WORKING CAPITAL

1. Concept And Definition Of Working Capital There are two concept of Working Capital : gross and net . a) b) 1. 2. The term gross working capital , also referred to as working capital , means the total current assets . The net working capital can be defined in two ways : The most common definition of net working capital ( NWC ) is the difference between current assets and current liabilities ; and Alternate definition of NWC is that portion of current assets which is financed with long term funds . The task of financing manager in managing working capital efficiently is to ensure sufficient liquidity in the operations of the enterprise . Net working capital , as a measure of liquidity is not very useful for comparing the performance of different firms , but it is quite useful for internal control . The NWC helps in comparing the liquidity of the same firm over time . For the purpose of working capital management , therefore , NWC can be said to measure the liquidity of the firm . In the other words , the goal of working capital management is to manage the current assets and liabilities in such a way that an acceptable level of NWC is maintained . 2. Components Of Working Capital The basic components of working capital are , Current Assets : a) Inventories i) ii) iii) iv) Raw Materials and Components Work in Progress Finished Goods Others

b) Trade Debtors c) Loans And Advances d) Investments e) Cash And Bank Balance

Current Liabilities: a) Sundry Creditors b) Trade Advances c) Borrowings d) Commercial Banks e) Provisions

3. Need For Working Capital Given the objective of financial decision making to maximise the shareholders wealth , it is necessary to generate sufficient profits . The extent to which profits can be earned will naturally depend , among other things , upon the magnitude of sales . A successful sales program is , in other words , necessary for earning profits by any business enterprise . However , sales do not convert into cash instantly ; there is invariably a time lag between sale of goods and the receipt of cash . There is therefore , a need for working capital in the form of current assets to deal with the problem arising out of the lack of immediate realisation of cash against goods sold . Therefore sufficient working capital is necessary to sustain sales activity . Technically this is referred to s operating cycle . The operating cycle can be said to be at the heart of the need for the working capital . In other words the operating cycle refers to the length of time necessary to complete the following cycle of events : a) Conversion of cash into raw materials; b) Conversion of raw materials to inventory ; c) Conversion of inventory into receivables ; d) Conversion of receivables into cash . If it were possible to complete the sequences instantaneously , there would be no need for current assets (working capital) . But since it is not possible , the firm is forced to have current assets . Since the cash inflows and outflows do not match , firms have to necessarily keep cash or invest in short term liquid securities so that they will be in position to meet obligations when they become due . Similarly , firms must have adequate inventory to guard against the possibility of not being able to meet demand for their products . Adequate inventory , therefore, provides a cushion against being out of

stock . If firms have to be competitive , they must sell goods to their customer on credit which necessitates the holding of accounts receivables . It is in these ways that an adequate level of working capital is absolutely necessary for smooth sales activity which , in turn , enhances the owners wealth . 4. Characteristics Of Current Assets In management of working capital two characteristics of current assets must be borne in mind : a) short life span and b) swift transformation into other assets forms . Current assets may have a short life. Cash balance may be held idle for a week or two, account receivables may have a life span of 30 to 60 days , and inventories may be held for 30 days to 100 days . The life span of current assets depend on the time required in the activities of procurement , production , sales and collection and the degree of synchronisation among them . Each current asset is swiftly transformed into other assets forms : cash is used for acquiring raw materials , raw materials are transformed into finished goods ( this transform may involve several stages of work in progress ) ; finished goods , generally sold on credit , are converted into accounts receivable , and finally account receivables on reliasation , generate cash . These two characteristics has certain implications , i) ii) iii) Decisions relating to working capital management are repetitive and frequent The difference between profit and present value is insignificant The close interaction among working capital components implies that efficient management of one component cannot be undertaken without simultaneous consideration of other components .

5. Factors Affecting Working Capital The working capital needs of a firm are influenced by numerous factors . The important ones are
i)

Nature of business : The working capital requirement of a firm is closely related to the nature of business . A service firm , like electricity undertaking or a transport corporation which has a short operating cycle and which sells predominantly on cash basis , has a modest working capital requirement . On

the other hand , manufacturing concern like a machine tools unit , which has a long operating cycle and which sells largely on credit has a very substantial working capital requirement .
ii)

Seasonality of Operation : Firms which have marked seasonality in there operations usually have highly fluctuating working capital requirement . For example , consider a firm manufacturing air conditioners . The sale of air conditioners reaches the peak during summer months and drops sharply during winter season . The working capital need of such a firm is likely to increase considerably in summer months and decrease significantly during winter period . On the other hand , a firm manufacturing consumer goods like soaps , oil , tooth pastes etc. which have fairly even sale round the year , tends to have a stable working capital need .

iii)

Production Policy : A firm marked by pronounced seasonal fluctuation in its sale may pursue a production policy which may reduce the sharp variations in working capital requirements . For example a manufacturer of air conditioners may maintain steady production through out the year rather than intensify the production activity during the peak business season . Such decision may dampen the fluctuations in working capital requirements .

iv)

Market Conditions : When competition is keen , larger inventory of finished goods is required to promptly serve the customers who may not be inclined to wait because other manufacturers are ready to meet their needs . Further generous credit terms may have to be offered to attract customers in highly competitive market . Thus , working capital needs tend to be high because of greater investment in finished goods inventory and accounts receivable . If the market is strong and competition is weak , a firm can manage with smaller inventory of finished goods because customers can be served with delay . Further in such situation the firm can insist on cash payment and avoid lock up of funds in accounts receivables it can even ask for advance payment , partial or total .

v)

Conditions of Supply : The inventory of raw material , spares and stores depends on the conditions of supply . If supply is prompt and adequate , the firm can manage with small inventories . However if the supply is unpredictable and scant then the firm , to ensure continuity of production , would have to acquire stocks as and when they are available and carry large

inventories on an average . A similar policy may have to be followed when the raw material is available only seasonally and production operations are carried out round the year . 6. Operating Cycle Analysis The Operating cycle of the firm begins with the acquisition of raw materials and ends with the collection of receivables . It may be divided into four stages a) raw material and stores storage stage , b) work-in-progress stage , c) finished goods inventory stage and d) debtors collection stage .

Duration of operating cycle : The duration of operating cycle is equal to the sum of the duration of each of these stages less the credit period allowed by the suppliers to the firms . It can be given as O=R+W+F+DC Where O = Duration of operating cycle R = Raw material and stores storage period W = Work-in-progress period F = Finished goods storage period D = debtors collection period C = Creditors payment period

The components of Operating cycle may be calculated as follows ; R = Average stock of raw materials and stores Average raw material and stores consumption per day W = Average Work-in-progress inventory Average cost of production per day F = Average Finished Goods Inventory Average cost of goods sold per day D = Average books debts Average credit sales pert day C = Average trade creditors Average credit purchase per day

7. Computation of Working capital The two components of working capital (WC) are current assets (CA) and current liabilities (CL) . They have a bearing on the cash operating cycle . In order to calculate working capital needs, what is required is the holding period of various types of inventories , the credit collection period and the credit payment period . Working capital also depends on the budgeted level of activity in terms of productivity / sales . The calculation of WC is based on the assumption that the productivity is carried on evenly throughout the year and all costs accrue similarly . As the working capital requirements are related to the cost excluding depreciation and not to the sale price , WC is computed with reference to cash cost . The cash cost approach is comprehensive and superior to the operating cycle approach based on holding period of debtors and inventories and payment period of creditors .

Estimation of Current Assets Raw Material Inventory : The investment in raw materials inventory is estimated on the basis of , Raw material inventory = Budgeted Production ( in units ) X Cost of raw material(s) per unit 12 months / 365 days Work-in-Progress (WIP) Inventory : The relevant costs to determine WIP inventory are the proportionate share of cost of raw materials and conversion costs ( labour and manufacturing overhead costs excluding depreciation ). In case of full unit of raw material is required in the beginning the unit cost of WIP would be higher , i.e. , cost of full unit + 50% of conversion cost , compared to the raw material requirement throughout the production cycle ; WIP is normally equivalent to 50% of total cost of production. Symbolically , Budgeted Production ( in units ) X Estimated WIP cost per unit 12 months / 365 days X Average time span of WIP inventory ( months / days ) X Average inventory holding period ( months/days )

Finished Goods Inventory : Working capital required to finance the finished goods inventory is given by factor as below Budgeted Production ( in units ) X Cost of goods produced per unit ( excluding depreciation ) 12 months / 365 days X Finished goods holding period ( months / days )

Debtors : The WC tied up in debtors should be estimated in relation to total cost price (excluding depreciation) , symbolically Budgeted Credit sale ( in units ) X Cost of sales per unit excluding depreciation 12 months / 365 days Cash and Bank Balances : Apart from WC needs for financing inventories and debtors , firms also find it useful to have some minimum cash balances with them . It is difficult to lay down the exact procedure of determining such an amount . This would primarily based on the motives for holding cash balances of the business firm , attitude of management toward risk , the access to the borrowing sources in times of need and past experience , and so on . Estimation of Current Liabilities The working capital needs of business firms are lower to that extent such needs are met through the current liabilities ( other than bank credits ) arising in the ordinary course of business . The important current liabilities ( CL ) , in this context are , trade creditors , wages and overheads : Trade Creditors : Budgeted yearly Production ( in units ) X Raw material requirement per unit 12 months / 365 days Note : proportional adjustment should be made to cash purchase of raw materials. X Credit period allowed by creditors ( months / days ) X Average debt collection period ( months / days )

Direct Wages : Budgeted yearly Production ( in units ) 12 months / 365 days The average credit period for the payment of wages approximates to a half-a-month in the case of monthly wage payment: The first days wages are , again , paid on the 30 th day of the month , extending credit for 28 days and so in . Average credit period approximates to half-a-month . Overheads ( Other Than Depreciation and Amortisation ) Budgeted yearly Production ( in units ) 12 months / 365 days The amount of overheads may be separately calculated for different types of overheads . In case of selling overheads , the relevant item would be sales volume instead of production volume . X Overhead cost per unit X Average time lag in payment of overheads ( months / days ) X Direct Labour cost per unit X Average time-lag in payment of wages ( months / days )

8. Trade-Off Between Profitability and Risk In evaluating firms net working capital position an important consideration is the tradeoff between profitability and risk . In other words , the level of NWC has a bearing on profitability as well as risk . The term profitability used in this context is measured by profit after expenses . The term risk is defined as the profitability that a firm will become technically insolvent so that it will not be able to meet its obligations when they become due for payment . The risk of becoming technically insolvent is measured using NWC . It is assumed that the greater the amount of NWC , the less risk prone the firm is . Or , the greater the NWC , the more liquid is the firm and , therefore , the less likely it is to become

technically insolvent . Conversely , lower level of NWC and liquidity are associated with increasing level of risk . The relationship between liquidity , NWC and risk is such that if either NWC or liquidity increases , the firms risk decreases . Nature of Trade-Off : If a firm wants to increase its profitability , it must also increase its risk . If it is to decrease risk , it must decrease profitability . The trade-off between these variables is that regardless of how the firm increases profitability through the manipulation of WC , the consequence is a corresponding increase in risk as measured by the level of NWC . In evaluating the profitability-risk trade-off related to the level of NWC , three basic assumptions which are generally true , are a) that we are dealing with a manufacturing firm , b) that current assets are less profitable than fixed assets and c) the short term funds are less expensive than long term funds . Effect of the Level of Current Assets on the Profitability-Risk Trade-Off : The effect of the level of current assets on profitability-risk and trade-off can be shown using the ratio of current assets to total assets . This ratio indicates the percentage of total assets that are in the form of current assets . A change in the ratio will reflect a change in the current assets . It may either increase or decrease . Effect of Increase / Higher Ratio An increase in the ratio of current assets to total assets will lead to a decline in profitability because current assets are assumed to be less profitable than fixed assets . A second effect of the increase in the ratio will be that the risk to technical insolvency would also decrease because the increase in current assets , assuming no change in current liabilities, will increase NWC . Effect of Decrease / Lower Ratio A decrease in the ratio of current assets to total assets will result in an increase in profitability as well as risk . The increase in profitability will primarily be due to the corresponding increase in fixed assets which are likely to generate higher returns. Since the current assets decrease without a corresponding reduction in current liabilities, the amount of NWC will decrease, thereby increasing risk.

