1

Dr. Adarsh Arora

Preface
The importance of Working Capital Management, as a field of study and practice, is being increasingly realized in schools, colleges, universities, commercial and industrial organizations both in India and abroad. Finance is the life blood of a business and every business requires certain amount of working capital in it to perform day to day activities of the business. Sufficient amount of working capital is the indicator of the efficiency and success of its business. It is a practical subject and learning of it means familiarizing oneself with many new principles and concepts of working capital. This Study Material is intended to serve as a Study Material for students of MFC III Semester Course of Amity University. This Study Material of Working Capital Management, is student oriented and written in teach yourself style. The primary objective of this study material is to facilitate clear understanding of the subject of Working Capital Management. This Material contains a wide range of theoretical and practical questions varying in content, length and complexity. Most of the illustrations and exercise problems have been taken from the various university examinations. This material contains a sufficiently large number of illustrations to assist better grasp and understanding of the subject. For the convenience of the students I have also included multiple questions and case study in this Study Material for better understanding of the subject. I hope that this Material will prove useful to both students and teachers. The contents of this Study Material are divided into six modules

covering various aspects of the syllabus of MFC and other related courses. At the end of this Material three assignments have been provided which are related with the subject matter.

I have taken considerable amount of help from various sources such as literatures, journals and media. I express my gratitude to all those personalities who have devoted their life to knowledge specially to Commerce, from whom I could learn and on the basis of those learning now, I am trying to deliver my knowledge to others through this material. It is by Gods loving grace that he brought me in to this world and blessed me with loving and caring parents, my respected father Mr. Manohar Lal Arora and my loving mother Mrs. Kamla Arora, who have supported me in this Study Material. Words may not be enough for me to express my deep sense of gratitude and indebtedness to Dr. Shipra Maitra, Director (Amity College of Commerce & Finance, Amity University, Noida) for the benevolent guidance, constructive criticism and constant encouragement throughout the period I have been involved in this Study Material. I am thankful to my beloved wife Mrs. Deepti Arora, without whose constant encouragement, advice and material sacrifice, this achievement would have been a far of dream.

SYLLABUS USED FOR DEVELOPING MODULE ON WORKING CAPITAL MANAGEMENT

Course Title: Working Capital Management Course: MFC - IIIrd Semester
Course Objective:- The objective of this course is to develop in students an understanding of the process of Working Capital Management and to familiarize them with methods of financing working capital.

Course Contents:Module I

Introduction: Working Capital Management Concepts of working capital, Classification, Importance, Need or Objects and Factors of Working Capital Nature of Working Capital Management Need for effective Working Capital Management Principles of Working Capital Management Sources of Financing:- Analyse and evaluate the financial implications of different working capital policies, A trade-off Financing Strategy Tandon/Chore Committee Report

Module II

Management of Cash Meaning and Nature of Cash Motives for holding Cash Cash Management:- Meaning, features and objectives Managing Cash Flows and Determining Optimum Cash Balance Cash Management Models Role of Cash in Working Capital Cycle Describe methods of Managing Bank Overdraft Management of Marketable Securities

Module III

Management of Receivables Meaning of Receivables, Cost of Maintaining Receivables, Factors Influencing Size of Receivables, Forecasting the Receivables Meaning and Objective of Receivables Management Dimensions of Receivables Management Formulation and Execution of Credit Policy, Analyse and Evaluate Financial implications of different Credit Policies Formulating and Execution of Collection Policy Factoring and Receivables Management

Module IV

Management of Creditors

Role of Creditors in Working Capital Cycle Advantages of Trade Credit Identify the risks of taking increased Credit and Role of Guarantee

Module V

Inventory Management Meaning, Nature and Purpose of Holding Inventory Inventory Management:- meaning and objectives Role of Inventory in Working Capital Cycle Tools and Techniques of Inventory Management

Module VI

Working Capital Management and Small Business Problems confronted by Small businesses in Managing Working Capital (e.g. market power, poor financial management skills, inadequate information system). Working Capital Management for Seasonal Industries, Sick Industries and Cooperatives.

INDEX
S. No.
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38.

Chapter No.
1. 1.1 1.2 1.3 1.3.i 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13 1.14 1.15 1.16 1.17 1.18 1.19 1.20 1.21 1.22 1.23 1.24 1.25 1.26 1.27 1.28 1.29 1.30 1.31 1.32 1.33 1.34 1.35 1.36

Subject

Page No.
11 11 13 15 16 17 17 17 20 22 23 23 25 27 28 31 32 36 36 39 40 41 41 42 43 44 45 46 48 49 50 52 56 58 59 60 62 63

Introduction:- Working Capital Management Introduction What affects working capital management Concept of gross working capital Concept of net working capital Analysis of working capital Gross Working capital Net working capital Components of working capital Management of w. capital Objectives of working capital Importance of working capital management Measures to improve working capital mgmt. Factors determining working capital Main dimensions of working capital mgmt. Principles of working capital Methods of analysis of working capital Importance of adequate working capital Danger of short working capital Working capital policy Forecast of working capital requirements Factors required while estimating w. capital Factors determining working capital requirements Importance of working capital ratios Other ways of calculating working capital Working capital cycle Sources of additional working capital Impact of redundant working capital Permanent and variable working capital Estimating working capital needs Current assets financing and & its approaches Tandon Committee Report Chore Committee Report, 1980 Introduction to Working capital management Working capital management Nature of working capital management Objectives of working capital mgmt. Factors affecting working capital

39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69. 70. 71. 72. 73. 74. 75. 76. 77. 78. 79. 80.

1.37 1.38 1.39 1.40 1.41

Operating cycle Working capital financing Advantage of trade credit Sources of additional working capital Elements of working capital End Chapter Quizzes Management of cash Management of current assets Cash management Needs for holding cash Objectives of cash management Functions of cash management Factors determining cash management Factors affecting cash level Cash forecasting and budget Estimation of cash receipts and payments Factors for efficient cash management Centralized purchases and payments to suppliers Cash management control Management of sundry debtors Aspects of management of debtors Optimal cash models End Chapter Quizzes Management of receivables Introduction Objectives of receivables Receivable management Objectives of receivable management Advantages of receivable management Steps involved in the mgmt. of receivables Formulation of credit policy Handling receivables End Chapter Quizzes Management of creditors Management of current liabilities Current liabilities Different current liabilities Test of a companys financial strength Creditors Trade credit Advantages & disadvantages of trade credit Current liability management

66 68 69 74 75 80 83 83 83 85 87 87 89 90 95 96 98 100 103 105 106 107 111 114 114 115 116 117 118 119 126 127 133 136 136 136 137 140 140 141 144 145

2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 2.14 2.15

3 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8

4 4.1 4.2 4.3 4.4 4.5 4.6 4.6.i 4.7

81. 82. 83. 84. 85. 86. 87. 88. 89. 90. 91. 92. 93. 94. 95. 96. 97. 98. 99. 100. 101. 102. 103. 104. 105. 106. 107. 108. 109. 110. 111. 112. 113. 114. 115. 116. 117. 118. 119. 120. 121.

4.8 4.9 4.10 4.11 4.11.i

Working capital cycle & role of creditors in working capital cycle Credit risk in a business The risk of taking out a loan Letters of credit Features of letter of credit End Chapter Quizzes Inventory management Introduction Characteristics if inventory Functions of inventory Purpose of inventory Types of inventory Importance of inventory Need to hold inventory Inventory management Objectives of inventory management Importance of inventory mgmt. Techniques of inventory mgmt. Role of inventory in working capital Economic Order Quantity Determination of optimum production quantity Safety stock End Chapter Quizzes Working capital management & small business Small business History of small business Advantages of small business Problems faced by small business Marketing the small business Sources of funding Small Business Administration Small business in India Problems faced by small business Effective small business working capital management Seasonal index Working capital requirement for small industries Working capital need for different businesses Sick industries and their problems Industrial sickness in India Causes of industrial sickness Cooperative

153 156 159 160 163 167 170 170 171 171 172 174 176 177 178 181 182 183 190 196 200 203 207

5 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5.14 5.15

6 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11 6.11.i 6.12 6.13 6.13.i 6.14 6.15

210 210 211 212 213 214 216 218 221 223 233 234 235 237 239 240 244 251

122. 123. 124. 125. 126. 127. 128. 129.

6.16

Cooperatives & their w. capital problems End Chapter Quizzes Answer key to End Chapter Quizzes Bibliography Assignments A Assignments B Assignments C Answer key to Assignment C

253 257 260 261 263 265 267 278

10

MODULE ONE
1. INTRODUCTION:- WORKING CAPITAL MANAGEMENT

1.1 INTRODUCTION "Cash is the lifeblood of business" is an often repeated maxim amongst financial managers. Working capital management refers to the management of current or short-term assets and short-term liabilities. Components of short-term assets include inventories, loans and advances, debtors, investments and cash and bank balances. Short-term liabilities include creditors, trade advances, borrowings and provisions. The major emphasis is, however, on short-term assets, since short-term liabilities arise in the context of short-term assets. It is important that companies minimize risk by prudent working capital management. Working capital is one of the most important measure of a companys financial strength. If the company has sufficient amount of working capital, it can easily complete or meet out its day to day activities. If however a company is below cash or there is shortage of cash, it will face a lot of problems in completing the activities in day to day business and will not be able to complete the demands of its customers. Working capital, also known as "WC", is a financial metric which represents operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. It is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. Net working capital is

11

working capital minus cash (which is a current asset) and minus interest bearing liabilities (i.e. short term debt). It is a derivation of working capital, that is commonly used in valuation techniques such as DCFs (Discounted cash flows).

Working Capital = Current Assets Current Liabilities

A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable and cash. For increasing shareholder's wealth a firm has to analyze the effect of fixed assets and current assets on its return and risk. Working Capital Management is related with the Management of current assets. The Management of current assets is different from fixed assets on the basis of the following points: 1. Current assets are for short period while fixed assets are for more than one Year.

12

2. The large holdings of current assets, especially cash, strengthens Liquidity position but also reduces overall profitability, and to maintain an optimum level of liquidity and profitability, risk return trade off is involved holding Current assets. 3. Only Current Assets can be adjusted with sales fluctuating in the short run. Thus, the firm has greater degree of flexibility in managing current Assets. The management of Current Assets helps affirm in building a good market reputation regarding its business and economic condition.

1.2 WHAT AFFECTS WORKING CAPITAL MANAGEMENT 1. Organizations are generally focused on cash, accounts payable, and supply chain issues. However, external issues like the legal and business environment, or internal mechanisms like organization structure and information systems, can significantly impact working capital. 2. Owing to market pressures, companies are led to paying a lot of attention to producing good quarterly results quarter after quarter. Undue focus on this may sometimes produce a flattering but inaccurate snapshot of working capital performance. This also happens in companies that have a marked seasonality of operations with working capital requirements varying widely from quarter to quarter. Two types of capitals are needed in each type of business named as i. Fixed Capital ii. Working Capital Fixed capital is required for a longer period and is invested for the acquisition of fixed assets, for example: Building, Machinery. Once the

13

finished products are supplied to its customers, it is then very important and difficult to collect payment from the debtors or customers with in a reasonable time limit. This is the another type of capital known as working capital which is needed for short term purposes for meeting the day to day workings. Capital invested for this purpose is used to meet out the daily expenses, it is invested in short term assets like cash, bank, debtors, short term securities & stock. The total of the current assets of any organization may be termed as Gross working capital.

Current Assets Current assets are those assets, which are easily convertible into cash in the normal functioning of the business. These assets are convertible into short term that's why these assets are also called as short-term assets; this period may range from one day to one year. Current Assets are helpful in meeting day to day requirements of the business. Without sufficient and adequate amount of Current Assets the business cannot meet out its day to day activities. The sufficient amount of Current Assets is an indication of the soundness of the business. Normally the current assets include cash, debtors receivable and inventory. However the other Current Assets also include cash at bank, short term investments, accrued incomes and advance payment towards expenses. Working capital may be regarded as the life blood of business. Working capital is of major importance to internal and external analysis because of its close relationship with the current day-to-day operations of a business. Every business needs funds for two purposes.

* Long term funds are required to create production facilities through purchase of fixed assets such as plants, machineries, lands, buildings & etc

14

* Short term funds are required for the purchase of raw materials, payment of wages, and other day-to-day expenses. It is other wise known as revolving or circulating capital. It is nothing but the difference between current assets and current liabilities. i.e. Working Capital = Current Asset Current Liability. Businesses use capital for construction, renovation, furniture, software, equipment, or machinery. It is also commonly used to purchase inventory, or to make payroll. Capital is also used often by businesses to put a down payment down on a piece of commercial real estate. Working capital is essential for any business to succeed. It is becoming increasingly important to have access to more working capital when we need it.

1.3 CONCEPT OF GROSS WORKING CAPITAL The concept of Gross Working Capital focuses attention on two aspects of Current Assets' management. They are:a) Way of optimizing investment in Current Assets. b) Way of financing current assets. a. Optimizing investment in Current Assets: Investment in Current Assets should be just adequate i.e., neither in excess nor deficit because excess investment increases liquidity but reduces profitability as idle investment earns nothing and inadequate amount of working capital can threaten the solvency of the firm because of its inability to meet its obligation. It is taken into consideration that the Working Capital needs of the firm may be fluctuating with changing business activities which may cause excess or

15

shortage of Working Capital frequently and prompt management can control the imbalances. b. Way of financing Current Assets: This aspect points to the need of arranging funds to finance Country Assets. It says whenever a need for working Capital arises; financing arrangement should be made quickly. The financial manager should have the knowledge of sources of the working Capital funds as wheel as investment avenues where idle funds can be temporarily invested.

1.3.i CONCEPT OF NET WORKING CAPITAL This is a qualitative concept. It indicates the liquidity position of and suggests the extent to which working Capital needs may be financed by permanent sources of funds. Current Assets should be optimally more than Courtney Liabilities. It also covers the point of right combination of long term and short-term funds for financing court Assents. For every firm a particular amount of net Working Capital in permanent. Therefore it can be financed with long-term funds. Thus both concepts, Gross and Net Working Capital, are equally important for the efficient management of Working Capital. There are no specific rules to determine a firm's Gross and Net Working Capital but it depends on the business activity of the firm. Working capital management is concerned with the problems that arise while managing the current assets the current liabilities and the interrelationship that exits between them. Thus, the WC management refers to all aspects of a administration of both current assets the current liabilities. Every business concern should not have neither redundant nor cause excess WC nor into should be short of W.C. both condition are harmful and

16

unprofitable for any business. But out of these two the shortage of WC is more dangerous for the well being of the firms.

1.4 ANALYSIS OF WORKING CAPITAL Working Capital refers to concerns investment in short term assets like cash, short term securities, debtors and inventories of all types. It can also be regarded as that portion of companys total capital which is employed in short-term operations. In other words, Working Capital is the investment needed for carrying out day today operations of the business smoothly. From the technical point of view its continuity is to be different in the opinion about definition of Working Capital. Currently, two schools of thought are acceptable namely Gross Working Capital concept and Net Working Capital concept. Gross Working Capital concept emphasizes on the quantitative aspect, while Net Working Capital quantitative aspect. 1.5 GROSS WORKING CAPITAL CONCEPT Companys investment in total current assets signifies the Working Capital. Amount of current liabilities is not considered and hence not deducted from total current assets. Gross Working Capital is also known as Circulating Capital or Current Capital. Bonnevilley and Deway have said that any fund received which increases the Current Assets can be termed as Working Capital. 1.6 NET WORKING CAPITAL CONCEPT Current assets minus current liabilities is known as Working Capital. When current assets exceed current liabilities a positive Working Capital concept highlight upon

17

arises and when current assets are less than current liabilities, negative Working Capital occurs. Really the Working Capital is the difference between current assets and current liabilities. Normally the Working Capital of any concern is invested in stock of raw materials, Stock of semi finished goods, finished goods, receivables, marketable securities and cash. Capital invested in all these forms continuously are being converted into cash and this cash again goes out in the form of other current assets. Thus, it circulates all the time continuously. If the current assets of a company is higher than its current liabilities the position of the company from the Working Capital point of view is considered to be sound and satisfactory if current assets and current liabilities are equal, It may be concluded that the company has resorted to short term funds for financing the Working Capital and long term sources of funds have been used to finance the acquisition of fixed assets.

So Working Capital refers to the funds invested in current assets i.e. investment in Stocks, Sundry Debtors, Cash and other Current Assets. Current Assets are very essential to use the fixed assets profitably. For e.g.:A Machine cannot be used without Raw Material. The investment on the purchase of Raw Material is identified as Working Capital. Thus, the basic objective of Working Capital is to provide adequate support for the smooth functioning of the normal business operations of the company. The term Working Capital can be segregated into 2 parts

18

Gross Working Capital:- The Gross Working Capital Refers to investment in all the current assets taken together. The total of investments in all current assets is known as Gross Working Capital.

Net Working Capital:- The Term Net Working Capital refers to the difference (excess) of Total Current Assets over Total Current Liabilities.

Since both Gross Working Capital and Net Working Capital are obtained from the data combined in the Balance Sheet, working capital viewed in either sense denotes the position of Current Asset s(or Net Current Assets) as at the end of a company's accounting year. An important aspect of current assets is conventionally considered to be their convertibility into cash within a single accounting year unlike Fixed Assets which provide the 'production capacity' for the manufacture of Finished Goods for Sale.

19

The magnitude of Working Capital is a measure of safety margin that exists for the protection of the Short-term Creditors. Working Capital may also be viewed as funds available for acquisition of non-current assets as well as to repay the non-current liabilities. Any transaction that causes an increase in the working capital is a source of Working Capital and any transaction that causes a net decrease in the working capital is an application of Working Capital. Some Transactions merely change the form of Working Capital, without altering the amount of Working Capital as such clearly. Such items neither constitute a source nor the use of working capital.

1.7 COMPONENTS OF WORKING CAPITAL The Working Capital is formed by the following two components i. Current Assets ii. Current Liabilities i. Current Assets Assets which can easily be converted into cash in the normal course of the business are known as current assets. These assets may include, the followingi. ii. iii. (a) (b) (c) iv. Cash in hand and cash at bank Debtors and Bills Receivables (i.e., Receivables) Stock or Inventory of Raw materials, stores, supplies and spares Works in progress Finished goods Advance payments towards expenses, purchases and other short-term

advances.

20

v. vi.

Temporary investments of surplus funds. Accrued incomes.

One common characteristic of all the above items of current assets is that each component is swiftly transformed into other assets forms. A part of the need for funds to finance the current assets may be met from supply of goods on credit and deferment, on account of custom, usage or arrangement of payment for expenses. The remaining part of the need for Working Capital may be met from short-term borrowings from financial institutions and bankers. These are collectively called Current Liabilities. These are the liabilities which are to be met in the normal course of the business within an accounting period out of current assets or profit from operations.

Following are the items included in the current liabilities arei. ii. iii. iv. Short term borrowings Taxes and Dividends Payable. Trade creditors, i.e., goods purchased on credit and Bills Payable. Outstanding or accrued expenses, i.e., expenses incurred in the course

of the business which are not yet paid. v. Advances received from parties against goods to be sold to them or as

short term deposits. vi. vii. Bank Overdrafts Outstanding liabilities currently payable. It is significant to note that in order to get the true picture regarding the volume of Working Capital required to sustain given activity level, adjustments should be made with respect to items which are not considered normal having record to normal course of operations. Just to illustrate, the

21

following items should be deducted from the respective figures of current assets:i. Obsolete items of Stock ii. Debtors not expected to be collected with in a reasonable period of time. iii. Investments of long terms nature. iv. Cash earmarked for the purchase of fixed assets or for redemption of debentures etc.

1.8 MANAGEMENT OF WORKING CAPITAL It has already been indicated earlier in the chapter that the term Working Capital (net) generally stands for excess of current assets over current liabilities. Working Capital management, therefore, 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 interrelation ships that exist between them. The basic objective of Working Capital Management is to manage the firms current assets and Current liabilities in such a way that a satisfactory level of Working Capital is maintained i.e., it is neither inadequate nor excessive. The current assets should be sufficient enough to cover current liabilities in order to maintain a reasonable safety margin. Moreover, different components of Working Capital are to be properly balanced. In the absence of such a situation, the financial position in respect of the firms liquidity may not be satisfactory in spite of satisfactory current ratio and liquidity ratio. Working Capital Management Policies have a great effect on a firms profitability, liquidity and its structural health. A finance manager should, therefore, chalk out appropriate Working Capital Management

22

polices in respect of each of the components of Working Capital so as to ensure the higher profitability, proper liquidity and sound structural health of the organization.

1.9 OBJECTIVES OF WORKING CAPITAL MANAGEMENT The basic objectives of Working Capital Management are as follows i. To optimize the investment in current assets and to reduce the level of

current liabilities, so that the company can reduce the locking up of funds in Working Capital and can improve the return on capital employed in the business. ii. The second important objective of Working Capital Management is

that the company should always be in a position to meet its Current obligations which should properly be supported by the current assets available with the firm, but maintaining excess funds in Working Capital means locking of funds with out returns. iii. To manage the firms current assets in such a way that the marginal

return of investment in these assets is not less than the cost of capital employed to finance of current assets.

1.10 IMPORTANCE OF WORKING CAPITAL MANAGEMENT Although it is essential to have fixed capital to start a business but it is also very necessary to have Working Capital in order to run the business successfully. To purchase raw material, for paying overheads, to keep stock of finished goods and to sell on credit sufficient Working Capital must be maintained. The following are the advantages of Working Capital Management

23

i. In-time payment of Vendors or Creditors :The payment to the persons from whom purchases made is done with in due time. It increases the credit of the business and sometimes cash discount is availed by making payment promptly. It reduces the cost of production. ii. Saving of Interest :When there is enough Working Capital in the business, they need not to take Short Term Bank Loan or Bank Overdraft and therefore the interest is not paid. This increases the profit of the business. In addition, the businessmen who makes payment after the due date have to pay interest with the purchase price. Thus if there is sufficient Working Capital, there will be saving of interest which will increase the profit of the business. iii. Distribution of Adequate Dividend :Sometimes, there is a difficulty in making distribution of dividend due to shortage of Working Capital even if there are enough profits in the business. But the companies which have sufficient Working Capital are able to distribute reasonable amount of dividend to their share holders at proper time. Due to this whenever the company requires additional capital for future projects, it is easy to get capital from investors. iv. Increase in Borrowing Power :Banks provide prompts and sufficient finance to those concerns which have sufficient Working Capital, because they expect the return of money gives us loan at proper time. This makes the business successful continuously. The companies which distribute reasonable dividend at proper time, have good credit in the market. If such companies issue debentures, these are purchased by investors promptly.

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v. Advantage of favourable Opportunities :Some times there is fall in the prices of raw materials in the market. The companies having sufficient Working Capital can make purchase of raw materials in large quantities and have much gain on such opportunities.

vi. Ability to Face Business Crisis :In the business there are occasional booms and depressions. At the time of depression a few companies have to face a crisis due to decrease in sales and accumulation of stock. At such time, the companies having sufficient Working Capital are able to face the crisis successfully. vii. Increase in productivity of Fixed Assets :If there is shortage of Working Capital in a business the productivity of the Fixed Assets also comes down. Just as a without sufficient Working Capital. If the amount of working capital is short, the stock of raw material will also be less. viii. Increase in Efficiency :Sufficient amount of Working Capital increases the enthusiasm of management and directors, employees get incentive if salaries are paid to them at proper time. This increases the efficiency of the business.

1.11

MEASURES

TO

IMPROVE

WORKING

CAPITAL

MANAGEMENT 1. The essence of effective working capital management is proper cash flow forecasting. This should take into account the impact of unforeseen events, market cycles, loss of a prime customer, and actions by competitors. The effect of unforeseen demands on working capital should be factored in.

25

2. It pays to have contingency plans to tide over unexpected events. While market leaders can manage uncertainty better, other companies must have risk management procedures. These must be based on an objective and realistic view of the role of working capital. 3. Addressing the issue of working capital on a corporate-wide basis has certain advantages. Cash generated at one location can well be utilized at another. For this to happen, information access, efficient banking channels, good linkages between production and billing, internal systems to move cash and good treasury practices should be in place. 4. An innovative approach, combining operational and financial skills and an all encompassing view of the company's operations will help in identifying and implementing strategies that generate short term cash. This can be achieved by having the right set of executives who are responsible for setting targets and performance levels. They are then held accountable for delivering. They are also encouraged to be enterprising and to act as change agents. 5. Effective dispute management procedures in relation to customers will go along way in freeing up cash otherwise locked in due to disputes. It will also improve customer service and free up time for legitimate activities like sales, order entry, and cash collection. Overall, efficiency will increase due to reduced operating costs. 6. Collaborating with your customers instead of being focused only on your own operations will also yield good results. If feasible, helping them to plan their inventory requirements efficiently to match your production with their consumption will help reduce inventory levels. This can be done with suppliers also.

26

Working capital management is an important yardstick to measure a company's operational and financial efficiency. This aspect must form part of the company's strategic and operational thinking. Efforts should constantly be made to improve the working capital position. This will yield greater efficiency and improve customer satisfaction.

1.12 FACTORS DETERMINING WORKING CAPITAL Many factors are involved in determining the amount of Working Capital. The amount of Working Capital is determined in the business on the basis of its size, nature of work, amount required in the business. So it is governed after studying many factors. Some business units require very less amount of Working Capital, some others require very huge amount of Working Capital, which is decided according to the nature and size of the business. It is seen that in some business unit the amount of Working Capital is less than the amount of Fixed Capital while in some other fixed capital is less than

Following factors are responsible for determining the working capital :i. Type of Business :Some of the business units require very huge amount of Fixed Capital but others require very less amount of Working Capital. But mostly in manufacturing concerns the amount of capital required is of both types, i.e. Working as well as Fixed. ii. Size of Business :The amount of Working Capital needed is calculated by determining the size of the business. If the size of business is large, than amount of

27

Working Capital required will be greater in comparison to if the size is small. For example- Car, Motor Cycle, Aeroplane, manufacturing companies require very huge amount of Working Capital, while the units that produces small domestic products require very less amount of Working Capital. iii. Seasonal Fluctuations :Those business units, which have continuous production and sales through out the whole year, requires less amount of Working Capital as compared to those which have seasonal productions, e.g. Woolen Articles, Cold Drinks etc. iv. Credit from Bank :The reputation of the business decides how much Working Capital can be obtained by the business unit. The business unit can get the overdraft facility from bank if it has very large number of transactions with Banks. v. Cash Requirement :If in a business, cash payments are continuously made for expenses, require much amount of cash balance so they require much Working Capital in the business. So units like manufacturing concerns require large amount of cash as payments of wages, material, labour, manufacturing expenses are high.

1.13

MAIN

DIMENSIONS

OF

WORKING

CAPITAL

MANAGEMENT Working Capital Management is concerned with the management of current assets and current liabilities properly. The following views indicates the important and main dimensions of Working Capital Management that should be followed by every finance manager. He should concentrate on the

28

Management of Working Capital where he will study deeply about Current Assets, Current Liabilities and about their management. Following are the main dimensions of Working Capital Management. i. Managing investment in Current Assets The first and one of the most important responsibility of a finance manager is looking after the Working Capital and also to determine the appropriate level of investments in Current Assets or the amount of investment in any type of Current Assets fluctuate due to day to day transactions of the business, but an average amount can be used in determining the permanent fluctuating investments in Current Assets what items we should include in inventory, which customers shall make receivables, what shall be included in securities etc. are the important factors which will decide the level of investments in Current Assets. ii. Financing of Working Capital Another important dimension of Working Capital Management is to determine the amount of Working Capital. Generally three types of sources of Financing the Working Capital are used which are spontaneous, short term and long term. Spontaneous sources consists of trade credit, account payables, out standing expenses and others which arrives in a natural way in the companies day to day activity whereas the short term recourses includes bills payables, short term loans and other commercial papers where as long term resources includes long term loans, retained earnings or profits, equality shares, debenture etc. There are the three types of working capital finance. So it is a big responsibility of every finance manager to combine all

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these three resources in such a manner as to make proper financing of both fixed and fluctuating amount of Working Capital. iii. Inter-relatedness Another very important feature of Working Capital is interrelatedness. The financial manager cannot remain silent only by deciding the amount of investment in inventory. The desired level of production can vary. No decision relating to inventory and sales could be made without considering the implication for accounts receivable and debtors. Any business decisions which results in the increment of sales and collection means that lower amount of cash balance will be required to maintain. Current assets and Current Liabilities are also inter related it means if on the one side sales increases then on the another side purchase must also increase. In the same way, if expenses increases the income should also increase. So inventory decisions are directly related to Current Liabilities and Current Assets are linked with to Current Assets. iv. Votality and reversibility One of the significant feature of Working Capital Management is that the amount of fund invested in Current Assets can change rapidly and also the financing requirements of the business. The amount of investments in Current Assets is largely affected by different factors. Seasonal and other fluctuations in demand may also cause quick changes in the investments in Current Assets. Another important feature is reversibility which means that flow of cash closely related to Current Assets and Current Liabilities.

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1.14 PRINCIPLES OF WORKING CAPITAL There are four principle of working capital management. They are being depicted as below:(i) Principle of Risk Variation: - The goal of WC management is to establish a suitable trade between profitability and risk. Risk here refers to a firm's ability to honor its obligation as and when they become due for payments. Larger investment in current assets will lead to dependence. Short term borrowings increases liquidity, reduces risk and thereby decreases the opportunity for gain or loss On the other hand the reserve situation will increase risk and profitability And reduce liquidity thus there is direct relationship between risk and profitability and inverse relationship between liquidity and risk. (ii) Principle of Cost Capital: - The various sources of raising WC finance have different cost of capital and the degree of risk involved. Generally higher the cost lower the risk, Lower the risk higher the cost. A sound WC management should always try to achieve the balance between these two. (iii) Principle of Equity Position: - This principle is considered with planning the total investment in current assets. As per this principle the amount of WC investment in each component should be adequately justified by a firms equity position Every rupee contributed current assets should contribute to the net worth of the firm The level of current assets may be measured with the help of two ratios. They are: Current assets as a percentage of total assets. Current assets as a percentage of total sales. (iv) Principle of Maturity Payment: - This principle is concerned with planning the source of finance for WC. As per this principle a firm should make every effort to relate maturities of its flow of internally generated

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funds in other words it should plan its cash inflow in such a way that it could easily cover its cash out flows or else it will fail to meet its obligation in time.

1.15 METHODS OF ANALYSIS OF WORKING CAPITAL Without the proper analysis of Working Capital, we can not easily judge the financial position of NEPA Limited. The company has managed its working capital in an effective manner or not for analyzing this we have used ratio technique. There are three main methods for the analysis of Working Capital i. Ratio Analysis ii. Schedule of Working Capital Changes iii. Statement of Sources and Application of Working Capital.

i. Ratio Analysis :The working capital can be analyzed by computing the following ratios i. (a) Current Ratio : It is also known as Working Capital Ratio. It is calculated as under Working Capital Ratio or Current Ratio = Current Assets/Current Liabilities This ratio clarifies the relationship between current assets and current liabilities. Generally this ratio should be 2:1 i.e. current assets should be double than the current liabilities. If this ratio is less, an effort should be made to improve it, so, that the Working Capital should remain sufficient in the business and current liabilities may be paid on the due time.

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i. (b). Liquid RatioIt is also known as Acid Test Ratio or Quick Ratio its formula is as follows :Liquid Ratio = Liquid Assets/ Current liabilities This ratio makes clear the relationship between liquid assets and current liabilities. All the current assets except stock and prepaid expenses are treated as liquid assets which are converted into cash again and again. It is necessary to have liquid ratio approximately 1:1 as current liabilities are paid out of liquid assets only. If liquid assets are less, the efforts should be made to bring them at the level of current liabilities.

i.(c) Cash Ratio :The Cash ratio can be calculated as follows :Cash Ratio = Cash and Bank Balance/Current Liabilities A business must have sufficient amount of cash and bank balance also, so that routine payments can be made. If cash and bank balance is 25% of total current liabilities, it is worth while because out of payments received from debtors the payment to creditors will be made. Cash balance is necessary for the payment of routine expenses and for contingencies.

i. (d) Ratio of Current Assets to Total Assets : The Ratio of Current Assets to Total Assets is used to compare current assets with total assets. This ratio gives an idea about the adequate investment or over investment or under investment in total assets. This ratio is most wisely use to make the analysis of a short term financial investment and liquidity of a firm.

