CHAPTER NO.

1:

INTRODUCTION

Working capital management is a significant in financial management .due to the fact that it
plays a pivotal role in keeping the wheels of a business enterprise running. Working capital
management is concerned with short-term financial decisions. Shortage of funds for working
capital has caused many businesses to fail and in many cases has retarded their growth. Lack of
efficient and effective utilization of working capital leads to earn low rate of return on capital
employed or even compels to sustain losses .the need for skilled working capital management
had thus become greater in recent years. A firm invests a part of its permanent capital in fixed
assets and keeps a part of it for working capital i.e., for meeting day-to-day requirements .we will
hardly find a firm which does not require any amount of working capital for its normal
operations. The requirement of working capital varies from firm to firm depending upon the
nature of business, production policy, market conditions, seasonality of operations, conditions of
supply etc.

The basic objective of Working Capital Management is to avoid over investment or under
investment in Current Assets, as both the extremes involve adverse consequences. Over
investment in Current Assets may lead to the reduced profitability due to cost of funds. Working
capital management is considered to be one of the most important functions of finance, as a very
large amount of funds are blocked in current assets in practical circumstances. Unless working
capital is managed properly, it may lead to the failure of business. The term ‘Working Capital’
may mean Gross Working Capital or Net Working Capital. Gross Working Capital means
Current Assets.Net Working Capital means Current Assets less Current Liabilities. Unless
otherwise specified, Working Capital means Net Working Capital. As such, Working Capital
Management refers to proper management of Current Assets and Current Liabilities.
Definition:

According to Guttmann &Doug all-

“Excess of current assets over current liabilities”

According to Park & Gadson-

“The excess of current assets of a business (i.e. cash, accounts receivables, inventories) over
current items owned to employees and others (such as salaries & wages payable, accounts
payable, taxes owned to government)”.

The assets which can be converted in the form of cash or used during the course of normal
operations within a short span of time say one year, without any reduction in value are referred
as current assets. Current assets change the shape very frequently. The current assets ensure
smooth and fluent business operations and are considered to be the life-blood of the business. In
case of a manufacturing organization, current assets may be found in the form of stocks,
receivables, cash and bank balances and sundry loans and advances. The term current liabilities
refer to those liabilities which are to be paid off during the course of business, within a short
span of time say one year. They are expected to be paid out of current assets or the earnings of
the business. Current liabilities consist of sundry creditors, bills payable, bank overdraft or cash
credit, outstanding expenses etc. The objective of Working Capital Management is to ensure
Optimum Investment in Current Assets. In other words, Working Capital Management intends to
ensure that the investment in Current Assets is reduced to the minimum possible extent.
However, the normal operations of the organization should not be affected adversely. If the
normal operations of the organization are affected adversely, reducing the investment in Current
Assets is fruitless. Generally, it will not be possible for any organization to operate without the
working capital. Let us assume that a manufacturing organization commences its business with a
certain amount of cash. This cash will be invested to buy the raw material. The raw material
purchased will be processed with the help of various infrastructural facilities like labor,
machinery etc. to convert the same in the form of finished products. These finished products will
be sold in 3 the market on credit basis whereby the receivables get created. And when
receivables make the payment to the organization, cash is generated again. As such, there is a
cycle in which cash available to the organization is converted back in the form of cash. This
cycle is referred to as Working Capital Cycle.

In between each of these stages, there is some time gap involved. The entire requirement of
working capital arises due to this time gap. As this time gap is unavoidable, requirement of
working capital is unavoidable. The finance professional is interested in reducing this time gap to
the minimum possible extent in order to manage the working capital properly. Business can
survive even if profits are not made but it may not survive without proper liquidity. Hence, in
order to retain the liquidity state, all business firms should manage their working capital
appropriately.

Working Capital Management:

Relationship between current assets and current liabilities for a business firm is called
management of working capital. “Working capital management is concerned with the problems
that arise in attempting to manage the current assets and current liabilities and the inter-
relationship that exists between them. There is habitually a distinction made amid the investment
decisions concerning current assets and the financing of working capital.”

