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INTRODUCTION

Financial management includes management of assets and liabilities in the long


run and the short run.

The management of fixed and current assets, however, differs in three important
ways: Firstly, in managing fixed assets, time is very important; consequently discounting
and compounding aspects of time element play an important role in capital budgeting and
a minor one in the management of current assets. Secondly, the large holdings of current
assets, especially cash, strengthen firm’s liquidity position (and reduce risk) but it also
reduces its overall profitability. Thirdly, the level of fixed as well as current assets
depends upon the expected sales, but it is only the current assets, which can be adjusted
with sales fluctuation in the short run.

Here, we will be focusing mainly on management of current assets and current


liabilities.

Management of current assets needs to seek an answer to the following question:

1. Why should you invest in current assets?

2. How much should be invested in each type of current assets?

3. What should be the proportion of short term and long-term funds to


finance the current assets?

4. What sources of funds should be used to finance current assets?

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What is working capital?
Working capital is the capital you require for the working i.e. functioning of your
business in the short run. Working capital to a company is like the blood of human body.
It is the most vital ingredient of a business. Working capital is the flow of ready funds
necessary working of the enterprise.

Purpose of working capital

1. To meet the cost of inventories, raw materials purchases, work-in-process,


finished goods, etc.

2. To pay wages and salaries

3. To meet overhead cost, factory cost, office and administration cost, taxes, etc.

4. To meet selling and distribution expenses, advertising, packing etc.

CASH

INVENTORIES

RECEVABLES

CIRCULATION OF CURRENT ASSETS

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DEFINITION OF WORKING CAPITAL

• GROSS WORKING CAPITAL The gross working capital concept focuses


attention on two aspects of current asset management:
a) Optimum investment in current asset; and
b) Financing of current assets

Following are the definitions of gross working capital:

1. Mead, Malott and Field. “Working capital means current assets.”

2. Bonneville. “Any acquisition of funds which increases the current asset


increases working capital, for they are one and the same.”

3. J.S.Mill. “The sum of the current assets is the working capital of business.”

• NET WORKING CAPITAL The net working capital refers to the difference
between current asset and current liabilities. It is the excess of current asset over
current liabilities. The concept may be in the following equation:
WORKING CAPITAL= CURRENT ASSETS – CURRENT LIABILITIES

Net working capital may be of the following types:


a) Positive net working capital. It arises when current assets exceeds current
liabilities.

b) Negative net working capital. It occurs when current liabilities are in excess
of current assets.

The net working capital (a) indicated the liquidity position of the firm; and (b)
suggest the extent to which working capital needs to be financed . Both the net and gross
concepts of working capital are two facets of working capital management.

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CLASSIFICATION OF WORKING CAPITAL

Working capital may be classified on the following two bases:

1. ON THE BASIS OF CONCEPT

• Gross working capital Represented by the total current assets.

• Net working capital It is the excess of current asset over current liabilities

2. ON THE BASIS OF PERIODICITY OF REQUIREMENTS

• Fixed or permanent working capital It represents the part of capital


permanently locked up in the current assets to carry out the business smoothly.
This investment in current assets increases as the size of business expands.
Examples of such investments are those required to maintain the minimum stock
of raw materials, work-in-progress, finished products, loose tools and equipments.
This arrangement requires minimum cash balance to be kept in reserve for the
payment of wages, salaries and all other current expenditure throughout the year.
The permanent fixed working capital may again be subdivided in the following:

a) Regular working capital It is the minimum amount of liquid capital


required to keep up the circulation of the capital from cash to inventories;
to receivable and again to cash. This includes sufficient minimum cash
balance to discount all bills and to maintain adequate supply of raw
materials etc.
b) Reserve margin or cushion working capital. It is the excess capital over
the needs of regular working capital that should be kept in reserve for
contingencies that may arise at any time. These contingencies include
rising prices, business depression, strikes, special operations such as
experiments with new products etc.

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• Variable working capital Variable working capital changes with the increase or
decrease in the volume of business. It may be subdivided into the following.
a) Seasonal variable working capital The working capital required to meet
the seasonal liquidity of the business is seasonal variable working capital.
b) Special variable working capital It is that part of the variable working
capital which is required for financing special operation such as extensive
marketing campaigns, experiments with products or methods of
production, carrying of special jobs etc.

Permanent and variable working


capital:
The minimum level of current assets
required is referred to as permanent
working capital and the extra working
capital needed to adapt to changing
production and sales activity is called
temporary working capital

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ADEQUACY OF WORKING CAPITAL

Working capital or investment in current assets is a must for meeting the day-to-
day expenditure on salaries, wages, rents, advertising etc., and for maintaining the fixed
assets. Large scale capital in fixed assets is often determined by a relatively small amount
of current assets. The heart of industry, working capital, if weak, the business cannot
prosper and survive, although there may be a large investment of fixed assets. Inadequate
as well as redundant working capital is dangerous for the health of industry. “Inadequate
working capital is disastrous; whereas redundant working capital is a criminal waste.”
Both situations are unwarranted in a sound organization. Adequacy of working capital is
the life blood and controlling nerve center of a business.

USES OF ADEQUATE WORKING CAPITAL

1. CASH DISCOUNT: By adequate working capital the business can avail the
advantages of cash discount by paying cash for the purchase of raw materials and
merchandise. If proper cash balance is maintained, this will reduce the cost of
production.

2. SENSE OF SECURITY AND CONFIDENCE: Adequate working capital


creates a sense of security, confidence and loyalty throughout the business and
also among its customers, creditors and business associates. The proprietor,
officials or management of a concern are carefree, if they have proper capital
arrangement because they need not worry for the payment of business expenditure
or creditors.

3. SOLVENCY AND CONTINUOUS PRODUCTION: In order to maintain the


solvency of the business, it is essential that sufficient amount of funds are
available to make all the payments in time as and when they are due. In the
absence of working capital, production will suffer in the era of cut throat

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competition. A business can never flourish in the absence of adequate working
capital.

4. SOUND GOODWILL AND INCREASE DEBT CAPACITY: Promptness of


payment in business creates goodwill and increases the debt capacity of the
business. If investors and borrowers are confident that they will get their due
interest and payment of principal in time, a firm can raise funds from the market,
purchase goods on credit and borrow short term funds from banks etc.

5. EASY LOANS FROM THE BANKS: An adequate working capital helps the
company to borrow unsecured loans from the bank because the excess provides a
good security to the unsecured loans. If the business has a good credit standing
and trade reputation, banks favour in granting seasonal loans.

6. DISTRIBUTION OF DIVIDEND: If there is shortage of working capital a


company cannot distribute dividend to its shareholders in spite of sufficient
profits. To make up for the deficiency of working capital profits are to be retained
in the business. On the other hand ample dividend can be declared and distributed
to the market value of shares by sufficient working capital.

7. EXPLOITATION OF GOOD OPPORTUNITIES: Good opportunities can be


exploited through adequacy of capital in a concern, for example, a company may
make off seasons purchases resulting in substantial savings or it can fetch big
supply orders resulting in good profits.

8. MEETING UNSEEN COTINGENCIES: As stockpiling of finished goods


becomes necessary depression shoots up the working demand of capital. If a
company maintains adequate working capital unseen contingencies such as
financial crises due to heavy losses, business oscillations etc. can easily be
overcome.

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9. INCREASE IN EFFICIENCY OF FIXED ASSETS: Proper maintenance and
adequate working capital increases the efficiency of the fixed assets of the
business. It has been rightly said, “The fate of large scale investment in fixed
capital is often determined by a relatively small amount of current assets.”

10. HIGH MORALE: The provision of adequate working capital improves the
morale of the executive as they get an environment of certainty, security and
confidence which is a great psychological factor in improving the overall
efficiency of the business and of the person who is at the helm of affaires in the
company.

11. INCREASE PRODUCTION EFFICIENCY: A continuous supply of raw


materials, research programmes, innovation and technical developments and
expansion programmes are successfully carried out if adequate capital is
maintained in the business. It increases production capacity which increases the
efficiency and morale of the employees.

EVILS OF INADEQUATE WORKING CAPITAL

1. LOSS OF CREDIT WORTHINESS AND GOODWILL: A firm loses its


credit worthiness and goodwill if it fails to honour its current liabilities. It finds it
difficult to procure the requisite funds for its business operations on easy terms.
This leads to reduced profitability as well as production interruptions.

2. NO BENEFIT FROM FAVOURABLE OPPORTUNITIES: With inadequate


working capital a firm fails to undertake profitable projects. It prevents the firm
from availing the benefits of available opportunities and stagnates its growth.

3. FAILURE TO AVAIL CREDIT OPPORTUNITIES: Due to inadequate


working capital a firm fails to avail the attractive credit opportunities.

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4. OPERATING INEFFICIENCIES: Inadequate working capital leads to
operating inefficiencies as day-to-day commitments cannot be met.

5. LOW RATE OF RETURN ON FIXED ASSETS: Inadequate working capital


results in lowering down the rate of return on fixed assets as these cannot be
efficiently utilized or maintained due to inadequacy of working capital.

6. INCREASE IN BUSINESS RISKS: Inadequate working capital increases the


business risk of the firm. Unable to discharge its current liabilities it is liable to be
declared as insolvent. Thus inadequate working capital poses a serious threat to
the survival of the firm.

7. CANNOT ACHIEVE PROFIT TARGET: Due to inadequate working capital


the firm cannot achieve its profit target as it cannot implement its operating plans
due to shortage of working capital.

8. LOW MORALE OF BUSINESS EXECUTIVES: Inadequate working capital


adversely lowers the morale of the firm’s executives as they do not have an
environment of certainty, security and confidence, which is a necessary
psychological factor in improving the overall efficiency of the business.

9. WEAKENING OF FINANCIAL CAPACITY: Inadequate working capital


weakens the shock-absorbing capacity of the firm as it cannot meet the
contingencies arising from business oscillations, financial losses, etc.

EVILS OF REDUNDANT OR EXCESSIVE WORKING CAPITAL

1. IDLE FUNDS: Excessive and redundant working capital implies the presence of
idle funds which earn no profit for the firm. A firm with excessive working
capital cannot earn proper rate of return on its total investments, as profits are
distributed on the whole of its capital. This brings down the rate of return to the

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shareholders. Lower dividend reduces the market value of shares and causes
capital losses to the shareholders.

2. DECLINE IN OPERATING EFFICIENCY: Companies often adopt some


objectionable devices to inflate profits to maintain or increase the rate of
dividend. Sometimes, unearned dividends are paid out of companies’ capital to
keep the show of prosperity by window dressing of accounts. In order to make up
the deficiency of reduced earnings, certain provisions, such as provision for
depreciation, repairs and renewals are not made. This leads to decline in operating
efficiency and fall in profits.

