WORKING CAPITAL MANAGEMENT

INVOLVES THE MANAGEMENT AND CONTROL OF THE

GROSS CURRENT ASSETS[ AS AGAINST THE NET
WORKING CAPITAL.
WORKING CAPITAL MANAGEMENT THUS COMPRISES THE
MANAGEMENT OF ALL THE COMPONENTS OF CURRENT
ASSETS, BOTH INDIVIDUALLY AND COLLECTIVELY.

WORKING CAPITAL MANAGEMENT

Goal of working capital management

Working capital management involves the

relationship between a firm's short-term assets and
its short-term liabilities. The goal of working capital
management is to ensure that a firm is able to
continue its operations and that it has sufficient
ability to satisfy both maturing short-term debt and
upcoming operational expenses. The management of
working capital involves managing inventories,
accounts receivable and payable, and cash.

CURRENT ASSETS
1
2

3
4

5
6

Cash and bank balances

Investments( marketable securities):
Government & other Trustee
securities other than for long term
purposes ex sinking fund, Gratuity fd
Fixed deposits with banks maturing
within one year)
Receivables arising out of sales
other than deferred receivables
(including bills purchased and
discounted by bankers).
Installments of deferred receivables
due within one year
Raw materials and components
used in the process of
manufacturing including those in
transit.

7
8
9
10
11
12
13

14

Stock in process including semi

finished goods
Finished goods including goods in
transit
Other consumable spares
Advance payment for tax
Prepaid expenses
Advances for purchase of raw
materials, components and
consumable stores
Deposits kept with public bodies, etc
for normal business operation ex
earnest money deposits kept by
construction companies etc maturing
within normal operating cycle
Money receivable from contracted sale
of fixed asset during the next 12
months

OBJECTIVE OF WCM
THE BASIC OBJECTIVE OF WORKING CAPITAL
MANAGEMENT IS TO MANAGE THE FIRMS
CURRENT ASSETS (AND CURRENT LIABILITIES) IN
SUCH A WAY THAT A SATISFACTORY LEVEL OF
WORKING CAPITAL IS MAINTAINED.

FACTORS DETERMINING WORKING CAPITAL

REQUIREMENTS OF A FIRM
1
2
3
4
5
6
7
8
9

Nature or Character of
Business/ Industry
Size of Business/Scale of
operations
Production Policy
Manufacturing
Process/Length of production
cycle
Seasonal variations
Working capital cycle
Rate of stock turnover
Volumes of sales
Terms of Purchase & sales

10 Business Cycles
11 Rate of Growth of Business
12 Fluctuations in the supply of
Raw material
13 Operating efficiency
14 Profit margin
15 Profit Appropriations
16 Price level changes
17 Capital structure of the firm
18 Credit Policies of RBI
19 Other factors like
management ability, import
policy, importance of labor,
banking facilities

FINANCING MIX OF WORKING CAPITAL

Sources of
Working capital

Spontaneous sources

Negotiated sources

Trade Credit
-Sundry Creditors
--Bills/Notes payable
And others

Internal
-Provision for
tax
-Provision for
dividend

External
-Bank OD/CC
-Trade deposits
-Public deposits
-Bills discounting
-Short term loans
-Commercial paper

Long term
Sources

Short term
sources

Internal

-Retained profit
-Provision for
depreciation

External

-Share Capital
-Long term loan
-Debentures
-Factoring

SPONTANEOUS SOURCE OF FINANCE

FINANCE WHICH NATURALLY ARISE IN THE

COURSE OF BUSINESS IS CALLED AS
SPONTANEOUS FINANCING.EXAMPLES ARE
TRADE CREDITORS
CREDIT FROM EMPLOYEES
CREDIT FROM SUPPLIERS OF SERVICES

NEGOTIATED FINANCING
FINANCING WHICH HAS TO BE NEGOTIATED
WITH LENDERS LIKE COMMERCIAL BANKS, FINANCIAL
INSTITUTIONS OR GENERAL PUBLIC IS CALLED AS
NEGOTIATED FINANCING. THIS KIND OF FINANCING
MAY BE SHORT TERM IN NATURE OR LONG TERM.

