MMPF-001

Working Capital
School of Management Studies Management

BLOCK 1 CONCEPTS AND DETERMINATION 5

BLOCK 2 MANAGEMENT OF CURRENT
ASSETS 71
BLOCK 3 FINANCING OF WORKING
CAPITAL 185
BLOCK 4 WORKING CAPITAL MANAGEMENT:
ISSUES AND PRACTICES 259
COURSE DESIGN AND PREPARATION TEAM
Prof. K. Ravi Sankar Prof. K.V. Rao
Director, Former Vice Chancellor,
School of Management Studies, Acharya Nagarjuna University, Guntur
IGNOU, New Delhi

Prof. Varadraj Bapat Prof. C. P. Gupta

Indian Institute of Technology, Department of Financial Studies,
Mumbai University of Delhi, Delhi
Prof. Jayant Kumar Seal Prof. G.V. Chalam
Indian Institute of Foreign Trade, Former Dean,
Qutub Institutional Area Dept. of Commerce and Business Admn.
New Delhi Acharya Nagarjuna University, Guntur

Prof. Madhu Vij Prof. Kamal Vagrecha

Faculty of Management Studies, School of Management Studies,
University of Delhi, Delhi IGNOU, New Delhi
Prof. Pankaj Gupta Dr. Shital Jhunjhunwala
Centre for Management Studies, Department of Commerce,
Jamia Milia Islamia University of Delhi, Delhi
*Prof. P.N. Varshney Dr. Ritu Sapra
E-30, Greater Kailesh – III Department of Commerce,
Masjid Moth, New Delhi University of Delhi, Delhi
*Prof. R.S. Dhankar *Prof. M.S. Narasimhan
Faculty of Management Studies, Finance & Control Area
University of Delhi, South Campus, Indian Institute of Management,
New Delhi Bangalore

*Prof. M. Chandrasekhar *Prof. V.K. Bhalla

Indian Institute of Advanced Management Faculty of Management Studies
M.V.P. Colony, Visakhapatnam University of Delhi, Delhi
Course Editor Course Coordinator
Prof. K.V. Rao Prof. Anjali. C. Ramteke
School of Management Studies,
IGNOU, New Delhi

*Acknowledgement: Some parts of this course have been adapted from the earlier course MS 41:
Working Capital Management. The persons marked (*) were the original contributors and their pro-
file is as it was on the date of initial print.

MATERIAL PRODUCTION
Mr. Tilak Raj
Assistant Registrar
MPDD, IGNOU, New Delhi

September, 2022
© Indira Gandhi National Open University, 2022
ISBN:
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means, without permission in writing from the Indira Gandhi National Open University. Further
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 Content
Pages
BLOCK 1 CONCEPTS AND DETERMINATION 5
Unit 1 Conceptual Framework 7
Unit 2 Operating Environment of Working Capital 28
Unit 3 Determination of Working Capital 49
BLOCK 2 MANAGEMENT OF CURRENT ASSETS 71
Unit 4 Management of Receivables 73
Unit 5 Management of Cash 105
Unit 6 Management of Marketable Securities 128
Unit 7 Management of Inventory 154
BLOCK 3 FINANCING OF WORKING CAPITAL 185
Unit 8 Theories and Approaches 187
Unit 9 Payables Management 202
Unit 10 Bank Credit - Principles and Practices 213
Unit 11 Other Sources of Short Term Finance 239
BLOCK 4 WORKING CAPITAL MANAGEMENT: ISSUES AND
PRACTICES 259
Unit 12 Working Capital Management in SMEs 261
Unit 13 Working Capital Management in Large Companies 285
Unit 14 Working Capital Management in MNCs 300
Unit 15 Case Studies 316
 BLOCK 1
CONCEPTS AND DETERMINATION
BLOCK I CONCEPTS AND DETERMINATION
This course has been designed in such a manner that after having gone
through it you will be in a position to manage the working capital at your
workplace. Most of the firms carry on their business basically with two kinds
of assets, fixed assets and current assets. The management of current assets is
widely understood as working capital management; ipso facto, it also implies
the discussion on current liabilities.
In many manufacturing units, current assets form more than half of the
capital employed. Truly, greater part of the time of the manager is spent in
dealing with the issues concerning the management of working capital. In the
present course, Block-1 covers three units, which attempt to highlight issues
pertaining definition, constituents, operating environment and assessing
working capital requirements. The first unit covers aspects pertaining to
definitions, flow, significance and trends in working capital. The impact of
inflation on working capital is also discussed in this unit.

Operating Environment of Working Capital is discussed in the unit-2. This

unit covers changes in the monetary and credit policies, financial markets and
economic liberalization. A framework for assessing the working capital
requirements is discussed in unit-3. This unit also covers the practical aspects
of lending by commercial banks.
 Conceptual
UNIT 1 CONCEPTUAL FRAMEWORK Framework

Objectives
The objectives of this unit are to:
• Explain the various types of working capital and their behaviour.
• Examine the cyclical flow and characteristics of working capital.
• Discuss the significance and tools of planning for working capital.
• Find out the impact of inflation on working capital and finally.
• Analyse the trends in working capital in Indian companies.

Structure
1.1 Introduction
1.2 Definition of Working Capital
1.3 Constituents of Working Capital
1.4 Types of Working Capital
1.5 Cyclical Flow and Characteristics of Working Capital
1.6 Planning for Working Capital
1.7 Working Capital and Inflation
1.8 Trends in Working Capital
1.9 Summary
1.10 Key Words
1.11 Self-Assessment Questions
1.12 Further Readings

1.1 INTRODUCTION
Financial management can be divided into two major parts as the
management of long-term capital and the management of short-term funds or
working capital. The management of working capital which constitutes a
major area of decision-making for financial managers is a continuous
function which involves the control of every ebb and flow of financial
resources circulating in the enterprise in one form or another. It also refers to
the management of current assets and current liabilities. Efficient
management of working capital is an essential pre–requisite for the
successful operation of a business enterprise and improving its rate of return
on the capital invested in short-term assets. As a matter of fact, the
operational efficiency of a business unit is solely dependent on the prudent
management of working capital.

Virtually every business enterprise requires working capital to pay-off its

short-term obligations. Moreover, every firm needs working capital because
it’s not possible that production, sales, cash receipts and payments are all
7
Concepts and instantaneous and synchronised. There elapses certain time for converting
Determination
raw materials into finished goods: finished goods into sales and finally
realisation of sale proceeds. Hence, funds are required to support all such
activities in the firm. A number of terms like working funds, circulating
capital, temporary funds are used synonymously for working capital.
However, the expression, Working Capital, is preferred by many due to its
popularity and simplicity.

1.2 DEFINITION OF WORKING CAPITAL

Working capital may be defined in two ways, either as the total of current
assets or as the difference between the total of current assets and total of
current liabilities.

Like, most other financial terms the concept of working capital is used in
different connotations by different writers. Thus, there emerged the following
two concepts of working capital.
i) Gross concept of working capital
ii) Net concept of working capital

Gross Concept:

No special distinction is made between the terms total current assets and
working capital by authors like Mehta, Archer, Bogen, Mead and Baker.
According to them working capital is nothing but the total of current assets
for the following reasons:

i) Profits are earned with the help of the assets which are partly fixed and
partly current. To a certain degree, similarity can be observed in fixed
and current assets in that both are partly borrowed and yield profit over
and above the interest costs. Logic then demands that current assets
should be taken to mean the working capital of the corporation.

ii) With every increase in funds, the gross working capital will increase
while according to the net concept of working capital there will be no
change in the funds available for the operating manager.

iii) The management is more concerned with the total current assets as they
constitute the total funds available for operating purposes than with the
sources from which the funds came, and that

iv) The net concept of working capital had relevance when the form of
organisation was single entrepreneurship or partnership. In other words a
close contact was involved between the ownership, management and
control of the enterprise and consequently the ownership of current and
fixed assets is not given so much importance as in the past.

Net Concept
Contrary to the aforesaid point of view, writers like Smith, Guthmann and
Dougall. Howard and Gross, consider working capital as the mere difference
between current assets and current liabilities. According to Keith. V. Smith, a
8
broader view of working capital would also include current liabilities such as Conceptual
Framework
accounts payable, notes payable and other accruals. In his opinion, working
capital management involves the managing of individual current liabilities
and the managing of all inter-relationships that link current assets with
current liabilities and other balance sheet accounts. The net concept is
advocated for the following reasons:
i) in the long-run what matters is the surplus of current assets over current
liabilities.
ii) it is this concept which helps creditors and investors to judge the
financial soundness of the enterprise.
iii) what can always be relied upon to meet the contingencies is the excess of
current assets over current liabilities, since it is not to be returned; and
iv) this definition helps to find out the correct financial position of
companies having the same amount of current assets.
In general, the Gross concept is referred to as the Economics concept, since
assets are employed to derive a rate of return. What rate of return is generated
by different assets is more important than the analysed difference between
assets and liabilities. On the contrary, the net concept is said to be the point
of view of an accountant. In this sense, working capital is viewed as a
liquidation concept. Therefore, the solvency of the firm is seen from the
point of view of this difference. Generally, lenders and creditors view this, as
the most pertinent approach to the problem of working capital.

1.3 CONSTITUENTS OF WORKING CAPITAL

No matter how, we define working capital, we should know what constitutes
current assets and current liabilities. Let us refer to the Balance Sheet of
Lupin Laboratories Ltd. for this purpose.

Current Assets: The following are listed by the Company as current assets:

1) Inventories:
a) Raw materials and packing materials
b) Work-in-progress
c) Finished/Traded goods
d) Stores, Spares and fuel
2) Sundry Debtors:
a) Debts outstanding for a period exceeding six months
b) Other debts
3) Cash and Bank balances:
a) With Scheduled Banks
i) in Current accounts
ii) in Deposit accounts

9
Concepts and b) With others in
Determination
i) Current accounts
4) Loans and advances:
a) Secured Advances
b) Unsecured (considered good)
i) Advances recoverable in cash or kind for value to be
received
ii) Deposits
iii) Balances with customs and excise authorities
Current liabilities: The following items are included under this category.

i) Current Liabilities:
a) Sundry creditors
b) Unclaimed dividend warrants
c) Unclaimed debenture interest warrants
ii) Short-term C redit:
a) Short term loans
b) Cash credit from banks
c) Other short-term payables
iii) Provisions:
a) For Taxation
b) Proposed Dividend
i) on preference shares
ii) on equity shares
Besides, items like prepaid expenses, certain advance payments are also
included in the list of current assets. Similarly, bills payable, income received
in advance for the services to be rendered are treated as current liabilities.
Nevertheless, there is difference of opinion as to what is current. In the strict
sense of the term, it is related to the, operating cycle, of the firm and current
assets are treated as those that can be converted into cash within the operating
cycle. The period of the operating cycle may be more or less compared to the
accounting period of the firm. In case of some firms the operating cycle
period may be small and in an accounting period there can be more than one
cycle. In order to avoid this confusion, a more general treatment is given to
the, currentness, of assets and liabilities and the accounting period (generally
one-year) is taken as the basis for distinguishing current and non-current
assets.

1.4 TYPES OF WORKING CAPITAL

Sometimes, working capital is divided into two varieties as:
i) Permanent working capital
ii) Variable working capital
10
Permanent Working Capital: Though working capital has a limited life and Conceptual
Framework
usually not exceeding a year, in actual practice some part of the investment in
that is always permanent. Since firms have relatively longer life and
production does not stop at the end of a particular accounting period, some
investment is always locked up in the form of raw materials, work-in-
progress, finished stocks, book debts and cash. The investment in these
components of working capital is simply carried forward to the next year.
This minimum level of investment in current assets that is required to
continue the business without interruption is referred to as permanent
working capital. While suggesting a methodology for financing working
capital requirements by commercial banks, the Tandon committee has also
recognised the need to maintain a minimum level of investment in current
assets. It referred them as, hard core current assets. The Committee wanted
the borrowers to meet this portion of investment out of their own sources and
not to depend on commercial banks.
Variable Working Capital: This is also known as the circulating or
transitory working capital. This is the amount of investment required to take
care of the fluctuations in the business activity. While permanent working
capital is meant to take care of the minimum investment in various current
assets, variable working capital is expected to care for the peaks in the
business activity. While investment in permanent portion can be predicted
with some probability, investment in variable portion of working capital
cannot be predicted easily as sudden changes in the business activity cause
variations in this portion of working capital.

1.4.1 Working Capital Behaviour

One of the implications of the division of working capital into two types is to
understand its behaviour over a period of time. Investment in working
capital is related to sales volume. A variation in sales volume over time
would consequently bring about a change in the investment of working
capital. This is said to vary depending upon the type of working capital.
These variations with respect to different types of firms are presumed to vary
as indicated in Fig. 1.1

Figure 1.1 exemplifies the behaviour of different types of working capital in

diverse firms affected by seasonal and cyclical variations in production or
sales. In case of non-growth, non-seasonal and non-cyclical firms, all the
working capital can be considered permanent as shown in (A). Similarly,
growing firms require more working capital over a period of time, but
fluctuations are not assumed to occur. As such, in this case also, no variable
portion of working capital is present. In the third case (growing seasonal and
non-cyclical firms), there are two types of working capital. On the contrary,
in case of growing, seasonal and cyclical firms, all the working capital is
assumed to be of varying type.

11
Concepts and
Determination

Fig. 1.1: Behaviour of Working Capital

Activity 1.1
Mention the points of differentiation between
i) Gross concept and Net concept
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
..............................................................................................................
ii) Permanent working capital & Variable working capital
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
12
 Conceptual
1.5 CYCLICAL FLOW AND CHARACTERISTICS Framework
OF WORKING CAPITAL
For every business enterprise there will be a natural cycle of activity. Due to
the interaction of the various forces affecting the working capital, it
transforms and moves from one to the other. The role of the financial
manager then, is to ensure that the flow proceeds through different working
capital stages at an effective rate and at the appropriate time. However, the
successive movements in this cycle will be different from one enterprise to
another, based on the nature of the enterprises. For example:

i) If the enterprise is a manufacturing concern, the cycle will run something

like:Cash→(buying) →Raw Materials→(production)→Finished Goods→
(sales on credit) Accounts Receivable→(Collections) →Cash.
ii) If the enterprise is purely a Retailing Company and one, which has no
manufacturing problem the cycle is shortened as:
Cash→(buying) →Merchandise→ (Sales) →Accounts Receivables→
(Collections) → Cash.
iii) If the enterprise is a purely financing enterprise, the cycle is still shorter
and it can be shown as:

Cash→ (sanction of loans) →Debtors→ (collections) →Cash.

But in real business situations, the cyclical flow of working capital is not
simple and smooth going, as one may be tempted to conclude from these
simple flows. This cyclical process is repeated again and again and so do the
values keep on changing as they move through the cash to cash path. In other
words the cash flows arising from cash sales and collections from debtors
will either exceed or be lower than cash outflows represented by the amounts
spent on materials, labour and other expenses. An excess cash outflow over
cash inflow is a clear indication of the enterprise having suffered a loss. Thus
it is apparent, that the amount of working capital required and its level at any
particular time will be governed directly by the frequency with which this
cash cycle can be sustained and repeated. The faster the cycle the lesser will
be the investment needed in working capital.

Form the aforesaid discussion, one can easily identify three important
characteristics of working capital, namely, short life span, swift
transformation and inter–related asset forms and synchronization of activity
levels.

1. Short-life Span
Components of working capital are short-lived. Typically their life span
does not exceed one year. In practice, however, some assets that violate
this criterion are still classified as current assets.
2. Swift Transformation and Inter-related Asset Forms
In addition to their short span of life, each component of the current
assets is swiftly transformed into the other assets. Thus cash is utilised to
replenish inventories. Inventories are diminished when sales occur, that 13
Concepts and augment accounts receivable and collection of accounts receivable
Determination
increases cash balances. So a natural corollary of this quick
transformation is the frequent and repetitive decisions that affect the
level of working capital and the close interaction that exists among the
members of the family of working capital. The latter entails the
assumption that efficient management of one asset cannot be undertaken
without simultaneous consideration of other assets.
3. Assets Forms and Synchronization of Activity Levels
A third characteristic of working capital components is that their life
span depends upon the extent to which the basic activities like
production, distribution and collection are non-instantaneous and
unsynchronized. If these three activities are only instantaneous and
synchronized, the management of working capital would obviously be a
trivial problem. If production and sales are synchronized there would be
no need to have inventories. Similarly, when all customers pay cash,
management of accounts receivable would become unnecessary.

1.6 PLANNING FOR WORKING CAPITAL

Planning provides a logical starting point for many of the decisions. It is very
much true for working capital decision also. Unless, we plan for procurement
and effective use we will not be in a position to get best out of working
capital. In a way, effective planning leads to appropriate allocation of the
resources among different components of working capital. Drawing a
distinction of the kind of Peter F. Drucker, between efficiency (doing things
right) and effectiveness (doing right things), planning clearly embraces the
latter. It is for this reason planning for working capital is considered highly
appropriate and inclusive of the present discussion on conceptual
framework.

While planning should logically begin at the top of the organisational

hierarchy, responsibility for planning exists at all levels within the
organisation. While working capital planning is a part of financial planning,
the responsibility permeates among different managers within the
organisation responsible for managing different components of working
capital. At the level of planning for individual components of working capital
persons like materials manager, credit manager and cash manager are
involved. However, the overall responsibility for co-ordinating the planning
of working capital typically rests with the top management.

1.6.1 Tools of Planning for Working Capital

It should be interesting to know how to identify the relevant tools for
completing the planning exercise. Treating the planning for working capital
as part of financial planning, we can note down the following tools of
analysis with respect to time- frame.

a) Short-term Planning – Cash Budgeting

b) Medium-term Planning – Determination of appropriate levels of
14 working capital items
c) Long-term Planning –Projected pay outs and returns to shareholders in Conceptual
Framework
terms of CVP and funds flow analysis.
Cash budget: In the short term cash budgeting is considered a handy device
for planning working capital. The use of cash budget technique as a means of
determining the size of the cash flows is considered superior to the use of
proforma balance sheets or judging by the past experience. A cash budget
is comparison of estimated cash inflows and outflows for a particular period
such as a day, a week, a month, a quarter or year. Typically Cash budget is
designed to cover one–year period and the period covered is sub-divided into
intervals. It can be prepared in various ways like the one based on cash
receipts and disbursements method, or the adjusted net income method, or the
working capital differential method.

The budgeting process begins with the beginning balance to which are added
expected receipts. This amount is reached by multiplying expected cash
receipts by the probability distribution that will prevail during the budgetary
period. If outlays exceed the beginning balance plus anticipated receipts, the
difference must be financed from external sources. If an excess exist,
management must make a decision regarding its disposal either in terms of
investing in short-term securities, repaying the existing debts or returning the
funds to the share-holders.

The preparation of the cash budget helps management in many ways.

Management will be able to ward off the disadvantages of excessive
liquidity, since there will be information on how and when such cash results
in. Similarly, it will be able to contact different sources of finance to tide over
a situation of cash shortage and can avoid rushing to obtain finance at
whatever cost. It allows the management to relate the maturity of the loan to
the need and determine the best source of funds, since the information
furnished by the budget reflects the amounts and time for which funds are
needed. Further, cash Budget establishes a sound basis for controlling the
cash position.

Of the several methods of preparing the cash budget, Receipts and Payments
method is popular among many undertakings. More so the preparation of
cash budgets in the organisations is an integral part of the budgetary process,
since the whole of the budgetary structure is divided into revenue budgets,
expenditure budgets and cash budgets. Cash budget was prepared by the
organisations by borrowing figures from various other budgets such as the
following:

i) Production budgets.
ii) Sales budget.
iii) Cost of production estimates with its necessary subdivisions for
example.
a) materials purchase estimates:
b) labour and personnel estimates:
c) plant maintenance estimates: etc.
iv) Manpower budget. 15
Concepts and v) Township and welfare estimates
Determination
vi) Profit and loss estimates.
vii) Capital expenditure budget.

Thus, cash budget is prepared as a means of identifying the past cash flows
and determine the future course of action. Cash budgets, generally are
prepared by all enterprises on yearly basis having monthly break–ups.

Medium-term Planning: In the medium term, determining appropriate level

of working capital is considered a focal point. In unit 3 of this course on
‘Determination of working Capital’, we have discussed in detail the
following three approaches to determine optimum investment in working
capital.
1) Industry Norm Approach
2) Economic Modelling Approach
3) Strategic Choice Approach

Therefore, students are advised to refer to that particular unit and hence
discussion on them is not repeated here.
CVP Analysis: As a measure of long term planning, macro-level techniques
like C-V-P and Funds Flow are considered helpful in making an effective
planning. These are helpful not only for working capital planning but also for
the entire financial planning. At the level of working capital planning, we are
required to establish relationships between costs; volume and profits. Though
the regular break-even point is used to determine that level of sales or
production which equals total costs, in the area of working capital, we can be
cautious about the costs and revenues akin to working capital items such as
inventory, receivables and cash. Firms often face a dilemma of whether to
place an order to keep a particular level of inventory or not and whether a
customer be provided credit or not. These matters can be effectively dealt
with orientation towards the C-V-P relationships.

In this context, a distinction may be made between cash break-even point and
profit break-even point, which represents liquidity and profitability
respectively. Cash break-even point, which is defined as that level of sales
per period for which sales revenue just equals the cash outlays associated
with the product or business. This kind of an analysis helps in focusing on the
areas of cash deficit and cash surplus leading to better liquidity management.
When we appreciate the fact that working capital is a liquidation concept, the
utility of CVP concept in making better exercise in planning for working
capital, needs no special emphasis.

Funds Flow: Funds flow is yet another tool used in the long run to analyse
the financial position of a company. Though the term funds can be
understood to include all financial resources, preparation of funds flow
statements on working capital basis are more common in finance. The
preparation of such flow statements gives an idea as to the movement of
funds in the organisation. The particulars relating to the funds generated from
operations and changes in net working capital position are highly relevant in
16
this analysis. A firm’s capacity to pay off its current debts depends mainly on Conceptual
Framework
its ability to secure funds from operations. The prime objective of funds flow
statement (prepared on the basis of working capital movements) is to show
the ebb and flow of funds through working capital and to shed light on
factors contributing to the movements. As a matter of fact, the internal
movement of wealth (to a large extent) usually takes place among working
capital items. An analysis of these movements therefore would provide an
understanding of the efficiency of working capital management.

Whereas, the schedule of working capital is designed to measure, the flow of

funds through working capital. For that matter, one has to ascertain changes
in current assets and current liabilities during the two balance sheet dates and
record variations in working capital. This would help in identifying the net
changes. i.e., increases and decreases in working capital position.

1.7 WORKING CAPITAL AND INFLATION

Inflation, which is commonly indicated by the rise in prices of goods and
services, is so rampant in the world that no economy is far off from its
deleterious effects. Inflation has been experienced by almost all the countries
in the world irrespective of their political system and the stage of
industrialisation. The fact is that, over the last two decades, annual rates of
inflation in excess of two to three percent have become common all over
the world.

In India, the rate of inflation was more grievous than in many other countries,
and the wholesale prices rose by almost 32 percent during 1956-61, by
slightly less than 30 percent during 1961-66, and 25 percent during the
Annual Plan periods (1966-69). Besides fluctuations the annual rate of rise in
the wholesale price was exceptionally high and in 1974-75, almost alarming.
Inflation rate based on Wholesale Price Index (WPI) averaged around 9 per
cent during 1970-71 to 1990-91. Again it touched the highest level of the
decade in 1991-92 at 16.7 percent, when the economic activity was at its
lowest ebb. Consequent upon the reforms, there has been some recovery in
the economy and the rate of inflation has come down to even 2 percent
during 1998-99, threatening the regime of deflation. Nevertheless, there is no
consistency in the performance of the economy. Again the rate of inflation is
moving towards an average of 5-6 percent during the present times (two
thousand twenties). Alongside these indices there are some hidden
inflationary potentials which are not apparent. Prominent among these are
generous subsidies, changing international prices of crude oil and petroleum
products and the administered prices for certain other products. Now that the
Government of India has freed the fixation of prices of petroleum products,
oil companies are fixing rates on daily basis. The cost of diesel and petrol
touching around Rs.100 per litre. The irony of the situation is that the prices
in India are shooting up day by day, even though the prices of crude in the
international markets are decelerating. The combined impact of these factors
is definitely seen on the inflation. The impact of inflation on working capital
could be understood in the following manner.

17
Concepts and 1.7.1 Size of Working Capital
Determination
Inflation causes a spurt in the prices of input factors like raw materials,
labour, fuel and power, even though there is no increase in the quantum of
such input factors used. Secondly inflationary conditions by providing
motivation for higher profits induce the manufacturers to increase their
volume of operations. High profits and high prices create further demand
thus, leading to further investments in inventories, receivables and cash. The
cycle, thus continues for a long time, entailing the finance manager to arrange
for larger working funds after each successive increase in the volume of
operations. Thirdly, companies also tend to accumulate inventories during
inflation to reap the speculative profits. This kind of blocking up of funds, in
turn necessitates enterprise to maintain larger working capital funds. Finally,
the existing financial reporting practices of firms on the basis of historical
costs as per the companies Act and Income Tax Act are also responsible, for
the reduction in the size of working capital finance. During the period of
inflation, since historical costs set against the current prices and inventories
are valued at current prices, higher profits would be reported. The reporting
of inflated profits creates two aberrations. The company has to pay higher
taxes on the inflated profit figure though much of it is unrealised and if the
company also declares the remaining profits as dividends, it leads to
distribution of dividends out of capital and eventually reduces the funds
available to the company for operations in inflationary years owing to
escalation in cost of inputs, increase in the volume of operations,
accumulation of speculative inventory and the adoption of historical cost
accounting system.

1.7.2 Availability of Working Capital

Besides the problem of increased demand for funds there would be a
reduction in the availability of such funds associated with higher costs
during inflation. There would be no problem if the working capital funds are
available to an unlimited extent at a reasonable cost, regardless of the
economic condition prevailing in the economy. In reality, the situation is
completely the opposite as both internal and external sources of funds for
financing working capital become scarce.

As pointed out earlier, during inflation the availability of internal sources gets
reduced because of the maintenance of records on historical cost basis. On
the other hand, the position with regard to external sources of funds is equally
disheartening. The rapid increase in inflation will give rise to the formulation
of tight money policy by the Reserve Bank of India with a view to restricting
the flow of credit in the economy. Consequently, the extension of credit
facilities from banks become extremely limited. Further, the diversion of
bank funds to priority sectors, after nationalisation has made it more difficult
to raise funds from banks.

Till recently, companies depended heavily on public deposits and debentures

for meeting their working capital requirements. Their availability however
was reduced due to the restrictions imposed by the Reserve Bank of India
(RBI) on the companies for the mobilisation of deposits from public,
18
particularly since 1978. Further the advent of Government companies into the Conceptual
Framework
capital market for accepting public deposits made it more difficult to attract
funds from the public. In view of failure of many companies in the recent
past (2020s) in meeting the payment obligations on debentures, raising
resources through this method for working capital became extremely
difficult.
Coming to the trade credit, one must note that it may not be available for long
periods, and the suppliers of goods tighten the credit facilities during
inflationary period. The issue of long term loans may also be slackened, as
the investors would be less attracted by investments offering a fixed return
like debentures and preference shares. This is so because in terms of
purchasing power the principal amount of investment as well as the interest
would dwindle. Thus, these restrictions and limitations on the availability of
working capital from internal and external sources makes it difficult for the
finance manager to raise funds during inflation.

1.7.3 Components of Working Capital

It may be interesting at this stage of the analysis to consider the impact of
inflation on the components of working capital, namely, inventory,
receivables and cash.

Inventory
Not many understand fully the impact of inflation on the management of
inventory. Inflation affects the decisions in respect of inventory in many
ways, namely;

i) It leads to over-investment in inventory.

ii) It results in shortages.
iii) It affects valuation of inventories; and
iv) It renders the traditional inventory control techniques ineffective.
During the periods of inflation when the prices rise rapidly, companies will
have an incentive to invest more heavily in inventory than is indicated by the
minimum cost calculation. If the management believes the price of an item
will increase by 10 per cent in the next month, substantially more of that item
may be ordered than normal. Of course, due to increase in inventory the
company may get speculative gain, but this speculative gain may be off-set
by the increase in taxes due to higher profit figures, reported in times of
inflation and higher carrying costs.

Another difficulty that the company is required to face is the material

shortages in the periods of inflation. It is not known whether inflationary
escalations result in shortages or shortages occur because of instability
caused by inflation. Whatever be the real source of the problem, companies
should be conscious of the price trends and accordingly re-evaluate their
internal purchasing and organisational systems.
Very few firms realise the impact of inflation on the valuation of inventory
and the extent to which it contributes to unrealised profits. In other words,
19
Concepts and inflation affects the valuation of inventories, affecting thereby the amount of
Determination
profits reported in the financial statements.

