and above the fixed working capital
in order to meet the unforced market changes and contingencies. In other words any
amount over and about the permanent level of working capital is variable or fluctuating
working capital. This type of working capital is generally financed from short term sources of
finance such as bank credit because this amount is not permanently required and is usually
paid back during off season or after the contingency.
Temporary
Amount of working Permanent

Capital (Rs.)
Time
Temporary
Amount of working Permanent

Capital (Rs.)
Time
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Working Capital Cycle:
Equity & loan
CASH
PAYABLES
OVERHEADS
Etc.
Receivable
s
INVENTORY
SALES
Each component of working capital (namely inventory, receivables and payables) has two
dimensions TIME and MONEY. When they comes to managing working capital, then TIME
IS MONEY. If you can get money to move fester around the cycle (collect monies due from
debtors more quickly) or reduce the amount of money tied up (e., reduce inventory level
relative to sales). The business will generate more cash or it will need to borrow less money
to fund working capital. As consequences, you could reduce the cost of bank interest or you
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will have additional freee4 money available to support addition sales growth or investment.
Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an
increased credit limit, you festively create freed finance to help fund future sales
A perusal of operational cycle reveals that the cash invested in operations are
recycled back in to cash. However it takes time to reconvert the cash. Cash flows in cycle
into around and out of a business it the business’s lifeblood and every manager’s primary
task to help keep it flowing and to use the cash flow to generate profits. The shorter the
period of operating cycle, the larger will be the turnover of the funds invested in various
purposes.
Determinants of Working Capital
Working capital requirements of a concern depends on a number of factors, each of which

should be considered carefully for determining the proper amount of working capital. It may
be however be added that these factors affect differently to the different units and these
keeps varying from time to time. In general, the determinants of working capital which re
common to all organization’s can be summarized as under:
1. Nature of business
Need for working capital is highly depends on what type of business, the firm in. there are
trading firms, which needs to invest a lot in stocks, ills receivables, liquid cash etc. public
utilities like railways, electricity, etc., need much less inventories and cash. Manufacturing
concerns stands in between these two extends. Working capital requirement for
manufacturing concerns depends on various factor like the products, technologies,
marketing policies.
2. Production policies
Production policies of the organizations effects working capital requirements very highly.
Seasonal industries, which produces only in specific season requires more working capital.
Some industries which produces round the year but sale mainly done in some special
seasons are also need to keep more working capital.
3. Size of business
Size of business is another factor to determines the need for working capital
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4. Length of operating cycle

Operating cycle of the firm also influence the working capital. Longer the orating cycle, the
higher will be the working capital requirement of the organization.
5. Credit policy
Companies; follows liberal credit policy needs to keep more working capital with them.
Efficiency of debt collecting machinery is also relevant in this matter. Credit availability form
suppliers also effects the company’s working capital requirements. A company doesn’t enjoy
a liberal credit from its suppliers will have to keep more working capital
6. Business fluctuation
Cyclical changes in the economy also influence the level of working capital. During boom
period, the tendency of management is to pile up inventories of raw materials and finished
goods to avail the advantage of rising prove. This creates demand for more capital. Similarly
during depression when the prices and demand for manufactured goods. Constantly reduce
the industrial and trading activities show a downward termed. Hence the demand for
working capital is low.
7. Current asset policies

The quantum of working capital of a company is significantly determined by its current
assets policies. A company with conservative assets policy may operate with relatively high
level of working capital than its sales volume. A company pursuing an aggressive amount
assets policy operates with a relatively lower level of working capital.
8. Fluctuations of supply and seasonal variations

Some companies need to keep large amount of working capital due to their irregular sales
and intermittent supply. Similarly companies using bulky materials also maintain large
reserves’ of raw material inventories. This increases the need of working capital. Some
companies manufacture and sell goods only during certain seasons. Working capital
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requirements of such industries will be higher during certain season of such industries
period.
9. Other factors
Effective co-ordination between production and distribution can reduce the need for working
capital. Transportation and communication means. If developed helps to reduce the working
capital requirement/.
Operating Cycle
The operating cycle of the company consists of time period between procurement of the
inventory and the collection of the cash from the receivables. The operating cycle is the
length of time between the company’s outlay on raw materials, wages, and other expenses
and inflow of cash from sale of goods. Operating cycle is an important concept in the
management of cash and management of working capital. The operating cycles reveals the
time that elapses between outlay of cash and inflow of cash.
The above said periods are ascertained as follow:
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(a) Raw material Holding Period =
Average Raw material stock _

Average consumption of Raw material/365
(b) Work-in-Process period =
Average Work-in-Process _
Average cost of goods/365
(c) Receivable collection period =
Average Receivables _
Average sales/365
(d) Creditors payment period =
Average Work-in-Process _
Average cost of goods/365
(e) Finished Goods Holding period =
Average finished goods stock _

Average cost of goods sold/365
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Sources of working capital
The company can choose to finance its current assets by

 Long term sources
 Short term sources
Long term sources of permanent working capital: - It include equity and preference
shares, retained earning, debentures and other long term debts from public deposits and
financial institution. The long term working capital needs should meet through long term
means of financing. Financing through long term means provides stability, reduces risk or
payment and increases liquidity of the business concern. Various types of long term sources
of working capital are summarized as follow
1. Issue of shares
It is the primary and most important sources of regular or permanent working capital.
Issuing equity shares as it does not create and burden on the income of the concern.
Nor the concern is obliged to refund capital should preferably raise permanent working
capital. Issue of preference shares is also a source of creating working capital
2. Retained earnings
Retain earning accumulated profits are a permanent sources of regular working capital.
It is regular and cheapest. It creates not charge on future profits of the enterprises.
3. Issue of debentures
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It crates a fixed charge on future earnings of the company. Company is obliged to pay
interest. Management should make wise choice in procuring funds by issue of
debentures.
4. Long term debt

Company can raise fund from accepting public deposits, debts from Financial Institution
like banks, corporations etc. the cost is higher than the other financial tools.
Other sources sale of idle fixed assets, securities received from employees and
customers are examples of other sources of finance.
Short term sources of temporary working capital: - Temporary working capital is

required to meet the day to day business expenditures. The variable working capital would
finance from short term sources of funds. And only the period needed. It has the benefits of,
low cost and establishes closer relationships with banker. Some sources of temporary
working capital are given below
1. Commercial bank
A commercial bank constitutes a significant source for short term or temporary working
capital. This will be in the form of short term loans, cash credit, and overdraft and though
discounting the bills of exchanges.
2. Public deposits
Most of the companies in recent years depend on these sources to meet their short term
working capital requirements ranging fro six month to three years.
3. Various credits
Trade credit, business credit papers and customer credit are other sources of short term
working capital. Credit from suppliers, advances from customers, bills of exchanges,
promissory notes, etc. helps to raise temporary working capital
4. Reserves and other funds

Various funds of the company like depreciation fund. Provision for tax and other
provisions kept with the company can be used as temporary working capital.
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The company should meet its working capital needs through both long term and short term
funds. It will be appropriate to meet at least 2/3 of the permanent working capital
equipments form long term sources, whereas the variables working capital should be
financed from short term sources. The working capital financing mix should be designed in
such a way that the overall cost of working capital is the lowest, and the funds are available
on time and for the period they are really required.
SOURCES OF ADDITIONAL WORKING CAPITAL

Sources of additional working capital include the following
• Existing cash reserves
• Profits (when you secure it as cash)
• Payables (credit from suppliers)
• New equity or loans from shareholder
• Bank overdrafts line of credit
• Long term loans
If you have insufficient working capital and try to increase sales, you can easily over stretch
the financial resources of the business, this is called overtrading.
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Policies for financing Current Assets
Long term financing: The sources of long term financing include Ordinary shares,
Preference shares, and debentures, long term borrowings from financial institutions and
reserves and surplus (retained earnings)
Short term borrowing: Short term financing include working capital, funds from banks, public
deposits, commercial paper and factoring of receivables etc.
Spontaneous financing: Spontaneous financing refers to the automatic sources of short term
funds arising in the normal course of a business. Trade creditors and outstanding expenses
are the example of it.
Depending on the mix of short term and long term financing, the approach followed by a
company may be referred to as:
• Matching approach
• Conservative approach
• Aggressive approach
Matching approach:
The firm can adopt a financial plan which matches the expected life of assets with the
expected life of the source of funds raised to finance assets. When the firms follow the
matching approach (known as hedging approach), long term financing will be used to
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finance the fixed assets and permanent current assets and short term financing to finance
temporary or variable current assets.
Temporary current assets Short-term Financing
Assets Permanent current assets

Long- term financing
Fixed assets
Time
Conservative approach:
The financing policy of the firm is said to be conservative when it depends more on long
term funds for financing needs. Under a conservative plan, the firm finances its permanent
assets and also a part of temporary current assets with long term financing.

