CAPITAL STRUCTURE

Capital structure of a company refers to the

composition of it’s capitalization and it includes all long term capital sources viz. loans, reserves, shares & bonds.

--Gerestenberg

The capital structure of business can be measured by the ratio of various kinds of permanent loan & equity capital to total capital.

__ Schwarty

Capital structure is made of debt & equity securities which comprise a firm’s financing

of it’s assets.

OBJECTIVES OF SUITABLE CAPITALSTRUCTURE :

i) Minimize the cost of capital & maximize the profit.

ii) To have a proper mix of debt & equity, to

attain an ‘Optimal Capital Structure’.

FACTORS AFFECTING FACTORS AFFECTING CAPITAL STUCTURE :CAPITAL STUCTURE :

Internal Factors:i) Financial Leverage – It measures the ability of

the firm to make the use of fixed charge bearing securities in the capital structure. It enables the firm to deploy debt funds in the capital structure with an intention to enjoy reduction in the incidence of tax. Such benefit will result in improving shareholder’s value provided---

A) Cost of debt is usually lower than the ROI. B) Interest paid on debt is permissible under Tax laws.

t

C) The benefit of tax is passed on to the

equity holders.

ii) Risk :- Debt securities increase the

financial risk, while equity securities do

not carry risk element. However there is

a trade-off between the two in terms of

returns to the shareholders. Thus there

needs to be a judicial mix between debt

& equity for optimum returns.

iii) Growth & Stability:- A company with

comfortable cash-flow position can raise

debt funds or plough back profits as capital.

A relatively new company with less revenuemust reduce it’s dependence on debt.

iv) Retaining Control:- The attitude of management towards retaining control over the company will have direct impact on the capital structure.

v) Cost of Capital:- The cost of capital refers to the expectation of suppliers of funds. In order to earn sufficient profits the firm should minimise the cost of capital & maximise the returns.

vi) Flexibility:- Flexibility means the firm’s ability to adopt it’s capital structure to the changing needs.Redeemable preference shares & redeemable debentures increase the flexibility of capital structure.

.It can be redeemed at the discretion of company.vii) Purpose of Finance:- Capital structure

depends on the purpose of financing – expansion, diversification or new venture etc.

ix) Asset Structure:- Funds are required to make investments in fixed assets, current assets. Fixed assets could be financed through long term sources & short term sources may be used for working capital requirements. Hence asset structure will influence capital structure.

External Factors : -

1. Size of the company :- 2. Nature of Industry :- Capital intensive industry (e.g. Iron & steel, power generation) has to depend upon equity financing & on debt to a smaller extent. A trading firm may depend upon

debt financing or preference capital. 3. Investors :- Risk perception & expectation of

investors in terms of returns contributes to the decisions regarding the capital structure.

4. Cost of Floatation :- It refers to the expenses incurred in the process of issuing securities.

The finance manager has to evaluate the various expenses like advertising, campaigning, printing

application forms, fees of merchant bankers, underwriting commission, brokerage etc.

5. Legal Requirements :- SEBI guidelines in respect of promoter’s contribution, debt-equity ratio, current ratio, investor protection norms influence the capital structure. Also monetary & fiscal policies have a direct bearing on capital structure.

6. Period of Finance :- Short – term (1-3 years), Medium – term ( 8 - !0 years), Long – Term periods will influence capital structure of the firm.

7. Interest Rates :- The general rates of interest in the economy will have direct impact on borrowed funds & indirect impact on all other funds. 8. Level of Business Activity :- In the periods of

heavy demand requirements of funds is more & leads to the changes in capital structure. Composition of the same in the recessionary trends is entirely different.

9. Availability of Funds :- Levels of liquidity in the capital & money market influences the capital structure.

10. Taxation Policy :- Corporate tax, taxes on dividend & capital gains directly influence the decision of capital structure.

11. General Price Level :- Stable price level of resources encourages investment of more long – term funds in the capital structure. While under fluctuating trends short – term funds will be preferred more than the long – term funds.

THEORIES OF CAPITAL STRUCTURE

The overall objective of wealth-maximisation is not only attained by allocating the available funds in the profitable proposals but also by selecting the optimal capital structure which reduces the overall cost of capital. However, this

premise has also been contradicted by thinkers like Miller, Modigliani-Miller etc. Thus various

theories of capital structure are categorized as

Theories of Relevance & Irrelevance.

