Project title: working capital management 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.

Profile: bank of Maharashtra The Birth Registered on 16th Sept 1935 with an authorized capital of Rs 10.00 lakh and commenced business on 8th Feb 1936. The Childhood Known as a common man's bank since inception, its initial help to small units has given birth to many of today's industrial houses. After nationalization in 1969, the bank expanded rapidly. It now has 1276 branches (as of 31st March 2004) all over India. The Bank has the largest network of branches by any Public sector bank in the state of Maharashtra. The Adult The bank has fine tuned its services to cater to the needs of the common man and incorporated the latest technology in banking offering a variety of services. Banks Philosophy Technology with personal touch. The 3m’s symbolizing
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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.

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
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Opening of 40 new branches at the most strategic business centers. Circle offices at Pune, Mumbai, Delhi, Banglore and Nagpur. 255 additional ATMs will be installed. To cross business level of around Rs 46000 crore. To increase customer base by 10%. To increase finance to Self Help Groups in rural areas. To substantially increase the Savings Bank Deposits. Bank is planning setting up of overseas representative offices in New York , London, Singapore & Dubai.


Concept of working capital There are two concepts of working capital: 1.Gross working capital It refers to the firm’s investment in total current assets or circulating assets. 2.Net working capital (defined in two ways) (i) It is the excess of current assets over current liabilities. (ii) It is that portion of a firm’s current assets which is financed by long-term funds. NEED FOR WORKING CAPITAL:The basic objective of financial management is to maximize shareholders wealth. This is possible only when the company earns sufficient profit. The amount of such profit largely depends upon the magnitude of sales. However, sales do not convert into cash instantaneously. There is always time gap between the sale of goods and receipt of cash. Working capital is required for this period in order to sustain the sales activity. OPERATING CYCLE:-

Finished goods



(D#1 Source: Dr. S N Maheshwari, Financial Management.)

It represents the current assets required on a continuing basis over the entire year. Permanent working capital 2. . This is the reason why the current ratio has to be substantially more than ‘1’. Temporary or Variable working capital 1. 2. Amount of permanent working capital remains in the business in one form or another. 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. This is particularly important from the point of view of financing.Types of working capital:Can be divided into two categories on the basis of time: 1. The following are the characteristics of this type of working capital:1. The suppliers of such working capital should not expect its return during the lifetime of the firm. Tandon committee has referred to this type of working capital as “core current assets”. 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.

) permanent Time (D#3 Source: Dr. In other words. it represents additional current assets required at different times during the operating year.) permanent Temporary Amount of working Capital (Rs. Temporary Amount of working Capital (Rs.) . Financial Management.2.) Time (D#2 Source: Dr. S N Maheshwari. S N Maheshwari.TEMPORARY OR VARIABLE WORKING CAPITAL:The amount of such working capital keeps on fluctuating from time to time on the basis of business activities. Financial Management.

i.. higher is the profitability. It will be interesting to understand the relation between working capital. after realization of sale proceeds of earlier cycle without any hurdles. it is generally accepted that higher levels of working capital decrease the risk and decrease the profitability too. which ultimately results in production interruptions. which earn no profit for the firm. 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 business including operating expenses.higher is the risk. the current liabilities and the interrelationships that exist between them. Both situations are dangerous. While lower levels of working capital increase the risk but have the potentiality of increasing the profitability also. working capital management is concerned with the problems that arise in attempting to manage the current assets. Inadequate working capital means the firm does not have sufficient funds for running its operations. In other words. . as much as needed by the firm.e. This principle is based on the following assumptions: (i) There is direct relationship between risk and profitability --. lower is the profitability.REASONS FOR ADEQUATE WORKING CAPITAL: A firm must have adequate working capital. Excessive working capital means the firm has idle funds. while lower is the risk. Moreover. risk and return. (ii) Current assets are less profitable than fixed assets. and lowering down the profitability. It should neither have excessive nor inadequate. In a manufacturing concern. MANAGEMENT OF WORKING CAPITAL:Working capital refers to all aspects of the administration of both current assets and current liabilities. (iii) Short-term funds are less expensive than long-term funds.

liquidity and its structural health. inventories. 2) Sources from which these funds have to be raised. the financial position in respect of the firm’s liquidity may not be satisfactory in spite of satisfactory liquidity ratio. length of manufacturing process. a number of factors viz. cash. ESTIMATING WORKING CAPITAL REQUIREMENTS: In order to determine the amount of working capital needed by a firm.. accounts payable. are to be considered by the finance manager. In order to achieve this objective the finance manager has to perform basically following two functions: 1) Estimating the amount of working capital. nature of business. Working capital management policy have a great effect on firm’s profitability. ESTIMATION OF COMPONENTS OF WORKING CAPITAL METHOD: Since working capital is the excess of current assets over current liabilities. rapidity of turnover. chalk out appropriate working capital management policies in respect of each of the components of working capital so as to ensure higher profitability. an assessment of the working capital requirements can be made by estimating the amounts of different constituents of working capital e. accounts receivable.g. seasonal fluctuations.In the absence of such situation. etc. . production policies. TECHNIQUES FOR ASSESSMENT OF WORKING CAPITAL REQUIREMENTS: - 1. A finance manager should therefore. proper liquidity and sound structural health of the organization. etc.

