Working Capital Management

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WORKING CAPITAL
What is WORKING CAPITAL? Working capital management is a significant fact of financial management due to the fact that it plays a pivotal role in keeping wheels of business enterprise running. Working capital management is concerned with short term financial decisions have been relatively neglected in the literature of finance shortage of funds for working capital has caused many businesses to fail and in many cases, has recorded there growth. Lack of efficient and effective utilization of working capital leads to earn low rate of return on capital employed or even compels to sustain losses. The need for skilled working capital management has thus become greater in recent years. A firm invest a part of its permanent capital in fixed assets and keeps a part of it for working capital for e.g. for meeting the day to day requirements. The requirement of working capital varies from firm to firm depending upon the nature of business, production policy, market conditions, seasonality of operations, conditions of supply etc. Working capital to a company is like the blood of human body. It is the most vital ingredient of a business. Working capital management if carried out effectively, efficiently and consistently, will assure the health of an organization. Every enterprise has to arrange for adequate funds for meeting day-to-day expenditure apart from investments in fixed assets. Working capital is the flow of ready funds necessary working of the enterprise. It consists of funds invested in current assets or those assets which in the ordinary course of business can be turned into cash within a brief period without undergoing diminution in value and without disruption of the organization. Current liabilities are those intended to be paid in the ordinary course of business within a short time. Thus net WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
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Purpose of working capital 1. To meet the cost of inventories, raw materials purchases, work-in-process, finished goods, etc.
2.
To pay wages and salaries
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To meet overhead cost, factory cost, office and administration cost, taxes, etc.
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To meet selling and distribution expenses, advertising, packing etc.
CASH
INVENTORIES
RECEVABLES
CIRCULATION OF CURRENT ASSETS
DEFINITION OF WORKING CAPITAL GROSS WORKING CAPITAL The gross working capital concept focuses attention on two aspects of current asset management: (a) Optimum investment in current asset; and (b) Financing of current assets. Following definition of working capital defines gross working capital 1. Mead, malott and field. Working capital means current assets.
2.
Bonneville. Any acquisition of funds which increases the current asset increases working capital, for they are one and the same.
3.
J.S.Mill. The sum of the current assets is the working capital of business.
NET WORKING CAPITAL according to new concept of working capital the working capital refers to the difference between current asset and current liabilities. It is the excess of current asset over current liabilities. A current liability refers to the claims of outsider which are expected to mature for payment within an accounting year. It includes creditors for goods, bills payable, bank overdraft etc. the concept may be in the following equation: Working capital = current assets current liabilities The net working capital (a) indicated the liquidity position of the firm; and (b) suggest the extent
to which working capital needs to be financed by permanent sources of funds. Both the net and gross concepts of working capital are two facets of working capital management. Net working capital may be of the following types: 1. Positive and quantitive net working capital. It arises when current assets exceeds current liabilities.
2.
Negative or quantitive net working capital. It occurs when current liabilities are in excess of current assets.
CLASSIFICATION OF WORKING CAPITAL Working capital may be classified on the following two bases: 1. ON THE BASIS OF CONCEPT Gross working capital. Represented by the total current assets.
Net working capital. It is the excess of current asset over current liabilities
2.
ON THE BASIS OF PERIODICITY OF REQUIREMENTS Fixed or permanent working capital. It represents the part of capital permanently locked up in the current assets to carry out the business smoothly. This investment in current assets increases as the size of business expands. Examples of such investments are those required to maintain the minimum stock of raw materials, work-in-progress, finished products, loose tools and equipments. This arrangement requires minimum cash balance to be kept in reserve for the payment of wages, salaries and all other current expenditure throughout the year. The permanent fixed working capital may again be subdivided in the following:
Regular working capital. It is the minimum amount of liquid capital required to keep up the circulation of the capital from cash to inventories; to receivable and again to cash. This includes sufficient minimum cash balance to discount all bills and to maintain adequate supply of raw materials etc.
Reserve margin or cushion working capital. It is the excess capital over the needs of regular working capital that should be kept in reserve for contingencies that may arise at any time. These contingencies include rising prices, business depression, strikes, special operations such as experiments with new products etc.
Variable working capital. Variable working capital changes with the increase or decrease in the volume of business. It may be subdivided into the following. (a) Seasonal variable working capital. The working capital required to meet the seasonal liquidity of the business is seasonal variable working capital.
(b) Special variable working capital. It is that part of the variable working capital which is required for financing special operation such as extensive marketing campaigns, experiments with products or methods of production, carrying of special jobs etc.
ADEQUACY OF WORKING CAPITAL Working capital or investment in current assets is a must for meeting the day-to-day expenditure on salaries, wages, rents, advertising etc., and for maintaining the fixed assets. Large scale capital in fixed is often determined by a relatively small amount of current assets. The heart of industry, working capital, if weak, the business cannot prosper and survive, although there may be a large investment of fixed assets. Inadequate as well as redundant working capital is dangerous for the health of industry. Inadequate working capital is disastrous; whereas redundant working capital is a criminal waste. Both situations are unwarranted in a sound organization. Adequacy of working capital is the life blood and controlling nerve center of a business.
USES OF ADEQUATE WORKING CAPITAL
1.
CASH DISCOUNT by adequate working capital the business can avail the advantages of cash discount by paying cash for the purchase of raw materials and merchandise. If proper cash balance is maintained, this will reduce the cost of production.
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SENSE OF SECURITY AND CONFIDENCE adequate working capital creates a sense of security, confidence and loyalty throughout the business and also among its customers, creditors and business associates. The proprietor, officials or management of a concern are carefree, if they have proper capital arrangements because they need not worry for the payment of business expenditure or creditors.
3.
SOLVENCY AND CONTINUOUS PRODUCTION in order to maintain the solvency of the business, it is essential that sufficient amount of funds are available to make all the payments in time as and when they are due. In the absence of working capital, production will suffer, era of cut throat competition. A business can never flourish in the absence of adequate working capital.
4.
SOUND GOODWILL AND INCREASE DEBT CAPACITY promptness of payment in business creates goodwill and increases the debit capacity of the business. If investors and borrowers are confident that they will get their due interest and payment of principal in time, a firm can raise funds from the market, purchase goods on credit and borrow short term funds from banks etc.
5.
EASY LOANS FROM THE BANKS an adequate working capital helps the company to borrow unsecured loans from the bank because the excess provides a good security to the unsecured loans. If the business has a good credit standing and trade reputation, banks favour in granting seasonal loans.
6.
DISTRIBUTION OF DIVIDEND short of working capital a company cannot distribute dividend to its shareholders in spite of sufficient profits. To make up for the deficiency of working capital profits are to be
retained in the business. On the other ample dividend can be declared and distributed to the market value of shares and increase by sufficient working capital.
7.
EXPLOITATION OF GOOD OPPORTUNITIES good opportunities can be exploited through adequacy of capital in a concern, for example, a company may make off seasons purchases resulting in substantial savings or it can fetch big supply orders resulting in good profits.
8.
MEETING UNSEEN COTINGENCIES as stockpiling of finished goods becomes necessary depression shoots up the working demand of capital. If a company maintains adequate working capital unseen contingencies such as financial crises due to heavy losses, business oscillations etc. can easily be overcome.
9.
INCREASE IN EFFICIENCY OF FIXED ASSETS proper maintenance and adequate working capital increases the efficiency of the fixed assets of the business. It has been rightly said, the fate of large scale investment in fixed capital is often determined by a relatively small amount of current assets.
10. HIGH MORAL the provision of adequate working capital improves the morale of the executive as they get an environment of certainty, security and confidence which is a great psychological factor in improving the overall efficiency of the business and of the person who is at the helm of affaires in the company.
11. INCREASE PRODUCTION EFFICIENCY a continuous supply of raw materials, research programmes, innovation and technical developments and expansion programmes are successfully carried out if adequate capital is maintained in the business. It increases production capacity which increases the efficiency and morale of the employees.
EVILS OF INADEQUATE WORKING CAPITAL
1.
LOSS OF CREDIT WORTHINESS AD GOODWILL a firm looses its credit worthiness and goodwill if it fails to honour its current liabilities. It finds it difficult to procure the requisite funds for its business operations on easy terms. This leads to reduce profitability as well as production interruptions.
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NO BENEFIT FROM FAVOURABLE OPPORTUNITIES with inadequate working capital a firm fails to undertake profitable projects. It prevents the firm from availing the benefits for available opportunities and stagnates its growth.
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FAILURE TO AVAIL CREDIT OPPORTUNITIES due to inadequate working capital a firm fails to avail the attractive credit opportunities.
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OPERATING INEFFICIENCIES inadequate working capital leads to operating inefficiencies as day-today commitments cannot be met.
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LOW RATE OF RETURN ON FIXED ASSETS inadequate working capital results in lowering down the rate of return on fixed assets as these cannot be efficiently utilized o maintain due to inadequacy of working capital.
