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Project title: working capital management Project objectives:

To learn the effective management of working capital. To study how to keep the capital that is tied up in the working capital cycle at a minimum and maximizing profit. To study the different components of working capital and its impact on the performance of the firm. To study how state bank of patiala finances working capital requirements of the firms.

Profile: State Bank Of Patiala

Date of Establishment



Head Office Building, The Mall, Mall Road, Patiala, 147001, Punjab, India

Management Team

A.C. Varma - MD Diwakar Gupta - Chief General Manager R. C. Baldu - General Manager (Operations) Sudhir Garg - General Manager (CB) T. Lokeshaiah - General Manager (Treasury) S.Sridhar - General Manager (Technology & Inspection) Sebastian Chacko - General Manager (P & D) M.K.Singh - General Manager (Vig) An associate bank of State Bank of India, State Bank of Patiala has a network of 847 service outlets, including 759 branches in all major cities of India. It offers personal banking, agricultural and rural banking, SME and corporate banking, internet banking, NRI services etc. It facilitates its clients to pay their taxes through its branches. State Bank of Patiala supports Malwa Gramin Bank. It also provides car loans, education loans, two-wheeler loans, consumer durable loans, loans against term deposits, gold ornaments and personal loans. On 24th January 2003 State Bank of Patiala became the first fully computerised Public Sector Bank in the country.



Concept of working capital There are two concepts of working capital: 1.Gross working capital It refers to the firms investment in total current assets or circulating assets. 2.Net working capital (defined in two ways) (i) It is the excess of current assets over current liabilities. (ii) It is that portion of a firms current assets which is financed by long-term funds. NEED FOR WORKING CAPITAL:The basic objective of financial management is to maximize shareholders wealth. This is possible only when the company earns sufficient profit. The amount of such profit largely depends upon the magnitude of sales. However, sales do not convert into cash instantaneously. There is always time gap between the sale of goods and receipt of cash. Working capital is required for this period in order to sustain the sales activity. OPERATING CYCLE:-

Finished goods



Types of working capital:Can be divided into two categories on the basis of time: 1. Permanent working capital 2. Temporary or Variable working capital 1. PERMANENT WORKING CAPITAL:This refers to that minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities. It represents the current assets required on a continuing basis over the entire year. . The following are the characteristics of this type of working capital:1. Amount of permanent working capital remains in the business in one form or another. This is particularly important from the point of view of financing. The suppliers of such working capital should not expect its return during the lifetime of the firm. 2. It also grows with the size of the business. Permanent working capital is permanently needed for the business and therefore it should be financed out of long-term funds. This is the reason why the current ratio has to be substantially more than 1.

2.TEMPORARY OR VARIABLE WORKING CAPITAL:The amount of such working capital keeps on fluctuating from time to time on the basis of business activities. In other words, it represents additional current assets required at different times during the operating year.

Temporary Amount of working Capital (Rs.) Time permanent

Temporary Amount of working Capital (Rs.) permanent



Source: Dr. S N Maheshwari, Financial Management.)

REASONS FOR ADEQUATE WORKING CAPITAL: A firm must have adequate working capital, i.e., as much as needed by the firm. It should neither have excessive nor inadequate. Both situations are dangerous. Excessive working capital means the firm has idle funds, which earn no profit for the firm. Inadequate working capital means the firm does not have sufficient funds for running its operations, which ultimately results in production interruptions, and lowering down the profitability. It will be interesting to understand the relation between working capital, risk and return. In a manufacturing concern, it is generally accepted that higher levels of working capital decrease the risk and decrease the profitability too. While lower levels of working capital increase the risk but have the potentiality of increasing the profitability also. This principle is based on the following assumptions: (i) There is direct relationship between risk and profitability --- higher is the risk, higher is the profitability, while lower is the risk, lower is the profitability. (ii) Current assets are less profitable than fixed assets. (iii) Short-term funds are less expensive than long-term funds. MANAGEMENT OF WORKING CAPITAL:Working capital refers to all aspects of the administration of both current assets and current liabilities. In other words, working capital management is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the interrelationships that exist between them. Moreover, different components of working capital are to be properly balanced in such a way that during one complete production or trade cycle the cash should be available for purchase of fresh material and for running the

business including operating expenses, after realization of sale proceeds of earlier cycle without any hurdles. In the absence of such situation, the financial position in respect of the firms liquidity may not be satisfactory in spite of satisfactory liquidity ratio. Working capital management policy have a great effect on firms profitability, liquidity and its structural health. A finance manager should therefore, chalk out appropriate working capital management policies in respect of each of the components of working capital so as to ensure higher profitability, proper liquidity and sound structural health of the organization. In order to achieve this objective the finance manager has to perform basically following two functions: 1) Estimating the amount of working capital. 2) Sources from which these funds have to be raised.

ESTIMATING WORKING CAPITAL REQUIREMENTS: In order to determine the amount of working capital needed by a firm, a number of factors viz. production policies, nature of business, length of manufacturing process, rapidity of turnover, seasonal fluctuations, etc. are to be considered by the finance manager.


ESTIMATION OF COMPONENTS OF WORKING CAPITAL METHOD: Since working capital is the excess of current assets over current liabilities, an assessment of the working capital requirements can be made by estimating the amounts of different constituents of working capital e.g., inventories, accounts receivable, cash, accounts payable, etc.


This is a traditional and simple method of estimating working capital requirements. According to this method, on the basis of past experience between sales and working capital requirements, a ratio can be determined for estimating the working capital requirements in future.

