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Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital.[16] These policies aim at managing the current assets(generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.  Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.  Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials ± and minimizes reordering costs ± and hence increases cash flow; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity (EPQ).  Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.  Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

WORKING CAPITAL

1. Concept And Definition Of Working Capital There are two concept of Working Capital : gross and net . a) The term gross working capital , also referred to as working capital , means the total current assets .

b) The net working capital can be defined in two ways : 1. The most common definition of net working capital ( NWC ) is the difference between current assets and current liabilities ; and 2. Alternate definition of NWC is that portion of current assets which is financed with long term funds . The task of financing manager in managing working capital efficiently is to ensure sufficient liquidity in the operations of the enterprise . Net working capital , as a measure of liquidity is not very useful for comparing the performance of different firms , but it is quite

useful for internal control . The NWC helps in comparing the liquidity of the same firm over time . For the purpose of working capital management , therefore , NWC can be said to measure the liquidity of the firm . In the other words , the goal of working capital management is to manage the current assets and liabilities in such a way that an acceptable level of NWC is maintained .

2. Components Of Working Capital

The basic components of working capital are ,

Current Assets : a) Inventories i) Raw Materials and Components ii) Work in Progress iii) Finished Goods iv) Others b) Trade Debtors c) Loans And Advances d) Investments e) Cash And Bank Balance Current Liabilities: .

a) Sundry Creditors b) Trade Advances c) Borrowings d) Commercial Banks e) Provisions 3. Need For Working Capital Given the objective of financial decision making to maximise the shareholders· wealth . The extent to which profits . it is necessary to generate sufficient profits .

among other things . Technically this is referred to s operating cycle . in other words . there is invariably a time lag between sale of goods and the receipt of cash . Therefore sufficient working capital is necessary to sustain sales activity . A successful sales program is . sales do not convert into cash instantly . a need for working capital in the form of current assets to deal with the problem arising out of the lack of immediate realisation of cash against goods sold . There is therefore . The operating cycle can be .can be earned will naturally depend . upon the magnitude of sales . However . necessary for earning profits by any business enterprise .

said to be at the heart of the need for the working capital . d) Conversion of receivables into cash . there would be no need for current assets (working capital) . In other words the operating cycle refers to the length of time necessary to complete the following cycle of events : a) Conversion of cash into raw materials. If it were possible to complete the sequences instantaneously . c) Conversion of inventory into receivables . Since the cash . the firm is forced to have current assets . But since it is not possible . b) Conversion of raw materials to inventory .

Similarly . firms have to necessarily keep cash or invest in short term liquid securities so that they will be in position to meet obligations when they become due . firms must have adequate inventory to guard against the possibility of not being able to meet demand for their products . It is in these ways that an adequate level of working capital is absolutely necessary for smooth . therefore. provides a cushion against being out of stock . Adequate inventory . If firms have to be competitive . they must sell goods to their customer on credit which necessitates the holding of accounts receivables .inflows and outflows do not match .

The life span of . Characteristics Of Current Assets In management of working capital two characteristics of current assets must be borne in mind : a) short life span and b) swift transformation into other assets forms .sales activity which . enhances the owner·s wealth . 4. account receivables may have a life span of 30 to 60 days . and inventories may be held for 30 days to 100 days . Current assets may have a short life. Cash balance may be held idle for a week or two. in turn .

sales and collection and the degree of synchronisation among them .current assets depend on the time required in the activities of procurement . finished goods . generate cash . . raw materials are transformed into finished goods ( this transform may involve several stages of work in progress ) . are converted into accounts receivable . production . generally sold on credit . These two characteristics has certain implications . and finally account receivables on reliasation . Each current asset is swiftly transformed into other assets forms : cash is used for acquiring raw materials .

i) Decisions relating to working capital management are repetitive and frequent ii) The difference between profit and present value is insignificant iii) The close interaction among working capital components implies that efficient management of one component cannot be undertaken without simultaneous consideration of other components . Factors Affecting Working Capital . 5.