Two major aspects of management of working capital are:

(1) To ascertain the current assets

(2) To conclude the method of financing

Concept of Working Capital Management

Working capital management can be conceptualized under two categories:

 Qualitative
 Quantitative
 These concepts are well known as “gross working capital” concept and “net working
capital” concept. In quantitative working capital concept, current assets are considered as
working capital which is termed as gross working capital too. In qualitative, current assets
and current liabilities are taken into account, working capital is defined as excess or deficit
of current assets over current liabilities. “Variance of current assets over current liabilities”
L.J. Guttmann also described working capital as “the portion of a firm’s current assets
which are financed from long–term funds.”

It becomes essential to know and understand the current assets components and current
liabilities components to understand working capital management.

Current assets –

This is imperative to facilitate “Current assets have a short life span. These types of assets
are connected in current operation of a business and normally used for short–term
operations of the firm. The two important characteristics of these assets are: (I) short life
span, and (ii) swift conversion into other form of assets. Cash balance may be held idle for
few weeks, account receivable may have a period of 30 to 60 days” Fitzgerald also
described current assets, “cash & other assets which are expected to be converted in to cash
in the ordinary course of business within one year or within such longer period as
constitutes the normal operating cycle of a business.”

Current assets are important to businesses because they can be used to fund day-to-day
business operations and to pay for the ongoing operating expenses. Since the term is
reported as a dollar value of all the assets and resources which can be easily converted to
cash in a short period of time, it also represents a company’s liquid assets.

However, care should be taken to include only the qualifying assets that are capable of being
liquidated at the fair price over the next one year. For instance, there is a high chance that a lot of
commonly used FMCG goods produced by a company can be easily sold over the next one year
which qualifies inventory to be included in the current assets, but it may be difficult to sell land
or heavy machinery easily which are excluded from the current assets.  Depending on the nature
of the business and the products it markets, current assets can range from barrels of crude oil,
fabricated goods, work in progress inventory, raw material, or foreign currency.

Key components of current assets:

While cash, cash equivalents and liquid investments in marketable securities (like interest
bearing short term Treasury bills or bonds) remain the obvious inclusion in current assets, the
following are also included in current assets:

1. Accounts receivable : which represents the money due to a company for goods or services
delivered or used but not yet paid for by customers, are considered current assets as long as
they can be expected to be paid within a year. If a business is making sales by offering longer
terms of credit to its customers, a portion of its accounts receivables may not qualify for
inclusion in current assets. It is also possible that some accounts may never be paid in full.
This consideration is reflected in an allowance for doubtful accounts, which is subtracted
from accounts receivable. If an account is never collected, it is written down as a bad debt
expense, and such entries are not considered for current assets.

2. Inventory : which represents raw materials, components and finished products, is included
as current assets, but the consideration for this item may need some careful thought?
Different accounting methods can be used to inflate inventory, and at times it may not be as
liquid as other current assets depending on the product and the industry sector. For example,
there is little or no guarantee that a dozen units of high-cost heavy earth moving equipment
may be sold for sure over the next year, but there is a relatively higher chance of successful
sale of a thousand umbrellas in the coming rainy season. Inventory may not be as liquid as
accounts receivable, and it blocks the working capital. If the demand shifts unexpectedly,
which is more common in some industries than others, inventory can become backlogged.
3. Prepaid expenses : which represent advance payments made by a company for goods and
services to be received in the future, are considered current assets? Though they cannot be
converted into cash, they are the payments which are already taken care of. Such components
free up the capital for other uses. Prepaid expenses could include payments to insurance
companies or contractors.

On the balance sheet, current assets will normally be displayed in order of liquidity, that is, the
items which have higher chance and convenience of getting converted into cash will be ranked
higher. The typical order in which the constituents of current assets may appear is cash
(including currency, checking accounts, and petty cash), short term investments (like liquid
marketable securities), accounts receivable, inventory, supplies and prepaid expenses.

