Professional Documents
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Project objectives:
To learn the effective management of working capital.
To study how to keep the capital that is tied up in the working
capital cycle at a minimum and maximizing profit.
To study the different components of working capital and its impact
on the performance of the firm.
To study how Bank of Maharashtra finances working capital
requirements of the firms.
Mobilisation of Money
Modernisation of Methods and
Motivation of Staff.
Banks Aims
The bank wishes to cater to all types of needs of the entire family, in the
whole country. Its dream is "One Family, One Bank, Maharashtra Bank".
The Autonomy
The Bank attained autonomous status in 1998. It helps in giving more and
more services with simplified procedures without intervention of Government.
Banks Social Aspect
The bank excels in Social Banking, overlooking the profit aspect; it has a
good share of Priority sector lending having 46% of its branches in rural areas.
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Other Attributes
Bank is the convener of State level Bankers committee
Bank has signed a MoU with EXIM bank for co-financing of project exports
Bank offers Depository services and Demat facilities in Mumbai.
Bank has captured 95.25% of its total business through computerization.
Banks Future Plans
Accounts
Cash
Raw
Finished goods
Work-in-
Types of working capital:Can be divided into two categories on the basis of time: 1. Permanent working capital
2. Temporary or Variable working capital
1. PERMANENT WORKING CAPITAL:This refers to that minimum amount of investment in all current assets
which is required at all times to carry out minimum level of business
activities. It represents the current assets required on a continuing basis over
the entire year.
Tandon committee has referred to this type of working capital as core current
assets.
The following are the characteristics of this type of working capital:1. Amount of permanent working capital remains in the business in one
form or another. This is particularly important from the point of view of
financing. The suppliers of such working capital should not expect its
return during the lifetime of the firm.
2. It also grows with the size of the business.
Permanent working capital is permanently needed for the business and
therefore it should be financed out of long-term funds.
This is the reason why the current ratio has to be substantially more than 1.
2.TEMPORARY OR VARIABLE WORKING CAPITAL:The amount of such working capital keeps on fluctuating from time to
time on the basis of business activities.
In other words, it represents additional current assets required at different
times during the operating year.
Temporary
Amount of working
permanent
Capital (Rs.)
Time
(D#2 Source: Dr. S N Maheshwari, Financial Management.)
Temporary
Amount of working
Capital (Rs.)
permanent
Time
(D#3
REASONS FOR ADEQUATE WORKING CAPITAL: A firm must have adequate working capital, i.e., as much as needed by
the firm.
It should neither have excessive nor inadequate. Both situations are
dangerous. Excessive working capital means the firm has idle funds, which
earn no profit for the firm. Inadequate working capital means the firm does
not have sufficient funds for running its operations, which ultimately results in
production interruptions, and lowering down the profitability.
It will be interesting to understand the relation between working capital,
risk and return. In a manufacturing concern, it is generally accepted that
higher levels of working capital decrease the risk and decrease the
profitability too.
While lower levels of working capital increase the risk but have the
potentiality of increasing the profitability also.
This principle is based on the following assumptions: (i) There is direct relationship between risk and profitability --- higher is the
risk, higher is the profitability, while lower is the risk, lower is the
profitability.
(ii) Current assets are less profitable than fixed assets.
(iii) Short-term funds are less expensive than long-term funds.
MANAGEMENT OF WORKING CAPITAL:Working capital refers to all aspects of the administration of both
current assets and current liabilities.
In other words, working capital management is concerned with the problems
that arise in attempting to manage the current assets, the current liabilities and
the interrelationships that exist between them.
Moreover, different components of working capital are to be properly
balanced in such a way that during one complete production or trade cycle the
cash should be available for purchase of fresh material and for running the
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ESTIMATING WORKING CAPITAL REQUIREMENTS: In order to determine the amount of working capital needed by a firm, a
number of factors viz. production policies, nature of business, length of
manufacturing process, rapidity of turnover, seasonal fluctuations, etc. are to
be considered by the finance manager.
TECHNIQUES FOR ASSESSMENT OF WORKING CAPITAL REQUIREMENTS: -
1.