The working capital needs of a firm are influenced by numerous factors . manufacturing concern like a machine tools unit . On the other hand . has a modest working capital requirement . The important ones are i) Nature of business : The working capital requirement of a firm is closely related to the nature of business . like electricity undertaking or a transport corporation which has a short operating cycle and which sells predominantly on cash basis . which has a long operating cycle and . A service firm .

which sells largely on credit has a very substantial working capital requirement . The working capital need of such a firm is likely to increase considerably in summer months and decrease significantly during winter period . On . For example . The sale of air conditioners reaches the peak during summer months and drops sharply during winter season . ii) Seasonality of Operation : Firms which have marked seasonality in there operations usually have highly fluctuating working capital requirement . consider a firm manufacturing air conditioners .

which have fairly even sale round the year .the other hand . Such . For example a manufacturer of air conditioners may maintain steady production through out the year rather than intensify the production activity during the peak business season . iii) Production Policy : A firm marked by pronounced seasonal fluctuation in its sale may pursue a production policy which may reduce the sharp variations in working capital requirements . a firm manufacturing consumer goods like soaps . tends to have a stable working capital need . oil . tooth pastes etc.

Thus .decision may dampen the fluctuations in working capital requirements . working capital needs tend to be high because of greater investment in finished goods inventory and accounts receivable . iv) Market Conditions : When competition is keen . . Further generous credit terms may have to be offered to attract customers in highly competitive market . larger inventory of finished goods is required to promptly serve the customers who may not be inclined to wait because other manufacturers are ready to meet their needs .

a firm can manage with smaller inventory of finished goods because customers can be served with delay . partial or total . v) Conditions of Supply : The inventory of raw material . Further in such situation the firm can insist on cash payment and avoid lock up of funds in accounts receivables ² it can even ask for advance payment . spares and stores depends on the conditions of supply . However if the supply is unpredictable and scant then the firm . the firm can manage with small inventories .If the market is strong and competition is weak . to ensure . If supply is prompt and adequate .

would have to acquire stocks as and when they are available and carry large inventories on an average . 6.continuity of production . It may be divided into four . A similar policy may have to be followed when the raw material is available only seasonally and production operations are carried out round the year . Operating Cycle Analysis The Operating cycle of the firm begins with the acquisition of raw materials and ends with the collection of receivables .

stages a) raw material and stores storage stage . Duration of operating cycle : The duration of operating cycle is equal to the sum of the duration of . c) finished goods inventory stage and d) debtors collection stage . b) work-in-progress stage .

each of these stages less the credit period allowed by the suppliers to the firms . It can be given as O=R+W+F+D²C Where O = Duration of operating cycle R = Raw material and stores storage period W = Work-in-progress period F = Finished goods storage period D = debtors collection period C = Creditors payment period The components of Operating cycle may be calculated as follows . .

R = Average stock of raw materials and stores Average raw material and stores consumption per day W = Average Work-in-progress inventory Average cost of production per day F = Average Finished Goods Inventory Average cost of goods sold per day D = Average books debts .

Net Working Capital Negative Working Capital Types of Working Capital Cash Working Capital Gross Working Capital Permanent Working capital . So following are some important types of working capital. It prominently works in the direction of performing different functions in different situation and in the context of divergent variables. Balance Sheet Working Capital Temporary Working Capital .Average credit sales pert day C = Average trade creditors Average credit purchase Types of working capital The type. kinds of a thing are depending upon the different utilization of working capital.

It represents the current assets. 2) Gross Working Capital: Gross working capital means the total current assets. which are required on a continuing basis over the year. which are needs to conduct the business even during the dullest season of the year. Permanent working capital has following features: i) ii) iii) It is classified on the basis of the time factor. It constantly shifted from one assets o another and continues to remain in the business process. 3) Permanent Working Capital: It is the minimum amount of the current assets. which are required at different times during the operating year. 4) Temporary Working Capital: It represents the additional assets. It is the amount of funds required to produce the goods and services. Amount left for operational requirement. Seasonal working capital is the additional amount of current assets particularly cash.1) Net Working Capital: Term Net working capital can be define in two way i) ii) It is the difference between current assets and current liabilities. It is maintain as the medium to carry on operation at any time. and inventory which is required during the more active . which are necessary to satisfy demand at a particular point. receivables. This amount varies from year to year depending upon the growth of a company and stage of the business cycle in which it operates. Its size increase with the growth of the business.

such a situation is absolutely theoretical and occurs when a firm is nearing a crisis of some magnitude. It shows the real flow of money or value at a particular time and considered to be most realistic approach in working capital management. which is calculated from the items appearing in he Profit and Loss Account. It is the basic of he operation cycle concept. 7) Negative Working Capital: It emerges when current liabilities exceeds current assets.business seasons of the year. which has assumed a great importance in financial management in recent year. Gross working capital. 6) Cash Working Capital: It is one. The reason is that the cash working capital indicates he adequacy of he cash flow which is an essential pre requisite of a business. b) It is particularly suited to business of seasonal on cyclical nature. It is the temporary investment in the current assets and possesses he following features: a) It is not always gainfully employed. 5) Balance Sheet Working Capital: The balance sheet working capital is one. which is calculated from the items appearing in the balance sheet. . though is May also shift from one asset to another as permanent working capital does. is example of the balance sheet working capital. which is represented by the excess of current assets over current liabilities.