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INCREASE IN BUSINESS RISKS inadequate working capital increases the business risk of the firm. Unable to discharge its current liabilities it is liable to be declared as insolvent. Thus inadequate working capital poses a serious threat to the survival of the firm.
7.
CANNOT ACHIEVE PROFIT TARGET due to inadequate working capital the firm cannot achieve its profit target as it cannot implement its operating plans due to shortage of working capital.
8.
LOW MORAL OF BUSINESS EXECUTIVES inadequate working capital adversely lowers the morale of the firms executives as they do not have an environment of certainty, security and confidence, which is a necessary psychological factor in improving the overall efficiency of the business.
9.
WEAKENING OF FINANCIAL CAPACITY inadequate working capital weakens the shock-absorbing capacity of the firm as it cannot meet the contingencies arising from business oscillations, financial losses, etc
EVILS OR REDUNDANT OR EXCESSIVE WORKING CAPITAL
Following are the dis-uses, evils and dangers or redundant working capital: 1. IDLE FUNDS excessive and redundant working capital implies the presence of idle funds which earn no profit for the firm. A firm with excessive working capital cannot earn proper rate of return on its total investments, as profits are distributed on the whole of its capital. This brings down the rate of return to the shareholders. Lower dividend reduces the market value of shares and causes capital losses to the shareholders.
2.
DECLINE IN OPERATING EFFICIENCY companies often adopt some objectionable devices to inflate profits to maintain or increase the rate of dividend. Sometimes, unearned dividends are paid out of companies capital to keep the show of prosperity by window dressing of accounts. In order to make up the deficiency of reduced earnings, certain provisions, such as provision for depreciation, repairs and renewals are not made. This lead to decline in operating efficiency and fall in profits.
3.
LOSS OF CONFIDENCE AND GOODWILL excessive working capital leads to lower rate of return on the companys total investments. Lower dividend leads to reduction of the market value of the companies shares much less than the book value. The shareholder loose confidence in the company and the goodwill or credit of the company suffers a serious set back. Thus the financial stability of the company is jeoparadised.
4.
MISAPPLICATION OF FUNDS companies with excessive working capital do not utilize the resources prudently. Excessive inventories and fixed assets are purchased by the company which do not add to its profitability and increase its maintenance cost and losses due to theft, waste and mishandling.
5. EVILS OF OVER CAPITALISATION excessive working capital leads to over capitalization which is disastrous to the smooth survival of the company and affects the interest of those associated with the company.
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INEFFICIENT MANAGEMENT excessive working capital indicates that the management is not interested in expanding the business, otherwise the excessive working capital might have been utilised for this purpose.
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DESTRUCTION OF TURNOVER RATIO redundant working capital destroys the control of turnover ratio, which is commonly used in a conduct of an efficient business. It eradicates all other guides and sign post commonly employed in conducting and operating a business. Thus a company must have working capital adequate to its requirements excessive nor inadequate. While inadequate working capital adversely affects the business operations and profitability, excessive working capital keeps idle and earns no profit. It has been rightly said, inadequate working capital is disasters; whereas redundant; working capital is a criminal waste.
WORKING CAPITAL MANAGEMENT
Working Capital is the money used to make goods and attract sales. The less Working Capital used to attract sales, the higher is likely to be the return on investment. Working Capital management is about the commercial and financial aspects of Inventory, credit, purchasing, marketing, and royalty and investment policy. The higher the profit margin, the lower is likely to be the level of Working Capital tied up in creating and selling titles. The faster that we create and sell the books the higher is likely to be the return on investment.
DEFINITIONS 1. Prof. K.V.Smith. Working capital management is concerned with problems that arise in attempting to manage the current assets, the current liabilities and the interrelationship that exist between them.
2.
Weston and Brigham. Working capital management refers to all aspects of the administration of both current assets and current liabilities.
3.
James C. van Horne. Current assets, by definition, are assets normally converted into cash within one year. Working capital management is concerned with the administration of these assets- namely cash and marketable securities, receivables and inventories.
OBJECTIVES 1. To decide upon the optimum level of investment in various current assets i.e. determining the size of working capital.
2.
By optimizing the investment in current assets and by reducing the level of current liabilities, the company can reduce the locking up of funds in working capital thereby, it can improve the return on capital employed in the business.
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To decide upon the optimum mix of short-term funds in relation to long-term capital.
4.
The company should always be in a position to meet its current obligations which should properly be supported by the current assets available with the firm. By maintaining excess funds in working capital means locking of funds without return.
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To locate appropriate sources of short term financing.
6.
Maintaining working capital at appropriate level.
7.
The firm should manage its current assets in such a way that marginal return on investment in current assets is not less than the cost of capital employed to finance the current assets.
8.
Availability of sufficient funds at the times of need.
IMPORTANCE OF WORKING CAPITAL
According to husband and dockery, the prime object of management is to make a profit, whether or not this is accomplished, as most business depend largely on the manner in which the working capital is administered. The primary objective of working capital management is to manage the firms current assets and current liabilities in such a way that a satisfactorily level of working capital is maintained. The firm may become insolvent if it cannot maintain a satisfactory level of working capital. Working capital assist in increasing the profitability of the concern. The working capital position decides the various policies in the business with receipt to general operations viz., importance of management of working capital.
Positive correlation between sale and current assets. There is a positive correlation between the sale of the product of the firm and its current assets. Increase in the sale of the product requires a corresponding increase in current assets. Therefore, the current assets must be managed properly.
Investment in current assets. Generally more than half of the total capital of the firm is invested in current assets. Thus less than half of the capital is blocked in fixed assets. Therefore management of working capital attracts the attention of the management.
No alternative for current assets. While fixed capital can be acquired on lease in emergency there is no alternative for current assets. Investment in current assets cannot be avoided without substantial loss. Financed through outside sources. Working capital needs are often financed through outside sources. Hence, it is necessary to utilize them in the best possible way.
Important for small units. The management of working capital is more important for small units because they do not rely on the long term capital market and have easy access to short term financial sources such as trade credit, short term bank loan etc.
FACTORS DETERMINING WORKING CAPITAL REQUIREMENT
1.
Nature of business. The amount of working capital is related to the nature of the business. In concerns, where the cost of the raw materials used in manufacture of a product is very large in production to its total cost of manufacture, the requirement of the working capital will be very large. For instance, a cotton or sugar mill requires a large amount of working capital on the contrary, concerns having large investments in fixed assets requires less amount of working capital. Public utility concerns such as railway or electricity services require a lesser amount of working capital as compared to trading or manufacturing concerns partly because of cash nature of their business and partly because they are selling a service instead of a commodity and there is no need of maintaining inventories.
2.
Size of business unit. The general principal in this regard is that the bigger the size of business the larger will be the amount of working capital required because the larger business units are required to maintain big inventories for the flow of the business and to spend more in carrying out the business operations smoothly.
3.
Seasonal variations. Strong seasonal variations create special problems of working capital in controlling the internal financial swings many companies such as sugar mills, oil mills or woolen mill etc. they require larger amount of working capital in the season to purchase the raw materials in large quantities and utilize them throughout the year they adjust their production schedule and maintain a steady rate of production during off season periods. Thus they require larger amount of working capital during season.
4.
Time consumed in manufacture. The average time taken in the process of manufacture as also an important factor in determining the amount of working capital the longer the period of manufacture, the larger the inventory required. Though capital goods industries managed to minimize their investment in inventories or working capital by asking advances from the customers as work proceeds in their orders.
5. Turnover of circulating capital. Turnover means the ratio of annual gross sales to average working assets. It means the speed with circulating capital completes its rounds or the number of times the amount invested in working assets has been converted into cash by sale of the finished goods and reinvested in working assets during a year. The faster the sales, the larger the turnover. Conversely, the greater the turnover, the larger the volume of business to be done with given working capital. It will require lesser amount of working capital inspite of larger sales because of greater turnover.
6.
Labour-intensive versus capital intensive industries. In labour intensive industries, larger working capital is required because of regular payment of heavy wage bills and more time taken in completing the manufacturing process. Conversely the capital intensive industries require lesser amount of working capital due to the heavy investment in fixed assets and shorter period in many acquiring processes.
7.
Need to stockpile Raw material and finished goods. The industries, where it is necessary to stockpile the raw materials and finished goods increased the amount of working capital is tide up in stocks and stores. In some lines of business where the materials are bulky and best purchased in large quantities such as cements, stockpiling of raw material is very usual and used. In companies where, labour strike is frequent such as public utilities concerns, stockpiling of raw material is advisable. In certain industries such as seasonal industries or retail stores finished goods stock have to be large in quantities which requires larger working capital.
8.