3. OPERATING CYCLE APPROACH: According to this approach, the requirements of working capital depend upon the operating cycle of the business. The operating cycle begins with the acquisition of raw materials and ends with the collection of receivables

It may be broadly classified into the following four stages viz. 1. Raw materials and stores storage stage. 2. Work-in-progress stage. 3. Finished goods inventory stage. 4. Receivables collection stage. The duration of the operating cycle for the purpose of estimating working capital requirements is equivalent to the sum of the durations of each of these stages less the credit period allowed by the suppliers of the firm. Symbolically the duration of the working capital cycle can be put as follows: O=R+W+F+D-C

O=Duration of operating cycle; R=Raw materials and stores storage period; W=Work-in-progress period; F=Finished stock storage period; D=Debtors collection period; C=Creditors payment period.

Each of the components of the operating cycle can be calculated as follows:R= Average stock of raw materials and stores Average raw materials and stores consumptions per day W=Average work-in-progress inventory Average cost of production per day D=Average book debts Average credit sales per day C=Average trade creditors Average credit purchases per day
After computing the period of one operating cycle, the total number of operating cycles that can be computed during a year can be computed by dividing 365 days with number of operating days in a cycle. The total expenditure in the year when year when divided by the number of operating cycles in a year will give the average amount of the working capital requirement.

SOURCES OF WORKING CAPITAL :The working capital requirements should be met both from short-term as well long-term sources of funds. Its will be appropriate to meet at least 2/3rd (if not the whole) of the permanent working capital requirements from longterm sources and only for the period needed. The financing of working capital through short-term sources of funds has the benefits of lower cost and establishing close relationship with the banks. Financing of working capital from long-term resources provides the following benefits: (i) It reduces risk, since the need to repay loans at frequent intervals is eliminated.


It increases liquidity since the firm has not to worry about the payment of these funds in the near future.

APPROACHES FOR DETERMINING THE FINANCING MIX:There are three basic approaches for determining the working capital financing mix.

(i) THE HEDGING APPRAOCH:According to this approach, the maturity of source of funds should match the nature of assets to be financed. The approach is, therefore, termed as Matching approach. It divides requirements of total working capital funds into two categories. a) Permanent working capital, i.e., funds required for purchase of core current assets. Such funds do not vary over time. b) Temporary or seasonal working capital, i.e., funds which fluctuate over time. The permanent working capital requirements should be financed by long-term funds while the seasonal working capital requirements should be financed out of short-term funds.

(ii) THE CONSERVATIVE APPROACH: According to this approach all requirements of funds should be met from long-term sources. The short-term sources should be used only for emergency requirements. The conservative approach is less risky, but more costly as compared to the hedging approach. In other words conservative approach is low profit-low risk (or high cost, high net working capital) while hedging approach results in high profithigh risk (or low cost, low net working capital).

(iii) TRADE-OFF BETWEEN HEDGING AND CONSERVATIVE APPROACH: The hedging and conservative approaches are both on two extremes. Neither of them can therefore help in efficient working capital management. A trade-off between these two can give satisfactory results. The level of such trade-off will differ from case to case depending upon perception of the risk by the persons involved in financial decision-making. However, one way of determining the level of trade-off is by finding the average of the minimum and the maximum requirements of working capital during a period. The average working capital so obtained may be financed by long-term funds and the balance by short-term funds. Management of different components of working capital Working capital management involves management of different components of working capital such as cash, inventories, accounts receivable, creditors, etc

*MANAGEMENT OF CASH It is the duty of the finance manager to provide adequate cash to all segments of the organization. He also has to ensure that no funds are blocked in idle cash since this will involve cost in terms of interest to the business. A sound cash management scheme, therefore, maintains the balance between the twin objectives of liquidity and cost. Meaning of cash The term cash with reference to cash management is used in two senses. In a narrower sense it includes coins, currency notes, cheques, bank drafts held by a firm with it and the demand deposits held by it in banks. In a broader sense it also includes near-cash assets such as, marketable securities and time deposits with banks. Such securities or deposits can immediately be sold or converted into cash if the circumstances require. The term cash management is generally used for management of both cash and near-cash assets. Motives for holding cash A distinguishing feature of cash as an asset, irrespective of the firm in which it is held, is that it does not earn any substantial return for the business. In spite of this fact cash is held by the firm with following motives. 1. Transaction motive A firm enters into a variety of business transactions resulting in both inflows and outflows. In order to meet the business obligation in such a situation, it is necessary to maintain adequate cash balance. Thus, cash balance is kept by the firms with the motive of meeting routine business payments. 2.Precautionary motive A firm keeps cash balance to meet unexpected cash needs arising out of unexpected contingencies such as floods, strikes, presentment of bills for payment earlier than the expected date, unexpected slowing down of collection of accounts receivable, sharp increase in prices of raw materials,

etc. The more is the possibility of such contingencies more is the cash kept by the firm for meeting them. 3.Speculative motive A firm also keeps cash balance to take advantage of unexpected opportunities, typically outside the normal course of the business. Such motive is, therefore, of purely a speculative nature. For example, A firm may like to take advantage of an opportunity of purchasing raw materials at the reduced price on payment of immediate cash or delay purchase of raw materials in anticipation of decline in prices. 4.Compensation motive Banks provide certain services to their clients free of charge. They, therefore, usually require clients to keep a minimum cash balance with them, which help them to earn interest and thus compensate them for the free services so provided. Business firms normally do not enter into speculative activities and, therefore, out of the four motives of holding cash balances, the two most important motives are the compensation motive. Objectives of cash management There are two basic objectives of cash management: 1. To meet the cash disbursement needs as per the payment schedule; 2. To minimize the amount locked up as cash balances. 1.Meeting cash disbursements The first basic objective of cash management is to meet the payments Schedule. In other words, the firm should have sufficient cash to meet the various requirements of the firm at different periods of times. The business has to make payment for purchase of raw materials, wages, taxes, purchases of plant, etc. The business activity may come to a grinding halt if the payment schedule is not maintained. Cash has, therefore, been aptly described as the oil to lubricate the ever-turning wheels of the business, without it the process grinds to a stop. 2.minimizing funds locked up as cash balances The second basic objective of cash management is to minimize the amount locked up as cash balances. In the process of minimizing the cash