Effect of Change in Current Liabilities on Profitability-Risk Trade-off : As in the case of current assets, the effect of change in current liabilities can also be demonstrated by using the ratio of current liabilities to total assets. This ratio will indicate the percentage of total assets financed by current liabilities. The effect of change in level of current liabilities would be that the current liabilities-total assets ratio will either a) increase or b) decrease . Effect of an Increase in the Ratio One effect of the increase in the ratio of current liabilities to total assets would be that profitability will increase. The reason for the increased profitability lies in the fact that current liabilities, which are a short term sources of finance will be reduced. As short term sources of finance are less expensive than long-run sources, increase in ratio will, in effect, means substituting less expensive sources for more expensive sources of financing. There will, therefore, be a decline in cost and a corresponding rise in profitability. The increased ratio will also increase the risk. Any increase in the current liabilities, assuming no change in current assets, would adversely affect the NWC. A decrease in NWC leads to an increase in risk. Thus, as the current liabilities-total assets ratio increases, profitability increases, but so does risk. Effect of a Decrease in the Ratio The consequences of a decrease in the ratio are exactly opposite to the results of an increase. That is, it will lead to a decrease in profitability as well as risk. The use of more long term funds which, by definition, are more expensive will increase the cost; by implication profits will also decline. Similarly, risk will decrease because of the lower level of current liabilities on the assumption that current assets remains unchanged. Combined Effect of Changes in Current Assets and Current Liabilities on Profitability-Risk Trade-off: The combined effects of changes in current assets and current liabilities can be measured by considering them simultaneously. We have seen the effect of decrease in the current assets-total assets ratio and effect of an increase in the current liabilities-total assets ratio. These changes, when considered independently, lead to an increased profitability coupled with a corresponding increase in risk. The combined effect of these

changes should, logically, be to increase over all profitability as also risk and at the same time decrease NWC.

FINANCING WORKING CAPITAL After determining the level of Working Capital, the firm has to decide how it is to be financed. The need for finance arises mainly because the investment in working capital/current assets, that is, raw material, work-in-progress, finished goods and receivables typically fluctuates during the year. Although long-term funds partly finance current assets and provide the margin money for working capital, such working capitals are virtually exclusively supported by short term sources. The main sources of working capital financing are namely, Trade credits, Bank credits and commercial bankers. 1. Trade Credit Trade credit refers to the credit extended by the supplier of goods and services in the normal course of business of the firm. According to trade practices, cash is not paid immediately for purchases but after an agreed period of time. Thus, trade credit represents a source of finance for credit purchases. There is no formal/specific negotiation for trade credit. It is an informal agreement between the buyer and the seller. Such credit appears in the books of buyer as sundry creditors/accounts payable. The most of the trade credit is on open account as accounts payable, the supplier of goods does not extend credits indiscriminately. Their decision as well as the quantum is based on a consideration of factors such as earnings record over a period of time, liquidity position of the firm and past record of payment. Advantages i) ii) iii) iv) It is easily, almost automatically available. It is flexible and spontaneous source of finance. The availability and the magnitude of trade credit is related to the size of operation of the firm in terms of sales/purchases. It is also an informal, spontaneous source of finance.

v)

Trade credit is free from restrictions associated with formal/negotiated source of finance/credit.

2. Bank Credit Bank credit is primarily institutional source of working capital finance in India. In fact, it represents the most important source for financing of current assets. Working Capital finance is provided by banks in five ways :
(a)

Cash Credit / Overdrafts : Under cash credit/ overdraft agreement of bank finance, the bank specifies a predetermine borrowing/credit limit. The burrower can burrow upto the stipulated credit. Within the specified limit, any number of drawings are possible to the extent of his requirements periodically. Similarly, repayment can be made whenever desired during the period. The interest is determined on the basis of the running balance/amount actually utilized by the burrower and not on the sanctioned limit. However, a minimum charge may be payable on the unutilized balance irrespective of the level of borrowing for availing of the facility. This type of financing is highly attractive to the burrowers because, firstly, it is flexible in that although borrowed funds are repayable on demand, and, secondly, the burrower has the freedom to draw the amount in advance as an when required while the interest liability is only on the amount actually outstanding. However, cash credit/overdraft is inconvenient to the banks and hampers credit planning. It was the most popular method of bank financing of working capital in India till the early nineties. With the emergence of the new banking since mid-nineties, cash credit cannot at present exceed 20% of the maximum permissible bank finance (MPBF)/credit limit to any borrower.

(b)

Loans : under this arrangement, the entire amount of borrowing is credited to the current 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 installments. 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. From a modest beginning in the early nineties, at least 80% of MPBF must be in form of loans in India.

(c)

Bills Purchased/Discounted : This arrangement is of relatively recent origin in India. With introduction of the New Bill Market Scheme in 1970 by RBI, bank credit is being made available through discounting of usance bills by banks. The RBI envisaged the progressive use of bills as an instrument of credit as against the prevailing practice of using the widely-prevalent cash credit arrangement for financing working capital. The cash credit arrangement gave rise to unhealthy practices. As the availability of bank credit was unrelated to production needs, borrower enjoyed facilities in excess of their legitimate needs. Moreover, it led to double financing. This was possible because credit was taken form different agencies for financing the same activity. This was done, for example, by buying goods on credit from suppliers and raising cash credit b hypothecating the same goods. The bill financing is intended to link credit with sale and purchase of goods and, thus eliminate the scope for misuse or diversion of credit to other purposes.Before discounting he bill, the bank satisfies itself about the credit worthiness of the drawer and the genuineness of the bill. To popularize the scheme, the discount rates are fixed at lower rates than those of cash credit. The discounting banker asks the drawer of the bill to have his bill accepted by the drawee bank before discounting it. The later grants acceptance against the cash credit limit, earlier fixed by it, on the basis of the borrowing value of stocks. Therefore, the buyer who buys goods on credit cannot use the same goods as a source of obtaining additional bank credit.

The modus operandi of bill finance as a source of working capital financing is that a bill that arises out of a trade sale-purchase transaction on credit. The seller of goods draws the bill on the purchaser of goods, payable on demand or after a usance period not exceeding 90 days. 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. The bill is presented by the bank to the purchaser/acceptor of the bill on due date for payment. The bills can be rediscounted with the other banks/RBI. However, this form of financing is not popular in the country. d) Term Loans for Working Capital : Under this arrangement, banks advance loans for 3-7 years payable in yearly or half-yearly installments.
e)

Letter of Credit : While the other forms of bank credit are direct forms of financing in which banks provide funds as well as bear risk, letter of credit is an indirect form of working capital financing and banks assume only the risk, the credit being provided by the suppliers himself. The purchaser of goods on credit obtains a letter of credit from a bank. The bank undertakes the responsibility to make payment to the supplier in case the buyer fails to meet his obligations. Thus , the modus operandi of letter of credit is that the supplier sells goods on credit/extends credit to the purchaser, the bank gives a guarantee and bears risk only in case of default by the purchaser.

3. Mode of Security
a)

Hypothecation : Under this mode of security, the banks provide credit to borrowers against the security of movable property, usually inventory of goods. The goods hypothecated, however, continue to be in the possession of the owner of these goods (i.e. the borrower ). The rights of the lending bank (hypothecate) depend upon the terms of the contract between the borrower and the lender. Although the bank does not have physical possession of the goods, it has the legal right to sell the goods to realize the outstanding loan. Hypothecation facility is normally is not available to new borrowers.

b) Pledge : Pledge, as a mode of security, is different from hypothecation in that in

the former, unlike in the later, the goods which are offered as security are

transferred to the physical possession of the lender. An, essential perquisite of pledge, therefore, is that the goods are in the custody of the bank. The borrower who offer the security is, called a pawnor (pledgor), while the bank is called the pawnee (pledgee). The lodging of goods by the pledgor to the pledgee is a kind of bailment. Therefore, pledge creates some liabilities for the bank. It must take reasonable care of goods pledged with it. In case of non-payment of the loans, the bank enjoys the right to sell the goods.
c)

Lien : The term lien refers to the right of a part to retain goods belonging to another party until a debt due to him is paid. Lien can be of two types: (i) particular lien, and (ii) general lien. Particular lien is a right to retain goods until a claim pertaining to theses goods is fully paid. On the other hand, general lien can be applied till all dues of the claimant are paid. Banks usually enjoy general lien.

d) Mortgage : It is the transfer of a legal/equitable interest in specific immovable

property for securing the payment of debt. The person who parts with the interest in the property is called mortgagor and the bank in whose favour the transfer takes place is the mortagagee. The instrument of transfer is called the mortgage deed. Mortgage is, thus, conveyance of interest in the mortgaged property. The mortgage interest in the property is terminated as soon as the debt is paid. Mortgage are taken as an additional security for working capital credit b banks.
e)

Charge : Where immovable property of one person is, by the act of parties or by the operation of law, made security for the payment of money to another and the transaction does not amount to mortgage, the latter person is said to have a charge on the property and all the provisions of simple mortgage will apply to such a charge. The provision are as follows: A charge is not the transfer of interest in the property though it is security for payment. But mortgage is a transfer of interest in the property. A charge may be created by the act of parties or by the operation of law. But a mortgage can be created only by the act of parties. A charge need not be made in writing but a mortgage deed must be attested. Generally, a charge cannot be enforced against the transferee for consideration without notice. In a mortgage, the transferee of the

mortgage property can acquire the remaining interest in the property, if any is left. 4. Reserve Bank of India Framework for Regulation of Bank Credit After mid-nineties, the framework for regulation of bank credits has been relaxed permitting banks greater flexibility in tune with the emergence of new banking in the country, focusing on viability and profitability in contrast to the earlier thrust on social/development banking. The notable features of the framework/regulation related to fixation of norms for bank lending to industry. The norms are:
a)

Inventory and Receivable Norms : The norms refer to the maximum level for holding inventories and receivables in each industry. Raw materials were expressed as so many months consumptions; WIP as so many months cost of production; finished goods and receivables as so many months of cost of sales and sales respectively. These norms represent the maximum levels of holding inventory and receivables in each industry. Borrowers were not expected to hold more than that level. The fixation of these norms was, thus, intended to reduce the dependency of industry on bank credit.

b) Lending Norms/Approach to Lending/MPBF : According to the lending norms,

a part of the current assets should be financed by the trade credit and other current liabilities. The remaining part of the current assets, termed as working capital gap, should be partly financed by the owners funds and long term borrowings and partly by short term bank credit. The approach to lending is vitally significant. It takes into account all the current assets requirements of borrowers total operational needs and not merely inventories or receivables; it also takes into account all the other sources of finance at his command. Another merit of the approach is that it invariably ensures a positive current ratio and, thus, keeps under check any tendency to overtrade with borrowed funds.
c)

Forms of Financing/Style of Credit : In 1995, a mandatory limit on cash credit and a loan system of delivery of bank credit was introduced. The cash-credit limit was initially limited to 60% of the MPBF. The balance 40% could be availed of as short term loans. The cash credit limit sanctions are currently 20% and loan component 80%.

d) Information and Reporting System : The main components of the information

and reporting system are four, namely,

Quarterly Information System : Form I. Its contents are (i) production and sales estimates for the current and the next quarter, and (ii) current assets and current liabilities estimates for the next quarter.