3. OPERATING CYCLE APPROACH: According to this approach, the requirements of working capital depend
upon the operating cycle of the business.
The operating cycle begins with the acquisition of raw materials and
ends with the collection of receivables
Where,
O=Duration of operating cycle;
R=Raw materials and stores storage period;
W=Work-in-progress period;
F=Finished stock storage period;
D=Debtors collection period;
C=Creditors payment period.
SOURCES OF WORKING CAPITAL :The working capital requirements should be met both from short-term
as well long-term sources of funds. Its will be appropriate to meet at least 2/3rd
(if not the whole) of the permanent working capital requirements from longterm sources and only for the period needed.
The financing of working capital through short-term sources of
funds has the benefits of lower cost and establishing close relationship with
the banks.
Financing of working capital from long-term resources provides the
following benefits:
(i)
It reduces risk, since the need to repay loans at frequent intervals is
eliminated.
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(ii)
It increases liquidity since the firm has not to worry about the
payment of these funds in the near future.
APPROACHES FOR DETERMINING THE FINANCING MIX:There are three basic approaches for determining the working capital
financing mix.
(i) THE HEDGING APPRAOCH:According to this approach, the maturity of source of funds should
match the nature of assets to be financed.
The approach is, therefore, termed as Matching approach.
It divides requirements of total working capital funds into two
categories.
a) Permanent working capital, i.e., funds required for purchase of core
current assets. Such funds do not vary over time.
b) Temporary or seasonal working capital, i.e., funds which fluctuate
over time.
The permanent working capital requirements should be financed by
long-term funds while the seasonal working capital requirements should
be financed out of short-term funds.
(ii) THE CONSERVATIVE APPROACH: According to this approach all requirements of funds should be met
from long-term sources.
The short-term sources should be used only for emergency requirements.
The conservative approach is less risky, but more costly as compared to
the hedging approach.
In other words conservative approach is low profit-low risk (or high
cost, high net working capital) while hedging approach results in high profithigh risk (or low cost, low net working capital).
*MANAGEMENT OF CASH
It is the duty of the finance manager to provide adequate cash to all
segments of the organization. He also has to ensure that no funds are blocked
in idle cash since this will involve cost in terms of interest to the business. A
sound cash management scheme, therefore, maintains the balance between the
twin objectives of liquidity and cost.
Meaning of cash
The term cash with reference to cash management is used in two
senses. In a narrower sense it includes coins, currency notes, cheques, bank
drafts held by a firm with it and the demand deposits held by it in banks.
In a broader sense it also includes near-cash assets such as, marketable
securities and time deposits with banks. Such securities or deposits can
immediately be sold or converted into cash if the circumstances require. The
term cash management is generally used for management of both cash and
near-cash assets.
Motives for holding cash
A distinguishing feature of cash as an asset, irrespective of the firm in
which it is held, is that it does not earn any substantial return for the business.
In spite of this fact cash is held by the firm with following motives.
1. Transaction motive
A firm enters into a variety of business transactions resulting in both
inflows and outflows. In order to meet the business obligation in such a
situation, it is necessary to maintain adequate cash balance. Thus, cash
balance is kept by the firms with the motive of meeting routine business
payments.
2.Precautionary motive
A firm keeps cash balance to meet unexpected cash needs arising out of
unexpected contingencies such as floods, strikes, presentment of bills for
payment earlier than the expected date, unexpected slowing down of
collection of accounts receivable, sharp increase in prices of raw materials,
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etc. The more is the possibility of such contingencies more is the cash
kept by the firm for meeting them.
3.Speculative motive
A firm also keeps cash balance to take advantage of unexpected
opportunities, typically outside the normal course of the business. Such
motive is, therefore, of purely a speculative nature.
For example,
A firm may like to take advantage of an opportunity of purchasing raw
materials at the reduced price on payment of immediate cash or delay
purchase of raw materials in anticipation of decline in prices.
4.Compensation motive
Banks provide certain services to their clients free of charge. They,
therefore, usually require clients to keep a minimum cash balance with them,
which help them to earn interest and thus compensate them for the free
services so provided.
