WORKING CAPITAL MANAGEMENT INTRODUCTION Effective financial management is the-outcome, among other things, of proper management of investment of funds

in business. Funds can be invested for permanent or long-term purposes such as acquisition of fixed assets, diversification and expansion of business, renovation or modernization of plants and machinery, and research and development. Funds are also needed for short-tem purposes, that is, for current operations of the business. For example, if you are managing a manufacturing unit you will have to arrange for procurement of raw material, payment of wages to your workmen and for meeting routine expenses. All the goods which are manufactured in a given time period may not be sold in that period. Hence, some goods remain in stock, e.g. raw material, semi-finished (manufacturing-in-process) goods and finished marketable goods. Funds are thus blocked in different types of inventory. Again, the whole of the stock of finished goods may not be sold against ready cash; some of it may be sold on - credit. The credit sales also involve blocking of funds with debtors till cash is received or the bills are cleared. Working Capital refers to a firms investment in short-term assets: viz. cash, short-term securities, amount receivables (debtors) and inventories of raw materials, workin-process and finished goods. It can also be regarded as that portion of the firms total capital which is employed in short-term operations. It refers to all aspects of current assets and current liabilities. In simple words, we can say that working capital is the investment needed for carrying out day to day operations of the business smoothly. The management of working capital is no less important than the management of lone-term financial investment. SIGNIFICANCE OF WORKING CAPITAL You will hardly find a running business firm which does not require some amount of working capital. Even a fully equipped manufacturing firm is sure to collapse without (a) an adequate supply of raw materials to process, (b) cash to meet the wage bill, (c) the capacity to wait for the market for its finished products, and (d) the ability to grant credit to its customers. Similarly, a commercial enterprise is virtually good for nothing without merchandise to sell. Working capital, thus, is the life-blood of a business. As a matter of

fact, any organization, whether profit-oriented or otherwise, will not be able to carry on day to day activities without adequate working capital. OPERATING CYCLE The time between purchase of inventory items (raw material or merchandise) and their conversion into cash is known as operating cycle or working capital cycle. The successive events which are typically involved in an operating cycle are depicted in Figure I. A perusal of the operating cycle would reveal that the funds invested in operations are recycled back into cash. The cycle, of course, takes some time to complete. The longer the period of this conversion the longer is the operating cycle. A standard operating cycle may be for any time period but does not generally exceed a financial year. Obviously, the shorter the operating cycle, the larger will be the turnover of funds invested for various purposes. The channels of the investment are called current assets. Sometimes the available funds may be in excess of the needs for investment in these assets, e.g. inventory, receivables and minimum essential cash balance. Any surplus may be invested in government securities rather than being retained as idle cash balance.

CONCEPTS AND NEEDS OF WORKING CAPITAL There are two concepts of working capital, namely Gross and Net concept. Gross Working Capital According to this concept, working capital refers to the firms investment in current assets; The amount of current liabilities is not deducted from the total of current assets. This concept views Working Capital and aggregate of Current Assets as two inter-changeable terms. This concept is also referred to as Current Capital or Circulating Capital. The proponents of the gross working capital concept advocate this for the following reasons: i) Profits are earned with the help of assets which are partly fixed and partly current. To a certain degree, similarity can be observed in fixed and current assets so far as both are partly financed by borrowed funds, and are expected to yield earnings over and above the interest costs. Logic then demands that the aggregate of current assets should be taken to mean the working capital. ii) Management is more concerned with the total current assets as they constitute the total funds available for operating purposes than with the sources from which the funds come. iii) An increase in the overall investment in the enterprise also brings about an increase in the working capital. Net Working Capital The net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors dues, bills payable, bank overdraft and outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise when current assets exceed current liabilities. A negative net working capital occurs when current liabilities are in excess of current assets. Whenever working capital is mentioned it brings to mind current assets and current liabilities with a general understanding that working capital is the difference between the two.

Net working capital is a qualitative concept which indicates the liquidity position of the firm and the extent to which working capital needs may be financed by permanent sources of funds. This needs some explanation. Current assets should be sufficiently in excess of current liabilities to constitute a margin or buffer for obligations maturing within the ordinary operating cycle of a business. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe. Excessive liquidity is also bad. It may be due to mismanagement of current assets. Therefore, prompt and timely action should be taken by management to improve and correct the imbalance in the liquidity position of the firm. The net working capital concept also covers the question of a judicious mix of longterm and short-term funds for financing current assets. Every firm has a minimum amount of net working capital which is permanent. Therefore, this portion of the working capital should be financed with permanent sources of funds such as owners capital, debentures, long-term debt, preference capital and retained earnings. Management must decide the extent to which current assets should be financed with equity capital and/or borrowed capital. Several economists uphold the net working capital concept. In support of their stand, they state that: In the long run what matters is the surplus of current assets over current liabilities. It is this concept which helps creditors and investors to judge the financial soundness of the enterprise. It is the excess of current assets over current liabilities which can be relied upon to meet contingencies since this amount is not liable to be returned. It helps to ascertain the correct comparative financial position of companies having the same amount of current assets. It may be stated that gross and net concepts of working capital are two important facets of working capital management. Both the concepts have operational significance for the management and therefore neither can be ignored. While the net concept of working capital emphasizes the qualitative aspect, the gross concept. underscores the quantitative.

KINDS OF WORKING CAPITAL Ordinarily, working capital is classified into two categories: Fixed, Regular or Permanent Working Capital; and Variable, Fluctuating, Seasonal, Temporary or Special Working Capital.

Fixed Working Capital The need for current assets is associated with the operating cycle which, as you know, is a continuous process. As such, the need for current assets is felt constantly. The magnitude of investment in current assets however may not always be the same. The need for investment in current assets may increase or decrease over a period of time according to the level of production. Nevertheless, there is always a certain minimum level of current assets which is essential for the firm to carry on its business irrespective of the level of operations. This is the irreducible minimum amount necessary for maintaining the circulation of the current assets. This minimum level of investment in current assets is permanently locked up in business and is therefore referred to as permanent or fixed or regular working capital. It is permanent in the same way as investment in the firms fixed assets is. Fluctuating Working Capital Depending upon the changes in production and sales, the need for working capital, over and above the permanent working capital, will fluctuate. The need for working capital may also vary on account of seasonal changes or abnormal or unanticipated conditions. For example, a rise in the price level may lead to an increase in the amount of funds invested in stock of raw materials as well as finished goods. Additional doses of working capital may be required to face cut-throat competition in the market or other contingencies like strikes and lock-outs. Any special advertising campaigns organized for increasing sales or other promotional activities may have to be financed by additional working capital. The extra working capital needed to support the changing business activities is called the fluctuating (variable, seasonal, temporary or special) working capital. Figures II and III give an idea about fixed and fluctuating working capital. Figure II: Fixed working capital remaining constant over time

It is shown in Figure II that fixed working capital is stable overtime, while variable Management of Working capital is fluctuatingsometimes increasing and sometimes decreasing. The permanent working capital line, however, may not always be horizontal. For a growing firm, permanent working capital may also keep on increasing over time as has been shown in Figure III. Both these kinds of working capitalpermanent and temporaryare required to facilitate production and sales through the operating cycle, but temporary working capital is arranged by the firm to meet liquidity requirements that are expected to be temporary. COMPONENTS OF WORKING CAPITAL You have already noted that working capital has two components: Current assets and Current liabilities. Current assets comprise several items. The typical items are: i) Cash to meet expenses as and when they occur. ii) Accounts Receivables or sundry trade debtors. iii) Inventory of:

a) Raw materials, stores, supplies and spares, b) Work-in-process, and c) Finished goods. iv)Advance payments towards expenses or purchases, and other short-term advances which are recoverable. v) Temporary investment of surplus funds which could be converted into cash whenever needed. Apart of the need for funds to finance the current assets may be met from supply of goods on credit, and deferment, on account of custom, usage or arrangement, of payment for expenses. The remaining part of the need for working capital may be met from shortterm borrowing from financiers like banks. These items arc collectively called current liabilities. Typical items of current liabilities are: i) Goods purchased on credit I ii) Expenses incurred in the course of the business of the organization (e.g. wages or salaries, rent, electricity bills, interest etc.) which are not yet paid for. iii) Temporary or short-term borrowings from banks, financial institutions or other parties. iv) Advances received from parties against goods to be sold or delivered, or as short-term deposits. v) Other current liabilities such as tax and dividends payable. IMPORTANCE OF WORKING CAPITAL MANAGEMENT Because of its close relationship with day to day operations of a business, a study of working capital and its management is of major importance to internal, as well as external analysts. It is being increasingly realized that inadequacy or mismanagement of working capital is the leading cause of business failures. We must not lose sight of the fact that management of working capital is an integral part of the overall financial management and, ultimately, of the overall corporate management. Working capital management thus throws a challenge and should be a welcome opportunity for a financial manager who is ready to play a pivotal role in his organization. Neglect of management of working capital may result in technical insolvency and even liquidation of a business unit. With receivables and inventories tending to grow and with 7

increasing demand for bank credit in the wake of strict regulation of credit in India by the Central Bank, managers need to develop a long-term perspective for managing working capital. Inefficient working capital management may cause either inadequate or excessive working capital which is dangerous. A firm may have to face the following adverse consequences from inadequate working capital: 1 Growth may be stunted. It may become difficult for the firm to undertake profitable projects due to non-availability of funds. 2 Implementation of operating plans may become difficult and consequently the firms profit goals may not be achieved. 3 Operating inefficiencies may creep in due to difficulties in meeting even day to day commitments. 4 Fixed assets may not be efficiently utilized due to lack of working funds, thus lowering the rate of return on investments in the process. 5 Attractive credit opportunities may have to be lost due to paucity of working capital. 6 The firm loses its reputation when it is not in a position to honour its short-term. obligations. As a result, the firm is likely to face tight credit terms. On the other hand, excessive working capital may pose the following dangers: 1 Excess of working capital may result in unnecessary accumulation of inventories, increasing the chances of inventory mishandling, waste, and theft. 2 It may provide an undue incentive for adopting too liberal a credit policy and slackening of collection of receivables, causing a higher incidence of bad debts. This has an adverse effect on profits. 3 Excessive working capital may make management complacent, leading eventually to managerial inefficiency. 4 It may encourage the tendency to accumulate inventories for making speculative profits, causing a liberal dividend policy which becomes difficult to maintain when the firm is unable to make speculative profits.

An enlightened management, therefore, should maintain the right amount of working capital on a continuous basis. Financial and statistical techniques can be helpful in predicting the quantum of working capital needed at different points of time. DETERMINANTS OF WORKING CAPITAL NEEDS There are no set rules or formulas to determine the working capital requirements of a firm. The corporate management has to consider a number of factors to determine the Level of working capital. The amount of working capital that a firm would need is affected not only by the factors associated when the firm itself but is also affected by economic, monetary and general business environment. Among the various factors the following are important ones. Nature and Size of Business The working capital needs of a firm are basically influenced by the nature of its business. Trading and financial firms generally have a low investment in fixed assets, but require a large investment in working capital. Retail stores, for example, must carry large stocks of a variety of merchandise to satisfy the varied demand of their customers. Some manufacturing businesses like tobacco, and construction firms also have to invest substantially in working capital but only a nominal amount in fixed assets. In contrast, public utilities have a limited need for working capital and have to invest abundantly in fixed assets. Their working capital requirements are nominal because they have cash sales only and they supply services, not products. Thus, the amount of funds tied up with debtors or in stocks is either nil or very small. The working capital needs of most of the manufacturing concerns fall between the two extreme requirements of trading firms and public utilities. The size of business also has an important impact on its working capital needs. Size may be measured in terms of the scale of operations. A firm with larger scale of operations will need more working capital than a small firm. The hazards and contingencies inherent in a particular type of business also have an influence in deciding the magnitude of working capital in terms of keeping liquid resources. Manufacturing Cycle The manufacturing cycle starts with the purchase of raw materials and is completed with the production of finished goods. If the manufacturing cycle involves a longer period

the need for working capital will be more, because an extended manufacturing time span means a larger tie-up of funds in inventories. Any delay at any stage of manufacturing process will result in accumulation of work-in-process and will enhance the requirement of working capital. You may have observed that firms making heavy machinery or other such products, involving long manufacturing cycle, attempt to minimise their investment in inventories (and thereby in working capital) by seeking advance or periodic payments from customers. Business Fluctuations Seasonal and cyclical fluctuations in demand for a product affect the working capital requirement considerably, especially temporary working capital requirements of the firm. An upward swing in the economy leads to increased sales, resulting in an increase in the firms investment in inventory and receivables or book debts. On the other hand, a decline in the economy may register a fall in sales and, consequently, a fall in the levels of stocks and book debts. Seasonal fluctuations may also create production problems. Increase in production level may be expensive during peak periods. A firm may follow a policy of steady production in all seasons to utilize its resources to the fullest extent. This will mean accumulation of inventories in off-season and their quick disposal in peak season. Therefore, financial arrangements for seasonal working capital requirement should be made in advance. The financial plan should be flexible enough to take care of any seasonal fluctuations: Production Policy If a firm follows steady production policy, even when the demand is seasonal, inventory will accumulate during off-season periods and there will be higher inventory costs and risks. If the costs and risks of maintaining a constant production schedule are high, the firm may adopt the policy of varying its production schedule in accordance with the changes in demand. Firms whose physical facilities can be utilized for manufacturing a variety of products can have the advantage of diversified activities. Such firms manufacture their main products during the season and other products during off-season. Thus, production policies may differ from firm to firm, depending upon the circumstances. Accordingly, the need for working capital will also vary.

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Turn-over of Circulating Capital The speed with which the operating cycle completes its round (i.e. cash materials cycle) Credit Terms The credit policy of the firm affects the size of working capital by influencing the level of book debts. Though the credit terms granted to customers, in a large measure depend upon the norms and practices of the industry or trade to which the fun belongs, yet it may endeavour to shape its credit policy within such constrains. A long collection period will generally mean tying of larger funds in book debts. Slave collection procedures may even increase the chances of bad debts. The working capital requirements of a firm are also affected by credit terms ranted by its creditors. A firm enjoying liberal credit terms will need less working capital. Growth and Expansion Activities As a company grows, logically, larger amount of working capital will be needed. Though it is difficult to state any firm rules regarding the relationship between growth in the volume of a firms business and its working capital needs. The fact to recognize is that the need for increased working capital funds may precede the growth ii business activities, rather than following it. The shift in composition of working capital in a company may be observed with changes in economic circumstances and corporate crate practices. Growing industries require more working capital than those that r static. Operating Efficiency Operating efficiency means optimum utilization of resources. The firm can minimise its need for working capital by efficiently controlling its operating costs. With increased operating efficiency the use of working capital is improved and pace of cash cycle is accelerated. Better utilization of resources improves profitability and helps in relieving the pressure on working capital. Price Level Changes Generally, rising price level requires a higher investment in working capital. Increasing prices at the same levels of current assets need enhanced investment .However, firms which 11 finished product accounts receivables raw cash) plays a

decisive role in influencing the working capital needs. (Refer to Figure 1 on operating

can immediately revise prices of their products upwards may not face a severe working capital problem in periods of rising price levels. The effects of increasing price level may, however, be felt differently by different firms are to variations in individual prices. It is possible that some companies may not be affected by the rising prices, whereas others may be badly hit by it. Other Factors There are some other factors which affect the determination of the need for working capital. A high net profit margin contributes towards the working capital. The net profit is a source of working capital to the extent it has been earned in cast. The cash inflow can be calculated by adjusting non-cash items such as depreciation. outstanding expenses, losses written off, etc. from the net profit. The firms appropriation policy, that is, the policy to retain or distribute profit use has a bearing on working capital. Payment of dividend consumes cash recourse and thus reduces the firms working capital to that extent. If the profits are retain in the business, the firms working capital position will be strengthened. In general, working capital needs also depend upon the means of transport and communication. If they are not well developed, the industries will have to keep huge stocks of raw materials, spares, finished goods, etc. at places of production. as well as at distribution outlets. APPROACHES TO MANAGING WORKING CAPITAL Two approaches are generally followed for the management of working capital (i) the conventional approach, and (ii) the operating cycle approach. The Conventional Approach This approach implies managing the individual components of working capital (ii) the inventory, receivables, payables, etc.) efficiently and economically so that there are neither idle funds nor paucity of funds. Techniques have been evolved for the Management of each of these components. In India, more emphasis is given to the Management of debtors because they generally constitute the largest share of the investment in working capital. On the other hand, inventory control has not yet been practiced on a wide scale perhaps due to scarcity of goods (or commodities) and ever rising prices.