Terms of purchase and sales. Cash or credit terms of purchase and sales also affect the amount of working capital. If a company purchases all goods in cash and sales its finished products on credit, it will require large amount of working capital. On the contrary, a concern having credit facilities and allowing no credit to its customers will require less amount of working capital. Terms and conditions of purchase and sales are generally governed by prevailing trade practices and by changing economic conditions.
9. Conversion of current assets into cash. The need of having cash in hand to meet the day-to-day requirements e.g. Payment of wages and salaries, rents rate etc, has an important bearing in deciding the adequate amount of working capital. The greater the cash requirements, the higher will be the need of working capital. A company has ample stock of liquid current assets will require lesser amount of working capital because it can encash its assets immediately in the open market.
10. Growth and extension of business. Growing concerns require more working capital then those that are static. It is logical to expect larger amount of working capital in a going concern to meet its growing needs of funds for its expansional programs though it varies with economic conditions and corporate practices.
11. Business cycle fluctuations. Business cycle affects the requirement of working capital. At times, when the prices are going up and boom conditions prevail, the management seeks to pile up a big stock of raw materials to have an advantage of lower prices and to maintain a big stock of finished goods with an expectation to earn more profits by selling it at higher price in future. The expansion of business units caused by the inflationary conditions creates demand for more and more working capital. Depression involves the locking up of a big amount in the working capital as the inventories remain unsolved and the book debts uncollected. The contraction in the volume of business may result in increasing the cash position because of reduction in inventories and receivables that usually accompanies decline in sales and curtailment in capital expenditures. In such cases, shortage of working capital develops.
12. Profit margin and profit appropriation. Some firms enjoy a dominant position in the market due to quality product or good marketing management, or monopoly power in the market and therefore earn a high profit. It contributes towards working capital provided it is earned in cash. Cash profit can be found by adjusting non-cash item such as depreciation, outstanding expenses, accumulated loss and expenses written off etc, in the net profit. But in practice, the whole cash inflows are not considered as cash available for use as cash is used upto augment the other assets such as stock, book debts and fixed assets. In a growing concern, the working capital requirement will be estimated on how the cash available is used rightfully.
Even if the net profit is earned in cash, whole of it is not available for working capital purpose. The contribution towards working capital is effected by the way in which profits are appropriated and affected by taxation, dividend, deprecation and reserve policy.
13. Price level changes. The financial manager should anticipate the effect of price level changes on working capital requirements of the firm. Rising price levels will require a higher amount of working capital to maintain the same levels of current assets as it will require higher investments. However if companies revise their product prices, they will not face a severe working capital problem. Thus the effects of rising price levels will be different for different firms depending upon their price policies, nature of the product etc.
14. Dividend policies. There is a well-established relationship between dividend and working capital in companies where conservative dividend policy is followed. The changes in working capital position bring about an adjustment in dividend policy. In order to maintain an established dividend policy, the management gives due consideration to its effect on cash requirements. A storage of cash may induce the management to reduce cash dividend. Strong cash position may justify the cash dividend, even if earnings are not sufficient to cover the payment. Storage of cash is one of the reasons for the issue of stock dividends. On the other hand, if the management follow the policy of retention of profits in the business, the working capital position will be quite adequate, alternatively, if the whole of the profits are distributed among the shareholders, companies working capital position would suffer.
15. Close coordination between production and distribution policy. This will reduce the demand of working capital.
16. An absence of specialization in the distribution of products. This will require more working capital as such concern will have to maintain its own marketing organization.
17. If the means of transporting and communications are less developed. More working capital required in such areas to store the materials and finished goods.
18. The hazards and contingencies inherent in a particular type of business. These also decide the magnitude of working capital
WORKING CAPITAL FINANCING The main source of working capital financing, namely, trade credit, bank credit, RBI framework /regulation of bank credit/finance/advances, factoring and commercial papers.
TRADE CREDIT Features Trade credit refers to the credit extended by the supplier of goods and services in th normal course of transaction/business/sale of the firm. According to trade practices, cash is not paid immediately for purchase but after an agreed period of time. There is however, no formal/ specific negotiation for trade credit. It is an informal arrangement between the buyer and the seller. There is no legal instrument of acknowledgment of debt, which are granted on an open account basis.
ADVANTAGES Trade credit, as a source of short term as working capital finance has certain advantages. It is easily, almost automatically available. Moreover it is flexible and spontaneous source of finance. The availability and magnitude of trade credits related to the size of operations of the firm in terms of sales/purchases. If the credit purchases of goods decline, the availability of trade credit will correspondingly decline. Trade credit is also and informal, spontaneous source of finance. Not requiring negotiation and formal agreement, trade credit is free from the restriction associated with formal/negotiated source of finance/credit.
COST Trade credit does not involve any explicit interest charged. However there is an implicit cost of trade credit. It depends on credit terms offered by the supplier of goods. The small the difference between the payment day and the end of the discount period, the larger is the annual interest/cost of trade credit.
BANK CREDIT Bank credit is the primary institutional source of working capital finance in India, in fact, it represents the most important source of financing of current assets.
FORMS OF CREDIT Working capital finance is provided by banks in five ways: 1. Cash credit/overdrafts: under cash credits, the bank specifies a predetermined borrowing/ credit limit. The borrows can draw/borrow up to the stipulated credit/overdraft limit. Similarly repayments can be made whenever desired during the period. The interest is determined on the basis of the running balance/amount actually utilized by the borrower and not on the sanctioned limit.
2.
Loans: under the arrangement the entire amount of borrowing is credited to the current account of the borrower or the released in cash. The borrower has to pay interest on the total amount.
3.
Bills purchased/discounted: the amount made available under this arrangement s coverd by the cash credit and overdraft limit. Before discounting the bill, the bank satisfiesd itself about the credit-worthiness of the drawer and the genuineness of the bill. To popularize the scheme, the discounting banker asks the drawer of the bill (i.e. seller of goods) to have his bill accepted by the drawee (buyers) bank before discounting is latter grants acceptance against the cash credit limit, earlier fixed by it on the basis of the borrowing value of stocks therefore, the buyer who byes goods on credit cannot use the same goods as source of obtaining additional bank credit.
4.
Term loans for working capital: under this arrangement, banks advance loans for 3-7 years repayable in yearly or half yearly installments.
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Letter of credit: while the other forms of bank credit are direct forms of financing in which banks provide funds as well as bear risk, letter of credit is an indirect form of working capital financing and banks assume only the risk, the credit being provided by the supplier himself.
MODE OF SECURITY Banks provide credit on the basis of the following modes of security:
Hypothecation: Under this mode of security, the banks provide credit to borrowers against the security of movable property, usually inventory of goods.
Pledge: pledge, as mode of security is different from hypothecation in that in the former, unlike in the latter the goods which are offered as security are transferred to the physical possession of the lender.
Lien: the term lien refers to the right of the party to retain goods belonging to another party until a debt due to him is paid.
Mortgage: it is the transfer of the legal stock equitable interest in specific immovable property for securing the payment of debts.
Charge: where immovable property of one person is, by the act of parties or by the operation of law, made security for the payment of money to another and the transaxction does not amount to mortgage, the later person is paid to have a charge on the property and all the provisions of simple mortgage will apply to such a charge.
RESERVE BANK OF INDIA FRAMEWORK FOR/REGULATION OF BANK CREDIT Till the mid sixties, the notable features of bank financing of working capital of corporate industrial borrowers were (i) easy access/over-reliance, i.e. in excess of legitimate requirements and (ii) preponderance of cash credit arrangement/device through which this finance was provided. In order to secure alignment of bank credit with planning priorities and ensures equitable distribution to various sectors of the Indian economy, the RBI initiated several policy measures to direct bank credit to priority sectors and enforce a measures of financial discipline among industrial borrowers. However the basic characters of bank financing of industry namely, over borrowing ad domination of cash credit system did not materially alter.
To reorient bank lending to industry to the two emerging realities of the Indian economy in terms of the imperatives of regulating /controlling it, the RBI constitutes from time to time a number of expert groups to examin the various aspects of banking policy relating to industrial financing, the notable being Dehejia Committee (1969), Tandon Committee (1974), chor committee (1980) and marathe committee (1984). The recommendations of these groups shaped the framework/regulation of industrial financing by banks after the mid seventies. After the mid nineties the framework has been relaxed permitting banks greater flexibility in tune with the emergence of new banking in the country, focusing on viabilities and profitability in contrast with the earlier trust on social/ development banking. The main elements of the framework and the subsequent relaxations are discussed.
FIXATION OF NORMS A notable feature of the framework/regulation to the fixation of norms for bank lending to industry. The norms fell into two categories:
(i) Inventory and receivables norms the norms refer to the maximum level for holding inventories and receivables in each industry. Initially the inventory and receivables norms were applied in respect of 15 major industries accounting for about one-half of the industrial advances of the banks.