Business firms normally do not enter into speculative activities and,
therefore, out of the four motives of holding cash balances, the two most
important motives are the compensation motive.
Objectives of cash management
There are two basic objectives of cash management:
1. To meet the cash disbursement needs as per the payment schedule;
2. To minimize the amount locked up as cash balances.
1.Meeting cash disbursements
The first basic objective of cash management is to meet the payments
Schedule. In other words, the firm should have sufficient cash to meet the
various requirements of the firm at different periods of times. The business
has to make payment for purchase of raw materials, wages, taxes, purchases
of plant, etc. The business activity may come to a grinding halt if the payment
schedule is not maintained. Cash has, therefore, been aptly described as the
oil to lubricate the ever-turning wheels of the business, without it the process
grinds to a stop.
2.minimizing funds locked up as cash balances
The second basic objective of cash management is to minimize the
amount locked up as cash balances. In the process of minimizing the cash
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(i)
Billing float:
(ii)
Capital float:
(iii)
(iv)
(a)
It means the number of days for which cash balance should be sufficient
to cover payments.
(i) Security:
This can be ensured by investing money in securities whose price
remain more or less stable.
(ii) Liquidity:
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(iii) Yield:
Most corporate managers give less emphasis to yield as compared to
security and liquidity of investment. They, therefore, prefer short-term
government securities for investing surplus cash. However, some corporate
managers follow aggressive investment policies, which maximize the yield on
their investments.
(iv) Maturity:
Surplus cash is available not for an indefinite period. Hence, it will be
advisable to select securities according to their maturities keeping in view the
period for which surplus cash is available. If such selection is done carefully,
the finance manager can maximize the yield as well as maintain the liquidity
of investments.
1.Baumol model: This model was suggested by William J Baumol. It is similar to one
used for determination of economic order quantity.
According to this model, optimum cash level is that level of cash where the
carrying costs and transactions costs are the minimum.
Carrying costs
This refers to the cost of holding cash, namely, the interest foregone on
marketable securities. They may also be termed as opportunity cost of keeping
cash balance.
Transaction costs
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2U x P
S
Where,
C = Optimum cash balance
U = Annual (or monthly) cash disbursements
P = Fixed costs per transaction
S = Opportunity cost of one rupee p.a. (p.m)
2. Miller-Orr Model
Baumol model is not suitable in those circumstances when the
demand for cash is not steady and cannot be known in advance.
Miller-Orr model helps in determining the optimum level of
cash in such circumstances. It deals with cash management problem
under the assumption of stochastic or random cash flows by laying
down control limits for cash balances. These limits consist of an
upper limit (h), lower limit (o) and return point (z). When cash
balance reaches the upper limit, a transfer of cash equal to h-z is
effected to marketable securities. When it touches the lower limit, a
transfer equal to z-o from marketable securities to cash is made.
No transaction between cash to marketable securities and
marketable securities to cash is made during the period when the
cash balance stays between the high and low limits.
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Return point
*MANAGEMENT OF INVENTORIES
Inventories are good held for eventual sale by a firm. Inventories are
thus one of the major elements, which help the firm in obtaining the desired
level of sales.
Kinds of inventories
Inventories can be classified into three categories.
(ii) Work-in-progress:
This includes those materials, which have been committed to
production process but have not yet been completed.
(iii) Obsolescence
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Management of inventory
Inventories often constitute a major element of the total working capital
and hence it has been correctly observed, good inventory management is
good financial management.
Inventory management covers a large number of issues including
fixation of minimum and maximum levels; determining the size of the
inventory to be carried ; deciding about the issue price policy; setting up
receipt and inspection procedure; determining the economic order quantity;
providing proper storage facilities, keeping check on obsolescence and setting
up effective information system with regard to the inventories.
However, management inventories involves two basic problems:
(i)
Maintaining a sufficiently large size of inventory for
efficient and smooth production and sales operations;
(ii) Maintaining a minimum investment in inventories to
minimize the direct-indirect costs associated with holding
inventories to maximize the profitability.