Quarterly Information System : Form II. It contains (i) actual production and sales during the current year and for the latest completed year, and (ii) actual current assets and current liabilities for the latest completed quarter.

Half-yearly Operating Statement : Form III. The actual operating performance for the half-year ended against the estimates are given in this.

Half-yearly Operating Statement : Form IIIB. The estimates as well as the actual sources and uses of funds for the half-year ended are given.

5. Commercial Papers 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 a 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. The companies announce current rates of CPs of various maturities, and investors can select those maturities which closely approximate their holding period. When CPs are issued by security dealer on behalf of their corporate customers, they are called dealer paper. They buy at a price less than the commission and sell at the highest possible level. The maturities of CPs can be tailored within the range to specific investments. a) Advantages CP is a simple instrument and hardly involves any documentation. It is flexible in terms of maturities which can be tailored to match the cash flow of the issuer. A well rated company can diversify its sort-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 end-use of funds raised through them. As negotiable/transferable instruments, they are highly liquid.

b) Framework of Indian CP Market The CPs emerged as sources of short-term financing in the early nineties. They are regulated by RBI. The main element of present framework are given below. CPs can be issued for periods ranging between 15 days and one year. Renewal of CPs is treated as fresh issue. The minimum size of an issue is Rs.25 lakh and the minimum unit of subscription is Rs.5 lakh. The maximum amount that a company can raise by way of CPs is 100% of the working capital limit. A company can issue CPs only if it has a minimum tangible net worth of Rs.4 crore, a fund-based working limit of Rs.4 crore or more, at least a credit rating of P2 (Crisil ), A2 ( Icra ), PR-2 ( Care ) and D-2 ( Duff & Phelps ) and its borrowal account is classified as standard asset. The CPs should be issued in the form of usance promissory notes, negotiable by endorsement and deliver at a discount rate freely determined by the issuer. The rate of discount also includes the cost of stamp duty ( 0.25 to 0.5% ), rating charges (0.1 to 0.2%), dealing bank fee ( 0.25% ) and stand by facility ( 0.25% ). The participants/investors in CPs can be corporate bodies, banks, mutual funds, UTI, LIC, GIC, NRIs on non-repatriation basis. The Discount and Finance House of India ( DFHI ) also participates by quoting its bid and offer prices. The holder of CPs would present them for payment to the issuer on maturity.

c) Effective Cost/Interest Yield As the CPs are issued at discount and redeemed at it face value, their effective pre-tax cost/interest yield = { (Face Value Net amount realised) / (Net amount realised) }x{(360) / (Maturity period) }

where net amount realised = Face value discount issuing and paying agent (IPA) charges that is, stamp duty, rating charges, dealing bank fee and fee for stand by facility.

6. Factoring Factoring provides resources to finance receivables as well as facilitates the collection of receivables. Although such services constitute a critical segment of the financial services scenario in the developed countries, they appeared in the Indian financial scene only in the early nineties as a result of RBI initiatives. There are two bank sponsored organisations which provide such services: (i) SBI Factors and Commercial Services Ltd., and (ii) Canbank Factors Ltd. The first private sector factoring company, Foremost Factors Ltd. Started operations since the beginning of 1997.
a) Definition : Factoring can broadly be defined as an agreement in which

receivables arising out of sales or goods/services are sold by a firm ( client ) to the factor ( a financial intermediary ) as a result of which the title of the goods/services represented by the said receivables passes on to the factor. Henceforth, the factor becomes responsible for all credit control, sales accounting and debt collection from the buyer. In a full service factoring concept ( without resource facility ), if any of the debtor fails to pay the dues as a result of his financial inability/insolvency/bankruptcy, the factor has to absorb the losses.
b) Mechanism : Credit sales generate the factoring business in the ordinary course

of business dealings. Realisation of credit sales is the main function of factoring services. Once a sale transaction is completed, the factor steps in to realise the sales. Thus the factor works between the seller and the buyer and sometimes with the sellers bank together.
c)

Functions of a Factor : Depending on the type/form of factoring, the main functions of a factor, in general terms, can be classified into five categories: i) Financing facility/trade debts : The unique feature of factoring is that a factor purchases the book debts of his client at a price and the debts are assigned in favour of the factor who is usually willing to grant advances to extent of, say, 80% of the assigned debts. Where the debts are factored with recourse, the finance

provided would become refundable by the client in case of non-payment of the buyer. However, where the debts are factored without recourse, the factors obligation to the seller becomes absolute on the due date of the invoice whether or not the buyer makes the payment. ii) Maintenance/administration of sales ledger : The factor maintains the clients sales ledger. In addition, the factor also maintains a customer-wise record of payments spread over a period of time so that any change in the payment pattern can be easily identified. iii) Collection facility of accounts receivable : The factor undertakes to collect the receivables on the behalf of the client relieving him of the problems involved in collection, and enables him to concentrate on other important functional areas of the business. This also enables the client to reduce the cost of collection by way of savings in manpower, time and efforts. iv) Credit Control and Credit Restriction : The factor in consultation with the client fixes credit limits for approved customers. Within these limits, the factor undertakes to purchase all trade debts of the customer without resource. In other words, the factor assumes the risk of default in payment by the customer. Operationally, the line of credit/credit limit up to which the client can sell to the customer depends on his financial position, his past payment record and value of goods sold by the client to the customer. v) Advisory Services : These services are a spin-off of the close relationship between a factor and a client. By virtue of their specialised knowledge and experience in finance and credit dealings and access to extensive credit information, factors can provide a variety of incidental advisory services to their clients. vi) Cost of Services : The factors provide various services at a charge. The charge for collection and sales ledger administration is in the form of a commission expressed as a value of debt purchased. It is collected in advance. The commission for short term financing as advance part-payment is in the form of interest charge for the period between the date of advance

payment and the date of collection date. It is also known as discount charge. MANAGING WORKING CAPITAL 1. Cash Management A) Objectives: The basic objective of cash management are two fold: a) to meet the cash disbursement needs and b) to minimise funds committed to cash balances. These are conflicting and mutually contradictory and the task of the cash management is to reconcile them. Meeting Payment Schedule In normal course of business, firms have to make payments of cash on a continuous and regular basis to suppliers of goods, employees and so on. At the same time, there is a constant inflow of cash through collections from debtors. A basic objective of cash management is to meet the payment schedule, that is, to have sufficient cash to meet the cash disbursement needs of a firm. The advantages of adequate cash are : (i) it prevents or bankruptcy , (ii) the relationship with banks is not strained, (iii) it helps in fostering good relations with trade creditors and suppliers of raw materials, as prompt payment may help their own cash management, (iv) a cash discount can be availed of if payment is made within the due date, (v) it leads to a strong credit rating , (vi) to take advantage of favorable business opportunities that may be available periodically, and finally (vii) the firm can meet unanticipated cash expenditure with a minimum of strain during emergencies, such as strikes, fires, or a new marketing campaign by competitors. Keeping large cash balances, however, implies a high cost. Minimising Funds Committed to Cash Balances The second objective of Cash Management is to minimise cash balances. In minimizing the cash balances, two conflicting aspects have to be reconciled. A high level of cash balances will, as mentioned above, ensure prompt payment together with all the advantages. But it also implies that large funds will remain idle, as cash is a non earning asset and the firm will have to forgo profits. A low level cash balances, on the other

hand, may mean failure to meet the payment schedule. The aim of cash management, therefore, should be to have optimal amount of cash balances. Factors Determining Cash Needs
i)

Synchonisation of cash flows : The proper synchronization between the outflows and inflows should be followed . This is possible by adopting cash budget technique. The properly prepared budget will pinpoint the months/periods when the firm will have an excess or a shortage of cash.

ii)

Short Costs : The cash budgets reveals the periods of shortage of cash, but, in addition, there may be some unexpected shortfalls. The expenses incurred as a result of shortfalls is called as Short Costs.

iii)

Excess Cash Balance Costs: The cost of having excessively large cash balances is known as the excess cash balance cost. If large funds are idle, the implication is that the firm has missed opportunities to invest those funds and has thereby lost interest which it would otherwise have earned. This loss of interest is primarily the excess cost.

iv)

Procurement and Management : These are the costs associated with establishing and operating cash management staff and activities. They are generally fixed and are mainly accounted for by salary, storage, handling of securities and so on.

v)

Uncertainty and Cash management : Finally, the impact on cash management strategy is also relevant as cash flows cannot be predicted with complete accuracy.

Cash Budget : Management Tool Cash Budget is the most important tool in cash management. It is the statement showing the estimated cash inflows and cash outflows over the planning horizon. The various purposes of cash budgets are : (i) to co-ordinate the timings of cash needs, (ii) it pinpoints the period when there is likely to be excess cash, (iii) it assists management in taking cash discounts on its account payables, (iv) it helps to arrange needed funds on the most favorable terms and prevents accumulation of excess funds.

Preparation of Cash Budget The principle aim of the cash budget, as a tool is to predict cash flows over a given period of time, and to ascertain whether at any point of time there is likely to be excess or shortage of cash. The first element of cash budget is the selection of the period of time to be covered by the budget. It s referred to as the planning horizon over which the cash flows are to be projected. There is no fixed rule , it varies from firm to firm. The period selected should be neither too long nor too short. If it is too long, it is likely that the estimates will be inaccurate. If, on the other hand, the time span is too small many important events which lie just beyond the period cannot be accounted for and the work associated with the preparation of the budget becomes excessive. If the flows are expected to be stable and dependable, such a firm may prepare a cash budget covering a long period, say, a year and divide it into quarterly intervals. In the case of firms whose flows are uncertain, a quarterly budget, divided into monthly intervals, may be appropriate. If the flows are subjected to extreme fluctuations, even a daily budget may be called for. The idea behind subdividing the budget period into smaller intervals is to highlight the movement of cash from one subperiod to another. The second element of the cash budget is the selection of the factors that have a bearing on cash flow. Items included in cash budget are only cash items; non-cash items like depreciation and amortisation are excluded. The cash budgets are broadly divided into two broad categories: (a)operating later consists of financial cash flows. Operating Cash Flow Operating Cash Flow Items Inflows / Cash Receipts 1. Cash Sales 2. Collection of Accounts Receivables 3. Disposals of Fixed Assets Outflows / Disbursements Accounts payable / Payable payments Purchase of raw materials Wages and Salaries Factory Expenses Administrative and selling expenses and (b) financial. The former includes cash generated by the operations of the firms and are known as operating cash flows, the

1. 2. 3. 4. 5.

