Project title: working capital management

Project objectives:To learn the effective management of working capital.

To study how to keep the capital that is tiedup 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 Bank of Maharashtra finances working capital requirements of the firms.

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Profile: bank of Maharashtra

The BirthRegistered on 16th Sept 1935 with an authorized capital of Rs 10.00 lakh and commenced business on 8th Feb 1936.

The ChildhoodKnown as a common man's bank since inception, its initial help to small units has given birth to many of today's industrial houses. After nationalization in 1969, the bank expanded rapidly. It now has 1276 branches (as of 31st March 2004) all over India. TheBank has the largest network of branches by any Public sector bank in the state of Maharashtra.

The AdultThe bank has fine tuned its services to cater to theneeds of the common man and incorporated the latest technology in banking offering a variety of services.

Banks Philosophy

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Technology with personal touch.

The 3m’s symbolizing

Mobilisation of Money Modernisation of Methods and Motivation of Staff.

Banks AimsThe bank wishes to cater to all types of needs of the entire family, in the whole country. Its dream is "One Family, One Bank, Maharashtra Bank".

The AutonomyThe Bank attained autonomous status in 1998. It helps in giving more and more services with simplified procedures without intervention of Government.

Banks Social AspectThe bank excels in Social Banking, overlooking the profit aspect; it has a good share of Priority sector lending having 46% of its branches in rural areas.

Other AttributesBank is the convener of State level Bankers committeeBank has signed a MoU with EXIM bank for co-financing of project exportsBank offers Depository services and Demat facilitiesin Mumbai.Bank has captured 95.25% of its total business through computerization.

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Banks Future Plans

Opening of 40 new branches at the most strategicbusiness centers.

Circle offices at Pune, Mumbai, Delhi, Banglore and Nagpur.

255 additional ATMs will be installed. To cross business level of around Rs 46000

crore. To increase customer base by 10%. To increase finance to Self Help Groups in rural

areas. To substantially increase the Savings Bank

Deposits. Bank is planning setting up of overseas

representative offices in New York , London, Singapore & Dubai.

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WORKING CAPITAL MANAGEMENT

Concept of working capital There are two concepts of working capital:

1.Gross working capital It refers to the firm’s investment in total current assets or circulating assets.

2.Net working capital (defined in two ways)(i) It is the excess of current assets over current liabilities.(ii) It is that portion of a firm’s current assets which is financed by long-term funds.

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

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OPERATING CYCLE:-

(D#1 Source: Dr. S N Maheshwari, Financial Management.)

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

1. Permanent working capital2. Temporary or Variable working capital

1. PERMANENT WORKING CAPITAL:-This refers to that minimum amount of investment

in all current assets which is required at all timesto carry out minimum level of business activities. It represents the current assets required on a continuing basis over the entire year.

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Cash

Raw

Accounts

Finished goods

Work-in-

Tandon committee has referred to this type ofworking 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 offinancing. The suppliers of such working capitalshould not expect its return during the lifetimeof 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 outof long-term funds.This is the reason why the current ratio has to be substantially more than ‘1’.

2.TEMPORARY OR VARIABLE WORKING CAPITAL:-

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The amount of such working capital keeps onfluctuating from time to time on the basis ofbusiness 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 (D#2 Source: Dr. S N Maheshwari, Financial Management.)

Temporary

Amount of working permanent

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Capital (Rs.)

Time

(D#3 Source: Dr. S N Maheshwari, Financial Management.)

REASONS FOR ADEQUATE WORKING CAPITAL: -

A firm must have adequate working capital, i.e.,as much as needed 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 noprofit 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 acceptedthat higher levels of working capital decrease the risk and decrease the profitability too.

While lower levels of working capital increase the risk but have the potentiality of increasing the profitability also.

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This principle is based on the followingassumptions: -(i) There is direct relationship between risk and profitability --- higher is the risk, higher is theprofitability, while lower is the risk, lower is theprofitability.(ii) Current assets are less profitable than fixed assets.(iii) Short-term funds are less expensive than long-term funds.

MANAGEMENT OF WORKING CAPITAL:-

Working capital refers to all aspects of the administration of both current assets and current liabilities.In other words, working capital management is concerned with the problems that arise in attemptingto manage the current assets, the current liabilities and the interrelationships that exist between them.

Moreover, different components of workingcapital are to be properly balanced in such a waythat during one complete production or trade cyclethe cash should be available for purchase of freshmaterial and for running the business includingoperating expenses, after realization of saleproceeds of earlier cycle without any hurdles.

