WORKING CAPITAL MANAGEMENT & FINANCE

‘A Handbook for Bankers and Finance Managers’

WORKING CAPITAL MANAGEMENT & FINANCE

‘A Handbook for Bankers and Finance Managers’

R.K. GUPTAHIMANSHU GUPTA

Notion Press

5 Muthu Kalathy Street, Triplicane,

Chennai - 600 005

First Published by Notion Press 2015

Copyright © R.K. Gupta 2015

All Rights Reserved.

ISBN: 978-93-52060-35-1

This book has been published in good faith that the work of the author is original. All efforts have been taken to make the material error-free. However, the author and the publisher disclaim the responsibility.

No part of this book may be used, reproduced in any manner whatsoever without written permission from the author, except in the case of brief quotations embodied in critical articles and reviews.

This book is dedicated to my parents, late Shri Jaggi Mal and late Smt. Ramvati Devi (both were committed to educating their children). Their unconditional love, dedication, high moral values, ethics and their vision have always inspired and motivated me.

R.K. Gupta

foreword

I have known Prof. Ram Kumar Gupta since 2009, when I was working with ABES IT Group of Institutions; he had just recently retired and planned to share the wealth of his knowledge acquired during a banking career spanning 40 years. Besides his knowledge and experience he brought with him amazing energy, commitment, dedication, ability to connect with the students and ability to make complex financial and accounting concepts simple to understand, even for non commerce back ground students. He effortlessly lends all these assets to the book on ‘Working Capital Management and Finance’.

The book builds all the concepts from scratch in a lucid, easy to understand manner. The book leverages itself on using simple language and focuses attention on explaining and breaking down complex financials into simple, comprehendible constructs. Citing numerical and practical examples, picking excerpts from annual reports, the book makes it easy to grasp sometimes what would be difficult jargon. Simple direct and clear explanations make for quick comprehension. Prof. Gupta has included up to date present scenario in working capital assessment to make the book relevant to latest developments in financial domain. Innumerable numerical examples have been used to simplify and explain financial and accounting practices and methods.

There are very few books available on the subject of Working Capital Management; the book is comprehensive and details all aspects of working capital management particularly addressing two important aspects. First, it focuses on elucidating working capital and its management for entrepreneurs and financial managers. Second, the book illustrates all possible methods of financing working capital available at the disposal of an enterprise. Prof. Gupta’s immense knowledge is reflected when he talks about RBI and IBA

viii Foreword

committees. Specific examples have been illustrated from different types of business and industries like sugar industry.

I believe the book will be helpful for the banking professionals and for management graduate and post graduate students enrolled for a course on working capital management to gain a clearer and deeper understanding. It will be particularly helpful for non commerce background students as it very simple, direct and clearly illustrates concepts using live examples and problem statement.

Dr. Monica Gupta

Director Academics

PrefACe

Working capital management and finance has always been a complex subject for enterprises and bankers. The financial enterprise wants maximum funds for working capital whereas the bankers are generally conservative on this aspect, specifically when it concerns new entrepreneurs. In fact, since the management of working capital is challenging, its financing too has become a huge challenge. Before nationalization, the financing by banks was more security centric than purpose centric.

Today, however, banking finance has become more purpose oriented than security oriented. In these circumstances, the financing of working capital has become more important in order to understand and analyze the functioning of the unit and make sufficient funds available for the purpose of running the unit efficiently on a continuing basis. I do not deny that field mangers still have a mindset of getting collateral security so as to ensure recovery in case of default but as a whole we find that if the unit is financed on a logical interpretation of the financial ratios and financial statements with due diligence, the chances of success of the enterprises are better.

This book has been written keeping in view two major points. On the one hand, it is for the purpose of providing systemic knowledge about working capital and its management to entrepreneurs and finance managers of the industry and on the other hand, its purpose is to provide systemic knowledge for various methods of financing working capital so that the enterprise/company/unit is provided with adequate working capital. If adequate working capital is available at the time of need, the success rate of the units and the banks is much higher than if financed on an ad hoc basis.

In this book, not only various committees set up by RBI & IBA have been discussed, various types of methods of financing have also been discussed keeping in view specific requirements of various types of businesses and industry - like the sugar industry which is seasonal, contractors, job work, petrol pumps etc besides general trade and industry.

The book has been written in very simple language without compromising on content.

x Preface

This book will be immensely helpful not only to all those officers who have joined the banking industry during the past decade, and officers who have recently joined the banking industry and have little or no knowledge of commerce but will also be a guide to all those students who plan to do specific courses on working capital management in their MBA or PGDM.

