MMPF-001

Working Capital
School of Management Studies Management

BLOCK 1 CONCEPTS AND DETERMINATION 5

BLOCK 2 MANAGEMENT OF CURRENT
ASSETS 71
BLOCK 3 FINANCING OF WORKING
CAPITAL 185
BLOCK 4 WORKING CAPITAL MANAGEMENT:
ISSUES AND PRACTICES 259
COURSE DESIGN AND PREPARATION TEAM
Prof. K. Ravi Sankar Prof. K.V. Rao
Director, Former Vice Chancellor,
School of Management Studies, Acharya Nagarjuna University, Guntur
IGNOU, New Delhi

Prof. Varadraj Bapat Prof. C. P. Gupta

Indian Institute of Technology, Department of Financial Studies,
Mumbai University of Delhi, Delhi
Prof. Jayant Kumar Seal Prof. G.V. Chalam
Indian Institute of Foreign Trade, Former Dean,
Qutub Institutional Area Dept. of Commerce and Business Admn.
New Delhi Acharya Nagarjuna University, Guntur

Prof. Madhu Vij Prof. Kamal Vagrecha

Faculty of Management Studies, School of Management Studies,
University of Delhi, Delhi IGNOU, New Delhi
Prof. Pankaj Gupta Dr. Shital Jhunjhunwala
Centre for Management Studies, Department of Commerce,
Jamia Milia Islamia University of Delhi, Delhi
*Prof. P.N. Varshney Dr. Ritu Sapra
E-30, Greater Kailesh – III Department of Commerce,
Masjid Moth, New Delhi University of Delhi, Delhi
*Prof. R.S. Dhankar *Prof. M.S. Narasimhan
Faculty of Management Studies, Finance & Control Area
University of Delhi, South Campus, Indian Institute of Management,
New Delhi Bangalore

*Prof. M. Chandrasekhar *Prof. V.K. Bhalla

Indian Institute of Advanced Management Faculty of Management Studies
M.V.P. Colony, Visakhapatnam University of Delhi, Delhi
Course Editor Course Coordinator
Prof. K.V. Rao Prof. Anjali. C. Ramteke
School of Management Studies,
IGNOU, New Delhi

*Acknowledgement: Some parts of this course have been adapted from the earlier course MS 41:
Working Capital Management. The persons marked (*) were the original contributors and their pro-
file is as it was on the date of initial print.

MATERIAL PRODUCTION
Mr. Tilak Raj
Assistant Registrar
MPDD, IGNOU, New Delhi

September, 2022
© Indira Gandhi National Open University, 2022
ISBN:
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means, without permission in writing from the Indira Gandhi National Open University. Further
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 Content
Pages
BLOCK 1 CONCEPTS AND DETERMINATION 5
Unit 1 Conceptual Framework 7
Unit 2 Operating Environment of Working Capital 28
Unit 3 Determination of Working Capital 49
BLOCK 2 MANAGEMENT OF CURRENT ASSETS 71
Unit 4 Management of Receivables 73
Unit 5 Management of Cash 105
Unit 6 Management of Marketable Securities 128
Unit 7 Management of Inventory 154
BLOCK 3 FINANCING OF WORKING CAPITAL 185
Unit 8 Theories and Approaches 187
Unit 9 Payables Management 202
Unit 10 Bank Credit - Principles and Practices 213
Unit 11 Other Sources of Short Term Finance 239
BLOCK 4 WORKING CAPITAL MANAGEMENT: ISSUES AND
PRACTICES 259
Unit 12 Working Capital Management in SMEs 261
Unit 13 Working Capital Management in Large Companies 285
Unit 14 Working Capital Management in MNCs 300
Unit 15 Case Studies 316
 BLOCK 1
CONCEPTS AND DETERMINATION
BLOCK I CONCEPTS AND DETERMINATION
This course has been designed in such a manner that after having gone
through it you will be in a position to manage the working capital at your
workplace. Most of the firms carry on their business basically with two kinds
of assets, fixed assets and current assets. The management of current assets is
widely understood as working capital management; ipso facto, it also implies
the discussion on current liabilities.
In many manufacturing units, current assets form more than half of the
capital employed. Truly, greater part of the time of the manager is spent in
dealing with the issues concerning the management of working capital. In the
present course, Block-1 covers three units, which attempt to highlight issues
pertaining definition, constituents, operating environment and assessing
working capital requirements. The first unit covers aspects pertaining to
definitions, flow, significance and trends in working capital. The impact of
inflation on working capital is also discussed in this unit.

Operating Environment of Working Capital is discussed in the unit-2. This

unit covers changes in the monetary and credit policies, financial markets and
economic liberalization. A framework for assessing the working capital
requirements is discussed in unit-3. This unit also covers the practical aspects
of lending by commercial banks.
 Conceptual
UNIT 1 CONCEPTUAL FRAMEWORK Framework

Objectives
The objectives of this unit are to:
• Explain the various types of working capital and their behaviour.
• Examine the cyclical flow and characteristics of working capital.
• Discuss the significance and tools of planning for working capital.
• Find out the impact of inflation on working capital and finally.
• Analyse the trends in working capital in Indian companies.

Structure
1.1 Introduction
1.2 Definition of Working Capital
1.3 Constituents of Working Capital
1.4 Types of Working Capital
1.5 Cyclical Flow and Characteristics of Working Capital
1.6 Planning for Working Capital
1.7 Working Capital and Inflation
1.8 Trends in Working Capital
1.9 Summary
1.10 Key Words
1.11 Self-Assessment Questions
1.12 Further Readings

1.1 INTRODUCTION
Financial management can be divided into two major parts as the
management of long-term capital and the management of short-term funds or
working capital. The management of working capital which constitutes a
major area of decision-making for financial managers is a continuous
function which involves the control of every ebb and flow of financial
resources circulating in the enterprise in one form or another. It also refers to
the management of current assets and current liabilities. Efficient
management of working capital is an essential pre–requisite for the
successful operation of a business enterprise and improving its rate of return
on the capital invested in short-term assets. As a matter of fact, the
operational efficiency of a business unit is solely dependent on the prudent
management of working capital.

Virtually every business enterprise requires working capital to pay-off its

short-term obligations. Moreover, every firm needs working capital because
it’s not possible that production, sales, cash receipts and payments are all
7
Concepts and instantaneous and synchronised. There elapses certain time for converting
Determination
raw materials into finished goods: finished goods into sales and finally
realisation of sale proceeds. Hence, funds are required to support all such
activities in the firm. A number of terms like working funds, circulating
capital, temporary funds are used synonymously for working capital.
However, the expression, Working Capital, is preferred by many due to its
popularity and simplicity.

1.2 DEFINITION OF WORKING CAPITAL

Working capital may be defined in two ways, either as the total of current
assets or as the difference between the total of current assets and total of
current liabilities.

Like, most other financial terms the concept of working capital is used in
different connotations by different writers. Thus, there emerged the following
two concepts of working capital.
i) Gross concept of working capital
ii) Net concept of working capital

Gross Concept:

No special distinction is made between the terms total current assets and
working capital by authors like Mehta, Archer, Bogen, Mead and Baker.
According to them working capital is nothing but the total of current assets
for the following reasons:

i) Profits are earned with the help of the assets which are partly fixed and
partly current. To a certain degree, similarity can be observed in fixed
and current assets in that both are partly borrowed and yield profit over
and above the interest costs. Logic then demands that current assets
should be taken to mean the working capital of the corporation.

ii) With every increase in funds, the gross working capital will increase
while according to the net concept of working capital there will be no
change in the funds available for the operating manager.

iii) The management is more concerned with the total current assets as they
constitute the total funds available for operating purposes than with the
sources from which the funds came, and that

iv) The net concept of working capital had relevance when the form of
organisation was single entrepreneurship or partnership. In other words a
close contact was involved between the ownership, management and
control of the enterprise and consequently the ownership of current and
fixed assets is not given so much importance as in the past.

Net Concept
Contrary to the aforesaid point of view, writers like Smith, Guthmann and
Dougall. Howard and Gross, consider working capital as the mere difference
between current assets and current liabilities. According to Keith. V. Smith, a
8
broader view of working capital would also include current liabilities such as Conceptual
Framework
accounts payable, notes payable and other accruals. In his opinion, working
capital management involves the managing of individual current liabilities
and the managing of all inter-relationships that link current assets with
current liabilities and other balance sheet accounts. The net concept is
advocated for the following reasons:
i) in the long-run what matters is the surplus of current assets over current
liabilities.
ii) it is this concept which helps creditors and investors to judge the
financial soundness of the enterprise.
iii) what can always be relied upon to meet the contingencies is the excess of
current assets over current liabilities, since it is not to be returned; and
iv) this definition helps to find out the correct financial position of
companies having the same amount of current assets.
In general, the Gross concept is referred to as the Economics concept, since
assets are employed to derive a rate of return. What rate of return is generated
by different assets is more important than the analysed difference between
assets and liabilities. On the contrary, the net concept is said to be the point
of view of an accountant. In this sense, working capital is viewed as a
liquidation concept. Therefore, the solvency of the firm is seen from the
point of view of this difference. Generally, lenders and creditors view this, as
the most pertinent approach to the problem of working capital.

1.3 CONSTITUENTS OF WORKING CAPITAL

No matter how, we define working capital, we should know what constitutes
current assets and current liabilities. Let us refer to the Balance Sheet of
Lupin Laboratories Ltd. for this purpose.

Current Assets: The following are listed by the Company as current assets:

1) Inventories:
a) Raw materials and packing materials
b) Work-in-progress
c) Finished/Traded goods
d) Stores, Spares and fuel
2) Sundry Debtors:
a) Debts outstanding for a period exceeding six months
b) Other debts
3) Cash and Bank balances:
a) With Scheduled Banks
i) in Current accounts
ii) in Deposit accounts

9
Concepts and b) With others in
Determination
i) Current accounts
4) Loans and advances:
a) Secured Advances
b) Unsecured (considered good)
i) Advances recoverable in cash or kind for value to be
received
ii) Deposits
iii) Balances with customs and excise authorities
Current liabilities: The following items are included under this category.

i) Current Liabilities:
a) Sundry creditors
b) Unclaimed dividend warrants
c) Unclaimed debenture interest warrants
ii) Short-term C redit:
a) Short term loans
b) Cash credit from banks
c) Other short-term payables
iii) Provisions:
a) For Taxation
b) Proposed Dividend
i) on preference shares
ii) on equity shares
Besides, items like prepaid expenses, certain advance payments are also
included in the list of current assets. Similarly, bills payable, income received
in advance for the services to be rendered are treated as current liabilities.
Nevertheless, there is difference of opinion as to what is current. In the strict
sense of the term, it is related to the, operating cycle, of the firm and current
assets are treated as those that can be converted into cash within the operating
cycle. The period of the operating cycle may be more or less compared to the
accounting period of the firm. In case of some firms the operating cycle
period may be small and in an accounting period there can be more than one
cycle. In order to avoid this confusion, a more general treatment is given to
the, currentness, of assets and liabilities and the accounting period (generally
one-year) is taken as the basis for distinguishing current and non-current
assets.

1.4 TYPES OF WORKING CAPITAL

Sometimes, working capital is divided into two varieties as:
i) Permanent working capital
ii) Variable working capital
10
Permanent Working Capital: Though working capital has a limited life and Conceptual
Framework
usually not exceeding a year, in actual practice some part of the investment in
that is always permanent. Since firms have relatively longer life and
production does not stop at the end of a particular accounting period, some
investment is always locked up in the form of raw materials, work-in-
progress, finished stocks, book debts and cash. The investment in these
components of working capital is simply carried forward to the next year.
This minimum level of investment in current assets that is required to
continue the business without interruption is referred to as permanent
working capital. While suggesting a methodology for financing working
capital requirements by commercial banks, the Tandon committee has also
recognised the need to maintain a minimum level of investment in current
assets. It referred them as, hard core current assets. The Committee wanted
the borrowers to meet this portion of investment out of their own sources and
not to depend on commercial banks.
Variable Working Capital: This is also known as the circulating or
transitory working capital. This is the amount of investment required to take
care of the fluctuations in the business activity. While permanent working
capital is meant to take care of the minimum investment in various current
assets, variable working capital is expected to care for the peaks in the
business activity. While investment in permanent portion can be predicted
with some probability, investment in variable portion of working capital
cannot be predicted easily as sudden changes in the business activity cause
variations in this portion of working capital.

1.4.1 Working Capital Behaviour

One of the implications of the division of working capital into two types is to
understand its behaviour over a period of time. Investment in working
capital is related to sales volume. A variation in sales volume over time
would consequently bring about a change in the investment of working
capital. This is said to vary depending upon the type of working capital.
These variations with respect to different types of firms are presumed to vary
as indicated in Fig. 1.1

Figure 1.1 exemplifies the behaviour of different types of working capital in

diverse firms affected by seasonal and cyclical variations in production or
sales. In case of non-growth, non-seasonal and non-cyclical firms, all the
working capital can be considered permanent as shown in (A). Similarly,
growing firms require more working capital over a period of time, but
fluctuations are not assumed to occur. As such, in this case also, no variable
portion of working capital is present. In the third case (growing seasonal and
non-cyclical firms), there are two types of working capital. On the contrary,
in case of growing, seasonal and cyclical firms, all the working capital is
assumed to be of varying type.

11
Concepts and
Determination

Fig. 1.1: Behaviour of Working Capital

Activity 1.1
Mention the points of differentiation between
i) Gross concept and Net concept
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
..............................................................................................................
ii) Permanent working capital & Variable working capital
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
12
 Conceptual
1.5 CYCLICAL FLOW AND CHARACTERISTICS Framework
OF WORKING CAPITAL
For every business enterprise there will be a natural cycle of activity. Due to
the interaction of the various forces affecting the working capital, it
transforms and moves from one to the other. The role of the financial
manager then, is to ensure that the flow proceeds through different working
capital stages at an effective rate and at the appropriate time. However, the
successive movements in this cycle will be different from one enterprise to
another, based on the nature of the enterprises. For example:

i) If the enterprise is a manufacturing concern, the cycle will run something

like:Cash→(buying) →Raw Materials→(production)→Finished Goods→
(sales on credit) Accounts Receivable→(Collections) →Cash.
ii) If the enterprise is purely a Retailing Company and one, which has no
manufacturing problem the cycle is shortened as:
Cash→(buying) →Merchandise→ (Sales) →Accounts Receivables→
(Collections) → Cash.
iii) If the enterprise is a purely financing enterprise, the cycle is still shorter
and it can be shown as:

Cash→ (sanction of loans) →Debtors→ (collections) →Cash.

But in real business situations, the cyclical flow of working capital is not
simple and smooth going, as one may be tempted to conclude from these
simple flows. This cyclical process is repeated again and again and so do the
values keep on changing as they move through the cash to cash path. In other
words the cash flows arising from cash sales and collections from debtors
will either exceed or be lower than cash outflows represented by the amounts
spent on materials, labour and other expenses. An excess cash outflow over
cash inflow is a clear indication of the enterprise having suffered a loss. Thus
it is apparent, that the amount of working capital required and its level at any
particular time will be governed directly by the frequency with which this
cash cycle can be sustained and repeated. The faster the cycle the lesser will
be the investment needed in working capital.

Form the aforesaid discussion, one can easily identify three important
characteristics of working capital, namely, short life span, swift
transformation and inter–related asset forms and synchronization of activity
levels.

1. Short-life Span
Components of working capital are short-lived. Typically their life span
does not exceed one year. In practice, however, some assets that violate
this criterion are still classified as current assets.
2. Swift Transformation and Inter-related Asset Forms
In addition to their short span of life, each component of the current
assets is swiftly transformed into the other assets. Thus cash is utilised to
replenish inventories. Inventories are diminished when sales occur, that 13
Concepts and augment accounts receivable and collection of accounts receivable
Determination
increases cash balances. So a natural corollary of this quick
transformation is the frequent and repetitive decisions that affect the
level of working capital and the close interaction that exists among the
members of the family of working capital. The latter entails the
assumption that efficient management of one asset cannot be undertaken
without simultaneous consideration of other assets.
3. Assets Forms and Synchronization of Activity Levels
A third characteristic of working capital components is that their life
span depends upon the extent to which the basic activities like
production, distribution and collection are non-instantaneous and
unsynchronized. If these three activities are only instantaneous and
synchronized, the management of working capital would obviously be a
trivial problem. If production and sales are synchronized there would be
no need to have inventories. Similarly, when all customers pay cash,
management of accounts receivable would become unnecessary.

