4 4 Project Report on Working Capital Management

7/31/2019 4 4 Project Report on Working Capital Management

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Profile: State Bank Of Patiala

Date of Establishment 1917

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

Management Team A.C. Varma - MDDiwakar 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)

Overview An associate bank of State Bank of India, State Bank of Patiala has a network of 847 service outlets, including 759branches in all major cities of India. It offers personalbanking, agricultural and rural banking, SME and corporatebanking, internet banking, NRI services etc. It facilitates itsclients to pay their taxes through its branches.

State Bank of Patiala supports Malwa Gramin Bank. It alsoprovides car loans, education loans, two-wheeler loans,consumer durable loans, loans against term deposits, goldornaments and personal loans. On 24th January 2003 StateBank of Patiala became the first fully computerised PublicSector Bank in the country.


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Types of working capital:-Can be divided into two categories on the basis of time: -

1. Permanent working capital2. 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 businessactivities. 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 itsreturn 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 andtherefore it should be financed out of long-term funds.This is the reason why the current ratio has to be substantially more than 1.


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(D#3 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 bythe firm.

It should neither have excessive nor inadequate. Both situations aredangerous. Excessive working capital means the firm has idle funds, whichearn no profit for the firm. Inadequate working capital means the firm doesnot 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 thathigher 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 therisk, 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 bothcurrent assets and current liabilities.In other words, working capital management is concerned with the problemsthat arise in attempting to manage the current assets, the current liabilities andthe 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 thecash should be available for purchase of fresh material and for running the


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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 firmsliquidity 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 capitalmanagement policies in respect of each of the components of working capitalso as to ensure higher profitability, proper liquidity and sound structural healthof the organization.

In order to achieve this objective the finance manager has to perform basicallyfollowing 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.

TECHNIQUES FOR ASSESSMENT OF WORKING CAPITAL REQUIREMENTS: -

1. ESTIMATION OF COMPONENTS OF WORKING CAPITALMETHOD: -

Since working capital is the excess of current assets over currentliabilities, an assessment of the working capital requirements can be made byestimating the amounts of different constituents of working capital e.g.,inventories, accounts receivable, cash, accounts payable, etc.


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2. PERCENT OF SALES APPROACH: -

This is a traditional and simple method of estimating working capitalrequirements.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 estimatingworking capital requirements is equivalent to the sum of the durations of eachof 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-CWhere,

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.


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Each of the components of the operating cycle can be calculatedas follows:-

R= Average stock of raw materials and storesAverage 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 creditorsAverage 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 bydividing 365 days with number of operating days in a cycle. The totalexpenditure in the year when year when divided by the number of operating

cycles in a year will give the average amount of the working capitalrequirement.

SOURCES OF WORKING CAPITAL :-

The working capital requirements should be met both from short-termas well long-term sources of funds. Its will be appropriate to meet at least 2/3 rd

(if not the whole) of the permanent working capital requirements from long-term 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 withthe banks.

Financing of working capital from long-term resources provides thefollowing benefits:

(i) It reduces risk, since the need to repay loans at frequent intervals iseliminated.


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(ii) 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 capitalfinancing 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 twocategories.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 bylong-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 metfrom 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 tothe 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 profit-high risk (or low cost, low net working capital).


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balances, the finance manager is confronted with two conflicting aspects. Ahigher cash balance ensures proper payment with all its advantages. But thiswill result in a large balance of cash remaining idle. Low level of cash balancemay result in failure of the firm to meet the payment schedule.

The finance manager should, therefore, try to have an optimum amountof cash balance keeping the above facts in view.