3. LOSS OF CONFIDENCE AND GOODWILL: Excessive working capital leads


to lower rate of return on the company’s total investments. Lower dividend leads
to reduction of the market value of the company’s shares much less than the book
value. The shareholders lose confidence in the company and the goodwill or
credit of the company suffers a serious set back. Thus the financial stability of the
company is jeopardized.

4. MISAPPLICATION OF FUNDS: Companies with excessive working capital


do not utilize the resources prudently. Excessive inventories and fixed assets are
purchased by the company which do not add to its profitability and increase its
maintenance cost and losses due to theft, waste and mishandling.

5. EVILS OF OVER CAPITALISATION: Excessive working capital leads to


over capitalization which is disastrous to the smooth survival of the company and
affects the interest of those associated with the company.

6. INEFFICIENT MANAGEMENT: Excessive working capital indicates that the


management is not interested in expanding the business; otherwise the excessive
working capital might have been utilized for this purpose.

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7. DESTRUCTION OF TURNOVER RATIO: Redundant working capital
destroys the control of turnover ratio, which is commonly used in a conduct of an
efficient business. It eradicates all other guides and sign post commonly employed
in conducting and operating a business.

Thus a company must have working capital adequate to its requirements neither
excessive nor inadequate. While inadequate working capital adversely affects the
business operations and profitability, excessive working capital keeps idle and earns no
profit. It has been rightly said, “Inadequate working capital is disastrous; whereas
redundant working capital is a criminal waste.”

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WORKING CAPITAL REQUIREMENT

FACTORS DETERMINING WORKING CAPITAL REQUIREMENT

1. NATURE OF BUSINESS: The amount of working capital is related to the


nature of the business. In concerns, where the cost of the raw materials used in
manufacture of a product is very large to its total cost of manufacture, the
requirement of the working capital will be very large. For instance, a cotton or
sugar mill requires a large amount of working capital on the contrary, concerns
having large investments in fixed assets requires less amount of working capital.
Public utility concerns such as railway or electricity services require a lesser
amount of working capital as compared to trading or manufacturing concerns
partly because of cash nature of their business and partly because they are selling
a service instead of a commodity and there is no need of maintaining inventories.

Current Fixed assets Industries


assets (%) (%)
10-20 80-90 Hotel and restaurants
20-30 70-80 Electricity generation and Distribution
30-40 60-70 Aluminum, Shipping
40-50 50-60 Iron and Steel, basic industrial chemical
50-60 40-30 Tea plantation
60-70 30-40 Cotton textiles and Sugar
70-80 20-30 Edible oils, Tobacco
80-90 10-20 Trading, Construction

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2. SIZE OF BUSINESS UNIT: The general principle in this regard is that the
bigger the size of business the larger will be the amount of working capital
required because the larger business units are required to maintain big inventories
for the flow of the business and to spend more in carrying out the business
operations smoothly.
3. SEASONAL VARIATIONS: Strong seasonal variations create special problems
of working capital in controlling the internal financial swings. Many companies
such as sugar mills, oil mills or woolen mill etc. require larger amount of working
capital in the season to purchase the raw materials in large quantities and utilize
them throughout the year. They adjust their production schedule and maintain a
steady rate of production during off season periods. Thus they require larger
amount of working capital during season.

4. TIME CONSUMED IN MANUFACTURE: The average time taken in the


process of manufacture is also an important factor in determining the amount of
working capital the longer the period of manufacture, the larger the inventory
required. Capital goods industries managed to minimize their investment in
inventories or working capital by asking advances from the customers as work
proceeds in their orders.

5. TURNOVER OF CIRCULATING CAPITAL: Turnover means the ratio of


annual gross sales to average working assets. It means the speed with circulating
capital completes its rounds or the number of times the amount invested in
working assets has been converted into cash by sale of the finished goods and
reinvested in working assets during a year. The faster the sales, the larger the
turnover. Conversely, the greater the turnover, the larger the volume of business
to be done with given working capital. It will require lesser amount of working
capital inspite of larger sales because of greater turnover.

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6. LABOUR-INTENSIVE VERSUS CAPITAL INTENSIVE INDUSTRIES: In
labour intensive industries, larger working capital is required because of regular
payment of heavy wage bills and more time taken in completing the
manufacturing process. Conversely the capital intensive industries require lesser
amount of working capital due to the heavy investment in fixed assets and shorter
period in many acquiring processes.

7. NEED TO STOCKPILE RAW MATERIAL AND FINISHED GOODS: The


industries, where it is necessary to stockpile the raw materials and finished goods
increased amount of working capital is tied up in stocks and stores. In some lines
of business where the materials are bulky and best purchased in large quantities
such as cements, stockpiling of raw material is very usual and used. In companies
where, labour strike is frequent such as public utilities concerns, stockpiling of
raw material is advisable. In certain industries such as seasonal industries or retail
stores finished goods stock have to be large in quantities which requires larger
working capital.

8. TERMS OF PURCHASE AND SALES: Cash or credit terms of purchase and


sales also affect the amount of working capital. If a company purchases all goods
in cash and sells its finished products on credit, it will require large amount of
working capital. On the contrary, a concern having credit facilities and allowing
no credit to its customers will require less amount of working capital. Terms and
conditions of purchase and sales are generally governed by prevailing trade
practices and by changing economic conditions.

9. CONVERSION OF CURRENT ASSETS INTO CASH: The need of having


cash in hand to meet the day-to-day requirements e.g. Payment of wages and
salaries, rents rate etc, has an important bearing in deciding the adequate amount
of working capital. The greater the cash requirements, the higher will be the need
of working capital. A company has ample stock of liquid current assets will

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require lesser amount of working capital because it can encash its assets
immediately in the open market.

10. GROWTH AND EXTENSION OF BUSINESS: Growing concerns require


more working capital then those that are static. It is logical to expect larger
amount of working capital in a going concern to meet its growing needs of funds
for its expansion programs though it varies with economic conditions and
corporate practices.
11. BUSINESS CYCLE FLUCTUATIONS: Business cycle affects the requirement
of working capital. At times, when the prices are going up and boom conditions
prevail, the management seeks to pile up a big stock of raw materials to have an
advantage of lower prices and to maintain a big stock of finished goods with an
expectation to earn more profits by selling it at higher price in future. The
expansion of business units caused by the inflationary conditions creates demand
for more and more working capital.
Depression involves the locking up of a big amount in the working capital
as the inventories remain unsolved and the book debts uncollected. The
contraction in the volume of business may result in increasing the cash position
because of reduction in inventories and receivables that usually accompanies
decline in sales and curtailment in capital expenditures. In such cases, shortage of
working capital develops.

12. PROFIT MARGIN AND PROFIT APPROPRIATION: Some firms enjoy a


dominant position in the market due to quality product or good marketing
management, or monopoly power in the market and therefore earn a high profit. It
contributes towards working capital provided it is earned in cash. Cash profit can
be found by adjusting non-cash item such as depreciation, outstanding expenses,
accumulated loss and expenses written off etc, in the net profit. But in practice,
the whole cash inflows are not considered as cash available for use as cash is used
up to augment the other assets such as stock, book debts and fixed assets. In a

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growing concern, the working capital requirement will be estimated on how the
cash available is used rightfully.
Even if the net profit is earned in cash, whole of it is not available for
working capital purpose. The contribution towards working capital is effected by
the way in which profits are appropriated and affected by taxation, dividend,
deprecation and reserve policy.

13. CLOSE COORDINATION BETWEEN PRODUCTION AND


DISTRIBUTION POLICY: This will reduce the demand of working capital.

14. PRICE LEVEL CHANGES: The financial manager should anticipate the effect
of price level changes on working capital requirements of the firm. Rising price
levels will require a higher amount of working capital to maintain the same levels
of current assets as it will require higher investments. However if companies
revise their product prices, they will not face a severe working capital problem.
Thus the effects of rising price levels will be different for different firms
depending upon their price policies, nature of the product etc.

15. DIVIDEND POLICIES: There is a well-established relationship between


dividend and working capital in companies where conservative dividend policy is
followed. The changes in working capital position bring about an adjustment in
dividend policy. In order to maintain an established dividend policy, the
management gives due consideration to its effect on cash requirements. Storage of
cash may induce the management to reduce cash dividend. Strong cash position
may justify the cash dividend, even if earnings are not sufficient to cover the
payment. Storage of cash is one of the reasons for the issue of stock dividends. On
the other hand, if the management follow the policy of retention of profits in the
business, the working capital position will be quite adequate, alternatively, if the
whole of the profits are distributed among the shareholders, companies’ working
capital position would suffer.

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16. AN ABSENCE OF SPECIALIZATION IN THE DISTRIBUTION OF
PRODUCTS: This will require more working capital as such concern will have
to maintain its own marketing organization.

17. IF THE MEANS OF TRANSPORTING AND COMMUNICATIONS ARE


LESS DEVELOPED: More working capital required in such areas to store the
materials and finished goods.

18. THE HAZARDS AND CONTINGENCIES INHERENT IN A


PARTICULAR TYPE OF BUSINESS: These also decide the magnitude of
working capital.

METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS

1. Operating cycle method: Operating cycle is the period that a business enterprise
takes in converting cash back into cash. It has the following four stages:
(i) The raw material and stores inventory stage
(ii) The semi finished goods or work in progress stage;
(iii) The finished goods inventory stage; and
(iv) The accounts receivable and book debt stage.
Each of the above stage is expressed in terms of number of days of relevant
activity. Each requires a level of investment to support it. The sum of these stage wise
investments will be total amount of working capital of the firm.
The following formulae will be used to express the framework of the operating cycle:
T = (R * C) + W + F + B

Where
T = stands for the total period of operating cycle in number of days
R = the number of days of raw material and stores consumption
requirements held in raw materials and stores inventory
C = the number of days of purchases in trade creditors

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W = the number of days of cost of production held in work in progress
F = the number of days of cost of sales held in finished goods inventory and
B = the number of days of sales in book debt

The computation may be made as under


R = Average inventory of raw material and stores
Average per day of consumption of raw material and stores

C = Average trade creditors


Average credit purchases per day

W = Average work in progress


Average cost of production per day

F = Average inventory of finished goods


Average cost of sales per day

B = Average book debts


Average sales per day

The average inventory, trade creditors, work in progress, finished goods and book
debts can be computed by adding the opening and closing balances at the end of the year
in the respective accounts and dividing the concerned annual figures by 365 or the
number of days in the given period.
The operational cycle method of determining working capital requirements gives
only an average figure. In this method the fluctuations in the intervening period due to
seasonal or other factors and their impact on the working capital requirements cannot be
judged. Continuous short run detailed forecasting and budgeting exercises are necessary
to identify these impacts.