I acknowledge the continuous support of Shri Ashish Tripathi, Asst Gen Manager & faculty, Regional Training Centre, IDBI North Zone, New Delhi, Shri J.P.Bansal, faculty from NIBSCOM Noida (UP), all my colleagues while working in the bank, various Banks’ staff training colleges & Institutes where I got opportunity to interact with the participants/Students. I convey my sincere thanks for the guidance of my Project Manager Mr. Santosh Kumar and Notion Press also, in the absence of whom this book could not have been presented in this form.

(R.K. GUPTA) (Himanshu Gupta)

Author Co Author

B.Com (Hons); CAIIB B.Tech. (Information Technology)

AIB-I (London); LL.B (I) MBA-Operations (IIM-Kozhikode)

Contents

1. MEANING & DEFINITION OF WORKING CAPITAL 1

A. Overview 1

B. Definitions by Some Economists 1

2. NATURE & SCOPE OF WORKING CAPITAL 5

Nature of Working Capital 5

A. Short Term 5

B. Long-Term Working Capital 6

3. WORKING CAPITAL CYCLE 7

4. COMPONENTS OF WORKING CAPITAL 9

A. Current Assets 9

a. Cash in Hand and Balance at the Bank 9

b. Bills Receivables/Sundry Debtors 10

c. Short-Term Loans and Advances 10

d. Inventories or Stock 10

e. Temporary Investment of Surplus Funds 11

f. Prepaid Expenses 11

g. Accrued Income 11

h. Marketable Securities 12

B. Current Liabilities 12

a. Bank Overdraft/Cash Credit Limits 12

b. Bills Payable/Sundry Creditors 12

c. Short-Term Loans, Advances and Deposits 12

d. Dividends Payable 13

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e. Provision for Taxation 13

f. Accrued or Outstanding Expenses 13

g. Contingent Expenses 13

5. RELATIONSHIP BETWEEN CURRENT ASSETS AND CURRENT LIABILITIES 15

Importance 15

Current Ratio 16

6. CONCEPT/CLASSIFICATION OF WORKING CAPITAL 19

CONCEPT OF WORKING CAPITAL 19

A. Balance Sheet Concept 19

a. Gross Working Capital 19

b. Net Working Capital 19

B. Operating Cycle Concept/on the Basis of Time Concept 20

C. Classification or Kinds of Working Capital 21

a. Permanent or Fixed Working Capital 21

i. Regular Working Capital 21

ii. Reserve Working Capital for Exigencies 21

b. Variable Working Capital 21

i Seasonal Working Capital 21

ii. Needed For Special Purpose/Activity 21

7. FACTORS DETERMINING WORKING CAPITAL 23

A. Nature of Business 23

i. Manufacturing 23

ii. Trading 23

iii. Services 24

iv. Fast-Moving Goods 24

B. Size or Scale of Business and its Rate of Growth 24

i. Total Costs Incurred on Materials, Wages and Overheads. Higher the Price, Higher the Requirement 25

ii. Minimum Quantity and Total Value of Raw Material Required at All Times 25

Contents xiii

iii. The Length of the Production Cycle or Work-in-Progress, i.e. the Time Taken For Conversion of Raw Materials to Finished Goods 25

iv. The Length of the Sales Cycle During Which Finished Goods are to be Kept Waiting for Sales 25

v. The Average Period of Credit Allowed to Customers - Credit Policy 25

vi. The Amount of Cash Required for Day-To-Day Expenses of the Business 26

vii. The Amount of Cash Required for Advance Payments, if Any 26

viii. The Average Period of Credit to be Allowed by Suppliers 26

ix. Other Factors 26

8. CALCULATION OF WORKING CAPITAL CYCLE WHILE ARRIVING AT THE HOLDING PERIOD 29

i. Average Period (in Number of Days) of Holding Raw Material 29

ii. Average Period (in Number of Days) of Holding of Semi-Finished Goods(SFG) 30

iii. Average Period (in Number of Days) of Holding of Finished Goods (FG) 30

iv. Average Period (in Number of Days) of Holding of Sundry Debtors/Book Debts 30

v. Average Period (in Number of Days) of Holding of Sundry Creditors/Trade Creditors 30

vi. What is ‘Average Period’? 30

9. ASSESSMENT OF WORKING CAPITAL REQUIREMENT 31

a. Liquidity: Which Current Assets are More Liquid? 31

b Availability of Cash 31

c. Inventory Turnover 32

d. Debtors’ Velocity 32

e. Creditor’s Velocity 33

f. Under Trading: Underutilization of Fixed Assets/Current Assets 33

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g. Overtrading: Excess Utilization of Fixed Assets/Current Assets 33

h. Under Trading and Overtrading Can Be Worked Out by Looking into the Working Capital Turnover Ratio 33