Not only inflation affects the inventory, but inflation itself is also increased
due to the inefficient management of inventory. Delivering the keynote
address at a National Convention on the subject of, ‘Curbing Inflation
through Effective Materials Management’, Shri P. J. Fernandes put forward
the following five propositions to show the impact of inflation on the
materials management.
a) The stocks which are held by the enterprises have a direct and immediate
relationship to general price levels.
b) The price level in any country is to a great extent determined by the cost
of production. The cost of production is to a great extent determined by
the cost of inputs. Hence, if the cost of inputs goes up, the cost of
production as well as the price level also goes up.
c) An effective system of materials management must necessarily result in
an increase in production.
d) The materials manager can have a total and absolute impact on
production outside his unit, and
e) It is the materials management, which can reduce the crushing burden of
credit expansion, and the money supply, which again will have a direct
and absolute impact on inflationary tendency.

Finally, it may be considered with the help of the following illustration how
inflation renders the traditional inventory control techniques ineffective.

Assumptions
1) Annual consumption Rs. 1,00,000
2) Economic Ordering Quantity Rs. 3,125
3) No of orders per year 32
4) Ordering cost Rs. 20 per order
5) Carrying cost Rs. 25 per cent
6) Lead time constant
7) Price rise 5 per cent per month.

The ordering and carrying costs would be as follows:

a) Ordering costs = 32 × 20 = Rs 640
3125 25
b) Carrying costs = Rs.390.63
2 100
c) Total costs = Rs. 640 + 390.63 = Rs 1030.63

If 32 orders are placed in a year, the distribution of the same in each month
and the material cost month-wise would be as given below:

20
 Conceptual
Total Material Cost Framework
No. of months No. of orders Material cost

1st. Month 2 3125 × 2 × 1.00 = 6,250.00

2nd Month 3 3125 × 3 × 1.05 = 9,843.75
3rd Month 3 3125 × 3 × 1.10 = 10,312.50
4th Month 2 3125 × 2 × 1.15 = 7,187.50
5th Month 3 3125 × 3 × 1.20 = 11,250.00
6th Month 3 3125 × 3 × 1.25 = 11,718.75
7th Month 3 3125 × 3 × 1.30 = 12,187.50
8th Month 2 3125 × 2 × 1.35 = 8,437.50
9th Month 3 3125 × 3 × 1.40 = 13,125.00
10th Month 3 3125 × 3 × 1.45 = 13,593.75
11th Month 3 3125 × 3 × 1.50 = 14,062.50
12th Month 2 3125 × 2 × 1.55 = 9,687.50
32 1,27,656,25

Based on the EOQ formula, if one places orders as shown in the example, the
total material cost comes to Rs. 1,27,656.25 (i.e. Material Cost + Ordering
Costs + Inventory Carrying Costs). In contrast, If the firm in question does
not apply the EOQ technique and simply resorts to buying at the single
stretch or lot buying, the total material cost would be only Rs. 1,12,520/- as
worked out below:
1) Quantity needed for the year = Rs. 1,00,000
2) No of orders = 1(one lot)
3) Ordering Costs = 1 × 20 = Rs. 20
4) Carrying Costs = 1,00,000/2 × 25/100 = 12,500
5) Material Cost = Rs. 1,00,000
6) Total Cost = 1,00,000 + 20 + 12,500 = Rs.1,12,520

Thus, it would appear that the conventional inventory control technique of

EOQ is not really valid under the assumed conditions.

Receivables
The effect of inflation on the receivables is felt through the size of investment
in receivables. The amount of investment in receivables varies depending
upon the credit and collection policies of the organisation. Evidently, during
the periods of inflation, the higher the amount involved in the receivables the
greater would be the loss to the company, since the debtor would be
paying cheaper rupees.
Likewise, the length of the time too makes the firm lose much in the
transaction. For instance, if the firm in the beginning made a credit sale of
about Rs. 1,00,000 with an allowed credit period of three months, assuming a 21
Concepts and 20 percent inflation in the economy, the amount the company receives in real
Determination
terms after the allowed credit period becomes to only Rs. 95,000. Here, even
considering the same time lag between delivery and realisation, as between
debtors and creditors, sundry debtors would create bigger problem than the
sundry creditors, because the declining value of sundry debtors would affect
adversely the anticipated profitability of the enterprise. Thus, the effect of
inflation varies in accordance with the quantum of receivables and the time
allowed to repay them.

Cash
Management of cash takes on an added importance during the periods of
inflation. With money losing value in real terms almost daily, idle cash
depreciates rapidly. A company that holds Rs.1, 00,000 in cash during 20
percent annual rate of inflation finds that the money’s real value is only Rs.
80,000 in terms of current purchasing power. Even more important, idle cash
is not earning any return. During inflationary periods, it is important that cash
is treated as an asset required to earn a reasonable return. The loss on the
excess cash may be off-set or partly mitigated, if it is invested to produce an
income in the form of interest earned. Obviously, if the rate of interest
exceeds the rise in the price level, the firm realises a gain equivalent to the
excess, or sustains a loss if it is vice versa. Further, the loss of the purchasing
power of excess cash is of particular concern, if the company sells debts or
fixed income securities with the intention of subsequently investing the
proceeds in fixed assets.

1.8 TRENDS IN WORKING CAPITAL

In order that we gain a better idea of the working capital, it is also necessary
to go into the working capital in Indian companies, besides having an idea of
the conceptual framework. For the purpose of analysing trends in working
capital, data is culled from the Database of Reserve Bank of India, pertaining
to Non-Government and Non-Financial Public Limited Companies. The list
of RBI comprises of a select companies numbering 16,045, belonging to
various industry groups. The readers can get a more comprehensive idea of
the trends in working capital in Indian industry, if they go through the
Database of the RBI through its Website: www.rbi.org.in

1.8.1 Size of Working Capital

Working capital, if taken, as the total of current assets increased from Rs.
27,27,407 crores in 2016-17 to Rs. 33,35,602 crores in 2018-19. In terms of
percentages, working capital worked out to about 35 percent of the total net
assets of the Indian companies (See Table-1.1). The implication of the study
of size is that the ratio of current assets to total assets provides a measure of
relative liquidity of the firm’s asset structure. The higher the ratio, the lower
would be the profitability and risk. In the sense that higher investment in
current assets not only locks up the funds that can be gainfully employed
elsewhere, but also necessitates the firm to incur additional costs in the
maintenance of such high volume of current assets.
22
An attempt is made to capture the position among diverse industries. An Conceptual
Framework
examination of this position has revealed that current assets as per cent of
total net assets stood high in the industries such as Jewellery, leather
products, chemical fertilizers and food products (See Table-1.2). It appears
that all traditional industries had higher amounts invested in working capital.
Naturally industries like real estate, computer services, accommodation
services, mining and quarrying required low working capital. This is evident
from the RBI Data also.

Further, the relation between current assets and current liabilities (as depicted
through current ratio) is sending a signal of poor liquidity. Accepting that a
2:1 relation between current assets and current liabilities as comfortable in
exhibiting adequate liquidity, the public limited companies have never been
closer to this standard. It was hovering between 1.0:1 and 1.1:1 during the
period 2016-19.

1.8.2 Constituents of Working Capital

In order to know the significance of each of the items of working capital, it is
better to decompose the total. Such an attempt is made both for current assets
and current liabilities. Among the current assets, trade receivables dominated
the total position. Almost half of the current assets are in the form of debtors
and advances (see Table-1.3). It is heartening to note that the dominant
position of inventories once has come down to only just 34.6 percent now.
Debtors can be considered more liquid than inventories. In that sense this
development can be considered a healthy feature of the Indian corporate
sector.

Among the current liabilities trade payables and other current liabilities have
occupied a prime place (see Table- 1.4), constituting around 60 percent. Bank
borrowings for working capital purposes have come down now to about 28
per cent, following the credit discipline exercised by the Reserve Bank, since
nineties. These trends give an idea of the behaviour of working capital in
Indian companies.

1.9 SUMMARY
This unit has aimed at providing a conceptual understanding of the issues
involved in working capital. Thus, it started with the discussion on definition
and ended with the trends in working capital in Indian companies. There is a
clear difference in the understanding of the concept of working capital among
accountants and economists. This unit has attempted to highlight this
aspect.
Similarly, what constitutes working capital is discussed to enhance //the
understanding of the readers. Though there is a broad consensus, there are a
few differences in identifying the constituents, particularly in the area of
investments and advance payments. Attempt has also been made to highlight
the significant characteristics of working capital. Working capital planning is
considered yet another issue, which engages the attention of corporate
managers. The discussion is further strengthened to incorporate matters on
23
Concepts and inflation and trends. At the end, a synoptic view is presented of the working
Determination
capital trends with the help of Database of RBI on Indian Corporate Sector.

1.10 KEY WORDS

Working Capital: Working capital is defined as the total of current assets or
as the difference between current assets and current liabilities.
Current Assets: The total of inventories, debtors, loans and advanced, cash
and marketable securities.
Current Liabilities: The sum of sundry creditors, unclaimed dividends short
term loans, bank credit and various types of provisions.
Permanent Working Capital: Minimum level of investment in current
assets required for production.
Variable working capital: Working capital which takes care of the
fluctuations in business activity.
Cash budget: A projection of estimated cash inflows and outflows.
CVP analysis: A measure of long term planning to study the relationship
among cost, volume and profit.
Funds flow : A tool to underline changes in the movement of funds.
Inflation: A phenomenon of rising prices.

1.11 SELF ASSESSMENT QUESTIONS

1) Distinguish between gross working capital and net working capital?
2) Why is working capital considered a liquidation concept?
3) Discuss the various types of working capital and trace out the behaviour
of working capital with respect to time?
4) What is the impact of inflation on working capital?
5) How do you plan for the working capital of an organisation? Choose
your own company as an example?
6) Refer to the Balance Sheets of a company known to you and analyse the
trends in working capital. How do you interpret them?

Table 1.1 : Select Working Capital Ratios of Non-Government, Non –

Financial Public Limited Companies in India

S. No. Ratio 2016-17 2017-18 2018-19

1. Current Ratio to 34.5 34.8 35.7
Total Net Assets
(%)
2. Current Assets to 1.1 1.0 1.1
Current Liabilities
(Times)

24
 Conceptual
3. Quick Assets to 51.8 49.5 51.1 Framework
Current Liabilities
(%)
4. Trade Payables to 30.2 31.6 29.7
Current Assets (%)
5. Inventories to Sales 15.0 14.9 14.6
(%)
6. Trade Receivables 15.3 15.6 14.9
(%)

Source: www.rbi.org.in//::// Data Releases PR – Reserve Bank of India, May 4, 2020.

Table – 1.2 : Current Assets to Total Net Assets (%) among diverse
industries of Non-Government, Non-Financial Public Limited
Companies

S. Industry No. of 2016-17 2017-18 2018-19

No. Companies
1. Mining & Quarrying 208 35.6 24.5 26.7
2. Manufacturing 6460 35.4 35.5 34.4
3. Food Products 699 48.4 49.6 49.1
4. Dairy Products 62 49.0 44.8 32.8
5. Sugar 71 43.3 42.7 48.7
6. Textiles 792 24.4 24.5 24.0
7. Wearing Apparel 206 43.4 44.4 46.1
8. Leather Products 62 66.6 68.7 69.7
9. Wood Products 62 49.1 41.7 49.6
10. Paper Products 168 28.8 30.5 33.1
11. Chemical Products 1152 39.2 39.4 39.5
12. Basic Chemicals 265 32.4 32.2 31.5
13. Chemical Fertilizers 46 61.5 53.6 50.9
14. Paints & Varnishes 36 47.4 44.3 45.2
15. Pharmaceuticals 469 38.1 40.1 41.2
16. Rubber & Plastic 318 38.3 38.7 37.4
Products
17. Tyres & Tubes 36 46.3 46.8 42.5
18. Plastic Products 220 33.9 34.0 34.7
19. Glass & Glass 41 33.0 33.4 37.0
Products
20. Ceramic Products 81 40.0 42.2 43.6
21. Cement & Cement 107 26.6 23.8 23.2
Products
25
Concepts and 22. Iron & Steel 568 28.1 37.1 27.6
Determination
23. Fabricated Metal 211 24.7 28.7 27.9
Products
24. Computer & 76 39.9 41.8 45.3
Electronic Equipment
25. Electrical Equipment 286 41.8 45.3 54.7
26. Machinery & 545 54.7 58.2 57.5
Equipment
27. Motor Vehicles & 125 29.9 29.5 32.8
Other Transport
Equipment
28. Jewellery 78 84.8 85.8 85.6
29. Air conditioning, etc. 445 18.7 21.3 21.6
30. Construction 1154 41.8 46.7 49.3
31. Services 7098 34.3 34.3 37.5
32. Wholesales & Retail 1706 48.7 48.4 48.1
Trade
33. Transport & others 313 30.9 32.9 33.4
34. Accommodation & 256 26.0 26.2 30.6
Others
35. Telecommunication 81 34.7 40.7 44.8
36. Computer Services 576 25.8 26.0 28.3
37. Real Estate 618 23.4 19.1 28.3
All Industries 16045 34.5 34.8 35.7

Source: www.rbi.org.in//::// Data Releases PR – Reserve Bank of India, May 4, 2020.

Table – 1.3 : Components of Current Assets of Select 16045 Non-

Government, Non-Financial Public Limited Companies
(In per cent)
S.No. Item 2016-17 2017-18 2018-19
1. Inventories 24.7 24.5 24.6
2. Trade Receivables 25.2 25.6 25.3
3. Short-term Loans & 17.9 17.9 18.0
Advances
4. Cash and Cash 9.7 9.2 9.5
Equivalents
5. Current Investments 14.2 13.1 12.0
6. Other Current Assets 8.3 9.7 10.6
Total Current Assets 100.0 100.0 100.0
(Rs. in Crore) (27,27,407) (29,81,160) (33,35,602)
Source: www.rbi.org.in//::// Data Releases PR – Reserve Bank of India, May 4, 2020.
26
 Table – 1.4 : Components of Current Liabilities of Select 16045 Non- Conceptual
Framework
Government, Non-Financial Public Limited Companies
(In per cent)

S.No. Item 2016-17 2017-18 2018-19

1. Short-Term Borrowings 29.4 28.3 28.8
2. Trade Payables 31.9 32.7 32.4
3. Short-Term Provisions 6.3 6.2 6.5
4. Other Current Liabilities 32.4 32.8 32.3
Total Current Liabilities 100.0 100.0 100.0
(Rs. in Crore) (25,87,712) (28,85,259) (30,55,686)
Source: www.rbi.org.in//::// Data Releases PR – Reserve Bank of India, May 4, 2020.

1.12 FURTHER READINGS

1) V.K. Bhalla, 2013, Working Capital Management, S. Chand Publishing.,
New Delhi.
2) Rao, K.V., 1990, Management of Working Capital, Deep & Deep
Publications, New Delhi.
3) Ramamoorthy, V.E., 1976, Working Capital Management,. IFMR,
Madras.
4) Dileep R. Mehta., 1974, Working Capital Management, Englewood
Cliffs, Prentice Hall.
5) Park and Gladson, 1963, Working Capital, Macmillan, New York.
6) Hrishkes Bhattacharya, Working Capital Management: Strategies and
Techniques, PHI Learning, 2014.
7) Sagner, James S. Working Capital Management: Applications and Cases,
Wiley, 2014.

27
Concepts and
Determination UNIT 2 OPERATING ENVIRONMENT OF
WORKING CAPITAL

Objectives
The objectives of this unit are to:

• Highlight the significance of scanning, operating environment of any

business
• Identify and discuss the operating environment relevant to the making of
working capital decisions.
• Explain the significant aspects of monetary and credit policies.
• Examine the impact of economic liberalisation on industry as a part of
operational environment.
• Survey the changing environment in financial sector.

Structure
2.1 Introduction
2.2 Monetary and Credit Policies
2.3 Financial Markets
2.4 Economic Liberalisation and Industry
2.5 Summary
2.6 Key Words
2.7 Self-Assessment Questions
2.8 Further Readings

2.1 INTRODUCTION
In our previous unit an attempt was made to provide you with a conceptual
framework in terms of understanding the definition, nature and components
of working capital. Further, a sketch was provided of the characteristics of
working capital. Tools for planning working capital and the impact of
inflation on working capital were also discussed along with major trends in
working capital that signify the importance of working capital to a Firm. This
discussion in the previous unit is expected to provide you a preliminary
understanding about the basic concepts.
Now in the present unit we will be dealing with the operating environment of
the working capital as analysed in the context of monetary, credit and
financial policies.
The term environment refers to the ‘surroundings’ or circumstances, which
affect the life of an object or individual. As applied to business establishments,
people talk of various types of environments like micro, macro or mega
environments. Some people also talk of internal and external environments.
28
Nevertheless, the term environment is meant, to a large extent, to signify the Operating
Environment of
surroundings or factors that are external to the firm, affecting the ability of Working Capital
the firm in achieving its desired objective. The nature of the environment is
such that the firm will have no control on the elements constituting the
environment. What the firm can do is to tailor its own policies and practices
in such a way so as to gain from the changes taking place in the environment.
These changes may pertain to economic, legal, social, cultural or ideological
aspects. Whatever be the aspect, the firm has to gear itself to meet the
challenges posed by the changing environment.

The significance of scanning the environment of business is trivial. After all,

businesses cannot be run in vacuum, they exist in a natural setting surrounded
by various elements in the society. The decisions of a manager are influenced
by the changes in these surroundings caused by the constituting elements.
The customers, the Government, the society within and outside the country
will also have their influence on the business decision-making. The value
system of the society, the rules and regulations laid down by the government,
the monetary and credit policies of the central bank, the trade, industrial and
fiscal policies of the government, the institutional set up available in the
country, the attitudes of foreign investors, NRIs, the ideological beliefs of the
political parties, etc., all constitute the environment system within which a
business firm is to operate.

The production schedules of the firm are to be restated if there is a change in

the preferences or attitudes of the customers, suppliers, competitors and the
import and export policies. Similarly, the firm may have to restructure its
financing pattern consequent upon the changes in the rates of interest and
conditions in the capital market. Same would be true in case of marketing and
personnel policies. As a matter of fact, several corporates are assuming
‘social responsibility functions’ on their own, mainly due to the changes in
the value system of the society and the fear of losing its confidence.
Environment, thus, has profound influence on business decision-making.
Students are advised to refresh themselves by having a glance at the contents
of MMPC-003: Business Environment.

As applied to working capital decisions, the following elements of environment

are considered relevant.
1) Changes in the Monetary and Credit Policies,
2) Changes in Inflation,
3) Changes in Financial Markets

2.2 MONETARY AND CREDIT POLICIES

During seventies after the economies have started experiencing high inflation
and low growth (a phenomenon called ‘stagflation’) economists have turned
their attention to the potentiality of the monetary policy in the economic
policy making. The relative importance of growth and price stability as the
objectives of monetary policy became the focus of attention in both
developed and developing economies. In a way, the objectives of monetary
29
Concepts and policy can be no different from the overall objectives of economic policy.
Determination
While some central banks consider monetary targeting as operationally
meaningful, some others focus on interest rates. Interestingly enough the
Reserve Bank of India Act, 1934 mandated that the RBI Shall strive to
regulate the issue of Bank notes and keeping of reserves with a view to
securing monetary stability in India and generally to operate the currency and
credit system of the country to its advantage. Whatever be the method,
growth with stability is attempted as the objective of monetary and economic
policy of India.

In the conduct of monetary policy, the following aspects become pertinent:

a) Money Supply
b) Bank Rate
c) CRR & SLR
d) Interest Rates
e) Selective Credit Controls
f) Flow of Credit

2.2.1 Money Supply

As a part of the policy exercise, monetary growth is targeted every year.
Policy measures are pronounced, so as to take care of this targeting exercise.
This is expected to maintain real growth and contain inflation. In this context,
the Central Bank specifies the order of expansion in broad money (known
popularly as M3 and comprises of currency with the public, demand and time
deposits with commercial banks, and other deposits with RBI) that would be
used as an intermediate target to realise the ultimate objective of the policy.
In the case of India, both output expansion and price stability are important
objectives; but depending on the specific circumstances of the year, emphasis
is placed on either of the two. Increasingly, it is being recognised that central
banks would have to target price stability since real growth itself would be in
jeopardy, if inflation rates go beyond the margin of tolerance. On a historical
basis, the average inflation rate’ in India (which had declined from 9.0
percent in 1970s to 8.0 percent in 1980s) went up markedly to a double-digit
level of 10.7 per cent during the first half of 1990s. Due to continuous and
unhindered effort towards putting inflation under control, it was maintained
at single digit for majority of the years during the twenties and later. During
the year 2021 (April-December), the Consumer Price Index – Combined
(CPI-C) moderated to 5.2 per cent from 6.6 per cent in the corresponding
period of 2020. Notably, the Food inflation came down significantly to just
2.9 per cent, as against 9.1 per cent. It is true that the prices of Food items
would be subjected to frequent variations due to short and excess supply; the
country could achieve stability even in this sector, due to the creation of
strong infrastructure in terms of network of cold storages, markets and
information sharing. The focus of monetary policy in recent years has,
therefore, been to bring down the inflation rate to a modest level. Monetary
growth is being moderated in such a way that the credit requirements for
productive activities are adequately met.
30
The Monetary Policy of India has an interesting story. Keeping in view of the Operating
Environment of
objective of planned development, the RBI also started aligning the Monetary Working Capital
Policy in tune with the same and thus focus on expansion of credit and
initiated measures to smoothen the flow of credit to every needy sector. In
order to achieve this objective, the Bank followed a policy of Multiple
Indicators (MI) Approach, wherein emphasis was placed more on interest
rates than on the factors that cause variations in the Money Supply. Perhaps,
it is for this reason that short-term interest rates emerged key instruments in
deciding the variations in Monetary Policy. This is quite evident in terms of
freedom extended to Banks and Financial Institutions in managing their
finances. Controls exercised hitherto in fixing the static CRR, SLR are made
more flexible and are kept at the levels low to make more money available to
banks to lend to the business and industry.

The key development in the setting of Monetary Policy in India has been the
constitution of Monetary Policy Committee (MPC), through an Amendment
made to the RBI Act, 1934 in 2016 to bring about more transparency and
accountability. Prior to the constitution of MPC, the RBI alone was the sole
agency to decide on the Monetary Policy. Now the responsibility is shifted to
MPC, which consists of three RBI officials and three outside experts
nominated by the Government of India.
A reflection of these changes in the Policy stance is evident from the figures
that constitute the vital statistics pertaining to Money Supply, Bank Credit,
Foreign Exchange Reserves, etc. The Broad Money (M3) which consists of the
following four components, stood around Rs.202,79,608 crore, registering an
increase of 7.6 per cent over the previous year ending March 31, 2021.
i) Currency with public (≈Rs.3018761 crore)
ii) Demand Deposits with Banks (≈Rs.2045194 crore)
iii) Time Deposits with Banks (≈Rs.15163972 crore)
iv) Other Deposits with RBI (≈Rs.51680 crore)

The Net Bank Credit to Government was also significant around Rs.6339925
crore at the end of March 11, 2022 up by 8.4 per cent over the previous year
ending March 31, 2021. The primary indicator which decides the expansion
in the economy is the flow of bank credit to industry. The Net Bank Credit to
commercial sector stood around Rs.124,22,531 crore by March 11, 2022,
registering a modest rise by 6.5 per cent over the previous year. The Net
Foreign Exchange Assets with Banks also are significant around
Rs.49,80,306 crore. All these figures indicate the size of the Indian Economy
and the major suppliers and demand units of the Money generated in the
Economy.

2.2.2 Bank Rate

The Bank Rate has been defined in Section 49 of the Reserve Bank of India
Act 1934, as the standard rate at which the bank is prepared to buy or
rediscount bills of exchange or other commercial papers eligible for purchase
under the Act. The significance of bank rate is that it indicates the rate at
which the public should be able to obtain accommodation on the specified 31
Concepts and types of paper from the commercial banks as well as the Central Bank. This
Determination
is expected to curb the tendency towards relatively high interest rates and
ensure satisfactory banking services and reasonable rates to the people.
Secondly, bank rate represents the basis of the rates at which people can
obtain credit. Thirdly, bank rate also has an important psychological value as
an instrument of credit control. In effect, a change in the bank rate is to make
the cost of securing funds from the Central Bank cheaper or more expensive,
bring about changes in the structure of market interest rates and serve as a
signal to the money market, business community and the public of the
relaxation or restrain in credit policy.

Nevertheless, the success of bank rate policy depends on the following:

1) That the bank rate of the Central bank should have a prompt and decisive
influence on money rates and credit conditions within its area of
operation;
2) That, there should be a substantial measure of elasticity on the economic
structure, in order that prices, wages, rents, production and trade might
respond to changes in money rates and credit conditions; and
3) That the international flow of capital should not be hampered by any
arbitrary restrictions and artificial obstacles.

As far as India is concerned, the use of bank rate as an instrument of credit

control is less frequent. During 1951- 74, Bank rate was changed nine times;
but was revised only thrice during 1975-96. More so, in majority of the cases,
bank rate has been used in conjunction with other instruments of credit
control to realise the needed effectiveness in the control exercise. It is, of late,
the RBI is taking measures to reactivate the Bank Rate and link it to the
interest rates of significance, so as to facilitate its emergence as the ‘reference
rate’ for the entire financial system. With effect from the close of business on
April 15, 1997, the Bank Rate was reduced from12 percent to 11 percent and
further to 10 percent w.e.f. June 25, 1997. Since then, the Reserve Bank
followed a Conscious Policy of Low Bank Rates. From the highest of 12.00
per cent, the Bank Rate came down presently to just 4.25 per cent (March
2022). This reduction in the Bank Rate signalled the beginning of a low
interest rate regime, as these downward movements resulted in similar
reductions in lending and deposit rates in the financial markets.
Developments in the external environment leading to speculative activity in
the Exchange market resulted in a change in the direction of interest rate
policy.

2.2.3 CRR and SLR

Variations in the reserve requirements is yet another credit control technique
used by a Central Bank. The Central Bank by this technique can change the
amount of cash reserves of banks and affect their credit creating capacity. It
may be applied on the aggregate outstanding deposits or on the increments
after a base date or even on certain specific categories of deposits. This has a
sure and identifiable impact as compared to Bank Rate changes or open
market operations. The two instruments under this category are:
32
1) Cash Reserve Ratio (CRR) Operating
Environment of
2) Statutory Liquidity Ratio (SLR) Working Capital

Under section 42(1) of the RBI Act, scheduled commercial banks were
required to maintain with the RBI, at the close of business on any day, a
minimum cash reserve on their demand and time liabilities. Similarly, banks
were required under section 24(2A) to maintain a minimum amount of liquid
assets equal to but not less than certain percentage of demand and time
liabilities.
Though the RBI did not use CRR and SLR as significant instruments of
credit control during the whole of the sixties, it started varying the ratios
since then actively. The implication of these variations is that when the ratio
is brought down it would release the funds that would have otherwise been
locked up for investment by the commercial banks. As per the Act, RBI is
empowered to vary CRR between 3 and 15 per cent. In tune with the
choosing of liberal Monetary and Credit Policy, RBI has been keeping every
threshold at its Minimum. The CRR, which was 15.0 per cent in 1990 was
brought down to just 5.0 per cent as part of implementing major Financial
Sector Reforms, based on the Narasimham Committee and was further
brought down to 3.0 per cent in October 2020.
Even though the obligation of banks is to maintain their liquid assets at a
minimum of 25 percent, in the light of the need to restrain the pace of
expansion of bank credit, the RBI has imposed a much higher percentage of
minimum liquid assets and in some cases to the extent of even 35 percent.
These measures have started impounding vast amount of resources of the
banks and encouraging governments [Central and State] to have an easy
access to bank credit. It also led to the shrinkage of resources available for
genuine credit purposes. In view of the strong opposition from the banks and
basing on the recommendations of the committee on “Financial Sector
Reforms”, RBI reduced the ceiling to its original level of 25 percent of the
Net Demand and Time Liabilities (NDTL). The banking system already holds
government securities of about 39 percent of its net demand and time
liabilities (NDTL) as against the statutory minimum requirement of 25
percent.
Table – 2.1: Major Monetary Policy Rates and Reserve Requirements
(In per cent)
Effective Bank Repo Reverse Marginal CRR SLR
Date Rate Rate Repo Standing
Facility
31-03-2004 6.00 6.00 4.75 --- 4.75 24.00
17-04-2012 9.00 8.00 7.00 9.00 4.75 24.00
01-08-2018 6.75 6.50 6.25 6.75 4.00 19.50
07-08-2019 5.65 5.40 5.15 5.65 4.00 19.50
27-03-2020 4.65 4.40 4.00 4.65 4.00 18.25
22-05-2021 4.25 4.00 3.35 4.25 4.00 18.00
Source: Compiled from the RBI Data available as on 15-09-2021.
(www.rbi.org.in/scripts/Data-Deployment.aspx) 33
Concepts and As could be seen from the table 2.1, there is perceptible deceleration in the
Determination
key rates maintained by the Central Bank. It is to be noted in this context that
the Indian Economy has undergone major reforms leading to the era of
Liberalization, Privatisation and Globalisation (LPG). Keeping these changes
in view, economy has been thrown open to private initiative and the
Government is seeking to withdraw its presence in business and industry.
Privatization of major Public Sector Enterprises during the year 2020 and
after is the testimony of the intention of the Government. Making available
credit to the maximum extent is the motto of the Government. Therefore,
policy measures are also kept in tune with this trend and philosophy.

