MF0007 – International Financial Management -Set-2

Note: Each question carries 10 Marks. Answer all the questions.

Q.1 Give any three measures taken by RBI in the recent past (1 year) to liberalise
exchange control?
Ans: Following are the measures taken by RBI to liberalise exchange control

1. Foreign Exchange Management Act (FEMA ):

Foreign Exchange Management Act, 1999 replaced FERA 1973 with effect from June 1,
2000. FEMA had the objective of facilitating external trade and payments by causing
orderly development and maintenance of foreign exchange market in India. FEMA was
brought at a time when the government planned a road map for convertibility of rupee
both on current account and on capital account. As a first step, FEMA was brought into
existence with full current account convertibility. It also contains provisions for
progressive liberalisation of capital account transactions. Full convertibility of the rupee
on both current account and capital account is a condition that is put forth by the foreign
investors. In times of changing sovereign rating, the foreign investors move the funds
quickly from one country to another. Therefore, the Indian government also has the
objective of moving towards full convertibility. The word of caution also continues to be
dominant.

FEMA is far more transparent than FERA. It identifies clearly the areas where the
permission of RBI on acquiring or holding foreign exchange is required. In the remaining
areas, funds can be remitted as per the provisions of the Act. It clearly distinguishes
between transactions on current account and transactions on capital account.

FEMA provides powers to the RBI for specifying the classes of permissible capital
account transactions. The limit of foreign exchange available for such transactions is
also prescribed. The Exchange Earners Foreign Currency (EEFC) and Resident
Foreign Currency (RFC) account holders are freely permitted to use the funds in these
accounts for payment of all permissible current account transactions. Remittances are
permitted for all current account transactions through authorised dealers.

FEMA is a vast improvement on FERA. It is a civil law providing for imprisonment only
in extreme causes. FERA put the burden of proof on the persons in question. FEMA put
the burden of proof on the enforcement agency. It provides for power of adjudicating
officers with an Appellate Tribunal. FERA was applicable to Indian citizens resident
abroad. However, FEMA is not applicable to such citizens.

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Provisions of FEMA and Role of RBI

FEMA is a product of liberalised regime and removes shackles from the hands and
foots of exporters, importers and the investors. However, RBI’s supervisory role
continues to ensure that the liberalised atmosphere is not misused. It attempts to build
the foreign exchange market on healthy lines.

2. Exports Control

1. The authorised dealers must conduct export transaction in conformity with the
Foreign Trade Policy in existence, Rules framed by Govt. of India and the directions
issued by the RBI from time to time.

2. Drawal of exchange for certain current account transactions is prohibited. Restrictions

are placed on certain other transactions, which require the prior permission of the RBI.

3. Any export of Indian currency of value exceeding Rs. 5000 except to the extent
permitted under any general permission granted under the Regulations will require prior
permission of the RBI.

4. Authorised Dealers are permitted to issue guarantees on behalf of exporters clients

on account of exports out of India.

5. Gift of Goods exceeding five lakh rupees require approval of the RBI.

6. The amount representing the full exports value of the goods exported shall be
received through an Authorised Dealer. The exporter in any of the following forms shall
receive payment for exports.

(a) Bank Draft, Pay order, Banker’s or personal cheques.

(b) Foreign currency Notes/Foreign currency traveller’s cheques.

(c) Out of funds held in the FCNR/NRE account maintained by the buyer.

(d) Through International credit cards.

7. Indian corporates who have set up overseas offices abroad have been permitted to
acquire immovable property outside India for their business as also staff residential
purposes with prior permission of RBI.

8. RBI also can accord permission for counter trade involving adjustment of value of
goods imported into India against value of goods exported from India.

9. Prior approval of RBI must be obtained for export of machinery, equipment etc., on
lease or hire basis. The exporters must obtain the approval through Authorised Dealers.
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10. General Permission is given for participation in international exhibitions/trade fair.

The net sale proceed received must be repatriated to India within one month.

11. The exporters must present document pertaining to exports to the Authorised Dealer
within 21 days of actual shipment. Where there is a delay, the Authorised Dealers
themselves can handle them without the prior approval of RBI, provided the Authorised
Dealers are satisfied with the reasons of the delay.

12. Refund of proceeds may be allowed by Authorised Dealers through whom the
original proceeds were received, provided such goods are re-imported into India on
account of poor quality or for any other reasons.

