Copy of Final Yatra Project NIHARIKA1

8/3/2019 Copy of Final Yatra Project NIHARIKA1

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A PROJECT REPORT ON

WORKING CAPITAL MANAGEMENT OF

SMALL SCALE INDUSTRY

Under the guidance of

Mrs.Manju vats

Faculty-MBA(FINANCE)

Submitted by

BHUPESH KUMAR

Roll No- 511028660

WebUniv. Infotech Ltd

Centre Code :01504

in partial fulfillment of the requirement

for the award of the degree

Of

MBA

IN

Finance Management

SESSION (2010- 2012)

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ACKNOWLEDGEMENT

This project has been possible through the direct and indirect co-operation of

various persons to whom I wish to express my appreciation and gratitude.

First and foremost, my thanks go to Mrs. Manju vats whose versatility of

creativeness, interest and enthusiasm gave a new dimension to my work with a

motto to seek, to strive and not to yield. Her unfailing guidance and

encouragement made me understand the situation of appropriation and help to

solve my problems.

In addition to this, I would like to thank all my respondents, who has spent theirvaluable time with me and help me in getting the requested information for this

project.

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BONAFIDE CERTIFICATE

Certified that this project report titled WORKING CAPITAL MANAGEMENT OF

SMALL SCALE INDUSTRY is the bonafide work of BHUPESH KUMAR who

carried out the project work under my supervision.

SIGNATURE SIGNATURE

HEAD OF THE DEPARTMENT FACULTY IN CHARGE

ABSTRACT

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In the past few years, the Indian industries have understood the importance of

managing the working capital requirements of the business and thus the need for

the correct evaluation and management of working capital came into existence.

Working capital plays a major role in running the day to day operations of the

organisation smoothly, may it be a small organisation, a mediocre one or a large

group company.

Since the sources of finance are scare now a days and available at a costly rate of

interest, it is very much important for an organisation to correctly evaluate its

requirement for the working capital and long term assets so as to manage the funds

accordingly.

TABLE OF CONTENTS

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1. Introduction .7

2. Factors Affecting Working Capital 10

3. Operating Cycle Analysis.12

4. Computation of Working Capital...14

5. Trade Off Bet.Profitability & Risk17

6. Financing Working Capital20

7. Managing Working Capital .31

8. Objective Of The Study.56

9. Research Methodology57

10.Ratio Analysis.59

11. Standards of Comparison61

12. Types of Comparsion62

13. Interpretation of Ratio..63

14. Classification of Ratio.64

15.Analysis & Findings65

16. Advantages of Ratio Analysis.83

17. Limitations of Ratio Analysis..85

18. Bibliography..90

LIST OF TABLES & FIGURES

TABLE:-

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Tables for finding of different types of Ratio:-

1. Current Ratio

2. Quick Ratio

3. Capital Turnover Ratio

4. Fixed Asset Turnover Ratio

5. Net Working Capital Turnover Ratio

6. Debt Equity Ratio

7. Interest Coverage Ratio

8. Total Debt Ratio

9. Fixed Asset Ratio

10. Proprietary Ratio

FIGURES:

1. Purpose of Performance appraisal

2. Appraisal technique

3. Graphs Of Results

INTRODUCTION

There are two concept of Working Capital : gross and net .

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a) The term gross working capital , also referred to as working capital , means the total

current assets .

b) The net working capital can be defined in two ways :

1. The most common definition of net working capital ( NWC ) is the difference

between current assets and current liabilities ; and

2. Alternate definition of NWC is that portion of current assets which is financed withlong term funds .

The task of financing manager in managing working capital efficiently is to ensure

sufficient liquidity in the operations of the enterprise . Net working capital , as a

measure of liquidity is not very useful for comparing the performance of different firms ,

but it is quite useful for internal control . The NWC helps in comparing the liquidity of

the same firm over time . For the purpose of working capital management , therefore ,

NWC can be said to measure the liquidity of the firm . In the other words , the goal of

working capital management is to manage the current assets and liabilities in such a way

that an acceptable level of NWC is maintained .

The basic components of working capital are ,

Current Assets :

a) Inventories

a. Raw Materials and Components

b. Work in Progress

c. Finished Goods

d. Others

b) Trade Debtors

c) Loans And Advances

d) Investments

e) Cash And Bank Balance

Current Liabilities:

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a) Sundry Creditors

b) Trade Advances

c) Borrowings

d) Commercial Banks

e) Provisions

Given the objective of financial decision making to maximise the shareholders wealth ,

it is necessary to generate sufficient profits . The extent to which profits can be earned

will naturally depend , among other things , upon the magnitude of sales . A successful

sales program is , in other words , necessary for earning profits by any business

enterprise . However , sales do not convert into cash instantly ; there is invariably a time

lag between sale of goods and the receipt of cash . There is therefore , a need for

working capital in the form of current assets to deal with the problem arising out of the

lack of immediate realisation of cash against goods sold . Therefore sufficient working

capital is necessary to sustain sales activity .

The two components of working capital (WC) are current assets (CA) and current

liabilities (CL) . They have a bearing on the cash operating cycle . In order to calculate

working capital needs, what is required is the holding period of various types of

inventories , the credit collection period and the credit payment period . Working capital

also depends on the budgeted level of activity in terms of productivity / sales . The

calculation of WC is based on the assumption that the productivity is carried on evenly

throughout the year and all costs accrue similarly . As the working capital requirements

are related to the cost excluding depreciation and not to the sale price , WC is computed

with reference to cash cost . The cash cost approach is comprehensive and superior to

the operating cycle approach based on holding period of debtors and inventories and

payment period of creditors .

After determining the level of Working Capital, the firm has to decide how it is to be

financed. The need for finance arises mainly because the investment in working8


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capital/current assets, that is, raw material, work-in-progress, finished goods

and receivables typically fluctuates during the year. Although long-term funds

partly finance current assets and provide the margin money for working capital,

such working capitals are virtually exclusively supported by short term sources.

The main sources of working capital financing are namely, Trade credits, Bank

credits and commercial bankers.

FACTORS AFFECTING WORKING CAPITAL

The working capital needs of a firm are influenced by numerous factors . The important

ones are

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i) Nature of business : The working capital requirement of a firm is closely

related to the nature of business . A service firm , like electricity undertaking

or a transport corporation which has a short operating cycle and which sells

predominantly on cash basis , has a modest working capital requirement . On

the other hand , 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 .

ii) Seasonality of Operation : Firms which have marked seasonality in there

operations usually have highly fluctuating working capital requirement . For

example , consider a firm manufacturing air conditioners . The sale of air

conditioners reaches the peak during summer months and drops sharply during

winter season . The working capital need of such a firm is likely to increase

considerably in summer months and decrease significantly during winter

period . On the other hand , a firm manufacturing consumer goods like soaps ,

oil , tooth pastes etc. which have fairly even sale round the year , tends to have

a stable working capital need .

iii) Production Policy : A firm marked by pronounced seasonal fluctuation in its

sale may pursue a production policy which may reduce the sharp variations in

working capital requirements . For example a manufacturer of air conditioners

may maintain steady production through out the year rather than intensify the

production activity during the peak business season . Such decision may

dampen the fluctuations in working capital requirements .

iv) Market Conditions : When competition is keen , larger inventory of finished

goods is required to promptly serve the customers who may not be inclined to

wait because other manufacturers are ready to meet their needs . Further

generous credit terms may have to be offered to attract customers in highly

competitive market . Thus , working capital needs tend to be high because of

greater investment in finished goods inventory and accounts receivable .