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A new concept that is gaining more and more importance in recent years is the
operating cycle concept of working capital. The operating cycle refers to the average time
elapsed between the acquisition of raw materials and the final cash realization.
Cash is used to buy the raw materials and other stores, so cash is converted into
raw materials and stores inventories. Then the raw materials and stores are issued to the
production department. Wages are paid and other expenses are incurred in the process
and work in process comes into existence. Work in process becomes finished goods.
Finished goods are sold to customers on credit. In the course of time, these customers pay
cash for the goods purchased by them. Cash is retrieved and the cycle is completed.

Thus operating cycle consists of four stages:


(i) The raw material and stores inventory stage
(ii) The work in process stage
(iii) The finished goods inventory stage
(iv) The receivable stage

The operating cycle of working capital is shown below


CASH

ACCOUNTS PURCHASE OF
RECEIVABLE RAW MATERIAL
INVENTORY

FINISHED WORK IN
GOODS PROCESS

2. Percentage of sales method: It assumes that certain balance sheet items vary
directly with sales. Thus the ratio of the given balance sheet item to sales remains

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constant. The firms need in terms of percentage of annual sales envisaged in each
individual balance sheet items are expressed in the following three ways:
(i) As number of days of sales
(ii) As turnover; and
(iii) As percentage of sales

3. Regression analysis method: This is very useful statistical technique of working


capital forecasting which helps in making projection after establishing the average
relationship in the past years between sales and working capital (current assets)
and its various components. This analysis may be carried out through the graphic
portrayals (scattered diagrams) or through mathematical formula. The relationship
between the sales and the working capital of various components may be simple
and direct indicating linearly between the two. It may be complex involving
simpler linear regressions or simple curvilinear regression and multiple regression
situations. This method is particularly suitable for long term forecasting.

ASSESSMENT OF WORKING CAPITAL REQUIREMENT IN SEASONAL


INDUSTRY

In the seasonal industries the level of working capital requirement will not be
similar all the year. In times of off-season, the working capital requirement is low and
therefore, the level of investment in current assets and liabilities are very low. But, during
season, the firm requirement of working capital is at peak level. Let us look at the sugar
industry. The crushing season in the year will remain for 5 to 6 months time. During the
season the plant is expected to work at full capacity with triple shift working and the
requirement of stocks is very high and resultant increase in stock of sugar. The
requirement for payment of labour, expenses and maintenance is also higher. There will
not be immediate sales of sugar and finished stock inventory would be much higher.

After the completion of the crushing season, the plant will be closed and only
upkeep and maintenance of plant will be incurred and the level of current assets and

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current liabilities comes down and the working capital requirement would be very low.
For efficient management of working capital, the finance manager should be able to
properly estimate the season and off-season requirements of working capital. For this the
following precautions are taken:

1. Preparation of projected cash flow statement showing the cash flow for peak
season, normal season and off-season requirements.

2. Make proper arrangements with the banks and other sources of finance to meet
the short-term need of season.

3. Make proper arrangement for meeting the contingencies of higher-level


requirement than the projected levels of requirement.

4. Proper and careful assessment of working capital requirements for the season and
off-season requirement.

5. Care to be taken to reduce the level of investments in current assets after the
season is completed.

IMPACT OF INFLATION ON WORKING CAPITAL REQUIREMENT

When the inflation rate is high, it will have its direct impact on the requirement of
working capital as explained below.

• Inflation will cause to show the turnover figure at higher level even if there is no
increase in the quantity of sales. The higher the sale means the higher levels of
balances in receivables.

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• Inflation will result in increase of raw material prices and hike in payment for
expenses and as a result increase in balance s of trade creditors and creditors for
expenses.

• Increase in valuation of closing stocks result in showing higher profits but without
its realization into cash causing the firm to pay higher tax dividend and bonus.
This will lead the firm in serious problems of funds shortage and firm may enable
to meets its short term and long-term obligations.

• Increase in investments is current assets means the increase in requirements of


working capital without corresponding increase in sales or profitability of the
firm.

Keeping in view of the above, the finance manager should be very careful about
the impact of inflation in assessment of working capital requirements and its
management.

IMPACT OF DOUBLE SHIFT WORKING ON WORKING CAPITAL


REQUIREMENT

If the firm which is presently running in single shift plans to go for working in double
shift the following factors should be considered while assessing the working capital
requirements of the firm.

• Working in double shift means requirement of raw materials will be doubled and
other variable expenses will also increase drastically.

• With the increase in raw materials requirement and expenses, the raw material
inventory and work in

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• Progress will increase simultaneously the creditors for goods and creditors for
expenses balances will also increase.

• Increase in production to meet the increased demand which ill also increase the
stock of finished goods. The increase in sales means increase in debtor’s balances.

• Increase in production will result in increased requirement of working capital.

• The fixed expenses will increase with the working on double shift bases.

The finance manager should reassess the working capital requirements if the
change is contemplated from single shift operation to double shift.

WORKING CAPITAL FINANCING

The main source of working capital financing is namely, trade credit, bank credit,
RBI framework or regulation of bank credit/finance/advances, factoring and commercial
papers.

1. TRADE CREDIT

• FEATURES
Trade credit refers to the credit extended by the supplier of goods and services in
the normal course of transaction/business/sale of the firm. According to trade practices,
cash is not paid immediately for purchase but after an agreed period of time. There is
however, no formal/ specific negotiation for trade credit. It is an informal arrangement
between the buyer and the seller. There is no legal instrument of acknowledgment of
debt, which is granted on an open account basis.

• ADVANTAGES

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Trade credit, as a source of short term as working capital finance has certain
advantages. It is easily, almost automatically available. Moreover it is flexible and
spontaneous source of finance. The availability and magnitude of trade credits related to
the size of operations of the firm in terms of sales/purchases. If the credit purchases of
goods decline, the availability of trade credit will correspondingly decline. Trade credit is
also and informal, spontaneous source of finance. Not requiring negotiation and formal
agreement, trade credit is free from the restriction associated with formal/negotiated
source of finance/credit.

• COST
Trade credit does not involve any explicit interest charged. However there is an
implicit cost of trade credit. It depends on credit terms offered by the supplier of goods.
The small the difference between the payment day and the end of the discount period, the
larger is the annual interest/cost of trade credit. If the supplier offers discount for prompt
payment, there is a cost associated with trade credit availed beyond the discount period. If
the terms of payment are saying, 2/10, net 30, then the cost of credit during the discount
period is nil, whereas the cost during non-discount period is:

Discount % * 360
1- Discount % Credit period- Discount period

In our case it would be:

0.02*360 = 36.7%
(1-0.02)(30-10)

Cost of trade credit for various credit terms is shown here

CREDIT TERMS COST OF TRADE CREDIT


1/10,net 20 36.4 %
2/10,net 45 21.0%
3/10,net 60 22.3%
2/15,net 45 24.5%

24
2. BANK CREDIT
Bank credit is the primary institutional source of working capital finance
in India; in fact, it represents the most important source of financing of current assets.

• FORMS OF CREDIT

a) Cash credit or overdrafts: Under cash credits, the bank specifies a


predetermined borrowing or credit limit. The borrower can draw/borrow up to the
stipulated credit/overdraft limit. Similarly repayments can be made whenever
desired during the period. The interest is determined on the basis of the running
balance/amount actually utilized by the borrower and not on the sanctioned limit.

b) Loans: Under this arrangement the entire amount of borrowing is credited to the
current account of the borrower or the released in cash. The borrower has to pay
interest on the total amount.

c) Bills purchased/discounted: The amount made available under this arrangement


is covered by the cash credit and overdraft limit. Before discounting the bill, the
bank satisfied itself about the credit-worthiness of the drawer and the genuineness
of the bill. To popularize the scheme, the discounting banker asks the drawer of
the bill (i.e. seller of goods) to have his bill accepted by the drawee (buyers) bank
before discounting. If latter grants acceptance against the cash credit limit, earlier
fixed by it on the basis of the borrowing value of stocks therefore, the buyer who
buys goods on credit cannot use the same goods as source of obtaining additional
bank credit.

d) Term loans for working capital: Under this arrangement, banks advance loans
for 3-7 years repayable in yearly or half yearly installments.

25
e) Letter of credit: While the other forms of bank credit are direct forms of
financing in which banks provide funds as well as bear risk, letter of credit is an
indirect form of working capital financing and banks assume only the risk, the
credit being provided by the supplier himself.

• MODE OF SECURITY
Banks provide credit on the basis of the following modes of security:

a) Hypothecation: Under this mode of security, the banks provide credit to


borrowers against the security of movable property, usually inventory of goods.

b) Pledge: Pledge, as mode of security is different from hypothecation i.e. unlike in


the latter, in the former the goods which are offered as security are transferred to
the physical possession of the lender.

c) Lien: The term ‘lien’ refers to the right of the party to retain goods belonging to
another party until a debt due to him is paid.

d) Mortgage: It is the transfer of the legal stock equitable interest in specific


immovable property for securing the payment of debts.

e) Charge: Where immovable property of one person is, by the act of parties or by
the operation of law, made security for the payment of money to another and the
transaction does not amount to mortgage, the latter person is paid to have a charge
on the property and all the provisions of simple mortgage will apply to such a
charge.

• RESERVE BANK OF INDIA FRAMEWORK FOR REGULATION OF


BANK CREDIT

26
Till the mid sixties, the notable features of bank financing of working capital of
corporate industrial borrowers were (i) easy access/over-reliance, i.e. in excess of
legitimate requirements and (ii) preponderance of cash credit arrangement/device through
which this finance was provided. In order to secure alignment of bank credit with
planning priorities and ensures equitable distribution to various sectors of the Indian
economy, the RBI initiated several policy measures to direct bank credit to priority
sectors and enforce a measures of financial discipline among industrial borrowers.
However the basic characters of bank financing of industry namely, over borrowing ad
domination of cash credit system did not materially alter.
To reorient bank lending to industry to the two emerging realities of the Indian
economy in terms of the imperatives of regulating /controlling it, the RBI constitutes
from time to time a number of expert groups to examine the various aspects of banking
policy relating to industrial financing, the notable being Dehejia Committee (1969),
Tandon Committee (1974), chor committee (1980) and marathe committee (1984). The
recommendations of these groups shaped the framework/regulation of industrial
financing by banks after the mid seventies. After the mid nineties the framework has been
relaxed permitting banks greater flexibility in tune with the emergence of new banking in
the country, focusing on viabilities and profitability in contrast with the earlier trust on
social/ development banking. The main elements of the framework and the subsequent
relaxations are discussed.

FIXATION OF NORMS
A notable feature of the framework/regulation to the fixation of norms for
bank lending to industry is explained below. The norms fell into two categories:

(i) Inventory and receivables norms The ‘norms’ refer to the maximum level for
holding inventories and receivables in each industry. Initially the inventory and
receivables norms were applied in respect of 15 major industries accounting for
about one-half of the industrial advances of the banks.