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The Operating Cycle Approach This approach views working capital as a function of the volume of operating expenses. Under this approach the working capital is determined by the duration of the operating cycle and the operating expenses needed for completing the cycle. The duration of the operating cycle is the number of days involved in the various stages, commencing with acquisition of raw materials to the realization of proceeds from debtors. The credit period allowed by creditors will have to be set off in the process. The optimum level of working capital will be the requirement of operating expenses for an operating cycle, calculated on the basis of operating expenses required for a year. In India, most of the organisations used to follow the conventional approach earlier, but now the practice is shifting in favour of the operating cycle approach. The banks - usually apply this approach while granting credit facilities to their clients. ISSUES AND ESTIMATION OF WORKING CAPITAL The factors discussed in the preceding section influence the quantum of working capital in a business enterprise. How to determine or measure the amount of working capital that an enterprise would need was discussed to some extent in Unit 6 dealing with funds flow analysis. Let us attempt to determine the amount of working capital needed by taking up an illustration. Illustration I Determine the magnitude of working capital (with the help of the following particulars) for Gujarat Tricycles Limited, a newly set up enterprise: a) The proforma cost sheet shows that the various elements of cost bear the under mentioned relationship to the selling price: Materials, parts and components Labour Overhead b) Production in 19X8 is estimated to be 6,000 tricycles. c) Raw material, parts and components are expected to remain in the stores for an average period of one month before issue to production. 40% 30% 10%

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d) Finished goods are likely to stay in the warehouse for two months on an average before being sold and delivered to customers. e) Each unit of production will be in-process for half a month on an average: f) Half of the sales are likely to be on credit. The debtors will be allowed two months credit from the date of sale. g) Credit period allowed by suppliers of raw material, parts and components is one month. h) The lag of payment to labour is one month.50% of the overhead consists of salaries of non-production staff. i) Selling price will be Rs 200 per tricycle j) Assume that sales and production follow a consistent pattern. k) Allow 20% to your computed figure for buffer cash and contingencies. Before we attempt to calculate the working capital, it will be helpful to work out the following basic data: a) The yearly production is 6,000 tricycles. Hence, monthly production will be 500 tricycles. b) The selling price per tricycle is Rs. 200. The various elements of cost (i.e. raw material, parts and components, labour and overheads) comprise 80% (40% +30%+ 10%) of the selling price. Hence, cost of production is Rs. 160 i.e. (200x
80 ). 100

Gujarat Tricycles Limited Statement of working capital requirements Current Assets: Stock of raw material, parts and components (l Month) Stock of finished goods (2 Months) 500x160x2 1,60 (in thousand Rs.) 40

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Work -in- Process (1/2 Month) 5X160X11/2 Debtors (50% of sales) (2 months credit) 500x1/2x160x Less current liabilities Creditors (one month) Wages and Salaries: Wages Salaries (Overheads) 5 30 75 2,45 Add 20% for buffer cash and contingencies Average working capital required The various figures have been worked out as follows: Cost of raw material etc. Monthly production cost of material etc. per unit Period for which stock required 1 month Hence amount locked up 500x80x1 Cost of finished goods Monthly Production 500 Units Rs.40,000 Rs80 500 Units 49 49 2,94 40 80 3,20 40

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Cost of production per unit Period for which stock required Hence amount locked up Work-in-Process Stock Monthly Production Cost of production per unit Period for which stock required Hence amount locked up 500x 1601/2 Debtors Sales per month Proportion of credit sales Cost of production per unit Period of credit Hence amount locked up 500x1/2160x2 Creditors Management of Monthly production Cost of production per unit Cost of raw material etc. being one half Period (or which credit available Hence, Working Capital unlocked 500x80x1

Rs160- (80+60+20)

2 months 500x 160x2 Rs.1,60,000

500 Units Rs. 160

1/2

Month

Rs. 40,000

500 Units

50 per cent Rs 160 2 months Rs.80.000

500 Units Rs. 160

Rs. 80 1 month

Rs.40,000

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Wages and Salaries I) Wages Monthly production . Labour cost per unit Lag period for payment I month Hence, Working Capital unlocked 500x60x1 II) Salaries Monthly Production Portion of Salaries in overheads Overhead cost per unit Lag period for payment Hence, working capital unlocked 500x20x1/2x1 Rs.5,000 500 Units
1/2

500 Units Rs. 60

Rs.30,000

Rs. 20 1 Month

WORKING CAPITAL MANAGEMENT UNDER INFLATION It is desirable to check the increasing demand for capital for maintaining the existing level of activity. Such a control acquires even more significance in times of inflation. In order to control working capital needs in periods of inflation, the following measures may be applied. Greater disciplines on all segments of the production front may be attempted as under: a) The possibility of using substitute raw materials without affecting quality must be explored in all seriousness. Research activities in this regard may be undertaken, with financial assistance provided by the Government and the corporate sector, if any. b) Attempts must be made to increase the productivity of the work force by proper motivational strategies. Bore going in for any incentive scheme, the cost involved must be weighed against the benefit to be derived. Though wages in accounting are considered a variable cost, they have tended to become partly fixed in nature due to the influence of various legislative measures adopted by the Central or State Governments in recent times.

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Increased productivity results in an increase in value added and this has the effect of reducing labour cost per unit. The managed costs should be properly scrutinized in terms of their costs and benefits. Such costs include office decorating expenses, advertising, managerial salaries and payments, etc. Managed costs are more or less fixed costs and once committed they are difficult to retreat. In order to minimise the cost impact of such items, the maximum possible use of facilities already created must be ensured. Further the management should be vigilant in sanctioning any new expenditure belonging to this cost area The increasing pressure to augment working capital will, to some extent, be neutralized if the span of the operating cycle can be i-educed. Greater turnover with shorter intervals and quicker realization of debtors will go a long way in easing the situation. Only when there is a pressure on working capital does the management become conscious of the existence of slow-moving and obsolete stock. The management tends to adopt ad hoc measures which are grossly inadequate. .Therefore, a clear cut policy regarding the disposal of slow-moving and obsolete stocks must be formulated and adhered to. In addition to this, there should be an efficient management information system reflecting the stock position from various standpoints. The payment to creditors in time leads to building up of good reputation and consequently it increases the bargaining power of the firm regarding period of credit for payment and other conditions. Projections of cash flows should be made to see that cash inflows and outflows match with each other. If they do not, either some payments have to be postponed or purchase of some avoidable items has to be deferred. EFFICIENCY CRITERIA Improved profitability of a firm, to a great extent, depends on its efficiency in managing working capital. A single criterion would not be sufficient to judge or evaluate the efficiency in a dynamic area like working capital. Some of the parameters for judging the efficiency in managing working capital are: a) Whether there is enough assurance for the creditors about the ability of the company to meet its short-term commitments on time. Hence, a reliable index is whether a company can settle the bills on due dates. The finance department has to plan in advance to maintain sufficient liquidity to meet maturing liabilities.