The statutory liquidity ratio (SLR) to be maintained by all scheduled

commercial banks remains unchanged at a minimum of 25 percent of net
demand and time liabilities (NDTL) since October 1997. As a prudential
measure to strengthen the urban co-operative banks (UCBs), the proportion
of SLR holding in the form of Government and other approved securities to
NDTL has been increased in a phased manner. From April 1, 2003, all
scheduled UCBs have to maintain the entire SLR holding of 25 percent of
NDTL in government and other approved securities only. Similarly, Regional
Rural Banks (RRBs) were required to maintain their entire SLR holding in
government and other approved securities by March 31, 2003 with SLR
holdings of RRBs in the form of deposits with sponsor banks maturing
beyond March 31, 2003 being reckoned for the SLR till maturity. The
maturity proceeds of such deposits would have to be converted into
government securities for RRBs not reaching the 25 percent minimum level
of SLR in Government securities by that time. Like the other rates, the SLR
is also slashed to 18 per cent, since October, 2020 and the same is holding as
of now.

2.2.4 Interest Rates

Realising the fact that Bank Rate is not functioning as an effective tool of
credit control, RBI started influencing the cost of credit, through the changes
in interest rates. The RBI derived the authority to regulate the interest rates of
banks under sections 21 and 35a of the Banking Regulation Act, 1949. This
power covers both the advances and deposit rates. The rates on loans and
advances are controlled mainly in order to influence the demand for credit
and to introduce an element of discipline in the use of credit. This is generally
done by stipulating minimum rates of interest for extending credit against
commodities covered under selective credit control. Also, concessive or
ceiling rates of interest are made applicable to advances for certain purposes
or to certain sectors to reduce the interest burden and thus facilitate their
development. Further, the objectives behind fixing the rates on deposits are
to avoid unhealthy competition amongst the banks for deposits, keep the level
of deposit rates in alignment with the lending rates of banks, and aid in
deposit mobilisation.
In addition to RBI, certain other agencies also have the authority to fix rates
of interest for different types of financial activities. For instance, the
controller of capital issues (now abolished) used to fix the ceiling on coupon
rates on industrial debentures and preference shares. The Indian Banks
34
Association (IBA) had been fixing the ceiling on call rates since 1973, until Operating
Environment of
1988, when call rates were freed from the ceiling. The Government of India Working Capital
fixes the rate on treasury bills and long-term government securities. The
Government has significant influence in the fixation of interest rates on long-
term loans of Development Finance Institutions [DFIs]. This is how the rates
of interest are administered in India, leading to a large variety of multiple
and complex interest rates.

Realising the deficiencies of this administered system of rates of interest and

following the recommendations of the committee to Review the working of
Monetary System (under the Chairmanship of Chakravarty), RBI has started
rationalising the interest rate structure since 1991. One of the objectives of
this policy was to reduce the multiplicity of interest rates and to bring about a
simplification in their structure. Efforts are being made to eliminate all
criteria, other than the size of loan, while deciding the credit policy. Recent
policy changes in this regard include:

i) Interest rate on domestic term deposits with maturity of 30 days to one

year was linked to the Bank Rate; by stipulating interest rate on these
deposits as ‘not exceeding Bank Rate minus 2 percentage points per
annum’ from April 16, 1997;
ii) Bringing under the same ceiling the Non-Resident (External) (NRE)
Rupee term deposits with that of domestic term deposits;
iii) Allowing banks to announce a separate Prime Term Lending Rate
(PTLR) for term loans of three years and above;
iv) Making the banks to announce the maximum spread over the PLR for all
advances other than consumer credit.
v) Permitting banks to prescribe separate Prime Lending Rates (PLRs) for
loan and cash credit components and also separate spreads for both the
components.
vi) Permitting banks to provide foreign currency denominated loans to their
customers for meeting either their foreign currency or rupee
requirements;
vii) Freedom for banks to decide the rate of interest on post-shipment export
credit on medium and long-term basis.

In recent years, there has been a persistent downward trend in the interest
rate structure reflecting moderation of inflationary expectations and
comfortable liquidity situation. Changes in policy rates reflected the overall
softening of interest rates as the Bank Rate has been reduced in stages from
8.0 percent in July 2000 to 4.25 per cent in October 2021.
The Interest rate structure in India is very complex. The Hitherto followed
‘Administered Structure of Interest Rates’ is discontinued and the Banks and
Financial Institutions are free to decide both deposit and lending rates. The
lending rates fixed by the banks are generally based on the ‘Base Rate’
indicated by the RBI. The current Base Rate of RBI is between 7.40 and 8.80
per cent. This is taken as the standard by the Banks in fixing their lending
rates. This concept of base rate system was introduced by the RBI in July
35
Concepts and 2010 and is followed even now. It is also to be noted that this rate shall be
Determination
taken as the minimum and the interest rates may be fixed above this base rate.
However, there may be certain special category of loans to whom (like DRI
loans, loans to employees) this system may not be applicable.

As a matter of fact, there had been a dramatic shift in the interest rate regime
in India. Surprisingly a high-interest rate driven economy turned into a low
interest rate economy and trying to compete with the advanced countries in
keeping interest rates low. India has experienced a regime of ‘assured
returns’ in both the public sector and Mutual Fund divisions. All of a sudden,
it was felt by the stakeholders that the economy cannot continue with these
high and assured returns and slowly marched towards low interest rate
regime. The situation now is such that there is no assured income to the
retirees, to part their retirement benefits, safely and securely. It is appreciable
that there is a ‘Pension Fund Trust’ created by the Central Government to
come to the rescue of retirees for keeping their benefits in the Trust for an
assured reasonable return.

The theoretical maxim that there shall be perceptible degree of difference

between short-term and long-term interest rates has vanished. At times, short-
term bank deposits are yielding more revenue than long-term investments. In
fact, Banks are notably shy of accepting long-term deposits, beyond 5-years.

2.2.5 Selective Credit Controls

Central banks, generally, have a policy to use qualitative techniques in
addition to quantitative techniques of credit control. The most widely used of
the qualitative techniques are selective credit control and moral suasion.
While the general credit controls operate on the cost and total volume of
credit, selective credit controls relate to tools available with the monetary
authority for regulating the distribution or direction of bank resources to
particular sectors of the economy in accordance with the broad national
priorities considered necessary for achieving the set, developmental goals.
These control techniques have special relevance to developing countries
owing to the meagre supply of credit and the chance of credit being mis-
utilised for unproductive and speculative purposes. In exercise of the powers
conferred on it, the RBI may give directions of the following kind to the
banks generally or to any bank or a group of banks in particular.
a) the purposes for which advances may or may not be made;
b) the margins to be maintained in respect of secured advances;
c) the maximum amount of advances; and
d) the rate of interest and other terms and conditions subject to which
advances may be granted or guarantees may be given.

Almost since the middle of 1956, RBI has started exercising powers vested in
it. A number of commodities and products have been covered at one time or
the other. Some of the commodities, which had been under frequent controls,
are food grains, cotton, raw jute, oil seeds, vegetable oils, sugar, cotton yarn
and textiles.
36
However, the situation has changed recently. After the implementation of Operating
Environment of
new economic policy in 1991, there has been a phasing out of the selective Working Capital
credit controls. By the end of 1996, almost all the controls were virtually
eliminated. However, keeping in view of the need to check the inflation and
achieve price stability, there has been an attempt to ensure proper flow of
credit to certain sectors and tightening of credit flow to others. Banks are also
advised to vary the margin requirements. Special favour to MSMEs and
Export oriented units is always present. India, primarily being an Agrarian
economy, needs support to Agriculture and allied sectors. Ensuring proper
credit supply to these sectors, based on the cropping season and pattern,
needs no particular mention. One thing that is to be noted specially in this
regard is that RBI only gives directions and it is Banks that are required to
follow, and mostly these are advisory in nature.

2.2.6 Flow of Credit

The flow of credit, which is evident through the data on the ‘Sectoral
Deployment Bank Credit’ to diverse sectors, clearly reflects the liberalization
of the Indian Economy. The so called restrictions imposed on the flow of
credit prior to 1991, were all withdrawn and the Banks and other Financial
Institutions are now on ‘Centre Stage’ in deciding the ‘Size and Direction’ of
the flow of credit. The only limitation as at present pertains to the flow of
credit to certain ‘Priority Sectors’; mostly to ensure the supply of adequate
‘Food Grains’. For this reason RBI tries to ensure balance between ‘Food and
Non-Food Credit’. After all, people have to be alive, before they engage upon
the trade and industry.
As per the latest data (February, 2022) made available by the RBI on
‘Deployment of Bank Credit’ to different Sectors, the following major trends
are discernable. The data set of the RBI covers a group of 40 select scheduled
banks, accounting for about 94 per cent of the Non-Food Credit, deployed by
all the scheduled Commercial Banks (see Table 2.2).
Table-2.2 : Sectoral Deployment of Credit by Major Sectors (Outstandings)
(Rs. in Crore)
S.No. Sector 28-02-2020 26-02-2021 25-02-2022
1. Food Credit 65596 78206 68224
(0.6) (0.7) (0.6)
2. Non-Food Credit 10039270 10699536 11558783
(99.4) (99.3) (99.4)
3. Agriculture & 1208508 1312285 1448928
Allied Activities (11.9) (12.2) (12.5)
4. Industry 2914719 2945152 3135271
(28.4) (27.3) (27.0)
5. Services 2579931 2808122 2966593
(25.5) (26.1) (25.5)
6. Personal Loans 2685964 2944789 3306650
(26.6) (27.3) (28.4)
7. Gross Bank Credit 10104866 10774742 11627008
(100.0) (100.0) (100.0)
37
Concepts and The flow of credit to agriculture and allied sectors has been significant at
Determination
12.46 per cent of the gross bank credit registering an annual growth rate of
10.4 per cent in February 2022, compared to 8.6 per cent in previous year.
Credit to industry (which includes all types of Micro, Small, Medium and
Large enterprises) stood at Rs.31,35,271 crore, which constitutes about 26.96
per cent of the total gross bank credit. Even the credit to services (which
include Transport, Software, Tourism, Shipping, Aviation, Trade, etc.) also
stood high and prominent at Rs.29,66,593 crore; accounting for about 25.51
per cent.

Keeping in view of the need to support the efforts to revive the capital
market, banks were allowed to extend loans to corporates against shares held
by them to enable such corporates to meet the promoters’ contribution. The
margin and the period of repayment of such loans would be determined by
banks. Banks were also permitted to sanction bridge loans to companies
against expected equity flows for a period not exceeding one year, subject to
the guidelines approved by their respective boards. Taking into account the
changing scenario, banks were asked to review the existing arrangements for
financing trade and services. RBI directed banks to evolve a suitable method
of assessing loan requirements of borrowers in the service sector and report
the arrangements made in this regard.
It is clear from the foregoing discussion that the changes in the monetary and
credit policies influence working capital decisions in terms of the availability
of credit and cost of credit directly and through the ‘balancing of the
economy’ indirectly. For the benefit of students, the salient features of the
monetary and credit policy measures announced by RBI for the year 2021-22
are given in Appendix-I.

Activity 2.1
i) Bring out the Role of Monetary Policy Committee (MPC) in shaping the
Monetary Policy of the country.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
ii) Highlight the salient features of the latest monetary and credit policy
announced by RBI.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

38 .....................................................................................................................
 Operating
2.3 FINANCIAL MARKETS Environment of
Working Capital
The role of financial markets is paramount, in the mobilisation and allocation
of savings in the economy. They are the agencies that provide necessary
funds for all productive purposes. In addition, the role of financial markets is
increasingly becoming critical in transmitting signals for policy and in
facilitating liquidity management. They are regarded as an essential
adjunct to economic growth.
The real economy can be sound and productive only when financial markets
operate on prudent lines.

The main organised financial markets in India are:

i) the credit market, which is dominated by commercial banks;
ii) the money market with call money segment forming a sizeable proportion;
iii) equity and term lending market consisting of primary, secondary and
term lending segments;
iv) corporate debt market comprising PSU bonds and corporate debentures;
v) gilt-edged market for Government securities;
vi) housing finance market;
vii) hire purchase and leasing finance market, wherein the non-bank financial
companies (NBFCs) predominate;
viii) insurance market; and
ix) foreign exchange market.
In addition, there is an unorganised and informal finance market comprising
of money lenders in villages and indigenous bankers in towns/cities. All the
agencies constitute the financial sector of India.
In the recent past (since 1991) government has embarked upon effecting
major changes in the areas of industrial trade and exchange rate policies.
These changes are designed to correct the macro-economic imbalances and
effect structural adjustments with the objective of bringing about a more
competitive system and promoting efficiency in the real sectors of the
economy. Economic reforms in the real sectors of the economy will not
produce desired results, unless the former are supplemented by suitable and
effective financial sector reforms. With this end in view, the Government of
India has appointed a committee on the working of financial system of the
country in August 1991 under the chairmanship of M.Narasimham.
The committee was asked, inter alia, to examine the existing structure of the
financial system and its various components and to make recommendations
for improving the efficiency and effectiveness of the system with particular
reference to the economy of operations, accountability and profitability of
the commercial banks and financial institutions. The committee has
submitted its report in November 1991. Since the submission of the report,
the Government has taken several steps on different aspects of the
recommendations. The significant steps that were taken are:
39
Concepts and i) A strict criterion was evolved for companies that access securities
Determination
markets. The issuers of securities are required to meet certain standards
like the payment of dividend, minimum share-holding requirement, etc.
ii) The Securities and Exchange Board of India (SEBI) took several steps
for widening and deepening different segments of the market for
promoting investor protection and market development;
iii) The safety and integrity of the securities market were strengthened
through the institution of risk management measures, which included a
comprehensive system of margins, intra-day trading and exposure limits,
capital adequacy norms for brokers and setting up of trade/settlement
guarantee funds.
iv) Reforms in the secondary market focused on improving market
transparency, integrity and infrastructure.
v) FIIs were permitted to invest upto 10 per cent in equity of any company,
to invest in unlisted companies and to invest in debt securities without
any requirement for investment in equity. They were also permitted to
invest in dated government securities within the framework of guidelines
on FII investment in debt instruments.
vi) Government has also initiated measures to deepen and broaden the
government securities market and increase its liquidity.
vii) The earlier restriction that debt instruments of a corporate could be listed
only after its equity had been listed on any exchange was removed.
viii) Investment guidelines regarding the utilisation of funds of LIC were
revised. Since the LIC being privatized with a large scale disinvestment
through IPO, the organisation will have complete autonomy in the
deployment of funds, subject to the broad guidelines of IRDA.
ix) The Mutual Fund Regulations issued by SEBI in 1993 were further
revised in 1996 and are being amended from time to time and the latest
amendment taking place on January 25, 2022. Mutual Funds are now the
significant players in both primary and secondary markets with about
Rs.38.56 lakh crore Assets under Management (AUM) as on February
28, 2022.

2.4 ECONOMIC LIBERALISATION AND

INDUSTRY
The economic liberalisation programme initiated by the Government in the
early ninties has changed the face of industry, more particularly the dynamics
of financial environment. There has been a sea change in the organisational
structure and operations of the players in money and capital markets. The
distinction between long term financing and short-term financing is slowly on
the wane. Development Banks have converted themselves into ordinary
commercial banks. Deregulation of interest rates, emergence of a liberalised
capital market and increasing participation of banks in terms of financing
have significantly influenced the operations of development banks. With their
fray into the realm of working capital loans; the traditional divide into the
40
operational domain of development banks and commercial banks got blurred. Operating
Environment of
One of the implications of this development is that the hitherto privileged Working Capital
access to assured sources of low cost funds has disappeared. There has
already been an attempt to align all the forces to market, making the latter
decide the equilibrium between supply of and demand for funds.

The monetary policy framework has undergone changes over the recent
period in response to reforms in the financial sector and the growing external
orientation of the economy. The endeavour of the policy has been to enhance
the allocative efficiency of the financial sector, preserve financial stability
and improve the transmission mechanism of monetary policy by moving
from direct to indirect instruments. The stance of the monetary policy has
been to ensure provision of adequate liquidity to meet credit growth and
support investment demand in the economy, while continuing a vigil on the
movements in the price level and to continue with the present policy of
interest rate structure in the medium term.

On the fiscal front, the government expenditure has been cut in real terms.
The burnt has been borne by cuts in investments and expenditure on social
sector. There were large slippages in the fiscal correction. The rising deficits
on the revenue account are often cited as the main cause for the observed
phenomenon. Behind these lie the erosion of excise tax base, mounting
interest burden on public debt, growing subsidies and the rising cost of
wages and salaries. The expected buoyancy in the collection of GST has
been varying from the lowest of Rs.91,000 crore to the highest of Rs.
1,46,000 crore during the Financial Year 2021-22. The Central Government
is still struggling to make good the shortfall on this account to States.

On the external front, following the liberalisation, India devalued its currency
leaving an impact on the exports and imports. With an unsuccessful interlude
with exim scrips and dual exchange rate system; India went in for a unified
market determined exchange rate system. Correcting the exchange rate
valuation of the past was a major event on the reform process. The lower
exchange rate enhances the profitability of existing exports, more
importantly, it broadens the range of eligible exports. It makes imports more
costly and provides scope for import substitution, thus narrowing the range of
potential imports. The rupee is now convertible on current account, subject to
exchange rate risk. Some of the important components of capital account are
considerably liberalised.

Another dimension of the liberalisation on the external front is that the gates
for foreign investment were wide open. Foreign trade and foreign investment
appear to be mutually influential. Portfolio investments have become very
significant in several developing countries, including India. After
liberalization, India has turned to be a welcome destination to the Foreign
Direct Investment (FDI). The Government of India has also brought about
sweeping reforms in allowing all sectors under ‘Automatic Route’, including
Defence Sector in select areas. Following the ‘Make-in-India’ initiative, the
Government stepped up the FDI limit from 26% to 49% and then to 74%.
Some special concessions are also provided to NRIs permitting them to
invest upto even 100 per cent in Ventures like Air India. By virtue of all these
41
Concepts and measures, India scaled upto 9th position in 2014 from 15th position in 2013,
Determination
among countries that are all out in attracting FDI flow. As per the latest (09-
02-2022) data available on the flow of FDI into India, the country has
received a total of USD 54.1 billion during April-November 2021-22, as
against USD 81.97 billion in 2020-21. As a matter of fact, Covid-19 had
struck a severe blow on the international capital flows; making it difficult for
every country. An oasis in this kind of environment is the growing success of
Start-up units; whereby India alone could house about 95 Unicorns, out of the
total of about 300. A Unicorn is a privately held Start-up company, which is
valued at over $ 1 billion.

These developments produce some direct and some indirect effects on the
growth and development of Indian industry in the years to come. More
specifically, developments in the financial sector pose serious concerns for
the effective use of working capital by the industry.

Activity 2.2
Attempt to make out a case as to what extent the liberalized environment has
contributed to accelerate the flow of credit to industry?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

2.5 SUMMARY
It is important that every business unit understands its environment. The
nature of environment is such that the business units, will have no control on
the elements constituting the environment. Change in the environment may
necessitate the unit to tailor its own business policies so as to suit to the
environment. The customers, the Government, the society will exert their
influence on the decision making process of the business. Changes in the
value system, sometimes, may even force firms to pursue distant goals like
‘social responsibility’.

This unit considers changes in monetary and credit policies, inflation and
financial markets as pertinent for their influence on working capital
decisions. Monetary and credit policies consisting of variables like money
supply, bank rate, CRR, SLR, Interest rates, selective credit controls are
decided by the central bank of the country, having significant influence on
business decisions. More specifically, these are expected to influence the
availability and cost of business credit.

Realising the fact that inflation is a common phenomenon, there is a need to

care for the impact of inflation on business decisions. Inflation causes a
spurt in the prices of input factors like raw materials, labour, fuel and power.
It may also influence the behaviour of business units to go in for speculative
42 activities. Rapid increase in inflation may force the central bank to formulate
a tight, monetary policy, thus restricting for flow of credit to the business. Operating
Environment of
Further, inflation may effect working capital decisions leading to over- Working Capital
investment in inventory, under or over pricing of inventories, loss to the unit
in the collection of debts due to depreciation in the value of money. Idle cash
flowing through the organisation will add further problems to the unit in
terms of loss in the value of money in real terms.
Financial markets are the agencies that provide necessary funds for all
productive purposes. The stage of development of these markets has
profound influence on the supply and demand for funds. For, the Government
has taken up a reform exercise meant for improving the efficiency and
effectiveness of the system.

The sweep of the reforms is wide enough to cover every constituent of the
organised financial system such as the money market, credit market, equity
and debt market, government securities market, insurance market and the
foreign exchange market.

2.6 KEY WORDS

Environment: Surroundings or circumstances, which affect the life of an
object.
Broad Money: Sum of money in circulation, demand and time deposits with
commercial works and other deposits with RBI.
Bank Rate: The Rate at which the Central Bank is prepared to buy or
rediscount bills of exchange and other eligible securities of commercial
banks.
Cash Reserve Ratio: Minimum reserve maintained by commercial banks
with RBI.
Selective Credit Controls: Tools available with the Central Bank to regulate
the flow of credit.
Statutory liquidity Ratio: Minimum Reserve to be maintained by
commercial banks with themselves, as a percentage of demand and time
liabilities.
Financial Market: An agency that helps in the mobilisation of funds for
industry and trade.
Credit Policy: A statement indicating the measures contemplated for
ensuring effective flow of credit to the needy.

2.7 SELF ASSESSMENT QUESTIONS

1) Bring out the necessity for scanning Business Environment.
2) What is the Role of Central Bank in designing and implementing
monetary and credit policy?
3) Trace out the Interest Rate policy in India. Can you identify what would
be the impact of interest rates on financial decision making?
43
Concepts and 4) ‘Money Supply is the key factor that reflects the volume of trade in any
Determination
country, Discuss.
5) Illustrate with suitable examples the impact of inflation on working
capital management.
6) How do changes in financial markets influence business decision
making?
7) Elucidate the financial sector reforms undertaken in the recent past in
India. Do you think that there is any unfinished agenda?

2.8 FURTHER READINGS

1) Reddy, Y. V., ‘Monetary and Credit Policy- Continuity, Context,
Change and Challenges’, RBI Bulletin, Vol.LII, No.6, June 98.
2) Economic Survey. 2021-22.
3) Rangarajan, C, ‘Dimensions of Monetary Policy’, RBI Bulletin, Vol. LI,
No.2, Feb. 97.
4) Bhole, L.M., (1992), Financial Institutions and Markets, Tata McGraw
Hill, New Delhi.
5) Rao, K.V. & Venkataramaiah, B., 1991, Bank Finance to Industries,
Printwell, Jaipur.
6) Report of the Committee on Financial System, 1991.
7) Rao, K.V., 1990, Management of Working Capital in PEs, Deep & Deep
Publications, New Delhi.
8) De Kock, M.H., Central Banking, New Delhi, Universal Book Stall,
1984.
9) RBI, Reserve Bank of India - Functions and Working, Bombay, 1983.
10) Reddy, Y. V., Advice and Dissent: My Life in Public Service, Harper
Collins Publishers, Noida, 2017.
11) Raguram G. Rajan, (2017), I Do What I Do, Harper Collins Publishers,
Noida.
12) Chakraborty, S.K. and Others, 1976, Topics in Accounting and Finance,
Oxford University Press, Calcutta.

44
 Operating
Appendix-I: Monetary and Credit policy for the year 2021-22 Environment of
Working Capital
The Monetary Policy Committee (MPC) at its meeting today (February 10,
2022) decided to:

• keep the policy repo rate under the liquidity adjustment facility (LAF)
unchanged at 4.0 per cent.
The reverse repo rate under the LAF remains unchanged at 3.35 per cent and
the marginal standing facility (MSF) rate and the Bank Rate at 4.25 per cent.