27
The norms pertained to (i) raw materials including stores and other items
used in the process of manufacture; (ii) stock in process; (iii) finished goods; (iv)
receivables and bills purchased and discounted. The norms were based on ‘time element’.

(ii) Lending norms/approach to lending/maximum permissible bank finance


(MPBF) the second categories of norms relate to lending. The ‘lending norms’ is
basic element of the framework of bank lending which has far reaching
implications.

According to the lending norms a part of the current assets should be


financed by trade credit and other current liabilities. The remaining part of the current
assets, termed, as ‘working capital gap’ should be partly financed by owner’s funds and
long-term borrowings and partly by short-term credit. There are three alternative methods
for working out the maximum permissible level of bank borrowing/finance (MPBF), each
successive method reducing the involvement of short-term bank credit to support current
assets.

1. In the first method the borrower will contribute 25 % of the working capital gap;
the remaining 75 % can be financed from bank borrowings. This method will give
a minimum current ratio of 1:1.

2. In the second method the borrower will constitute 75 % of the total current assets.
The remaining will be financed by the bank. MPBF = 0.75(CA) – CL. This
method will give a current ratio of 1.3:1. In this case current liability including
MPBF will be 30+45 =75.Therefore the current ratio will be 100/75 = 1.3.

3. In the third method the borrower will finance 100 percent of core assets
(permanent component of the WC), as defined and 25 % of the balance of the
current assets. The remaining can be met from the bank borrowing 0.75 (CA –
CCA) – CL = 0.75(100-20) – 30 = 30 (assuming that CCA is 20)
a. CA = current assets

28
b. CL = non bank current liabilities
c. CCA = core current assets.

First method Second method


(a) Current assets Rs. 100 Rs. 100
(b)Current liabilities, excluding bank 30 30
borrowings.
(c) Working capital gap (a-b) 70 70
(d) Borrower’s contribution 17.5 (25 % of c) 25 (25 % of a)
(e) Permissible bank finance 52.5 45

3. FACTORING

Factoring provides resources to finance receivables as well as facilitates the


collection of receivables. Although such services constitute a critical segment of the
financial services scenario in the developed countries, they appeared in the Indian
financial scene only in early nineties as a result of RBI initiatives. There are two bank
sponsored organizations which provide such services: (i) SBI factors and commercial
services ltd., and (ii) Canbank factors. The first private sector factoring company,
foremost factors ltd. Started operations since the beginning of 1997.

• DEFINITION
Factoring can broadly be defined as an agreement in which receivables arising out
of sale of goods/services are sold by a firm (client) to the ‘factors’ (a financial
intermediary) as a result of which the title of the goods/services represented by the
said receivables passes on the factor. Hence forth, the factor becomes responsible for
all credit control, sales accounting and debt collection from the buyers.

• MECHANISM

29
Credit sales generate the factoring business in the ordinary course of business
dealing. Realization of credit sales is the main function of factoring services. Once the
sales transaction is completed, the factors step in to realize the sales. Thus the factor
works between the seller and the buyer and sometimes with the seller’s banks together.

• FUNCTION OF A FACTOR
Depending on the type/form of factoring, the main functions of a factor, in
general terms can be classified into 5 categories
a) Financing facility/trade debts,
b) Maintenance/administration of sales ledger,
c) Collection facility of accounts receivables,
d) Assumptions of credit risk/credit control and credit restriction;
e) Provision of advisory services
• COST OF SERVICES
The factors provide various services at a charge. The charge for collection and
sales ledger administration is in the form of a commission expressed as value of debt
purchase. It is collected up-front/in advance. The commission for short term financing as
advance part-payment is in the form of interest charged for the period between the date of
advance payment and the date of collection guaranteed payment date. It is also known as
discount charge.

4. COMMERCIAL PAPERS

• FEATURES
A commercial paper has several advantages for both the issuer and investors. It is
a simple instrument and hardly involves any documentation. It is additionally flexible in
terms of maturities which can be tailored to march the cash flow of the issuer. Companies
which are able to raise funds through commercial papers have better financial standing.
The commercial papers are unsecured and there are no limitations on the end use of funds
raised to them.

30
OPERATING CYCLE AND CASH CYCLE

The duration of time required to complete the following sequences of events in


case of a manufacturing firm is called the operating cycle.
(i) Conversion of cash into raw material
(ii) Conversion of raw material into WIP
(iii) Conversion of WIP into FG
(iv) Conversion of FG into debtors and bills receivable through sales
(v) Conversion of debtors and bills receivable into cash

If you....... Then......
Collect receivables (debtors) faster You release cash from
the cycle
Collect receivables (debtors) slower Your receivables soak
up cash
Get better credit (in terms of duration or You increase your cash
amount) from suppliers resources
Shift inventory (stocks) faster You free up cash
Move inventory (stocks) slower You consume more

31
cash

Operating Cycle of Non Manufacturing Firms / Operating Cycle of Service and


Financial Firms

DEBTORS

CASH CASH DEBTORS

STOCK OF
FINISHED
GOODS

Operating cycle of non-manufacturing firm includes conversion of cash into stock


of finished goods, stock of finished goods into debtors and debtors into cash. Also the
operating cycle of financial and service firms involves conversion of cash into debtors
and debtors into cash.

Thus we can say that the time that elapses between the purchase of raw
material and collection of cash for sales is called operating cycle whereas time length
between the payment for raw material purchases and the collection of cash for sales is
referred to as cash cycle. The operating cycle is the sum of the inventory period and the
accounts receivables period, whereas the cash cycle is equal to the operating cycle less
the accounts payable period.

STOCK ARRIVES
CASH RECD.

ORDER PLACED INV. PERIOD A/C’S REC. PERIOD

A/C’s PAY
PERIOD

32
CASH PAID FOR MATERIALS
FIRM REC. INVOICE

OPERATING CYCLE

CASH CYCLE

WORKING CAPITAL IS A MEANS AND NOT END

As a matter of policy, a company does not want to employ large funds in working
capital so long as undue solvency risks are not imposed on it. Although no quantitative
limit of working capital may be set for an individual firm yet adequate amount of
working capital must be available to meet the needs of the company. It is a logical
approach indicating that working capital is a means to an end and not an end in itself. The
purpose (end) of every business is to run to operations smoothly so that the corporate
objectives may be achieved. This requires adequate working capital. The corporate
management has to consider the various factors in making decision regarding the
qualitative amount of working capital.

 WORKING CAPITAL RATIOS

Working capital ratios indicate the ability of business concern in meeting its
current obligations as well its efficiency in managing its current assets in generation of
sales. These ratios are applied to evaluate efficiency with the firm manages and utilizes
its current assets.
The following three categories of ratios are used for efficient management of
working capital:
1. Efficiency ratios
2. Liquidity ratios

33
3. Structural health ratios

1. EFFICIENCY RATIOS

• INVENTORY TURNOVER RATIOS


This ratio indicates the effectiveness and efficiency of the inventory management.
The ratio shows how speedily the inventory is turned into accounts receivables through
sales. The lower the inventory of sales ratio, the more efficiently the inventory is said to
be managed visa versa.

INVENTORY TURNOVER RATIO = SALES


INVENTORY

• CURRENT ASSET TURNOVER RATIOS


This ratio indicated the efficiency with which current assets turn into sales. The
lower current assets to sales ratio implies by enlarge a more efficient use of funds. Thus,
a high turnover rate indicates reduced lock up of funds in current assets. An analysis of
this ratio over a period of time reflects working capital management of a firm.

CURRENT ASSET TURNOVER RATIO = SALES


CURRENT ASSETS

2. LIQUIDITY RATIOS

• CURRENT RATIOS
This ratio indicates the extent of the soundness of the current financial position of
an undertaking and the degree of safety provided to the creditors. The higher the current
ratio more is the firm’s ability to meet current obligations and the greater is the safety of
funds of short term creditors. Current assets are those assets which can be converted into
cash within a year. Current liabilities and provisions are those liabilities that are payable
within a year. A current ratio of 2:1 indicates a highly solvent position. Banks consider a

34
current ratio of 1.3:1 as minimum acceptable level for proving working capital finance.
The constituents of the current assets are as important as the current assets themselves for
evaluation of company’s solvency position.

CURRENT RATIOS = CURRENT ASSETS, LOANS, ADVANCES


CURRENT LIABILITES AND PROVISIONS

• QUICK RATIOS
Quick ratio is a more refined tool to measure the liquidity of an organization. It is
better taste of financial strength then the current ratio, because it excludes very slow
moving inventories and the items of current assets which cannot be converted into cash
easily. This ratio shows the extent of cushion of protection provided from the quick assets
to the current creditors. A quick ratio of 1:1 is usually considered satisfactory though it is
again a rule of thumb only.

QUICK RATIO = CA, LOANS AND ADVANCES – INVENTORIES


CL AND PROVISIONS – BANK OVERDRAFT
Where,
CA= CURRENT ASSETS
CL= CURRENT LIABILITIES

3. STRUCTURAL HEALTH RATIOS

• CURRENT ASSETS TO TOTAL NET ASSETS RATIOS


This ratio explains the relationship between current assets and total investment in
current assets. A business enterprise should use its current assets effectively and
economically because it is out of the management of these assets that profits accrue. A
business will end up in losses if there is any lacuna in managing assets to the advantage

35
of business. Investment in fixed assets being inelastic in nature, there is no elbowroom to
make an amends in this sphere and its impact on profitability remains minimal.

CURRENT ASSET TO TOTAL NET ASSETS RATIO= CURRENT ASSETS


NET ASSETS

COMPOSITION OF CURRENT ASSETS


An analysis of current assets component enables one to examine in which
component the working capital funds are locked up. Large tie up of funds in inventories
effects profitability of the business adversely owing to carry over costs. In addition losses
are likely to occur by way of depreciation, decay, obsolescence, evaporation and so on.
Receivables constitute another component of current assets. If the major portion of
current assets is made up of cash alone, the profitability will be decreased because cash is
a non-earning asset. If the portion of cash balance is excessive, then it can be said that
management is not efficient to employee the surplus cash.

• DEBTOR TURNOVER RATIOS


This ratio shows the extent of trade credit granted and the efficiency in the
collection of debts thus; it is an indicative of efficiency of trade credit management. The
lower the debtors to sales ratio, the better the trade credit management and better the
quality (liquidity) of debtors. The lower debtors mean prompt payment by customers. An
excessively long collection period, on the other hand, indicates a very liberal, ineffective
and inefficient credit and collection policy.

DEBTORS TURNOVER RATIO = SALES


DEBTORS

AVERAGE COLLECTION PERIOD


Average collection period, which measures how long it takes to collect amounts
from debtors. The actual collection period can be compared with the stated credit terms

36
of the company. If it is longer than those terms, then this indicates some insufficiency in
the procedures for collecting debts.
AVERAGE COLLECTION PERIOD (in days) = DEBTORS * 365
SALES

BAD DEBTS TO SALES RATIOS


This ratio indicates efficiency of the control procedures of the company. The
actual ratio is compared with the target or norm to decide whether or not it is acceptable.

