WORKING CAPITAL MANAGEMENT

INTRODUCTION

WORKING CAPITAL REFERS TO THE CASH A BUSINESS REQUIRES FOR

DAY-TO-DAY OPERATIONS, OR MORE SPECIFICALLY, FOR FINANCING THE
CONVERSION OF RAW MATERIALS INTO FINISHED GOODS, WHICH THE
COMPANY SELLS FOR PAYMENT. AMONG THE MOST IMPORTANT ITEMS OF
WORKING CAPITAL ARE LEVELS OF INVENTORY, ACCOUNTS RECEIVABLE
AND ACCOUNTS PAYABLES. Analysts look at these items for signs of a company’s
efficiency and financial strength.

In other words, Working capital refers to that part of the firm’s capital which is
required for financing short term or current assets such as cash, marketable securities, debtors
and inventories.

DEBTORS
(Receivables)

FINISHED
CASH GOODS

RAW WORK-IN-
MATERIAL PROGRESS

WORKING CAPITAL CYCLE

CONCEPTS OF WORKING CAPITAL

There are two concepts of working capital:
1. GROSS WORKING CAPITAL.
2. NET WORKING CAPITAL.

In broader sense, the term working capital refers to the gross working capital and represents
the amount of funds invested in current assets. Thus, the gross working capital is the
capital invested in total current assets of the enterprise. In narrow sense, the term working
capital refers to net working capital. Net working capital is the excess of current assets
over current liabilities, or say,
Net working capital = Current assets – Current liabilities.

Net working capital may be positive or negative. When the current assets exceed the
current liabilities the working capital is positive and the negative working capital results
when current liabilities are more than the current assets.
CLASSIFICATION OF WORKING CAPITAL

Working capital may be classified in two ways:

1. On the basis of concept.
2. On the basis of time.

On the basis of concept it is classified as:

 Gross working capital.
 Net working capital.

On the basis of time it is classified as:

 Permanent or fixed working capital.
 Temporary or variable working capital.

Gross and net working capital are discussed earlier so, here it will be discussed on the basis
of time.
 PERMANENT OR FIXED WORKING CAPITAL:
A minimum level of current asset is continuously required by the enterprise to carry
out its normal business operations. This minimum level of current is called permanent or
fixed working capital as this part of capital is permanently blocked in current assets.
The permanent working capital can further be classified as :
 Regular working capital.
 Reserve working capital.
Regular working capital is capital required to ensure circulation of current assets from cash to
inventories, from inventories to receivables and from receivables to cash and so on.
Reserve working capital is excess amount over the requirement for regular working capital
which may be provided for contingencies that may arise at unstated periods such as strikes,
rise in prices, depression etc.

 TEMPORARY OR VARIABLE WORKING CAPITAL:

Temporary or variable working capital is the amount of working capital, which is
required to meet the seasonal demands and some special exigencies. Variable working
capital can be further classified as seasonal working capital and special working capital.
Seasonal working capital is the capital required to meet the seasonal meets of the
enterprise.
Special working capital is the capital required to meet special exigencies such as
launching of extensive marketing campaigns for conducting research
Temporary working capital differs from permanent working capital in the sense
that it is required for short period and cannot be permanently employed gainfully in
business.

FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

 1. Nature or Character of Business
2. Size of business\Scale of Operation
3. Production Policy
4. Manufacturing Process\Length of Production Cycle
5. Seasonal Variations
6. Working Capital Cycle
7. Rate of Stock Turnover
8. Credit Policy
9. Business Cycle
10. Rate of Growth of Business
11. Earning Capacity and Dividend Policy
12. Price Level Changes
13. Other Factors

1. Nature or Character of Business: The working capital requirement of a firm

basically depends upon the nature of its business. It may be said that public utility
undertakings require small amount of working capital, trading and financial firms
require relatively very large amount, whereas manufacturing undertakings require
sizeable working capital between these two extremes.

2. Size of Business\Scale of operations: The working capital requirements of a concern

are directly influenced by the size of its business, which may be measured in terms of
scale of operations and vise versa.

3. Production Policy: In certain industries the demand is subject to wide fluctuations

due to seasonal variations. The requirements of working capital, in such cases,
depend upon the production policy. If the policy is to keep production steady by
accumulating inventories in slack periods then it will require higher working capital
and vise versa.

4. Manufacturing Process\Length of Production Cycle: In manufacturing business,

the requirements of working capital increases in direct proportion to length of
manufacturing process. Longer the process period of manufacture, larger is the
amount of working capital required and vise versa.

5. Seasonal Variations: In certain industries raw material is not available throughout

the year. They have to buy raw materials in bulk during the season to ensure an
uninterrupted flow and process them during the entire year. A huge amount is, thus,
blocked in form of material inventories during such season, which gives rise to more
working capital requirements. Generally during the busy season, a firm requires a
larger working capital than in the slack season.

6. Working Capital Cycle: In a manufacturing concern, the working capital cycle starts
with the purchase of raw material and ends with the realization of cash from the sale
of finished products. The speed with which the working capital completes one cycle
determines the requirements of working capital-longer the period of cycle larger is the
requirement of working capital.

7. Rate of Stock Turnover: There is high degree of inverse co-relationship between the
quantum of working capital and the velocity or speed with which the sales are
effected. A firm having a high rate of stock turnover will need lower amount of
working capital compared to a firm having a low rate of turnover.
 8. Credit Policy: The credit policy of a concern in its dealings with debtors and
creditors influence considerably the requirements of working capital. A concern that
purchases its requirements on credit and sells its product or services on cash requires
lesser amount of working capital. On the other hand a concern buying its
requirements for cash and allowing credit to its customers, shall need larger amount of
working capital.

9. Business Cycle: In a boom period, there is a need for larger amount of working
capital due to increase in sales, rise in prices, optimistic expansion of business, etc.
On the contrary in the times of depression lesser amount of working capital is
required.

10. Rate of Growth of Business: The working capital requirement of a concern increase
with the growth and expansion of its business activites.

11. Earning Capacity and Dividend Policy: Firms with higher earning capacity may
generate cash profits from operations and contribute to there working capital. The
dividend policy of a concern also influences its requirements of its working capital. A
firms that maintains a steady high rate of cash dividend irrespective of its generation
of profits needs more working capital than the firm that retains larger part of its
profits and does not pay so high rate of cash dividend.

12. Price Level Changes: Changes in the price level also affects the working capital
requirements. Generally, the rising prices will require the firm to maintain the same
current assets.

13. Other Factors: Certain other factors such as operating efficiency, management
ability, irregularities of supply, import policy, asset structure, importance of labour,
banking facility, etc., also influence the requirement of working capital.
WORKING CAPITAL: POLICY AND MANAGEMENT

THE WORKING CAPITAL MANAGEMENT INCLUDES AND REFERS TO THE

PROCEDURES AND POLICIES REQUIRED TO MANAGE THE WORKING CAPITAL.
The basic goal of working capital is to manage working is to manage the current assets and
liabilities of a firm in such a way that a satisfactory level of working capital is maintained,
i.e., it is neither inadequate nor excessive. Inadequacy of working capital may lead to
insolvency and excessive working capital implies idle funds which earn no profits for the
business. Working capital management policies of a firm have a great effect on its
profitability, liquidity and structural health of the organization.

Working capital management is three dimensional in nature:

1. Dimension I is concerned with the formulation of policies with regard to profitability,
risk and liquidity.
2. Dimension II is concerned with the decisions about the composition and level of
current assets.
3. Dimension III is concerned with the decision with the decisions about the composition
Profitability, risk&liquidity
and level of current liabilities.

DIM I

Composition and
Composition and Level of
Level of Current Current Liabilities
Assets DIM II DIM III
WORKING CAPITAL POLICIES
There is an inevitable relationship, between the sales and the current assets. The sales have a
major impact on the amount of current assets which a firm must maintain. There are three
types of working capital polices which a firm may adopt i.e.,
1. Conservative working capital policy
2. Moderate working capital policy
3. Aggressive working capital policy
These policies explain the relationship between sales level and the level of current assets as
have been shown in the figure:

Conservative Policy

Moderate Policy

Costs of Assets
Aggressive Policy

Sales
CONSEREVATIVE POLICY: Under this policy every increase in sales, the level of
current assets will be increased more than proportionately. Such a policy tends to reduce the
risk of shortage of working capital by increasing the safety component of current assets. This
policy also reduces the risk of non payment to liabilities.a firm adopting this policy does not
like to take risk.

MODERATE POLICY: Under this policy the increased in sales level will be coupled with
proportionate increase in level of current assets also.

AGGRESSIVE POLICY: A firm has said to adopt AGGRESSIVE POLICY if the increase
in sales does not result in proportionate increase in current assets.