Raw materials and stores storage stage. W=Work-in-progress period. According to this method. The duration of the operating cycle for the purpose of estimating working capital requirements is equivalent to the sum of the durations of each of these stages less the credit period allowed by the suppliers of the firm. D=Debtors collection period. 3. a ratio can be determined for estimating the working capital requirements in future. Work-in-progress stage. PERCENT OF SALES APPROACH:- This is a traditional and simple method of estimating working capital requirements. OPERATING CYCLE APPROACH: According to this approach. F=Finished stock storage period. 3. 1. 2. 4. Symbolically the duration of the working capital cycle can be put as follows: O=R+W+F+D-C Where. O=Duration of operating cycle. the requirements of working capital depend upon the operating cycle of the business. Receivables collection stage. C=Creditors payment period. .2. R=Raw materials and stores storage period. Finished goods inventory stage. on the basis of past experience between sales and working capital requirements. The operating cycle begins with the acquisition of raw materials and ends with the collection of receivables It may be broadly classified into the following four stages viz.

the total number of operating cycles that can be computed during a year can be computed by dividing 365 days with number of operating days in a cycle. 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 total expenditure in the year when year when divided by the number of operating cycles in a year will give the average amount of the working capital requirement. since the need to repay loans at frequent intervals is eliminated. . The financing of working capital through short-term sources of funds has the benefits of lower cost and establishing close relationship with the banks.Each of the components of the operating cycle can be calculated as follows:R= Average stock of raw materials and stores Average raw materials and stores consumptions per day W=Average work-in-progress inventory Average cost of production per day D=Average book debts Average credit sales per day C=Average trade creditors Average credit purchases per day After computing the period of one operating cycle. SOURCES OF WORKING CAPITAL :The working capital requirements should be met both from short-term as well long-term sources of funds. Financing of working capital from long-term resources provides the following benefits: (i) It reduces risk. (ii) It increases liquidity since the firm has not to worry about the payment of these funds in the near future.

.e. i. (ii) THE CONSERVATIVE APPROACH: According to this approach all requirements of funds should be met from long-term sources. It divides requirements of total working capital funds into two categories. therefore. funds required for purchase of core current assets. The short-term sources should be used only for emergency requirements. .. a) Permanent working capital. low net working capital).APPROACHES FOR DETERMINING THE FINANCING MIX:There are three basic approaches for determining the working capital financing mix. The conservative approach is less risky. i. termed as “Matching approach”. Such funds do not vary over time.e. (i) THE HEDGING APPRAOCH:According to this approach. 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. high net working capital) while hedging approach results in high profithigh risk (or low cost. The approach is. but more costly as compared to the hedging approach. funds which fluctuate over time. b) Temporary or seasonal working capital. the maturity of source of funds should match the nature of assets to be financed. In other words conservative approach is “low profit-low risk” (or high cost.

(iii) TRADE-OFF BETWEEN HEDGING AND CONSERVATIVE APPROACH: The hedging and conservative approaches are both on two extremes. creditors. A trade-off between these two can give satisfactory results. accounts receivable. inventories. Management of different components of working capital Working capital management involves management of different components of working capital such as cash. The average working capital so obtained may be financed by long-term funds and the balance by short-term funds. However. etc . The level of such trade-off will differ from case to case depending upon perception of the risk by the persons involved in financial decision-making. Neither of them can therefore help in efficient working capital management. one way of determining the level of trade-off is by finding the average of the minimum and the maximum requirements of working capital during a period.

maintains the balance between the twin objectives of liquidity and cost. The term cash management is generally used for management of both cash and near-cash assets. therefore. Meaning of cash The term “cash” with reference to cash management is used in two senses. unexpected slowing down of collection of accounts receivable. strikes. is that it does not earn any substantial return for the business. Such securities or deposits can immediately be sold or converted into cash if the circumstances require. In order to meet the business obligation in such a situation. 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. Motives for holding cash A distinguishing feature of cash as an asset. currency notes. bank drafts held by a firm with it and the demand deposits held by it in banks. sharp increase in prices of raw materials. A sound cash management scheme. it is necessary to maintain adequate cash balance. etc. . 1. In spite of this fact cash is held by the firm with following motives. cash balance is kept by the firms with the motive of meeting routine business payments.Precautionary motive A firm keeps cash balance to meet unexpected cash needs arising out of unexpected contingencies such as floods. Thus. marketable securities and time deposits with banks. presentment of bills for payment earlier than the expected date. The more is the possibility of such contingencies more is the cash kept by the firm for meeting them.*MANAGEMENT OF CASH It is the duty of the finance manager to provide adequate cash to all segments of the organization. In a narrower sense it includes coins. cheques. Transaction motive A firm enters into a variety of business transactions resulting in both inflows and outflows. In a broader sense it also includes “near-cash assets” such as. irrespective of the firm in which it is held. 2.