If the market is strong and competition is weak , a firm can manage with

smaller inventory of finished goods because customers can be served with

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delay . Further in such situation the firm can insist on cash payment and avoid

lock up of funds in accounts receivables it can even ask for advance payment

, partial or total .

v) Conditions of Supply : The inventory of raw material , spares and stores

depends on the conditions of supply . If supply is prompt and adequate , the

firm can manage with small inventories . However if the supply is

unpredictable and scant then the firm , to ensure continuity of production ,

would have to acquire stocks as and when they are available and carry large

inventories on an average . A similar policy may have to be followed when the

raw material is available only seasonally and production operations are carried

out round the year .

Operating Cycle Analysis

The Operating cycle of the firm begins with the acquisition of raw materials and

ends with the collection of receivables . It may be divided into four stages a) raw

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material and stores storage stage , b) work-in-progress stage , c) finished goods

inventory stage and d) debtors collection stage .

Duration of operating cycle : The duration of operating cycle is equal to the sum of the

duration of each of these stages less the credit period allowed by the suppliers to the

firms . It can be given as

O = R + W + F + D C

Where O = Duration of operating cycle

R = Raw material and stores storage period

W = Work-in-progress period

F = Finished goods storage period

D = debtors collection period

C = Creditors payment period

The components of Operating cycle may be calculated as follows ;

R = Average stock of raw materials and stores

Average raw material and stores consumption per day

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W = Average Work-in-progress inventory

Average cost of production per day

F = Average Finished Goods Inventory

Average cost of goods sold per day

D = Average books debts

Average credit sales pert day

C = Average trade creditors

Average credit purchase per day

Computation Of Working Capital

The two components of working capital (WC) are current assets (CA) and current

liabilities (CL) . They have a bearing on the cash operating cycle . In order to calculate

working capital needs, what is required is the holding period of various types of

inventories , the credit collection period and the credit payment period . Working capital

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also depends on the budgeted level of activity in terms of productivity / sales.

Estimation of Current Assets :

Raw Material Inventory : The investment in raw materials inventory is estimated on

the basis of ,

Raw material inventory = Budgeted Cost of raw Average inventory

Production X material(s) X holding

period

( in units ) per unit ( months/days )

12 months / 365 days

Work-in-Progress (WIP) Inventory : The relevant costs to determine WIP inventory

are the proportionate share of cost of raw materials and conversion costs ( labour and

manufacturing overhead costs excluding depreciation ). In case of full unit of raw

material is required in the beginning the unit cost of WIP would be higher , i.e. , cost of

full unit + 50% of conversion cost , compared to the raw material requirement

throughout the production cycle ; WIP is normally equivalent to 50% of total cost ofproduction. Symbolically ,

Budgeted Estimated Average time span

Production X WIP cost X of WIP inventory

( in units ) per unit ( months / days )


Finished Goods Inventory : Working capital required to finance the finished goods

inventory is given by factor as below

Budgeted Cost of goods produced Finished goods

Production X per unit ( excluding X holding period

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( in units ) depreciation ) ( months / days )


Debtors : The WC tied up in debtors should be estimated in relation to total cost price

(excluding depreciation) , symbolically

Budgeted Cost of sales per Average debt

Credit sale X unit excluding X collection period

( in units ) depreciation ( months / days )


Cash and Bank Balances : Apart from WC needs for financing inventories and debtors

, firms also find it useful to have some minimum cash balances with them . It is difficult

to lay down the exact procedure of determining such an amount . This would primarily

based on the motives for holding cash balances of the business firm , attitude of

management toward risk , the access to the borrowing sources in times of need and past

experience , and so on .

Estimation of Current Liabilities:

The working capital needs of business firms are lower to that extent such needs are met

through the current liabilities ( other than bank credits ) arising in the ordinary course of

business . The important current liabilities ( CL ) , in this context are , trade creditors ,

wages and overheads :

Trade Creditors :

Budgeted yearly Raw material Credit period

Production X requirement X allowed by creditors

( in units ) per unit ( months / days )


Note : proportional adjustment should be made to cash purchase of raw materials.

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Direct Wages :

Budgeted yearly Direct Labour Average time-lag in

Production X cost per unit X payment of wages

( in units ) ( months / days )


The average credit period for the payment of wages approximates to a half-a-month in

the case of monthly wage payment: The first days wages are , again , paid on the 30 th

day of the month , extending credit for 28 days and so in . Average credit period

approximates to half-a-month .

Overheads ( Other Than Depreciation and Amortisation )

Budgeted yearly Overhead Average time lag in

Production X cost per unit X payment of overheads

( in units ) ( months / days )


The amount of overheads may be separately calculated for different types of overheads .

In case of selling overheads , the relevant item would be sales volume instead of

production volume .

Trade Off Between Profitability And Risk

In evaluating firms net working capital position an important consideration is the trade-

off between profitability and risk . In other words , the level of NWC has a bearing on

profitability as well as risk . The term profitability used in this context is measured by

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profit after expenses . The term risk is defined as the profitability that a firm will

become technically insolvent so that it will not be able to meet its obligations when they

become due for payment .

The risk of becoming technically insolvent is measured using NWC . It is assumed that

the greater the amount of NWC , the less risk prone the firm is . Or , the greater the

NWC , the more liquid is the firm and , therefore , the less likely it is to become

technically insolvent . Conversely , lower level of NWC and liquidity are associated

with increasing level of risk . The relationship between liquidity , NWC and risk is such

that if either NWC or liquidity increases , the firms risk decreases .

Nature of Trade-Off :

If a firm wants to increase its profitability , it must also increase its risk . If it is to

decrease risk , it must decrease profitability . The trade-off between these variables is

that regardless of how the firm increases profitability through the manipulation of WC ,

the consequence is a corresponding increase in risk as measured by the level of NWC .

In evaluating the profitability-risk trade-off related to the level of NWC , three basic

assumptions which are generally true , are a) that we are dealing with a manufacturing

firm , b) that current assets are less profitable than fixed assets and c) the short term

funds are less expensive than long term funds .

Effect of the Level of Current Assets on the Profitability-Risk Trade-Off

The effect of the level of current assets on profitability-risk and trade-off can be shown

using the ratio of current assets to total assets . This ratio indicates the percentage of

total assets that are in the form of current assets . A change in the ratio will reflect a

change in the current assets . It may either increase or decrease .

Effect of Increase / Higher Ratio

An increase in the ratio of current assets to total assets will lead to a decline in

profitability because current assets are assumed to be less profitable than fixed assets . A

second effect of the increase in the ratio will be that the risk to technical insolvency

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would also decrease because the increase in current assets , assuming no change in

current liabilities, will increase NWC .

Effect of Decrease / Lower Ratio

A decrease in the ratio of current assets to total assets will result in an increase in

profitability as well as risk . The increase in profitability will primarily be due to the

corresponding increase in fixed assets which are likely to generate higher returns. Since

the current assets decrease without a corresponding reduction in current liabilities, the

amount of NWC will decrease, thereby increasing risk.

Effect of Change in Current Liabilities on Profitability-Risk Trade-off

As in the case of current assets, the effect of change in current liabilities can also be

demonstrated by using the ratio of current liabilities to total assets. This ratio will

indicate the percentage of total assets financed by current liabilities.

The effect of change in level of current liabilities would be that the current liabilities-

total assets ratio will either a) increase or b) decrease .

Effect of an Increase in the Ratio

One effect of the increase in the ratio of current liabilities to total assets would be that

profitability will increase. The reason for the increased profitability lies in the fact that

current liabilities, which are a short term sources of finance will be reduced. As short

term sources of finance are less expensive than long-run sources, increase in ratio will,

in effect, means substituting less expensive sources for more expensive sources of

financing. There will, therefore, be a decline in cost and a corresponding rise in

profitability.

The increased ratio will also increase the risk. Any increase in the current liabilities,assuming no change in current assets, would adversely affect the NWC. A decrease in

NWC leads to an increase in risk. Thus, as the current liabilities-total assets ratio

increases, profitability increases, but so does risk.