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Ratio of Current Assets to Total Assets = Current Assets / Total Assets * 100

i. (e) Ratio of Net Working Capital to Total Assets :This ratio helps to measure the relationship between Net Working Capital to Total Assets. It can be calculated as follows: Ratio of Net Working Capital to Total Assets = Net Working Capital / Total Assets x 100

i. (f) Ratio of Capital Employed to Net Working Capital :This ratio can be used to compare and analyze the Ratio of Capital Employed to Net Working Capital. It is helpful in the comparative study of Capital Employed in the business with Net Working Capital. It can be calculated as follows :Ratio of Capital Employed to Net Working Capital = Net Working Capital/Capital Employed x 100

i. (g) Cash to Net Working Capital Ratio :Cash to Net Working Capital Ratio is calculated to judge the position of cash in comparison to working capital of the company. Higher ratio shows the better performance of the company and its management. It can be calculated as follows :-

Cash to Net Working Capital Ratio = (Cash /Net Working Capital) * 100

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i. (h) Receivables to Net Working Capital Ratio :Receivables to Net Working Capital Ratio is used to check the position of receivables in comparison to Net Working Capital. It can be calculated with the help of the following formula :Receivables to Net Working Capital Ratio = (Receivables / Net Working Capital) * 100

i. (i) Inventory to Net Working Capital Ratio:This ratio can be used to compare the Inventory with Net Working Capital. This ratio indicates the percentage of Inventory to Net Working Capital. It can be calculated by using the following formula :Inventory to Net Working Capital = Inventory / Net Working Capital

i. (j) Current Assets Turnover Ratio :Current Assets Turnover Ratio is used to measure the effective utilization of Current Assets. It is the ratio between cost of sales or sales and Current Assets. This ratio is very significant for non-manufacturing concerns or for concerns using lesser amount of fixed assets. Adequate highlights may be thrown on the basis of this ratio on the efficiency in the use of Current Assets or state of over-investment and under-investment in Current Assets. It may be pointed out that over or under-investment in Current Assets may indirectly affect the solvency position of the concern also. This ratio can be calculated as follows :Current Assets Turnover Ratio = Sales or Cost of sales / Current Assets

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i. (k) Net Working Capital Turnover Ratio :In order to know the position and utilization of Net Working Capital, this ratio is calculated by using the following formula :Net Working Capital Turnover Ratio = Cost of Goods sold or Net Sales / Net Working Capital This ratio is calculated by dividing the Cost of Goods sold by the Net Working Capital. Greater the ratio means better the efficiency of the business.

1.16 IMPORTANCE OF ADEQUATE WORKING CAPITAL *A business firm must maintain an adequate level of working capital in order to run its business smoothly. *It is worthy to note that both excessive and inadequate working capital positions are harmful. *Working capital is just like the heart of business. *If it becomes weak, the business can hardly prosper and survive. *No business can run successfully without an adequate amount of working capital.

1.17 DANGERS OF SHORT OR INADEQUATE WORKING CAPITAL A concern, which had adequate WC, cannot pay its short-term liabilities in time. Thus it will lose its reputation and should be not be able to get good credit facilities. * It cannot by its requirements in bulk and cannot avail of discounts. It stagnates growth.

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* It becomes difficult for the firms to exploit favorable market conditions and undertake profitable projects due to non-availability of WC funds. * The firm cannot pay day-to-day expenses of its operations and its credit inefficiencies, increases cost and reduces the profits of the business. * It becomes impossible to utilize efficiently the fixed assets due to nonavailability of liquid funds thus the firms profitability would deteriorate. * The rate of return on investments also falls with the shortage of WC. * Operating inefficiency creeps in and it becomes difficult to implement operating plans and achieve the firms profit targets. * Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficient working capital. * Low liquidity position may lead to liquidation of firm. When a firm is unable to meets its debts at maturity, there is an unsound position. Credit worthiness of the firm may be damaged because of lack of liquidity. * It will lose its reputation. There by, a firm may not be able to get credit facilities. It may not be able to take advantages of cash discount.

Current Assets
Cash in hand / at bank Bills Receivable Sundry Debtors Short term loans Investors/ stock Temporary investment Prepaid expenses Accrued incomes

Current Liabilities
Bills Payable Sundry Creditors Outstanding expenses Accrued expenses Bank Over draft

One of the most important areas of finance to monitor is your company's working capital, which is the difference between current assets and current liabilities. As a small business owner, you must constantly be alert to

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changes in working capital and their implications; otherwise, you may miss some warning signs that can lead to business failure. The most important component of working capital is cash, far the most important asset of any business, particularly a small business. Without it, the business will fail. So it is of paramount importance for you as the business owner to control all cash transactions.

It is helpful for us, as a business owner, to think of working capital in terms of five components:1. Cash and equivalents. This most liquid form of working capital requires constant supervision. A good cash budgeting and forecasting system provides answers to key questions such as: Is the cash level adequate to meet current expenses as they come due? What is the timing relationship between cash inflow and outflow? When will peak cash needs occur? When and how much bank borrowing will be needed to meet any cash shortfalls? When will repayment be expected and will the cash flow cover it?

2. Accounts receivable. Many businesses extend credit to their customers. If you do, is the amount of accounts receivable reasonable relative to sales? How rapidly are receivables being collected? Which customers are slow to pay and what should be done about them?

3. Inventory. Inventory is often as much as 50 percent of a firm's current assets, so naturally it requires continual scrutiny. Is the inventory level reasonable compared with sales and the nature of your business? What's the rate of inventory turnover compared with other companies in your type of business?

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4. Accounts payable. Financing by suppliers is common in small business; it is one of the major sources of funds for entrepreneurs. Is the amount of money owed suppliers reasonable relative to what you purchase? What is your firm's payment policy doing to enhance or detract from your credit rating?

5. Accrued expenses and taxes payable. These are obligations of your company at any given time and represent a future outflow of cash.

1.18 WORKING CAPITAL POLICY

Principles of Risk variation * Here risk refers to the inability of a firm to meet its obligation, when they become due for payment. * There is a definite inverse relationship between the degree of risk & profitability.

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* A management prefers to minimize risk by maintaining a higher level of current assets or working capital.

Principles of cost of capital * Generally, higher the risk lower is the cost & lowers the risk, higher is the cost. * A sound working capital management should always try to achieve a proper balance b/w these two.

Principles of equity position * It is concerned with planning the total investment in Current Asset. * Every rupee invested in the current assets should contribute to the net worth of the firm. The level of Current Asset may be measured with the help of two ratios Current assets as a % of total assets. Current assets as a % of total sales.

Principle of maturity of payment It is concerned with planning the sources of finance for working capital. A firm should make every effort to relate maturities of payment to its flow of internally generated funds.

1.19 ESTIMATION / FORECAST OF WORKING CAPITAL REQUIREMENTS

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"Working capital is the life blood & controlling nerve centre of a business." No business can be successfully run without an adequate amount of working capital. To avoid the shortage of working capital at once, an estimate of working capital requirement should be made in advance. But estimation of working capital requirements is not an easy task & a large no. of factors has to be considered before starting this.

1.20

FACTORS

REQUIRING

CONSIDERATION

WHILE

ESTIMATING WORKING CAPITAL The average credit period expected to be allowed by suppliers. Total costs incurred on material, wages. The length of time for which raw material are to remain in stores before they are issued for production. The length of the production cycle (or) work in process. The length of sales cycle during which finished goods are to be kept waiting for sales. The average period of credit allowed to customers The amount of cash required to make advance payment

1.21

FACTORS

DETERMINING

WORKING

CAPITAL

REQUIREMENTS Nature of business Size of business Production policy Manufacturing process Seasonal variations

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Working capital cycle Rate of stock turn over Credit policy Business cycles Rate of growth of business Price level changes Earning capacity & dividend policy Other factors.

1.22 IMPORTANCE OF WORKING CAPITAL RATIOS Ratio analysis can be used by financial executives to check upon the efficiency with which working capital is being used in the enterprise. The following are the important ratios to measure the efficiency of working capital. The following, easily calculated, ratios are important measures of working capital utilization. Ratio
Stock Turnover (in days)

Formulae
Average Stock * 365/ Cost of Goods Sold

Result
= x days

Interpretation
On average, you turn over the value of your entire stock every x days. You may need to break this down into product groups for effective stock management. Obsolete stock, slow moving lines will extend overall stock turnover days. Faster production, fewer product lines, just in time ordering will reduce average days. It take you on average x days to collect monies due to you. If your official credit terms are 45 day and it takes you 65 days... why ? One or more large or slow debts can drag out the average days. Effective debtor management will minimize the days. On average, you pay your suppliers every x days. If you negotiate better credit terms this will increase. If you pay earlier, say, to get a discount this will decline. If you simply defer paying your suppliers (without agreement) this will also increase - but your reputation, the quality of service and any flexibility provided by your suppliers may suffer. Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. Current Liabilities are amount you are due to pay within the coming 12 months. For example, 1.5 times means that you should be able to lay your hands on $1.50 for every $1.00 you owe. Less than 1 times e.g. 0.75 means that you could have liquidity problems and be under pressure to generate sufficient cash to meet oncoming

Receivables Ratio (in days)

Debtors * 365/ Sales

= x days

Payables Ratio (in days)

Creditors * 365/ Cost of Sales (or Purchases)

= x days

Current Ratio Total Current Assets/ Total Current Liabilities

= x times

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Quick Ratio

Working Capital Ratio

(Total Current Assets - = x times Inventory)/ Total Current Liabilities (Inventory + As % Sales Receivables - Payables)/ Sales

demands. Similar to the Current Ratio but takes account of the fact that it may take time to convert inventory into cash. A high percentage means that working capital needs are high relative to your sales.

Other

working

capital

measures

include

the

following:-

* Bad debts expressed as a percentage of sales. * Cost of bank loans, lines of credit, invoice discounting etc. * Debtor concentration - degree of dependency on a limited number of customers. Once ratios have been established for our business, it is important to track them over time and to compare them with ratios for other comparable businesses or industry sectors.

1.23 OTHER WAYS OF CALCULATING WORKING CAPITAL

1. Positive Working Capital:- Positive working capital means that the company is able to pay off its short-term liabilities. 2. Negative Working Capital:- Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable, inventory), which is also known as "net working capital". If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it

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could be that the company's sales volumes are decreasing, and as a result, its accounts receivables number continues to get smaller and smaller. Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations.

1.24 WORKING CAPITAL CYCLE Cash flows in a cycle into, around and out of a business. It is the business's life blood and every manager's primary task is to help keep it flowing and to use the cash flow to generate profits. If a business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't generate surpluses, the business will eventually run out of cash and expire. The faster a business expands, the more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right within business. Good management of working capital will generate cash will help improve profits and reduce risks. Bear in mind that the cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm's total profits. There are two elements in the business cycle that absorb cash Inventory (stocks and work-in-progress) and Receivables (debtors owing you money). The main sources of cash are Payables (your creditors) and Equity and Loans.

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Each component of working capital (namely inventory, receivables and payables) has two dimensions ........TIME ......... and MONEY. When it comes to managing working capital - TIME IS MONEY. If you can get money to move faster around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory levels relative to sales), the business will generate more cash or it will need to borrow less money to fund working capital. As a consequence, you could reduce the cost of bank interest or you'll have additional free money available to support additional sales growth or investment. Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit, you effectively create free finance to help fund future sales.

1.25 SOURCES OF ADDITIONAL WORKING CAPITAL Sources of additional working capital include the following:* Existing cash reserves * Profits (when you secure it as cash!) * Payables (credit from suppliers) * New equity or loans from shareholders * Bank overdrafts or lines of credit * Long-term loans

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If you have insufficient working capital and try to increase sales, you can easily over-stretch the financial resources of the business. This is called overtrading. Early warning signs include: * Pressure on existing cash * Exceptional cash generating activities e.g. offering high discounts for early cash payment * Bank overdraft exceeds authorized limit * Seeking greater overdrafts or lines of credit * Part-paying suppliers or other creditors * Paying bills in cash to secure additional supplies * Management pre-occupation with surviving rather than managing * Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque).

1.26

IMPACT/HARM

OF

REDUNDANT

OR

EXCESSIVE

WORKING CAPITAL * Excessive WC means idle funds, which earn no profits for the business, cannot earn proper rate of return on its investment. * When there is a redundant WC, it may lead to unnecessary purchasing and accumulation of inventories causing more chances if theft, waste and losses. * Excessive WC implies excessive debtors and defective credit policy, which may cause higher incidences of bad debts. * It may result into overall inefficiency in the organizations. * When there is excessive WC relation with banks and other financial institutions may not be maintained. * The redundant WC gives rise to speculative transaction.

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* Due to low rate of return on investments the value of shares may also fall. * In case of redundant WC there is always a chance of financing long terms assets from short terms funds, which is very harmful in long run for any organization.

OPERATING CYCLE Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. Investment in current assets such as inventories and debtors is realized during the firm's operating cycle, which is usually less than a year. The operating cycle of a manufacturing company involves three phases: 1. Acquisition of resources such as raw material, labor, power and fuel etc. 2. Manufacture of the product which includes conversion into work-inprogress into finished goods. 3. Sale of the product either for cash or on credit. These phases affect cash flows because sometimes sale is done on credit and it takes sometimes to realize.

Length or Duration of the Operating Cycle: The length of the operating cycle of a manufacturing firm in the sum of the following:1. Inventory Conversion period. 2. Debtors Conversion periods.

The total of Debtors Conversion Period and Inventory Conversion Period is referred to as Gross Operating Cycle.

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1. Inventory Conversions Period: The Inventory Conversion Period is the total time needed for Producing and selling the product. It includes: a. Raw Material Conversion Period. b. Work-in-Progress Conversion Period. c. Finished Goods Conversion Period. 2. Debtors Conversion Period: It is the time required to collect the outstanding amount from the customers. Net Operating Cycle: Generally, a firm may resources (raw materials) on credit and temporarily postpones payment of certain expenses. Payables, which the firm can defer, are spontaneous sources of capital to finance investment in Courtney Assets. The length of the time in which the firm is able to defer payments on various resource purchases is Payables Deferral period. The deference between Gross Operating Cycle and payables Deferral Period is called Net Operating Cycle. If depreciation is excluded from Net Operating Cycle, the computation repercussion represents Cash Conversion Cycle. It is net time interval between cash outflow. Operating Cycle also represent the time interval over which additional funds, called Working Capital, should be obtained in order to carry out the firm's operations. The firm has to negotiate Working Capital from sources such as banks. The negotiated sources of Working Capital financing are called non-spontaneous sources. If net Operating Cycle of a firm increases it means further need for negotiated Working Capital.

1.27 PERMANENT AND VARIABLE WORKING CAPITAL There is always a minimum level of current Assets, which is continuously required by the firm to carry on its business operations. The

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minimum level of Current Assets is referred to as permanent of fixed Working Capital. It is permanent in the same way as the firm's fixed assets are. The extra Working Capital, needed to support the changing production and sales activities are called fluctuating or variable or temporary Working Capital. Both Kinds of Working Capital, permanent and temporary, are necessary to facilitate production and sale through the operating Cycle.

1.28 ESTIMATING WORKING CAPITAL NEEDS Working Capital needs can be estimated by three different methods, which have been successfully applied in practice. They are follows:1. Current Assets Holding Period: To estimate Working Capital requirements on the basis of average holding period of Current Assets and relating them to costs based on the company's experience in the previous years. This method is based on the operating cycle concept. 2. Ratio of Sales: To estimate Working Capital requirements as a ratio of sales on assumption that Current Assets change with sales. 3. Ratio of fixed Investment: To estimate Working Capital requirements as a percentage of fixed investment. The most appropriate method of calculating the Working Capital needs of firm is the concept of operating cycle. There are some limitations with all the three approaches therefore some factors govern the choice of method of Working Capital. Factors considered are seasonal variations in operations, accuracy sales forecasts, investment cost and variability in sales price would generally be considered. The production cycle and credit and collection policy of the firm would have an impact on Working Capital requirements.

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1.29 CURRENT ASSETS FINANCING & ITS APPROACHES A firm can adopt different financing policies for Current Assets Three types of financing used can be: 1. Long-term financing such as shares, debentures etc. 2. Short-term financing such as public deposits, commercial papers etc. 3. Spontaneous financing refers to the automatic sources of short-term funds arising in the normal course of a business such as trade credit (suppliers) and outstanding expenses etc. The real choice of financing Current Assets is between the long term and short-term sources of finances.

The three approaches based on the mix of long and short-term mix are:1. Matching Approach: When the firm follows matching approach (also known as hedging approach), long term financing will be used to finance Fixed Assets and permanent Current Assets and short-term financing to finance temporary or variable Current Assets. The justification for the exact matching is that, since the purpose of financing is to pay for assets, the source of financing and the assets should be relinquished simultaneously so that financing becomes less expensive and inconvenient. However, exact matching is not possible because of the uncertainty about the expected lives of assets. 2. Conservative Approach: The financing policy of the firm is said to be a conservative when it depends more on long-term funds for financing needs. Under a conservative plan, the firm finances its permanent assets and also a part of temporary Current Assets with long term financing. In the periods when the firm has no need for temporary Current Assets, the idle long-term

50

funds can be invested in the tradable securities to conserve liquidity. Thus, the firm has less risk of shortage of funds. 3. Aggressive Approach: An aggressive approach is said to be followed by the firm when it uses more short term financing than warranted by the matching approach. Under an aggressive approach, the firm finances a part of its permanent current assets with short term financing. Some firms even finance a part of their fixed assets with short term financing which makes the firm more risky.

Managing Current Assets: Management of Current Assets is done in three parts. They are:1) Management of cash and cash equivalents. 2) Management of inventory. 3) Management of accounts receivable and factoring. Thus, the basic goal of WC management is to manage the current assets the current liabilities of the firm in such a way that a satisfactory level of WC is maintained, i.e. it is neither inadequate nor excessive WC management policies of a firms have a great effect on its Profitability, Liquidity and Structural health of the organization. WC management is an integral part of overall corporate management. For proper WC management the financial manager has to perform the following basic functions: Estimating the WC requirement. Determining the optimum level of current assets. Financing of WC needs. Analysis and control of WC.

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WC management decisions are three dimensional in nature i.e. these decisions are usually related to these there sphere or fields. Profitability, risk and liquidity. Composition and level of current assets. Composition and level of current liabilities.

1.30 TANDON COMMITTEE REPORT ON WORKING CAPITAL REPORT

Committees A study group headed by Shri Prakash Tandon, the then Chairman of Punjab National Bank, was constituted by the RBI in July 1974 with eminent personalities drawn from leading banks, financial institutions and a wide cross-section of the industry with a view to study the entire gamut of Bank's finance for working capital and suggest ways for optimum utilization of Bank credit. This was the first elaborate attempt by the central bank to organize the Bank credit. Most banks in India even today continue to look at the needs of the corporate in the light of methodology recommended by the Group. The report of this group is widely known as Tandon Committee report. The weaknesses in the Cash Credit system have persisted with the non-implementation of one of the crucial recommendations of the Committee. In the background of credit expansion seen in 1977-79 and its ill effects on the economy, RBI appointed a working group to study and suggest i) modifications in the Cash Credit system to make it amenable to better management of funds by the Bankers and ii) alternate type of credit

52

facilities to ensure better credit discipline and co relation between credit and production. The Group was headed by Sh. K.B. Chore of RBI and was named Chore Committee. Another group headed by Sh. P.R. Nayak (Nayak Committee) was entrusted the job of looking into the difficulties faced by Small Scale Industries due to the sophisticated nature of Tandon & Chore Committee recommendations. His report is applicable to units with credit requirements of less than Rs.50 lacs. The recommendations made by Tandon Committee and reinforced by Chore Committee were implemented in all Banks and Bank Credit became much more organised. However, the recommendations were perceived as too strict by the industry and there has been a continuous clamour from the Industry for movement from mandatory control to a voluntary market related restraint. With recent liberalisation of economy and reforms in the financial sector, RBI has given the freedom to the Banks to work out their own norms for inventory and the earlier norms are now to be taken as guidelines and not a mandate. In fact, beginning with the slack season credit policy of 1997-98, RBI has also given full freedom to all the Banks to devise their own method of assessing the short term credit requirements of their clients and grant lines of credit accordingly. Most banks, however, continue to be guided by the principles enunciated in Tandon Committee report.

TANDON COMMITTEE REPORT (A BRIEF SUMMARY) (Methods of lending) Like many other activities of the banks, method and quantum of shortterm finance that can be granted to a corporate was mandated by the Reserve

53

Bank of India till 1994. This control was exercised on the lines suggested by the recommendations of a study group headed by Shri Prakash Tandon. The study group headed by Shri Prakash Tandon, the then Chairman of Punjab National Bank, was constituted by the RBI in July 1974 with eminent personalities drawn from leading banks, financial institutions and a wide cross-section of the Industry with a view to study the entire gamut of Bank's finance for working capital and suggest ways for optimum utilisation of Bank credit. This was the first elaborate attempt by the central bank to organise the Bank credit. The report of this group is widely known as Tandon Committee report. Most banks in India even today continue to look at the needs of the corporates in the light of methodology recommended by the Group. As per the recommendations of Tandon Committee, the corporates should be discouraged from accumulating too much of stocks of current assets and should move towards very lean inventories and receivable levels. The committee even suggested the maximum levels of Raw Material, Stockin-process and Finished Goods which a corporate operating in an industry should be allowed to accumulate. These levels were termed as inventory and receivable norms. Depending on the size of credit required, the funding of these current assets (working capital needs) of the Corporate could be met by one of the following methods:-

First Method of Lending Banks can work out the working capital gap, i.e. total current assets less current liabilities other than bank borrowings (called Maximum Permissible Bank Finance or MPBF) and finance a maximum of 75 per cent of the gap; the balance to come out of long-term funds, i.e., owned funds and

54

term borrowings. This approach was considered suitable only for very small borrowers i.e. where the requirements of credit were less than Rs.10 lacs.

Second Method of Lending Under this method, it was thought that the borrower should provide for a minimum of 25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for purchases and other current liabilities will be available to fund the build up of current assets and the bank will provide the balance (MPBF). Consequently, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets. RBI stipulated that the working capital needs of all borrowers enjoying fund based credit facilities of more than Rs. 10 lacs should be appraised (calculated) under this method.

Third Method of Lending Under this method, the borrower's contribution from long term funds will be to the extent of the entire CORE CURRENT ASSETS, which has been defined by the Study Group as representing the absolute minimum level of raw materials, process stock, finished goods and stores which are in the pipeline to ensure continuity of production and a minimum of 25% of the balance current assets should be financed out of the long term funds plus term borrowings. (This method was not accepted for implementation and hence is of only academic interest). As can be seen above, the basic foundation of all banks' appraisal of the needs of creditors is the level of current assets. The classification of assets and balance sheet analysis, therefore, assumes a lot of importance.

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RBI has mandated a certain way of analyzing the balance sheets. The requirements of this break-up of assets and liabilities differs slightly from that mandated by the Company Law Board (CLB). The analysis of balance sheet in CMA data is said to give a more detailed and accurate picture of the affairs of a corporate. The corporate are required by all banks to analyze their balance sheet in this specific format called CMA data format and submit to banks. While most qualified accountants working with the firms are aware of the method of classification in this format, professional help is also available in the form of Chartered Accountants, Financial Analysts for this analysis. As can be seen above, the basic foundation of all banks' appraisal of the needs of creditors is the level of current assets. The classification of assets and balance sheet analysis, therefore, assumes a lot of importance. RBI has mandated a certain way of analyzing the balance sheets. The requirements of this break-up of assets and liabilities differs slightly from that mandated by the Company Law Board (CLB). The analysis of balance sheet in CMA data is said to give a more detailed and accurate picture of the affairs of a corporate. The corporate are required by all banks to analyze their balance sheet in this specific format called CMA data format and submit to banks. While most qualified accountants working with the firms are aware of the method of classification in this format, professional help is also available in the form of Chartered Accountants, Financial Analysts for this analysis.

1.31 CHORE COMMITTEE REPORT 1980 After implementing the Tondon Committees recommendations, the Reserve bank of India constituted a committee under the chairmanship of

56

Mr. [Link], the Chief Executive of banking operations and development department Terms of reference - The committee was asked to review the system of credit in all aspects. This review was specially to be made with reference to the gap between sanctioned credit this limits and the extent of their utilization. The committee was also requested to suggest alternative types of credit facilities which would ensure credit discipline and also enable banks to relate credit limits to increase in output or other productive activities.

Recommendations: The important recommendations of the committee are as under: i. Continuance of existing system: All the existing types of lending viz. cash, credit, loans, bills should be continued. However as far as possible loan and bill should be used in place of cash credit. ii. No bifurcation of cash credit accounts : Bifurcation of cash credit accounts into loan component and demand cash credit component has not found acceptance either on the part of bankers and the borrowers. iii. Reduction in over dependence on bank credit: The need of reducing over dependence of the medium and large borrowers both in private and public sectors on the bank credit for their production and trading purposes is much felt. The net surplus generation of an established industrial concern should be utilized partly at least for reducing the borrowing for working capital purposes. iv. No frequent sanction of temporary limits: Banks should not encourage the additional finance limit for any ad-hoc or temporary accommodation in excess of sanctioned limit to meet unforeseen contingencies.

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v.

Submission of quarterly statements: All the borrowers having working capital limits of Rs. 50 lakh or more from total banking system should be submit quarterly statements. Earlier this limit was Rs. One crore.

1.32 WORKING CAPITAL MANAGEMENT Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Decision criteria By definition, working capital management entails short term decisions generally, relating to the next one year period - which are "reversible". These decisions are therefore not taken on the same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or profitability. One measure of cash flow is provided by the cash conversion cycle the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.

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In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. See Economic value added (EVA).

1.33 MANAGEMENT OF WORKING CAPITAL Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable. Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs. Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased

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revenue and hence Return on Capital (or vice versa); see Discounts and allowances. Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

1.34 NATURE OF WORKING CAPITAL Working Capital Management is concerned with the problems that arise in attempting to manage the Current Assets, the Current Liabilities and the inter-relationship that exists between them. The term Current Assets refers to those Assets which in the ordinary course of business can be, or will be, converted into Cash within one year without undergoing a diminution in value and without disrupting the operations of the firm. The Major Current Assets are Cash, Marketable Securities, Accounts Receivables and Inventory. Current Liabilities are those Liabilities, which are intended at their inception, to be paid in the ordinary course of business, within a year out of the current assets or the earnings of the concern .The basic Current Liabilities are Accounts Payable, Bills Payable, Bank Overdraft and outstanding expense. The goal of Working Capital Management is to manage the firm's Assets and Liabilities in such a way that a satisfactory level of working capital is maintained. This is so because if the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy.

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The Current Assets should be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. Each of the current assets must be managed efficiently in order to maintain the liquidity of the firm while not keeping too high a level of any one of them. Each of the short term sources of financing must be continuously managed to ensure that they are obtained and used in the best possible way. The interaction between current assets and current liabilities is, therefore, the main theme of the theory of management of working capital. Working Capital Management is concerned with the problems that arise in attempting to manage the Current Assets, the Current Liabilities and the inter-relationship that exists between them. The term Current Assets refers to those Assets which in the ordinary course of business can be, or will be, converted into Cash within one year without undergoing a diminution in value and without disrupting the operations of the firm. The Major Current Assets are Cash, Marketable Securities, Accounts Receivables and Inventory. Current Liabilities are those Liabilities, which are intended at their inception, to be paid in the ordinary course of business, within a year out of the current assets or the earnings of the concern .The basic Current Liabilities are Accounts Payable, Bills Payable, Bank Overdraft and outstanding expense. The goal of Working Capital Management is to manage the firm's Assets and Liabilities in such a way that a satisfactory level of working capital is maintained. This is so because if the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy.

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The Current Assets should be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. Each of the current assets must be managed efficiently in order to maintain the liquidity of the firm while not keeping too high a level of any one of them. Each of the short term sources of financing must be continuously managed to ensure that they are obtained and used in the best possible way. The interaction between current assets and current liabilities is, therefore, the main theme of the theory of management of working capital.

1.35 OBJECTIVE OF WORKING CAPITAL MANAGEMENT The Basic Objective of Working Capital Management is to provide adequate support for the smooth functioning of the normal business operations of a company. This Objective can be sub-divided into 2 parts:1. 2. Liquidity Profitability

1) Liquidity The quantum of Investment in Current Assets has to be made in a manner that it not only meets the needs of the forecasted sales but also provides a built in cushion in the form of safety stocks to meet unforeseen contingencies arising out of factors such as delays in arrival of Raw Material, sudden spurts in demand etc. Consequently, the investment in current assets for a given level of forecasted sales will be higher if the management follows a conservative attitude than when it follows an aggressive attitude. Thus, a company following a conservative approach is subject to a lower degree of risk than the one following an aggressive

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approach. Further, in the former situation the high amount of Investment in Current Assets imparts greater liquidity to the company than under the latter situation wherein the quantum of investment in Current Asset is less. This aspect exclusively covers the liquidity dimension of Working Capital.

2) Profitability Once we recognize the fact that the total amount of financial resources at the disposal of a company is limited and these can be put to alternative uses, the larger the amount of investment in current assets, the smaller will be the amount available for investment in other profitable avenues at hand with the company. A conservative approach in respect of Investment in Current Assets leaves fewer amounts for other Investments than an aggressive approach does. Further, since the Current Assets will be more for a given level of Sales forecast under the conservative approach, the turnover of Current Assets (calculated as ratio of Net Sales to Current Assets) will be less than what they would be under the aggressive approach. Even if we assume the same level of Sales Revenue, operating Profit before Interest and Tax and Net (Operating) fixed assets, the company following a conservative policy will have a low percentage of operating profitability as compared to its counter part following an aggressive approach.

1.36 FACTORS AFFECTING THE COMPOSTITION OF WORKING CAPITAL

The factors affecting the Composition of Working Capital are:1. Nature of Business

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Different companies operating in different Industries have different Working Capital requirements. A purely Trading Organization will basically have finished goods Inventory, Accounts Receivable and Cash as Current Assets and Accounts Payable as Current Liability. On the other hand, Capital Goods manufacturing and Trading Companies will have a high proportion of Current Assets in the form of inventory of Raw Materials and Work-in-Progress. Thus, the nature of Business is directly linked to the requirement of Working Capital.

2.

Nature of Raw Material Used The nature of Raw Material used in the manufacture of finished goods

greatly influences the quantum of Raw Material Inventory. For example, if the raw Material is an agricultural product whose availability is pronouncedly seasonal in character, the proportion of Raw Material Inventory to Finished Goods Inventory will be quite high. Similarly companies using Imported Raw Materials with long lead time tend to have a high proportion of Raw Material Inventory. In the case of Capital Goods Manufacturing Company the demand for whose product is growing over time, the tendency will be to have high Inventory of Raw Material and Components.

3.

Process Technology Used In case the Raw Material has to go through several stages during the

process of production, the Work-in-Progress Inventory is likely to be much higher than any other item of the Current Assets thereby increasing the need of Working Capital.

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4.

Nature of Finished Goods The nature of Finished Goods greatly affects the amount of finished

goods inventory. For example, if the finished goods have a short span of 'shelf-life' as in the case of cigarettes the finished goods inventory will constitute a very low percentage of current assets. In the case of companies the demand for whose finished goods is seasonal in nature, as in the case of fans, the inventory of finished goods will constitute a high percentage of total current assets. This is mainly because from the point of view of the fixed costs to be incurred by the company it would be more economical to maintain an optimum level of production throughout the year than by stepping up production operations during the busy season.

5.

Degree of Competition in the Market When the Degree of Competition in the market for finished goods in

an industry is high, then companies belonging to the Industry may have to resort to an increased credit period to its customers, partially lowering credit standards and similar other practices to push their products. These practices are likely to result in a high proportion for Accounts Receivables thereby increasing the need for Working Capital.

6.

Growth and Expansion As the company grows, it is logical to expect that a larger amount of

working capital is required. It is, of course, difficult to determine precisely the relationship between the growth in volume of business of a company and the increase in the working capital. The composition of working capital also shifts with economic circumstances and corporate practices. Other things

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being equal, growth Industries require more working capital than those that are static. The Critical fact however, is that the need for increased working capital funds does not follow the growth in business activities but precedes it. Advance planning of working capital, is therefore a continuing necessity for a growing concern.

1.37 OPERATING CYCLE In practical life, Sales never convert into Cash instantly; there is invariably a lag between the sale of goods and the receipt of cash. There is, therefore, a need of working capital in the form of current assets to deal with the problem arising out of the lack of immediate realization of cash against goods sold. Therefore, sufficient working capital is necessary to sustain sales activity. Technically, this is referred to as Operating or Cash Cycle. The Operating cycle can be said to be at the heart of the need of working capital. The continuing flow from cash to suppliers, to inventory, to accounts receivable and back to cash is what is called the operating cycle. In other words, the term cash cycle refers to the length of time necessary to complete the following cycle of events:1. 2. 3. Conversion of Cash into Inventory Conversion of Inventory into Receivables Conversion of Receivables into Cash

The operating cycle which is a continuous process has been shown in the following figure.