6. Maintenance Expenses 7. Purchase of Fixed Assets

Among the operating factors affecting cash flows, are the collection of accounts ( inflows ) and accounts payable ( outflows ). The terms of credit and the speed with which the customer pay would determine the lag between the creation of accounts receivable and their collection. Also, discounts and allowances for early payments, returns from customers and bad debts affect cash inflows. Similarly in case of accounts payable relating to credit purchase, cash outflows are affected by the purchase terms.

Financial Cash Flows Financial Cash Flow Items Cash Inflows / Receipts 1. Loans / Borrowings 2. Sales of Securities 3. Interest received 4. Dividend received 5. Rent received 6. Refund of tax 7. Issue of new shares and securities

1. 2. 3. 4. 5.

Cash Outflows / Payments Income-tax / Tax payment Redemption of loan Repurchase of shares Interest paid Dividend paid

Preparation of Cash Budget After the time span of the cash budget decided and the pertinent operating and financial factors have been identified, the final step is the construction of the cash budget. Thus the total cash inflows, cash outflows and the net receipt or payment is worked out. C) Cash Management : Basic Strategies The cash budget, as a management tool, would throw light on the net cash position of the firm. After knowing the cash position, the management should workout the basic strategies to be employed to manage its cash. The broad cash management strategies are essentially related to the cash turnover process, that is, the cash cycle together with the cash turnover. The cash cycle refers to the process by which the cash is used to purchase materials from which are produced goods, which are then sold to customers, who later pay the bills. The firm receives cash from customers and the cycle repeats itself. The cash turnover means the number of

times the cash is used during each year. The cash cycle involves several steps along the way as fund flows from the firms accounts. Minimum Operating Cash The higher the cash turnover, the less is the cash a firm requires. A firm should, therefore, try to maximize the cash turnover. But it must maintain a minimum amount of operating cash balance so that it does not run out of cash. The basic strategies that can be employed to do the needful are as follows:
i)

Stretching accounts payable : In other words, a firm should pay its accounts payable as late as possible without damaging its credit standing. It should, however take advantage of the cash discount available on prompt payment.

ii)

Efficient Inventory-Production Management : Increase inventory turnover, avoiding stock-outs, that is, shortage of stocks. This can be done in following ways: a) Increasing the raw materials turnover by using more efficient inventory control techniques. b) Decreasing the production cycle through better production planning, scheduling and control techniques, it will lead to an increase in WIP inventory turnover. c) Increasing the finished goods turnover through better forecasting of demand and a better planning of production.

iii)

Speeding Collection of Accounts Receivable : Another strategy for efficient cash management is to collect account receivable as quickly as possible without losing future sales because of high-pressure collection techniques. The average collection period of the receivables can be reduced by changes in (a) credit terms, (b) credit standards, and (c) collection policies.

iv)

Combined Cash Management Strategies : We have seen strategies related to (i) accounts receivables, (ii) inventory, and (iii) accounts receivables but there are certain problems for management . First, if the accounts payable are postponed too long, the credit standing of the firm may be adversely affected. Secondly, a low level of inventory may lead to a stoppage of production as sufficient raw materials may not be available for uninterrupted production, or the firm may be short of enough stock to meet the demand for

its product, that is, stock-out. Finally, restrictive credit standards, credit terms and collection policies may jeopardize sales. These implications should be constantly kept in view while working out cash management strategies.

2. Receivables Management A) Objectives The term receivables is defined as debt owed to the firm by the customers arising from sale of goods or services in the ordinary course of business. When a firm makes an ordinary sale of goods or services and does not receive payment, the firm grants trade credit and creates accounts receivables which could be collected in the future. Receivables management is also called trade credit management. Thus accounts receivable represent an extension of credit to customers, allowing them a reasonable period of time in which to pay for the goods received. The sale of goods on credit is an essential part of the modern competitive economic systems. In fact, the credit sale and, therefore, the receivables, are treated as a marketing tool to aid the sale of goods. As a marketing tool, they are intended to promote sales and obligations through a financial instrument. Management should weigh the benefits as well as cost to determine the goal of receivables management. The objective of receivable management is to promote sales and profits until that point is reached where the return on investment in further funding receivables is less than the cost of funds raised to finance that additional credit. The specific costs and benefits which are relevant to the determination of the objectives of receivables management are examined below.
a)

Costs : The major categories of costs associated with the extension of credit and accounts receivable are (i) Collection Cost : Collection costs are administrative costs incurred in collecting the receivables from the customers to whom credit sales have been made.
(ii)

Capital Cost : The increased level of accounts receivable is an investment in assets. They have to be financed thereby involving a cost. It includes the additional funds required to

meet its own obligation while waiting for payment from its customer and also the cost on the use of additional capital to support credit sales, which alternatively could be profitably employed elsewhere.
(iii)

Delinquency Cost : This cost arises out of the failure of the customers to meet their obligations where payment on credit sales become due after the expiry of the credit period. Such costs are called delinquency costs.

(iv)

Default Costs : Finally, the firm may not be able to recover the overdues because of the inability of the customers. Such debts are treated as bad debts and have to be written off as they cannot be realized. Such costs are treated as default costs associated with credit sales and accounts receivables.

b) Benefits : Apart from the costs, another factor that has a bearing on accounts

receivable management is the benefit emanating from credit sales. The benefits are the increased sales and anticipated profits because of the more liberal policy. The impact of the liberal trade credit policy is likely to take two forms. Firstly, it is oriented to sales expansion. Secondly, the firm may extend credit to protect its current sales against emerging competition. Here, the motive is sales-retention. From the above discussion, it is clear that investments in receivables involve both benefits and costs. The extension of trade credit has a major impact on sales, cost and profitability. Therefore account receivable management should aim at a trade off between profit (benefits) and risk (cost). While it is true that general economic conditions and industry practices have a strong impact on the level of receivables, a firms investment in this type of current assets is also greatly affected by its internal policy. A firm has little or no control over environmental factors, such as economic conditions and industry practices. But it can improves its profitability through a properly conceived trade credit policy or receivables management. B) Credit Policies

In the preceding discussion it has been clearly shown that the firms objective with respect to receivables management is not merely to collect receivables quickly but attention should also be given to the benefit-cost trade-off involved in the various areas of accounts receivable management. The first decision area is Credit Policies. The credit policy of the firm provides the framework to determine (a) whether or not to extend credit to a customer and (b) how much credit to extend. The credit policy decision of firm has two broad dimensions:
(i)

Credit Standards : The term credit standards represents the basic criteria for the extension of credit to customers. The quantitative basis of establishing credit standards are factors such as credit ratings, credit references, average payment period and certain financial ratios. Since we are interested in illustrating the trade-off between benefit and cost to the firm as a whole, we do not consider here these individual components of credit standards. To illustrate the effect, we have divided the overall standards into (a) tight or restrictive, and (b) liberal or non-restrictive. The trade-off with reference to credit standards covers
(a) Collection Costs : The implications of the relaxed credit standards are (i)

more credit, (b) a large credit department to service accounts receivable and related matters, (iii) increase in collection costs. The effect of tightening of credit standards will be exactly the opposite. These costs are likely to be semi-variable.
(b) Investments in Receivables or the Average Collection Period : The

investment in accounts receivable involves a capital cost as funds have to be arranged by the firm to finance them till customer makes payment. Moreover higher the average accounts receivables, the higher is the capital or carrying cost. A change in credit standards-relaxation or tightening-leads to a change in the level of accounts receivable either (i) through a change in sales, or (ii) through a change in collections. A relaxation in credit standards, as already stated, implies an increase in sales which, in turn, would lead to higher average accounts receivable. Further relaxed standards would mean that credit is extended liberally so that it is available to even less credit-worthy customers who will take a longer period to pay overdues. In contrast, a tightening of credit standards would signify (i) a decrease in sales and lower average accounts

receivables, and (ii) an extension of credit limited to more credit-worthy customers who can promptly pay their bills and, thus, a lower average level of accounts receivable. (c) Bad Debt Expenses : Another factor which is expected to be affected by changes in credit standards is bad debt expenses. They can be expected to increase with relaxation in credit standards and decrease if credit standards become more restrictive. (d) Sales Volume : Changing credit standards can also be expected to change the volume of sales. As standards are relaxed, sales are expected to increase; conversely, a tightening is expected to cause a decline in sales. B) Credit Analysis Besides establishing credit standards, a firm should develop procedures for evaluating credit applicants. The second aspect of credit policies of a firm is credit analysis and investigation. Two basic steps are involved in the credit investigation process : (a) Obtaining Credit information : The first step in credit analysis is obtaining credit information on which to base the evaluation of a customer. The sources of information, broadly speaking, are
(i)

Internal : Usually, firms require their customers to fill various forms and documents giving details about financial operations. They are also required to furnish trade references with whom the firms can have contacts to judge the suitability of the customer for credit. This type of information is obtained from internal sources of credit information. Another internal source of credit information is derived from the records of the firms contemplating an extension of credit.

(ii)

External : The availability of information from external sources to assess the credit-worthiness of customers depends upon the development of institutional facilities and industry practices. In India, the external sources of credit information are not as developed as in the industrially advanced countries of the world. Depending upon the availability, the following external sources may be employed o collect information.

Financial Statements : One external source of credit information is the published financial statements, that is, the balance sheet and the profit and loss account. They contain very useful information such as applicants financial viability, liquidity, profitability, and debt capacity. They are very helpful in assessing the overall financial position of a firm, which significantly determines its credit standing.

Bank References : Another useful source of credit information is the bank of the firm which is contemplating the extension of credit. The modus operandi here is that the firms banker collects the necessary information from the applicants bank. Alternatively, the applicant may be required to ask his banker to provide the necessary information either directly to the firm or to its bank.

Trade References : These refer to the collection of information from firms with whom the applicant has dealings and who on the basis of their experience would vouch for the applicant.

Credit Bureau Report : Finally, specialist credit bureau reports from organizations specializing in supplying credit information can also be utilized.

(b) Analysis of Credit Information : Once the credit information has been collected from different sources, it should be analysed to determine the creditworthiness of the applicant. The analysis should cover two aspects:
(i)

Quantitative : The assessment of the quantitative aspects is based on the factual information available from the financial statements, the past records of the firm, and so on. The first step involved in this type of assessment is to prepare an Aging Schedule of the accounts payable of the applicant as well as calculate the average age of accounts payable. This exercise will give an insight into the past payment pattern of the customer. Another step in analyzing the credit information is through a ratio analysis of the liquidity, profitability and debt capacity of the applicant. These ratios should be compared with the industry average. Morever, trend analysis over a period of time would reveal the financial strength of the customer.

(ii)

Qualitative : The quantitative assessment should be supplemented by a qualitative/subjective interpretation of the applicants credit-worthiness. The subjective judgement would cover aspects relating to the quality of management. Here, the reference from other suppliers, bank references and specialist bureau reports would form the basis for the conclusion to be drawn. In the ultimate analysis, therefore, the decision whether to extend credit to the applicant and what amount to extend will depend upon the subjective interpretation of his credit standing.