3. Imports Control

(1) While understanding import transactions, the Authorised Dealers should ensure that
the imports into in India are in conformity with directions issued by the RBI among other
things.

(2) Authorised Dealers should follow normal banking procedures while opening letters of
credit for import into India on behalf of their clients.

(3) Any person buying foreign exchange is allowed to use it for the purpose made
known to the Authorised Dealer or for any purpose permitted by the provisions of
FEMA.

(4) Where foreign exchange purchased is used for import of goods, the Authorised
Dealer should ensure that the importer furnishes an evidence of import to his
satisfaction.

(5) Authorised Dealers may permit settlement of import dues delayed due to disputes,
financial difficulties etc. Interest in respect of such delayed payments may be permitted
in terms of the directions provided by FEMA.

(6) Authorised Dealers should preserve documents evidencing import into India for a
period of one year from the date of its verification.

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Q.2 Explain various objectives of liquidity management by Banks. What steps

Banks can take to meet the impending shortage of liquidity?
Unit-6,6.2,6.4,6.5
Ans:For banking institutions, liquidity is the lifeline, not merely a question of reputation
as in the case of non-banking institutions. The banker’s ability to raise deposits depends
upon the public confidence he enjoys. The public will have confidence only as long as it
feels that its deposits are safe with the banker and the banker has the ability to meet the
demand of the depositor in the form of withdrawal. Once the depositors lose their
confidence, they rush to the bank to withdraw their deposits (known as “run” on the
bank). As the banker has invested the deposit money in loans and advances and in
investment, he is in no position to call back the loans immediately. Once he does not
have enough cash even to pay back the claims of a few depositors, he can not convince
the public any longer of his ability to meet the cash withdrawal of all the depositors.

Where there is a run on the bank, no bank however big or small, efficient or inefficient
can meet the deluge of people in its premises. The scene may also quickly turn nasty
with the public ire turned towards the property and employees of the bank. Thus,
liquidity risk for non-banking institutions is in the form of loss of interest on premature
withdrawal of deposits, liquidation of investment at a higher loss of interest or market
value, emergency borrowing. The extreme form of risk is loss of reputation with
suppliers, employees etc., regarding the firm’s inability to make timely payments. For
banking institutions, liquidity risk is the possibility of loss due to emergency disposal of
investment, higher cost of emergency borrowing, penalties levied by the RBI for non-
maintenance of cash reserve ratio and, in the extreme, threatening the very survival of
the bank. As Theodore Levitt puts it, “The main business of every business is to remain
in business.” The bank would be putting such a main object at risk by not maintaining
sufficient liquidity.

If a bank wants to survive in the business, it has to manage its liquidity risk very well. On
its failure to meet the obligations, the Reserve Bank of India can impose a moratorium
and later on force it to merge with a bigger bank as in the case of Global Trust Bank
having been forced to be taken over by Oriental Bank of Commerce. The bank
management is silenced and the book value of the bank’s equity may be taken as zero.
For banking institutions, liquidity risk may assume the dimension of a nightmare.
Liquidity Risk can be defined as the possibility of loss due to lack of sufficient cash and
near cash to meet the payment schedules (i.e. timely payments). It may assume the
form of increased loss, reduced income, and loss of reputation or in the extreme cases
winding up of the organization.

Objectives of Liquidity Management:

For the banks, liquidity management is a main driver of many functions. With an efficient
liquidity management, the banks stand to gain in many fronts. Even though there are
hundreds of banks and thousands of branches, each bank or each branch has brand
equity of its own. One of the main contributors to such brand equity is liquidity
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management. The main objectives and the purposes of liquidity management are
highlighted through the following aspects:

1) Retaining Public Confidence: Public confidence is crucial for mobilizing deposits.

Good liquidity management helps the bank never to run short of cash. Ready meeting of
payment and maturity schedules convince the public that the bank is built upon a sound
foundation of liquidity. The State Bank of India along with its subsidiaries never runs
short of cash due to maintaining government and public sector units’ accounts. This has
created in the minds of the public that the SBI group is one big giant of infallible
strength.

2) Proper Liquidation of Investment Products: The banks invest sizeable amount of

funds in money market instruments and capital market securities. These are either held
for profitable sale or until maturity. With a good liquidity management, the bank has no
compulsion to sell these in adverse market conditions. In case of securities held for
maturity, redemption should not be made premature to avoid incurring losses. Even
securities held for sale should not be sold in emergency. The bank may incur losses or
experience a loss of profit in adverse market conditions. A good liquidity management
helps in proper liquidation of investment products at the end of the investment horizon.

