Module 1

Working capital management

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Introduction

Working capital or Short term finance: refers to current assets and current liabilities There are two concepts of working capital: Gross working capital i.e. current assets Net working capital i.e. current assets current liabilities

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Introduction

Working capital management : it is a continuous process of making decisions relating to short term financing it deals with current assets and current liabilities. Management of working capital refers to the management of current assets as well as current liabilities

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Determination of level of current assets

An important working capital decision is concerned with determining the level investment in current assets. There are two types of working capital policies Flexible policy (conservative) Restrictive policy (aggressive)

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Flexible policy: under this policy the investment in current asset is high. This means that a firm has huge balance of cash and marketable securities, large amount of inventories, and high level of debtors. Restrictive policy: under this policy the investment in current asset is low. This means that firm has small balance of cash and marketable securities, small amount of inventories, and low level of debtors.

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Determining the optimal level of current assets involves a tradeoff between costs that rise with current assets (carrying costs) and costs that fall with current assets (shortage costs) Carrying costs: are mainly in nature of the cost of financing a higher level of current assets. Shortage costs: are mainly in the form of disruption in production schedule, loss of sale, and loss of customer goodwill.
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Carrying cost and shortage cost

Total Cost

Carrying Cost

Shortage Cost

Optimal level of CA
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Level of current assets

Sources of financing working capital

Accruals Trade credits Working capital advanced by commercial banks Public deposits Inter corporate deposits Short term loans from financial institutions Rights debenture for working capital Commercial papers Factoring

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Accruals

Expenses incurred but not paid. The major accruals items are wages and taxes. Since no interest is paid by the firms on its accruals they are often regarded as free source of finance they are a good source of finance but they are not under the control of management

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Trade credit

Refers to the credit that a customer gets from suppliers of goods in the normal course of business. In practice the buying firm do not have to pay cash immediately for the purchases made. This delay of payment is a short term financing called trade credits it contributes to about one third of the short term financing . Requirements for Obtaining Trade Credit Earnings record over a period of time Liquidity position Record of payment Cultivating good supplier relationship

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Benefits Easy availability Flexibility Informality

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Working capital advance by commercial bank

Bank finance are the main institutional sources of working capital finance in India. Bank considers firms sales and production plans and the desirable level of current assets in determining the working capital requirements. The amount approved is called credit limit. In practice banks do not lend 100% of the credit limit they deduct margin money. Margin requirement is meant to ensure security

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Forms of bank finance

Cash credits or overdrafts Loans Purchasing or discounting of bill Letter of credit

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Public deposits

Many firms have solicited unsecured deposits from the public in recent years, mainly to finance their working capital requirements. Advantages To the company The procedure for obtaining public deposits is fairly simple No restrictive covenant (agreement or contract) are involved No security is offered against public deposit

The post-tax cost is fairly reasonable

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To the public Rate of interest is higher than other alternatives The maturity period is fairly short- one to three years Disadvantages To the company The quantum of funds that can be raised by way of public deposit is limited. The maturity period is relatively short To the public No security offered by the company Interest on public deposits is not exempt from taxation
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Inter corporate deposits

A deposit made by one company with another, normally for a period up to six months, is referred to as inter corporate deposit. These are of three types Call deposits: in theory, a call deposit is withdrawable by the lender on a giving a days notice. In practice, however, the lender has to wait for at least three days. The interest rate on these deposits may be around 10% per annum Three months deposit : most popular in practice the interest rate on such deposits is around 12% per annum Six month deposit : normally lending companies do not exceed deposits beyond this time they carry interest rate of around 15% per annum.
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Features Lack of regulation Secrecy Importance of personal contact

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Short term loans from financial institutions

The Life Insurance Corporation of India and the General Insurance Corporation of India provide short-term loans to manufacturing companies with an excellent track record. Features They are totally unsecured and are given on the strength of a demand promissory note. The loan is given for a period of 1 year and can be renewed for two consecutive years After a loan is repaid, the company will have to wait for at least 6 months before availing of a fresh loans