In the absence of such situation, the financial position in respect of the firm’s liquidity may not

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be satisfactory in spite of satisfactoryliquidity ratio.

Working capital management policy have a great effect on firm’s 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 capitalso as to ensure higher profitability, proper liquidity and sound structural health of the organization.

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.

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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: -According to this approach, the requirements of

working capital depend upon the operating cycle of the business.

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The operating cycle begins with theacquisition of raw materials and ends with thecollection of receivables

It may be broadly classified into the following fourstages 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 ofthese 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.

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Each of the components of the operating cyclecan be calculated as follows:- R= Average stock of raw materials and stores

Average raw materials and stores consumptions per day W=Average work-in-progress inventory Average cost of production per day

D=Average book debts Average credit sales per day

C=Average trade creditors Average credit purchases per day

After computing the period of one operating cycle, the total number of operating cycles that canbe computed during a year can be computed by dividing 365 days with number of operating days in acycle. The total expenditure in the year when year when divided by the number of operating cycles in a year will give the average amount of the working capital requirement.

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SOURCES OF WORKING CAPITAL :-

The working capital requirements should be met both from short-term as well long-term sources of funds. 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 theperiod needed.

The financing of working capital throughshort-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 loansat 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.

APPROACHES FOR DETERMINING THE FINANCING MIX:-

There are three basic approaches for determining theworking capital financing mix.

(i) THE HEDGING APPRAOCH:-According to this approach, the maturity of

source of funds should match the nature of assets tobe financed.

The approach is, therefore, termed as “Matching approach”.

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It divides requirements of total workingcapital 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).

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(iii) TRADE-OFF BETWEEN HEDGING ANDCONSERVATIVE APPROACH: -

The hedging and conservative approaches are bothon 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 personsinvolved 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. Theaverage 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

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*MANAGEMENT OF CASH

It is the duty of the finance manager to provideadequate 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 thetwin 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 into cash if

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the circumstances require. The term cashmanagement is generally used for management ofboth cash and near-cash assets.

Motives for holding cashA 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 thebusiness. 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 cashbalance. 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 motiveA firm also keeps cash balance to take advantage

of unexpected opportunities, typically outside the

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normal course of the business. Such motive is,therefore, of purely a speculative nature.For example,

A firm may like to take advantage of an opportunity of purchasing raw materials at the reduced price on payment of immediate cash or delay purchase of raw materials in anticipation of declinein prices.

4.Compensation motive 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 compensatethem 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 managementThere 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 disbursementsThe first basic objective of cash management is

to meet the payments Schedule. In other words, the firm should have sufficient cash to meet the variousrequirements of the firm at different periods of times. The business has to make payment for purchaseof raw materials, wages, taxes, purchases of plant,

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etc. The business activity may come to a grindinghalt 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 balancesThe 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 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.

Cash management - - - - - basic problemsCash management involves the following four basic problems:

1.Controlling levels of cash;2.Controlling inflows of cash;3.Controlling outflows of cash;4.Optimum investment of surplus cash.

1.Controlling levels of cashOne of the basic objectives of cash management

is to minimize the level of cash balance with the firm. This objective is sought to be achieved by means of the following: -

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(i) Preparing cash budget:Cash budget or cash forecasting is the most

significant device for planning and controlling the use of cash. It involves a projection of future cashreceipts and cash disbursements of the firm over various intervals of time. It reveals to the financemanager the timings and amount of expected cash inflows and outflows over a period studied. With this information, he is better able to determine thefuture cash needs of the firm, plan for the financing of these needs and exercise control over the cash and liquidity of the firm.Thus in case a cash budget is properly prepared it correctly reveals the timings and size of net cash flows as well as the periods during which the excesscash may be available for temporary investment. In asmall company, the preparation of cash budget or a cash forecast does not involve much of complicationsand, therefore, relatively a minor job. However, in case of big companies, it is almost a full time job handled by a senior person, namely, the budget controller or the treasurer.

(ii) Providing for unpredictable discrepancies: Cash budget predicts discrepancies between cash

inflows and outflows on the basis of normal businessactivities. It does not take into account discrepancies between cash inflows and cash outflowson account of unforeseen circumstances such as strikes, short-term recession, floods, etc. a certain minimum amount of cash balance has, therefore, to be kept for meeting such unforeseen contingencies. Such amount is fixed on the basis of

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past experience and some intuition regarding thefuture.