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The Operating Cycle consists of 3 phases:1. Phase 1

In Phase 1, Cash gets converted into Inventory. This includes purchase of Raw Material, Conversion of Raw Material into Work-in-Progress, Finished Goods and finally the transfer of goods to stock at the end of the manufacturing process. In the case of Trading Companies, this phase is shorter as there would be no manufacturing activity and cash is directly converted into Inventory. This Phase is of course totally absent in the case of Service Organizations.

2.

Phase 2 In Phase 2 of the cycle, the Inventory is converted into Receivables as

Credit Sales are made to customers. Firms which do not sell on Credit obviously don't have the Phase 2 of the operating Cycle.

3.

Phase 3

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The Last Phase i.e. Phase 3 of the Operating Cycle, represents the stage when Receivables are collected. This phase completes the operating cycle. Thus, the firm has moved from cash to inventory, to receivables and to cash again.

1.38 WORKING CAPITAL FINANCING After determining the level of Working Capital, a firm has to decide how it is to be financed. The need for Financing arises mainly because the Investment in Working Capital/Current Assets, that is Raw Material, Work/Stock-in-progress, finished goods and receivables typically fluctuates during the year. The main sources of Financing are:1. 2. 3. 4. Trade Credit Bank Credit Commercial Paper Factoring

TRADE CREDIT Trade Credit refers to the credit extended by the supplier of goods and services in the normal course of transaction. According to Trade practices, cash is not paid immediately for purchases but after an agreed period of time. Thus, deferral of payment (Trade Credit) represents a source of finance for Credit Purchases. There is however, no formal/specific negotiation for Trade Credit. It is an Informal agreement between the buyer and the seller. There are legal instruments/acknowledgements of debt which are granted on open account

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basis. Such Credit appears in the records of the buyer of goods as Sundry Creditors/Accounts Payable.

A variant of Accounts Payable is Notes Payable. Unlike the open account nature of Accounts Payable, Bills/Notes Payable represent documentary evidence of Credit Purchases and a formal acknowledgement of obligation to pay for Credit purchases on a specified(maturity) date failing which legal/penal action for the seller does not necessarily have to hold it till maturity whereas the accounts payable have more flexible payment obligations.

1.39 ADVANTAGES OF TRADE CREDIT Trade Credit, as a source of short term finance, has certain advantages. It is easily, almost automatically, available. Moreover, it is a flexible and spontaneous source of finance. The availability and magnitude of finance of trade credit is related to the size of operations of the firm in terms of sales/purchases. For Instance, the requirement of Credit Purchases to support the existing Sales is $ 5 million per day. If the purchases are made on credit for 30 days, the average outstanding accounts payable/trade credit will amount to $ 150 million ($ 5million X 30 days). The increase in purchases of goods to support higher sales level of $ 6 million will imply a trade credit finance of $ 180 million ($ 6 million X 30days). If the credit purchases of the goods decline, the availability of trade credit will correspondingly decline. Trade Credit is also an informal, spontaneous source of Finance.

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Implicit Cost of Trade Credit Trade Credit does not involve any explicit Interest charge. However, there is an implicit cost of Trade Credit. It depends on the Credit Terms offered by the supplier of goods.

For example:- If the terms of the credit sales are, say, 45 days net, the payable amount to the supplier of goods is the same whether paid on the date of purchase or on the 45th day and therefore, trade credit has no cost, that is it is cost free. But if the credit terms are, say, 2/15 net 45,implying that the buyer is entitled to 2% discount for payment made within 15 days when the entire payment is to be made within 45 days. The trade credit beyond the discount period (i.e. 15 days) has a cost equal to
Discount (1-Discount)
X

360 days (Credit Period - Discount Period)

Therefore the Implicit Interest Rate/Cost for the above case is 0.02 360 days = 24.5% X (1-0.02) (45 -15) Thus the cost of not paying the amount due within 15 days is 24.5% p.a.

To sum up, as the cost of trade credit is generally very high beyond the discount period, firms should avail of the discount on prompt payment.

Bank Credit Bank Credit is the primary institutional source of finance for any organization. In fact, it represents the most important source for financing of Current Assets. The Working Capital is provided by the banks in 5 ways:1. 2. 3. Cash Credits/Overdrafts Loans Purchase/Discount Bills

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4. 5.

Letter of Credit and Working Capital Term Loans

Cash Credit/Overdrafts Under Cash credit/ Overdraft form/ arrangement of Bank Finance, the Bank specifies a pre-determined borrowing/credit Limit. The Borrower can draw/borrow up to the stipulated Credit/Overdraft Limit. Within the specified limits, any number of drawls/drawings is possible to the extent of his requirements periodically. Similarly, repayments can be made whenever desired during the period. The Interest is determined on the basis of the running balance/ amount actually utilized by the borrower and not on the sanctioned limit. However, a minimum (commitment) charge may be payable on the unutilized balance irrespective of the level of borrowing for availing of facility. This form of Bank Financing of Working Capital is highly attractive to the borrowers because:1. It is flexible in the sense that although borrowed funds are repayable

on demand, banks usually do not recall cash advances/roll them over 2. The borrower has the freedom to draw the amount in advance as and

when required while the Interest Liability is only on the amount actually outstanding.

Loans Under this arrangement, the entire amount of borrowing is credited to the current account of the borrower or released in cash. The borrower has to pay interest on the total amount. The loans are repayable on demand or in periodic installments. They can also be renewed from time to time. As a

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

Bills Purchased/Discounted The modus operandi of bill finance as a source of working capital financing is that a bill arises out of a trade sale-purchase transaction on credit. The seller of goods draws the goods on the purchaser of goods, payable on demand on or after a period. On acceptance of the bill by the purchaser, seller offers it back to the bank for discount/purchase. On discounting the bill, the bank releases the funds to the seller. The bill is presented by the bank to the purchaser/accepter of the bill on due date for payment. The bills can also be rediscounted with the other banks.

Letter of Credit While the other forms of financing in which banks provide funds as well as bear risk, letter of credit is an indirect form of working capital financing and banks assume only the risk, the credit period being provided by the supplier himself. The purchaser of goods on credit obtains a letter of credit from a bank. The bank undertakes the responsibility to make payment to the supplier in case the buyer fails to meet his obligations. Thus, the modus operandi of letter of credit is that the supplier sells goods on credit/extends credit (finance) to the purchaser, the bank gives a guarantee and bears the risk only in case of default by the purchaser.

COMMERCIAL PAPER

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Commercial Paper (CP) is a short-term unsecured negotiable instrument, consisting of promissory notes with maturity. It is issued on a discount on face value basis but it can also be issued in Interest-bearing form. A Commercial Paper (CP) when issued by a company directly to the investor is called a direct paper. The companies announce current rates of CP's of various maturities, and Investors can select those maturities which closely approximate their closing period. When securities are issued by security dealers on behalf of their corporate customers, they are called Dealer paper. They buy at a price less than commission and sell at the highest possible level. The maturities of Commercial Papers (CPs) can be tailored within the range to specific investments.

ADVANTAGES OF COMMERCIAL PAPER 1. 2. Simple Instrument and hardly involves any documentation Flexible in terms of maturities which can be tailored to match the cash

flows of the issuer. 3. A well rated company can diversify its short-term sources of Finance

from banks to the money markets at cheaper rates. 4. Commercial Papers are unsecured and there is no restriction on the

end use of the funds raised. 5. Companies which are bale to raise funds through the use of

Commercial Paper have a better Financial Standing. 6. 7. Highly Liquid as they are Negotiable Instruments Investors get a high return than what they can get from the banking

system.

EFFECTIVE COST/INTEREST YIELD

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As the CP's are issued at a discount and redeemed at its face value, their effective pre-tax/interest yield is
Face Value - Net Amount Realized X 360______ Net Amount Realized Maturity Period Where Net Amount Realized = Face Value - Discount - Agent Charges

Illustration: Compute the Pre-Tax effective cost of a CP given that:Face Value of CP $ 500,000 Maturity Period 90 days Net Amount Realized $480,000 Discount and other charges 1.5%
Solution Pre Tax Effective Cost = Face Value - Net Amount Realized X 360_ Net Amount Realized Maturity Period X 360 90

= 500000 - (480000 -7500*) 480000 - 7500 = 23.30%

Where Discount = 1.5% of 500,000 = 7500

1.40 SOURCES OF ADDITIONAL WORKING CAPITAL Sources of additional working capital include the following: * Existing cash reserves * Profits (when you secure it as cash !) * Payables (credit from suppliers) * New equity or loans from shareholders * Bank overdrafts or lines of credit * Long-term loans

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If you have insufficient working capital and try to increase sales, you can easily over-stretch the financial resources of the business. This is called overtrading. Early warning signs include: Pressure on existing cash Exceptional cash generating activities e.g. offering high discounts for early cash payment Bank overdraft exceeds authorized limit Seeking greater overdrafts or lines of credit Part-paying suppliers or other creditors Paying bills in cash to secure additional supplies Management pre-occupation with surviving rather than managing Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque).

1.41 ELEMENTS OF WORKING CAPITAL Working capital has certain elements and for a business to function smoothly, it needs to be aware of these elements of working capital. These are as follows:Cash this is probably the most essential element or component of working capital. Without cash a business cannot run smoothly. But cash in the business needs to be monitored careful along with proper budgeting and forecasting. Cash inflow and cash outflow need to be monitored properly. Accounts receivable every business has some debtors, people or other businesses that owe them money, these in accounts lingo are called accounts receivable. Simply put these are amounts that are yet to be received

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from debtors. Accounts receivable have to be monitored properly and checked. Inventory or Stock - the inventory in a company is half of its currents assets and hence needs more monitoring than everything else. The level of the inventory or stock needs to be at a particular level, the rate of turnover also needs to be monitored closely. All this is an important aspect of the working capital. Accounts payable like every company has debtors, people who owe you money, similarly every company has creditors to whom they owe money. Its normal for businesses to owe money to their suppliers and other businesses, this is because sometimes the amounts to be paid are large and will need some time to be paid off. It is important to track these payable amounts also called accounts payable for the purpose of working capital but also for goodwill reasons. Outstanding expenses and payable taxes these are certain outstanding that the company has and that will reflect on the working capital. Each company has different working capital requirements, this requirement depends on different factors, and these are: Type of Business. Size of business. Production policy. Process of manufacturing. Changes in seasons. Working capital cycle. Turnover rate of inventory. Policy for credit.

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Business cycles. Rate at which business grows. Changes in pricing. Dividend policy and capacity of earning.

We now know how important working policy is, but what happens to the business when there isnt sufficient working capital? Immediately affected will be the fixed assets that wont be able to function properly because of lack of working capital. There is always the risk of dissolving the company because it cannot sustain on the lack of working capital. The credibility of the company will also be affected; all these will just result in bad losses and like mentioned before the liquidation of the business to cope with these losses. PRACTICAL QUESTIONS:Illustration 1:From the following particulars, prepare a funds flow statement for the year ended 31st March, 2005. Net profit for the year Depreciation charged during the year Dividend paid Shares issued for cash Purchase of machinery Increase in working capital Sale of investments Payment of loan 16000 60000 25000 20000 64500 10500 24000 30000

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Solution:FUND FLOW STATEMENT FOR 2004-05

Sources of funds Issue of shares Sale of investments Funds from investments Net profit 64500 + depreciation 10500

Rs. 30000 20000

Uses of funds Payment of dividend Purchase of machinery Payment of loan Increase in working capital

Rs. 24000 60000 16000 25000

75000
125000 125000

Illustration 2:Calculate the estimate of working capital required by an organization:-

Expected annual production Stock of raw materials Processing period Stock of finished goods Credit period to customers Credit allowed by the suppliers Price of raw material Wages and overheads Selling price Cash balance needed

2600 tons 4 weeks 2 weeks 6 weeks 8 weeks 4 weeks 70% of sales 20% of sales Rs. 200 per ton Rs. 20000

Solution:-

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Statement showing working capital requirement Current assets:Stock of raw material (2600 x 200 x 70/100 x 4/52) Stock of work in progress (2600 x 200 x 80/100 x 2/52) Stock of finished goods (2600 x 200 x 90/100 x 6/52) Sundry debtors (2600 x 200 x 90/100 x 8/52) Cash balance Total current assets Less creditors (2600 x 200 x 70/100 x 4/52) 28000 16000 54000 72000 20000 190000 28000

Working capital required

162000

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MODULE - ONE END CHAPTER QUIZES

1. The phenomenon of overtrading in working capital is characterized bya. Less amount of cash invested in current assets b. Over capitalized of the company as compared to volume of sales c. High amount of cash invested in current assets d. Both a and c above

2. If the average collection period of a company is higher than the credit period extended by it, the firm is supposed to have a a. Satisfactory liquidity position b. Liquidity crunch c. High liquidity d. Collection period has no effect on liquidity

3. Which of the following is/are not measure (s) as to curb the situation of under trading? a. Changing the capital structure to bring down dept/equity ratio b. Selling of some fixed assets c. Hastening the collection process d. Reducing inventory levels

4. Which of the following items does not figure while calculating finished goods storage period? a. Excise duty

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b. Selling and distribution costs c. Financial costs d. Average daily credit purchases

5. Which of the following is a determinant of working capital of a firm? a. Depreciation policy b. Taxes payable by the firm c. Production policy d. All of the above 6. Operating cycle can be delayed by a. Increase in WIP period b. Decrease in raw materials storage period c. Decrease in credit payment period d. Both a and c above

7. In which of the following enterprises the ratio of current assets to total assets is highest? a. Electricity and distribution firms b. Restaurants and bakeries c. Software development firms d. Construction and real estate firms

8. Technical insolvency refers to a. Bankruptcy on the part of the firm b. Inability to pay depts by a firm for the purchase of machinery c. Inability to pay depts by a firm for the transfer of technology

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d. inability to honor its current liabilities

9. The management of current assets is a trade-off betweena. Risk and Return b. Liquidity and Profitability c. Current ratio and current assets turnover ratio d. Both a and c above 10. If the conversion period is arrived at as 10, it means a. It takes 10 days to convert the raw materials to finished goods b. 10 days costs of production is held on an average as WIP c. Raw materials which can be consumed in 10 days are held in WIP d. Both a and b above

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MODULE TWO 2. MANAGEMENT OF CASH

2.1 MANAGEMENT OF CURRENT ASSETS Current Assets play an important role in judging the financial position and status of the enterprises. Every Company tries to utilize its available resources in forming the Current Assets also. It includes the following items effectively i. Cash Management ii. Receivable Management iii. Inventory Management

2.2 CASH MANAGEMENT For every business and organization, cash is the most important requirement. Without cash no arrangements, whether purchase, sale, payment of expenses or expenditure can be made, so at every stage cash is required. On the other hand to meet out future requirements balance at bank should also be maintained, as bank is that institution that deposit our money and lend it when required, interest on amount deposited. Cash is the basic and primary foundation of any business. No business can survive without cash. Cash is an important asset not earning anything itself and therefore excessive cash can have negative effects on the profitability and soundness of the business. Generally cash indicates only the cash balance in hand but for the analysis of financial management cash in hand, cheques in hand, bank balance and cash securities. Every business has to hold a certain amount of cash in any form to meet out its requirement in the business. It is the most important

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responsibility of a finance manager to understand the cash requirement of the business. Calculation of expenses, productions, income, taxes should be determined by the finance manager and on behalf of all the items he should estimate the requirement of cash. A finance manager should also understand the area of cash management and forecasting with the help of good understanding of business financial statements. Todays electronic delivery and payment system has the form of business quite a lot and it has become very fast so cash is required to meet out the transactions quickly. Cash management simply refers to the effective management of cash. In wide a term Cash Management refers to the techniques, designs to accelerate and control collections, quick deposits and payments. In general the Cash Management involves the effective and most efficient use of cash to maximize cash inflow and outflow at minimum cost. Today's quick, electronic & fast growing environment, where not only business but also every field has changed quite a lot, it is also very important in a business, how effectively we manage the cash. If we have to transfer cash from our business to another, now we can do it very easily and quickly but which is most important is that how we do it? Means how we manage the cash, its inflow and outflow. Some businesses, falls not because they don't have the sufficient amount of cash, but also because they don't have the effective and sound policy to control the inflow and outflow of cash. So it is the most important responsibility of the business and the finance manager, to understand how he has to manage cash requirements of the business. He has to get the complete knowledge of the business first of all, after that he can work effectively in cash management. He should forecast how much cash would be required for the inflow and outflow of the business.

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The finance manager should also have the complete knowledge of every aspect and area of the business and his forecasting should be based upon the need and requirements of the firm and also on common sense and logic. Not only the finance manager should have the complete knowledge about every aspect of the business but also he should also be provided a responsibility towards collection, payments and investment of cash means he should be free to invest, collect and for payments with the cash available in the business, which will be beneficial for the business in future. Without such authority he will not be able to deliver the required performance from his side. If the company or organization has given the manager broad cash management, he should also be given some authorities to complete his duties effectively, when we study about the management of cash, a good management of cash is one of the major element of a manager's performance and in many case it is directly linked to the manager. So the manager should be provided reasonable authority and power to perform his duties more efficiently and effectively.

2.3 NEEDS FOR HOLDING CASH According to the economic theory there are four basic needs for holding cash. The needs for holding cash can be described as follows i. Transactionary motive Every business requires a fixed amount of cash in order to meet out its day to day transactions of the business. Payments for different transactions such as purchase of raw material, wages, over head expenses, taxes and dividends should be given in cash on due date or before due dates. So the motive of holding cash and cash management is to access the transactions

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for which cash is required. So it should be the policy of the business to meet out its payments well with in due dates.

ii. Speculative Motives A business should decide to maintain cash balance to such extent from where it can exploit profitable opportunity for the business as and when the arise for example:- suppose the prices of raw material has decrease 20% than the business should have adequate amount of cash so that it can avail this opportunity. Now the business can purchase material in cheaper rates and sale them at higher prices and will be in a position to gain more & more profit.

iii. Pre-cautionary Motive It is very important for every business to hold a balance of cash for meeting the unknown or contingent, needs or liabilities for which the business cannot forecast but these may happen in any business. For example:- Loss by fire, strikes by the worker, lock outs etc. So sufficient amount of cash balance should be maintain as a precaution. This is one of the important reason for holding cash.

iv. Compensative Motive Apart from the above three objectives of holding cash another motive called as compensative motive also relates with holding cash. Specially the bank balance is called as compensative motive. Bank offers a number of services to its customers for which it compels its customers to leave a minimum balance in their accounts so that the banker may earn some interest and can compensate to its clients and providing cost free services.

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2.4 OBJECTIVES OF CASH MANAGEMENT The main objective of Cash Management is to meet out the requirements of cash for the business and to maintain liquidity and profitability for maximizing the profit of the business as we have discussed cash is required to continue the every transaction of the business. The main objective of cash management system is to forecast cash needs based on a companys collection and payments. Another objective is to minimize the mount to be kept as cash balance, financial manager may face two aspects while making efforts to keep the minimum cash balance while higher cash balance insures payment and appropriate time along with other benefits also appropriate cash balance is found lying is idle. The management of cash aims to achieve the minimum level of the amount of cash that should be fixed as cash balance. The cash is just like a lubricant to the ever running wheels of the business without which the business of the business activities can not be completed. So the business should have reasonable amount of cash to meet the needs of cash.

2.5 FUNCTIONS OF CASH MANAGEMENT Cash is an important part of asset which is required in each and every aspect of the business. Every business has to keep adequate amount of cash to meet out its requirements. If there is a shortage of cash, the firm will not be able to meet out its requirements. On the other hand if cash is more than what is required of the business than it will not result in taking the advantage of more profit. If the firm keeps excessive cash in the bank it losses the opportunity to earn interest more over there is a cost of holding too much cash that is the

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interest for gone. Therefore the finance manager will look upon to hold cash to that point where the business will not loose the opportunity to earn interest. This is whole understand in Cash Management. So the function of Cash Management is to give an education how much cash is required and how balance of cash should be kept in the business to meet out its requirement. So a cash management system not only tells the organization about the optimum cash balance but also implements processes and given procedure to speed up the collection and payment of cash. The function of an effective cash management & system is to forecast cash requirements of the business, taking in to account, past record of the business present situation, and future expectations and seasonal changes in the business activity.

The main functions of cash management can be discussed as follows:i. Eliminating idle cashOne of the important function of cash management is to tell the business how it can eliminate the idle cash. Idle cash is that amount of cash which is presently not required in the business but is available with the business as it is not required at present and also not providing any benefit to the business. So it called as idle cash. The main function of Cash

Management is to tell how we can eliminate this idle cash. To find out the amount of idle cash which is required to forecast the amount of cash needed to meet cash requirements in future. The finance manager must minimize cash balance in the balance sheet to prepare and present a successful working capital programme. ii. Facilitating Payments

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The suitable amount of cash is required to meet out the payments at the business. Prepayment for goods or services unless required by the supplies should be avoided. Some payments are to be made on a specific of legal date such as payment of taxes loans etc. For these type of payments there is no cash management is required because these type of expenses are to be met on a specific date. For other payment such as inventory payment, discretion in timing is possible. The suppliers offer discounts and other incentives for time to time payment. The business firm should avail the facility of discounts and other incentives by making payment on time for that purpose the firm should maintain adequate amount of cash balance that will permit it to make the required payments on time.

iii. Depositing Collections The funds on amount in hand is always better to have bills receivable because cash is always convertible immediately but bills receivables are convertible after the expiry of certain time limit so cash is easier to convert. So we can complete our transaction quickly with cash in comparison to bills receivable when funds are due from the bills receivables or from investments they should be converted into cash immediately to meet out the requirements of the cash.

2.6 FACTORS DETERMINING CASH MANAGEMENT How much cash should be held by the business can be determined on different factors if a business is capable of borrowing easily and quickly then the amount of cash it require should be reduced. The business holds assets

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which can be easily convertible into cash, the amount of cash hold can be reduced. But business must have as much as required to meet out unexpected transactions and contingencies when they occur and to meet out daily needs. Different types of businesses will have different policies on the amount of cash which should be held.

2.7 FACTORS AFFECTING CASH LEVEL Following are the factors that affect the level of cash to be maintained in the businessi. Credit standing of the Business The need of cash balance is directly affected by the credit standing of the business in the market. If credit rating of the business is good then lower cash balance will be sufficient because the business can borrow easily from the market. So excess amount of cash balance is not required.

ii. Collection Policy If the collection policy adopted by the business is effective and impressive, the business will receive cash from time to time on a regular basis and the amount of bad debts will be reduced. So there will be less requirement for holding the cash on the other hand if the collection policy is not effective and business not able to receive the dues from customers on the regular basis then heavy amount of cash balance will be required.

iii. Production Process If production process is lengthy then higher amount of cash balance will be required to meet out its expenses but when the production process of

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short nature and consumes less time then lower cash balance will be sufficient.

iv. Production Policy If the production policy of the business is to produced according to the present demand and quantity of raw materials to be purchased according to present demand, the business has to maintain lower amount of cash.

v. Terms of Sale and Purchase If the business gets raw materials at easy terms and conditions and also able to sell finished goods either for cash or on credit for shorter duration then less amount of cash will be required. vi. Nature of the Business Some businesses such as public utilities for example Water supply companies, Gas companies, Railways, Electricity Companies, Road & Transport companies, Communication department may have sufficient cash in flows. This will enable to hold lower cash balances but if the business is seasonal then the business have to maintain higher amount of cash balance. vii. Availability of Opportunities When it is expected to receive profitable opportunity it may not be wise to hold a large cash balance but if opportunities are not good then suitable amount of cash balance is required.

viii. Economic Conditions -

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If the economy of the country and economic policies of the Government are suitable and beneficial for the business then business is required to maintain less cash balance. So incase of inflation the business should maintain lower cash balances but in case of deflation it is required to maintain higher amount of cash balance.

PRACTICAL QUESTIONS:ILLUSTRATION:- 1 From the following information, prepare a Cash Budget for the period of January to April: Months January February March April Cash sales 60,000 50,000 70,000 60,000 Rs. 45,000 72000 60,000 56,000

In January a machine will be purchased for Rs. 40000; Wages will be paid Rs. 18000 every month; Cash balance expected on Ist January Rs. 10000 it has been decided by the management that: (a) bank. (b) In case of deficit exceeding Rs. 10000 but upto Rs. 50000 debentures will be issued in multiples of Rs. 10000. In case of deficit upto Rs. 10000 arrangement can be made with the

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(c)

In case of deficit exceeding Rs. 50000 the shares will be issued in multiples of Rs. 20000.

Solution:Opening Balance Salaes for 4 months Total Less cash purchases for 4 months Purchases for machine Wages(18000*4) Rs. 10000 2,40000 250000

233000 40000 72000 345000 Deficit 95000 As deficit is more than Rs. 50000shares will be issued for Rs. 1,00,000 which is multiple of Rs. 20,000. Cash budget (for 4 months ended April 20) Months Jan. Feb. Mar. Cash balance Rs. Rs. Rs. opening 10000 67000 27000 Receipts Issue of 1,00000 _ _ shares Cash sales 60000 50000 70000 Total 1700000 117000 97000 Payments Purchases of 40000 _ _ machine Cash 45000 72000 60000 purchases Payment of 18000 18000 18000 wages Total 103000 90000 78000 Cash balance 67000 27000 19000 closing

Apr. Rs. 19000 _ 60000 79000 _ 56000 18000 74000 5000

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Illustration 2:From the following forecast, prepare a cash budget for three months commencing from Ist June cash balance on Ist June was Rs. 50000: Months Sales Purchases Wages Expenses Rs. Rs. Rs. Rs. April 80000 41000 6000 12000 May 75000 45000 5000 15000 June 78000 40000 6000 18000 July 90000 37000 5000 20000 August 85000 35000 5000 18000 1. 2. 3. 4. 5. Payment from debtors is received after two months. Payment to creditors is made after one month. Wages and expenses are paid in the same month. A machine costing is Rs. 65000 will be purchased in August. Dividend of Rs. 15000 will be paid in July.

Solution:Cash budget (for three months ending on August 20) June July August Rs. Rs. Rs. 50000 61000 56000 80000 75000 78000 130000 45000 6000 18000 136000 40000 5000 20000 134000 37000 5000 18000 65000

Months Cash balance opening Receipts Collection from debtors Total Payments Payments to creditors Payment of wages Payment of expenses Purchase of

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machine Pay of dividend Total Cash balance closing Illustration 3:-

69000 61000

15000 80000 56000

125000 9000

If a firms annual expenses are Rs. 60 Lakhs and period of cash cycle is 25 days. The firm maintains cash ratio of 10% of working capital. If working days in a year are taken as 300, then how much of cash balance will be required?

Solution:Cash turnover Working days in a year / Period of cash cycle = 300 / 25 = 12 days.

Working capital required = Cash expenses per annum / Cash turnover period = 60 Lakhs / 12 = Rs. 5 Lakhs Cash balance required = 10% of 5.0 Lakhs = Rs. 0.5 Lakhs Or Rs. 50000.

2.8 CASH FORECASTING AND BUDGET The Principal tool of Cash Management is Cash Budgeting or shortterm Cash Forecasting. Usually the time chosen for making short-term forecasts for preparing cash budgets is taken to be one year. For the purpose

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of better monitoring and control, however the year is divided into quarters, quarters into months and months into weeks. Under critical conditions a week is further divided into days.

Cash Budget becomes a part of the total budgeting process under which other budgets and statements are prepared. The information generated during the preparation of Operating Budgets such as Sales Forecasts, Wages and Salaries, Manufacturing expenses, overheads etc. will become useful. While the Operating Budgets are prepared based on the principal of accrual, Cash budget is concerned with Cash inflows and outflows.

Short-Term cash forecasting is prepared under the Receipts and Payments Method, showing the time and magnitude of the expected Cash Receipts and Payments.

2.9 STATEMENT SHOWING BASIS FOR ESTIMATION OF CASH RECEIPTS AND PAYMENTS Items of Cash Flow Cash Sales Collections Credit Sales Basis of Estimation Sales Forecast. The proportion of Cash Sales and Credit Sales are based on averages of recent past. from Same as above along with past collection pattern unless there is a policy change to depart from past practices

Proceeds from sale of Based on the past proportion of these items to sales scrap and/or byproducts Receipts of Interest Based on Company's Investment Portfolio and the and Dividends returns expected.

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Increase in Long- Based on the Capital Expenditure budget and the Term Loans, Public Financing Plan Deposits and other long-term securities Sale of Assets Payments Purchases Based on the Proposed Disposal of Assets for Purchases planned based on Sales Forecast, anticipated changes in the Inventory of Raw Materials, Stores & Spares, proportion of Cash and Credit Purchases as well as the payment pattern based on past practice.

Wages and Salary Based on the Payroll Accounts of the Previous Year Payments with suitable adjustments, manning pattern and the structure of Wages and salaries along with prerequisites. Payments for other Based on the production Plan and the Past Manufacturing experiences Expenses Payments for Selling Based on the Sales Promotion Plans, Distribution & Distribution Costs, and Salary Structure of the personnel in the expense Marketing Dep't. , Interest Payment and Based on the existing structure of Fixed Return Repayment of Loans Bearing Securities and the Financing Plan. Payment Dividends of Based on the projected after Tax Profit and the Dividend pay-out policy followed

Payments for the Based on the capital expenditure budget and the purchase of Capital payment pattern. Assets Lease Rentals Taxes Based on the terms under which the Capital Equipment was taken on Lease. Based on the estimated pre-tax profit

Initially it will be useful to prepare a work-sheet containing items of Cash inflows and outflows and the net cash flows. At this state, one can have

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an idea of cash by scrutinizing the pattern and the amount of Inflows and outflows to see whether some of the items of outflows can either be advanced or postponed so that the outflows are not clustered during certain months. This is possible only with discretionary payments, such as, payment for the purchase of capital equipment, non-recurring items of outflows for Research and Development activities etc. While these are important, no significant impact on the profitability of the company is likely to be felt if these items of Cash outflows are differed by a couple of Months.

2.10 FACTORS FOR EFFICIENT CASH MANAGEMENT Cash reports help in monitoring actual data for comparison with the budgeted amounts, understating the reasons for the deviation between the two and in the light of this knowledge, controlling and revising the budget on a regular basis. The efficiency of Cash Management can be enhanced considerably by keeping a close watch and controlling a few important factors briefly described and illustrated below:-

Prompt Billing and Mailing A time lag occurs from the date of dispatching goods to the date of preparing Invoice documents and mailing the same to the customers. If this time gap can be minimized early remittances can be expected, otherwise remittances get delayed.

In the case of an organization it was observed that the time lag was as high as one week. Subsequently scrutiny revealed that the reason for the

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delay was the practice of preparing bills and mailing them in 'bunches'. As a result the bills on the earlier sales got delayed resulting in late realization. Once the reason for the delay was identified, corrective measures were taken to prevent the accumulation of the bills. This reduced the delay in remittances. Thus accelerating the process of preparing and mailing bills will help reduce the delay in remittances and early realization of Cash.

Collection of Checks and Remittance of Cash Delay in the receipt of checks and depositing the same in the bank will inevitably result in delayed Cash realization. This delay can be reduced by taking measures to hasten the process of collecting and depositing/cash from customers. An Illustration will help understand how this can be achieved.

Illustration An organization having branches in all districts of California had been selling fertilizers to a great extent by a vast network of consignees receiving a margin for the services rendered. Quite often the consignees would make remittances to the head office in Los Angeles resulting in delays in Cash realization. An in-depth study revealed that the delays could be considerably reduced by adopting the following procedure:The consignee should be asked to prepare the Invoice on Credit Sales which would cut-short the work of raising separate bills Non-Operating Collection accounts had to be opened in the district level branches of the head office bank into which the checks and cash from sales are to be deposited by the consignees, under advice to the branch Manager. The amounts so deposited are to be transferred to the

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main bank account of the head office telegraphically, under advice to the head office. The Branch Managers/their assistants should make occasional visits to the bank branches as also to the consignees for ensuring compliance with the instructions issued. The above practice considerably reduced the delay in receipts with a resultant decrease in the incidence of Interest on the Cash Credit Account of the Head Office.

2.11

CENTRALIZED

PURCHASES

AND

PAYMENTS

TO

SUPPLIERS The company can gain some advantages, as listed below, when purchases and payments to suppliers are centralized at the head office: By the sheer size of purchases there is scope to obtain bulk purchase discounts on certain items which will effectively reduce the cost As Cash Receipts get consolidated at the Head Office, the disbursement schedule can be more effectively implemented. As far as possible, the company can make arrangements with suppliers so that the payment schedule matches with the schedule of the Cash Receipts. As far as possible, the cash receipts on purchases can be utilized, preferable by remitting checks on the last day for utilizing such facility. This will release the Cash within the Discount Period and the company can also avoid the implicit rate of Interest underlying the failure to avail Cash Discount, as this rate will be considerably high. Under the centralized purchase system, arrangements can be made with the suppliers for direct shipment of materials to the Company's units located at different parts. This will reduce to some extent the total Cost of Transportation, Handling and Storage.