C) Credit Terms The second decision area in accounts receivables management is the credit terms. After the credit standards have been established and the credit-worthiness of the customer has been assessed, the management of a firm must determine the terms and conditions on which the trade credit will be made available. The stipulations under which goods are sold on credit are referred to as credit terms. The credit terms specifies the repayment terms of receivables. The credit terms have three components : (i) credit period, in terms of duration of time for which trade credit is extended-during this period the overdue amount must be paid by the customer; (ii) cash discount, if any, which the customer can take advantage of, that is, the overdue amount will be reduced by this amount; and (iii) cash discount period, which refers to the duration during which the discount can be availed of. The credit terms, like the credit standards, affect the profitability as well as the cost of a firm. A firm should determine the credit terms on the basis of cost-benefit trade-off. The components of credit are here below: (a) Cash Discount : The cash discount has implications for the sales volume, average collection period/average investment receivables, bad debt expenses and profit per unit. In taking a decision regarding the grant of cash discount the management has to se what happens to these factors if it initiates increase, or decrease in the discount rate. The changes in the discount rate would have both positive and negative effects. The implications of increasing or initiating cash discount are as follows: i. The sales volume will increase. The grant of discount implies reduced prices. If the demand for the products is elastic, reduction in prices will result in higher sales volume.

ii.

Since the customers, to take advantage of the discount, would

like to pay within the discount period, the average collection period would be reduced. The reduction in the collection period would lead to a reduction in the investment in receivables as also the cost. The decrease in the average collection period would also cause a fall in bad debt expenses. As a result, profits would increase. iii. D) Collection Policies The third area involved in accounts receivable management is collection policies. Thy refer to the procedures followed to collect the accounts receivable when, after the expiry o the credit period, they become due. These policies cover two aspects: (i) Degree of Collection Effort : To illustrate the effect of the collection effort, the credit policies of a firm may be categorised into (i) strict / light, and (ii) lenient. The collection policy would be tight if very rigorous procedures are followed. A tight collection policy has implications which involve benefits as well as costs. The management has to consider a trade-off between them. Likewise, a lenient collection effort also affects the cost-benifit trade-off. The effect of tightening the collection is discussed below : Bad debt expenses would decline. The average collection period will be reduced. As a result profit will increase. Increased collection costs. Decline in sales volume. The discount would have a negative effect on the profits. This is because the decrease in prices would affect the profit margins per unit of sale.

The effect of lenient policy will just be the opposite. (ii) Type of Collection Efforts : The second aspect of collection policies relates to the steps that should be taken to collect overdues from the customers. A well established collection policy should have clear-cut guidelines as to the sequence of collection efforts. After the credit period is over and payment remains due, the firm should initiate measures to collect them. The effort should in the beginning be polite, but, with the passage of time, it should gradually become strict. The steps usually taken are (i) letters, including reminders, to expedite payment; (ii) telephone calls for personal contact; (iii) personal visits; (iv) help of collection agencies; and finally,(v) legal action. The firm

should take recourse to very stringent measures, like legal actions, only after all other avenues have been fully exhausted. They not only involve cost but also affect the relationship with the customers. The aim should be to collect as early as possible; genuine difficulties of the customers should be given due consideration. 3. Marketable Securities A) Meaning And Characteristics Once the optimal level of cash balance of a firm has been determined, the residual of its liquid assets is invested in marketable securities. Such securities are short term investment instruments to obtain a return on temporarily idle funds. In other words, they are securities which can be converted into cash in a short period of time, typically a few days. To be liquid, a security must have two basic characteristics: a ready market and safety of principal. Ready marketability minimizes the amount of time required to convert a security into cash. A second determinant of liquidity is that there should be little or no loss in the value of a marketable security over time. Only those securities that can be easily converted into cash without any reduction in the principal amount qualify for short term investments. A firm would be better off leaving the balances in cash if the alternative were to risk a significant reduction in principle. B) Selection Criterion A major decision confronting the financial managers involves the determination of the mix of cash and marketable securities. In general, the choice of the mix is based on a trade-off between the opportunity to earn a return on idle funds during the holding period, and the brokerage costs associated with the purchase and sale of marketable securities. There are three motives for maintaining liquidity and therefore for holding marketable securities: transaction motive, safety motive and speculative motive. Each motive is based on the premise that a firm should attempt to earn a return on temporarily idle funds. An assessment of certain criteria can provide the financial manager with a useful framework for selecting a proper marketable securities mix. These considerations include evaluation of :

(i)

Financial Risk : It refers to the uncertainty of expected returns from a security attributable to possible changes in the financial capacity of the security issuer to make future payments to the security owner. If the chances of default on the terms of the investment is high, then the financial risk is said to be high and vise versa .

(v)

Interest Rate Risks : The uncertainty associated with the expected returns from a financial instrument attributable to changes in interest rates is known as interest rate risk. If prevailing interest rates rise compared with the date of purchase, the market price of the securities will fall to bring their yield to maturity in line with what financial managers could obtain by buying a new issue of a given instrument, for instance, treasury bills. The longer the maturity of the instrument, the larger will be the fall in prices. To hedge against the price volatility caused by interest rate risk, the market securities portfolio will tend to be composed of instruments that mature over short period.

(vi)

Taxability : Another factor affecting observed difference in market yields is the differential impact of taxes. A differential impact on yields arises because interest income is taxed at the ordinary tax rate while capital gains are taxed at a lower rate.

(vii)

Liquidity

: With reference to marketable securities portfolio, liquidity

refers to the ability to transform a security into cash. The financial manager will want the cash quickly and will not want to accept a large price reduction in order to convert the securities. (viii) Yield : The final selection criterion is the yields that are available on the different financial assets suitable for inclusion in the marketable portfolio. All the four factors listed above, influence the available yields on financial instruments. The finance manager must focus on the riskreturn trade-offs associated with the four factors on yield through his analysis. Marketable Security Alternatives
i)

Treasury Bills : There are obligations of the government. They are sold on a discount basis. The investor does not receive an actual interest

payment. The return is the difference between the purchase price and the face value of the bill. The treasury bills are issued only in bearer form. They are purchased, therefore, without the investors name on them. As the bills have the full financial backing of the government, they are, for all practical purposes, risk-free.
ii) Negotiable Certificates of Deposits : These are marketable receipts for

funds that have been deposited in a bank for a fixed period of time. The deposit funds earn a fixed rate of interest. The CDs are offered by banks on a basis different from treasury bills, that is, they are not sold at discount. When the certificate mature, the owner receives the full amount deposited plus the earned interest.
iii) Commercial Paper : It refers to short-term unsecured promissory note sold

by large business firms to raise cash. As they are unsecured, the issuing side of the market is dominated by large companies which typically maintain sound credit rating. Commercial paper can be sold either directly or through dealers. Companies with high credit ratings can sell directly to the investors. They can even be purchased with varying maturities. For all practical purposes, there is no active trading in secondary market for commercial papers although direct sellers of CPs often repurchase it on request.
iv) Bankers Acceptances : These are draft (order to pay) drawn on a specific

bank by an exporter in order to obtain payment for goods he has shipped to a customer who maintains an account with that specific bank. They can also be used in financing domestic trade. The draft guarantees payment by the accepting bank at a specific point of time. The seller who holds such acceptance may sell it at a discount to get immediate funds. They serve the wide range of maturities and are sold on a discount basis, payable to the bearer.
v) Repurchase Agreements : These are legal contracts that involves the actual

sale of securities by a borrower to the lender with a commitment on the part of the former to repurchase the securities at the current price plus a stated interest charge. The securities involved are government securities and other money market instruments. The borrower is either a financial institution or a security dealer.

vi) Units : The units of Unit Trust of India (UTI) offers a reasonably convenient

alternative avenue for investing surplus liquidity as (i) there is a very active secondary market for them, (ii) the income for units is tax-exempt up to a specified amount and, (iii) the units appreciate in a fairly predictable manner.
vii) Intercorporate Deposits : Intercorporate deposits, that is, short-term

deposits with other companies is a fairly attractive form of investment of short-term funds in terms of rate of return which currently ranges between 12 and 15 per cent. However, apart from the fact that one months time is required to convert them into cash, intercorporate deposits suffers from high degree of risk.
viii) Bill Discounting : Surplus funds may be developed to purchase/discount

bills. Bills of exchange are drawn by seller on the buyer for the value of goods delivered to him. If the seller is in need of funds, he may get the bills discounted. Bill discounting is superior to intercorporate deposits for investing surplus funds.
ix) Call market : It deals with funds borrowed/lent overnight/one-day (call)

money and notice money for periods up to 14 days. It enables corporates to utilize their float money gainfully. However the returns are highly volatile. The stipulations pertaining to the maintenance of cash reserve ratio (CRR) by banks is the major determinant of the demand of funds and is responsible for volatility in call rates. Large borrowings by them to fulfill their CRR requirements pushes up the rates and a sharp decline takes place once these funds are met.

4. Inventory Management A) Objectives

The basic responsibility of the financial manager is to make sure the firms cash flows are managed efficiently. Efficient management of inventory should ultimately result in the maximization of the owners wealth. As we know that in order to minimise cash requirements, inventory should be turned over as quickly as possible, avoiding stockouts that might result in closing down the production line or lead to a loss of sales. It implies that while the management should try to pursue the financial objective of turning inventory as quickly as possible, it should at the same time ensure sufficient inventories to satisfy production and sales demands. The objective of inventory management consists of two counterbalancing parts: (i) to minimise investment in inventory, and (ii) meet a demand for the product by efficiently organizing the production and sales operations. These two conflicting objectives of inventory management can also be expressed in terms of cost and benefit associated with inventory. That the firm should minimise investment in inventory implies that maintaining inventory involves costs, such that the smaller the inventory, the lower is the cost to the firm. But inventories also provide benefits to the extent that they facilitate the smooth functioning of the firm: the larger the inventory, the better it is from the viewpoint. Obviously, the financial managers should aim at a level of inventory which will reconcile these conflicting elements. That is to say, an optimum level of inventory should be determined on the basis of the trade-off between costs and benefits associated with the levels of inventory. B) Costs of Holding Inventory One operating objective of inventory management is to minimise cost. Excluding the cost of merchandise, the cost associated with inventory fall into two basic categories:
(i)

Ordering or Acquisition or Set-up costs : This category of cost is associated with the acquisition or ordering of inventory. Firms have to place orders with suppliers to replenish inventory of raw materials. The expense involved are referred to as ordering costs. The ordering costs consist of (a) preparing the purchase order or requisition form and (b) receiving, inspection, and recording the goods received to ensure both quantity and quality. The cost of acquiring materials consists of clerical costs and costs of stationery. It is therefore, called, a set-up cost. They are generally fixed per order placed, irrespective of the amount of the order. The acquisition costs are inversely related to the size of inventory: they decline with the inventory. Thus, such costs can be minimised

by placing fewer orders for a large amount. But acquisition of a large quantity would increase the cost associated with the maintenance of inventory, that is, carrying cost.
(ii)

Carrying costs : The second broad category of costs associated with inventory are the carrying costs. They are involved in maintaining or carrying inventory. The cost of holding inventory may be divided into two categories: (a) Those that arise due to the storing of inventory : The main components of this category of carrying costs are (1). Storage costs, that is, tax, depreciation, insurance, maintenance of the building, utilities and janitorial services; (2). insurance of inventory against fire and theft; (3). Deterioration in inventory because of pilferage, fire, technical obsolescence, style obsolescence and price decline; (4). Serving costs, such as, labour for handling inventory, clerical and accounting costs. (b) The opportunity cost of funds : This consists of expenses in raising funds (interest on capital) to finance the acquisition of inventory. If funds are not locked in inventory, they would have earned a return. This is the opportunity cost of funds or financial cost component of the cost. The carrying costs and the inventory size are positively related and move in the same direction. If the level of inventory increases, the carrying costs also increase and vice versa. The sum of the order and carrying costs represents the total cost of inventory. This is compared with the benefits arising out of inventory to determine the optimum level of inventory.