(iii) Consideration of short costs: The term short cost refers to the cost incurred as a result of shortage of cash. Such costs may take any of the following forms:

(a) The failure of the firm to meet its obligations in time may result in legal action by the firm’s creditors against the firm. This cost is in terms of fall in the firm’s reputation besides financial costs incurred in defending the suit;

(b) Borrowing may have to be resorted to at high rate of interest. The firm may also be required to pay penalties, etc., to banks for not meeting the obligations in time.

(iv) Availability of other sources of funds:A firm can avoid holding unnecessary large

balance of cash for contingencies in case it has adequate arrangements with its bankers for borrowingmoney in times of emergencies. For such arrangementsthe firm has to pay a slightly higher rate of interest than that on a long-term debt. But considerable saving in interest costs will be effected because such interest will have to be paid only for shorter period.

2. Controlling inflows of cash Having prepared the cash budget, the finance

manager should also ensure that there is no

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significant deviation between the projected cashinflows and the projected cash outflows. Thisrequires controlling of both inflows as well as outflows of cash.Speedier collection of cash can be made possible by adoption of the following techniques, which have been found to be quite useful and effective. (i) Concentration Banking:

Concentration banking is a system of decentralizing collections of accounts receivables in case of large firms having their business spread over a large area. According to this system, a largenumber of collection centers are established by the firm in different areas selected on geographical basis. The firm opens its bank accounts in local banks of different areas where it has its collectioncenters. The collection centers are required to collect cheques from their customers and deposits them in the local bank account. Instructions are given to the local collection centers to transfer funds over a certain limit daily telegraphically to the bank at the head office. This facilitates fast movements of funds.

The company’s treasurer on the basis of the daily report received from the head office bank about the collected funds can use them for disbursement according to needs.

This system of concentration banking results in the following advantages:

(a) The mailing time is reduced since the collection centers themselves collect cheques

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from the customers and immediately depositthem in local bank accounts. Moreover, whenthe local collection centres are also used to prepare and send bills to the customers in theirareas, the mailing time in sending bills to the customer is also reduced;

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

This helps in quicker collection of cash.

(ii) Lock-box system: Lock-box system is a further step in speeding up

collection of cash. In case of concentration bankingcheques are received by collection centres who, after processing, deposit them in the local bank accounts. Thus, there is time gap between actual receipt of cheques by a collection centre and its actual depositing in the local bank account.

Lock-box system has been devised to eliminate delay on account of this time gap.

According to this system, the firm hires a post-office box and instructs its customers to mail theirremittances to the box. The firm’s local bank is given the authority to pick the remittances directlyfrom the post-office box. The bank picks up the mailseveral times a day and deposits the cheques in the firm’s account. Standing instructions are given to the local bank to transfer funds to the head office bank when they exceed a particular limit.

The Lock-Box system offers the following advantages:

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(a) All remittances are handled by the bankseven prior to their de3posits with them at avery low cost;

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

3.control over cash flowsAn effective control over cash outflows or

disbursements also helps a firm in conserving cash and reducing financial requirements. However, there is a basic difference between the underlying objective of exercising control over cash inflows and cash outflows. In case of the former, theobjective is the maximum acceleration of collectionswhile in the case of latter, it is to slow down the disbursements as much as possible. The combination of fast collections and slow disbursements will result in maximum availability of funds.

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

(i) Centralized system of disbursement should be followed as compared to decentralized system in case of collections. All payments should be made from a single control account. This will result in delayin presentment of cheques for payment by parties who are away from the place of control account.

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(ii)Payments should be made on the duedates, neither before nor after. Thefirm should neither lose cash discount norits prestige on account of delay in payments. In other words, the firm should pay within the terms offered by the suppliers.

(iii) The firm may use the technique of “playing float” for maximizing the availability of funds. The term float refers to the period taken from one stage to another in the cash collection process.

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

(ii) Capital float: It refers to the time, which elapses between receiving of the chequeby the post office or other messenger from the buyer till it is actually delivered to the seller.

(iii) Cheque processing float: It refers to the time required for the seller to sort, record and

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deposit the cheque after it has beenreceived by him.

(iv) Bank processing float: This refers to the time period which elapses between deposit of the cheque with the banker and final credit of funds by the banker to the seller’s account.

4.investing surplus cash(i) Determination of the amount of surplus cash;(ii) Determination of the channels of investments.

(i) Determining of surplus cash Surplus cash is the cash in excess of the firm’s normal cash requirements. While determining the amount of surplus cash, the finance manager has to take into account the minimum cash balance that the firm must keep to avoid risk or cost of running out of funds. Such minimum level may be termed a “safety level of cash”.