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b) Whether maximum possible inventory turnover is achieved. The adverse effect of ineffective inventory management may not be offset even by the most efficient management of other components of working capital. c) Whether reasonable credit is extended to customers. This powerful instrument to promote sales should not be misused. The other side of the same coin is receiving credit. Both depend upon a companys strength as a seller and as a buyer. d) Whether adequate credit is obtained from suppliers. It depends upon the companys position in relation to its suppliers and the nature of supply market i.e. whether there is a single supplier or an oligarchy or a large number of suppliers. With coordination of efforts buyers can be in a position to negotiate competitive credit terms even if there is a single supplier and his ability to control the market. At times the supplier imposes the credit terms as 100% advance i.e. negative trade credit. e) Whether there are adequate safeguards to ensure that neither overtrading nor - under trading takes place. The following indices can be used for measuring the efficiency in managing working capital: Current Ratio (CR) CR = Current Assets / Current Liabilities It indicates the ability of a company to manage the current affairs of business. It is useful to study the trend of working capital over a period of time. Though the current ratio of 2:1 is considered ideal, this may have to be modified depending on the peculiar conditions prevailing in a particular trade or industry. It is not only the quantum of current ratio that is important but also its quality. i.e. extent to which assets and liabilities are really current. Quick Ratio (QR) QR=Liquid Assets/Current Liabilities Liquid assets mean current assets minus those which are not quickly realisable. Inventory and sticky debts are generally treated as non-quick assets.

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The relationship of 1:1 between quick assets and current liabilities is considered ideal, but, like current ratio, it also varies from industry to industry, depending on the peculiar conditions of a particular industry. Cash to Current Assets If cash alone is a major item of current assets then it may be a good indicator of the profitability of the organisation as cash by itself does not earn any profit, the proportion should usually be kept low. Sales to Cash Ratio Sales to Cash Ratio=Sales/Average cash balance during the period. Cash should turned over as many times as possible, in order achieve maximum sales with minimum cash on hand. Average Collection Period (Debtors/Credit Sales) X 365 This ratio explains how many days of credit a company is allowing to its customers to settle their bills. Average Payment Period Average payment period=(Creditors/Credit purchases) x 365 It indicates how many days of credit is being enjoyed by the company from its suppliers. Inventory Turnover Ratio (ITR) ITR=Sales/Average Inventory It shows how many times inventory has turned over to achieve the sales. Inventory should be maintained at a level which balances production facilities and sales needs. Working Capital to Sales Usually expressed in terms of percentage, it signifies that for any amount of sales a relative amount of working capital is needed. If any increase in sales is contemplated it has to be seen that working capital is adequate. Therefore, this ratio helps management in maintaining working capital which is adequate for the planned growth in sales.

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Working Capital to Net Worth Working Capital/Net worth This ratio shows the relationship between working capital and the funds belonging to the owners. When this ratio is not carefully watched, it may lead to: a) Overtrading when the conditions are in the upswing. Its symptoms being (I) High Inventory Turnover Ratio (ii) Low Current Ratio; or b) Undertrading when the conditions of market are not good. Its major symptoms are: i) Low Inventory Turnover Ratio ii) High Current Ratio. Efficient working capital management should, therefore, avoid both overtrading and undertrading.

3.12 QUESTIONS FOR UNDERSTANDING 1 Discuss the concept of working capital. Are the gross and net concepts of working capital exclusive? Explain. 2 Distinguish between fixed and fluctuating working capitals. What is the significance of such distinction in financing working needs of an enterprise? 3 Discuss the significance of working capital management in a business enterprise. What shall be the repercussions if a firm has (a) shortage of working capital and (b) excess working capital? 4 A firm desires to finance its current assets entirely with short-term loans. Do you think this pattern of financing would be in the interest of the firm? Support your answer with cogent argument. 5 What factors a financial manager would ordinarily take into consideration while estimating working capital needs of his firm? 6 What is an operating cycle and how a close study of the operating cycle is helpful?

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7 How would you as a Finance Manager control the need of increased working capital on account of inflationary pressures? Narrate some real-life examples you might have come across. 8 How would you judge the efficiency of the management of working capital in a business enterprise? Explain with the help of hypothetical data. 3.13 SUMMARY An enterprise needs funds to operate profitably. The working capital of a business reflects the short-term uses of funds. Apart from the investment in the long-term assets such as buildings, plant and equipment, funds are also needed for meeting day to day operating expenses and for amounts held in current assets. Within the time span of one year there is a continuing cycle or turnover of these assets. Cash is used to acquire stock which on being sold results in an inflow of cash, either immediately or after a time lag in case the sales are on credit. The rate of turnover of current assets in relation to total sales of a given time period is of critical importance to the total funds employed in those assets. The amount needed to be invested in current assets is affected by many factors and may fluctuate over a period of time. Manufacturing cycle, production policies, credit terms, growth and expansion needs, and inventory turnover are some of the important factors influencing the determination of working capital. Inflation magnifies the need for working capital. The constant rise in the cost of inputs, if not accompanied with corresponding increase in output prices, puts an additional strain on the management. However, by taking several measures on production front and by keeping a strict watch on managed costs and expediting collection of credit sales, etc. the management can contain or atleast minimise the upward thrusts for additional working capital. The management should ensure the adequacy and efficiency in the utilisation of working capital. For this purpose various ratios can be periodically computed and compared against the norms established in this regard. 3.14 EXERCISES 1. Assam Timber Ltd., a newly founded company, has applied for a short-term loan to a commercial bank for financing its working capital requirement. You are requested by the bank to prepare a statement on the requirement for working capita) for that company. You

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may add 10% to your estimated figure to cover for unforeseen contingencies. The projected profit and loss account of the company is as under Sales Cost of goods sold Gross Profit Additional expenses Selling expenses Profit before tax Provision for tax Profit after tax Cost of goods sold has been derived as follows: Material sold Wages & manufacturing expenses Depreciation 9,60,000 7,40,000 3,60,000 20,00,000 Less Stock of finished goods estimated at 10% of production 2,00,000 18,00,000 1,80,000 1,50,000 3,30,000 3,70,000 1,20,000 2,50,000 25,00.000 18,00,000 7,00,000

The figures above relate to the goods that would be finished (or completed) and not to work in process. Goods equal of 20% of the years production in terms of physical units are expected to be in progress on an average, requiring full materials but only 50 per cent of other expenses. The company intends to keep two months consumption of material in stock. All the expenses will be paid one month in arrears. Suppliers of material would extend one month credit. Sixty per cent of the sales are estimated on cash basis while the rest are on two months credit. Seventy per cent of the income tax has to be paid in advance in quarterly instalments. The company will require Rs. 50,000 cash to meet day-to-day needs

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of business. For the purpose of the question you may ignore profit as a source of working capital. Answer to the problems Exercise 9 TOTAL INVESTMENT IN CURRENT ASSETS i) Less current liabilities: 89,167 Lag in payment of expenses Creditors Add 10% for contingencies 80,000 1,69,167 6,00,833 60,083 Total working capital required 6,60,916 7,70,000

ii) Depreciation is not a cash expense and hence it has been excluded from cost of goods sold for the purpose of determining investment in debtors. Similarly, depreciation has not been taken into account in determining investment in work-in-process and stock of finished goods. iii) For the purpose of determining investment in work-in-process, advertising and selling expenses are not relevant. Hence, they have not to be taken into account. iv) For the purpose of this question profit is to be ignored as a source of working capital. As such income tax has also been disregarded since income tax is paid out of profit.. 3.15 REFERENCES Van Home, James C., 1985. Fundamentals of Financial Management, Prentice-Hall of India: New Delhi. Kulkarni, P.V., 1985. Financial Management, Himalaya Publishing: Bombay. Kuchhal, S.C., 1985. Financial Management, Chaitanya Publishing: Allahabad. SOURCESS OF WORKING CAPITAL SOURCES OF WORKING CAPITAL