BAD DEBTS TO SALES = BAD DEBTS


SALES
• CREDITORS TURNOVER PERIOD
The measurement of the creditor turnover period shows the average time taken to
pay for goods and services by the company. In general the longer the credit period
achieved the better, because delays in payment mean that the operation of the company
are being financed interest free by suppliers funds. But there will be a point beyond
which if they are operating in a seller’s market, may harm the company. If too long a
period is taken to pay creditors, the credit rating of the company may suffer, thereby
making it more difficult to obtain supplier in the future.
CREDITORS TURNOVER PERIOD (in days) = CREDITORS *365
PURCHASES

 WORKING CAPITAL LEVERAGE


One of the important objectives of working capital management is maintaining
the optimum levels of investments in current assets and reducing the levels of current
liabilities. By doing this the company can minimize the investment in working capital
thereby improvement in return on capital employed is achieved. The term working capital
leverage refers to the impact of level of working capital on company’s profitability. The
working capital management should improve the productivity of investments in current
assets and ultimately it will increase the return on capital employed. Higher levels of
investments in current assets than is actually required mean increase in the cost of interest

37
charges on the short-term loans and working capital finance raised from banks etc. and
will result in lower return on capital employed and vise versa. Working capital leverage
measures the responsiveness of ROCE for changes in current assets. It is measured by
applying the following formula.

WORKING CAPITAL LEVERAGE = CA


TA - ∇ CA
Where,
CA = CURRENT ASSETS
TA = TOTAL ASSETS (NET FIXED ASSETS + CURRENT ASSETS)
∇ CA= CHANGE IN CURRENT ASSETS
WORKING CAPITAL MANAGEMENT

Working Capital is the money used to make goods and attract sales. The less
Working Capital used to attract sales, the higher is likely to be the return on investment.
Working Capital management is about the commercial and financial aspects of Inventory,
credit, purchasing, marketing, and royalty and investment policy. The higher the profit
margin, the lower is likely to be the level of Working Capital tied up in creating and
selling titles. The faster that we create and sell the books the higher is likely to be the
return on investment.

DEFINITIONS

1. Prof. K. V. Smith. “Working capital management is concerned with problems


that arise in attempting to manage the current assets, the current liabilities and the
interrelationship that exist between them.”

2. Weston and Brigham. “Working capital management refers to all aspects of the
administration of both current assets and current liabilities.”

38
3. James C. van Horne. “Current assets, by definition, are assets normally
converted into cash within one year. Working capital management is concerned
with the administration of these assets- namely cash and marketable securities,
receivables and inventories.”

OBJECTIVES

1. To decide upon the optimum level of investment in various current assets i.e.
determining the size of working capital.

2. By optimizing the investment in current assets and by reducing the level of


current liabilities, the company can reduce the locking up of funds in working
capital thereby; it can improve the return on capital employed in the business.

3. To decide upon the optimum mix of short-term funds in relation to long-term


capital.

4. The company should always be in a position to meet its current obligations which
should properly be supported by the current assets available with the firm. By
maintaining excess funds in working capital means locking of funds without
return.

5. To locate appropriate sources of short term financing.

6. Maintaining working capital at appropriate level.

7. The firm should manage its current assets in such a way that marginal return on
investment in current assets is not less than the cost of capital employed to finance
the current assets.

8. Availability of sufficient funds at the times of need.

39
IMPORTANCE OF WORKING CAPITAL

According to Husband and Dockery, “the prime object of management is to make


a profit, whether or not this is accomplished, as most business depends largely on the
manner in which the working capital is administered.” The primary objective of working
capital management is to manage the firm’s current assets and current liabilities in such a
way that a satisfactorily level of working capital is maintained. The firm may become
insolvent if it cannot maintain a satisfactory level of working capital. Working capital
assists in increasing the profitability of the concern. The working capital position decides
the various policies in the business with receipt to general operations viz., importance of
management of working capital.

1. Positive correlation between sale and current assets. There is a positive


correlation between the sale of the product of the firm and its current assets.
Increase in the sale of the product requires a corresponding increase in current
assets. Therefore, the current assets must be managed properly.

2. Investment in current assets. Generally more than half of the total capital of the
firm is invested in current assets. Thus less than half of the capital is blocked in
fixed assets. Therefore management of working capital attracts the attention of the
management.

3. No alternative for current assets. While fixed capital can be acquired on lease in
emergency there is no alternative for current assets. Investment in current assets
cannot be avoided without substantial loss.

4. Financed through outside sources. Working capital needs are often financed
through outside sources. Hence, it is necessary to utilize them in the best possible
way.

40
5. Important for small units. The management of working capital is more
important for small units because they do not rely on the long term capital market
as they have easy access to short term financial sources such as trade credit, short
term bank loan etc.

SYMPTOMS OF POOR WORKING CAPITAL MANAGEMENT

In general, the following causes are seen due to inefficient management of


working capital:

1. Excessive carriage of inventory over the normal levels required for the business
will result in more balance in trade creditors’ accounts. More creditors’ balances
will cause strain on the management in management of cash.

2. Working capital problems will arise when there is a show down in collection of
debtors.

3. Sometimes capital goods will be purchased from the funds available for working
capital. This will result in storage of working capital and its impact is on
operations of the company.

4. Unplanned production schedules will cause excessive stocks of finished goods or


failure in meeting dispatch schedules. More funds kept in the form of cash will
not generate any profit for the business.

41
5. In efficiency in using potential trade credit require more funds for financing
working capital.

6. Overtrading will cause shortage of working capital and its ultimate effect is on the
operations of the company.

7. Dependence in short term sources of finance for financing permanent working


capital causes lesser profitability and will increase strain on the management in
managing working capital.

8. Inefficiency in cash management causes embezzlement of cash.


TRENDS IN WORKING CAPITAL MANAGEMENT

1. ZERO WORKING CAPITAL

This is one of the latest trends in working capital management. The idea is to have
zero working capital. For e.g. at all times the current assets shall equal the current
liabilities. Excess investment in current assets is avoided and firm meets its current
liabilities out of the matching current assets.

As current ratio is 1 and the quick ratio below 1, there may be apprehensions
about the liquidity, but if all current assets are performing and are accounted at their
realizable values, these fears are misplaced. The firm saves opportunity cost on excess
investments in current assets and as bank cash credit limits are linked to the inventory
levels, interest cost is also sold. There would be a self imposed financial discipline on the
firm to manage their activities within their current liabilities and current assets and there
may not be a tendency to over borrow or divert funds.

Zero working capital also ensures a smooth and uninterrupted working capital
cycle, and it would pressure the finance manager to improve the quality of current assets
at all times, to keep them 100 % realizable. There would also be constant displacements

42
in the current liabilities and the possibility of having overdue may diminish. The
tendency to postpone current liability payments has to be curbed and working capital
always maintained at zero. Zero working capital would call for a fine balancing act in
financial management, and the success in this endeavor would get reflected in healthier
bottom lines.

2. OVERTRADING

Overtrading arises when a business expands beyond the level of funds available
overtrade means and attempt to finance a certain volume of production and sales with
inadequate working capital. If the company does not have enough funds of its own to
finance stock and debtors, and it wishes to expand, it is forced to borrow from creditors
and from the bank on overdraft sooner or later such expansion, financed completely by
the funds of others, will lead to a chronic imbalance in the working capital ratio.

Expansion is advantageous so long as the business has the funds available to


finance the stocks and debtors involved. Overtrading begins at the point where the
business relies on extra trade credit and increased turnover are financed by taking longer
periods of credit from suppliers and/or negotiating an extension of overdraft limits wit the
bank.

Over dependence on outside finance is a sign of weakness, unless the expansion is


curtailed, suppliers may refuse credit beyond certain limits, and the bank may call for a
reduction of the overdraft. If this happens, the business may be insolvent and it does not
have sufficient liquid resources (cash) to pay for current operations or to repay current
liabilities until customers pay for sales made on credit terms, or unless stock is sold at a
loss for immediate cash payment.

The following ratios will analysis the situation properly and help to detect a
deterioration of liquidity position of business.
Working capital = current assets: current liabilities

43
Acid test = quick assets: quick liabilities
Stock turnover = stock: cost of sales
Debtor’s turnover = debtors: credit sales

3. OVERCAPITALISATION OF WORKING CAPITAL

If there are excessive stocks, debtors and cash and very few creditors, there will
be an over investment in current assets. The inefficiency in managing working capital
will cause this excessive working capital resulting in lower return on capital employed
and long term funds will be unnecessarily tied up when they could be invested as well to
earn profit.
4. UNDER CAPITALIZATION OF WORKING CAPITAL

Undercapitalization is a situation where a company does not have funds sufficient


to run its normal operations smoothly. This may happen due to insufficient working
capital or diversion of working capital funds to finance capital items. If the company
faces the situation of undercapitalization, it will face difficulties in current obligations,
procurement of raw material in stores items; meeting day-to-day running expenses etc. its
impact will ultimately be the reduced turnover and reduced profitability. The finance
manager should take immediate and proper steps to overcome the situation of unde15r
capitalization by making arrangement for the sufficient working capital. For this purpose
he should prepare the realistic cash flow and funds flow statement of the company.

STRATEGIES IN WORKING CAPITAL MANAGEMENT

At present more finance options are available to finance manager to see the
operations of his firm go smoothly. Depending on the risk exposure of business, to
strategies are evolved to manage the working capital.

1. Conservative working capital strategy a conservative strategy suggests carrying


high levels of current assets in relation to sales. Surplus current assets unable the

44
firm to absorb sudden variations in sales, production plans, and procurement time
without destructing production plans. Additionally, the higher liquidity levels
reduce the risk of insolvency. But lower risk translates into lower return. Large
investments in current assets lead to higher interest and carrying cost and
encouragement for efficient. But conservative policy will unable the firm to
absorb day-to-day business risk. It assures continuous flow of operations and
illuminates worry about recurring obligations. Under this strategy, long term
financing covers more then the total requirement for capital. The excess cash is
invested in short-term marketable securities and in need; these securities are sold
off in the market to meet the urgent requirements of working capital.