Determining safety level for cashThe finance manager determines the safety level

of cash separately both for normal periods and peak periods.

In both the cases, he has to decide about the following two basic factors:

(a) Desired days of cash:

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It means the number of days for which cashbalance should be sufficient to cover payments.

(b) Average daily cash outflows:This means the average amount of disbursements,

which will have to be made daily.The “desired days of cash” and “ average daily cash outflows” are separately determined for normal and peak periods. Having determined them, safety level of cash can be calculated as follows:

During normal periods:Safety level of cash = Desired days of cash x average daily cash outflows

During peak periods:Safety level of cash = Desired days of cash at the busiest period x

Average of highest daily cash outflows.(ii) Determining of channels of investments

The finance manager can determine the amount of surplus cash, by comparing the actual mount of cash available with the safety or minimum level of cash. Such surplus may be either of a temporary or a permanent nature.

Temporary cash surplus consists of funds, which are available for investment on a short-term basis (maximum 6 months), since they are required tomeet regular obligations such as those of taxes, dividends, etc.

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Permanent cash surplus consists of funds, whichare kept by the firm to avail of some unforeseenprofitable opportunity of expansion or acquisition of some asset. Such funds are, therefore, available for investment for a period ranging from six months to a year.

Criteria for investment In most of the companies there are usually no

written instructions for investing the surplus cash.It is left to the discretion and judgement; he usually takes into consideration the following factors:

(i) Security: This can be ensured by investing money in securities whose price remain more or less stable.

(ii) Liquidity: This can be ensured by investing moneyin short-term securities including short-term fixed deposits with bank.

(iii) Yield:Most corporate managers give less emphasis to

yield as compared to security and liquidity of investment. They, therefore, prefer short-term government securities for investing surplus cash. However, some corporate managers follow aggressive

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investment policies, which maximize the yield ontheir investments.

(iv) Maturity:Surplus cash is available not for an indefinite

period. Hence, it will be advisable to select securities according to their maturities keeping in view the period for which surplus cash is available.If such selection is done carefully, the finance manager can maximize the yield as well as maintain the liquidity of investments.

Cash management modelsSeveral types of cash management models have been recently designed to help in determining optimum cash balance. These models are interesting and are beginning to be used in practice.Two of such models are given below:

1.Baumol model: -This model was suggested by William J Baumol. It

is similar to one used for determination of economicorder quantity. According to this model, optimum cash level is that level of cash where the carrying costs and transactions costs are the minimum.

Carrying costs This refers to the cost of holding cash, namely,

the interest foregone on marketable securities. Theymay also be termed as opportunity cost of keeping cash balance.

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Transaction costsThis refers to the cost involved in getting

the marketable securities converted into cash. This happens when the firm falls short of cash and to sell the securities resulting in clerical, brokerage, registration and other costs.

There is an inverse relationship between the twocosts. When one increases, the other decreases, the other decreases. Hence, optimum cash level will be at that point where these two costs are equal.

The formula for determining optimum cash balance can be put as follows:

C= 2U x P S

Where, C = Optimum cash balance U = Annual (or monthly) cash disbursements P = Fixed costs per transaction S = Opportunity cost of one rupee p.a. (p.m)

2. Miller-Orr Model

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Baumol model is not suitable in thosecircumstances when the demand for cash isnot steady and cannot be known in advance.

Miller-Orr model helps in determining the optimum level of cash in such circumstances. It deals with cash management problem under the assumption of stochastic or random cash flows by laying down control limits for cash balances. These limits consist of an upper limit (h), lower limit (o) and return point (z). When cash balance reaches the upper limit, a transfer of cash equal to “h-z” is effected to marketable securities. When it touches the lower limit, a transfer equal to “z-o” from marketable securities to cash is made. No transaction between cash to marketable securities and marketable securities to cash is made during the period when the cash balance stays between the high and low limits.

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

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upper control

limit h

Cash balancez Return

point

O lower control limit

Time

(D#4 source: Dr.S.N.Maheshwari, Financial management)

The above chart shows that when cash balances reaches the upper limit, an account equal to “h-z” is invested in the marketable securities and cash balance comes down to “z” level. When cash balance touches the lower limit marketable securities of thevalue of “z-o” are sold and the cash balance again goes up to ‘z’ level.

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The upper limit and lower limit are set onthe basis of opportunity cost of holding cash;degree of likely fluctuation in cash balances and the fixed costs associated with securities transactions.

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

firm. Inventories are thus one of the major elements, which help the firm in obtaining the desired level of sales.

