Javaid Final

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WORKING CAPITAL MANAGEMENT

DECLARATION

I JAVAID AHMAD GANAIE, do hereby declare that the training report

entitled An Overview on Working Capital Management submitted to

LOVELY PROFESSINAL UNIVERSITY for the partial fulfillment of the

requirement for the degree of BBA is one of my original work under thecontinuous guidance of LECT. GURPREET KAUR.

I have not submitted this training report to any University for the

award of any other degree.

JAVAID AHMAD GANAIE

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ACKNOWLEDGEMENT.

Gratitude is not a thing of expression,; it is more, a matter of felling

There is always a sense of gratitude which one expresses towards for their help

and supervision in achieving the goals.

It is my proud to privilege to have been inducted into JAMMU AND

KASHMIR BANK LTD. at M.A Road Srinagar, a well known industry for themanufacturing of the spare parts.

My words of thanks go to Mr.Altaf Ahmad, (Managing Director), for

giving me the opportunity to do SUMMER TRAINING in his esteemed

organization. I am also thank full to Mr. Sajid Ahmad, our training supervisors,and all the staff of Jammu & Kashmir Bank Limited, for their guidance,

support, and co-operation extended to me. During the course of project.

Special thanks to my guide who guided me to work honestly and gain

knowledge in Summer Training.

No words can express my feelings to my parents, friends whose co-

operative attitude was the constant source of inspiration during the entire period

of the project.

I would like to thank to almighty GOD for his blessings showered on

me during the completion of this project.

J A V A I D A H M A D

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Contents

1. Execute Summary.6

2. Project & Objective...7

3. Profile of J&K Bank..8

4. Vision & Mission..9

5. History.10

6. Bank at Glance.13

7. Share Holding pattern..14

8. Unique Characteristics & Services.15

9. Products & Services15

10.Financial services & portfolio..18

11.Management.19

12.Awards & Accolades.20

13.Corporate Address21

14.Introduction.22

15.Working Capital Management.23

16.Need For WCM.24

17.Types of WCM.25

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18.Factors effecting WCM27

19.Operating & Cash Cycle..30

20.Reasons for Adequate WC..32

21.Management of WC34

22.Techniques for estimating WC requirement35

23.Approaches for determining the financial mix.38

24.Management of different components of WC39

25.Management of inventories.43

26.Management of Account Receivables47

27.Factors effecting the Receivables..50

28.Management of Account payables52

29.Overtrading & Undertrading.52

30. Undertrading.56

31.Sources of Working Capital..58

32.Regulation of Bank Finance..63

33.Small Scale Industries. 67

34.View of Managing Working Capital67

35.Observations Regarding WC..71

36.Key Working Capital Ratios..73

37.Performance Report75

38.Cash Credit Analysis & Computation In Jammu & Kashmir

Bank75

39.Assessment of WC80

40.Balance Sheet As on 31th March, 200982

41. Profit & Loss Account83

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42. WC Assessment in J&K Bank.8443. Recommendations.87

44. Scanning of WC Financing in J&K bank..87

45. Estimation of WCM.89

46. Calculation of WC9147. Know Ur customer guidelines Anti Money laundering

Standards..93

49. RTGS in J&K bank10550. NEFT105

52. News regarding J&K bank106

53. Bibliography.107

Executive summary

Working capital management refers to the administration of all aspects of current

assets, namely cash, marketable securities, debtors and stock (inventories) and current

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liabilities. The financial manager must determine levels and composition of current assets.

He must see that right sources are tapped to finance current assets, and that current

liabilities are paid in time. He must see that right sources are tapped to finance current

assets, and that current liabilities are paid in time.

There are many aspects of working capital management, which make it an

important function of the financial manager:

Time: working capital management requires much of the financial managers time.

Investment: working capital represents a large portion of the total investments in

assets.

Significance: working capital management has great significance for all firms but it

is very critical for small firms.

Growth: the need for working capital is directly related to the firms growth.

Investment in current assets represents a very significant portion of the total investment in

assets. Working capital management is critical for all firms. A small firm may not have

much investment in fixed assets, but it has to invest to in current assets. Small firms inIndia face a severe problem of collecting their debtors.

Banks have their own policies to assess the working capital of the firm to finance them

with the shortage.

J&K Bank adopts certain method for financing their customers working capital

requirements. There are certain recommendations from the committees for the banks to

finance the working capital needs of their clients.

It may, thus, be concluded that all precautions should be taken for the effective and

efficient management of working capital. The finance manager should pay regular attention

to the levels of current assets and the financing of current assets.

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PROJECT TITLE:

Working capital management

Project Objectives:

To learn the effective management of working capital.

To study how to keep the capital that is tied up in the working capital cycle at a minimum

and maximizing profit.

To study the different components of working capital and its impact on the performance

of the firm.

To study how J&K Bank finances working capital requirements of the firms.

Profile: Jammu & Kashmir Bank

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Birth

Registered on 1st of October 1938 with an authorized capital of Rs 10.00 lakh and

commenced business from 4th of July 1939.

Childhood

Registered on 1st of October 1938 with an authorized capital of Rs 10.00 lakh and

commenced business from 4th of July 1939.

After nationalization in 1969, the bank expanded rapidly. It now has more than 500

branches (as of 31st March 2009) all over India. The Bank has the largest network of

branches by any Public sector bank in the state of Jammu & Kashmir.

Adult

The bank has fine tuned its services to cater to the needs of the common man and

incorporated the latest technology in banking offering a variety of services.

Banks Tagline

Serving To Empower

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VISION

To catalyze economic transformation and capitalize on growth.The bank aspires to make

Jammu & Kashmir the most prosperous state in the country, by helping create a new

financial architecture for the J&K economy, at the centre of which will be the J&K.

MISSION

To provide the people of J&K international quality financial service and solutions and to be

a super-specialist bank in the rest of the country.

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Company History:

YEAR EVENTS1938

- The Jammu & Kashmir Bank Ltd was incorporated in 1938 to extend banking facilities in

Jammu & Kashmir.

- The bank was constituted as a government company under Companies Act 1956 and isfunctioning as bankers to the state government.

1993

- The Bank tied up with Reuter News Agency for instantaneous information about globalforeign currency rates and fluctuations thereof.

1994

- The Bank tied up with Reuter News Agency for instantaneous information about global

foreign currency rates and fluctuations thereof.

1995- Banking Ombudsman Scheme was launched in June with a view to provide quick and

inexpensive facility to resolve the grievances of banks' customers.- A loan delivery system was introduced in April to instil discipline in the utilization of

bank credit especially by large borrowers.

1998- Jammu and Kashmir Bank Ltd (J&K Bank) is coming out with a public issue of 1 85 00

000 equity shares of Rs.10 each for cash at a premium of Rs.28 per share aggregating

Rs.70.30 crore.- A recovery drive was launched which included settlement of long outstanding loan

accounts of chronic defaulters by outside court compromises.

- Bank introduced a new term deposit scheme under the title "Jana Priya Jamma Yojna"carrying flexibility in the repayment schedule.- Housing Loan and Education Loan Schemes for general public have been introduced

during the current financial year.

1999

- The bank entered into an agreement with IBA to connect its ATMs through a shared

network.

2000- Jammu and Kashmir Bank has tied up with Infosys Technologies to offer internet banking

and for its e-commerce initiatives.

- Jammu and Kashmir Bank is in talks with two foreign insurance companies for a joint

venture for its insurance subsidiary to be floated by the year end.- Jammu and Kashmir Bank Ltd the Srinagar-based listed bank in the country tied up with

Infosys Technologies Ltd.

- Jammu and Kashmir Bank has tied up with American Express to launch a co-brandedcredit card. The J&K Bank American Express Credit card offers high value features

including global validity balance transfer facility membership rewards and emergency cash.

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- The Bank will broaden its areas of diversification by getting into non-life insurance anddepository business apart from life Insurance and asset management business following the

recommendations of pricewaterhouse Coopers .