(b)
Assets
Permanent current assets Long- term financing
Fixed assets
Time
Aggressive approach:
A firm may be aggressive in financing its assets. An aggressive policy is said to be followed
by the firm when its uses more short term financing than warranted by the matching plan.
Under an aggressive policy, the firm finances a part of its permanent current assets with
short term financing.
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(b)
Assets
Permanent current assets Long- term financing
Fixed assets
Time
Working Capital Ratios
Working capital ratios indicate the ability of the business concern in meeting its current
obligation as well as its efficiency in managing the currents assets for generation of the
sales. The ratios are applied to evaluate the efficiency with which the firm manages and
utilizes its current assets. The following three categories of ratios are used for efficient
management of working capital:
(1) Efficiency Ratios:
• Working capital to sales ratios = Sales / Working capital
• Inventory turnover ratio = sales / Inventory
• Current Assets turnover ratio = sales / Current Assets
(2) Liquidity Ratios:
• Current ratio = Current Assets / Current Liability
• Quick ratio = Current assets – Inventory/ Current liability – Bank overdraft
• Absolute liquid ratio = Absolute liquid Assets / Current Liability
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(3) Structural Health Ratios:
• Current Assets to Total Net Assets = Total Net Assets / Current Assets
• Debtor turnover ratio = Credit Sales / Debtors
• Debtor collection periods = Debtors X 365 / Credit sales
• Bad debts to sales = Bad Debts / Sales
• Creditors Payment Periods = Creditors X 365 / Credit Purchase
Working capital financing
Tandon Committee: Norms and Recommendations:

In 1974, a study group under the chairmanship of Mr. P. L. Tandon was constituted for
framing guidelines for commercial banks for follow-up & supervision of bank credit for
ensuring proper end-use of funds. The group submitted its report in August 1975, which
came to be popularly known as Tandon Committee’s Report. Its main recommendations
related to norms for inventory and receivables, the approach to lending, style of credit, follow
ups & information system.
It was a landmark in the history of bank lending in India. With acceptance of major
recommendations by Reserve Bank of India, a new era of lending began in India.
Tandon committee’s recommendations
Breaking away from traditional methods of security oriented lending, the committee enjoyed
upon the banks to move towards need based lending. The committee pointed out that the
best security of bank loan is a well functioning business enterprise, not the collateral.
Major recommendations of the committee were as follows:

1. Assessment of need based credit of the borrower on a rational basis on the basis of their
business plans.
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2. Bank credit would only be supplementary to the borrower’s resources and not replace
them, i.e. banks would not finance one hundred percent of borrower’s working capital
requirement.
3. Bank should ensure proper end use of bank credit by keeping a closer watch on the
borrower’s business, and impose financial discipline on them.
4. Working capital finance would be available to the borrowers on the basis of industry wise
norms (prescribe first by the Tandon Committee and then by Reserve Bank of India) for
holding different current assets, viz.
 Raw materials including stores and others items used in manufacturing
process.
 Stock in Process.
 Finished goods.
 Accounts receivables.
5. Credit would be made available to the borrowers in different components like cash
credit; bills purchased and discounted working capital, term loan, etc., depending upon
nature of holding of various current assets.
6. In order to facilitate a close watch under operation of borrowers, bank would require
them to submit at regular intervals, data regarding their business and financial
operations, for both the past and the future periods.
The Norms
Tandon committee had initially suggested norms for holding various current assets for fifteen
different industries. Many of these norms were revised and the least extended to cover
almost all major industries of the country.
Expression of Norms
The norms for holding different current assets were expressed as follows:
(a) Raw materials as so many months’ consumption. They include stores and other items
used in the process of manufacture.
(b) Stock-in-process, as so many months’ cost of production.
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(c) Finished goods and accounts receivable as so many months’ cost of sales and sales
respectively. These figures represent only the average levels. Individual items of finished
goods and receivables could be for different periods which could exceed the indicated
norms so long as the overall average level of finished goods and receivables does not
exceed the amounts as determined in terms of the norm.
(d) Stock of spares was not included in the norms. In financial terms, these were considered
to be a small part of total operating expenditure. Banks were expected to assess the
requirement of spares on case-by-case basis. However, they should keep a watchful eye
if spares exceed 5% of total inventories.
Suggested norms for inventory and receivables as suggested by the Tandon Committee are
given in Annexure (I).
The norms were based on average level of holding of a particular current asset, not on the
individual items of a group. For example, if receivables holding norms of an industry was two
months and an unit had satisfied this norm, calculated by dividing annual sales with average
receivables, then the unit would not be asked to delete some of the accounts receivable,
which were being held for more than two months.
The Tandon committee while laying down the norms for holding various current assets made
it very clear that it was against any rigidity and straight jacketing. On one hand, the
committee said that norms were to be regarded as the outer limits for holding different
current assets, but these were not to be considered to be entitlements to hold current assets
upto this level. If a borrower had managed with less in the past, he should continue to do so.
On the other hand, the committee held that allowance must be made for some flexibility
under circumstances justifying a need for re-examination. The committee itself visualized
that there might be deviations of norms in the following circumstances.
(a) Bunched receipt of raw materials including imports.

(b) Interruption of production due to power cuts, strikes or other unavoidable circumstances.
(c) Transport delays or bottlenecks.
(d) Accumulation of finished goods due to non-availability of shipping space for exports or
other disruption in sales.
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(e) Building up of stocks of finished goods, such as machinery, due to failure on the part of
the purchaser for whom these were specifically designed and manufactured.
(f) Need to cover full or substantial requirement of raw materials for specific export contract
of short duration.
While allowing the above exceptions, the committee observed that the deviations should be
for known and specific circumstances and situation, and allowed only for a limited period to
tide over the temporary difficulty of a borrowing unit. Returns to norms would be automatic
when conditions return to normal.
Methods of Lending
The lending framework proposed by Tandon Committee dominated commercial bank lending
in India for more than 20 years and its continues to do so despite withdrawal of mandatory
provision of Reserve Bank of India in 1997.
As indicated before, the essence of Tandon Committee’s recommendations was to finance

only portion of borrowers working capital needs not the whole of it. It was thought that
gradually, the borrower should depend less on banks to fund its working capital needs. From
this point of view the committee three graduated methods of lending, which came to be
known as maximum permissible bank finance system or in short MPBF system.
For the purpose of calculating MPBF of a borrowing unit, all the three methods adopted
equation:
Working Capital Gap = Gross Current Assets – Accounts Payable

…. as a basis which is translated arithmetically as follows:
Gross Current Assets Rs. ………………

Less: Current Liabilities
other than bank borrowings Rs. ……………….
Working Capital Gap Rs. ……………….
FIRST METHOD OF LENDING
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The contribution by the borrowing unit is fixed at a minimum of 25% working capital gap
from long-term funds. In order to reduce the reliance of the borrowers on bank borrowings
by bringing in more internal cash generation for the purpose, it would be necessary to raise
the share of the contribution from 25% of the working capital gap to a higher level. The
remaining 75% of the working capital gap would be financed by the bank. This method of
lending gives a current ratio of only 1:1. This is obviously on the low side.
SECOND METHOD OF LENDING
In order to ensure that the borrowers do enhance their contributions to working capital and
to improve their current ratio, it is necessary to place them under the Second Method of
lending recommended by the Tandon Committee which would give a minimum current ratio
of 1.33:1. The borrower will have to provide a minimum of 25% of total current assets from
long-term funds. However, total liabilities inclusive of bank finance would never exceed 75%
of gross current assets. As many of the borrowers may not be immediately in a position to
work under the Second Method of lending, the excess borrowing should be segregated and
treated as a working capital term loan which should be made repayable in installments. To
induce the borrowers to repay this loan, it should be charged a higher rate of interest. For
the present, the Group recommends that the additional interest may be fixed at 2% per
annum over the rate applicable on the relative cash credit limits. This procedure should be
made compulsory for all borrowers (except sick units) having aggregate working capital
limits of Rs.10 lakhs and over.
THIRD METHOD OF LENDING
Under the third method, permissible bank finance would be calculated in the same manner
as the second method but only after deducting four current assets from the gross current
assets.
The borrower’s contribution from long-term funds will be to the extent of the entire core
current assets, as defined, and a minimum of 25% of the balance current assets, thus
strengthening the current ratio further. This method will provide the largest multiplier of bank
finance.
Core portion current assets were presumed to be that permanent level which would
generally vary with the level of the operation of the business. For example, in case of stocks
of materials the core line goes horizontally below the ordering level so that when stocks are
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ordered materials are consumed down the ordering level during the lead time and touch the
core level, but are not allowed to go down further. This core level provides a safety cushion
against any sudden shortage of materials in the market or lengthening of delivery time. This
core level is considered to be equivalent to fixed assets and hence, was recommended to
be financed from long-term sources.
A real time example:
Current liabilities Rs. Rs. Current Assets Rs. Rs.

