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 Bank of Maharashtra finances working capital

requirements of the firms.

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Profile: bank of Maharashtra

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

The Childhood
Known 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. The Bank has the largest network of branches by any
Public sector bank in the state of Maharashtra.

The 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 Philosophy

Technology with personal touch.

The 3m’s symbolizing

 Mobilisation of Money
 Modernisation of Methods and
 Motivation of Staff.

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

Banks Social Aspect

The 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.

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

Banks Future Plans

 Opening of 40 new branches at the most strategic business 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 order to sustain the sales activity.

OPERATING CYCLE:-

Accounts

Cash
Finished goods

Raw Work-in-

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

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Types of 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

(D#2 Source: Dr. S N Maheshwari, Financial Management.)

Temporary

Amount of working permanent

Capital (Rs.)

Time

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

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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.

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 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.

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 In the absence of such situation, the financial position in respect of the
firm’s liquidity may not be satisfactory in spite of satisfactory liquidity 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 capital
so 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.

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.

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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.
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.

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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

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 can be computed during a year can be computed by
dividing 365 days with number of operating days in a cycle. 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.

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 the period needed.
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.

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APPROACHES FOR DETERMINING THE FINANCING MIX:-

There are three basic approaches for determining the working capital
financing mix.

(i) THE HEDGING APPRAOCH:-

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).

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

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

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*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 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.

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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 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 decline in 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 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 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.

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 The finance manager should, therefore, try to have an optimum
amount of cash balance keeping the above facts in view.

Cash management - - - - - basic problems

Cash 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 cash

One 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: -

(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 cash
receipts and cash disbursements of the firm over various intervals of time. It
reveals to the finance manager the timings and amount of expected cash
inflows and outflows over a period studied. With this information, he is better
able to determine the future 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 excess cash
may be available for temporary investment. In a small company, the
preparation of cash budget or a cash forecast does not involve much of
complications and, 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 business activities. It does not take into account
discrepancies between cash inflows and cash outflows on 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
past experience and some intuition regarding the future.

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(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
borrowing money in times of emergencies. For such arrangements the 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 significant deviation between the projected cash
inflows and the projected cash outflows. This requires 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 large number 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
collection centers. 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.

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 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 from the customers and immediately deposit them in
local bank accounts. Moreover, when the local collection centres are
also used to prepare and send bills to the customers in their areas, 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 banking cheques 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 their remittances to the box. The firm’s local bank is
given the authority to pick the remittances directly from the post-office box.
The bank picks up the mail several 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:

(a) All remittances are handled by the banks even prior to their de3posits
with them at a very 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 flows

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 An 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, the objective is the maximum acceleration of collections while 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 delay in presentment of cheques for payment by
parties who are away from the place of control account.
(ii) Payments should be made on the due dates, neither before nor
after. The firm should neither lose cash discount nor its 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 cheque by the post office or other messenger from the buyer till
it is actually delivered to the seller.

(iii) Cheque processing float:

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 It refers to the time required for the seller to sort,
record and deposit the cheque after it has been received 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 cash

The 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:

It means the number of days for which cash balance 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:

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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 to meet regular obligations such as those of taxes, dividends, etc.
Permanent cash surplus consists of funds, which are kept by the firm to avail
of some unforeseen profitable 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 money in short-term securities
including short-term fixed deposits with bank.

(iii) Yield:

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 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 investment policies, which maximize
the yield on their 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 models

Several 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 economic order 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. They may also be termed as opportunity cost of keeping
cash balance.

Transaction costs
This 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 two costs. When one
increases, the other decreases, the other decreases. Hence, optimum cash level
will be at that point where these two costs are equal.

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 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
Baumol model is not suitable in those circumstances when the
demand for cash is not 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 balance
z 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 the value of “z-o” are sold and the cash balance again
goes up to ‘z’ level.

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

*MANAGEMENT OF INVENTORIES

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 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.

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 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 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:

24
(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 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 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.

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

25
 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 financial management”.
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 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.

26
 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.

Techniques of inventory management

Effective inventory requires an effective control over inventories.
Inventory control refers to a system which ensures supply of required quantity
and quality of inventories at the required time and the same time prevent
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 the order should be placed is
one of the important problems concerned with efficient inventory
management. Economic Order Quantity refers to the size of the order, which
gives maximum economy in purchasing any item of raw material or finished
product. It is fixed mainly taking into account the following costs.
(i) Ordering costs:
It is the cost of placing an order and securing the supplies.
It varies from time to time depending upon the number of orders placed
and the number of items ordered. The more frequently the orders are
placed, and fewer the quantities purchased on each order, the greater
will be the ordering costs and vice versa.

27
 (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 of inventory, the higher
will be the inventory carrying cost and vice versa.

The former cost may be referred as the “cost of acquiring” while the
latter as the “ cost of holding” inventory. The cost of acquiring decreases
while the cost of holding increases with every increase in the quantity of
purchase lot. A balance is, therefore, struck between the two opposing factors
and the economic ordering quantity is determined at a level for which
aggregate of two costs is the minimum.