The norms pertained to (i) raw materials including stores and other items used in the process of manufacture; (ii) stock in process; (iii) finished goods; and (iv) receivables and bills purchased and discounted. The norms were based on time element.
(ii) Lending norms/approach to lending/maximum permissible bank finance (MPBF) the second categories of norms relate to lending. The lending norms are more basic element of the framework of bank lending to have far reaching implications.
According to the lending norms a part of the current assets should be financed by trade credit and other current liabilities. The remaining part of the current assets, termed, as working capital gap should be partly financed by owners funds and long-term borrowings and partly by short-term credit. There are three alternative methods for working out the maximum permissible level of bank borrowing/finance (MPBF), each successive method reducing the involvement of short-term bank credit to support current assets.
COMMERCIAL PAPERS Advantages A CP has several advantages for both the issuer and investors. It is a simple instrument and hardly involves any documentation. It is additionally flexible in terms of maturities which can be tailored to march the cash flow of the issuer. Companies which are able to raise funds through CPs have better financial standing. The CPs are unsecured and there are no limitations on the end use of funds raised to them.
Effective cost/interest yield As the CPs are issued at discount and redeemed at it face value, their effective pretax cost/interest yield = Face value in net amount realised Net amount realised = 360 maturity period
Where net amount realised = face value-discount-issuing and paying agent (IPA) charges, that is, stamp duty, rating charges, dealing bank fee and fee for stand by facility.
FACTORING Factoring provides resources to finance receivables as well as facilitates the collection of receivables. Although such services constitute a critical segment of the financial services scenario in the developed countries, they appeared in the Indian financial scene only in early nineties as a result of RBI initiatives. There are two bank sponsored organizations which provide such services: (i) SBI factors and commercial services ltd., and (ii) canbank factors. The first private sector factoring company, foremost factors ltd. Started operations since the beginning of 1997. DEFINITION AND MECHANISM Definition: definition factoring can broadly be defined as an agreement in which receivables arising out of sale of goods/services are sold by a firm (client) to the factors (a financial intermediary) as a result of which the
title of the goods/services represented by the said receivables passes on the factor. Hence forth, the factor becomes responsible for all credit control, sales accounting and debt collection from the buyers. Mechanism: credit sales generate the factoring business in the ordinary course of business dealing. Realisation of credit sales is the main function of factoring services. Once the sales transaction is completed, the factors steps into realize the sales. Thus the factor works between the seller and the buyer and sometimes with the sellers banks together. FUNCTION OF A FACTOR Depending on the type/form of factoring, the main functions of a factor, in general terms can be classified into 5 categories Financing facility/trade debts, Maintenance/administration of sales ledger, Collection facility/of accounts receivables, Assumptions of credit risk/credit control and credit restriction; and next provision of advisory services
COST OF SERVICES the factors provide various services at a charge. The charge for collection and sales ledger administration is in the form of a commission expressed as value of debt purchase. It is collected up-front/in advance. The commission for short term financing as advance part-payment is in the form of interest charged for the period between the date of advance payment and the date of collection guaranteed payment date. It is also known as discount charge.
MAKING MORE EFFECIENT USE OF WORKING CAPITAL The table below lists items, which influence Working Capital levels favourably and adversely Items that reduce Working Capital levels Items that increase Working Capital for publishers - Increased profit margins - Customers who pay promptly - Advance payments by customers levels for publishers - Lower profit margins - Long print runs except where all the books are required on publication e.g. School and university textbooks - Inventory which is sold and paid for quickly by customers after publication - Lower Inventory levels by reducing print quantities and working with printers who will deliver quickly and produce low print runs economically - Slow authors who deliver late and whose manuscripts require substantial editing - Holding paper stock unless market conditions demand and the savings are large - Slow schedules for the development of new titles - Successful promotion that speeds up the rate of sale - Making advance payments to printers - Seasonal sales except where the publishers prints only for the season - Licensing (but problematic in young economies) - Paying suppliers on completion with credit - Authors who deliver manuscripts on disk ready for computer make-up - Incentives to staff, authors, suppliers, customers, sales staff and agents to speed up the rate of sale and of developing new books, delivering manuscripts on schedule
ASSESSMENT OF WORKING CAPITAL REQUIREMENT IN SEASONAL INDUSTRY
In the seasonal industries the level of working capital requirement will not be similar all the year. In times of off-season, the working capital requirement and therefore, the level of investment in current assets and liabilities are very low. But, during season, the firm requirement of working capital is at peak level. Let us look at the sugar industry. The crushing season in the year will remain for 5 to 6 months time. During the season the plant is expected to work at full capacity with triple shift working and the requirement of stocks is very high and resultant increase in stock of sugar. The requirement for payment of labour, expenses and maintenance is also higher. There will not be immediate sales of sugar and finished stock inventory would be much higher. After the completion of the crushing season, the plant will be close and only upkeep and maintenance of plant will be incurred and the level of current assets and current liabilities comes down and the working capital requirement would be very low. For efficient management of working capital, the finance manager should be able to properly estimate the season and off-season requirements of working capital. For this the following precautions are taken: 1. Preparation of projected cash flow statement showing the cash flow for peak season, normal season and off-season requirements.
2.
Make proper arrangements with the banks and other sources of finance to meet the short-term need of season.
3.
Make proper arrangement for meeting the contingencies of higher-level requirement than the projected levels of requirement.
4.
Proper and careful assessment of working capital requirements for the season and off-season requirement.
5.
Care to be taken to reduce the level of investments in current assets after the season is completed.
METHODS OF ESTIMATING WORKING CAPITLA REQUIREMENTS
Operating cycle method:. Operating cycle is the period that a business enterprise takes in converting cash back into cash. It has the following four stages: (i) (ii) (iii) (iv) The raw material and stores inventory stage The semi finished goods or work in progress stage; The finished goods inventory stage; and The accounts receivable and book debit stage.
Each of the above stage is expressed in terms of number of days of relevant activity. Each requires a level of investment to support it. The sum of these stage wise investments will be total amount of working capital of the firm. The following formulae will be used to express the framework of the operating cycle: T = (S * C) + W + F + B Where T = stands for the total period of operating cycle in number of days; R = the number of days of raw material and stores consumption requirements held in raw materials and stores inventory; C = the number of days of purchases in trade creditors; W = the number of days of cost of production held in work in progress F = the number of days of cost of sales held in finished goods inventory and B = the number of days of sales in book debt
The computation may be made as under Average inventory of raw material and stores Average per day of consumption of raw material and stores Average trade creditors Average credit purchases per day Average work in progress Average cost of production per day Average inventory of finished goods Average cost of sales per day Average book debts Average sales per day
W =
The average inventory, trade creditors, work in progress, finished goods and book debts can be computed by adding the opening and closing balances at the end of the year in the respective accounts and dividing the concerned annual figures by 365 or the number of days in the given period. The operational cycle method of determining working capital requirements gives only an average figure. In this method the fluctuations in the intervening period due to seasonal or other factors and their impact ion the working capital requirements cannot be judged. Continuous short run detailed forecasting and budgeting exercises are necessary to identify these impacts. A new concept that is gaining more and more importance in recent years is the operating cycle concept of working capital. The operating cycle refers to the average time elapsed between the acquisition of raw materials and the final cash realization. Cash is used to buy the raw materials and other stores, so cash is converted into raw materials and stores inventories. Then the raw materials and stores are issued to the production department. Wages are paid and other expenses are incurred in the process and work in process comes into existence. Work in process becomes finished goods. Finished goods are sold to customers on credit. In the course of time, these customers pay cash for the goods purchased by them. Cash is retrieved and the cycle is completed. Thus operating cycle consists of four stages: The raw material and stores inventory stage The work in process stage The finished goods inventory stage
The receivable stage The operating cycle of working capital is shown below
CASH
PURCHASE OF RAW MATERIAL INVENTORY
ACCOUNTS RECEIVABLES WORK IN PROCESS
FINISHED GOODS
Percentage of sales method. It assumes that certain balance sheet items vary directly with sales. Thus the ratio of the given balance sheet item to sales remain constant. The firms need in terms of percentage of annual sales envisaged in each individual balance sheet items are expressed in the following three ways: (v) (vi) (vii) As number of days of sales; As turnover; and As percentage of sales
Regression analysis method.: This is very useful statistical technique of working capital forecasting which helps in making projection after establishing the average relationship in the past years between sales and working capital (current assets) and its various components. This analysis may be carried out through the graphic portrayals (scattered diagrams) or through mathematical formula. The relationship between the sales and the working capital of various components may be simple and direct indicating linearly between the two. It may be complex involving simpler linear regressions or simple curvilinear regression and multiple regression situations. This method is particularly suitable for long term forecasting