Kinds of inventoriesInventories can be classified into three categories.

(i) Raw materials:These are goods, which have not yet been

committed to production in a manufacturing firm. They may consist of basic raw materials or finished components.

(ii) Work-in-progress: This includes those materials, which have been

committed to production process but have not yet been completed.

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(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 the business.

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 indelay in executing the order because of difficultiesin obtaining/ procuring raw materials, finished goods, etc. thus inventories provide cushion so thatthe purchasing, production and sales functions can proceed at optimum speed.

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

(i) Avoiding losses of sales

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If a firm maintains adequate inventories itcan avoid losses on account of losing thecustomers for non-supply of goods in time.

(ii) Reducing ordering costThe variable cost associated with individual

orders, e.g., typing, checking, approving and mailing the order, etc., can be reduced if a firm places a few large orders than numerous small orders.

(iii) Achieving efficient production runsMaintenance of large inventories helps a firm in

reducing the set-up cost associated with each production run.

Risks and costs associated with inventories Holding of inventories exposes the firm to a

number of risks and costs. Risk of holding inventories can be put as follows:

(i) Price declineThis may be due to increase in the market supply

of the product, introduction of a new competitive product, price cutting by the competitors, etc.

(ii) Product deteriorationThis may due to holding a product for too long a

period or improper storage conditions.

(iii) Obsolescence

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This may be due to change in customers taste,new production technique, improvements in theproduct design, specifications, etc.

The costs of holding inventories are as follows:(i) Materials cost

This includes the cost of purchasing the goods,transportation and handling charges less anydiscount allowed by the supplier of the goods.

(ii) Ordering costThis includes the variable cost associated with

placing an order for the goods. The fewer theorders, the lower will be the ordering costs for thefirm.

(iii) Carrying costThis includes the expenses for storing the

goods. It comprises storage costs, insurance costs,spoilage costs, cost of funds tied up ininventories, etc.

Management of inventory Inventories often constitute a major element of

the total working capital and hence it has beencorrectly observed, “good inventory management isgood financial management”.

Inventory management covers a large number ofissues including fixation of minimum and maximumlevels; determining the size of the inventory to becarried ; deciding about the issue price policy;setting up receipt and inspection procedure;determining the economic order quantity; providing

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proper storage facilities, keeping check onobsolescence and setting up effective informationsystem with regard to the inventories.

However, management inventories involves two basicproblems:

(i) Maintaining a sufficiently large size ofinventory for efficient and smoothproduction and sales operations;

(ii) Maintaining a minimuminvestment in inventories to minimizethe direct-indirect costs associatedwith holding inventories to maximize theprofitability.

Inventories should neither be excessive norinadequate. 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 mayresult in frequent interruption in the productionschedule resulting in underutilization of capacityand lower sales.

The objective of inventory management is,therefore, to determine and maintain the optimum

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level of investment in inventories, which help inachieving the following objectives:

(i) Ensuring a continuous supply ofmaterials to production departmentfacilitating uninterrupted production.

(ii)Maintaining sufficient stock of rawmaterial in periods of short supply.

(iii) Maintaining sufficient stockof finished goods for smooth salesoperations.

(iv)Minimizing the carrying costs.(v) Keeping investment in inventories

at the optimum level.

Techniques of inventory management Effective inventory requires an effective

control over inventories.Inventory control refers to a system which ensuressupply of required quantity and quality ofinventories at the required time and the same timeprevent unnecessary investment in inventories.

The techniques of inventory control/management are as follows:

1. Determination of Economic Order Quantity(EOQ)

Determination of the quantity for which theorder should be placed is one of the importantproblems concerned with efficient inventory

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management. Economic Order Quantity refers to thesize of the order, which gives maximum economy inpurchasing any item of raw material or finishedproduct. It is fixed mainly taking into account thefollowing costs.

(i) Ordering costs: It is the cost of placing an order

and securing the supplies. It varies from timeto time depending upon the number of ordersplaced and the number of items ordered. The morefrequently the orders are placed, and fewer thequantities purchased on each order, the greaterwill be the ordering costs and vice versa.

(ii) Inventory carrying cost:It is the cost of keeping items in

stock. It includes interest on investment,obsolescence losses, store-keeping cost,insurance premium, etc. The larger the value ofinventory, the higher will be the inventorycarrying cost and vice versa.

The former cost may be referred as the “cost ofacquiring” while the latter as the “ cost ofholding” inventory. The cost of acquiring decreaseswhile the cost of holding increases with everyincrease in the quantity of purchase lot. A balanceis, therefore, struck between the two opposingfactors and the economic ordering quantity isdetermined at a level for which aggregate of twocosts is the minimum.