2001

- The Bank has launched J&K Bank - AMEX Co. Branded Credit Card pursuant toagreement entered with American Express Bank.

- The Bank has tied up with the US-based insurance giant Metlife for the proposed foray in

the insurance sector.

2002

-Jammu & Kashmir Bank Ltd has informed that following persons have ceased to be

Directors of the Bank. Mr H S Anand and Mr M I Shahdad. Further the Company hasinformed that the following persons were appointed as Directors:Dr G Q Allaqaband and

Mr D S Kandhari Further the following finance luminaries were reappointed as additional

Directors of the Bank in the aforesaid Board Meeting.Dr A M Khusro Mr G P Gupta and

Mr Vipin Malik.

2003- Jammu and Kashmir Bank Ltd has informed the following change in the Board:

1) Mr G R Khan and Mr G M Dug have ceased to be directors of the bank at AGM held onJune 02 2003.2) Mr Mohammad Yasin Mir and Mr B L Dogra have been appointed as

directors on the Board at AGM held on June 02 2003.3) Dr A M Khusro Mr G P Gupta and

Mr Vipin Malik have been appointed as Directors of bank on June 3 2003.

-Jammu and Kashmir Bank has agreed to reduce the rate of interest rom 16 to 12%

onvarious loans advanced to houseboat owners taxi and shikariwalas.-Dr Haseeb A Drabu consultant to the Economic Advisory Council of Prime Minister and

presently the Economic Advisor to the government of J & K has been appointed as the

Director of the Bank.-J & K Bank has informed that Mr D S Khandhari Director has ceased to be a directorto thebank on account of his resignation to the directorship.

-Jammu and Kashmir Bank has strengthened its bonds with Infosys by successfully

deploying Finacle Core Banking.-J & K bank has decided to launch Global Access Card ( an International Debit Card) in

association with Master Card International.

-Mr.J B Moria Mr J A Khan and Mr. A M Khusro were ceased to be the directors of thebank.

-Mr Sudhakar Kaza General Manager National Clearing Centre RBI was appointed as the

additional Director to the bank on the board.

2004-J&K Bank slashes PLR to 11-pc

-J&K Bank approves Rs 300-cr for Reliance Infocom

-Jammu and Kashmir Bank ties up with ICICI Bank to share the ATM network-Jammu & Kashmir bank has received the Asian Banking Award 2004 in Manila for its

customer convenience programme'.

-J&K Bank signs MoU with Bajaj Tempo

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-Jammu & Kashmir Bank Ltd has informed that the following persons were appointed asDirectors on the Board of the Bank at the Annual General Meeting of the Shareholders held

on June 12 2004: 1. Dr Haseeb A Drabu 2. Mr Umar Khurshid Tramboo 3. Mr Munir-ud-

din Shawl

-J & K Bank unveils international division in Srinagar-IDBI Bank ties up for Visa transactions with Jammu & Kashmir Bank to launch a

platform for the state's merchant establishment.

-JK Bank inks pact with Birla Power Solutions

2006

-Jammu & Kashmir Bank receives approval from RBI for increasing the FII's Holding.

2007

Jammu & Kashmir Bank Ltd has appointed Mr. M S Verma (Ex-Chairman State Bank of

India) and Mr. G P Gupta (Ex-Chairman & Managing Director IDBI) as Directors of the

Bank in the meeting of the Board of Directors held on June 09 2007.

2008

-Jammu & Kashmir Bank Ltd has appointed Mr. Ashok Kumar Mehta and Mr. AbdulMajid Mir Presidents as Executive Directors on the Board of Directors of the Bank w.e.f.

May 01 2008 pursuant to the approval accorded by the Reserve Bank of India vide theirletter dated April 30 2008.

- Jammu & Kashmir Bank Ltd has informed that Mr. B L Dogra was reappointed asDirector of the Bank at the 70th Annual General Meeting held on July 19 2008. Further the

Bank has informed that Mr. M S Verma (Ex-Chairman State Bank of India) and Mr. G P

Gupta (Ex-Chairman & Managing Director IDBI) were re-appointed as Directors of theBank in the meeting of the Board of Directors held on July 19 2008.

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BANK AT A GLANCE

Profile:-

Incorporated in 1938 as a limited liability company.

Governed by companies Act and Banking regulation Act of India.

Regulated by the Reserve bank of India and SEBI.

Listed on National Stock Exchange (NSE) and Bombay Stock exchange

(BSE).

53 per cent owned by the Govt. of J&K.

Rated p1+ by standard and poor-CRISIL connecting highest degree of

safety.

Four decades of uninterrupted profitability and dividends.

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Share Holding pattern (as on 31-03-2009)

S.NO Particulars as on 31-03-2009 Percentage of share

holding

1 Govt .of Jammu & Kashmir 53.17

2 Foreign institutional investors 27.79

3 Resident individual 14.32

4 Indian Mutual Funds 1.71

5 Insurance companies 1.27

6 Bodies corporate 1.26

7 Non resident Indians 0.40

8 Banks 0.03

9 Transit / clearing members 0.03

10 Trusts 0.02

Unique Characteristics & Services

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J&K Bank carries out banking business of the Central Government

Inspite of a government equity holding of 53 per cent, Jammu & Kashmir Bank

(J&K Bank) is regarded as a private sector bank

J&K Bank is the one and only banker and lender of last resort to the Government

of J&K

Plan and non-plan funds, taxes and non-tax revenues are routed through the J&K

Bank

J&K Bank claims the distinction of being the only private sector bank that has

been designated as agent of RBI for banking

The services of J&K Bank are utilized for the purposes of disbursing the salaries

of Government officials

J&K Bank collects taxes pertaining to Central Board of Direct Taxes, in Jammu &

Kashmir

Products & Services

Support Services

Anywhere Banking

Internet Banking

SMS Banking

ATM Services

Debit Cards

Credit Cards

Merchant Acquiring

Depository Services

Demat Account

Saving bank deposits

Term deposits

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Current accounts

Stock Broking

Loan Products And Services

Real Estate and Home Loans

Education loans

Automobile finance

Consumer loans for various purposes,

Consumption loans

Personal loans to pensioners

Mortgage loans for trade and service sectors

Loans against mortgage of immovable property

Specialized finance schemes and tax products and planning.

Third Party Services

Mutual Funds

Insurance Services - Life & Non Life

Remittance Services

Cash Management Services

Real Time Gross Settlement (RTGS)

National Electronic Fund Transfer (NEFT)

Infrastructure: Global Standards

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- The fastest growing bank with 550 branches across the country

- 98% of the business is computerized

- Anywhere Banking, Tele-Banking and SWIFT facilities available

- Internet Banking, SMS and Mobile Banking provided

- ATMs connected globally to all MasterCard networked ATMs

- Mobile ATM Service available first of its kind in Northern India

- J&K Bank Global Access Debit Cards: Cirrus and Maestro enabled

- Own credit card

- Live on RTGS System of RBI

Financial Services portfolio: One stop for all financial needs

- Insurance joint venture with MetLife international

- Life insurance products of MetLife (India) Pvt. Limited

- Non-life insurance products of Bajaj Allianz General Insurance Co. Limited

- Offering UTI and Kotak Mutual Funds

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- Providing Depository Services

- Offering Stock Broking services

- Collection agent for utility services provided by State and Private sector

New Business Initiatives: Shaping ourselves to serve better.

To meet the growing needs of the economy, in tune with the competitive

banking innovative financial products.

Monetizing the Banks branch network.

Third party products distribution.

Investment Banking.

Offshore Banking.

MANAGEMENT

Corporate Headquarter:

The Corporate Headquarter of the Bank is located at Srinagar and is headed by Chairman

and Chief Executive officer (CEO), who is appointed by the J&K Government for a period

of 3 to 5 years. Generally, the Chairman is selected among reputed Economists, Bankers

or/and the Administrators of the State. The Chairman is guided by the Board of Directorsof the Bank.