Trade credit 300 Inventories:-
Other current liabilities 150 450 Raw materials 600
Work in process 60
Bank Borrowing,
including bill
discounted 600 Finished Goods 270 930
Accounts Receivable
(Bills Discounted) 150
Other CA 30
Total 1050 1110
First Method
Particulars (Rs.)
Gross current Asset 1110
(Other than bank borrowings) 450
Working Capital Gap 660
25% of the above from long term sources 165
Maximum permissible bank Finance 495
Actual bank borrowing 600
Excess borrowing 105
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Current Ratio 1.17
Second Method
Particulars (Rs.)
Less: 25% of the above from
Long-term sources 276
834
Current Ratio 1.33
Third Method
Particulars (Rs.)
Less: Core current Assets 285
Real current Asset 825
Less: 25% of the above from
Long-term sources 207
618
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Current Ratio 1.79
It would appear from the above illustration that there is a gradual decrease in MPBF from
one method to the other, which is reflected by the gradual rise of current ratio. The
committee proposed that excess borrowing over the MPBF, shown above should be placed
on a repayment basis to be adjusted over a period of time.
The level of holding under the prescribed three methods of lending should be considered as
minimum threshold level. For units whose existing current ratio is higher than minimum
prescribed, would not be allowed any slip back except under special circumstances.
Reserve Bank of India allowed such slip back for the following purposes only if current ratio
of at least 1.33 was maintained:
(a) For undertaking either an expansion of existing capacity which would also include setting
up of new units.
(b) For fuller utilization of existing capacity, for meeting a substantial increase in the unit’s
working capital requirements on account of abnormal price rise.
(c) For investment in allied concern with the concurrence of the bank.
(d) For bringing about a reduction in the level of deposit accepted from the public in order to
comply with statutory requirements.
(e) For repayment by installments foreign currency loans and other term loans.
(f) For rehabilitation or reviving weaker units in the group while allowing funds from cash
rich companies, provided that by such transfer the current ratios of the transferor
companies would not fall below 1.33.
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Under the liberalized lending regime the RBI has allowed the banks to decide on permitting
‘slip-back’ on their own. But the circumstances mentioned above being exhaustive, continue
to act as guidelines.
From an analysis of the operations of cash credit accounts of many non- seasonal
industries, Tandon Committee observed that the outstanding in a cash credit account did not
fall below certain level, which represented the stable fund requirement during the year. The
committee therefore suggested that permissible bank finance be made available to a
borrower in the form of a demand loan for that minimum level which constituted the stable
fund requirement and the fluctuating portion by cash credit. But the concept of core current
asset did not find found favor with banks because of difficulties in calculating them, and
where abandoned by Chore Committee.
Lending Policies of Commercial Banks during Post Liberalization Period
In the credit policy announcements of 1997-98 of RBI give freedom to the banks and the
borrowers in respect of sanction or availability of working capital facilities. Banks would
henceforth make their own assessment of credit requirement of borrowers based on a total
study of the borrowers’ business operations. RBI would no longer prescribe detailed industry
wise norms for holding of various current assets as in MPBF system, except that it may
provide broad indicative level for the guidance of banks. Accordingly, banks can decide the
levels of holding of each item of current assets, which in their view, would represent a
reasonable build up of current assets for being supported by banks.
Banks are encouraged to evolve suitable internal guidelines for evaluating various
projections made by borrowers including level of trade credits available to them, and also to
install appropriate risk analysis mechanisms in view of changing risk perceptions under a
liberalized regime.
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The Concept of Zero Working Capital
In today’s world of intense global competition, working capital management is receiving

increasing attention form managers striving for peak efficiency the goal of many leading
companies today, is zero working capital. Proponent of the zero working capital concept
claims that a movement toward this goal not only generates cash but also speeds up
production and helps business make more timely deliveries and operate more efficiently.
The concept has its own definition of working capital: inventories+ receivables- payables.
The rational here is (i) that inventories and receivables are the keys to making sales, but
(II) that inventories can be financed by suppliers through account payables.
Companies use about 20% of working capital for each sale. So, on average,
working capital is turned over five times per year. Reducing working capital and thus
increasing turnover has two major financial benefits. First every money freed up by
reducing inventories or receivables, by increasing payables, results in a one time
contribution to cash flow. Second, a movement toward zero working capital permanently
raises a company’s earnings.
The most important factor in moving toward zero working capital is increased speed. If
the production process is fast enough, companies can produce items as they are
ordered rather than having to forecast demand and build up large inventories that are
managed by bureaucracies. The best companies delivery requirements. This system is
known as demand flow or demand based management. And it builds on the just in time
method of inventory control.
Clearly it is not possible for most firm to achieve zero working capital and infinitely
efficient production. Still, a focus on minimizing receivables and inventories while
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maximizing payables will help a firm lower its investment in working capital and achieve
financial and production economies.
Technique for assessment of Working Capital requirement

1. Estimation of Component of working capital Method: Since working capital is the excess
of current assets over current liabilities, an assessment of the working capital requirements
can be made by estimating the amounts of different constituents of working capital e.g.,
inventories, accounts receivable, cash, accounts payable, etc.
2. Percent of sales Approach:

This is a traditional and simple method of estimating working capital requirements.
According to this method, on the basis of past experience between sales and working
capital requirements, a ratio can be determined for estimating the working capital
requirements in future.
3. Operating Cycle Approach:

According to this approach, the requirements of working capital depend upon the operating
cycle of the business. The operating cycle begins with the acquisition of raw materials and
ends with the collection of receivables
It may be broadly classified into the following four stages viz.

• Raw materials and stores storage stage.
• Work-in-progress stage.
• Finished goods inventory stage.
• Receivables collection stage.
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The duration of the operating cycle for the purpose of estimating working capital
requirements is equivalent to the sum of the durations of each of these stages less the credit
period allowed by the suppliers of the firm.
Symbolically the duration of the working capital cycle can be put as follows: -
O=R+W+F+D-C
Where,
O = Duration of operating cycle;
R = Raw materials and stores storage period;
W = Work-in-progress period;
F = Finished stock storage period;
D = Debtors collection period;
C = Creditors payment period.
Each of the components of the operating cycle can be calculated as follows:-

R= Average stock of raw materials and stores
Average raw materials and stores consumptions per day
W = Average work-in-progress inventory

Average cost of production per day
D = Average book debts

Average credit sales per day
C = Average trade creditors

Average credit purchases per day
After computing the period of one operating cycle, the total number of operating
cycles that can be computed during a year can be computed by dividing 365 days with
number of operating days in a cycle. The total expenditure in the year when year when
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divided by the number of operating cycles in a year will give the average amount of the
working capital requirement.
CASH MANAGEMENT
It is the duty of the finance manager to provide adequate cash to all segments of the
organization. He also has to ensure that no funds are blocked in idle cash since this will
involve cost in terms of interest to the business. A sound cash management scheme,
therefore, maintains the balance between the twin objectives of liquidity and cost.
Meaning of cash
The term “cash” with reference to cash management is used in two senses. In a narrower
sense it includes coins, currency notes, cheques, bank drafts held by a firm with it and the
demand deposits held by it in banks.
In a broader sense it also includes “near-cash assets” such as, marketable securities and
time deposits with banks. Such securities or deposits can immediately be sold or converted
into cash if the circumstances require. The term cash management is generally used for
management of both cash and near-cash assets.
Motives for holding cash