This type of aggressive policy has many implications :

1. The risk of insolvency of the firm increases as the firm maintains lower
liquidity.
2. The firm is exposed to greater risk as the firm may not be able to face
unexpected change in the market.
3. Reduced investments in current assets will result in increase in profitability of
the firm.

DETERMINING THE WORKING CAPITAL FINANCING MIX

Broadly speaking, there are two sources of financing working capital requirements :
(i)Long term sources and (ii) Short term sources. Therefore, a question arises as to what
portion of working capital should be financed by long term sources and how much by short-
term sources.

THERE ARE THREE BASIC APPROACHES FOR DETERMINING AN

APPROPRIATE WORKING CAPITAL FINANCING MIX.

APPROACHES TO FINANCING MIX

HEDGING APPROACH CONSERVATIVE AGGRESSIVE

APPROACH APPROACH

Approaches to Financing Mix

1. HEDGING APPROACH: The hedging principle states that the financing maturity
should follow the cash flow characteristics of the assets being financed. The hedging
approach involves matching the cash flows generating characteristics of an asset with
the maturity of the sources of financing used to finance it. The Hedging Approach to
working capital financing is based upon the concept of bifurcation of total working
capital needs into permanent working capital & temporary working capital. The life
duration of the current asset & the maturity period of the sources of funds are
matched. The general rule is that the length of the finance should match with life
duration of the assets. The permanent working capital needs are financed by long-
term sources of funds and the temporary working capital needs are financed by short-
term sources of funds.

Total working capital

Short-term finance
Amount
of
Workin
g
capital
Long-term finance

Time
THE HEDGING APPROACH TO WORKING CAPITAL FINANCING

2. CONSERVATIVE APPROACH: The working capital policy of a firm is called a

conservative policy when all or most of the working capital needs are meet by long-
term sources and thus the firm avoids the risk of insolvency. All the working capital
needs are primarily financed by long term sources & the use of short-term sources are
restricted to the unexpected and emergency situations only. In case, the firm has no
working capital need then the idle long-term funds can be invested in marketable
securities. This will help the firm to earn some income.

Short term finance

Amount
of WC

Long-
term
Marketable securities finance

Time
3. AGGRESSIVE APPROACH: A working capital policy is called a aggressive
policyTHE
if a CONSERVATIVE
firn decides to finance a part ofTO
APPROACH permanent
WORKING working capital by short-term
CAPITAL
sources. The aggressive policy seeks to minimize excess liquidity while meeting the
short-term requirements. The may accept even greater risk of insolvency in order to
save cost of long-term financing and in order to earn better return.
 Total working Capital
Amount
of
Working
Capital Permanent W C

Short-term financing

Long-term
Long-term sources
sources

Time

THE AGGRESSIVE APPROACH TO WORKING CAPITAL FINANCING

CASH MANAGEMENT

INTRODUCTION
Cash includes cash in hand, cash at bank and near cash assets e.g. marketable
securities.these are the securities which can be easily converted into cash. cash it self does not
produce goods and services. it is used as a medium to acquire other assets.
CASH MANAGEMENT HAS ASSUMED IMPORTANCE BECAUSE CASH IS
THE MOST SIGNIFICANT OF ALL THE CURRENT ASSETS. IT IS REQUIRED TO
MEET BUSINESS OBLIGATIONS AND IT IS UNPRODUCTIVE WHEN NOT USED.
CASH MANAGEMENT DEALS WITH THE FOLLOWING:
 1. CASH INFLOWS & OUTFLOWS.
2. CASH INFLOWS WITH IN THE FIRM.
3. CASH BALANCES HELD BY THE FIRM AT A POINT OF TIME.

MOTIVES FOR HOLDING CASH

There are four primary motives for holding cash balances:
 Transaction motive
 Precautionary motive
 Speculative motive
 Compensating motive

TRANSACTION MOTIVE
An important reason for maintaining cash balances is the transactive motive.
This refers to holding of cash to meet routine cash requirements to finance the transactions,
which a firm carries on in a ordinary course of business.

PRECAUTIONARY MOTIVE
The cash balances held in reserve for random and unforeseen fluctuations in
cash flow are called precautionary balances. It provides a cushion to meet unexpected
contingencies.

SPECULATIVE MOTIVE
It refers to the desire of the firm to take advantage of opportunities which present
themselves at unexpected moments and which are typically outside the normal course of
business.

COMPENSATING MOTIVE
FIRMS HOLD CASH BALANCES to compensate banks for providing services &
loans. For the services banks provide, they charge a commission or fee. Usually clients are
required to maintain a minimum balance of cash at the bank. Since these balances cannot be
utilized by the firms for transaction purposes, the banks themselves can use the amount to earn
a return. Such balances are compensating balances.

OBJECTIVES OF CASH MANAGEMENT

The basic objectives of cash management are two fold:
 To meet cash disbursement needs
 To minimize funds committed to cash balances.

Meeting cash disbursement needs

Firms to make payments of cash on a continuous & regular basis to
suppliers, employees, etc. At the same time, there is constant inflow of cash through
collection of debtors. This objective implies to have sufficient cash to meet the cash
disbursement needs of the firm.

Minimising funds committed to cash balances

Though a high level of funds with the firm ensures prompt payment, but it
also implies large funds will remain idle. On the other hand a low cash balance may mean
failure to meet payment schedule. The aim of cash management, therefore, should be to have
an optimal amount of cash balances.

CASH MANAGEMENT SYSTEM

The cash system of a firm is the mechanism that provides the linkage between cash flows.
The firm should develop and maintain the policies & procedures necessary to achieve an
efficient flow of cash for the firms operation.

ELEMENTS OF CASH MANAGEMENT SYSTEM

(1) External Elements Internal Elements.

(a) Collection System Concentration system

(b) Disbursement System Disbursement funding system.

Collection System: - For getting cash into firm.

Disbursement System: - For paying suppliers & others receives of cash.

Concentration System: - To move cash from entry point in the firm to the
. concentration bank.

Disbursement funding: - To move funds from the concentration bank to the

System disbursement banks so that payments can be made.

CASH COLLECTION SYSTEM

Objectives

(i) To receive value from the buyer as early as possible.

(ii) To receive & process information associated with the payment.
(iii) Not to bitter relationship of firm with those making payments.

Minimise cost of collection float.

- Value of payment information.
- Value of relationship with payers.
+Collection system cost.
+ cost of losses through theft/fraud.

Cost of collection Float:

Collection float refer to the total time log between the mailing of the payment by the
payer and availability of cash in the bank.
Cost of float represents the opportunity cost because the cash is unavailable for use during
the time the payments are tied up in collection

TYPES OF COLLECTION SYSTEM

  Over-the-counter collection system
 Mailed payment collection system
 Preauthorised payments
 Electronic collection procedures
 Lockbox systems

OVER-THE-COUNTER COLLECTION SYSTEM

A system where the payment is received in a face to face meeting with the customers.
Since payments are not mailed, this system does not contain mail float

CUSTOMER

LOCAL FIELD CENTRAL

Makes Deposit UNIT Reports Information INFOMA-
DEPOSIT
BANK TION
SYSTEM

Customer may pay in cash or cheque at field office location (where firm delivers goods or
services to the customers & collects payments). Field unit will deposit the amount at the
bank and gives information of receipts & the deposits. Deposit bank gives information about
the deposit & the availability of funds to central information system. These information is
necessary for finance manager for control purposes.

MAILED PAYMENT COLLECTION SYSTEM

A collection system where a company receives cash by way of cheques mailed by the
customerCOMPONENTS
in response to anOF invoice.
MAILEDThisPAYMENT
system contains all three components
COLLECTION SYSTEM of collection
float: mail float, processing float and availability float.

Customer 1
Basic components Customer 2 Customer 3 Customer 4
The mailed payment collection system consists of:
(a) Collection centers
(b) Deposit banks
(c) Information system
Payments are mailed Collection
by customers to a designated collection
center center
Collection operated either by the
center
company or by an outside agent.
A Payments are processed at the collection
B center; cheques are
encoded, the deposit is prepared and made, and data are transmitted to the company’s
information system.

Deposit made
Deposit made

Deposit Bank Deposit Bank

X Y

Payment mailed Payment mailed

Central
information
system
PREAUTHERSIDED PAYMENTS
(a) Preauthorized cheques\drafts are used when the payment amount and the payment date
are specied in advance. On the agreed date value transfer from the payer through banking
system.
(b) Electronic collection procedure helps in making an electronic message of payment for
the cheque . This eliminates the need for the paper and thus various floats associated with
paper work.

LOCK BOX SYSTEM

A “Lock box “ is a post office number to which the firm’s customers are instructed to send
their cheques and immediately start processing on them. This helps in reducing at firm float
start processing on them. This helps in reducing at firm float by facilitating direct delivery, to
the firm’s lock box bank of cheques.