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Effect of a Decrease in the Ratio

The consequences of a decrease in the ratio are exactly opposite to the results of an

increase. That is, it will lead to a decrease in profitability as well as risk. The use of

more long term funds which, by definition, are more expensive will increase the cost; by

implication profits will also decline. Similarly, risk will decrease because of the lower

level of current liabilities on the assumption that current assets remains unchanged.

Combined Effect of Changes in Current Assets and Current Liabilities on

Profitability-Risk Trade-off:

The combined effects of changes in current assets and current liabilities can be

measured by considering them simultaneously. We have seen the effect of decrease in

the current assets-total assets ratio and effect of an increase in the current liabilities-total

assets ratio. These changes, when considered independently, lead to an increased

profitability coupled with a corresponding increase in risk. The combined effect of these

changes should, logically, be to increase over all profitability as also risk and at the same

time decrease NWC.

FINANCING WORKING CAPITAL

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financed. The need for finance arises mainly because the investment in working

capital/current assets, that is, raw material, work-in-progress, finished goods

and receivables typically fluctuates during the year. Although long-term funds

partly finance current assets and provide the margin money for working capital,

such working capitals are virtually exclusively supported by short term sources.

The main sources of working capital financing are namely, Trade credits, Bank

credits and commercial bankers.

1. Trade Credit

Trade credit refers to the credit extended by the supplier of goods and services in the

normal course of business of the firm. According to trade practices, cash is not paid

immediately for purchases but after an agreed period of time. Thus, trade credit

represents a source of finance for credit purchases.

There is no formal/specific negotiation for trade credit. It is an informal agreement

between the buyer and the seller. Such credit appears in the books of buyer as

sundry creditors/accounts payable. The most of the trade credit is

on open account as accounts payable, the supplier of goods does not extend credits

indiscriminately. Their decision as well as the quantum is based on a consideration offactors such as earnings record over a period of time, liquidity position of the firm and

past record of payment.

Advantages :-

i) It is easily, almost automatically available.

ii) It is flexible and spontaneous source of finance.

iii) The availability and the magnitude of trade credit is related to the size of

operation of the firm in terms of sales/purchases.

iv) It is also an informal, spontaneous source of finance.

v) Trade credit is free from restrictions associated with formal/negotiated source of

finance/credit.

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2. Bank Credit

Bank credit is primarily institutional source of working capital finance in India. In fact,

it represents the most important source for financing of current assets. Working Capital

finance is provided by banks in four ways :

Cash Credit / Overdrafts : Under cash credit/ overdraft agreement of bank

finance, the bank specifies a predetermine borrowing/credit limit. The

burrower can burrow upto the stipulated credit. Within the specified limit,

any number of drawings are possible to the extent of his requirements

periodically. Similarly, repayment can be made whenever desired during the

period. The interest is determined on the basis of the running

balance/amount actually utilized by the burrower and not on the sanctioned

limit. However, a minimum charge may be payable on the unutilized

balance irrespective of the level of borrowing for availing of the facility.

This type of financing is highly attractive to the burrowers because, firstly, it

is flexible in that although borrowed funds are repayable on demand, and,

secondly, the burrower has the freedom to draw the amount in advance as an

when required while the interest liability is only on the amount actually

outstanding. However, cash credit/overdraft is inconvenient to the banks and

hampers credit planning. It was the most popular method of bank financing

of working capital in India till the early nineties. With the emergence of the

new banking since mid-nineties, cash credit cannot at present exceed 20% of

the maximum permissible bank finance (MPBF)/credit limit to any

borrower.

Loans : under this arrangement, the entire amount of borrowing is credited to

the current account of the borrower or released in cash. The borrower has to

pay interest on the total amount. The loans are repayable on demand or in

periodic installments. They can also be renewed from time to time. As a form

of financing, loans imply a financial discipline on the part of the borrowers.

From a modest beginning in the early nineties, at least 80% of MPBF must

be in form of loans in India.

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Bills Purchased/Discounted : This arrangement is of relatively recent origin

in India. With introduction of the New Bill Market Scheme in 1970 by RBI,

bank credit is being made available through discounting of usance bills by

banks. The RBI envisaged the progressive use of bills as an instrument of

credit as against the prevailing practice of using the widely-prevalent cash

credit arrangement for financing working capital. The cash credit

arrangement gave rise to unhealthy practices. As the availability of bank

credit was unrelated to production needs, borrower enjoyed facilities in

excess of their legitimate needs. Moreover, it led to double financing. This

was possible because credit was taken form different agencies for financing

the same activity. This was done, for example, by buying goods on credit

from suppliers and raising cash credit b hypothecating the same goods. The

bill financing is intended to link credit with sale and purchase of goods and,

thus eliminate the scope for misuse or diversion of credit to other

purposes.Before discounting he bill, the bank satisfies itself about the credit

worthiness of the drawer and the genuineness of the bill. To popularize the

scheme, the discount rates are fixed at lower rates than those of cash credit.

The discounting banker asks the drawer of the bill to have his bill accepted

by the drawee bank before discounting it. The later grants acceptance against

the cash credit limit, earlier fixed by it, on the basis of the borrowing value of

stocks. Therefore, the buyer who buys goods on credit cannot use the same

goods as a source of obtaining additional bank credit.

The modus operandi of bill finance as a source of working capital financing

is that a bill that arises out of a trade sale-purchase transaction on credit. The

seller of goods draws the bill on the purchaser of goods, payable on demand

or after a usance period not exceeding 90 days. On acceptance of the bill by

the purchaser, the seller offers it to the bank for discount/purchase. On

discounting the bill, the bank releases the funds to the seller. The bill is

presented by the bank to the purchaser/acceptor of the bill on due date for

payment. The bills can be rediscounted with the other banks/RBI. However,22


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this form of financing is not popular in the country.

Term Loans for Working Capital : Under this arrangement, banks advance loans for

3-7 years payable in yearly or half-yearly installments.

The purchaser of goods on credit obtains a letter of credit from a bank. The

bank undertakes the responsibility to make payment to the supplier in case

the buyer fails to meet his obligations. Thus , the modus operandi of letter

of credit is that the supplier sells goods on credit/extends credit to the

purchaser, the bank gives a guarantee and bears risk only in case of default

by the purchaser.

3. Mode of Security

a) Hypothecation : Under this mode of security, the banks provide credit to

borrowers against the security of movable property, usually inventory of goods.

The goods hypothecated, however, continue to be in the possession of the owner

of these goods (i.e. the borrower ). The rights of the lending bank (hypothecate)

depend upon the terms of the contract between the borrower and the lender.

Although the bank does not have physical possession of the goods, it has the legal

right to sell the goods to realize the outstanding loan. Hypothecation facility is

normally is not available to new borrowers.

b) Pledge : Pledge, as a mode of security, is different from hypothecation in that in

the former, unlike in the later, the goods which are offered as security are

transferred to the physical possession of the lender. An, essential perquisite of

pledge, therefore, is that the goods are in the custody of the bank. The borrowerwho offer the security is, called a pawnor (pledgor), while the bank is called the

pawnee (pledgee). The lodging of goods by the pledgor to the pledgee is a kind

of bailment. Therefore, pledge creates some liabilities for the bank. It must take

reasonable care of goods pledged with it. In case of non-payment of the loans, the

bank enjoys the right to sell the goods.

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c) Lien : The term lien refers to the right of a part to retain goods belonging to

another party until a debt due to him is paid. Lien can be of two types: (i)

particular lien, and (ii) general lien. Particular lien is a right to retain goods until a

claim pertaining to theses goods is fully paid. On the other hand, general lien can

be applied till all dues of the claimant are paid. Banks usually enjoy general lien.

d) Mortgage : It is the transfer of a legal/equitable interest in specific immovable

property for securing the payment of debt. The person who parts with the interest

in the property is called mortgagor and the bank in whose favour the transfer takes

place is the mortagagee. The instrument of transfer is called the mortgage deed.