A distinguishing feature of cash as an asset, irrespective of the firm in which it is held, is that
it does not earn any substantial return for the business. In spite of this fact cash is held by
the firm with following motives.
1. Transaction motive
A firm enters into a variety of business transactions resulting in both inflows and
outflows. In order to meet the business obligation in such a situation, it is necessary to
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maintain adequate cash balance. Thus, cash balance is kept by the firms with the motive of
meeting routine business payments.
2. Precautionary motive
A firm keeps cash balance to meet unexpected cash needs arising out of unexpected
contingencies such as floods, strikes, presentment of bills for payment earlier than the
expected date, unexpected slowing down of collection of accounts receivable, sharp
increase in prices of raw materials, etc. The more is the possibility of such contingencies
more is the cash kept by the firm for meeting them.
3. Speculative motive
A firm also keeps cash balance to take advantage of unexpected opportunities, typically
outside the normal course of the business. Such motive is, therefore, of purely a speculative
nature.
For example,
A firm may like to take advantage of an opportunity of purchasing raw materials at
the reduced price on payment of immediate cash or delay purchase of raw materials in
anticipation of decline in prices.
4. Compensation motive
Banks provide certain services to their clients free of charge. They, therefore, usually require
clients to keep minimum cash balance with them, which help them to earn interest and thus
compensate them for the free services so provided.
Business firms normally do not enter into speculative activities and, therefore, out of the
four motives of holding cash balances, the two most important motives are the
compensation motive.
Objectives of cash management

There are two basic objectives of cash management:
• To meet the cash disbursement needs as per the payment schedule;
• To minimize the amount locked up as cash balances.
1. Meeting cash disbursements

The first basic objective of cash management is to meet the payments Schedule. In
other words, the firm should have sufficient cash to meet the various requirements of the
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firm at different periods of times. The business has to make payment for purchase of raw
materials, wages, taxes, purchases of plant, etc. The business activity may come to a
grinding halt if the payment schedule is not maintained. Cash has, therefore, been aptly
described as the “oil to lubricate the ever-turning wheels of the business, without it the
process grinds to a stop.”
2. Minimizing funds locked up as cash balances
The second basic objective of cash management is to minimize the amount locked up as
cash balances. In the process of minimizing the cash balances, the finance manager is
confronted with two conflicting aspects. A higher cash balance ensures proper payment with
all its advantages. But this will result in a large balance of cash remaining idle. Low level of
cash balance may result in failure of the firm to meet the payment schedule.
The finance manager should, therefore, try to have an optimum amount of cash
balance keeping the above facts in view.
Cash management - - - - - basic problems

Cash management involves the following four basic problems:
• Controlling levels of cash;
• Controlling inflows of cash;
• Controlling outflows of cash;
• Optimum investment of surplus cash.
1. Controlling levels of cash

One of the basic objectives of cash management is to minimize the level of cash balance
with the firm. This objective is sought to be achieved by means of the following: -
(i) Preparing cash budget:

Cash budget or cash forecasting is the most significant device for planning and
controlling the use of cash. It involves a projection of future cash receipts and cash
disbursements of the firm over various intervals of time. It reveals to the finance
manager the timings and amount of expected cash inflows and outflows over a
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period studied. With this information, he is better able to determine the future cash
needs of the firm, plan for the financing of these needs and exercise control over the
cash and liquidity of the firm.
Thus in case a cash budget is properly prepared it correctly reveals the timings and
size of net cash flows as well as the periods during which the excess cash may be
available for temporary investment. In a small company, the preparation of cash
budget or a cash forecast does not involve much of complications and, therefore,
relatively a minor job. However, in case of big companies, it is almost a full time job
handled by a senior person, namely, the budget controller or the treasurer.
(ii) Providing for unpredictable discrepancies:

Cash budget predicts discrepancies between cash inflows and outflows on the basis
of normal business activities. It does not take into account discrepancies between
cash inflows and cash outflows on account of unforeseen circumstances such as
strikes, short-term recession, floods, etc. a certain minimum amount of cash balance
has, therefore, to be kept for meeting such unforeseen contingencies. Such amount
is fixed on the basis of past experience and some intuition regarding the future.
(iii) Consideration of short costs:

The term short cost refers to the cost incurred as a result of shortage of cash. Such
costs may take any of the following forms:
(a) The failure of the firm to meet its obligations in time may result in legal action by the
firm’s creditors against the firm. This cost is in terms of fall in the firm’s reputation
besides financial costs incurred in defending the suit;
(b) Borrowing may have to be resorted to at high rate of interest. The firm may also be
required to pay penalties, etc., to banks for not meeting the obligations in time.
(iv) Availability of other sources of funds:

A firm can avoid holding unnecessary large balance of cash for contingencies in case
it has adequate arrangements with its bankers for borrowing money in times of
emergencies. For such arrangements the firm has to pay a slightly higher rate of
interest than that on a long-term debt. But considerable saving in interest costs will
be effected because such interest will have to be paid only for shorter period.
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2. Controlling inflows of cash

Having prepared the cash budget, the finance manager should also ensure that there is no
significant deviation between the projected cash inflows and the projected cash outflows.
This requires controlling of both inflows as well as outflows of cash.
Speedier collection of cash can be made possible by adoption of the following techniques,
which have been found to be quite useful and effective.
(i) Concentration Banking:

Concentration banking is a system of decentralizing collections of accounts
receivables in case of large firms having their business spread over a large area.
According to this system, a large number of collection centers are established by the
firm in different areas selected on geographical basis. The firm opens its bank
accounts in local banks of different areas where it has its collection centers. The
collection centers are required to collect cheques from their customers and deposits
them in the local bank account. Instructions are given to the local collection centers
to transfer funds over a certain limit daily telegraphically to the bank at the head
office. This facilitates fast movements of funds.
The company’s treasurer on the basis of the daily report received from the
head office bank about the collected funds can use them for disbursement according
to needs.
This system of concentration banking results in the following advantages:

(a) The mailing time is reduced since the collection centers themselves collect cheques
from the customers and immediately deposit them in local bank accounts. Moreover,
when the local collection centres are also used to prepare and send bills to the
customers in their areas, the mailing time in sending bills to the customer is also
reduced;
(b) The time required to collect cheques is also reduced since the cheques deposited in
the local bank accounts are usually drawn on banks in that area.
This helps in quicker collection of cash.
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(ii) Lock-box system:

Lock-box system is a further step in speeding up collection of cash. In case of
concentration banking cheques are received by collection centres who, after
processing, deposit them in the local bank accounts. Thus, there is time gap
between actual receipt of cheques by a collection centre and its actual depositing in
the local bank account.
Lock-box system has been devised to eliminate delay on account of this time gap.
According to this system, the firm hires a post-office box and instructs its
customers to mail their remittances to the box. The firm’s local bank is given the
authority to pick the remittances directly from the post-office box. The bank picks up
the mail several times a day and deposits the cheques in the firm’s account.
Standing instructions are given to the local bank to transfer funds to the head office
bank when they exceed a particular limit.
The Lock-Box system offers the following advantages:

(a) All remittances are handled by the banks even prior to their de3posits with
them at a very low cost;
(b) The cheques are deposited immediately upon receipt of remittances and the
collecting process starts much earlier than that under the system of
concentration banking.
3. Control over cash flows
An effective control over cash outflows or disbursements also helps a firm in conserving
cash and reducing financial requirements. However, there is a basic difference between
the underlying objective of exercising control over cash inflows and cash outflows. In
case of the former, the objective is the maximum acceleration of collections while in the
case of latter, it is to slow down the disbursements as much as possible. The
combination of fast collections and slow disbursements will result in maximum
availability of funds.
A firm can advantageously control outflows of cash if the following considerations are
kept in view:
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(i) Centralized system of disbursement should be followed as compared to

decentralized system in case of collections. All payments should be made
from a single control account. This will result in delay in presentment of
cheques for payment by parties who are away from the place of control
account.
(ii) Payments should be made on the due dates, neither before nor after. The
firm should neither lose cash discount nor its prestige on account of delay
in payments. In other words, the firm should pay within the terms offered by
the suppliers.
(iii) The firm may use the technique of “playing float” for maximizing the
availability of funds. The term float refers to the period taken from one stage
to another in the cash collection process.
It can be of the following types: -