Lock boxes are not free from floatation problems but their proper can reduce all types of
floatation on incoming cheques.
Lock box strategy requires to take decisions on:
(1) Where should the firm locate its lock boxes,
(2)To which lock boxes should each of the firm’s customers send their cheques.

Lock box location problem is a cost minimization problem.

COSTS OF LOCKBOXE VERSUS NUMBER OF LOCKBOXES
MINIMISE (a) The opportunity cost of the float on incoming cash.
(b) The cost of the lock box system.
Opportunity cost = total float in the amount times the firm’s required return.
Cost of the lock box system =Bank charges to provide lock box services.(Fixed cost)

There is a trade off between these two sets of cost. As the firmTotal
increases theSystem
cost of number of lock
boxes, the opportunity cost of float will be reduced. However each additional lockbox adds
another fixed charge to the cost of lock box system. Additional lock box increases rather
decreases total costs.
Costs Fixed Lockbox cost

Opportunity cost of float

Optimum no. of Lockboxes

No. of Lockboxes in the System

CASH CONCENTRATION STRATIGES
It is useful for the firm to gather these balances from the lock box banks into a central bank
account. The process of collecting funds is called cash concentration.
A concentration bank is simply a bank designated by a firm to perform three main task:
 Receives deposits from the bank in the firm’s collection system.
 Transfer funds to the firm’s disbursement bank.
 Serves as the focal point for short-term credit & investment
transaction
When the level becomes to high, extra cash is moved into short-term investments or used to
pay off credit lines. When the level dips too low, needed cash is supplied by sale of short-
term investments or from a draw on short-term borrowing sources. This process is called
aggregate cash position management.
Objectives of cash concentration
Cash concentration cost arises from several sources:
1. Opportunity cost of holding excess balances in deposit banks.
2. Transaction cost of moving cash into the concentration bank.
3. The value of dual balances (in which the same cash is counted in both
the deposit bank & the concentration bank at the same time)
4. Administrative cost of managing the concentration system.
5. Control costs associated with the risk of cash loses encountered in
some concentration system.
Minimise = Opportunity cost of excess balances
(+) transaction costs
(-) interest on dual balances
(+) administrative cost
(+) control costs.

DISBURSEMENT SYSTEM
Disbursement system includes the banks & the delivery mechanisms and procedures firms
use to facilitate the movement of cash from the firm’s centralized cash pool to disbursement
banks and then on to suppliers and other payers. The concentration bank serves as the valve
between the firm’s collection system, liquidity portfolio, and disbursement banks.
Disbursements banks are the banks on which disbursements cheques are drawn.
Objectives of disbursement system
Minimise = (+) Value of disbursement float.
(-) Loss of discount for early payment.
(-) Cost of excess balances in disbursement accounts.
(-) Transactions costs.
(+) Value of payee relations.
(+) The value from dual balances.
(-) Administrative, information, and control costs.

Receivables Management:

The term receivables defined as ‘debt owed to the firm by customers arising from the sale of
goods or services in ordinary course of business’. When the firm makes
an ordinary sale or services and does not receive payment the firm grants trade payment and
account receivables. Receivable management is also called trade credit management.
Receivables are treated as marketing to aid the sale of goods. They intended to promote sales
and thereby profit. The objective of receivable management is to promote sales and profits
until that point is reached where the return on investment in further finding receivables is less
than the cost of funds raised to finance that additional credit that is cost of capital.

COSTS.
The major categories of costs associated with the receivables are:-
1. Collection cost.
2. Capital cost.
3. Delinquency cost.
4. Default cost.

CREDIT POLICY.
The credit policy of firm provides the frame work to determine:-
. Whether or not to extend credit to a customer &
. How much credit to extend.

The credit policy decision of firm has two broad dimensions:-

. Credit standards.
. Credit analysis.

Credit standards

The terms Credit Standards represents the basic criteria for the extension of credit to
customers. The quantitative basic of establishing credit standardising factors rating credit
references average payment period and certain financial ratios.

To illustrate the effect we have divided the overall stands into:

. Right or restrictive.
. Liberal or non-restrictive.

The trade off with credit standards covers:

(a) The collection cost.
(b) The average collection period/investment in accounts receivable.
(c) Level of bad debt losses.
(d) Level of sales.

(a) The collection cost.

These costs are likely to be semi variable. This is because upto a certain point the existing
staff will be able to carry on the increased workload but beyond that additional staff would be
required.

(b) The average collection period/investment in account receivable.

Investment in the receivables or the average collection period the investment accounts
receivables involves a capital cost as funds have to be arranged by the firm to finance then till
customers make payments.

(c) Level of bad debt losses.

Bad debt expenses another factor which is expected to be affected by charges in the credit
standard is bad debt (defallt) they be expected to increase with relaxation in credit standards.

(d) Level of Sales.

Sales volume changing credit standards can also be expected to change the volume of sales.
As standards are relaxed sales are expected to and a tightening is expected to cause a decline
the sales.

Credit analysis:

Besides establishing credit standards, a firm should develop procedures for evaluating credit
applicants. Two basic steps are involved in the credit investigation process:
(a) Obtaining credit info.
(b) Analysis of the credit info.

It is on the basis of credit analysis that the decisions to grant credit to a customer as well as
the quantum of credit would be taken.
Obtaining Credit info:- The sources of info are:
1. Internal
2. External
1. Internal.
Usually, firms require their customers to fill various forms & documents giving the details
about financial operations. The trade references furnished by the customers can be used to
judge the suitability of the customers for credit. Moreover, if the particular applicant has
enjoyed the credit facility in the past then the records of such customer regarding the payment
pattern can be used for collecting the information.
. External.
Financial statements i.e. the business standard & profit & loss accounts can be used to
determine the financial viability, liquidity, profitability & debt capacity. Bank references &
trade references provide the useful credit information.
Analysis of the credit information:- covers two aspects:
(1) Quantitative.
() Qualitative.
(1) Quantitative.
The assessment of the quantitative aspects is based on the factual info.available from the
financial statement, the past records of the firm. The nalysis of the credit info can be done
through a ratio analyses of the liquidity, profitability and the debt capacity of the applicat.
() Qualitative:
The qualitative assessment should be supplemented by a qualitative interpretation of the
applicats credit worthiness. References from the suppliers, bank references and the specialist
bureau reports are used for this purpose.

CREDIT TERMS:

The second division area in the accounts receivable management is the credit terms. After
the credit standards have been established and the credit worthiness of the customers has been
assessed the management of the firm must determine the terms and the conditions on which
trade credit would be available. The stipulations under which goods are sold on the credit are
referred to as credit terms. Credit terms have 3 components.

i. Credit period, in the terms of the duration of the time for which trade credit is
extended during this period the over due amount must be paid by the customer.
ii. Cash discount, if any, which the customer can take advantage of, that is, the over due
amount will be reduced by this amount.
iii. Cash discount period, which refers to the duration during which the discount can be
availed of.
The implications of increasing the cash discount are as follows:-
(i) The sales volume will increase:-
The grant of disc implies reduced prices. Thus the reduction in prices will result
in higher sales volume.

(ii) The average collection period would be reduced:-

Customers would like to pay within the discount period to take the advantage of
the discount. The decrease in the average collection period would lead to fall in
the bad debt expenses. Investment in receivable would also be reduced. As a
result, the II would I.

(iii) The discount would have a negative effect on the profit’s:-

This is because the decrease in prices would affect the II margin per unit of the
sale.
COLLECTION POLICIES
The third area involved in the accounts receivables in the collection policies. They refer to
the procedures followed to collect accounts receivables when, after the expiry of the credit
period they become due. These policies cover two aspects:-
(i) Degree of efforts to collect the overdue.
(ii) Type of the collection efforts.
The credit policies of the firm may be categorized into:-
(i) Strict
(ii) Lenient.
The collection policy would be tight if the firm follows rigorous procedure to collect the dues
from its customers. The bad debt expenses would decline. Average collection period will be
reduced. The firm will be benefited, as the profits will also increase. However, it may lead
to decline in volume of sales, as some customers may not like the pressure initiated by the
firm. The effect of the lenient policy will be just the opposite.

Type of the collection efforts.

The second aspect of the collection policies related to the steps that should be taken to collect
over due from the customers. The steps usually taken are:
 (i) Letters including reminders;
(ii) Telephone calls for the personal contact;
(iii) Personal visits;
(iv) Help of the collection agencies & finally;
(v) Legal action. The aim is to collect the payment as early as possible.

5 C’s of CREDIT
To grant credit it is necessary to access the credit worthiness of customer Credit
worthiness is a concept related to the positive and negative aspects of granting credit to the
applicant. These aspects include the business history of the applicant, the manner in which
the applicant makes payments to other trade suppliers, the profitability of the products that
the applicant wants to purchase, the applicant’s financial position and so forth. These
dimensions are called the five Cs of credit- Capital, Character, Collateral, Capacity and
Conditions.