Rs

SECULAR GROWTH

LONG TERM
FINANCING

SEASONAL INVESTMENT IN
VARIATION MARKETABLE SECURITIES

Time
CONSERVATION OF WORKING CAPITAL STRATEGY

2. Aggressive working capital strategy under this approach current assets are
maintained just to meet the current liabilities without keeping and cushion for the

45
variations in working capital needs. The core working capital is financed by long-
term sources of capital, and seasonal variations are met through short-term
borrowing. Adoption of this strategy will minimize the investment in net working
capital and ultimately it lowers the cost of financing working capital. The main
drawback of this strategy is that it necessitates frequent financing and also
increases as the firm is vulnerable to sudden shocks. A conservative current asset
financing strategy would go for more long-term finance which reduces the risk of
uncertainty associated with frequent re financing. The price of this strategy is
higher financing cost since long-term rates will normally exceeds short-term rates.
But when aggressive strategy is adopted, some time the firm runs into mismatches
and defaults. It is a cardinal principal of corporate finance that long-term sources
and short-term assets should finance long terms asset by a mix of long and short-
term sources.

SEASONAL VARIATION
Rs SHORT TERM
FINANCING

LONG TERM
FINANCING
SECULAR GROWTH

Time
AGGRESSIVE WORKING CAPITAL STRATEGY

A conservative current asset financing strategy would go for more long-term


finance which reduces the risk of uncertainty associated with frequent re financing. The
price of this strategy is higher financing cost since long-term rates will normally exceeds

46
short-term rates. But when aggressive strategy is adopted, some time the firm runs into
mismatches and defaults. It is a cardinal principal of corporate finance that long-term
sources and short-term assets should finance long terms asset by a mix of long and short-
term sources.

Efficient working capital management techniques are those that compressed


operating cycle. The length of the operating cycle is equal to the sum of the length of the
inventory period and the receivables period. Just in time inventory management
techniques reduce carrying cost by slashing the time that goods are parked and as
inventories. To shorten the receivables period without necessarily reducing the credit
period, corporate can offer trade discounts for prompt payment.
CASH MANAGEMENT

Cash is the money, which the firm can disburse immediately without any
restriction. Near- cash items like marketable securities or bank time deposits are also
included in cash.
Cash management is concerned with the managing of:
(i) Cash flows into and out of the firm
(ii) Cash flows within the firm and
(iii) Cash balances held by a firm at a point of time.

Importance of Cash management

• Cash is used for paying the firms obligation


• Cash is an unproductive asset, you need to invest it somewhere
• It is difficult to predict cash flows accurately as there can not be perfect
coincidence between the inflows and outflows of cash
• Though cash constitutes the smallest portion of total current assets, management’s
considerable time is devoted in managing it.

47
The obvious aim of the firm these days is to keep its cash balance minimum and
to invest the released cash funds in profitable opportunities.
In order to overcome the uncertainty about predictability of cash flow, the firms
should evolve strategies regarding the following four facets of cash management:
1. Cash planning: Cash surplus or deficit for each period should be planned; this
can be done by preparing the cash budget.
2. Managing the cash flows: The firm should try to accelerate the inflows of cash
flow while trying to minimize the outflows.
3. Optimum cash level: The cost of excess cash and the dangers of cash deficit
should be matched to determine the optimum level.
4. Investing idle cash: The firm should about the division of such cash balances
between bank deposits and marketable securities.
MOTIVES OF HOLDING CASH

1. Transaction motive
Firms need cash to meet their transaction needs. The collection of cash (from sale
of goods and services, sale of assets, and additional financing) is not perfectly
synchronized with the disbursement of cash (for purchase of goods and services,
acquisition, of capital assets, and meeting other obligations. Hence, some cash balance is
required as a buffer.

2. Precautionary motive
There may be some uncertainty about the magnitude and timing of cash inflow
from sale of goods and services, sale of assets, insurance of securities. Like wise, there
may be uncertainty about cash inflow on account of purchases and other obligations. To
protect itself against such uncertainties a firm may require some cash balance.

3. Speculative motive
Firms would like to tap profit making opportunities arising from fluctuations in
commodity prices, securing prices, & interest rates. Cash-rich firms is better prepared to
exploit such bargains may carry additional equity. However for most firms their reserve

48
borrowing capacity & marketable securities would suffice to meet their speculative
needs.

CASH PLANNING

Cash planning is a technique to plan for and control the use of cash. The forecast
may be based on the present operations or the anticipated future operations.
Normally large, professionally managed firms do it on a daily or weekly basis,
whereas, medium size firms do it on a monthly basis. Small firms normally do not do
formal cash planning, incase they do it; it is on a monthly basis.
As the firm grows and its operation becomes complex, cash planning becomes
inevitable for them.

• Cash Forecasting And Budgeting

A cash budget is a summary statement of the firms expected cash inflows and
outflows over a projected time period.
It helps the financial manager to determine the future cash needs, to arrange for it
and to maintain a control over the cash and liquidity of the firm. If the cash flows are
stable, budgets can be prepared monthly or quarterly, if they are unstable they can be
prepared daily or weekly.
Cash budgets are helpful in:
 Estimating cash requirements
 Planning short term financing
 Scheduling payments in connection with capital expenditure
 Planning purchases of materials
 Developing credit policies
 Checking the accuracy of long- term forecasts.

Short Term Forecasting Methods of cash budgeting


Two most commonly used methods of short- term forecasting are:

49
1. The receipt and payment method The receipt and payment method is used for
forecasting limited periods, like a week or a month. The cash flows can be
compared with budgeted income and expense items if the receipts and payment
approach is followed. It simply shows the timing and magnitude of expected cash
receipts and payments over the forecast receipts.
Its main advantages are:
 Provides a complete picture of expected cash flows
 Helps to keep a check over day-to-day transactions
Its main drawbacks are:
 Its reliability is impaired by delays in collection or sudden demand for large
payments and other similar factors
 It fails to provide a clear picture regarding the changes in the movement of
working capital, especially those related to the inventories and receivables.

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ITEMS BASIS OF ESTIMATION
Cash sales Estimated sales and its division between cash/credit sales

Collection of a/c’s Estimated sales, its division between cash and credit sales,
receivables and collection pattern
Interest and dividend Firms portfolio of securities and return expected from the
receipts portfolio
Increase in Financing plan
loans/deposits and issue
of securities
Sale of assets Proposed disposal of assets

Cash purchases Estimated purchases, its division between cash/credit


purchases, and terms of credit purchases.
Payment for purchases Estimated purchases and its division between cash/credit
purchases.
Wages and salaries Manpower employed and wages and salaries structure

Manufacturing expense Production plan

General, administration Administration and sales personnel and proposed sales


and selling expenses promotion and distribution expenditure.
Capital equipment Capital expenditure budget and payment pattern associated
purchases with capital equipment purchases
Repayment of loans and Financing plan
retirement of securities

2. Adjusted net income method: The adjusted net income method is used for
longer durations. The adjusted net income method is appropriate in showing the
company’s working capital and future financing needs. It is also called the
sources and use approach.
Its main advantages are:
 Helps to keep a control on working capital
 Helps anticipate financial requirements.

51
Its main disadvantages are:
 It fails to trace the flow of cash.
 Not useful in controlling day-to-day transaction

2004 2005 2006 2007


SOURCES
Net income after taxes
Non cash charges (depreciation,
amortization etc)
Increasing in borrowings
Sale of equity shares
Miscellaneous
USES
Capital expenditures
Increase in current assets
Repayment of borrowings
Dividend payment
Miscellaneous
SURPLUS/DEFICIT
Opening cash balance
Closing cash balance

Long-Term Cash Forecasting


They are generally prepared for a period of two to five years and hence provide a broad
picture of firms financing needs and availability of investible surplus in future .Its major
uses are:
(i) Indicate future financial needs
(ii) Helps evaluate proposed capital projects
(iii) Improve corporate planning

52
The adjusted net income method can be used here also. Long term forecasting not
only reflects more accurately the impact of any recent acquisitions but also foreshadows
financial problems these new additions may pose for the firm.
To enhance the efficiency of cash management, collection and payment must be
properly monitored. In this respect the following will be helpful:

 Prompt Billing: It ensures early remittances. Also the firm has high control in
this area and hence there is a sizeable opportunity to free up the cash. To tap this
opportunity the treasurer should work with the controller and others in:
 Accelerating invoice data
 Mailing bills promptly
 Identifying payment locations

 Expeditious Collection Of Cheques: Two important methods for expediting the


collection process are:

1. Concentration banking: The important features of concentration banking


are:
 A major bank account of the company is set up with a concentration bank,
generally situated at the same place where the company is headquartered.
 Customers are advised to mail their remittances to collection center closest
to them.
 Payments received in different collection centers are deposited in local
banks, which in turn transfer them to the concentration bank.
This thus helps saving mailing and processing time, reducing financial
requirements. This system leads to potential savings, which should be compared to the
cost of maintaining the system.

2. Lock box system: It functions as follows:


 A number of post boxes are rented by the company in different locations.

53
 Customers send their remittances to the lock box.
 Banks are instructed and authorized to pick up the cheques from the local
boxes and deposit them in the company’s account.

The main advantages of this system are, firstly, the bank handles the remittances
prior to deposit at a lower cost. Secondly the cheques are deposited immediately upon
receipt of remittances and their collection process starts sooner than if a firm would have
processed them for internal accounting purposes prior to their deposits.

 Control Of Payables: Payments arise due to trade credit, which is a source of


funds, and hence, the firm should try to slow them down as much as possible. By
proper control of payables a firm can conserve its cash resources. Following are
some of the ways of doing it:
 Payments should be made only as and when they fall due.
 Payments must be centralized. This helps in consolidating funds at the
head office, and investing surplus funds more effectively.
 Arrangements may be made with the suppliers to set due dates of their
bills to match the firm’s period of peak receipts, thus helping the firm to
get a better mileage.

 Playing The Float: The amount of cheques issued by the firm but not paid for by
the bank is referred to as payment float. At the same time the amount of cheques
deposited but not cleared is referred to as collection float.

The difference between the payment float and the collection float is referred to
as the net float. So if a firm enjoys a positive net float, it can still issue cheques, even
if it means overdrawn bank accounts in its books. This action is referred to as
‘playing of float’. Though risky the firm may choose to play it safely and get a higher
mileage from its cash resource.

OPTIMAL CASH BALANCE

54
Cash balance is maintained for transaction purposes and an additional amount
may be maintained as a buffer or safety stock. It involves a trade off between the costs
and the risk.
If a firm maintains a small cash
balance, it has to sell its marketable
securities and probably buy them later
more often, than if it holds a large cash
balance. More the number of
transactions more will be the trading
cost and vice-versa; also, lesser the
cash balance, more will be the number of transaction and vice-versa. However the
opportunity cost of maintaining the cash rises, as the cash balance increases.

INVESTMENT IN MARKETABLE SECURITIES


The excess amount of cash held by the firm to meet its variable cash requirements
and future contingencies should be temporarily invested in marketable securities for
earning returns. In choosing among the alternative securities the firm should examine
three basic features of security:
 Safety: The firm has to invest in a security, which has a low default risk.
However it should be noted that, higher the default risk, higher the return on
security and vice-versa.
 Maturity: Maturity refers to the time period over which interest and principle are
to be paid. The price of long-term securities fluctuates more widely with the
change in interest rates, then the price of short-term security. Over a period of
time interest rates have a tendency to change, and hence, long-term securities are
considered to be riskier, thus less preferred.
 Marketability: If the security can be sold quickly and at a high price it is
considered to be a highly liquid or marketable. Since the firm would need the
invested money in near future for meting its WC requirements, it would invest in
security, which is readily marketable. Normally securities with low marketability
have high yields and vice-versa.