Following are some of the important theories

of capital structure.

Net Income Approach or Durand Approach

According to this approach there exists a direct relationship between the capital structure, cost of capital & valuation of the firm. The weighted average cost of capital can be reduced by increasing the debt component in the capital mix

& thus valuation of the firm can be increased. It is based on the following assumptions.

• The cost of debt is cheaper than the cost of equity.

• There are no taxes.• The use of debt does not change the risk

perception of the investors.

NET OPERATING INCOME APPROACH This approach is also proposed by Durand

advocating that there is no one optimal structure. Thus valuation of the firm & it’s cost of capital are not

dependent on the capital structure. Any combination of debt to equity mix in the capital structure does not affect the value of the firm. It is just an opposite theory to NI approach.

Basic assumptions of this theory are:-• Overall capitalisation rate remain constant regardless of

debt in the capital structure. Market capitalises the value of the firm.

• Increase in cost of debt financing in capital mix is offset by increase in returns to equity shareholders. • The debt capitalisation rate is constant. • Corporate income-tax does not exist.• The advantage of debt in capital mix is offset by the

increase in equity capitalisation rate.

TRADITIONAL APPROACH :- It is the mean between two extreme approaches of Net

Income & Net Operating Income. It believes in the existence of ‘Optimal Capital Structure’.

Accordingly it believes that upto a certain point additional introduction of debt capital in the capital structure will reduce the overall cost of capital & increase the total value of the firm. Beyond the point, the overall cost of capital will tend to rise & value of the firm will reduce. Thus by judicious mix of debt & equity capital, it is possible to maximise the total value of the firm.

MODIGLIANI-MILLER APPROACH :-

This approach closely operating income approach. According to this approach, value of the firm & it’s cost of capital are independent of it’s capital structure. Weighted average cost of capital remains constant irrespective of

debt to equity mix in the capital structure. The NOI approach is being restated & a behavioral justification is on part of investors is added in this model.

Assumptions:- i) Corporate tax does not exist. ii) Investors have the complete information of the capital market. This

implies that investors can borrow and lend funds at the same rate and can move quickly from one security to another without incurring any transaction cost.

iii) Securities are infinitely divisible. iv) Investors are rational and well informed about the risk-return of all

securities. v) All the investors have same probability distribution about the

expected future earnings. vi) The personal leverage & the corporate leverage are perfect

substitute.On the basis of these assumptions, MM model derived that-A) The total value of the firmis equal to the capitalised value of the

operating earnings. The capitalisation rate is appropriate to the risk-class of the firm.

B) The total value of the firm is independent of the financing mix.C) The cut-off rate for the investment decision of the firm depends upon the risk-class to which the firm belongs and thus is not affected by the financing pattern of these investment.

The MM model argues that if two firms are alike in all respect except that they differ in respect of their financing pattern and their market value, then the investors will develop a tendency to sell the shares of the over valued firm (creating selling pressure) and buy the shares of the under-valued firm (creating the demand pressure). This buying & selling will continue till the two firms have the same market values.

CAPITAL BUDGETTING DECISIONS

Capital budgeting decisions are often the most important decisions of corporate financial management as they affect the profitability of the firm.

Any decision that requires the use of resources is a capital budgetting decision. The relevance & significance of capital budgetting may be stated as follows.

A) Long term effects

B) Substantial Commitments

C) Irreversible decisions

D) Affect the capacity & strength to compete.

IRR vs NPV METHOD• IRR approach gives a rate which is unique to each

project. NPV approach gives a trade-off between the cash-inflows & cash-outflows using a general required rate of return.

• IRR gives % return while NPV gives absolute return.• For IRR, the availability of required rate of return is not a

pre-requisite while for NPV it is necessary.• NPV can be used as an indicator of expected increase

in the wealth of the shareholders, while IRR can’t be used so.

• NPV can be more conclusive in accept-reject decisions. IRR may give multiple results.• NPV gives better ranking as compared to the IRR.• NPV calculations are relatively easier compared to IRR

calculations which are based on Trial & Error method.