Capital: The evaluation of the applicant’s capital refers to an analysis of the

applicant firm’s financial position. The usual procedure is to perform an extensive ratio
analysis, comparing the applicant’s financial ratios to ratios for the applicant’s industry and
performing trend analysis of the applicant’s ratios overtime. Focus should also be made on
firms aggregate liquidity position and its total debt position. First is measured by ratios such
as current ratio and the quick ratio, while the later is measured by the total debt to total equity
and total debt to total asset ratio.

Character: In order to make payments to trade suppliers, the applicant must have
both the firms to pay the debts and willingness to pay the debts. In assessing character the
credit analyst considers all the information that relates to willingness to pay be the applicant’s
management. What is the applicant history of payment to the trade? etc. Information in these
areas bears on the analyst’s assessment of the applicant’s character.

Collateral: If the applicant experiences financial difficulty, it may force to

liquidate. In such a situation, the recoveries to trade creditors will depend on (i) the
recoveries on assets sold, (ii) the amount of debt owed by the firm, and (iii) the extent to
which these debts are secured. If the firm liquidates, the recoveries on assets that are security
of debt will go to the holders of that secured debt Since it becomes difficult for trade
creditors to obtain secured position, this means that the recoveries to trade creditors are
significantly lowers when the applicant has financed by using secured borrowings.
Information on secured borrowings is gleaned from the applicant’s financial statements, from
the applicant’s bank, from credit reports on the applicant, or directly from conversations with
the applicant. More existing secured financing means lower credit worthiness from the trade
creditor’s standpoint.

Capacity: This dimension has two aspects; managements capacity to run the
business and applicant firm’s plant capacity. First one relates to ability of the management
personnel in the applicant’s operation. The better is management’s capacity to run the
business, the lower is the chance of default.
Physical capacity refers to the value and technology of the applicant’s
productions or service facilities. The better it is, the lower is the chance of default.

Conditions: What are the economic conditions in the applicant’s industry and in the
economy in general? If there is a good deal of foreign and domestic competition in the
applicant’s industry, the possibility of failure and default to trade creditors is larger, since
profit margins are likely to the lower. If the economy in general is undergoing a contraction,
failures are more likely to occur than during an expansionary period.
FACTORING AND RECEIVABLES MANAGEMENT
Factoring may be defined as the relationship between the seller of goods and the financial
institution called the factor, whereby the latter purchases the receivables of the former and
also administer receivables of the former. So, factoring is a tool to release working capital
tied up in credit extended to the customers, for more profitable uses and thereby relieving the
management from the sales collection chores so that they can concentrate on other important
activities. In a way the collection firm works as the collection department of the selling firm.

The functions of a factor may be described as:

1. Credit investigation,
2. Credit administration,
3. Credit monitoring,
4. Credit collection,
5. Credit protection &
6. Credit financing

THE MECHANISM OF FACTORING

Sale of goods (1)

Selling Factor Customer

firm or
receivable
Invoice copy (2)
Payment on due date (4)
Advanced payment (3)

Final payment, if any (5)

 PAYABLES MANAGEMENT

A substantial part of purchase of good and services in business are on credit terms
rather than against cash payment. While the supplier of goods and services tends to perceive
credits as a leaver for enhancing sales or as a form of non-prize instrument of competition,
the buyer tends to look upon it as a loaning of goods or inventory. The suppliers: credit is
referred to as Accounts payable, Trade credit, Trade Bill, Trade acceptance, commercial
drafts of bills payable depending on the nature of the credit.the extent to which this ‘buy-
now, pay-later’ facility is provided will depend upon a variety of factors such as nature,
quality and volumes of items to be purchased, the prevalent practices in trade, the degree of
competition and the financial status of the parties concerned. Trade creditors or payables
constitute a major segment of current liabilities in many business enterprises. And they
primarily finance inventories which form a major components of current assets in many
cases.

TYPES OF TRADE CREDIT

Trade creditors or payables could be of three types :Open Account, Promissory notes
and Bills payables.
Open Account or open credit operates as an informal arrangement wherein the
suppliers, after satisfying himself about the credit-worthiness of the buyer , dispatches the
goods as required by the buyer and sends the invoice with particulars of quantity dispatched
the goods as required by the buyer and sends the invoice with particulars of quantity
dispatched, the rate and the total price payable and the payment terms. The buyer records his
liability to the supplier in his books of accounts and this is shown as payables on open
account. The buyer is then expected to meet his obligations on the due date.

The promissory note is a formal document signed by the buyer promising to pay the
amount to the seller at a fixed or determinable future times. Where the client fails to meet his
obligation as per open credit on the due date, the supplier may require a formal
acknowledgment of debt and a commitment of payment by a fixed date. The promissory note
is thus an instrument of acknowledgement of debt and promise to pay. The supplier may
even stipulate an interest payment for the delay involved in payment.

Bills payable or commercial drafts are instruments drawn by the seller and accepted
by the buyer for payment on the expiry of the specified duration. The bill or draft indicate
the banker to whom the amount is to be paid on the due date, and the goods will be delivered
to against acceptance of the bill. The seller may either retain the bill present it for payment
on due date or may raise funs immediately thereon by discounting it with the banker. The
buyer will then pay the amount of the bill to the banker on due date

DETERMINATION OF TRADE CREDIT:

 Size of the firm:

Smaller firm have increasing dependence on trade credits as they find it difficult to
obtain alternative source of finance as easily as medium or large size firms. At the same
time, larger firms that are less vulnerable to adverse turns in business can command
prompt credit facility from supplier, while smaller firms may find it difficult to sustain
creditworthiness during period of financial strain and may have reduced acess to credit
due to weak financial position.

 Industrial Credit:
Different categories of industries or commercial enterprises show varying degree of
dependence on trade credit. In certain lines of business the prevailing commercial
practices may stipulate purchases against payment in most cases. Monopoly firm may
insists on cash on delivery. There could be instance where the firm inventory turn over
every fortnight but the firm enjoys thirty days credit from suppliers, whereby the trade
 credit not only finances the firms inventory but also provides part of the operating funds
or additional working capital.

 Nature of Product:
Product that sell faster or which have higher turn over may need shorter-term credit.
Products with slower turnover takes longer to generate cash flows and will need extended
credit terms.

 Financial Position of Seller:

The financial position of the seller will influence the quantities and period of credit
he wishes to extent. Financially weak suppliers will have to be stick and operate on
higher credit terms to buyers. Financially stronger suppliers, on the other hand, can
dictate stringent credit terms but may prefer to extend liberal credit so long as the
transactions provide benefits in excess of the costs of extending credit. They can afford
to extend credits to smaller firms and assume higher risks. Suppliers with working
capital crunch will be willing to offer higher cash discounts to encourage early
payments.

 Financial position of the buyer:

Buyer’s creditworthiness is an important factor in determining the credit quantum
and period. It may be logical to expect large buyers not to insist on extending credit
terms for small suppliers with weal bargaining power. Where goods are supplied on
consignment basis, the supplier provides extra finance for merchandise and pays
commission to consignee for the goods sold. Small retailers are thus enable to carry
much larger levels of stocks then they will be able to finance by themselves. Slow
paying or delinquent accounts may be compelled to accept stricter credit terms or
higher prices for products, to cover risk.

 Cash discounts:
Cash discount influences the effective length of credit. Failure to take advantage of
the cash discount could result in the buyer using the funds at an effective rate of
interest higher than the alternative sources of finance available. By providing cash
discount and inducing good credit risk to pay within the discount period, the supplier
will also sale on the cost of administration connected with keeping records of dues
and collecting overdue accounts.
 Degree of risk:
Estimate of credit risk associated with the buyer will indicate what credit policy is
to adopted. The risk may be with references to the buyer’s financial standing or with
references to the buyer’s financial standing or with reference to the nature of the
business the buyer is in.

 Nature and extent of competition:

Monopoly status facilities imposition of tight credit terms where as intense
competition will promote the tendency to liberalize credit. Newly established
companies in competitive fields may more readily resort to liberal trade credit for
promoting sales then establish firms, which are more formal in deciding on credit
policies.

ADVANTAGE OF PAYABLES:

Easy to obtain:
Payables or trade credit is readily obtainable, in most cases, without extended
procedural formalities. During periods of credit crunch or paucity of working capital, trade
credit from large suppliers can be boon to small buyers.
Suppliers assume the risk:
Where the suppliers have the advantage of high gross margins on their products, they
would be able to assume greater risk and extend more liberal credit.
Informality:
In trade credit, there is no rigidity in the matter of repayment of schedule dates,
occasional delays are not frowned upon. It serves as an extendible, convenient source of
unsecured credit.
Continuous financing:
Even as the current dues are paid, fresh credit flows in as further purchases are made.
It is continuous source of finance. With a steady credit terms and the expectations continuous
circulation of trade credit backing up repeat purchases, trade credit does , in affect, operate as
long term source.