55
Type Of Marketable Securities: The choice in this case is restricted to the govt.
treasury bills and commercial bank deposits.

1. Treasury bills: It represents short-term obligations of govt. that have maturities


like 91 days, 182 days and 364 days. They are instead sold at a discount and
redeemed at par value. Though the return on them is low they appeal for the
following reasons:
 Can be transacted easily as they are issued in bearer form.
 There is a very active secondary market for treasury bills and the Discount
and Finance House Of India is a major market maker.
 They are virtually risk- free.

2. Commercial bank deposits: The firm can deposit its excess cash with
commercial banks for a fixed interest rate, which further depends on the period of
maturity. Longer the period, higher the rate .It is the safest short run investment
option for the investors. If the firm wishes to withdraw its funds before maturities,
it will lose on some interest.

Other Options For Investing Surplus Funds


1. Ready Forwards: A commercial bank or some other organization may do a ready
forward deal with a firm interested in deploying surplus funds on short- term
basis. Here, the bank sells and repurchases the same securities (this means that the
company, in turn, buys and sells securities) at prices determined before hand.
Hence, the name ready forward. The return in ready forward deal is closely linked
to money market conditions, which is tight during the peak season as well as the
time of year closing.

2. Commercial paper: It represents short term unsecured promissory notes issued


by firms that are generally considered to be financially strong .It has a maturity
period of 90 or 180 days. It is sold at a discount and redeemed at par. It is either

56
directly placed with the investor or sold through dealers. Its main benefit is that it
offers high interest rate, while its main drawback is that it does not have a
developed secondary market.

3. Inter-corporate deposits: A deposit made by a company with another, normally


up to a period of six months is referred to as inter-corporate deposits. They are
usually of three types:
• Call deposits: It is withdrawable by lender on giving a day’s notice. However in
practice, the lender has to wait for at least three days.
• Three-month deposits: These deposits are taken by the borrowers to tide over a
short-term inadequacy.
• Six- month deposits: Normally lending companies do not extend deposits beyond
this time frame. Such deposits are usually made with first class borrowers.

4. Bill discounting: A company may also deploy its surplus funds to


discount/purchase the bills the way a bank does. As bills are self-liquidating
instruments, bill discounting may be considered superior to lending in the inter-
corporate deposit market. While participating in bill discounting a company
should:
 Ensure that the bills are trade bills
 Try to go for bills backed by letter of credit rather than open bills as the
former are more secure because of the guarantee provided by the buyer’s
bank.

RECEIVABLE MANAGEMENT

The term receivable is defines as ‘debt owed to the firm by customers arising
from sale of goods or services in the ordinary course of business’. When a firm makes an
ordinary sale of goods or services and does not receive payment the firms grant credit and
creates accounts receivables which could in the future. Receivables management is also
called trade credit management thus, accounts receivable represents and extension of

57
credit to customers, allowing them a reasonable period of time in which to pay for the
goods received.

Goal Of Credit Management


To manage the credit in such a way that sales are expanded to an extent to which
the risk remains within an acceptable limit. Hence for maximizing the value, the firm
should manage its credit to:
 Obtain optimum (not maximum) value of sales.
 Control the cost of credit and keep it at minimum.
 Maintain investment in debtors at optimum level.

Costs involved in receivables management


The sale of goods on credit is an essential part of the modern competitive
economic systems. In fact, credit sales and therefore, receivables, are treated as a
marketing tool to aid the sale of goods. The objective of receivables management is ‘to
promote sales and profit until that point is reached where the return on investment in
further funding receivables is less than the cost of funds raised to finance that additional
credit i.e. cost of capital.’
 Collection cost: Collection costs are administrative cost incurred in collecting the
receivables from the customers to whom credit sales have been made.
 Capital cost: The increased level; of accounts receivables is an investment in
assets. They have to be financed thereby involving a cost. The cost on the use of
additional capital; to support credit sales which alternatively profitably employed
elsewhere, is, therefore, a part of the cost of extending credit or receivables.
 Delinquency cost: These costs arise out of the failure of the customers to meet
their obligations when payment on credit sales becomes due after the expiry of the
credit period. Such costs are called the delinquency cost.
 Default cost: Finally the firm may not be able to recover the over dews because
of the inability of the customers. Such that are treated as bad debts and have to be
return off as they cannot be realized. Such costs are known as default cost
associated with credit sales and accounts receivables.

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Benefits of receivables management
The benefits are increased sales and anticipated profits because of a more liberal
policy. When firms extend trade credit, that is, invest in receivables, they intend to
increase the sales. The impact of the liberal trade credit policy is likely to take two forms.
First it is oriented to sales expansion. In other words, a firm may grant trade credit policy
is likely to take two forms. First it is oriented to sales expansion. In other words a firm
may grant trade credit either to increase sales to existing customers. Secondly, the firm
may extend credit to protect its current sales against emerging competition. Here the
motive is sales retention. As a result of increased sales, the profit of the firm will
increase.

Credit Policies
The first decision area is credit policies. The credit policy of a firm provides the
framework to determine (a) whether or not to extend credit to a customer and (b) how
much credit to extend. The credit policy decision of firm has two broad dimensions; (I)
credit standards and (II) credit analysis.

 CREDIT STANDARDS
The term credit standards represent the basic criteria for the extension of credit to
customers. The quantitative basis of establishing credit standards is factors such as credit
ratings, credit references, average payments period and certain financial ratios. Since we
are interested in illustrating the trade off between benefit and cost to the firm as a whole,
we do not consider this individual component. To illustrate the effect, we have divided
the overall standards into (a) tight or restrictive, and (b) liberal or non restrictive i.e. to
say, our aim is to show what happens to the trade off when standards are relaxed or,
alternatively, tightened. The trade off with reference to credit standards covers (I) the
collection cost, (II) the average collection period/investment in accounts receivables, (III)
level of bad debts losses, and (IV) level of sales. These factors should be considered
while deciding whether to relaxed credit standards or not. If standards are relaxed it

59
means more credit will be extended while if standards are tightened less credit will be
extended.

 CREDIT ANALYSIS
The credit information supplied should be properly analyzed. The ratios should be
calculated to find out the liquidity position and should be compared with the industry
average. This will tell us whether the downfall if any is because of general industrial
environment or due to internal inefficiencies of the firm.
For judging the customer the credit analyst may use quantitative measure like the
financial ratios and qualitative assessments like trustworthiness etc.
Credit analyst may use the following numerical credit scoring system:
 Identify factors relevant for credit evaluation.
 Assign weights to these factors that reflect their relative importance.
 Rate the customers on various factors, using the suitable rating scale.
 For each factor multiply the factor rating with the factor weight to get the factor
score.
 Add all the factor score to get the over all customer rating index
 Based on the rating index, classify the customer.

INVENTORY MANAGEMENT

Inventories are the stock of the products a company is manufacturing for sale and
the components that make up the product. They exist in three forms; raw materials, work-
in-process and finished goods. A fourth kind of inventory the firms also maintain i.e. the

60
inventories of supplies. It includes office and plant cleaning material, oil, fuel, light
bulbs, etc.

Inventories constitute the most significant part of current assets of a large majority
of companies in India. For e.g. on an average, 60 % of the current assets in the public
limited companies are inventories.

INDUSTRY % OF INVENTORY
TO CURRENT ASSETS
Tea plantation, edible vegetables, hydrogenated oils, 60 %
sugar, cotton, jute and woolen textiles, non-ferrous metals,
transport equipments, engineering workshops etc
Printing and publishing, electricity generation and supply, 30 %
trading and shipping industries.
Tobacco 76 %

OBJECTIVES OF INVENTORY MANAGEMENT


The firms are required to maintain enough inventories for smooth production and
selling process, also at the same time they need to keep the investment in them minimum.
The investment in the inventories should be justified at the optimum level. The major
dangers of over investment include blockage of funds leading to reduced profits,
excessive carrying cost and the risk of liquidity. On the other hand major dangers of
inadequate inventories include production hold ups, failure to meet delivery
commitments further leading to loss of firm’s image, losing customers to competitors etc.

Hence an effective inventory management should:


 Ensure continuous supply of materials.
 Maintain sufficient stock of RM in periods of short supply and anticipate price
changes.
 Maintain sufficient FG inventory for smooth sales operation and efficient
customer service

61
 Minimize the carrying cost and time.
 Control investment in inventory, and keep it at an optimum level.

INVENTORY MANAGEMENT TECHNIQUES


The two basic questing related to inventory management are:
 What should be the size of the
order?
 At what level the order should be
placed?
The answer to the first question is the
Economic Order Quantity (EOQ) model,
which talks about three types of costs in
relation to inventory management i.e.
ordering cost, carrying cost and
shortage cost.

ORDERING COSTS CARRYING COSTS SHORTAGE COSTS

Preparation of purchase Interest on capital locked Purchase at a high cost due to


order. in inventory. shortage.
Expediting. Storage. Extra cost incurred to meet
Transport. Insurance. the customers demand due to
Receiving and placing in Obsolescence. existing shortage.
storage. Taxes. Losing the customer.

When a firm orders a large quantity, with the aim of reducing the total ordering
cost, the average inventory, other things being equal, tends to be high thereby increasing
the carrying cost. Also, when a firm carries a larger safety stock to reduce the shortage
costs its carrying costs tends to be high. Hence the minimization of the overall costs of
inventory would requires considerable trade off between these costs.

Assumptions of the EOQ model:

62
 The forecast/demand for a given period, usually a year, is known.
 The usage/demand is even throughout the year.
 Inventory orders can be replenished immediately.
 Ordering costs and carrying costs can be easily differentiated.
 Cost per order is constant, irrespective of the size of the order.

EOQ formula:
TC = U * F + Q * P * C
Q 2
TC= (Ordering Cost * Cost Per Order) + (Average Value Of Inventory * %
Carrying Cost)
U = Annual usage/demand
Q = Quantity ordered
F = Cost per order.
C = % carrying cost
P = Price per unit
TC = total of ordering and carrying costs.
The total cost of carrying and ordering is minimized when Q = √ 2FU
PC

Quantity Discounts And Order Quantity: When quantity discounts are available, the
price per unit is influenced by the order quantity. Hence total cost should be calculated
for various order quantity offered at discounted rates, and the one with the least cost
should be adapted.
Order Point: It is the quantity level on the attainment of which the next order has to be
placed. This is done in order to ensure continuous and smooth flow of materials for
production. If the usage rate of material and the lead-time for procurement were known
then the reorder level would be: lead time for procurement (days) * average daily usage.
However in real life due to uncertainties in lead-time and usage rate, an extra level of
stock i.e. safety stock is also maintained.
Therefore, Reorder Level = Normal Consumption +Safety Stock

63
Here, Safety Stock = (Maximum Usage Rate – Average Usage Rate) * Lead Time
Reorder point = S (L) + √SR (L)
Where,
S= Usage; L = lead time for obtaining additional inventory;
R = average qty ordered; F = stock out acceptance factor.