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A company never keeps all the cash in its current account for the simple reason that the opportunity cash of Idle Cash is very high. That is why, companies try to maintain, besides cash, other liquid assets which provide some return but at the same time can be converted into cash within a reasonably short time with relatively low risk.

The various forms of Liquidity in which a firm can keep its cash are:Forms of Liquidity

1.

Cash Balance in the Current Account This is the highest form of Liquidity Asset a company can conceive

of, but the return provided by it is Nil. However, companies maintain approximately four to five percent of their total assets, on the average, in this form.

2.

Keeping Reserve Drawing Power under Cash Credit/Overdraft

Arrangement This form of Liquidity appears to be quite attractive as it can have access to bank borrowing. However, constraints imposed by the Banking Sector made it much less attractive than what it once used to be. Close scrutiny of the quarterly budgets of the companies by banks and imposition of penal Interest of 2 per cent over and above the normal rate of Interest on under- or over-utilization makes this form more tedious and time consuming. However, a built-in cushion may possibly be included while preparing the quarterly budgets and during some periods the full amount may be drawn.

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The tax benefit on the Interest makes effective after tax rate to be much less costly, even if part of it is held in the form of Idle Cash. This not only helps as a Liquid Source but also helps in obtaining equal or higher limits during the forthcoming years.

3.

Marketable Securities These are short-term securities of government such as treasury bills

and other Gilt edged securities whose default risk is nil and, for that very reason, the return is low. It is preferable to ensure the maturity structure of these short-term securities with the likely period of excessive drain on the part of the company. Then, the transaction costs can be considerably minimized as early liquidation prior to maturity may result in low return from these assets.

4.

Investment in Inter-Corporate Deposits A company can invest money with other companies in the form of

short-term deposits ranging from two to three months to five or six month at remunerative rates. However, these deposits being unsecured in Nature are subject to considerable risk, unless the companies accepting such deposits have excellent antecedents to their paying habits.

From among the different forms of liquidity available to a company a deliberate choice has to be made in selecting an appropriate mix that suits the liquidity requirements of the company and disposition of its management towards risk.

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2.12 CASH MANAGEMENT CONTROL The task of controlling the Cash Balance at various points of time is the responsibility of the Finance Manager. This task assumes special importance on account of the fact that there is generally a tendency amongst the divisional managers to keep cash balance in excess of their needs. Hence, financial managers must devise a system whereby each division of an organization retains enough cash to meet its day-to-day requirements without having surplus balances on hand. To attain this, various methods have to be employed so as to:a) b) Speed up the mailing time of payments from customers Reduce the time during which payments received by the firm remain

uncollected and speed up the movement funds to disbursement banks.

Two very important methods to speed up the collection process are:1. 2. 1. Concentration Banking Lock-Box System Concentration Banking In Concentration Banking, the company establishes a number of strategic collection centers in different regions instead of a single collection centre at the head office. This system reduces the period between the time a customer mails in his remittance and the time when the spendable funds with the company. Payment received by the different collection centers are deposited with their respective local banks which in turn transfer all surplus funds to the concentration bank of the head office. The concentration bank with which the company has its major bank account is generally located at the headquarters. Concentration banking is one important way of reducing the size of the float.

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2.

Lock-Box System Another means to accelerate the flow of the funds is a lock-box

system. With concentration banking, remittances are received by a collection centre and deposited in the bank after processing. The purpose of the lockbox system is to eliminate the time between the receipt of remittances by the company and its deposit in the banks. A lock-box arrangement usually is on regional basis which a company chooses according to its billing patterns. Before determining the regions to be used, a feasibility study is made of the possibility of checks that would be deposited under alternative plans. In this regard, operation research techniques have proved useful in the location of the lock-box sites.

Under this arrangement, the company rents the local post office box and authorizes its bank at each of the locations to pick up remittances in the boxes. Customers are billed with instructions to mail their remittances in the lock boxes. The bank picks up the mail several times a day and deposits the checks in the company's account. The checks may be micro-filmed for record purposes and cleared for collection. The company receives a deposit slip and lists all the payments together with any other material in the envelope. This procedure frees the company from handling and depositing the checks. The main advantage of the lock-box system is that the checks are deposited with the banks and get collected sooner than if they were processed by the company prior to its deposit. In other words, the lag between the time checks are received by the company and the time they are actually deposited in the bank is reduced.

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The main drawback of the Lock-Box system is its cost of operation. The bank provides a number of services in addition to usual clearing of checks require a compensation for them. Since the cost is directly proportional to the number of checks deposited, Lock box systems are usually not much proffered if the average remittance is small. The appropriate rule for deciding whether a lock-box system or Concentration Banking is profitable is simply to compare the added cost of the most efficient system with the marginal Income that can be generated from the released funds. If costs are less than the Income, the system is profitable, if not the system is not a profitable undertaking.

2.13 MANAGEMENT OF SUNDRY DEBTORS The Finance Manager has an operating responsibility for the management of investment in receivables. On addition to his role of administration of credit, the finance Manager is in a particular, strategic position to contribute to the top Management decisions relating to the best credit policies of the firm.

The basic objective of the management of sundry debtors is to optimize the return on Investment on this asset. It is obvious that if there are large amounts tied up in Sundry Debtors, Working Capital Requirements and consequently Interest charges will be high. Also, in such a case, the bad debts and the cost of collection of debts would be high. On the other hand, if the Investment in sundry debtors is low, the sales may be restricted since the competitors may offer more liberal terms. Therefore, the management of sundry debtors is an important issue and requires proper policies and efficient execution of such policies.

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2.14 ASPECTS OF MANAGEMENT OF DEBTORS There are basically three aspects of Management of Sundry Debtors:a) Credit Policy: - The determination of the Credit Policy involves a

trade-off between the profits on additional sales that arise due to the credit being extended on one hand and the cost of carrying those debtors' bad debt losses on the other. b) Credit Analysis: - this requires the Finance Manager to determine as

to how risk would it be to advance credit to a particular party. c) Control of Receivables: - this requires the Finance Manager to follow

up the Debtors and decide about a suitable Credit Policy. It involves both laying down the credit policies and the cost of execution of such policies.

There is also a cost of Maintaining the receivables which comprises of the following:1. Additional Funds Required for the Company When a firm maintains the receivables, some of the firm's resources remain blocked in them because there is a time lag between the Credit sale to customer and the receipt of Cash form them as Payment. To the extent that the firms resources are blocked in its receivables it has to arrange additional finance to meet its own obligations towards its creditors and employees, like payments for purchases, salaries and other production and administrative expenses. Whether this additional finance is met form its own resources or from outside, it involves a cost to the firm in terms of Interest (if financed from outside) or the opportunity costs (If Internal resources, they could have been put to some other use).

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2.

Administrative Cost When a company maintains its receivables, it has to incur additional

administrative expenses in the form of salaries to the clerks who maintain records of Debtors, expenses on investigating the Credit Worthiness of Debtors etc.

3.

Collection Costs These are the costs which the firm has to incur for collection of

amounts at the appropriate time form the customers.

4.

Defaulting Costs When the customers make default in payment, not only is the

collection effort to be increased but the firm may also have to suffer losses from the bad debts.

2.15 OPTIMAL CASH MODELS Given the overall transactions and precautionary balances, the finance manager of a firm would like to consider the appropriate balance between cash and marketable securities. This is because optimal levels of cash and marketable securities would reduce and minimize the costs such as Transaction Costs, Inconvenience Costs and Opportunity Costs. The following two models are used in determining the optimum level of Cash:1. 2. Inventory Model Stochastic Model

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Inventory Model If the future cash flows are known with certainty, the EOQ model (used in Inventory Management) is one of the simplest models for determining the optimal average amount of transaction cash. Here, in this model, the opportunity (carrying) cost of holding cash is balanced against the fixed costs associated with securities transactions to arrive at an optimal balance.

By using the EOQ formula, the firm attempts to determine the funds transfer size that will minimize the total cash costs, i.e. total transaction cost and the total carrying (opportunity) costs.

Total Cost = transaction Cost + Carrying (Opportunity Cost) This cost can be represented as: - F (T/C) + I (C/2) Where, F = Fixed Transaction Cost associated with a transaction T = Total Demand for Cash over the specified period I = Interest Rate on Marketable securities for the period C = Cash Balance for the period

In the above formula, T/C reflects the number of transactions during the period. If we multiply T/C with F that is, fixed cost per transaction, we will get the total fixed cost for the period. C/2 implies the average level of cash balance over the period of time involved and when it is multiplied with the Interest rate (I), we will obtain the total carrying (opportunity) cost. From the above equation, we conclude that the larger the C or C/2, the smaller would be the transaction cost [F (T/C)] and the higher the

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opportunity cost [I (C/2)]. Balancing the two costs can minimize the total costs. The optimal level of cash can be determined using the underlying equation:
C= 2FT / I

Stochastic Models Since the EOQ Model assumes a constant demand for Cash, this Inventory model becomes inappropriate when the cash flows of the firms are relatively or reasonably unpredictable, and some other models must be applied to determine the optimal cash balances. If the cash balances fluctuate randomly, we can apply control theory to the problem. To apply, assume that the cash flows are stochastic and random, and then set control limits such that when the cash balance touches the upper bound, a conversion of cash into marketable securities is undertaken and when it approaches the lower bound, a transfer from Marketable securities to cash is activated. And, no transactions take place as the cash balance remains within these bounds.

Here, the question is how to fix these boundaries such that they should depend upon both the fixed costs of a transaction and the opportunity cost of holding cash. For determining these limits, the Miller-Orr Model is used. This model specifies two bounds- h dollars as an upper bound and zero dollars as a lower bound.

When the cash balances hit the lower bound (zero dollars), z dollars of marketable securities are transferred to cash, and the new balance again

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becomes z dollars. And, as long as the cash balance stays within the bounds, no transaction is undertaken. Miller-Orr Model reduces the total fixed transaction cost and the total opportunity cost by setting these bounds. However, the average Cash Balance recommended by the Control limit models will be higher than that of the EOQ model, as these models assume that the cash flows are stochastic and unpredictable.

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MODULE TWO END CHAPTER QUIZES

1. Which of the following investments have no default risk? a. Inter corporate deposits b. Treasury Bills c. Commercial papers d. money market mutual funds

2. Which of the following assumes paramount importance for investing surplus cash by a firm:a. Yield b. Liquidity c. Tax shelter d. Security

3. In a broader sense, cash includes a. Notes and coins b. Bank balance c. Bank drafts d. All of the above

4. Which of the following is not a motive for holding cash:a. Transaction purposes b. Precaution against unexpected expenses c. Extending loans to group companies

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d. speculation purposes

5. Which of the following is not the motive for the companies to hold cash? a. Transaction motive b. Precautionary motive c. Speculative motive d. Capital investments

6. Cheques that have been deposited may not be immediately available for use due to a. collection float b. payment float c. Net float d. Deposit float

7. Float denotes the a. Difference between bank balance and the balance shown in the firms books b. An instrument expedite cash inflows c. difference between cash inflows and outflows d. both a and b

8. Cash management does not call for a. Lengthening creditors period b. Lengthening receivables period c. Investing surplus funds d. Nullyfying idle funds

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9. Holding cash balance to pay for the purchases made is a. An indication of the pre cautionary motive b. An implication for the transaction motive c. A motivation due to the speculative motive d. Caused by lack of synchronization between cash inflows and out flows

10. In a broader sense, cash may include a. Notes and coins only b. Notes, coins and deposits in a bank c. Notes, coins deposits in a bank and drafts only d. Notes, coins deposits in a bank, drafts cheques and highly liquid marketable securities

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MODULE THREE 3. MANAGEMENT OF RECEIVABLES

3.1 INTRODUCTION Accounts receivables play an important role in constituting Current Assets. Receivables are the direct consequences or result of credit sale. Credit sales is an important part of a business, without it no business can survive. Every individual customer is not willing to purchase goods in cash. If a business has a policy of selling goods in cash only, it will not be possible to attract the customers, so the credit sale has become very essential and effective tool of marketing in this modern business. When a business sells goods for cash, the business receives the payment immediately and therefore receivables are not generated. However when a firm sells goods or services on credit, the payments are delayed for some times and receivables are created. Usually the credit sales are made on open account which means that no formal acknowledgement of debt obligations are taken from the buyers. The only documents evidencing are a purchase order, shipping invoice or even a billing statement. The policy of open account sales facilitates the business transactions and reduces to a great extent the paper work required in credit sales. If a business concern sells its goods or services only for cash so only those customers will purchase the goods who are capable of purchasing goods for cash. So the other customers will not purchase from the business who want to purchase at present but interested in making payments in future. Most of the retail traders purchase goods on credit and would like to pay after some time. So credit sales have become an important requirement today. Credit

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sale is now must in all types of businesses whether it is a trading business, whether it is a manufacturing concern or a business supplying services. Generally a firm grants trade credit to protect its sales from its competitors and to attract the customers to buy their products. Receivable are asset accounts representing amounts owed to the firm as a result of sale of goods or services in the ordinary course of business. They, therefore, represent the claims of a firm against its customers and are carried to the asset side of a balance sheet under titles such as accounts receivable, trade receivables, customer receivables or book debts. They are as stated earlier, the result of extension of credit facilities to the customers. The objective of such facility is to allow the customers a reasonable period of time in which they can pay for the goods purchased by them.

3.2 OBJECTIVES OF RECEIVABLES When ever the goods are sold on credit basis to the customers the payments becomes due from the customers. The main objectives of the receivable are i. To enhance the salesIf goods are not sold on credit to the customers then it will effect our total sales, so the total sales will be less. Therefore, to increase the sales is the main objective of credit sales. If receivables have not been created, the production will be less on the one hand, and on the other hand the cost of production per unit will be higher, so to increase the volume of production and to attract huge number of customers it is very important to sell goods on credit and create receivables. ii. To face Competition-

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The present age is the age of competition various types of schemes are applied by the business to increase its sale. To sell goods on credit and allowing trade discount is one of the schemes. Today the other business units are selling goods on credit, so we have to also sell our goods on credit in order to face competition.

iii. To attract the customersIn todays environment we can only attract the public by selling goods on credit and allowing them a reasonable period for payment.

iv. To increase the profitCredit sales always increases the total sales and decreases the cost of production, as a result the profit of the business increases. In addition to its cash sales is made at cheaper rate due to discount, while higher prices and received from credit sales due to not allowing discount, which is help full in increasing the profit.

3.3 RECEIVABLE MANAGEMENT Receivable are a direct result of credit sales. Credit sales is resorted to by a firm to push up its sales which ultimately result in pushing up the profits earn by the firm. At the same time, selling goods on credit result in blocking of funds in accounts receivable, Additional funds are, therefore, required for the operating needs of the business which involve extra costs in terms of interest. Moreover, increase in receivables also increases chances of bad debts. Thus, creation of accounts receivable is beneficial as well as dangerous.

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The financial manager has to follow a policy which uses cash fund as economically as possible in extending receivables without adversely affecting the chances of increasing sales and making more profits. Management of accounts receivable may, therefore, be defined as the process of making decisions relating to the investment of funds in the assets which will result in maximizing the overall return on the investment of the firm.

3.4 OBJECTIVES OF RECEIVABLE MANAGEMENT The object of receivables management is to achieve the trade off between risk and profitability. The aim of receivables management is neither to maximize the sales nor to reduce the risk of bad debts actually the object of receivable management is to increase the sales to such an extent that the risk of bad debt is reasonable and with in control. As in case of any business decision, an effective receivables management should do the cost benefit analysis. The costs involved in the receivables management are in the form of credit administration costs, costs of bad debts and opportunity costs of funds blocked in receivables. An effective receivables management policy tries to increase the credit sales in such an extent that the profit arising there from are more than the costs attached to it. According to S.E. Bolten The objectives of receivables management is to promote sales and profits until that point is reached where the return an investment in further funding or receivables is less than the cost of funds raised to finance that additional credit i.e. cost of capital.

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Following are the objectives of receivable management:i. ii. iii. iv. v. To create an essential part of competitive business. To create additional source of finance through accounts receivable. To measure the effective handling of accounts receivables. To Promote international trade transactions. To ensure the adequate flow of cash from trade debtors to meet

current obligations. vi. To take the maximum advantages of trade discount and cash discount

facilities. vii. To create a written proof about debt obligations.

viii. To facilitate liberal credit transactions. ix. x. xi. xii. To aim at a weigh the benefit against risk or cost. To maintain adequate liquid capital of the firm. To settle trade debts without loss. To achieve the target return on investments.

xiii. To achieve the objectives or goals of the organization. xiv. xv. To ensure credit worthiness or financial soundness of the concern. To minimize the cost and risk involved in trade credit planning and

control. xvi. To increase the volume of sales.

3.5

ADVANTAGES

OR

BENEFITS

OF

RECEIVABLE

MANAGEMENT The main advantages or benefits of receivable management can be enumerated as follows :-

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i.

Credit sales helps to attract the existing customers but also to new

customers in the ordinary course of business. ii. It gives the guidance to the management for effective financial

planning and control. iii. iv. v. vi. It ensure higher investment in trade debtors will produce larger sales. It helps to increase the operating profits because of more credit sales. It facilitates adequate working capital to meet its current obligations. It helps to make effective co-ordination between finance, production,

sales, profit and cost. vii. Credit policy helps to meet the competition.

viii. Liberalized credit policy helps to increase the growth of sales. ix. It helps to minimize bad debts without taking stringent measures.

3.6 STEPS INVOLVED IN THE MANAGEMENT OF RECEIVABLE When an enterprise offer to sell its goods or services on credit, it must think of seriously about the following :i. ii. To which customer the enterprise is prepared to offer credit? What factors should be taken in to account while analyzing the

customers who are interested to purchase goods on credit? iii. iv. What collection policies should be adopted? What should be the system of monitoring and controlling the

receivables accounts? The following steps are involved in considering the preceding matters in the case of receivable management:i. Credit analysis ii. Credit standards

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iii. Credit terms iv. Collection Policies v. Control and Monitoring i. Credit AnalysisNo enterprise can sell goods on credit blindly to each and every customer. It has to evaluate and examine the ability of the customers whether he can make the payment at the time as per promise or not. If an enterprise ignores the analysis of customers financial position and his status, it finds itself in trouble because adequate resources may not be generated to meet the daily requirements fund. Therefore, an analysis of those risks which may arise on account of non-payment or late payment, must be undertaken before granting credit facilities to the customers. Credit analysis involves the study of three aspectsi.a- Collection of information about the customers ii.b- Analysis of collected information iii.c- Decision on the basis of analysis

i-(a)- Collection of information about the customersBoth financial as well as qualitative type of information are needed relating to customers. There are various sources of information available to the enterprise to help in assessing the financial health of a customer. (a)- Financial statementsThese are published accounts containing the Profit and Loss Account and Balance Sheet. In the case of corporate bodies, these accounts are available for public inspection and provide useful information. (b)- Trade Reference-

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Some enterprises may request the potential customers to furnish them with reference from other suppliers who have had dealings with them. This may be externally useful provided the references supplied are truly representative of the opinions of a customers supplies. (c)- Bankers EnquiriesIt is possible to ask the potential customers for a bank reference. Although banks are usually prepared to oblige the contents of such a reference are not always very informative. If customers are in financial difficulties the bank may be unwilling to add their problems by supplying poor reference.

(d)- Market ReportsRelevant and valuable information can also be collected from the market reports. Such reports are prepared in such a way that they contain meaningful data relating to the financial position and repaying ability as well as willingness to pay in respect of several customers.

(e)- Own experience of the concernThe enterprise may use its own experience in collecting information about the potential customers.

(f)- Other sources like Trade AssociationsCommercial Trade Directories, Public Documents etc. may also be used for collecting information about the customers.

i-(b)- Analysis of collected information -

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This analysis attempts to measure the credit worthiness of the customers as well as risk involved. One can guess about the credit worthiness of the customers on the basis of financial and non financial data. Normally, following six Cs are considered in analyzing the credit worthiness (a) Character (b) Capacity (c) Capital (d) Conditions (e) Cost (f) Collateral. i-(c)- Decision on the basis of analysisAfter making detailed analysis of the collected information, a decision is taken whether to grant credit to a customer in question or not. For this purpose, the assessed Credit worthiness of the customer is compared with the credit standards. If customers credit worthiness is lower than the credit standards of the enterprise, credit facility is not to be provided to him.

ii. Credit StandardsAn important component of credit policy is well defined credit standards. Such credit standards provide a base of for deciding whether to grant credit to a customer or not. Credit standards may be defined and explained in both conservatives or strict manner and aggressive or liberal manner. In the case of strict credit standards, credit facility is not granted to each and every customer. Enterprise, which do not like to take risk, usually follow strict standards. Alternatively, an enterprise may be very aggressive in taking the risks and they may follow a very liberal credit standards. But due to increased level of investment in receivables costs in terms of bad debts, collection expenses and administrative expenses also rise. Thus, profit arising due to additional sales must be compared with possible rise in costs associated with additional investments in receivables whenever a decision to liberalize the credit standards is being taken. So far

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as the profitability is more than the added cost, the enterprise can lower down i.e., liberalize the credit standards. The liberalized credit standards will affect :

ii-(a)- Collection costs ii-(b)- Average collection period ii.-(c)- Loss from bad debts ii-(d)- Change in the volume of Sales The likely effect on all these variables (items) may be explained as underii-(a)- Collection CostsLiberalized credit standards imply more credit, increase in the work load of the credit department and rise in collection efforts. Due to liberal credit standards, collection costs and other administrative costs would tend to rise. ii-(b)- Average collection periodWhen credit standards are made liberal, receivables rise due to increase in sales on the one hand and there is delay in collection from customer due to credit sales to below standard customers on the other hand. ii-(c)- Loss of Bad debtsDue to liberal credit standards, credit facilities are made available even to those customers, whose financial position or credit worthiness is bad and doubtful. As a result chances for bad debts increase. ii-(d)- Change in the volume of SalesAs pointed out earlier liberal credit standards may in crease the volume of sales and strict ones may reduce the sales volume. This change (increase or decrease) in turn affects the profit in a positive way.

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iii. Credit TermsAnother important decisional area in receivable management in term of credit which must be decided in advance. After analyzing the customers credit worthiness and setting up enterprises credit standards one has to determine the terms and conditions on which trade credit will be made available to the customers. Credit terms include the terms in which payment from receivable may be received and it has three variables or components iii-(a)- Credit period iii-(b)- Cash Discount iii-(c)- Cash Discount period

iii-(a)- Credit periodCredit period is the time for which an enterprise allows its customers not to pay their bills. It is length of credit period by the end of which enterprise expects that the customers would pay their bills. The extension of credit period also means more investment in receivables. It also increase credit period also means more investment in receivable. It also increase the average collection period and losses due to bad debts. iii-(b)- Cash DiscountAn enterprise may decide to offer a cash discount in order to encourage prompt payment from its customers, particularly when it finds itself short of cash resources and is facing liquidity problem. Cash discount offer does not affect the demand because it does not amount to reduction in price. Cash discount offer is only a mechanism. Through which some benefit is given to those customers who are ready to pay early. The policy of Cash discount would result in to loss of revenue to enterprise. However average collection period becomes due to quick

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collections lower collection period in turn would reduce the investment in receivables.

iii-(c)- Cash Discount Period A Cash Discount Period is the time period allowed to the debtors in which the debtors are encouraged to pay their dues and to avail the cash discount It is with in the time period of net credit days.

iv. Collection Policies Another aspect of receivable management is related to collection policy, which is basically concerned with the procedure to be followed in collection the accounts not realised with in the credit period allowed. The enterprise has to assess the chances of collecting the receivable by putting some efforts.

iv-(a)- Types of collection efforts Some efforts are to be taken to collect payment from those customers who do not pay within the time given. A good collection policy should always imply clear instruction regarding the steps and efforts to be taken. Such efforts may include dunning letters, telephone, personal visit, help from collecting agencies and ultimately legal action.

iv-(b)- Degree of collection effortsDegree of Collection efforts in one sense refers to the policy which is being adopted in pursuing credit policy i.e. whether conservative or aggressive. What is needed is to maintain a balance between two types of effect.

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v. Control and MonitoringOnce the business concern has set credit standards, credit terms and collection policies etc. It is important for the financial manager to control and monitor the effectiveness of the collection for this purpose some targets in terms of average collection period as well as ratios of bad debts to sales may be set up by the finance manager and he may monitor the receivables particularly the debtors with reference to there ratios.

3.7 FORMULATION OF CREDIT POLICY For the management of receivables the first task is to formulate the credit policy. This include the amount to be invested in receivables, what should be the terms of credit sales, in what time the payment is to made, benefit of cash discount for what period will be given etc.

The credit policy of a concern may be of two types: 1. Liberal credit policy- Under this policy the credit sales is made to customers on easy terms, credit is allowed for long period, the proportion of credit sales to total sales is much more(up to 90%) and thus a large amount is invested in the receivables. The quantity of bad debts in this policy is greater. 2. Strict credit policy- Under this policy the credit is allowed to customers after detailed examination, credit is allowed only for the short period, the credit sales is between 50% to 60% of total sales and thus the credit is allowed only to a small numbers of customers and for a short period. The

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amount of investment in receivables is very less under this policy and bad debts are also less.

Credit standards- On what grounds the credit will be allowed to a customer are fixed. For this detailed information about the customers who want credit purchases are gathered. A few standards may be fixed for this purpose. Upto what percentage of bad debt expectation, the credit sales is given to the customer.

3.8 HANDLING RECEIVABLES (DEBTORS)

Cash flow can be significantly enhanced if the amounts owing to a business are collected faster. Every business needs to know.... who owes them money.... how much is owed.... how long it is owing.... for what it is owed. Slow payment has a crippling effect on business, in particular on small businesses who can least afford it. If you don't manage debtors, they will begin to manage your business as you will gradually lose control due to reduced cash flow and, of course, you could experience an increased incidence of bad debt. The following measures will help manage your debtors:1. Have the right mental attitude to the control of credit and make sure that it gets the priority it deserves. 2. 3. Establish clear credit practices as a matter of company policy. Make sure that these practices are clearly understood by staff, suppliers and customers.

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4. ones. 5.

Be professional when accepting new accounts, and especially larger

Check out each customer thoroughly before you offer credit. Use credit agencies, bank references, industry sources etc.

6. 7.

Establish credit limits for each customer... and stick to them. Continuously review these limits when you suspect tough times are coming or if operating in a volatile sector.

8. 9. 10. 11. 12.

Keep very close to your larger customers. Invoice promptly and clearly. Consider charging penalties on overdue accounts. Consider accepting credit /debit cards as a payment option. Monitor your debtor balances and ageing schedules, and don't let any debts get too large or too old. Recognize that the longer someone owes you, the greater the chance you will never get paid. If the average age of your debtors is getting longer, or is already very long, you may need to look for the following possible defects: weak credit judgement poor collection procedures lax enforcement of credit terms slow issue of invoices or statements errors in invoices or statements customer dissatisfaction. Debtors due over 90 days (unless within agreed credit terms) should generally demand immediate attention. Look for the warning signs of a future bad debt. For example:longer credit terms taken with approval, particularly for smaller orders

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use of post-dated checks by debtors who normally settle within agreed terms evidence of customers switching to additional suppliers for the same goods new customers who are reluctant to give credit references receiving part payments from debtors.

The act of collecting money is one which most people dislike for many reasons and therefore put on the long finger because they convince themselves there is something more urgent or important that demand their attention now. There is nothing more important than getting paid for your product or service. A customer who does not pay is not a customer. Here are a few ideas that may help you in collecting money from debtors: Develop appropriate procedures for handling late payments. Track and pursue late payers. Get external help if your own efforts fail. Don't feel guilty asking for money.... its yours and you are entitled to it. Make that call now. And keep asking until you get some satisfaction. In difficult circumstances, take what you can now and agree terms for the remainder. It lessens the problem. When asking for your money, be hard on the issue - but soft on the person. Don't give the debtor any excuses for not paying. Make it your objective is to get the money - not to score points or get even.

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PRACTICAL QUESTIONS:Illustration 1: Prakash Ltd. sells goods to its customers of A, B and C categories and its current sales is Rs. 10,00,000 per year. If sale is made to customer of D category for 1.5 months credit, additional sales of Rs. 10,00,000 per year can be made. In such a case 10% bad debtors are expected. The company earns the contribution of 15% on the sales and collection cost is expected at 4%.if its cost of capital is 10%, should it make sales to customers of D category? Solution: Contribution 15% on additional sales of Rs. 10,00,000 Less expected bad debts (10% of Rs. 10,00,000) Balance Less collection charges (4% of Rs. 10,00,000) Balance Less cost of capital (10% of Rs. 106250) Expected loss 10625 Investment in receivables = (1000000*1.5/12)*(85/100) = Rs. 106250 Rs. 150000 1,00,000 50000 40000 10000

Illustration 2: Ashoka Ltd. provides credit to its customers for 30 days. Its present sales is Rs. 1000000 per year. The cost of capital of the company is 10% and variable cost is 80%of sales. Company is considering to extend credit period to 60 days, this will increase the sales by Rs. 500000 per year. The bad debt on additional sales is expected at 8% will be fair to extend the credit period? Solution: Contribution on additional sales: Rs.

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100-80=20%on Rs.500000 Less bad debts 8% of Rs. 500000 Balance Less cost of capital on additional investment: Additional investment in present sales10,00,000*80/100*30/360=Rs. 66,667 Additional investment in additional sales500000*80/100*60*360=Rs. 66667 Cost of capital=10/100(66667+66667)= Additional profit

100000 40000 60000

13333 466667

Illustration 3: From the following data ascertain the average collection period of Jai Prakash and brothers: Total annual sales Cash sales (include in above) Sales return during the year Sundry debtors (all the end of the year) Bills receivables Provision for doubtful debts Rs. 800000 60000 10000 86000 44000 6500

Solution: Annual credit sales =Total annual sales Cash sales sales return =800000-60000-10000=730000 Average collection period = Debtors + B/R/Annual credit sales *365 = 86000+44000/730000*365 =130000/730000*365=65 Days

Illustration 4: Calculate average collection period of a firm : Receivables on 1-1-2005

Rs. 45000

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Receivables on 31-12-2005 Annual credit sales

51000 438000

Solution: Average receivables Average daily credit sales =45000+51000/2= Rs. 48000 =438000/365= Rs. 1200

Average collection period =Average receivables/Average daily credit Sales = 48000/1200 =40 days

Illustration 5: The debtors of the company were Rs. 180000,Rs. 21000 and Rs. 230000 Respectively on 31st March, 2003,2004 and 2005. the sales during 2003-2004was Rs. 980000 and 2004-05 Rs. 1010000. You are required to calculate receivables turnover for two years and comment.

Solution: Average receivables for 2003-04 =180000+210000/2 =Rs. 195000 Average receivables for 2004-05 =210000+230000/2 = Rs. 220000 Receivables turnover for 2003-04 =980000/195000=5.0 times 2004-03 =1010000/220000=4.6 times

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MODULE THREE END CHAPTER QUIZES

1. Which of the following costs is not associated with the extention of credit and accounts receivables? a. Cost of investments tied up in accounts receivables b. collection cost c. Cost of measure initiated to collect blocked finds beyond expiry dates d. all are associated

2. Which of the following is not a cost linked with maintaining receivables:a. Cost of funds b. Discount costs c. Collection costs d. None of the above

3. The variable associated with credit policy are:a. Credit standards b. Credit periods c. Cash discount d. All of the above

4. Which of the following is not used for credit evaluation:a. Ratio analysis b. Bank references c. Past experiences with the customers

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d. None of the above

5. Which of the following is not a cost of marinating receivables:a. Administrative costs b. Collection costs c. Defaulting costs d. Marketing costs 6. Which of the following is not the Cs for judgeing credit worthiness of a customer a. Collateral b. Capacity c. Credibility d. Character 7. Which of the following is not a measure for monitoring receivable a. Collection matrix b. ABC system c. Days sales outstanding d. Ageing scheduled

8. Which of the following is not a credit policy variable or a non financial company? a. over draft limit b. Credit standard c. Collection program d. Cash discount

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9. Which of the following is objective of companies making credit sales? a. Increasing total sales b. Increasing profits as a result of increase in sales c. To ward off competition d. All of the above

10. Ignoring the time value of money, how much does a firm lose on a rupees 1000 sale that has a 25% profit margin if the 20% probability default occurs? a. Rs. 150 b. Rs. 600 c. Rs. 650 d. Rs. 750

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MODULE FOUR 4. MANAGEMENT OF CREDITORS

4.1 MANAGEMENT OF CURRENT LIABILITIES Balance sheet is an indicator of the financial position of a business concern in terms of assets and liabilities. Balance sheet is always prepared in such a way that the true and fair financial position of a business is revealed, which will be easily readable and more quickly understood form. Balance sheet represents the nature and value of assets of the business, the nature and value of all liabilities and residual in the form of owners fund. Today in this competitive age, only that enterprise can get success which is managing its current liabilities in a proper form. If the company is not properly arranging the amount to pay its current liabilities, its financial position can be said sound. The Balance sheet of each and every organization or enterprise includes various types of assets on one side and liabilities on the other side. Current assets and current liabilities of each organization play an important role in forming the working capital. Each organization is liable to pay its current liabilities within a year, so the organization has to manage its current liabilities and its payment in an effective manner.