( i ) Billing float:
It refers to the time interval between the making of a formal invoice by the seller
for the goods sold and mailing the invoice to the purchaser;
(ii) Capital float:

It refers to the time, which elapses between receiving of the cheque by the post
office or other messenger from the buyer till it is actually delivered to the seller.
(iii) Cheque processing float:

It refers to the time required for the seller to sort, record and deposit the
cheque after it has been received by him.
(iv) Bank processing float:

This refers to the time period which elapses between deposit of the cheque
with the banker and final credit of funds by the banker to the seller’s account.
4. Investing surplus cash

(i) Determination of the amount of surplus cash;
(ii) Determination of the channels of investments.
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(i) Determining of surplus cash

Surplus cash is the cash in excess of the firm’s normal cash requirements. While
determining the amount of surplus cash, the finance manager has to take into account the
minimum cash balance that the firm must keep to avoid risk or cost of running out of funds.
Such minimum level may be termed a “safety level of cash”.
Determining safety level for cash

The finance manager determines the safety level of cash separately both for normal periods
and peak periods.
In both the cases, he has to decide about the following two basic factors:
(a) Desired days of cash:

It means the number of days for which cash balance should be sufficient to cover
payments.
(b) Average daily cash outflows:

This means the average amount of disbursements, which will have to be made daily.
The “desired days of cash” and “ average daily cash outflows” are separately determined for
normal and peak periods. Having determined them, safety level of cash can be calculated
as follows:
During normal periods:

Safety level of cash = Desired days of cash x average daily cash outflows
During peak periods:

Safety level of cash = Desired days of cash at the busiest period x
Average of highest daily cash outflows.
(ii) Determining of channels of investments :

The finance manager can determine the amount of surplus cash, by comparing the
actual mount of cash available with the safety or minimum level of cash. Such surplus may
be either of a temporary or a permanent nature.
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Temporary cash surplus consists of funds, which are available for investment on a
short-term basis (maximum 6 months), since they are required to meet regular obligations
such as those of taxes, dividends, etc.
Permanent cash surplus consists of funds, which are kept by the firm to avail of some
unforeseen profitable opportunity of expansion or acquisition of some asset. Such funds are,
therefore, available for investment for a period ranging from six months to a year.
Criteria for investment

In most of the companies there are usually no written instructions for investing the
surplus cash. It is left to the discretion and judgment; It usually takes into consideration the
following factors:
(i) Security:
This can be ensured by investing money in securities whose price remain more or
less stable.
(ii) Liquidity:
This can be ensured by investing money in short-term securities including short-
term fixed deposits with bank.
(iii) Yield:
Most corporate managers give less emphasis to yield as compared to security and
liquidity of investment. They, therefore, prefer short-term government securities for investing
surplus cash. However, some corporate managers follow aggressive investment policies,
which maximize the yield on their investments.
(iv) Maturity:
Surplus cash is available not for an indefinite period. Hence, it will be advisable to
select securities according to their maturities keeping in view the period for which surplus
cash is available. If such selection is done carefully, the finance manager can maximize the
yield as well as maintain the liquidity of investments.
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INVENTORY MANAGEMENT
Inventories are good held for eventual sale by a firm. Inventories are thus one of the major
elements, which help the firm in obtaining the desired level of sales.
Kinds of inventories
Inventories can be classified into three categories.
(i) Raw materials:

These are goods, which have not yet been committed to production in a manufacturing firm.
They may consist of basic raw materials or finished components.
(ii) Work-in-progress:
This includes those materials, which have been committed to production process but have
not yet been completed.
(iii) Finished goods:

These are completed products awaiting sale. They are the final output of the production
process in a manufacturing firm. In case of wholesalers and retailers, they are generally
referred to as merchandise inventory.
The levels of the above three kinds of inventories differ depending upon the nature of the
business.
Benefits of holding inventories
39
Holding of inventories helps a firm in separating the process of purchasing, producing and
selling. In case a firm does not hold sufficient stock of raw materials, finished goods, etc.,
the purchasing would take place only when the firm receives the order from a customer. It
may result in delay in executing the order because of difficulties in obtaining/ procuring raw
materials, finished goods, etc. thus inventories provide cushion so that the purchasing,
production and sales functions can proceed at optimum speed.
The specific benefits of holding inventories can be put as follows:
(i) Avoiding losses of sales

If a firm maintains adequate inventories it can avoid losses on account of losing the
customers for non-supply of goods in time.
(ii) Reducing ordering cost

The variable cost associated with individual orders, e.g., typing, checking, approving and
mailing the order, etc., can be reduced if a firm places a few large orders than numerous
small orders.
(iii) Achieving efficient production runs

Maintenance of large inventories helps a firm in reducing the set-up cost associated with
each production run.
Risks and costs associated with inventories

Holding of inventories exposes the firm to a number of risks and costs. Risk of holding
inventories can be put as follows:
(i) Price decline

This may be due to increase in the market supply of the product, introduction of a new
competitive product, price cutting by the competitors, etc.
(ii) Product deterioration

This may due to holding a product for too long a period or improper storage conditions.
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(iii) Obsolescence
This may be due to change in customers taste, new production technique, improvements in
the product design, specifications, etc.
The costs of holding inventories are as follows:

(i) Materials cost
This includes the cost of purchasing the goods, transportation and handling charges less
any discount allowed by the supplier of the goods.
(ii) Ordering cost

This includes the variable cost associated with placing an order for the goods. The fewer the
orders, the lower will be the ordering costs for the firm.
(iii) Carrying cost

This includes the expenses for storing the goods. It comprises storage costs, insurance
costs, spoilage costs, cost of funds tied up in inventories, etc.
Management of inventory
Inventories often constitute a major element of the total working capital and hence it has
been correctly observed, “good inventory management is good financial management”.
Inventory management covers a large number of issues including fixation of
minimum and maximum levels; determining the size of the inventory to be carried ; deciding
about the issue price policy; setting up receipt and inspection procedure; determining the
economic order quantity; providing proper storage facilities, keeping check on obsolescence
and setting up effective information system with regard to the inventories.
However, a management inventory involves two basic problems:

(i) Maintaining a sufficiently large size of inventory for efficient and smooth
production and sales operations;
(ii) Maintaining a minimum investment in inventories to minimize the direct-
indirect costs associated with holding inventories to maximize the
profitability.
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Inventories should neither be excessive nor inadequate. If inventories are kept at a high
level, higher interest and storage costs would be incurred. On the other hand, a low level of
inventories may result in frequent interruption in the production schedule resulting in
underutilization of capacity and lower sales.
The objective of inventory management is, therefore, to determine and maintain the
optimum level of investment in inventories, which help in achieving the following objectives:
(i) Ensuring a continuous supply of materials to production department
facilitating uninterrupted production.
(ii) Maintaining sufficient stock of raw material in periods of short supply.
(iii) Maintaining sufficient stock of finished goods for smooth sales
operations.
(iv) Minimizing the carrying costs.
(v) Keeping investment in inventories at the optimum level.
Techniques of inventory management
Effective inventory requires an effective control over inventories.
Inventory control refers to a system which ensures supply of required quantity and quality of
inventories at the required time and the same time prevent unnecessary investment in
inventories.
The techniques of inventory control/ management are as follows:
1. Determination of Economic Order Quantity (EOQ)

Determination of the quantity for which the order should be placed is one of the important
problems concerned with efficient inventory management. Economic Order Quantity refers
to the size of the order, which gives maximum economy in purchasing any item of raw
material or finished product. It is fixed mainly taking into account the following costs.
(i) Ordering costs:

It is the cost of placing an order and securing the supplies. It varies from
time to time depending upon the number of orders placed and the number of items
ordered. The more frequently the orders are placed, and fewer the quantities
purchased on each order, the greater will be the ordering costs and vice versa.
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(ii) Inventory carrying cost:

It is the cost of keeping items in stock. It includes interest on
investment, obsolescence losses, store-keeping cost, insurance premium, etc. The
larger the value of inventory, the higher will be the inventory carrying cost and vice
versa.
The former cost may be referred as the “cost of acquiring” while the latter as the
“cost of holding” inventory. The cost of acquiring decreases while the cost of holding
increases with every increase in the quantity of purchase lot. A balance is, therefore, struck
between the two opposing factors and the economic ordering quantity is determined at a
level for which aggregate of two costs is the minimum.
Formula:
Q= 2U x P
Where,
Q = Economic Ordering Quantity
U = Quantity (units) purchased in a year (month)
P = Cost of placing an order
S = Annual (monthly) cost of storage of one unit.
2. Determination of optimum production quantity

The EOQ model can be extended to production runs to determine the optimum production
quantity.
The two costs involved in this process are:
(i) Set up costs;
(ii) Inventory carrying cost.
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The set up cost is of the nature of fixed cost and is to be incurred at the time of
commencement of each production run. Larger the size of the production run, lower will be
the set-up cost per unit.
However, the carrying cost will increase with increase in the size of the production run.
Thus, there is an inverse relationship between the set-up cost and inventory carrying cost.
The optimum production size is at that level where the total of the set-up cost and the
inventory carrying cost is the minimum.
In other words, at this level the two costs will be equal.
The formula for EOQ can also be used for determining the optimum production
quantity as given below:
E= 2U x P
Where
E = Optimum production quantity
U = Annual (monthly) output
P = Set-up cost for each production run
S = Cost of carrying inventory per annum (per month)
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RECEIVABLES MANAGEMENT
Accounts receivables (also properly termed as receivables) constitute a significant portion of

the total currents assets of the business next after inventories. They are a direct
consequences of “trade credit” which has become an essential marketing tool in modern
business.
When a firm sells goods for cash, payments are received immediately and, therefore,
no receivables are credited. However, when a firm sells goods or services on credit, the
payments are postponed to future dates and receivables are created. Usually, the credit
sales are made on open account, which means that, no, formal acknowledgements of debt
obligations are taken from the buyers. The only documents evidencing the same are a
purchase order, shipping invoice or even a billing statement. The policy of open account
sales facilities business transactions and reduces to a great extent the paper work required
in connection with credit sales.
Meaning of receivables
Receivables are assets accounts representing amounts owed to the firm as a result of sale
of goods / services in the ordinary course of business.
They, therefore, represent the claims of a firm against its customers and are carried
to the “assets side” of the balance sheet under titles such as accounts receivables,
customer receivables or book debts. They are, as stated earlier, the result of extension of
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credit facility to then customers a reasonable period of time in which they can pay for the
goods purchased by them.
Purpose of receivables
Accounts receivables are created because of credited sales. Hence the purpose of
receivables is directly connected with the objectives of making credited sales.
The objectives of credited sales are as follows:
(i) Achieving growth in sales:
If a firm sells goods on credit, it will generally be in a position to sell more goods than if it
insisted on immediate cash payments. This is because many customers are either not
prepared or not in a position to pay cash when they purchase the goods. The firm can sell
goods to such customers, in case it resorts to credit sales.
(ii) Increasing profits:

Increase in sales results in higher profits for the firm not only because of increase in the
volume of sales but also because of the firm charging a higher margin of profit on credit
sales as compared to cash sales.
(iii) Meeting competition:
A firm may have to resort to granting of credit facilities to its customers because of similar
facilities being granted by the competing firms to avoid the loss of sales from customers who
would buy elsewhere if they did not receive the expected output.
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The overall objective of committing funds to accounts receivables is to generate a

large flow of operating revenue and hence profit than what would be achieved in the
absence of no such commitment.
Costs of maintaining receivables
The costs with respect to maintenance of receivables can be identified as follows:
1. Capital costs:
Maintenance of accounts receivables results in blocking of the firm’s financial resources in

them. This is because there is a time lag between the sale of goods to customers and the
payments by them. The firm has, therefore, to arrange for additional funds top meet its own
obligations, such as payment to employees, suppliers of raw materials, etc., while awaiting
for payments from its customers. Additional funds may either be raised from outside or out
of profits retained in the business. In both the cases, the firm incurs a cost. In the former
case, the firm has to pay interest to the outsider while in the latter case, there is an
opportunity cost to the firm, i.e., the money which the firm could have earned otherwise by
investing the funds elsewhere.
2. Administrative costs:
The firm has to incur additional administrative costs for maintaining accounts receivable in
the form of salaries to the staff kept for maintaining accounting records relating to
customers, cost of conducting investigation regarding potential credit customers to
determine their creditworthiness, etc.
3. Collection costs:
The firm has to incur costs for collecting the payments from its credit customers.
Sometimes, additional steps may have to be taken to recover money from defaulting
customers.
4. Defaulting costs:
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Sometimes after making all serious efforts to collect money from defaulting customers, the
firm may not be able to recover the overdues because of the of the inability of the
customers. Such debts are treated as bad debts and have to be written off since they cannot
be realized.
Factors affecting the size of receivables
The size of the receivable is determined by a number of factors.
Some of the important factors are as follows:
(1) Level of sales:
This is the most important factor in determining the size of accounts receivable. Generally in
the same industry, a firm having a large volume of sales will be having a larger level of
receivables as compared to a firm with a small volume of sales.
Sales level can also be used for forecasting change in accounts receivable.
(2) Credited policies:
The term credit policy refers to those decision variables that influence the amount of trade
credit, i.e., the investment in receivables. These variables include the quantity of trade
accounts to be accepted, the length of the credit period to be extended, the cash discount to
be given and any special terms to be offered depending upon particular circumstances of
the firm and the customer. A firm’s credit policy, as a matter of fact, determines the amount
of risk the firm is willing to undertake in its sales activities. If a firm has a lenient or a
48
relatively liberal credit policy, it will experience a higher level of receivables as compared to
a firm with a more rigid or stringent credit policy.
This is because of two reasons:
• A lenient credit policy encourages even the financially strong customers to make
delays in payments resulting in increasing the size of the accounts receivables;
• Lenient credit policy will result in greater defaults in payments by financially weak
customers thus resulting in increasing the size of receivables.
(3) Terms of trade:
The size of the receivables is also affected by terms of trade (or credit terms) offered by the
firm.
The two important components of the credit terms are:
(i) Credit period;

(ii) Cash discount.
(i) Credit period:
The term credit period refers to the time duration for which credit is extended to the
customers. It is generally expressed in terms of “net days”.
For example,
If a firm’s credit terms are “net 15”, it means the customers are expected to pay
within 15 days from the date of credit sale.
(ii) Cash discount:
Most firms offer cash discount to their customers for encouraging them to pay their dues
before the expiry of the credit period. The terms of the cash discounts indicate the rate of
discount as well as the period for which the discount has been offered.
49
PAYABLE MANAGEMENT
Management of accounts payable is as much important as management of accounts
receivable. There is a basic difference between the approach to be adopted by the finance
manager in the two cases. Whereas the underlying objective in case of accounts receivable
is to maximize the acceleration of the collection process, the objective in case of accounts
payable is to slow down the payments process as much as possible. But it should be noted
that the delay in payment of accounts payable may result in saving of some interest costs
but it can prove very costly to the firm in the form of loss credit in the market.
The finance manager has, therefore, to ensure that the payments after obtaining the
best credit terms possible.
Overtrading and undertrading:
The concepts of overtrading and undertrading are intimately connected with the net working
capable position of the business. To be more precise they are connected with the cash
position of the business.
OVERTRADING:
50
Overtrading means an attempt to maintain or expand scale of operations of the

business with insufficient cash resources. Normally, concerns having overtrading have a
high turnover ratio and a low current ratio. In a situation like this, the company is not in a
position to maintain proper stocks of materials, finished goods, etc., and has to depend on
the mercy of the suppliers to supply them goods at the right time. It may also not be able to
extend credit to its customers, besides making delay in payment to the creditors.
Overtrading has been amply described as “overblowing the balloon”. This may, therefore,
prove to be dangerous to the business since disproportionate increase in the operations of
the business without adequate resources may bring its sudden collapse.
Causes of overtrading
The following may be the causes of over-trading:
(i) Depletion of working capital:
Depletion of working capital ultimately results in depletion of cash resources. Cash

resources of the company may get depleted by premature repayment of long-term loans,
excessive drawings, dividend payments, purchase of fixed assets and excessive net trading
losses, etc.
(ii) Faulty financial policy:
Faulty financial policy can result in shortage of cash and overtrading in several ways:
(a) Using working capital for purchase of fixed assets.