balances, the finance manager is confronted with two conflicting aspects. A higher cash balance ensures proper payment with all its advantages. But this will result in a large balance of cash remaining idle. Low level of cash balance may result in failure of the firm to meet the payment schedule. The finance manager should, therefore, try to have an optimum amount of cash balance keeping the above facts in view. Cash management - - - - - basic problems Cash management involves the following four basic problems: 1. Controlling levels of cash; 2. Controlling inflows of cash; 3. Controlling outflows of cash; 4. Optimum investment of surplus cash. 1.Controlling levels of cash One of the basic objectives of cash management is to minimize the level of cash balance with the firm. This objective is sought to be achieved by means of the following: (i) Preparing cash budget: Cash budget or cash forecasting is the most significant device for planning and controlling the use of cash. It involves a projection of future cash receipts and cash disbursements of the firm over various intervals of time. It reveals to the finance manager the timings and amount of expected cash inflows and outflows over a period studied. With this information, he is better able to determine the future cash needs of the firm, plan for the financing of these needs and exercise control over the cash and liquidity of the firm. Thus in case a cash budget is properly prepared it correctly reveals the timings and size of net cash flows as well as the periods during which the excess cash may be available for temporary investment. In a small company, the preparation of cash budget or a cash forecast does not involve much of complications and, therefore, relatively a minor job. However, in case of big companies, it is almost a full time job handled by a senior person, namely, the budget controller or the treasurer. (ii) Providing for unpredictable discrepancies: Cash budget predicts discrepancies between cash inflows and outflows on the basis of normal business activities. It does not take into account discrepancies between cash inflows and cash outflows on account of unforeseen circumstances such as strikes, short-term recession, floods, etc. a

certain minimum amount of cash balance has, therefore, to be kept for meeting such unforeseen contingencies. Such amount is fixed on the basis of past experience and some intuition regarding the future.

(iii) Consideration of short costs: The term short cost refers to the cost incurred as a result of shortage of cash. Such costs may take any of the following forms: (a) The failure of the firm to meet its obligations in time may result in legal action by the firms creditors against the firm. This cost is in terms of fall in the firms reputation besides financial costs incurred in defending the suit; (b) Borrowing may have to be resorted to at high rate of interest. The firm may also be required to pay penalties, etc., to banks for not meeting the obligations in time. (iv) Availability of other sources of funds: A firm can avoid holding unnecessary large balance of cash for contingencies in case it has adequate arrangements with its bankers for borrowing money in times of emergencies. For such arrangements the firm has to pay a slightly higher rate of interest than that on a long-term debt. But considerable saving in interest costs will be effected because such interest will have to be paid only for shorter period. 2. Controlling inflows of cash Having prepared the cash budget, the finance manager should also ensure that there is no significant deviation between the projected cash inflows and the projected cash outflows. This requires controlling of both inflows as well as outflows of cash. Speedier collection of cash can be made possible by adoption of the following techniques, which have been found to be quite useful and effective. (i) Concentration Banking: Concentration banking is a system of decentralizing collections of accounts receivables in case of large firms having their business spread over a large area. According to this system, a large number of collection centers are established by the firm in different areas selected on geographical basis. The firm opens its bank accounts in local banks of different areas where it has its collection centers. The collection centers are required to collect cheques from

their customers and deposits them in the local bank account. Instructions are given to the local collection centers to transfer funds over a certain limit daily telegraphically to the bank at the head office. This facilitates fast movements of funds. The companys treasurer on the basis of the daily report received from the head office bank about the collected funds can use them for disbursement according to needs. This system of concentration banking results in the following advantages: (a) The mailing time is reduced since the collection centers themselves collect cheques from the customers and immediately deposit them in local bank accounts. Moreover, when the local collection centres are also used to prepare and send bills to the customers in their areas, the mailing time in sending bills to the customer is also reduced; (b) The time required to collect cheques is also reduced since the cheques deposited in the local bank accounts are usually drawn on banks in that area. This helps in quicker collection of cash. (ii) Lock-box system: Lock-box system is a further step in speeding up collection of cash. In case of concentration banking cheques are received by collection centres who, after processing, deposit them in the local bank accounts. Thus, there is time gap between actual receipt of cheques by a collection centre and its actual depositing in the local bank account. Lock-box system has been devised to eliminate delay on account of this time gap. According to this system, the firm hires a post-office box and instructs its customers to mail their remittances to the box. The firms local bank is given the authority to pick the remittances directly from the post-office box. The bank picks up the mail several times a day and deposits the cheques in the firms account. Standing instructions are given to the local bank to transfer funds to the head office bank when they exceed a particular limit. The Lock-Box system offers the following advantages: (a) All remittances are handled by the banks even prior to their de3posits with them at a very low cost;