Cash management - - - - - basic problemsCash 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 cashOne of the basic objectives of cash management is to minimize thelevel of cash balance with the firm. This objective is sought to be achieved bymeans 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 cashreceipts and cash disbursements of the firm over various intervals of time. Itreveals to the finance manager the timings and amount of expected cashinflows 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 timingsand size of net cash flows as well as the periods during which the excess cashmay 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 bigcompanies, 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 accountdiscrepancies between cash inflows and cash outflows on account of unforeseen circumstances such as strikes, short-term recession, floods, etc. a


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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 legalaction by the firms creditors against the firm. This cost is in terms of fall in the firms reputation besides financial costs incurred in defendingthe suit;

(b)Borrowing may have to be resorted to at high rate of interest. The firmmay also be required to pay penalties, etc., to banks for not meeting theobligations 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 firmhas to pay a slightly higher rate of interest than that on a long-term debt. Butconsiderable saving in interest costs will be effected because such interest willhave to be paid only for shorter period.

2. Controlling inflows of cashHaving prepared the cash budget, the finance manager should also

ensure that there is no significant deviation between the projected cashinflows and the projected cash outflows. This requires controlling of bothinflows as well as outflows of cash.Speedier collection of cash can be made possible by adoption of the followingtechniques, 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 alarge area. According to this system, a large number of collection centers areestablished by the firm in different areas selected on geographical basis. Thefirm opens its bank accounts in local banks of different areas where it has itscollection centers. The collection centers are required to collect cheques from


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their customers and deposits them in the local bank account. Instructions aregiven to the local collection centers to transfer funds over a certain limit dailytelegraphically to the bank at the head office. This facilitates fast movementsof 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 disbursementaccording 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 inlocal bank accounts. Moreover, when the local collection centres arealso used to prepare and send bills to the customers in their areas, themailing time in sending bills to the customer is also reduced;

(b)The time required to collect cheques is also reduced since the chequesdeposited in the local bank accounts are usually drawn on banks in thatarea.

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 timegap between actual receipt of cheques by a collection centre and its actualdepositing 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 instructsits customers to mail their remittances to the box. The firms local bank isgiven 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 thefirms 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;


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(b)The cheques are deposited immediately upon receipt of remittances andthe collecting process starts much earlier than that under the system of concentration banking.

3.control over cash flowsAn effective control over cash outflows or disbursements also helps a

firm in conserving cash and reducing financial requirements. However, thereis a basic difference between the underlying objective of exercising controlover cash inflows and cash outflows. In case of the former, the objectiveis the maximum acceleration of collections while in the case of latter, it is toslow down the disbursements as much as possible. The combination of fastcollections and slow disbursements will result in maximum availability of funds.

A firm can advantageously control outflows of cash if the followingconsiderations are kept in view:

(i) Centralized system of disbursement should be followed ascompared to decentralized system in case of collections. All

payments should be made from a single control account. Thiswill 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 prestigeon account of delay in payments. In other words, the firmshould 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 tothe period taken from one stage to another in the cash collection

process.

It can be of the following types: -(i) Billing float: It refers to the time interval between the making of aformal invoice by the seller for the goods sold and mailing theinvoice to the purchaser;

(ii) Capital float:


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

(iii) 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.

(iv) Bank processing float : This refers to the time period which elapses betweendeposit 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 cashSurplus 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 avoidrisk or cost of running out of funds. Such minimum level may be termed asafety level of cash.

Determining safety level for cashThe 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:


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This means the average amount of disbursements, which will have to bemade daily.The desired days of cash and average daily cash outflows are separatelydetermined for normal and peak periods. Having determined them, safetylevel 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 investmentsThe finance manager can determine the amount of surplus cash, by

comparing the actual mount of cash available with the safety or minimumlevel of cash. Such surplus may be either of a temporary or a permanentnature.

Temporary cash surplus consists of funds, which are available for investment on a short-term basis (maximum 6 months), since they arerequired to meet regular obligations such as those of taxes, dividends, etc.Permanent cash surplus consists of funds, which are kept by the firm to availof some unforeseen profitable opportunity of expansion or acquisition of someasset. Such funds are, therefore, available for investment for a period rangingfrom six months to a year.

Criteria for investmentIn most of the companies there are usually no written instructions for

investing the surplus cash. It is left to the discretion and judgement; he usuallytakes 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:


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This can be ensured by investing money in short-term securitiesincluding 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-termgovernment securities for investing surplus cash. However, some corporatemanagers follow aggressive investment policies, which maximize the yield ontheir investments.