Thus, the current assets formulation is a simple summation of all the assets that can be converted
to cash within one year. For instance, looking at a firm's balance sheet we can add up:

Current Assets = Cash + Cash Equivalents + Inventory + Accounts Receivables +

Marketable Securities + Prepaid Expenses + Other Liquid Assets

Uses of Current Assets:

Current assets figure is of prime importance to the company management with regards to the
daily operations of a business. As payments towards bills and loans become due at regular
frequency (like, at the end of each month), the management must be able to arrange for the
necessary cash in time to pay its obligations. The dollar value represented by the current assets
figure provides a general insight into company’s cash and liquidity position, and allows the
management to remain prepared for the necessary arrangements to continue business operations.
Additionally, creditors and investors keep a close eye at the current assets of a business to assess
the value and risk involved in its operations. Many use a variety of liquidity ratios, which
represent a class of financial metrics used to determine a debtor's ability to pay off current debt
obligations without raising external capital. Such commonly used ratios include current assets, or
its components, as a key ingredient in their calculations.

Financial Ratios Using Current Assets or Their Components:

Owing to different attributes attached to the business operations, different accounting methods
and payment cycles, it often becomes a challenging exercise to correctly categorize what all
components can be termed as assets over a given time horizon. The following ratios are
commonly used to measure a company’s liquidity position with each one using a different
number of asset components against the current liabilities of a company.

The current ratio measures a company's ability to pay short-term and long-term obligations and
takes into account the current total assets (both liquid and illiquid) of a company relative to
the current liabilities.

The quick ratio measures a company's ability to meet its short-term obligations with its most
liquid assets. It considers cash and equivalents, marketable securities and accounts
receivable (but not the inventory) against the current liabilities.

The cash ratio measures the ability of a company to pay off all of its short-term liabilities
immediately, and is calculated by dividing the cash and cash equivalents by current liabilities.
While the cash ratio is the most conservative one as it takes only cash and cash equivalents into
consideration, the current ratio is the most accommodating and includes a wide variety of
components for consideration as assets. These various measures are used to assess the company’s
ability to pay outstanding debts and cover liabilities and expenses without having to sell fixed
assets.

Current Liabilities –

Business generates liability for purchasing raw material and other essential things on credit, these
are called as creditors or account payable. Until remittances towards creditors are made, it is
categorized under liabilities section of balance sheet. Current liabilities are explained as all
obligations that are due in near future for payment.

Current liabilities are a company's debts or obligations that are due within one year or within a
normal operating cycle.  Furthermore, current liabilities are settled by the use of a current asset,
such as cash, or by creating a new current liability.  Current liabilities appear on a company's
balance sheet and include short-term debt, accounts payable, accrued liabilities, and other similar
debts.

Analysts and creditors often use the current ratio (current assets divided by liabilities), or
the quick ratio (current assets minus inventories divided by current liabilities), to determine
whether a company is able to pay off its current liabilities.

On the balance sheet, current liabilities are typically presented as follows: the principal portion
of notes payable due within one year, accounts payable, and then other current liabilities, such as
income taxes payable, interest payable, etc.
Example of Current Liabilities:

Accounts payable: is typically one of the largest current liability accounts on a company's
financial statements, and it represents unpaid supplier invoices. Current liability accounts vary
per industry or according to various government regulations; examples include dividends
payable, customer deposits, current portion of deferred revenue, current maturities of long-term
debt, and interest payable. Sometimes, companies use an account called "other current liabilities"
as a catch-all line item on their balance sheets to include all other liabilities due within a year not
classified elsewhere.

Gross and Net Working Capital:

1. Gross Working Capital:

It is also called the circulating capital. It is equal to the total sum of current assets only and it
may represent both owned capital as well as loan capital used for financing the current assets.
The concept of gross capital is a financial concept whereas that of net concept is an accounting
concept. Management is interested more in the amount of current assets with which it has to
operate. If it can balance receipts and disbursements perfectly, the business would operate with
maximum efficiency.

2. Net Working Capital:

It represents the excess of total current assets over total current liabilities. It is a qualitative
concept indicating the soundness of current financial position. It is of major importance to
investors and lenders. On the basis of this concept, the management will also get an idea about
the ease and cost of raising working capital.

Net working capital is measured by the current ratio, viz. Current assets/Current liabilities.
Normally, the current ratio should be 2:1, a larger ratio indicates greater solvency and vice versa.
Of course, excessive current ratio would point out poor financial planning and it would reduce
income.

Net working capital = Current assets – Current liabilities

= (cash+ marketable securities+ accounts receivables + notes and bills receivable + inventories).

Permanent and Temporary Working Capital:

Considering time as the basis of classification, there are two types of working capital via,
“permanent” and “temporary”.