(b) The cheques are deposited immediately upon receipt of remittances and the collecting process starts much earlier than that under the system of concentration banking. 3.control over cash flows An effective control over cash outflows or disbursements also helps a firm in conserving cash and reducing financial requirements. However, there is a basic difference between the underlying objective of exercising control over cash inflows and cash outflows. In case of the former, the objective is the maximum acceleration of collections while in the case of latter, it is to slow down the disbursements as much as possible. The combination of fast collections and slow disbursements will result in maximum availability of funds. A firm can advantageously control outflows of cash if the following considerations are kept in view: (i) Centralized system of disbursement should be followed as compared to decentralized system in case of collections. All payments should be made from a single control account. This will result in delay in presentment of cheques for payment by parties who are away from the place of control account. (ii) Payments should be made on the due dates, neither before nor after. The firm should neither lose cash discount nor its prestige on account of delay in payments. In other words, the firm should pay within the terms offered by the suppliers. (iii) The firm may use the technique of playing float for maximizing the availability of funds. The term float refers to the period taken from one stage to another in the cash collection process. It can be of the following types: -


Billing float:

It refers to the time interval between the making of a formal invoice by the seller for the goods sold and mailing the invoice to the purchaser;


Capital float:

It refers to the time, which elapses between receiving of the cheque by the post office or other messenger from the buyer till it is actually delivered to the seller.


Cheque processing float:

It refers to the time required for the seller to sort, record and deposit the cheque after it has been received by him.


Bank processing float:

This refers to the time period which elapses between deposit of the cheque with the banker and final credit of funds by the banker to the sellers account.

4. Investing surplus cash (i) Determination of the amount of surplus cash;

(ii) Determination of the channels of investments.

(i) Determining of surplus cash

Surplus cash is the cash in excess of the firms normal cash requirements. While determining the amount of surplus cash, the finance manager has to take into account the minimum cash balance that the firm must keep to avoid risk or cost of running out of funds. Such minimum level may be termed a safety level of cash.

Determining safety level for cash

The finance manager determines the safety level of cash separately both for normal periods and peak periods. In both the cases, he has to decide about the following two basic factors:


Desired days of cash:

It means the number of days for which cash balance should be sufficient to cover payments.

(b) Average daily cash outflows:

This means the average amount of disbursements, which will have to be made daily. The desired days of cash and average daily cash outflows are separately determined for normal and peak periods. Having determined them, safety level of cash can be calculated as follows:

During normal periods:

Safety level of cash = Desired days of cash x average daily cash outflows

During peak periods:

Safety level of cash = Desired days of cash at the busiest period x Average of highest daily cash outflows.

(ii) Determining of channels of investments

The finance manager can determine the amount of surplus cash, by comparing the actual mount of cash available with the safety or minimum level of cash. Such surplus may be either of a temporary or a permanent nature. Temporary cash surplus consists of funds, which are available for investment on a short-term basis (maximum 6 months), since they are required to meet regular obligations such as those of taxes, dividends, etc. Permanent cash surplus consists of funds, which are kept by the firm to avail of some unforeseen profitable opportunity of expansion or acquisition of some asset. Such funds are, therefore, available for investment for a period ranging from six months to a year.

Criteria for investment

In most of the companies there are usually no written instructions for investing the surplus cash. It is left to the discretion and judgement; he usually takes into consideration the following factors:

(i) Security:
This can be ensured by investing money in securities whose price remain more or less stable.

(ii) Liquidity:

This can be ensured by investing money in short-term securities including short-term fixed deposits with bank.

(iii) Yield:
Most corporate managers give less emphasis to yield as compared to security and liquidity of investment. They, therefore, prefer short-term government securities for investing surplus cash. However, some corporate managers follow aggressive investment policies, which maximize the yield on their investments.

(iv) Maturity:
Surplus cash is available not for an indefinite period. Hence, it will be advisable to select securities according to their maturities keeping in view the period for which surplus cash is available. If such selection is done carefully, the finance manager can maximize the yield as well as maintain the liquidity of investments.

Cash management models

Several types of cash management models have been recently designed to help in determining optimum cash balance. These models are interesting and are beginning to be used in practice. Two of such models are given below:

1.Baumol model: This model was suggested by William J Baumol. It is similar to one used for determination of economic order quantity. According to this model, optimum cash level is that level of cash where the carrying costs and transactions costs are the minimum.

Carrying costs
This refers to the cost of holding cash, namely, the interest foregone on marketable securities. They may also be termed as opportunity cost of keeping cash balance.

Transaction costs

This refers to the cost involved in getting the marketable securities converted into cash. This happens when the firm falls short of cash and to sell the securities resulting in clerical, brokerage, registration and other costs. There is an inverse relationship between the two costs. When one increases, the other decreases, the other decreases. Hence, optimum cash level will be at that point where these two costs are equal.

The formula for determining optimum cash balance can be put as follows: C= 2U x P S

Where, C = Optimum cash balance U = Annual (or monthly) cash disbursements P = Fixed costs per transaction S = Opportunity cost of one rupee p.a. (p.m) 2. Miller-Orr Model Baumol model is not suitable in those circumstances when the demand for cash is not steady and cannot be known in advance. Miller-Orr model helps in determining the optimum level of cash in such circumstances. It deals with cash management problem under the assumption of stochastic or random cash flows by laying down control limits for cash balances. These limits consist of an upper limit (h), lower limit (o) and return point (z). When cash balance reaches the upper limit, a transfer of cash equal to h-z is effected to marketable securities. When it touches the lower limit, a transfer equal to z-o from marketable securities to cash is made. No transaction between cash to marketable securities and marketable securities to cash is made during the period when the cash balance stays between the high and low limits.