Board of Directors:

Currently there are 8 members on the Board of Directors of the Bank, excluding Chief

Executive Officer. The Board sits more than a dozen times in a year to review the business

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activities of the Bank. It also plans and regulates the future activities of the Bank through

policy decisions and administrative guidelines. All the important decisions of the Bank

have to be endorsed by the Board of Directors before their implementation.

NAME OF THE BOARD OF DIRECTORS:

1.Haseeb A Drabu Chairman & CEO

2. M S Verma Director

3. G P Gupta Director

4. B B Vyas,IAS Director

5. Ashok Kumar Mehta Executive Director

6. Abdul Majid Mir Executive Director

7. B L Dogra Director

Corporate Management:

The Management of the Bank consists of the following three categories:

- Senior Management

- Middle Management

- Junior Management.

At the top of management, there is Chairman and Chief Executive Officer, who is followed

by two Executive Directors and five Presidents.

The Presidents are followed by 20 Vice Presidents, who in turn are followed by the Senior

Executive Managers. The Senior Executive Managers are assisted by the Executive

Managers.

In the Middle Management, there are Senior Executives and Executives and in the Junior

Management there are Associate Executives.

AWARDS AND ACCOLADES

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In recognition of its excellent customer service, fair business practices, overall operational

efficiency, overall performance, etc the bank has been felicitated by the following awards

during the last few years:

- Asian Banking Awards 2004

- No. 1 Bank in India _ ET _ CMIE Survey 98-99

- The Best Bank - Rediff.com & PWC Survey

- Indias Fastest Growing Bank Business Standard

- Excellence Award Institute of Economic Studies

- Ranked as No. 1 on Safety Parameters Business Standard Survey

- Ranked as No. 2 on Profitability front _ Business Standard Survey

- Jamnalal Bajaj Uchit Vyavahar Puraskar 2002 Council for Fair Business Practices

dated 26th March 2003.

- Best Private Sector Bank Award- Financial Express, Presented by Dr. Bimal Jalan,

Governor, Reserve Bank of India on 4th April 2003.

- Best Universal Bank Award - Financial Express, Presented by Dr. Bimal Jalan,

Governor, Reserve Bank of India on 4th April 2003

- Ranked 87th

among Indias Top 500 Companies by worlds renowned rating

agency DUN & BRADSTREET

- Asian Banking Award 2004 for the Customer Convenience programme.

CORPORATE ADDRESS

The Jammu and Kashmir Bank Limited Profile:-

Founded. . 1938

Headquarters Srinagar, India

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Number of locations> 577 branches/offices Atm = 300

Area served . Mostly J & K

Industry Financial, Commercial banks

Revenue 20,595,000,000 (2007)

Employees 7267

Website http://www.jkbank.net

Phone:............................................. (+91-0194) -2481930-2481935

INTRODUCTION

Financial Management is that managerial activity which is concerned with the planning and

controlling of the firms financial resources.

Financial management focuses on finance manager performing various tasks as

Budgeting, Financial Forecasting, Cash Management, Credit Administration,

Investment Analysis, Funds Management, etc. which help in the process of decision

making.

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The management of fixed and current assets, however, differs in three important

ways: Firstly, in managing fixed assets, time is very important; consequently discounting

and compounding aspects of time element play an important role in capital budgeting and a

minor one in the management of current assets. Secondly, the large holdings of current

assets, especially cash, strengthen firms liquidity position but it also reduces its overall

profitability. Thirdly, the level of fixed as well as current assets depends upon the expected

sales, but it is only the current assets, which can be adjusted with sales fluctuation in the

short run. Here, we will be focusing mainly on management of current assets and current

liabilities.

Management of current assets needs to seek an answer to the following question:

1. Why should you invest in current assets?

2. How much should be invested in each type of current assets?

3. What should be the proportion of short term and long-term funds to finance

the current assets?

4. What sources of funds should be used to finance current assets?


Working Capital Management is the process ofplanning and controlling the level

and mix of current assets of the firm as well as financing these assets. Specifically,

Working Capital Management requires financial managers to decide what quantities of

cash, other liquid assets, accounts receivables and inventories the firm will hold at any

point of time.

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Working capital is the capital you require for the working i.e. functioning of your business

in the short run.

CONCEPT OF WORKING CAPITAL

There are two concepts of working capital:

(1)Gross Working Capital

(2)Net Working Capital

1.Gross working capital

It refers to the firms investment in the current assets and includes cash, short term

securities, debtors, bills receivables and inventories.

It is necessary to concentrate on the fact that the investment in the current assets should be

neither excessive nor inadequate.

WC requirement of a firm keeps changing with the change in the business activity and

hence the firm must be in a position to strike a balance between them. The financial

manager should know where to source the funds from, in case the need arise and where to

invest in case of excess funds.

2.Net working capital

It refers to the difference between the current assets and the current liabilities. Currentliabilities are those claims of outsiders, which are expected to mature for payment within

an accounting year and include creditors, bills payable, bank overdraft and outstanding

expenses.

When current assets exceed current liabilities it is called Positive WC and when current

liabilities exceed current assets it is called Negative WC.

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The Net WC being the difference between the current assets and current liabilities is a

qualitative concept. It indicates:

The liquidity position of the firm

Suggests the extent to which the WC needs may be financed by permanent

sources of funds

It is a normal practice to maintain a current ratio of 2:1. Also, the quality of current assets

is to be considered while determining the current ratio. On the other hand a weak liquidity

position poses a threat to the solvency of the company and implies that it is unsafe and

unsound. The Net WC concept also covers the question of judicious mix of long term andshort-term funds for financing the current assets.

NEED FOR WORKING CAPITAL

The basic objective of financial management is to maximize

shareholders wealth. This is possible only when the company earns sufficient profit. The

amount of such profit largely depends upon the magnitude of sales.

However, sales do not convert into cash instantaneously. There is always time gap between

the sale of goods and receipt of cash.

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Working capital is required for this period in order to sustain the sales activity.

TYPES OF WORKING CAPITAL

Working Capital can be divided into two categories on the basis of time: -

1. Permanent working capital

2. Temporary or Variable working capital

1. PERMANENT WORKING CAPITAL:-

This refers to that minimum amount of investment in all current assets which is

required at all times to carry out minimum level of business activities. It represents the

current assets required on a continuing basis over the entire year.

Tandon committee has referred to this type of working capital as core current assets.

The following are the characteristics of this type of working capital:-

1. Amount of permanent working capital remains in the business in one form or

another. This is particularly important from the point of view of financing. The

suppliers of such working capital should not expect its return during the lifetime of

the firm.

2. It also grows with the size of the business.

Permanent working capital is permanently needed for the business and therefore it should

be financed out of long-term funds.

This is the reason why the current ratio has to be substantially more than 1.

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2.TEMPORARY OR VARIABLE WORKING CAPITAL:-

The amount of such working capital keeps on fluctuating from time to time on the

basis of business activities.

In other words, it represents additional current assets required at different times during the

operating year.

Temporary

Amount of working permanent

Capital (Rs.)

Time

Temporary

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Amount of working permanent

Capital (Rs.)

Time

FACTORS INFLUENCING THE WORKING CAPITAL REQUIREMENT

All firms do not have the same WC needs .The following are the factors that affect the WC

needs:

1. Nature and size of business: The WC requirement of a firm is closely related

to the nature of the business. We can say that trading and financial firms have

very less investment in fixed assets but require a large sum of money to be

invested in WC. On the other hand Retail stores, for example, have to carry

large stock of variety of goods little investment in the fixed assets.

Also a firm with a large scale of operations will obviously require more WC

than the smaller firm.