WORKING CAPITAL REPORT MEANING A prudent financial manager is always vigilant for avoiding the financial embarrassment likely to be caused to the concern due to the inadequacy of working capital. He takes utmost care so as to keep himself well informed of the working capital position, its present aspects and the future prospects. Working capital reports vary according to the nature of the requirements of the individual concern and circumstances, etc.
TYPES 1. Inventory report. It gives in detail a comparative analysis of the composition of closing stores of raw material and finished products. It may be prepared weekly, monthly or quarterly. It brings into light the fact whether working capital is unnecessarily blocked up in the inventory. Following is an example of monthly inventory report:
SI. No.
Item
Code no.
Max Stock Limit
Monthly inventory report Min . Order Opg. Bal Stock Size Limit
Received During the month
Issued during the month
Balance
2. Cash report. It reflects the net liquid position of the concern. It is prepared on daily basis. It shows the summary of daily cash receipts, cash disbursements and the cash balance. Following is the cash Performa of the cash report.
Particulars A. REVENUE X Y Z B. CAPITAL X Y Z TOTAL
Current a/c
Letter of credit a/c
Weekly cash report Fixed deposit Cash in chest a/c
Total
Previous week
3.
Receivables reports. These help in studying up efficiency of the collection policies and the desirability of credit policies. Detailed reports may be made to depict the reserve for bad and doughtful debts position. Some companies prepare ageing reports in respect of debtors and receivables. A Performa of receivables report is given below.
S.N.
Receivable report Monthly statement of sundry debtors Balance at the beginning Supplies made Realisation made during during the month Party More Six Less Bill Bills More More Belo than 1 months than six realised not than 1 than six w six year months realised year months mont hs
Back recoveries
Balance
RECEIVABLES MANAGEMENT The receivables represent an important component of the current assets of a firm. The purpose of the present chapteris to abnalysis the important diamentions of efficient management of receivables within the framework of a firms objectives of value maximization. The first section of this chapter discusses the objectives of receivables management. Ths is followed by n in debt analysis of the three crucial aspects of management of receivables.
OBJECTIVES The term receivables is defines as debt owed to the firm by customers arising from sale of goods or services in the ordinary course of business. When a firm makes an ordinary sales of goods or services and does not receive payment the firms grant credit and creates accounts receivables which could in the future. Receivables management is also called trade credit management thus, accounts receivables represents and extension of credit to customers, allowing them a reasonable period of time in which to pay for the goods received. The sale of goods on credit is an essential part of the modern competitive economic systems. Infact, credit sales and therefore, receivables, are treated as a marketing tool to aid the sale of goods. The objective of receivables management is to promote sales and profit until that point is reached where the return on investment in further funding receivables is less than the cost of funds raised to finance that additional credit (i.e.) cost of capital, Costs title I) Collection cost: collection costs are administrative cost incurred in collecting the receivables from the customers to whom credit sales have been made. II) Capital cost: the increased level; of accounts receivables is an investment in assets. They have to be financed thereby involving a cost. The cost on the use of additional capital; to support credit sales which alternatively profitably employed elsewhere, is, therefore, a part of the cost of extending credit or receivables. III) Delinquency cost: these cost arises out of the failure of the customers to meet their obligations when payment on credit sales become dew after the expiry of the credit period. Such cost are called the delinquency cost.
IV)
Default cost: finally the firm may not be able to recover the over dews because of the inability of the customers. Such that are treated as bad debts and have to be return off as they cannot be realized. Such cost are known as default cost associated with credit sales and accounts receivables.
BENEFITS The benefits are increased sales and anticipated profits because of a more liberal policy. When firms extend trade credit, that is, invest in receivables, they intend to increase the sales. The impact of the liberal trade credit policy is likely to take two forms. First it is oriented to sales expansion. In other words, a firm may grant trade credit policy is likely to take two forms. First it is oriented to sales expansion. In other words a firm may grant trade credit either to increase sales to existing customers. Secondly, the firm may extend credit to protect its current sales against emerging competition. Here the motive is sales retention. As a result of increased sales, the profit of the firm will increase.
CREDIT POLICIES The first decision area is credit policies. The credit policy of a firm provides the framework tom determine (a) whether or not to extend credit to a customer and (b0 how much credit to extend. The credit policy decision of firm has two broad diamentions; (I) credit standards and (II) credit analysis.
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The term credit standards represents the basic criteria for the extyention of credit to customers. The quantitative basis of establishing credit standards is factors such as credit ratings, credit references, average payments period and certain financial ratios. Since we are interested in illustrating the trade off between benefit and cost to the firm as a whole, we do not consider here this individual components credit standards. To illustrate the effect, we have divided the overall standards into(a) tight or restrictive, and (b) liberalal or non restrictive.i.e. to say, our aim to show what happens to the trade off when standards are relaxed or, alternatively, tightened. The trade off with reference to credit standars covers(I) the collection cost, (II) the aerage collection period/investm,ent in accounts receivables, (III) level of bad debts losses, and (iv) level of sales. These factors should be considered while deciding whether to rexed credit standards or not. If standards are relaxed it means more credit will be extended while if standards are tighned less creit will be extended. The implications of the four factors are elaborated below.
Collection cost: the implications of relaxed credit standards are (i) more credit, (ii) a large credit department to
service accounts receivables and related matters, (iii) increase in collection cost. The effect of tightening of credit standard will be exactly the opposite. These cost are likely to be semi variable.
WORKING CAPITAL IS A MEANS AND NOT END As a matter of policy, a company does not want to employ large funds in working capital so long as undue solvency risks are not imposed on it. Although no quantitative limit of working capital may be set for an individual firm yet adequate amount of working capital must be available to meet the needs of the company. It is a logical approach indicating that working capital is a means to an end and not an end in itself. The purpose (end) of every business is to run to operations smoothly so that the corporate objectives may be achieved. This requires adequate working capital. The corporate management has to consider the various factors in making decision regarding the qualitative amount of working capital.
WORKING CAPITAL RATIOS Working capital ratios indicate the ability of business concern in meeting its current obligations as well its efficiency in managing its current assets in generation of sales. These ratios are applied to evaluate efficiency with the firm manages and utilizes its current assets. The following three categories of ratios are used for efficient management of working capital: Efficiency ratios Liquidity ratios Structural health ratios
Efficiency ratios: working capital to sales ratios
SALES WORKING CAPITAL
This ratios is computed by dividing working capital by sales. This ratios helps to measure the efficiency of the utilization of networking capital. It signifies for an amount of sales a relative amount of working capital is needed. If any increase in sales is contemplated, working capital should be adequate and thus, this ratios management to maintain the adequate level of working capital.
INVENTORY TURNOVER RATIO
SALES INVENTORY
This ratio indicates the effectiveness and efficiency of the inventory management. The ratio shows how speedily the inventory is turned into accounts receivables through sales. The lower the inventory of sales ratio, the more efficiently the inventory is said to be managed visa versa
CURRENT ASSETS TURNOVER RATIO
SALES CURRENT ASSETS
This ratio indicated the efficiency with which current assets turn into sales. The lower current assets to sales ratio implies by enlarge a more efficient use of funds. Thus, a high turnover rate indicates reduced lock up of funds in current assets. An analysis of this ratio over a period of time reflects working capital management of a firm.
LIQUIDITY RATIOS CURRENT RATIOS = CURRENT ASSETS, LOANS, ADVANCES CURRENT LIABILITES AND PROVISIONS
This ratio indicates the extent of the soundness of the current financial position of an undertaking and the degree of safety provided to the creditors. The higher the current ratio the large amount of rupee available per rupee for current liability, the more the firms ability to meet current obligations and the greater safety of funds of short term creditors. Current assets are those assets which can be converted into cash within a year. Current liabilities and provisions are those liabilities that are payable within a year. A current ratio of 2:1 indicates a highly solvent position. Banks consider a current ratio of 1.3:1 as minimum acceptable level for proving working capital finance. The constituents of the current assets are as important as the current assets themselves for evaluation of companys solvency position.
QWICK RATIO = CURRENT ASSETS, LOADS AND ADVANCES INVENTORIES CURRENT LIABILITES AND PROVISIONS BANK OCERDRAFT
Quick ratio is a more refined tool to measure the liquidity of an organization. It is better taste of financial strength then the current ratio, because it excludes very slow moving inventories and the items of current assets which cannot be converted into cash easily. This ratio shows the extent of cushion of protection provided from the quick assets to the current creditors. A quick ratio of 1:1 is usually considered satisfactory though it is again a rule of thumb only.
STRUCTURAL HEALTH RATIO CURRENT ASSETS TO TOTAL NET ASSETS = NET ASSETS CURRENT ASSETS
This ratio explains the relationship between current assets and total investment in current assets. A business enterprise should use its current assets effectively and economically because it is out of the management of these assets that profits accrue. A business will end up in losses if there is any lacuna in managing assets to the advantage of business. Investment in fixed assets being in elastic in nature, there is no elbowroom to make a amends in this sphere and its impact on profitability remains minimal.
COMPOSITION OF CURRENT ASSETS An analysis of current assets component enables one to examine in which component the working capital funds are locked up. Large tie up of funds in inventories effects profitability of the business adversely owing to carry over costs. In addition losses are likely to occur by way of depreciation, decay, obsolescence, evaporation and so on. Receivables constituting another component of current assets. If the major portion of current assets are made up of cash alone, the profitability will be decreased because cash is a non-earning assets. If the portion of cash balance is excessive, then it can be said that management is not efficient to employee the surplus cash. DEBTORS TURNOVER RATIO = SALES DEBTORS