The model is illustrated in the form of the following chart:

upper control limit h Cash balance z Return point

O Time

lower control limit

(D#4 source: Dr.S.N.Maheshwari, Financial management)

The above chart shows that when cash balances reaches the upper limit, an account equal to h-z is invested in the marketable securities and cash balance comes down to z level. When cash balance touches the lower limit marketable securities of the value of z-o are sold and the cash balance again goes up to z level. The upper limit and lower limit are set on the basis of opportunity cost of holding cash; degree of likely fluctuation in cash balances and the fixed costs associated with securities transactions.

Inventories are good held for eventual sale by a firm. Inventories are thus one of the major elements, which help the firm in obtaining the desired level of sales.

Kinds of inventories
Inventories can be classified into three categories.

(i) Raw materials:

These are goods, which have not yet been committed to production in a manufacturing firm. They may consist of basic raw materials or finished components.

(ii) Work-in-progress:
This includes those materials, which have been committed to production process but have not yet been completed.

(iii) Finished goods:

These are completed products awaiting sale. They are the final output of the production process in a manufacturing firm. In case of wholesalers and retailers, they are generally referred to as merchandise inventory. The levels of the above three kinds of inventories differ depending upon the nature of the business.

Benefits of holding inventories

Holding of inventories helps a firm in separating the process of purchasing, producing and selling. In case a firm does not hold sufficient stock of raw materials, finished goods, etc., the purchasing would take place only when the firm receives the order from a customer. It may result in delay in executing the order because of difficulties in obtaining/ procuring raw

materials, finished goods, etc. thus inventories provide cushion so that the purchasing, production and sales functions can proceed at optimum speed.

The specific benefits of holding inventories can be put as follows:

(i) Avoiding losses of sales

If a firm maintains adequate inventories it can avoid losses on account of losing the customers for non-supply of goods in time.

(ii) Reducing ordering cost

The variable cost associated with individual orders, e.g., typing, checking, approving and mailing the order, etc., can be reduced if a firm places a few large orders than numerous small orders.

(iii) Achieving efficient production runs

Maintenance of large inventories helps a firm in reducing the set-up cost associated with each production run.

Risks and costs associated with inventories

Holding of inventories exposes the firm to a number of risks and costs. Risk of holding inventories can be put as follows:

(i) Price decline

This may be due to increase in the market supply of the product, introduction of a new competitive product, price cutting by the competitors, etc.

(ii) Product deterioration

This may due to holding a product for too long a period or improper storage conditions.

(iii) Obsolescence
This may be due to change in customers taste, new production technique, improvements in the product design, specifications, etc.

The costs of holding inventories are as follows: (i) Materials cost This includes the cost of purchasing the goods, transportation and handling charges less any discount allowed by the supplier of the goods. (ii) Ordering cost This includes the variable cost associated with placing an order for the goods. The fewer the orders, the lower will be the ordering costs for the firm.

(iii) Carrying cost

This includes the expenses for storing the goods. It comprises storage costs, insurance costs, spoilage costs, cost of funds tied up in inventories, etc.

Management of inventory
Inventories often constitute a major element of the total working capital and hence it has been correctly observed, good inventory management is good financial management. Inventory management covers a large number of issues including fixation of minimum and maximum levels; determining the size of the inventory to be carried ; deciding about the issue price policy; setting up receipt and inspection procedure; determining the economic order quantity; providing proper storage facilities, keeping check on obsolescence and setting up effective information system with regard to the inventories. However, management inventories involves two basic problems: (i) Maintaining a sufficiently large size of inventory for efficient and smooth production and sales operations; (ii) Maintaining a minimum investment in inventories to minimize the direct-indirect costs associated with holding inventories to maximize the profitability. Inventories should neither be excessive nor inadequate. If inventories are kept at a high level, higher interest and storage costs would be incurred. On the other hand, a low level of inventories may result in frequent interruption in the production schedule resulting in underutilization of capacity and lower sales.

The objective of inventory management is, therefore, to determine and maintain the optimum level of investment in inventories, which help in achieving the following objectives: (i) (ii) (iii) (iv) Ensuring a continuous supply of materials to production department facilitating uninterrupted production. Maintaining sufficient stock of raw material in periods of short supply. Maintaining sufficient stock of finished goods for smooth sales operations. Minimizing the carrying costs.


Keeping investment in inventories at the optimum level.

Techniques of inventory management

Effective inventory requires an effective control over inventories. Inventory control refers to a system which ensures supply of required quantity and quality of inventories at the required time and the same time prevent unnecessary investment in inventories.

The techniques of inventory control/ management are as follows: 1. Determination of Economic Order Quantity (EOQ)
Determination of the quantity for which the order should be placed is one of the important problems concerned with efficient inventory management. Economic Order Quantity refers to the size of the order, which gives maximum economy in purchasing any item of raw material or finished product. It is fixed mainly taking into account the following costs.

(i) Ordering costs:

It is the cost of placing an order and securing the supplies. It varies from time to time depending upon the number of orders placed and the number of items ordered. The more frequently the orders are placed, and fewer the quantities purchased on each order, the greater will be the ordering costs and vice versa.

(ii) Inventory carrying cost:

It is the cost of keeping items in stock. It includes interest on investment, obsolescence losses, store-keeping cost, insurance premium, etc. The larger the value of inventory, the higher will be the inventory carrying cost and vice versa. The former cost may be referred as the cost of acquiring while the latter as the cost of holding inventory. The cost of acquiring decreases while the cost of holding increases with every increase in the quantity of purchase lot. A balance is, therefore, struck between the two opposing factors and the economic ordering quantity is determined at a level for which aggregate of two costs is the minimum.