1.6 PLANNING FOR WORKING CAPITAL

Planning provides a logical starting point for many of the decisions. It is very
much true for working capital decision also. Unless, we plan for procurement
and effective use we will not be in a position to get best out of working
capital. In a way, effective planning leads to appropriate allocation of the
resources among different components of working capital. Drawing a
distinction of the kind of Peter F. Drucker, between efficiency (doing things
right) and effectiveness (doing right things), planning clearly embraces the
latter. It is for this reason planning for working capital is considered highly
appropriate and inclusive of the present discussion on conceptual
framework.

While planning should logically begin at the top of the organisational

hierarchy, responsibility for planning exists at all levels within the
organisation. While working capital planning is a part of financial planning,
the responsibility permeates among different managers within the
organisation responsible for managing different components of working
capital. At the level of planning for individual components of working capital
persons like materials manager, credit manager and cash manager are
involved. However, the overall responsibility for co-ordinating the planning
of working capital typically rests with the top management.

1.6.1 Tools of Planning for Working Capital

It should be interesting to know how to identify the relevant tools for
completing the planning exercise. Treating the planning for working capital
as part of financial planning, we can note down the following tools of
analysis with respect to time- frame.

a) Short-term Planning – Cash Budgeting

b) Medium-term Planning – Determination of appropriate levels of
14 working capital items
c) Long-term Planning –Projected pay outs and returns to shareholders in Conceptual
Framework
terms of CVP and funds flow analysis.
Cash budget: In the short term cash budgeting is considered a handy device
for planning working capital. The use of cash budget technique as a means of
determining the size of the cash flows is considered superior to the use of
proforma balance sheets or judging by the past experience. A cash budget
is comparison of estimated cash inflows and outflows for a particular period
such as a day, a week, a month, a quarter or year. Typically Cash budget is
designed to cover one–year period and the period covered is sub-divided into
intervals. It can be prepared in various ways like the one based on cash
receipts and disbursements method, or the adjusted net income method, or the
working capital differential method.

The budgeting process begins with the beginning balance to which are added
expected receipts. This amount is reached by multiplying expected cash
receipts by the probability distribution that will prevail during the budgetary
period. If outlays exceed the beginning balance plus anticipated receipts, the
difference must be financed from external sources. If an excess exist,
management must make a decision regarding its disposal either in terms of
investing in short-term securities, repaying the existing debts or returning the
funds to the share-holders.

The preparation of the cash budget helps management in many ways.

Management will be able to ward off the disadvantages of excessive
liquidity, since there will be information on how and when such cash results
in. Similarly, it will be able to contact different sources of finance to tide over
a situation of cash shortage and can avoid rushing to obtain finance at
whatever cost. It allows the management to relate the maturity of the loan to
the need and determine the best source of funds, since the information
furnished by the budget reflects the amounts and time for which funds are
needed. Further, cash Budget establishes a sound basis for controlling the
cash position.

Of the several methods of preparing the cash budget, Receipts and Payments
method is popular among many undertakings. More so the preparation of
cash budgets in the organisations is an integral part of the budgetary process,
since the whole of the budgetary structure is divided into revenue budgets,
expenditure budgets and cash budgets. Cash budget was prepared by the
organisations by borrowing figures from various other budgets such as the
following:

i) Production budgets.
ii) Sales budget.
iii) Cost of production estimates with its necessary subdivisions for
example.
a) materials purchase estimates:
b) labour and personnel estimates:
c) plant maintenance estimates: etc.
iv) Manpower budget. 15
Concepts and v) Township and welfare estimates
Determination
vi) Profit and loss estimates.
vii) Capital expenditure budget.

Thus, cash budget is prepared as a means of identifying the past cash flows
and determine the future course of action. Cash budgets, generally are
prepared by all enterprises on yearly basis having monthly break–ups.

Medium-term Planning: In the medium term, determining appropriate level

of working capital is considered a focal point. In unit 3 of this course on
‘Determination of working Capital’, we have discussed in detail the
following three approaches to determine optimum investment in working
capital.
1) Industry Norm Approach
2) Economic Modelling Approach
3) Strategic Choice Approach

Therefore, students are advised to refer to that particular unit and hence
discussion on them is not repeated here.
CVP Analysis: As a measure of long term planning, macro-level techniques
like C-V-P and Funds Flow are considered helpful in making an effective
planning. These are helpful not only for working capital planning but also for
the entire financial planning. At the level of working capital planning, we are
required to establish relationships between costs; volume and profits. Though
the regular break-even point is used to determine that level of sales or
production which equals total costs, in the area of working capital, we can be
cautious about the costs and revenues akin to working capital items such as
inventory, receivables and cash. Firms often face a dilemma of whether to
place an order to keep a particular level of inventory or not and whether a
customer be provided credit or not. These matters can be effectively dealt
with orientation towards the C-V-P relationships.

In this context, a distinction may be made between cash break-even point and
profit break-even point, which represents liquidity and profitability
respectively. Cash break-even point, which is defined as that level of sales
per period for which sales revenue just equals the cash outlays associated
with the product or business. This kind of an analysis helps in focusing on the
areas of cash deficit and cash surplus leading to better liquidity management.
When we appreciate the fact that working capital is a liquidation concept, the
utility of CVP concept in making better exercise in planning for working
capital, needs no special emphasis.

Funds Flow: Funds flow is yet another tool used in the long run to analyse
the financial position of a company. Though the term funds can be
understood to include all financial resources, preparation of funds flow
statements on working capital basis are more common in finance. The
preparation of such flow statements gives an idea as to the movement of
funds in the organisation. The particulars relating to the funds generated from
operations and changes in net working capital position are highly relevant in
16
this analysis. A firm’s capacity to pay off its current debts depends mainly on Conceptual
Framework
its ability to secure funds from operations. The prime objective of funds flow
statement (prepared on the basis of working capital movements) is to show
the ebb and flow of funds through working capital and to shed light on
factors contributing to the movements. As a matter of fact, the internal
movement of wealth (to a large extent) usually takes place among working
capital items. An analysis of these movements therefore would provide an
understanding of the efficiency of working capital management.

Whereas, the schedule of working capital is designed to measure, the flow of

funds through working capital. For that matter, one has to ascertain changes
in current assets and current liabilities during the two balance sheet dates and
record variations in working capital. This would help in identifying the net
changes. i.e., increases and decreases in working capital position.

1.7 WORKING CAPITAL AND INFLATION

Inflation, which is commonly indicated by the rise in prices of goods and
services, is so rampant in the world that no economy is far off from its
deleterious effects. Inflation has been experienced by almost all the countries
in the world irrespective of their political system and the stage of
industrialisation. The fact is that, over the last two decades, annual rates of
inflation in excess of two to three percent have become common all over
the world.

In India, the rate of inflation was more grievous than in many other countries,
and the wholesale prices rose by almost 32 percent during 1956-61, by
slightly less than 30 percent during 1961-66, and 25 percent during the
Annual Plan periods (1966-69). Besides fluctuations the annual rate of rise in
the wholesale price was exceptionally high and in 1974-75, almost alarming.
Inflation rate based on Wholesale Price Index (WPI) averaged around 9 per
cent during 1970-71 to 1990-91. Again it touched the highest level of the
decade in 1991-92 at 16.7 percent, when the economic activity was at its
lowest ebb. Consequent upon the reforms, there has been some recovery in
the economy and the rate of inflation has come down to even 2 percent
during 1998-99, threatening the regime of deflation. Nevertheless, there is no
consistency in the performance of the economy. Again the rate of inflation is
moving towards an average of 5-6 percent during the present times (two
thousand twenties). Alongside these indices there are some hidden
inflationary potentials which are not apparent. Prominent among these are
generous subsidies, changing international prices of crude oil and petroleum
products and the administered prices for certain other products. Now that the
Government of India has freed the fixation of prices of petroleum products,
oil companies are fixing rates on daily basis. The cost of diesel and petrol
touching around Rs.100 per litre. The irony of the situation is that the prices
in India are shooting up day by day, even though the prices of crude in the
international markets are decelerating. The combined impact of these factors
is definitely seen on the inflation. The impact of inflation on working capital
could be understood in the following manner.

17
Concepts and 1.7.1 Size of Working Capital
Determination
Inflation causes a spurt in the prices of input factors like raw materials,
labour, fuel and power, even though there is no increase in the quantum of
such input factors used. Secondly inflationary conditions by providing
motivation for higher profits induce the manufacturers to increase their
volume of operations. High profits and high prices create further demand
thus, leading to further investments in inventories, receivables and cash. The
cycle, thus continues for a long time, entailing the finance manager to arrange
for larger working funds after each successive increase in the volume of
operations. Thirdly, companies also tend to accumulate inventories during
inflation to reap the speculative profits. This kind of blocking up of funds, in
turn necessitates enterprise to maintain larger working capital funds. Finally,
the existing financial reporting practices of firms on the basis of historical
costs as per the companies Act and Income Tax Act are also responsible, for
the reduction in the size of working capital finance. During the period of
inflation, since historical costs set against the current prices and inventories
are valued at current prices, higher profits would be reported. The reporting
of inflated profits creates two aberrations. The company has to pay higher
taxes on the inflated profit figure though much of it is unrealised and if the
company also declares the remaining profits as dividends, it leads to
distribution of dividends out of capital and eventually reduces the funds
available to the company for operations in inflationary years owing to
escalation in cost of inputs, increase in the volume of operations,
accumulation of speculative inventory and the adoption of historical cost
accounting system.

1.7.2 Availability of Working Capital

Besides the problem of increased demand for funds there would be a
reduction in the availability of such funds associated with higher costs
during inflation. There would be no problem if the working capital funds are
available to an unlimited extent at a reasonable cost, regardless of the
economic condition prevailing in the economy. In reality, the situation is
completely the opposite as both internal and external sources of funds for
financing working capital become scarce.

As pointed out earlier, during inflation the availability of internal sources gets
reduced because of the maintenance of records on historical cost basis. On
the other hand, the position with regard to external sources of funds is equally
disheartening. The rapid increase in inflation will give rise to the formulation
of tight money policy by the Reserve Bank of India with a view to restricting
the flow of credit in the economy. Consequently, the extension of credit
facilities from banks become extremely limited. Further, the diversion of
bank funds to priority sectors, after nationalisation has made it more difficult
to raise funds from banks.

Till recently, companies depended heavily on public deposits and debentures

for meeting their working capital requirements. Their availability however
was reduced due to the restrictions imposed by the Reserve Bank of India
(RBI) on the companies for the mobilisation of deposits from public,
18
particularly since 1978. Further the advent of Government companies into the Conceptual
Framework
capital market for accepting public deposits made it more difficult to attract
funds from the public. In view of failure of many companies in the recent
past (2020s) in meeting the payment obligations on debentures, raising
resources through this method for working capital became extremely
difficult.
Coming to the trade credit, one must note that it may not be available for long
periods, and the suppliers of goods tighten the credit facilities during
inflationary period. The issue of long term loans may also be slackened, as
the investors would be less attracted by investments offering a fixed return
like debentures and preference shares. This is so because in terms of
purchasing power the principal amount of investment as well as the interest
would dwindle. Thus, these restrictions and limitations on the availability of
working capital from internal and external sources makes it difficult for the
finance manager to raise funds during inflation.

1.7.3 Components of Working Capital

It may be interesting at this stage of the analysis to consider the impact of
inflation on the components of working capital, namely, inventory,
receivables and cash.

Inventory
Not many understand fully the impact of inflation on the management of
inventory. Inflation affects the decisions in respect of inventory in many
ways, namely;

i) It leads to over-investment in inventory.

ii) It results in shortages.
iii) It affects valuation of inventories; and
iv) It renders the traditional inventory control techniques ineffective.
During the periods of inflation when the prices rise rapidly, companies will
have an incentive to invest more heavily in inventory than is indicated by the
minimum cost calculation. If the management believes the price of an item
will increase by 10 per cent in the next month, substantially more of that item
may be ordered than normal. Of course, due to increase in inventory the
company may get speculative gain, but this speculative gain may be off-set
by the increase in taxes due to higher profit figures, reported in times of
inflation and higher carrying costs.

Another difficulty that the company is required to face is the material

shortages in the periods of inflation. It is not known whether inflationary
escalations result in shortages or shortages occur because of instability
caused by inflation. Whatever be the real source of the problem, companies
should be conscious of the price trends and accordingly re-evaluate their
internal purchasing and organisational systems.
Very few firms realise the impact of inflation on the valuation of inventory
and the extent to which it contributes to unrealised profits. In other words,
19
Concepts and inflation affects the valuation of inventories, affecting thereby the amount of
Determination
profits reported in the financial statements.

Not only inflation affects the inventory, but inflation itself is also increased
due to the inefficient management of inventory. Delivering the keynote
address at a National Convention on the subject of, ‘Curbing Inflation
through Effective Materials Management’, Shri P. J. Fernandes put forward
the following five propositions to show the impact of inflation on the
materials management.
a) The stocks which are held by the enterprises have a direct and immediate
relationship to general price levels.
b) The price level in any country is to a great extent determined by the cost
of production. The cost of production is to a great extent determined by
the cost of inputs. Hence, if the cost of inputs goes up, the cost of
production as well as the price level also goes up.
c) An effective system of materials management must necessarily result in
an increase in production.
d) The materials manager can have a total and absolute impact on
production outside his unit, and
e) It is the materials management, which can reduce the crushing burden of
credit expansion, and the money supply, which again will have a direct
and absolute impact on inflationary tendency.

Finally, it may be considered with the help of the following illustration how
inflation renders the traditional inventory control techniques ineffective.

Assumptions
1) Annual consumption Rs. 1,00,000
2) Economic Ordering Quantity Rs. 3,125
3) No of orders per year 32
4) Ordering cost Rs. 20 per order
5) Carrying cost Rs. 25 per cent
6) Lead time constant
7) Price rise 5 per cent per month.

The ordering and carrying costs would be as follows:

a) Ordering costs = 32 × 20 = Rs 640
3125 25
b) Carrying costs = Rs.390.63
2 100
c) Total costs = Rs. 640 + 390.63 = Rs 1030.63

If 32 orders are placed in a year, the distribution of the same in each month
and the material cost month-wise would be as given below:

20
 Conceptual
Total Material Cost Framework
No. of months No. of orders Material cost

1st. Month 2 3125 × 2 × 1.00 = 6,250.00

2nd Month 3 3125 × 3 × 1.05 = 9,843.75
3rd Month 3 3125 × 3 × 1.10 = 10,312.50
4th Month 2 3125 × 2 × 1.15 = 7,187.50
5th Month 3 3125 × 3 × 1.20 = 11,250.00
6th Month 3 3125 × 3 × 1.25 = 11,718.75
7th Month 3 3125 × 3 × 1.30 = 12,187.50
8th Month 2 3125 × 2 × 1.35 = 8,437.50
9th Month 3 3125 × 3 × 1.40 = 13,125.00
10th Month 3 3125 × 3 × 1.45 = 13,593.75
11th Month 3 3125 × 3 × 1.50 = 14,062.50
12th Month 2 3125 × 2 × 1.55 = 9,687.50
32 1,27,656,25

Based on the EOQ formula, if one places orders as shown in the example, the
total material cost comes to Rs. 1,27,656.25 (i.e. Material Cost + Ordering
Costs + Inventory Carrying Costs). In contrast, If the firm in question does
not apply the EOQ technique and simply resorts to buying at the single
stretch or lot buying, the total material cost would be only Rs. 1,12,520/- as
worked out below:
1) Quantity needed for the year = Rs. 1,00,000
2) No of orders = 1(one lot)
3) Ordering Costs = 1 × 20 = Rs. 20
4) Carrying Costs = 1,00,000/2 × 25/100 = 12,500
5) Material Cost = Rs. 1,00,000
6) Total Cost = 1,00,000 + 20 + 12,500 = Rs.1,12,520

Thus, it would appear that the conventional inventory control technique of

EOQ is not really valid under the assumed conditions.