This ratio shows the extent of trade credit granted and the efficiency in the collection of debts thus, it is an indicative of efficiency of trade credit management. The lower the debtors to sales ratio, the better the trade credit management and better the quality (liquidity) of debtors. The lower debtors means prompt payment by customers. An excessively long collection period, on the another hand, indicates a very liberal, ineffective and inefficient credit and collection policy.
AVERAGE COLLECTION PERIOD (in days) = DEBTORS * 365
SALES Average collection period, which measures how long it takes to collect amounts from debtors. The actual collection period can be compared with the stated credit terms of the company. If it is longer than those terms, than this indicates some in sufficiency in the procedures for collecting debts.
BAD DEVTS TO SAES = BAD DEBTS SALES This ratios indicates efficiency of the control procedures of the company. The actual ration is compared with the target or norm to decide whether or not it is acceptable.
CREDITORS TURNOVER PERIOD (in days)= CREDITORS *365 PURCHASES The measurement of the creditor turnover period shows the average time taken to pay for goods and services by the company. In general the longer the credit period achieved the better, because delays in payment mean that the operation of the company are being financed interest free by suppliers funds. But there will be a point beyond which if they are operating in a sellers market, may harm the company. If too long a period is taken to pay creditors, the credit rating of the company may suffer, thereby making it more difficult to obtain supplier in the future.
WORKING CAPITAL LEVERAGE One of the important objectives of working capital management is by maintaining the optimum levels of investment sin current assets and by reducing the levels of current liabilities, the company an minimize the investment in working capital thereby improvement in return on capital employed is achieved. The term working capital leverage refers to the impact of level of working capital on companys profitability. The working capital management should improve the productivity of investments in current assets and ultimately it will increase the return on capital employed. Higher levels of investments in current assets than is actually required mean increase in the cost of interest charges on the short-term loans and working capital finance raised from banks etc. and will result
ion lower return on capital employed and vise versa. Working capital leverage measures the responsiveness of ROCE for changes in current assets. It is measured by applying the following formula.
Working capital leverage = C.A. T.A.- C.A. Where C.A. = current assets T.A. = total assets (net fixed assets + current assets) Change in current assets Impact of inflation on working capital requirement When the inflation rate is high, it will have its direct impact on the requirement of 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 sales. The higher the sale means the higher levels of balances in receivables.
Inflation will result in increase of raw material prices and hike in payment for expenses and as a result increase in balance s of trade creditors and creditors for expenses.
Increase in valuation of closing stocks result in showing 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 problems of funds shortage and firm may enable to meets its short term and long-term obligations.
Increase in investments is current assets means the increase in requirements 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 inflation in assessment of working capital requirements and its management.
IMPACT OF DOUBLE SHIFT WORKING ON WORKING CAPITAL REQUIREMENT
If the firm which is presently running in single shift, plans to go for working in double shift the following factors should be considered while assessing the working capital requirements of the firm.
Working in double shift means requirement of raw materials will be doubled and another variable expenses will also increase drastically.
With the increase in raw materials requirement and expenses, the raw material inventory and work in
Progress will increase simultaneously the creditors for goods and creditors for expenses balances will also increase.
Increase in production to meet the increased demand which ill also increase the stock of finished goods. The increase in sales means increase in debtors balances.
Increase in production will result in increased requirement of working capital.
The fixed expenses will increase with the working on double shift bases.
The finance manager should reassess the working capital requirements if the change is contemplated from single shift operation to double shift.
ZERO WORKING CAPITAL This is one of the latest trends in working capital management. The idea is to have zero working capital. For e.g. at all times the current assets shall equal the current liabilities. Excess investment in current assets is avoided and firm meets its current liabilities out of the matching current assets. As current ratio is 1 and the quick ratio below 1, there may e apprehensions about the liquidity, but if all current assets are performing and are accounted at their realizable values, these fears are misplaced. The firm saves opportunity cost on excess investments in current assets and as bank cash credit limits are linked to the inventory levels, interest cost is also sold. There would be a self imposed financial discipline on the firm to manage their activities within their current liabilities an current assets and there may not be attendancy to over borrow or divert funds. Zero working capital also ensure a smooth and uninterrupted working capital cycle, and it would pressure the finance manager to improve the quality of current assets at all times, to keep them 100 % realizable. There would also be constant displacements in the current liabilities and the possibility of having overdue may diminish. The tendency to postpone current liability payments has to be curbed and working capital always maintained at zero. Zero working capital would call for a fine balancing act in financial management, and the success in this endeavor would get reflected in healthier bottom lines.
OVERTRADING Overtrading arises when a business expands beyond the level of funds available overtrade means and attempt to finance a certain volume of production and sales with inadequate working capital. If the company does
not have enough funds of its own to finance stock and debtors it is forced, if it wishes it expand, to borrow from creditors and from the bank on overdraft sooner or later such expansion, financed completely by the funds of others, will lead to a chronic imbalance in the working capital ratio. Expansion is advantageous so long as the business has the funds available to finance the stocks and debtors involved. Overtrading begins at the point where the business relies on extra trade credit and increased turnover are financed by taking longer periods of credit from suppliers and/or negotiating an extension of overdraft limits wit the bank. Over dependence on outside finance is a sign of weakness, unless the expansion is curtailed, suppliers may refuse credit beyond certain limits, and the bank may call for a reduction of the overdraft. If this happens, the business may be insolvent in that it does not have sufficient liquid resources (cash) to pay for current operations or to repay current liabilities until customers pay for sales made on credit terms, or unless stock is sold at a loss for immediate cash payment. The following ratios will analysis the situation properly: Working capital = current assets: current liabilities Acid test = quick assets: current liabilities Stock turnover = stock: cost of sales Debtors turnover = debtors: credit purchases The object of using these ratios is to detect a deterioration of the liquidity position of the business end an increasing reliance upon trade creditors and overdraft facilities
OVERCAPITALISATION OF WORKING CAPITAL If there are excessive stocks, debtors and cash and very few creditors, there will be an over investment in current assets. The inefficiency in managing working capital will cause this excessive working capital resulting in lower return on capital employed and long term funds will be unnecessarily tied up when they could be invested as well to earn profit.
SYMPTOMS OF POOR WORKING CAPITAL MANAGEMENT. In general, the following causes are seen inefficient management of working capital: Excessive carriage of inventory over the normal levels required for the business will result in more balance in trade creditors accounts. More creditors balances will cause strain on the management in management of cash. Working capital problems will arise when there is a show down in collection of debtors. Sometimes capital gods will be purchased from the funds available for working capital. This will result in storage of working capital and its impact is on operations of the company. Unplanned production schedules will cause excessive stocks of finished gods or failure in meeting dispatch schedules. More funds kept in the form of cash will not generate any profit for the business. In efficiency in using potential trade credit require more funds for financing working capital. Overtrading will cause shortage of working capital and its ultimate effect is on the operations of the company. Dependence in short term sources of finance for financing permanent working capital causes lesser profitability and will increase strain on the management in managing working capital.
Inefficiency in cash management cause embezzlement of cash.
Inability to get working capital limits will cause serious concern to the company and sometime may turnout to be sick.
UNDER CAPITALIZATION Undercapitalisation is a situation where a company does not have funds sufficient to run its normal operations smoothly. This may happen due to insufficient working capital or diversion of working capital funds to finance capital items. If the company faces the situation of undercapitalisation, it will face difficulties in current obligations, procurement of raw material in stores items, meeting day-to-day running expenses etc. its impact will ultimately be the reduced turnover and reduced profitability. The finance manager should take immediate and proper steps to overcome the situation of unde15r capitalization by making arrangement for the sufficient working capital. For this purpose he should prepare the realistic cash flow and funds flow statement of the company.
STRATEGIES IN WORKING CAPITAL MANAGEMENT So for the banks where the sole source of funds for working capital needs of business sector. At present more finance options are available to finance manager to see the operations of his firm go smoothly. Depending on the risk exposure of business, to strategies are evolved to manage the working capital.
Conservative working capital strategy- a conservative strategy suggests to carry high levels of current assets in relation to sales. Surplus current assets unable the firm to absorb sudden variations in sales, production plans, and procurement time without destructing production plans. Additionally, the higher liquidity levels reduce the risk of insolvency. But lower risk translates into lower return. Large investments in current assets lead to higher interest and carrying cost and encouragement for efficient. But conservative policy will unable the firm to absorb day-to-day business risk. It assures continuous flow of operations and illuminates worry about recurring obligations. Under thi9s strategy, long term financing covers more then the total requirement for capital. The excess cash is invested in short-term marketable securities and in need, these securities are sold off in the market to meet the urgent requirements of working capital.