Meeting cash disbursements The first basic objective of cash management is to meet the payments Schedule. etc. therefore. without it the process grinds to a stop. A higher cash balance ensures proper payment with all its advantages.minimizing funds locked up as cash balances The second basic objective of cash management is to minimize the amount locked up as cash balances.3. But this . usually require clients to keep a minimum cash balance with them. 2. 4. To meet the cash disbursement needs as per the payment schedule.Compensation motive Banks provide certain services to their clients free of charge. the finance manager is confronted with two conflicting aspects. out of the four motives of holding cash balances. typically outside the normal course of the business. In other words. therefore. Such motive is. Business firms normally do not enter into speculative activities and. therefore. For example. of purely a speculative nature. To minimize the amount locked up as cash balances. the firm should have sufficient cash to meet the various requirements of the firm at different periods of times. Objectives of cash management There are two basic objectives of cash management: 1. In the process of minimizing the cash balances. wages.” 2. The business has to make payment for purchase of raw materials. the two most important motives are the compensation motive. 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. taxes. They. purchases of plant.Speculative motive A firm also keeps cash balance to take advantage of unexpected opportunities. Cash has. The business activity may come to a grinding halt if the payment schedule is not maintained. therefore. been aptly described as the “oil to lubricate the ever-turning wheels of the business. 1. which help them to earn interest and thus compensate them for the free services so provided.

It does not take into account discrepancies between cash inflows and cash outflows on account of unforeseen circumstances such as strikes. a certain minimum amount of cash balance has. The finance manager should.will result in a large balance of cash remaining idle. Controlling outflows of cash. it is almost a full time job handled by a senior person.. Controlling levels of cash. It involves a projection of future cash receipts and cash disbursements of the firm over various intervals of time. Optimum investment of surplus cash. namely. Controlling inflows of cash. to be kept for . Cash management . the budget controller or the treasurer. With this information. relatively a minor job. etc.. plan for the financing of these needs and exercise control over the cash and liquidity of the firm. therefore. However.Controlling levels of cash One of the basic objectives of cash management is to minimize the level of cash balance with the firm. It reveals to the finance manager the timings and amount of expected cash inflows and outflows over a period studied. 2. (ii) Providing for unpredictable discrepancies: Cash budget predicts discrepancies between cash inflows and outflows on the basis of normal business activities. in case of big companies. 1. Thus in case a cash budget is properly prepared it correctly reveals the timings and size of net cash flows as well as the periods during which the excess cash may be available for temporary investment. floods. the preparation of cash budget or a cash forecast does not involve much of complications and. This objective is sought to be achieved by means of the following: (i) Preparing cash budget: Cash budget or cash forecasting is the most significant device for planning and controlling the use of cash. he is better able to determine the future cash needs of the firm.. therefore. 4. Low level of cash balance may result in failure of the firm to meet the payment schedule. In a small company.basic problems Cash management involves the following four basic problems: 1. therefore. 3. short-term recession.. try to have an optimum amount of cash balance keeping the above facts in view.

The firm opens its bank accounts in local banks of different areas where it has its collection centers. Such amount is fixed on the basis of past experience and some intuition regarding the future. the finance manager should also ensure that there is no significant deviation between the projected cash inflows and the projected cash outflows. etc. Controlling inflows of cash Having prepared the cash budget. But considerable saving in interest costs will be effected because such interest will have to be paid only for shorter period. (b) Borrowing may have to be resorted to at high rate of interest. which have been found to be quite useful and effective. The collection centers are required to collect cheques from their customers and deposits them in the local bank account. (iii) Consideration of short costs: The term short cost refers to the cost incurred as a result of shortage of cash. to banks for not meeting the obligations in time. For such arrangements the firm has to pay a slightly higher rate of interest than that on a long-term debt. This requires controlling of both inflows as well as outflows of cash. According to this system. The firm may also be required to pay penalties. a large number of collection centers are established by the firm in different areas selected on geographical basis. Instructions are . Such costs may take any of the following forms: (a) The failure of the firm to meet its obligations in time may result in legal action by the firm’s creditors against the firm. Speedier collection of cash can be made possible by adoption of the following techniques. 2.meeting such unforeseen contingencies. This cost is in terms of fall in the firm’s reputation besides financial costs incurred in defending the suit. (i) Concentration Banking: Concentration banking is a system of decentralizing collections of accounts receivables in case of large firms having their business spread over a large area.. (iv) Availability of other sources of funds: A firm can avoid holding unnecessary large balance of cash for contingencies in case it has adequate arrangements with its bankers for borrowing money in times of emergencies.

This system of concentration banking results in the following advantages: (a) The mailing time is reduced since the collection centers themselves collect cheques from the customers and immediately deposit them in local bank accounts. the firm hires a post-office box and instructs its customers to mail their remittances to the box. after processing. Thus. This helps in quicker collection of cash. there is time gap between actual receipt of cheques by a collection centre and its actual depositing in the local bank account. The Lock-Box system offers the following advantages: (a) All remittances are handled by the banks even prior to their de3posits with them at a very low cost. Moreover. when the local collection centres are also used to prepare and send bills to the customers in their areas. According to this system. The firm’s local bank is given the authority to pick the remittances directly from the post-office box. In case of concentration banking cheques are received by collection centres who. Standing instructions are given to the local bank to transfer funds to the head office bank when they exceed a particular limit. deposit them in the local bank accounts.given to the local collection centers to transfer funds over a certain limit daily telegraphically to the bank at the head office. Lock-box system has been devised to eliminate delay on account of this time gap. This facilitates fast movements of funds. The bank picks up the mail several times a day and deposits the cheques in the firm’s account. the mailing time in sending bills to the customer is also reduced. (ii) Lock-box system: Lock-box system is a further step in speeding up collection of cash. The company’s treasurer on the basis of the daily report received from the head office bank about the collected funds can use them for disbursement according to needs. (b) The time required to collect cheques is also reduced since the cheques deposited in the local bank accounts are usually drawn on banks in that area. .