Other factors you need to consider before deciding the reorder level include:
 Anticipated scarcity
 Expected price change: An
expected increase in price
may warrant an increase in
the level of inventory and
vice-versa
 Obsolescence risk: The
presence of obsolescence
risk suggests a level of
reduction in inventory
carried and vice-versa
 Government restriction: Government may impose restrictions on the level of
inventory that can be maintained (may be through policies of commercial banks)
 Marketing considerations: If the demand is unexpected and there is heavy
competition, high level of inventory may be maintained to meet the demand.

MONITORING AND CONTROL OF INVENTORIES

ABC analysis can be used for the control of inventories Firms need to maintain various
types of inventories .In most inventory a large portion of the inventories account for only
small amount of cost whereas small portion of inventory contribute to a large value (in
monetary terms). ABC analysis concentrates on this fact, thus requires us to put in more

64
efforts to control inventory that leads to the maximum cost. This approach classifies the
inventories in three broad categories A, B, and C.

CATEGORY IMPORTANCE % OF INVENTORY %VALUE IN


ITEMS MONEY TERMS
A Most important 15 to 25 % 60 TO 75 %
B Moderate 20 to 30 % 20 to 30 %
importance
C Least important 40 to 60 % 10 to 15 %

The following procedure may be used for determining the three categories:
 Rank the items of inventory in descending order, on the basis of their annual
consumption value and number them 1 through n
 Record the running cumulative totals of annual consumption values and express
them as percentages of the total value of consumption
 Express each number in this list, 1 through n, as a percentage of n (these
percentages are actually cumulative percentages)
 Look at the cumulative percentages of consumption value against the cumulative
percentage of numbers and classify them into three broad categories: A, B and C.

Just In Time Inventory Control Taichi Okno of Japan originally developed it. It simply
implies that the firm should carry minimum level of inventory and depend on suppliers to
get it ‘just-in-time.’ Normally the firm wants to keep more inventories so that they do not
have shortage problems leading to production and sales delays. It however is very
difficult to implement since:
 It requires a strong and dependable relationships with suppliers who are
geographically not very remote from the manufacturing plant
 A reliable transportation system
 Proper storage facility at a place, which can be easily accessed as and
when, required.

65
However many believe that the just in time concept is not about getting the material
just in time but reducing the lead time of the process, that is, shortening the
production cycle.
The following steps will help to achieve this goal:
 Exercise of vigilance against imbalances of raw material and work in progress to
limit the utility of stock
 Efforts to finish the job faster
 Active disposal of goods that are surplus, obsolete or unusable
 Change of design to maximize the use of standard parts and components that are
of the shelf
 Strict adherence to the production schedules
 Special pricing to dispose unusually slow moving items

COMPANY’S ANALYSIS

ABBOTT PHARMACEUTICALS INDIA LIMITED

STATEMENT OF WORKING CAPITAL

66
PARTICULARS 2006 2005
In millions (Rs.) In millions (Rs.)
CURRENT ASSETS
INVENTORY 547.4 442.1
SUNDRY DEBTORS 235.2 200.1
CASH AND BANK BALANCES 131.8 93.5
LOANS AND ADVANCES 128.3 123.3
LESS:
CURRENT LIABILITIES
LIABILITIES 380.1 374.0
PROVISIONS 502.3 494.0
NET WORKING CAPITAL 160.3 9.0

INVENTORIES
PARTICULARS 2006 2005
In millions (Rs.) In millions (Rs.)
STOCK IN TRADE
RAW MATERIALS 9.2 8.2
PACKING MATERIALS 6.1 1.6
WORK IN PROGRESS 4.4 4.3
FINISHED GOODS 527.7 428.0
TOTAL 547.4 442.1

SUNDRY DEBTORS
PARTICULARS 2006 2005
In millions (Rs.) In millions (Rs.)
DEBTS OUTSTANDING FOR A
PERIOD EXCEEDING 6
MONTHS
CONSIDERED GOOD 10.3 -
CONSIDERED DOUBTFUL 9.2 8.8
LESS: PROVISIONS FOR 9.2 8.8
DOUBTFUL DEBTS
OTHER DEBTS
CONSIDERED GOOD 224.9 200.1
CONSIDERED DOUBTFUL - 0.7
LESS: PROVISIONS FOR - 0.7

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DOUBTFUL DEBTS
TOTAL 235.2 200.1

CASH AND BANK BALANCES

PARTICULARS 2006 2005


In millions (Rs.) In millions (Rs.)
CASH, CHEQUES AND STAMPS 0.1 0.1
ON HAND
WITH SCHEDULED BANKS
ON CURRENT ACCOUNT 126.5 93.4
ON ESCROW ACCOUNT 5.2 -
TOTAL 131.8 93.5

LOANS AND ADVANCES


PARTICULARS 2006 2005
In millions (Rs.) In millions (Rs.)
ADVANCES TO BE RECOVERED 99.1 91.6
IN CASH OR IN KIND OR FOR
VALUE TO BE RECEIVED
SUNDRY DEPOSITS 28.2 31.7
BALANCES WITH CUSTOMS AND 1.0 -
EXCISE ON CURRENT ACCOUNT
TOTAL 128.3 123.3

LIABILITIES

PARTICULARS 2006 2005


In millions (Rs.) In millions (Rs.)
SUNDRY CREDITORS
DUE TO SMALL SCALE 36.7 0.9
INDUSTRIAL UNDERTAKINGS
OTHERS 249.9 277.2
UNCLAIMED DIVIDENDS 22.1 21.2

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OTHER LIABILITIES 71.4 74.7
TOTAL 380.1 374.0

PROVISIONS
PARTICULARS 2006 2005
In millions (Rs.) In millions (Rs.)
FOR TAXATION
CURRENT INCOME TAX LESS 169.5 161.7
PAYMENTS OF RS 259.5 MILLION
(2005 – Rs 301.9
MILLION)
FRINGE BENEFIT TAX LESS 8.1 5.5
PAYMENTS OF Rs 8.6 MILLION
(2005 – RS 7.5 MILLION)
FOR PROPOSED DIVIDENDS 267.4 267.4
FOR CORPORATE DIVIDEND TAX 37.5 37.5
FOR GRATUITY/ PENSION 7.0 8.0
FOR LEAVE ENCASHMENT 12.8 13.9
TOTAL 502.3 494.0

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WOCKHARDT PHARMACEUTICALS

STATEMENT OF WORKING CAPITAL


PARTICULARS 2006 2005
In millions (Rs.) In millions (Rs.)
CURRENT ASSETS
INVENTORY 2149.82 1561.49
SUNDRY DEBTORS 2543.78 2066.80
CASH AND BANK BALANCES 5192.17 6460.76
LOANS AND ADVANCES TO 1061.55 672.69
SUBSIDARIES
OTHER LOANS AND ADVANCES 1061.47 861.57
LESS:
CURRENT LIABILITIES
LIABILITIES 2336.42 1985.34
PROVISIONS 826.61 758.61
NET WORKING CAPITAL 8845.76 8879.36

INVENTORIES
PARTICULARS 2006 2005
In millions (Rs.) In millions (Rs.)
STORES AND SPARES 45.11 5.30
RAW MATERIALS 787.39 511.02
PACKING MATERIALS 172.17 131.38
WORK IN PROGRESS 410.68 146.59
FINISHED GOODS 703.74 742.57
SAMPLES 30.73 24.63
TOTAL 2149.82 1561.49

70
SUNDRY DEBTORS

PARTICULARS 2006 2005

In millions (Rs.) In millions (Rs.)


DEBTS OUTSTANDING FOR A
PERIOD EXCEEDING 6
MONTHS
CONSIDERED GOOD 393.29 586.37
CONSIDERED DOUBTFUL 402.94 131.23
LESS: PROVISIONS FOR 402.94 131.23
DOUBTFUL DEBTS
OTHER DEBTS
CONSIDERED GOOD 2150.49 1480.43
TOTAL 2543.78 2066.80

CASH AND BANK BALANCES

PARTICULARS 2006 2005


In millions (Rs.) In millions (Rs.)
ON HAND 0.77 1.03
WITH SCHEDULED BANKS
ON CURRENT ACCOUNT 30.61 61.21
ON MARGIN ACCOUNT 24.53 37.73
ON DEPOSIT ACCOUNT 5136.26 6360.79
TOTAL 5192.17 6460.76

OTHER LOANS AND ADVANCES


PARTICULARS 2006 2005
In millions (Rs.) In millions (Rs.)
UNSECURED CONSIDERED

71
GOOD
LOANS TO EMPLOYEES 12.74 12.01
LOANS TO COMPANIES 0.10 0.01
ADVANCES RECOVERABLE IN 544.07 477.20
CASH OR IN KIND OR FOR
VALUE TO BE RECEIVED
ACCRUED INCOME - 154.02
BALANCE WITH CUSTOMS AND 127.72 95.42
EXCISE AUTHORITIES
OTHER DEPOSITS 75.47 64.21
MINIMUM ALTERNATIVE TAX 199.16 -
(MAT) CREDIT ENTITLEMENT
ADVANCE TAX, NET OF 102.21 58.70
PROVISION FOR TAX
TOTAL 1061.47 861.57

LIABILITIES

PARTICULARS 2006 2005


In millions (Rs.) In millions (Rs.)
SUNDRY CREDITORS
DUE TO SMALL SCALE 2.30 78.22
INDUSTRIAL UNDERTAKINGS
SUBSIDARY COMPANY 59.47 7.81
OTHERS 1638.33 1342.91
SECURITY DEPOSITS 143.91 139.17

72
UNCLAIMED DIVIDENDS 9.04 6.41
INTERST ACCRUED BUT NOT 21.75 20.86
DUE
OTHER LIABILITIES 461.62 389.96
TOTAL 2336.42 1985.34

PROVISIONS
PARTICULARS 2006 2005
In millions (Rs.) In millions (Rs.)
INTERIM DIVIDEND 547.18 -
TAX ON INTERIM DIVIDEND 76.74 -
PROPOSED DIVIDEND - 547.17
TAX ON PROPOSED DIVIDEND - 76.74
PROVISION FOR RETIREMENT 157.69 119.70
BENEFITS
OTHER PROVISIONS 45.00 15.00
TOTAL 826.61 758.61

73