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The loan historically carried an interest rate at 18% per annum this has been lowered in the wake of falling interest rates. However, there is a rebate of 1% for prompt payment, in which case the effective rate comes down accordingly

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Rights debenture for working capital

Public limited companies can issue rights debentures to their shareholders with the object of augmenting the long term resources of the company for working capital requirements. Key guidelines applicable to such debentures The amount of debenture issue should not exceed (a) 20 percent of the gross current assets , loans and advances minus the long term funds presently available for financing working capital, or (b) 20 percent of the paid up share capital, including preference capital and free reserves, whichever is lower of the two The debt : equity ratio , including the proposed debenture issue, should not exceed 1:1 The debenture shall first be offered to the existing Indian resident shareholders of the company on a pro rata basis
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Commercial paper

Commercial paper represents short-term unsecured promissory notes issued by the firms which enjoy a fairly high credit rating. Generally, large firms with considerable financial strength are able to issue commercial paper. Features The maturity period of commercial paper usually range from 90 days to 360 days. Commercial paper is sold at a discount from its face value and redeemed at its face value. Hence the implicit interest rate is a function of the size of discount and the period of maturity. Commercial paper is either directly placed with investors who intend holdings it till its maturity hence there is no well developed secondary market for commercial paper
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Factoring

A factor is a financial institution which offers services relating to management and financing of debts arising from credit sales. While factoring is well established in developed countries like USA and UK. It has extended to number of other countries in recent past including India. Subsidiaries of four Indian banks provide factoring services. Factoring is a unique financial innovation. It is both a financial as well as management support to a client. It is a method of converting a non productive, inactive asset(receivables) into a productive asset (cash) by selling receivables to a company that specializes in their collection and administration
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Features The factor selects the account of the client that would be handled by it and establishes, along with the client, the credit limits applicable to the selected accounts. The factor assumes responsibility for collecting the debt of accounts handled by it. For each account, the factor pays to the client at the end of the credit period or when the amount is received whichever is earlier. The factor advances money to the client against not yet collected or not yet due debts. Typically the amount advanced may be 70 to 80% of the face value of the debt .
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It carries an interest rate which may be equal to or marginally higher then the lending rate of commercial banks. Factoring may be on a recourse basis (that means the credit risk is borne by the client ) or on a non recourse basis ( means credit risk is borne by the factor) Besides the interest on advances against debt the factor charges a commission which may be 1 to 2 percent of the face value of the debt factored

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Bank finance for working capital

Forms of bank finance Cash credits or overdrafts :Under such arrangement a predetermined limit for borrowing is specified by the bank, the borrower can draw as often as required provided it should be in cash credit or overdraft limit. Interest is charged on the amount actually withdrawn. There is no requirement to borrow the entire sanctioned credit at once, rather he can draw periodically to the extent of his requirement. Overdraft have some minimum charges but in cash credit there is no such charge. Cash credit limits are sanctioned against the securities of current assets.
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Loans
These are advances of fixed amount which are credited to the current account of the borrower or released to him in cash. The borrower is charged with interest on the entire amount irrespective of how much he withdraws. Loans are payable either on demand or in periodical installments. When payable on demand, loans are supported by a demand promissory note executed by the borrower. There is often a possibility of renewing the loan.

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Purchasing/discounting of bills

Under the purchase or discounting of bill a borrower can obtain credit from a bank against its bills. The bank purchases or discounts the borrowers bills. The bill may be either clean or documentary. Though the term bill purchased implies that the bank become owner of the bills, in practice bank holds bills as security for the credit.