However. 3. In other words. (ii) Capital float: . All payments should be made from a single control account. In case of the former. The firm should neither lose cash discount nor its prestige on account of delay in payments. The combination of fast collections and slow disbursements will result in maximum availability of funds. the firm should pay within the terms offered by the suppliers. (ii) Payments should be made on the due dates. It can be of the following types: - (i) Billing float: It refers to the time interval between the making of a formal invoice by the seller for the goods sold and mailing the invoice to the purchaser. there is a basic difference between the underlying objective of exercising control over cash inflows and cash outflows.(b) The cheques are deposited immediately upon receipt of remittances and the collecting process starts much earlier than that under the system of concentration banking. (iii) The firm may use the technique of “playing float” for maximizing the availability of funds. The term float refers to the period taken from one stage to another in the cash collection process. A firm can advantageously control outflows of cash if the following considerations are kept in view: (i) Centralized system of disbursement should be followed as compared to decentralized system in case of collections. the objective is the maximum acceleration of collections while in the case of latter. neither before nor after. This will result in delay in presentment of cheques for payment by parties who are away from the place of control account. it is to slow down the disbursements as much as possible.control over cash flows An effective control over cash outflows or disbursements also helps a firm in conserving cash and reducing financial requirements.

he has to decide about the following two basic factors: (a) Desired days of cash: It means the number of days for which cash balance should be sufficient to cover payments. the finance manager has to take into account the minimum cash balance that the firm must keep to avoid risk or cost of running out of funds. Such minimum level may be termed a “safety level of cash”.It refers to the time. (i) Determining of surplus cash Surplus cash is the cash in excess of the firm’s normal cash requirements. (iii) Cheque processing float: It refers to the time required for the seller to sort. While determining the amount of surplus cash. which elapses between receiving of the cheque by the post office or other messenger from the buyer till it is actually delivered to the seller. Determining safety level for cash The finance manager determines the safety level of cash separately both for normal periods and peak periods. record and deposit the cheque after it has been received by him. 4. (iv) Bank processing float: This refers to the time period which elapses between deposit of the cheque with the banker and final credit of funds by the banker to the seller’s account. In both the cases. (ii) Determination of the channels of investments.investing surplus cash (i) Determination of the amount of surplus cash. (b) Average daily cash outflows: .

dividends. (ii) Liquidity: . which will have to be made daily. available for investment for a period ranging from six months to a year. The “desired days of cash” and “ average daily cash outflows” are separately determined for normal and peak periods. Permanent cash surplus consists of funds. which are available for investment on a short-term basis (maximum 6 months). he usually takes into consideration the following factors: (i) Security: This can be ensured by investing money in securities whose price remain more or less stable. Having determined them. since they are required to meet regular obligations such as those of taxes. Such funds are. by comparing the actual mount of cash available with the safety or minimum level of cash. therefore. which are kept by the firm to avail of some unforeseen profitable opportunity of expansion or acquisition of some asset. etc. It is left to the discretion and judgement. Criteria for investment In most of the companies there are usually no written instructions for investing the surplus cash.This means the average amount of disbursements. Temporary cash surplus consists of funds. safety level of cash can be calculated as follows: During normal periods: Safety level of cash = Desired days of cash x average daily cash outflows During peak periods: Safety level of cash = Desired days of cash at the busiest period x Average of highest daily cash outflows. Such surplus may be either of a temporary or a permanent nature. (ii) Determining of channels of investments The finance manager can determine the amount of surplus cash.

(iii) Yield: Most corporate managers give less emphasis to yield as compared to security and liquidity of investment. According to this model. optimum cash level is that level of cash where the carrying costs and transactions costs are the minimum. They.Baumol model: This model was suggested by William J Baumol. (iv) Maturity: Surplus cash is available not for an indefinite period. the interest foregone on marketable securities. namely. some corporate managers follow aggressive investment policies. Cash management models Several types of cash management models have been recently designed to help in determining optimum cash balance. Two of such models are given below: 1. it will be advisable to select securities according to their maturities keeping in view the period for which surplus cash is available. which maximize the yield on their investments. However. prefer short-term government securities for investing surplus cash. If such selection is done carefully. Hence. It is similar to one used for determination of economic order quantity. the finance manager can maximize the yield as well as maintain the liquidity of investments.This can be ensured by investing money in short-term securities including short-term fixed deposits with bank. therefore. Transaction costs . They may also be termed as opportunity cost of keeping cash balance. Carrying costs This refers to the cost of holding cash. These models are interesting and are beginning to be used in practice.

Hence. The formula for determining optimum cash balance can be put as follows: C= 2U x P S Where. There is an inverse relationship between the two costs. 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. These limits consist of an upper limit (h).a.m) 2. C = Optimum cash balance U = Annual (or monthly) cash disbursements P = Fixed costs per transaction S = Opportunity cost of one rupee p. This happens when the firm falls short of cash and to sell the securities resulting in clerical. It deals with cash management problem under the assumption of stochastic or random cash flows by laying down control limits for cash balances.This refers to the cost involved in getting the marketable securities converted into cash. 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. brokerage. optimum cash level will be at that point where these two costs are equal. Miller-Orr model helps in determining the optimum level of cash in such circumstances. a transfer equal to “z-o” from marketable securities to cash is made. lower limit (o) and return point (z). When one increases. the other decreases. a transfer of cash equal to “h-z” is effected to marketable securities. registration and other costs. (p. the other decreases. . When cash balance reaches the upper limit. When it touches the lower limit.