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Formula: Q = 2U x P

S

Where, Q = Economic Ordering Quantity U = Quantity (units) purchased in ayear (month) P = Cost of placing an order S = Annual (monthly) cost of storage ofone unit.

2. Determination of optimum production quantity The EOQ model can be extended to production runs

to determine the optimum production quantity.The two costs involved in this process are:

(i) Set up costs;(ii)Inventory carrying cost.

The set up cost is of the nature of fixed cost andis to be incurred at the time of commencement of each production run. Larger the size of the production run, lower will be the set-up cost per unit. However, the carrying cost will increase with increase in the size of the production run.

Thus, there is an inverse relationship between the set-up cost and inventory carrying cost. The optimum production size is at that level where the

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total of the set-up cost and the inventorycarrying cost is the minimum.

In other words, at this level the two costs willbe equal.

The formula for EOQ can also be used for determining the optimum production quantity as givenbelow:

E = 2U x P

S

Where E = Optimum production quantity U = Annual (monthly) output P = Set-up cost for each production run S = Cost of carrying inventory per annum(per month)

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MANAGEMENT OF ACCOUNTS RECEIVABLES Accounts receivables (also properly termed as

receivables) constitute a significant portion of thetotal currents assets of the business next afterinventories. They are a direct consequences of“trade credit” which has become an essentialmarketing tool in modern business.

When a firm sells goods for cash, payments arereceived immediately and, therefore, no receivablesare credited. However, when a firm sells goods orservices on credit, the payments are postponed tofuture dates and receivables are created. Usually,the credit sales are made on open account, whichmeans that, no, formal acknowledgements of debtobligations are taken from the buyers. The onlydocuments evidencing the same are a purchase order,shipping invoice or even a billing statement. Thepolicy of open account sales facilities businesstransactions and reduces to a great extent the paperwork required in connection with credit sales.

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Meaning of receivables Receivables are assets accounts representing

amounts owed to the firm as a result of sale ofgoods / services in the ordinary course of business.

They, therefore, represent the claims of a firm against its customers and are carried to the “assetsside” 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 receivablesAccounts 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 willgenerally be in a position to sell more goods thanif it insisted on immediate cash payments. This isbecause many customers are either not prepared ornot in a position to pay cash when they purchase thegoods. The firm can sell goods to such customers, incase it resorts to credit sales.

(ii) Increasing profits:Increase in sales results in higher profits for

the firm not only because of increase in the volume

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of sales but also because of the firm charging ahigher margin of profit on credit sales ascompared 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 buyelsewhere 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 firm’s financial resources in them. This is because there is a time lag between the saleof goods to customers and the payments by them. The firm has, therefore, to arrange for additional fundstop meet its own obligations, such as payment to employees, suppliers of raw materials, etc., while awaiting for payments from its customers. Additionalfunds 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 firmhas to pay interest to the outsider while in the

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latter case, there is an opportunity cost to thefirm, i.e., the money which the firm could haveearned 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 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 defaulting customers, the firm may not be able to recover the overdues because of the of the inability of the customers. Such debts are treated as bad debts and have to be written off since they cannot be realized.

Factors affecting the size of receivablesThe size of the receivable is determined by a

number of factors.Some of the important factors are as follows:

(1) Level of sales: This is the most important factor in determining

the size of accounts receivable. Generally in the

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same industry, a firm having a large volume ofsales will be having a larger level ofreceivables 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 variablesinclude the quantity of trade accounts to be accepted, the length of the credit period to be extended, the cash discount to be given and any special terms to be offered depending upon particular circumstances of the firm and the customer. A firm’s 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 customersto 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

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financially weak customers thusresulting in increasing the sizeof 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 termsare:

(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 firm’s credit terms are “net 15”, it means

the customers are expected to pay within 15 days from the date of credit sale.

(ii) Cash discount:Most firms offer cash discount to their

customers for encouraging them to pay their dues before the expiry of the credit period. The terms ofthe cash discounts indicate the rate of discount as well as the period for which the discount has been offered.

MANAGEMENT OF ACCOUNTS PAYABLE

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Management of accounts payable is as muchimportant 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 accountsreceivable 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 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 undertradingThe 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

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to depend on the mercy of the suppliers to supplythem goods at the right time. It may also not beable to extend credit to its customers, besides making delay in payment to the creditors. Overtrading has been amply described as “overblowingthe 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, excessive drawings, dividend payments, purchase of fixed assets and excessive nettrading 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:

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In national emergencies like war, naturalcalamities, etc., a firm may be required toproduce 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 ofthe 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, therefoe, needs more money even to maintain the existing level of activity.