• The MPC also decided to continue with the accommodative stance as long
as necessary to revive and sustain growth on a durable basis and continue to
mitigate the impact of COVID-19 on the economy, while ensuring that
inflation remains within the target going forward.
These decisions are in consonance with the objective of achieving the
mediumterm target for consumer price index (CPI) inflation of 4 per cent
within a band of +/- 2 per cent, while supporting growth.
The main considerations underlying the decision are set out in the statement
below:

Assessment
Global Economy
2. Since the MPC’s meeting in December 2021, the rapid spread of the
highly transmissible Omicron variant and the associated restrictions have
dampened global economic activity. The global composite purchasing
managers’ index (PMI) slipped to an 18 month low of 51.4 in January
2022, with weakness in both services and manufacturing. World
merchandise trade continues to grow. There are, however, headwinds
emanating from persistent container and labour shortages, and elevated
freight rates. In its January 2022 update of the World Economic Outlook,
the International Monetary Fund (IMF) revised global output and trade
growth projections for 2022 downward to 4.4 per cent and 6.0 per cent
from its earlier forecasts of 4.9 per cent and 6.7 per cent, respectively.
3. After reversing the transient correction that had occurred towards
endNovember, commodity prices resumed hardening and accentuated
inflationary pressures. With several central banks focused on policy
normalisation, including ending asset purchases and earlier than expected
hikes in policy rates, financial markets have turned volatile. Sovereign
bond yields firmed up across maturities and equity markets entered
correction territory. Currency markets in emerging market economies
(EMEs) have exhibited two-way movements in recent weeks, driven by
strong capital outflows from equities with elevated uncertainty on the
pace and quantum of US rate hikes. The latter also led to an increasing
and volatile movement in US bond yields.
Domestic Economy
4. The first advance estimates (FAE) of national income released by the
National Statistical Office (NSO) on January 7, 2022 placed India’s real
45
Concepts and gross domestic product (GDP) growth at 9.2 per cent for 2021-22,
Determination
surpassing its pre-pandemic (2019-20) level. All major components of
GDP exceeded their 2019-20 levels, barring private consumption. In its
January 31 release, the NSO revised real GDP growth for 2020-21 to (-)
6.6 per cent from the provisional estimates of (-) 7.3 per cent.
5. Available high frequency indicators suggest some weakening of demand
in January 2022 reflecting the drag on contact-intensive services from
the fast spread of the Omicron variant in the country. Rural demand
indicators – two-wheeler and tractor sales – contracted in December-
January. Area sown under Rabi up to February 4, 2022 was higher by 1.5
per cent over the previous year. Amongst the urban demand indicators,
consumer durables and passenger vehicle sales contracted in November-
December on account of supply constraints while domestic air traffic
weakened in January under the impact of Omicron. Investment activity
displayed a mixed picture – while import of capital goods increased in
December, production of capital goods declined on a year-on-year (y-o-
y) basis in November. Merchandise exports remained buoyant for the
eleventh successive month in January 2022; non-oil non-gold imports
also continued to expand on the back of domestic demand.
6. The manufacturing PMI stayed in expansion zone in January at 54.0,
though it moderated from 55.5 in the preceding month. Among services
sector indicators, railway freight traffic, e-way bills, and toll collections
posted y-o-y growth in December-January; petroleum consumption
registered muted growth and port traffic declined. While finished steel
consumption contracted y-o-y in January, cement production grew in
double digits in December. PMI services continued to exhibit expansion
at 51.5 in January 2022, though the pace weakened from 55.5 in
December.
7. Headline CPI inflation edged up to 5.6 per cent y-o-y in December from
4.9 per cent in November due to large adverse base effects. The food
group registered a significant decline in prices in December, primarily on
account of vegetables, meat and fish, edible oils and fruits, but sharp
adverse base effects from vegetables prices resulted in a rise in y-o-y
inflation. Fuel inflation eased in December but remained in double digits.
Core inflation or CPI inflation excluding food and fuel stayed elevated,
though there was some moderation from 6.2 per cent in November to 6.0
per cent in December, driven by transportation and communication,
health, housing and recreation and amusement.
8. Overall system liquidity continued to be in large surplus, although
average absorption (through both the fixed and variable rate reverse
repos) under the LAF declined from ₹8.6 lakh crore during October-
November 2021 to ₹7.6 lakh crore in January 2022. Reserve money
(adjusted for the first-round impact of the change in the cash reserve
ratio) expanded by 8.4 per cent (y-o-y) on February 4, 2022. Money 3
supply (M3) and bank credit by commercial banks rose (y-o-y) by 8.4
per cent and 8.2 per cent, respectively, as on January 28, 2022. India’s
foreign exchange reserves increased by US$ 55 billion in 2021-22 (up to
46 February 4, 2022) to US$ 632 billion.
 Operating
Outlook Environment of
Working Capital
9. Since the December 2021 MPC meeting, CPI inflation has moved along
the expected trajectory. Going forward, vegetables prices are expected to
ease further on fresh winter crop arrivals. The softening in pulses and
edible oil prices is likely to continue in response to strong supply-side
interventions by the Government and increase in domestic production.
Prospects of a good Rabi harvest add to the optimism on the food price
front. Adverse base effect, however, is likely to prevent a substantial
easing of food inflation in January. The outlook for crude oil prices is
rendered uncertain by geopolitical developments even as supply
conditions are expected to turn more favourable during 2022. While cost-
push pressures on core inflation may continue in the near term, the
Reserve Bank surveys point to some softening in the pace of increase in
selling prices by the manufacturing and services firms going forward,
reflecting subdued pass-through. On balance, the inflation projection for
2021-22 is retained at 5.3 per cent, with Q4 at 5.7 per cent. On the
assumption of a normal monsoon in 2022, CPI inflation for 2022-23 is
projected at 4.5 per cent with Q1:2022-23 at 4.9 per cent; Q2 at 5.0 per
cent; Q3 at 4.0 per cent; and Q4:2022-23 at 4.2 per cent, with risks
broadly balanced (Chart 1).
10. Recovery in domestic economic activity is yet to be broad-based, as
private consumption and contact-intensive services remain below pre-
pandemic levels. Going forward, the outlook for the Rabi crop bodes
well for agriculture and rural demand. The impact of the ongoing third
wave of the pandemic on the recovery is likely to be limited relative to
the earlier waves, improving the outlook for contactintensive services
and urban demand. The announcements in the Union Budget 2022-23 on
boosting public infrastructure through enhanced capital expenditure are
expected to augment growth and crowd in private investment through
large multiplier effects. The pick-up in non-food bank credit, supportive
monetary and liquidity conditions, sustained buoyancy in merchandise
exports, improving capacity utilisation and stable business outlook augur
well for aggregate demand. Global financial market volatility, elevated
international commodity prices, especially crude oil, and continuing
global supply-side disruptions pose downside risks to the outlook.
Taking all these factors into consideration, the real GDP growth for
2022-23 is projected at 7.8 per cent with Q1:2022-23 at 17.2 per cent; Q2
at 7.0 per cent; Q3 at 4.3 per cent; and Q4:2022-23 at 4.5 per cent.
11. The MPC notes that inflation is likely to moderate in H1:2022-23 and
move closer to the target rate thereafter, providing room to remain
accommodative. Timely and apposite supply side measures from the
Government have substantially helped contain inflationary pressures.
The potential pick up of input costs is a contingent risk, especially if
international crude oil prices remain elevated. The pace of the domestic
recovery is catching up with pre-pandemic trends, but private
consumption is still lagging. COVID-19 continues to impart some
uncertainty to the future outlook. Measures announced in the Union
Budget 2022-23 should boost aggregate demand. The global
47
Concepts and macroeconomic environment is, however, characterised by deceleration
Determination
in global demand in 2022, with increasing headwinds from financial
market volatility induced by monetary policy normalisation in the
systemic advanced economies (AEs) and inflationary pressures from
persisting supply chain disruptions. Accordingly, the MPC judges that
the ongoing domestic recovery is still incomplete and needs continued
policy support. It is in this context that the MPC has decided to keep the
policy repo rate unchanged at 4 per cent and to continue with an
accommodative stance as long as necessary to revive and sustain growth
on a durable basis and continue to mitigate the impact of COVID-19 on
the economy, while ensuring that inflation remains within the target
going forward.
12. All members of the MPC – Dr. Shashanka Bhide, Dr. Ashima Goyal,
Prof. Jayanth R. Varma, Dr. Mridul K. Saggar, Dr. Michael Debabrata
Patra and Shri Shaktikanta Das – unanimously voted to keep the policy
repo rate unchanged at 4.0 per cent.
13. All members, namely, Dr. Shashanka Bhide, Dr. Ashima Goyal, Dr.
Mridul K. Saggar, Dr. Michael Debabrata Patra and Shri Shaktikanta
Das, except Prof. Jayanth R. Varma, voted to continue with the
accommodative stance as long as necessary to revive and sustain growth
on a durable basis and continue to mitigate the impact of COVID-19 on
the economy, while ensuring that inflation remains within the target
going forward. Prof. Jayanth R. Varma expressed reservations on this
part of the resolution.
14. The minutes of the MPC’s meeting will be published on February 24,
2022.
15. The next meeting of the MPC is scheduled during April 6-8, 2022.

48
 Determination of
UNIT 3 DETERMINATION OF WORKING Working Capital

CAPITAL

Objectives
The objectives of this unit are to:

• Provide a framework for assessing the working capital requirements of a

firm.
• Explain the concept of operating cycle and its utility in the determination
of working capital requirements.
• Examine the theoretical basis for the determination of Working Capital
needs.
• Highlight the recommendations of Tandon committee.
• Discuss the present policy of the commercial banks in determining
working capital requirements of their borrowers.

Structure
3.1 Introduction
3.2 Determination of Working Capital Needs: Different Approaches
3.3 Factors Influencing Determination
3.4 Tandon Committee Norms
3.5 Present Policy of Banks
3.6 Summary
3.7 Key Words
3.8 Self-Assessment Questions
3.9 Further Readings

3.1 INTRODUCTION
In the previous unit, we have learnt about the crucial issues affecting the
working capital decisions. A survey of the policy aspects pertaining to
monetary and credit policies has been attempted. These developments are
considered to affect the quantum and availability of working capital in the
country. More particularly, the recent changes in the economic liberalization
of the country are expected to produce a tremendous impact on the working
of Indian industries.

Indian companies today have value maximization as the major objective and
to achieve it one should be capable of estimating the requirements precisely.
Both excessive and inadequate investment in working capital items may lead
to unnecessary strain on the objective function. Therefore, the finance
manager has to examine all the factors that determine the working capital
requirements within the theoretical and practical points of view. For, the
theoretical considerations sometimes dominate the methodology of 49
Concepts and assessment; while the firms are constrained to follow the restrictions imposed
Determination
by the borrowers.

The finance manager, therefore, should consider all the factors that have a
bearing on the working capital including cash, receivables and inventories.
Though certain models are developed to determine the optimum investment
in each of the working capital items, an aggregate approach is yet to be
formulated. In the mean time, firms are basing their computations on the
concept of operating cycle. These and other related issues are discussed in
detail in this unit.

3.2 DETERMINATION OF WORKING CAPITAL

NEEDS: DIFFERENT APPROACHES
The question that what is the adequate amount of working capital required to
run a business, is attempted to be answered in several ways. Theoreticians, by
their natural inclination to construct models, have based their analogy on
certain foundations and constructed models to estimate the optimum
investment in working capital. Whereas, lenders such as banks, financial
institutions have based their decisions on production schedules and industry
practices. In between, there is different point of view calling for the adoption
of a strategic approach to the decision-making. Let us now discuss these
theoretical issues to further our understanding of the subject matter.

3.2.1 Industry Norm Approach

This approach is based on the premise that every company is guided by the
industry practice. If a majority of the units constituting a particular industry
adopt a type of practice, other units may also follow suit. This may finally,
turn out to be an industry practice. This practice decides the normal level of
investment in different current asset items. As a matter of fact, optimum level
of investment in receivables is to a great extent influenced by the industry
practices. If majority of the firms of a particular industry have been granting
say three months credit to a customer, others will have no other way except to
follow the majority; due to the fear of losing customers. Though there is no
basis for such a type of fear in fixing norms for other items of current assets,
industrial units generally prefer to follow majority.

a) However, the problems in following this type of an approach are

obvious: The classification of units into a particular industry is not that
easy. Firms may not be susceptible for such a neat classification; when
the units are multi-product firms.
b) Deciding an average to represent a particular industry is highly difficult.
The norms, thus, developed can be less of a reality and more of a
myth.
c) Averages have no meaning to many firms, since the nature of firms
differ.

50
d) Industry norm approach may result in imitative behaviour resulting in Determination of
Working Capital
damage to innovation. Sometimes this may lead to herding of imitative
and inexperienced.
e) This approach may also promote ‘hard mentality’, thus limiting the scope
for excellence. For example, if X unit is able to maintain its production
schedule with only one month requirement of raw material, while the
industry norm being 2 months, there is no wisdom as to why X should
also keep 2 months.

For the above reasons, industry norm approach is not suggested by many as a
benchmark for making investment in current assets. Nevertheless, this has
been a practice followed by many as a tradition, even the lenders are basing
their decisions on this model; though illogical.

3.2.2 Economic Modeling Approach

Model building, of late, has become a crucial exercise in many disciplines.
Theoreticians are making efforts to be as much precise as possible.
Widespread use of quantitative techniques has helped theoreticians to
develop a framework to test their hypotheses. Models attempt to suggest an
optimum solution to a given problem. As in the case of many disciplines, in
the area of finance also model building has been attempted. As far as
working capital is concerned, optimum investment in inventory is sought to
be decided with the help of EOQ model.
This has turned out to be an important concept in the purchase of raw
materials and in the storage of finished goods and in-transit inventories.
EOQ is given by a simple equation:

2SO
Q* =
C

Where Q* = Optimum order quantity

S = Annual usage of material
O = Ordering costs per order
C = Carrying costs per unit
William J. Baumol has attempted to apply this inventory model to the
determination of optimum cash balances that can be held by an enterprise.
The transactions demand for money is sought to be analysed from this point
of view. As per the model, the optimum level of cash is decided by the
carrying cost of holding cash and the cost of transferring marketable
securities to cash and vice- versa.

His equation is as follows:

2bT
C*=
i
C*= Optimum cash balance
b = Transaction costs per transaction
51
Concepts and T = Total demand for cash
Determination
i = Interest rate

Similarly, the decision to sell to a particular account should be based

objectively upon the application of profit maximising model. In this regard,
Robert M. Soldofsky developed a model for Accounts receivable
management. He has laid down the following formula for making a credit
decision, leading to optimum investment in receivables.

Sell, when M – (b + Ti + c/o) ≥ 0

where M = Profit Margin
b = Probability of a credit sale becoming a bad debt
i = Interest rate
c = Costs per order of selling on credit as an implicit function of risk,
o = Order size
T = Time period
Though models are available to decide optimum investment in case of some
important components of working capital, for many other items, no such
modeling is attempted; nor is there an attempt at the aggregate level.
Moreover, these models are subject to certain assumptions and conditions.
Their utility comes under scrutiny for want of these assumptions turning out
to be far from reality. For this and several other reasons, economic modeling
is not much popular with Indian companies.

3.2.3 Strategic Choice Approach

Unlike industry norm approach and economic modeling approach, this is
not a standard method which suggests certain benchmarks to work with.
The earlier methods suggest the use of certain yardsticks or guidelines,
irrespective of the differences in size of the business units, nature of industry,
business structure or competition. For example, optimum investment in
inventory can be had by applying the equation and it is almost universal for
every business unit. Similarly, industry norm approach suggests the same
yardstick for every unit constituting that industry, in spite of variations in the
size, nature of business, terms of sale and purchase, and competition.

In contrast, the strategic choice approach recognises the variations in business

practice and advocates the use of ‘strategy’ in taking working capital
decisions. The spirit behind this approach is to prepare the unit to face
challenges of competition and take a strategic position in the market place.
The emphasis is on the strategic behaviour of the business unit. After all, no
two units would be alike, in terms of their nature, opportunities and
Environment. The firm is independent in choosing its own course of action;
not necessarily guided by the rules of the industry. This makes it obligatory
on the part of the firm to set its own targets for achievement in the area of
working capital. For instance, if the firm has set an objective like increasing
market share from the present level of 20 percent to 40 percent, it can
think of devising a suitable credit policy. Such a policy may involve
variations in the terms followed at present such as extending the credit
52
 period, enhancing the credit limit or increasing the percentage of cash Determination of
Working Capital
discount, etc.

Thus, the strategic choice approach presupposes a highly competitive

environment and the willingness of the management to take risks. The
success of the approach also depends on the ability of the management to set
realistic goals and prepare suitable strategy to achieve them. Any wrong
planning will lead the firm into trouble; much worse than what it was when
either of the earlier methods were being followed. All said and done, this can
be dubbed as the most innovative style in approaching the Working Capital
Issues.

Activity 3.1
i. Giving reasons indicate the meaningful and logical approach suitable for
determining the working capital requirement of a business.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
ii. Mention 2/3 points about relevance of strategic choice approach in
practical business decision making.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................

3.3 FACTORS INFLUENCING DETERMINATION

The working capital requirements of a firm depends on a number of factors.
It is a common proposition that the size of working capital is a function of
sales. Sales alone will not determine the size of the working capital, but
instead it is constantly affected by the criss-crossing economic currents
flowing in a business. The nature of the firm’s activities, the industrial health
of the country, the availability of materials, the ease or tightness of the money
market, are all parts of these shifting forces. Of them, the influence of
operating cycle is considered paramount.

3.3.1 Operating Cycle

Since working capital is represented by the sum of current assets, the
investment in the same is determined by the level of each current asset item.
To a large extent, the investment in current asset items is decided by the
‘Operating Cycle’ (OC) of the enterprise. The concept of operating cycle is
very significant for computation of working capital requirements. The size of
53
Concepts and investment in each component of working capital is decided by the length
Determination
of OC.

The term operating cycle can be understood to represent the length of time
required for the completion of each of the stages of operation involved in
respect of working capital items. This helps portray different stages of
manufacturing activity in its various manifestations, such as peaks and
troughs, along with the required supporting level of investment at each stage
in working capital. The sum of these stage-wise investments is the total
amount of working capital required to support the manufacturing activity at
different stages of the cycle. The four important stages of that can be
identified as:
1) Raw materials and stores inventory stage
2) Work-in-progress stage
3) Finished goods inventory stage
4) Book Debts stage
The following is the formula used to arrive at the OC period in an enterprise.
‘t’ = (r–c) + w + f + b,
where
‘t’ = stands for the total period of the operating cycle in number of days;
‘r’ = the number of days of raw materials and stores consumption
requirements held in raw materials and stores inventory;
‘c’ = the number of days purchases, included in trade creditors;
‘w’ = the number of days of cost of production held in work-in-progress;
‘f’ = the number of days cost of sales included in finished goods; and
‘b’ = the number of days sales in book debts.

The computations involved are:

Average inventory of raw materials and stores
r = ————————————————————
Average materials and stores consumption per day
Average trade creditors
c = ————————————
Average purchase per day
Average work in progress
w = ————————————————
Average cost of production per day
Average inventory of finished goods
f = ————————————————
Average cost of sales per day
Average book debts
b = ——————————
Average sales per day
The average inventory or book debts level can be arrived at by finding the
mean between the relevant opening and closing balances for the year. The
average consumption or output or cost of sales or sales per day can be
54
obtained by dividing the respective annual figures by 365. Some authors and Determination of
Working Capital
Bank Managers use 300-360 days as the denominator to reflect upon the
operational days in a year.

The first comprehensive and coherent exposition of the OC concept is to be

that of Park and Gladson. They attempted to establish how current assets and
liabilities were linked together as the two important determinants of working
capital. This search led them to the conclusion that the prevailing one-year
temporal standard applied in classifying assets or liabilities as current’ was
not universally valid. What was current or non-current depended on the
nature of the core business activity. Thus, for a fruit processing business
two to three months would be the correct criterion of currentness. For a
lumbering or wine-making business, however, a period of longer than one
year would be the standard. Between such extremes, the currentness of period
for each business would be a function of the nature of its basic activity as
dictated by the technological requirements and trading conventions.

Instead they used the term ‘natural business year’ within which an activity
cycle is completed. Later, the accounting principles board of the American
Institute of the Certified Public Accountants while defining working capital
used this concept.

3.3.2 Determination of Working Capital Using O.C.

Now, we may attempt to determine the amount of working capital required
for a firm using the above concept.

Illustration 3.1
ABC company plans to achieve annual sales of 1,00,000 units for the year
2020. The following is the cost structure of the company as per the
previous figures.

Materials .. 50%
Labour .. 20%
Overheads .. 10%

The following further particulars are available from the records of the company.

1) Raw materials are expected to remain in stores for an average period of

one month before issue to production.
2) Finished goods are to stay in the warehouse for two months on an
average before being sold and sent to customers.
3) Each unit of production will be in process for one month on the
average.
4) Credit allowed by the suppliers of raw material is one month from the
date of delivery of materials.
5) Debtors are allowed credit for two months from the date of sale of
goods.
6) Selling price per unit is Rs.9 per unit.
55
Concepts and 7) Production and sales follow a consistent pattern and there are no wide
Determination
fluctuations.

Determine the quantum of working capital required to finance the activity

level of 1,00,000 units for the year 2020.

SOLUTION:
Statement of Working Capital Required
Current Assets:
Theories and Approaches
Amount (Rs.)
1 50
1. Raw Material Inventory (1 month) 1,00,000 9 = 37,500
12 100
1 80
2. Work-in-progress Inventory (1 month) 1,00,000 9 = 60,000
12 100

2 80
3. Finished goods Inventory (2 months) 1,00,000 9 =1,20,000
12 100
2 100
4. Debtors (2 months) 1,00,000 9 = 1,50,000
12 100
3,67,500
Less: Current Liabilities:
1 50
1. Creditors (1 month) 1,00,000 9 = 37,500
12 100
–———
Working capital required = 3,30,000
–––––––
Notes: 1) Raw material inventory is expressed in raw material consumption.
2) Work-in-progress inventory is expressed in cost of production
(COP) where, COP is deemed to include materials, labour and
overheads.
3) Finished goods inventory is supposed to have been expressed in
terms of cost of sales. Since separate details are not given, the
figures are worked out on COP.
4) Debtors are expressed in terms of total sales value.
5) Creditors are expressed in terms of raw material consumption,
since separate figures are not available for purchases.
Illustration 3.2
A company plans to achieve annual sales of Rs.1,00,000. What would be its
working capital requirements under the following conditions:
1) The average period during which raw materials are kept in stock before
being issued to factory - 2 months.
2) The length of the production cycle i.e., the period from the date of
56
 receipt of raw materials by factory to the date of completion of goods - Determination of
Working Capital
or say stock-in-process - 1/2 month.
3) Average period during which finished goods are stocked pending sale- 1
month.
4) The period of credit allowed to customers - 1 month.
5) The period of credit granted by suppliers of raw materials - 1 month.
6) The analysis of cost as a percentage of sales:
Raw materials .. .. .. 45%
Manufacturing expenses including wages & depreciation 30%
Overheads (Excluding depreciation) .. .. 10%
Net Profit .. .. .. 15%
Total .. 100%
7) Cash available in business to meet urgent requirements is Rs.5,000.
SOLUTION:
Current Assets:
Amount (Rs.)
45 2
1) Raw material inventory (2 months) 1,00,000 = 7,500.00
100 12
75 1
2) Work-in-progress inventory (½ month) 1,00,000 = 3,125.00
100 24
85 1
3) Finished goods inventory (1 month) 1,00,000 = 7,083.33
100 12
100 1
4) Receivables (1 month) 100, 000 = 8,333.33
100 12
26,041.66
5) Cash available in the firm .... .... 5,000.00
31,041.66
Less: Current Liabilities:
45 1
1. Creditors (1 month) 1, 00, 000 = 3,750.00
100 12
––––––––––
Working capital required 27,291.66
––––––––––
Notes: (1) Workings are made as per assumptions given in Illustration- 3.1
excepting that the finished goods inventory is expressed in terms of cost of
sales, which is considered to be inclusive of raw materials, manufacturing
expenses and overheads.

3.3.3 Other Factors

In addition to the influence of operating cycle, there are a variety of factors
that influence the determination of working capital. A brief explanation of the
same is provided hereunder:

57
Concepts and Nature of Business
Determination
A company’s working capital requirements are directly related to the type of
business operations. In some industries like public utility services the
consumers are generally asked to make payments in advance and the money
thus received is used for meeting the requirements of current assets. Such
industries can carry on their business with comparatively less working
capital. On the contrary, industries like cotton, jute etc. may have to purchase
raw materials for the whole of the year only during the harvesting season,
which obviously increases the working capital needs in that period.

Management’s Attitude Towards Risk

Management’s attitude towards risk also influences the size of working
capital in an undertaking. It is, of course, difficult to give a very precise and
determinable meaning to the management’s attitude towards risk, but as
suggested by Walker, the following principles involving risk may serve as the
basis of policy formulation:

1) If working capital is varied relative to sales the amount of risk that firm
assumes also varies and the opportunity for gain or loss is increased;
2) Capital should be invested in each component of working capital as long
as the equity position of the firm increases;
3) The type of capital used to finance working capital directly affects the
amount of risk that a firm assumes as well as the opportunity for gain
or loss and cost of capital; and
4) The greater the disparity between the maturities of a firm’s short-term
debt instruments and flow of internally generated funds, the greater the
risk and vice-versa.

Briefly, these principles imply that the policies governing the size of the
working capital are determined by the amount of risk, which the management
is prepared to undertake.

Growth and Expansion of Business

It is logical to expect that larger amounts of working capital are needed to
support the increasing operations of a business concern. But, there is no
simple formula to establish the link between growth in the company’s
volume of business and the growth of working capital. The critical fact is that
the need for increased working capital funds does not follow the growth in
business activity but precedes it. Citerus paribus, growth industries require
more working capital than those that are static.

Product Policies
Depending upon the kind of items manufactured by adjusting its production
schedules a company may be able to off-set the effects of seasonal
fluctuations upon working capital. The choice rests between varying output in
order to adjust inventories to seasonal requirements and maintaining a steady
rate of production and permitting stocks of inventories to build up during off-
season period. In the first instance, inventories are kept to minimum levels; in
58
the second, the uniform manufacturing rate avoids high fluctuations of Determination of
Working Capital
production schedules but enlarged inventory stocks create special risks and
costs.

Position of the Business Cycle

Besides the nature of business, manufacturing process and production
policies, cyclical and seasonal changes also influence the size and behaviour
of working capital. During the upswing of the cycle and the busy season of
the enterprise, there will be a need for a larger amount of working capital to
cover the lag between increased need and the receipts. The cyclical and
seasonal changes mainly influence the size of the working capital through the
inventory stock. As regards the behaviour of inventory during the business
cycles, there is no unanimity of opinion among economists. A few say that
inventory moves in conformity with business activity. While others hold the
view that business activity depends upon the behaviour of the inventory of
finished goods which is determined by the credit mechanism and short-term
rate of interest. Whatever be the view points, the fact remains that the cyclical
changes do influence the size of the working capital.

Terms of Purchase and Sale

The magnitude of the working capital of a business is also affected by the
terms of purchase and sale. If, for instance, an undertaking purchases its
materials on credit basis and sells its finished goods on cash basis, it requires
less working capital over an undertaking which is following the other way of
purchasing on cash basis, and selling on credit basis. It all depends on the
management’s discretion to set credit terms in consideration with the
prevailing market conditions and industry practices.

Miscellaneous
Apart from the above mentioned factors some others like the operating
efficiency, profit levels, management’s policies towards dividends,
depreciation and other reserves, price level changes, shifts in demand for
products competitive conditions, vagaries in supply of raw materials, import
policy of the government, hazards and contingencies in the nature of
business, etc., also determine the amount of working capital required by an
undertaking.

Activity 3.2
i) Highlight few important factors on which the working capital
requirement of your organisation depends.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
59
Concepts and ii) Comment on the method of assessment being followed in your
Determination
organisation for working capital determination.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................

3.4 TANDON COMMITTEE NORMS

Since mid-sixties, the issue of financing working capital has been engaging
the attention of industry and the policy makers. The measures taken by the
Reserve Bank of India included the introduction of Credit Authorisation
Scheme in November 1965, Constitution of the Dahejia Committee in
October 1968, Tandon Committee in July 1974 and the Chore Committee in
March 1979. Over the years, attempt has been made to streamline the flow of
credit from the banking sector to the industry. The link between financing of
working capital and the recommendations of various committees is that the
latter tried to make out a case for fixing norms for the maintenance of
various current assets; thus leading to the determination of optimum working
capital.

In this regard, Tandon Committee, for the first time, made an attempt to
prescribe norms for holding diverse current asset items. The committee
wanted the commercial banks to quantify the desirable level of net working
capital and the maximum permissible lending by the banks. In its approach to
the methods of lending, the Committee sought to identify the ‘Reasonable
level of current assets’ as the basis of its calculation of different methods. In
other words, the total of current assets is based on the norms suggested by
them rather than the actual current assets held by the undertakings. For this
purpose, the Committee suggested norms for carrying raw materials, work-in-
progress, finished goods, and receivables in respect of 15 major industries.
The norms for the four kinds of assets are related in the following manner:

Type of Asset Relation to

1) Raw Materials Month’s consumption of raw materials
2) Work-in-progress Month’s cost of production
3) Finished goods Month’s cost of sales
4) Receivables Month’s sales
The norms represent the maximum levels of inventories and receivables in
each type of industry. It is further laid down that, if the holding of any kind
of asset is higher than the level fixed by the relative norms, the surplus would
be treated ‘excess’ holding to be shed off, failing which an amount equal to
the value thereof would be treated as excess borrowing and a levy of penal
rate of interest is suggested on such excess borrowing. Again, it is not
permitted to set off such excess against any shortfall in the holding of other
60
current assets, as the norms represent the maximum permissible levels of Determination of
Working Capital
holdings. The list of fifteen industries included cotton textiles, synthetic
textiles, jute, pharmaceuticals, rubber, fertilisers, vanaspati, paper and
engineering. This system of lending continued with little variations almost
upto the beginning of the present decade. But there is no change in the basic
philosophy as to the assessment of working capital norms, based on the
industry norm approach.

3.5 PRESENT POLICY OF BANKS

After the implementation of a phased liberation programme since 1991, the
RBI decided to allow full operational freedom to the banks in assessing the
working capital requirements of the borrowers. All the instructions relating to
Maximum Permissible Bank Finance (MPBF) have been withdrawn. As an
alternative, a revised system of assessing working capital limits has been
evolved. Accordingly, one of the following three methods has been suggested
for adoption by the commercial banks.
a) Turnover method
b) Eligible working capital limit method
c) Cash-flow method
Under the ‘Turnover method’, working capital requirements of all the
borrowers enjoying aggregate fund based working capital limits up to Rs.2
crore from the banking system are being assessed on the basis of a minimum
of 25% of their projected annual turnover. Of this, 5% of the annual turnover
should be brought by way of promoter’s contribution. Thus, the remaining 20
% is only financed by the banks.
As is evident, this calls for a change in the approach of the RBI in assessing
working capital needs of the industrial units. The industry norm approach
followed so far yields a place to the simple turnover method and norms have
no role to play. Higher the turnover, higher would be the credit facility
available. In the earlier system, (industry norm approach), maintenance of a
high level of current assets or any other assets has no significance to the
computation of working capital needs, excepting the industry norms fixed on
some practical basis. On the contrary, units having higher turnover are
permitted to hold higher current assets, though as per norms it is excess.
Moreover, this type of a practice encourages firms to stock materials and
finished goods with lax inventory control. Small firms lag in competition to
large firms, as there is an inherent advantage to the latter.

Alternatively, banks may also follow ‘Cash-flow method’ to finance the

working capital needs of the industrial units. Under this method, banks will
meet the deficit, if any, due to payments being higher than the receipts in that
month. For this purpose, borrowers are instructed to prepare monthly cash
flow statements and impose certain control measures to ensure smooth
operation of the system.

This method too abandons the industry norm approach in assessing working
capital needs. This method takes into account only the difference between 61
Concepts and receipts and payments. This difference may arise for several reasons and may
Determination
not be entirely due to changes in working capital items. Though care is
expected to be taken by the industrial units in preparing cash flow statements,
implementation of the method in practice will only highlight its suitability.

3.5.1 RBI Guidelines in Financing Working Capital

The Reserve Bank of India, in order to strengthen the credit discipline among
borrowers and also to guide the Banks, has issued the following revised
guidelines on working capital loans:

 RBI has stipulated a ‘minimum level’ of loan component in fund based

working capital finance.
 It also specified a mandatory ‘Credit Conversion Factor (CCF)’ for the
undrawn part of the cash credit limit or the O.D. facility given.
 Redefined the large borrowers as having fund based working capital
limit of Rs.150 crore and above. This was Rs.100 crore earlier.
 With effect from October, 2018, the minimum loan component is fixed
as 40% of the total limit.
 The Credit Conversion Factor (CCF) for large borrowers for the
unutilised portion of cash credit/overdraft was put at 20 per cent with
effect from April 1, 2019.
 The ‘Minimum Loan’ component is proposed to be enhanced from 40
per cent to 60 per cent with effect from April 1, 2019.
 In case of consortium lending, all the lenders, by mutual agreement fix
up ground rules for sharing cash credit and loan components.
 Banks are also provided with freedom to decide on the splitting of loan
component with different maturity periods, as per the need of the
borrowers.
 The other conditions imposed on the proper use of working capital
finance is that the borrowers are not supposed to buy assets or make
long–term investments.