The upper limit and lower limit are set on the basis of opportunity cost of holding cash.N.The model is illustrated in the form of the following chart: upper control limit h Cash balance z Return point O Time lower control limit (D#4 source: Dr.S. degree of likely fluctuation in cash balances and the fixed costs associated with securities transactions. . an account equal to “h-z” is invested in the marketable securities and cash balance comes down to “z” level. Financial management) The above chart shows that when cash balances reaches the upper limit. When cash balance touches the lower limit marketable securities of the value of “z-o” are sold and the cash balance again goes up to ‘z’ level.Maheshwari.

(i) Raw materials: These are goods. (iii) Finished goods: These are completed products awaiting sale. which help the firm in obtaining the desired level of sales. etc. finished goods. It may result in delay in executing the order because of difficulties in obtaining/ procuring raw materials. Inventories are thus one of the major elements. Benefits of holding inventories Holding of inventories helps a firm in separating the process of purchasing. they are generally referred to as merchandise inventory. In case of wholesalers and retailers.. (ii) Work-in-progress: This includes those materials. etc. The levels of the above three kinds of inventories differ depending upon the nature of the business. thus inventories provide cushion so that the . They may consist of basic raw materials or finished components. finished goods. which have been committed to production process but have not yet been completed. In case a firm does not hold sufficient stock of raw materials. producing and selling. the purchasing would take place only when the firm receives the order from a customer. Kinds of inventories Inventories can be classified into three categories. They are the final output of the production process in a manufacturing firm. which have not yet been committed to production in a manufacturing firm.*MANAGEMENT OF INVENTORIES Inventories are good held for eventual sale by a firm.

new production technique. Risk of holding inventories can be put as follows: (i) Price decline This may be due to increase in the market supply of the product. (iii) Achieving efficient production runs Maintenance of large inventories helps a firm in reducing the set-up cost associated with each production run. . The specific benefits of holding inventories can be put as follows: (i) Avoiding losses of sales If a firm maintains adequate inventories it can avoid losses on account of losing the customers for non-supply of goods in time. approving and mailing the order. etc. etc. e. specifications. can be reduced if a firm places a few large orders than numerous small orders. introduction of a new competitive product. etc. price cutting by the competitors. (ii) Product deterioration This may due to holding a product for too long a period or improper storage conditions. improvements in the product design.. Risks and costs associated with inventories Holding of inventories exposes the firm to a number of risks and costs. checking. production and sales functions can proceed at optimum speed. (ii) Reducing ordering cost The variable cost associated with individual orders. (iii) Obsolescence This may be due to change in customers taste.g.purchasing.. typing.

providing proper storage facilities. The fewer the orders. If inventories are kept at a high level. spoilage costs. a low level of inventories may result in frequent interruption in the production schedule resulting in underutilization of capacity and lower sales. determining the size of the inventory to be carried . Management of inventory Inventories often constitute a major element of the total working capital and hence it has been correctly observed. (ii) Ordering cost This includes the variable cost associated with placing an order for the goods. Inventory management covers a large number of issues including fixation of minimum and maximum levels. setting up receipt and inspection procedure. On the other hand. the lower will be the ordering costs for the firm. management inventories involves two basic problems: (i) Maintaining a sufficiently large size of inventory for efficient and smooth production and sales operations. etc. determining the economic order quantity. . However. transportation and handling charges less any discount allowed by the supplier of the goods.The costs of holding inventories are as follows: (i) Materials cost This includes the cost of purchasing the goods. It comprises storage costs. deciding about the issue price policy. (ii) Maintaining a minimum investment in inventories to minimize the direct-indirect costs associated with holding inventories to maximize the profitability. keeping check on obsolescence and setting up effective information system with regard to the inventories. “good inventory management is good financial management”. (iii) Carrying cost This includes the expenses for storing the goods. Inventories should neither be excessive nor inadequate. cost of funds tied up in inventories. higher interest and storage costs would be incurred. insurance costs.

Techniques of inventory management Effective inventory requires an effective control over inventories. Minimizing the carrying costs. to determine and maintain the optimum level of investment in inventories. Determination of Economic Order Quantity (EOQ) Determination of the quantity for which the order should be placed is one of the important problems concerned with efficient inventory management. It is fixed mainly taking into account the following costs. (v) Keeping investment in inventories at the optimum level. therefore. Maintaining sufficient stock of finished goods for smooth sales operations. The techniques of inventory control/ management are as follows: 1. Inventory control refers to a system which ensures supply of required quantity and quality of inventories at the required time and the same time prevent unnecessary investment in inventories.The objective of inventory management is. which help in achieving the following objectives: (i) (ii) (iii) (iv) Ensuring a continuous supply of materials to production department facilitating uninterrupted production. which gives maximum economy in purchasing any item of raw material or finished product. Maintaining sufficient stock of raw material in periods of short supply. Economic Order Quantity refers to the size of the order. (i) Ordering costs: .