RISK & UNCERTAINTY IN CAPITAL BUDGETTING

The types of risks can be classified into different categories

1) Project –Specific Risk :- Risk specific to the project under consideration & may be due to estimation error.

2) Competition Risk :- Risk due to the strategic-actions of competitors leading to affect the cash-flows of the project.

3) Industry-specific Risk :- This risk is specific to industry & can be analysed in three ways.

a) Technology Risk – Reflecting the effects of changing technology.

b) Legal Risk - Reflecting the effect of changing laws

& regulation affecting particular industry only.

c) Commodity Risk – Reflecting the effect of price changes in goods & services used.

4) International Risk :- This risk is a risk associated with the projects outside the domestic market. It arises due to variation in the movement of various currencies.

5) Market-Risk :- This risk related changes in the market factors like changes in interest-rates, inflation, economic conditions etc.

Following are the important methods of risk analysis in capital budgetting.

I) Risk adjusted Rate of Return

II) Certainty Equivalent coefficient

III) Probabilistic Method

IV) Sensitivity Analysis

V) Coefficient of Variation method or Std. deviation

VI) Decision Tree Analysis

RISK ADJUSTED RATE OF RETURN :

Risk free return is one at which the business firms comfortably earn sufficient profits without assuming the risk. In order to adjust the risk associated with the business, a premium must be added to the discount rate.

This premium indicates the quantified version of risk of the business. According to this method, certain % of discount factor will be added to the risk-free return & such risk-adjusted ROR will be used to find the PV of actual cash inflows.

Risk Adjusted ROR = Rf + R

Rf =Risk free return

R = Risk Premium

CERTAINTY EQUIVALENT COEFFICIENT

Under this method, the risk in the project is quantified by using the certainty equivalent coefficients. The given cash-flows are reduced by using the certainty equivalent

coefficients. The expected future cash flows which are risky & uncertain are converted into certainty cash-flows.

These adjusted cash-flows are then discounted at risk-free discount rate to find out NPV of the proposal. The certainty equivalent factors may be different for different years.

PROBABLISTIC METHOD In capital budgetting decisions outlay of investments are

known with certainty, however cash-flows are unknown & thus are uncertain. Therefore probability values are used to reduce the uncertain cash-flows to certain cash-flows. Later the discount factor will be used to find NPV.

SENSITIVITY ANALYSIS

Cash-flows are very sensitive to business situations. Every product sales are influenced by many factors like seasons, prevailing economic situation in the country etc. Seasonal products have very high cash-flows during a particular period. Thus overall situation of the business or economy will be grouped into three different categories – Optimistic, Most likely & Pessimistic. These cash-flows are discounted for different projects by using the discounting factor, through which NPV is calculated.

COEFFICIENT OF VARIATION / STD. DEVIATION

According to this method, the risk in the project is calculated by using standard deviation or variance. The stability of cash-flows are measured by coefficient of variation. Higher the CV or SD, higher is the risk in the project.

DECISION – TREE ANALYSIS

A decision-tree is the graphic display of the relationship between a present decision & a possible future event, future decisions and their consequences. It indicates sequence of events, which is mapped out in a form resembling the branches of a tree. It is possible for a firm to look systematically at decisions and forecast their outcomes with the help of a decision tree. A decision tree approach may be described as a way of displaying the anatomy of a business investment decision and of showing the interplay of present decisions, chance events, competitors’ moves & possible future decisions and their consequences. A decision tree enables one to explore a variety of problems.

CAPITAL - RATIONING

Capital Rationing may be defined as a situation where the firm has limited funds available for fresh investments. Many profitable and financially viable proposals may be available but can’t be undertaken in view of limited funds.

Internal Capital Rationing:- It is a situation where the firm has imposed limit on the funds

allocated for fresh investment though, funds might be available or could be generated through capital markets. Internal capital rationing is not in the best interest of the shareholders in the long run, as it results foregoing the profitable proposals.

External Capital Rationing :- It is a situation when the firm is willing to undertake the

financially viable proposals but can’t do so either due to lack of sufficient funds or depressed capital markets.

External Capital Rationing may occur due to following reasons.