Mortgage is, thus, conveyance of interest in the mortgaged property. The

mortgage interest in the property is terminated as soon as the debt is paid.

Mortgage are taken as an additional security for working capital credit b banks.

e) Charge : Where immovable property of one person is, by the act of parties or by

the operation of law, made security for the payment of money to another and the

transaction does not amount to mortgage, the latter person is said to have a charge

on the property and all the provisions of simple mortgage will apply to such a

charge. The provision are as follows:

A charge is not the transfer of interest in the property though it is

security for payment. But mortgage is a transfer of interest in the

property.

A charge may be created by the act of parties or by the operation of law.

But a mortgage can be created only by the act of parties.

A charge need not be made in writing but a mortgage deed must be

attested.

Generally, a charge cannot be enforced against the transferee forconsideration without notice. In a mortgage, the transferee of the

mortgage property can acquire the remaining interest in the property, if

any is left.

4.Reserve Bank of India Framework for Regulation of Bank Credit

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After mid-nineties, the framework for regulation of bank credits has been relaxed

permitting banks greater flexibility in tune with the emergence of new banking in the

country, focusing on viability and profitability in contrast to the earlier thrust on

social/development banking. The notable features of the framework/regulation related to

fixation of norms for bank lending to industry. The norms are:

a) Inventory and Receivable Norms : The norms refer to the maximum level for

holding inventories and receivables in each industry. Raw materials were

expressed as so many months consumptions; WIP as so many months cost of

production; finished goods and receivables as so many months of cost of sales and

sales respectively. These norms represent the maximum levels of holding

inventory and receivables in each industry. Borrowers were not expected to hold

more than that level. The fixation of these norms was, thus, intended to reduce the

dependency of industry on bank credit.

b) Lending Norms/Approach to Lending/MPBF : According to the lending norms,

a part of the current assets should be financed by the trade credit and other current

liabilities. The remaining part of the current assets, termed as working capital gap,

should be partly financed by the owners funds and long term borrowings and

partly by short term bank credit. The approach to lending is vitally significant. It

takes into account all the current assets requirements of borrowers total

operational needs and not merely inventories or receivables; it also takes into

account all the other sources of finance at his command. Another merit of the

approach is that it invariably ensures a positive current ratio and, thus, keeps

under check any tendency to overtrade with borrowed funds.

c) Forms of Financing/Style of Credit : In 1995, a mandatory limit on cash credit

and a loan system of delivery of bank credit was introduced. The cash-credit limit

was initially limited to 60% of the MPBF. The balance 40% could be availed of as

short term loans. The cash credit limit sanctions are currently 20% and loan

component 80%.

d) Information and Reporting System : The main components of the information

and reporting system are four, namely,

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Quarterly Information System : Form I. Its contents are (i) production

and sales estimates for the current and the next quarter, and (ii) current

assets and current liabilities estimates for the next quarter.

Quarterly Information System : Form II. It contains (i) actual production

and sales during the current year and for the latest completed year, and (ii)

actual current assets and current liabilities for the latest completed quarter.

Half-yearly Operating Statement : Form III. The actual operating

performance for the half-year ended against the estimates are given in this.

Half-yearly Operating Statement : Form IIIB. The estimates as well as

the actual sources and uses of funds for the half-year ended are given.

5.Commercial Papers

Commercial Paper (CP) is a short term unsecured negotiable instrument, consisting of

usance promissory notes with a fixed maturity. It is issued on a discount on a face value

basis but it can also be issued in interest bearing form. A CP when issued by a company

directly to the investor is called a direct paper. The companies announce current rates of

CPs of various maturities, and investors can select those maturities which closely

approximate their holding period. When CPs are issued by security dealer on behalf of

their corporate customers, they are called dealer paper. They buy at a price less than the

commission and sell at the highest possible level. The maturities of CPs can be tailored

within the range to specific investments.

a)Advantages

- CP is a simple instrument and hardly involves any documentation.- It is flexible in terms of maturities which can be tailored to match the cash

flow of the issuer.

- A well rated company can diversify its sort-term sources of finance from

banks to money market at cheaper cost.

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- The investors can get higher returns than what they can get from the

banking system.

- Companies which are able to raise funds through CPs have better financial

standing.

- The CPs are unsecured and there are no limitations on the end-use of funds

raised through them.

- As negotiable/transferable instruments, they are highly liquid.

b) Framework of Indian CP Market

The CPs emerged as sources of short-term financing in the early nineties. They are

regulated by RBI. The main element of present framework are given below.

CPs can be issued for periods ranging between 15 days and one year. Renewal of

CPs is treated as fresh issue.

The minimum size of an issue is Rs.25 lakh and the minimum unit of subscription

is Rs.5 lakh.

The maximum amount that a company can raise by way of CPs is 100% of the

working capital limit.

A company can issue CPs only if it has a minimum tangible net worth of Rs.4crore, a fund-based working limit of Rs.4 crore or more, at least a credit rating of

P2 (Crisil ), A2 ( Icra ), PR-2 ( Care ) and D-2 ( Duff & Phelps ) and its borrowal

account is classified as standard asset.

The CPs should be issued in the form of usance promissory notes, negotiable by

endorsement and deliver at a discount rate freely determined by the issuer. The

rate of discount also includes the cost of stamp duty ( 0.25 to 0.5% ), rating

charges (0.1 to 0.2%), dealing bank fee ( 0.25% ) and stand by facility ( 0.25% ).

The participants/investors in CPs can be corporate bodies, banks, mutual funds,

UTI, LIC, GIC, NRIs on non-repatriation basis. The Discount and Finance House

of India ( DFHI ) also participates by quoting its bid and offer prices.

The holder of CPs would present them for payment to the issuer on maturity.

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c) Effective Cost/Interest Yield

As the CPs are issued at discount and redeemed at it face value, their effective pre-tax

cost/interest yield

= { (Face Value Net amount realised) / (Net amount realised) }x{(360) / (Maturity

period) }

where net amount realised = Face value discount issuing and paying agent (IPA)

charges that is, stamp duty, rating charges, dealing bank fee and fee for stand by facility.

6.Factoring

Factoring provides resources to finance receivables as well as facilitates the collection of

receivables. Although such services constitute a critical segment of the financial services

scenario in the developed countries, they appeared in the Indian financial scene only in

the early nineties as a result of RBI initiatives. There are two bank sponsored

organisations which provide such services: (i) SBI Factors and Commercial Services

Ltd., and (ii) Canbank Factors Ltd. The first private sector factoring company, Foremost

Factors Ltd. Started operations since the beginning of 1997.

a) Definition : Factoring can broadly be defined as an agreement in which

receivables arising out of sales or goods/services are sold by a firm ( client ) to the

factor ( a financial intermediary ) as a result of which the title of the

goods/services represented by the said receivables passes on to the factor.

Henceforth, the factor becomes responsible for all credit control, sales accounting

and debt collection from the buyer. In a full service factoring concept ( without

resource facility ), if any of the debtor fails to pay the dues as a result of his

financial inability/insolvency/bankruptcy, the factor has to absorb the losses.