The following table shows the relative proportion of investment in current assets and

fixed assets for certain industries:

Current

assets

(%)

Fixed assets

(%)

Industries

10-20 80-90 Hotel and restaurants

20-30 70-80 Electricity generation and Distribution

30-40 60-70 Aluminum, Shipping

40-50 50-60 Iron and Steel, basic industrial chemical

50-60 40-30 Tea plantation

60-70 30-40 Cotton textiles and Sugar

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70-80 20-30 Edible oils, Tobacco

80-90 10-20 Trading, Construction

2. Manufacturing cycle: It starts with the purchase and use of raw materials andcompletes with the production of finished goods. Longer the manufacturing

cycle larger will be the WC requirement; this is seen mostly in the industrial

products.

3. Business fluctuation: When there is an upward swing in the economy, sales

will increase also the firms investment in inventories and book debts will also

increase, thus it will increase the WC requirement of the firm and vice-versa.

4. Production policy: To maintain an efficient level of production the firms may

resort to normal production even during the slack season. This will lead to

excess production and hence the funds will be blocked in form of inventories

for a long time, hence provisions should be made accordingly. Since the cost

and risk of maintaining a constant production is high during the slack season

some firms may resort to producing various products to solve their capital

problems. If they do not, then they require high WC.

5. Firms Credit Policy: If the firm has a liberal credit policy its funds will

remain blocked for a long time in form of debtors and vice-versa. Normally

industrial goods manufacturing will have a liberal credit policy, whereas dealers

of consumer goods will a tight credit policy.

6. Availability of Credit: If the firm gets credit on liberal terms it will require less

WC since it can always pay its creditors later and vice-versa.

7. Growth and Expansion Activities: It is difficult precisely to determine the

relationship between volume of sales and need for WC. The need for WC does

not follow the growth but precedes it. Hence, if the firm is planning to increase

its business activities, it needs to plan its WC requirements during the growth

period.

8. Conditions of Supply of Raw Material: If the supply of RM is scarce the firm

may need to stock it in advance and hence need more WC and vice-versa.

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9. Profit Margin and Profit Appropriation: A high net profit margin contributes

towards the WC pool. Also, tax liability is unavoidable and hence provision for

its payment must be made in the WC plan, otherwise it may impose a strain on

the WC.

Also if the firms policy is to retain the profits it will increase their WC, and if

they decide to pay their dividends it will weaken their WC position, as the cash will flow

out. However this can be avoided by declaring bonus shares out of past profits. This will

help the firm to maintain a good image and also not part with the money immediately, thus

not affecting the WC position.

Depreciation policy of the firm, through its effect on tax liability and

retained earning, has an influence on the WC. The firm may charge a high rate of

depreciation, which will reduce the tax payable and also retain more cash, as the cash does

not flow out. If the dividend policy is linked with net profits, the firm can pay fewer

dividends by providing more depreciation. Thus depreciation is an indirect way of retaining

profits and preserving the firms WC position.

OPERATING CYCLE AND CASH CYCLE

All business firms aim at maximizing the wealth of the shareholder for which they

need to earn sufficient return on their operations. To earn sufficient profits they need to do

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enough sales, which further necessitates investment in current assets like raw materiel etc.

There is always an operating cycle involved in the conversion of sales into cash.

The duration of time required to complete the following sequences of events in case of a

manufacturing firm is called the operating cycle:-

1. Conversion of cash into raw material

2. Conversion of raw material into WIP

3. Conversion of WIP into FG

4. Conversion of FG into debtors and bills receivable through sales

5. Conversion of debtors and bills receivable into cash

Each component of working capital namely inventory, receivables and payables has

two dimensions time and money. When it comes to managing working capital - Time Is

Money. Therefore, if cash is tight, consider other ways of financing capital investment -

loans, equity, leasing etc. Similarly, if you pay dividends or increase drawings, these are

cash outflows remove liquidity from the business.

If YOU Then ......

Collect receivables (debtors) faster You release cash from the cycle

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Collect receivables (debtors) slower Your receivables soak up cash

Get better credit from suppliers You increase your cash resources

Shift inventory (stocks) faster You free up cash

Move inventory (stocks) slower You consume more cash

OPERATING CYCLE

Operating Cycle Of Non Manufacturing Firms / Operating Cycle Of

Service And Financial Firms

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Cash

Raw materials

Accounts Receivable

Finished goods

WIP


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Operating cycle of non-manufacturing firm like the wholesaler and retail includes

conversion of cash into stock of finished goods, stock of finished goods into debtors and

debtors into cash. Also the operating cycle of financial and service firms involves

conversion of cash into debtors and debtors into cash.

Thus we can say that the time that elapses between the purchase of raw material and

collection of cash for sales is called operating cycle whereas time length between the

payment for raw material purchases and the collection of cash for sales is referred to

as cash cycle.

The operating cycle is the sum of the inventory period and the accounts receivables period,

whereas the cash cycle is equal to the operating cycle less the accounts payable period.

33

DEBTORS

CASH

STOCK OF

FINISHEDGOODS

DEBTORSCASH

ORDER PLACED

STOCK ARRIVES

INV. PERIOD

CASH RECD.

A/CS REC. PERIOD


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Cash cycle

REASONS FOR ADEQUATE WORKING CAPITAL

A firm must have adequate working capital, i.e., as much as needed by the firm.

It should neither have excessive nor inadequate. Both situations are dangerous.

Excessive working capital means the firm has idle funds, which earn no profit for the firm.

Inadequate working capital means the firm does not have sufficient funds for running its

operations, which ultimately results in production interruptions, and lowering down the

profitability.

It will be interesting to understand the relation between working capital, risk and

return. In a manufacturing concern, it is generally accepted that higher levels of working

capital decrease the risk and decrease the profitability too.

34

CASH Pd. FOR MATERIALS

OPERATING CYCLE

FIRM REC. INVOICE

A/CS Pay.Period

CASH CYCLE


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While lower levels of working capital increase the risk but have the potentiality of

increasing the profitability also.

This principle is based on the following assumptions: -

(i) There is direct relationship between risk and profitability --- higher is the risk, higher is

the profitability, while lower is the risk, lower is the profitability.

(ii) Current assets are less profitable than fixed assets.

(iii) Short-term funds are less expensive than long-term funds.

MANAGEMENT OF WORKING CAPITAL

Working capital Management refers to all aspects of the administration of both

current assets and current liabilities.

In other words, working capital management is concerned with the problems that arise in

attempting to manage the current assets, the current liabilities and the interrelationships that

exist between them.

Moreover, different components of working capital are to be properly balanced in

such a way that during one complete production or trade cycle the cash should be available

for purchase of fresh material and for running the business including operating expenses,

after realization of sale proceeds of earlier cycle without any hurdles.

In the absence of such situation, the financial position in respect of the firms liquidity

may not be satisfactory in spite of satisfactory liquidity ratio.

Working capital management policy have a great effect on firms profitability, liquidity

and its structural health.

A finance manager should therefore, chalk out appropriate working capital

management policies in respect of each of the components of working capital so as to

ensure higher profitability, proper liquidity and sound structural health of the organization.

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In order to achieve this objective the finance manager has to perform basically

following two functions: -

1) Estimating the amount of working capital.

2) Sources from which these funds have to be raised.

ESTIMATING WORKING CAPITAL REQUIREMENTS

In order to determine the amount of working capital needed by a firm, a number of

factors viz. production policies, nature of business, length of manufacturing process,

rapidity of turnover, seasonal fluctuations, etc. are to be considered by the finance

manager.

TECHNIQUES FOR ASSESSMENT OF WORKING CAPITAL

REQUIREMENTS

1. ESTIMATION OF COMPONENTS OF WORKING CAPITAL METHOD: -

Since working capital is the excess of current assets over current liabilities, an

assessment of the working capital requirements can be made by estimating the amounts of

different constituents of working capital e.g., inventories, accounts receivable, cash,

accounts payable, etc.

2. PERCENT OF SALES APPROACH:-

This is a traditional and simple method of estimating working capital requirements.

According to this method, on the basis of past experience between sales and

working capital requirements, a ratio can be determined for estimating the working capital

requirements in future.