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Letter of credit Suppliers particularly the foreign suppliers insist that the buyer should ensure that his bank will make the payments if he fails to honour its obligations. This is ensured through a letter of credit arrangement. Bank opens a letter of credit in favor of a customer to facilitate his purchase of goods, if the customer does not pay to the supplier within the credit period the bank makes the payment under the letter of credit arrangement. This arrangement passes the risk of suppliers to the bank. Bank charges the customer for opening the letter of credit. It is an indirect financing.
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Security required in bank finance Hypothecation Under hypothecation, the borrower is provided with working capital finance by the bank against the security of moveable property, generally inventories. The borrower does not transfer the property to the bank and the possession remains with the owner itself. Pledge Under this arrangement, the borrower is required to transfer the physical possession of the property offered as a security to the bank to obtain credit the banker has a right of lien and can retain possession of the goods pledged unless payment of interest , principal and any other expenses is made.
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Mortgage : is the transfer of legal or equitable interest in a specific immovable property for the payment of debt. In this case the possession of the asset will remain with the borrower and the lender getting full legal title. Borrower is called as mortgagor, the bank is called the mortgagee, and the instrument of transfer is called the mortgage deed. Lien : means right of the lender to retain property belonging to the borrower until he repays credit. There are two types of lien particular lien and general lien. Banks usually enjoy general lien.

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1.

Tondon committee recommendations The recommendations of Tondon committee are based on the following notions: Operating plan The borrower should indicate the likely demand for credit. For this purpose he should draw the operating plans for the ensuing year and supply them to the banker. This procedure will facilitate credit planning at the bank level. It will also help the banker in evaluating the borrowers credit needs in a realistic manner and in the periodic follow up during the ensuing year
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2. Production based financing

The banker should finance only the genuine production needs of the borrower. The borrower should maintain responsible level of inventory and receivable. He should hold just enough to carry on his target production. Efficient management of resources should, therefore, be ensured to eliminated slow moving and flabby inventories.

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3.

Partial bank financing The working capital needs of the borrower cannot be entirely financed by the banker. The banker will finance only a reasonable part of it for the remaining the borrower should depend upon his own funds, generated internally or externally.

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Norms for inventory and receivables

In the mid 1970s the RBI accepted the norms for raw materials , stock-in-progress, finished goods, and receivables that were suggested by Tondon committee for fifteen major industries. These norms were based on companies finance studies made by RBI. These norms represent the maximum level for holding inventory and receivables in each period.

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Lending Norms

Maximum Permissible Bank Finance (MPBF) In view of the above approach to bank lending, the committee suggested the following three methods of determining permissible level of bank borrowing: First Method In the first method, the borrower will contribute 25 percent of the working capital gap; the remaining 75 percent can be financed from bank borrowings. This method will give a minimum current ratio of 1:1 MPBF = 0.75 (CA-CL) CA = current assets as per the norms CL = non bank current liabilities like trade credit and provisions
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Second Method In the second method, the borrower contribute 25 percent of the total current assets. 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 1.3:1 MPBF= 0.75(CA)-CL

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Third Method In the third method, the borrower will contribute 100 percent of core assets, as defined and 25 percent 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. MPBF= 0.75(CA-CCA)-CL CCA= core current assets : this represents the permanent component of working capital.

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Working capital financing

Long term financing: the sources of long term financing include ordinary shares capital, preference share capital, debentures, long term borrowings and reserves and surplus. Short term financing: short term financing is obtained for a period less then 1 year. It includes loans from banks, public deposits, commercial papers, factoring of receivables etc.

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Approach

Matching Conservative Aggressive

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Working capital leverage

The term working capital leverage, refers to the impact of level of working capital on companys profitability. Higher level of investment in current assets than is actually required means 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 measures the Responsiveness of ROCE ( return on capital employed) for changes in current assets. It is calculated by using the following formula: Working capital leverage = C.A T.A D.C.A
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C.A= Current Assets T.A= total assets (i.e., net fixed assets +current assets) D.C.A = change in current assets.

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Factors affecting working capital

Nature of business Seasonality of operations Production policy Market conditions Conditions of supply

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