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b) Mechanism : Credit sales generate the factoring business in the ordinary course of

business dealings. Realisation of credit sales is the main function of factoring

services. Once a sale transaction is completed, the factor steps in to realise the

sales. Thus the factor works between the seller and the buyer and sometimes with

the sellers bank together.

c) Functions of a Factor : Depending on the type/form of factoring, the main

functions of a factor, in general terms, can be classified into six categories:

i) Financing facility/trade debts :

The unique feature of factoring is that a factor purchases the book debts of

his client at a price and the debts are assigned in favour of the factor who is

usually willing to grant advances to extent of, say, 80% of the assigned

debts. Where the debts are factored with recourse, the finance provided

would become refundable by the client in case of non-payment of the

buyer. However, where the debts are factored without recourse, the factors

obligation to the seller becomes absolute on the due date of the invoice

whether or not the buyer makes the payment.

ii) Maintenance/administration of sales ledger :

The factor maintains the clients sales ledger. In addition, the factor also

maintains a customer-wise record of payments spread over a period of time

so that any change in the payment pattern can be easily identified.

iii)Collection facility of accounts receivable :

The factor undertakes to collect the receivables on the behalf of the client

relieving him of the problems involved in collection, and enables him to

concentrate on other important functional areas of the business. This also

enables the client to reduce the cost of collection by way of savings in

manpower, time and efforts.

iv) Credit Control and Credit Restriction :

The factor in consultation with the client fixes credit limits for approved

customers. Within these limits, the factor undertakes to purchase all trade

debts of the customer without resource. In other words, the factor assumes

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the risk of default in payment by the customer. Operationally, the line of

credit/credit limit up to which the client can sell to the customer depends on

his financial position, his past payment record and value of goods sold by

the client to the customer.

v) Advisory Services :

These services are a spin-off of the close relationship between a factor and

a client. By virtue of their specialised knowledge and experience in finance

and credit dealings and access to extensive credit information, factors can

provide a variety of incidental advisory services to their clients.

vi) Cost of Services :

The factors provide various services at a charge. The charge for collection

and sales ledger administration is in the form of a commission expressed as

a value of debt purchased. It is collected in advance. The commission for

short term financing as advance part-payment is in the form of interest

charge for the period between the date of advance payment and the date of

collection date. It is also known as discount charge.

MANAGING WORKING CAPITAL

1.Cash Management

A) Objectives:

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The basic objective of cash management are two fold: a) to meet the cash disbursement

needs and b) to minimise funds committed to cash balances. These are conflicting and

mutually contradictory and the task of the cash management is to reconcile them.

Meeting Payment Schedule

In normal course of business, firms have to make payments of cash on a continuous and

regular basis to suppliers of goods, employees and so on. At the same time, there is a

constant inflow of cash through collections from debtors. A basic objective of cash

management is to meet the payment schedule, that is, to have sufficient cash to meet the

cash disbursement needs of a firm.

The advantages of adequate cash are : (i) it prevents or bankruptcy , (ii) the relationship

with banks is not strained, (iii) it helps in fostering good relations with trade creditors

and suppliers of raw materials, as prompt payment may help their own cash

management, (iv) a cash discount can be availed of if payment is made within the due

date, (v) it leads to a strong credit rating , (vi) to take advantage of favorable business

opportunities that may be available periodically, and finally (vii) the firm can meet

unanticipated cash expenditure with a minimum of strain during emergencies, such as

strikes, fires, or a new marketing campaign by competitors. Keeping large cash balances,

however, implies a high cost.

Minimising Funds Committed to Cash Balances

The second objective of Cash Management is to minimise cash balances. In minimizing

the cash balances, two conflicting aspects have to be reconciled. A high level of cash

balances will, as mentioned above, ensure prompt payment together with all the

advantages. But it also implies that large funds will remain idle, as cash is a non earning

asset and the firm will have to forgo profits. A low level cash balances, on the other

hand, may mean failure to meet the payment schedule. The aim of cash management,

therefore, should be to have optimal amount of cash balances.

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Factors Determining Cash Needs

i) Synchonisation of cash flows : The proper synchronization between the

outflows and inflows should be followed . This is possible by adopting cash

budget technique. The properly prepared budget will pinpoint the

months/periods when the firm will have an excess or a shortage of cash.

ii) Short Costs : The cash budgets reveals the periods of shortage of cash, but, inaddition, there may be some unexpected shortfalls. The expenses incurred as a

result of shortfalls is called as Short Costs.

iii) Excess Cash Balance Costs: The cost of having excessively large cash

balances is known as the excess cash balance cost. If large funds are idle, the

implication is that the firm has missed opportunities to invest those funds and

has thereby lost interest which it would otherwise have earned. This loss of

interest is primarily the excess cost.

iv) Procurement and Management : These are the costs associated with

establishing and operating cash management staff and activities. They are

generally fixed and are mainly accounted for by salary, storage, handling of

securities and so on.

v) Uncertainty and Cash management : Finally, the impact on cash

management strategy is also relevant as cash flows cannot be predicted with

complete accuracy.

Cash Budget : Management Tool

Cash Budget is the most important tool in cash management. It is the statement showing

the estimated cash inflows and cash outflows over the planning horizon.

The various purposes of cash budgets are : (i) to co-ordinate the timings of cash needs,

(ii) it pinpoints the period when there is likely to be excess cash, (iii) it assists

management in taking cash discounts on its account payables, (iv) it helps to arrange

needed funds on the most favorable terms and prevents accumulation of excess funds.

Preparation of Cash Budget

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The principle aim of the cash budget, as a tool is to predict cash flows over a given

period of time, and to ascertain whether at any point of time there is likely to be excess

or shortage of cash.

The first element of cash budget is the selection of the period of time to be covered by

the budget. It s referred to as the planning horizon over which the cash flows are to be

projected. There is no fixed rule , it varies from firm to firm. The period selected should

be neither too long nor too short. If it is too long, it is likely that the estimates will be

inaccurate. If, on the other hand,

the time span is too small many important events which lie just beyond the period

cannot be accounted for and the work associated with the preparation of the budget

becomes excessive. If the flows are expected to be stable and dependable, such a firm

may prepare a cash budget covering a long period, say, a year and divide it into quarterly

intervals. In the case of firms whose flows are uncertain, a quarterly budget, divided into

monthly intervals, may be appropriate. If the flows are subjected to extreme fluctuations,

even a daily budget may be called for. The idea behind subdividing the budget period

into smaller intervals is to highlight the movement of cash from one sub period to

another.

Operating Cash Flow

Operating Cash Flow Items

Inflows / Cash Receipts Outflows / Disbursements

1. Cash Sales 1. Accounts payable / Payable payments

2. Collection of Accounts Receivables 2. Purchase of raw materials

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3. Disposals of Fixed Assets 3. Wages and Salaries

4. Factory Expenses

5. Administrative and selling expenses

6. Maintenance Expenses

7. Purchase of Fixed Assets

Among the operating factors affecting cash flows, are the collection of accounts

( inflows ) and accounts payable ( outflows ). The terms of credit and the speed with

which the customer pay would determine the lag between the creation of accounts

receivable and their collection.

Financial Cash Flows

Financial Cash Flow Items

Cash Inflows / Receipts Cash Outflows / Payments

1. Loans / Borrowings 1. Income-tax / Tax payment

2. Sales of Securities 2. Redemption of loan

3. Interest received 3. Repurchase of shares

4. Dividend received 4. Interest paid

5. Rent received

6. Refund of tax

5. Dividend paid

7. Issue of new shares and securities

Preparation of Cash Budget

After the time span of the cash budget decided and the pertinent operating and financial

factors have been identified, the final step is the construction of the cash budget. Thus

the total cash inflows, cash outflows and the net receipt or payment is worked out.

C) Cash Management : Basic Strategies

The cash budget, as a management tool, would throw light on the net cash position of

the firm. After knowing the cash position, the management should workout the basic

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strategies to be employed to manage its cash.

The broad cash management strategies are essentially related to the cash turnover

process, that is, the cash cycle together with the cash turnover. The cash cycle refers to

the process by which the cash is used to purchase materials from which are produced

goods, which are then sold to customers, who later pay the bills. The firm receives cash

from customers and the cycle repeats itself. The cash turnover means the number of

times the cash is used during each year. The cash cycle involves several steps along the

way as fund flows from the firms accounts.