3. OPERATING CYCLE APPROACH: -

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According to this approach, the requirements of working capital depend upon the

operating cycle of the business.

The operating cycle begins with the acquisition of raw materials and ends with

the collection of receivables

It may be broadly classified into the following four stages viz.

1. Raw materials and stores storage stage.

2. Work-in-progress stage.

3. Finished goods inventory stage.

4. Receivables collection stage.

The duration of the operating cycle for the purpose of estimating working

capital requirements is equivalent to the sum of the durations of each of these stages less

the credit period allowed by the suppliers of the firm.

Symbolically the duration of the working capital cycle can be put as follows:

O=R+W+F+D-C

Where,

O=Duration of operating cycle;

R=Raw materials and stores storage period;

W=Work-in-progress period;

F=Finished stock storage period;

D=Debtors collection period;

C=Creditors payment period.

Each of the components of the operating cycle can be calculated as follows:-

R= Average stock of raw materials and stores

Average raw materials and stores consumptions per day

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According to this approach, the maturity of source of funds should match the nature

of assets to be financed.

The approach is, therefore, termed as Matching approach.

It divides requirements of total working capital funds into two categories.

a) Permanent working capital, i.e., funds required for purchase of core current

assets. Such funds do not vary over time.

b) Temporary or seasonal working capital, i.e., funds which fluctuate over time.

The permanent working capital requirements should be financed by long-term

funds while the seasonal working capital requirements should be financed out of

short-term funds.

(ii) THE CONSERVATIVE APPROACH: -

According to this approach all requirements of funds should be met from long-term

sources.

The short-term sources should be used only for emergency requirements.

The conservative approach is less risky, but more costly as compared to the hedging

approach.

In other words conservative approach is low profit-low risk (or high cost, high

net working capital) while hedging approach results in high profit-high risk (or low cost,

low net working capital).

(iii) TRADE-OFF BETWEEN HEDGING AND CONSERVATIVE APPROACH: -

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The hedging and conservative approaches are both on two extremes.

Neither of them can therefore help in efficient working capital management. A trade-off

between these two can give satisfactory results. The level of such trade-off will differ from

case to case depending upon perception of the risk by the persons involved in financial

decision-making. However, one way of determining the level of trade-off is by finding the

average of the minimum and the maximum requirements of working capital during a

period. The average working capital so obtained may be financed by long-term funds and

the balance by short-term funds.

MANAGEMENT OF DIFFERENT COMPONENTS OF

WORKING CAPITAL

Working capital management involves management of different components of

working capital such as cash, inventories, accounts receivable, creditors, etc

MANAGEMENT OF CASH

It is the duty of the finance manager to provide adequate cash to all segments of the

organization. He also has to ensure that no funds are blocked in idle cash since this will

involve cost in terms of interest to the business. A sound cash management scheme,

therefore, maintains the balance between the twin objectives of liquidity and cost.

Meaning of cash

The term cash with reference to cash management is used in two senses. In a

narrower sense it includes coins, currency notes, cheques, bank drafts held by a firm with it

and the demand deposits held by it in banks.

In a broader sense it also includes near-cash assets such as, marketable securities and

time deposits with banks. Such securities or deposits can immediately be sold or converted

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into cash if the circumstances require. The term cash management is generally used for

management of both cash and near-cash assets.

Motives for holding cash

A distinguishing feature of cash as an asset, irrespective of the firm in which it is

held, is that it does not earn any substantial return for the business. In spite of this fact cash

is held by the firm with following motives.

1. Transaction motive

A firm enters into a variety of business transactions resulting in both inflows and

outflows. In order to meet the business obligation in such a situation, it is necessary to

maintain adequate cash balance. Thus, cash balance is kept by the firms with the motive of

meeting routine business payments.

2.Precautionary motive

A firm keeps cash balance to meet unexpected cash needs arising out of unexpected

contingencies such as floods, strikes, presentment of bills for payment earlier than the

expected date, unexpected slowing down of collection of accounts receivable, sharp

increase in prices of raw materials, etc. The more is the possibility of such contingencies

more is the cash kept by the firm for meeting them.

3.Speculative motive

A firm also keeps cash balance to take advantage of unexpected opportunities,

typically outside the normal course of the business. Such motive is, therefore, of purely aspeculative nature.

4.Compensation motive

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Banks provide certain services to their clients free of charge. They, therefore,

usually require clients to keep a minimum cash balance with them, which help them to earn

interest and thus compensate them for the free services so provided.

Business firms normally do not enter into speculative activities and, therefore, out of

the four motives of holding cash balances, the two most important motives are the

compensation motive.

Objectives of cash management

There are two basic objectives of cash management:

1. To meet the cash disbursement needs as per the payment schedule;

2. To minimize the amount locked up as cash balances.

1.Meeting cash disbursements

The first basic objective of cash management is to meet the payments Schedule. In

other words, the firm should have sufficient cash to meet the various requirements of the

firm at different periods of times. The business has to make payment for purchase of raw

materials, wages, taxes, purchases of plant, etc. The business activity may come to a

grinding halt if the payment schedule is not maintained. Cash has, therefore, been aptly

described as the oil to lubricate the ever-turning wheels of the business, without it the

process grinds to a stop.

2.minimizing funds locked up as cash balances

The second basic objective of cash management is to minimize the amount locked

up as cash balances. In the process of minimizing the cash balances, the finance manager is

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confronted with two conflicting aspects. A higher cash balance ensures proper payment

with all its advantages. But this will result in a large balance of cash remaining idle. Low

level of cash balance may result in failure of the firm to meet the payment schedule.

The finance manager should, therefore, try to have an optimum amount of cash

balance keeping the above facts in view.

MANAGEMENT OF INVENTORIES

Inventories are good held for eventual sale by a firm. Inventories are thus one of the

major elements, which help the firm in obtaining the desired level of sales.

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Kinds of inventories

Inventories can be classified into three categories.

(i) Raw materials:

These are goods, which have not yet been committed to production in a

manufacturing firm. They may consist of basic raw materials or finished components.

(ii) Work-in-progress:

This includes those materials, which have been committed to production process

but have not yet been completed.

(iii) Finished goods:

These are completed products awaiting sale. They are the final output of the

production process in a manufacturing firm. In case of wholesalers and retailers, they are

generally referred to as merchandise inventory.

The levels of the above three kinds of inventories differ depending upon the nature of thebusiness.

Benefits of holding inventories

Holding of inventories helps a firm in separating the process of purchasing,

producing and selling. In case a firm does not hold sufficient stock of raw materials,

finished goods, etc., the purchasing would take place only when the firm receives the order

from a customer. It may result in delay in executing the order because of difficulties in

obtaining/ procuring raw materials, finished goods, etc. thus inventories provide cushion so

that the purchasing, production and sales functions can proceed at optimum speed.

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

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(i) Avoiding losses of sales

If a firm maintains adequate inventories it can avoid losses on account of losing the

customers for non-supply of goods in time.

(ii) Reducing ordering cost

The variable cost associated with individual orders, e.g., typing, checking,

approving and mailing the order, etc., can be reduced if a firm places a few large orders

than numerous small orders.

(iii) Achieving efficient production runs

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

Risks and costs associated with inventories

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

(i) Price decline

This may be due to increase in the market supply of the product, introduction of a

new competitive product, price cutting by the competitors, etc.

(ii) Product deterioration

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

conditions.

(iii) Obsolescence

This may be due to change in customers taste, new production technique,

improvements in the product design, specifications, etc.

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The costs of holding inventories are as follows:

(i) Materials cost

This includes the cost of purchasing the goods, transportation and handling charges

less any discount allowed by the supplier of the goods.

(ii) Ordering cost

This includes the variable cost associated with placing an order for the goods. The

fewer the orders, the lower will be the ordering costs for the firm.

(iii) Carrying cost

This includes the expenses for storing the goods. It comprises storage costs,

insurance costs, spoilage costs, cost of funds tied up in inventories, etc.