TRADE CREDIT
TRADE CREDIT REFERS TO THE CREDIT EXTENDED BY THE
SUPPLIER OF GOODS AND SERVICES IN THE NORMAL COURSE
OF BUSINESS. THIS FORM OF BUSINESS CREDIT IS MORE
POPULAR AND CONTRIBUTES TO ABOUT ONE-THIRD OF THE
TOTAL SHORT TERM CREDIT. THE DEPENDENCE ON THIS
SOURCE OF WORKING CAPITAL FINANCE IS HIGHER DUE TO :
NEGLIGIBLE COST OF FINANCE AS COMPARED TO
NEGOTIATED FINANCES
SIMPLICITY OF NATURE
EASIER TO OBTAIN
NO EXPLICIT COSTS INVOLVED
NO LEGAL INSTRUMENTS TO BACK THE TRANSACTION

TRADE CREDIT

COST OF TRADE CREDIT

The trade credit has no explicit cost, but it is
not cost-free.
There are implicit costs or opportunity costs involved in using trade
credit. These costs have to be evaluated and compared with the
explicit cost of negotiated source of finance to justify its employment
in financing working capital requirements.
Credit purchases always cost more than cash purchases and
the sellers incur the following additional costs when goods are sold
on credit:
- the funds are invested in the form of book debts in which explicit costs are involved.
- the sellers incur the cost of cash discount if availed by the buyers.
- the sellers undergo the risk of bad debts and often bear them.
- direct cost are incurred to monitor, extend and collect outstanding.

TRADE CREDIT-TERMS & CONDITIONS

THE TRADE CREDIT IS EXTENDED GENERALLY ON THE
F0LLOWING TERMS AND CONDITIONS

MAXIMUM CREDIT LIMIT IS SET

CREDIT PERIOD
CASH DISCOUNT
STARTING DATE
TO FACILITATE THE MANAGEMENTS DECISION MAKING

FROM THE BUYERS POINT OF VIEW A PROPER

MANAGEMENT POLICY IS CALLED FOR PLANNING AND
CONTROL OF TRADE CREDIT. TO FACILITATE THE
MANAGEMENTS DECISION MAKING.

TECHNIQUES OF CONTROL OF TRADE CREDIT

A PROPER MANAGEMENT POLICY IS CALLED FOR PLANNING AND CONTROL OF
TRADE CREDIT. A LACKLUSTRE POLICY MAY RESULT IN USING A SOURCE WITH
AN IMPLICIT COST MUCH HIGHER THAN THE EXPLICIT COST OF A NEGOTIATED
SOURCE, THUS RUSULTING IN ERODED PROFITABILITY. TO FACILITATE
MANAGEMENTS DECISION MAKING THE FOLLOWING FINANCIAL RATIOS ARE
USED:
Trade Credit to total current assets ratio The lower the ratio , the better will be
the liquidity of the firm.
Trade Credit to total current liabilities ratio- A high ratio means increased
dependence on spontaneous sources and difficulties in getting funds from
negotiated source. It is a pointer at impending financial difficulties.
Trade Credit to sales ratio Is useful from the point of inter-period and inter-firm
comparisons.
Percentage change in trade credit to percentage change in sales ratio-This ratio
indicates the behavioural relationship between sales and trade credit. A
quotient of 1 signifies proportionate relationship between the two. The lower
the quotient, the better will be the management of trade credit.

BANK CREDIT

BANK CREDIT IS THE PRIMARY

INSTITUTIONAL SOURCE OF WORKING
CAPITAL IN INDIA .WORKING CAPITAL
FINANCE IS PROVIDED BY BANKS IN
FIVE WAYS:
1. Cash credit/overdrafts
2. Loans
3. Purchase/discount bills
4. Letter of Credit
5. Working Capital Term Loan

BANK CREDIT- Contd.