and fewer the quantities purchased on each order. The former cost may be referred as the “cost of acquiring” while the latter as the “ cost of holding” inventory. The two costs involved in this process are: (i) Set up costs. struck between the two opposing factors and the economic ordering quantity is determined at a level for which aggregate of two costs is the minimum. store-keeping cost. The more frequently the orders are placed. insurance premium. etc. A balance is. the higher will be the inventory carrying cost and vice versa.It is the cost of placing an order and securing the supplies. It varies from time to time depending upon the number of orders placed and the number of items ordered. Determination of optimum production quantity The EOQ model can be extended to production runs to determine the optimum production quantity. 2. Formula: Q= 2U x S Where. the greater will be the ordering costs and vice versa. The larger the value of inventory. It includes interest on investment. obsolescence losses. P . therefore. The cost of acquiring decreases while the cost of holding increases with every increase in the quantity of purchase lot. 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. (ii) Inventory carrying cost: It is the cost of keeping items in stock.

In other words. there is an inverse relationship between the set-up cost and inventory carrying cost. the carrying cost will increase with increase in the size of the production run. Thus. The set up cost is of the nature of fixed cost and is to be incurred at the time of commencement of each production run. lower will be the set-up cost per unit. at this level the two costs will be equal. Larger the size of the production run. The optimum production size is at that level where the total of the set-up cost and the inventory carrying cost is the minimum. However.(ii) Inventory carrying cost. The formula for EOQ can also be used for determining the optimum production quantity as given below: E= 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) .

payments are received immediately and. The policy of open account sales facilities business transactions and reduces to a great extent the paper work required in connection with credit sales. no. However. shipping invoice or even a billing statement. 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. formal acknowledgements of debt obligations are taken from the buyers. customer receivables or book debts. the result of extension of credit facility to then customers a reasonable period of time in which they can pay for the goods purchased by them. The only documents evidencing the same are a purchase order. Hence the purpose of receivables is directly connected with the objectives of making credited sales. no receivables are credited. They. which means that. When a firm sells goods for cash. therefore. .MANAGEMENT OF ACCOUNTS RECEIVABLES Accounts receivables (also properly termed as receivables) constitute a significant portion of the total currents assets of the business next after inventories. They are. Purpose of receivables Accounts receivables are created because of credited sales. They are a direct consequences of “trade credit” which has become an essential marketing tool in modern business. therefore. when a firm sells goods or services on credit. the credit sales are made on open account. Usually. 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. the payments are postponed to future dates and receivables are created. as stated earlier.

. . This is because there is a time lag between the sale of goods to customers and the payments by them. Additional funds may either be raised from outside or out of profits retained in the business. the firm has to pay interest to the outsider while in the latter case..e. i. in case it resorts to credit sales. suppliers of raw materials. while awaiting for payments from its customers. (ii) Increasing profits: Increase in sales results in higher profits for the firm not only because of increase in the volume of sales but also because of the firm charging a higher margin of profit on credit sales as compared to cash sales. In both the cases. therefore. the firm incurs a cost. The firm can sell goods to such customers. The firm has. The overall objective of committing funds to accounts receivables is to generate a large flow of operating revenue and hence profit than what would be achieved in the absence of no such commitment. Costs of maintaining receivables The costs with respect to maintenance of receivables can be identified as follows: 1. to arrange for additional funds top meet its own obligations. This is because many customers are either not prepared or not in a position to pay cash when they purchase the goods. it will generally be in a position to sell more goods than if it insisted on immediate cash payments.The objectives of credited sales are as follows: (i) Achieving growth in sales: If a firm sells goods on credit. etc. there is an opportunity cost to the firm. (iii) Meeting competition: A firm may have to resort to granting of credit facilities to its customers because of similar facilities being granted by the competing firms to avoid the loss of sales from customers who would buy elsewhere if they did not receive the expected output. Capital costs: Maintenance of accounts receivables results in blocking of the firm’s financial resources in them. the money which the firm could have earned otherwise by investing the funds elsewhere. such as payment to employees. In the former case.

as a matter of fact. If a firm has a lenient or a relatively liberal credit policy.e. 4. the length of the credit period to be extended. Defaulting costs: Sometimes after making all serious efforts to collect money from defaulting customers. additional steps may have to be taken to recover money from defaulting customers. Factors affecting the size of receivables The size of the receivable is determined by a number of factors. (2) Credited policies: The term credit policy refers to those decision variables that influence the amount of trade credit.2. 3. cost of conducting investigation regarding potential credit customers to determine their creditworthiness. A firm’s credit policy. . determines the amount of risk the firm is willing to undertake in its sales activities. etc. it will experience a higher level of receivables as compared to a firm with a more rigid or stringent credit policy. Such debts are treated as bad debts and have to be written off since they cannot be realized. 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. i. Sales level can also be used for forecasting change in accounts receivable. These variables include the quantity of trade accounts to be accepted. Collection costs: The firm has to incur costs for collecting the payments from its credit customers. 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.. Sometimes. the investment in receivables. the cash discount to be given and any special terms to be offered depending upon particular circumstances of the firm and the customer. 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. the firm may not be able to recover the overdues because of the of the inability of the customers. Generally in the same industry.