C) Benefits of Holding Inventory The second element in the optimum inventory decision deals with the benefits associated with holding inventory. The three types of inventory, raw materials, work-inprogress and finished goods, perform certain useful functions. The rigid tying (coupling) of purchase and production to sales schedules is undesirable in the short run as it will

deprive the firms certain benefits. The effect of uncoupling (maintaining inventory) are as follows
(i)

Benefits in Purchasing : If the purchasing of raw materials and other goods is not tied to production/sales, that is, a firm can purchase independently to ensure the most efficient purchase, several advantages would become available. In the first place, a firm can purchase larger quantities than is warranted by usage in production or the sales level. This will enable it to avail of discounts that are available on bulk purchases. Moreover, it will lower the ordering cost as fewer acquisitions would be made. There will, thus, be a significant saving in the costs. Secondly, firms can purchase goods before anticipated or announced price increases. This will lead to a decline in the cost of production. Inventory, thus, serves as a hedge against price increases as well as shortages of raw materials. This is highly desirable inventory strategy.

(ii)

Benefits in Production : Finished goods inventory serves to uncouple production and sale. This enables production at rate different from that of sales. That is, production can be carried on at a rate higher or lower than the sales rate. This would be a special advantage to firms with seasonal sales pattern. In their case, the sales rate will be higher than the production rate during the part of the year (peak season) and lower during the off season. The choice before the firm is either to produce at a level to meet the actual demand, that is, higher production during peak season and lower (or nil) production during off-season, or, produce continuously throughout the year and build up inventory which will be sold during the period of seasonal demand. The former involves discontinuity in the production schedule while the later ensures level production. The level production is more economical as it allows the firm to reduce the cost of discontinuities in the production process. This is possible because excess production is kept as inventory to meet future demands. Thus, inventory helps a firm to coordinate its production scheduling so as to avoid disruption and the accompanying expenses. In brief, since inventory permits least cost production scheduling, production can be carried on more efficiently.

(iii)

Benefits in Work-in-Progress : The inventory in Work-in-Progress performs two functions. In the first place, it is necessary because production processes

are not instantaneous. The amount of such inventory depends upon technology and efficiency of production. The larger the steps involved in the production process, the larger the WIP and vice versa. By shortening the production time, efficiency of the production process can be improved and the size of this type of inventory reduced. In a multi-stage production process, the WIP serves a second purpose also. It uncouples the various stages of production so that all of them do not have to be performed at the same time rate. The stages involving higher set-up costs may be most efficiently performed in batches with WIP inventory accumulated during a production run.
(iv)

Benefits in Sales : The maintenance in inventory also helps a firm to enhance its sales efforts. For on thing, if there are no inventories of finished goods, the level of sales will depend upon the level of current production. A firm will not be able to meet demand instantaneously. The inventory serves to bridge the gap between current production and actual sales. A basic requirement in a firms competitive position is its ability vis--vis its competitor to supply goods rapidly. If it is not able to do so, the customer are likely to switch to suppliers who can supply goods at short notice. Moreover, in the case of firm having a seasonal pattern of sales, there should be a substantial finished goods inventory prior to the peak sales season. Failure to do so may mean loss of sales during the peak season.

To summarise the preceding discussion relating to objective of inventory management, the two main aspects pertain to the minimisation of investment in inventory, on the one hand, and the need to ensure that there is enough inventory to meet demand such that production and sales operations are smooth. By holding less inventory, the cost can be minimized, but there is a risk that the operations will be disturbed as the emerging demands cannot be met. On the other hand, by holding a large inventory, the chances of disruption of operations are reduced, but, the cost will increase. The appropriate level of inventory should be determined in terms of a trade-off between the benefits and cost associated with maintaining inventory. D) Techniques

There are many sophisticated mathematical techniques available to handle inventory management problems. We will discuss some of the simple production-oriented methods of inventory control to indicate a broad framework for managing inventories efficiently in conformity with the goal of wealth maximization. The major problem areas that comprise the heart of inventory control are (i) Classification Problem : A B C System The A B C System is a widely used classification technique to classify different types of inventories and to determine the type and degree of control required for each. This technique is based on the assumption that a firm should not exercise the same degree of control on all items of inventory. It should rather keep a more rigorous control on items that are (a) the most costly, and/or (b) the slowest-turning, while items that are less expensive should be given less control effort. On the basis of the cost involved, the various inventory items are classified into three classes A, B and C. The items included in group A involves largest investment. Inventory control for such items must be most rigorous and intensive and most sophisticated inventory control techniques should be applied to these items. The C group item consists of items of inventory which involve relatively small investments although the number of items is fairly large. These items deserve minimum attention. The B group stands midway. It deserves less attention than A but more than C. It can be controlled by less sophisticated technique. (ii) Order Quantity Problem : Economic Order Quantity ( EOQ ) Model After determining the type of controls for each categories of items ( A B and C ), question arises regarding the appropriate quantity to be purchased in each lot to replenish the stock. Buying a large quantity implies a higher average inventory level which will assure (a) smooth production/sales operations, and (b) lower ordering or setup costs. But it will involve higher carrying costs. On the other hand, if the order quantity is small then the carrying cost is reduced but it will increase the ordering costs. On the basis of the trade-off between the both the optimum level of order to be placed should be determined. The optimum level of inventory is called as economic order quantity (EOQ). The economic order quantity can be defined as that level of inventory order that minimises the total cost associated with inventory management.

Assumptions : EOQ model is based on following assumptions: the firm knows with certainty the annual consumption of a particular item of inventory. The rate at which the firm uses inventory is steady over time. The order placed to replenish inventory stocks are received at exactly that point in time when inventories reach zero. There are two distinguishable costs associated with inventories: cost of ordering and cost o carrying. Cost of order is constant regardless of the size of the order. The cost of carrying is fixed percentage of the average value of inventory.

EOQ Formula : EOQ = I 2FU PC

where U = annual sales F = fixed cost per order P = purchase price per unit C = Carrying cost Limitations :
-

The assumption of constant consumption and the instantaneous replenishment of inventories are of doubtful validity. It is possible that deliveries from suppliers may be slower than expected for reasons beyond control. It is also possible that there may be an unusual and unexpected demand for stocks. To meet such contingencies additional stock called as safety stock is kept.

Another weakness of EOQ model is that the assumption of a known annual demand for inventories is open to question. There is likelihood of discrepancy between the actual and the expected demand, leading to a wrong estimate of the economic ordering quantity.

In addition, there are some computation problems involved. A more difficult situation may occur when the number of orders to be placed may turn out to be a fraction.

A Case Study On SIEMENS LTD :

The present study seeks to analyse the working capital management with a case study of a noted company in the capital goods industry, viz. Siemens Ltd. The case study aims at examining in the context of the published figures of the accounting statements how far the management of WC has been successful in case of Siemens during period 1997 to 2001.

Siemens Ltd. is a leading electrical and electronics engineering company in India. Established in 1922, it was incorporated as a company in 1957 and in 1962 was converted into a public limited company with 51% of its equity held by Siemens AG and the remaining 49% held by Indian shareholders. It operates in the energy, industry, health care, transportation, information, communications and components business segments It also operates joint ventures in the fields of

telecommunications and information technology. In addition, Siemens Group in India has presence in the field of Power Design, Renovation & Modernisation of existing power plant, Lighting, and Household goods. The Siemens Group in India has a widespread marketing and distribution network in addition to multiple manufacturing facilities in India. It also has a well organised up-market value addition in Engineering, Software, System Integration, Erection, Commissioning and Customer Services

General Performance Review The first recession of the new millennium has set in. Most indicators suggest that the Indian economy is running out of steam. The uncertainty of its revival has cast a shadow on the prospects of a 6.5% GDP growth rate for the current fiscal. Consequently, the Central Statistical Organization has scaled down GDP growth for 2000-01 to 5.2% This makes it the third worst growth rate since 1991-92. In the Infrastructure area, the Power Generation sector continued to experience a sluggish growth for the 6th consecutive year, with a meager 4,000 MW being added to the installed capacity last year. The issue of payment security as offered by the State Electricity Boards has put investors on high caution. As part of power sector reforms, the Governments focus on the Power Transmission and Distribution (T&D) sector, generated a higher demand in the High Voltage and Metering businesses. Reduced budgetary support to Railways put new projects on hold, with emphasis shifting to areas such as safety. Siemens too experienced similar trends, with Power Generations order inflow contracting, although the Power Plant Automation and High Voltage business witnessed higher growth than other segments. Transportation Systems business volume too remained steady. Despite the difficult environment, these businesses have posted satisfactory results. The Industrial segment continued to remain stagnant due to the lack of fresh investments. In the first four months of 2001-02 (April July 2001), industrial production grew by only 2.3% as compared to 5.9% during the same period of the previous year. Overall, the market characteristics changed to smaller sized orders, while the industry

continued to experience price cut-backs due to competitive forces. In order to combat the pressures, several key players in this segment were engaged in restructuring their businesses in order to optimize capacities and reduce costs. Besides, as a consequence of lower demand, new projects suffered. Yet, in this lackluster market, Siemens succeeded in gaining market shares in most areas, while improving its overall profitability position through the launch of innovative products, systems, solutions and services, as well as an improved cost structure. One area that remains of high concern is the Low Voltage Distribution Systems, which is saddled with excess capacity. Siemens overall market and customer focus approach saw it launch numerous innovative products, systems, solutions and service. This enabled it to attain an increased market share. At the same time, improved productivity and effective asset management, gave the Company a better cost structure, which boosted its bottom-line. While the top-line has remained steady, the Company substantially improved the quality of its results, bringing it further to a healthier and more stable position. Energy Power Generation In the last year, Power Generation in India continued to experience sluggish growth, which saw a meager 4,000 MW being added to the installed capacity. In the wake of the continued slow pace of reforms, no major projects took off the ground, considerably affecting the new order inflow position. Issues surrounding the payment security as offered by the State Electricity Boards (SEBs) have additionally acted as deterrents putting investors on high caution. The Power Generation Divisions business was therefore impacted due to the declining market conditions. While New Order intake and turnover overall declined by 23% and 28% respectively as compared to the previous year, the Divisions export business volume witnessed a two-fold increase. The Division posted a healthy margin, with the Automation group being a major contributor to the profitability, which also gained substantial market share. In the last year, the Division signed an agreement with Instrumentation Ltd., Kota, a public sector enterprise, to address the power plant automation needs of SEBs and Central Power Sector Utilities. In keeping with its policy to continually provide enhanced