4.2 CURRENT LIABILITIES In accounting, current liabilities are considered liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle, whichever period is longer. An operating cycle is the average time

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that is required to go from cash to cash in producing revenues. For example, accounts payable for goods, services or supplies that were purchased for use in the operation of the business and payable within a normal period of time would be current liabilities. Bonds, mortgages and loans that are payable over a term exceeding one year would be fixed liabilities or long-term liabilities. However, the payments due on the long-term loans in the current fiscal year could be considered current liabilities if the amounts were material. The proper classification of liabilities is essential when considering a true picture of an organization's fiscal health.

4.3 DIFFERNT CURRENT LIABILITIES Current Liability Amounts owed (within one year) for goods and services purchased on credit terms. This means payment for goods and services is due at a date later than the date of sale. Current liabilities can be classified as:Trade creditors, which is the name we give to amounts owed to suppliers. Accruals, which is the name we give to amounts still owed at the year end and not yet recorded in the books of account. Proposed items such as Dividends proposed, which means amounts the business promises to pay in the coming year. Payable items such as Tax payable which is payable within the coming year. Overdraft, which is amounts owed to the bank. Short term loans.

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Accounts Payable - The Most Popular Current Liability Accounts payable is the opposite of accounts receivable. It arises when a company receives a product or service before it pays for it. Accounts payable, or A/P as it is often shorthanded, is one of the largest current liabilities a company will face because they are constantly ordering new products or paying vendors for services or merchandise. Really well managed companies attempt to keep accounts payable high enough to cover all existing inventory, meaning that the vendors are paying for the company's shelves to remain stocked, in effect. Accrued Benefits and Payroll as a Current Liability This item in the current liabilities section of the balance sheet represents money owed to employees as salary and bonus that the company has not yet paid. Short Term and Current Long Term Debt These current liabilities are sometimes referred to as notes payable. They are the most important item under current liabilities section of the balance sheet and most of the time, they represent the payments on a company's bank loans that are due in the next twelve months. Borrowing money in itself is not necessarily a sign of financial weakness; an intelligent department store executive may work out short term loans at Christmas so she can stock up on merchandise before the Holiday rush. If demand is high, the store would sell all of its inventory, pay back the short term loans, and pocket the difference. This is known as utilizing leverage. The department store used borrowed money to make a profit. So how can you ever hope to tell if a company is wisely borrowing money (such as our department store), or recklessly going into debt? Look at

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the amount of notes payable on the balance sheet (if they aren't classified under 'notes payable', combine the company's short term obligations and long term current debt). If the amount of cash and cash equivalents is much larger than the notes payable, you shouldn't have any reason to be concerned. If, on the other hand, the notes payable has a higher value than the cash, short term investments, and accounts receivable combined, you should be seriously concerned. Unless the company operates in a business where inventory can quickly be turned into cash, this is a serious sign of financial weakness. Other Current Liabilities Depending on the company, you will see various other current liabilities listed. Sometimes they will be lumped together under the title "other current liabilities." Normally, you can find a detailed listing of what these "other" liabilities are buried somewhere in the annual report or 10k. Often, you can figure out the meaning of the entry by its name. If a business lists "Commercial Paper" or "Bonds Payable" as a current liability, you can be fairly confident the amount listed is what will be paid out to the company's bond holders in the short term. Consumer Deposits Are Liabilities to Banks If you are looking at the balance sheet of a bank, you will want to pay close attention to an entry under the current liabilities called "Consumer Deposits". Often, they will be will lumped under other current liabilities. This is the amount that customers have deposited in the bank. Since, theoretically, all of the account holders could withdrawal all of their funds at the same time, the bank must list the deposits as a current liability.

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4.4 TESTS OF A COMPANY'S FINANCIAL STRENGTH AND LIQUIDITY

The strength of every company depends upon many factors. Following methods of its valuation are as under:1. Working Capital: Current Assets - Current Liabilities 2. Working Capital per Dollar of Sales: Working Capital Total Sales 3. Current Ratio: Current Assets Current Liabilities 4. Quick / Acid Test / Current Ratio: Current Assets minus inventory called "Quick Assets) Current Liabilities 5. Debt to Equity Ratio: Total Liabilities Shareholders' Equity

4.5 CREDITORS A creditor is a party (e.g. person, organization, company, or government) that has a claim to the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption (usually enforced by contract) that the second party will return an equivalent property or service. The second party is frequently called a debtor or borrower. The first party is the creditor, which is the lender of property, service or money. The term creditor is frequently used in the financial world, especially in reference to short term loans, long term bonds, and mortgage loans. In law, a person who has a money judgment entered in their favor by a court is called a judgment creditor.

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The term creditor derives from the notion of credit. In modern America, credit refers to a rating which indicates the likelihood a borrower will pay back his or her loan. In earlier times, credit also referred to reputation or trustworthiness.

4.6 TRADE CREDIT Definition: An arrangement to buy goods or services on account, that is, without making immediate cash payment For many businesses, trade credit is an essential tool for financing growth. Trade credit is the credit extended to you by suppliers who let you buy now and pay later. Any time you take delivery of materials, equipment or other valuables without paying cash on the spot, you're using trade credit. When you're first starting your business, however, suppliers most likely aren't going to offer you trade credit. They're going to want to make every order c.o.d. (cash or check on delivery) or paid by credit card in advance until you've established that you can pay your bills on time. While this is a fairly normal practice, you can still try and negotiate trade credit with suppliers. One of the things that will help you in these negotiations is a properly prepared financial plan. When you visit your supplier to set up your order during your startup period, ask to speak directly to the owner of the business if it's a small company. If it's a larger business, ask to speak to the CFO or any other person who approves credit. Introduce yourself. Show the officer the financial plan you've prepared. Tell the owner or financial officer about your business, and explain that you need to get your first orders on credit in order to launch your venture.

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Depending on the terms available from your suppliers, the cost of trade credit can be quite high. For example, assume you make a purchase from a supplier who decides to extend credit to you. The terms the supplier offers you are two-percent cash discount with 10 days and a net date of 30 days. Essentially, the suppliers are saying that if you pay within 10 days, the purchase price will be discounted by two percent. On the other hand, by forfeiting the two-percent discount, you're able to use your money for 20 more days. On an annualized basis, this is actually costing you 36 percent of the total cost of the items you are purchasing from this supplier! (360 ( 20 days = 18 times per year without discount; 18 ( 2 percent discount = 36 percent discount missed.) Cash discounts aren't the only factor you have to consider in the equation. There are also late-payment or delinquency penalties should you extend payment beyond the agreed-upon terms. These can usually run between one and two percent on a monthly basis. If you miss your net payment date for an entire year, that can cost you as much as 12 to 24 percent in penalty interest. Effective use of trade credit requires intelligent planning to avoid unnecessary costs through forfeiture of cash discounts or the incurring of delinquency penalties. But every business should take full advantage of trade that is available without additional cost in order to reduce its need for capital from other sources. Trade credit for example, Wal-Mart, the largest retailer in the world, has used trade credit as a larger source of capital than bank borrowings; trade credit for Wal-Mart is 8 times the amount of capital invested by shareholders.

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There are many forms of trade credit in common use. Various industries use various specialized forms. They all have, in common, the collaboration of businesses to make efficient use of capital to accomplish various business objectives. For example:- The operator of an ice cream stand may sign a franchising agreement, under which the distributor agrees to provide ice cream stock under the terms "Net 60" with a ten percent discount on payment within 30 days, and a 20% discount on payment within 10 days. This means that the operator has 60 days to pay the invoice in full. If sales are good within the first week, the operator may be able to send a cheque for all or part of the invoice, and make an extra 20% on the ice cream sold. However, if sales are slow, leading to a month of low cash flow, then the operator may decide to pay within 30 days, obtaining a 10% discount, or use the money another 30 days and pay the full invoice amount within 60 days. The ice cream distributor can do the same thing. Receiving trade credit from milk and sugar suppliers on terms of Net 30, 2% discount if paid within ten days, means they are apparently taking a loss or disadvantageous position in this web of trade credit balances. Why would they do this? First, they have a substantial markup on the ingredients and other costs of production of the ice cream they sell to the operator. There are many reasons and ways to manage trade credit terms for the benefit of a business. The ice cream distributor may be well-capitalized either from the owners' investment or from accumulated profits, and may be looking to expand his markets. They may be aggressive in attempting to locate new customers or to help them get established. It is not on their interests for customers to go out of business from cash flow instabilities, so their financial terms aim to accomplish two things:

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1.

Allow startup ice cream parlors the ability to mismanage their investment in inventory for a while, while learning their markets, without having a dramatic negative balance in their bank account which could put them out of business. This is in effect, a short term business loan made to help expand the distributor's market and customer base.

2.

By tracking who pays, and when, the distributor can see potential problems developing and take steps to reduce or increase the allowed amount of trade credit he extends to prospering or faltering businesses. This limits the exposure to losses from customers going bankrupt who would never pay for the ice cream delivered.

4.6.i ADVANTAGES AND DISADVANTAGES OF TRADE CREDIT

ADVANTAGES OF TRADE CREDIT Following are the main advantages of trade credit:1. Reduced capital requirements, this means that if a new business setting up has trade credit, they will obviously require less money in capital to start up the business. This is a major advantage to someone who has very little money but has a good idea about starting a new business.

2. Trade credit with improve the cash flows and therefore provide smoother operation for the business. 3. Businesses can buy now and pay later which means even if they don't have the money at first they can purchase items, sell them as a business and then make the payments at the end of the month when the products have been sold and a profit has been made.

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4. Businesses can look to grow without having to worry of needing to make immediate payments which may set them back. 5. With trade credit, the business can focus on other areas such as sales, marketing and research rather than worrying about meeting targets just to have enough money to pay the bills.

DISADVANTAGES OF TRADE CREDIT 1. If repayments are not made by certain deadlines, the business will receive a poor credit history which will be a big blow to any business as they will not trusted in the future if they require any loans, trade credit, credit cards or leasing. 2. Only companies with a good credit history will get trade credit and these can often be hard to build up, especially for new businesses.

4.7 CURRENT LIABILITIES MANAGEMENT Spontaneous Liabilities Spontaneous liabilities arise from the normal course of business. The two major spontaneous liability sources are accounts payable and accruals. As a firms sales increase, accounts payable and accruals increase in response to the increased purchases, wages, and taxes. There is normally no explicit cost attached to either of these current liabilities.

Spontaneous Liabilities: Accounts Payable Management

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Accounts payable are the major source of unsecured short-term financing for business firms.

The average payment period has two parts: The time from the purchase of raw materials until the firm mails the payment. Payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds from the firms account

The firms goal is to pay as slowly as possible without damaging its credit rating.

Spontaneous Liabilities: Analyzing Credit Terms

Credit terms offered by suppliers allow a firm to delay payment for its purchases. However, the supplier probably imputes the cost of offering terms in its selling price. Therefore, the firm should analyze credit terms to determine its best credit strategy. If a cash discount is offered, the firm has two optionsto take the cash discount or to give it up.

Taking the Cash Discount If a firm intends to take a cash discount, it should pay on the last day of the discount period.

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There is no cost associated with taking a cash discount. Giving Up the Cash Discount If a firm chooses to give up the cash discount, it should pay on the final day of the credit period. The cost of giving up a cash discount is the implied rate of interest paid to delay payment of an account payable for an additional number of days.

Giving Up the Cash Discount

Giving Up the Cash Discount

Cost % Discount 365 100% - % Discount Credit Period - Discount Period Cost 2% 365 100% - 2% 30 10 37.24%

Giving Up the Cash Discount

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The preceding example suggest that the firm should take the cash discount as long as it can borrow from other sources for less than 37.24%. Because nearly all firms can borrow for less than this (even using credit cards!) they should always take the terms 2/10 net 30.

Spontaneous Liabilities: Effects of Stretching Accounts Payable

Stretching accounts payable simply involves paying bills as late as possible without damaging credit rating. This can reduce the cost of giving up the discount.

Spontaneous Liabilities: Accruals

Accruals are liabilities for services received for which payment has yet to be made. The most common items accrued by a firm are wages and taxes. While payments to the government cannot be manipulated, payments to employees can. This is accomplished by delaying payment of wages, or stretching the payment of wages for as long as possible.

Spontaneous Liabilities: Accruals

Accruals are liabilities for services received for which payment has yet to be made. The most common items accrued by a firm are wages and taxes.

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While payments to the government cannot be manipulated, payments to employees can. This is accomplished by delaying payment of wages, or stretching the payment of wages for as long as possible.

Unsecured Sources of Short-Term Loans: Bank Loans

The major type of loan made by banks to businesses is the shortterm, self-liquidating loans which are intended to carry firms through seasonal peaks in financing needs.

These loans are generally obtained as companies build up inventory and experience growth in accounts receivable. As receivables and inventories are converted into cash, the loans are then retired. These loans come in three basic forms: single-payment notes, lines of credit, and revolving credit agreements. Loan Interest Rates. Most banks loans are based on the prime rate of interest. which is the lowest rate of interest charged by the nations leading banks on loans to their most reliable business borrowers.

Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrowers riskiness.

Fixed & Floating-Rate Loans On a fixed-rate loan, the rate of interest is determined at a set increment above the prime rate and remains at that rate until maturity.

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On a floating-rate loan, the increment above the prime rate is initially established and is then allowed to float with prime until maturity. Like ARMs, the increment above prime is generally lower on floating rate loans than on fixed-rate loans.

Unsecured Sources of Short-Term Loans: Commercial Paper Commercial paper is a short-term, unsecured promissory note issued by a firm with a high credit standing. Generally only large firms in excellent financial condition can issue commercial paper. Most commercial paper has maturities ranging from 3 to 270 days, is issued in multiples of $100,000 or more, and is sold at a discount form par value. Commercial paper is traded in the money market and is commonly held as a marketable security investment.

Unsecured Sources of Short-Term Loans: International Loans

The main difference between international and domestic transactions is that payments are often made or received in a foreign currency A U.S.-based company that generates receivables in a foreign currency faces the risk that the U.S. dollar will appreciate relative to the foreign currency.

Likewise, the risk to a U.S. importer with foreign currency accounts payables is that the U.S. dollar will depreciate relative to the foreign currency.

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Secured Sources of Short-Term Loans: Characteristics

Although it may reduce the loss in the case of default, from the viewpoint of lenders, collateral does not reduce the riskiness of default on a loan.

When collateral is used, lenders prefer to match the maturity of the collateral with the life of the loan. As a result, for short-term loans, lenders prefer to use accounts receivable and inventory as a source of collateral. Depending on the liquidity of the collateral, the loan itself is normally between 30 and 100 percent of the book value of the collateral. Perhaps more surprisingly, the rate of interest on secured loans is typically higher than that on comparable unsecured debt. In addition, lenders normally add a service charge or charge a higher rate of interest for secured loans.

Secured Sources of Short-Term Loans

The Use of Accounts Receivable as Collateral Pledging accounts receivable occurs when accounts receivable is used as collateral for a loan. After investigating the desirability and liquidity of the receivables, banks will normally lend between 50 and 90 percent of the face value of acceptable receivables.

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In addition, to protect its interests, the lender files a lien on the collateral and is made on a non-notification basis (the customer is not notified).

The Use of Accounts Receivable as Collateral Factoring accounts receivable involves the outright sale of receivables at a discount to a factor. Factors are financial institutions that specialize in purchasing accounts receivable and may be either departments in banks or companies that specialize in this activity.

Factoring is normally done on a notification basis where the factor receives payment directly from the customer. The Use of Inventory as Collateral The most important characteristic of inventory as collateral is its marketability. Perishable items such as fruits or vegetables may be marketable, but since the cost of handling and storage is relatively high, they are generally not considered to be a good form of collateral.

Specialized items with limited sources of buyers are also generally considered not to be desirable collateral. The Use of Inventory as Collateral A floating inventory lien is a lenders claim on the borrowers general inventory as collateral. This is most desirable when the level of inventory is stable and it consists of a diversified group of relatively inexpensive items. Because it is difficult to verify the presence of the inventory, lenders generally advance less than 50% of the book value of the average inventory and charge 3 to 5 percent above prime for such loans.

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The Use of Inventory as Collateral A trust receipt inventory loan is an agreement under which the lender advances 80 to 100 percent of the cost of a borrowers relatively expensive inventory in exchange for a promise to repay the loan on the sale of each item.

The interest charged on such loans is normally 2% or more above prime and are often made by a manufacturers wholly -owned subsidiary (captive finance company).

Good examples would include GE Capital and GMAC. The Use of Inventory as Collateral A warehouse receipt loan is an arrangement in which the lender receives control of the pledged inventory which is stored by a designated agent on the lenders behalf.

The inventory may stored at a central warehouse (terminal warehouse) or on the borrowers property (field warehouse). Regardless of the arrangement, the lender places a guard over the inventory and written approval is required for the inventory to be released.

Costs run from about 3 to 5 percent above prime.

4.8 WORKING CAPITAL CYCLE & ROLE OF CREDITORS IN WORKING CAPITAL CYCLE INTRODUCTION The working capital cycle can be defined as:-

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The period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a customer. The diagram below illustrates the working capital cycle for a manufacturing firm:-

The upper portion of the diagram above shows in a simplified form the chain of events in a manufacturing firm. Each of the boxes in the upper part of the diagram can be seen as a tank through which funds flow. These tanks, which are concerned with day-to-day activities, have funds constantly flowing into and out of them. The chain starts with the firm buying raw materials on credit. In due course this stock will be used in production, work will be carried out on the stock, and it will become part of the firms work in progress (WIP)

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 Work will continue on the WIP until it eventually emerges as the finished product As production progresses, labour costs and overheads will need to be met Of course at some stage trade creditors will need to be paid When the finished goods are sold on credit, debtors are increased They will eventually pay, so that cash will be injected into the firm Each of the areas stocks (raw materials, work in progress and finished goods), trade debtors, cash (positive or negative) and trade creditors can be viewed as tanks into and from which funds flow.

Working capital is clearly not the only aspect of a business that affects the amount of cash: The business will have to make payments to government for taxation Fixed assets will be purchased and sold Lessors of fixed assets will be paid their rent Shareholders (existing or new) may provide new funds in the form of cash Some shares may be redeemed for cash Dividends may be paid Long-term loan creditors (existing or new) may provide loan finance, loans will need to be repaid from time to time, and Interest obligations will have to be met by the business. Unlike movements in the working capital items, most of these non-working capital cash transactions are not everyday events. Some of them are annual events (e.g. tax payments, lease payments, dividends, interest and, possibly, fixed asset purchases and sales). Others (e.g. new equity and loan finance and redemption of old equity and loan finance) would typically be rarer events.

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The role of trade creditors in the working capital cycle is very important as they put a huge impact on the amount of working capital, which will be available for the business. As the trade creditors will increase, amount availability of working capital will reduce in the business.

4.9 CREDIT RISK IN A BUSINESS Credit risk is the risk of a loss resulting from the debtor's failure to meet its obligations to the Bank in full when due under the terms agreed. Credit risk has the highest weight among risks taken by the Bank in the course of its banking activities. Credit risk management in the Bank is carried out using the following main procedures:putting in place limits for operations to limit credit risk; putting in place indicative limits for credit risk concentration and the share of unsecured loan portfolio; creation of security for credit operations; setting value conditions for operations with respect to payment for risks taken; permanent monitoring of risks taken and preparation of management reporting for the Credit Committee, the Bank's management and units concerned; evaluation of regulatory and economic capital necessary to cover the risks taken in respect of the Bank's operations and ensuring its sufficiency; carrying out hedging operations; permanent internal control over the Bank's units in respect of observing regulations on operations procedure and risk assessment and management procedures by independent units.

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The Bank's risk management envisages: 1. applying systematic approach to overall Bank's loan portfolio risk management and separate operations (group of with certain related

borrowers/counterparties borrowers/counterparties);

2. applying unified methodology for identification and quantitative assessment of credit risk which is adequate to the nature and scale of the Bank's operations; and 3. balanced combination of centralized and decentralized decisionmaking in respect of operations related to taking credit risk. The main tool to restrict and control the credit risk taken by the Bank is the credit limit system. The following types of credit risk limits are put in place: counterparty limits; limits for independent risk-taking by the Bank's branches; and credit risk limits by countries/industries/regions. Credit risk limits are determined by the Credit Committee and approved by the Bank's Management Board (in case the Credit Committee does not have the required authority). A part of authorities for putting credit limits in place is delegated to Branch Credit Committees (for standard credit operations within the special limit for independent credit risk-taking by branches), as well as to the Small Credit Committee and the Moscow Region Credit Committee (for medium-sized and small customer lending).

Along with its internal credit risk limits, the Bank observes the mandatory requirements established by the Bank of Russia in terms of risk size by borrower/group of related borrowers (N6 ratio) and size of large loans (N7).

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Assessment of credit risk taken by the Bank for counterparty to determine limits is done on the basis of multifactor analysis with the use of rating system, and comprises analysis of the following aspects:specific risks related to the shareholder structure of the counterparty; market positioning of the counterparty; credit capacity and financial standing of the counterparty; possible impact of limit-setting on the financial standing and performance of the counterparty; economic acceptability of the proposed security to ensure proper coverage of the counterparty's obligations to the Bank; acceptability of value conditions; background of the counterparty's relations with the Bank, including operations implying credit risk-taking by the Bank; impact of limit-setting for the counterparty on the level of industry, region and country risks taken by the Bank; and impact of limit-setting on liquidity risk, market risks (interest risk, currency risk, price risk, if any), and reputation risk.

The most important tool to minimize credit risks taken by the Bank is the creation of security for credit operations. The Bank's policy in this sphere is based on the principle of forming a reliable and liquid security portfolio, sufficient to cover the credit risks taken by the Bank. At the same time, it does not lift the requirement to conduct due diligence of the borrower and does not compensate for the insufficient payment and credit capacity of the borrower or lack of information on its business.

The following items can be accepted as security:

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real estate mortgage, pledge of inventory, equipment, receivables, securities, precious metals; guarantees and sureties. Property is accepted as pledge if there are no legal restrictions determined in the course of liquidity and market value assessment (as a rule, conducted by an independent assessor satisfying the Bank's requirements), as well as verification of its safety. Besides, the Bank usually demands that the items pledged should be insured.

4.10 THE RISK OF TAKING OUT A LOAN (CREDIT) Loans are something that most people will need at some point in their lifetime. Whether it's for school or to get a car or even to get a home, there will be times when you will have to make a decision of whether or not to borrow money and go into debt in order to get what you want. Many people will make justifications that basically say it's always a good idea to take out a loan because you can always make money and pay it back. However, if you look at the stats on how many people actually owe money and are unable to pay it back, you might want to think twice. Before you take out any type of loan, you will want to weigh the risks. Just because it may seem like a good decision at the time, it doesn't necessarily mean that it is. Let's take education as an example. Most people who go through college will need to take out some amount of a loan. The amount will depend on what school you go to as well as what degree you are going after. On the surface, one would think that going into debt in order to get an education is one of the best investments you can make. In general, it is. Without a degree, a lot of opportunities will be closed to you. Many

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companies won't even look at your resume unless you have a college degree. However, this doesn't mean that it's always the best decision. In many cases, depending on the loan amount, it may be better to just put off the decision until a later time or to get the money by other means. Most people want the good life. They want the nice cars and the big homes. They want to be able to go on luxury vacations and there's nothing wrong with these things but if you are not in a position to do so with extra money that you saved up, then it's probably not a good idea to owe more money than you have to just because you want some temporary satisfaction. Every loan you take out is a responsibility that can follow you for years, many times decades. Therefore, before even thinking about getting a loan, you will want to look at all other options in term of financing what you want but at the same time, you will also want to consider delaying it. There's nothing wrong with working a few years for example, in order to save up some money to finish college.

4.11 LETTERS OF CREDIT Letters of credit accomplish their purpose by substituting the credit of the bank for that of the customer, for the purpose of facilitating trade. There are basically of two types:A. Commercial and B. Standby. The commercial letter of credit is the primary payment mechanism for a transaction, whereas the standby letter of credit is a secondary payment mechanism.

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A. COMMERCIAL LETTER OF CREDIT Commercial letters of credit have been used for centuries to facilitate payment in international trade. Their use will continue to increase as the global economy evolves. Letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The general provisions and definitions of the International Chamber of Commerce are binding on all parties. Domestic collections in the United States are governed by the Uniform Commercial Code. A commercial letter of credit is a contractual agreement between a bank, known as the issuing bank, on behalf of one of its customers, authorizing another bank, known as the advising or confirming bank, to make payment to the beneficiary. The issuing bank, on the request of its customer, opens the letter of credit. The issuing bank makes a commitment to honor drawings made under the credit. The beneficiary is normally the provider of goods and/or services. Essentially, the issuing bank replaces the bank's customer as the payee.

ELEMENTS OF A LETTER OF CREDIT A payment undertaking given by a bank (issuing bank) On behalf of a buyer (applicant) To pay a seller (beneficiary) for a given amount of money On presentation of specified documents representing the supply of goods Within specified time limits

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Documents must conform to terms and conditions set out in the letter of credit Documents to be presented at a specified place Beneficiary The beneficiary is entitled to payment as long as he can provide the documentary evidence required by the letter of credit. The letter of credit is a distinct and separate transaction from the contract on which it is based. All parties deal in documents and not in goods. The issuing bank is not liable for performance of the underlying contract between the customer and beneficiary. The issuing bank's obligation to the buyer, is to examine all documents to insure that they meet all the terms and conditions of the credit. Upon requesting demand for payment the beneficiary warrants that all conditions of the agreement have been complied with. If the beneficiary (seller) conforms to the letter of credit, the seller must be paid by the bank.

Issuing Bank The issuing bank's liability to pay and to be reimbursed from its customer becomes absolute upon the completion of the terms and conditions of the letter of credit. Under the provisions of the Uniform Customs and Practice for Documentary Credits, the bank is given a reasonable amount of time after receipt of the documents to honor the draft. The issuing banks' role is to provide a guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due and to examine the documents, and only pay if these documents comply with the terms and conditions set out in the letter of credit. Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill and an insurance

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document; but there are many others. Letters of credit deal in documents, not goods.

Advising Bank An advising bank, usually a foreign correspondent bank of the issuing bank will advise the beneficiary. Generally, the beneficiary would want to use a local bank to insure that the letter of credit is valid. In addition, the advising bank would be responsible for sending the documents to the issuing bank. The advising bank has no other obligation under the letter of credit. If the issuing bank does not pay the beneficiary, the advising bank is not obligated to pay.

Confirming Bank The correspondent bank may confirm the letter of credit for the beneficiary. At the request of the issuing bank, the correspondent obligates itself to insure payment under the letter of credit. The confirming bank would not confirm the credit until it evaluated the country and bank where the letter of credit originates. The confirming bank is usually the advising bank.

4.11.i FEATURES OF LETTER OF CREDIT 1. Negotiability Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are passed freely from one party to another almost in the same way as money. To be negotiable, the letter of

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credit must include an unconditional promise to pay, on demand or at a definite time. The nominated bank becomes a holder in due course. As a holder in due course, the holder takes the letter of credit for value, in good faith, without notice of any claims against it. A holder in due course is treated favorably under the UCC. The transaction is considered a straight negotiation if the issuing bank's payment obligation extends only to the beneficiary of the credit. If a letter of credit is a straight negotiation it is referenced on its face by "we engage with you" or "available with ourselves". Under these conditions the promise does not pass to a purchaser of the draft as a holder in due course.

2. Revocability Letters of credit may be either revocable or irrevocable. A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification. A revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a transaction that involves a revocable letter of credit, it serves as the advising bank. Once the documents have been presented and meet the terms and conditions in the letter of credit, and the draft is honored, the letter of credit cannot be revoked. The revocable letter of credit is not a commonly used instrument. It is generally used to provide guidelines for shipment. If a letter of credit is revocable it would be referenced on its face. The irrevocable letter of credit may not be revoked or amended without the agreement of the issuing bank, the confirming bank, and the beneficiary. An irrevocable letter of credit from the issuing bank insures the beneficiary that if the required documents are presented and the terms and

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conditions are complied with, payment will be made. If a letter of credit is irrevocable it is referenced on its face.

3. Transfer and Assignment The beneficiary has the right to transfer or assign the right to draw, under a credit only when the credit states that it is transferable or assignable. Credits governed by the Uniform Commercial Code (Domestic) maybe transferred an unlimited number of times. Under the Uniform Customs Practice for Documentary Credits (International) the credit may be transferred only once. However, even if the credit specifies that it is nontransferable or non assignable, the beneficiary may transfer their rights prior to performance of conditions of the credit.

4. Sight and Time Drafts All letters of credit require the beneficiary to present a draft and specified documents in order to receive payment. A draft is a written order by which the party creating it, orders another party to pay money to a third party. A draft is also called a bill of exchange. There are two types of drafts: sight and time. A sight draft is payable as soon as it is presented for payment. The bank is allowed a reasonable time to review the documents before making payment. A time draft is not payable until the lapse of a particular time period stated on the draft. The bank is required to accept the draft as soon as the documents comply with credit terms. The issuing bank has a reasonable time to examine those documents. The issuing bank is obligated to accept drafts and pay them at maturity.

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B. Standby Letter of Credit The standby letter of credit serves a different function than the commercial letter of credit. The commercial letter of credit is the primary payment mechanism for a transaction. The standby letter of credit serves as a secondary payment mechanism. A bank will issue a standby letter of credit on behalf of a customer to provide assurances of his ability to perform under the terms of a contract between the beneficiary. The parties involved with the transaction do not expect that the letter of credit will ever be drawn upon. The standby letter of credit assures the beneficiary of the performance of the customer's obligation. The beneficiary is able to draw under the credit by presenting a draft, copies of invoices, with evidence that the customer has not performed its obligation. The bank is obligated to make payment if the documents presented comply with the terms of the letter of credit. Standby letters of credit are issued by banks to stand behind monetary obligations, to insure the refund of advance payment, to support performance and bid obligations, and to insure the completion of a sales contract. The credit has an expiration date. The standby letter of credit is often used to guarantee performance or to strengthen the credit worthiness of a customer. In the above example, the letter of credit is issued by the bank and held by the supplier. The customer is provided open account terms. If payments are made in accordance with the suppliers' terms, the letter of credit would not be drawn on. The seller pursues the customer for payment directly. If the customer is unable to pay, the seller presents a draft and copies of invoices to the bank for payment. The domestic standby letter of credit is governed by the Uniform Commercial Code. Under these provisions, the bank is given until the close of the third banking day after receipt of the documents to honor the draft.

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MODULE FOUR END CHAPTER QUIZZES

1. Which of the following is/are spontaneous liability? a. Sundry creditors b. Salary accrued but not due c. Provision for payment of bonus d. All a, b and c

2. If the interest rate on long term debt is 18% p.a. and the tax rate is of the company is 35% the cost of debt is a. 10.70% b. 11.70% c. 12.85% d. 12.70%

3. If the cost of equity is 18% and the cost of debt is 15%, what would be the cost of capital at a tax rate of 30% and the debt equity ratio of 2:1? a. 13.50% b. 13.25% c. 12.50% d. 17.01%

4. Average payment period isa. 20 days b. 30 days

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c. 40 days d. 25 days 5. The net operating cycle of the firm is a. 91 days b. 100 days c. 117 days d. 87 days

6. If the current assets and current liabilities are Rs. 2000 lakhs and Rs. 1200 lakhs respectively, how much amount can be borrowed on a short term basis without reducing current ratio below 1.5? a. Rs. 400 lakh b. Rs. 1000 lakh c. Rs. 1200 lakh d. Rs. 1400 lakh

7. If average balance of sundry creditors is Rs. 75000 and annual credit purchases is Rs. 24 lakh, then average payment period(assume 360 days a year) is a. 5 days b. 8.25 days c. 11.25 days d. 14.50 days

8. What is the cash conversion cycle for the firm with a receivables period of 35 days, a payables period of 40 days and an inventory period of 55 days?