Management of inventory

Inventories often constitute a major element of the total working capital and hence

it has been correctly observed, good inventory management is good financialmanagement.

Inventory management covers a large number of issues including fixation of

minimum and maximum levels; determining the size of the inventory to be carried ;

deciding about the issue price policy; setting up receipt and inspection procedure;

determining the economic order quantity; providing proper storage facilities, keeping check

on obsolescence and setting up effective information system with regard to the inventories.

However, management inventories involves two basic problems:

(i) Maintaining a sufficiently large size of inventory for efficient and

smooth production and sales operations;

(ii) Maintaining a minimum investment in inventories to minimize the

direct-indirect costs associated with holding inventories to maximize

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the profitability. Inventories should neither be excessive nor

inadequate. If inventories are kept at a high level, higher interest and

storage costs would be incurred. On the other hand, a low level of

inventories may result in frequent interruption in the production

schedule resulting in underutilization of capacity and lower sales.

The objective of inventory management is, therefore, to determine and

maintain the optimum level of investment in inventories, which help in achieving the

following objectives:

(i) Ensuring a continuous supply of materials to production department

facilitating uninterrupted production.

(ii) Maintaining sufficient stock of raw material in periods of short

supply.

(iii) Maintaining sufficient stock of finished goods for smooth sales

operations.

(iv) Minimizing the carrying costs.

(v) Keeping investment in inventories at the optimum level.

MANAGEMENT OF ACCOUNTS RECEIVABLES

Accounts receivables (also properly termed as receivables) constitute a significant portion

of the total currents assets of the business next after inventories. They are a direct

consequences of trade credit which has become an essential marketing tool in modern

business.

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When a firm sells goods for cash, payments are received immediately and,

therefore, no receivables are credited. However, when a firm sells goods or services on

credit, the payments are postponed to future dates and receivables are created. Usually, the

credit sales are made on open account, which means that, no, formal acknowledgements of

debt obligations are taken from the buyers. The only documents evidencing the same are a

purchase order, shipping invoice or even a billing statement. The policy of open account

sales facilities business transactions and reduces to a great extent the paper work required

in connection with credit sales.

Meaning of receivables

Receivables are assets accounts representing amounts owed to the firm as a result

of sale of goods / services in the ordinary course of business.

They, therefore, represent the claims of a firm against its customers and are carried

to the assets side of the balance sheet under titles such as accounts receivables, customer

receivables or book debts. They are, as stated earlier, the result of extension of credit

facility to then customers a reasonable period of time in which they can pay for the goods

purchased by them.

Purpose of receivables

Accounts receivables are created because of credited sales. Hence the purpose of

receivables is directly connected with the objectives of making credited sales.

The objectives of credited sales are as follows:

(i) Achieving growth in sales:

If a firm sells goods on credit, it will generally be in a position to sell more goods

than if it insisted on immediate cash payments. This is because many customers are either

not prepared or not in a position to pay cash when they purchase the goods. The firm can

sell goods to such customers, in case it resorts to credit sales.

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(ii) Increasing profits:

Increase in sales results in higher profits for the firm not only because of increase in

the volume of sales but also because of the firm charging a higher margin of profit on

credit sales as compared to cash sales.

(iii) Meeting competition:

A firm may have to resort to granting of credit facilities to its customers because of

similar facilities being granted by the competing firms to avoid the loss of sales from

customers who would buy elsewhere if they did not receive the expected output.

The overall objective of committing funds to accounts receivables is to generate a

large flow of operating revenue and hence profit than what would be achieved in the

absence of no such commitment.

Costs of maintaining receivables

The costs with respect to maintenance of receivables can be identified as follows:

1. Capital costs:

Maintenance of accounts receivables results in blocking of the firms financial

resources in them. This is because there is a time lag between the sale of goods to

customers and the payments by them. The firm has, therefore, to arrange for additional

funds top meet its own obligations, such as payment to employees, suppliers of raw

materials, etc., while awaiting for payments from its customers. Additional funds may

either be raised from outside or out of profits retained in the business. In both the cases, the

firm incurs a cost. In the former case, the firm has to pay interest to the outsider while in

the latter case, there is an opportunity cost to the firm, i.e., the money which the firm couldhave earned otherwise by investing the funds elsewhere.

2. Administrative costs:

The firm has to incur additional administrative costs for maintaining accounts

receivable in the form of salaries to the staff kept for maintaining accounting records

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relating to customers, cost of conducting investigation regarding potential credit customers

to determine their creditworthiness, etc.

3. Collection costs:

The firm has to incur costs for collecting the payments from its credit customers.

Sometimes, additional steps may have to be taken to recover money from defaulting

customers.

4. Defaulting costs:

Sometimes after making all serious efforts to collect money from defaultingcustomers, the firm may not be able to recover the over dues because of the of the inability

of the customers. Such debts are treated as bad debts and have to be written off since they

cannot be realized.

Factors affecting the size of receivables

The size of the receivable is determined by a number of factors.

Some of the important factors are as follows:

(1) Level of sales:

This is the most important factor in determining the size of accounts receivable.

Generally in the same industry, a firm having a large volume of sales will be having a

larger level of receivables as compared to a firm with a small volume of sales.

Sales level can also be used for forecasting change in accounts receivable.

(2) Credited policies:

The term credit policy refers to those decision variables that influence the amount

of trade credit, i.e., the investment in receivables. These variables include the quantity of

trade accounts to be accepted, the length of the credit period to be extended, the cash

discount to be given and any special terms to be offered depending upon particular

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circumstances of the firm and the customer. A firms credit policy, as a matter of fact,

determines the amount of risk the firm is willing to undertake in its sales activities. If a firm

has a lenient or a relatively liberal credit policy, it will experience a higher level of

receivables as compared to a firm with a more rigid or stringent credit policy.

This is because of two reasons:

(i) A lenient credit policy encourages even the financially strong

customers to make delays in payments resulting in increasing

the size of the accounts receivables;

(ii) Lenient credit policy will result in greater defaults in payments

by financially weak customers thus resulting in increasing thesize of receivables.

(3) Terms of trade:

The size of the receivables is also affected by terms of trade (or credit terms)

offered by the firm.

The two important components of the credit terms are:

(i) Credit period;

(ii) Cash discount.

(i) Credit period:

The term credit period refers to the time duration for which credit is extended to the

customers. It is generally expressed in terms of net days.

For example,

If a firms credit terms are net 15, it means the customers are expected to pay

within 15 days from the date of credit sale.

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(ii) Cash discount:

Most firms offer cash discount to their customers for encouraging them to pay their

dues before the expiry of the credit period. The terms of the cash discounts indicate the rate

of discount as well as the period for which the discount has been offered.

MANAGEMENT OF ACCOUNTS PAYABLE

Management of accounts payable is as much important as management of accounts

receivable. There is a basic difference between the approach to be adopted by the finance

manager in the two cases. Whereas the underlying objective in case of accounts receivable

is to maximize the acceleration of the collection process, the objective in case of accounts

payable is to slow down the payments process as much as possible. But it should be noted

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that the delay in payment of accounts payable may result in saving of some interest costs

but it can prove very costly to the firm in the form of loss credit in the market.

The finance manager has, therefore, to ensure that the payments after obtaining the

best credit terms possible.

OVERTRADING AND UNDERTRADING

The concepts of overtrading and undertrading are intimately connected with the net

working capable position of the business. To be more precise they are connected with the

cash position of the business.

OVERTRADING:

Overtrading means an attempt to maintain or expand scale of operations of the

business with insufficient cash resources. Normally, concerns having overtrading have a

high turnover ratio and a low current ratio. In a situation like this, the company is not in a

position to maintain proper stocks of materials, finished goods, etc., and has to depend on

the mercy of the suppliers to supply them goods at the right time. It may also not be able to

extend credit to its customers, besides making delay in payment to the creditors.