Receivables
The effect of inflation on the receivables is felt through the size of investment
in receivables. The amount of investment in receivables varies depending
upon the credit and collection policies of the organisation. Evidently, during
the periods of inflation, the higher the amount involved in the receivables the
greater would be the loss to the company, since the debtor would be
paying cheaper rupees.
Likewise, the length of the time too makes the firm lose much in the
transaction. For instance, if the firm in the beginning made a credit sale of
about Rs. 1,00,000 with an allowed credit period of three months, assuming a 21
Concepts and 20 percent inflation in the economy, the amount the company receives in real
Determination
terms after the allowed credit period becomes to only Rs. 95,000. Here, even
considering the same time lag between delivery and realisation, as between
debtors and creditors, sundry debtors would create bigger problem than the
sundry creditors, because the declining value of sundry debtors would affect
adversely the anticipated profitability of the enterprise. Thus, the effect of
inflation varies in accordance with the quantum of receivables and the time
allowed to repay them.

Cash
Management of cash takes on an added importance during the periods of
inflation. With money losing value in real terms almost daily, idle cash
depreciates rapidly. A company that holds Rs.1, 00,000 in cash during 20
percent annual rate of inflation finds that the money’s real value is only Rs.
80,000 in terms of current purchasing power. Even more important, idle cash
is not earning any return. During inflationary periods, it is important that cash
is treated as an asset required to earn a reasonable return. The loss on the
excess cash may be off-set or partly mitigated, if it is invested to produce an
income in the form of interest earned. Obviously, if the rate of interest
exceeds the rise in the price level, the firm realises a gain equivalent to the
excess, or sustains a loss if it is vice versa. Further, the loss of the purchasing
power of excess cash is of particular concern, if the company sells debts or
fixed income securities with the intention of subsequently investing the
proceeds in fixed assets.

1.8 TRENDS IN WORKING CAPITAL

In order that we gain a better idea of the working capital, it is also necessary
to go into the working capital in Indian companies, besides having an idea of
the conceptual framework. For the purpose of analysing trends in working
capital, data is culled from the Database of Reserve Bank of India, pertaining
to Non-Government and Non-Financial Public Limited Companies. The list
of RBI comprises of a select companies numbering 16,045, belonging to
various industry groups. The readers can get a more comprehensive idea of
the trends in working capital in Indian industry, if they go through the
Database of the RBI through its Website: www.rbi.org.in

1.8.1 Size of Working Capital

Working capital, if taken, as the total of current assets increased from Rs.
27,27,407 crores in 2016-17 to Rs. 33,35,602 crores in 2018-19. In terms of
percentages, working capital worked out to about 35 percent of the total net
assets of the Indian companies (See Table-1.1). The implication of the study
of size is that the ratio of current assets to total assets provides a measure of
relative liquidity of the firm’s asset structure. The higher the ratio, the lower
would be the profitability and risk. In the sense that higher investment in
current assets not only locks up the funds that can be gainfully employed
elsewhere, but also necessitates the firm to incur additional costs in the
maintenance of such high volume of current assets.
22
An attempt is made to capture the position among diverse industries. An Conceptual
Framework
examination of this position has revealed that current assets as per cent of
total net assets stood high in the industries such as Jewellery, leather
products, chemical fertilizers and food products (See Table-1.2). It appears
that all traditional industries had higher amounts invested in working capital.
Naturally industries like real estate, computer services, accommodation
services, mining and quarrying required low working capital. This is evident
from the RBI Data also.

Further, the relation between current assets and current liabilities (as depicted
through current ratio) is sending a signal of poor liquidity. Accepting that a
2:1 relation between current assets and current liabilities as comfortable in
exhibiting adequate liquidity, the public limited companies have never been
closer to this standard. It was hovering between 1.0:1 and 1.1:1 during the
period 2016-19.

1.8.2 Constituents of Working Capital

In order to know the significance of each of the items of working capital, it is
better to decompose the total. Such an attempt is made both for current assets
and current liabilities. Among the current assets, trade receivables dominated
the total position. Almost half of the current assets are in the form of debtors
and advances (see Table-1.3). It is heartening to note that the dominant
position of inventories once has come down to only just 34.6 percent now.
Debtors can be considered more liquid than inventories. In that sense this
development can be considered a healthy feature of the Indian corporate
sector.

Among the current liabilities trade payables and other current liabilities have
occupied a prime place (see Table- 1.4), constituting around 60 percent. Bank
borrowings for working capital purposes have come down now to about 28
per cent, following the credit discipline exercised by the Reserve Bank, since
nineties. These trends give an idea of the behaviour of working capital in
Indian companies.

1.9 SUMMARY
This unit has aimed at providing a conceptual understanding of the issues
involved in working capital. Thus, it started with the discussion on definition
and ended with the trends in working capital in Indian companies. There is a
clear difference in the understanding of the concept of working capital among
accountants and economists. This unit has attempted to highlight this
aspect.
Similarly, what constitutes working capital is discussed to enhance //the
understanding of the readers. Though there is a broad consensus, there are a
few differences in identifying the constituents, particularly in the area of
investments and advance payments. Attempt has also been made to highlight
the significant characteristics of working capital. Working capital planning is
considered yet another issue, which engages the attention of corporate
managers. The discussion is further strengthened to incorporate matters on
23
Concepts and inflation and trends. At the end, a synoptic view is presented of the working
Determination
capital trends with the help of Database of RBI on Indian Corporate Sector.

1.10 KEY WORDS

Working Capital: Working capital is defined as the total of current assets or
as the difference between current assets and current liabilities.
Current Assets: The total of inventories, debtors, loans and advanced, cash
and marketable securities.
Current Liabilities: The sum of sundry creditors, unclaimed dividends short
term loans, bank credit and various types of provisions.
Permanent Working Capital: Minimum level of investment in current
assets required for production.
Variable working capital: Working capital which takes care of the
fluctuations in business activity.
Cash budget: A projection of estimated cash inflows and outflows.
CVP analysis: A measure of long term planning to study the relationship
among cost, volume and profit.
Funds flow : A tool to underline changes in the movement of funds.
Inflation: A phenomenon of rising prices.

1.11 SELF ASSESSMENT QUESTIONS

1) Distinguish between gross working capital and net working capital?
2) Why is working capital considered a liquidation concept?
3) Discuss the various types of working capital and trace out the behaviour
of working capital with respect to time?
4) What is the impact of inflation on working capital?
5) How do you plan for the working capital of an organisation? Choose
your own company as an example?
6) Refer to the Balance Sheets of a company known to you and analyse the
trends in working capital. How do you interpret them?

Table 1.1 : Select Working Capital Ratios of Non-Government, Non –

Financial Public Limited Companies in India

S. No. Ratio 2016-17 2017-18 2018-19

1. Current Ratio to 34.5 34.8 35.7
Total Net Assets
(%)
2. Current Assets to 1.1 1.0 1.1
Current Liabilities
(Times)

24
 Conceptual
3. Quick Assets to 51.8 49.5 51.1 Framework
Current Liabilities
(%)
4. Trade Payables to 30.2 31.6 29.7
Current Assets (%)
5. Inventories to Sales 15.0 14.9 14.6
(%)
6. Trade Receivables 15.3 15.6 14.9
(%)

Source: www.rbi.org.in//::// Data Releases PR – Reserve Bank of India, May 4, 2020.

Table – 1.2 : Current Assets to Total Net Assets (%) among diverse
industries of Non-Government, Non-Financial Public Limited
Companies

S. Industry No. of 2016-17 2017-18 2018-19

No. Companies
1. Mining & Quarrying 208 35.6 24.5 26.7
2. Manufacturing 6460 35.4 35.5 34.4
3. Food Products 699 48.4 49.6 49.1
4. Dairy Products 62 49.0 44.8 32.8
5. Sugar 71 43.3 42.7 48.7
6. Textiles 792 24.4 24.5 24.0
7. Wearing Apparel 206 43.4 44.4 46.1
8. Leather Products 62 66.6 68.7 69.7
9. Wood Products 62 49.1 41.7 49.6
10. Paper Products 168 28.8 30.5 33.1
11. Chemical Products 1152 39.2 39.4 39.5
12. Basic Chemicals 265 32.4 32.2 31.5
13. Chemical Fertilizers 46 61.5 53.6 50.9
14. Paints & Varnishes 36 47.4 44.3 45.2
15. Pharmaceuticals 469 38.1 40.1 41.2
16. Rubber & Plastic 318 38.3 38.7 37.4
Products
17. Tyres & Tubes 36 46.3 46.8 42.5
18. Plastic Products 220 33.9 34.0 34.7
19. Glass & Glass 41 33.0 33.4 37.0
Products
20. Ceramic Products 81 40.0 42.2 43.6
21. Cement & Cement 107 26.6 23.8 23.2
Products
25
Concepts and 22. Iron & Steel 568 28.1 37.1 27.6
Determination
23. Fabricated Metal 211 24.7 28.7 27.9
Products
24. Computer & 76 39.9 41.8 45.3
Electronic Equipment
25. Electrical Equipment 286 41.8 45.3 54.7
26. Machinery & 545 54.7 58.2 57.5
Equipment
27. Motor Vehicles & 125 29.9 29.5 32.8
Other Transport
Equipment
28. Jewellery 78 84.8 85.8 85.6
29. Air conditioning, etc. 445 18.7 21.3 21.6
30. Construction 1154 41.8 46.7 49.3
31. Services 7098 34.3 34.3 37.5
32. Wholesales & Retail 1706 48.7 48.4 48.1
Trade
33. Transport & others 313 30.9 32.9 33.4
34. Accommodation & 256 26.0 26.2 30.6
Others
35. Telecommunication 81 34.7 40.7 44.8
36. Computer Services 576 25.8 26.0 28.3
37. Real Estate 618 23.4 19.1 28.3
All Industries 16045 34.5 34.8 35.7

Source: www.rbi.org.in//::// Data Releases PR – Reserve Bank of India, May 4, 2020.

Table – 1.3 : Components of Current Assets of Select 16045 Non-

Government, Non-Financial Public Limited Companies
(In per cent)
S.No. Item 2016-17 2017-18 2018-19
1. Inventories 24.7 24.5 24.6
2. Trade Receivables 25.2 25.6 25.3
3. Short-term Loans & 17.9 17.9 18.0
Advances
4. Cash and Cash 9.7 9.2 9.5
Equivalents
5. Current Investments 14.2 13.1 12.0
6. Other Current Assets 8.3 9.7 10.6
Total Current Assets 100.0 100.0 100.0
(Rs. in Crore) (27,27,407) (29,81,160) (33,35,602)
Source: www.rbi.org.in//::// Data Releases PR – Reserve Bank of India, May 4, 2020.
26
 Table – 1.4 : Components of Current Liabilities of Select 16045 Non- Conceptual
Framework
Government, Non-Financial Public Limited Companies
(In per cent)

S.No. Item 2016-17 2017-18 2018-19

1. Short-Term Borrowings 29.4 28.3 28.8
2. Trade Payables 31.9 32.7 32.4
3. Short-Term Provisions 6.3 6.2 6.5
4. Other Current Liabilities 32.4 32.8 32.3
Total Current Liabilities 100.0 100.0 100.0
(Rs. in Crore) (25,87,712) (28,85,259) (30,55,686)
Source: www.rbi.org.in//::// Data Releases PR – Reserve Bank of India, May 4, 2020.

1.12 FURTHER READINGS

1) V.K. Bhalla, 2013, Working Capital Management, S. Chand Publishing.,
New Delhi.
2) Rao, K.V., 1990, Management of Working Capital, Deep & Deep
Publications, New Delhi.
3) Ramamoorthy, V.E., 1976, Working Capital Management,. IFMR,
Madras.
4) Dileep R. Mehta., 1974, Working Capital Management, Englewood
Cliffs, Prentice Hall.
5) Park and Gladson, 1963, Working Capital, Macmillan, New York.
6) Hrishkes Bhattacharya, Working Capital Management: Strategies and
Techniques, PHI Learning, 2014.
7) Sagner, James S. Working Capital Management: Applications and Cases,
Wiley, 2014.

27
Concepts and
Determination UNIT 2 OPERATING ENVIRONMENT OF
WORKING CAPITAL

Objectives
The objectives of this unit are to:

• Highlight the significance of scanning, operating environment of any

business
• Identify and discuss the operating environment relevant to the making of
working capital decisions.
• Explain the significant aspects of monetary and credit policies.
• Examine the impact of economic liberalisation on industry as a part of
operational environment.
• Survey the changing environment in financial sector.

Structure
2.1 Introduction
2.2 Monetary and Credit Policies
2.3 Financial Markets
2.4 Economic Liberalisation and Industry
2.5 Summary
2.6 Key Words
2.7 Self-Assessment Questions
2.8 Further Readings

2.1 INTRODUCTION
In our previous unit an attempt was made to provide you with a conceptual
framework in terms of understanding the definition, nature and components
of working capital. Further, a sketch was provided of the characteristics of
working capital. Tools for planning working capital and the impact of
inflation on working capital were also discussed along with major trends in
working capital that signify the importance of working capital to a Firm. This
discussion in the previous unit is expected to provide you a preliminary
understanding about the basic concepts.
Now in the present unit we will be dealing with the operating environment of
the working capital as analysed in the context of monetary, credit and
financial policies.
The term environment refers to the ‘surroundings’ or circumstances, which
affect the life of an object or individual. As applied to business establishments,
people talk of various types of environments like micro, macro or mega
environments. Some people also talk of internal and external environments.
28
Nevertheless, the term environment is meant, to a large extent, to signify the Operating
Environment of
surroundings or factors that are external to the firm, affecting the ability of Working Capital
the firm in achieving its desired objective. The nature of the environment is
such that the firm will have no control on the elements constituting the
environment. What the firm can do is to tailor its own policies and practices
in such a way so as to gain from the changes taking place in the environment.
These changes may pertain to economic, legal, social, cultural or ideological
aspects. Whatever be the aspect, the firm has to gear itself to meet the
challenges posed by the changing environment.

The significance of scanning the environment of business is trivial. After all,

businesses cannot be run in vacuum, they exist in a natural setting surrounded
by various elements in the society. The decisions of a manager are influenced
by the changes in these surroundings caused by the constituting elements.
The customers, the Government, the society within and outside the country
will also have their influence on the business decision-making. The value
system of the society, the rules and regulations laid down by the government,
the monetary and credit policies of the central bank, the trade, industrial and
fiscal policies of the government, the institutional set up available in the
country, the attitudes of foreign investors, NRIs, the ideological beliefs of the
political parties, etc., all constitute the environment system within which a
business firm is to operate.

The production schedules of the firm are to be restated if there is a change in

the preferences or attitudes of the customers, suppliers, competitors and the
import and export policies. Similarly, the firm may have to restructure its
financing pattern consequent upon the changes in the rates of interest and
conditions in the capital market. Same would be true in case of marketing and
personnel policies. As a matter of fact, several corporates are assuming
‘social responsibility functions’ on their own, mainly due to the changes in
the value system of the society and the fear of losing its confidence.
Environment, thus, has profound influence on business decision-making.
Students are advised to refresh themselves by having a glance at the contents
of MMPC-003: Business Environment.

As applied to working capital decisions, the following elements of environment

are considered relevant.
1) Changes in the Monetary and Credit Policies,
2) Changes in Inflation,
3) Changes in Financial Markets

2.2 MONETARY AND CREDIT POLICIES

During seventies after the economies have started experiencing high inflation
and low growth (a phenomenon called ‘stagflation’) economists have turned
their attention to the potentiality of the monetary policy in the economic
policy making. The relative importance of growth and price stability as the
objectives of monetary policy became the focus of attention in both
developed and developing economies. In a way, the objectives of monetary
29
Concepts and policy can be no different from the overall objectives of economic policy.
Determination
While some central banks consider monetary targeting as operationally
meaningful, some others focus on interest rates. Interestingly enough the
Reserve Bank of India Act, 1934 mandated that the RBI Shall strive to
regulate the issue of Bank notes and keeping of reserves with a view to
securing monetary stability in India and generally to operate the currency and
credit system of the country to its advantage. Whatever be the method,
growth with stability is attempted as the objective of monetary and economic
policy of India.