Formula: Q= 2U x S Where, Q = Economic Ordering Quantity U = Quantity (units) purchased in a year (month) P = Cost of placing an order S = Annual (monthly) cost of storage of one unit.
2. Determination of optimum production quantity The EOQ model can be extended to production runs to determine the optimum production quantity. The two costs involved in this process are: (i) Set up costs;


Inventory carrying cost.

The set up cost is of the nature of fixed cost and is to be incurred at the time of commencement of each production run. Larger the size of the production run, lower will be the set-up cost per unit. However, the carrying cost will increase with increase in the size of the production run. Thus, there is an inverse relationship between the set-up cost and inventory carrying cost. The optimum production size is at that level where the total of the set-up cost and the inventory carrying cost is the minimum. In other words, at this level the two costs will be equal. The formula for EOQ can also be used for determining the optimum production quantity as given below: E= 2U x P S Where E = Optimum production quantity U = Annual (monthly) output P = Set-up cost for each production run S = Cost of carrying inventory per annum (per month)

MANAGEMENT OF ACCOUNTS RECEIVABLES Accounts receivables (also properly termed as receivables) constitute a significant portion of the total currents assets of the business next after inventories. They are a direct consequences of trade credit which has become an essential marketing tool in modern business. When a firm sells goods for cash, payments are received immediately and, therefore, no receivables are credited. However, when a firm sells goods or services on credit, the payments are postponed to future dates and receivables are created. Usually, the credit sales are made on open account, which means that, no, formal acknowledgements of debt obligations are taken from the buyers. The only documents evidencing the same are a purchase order, shipping invoice or even a billing statement. The policy of open account sales facilities business transactions and reduces to a great extent the paper work required in connection with credit sales.

Meaning of receivables Receivables are assets accounts representing amounts owed to the firm as a result of sale of goods / services in the ordinary course of business. They, therefore, represent the claims of a firm against its customers and are carried to the assets side of the balance sheet under titles such as accounts receivables, customer receivables or book debts. They are, as stated earlier, the result of extension of credit facility to then customers a reasonable period of time in which they can pay for the goods purchased by them. Purpose of receivables Accounts receivables are created because of credited sales. Hence the purpose of receivables is directly connected with the objectives of making credited sales.

The objectives of credited sales are as follows: (i) Achieving growth in sales: If a firm sells goods on credit, it will generally be in a position to sell more goods than if it insisted on immediate cash payments. This is because many customers are either not prepared or not in a position to pay cash when they purchase the goods. The firm can sell goods to such customers, in case it resorts to credit sales. (ii) Increasing profits: Increase in sales results in higher profits for the firm not only because of increase in the volume of sales but also because of the firm charging a higher margin of profit on credit sales as compared to cash sales. (iii) Meeting competition: A firm may have to resort to granting of credit facilities to its customers because of similar facilities being granted by the competing firms to avoid the loss of sales from customers who would buy elsewhere if they did not receive the expected output. The overall objective of committing funds to accounts receivables is to generate a large flow of operating revenue and hence profit than what would be achieved in the absence of no such commitment. Costs of maintaining receivables The costs with respect to maintenance of receivables can be identified as follows: 1. Capital costs: Maintenance of accounts receivables results in blocking of the firms financial resources in them. This is because there is a time lag between the sale of goods to customers and the payments by them. The firm has, therefore, to arrange for additional funds top meet its own obligations, such as payment to employees, suppliers of raw materials, etc., while awaiting for payments from its customers. Additional funds may either be raised from outside or out of profits retained in the business. In both the cases, the firm incurs a cost. In the former case, the firm has to pay interest to the outsider while in the latter case, there is an opportunity cost to the firm, i.e., the money which the firm could have earned otherwise by investing the funds elsewhere.

2. Administrative costs: The firm has to incur additional administrative costs for maintaining accounts receivable in the form of salaries to the staff kept for maintaining accounting records relating to customers, cost of conducting investigation regarding potential credit customers to determine their creditworthiness, etc. 3. Collection costs: The firm has to incur costs for collecting the payments from its credit customers. Sometimes, additional steps may have to be taken to recover money from defaulting customers. 4. Defaulting costs: Sometimes after making all serious efforts to collect money from defaulting customers, the firm may not be able to recover the overdues because of the of the inability of the customers. Such debts are treated as bad debts and have to be written off since they cannot be realized. Factors affecting the size of receivables The size of the receivable is determined by a number of factors. Some of the important factors are as follows: (1) Level of sales: This is the most important factor in determining the size of accounts receivable. Generally in the same industry, a firm having a large volume of sales will be having a larger level of receivables as compared to a firm with a small volume of sales. Sales level can also be used for forecasting change in accounts receivable. (2) Credited policies: The term credit policy refers to those decision variables that influence the amount of trade credit, i.e., the investment in receivables. These variables include the quantity of trade accounts to be accepted, the length of the credit period to be extended, the cash discount to be given and any special terms to be offered depending upon particular circumstances of the firm and the customer. A firms credit policy, as a matter of fact, determines the amount of risk the firm is willing to undertake in its sales activities. If a firm has a lenient or a relatively liberal credit policy, it will experience a higher level of receivables as compared to a firm with a more rigid or stringent credit policy.