10. COMPUTATION OF WORKING CAPITAL REQUIREMENT 37

1. Ratio of Total Current Assets to Total Assets or Fixed Assets of the Firm 37

2. Ratio of Total Current Assets to Net Sales of the Firm 38

3. Working Capital Based on Working Capital Cycle or Operating Cycle 39

11. REDUCTION OF HOLDING PERIOD/OPERATING CYCLE 41

A. Case of Holding Current Assets at More than the Desired Level 42

i. Funds That are Idle in Any Shape Will Result in Loss of Income/Loss of Interest 42

ii. May Be Diverted for Unproductive/ Speculative Purposes 42

iii. Lukewarm Attitude Towards Realization of Book Debts 42

B. Case of Under Financing (Inadequate Working Capital) 43

i. Unable to Adapt to Change 43

ii. Trade/Cash Discounts are Lost 43

iii. Financial Reputation 43

iv. Insolvency 44

12. ADEQUATE FINANCING 47

A. What is Adequate Working Capital? 47

B. Advantages of Maintaining Adequate Working Capital 50

A. Goodwill 50

B. Easy Loans 50

C. Cash Discounts 50

D. Regular Supply of Raw Material 51

E. Regular Payment of Salaries, Wages and Other Day-To-Day Commitments 51

Contents xv

F. Exploitation of Favourable Market Conditions 51

G. Ability to Face Crises 51

H. Quick and Regular Return on Investments 51

I. Solvency of the Business 52

J. High Morale 52

13. WORKING CAPITAL POLICY 53

A. Defensive Working Capital Policy 53

B. Aggressive Working Capital Policy 54

C. Moderate Working Capital Policy 55

14. OVERVIEW OF WORKING CAPITAL 57

A. Formulation of Policies Regarding Profitability, Risk and Liquidity 57

B. Decisions about Composition and Level of Current Assets 58

C. Decisions about Composition and Level of Current Liabilities 59

15. SYMPTOMS OF POOR WORKING CAPITAL MANAGEMENT 63

A. What is Poor Working Capital Management? 63

B. Reasons for and Results of Poor Working Capital Management 63

a. Diversion of Short-Term Funds for Purchase of Fixed Assets 63

b. Diversion of Funds for Non-Productive Purposes 64

c. Diversion of Funds for Speculative Purposes 64

d. Lack of Monitoring of the Level of Any of the Components of Working Capital Which May Result in Low Profit and High Risk as Well 64

e. Perceptions and Projections Go Wrong 64

f. Lack of Proper Marketing/Quality Control 65

g. Higher Credit Allowed to Debtors to Push Sales, and Quality of the Debtors is Compromised 65