Minimum Operating Cash

The higher the cash turnover, the less is the cash a firm requires. A firm should,

therefore, try to maximize the cash turnover. But it must maintain a minimum amount of

operating cash balance so that it does not run out of cash. The basic strategies that can be

employed to do the needful are as follows:

i) Stretching accounts payable : In other words, a firm should pay its accounts

payable as late as possible without damaging its credit standing. It should,

however take advantage of the cash discount available on prompt payment.

ii) Efficient Inventory-Production Management : Increase inventory turnover,

avoiding stock-outs, that is, shortage of stocks. This can be done in following

ways:

a) Increasing the raw materials turnover by using more efficient inventory

control techniques.

b) Decreasing the production cycle through better production planning,

scheduling and control techniques, it will lead to an increase in WIP

inventory turnover.

c) Increasing the finished goods turnover through better forecasting of demand

and a better planning of production.

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iii) Speeding Collection of Accounts Receivable : Another strategy for efficient

cash management is to collect account receivable as quickly as possible without

losing future sales because of high-pressure collection techniques. The average

collection period of the receivables can be reduced by changes in (a) credit

terms, (b) credit standards, and (c) collection policies

iv) Combined Cash Management Strategies : We have seen strategies related to

(i) accounts receivables, (ii) inventory, and (iii) accounts receivables but there

are certain problems for management . First, if the accounts payable are

postponed too long, the credit standing of the firm may be adversely affected.

Secondly, a low level of inventory may lead to a stoppage of production as

sufficient raw materials may not be available for uninterrupted production, or

the firm may be short of enough stock to meet the demand for its product, that

is, stock-out. Finally, restrictive credit standards, credit terms and collection

policies may jeopardize sales. These implications should be constantly kept in

view while working out cash management strategies.

2.Receivables Management

A) Objectives

The term receivables is defined as debt owed to the firm by the customers arising from

sale of goods or services in the ordinary course of business. When a firm makes anordinary sale of goods or services and does not receive payment, the firm grants trade

credit and creates accounts receivables which could be collected in the future.

Receivables management is also called trade credit management. Thus accounts

receivable represent an extension of credit to customers, allowing them a reasonable

period of time in which to pay for the goods received.

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a) The sale of goods on credit is an essential part of the modern competitive

economic systems. In fact, the credit sale and, therefore, the receivables, are

treated as a marketing tool to aid the sale of goods. As a marketing tool, they are

intended to promote sales and obligations through a financial instrument.

Management should weigh the benefits as well as cost to determine the goal of

receivables management. The objective of receivable management is to promote

sales and profits until that point is reached where the return on investment in

further funding receivables is less than the cost of funds raised to finance that

additional credit. The specific costs and benefits which are relevant to the

determination of the objectives of receivables management are examined below.

a)Costs : The major categories of costs associated with the extension of credit and

accounts receivable are :-

Collection Cost: Collection costs are administrative costs incurred in collecting the

receivables from the customers to whom credit sales have been made.

Capital Cost: The increased level of accounts receivable is an investment in assets.

They have to be financed thereby involving a cost. It includes the additional funds

required to meet its own obligation while waiting for payment from its customer and

also the cost on the use of additional capital to support credit sales, which

alternatively could be profitably employed elsewhere.

Delinquency Cost: This cost arises out of the failure of the customers to meet their

obligations where payment on credit sales become due after the expiry of the credit

period. Such costs are called delinquency costs.

Default Costs: Finally, the firm may not be able to recover the overdues because of

the inability of the customers. Such debts are treated as bad debts and have to be

written off as they cannot be realized. Such costs are treated as default costs

associated with credit sales and accounts receivables.

b) Benefits: Apart from the costs, another factor that has a bearing on accounts

receivable management is the benefit emanating from credit sales. The benefits

are the increased sales and anticipated profits because of the more liberal policy.

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The impact of the liberal trade credit policy is likely to take two forms. Firstly, it

is oriented to sales expansion. Secondly, the firm may extend credit to protect its

current sales against emerging competition. Here, the motive is sales-retention.

From the above discussion, it is clear that investments in receivables involve both

benefits and costs. The extension of trade credit has a major impact on sales, cost

and profitability. Therefore account receivable management should aim at off

between profit (benefits) and risk (cost).

B) Credit Policies

In the preceding discussion it has been clearly shown that the firms objective with

respect to receivables management is not merely to collect receivables quickly but

attention should also be given to the benefit-cost trade-off involved in the various areas

of accounts receivable management. The first decision area is Credit Policies.

The credit policy of the firm provides the framework to determine (a) whether or not to

extend credit to a customer and (b) how much credit to extend. The credit policy

decision of firm has two broad dimensions:

(i) Credit Standards : The term credit standards represents the basic criteria for

the extension of credit to customers. The quantitative basis of establishing

credit standards are factors such as credit ratings, credit references, average

payment period and certain financial ratios. Since we are interested in

illustrating the trade-off between benefit and cost to the firm as a whole, we do

not consider here these individual components of credit standards. To illustrate

the effect, we have divided the overall standards into (a) tight or restrictive,

and (b) liberal or non-restrictive. The trade-off with reference to credit

standards covers(a) Collection Costs : The implications of the relaxed credit standards are (i)

more credit, (b) a large credit department to service accounts receivable and

related matters, (iii) increase in collection costs. The effect of tightening of

credit standards will be exactly the opposite. These costs are likely to be

semi-variable.

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(b) Investments in Receivables or the Average Collection Period : The

investment in accounts receivable involves a capital cost as funds have to

be arranged by the firm to finance them till customer makes payment.

Moreover higher the average accounts receivables, the higher is the capital

or carrying cost. A change in credit standards-relaxation or tightening-leads

to a change in the level of accounts receivable either (i) through a change in

sales, or (ii) through a change in collections.

A relaxation in credit standards, as already stated, implies an increase in

sales which, in turn, would lead to higher average accounts receivable.

Further relaxed standards would mean that credit is extended liberally so

that it is available to even less credit-worthy customers who will take a

longer period to pay overdues. In contrast, a tightening of credit standards

would signify (i) a decrease in sales and lower average accounts

receivables, and (ii) an extension of credit limited to more credit-worthy

customers who can promptly pay their bills and, thus, a lower average level

of accounts receivable.

(c) Bad Debt Expenses : Another factor which is expected to be affected by

changes in credit standards is bad debt expenses. They can be expected to

increase with relaxation in credit standards and decrease if credit standards

become more restrictive.

(d) Sales Volume : Changing credit standards can also be expected to change

the volume of sales. As standards are relaxed, sales are expected to

increase; conversely, a tightening is expected to cause a decline in sales.

B) Credit AnalysisBesides establishing credit standards, a firm should develop procedures for evaluating

credit applicants. The second aspect of credit policies of a firm is credit analysis and

investigation. Two basic steps are involved in the credit investigation process

(a)Obtaining Credit information : The first step in credit analysis is obtaining credit

information on which to base the evaluation of a customer. The sources of information,39


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broadly speaking, are

(i) Internal : Usually, firms require their customers to fill various forms and

documents giving details about financial operations. They are also required

to furnish trade references with whom the firms can have contacts to judge

the suitability of the customer for credit. This type of information is

obtained from internal sources of credit information. Another internalsource of credit information is derived from the records of the firms

contemplating an extension of credit.

(ii) External : The availability of information from external sources to assess

the credit-worthiness of customers depends upon the development of

institutional facilities and industry practices. In India, the external sources

of credit information are not as developed as in the industrially advanced

countries of the world. Depending upon the availability, the following

external sources may be employed o collect information.