In the conduct of monetary policy, the following aspects become pertinent:

a) Money Supply
b) Bank Rate
c) CRR & SLR
d) Interest Rates
e) Selective Credit Controls
f) Flow of Credit

2.2.1 Money Supply

As a part of the policy exercise, monetary growth is targeted every year.
Policy measures are pronounced, so as to take care of this targeting exercise.
This is expected to maintain real growth and contain inflation. In this context,
the Central Bank specifies the order of expansion in broad money (known
popularly as M3 and comprises of currency with the public, demand and time
deposits with commercial banks, and other deposits with RBI) that would be
used as an intermediate target to realise the ultimate objective of the policy.
In the case of India, both output expansion and price stability are important
objectives; but depending on the specific circumstances of the year, emphasis
is placed on either of the two. Increasingly, it is being recognised that central
banks would have to target price stability since real growth itself would be in
jeopardy, if inflation rates go beyond the margin of tolerance. On a historical
basis, the average inflation rate’ in India (which had declined from 9.0
percent in 1970s to 8.0 percent in 1980s) went up markedly to a double-digit
level of 10.7 per cent during the first half of 1990s. Due to continuous and
unhindered effort towards putting inflation under control, it was maintained
at single digit for majority of the years during the twenties and later. During
the year 2021 (April-December), the Consumer Price Index – Combined
(CPI-C) moderated to 5.2 per cent from 6.6 per cent in the corresponding
period of 2020. Notably, the Food inflation came down significantly to just
2.9 per cent, as against 9.1 per cent. It is true that the prices of Food items
would be subjected to frequent variations due to short and excess supply; the
country could achieve stability even in this sector, due to the creation of
strong infrastructure in terms of network of cold storages, markets and
information sharing. The focus of monetary policy in recent years has,
therefore, been to bring down the inflation rate to a modest level. Monetary
growth is being moderated in such a way that the credit requirements for
productive activities are adequately met.
30
The Monetary Policy of India has an interesting story. Keeping in view of the Operating
Environment of
objective of planned development, the RBI also started aligning the Monetary Working Capital
Policy in tune with the same and thus focus on expansion of credit and
initiated measures to smoothen the flow of credit to every needy sector. In
order to achieve this objective, the Bank followed a policy of Multiple
Indicators (MI) Approach, wherein emphasis was placed more on interest
rates than on the factors that cause variations in the Money Supply. Perhaps,
it is for this reason that short-term interest rates emerged key instruments in
deciding the variations in Monetary Policy. This is quite evident in terms of
freedom extended to Banks and Financial Institutions in managing their
finances. Controls exercised hitherto in fixing the static CRR, SLR are made
more flexible and are kept at the levels low to make more money available to
banks to lend to the business and industry.

The key development in the setting of Monetary Policy in India has been the
constitution of Monetary Policy Committee (MPC), through an Amendment
made to the RBI Act, 1934 in 2016 to bring about more transparency and
accountability. Prior to the constitution of MPC, the RBI alone was the sole
agency to decide on the Monetary Policy. Now the responsibility is shifted to
MPC, which consists of three RBI officials and three outside experts
nominated by the Government of India.
A reflection of these changes in the Policy stance is evident from the figures
that constitute the vital statistics pertaining to Money Supply, Bank Credit,
Foreign Exchange Reserves, etc. The Broad Money (M3) which consists of the
following four components, stood around Rs.202,79,608 crore, registering an
increase of 7.6 per cent over the previous year ending March 31, 2021.
i) Currency with public (≈Rs.3018761 crore)
ii) Demand Deposits with Banks (≈Rs.2045194 crore)
iii) Time Deposits with Banks (≈Rs.15163972 crore)
iv) Other Deposits with RBI (≈Rs.51680 crore)

The Net Bank Credit to Government was also significant around Rs.6339925
crore at the end of March 11, 2022 up by 8.4 per cent over the previous year
ending March 31, 2021. The primary indicator which decides the expansion
in the economy is the flow of bank credit to industry. The Net Bank Credit to
commercial sector stood around Rs.124,22,531 crore by March 11, 2022,
registering a modest rise by 6.5 per cent over the previous year. The Net
Foreign Exchange Assets with Banks also are significant around
Rs.49,80,306 crore. All these figures indicate the size of the Indian Economy
and the major suppliers and demand units of the Money generated in the
Economy.

2.2.2 Bank Rate

The Bank Rate has been defined in Section 49 of the Reserve Bank of India
Act 1934, as the standard rate at which the bank is prepared to buy or
rediscount bills of exchange or other commercial papers eligible for purchase
under the Act. The significance of bank rate is that it indicates the rate at
which the public should be able to obtain accommodation on the specified 31
Concepts and types of paper from the commercial banks as well as the Central Bank. This
Determination
is expected to curb the tendency towards relatively high interest rates and
ensure satisfactory banking services and reasonable rates to the people.
Secondly, bank rate represents the basis of the rates at which people can
obtain credit. Thirdly, bank rate also has an important psychological value as
an instrument of credit control. In effect, a change in the bank rate is to make
the cost of securing funds from the Central Bank cheaper or more expensive,
bring about changes in the structure of market interest rates and serve as a
signal to the money market, business community and the public of the
relaxation or restrain in credit policy.

Nevertheless, the success of bank rate policy depends on the following:

1) That the bank rate of the Central bank should have a prompt and decisive
influence on money rates and credit conditions within its area of
operation;
2) That, there should be a substantial measure of elasticity on the economic
structure, in order that prices, wages, rents, production and trade might
respond to changes in money rates and credit conditions; and
3) That the international flow of capital should not be hampered by any
arbitrary restrictions and artificial obstacles.

As far as India is concerned, the use of bank rate as an instrument of credit

control is less frequent. During 1951- 74, Bank rate was changed nine times;
but was revised only thrice during 1975-96. More so, in majority of the cases,
bank rate has been used in conjunction with other instruments of credit
control to realise the needed effectiveness in the control exercise. It is, of late,
the RBI is taking measures to reactivate the Bank Rate and link it to the
interest rates of significance, so as to facilitate its emergence as the ‘reference
rate’ for the entire financial system. With effect from the close of business on
April 15, 1997, the Bank Rate was reduced from12 percent to 11 percent and
further to 10 percent w.e.f. June 25, 1997. Since then, the Reserve Bank
followed a Conscious Policy of Low Bank Rates. From the highest of 12.00
per cent, the Bank Rate came down presently to just 4.25 per cent (March
2022). This reduction in the Bank Rate signalled the beginning of a low
interest rate regime, as these downward movements resulted in similar
reductions in lending and deposit rates in the financial markets.
Developments in the external environment leading to speculative activity in
the Exchange market resulted in a change in the direction of interest rate
policy.

2.2.3 CRR and SLR

Variations in the reserve requirements is yet another credit control technique
used by a Central Bank. The Central Bank by this technique can change the
amount of cash reserves of banks and affect their credit creating capacity. It
may be applied on the aggregate outstanding deposits or on the increments
after a base date or even on certain specific categories of deposits. This has a
sure and identifiable impact as compared to Bank Rate changes or open
market operations. The two instruments under this category are:
32
1) Cash Reserve Ratio (CRR) Operating
Environment of
2) Statutory Liquidity Ratio (SLR) Working Capital

Under section 42(1) of the RBI Act, scheduled commercial banks were
required to maintain with the RBI, at the close of business on any day, a
minimum cash reserve on their demand and time liabilities. Similarly, banks
were required under section 24(2A) to maintain a minimum amount of liquid
assets equal to but not less than certain percentage of demand and time
liabilities.
Though the RBI did not use CRR and SLR as significant instruments of
credit control during the whole of the sixties, it started varying the ratios
since then actively. The implication of these variations is that when the ratio
is brought down it would release the funds that would have otherwise been
locked up for investment by the commercial banks. As per the Act, RBI is
empowered to vary CRR between 3 and 15 per cent. In tune with the
choosing of liberal Monetary and Credit Policy, RBI has been keeping every
threshold at its Minimum. The CRR, which was 15.0 per cent in 1990 was
brought down to just 5.0 per cent as part of implementing major Financial
Sector Reforms, based on the Narasimham Committee and was further
brought down to 3.0 per cent in October 2020.
Even though the obligation of banks is to maintain their liquid assets at a
minimum of 25 percent, in the light of the need to restrain the pace of
expansion of bank credit, the RBI has imposed a much higher percentage of
minimum liquid assets and in some cases to the extent of even 35 percent.
These measures have started impounding vast amount of resources of the
banks and encouraging governments [Central and State] to have an easy
access to bank credit. It also led to the shrinkage of resources available for
genuine credit purposes. In view of the strong opposition from the banks and
basing on the recommendations of the committee on “Financial Sector
Reforms”, RBI reduced the ceiling to its original level of 25 percent of the
Net Demand and Time Liabilities (NDTL). The banking system already holds
government securities of about 39 percent of its net demand and time
liabilities (NDTL) as against the statutory minimum requirement of 25
percent.
Table – 2.1: Major Monetary Policy Rates and Reserve Requirements
(In per cent)
Effective Bank Repo Reverse Marginal CRR SLR
Date Rate Rate Repo Standing
Facility
31-03-2004 6.00 6.00 4.75 --- 4.75 24.00
17-04-2012 9.00 8.00 7.00 9.00 4.75 24.00
01-08-2018 6.75 6.50 6.25 6.75 4.00 19.50
07-08-2019 5.65 5.40 5.15 5.65 4.00 19.50
27-03-2020 4.65 4.40 4.00 4.65 4.00 18.25
22-05-2021 4.25 4.00 3.35 4.25 4.00 18.00
Source: Compiled from the RBI Data available as on 15-09-2021.
(www.rbi.org.in/scripts/Data-Deployment.aspx) 33
Concepts and As could be seen from the table 2.1, there is perceptible deceleration in the
Determination
key rates maintained by the Central Bank. It is to be noted in this context that
the Indian Economy has undergone major reforms leading to the era of
Liberalization, Privatisation and Globalisation (LPG). Keeping these changes
in view, economy has been thrown open to private initiative and the
Government is seeking to withdraw its presence in business and industry.
Privatization of major Public Sector Enterprises during the year 2020 and
after is the testimony of the intention of the Government. Making available
credit to the maximum extent is the motto of the Government. Therefore,
policy measures are also kept in tune with this trend and philosophy.

The statutory liquidity ratio (SLR) to be maintained by all scheduled

commercial banks remains unchanged at a minimum of 25 percent of net
demand and time liabilities (NDTL) since October 1997. As a prudential
measure to strengthen the urban co-operative banks (UCBs), the proportion
of SLR holding in the form of Government and other approved securities to
NDTL has been increased in a phased manner. From April 1, 2003, all
scheduled UCBs have to maintain the entire SLR holding of 25 percent of
NDTL in government and other approved securities only. Similarly, Regional
Rural Banks (RRBs) were required to maintain their entire SLR holding in
government and other approved securities by March 31, 2003 with SLR
holdings of RRBs in the form of deposits with sponsor banks maturing
beyond March 31, 2003 being reckoned for the SLR till maturity. The
maturity proceeds of such deposits would have to be converted into
government securities for RRBs not reaching the 25 percent minimum level
of SLR in Government securities by that time. Like the other rates, the SLR
is also slashed to 18 per cent, since October, 2020 and the same is holding as
of now.

2.2.4 Interest Rates

Realising the fact that Bank Rate is not functioning as an effective tool of
credit control, RBI started influencing the cost of credit, through the changes
in interest rates. The RBI derived the authority to regulate the interest rates of
banks under sections 21 and 35a of the Banking Regulation Act, 1949. This
power covers both the advances and deposit rates. The rates on loans and
advances are controlled mainly in order to influence the demand for credit
and to introduce an element of discipline in the use of credit. This is generally
done by stipulating minimum rates of interest for extending credit against
commodities covered under selective credit control. Also, concessive or
ceiling rates of interest are made applicable to advances for certain purposes
or to certain sectors to reduce the interest burden and thus facilitate their
development. Further, the objectives behind fixing the rates on deposits are
to avoid unhealthy competition amongst the banks for deposits, keep the level
of deposit rates in alignment with the lending rates of banks, and aid in
deposit mobilisation.
In addition to RBI, certain other agencies also have the authority to fix rates
of interest for different types of financial activities. For instance, the
controller of capital issues (now abolished) used to fix the ceiling on coupon
rates on industrial debentures and preference shares. The Indian Banks
34
Association (IBA) had been fixing the ceiling on call rates since 1973, until Operating
Environment of
1988, when call rates were freed from the ceiling. The Government of India Working Capital
fixes the rate on treasury bills and long-term government securities. The
Government has significant influence in the fixation of interest rates on long-
term loans of Development Finance Institutions [DFIs]. This is how the rates
of interest are administered in India, leading to a large variety of multiple
and complex interest rates.

Realising the deficiencies of this administered system of rates of interest and

following the recommendations of the committee to Review the working of
Monetary System (under the Chairmanship of Chakravarty), RBI has started
rationalising the interest rate structure since 1991. One of the objectives of
this policy was to reduce the multiplicity of interest rates and to bring about a
simplification in their structure. Efforts are being made to eliminate all
criteria, other than the size of loan, while deciding the credit policy. Recent
policy changes in this regard include:

i) Interest rate on domestic term deposits with maturity of 30 days to one

year was linked to the Bank Rate; by stipulating interest rate on these
deposits as ‘not exceeding Bank Rate minus 2 percentage points per
annum’ from April 16, 1997;
ii) Bringing under the same ceiling the Non-Resident (External) (NRE)
Rupee term deposits with that of domestic term deposits;
iii) Allowing banks to announce a separate Prime Term Lending Rate
(PTLR) for term loans of three years and above;
iv) Making the banks to announce the maximum spread over the PLR for all
advances other than consumer credit.
v) Permitting banks to prescribe separate Prime Lending Rates (PLRs) for
loan and cash credit components and also separate spreads for both the
components.
vi) Permitting banks to provide foreign currency denominated loans to their
customers for meeting either their foreign currency or rupee
requirements;
vii) Freedom for banks to decide the rate of interest on post-shipment export
credit on medium and long-term basis.

In recent years, there has been a persistent downward trend in the interest
rate structure reflecting moderation of inflationary expectations and
comfortable liquidity situation. Changes in policy rates reflected the overall
softening of interest rates as the Bank Rate has been reduced in stages from
8.0 percent in July 2000 to 4.25 per cent in October 2021.
The Interest rate structure in India is very complex. The Hitherto followed
‘Administered Structure of Interest Rates’ is discontinued and the Banks and
Financial Institutions are free to decide both deposit and lending rates. The
lending rates fixed by the banks are generally based on the ‘Base Rate’
indicated by the RBI. The current Base Rate of RBI is between 7.40 and 8.80
per cent. This is taken as the standard by the Banks in fixing their lending
rates. This concept of base rate system was introduced by the RBI in July
35
Concepts and 2010 and is followed even now. It is also to be noted that this rate shall be
Determination
taken as the minimum and the interest rates may be fixed above this base rate.
However, there may be certain special category of loans to whom (like DRI
loans, loans to employees) this system may not be applicable.

As a matter of fact, there had been a dramatic shift in the interest rate regime
in India. Surprisingly a high-interest rate driven economy turned into a low
interest rate economy and trying to compete with the advanced countries in
keeping interest rates low. India has experienced a regime of ‘assured
returns’ in both the public sector and Mutual Fund divisions. All of a sudden,
it was felt by the stakeholders that the economy cannot continue with these
high and assured returns and slowly marched towards low interest rate
regime. The situation now is such that there is no assured income to the
retirees, to part their retirement benefits, safely and securely. It is appreciable
that there is a ‘Pension Fund Trust’ created by the Central Government to
come to the rescue of retirees for keeping their benefits in the Trust for an
assured reasonable return.

The theoretical maxim that there shall be perceptible degree of difference

between short-term and long-term interest rates has vanished. At times, short-
term bank deposits are yielding more revenue than long-term investments. In
fact, Banks are notably shy of accepting long-term deposits, beyond 5-years.

2.2.5 Selective Credit Controls

Central banks, generally, have a policy to use qualitative techniques in
addition to quantitative techniques of credit control. The most widely used of
the qualitative techniques are selective credit control and moral suasion.
While the general credit controls operate on the cost and total volume of
credit, selective credit controls relate to tools available with the monetary
authority for regulating the distribution or direction of bank resources to
particular sectors of the economy in accordance with the broad national
priorities considered necessary for achieving the set, developmental goals.
These control techniques have special relevance to developing countries
owing to the meagre supply of credit and the chance of credit being mis-
utilised for unproductive and speculative purposes. In exercise of the powers
conferred on it, the RBI may give directions of the following kind to the
banks generally or to any bank or a group of banks in particular.
a) the purposes for which advances may or may not be made;
b) the margins to be maintained in respect of secured advances;
c) the maximum amount of advances; and
d) the rate of interest and other terms and conditions subject to which
advances may be granted or guarantees may be given.