h. Laxity on the Part of the Management for Recovery of Debtors in Time 65

i. Difficulty in Getting Working Capital Finance from Available Sources 65

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16. MEANING OF CASH 67

A. Nature of Cash 68

B. Shortage of Cash has its Own Cost 68

C. Minimum Cash Level - Critical Level of Cash 68

D. Motive/Objectives of Holding Cash/Factors Determining Cash Needs 68

a. Transaction Motive 69

b. Precautionary Motives 69

c. Speculative Motives 70

d. Compensation Motives 70

17. CASH BUDGET 75

1. Meaning and Definition of Cash Budget 75

2. How to Prepare A Cash Budget 75

3. What One Should Know Before Getting Started 75

4. Watch Out for the Creation of A Cash Budget 76

5. A Cash Budget Cannot Be Created in A Vacuum 76

6. Why Prepare A Cash Budget? 76

7. How To Create A Cash Budget 77

A. Time Period 77

B. Desired Cash Position 77

C. Estimated Sales and Expenses. 77

D. Description of Each Line Item 78

E. How to Analyze a Cash Budget 82

F. Check List 83

18. MARKETABLE SECURITIES 85

1. Concept, Types, Reasons for Holding Marketable Securities 85

a. It is Kept as a Reserve for Exigencies 87

b. It is Kept for Planned Expenditure for A Particular Date or Period 87

c. The Surplus Funds are Kept for the Purpose of Earning Income 87

Contents xvii

2. Money Market Instruments 87

i. Gilt-Edged Securities or Government Securities 88

ii. State Government And Public Sector Instruments 89

iii. Municipal Bonds 89

iv. Treasury Bills 90

v. Ad-Hoc Treasury Bills 91

vi. Certificate of Deposit 92

vii. Commercial Paper 96

viii. Bankers’ Acceptances 104

ix. Short-Term Deposit in Banks in Various Forms 104

x. Mutual Fund Units 105

a. Other Types of Investment Companies 105

b. Characteristics of Funds 106

c. Advantages and Disadvantages 106

d. Important Features of Mutual Funds that Make them Attractive 106

e. Different Types of Funds 107

a) Money Market Funds 108

b) Bond Funds 108

c) Stock Funds 110

xi. Inter-Corporate Deposits 112

xii. Call Market 112

xiii. Choice of Securities 115

19. RECEIVABLE MANAGEMENT 119

a. Introduction 119

b. Meaning and Definition 120

c. Instruments Indicating Receivables 121

i. Open Book Account 121

ii Negotiable Promissory Note 121

xviii Contents

d. Purpose of Management of Receivables 122

i. Increase in Profit 122

ii. Meeting Competition 122

iii. Augment Customer’s Resources 122

iv. Speedy Distribution 122

Miscellaneous 123

e. Cost of Maintaining Receivables 123

i. Administrative Cost 123

a) Credit Investigation and Supervision Cost 124

b) Collection Cost 124

ii. Capital Cost 124

iii. Production and Selling Cost 124

iv. Delinquency Cost 124

v. Default Cost 125

f. Factors Affecting the Size of Receivables 125

g. How to Ascertain the Buyer’s Character or Intention 127

h. How to Decide the Type of Policy to be Adopted for Different Types of Receivables 128

20. INVENTORY MANAGEMENT 131

A. Types of Inventories 132

a) Raw Material 132

b) Work In Progress or Semi-Finished Goods 133

c) Finished Goods 133

d) Consumables, Stores and Spares 133

e) Cash and Marketable Securities 134

B. Motive for Holding Inventory 134

a. Transaction Motive 134

b. Precautionary Motive 135

c. Speculative Motive 135

d. Compensation Motive 136

e. Contractual Requirement 137

Contents xix

C. Model For Holding The Inventory 137

i. EOQ 138

ii. Reorder Level = Lead Time/Demand 138

iii. ABC (Always Better Control) Analysis 138

iv. SDE Analysis 139

v. VED Analysis 139

vi. FSN Analysis 140

vii. GOLF Analysis 140

viii. SOS Analysis 140

ix. JIT ( Just In Time) Analysis 140

21. WORKING CAPITAL FINANCING 143

A. Needs and Objectives of Financing Working Capital 143

B. Arrangement of Funds for Working Capital 144

a. Own Funds 144

b. Credit Available from the Market 145

c. Finance Available from Banks And Financial Institutions 145

C. The Cycle of Movement of Current Assets 146

D. Definition of Working Capital 146

E. Over Financing/Under Financing 147

F. Security Based Financing Before Nationalization and Reforms After Nationalization 147

22. VARIOUS COMMITTEES ON WORKING CAPITAL FOR FINANCE AND MONITORING SET UP BY THE RESERVE BANK OF INDIA 149

A. Tandon Committee 149

a. Terms of Reference 150

b. Level of Current Assets 151

c. Holding Period as Suggested by the Tandon Committee 152

d. The Three Methods of Lending as Suggested by The Group Were 160

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e. Loan System: Bifurcation of Cash Credit Limits in Two Parts 163

f. Periodic Information and Report System 164

g. Important Relaxation Permitted in Calculation of MPBF/Current Ratio of 1.33:1 165

h. Treatment of Bills Negotiated Under Usance Letters of Credit as Receivables 166