Rs
Secular growth
LONG TERM FINANCING
SEASONAL VARIATION
Investment in marketable securities
Time CONSERVATION OF WORKING CAPITAL STRATEGY
Aggressive working capital strategy- under this approach current assets are maintained just to meet the current liabilities without keeping and cushion for the variations in working capital needs. The core working capital is financed by long-term sources of capital, and seasonal variations are met through short-term borrowing. Adoption of this strategy will minimize the investment in net working capital and ultimately it lowers the cost of financing working capital. The main drawback of this strategy is that it necessitates frequent financing and also increases as the firm is vulnerable to sudden shocks.
Seasonal variation Rs Short term Financing
Long term Financing Secular growth
Tim AGGRESSIVE WORKING CAPITAL STRATEGY A conservative current asset financing strategy would go for more long-term finance which reduces the risk of uncertainty associated with frequent re financing. The price of this strategy is higher financing cost since longterm rates will normally exceeds short-term rates. But when aggressive strategy is adopted, some time the firm runs
into mismatches and defaults. It is a cardinal principal of corporate finance that long-term sources and short-term assets should finance long terms asset by a mix of long and short-term sources. Efficient working capital management techquines are those that compressed operating cycle. The length of the operating cycle is equal to the sum of the length of the inventory period and the receivables period. Just in time inventory management techniques reduce carrying cost by slashing the time that goods are parked and as inventories. To shorten the receivables period without necessarily reducing the credit period, corporate can offer trade discounts for prompt payment. COMPANYS ANALYSIS
HINDUSTAN LEVER LIMITED
STATEMENT OF WORKING CAPITAL 2002 2001 CURRENT ASSETS Inventories 127873.62 124003.62 Sundry debtors 36785.04 42478.47 Cash and bank balances 94262.60 91315.69 Other current assets 4630.22 5061.56 Loans and advances 79555.40 79818.70 TOTAL C A 343106.88 342678.04 CURRENT LIABILITES Liabilities Provisions TOTAL C L NET WORKING CAPITAL ASSUMPTIONS (hll) INVENTORIES 2002 3239.26 55629.08 6458.53 4593.68 584.76 56003.09 1365.22 127873.62 2001 2880.87 51014.06 5816.50 4771.85 1087.20 57711.56 721.58 124003.62
(246534.09) (120555.34) (367089.43) (23982.55)
(241041.86) (109140.42) (350182.28) (7504.24)
Stores and spare parts etc Raw materials Packing material Work in progress Processed chemicals Finished goods Property development activity Total SUNDRY DEBTORS
2002
2001
Considered good Over 6 months old Others Considered doubtful Over 6 months old Others Less: provision doubtful debt Total 768.12 36016.92 2799.35 876.08 (3675.43) 36785.04 781.74 41696.73 3663.75 149.31 (3813.06) 42478.47
CASH AND BANK BALANCES 2002 2001 Cash on hand 132.08 141.39 With schedule banks-on 25169.96 22221.47 current accounts On deposit 68952.37 68944.64 accounts Non schedule banks 8.19 8.19 On current accounts Total 94262.60 91315.69 Nepal grindlays bank limited (maximum amount outstanding during the year Rs. 8.19 lakhs; 2001 Rs. 8.19 lakhs) OTHER CURRENT ASSETS 2002 3947.43 184.00 498.79 4630.22 2001 3975.23 600.00 486.33 5061.56
Income accrued on investment Dividends receivables Fixed assets for sale Total
LOANS AND ADVANCES 2002 To subsidiaries Considered good Considered doubtful Less: provision doubtful adv. Adv. recoverable in cash/kind Considered doubtful Less: provision doubtful adv. Receivables from PEGSL Deposit with customs, port trust, excise etc. Taxation Total 12330.36 300.00 (300.00) 57932.99 4948.49 (4948.49) 1680.00 7555.29 56.76 79555.40 2001 7484.54 300.00 (300.00) 67760.70 5676.16 (5657.16) ----------4573.46 ----------79818.70
LIABILITIES 2002 32453.35 4207.56 202992.11 1139.60 2627.96 2857.26 ---------256.25 246534.09 2001 20342.65 5585.30 208790.17 708.96 2982.34 2352.57 16.22 263.65 241041.86
Acceptances Sundry creditors Small scale industry undertakings Others Advances &progress payments Security advances Dividends declared Interim dividend Interest accrued but not due Total
COLGATE PALMOLIVE (INDIA) INDIA STATEMENT OF WORKING CAPITAL 2002-03 2001-02 CURRENT ASSETS Inventories 5331.98 7312.13 Sundry debtors 4104.85 7299.84 Cash and bank balances 9847.95 9876.34 Interest accrued on investment 450.17 196.32 Loans and advances 15281.96 10866.51 TOTAL C A 35016.91 35551.14 CURRENT LIABILITES Liabilities Provisions TOTAL C L NET WORKING CAPITAL
(24727.05) (7337.27) (32064.32) 2952.59
(24713.66) (5151.25) (29864.91) 5686.23
ASSUMPTIONS (Colgate) INVENTORIES: inventories of raw and packing materials, work in progress and finished goods are valued at lower of cost and net realizable value. Cost of work in progress and finished goods includes materials, labour and manufacturing overheads. Cost is determined using standard cost method that approximates actual cost. The company accrues for customs duty liability In respect of stock of raw material lying in bound and excise duty liability in respect of stocks of finished goods lying in bound and warehouses. Inventories include:
INVENTORIES Stores and spares Raw and packing material Work in progress Finished goods Total
2002-03 187.79 1017.70 329.73 3796.76 5331.98
2001-02 251.84 1085.24 314.30 5660.75 7312.13
SUNDRY DEBTORS
SUNDRY DEBTORS Unsecured: considered good Over six months Others Total CASH AND BANK BALANCES CASH AND BANK Cash on hand Bal. With schedule bank Current accounts Deposit accounts Unpaid dividend accounts Total 2002-03 73.82 4031.03 4104.85 2001-02 203.83 7096.01 7299.84
2002-03 4386.70 5053.17 408.02001-028 9847.95
2001-02 11.37 5140.07 2878.93 1845.97 9876.34
LOANS AND ADVANCES As the year end the companyA) Has no loans and advances in the nature of loans to subsidiary and associates. B) Has no loans and advances in the nature of loans, wherein there is no repayment schedule or repayment is beyond seven years. C) Has no loans and advances in the nature of loans to firms/companies in which directors are interested. Secured: Loans to employees [include amounts due from an officer of the company Rs. 30.97 lacs (previous year: Rs.32.15 lacs) maximum amounts due during the year: Rs. 32.15lacs (Previous year: Rs. 33.42 lacs)] Unsecured: considered good Interest free loan to Camelot Investments Company limited, wholly owned subsidiary (maximum amount due during the year Rs 360.00 lacs (previous year: Rs. 606.33) Inter corporate deposits Advances recoverable in cash or in kind or for value to be received [Include amount due from a wholly owned subsidiary: Rs.215.89 lacs (Previous year: Rs.645.97 lacs)] Balances with excise authorities Deposit others Unsecured considered doubtful Loan to Camelot Investments Company limited wholly owed subsidiary [Maximum amount due during the year Rs. 540.00 lacs (Previous year: Rs. 540.00 lacs)] Less: provision Total
251.82
197.94
--------12167.00 916.80
360.00 6576.00 1791.18
21.99 1924.35
114.56 1826.83
----------
540.00
----------15281.96
540.00 10866.51
LIABILITIES ACCEPTANCES Sundry creditors 2002-03 2079.87 2001-02 111.70
Incl. Amt due to subsidiary Previous year (Rs. 1.77 lacs) Other liabilities Unclaimed dividends Total 21481.84 757.26 408.08 24727.05 21679.18 1076.81 1845.97 24713.66
Creditors To the best of the knowledge as per the information available with the management: (a) Sundry creditors include amounts due to small scale industrial undertakings 742.58 1591.18 (b) There are no dues to small scale undertakings outstanding for more than 30 days
PROVISIONS Taxation (adv tax payments) Second interim dividend Dividend tax on 2nd div. Leave encashment Other contingency Total 2002-03 3062.18 2719.86 348.48 591.03 615.72 7337.27 2001-02 1903.31 2379.87 ---------605.18 262.89 5151.25
Leave encashment The company provides for employees retirement benefits (comprising payments to gratuity fund, provident fund, superannuation fund) and leave encashment entitlements, in accordance with the policies of the company. Annual contributions to the provident and super annuation funds are charged to the profit and loss account as incurred. Liabilities in respect of gratuity and leave encashment are provided on the bases of independent actuarial valuation.
SUMMARY Working capital to a company is like the blood of human body. It is the most vital ingredient of a business. Working capital management if carried out effectively, efficiently and consistently, will assure the health of an organization. Every enterprise has to arrange for adequate funds for meeting day-to-day expenditure apart from investments in fixed assets. Working capital is the flow of ready funds necessary working of the enterprise. It consists of funds invested in current assets or those assets which in the ordinary course of business can be turned into cash within a brief period without undergoing diminution in value and without disruption of the organization. Current liabilities are those intended to be paid in the ordinary course of business within a short time. The need for working capital (gross) or current assets arise from the operating or cash cycle of the firm. The operating cycle refers to the length of time to convert the non-cash current assets into cash. Working capital can be divided into permanent or temporary, depending on the need of the firm. Working capital requirements are determined by a variety of factors. A) Prerequisite of efficient working capital management is its correct computation. Typically, working capital requirements/current assets are financed by a combination of long terms and short-term sources. The important traditional short-term sources of current assets of financing are trade credit and bank credit. Two newly emerging sources of working capital finance are factoring and commercial papers.
DECLARATION
I,
OF M.L.DAHANUKAR COLLEGE
T.Y.B.M.S. (SEM 5) HEREBY DECLARE THAT I HAVE COMPLETED THIS PROJECT ON WORKING CAPITAL MANAGEMENT IN THE ACEDEMIC YEAR 2003. THE INFORMATION SUBMITTED IS TRUE AND ORIGINAL TO THE BEST OF MY KNOWLEDGE.
SIGNATURE OF STUDENT
CERTIFICATE
I,
HEREBY CERTIFY THAT
OF M.L.DAHANUKAR COLLEGE OF T.Y.B.M.S. (SEM 5) HAS COMPLETED PROJECT ON WORKING CAPITAL MANAGEMENT IN THE ACEDEMIC YEAR 2003. THE INFORMATION SUBMITTED IS TRUE AND ORIGINAL TO THE BEST OF MY KNOWLEDGE
SIGNATURE OF PRODUCT CO ORDINATOR
SIGNATURE OF PRINCIPAL OF THE COLLEGE/INSTITUTION
ACKNOWLEDGEMENT
I sincerely thank all the contributors for imparting their valuable experience and guiding me to take this project complete in all respect and in time I hereby thank prof. MOSSES for his guidance and Mrs. SUMI of HLL to give me the required information on working capital management
PREFACE
Working capital is very vital part of production process, as it requires more than 50% of capital employed in the business. Adequate capital helps the entrepreneur in acquiring fixed assets like machinery, plant, equipment, buildings and other physical facilities. Besides capital is needed to meet the day-to-day requirements of the enterprise. In simple language, capital is bifurcated into fixed and working capital and these two are the two sides of the same coin. From the functional point of view, capital of the company is like that of blood of human body without which human body gets perished. Working capital is that portion of total capital which is highly necessary to manage the whole gamut of day to day running expenses to avoid technical insolvency of a firm. Working capital is the excess of current assets over current liabilities. It is sometimes called net working capital or net current assets. That means te working capital is also called as current assets management