Permanent working capital:

The magnitude of investment in working capital may increase or decrease over a period of time
according to level of production. But there is a need for minimum level of working capital to
carry its business irrespective of change in level of sales or production. Such minimum level of
working capital is called ‘permanent working capital’ or ‘fixed working capital’. It is the
irreducible minimum amount necessary for maintaining circulation of current assets. The
minimum level of investment in current assets is permanently locked-up in business and it is also
referred to as ‘regular working capital’. It represents the assets required on continuing basis over
the entire year. The permanent component current assets which are required throughout the year
will generally be financed from long-term debt and equity. Tendon committee has referred to this
type of working capital as ‘core current assets’. Core current assets are those required by the firm
to ensure the continuity of operations which represents the minimum level of various items of
current assets via, stock of raw materials, Stock of work-in-process, stock of finished goods,
debtor’s balances, cash and bank etc. This minimum level of current assets will be financed by
the long-term sources and any fluctuations over the minimum level of current assets will be
financed by the short-term financing.

Temporary working capital:

It is also called as ‘fluctuating working capital’. It depends upon the changes in production and
sales, over and the above the permanent working capital. It is the extra working capital needed to
support the changing business activities. It represents additional assets required at different items
during the operation of the year. A firm will be finance its seasonal and current fluctuations in
business operations through short-term debt financing. For example, in peak seasons, more raw
materials to be purchased, manufacturing expenses to be incurred, more funds will be locked in
debtor’s balances etc. In such times excess requirement of working capital would be financed
from short-term financing sources.

The management of working capital is concerned with maximising the return to shareholders
within the accepted risk constraints carried by the participants in the company. Just as excessive
long-term debt puts company at risk, so an inordinate quantity of short-term debt also increases
the risk to a company by straining its solvency. The suppliers of permanent working capital look
for long-term return on funds invested whereas the suppliers of temporary working capital will
look for immediate return and the cost of such financing will also be costlier than the cost of
permanent funds used for working capital.

Source of Working Capital:

Source of working capital is very important as it’s important to keep business liquid as well as
stress free from financial burden. Basic current assets requirement must be met with long term
sources and current assets which are required for circulation should be met with short term
sources. It benefits business by keeping cost of capital low and increases return on investment.

For financing temporary requirement of working capital, the organization can go for various
sources which can be discussed as below:

 Spontaneous sources
 Inter-corporate deposit
 Commercial paper’s
 Banks

The selection of source is very important as it determines the level of liquidity and flexibility in
any business firm.

Spontaneous Sources

Spontaneous Sources for financing the working capital requirement arise during the course of
normal business operations. During the course of business operations, the company may be able
to buy certain goods or services for which the payment is to be made after a certain time gap. As
such, the company is able to buy goods or services without making payment for the same. These
spontaneous sources are unsecured in nature and vary with the level of sales. These spontaneous
sources do not have any explicit cost attached to the same.

Following forms of current liabilities may be used as spontaneous sources for financing the
working capital requirement.

Trade Credit:

If the company buys the raw material from the suppliers on credit basis, it gets the raw material
for utilization immediately with the facility to make the payment at a delayed lime. By accepting
the delayed payment, the suppliers of raw material finance the requirement of working capital.
For using this source, certain factors may play an important role:

 Trends in the industry

 Liquidity position of the company
 Earnings of the company over a period of time
 Record of payment by the company to the suppliers
 Relationship of the company with suppliers.

Outstanding expenses

All the services enjoyed by the company are not required to be paid for immediately. They are
paid for after a certain time gap. As such, the company is able to get the benefit of these services
without paying for the same immediately, thus getting the finance for working capital purposes.
These are called ‘outstanding expenses’. This may apply to salaries, wages, telephone expenses,
electricity expenses, water charges etc.

Inter-Corporate Deposits (ICD)

Inter-corporate Deposits indicate the amount of funds borrowed by one company from another
company, usually both the companies being under the same management but not necessarily so.
Point to be noted here is that ICDs are not considered to be deposits as stated by the provisions
of Section 58-A of the Companies Act, 1956 and in isolation the set of laws pertinent to the
public deposits does not affect the ICD’s. Inter-corporate Deposits as a source for financing the
working capital requirement has the following characteristic features.