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Sources of working capital are many. There are both external or internal sources. The external sources are both short-term and long-term. Trade credit, commercial banks, finance companies, indigenous bankers, public deposits, advances from customers, accrual accounts, loans and advances from directors and group companies etc. are external shortterm sources. Companies can also issue debentures and invite public deposits for working capital which re external long term sources. Equity funds may also be used for working capital. A brief discussion of each source is attempted below. Trade credit is a short term credit facility extended by suppliers of raw materials and other suppliers. It is a common source. It is an important source. Either open account credit or acceptance credit may be adopted. In the former as per business custom credit is extended to the buyer, the buyer is not goring any debt instrument as such. The invoice is the basic document. In the credit system a bill of exchange is drawn on the buyer who accepts and returns the same. The bill of exchange evidences the debt. Trade credit is an informal and readily available credit facility. It is unsecured. It is flexible too; that is advance retirement or extension of credit period can be negotiated. Trade credit might be costlier as the supplier may inflate the price to account for the loss of interest for delayed payment. Commercial banks are the next important source of working capital finance commercial banking system in the country is broad based and fairly developed. Straight loans, cash credits, hypothecation loans, pledge loans, overdrafts and bill purchase and discounting are the principal forms of working capital finance provided by commercial banks. Straight loans are given with or without security. A one time lump-sum payment is made, while repayments may be periodical or one time. Cash credit is an arrangement by which the customers (business concerns) are given borrowing facility upto certain limit, the limit being subjected to examination and revision year after year. Interest is charged on actual borrowings, though a commitment charge for utilization may be charged. Hypothecation advance is granted on the hypothecation of stock or other asset. It is a secured loan. The borrower can deal with the goods. Pledge loans are made against physical deposit of security in the banks custody. Here the borrower cannot deal with the goods until the loan is settled. Overdraft facility is given to current account holding customers tn overdraw the account upto certain limit. It is a very common form of extending working capital assistance. Bill financing by purchasing or discounting bills of exchange is another common form of financing. Here, the seller of goods on credit draws a bill on the buyer and

25

the latter accepts the same. The bill is discounted per cash will the banker. This is a popular form. Finance companies abound in the country. About 50000 companies exist at present. They provide services almost similar to banks, though not they are banks. They provide need based loans and sometimes arrange loans from others for customers. Interest rate is higher. But timely assistance may be obtained. Indigenous bankers also abound and provide financial assistance. to small business and trades. They change exorbitant rates of interest by very much understanding. Public deposits are unsecured deposits raised by businesses for periods exceeding a year but not more than 3 years by manufacturing concerns and not more than S years by non-banking finance companies. The RB! is regulating deposit taking by these companies in order to protect the depositors. Quantity restriction is placed at 25% of paid up capital + free services for deposits solicited from public is prescribed for non-banking manufacturing concerns. The rate of interest ceiling is also fixed. This form of working capital financing is resorted to by well established companies. Advances from customers are normally demanded by producers of costly goods at the time of accepting orders for supply of goods. Contractors might also demand advance from customers. Where sellers market prevail advances from customers may be insisted. In certain cases to ensure performance of contract in advance may be insisted. Accrual accounts are simply outstanding suppliers of overhead service requirements and the like taxes due, dividend provision, etc. Loans from directors, loans from group companies etc. constitute another source of working capital. Cash rich companies lend to liquidity crunch companies of the group. Commercial papers are usance promissory notes negotiable by endorsement and delivery. Since 1990 CPs came to be introduced. There are restrictive conditions as to issue of commercial paper& CPs are privately placed after RBIs approval with any firm, incorporated or not, any bank or financial institution. Big and sound companies generally float CPs. Debentures and equity fund can be issued to finance working capital so that the permanent working capital can be matchingly financed through long term funds. 3.6 TANDON COMMITTEE RECOMMENDATIONS

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Tandon committee was appointed by RBI in July 1974 under the chairpersonship of Shri. P.L. Tandon who was the Chairman of PNB then. he terms of references of the committee were: i. To suggest guidelines for commercial banks to follow up and supervise credit from the point of view of ensuring proper use of funds and keeping a watch on the safety of advances. ii. To suggest the type of operational data and other information that may be obtained by banks periodically from the borrowers and by the Reserve bank from the lending banks. iii. To make suggestions for prescribing inventory norms for different industries both in the private and public sectors and indicate the broad criteria for deviating from these norms. iv. To suggest criteria regarding satisfactory capital structure and sound financial basis in relation to borrowing. v. To make recommendations regarding resources for financing the minimum working capital requirements. vi. To suggest whether the existing pattern of financing working capital requirements by cash credit / overdraft requires to be modified, if so, vii. Suggest suitable modification. Findings of the committee: The committee studied the existing system of extending working capital finance to industry and identified following as its major weaknesses: i. It is the borrower who decides how much he would borrow. The banker cannot do any credit planning since he does not decide how much he would lend. ii. ii) Bank credit, instead of being taken as a supplementary to other source finance, is treated as the first source of finance. iii. iii) Bank credit is extended on the account of security available and not according to the level of operations of the borrower, iv. iv) There is a wrong notion that security by itself ensures the safety of bank funds. As a matter of fact, safety essentially lies in efficient follow-up of the industrial operations of the borrower. 27

Commitment Recommendations: The report submitted by the Tandon committee introduced major changes in financing of working capital by commercial banks in India. The report was submitted on 9th August 1975. Fixation of norms. An important feature of the Tandon Committees recommendations relate of fixation of norms for bank tending to industry.

Working capital gap i. In order to reduce the dependence of businesses on banks fo; working capital, ceiling on bank credit to individual firms has been prescribed. Accordingly, businesses have to compute the current assets requirement on the basis of stipulations as to size. So, flabby inventory, speculative inventory cannot be carried on with bank finance. Normal current liabilities, other than bank finance, are also worked out considering industry and geographical features and factors. Working capital gap is the excess of current assets as per stipulations over normal current liabilities (other than bank assistance). Bank assistance for working capital shall be based on the working capital gap, instead of the current assets need of a business. This type of financing assistance by banks was introduced on the basis of recommendations of Tandon Committee. ii. Inventory and Receivables norms: The committee has suggested norms rot 15 major industries. The norms proposed represent the maximum level for holding ventures and receivables. They pertain to the following: i. Raw materials including stores and other items used in the process of manufacture

ii) Stock in process iii) Finished goods iv) Receivables and bills discounted and purchased. Raw materials are expressed so many months cost of production. Stock in process is expressed as so many months cost of production. Finished goods and receivables are expressed as so many months cost of sales and sales respectively. 28

iii) Lending norms: The lending norms have been suggested in view of the realization that the bankers role as a lender is only to supplement the borrowers resources. The committee has suggested three alternative methods for working out the maximum permissible level of bank borrowings. Each successive method reduces the involvement of short-term credit to finance the current assets, and increases the use of long term funds. The first method provided for a maximum 75% of bank funding of the working capital gap. That is, at least 25% of working capital gap must be financed through long term fluids. The second method provided for full bank financing of working capital gap based on 75% of current assets only. That is, 25% of current assets should be financed through long term hind. 25% of current assets is greater than 25% of working capital gap. Hence 2 method meant more non-bank finance for working capital. The third method provided for long-term fund financing of whole permanent current asset and 25% of varying current assets. That is bank financing will be limited to working capital gap computed taking 75% of varying current assets only. The three methods are discussed below to show permitted bank funding of working capital:

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Today, Tandon committee recommendations are not relevant. Now banks are flushed with fluids. But good borrowers arent many. Tandon committee recommendations were relevant when controlled economy prepared. Today, it open economy. Besides, these recommendations were relevant in these years when money market was tight and capital rationing was needed. Today, the whole environment has changed. Now banks want to

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provide long-term loans well. Actually from April 15, 1997, all instructions relating to maximum permissible bank finance (MPBF) were with drawn. 3.7 CHORE COMMITFEE RECOMMENDATIONS Following the Tandon Committee the Chore Committee under the Chairmanship of Shri. C.B. Chore, of RBI, was constituted in April 1979. The terms of reference were: I. to review the working of cash credit system II. to study the gap between sanctioned and utilized cash credit levels III. to suggest measures to ensure better credit discipline IV. to suggest measures to enable banks to relate credit limits with output levels. The recommendations of the committee were: I. To continue the present system of working capital financing, viz., credit, bill finance and loan II. If possible supplement cash credit system by bill and loan financing III. To periodically review cash credit levels IV. No need to bifurcate cash credit accounts into demand loan and cash credit components. V. To fix peak level and non-peak level limits of bank assistance wherever, seasonal factors significantly affect level of business activity. VI. Borrowers to indicate before commencement requirement of bank credit within peak and sanctioned. A variation of 10% is to be tolerated. VII. Excess or under utilization beyond 10% tolerance level is to be considered as irregularity and corrective actions b3 taken up. VIII. Quarterly statement of budget and performance be submitted by all borrowers having Rs.50 lakh working capital limit from the whole of banking system. IX. To discourage borrowers depending on ad hoc assistances over and above sanctioned levels.