EFFECTIVE MANAGEMENT OF PAYABLES:

The silent points to be noted on affective management of payables:

 Negotiate and obtain the most favorable credit terms consistent with the prevailing
commercial practice pertaining to the concerned product line.
 Where cash discount is offered for prompt payment, take advantage of the offer and
derive the saving therefrom.
 Where cash discount is not provided, settle the payment on its date of maturity and
not earlier. It pays to avail the full credit terms.
 Do not stretch Payables beyond due dates, except in inescapable situations, as such
delays in meeting obligations has adverse affect on buyer’s credibility and may result
in more stringent credit terms, denial of credit or higher prices on goods and services
procured.
 Sustain healthy financial status and a good track record of past dealings with the
supplier such as would maintain his confidence. The quantum and the terms o credit
are mainly influenced by supplier’s assessment of buyer’s financial health and ability
to meet maturing obligations promptly.
 Avoid the tendency to avoid the payables. Maintain the self liquidating character of
payables and do not use the funds therefrom for acquiring fixed assets. Payables are
meant to flow through sales for meeting maturing short terms obligations.
 In highly competitive situations, suppliers may be willing to stretch credit limits and
periods. Assess your bargaining strength and get the best possible deal.
 Provide full information to suppliers and concerned credit agency to facilitate a frank
and fair assessment of financial status and associated problems. With fuller
appreciation of client’s initiatives to honor his obligations and the occasional
 financial strains, which he might be subjected to for a variety of reasons, the supplier
will be more considerate and flexible in the matter of credit extension.
 Keep a constant check on incidence of delinquency. Delays in settlement of payables
with references to due dates can be classified into age groups to identify delays
exceeding one month, two months, three months, etc. Once overdue Payables are
given priority of attention of payment, the delinquency rate can be minimized or
eliminated altogether.
 INVENTORY MANAGEMENT

INTRODUCTION
Inventory management is concern with keeping enough product on hand to avoid
running out while at the same time maintaining a small enough inventory balance to allow for
a reasonable return on investment. Proper inventory management is important to the
financial health of the corporation; being out of stock forces customers to turn to competitors
or results in a loss of sales. Excessive level of inventory, however, results in large inventory
carrying costs, including the cost of capital tied up in inventory warehouse fees, insurance
etc.

OBJECTIVES
There are two objectives of investment management:
1. To minimize investment in inventory,
2. To meet a demand for a product by efficiently organizing the production and
sales operations.
That the firm should minimize investment implies that maintaining inventory involves costs,
such that the smaller the inventory, the lower is the cost to the firm. But inventories also
provide benefits to the extent that they facilitate the smooth functioning of the firm : the
larger the inventory, the better it is from this point of view. An optimum level of inventory
should be determined on the basis of the trade-off between costs and benefits associated with
the level of inventory.

COSTS OF HOLDING INVENTORY

The cost associated with inventory fall into to basic categories:

 Ordering costs,
 Carrying costs.

Ordering cost is associated with the acquisition or ordering of inventory. Ordering costs are
the costs involved in:
1. Preparing of purchase order or requisition form.
2. Receiving, inspecting, and recording the goods received to ensure both
quality and quantity.

It is generally fixed per order placed. The acquisition costs are inversely related to the size of
inventory.

Carrying costs are associated with maintaining inventory. This may be divided into two
broad categories:
1. Cost of storing inventory :(i) Storage cost, that
is, tax, depreciation, insurance
(ii) Insurance of inventory against fire and theft.

2. The opportunity cost of funds: This consists of expenses in raising funds to

finance the acquisition of inventory. If
funds not locked up in inventory, they
would have earned a return.
TECHNIQUES OF INVENTORY MANAGEMENT

There are four methods of inventory control which are as follows:

(a) ABC System
(b) EOQ Model
(c) Order point problem.

ABC System: The ABC System classifies different types of inventories to determine
the type and degree of control required for each. This technique is based on the
assumption that a firm should not exercise the same degree of control on all items of
inventory. It should rather keep a more rigorous control on items that are the most costly,
while items at are less expensive should be given less control effort.
On the basis of cost involved, the various inventory items are categorized into three
classes(i) A (ii) B and (iii) C. The items included in group A involved the largest
investment. Inventory control should be the most rigorous and intensive and the most
sophisticated inventory control techniques should be applied on these items. The C group
consists the items of inventory which involve relatively smaller investments although the
number of items is fairly large. These items deserve minimum attention. The group B
stands midway. It deserve less attention then A but more than C. It can be controlled by
employing less sophisticated techniques.

Value Quantity
10%
70% A

20%
B
20%

70%
C
10%

ABC Classification of goods

EOQ Model: It is necessary for every firm to determine that quantity of inventory
which it requires to purchase in a lot, which (i) does not result in blockage of money in
idle inventory, (ii) does not affect smooth production process. In other words a firm
should not place neither too large nor too small orders. Costs associated with inventory
are of two types
(a) Ordering costs
(b) Carrying costs
On the basis of a trade-off between benefits derive from the availability of inventory and the
cost of carrying that a level of inventory, the optimum level of the order to be placed should
be determined. This optimum level is known as economic order quantity(EOQ).

Assumptions:
(a) The firm known with certainty the annual usage of a particular item of inventory.
(b) The rate at which the firm uses inventory steady over time.
(c) The orders placed to replenish inventory stocks are received at exactly that point in time
when inventories reach zero.

Limitations:
(a) The assumption of a constant usage and the instantaneous replenishment of inventories
are of doubtful validity.
(b) The assumption of a known annual demand for inventories is open to question.

Total Cost
Costs
Carrying Cost

Ordering Cost

EOQ No. of units

Order point problems: After determining economic order quantity, another decision a firm
is required to take is when should the order to procure inventory be placed.
The reorder point is stated in terms of the level of inventory at which an order should be
placed for replenishing the current stock of inventory.
The reorder point is = Lead time in days average daily usage of inventory.The
term Lead time refers to the time normally taken in receiving the delivery after placingrders
with the suppliers.The average usage means the quantity of inventory consumed daily.
 SOURCE OF FINANCE

The various sources for financing of working capital are as follows:

SOURCES OF FINANCE

Temporary or Variable
Permanent or Fixed

1. Commercial Paper
1. Shares
2. Indigeneous Bankers
2. Debentures
3. Trade Creditors
3. Public Deposits
4. Instalment Credit
4. Plouging back of profits
5. Advances
5. Loans from Financial institutions
6. Accounts Receivables

7. Accured Expences

8. Commercial Paper

FINANCING OF PERMANENT/FIXED OR LONG TERM WORKING CAPITAL

Permanent working capital should be financed in such a manner that the enterprise
may have its uninterrupted use for a sufficiently long period. There are five important
sources of permanent working capital.

1. Shares: Issue of shares is the most important source for raising the permanent
capital. A company can issue various types of shares as equity, preference and
deffered shares. According to the companies Act, 1956, however, a public company
cannot issue deffered shares.

2. Debentures: A debenture is an instrument issued by the company acknowledging its

debt to its holder. It is also an important methed of raising long-term working capital.
The debenture holders are the creditors of the company. A fixed rate of interest is
paid on debentures. The debentures are generally given floating charge on the assets
of the company. When the debentures are secured they are paid on priority to other
creditors. The firm issuing debentures also enjoys a number of benefits such as
trading on equity, retention of control, tax benefits, etc.

3. Public Deposits: Public deposits are the fixed deposits accepted by a business
enterprise directly from the public. This source of raising short term and medium
term finance was very popular in the absence of banking facilities. The Reserve Bank
of India has also laid down certain limits on public deposits. Non banking concerns
can not borrow by way of public deposits more than 25% of its paid-up capital and
free reserves.
4. Ploughing Back of Profits: Ploughing back of profits means the reinvestments by
concerns of its surplus earnings in its business. It is internal source of finance and is
most suitable for an established firm for its expansion, modernization and replacement
etc.

5. Loans from Financial institutions: This source of finance is more suitable to meet
the medium-term demands of working capital. Interest is charged on such loans at the
fixed rate and the amount of loan is to be repaid by way of installments in a number of
years.