 ICD is for a very short period of time, i.e. three months or six months.
 ICD is an unsecured source for raising the funds required for working capital purposes.
 ICD as a source is not regulated by any law. As such, the rate of interest, period of ICD etc.
can be decided by the company on its own.
 ICD is a relationship based borrowing made by the company.

Commercial Papers

In the earlier period, Commercial Papers (CPs) have turned one of the most excellent mode for
financing the working capital obligations of the companies. The companies demanding to raise
the funds through issue of Commercial Papers are being regulated by guiding principles for issue
of Commercial Papers issued by RBI on 10th October year 2000. These guiding principles apply
to the companies those are making efforts to increase the funds by issuing the CPs. According to,
these guidelines, a company means a company as described in Section 45-I (as) of Reserve Bank
of India Act, 1934. Section 45-1(as) of Reserve Bank Act, 1934 defines a company as the
company as defined in section 3 of the Companies Act, 1956.

Banks

The scenario of India is structured in a way where, banks play exceedingly significant role in
financing the working capital requirement of a business firm. Banks are considered as a
foundation for financing the working capital requirement of the organizations on the basis of
below mentioned points:

 What should be the amount of assistance?

 What should be the form in which working capital assistance is extended?
 What security should be obtained for working capital assistance?
 What are the various applicable regulations to be considered by the banks while extending
the working capital assistance?

Quantum of Assistance:

A business firm is firstly mandated to measure and calculate its requirement of working capital
appropriately in order to acquire the bank credit for financing the working capital requirements.
And for estimating the working capital requirement optimally, the business firm should primarily
estimate the current assets and current liabilities level, because working capital is the difference
between the amount of current assets and of current liabilities. To calculate the values of
optimum working capital, techniques like ratio analysis, trend analysis etc. could be
implemented on data of the company. The accuracy level of estimating the current assets as well
as current liabilities decide the accuracy of evaluating the requirement of working capital level.
Then, the business firm would have to move towards the bank along with the essential sustaining
financial data. On the basis of the anticipated figures submitted by the concern, the bank decides
the quantum of assistance level which is to be unmitigated. The bank prescribes the margin
money required at the time of extending the working capital assistance. The margin money
specification is fixed by the banks in accordance to make sure the borrowing company’s
individual stake in the business in addition to provide the safeguard against the probable
diminution in the value of security presented to the bank. The fraction of margin money
specification might depend in the lead of credit reputation of the borrowing firm, variations in
the price of the security moreover, the time to time directives of RBI. The common principle
validated will be, “more dicer the nature of security, higher will be the margin money
stipulations.”
Assistance structure:

The bank will be able to disburse the amount in one of the subsequent forms, after deciding the
amount of total assistance that can be extended for the business firm:

 Non-Fund Based Lending

Considering Non-Fund Based Lending, the lending bank does not entrust any substantial outflow
of funds. Therefore, the funds arrangement of the lending bank remains integral. The Non- Fund
Based Lending could be done by the banks through these two ways:

 Bank Guarantees:

The bank guarantees mechanism is described below:

Suppose Company A is the selling company and Company B is the purchasing company.
Company A does not know Company B and as such is concerned whether Company B will make
the payment or not. In such circumstances, D who is the Bank of Company B, opens the Bank
Guarantee in favour of Company A in which it undertakes to make the payment to Company A,
if Company B fails to honour its commitment to make the payment in future. As such, interests
of Company A are protected as it is assured to get the payment, either from Company B or from
its Bank D. As such, Bank Guarantee is the mode which will be found typically in the seller’s
market. As far as Banks is concerned, while issuing the guarantee in favour of Company a, it
does not 26 commit any outflow of funds. As such, it is a Non-Fund Based Lending for Bank D.
If on due date, Bank D is required to make the payment to Company A due to failure on account
of Company B to make the payment, this Non Fund Based Lending becomes the Fund based
Lending for Bank D which can be recovered by Bank D from Company B. For issuing the Bank
Guarantee, Bank D charges the Bank Guarantee Commission to Company B which gets decided
on the basis of two factors i.e. what is the amount of Bank Guarantee and what the period of
validity of Bank Guarantee is. In case of this conventional form of Bank Guarantee, both
Company A as well as Company B gets benefited. Company A is benefited as it is assured to get
the payment. Company B is benefited, as it is able to make the credit purchases from Company
A without knowing Company A. As such, Bank Guarantee transactions will be applicable in case
of credit transactions.