This is because of two reasons: (i) A lenient credit policy encourages even the financially strong customers to make delays in payments resulting in increasing the size of the accounts receivables; (ii) Lenient credit policy will result in greater defaults in payments by financially weak customers thus resulting in increasing the size of receivables. (3) Terms of trade: The size of the receivables is also affected by terms of trade (or credit terms) offered by the firm. The two important components of the credit terms are: (i) Credit period; (ii) Cash discount. (i) Credit period: The term credit period refers to the time duration for which credit is extended to the customers. It is generally expressed in terms of net days. For example, If a firms credit terms are net 15, it means the customers are expected to pay within 15 days from the date of credit sale. (ii) Cash discount: Most firms offer cash discount to their customers for encouraging them to pay their dues before the expiry of the credit period. The terms of the cash discounts indicate the rate of discount as well as the period for which the discount has been offered. MANAGEMENT OF ACCOUNTS PAYABLE Management of accounts payable is as much important as management of accounts receivable. There is a basic difference between the approach to be adopted by the finance manager in the two cases. Whereas the underlying

objective in case of accounts receivable is to maximize the acceleration of the collection process, the objective in case of accounts payable is to slow down the payments process as much as possible. But it should be noted that the delay in payment of accounts payable may result in saving of some interest costs but it can prove very costly to the firm in the form of loss credit in the market. The finance manager has, therefore, to ensure that the payments after obtaining the best credit terms possible.

Overtrading and undertrading The concepts of overtrading and undertrading are intimately connected with the net working capable position of the business. To be more precise they are connected with the cash position of the business. OVERTRADING: Overtrading means an attempt to maintain or expand scale of operations of the business with insufficient cash resources. Normally, concerns having overtrading have a high turnover ratio and a low current ratio. In a situation like this, the company is not in a position to maintain proper stocks of materials, finished goods, etc., and has to depend on the mercy of the suppliers to supply them goods at the right time. It may also not be able to extend credit to its customers, besides making delay in payment to the creditors. Overtrading has been amply described as overblowing the balloon. This may, therefore, prove to be dangerous to the business since disproportionate increase in the operations of the business without adequate resources may bring its sudden collapse. Causes of overtrading The following may be the causes of over-trading: (i) Depletion of working capital: Depletion of working capital ultimately results in depletion of cash resources. Cash resources of the company may get depleted by premature repayment of long-term loans, excessive drawings, dividend payments, purchase of fixed assets and excessive net trading losses, etc. (ii) Faulty financial policy:

Faulty financial policy can result in shortage of cash and overtrading in several ways: (a) Using working capital for purchase of fixed assets. (b) Attempting to expand the volume of the business without raising the necessary resources, etc.

(iii) Over-expansion: In national emergencies like war, natural calamities, etc., a firm may be required to produce goods on a larger scale. Government may pressurize the manufacturers to increase the volume of production without providing for adequate finances. Such pressure results in over-expansion of the business ignoring the elementary rules of sound finance. (iv) Inflation and rising prices: Inflation and rising prices make renewals and replacements of assets costlier. The wages and material costs also rise. The manufacturer, therefoe, needs more money even to maintain the existing level of activity. (v) Excessive taxation: Heavy taxes result in depletion of cash resources at a scale higher than what is justified. The cash position is further strained on account of efforts of the company to maintain reasonable dividend rates for their shareholders. Consequences of overtrading The consequences of over-trading can be summarized as follows: (i) Difficulty in paying wages and taxes: This is one of the most dangerous consequences of overtrading. Nonpayments of wages in time create a feeling of uncertainty, insecurity and dissatisfaction in all ranks of the labour. Non-payments of taxes in time may result in bringing down the reputation of the company considerably in the business and government circles. (ii) Costly purchases: The company has to pay more for its purchases on account of its inability to have proper bargaining, bulk buying and selecting proper source of supplying quality materials.

(iii) Reduction in sales: The company may have to suffer in terms of sales because the pressure for cash requirements may force it to offer liberal cash discounts to debtors for prompt payments, as well as selling goods at throwaway prices. (iv) Difficulties in making payments: The shortage of cash will force the company to persuade its creditors to extend credit facilities to it. Worry, anxiety and fear will be the managements constant companions. (v) Obsolete plant and machinery: Shortage of cash will force the company to delay even the necessary repairs and renewals. Inefficient working, unavoidable breakdowns will have an adverse effect both on volume of production and rate of profit.

Symptoms and remedies for overtrading

The situation of overtrading should be remedied at the earliest possible opportunity, i.e., as soon as its first symptoms are visible. The symptoms can be put as follows: (a) A higher increase in the amount of creditors as compared to debtors. This is because of firms inability to pay its creditors in time and exercising of undue pressure on debtors for payments; (b) Increased bank borrowing with corresponding increase in inventories; (c) Purchase of fixed assets out of short-term funds; (d) A fall in the working capital turnover (working capital/sales) ratio. (e) A low current ratio and high turnover ratio. The cure for overtrading is easier to prescribe but difficult to follow. The cure is simple-reduce the business or increase finance. Both are difficult. However, arrangement of more finance is better. If this is not possible, the only advisable course left will be to sell the business as a going concern.

It is the reverse of overtrading. It means improper and underutilization of funds lying at the disposal of the undertaking. In such a situation the level of trading is low as compared to the capital employed in the business. It

results in increase in the size of inventories, book debts and cash balances. Undertrading is a matter of fact an aspect of overcapitalization. The basic cause of undertrading is, therefore, underutilization of the firms resources. Such underutilization may be due any one or more of the following causes: Conservative policies followed by the management; Non-availability or shortage of basic facilities necessary for production such as, raw materials, power, labour, etc; General depression in the market resulting in fall in the demand of companys products;

The symptoms of undertrading are the following:

(i) (ii) (iii) A very high current ratio; Low turnover ratios; An increase in working capital turnover (working capital/ sales) ratio.