(iv) Maturity:Surplus cash is available not for an indefinite period. Hence, it will beadvisable 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 liquidityof investments.

Cash management modelsSeveral types of cash management models have been recently designed tohelp in determining optimum cash balance. These models are interesting andare 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 thecarrying costs and transactions costs are the minimum.

Carrying costsThis refers to the cost of holding cash, namely, the interest foregone on

marketable securities. They may also be termed as opportunity cost of keepingcash balance.

Transaction costs


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This refers to the cost involved in getting the marketable securitiesconverted into cash. This happens when the firm falls short of cash and to sellthe securities resulting in clerical, brokerage, registration and other costs.

There is an inverse relationship between the two costs. When oneincreases, the other decreases, the other decreases. Hence, optimum cash levelwill be at that point where these two costs are equal.

The formula for determining optimum cash balance can be put asfollows:

C= 2U x PS

Where,C = Optimum cash balanceU = Annual (or monthly) cash disbursementsP = Fixed costs per transactionS = Opportunity cost of one rupee p.a. (p.m)

2. Miller-Orr ModelBaumol model is not suitable in those circumstances when thedemand 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 problemunder the assumption of stochastic or random cash flows by layingdown control limits for cash balances. These limits consist of anupper limit (h), lower limit (o) and return point (z). When cash

balance reaches the upper limit, a transfer of cash equal to h-z iseffected to marketable securities. When it touches the lower limit, atransfer equal to z-o from marketable securities to cash is made. Notransaction between cash to marketable securities and marketablesecurities to cash is made during the period when the cash balancestays between the high and low limits.


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

upper control limith

Cash balancez Return point

O lower control limitTime

(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 againgoes up to z level.

The upper limit and lower limit are set on the basis of opportunity costof holding cash; degree of likely fluctuation in cash balances and the fixedcosts associated with securities transactions.


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*MANAGEMENT OF INVENTORIESInventories are good held for eventual sale by a firm. Inventories are

thus one of the major elements, which help the firm in obtaining the desiredlevel of sales.

Kinds of inventoriesInventories 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 finishedcomponents .

(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 andretailers, they are generally referred to as merchandise inventory.

The levels of the above three kinds of inventories differ depending upon thenature of the business.

Benefits of holding inventoriesHolding of inventories helps a firm in separating the process of

purchasing, producing and selling. In case a firm does not hold sufficientstock of raw materials, finished goods, etc., the purchasing would take placeonly when the firm receives the order from a customer. It may result in delayin executing the order because of difficulties in obtaining/ procuring raw


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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 salesIf 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 costThe 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 runsMaintenance 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 declineThis 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 deteriorationThis may due to holding a product for too long a period or improper storage conditions.

(iii) ObsolescenceThis may be due to change in customers taste, new production

technique, improvements in the product design, specifications, etc.


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(ii) Inventory carrying cost.

The set up cost is of the nature of fixed cost and is to be incurred at thetime 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 wherethe 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

WhereE = Optimum production quantityU = Annual (monthly) outputP = Set-up cost for each production runS = Cost of carrying inventory per annum (per month)


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MANAGEMENT OF ACCOUNTS RECEIVABLESAccounts 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 immediatelyand, therefore, no receivables are credited. However, when a firm sells goodsor services on credit, the payments are postponed to future dates andreceivables are created. Usually, the credit sales are made on open account,which means that, no, formal acknowledgements of debt obligations are takenfrom the buyers. The only documents evidencing the same are a purchaseorder, shipping invoice or even a billing statement. The policy of openaccount 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 asaccounts 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 receivablesAccounts receivables are created because of credited sales. Hence the

purpose of receivables is directly connected with the objectives of makingcredited sales.


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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 sellmore goods than if it insisted on immediate cash payments. This is becausemany customers are either not prepared or not in a position to pay cash whenthey purchase the goods. The firm can sell goods to such customers, in case itresorts 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 ahigher 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 theloss of sales from customers who would buy elsewhere if they did not receivethe expected output.