In some cases, interests of purchasing company are also to be protected. Suppose that Company
A which manufactures capital goods takes some advance from the purchasing Company B. If
Company A fails to fulfil its part of the contract to supply the capital goods to Company B, there
needs to be some protection available to Company B. In such circumstances, Bank C which is
the banker of Company A opens a Bank Guarantee in favour of Company B in which it
undertakes that if Company A fails to fulfil its part of the contract; it will reimburse any losses
incurred by Company B due to this non-fulfilment of contractual obligations. Such Bank
Guarantee is technically referred to as Performance Bank Guarantee and is ideally found in the
buyer’s market.

Letter of Credit:

The non-fund based lending by the way of Letter of Credit (LC) is incredibly found in the
international business regularly. Under this, the exporter and importer are anonymous with each
other. Due to this reason, the exporter 27 remains in dilemma about getting the disbursement
from the importer at the same time, the importer gets worried about whether he will get a hold of
goods or not. In order to solve this problem, the importer applies to his bank in his own country
to release a letter of credit in name of the exporter whereby, the importer’s bank assures to pay
the exporter or allow the bills or drafts drawn by the exporter on the exporter gratifying the
provisions and stipulations specified in the letter of credit.
Fund based lending

In the matter of Fund Based Lending, the lending bank supports the substantial outflow of funds.
The funds position of the lending bank gets pretentious because of this reason. The Fund Based
Lending is done by the banks using the following methods:

 Loan:

Disbursement of the total amount of assistance is made at one time simply under this case, either
in cash or through transfer in company’s account. It is a solitary proceed. The loan might be
reimbursed in instalments, and the interest would be charged on outstanding amount.

 Overdraft:

In this scenario, the firm is permitted to withdraw in surfeit of the balance remaining in its Bank
account. Though, a fixed limit is specified by the Bank ahead of which the firm is not able to
overdraw from the account. Conceding of the assistance by the way of overdraft presupposes the
opening of a prescribed current bank account. Officially, overdraft is an on demand assistance
granted by the bank that means the bank can ask over the settlement at any moment of time.
Overdraft is facilitated by the bank for a very short duration of time, at the end of which the
business firm is thought to pay back the amount. Interest gets due on the actual amount drawn
and is estimated on daily product basis.

 Cash credit:

Actually, the proceedings in cash credit facility are same as in those of bank overdraft facility
other than the fact that the firm does not require to open a formal current account. In this case as
well a fixed perimeter is stipulated beyond which the firm cannot withdraw the amount. Legally,
cash credit is too a demand facility, but in real, it is on incessant basis. Under cash credit also,
the interest is allocated on the actual amount drawn and is deliberated on daily product basis.
 Bills Purchased/Discounted:

This form of assistance is comparatively of recent origin. This facility enables the company to
get the immediate payment against the credit bills/invoices raised by the company. The bank
holds the bills as a security till the payment is made by the customer. The entire amount of bill is
not paid to the company. The company gets only the present worth of the amount of the bill, the
difference between the face value of the bill and the amount of assistance being in the form of
discount charges. However, on maturity, the bank collects the full amount of bill from the
customer. While granting this facility to the company, the bank inevitably satisfies itself about
the credit worthiness of the customer and the genuineness of the bill. A fixed perimeter is
specified in case of the company, further than which the bills are not purchased or discounted by
the bank.

 Working Capital Term Loans:

In accordance to match up the working capital requirement of the business firm, banks possibly
will grant the working capital term loans for a time period of 3 years to 7 years, payable both in
yearly instalments or half yearly instalments.

 Packing Credit:

This kind of assistance can be granted by the bank on the way to take concern of particular
requirement of the company at the time it avails any export order. To facilitate the company in
buying or manufacturing the goods to be exported, packing credit facility is given by the bank. In
case the company holds a confirmed export order given by the international buyer 29 or an
irretrievable letter of credit in the favour of company, the company can approach the bank to
avail packing credit assistance.