3.5.2 Revised Policy Guidelines for Assessment of Working

Capital - A Case Study
In this section, an attempt has been made to provide readers with the insight
of actual guidelines under operation in one of the nationalised banks.

A. Methodology
The following are the methods followed by the banks as per their policy
stance in assessing working capital requirements of the borrowers.
Quantum of limits requested (Rs. in lakh) Method
i) Upto Rs.200.00 lakh from the Banking system Turnover Method
ii) Rs.200.00 lakh and above from the banking Eligible Working Capital
system but upto & inclusive of Rs.2000.00 Limit (EWCL) Method
lakh from the Bank.
62
iii) For limits above Rs.2000.00 lakh EWCL or Cash Budget Determination of
Working Capital
Method as may be decided
by the Bank.
B. TURNOVER METHOD:
In the case of SSI borrowers who are seeking fund-based limits upto
Rs.200.00 lakh from the banking system, it is made mandatory by the RBI to
assess the working capital limits as under:
1) Projected Gross Sales .. Rs..............
2) Working Capital requirements at 25% of A .. Rs..............
3) Margin to be provided by the borrower at 5% of A
(Corresponding to a Current ratio of 1.25) or the
actual net working capital available, whichever is higher Rs..............
4) Eligible Working Capital finance (b–c) Rs..............

In the case of Non-SSI borrowers, seeking fund based limits up to Rs.200.00

lakh from the banking system, the assessment methodology, remains the
same as in the case of SSI borrowers except that minimum margin to be
brought in by the borrower shall be 6.25% of the Projected Gross Sales which
corresponds to a Current Ratio of 1.33, which can be relaxed upto 5% of the
Projected Gross Turnover which corresponds to a current ratio of 1.25 subject
to other Financial Parameters being satisfactory.
While arriving at Eligible Working Capital Finance under the Turnover
Method, for SSI and Non-SSI borrowers, if the available NWC is higher than
the required minimum, the higher available NWC shall be reckoned with.
Also, the unpaid stocks in excess of unfinanced eligible receivables shall not
be taken into account for the purpose of computation of drawing power. The
inventory margin requirement shall be 20% in the case of SSI borrowers and
20% to 25% in the case of Non-SSI borrowers depending on the stipulated
current ratio. While the limit shall be assessed and sanctioned on the basis of
25% of projected gross sales less prescribed margin to be provided by the
borrower, the actual release under the sanctioned limit shall be on the basis
of drawing power.
Like SSI borrowers, in the case of Non-SSI borrowers also, if any borrower
requests for working capital limits higher than what he would have been
eligible if assessed under the Turnover Method, his requirements can be
assessed under EWCL method and limits to the extent he is eligible under
EWCL method may be made available.
In the case of borrowers seeking fund based working capital limits less than
Rs.10.00 lakh from the Bank, the need based requirement for credit
facilities may be arrived at adopting a holistic approach, instead of Turnover
Method, taking into account the applicant’s business potential, business
plans, past dealings, credit- worthiness, market standing, collateral wherever
available and ability to repay, etc.

The limits assessed through simplified procedure shall be secured by current

assets primarily wherever the credit facilities are extended for procuring
63
Concepts and against the current assets. In addition the collateral security to an extent of at
Determination
least 150% of the value of advance shall be obtained from the borrowers
assessed through simplified procedure. However, the Zonal Heads are
empowered to reduce the cover of collateral security, but not below 100% of
value of the advance, on merit of the case. In the case of borrowers seeking
fund based limits less than Rs.10.00 lakhs where the assessment is done
under the Turnover method, the stipulation as above for the collateral security
will not be applicable as the borrowers assessed under Turnover Method will
have to comply with the security cover as under Basic Financial
Parameters.

The Working Capital limits less than Rs.10.00 lacs may also be extended by
way of short-term loan of not more than one year maturity. This short-term
loan repayable in instalments (i.e., balloon form) or in one lump sum (i.e.
bullet form) is available for renewal/rollover at the end of expiry, if the
sanctioning authority, after a review is satisfied to continue the advance. The
short-term loan is permitted to be arranged for the part amount of the limit
assessed while the balance is permitted to be extended by way of
overdraft.

To ensure continued use in the case of short term loans extended as above,
the stock statement shall be obtained at the end of every calendar quarter,
within 7 days from the end of the quarter and for any drawings beyond the
drawing Power (DP), penal interest as in force shall be recovered on the
drawings beyond the DP. The drawings beyond the DP shall not be recovered
immediately but the loan shall be allowed to be repaid as per repayment
programme specified.

The SSI borrowers seeking working capital limits less than Rs.10.00 lacs shall
be assessed under Turnover Method but they will be eligible to avail the
advance by way of short-term loan as above and/or overdraft. The short-term
loans as above will be eligible for 0.5% p.a. less interest (net of tax) subject to
a minimum of PLR, as compared to the interest chargeable on overdraft.

C. ELIGIBLE WORKING CAPITAL LIMIT METHOD (EWCL):

EWCL method, a suitably relaxed form of the erstwhile Maximum

Permissible Bank Finance (MPBF) Method, shall be applied in the case of
borrowers seeking fund based working capital limits of Rs.200.00 lacs and
above (from the banking system) but upto (and inclusive of) Rs.2000.00 lacs
from the Bank and the assessment shall be carried out as under:

Projections for ensuing year

a) Total Current Assets .. .. Rs………..

b) Less: Current Liabilities other than bank borrowings .. Rs…………
c) Working Capital Gap (a–b) Rs…………
d) Less: 25% (bench-mark) of Current Assets as Net
Working Capital (NWC) or
Projected NWC, whichever is higher .. Rs…………
e) Eligible Working Capital Limit (c–d) .. Rs…………
64
The identification/treatment of Current Assets and Current Liabilities shall Determination of
Working Capital
continue to be as before when the MPBF Method was practiced. The 25% of
current assets as margin (NWC) corresponds to a Current Ratio of 1.33,
which would be a benchmark current Ratio under this method of assessment.
However, relaxation of current ratio under EWCL method may be allowed
upto 1.1 selectively provided other basic financial parameters are satisfactory.
To arrive at the current ratio, the term loan instalments falling due in next 12
months shall be reckoned with but the same to be excluded as a component of
current liability to arrive at working capital gap under EWCL method.
Similarly the export receivables shall continue to be excluded from the
current assets to determine the required NWC.

D. CASH BUDGET METHOD

The working capital requirements of the borrowers seeking fund based limits
of above Rs.2000.00 lakhs shall be assessed either under CASH BUDGET
Method or the EWCL Method discussed earlier, as may be decided by the
Bank. The corporate borrowers whose management of finance is cash budget
driven and the existing clients of the Bank who have a consistently good
track record of fulfilling the specified norms/covenants - financial and
performance related - can opt for assessment under Cash Budget Method.
The assessment methodology under Cash Budget Method is as under:

Heads Quarterly details

1) Cash Flow from Business Operations:
i) All inflows (receipts)
ii) All outflows (payments)
2) Cash Flow from Non-business operations:
i) All inflows
ii) All outflows
3) Cash Flow from Capital Accounts:
i) All inflows
ii) All outflows
4) Cash Flow from sundry items:
i) All inflows
ii) All outflows
5) Assessment of bank finance:
(i) Cash Gap in the business-operations {I(ii) – I (i)}
Less: (ii) Amount brought/proposed to be brought from other sources i.e.
cash surplus under II, III & IV above.
(iii) Net Cash Gap {V(i) – V (ii)}
The Highest (Peak) Cash Gap during the period under assessment is to be
extended by way of eligible working capital limit. The following prerequisites
are advised for the borrowers to be assessed under Cash Budget system. The
borrower should:
65
Concepts and a) Preferably be a company under the Indian Companies Act, listed and
Determination
quoted at one or more of the Stock Exchanges in India. This however
may not be a restrictive parameter and if the Bank is satisfied on
financial strengths, the partnership and proprietorship concerns may also
be allowed under the system. The preference to listed/quoted companies
is only with an intent to have access to their published data.
b) Have in place a data base and system for doing the financial planning on
cash budget basis.
c) Have Inventory and Receivable management on the professional lines,
adhering to Stock Audit norms with stores management, shop floor
control and costing norms as provided in the industry. The Cash Budget
method shall continue to be used in the case of seasonal industries like
Sugar, Tea and others, and also in construction industry as before
irrespective of the quantum of working capital finance sought.
Since the requirements of working capital finance is directly related to the
levels of activity under production and sales and the inputs required to
achieve these levels, it is necessary to obtain the above requirements in
addition to the detailed Cash Budget. While the assessment to arrive at
quantum of finance should be carried out on the basis of cash budget obtained
from the borrower, the financial statements. CMA data with fund flows also
are to be taken into account to ascertain the level of business activity for
which the working capital finance is sought by the borrower. It may be also
necessary to conduct a sensitivity analysis based on variance of major
financial assumptions for a proper risk perception.

Activity 3.3
i) Visit any of the Banks nearby and have discussion with the concerned
Manager to understand the issues and methods involved in Working
Capital Finance
……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

3.6 SUMMARY
Determination of adequate amount of working capital required for a business
is of great significance in its prudent management. Value maximisation
implies optimum investment in all types of assets. There are three approaches
to decide the optimum investment in working capital. They are: industry
norm approach, economic modeling approach, and the strategic choice
66 approach. Under the first one, certain norms have been worked out taking the
nature of operations into account. Each unit’s requirements are assessed with Determination of
Working Capital
respect to such ‘industry bench mark’ norm. Economic models are pressed
into service to make certain projections, current asset items are projected on
the basis of these models and an optimum quantum is arrived at. Under the
strategic choice approach, business forms are advised to follow their own
‘unique’ approach basing on the circumstances prevailing; they need not be
guided by the industry practices.
As against these theoretical considerations, operating cycle concept is widely
followed in practice. Working capital requirements are assessed basing on
this methodology. Various other factors such as nature of business,
management’s attitude towards risk, growth and expansion of business,
product policies, position of the business cycle, terms of purchase and sale
and operating efficiency also exert their influence on the determination of
working capital. The methodology suggested by the Tandon Committee has
particular relevance to the assessment of working capital requirements.
Against this background, the approach followed by the commercial banks is
also highlighted. The present policy of the banks is to fix up working capital
limits basing on their own policy stance. After liberalization, banks are also
liberal in fixing their own norms, subject to the broad guidelines of RBI.

3.7 KEY WORDS

Operating cycle: Length of time required for the completion of each of the
stages involved in the manufacturing process, covering working capital items.
Turnover method: It is a method of calculation of working capital
requirements, basing on sales turnover.
Cash budget method: It is a method of calculation of working capital
requirements using cash budget.
Industry norm: It is a method of taking industry practices into account while
deciding working capital requirements.
Economic modelling: This refers to the use of quantitative techniques for
assessing working capital requirements.
Strategic choice: It is a need based approach taking into account the
circumstances prevailing in the industry to decide the optimum amount of
working capital.

3.8 SELF ASSESSMENT QUESTIONS

1) Explain different approaches to the determination of working capital. As
a new entrepreneur, which of the three broad approaches would you
prefer and why?
2) What are the various factors influencing the determination of working
capital?
3) Illustrate, using hypothetical data, how working capital requirements are
assessed using operating cycle concept.
4) Do you find any relevance of the recommendations of the Tandon
Committee in determining working capital requirements in the present
circumstances
67
Concepts and 5) Distinguish between turnover method and cash budget method which of
Determination
them do you suggest to a banker?
6) Management of Infotech Limited seeks your assistance on assessing the
working capital requirements for an activity level of 1,00,000 units of
output for the year 2020. The cost details of the product are as
follows:
Particulars Cost per Unit (Rs.)
Raw materials .. 20
Direct labour .. 5
Overheads .. 15
Total cost .. 40
Profit .. .. 10
Selling price .. 50
The other details are:
1) In order to ensure smooth flow of production 2 months raw material
inventory is to be held in the stores.
2) Finished goods remain in stores for one month.
3) Credit allowed for purchase of raw material is one month.
4) Credit allowed to customers is 2 months.
5) Cash Balance to be maintained is Rs.25,000.
6) Assuming that the product process is uninterrupted and even, compute
the amount of working capital required for the given level of activity.
7) The following information has been extracted from the accounts of ABC
Limited for the year 2 0 2 0 -21.
Statement of Cost Structure
S.No. Particulars (Rs. in crores)
1. Raw materials stock (opening) 33.89
2. Purchases 377.34
3. Raw materials stock (closing) 39.76
4. Raw Materials consumed (1+2–3) 371.47
5. Personnel Expenses 45.32
6. Other manufacturing Expenses 132.03
7. Depreciation 11.92
8. Total cost (4+5+6+7) 560.74
9. Work-in-progress inventory (opening) 55.56
10. Work-in-progress inventory (closing) 67.69
11. Cost of production (8+9–10) 548.61
12. Finished goods inventory (opening) 37.37
(including stores and spares)
68
 Determination of
13. Finished goods inventory (closing) 42.02 Working Capital
14. Cost of Goods sold (11+12–13) 543.96
15. Selling Expenses 8.71
16. Cost of Sales (14+15) 552.67

The following additional information is as given:

Particulars (Rs. in crores)

Accounts receivables (opening) 193.07
Accounts receivables (closing) 199.40
Accounts payable (opening) 127.72
Accounts payable (closing) 139.43
Sales (assumed to be credit sales) 715.73
Interest 51.58
PBT 26.80
PAT 25.30
Net Block 218.16
Using the above information compute operating cycle.
Hint: Use a 360-day year.
Ans: Q.6: Working capital required is Rs.44.00 lacs.
Ans: Q.7: Operating cycle = 107 days

3.9 FURTHER READINGS

1) V. K. Bhalla, 2003, Working capital Management; Anmol Publications,
New Delhi
2) Pandey, I. M. Eigth Edition 1999, Financial Management, Vikas
Publication house, New Delhi.
3) Weston, Fred J. & Brigham, E. F., 1978, Managerial Finance, Hinsade,
The Dryden Press.
4) Smith, Keith, V., 1977, Guide to Working Capital Management,
Mc.Graw Hill Book Co., New York.
5) Michael Firth, 1976, Management of Working Capital, The Macmillan
Press, London.
6) Gupta, L.C., ‘Banking and Working Capital Finance’, MacMillan, Delhi,
1978.
7) Chakrabarthy, S.K., & Others, ‘Topics in Accounting and Finance’,
Oxford University Press, Calcutta, 1976.

69
Concepts and
Determination

70
 Determination of
Working Capital

BLOCK 2
MANAGEMENT OF CURRENT ASSETS

71
Concepts and
Determination BLOCK 2 MANAGEMENT OF CURRENT
ASSETS
This block consists of four units dealing with all the important components of
working capital, viz., Receivables, cash, marketable securities and inventory.
Unit – 4 deals with the issue pertaining to receivables management. When
credit becomes pervasive, receivables management assumes significance. In
today’s business world of intense competition, every business unit is after the
consumer. Firms are now lead to a situation wherein, it is almost difficult to
sell without credit. The plight of automobile units and certain Fast Moving
Consumer Goods (FMCG) bears testimony to the indispensable need of
consumer credit. Keeping this in view, the present unit focuses on the need
for offering credit, designing credit policy, and setting diverse credit terms.
The unit also discusses the issues pertaining to the monitoring of the
receivables by looking into the size of receivables, collection periods and
through variance analyses.
Unit-5: Management of Cash, explains the role of cash in business
operations. This unit also focuses on the motives for holding cash,
determinants that affect and create uncertainity in the cash flows and various
techniques of cash forecasting. The discussion provides an understanding to
the student on major issues of cash management. Managing surplus cash is
considered an important activity by businesses now. Though cash is
considered the best productive asset, surplus cash is put to use to take
advantage of increases in prices of raw materials, services and if possible to
gain control over the operations of other business unit. This unit specially
highlights the significance of MIS in cash management. It is regarded that an
effective control of cash inflows and outflows presupposes an efficient
management information system.
Management of surplus cash is an intelligent activity by itself. How to invest
surplus cash is highlighted in unit-6. Through this unit, you will know the
merits and demerits of different securities, and the characteristics of money
and capital markets. A basic understanding of the financial markets is highly
essential for gaining more mileage out of investment of cash. In this context,
the optimisation models developed by Bierman, Baumol, Beronek, Miller-orr
and stone come very handy. Every corporate, cash manager has to have a
reasonable understanding of the implication of these models. Studying the
behaviour of cash flows is important, before devising a strategy. Each firm
should design its own strategy. These matters are discussed in this unit in
detail.
Issues relating to inventory management are discussed in unit-7 of this block.
This unit mainly highlights the motives for holding inventory by the
corporations. It is normally presumed that inventories are required due to
uncertainities on the supply of materials. But materials may also be
maintained owing to seasonality and inflation. Diverse costs associated with
holding inventory are analysed with illustrations. Techniques of inventory
management to optimise on the costs are outlined in this unit. More
specifically, the issues pertaining to quality discounts, buffer stocks and
uncertainities are examined in detail. The unit also discusses the utility of
selective inventory control techniques like ABC analysis FSN analysis and
VED analysis.
72
 Management of
UNIT 4 MANAGEMENT OF RECEIVABLES Receivables

Objectives
The objectives of this unit are to:
• Highlight the need for offering credit in the operation of business
enterprises.
• Discuss and design various elements of credit policy.
• Analyse the impact of changes in the terms of credit policy.
• Discuss different credit evaluation models in evaluating the credit
worthiness of customers.
• Discuss various techniques available in monitoring receivables in order
to speed up the collection process.
• Explain options available before the credit managers in dealing with
delinquent customers.
• Analyse the strategic importance of receivables management in designing
business strategies.

Structure
4.1 Introduction
4.2 Credit Policy
4.3 Credit Evaluation Models
4.4 Monitoring Receivables
4.5 Collecting Receivables
4.6 Strategic Issues in Receivables Management
4.7 Summary
4.8 Key Words
4.9 Self-Assessment Questions
4.10 Further Readings

4.1 INTRODUCTION
“Buy now, pay later” philosophy is increasingly gaining importance in the
way of living of the Indian Families. In other words, consumer credit has
become a major selling factor. When consumers expect credit, business
units in turn expect credit form their suppliers to match their investment in
credit extended to consumers. If you ask a practicing manager why
her/his firm offers credit for the purchases, the manager is likely to be
perplexed. The use of credit in the purchase of goods and services is so
common that it is taken for granted. The granting of credit from one
business firm to another, for purchase of goods and services popularly
known as trade credit, has been part of the business scene for several
years. Trade credit provided the major means of obtaining debt financing
73
Management of by businesses before the existence of banks. Though commercial banks
Current Assets
provide a significant part of requirements for working capital, trade credit
continues to be a major source of funds for firms and accounts receivables
that result from granting trade credit are major investment for the firm.
The importance of accounts receivables can be seen from Table 4 .1,
which presents investments in accounts receivables for different industries
over the years. This is expected to provide an idea of the size of investment
in receivables in the Indian Industry.

Going by the Data of the Bombay Stock Exchange (as on 07-04-2022), there
are companies having investment above Rs.10,000 crore in terms of volume.
They included companies like IRFC with total sundry debtors at Rs.1,65,569
crore, L&T with Rs.29,948 crore, TCS with Rs.25,222 crore, Infosys with
Rs.16,394 crore, NTPC with Rs.13,702 crore and IOC with Rs.13,398 crore.
The most striking fact of the trend is that there are 25 companies, whose
investment in Sundry Debtors exceeded 70 per cent of the total current assets.
These details are provided in the following Table-4.1.

Table-4.1: Select Indian Companies, whose Invest in Debtors is above 70

per cent

S. No. Name of the Company Amount (Rs. Per cent of

Crore) Current Assets
1. IRFC 165,569 99.7
2. L&T 29,948 81.9
3. TCS 25,222 88.9
4. PTC India 5836 93.3
5. NLC India 5611 73.4
6. Tech Mahindra 5153 83.1
7. Rajesh Exports 4563 81.6
8. Hind Constructions 4398 89.6
9. Indus Towers 3829 99.7
10. Kalpataru Power 3732 80.4
11. NHPC 3206 75.5
12. Bharti Airtel 3178 75.4
13. Reliance Infra 2848 95.5
14. NFL 2634 84.6
15. ITI 2552 77.5
16. HFCL 2528 80.8
17. NCC 2521 72.3
18. Glenmark 2489 76.2
19. ISGEC Heavy Engg. 2359 79.8
20. GE Power India 2213 84.0
21. Spicejet 2040 91.6
22. L&T Infotech 2021 83.4
74
 Management of
23. Rattan Power 1951 79.3 Receivables
24. GET & D India 1905 74.9
25. Sterlite Techno 1376 73.6
Source: Data of the Bombay Stock Exchange:
(https://moneycontrol.com/stocks/marketinfo/sdrs/bse/index.html)

Management of Current Assets

With the increasing popularity of credit card business in India and abroad, a
new dimension got added to the credit market. As per the Report of the
Research and Markets titled ‘Credit Card Market in India-2022; the total
value of credit and transactions is expected to reach INR 51.72 trillion by the
end of Financial Year 2026-27; registering a Compounded Annual Growth
Rate (CAGR) at 39.22 per cent during 2022-27. Banks are estimated to add
about 1.2 million new credit cards, every month. Though the volume of credit
generated through credit card mechanism is short-term, it has emerged one of
the great contributors in accelerating sales volumes.
The investment in accounts receivable is an important aspect which
requires careful management. Besides the cost of investment, there are
two types of risks which are associated with the accounts receivable
management. One is the risk of OPPORTUNITY LOSS and the other
LIQUIDITY risk. The firm has to extend credit to its customers to
generate enough sales. The grant of credit is an important tool to realize
the operating plans and budgets of the company. But at the same time
management has to see that the company has not extended too much of
credit to its customers which has resulted in high degree of liquidity risk.
By liquidity risk we mean the ability to collect back the amounts due from
the customers. This would happen if the company extends the credit to
customers whose financial position is doubtful or weak and subsequently
the funds tied up with them are recovered after a long period or they are
not at all realised. If this happens it would result in the companies’ ability
to meet its own obligations and thus affecting short term and long term
solvency of the company. The decision to extend the credit to its
customers also determines the timing and amount of cash flows accruing
to the company.

At the same time minimisation of liquidity risk would imply the risk of
opportunity loss. The opportunity loss here means loss of sales by refusing
the credits to its potential customers. This would further affect the loss of
revenue and the loss of profits. Thus the objective of accounts receivable
management is to arrive at an optimum balance of these two risks and
help the company to realize its operating plans. This balancing is not a
static but a dynamic one. To arrive at the balancing of these two risk, the
company would frequently require to adjust their credit standards, credit
terms and credit policies. Management of the company would also be
required to consider general economic conditions while making such
adjustments. Covid-19 has been one such example, where every activity
came to a grinding halt due to a series of lock downs imposed across the
country.
75
Management of While high investments in accounts receivable warrant efficient management,
Current Assets
significant differences between industries call for proper structuring of credit
policy that match the industry norms. These two are essential issues in
management of receivables. The receivables management system thus
involves the following:
• Terms of credit
• Assessing customers’ credit worthiness to grant credit
• Monitoring the level of accounts receivables and improving collection
efficiency.

Setting of terms of credit is first step, in the receivables management. It is a

corporate policy and thus has a close interrelationship with other corporate
policies. For example, if a company pursues a policy of market leadership,
then it requires aggressive credit policy to achieve maximum sales volume.
Terms of credit requires management to decide period of credit, a broad
guideline on the eligibility of credit, credit limit for different customers and
discount rate offered to customers who settles the bill within a predetermined
period. Credit policy is determined by trading off risk associated with
granting credit and additional revenue available from granting credit. The
credit policy once determined is fixed in the short-run and may warrant
periodic adjustment depending on the changes in environment and
corporate policies.
Determining creditworthiness of customers, first, requires a system to
collect basic information about the customers and then fit the data into a
Model that determines the suitability of the customer in granting credit and
other credit terms. Once credit is granted, the focus is shifted to collection
of dues in time. The efficiency of receivables management is measured by
comparing the extent to which collection flows are in line with credit
terms.

The objectives that drive the above issues of receivables management are:
1) Obtain maximum (optimum) volume of sales.
2) Maintain proper control over the quantum or amount of investment in
debtors.
3) Exercise control over the cost of credit and collections.

Activity 4.1
i) Why companies sell/provide goods/services on credit basis?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
76
ii) How does the decision on granting credits affect the finance of the Management of
Receivables
company?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
iii) Analyse the impact of Covid-19 on the investment in receivables.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

4.2 CREDIT POLICY

Designing credit policy is the first step in receivables management. In
designing credit policy, the management can follow two broad approaches.
Firstly, the policy can be designed under the assumption of unlimited
production/sales and funds available for investment in receivables. If credit
policy is designed under this assumption and subsequently some
constraints are experienced on sales or funds available for receivables,
then managers have to restrict the credit at the time of implementing the
credit policy. But this may cause certain difficulties to customers because
of deviation from the announced credit policy. For example, if a company
announces that credit will be unlimited to certain categories of customers
based on unlimited funds assumption and subsequently refuse to grant
credit due to limited funds available for investment in receivables, it will
create hardship to the customer. Under the second approach, the credit
policy could be designed keeping in mind the limitations on production/
sales volume and funds available for investment in receivables. This is aimed
to achieve optimum utilisation of production capacity and funds available
for receivables. It also ensures consistency of credit policy.

The credit policy consists of the following components:

• Credit Period
• Discount
• Credit Eligibility
• Credit Limit

a) Credit Period
Decision on credit period is determined by several factors. It is important
to check the credit period given by other firms in the industry. It would be
difficult to sustain by adopting a completely different credit policy as 77
Management of compared to that of industry. For example, if the industry practice is 30
Current Assets
days of credit period, a firm which offers 120 days credit would certainly
attract more business but the cost associated with managing longer credit
period also increases simultaneously. On the other hand, if the firm
reduces the credit period to 10 days, it would certainly reduce the cost of
carrying receivables but volume would also decline because many
customers would prefer other firms, which offer 30 days credit. In other
words, granting trade credit is an aspect of price.

The time that the buyer gets before payment is due, is one of the
dimensions of the product (like quality, service, etc.) which determine the
attractiveness of the product. Like other aspects of price, the firm’s terms
of credit affect its volume. All other things being equal, longer credit
period and more liberal credit-granting policies increase sales, while shorter
credit period and more stringent credit- granting policies decrease sales.
These policies also affect the level and timing of certain costs. Evaluation
of credit policy changes must compare with the changes in sales and
additional revenues generated by the sales as a result of this policy
change and costs effects. While additional volume and revenue associated
with such additional volume are clear and measurable, the cost effects
require further analysis.

Cost of Extending Credit Period

Lengthening credit period delays the cash inflows. For example, suppose a
firm increases the credit period from 30 days to 90 days. Customers, old
as well as new, will now pay at the end of 90 days and the cash inflows
from these sales would occur further into the future. That means, the firm
has to delay in settling its dues to others or resort to short-term borrowing if
the payments cannot be delayed. The interest cost of short-term borrowing
arises mainly on account of extending the credit period.

Example 4.1
Flysafe Travels is one of the large air-ticket sellers in the city. It offers
one- month credit for the air-tickets booked through the firm. Since it also
gets one- month credit from the air-lines, the payables and receivables are by
and large matched and there is no need of additional investment. The
present annual turnover of the firm is around Rs.40 crores. The firm is
now contemplating to increase the credit period from one-month to two-
months and this is expected to increase the volume by 40% and nearly
80% of the customers (old and new) are expected to avail the new credit
facility. The firm has just concluded a credit proposal with a nationalised
bank to meet payment liability at 15%. How much more it costs for
Flysafe Travels to meet the increased credit volume.

Revised Sales Rs. 40 cr. × 1.40 = Rs. 56.00 cr.

Customers, who are expected to use additional
credit period = 80%
Sales which are likely to be collected at the end of
78 second month = Rs. 56 × 0.80 = 44.80 cr.
Total Credit Period = 2 months Management of
Receivables
Less: Credit given by Air-line operators = 1 month
Funds required for additional credit period of 1 month
Interest cost per year = 15%
Additional interest cost to sustain 1 month credit = Rs. 44.80 × 15%
= Rs. 6.72 cr.