FINANCING OF TEMPORARY, VARIABLE OR SHORT TERM WORKING

CAPITAL

The main source of short term working capital are as follows:

1. Indigenous Bankers: Private money lenders and other country bankers used to be
the only source of finance prior to establishment of commercial banks. They used to
charge a very rate of interest. Now a days with the development of commercial
banks they have lost their monopoly.
2. Trade Credit: Trade credit refers to the credit extended by the suppliers of goods in
normal course of business. It is an important source of short terms finance. The
credits-worthiness of a firm and the confidence of its suppliers are the main basis of
securing trade credit. It is mostly granted on an open account basis whereby
suppliers sends goods to the buyers for the payment to be received in future as per
terms of the sales invoice. It may also take the form of bills payable whereby the
buyer signs a bill of exchange payable on a specified future date.
3. Installment Credit: It is a method by which assets are purchased and the
possession of goods is taken immediately but the payment is made in installments
over a predetermined period of time. Generally, interest is charged on the unpaid
price or it may be adjusted in the price.
4. Advances: Some business houses get advances from their customers and agents
against orders and this source is the short-term source of finance for them. It is a
cheap source of finance and minimizes their investment in working capital.
5. Factoring or accounts receivable credit: A factor is a financial institution which
offers services relating to management and financing of debts arising out of credit
sales. Factor render services varying from bill discounting facilities offered by
commercial banks to a total take over of administration of credit sales including
maintenance of sales ledger, collection of account receivables, credit control and
protection from bad debts, provision of finance and rendering of advisory services to
their clients. Factoring may be on a recourse basis, where the risk of bad debts is
borne by the client, or on a non-recourse basis, where the risk of credit is borne by
the factor. In spite of many services rendered by factoring, it suffers from certain
limitations (i) The high cost to factoring as compared to other sources. (ii) The
perception of financial weakness about the firm availing factoring services. (iii)
Adverse impact of tough stance taken by factor, against a defaulting buyer, upon the
borrower resulting into reduced future sales.
6. Accrued Expenses: Accrued Expenses are the expenses which have been incurred
but not yet due and hence not yet paid also. The simply represent a liability that a
firm has to pay for the services already received by it. Thus all accrued expenses
can be used as a source of finance. As no interest is payable on accrued expenses,
they represent a free source of financing.
7. Deffered Incomes: These are incomes received in advance before supplying goods
or services. They represents funds received by a firm for which it has to supply
goods or services in future. These funds increase the liquidity of a firm.
8. Commercial Papers: Commercial paper represents unsecured promissory notes
issued by firms to raise short-term funds. It is an important money market
instrument in advanced countries like U.S.A. In India, the Reserve Bank of India
introduced commercial paper in the Indian money market on the recommendations
of the working group on money market on the recommendations of the working
group of money market. But, only large enjoying high credit rating and sound
financial help can issue commercial paper to raise short-term funds. Only a
company which is listed on the stock exchange, has a net worth of atleast Rs. 10
crores and the maximum permissible bank finance of Rs. 25 crores can issue
commercial paper not exceeding 30% of its working capital limit. The maturity
period of commercial paper, in India, mostly ranges from 91 to 180 days. It is sold
at a discount from its face value and redeemed at face value on its maturity.
Commercial paper is usually brought by investors including banks, insurance
companies, unit trusts and firms to invest surplus funds for short period. A credit
rating agency, called CRISIN, has been set up in India by ICICI and UTI to rate
commercial papers.

9. Working Capital Financing by Commercial Banks: Commercial banks provide a

wide variety of loans tailored to meet the specific requirements of a concern.
Various forms of credit by banks are:

(a) Loans: When a bank makes an advance in lump sum against some security it
is called a loan. The bank sanctions some specified amount to its customer.
The borrower is required to pay interest on the entire amount of the loan from
the date of the sanction.
(b) Cash Credit: A cash credit is an arrangement by which a bank allows his
customer to borrow money upon a certain limit against some tangible
securities or guarantees. The customer can withdraw from his cash credit
limit according to his needs and he can also deposit any surplus amount with
him. The interest in case of cash credit is charged on the daily balance and
not on the entire amount of the account.
(c) Over drafts: Over draft means an agreement with the bank by which a current
account holder is allowed to withdraw more than the balance on his credit up
to a certain limit. The interest is charged on daily over drawn balances. Over
draft is allowed for a short period whereas cash credit is allowed for a longer
period.
(d) Purchasing and discounting of bills: Under this bank lends money without
any collateral security. The seller draws a bill of exchange on the buyer of
goods on credit. It may be either a clean bill or documentary bill which is
accompanied by documents of title to goods such as a railway receipt. The
bank purchases the bills payable on demand and credits the customer’s
account with the amount of bill less discount. At the maturity of the bills,
bank presents the bill do its acceptor for payment. In case the bill discounted
is dishonored, the bank recovers the full amount of the bill from the customer
along with the expenses in that connection.

10. Letter Of Credit: A letter of credit popularly known as L/c is an undertaking by a

bank to honour the obligations of its customer up to a specified amount, should the
customer fail to do so. It helps its customers to obtain credit from suppliers because
it ensures that there is no risk of non payment. L/c is simply a guarantee by the bank
to the suppliers that their bills upto a specified amount would be honoured. In case
the customer fails to pay the amount, on the due date, to its suppliers, the bank
assumes the liability of its customer for the purchases made under the letter of credit
arrangement.
A letter of credit may be of many types, such as:
  Clean letter of credit: It is a guarantee for the acceptance and payment
of bills without any conditions.
 Documentary letter of credit: It requires that the exporters bill of
exchange be accompanied by a certain documents evidencing title to the
goods.
 Revocable letter of credit: It can not be withdrawn without the consent
of beneficiary.
 Revolving letter of credit: In this the amount of credit is automatically
reversed to the original amount after such an amount has once been paid
as per defined conditions of the business transaction. There is no deed
for further application for another letter of credit to be issued provided
the conditions specified in the first credit are fulfilled.
Fixed letter of credit: It fixes the amount of financial obligation of the issuing bank either in
one bill or in several bills put together.
 Sources of working capital
Achieving the goals of corporate finance requires appropriate financing of any corporate investment.
The sources of financing are, generically, capital that is self-generated by the firm and capital from
external funders, obtained by issuing new debt and equity. Management must attempt to match the
long-term or short-term financing mix to the assets being financed as closely as possible, in terms of
both timing and cash flows.
Long-Term Financing :
Businesses need long-term financing for acquiring new equipment, R&D, cash flow enhancement and
company expansion. Major methods for long-term financing are as follows:
Equity Financing
This includes preferred stocks and common stocks and is less risky with respect to cash flow
commitments. However, it does result in a dilution of share ownership, control and earnings. The cost
of equity is also typically higher than the cost of debt - which is, additionally, a deductible expense -
and so equity financing may result in an increased hurdle rate which may offset any reduction in cash
flow risk.
Corporate Bond
A corporate bond is a bond issued by a corporation to raise money effectively so as to expand its
business. The term is usually applied to longer-term debt instruments, generally with a maturity date
falling at least a year after their issue date.
Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before
its maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into
equity.
Capital Notes
Capital notes are a form of convertible security exercisable into shares. They are equity vehicles.
Capital notes are similar to warrants, except that they often do not have an expiration date or an
exercise price (hence, the entire consideration the company expects to receive, for its future issue of
shares, is paid when the capital note is issued). Many times, capital notes are issued in connection
with a debt-for-equity swap restructuring: instead of issuing the shares (that replace debt) in the
present, the company gives creditors convertible securities – capital notes – so the dilution will occur
later.
Short-Term Financing
Short-term financing can be used over a period of up to a year to help corporations increase inventory
orders, payrolls and daily supplies. Short-term financing includes the following financial instruments:
Commercial Paper
This is an unsecured promissory note with a fixed maturity of 1 to 364 days in the global money
market. It is issued by large corporations to get financing to meet short-term debt obligations. It is
only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date
specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from
a recognized rating agency will be able to sell their commercial paper at a reasonable price.
Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other
financial assets. ABCP is typically a short-term instrument that matures between 1 and 180 days from
issuance and is typically issued by a bank or other financial institution.
Promissory Note
This is a negotiable instrument, wherein one party (the maker or issuer) makes an unconditional
promise in writing to pay a determinate sum of money to the other (the payee), either at a fixed or
determinable future time or on demand of the payee, under specific terms.
Asset-based Loan
This type of loan, often short term, is secured by a company's assets. Real estate, accounts receivable
(A/R), inventory and equipment are typical assets used to back the loan. The loan may be backed by a
single category of assets or a combination of assets (for instance, a combination of A/R and
equipment).
Repurchase Agreements
These are short-term loans (normally for less than two weeks and frequently for just one day)
arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on
a fixed date.
Letter of Credit
This is a document that a financial institution or similar party issues to a seller of goods or services
which provides that the issuer will pay the seller for goods or services the seller delivers to a third-
party buyer. The issuer then seeks reimbursement from the buyer or from the buyer's bank. The
document serves essentially as a guarantee to the seller that it will be paid by the issuer of the letter of
credit, regardless of whether the buyer ultimately fails to pay.
Inter corporate deposits :
Inter corporate deposits are deposits made by one company with another company, and usually carry a
term of six months. The three types of inter-corporate deposits are: three month deposits, six month
deposits, and call deposits. Three month deposits are the most popular type of inter-corporate
deposits. These deposits are generally considered by the borrowers to solve problems of short-
term capital inadequacy. This type of short-term cash problem may develop due to various issues,
including tax payment, excessive raw material import, breakdown in production, payment of
dividends, delay in collection, and excessive expenditure of capital.