Security for Assistance:

The bank may possibly be able to give the assistance in either of the modes as mentioned above.
However, no assistance would be accessible until the company presents any kind of security out
of these:

 Hypothecation:

Under this mode of security, the bank extends the assistance to the company against the security
of movable property, usually inventories. Under this mode of security neither the property not
the possession of the goods hypothecated is transferred to the bank. But the bank

has the right to sell the goods hypothecated to realize the outstanding amount of assistance
granted by it to the company.

 Pledge:

Under this mode of security, the bank extends the assistance to the company against the security
of movable property, usually inventories. But unlike in case of hypothecation, possession of the
goods is with the Bank and the goods pledged are in the custody of the bank. As such, it is the
duty of the bank to take care of the goods in its custody. In case of default on the part of
company to repay the amount of assistance, the bank has the right to sell the goods to realize the
outstanding amount of assistance.

 Lien:
Under this mode of security, the bank has a right to retain the goods belonging to the company
until the debt due to the bank is paid.

Mortgage:

This mode of security pertains to immovable properties like land and buildings. It indicates
transfer of legal interest in a specific immovable property as security for the payment of debt.
Under this mode, the possession of the property remains with the borrower while the bank gets
full legal title there, subject to borrower’s right, to repay the debt. The party who transfers 30 the
interest (i.e. the company) is called mortgager and the party in whose favour the interest is so
transferred (i.e. the bank) is called mortgagee.

Importance of working capital management:

Management of working capital is very much important for the success of the business. It has
been emphasized that a business should maintain sound working capital position and also that
there should not be an excessive level of investment in the working capital components. As
pointed out by Ralph Kennedy and Stewart MC Muller, “the inadequacy or mis-management of
working capital is one of a few leading causes of business failure.

DETERMINANTS OF WORKING CAPITAL

There is no specific method to determine working capital requirement for a business. There are a
number of factors affecting the working capital requirement. These factors have different
importance in different businesses and at different times. So a thorough analysis of all these
factors should be made before trying to estimate the amount of working capital needed. Some of
the different factors are mentioned here below:-
 General Nature of Business

The working capital requirements of an enterprise are basically related to the conduct of the
business. Enterprises fall into some broad categories depending on the nature of their business.
For instance, public utilities have certain features, which have a bearing on their working capital
needs. The two relevant features are:

a) Cash Nature of business, i.e., Cash sale

b) Sale of services rather than commodities

In view of these features they do not maintain big inventories and have, therefore, probably the
latest requirement of working capital. At the other extreme are the trading and financial
enterprises. The nature of their business is such that they have to maintain a sufficient amount of
cash, inventories and book debts. They have necessarily to invest proportionately large amounts
in working capital.

 Production Cycle

Another factor, which has a bearing on the quantum of working capital, is the production cycle.
The term ‘production’ or ‘manufacturing cycle’ refers to the time involved in the manufacturing
of goods. It covers the time span between the procurement of the raw materials and the
completion of the manufacturing process leading to the production of finished goods. Funds will
have to be necessarily tied-up during the process of manufacture, necessitating enhanced
working capital. In other words, there is some gap before raw materials become finished goods.
To sustain such activities the need for working capital is obvious. The longer the time span (i.e.,
the production cycle), the larger will be the funds tied-up and, therefore, the larger the working
capital needed and vice-versa. There are enterprises, which due to the nature of business will
have a shorter operating cycle. A distillery, which has an aging process, has relatively to make a
heavy investment in inventory. The bakery provides the other extremes. The bakeries sell their
products at short intervals and have a very high inventory turnover. The investment in inventory
and, consequently, working capital is not large.

 Business Cycle

The working capital requirements are also determined by the nature of the business cycle.
Business fluctuations lead to cyclical and seasonal changes, which, in turn, cause a shift in the
working capital position, particularly for temporary working capital requirements. The variations
in business conditions may be in two directions:

a) Upward phase when boom conditions prevail.

b) Downswing phase when economic activities are marked by a decline.