The cost of Rs. 6.72 cr. is compared with the additional profit generated
by the new sales to decide whether it is desirable to increase the credit
period or not.

Changes in credit period also affect the cost of carrying inventory. This
arises mainly on account of increased volume attracted by the extended
credit period, which in turn requires more inventory to support increased
volume. For example, if expected additional sales is Rs. 5 cr. and the
firm’s present operating cycle requires an inventory at 20% of its sales
value, the additional inventory requirement is Rs. 1 cr. Again, inventory
is a idle investment and consumes cost in the form of cost of storage and
cost of carrying inventory. If the two costs together amount to 17%, the
changes in credit policy has caused an additional cost of Rs. 17 lakhs.
Another cost associated with extending credit term and increase in sales
volume on account of extended credit term is discount and bad debts
expenses. Increase in credit sales and period would prompt firms to
announce attractive discount policy for prompt payment. Similarly, bad
debts will also go up due to increased volume of credit sales.

The cost of collection also goes up when the credit period is increased
and more credit volume is done. The cost of collection includes cost of
maintaining records of credit sales, telephone calls, letters, personal visits
to customers, etc. These costs tend to show an uptrend with increased
volume and credit sales.

Example 4.2
Suppose the cost of collection for the Flysafe Travels is 1% and bad
debts are likely to increase from 0.50% to 0.75% due to increased credit
period. These costs are to be added along with interest cost on additional
investments in receivables arising out of changes in credit period. These two
costs are computed as follows:

Cost of Collection

Case Sales (Rs.) Cost of Collection (Rs.)

Present 56.00 cr. 0.56 cr.
Previous 40.00 cr. 0.40 cr.
Difference 16.00 cr. 0.16 cr.

79
Management of Cost of Bad Debts
Current Assets
If we follow the methodology adopted earlier in computing cost of
collection, then the additional bad debts works out to Rs. 0.22 cr. (i.e.,
0.75% of Rs. 56 cr. less 0.50% of Rs. 40 cr.). However, the entire value
of additional bad debts is not on account of change in credit period. A
part of it is on account of increase in sales. The actual impact of increase
in bad debts can be computed in two stages as follows:

Increased cost of bad debts for existing sales of Rs. 40 cr.

Bad debts as per revised percentage of bad debts, 0.75% of
Rs. 40 cr. = 0.30 cr.

Bad debts as per earlier percentage of bad debts, 0.50% of

Rs. 40 cr. = 0.20 cr.

Increased value of bad debts attributable to new credit policy

= 0.10 cr.
Increased cost of bad debts for additional sales of Rs. 16 cr.
Bad debts as per revised percentage of bad debts, 0.75% of
Rs. 16 cr. = 0.12 cr.
Bad debts as per existing percentage of bad debts, 0.50% of
Rs. 16 cr. = 0.08 cr.
Increased value of bad debts attributable to new credit policy = 0.04 cr.

Total value of bad debts attributable to new credit policy (0.10+0.04) =

Rs. 0.14 cr.
The balance of Rs. 0.08 cr. is on account of increase in sales.

b) Discount
When a firm pursues aggressive credit policy, it affects cash flows in the
form of delayed collection and bad debts. Discounts are offered to the
customers, who purchased the goods on credit, as an incentive to give up
the credit period and pay much earlier. For example, suppose the terms of
credit is “3/10 net 60”. It means if the customer, who gets 60 days credit
period can pay within 10 days from the date of purchase and get a
discount of 3% on the value of order.

Since the customer uses the opportunity cost of funds and availability of cash
in taking decision, the cash discount should be set attractive. The discount
quantum should be greater than interest rate of short-term borrowings.

Example 4.3
Excel Industries is presently offering a credit period of 60 days to some of
their customers. It now intends to introduce a discount policy of “3/10 net
60”. We will now see how a customer would evaluate the discount policy
here. If a customer bought goods worth of Rs. 1 lakh, the amount due at
80 the end of 60 days is Rs. 1 lakh and if he pays within 10 days, it costs Rs.
97,000. The customer evaluates the interest cost of Rs.97,000 for 50 days Management of
Receivables
to take a decision on availing the discount and advancing the payment.
Suppose the interest cost is 15%, then cost of interest for 50 days on
Rs.97,000 is Rs. 97,000 × 0.15 × (50/365), which works out to Rs.
1,993.15. Since the discount value is greater than the cost, it is profitable
for the customer to pay the money earlier within 10 days and avail the
discount. In other words, if the customer borrows money for 50 days at
15% interest cost in the short-term market or bank and uses the money to
settle the account within 10 days, the loan amount due at the end of two
months is Rs.98,993.15, which is lower than Rs. 1,00,000 due at the end
of the period in the normal course. If the cost of borrowing is 24%, the
customer would take a different decision. The interest cost of borrowing for
50 days in this case is Rs.3189, which is greater than the discount benefit.
Of course, the customer will look into the availability of funds and other
options available to the firm before deciding whether to accept the offer or
not.

How do we evaluate the discount terms of the company? Cost of funds is an

important factor but it is not the only factor in evaluating the discount
term. For instance, if the cost of borrowing is 15% of this firm also, then
the discount value of Rs. 3000 is to be compared to the interest cost of
Rs.97000 at 15% for 50 days, which works out to Rs.1993.15. In other
words, if the company is in a position to raise a loan of Rs. 97,000 for 50
days at 15% cost, there is no need to raise Rs. 97000 in the form of
offering discount to the customers, where the cost of offering discount
works out to Rs. 3000. But, there are other issues in deciding the discount
policy. Cash discount reduces the probabilities of delayed collection as well
as bad debts. In the above example, we have assumed that the customer,
who has not availed the discount, promptly pays up the dues at the end of
50 days. The interest cost of Rs.1993.15 will undergo a change if the
customer fails to pay at the end of 50 days. Further, the value of bad
debts will go up if more credit sales are made and period of credit
increases.

Example 4.4
Royal Textiles is contemplating to increase the credit period from 30 days
to 60 days. This is expected to increase the sales from Rs. 20 cr. to Rs.
23 cr. but the bad debts is also expected to go up from 0.5% on sales to
1% on sales. Marketing Director felt that by giving 3% discount for
payment within 10 days would prompt several customers to avail the
facility and thus would bring back the bad debts value to 0.5% on sales.
The interest cost of short-term borrowing is 15% and nearly 40% worth of
sales are expected to be collected at the end of 10 days. Is it desirable to
introduce the discount policy?
As far as interest cost component is concerned, our earlier working on Excel
Industries shows the interest cost of 15% is higher than the discount value
of 3%. We will work out the interest cost and discount value again. The
40% sales, which is expected to be collected at the end of 10 days works
out to Rs. 9.20 cr. (23 × 0.4). The discount to be given on this value at
81
Management of 3% is Rs.0.276 cr. or Rs. 27,60,000 (i.e. 9.2 × 0.03). The net collection is
Current Assets
Rs. 8.924 cr. (i.e. 9.2 - 0.276). If the company is in a position to borrow
this money at 15%, the interest cost for 50 days would be Rs. 18,33,700
(i.e. 8.924 × .15 × (50/365). Since the discount value is greater than cost
of borrowing, 3% discount is not economical if interest cost alone is
considered. However, it is not correct to ignore the impact of discount
policy on bad debts.

The discount policy will bring down the value of bad debts from 1% to
0.50%. The savings in terms of values is Rs. 11,50,000 i.e. 23,00,00,000 ×
(1% – 0.50%). If this saving is deducted from the discount value of Rs.
27,60,000, the net discount cost is Rs. 16,10,000. When the net discount
cost of Rs. 16,10,000 is compared with the interest cost of Rs. 18,33,700,
then offering 3% discount for payment within 10 days is economical.
(However, before implementing this new credit policy, the overall impact
of the policy on profit is to be assessed and this will be discussed later).

The above analysis also highlights the factors that are involved in
evaluating the discount policy. The discount policy is judged on the basis
of discount percent (3%), discount period (10 days), percentage of
customers expected to avail the discount term (40%), and interest cost
(15%). For example, if 80% of the customers are likely to avail this
facility, then the discount value and interest cost will double to Rs.
55,20,000 and Rs. 36,67,400 respectively. If there is no change in
reduction of bad debts value, then the cost (Rs.55.20 – 11.50 lakhs)
exceeds benefit (Rs.36.674 lakhs) and thus, the discount policy is
uneconomical. To make the policy economical, the company has to reduce
the discount rate from 3% to lower level, which will cut down the discount
cost as well as percentage of customers using the discount offer.

Example 4.5: Cost-Benefit Analysis

American Pharma is a multinational pharmaceutical company selling certain
premium tablets in the domestic market for the last three years. The
company has not offered any credit on sales and the annual turnover for
the year was Rs. 10 cr. Due to increased competition, the company is now
evaluating new credit policy, which it intends to introduce. As per the
policy, the company will offer 30 days credit and a discount of 2% if the
amount is paid within a day (i.e., 2/1 net 30). Without this new credit
policy, the sales are expected to increase to Rs. 12 crore and with the new
policy, the sales will be Rs. 15 cr. It is estimated that 40% of the
customers would avail the discount. The contribution margin for its sales is
30% and the company is operating above break-even point. The new
credit policy will cause additional costs in terms of collection charges at
1% and bad debts at 0.5%. The interest cost is 16%. Evaluate the credit
policy and its implication on profit.

Increase in sales on account of credit policy (Rs.15 cr. less Rs. 12 cr.): Rs.
3.00 cr.

82
 Management of
Contribution from increased sales (30% on : Rs. 0.90 cr. Receivables
cr.) Rs. 3
Cost associated with credit policy
1. Collection charges @ 1% on Rs. 15 cr. Rs. 0.150 cr.
2. Bad debts at 0.5% on Rs. 15 cr. Rs. 0.075 cr.
3. Discount at 2% on 40% of Rs. 15 cr. Rs. 0.120 cr.
4. Interest cost on receivables @ 16%
Sales not likely to take discount: Rs. 9 cr.
Investments on 30 days receivable
Rs. 9 cr. x (30/365) = Rs. 0.74 cr.
Interest on Rs. 0.74 cr. at 16% Rs. 0.118 cr. Rs. 0.463 cr.
Net benefit before tax Rs. 0.437 cr.

c) Credit Eligibility
Having designed credit period and discount rate, the next logical step is to
define the customers, who are eligible for the credit terms. The credit-
granting decision is critical for the seller since credit-granting has
economic value to buyers and buyers decision on purchase is directly
affected by this policy. For instance, if the credit eligibility terms reject a
particular customer and requires the customer to make cash purchase, the
customer may not buy the product from the company and may look
forward to someone who is agreeable to grant credit. Nevertheless, it may
not be desirable to grant credit to all customers. It may instead analyse
each potential buyer before deciding whether to grant credit or not based
on the attributes of that particular buyer. While the earlier two terms of
credit policy viz. credit period and discount rate are not changed frequently
in order to maintain consistency in the policy, credit eligibility is
periodically reviewed. For instance, an entry of new customer would
warrant a review of credit eligibility of existing customers.

The decision whether a particular customer is eligible for credit terms

generally involves a detailed analysis of some of the attributes of the
customer. Credit analysts normally group the attributes in order to assess
the credit worthiness of customers. One traditional way of organising the
information is by characterising the applicant along five dimensions namely,
Capital, Character, Collateral, Capacity and Conditions. These five
dimensions are also popularly called Five Cs of credit analysis.
Capital: The term capital here refers to financial position of the applicant
firm. It requires an analysis of financial strength and weakness of the firm
in relation to other firms in the industry to assess the credit worthiness of
the firm. Financial information is normally derived from the financial
statements of the firm and analysed through ratio analysis. The liquidity
ratios like current ratio, debt- service coverage ratio, etc. are often used to
get a preliminary idea on the financial strength of the firm. Further
analysis includes trend analysis and comparison with the other industry
norm or other firms in the industry.
83
Management of Character: A prospective customer may have high liquidity but delay
Current Assets
payment to their suppliers. The character thus relates to willingness to pay
the debts.

Some relevant questions relating to character are:

• What is the applicant’s history of payments to the trade?
• Has the firm defaulted to other trade suppliers?
• Does the applicant’s management make a good-faith effort to honour
debts as they become due?

Information on these areas are useful to assess the applicant’s character.

Collateral: If a debt is supported by collateral, then the debt enjoys lower
risk because in the event of default, the debt holder can liquidate the
collateral to recover the dues. The collateral causes hardship to other
debt holders. Thus, the analysts should look into both the availability of
collateral for the debt and the amount of collateral the firm has given to
others. In computing the liquidity of the firm, the analysts should remove
the assets used for collateral and take into account only the free assets.
The credit worthiness improves if the customer is willing to offer
collateral assets or the value of collateral asset backed loan is low.
Capacity: The capacity has two dimension - management’s capacity to
run the business and applicant firm’s plant capacity. The future of the firm
depends on the management’s ability to meet the challenges. Similarly, the
facility should exist to exploit the opportunity. Since the assessment of
capacity is a judgement on the part of analysts, a lot of care should be
taken in assessing this feature.

Conditions: These are the economic conditions in the applicant’s industry

and in the economy in general. Scope for failure and default is high when
the industry and economy are in contraction phase. Credit policy is
required to be modified when the conditions are not favourable. The policy
changes include liberal discount for payment within a stipulated period and
imposing lower credit limit.
Management of Current Assets
The information collected under five Cs can be analysed in general to decide
whether the customer is eligible for credit or fit into a statistical model to
get an unbiased credit rating of the customer. Discussion on credit
evaluation model is presented in the next section.
d) Credit Limit
If a customer falls within the desired limit of credit worthiness, the next
issue is fixing the credit amount. This is something similar to banks fixing
overdraft limit for the account holders. If a customer is new, normally the
credit limit is fixed at the lowest level initially and expanded over the
period based on the performance of the customer in meeting the liability.
Credit limit may undergo a change depending on the changes in the credit
worthiness of the customer and changes in the performance of customer’s
84 industry.
 Management of
Example 4.6
Receivables
Alpha Electronics is presently grouping its customers into three categories.
It offers unlimited credit to first group, a maximum credit of Rs. 1 cr. to
second group and Rs. 5 lakhs for third group. It is presently doing a
turnover of Rs. 50 cr. at 60% production capacity. One of the proposals
received to increase the capacity utilisation during the annual review
meeting is increasing the credit limit for second and third groups of
customers. Instead of relaxing credit limit to all groups, the Marketing
Chief felt it is desirable to upgrade some of the customers based on their
past performance by relaxing the review procedure. The Marketing Chief
felt this will also give a right signal to their customers. After completing
the upgrading exercise, the marketing manager projected that the sales will
go up by another Rs. 10 cr. Based on the average collection period of 40
days, the Finance Manager estimated the revised investments in
receivables at Rs. 6.58 cr. against the earlier figure of Rs. 5.48 cr. The
interest cost on short-term borrowing is 14%. No major change is
expected in collection and bad debts values on account of this regrouping.
The firm presently has a contribution margin of 20% and operating above
break-even level.
The additional contribution on account of increase in sales works out to
Rs. 2 cr. (20% of Rs. 10 cr.). The investment in receivables has gone up
by Rs. 1.10 cr. and it costs additional interest burden of Rs. 0.154 cr. per
year. Since additional contribution of Rs. 2 cr. is higher than the additional
cost of Rs. 0.154 cr., the revision is profitable to the firm.
There are several reasons for limiting the credit facility to the customers.
Some of the important reasons are:
• reduce the impact of deficiencies in credit-granting decision;
• reduce the scope for over buying by the customers;
• rationally allocate the limited funds available for investment in bills
receivable; and
• mitigate agency problem

The last reason, mitigating agency problem, requires further discussion.

Agency problem arises on account of conflict of interest between the
managers (agents) and equity shareholders (owners or principal). Agents will
always try to maximise their return even if it is at the cost of principal.
Two types of agency problems arise in credit-granting decision. Firstly,
managers may collude with some of the customers and grant credit even to
undesirable customers. Credit limit puts a cap on the potential loss.
Secondly, managers may hesitate to give credit to even creditworthy
customers when the performance of the managers is assessed on the basis
of collection efficiency. Recently, many public sector banks were criticised
for not granting fresh loan despite comfortable monetary position and
funds are simply used to buy government securities. The fear of default
and delay in collection would prevent in granting credit even to good
customers and thus, take away the opportunity to maximise the profit.
Credit limit would to some extent take away this fear of managers since
85
Management of default is restricted and thus would encourage them to accept credit
Current Assets
proposals. The situation will improve further if credit limits are built into
the system of performance evaluation and managers are not penalised as
long as they have restricted the credit.

Activity 4.2
i) What are the major components of credit policy?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
ii) List out important factors that are used in assessing credit worthiness.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
iii) How do you evaluate alternative credit policies? Identify the principles
to be used in evaluating credit policies.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………

4.3 CREDIT EVALUATION MODELS

In the previous section, how the credit analysts collect the information
required for processing credit application under five C’s was discussed.
Credit evaluation models are useful for the analysts to process the
information to decide credit worthiness of the customer. It is possible to
structure credit evaluation model in different ways. An experienced credit
analyst can evaluate the credit worthiness by simply scanning the
information received or collected for the credit proposal. When the credit
transactions increase or number of customer increases, it may be difficult
to apply this methodology.

It will also cause delay in processing credit proposals and lead to

inconsistent decision. Thus, it is always useful to create a credit evaluation
system and standardise the appraisal. Decision-tree model and multivariate
statistical model are generally used to create credit evaluation system
86
Decision Tree Model: Under decision-tree model, credit applications are Management of
Receivables
rated under different parameters. For instance, if a company uses five C’s
factors, the analysts rate the credit applicant under each of the five Cs.
Decision-tree is initially created for all possible routes and decisions at the
end of each route are indicated. Figure 4.1 illustrates decision-tree model
using three credit information namely capital, character and collateral. If a
character, capital and collateral are strong, then the applicant firm is
granted large amount of credit.

Should
Credit
be
granted?

Character

Strong Weak

Capital
Capital

Strong Weak Strong

Weak
Collateral Collateral
Collateral

Collateral

Strong Strong/ Strong/

Strong
Weak Weak
Weak

Excellent Risk Fair Risk Fair Risk Dangerous

Risk

Large Credit Limited Limited to No Credit

Limit Credit Collateral Limit

Fig. 4.1: Decision Tree Credit Evaluation Model

On the other hand, if the first two are strong but the collateral is weak, a
limited credit could be granted.
If character is weak but capital and collateral are strong, then credit is
limited to collateral value. On the other hand, if all the three are weak, it
is a dangerous credit proposal and hence to be rejected. In Figure 4 .1, we
87
Management of have taken two broad ratings, which can be further divided into three or
Current Assets
five scale rating. Increasing the credit variable and rating scale will lead to
more branches and credit limit can be prescribed for each branch
separately.

It is also possible to use the above decision-tree to decide whether a

detailed credit evaluation has to be conducted. For example, if character,
capacity and conditions are good but capacity and collateral are weak, it
may require a detailed credit evaluation. That means, the information
collected is inadequate and a rigorous analysis is required.
Multivariate Statistical Model: Many firms have started using sophisticated
statistical techniques in conducting their credit analysis. Multiple
Discriminant Analysis (MDA) employs a series of variables to categorise
people or objects into two or more distinct groups. A credit scoring system
utilises multiple discriminant analysis to categorise potential credit
customers into two groups: good credit risk and bad credit risk. An
important advantage of credit scoring system is that all of the variables are
considered simultaneously, rather than individually as in the decision tree
analysis. The model is capable of handling both numerical measures such
as debt-equity ratio, current ratio, profit margin, etc., as well as non-
numerical measures like character of the customer as good, bad, average.
When a credit scoring model is constructed with historical data of a few
customers, the model would produce a equation as given below:
MDA Score Y = b1X1 + b2X2 + b3X3 + ……. + bnXn
where, b1, b2, b3, .... bn are co-efficient values of variables X1, X2, X3 … Xn.
X1, X2, etc. are variables such as debt-equity, current ratio, etc.

The model produces the coefficient values and when a new application is
received for credit scoring, the values of X’s are to be measured and
substituted in the model equation to get the discriminant score. The
discriminant is then compared with the point of separation to place the
applicant in one of the two groups. For example, if the point of separation
is 3.80, when the applicant’s score is above 3.80, then the applicant is
placed in fair or excellent risk group. If the score is below 3.80, then it is
risky proposal. Thus, it is possible to evaluate where a particular customer
stands in terms of credit worthiness. No difficulty is felt when the scores
are much above or below the separation point but credit worthiness of
customers, whose scores are close to separation point, are difficult to
assess. In such cases, further analysis is made to understand the credit
worthiness of the customers. It is also possible to outsource credit rating
evaluation from specialised credit rating agencies.

Credit scoring models are periodically updated to take into account changes
in the environment and also reassess the credit worthiness of the customers.
An outdated model may wrongly classify the customers and lead to heavy
losses. Further, while developing the system, it is necessary to ensure good
sample for developing the model. It is equally important that the model is
validated before employing it. Many foreign banks and credit card agencies
88
extensively use credit rating schemes and found them useful in taking credit Management of
Receivables
decision.

4.3.1 Rating Methodologies of Credit Rating Institutions

Credit rating has become one of the professionalised services in the recent
past. Though rating is more common with different securities offered by
industrial units, there is also focus on the rating of individuals and
institutions as credit applicants. For instance, CRISIL's rating methodology
includes the following key factors for deciding the credit worthiness of a
borrowing company.

A. Business Analysis
• Industry Risk (nature and basis of competition, key sucess factors,
demand supply position, structure of industry, cyclical/seasonal
factors. Goverment policies etc.)
• Market position of the company within the industry (market share,
competitive advantages, selling and distribution arrangements
product and customer diversity, etc.).
• Operating efficiency of the company (locational advantages, labour
relationships, cost structure, technological advantages and
manufacturing efficiency as compared to those of competitors
etc.)
• Legal position (terms of prospectus, trustees and their
responsiblities: systems for timely payment and for protection
against forgery/fraud; etc.)

B. Financial Analysis
• Accounting quality (overstatement/understatement of profits;
auditors qualifications; method of income recognition; inventory
valuation and depreciation policies; off balance sheet liabilities;
etc.)
• Earnings protection (sources of future earnings growth;
profitability ratios; earnings in relation to fixed income charges;
etc.)
• Adequacy of cash flows (in relation to debt and fixed working
capital needs; sustainability of cash flow; capital spending
flexibility; working capital management, etc.)
• Financial flexibility (alternative financing plans in times of stress;
ability to raise funds; asset redeployment potential; etc.)

C. Management Evaluation
• Track record of the management; planning and control systems;
depth of managerial talent; succession plans.
• Evaluation of capacity to overcome adverse situations
• Goals, philosophy and strategies
89
Management of The above factors are considered for companies with manufacturing
Current Assets
activities.The assessment of finance companies lays emphasis on the
following factors in addition to the financial analysis and management
evaluation as outlined above.

D. Regulatory and Competitive Environment

• Structure and regulatory framework of the financial system
• Trends in regulation/deregulation and their impact on the company.

E. Fundamental Analysis
• Capital Adequacy (assessment of true net worth of the company, its
adequacy in relation to the volume of business and the risk profile
of the assets.)

• Asset Quality (quality of the company's credit-risk management

systems for Monitoring credit; sector risk; exposure to individual
borrowers; management of problem credits; etc.)

• Liquidity Management (capital structure; term matching of assets

and liabilities; policy on liquid assets in relation to financing
commitments and maturing deposits.)
• Profitability and Financial Position (historic profits; spreads on
fund deployment; revenues on non-fund based services; accretion
to reserves; etc.)
• Interest and Tax Sensitivity (exposure to interest rate changes; tax
law changes and hedge against interest rate; etc.)

Individual Credit Rating: As indicated earlier, credit rating has become

more popular now, with financial instruments than individuals.
Nevertheless, there are now costing institutions like the Onida Individual
Credit Rating Agency (ONICRA), developing specific methodology to help
in rating individuals as consumers. The ONICRA model considers the
following three parameters as important:

I. Individual Considerations
i) Personal strengths - Qualification Occupation.
ii) Stability - Job Tenure
Duration of stay in personal
place of residence
iii) Capability - Income
Future Job Prospects
iv) Strengths - Financial aspects, Discipline
Willingness to pay
II. Transaction Considerations
i) Risk - Security
Ownership of the asset
Control over end use of the product
90
 Collateral Management of
Receivables
Exposure
ii) Modalities of payment - Direct deduction from salary
Advance post dated cheques
Automated debiting of bank account
Payment on due date
Payment on demand
III. Environmental Considerations- Economy

Activity 4.3
i) Why do we need models to evaluate credit proposals?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
ii) List down some of the important inputs required in evaluating credit
proposals.
……………………………………………………………………………
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……………………………………………………………………………
……………………………………………………………………………
iii) Briefly explain multivariate discriminant model of credit evaluation.
……………………………………………………………………………
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……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

4.4 MONITORING RECEIVABLES

Managing receivables does not end with granting of credit as dictated by
the credit policy. It is necessary to ensure that customers make payment
as per the credit terms and in the event of any deviation, corrective actions
are required. Thus, monitoring the payment behaviour of the customers
assumes importance. There are several possible reasons for customers to
deviate from the payment terms. Three of these possible reasons and their
implications in credit management are discussed below:
Changing Customer Business Characteristics: The customers, who
have earlier agreed to make payment within a certain period of time, may
deviate from their acceptance and delay the payment. For example,
economic slow down or slow d own in the industry of the customers
91
Management of business may force the customers to delay the payment. In fact, the bills
Current Assets
payable become discretionary cash outflow item in economic recession.
Thus, a close watch on the performance of customer’s industry is
required.

Inaccurate Policy Forecasts: A wide deviation from the credit terms and
actual flow of cash flows show inaccurate forecast and defective credit
policy. It is quiet possible that a firm uses defective credit rating model or
wrongly assesses the credit variable. For example, it is quiet possible to
overestimate the collateral value and then lend more credit. If this is the
reason for wide deviation, it requires updating the model or training the
employees.

Improper Policy Implementation: Often wide deviation is noticed in

practice while implementing credit policy. This may not be intentional but
frequently in the form of accommodating special requests of the
customers. For example, a customer may not be eligible for credit or higher
credit as per the model in force. The customer may personally see the
concerned manager and request her/him to relax the credit restriction. If
there is no policy in place to deal with these types of request and ad hoc
decisions are made, then wide deviation is possible. Often these deviations
become costly for the firm. Intervention of top officials and ad hoc
decisions are cited as major reasons for widespread defaults in many
public financial institutions. Thus, it is necessary to ensure that policies are
implemented in letter and spirit.
Monitoring provides signals of deviation from expectations. There are
several monitoring techniques available to the credit managers. The
monitoring system begins with aggregate analysis and then move down to
account-specific analysis.

Investments in Receivables: The decision to supply on credit basis leads to

investments in receivables. Credit policy is designed in such a way that
investment needs of receivables are optimized, i.e return is greater than cost
associated with investments. Credit monitoring starts with an assessment of
investment in receivables as a percentage of total assets. The investments in
receivables are then compared with the budget. Any deviation from
budgeted value shows delay in collection or managers deviating from the
credit policy. For example, if a firm based on credit policy worked out that
investments in receivables is 12%, the actual value for the last three
months is around 18%, there are two possible reasons. Firstly, some of
the customers are not paying and thus, the receivables value has gone up.
Secondly, the managers would be giving more credit than the prescribed
limit or extend the credit period. In either case, it requires an investigation
and explanation from managers for the increased investment in receivables.

Collection Period: Receivables can be related to sales in different ways. The

simplest form of analysis is comparing sales and receivables for different
periods to know the trend. While this analysis gives a reasonable
understanding on how the receivables have moved over the period, it fails
to give an implication of the changes in the trend. For example, if sales
92
and receivables of two periods are Rs. 90 lakhs, 120 lakhs and Rs.120 Management of
Receivables
lakhs, Rs.140 lakhs respectively, the figures show (i) the sales value has
gone up during the period, and (ii) receivables have also gone up along
with sales. A shaper focus on changes in the trend can be obtained by
computing the collection period of the two periods. The collection period is
computed as follows:
Accounts Receivable
Collection Period = –––––––––––––––––––
Credit Sales per day

Credit sales per day is computed by dividing the total credit sale of the
period by the number of days of the period. If the sales value given above
are related to quarterly sales value, then sales per day for the two quarters
are Rs. 1 lakh (Rs.90 lakhs/90 days) and Rs. 1.33 lakh (Rs.120 lakhs/90
days) respectively. The collection period for the two quarters are:
Period 1: 120/1 = 120 days

Period 2: 140/1.33 =105 days

The collection period shows a decline and thus improved performance,

which was not visible earlier in simple comparison. If the sales value for
the second period is Rs.100 lakhs instead of Rs.120 lakhs, then average
credit sales per day is Rs.1.11 lakh and collection period is 126 days. The
collection performance in this case has marginally come down.