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X. The second method of financing of working capital as suggested by the Tandon committee be uniformly adopted by banks. XI. To treat as working capital term loan the excess of bank funding when the switch over to the second method bank financing is adopted and the borrower is not able to repay the excess loan. MARATHE COMMTTEE RECOMMENDATIONS Later Marathe Committee was appointed to suggest meaningful credit Management function of the RBI. The recommendations are: I. the second method of financing Tandon committee should be followed II. fast-track system of advance releasing upto 50% of additional credit required by borrowers pending RBIs approval of such enhanced credit authorization III. the bank should ensure the reasonableness of projections as to sales, current assets, current liability, net working capital by looking into past performance and assumptions of the future trend IV. the current assets and liabilities to be classified in conformity with the guidelines issued by the RBI. For instance current liability should include any liability that needs to be retired within 12 months from the date of previous balance sheet V. a minimum of 1.33 current ratio should be maintained. That is, 25% current assets should be financed from long term funds VI. a quarterly information system (QISO giving details as to project level of current assets and current liabilities be evolved such that the information is given to the banker in the week preceding commencement of the quarter to which the data are related, adopted VII. a quarterly performance reporting system giving data on performance within 6 weeks following the end of the quarter to which the data an related be adopted VIII. a half yearly operating and fund flow statement to be submitted with 2 months from the close of the half-year IX. the banker should review the borrowers accounts at least once a year

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3.9 VAZ COMMITTEE RECOMMENDATIONS As per VAZ committee recommendations working requirement is taken as 25% of annual turnover, and the borrower has to 5% of projected turnover from long-term sources as his contribution and 20% of projected turnover will be provided by the financing bank. thus bank finance for working capital is totally de-linked from current assets level. Hence the total departure from Tandon and Chore committee recommendations. Since 15-4-1997, banks were instructed to evolve their own method such of turnover method, the cash budget system or any other system including erstwhile working capital gap system, for assessing the working capital needs of businesses. 3.10 QUESTIONS 1. Define working capital and describe its components 2. Bring out the kinds and concepts of working capital and the nature and significance each type of working capital 3. What do you mean by working capital management? What approaches would you adopt to ensure effectiveness? 4. Discuss clearly the factors affecting the size and composition of working capital. 5. Explain how would you plan the working capital requirements of a manufacturing undertaking. 6. What is operating cycle? Explain its significance in the context of estimation of working capital and ensuring efficient management of working capital. 7. 8. Explain the different sources of working capital finance. Discuss the terms of reference and recommendations of the Tandon Committee. Give the impact on financing of working capital. 9. What are the recommendations of Chore Committee? Explain them.

10. The cost structure for a firm is: Raw materials Rs.10 per unit; labour Rs.8 per unit; overhead Rs.l0 per unit; profit Rs.7 per unit. Credit allowed by creditors is 2 months and allowed to debtors is 3 months. Time lag in payment of expenses 1 month. Production and consumption are equal and even. For an equal production of 1,80,000 units prepare working capital budget. Cash balance required is Rs.S0,000 and provision for contingency is required at 5%.

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11. A business has projected its turnover as Rs.12 crs. As per Vaz committee find its working capital need and extent of bank finance. 12. Now bank finance for working capital is de-linked from current asserts. Examine implications of such a policy. 13. A firms cost of goods sold is expected to be Rs.6 crores. Expected operating cycle is 90 days. It wants to keep a cash balance of 1% of cost of goods sold. Find its expected working capital taking 360 days in the year. 3.11 SUMMARY Working capital is the life sustaining system of businesses. There are different types and concepts of working capital. Permanent working capital, temporary working capital, gross working capital and net working capital are different types. There are aggressive, matching and conservative approaches to financing working capital. Trade credit, bank finance, internal accruals, debt and equity finances are used to finance working capital. 3.12 REFERENCES 1. Financial Management and Policy - Van Home 2. Financial Decision Making Hampton 3. Management of Finance - Weston and Brigham 4. Financial Management - P.Chandra 5. Financial Management Ravi M. Kishore CASH MANAGEMENT Unit Structure 1. Introduction 2. Learning Objectives 3. Section Title 3.1 Why is Cash Needed? 3.2 Determining Optimal Cash Balance 3.4 Cash Management 3.5 Cash Budgeting

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3.5 Have you understand question 3.6 Summary 3.7 Exercises 3.8 Further Readings 1. INTRODUCTION In the previous unit, various issues regarding management of working capital were discussed. it was explained that current assets form an important aspect of working capital management. In fact, each current asset requires a detailed treatment to understand the issues related to the need and method of its management. In this unit we shall discuss the planning and managing of cash needs. It is needless to impress upon you that cash, like blood stream in human body, is vital for a business. Cash denotes the liquidity of a business enterprise and plays an important role in nurturing and improving the profitability of an organisation. It is, therefore, essential to make a proper estimate of the cash needs and plan for it so as to avoid technical or legal insolvency. Hence, effective management ensuring adequate cash is necessary. The cash available with the organisation should neither be short nor too excessive. 2. LEARNING OBJECTIVES The objectives of this unit are to acquaint you with the: importance of maintaining adequate liquidity concept of optimum cash balance importance of cash management and the usefulness of cash budgeting as a technique of liquidity planning 3. SECTION TITLE 3.1 WHY IS CASH NEEDED? The demand for liquid assets like cash, whether by individuals or firms, is normally attributed to three behavioral motives, viz., the transaction motive, the precautionary motive and the speculative motive. The transaction motive for holding cash is helpful in the conduct of everyday ordinary business such as making of purchases and sales. The amount of cash needed,

35

however, differs from business to business and from firm to firm depending on the frequency of cash transactions. Retail trade, for example, requires a higher ratio of cash to sales and of cash to total assets. Firms having seasonal business will need greater amount of cash during the season. The precautionary motive is concerned with predictability of cash inflows and outflows. Higher the predictability of cash, lower is the amount needed against emergencies or contingencies. This motive for holding cash is also influenced by the ability of the firm to obtain additional cash on short notice through short-term borrowings. A minimum reservoir of cash must always be kept in hand to meet the unexpected payments and other contingencies. The speculative motive for holding cash is concerned with availing the opportunities arising from unexpected developments, e.g. an abnormal increase in prices. However, keeping additional cash for speculative purpose is not common in business. 3.2 DETERMINING OPTIMAL CASH BALANCE Holding of excessive cash is a non-profitable proposition as idle cash does not earn any income. Similarly shortage of cash may deprive the business unit of availing the benefits of cash discounts, and of taking advantage of other favourable opportunities. It may even lead to loss of credit-worthiness on account of default in paying liabilities when the same become due. Hence, every organisation, irrespective of its size and nature, has to determine the appropriate or optimum cash balance that it would need. A firms cash balance, generally, may not be constant overtime. It would therefore be worthwhile to investigate the maximum, minimum and average cash needs over a designated period of time. You are aware that cash is needed for various transactions of the organisation. Maintenance of a cash balance however has an opportunity cost in the following ways: a) Cash can be invested in acquiring assets such as inventory, or for purchasing securities. Opportunities for such investments may have to be lost if a certain minimum cash balance is held. b) Holding of cash means that it cannot be used to offset financial risks from the shortterm debts.