The annual rate of interest given for three month deposits is 12%. Six month deposits are usually
made with first class borrowers, and the term for such deposits is six months. The annual interest rate
assigned for this type of deposit is 15%. The concept of call deposit is different from the previous two
deposits. On giving a one day notice, this deposit can be withdrawn by the lender. The annual interest
rate on call deposits is around 10%. The inter-corporate deposits market shows a number of
interesting characteristics. The biggest advantage of inter-corporate deposits is that the transaction is
free from bureaucratic and legal hassles. The business world otherwise is regulated by a number of
rules and regulations.

The existence of the inter-corporate deposits market shows that the corporate world can be regulated
without rules. The market of inter-corporate deposits maintains secrecy. The brokers in this market
never reveal their lists of lenders and borrowers, because they believe that if proper secrecy is not
maintained the rate of interest can fall abruptly. The market of inter-corporate deposits depends
crucially on personal contacts. The decisions of lending in this market are largely governed by
personal contacts.

Public deposits  :
The public deposits refer to the deposits that are attained by the numerous large and small firms from the
public. The public deposits are generally solicited by the firms in order to finance the working capital
requirements of the firm. The companies offer interest to the investors over public deposits.
The rate of interest, however, varies with the time period of the public deposits. The companies generally
offer 8 to 9 percent interest rate on the deposits made for one year.

The companies offer 9 to 10 percent interest rate over public deposits for two years while 10 to 11 percent
interest rate is offered for the three year deposits. There are rules regulating the fixed deposits.

According to the Companies Amendment Rules 1978, here is the list of rules for public deposits:
The maximum maturity period for a public deposit is 3 years
The minimum maturity period for public deposits is 6 months
The maximum maturity period for a public deposit for Non-Banking Financial Corporation is 5 years
The public deposits of a company cannot go past 25% of free reserves and share capitals
The companies asking for public deposits need to publish information regarding the position and financial
performance of the firm
The companies having public deposits need to keep aside the 10% of the deposits by 30th April every year
that will mature by 31st March next year.

The various advantages of public deposits enjoyed by the companies are:

There is no involvement of restrictive agreement
The process involved in gaining public deposit is simple and easy
The cost incurred after tax is reasonable
Since there is no need to pledge security for public deposits, the assets of firm that can be mortgaged can
be preserved

The disadvantages of public deposits from the company’s point of view are:
The maturity period is short enough
Limited fund can be obtained from the public deposits

The advantages of public deposits enjoyed by the investors are:

The interest rate is higher than the other financial investment instruments
The fund maturity period is short

The disadvantages of public deposits from the investors’ pint of view are: 
The interest that is charged on the public deposits does not enjoy tax exemption
There is no pledging of security against public deposits

Factoring:
Factoring may be defined as the relationship between the seller of goods and the financial
institution called the factor, whereby the latter purchases the receivables of the former and
also administer receivables of the former. So, factoring is a tool to release working capital
tied up in credit extended to the customers, for more profitable uses and thereby relieving the
management from the sales collection chores so that they can concentrate on other important
activities. In a way the collection firm works as the collection department of the selling firm.

The functions of a factor may be described as:

1. Credit investigation,
2. Credit administration,
3. Credit monitoring,
4. Credit collection,
5. Credit protection &
6. Credit financing

THE MECHANISM OF FACTORING

Sale of goods (1)

Selling Factor Customer

firm or
receivable
Invoice copy (2)
Payment on due date (4)
Advanced payment (3)

Final payment, if any (5)

 Sources of working capital
Working capital financing is done by various modes such as trade credit, cash credit / bank overdraft,
working capital loan, purchase of bills / discount of bills, bank guarantee, letter of credit, factoring,
commercial paper, inter corporate deposits etc. Arrangement of working capital financing forms a
major part of the day to day activities of a finance manager. It is a very crucial activity and requires
continuous attention because working capital is the money which keeps the day to day business
operations smooth. Without appropriate and sufficient working capital financing, a firm may get into
troubles. Insufficient working capital may result into nonpayment of certain dues on time.
Inappropriate mode of financing would result in loss of interest which directly hits the profits of the
firm.
Types of Working Capital Financing / Loans:
Trade Credit: This is simply the credit period which is extended by the creditor of the business.
Trade credit is extended based on the creditworthiness of the firm which is reflected by its earning
records, liquidity position and records of payment. Just like other sources of working capital
financing, trade credit also comes with a cost after the free credit period. Normally, it is a costly
source as a means of financing business working capital.
Cash Credit / Bank Overdraft: Cash credit or bank overdraft is the most useful and appropriate type
of working capital financing extensively used by all small and big businesses. It is a facility offered
by commercial banks whereby the borrower is sanctioned a particular amount which can be utilized
for making his business payments. The borrower has to make sure that he does not cross the
sanctioned limit. Best part is that the interest is charged to the extend the money is used and not on the
sanctioned amount which motivates him to keep depositing the amount as soon as possible to save on
interest cost. Without a doubt, this is a cost effective working capital financing.
Working Capital Loans: Working capital loans are as good as term loan for a short period. These
loans may be repaid in installments or a lump sum at the end. The borrower should take such loans for
financing permanent working capital needs. The cost of interest would not allow using such loans for
temporary working capital.
Purchase / Discount of Bills: For a business, it is another good service provided by commercial
banks for working capital financing. Every firm generates bills in the normal course of business while
selling goods to debtors. Ultimately, that bill acts as a document to receive payment from the debtor.
The seller who requires money will approach bank with that bill and bank will apply discount on the
total amount of the bill based on the prevailing interest rates and pay the remaining amount to the
seller. On the date of maturity of that bill, the bank will approach the debtor and collect the money
from him.
Bank Guarantee: It is primarily known as non fund based working capital financing. Bank guarantee
is acquired by a buyer or seller to reduce the risk of loss to the opposite party due to non performance
of agreed task which may be repaying of money or providing of some services etc. A buyer ‘B1’ is
buying some products from seller ‘S1’. In this case, ‘B1’ may acquire bank guarantee from bank and
give it to ‘S1’ to save him from the risk of nonpayment. Similarly, if ‘S1’ may acquire bank guarantee
and hand it over to ‘B1’ to save him from the risk of getting lower quality goods or late delivery of
goods etc. In essence, a bank guarantee is revoked by the holder only in case of non performance by
the other party. Bank charges some commission for same and may also ask for security.
Letter of Credit: It is also known as non fund based working capital financing. Letter of credit and
bank guarantee has a very thin line of difference. Bank guarantee is revoked and bank makes payment
to the holder in case of non performance of the opposite party whereas in case of letter of credit, the
bank will pay the opposite party as soon as the party performs as per agreed terms. So, a buyer would
buy a letter of credit and send it to the seller. Once the seller sends the goods as per agreement, the
bank would pay the seller and collects that money from buyer.
Factoring: Factoring is an arrangement whereby a business sells all or selected accounts payables to a
third party at a price lower than the realizable value of those accounts. The third party here is known
as the ‘factor’ who provides factoring services to business. The factor would not only provide
financing by purchasing the accounts but also collects the amount from the debtors. Factoring is of
two types – with recourse and without recourse. The credit risk of nonpayment by the debtor is borne
by the business in case of with recourse and it is borne by the factor in case of without recourse.
Some other sources of working capital financing used are inter corporate deposits, commercial paper,
public deposits etc.
 Regulation of bank finance in India
Tandon study group
The Reserve Bank of India formed a committee in July 1974 under the leadership of
Sri Prakash Tandon. The purpose to set up this committee was to frame guidelines for

follow up of bank credit. The terms of references of the group were-

1. To suggest the guidelines for the commercial banks to follow up and supervise
the credit from the view point of ensuring the end use of funds and keeping a watch
on the safety of the advances.