Overtrading has been amply described as overblowing the balloon. This may, therefore,

prove to be dangerous to the business since disproportionate increase in the operations of

the business without adequate resources may bring its sudden collapse.

CAUSES OF OVERTRADING

The following may be the causes of over-trading:

(i) Depletion of working capital:

Depletion of working capital ultimately results in depletion of cash resources. Cash

resources of the company may get depleted by premature repayment of long-term loans,

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excessive drawings, dividend payments, purchase of fixed assets and excessive net trading

losses, etc.

(ii) Faulty financial policy:

Faulty financial policy can result in shortage of cash and overtrading in several

ways:

(a) Using working capital for purchase of fixed assets.

(b) Attempting to expand the volume of the business without raising the necessary

resources, etc.

(iii) Over-expansion:

In national emergencies like war, natural calamities, etc., a firm may be required to

produce goods on a larger scale. Government may pressurize the manufacturers to increase

the volume of production without providing for adequate finances. Such pressure results in

over-expansion of the business ignoring the elementary rules of sound finance.

(iv) Inflation and rising prices:

Inflation and rising prices make renewals and replacements of assets costlier. The

wages and material costs also rise. The manufacturer, therefore, needs more money even to

maintain the existing level of activity.

(v) Excessive taxation:

Heavy taxes result in depletion of cash resources at a scale higher than what isjustified.

The cash position is further strained on account of efforts of the company to

maintain reasonable dividend rates for their shareholders.

CONSEQUENCES OF OVERTRADING

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The consequences of over-trading can be summarized as follows:

(i) Difficulty in paying wages and taxes:

This is one of the most dangerous consequences of overtrading. Non-payments of

wages in time create a feeling of uncertainty, insecurity and dissatisfaction in all ranks of

the labour. Non-payments of taxes in time may result in bringing down the reputation of

the company considerably in the business and government circles.

(ii) Costly purchases:

The company has to pay more for its purchases on account of its inability to have

proper bargaining, bulk buying and selecting proper source of supplying quality materials.

(iii) Reduction in sales:

The company may have to suffer in terms of sales because the pressure for cash

requirements may force it to offer liberal cash discounts to debtors for prompt payments, as

well as selling goods at throwaway prices.

(iv) Difficulties in making payments:

The shortage of cash will force the company to persuade its creditors to extend

credit facilities to it. Worry, anxiety and fear will be the managements constant

companions.

(v) Obsolete plant and machinery:

Shortage of cash will force the company to delay even the necessary repairs and

renewals. Inefficient working, unavoidable breakdowns will have an adverse effect both on

volume of production and rate of profit.

Symptoms and remedies for overtrading

The situation of overtrading should be remedied at the earliest possible opportunity,

i.e., as soon as its first symptoms are visible.

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The symptoms can be put as follows:

(a) A higher increase in the amount of creditors as compared to debtors. This is

because of firms inability to pay its creditors in time and exercising of undue

pressure on debtors for payments;

(b) Increased bank borrowing with corresponding increase in inventories;

(c) Purchase of fixed assets out of short-term funds;

(d) A fall in the working capital turnover (working capital/sales) ratio.

(e) A low current ratio and high turnover ratio.

The cure for overtrading is easier to prescribe but difficult to follow. The cure is simple-

reduce the business or increase finance. Both are difficult. However, arrangement of more

finance is better. If this is not possible, the only advisable course left will be to sell the

business as a going concern.

UNDERTRADING:

It is the reverse of overtrading. It means improper and underutilization of funds

lying at the disposal of the undertaking. In such a situation the level of trading is low as

compared to the capital employed in the business. It results in increase in the size of

inventories, book debts and cash balances. Undertrading is a matter of fact an aspect of

overcapitalization. The basic cause of undertrading is, therefore, underutilization of the

firms resources. Such underutilization may be due any one or more of the following

causes:

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undertaking new profitable jobs, projects, etc., resulting in a better and efficient utilization

of the firms resources.

SOURCES OF WORKING CAPITAL

The working capital requirements should be met both from short-term as well long-term

sources of funds. Sources of long term financing are shares, debentures, preference share,

retained earnings and debt from financial institution, sources of short term finance include

bank loans, commercial papers and factoring receivables Its will be appropriate to meet at

least 2/3rd (if not the whole) of the permanent working capital requirements from long-term

sources and only for the period needed.

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The financing of working capital through short-term sources of funds has the

benefits of lower cost and establishing close relationship with the banks.

Financing of working capital from long-term resources provides the following

benefits:

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

(ii) It increases liquidity since the firm has not to worry about the payment of these

funds in the near future.

SHORT TERM SOURCES OF FINANCE

Two most important sources of working capital finance are trade credit and bank credit.

Over the period of years the amount of trade credit has gone up significantly, at the same

time obtaining the trade credit from banks for large-scale industries has become

increasingly difficult. A combination of short and long term finances is used to finance to

working capital requirements. Current assets are normally financed by the short-term

sources, which include the following:

Accruals: This includes what the firm owes to the employees. Its main

components are wages and taxes. Since they are payable at a future date, they have been

accrued but not shown as paid in the balance sheet. Till that time they serve as source of

finance. They are a source of spontaneous financing. Since the firm pays no interest, they

are regarded as a free source of finance.

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Trade Credit: It is a spontaneous source of financing, which constitutes 25 to 50

% of short term financing. Obtaining trade credit depends on:

Earnings record over a period of time

Liquidity position of a firm over a period of time

Record of payment.

Cost of Trade Credit: If the supplier offers discount for prompt payment, there is a

cost associated with trade credit availed beyond the discount period. If the terms of

payment are say 2/10, net 30, then the cost of credit during the discount period is nil,

whereas the cost during non-discount period is:

Discount % * 360

1 Discount % Credit Period - Discount Period

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In our case it would be: 0.02*360 = 36.7 %

(1-0.02) (30 10)

Cost of trade credit for various

credit terms is shown here

1) Unless the firm is hard

pressed financially it should

not forgo the discount for prompt payment

2) If the firm is unable to avail the discount, it should try to postpone the payment

up till the last date, to save on the interest part.

Forms Of Bank Finance: The banks give working capital advances in

the following ways:

Cash Credits / Overdrafts: Under this arrangement the borrower can

borrow upto a fixed limit and repay it as and when he desires. Interest is

charged only on the running balance and not on the sanctioned amount. A

minimal chare is payable for availing this facility.

Loans: They are either credited to the current account of the borrower or

given to him in cash. A fixed rate of interest is charged and the loan amount is

repayable on demand or in periodical installments.

Purchase/Discount of Bills: A bill may be discounted with the bank and

when it matures on a future date the bank collects the amount from the party

who had accepted the bill. When a bank is short of funds it can sell or

rediscount the bill on the other hand the bank with surplus funds would invest

in bills. However, with discount rates at 13-14 per cent for 90-day paper, bill

discounting is an expensive source of short-term funds.

CREDIT

TERMS

COST OF TRADE

CREDIT

1/10,net 20 36.4 %

2/10,net 45 21.0%

3/10,net 60 22.3%

2/15,net 45 24.5%

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Letter Of Credit: When an L/C is opened by the bank in favour of the

customer it takes the responsibility of honoring the obligation in case the

customer fails to do so. In this case though the customer provides the creditthe risk is borne by the bank. Hence we can say that it is an indirect form of

financing.

Some other sources of finance are explained below:

(1)Short-Term Loans from Financial Institutions: The LIC, GIC and UTI

provide short-term loans to manufacturing companies that have a good track

record. The following are the eligibility conditions if obtaining the loans:

Declared an annual dividend of 6 % for the past 5 years, in some cases it

is 10 % over last 3 years

The debt equity ratio should not exceed 2:1

The current ratio should be at least 1:1

The average of the interest cover ratios for the past three years should be

at least 2:1.

(2)Public Deposits: Unsecured deposits are taken from the public to finance the working

capital requirements. They are an important source of short and medium term finances. A

Co. can accept public deposits subject to the stipulations of RBI from time to time

maximum up to 35% of its paid up capital and reserves, from the public and shareholders.