3) Avoiding Emergency Borrowing: A good liquidity management enables the borrowing

programme in the money market in the normal way. The maturing of the money market
with a large number of players and also the supply of huge funds contributed to wide
fluctuations in the market. Where it creates a temporary shortage of funds for most of
the banks, the interest rates shoot up sky -high. Longer queues of bankers in
emergency borrowing will push up the cost of funds resulting in a strain on the banker’s
margins. Liquidity management makes a serious attempt in avoiding such emergency
borrowing.

4) Smooth Lending Programme: Banks follow a disbursement schedule of loans given to

customers. The customers on learning about the disbursement schedules make their
own payment schedule and purchase commitment. In order to ensure such schedules
are followed, the banks should have no problem with liquidity. Any such liquidity
problem will make the bank postpone the disbursement. This may not only render the
customer dissatisfied, but it may force him to try to raise the finance from other banks or
from alternative sources. This will also cause an unfavourable impression in the trading
and business circles.

5) Reputation in Financial Markets: A bank with good liquidity management impresses

the financial market. The track record of a bank in repayment in time and never running
short of cash sends a strong signal in the financial market about the soundness of the
bank. Reputation in the financial markets has a commercial value. It helps the bank in
borrowing at an interest rate that is lower than that of any other bank. Such a good
image maintained consistently over the period of time impresses the overseas
investors. The impressed foreign investors may be willing to lend to the banks or may
take a stake in the equity of the firm in the future.
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6) Avoiding Penalty of RBI: Banks not maintaining the needed Cash Reserve Ratio on a
weekly basis (every Friday) will be penalized by the central bank of the country. The
relation of any bank with the central bank of the country should be based on respect
and admiration. The RBI views the banks, which are defaulting in the maintenance of
CRR, unfavourably. Good liquidity management will help in maintenance of the CRR
without much difficulty. The relation with the central bank also will be smooth. As a
regulator, the RBI is very much concerned with the financial health of the banks. The
financial health of a bank is measured first by the liquidity position of the bank and then
measured by the profitability.

7) Participation in Liquidity Adjustment Facility (LAF): For the banks to participate in the
Repo and Reverse Repo, they have to satisfy certain eligibility criteria. Though every
bank was allowed to participate the RBI, since the year 2006, is restricting the facility to
those banks that are maintaining the balance with the RBI well above the CRR. By this
message, the RBI has been sending the signal that the CRR is only a bare minimum
liquidity. The banks are advised to maintain it well above the prescribed level. Good
liquidity management will help the banks in achieving the eligibility to participate in the
LAF Facility. Where the money market undergoes an abnormal phase of high interest
rates, the banks find the Repo to be a good source of borrowing. Where the market
faces a glut of funds and low interest rates, the Reverse Repo window of the RBI
becomes a good avenue of investment for the banks.

8) Attracting FII Investment: Foreign Institutional Investment always finds the bank stock
to be a preferred one due to the importance enjoyed by the banking sector in the
economy. Such investment is preferred so that they can take a strategic stake at later
period in the ownership of the bank. Such FIIs consider both profitability and liquidity
management to be crucial while selecting a bank for equity participation. Generally,
these FIIs invest a very huge amount in the bank with the objective of making the bank
to go for expansion and diversification immediately. Such a programme calls for huge
liquidity or cash reserves with the bank. That is why the FIIs will eye only those banks,
which enjoy a good liquidity position.

9) Absorption of Information Technology: Banks need to absorb the IT more and more
for their basic operations and for providing sophisticated remittance facilities. This will
enable the banks to move the funds very quickly and also will enable them to act as
financial intermediaries providing sophisticated services. There is a severe competition
among the banks to absorb new systems and updating existing systems. The foreign
banks operating in India have a better liquidity management and a higher level of
profitability. They could achieve this due to the absorption of a very high level of IT in
their operations. In spite of many IT initiatives of the RBI, Indian banks are still lagging
behind in updating the systems regularly. However, such a level of IT absorption entails
huge expenses on its maintenance. A bank’s liquidity management should be
impeccable enough to meet such huge expenses of maintenance.