i. Treatment of Term Loan Instalments 166

B. Chore Committee Recommendations 167

a. The Important Recommendations of the Committee Were 167

b. Non-Submission of QIS Statements 168

c. New Information System 169

d. Review of Borrowal Accounts 169

e. Working Capital Term Loan 170

f. ‘Peak Level’ and ‘ Non-Peak Level’ Limits 170

g. Ad Hoc or Temporary Limits 170

h. Drawee Bill Scheme 171

i Slip Back in Current Ratio 172

j. Diversion of Working Capital Finance 173

C. Nayak Committee Recommendations 175

i. Terms of Reference 175

ii. Recommendations Made by the Committee 175

iii. Method of Lending for Working Capital Limits 176

D. Marathe Committee Recommendations 177

a. Principal Recommendations of the Committee (Accepted By RBI) 177

b. Credit Monitoring Arrangements (CMA) 178

c. Balance Sheet as Per Companies Act 2013 179

d. Preparing CMA Report – 200

e. Liquidity Ratios 203

Contents xxi

f. Activity Ratios 204

i. Inventory Turnover Ratio 204

ii. Debtors’ Velocity Ratio 204

iii. Creditors’ Velocity Ratio 205

iv. Fixed Asset Turnover Ratio 205

g. Solvency Ratios 205

i. Debt Equity Ratio 205

ii. Total Leverage Ratio 205

iii. Debt Service Coverage Ratio (DSCR) 206

h. Profitability Ratios 206

i. Gross Profit Ratio 206

ii. Operating Profit Ratio 207

iii. Net Profit Ratio 207

iv. Return on Investment (ROI)/Return on capital employed 207

v. Return on Asset (ROA) 207

vi. Return on Equity 207

E. Vaz Committee Recommendations 208

F. Kannan Committee Recommendations: Report on Working Capital Finance and Withdrawal of Prescription Relating to MPBF 208

23. PRESENT SCENARIO 231

A Present System in Vogue for Assessing Working Capital Limits 231

B. Treatment of Some Assets as Current Asset for Current Ratio/ MPBF 232

C. Treatment of Acceptance of Public Deposit Obtained by the Company 232

D. Working Capital in Case of Phased Expansion Programme 235

E. Working Capital in Case of Expansion Programme with Enhancement of Existing Working Capital Limits 236

F. Working Capital Limits in Case of Unexpected/Unplanned Bulk Orders 236

xxii Contents

G. Working Capital Finance to Information Technology and Software Industry as Per RBI Guidelines 237

24. FORMS/TYPES OF WORKING CAPITAL FINANCE 239

A. Fund Based 240

1. Domestic Fund Based Limits 240

a. Hypothecation 240

b. What Type of Security Can Be Hypothecated? 241

c. Pledge 242

d. Book Debts/Trade Receivables/Trade Debtors 243

e. DP Bills, i.e. Documents Against Payment Bills 244

f. DA. Bills, i.e. Documents Against Acceptance Bills 245

g. Overdraft 246

2. Export Funds Based Credit Limits 246

a. Packing Credit Limit (PCL) 246

b. Post-Shipment Credit (PSL) 247

B. Non-Fund Based Limits 248

a. Why are Non-Fund Based Limits Preferred? 248

1. Bank Guarantee 249

a. Performance Guarantee 249

1) Purpose of Issuing Performance Bank Guarantees 250

2) Monitoring of Performance Bank Guarantees Issued 250

a) Bank Guarantees Issued in Case of Infrastructure Projects for Executing the Project for a Long Duration Beyond Two Years 250

b) In case any delay is observed in execution of the project 251

c) If finance is made under consortium/multiple banking 251

d) Bank Guarantee is for mobilization advance 252

b. Financial Guarantee 252

c. Important Factors for Bank Guarantee (BG) 253

d. RBI Guidelines for Invocation of Guarantees 257

e. Procedure When the Judgment of the Honourable Court is in Favour of Beneficiary 259

Contents xxiii

f. Procedure in Respect of Guarantees Issued in Favour of Directorate General of Supplies and Disposal (DGS&D), or Guarantees for Unlimited Period 260

g. Guarantees on Behalf of Share and Stock Brokers/Commodity Brokers 261

2. Letter of Credit (LC) 261

a. Definition of Letter of Credit 261

b. Parties to the Letter of Credit 262

c. Types of Letters of Credit 263

d. Assessing Limits for Working Capital Under L/C 267

e. Precautions to be Taken While Issuing A Letter of Credit 270

f. Precautions for Opening Revolving LC 272

g. Restrictions on Opening Letters of Credit 273

h. Discrepancies in Letter of Credit 273

i. Precautions Before and at the Time of Presentations 273

j. Precautions to Be Taken by the Exporter and the Banker 274

C. Structured Products 274

1. Commercial Paper: 275

2. Suppliers’ Credit and Buyers’ Credit 275

3. Corporate Loans 275

4. Securitization of Receivables 277

5. Factoring 279

6. Forfeiting 284

25. WORKING CAPITAL FINANCE FOR SPECIFIC TYPES OF SEASONAL INDUSTRIES AND CONTRACTORS 287

a. Introduction 287

b. Exercise 287

c. Working Out the Drawing Power Based on Stock Statement Submitted by the Borrower 294

d. Stock on Job Work 296

e. Financing to Contractors 296

WORKING CAPITAL MANAGEMENT & FINANCE

‘A Handbook for Bankers and Finance Managers’