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a. 20 days b. 50 days c. 60 days d. 80 days

9. If credit term is 2/10 net 30, the cost of trade credit if payment is made after 10th day, but before 30th day of purchase is a. 2% b. 20% c. 36.73% d. 40%

10. With terms of 4/15, net 45, what is the implied interest rate foregoing a cash discount and paying at the end of the perioda. 25.63% b. 39.29% c. 50% d. 64.32%

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MODULE FIVE 5. INVENTORY MANAGEMENT

5.1 INTRODUCTION Inventory is the main component of working capital. Inventory is also known as stock and merchandise. The inventory means and includes the goods and services being sold by the firm and the raw materials or other components being used in the manufacturing of such goods and services. It also means the stock that has been kept for sale or consumption in the business. For the business concerns whose business is only purchase and sale of goods, the stock of goods kept for sale is called inventory and for the manufacturing concern the stock of raw materials, stock of work in progress and the stock of finished goods all are included in the inventory. In addition the other consumable material needed for production purposes known or stores, are also included in inventory. The raw material inventory contains items that are purchased by the firm from suppliers and are converted into finished goods through the manufacturing process. They are an important input of the final product. The work in progress inventory consists of items currently being used in the production process. They are normally partially or semi finished goods that are at various stages of production in a multi stage production process. Finished goods represent the final or completed products which are available for sale. As such a large quantum of fund is necessary to finance the required volume of inventory. Holding finished goods inventory ensures better customer services. As a matter of fact inventories are very important for the management as they have direct impact on the firms profit. The financial manager has the

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responsibility to ensure that inventories are properly monitored and effectively controlled.

5.2 CHARACTERISTICS OF INVENTORY The Characteristics of inventory are as follows :(i) Inventory ensure to maintaining undisturbed production and rates.

employment (ii) (iii)

Inventory provides production economies. Inventory requires valuable space and consumes taxation and

insurance charges. (iv) (v) Inventory as the physical stock of items of tangible assets. Inventories are the result of Many interrelated decisions and policies

with in an organization. (vi) Inventories are used in the Production process for the purpose of sale

in the business.

5.3 FUNCTIONS OF INVENTORY The important functions of inventories are as follows: (i) (ii) (iii) (iv) (v) (vi) It ensure continuity of supply of uniform quality goods. Inventories helps to achieve the objectives of the company. Inventories ensure optimum investment in materials. Inventories activised the market. Inventories help to prevent the excessive investment in material. It ensure continuous flow of production without any interruption

(vii) It provide maximum services and satisfaction to the customers. (viii) It helps in avoiding unnecessary wastage and losses.

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(ix)

Inventories make sure of the availability of all types of materials.

5.4 PURPOSE OF INVENTORY The purpose of holding Inventories is to allow the firm to separate the processes of purchasing, manufacturing, and marketing of its primary products. The goal is to achieve efficiencies in areas where costs are involved and to achieve sales at competitive prices in the market place. Within this broad statement of purpose, we can identify specific benefits that accrue form holding inventories.

1.

Avoiding Lost Sales Without goods on hand which are ready to be sold, most firms would

loose business. Some customers are willing to wait, particularly when an item must be made to order or is not widely available from competitors. In most cases, however a firm must be prepared to deliver goods on demand. Shelf stock refers to items that are stored by the firm and sold with little or no modification to customers. An automobile is an item of shelf stock. Even though the customers may specify minor variations, the basic item leaves a factory and is sold as a standard item. The same situation exists for many items of heavy machinery, consumer products, and light industrial goods.

2.

Gaining Quantity Discounts In return for making bulk purchases, many suppliers will reduce the

price of supplies and component parts. The willingness to place large orders may allow the firm to achieve discounts on regular prices. These discounts will reduce the cost of goods sold and increase the profits earned on a sale.

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3.

Reducing Order Costs Each time a firm places an order, it incurs certain expenses. Forms

have to be completed, approvals have to be obtained, and goods that arrive must be accepted, inspected and counted. Later, an Invoice must be processed and payments made. Each of thee costs will vary with the number of orders placed. By placing fewer orders, the firm will pay less to process each order.

4.

Achieve Efficient Production Runs Each time a firm sets up workers and machines to produce an item,

start-up costs are incurred. These are then absorbed as production begins. The longer the run, the smaller will be the costs to begin production of the goods.

These benefits arise because inventories provide a "buffer" between purchasing, producing and marketing the goods. Raw Materials and other Inventory items can be purchased at appropriate times and in proper amounts to take advantage of economic conditions and price incentives. The manufacturing process can occur in significantly long production runs and with prep-planned schedules to achieve efficiency and economies. The sales force can respond to customer needs and demand based on existing finished products. To allow each area to function effectively, inventory separates the three functional areas and facilitates the interaction among them.

5.

Reducing the risk of Production Shortages Manufacturing firms frequently produce goods with hundreds or

thousands of components. If any of these are missing, the entire production

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process can be halted, with consequent heavy expenses. To avoid starting a production run and then discovering the shortage of a vital Raw Material or other component, the firm can maintain larger than needed inventories

5.5 TYPES OF INVENTORY Every business concern may have different types of inventories. The import types of inventory are as follows :i Inventory of raw materials In manufacturing businesses different types of stock of raw materials may be found which are used at the time of production. It is very important for every business concern to hold reasonable quantity of raw material to avoid delay in the production process, as raw materials is a primary requirement for production process. ii Inventory of stores & spare parts These are called as the accessories which helps in the production process and serve like a tool in the production. The inventory of such type should be maintained in the business. iii Inventory of work in progress Sometimes in the manufacturing system it involves various types of products which are not raw materials as well as not finished goods. These are called as the stock of work in progress. This type of stock is known as work in progress inventory. If the production process is very lengthy and time taking it clearly suggest that the larger amount will be there for such stock.

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iv Inventory of finished goods Every type of goods which have been produced and not in the production process as well as ready for sale is called as inventory of finished goods. v Safety Inventory This type of stock is kept by the manufacturing concerns for safety point of view and when supplies are not good, the stock from safety inventory can be used. vi Flabby Inventory It contains the quality of finished goods raw material and of work in progress and stores, which is held due to poor working capital management in afficiate distribution. This type of inventory should be avoidable. vii. Normal Inventory It is the inventory which is maintained on the basis of production plan and economic order level. This type of inventory generally fluctuate with the change in production plan. viii. Profit making Inventory It includes all types of stock of raw material and of finished goods which are kept for realizing stock profits. This type of inventory should be discourage. ix. Excessive Inventory

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Some times an effective and efficient management should also have to hold excessive inventory. x. Consumables Envelops cleaning materials lubricates computer and photo copying paper brouchers etc. are used in many operations and usually treated as raw materials.

5.6 IMPORTANCE OR BENEFITS OF INVENTORY Inventory is an important part of any business and is an urgent asset which is used for sale and for producing goods. It contains and includes all goods and materials that are used in the production and distribution process. To smoothly run the business concern, we require some inventory on the other hand financial institutions and other service industries hold less inventory in their business. Generally inventory is stored in order to have goods available for sale or raw material for production specially in retail business inventory is vary important because it attracts the customers means if goods ready for sale are not kept in the business the business concern could loose the opportunity to sell the product. Only few customers could wait but others will move to another business in case of shortage of stock. Also we can get extra or higher discount at the times of purchase of material from the suppliers because they will offer higher discount if purchases are made in bulk. The business concern will not suffer with the problem of shortage of stock if sufficient quantity of stock is kept. The importance or benefits of inventory are -

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(i)

Inventory provides the favorable and good returns on the investments.

(ii) (iii) stock. (iv) (v)

Inventory allows the buyer to get the advantage of higher discount. Inventory protects the manufacturer of goods against fluctuations of

It protects from shortage of stock at the time of production process. Inventory protects from fluctuations in demand, delayed supply of

goods from the supplier, and in case of fluctuations.

5.7 NEED TO HOLD INVENTORIES Inventories are typically not end in themselves. What are then the main purposes which they serve? There are three needs or motives for holding inventories. i. Transaction Motives ii. Precautionary Motives iii. Speculative Motives i. Transaction Motives Transaction implies the total time of converting an intent into the material, after finalizing the order or processing the customers order in a marketing situation or setup time in manufacturing situation, producing the item, transporting the item and inspecting the item before taking into the warehouse. It is not generally possible to synchronize the inflow and outflow of the commodity in question completely. So inventories are held. In other words, it expresses the need to maintain inventories to facilitate production and sales operation smoothly. The cycle of production involves a steady and

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smooth flow of raw materials for conversion into finished product which is meant for sale and conversion into cash. ii. Precautionary Motives Precaution means safety or minimum stock as commonly understood in the industry. Inventories are held due to the usual inability to predict

demand exactly and the consequent need to maintain some kind of a safety margin. This occurs due to the inability to obtain instantaneous delivery of commodities without extra costs. In other words, it necessitates holding of inventories to guard against the risk of unpredictable change in demand and supply forces. iii. Speculative Motives The speculative element is more prominent in the case of sensitive commodities. Speculation could be due to non - availability of item as demand exceeds supply or fear of increase price levels in future, forcing the inventory controller to heard the stock. And also, when prices are rising or when there are expected changes in costs, profits many be made by holding inventories at the lower price untill the higher price obtains. In other words, it influences the decision to increase or reduce inventory levels to take advantages of price fluctuations.

5.8 INVENTORY MANAGEMENT Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash resources of a business. Insufficient stocks can result in lost sales, delays for customers etc.

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The key is to know how quickly your overall stock is moving or, put another way, how long each item of stock sit on shelves before being sold. Obviously, average stock-holding periods will be influenced by the nature of the business. For example, a fresh vegetable shop might turn over its entire stock every few days while a motor factor would be much slower as it may carry a wide range of rarely-used spare parts in case somebody needs them. Nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the components to be assembled on a particular today, arrive at the factory early that morning, no earlier - no later. This helps to minimize manufacturing costs as JIT stocks take up little space, minimize stockholding and virtually eliminate the risks of obsolete or damaged stock. Because JIT manufacturers hold stock for a very short time, they are able to conserve substantial cash. JIT is a good model to strive for as it embraces all the principles of prudent stock management. The key issue for a business is to identify the fast and slow stock movers with the objectives of establishing optimum stock levels for each category and, thereby, minimize the cash tied up in stocks. Factors to be considered when determining optimum stock levels include: What are the projected sales of each product? How widely available are raw materials, components etc.? How long does it take for delivery by suppliers? Can you remove slow movers from your product range without compromising best sellers? Remember that stock sitting on shelves for long periods of time ties up money which is not working for you. For better stock control, try the following:

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Review the effectiveness of existing purchasing and inventory systems. Know the stock turn for all major items of inventory. Apply tight controls to the significant few items and simplify controls for the trivial many. Sell off outdated or slow moving merchandise - it gets more difficult to sell the longer you keep it. Consider having part of your product outsourced to another manufacturer rather than make it yourself. Review your security procedures to ensure that no stock "is going out the back door !" Higher than necessary stock levels tie up cash and cost more in insurance, accommodation costs and interest charges.

The application of managerial functions on the basis of some management principles relating to inventory is termed as inventory management. The important managerial functions are planning, organising, directing, communicating, controlling and coordination. If we combine all the above managerial functions relating to inventory it may be called as inventory management so it clearly suggest that inventory management relates with the planning of inventory organisation of inventory. Direction to employees about inventory, communication of related information to the related employer about the inventory through a reasonable or correct medium of communication, controlling the inventory process and inspection of performance of employees about the inventory

management which includes their jobs, role and duties towards inventory management and coordination with employees in the field of inventory in management.

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In inventory management the quality, quantity and value of inventory is measured in terms of the above heads. So the main objective of inventory management is to plan for the correct or reasonable size of inventory which should be avoidable in the business over a period of time as well as according to the need, demand and nature of the product. The effective controlling of inventory basically depends upon proper management through organizing, planning and controlling. In inventory management we basically study about all types of goods, their nature, their quality, quantity status, inflow and outflow, etc. We study about the opening stock, closing stock, stock of raw material stock of work in progress, stock of finished goods, which are purchased and sold during a period of time from the business. So we can conclude that the inventory management is a scientific method or technique which analysis how, when, how much what and which type of goods should be purchased and sold in the business means the inflow and outflow of stock and their management also. In inventory management the effective measures are also taken to analysis that inventory has been manages correctly or not.

5.9 OBJECTIVES OF INVENTORY MANAGEMENT If inadequate inventory is there, it may result in shortage of sale, on the other hand the excessive quantity of inventory may block up our investment which will reduce the amount of working capital. In an effective management in terms of inventory is what requires in the business, so it is very important for every business concern to have experts in this particular field so that it can easily be analyzed about inventory management.

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Following are the main objectives of Inventory Management:(i) (ii) To minimize the fund in inventory. To ensure that raw material is available on time or at the time of

production. (iii) (iv) Sufficient quantity is available at the time of production. To ensure that the goods is available which is finished goods for

delivery to its customers. (v) Sufficient quantity of finished should be available to company with

the demand of its customers immediately. (vi) To protect with the delay in production process due to short age of

material. So a goods inventory management policy should ensure smooth and uninterrupted supply with out making unnecessary adjustment. The inventory management policy must be so that it can balance the requirement of inventory, for production as well as for customers.

5.10 IMPORTANCE OF INVENTORY MANAGEMENT From the following point of view the efficient management of inventory is essential:i. To check the misuse of capital Materials should be kept in the store only in reasonable quantity so that the excess capital is blocked in it, because there will be a possibility of decrease in profit. But this does not mean that the stock of material is so little maintained that sometimes the production work is stopped or the customer of finished goods returns without purchases.

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ii. Continuity in production The inventory is so managed that production work continues without obstacle for this minimum stock level, maximum stock level, ordering level, danger level etc. Should be determined after making estimate per day and minimum and maximum lead time taken in receiving ordered goods. iii. Proper storage of materials All types of materials should be kept in the store safely according to A,B, C classification so that there is neither wastage of material or theft of material and no chance of fire should be there, the quantity of materials may be checked at , any time and all records regarding materials are properly maintained. iv. Maximum profits If the stock of material and finished goods is neither less nor more than needs, production continues. Continuously, not more then required investment in stock will be made and sales will continue and there will be no loss due to wastage and finally the profit will be maximum.

5.11 TECHNIQUES OF INVENTORY MANAGEMENT Techniques of inventory management to can be explained in two approaches :i. Traditional approach In this approach various levels of inventory can be compared from time to time between companies relating to the same industry or with in the same company over a period of time this is based on that principal that

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comparison is very important for selling standards which can be used in analyzing the efficiency in inventory management. Different Ratios are used to analyze whether material and stores are over purchased or not, production control is defective and finished goods are slow moving. These ratios can be viewed as an important indicator of efficiency in the management and control of raw materials work in progress inventory and finished goods inventory. Higher the ratio is the shorter the average time between investment in a particular type of inventory. Quick up the turnover is greater the profitability. On the other hand if the ratio is low it can be viewed or an angle of danger which may happen due to excessive inventory and defective purchasing.

ii. Modern or scientific approach The following techniques under scientific approach method are being used to manage the inventory properly:ii.- (a) Economic Order Quantity Analysis. ii.- (b) Re order Point. ii.- (c) Safety Stock ii.- (d) A.B.C. Analysis ii.- (e) F.S.N. Analysis. ii.- (f) H.M.L. Analysis. ii.- (g) V.E.D. Analysis. ii.- (a) Economic Order Quantity Analysis Any business can obtain the material or goods in two ways which is required by the business, the first way that it can adopt is that it can purchase the total quantity require for the whole year only one time and can keep that

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quantity in its godown or ware house. The second thing is that it can purchase the required material in small quantity through out the year. The above study explains that if the business concern purchases the total quantity only once. It will increase the carrying cost of holding. But on the other hand the purchase of total quantities in small units will increase the ordering cost due to frequent order. So it is effective to place orders or that quantity and quality of materials or goods where carrying cost and ordering cost can be balanced to minimize the total cost of inventory. This is a cost of inventory where. We can same money in terms of cost. This quantity of stock are inventory is called as economic order quantity. So economic order quantity relates to the size of the order which provides maximum economy or saving in purchasing or acquiring any type of material. The economic order quantity can be determined after taking into consideration the following costs :(a) Ordering Cost The ordering costs, basically known as the acquisition of and the set up costs, which is paid by the business concern, when the order is placed. The ordering cost of we know the name indicates the costs which varies depeding upon the number of orders given, issued from time to time. If number of orders increase, the cost of order will also increase. The opposite aspect of it that if the firm is placing ben orders then ordering cost will comparatively small. (b) Carrying CostThe cost which is paid to keep the inventory in stock. The carrying cost relates to the management and maintenance of inventory. This cost can be divided into four parts. Storage cost, servicing cost, cost of deterioration, opportunity cost. The carrying cost and the cost of ordering although are two

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opposites terms but collectively the level of inventory is calculated with the help of these two costs. Storage cost basically covert expenses like insurance, depreciation on handling plants machinery and other equipments rent of ware house or godown. On the other hand serving cost refers to the cost of labour handling inventory, cost of record keeping and other clerical cost. Cost of deterioration includes theft of goods and loss by fire. Where as opportunity cost means the loss of income or revenue which a business concern would have earned by the investment in inventory. The economic order quantity analysis is very much useful for the business as it is helpful in providing all the valuable and required information regarding the quantity which should be ordered, number of orders. Decisions regarding inventory can be taken easily through this method. ii.- (b) Re-order Point When we have decided the order quantity, it is then important to decide when the next order will be made. This problem is solved by determining the re order lable. So re order liable or re-order point tells when a new order for goods or material should be placed if the business has sufficient quantity of inventory available in stock and apart from that it is still placing the new order this will definately increase the carrying cost of inventory. If the business is placing order stock is very low, the fear of to be out of stock increase but the carrying cost will be low. So when inventory reaches to a point where carrying cost and fear of shortage of stock or out of stock tend to be equal, order should be placed. This level of stock is called or reorder point. The reorder level depends upon the minimum stock level or safety stocks, procurement time or lead time, daily usage of inventory. Re- order point can be calculated as follows -

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12-

R.O.P. = E + [S x L] - When safety stock is there R.O.P. = S x L When E = Safety stock

S = Overage use or consumption per day/ per month/per week. L = Lead time ( in days, months weeks. ) ii.-(c) Safety Stocks Safety stock is known as minimum stock. If the demand increases suddenly at that time safety stock is used to fulfill that demand. The question that arises when talking about safety stock is that what should be the appropriate level of stock. If it is viewed from cost consideration the optimum level of safety stock is the result of stock out cost and carrying cost. The objective should be to reduce the total cost. The safety stock can be calculated by applying the following formula. Safety stock = Average usage of stock x period of safety stock. ii.-(d) A.B.C. analysis techniques A.B.C. analysis is a technique of excercising selective control over inventory items. This technique is basically related with the assumption that a firm should not adopt the same type of control on all types of items of inventory. The controlling should be based upon the price are cost of the product and its demand which means the control should be greater over those items which are more costly are compared to those items which are less costly. This technique assumes the basic theory of Vital Few Trivial Many while considering inventory structure of any type of business and is popularly known as Always Better Control. A.B.C. analysis is also called as control by importance and exception which means in this method the

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control on inventory is made in those areas where attention is required most in terms of amount of investment, inventory or of consumption. It has been generally observed that only a few numbers of items are more important. This technique classify the various inventory items according to their value, price and importance. A class inventory consists of only small % of total number of items but are very important in nature. Where as B class items includes relatively less important items and C class items consists of very large number of items which are very less important. Category A - In this category material which are more valuable are included. Generally the quantity of this category is between the range of 5% to 10% of total weight of all the materials but their value is approximately between the range of 70% to 75%. These material are kept under lock and the key is kept by the store keeper and if the quantity is kept by falls short the store keeper is held responsible. Category B - For example papers, oils, chemicals, cement, spare parts, colour, etc. are included in this category the quantity of these materials in the business is generally between 20% to 30% of total quantity and the value between 15% to 20% of total value of all the materials. These materials are put in different lines in the store. Normal control is required on this category of material. Category C - This type of category contains a list of cheap and heavy material such as coal, chalk, lime, wood, water, coal etc. These are generally not put in the store or godown but are kept out side the store. Not a necessary control is required on this type of inventory, means a very little control is required on it. The quality of this category of goods is generally between the range of 65% to 70% of total quantity of all the materials, while their value is only 5% to 10% to total value of all the materials.

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There is no definite procedure available for classifying the inventory into A,B,C, because it depends upon the large number of factors, such as nature and varities of items, their requirements and their importance and demand in the business. But apart from that the following method have been adopted1- The value and quantity of each material is always expected to be used in a period is estimated. 2- The items of the materials are multiplied with their quantity and price. 3- The items are then arranged in the descending order of their values. 4- Total of all the values is taken then. 5- It will be found that a small number of first few items may amount to a large% of total value of the items. To categorized A.B.C. items all the items are to be ranked in the descending order of their usage value. ii.-(e) F.S.N. Classification This method classifies the items on the basis of their movement so a movement analysis is done based on the consumption of these items. It classifies the movements of all the items as items fast moving, slow moving and items which are non moving. Due to the rapid change in the technology and in other factors. This type of classification will have to be updated. For example, If any item which is available but had not been issued at all in the past few years it may be placed in the non moving class, if any tiems which had been issued upto ten times it may be put in the slow moving class and in the case where items has been issued more then ten times, can be put into fast moving class.

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ii.-(f) H.M.L. Classification This method is just like A.B.C. analysis but although the unit value of the item is considered and consumption value of items is not considered in this method. The material are classified according to their prices which can be high medium or low. The main emphasis in this classification is directed to control the unit prices of high value items. ii.-(g) V.E.D. and V.E.I.N. Classification This classification considers how inventory components are critical. This classification is very much suitable to machinery spare parts and loose tools which have a different behaviour. Here the criticality means the vital, essential and desirable behaviour of the component. This approach tells that there may be a chance of closer of a business of or industry if vital material is not available means vital material should be available in the business in sufficient quantity. However in case of essential parts little bit of risk can be taken in stocking these items. Stocking of desirable itmes can be neglected. As we have studied so far in V.E.D. analysis of spare parts, the machineries can also be classified and studied according to vital essential, important and normal features.

5.12 ROLE OF INVENTORY IN WORKING CAPITAL Inventories are a part of the firm's working capital and, as such, represent a Current Asset of the firm. Some of the characteristics that are important in the broad context of the Working Capital Management include: -

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1.

Current Asset It is assumed that the Inventories will be converted into Cash in the

Current Accounting Cycle, which is normally, one year. In some Cases, this is not entirely true, for example, a winter may require that the wine be aged in casks or bottles for many years. Or, a manufacturer of fine pianos may have a production process that exceeds one year. In spite of these and similar problems, we will view all Inventories as being Convertible into Cash in a single year.

2.

Level of Liquidity Inventories are viewed as a source of near Cash. For most of the

products this description is accurate. At the same time, most firms hold some slow-moving items that may not be sold for a long time. With economic slowdown or changes in the market for goods, the prospects for sale of the entire product lines may be diminished. In these cases, the liquidity aspects of Inventories become highly important to the Manager of Working Capital. At a minimum, the analyst must recognize that inventories are the least liquid of Current Assets. For firms with highly uncertain operating environments, the analyst must discount the liquidity value of the Inventories significantly.

3.

Liquidity Lags Inventories are tied to the firm's pool of working capital in a process

that involves three specific lags, namely:a) Creation Lag:-In most cases, the Inventories are purchased on Credit,

creating an account payable. When the Raw Materials are processed in the factory, the Cash to pay production expenses is transferred at future times,

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perhaps a week, a month or so. Labor is paid on payday. The utility that provided the electricity for manufacturing is paid after it submits the bill. Or for goods purchased for Resale, the firm may have 30 or more days to hold the goods before the payment is due. Whether manufactured or purchased, the firm will hold inventories for a certain time period before the payment is made. This Liquidity Lag offers a benefit to the firm.

b)

Storage Lag:-Once goods are available for resale, they will not be

immediately converted into Cash. First, the time must be sold. Even when sales are moving briskly, a firm will hold Inventory as a back-up. Thus, the firm will usually pay its suppliers, Workers, and overhead expenses before the goods are actually sold. This lag represents a cost to the firm.

c)

Sale Lag:-Once the goods have been sold, they normally do not create

cash immediately. Most Sales occur on Credit and become Accounts Receivable. The firm must wait to collect its Receivables. This lag also represents a cost to the firm.

4.

Circulating Activity Inventories are in a rotating pattern with other current assets. They get

converted into receivables which generate the much needed cash and invested again in Inventory to continue the operating cycle.

INVENTORY COSTS The effective Management of Inventory involves a trade off between having too little and having too much Inventory. In achieving this trade off,

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the Finance Manager should realize that the costs may be closely related. To examine inventory from the cost side, four categories of costs can be identified of which two are direct costs that are immediately connected to buying and holding goods and the last two are indirect Costs which are losses of Revenues that vary with different Inventory Management Decisions.

The various costs associated with holding Inventories are:-

1.

Ordering Costs Any manufacturing organization has to purchase Materials. In that

event the ordering costs refer to the costs associated with the preparation of purchase requisition by the user department, preparation of the purchase order and follow up measures taken up by the purchase department, transpiration of Materials ordered for, inspection and handling at the warehouse for storing. At times the Demurrage charges for not lifting the goods in time are included as a part of the ordering costs. Sometimes some of the components and/or Materials required for production may have facilities for manufacturing internally. If it is found to be more economical to manufacture such items internally, then the ordering costs refer to the costs associated with the preparation of the requisition forms by the user department, set-up costs to be incurred by the manufacturing department and transport, inspection and handling at the warehouse of the user department. By and large, ordering costs remain more or less constant irrespective of the size of the order although transportation and inspection costs may vary to a certain extent depending upon the order size. But this does not

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significantly affect the behavior of the ordering costs. As the ordering costs are considered invariant to the order size, the total ordering costs can be reduced by increasing the size of the orders. Suppose the cost per order is $100 and the company uses 1200 units of a material during the year. The size of the order and the total ordering costs to be incurred by the company are given below:-

Size of Order (Units)

100

150 8 $800

200 6 $600

No. of orders in an 12 year Total Ordering Costs @ $100 per order $1200

From the above it can be easily seen that a company can reduce its total ordering cost by increasing the order size which in turn will reduce the number of orders. However, reduction in ordering costs is usually followed by an increase in carrying costs.

2.

Carrying Costs These are the expenses of storing goods. Once the goods have been

accepted, they become a part of the firm's inventories. These costs include Insurance, Rent/Depreciation of the warehouse, and salaries of the storekeeper, his assistants and security personnel, financing costs of money locked up in Inventories, obsolescence, spoilage and taxes. By and large, the carrying costs are considered to be a given percentage of the value of Inventory held in the warehouse, despite some fixed elements of costs which comprise only a small portion of the total carrying costs. Approximately, the carrying costs are considered to be 25% of the value of Inventories held in

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Stock. The greater the Investment in Inventories, the greater is the carrying costs. In the example considered above, let us assume that the price per unit of Material is $40 and that on an average about half of the Inventory will be held in storage. Then, the average values of Inventory for sizes of order 100, 150 and 200 along with carrying costs @25 % of the Inventory held in storage are given below:Size of Order (Units) Average Inventory value 100 of $2000 150 $3000 $750 200 $4000 $1000

Carrying Costs @ 25% of $500 value

From the above calculations, it can be shown that as the order size increase, the carrying cost also increase in a directly proportionate manner.

3.

Costs of funds tied up with Inventory Whenever a firm commits its resources to Inventory, it is using funds

that otherwise might have been available for other purposes. The firm has lost the use of funds for other profit making purposes. This is its Opportunity Cost. Whatever be the source of the funds, the inventory has a cost in terms of its financial resources. Excess resources represent unnecessary cost.

4.

Cost of Running out of Goods These are the costs associated with the inability to provide materials

to the production department and/or the inability to provide finished goods to the marketing department as the requisite inventories are not available. In

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other words, the requisite items have run out of stock for want of timely replenishment. These costs have both quantitative and qualitative dimensions. These are, in the case of Raw Materials, the loss of production due to stoppage of work, the uneconomical prices associated with 'cash' purchases and the set-up costs which can be quantified in monetary terms with a reasonable degree of precision. As a consequence of this, the production department may not be able to reach its target for providing finished goods for sale.

When the marketing personnel are unable to honor their commitments to the customer for making the finished goods available for sale, the sale may be lost. This can be quantified to a certain extent. However, the erosion of the good customer relations and the consequent damage done to the image and the goodwill of the company fall into the qualitative dimension and elude the quantification. Even if the stock out costs cannot be fully quantified, a reasonable measure based on the loss of sales for the want of finished goods inventory can be used with the understanding that the amount so measured cannot capture the qualitative aspects.

5.13 ECONOMIC ORDER QUANTITY (EOQ) The Economic Order Quantity (EOQ) refers to the optimal order size that will result in the lowest total of ordering and carrying costs for an item of Inventory given its expected usage. By calculating an economic order quantity, the firm attempts to determine the order size that will minimize the total inventory costs. Total inventory Cost = Ordering Cost + Carrying Cost

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Total ordering Costs = Number of Orders X Cost per Order = U/Q (X) F Where U = Annual Usage Q = Quantity Ordered F = Fixed Cost per Order The total carrying costs = Average Level of Inventory (X) Price per unit (X) Carrying Cost Therefore, Total Carrying Cost = Q/2 (X) P (X) C Where Q = Quantity Ordered P = Purchase Price per Unit C = Carrying Cost As the Lead Time (i.e. the Time required for the procurement of Material) is assumed to be zero, an order for replenishment is made when the Inventory Level reduces to zero.

ASSUMPTIONS The major weakness of the EOQ Model is associated with several of its assumptions, in spite of which the model tends to yield quite good results. The models assumptions are as follows: -

1.

Constant or Uniform Demand Although the EOQ Model assumes constant demand, the demand may

vary from day to day. If the demand is stochastic that is, not known in advance - the model must be modified through the inclusion of a safety stock.

2.

Constant Unit Price The EOQ formula derived is based on the assumption that the

purchase price Rs. P per unit of Material will remain unaltered irrespective of the order size. Quite often, bulk purchase discounts or quantity discounts

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are offered by the suppliers to induce the customers for buying in larger quantities. The inclusion of variable prices resulting from quantity discounts can be handled quite easily through a modification of the original EOQ model, redefining total costs and solving for the optimum order quantity.

3.

Constant Carrying Costs Unit carrying costs may vary substantially as the size of the inventory

rises, perhaps decreasing because of economies of scale or storage efficiency or increasing as the storage space runs out and new warehouses have to be rented. This situation can be handled through a modification in the original model similar to the one used for variable unit price.

4.

Constant Ordering Costs While this assumption is generally valid, its violation can be

accommodated by modifying the original EOQ model in a manner similar to the one used for variable unit price.

5.

Instantaneous Delivery If delivery is not instantaneous, which is generally the case, the

original EOQ model must be modified by including a safety stock.

6.

Independent orders If multiple orders result in cost savings by reducing the paperwork

and the transportation cost, the original EOQ model must be further modified. While this modification is somewhat complicated, special EOQ models have been developed to deal with this.

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These assumptions have been pointed out to illustrate the Limitations of the basic EOQ Model and the ways in which it can be easily modified to compensate for them. Moreover, an understanding of the limitations and assumptions of the EOQ Model will provide the finance manager with a string base for making Inventory decisions

INFLATION AND EOQ Inflation affects the EOQ Model in two major ways. Firstly while the EOQ Model can be modified to assume constant price increases, many times major price increases occur only once or twice a year and are announced ahead of time. If this is the case, the EOQ Model may lose its applicability and may be replaced with anticipatory buying - that is buying in anticipation of a price increase in order to secure a price increase in order to secure the goods at a lower cost. Of course, as with most decisions, there are trade offs associated with anticipatory buying. The costs are the added carrying costs associated with Inventory that you would normally be holding. The benefits of course, come from buying the Inventory at a lower price.

The second way in which Inflation affects the EOQ Model is through increased carrying costs. As the Inflation pushes the Interest rates up, the cost of carrying Inventory also increases. In the EOQ Model this means that C increases, which results in a decline in the optimal economic order quantity.

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5.14 DETERMINATION OF OPTIMUM PRODUCTION QUANTITY

The EOQ Model can be extended to its production runs to determine the optimum production quantity. The two costs involved in this process are:i. ii. Set-up Costs Inventory Carrying Costs The Set-up cost is of the nature of fixed costs and is to be incurred at the tie of commencement of each production run. The larger the size of the production run, the lower will be the set-up costs per unit. However the carrying cost will increase in the size of the production run. Thus, there is an inverse relationship between the set-up costs and the inventory carrying cost. The optimum production size is at that level where the total of the setup 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 Where E U P S per annum = = = = = (2U X P)/S Optimum Production Quantity Annual Production Quantity Set-up costs for each production run Cost of carrying inventory per unit

MODIFIED EOQ TO INCLUDE VARYING UNIT PRICES Bulk Purchase discount is offered when the size of the order is at least equal to some minimum quantity specified by the supplier. The question

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may arise whether Q*, EOQ calculated on the basis of a price without discount will still remain valid even after reckoning with the discount. While no general answer can be given to this question, the general approach using the EOQ framework will prove useful in decision making - whether to avail oneself of the discount offered and if so what should be the optimal size of the order.