1. Lack of Credibility

2. High floatation cost

3. Higher marginal cost of capital

The projects subject to capital rationing can be classified as-• Divisible Projects :- The projects which could be

undertaken completely or partially are divisible projects.• Indivisible Projects :- Such projects can’t be undertaken

in parts rather they would be subject to investment either full or not at all.

CAPITAL BUDGETTING UNDER INFLATION

Inflation indicates diminishing purchasing power of the money. The inflation not only affects the cash flows but also the discount-rates because of the irreversible relationship between inflation, interest rates & discount rates in capital budgetting. Thus finance manager has two choices in dealing with inflation; first to incorporate the expected inflation in the estimates of future cash flows & second to discount the cash flows at a rate that incorporates the expected inflation.

Discount-Rate/ Cut-off Rate & Inflation :-Discount rate should take care of the inflation & the pure

required rate of return. Thus – Nominal Discount Rate = ( 1+ Inflation Rate ) x ( 1+ Real Rate of Discount ) – 1

PV = Cash Inflow ( 1+Inflation rate)( 1+ Real rate of Discount )

NPV = PV – Cash OutflowCash Flows & Inflation:- Just like the two types of discount rates i.e. Real & Nominal,

there are two types of cash flows,i) Money cash flows :- These cash flows include the effect

of inflation. They are known as the nominal cash flows. The money cash flows occur in terms of the purchasing power of the period in which they occur.

ii) Real Cash flows :- These cash flows which are expressed in terms of constant prices. They are expressed in terms of real values.

Real C/F = Money C/F 1+ Inflation Rate

DIVIDEND DISTRIBUTION THEORIES

Dividend is that portion of earnings after tax which is distributed among the shareholders.

Formulation of proper dividend policy is one of the major financial decision to be taken by financial manager as it may have a critical influence on the value of the firm.

FACTORS INFLUENCING DIVIDEND POLICY

1. Stability Of Earnings

2. Financing Policy of the Company

3. Liquidity position

4. Dividend policy of competitors

5. Past dividend Rates

6. Debt Obligations

7. Ability to borrow

8. Growth needs of the company.

9. Profit Rate

10. Legal Requirements

11. Policy of control

12. Effect of Taxation

13. Cyclical Variations

14. Attitude of the interested group

TYPES OF DIVIDEND• Cash Dividend :- Here the shareholders receive the

cheques for the amounts out of earnings of the business.

• Scrip Dividend :- When earnings of the company justify dividend, but the company’s cash position is temporarily weak, it may declare dividend in the form of scrips. In this method shareholders are issued

transferable promissory notes which may or may not be interest bearing.

• Bond Dividend :- It is similar to scrip dividend except in place of promissory notes bonds are issued.

• Property Dividend :- This involves a payment with assets other than cash. This form of dividend is paid wherever there are assets that are no longer necessary in the operation of the business.

• Stock Dividend :- It is a dividend paid in kind. When stock dividends are paid, a portion of the surplus is transferred to the capital account and shareholders are issued additional shares. Such shares are known as bonus shares and the process is known as capitalisation of profit. Stock-dividend does not alter the cash position of the company.

PAYMENT OF DIVIDEND : Provisions of Company Act :

• Dividend should be paid to the shareholders of the company, if so authorised by it’s articles on paid-up value of shares u/s93.

• The rate of the dividend to be paid will be recommended by the board of directors and declared in the AGM of the shareholders. However, shareholders can’t increase the rate of dividend recommended by BOD.

• The dividend is payable out of the current year’s profit after providing for necessary depreciation on assets for the current year or for past years (if not already provided) as per the provisions of Schedule XIV of the Company Act 1956.

• Before any dividend is paid in cash, the company is required to transfer a certain minimum amount to reserves

from current year’s profit. The rates at which profits need

to be transferred to reserves for various rates of dividend are-

Dividend more than 10% but less than 12.5% - 2.5% trfr. >12.5% - 15% --- 5% >15% -- 20% --- 7.5% > 20% ---- 10%• The company can’t declare dividend out of capital

[Sec205(1)]. If the board of directors declare dividend out of capital, they are personally liable to make good for the loss to the company.

• Any amount of dividend declared including interim dividend shall be deposited into a separate bank account within five days from the date of declaration of such dividend.