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c) Excessive reliance on internally generated liquidity can isolate the firm from the short-term financial market. Now the financial manager should understand the benefits and the opportunity costs for holding cash. Thereafter, he must proceed to work out a mode! for determining the optimal amount of cash. First of all? critical minimum cash balance should be conceived below which the firm will incur definite and measurable costs. Apart from risk aversion the existence of the minimum balance is justified by institutional requirements such as credit ratings, checking accounts, lines of credit. The violation of maintaining a minimum cash balance will create shortage costs which will be determined by the actions of creditors on account of postponing their payments or non availing of cash discounts. At any point of time a firms (ending) cash balance can be represented as follows: Ending balance-Beginning Balance + Receipts Disbursements If receipts and disbursements are equal for any unit of time, no problem is involved. Ordinarily, however, receipts may be more than disbursements or vice versa, hence, the ending balance will keep on fluctuating . In actual practice receipts and disbursements do vary, particularly in case of firms having seasonal activities. Suppose, the receipts and disbursements are not synchronised but the variation is predictable, then the main problem will be that of minimising total costs. In case you set the balance too low you will incur high transaction costs. If you set the balance too high you will lose interest which you can earn by investing cash in marketable Figure 1: The Optimal Working Cash Balance

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securities. The determination of optimal cash balance under these conditions of known certainty is similar to the inventory problem. The costs of too little cash (transaction costs) can be balanced against the costs of too much cash (opportunity costs). Figure I clarifies this position. Point C in Figure I denotes the point where the sum of two costs (opportunity and transaction costs) is minimum. Efficient management should try to locate this point for determining the optimal cash balance. M is the point where working cash balance is optimal. It is seldom that receipts and disbursements are completely predictable. For a moment let us take one extreme case where receipts and disbursements are completely random. A model can be developed using the Control Theory and fix maximum and minimum optimal balances as illustrated in the Figure II. Figure II: Cash Balance Control Limits

You can observe from Figure II that the fluctuating cash balance is on account of random receipts and disbursements. At time t1 the balance touches the upper control point. At this point the excess of cash is invested in marketable securities. The balance falls to zero point at time t2 and at this stage marketable securities have to be sold to create cash balances. These two control points lay only the maximum and minimum balance. We can conclude that where cash flows (receipts and disbursements) are uncertain the principle will be: the greater the variability the higher the minimum cash balance. Activity 1 What are the main groups of expenditure for which cash is needed in your organisation:

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i) (a) on daily basis ... (b) on monthly basis (c) at irregular intervals ... (d) at regular intervals, other than daily or monthly basis ... ii) What are the main sources of cash and what arrangements exist for collection, accounting and banking of cash receipts. ... 3.3 CASH MANAGEMENT Cash being a sensitive asset, it has to be regulated according to needs. Any deficits (or inadequacies) should be rectified and any excess amount be gainfully invested. Cash Management involves two main questions How should the storage, collection and disbursement of cash balances be managed? How should the appropriate cash balance be determined, and how should any temporarily idle cash be invested in interest earning assets? Managing Collections and Disbursements

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The Cash Cycle: In order to deal with the problem of cash management we must have an idea about the flow of cash through a firms accounts. The entire process of this cash flow is known as Cash Cycle. This has been illustrated in Figures III and IV. Cash is used to purchase materials from which goods are produced. Production of these goods involves use of funds for paying wages and meeting other expenses. Goods produced are sold either on cash or credit. In the latter case the pending bills are received at a later date. The firm thus receives cash immediately or later for the goods sold by it. The cycle continues repeating itself.

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The diagram in Figure III only gives a general idea about the channels of flow of cash Managing Cash in a business. The magnitude of the flow in terms of time is depicted in the diagram given in Figure IV. The following information is reflected by Figure IV: a) Raw material for production is received 10 days after placement of order. b) The material is converted into goods for sale in 37 days (15+2+20) from point B to E. c) The payment for material purchased can be deferred to 17 days (15+2) after it is received (i.e. the distance of time between points B to D), assuming that it takes 2 days for collection of payment of the cheque. d) The amount of the bill for goods sold is received 36 days (32+2+2) after the sale of goods as is depicted by duration of time between point F to H. e) The recovery of cash spent till point D is made after 56 days (20+30+2+2+2) as shown between points D to H. Activity 2 Meet a responsible executive of Accounting and Finance Department of a manufacturing organisation regarding the following: a) What is the length of its Cash Cycle? Cash Cycle is approximately of .days.

b) Draw the sequence of Cash Cycle showing its successive events with the respective number of days. . c) Inquire whether or not the organisation is satisfied with its length of cash cycle. What steps it proposes to take for reducing the Cash Cycle?

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d) How does the top management judge the efficiency about cash management? e) Does the organisation have any imprest system of cash? What are the major objectives and procedures of the system? . Speeding up Collections In order to minimise the size of cash holding, the time gap between sale of goods and their cash collection should be reduced and the flow be controlled. Normally, certain factors creating time lags are beyond the control of management. Yet, in order to improve the efficiency, attention should be paid to the following. All cash collected should be directly deposited in one account. If there are more than one collection centers, all cash receipts should be remitted to the main account with. top speed. Compared to a single collection centre, the aggregate requirement for cash will be more when there are several centers. Concentration of collections at one place will thus permit the firm to store its cash more efficiently. The time lag between the dispatch of cheque by the customer and its credit to our account with the bank should be reduced. Some firms with large collection transactions introduce lock box system. In this system the post boxes are hired at different centers where cash/cheques can be dropped in. The local banker can daily collect the same from the lockers. The collecting bank is paid service charges. In order to minimise time, banks may be asked to devise methods for speeding up the collection of cash. Recovering Dues After sale of goods on credit, either on account of convention or for promoting sales, receivables are created. It may however be useful to reduce the amount block in receivables by seeing to it that they do not become overdue accounts. Incentive in the form of discounts for early payment may be given. More important than anything else is a constant follow-up action for the recovery of dues. This will improve position of cash balance.

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Controlling Disbursements Needless to assert that speeding up of collections helps conversion of receivables into cash and thus reduces the financing requirements of the firm. Similar kind of benefit can be derived by delaying disbursements. Trade credit is a costless source of funds for it allows us to pay the creditors only after the period of credit agreed upon. The dues can be withheld till the last date. This will reduce the requirement for holding large cash balances. Some firms may like to take advantage of cheque book float which is the time gap between the date of issue of a cheque and the actual date when it is presented for payment directly or through the bank. Investment of Idle Cash Balances Two other important aspects in cash management are how to determine appropriate cash balance and how to invest temporarily idle cash in interest earning assets or securities. The first part relating to the theory of determining appropriate cash balance has already been discussed earlier. Now we shall discuss the investment of idle cash balances on temporary basis. Cash by itself yields no income. If we know that some cash will be in excess of our need for a short period of time, we must invest it for earning income without depriving ourselves of the benefit of liquidity of funds. While doing this, we must weigh the advantages of carrying extra cash (i.e. more than the normal requirement) and the disadvantages of not carrying it. The carrying of extra cash may be necessitated due to its requirement in future, whether predictable or unpredictable. The experience indicates that cash flows cannot be predicted with complete accuracy. Competition, technological changes, unexpected failure of products, strikes and variations in economic conditions make it difficult to predict cash needs accurately. Investment Criteria When it is realised that the excess cash will remain idle, it should be invested in such a way that it would generate income and at the same time ensure quick re-conversion of investment in cash. While choosing the channels for investment of any idle cash balance for a short period, it should be seen that (i) the investment is free from default risk, that is, the risk involved due to the possibility of default in timely payment of interest and repayment of principal amount; (ii) the investment shall mature in short span of time; and (iii) the investment has adequate marketability. Marketability refers to the ease with which an asset can be converted back into cash. Marketability has two 43

dimensions--price and time-which are inter-related. If an asset can be sold quickly in large amounts at a price determinable in advance the asset will be regarded as highly marketable and highly liquid. The assets which largely satisfy the aforesaid criteria are: Government Securities, Bankers Acceptances and Commercial Paper. Activity 3 Discuss with the Chief Executive of Accounting and Finance department of your organisation regarding the broad policies and procedures followed in the sphere of cash management? 3.4 CASH BUDGETING Planning cash and controlling its use are very important tasks. If the future cash flows are not properly anticipated, it is likely that idle cash balances may be created which may result into unnecessary tosses. It may also result in cash deficits and consequent problems. The financial manager should, therefore, plan the cash needs and uses. Budget is a useful device for this purpose. Cash budget basically incorporates estimates of future inflows and outflows of cash over a projected short period of tine which may usually be a year, a quarter or a half-year. Effective cash management is facilitated if the cash budget is further broken down into month, week or even daily basis. Preparing a Cash Budget There are two components of a cash budgetcash inflows and cash outflows. In both these components there are two types of flows, viz. operating cash flows and financial cash flows. Some common elements of each are as follows: Cash Inflows (a) Operating: cash sales, receivable collections. (b) Financial: interest receipts, sale of marketable securities, issue of new securities. Cash Outflows (a) Operating: wage payments, payments of bills and accounts payable, and capital expenditure (b) Financial: dividend payments, interest payments, redemption of securities, loan repayments, purchase of marketable securities, tax payments.