REORDER POINT SYSTEM The reorder point for replenishment of stock occurs when the level of Inventory drops down to zero. In view of instantaneous replenishment of stock, the level of Inventory jumps to the original level from the zero level. In real life situations one never encounters a zero lead time. There is always a time lag from the date of placing an order for material and the date on which the materials are received. As a result the reorder level is always at a level higher than zero, and if the firm places the order when the inventory reaches the reorder point, the new goods will arrive before the firm runs out of goods to sell. The decision on how much stock to hold is generally referred to as the order point problem, that is, how long should the Inventory be depleted before it is reordered.

The two factors that determine the appropriate order point are the procurement or delivery time stock which is the inventory needed during the lead time ( i.e. the difference between the order date and the receipt of the Inventory ordered) and the safety stock which is the minimum level of Inventory held as a protection against shortages.

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Reorder Point Stock

= Normal Consumption during Lead Time + Safety

Several Factors determine how much delivery time stock and safety stock should be held. In summary, the efficiency of replenishment system affects amount of much delivery time needed. Since the delivery time stock is the expected inventory usage between ordering and receiving Inventory, efficient replenishment of Inventory would reduce the need for delivery time stock. And the determination of level of safety stock involves a basic trade off between the risk of stock-out, resulting in possible customer dissatisfaction and lost sales, and the increased costs associated with carrying additional Inventory.

Another method of calculating reorder level involves the calculation of usage rate per day, lead time which is the amount of time between placing an order and receiving the goods, and the safety stock level expressed in terms of no. of days' sales. Reorder Level = Average daily usage rate X Lead Time in days

From the above formula it can be easily deducted that an order for replenishment of materials be made when the Inventory is just adequate to meet the needs of the production during the lead time.

If the average daily usage rate of Material is 50 units and the lead time is 7 days, then Reorder Level =Average daily usage rate X Lead time in days = 50 units X 7 days

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= 350 units

When the Inventory reaches 350 units an order should be placed for material. By the time the Inventory level reaches towards the end of the seventh day from placing the order materials and there is no confusion for the concern.

5.15 SAFETY STOCK Once it is realized that higher the quantity of safety stock, lower will be the stock-out costs and higher will be the incidence of carrying costs, the formula for estimating the reorder level will call for estimating the reorder level will call for a trade-off between stock-put costs and carrying costs. The reorder level will then become one at which the total stock out costs and the carrying costs will be at its minimum.

PRACTICAL QUESTIONS:Illustration 1: From the following information, calculate re-order level, minimum stock level, maximum stock level, average stock levelRe-quantity 4000 units Minimum usage per day 200 units Maximum usage per day 300 units Average usage per day 250 units Minimum delivery period 4 days Maximum delivery period 6 days Normal delivery period 5 days Solution: Re-order level =maximum usage *maximum delivery period

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= 300*6= 1800 units Minimum level = re-order level-(normal consumption * normal delivery period) =1800- (250*5) =550 units Maximum level = (ordering level +re-order quantity)(minimum usage*minimum delivery period) =(1800+4000)-(200*4)= 5000 units Average stock level = minimum level +ordering quantity/2 =550+4000/2 =2550 units

Illustration 2: A factory uses three kinds of materials A,B, and C the details about them are as given below: A B C Rs. Rs. Rs. Opening stock 12000 4000 600 Purchases during the year 94000 22000 3200 Stock at the end 18000 6000 400 Calculate stock turnover of each material. Which material is fast moving and which is slow moving? Solution: Material consumed = opening stock + purchases closing stock Material A = 12000+94000-18000 =Rs. 88000 Material B = 4000+22000-6000 =Rs. 20000 Material C = 600+3200-400 = Rs. 3400 Average stock =opening stock +closing stock /2 Material A = 12000+18000/2 =30000/2 = Rs. 15000 Material B = 4000+6000/2 = 10000/2 = Rs. 5000 Material C = 600+400/2 = 1000/2 = Rs. 500 Inventory (stock) turnover = Raw material consumed in the year / Average raw material inventory Material A = 88000/15000 =5.87 times Material B = 20000/5000 =4 times Material C = 3400/500 = 6.8 times

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Illustration 3:A firm requires 2400 units per annum of a material. Annual storing cost per unit is Rs. 4 and ordering cost per order is Rs. 75. What quantity should be ordered in one time? How many orders will be placed in a year? What will be the time interval between two orders? Solution:Ordering cost = Rs. 75 per order (O) Annual consumption = 2400 units (A) Carrying cost = Rs. 4 per unit per annum ( C)

= 300 units

Illustration 4 :A company has an expected usage of 50000 units of 50000 units of a commodity during the coming year. The cost of placing an order is Rs. 100 and carrying cost per unit is Rs. 2.50 Lead time of an order is 5 days and company will keep a reserve of two days usage. You are required to calculate 1. Economic order quantity 2. Re- order level Assume 250 days working in an year.

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Solution:-

= 2000 units Re order level = safety stock + lead time x usage Daily usage = 50000 / 250 = 200 units Safety stock = 2 x 200 = 400 units Re order level = 400 + 5 x 200 = 1400 units.

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MODULE FIVE END CHAPTER QUIZES

1. Shelf stock refers to a. Perishable goods b. Items that are to be packaged and sold c. Items that are stored by the firm and sold with little or no modification d. Accessories which are not part of the standard equipment

2. If the material is priced at the value that is realizable at the time of issue such pricing method is referred to as a. Standard price method b. Replacement method c. LIFO methods d. Weighted average cost methods

3. Which of the following is not a benefit of storing inventories:a. Avoidance of lost sales b. Availing of quantity discounts c. Reduction of order costs d. Reduction of carrying costs

4. Which of the following are sub-systems of inventory management system? a. EOQ sub system b. Stock level sub system

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c. Reorder point sub system d. All of the above

5. Which of the following is not a method of pricing inventories? a. FIFO method b. LIFO method c. Standard price method d. Shadow price method

6. Which of the following is/ are assumption under lying the EOQa. Constant / uniform demand b. Constant unit price c. Independent orders d. All of the above

7. Which of the following costs are not associated with inventories:a. Material costs b. Ordering costs c. Carrying costs d. Cost of long term debts locked in inventories

8. The cost of issue of materials during a period of deflation is high in the method ofa. FIFO b. LIFO c. Weighted average cost d. All of the above

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9. Optimal safety stock are determined to reduce a. Ordering costs b. Carrying costs c. Stock out costs d. Both b and c

10. Which of the following is included in carrying costs:a. Obsolescence b. Cost of capital c. Leakages and normal wastage d. All of the above

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MODULE SIX 6. WORKING CAPITAL MANAGEMENT AND SMALL BUSINESS

6.1 SMALL BUSINESS A small business is a business that is privately owned and operated, with a small number of employees and relatively low volume of sales. Small businesses are normally privately owned corporations, partnerships, or sole proprietorships. The legal definition of "small" varies by country and by industry. In the United States the Small Business Administration establishes small business size standards on an industry-by-industry basis, but generally specifies a small business as having fewer than 500 employees for manufacturing businesses and less than $7 million in annual receipts for most non manufacturing businesses. In the European Union, a small business generally has under 50 employees. However, in Australia, a small business is defined by the Fair Work Act 2009 as one with fewer than 15 employees. By comparison, a medium sized business or mid-sized business has under 500 employees in the US, 250 in the European Union and fewer than 200 in Australia. In addition to number of employees, other methods used to classify small companies include annual sales (turnover), value of assets and net profit (balance sheet), alone or in a mixed definition. These criteria are followed by the European Union, for instance (headcount, turnover and balance sheet totals). Small businesses are usually not dominant in their field of operation. Examples of Small Business

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Small businesses are common in many countries, depending on the economic system in operation. Typical examples include: convenience stores, other small shops (such as a bakery or delicatessen), hairdressers, tradesmen, lawyers, accountants, restaurants, guest houses, photographers, small-scale manufacturing etc. The smallest businesses, often located in private homes, are called micro businesses (term used by international organizations such as the World Bank and the International Finance Corporation) or SoHos. The term "mom and pop business" is a common colloquial expression for a singlefamily operated business with few (or no) employees other than the owners. When judged by the number of employees, the American and the European definitions of a micro business are the same: under 10 employees. There is a notable trend to further segment different-sized micro business; for instance, the term Very Small Business is now being used to refer to businesses that are the smallest of the smallest, such as those operated completely by one person or by 1-3 employees.

6.2 HISTORY OF SMALL BUSINESS The SBA was established on July 30, 1953, by the United States Congress with the passage of the Small Business Act. Its function was to "aid, counsel, assist and protect, insofar as is possible, the interests of small business concerns." Also stipulated was that the SBA should ensure a "fair proportion" of government contracts and sales of surplus property to small business. This was accomplished primarily through the Small Business Innovative Research program and government "set-asides." The SBA has survived a number of threats to its existence. In 1996 the then newly Republican-controlled House of Representatives planned to

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eliminate the agency. It survived and went on to receive a record high budget in 2000. Renewed efforts by the Bush Administration to end the SBA loan program have met congressional resistance, although the SBA's budget has been repeatedly cut, and in 2004 certain expenditures were frozen.

6.3 ADVANTAGES OF SMALL BUSINESS A small business can be started at a very low cost and on a part-time basis. Small business is also well suited to internet marketing because it can easily serve specialized niches, something that would have been more difficult prior to the internet revolution which began in the late 1990s. Adapting to change is crucial in business and particularly small business; not being tied to any bureaucratic inertia, it is typically easier to respond to the marketplace quickly. Small business proprietors tend to be intimate with their customers and clients which results in greater accountability and maturity. Independence is another advantage of owning a small business. One survey of small business owners showed that 38% of those who left their jobs at other companies said their main reason for leaving was that they wanted to be their own bosses. Freedom to operate independently is a reward for small business owners. In addition, many people desire to make their own decisions, take their own risks, and reap the rewards of their efforts. Small business owners have the satisfaction of making their own decisions within the constraints imposed by economic and other environmental factors. However, entrepreneurs have to work very long hours and understand that ultimately their customers are their bosses.

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Several organizations also provide help for the small business sector, such as the Internal Revenue Service's Small Business and Self-Employed One-Stop Resource.

6.4 PROBLEMS FACED BY SMALL BUSINESSES Small businesses often face a variety of problems related to their size. A frequent cause of bankruptcy is undercapitalization. This is often a result of poor planning rather than economic conditions - it is common rule of thumb that the entrepreneur should have access to a sum of money at least equal to the projected revenue for the first year of business in addition to his anticipated expenses. For example, if the prospective owner thinks that he will generate $100,000 in revenues in the first year with $150,000 in start-up expenses, then he should have no less than $250,000 available. Failure to provide this level of funding for the company could leave the owner liable for all of the company's debt should he end up in bankruptcy court, under the theory of undercapitalization. In addition to ensuring that the business has enough capital, the small business owner must also be mindful of contribution margin (sales minus variable costs). To break even, the business must be able to reach a level of sales where the contribution margin equals fixed costs. When they first start out, many small business owners under price their products to a point where even at their maximum capacity, it would be impossible to break even. Cost controls or price increases often resolve this problem. In the United States, some of the largest concerns of small business owners are insurance costs (such as liability and health), rising energy costs

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and taxes. In the United Kingdom and Australia, small business owners tend to be more concerned with excessive governmental red tape. Another problem for many small businesses is termed the 'Entrepreneurial Myth' or E-Myth. The mythic assumption is that an expert in a given technical field will also be expert at running that kind of business. Additional business management skills are needed to keep a business running smoothly. Still another problem for many small businesses is the capacity of much larger businesses to influence or sometimes determine their chances for success.

6.5 MARKETING THE SMALL BUSINESS Small businesses typically find themselves strapped for time but in order to create a continual stream of new business, they must work on marketing their business every day. Common marketing techniques for small business include networking, word of mouth, customer referrals, yellow pages directories, television, radio, outdoor (roadside billboards), print, email marketing, and internet. Electronic media like TV can be quite expensive and is normally intended to create awareness of a product or service. Many small business owners find internet marketing more affordable. Google AdWords and Yahoo! Search Marketing are two popular options of getting small business products or services in front of motivated Web searchers. Advertising on niche sites can also be effective, but with the long tail of the internet, it can be time intensive to advertise on enough sites to garner an effective reach.

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Creating a business Web site has become increasingly affordable with many do-it-yourself programs now available for beginners. A Web site can provide significant marketing exposure for small businesses when marketed through the Internet and other channels. Social media has proven to be very useful in gaining additional exposure for many small businesses. Franchise businesses Franchising is a way for small business owners to benefit from the economies of scale of the big corporation (franchiser). McDonald's restaurants, True Value hardware stores, and NAPA Auto Parts stores are examples of a franchise. The small business owner can leverage a strong brand name and purchasing power of the larger company while keeping their own investment affordable. However, some franchisees conclude that they suffer the "worst of both worlds" feeling they are too restricted by corporate mandates and lack true independence. However, in some chains, such as the aforementioned True Value and NAPA, franchises may have their own name alongside the franchise's name. Small business bankruptcy When small business fails, the owner may file bankruptcy. In most cases this can be handled through a personal bankruptcy filing. Corporations can file bankruptcy, but if it is out of business and valuable corporate assets are likely to be repossessed by secured creditors there is little advantage to going to the expense of a corporate bankruptcy. Many states offer exemptions for small business assets so they can continue to operate during and after personal bankruptcy. However, corporate assets are normally not exempt, hence it may be more difficult to continue operating an incorporated business if the owner files bankruptcy.

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Certification and trust Building trust with new customers can be a difficult task for a new and establishing business. Some organizations like the Better Business Bureau and the International Charter now offer Small Business Certification, which certifies the quality of the services and goods produced and can encourage new and larger customers. These services may require a few hours of work, but a certification may reassure potential customers. Contribution to the economy In the US, small business (less than 500 employees) accounts for around half the GDP and more than half the employment. Regarding small business, the top job provider is those with less than 10 employees, and those with 10 or more but less than 20 employees comes in as the second, and those with 20 or more but less than 100 employees comes in as the third (interpolation of data from the following references). The most recent data shows firms with less than 20 employees account for slightly more than 18% of the employment. Of the 5,369,068 employer firms in 1995, 78.8 percent had fewer than 10 employees, and 99.7 percent had fewer than 500 employees.

6.6 SOURCES OF FUNDING Small businesses use several sources available for start-up capital: Self-financing by the owner through cash, equity loan on his or her home, and or other assets. Loans from friends or relatives Grants from private foundations Personal Savings

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Private stock issue Forming partnerships Angel Investors Banks SME finance, including Collateral based lending and Venture capital, given sufficiently sound business venture plans Some small businesses are further financed through credit card debt usually a poor choice, given that the interest rate on credit cards is often several times the rate that would be paid on a line of credit or bank loan. Many owners seek a bank loan in the name of their business, however banks will usually insist on a personal guarantee by the business owner. In the United States, the Small Business Administration (SBA) runs several loan programs that may help a small business secure loans. In these programs, the SBA guarantees a portion of the loan to the issuing bank and thus relieves the bank of some of the risk of extending the loan to a small business. The SBA also requires business owners to pledge personal assets and sign as a personal guarantee for the loan. Canadian small businesses can take advantage of federally funded programs and services. See Federal financing for small businesses in Canada (grants and loans).

BUSINESS NETWORKS AND ADVOCACY GROUPS Small businesses often join or come together to form organizations to advocate for their causes or to achieve economies of scale that larger businesses benefit from, such as the opportunity to buy cheaper health insurance in bulk. These organizations include local or regional groups such as Chambers of Commerce, as well as national or international industry-

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specific organizations. Such groups often serve a dual purpose, as business networks to provide marketing and connect members to potential sales leads and suppliers, and also as advocacy groups, bringing together many small businesses to provide a stronger voice in regional or national politics. The largest regional small business group in the United States is the Council of Smaller Enterprises, located in Greater Cleveland.

6.7 SMALL BUSINESS ADMINISTRATION The Small Business Administration (SBA) is a United States government agency that provides support to small businesses. The mission of the Small Business Administration is "to maintain and strengthen the nation's economy by enabling the establishment and viability of small businesses and by assisting in the economic recovery of communities after disasters." The SBA does not make loans directly to small businesses but does help to educate and prepare the business owner to apply for a loan through a financial institution or bank. The SBA then acts as a guarantor on the bank loan. In some circumstances it also helps to procure loans to victims of natural disasters, works to get government procurement contracts for small businesses, and assists businesses with management, technical and training issues. The SBA has directly or indirectly helped nearly 20 million businesses and in 2008 had a loan portfolio of roughly 219,000 loans worth more than $84 billion making it the largest single financial backer of businesses in the United States.

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SMALL BUSINESS ADMINISTRATION (SBA) LOAN PROGRAMS The most visible elements of the SBA are the loan programs it administers. The SBA itself does not grant loans with the exception of Disaster Relief Loans. Instead, the SBA guarantees against default certain portions of business loans made by banks and other lenders that conform to its guidelines. Disaster Relief Loans are issued directly from the SBA. Contrary to popular belief, these programs are not generally for persons with bad credit who can't get bank loans, nor are they primarily used for startup funding; rather, the primary use of the programs is to make loans for longer repayment periods and with looser affordability requirements than normal commercial business loans. Also, a business can qualify for the loan even if the yearly payment would be the same as the previous year's profit, whereas most banks would want payment for a loan to be no more than twothirds (2/3) of the prior year's profits for a business. The lower payments, longer terms and looser affordability calculations allow some businesses to borrow more money than they could otherwise. One of the most popular uses of SBA loans is for commercial mortgages on buildings occupied or to be occupied by a small business. These programs are beneficial to the small business because most bank programs frequently require larger down payments and/or have shorter terms requiring borrowers to refinance every five years. They can be beneficial to the bank in that the bank can reduce its risk by taking a first lien position for a smaller percentage of the entire project and then arranging for a SBA Certified Development Company to finance the remainder through a second lien position.

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Types of Guaranteed Business Loans through banking institutions include: Loan Guarantee Program: The 7(a) Loan Guarantee Program is designed to help small entrepreneurs start or expand their businesses. The program makes capital available to small businesses through bank and nonbank lending institutions. 504 Fixed Asset Financing Program: The 504 Fixed Asset Financing Program is administered through non-profit Certified Development Companies throughout the country. This program provides funding for the purchase or construction of real estate and/or the purchase of business equipment/machinery. Of the total project costs, a lender must provide 50% of the financing, a Certified Development Company provides up to 40% of the financing through a 100% SBA-guaranteed debenture, and the applicant provides approximately 10% of the financing. Aggressive vetting of any property purchased through this program is required. Specific SBA Phase I Environmental Site Assessment guidelines apply as all properties are treated as "high risk." Micro Loan Program: Available for up to $35,000 through non-profit, micro loan intermediaries, to small businesses considered unbankable in the traditional banking industry. Economic Development Program: SBA partners such as SCORE and the Small Business Development Centers (SBDCs), operating in each state, provide free and confidential counseling and low-cost training to small businesses. 8(a) Business Development Program: Assists in the development of small businesses owned and operated by individuals who are socially and economically disadvantaged.

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6.8 SMALL BUSINESS IN INDIA Global trends have suggested that small business is the biggest contributor to the economy of any country. Small business is big in India

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too. It is one of the most crucial sectors of the economy in terms of the number of employments generated. As more than 65% of its population lives in rural and semi rural areas, small business is one of the most viable options for the population residing in these areas. After agriculture, small business in India is the second largest employer of human resources. In India an industrial undertaking that has investments in fixed assets which do not exceed more than Rs.10 million falls under the category of small business. The Government of India has undertaken several reforms to attract more investors to the small business sector in India. Some of the reforms undertaken include provision of training facilities, availability of machinery on hire-purchase terms, special bonus for setting up small business in backwards areas, tax deduction for small business and assistance for marketing the products in domestic markets and exports. All small business in India needs to get registration from Director of Industries of the respective state government. Most states across India follow a uniform process of registration, though there may be slight variation from state to state. There are various reasons due to which the small scale business in India has witnessed a spurt of growth. Chief among them are an increase in the export potential of Indian goods, the industry is less capital intensive, the industry has availability of manpower training facility, there is ease of machinery and manpower procurement, goods from some of the sectors are exclusively purchase by government and there is also reservation of exclusive manufacture of goods in this sector.

List of some of the items reserves for exclusive manufacture: Food and allied Industries Textile Products Including Hosiery

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Art Silk/Man-Made Fiber Hosiery Wood and Wood Products Paper Products Rubber Products Plastic Products Leather and Leather Products Chemicals and Chemical Products All small business is liable to be de-registered if they are found to be violating any of the mandatory registration norms. Some of the measures taken by small scale industries that can attract recognition include surpassing the investment limit, manufacturing of any new item that requires industrial license or if the enterprise does not satisfy the condition of being owned, controlled or being the subsidiary of any other industrial undertaking.

The growing business trend in India indicates that the small business sector in India is poised for much higher things. Investors in this sector must ensure that they make use of all the resources available to reap the benefits.

6.9 PROBLEMS FACED BY SMALL BUSINESS Small and medium-size companies comprise between 90% and 98% of all manufacturers in Latin America. They generate about 63% of all jobs, and contribute between 35% and 40% of the regions total production, according to studies by such institutions as the World Bank, the InterAmerican Development Bank and the Economic Commission for Latin America and the Caribbean (ECLAC).

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Small companies are active in every sector, from retailing to manufacturing, and even services, healthcare and finance. They are known as SMEs small and medium-sized enterprises. According to the World Bank, they underpin the social fabric of the entire continent. They are in large cities, medium-sized cities, small towns, and even the most remote villages in the countryside, where they engage in a wide range of agricultural activities. For all that, SMEs face various challenges to their efficiency, productivity and competitiveness. There are as many problems as there are companies, says Jorge Yarce Maya, president of the Latin American Leadership Institute and an international consultant and college professor. No government devotes a special role to these companies in its social policies including its laws, regulations and resolutions and they are falling significantly behind the large companies. According to the Bogot-based Institute, which brings together leaders from Latin America, one of the problems affecting small and medium-sized companies in the region is their role in the underground economy. Jorge Hernn Crdenas, former dean of the business department at the University of the Andes in Colombia, says that the underground phenomenon affects 50% of all SMEs, ranging from tiny companies that have two or three employees, to small companies (between 10 and 15 employees, depending on the country), and medium-sized companies (that have up to 200 employees). In Colombia, its hard to collect detailed statistics about the underground economy. According to the Foundation for Development and Higher Education (Fedesarrollo), 55% of all companies in Colombia fall into this category. It may be a higher number because our surveys only have a

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63% response rate, affirms Norman Correa, president of ACOPI, the Colombian association for micro, small and medium-sized companies. The underground economy accounts for 63% of all jobs in the countrys 32 departments and its 1,002 municipalities. The problem with the underground economy is not simply that there are no processes for registering businesses that can assure banks of their creditworthiness and enable these companies to get business loans. These kinds of companies also fail to get support from institutions and organizations and they lack access to international cooperation agencies, notes the report. In addition, these companies generate poor quality jobs, and shut themselves off from foreign competition. Hugo Betancur, director of Visin, a business consulting unit at the University of La Sabana, in Colombia, notes that the problem for SMEs is linked to the absence of entrepreneurial management in their top management. One key factor that contributes to their informal [or underground] nature is that many productive units are born out of entrepreneurs needs rather than as a result of a planning decision.

In Latin America, the law of the carrot and the stick prevails. In other words, those companies that dont pay their tax bills on time face the threat of being shut down. According to Julin Domnguez, president of the Chamber of Commerce of Cali, an industrial city in Colombia, people have to get the idea into their heads that you have to pay when youre legal, and compliance opens opportunities for companies to grow, to become more productive and to compete.

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Cristina Rico Carroll, dean of the University of the North, in Barranquilla (Colombia), is an expert at choosing managerial personnel. Carroll warns that during the last 10 years, managers of SMEs have fortunately learned that businesses cannot be administered efficiently without complying with the letter of the law. Now you can see presidents, vice-presidents and managerial personnel going to the university to prepare themselves and train in managerial and administrative areas, he says. In the world of academia, they are taught that it is important to enter the formal, legal economy.

Technology that Falls Behind SMEs also invest comparatively little in technology. And when they do, often they acquire equipment, machinery and software that are inappropriate. Why? Because, in order to modernize yourself, the first thing you have to do is to focus on the core of the business and only later think about technology, notes Juan Carlos Lpez, an executive at Neoris, a multinational consulting firm. Many SMEs ignore the importance of technology and

communications, which are indispensable ingredients of any strategy for achieving competitiveness in todays global economy, notes Germn Andrs Camacho. Camacho manages the Zeiky program at the Sergio Arboleda University [in Bogot, Colombia], the universitys center for consulting services and information about foreign trade. The Latin American manager of a small business is generally empirical, and is not in the habit of training himself or permanently staying up-to-date, which is something that is a requirement in todays information society, notes Camacho, an expert in finance and foreign trade.

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A recent study by FUNDES, a foundation for sustainable development in Latin America, provides some discouraging numbers: SMEs, especially the smallest among them, only invest two percent of their budgets in technology. Naturally, any company that does not bring its technology up to date is condemned to lag behind in competitiveness and productivity, states Camacho. When an entrepreneur thinks about his technology budget, he views it as an expenditure and not as an investment, says Jorge Hernn Crdenas of the prestigious University of the Andes. He buys the cheapest thing or simply the least appropriate thing for the focus of his business. And then the results arepoor or at least insufficient, Cardenas says.

Underdeveloped Human Capital Nowadays, the new paradigm for management is to get your personnel continuously up to speed with the latest developments by providing training sessions and conferences. In many organizations, employees are known as internal customers. Thats another area where SMEs lag behind. According to Pedro Nio, director of Inalde, the business school at the University of Sabana in Bogot, the most important thing for companies is not the results they register in the form of profits and losses. Instead, its the way they manage their human capital. Juan Carlos Echeverry, professor at the University of the Andes, agrees. Small and medium-sized companies often lack career planning programs because they dont have appropriate hiring practices that identify job candidates skills, weaknesses, aptitudes and knowledge. Echeverry supported Colombias Mipyme Law, which provides institutional support programs for the SME sector.

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In most small Latin American companies, the dominant way to get hired is through personal recommendations, notes Andrs Escobar, an economist at the University of Andes and specialist in public administration. An Obstacle Known as Marketing At a recent forum that took place simultaneously in Bogot and Caracas, the Andean Development Corporation laid out its development strategy for the most vulnerable segment of the population. Experts agreed that SMEs know how to produce things but they dont know how to sell them. They have a hard time adopting a marketing strategy in which the focus of the business is the customer; in which markets are segmented, new business opportunities become more visible, and a company moves into new areas, says ngela Enrquez, a marketing experience and dean of the Sergio Arboleda University, based in Bogot. Generally speaking, managers of small companies view marketing as an expense, not as an investment. So it is hard for their customer base to grow. They dont create a new supply of goods and services, leaving untapped the great potential in the marketplace. Without doubt, the customer is the person who makes any business profitable; its not the product, agrees Martha Lucia Restrepo, who teaches at the University of Rosario in Colombia. This means that companies depend on markets and on how markets react to the products and services they offer. On the other hand, this doesnt mean that it is unimportant to have an efficient production process or to manage costs or channels effectively. However, once youre sure that you have a competitive product, the other part of the job remains in the hands of your customer.

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Thats the case for every company, where it offers goods or services; or is small or large. The big difference is that SMEs dont apply this approach, says Restrepo.

Restrictions on Loans No business can possibly exist without having access to credit. However, loans are a scarce resource for SMEs for a variety of reasons: their informal [or underground] nature; the administrative disorder that characterizes some SMEs; their lack of leadership; the absence of real [loan] guarantees; and a shortage of [business] information [about small companies]. According to Jorge Londoo, president of Bancolombia, The first thing that every micro-enterprise must deal with is how to achieve transparency in its supply of information while maintaining an organized accounting system. For Londoo, who manages Colombias largest financial institution, it is worth the effort to seek out advice about how to diagnose the condition of your business and to implement mechanisms that improve its financial structure.

Several small business associations have been working on a constitution for a Regional Fund for Guarantees for SMEs, but access to credit remains limited for small companies in the region. The Andean Community of Nations -- comprising Peru, Bolivia, Ecuador, Colombia and Venezuela -- has distanced itself from this approach. Although banking has opened itself to this segment of the economy and banks see it as good business, SMEs are punished by higher interest rates and shorter

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amortization periods because of the way banks assess their risks, notes Norman Correa, president of ACOPI. The reasoning is simple: Because they are riskier, banks charge them more, as well as cut the time they can take to repay their loans. In many cases, these companies wind up being excluded from traditional financial markets, notes Correa.

Looking to the Future Despite such challenges, governments, international agencies and multilateral institutions are taking action to promote and assist the SME sector. These efforts will take a long time to bear fruit, Luis Alberto Moreno, president of the Inter-American Development Bank (IDB), stated in his recent presentation on that institutions new policy for micro-financing. According to the IDB, SMEs must do a lot of work when it comes to innovation, an area where Chile, Brazil and Mexico are pioneers. They must also work on building partnerships so they can compete globally, and they must create clusters to increase their productivity and competitiveness. According to the World Bank, the SME sector benefits from the fact that small companies can be more flexible in their response to todays global changes. Ben Schneider, who developed, promoted and spread the concept of outsourcing, agrees an appropriate business culture for doing that [outsourcing] exists in the region. From an institutional viewpoint, several support organizations exist in each country, including Sebrae in Brazil and CORFO in Chile; Fomipyme and Expopyme in Colombia; the ministry of small business and development in Argentina; Hondurass Conapyme and Mexicos ministry for small and medium-size business.

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The IDB has given its Multilateral Investment Fund responsibility for managing several programs that assist the small business sector, with financing, technology, trade, training, innovation and modernization. Various other organizations have become the right arm for SMEs in the region, including the World Bank, the United Nations Industrial Development Organization, the Andean Development Corporation and the Organization for Economic Cooperation and Development (OECD). Moreno, president of the IDB, notes that its goal is to enable small companies to get involved in the globalization process. Instead of merely subsisting and acting as [ordinary] corporations, they can develop corporate governance policies that enable them to actively participate in Corporate Social Responsibility programs and to take part in the Global Compact (the initiative to encourage businesses worldwide to adopt sustainable and socially responsible policies) that Kofi Annan, then Secretary General of the UN, proposed in 1999.

1. Small businesses are constantly faced with problems before they can claim success. However, the difference between a well run business and one that is not is how they tackle their problems. They can often be faced with financial problems. Since business has its good and challenging months you may be swamped with bills when the tough months come. There are wages, rent etc to be paid and you don't know where to get the money. It is therefore advisable to always have an emergency account that can cushion you through the tough months. 2. Incompetent employees are yet another problem faced by small businesses. In comparison to larger companies, small businesses have a high employee turnover. It is always a real challenge for the business owners to

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get reliable and trustworthy employees. You may have employees who lie to customers about specific products or services for their own selfish gain. Unfortunately it is you who will end up "looking bad." 3. Customers can also be a source of problems for the small business. This is because sometimes you could have an in house problem like the office machinery lets you down and you cannot give your customer the service they require. Many customers get easily irritated and may think you cannot effectively run your business. They may even ask for their money back. 4. You can also be faced with problems if your suppliers do not deliver on time or as agreed on. This can be really frustrating and nerve racking especially if it is an order that is being waited for. Your family can also be a part of the problem especially if they are not willing to understand why you work so hard or late. They may begin to feel that they are secondary in your life. It is even difficult to go on vacation because you are constantly "on call". You should be ready to make sacrifices if you want to succeed in your business. 5. The production problems include raw material availability, capacity utilization, and storage problems. 6. The marketing problems arises because of dealing in only one product, cut throat competition, adopting cost oriented method of pricing, lack of advertisement, not branding their products etc. 6. The financial problems include investment risks, procurement of loan from banks and their repayment, meeting day to day expenses and the like. 7. The labour problems include highly demanding employees, absenteeism lack of skilled workers and transportation of workers. 8. Infrastructure problems also add coal to the fire. Unless and until you have the infrastructure in its place the rest of the efforts are futile.

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9. Personal problems like spending less time with family and for the whole sweat exerted the rewards have not been favorable.

6.10

EFFECTIVE

SMALL

BUSINESS

WORKING

CAPITAL

MANAGEMENT Entrepreneurs know the importance of having a sufficient working capital in managing a business. Newly start-up businesses particularly are in need of financing help to gain footing in the market. In fact, one of the biggest challenges that businesses face is maintaining a sufficient financial resource.