In other word these is a definite inverse relationship between he degree of risk and profitability.Principles of Working Capital Management: There are some principles of sound working capital management policy. 2) Principle of Cost of Capital: The various sources of rising of working capital finance have different cost of capital and the degree of risk involved. They are as follows: 1) Principle of Risk Variation: Risk here refers to inability of a firm to meet its obligation when they become due for payment. 4) Principle of Maturity of Payment: . Large investment in current assets with less dependence on a short term borrowing increase liquidity. reduces dependence on short term borrowing increases liquidity. Every rupee invested in the current assets should contribute to he net worth of he firm. Generally higher the risk lower is the cost and lower the risk higher is the cost. the amount of working capital invested in each component should be adequately justified by a firm¶s equity position. A sound working capital management should always try to achieve a proper balance between these two. 3) Principle of Equity position: According this principle. reduces liquidity and increases profitability. reduces risk. On the other hand less investment in current assets and greater dependence on debt increase the risk. A conservative management prefers to minimize risk by maintaining a higher level of current assets or working capital while a liberal management should be to establish a suitable trade off between profitability and risk.

On the other hand trading and financial firms require less investment in fixed assets but they have to invest large amount in current assets like inventories. According to this principle.This principle is concerned with planning he sources of finance for working capital. In other words. It covers the time span between the procurement of raw material and the completion of the manufacturing process leading to the production of finished goods. . To sustain such activities that need for working capital is obvious. there is sometime gap before raw material becomes finished goods. Factors determining working capital 1) Nature or character of Business: The working capital requirement of a firm basically depends upon he nature of its business. receivables and cash. Maturity pattern of various current obligations is an impotent factor in risk assumptions and risk assessment. So they need large amount of working capital. and Railways need very limited working capital because they offer cash sales only and supply services. a firm should make every efforts o related maturity of payment to its flow of internally generated funds. 2) Production cycle: Another factor. is the production cycle. The term µproduction or manufacturing cycle¶ refers to the time involved in the manufacturing of goods. not products and as such no funds are tied up in inventories and receivables. larger is working capital need and vise versa. The longer time span (production cycle) the large will be the tied up funds and therefore. Water Supply. which has a bearing on the quantum of working capital. Public utility undertaking like Electricity.

The credit sales result in higher book debs. The working capital requirement of a business are thus. affected by term of purchase and sale. depend upon the production policy. If policy is to keep production steady by accumulating inventories it will require higher working capital. Higher book debts mean more working capital. yet it may be concluded that for normal rate of expansion in the volume of business. Although. if liberal credit terms are available from the supplies of goods trade needs less working capital. 4) Credit Policy: The credit terms granted to customers have a bearing in the magnitude of working capital by determining the level of book debts. we shall require lager amount of working capital. and the ole given to credit by a company in its dealing with creditors and debtors. On the other hand. The requirement of working capital in such case. We may have retained profits to provide for me working capital but in fast growing concern. It is difficult to determine the relationship between the growth in the volume of business and the growth in the working capital of a business.3) Production Policy: In certain industry the demand is subject to wide fluctuations due to seasonal variations. 5) Growth and Expansion: The working capital requirement of concern increase with the growth and expansion of its business activities. 6) Seasonal Variation: . The production can be either kept steady by accumulating inventories during slack period with a view to meet high demand during peak season of the production could be curtailed during the slack season and increased during the peak season.