(v) Excessive taxation:Heavy taxes result in depletion of cash

resources at a scale higher than what is justified.The cash position is further strained on account

of efforts of the company to maintain reasonable dividend rates for their shareholders.

Consequences of overtrading 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 createa feeling of uncertainty, insecurity and dissatisfaction in all ranks of the labour. Non-payments of taxes in time may result in bringing

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down the reputation of the company considerablyin 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 supplyingquality materials.

(iii) Reduction in sales:The company may have to suffer in terms of sales

because the pressure for cash requirements may forceit 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 management’s constant companions.

(v) Obsolete plant and machinery: Shortage of cash will force the company to delay

even the necessary repairs and renewals. Inefficientworking, unavoidable breakdowns will have an adverseeffect both on volume of production and rate ofprofit.

Symptoms and remedies for overtrading The situation of overtrading should be remedied

at the earliest possible opportunity, i.e., as soonas 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 offirms inability to pay its creditors in timeand exercising of undue pressure on debtors forpayments;

(b) Increased bank borrowing with correspondingincrease in inventories;

(c) Purchase of fixed assets out of short-termfunds;

(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 butdifficult to follow. The cure is simple-reduce thebusiness or increase finance. Both are difficult.However, arrangement of more finance is better. Ifthis is not possible, the only advisable course leftwill 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 thedisposal of the undertaking. In such a situation thelevel of trading is low as compared to the capitalemployed in the business. It results in increase inthe size of inventories, book debts and cashbalances. Undertrading is a matter of fact an aspectof overcapitalization. The basic cause ofundertrading is, therefore, underutilization of the

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firm’s resources. Such underutilization may bedue any one or more of the following causes:

Conservative policies followed by themanagement;

Non-availability or shortage of basicfacilities necessary for production suchas, raw materials, power, labour, etc;

General depression in the marketresulting in fall in the demand ofcompany’s products;

The symptoms of undertrading are thefollowing:

(i) A very high current ratio;(ii)Low turnover ratios;(iii) An increase in working capital

turnover (working capital/ sales) ratio.Consequences of undertradingThe following are the consequences of undertrading:

(i) The profits of the firm show a decliningtrend resulting in a lower return on capitalemployed (ROI) in the business.(ii) The value of the shares of the company onthe stock exchange starts falling on account oflower profitability;(iii) There is loss to the reputation of the firmon account of lower profitability and creation ofimpression in the minds of investors that themanagement is inefficient.

Remedies for undertrading

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The condition of undertrading is set inbecause of underutilization of the firm’sresources. The situation can, therefore, be remediedby the management by adopting a more dynamic andresult-oriented approach. The firm may go fordiversification and undertaking new profitable jobs,projects, etc., resulting in a better and efficientutilization of the firm’s resources.

Key Working Capital RatiosThe following, easily calculated, ratios areimportant measures of working capital utilization.

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Ratio Formulae Result InterpretationStock Turnover(in days)

Average Stock * 365/Cost of Goods Sold

= x days

On an average, your stock turnover is in x days. Obsolete stock, slow moving lines will extend overall stock turnover days.

Receivables Ratio(in days)

Debtors * 365/Sales

= x days

It takes your average x days to collect receivablesdue to you. Effective debtor management will minimize the days

Payables Ratio(in days)

Creditors * 365/Cost of Sales (or Purchases)

= x days

On an average, you pay yoursuppliers every x days. If you negotiate better creditterms this will increase. If you pay earlier, say, toget a discount this will decline.

Current Ratio

Total Current Assets/Total Current Liabilities

= x times

Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. CurrentLiabilities are amount you are due to pay within the coming 12 months.

Quick Ratio

(Total Current Assets - Inventory)/

= x times

Similar to the Current Ratio but takes account of the fact that it may take time to convert inventory into cash

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Total Current Liabilities

FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS

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

The important ones are:

Nature of businessThe working capital requirement of a firm is

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

Seasonality of operationsFirms which have marked seasonality in their

operations usually have highly fluctuating working capital requirements. To illustrate, consider a firmmanufacturing ceiling fans. The sale of ceiling fans

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reaches a peak during the summer months and dropssharply during the winter period.

Production policyA firm marked by pronounced seasonal fluctuation

in its sales pursue a production policy, which may reduce the sharp variations in working capital requirements.