The overall objective of committing funds to accounts receivables is togenerate a large flow of operating revenue and hence profit than what would

be achieved in the absence of no such commitment.

Costs of maintaining receivablesThe 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 thesale 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 paymentsfrom its customers. Additional funds may either be raised from outside or outof profits retained in the business. In both the cases, the firm incurs a cost. Inthe 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 firmcould have earned otherwise by investing the funds elsewhere.


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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 maintainingaccounting records relating to customers, cost of conducting investigationregarding 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 baddebts and have to be written off since they cannot be realized.

Factors affecting the size of receivablesThe 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 asmall 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 variablesinclude 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 thecustomer. 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 alenient 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.


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This is because of two reasons:(i) A lenient credit policy encourages even the financially

strong customers to make delays in payments resultingin increasing the size of the accounts receivables;

(ii) Lenient credit policy will result in greater defaults in payments by financially weak customers thus resultingin 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 cashdiscounts indicate the rate of discount as well as the period for which the

discount has been offered.

MANAGEMENT OF ACCOUNTS PAYABLEManagement of accounts payable is as much important as management

of accounts receivable. There is a basic difference between the approach to beadopted by the finance manager in the two cases. Whereas the underlying


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Faulty financial policy can result in shortage of cash and overtrading inseveral 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 themanufacturers to increase the volume of production without providing for adequate finances. Such pressure results in over-expansion of the businessignoring 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 overtradingThe 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. Non-

payments of wages in time create a feeling of uncertainty, insecurity anddissatisfaction 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.


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(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 managementsconstant 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 overtradingThe 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 cureis simple-reduce the business or increase finance. Both are difficult. However,arrangement of more finance is better. If this is not possible, the onlyadvisable course left will be to sell the business as a going concern.

UNDERTRADING: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 levelof trading is low as compared to the capital employed in the business. It


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results in increase in the size of inventories, book debts and cash balances.Undertrading is a matter of fact an aspect of overcapitalization. The basiccause 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 thedemand of companys products;

The symptoms of undertrading are the following:(i) A very high current ratio;

(ii) Low turnover ratios;(iii) An increase in working capital turnover (working capital/sales) ratio.

Consequences of undertradingThe 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 startsfalling 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 themanagement is inefficient.

Remedies for undertradingThe condition of undertrading is set in because of underutilization of

the firms resources. The situation can, therefore, be remedied by themanagement by adopting a more dynamic and result-oriented approach. Thefirm may go for diversification and undertaking new profitable jobs, projects,etc., resulting in a better and efficient utilization of the firms resources.


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Key Working Capital RatiosThe following, easily calculated, ratios are important measures of workingcapital utilization .

Ratio Formulae Result Interpre tationStock Turnover (in days)

Average Stock * 365/Cost of GoodsSold

= x days On an average, your stock turnover is in x days.

Obsolete stock, slow moving lines will extendoverall stock turnover days.

ReceivablesRatio(in days)

Debtors * 365/Sales

= x days It takes your average x days to collectreceivables due to you. Effective debtor management will minimize the days

PayablesRatio(in days)

Creditors *365/Cost of Sales(or Purchases)

= x days On an average, you pay your suppliersevery x days. If you negotiate better credit terms this will increase. If you payearlier, say, to get a discount this willdecline.

Current

Ratio

Total Current

Assets/Total CurrentLiabilities

= x

times

Current Assets are assets that you can

readily turn in to cash or will do sowithin 12 months in the course of business. Current Liabilities are amountyou are due to pay within the coming 12months.

Quick Ratio (Total Current = x Similar to the Current Ratio but takes


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Assets -Inventory)/Total CurrentLiabilities

times account of the fact that it may take timeto convert inventory into cash

FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS

The working capital needs of affirm are influenced by numerous factors.The important ones are:

Nature of businessThe working capital requirement of a firm is closely related to the

nature of its business. A service firm, like an electricity undertaking which hasa short operating cycle, which sells predominantly on cash basis, has a modestworking capital requirement. On the other hand, a manufacturing concern likea machine tools unit, which has a long operating cycle and which sells largelyon credit, has a very substantial working capital requirement.