Such firms with high earning capacity may generate cash profits from operations and contribute to their working capital. Sources of Working Capital Mainly there are two sources of working capital: i. 7) Earning Capacity: Some firm have more earning capacity than others due to quality of the products. 9) Other Factors: Certain other factors such as operating efficiency. monopoly condition etc.In certain industry raw material is no available throughout the year. A firm that maintains a steady high rate of cash dividend irrespective of its profits level needs more working capital than the firm that retains large part of its profits and does not pay at high rate of cash dividend. They have to buy raw material in bulk during the season to ensure uninterrupted flow and process them during the entire year. irregularities in supply. So a huge amount is blocked in form of row material during the peak season. Permanent or Fixed working capital ii. management ability. import policy. importance of labour. banking facilities etc. also influence the requirement of working capital. which gives more requirements for working capital and less requirement during the slack season. 8) Dividend Policy: The dividend policy of a concern influence on the requirement of the working capital. Temporary or variables working capital . assets structure.

which are copiously required by the enterprise to carry out its day-to-day business operation and this minimum. This minimum level of current assets need long term working capital. This is so because there is always a minimum level of current assets. this gives rise to short term working capital which is required for day to day transaction also. etc. some amount of working capital may be required to meet the seasonal demands and some special exigencies such as rise in prices. cannot be expected to reduce at any time. The fixed proportion of working capital should be generally financed from the fixed capital sources while the temporary or variable working capital equipment may be met from the short term sources of capital. Sources of Working Capital Long term Sources 1) Shares 2) Debentures 3) Public Deposits 4) Ploughing back of Profits 5) Loans from Financial institution Short Term sources 1) Commercial Banks 2) Indigenous Banks 3) Trade Creditors 4) Installment Credit 5) Advances 6) Account receivable 7) Credit 8) Accrued Expenses 9) Differed Income Methods of Calculation of Required Working Capital 10) Commercial Paper The methods of calculation of required working capital are as follows: . Similarly. which is permanently blocked. a part of the working capital investments are as investment in fixed assets.In any concern. strikes.

components involve are raw material. overheads and profits. In work in process. The operating cycle consists of him following events. Finished stock consists components of material. Credit involves for the components of raw material. and overhead more specifically manufacturing overheads. wages. wages.e. etc. entering into production and inflow of cash from debtors and realization of receivables. operating cycle is the duration between the outflow of cash and inflow of cash and this may be evidenced from the following working capital cycle. stock refers to material only. raw material. In the diagram. . something a contingency margin is also given while estimating the working capital requirement. It refers to the duration between the firm¶s payment of cash for raw material. Receivables Cash Finished Goods Raw Material Work In Process The above and network diagram may offer a clear picture of a complete working capital i. it is a cash phenomenon. wages and overheads inclusive of factory. office and administration and selling and distribution. Simply speaking. which continues throughout his life of a firm remaining engaged in commercial activities. Debtors include material.Working Capital Cycle: The working capital cycle is also known as operating cycle.

Total Operating Cost Working Capital Required = Number of Operating Cycle . Cost of Consumption per day Avg. Credit Purchased per day In the form of a simple equation working capital cycle or operating cycle can be represented as bellow: O = R+W+F+D-C Where. Book Debt 4) Receivables Collection Period = Avg.Avg. Cost of Production per day Avg. Cost of Goods Sold per day Avg. Stock of Finished Goods 3) Finished Goods Holding Period = Avg. Credit Sales per day Avg. Trade Creditors 5) Creditors Collection Period = Avg. O = Operating Cycle (In Days) R = Raw Materials Holding Period W = Work in Process Holding Period F = Finished Goods Holding Period D = Receivables Collection Period C = Creditors Collection Period. Stock of Raw Material 1) Raw Material Holding Period = Avg. Stock of Work in Process 2) Work in Process Holding Period = Avg.

Components of Working Capital: Current Assets: i) ii) Stock of Raw Material (for«month consumption) Work In Process (for«Month) a) Raw Materials b) Direct Labour c) Overheads Stock of Finished Goods (for«month sales) Sundry Debtors or Receivables (for«month sales) Payments in Advance (if any) Balance of Cash (required to meet day-to-day Expenses) Any Other (if any) Amount ----------- iii) iv) v) vi) vii) -------------------------- Less: Current Liabilities: i) ii) iii) Creditors (for«month purchase of raw materials) Outstanding Expenses (for month) Others (if any) -------------------------------------- Working Capital (CA ± CL) Add: Provision/ Margin for contingencies Net Working Capital Required .