Market conditions The degree of competition prevailing in the

market place has an important bearing on working capital needs. When competition is keen, a larger inventory of finished goods is required to promptly serve customers who may not be inclined to wait because other manufacturers are ready to meet there needs.

Conditions of supplyThe inventory of raw materials, spares, and

stores depends on the conditions of supply. If the supply is prompt and adequate, the firm can manage with small inventory.

Working capital assessment in Bank of Maharashtra: -PURI COMMITTEE RECOMMENDATIONS.FORMULA RECOMMENDED FOR ASSESSMENT OF WORKING CAPITAL REQUIREMENTS OF SSI.

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

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

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

1 IMPORTED          RAW MATERIAL          ________ DAYS                   

2 INDIGENOUS          RAW MATERIALS          ______ DAYS                   

3 STOCK IN PROGRESS          _________ DAYS                   

4 FINISHED GOODS          _______ DAYS                   

5 SUNDRY DEBTORS          ______ DAYS                   

6 MONTHLY EXPENSES          FOR ONE MONTH                     TOTAL       (A)

LESS: - LIQUID SURPLUS IN BALANCESHEET AS ON: -________: RS. _______

AND CREDIT ON PURCHASES

_____ DAYS RS. ______ RS.______ (B)

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

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Method #1 for assessment of working capitalWorking capital assessment

(Rs. In lakhs)

Sr.no Particulars Mar’03 Mar’04Provisional mar'05

Projected mar'-6

a Total current assets        

 (Excluding fixed deposits 57.03 69.65 56.6 62.5

  Money margin)                   

b Other current liabilities 33.84 33.21 23 25

 Excluding short-term bank bal.)        

           

cWorking capital GAP (a-b) 23.19 36.44 33.6 37.5

           d Minimum stipulated          Net working capital 11.41 13.93 11.32 12.5

 (25% of total current assets        

 Excluding expected receivables.)        

           

eActual /projected net w.cap 6.84 14.67 15.6 12.5

           f Item (c-d) 11.78 22.51 22.28 25           g Item (c-e) 16.35 21.77 18 25           

hMPBF (lower of ( f or g)) 11.78 21.77 18 25

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         I Excess borrows if any                   

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

Sr.no Particulars (Rs.in lakhs)

AProjected sales for the year2004-05 115.09

       25% of sales 28.77     

 Less:- 5% of gross sales margin 5.75

       Permissible bank finance 23.02     B 25% of sales 28.77

 Less: - projected net working capital 15.21

     

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E Bank finance 15.21     

 Bank borrowings shown in theprojections  

  Of the company 15.00     F Limit applied for 10.00     

 Limit recommended for sanction 10.00

  E or F whichever is lower            

RECOMMENDATIONS BY TANDON COMMITTEE

The report submitted by the Tandon committee is a landmark in the history of financing of working capital by commercial banks in India. The report was

63

submitted on 9th August 1975. The report includedrecommendations covering all aspects of lending.

The recommendations were essentially based on three principles:

(i) A proper financial discipline has to be observed by the borrower. He should supply to the banker information regarding his operational plans well in advance.

(ii) The main function of the banker as a lenderis to supplement the borrower’s resources to carry an acceptable level of current assets.

(iii) The bank should know the end-use of bank credit so that it is used only for the purposes for which it is made available.

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SCANNING OF WORKING CAPITAL FINANCING IN MAHABANK

Working capital financing in Bank of Maharashtrais done as per the recommendations proposed by different competent authorities, such as Tandon committee report, Chore committee report.

There is still scope for more efficient working capital financing in the bank.

Recommendations after Scanning of working capital financing Bank of Maharashtra:

(i) While assessing the project, the profit element should be considered with the risk element collectively.

(ii) Financing of working capital should be avoided to a long loss making firm, even though regular customer.

(iii) Some times the clients business looks promising and real to his words then certain relaxation should be provided as far as policies areconsidered.

(iv) Sectoral analysis should be considered before providing the working capital finance to any firm, trends should be considered.

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(v) Statement of financial transactionsshould be review at regular interval to minimizelosses due to irregular payments and defaulters.

BIBLIOGRAPHY1. Author: Dr. S N MaheshwariName of the book: Financial ManagementEdition 2004Publisher name: SULTAN CHAND &SONSPages no.: D.290 onwards

2. Author: I .M. PandeyName of the book: Financial Management8th Edition 2004

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Publisher name: VIKAS PUBLISHING HOUSE PVT. LTDPage no.: 820

3.Bank of Maharashtra journals

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