Almost since the middle of 1956, RBI has started exercising powers vested in
it. A number of commodities and products have been covered at one time or
the other. Some of the commodities, which had been under frequent controls,
are food grains, cotton, raw jute, oil seeds, vegetable oils, sugar, cotton yarn
and textiles.
36
However, the situation has changed recently. After the implementation of Operating
Environment of
new economic policy in 1991, there has been a phasing out of the selective Working Capital
credit controls. By the end of 1996, almost all the controls were virtually
eliminated. However, keeping in view of the need to check the inflation and
achieve price stability, there has been an attempt to ensure proper flow of
credit to certain sectors and tightening of credit flow to others. Banks are also
advised to vary the margin requirements. Special favour to MSMEs and
Export oriented units is always present. India, primarily being an Agrarian
economy, needs support to Agriculture and allied sectors. Ensuring proper
credit supply to these sectors, based on the cropping season and pattern,
needs no particular mention. One thing that is to be noted specially in this
regard is that RBI only gives directions and it is Banks that are required to
follow, and mostly these are advisory in nature.

2.2.6 Flow of Credit

The flow of credit, which is evident through the data on the ‘Sectoral
Deployment Bank Credit’ to diverse sectors, clearly reflects the liberalization
of the Indian Economy. The so called restrictions imposed on the flow of
credit prior to 1991, were all withdrawn and the Banks and other Financial
Institutions are now on ‘Centre Stage’ in deciding the ‘Size and Direction’ of
the flow of credit. The only limitation as at present pertains to the flow of
credit to certain ‘Priority Sectors’; mostly to ensure the supply of adequate
‘Food Grains’. For this reason RBI tries to ensure balance between ‘Food and
Non-Food Credit’. After all, people have to be alive, before they engage upon
the trade and industry.
As per the latest data (February, 2022) made available by the RBI on
‘Deployment of Bank Credit’ to different Sectors, the following major trends
are discernable. The data set of the RBI covers a group of 40 select scheduled
banks, accounting for about 94 per cent of the Non-Food Credit, deployed by
all the scheduled Commercial Banks (see Table 2.2).
Table-2.2 : Sectoral Deployment of Credit by Major Sectors (Outstandings)
(Rs. in Crore)
S.No. Sector 28-02-2020 26-02-2021 25-02-2022
1. Food Credit 65596 78206 68224
(0.6) (0.7) (0.6)
2. Non-Food Credit 10039270 10699536 11558783
(99.4) (99.3) (99.4)
3. Agriculture & 1208508 1312285 1448928
Allied Activities (11.9) (12.2) (12.5)
4. Industry 2914719 2945152 3135271
(28.4) (27.3) (27.0)
5. Services 2579931 2808122 2966593
(25.5) (26.1) (25.5)
6. Personal Loans 2685964 2944789 3306650
(26.6) (27.3) (28.4)
7. Gross Bank Credit 10104866 10774742 11627008
(100.0) (100.0) (100.0)
37
Concepts and The flow of credit to agriculture and allied sectors has been significant at
Determination
12.46 per cent of the gross bank credit registering an annual growth rate of
10.4 per cent in February 2022, compared to 8.6 per cent in previous year.
Credit to industry (which includes all types of Micro, Small, Medium and
Large enterprises) stood at Rs.31,35,271 crore, which constitutes about 26.96
per cent of the total gross bank credit. Even the credit to services (which
include Transport, Software, Tourism, Shipping, Aviation, Trade, etc.) also
stood high and prominent at Rs.29,66,593 crore; accounting for about 25.51
per cent.

Keeping in view of the need to support the efforts to revive the capital
market, banks were allowed to extend loans to corporates against shares held
by them to enable such corporates to meet the promoters’ contribution. The
margin and the period of repayment of such loans would be determined by
banks. Banks were also permitted to sanction bridge loans to companies
against expected equity flows for a period not exceeding one year, subject to
the guidelines approved by their respective boards. Taking into account the
changing scenario, banks were asked to review the existing arrangements for
financing trade and services. RBI directed banks to evolve a suitable method
of assessing loan requirements of borrowers in the service sector and report
the arrangements made in this regard.
It is clear from the foregoing discussion that the changes in the monetary and
credit policies influence working capital decisions in terms of the availability
of credit and cost of credit directly and through the ‘balancing of the
economy’ indirectly. For the benefit of students, the salient features of the
monetary and credit policy measures announced by RBI for the year 2021-22
are given in Appendix-I.

Activity 2.1
i) Bring out the Role of Monetary Policy Committee (MPC) in shaping the
Monetary Policy of the country.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
ii) Highlight the salient features of the latest monetary and credit policy
announced by RBI.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

38 .....................................................................................................................
 Operating
2.3 FINANCIAL MARKETS Environment of
Working Capital
The role of financial markets is paramount, in the mobilisation and allocation
of savings in the economy. They are the agencies that provide necessary
funds for all productive purposes. In addition, the role of financial markets is
increasingly becoming critical in transmitting signals for policy and in
facilitating liquidity management. They are regarded as an essential
adjunct to economic growth.
The real economy can be sound and productive only when financial markets
operate on prudent lines.

The main organised financial markets in India are:

i) the credit market, which is dominated by commercial banks;
ii) the money market with call money segment forming a sizeable proportion;
iii) equity and term lending market consisting of primary, secondary and
term lending segments;
iv) corporate debt market comprising PSU bonds and corporate debentures;
v) gilt-edged market for Government securities;
vi) housing finance market;
vii) hire purchase and leasing finance market, wherein the non-bank financial
companies (NBFCs) predominate;
viii) insurance market; and
ix) foreign exchange market.
In addition, there is an unorganised and informal finance market comprising
of money lenders in villages and indigenous bankers in towns/cities. All the
agencies constitute the financial sector of India.
In the recent past (since 1991) government has embarked upon effecting
major changes in the areas of industrial trade and exchange rate policies.
These changes are designed to correct the macro-economic imbalances and
effect structural adjustments with the objective of bringing about a more
competitive system and promoting efficiency in the real sectors of the
economy. Economic reforms in the real sectors of the economy will not
produce desired results, unless the former are supplemented by suitable and
effective financial sector reforms. With this end in view, the Government of
India has appointed a committee on the working of financial system of the
country in August 1991 under the chairmanship of M.Narasimham.
The committee was asked, inter alia, to examine the existing structure of the
financial system and its various components and to make recommendations
for improving the efficiency and effectiveness of the system with particular
reference to the economy of operations, accountability and profitability of
the commercial banks and financial institutions. The committee has
submitted its report in November 1991. Since the submission of the report,
the Government has taken several steps on different aspects of the
recommendations. The significant steps that were taken are:
39
Concepts and i) A strict criterion was evolved for companies that access securities
Determination
markets. The issuers of securities are required to meet certain standards
like the payment of dividend, minimum share-holding requirement, etc.
ii) The Securities and Exchange Board of India (SEBI) took several steps
for widening and deepening different segments of the market for
promoting investor protection and market development;
iii) The safety and integrity of the securities market were strengthened
through the institution of risk management measures, which included a
comprehensive system of margins, intra-day trading and exposure limits,
capital adequacy norms for brokers and setting up of trade/settlement
guarantee funds.
iv) Reforms in the secondary market focused on improving market
transparency, integrity and infrastructure.
v) FIIs were permitted to invest upto 10 per cent in equity of any company,
to invest in unlisted companies and to invest in debt securities without
any requirement for investment in equity. They were also permitted to
invest in dated government securities within the framework of guidelines
on FII investment in debt instruments.
vi) Government has also initiated measures to deepen and broaden the
government securities market and increase its liquidity.
vii) The earlier restriction that debt instruments of a corporate could be listed
only after its equity had been listed on any exchange was removed.
viii) Investment guidelines regarding the utilisation of funds of LIC were
revised. Since the LIC being privatized with a large scale disinvestment
through IPO, the organisation will have complete autonomy in the
deployment of funds, subject to the broad guidelines of IRDA.
ix) The Mutual Fund Regulations issued by SEBI in 1993 were further
revised in 1996 and are being amended from time to time and the latest
amendment taking place on January 25, 2022. Mutual Funds are now the
significant players in both primary and secondary markets with about
Rs.38.56 lakh crore Assets under Management (AUM) as on February
28, 2022.

2.4 ECONOMIC LIBERALISATION AND

INDUSTRY
The economic liberalisation programme initiated by the Government in the
early ninties has changed the face of industry, more particularly the dynamics
of financial environment. There has been a sea change in the organisational
structure and operations of the players in money and capital markets. The
distinction between long term financing and short-term financing is slowly on
the wane. Development Banks have converted themselves into ordinary
commercial banks. Deregulation of interest rates, emergence of a liberalised
capital market and increasing participation of banks in terms of financing
have significantly influenced the operations of development banks. With their
fray into the realm of working capital loans; the traditional divide into the
40
operational domain of development banks and commercial banks got blurred. Operating
Environment of
One of the implications of this development is that the hitherto privileged Working Capital
access to assured sources of low cost funds has disappeared. There has
already been an attempt to align all the forces to market, making the latter
decide the equilibrium between supply of and demand for funds.

The monetary policy framework has undergone changes over the recent
period in response to reforms in the financial sector and the growing external
orientation of the economy. The endeavour of the policy has been to enhance
the allocative efficiency of the financial sector, preserve financial stability
and improve the transmission mechanism of monetary policy by moving
from direct to indirect instruments. The stance of the monetary policy has
been to ensure provision of adequate liquidity to meet credit growth and
support investment demand in the economy, while continuing a vigil on the
movements in the price level and to continue with the present policy of
interest rate structure in the medium term.

On the fiscal front, the government expenditure has been cut in real terms.
The burnt has been borne by cuts in investments and expenditure on social
sector. There were large slippages in the fiscal correction. The rising deficits
on the revenue account are often cited as the main cause for the observed
phenomenon. Behind these lie the erosion of excise tax base, mounting
interest burden on public debt, growing subsidies and the rising cost of
wages and salaries. The expected buoyancy in the collection of GST has
been varying from the lowest of Rs.91,000 crore to the highest of Rs.
1,46,000 crore during the Financial Year 2021-22. The Central Government
is still struggling to make good the shortfall on this account to States.

On the external front, following the liberalisation, India devalued its currency
leaving an impact on the exports and imports. With an unsuccessful interlude
with exim scrips and dual exchange rate system; India went in for a unified
market determined exchange rate system. Correcting the exchange rate
valuation of the past was a major event on the reform process. The lower
exchange rate enhances the profitability of existing exports, more
importantly, it broadens the range of eligible exports. It makes imports more
costly and provides scope for import substitution, thus narrowing the range of
potential imports. The rupee is now convertible on current account, subject to
exchange rate risk. Some of the important components of capital account are
considerably liberalised.

Another dimension of the liberalisation on the external front is that the gates
for foreign investment were wide open. Foreign trade and foreign investment
appear to be mutually influential. Portfolio investments have become very
significant in several developing countries, including India. After
liberalization, India has turned to be a welcome destination to the Foreign
Direct Investment (FDI). The Government of India has also brought about
sweeping reforms in allowing all sectors under ‘Automatic Route’, including
Defence Sector in select areas. Following the ‘Make-in-India’ initiative, the
Government stepped up the FDI limit from 26% to 49% and then to 74%.
Some special concessions are also provided to NRIs permitting them to
invest upto even 100 per cent in Ventures like Air India. By virtue of all these
41
Concepts and measures, India scaled upto 9th position in 2014 from 15th position in 2013,
Determination
among countries that are all out in attracting FDI flow. As per the latest (09-
02-2022) data available on the flow of FDI into India, the country has
received a total of USD 54.1 billion during April-November 2021-22, as
against USD 81.97 billion in 2020-21. As a matter of fact, Covid-19 had
struck a severe blow on the international capital flows; making it difficult for
every country. An oasis in this kind of environment is the growing success of
Start-up units; whereby India alone could house about 95 Unicorns, out of the
total of about 300. A Unicorn is a privately held Start-up company, which is
valued at over $ 1 billion.

These developments produce some direct and some indirect effects on the
growth and development of Indian industry in the years to come. More
specifically, developments in the financial sector pose serious concerns for
the effective use of working capital by the industry.

Activity 2.2
Attempt to make out a case as to what extent the liberalized environment has
contributed to accelerate the flow of credit to industry?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

2.5 SUMMARY
It is important that every business unit understands its environment. The
nature of environment is such that the business units, will have no control on
the elements constituting the environment. Change in the environment may
necessitate the unit to tailor its own business policies so as to suit to the
environment. The customers, the Government, the society will exert their
influence on the decision making process of the business. Changes in the
value system, sometimes, may even force firms to pursue distant goals like
‘social responsibility’.

This unit considers changes in monetary and credit policies, inflation and
financial markets as pertinent for their influence on working capital
decisions. Monetary and credit policies consisting of variables like money
supply, bank rate, CRR, SLR, Interest rates, selective credit controls are
decided by the central bank of the country, having significant influence on
business decisions. More specifically, these are expected to influence the
availability and cost of business credit.

Realising the fact that inflation is a common phenomenon, there is a need to

care for the impact of inflation on business decisions. Inflation causes a
spurt in the prices of input factors like raw materials, labour, fuel and power.
It may also influence the behaviour of business units to go in for speculative
42 activities. Rapid increase in inflation may force the central bank to formulate
a tight, monetary policy, thus restricting for flow of credit to the business. Operating
Environment of
Further, inflation may effect working capital decisions leading to over- Working Capital
investment in inventory, under or over pricing of inventories, loss to the unit
in the collection of debts due to depreciation in the value of money. Idle cash
flowing through the organisation will add further problems to the unit in
terms of loss in the value of money in real terms.
Financial markets are the agencies that provide necessary funds for all
productive purposes. The stage of development of these markets has
profound influence on the supply and demand for funds. For, the Government
has taken up a reform exercise meant for improving the efficiency and
effectiveness of the system.

The sweep of the reforms is wide enough to cover every constituent of the
organised financial system such as the money market, credit market, equity
and debt market, government securities market, insurance market and the
foreign exchange market.

2.6 KEY WORDS

Environment: Surroundings or circumstances, which affect the life of an
object.
Broad Money: Sum of money in circulation, demand and time deposits with
commercial works and other deposits with RBI.
Bank Rate: The Rate at which the Central Bank is prepared to buy or
rediscount bills of exchange and other eligible securities of commercial
banks.
Cash Reserve Ratio: Minimum reserve maintained by commercial banks
with RBI.
Selective Credit Controls: Tools available with the Central Bank to regulate
the flow of credit.
Statutory liquidity Ratio: Minimum Reserve to be maintained by
commercial banks with themselves, as a percentage of demand and time
liabilities.
Financial Market: An agency that helps in the mobilisation of funds for
industry and trade.
Credit Policy: A statement indicating the measures contemplated for
ensuring effective flow of credit to the needy.

2.7 SELF ASSESSMENT QUESTIONS

1) Bring out the necessity for scanning Business Environment.
2) What is the Role of Central Bank in designing and implementing
monetary and credit policy?
3) Trace out the Interest Rate policy in India. Can you identify what would
be the impact of interest rates on financial decision making?
43
Concepts and 4) ‘Money Supply is the key factor that reflects the volume of trade in any
Determination
country, Discuss.
5) Illustrate with suitable examples the impact of inflation on working
capital management.
6) How do changes in financial markets influence business decision
making?
7) Elucidate the financial sector reforms undertaken in the recent past in
India. Do you think that there is any unfinished agenda?

2.8 FURTHER READINGS

1) Reddy, Y. V., ‘Monetary and Credit Policy- Continuity, Context,
Change and Challenges’, RBI Bulletin, Vol.LII, No.6, June 98.
2) Economic Survey. 2021-22.
3) Rangarajan, C, ‘Dimensions of Monetary Policy’, RBI Bulletin, Vol. LI,
No.2, Feb. 97.
4) Bhole, L.M., (1992), Financial Institutions and Markets, Tata McGraw
Hill, New Delhi.
5) Rao, K.V. & Venkataramaiah, B., 1991, Bank Finance to Industries,
Printwell, Jaipur.
6) Report of the Committee on Financial System, 1991.
7) Rao, K.V., 1990, Management of Working Capital in PEs, Deep & Deep
Publications, New Delhi.
8) De Kock, M.H., Central Banking, New Delhi, Universal Book Stall,
1984.
9) RBI, Reserve Bank of India - Functions and Working, Bombay, 1983.
10) Reddy, Y. V., Advice and Dissent: My Life in Public Service, Harper
Collins Publishers, Noida, 2017.
11) Raguram G. Rajan, (2017), I Do What I Do, Harper Collins Publishers,
Noida.
12) Chakraborty, S.K. and Others, 1976, Topics in Accounting and Finance,
Oxford University Press, Calcutta.