10) Diversification: Banks are also entering new areas of operation like sale of gold,
custodianship, investment banking, mutual funds, insurance, depository participation,
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and acting as a financial intermediary in the capital market. All new areas of endeavour
call for investment of huge amount of funds. Unless liquidity is managed well, the funds
for such diversified activities and basic operations will dry up quickly. The examples of
ICICI Bank, HDFC Bank, and Kotak Mahindra Bank in undertaking diversified activities
in such a short span of time speak volumes about their ability regarding liquidity

Q.3 What is operating cycle? How does it affect working capital management? What are
other major factors that influence working capital management?

Unit-3 ,3.10.3,3.10.2

Ans: Concept of Operating Cycle:

Operating cycle is the time involved in converting cash into raw material, raw material
into work-in-progress, work-in-progress into finished goods, finished goods into debtors
and debtors into cash. The length of the operating cycle determines the size of working
capital of a firm. Sometimes, the production process is long, as in plantations (coffee,
tea, rubber), ship building, air-craft manufacturing, assembling satellites etc. Investment
in work-in-progress is high leading to higher working capital. Compared with them,
manufacturing cosmetics, personal care products like soaps involve shorter operating
cycles. Thus, working capital needed is less.

There are four components for an operating cycle of a manufacturing firm.

A) Raw Material Conversion Period (RMCP): It is the length of the period needed for
buying raw material and converting raw material into work-in-progress.

B) Work-In-Progress Conversion Period: It is the length of the period required to

convert work-in-progress into Finished Goods.

C) Finished Goods Conversion Period (FGCP): It is the period needed for selling the
finished goods to the customers (Debtors)

The total of the above three periods is called Inventory Conversion Period.

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Inventory Conversion Period= RMCP+WIPCP+FGCP

D) Book Debt Conversion Period: (BDCP): It is the period needed for collecting cash
from debtors.

Gross Operating Cycle and Net Operating Cycle:

Gross Operating Cycle is the period needed for buying raw material, producing the
goods, selling them and collecting cash from debtors. In other words, it is the total of
RMCP, WIPCP, FGCP and BDCP.

Gross Operating Cycle=RMCP+WIPCP+FGCP+BDCP

If the firm is buying raw material from its supplier on credit, the payment need not be
made immediately. It is postponed to the future. This period is called Payment Deferral
Period. It is the period between date of purchase and date of payment. If this period is
deducted from Gross Operating Cycle, we get Net Operating Cycle.

Net Operating Cycle = Gross Operating Cycle–Payment Deferral Period.

Estimation of Working Capital Requirement: Working Capital Requirement can be

estimated by any one of the following four methods:

i) Components of Working Capital Method

ii) Percentage of Sales Method
iii) Operating Cycle Method.

i) Components of Working Capital Method:

Under this, every component of Current Assets and Current Liabilities will be estimated.
The total of current assets will yield Gross Working Capital. When current liabilities are
subtracted, Net Working Capital is arrived at.

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ii) Percentage of Sales Method:

As sales determine production & production determines the size of working capital, a
relation is established between sales and working capital, e.g., 10% of the sale is
required for working capital. If the estimated sale is Rs. 2 cr. working capital needed is
Rs. 20 lakhs i.e., 10% of Rs. 2 cr. The relation is determined based on experience.

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iii) Operating Cycle method:

Under this method, Gross Operating Cycle and Net Operating Cycle are calculated.

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Working Capital Management:

The modern organisation incurs a huge amount of expenses for its daily operation.
Some of the expenses are basic and traditional like cost of material, labour and other
usual overheads. Many new expenses have cropped up recently like telephone
expenses, broadband services, and network maintenance, maintenance of computers
and other IT systems, fee-based services of banks etc. The capital needed for meeting
these expenses is called Working Capital. Cash or near-cash items like cash at bank or
investment in money market mutual funds, commercial paper or certificate of deposit
are needed for meeting these expenses. Cash in hand and the balances at bank do not
bring in any returns. However, they are needed to meet the daily expenses. Hence, a
minimum amount of cash should be maintained without running short of it at any time.

Working Capital can be defined in the following 4 different ways:

1) Gross Working Capital: This represents the total investment made by the firm in the
current assets. Current Assets include cash in hand, cash at bank, money market
instruments, investments in units of money market mutual funds, Accounts Receivable
(debtors), Inventory, Prepaid Expenses and Accrued Income. The total of all these
Current Assets represents Gross Working Capital. Gross Working Capital is partiality
financed by current liabilities. The remaining part is financed by long-term securities like
equity shares, debentures, bonds or any other such security.