Factors that Affect the Working Capital Management If youre a business owner, where can you find reliable financing? Sadly, some entrepreneurs focus only on making big profit. They forget to consider other factors that can affect the resources of the business. For instance, issues on legalities, the organizations structure and marketing can have a huge impact on business management. At first, there may not be any problem with the business finances. But if problems are not anticipated early one and no back-up plan has been prepared, it could eventually cause damage to the business.

How to improve Working Capital Management How can you manage your working capital effectively? First, a small business owner must be prepared for possible problems or unexpected circumstances. Anticipating the possibilities and creating a plan to be able to deal with such events is indispensable.

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An entrepreneur must also set realistic goals. Here, we are not just speaking about short term goals but long term goals as well. Do you have a target goal for this month or the following months? Have you set a goal for this year and the years to come? Setting definite goals- both short term and long term- will enable you to make wiser decisions especially when it comes to marketing and financing strategies. Speaking of marketing goals, building new customer relationships and strengthening existing customer relationships are also important steps. Make sure that you are able to give your customers what they really want. Ensure customer satisfaction with each of your deals. Taking care of your customer relationships will certainly make a big difference in your performance as a business. Protect your cash flow by using the right tools such as business credit cards. Credit cards for business are not just for large companies but for small business enterprises as well. Using business credit cards to your advantage will be a big help in keeping a steady cash resource. Apart from business credit cards, applying for a business loan may also be necessary especially in executing bigger projects for your business. Having a solid credit history will surely enable you to obtain the business loan you need without much difficulty.

6.11 SEASONAL INDUSTRY A seasonal industry is activity within an economic sector in which the majority of operations take place during only part of the year, generally in the context of a single country or region. In some cases, as with agriculture, this limitation may relate to climate or other forces of nature. In

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others, the seasonality may relate to annual variations in human activity (for example, tourism, restaurants, some forms of manufacturing). Seasonal industries often feature large swings in labor force size, and in many cases, precipitate mass migrations of workers. In those countries that provide them, unemployment benefits may be affected by a worker's seasonal status. That is, in certain cases, a seasonal worker may not be considered "unemployed" during the off-season for the sake of benefits or aggregated statistics, despite being functionally inactive.

6.11.i WORKING CAPITAL REQUIREMENT FOR SEASONAL INDUSTRIES A great many companies work under the handicap of extreme variations in the amount or the character of their business from one season to another. This was formerly true, for example, in the automobile business. During the early period of the popularity of pleasure vehicles the great mass of sales were made in the spring and early summer of each year; it is reported that in this industry the seasonal variation is being much reduced. Manufacturers of rubber goods, especially rubber shoes, find their sales concentrated at certain seasons; the same thing is true of manufacturers of agricultural implements, of sporting goods, and of many other products that will readily occur to every one. Manufacturers of textiles, of beet sugar, and of other products made from raw materials gathered from the soil are under the necessity of buying heavily at certain seasons of the year in order to secure the benefit of minimum prices. In all these lines of industry, either large stocks of finished products must be accumulated during the remainder of the year in order to meet the requirements of the busy season, or large stocks of raw materials must be

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purchased at a given season and gradually used up during the remainder of the year. In either case it is clear that much larger sums of money must be tied up in working assets during certain periods than during other periods of the year. This is a situation that involves unusual difficulties and greatly affects the amount of working capital that is required. The usual method is to secure a gradually increasing amount of bank loans as finished products are accumulated which are rapidly paid off during the sales season; or, if the other situation prevails, a large loan is effected during the buying season which is gradually paid off during the remainder of the year. Dependence upon bank loans exclusively, however, is unsafe, as many companies have discovered. Textile manufacturing companies have been peculiarly subject to failure because of their inability, owing to some unforeseen contingency, to meet the obligations held by their banks. Some years ago, when the so-called "Sugar Trust" desired to obtain control of an important beet sugar refinery, it is alleged to have obtained this result by secretly buying up all the short-time notes given by the sugar refinery during its purchasing season and then demanding prompt payment of these notes instead of granting the customary partial renewals. As a result, the prosperous refinery suddenly found itself confronted with the prospect of bankruptcy and was forced to surrender. Although it would not be economical for companies engaged in seasonal industries to keep themselves supplied with the amount of working capital that is required at the maximum period of each year, it is highly desirable and prudent that they should carry a much larger working capital than would be required during the off seasons. This is a part of their normal expense of doing business. Such companies sometimes find it advantageous to invest their surplus cash reserves during the off seasons in short-term securities.

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6.12 WORKING CAPITAL NEEDS FOR DIFFERENT BUSINESSES INTRODUCTION Different industries have different optimum working capital profiles, reflecting their methods of doing business and what they are selling. Businesses with a lot of cash sales and few credit sales should have minimal trade debtors. Supermarkets are good examples of such businesses; Businesses that exist to trade in completed products will only have finished goods in stock. Compare this with manufacturers who will also have to maintain stocks of raw materials and work-in-progress. Some finished goods, notably foodstuffs, have to be sold within a limited period because of their perishable nature. Larger companies may be able to use their bargaining strength as customers to obtain more favourable, extended credit terms from suppliers. By contrast, smaller companies, particularly those that have recently started trading (and do not have a track record of credit worthiness) may be required to pay their suppliers immediately. Some businesses will receive their monies at certain times of the year, although they may incur expenses throughout the year at a fairly consistent level. This is often known as seasonality of cash flow. For example, travel agents have peak sales in the weeks immediately following Christmas.

FLUCTUATION IN WORKING CAPITAL NEEDS The amount of funds tied up in working capital would not typically be a constant figure throughout the year. Only in the most unusual of businesses would there be a constant need for working capital funding. For most businesses there would be weekly fluctuations.

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Many businesses operate in industries that have seasonal changes in demand. This means that sales, stocks, debtors, etc. would be at higher levels at some predictable times of the year than at others. In principle, the working capital need can be separated into two parts: A fixed part, and A fluctuating part The fixed part is probably defined in amount as the minimum working capital requirement for the year. It is widely advocated that the firm should be funded in the way shown in the diagram below:

The more permanent needs (fixed assets and the fixed element of working capital) should be financed from fairly permanent sources (e.g. equity and loan stocks); the fluctuating element should be financed from a short-term source (e.g. a bank overdraft), which can be drawn on and repaid easily and at short notice.

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6.13 SICK INDUSTRIES AND THEIR PROBLEMS New Delhi, February 25:- The Federation of Indian Chambers of Commerce & Industry of India (FICCI) has demanded a review of the definition of sick company including the provision which declares a company sick if it fails to repay debt within any three consecutive quarters. The chamber has also opposed the imposition of cess on companies to build up a fund for rehabilitating the assets of sick companies, stating that healthy companies should not be penalized for faults of others. The definition of sick company is very harsh especially the criterion of default in repayment of debts. This need to be reviewed, otherwise the tribunal (National Company Law Tribunal) will be flooded with references, a FICCI official said. According to new definition an industrial company is declared sick if its accumulated loss in any financial year is equal to 50 per cent or more of its average net worth during four years immediately preceding the financial year. A company is also declared sick if does not pay its creditors for three consecutive quarters on demand made in writing by any of the creditors. Raising doubt about the effective administration of the fund, FICCI said, it (the cess) will be extra cost to the company irrespective of profitability. As per the new law, a cess between 0.005 per cent and 0.1 per cent on value of turnover or its annual gross receipts, whichever is higher is levied on companies to create Rehabilitation & Revival Fund. The fund will be utilized for making interim payments to workmen, protection of assets of sick company and revival and rehabilitation of sick companies. The apex chamber has also raised its doubt about the speedy disposal of cases by the National Company Law Tribunal (NCLT) in terms of increased workload. Would NCLT alone be in a position to take the entire

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workload of High Courts, Board for Industrial and Financial Reconstruction and Company Law Board, it said. It has also raised the issue of integrity of the NCLT. The tribunal is to be a quasi-judicial body with its members having a contractual tenure of three years. At the end of three years, the contract can be renewed by the minister in-charge in consultation with the chief justice of India. This arrangement gives rise to doubts regarding the independence and autonomy of the Tribunal as the member may take certain decision in order to be in the good books of the government.

6.13.i INDUSTRIAL SICKNESS IN INDIA 1. Alarming Rate of Sickness in the Small Scale Industry Sector In India, Industrial Sickness increased at an alarming rate in the eighties and has also increased in the nineties particularly in the small scale sector. Small Scale industry in India is defined on the basis of investment in plant and machinery. The investment limits varied over the passage of time. This limit was Rs. 35 lakhs from 1985-86 to 1990-91 and Rs. 60 lakhs from 1991-92 as of today. Similarly, the small scale ancillary units are defined as having investment in plant & machinery below Rs. 75 lakhs. The incidence of sickness in the small scale sector is a matter of serious concern in India. SSI sick units which accounted for 94% of the total incidence of industrial sickness in 1980, have increased their share to 99% in the overall profile of industrial sickness in 1990. Large and medium scale sick units account for only 1% of the total incidence of sickness. But in terms of locked up bank credit, they represent 75% of the total bank credit outstanding from all sick units. On the other hand, the locked up bank credit in the small scale sick units which constitute 99% of the total incidence of

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sickness, represent only 25% of the total bank credit outstanding from all sick units. Again, of the identified SSI sick units, 92% are found to be unviable.

2. Definition of Sick Industry by Different Institutions Industrial sickness in India has been defined by different institutions in different ways. The Reserve Bank of India (RBI) has given two definitions one for large and medium scale units and the other for small scale units. According to the RBI definition, large and medium scale sick unit is one which incurs cash losses for one year and which, in the judgement of the bank, is likely to continue to incur cash losses for the current as well as the following year and which has an imbalance in its financial structure, such as current ratio of less than 1:1 and worsening debt equity ratio. RBIs definition of a sick small scale unit follows like if it has (a) incurred cash losses in the previous year and is likely to incur cash loss in the current year and has an erosion of 50% or more of its networth; and/or (b) made defaults in payment of four consecutive quarterly installments of interest or two halfyearly installments of principal on the term loans and there are persistent irregularities in the operation of its credit limits with the bank. The Study Team of the State Bank of India in its report on SmallScale Industry Advances defined a sick unit as "one which fails to generate internal surplus on a continuing basis and depends for its survival upon frequent infusion of external funds". The Government of India enacted the Sick Industrial Companies (Special Provisions) Act, 1985. As per the revised definition provided by this Act, a sick industrial company would be one which is registered for a

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period not less than five years and whose accumulated losses are equal to the sum of paid up capital and free reserves.

3. Findings of Various Studies about the causes of Sickness A number of studies were conducted to determine the relative importance of different factors in the causation of sickness of the industrial units in India. One study was conducted in 1990 to examine the causes of sickness in the new SSI units. It was found that marketing problems as a whole (resulting from highly competitive markets, unfavourable linkage with ancillary and medium units etc.) were the most important factor (29.6%) for sickness in the group followed by mismanagement (21.9%), inadequacy of working capital (16.6%), time overrun (13.4%) and govt. policy (11%). The total weight of all external causal factors for the group is 59.2 and that of internal causal factor 40.8. It appears that external causal factors are dominant in causing sickness in the new SSIs than internal causal factors. Another study conducted by the Reserve Bank of India on 378 medium and large sized sick industrial enterprises enjoying credit limits of Rs. 1.00 crore and above revealed that 52% of the units fell sick due to management problem, 23% of the units went sick because of market recession, 14% for initial faulty planning, 9% for power-cuts, shortage of raw-materials, etc. and the rest 2% became sick due to labour trouble.

4. Govt. Concessions and Incentives for the SSI Sector The Government of India provided various concessions and incentives to the SSI sector for their sustained growth, which have briefly been outlined here as under:-

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a. b. c. materials, d. e.

Assisting new SSI units on soft terms by lending institutions, Reservation of Certain Industries for the SSI sector, Incentives related to land/shed financing, machinery and raw-

Provision of facilities within the Industrial Estates, and Excise duty exemption and price preference

5. Govt. Measures to deal with the Problem of Industrial Sickness Various measures have been initiated by the Govt. of India in order to deal with the problem of sickness in industries. These may be briefly described here. i. The RBI set up a Sick Industrial Undertaking Cell to monitor the performance of the banks in identifying the sick units and initiating appropriate remedial measures, and to co-ordinate the efforts of banks, financial institutions, Govt. and other agencies involved. ii. RBI advised banks to take urgent measures to set up Special Sick Unit Cells to carryout periodical inspection and to undertake diagnostic studies for techno-economic viability. iii. The Ministry of Finance of the Govt. of India and RBI provides supportive measures for rehabilitation of viable sick units in terms of relief in excise arrears, reduction in interest rate on term loans and waiver of penalty applied to cash credit facility. iv. The Industrial Reconstruction Corporation of India (IRCI) was set up by the Govt. of India for industrial revival and rehabilitation of sick and closed industrial units. v. Sick Industrial Companies (Special Provisions) Act (1985), was enacted in 1987 as a landmark in Govt. Policy to combat the problem of

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sickness. Under this Act, the Board for Industrial and financial Reconstruction (BIFR) came into being with vast powers aimed at assessment and implementation of revival plans for the sick industrial companies. However, this Act has no applicability for the sick SSI units. However, different studies revealed that in some cases liberal policies for the growth of the small industry sector were counter-productive in terms of affecting the viability through unhealthy growth and inefficiency of the units. On the other hand, the measures aimed at revival of sick industries could not achieve a desired breakthrough in curbing the magnitude of sickness due to their inadequacies and implementation bottlenecks.

6.14 SUMMARY OF CAUSES OF INDUSTRIAL SICKNESS AND SUGGESTED POLICY MEASURES FOR PREVENTION AND REHABILITATION

Summary of Causes The deliberations elaborated on the causes of industrial sickness in Section III & IV indicate that a number of factors, both internal and external are responsible for turning an industrial unit as sick. The major causes pushing the industrial units towards sickness in Bangladesh have been summed up in the following table :
Sl. # Broad Area 01. Management INTERNAL Detail Causes Lack of proper education, training, experience and business outlook of the Sponsors/Entrepreneurs Poor Entrepreneurial skills Poor Management Poor Equity base Lack of Integrity/Division of Funds Faulty Project Planing and Appraisal

a. b. c. d. e. f.

02.

Production/

a. Wrong choice of technology

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Technical

b. c. d. e. f. g. a. b. c. d. a. b. c. d. e.

Improper utilization of production capacity Imbalanced and Defective Machinery Poor Raw-material Planning Inadequate Quality Control Poor labour relations Location problem Lack of Market Planning Inadequate Market Survey Poor Collections Defective Pricing Poor Management of Financial Resources Delay in Mobilisation of Equity Funds Faulty Costing Adverse debt-equity combination Lack of Proper Accounting system

03.

Marketing

04.

Finance

05.

Personnel

a. Lack of Competence b. Lack of Loyalty c. Lack of Professionalism EXTERNAL Detail Causes Frequent Policy changes Lack of Proper Implementation of Industrial Policies Liberal Import Policies Poor Infrastructure / Frequent Power Disruption Smuggling Fiscal Anomalies Exchange Rate Fluctuation Lack of Co-ordination between various ministries and Govt. Departments, etc. Over-Saturation of particular industry type / Sector due to wrong policy Non-availability of Raw-material, etc. Non-availability/Inadequacy of Working Capital Lack of required financial assistance for BMRE High rate of Interest on bank loan Lack of timely decision & support by the banks and financial institutions. Political Unrest Labour Unrest Market Recession Delay in Project Implementation

Sl. # Broad Area 01. Govt. Policy & Implementation

a. b. c. d. e. f. g. h. i. j.

02.

Bank & Financial Institutions

a. b. c. d.

03.

Environment

a. b. c. d.

Preventive Measures

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Experience indicates that small industrial units fall sick much to the occurrence of external causes while medium and large industries get exposed to sickness largely due to internal causes. Though it would be hardly impossible to eliminate the causes altogether, attempts should be made to undertake measures that would reduce the magnitude of ailment in the industrial units for healthy survival and growth. Viewed in this context, the following measures may be suggested to prevent industrial sickness: (i) Macro-economic Policy changes: The industrial entrepreneurs should make their own appraisal within a predictable macro-economic environment. For this, policy changes should not be abrupt, have to be pre-announced and gradual. (ii) Sub-Sectorwise Long term Policy: For each sub-sector, the long-term policy (e.g. for a period of 5 years) should be announced by the Government so that entrepreneurs appraisal of the policy implications do take a nearaccurate shape. (iii) Implementation of the Announced Polices: There should be effective co-ordination amongst the various ministries, Govt. Departments and relevant agencies involved for proper implementation of policies related to industrialization. (iv) Development of Small Industry Sector: The small industry sector is characterized by low-level of technology, low equity base, traditional management practices, poor marketing outlets and undeveloped subcontracting arrangement. The small industries should not be left to the market forces only. The following measures may be taken for preventing sickness in the small scale sector : a. Arranging access to institutional credit at reasonably lower rate of interest.

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b.

Industrial Estates equipped with the required facilities should be set up in suitable locations.

c.

Entrepreneurship and Technology training should be arranged and then linked with the provision of credit facilities. A national level training institute for entrepreneurship development in the small scale sector should be set up. Meanwhile, BSCIC Training Institute and DCCI Business Institute may be strengthened for upgradation of capability of the existing entrepreneurs.

d.

Sub-contracting arrangements should be made by establishing complimentary relationship with the medium and large industries. Government supplies may be procured from small industries as far as possible.

e.

Data Bank should be developed at the Chamber Bodies/BOI/BSCIC to facilitate the adequate flow of market-related information.

f.

There may be one marketing agency entrusted with the responsibility of purchasing all goods manufactured by SSI units (Say, upto Tk. 10 million investment) and the task of channeling sales through various sales depots. (v) Rationalization of Tariff : In cases where deemed necessary, some protective measures should be taken by restricting import of the locally produced finished goods so that fiscal anomalies could be removed. (vi) Improvement of Infrastructural Facilities: Infrastructural facilities including utilities should be made available to the entrepreneurs at low cost and at the appropriate time. (vii) Monitoring of Saturation in Particular Industry Sub-sector: There should be some agency entrusted with the task of monitoring the establishment of too many units in the same sub-sector so that overcrowding could be prevented.

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(viii) Development of Linkage Industries: In order to mitigate the problem of non-availability/scarcity of raw-material as well as marketing of finished goods, backward and forward linkage industries should be set up in a planned way. Moreover, close linkage of Industry with agriculture will help ease problem of scarcity of raw-material. (ix) Active Support of Banks and Financial Institutions: a. In case of industrial units where term loan is needed, the availability of working capital should be ensured as part of the financial package. b. Banks should provide due attention to process the working capital needs of the industrial units without any delay. c. BMRE Loan should be actively considered by the banks and financial institutions for the existing industrial units undergoing the reality of rapid change in technology so that productive capacities are not rendered idle/underutilized. d. Interest rate on loan should be made lower by improving operational efficiency of the banks. This will help reduce financial costs of the industrial units and thus gain access to competitiveness. e. Bank-client relationship should be based on understanding of the mutual problems and prospects for greater interest of survival of both the entities. f. Banks should improve the quality of project appraisal in order to prevent the growth of born-sick projects and for that, availability of adequate and accurate data and skilled manpower have to be ensured. g. Banks could fix up a time limit for sanction and disbursement of loan limits for helping timely implementation of the projects/utilization of capacity of the borrowing industrial units.

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h.

Monitoring system of the projects financed by the banks should be thoroughly intensive and for this, both off-site and on-site mechanisms should be used in conjunction with each other in order to take timely steps for prevention of sickness.

i.

Educated entrepreneurs with technical know-how should be encouraged to set up industrial units. They should be provided with all possible support, both financial and non-financial without emphasis on collateral. (x) Expansion of Market Base through Increased Exports : Domestic market is gradually getting squeezed due to the influx of officially imported foreign goods and smuggled goods. On the one hand, export market should be expanded by increasing the number of exportable products. On the other, anti-smuggling drive should be strengthened. For this, import policy should be restructured in a way that discourages smuggling to a great extent. (xi) Use of Predictive Models : Banks and entrepreneurs should follow some predictive models for early detection of sickness on the basis of evaluation of financial health of the industrial units. (xii) Facilitation of Enabling Environment: Deterioration of Law and Order, extortion, harassment etc. should be checked at any cost. In case of natural calamities, special assistance should be provided for resilience.

REMEDIAL MEASURES Despite all preventions and sincerity of the policy-makers and stakeholders, some industrial units would genuinely face sickness. In order to provide scope for timely revival of those units, efforts should be underway from all concerned. However, some unviable units should be allowed to die a natural death without delay.

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The suggested remedial measures for the industrial units approaching towards sickness and already turned sick, are as follows : (i) Every bank and financial institution should have a "Project Rehabilitation Cell" manned by the experts of various disciplines. There should be ongoing process of evaluation of the heath of the assisted units by the banks to detect early warning signals. For this, congenial bank-client relationship is a must for extending co-operation to each other. i. Genuine sick units capable of being revived should be allowed rehabilitation package by way of rescheduling of existing loans, waiver/remission of interest payments, conversion of short term liabilities into long term obligations, etc. depending on the merit of the each case. ii. There might be one "Interest Remission Committee" to be formed by the Govt. from time to time to address the genuine problems of small sick units (where investment ceiling may be upto Tk. 1 crore). However, this step should not encourage the non-sick units to avail of this temporary facility. The screening process should be strict enough to select the genuine sick units for such concession. As it was followed previously, the Govt. may compensate upto 50% of the waived interest to the concerned banks. iii. If necessary, change of management of the sick units should be brought in to facilitate successful running of the projects. iv. Only financial and management rehabilitations of the sick units will not bring the desired result unless Govt. assistance in the form of reduced taxes, duties, concessions on various charges like gas, electricity, etc., imposition of restriction on related import items etc are made available. v. Bangladesh Bank may set up a Sick Industry Cell to monitor the performance of the lending institutions in handling the problems of sick

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units and to co-ordinate the rehabilitation efforts of banks, financial institutions, Govt. and other agencies involved. vi. Possibilities of mergers and acquisitions may be explored in case of sick industrial units not capable of being revived by their own strengths. Suitable policy guidelines may be framed in this regard. vii. SOEs found chronically sick should not be allowed to operate in the limping state any further. In case of sick SOEs capable of being revived, disinvestment process may be expedited. viii. The provisions of Bankruptcy Act should be strictly enforced in case of sick industrial enterprises with liabilities for exceeding assets.

6.15 COOPERATIVE A cooperative (also co-operative; often referred to as a co-op) is a business organization owned and operated by a group of individuals for their mutual benefit. Cooperatives are defined by the International Co-operative Alliance's Statement on the Co-operative Identity as autonomous associations of persons united voluntarily to meet their common economic, social, and cultural needs and aspirations through jointly-owned and democratically-controlled enterprises. A cooperative may also be defined as a business owned and controlled equally by the people who use its services or by the people who work there. Cooperative enterprises are the focus of study in the field of cooperative economics.

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Cooperatives as legal entities A cooperative is a legal entity owned and democratically controlled by its members. Members often have a close association with the enterprise as producers or consumers of its products or services, or as its employees. In some countries, e.g. Finland and Sweden, there are specific forms of incorporation for co-operatives. Cooperatives may take the form of companies limited by shares or by guarantee, partnerships or unincorporated associations. In the USA, cooperatives are often organized as non-capital stock corporations under state-specific cooperative laws. However, they may also be unincorporated associations or business corporations such as limited liability companies or partnerships; such forms are useful when the members want to allow: 1. 2. some members to have a greater share of the control, or some investors to have a return on their capital that exceeds fixed interest, Neither of which may be allowed under local laws for cooperatives. Cooperatives often share their earnings with the membership as dividends, which are divided among the members according to their participation in the enterprise, such as patronage, instead of according to the value of their capital shareholdings (as is done by a joint stock company).

Identity Cooperatives are based on the cooperative values of "self-help, selfresponsibility, democracy and equality, equity and solidarity" and the seven cooperative principles. 1. Voluntary and Open Membership

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2. 3. 4. 5. 6. 7.

Democratic Member Control Member Economic Participation Autonomy and Independence Education, Training and Information Cooperation among Cooperatives Concern for Community. In the tradition of their founders, cooperative members believe in the ethical values of honesty, openness, social responsibility and caring for others. Such legal entities have a range of unique social characteristics. Membership is open, meaning that anyone who satisfies certain nondiscriminatory conditions may join. Economic benefits are distributed proportionally according to each member's level of participation in the cooperative, for instance by a dividend on sales or purchases, rather than divided according to capital invested. Cooperatives may be generally classified as either consumer cooperatives or producer cooperatives. Cooperatives are closely related to collectives, which differ only in that profit-making or economic stability is placed secondary to adherence to social-justice principles. Co-ops can sometimes be identified on the Internet through the use of the .coop gTLD. Organizations using .coop

6.16 COOPERATIVES AND THEIR PROBLEMS RELATING TO WORKING CAPITAL Information for this study was collected by adding two open-ended questions to Rural Business-Cooperative Services (RBSs) annual survey of farmer cooperatives. The questions sought to identify problems and issues facing cooperative management both in the near past and the near future

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(next 1-2 years). More cooperatives (1,147) responded to the question concerning the past year than those (1,128) about the future. However, the total responses for the future (1,565) were greater than for the past (1,496). Seventeen problem areas were identified for classifying past and future problems. These included: accounts receivable, agricultural economy, competition, consolidation, technology, genetically modified crops, Government regulation, Government programs, increasing costs, labor, low commodity prices, operational, other, transportation, weather, members, and low margins. A two-tier methodology was used to report the findings. In the first tier, the minimum number of problem areas that accounted for at least 50 percent of the responses were reported. In the second tier, problems reported accounted for at least an additional 5 percent of the total responses in a specific category or included at least 10 responses. Among all cooperatives, low commodity prices, the agricultural economy, operational difficulties, and increasing costs were the most frequently mentioned problems management faced the past year. Second-tier problems included labor, low margins, competition, and weather. In the near future, the agricultural economy, low commodity prices, operational difficulties, and increasing costs were most frequently mentioned, just as in the past, but with some shifting of emphasis. Competition, low margins, and labor were included in the second tier. Weather was considered a problem less often. In marketing cooperatives, low commodity prices, operational difficulties, the agricultural economy, and competition were mentioned the most frequently for the past year.

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Labor, low margins, weather, and increasing costs were also frequently mentioned. These same problems were identified for the near future except the agricultural economy and increasing costs were considered to be of greater concern. Management of farm supply cooperatives identified the agricultural economy, low commodity prices, increasing costs, and low margins as the first-tier set of problems. Second-tier problems for the past year included operational difficulties, labor, competition, weather, and accounts receivable. The problems identified for the near future, in the first tier were the same. The second tier, however, included only labor, operational difficulties, and competition. Among related-service cooperatives for the past year, low commodity prices, weather, increasing costs, and labor were mentioned most frequently. Other problem areas included operational difficulties, the agricultural economy, and competition. In the near future, the agricultural economy was of more concern and weather and competition of less concern. By selected type of cooperative, grain cooperatives cited operational difficulties, low commodity prices, low margins, and the agricultural economy most frequently for the past year. The agricultural economy, operational difficulties, low commodity prices, increasing costs, and competition were the most frequent responses for the near future. More concern was given to the agricultural economy and increasing costs and less to low margins. Highlights Fruit and vegetable cooperatives mentioned low commodity prices, competition, operational difficulties, and the agricultural

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economy most frequently as the major problems they faced the past year. These same problem areas were cited most frequently for the near future, but in a different order. The problem area mentioned most frequently by dairy cooperatives for the past year was low commodity prices. Members was also a concern. For the near future, other problem areas surfaced. Low commodity prices were still of major concern. However, the agricultural economy, operational difficulties, and members were also frequently mentioned problems or issues. Wool cooperatives identified low commodity prices and competition as their major problems for the past and coming years, but with more future emphasis on the agricultural economy and operational difficulties. Cotton ginning cooperatives cited low commodity prices, weather, and labor most frequently as problems for the past year. Low commodity prices, increasing costs, weather, the agricultural economy, and labor were mentioned most frequently for the near future. Weather was less of a concern. Low commodity prices and the agricultural economy were among the most frequently cited problems by size of cooperative for the past year. Only one size, cooperatives with revenues of $500 million and more, did not show both of these problem areas among their most frequently cited concerns. Larger-sized cooperatives cited operational problems and increasing costs more frequently.

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MODULE - SIX END CHAPTER QUIZZES

1. At present, which of the following financial instruments are non-existent in India? a. Convertible preference shares b. Partly convertible debentures c. Non voting shares d. Perpetual preference shares

2. Agency cost arises due to a. Cost overrun in implementing new projects b. Failure of budgeted cost c. Restrictions imposed by the supplier of debt capital d. Rise in the cost of production

3. The debt equity ratio of a companya. Affects its financial leverage b. Does not affect the earning per share c. Affects the dividend decision of the company d. Both a and c

4. Technical insolvency refers toa. Bankruptcy on the part of the firm b. Inability to pay debts by the firm for the purchase of machinery c. Inability to pay debts by a firm for the transfer of technology

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d. Inability to honor its current liability

5. Smart software limited buys in lot of 150 boxes, which is a four month supply. The cost per box is Rs. 150 and ordering cost is Rs. 300 per order. The inventory carrying cost is estimated at 25% of unit value per annum. The total annual cost of the existing inventory policy is a. Rs. 82000 b. Rs. 71212.50 c. Rs. 88500.50 d. Rs. 67890.55

ABC ltd. has total revenue of Rs. 25 lakh a year, of which 60% are credit sale. The collection occur at an even rate and the total working days of the firm in the year are 300. The accounts department ties up 5 days worth of remittance checks. On the basis of above question answer question No. 6 and 7.

6. The credit sale per day isa. Rs. 600 b. Rs. 6000 c. Rs. 5000 d. Rs. 2000

7. If the internal delays are arrested this could be reduced by two days. If the release could earn a rate of 6% p.a.. What are the annual savings for the firm? a. Rs. 600

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b. Rs. 6000 c. Rs. 5000 d. Rs. 2000

On the basis of question no. 8, answer question No. 8, 9 and 10. 8. Western cosmetics limited has an excess cash of Rs. 20 lakh which can be invested in short term marketable securities for these transactions the firm incurs an expenditure of Rs. 50000. If the securities invested have annual yield of 8%, the income for 15 days and 1 month are ---- and ----a. Rs. 6667, Rs. 13333 b. Rs. 5555, Rs. 12222 c. Rs. 4044, Rs. 10700 d. Rs. 7500, Rs. 11115

9. The income for 2 months and 4 months are ---- and ---a. Rs. 18354, Rs. 44440 b. Rs. 26666, Rs. 53333 c. Rs. 12777, Rs. 32222 d. Rs. 17988, Rs. 56677

10. The income for month and one year are ---- and ---a. Rs. 80000, Rs. 160000 b. Rs. 40000, Rs. 80000 c. Rs. 60000, Rs. 120000 d. Rs. 50000, Rs. 100000

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ANSWER KEY TO END CHAPTER QUIZZES

KEY TO END CHAPTER QUIZZES
Module One 1(a), 2(b), 3(b), 4(d), 5(d), 6(d), 7(d), 8(d), 9(b), 10(d)

Module Two 1(b), 2(d), 3(d), 4(c), 5(d), 6(a), 7(a), 8(b), 9(b), 10(d)

Module Three 1(d), 2(d), 3(d), 4(d), 5(d), 6(c), 7(b), 8(a), 9(d), 10(d)

Module Four 1(d), 2(b), 3(d), 4(d), 5(d), 6(a), 7(c), 8(b), 9(c), 10(c) Module Five 1(c), 2(b), 3(d), 4(d), 5(d), 6(d), 7(d), 8(a), 9(d), 10(d)

Module Six 1(d), 2(c), 3(d), 4(d), 5(b), 6(c), 7(a), 8(a), 9(b), 10(a)

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BIBLIOGRAPHY
(I) Books : 1. Bansal, B. L. : Financial Planning and Public Enterprises 2. Chandra Prasanna 3. Dag Lay, V. 4. Garg, A. K. 5. Gupta, S. P. 6. Kumar, R. 7. Lal, G. S. 8. Maheshwari, S. N. 9. Pandey, I. M. [Link], W. E. [Link], S. C. : Financial Management : Financial Institution in India : Elements of Financial Management : Financial Management : Financial Management : Financial Administration in India : Elements of Financial Management : Financial Management : Essentials of Financial Management : Financial Management, Analytical and Conceptual

II) Journals, Periodicals, Newspapers and Other useful Publications

1. Economic and Political Weekly. 2. India Today. 3. Business India. 4. Journal of Accounting & Management. 5. Financial Express. 6. Management Accountant. 7. Times of India Directory.

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III) Reports and Other Materials 1. Journals & reports in Financial Management. 2. Various reports on Accounting & Management practices.

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