value, the Division launched new automation solutions that have met with considerable success. The introduction of new technologies and innovative customer-centric strategies supported its increased market penetration. In the area of service, the Division has launched new initiatives, which included a Call Center concept to ensure round-theclock connectivity with customers. It also received its first comprehensive C&I maintenance contract worth Rs. 8 million from DVC Mejia. Some of the other important orders received last year include those bagged by the Divisions Automation Group for the Renovation & Modernisation of WBSEB Santaldih valued at Rs 45 million and captive power plant units of Hindalco, Renusagar (2x84 MW) valued at Rs. 71 million. In addition the Service Groups too, received significant orders from Paguthan (655 MW CCPP) and Reliance for a 25 MW Replacement Turbine at Patalganga. Outlook: In the backdrop of the continued slow pace of reforms and the long gestation period for the benefits to be realized, this sector is expected to remain stagnant for the current year. The scaling down of the power capacity addition from 40,000 MW to 20,000 MW in the Ninth Five-Year Plan period (1997-2001) is a further dampener to the much-needed progress. While the Union Budget 2001 has not provided any major relief to the IPPs, it is expected that captive power generation and co-generation will see some growth. The Power Generation Divisions focus will continue to be the same as in the last year with added thrust on providing newer technologies to various areas, like steam generation for thermal power plants. It intends to step up providing comprehensive services by enhancing its all-India network and providing maximum benefits to its customers Energy Power Transmission and Distribution Division The Transmission and Distribution (T&D) sector emanated mixed signals last year. Identification of T&D as a priority sector, with the Governments plans to invest Rs 400 million over three years, is a positive sign. On the other hand, the poor financial state of the State Electricity Boards (SEBs), continues to hinder growth. Overall, the T&D market

has a CAGR of 5%, with below average growth in the medium voltage and transformer segments, and above average growth in the high voltage and automation segments. During the last fiscal, the Division introduced new products such as the 36kV Air Insulated metal-clad Switchgear as well as the low-cost numerical relays targeted at the Industry and Utilities segment. It also ventured into a new business area, that of protection systems for high-capacity generators. In a significant development, the Division was awarded market development responsibilities in eight more Asian and African countries by Siemens AG. It also signed a Technical Collaboration agreement with a Switchboard manufacturer abroad to promote exports.. Some major orders bagged by the Division in the last year include those from Karnataka Power Transmission Corporation Ltd (KPTCL) and Haryana Vidyut Prasarak Nigam Ltd (HVPNL) for HV Switchgear worth Rs 392 million and Rs 287 million respectively. It also procured an order worth Rs 80 million from MSEB for Energy Management systems. The Division has successfully executed orders from KPTCL and Gridco notched in the previous fiscal. Outlook: With T&D emerging as a priority sector, increase in demand for substations, transmission lines and metering equipment is expected to provide greater business opportunities in which the Division looks forward to being a key participant. While enhancing its dominance as a major T&D player in India, it has in the offing new initiatives in the area of Energy Management Systems. The Division will increase its presence in the overseas market through a higher thrust in export business. In order to stem losses and return back to profitability, the Division will undertake restructuring measures entailing resource adjustments across all processes, particularly in the manufacturing area. Industry Automation & Drives The Industry segment, as a whole, witnessed a downward trend during the last fiscal, mainly due to the substantial drop in new investments. A major portion of the Standard Products Divisions (A&D) business is triggered as a result of such investments, as well as from the maintenance sector, both of which have remained sluggish during the last fiscal. To remain afloat in the difficult competitive environment, several leading

companies in this segment to which A&D caters, focused attention on restructuring, rather than enhancing business. Outlook: The market in which A&D operates is expected to remain stagnant in the year ahead. In order to strengthen its position in this situation, the Division is working on strategies for increasing sales through an increased presence in unserved market and will introduce new offerings in Motors, Generators and Drives. It is investing in improving service levels and will review processes so as to reduce cycle time, and costs. Industrial Solutions & Services Division Recessionary trends in the Indian economy dampened business sentiment in the investment dependent industrial sector. During the last fiscal, the capital goods sector of the industry continued its downward slide due to paucity of new investments and in the first four months of 2001-02 (Apr July 2001), it shrunk by 6.1%, compared to a growth of 4.5% during the corresponding period of the previous year. Outlook: With the decline in new investments in the industrial sector and sections of industry shifting focus on restructuring operations, the market sentiments are expected to remain dampened. Under the circumstances, the Division foresees a challenging year ahead, specially since realizations from industrial projects usually have long gestation periods. Low Voltage Distribution Systems At present, the low voltage distribution industry in India suffers from excessive manufacturing capacity due to the presence of a large number of players and dwindling demand as a result of the depressed market conditions. In its endeavor to make operations viable, the Division has proposed to introduce several measures. This includes an offer of alternative jobs to its workers at Siemens Metering, a plant in the neighborhood. This process of implementation has seen some delays resulting in the unit making even more production losses, thus affecting the overall result. Outlook: The market conditions are expected to remain depressed, with the prices witnessing a further drop due to competitive forces. Under the present circumstances, the Divisions business outlook is not very encouraging and it will have to undertake

some major actions to make the operations viable. Therefore, the Divisions major objective during the new fiscal is to bring the business back into the black with a new approach. Healthcare Medical Solutions Division The Indian healthcare market grew at about 15% with cardiology, oncology and high-end diagnostics being the key growth areas in the metro centers and routine imaging and critical care equipment in the non-metros. The entry of private healthcare service providers had a catalytic influence in offering world-class medical diagnostic and treatment facilities. These positive trends fueled business opportunities for the Medical Solutions Division. Outlook: The outlook for the Healthcare sector in India looks highly positive. Sizable investments are expected to be made by private players for setting up corporate hospitals and diagnostic centers Transportation Transportation Solutions Division In the face of the severe resource crunch over the last two years, the Indian Railways have put new investment programs on hold. Barring wagons, procurement of all rolling stock items such as EMUs, Metro Coaches, Diesel & Electric Locomotives have been curtailed and there are no fresh projects in the pipeline. Outlook: Indian Railways' emphasis on safety improvements will see higher investments in this segment in the future with a projected 11% growth in Signalling and 18% growth in miscellaneous electricals. To retain its leadership position, the Division will seek out opportunities that may so arise and will also venture into newer segments such as rolling stock upgradation, multiple units etc. Information & Communication Enterprise Networks

The Information & Communication Enterprise Networks (ICN EN) Division, after a slow start during the first quarter, had a successful fiscal year registering a 15% growth in line units versus the previous fiscal year. It made a substantial recovery from the second half onwards with a strong sales momentum that resulted in a modest increase in revenues by 6% over the previous year. . Outlook: The Indian enterprise telecommunication market is poised to grow at 18 20% in the current year. The migration to Voice over IP (VOIP) technology, drop in tariffs for long distance calls, availability of leased lines at competitive rates, growth in the service industry with attendant boost in the call center market, are some key factors that are expected to drive growth in the data, voice and video usage. Information & Communication Mobile Phones The Information and Communication Mobile Phones Division (ICM MP), has achieved a commendable 147% growth in sales units during the last fiscal. Correspondingly, revenues surged by 89% as a result of the Divisions aggressive sales and marketing efforts. Demand for mobile phones in India is being increasingly fueled by preference for lifestyle-oriented brands, rather than technology and features. In keeping with this trend, in the last year, ICM launched two new models, the A35 at the lower end and the SL 45 at the higher end. SL45, a technological revolution with a built-in MP3 player and a 32-bit multimedia card, enables the user to listen to high-quality music. It is positioned as a lifestyle accessory for the status-conscious. The A35, being one of the smallest and lightest phones, is particularly attractive for the youth segment. Outlook: In the current fiscal, the mobile phones market is expected to grow by nearly 70%. To meet the increased demand, ICM will increase retail visibility, strengthen distribution network and further intensify its dealer development program to increase sales at point-of-sale in major cities in India. It would also concentrate on continued brand building efforts through the Siemens Inspired Dealers program and Siemens Shop-in-Shop program. Information & Communication

Siemens Information Systems Limited The Indian software sector, which saw a phase of rapid growth in the last decade, has begun to experience the effects of the global economic slowdown. Globally and in India, the industry has witnessed a downward trend that began in the last quarter of FY 2000, and in 2001, experienced its full impact. Outlook: The current fiscal would continue to be tough for the software development sector. In partnership with Siemens Business Systems, SISL expects to grow in the Europe & AsiaPacific regions. The company also plans to improve its EVA through better payment collection. Outlook for Siemens Ltd. In the backdrop of continued economic slowdown, the infrastructure and industry sectors in India are expected to remain stagnant. Even if there is a pick-up, its effects will be evident anywhere between six months to one year in time lag. While the scaling down of the power capacity addition from 40,000 MW to 20,000 MW in the 9th five year plan period (1997-2001) has retarded growth in this sector, it is expected that captive power generation and co-generation will pickup, providing opportunities for Siemens. Power Transmission & Distribution is emerging as a priority sector in India and if the issues surrounding payments and financing are resolved, this segment is expected to see an increased demand for substations, transmission lines and metering equipment. If this happens, Siemens expects to garner business opportunities as a key participant in the development of this sector. The low voltage distribution industry in India is suffering from over capacity and so is the Siemens manufacturing unit at Joka, Kolkata. In order to make the operations of this unit viable, the Company plans to initiate further actions to streamline and optimize resources The telecommunications sector, in particular for Enterprise Networks, is on the upswing. New business opportunities continue to emerge in this sector, with the hospitality and corporate sector showing stronger growth. Siemens plans to strengthen sales channels to take advantage of this growth potential. In the fast growing mobile phones business, Siemens plans to focus on increased retail visibility through special programs,

strengthen the distribution network and further intensify its channel sales to boost pointof-sale volumes in major Indian cities. The entry of corporate healthcare service providers and opening up of the healthcare insurance sector to private players will make access to healthcare services easier and provide the much-needed fillip to this sector. Here, Siemens is strongly poised to leverage these emerging opportunities and plans to launch top-of-line products and services, as called for by the market.