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Sales Work Sheet Sales bring in a major part of cash inflows. All sales may not be against cash; credit sales are quite common. Each business establishment has its own credit policy for promoting sales. Even when care is taken to ensure that credit sales do not exceed the permitted percentage of total sales and that debtors do not default in paying bills in time, it is a common experience that the total amount of sales is recovered over a period of time. Let us take an example. In a business, 10 per cent of the sales value in a, month is realised in cash during the same month; 50 per cent is received in the next month; and the remaining 40 per cent in the month after that. We can find out the estimated cash inflow due to sales for every month with the help of the data on past and future sales.

In a similar manner, a Purchase Work Sheet can also be prepared to find out the estimated total cash disbursements for purchases. For example, 50 per cent of current months purchases maybe paid for in the current month, 40 per cent in the next month and the remaining 10 per cent in the month after that. A proforma Cash Budget with hypothetical figures is presented in Table 1 Table I: Proforma for Cash Budget

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I llustration 1 You are appointed as the Finance Manager of Orissa Polymers Limited. Prepare a cash budget for six months of 19x8 with the help of the following information: a) Sales on credit, cost of material and wages are budgeted as follows (figures for November and December of the previous year are the actual figures for those months).

Months Nov Dec. Jan. Feb. March. April

Credit sales 32,000 32,000 28,000 31,000 34,000 29,000

Cost of material 5,000 6,000 5,000 7,000 8,000 5,000

Wages 10,000 12,000 10,000 11,000 12,000 9,000

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May June

30,000 36,000

6,000 7,000

11,000 12,000

b) Fixed overheads amount to Rs. 10,000 per month. c) Preference dividend of Rs. 8,000 for the half year will be due in June. d) Income tax amount of Rs. 10,000 is payable in January. e) Progress payments under a building contract are due as follows: March 31 May 31 Rs. 12,000 Rs. 15,000

f) Goods are sold on terms: Net cash in the following month. Experience indicates that 80% of debtors pay within the period of credit and the remainder do not pay until the following month. g) Cost of material is payable in the month following the month in which the cost is incurred. Half of the purchases are subject to a 2% discount and the remaining are payable net. h) The company pays all its accounts promptly.

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Cash Budget

It will be seen that deficiency of cash occurs in the months of January, March, May and June, mainly because some unusual payments like preference dividend, advance income-tax and progress payments under building contract are to be made in those months. With the help of the cash budget, the company will be able to plan its short-term financing. One of the courses is to obtain overdraft facilities from its bankers. The net cash position in a particular period may show deficit. Hence, arrangements should be made in advance to fill this gap by borrowing or by other means. In case there is a surplus balance, the desirability of investing it in government or other short-term securities should be examined. Any surplus should be invested in

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safe securities, provided the surplus is fairly considerable and the period of investment is short so as to ensure quick conversion of securities in cash without loss of value. Activity 4 Arrange a meeting with an accounting executive of your organisation and ascertain if cash budgeting is being practised? Obtain a proforma of cash budget for your record. What are the major sources of cash inflows and the main uses of cash outflows? In what way your organisation manages any deficit or surplus of cash revealed by the cash budget? 3.5 QUESTIONS 1 What are the three motivations behind holding cash? Explain briefly. 2 In managing cash the Finance Manager faces the problem of compromising the conflicting goals of liquidity and profitability. Comment. What strategy should the Finance Managers develop to solve this problem? 3 What is optimum cash balance and how can it be arrived at? 4 What is cash cycle and how can it be reduced? 5 If a firm estimates that it will have some idle cash balances from time to time, what advice would you render to the firm? 6 What is a cash budget and in what way can it be helpful in liquidity planning? 7 How would you judge the efficiency of cash management of a company? 3.6 SUMMARY An adequate amount of cash is required for meeting liabilities and day-to-day operating expenses of the business. Cash is also needed as a reserve for meeting any unforeseen contingencies. The management of cash is as important as the management of other items of current assets like receivables and inventories. Too little cash may place the firm in an illiquid position which may force the creditors and other claimants to stop transacting with the firm. Too much cash results in funds lying idle, thereby lowering the overall return on capital employed below the acceptable level. The firm 49

must plan its cash requirements on a short run basis. Cash budgeting is a useful tool for forecasting cash inflows and outflows. For this purpose the firm must identify the sources and timings of all receipts and timings and uses of all payments. The cash budget indicates the shortages or excesses of cash at particular points of time. Steps can then be taken to arrange for additional financing for filling the gap or investing any surplus funds so as to generate additional income. The close monitoring of cash position implies an efficient and regular data collection and reporting system that highlights the likely shortfalls well in advance. This enables corrective action to be taken by expediting receipts, curtailing expenses and rescheduling expenditure. If liquidity position of the firm is insisted upon as an index of managerial performance, it will reduce occurrence of cash shortages and will help to instill an inbuilt liquidity discipline. 3.7 EXERCISES 1. West Bengal Lamps Limited wishes to arrange over-draft facilities with its banker during the period April-June of a particular year. It intends to manufacture mostly for stock. Prepare a cash budget with the help of the following data, indicating the extent of bank facilities the company would require at the end of each month: a) Sales, purchase and wages will be as follows: Month February March April May June Sales 2,00,000 2,20,000 1,60,000 1,80,000 1,50,000 Purchases 1,30,000 1,50,000 2,50,000 2,60,000 2,80,000 Wages 15,000 16,000 13,000 12,000 16,000

b) 75% of the credit sales are realised in the month following the sales and the remaining in the second month following. c) Creditors are paid in the month following the purchases. d) Cash at bank on 1st April is estimated at Rs. 30,000. e) Payment for purchases are made in the month following.

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f) Wages are payable in the same month. The following data pertain to Travancore Traders. Prepare a cash budget for the first quarter of the year with the information given below: a) The owner has made sales forecasts for the first five months of the coming year: Month January February March April May Rs 50,000 60,000 60,000 70,000 80,000

b) Debtors and creditors balances at the beginning of the year are Es. 30,000 and Rs. 25,000 respectively The balances of other assets and liabilities are: Cash Balance Stock Accrued Sales Commission Rs. 4,000 Rs. 8,000 Rs. 60,000

c) 50% of sales are on cash basis. Credit sales are collected in the wing month of sales. d) Cost of sales is 75% of sales. e) The only other variable cost is a 5% commission to sales agents who are paid in the following month with a time lag of nearly 30 days. 75% of sales are subject to commission. f) Trade creditors are paid in the following month after purchase. g) Fixed costs are Rs. 6,000 per month including Its. 1,000 depreciation.

Answers to Self-assessment Questions/Exercises

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April 8. Total Cash Inflows Total Cash Outflows 2,15,000 1,63,000 January 9. Total Cash Receipts Total Cash Payments Ending Balance 3.8 REFERENCES 55,000 34,000 29,000

May 1,75,000 2,62,000 February 55,000 474,375 10,375

June 1,75,000 2,76,000 March 60,000 59,750 10,625

Solomon, Ezra and Pringle John, 1978. An Introduction to Financial Management, Prentice-Hall of India: New Delhi. Kuchhal, S.C., 1985. Financial Management, Chaitanya Publishing: Allahabad. Kulkanii, PS., 1985. Financial Management, Himalaya Publishing: Bombay.

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