UNDER CASH CREDIT/OVERDRAFT FORM/ARRANGEMENT OF BANK
FINANCE, THE BANK SPECIFIES A PREDETERMINED
BORROWING/CREDIT LIMIT. THE BORROWER CAN DRAW/BORROW
UPTO THE STIPULATED CREDIT/OVERDRAFT LIMIT AND ALSO DEPOSIT
AMOUNTS . THE INTEREST IS DETERMINED ON THE BASIS OF THE
RUNNING BALANCE/AMOUNT ACTUALLY UTILISED BY THE BORROWER
AND NOT ON THE SANCTIONED LIMIT.
THIS FORM OF FINANCING IS HIGHLY ATTRACTIVE TO THE
BORROWERS BECAUSE:
1. IT IS FLEXIBLE AS THE LIMITS ARE USUALLY ROLLED OVER
DESPITE BEING REPAYABLE ON DEMAND.
2. THE BORROWER CAN HAVE THE FREEDOM TO DRAW THE AMOUNT
IN ADVANCE AS AND WHEN REQUIRED WHILE THE INTEREST LIABILITY
IS ONLY ON THE AMOUNT ACTUALL OUTSTANDING.
HOWEVER, CASH CREDIT/OVERDRAFT IS INCONVENIENT TO BANKS AS IT
HAMPERS THEIR CREDIT PLANNING.

BANK CREDIT - LOANS

UNDER THIS ARRANGEMENT, THE ENTIRE AMOUNT OF

BORROWING IS CREDITED TO THE LOAN ACCOUNT OF THE
BORROWER OR RELEASED IN CASH.

THE BORROWER HAS TO PAY INTEREST ON THE TOTAL AMOUNT.

THE LOANS ARE REPAYABLE ON DEMAND OR IN PERIODIC
INSTALMENTS . THEY CAN ALSO BE RENEWED FROM TIME TO
TIME.

AS A FORM OF FINANCING, LOANS IMPLY A FINANCIAL DISCIPLINE

ON THE PART OF THE BORROWERS.

BANK CREDIT-BILLS
PURCHASED/DISCOUNTED
THE BILL FINANCING IS INTENDED TO LINK CREDIT WITH THE
SALE AND PURCHASE OF GOODS AND THUS ELIMINATE THE
SCOPE
FOR MISUSE OR DIVERSION OF CREDIT TO OTHER PURPOSES.
THE MODUS OPERANDI OF BILL FINANCE AS A SOURCE OF
WORKING CAPITAL IS THAT A BILL ARISES OUT OF A TRADE SALEPURCHASE TRANSACTION ON CREDIT. ON ACCEPTANCE OF THE
BILL BY THE PURCHASER, THE SELLER OFFERS IT TO THE BANK
FOR DISCOUNT/PURCHASE. ON DISCOUNTING THE BILL, THE
BANK
RELEASES THE FUNDS TO THE SELLER. ON THE DUE DATE OF
PAYMENT THE BANKER PRESENTS THE BILL TO THE PURCHASER/
ACCEPTOR OF THE BILL FOR PAYMENT.

BANK CREDIT- TERM LOAN FOR WORKING

CAPITAL/LETTER OF CREDIT

TERM LOANS FOR WORKING CAPITAL- Under this

arrangement, banks advance loans for 3-7 years repayable
in yearly or half-yearly instalments.
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.
The Modus operandi of letter of credit is that the supplier
sells goods on credit/extends credit(finance) to the
purchaser, the bank gives a guarantee and bears risk only in
case of default by the purchaser.

MODES OF SECURING BANK ADVANCES

HYPOTHECATION:
IS THE USE OF INVENTORY AS A SECURITY/COLLATERAL TO OBTAIN A SHORTTERM LOAN. UNDER THIS MODE OF SECURITY.
PLEDGE:
USE OF GOODS AS SECURITY/COLLATERAL TO OBTAIN A SHORT-TERM LOAN
LIEN:
RIGHT OF A PARTY TO RETAIN GOODS BELONGING TO ANOTHER PARTY UNTIL A
DEBT DUE TO HIM IS PAID.
MORTGAGE:
IS THE ADDITIONAL SECURITY OF IMMOVABLE PROPERTY TO OBTAIN SHORT
TERM LOAN
CHARGE:
WHEN 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 TRANSACTION DOES NOT AMOUNT TO MORTGAGE, THE
LATTER PERSON IS SAID TO HAVE A CHARGE ON THE PROPERTY.