Audited Balance Sheet Of Siemens LTD Table 1

S.R. No. Particulars Year Year Year Year Year ended ended ended ended ended 30.9.01 30.09.00 30.09.99 30.09.98 30.09.97 (12 mts) ( 12 mts ) ( 12 mts ) ( 12 mts ) ( 18 mts )

Net Sales & Services (excluding Excise Duty) Lease and Other Income Total Expenditure Operating Profit before Interest & Depreciation Interest Gross Profit/Loss(-) after Interest but before Depreciation Depreciation

11572.8

10832.75 10505.88

9959.3

17514.1

2 3

778.74 10962

896.39

715.06

525.2

461.9 16807.7

10573.94 10235.21 9680.67

4 5

1389.3 17.12

1155.2 48.85

985.73 278.2

803.83 466.02

1168.3 1243.1

1372.18

1106.35

707.53

337.81

-74.8

294.58

315.01

358.08

472.76

724.4

Profit / Loss(-) before Exceptional items and Tax Adjustment

1077.6

791.34

349.45

-134.95

-799.2

9 10 11 12

Exceptional items Tax Adjustment NetProfit/Loss(-) Paid up Equity Share Capital

-113.37 -236.43 687.21 336.27

154.86 106.16 840.04 354.94

31.55 29.8 351.2 283.97

-331.87 -93.41 -560.23 283.97

-924.6 -37.5 -1556.3 284

13

Reserves excluding revaluation reserves

2873.69

2480.82

591.13

1173.77

1188.9

2. Objectives of the Study The objective of the study is to make a comprehensive analysis of Working Capital Management of the company . Specifically the objectives are : i) ii) To find out the size of Working Capital ( WC ) and to measure its liquidity and the operational efficiency by using ratio analysis . To ascertain the estimated WC needs by fitting linear regression line , to find out the degree of association between the estimated and the actual WC by competing simple correlation coefficient and to test the significance of such coefficient . iii) To make element-wise analysis of WC and to identify the elements / components responsible for variation in WC . 3. Methodology of Study The methods or the techniques which have been used for collection and analysis of data in this study are as follows : (i)
(ii)

Collection of Data : The data of SL for the period 1997 to 2001 used in this study has been collected from the Annul Reports for the years 1997 to 2001. Analysis of Data : For analysing the data the technique of ratio analysis , simple mathematical tools like percentages and averages etc. and simple statistical technique like Simple Correlation Technique have been used .

Findings of the study with detailed discussion The observations on the findings of the study are as follows : A. The size of WC and some liquidity and efficiency ratios of Siemens for the period of study have been depicted in Table2 and 3. For this purpose , Gross Working Capital ( GWC ) Concept is followed . The amount of GWC decreased from 729.6 crores in 1998 to 472.86 crores in 2000 showing a decrease of 35.2 %t . This quantitative comparison is not sufficient to judge the efficiency of the WCM . For this reason , liquidity analysis and analysis of operational efficiency have been done to assess the quantitative efficiency of the WCM of the company by computing the following ratios .

( 55 )

I.

Liquidity Analysis :

Liquidity ratio
Table 2

S.R.No
1 2 3 4 5
(i)

Particulars
Quick Ratio Current ratio Debt equity Ratio PBDIT / Interest Interest Incidence

1998
0.40 0.85 1.99 0.47 31.84

1999
0.35 0.93 1.25 0.37 17.85

2000
0.42 0.90 0.51 1.52 17.38

2001
0.63 1.01 0.15 8.18 12.54

Current Ratio ( CR ) : This ratio is a basic measure of judging the ability of the company to pay off its current obligations out of its short-term resources . The higher the CR, the larger is the amount available per rupee of short term obligations and accordingly , the greater is the feeling of security . Although sometimes it is said that a CR of 2 : 1 is ideal , but there is no rigidity about it . Each firm has to develop its own standards or ideal ratio from past experience and this only can be taken as a norm . It is observed from Table 1 from year 1998 the ratio was 0.85 : 1 . In the year 2001 the CR was 1.01 which is far below the conventional standard of 2 : 1 which implies that liquidity position of the company was not satisfactory .

(ii)

Quick Ratio ( QR ) : This ratio is a stricter test of liquidity than the CR as it gives no consideration to inventory which may be slow moving . QR places more emphasis on immediate conversion of assets into cash than does the CR. Rule of thumb is 1 : 1 for the QR . Judged from the traditional norms, liquidity position of SL as weak as its QR fluctuated between 0.40 in 1998 to 0.63 in 2001. On an average , this ratio was 0.5 . However, there was a slight improvement in the QR during the last 3 years of the study period. Although it is clear that in all the years under study liquid assets of the company were not adequate to meet very short term debt, it is a fact that many well managed private sector enterprises in India are successfully operating with a QR of just 0.5.

(iii)

Debt Equity Ratio : The debt equity ratio has shown a downward trend in the recent years and has also been in good . In the year 1998 the D/E ratio was 1.99 while in 2001 the same is 0.15

(iv)

Interest Coverage Ratio : This ratio measures the firms capacity to service the fixed interest on term loan It is determined by dividing the operating profits or earnings before interest and ( 56 )

tax by the fixed assets interest charges on loans . It has been observed that SL has continuously been increasing the service coverage ratio from 1998 to 2001. In the year 1998 the ratio was 0.47 and the same today in the year 2001 is 8.18

II.

Operational Efficiency Analysis :

Inventory Turn Over Ratio Table 3

S.R.No
1. 2. 3. 4. 5. 6. 7.

Particulars
Average days of raw material in Stores Average Days of Production Average days of finished goods Average days of Debtors Gross working Capital Cycle Average days of Creditors Net working capital cycle

1998
100 30 20 87 236 118 119

1999
127 27 24 135 313 203 111

2000
79 22 19 113 233 196 36

2001
52 17 12 103 185 181 4

(i)

Inventory Turnover Ratio ( ITR ) : This ratio is a valuable measure of the efficiency of inventory management . Generally speaking, the higher the ITR the shorter the average time between investment in inventory and its conversion into sales and thus the greater the efficiency of inventory management. The ITR of the company was higher in all the years under when compared to Indian Manufacturing industry average of 2.12. It indicates that the company had cared or been able to manage its inventory very impressively. In 1998 the cost of goods sold was Rs 824.94( crores )where as the inventory was Rs 150.71 ( crores ) the calculated Inventory turn over ratio is 5.47. While in 2001 the same was 11.81.Hence we also see an increase in the Inventory turnover ratio which shows a positive trend during the period under study reflecting the substantial improvement in the efficiency of inventory management of the company.

(ii)

Debtor Turnover Ratio ( DTR ) : This ratio shows the efficiency achieved in using the funds invested in debtors. This ratio can be given as Total Sales to debtor ( Sundry Debtors and Advances recoverable in Cash ). The higher DTR implies quicker collection of debtors and also enables the company to transact a larger volume of business without corresponding increase in investment in debtors.

( 57 )

B. To estimate the required amount of WC of SL assuming a linear dependency of WC on Sales, the regression equation of WC on Sales y = a + bx has been considered where y = WC , x = Sales b = regression coefficient of y on x and a = intercept . Refer Table 4 . Further , the deviation between WC (y) and the estimated WC (y) and co-efficient of correlation between them have been found out . Table 4 Sr. Year No. X Sales Rs.'00 Crores 1777.3 1042.1 1099.4 1142.8 Y GWC Rs.'00 Crores 961.84 729.06 552.48 472.86 2716 679.1 X^2 XY Y^2

1 2 3 4

1997 1998 1999 2000

3158937.5 1085930.7 1208570.4 1306014.7 6759453 1689863.3

1709516.7 759738.84 607368.89 540389.14

925136 531528 305234 223597

Summ 5061.6 1265.4 MEAN

3617014 1985495 904253.4 496373.8

From Table 4 we can say Mean x = 1265.25 Mean y = 679.05 Syx = Summation(yx) (Summation(x).summation(y))/n ( Where n = number of years ) Syx = 179330 Sxx = Summation(x^2)-((Summation(x))^2)/n Sxx = 354553 Syy = Summation(y^2)-((Summation(y))^2)/n ( 58 )

Syy = 141058 Co-efficient of Correlation r = Syx / Sqrt.(SxxxSyy) = 0.80 b = Sxy/Sxx = 0.80 therefore a = 337.10 using the equation Y=a+bX where Y and X are the mean values ) The value of co-efficient of correlation signifies that there is a direct relation between WC and sales . Using these values we can arrive to the equation as Y = 337.10 + 0.80X

C. Operating Cycle For the year 1999 the operating cycle can be calculated as O=R+W+F+DC R = Raw Material storage period = Average stock of raw materials and stores Average raw material & stores consumption per day

W = WIP Storage period

Average WIP Inventory Average cost of production per day

F = Finished Goods Storage Period = Average Finished Goods Inventory Average cost of goods sold per day D = Debtors Collection Period = Average Book Debts ( 59 )

Average credit Sales/day C = Creditors Payment Period = Average Trade Credit Average Credit Purchase/day

Particulars

Year Sep 97 18 mts

Year Sep 98 Year Sep 99 12 mts 12 mts

Year Sep 00 12 mts

Inventory management ( times ) Raw Material Stores Turn over Semi Finished goods turn over Finished goods turn over Debtors TurnOver Creditors Turnover Stock accumulation rate (%) Inventories / Current assets ( % ) Inventories / working Capital( % ) Working Capital Cycle Average Daily ( Rs cr ) Purchase of raw material Cost of sales Sales Holding period ( Nos of days ) Raw material and spares Production Finished goods Debtors

3.6 7.18 12.19 18.68 4.21 3.1 -31.36 24.04 -136.45

2.94 1.32 13.55 15.1 2.7 1.8 -26.25 21.77 -269.61

4.82 0.86 16.93 19.43 3.24 1.86 -13.01 18.78 -171.49

6.89 0.72 21.65 29.65 3.53 2.02 -46.29 11.21 825.82

0.8 4.07 4.87

0.47 2.33 2.85

0.51 2.38 3.01

0.51 2.56 3.13

100 30 20 87

127 27 24 135

79 22 19 113

52 17 12 103

Gross working capital cycle Credit availed from creditors Net working capital cycle Gross working Capital reqd . ( Cr ) Net working capital cycle ( Cr ) Raw Material productivity ( Times )

236 118 119 961.84 482.62

313 203 111 729.06 257.51

233 196 36 552.48 86.27

185 181 4 472.86 9.94

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VOP/ Raw material Gross Value added / raw material cost Management of Sundary debtors Incremantal Sales Incremental Contribution Incremental Bad Debts Net Contribution Incremental Debtors Incremental Debtors at cost Opportunity cost of debtors Surplus Credit Period ( Nos of days )

2.44 1.18

2.23 1.1

3.98 1.12

4.96 1.39

702.64 101.01 40.3 60.71 -12.21 -10.2 -3.66 64.37 87

-735.29 -178.36 -50.58 -127.78 -58.27 -47.49 -10.97 -116.81 135

57.3 31.32 0 31.32 -35.55 -28.04 -7.96 39.28 113

43.46 -27.44 0 -27.44 3.28 2.68 0.57 -28.01 103

4. Observations The general performance regarding the Working Capital Management in SL encouraging during the period under study . The Plus Points are : The company is in right direction of reducing the inventory , it is reduced from 72% in 1988 to 41.8% in 1994 and then it is nearly constant there after with 43.5% in 1999 of the GWC. Debtors have shown an increasing trend say from 87 days in 1998 to 103 days in 2001this is also keeping in mind the recession shown by the market Through regression analysis we also have realized that the estimated working capital and the actual can be analysed give the standard deviation between them . The fluctuation between them is also minimum to operate at a better margins there by increasing over all profitability of the business Hence the company would not face the risk of maximum over or under utilization of WC funds which is also an indicator of better efficiency in managing WC on the part of the company. Operating Cycle has reduced from 119 days in 1998 to just 4 days in the year 2001 . Profit can be increased by controlling (a) bad debts , (b) control over Debtors and (c) also by controlling inventory. was very much

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BIBLIOGRAPHY

1. Finance India Magazine 2. Annual Report ( 1997 2001 ) 3. Web Site Indiaifoline.com 4. Confideration for Monitoring Indian Economy ( Software Prowess) 5. Financial Management Khan & Jain 7. Financial Management Prasannachandra 8. Cash Management and working Capital Management S Srinivasan

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