44
 Operating
Appendix-I: Monetary and Credit policy for the year 2021-22 Environment of
Working Capital
The Monetary Policy Committee (MPC) at its meeting today (February 10,
2022) decided to:

• keep the policy repo rate under the liquidity adjustment facility (LAF)
unchanged at 4.0 per cent.
The reverse repo rate under the LAF remains unchanged at 3.35 per cent and
the marginal standing facility (MSF) rate and the Bank Rate at 4.25 per cent.

• The MPC also decided to continue with the accommodative stance as long
as necessary to revive and sustain growth on a durable basis and continue to
mitigate the impact of COVID-19 on the economy, while ensuring that
inflation remains within the target going forward.
These decisions are in consonance with the objective of achieving the
mediumterm target for consumer price index (CPI) inflation of 4 per cent
within a band of +/- 2 per cent, while supporting growth.
The main considerations underlying the decision are set out in the statement
below:

Assessment
Global Economy
2. Since the MPC’s meeting in December 2021, the rapid spread of the
highly transmissible Omicron variant and the associated restrictions have
dampened global economic activity. The global composite purchasing
managers’ index (PMI) slipped to an 18 month low of 51.4 in January
2022, with weakness in both services and manufacturing. World
merchandise trade continues to grow. There are, however, headwinds
emanating from persistent container and labour shortages, and elevated
freight rates. In its January 2022 update of the World Economic Outlook,
the International Monetary Fund (IMF) revised global output and trade
growth projections for 2022 downward to 4.4 per cent and 6.0 per cent
from its earlier forecasts of 4.9 per cent and 6.7 per cent, respectively.
3. After reversing the transient correction that had occurred towards
endNovember, commodity prices resumed hardening and accentuated
inflationary pressures. With several central banks focused on policy
normalisation, including ending asset purchases and earlier than expected
hikes in policy rates, financial markets have turned volatile. Sovereign
bond yields firmed up across maturities and equity markets entered
correction territory. Currency markets in emerging market economies
(EMEs) have exhibited two-way movements in recent weeks, driven by
strong capital outflows from equities with elevated uncertainty on the
pace and quantum of US rate hikes. The latter also led to an increasing
and volatile movement in US bond yields.
Domestic Economy
4. The first advance estimates (FAE) of national income released by the
National Statistical Office (NSO) on January 7, 2022 placed India’s real
45
Concepts and gross domestic product (GDP) growth at 9.2 per cent for 2021-22,
Determination
surpassing its pre-pandemic (2019-20) level. All major components of
GDP exceeded their 2019-20 levels, barring private consumption. In its
January 31 release, the NSO revised real GDP growth for 2020-21 to (-)
6.6 per cent from the provisional estimates of (-) 7.3 per cent.
5. Available high frequency indicators suggest some weakening of demand
in January 2022 reflecting the drag on contact-intensive services from
the fast spread of the Omicron variant in the country. Rural demand
indicators – two-wheeler and tractor sales – contracted in December-
January. Area sown under Rabi up to February 4, 2022 was higher by 1.5
per cent over the previous year. Amongst the urban demand indicators,
consumer durables and passenger vehicle sales contracted in November-
December on account of supply constraints while domestic air traffic
weakened in January under the impact of Omicron. Investment activity
displayed a mixed picture – while import of capital goods increased in
December, production of capital goods declined on a year-on-year (y-o-
y) basis in November. Merchandise exports remained buoyant for the
eleventh successive month in January 2022; non-oil non-gold imports
also continued to expand on the back of domestic demand.
6. The manufacturing PMI stayed in expansion zone in January at 54.0,
though it moderated from 55.5 in the preceding month. Among services
sector indicators, railway freight traffic, e-way bills, and toll collections
posted y-o-y growth in December-January; petroleum consumption
registered muted growth and port traffic declined. While finished steel
consumption contracted y-o-y in January, cement production grew in
double digits in December. PMI services continued to exhibit expansion
at 51.5 in January 2022, though the pace weakened from 55.5 in
December.
7. Headline CPI inflation edged up to 5.6 per cent y-o-y in December from
4.9 per cent in November due to large adverse base effects. The food
group registered a significant decline in prices in December, primarily on
account of vegetables, meat and fish, edible oils and fruits, but sharp
adverse base effects from vegetables prices resulted in a rise in y-o-y
inflation. Fuel inflation eased in December but remained in double digits.
Core inflation or CPI inflation excluding food and fuel stayed elevated,
though there was some moderation from 6.2 per cent in November to 6.0
per cent in December, driven by transportation and communication,
health, housing and recreation and amusement.
8. Overall system liquidity continued to be in large surplus, although
average absorption (through both the fixed and variable rate reverse
repos) under the LAF declined from ₹8.6 lakh crore during October-
November 2021 to ₹7.6 lakh crore in January 2022. Reserve money
(adjusted for the first-round impact of the change in the cash reserve
ratio) expanded by 8.4 per cent (y-o-y) on February 4, 2022. Money 3
supply (M3) and bank credit by commercial banks rose (y-o-y) by 8.4
per cent and 8.2 per cent, respectively, as on January 28, 2022. India’s
foreign exchange reserves increased by US$ 55 billion in 2021-22 (up to
46 February 4, 2022) to US$ 632 billion.
 Operating
Outlook Environment of
Working Capital
9. Since the December 2021 MPC meeting, CPI inflation has moved along
the expected trajectory. Going forward, vegetables prices are expected to
ease further on fresh winter crop arrivals. The softening in pulses and
edible oil prices is likely to continue in response to strong supply-side
interventions by the Government and increase in domestic production.
Prospects of a good Rabi harvest add to the optimism on the food price
front. Adverse base effect, however, is likely to prevent a substantial
easing of food inflation in January. The outlook for crude oil prices is
rendered uncertain by geopolitical developments even as supply
conditions are expected to turn more favourable during 2022. While cost-
push pressures on core inflation may continue in the near term, the
Reserve Bank surveys point to some softening in the pace of increase in
selling prices by the manufacturing and services firms going forward,
reflecting subdued pass-through. On balance, the inflation projection for
2021-22 is retained at 5.3 per cent, with Q4 at 5.7 per cent. On the
assumption of a normal monsoon in 2022, CPI inflation for 2022-23 is
projected at 4.5 per cent with Q1:2022-23 at 4.9 per cent; Q2 at 5.0 per
cent; Q3 at 4.0 per cent; and Q4:2022-23 at 4.2 per cent, with risks
broadly balanced (Chart 1).
10. Recovery in domestic economic activity is yet to be broad-based, as
private consumption and contact-intensive services remain below pre-
pandemic levels. Going forward, the outlook for the Rabi crop bodes
well for agriculture and rural demand. The impact of the ongoing third
wave of the pandemic on the recovery is likely to be limited relative to
the earlier waves, improving the outlook for contactintensive services
and urban demand. The announcements in the Union Budget 2022-23 on
boosting public infrastructure through enhanced capital expenditure are
expected to augment growth and crowd in private investment through
large multiplier effects. The pick-up in non-food bank credit, supportive
monetary and liquidity conditions, sustained buoyancy in merchandise
exports, improving capacity utilisation and stable business outlook augur
well for aggregate demand. Global financial market volatility, elevated
international commodity prices, especially crude oil, and continuing
global supply-side disruptions pose downside risks to the outlook.
Taking all these factors into consideration, the real GDP growth for
2022-23 is projected at 7.8 per cent with Q1:2022-23 at 17.2 per cent; Q2
at 7.0 per cent; Q3 at 4.3 per cent; and Q4:2022-23 at 4.5 per cent.
11. The MPC notes that inflation is likely to moderate in H1:2022-23 and
move closer to the target rate thereafter, providing room to remain
accommodative. Timely and apposite supply side measures from the
Government have substantially helped contain inflationary pressures.
The potential pick up of input costs is a contingent risk, especially if
international crude oil prices remain elevated. The pace of the domestic
recovery is catching up with pre-pandemic trends, but private
consumption is still lagging. COVID-19 continues to impart some
uncertainty to the future outlook. Measures announced in the Union
Budget 2022-23 should boost aggregate demand. The global
47
Concepts and macroeconomic environment is, however, characterised by deceleration
Determination
in global demand in 2022, with increasing headwinds from financial
market volatility induced by monetary policy normalisation in the
systemic advanced economies (AEs) and inflationary pressures from
persisting supply chain disruptions. Accordingly, the MPC judges that
the ongoing domestic recovery is still incomplete and needs continued
policy support. It is in this context that the MPC has decided to keep the
policy repo rate unchanged at 4 per cent and to continue with an
accommodative stance as long as necessary to revive and sustain growth
on a durable basis and continue to mitigate the impact of COVID-19 on
the economy, while ensuring that inflation remains within the target
going forward.
12. All members of the MPC – Dr. Shashanka Bhide, Dr. Ashima Goyal,
Prof. Jayanth R. Varma, Dr. Mridul K. Saggar, Dr. Michael Debabrata
Patra and Shri Shaktikanta Das – unanimously voted to keep the policy
repo rate unchanged at 4.0 per cent.
13. All members, namely, Dr. Shashanka Bhide, Dr. Ashima Goyal, Dr.
Mridul K. Saggar, Dr. Michael Debabrata Patra and Shri Shaktikanta
Das, except Prof. Jayanth R. Varma, voted to continue with the
accommodative stance as long as necessary to revive and sustain growth
on a durable basis and continue to mitigate the impact of COVID-19 on
the economy, while ensuring that inflation remains within the target
going forward. Prof. Jayanth R. Varma expressed reservations on this
part of the resolution.
14. The minutes of the MPC’s meeting will be published on February 24,
2022.
15. The next meeting of the MPC is scheduled during April 6-8, 2022.

48
 Determination of
UNIT 3 DETERMINATION OF WORKING Working Capital

CAPITAL

Objectives
The objectives of this unit are to:

• Provide a framework for assessing the working capital requirements of a

firm.
• Explain the concept of operating cycle and its utility in the determination
of working capital requirements.
• Examine the theoretical basis for the determination of Working Capital
needs.
• Highlight the recommendations of Tandon committee.
• Discuss the present policy of the commercial banks in determining
working capital requirements of their borrowers.

Structure
3.1 Introduction
3.2 Determination of Working Capital Needs: Different Approaches
3.3 Factors Influencing Determination
3.4 Tandon Committee Norms
3.5 Present Policy of Banks
3.6 Summary
3.7 Key Words
3.8 Self-Assessment Questions
3.9 Further Readings

3.1 INTRODUCTION
In the previous unit, we have learnt about the crucial issues affecting the
working capital decisions. A survey of the policy aspects pertaining to
monetary and credit policies has been attempted. These developments are
considered to affect the quantum and availability of working capital in the
country. More particularly, the recent changes in the economic liberalization
of the country are expected to produce a tremendous impact on the working
of Indian industries.

Indian companies today have value maximization as the major objective and
to achieve it one should be capable of estimating the requirements precisely.
Both excessive and inadequate investment in working capital items may lead
to unnecessary strain on the objective function. Therefore, the finance
manager has to examine all the factors that determine the working capital
requirements within the theoretical and practical points of view. For, the
theoretical considerations sometimes dominate the methodology of 49
Concepts and assessment; while the firms are constrained to follow the restrictions imposed
Determination
by the borrowers.

The finance manager, therefore, should consider all the factors that have a
bearing on the working capital including cash, receivables and inventories.
Though certain models are developed to determine the optimum investment
in each of the working capital items, an aggregate approach is yet to be
formulated. In the mean time, firms are basing their computations on the
concept of operating cycle. These and other related issues are discussed in
detail in this unit.

3.2 DETERMINATION OF WORKING CAPITAL

NEEDS: DIFFERENT APPROACHES
The question that what is the adequate amount of working capital required to
run a business, is attempted to be answered in several ways. Theoreticians, by
their natural inclination to construct models, have based their analogy on
certain foundations and constructed models to estimate the optimum
investment in working capital. Whereas, lenders such as banks, financial
institutions have based their decisions on production schedules and industry
practices. In between, there is different point of view calling for the adoption
of a strategic approach to the decision-making. Let us now discuss these
theoretical issues to further our understanding of the subject matter.

3.2.1 Industry Norm Approach

This approach is based on the premise that every company is guided by the
industry practice. If a majority of the units constituting a particular industry
adopt a type of practice, other units may also follow suit. This may finally,
turn out to be an industry practice. This practice decides the normal level of
investment in different current asset items. As a matter of fact, optimum level
of investment in receivables is to a great extent influenced by the industry
practices. If majority of the firms of a particular industry have been granting
say three months credit to a customer, others will have no other way except to
follow the majority; due to the fear of losing customers. Though there is no
basis for such a type of fear in fixing norms for other items of current assets,
industrial units generally prefer to follow majority.

a) However, the problems in following this type of an approach are

obvious: The classification of units into a particular industry is not that
easy. Firms may not be susceptible for such a neat classification; when
the units are multi-product firms.
b) Deciding an average to represent a particular industry is highly difficult.
The norms, thus, developed can be less of a reality and more of a
myth.
c) Averages have no meaning to many firms, since the nature of firms
differ.

50
d) Industry norm approach may result in imitative behaviour resulting in Determination of
Working Capital
damage to innovation. Sometimes this may lead to herding of imitative
and inexperienced.
e) This approach may also promote ‘hard mentality’, thus limiting the scope
for excellence. For example, if X unit is able to maintain its production
schedule with only one month requirement of raw material, while the
industry norm being 2 months, there is no wisdom as to why X should
also keep 2 months.

For the above reasons, industry norm approach is not suggested by many as a
benchmark for making investment in current assets. Nevertheless, this has
been a practice followed by many as a tradition, even the lenders are basing
their decisions on this model; though illogical.

3.2.2 Economic Modeling Approach

Model building, of late, has become a crucial exercise in many disciplines.
Theoreticians are making efforts to be as much precise as possible.
Widespread use of quantitative techniques has helped theoreticians to
develop a framework to test their hypotheses. Models attempt to suggest an
optimum solution to a given problem. As in the case of many disciplines, in
the area of finance also model building has been attempted. As far as
working capital is concerned, optimum investment in inventory is sought to
be decided with the help of EOQ model.
This has turned out to be an important concept in the purchase of raw
materials and in the storage of finished goods and in-transit inventories.
EOQ is given by a simple equation:

2SO
Q* =
C

Where Q* = Optimum order quantity

S = Annual usage of material
O = Ordering costs per order
C = Carrying costs per unit
William J. Baumol has attempted to apply this inventory model to the
determination of optimum cash balances that can be held by an enterprise.
The transactions demand for money is sought to be analysed from this point
of view. As per the model, the optimum level of cash is decided by the
carrying cost of holding cash and the cost of transferring marketable
securities to cash and vice- versa.

His equation is as follows:

2bT
C*=
i
C*= Optimum cash balance
b = Transaction costs per transaction
51
Concepts and T = Total demand for cash
Determination
i = Interest rate

Similarly, the decision to sell to a particular account should be based

objectively upon the application of profit maximising model. In this regard,
Robert M. Soldofsky developed a model for Accounts receivable
management. He has laid down the following formula for making a credit
decision, leading to optimum investment in receivables.

Sell, when M – (b + Ti + c/o) ≥ 0

where M = Profit Margin
b = Probability of a credit sale becoming a bad debt
i = Interest rate
c = Costs per order of selling on credit as an implicit function of risk,
o = Order size
T = Time period
Though models are available to decide optimum investment in case of some
important components of working capital, for many other items, no such
modeling is attempted; nor is there an attempt at the aggregate level.
Moreover, these models are subject to certain assumptions and conditions.
Their utility comes under scrutiny for want of these assumptions turning out
to be far from reality. For this and several other reasons, economic modeling
is not much popular with Indian companies.

3.2.3 Strategic Choice Approach

Unlike industry norm approach and economic modeling approach, this is
not a standard method which suggests certain benchmarks to work with.
The earlier methods suggest the use of certain yardsticks or guidelines,
irrespective of the differences in size of the business units, nature of industry,
business structure or competition. For example, optimum investment in
inventory can be had by applying the equation and it is almost universal for
every business unit. Similarly, industry norm approach suggests the same
yardstick for every unit constituting that industry, in spite of variations in the
size, nature of business, terms of sale and purchase, and competition.