• If the dividend has been declared but has not been paid or dividend warrents have not been posted within 30days from the declaration of dividend to any shareholder

entitled to the payment of the dividend, every director of the company who knowingly a party to the default, shall be punishable.

• Dividend shall be paid only to the registered members of the company i.e. to those members whose names are found in the register of members.(sec206)

• The declared dividend should be paid within 42 days from the date of declaration ( sec207). In case of default the defaulting director shall be liable for punishment of seven days simple imprisonment or a fine Rs.500 per day, during the period when default continues or both.

• Any unclaimed dividends after 30 days from the declaration of the same are required to be transferred to a separate account opened with a scheduled bank. If any amount remains pending in this account for a period of 7 years, such amount will be transferred by the company to a fund established by the Central Government as ‘Investor Education & Protection Fund’.

Guidelines Regarding Issue of Bonus Shares

• Articles of Association of the company should permit the issue of bonus shares. If there is no such provision in the articles, they need to be amended first.

• The authorised share capital should be sufficient to absorb the share capital of the company after the issue of bonus shares. If the authorised share capital is not sufficient, the same needs to be increased first

• Bonus shares can’t be issued in respect of partly-paid shares.

• Issue of bonus shares needs to be approved by the BOD & the company should issue the bonus shares within a period of six months from the date of approval given by BOD.

• Bonus shares can be issued out of the free reserves appearing on the balance sheet & the share premium a/c collected in cash.

• Company can’t issue bonus shares if it has defaulted- - In respect of payment of interest or repayment of principal amount, either in case of debentures or in case of public

deposits.

- In respect of payment of employee dues, like provident fund, gratuity, bonus etc.

- Pending conversion of fully convertible debentures or partly convertible debentures into shares of the company, no company can issue bonus shares unless the same benefit is extended to holders of these FCDs or PCDs by by reserving a part of shares for them. Such shares can be actually issued when the conversion into shares takes place.

- A listed company shall forward a certificate duly signed by the company & countersigned by it’s statutory auditor or a company secretary in practice certifying that the company

has complied with all the terms & conditions in respect of

issue of bonus shares.

THEORIES OF DIVIDEND Relevance Of Dividend Policy :- In these theories it is argued that dividend policy has an effect on the market value of shares & the value of the firm. A firm should pay a dividend to shareholders to fulfill the expectations of shareholders in order to maintain or increase the market price of the share.1. Walter Model :-

This theory is based on following assumptions. All investment proposals of the firm are financed through retained earnings only. The cost of capital ( K ), the rate of return ( r ) remain constant even after fresh investment decisions are taken.Firm has a long life. This model considers that the investment decision &

dividend decision are inter-related. A firm should or should not pay dividends, depends upon whether it has suitable investment

opportunities to invest the retained earnings. If the firm pays dividends to shareholders, they in turn, will invest this income to get further returns. This expected return to shareholders is the opportunity cost of the firm & hence cost of capital k to the firm. If the firm doesn’t pay dividends, and retains the earnings which will be reinvested to get returns. This rate of return must be atleast equal to cost of capital k.

According to this model, a firm can maximise the market value of it’s shares by adopting dividend policy as follows.

If r> k, payout zero & retain 100%.

r< k, payout 100% & retain nil.

r = k, dividend is irrelevant & the dividend is not expected

to affect market value of shares.

Walter’s mathematical model is

P = D/k + ( r/ k ) ( E – D )

k where, P = Market price of equity share D = Dividend per share paid by firm k = Cost of equity share capital r = Rate of return on investment E = Earnings per share of the firm2. Gordon Model :- A model developed by Myron Gordon is also based on the

assumptions similar to that made in Walter’s model. However, two additional assumptions made by this model are –

i) The growth rate of the firm ‘g’, is the product of it’s retention ratio ‘b’, & it’s rate of return ‘r’. i.e. g = br.

ii) Cost of capital is more than growth rate i.e. k > g.

Gordon model is based on premise that investors are

basically risk averse & value current dividends more than future capital gains which are seemingly uncertain. The mathematical equation is –

P = E( 1- b) k – br where, b = Retention ratio ( 1- payout ratio )Irrelevance of Dividend Theory:-These theories argue that dividend policy has no effect on the

market price of shares. The shareholders do not differentiate between the present dividend or future capital gains. They are basically interested in higher returns either earned by the firm by reinvesting profits in profitable

options or earned by themselves by making investment of dividend income.