These deposits may be accepted for a period of 6 months to 3 years.

Advantages

Method of financing is simple and easy as it does not require much

formality.

Cheaper method of raising short term finance.

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Does not require any security.

Disadvantages Only for Co.s enjoying good reputation in the market.

The public depositors may put pressure on the Co. to refund the deposits

if there is a rumour that Co. is not doing well.

Right Debentures for working capital: In order to get long term resources for

working capital, the public limited companies can issue rights debentures to their

shareholders. The key guidelines to be followed include:

The amount of debenture issue should not exceed 20 % of the gross

current assets, loans and advances minus the long term loans presently available for

financing working capital OR 20 % of paid up share capital, including preference

capital and free reserves, whichever is the lower of the two

The debt equity ratio including the proposed dividend issue should not

exceed 1:1

They shall be first offered to Indian resident shareholders of the

company on a pro rata basis.

REGULATION OF BANK FINANCE

The RBI issues guidelines to the banks in this respect. Recommendations of the

Tondon Committee and the Chore Committee have been incorporated in the guidelines.

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Tondon committee was appointed by the RBI in 1974 to suggest guidelines for the rational

allocation and the optimum use of the bank credit. The major weaknesses in the working

capital finance as pointed out by the Dehejia committee and again identified by the Tondon

committee are:

Borrower decides how much to borrow, hence the banker is in no position

to do any credit planning

Bank credit is treated as the first source of finance and not the

supplementary source

Credit given is based on security available and not on the basis of

operations of the borrower

Security given alone is not enough; safety lies in the efficient follow up of

the industrial operations of the borrower.

Recommendations of the Tondon Committee:

They are based on the following notions:

The borrower should indicate the likely demand for credit

The banker should finance only the genuine production needs

The banker will finance only the reasonable part of it; the borrower

himself will bring in the remaining part.

Inventory And Receivables Norms: Only the normal inventory, based on a production

plan, lead time of supplies, economic order levels and reasonable factor of safety, should

be financed by the banker. Flabby, profit making or excessive inventory should not be

permitted under any circumstances. Norms should be laid down to bring uniformity in

banks approach in assessing the working capital requirement.

The committee has suggested norms for fifteen industries. The norms were

applicable to all borrowing industries, including the small-scale industries, with aggregate

limits from the banking system in excess of Rs. 10 lacs. The norms laid down the

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maximum limit upto which credit could be granted. The central committee of direction,

constituted by the RBI has been empowered to make the on-going review of the bank.

Lending Norms: Most firms face problems of inadequate working capital due to credit

indiscipline (diversion of working capital to meet long term requirements or to acquire

other assets).The banker is required to finance only a part of the working capital gap. The

working capital gap is defined as current assets current liabilities excluding bank

borrowings.

The committee had suggested the following three methods for determining the

maximum permissible bank finance (MPBF):

In the first method the borrower will contribute 25 % of the working

capital gap; the remaining 75 % can be financed from bank borrowings. This method

will give a minimum current ratio of 1:1.

In the second method the borrower will constitute 75 % of the total

current assets. The remaining will be financed by the bank. MPBF = 0.75(CA) CL =

this method will give a current ratio of 1.3:1. In this case current liability including

MPBF will be 30+45 =75.Therefore the current ratio will be 100/75 = 1.33

In the third method the borrower will finance 100 percent of core assets

(permanent component of the working capital), as defined and 25 % of the balance of

the current assets. The remaining can be met from the bank borrowing 0.75 (CA

CCA) CL = 0.75(100-20) 30 = 30 (assuming that CCA is 20).

CA = current assets

CL = non bank current liabilities

CCA = core current assets.

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Style Of Credit: The committee has suggested a bifurcation of the total credit limit into

fixed and fluctuating parts. The fixed part will be treated as a demand loan for the

representing the minimum level of borrowing. The fluctuating part will be taken care of by

the demand cash credit. The cash credit part may be partly be used as bills.

The committee also suggested that interest rate on the loan component be charged

lower than that on cash credit. The RBI has stipulated the differential at 1 %.

Information System: Information is to be provided in three forms operating statement,

quarterly budget and funds flow statement. Borrowers with credit limit of more than Rs 1

crore are required to submit quarterly information. This information should be used to see

if the desired results have been achieved. A variance of about 10 % is considered to be

normal.

This report has helped in bringing a financial discipline through a balanced and

integrated scheme for bank lending.

Also the key components of the Chore Committee recommendations, which highly

influence the existing reporting system, are as follows:

Quarterly information system-form 1: It gives estimation of production and

sales for the current year and the ensuing quarter, and the estimates of current assets and

liabilities for the ensuing year.

Quarterly information system-form 2: This gives the actual production and

sales in the current year and for the latest completed year and the actual current assets

and liabilities for the latest completed year.

First method Second method

(a) Current assets Rs. 100 Rs. 100

(b)Current liabilities, excluding bank borrowings. 30 30

(c) Working capital gap (a-b) 70 70

(d) Borrowers contribution 17.5 (25 % of c) 25 (25 % of a)

(e) Permissible bank finance 52.5 45

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Half yearly operating statements- form 3: It gives the actual operating

performance for the half year ended.

Half yearly funds flow statement-form 3b: It gives the sources and uses of

funds for the half year ended.

Credit monitoring:Based on the recommendations of the Marathe Committee, the RBI

replaced its Credit Authorization Scheme by its Credit Monitoring Arrangement in 1988.

The issues examined are:

Whether the minimum current ratio is 1.33?

Whether the sales, production, etc estimates match with the actual? If not,

what are the reasons for deviations?

Are the information system requirements complied with?

Are the renewals of the limits in time?

Is the bank following the norms for inventory and receivables prescribed

by the RBI standing committee, if they are different, are they justified?

Financial information, specific industry analysis and financial models are used to determine

the credit worthiness of the borrower.

SMALL SCALE INDUSTRIES VIEW OF MANAGING

WORKING CAPITAL

As we all know that working capital management is more important to small firms

as compared to large firms because they may have little investment in fixed assts but high

investment in current assets. Here we will look at working capital management in the small

scale-manufacturing units and how it affects them.

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The small-scale sector has emerged as a dynamic and vibrant sector of the

Indian economy. The sector accounts for 40% of the industrial production, 35% of

the total exports. There are about 30 lacs Small Scale Industries in the country and

about 90% of employment in the country is in this sector.

We will now look at the management of working capital in SSIs. For the purpose

of this project the details about various SSIs are given below:

GIRNAR PACKAGING[Vapi (Gujarat)]

The main unit under the name of Girnar Packaging is situated at Vapi (Gujarat)

approximately 150Kms from Mumbai. It was started in 1980.

Sources of finance

The long-term finance, if required, is raised from commercial banks. The banks

provide loans to them to an extent of four times the money contributed by the partners.

The short-term finance is raised by hundis. The company makes purchases of raw materials

with a credit period of 30 days. Similarly, they sell the goods also at 30 days credit period.

The amount to be paid to the suppliers is normally paid after the credit period of 30 days.

Hence they efficiently manage their funds and reduce their WC requirements.

As soon as the goods are sold, they draw a bill on the customer and then discount the

bill with the bank for funds. Also, the customer and the company share the interest

charged equally. Thus this provides a good source of short-term finance.

Inventory, Receivables

Formerly, they used to keep inventory of four weeks. But now they are practicing JIT.

They now maintain a stock for only 3 days. The value of the 3-day inventory is around

Rs 20 lakhs. They have realized the importance of funds and hence are trying to avoid

blocking of too much money in the inventory and hence are resorting to modern

inventory management practices.

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Capacity utilization

The entire plant capacity is utilized, as Girnar gets enough orders. In fact, they receive

and accept 20 % more orders than their actual capacity. They do so to earn more profits

and because they expect a few cancellations or postponement of some orders that they

receive. If they cannot complete

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