Whereas the underlying objective in case of accounts receivable is to maximize the acceleration of the collection process. (3) Terms of trade: The size of the receivables is also affected by terms of trade (or credit terms) offered by the firm. the objective in case of accounts payable is to slow down the payments process as much as possible. (i) Credit period: The term credit period refers to the time duration for which credit is extended to the customers. The two important components of the credit terms are: (i) Credit period. For example.This is because of two reasons: (i) A lenient credit policy encourages even the financially strong customers to make delays in payments resulting in increasing the size of the accounts receivables. (ii) Lenient credit policy will result in greater defaults in payments by financially weak customers thus resulting in increasing the size of receivables. MANAGEMENT OF ACCOUNTS PAYABLE Management of accounts payable is as much important as management of accounts receivable. The terms of the cash discounts indicate the rate of discount as well as the period for which the discount has been offered. If a firm’s credit terms are “net 15”. (ii) Cash discount. (ii) Cash discount: Most firms offer cash discount to their customers for encouraging them to pay their dues before the expiry of the credit period. But it should be noted that the delay in payment of accounts payable may result in saving of some interest . It is generally expressed in terms of “net days”. There is a basic difference between the approach to be adopted by the finance manager in the two cases. it means the customers are expected to pay within 15 days from the date of credit sale.

therefore. To be more precise they are connected with the cash position of the business. Normally. The finance manager has. etc. (b) Attempting to expand the volume of the business without raising the necessary resources.. besides making delay in payment to the creditors. therefore. dividend payments. etc.costs but it can prove very costly to the firm in the form of loss credit in the market. In a situation like this. Causes of overtrading The following may be the causes of over-trading: (i) Depletion of working capital: Depletion of working capital ultimately results in depletion of cash resources. prove to be dangerous to the business since disproportionate increase in the operations of the business without adequate resources may bring its sudden collapse. purchase of fixed assets and excessive net trading losses. OVERTRADING: Overtrading means an attempt to maintain or expand scale of operations of the business with insufficient cash resources. etc. It may also not be able to extend credit to its customers. Overtrading and undertrading The concepts of overtrading and undertrading are intimately connected with the net working capable position of the business. Overtrading has been amply described as “overblowing the balloon”. Cash resources of the company may get depleted by premature repayment of long-term loans. finished goods. (ii) Faulty financial policy: Faulty financial policy can result in shortage of cash and overtrading in several ways: (a) Using working capital for purchase of fixed assets. This may. and has to depend on the mercy of the suppliers to supply them goods at the right time. to ensure that the payments after obtaining the best credit terms possible. the company is not in a position to maintain proper stocks of materials. excessive drawings. concerns having overtrading have a high turnover ratio and a low current ratio. .

(ii) Costly purchases: The company has to pay more for its purchases on account of its inability to have proper bargaining. Nonpayments of wages in time create a feeling of uncertainty. therefoe. (iii) Reduction in sales: The company may have to suffer in terms of sales because the pressure for cash requirements may force it to offer liberal cash discounts to debtors for prompt payments.. natural calamities. The wages and material costs also rise. as well as selling goods at throwaway prices. Such pressure results in over-expansion of the business ignoring the elementary rules of sound finance. etc. . (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. bulk buying and selecting proper source of supplying quality materials. Consequences of overtrading The consequences of over-trading can be summarized as follows: (i) Difficulty in paying wages and taxes: This is one of the most dangerous consequences of overtrading. needs more money even to maintain the existing level of activity. Government may pressurize the manufacturers to increase the volume of production without providing for adequate finances. The manufacturer. a firm may be required to produce goods on a larger scale. Non-payments of taxes in time may result in bringing down the reputation of the company considerably in the business and government circles.(iii) Over-expansion: In national emergencies like war. insecurity and dissatisfaction in all ranks of the labour. (iv) Inflation and rising prices: Inflation and rising prices make renewals and replacements of assets costlier.

book debts and cash balances.e. therefore. The cure is simple-reduce the business or increase finance. Inefficient working. In such a situation the level of trading is low as compared to the capital employed in the business. Such underutilization may be due any one or more of the following causes: . If this is not possible. The basic cause of undertrading is. UNDERTRADING: It is the reverse of overtrading. This is because of firms inability to pay its creditors in time and exercising of undue pressure on debtors for payments. (v) Obsolete plant and machinery: Shortage of cash will force the company to delay even the necessary repairs and renewals. (c) Purchase of fixed assets out of short-term funds. arrangement of more finance is better.(iv) Difficulties in making payments: The shortage of cash will force the company to persuade its creditors to extend credit facilities to it. It results in increase in the size of inventories. Both are difficult. the only advisable course left will be to sell the business as a going concern. Undertrading is a matter of fact an aspect of overcapitalization. unavoidable breakdowns will have an adverse effect both on volume of production and rate of profit. It means improper and underutilization of funds lying at the disposal of the undertaking. However. The cure for overtrading is easier to prescribe but difficult to follow. i. Symptoms and remedies for overtrading The situation of overtrading should be remedied at the earliest possible opportunity. The symptoms can be put as follows: (a) A higher increase in the amount of creditors as compared to debtors.. underutilization of the firm’s resources. as soon as its first symptoms are visible. (b) Increased bank borrowing with corresponding increase in inventories. (d) A fall in the working capital turnover (working capital/sales) ratio. (e) A low current ratio and high turnover ratio. anxiety and fear will be the management’s constant companions. Worry.