COMMERCIAL PAPER

COMMERCIAL PAPER (CP) IS A SHORT TERM UNSECURED

NEGOTIABLE INSTRUMENT, CONSISTING OF USANCE
PROMISSORY NOTES WITH A FIXED MATURITY. IT IS ISSUED ON A
DISCOUNT ON FACE VALUE BASIS BUT IT CAN ALSO BE ISSUED IN
INTEREST-BEARING FORM.
A CP WHEN ISSUED BY A COMPANY DIRECTLY TO THE INVESTOR
IS CALLED A DIRECT PAPER.
WHEN CPs ARE ISSUED BY A SECURITY DEALER/S ON BEHALF OF
THEIR CORPORATE CUSTOMERS, THEY ARE CALLED DEALER
PAPER.

COMMERCIAL PAPER-ADVANTAGES

It is a simple instrument and hardly involves any documentation.

It is additionally flexible in terms of maturities which can be
tailored to match the cash flow of the issuer.
A well rated company can diversify its short term sources of
finance from banks to money market at cheaper cost.
The investors can get higher returns than what they can get from
the banking system.
Companies which are able to raise funds through CPs have
better financial standing.
The CPs are unsecured and there are no limitations on the enduse of funds raised through them.
As negotiable/transferable instruments, they are highly liquid.
The creation of the CP market can result in a part of intercorporate funds flowing into the money market which would come
under the control of monetary authorities in India.

FACTORING

FACTORING PROVIDES RESOURCES TO FINANCE RECEIVABLE AS WELL

AS FACILITATES THE COLLECTION OF RECEIVABLES. IT INVOLES THE

OUTRIGHT SALE OF RECEIVABLES AT A DISCOUNT TO FACTOR WHO
CHARGES A COMMISSION, BEARS THE CREDIT RISK ASSOCIATED WITH
THE ACCOUNTS RECEIVABLE PURCHASED BY IT AND PROVIDES FUNDS
IN ADVANCE OF COLLECTION AND THUS FINANCES RECEIVABLES

BANK FINANCE FOR WORKING CAPITAL

TANDON COMMITTEE RECOMMENDATIONS
RBI appointed in 1974 a Study Group with Shri. P.L. Tandon,
then Chairman Punjab National Bank, as the Chairman. This Study
group for framing guidelines for the follow up of Bank Credit came to
be popularly known as the Tandon Committee.
The RBI accepted the major recommendations of the
committee which suggested three methods of working out the
maximum permissible bank finance.
The banker was required to finance only a part of the
working capital gap; the other part was to be financed by the
borrower from the long-term sources. Working capital gap is defined
as Current Assets minus current liabilities excluding bank
borrowings. Current Assets will be taken at estimated values or
values as per the Tandon Committee norms, whichever is lower.
Current Assets will consist of inventory and receivables, referred as
Chargeable Current Assets (CCA) and other current assets (OCA). In
view of this approach to bank lending , the committee suggested
three methods of determining the permissible level of bank
borrowings.

TANDON COMMITTEE RECOMMENDATIONS

THE COMMITTEE SUGGESTED THE FOLLOWING THREE METHODS OF
DETERMINING THE PERMISSIBLE LEVEL OF BANK BORROWINGS:

First method: In the first method, the borrower will contribute 25% of
the working capital gap; the remaining 75% can be financed from bank
borrowings. This method will give a minimum current ratio of 1:1.

Second method: In the second method, the borrower will contribute

25% of the total current asset. The remaining of the working capital gap( I.e.
the working capital gap less the borrowers contribution) can be bridged
from the bank borrowings. This method will give a current ratio of 1.33:1

Third method: In the third method, borrower will contribute 100% of

core assets, ad defined and 25% of the balance of current assets. The
remaining of the working capital gap can be met from the borrowings. This
method will further strengthen the current ratio.