which earn no profit for the business. i. refers to him excess of current assets over current liabilities. The basic goal of working capital management is to manage the current assets and current liabilities of a firm in such way that a satisfactory level of working capital is maintained. This is so because both inadequate as well as excessive working capital position is bad for the business. 2) Dimension II is concerned with the decision about his composition and level of current assets. Management of working capital therefore.e. liquidity and structural health of the organization. Inadequacy of working capital. neither inadequate nor excessive.Management of working capital: Working capital. risk and liquidity. In this context. may lead the firm insolvency and excessive working capital implies idle funds. working capital management is three-dimensional nature: 1) Dimension I is concerned with the formulation of he policy with regard to Profitability. . in general practice. In other word it refers to all aspects of administration of both current assets and current liabilities. is concerned with problems that arise in attempting to mange him current assets. current liabilities. and interrelationship that exists between them. Working capital management policies of the firm have a great effect on its profitability.

Profitability.3) Dimension III is concerned with the decision about his composition and level of current liabilities. This dimension aspect of his working capital has been more clearly and precisely Explains by the following diagram. Risk & Liquidity Dimension I Dimension III Dimension II Composition & Level of current assets Composition & level Of current Liabilities Evaluation of working capital .

finished goods and receivables typically fluctuates during the year. It is flexible and spontaneous source of finance. . There is no formal/specific negotiation for trade credit. The need for finance arises mainly because the investment in working capital/current assets.The working capital management needs attention of all the finance head/ working capital management is important for avoiding unnecessary blockage of fund. Bank credits and commercial bankers. trade credit represents a source of finance for credit purchases. liquidity position of the firm and past record of payment. the firm has to decide how it is to be financed. Although long-term funds partly finance current assets and provide the margin money for working capital. work-in-progress. Advantages i) ii) It is easily. almost automatically available. Trade credits. FINANCING WORKING CAPITAL FINANCING WORKING CAPITAL After determining the level of Working Capital. It is an informal agreement between the buyer and the seller. such working capitals are virtually exclusively supported by short term sources. Thus. cash is not paid immediately for purchases but after an agreed period of time. According to trade practices. the supplier of goods does not extend credits indiscriminately. Trade Credit Trade credit refers to the credit extended by the supplier of goods and services in the normal course of business of the firm. Such credit appears in the books of buyer as sundry creditors/accounts payable. that is. The most of the trade credit is on open account as accounts payable. raw material. Their decision as well as the quantum is based on a consideration of factors such as earnings record over a period of time. The main sources of working capital financing are namely. It is very important to have proper balance in regard to the liquidity of the firm. 1. Like that liquidity is important at it refer to the short-term financial strength of company.

They can also be renewed from time to time. This type of financing is highly attractive to the burrowers because. Trade credit is free from restrictions associated with formal/negotiated source of finance/credit. 2. it represents the most important source for financing of current assets. firstly. With the emergence of the new banking since mid-nineties.iii) iv) v) The availability and the magnitude of trade credit is related to the size of operation of the firm in terms of sales/purchases. From a modest . cash credit/overdraft is inconvenient to the banks and hampers credit planning. spontaneous source of finance. The borrower has to pay interest on the total amount. Within the specified limit. a minimum charge may be payable on the unutilized balance irrespective of the level of borrowing for availing of the facility. As a form of financing. The burrower can burrow upto the stipulated credit. Bank Credit Bank credit is primarily institutional source of working capital finance in India. any number of drawings are possible to the extent of his requirements periodically. (b) Loans : under this arrangement. However. cash credit cannot at present exceed 20% of the maximum permissible bank finance (MPBF)/credit limit to any borrower. Working Capital finance is provided by banks in five ways : (a) Cash Credit / Overdrafts : Under cash credit/ overdraft agreement of bank finance. secondly. However. In fact. it is flexible in that although borrowed funds are repayable on demand. Similarly. the entire amount of borrowing is credited to the current account of the borrower or released in cash. repayment can be made whenever desired during the period. the burrower has the freedom to draw the amount in advance as an when required while the interest liability is only on the amount actually outstanding. loans imply a financial discipline on the part of the borrowers. The loans are repayable on demand or in periodic installments. It is also an informal. It was the most popular method of bank financing of working capital in India till the early nineties. The interest is determined on the basis of the running balance/amount actually utilized by the burrower and not on the sanctioned limit. and. the bank specifies a predetermine borrowing/credit limit.