Consequences of undertrading
The following are the consequences of undertrading: (i) The profits of the firm show a declining trend resulting in a lower return on capital employed (ROI) in the business. (ii) The value of the shares of the company on the stock exchange starts falling on account of lower profitability; (iii) There is loss to the reputation of the firm on account of lower profitability and creation of impression in the minds of investors that the management is inefficient.

Remedies for undertrading

The condition of undertrading is set in because of underutilization of the firms resources. The situation can, therefore, be remedied by the management by adopting a more dynamic and result-oriented approach. The firm may go for diversification and undertaking new profitable jobs, projects, etc., resulting in a better and efficient utilization of the firms resources.

Key Working Capital Ratios

The following, easily calculated, ratios are important measures of working capital utilization.
Ratio Formulae Result

On an average, your stock turnover is in x days. Obsolete stock, slow moving lines will extend overall stock turnover days. It takes your average x days to collect receivables due to you. Effective debtor management will minimize the days On an average, you pay your suppliers every x days. If you negotiate better credit terms this will increase. If you pay earlier, say, to get a discount this will decline. Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. Current Liabilities are amount you are due to pay within the coming 12 months. Similar to the Current Ratio but takes

Stock Turnover (in days) Receivables Ratio (in days) Payables Ratio (in days) Current Ratio

Average Stock * 365/ Cost of Goods Sold Debtors * 365/ Sales Creditors * 365/ Cost of Sales (or Purchases) Total Current Assets/ Total Current Liabilities

= x days

= x days = x days

=x times

Quick Ratio

(Total Current


Assets Inventory)/ Total Current Liabilities


account of the fact that it may take time to convert inventory into cash


The working capital needs of affirm are influenced by numerous factors. The important ones are: Nature of business The working capital requirement of a firm is closely related to the nature of its business. A service firm, like an electricity undertaking which has a short operating cycle, which sells predominantly on cash basis, has a modest working capital requirement. On the other hand, a manufacturing concern like a machine tools unit, which has a long operating cycle and which sells largely on credit, has a very substantial working capital requirement. Seasonality of operations Firms which have marked seasonality in their operations usually have highly fluctuating working capital requirements. To illustrate, consider a firm manufacturing ceiling fans. The sale of ceiling fans reaches a peak during the summer months and drops sharply during the winter period. Production policy A firm marked by pronounced seasonal fluctuation in its sales pursue a production policy, which may reduce the sharp variations in working capital requirements. Market conditions The degree of competition prevailing in the market place has an important bearing on working capital needs. When competition is keen, a larger inventory of finished goods is required to promptly serve customers who may not be inclined to wait because other manufacturers are ready to meet there needs.

Conditions of supply The inventory of raw materials, spares, and stores depends on the conditions of supply. If the supply is prompt and adequate, the firm can manage with small inventory.

Working capital assessment in Bank of patiala: PURI COMMITTEE RECOMMENDATIONS.




RS. ______ RS. ______

(B) (C)


Method #1 for assessment of working capital

Working capital assessment a Particulars Total current assets (Excluding fixed deposits Money margin) Other current liabilities Excluding short-term bank bal.) Working capital GAP (a-b) Minimum stipulated Net working capital (25% of total current assets Excluding expected receivables.) Actual /projected net w.cap Item (c-d) Item (c-e) MPBF (lower of ( f or g)) Mar03 Mar04 (Rs. In lakhs) Provisional mar'05 Projected mar'-6 56.6 62.5







c d









e f g h I

6.84 11.78 16.35 11.78

14.67 22.51 21.77 21.77

15.6 22.28 18 18

12.5 25 25 25

Excess borrows if any

Method #2 (sales approach) for assessment of working capital

Working capital assessment A Particulars Projected sales for the year 2006-7 25% of sales Less:- 5% of gross sales margin Permissible bank finance B 25% of sales Less: - projected net working capital Bank finance Bank borrowings shown in the projections Of the company F Limit applied for Limit recommended for sanction E or F whichever is lower ( lakhs) 115.09 28.77 5.75 23.02 28.77 15.21 15.21

15.00 10.00 10.00

RECOMMENDATIONS BY TANDON COMMITTEE The report submitted by the Tandon committee is a landmark in the history of financing of working capital by commercial banks in India. The report was submitted on 9th August 1975. The report included recommendations covering all aspects of lending. The recommendations were essentially based on three principles: (i) A proper financial discipline has to be observed by the borrower. He should supply to the banker information regarding his operational plans well in advance. (ii) The main function of the banker as a lender is to supplement the borrowers resources to carry an acceptable level of current assets. (iii) The bank should know the end-use of bank credit so that it is used only for the purposes for which it is made available.

SCANNING OF WORKING CAPITAL FINANCING IN STATE BANK OF PATIALA Recommendations after Scanning of working capital financing Bank of patiala: (i) While assessing the project, the profit element should be considered with the risk element collectively. (ii) Financing of working capital should be avoided to a long loss making firm, even though regular customer. (iv) (v) (vi) Some times the clients business looks promising and real to his words then certain relaxation should be provided as far as policies are considered. Sector analysis should be considered before providing the working capital finance to any firm, trends should be considered.

(v) Statement of financial transactions should be review at regular interval to minimize losses due to irregular payments and defaulters.