The irrelevance approach is based on two pre-conditions--

i) Investment & financing decisions have already been made

& these decisions will not be altered by the amount of dividends payment.

ii) The capital markets are perfect, as such there are no transaction costs for investors & no floatation costs for the companies.

Residuals Theory of Dividends:- This theory is based on following assumptions—

i) External financing is not available to the firmii) Even if external financing is available, due to it’s

excessive costs, firm will prefer to retain it’s earnings for investments in the profitable opportunities.

iii) If the firm doesn’t have such opportunities, the profits may be distributed among shareholders.

In this approach the firm doesn’t decide as to how much dividends be paid rather it decides how much

profits be retained. The profits not required to be retained may be distributed as dividends. Therefore dividend

decision is a passive decision. The dividends are distribution of residual profits. The firm

would treat the dividend decision in three steps:i) Determining the level of capital expenditures by taking

into consideration investment opportunities.ii) Using the optimal financing mix, find out the amount of

equity financing needed to support the capital expenditure in step i) above.

iii) As the cost of retained earnings ‘k’ is less than the cost of new equity capital, the retained earnings would be used to meet the equity portions financing in step ii)

above. If the available profits are more than this need, then the surplus profits may be distributed as dividends to shareholders. As far as required if equity financing is in excess of the amount of profits available

no dividends would be paid to the shareholders.

Modigliani & Miller Approach:- According to this approach market price of shares is affected by the earnings of the firm & not by the pattern of income distribution.

Assumptions in M&M approach:-

i) The capital markets are perfect.

ii) All information is freely available to all the investors.

iii) The investors are rational.

iv) Securities are divisible & can be split into any fraction.

v) There are no taxes.

vi) Investment & dividend decisions are independent.

vii) Investment opportunities & future profits of firms are known with certainty.

The argument in the model is, neither the firm paying dividends nor the shareholders receiving the dividends

will be adversely affected by the proportion of dividends. It is an arbitration mechanism that actually works. Given the investment opportunities, a firm will finance these either by ploughing back profits or if pays the dividends, then will raise an equal amount of new share capital externally by selling new shares. The amount of dividends paid to existing shareholders will be replaced by new share capital raised externally. The benefit of increase in market value will be offset completely by the decrease in terminal value of the share. The shareholders will be indifferent between the dividend payment or retaining the profits.

Po = 1/ ( 1+ k ) x ( D 1+P1)

Where, Po = Present market price of the share

k = cost of equity capital

D1 = Expected dividend at the end of year1

P1 = Expected market price of the share at the

end of year1 __________________________________________

MANAGEMENT OF CASH

Motives Of Holding Cash

i) Transaction Motive

ii) Precautionary Motive

iii) Speculative Motive

Estimating Cash Requirements

• Operating Cash flows :- These cash flows arise as the result of regular operations of the business. E.g.cash sales, collection from debtors, Interest/dividend received, payment to creditors,purchases of raw material, wages

Non-operating cash flows: These are the items of cash flow

which arise as the result of other operations of the business.E.g. Issue of shares/debentures, Receipt of loans, sale of

fixed assets, redemption of debentures, loan instalment, purchase of fixed assets, interest, taxes, dividends.

Concept of Float :- Float is a time lag between issue & actual receipt of the payment. This time gap arises due to various reasons as—

i) Postal Float – Time required for receiving the cheque from customer through post office.

ii) Deposit Float --Time required by the company to process the received cheque & deposit the same into bank.

iii) Bank Float – Time required by the banker of the company to collect the payment from the customers’ bank.

PRINCIPLES OF CASH MANAGEMENT

• Accelerate Cash Collections: The customer could be insisted upon to make payments through DD, LC, Hundies / Bills of Exchange to reduce bank float. Cash discounts, de-centralising the collections, lock-box ( P.O box) help in accelerating the collections.

• Delay Cash Payments :- Availing more credit period, centralising disbursements will be helpful in delaying payments.