- Financial Statements : One external source of credit information is the

published financial statements, that is, the balance sheet and the profit

and loss account. They contain very useful information such as

applicants financial viability, liquidity, profitability, and debt capacity.

They are very helpful in assessing the overall financial position of a

firm, which significantly determines its credit standing.

- Bank References : Another useful source of credit information is the

bank of the firm which is contemplating the extension of credit. The

modus operandi here is that the firms banker collects the necessary

information from the applicants bank. Alternatively, the applicant may

be required to ask his banker to provide the necessary information eitherdirectly to the firm or to its bank.

- Trade References : These refer to the collection of information from

firms with whom the applicant has dealings and who on the basis of

their experience would vouch for the applicant.

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- Credit Bureau Report : Finally, specialist credit bureau reports from

organizations specializing in supplying credit information can also be

utilized.

(b) Analysis of Credit Information : Once the credit information has been collected

from different sources, it should be analysed to determine the credit-worthiness of the

applicant. The analysis should cover two aspects:

(i) Quantitative : The assessment of the quantitative aspects is based on the

factual information available from the financial statements, the past

records of the firm, and so on. The first step involved in this type of

assessment is to prepare an Aging Schedule of the accounts payable of the

applicant as well as calculate the average age of accounts payable. This

exercise will give an insight into the past payment pattern of the customer.

Another step in analyzing the credit information is through a ratio analysis

of the liquidity, profitability and debt capacity of the applicant. These

ratios should be compared with the industry average. Morever, trend

analysis over a period of time would reveal the financial strength of the

customer.

(ii) Qualitative : The quantitative assessment should be supplemented by a

qualitative/subjective interpretation of the applicants credit-worthiness.

The subjective judgement would cover aspects relating to the quality of

management. Here, the reference from other suppliers, bank references

and specialist bureau reports would form the basis for the conclusion to be

drawn. In the ultimate analysis, therefore, the decision whether to extend

credit to the applicant and what amount to extend will depend upon the

subjective interpretation of his credit standing.

C) Credit Terms

The second decision area in accounts receivables management is the credit terms. After

the credit standards have been established and the credit-worthiness of the customer has

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been assessed, the management of a firm must determine the terms and conditions on

which the trade credit will be made available. The stipulations under which goods are

sold on credit are referred to as credit terms. The credit terms specifies the repayment

terms of receivables.

The credit terms have three components : (i) credit period, in terms of duration of time

for which trade credit is extended-during this period the overdue amount must be paid

by the customer; (ii) cash discount, if any, which the customer can take advantage of,

that is, the overdue amount will be reduced by this amount; and (iii) cash discount

period, which refers to the duration during which the discount can be availed of.

The credit terms, like the credit standards, affect the profitability as well as the cost of a

firm. A firm should determine the credit terms on the basis of cost-benefit trade-off. The

components of credit are here below:

(a) Cash Discount : The cash discount has implications for the sales volume, average

collection period/average investment receivables, bad debt expenses and profit per unit.

In taking a decision regarding the grant of cash discount the management has to se what

happens to these factors if it initiates increase, or decrease in the discount rate. The

changes in the discount rate would have both positive and negative effects. The

implications of increasing or initiating cash discount are as follows:

i. The sales volume will increase. The grant of discount

implies reduced prices. If the demand for the products is elastic, reduction in

prices will result in higher sales volume.

ii. Since the customers, to take advantage of the discount, would like

to pay within the discount period, the average collection period would be

reduced. The reduction in the collection period would lead to a reduction in the

investment in receivables as also the cost. The decrease in the average

collection period would also cause a fall in bad debt expenses. As a result,

profits would increase.

iii. The discount would have a negative effect on the profits. This is

because the decrease in prices would affect the profit margins per unit of sale.

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E)Collection Policies

The third area involved in accounts receivable management is collection policies. Thy

refer to the procedures followed to collect the accounts receivable when, after the expiry

o the credit period, they become due. These policies cover two aspects:

(i) Degree of Collection Effort : To illustrate the effect of the collection effort, the

credit policies of a firm may be categorised into (i) strict / light, and (ii) lenient. The

collection policy would be tight if very rigorous procedures are followed. A tight

collection policy has implications which involve benefits as well as costs. The

management has to consider a trade-off between them. Likewise, a lenient collection

effort also affects the cost-benifit trade-off. The effect of tightening the collection is

discussed below :

- Bad debt expenses would decline.

- The average collection period will be reduced.

- As a result profit will increase.

- Increased collection costs.

- Decline in sales volume.

The effect of lenient policy will just be the opposite.

(iii) Type of Collection Efforts : The second aspect of collection policies

relates to the steps that should be taken to collect overdues from the

customers. A well established collection policy should have clear-cut

guidelines as to the sequence of collection efforts. After the credit period is

over and payment remains due, the firm should initiate measures to collect

them. The effort should in the beginning be polite, but, with the passage of

time, it should gradually become strict. The steps usually taken are (i)

letters, including reminders, to expedite payment; (ii) telephone calls for

personal contact; (iii) personal visits; (iv) help of collection agencies; and

finally,(v) legal action. The firm should take recourse to very stringent

measures, like legal actions, only after all other avenues have been fully

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exhausted. They not only involve cost but also affect the relationship with

the customers. The aim should be to collect as early as possible; genuine

difficulties of the customers should be given due consideration.

3. Marketable Securities

A) Meaning And CharacteristicsOnce the optimal level of cash balance of a firm has been determined, the residual of its

liquid assets is invested in marketable securities. Such securities are short term

investment instruments to obtain a return on temporarily idle funds. In other words, they

are securities which can be converted into cash in a short period of time, typically a few

days. To be liquid, a security must have two basic characteristics: a ready market and

safety of principal. Ready marketability minimizes the amount of time required to

convert a security into cash. A second determinant of liquidity is that there should be

little or no loss in the value of a marketable security over time. Only those securities that

can be easily converted into cash without any reduction in the principal amount qualify

for short term investments. A firm would be better off leaving the balances in cash if the

alternative were to risk a significant reduction in principle.

B) Selection Criterion

A major decision confronting the financial managers involves the determination of the

mix of cash and marketable securities. In general, the choice of the mix is based on a

trade-off between the opportunity to earn a return on idle funds during the holding

period, and the brokerage costs associated with the purchase and sale of marketable

securities.There are three motives for maintaining liquidity and therefore for holding marketable

securities: transaction motive, safety motive and speculative motive. Each motive is

based on the premise that a firm should attempt to earn a return on temporarily idle

funds. An assessment of certain criteria can provide the financial manager with a useful

framework for selecting a proper marketable securities mix. These considerations

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include evaluation of :

Financial Risk : It refers to the uncertainty of expected returns from

a security attributable to possible changes in the financial capacity of

the security issuer to make future payments to the security owner. If

the chances of default on the terms of the investment is high, then the

financial risk is said to be high and vise versa .

Interest Rate Risks : The uncertainty associated with the expected

returns from a financial instrument attributable to changes in interest

rates is known as interest rate risk. If prevailing interest rates rise

compared with the date of purchase, the market price of the securities

will fall to bring their yield to maturity in line with what financial

managers could obtain by buying a new issue of a given instrument,for instance, treasury bills. The longer the maturity of the instrument,

the larger will be the fall in prices. To hedge against the price

volatility caused by interest rate risk, the market securities portfolio

will tend to be composed of instruments that mature over short

period.

Taxability : Another factor affecting observed difference in market

yields is the differential impact of taxes. A differential impact on

yields arises because interest income is taxed at the ordinary tax rate

while capital gains are taxed at a lower rate.

Liquidity : With reference to marketable securities portfolio,

liquidity refers to the ability to transform a security into cash. The

financial manager will want the cash quickly and will not want to

accept a large price reduction in order to convert the securities.