The discounting banker asks the drawer of the bill to have his bill accepted by the drawee bank before discounting it. at least 80% of MPBF must be in form of loans in India. by buying goods on credit from suppliers and raising cash credit b hypothecating the same goods. the buyer who buys goods on credit cannot use the same goods as a source of obtaining additional bank credit. Moreover. bank credit is being made available through discounting of usance bills by banks. To popularize the scheme. borrower enjoyed facilities in excess of their legitimate needs. The bill financing is intended to link credit with sale and purchase of goods and. for example. (c) Bills Purchased/Discounted : This arrangement is of relatively recent origin in India. With introduction of the New Bill Market Scheme in 1970 by RBI. the bank satisfies itself about the credit worthiness of the drawer and the genuineness of the bill.Before discounting he bill. . Therefore. This was done. earlier fixed by it. on the basis of the borrowing value of stocks. The later grants acceptance against the cash credit limit. the discount rates are fixed at lower rates than those of cash credit. This was possible because credit was taken form different agencies for financing the same activity. thus eliminate the scope for misuse or diversion of credit to other purposes. As the availability of bank credit was unrelated to production needs. The RBI envisaged the progressive use of bills as an instrument of credit as against the prevailing practice of using the widely-prevalent cash credit arrangement for financing working capital.beginning in the early nineties. The cash credit arrangement gave rise to unhealthy practices. it led to double financing.

However. the banks provide credit to borrowers against the security of movable property. essential perquisite of pledge. banks advance loans for 37 years payable in yearly or half-yearly installments. The rights of the lending bank (hypothecate) depend upon the terms of the contract between the borrower and the lender. b) Pledge : Pledge. 3. The bills can be rediscounted with the other banks/RBI. is that the goods are in the custody of the bank. as a mode of security. letter of credit is an indirect form of working capital financing and banks assume only the risk. the goods which are offered as security are transferred to the physical possession of the lender. The seller of goods draws the bill on the purchaser of goods. therefore. The purchaser of goods on credit obtains a letter of credit from a bank. Hypothecation facility is normally is not available to new borrowers. Mode of Security a) Hypothecation : Under this mode of security. it has the legal right to sell the goods to realize the outstanding loan. The bank undertakes the responsibility to make payment to the supplier in case the buyer fails to meet his obligations. The borrower who offer the security is.e. the credit being provided by the suppliers himself.The modus operandi of bill finance as a source of working capital financing is that a bill that arises out of a trade sale-purchase transaction on credit. the modus operandi of letter of credit is that the supplier sells goods on credit/extends credit to the purchaser. the bank releases the funds to the seller. The goods hypothecated. 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. Although the bank does not have physical possession of the goods. continue to be in the possession of the owner of these goods (i. the bank gives a guarantee and bears risk only in case of default by the purchaser. Thus . the seller offers it to the bank for discount/purchase. however. An. The bill is presented by the bank to the purchaser/acceptor of the bill on due date for payment. On acceptance of the bill by the purchaser. usually inventory of goods. is different from hypothecation in that in the former. payable on demand or after a usance period not exceeding 90 days. d) Term Loans for Working Capital : Under this arrangement. called a . unlike in the later. the borrower ). On discounting the bill. this form of financing is not popular in the country.

Particular lien is a right to retain goods until a claim pertaining to theses goods is fully paid. c) Lien : The term lien refers to the right of a part to retain goods belonging to another party until a debt due to him is paid. The lodging of goods by the pledgor to the pledgee is a kind of bailment. Therefore. Mortgage is. pledge creates some liabilities for the bank. thus. Reserve Bank of India Framework for Regulation of Bank Credit After mid-nineties. Banks usually enjoy general lien. But a mortgage can be created only by the act of parties. In case of non-payment of the loans. y A charge may be created by the act of parties or by the operation of law. The person who parts with the interest in the property is called mortgagor and the bank in whose favour the transfer takes place is the mortagagee. The mortgage interest in the property is terminated as soon as the debt is paid. It must take reasonable care of goods pledged with it. and (ii) general lien. On the other hand. y y A charge need not be made in writing but a mortgage deed must be attested.µpawnor¶ (pledgor). the bank enjoys the right to sell the goods. conveyance of interest in the mortgaged property. Mortgage are taken as an additional security for working capital credit b banks. Lien can be of two types: (i) particular lien. In a mortgage. the transferee of the mortgage property can acquire the remaining interest in the property. if any is left. made security for the payment of money to another and the transaction does not amount to mortgage. the latter person is said to have a charge on the property and all the provisions of simple mortgage will apply to such a charge. The instrument of transfer is called the mortgage deed. d) Mortgage : It is the transfer of a legal/equitable interest in specific immovable property for securing the payment of debt. a charge cannot be enforced against the transferee for consideration without notice. But mortgage is a transfer of interest in the property. by the act of parties or by the operation of law. Generally. 4. general lien can be applied till all dues of the claimant are paid. the framework for regulation of bank credits has been relaxed permitting banks greater flexibility in tune with the emergence of new banking in the . while the bank is called the µpawnee¶ (pledgee). e) Charge : Where immovable property of one person is. The provision are as follows: y A charge is not the transfer of interest in the property though it is security for payment.