• Maintenance of optimum cash balance :-By preparing the cash-budget the optimum levels of cash requirements could be worked out. Accordingly company can take the decision of investment of excess cash on short-term basis or to meet the short-fall.

• Investment of Excess Cash Balance :- Idle cash involves

opportunity cost. Thus avenues to invest excess cash balance must be explored. Inter-corporate loans/deposits,

Stock-market options, commercial papers are some of the avenues.

WORKING CAPITAL MANAGEMENT

Factors Determining Working Capital Requirement:--• Basic Nature of Business-Trading, Manufacturing etc.• Business Cycle Fluctuations- Periods of boom, recession

or recovery• Seasonal Operations- Cycles of high & low demand• Market Competitiveness- Highly competitive,

monopolistic etc.• Credit Policy –Towards suppliers & customers • Supply Conditions- Lag period in stock replenishment

Gross Working Capital:- Total Current Assets

Net Working Capital:- Total C.A. – Total C.L.

OPERATING CYCLE- It is a time duration starting from procurement of goods or raw materials & ending with sales realisation.

Operating Cycle of a firm consists of the time required for the completion of the sequence of following activities.

1. Procurement of raw materials & services.

2. Conversion of raw materials into W-I-P.

3. Conversion of W-I-P into finished goods.

4. Sale of finished goods ( cash or credit )

5. Conversion of receivables into cash.

Operating Cycle period is the sum of –• Inventory Conversion Period ( ICP ) – Time required

for conversion of raw materials into finished goods.• Receivables Conversion Period ( RCP ) – Time

required to convert the credit sales into cash realisation.

NOC ( Net Operating Cycle ) = TOCP – DP

= ICP + RCP – DP ( Deferral Period )

OVERTRADING & UNDERTRADING

The concepts of over-trading and under-trading are intimately connected with the net working capital position of the business. To be more precise, they are connected with the cash position of the business.

OVER-TRADING : Over-trading means an attempt to maintain or expand scale of operations of the business without sufficient cash resources. The firms involved in over-trading have a high turnover ratio & a low current ratio. In such situation, it is not in a position to maintain proper stocks of materials, finished goods, etc., & has to depend entirely on the suppliers to supply them at the right time.

Causes of Over-trading :-• Depletion Of working capital – Results in depletion of

cash resources. Cash resources may get depleted by

premature repayment of long –term loans, excessive drawings,

dividend payments, purchase of fixed assets & excessive net trading losses etc.

• Faulty Financial Policy :- Such policy can result in shortage of cash & over-trading in several ways like—

Using working capital for purchase of fixed assets. Attempting to expand the volume of business without

raising necessary resources.• Over-Expansion :- In national emergencies like war,

natural calamities etc. a firm may require to produce goods on a larger scale. The government may pressurise the manufacturers to increase the volume of production without providing for adequate finances.

• Inflation & Rising Prices:- inflationary trend in the economy puts pressure on the prices of the resources. The manufacturer needs more cash resources even to maintain the existing level of activity.

• 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 to the company to maintain reasonable dividend rates for their shareholders.

CONSEQUENCES OF OVER-TRADING • Difficulty in Paying Wages & Taxes – Leads to

insecurity & dissatisfaction among the labour & affects the reputation of the company in the business.

• Costly Purchases- • Reduction in Sales- Company may suffer in terms of

sales because cash needs may compel it to offer liberal cash discounts to debtors & also resort to distress sale.

• Difficulties in making payments- Will force the company to persuade creditors to extend credit facilities.

• Obsolete Plant & Machinery-

SYMPTOMS & REMEDIES FOR OVERTRADING

Symptoms • Considerable rise in amount of creditors as compared to

debtors• Increased bank borrowings & corresponding inventories• Purchase of fixed assets from short term funds.• Low current ratio & high turnover ratio.• Fall in working capital turnover

Remedies- Reduce the business or increase finance

- Sell or merge with healthy business entity, preferably under the same management.

UNDERTRADING

• It is reverse of Overtrading. It means improper & under-utilisation of funds lying at the disposal of a firm. 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. Basic cause of undertrading is under-utilisation of the firm’s resources. This may be due to following causes.

• Conservative policies followed by the management.• Non-availability or shortage of basic facilities necessary for

production such as, raw materials, labour, power etc.• General depression in the market resulting in fall in the demand.