(b) Attempting to expand the volume of the business without raising the necessary
resources, etc.
(iii) Over-expansion:
51
In national emergencies like war, natural calamities, etc., a firm may be required to produce
goods on a larger scale. Government may pressurize the manufacturers to increase the
volume of production without providing for adequate finances. Such pressure results in over-
expansion of the business ignoring the elementary rules of sound finance.
(iv) Inflation and rising prices:
Inflation and rising prices make renewals and replacements of assets costlier. The wages
and material costs also rise. The manufacturer, therefore, needs more money even to
maintain the existing level of activity.
(v) Excessive taxation:
Heavy taxes result in depletion of cash resources at a scale higher than what is justified.
The cash position is further strained on account of efforts of the company to maintain
reasonable dividend rates for their shareholders.
Consequences of overtrading
The consequences of over-trading can be summarized as follows:
(i) Difficulty in paying wages and taxes:
This is one of the most dangerous consequences of overtrading. Non-payments of

wages in time create a feeling of uncertainty, insecurity and dissatisfaction in all ranks of the
labour. Non-payments of taxes in time may result in bringing down the reputation of the
company considerably in the business and government circles.
(ii) Costly purchases:
The company has to pay more for its purchases on account of its inability to have
proper bargaining, bulk buying and selecting proper source of supplying quality materials.
(iii) Reduction in sales:
52
The company may have to suffer in terms of sales because the pressure for cash
requirements may force it to offer liberal cash discounts to debtors for prompt payments, as
well as selling goods at throwaway prices.
(iv) Difficulties in making payments:
The shortage of cash will force the company to persuade its creditors to extend credit
facilities to it. Worry, anxiety and fear will be the management’s constant companions.
(v) Obsolete plant and machinery:
Shortage of cash will force the company to delay even the necessary repairs and
renewals. Inefficient working, unavoidable breakdowns will have an adverse effect both on
volume of production and rate of profit.
Symptoms and remedies for overtrading

The situation of overtrading should be remedied at the earliest possible opportunity,
i.e., as soon as its first symptoms are visible.
The symptoms can be put as follows:

(a) A higher increase in the amount of creditors as compared to debtors. This is
because of firms inability to pay its creditors in time and exercising of undue
pressure on debtors for payments;
(b) Increased bank borrowing with corresponding increase in inventories;
(c) Purchase of fixed assets out of short-term funds;
(d) A fall in the working capital turnover (working capital/sales) ratio.
(e) A low current ratio and high turnover ratio.
The cure for overtrading is easier to prescribe but difficult to follow. The cure is simple-
reduce the business or increase finance. Both are difficult. However, arrangement of more
finance is better. If this is not possible, the only advisable course left will be to sell the
business as a going concern.
53
Investing in working capital management with real time examples:
Successful investors have always given a lot of thrust on working capital management. A
study of top Indian companies with high return on capital employed (ROCE) shows that
many of these companies have operated on negative working capital management. These
companies are known to give good returns to their shareholders, both in terms of dividends
and capital gains. Interestingly, most of these companies belong to the FMCG or the auto
sector.
Of the 30 stocks in the Sensex, seven stocks have negative working capital and ROCEs in
the range of 20-80%. The total market capitalisation of these companies has moved up by
94% as against the entire Sensex, which moved up by 67% over the last one year.
Industries like steel and cement, which are working capital-intensive, may not show high
ROCEs on account of high capital costs. But some companies have begun to show negative
working capital. A better credit management system will help these companies generate
higher ROCEs in the long run.
Now a days cement companies carry a feedstock ranging from 5-6 days; it was earlier
54
around 15-30 days.
Overall, the cement industry's inventory turnover ratio is in the range of 10-12. Piling cement
stocks in the warehouses of the companies is no longer a phenomenon. When the cement
dispatches from the warehouses are growing at more than 20-30%, Indian cement
companies are able to move cement from factories in less than a day.
As a result of this, top cement companies such as ACC, Gujarat Ambuja, UltraTech Cement
and Madras Cement have negative working capital. The same companies have given high
returns to their shareholders in terms of dividends, bonuses as well as capital gains.
Negative is positive
HLL, Nestle and Godrej Consumers Products Ltd have ROCE in excess of 40%. The same
goes for two-wheeler companies like Bajaj Auto, TVS and Hero Honda, which have given
high returns on their investment. The success of this high return is associated with the way
these companies have managed their working capital management cycles.
These are the companies that first sell their goods and later on pay their raw material
suppliers. This is possible only when the companies are huge in size and account for the
bulk of turnover for their suppliers. In such a situation, they are always in a position to arm-
twist the suppliers by taking more credit.
Says Jigar Shah of broking firm KR Choksey: “Companies operating in industries like FMCG
and automobiles have been able to manage working capital efficiently and, thus, create
value for shareholders by way of high ROCE.”
Leveraging on supply chain
HLL, which had a net negative working capital of Rs 183.3 crore in FY05, has been able to
maintain its creditor days at 64 as compared to receivable days at 16. The company has
generated a ROCE at 44.1%. On the other hand, Godrej Consumer Products (GCPL) is
another company with negative working capital of Rs 45.48 crore and creditor days at 53,
compared to average debtors of six days only. The company has earned an ROCE at almost
158%.
55
“Effective use of ERP systems, involving trade partners in planning and monitoring working
capital items, following win-win policies, efficient operations at all levels enable GCPL to
manage working capital efficiently. It has given us an advantage of higher sales and better
ROCE.”
- Mr. Sunil Sapre, vice-president, finance, Godrej Consumer Products (GCPL)
The strong distribution and dominant position in the FMCG industry has made these
companies to bargain with the debtors and creditors to expand the payment cycle in favour
of the company.
The FMCG companies have been able to keep their creditors almost equal to debtors and
inventory, which have resulted in a lot of cash generation for these companies, which is
again invested in the business. These companies also make investment in short-term
papers and call money, which allows them to earn good returns.
“Traditionally, the FMCG companies are known for maintaining negative working capital
which is leveraged on strong supply chain management. Since this industry accounts for
very negligible amount of debtors, the whole trade is financed by creditors from the
production side and vendors and dealers from the supply side,” says an FMCG analyst.
The fast track
For the automobile industry, the most critical factor of the working capital is inventory
management. In the two-wheeler segment, Hero Honda and Bajaj Auto have negative
working capital of Rs 1047 crore and Rs 344 crore and generate RoCE of 81% and 21.6%,
respectively. The Indian automobile industry has come a long way in terms of managing
inventory. The inventory-turnover ratio in the last five years has improved more than two
times.
56
Companies have been able to produce fast and sell in the market and realise the cash. Hero
Honda, which had an inventory turnover ratio of as low as 18.50 in FY01 has improved
significantly to 47.59 and Bajaj Auto notched it from 17.14 for FY01 to 32.37 in FY05.
“Hero Honda has asked its major suppliers to have their warehouses around its
manufacturing locations to reduce the inventory at our end. The concept of direct on line has
been implemented for about 100 vendors where the material is supplied directly on the
assembly line without being stored.”
- Ravi Sud, CFO, Hero Honda,
Hero Honda has managed its working capital very efficiently and has been having negative
working capital for the last six years. The inventory number of days has come down from 29
days in 1999 to 10 days in 2005 due to indigenous production. Imported inventory has
reduced to about 30 days stock in the factory and similar stock is kept in transit due to long
transportation time.
It is evident that the companies have significantly reduced the level of inventory. In the four-
wheeler and commercial vehicle segment, Tata Motors has a negative working capital of
Rs19.92 crore and a ROCE of 32.76%. The companies with good brand image have been
the major beneficiaries of the country's booming automobiles market.
On the one hand, these companies have been giving bulk orders to auto ancillaries
companies while sourcing the auto parts with the condition of extended credit cycles. On the
other hand, the dealers have been pushed to pay upfront or in advance.
Companies like Hero Honda, Bajaj Auto and TVS Motors enjoy a significant gap of number
of days between the payment to creditors and their receivables. Receivables are managed
through implementing a credit policy, which rewards efficient dealers and penalises
inefficient ones.
The dealers are required to keep 15 days paid-up stock and then enjoy 15 days credit for
stock beyond 15 days. If the payment is not received within 15 days, the interest is charged
from day one. This does not mean that companies with high working capital do not generate
57
returns to their shareholders. It is in the nature of some businesses to sustain efficiency in