. a part of the current assets should be financed by the trade credit and other current liabilities. focusing on viability and profitability in contrast to the earlier thrust on social/development banking. y Quarterly Information System : Form I. intended to reduce the dependency of industry on bank credit. thus. The actual operating performance for the half-year ended against the estimates are given in this. y Quarterly Information System : Form II. finished goods and receivables as so many months of cost of sales and sales respectively. keeps under check any tendency to overtrade with borrowed funds. y Half-yearly Operating Statement : Form III. The notable features of the framework/regulation related to fixation of norms for bank lending to industry. Its contents are (i) production and sales estimates for the current and the next quarter. b) Lending Norms/Approach to Lending/MPBF : According to the lending norms. The norms are: a) Inventory and Receivable Norms : The norms refer to the maximum level for holding inventories and receivables in each industry. Another merit of the approach is that it invariably ensures a positive current ratio and. It takes into account all the current assets requirements of borrowers total operational needs and not merely inventories or receivables. a mandatory limit on cash credit and a loan system of delivery of bank credit was introduced. It contains (i) actual production and sales during the current year and for the latest completed year. The approach to lending is vitally significant.country. d) Information and Reporting System : The main components of the information and reporting system are four. and (ii) current assets and current liabilities estimates for the next quarter. Raw materials were expressed as so many months consumptions. The balance 40% could be availed of as short term loans. The cash-credit limit was initially limited to 60% of the MPBF. it also takes into account all the other sources of finance at his command. namely. The remaining part of the current assets. c) Forms of Financing/Style of Credit : In 1995. should be partly financed by the owners funds and long term borrowings and partly by short term bank credit. These norms represent the maximum levels of holding inventory and receivables in each industry. WIP as so many month¶s cost of production. The cash credit limit sanctions are currently 20% and loan component 80%. The fixation of these norms was. Borrowers were not expected to hold more than that level. and (ii) actual current assets and current liabilities for the latest completed quarter. termed as working capital gap. thus.

5 lakh. they are highly liquid. y CP¶s can be issued for periods ranging between 15 days and one year. The main element of present framework are given below. The companies announce current rates of CPs of various maturities. consisting of usance promissory notes with a fixed maturity. The estimates as well as the actual sources and uses of funds for the half-year ended are given. They buy at a price less than the commission and sell at the highest possible level.y Half-yearly Operating Statement : Form IIIB. and investors can select those maturities which closely approximate their holding period. b) Framework of Indian CP Market The CPs emerged as sources of short-term financing in the early nineties. A well rated company can diversify its sort-term sources of finance from banks to money market at cheaper cost. 5. A CP when issued by a company directly to the investor is called a direct paper. Renewal of CP¶s is treated as fresh issue. They are regulated by RBI. The investors can get higher returns than what they can get from the banking system.25 lakh and the minimum unit of subscription is Rs. As negotiable/transferable instruments. they are called dealer paper. The maturities of CPs can be tailored within the range to specific investments. y The minimum size of an issue is Rs. It is issued on a discount on a face value basis but it can also be issued in interest bearing form. . It is flexible in terms of maturities which can be tailored to match the cash flow of the issuer. a) Advantages CP is a simple instrument and hardly involves any documentation. Commercial Papers Commercial Paper (CP) is a short term unsecured negotiable instrument. Companies which are able to raise funds through CPs have better financial standing. When CPs are issued by security dealer on behalf of their corporate customers. The CPs are unsecured and there are no limitations on the end-use of funds raised through them.