Inventories should neither be excessive nor inadequate. If inventories
are kept at a high level, higher interest and storage costs would be incurred.
On the other hand, a low level of inventories may result in frequent
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(v)
Formula:
Q=
2U x
S
Where,
Q = Economic Ordering Quantity
U = Quantity (units) purchased in a year (month)
P = Cost of placing an order
S = Annual (monthly) cost of storage of one unit.
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2U x P
S
Where
E = Optimum production quantity
U = Annual (monthly) output
P = Set-up cost for each production run
S = Cost of carrying inventory per annum (per month)
Meaning of receivables
Receivables are assets accounts representing amounts owed to the firm
as a result of sale of goods / services in the ordinary course of business.
They, therefore, represent the claims of a firm against its customers and
are carried to the assets side of the balance sheet under titles such as
accounts receivables, customer receivables or book debts. They are, as stated
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sale of goods to customers and the payments by them. The firm has,
therefore, to arrange for additional funds top meet its own obligations,
such as payment to employees, suppliers of raw materials, etc., while awaiting
for payments from its customers. Additional funds may either be raised from
outside or out of profits retained in the business. In both the cases, the firm
incurs a cost. In the former case, the firm has to pay interest to the outsider
while in the latter case, there is an opportunity cost to the firm, i.e., the money
which the firm could have earned otherwise by investing the funds elsewhere.
2. Administrative costs:
The firm has to incur additional administrative costs for maintaining
accounts receivable in the form of salaries to the staff kept for maintaining
accounting records relating to customers, cost of conducting investigation
regarding potential credit customers to determine their creditworthiness, etc.
3. Collection costs:
The firm has to incur costs for collecting the payments from its credit
customers. Sometimes, additional steps may have to be taken to recover
money from defaulting customers.
4. Defaulting costs:
Sometimes after making all serious efforts to collect money from
defaulting customers, the firm may not be able to recover the overdues
because of the of the inability of the customers. Such debts are treated as bad
debts and have to be written off since they cannot be realized.
Factors affecting the size of receivables
The size of the receivable is determined by a number of factors.
Some of the important factors are as follows:
(1) Level of sales:
This is the most important factor in determining the size of accounts
receivable. Generally in the same industry, a firm having a large volume of
sales will be having a larger level of receivables as compared to a firm with a
small volume of sales.
Sales level can also be used for forecasting change in accounts receivable.
(2) Credited policies:
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discounts indicate the rate of discount as well as the period for which the
discount has been offered.
MANAGEMENT OF ACCOUNTS PAYABLE
Management of accounts payable is as much important as management
of accounts receivable. There is a basic difference between the approach to be
adopted by the finance manager in the two cases. Whereas the underlying
objective in case of accounts receivable is to maximize the acceleration of the
collection process, the objective in case of accounts payable is to slow down
the payments process as much as possible. But it should be noted that the
delay in payment of accounts payable may result in saving of some interest
costs but it can prove very costly to the firm in the form of loss credit in the
market.
The finance manager has, therefore, to ensure that the payments after
obtaining the best credit terms possible.
(iii) Over-expansion:
In national emergencies like war, natural calamities, etc., a firm may be
required to produce goods on a larger scale. Government may pressurize the
manufacturers to increase the volume of production without providing for
adequate finances. Such pressure results in over-expansion of the business
ignoring the elementary rules of sound finance.
(iv) Inflation and rising prices:
Inflation and rising prices make renewals and replacements of assets
costlier. The wages and material costs also rise. The manufacturer, therefoe,
needs more money even to maintain the existing level of activity.
(v) Excessive taxation:
Heavy taxes result in depletion of cash resources at a scale higher than
what is justified.
The cash position is further strained on account of efforts of the
company to maintain reasonable dividend rates for their shareholders.
Consequences of overtrading
The consequences of over-trading can be summarized as follows:
(i) Difficulty in paying wages and taxes:
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The cure for overtrading is easier to prescribe but difficult to follow. The
cure is simple-reduce the business or increase finance. Both are difficult.
However, arrangement of more finance is better. If this is not possible, the
only advisable course left will be to sell the business as a going concern.