Yield : The final selection criterion is the yields that are available on

the different financial assets suitable for inclusion in the marketable

portfolio. All the four factors listed above, influence the available

yields on financial instruments. The finance manager must focus on

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the risk-return trade-offs associated with the four factors on yield

through his analysis.

Marketable Security Alternatives

(i) Treasury Bills : There are obligations of the government. They are sold on a

discount basis. The investor does not receive an actual interest payment. The

return is the difference between the purchase price and the face value of the

bill. The treasury bills are issued only in bearer form. They are purchased,

therefore, without the investors name on them. As the bills have the full

financial backing of the government, they are, for all practical purposes, risk-

free.

(ii) Negotiable Certificates of Deposits : These are marketable receipts for funds

that have been deposited in a bank for a fixed period of time. The deposit

funds earn a fixed rate of interest. The CDs are offered by banks on a

basis different from treasury bills, that is, they are not sold at discount.

When the certificate mature, the owner receives the full amount deposited

plus the earned interest.

(iii) Commercial Paper : It refers to short-term unsecured promissory note

sold by large business firms to raise cash. As they are unsecured, the

issuing side of the market is dominated by large companies which

typically maintain sound credit rating. Commercial paper can be sold

either directly or through dealers. Companies with high credit ratings can

sell directly to the investors. They can even be purchased with varying

maturities. For all practical purposes, there is no active trading in

secondary market for commercial papers although direct sellers of CPs

often repurchase it on request.

(iv)Bankers Acceptances : These are draft (order to pay) drawn on a specific

bank by an exporter in order to obtain payment for goods he has shipped

to a customer who maintains an account with that specific bank. They can

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also be used in financing domestic trade. The draft guarantees payment by

the accepting bank at a specific point of time. The seller who holds such

acceptance may sell it at a discount to get immediate funds. They serve

the wide range of maturities and are sold on a discount basis, payable to

the bearer.

(v) Repurchase Agreements : These are legal contracts that involves the actual

sale of securities by a borrower to the lender with a commitment on the

part of the former to repurchase the securities at the current price plus a

stated interest charge. The securities involved are government securities

and other money market instruments. The borrower is either a financial

institution or a security dealer.

(vi)Units : The units of Unit Trust of India (UTI) offers a reasonably convenient

alternative avenue for investing surplus liquidity as (i) there is a very

active secondary market for them, (ii) the income for units is tax-exempt

up to a specified amount and, (iii) the units appreciate in a fairly

predictable manner.

(vii) Intercorporate Deposits : Intercorporate deposits, that is, short-term

deposits with other companies is a fairly attractive form of investment of

short-term funds in terms of rate of return which currently ranges between

12 and 15 per cent. However, apart from the fact that one months time is

required to convert them into cash, intercorporate deposits suffers from

high degree of risk.

(viii) Bill Discounting : Surplus funds may be developed to purchase/discount

bills. Bills of exchange are drawn by seller on the buyer for the value of

goods delivered to him. If the seller is in need of funds, he may get the

bills discounted. Bill discounting is superior to intercorporate deposits for

investing surplus funds.

(ix)Call market : It deals with funds borrowed/lent overnight/one-day (call)

money and notice money for periods up to 14 days. It enables corporates

to utilize their float money gainfully. However the returns are highly

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volatile. The stipulations pertaining to the maintenance of cash reserve

ratio (CRR) by banks is the major determinant of the demand of funds and

is responsible for volatility in call rates. Large borrowings by them to

fulfill their CRR requirements pushes up the rates and a sharp decline

takes place once these funds are met.

4. Inventory Management

A) Objectives

The basic responsibility of the financial manager is to make sure the firms cash flows

are managed efficiently. Efficient management of inventory should ultimately result in

the maximization of the owners wealth. As we know that in order to minimise cash

requirements, inventory should be turned over as quickly as possible, avoiding stock-

outs that might result in closing down the production line or lead to a loss of sales. It

implies that while the management should try to pursue the financial objective of turning

inventory as quickly as possible, it should at the same time ensure sufficient inventories

to satisfy production and sales demands. The objective of inventory management

consists of two counterbalancing parts: (i) to minimise investment in inventory, and (ii)

meet a demand for the product by efficiently organizing the production and sales

operations. These two conflicting objectives of inventory management can also beexpressed in terms of cost and benefit associated with inventory. That the firm should

minimise investment in inventory implies that maintaining inventory involves costs,

such that the smaller the inventory, the lower is the cost to the firm. But inventories also

provide benefits to the extent that they facilitate the smooth functioning of the firm: the

larger the inventory, the better it is from the viewpoint. Obviously, the financial

managers should aim at a level of inventory which will reconcile these conflicting

elements. That is to say, an optimum level of inventory should be determined on the

basis of the trade-off between costs and benefits associated with the levels of inventory.

B) Costs of Holding Inventory

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One operating objective of inventory management is to minimise cost. Excluding the

cost of merchandise, the cost associated with inventory fall into two basic categories:

(i) Ordering or Acquisition or Set-up costs : This category of cost is associated

with the acquisition or ordering of inventory. Firms have to place orders with

suppliers to replenish inventory of raw materials. The expense involved are

referred to as ordering costs. The ordering costs consist of (a) preparing the

purchase order or requisition form and (b) receiving, inspection, and recording

the goods received to ensure both quantity and quality. The cost of acquiring

materials consists of clerical costs and costs of stationery. It is therefore, called, a

set-up cost. They are generally fixed per order placed, irrespective of the amount

of the order. The acquisition costs are inversely related to the size of inventory:

they decline with the inventory. Thus, such costs can be minimised by placing

fewer orders for a large amount. But acquisition of a large quantity would

increase the cost associated with the maintenance of inventory, that is, carrying

cost.

(ii) Carrying costs : The second broad category of costs associated with inventory

are the carrying costs. They are involved in maintaining or carrying inventory.

The cost of holding inventory may be divided into two categories:

1. Those that arise due to the storing of inventory : The main

components of this category of carrying costs are (1). Storage

costs, that is, tax, depreciation, insurance, maintenance of the

building, utilities and janitorial services; (2). insurance of

inventory against fire and theft; (3). Deterioration in inventory

because of pilferage, fire, technical obsolescence, style

obsolescence and price decline; (4). Serving costs, such as, labour

for handling inventory, clerical and accounting costs.

2. The opportunity cost of funds : This consists of expenses in raising

funds (interest on capital) to finance the acquisition of inventory. If

funds are not locked in inventory, they would have earned a return.

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This is the opportunity cost of funds or financial cost component

of the cost.

The carrying costs and the inventory size are positively related and

move in the same direction. If the level of inventory increases, the

carrying costs also increase and vice versa.

The sum of the order and carrying costs represents the total cost of

inventory. This is compared with the benefits arising out of

inventory to determine the optimum level of inventory.

C) Benefits of Holding Inventory

The second element in the optimum inventory decision deals with the benefits associated

with holding inventory. The three types of inventory, raw materials, work-in-progress

and finished goods, perform certain useful functions. The rigid tying (coupling) of

purchase and production to sales schedules is undesirable in the short run as it will

deprive the firms certain benefits. The effect of uncoupling (maintaining inventory) are

as follows

(i) Benefits in Purchasing : If the purchasing of raw materials and other goods is

not tied to production/sales, that is, a firm can purchase independently to

ensure the most efficient purchase, several advantages would become

available. In the first place, a firm can purchase larger quantities than is

warranted by usage in production or the sales level. This will enable it to avail

of discounts that are available on bulk purchases. Moreover, it will lower the

ordering cost as fewer acquisitions would be made. There will, thus, be a

significant saving in the costs. Secondly, firms can purchase goods before

anticipated or announced price increases. This will lead to a decline in the cost

of production. Inventory, thus, serves as a hedge against price increases as well

as shortages of raw materials. This is highly desirable inventory stra

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