TANDON COMMITTEE RECOMMENDATIONS-contd

The Tandon Committee Report has been widely debated and criticised.
It is true that bankers found difficulties in implementing the
Committees recommendations. But it must be admitted that the
Tandon Committee Report has brought about a perceptible change in
the outlook and attitude of both the bankers and their customers. They
have become quite aware in the matter of making best use of a scarce
resource like bank credit. The report has helped in bringing a financial
discipline through a balanced and integrated scheme for bank lending.
On reviewing the monetary and credit trends for the busy season
1978-79, the RBI felt that the extensive use of cash credit system was
a deterrent factor in implementing the credit regulatory measures by
the banks. The Tandon committee had recommended bifurcation of
credit limits into a demand loan and a fluctuating cash credit
component. But implementation of the recommendation was very
slow. The RBI, therefore, thought that this problem needed a deep
study and decision was taken to entrust the work to a working group.
Accordingly a Working group to review the system of cash credit was
constituted in April 1979 under the Chairmanship of Shri. K.B. Chore,
Chief Officer, Reserve Bank of India.

CHORE COMMITTEE RECOMMENDATIONS

The working group headed by Shri. K.B.Chore submitted its final report in
August 1979. The major areas covered by the recommendations are:
-Use of different types of advances, cash credit, loans and bills- all types to
continue.
-Bifurcation of cash credit limit into demand loan and fluctuating cash credit
portions
not favoured because:
(I) for seasonal industries the difference is too much; for sales season
period the account may be in credit in which case the loan portion
should be nil.
(ii)for non-seasonal industries the difference is too narrow to be of any
help to the banker.
-Separate limits to be granted for peak level and normal non-peak level credit
requirements.
- All borrowers (except sick units) with working capital requirements of
Rs10lakh and above to be placed under the second method of lending
recommended by Tandon Committee.
-The flow of information from borrower to banks to be simplified.
-Bank to take up financing a portion of raw material by way of drawee bills.
The recommendations of the committee were accepted by the RBI subject to
certain
Modifications.

NAYAK COMMITTEE RECOMMENDATIONS

CONSIDERING THE CONTRIBUTION OF SSI SECTOR TO
OVERALL INDUSTRIAL PRODUCTION, EXPORTS AND
EMPLOYMENT AND ALSO RECOGNISING THE NEED TO GIVE
PHILLIP TO THIS SECTOR, THE RBI HAS ACCEPTED THE
RECOMMENDATIONS OF THE NAYAK COMMITTEE. THE
COMMITTEE WAS CONSTITUTED UNDER THE CHAIRMANSHIP
OF SHRI. P.R. NAYAK TO EXAMINE THE ADEQUACY OF
INSTITUIONAL CREDIT TO SSI SECTOR AND RELATEDS
ASPECTS.

NAYAK COMMITTEE RECOMMENDATIONS-salient features

To give preference to village industries, tiny industries and other small scale units
in that order while meeting the credit requirements of small scale sector.

For the credit requirements of village industries, tiny industries and other SSI
units up to aggregate fund based working capital credit requirement of Rs.50
lakhs from the banking system , the working capital limit will be computed at 20%
of their projected annual turnover (for both new as well as existing units). These
SSI units will be required to bring in 5 % of their annual turnover as margin
money. In other words, 25% of the output value should be computed as working
capital requirement, of which at least 4/5 th should be provided by Banking sector,
the remaining 1/5th representing borrowers contribution towards margin money
for the working capital. Banks have to satisfy themselves about the
reasonableness of projected annual turnover of the applicants .

NAYAK COMMITTEE RECOMMENDATIONS-salient features, contd

Preparation of annual budget in respect of working capital requirements of

SSI sector on bottom up basis.

Sick SSI unit redefined.

Banks are advised to adopt Single Financing Approach for meeting both
Term Loan and working capital requirements of SSI sector.

Banks to set up effective grievance cells to enable SSI borrowers to

approach in case of difficulties.