2) Net Working Capital: It is the excess of current assets over current liabilities.
Current liabilities include Accounts Payable (Creditors), Bank Overdraft, Customer
Deposit, Dealers Deposit, Outstanding Expenses and Short -Term Provisions.

Net Working Capital= Current Assets-Current Liabilities.

Net Working Capital is fully financed by long-term sources of finance.

3) Permanent Working Capital: It is the working Capital needed throughout the year,
and also from one year to another. It finances the normal activity of the firm. Then, it
becomes the basic component of the working capital. It is advisable to finance such
working capital out of long-term sources of finance.

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4) Temporary or Fluctuating working Capital: A sudden increase in the activity may

call for more working capital temporarily. This may be due to seasonality in demand,
getting unexpected orders, temporary rise in the price of raw material, a temporary rise
in wage bill due to overtime work etc. This is generally financed by short-term sources
like Trade Creditors & Bank Overdraft.

Factors Determining the Size of Working Capital: The size of working capital of a
firm depends upon a myriad of factors. So much so, the working capital is determined
more by experience than by any scientific method of estimation. The following factors
generally affect the size of working capital of a firm.

1) Nature of Business: Certain business or industries need large working capital either
due to employing a large labour force or buying huge quantity of raw material or
components. The following types of undertaking need huge working capital.

(a) Heavy Industries like Steel Industry, Cement Industry etc.

(Raw material & Labour)

(b) Public Utilities like Railway, Airway, Electricity producing or distributing companies
etc (labour)

(c) Mines like coal mines, copper mines, gold mines etc (labour)

(d) Automobiles (labour and components)

2) Scale of Operation: Large-scale industries need huge working capital for employing
more people and buying large quantity of raw material. Therefore, scale of operation is
also an important factor.

3) Length of Operating Cycle: The size of working capital varies directly with the
length of operating cycle. In case of longer operating cycle like shipbuilding, aircraft
manufacturing, construction of dams, executing turnkey projects, larger investment is
there in work in progress, and hence large working capital is needed.

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4) Rapidity of Turnover: If goods get sold quickly, lesser capital is needed. In case of
FMCG Goods (Fast Moving Consumer Goods) like soaps, toothpastes, cosmetics, the
turnover is quick. Hence, lesser working capital is needed.

5) Nature of Demand: If the demand is stable, the working capital is predictable. It can
be maintained relatively at a lower level. Where the demand is highly fluctuating as in
the case of readymade dresses, jewelry, automobiles etc., higher size of working capital
is needed.

6) Level of Automation: Higher level of automation in the industry reduces the labour
force. Hence, lesser size of working capital is needed. Lower level of automation
requires larger labour force, larger payment of wages, and thus larger working capital.

7) Reliability of Supply: The nature of supply of raw material and components also
decides the size of working capital. If the supply is not certain, a larger inventory should
be carried resulting in larger working capital.

8)Operative Efficiency: Highly efficient companies carry on production with minimum

raw material and minimum labour force. Naturally, they can carry on with lesser working
capital.

9) Credit Policy: Companies that sell the goods only on cash basis need minimum
working capital. When credit sale is allowed, the length of the credit period allowed
determines the size of working capital. Longer the period more will be the size of
working capital.

10) Suppliers’ Credit: Companies buying only on cash basis need a large size of
working capital. If credit purchase is possible, the period of credit allowed decides the
size of working capital. Longer the period less will be the working capital.

11) Prices of Inputs: If costly inputs like diamonds, gold and platinum are used as in
the case of watch- manufacturing, jewellery industry etc., working capital needed is
large.

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12) Level of Profits: Industries that are highly profitable like computer software need
lesser working capital. Their profits themselves contribute to the working capital.

13) Banking Norms: Banks may prescribe the norms to be followed by the industry in
order to lend for the working capital requirements. If so, such norms have a great effect
on the size of working capital.

14) Taxes: Heavily taxed industries like cigarette manufacturing, breweries etc, need
larger working capital just to pay the excise duty to the government.

15) Dividend Policy: Some companies like Castrol, Punjab Tractors etc, declare 3 to 4
interim dividends in a year. Naturally, it will call for a larger working capital.

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