UNDERTRADING:
It is the reverse of overtrading. It means improper and underutilization
of funds lying at the disposal of the undertaking. In such a situation the level
of trading is low as compared to the capital employed in the business. It
results in increase in the size of inventories, book debts and cash balances.
Undertrading is a matter of fact an aspect of overcapitalization. The basic
cause of undertrading is, therefore, underutilization of the firms resources.
Such underutilization may be due any one or more of the following causes:
Conservative policies followed by the management;
Non-availability or shortage of basic facilities necessary for
production such as, raw materials, power, labour, etc;
General depression in the market resulting in fall in the
demand of companys products;
Consequences of undertrading
The following are the consequences of undertrading:
(i) The profits of the firm show a declining trend resulting in a lower
return on capital employed (ROI) in the business.
(ii) The value of the shares of the company on the stock exchange starts
falling on account of lower profitability;
(iii) There is loss to the reputation of the firm on account of lower
profitability and creation of impression in the minds of investors that the
management is inefficient.
Formulae
Result
Interpretation
Stock
Turnover
(in days)
Average Stock
* 365/
Cost of Goods
Sold
Debtors * 365/
Sales
= x days
Creditors *
= x days
Receivables
Ratio
(in days)
Payables
= x days
Ratio
(in days)
365/
Cost of Sales
(or Purchases)
Current
Ratio
Total Current
Assets/
Total Current
Liabilities
=x
times
Quick Ratio
(Total Current
Assets Inventory)/
Total Current
Liabilities
=x
times
Production policy
A firm marked by pronounced seasonal fluctuation in its sales pursue a
production policy, which may reduce the sharp variations in working capital
requirements.
Market conditions
The degree of competition prevailing in the market place has an
important bearing on working capital needs. When competition is keen, a
larger inventory of finished goods is required to promptly serve customers
who may not be inclined to wait because other manufacturers are ready to
meet there needs.
Conditions of supply
The inventory of raw materials, spares, and stores depends on the
conditions of supply. If the supply is prompt and adequate, the firm can
manage with small inventory.
1IMPORTED
RAW MATERIAL
________ DAYS
2INDIGENOUS
RAW MATERIALS
______ DAYS
MARGIN
%AGE
VALUE
PBF
3STOCK IN PROGRESS
_________ DAYS
4FINISHED GOODS
_______ DAYS
5SUNDRY DEBTORS
______ DAYS
6MONTHLY EXPENSES
FOR ONE MONTH
TOTAL
(A)
(B)
(C)
Particulars
Total current assets
(Excluding fixed deposits
Money margin)
(Rs. In lakhs)
Mar03 Mar04 Provisional mar'05 Projected mar'-6
57.03
69.65
56.6
62.5
33.84
33.21
23
25
23.19
36.44
33.6
37.5
Minimum stipulated
Net working capital
(25% of total current assets
Excluding expected receivables.)
11.41
13.93
11.32
12.5
6.84
14.67
15.6
12.5
Item (c-d)
11.78
22.51
22.28 25
Item (c-e)
16.35
21.77
18
25
MPBF (lower of
11.78
21.77
18
25
( f or g))
Particulars
Projected sales for the year 2004-05
25% of sales
Less:- 5% of gross sales margin
(Rs.in lakhs)
115.09
28.77
5.75
23.02
25% of sales
Less: - projected net working capital
28.77
15.21
Bank finance
15.21
15.00
10.00
10.00
(iii) The bank should know the end-use of bank credit so that it is
used only for the purposes for which it is made available.
(iii) Some times the clients business looks promising and real to
his words then certain relaxation should be provided as far as policies are
considered.
(iv) Sectoral analysis should be considered before providing the
working capital finance to any firm, trends should be considered.
(v) Statement of financial transactions should be review at regular
interval to minimize losses due to irregular payments and defaulters.
BIBLIOGRAPHY
1. Author: Dr. S N Maheshwari
Name of the book: Financial Management
Edition 2004
Publisher name: SULTAN CHAND &SONS
Pages no.: D.290 onwards
2. Author: I .M. Pandey
Name of the book: Financial Management
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