If customers are granted different credit periods, then customers of similar

nature are to be grouped separately and then sales, receivables and collection
period relating to each group of customers are to be computed separately.
Otherwise, it will give a distorted figure. In addition to comparing
collection period of one period with other periods, they are also compared
with credit terms. Any abnormal deviation warrants customer-wise
analysis. That is, all these three values for two periods can be computed for
each customer to know the trends in collection period of different customers.
Such an analysis will help to narrow down the customers who take longer
time for paying the dues.

Ageing Schedule or Age Analysis: This is one of the age-old techniques

employed to analyse the trade receivables. The receivables are categorized
into diverse slots, based on the time frame, by which they are due. The
general assumption in case of receivables is that longer the time schedules,
the more likely is the default. The other way of looking at them is to make a
comparison of the credit period allowed and the time they are collected. This
gives the firm, a picture relating to the overdue accounts. Supposing, the
company permitted one month credit to X -customer. If he is not paying after
one month and paid only after three months, the company will face the
problem of liquidity. The financial plan of the company also goes disarray.
Therefore, one must be on a continuous watch as to the time periods allowed
and the time by which the debtors were able to be collected. Generally,
companies make three to four categories and put focus on them. Ageing
Analysis will also be useful in prompting legal action, if any, to be taken on
93
Management of the overdue accounts. The general format employed by companies for
Current Assets
making Ageing Analysis would be, like as follows:
Format for Ageing Schedule
(Rs.in Lakh)
Interval Quarter-1 Quarter-2 Quarter-3 Quarter-4
(Days)
0-30
31-60
61-90
91-120
Above 120

The above two measures namely, average collection period and ageing
schedule may give misleading picture when the sales are seasonal.
Suppose the average sales per month of a quarter is Rs. 10 lakhs. The sales
figures for the three months are Rs.10 lakhs, Rs.15 lakhs and Rs. 5 lakhs.
Suppose the collection pattern shows that 50 per cent of the sales is
collected in the same month, 25% in the following month and the
remaining 25% in the third month. If there is no outstanding receivables at
the beginning of the quarter, then the receivables values at the end of
each month are Rs. 5 lakhs, Rs.10 lakhs and Rs.12.5 lakhs. The average
collection period for the last month will be very high compared to other
months though there is no change in the payment pattern of the
customers. In order to overcome this problem, particularly in a seasonal
sales pattern, the following alternatives are suggested:
• Ratio of receivables outstanding to original sales, and
• Sales-weighted Collection Period.
Both the above measures require decomposing receivable outstanding at
the end of each month to trace the receivables with original sales. Such a
decomposition will be useful even for non-seasonal firms.
Decomposing Receivables Outstanding at the End of Month: Another
way to spot changes in customer behaviour is to decompose outstanding
receivables at the end of each month. This is achieved by preparing a
schedule of the percentage portions of each month’s sales that are still
outstanding at the end of successive months. An illustrative table is given
below:
Table 4 .2: Percentage of Receivables Outstanding at the end of month
Percentage outstanding after January February March
Current Month 94 98 96
1 month 70 80 78
2 months 21 28 32
3 months 6 9 12
4 months and above 1 1 2
94
The following example will help you to understand the figures in the above Management of
Receivables
Table 4.2. Suppose Rs. 40 lakhs is outstanding receivables at the end of
January, this consists of 94% of January’s sales, 70% of December's sales,
21% of November’s sales, 6% of October's sales and 1% of September's
sales. If the credit period is 30 days, the above analysis shows that a
significant part of the debtors takes more than one month in settling dues.
While a significant part of the customers settle down their dues by the end
of second month, outstanding beyond 2 months is also high and more
importantly growing. Receivables outstanding more than two months have
gone up from 21% to 32%. The growing trend in non-collection of dues
continues for other two months too. This clearly shows the customers have
slowed down in settling their dues and thus requires more careful analysis.
If this Table 4.2 is supplemented with the names of customers along with
their dues for the second, third and fourth months, it is helpful for follow
up and for taking appropriate action.
Sales-weighted Collection Period: In the above Table 4.2, percentages of
receivables outstanding to original sales are given. To compute sales-
weighted collection period, the values are to be summed up for each month
and then multiplied by 30. The sales-weighted collection period for
January, February and March are 57.60 days (1.92 × 30), 64.80 days (2.16
× 30) and 66 days (2.20 × 30) respectively. The general equation is:
n
Sales-weighted Collection Period = AR t St 30 days
t 0

Where, ARt is Accounts Receivables of the month ‘t’ and

St is Sales of the month ‘t’

A similar table prepared for each customer will be useful to evaluate the
behaviour of each customer in settling the dues. An analysis of this
behaviour for a year can be used to assign ranks to the customers and
such ranking can be used while taking credit policy or credit decision.
Instead of using outstanding receivables values, some organisations use the
payment values. However, both should lead to same conclusion.

CIBIL Scoring: Transunion Credit Information Bureau (India) Ltd., is

India’s first Credit Information Company; which prepared and maintained
reports on the credit worthiness of borrowers, who take loans from Banks and
Financial Institutions. The general focus of the company is on the rating of
individuals; yet, it also has started generating credit reports for the
companies, having credit exposure up to Rs.50 crore. The minimum CIBIL
score for business loan is generally 750. The score ranges from 300 to 900.
Anything above 750 is considered ideal to grant loan to a borrower. Any
borrower can get his/her score by paying the subscription to the Agency. Like
the CIBIL, there are many other credit bureaus that are extending this kind of
service. Such agencies include: Equifax, Experian, CRIF High Mark. Way
back in 2004 itself, the Reserve Bank of India issued a circular dated 17-06-
2004, advising all the Banks and Financial Institutions to submit credit
information in respect of all of their borrowers to CIBIL and get reports from
the agency and take appropriate follow-up action. As at present, every bank is
95
Management of following this mandate and considering the grant of loans only when the
Current Assets
score is in the minimum range.

Conversion Matrix: This is a simple technique, whereby credit sales of

each month are patterned as per their collection. This shows how the
credit sales of a month are collected in the subsequent months. This
reveals the laxity or otherwise of the collection department. Look at the
following conversion matrix to judge whether the collection pattern is
improving, stable or deteriorating.
Conversion Matrix
Month Credit Jan Feb Mar Apr May June July Aug Sept
Sales
(Rs.)
Jan 1,00,000 10,000 40,000 30,000 20,000

(10%) (40%) (30%) (20%)

Feb 80,000 11,000 28,000 32,000 9,000
(14%) (35%) (21%) (24%)
Mar 1,20,000 18,000 48,000 25,000 29,000
(15%) (40%) (21%) (24%)
Apr 1,60,000 19,500 72,500 38,000 30,000
(12%) (45%) (24%) (19%)
May 2,00,000 20,000 72,000 60,000 48,000
(10%) (36%) (30%) (24%)
June 1,60,000 14,500 56,000 49,000 40,500
(9%) (35%) (31%) (25%)
Total Collection 10,000 51,000 76,000 1,19,500 1,26,500 1,53,500 1,46,000 97,000 40,500

It may be observed from the above data that our Hypothetical company,
making a sale of Rs. 1 lakh could collect only 10% in the same month
and around 50% after two months. The above represents a case of
deteriorating collection efficiency.

Receivables Variance Analysis: Receivables budget can be prepared from

sales budget and credit policy. This information is any way required to
prepare cash budget. In receivables variance analysis, the actual reason for
actual value of receivables varying with budgeted value. Actual receivables
vary with that of budget for two reasons - the level of sales and ratio of
receivable outstanding. For example, if the budgeted sales for a month is
Rs. 20 lakhs and normally 80 per cent of the sales are outstanding at the
end of month, then receivables at the end of month as per the budget
should be Rs. 16 lakhs. If the actual receivables is Rs. 18 lakhs, it could
be due to increase in the actual sales from Rs. 20 lakhs to Rs. 22.50 lakhs
or alternatively increase in the percentage of credit sales from 80 to 90 or
combination of both. In order to compute the causes for variance, three
inputs are required: budgeted receivables, revised budgeted receivables
based on actual sales and actual receivables. The revised budgeted
receivables is computed based on actual sales and credit policy. In other
96 words, it is the budgeted receivables value for the actual sales. The
difference between the first two values (budgeted receivables and revised Management of
Receivables
budgeted receivables for actual sales) explains the part of receivable
variance arising out of changes in the sales. The difference between the
second and third values (revised budgeted receivables and actual
receivables) is on account of changes in the collection efficiency. The
difference between the first and last values is the total receivables
variance.

Other simple measures of receivables management are ratio of credit sales

to total sales, Number of credit proposals rejected to total credit proposals
received and bad debt loss index.

Activity 4.4
i) Why customers often fail to adhere the credit terms?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
ii) List down various indicators used in macro-analysis of receivables.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
3) Discuss the Crucial Issues with Credit Manager/Finance Manager of any
company and Prepare a Note.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
iv) How do you set right the seasonal variation in sales affecting some of
the indicators used in receivables analysis?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

97
Management of
Current Assets
4.5 COLLECTING RECEIVABLES
The analysis explained earlier are useful to know the trend of collection and
identify customers, who are not paying on due dates. This should enable
the management to take appropriate action to collect the dues, which is the
main objective of receivables management. Collecting receivables begins
with timely mailing of invoices. There are several procedures available to
credit managers, who must judiciously decide when, where and to what
extent pressure should be applied on delinquent customers. Management of
collection activity should be based on careful comparison of likely benefits
and costs.

Inexpensive procedures include periodical mailing of duplicate bills

reminding the customers that the account is not settled or sending a formal
letter informing non- payment of bill and requesting the customer to pay
immediately. Written follow-up on an overdue account is referred to as
dunning. If a customer fails to respond to these reminders, then expensive
procedures are initiated. Personal telephone calls and reminder through
registered post are initially tried. Even if these steps fail to deliver the
desired results, a personal visit by the credit manager or representative to sort
out the issue would be useful. If the credit manager realises that the
customer is willfully defaulting or is in deep trouble and hence unlikely to
pay the dues, a formal legal action is initiated either to recover the dues or
file a liquidation petition before the court to recover the dues. It is
difficult to prescribe exactly as to which and when these collection
procedures should be adopted. If collection policy is strict, then it would
reduce the outstanding receivables but at the same time frightened many
potential customers from doing business. On the other hand, a liberal
collection policy would invite many willful defaulters to do business with
the company.
The above discussion assumes that the firm takes the responsibility of
collection. Two alternatives are available to firms in collecting the
receivables. The first one called factoring enables the firm to transfer the
receivables to factoring agent, who takes the responsibility of collection.
Some factoring agents take the credit risk (i.e. the factoring agents bear
the loss on account of bad debts) and others accept factoring without
credit risk. In India, we have factoring subsidiaries of Canara Bank, SBI,
etc. and Exim Bank does the factoring service relating to export bills. The
second one is called receivables securitisation. Securitisation is somewhat
similar to factoring but here the securitising agent sells the units of
receivables to investors in the market. Though the concept of securitisation
is popular in finance related receivables like housing loans, credit cards
receivables, lease rentals, etc., the concept is slowly spreading to other
types of receivables. A few securitisation deals have already been
completed in India and the market will witness more such transactions in
the near future.

98
 Management of
4.6 STRATEGIC ISSUES IN RECEIVABLES Receivables
MANAGEMENT
Business management today involves continuous formulation of strategies
and also, to develop and carry out tactics to implement the strategies to gain
competitive advantage. The discussion on receivables management so far
focused on operational issues such as how changes in credit policy affects
investments in receivables, how to monitor collection pattern, what are the
options available in dealing with delinquent customers, etc. Receivables
management, however, can support the strategies being pursued by the
organisation to gain certain competitive strength.
Firms pursuing strategies to acquire cost leadership need a suitable credit
policy to support their strategies. For instance, if a firm is trying to achieve
cost leadership through economies of scale of production, then it has to
generate a large volume of sales. Since credit term is an economic variable
in buying decision, the credit terms should be supportive to sell large
volume. That means, the firm may have to offer more days of credit
particularly for those who buy in large quantity. Of course, the cost of
investment in receivables will go up initially but without a liberal credit
policy, the assets created to achieve economies of scale will be idle. In
fact, the additional cost of investments in receivables need to be considered
while computing the benefit arising out of economies of scale.

Firms pursuing strategies to acquire product differentiation have limited

customer base. In order to gain access to this segment, the firm may have
to pursue liberal credit term but once the brand acquired the desired value,
credit terms can be made tight. For instance, many established
multinational firms now require the dealers and distributors to deposit the
entire amount of the consignment before lifting the delivery. Similarly,
firms pursuing market penetration may have to work with low profit margin
or selling just above the variable cost. Liberal credit terms would add cost
and increase bad debts value. Firms may be reluctant to have liberal policy
at this stage unless it is essential to achieve penetration. Firms with a large
market share in a low growth industry would not invest additional capital
in receivables since the strategy is to harvest the benefit. In other words,
instead of allowing the market to decide the credit terms of the company,
it is possible for the firm to influence the market through credit policy.

Credit policy can also be used to change the product life cycle and
investment pattern. For instance, the life cycle of a product X is 10 years,
which is worked out on the basis of existing credit terms and volume of
turnover. Assume the total sales during the period is 2,50,000 units. The
volume achieved is initially low, then it increases to reach a peak at the
end of 4th year and then declines over the remaining 6 years. Based on
different capacity options, it is found that a capacity of 20,000 units for six-
year period is optimum and offers highest net present value. The firm now
found that by increasing the credit period, it can sell more units and thus
can go for a capacity of 30,000 units and achieve same NPV in four-year
period. The second option may be suitable on account of increased
99
Management of uncertainty on the product as the product moves into the latter part of the
Current Assets
life cycle and also getting economies of scale, which was not possible
with lower turnover in the first case. Shortening product life cycle has
certain advantages as well as disadvantages. The advantages are obvious.
It increases NPV and removes uncertainty. At the same time, it requires
more R&D to come out with a new and improved product and additional
investment much earlier than originally visualised. If competitors are able
to come out with better product version, the firm has to suffer higher loss
because of higher capacity. The firm has to develop various scenarios and
study their impact on the overall organizational goal.

Credit policy and its terms assume strategic importance if a firm is primarily
supplying its products or services to select firms. Suppose company R is
one of the ten customers of Company L. Company R is now going for
massive expansion and found it difficult to borrow to meet the normal
credit terms of Company R since the debt-capacity remaining is not
adequate. If Company L has reasonable borrowing capacity or internal
generation, it can extend the terms of credit. L&T had come out with a
major issue some years back to provide suppliers credit to Reliance
Industries for their expansion projects. Such kind of suppliers credit may
also be feasible when the interest cost of a domestic firm is much higher
than the interest cost of supplier firm located in a different country.

A firm dealing with a large number of customers may find it difficult to

manage the receivables within the existing organisational set up. If a few
other group companies also face similar problems, it may start a separate
subsidiary to manage the receivables of all group companies. Many
companies have started their subsidiary to manage share transfer jobs of
group companies. It is also equally possible to centralise the credit rating
service of the customers through subsidiaries. Instead of starting their own
subsidiaries, it is also possible to go in for factoring services and credit
rating agencies to outsource these services. Many foreign banks outsource
the services not directly related to their core activities in order to keep the
organisation lean. It is a way to convert many of the fixed costs into
variable costs. All these decisions have strategic implications and thus, it is
difficult to visualise the receivables management as a operational issues of
management in the modern business environment.

Activity 4.5
i) List down a few inexpensive and expensive methods of credit follow-
up.
……………………………………………………………………………
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……………………………………………………………………………
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100
ii) A firm in high-growth industry would like to build up more market Management of
Receivables
share.What type of credit policy is suitable to be consistent with this
strategy?
……………………………………………………………………………
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……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
iii) How credit policy affects investment decisions?
……………………………………………………………………………
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……………………………………………………………………………
……………………………………………………………………………

4.7 SUMMARY
The use of credit in the purchase of goods and services is so common that
it is taken for granted. Selling goods or providing services on credit basis
leading to accounts receivables. Though a lot of discussion is going on in
the Indian industry on how to cut down the investments in inventories
through concepts such as Just-in-Time (JIT), MRP, etc., investments in
receivables have gone up and firms are demanding more credit from banks
and specialised institutions to deal with receivables. The problem of
managing receivables has got aggravated due to uncertain business situations
arising of Covid-19 fall out. Managing in uncertain times has become the
order of the day. Since investment in receivables has a cost, managing
receivables assumes importance. Receivables management starts with
designing appropriate credit policy. Credit policy involves fixing credit
period, discount to be offered in the event of early payment, conditions to
be fulfilled to grant credit and fixing credit limit for different types of
customers. It is essential for the operating managers to strictly follow the
credit policy in evaluating credit proposals and granting credit. To evaluate
the credit proposal, it is necessary to know the credit worthiness of the
customers. Credit worthiness is assessed by collecting information about
the customers and then fitting the values into credit evaluation models.
There are number of credit evaluation models which range from simple
decision tree analysis to sophisticated multivariate statistical models. The
firm has to develop a suitable model, test the model with historical data to
validate the model and use it for credit evaluation. Models also need to be
periodically updated. Once the credit is granted, then it should be
monitored for collection. Different methodologies are available to get a
macro picture on collection efficiency. Micro analysis in the form of
individual customer analysis is done wherever there is a deviation from the
expectation. It is equally important in dealing with delinquent customers.
101
Management of There are several options, simple reminders to legal action, available before
Current Assets
the credit managers in dealing with such default accounts and appropriate
method is to be selected with an objective of benefit exceeding cost. The use
of credit policy and credit analysis is not restricted to the operational
managers in dealing with day-to-day activities of the firm. In the
competitive world, credit policy and analysis provide a lot of strategic
inputs. Credit policy of an organisation is in line with the desired strategy
that the organisation wants to pursue to gain certain competitive
advantages.

4.8 KEY WORDS

Terms of Credit: These refer to eligibility conditions and payment details
for granting credit by the company to a customer.
Creditworthiness: Capacity of the customer to meet payment obligations.
Credit Policy: Decision of the firm to grant or not to grant credit. It
consists of the components such as credit period, discount, credit eligibility
and credit limit.
Credit Period: Refers to the minimum and maximum time limits for
which credit is granted.
Credit limit: Is the limit upto which credit is granted
Decision Tree: Is a model indicating decision points and chance events
for taking a decision.
Credit Scoring System: A system which attempts to rank customers as
good, bad or average by a scoring mechanism.
Business Analysis: An examination of risk factors influencing business
prospects in terms of competition, demand and supply position, structure of
industry, cost structure, labour relations, etc.
Financial Analysis: An examination of financial performance and ability
of a business unit to generate income.
Fundamental Analysis: Refers to capital adequacy asset quality, liquidity
management and interest over tax sensitivity.
Collection Period: Indicates the time taken by the collection department in
collecting its book debts. A comparison of collection period with credit
period tells us whether the debts were collected within the stipulated time
or not.
Ageing Schedule: A method of classifying debts according to the number
of days the debt remained outstanding.
Conversion matrix: Sequencing of debts in the order of their collection.
Variance Analysis: A comparison of Budgeted figures with Actuals to
note down deviations.
CIBIL Score: CIBIL Score is a score which reflects the credit worthiness of
a borrower. This is the score calculated by Credit Information Bureau (India)
102 Ltd., a credit rating agency in India.
 Management of
4.9 SELF-ASSESSMENT QUESTIONS Receivables

1. Explain important components of Receivables Management System?

2. Why do we need a credit policy? How do you evaluate credit policy?
3. How do you assess the credit worthiness of customers?
4. Discuss a few important financial ratios and analysis used in managing
receivables.
5. Assume a customer, who used to pay the dues in time earlier, has
suddenly defaulted. A couple of reminders sent to him fail to get any
response. As a credit manager, you have two issues to decide. You have
to first decide whether to continue the supply to the customer on
credit basis. The second issue is how to deal with the customer to
recover the dues. In the normal course, you have to initiate legal
process to recover the dues but this may strain your firm’s relationship
with the customer. You can’t also be silent since the money involved
is quiet high and your firm is incurring interest cost on this credit. How
do you deal with this customer and decide the two issues?
6. Hindustan Automobiles is manufacturing heavy vehicles and presently
offering a credit period of 45 days. In order to increase the sales from
its current level of Rs. 400 crore., it is contemplating to increase the
credit period to 60 days. This is expected to bring additional sales of
Rs. 40 crore. There is no change in the collection and bad debts cost.
The company is likely to earn a contribution margin of 20%. The short-
term borrowing cost is 15%. Evaluate the new credit period and its
impact on profitability.
7. Regal Industries found that a very few debtors avail the discount,
which is “1.5/10 net 60”. The firm is presently borrowing at 15%.
Since finance for receivables is limited, it is turning down many credit
proposals and thus loose the opportunity to increase the sales. The firm
now wants to revise the discount policy and make it attractive to
motivate some of the existing customers to avail the discount. The funds
released could be used for accepting new customers. The additional
details available to you are: Contribution margin is 20%; Average
collection period is 60 days; Sales could be increased to any level.
With these additional details evaluate the proposed discount policy of
“4/10 net 60”. Compute the impact of new policy on profitability of the
firm.
8. The proposed credit policy of R.K. mills would cut down the bad
debts from 4% to 2%. It will also improve the collection period from
60 days to 30 days. The firms current sale of Rs. 80 lakhs will
decline by 20% on account of this new policy. If the contribution
margin cost of borrowing are 15% and 14% respectively, how the new
credit policy affect the profit of the firm.
9. Your firm is following a credit rating model developed internally to
assess the credit worthiness of customers. The cut-off score is 4.8
103
Management of points. Your analysis of historical behaviour of customers with
Current Assets
different points shows the customers, which score is between 4.80 to
5.00, are difficult to assess and nearly 60% of the overall default is
accounted by this group. You have a new customer, whose score as per
the credit rating model is 4.95. The customer wants goods worth of Rs. 5
crore for normal credit period of 60 days and the profit margin on this
sale is 20% without taking into account interest cost on receivables. Your
analysis shows that there is 60% chance that the customer pays the dues
in time, 30% chance for delay of another 60 days and 10% chance of
default. How do you assess the credit proposal?
10. Dynamic Chemicals offers a credit period of 30 days to its customers.
The budgeted sales for the period ending March, 2021 were Rs. 60 lakhs.
The company during the year has sold goods worth Rs. 72 lakhs. The
average receivables were Rs. 7 lakhs against the budgeted value of Rs. 5
lakhs. The interest cost for short-term borrowing during the period was
16%. Analyse the receivables variance and show how much the firm has
lost on the account of delayed collection.

4.10 FURTHER READINGS

Bond, Cecil J., Credit Management Handbook, Mc Graw Hill Inc. New York
Keith V. smith, Guide to Working Capital Management, Mc Graw Hill Inc.
New York.

104
 Management of
UNIT 5 MANAGEMENT OF CASH Cash

Objectives
The objectives of this unit are to:
• Highlight the role of cash in the operation of business.
• Explain different motives behind holding the cash.
• Discuss various determinants that affect and create uncertainty in the
cash flows.
• Stress the importance of cash forecasting and techniques of
forecasting.
• Discuss the importance of managing cash surplus and cash-in-transit.
• Explain the need for good management information system in cash
management.
Structure
5.1 Introduction
5.2 Motives of holding cash
5.3 Determinants of Cash Flows
5.4 Cash Forecasting
5.5 Managing Uncertainty In Cash Flow Forecast
5.6 Managing Surplus Cash
5.7 Electronic Funds Transfer and Anywhere Banking
5.8 MIS in Cash Management
5.9 Summary
5.10 Key Words
5.11 Self-Assessment Questions
5.12 Further Readings

5.1 INTRODUCTION
Cash is basic input to start a business unit. Cash is initially invested in
fixed assets like plant and machinery, which enable the firm to produce
products and generate cash by selling them. Cash is also required and
invested in working capital. Investments in working capital are required
because firms have to store certain quantity of raw materials and finished
goods and provide credit terms to the customers. The cash invested in raw
materials at the beginning of working capital cycle goes through several
stages (work-in-progress, finished goods and sundry debtors) and gets
released at the end of cycle to fund fresh investment needs of raw
materials. The firm needs additional cash during its life whenever it needs
to buy more fixed assets, increase the level of operations and any change
in working capital cycle such as extending credit period to the customers. In
105
Management of other words, the demand for cash is affected by several factors and some
Current Assets
of them are within the control of the managers and others are outside the
control of the managers. Cash management thus, in a broader sense is
managing the entire business.

In the context of working capital management, cash management refers to

optimising the benefits and costs associated with holding cash. As described
earlier, unless the cash is put into use, there is no benefit derived out just
by holding it. Further, holding cash without a purpose also costs firm either
directly in the form of interest or opportunity income that could be earned
out of the cash. At the same time, it is not possible to operate the business
without holding cash. Many of us take cash while going to office though
we have bought the tickets earlier and taking lunch with us or have a
credit facility to take lunch.

Though no major demand for cash is expected, we feel uncertain without

cash. Firms also feel uncertain without holding cash for various reasons.
For instance, any delay in collection will force the firm to delay the salary
to employees or payment to creditors or bankers which in turn affects
long-term relationship with them. Firms, which are experiencing volatile
price behaviour in some of the critical raw materials, would like to have
more cash to buy the material, whenever the price is low. There are
several other motives of holding cash and we will shortly discuss these
motives in detail.

The objective of cash management is to balance the cost associated with

holding cash and benefits derived out of holding the cash. The objective is
best achieved by speeding up the working capital cycle, particularly the
collection process and investing surplus cash in short-term assets in most
profitable avenues. The term ‘cash’ under cash management thus refers to
both cash and credit balance in the bank and short-term investments in
marketable securities. Table-5.1 shows the details of select companies that
are preferring to hold huge cash balances with them. There is a new trend
developed among the large companies that they are accumulating huge cash
balances with them and they wish to take advantage of the fluctuations in
market and to buy out the other small companies or invest in them to gain
strategic control.

Table -5.1: Cash Holdings of Select Companies as on 19-04-2022

(Rupees in Crores)
S. No. Name of the Company Cast at Bank % of Total
Liabilities
Balances
1. Shriram Transport 11,051 12.87
2. India Bulls Housing 11,245 19.20
3. JSW Steel 11,121 13.38
4. Wipro 9783 19.17
5. ACC 7247 52.04
6. Hindustan Aeron 7141 46.64
7. BPCL 6479 9.41
106
 Management of
8. PNB Housing Fin. 6906 10.13 Cash
9. Jindal Steel 5552 11.52
10. Reliance 5573 0.83
11. Power Grid Corporation 4430 2.63
12. HCL Tech. 2876 11.55
13. Bharat Electric 3016 46.34
14. Vedanta 2861 4.13
15. Adani Ports 3311 14.11
16. Divis Labs 2016 23.10
17. Whirlpool 2060 73.08
18. Rail Vikas 1416 19.20
19. REC 1140 0.82
20. Larsen 3094 4.47
Source: BSE Data Bank
(www.moneycontrol.com/stocks/marketinfo/cashbank/bse/index.html)

Thus, while structuring cash management policy, the firm has to consider
the internal business process and external environment. The important
issues relating to management of cash are:
• Understanding the motives behind holding the cash;
• Quantifying the cash needs of the firms to achieve the above motives;
and
• Developing a cash management model to enable operating managers
to take decisions on investing surplus cash and selling investment to
fund shortage.

Activity 5.1
i) How do you relate cash management in a broader s ense? What is its
focus in the context of working capital management?
……………………………………………………………………………
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……………………………………………………………………………
……………………………………………………………………………
ii) Why do we need to manage cash?
……………………………………………………………………………
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107
Management of iii) Collect the cash and marketable securities data of your company or any
Current Assets
one company you are familiar with from published accounts for the
last three t o five years. Examine the trend and its relationship with
level of operation.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

5.2 MOTIVES OF HOLDING CASH

Fixed assets are used to convert the raw materials into finished goods.
Investments in current assets cannot be avoided due to constraints in
technology, manufacturing process and customer’s behaviour of demanding
different models at a point close to her/his house and at the point of
consumption. Inventory and bills receivables have become essential to
continue business operations more fruitfully. Emphasis is always given to
reduce the investments in these assets and thus reduce the working capital
cycle. Investment in cash and marketable securities are the least
productive assets. Often, firm is not dependent on this asset in the
manufacturing process nor is required for creating inventory or selling.
Thus, the basic question is why firms hold cash and marketable securities?
Some of the reasons for holding cash are listed below.

Transaction Motive: Money is required to settle customers’ bills, pay

salary and wages to workers, pay duties and taxes, etc. Some cash balance
is to be maintained to complete these transactions. The amount to be
maintained for the transaction motive depends on the cash inflows and
outflows. Often, firms prepare a cash budget by incorporating the
estimates of inflows and outflows to know whether the cash balance
would be adequate to meet the transactions.