Seasonality of operationsFirms which have marked seasonality in their operations usually have

highly fluctuating working capital requirements. To illustrate, consider a firmmanufacturing ceiling fans. The sale of ceiling fans reaches a peak during thesummer months and drops sharply during the winter period.

Production policyA firm marked by pronounced seasonal fluctuation in its sales pursue a

production policy, which may reduce the sharp variations in working capitalrequirements.

Market conditionsThe degree of competition prevailing in the market place has an

important bearing on working capital needs. When competition is keen, alarger inventory of finished goods is required to promptly serve customerswho may not be inclined to wait because other manufacturers are ready tomeet there needs.


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Conditions of supplyThe inventory of raw materials, spares, and stores depends on the

conditions of supply. If the supply is prompt and adequate, the firm canmanage with small inventory.

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

FORMULA RECOMMENDED FOR ASSESSMENT OF WORKING CAPITAL REQUIREMENTS OF SSI.

I) ADVANCED UPTO RS.25000(OPERATING CYCLE * MONTHLY EXPENDITURE)/30

II) ADVANCES ABOVE RS.25000 AND UPTO RS.2 LAKHS

SR.NO STOCKING PERIOD WORKING CAPITAL REQUIREMENTS MARGIN %AGE VALUE PBF

1IMPORTEDRAW MATERIAL

________ DAYS

2INDIGENOUSRAW MATERIALS

______ DAYS

3STOCK IN PROGRESS _________ DAYS

4FINISHED GOODS _______ DAYS

5SUNDRY DEBTORS ______ DAYS

6MONTHLY EXPENSESFOR ONE MONTH

TOTAL (A)

LESS: - LIQUID SURPLUS IN


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BALANCESHEET AS ON: -________: RS. _______

AND CREDIT ON PURCHASES _____ DAYS RS. ______ RS. ______ (B)

LIMIT RECOMMENDED / SANCTIONED (A -B) RS. _______ (C)

Method #1 for assessment of working capitalWorking capital assessment

(Rs. In lakhs)Sr.no Particulars Mar03 Mar04 Provisional mar'05 Projected mar'-6a Total current assets

(Excluding fixed deposits 57.03 69.65 56.6 62.5Money margin)

b Other current liabilities 33.84 33.21 23 25Excluding short-term bank bal.)

c Working capital GAP (a-b) 23.19 36.44 33.6 37.5 d Minimum stipulated

Net working capital 11.41 13.93 11.32 12.5

(25% of total current assetsExcluding expected receivables.)

e Actual /projected net w.cap 6.84 14.67 15.6 12.5 f Item (c-d) 11.78 22.51 22.28 25 g Item (c-e) 16.35 21.77 18 25 h MPBF (lower of ( f or g)) 11.78 21.77 18 25

I Excess borrows if any


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

Sr.no Particulars (Rs.in lakhs)A Projected sales for the year 2006-7 115.09

25% of sales 28.77

Less:- 5% of gross sales margin 5.75

Permissible bank finance 23.02 B 25% of sales 28.77

Less: - projected net working capital 15.21 E Bank finance 15.21

Bank borrowings shown in the projectionsOf the company 15.00

F Limit applied for 10.00

Limit recommended for sanction 10.00E or F whichever is lower


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RECOMMENDATIONS BY TANDON COMMITTEE

The report submitted by the Tandon committee is a landmark in thehistory of financing of working capital by commercial banks in India. Thereport was submitted on 9 th 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. Heshould supply to the banker information regarding his operational plans wellin 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 usedonly for the purposes for which it is made available.


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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 lossmaking firm, even though regular customer.

(iv) Some times the clients business looks promising and real tohis words then certain relaxation should be provided as far as policies are considered.

(v)(vi) Sector analysis should be considered before providing the

working capital finance to any firm, trends should beconsidered.

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


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4 4 Project Report on Working Capital Management

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