SSI loan applications should be disposed off within time frame laid down as
follows:
- in case of credit up to Rs.25000 within 15 days; other 8 9 weeks

VAZ COMMITTEE RECOMMENDATIONS

THE VAZ COMMITTEE HAS EXTENDED THE CONCEPT OF NAYAK

COMMITTEE TO ALL BUSINESS ENTERPRISES, WHICH ALSO HAS
BEEN ACCEPTED AND IMPLEMENTED.
THE BORROWERL HAS TO BRING IN A MARGIN OF 5% OF THE
PROJECTED TURNOVER FROM LONG TERM SOURCES AS HIS
CONTRIBUTION AND 20% WOULD BE PROVIDED BY THE FINANCING
BANK. THUS THE WORKING CAPITAL LIMITS HAVE NO RELATION TO
THE CURRENT ASSETS WHICH IS A TOTAL DEPARTURE FROM
TANDON AND CHORE COMMITTEES.
IN ARRIVING AT 25% OF THE PROJECTED TURNOVER AS THE
WORKING CAPITAL REQUIREMENT, THE COMMITTEE HAS ASSUMED
AN AVERAGE OF FOUR WORKING CAPITAL CYCLES IN A YEAR.

WORKING CAPITAL LEVERAGE

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
INVESTMENT 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 IN LOWER RETURN ON CAPITAL EMPLOYED AND VICE
VERSA.

WORKING CAPITAL LEVERAGE

WORKING CAPITAL LEVERAGE MEASURES THE

RESPONSIVENESS OF ROCE FOR CHANGES IN
CURRENT ASSETS. IT IS WORKED BY APPLYING THE
FORMULA:
Working capital leverage = % change in ROCE
% change in Current Assets
Return on Capital employed i.e. ROCE =
Earnings Before Interest and Taxes
Total Assets

WORKING CAPITAL LEVERAGE

The working capital leverage reflects the

sensitivity of the return on capital employed to
the changes in level of current assets. Working
capital leverage would be less in the case of
capital intensive units, even though total capital
employed is the same. Working capital leverage
expresses the relation of efficiency of working
capital management with the profitability of the
company.

WORKING CAPITAL LEVERAGE

Working capital leverage = C.A.

----------T.A C.A
where
CA
= Current Assets
TA
= Total Assets
(Net fixed assets + Current Assets)
C.A = Change in Current Assets.

PROBLEM 1 ON WORKING CAPITAL LEVERAGE

From the following information calculate the responsiveness of

ROCE for changes in current assets: (Rs. Lakhs)

Particulars

Company X

Company Y

Fixed Assets

300

200

Current Assets

200

300

Total Assets

500

500

90

90

EBT
ROCE

18%

18%

SOLUTION TO THE ABOVE PROBLEM ON WCL

Working capital leverage = CA / TA CA

Company X = Rs. 200 lakhs / Rs.500 lakhs Rs. 40 lakhs = 0.435
Company Y = Rs.300 lakhs / Rs.500 lskhs Rs.60 lakhs = 0.682
Analysis From the above analysis it is observed that, working capital leverage
is higher for Company Y , and therefore, it is more responsive as compared to
Company X.

PROBLEM 2 ON WORKING CAPITAL LEVERAGE

Following information is given of Mars Ltd:

( Rs. Lakhs)

Fixed Assets
300
Current Assets
200
Total Assets
500
The entire current assets are being financed by the bank finance at 16% p.a. The earnings
Before tax (EBT) of the company is Rs. 100 lakhs. The company is planning to reduce its
Level of investment in current assets by Rs. 100 lakhs with an efficient working capital
Management. Show the impact of change in working capital on the companys return on
Investment (ROI).
(i)
Calculation of ROI prior to reduction in Current Assets
ROI = EBT x 100
= Rs.100 lakhs x 100
= 20%
Total Assets
Rs. 500 lakhs
(ii)
Calculation of ROI after reduction of current asses to Rs.100 lakhs (Rs Lakhs)
EBT
100
Add: Savings in interest charges due to restriction in investment in C A
16
Total EBT
116
Revised ROI = Rs.116 lakhs / Rs400 lakhs x 100 = 29% . Thus with the efficient
Management of working capital, by reducing the level of investments in CA, the company can improve
its
ROI from 20% to 29%.