y A company can issue CPs only if it has a minimum tangible net worth of Rs. a fund-based working limit of Rs. and (ii) Canbank Factors Ltd. The Discount and Finance House of India ( DFHI ) also participates by quoting its bid and offer prices. c) Effective Cost/Interest Yield As the CPs are issued at discount and redeemed at it face value. they appeared in the Indian financial scene only in the early nineties as a result of RBI initiatives.25 to 0. at least a credit rating of P2 (Crisil ). rating charges (0.25% ) and stand by facility ( 0.25% ). dealing bank fee ( 0. Factoring Factoring provides resources to finance receivables as well as facilitates the collection of receivables. their effective pre-tax cost/interest yield = { (Face Value ± Net amount realised) / (Net amount realised) }x{(360) / (Maturity period) } where net amount realised = Face value ± discount ± issuing and paying agent (IPA) charges that is. Started operations since the beginning of 1997.4 crore or more. GIC. dealing bank fee and fee for stand by facility. . The rate of discount also includes the cost of stamp duty ( 0.5% ). y The participants/investors in CPs can be corporate bodies. UTI. A2 ( Icra ).2%).4 crore. NRI¶s on non-repatriation basis. Foremost Factors Ltd. 6.1 to 0. Although such services constitute a critical segment of the financial services scenario in the developed countries.y The maximum amount that a company can raise by way of CPs is 100% of the working capital limit. negotiable by endorsement and deliver at a discount rate freely determined by the issuer. y The CPs should be issued in the form of usance promissory notes.. LIC. rating charges. stamp duty. The first private sector factoring company. PR-2 ( Care ) and D-2 ( Duff & Phelps ) and its borrowal account is classified as standard asset. There are two bank sponsored organisations which provide such services: (i) SBI Factors and Commercial Services Ltd. banks. y The holder of CPs would present them for payment to the issuer on maturity. mutual funds.

iii) Collection facility of accounts receivable : The factor undertakes to collect the receivables on the behalf of the client relieving him of the problems involved in collection. the factor¶s obligation to the seller becomes absolute on the due date of the invoice whether or not the buyer makes the payment. and enables him to concentrate on other important functional areas of the business. ii) Maintenance/administration of sales ledger : The factor maintains the clients¶ sales ledger. However. the factor steps in to realise the sales. Realisation of credit sales is the main function of factoring services. This also enables the client to reduce the cost of collection by way of savings in manpower. Thus the factor works between the seller and the buyer and sometimes with the seller¶s bank together. iv) Credit Control and Credit Restriction : . in general terms. In addition. where the debts are factored without recourse. can be classified into five categories: i) Financing facility/trade debts : The unique feature of factoring is that a factor purchases the book debts of his client at a price and the debts are assigned in favour of the factor who is usually willing to grant advances to extent of.a) Definition : Factoring can broadly be defined as an agreement in which receivables arising out of sales or goods/services are sold by a firm ( client ) to the µfactor¶ ( a financial intermediary ) as a result of which the title of the goods/services represented by the said receivables passes on to the factor. say. if any of the debtor fails to pay the dues as a result of his financial inability/insolvency/bankruptcy. the main functions of a factor. Once a sale transaction is completed. the factor also maintains a customer-wise record of payments spread over a period of time so that any change in the payment pattern can be easily identified. In a full service factoring concept ( without resource facility ). time and efforts. Henceforth. sales accounting and debt collection from the buyer. the finance provided would become refundable by the client in case of non-payment of the buyer. the factor becomes responsible for all credit control. the factor has to absorb the losses. c) Functions of a Factor : Depending on the type/form of factoring. Where the debts are factored with recourse. 80% of the assigned debts. b) Mechanism : Credit sales generate the factoring business in the ordinary course of business dealings.

. Operationally. the factor assumes the risk of default in payment by the customer. the factor undertakes to purchase all trade debts of the customer without resource. factors can provide a variety of incidental advisory services to their clients. By virtue of their specialised knowledge and experience in finance and credit dealings and access to extensive credit information. In other words. his past payment record and value of goods sold by the client to the customer. It is also known as discount charge. The charge for collection and sales ledger administration is in the form of a commission expressed as a value of debt purchased. The commission for short term financing as advance part-payment is in the form of interest charge for the period between the date of advance payment and the date of collection date. v) Advisory Services : These services are a spin-off of the close relationship between a factor and a client. the line of credit/credit limit up to which the client can sell to the customer depends on his financial position. Within these limits. It is collected in advance.The factor in consultation with the client fixes credit limits for approved customers. vi) Cost of Services : The factors provide various services at a charge.