SYMPTOMS • High current ratio.• Low Turnover ratios.

•Increase in working capital turnover(working capital/sales)

• CONSEQUENCES• Profits showing declining trend resulting a lower ROI.• Decline in market value of shares.• Loss of reputation• REMEDIES• Dynamic & result oriented approach• Diversification and attempt to improve utilisation factor of

the firm’s resources.s

RBI Guidelines on W.C. finance

• Tandon Committee Recommendations

The recommendations are based on following points.• Determination of working capital requirements of industry,

which the banks should finance.• Supervision of credit for ensuring proper end-use of

funds.• Methodology of sending periodical forecasts by borrowers

relating to: business of the company, production plans and credit requirements

• Norms for build-up of current assets and for debt to equity ratio to ensure minimal dependence on bank finance.

• Suggestions for improvement of manner & style of lending.

The committee submitted it’s report in Aug 1975.This report has been a major breakthrough in the improvement of bank credit system. The recommendations relate to:• Norms for holding inventory and receivables.• Quantum of permissible bank loans.• Style of credit.• Follow-up & supervision of credit.Norms For Inventory & Receivables :- These norms have been

suggested for 15 major industries. The committee has suggested the level of current assets which each industrial unit is supposed to hold. Norms are maximum level of current assets that a unit is to hold. The norms are expressed as follows -

Raw Materials – so many months of cost of materials consumedW-I-P – so many months of cost of productionFinished Goods – so many months of cost of salesReceivables – so many months of cost of salesQuantum of Permissible Bank Finance :- Three methods have been

suggested for determining the maximum permissible amount of bank finance. The extent of bank finance will gradually reduce stepwise.

Method 1:- MPBF = 0.75(CA-CL)Method 2:- MPBF = 0.75(CA)-CLMethod 3:- MPBF = 0.75(CA-CCA)-CL CCA=Core Current Assets

Tandon Committee suggested that borrowings in excess of what is permissible under the first method should be converted into a working capital term loan and repaid over a period of time.

• Chore Committee RecommendationsOne recommendation of Tandon Committee Report was to bifurcate cash

credit limits into a demand loan and a fluctuating cash credit component. Chore committee(1979) made a deep study on this issue. The committee was to:

A) Review the operation of the cash credit system in recent years particularly with reference to the gap between sanctioned credit limits and the extent of their utilisation.

B) Suggest – i) modifications to ensure rational management of funds by

commercial banks. ii) Alternate type of credit facilities, which would ensure greater

discipline and enable banks to relate credit limits to increase in output or other productive activities.

Implementation of Recommendations• A) Working Capital Advances of Rs.10 lakhs and over per

borrower:- For this category, banks should review the accounts of the borrower to verify the continued viability and also the need based character of the advance.

• B) Working Capital Advances of Rs.50 lakhs and over per borrower:- It was proposed that banks should sanction separate limits for peak level requirements and non-peak level requirements. The important criteria would be borrowers’ utilisation of bank credit in the past.

• Withdrawals from accounts are to be regulated through quantity statements. If the borrower does not submit the statement in time, bank may charge 1% premium on the total outstanding till the statement is submitted. In the event of default being persistent in nature the account of the borrower may be frozen.

• Ad-hoc or temporary advances may be sanctioned for predetermined period to meet unforeseen contingencies. For all these advances banks are to charge 1% more than the normal rate except in cases of natural calamity.

• Discounting bills should be encouraged in place of cash credit against book debt for financing sales.

• Recent RBI Guidelines :-

Following recent changes have been made by RBI in the guidelines for bank lending for working capital purposes and by way of term loans.

I) Lending Norms for Working Capital :-

a) Banks would henceforth decide the levels of holding of individual items of inventory as also of receivables, which should be supported by bank finance, after taking into account the production/processing cycle of an industry. RBI would only advise about the overall levels of inventory and receivables for various industries to serve as a broad indicators for guidance of banks.

b) Banks would be free to sanction ad hoc credit limits to borrowers, where considered necessary and charging of additional interest for this purpose is no longer mandatory.

c) Other aspects like maintenance of minimum current ratio, submission of quarterly data would continue with simplification of presentation of information.