In contrast, the strategic choice approach recognises the variations in business

practice and advocates the use of ‘strategy’ in taking working capital
decisions. The spirit behind this approach is to prepare the unit to face
challenges of competition and take a strategic position in the market place.
The emphasis is on the strategic behaviour of the business unit. After all, no
two units would be alike, in terms of their nature, opportunities and
Environment. The firm is independent in choosing its own course of action;
not necessarily guided by the rules of the industry. This makes it obligatory
on the part of the firm to set its own targets for achievement in the area of
working capital. For instance, if the firm has set an objective like increasing
market share from the present level of 20 percent to 40 percent, it can
think of devising a suitable credit policy. Such a policy may involve
variations in the terms followed at present such as extending the credit
52
 period, enhancing the credit limit or increasing the percentage of cash Determination of
Working Capital
discount, etc.

Thus, the strategic choice approach presupposes a highly competitive

environment and the willingness of the management to take risks. The
success of the approach also depends on the ability of the management to set
realistic goals and prepare suitable strategy to achieve them. Any wrong
planning will lead the firm into trouble; much worse than what it was when
either of the earlier methods were being followed. All said and done, this can
be dubbed as the most innovative style in approaching the Working Capital
Issues.

Activity 3.1
i. Giving reasons indicate the meaningful and logical approach suitable for
determining the working capital requirement of a business.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
ii. Mention 2/3 points about relevance of strategic choice approach in
practical business decision making.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................

3.3 FACTORS INFLUENCING DETERMINATION

The working capital requirements of a firm depends on a number of factors.
It is a common proposition that the size of working capital is a function of
sales. Sales alone will not determine the size of the working capital, but
instead it is constantly affected by the criss-crossing economic currents
flowing in a business. The nature of the firm’s activities, the industrial health
of the country, the availability of materials, the ease or tightness of the money
market, are all parts of these shifting forces. Of them, the influence of
operating cycle is considered paramount.

3.3.1 Operating Cycle

Since working capital is represented by the sum of current assets, the
investment in the same is determined by the level of each current asset item.
To a large extent, the investment in current asset items is decided by the
‘Operating Cycle’ (OC) of the enterprise. The concept of operating cycle is
very significant for computation of working capital requirements. The size of
53
Concepts and investment in each component of working capital is decided by the length
Determination
of OC.

The term operating cycle can be understood to represent the length of time
required for the completion of each of the stages of operation involved in
respect of working capital items. This helps portray different stages of
manufacturing activity in its various manifestations, such as peaks and
troughs, along with the required supporting level of investment at each stage
in working capital. The sum of these stage-wise investments is the total
amount of working capital required to support the manufacturing activity at
different stages of the cycle. The four important stages of that can be
identified as:
1) Raw materials and stores inventory stage
2) Work-in-progress stage
3) Finished goods inventory stage
4) Book Debts stage
The following is the formula used to arrive at the OC period in an enterprise.
‘t’ = (r–c) + w + f + b,
where
‘t’ = stands for the total period of the operating cycle in number of days;
‘r’ = the number of days of raw materials and stores consumption
requirements held in raw materials and stores inventory;
‘c’ = the number of days purchases, included in trade creditors;
‘w’ = the number of days of cost of production held in work-in-progress;
‘f’ = the number of days cost of sales included in finished goods; and
‘b’ = the number of days sales in book debts.

The computations involved are:

Average inventory of raw materials and stores
r = ————————————————————
Average materials and stores consumption per day
Average trade creditors
c = ————————————
Average purchase per day
Average work in progress
w = ————————————————
Average cost of production per day
Average inventory of finished goods
f = ————————————————
Average cost of sales per day
Average book debts
b = ——————————
Average sales per day
The average inventory or book debts level can be arrived at by finding the
mean between the relevant opening and closing balances for the year. The
average consumption or output or cost of sales or sales per day can be
54
obtained by dividing the respective annual figures by 365. Some authors and Determination of
Working Capital
Bank Managers use 300-360 days as the denominator to reflect upon the
operational days in a year.

The first comprehensive and coherent exposition of the OC concept is to be

that of Park and Gladson. They attempted to establish how current assets and
liabilities were linked together as the two important determinants of working
capital. This search led them to the conclusion that the prevailing one-year
temporal standard applied in classifying assets or liabilities as current’ was
not universally valid. What was current or non-current depended on the
nature of the core business activity. Thus, for a fruit processing business
two to three months would be the correct criterion of currentness. For a
lumbering or wine-making business, however, a period of longer than one
year would be the standard. Between such extremes, the currentness of period
for each business would be a function of the nature of its basic activity as
dictated by the technological requirements and trading conventions.

Instead they used the term ‘natural business year’ within which an activity
cycle is completed. Later, the accounting principles board of the American
Institute of the Certified Public Accountants while defining working capital
used this concept.

3.3.2 Determination of Working Capital Using O.C.

Now, we may attempt to determine the amount of working capital required
for a firm using the above concept.

Illustration 3.1
ABC company plans to achieve annual sales of 1,00,000 units for the year
2020. The following is the cost structure of the company as per the
previous figures.

Materials .. 50%
Labour .. 20%
Overheads .. 10%

The following further particulars are available from the records of the company.

1) Raw materials are expected to remain in stores for an average period of

one month before issue to production.
2) Finished goods are to stay in the warehouse for two months on an
average before being sold and sent to customers.
3) Each unit of production will be in process for one month on the
average.
4) Credit allowed by the suppliers of raw material is one month from the
date of delivery of materials.
5) Debtors are allowed credit for two months from the date of sale of
goods.
6) Selling price per unit is Rs.9 per unit.
55
Concepts and 7) Production and sales follow a consistent pattern and there are no wide
Determination
fluctuations.

Determine the quantum of working capital required to finance the activity

level of 1,00,000 units for the year 2020.

SOLUTION:
Statement of Working Capital Required
Current Assets:
Theories and Approaches
Amount (Rs.)
1 50
1. Raw Material Inventory (1 month) 1,00,000 9 = 37,500
12 100
1 80
2. Work-in-progress Inventory (1 month) 1,00,000 9 = 60,000
12 100

2 80
3. Finished goods Inventory (2 months) 1,00,000 9 =1,20,000
12 100
2 100
4. Debtors (2 months) 1,00,000 9 = 1,50,000
12 100
3,67,500
Less: Current Liabilities:
1 50
1. Creditors (1 month) 1,00,000 9 = 37,500
12 100
–———
Working capital required = 3,30,000
–––––––
Notes: 1) Raw material inventory is expressed in raw material consumption.
2) Work-in-progress inventory is expressed in cost of production
(COP) where, COP is deemed to include materials, labour and
overheads.
3) Finished goods inventory is supposed to have been expressed in
terms of cost of sales. Since separate details are not given, the
figures are worked out on COP.
4) Debtors are expressed in terms of total sales value.
5) Creditors are expressed in terms of raw material consumption,
since separate figures are not available for purchases.
Illustration 3.2
A company plans to achieve annual sales of Rs.1,00,000. What would be its
working capital requirements under the following conditions:
1) The average period during which raw materials are kept in stock before
being issued to factory - 2 months.
2) The length of the production cycle i.e., the period from the date of
56
 receipt of raw materials by factory to the date of completion of goods - Determination of
Working Capital
or say stock-in-process - 1/2 month.
3) Average period during which finished goods are stocked pending sale- 1
month.
4) The period of credit allowed to customers - 1 month.
5) The period of credit granted by suppliers of raw materials - 1 month.
6) The analysis of cost as a percentage of sales:
Raw materials .. .. .. 45%
Manufacturing expenses including wages & depreciation 30%
Overheads (Excluding depreciation) .. .. 10%
Net Profit .. .. .. 15%
Total .. 100%
7) Cash available in business to meet urgent requirements is Rs.5,000.
SOLUTION:
Current Assets:
Amount (Rs.)
45 2
1) Raw material inventory (2 months) 1,00,000 = 7,500.00
100 12
75 1
2) Work-in-progress inventory (½ month) 1,00,000 = 3,125.00
100 24
85 1
3) Finished goods inventory (1 month) 1,00,000 = 7,083.33
100 12
100 1
4) Receivables (1 month) 100, 000 = 8,333.33
100 12
26,041.66
5) Cash available in the firm .... .... 5,000.00
31,041.66
Less: Current Liabilities:
45 1
1. Creditors (1 month) 1, 00, 000 = 3,750.00
100 12
––––––––––
Working capital required 27,291.66
––––––––––
Notes: (1) Workings are made as per assumptions given in Illustration- 3.1
excepting that the finished goods inventory is expressed in terms of cost of
sales, which is considered to be inclusive of raw materials, manufacturing
expenses and overheads.

3.3.3 Other Factors

In addition to the influence of operating cycle, there are a variety of factors
that influence the determination of working capital. A brief explanation of the
same is provided hereunder:

57
Concepts and Nature of Business
Determination
A company’s working capital requirements are directly related to the type of
business operations. In some industries like public utility services the
consumers are generally asked to make payments in advance and the money
thus received is used for meeting the requirements of current assets. Such
industries can carry on their business with comparatively less working
capital. On the contrary, industries like cotton, jute etc. may have to purchase
raw materials for the whole of the year only during the harvesting season,
which obviously increases the working capital needs in that period.

Management’s Attitude Towards Risk

Management’s attitude towards risk also influences the size of working
capital in an undertaking. It is, of course, difficult to give a very precise and
determinable meaning to the management’s attitude towards risk, but as
suggested by Walker, the following principles involving risk may serve as the
basis of policy formulation:

1) If working capital is varied relative to sales the amount of risk that firm
assumes also varies and the opportunity for gain or loss is increased;
2) Capital should be invested in each component of working capital as long
as the equity position of the firm increases;
3) The type of capital used to finance working capital directly affects the
amount of risk that a firm assumes as well as the opportunity for gain
or loss and cost of capital; and
4) The greater the disparity between the maturities of a firm’s short-term
debt instruments and flow of internally generated funds, the greater the
risk and vice-versa.

Briefly, these principles imply that the policies governing the size of the
working capital are determined by the amount of risk, which the management
is prepared to undertake.

Growth and Expansion of Business

It is logical to expect that larger amounts of working capital are needed to
support the increasing operations of a business concern. But, there is no
simple formula to establish the link between growth in the company’s
volume of business and the growth of working capital. The critical fact is that
the need for increased working capital funds does not follow the growth in
business activity but precedes it. Citerus paribus, growth industries require
more working capital than those that are static.

Product Policies
Depending upon the kind of items manufactured by adjusting its production
schedules a company may be able to off-set the effects of seasonal
fluctuations upon working capital. The choice rests between varying output in
order to adjust inventories to seasonal requirements and maintaining a steady
rate of production and permitting stocks of inventories to build up during off-
season period. In the first instance, inventories are kept to minimum levels; in
58
the second, the uniform manufacturing rate avoids high fluctuations of Determination of
Working Capital
production schedules but enlarged inventory stocks create special risks and
costs.

Position of the Business Cycle

Besides the nature of business, manufacturing process and production
policies, cyclical and seasonal changes also influence the size and behaviour
of working capital. During the upswing of the cycle and the busy season of
the enterprise, there will be a need for a larger amount of working capital to
cover the lag between increased need and the receipts. The cyclical and
seasonal changes mainly influence the size of the working capital through the
inventory stock. As regards the behaviour of inventory during the business
cycles, there is no unanimity of opinion among economists. A few say that
inventory moves in conformity with business activity. While others hold the
view that business activity depends upon the behaviour of the inventory of
finished goods which is determined by the credit mechanism and short-term
rate of interest. Whatever be the view points, the fact remains that the cyclical
changes do influence the size of the working capital.

Terms of Purchase and Sale

The magnitude of the working capital of a business is also affected by the
terms of purchase and sale. If, for instance, an undertaking purchases its
materials on credit basis and sells its finished goods on cash basis, it requires
less working capital over an undertaking which is following the other way of
purchasing on cash basis, and selling on credit basis. It all depends on the
management’s discretion to set credit terms in consideration with the
prevailing market conditions and industry practices.

Miscellaneous
Apart from the above mentioned factors some others like the operating
efficiency, profit levels, management’s policies towards dividends,
depreciation and other reserves, price level changes, shifts in demand for
products competitive conditions, vagaries in supply of raw materials, import
policy of the government, hazards and contingencies in the nature of
business, etc., also determine the amount of working capital required by an
undertaking.

Activity 3.2
i) Highlight few important factors on which the working capital
requirement of your organisation depends.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
59
Concepts and ii) Comment on the method of assessment being followed in your
Determination
organisation for working capital determination.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................

3.4 TANDON COMMITTEE NORMS

Since mid-sixties, the issue of financing working capital has been engaging
the attention of industry and the policy makers. The measures taken by the
Reserve Bank of India included the introduction of Credit Authorisation
Scheme in November 1965, Constitution of the Dahejia Committee in
October 1968, Tandon Committee in July 1974 and the Chore Committee in
March 1979. Over the years, attempt has been made to streamline the flow of
credit from the banking sector to the industry. The link between financing of
working capital and the recommendations of various committees is that the
latter tried to make out a case for fixing norms for the maintenance of
various current assets; thus leading to the determination of optimum working
capital.

In this regard, Tandon Committee, for the first time, made an attempt to
prescribe norms for holding diverse current asset items. The committee
wanted the commercial banks to quantify the desirable level of net working
capital and the maximum permissible lending by the banks. In its approach to
the methods of lending, the Committee sought to identify the ‘Reasonable
level of current assets’ as the basis of its calculation of different methods. In
other words, the total of current assets is based on the norms suggested by
them rather than the actual current assets held by the undertakings. For this
purpose, the Committee suggested norms for carrying raw materials, work-in-
progress, finished goods, and receivables in respect of 15 major industries.
The norms for the four kinds of assets are related in the following manner:

Type of Asset Relation to

1) Raw Materials Month’s consumption of raw materials
2) Work-in-progress Month’s cost of production
3) Finished goods Month’s cost of sales
4) Receivables Month’s sales
The norms represent the maximum levels of inventories and receivables in
each type of industry. It is further laid down that, if the holding of any kind
of asset is higher than the level fixed by the relative norms, the surplus would
be treated ‘excess’ holding to be shed off, failing which an amount equal to
the value thereof would be treated as excess borrowing and a levy of penal
rate of interest is suggested on such excess borrowing. Again, it is not
permitted to set off such excess against any shortfall in the holding of other
60
current assets, as the norms represent the maximum permissible levels of Determination of
Working Capital
holdings. The list of fifteen industries included cotton textiles, synthetic
textiles, jute, pharmaceuticals, rubber, fertilisers, vanaspati, paper and
engineering. This system of lending continued with little variations almost
upto the beginning of the present decade. But there is no change in the basic
philosophy as to the assessment of working capital norms, based on the
industry norm approach.

3.5 PRESENT POLICY OF BANKS

After the implementation of a phased liberation programme since 1991, the
RBI decided to allow full operational freedom to the banks in assessing the
working capital requirements of the borrowers. All the instructions relating to
Maximum Permissible Bank Finance (MPBF) have been withdrawn. As an
alternative, a revised system of assessing working capital limits has been
evolved. Accordingly, one of the following three methods has been suggested
for adoption by the commercial banks.
a) Turnover method
b) Eligible working capital limit method
c) Cash-flow method
Under the ‘Turnover method’, working capital requirements of all the
borrowers enjoying aggregate fund based working capital limits up to Rs.2
crore from the banking system are being assessed on the basis of a minimum
of 25% of their projected annual turnover. Of this, 5% of the annual turnover
should be brought by way of promoter’s contribution. Thus, the remaining 20
% is only financed by the banks.
As is evident, this calls for a change in the approach of the RBI in assessing
working capital needs of the industrial units. The industry norm approach
followed so far yields a place to the simple turnover method and norms have
no role to play. Higher the turnover, higher would be the credit facility
available. In the earlier system, (industry norm approach), maintenance of a
high level of current assets or any other assets has no significance to the
computation of working capital needs, excepting the industry norms fixed on
some practical basis. On the contrary, units having higher turnover are
permitted to hold higher current assets, though as per norms it is excess.
Moreover, this type of a practice encourages firms to stock materials and
finished goods with lax inventory control. Small firms lag in competition to
large firms, as there is an inherent advantage to the latter.