Formula:
Q= 2U x P
S

Where,
Q = Economic Ordering Quantity
U = Quantity (units) purchased in a year (month)
P = Cost of placing an order
S = Annual (monthly) cost of storage of one 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 and is 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.

28
 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 total of the set-up cost and the inventory carrying cost is the
minimum.
In other words, at this level the two costs will be equal.

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

E= 2U x P

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)

29
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.
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

30
they purchase the goods. The firm can sell goods to such customers, in
case 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 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 firm’s
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
could have 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 relating to customers, cost of conducting investigation
regarding potential credit customers to determine their creditworthiness, etc.

31
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 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 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 customers to make delays in payments resulting
in increasing the size of the accounts receivables;

32
 (ii) Lenient credit policy will result in greater defaults
in payments by financially weak customers thus
resulting in increasing the size 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 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 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 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.

33
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, 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

34
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, 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 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 management’s
constant companions.

35
(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.

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

 Conservative policies followed by the management;

 Non-availability or shortage of basic facilities necessary for
production such as, raw materials, power, labour, etc;
 General depression in the market resulting in fall in the
demand of company’s products;

36
The symptoms of undertrading are the following:
(i) A very high current ratio;
(ii) Low turnover ratios;
(iii) An increase in working capital turnover (working capital/
sales) ratio.
Consequences of undertrading
The following are the consequences of undertrading:
(i) The profits of the firm show a declining trend resulting in a lower
return on capital employed (ROI) in the business.
(ii) The value of the shares of the company on the stock exchange starts
falling on account of lower profitability;
(iii) There is loss to the reputation of the firm on account of lower
profitability and creation of impression in the minds of investors that the
management is inefficient.

Remedies for undertrading

The condition of undertrading is set in because of underutilization of
the firm’s resources. The situation can, therefore, be remedied by the
management by adopting a more dynamic and result-oriented approach. The
firm may go for diversification and undertaking new profitable jobs, projects,
etc., resulting in a better and efficient utilization of the firm’s resources.

37
Key Working Capital Ratios
The following, easily calculated, ratios are important measures of working
capital utilization.

Ratio Formulae Result

Interpretation
Stock Average Stock = x days On an average, your stock turnover
Turnover * 365/ is in x days.
(in days) Cost of Goods Obsolete stock, slow moving lines will extend
Sold overall stock turnover days.
Receivables Debtors * 365/ = x days It takes your average x days to collect
Ratio Sales receivables due to you. Effective debtor
(in days) management will minimize the days
Payables Creditors * = x days On an average, you pay your suppliers
Ratio 365/ every x days. If you negotiate better
(in days) Cost of Sales credit terms this will increase. If you pay
(or Purchases) earlier, say, to get a discount this will
decline.
Current Total Current =x Current Assets are assets that you can
Ratio Assets/ times readily turn in to cash or will do so
Total Current within 12 months in the course of
Liabilities business. Current Liabilities are amount
you are due to pay within the coming 12
months.

Quick Ratio (Total Current =x Similar to the Current Ratio but takes
Assets - times account of the fact that it may take time
Inventory)/ to convert inventory into cash
Total Current
Liabilities

38
FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS

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

The important ones are:

Nature of business
The 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 operations
Firms which have marked seasonality in their operations usually have
highly fluctuating working capital requirements. To illustrate, consider a firm
manufacturing ceiling fans. The sale of ceiling fans reaches a peak during the
summer months and drops sharply during the winter period.

Production policy
A 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 supply
The 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.

39
Working capital assessment in Bank of Maharashtra: -
PURI COMMITTEE RECOMMENDATIONS.
FORMULA RECOMMENDED FOR ASSESSMENT OF WORKING CAPITAL REQUIREMENTS OF SSI.

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)

Method #1 for assessment of working capital

40
 Working capital assessment
(Rs. In lakhs)
Sr.no Particulars Mar’03 Mar’04 Provisional 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.)

c Working 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.)

e Actual /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

h MPBF (lower of ( f or g)) 11.78 21.77 18 25

I Excess borrows if any

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

41
 Working capital assessment

Sr.no Particulars (Rs.in lakhs)

A Projected sales for the year 2004-05 115.09

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

E Bank finance 15.21

Bank borrowings shown in the projections

Of the company 15.00

F Limit applied for 10.00

Limit recommended for sanction 10.00

E or F whichever is lower

42
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 submitted on 9th August 1975. The report included
recommendations 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 lender is 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.

43
SCANNING OF WORKING CAPITAL FINANCING IN
MAHABANK

Working capital financing in Bank of Maharashtra is 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 are
considered.

(iv) Sectoral analysis should be considered before providing the

working capital finance to any firm, trends should be considered.

(v) Statement of financial transactions should be review at regular

interval to minimize losses due to irregular payments and defaulters.

44
BIBLIOGRAPHY
1. Author: Dr. S N Maheshwari
Name of the book: Financial Management
Edition 2004
Publisher name: SULTAN CHAND &SONS
Pages no.: D.290 onwards

2. Author: I .M. Pandey

Name of the book: Financial Management
8th Edition 2004
Publisher name: VIKAS PUBLISHING HOUSE PVT. LTD
Page no.: 820

3.Bank of Maharashtra journals

45