managing their working capital, while some industries are simply working capital-intensive.
But even for industries that have high working capital, they need to generate higher
revenues to maintain a healthy operating ratio. But negative working capital is one important
parameter that no successful investor has ever missed....
Case study: Bharat Heavy Electricals Ltd.
Introduction
BHEL or Bharat Heavy Electricals Limited is a gas and steam turbine manufacturer in
India. It is one of India's nine largest Public Sector Undertakings or PSUs, known as the
Navratnas or 'the nine jewels'
Founded in the late 1950s, BHEL is today a key player in the power sector through the
construction, commissioning and servicing of power plants all over the world. BHEL has
around 14 manufacturing divisions, four power sector regional centres, over 100 project
sites, eight service centres and 18 regional offices.
58
The greatest strength of BHEL is its highly skilled and committed 42,600 employees.
Every employee is given an equal opportunity to develop himself and grow in his
career. Continuous training and retraining, career planning, a positive work culture
and participative style of management. All these have engendered development of a
committed and motivated workforce setting new benchmarks in terms of productivity,
quality and responsiveness.
(Rs. In
lakhs)
59
2007 2006 2005 2004 2003

Operating income 1,736,289.00 1,344,145.00 963,900.00 803,673.00 699,931.00
%Change in Sales 29.17423343 39.44859425 19.93683998 14.82174672
Current Assets
Inventories 421767 374437 291610.73 210388.36 200105.61
Sundry Debtors 969582 716807 597214.22 460848.04 407578.21
Cash 580891 413397 317786.21 265963.89 132091.11
Other Current assets 19970 8450 4717.63 1350.59 99.84
1992210 1513091 1211328.79 938550.88 739874.77
%Change in Current Assets 31.66491639 24.91166828 29.06373174 26.85266724
Current Liabilities 200700 200600 2005 2004 2003
Acceptances 5542 4814 3411.24 2301.87 1718.98

Sundry Creditors
Total outstanding dues of SSI undertakings(Inc Interest) 8668 17591 12624.34 9247.99 7098.27
Other Sundry Creditors 345227 262818 197343.7 164549.1 149239.64
353895 280409 209968.04 173797.09 156337.91
Advances received from customers 777554 547916 458498.91 313302.7 180156.15
Deposits from Contractors 17051 14059 8905.93 6844.02 5839.39
Investor Education & Protection Fund
- Unclaimed dividend * 73 119 47.39 71.45 39.39

Other liabilities 35623 31768 29524.55 21661.4 23829.83
Interest accrued but not due 49 1689 1688.62 1712.54 1709.27

ST Borrowings 830350 595551 498665.4 343592.11 211574.03
Total Current Liabilities 1189787 880774 712044.68 519691.07 369630.92
%Change in ST Borrowings 39.4255068 19.42897983 45.13296013 62.39805519
WorkingCapital 802423 632317 499284.11 418859.81 370243.85
%Change in WC 26.90201276 26.64472739 19.20076791 13.13079475
Loan funds
Secured loans - 500 500 500 500
Unsecured loans 89.33 58.24 36.98 40.03 31.09
Total 8,877.59 7,859.62 6,563.88 5,835.97 5,334.76
%Change in LT Borrowings 12.95189844 19.74045839 12.47281943 9.395174291
Cost of sales 1,381,769.00 1,121,786.00 833,561.00 718,278.00 604,322.00
Source : Annual Reports
60
Liquidity Ratio 2007 2006 2005 2004 2003
Current Ratio 1.43 1.53 1.63 1.71 1.81
Current Ratio (In. Short term Loan) 1.43 1.53 1.63 1.71 1.81
Quick Ratio 1.13 1.17 1.22 1.28 1.29
Inventory turn Over Ratio 4.64 4.15 3.79 4.41 4.02
Long Term Debt/Equity 0.01 0.07 0.08 0.1 0.1
Total Debt/Equity 0.01 0.07 0.08 0.1 0.11
Fixed assets Turn over ratio 4.27 3.54 2.67 2.33 2.09
Avg. Receivable Days 189 180 211 194 199
Inventory Days 82 94 103 89 98
WCT 2.16380 2.12574 1.93056 1.91871 1.89045
CAT 0.87154 0.88834 0.795738 0.856291 0.94601
Avg. Payable Days 93 91 92 88 94
Operating Margin (%) 20.41 16.54 13.52 10.62 13.65
Gross Profit Margin (%) 19 14.71 11.25 8.16 11.01
Net Profit Margin (%) 13.51 12.19 9.58 7.91 6.14
Source: Annual Reports
Conclusion:
Net working capital increased year on year. The factors contributing to the increase are:
a) Increase in Sundry Debtors due to relaxing of the credit policy, although the AR days has
remained more or less constant
b) Increase in Inventory from Rs. 200105.61 lakhs in 2003 to Rs. 421767 lakhs in 2007
c) Increase in Other Current Assets and Loans and Advances by Rs. 99.84 lakhs in 2003 to
19970 lakhs in 2007.
61
However, increase in Current Liabilities and Provisions has offset the increase in Current
Assets thereby making marginal impact on the working capital.
• The inventory turnover ratio is around 4 which is near the industry average of 4.01
• The Current and Quick ratio are around 1.5 and 1.2 respectively indicating that the
firm is highly liquid and would be able to meet its short term liabilities effectively
• The current assets turnover which is <1 indicates that the sales are not growing in
same proportion as the current assets employed which can be attributed to inefficient
utilization of current assets or especially high portion of accounts receivables
62
Bibliography:
Books:
• Dr. S. N. Maheshwari, Financial Management, English Revised Edition.
• M.Y. Khan and P. K. Jain, Financial Management,
• Ravi M. Kishore, Financial Management, 6th Edition.
• I.M. Pandey, Financial Management.
Website:
• http://www.google.com
• http://www.wikipedia.com
• http://www.scribd.com
63

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-Working Capital Management

Introduction to Working Capital Management

For example, an organization may be faced with an uncertainty regarding availability

The working capital management includes decisions

Impact of inflation on Working Capital Management

• Increase in investment in current assets means the increase in the requirement of

What is Working Capital?

Types of working capital

On the basis of concept On the basis of time

Gross Net Working Temporary

Gross working capital

2) Current asset whatever my be the sources of acquisition, are used in activities

*Gross Working capital = Total Current Assets

*Net Working Capital = Current assets – Current Liabilities

Fixed or Permanent Working Capital

Variable or Temporary Working Capital

Amount of working Permanent

Amount of working Permanent

Working Capital Cycle:

Equity & loan

Working capital requirements of a concern depends on a number of factors, each of which

4. Length of operating cycle

7. Current asset policies

8. Fluctuations of supply and seasonal variations

The above said periods are ascertained as follow:

(a) Raw material Holding Period =

Average Raw material stock _

(b) Work-in-Process period =

(c) Receivable collection period =

(d) Creditors payment period =

(e) Finished Goods Holding period =

Average finished goods stock _

Sources of working capital

The company can choose to finance its current assets by

4. Long term debt

Short term sources of temporary working capital: - Temporary working capital is

4. Reserves and other funds

SOURCES OF ADDITIONAL WORKING CAPITAL

• Profits (when you secure it as cash)

• Payables (credit from suppliers)

• New equity or loans from shareholder

• Bank overdrafts line of credit

• Long term loans

Policies for financing Current Assets

Temporary current assets Short-term Financing

Assets Permanent current assets

Temporary current assets Short-term Financing

Temporary current assets Short-term Financing

Working Capital Ratios

(1) Efficiency Ratios:

• Working capital to sales ratios = Sales / Working capital

• Inventory turnover ratio = sales / Inventory

• Current Assets turnover ratio = sales / Current Assets

(2) Liquidity Ratios:

• Current ratio = Current Assets / Current Liability

• Quick ratio = Current assets – Inventory/ Current liability – Bank overdraft

• Absolute liquid ratio = Absolute liquid Assets / Current Liability

(3) Structural Health Ratios:

• Debtor turnover ratio = Credit Sales / Debtors

• Debtor collection periods = Debtors X 365 / Credit sales

• Bad debts to sales = Bad Debts / Sales

• Creditors Payment Periods = Creditors X 365 / Credit Purchase