Alternatively, banks may also follow ‘Cash-flow method’ to finance the

working capital needs of the industrial units. Under this method, banks will
meet the deficit, if any, due to payments being higher than the receipts in that
month. For this purpose, borrowers are instructed to prepare monthly cash
flow statements and impose certain control measures to ensure smooth
operation of the system.

This method too abandons the industry norm approach in assessing working
capital needs. This method takes into account only the difference between 61
Concepts and receipts and payments. This difference may arise for several reasons and may
Determination
not be entirely due to changes in working capital items. Though care is
expected to be taken by the industrial units in preparing cash flow statements,
implementation of the method in practice will only highlight its suitability.

3.5.1 RBI Guidelines in Financing Working Capital

The Reserve Bank of India, in order to strengthen the credit discipline among
borrowers and also to guide the Banks, has issued the following revised
guidelines on working capital loans:

 RBI has stipulated a ‘minimum level’ of loan component in fund based

working capital finance.
 It also specified a mandatory ‘Credit Conversion Factor (CCF)’ for the
undrawn part of the cash credit limit or the O.D. facility given.
 Redefined the large borrowers as having fund based working capital
limit of Rs.150 crore and above. This was Rs.100 crore earlier.
 With effect from October, 2018, the minimum loan component is fixed
as 40% of the total limit.
 The Credit Conversion Factor (CCF) for large borrowers for the
unutilised portion of cash credit/overdraft was put at 20 per cent with
effect from April 1, 2019.
 The ‘Minimum Loan’ component is proposed to be enhanced from 40
per cent to 60 per cent with effect from April 1, 2019.
 In case of consortium lending, all the lenders, by mutual agreement fix
up ground rules for sharing cash credit and loan components.
 Banks are also provided with freedom to decide on the splitting of loan
component with different maturity periods, as per the need of the
borrowers.
 The other conditions imposed on the proper use of working capital
finance is that the borrowers are not supposed to buy assets or make
long–term investments.

3.5.2 Revised Policy Guidelines for Assessment of Working

Capital - A Case Study
In this section, an attempt has been made to provide readers with the insight
of actual guidelines under operation in one of the nationalised banks.

A. Methodology
The following are the methods followed by the banks as per their policy
stance in assessing working capital requirements of the borrowers.
Quantum of limits requested (Rs. in lakh) Method
i) Upto Rs.200.00 lakh from the Banking system Turnover Method
ii) Rs.200.00 lakh and above from the banking Eligible Working Capital
system but upto & inclusive of Rs.2000.00 Limit (EWCL) Method
lakh from the Bank.
62
iii) For limits above Rs.2000.00 lakh EWCL or Cash Budget Determination of
Working Capital
Method as may be decided
by the Bank.
B. TURNOVER METHOD:
In the case of SSI borrowers who are seeking fund-based limits upto
Rs.200.00 lakh from the banking system, it is made mandatory by the RBI to
assess the working capital limits as under:
1) Projected Gross Sales .. Rs..............
2) Working Capital requirements at 25% of A .. Rs..............
3) Margin to be provided by the borrower at 5% of A
(Corresponding to a Current ratio of 1.25) or the
actual net working capital available, whichever is higher Rs..............
4) Eligible Working Capital finance (b–c) Rs..............

In the case of Non-SSI borrowers, seeking fund based limits up to Rs.200.00

lakh from the banking system, the assessment methodology, remains the
same as in the case of SSI borrowers except that minimum margin to be
brought in by the borrower shall be 6.25% of the Projected Gross Sales which
corresponds to a Current Ratio of 1.33, which can be relaxed upto 5% of the
Projected Gross Turnover which corresponds to a current ratio of 1.25 subject
to other Financial Parameters being satisfactory.
While arriving at Eligible Working Capital Finance under the Turnover
Method, for SSI and Non-SSI borrowers, if the available NWC is higher than
the required minimum, the higher available NWC shall be reckoned with.
Also, the unpaid stocks in excess of unfinanced eligible receivables shall not
be taken into account for the purpose of computation of drawing power. The
inventory margin requirement shall be 20% in the case of SSI borrowers and
20% to 25% in the case of Non-SSI borrowers depending on the stipulated
current ratio. While the limit shall be assessed and sanctioned on the basis of
25% of projected gross sales less prescribed margin to be provided by the
borrower, the actual release under the sanctioned limit shall be on the basis
of drawing power.
Like SSI borrowers, in the case of Non-SSI borrowers also, if any borrower
requests for working capital limits higher than what he would have been
eligible if assessed under the Turnover Method, his requirements can be
assessed under EWCL method and limits to the extent he is eligible under
EWCL method may be made available.
In the case of borrowers seeking fund based working capital limits less than
Rs.10.00 lakh from the Bank, the need based requirement for credit
facilities may be arrived at adopting a holistic approach, instead of Turnover
Method, taking into account the applicant’s business potential, business
plans, past dealings, credit- worthiness, market standing, collateral wherever
available and ability to repay, etc.

The limits assessed through simplified procedure shall be secured by current

assets primarily wherever the credit facilities are extended for procuring
63
Concepts and against the current assets. In addition the collateral security to an extent of at
Determination
least 150% of the value of advance shall be obtained from the borrowers
assessed through simplified procedure. However, the Zonal Heads are
empowered to reduce the cover of collateral security, but not below 100% of
value of the advance, on merit of the case. In the case of borrowers seeking
fund based limits less than Rs.10.00 lakhs where the assessment is done
under the Turnover method, the stipulation as above for the collateral security
will not be applicable as the borrowers assessed under Turnover Method will
have to comply with the security cover as under Basic Financial
Parameters.

The Working Capital limits less than Rs.10.00 lacs may also be extended by
way of short-term loan of not more than one year maturity. This short-term
loan repayable in instalments (i.e., balloon form) or in one lump sum (i.e.
bullet form) is available for renewal/rollover at the end of expiry, if the
sanctioning authority, after a review is satisfied to continue the advance. The
short-term loan is permitted to be arranged for the part amount of the limit
assessed while the balance is permitted to be extended by way of
overdraft.

To ensure continued use in the case of short term loans extended as above,
the stock statement shall be obtained at the end of every calendar quarter,
within 7 days from the end of the quarter and for any drawings beyond the
drawing Power (DP), penal interest as in force shall be recovered on the
drawings beyond the DP. The drawings beyond the DP shall not be recovered
immediately but the loan shall be allowed to be repaid as per repayment
programme specified.

The SSI borrowers seeking working capital limits less than Rs.10.00 lacs shall
be assessed under Turnover Method but they will be eligible to avail the
advance by way of short-term loan as above and/or overdraft. The short-term
loans as above will be eligible for 0.5% p.a. less interest (net of tax) subject to
a minimum of PLR, as compared to the interest chargeable on overdraft.

C. ELIGIBLE WORKING CAPITAL LIMIT METHOD (EWCL):

EWCL method, a suitably relaxed form of the erstwhile Maximum

Permissible Bank Finance (MPBF) Method, shall be applied in the case of
borrowers seeking fund based working capital limits of Rs.200.00 lacs and
above (from the banking system) but upto (and inclusive of) Rs.2000.00 lacs
from the Bank and the assessment shall be carried out as under:

Projections for ensuing year

a) Total Current Assets .. .. Rs………..

b) Less: Current Liabilities other than bank borrowings .. Rs…………
c) Working Capital Gap (a–b) Rs…………
d) Less: 25% (bench-mark) of Current Assets as Net
Working Capital (NWC) or
Projected NWC, whichever is higher .. Rs…………
e) Eligible Working Capital Limit (c–d) .. Rs…………
64
The identification/treatment of Current Assets and Current Liabilities shall Determination of
Working Capital
continue to be as before when the MPBF Method was practiced. The 25% of
current assets as margin (NWC) corresponds to a Current Ratio of 1.33,
which would be a benchmark current Ratio under this method of assessment.
However, relaxation of current ratio under EWCL method may be allowed
upto 1.1 selectively provided other basic financial parameters are satisfactory.
To arrive at the current ratio, the term loan instalments falling due in next 12
months shall be reckoned with but the same to be excluded as a component of
current liability to arrive at working capital gap under EWCL method.
Similarly the export receivables shall continue to be excluded from the
current assets to determine the required NWC.

D. CASH BUDGET METHOD

The working capital requirements of the borrowers seeking fund based limits
of above Rs.2000.00 lakhs shall be assessed either under CASH BUDGET
Method or the EWCL Method discussed earlier, as may be decided by the
Bank. The corporate borrowers whose management of finance is cash budget
driven and the existing clients of the Bank who have a consistently good
track record of fulfilling the specified norms/covenants - financial and
performance related - can opt for assessment under Cash Budget Method.
The assessment methodology under Cash Budget Method is as under:

Heads Quarterly details

1) Cash Flow from Business Operations:
i) All inflows (receipts)
ii) All outflows (payments)
2) Cash Flow from Non-business operations:
i) All inflows
ii) All outflows
3) Cash Flow from Capital Accounts:
i) All inflows
ii) All outflows
4) Cash Flow from sundry items:
i) All inflows
ii) All outflows
5) Assessment of bank finance:
(i) Cash Gap in the business-operations {I(ii) – I (i)}
Less: (ii) Amount brought/proposed to be brought from other sources i.e.
cash surplus under II, III & IV above.
(iii) Net Cash Gap {V(i) – V (ii)}
The Highest (Peak) Cash Gap during the period under assessment is to be
extended by way of eligible working capital limit. The following prerequisites
are advised for the borrowers to be assessed under Cash Budget system. The
borrower should:
65
Concepts and a) Preferably be a company under the Indian Companies Act, listed and
Determination
quoted at one or more of the Stock Exchanges in India. This however
may not be a restrictive parameter and if the Bank is satisfied on
financial strengths, the partnership and proprietorship concerns may also
be allowed under the system. The preference to listed/quoted companies
is only with an intent to have access to their published data.
b) Have in place a data base and system for doing the financial planning on
cash budget basis.
c) Have Inventory and Receivable management on the professional lines,
adhering to Stock Audit norms with stores management, shop floor
control and costing norms as provided in the industry. The Cash Budget
method shall continue to be used in the case of seasonal industries like
Sugar, Tea and others, and also in construction industry as before
irrespective of the quantum of working capital finance sought.
Since the requirements of working capital finance is directly related to the
levels of activity under production and sales and the inputs required to
achieve these levels, it is necessary to obtain the above requirements in
addition to the detailed Cash Budget. While the assessment to arrive at
quantum of finance should be carried out on the basis of cash budget obtained
from the borrower, the financial statements. CMA data with fund flows also
are to be taken into account to ascertain the level of business activity for
which the working capital finance is sought by the borrower. It may be also
necessary to conduct a sensitivity analysis based on variance of major
financial assumptions for a proper risk perception.

Activity 3.3
i) Visit any of the Banks nearby and have discussion with the concerned
Manager to understand the issues and methods involved in Working
Capital Finance
……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

3.6 SUMMARY
Determination of adequate amount of working capital required for a business
is of great significance in its prudent management. Value maximisation
implies optimum investment in all types of assets. There are three approaches
to decide the optimum investment in working capital. They are: industry
norm approach, economic modeling approach, and the strategic choice
66 approach. Under the first one, certain norms have been worked out taking the
nature of operations into account. Each unit’s requirements are assessed with Determination of
Working Capital
respect to such ‘industry bench mark’ norm. Economic models are pressed
into service to make certain projections, current asset items are projected on
the basis of these models and an optimum quantum is arrived at. Under the
strategic choice approach, business forms are advised to follow their own
‘unique’ approach basing on the circumstances prevailing; they need not be
guided by the industry practices.
As against these theoretical considerations, operating cycle concept is widely
followed in practice. Working capital requirements are assessed basing on
this methodology. Various other factors such as nature of business,
management’s attitude towards risk, growth and expansion of business,
product policies, position of the business cycle, terms of purchase and sale
and operating efficiency also exert their influence on the determination of
working capital. The methodology suggested by the Tandon Committee has
particular relevance to the assessment of working capital requirements.
Against this background, the approach followed by the commercial banks is
also highlighted. The present policy of the banks is to fix up working capital
limits basing on their own policy stance. After liberalization, banks are also
liberal in fixing their own norms, subject to the broad guidelines of RBI.

3.7 KEY WORDS

Operating cycle: Length of time required for the completion of each of the
stages involved in the manufacturing process, covering working capital items.
Turnover method: It is a method of calculation of working capital
requirements, basing on sales turnover.
Cash budget method: It is a method of calculation of working capital
requirements using cash budget.
Industry norm: It is a method of taking industry practices into account while
deciding working capital requirements.
Economic modelling: This refers to the use of quantitative techniques for
assessing working capital requirements.
Strategic choice: It is a need based approach taking into account the
circumstances prevailing in the industry to decide the optimum amount of
working capital.

3.8 SELF ASSESSMENT QUESTIONS

1) Explain different approaches to the determination of working capital. As
a new entrepreneur, which of the three broad approaches would you
prefer and why?
2) What are the various factors influencing the determination of working
capital?
3) Illustrate, using hypothetical data, how working capital requirements are
assessed using operating cycle concept.
4) Do you find any relevance of the recommendations of the Tandon
Committee in determining working capital requirements in the present
circumstances
67
Concepts and 5) Distinguish between turnover method and cash budget method which of
Determination
them do you suggest to a banker?
6) Management of Infotech Limited seeks your assistance on assessing the
working capital requirements for an activity level of 1,00,000 units of
output for the year 2020. The cost details of the product are as
follows:
Particulars Cost per Unit (Rs.)
Raw materials .. 20
Direct labour .. 5
Overheads .. 15
Total cost .. 40
Profit .. .. 10
Selling price .. 50
The other details are:
1) In order to ensure smooth flow of production 2 months raw material
inventory is to be held in the stores.
2) Finished goods remain in stores for one month.
3) Credit allowed for purchase of raw material is one month.
4) Credit allowed to customers is 2 months.
5) Cash Balance to be maintained is Rs.25,000.
6) Assuming that the product process is uninterrupted and even, compute
the amount of working capital required for the given level of activity.
7) The following information has been extracted from the accounts of ABC
Limited for the year 2 0 2 0 -21.
Statement of Cost Structure
S.No. Particulars (Rs. in crores)
1. Raw materials stock (opening) 33.89
2. Purchases 377.34
3. Raw materials stock (closing) 39.76
4. Raw Materials consumed (1+2–3) 371.47
5. Personnel Expenses 45.32
6. Other manufacturing Expenses 132.03
7. Depreciation 11.92
8. Total cost (4+5+6+7) 560.74
9. Work-in-progress inventory (opening) 55.56
10. Work-in-progress inventory (closing) 67.69
11. Cost of production (8+9–10) 548.61
12. Finished goods inventory (opening) 37.37
(including stores and spares)
68
 Determination of
13. Finished goods inventory (closing) 42.02 Working Capital
14. Cost of Goods sold (11+12–13) 543.96
15. Selling Expenses 8.71
16. Cost of Sales (14+15) 552.67

The following additional information is as given:

Particulars (Rs. in crores)

Accounts receivables (opening) 193.07
Accounts receivables (closing) 199.40
Accounts payable (opening) 127.72
Accounts payable (closing) 139.43
Sales (assumed to be credit sales) 715.73
Interest 51.58
PBT 26.80
PAT 25.30
Net Block 218.16
Using the above information compute operating cycle.
Hint: Use a 360-day year.
Ans: Q.6: Working capital required is Rs.44.00 lacs.
Ans: Q.7: Operating cycle = 107 days

3.9 FURTHER READINGS

1) V. K. Bhalla, 2003, Working capital Management; Anmol Publications,
New Delhi
2) Pandey, I. M. Eigth Edition 1999, Financial Management, Vikas
Publication house, New Delhi.
3) Weston, Fred J. & Brigham, E. F., 1978, Managerial Finance, Hinsade,
The Dryden Press.
4) Smith, Keith, V., 1977, Guide to Working Capital Management,
Mc.Graw Hill Book Co., New York.
5) Michael Firth, 1976, Management of Working Capital, The Macmillan
Press, London.
6) Gupta, L.C., ‘Banking and Working Capital Finance’, MacMillan, Delhi,
1978.
7) Chakrabarthy, S.K., & Others, ‘Topics in Accounting and Finance’,
Oxford University Press, Calcutta, 1976.

69
Concepts and
Determination

70