2. To make suggestion regarding the types of data and other information that are to be
collected by the banks from the borrowers periodically and those are to be collected
by the RBI from the lending banks.
3. To make recommendation regarding the sources for financing the minimum
working capital requirements.
4. To make suggestions for prescribing inventory norms for different
industries both in the private and public sectors and to indicate the broad criteria for
deviating from these norms.
5. To make recommendations as to whether the existing pattern of financing of working
capital requirements by cash credit or overdrafts requires to be modified, if so, to
suggest suitable modification.
6. To suggest criteria regarding satisfactory capital structure and sound financial
basis in relation to borrowings.
7. To make recommendation on any other related matters, as the committee may
consider necessary to the subject of enquiry or any other allied matter which may be
specified by the Reserve Bank of India.
Observations & recommendations:
The study group submitted its report to the Reserve Bank of India in August, 1975. The
major recommendations of the committee were; -

a) The borrowers should prepare the operating plan for the ensuing year and
submit it to the bank. On the basis of such plan, the borrower should indicate the
likely demand for credit. In this way, it will be helpful for the lending bank to
evaluate the borrower's credit need in realistic manner and to follow up
periodically during the ensuing year.

b) The banker should finance only the genuine production needs of the
borrowers. The borrower should maintain the reasonable level of inventory and
receivables which should be just enough to cany out its desired production. In
this way, the efficient management would be able to eliminate the slow moving
and obsolete inventories.
 a. Firstly, the borrowers will provide 25% of the working capital gap and
the balance 75% can be financed from the bank borrowings which will
give a minimum current ratio 1:1.

b. Secondly, the borrower should contribute 25% of the total current

assets and the remaining working capital gap (i.e., the working capital
gap-borrower's contribution) can be collected from the bank
borrowings. This alternative will provide the current ration of 1.3:1.

c. Thirdly, the borrower will provide 100% of the core current assets and
25% of the balance current assets. The remaining working capital gap
can be financed from bank borrowings. This method will also be
helpful to strengthen the current ratio further.

h) ' The committee had also suggested the inventory and receivable norms. The
term 'NORM' refers to the maximum level of holding inventories and
receivables in each industry. In this context, the committee suggested the norms
The committee
c) for inventories recommended
and receivables for that the bank
15 major would finance
industries. a reasonable
This covers part
about one-
of the
half working
of the capital
industrial needs ofofthe
advances theborrowers,
banks. Thenotstudy
the entire
grouppart. Theout
worked remaining
the
part offorthe
.norms working
Cotton capital needs
& Synthetic should
Textiles, be financed
Man-made by the
Fiber, Juteborrowers from their
Textiles, Rubber
own funds.
products. Fertilizers, Pharmaceuticals, Dye and Dyestuffs, Basic Industrial
d) The bank
Chemicals, should ensure
Vegetables the proper end-use
and Hydrogenated of theCement,
oils. Paper, bank credit. For this
Engineering
purpose, it should
manufacturers and have to keep
other closeequipment
Capital contract with the borrower's business.
suppliers,(other than Heavy
For financing
engineering). working
The group had capital needs, the borrower
not suggested norms forcan obtain
Heavy bank credit
engineering andin
e)
different
highly forms
seasonal like cash In
industries. credit,
case bills purchased
of other and the
industries, discounted; working
group had capital
suggested
thatterm loannorms
those etc. should be progressively extended to cover more and more

f) industries includingclose
By keeping smallcontract
scale industries.
on the operation of the borrower's business, it
would be possible for a bank by requiring them to submit data regarding their
business
The group and financial
suggested operations
the norms relating for both
to (i) rawthe past andincluding
materials future periods
sparesatand
regular
intervals.
other items used in the process of manufacture, (ii) Stock in process (iii) finished
g) The committee had also recommended the lending norms under three
altematives-
 goods (IV) receivables. The norms had been suggested on the basis of time element
which are -
1. Raw materials as so many months' consumption.

2. Stock in process as so many month's cost of production.

3. Finished goods and receivables as so many months' cost of sales and sales
respectively.

The norms prescribed for the account receivable was related to the inland sales
only on a short term basis. The receivables arising out of deferred payment of sales
and export were excluded. The group did not suggest the norms for the stock of spares

because this item forms a small part of the operational expenditure.

These norms indicated the maximum level of holding of inventory and receivables
in each industiy. The borrowers are not generally interested to hold more than that.

But if the borrower can manage with the less amount; then they are allowed to do so.
The norms suggested by the study group for inventory and receivables were not
rigidly to apply. Any deviation from the suggested norms may be permitted where it
is found to be justified.

Chore committee
The Reserve Bank of India constituted another committee in April, 1979 under the
leadership of Mr. K.B Chore. The main purpose of appointing such committee was to
review the operation of cash credit system in regard to the gap between the sanctioned
credit amount and the extent of their use. The committee submitted its report in
August, 1979. The major recommendations of the committee were-

a) The borrowers should provide more funds for financing their working capital
requirements. They must take steps to reduce their dependence on bank credit. In
this context, the committee suggested to adopt the second method of financing as
recommend by the Tandon Committee. If it is not possible for the firm to
provide the sufficient fimds as per its requirement immediately, the firm would
be provided loan in the form of working capital term- loan and this should be
 repaid in instalments within a period not exceeding five years. The rate of
interest would be higher in that case than the usual rate under cash credit system,

b) The bank should fix up separate credit limit for the peak and non-peak level
indicating the relevant period also for all the barrowers in excess of Rs.lO lacs.
Adhoc or temporary credit limits should be generally discouraged by bank. If it
is to be sanctioned under special circumstances, an additional interest of 1% p.a
should be charged on such sanctioned amount.

c) The existing three types of lending system viz. cash credit, loans and bills
should be continuing. On the basis of the prevailing circumstances, the bank
should take steps to replace the existing cash credit system by loans and bills.

d) The Conmiittee also recommended for implementing the corrective measures

to remove the obstacles in using the bill system of finance and also to remove
the drawbacks observed in cash credit system.

e) Quarteriy statement in the prescribed format should be obtained by the banks

from all the borrowers having working capital credit hmit of Rs.50 lacs and
above

Marathe Committee
On account of following the recommendations of the Tandon committee and chore
committee at the time of granting credit, the bank credit to the industries had been
increasing under the direct control and supervision of the Reserve Bank of India. In
1982, it was felt to review the Credit Authorizations Scheme (CAS) which continued
for several years and for this purpose, the RBI constituted a committee in November,
1982 to review the working of CAS. This committee was known as Marathe
Committee. The Committee was given the wide term of references to examine the
credit authorization scheme. The Marathe Committee submitted their report in July
1983. The important observations and recommendations ofthe Committee were-

1. Credit Authorization Scheme is not to be considered as a regulatory measure only

confined to the large borrowers. The main purpose for the implementation of this
scheme is to ensure the orderly credit management. This is also helpful to improve the
quality of credit by ensuring all types of credit whether large or small and which are
in conformity with the policies and priorities as prescribed by the central banking
authority.

2. The Committee recommended for evolving a system where there are incentives for
the borrowers to comply all the requirements of the scheme. This incentive should
also be extended to the bankers to bring improvement in quality of credit appraisal.
3. Another recommendation of the Committee was that the bank can exercise its
discretion to disburse credit in CAS cases without obtaining prior authorization of
RBI, if the borrower fiilfils the follov^ng requirements-

i) Reasonableness in estimates /projections in regard to sales, chargeable current

assets, other current assets, current liabilities and net working capital.

ii) Classification of current assets and current liabilities as per guidelines suggested
by RBI.

iii) Quick submission of quarterly operational statements for the last six months
with an undertaking to do so in future.

iv) Maintenance of minimum current ratio of 1.33:1

4. In case of deployment of credit by bank in its own discretion, a certificate duly

signed by a senior executive is to be furnished along with the proposal complying all
the requirements stated in (3) above.

5. The bank will be able to dispose off the credit proposal of an export oriented
business having export not less than 75% of the turnover of the goods manufactured at
the bank level without the prior approval of RBI, if the bank satisfies with
reasonableness of the exporter's credit needs.

6 . Bank can allow adhoc limit for the period up to 3 months to the extent of 25% of
the additional limit to the borrowers having working capital limit in excess of 5 crore.
But in that case, bank should be satisfied about their needs.
7. A booklet on CAS is to be prepared by RBI and this should be available as priced
publication. This should also be revised and updated periodically.

8. RBI should take steps to ensure prompt submission of data by banks in form No.
A and B. This is to be considered as an effective instrument of monitoring their
advance portfolios.

9. The present Credit Authorization Scheme may be redesignated as credit monitoring

scheme, so as to reflect the important changes in broad approach.
i) To suggest the guidelines for the commercial banks to follow up and
supervise the credit from the view point of ensuring the end use of funds
and keeping a watch on the safety of the advances.

To make suggestion regarding the types of data and other information that
are to be collected by the banks from the borrowers periodically and those
are to be collected by the RBI from the lending banks.
To make recommendation regarding the sources for financing the
minimum working capital requirements.
To make suggestions for prescribing inventory norms for different
industries both in the private and public sectors and to indicate the broad criteria
for deviating from these norms.
To suggest criteria regarding satisfactory capital structure and sound
financial basis in relation to borrowings.
To make recommendations as to whether the existing pattern of financing
of working capital requirements by cash credit or overdrafts requires to be
modified, if so, to suggest suitable modification.

To make recommendation on any other related matters, as the committee

may consider necessary to the subject of enquiry or any other allied matter
which may be specified by the Reserve Bank of India.