therefore. projects.  Non-availability or shortage of basic facilities necessary for production such as. Remedies for undertrading The condition of undertrading is set in because of underutilization of the firm’s resources.. be remedied by the management by adopting a more dynamic and result-oriented approach. (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. etc. The firm may go for diversification and undertaking new profitable jobs. etc. An increase in working capital turnover (working capital/ sales) ratio.  General depression in the market resulting in fall in the demand of company’s products. raw materials. The situation can. . power. The symptoms of undertrading are the following: (i) (ii) (iii) A very high current ratio. Low turnover ratios. 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. Conservative policies followed by the management. labour. resulting in a better and efficient utilization of the firm’s resources. (ii) The value of the shares of the company on the stock exchange starts falling on account of lower profitability.

to get a discount this will decline. If you pay earlier. Ratio Formulae Result Interpretation On an average. easily calculated. It takes your average x days to collect receivables due to you. say. ratios are important measures of working capital utilization. slow moving lines will extend overall stock turnover days. If you negotiate better credit terms this will increase. Effective debtor management will minimize the days On an average. Obsolete stock.Key Working Capital Ratios The following. Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. Current Liabilities are amount you are due to pay within the coming 12 months. Similar to the Current Ratio but takes account of the fact that it may take time to convert inventory into cash Stock Turnover (in days) Receivables Ratio (in days) Payables Ratio (in days) Current Ratio Average Stock * 365/ Cost of Goods Sold Debtors * 365/ Sales Creditors * 365/ Cost of Sales (or Purchases) Total Current Assets/ Total Current Liabilities = x days = x days = x days =x times Quick Ratio (Total Current Assets Inventory)/ Total Current Liabilities =x times . you pay your suppliers every x days. your stock turnover is in x days.

which sells predominantly on cash basis. like an electricity undertaking which has a short operating cycle. On the other hand. . and stores depends on the conditions of supply. The sale of ceiling fans reaches a peak during the summer months and drops sharply during the winter period.FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS The working capital needs of affirm are influenced by numerous factors. Seasonality of operations Firms which have marked seasonality in their operations usually have highly fluctuating working capital requirements. consider a firm manufacturing ceiling fans. the firm can manage with small inventory. Market conditions The degree of competition prevailing in the market place has an important bearing on working capital needs. A service firm. which has a long operating cycle and which sells largely on credit. If the supply is prompt and adequate. has a very substantial working capital requirement. Production policy A firm marked by pronounced seasonal fluctuation in its sales pursue a production policy. The important ones are: Nature of business The working capital requirement of a firm is closely related to the nature of its business. which may reduce the sharp variations in working capital requirements. 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. has a modest working capital requirement. spares. a manufacturing concern like a machine tools unit. When competition is keen. To illustrate.


no a Particulars Total current assets (Excluding fixed deposits Money margin) Other current liabilities Excluding short-term bank bal.) Working capital GAP (a-b) Minimum stipulated Net working capital (25% of total current assets Excluding expected receivables.5 11.77 15.28 18 18 12.Method #1 for assessment of working capital Working capital assessment Sr.cap Item (c-d) Item (c-e) MPBF (lower of ( f or g)) Mar’03 Mar’04 (Rs.93 11.35 11.41 13.6 62.21 23 25 c d 23.44 33.6 37.32 12.51 21.5 e f g h I 6.77 21.5 57. In lakhs) Provisional mar'05 Projected mar'-6 56.84 33.19 36.78 14.6 22.03 69.5 25 25 25 Excess borrows if any .84 11.67 22.78 16.) Actual /projected net w.65 b 33.

00 A Particulars Projected sales for the year 2004-05 25% of sales lakhs) 115.75 23.Method #2 (sales approach) for assessment of working capital Working capital assessment Sr.77 15.00 .00 10.projected net working capital Bank finance Bank borrowings shown in the projections Of the company F Limit applied for Limit recommended for sanction E or F whichever is lower (Rs.02 28.21 E 15.21 15.77 5.09 28.5% of gross sales margin Permissible bank finance B 25% of sales Less: .

RECOMMENDATIONS BY TANDON COMMITTEE The report submitted by the Tandon committee is a landmark in the history of financing of working capital by commercial banks in India. The report was submitted on 9th August 1975. The recommendations were essentially based on three principles: (i) A proper financial discipline has to be observed by the borrower. The report included recommendations covering all aspects of lending. (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. He should supply to the banker information regarding his operational plans well in advance. . (ii) The main function of the banker as a lender is to supplement the borrower’s resources to carry an acceptable level of current assets.

the profit element should be considered with the risk element collectively. trends should be considered. Recommendations after Scanning of working capital financing Bank of Maharashtra: (i) While assessing the project. (iv) Sectoral analysis should be considered before providing the working capital finance to any firm.SCANNING OF WORKING CAPITAL FINANCING IN MAHABANK Working capital financing in Bank of Maharashtra is done as per the recommendations proposed by different competent authorities. Chore committee report. There is still scope for more efficient working capital financing in the bank. even though regular customer. (v) Statement of financial transactions should be review at regular interval to minimize losses due to irregular payments and defaulters. (ii) Financing of working capital should be avoided to a long loss making firm. (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. . such as Tandon committee report.

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