Working Capital Management

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Working Capital Management

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Uploaded by Saurabh for http://www.linny.

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To pay wages and salaries

To meet selling and distribution expenses, advertising, packing etc.

CIRCULATION OF CURRENT ASSETS

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EVILS OF INADEQUATE WORKING CAPITAL

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EVILS OR REDUNDANT OR EXCESSIVE WORKING CAPITAL

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To locate appropriate sources of short term financing.

Maintaining working capital at appropriate level.

Availability of sufficient funds at the times of need.

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ASSESSMENT OF WORKING CAPITAL REQUIREMENT IN SEASONAL INDUSTRY

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METHODS OF ESTIMATING WORKING CAPITLA REQUIREMENTS

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PURCHASE OF RAW MATERIAL INVENTORY

ACCOUNTS RECEIVABLES WORK IN PROCESS

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Max Stock Limit

Received During the month

Issued during the month

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Particulars A. REVENUE X Y Z B. CAPITAL X Y Z TOTAL

Letter of credit a/c

Weekly cash report Fixed deposit Cash in chest a/c

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Efficiency ratios: working capital to sales ratios

SALES WORKING CAPITAL

INVENTORY TURNOVER RATIO

CURRENT ASSETS TURNOVER RATIO

SALES CURRENT ASSETS

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