During the upswing of business activity the need for working capital is likely to grow to cover
the lag between increased sales and receipt of cash as well as to finance purchase of additional
material to cater to the expansion of the level of the activity. Additional funds may be required to
invest in the plant and machinery to meet the increased demand. The downswing phase of the
business cycle will have exactly and opposite effect on the level of working capital requirement.
The decline in the economy is associated with a fall in the volume of sales which, in turn, will
lead to fall in the level of inventories and book debts. The need for working capital in the
recessionary conditions is bound to decline. In brief, business fluctuations influence the size of
working capital mainly through the effect on inventories. The response of inventory to business
cycles is mild or violent according to the mild or violent nature of the business cycle.

 Credit Policy

The level of working capital is also determined by credit policy, which relates to sales and
purchases. The credit policy influences the requirement of the working capital in two ways:
a) Through credit terms granted by the firm to its customers/buyers of goods.
b) Credit terms available to the firm from its creditors.

The credit terms granted to the customers have a bearing on the magnitude of the working capital
by determining the level of book debts. The credit sales will result in higher book debts
(receivables). Higher book debts will mean more working capital. On the other hand, if liberal
credit terms are available from the suppliers of the goods (trade creditors), the need for working
capital will be less. The working capital requirements of a business are, thus, affected by the
terms of purchase and sale and the role given to credit by a company in its dealings with the
creditors and the debtors.

 Profit Level

The level of profits earned differs from to enterprise to enterprise. In general, the nature of the
products, hold on the market, quality of management and monopoly power would by and large
determine the profit earned by the firm. A priori, it can be generalised that a firm dealing in a
high quality product, having a good marketing arrangement and enjoying monopoly power in the
market is likely to earn high profits and vice-versa. Higher profit margin would improve the
prospects of generating more internal funds thereby contributing to the working capital pool. The
net profit is a source of working capital to the extent that it has been earned in cash. The cash
profit can be found by adjusting non-cash items such as depreciation, outstanding expenses and
losses written off, in the net profit. But, in practice, the net cash inflows from operations cannot
be considered as cash available for use at the end of the cash cycle. Even as company’s
operations are in progress, cash is used for augmenting stock, book debts and fixed assets. It
must, therefore, be seen that cash generation has been used for furthering the use of enterprise. It
is in this context that elaborate planning and projections of expected activities and the resulting
cash inflows on a day to day, week to week and month to month basis assume importance
because steps can then be taken to deal with surplus and deficit cash. The availability of internal
funds for working capital requirements is determined not merely by the profit margin but also on
the manner of appropriating profits. The availability of such funds would depend upon the profit
appropriations for taxation, dividend, reserves and depreciation. No person was ever honoured
for what he received. Honour has been the reward for what he gave.”
NEED FOR WORKING CAPITAL

The need for working capital (gross) or current assets cannot be over emphasized. As the
objective of financial decision making is to maximize the shareholder’s wealth, it is necessary to
generate sufficient profits. The extent to which profits can be earned will naturally depend upon
the magnitude of the sales, among other things. A successful sales program is, in other words,
necessary for earning profits by any business enterprise. However, sales do not convert into cash
instantly; there is invariably a time lag between the sale of goods and the receipt of cash. There
is, therefore, a need for working capital in the form of current assets to deal with the problem
arising out of the lack of immediate realisation of cash against goods sold. Therefore, sufficient
working capital is necessary to sustain sales activity.

Technically, this is referred to as the operating or cash-cycle. The operating cycle can be said to
be at the heart of the need for working capital. The continuing flow from cash to suppliers, to
inventory, to accounts receivable and back into cash. The cycle refers to the length of time
necessary to complete the following cycle of events:

 Conversion of cash into inventory.

 Conversion of raw materials into work in progress
 Conversion of work in progress into finished goods
 Conversion of finished goods into account receivable
 Conversion of account receivable into cash

If it were possible to complete the sequences instantaneously, there would be no need for current
assets (working capital). But since it is not possible, the firm is forced to have current assets.
Since cash inflows and cash inflows do not match, firms have to necessarily keep cash or invest
in short-term liquid securities so that they will be in position to meet obligations when they
become due. Similarly, firm must have adequate inventory to guard against the possibility of not
being able to meet a demand for their products. Adequate inventory, therefore, provides a
cushion against being out of stock. If firms have to be competitive, they must sell goods to their
customers on credit, which necessitates the holding of accounts receivable. It is in these ways
that an adequate level of working capital is absolutely necessary for smooth sales activity which,
in turn, enhances the owner’s wealth.