Precautionary or Hedging Motive: The transaction motive takes into

account the routine cash needs of the firm. It is also based on the
assumption that inflows are as per estimation. However, the future cash
needs for transaction purposes are uncertain. The uncertainty arises on
account of sudden increase in expenditure or delay in cash collection or
inability to source the materials and other supplies on credit basis. The firm
has to protect itself from such contingencies by holding additional cash.
This is called as precautionary motive of holding cash balance.
Precautionary cash balance is also maintained to meet the non-routine
needs. Generally, cash required for precautionary motive is held in the form
of short-term securities with the objective to earn atleast some positive
return. The securities are sold and cash is realised as and when such
emergency demand for cash arises. Companies will be able to gain benefit
out of these investments, if Money Market is dynamic.

108
Speculative Motive: If the firm intends to exploit the opportunities that Management of
Cash
may arise in the future suddenly, it has to keep some cash balance. The
term “speculative motive” to some extent is a misnomer since cash is not
kept to conduct any speculation but merely to exploit opportunity. This is
particularly relevant in commodity sector, where the prices of material
fluctuate widely in different periods and the firm's business success
depends on its ability to source the material at right time. Some of the
materials, whose prices show significant volatility, are cotton, aluminum,
steel, chemicals, etc. Surplus cash is also used for taking over of other
firms. Firms that intend to take advantage on the above counts keep large
cash balances with them, though the same are not required either for
transactions or as a precaution. Due to Covid-19 pandemic, supply chains
got disrupted badly and situation turned uncertain forcing firms to look into
this aspect also.
Managing uneven supply and demand for cash: Firms generally
experience some seasonality in sales, which leads to excess cash flows in
certain period of the year. This is not permanent surplus and cash is required
at different points of time. One possible solution to address this mismatch of
cash flows is to pay off bank loans whenever there is excess cash and
negotiate fresh loan to meet the subsequent demands. Since firms are exposed
to some amount of uncertainty in getting the loan proposal sanctioned in
time, the surplus cash is retained and invested in short-term securities.

In a competitive environment, firms also felt the desire of holding cash to

get flexibility in meeting competition. For instance, when a competitor
suddenly resorts to massive advertisement and other product promotion, it
forces other firms to increase advertisement cost or some other sales
promotion such as “free gift” for every purchase or lottery scheme, etc.

Activity 5.2
i) Can we consider investments in cash and marketable securities as
least productive?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
ii) Why companies maintain huge cash and marketable securities despite
they being least productive assets? List down a few industries, where
the demand for cash for speculative motive would be more.
……………………………………………………………………………
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……………………………………………………………………………
…………………………………………………………………………… 109
Management of iii) Draw out reasons as to why large companies in these days are trying to
Current Assets
hold huge cash balances with them?
……………………………………………………………………………
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……………………………………………………………………………
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5.3 DETERMINANTS OF CASH FLOWS

Investments in cash and marketable securities depend on the cash flow of
the firm. Firms, which primarily sell the product against cash (e.g.
petroleum products, gold, etc.) may not require much cash balance to be
maintained since there is always cash inflows to the firm. Banks and
insurance companies, which receive cash on regular intervals, can work
with smaller cash balance at branch level. On the other hand, firms in a
competitive industry which have to extend credit to the customers need to
maintain large amount of cash to meet different motives of holding cash.
Cash flows are also affected by several other factors, which can be
broadly classified into internal and external factors.

Internal Factors
Internal factors relate to policies of management relating to working capital
components and future growth plan. These factors are determined by the
firm and arising out of management decisions. The internal factors that
affect the cash flows of firms are discussed below.

Production-related policies: Production-related policies determine

production plan, which in turn affect, purchase of material and other
components and level of finished goods. For example, firms that follow
production policy of manufacturing for inventory and then selling the
product in the market will normally carry high volume of material and other
inventory in order to ensure smooth production process. The increase in
purchase activity will demand more cash compared to other firms, which
follow order-based production policy. Similarly, if production process is
automated, then the demand for cash to pay wages to workers will come
down significantly. Firms following JIT, MRP, FMS, etc., could reduce the
general level of inventory and they also favourably contribute to the
demand for cash.

Policies on Discretionary Expenses: Expenses not directly connected to the

manufacturing process, which have some amount of flexibility in timing the
expenditure are called discretionary expenses. Examples of discretionary
expenses are Research & Development cost, advertisement, replacement of
a machine before its life, etc. Some of the discretionary expenditure is
planned in advance whereas in other cases, the need arises suddenly. The
management policy on sanctioning discretionary expenses has a bearing on
the cash flow. If management follows a flexible policy and allows the
110
expenses after seeing the current cash position, the pressure on cash will Management of
Cash
come down significantly.

Policies on Receivables: The policies on trade receivable, which is last

stage of operating cycle, affect the cash flow. The credit period and cash
discount together determine the flow of cash. While liberal credit policy
delays cash flow, attractive discount policy speeds up the collection
process.

Financial Policies: Firms, which pursue active capital expenditure

programme in the form of new projects or expansion, need cash. While part
of resources is raised externally in the form of fresh debt or equity, the
balance is expected from the internal surplus. The financing policy of the
firm determines the cash flow. Internal funding is also expected to meet
any delay in raising external sources. These firms may require more cash to
meet such eventuality. Similarly, the dividend policy of the firm affects the
cash flow. Firms, which follow liberal dividend policy, will put pressure on
internal cash flows.

Payment Polices: The ability to get credit terms for purchases of materials
and other products and services also affects the cash flow. If the firm
maintains creditworthiness, it could always find it easy to source material
and other items on credit basis. On the other hand, if materials and other
items are to be bought on cash basis or only limited credit period is
available, the demand for cash increases.

External Factors
External factors can be broadly classified into monetary and fiscal factors
and industry-related factors. These are discussed below.

Monetary and Fiscal Factors: The central bank (Reserve Bank of India)
periodically spells out monetary policies and through which influences the
availability of money. The monetary policy in turn is affected by the fiscal
factors of the country. In a liberal monetary policy regime, it will not be
difficult to get credit from banks as well as from suppliers of material and
services. More so, the Government of India has set out an objective of
making India a USD 5 Trillion economy to be one of the Global Power
House by 2024-25. To attain this target, flow of credit to private and
public sectors is stepped up significantly. Further, Public-Private-
Partnership (PPP) has been considered the sine qua non of new economy.
Thus, the need for holding cash is thus limited to transaction motive. Cash
required for precautionary and speculative motives can be easily raised.
Unit-2 o f B l o c k 1 on 'Operating Environment of Working Capital'
contains more discussion on monetary policy issues.

Industry-related factors: Industry-related factors affect the cash flow in

the form of practices followed by other firms in the industry on terms of
sale and nature of material and services required. Cash flow will be
positive in retail industry. Cash flow will be cyclical for industries such as
plantation and agro- based products. Cash flow is volatile in certain
industries like entertainment and hospitality industry. Cash flow is generally
111
Management of negative for manufacturing industries. Depending on the nature of cash
Current Assets
flow relating to the industry, the demand for holding cash is determined.

Activity 5.3
i) Why do we need to analyse the cash flows to determine the balance
to be maintained in the form of cash and marketable securities?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
ii) List down the factors that affect the cash flows of the firm.
……………………………………………………………………………
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……………………………………………………………………………
iii) Name any three industries in which you expect a positive or negative
cash flow.
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……………………………………………………………………………

5.4 CASH FORECASTING

The discussion in the previous section shows various factors that affect
the cash inflows and outflows. An understanding of determinants of cash
inflows and outflows alone is not adequate in managing cash. It is
necessary to forecast cash flows using our understanding on the
determinants of cash flows of the firm. Cash forecasting is the core of
cash management. A firm, which is not forecasting the cash flows as a part
of managing the cash flows, will face unanticipated cash shortage. In order
to mitigate the unanticipated cash shortage, typically the firm will either
delay the payment process or resort to emergency borrowing. Delay in
payments to suppliers will affect the price or delay in supply, causing
increased cost or expensive production delays. Emergency borrowing will
also increase the cost of borrowings. A firm with surplus cash flow will
also find it difficult to manage the cash without a forecast. Since the
information on how long the surplus cash will remain is not known, there
is no way for the firm to effectively use the cash. If short-term surplus
112
cash is invested for long-term, it will create unanticipated cash shortage. Management of
Cash
Surplus cash lying within the firm will also encourage operating managers to
pile up the inventory and resort to many unproductive investments. Thus,
cash forecast is inevitable in managing the cash.

A major problem in forecasting of cash flows is that it cannot be done

independently. The determinants are many as seen in the previous section
and also highly inter-related with other budgets. Cash forecast/budget
integrates several other forecasts.
Types of Cash Forecast: The cash forecasts generated by the firms can
be broadly differentiated under two dimensions: the length of periods
included within the cash forecast and the approaches to cash flows used in
the cash forecast. Cash forecasts are normally prepared for one-year period
but the forecast is broken down to several smaller periods like, quarterly,
monthly or weekly cash forecasts. The choice of particular periodicity
depends on the volume of cash flows, nature of cash flows and the
desirability of the management. Firms broadly follow two approaches in
the preparation of cash forecast. Under the direct approach, firms forecast
various receipts and payments items for different periods and consolidate
the forecasts into cash budget. Under indirect approach, firms start with
forecast of earnings and then add back all non-cash expenses and deduct
all non-cash revenues, to get cash forecast. This is similar to preparation
of funds flow/cash flow statement, which is normally prepared using
historical accounting information as a part of financial statement analysis.
The format of monthly cash budget is illustrated in Table-5.2. It lists out
major cash inflow and outflow that arise in the normal operation of
business. The example also shows how the cash deficit and cash surplus
are dealt with to maintain the minimum balance.

Table 5.2: Monthly Cash Budget

Cash Flow Item January February March Total for the

Quarter
Beginning cash balance 60000 66078 61320 60000
Collection from 415488 373392 368280 1157160
sales/receivables
Total 475488 439470 429600 1217160
Disbursements
Suppliers 68648 60960 56957 186565
Payment of Salaries & Wages 49202.4 42150 44670 136022.4
Other Overhead Expenses 30160 28290 29130 87580
S & A Expenses 51400 48850 50130 150380
Total 199410 180250 180887 560547
Excess / -Inadequacy 276078 259220 248713 656613
Minimum Balance 60000 60000 60000 60000
Cash Available / -Needed (A) 216078 199220 188713 596613
Financing
113
Management of Borrowing/ -Repayments 0 0 0 0
Current Assets
Fresh Equity Issue 0 0 0 0
Sell/ -Acquire Investments -210000 30000 60000 -120000
Payment to Fixed Assets -230000 -230000
Receive/ -pay interest 2100 1800 3900
Dividend -250000 -250000
Total of Financing Plan (B) -210000 -197900 -188200 -596100
Closing Cash Balance (A - B) 66078 61320 60513 60513

Methods of Cash Flow Forecasting: The Table 5.2 gives the output as a
result of forecasting exercise. However, each item in the above Table
requires several computations and assumptions. While a few cash flow items
are independent, several others are dependent on many other variables.
Forecasting method depends on the nature of cash flows. Some of the
common methods of forecasting are explained below:
1. Independent Cash Flow Items: These cash flow items are independent
of other factors or predetermined. Lease rent for office building, property
tax, insurance premium, etc., are few items which are determined
independently.
2. Dependent Cash Flow Items: Many cash flow items are dependent
on other financial variables. For instance, cash collection from sundry
debtors depends on sales of the previous months, credit terms and
collection pattern. An understanding of the relationship between the cash
flow variables is important in forecasting the cash flows. If only one
variable is associated with cash flow items, then estimation is not
difficult. On the other hand, if several variables are associated with a
cash flow item, econometric models are used to get the value. For
instance, if customers take more than two months credit period to pay
the amount, it is possible to construct a multiple regression model to
measure the proportion of amount collected from various months’
sales. The model uses cash collection of the month as dependent
variable and previous months sales values as independent variables.
3. Growth in Cash Flow Items: As business grows, the cash flow items
also see a positive growth. Suppose the total sales grow at five percent
every quarter and credit (60 days) sales is eighty percent of the sales. If
forty percent of the customers pay at the end of two months in time,
another 40 percent pays at the end of three months and the balance
20 percent pays at the end of fourth month the amount collected from
the customers is also expected to show an uptrend due to growth in
sales.

The most usual approach to cash forecasting is the Receipts and

Payments methods as shown in Table-5.2. After the firm has determined
what types of receipts and payments are important in its overall cash
flow, an important question is how to forecast the future level of inflows
and outflows. There are four common techniques of forecasting these
114 items of receipt and payment.
a) Direct Method – In using this technique, it is assumed that the variable Management of
Cash
to be forecast is independent of all other variables, or alternatively, is
predetermined. The variables (e.g. lease rental) is forecast by using its
expected or predetermined level.
b) Proportion of Another Account – This technique is used to project
financial variables that are expected to vary directly with the level of
another variable. For example, if sales volume increases, it is natural that
more units will have to be produced to replenish inventory. It is then
reasonable to project certain direct costs of production, such as direct
materials, as a per cent of sales.
c) Compounded Growth – This method is used when a particular financial
variable is expected to grow at a steady growth rate over time. The
formula used is:
Yt = (1 + g) Y t-1

Where Yt-1 is the prior period’s level of Y and g is the growth rate.
d) Multiple Dependencies: Under this technique the variable is considered
to be influenced by more than one factor. The statistical technique of
linear regression is often employed with historical data to determine
which explanatory variables are significant in explaining the
dependent variable. We will see the application of regression technique
after a while.

Since cash forecasts deal mostly with the near future, many of the items on
the cash forecast are usually estimated by some variation of the spot method.
The bases of these spot estimates are usually the firm’s other financial plans.
The other two methods are employed less frequently.

It is a common experience that forecast of disbursements is much easier than

receipts, because the cash manager can rely on internal information and
knowledge of payment policy in order to determine what needs to be paid
and when. Besides, he has the knowledge of firm’s other plans (or budgets)
and can make use of the forecasting techniques described above. However, a
major challenge for him comes in estimating the receipts from the
collection of the firm’s receivables. In this regard, an useful forecasting
method is to analyse the historical payment patterns to determine the
proportion of credit sales that are collected at various times after the date of
sale, and then to use this information (along with the estimates of future sales)
to project future receipts.

We may, however, adopt a better and a more sophisticated approach. In this

all collection rates are estimated simultaneously by regressing past sales
figures against past collections. The estimated coefficients of the sales
figures in the regression can be interpreted as the collection proportions, and
the standard errors of the estimated regression coefficients as the uncertainty
inherent in the estimation of these collection proportions.

115
Management of Let us take an example. Suppose that a firm has regressed its monthly
Current Assets
collections for past months against the appropriate past monthly sales figures
and has obtained the following results:
Ct = 0.754 St – 1 + 0.241St – 2
(0.250) (0.087)
The figures in parentheses below the estimated collection rates are the
standard errors of these collection rates. In this equation, Ct is the collection
from receivable in period t, St – 1 is the sales in period t -1 (say, previous
month), and St – 2 is the sales in period t-2 (say, two months previously).
Assume also that these were the only statistically significant explanatory
variables (the variables like St – 3, St – 4, etc. and dummy variables to assess
seasonality, were not significant), and that the overall estimated equation was
highly significant. We may now interpret the regression results in the
following way. The estimated collection rates are 75.4 per cent (regression
coefficient on St–1) of the previous month’s sales and 24.1 per cent
(regression coefficient on St – 2) of the sales from two months previously. The
implied bad debt rate is 0.5 per cent, equal to one minus the sum of the
collection rates. The standard error figures are used to test the statistical
significance of the estimated regression coefficients.
Simulation Approach
Simulation analysis permits the financial manager to incorporate in his
forecasting both most likely value of ending cash balances (surplus/deficits)
for each of the forecast periods (say, for each month over the next quarter)
and the margin of error associated with this estimate. It involves the
following steps: First, probability distributions for each of the major
uncertain variables are developed. The variables would generally include
sales, selling price, proportion of cash and credit sales, collection rates,
production costs, and capital expenditures. Some of these variables have the
greatest influence upon cash balances. Clearly, more time and effort should
be spent in obtaining probability distributions of these variables. Second,
values aredrawn at random for the variables from their respective probability
distributions, and using these values each balances are estimated. Third, the
process is repeated several times (say, 100 times). Needless to say, such
tedious and cumbersome computations are done on computer. From the trial
results, information of the kind as shown in table-5.3 would be generated.

Table 5.3: Hypothetical Simulation Results

Month Average Cash Balance Standard Deviation

(Rs. in '000) (Rs. in '000)
April 3,104 334
May 1,258 375
June -1,221 353
July -1,104 402
August -363 403
September 591 421

116
How can the finance manager use the results of the simulation? The Management of
Cash
usefulness of the results as shown in Table-5.3 lies in the fact that summary
statistics (i.e. average cash balances and standard deviation) can be used to
determine upper/lower estimates of cash surplus or deficit for each month,
with a probability of say 95 per cent, that cash balance will remain within the
estimated range. Assuming that the distribution of month-ending cash
balances is normal, we can obtain the upper/lower estimates by applying the
following formula.
Upper/Lower Estimates
= Average Cash Balance + Z × Standard Deviation
where Z is the standard normal variate.
With the information of this type in hand, finance manager can now address
the formulation of appropriate investment and financing strategies. Let us
now proceed with some examples to illustrate the point.
Consider our hypothetical simulation results and assume that the costs of
having insufficient cash and the costs of hedges (i.e. financial arrangement to
fall back upon in case of shortage of cash) are such that the firm desires to
incur, at maximum, a 5 per cent chance of having insufficient cash to cover
expenses. What is the maximum amount for which the firm should secure a
line of credit? The maximum expected deficit is in the month of June, with a
mean of Rs. 12,21,000 and a standard deviation of Rs. 3,53,000. The Z
statistic for 95 per cent confidence interval is 1.645; and 1.645 times of Rs.
3,53,000 is Rs.5,80,685. The maximum amount that the firm should arrange
to borrow is Rs. 12,21,000 plus. Rs. 5,80,685 or Rs. 18,01,685. There is a 5
per cent chance that the actual borrowing needs in June will be greater than
this and a 95 per cent chance that the requirements will be less than this.
Let us now consider that the firm is contemplating how much of the estimated
surplus in September, to invest in a 60-day investment. How much can the
firm invest and have only 10 per cent chance of having to resell the
investment in September? Z statistic for 90 per cent confidence interval is
1.28 times of Rs. 4,21,000 is Rs.5,38,880; Rs. 5,91,000 less Rs. 5,38,880 is
Rs.52,120. There is 10 per cent chance that cash surplus in September will be
less than Rs. 52,120. So, the firm can invest the amount in the 60-days
investment and have a 10 per cent chance that they will have to liquidate the
investment prior to maturity.
The above examples are intended to illustrate the mechanics of manipulating
means, standard deviations, and probabilities of cash balances rather than to
present realistic hedging strategies. In practice, the array of possible hedging
strategies is quite a bit more complicated. One is required to consider various
alternatives and the associated costs and risk in hedging strategies.

Activity 5.4
i) How significant is cash forecasting to a firm?
……………………………………………………………………………
……………………………………………………………………………
117
Management of ……………………………………………………………………………
Current Assets
……………………………………………………………………………
……………………………………………………………………………
ii) Collect cash flow statement given in the annual report of a large listed
Company for the last five years. Comment on the trend in the component.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
iii) How does simulation approach help in cash forecasting?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

5.5 MANAGING UNCERTAINTY IN CASH

FLOW FORECAST
Cash flow forecast is crucial in cash management. Thus, the efficiency of
cash management is directly related to the ability to accurately forecast cash
flows. Unfortunately, two important cash flow variables namely sales and
collection carry a lot of uncertainty and thus affects the cash flow forecast.
It is also difficult to adjust the production and purchasing activity
immediately in reaction to the lower sales and there is always some time
lag between decline in sales and actual adjustment in manufacturing
activities. Sales and collection pattern are affected by several variables and
most of them are external factors such as competition from internal and
external market, seasonality, changes in consumers’ taste, recession in the
market, government policy, etc. Firms have little control on these variables.
Recognising and managing cash flow variation is thus another important
issue in cash management. There are several methods through which firms
recognise and manage the uncertainty associated with cash flow variation.

Sensitivity Analysis: The impact of changes in cash flow variables on cash

balance is examined through sensitivity analysis. The objective of the
analysis is to determine the most sensitive cash flow variables that will place
the cash management in a difficult position. This information is useful to
evaluate the possibility of cash flow variable affected to that extent, plan
to ensure that the cash flow variable is within the normal limit and prepare
a contingency plan.

118
Scenario Analysis: Here cash flows are forecasted under different Management of
Cash
assumptions and cash requirement under different scenarios are worked
out. Depending on the level of risk taking capability, firm selects a scenario
and uses it for cash management

Simulation Analysis: It is an extension of scenario analysis. In scenario

analysis, the user defines possible scenarios and the computer generates
the cash forecast. In simulation, the computer is allowed to generate various
scenarios based on random numbers. Since a large number of scenarios are
generated, it is possible to define the distribution of cash flow forecast and
uncertainty associated with the forecast. This is discussed in more detail in
the previous section.

Holding a Stock of Extra Cash or Near-Cash Asset: This is the simplest

solution to manage the uncertainty associated with the forecasting of cash
flow. This is relied upon when the level of uncertainty is high.
Extra Borrowing Capacity: If the uncertainty analysis model helps to
figure out the period in which the firm is likely to face serious problem of
cash management, then it is worth to negotiate with bankers or other
financing agencies well in advance for additional temporary credit. It is
possible to have a standby arrangement with the bank or financial
intermediaries.

Using Interest-Rate Derivatives: If uncertainty in cash flows is on

account of expected changes in the interest rate affecting the interest income
or interest payments, the interest-rate derivatives such as interest rates
futures and interest rate options are useful to manage this part of risk.

Activity 5.5
i) Why the actual cash flows show significant variation from the
forecast?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
ii) How do you recognise and measure the uncertainty associated with
cash flows?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
119
Management of iii) List down important techniques in managing the uncertain cash flows?
Current Assets
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

5.6 MANAGING SURPLUS CASH

Profit making firms have to generate surplus cash at the end of operating
cycle since the cash collected from debtors is greater than cash invested
initially. However, in reality, many profit making firms see the pressure of
negative flow of cash. There are several reasons for this situation. The
mismatch of inflows and outflows and diversion of short-term funds for
long-term needs are two major reasons for this condition. Though it is not
desirable to divert the short-term funds for long-term needs, often firms
resort to this diversion if there is some delay in getting long-term funds.
The situation is set right once the firm r eceives the long-term funds. In
other words, profit-making firms periodically generate cash surplus even
though they face pressure on cash flows in other times. The issue is how
to deal with such surplus cash. Excess cash balance is the least productive
asset of the firm and thus should be minimised. But corporate firms are
now thinking differently. They are feeling that ‘more cash means more
opportunity’ in times of uncertainty.

Firms normally resort to investing short-term surplus cash in short-term

liquid securities to earn some return. The firm has to decide on two issues at
this juncture. First, it should decide on investment avenues and products.
The amount to be invested is the next important decision.
The investment product is typically short-term, highly liquid government
securities. The Indian money market is not fully developed and generally
restricted to banks and other institutional investors. The investment widely
used by the Indian corporate sector to place short-term capital in Unit-64
scheme of Unit Trust of India. Earlier, investment in Unit-64 enjoyed
certain tax benefit also for the corporate sector. Since many private sector
mutual funds have floated open- ended debt-based schemes, the demand
for this source of investment has increased in recent times. Certificate of
deposits, commercial paper and inter- corporate deposits are other popular
schemes in which short-term funds are placed. After liberalisation of the
economy, money and capital markets have become active and the volume
and variety in the instruments traded has increased. The advent of money
market mutual funds has broaden the scope for surplus cash investment.
Yet, the short-term market has turned more volatile and complex these days.
Variety in the money market instruments also made this market more clumsy
and the ‘assured return’ phase has gone into oblivion.

120
The amount to be invested depends on transaction cost associated with Management of
Cash
investment and period for which the amount is available for investment.
Since the return on short-term securities is generally low, frequent
investment and divestment increases the transaction cost and thus affect
the overall return. Investment optimisation models like Baumol, Miller-Orr
and Stone are available to guide firms to decide on how much to be invested.
These models will be discussed in detail in the next unit.

5.7 ELECTRONIC FUNDS TRANSFER AND

ANYWHERE BANKING
The advent of banking technology and the spread of internet facilities has
changed the face of corporate cash management. The more towards
paperless economy reduces many of the difficulties in dealing with
cheques/drafts. It should be clear now that the time necessary for transmittal
of cash from one firm to another revolves largely around the passing
from one hand to another of a piece of paper, i , e., the cheque. If we can
eliminate this paper there will be a major saving in the time and cost.
The system of electronic remittances introduced by many foreign and
Indian banks has almost achieved the objective of cheque-less payment
mechanism. Added to this, the concept of 'Anywhere Banking' practiced
by many banks also is helping speedy flow of remittances. With these
developments, it should not be difficult for the firms to eliminate the 'Float.
Unfortunately, many corporates in India are not much in favour of the'
Electronic Funds Transfer System' mainly because of their habit of
delaying the payments. However, the RTGS/NEFT transfer mechanisms
have changed the entire face of cash management. Also because of changes
in the Negotiable Instruments Act, 1881 making cheque dishonor both a Civil
and Criminal liability, payment mechanisms are to be ensured properly and
effectively.
The collection process in the near future will be fully automatic, as far as
the banking operations are concerned.

Activity 5.6
i) What is the significance of Electronic Fund Transfer Systems?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
ii) What are different options available before the firm for improving the
collection efficiency?
……………………………………………………………………………
……………………………………………………………………………
121
Management of ……………………………………………………………………………
Current Assets
……………………………………………………………………………
……………………………………………………………………………
iii) Outline the impact of internet banking on corporate cash management,
by having an interaction with the Bank Branch Manager or Finance
Manager of a company.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

5.8 MIS IN CASH MANAGEMENT

The preparation of cash budget based on forecast of cash flows is only
the starting point of cash management. It is the planning part of cash
management. The forecast of cash flows and budget exercises help the
management to locate cash deficient and surplus periods. Managers decide
on dealing with the deficit and surplus, which is decision-making part of
cash management. The exercise is completed, if the control element is also
brought into the cash management system. The control element is required
since the operations of the business enterprise may often deviate from the
plan. It is very common that wide deviation arises between planned and
actual cash flows, which keeps the financial managers always under severe
pressure. Often, attention of the managers is drawn after the problem
developed to a full level. Thus, the crucial issue in cash management is
continuous information on actual cash flows and reporting of deviation.
Minor deviation can be tackled by postponing certain discretionary payments
or speedy collection of book debts by offering cash discounts. If the
deviation is expanding, it requires major corrections in the form of
negotiating fresh loan with bankers and improving the collection
mechanism. Such corrective actions are possible by developing a good
reporting system that highlights such deviations without loss of time.

The daily cash report is the best vehicle for obtaining a running comparison
between the forecast and actual cash flows. Daily cash reporting is useful
even if cash budget and forecast are not available on daily basis. It helps
the managers to understand the flow of cash on daily basis and a comparison
of cumulative figures with the budget indicates the target still to be
achieved to keep the budget in force. In addition, the reporting on daily
basis to top management forces the operating people to work efficiently.
This is very useful since accounting profit cannot be computed on daily
basis and available only at the end of quarter.

Meaningful analysis can be done by consolidating cash flows on daily basis

into two documents namely Cash Flow Budget-Actual Variance Analysis and
Cumulative Cash Flow Statement for the Year to Date. The formats for
the two reporting documents are given below.
122
 Management of
Table 5.4: Cash Flow Budget-Actual Variance Analysis from .... to …….
Cash

Cash Flow Item Budget Actual Variance Remarks

Beginning cash balance
Collection from
sales/receivables
Total
Disbursements
Suppliers
Payment of Salaries & Wages
Other Overhead expenses
S &A Expenses
Total
Excess / -Inadequacy
Minimum Balance
Cash Available/-Needed (A)
Financing
Borrowing/-Repayments
Fresh Equity Issue
Sell/ -Acquire Investments
Payment to Fixed Assets
Receive/ -pay interest
Dividend
Total of Financing Plan (B)
Closing Cash Balance (A - B)

Table 5.5: Cumulative Cash Flow Statement For the Year-to -Date

Budget for Performance till Target for the

Cash Flow Item the Year Date Remaining
Period
Collection from sales/receivables

Total
Disbursements
Suppliers
Payment of Salaries & Wages
Other Overhead expenses
S & A Expenses
Total
Excess / -Inadequacy
123
Management of Financing
Current Assets
Borrowing/ -Repayments
Fresh Equity Issue
Sell/ -Acquire Investments
Payment to Fixed Assets
Receive/ -pay interest
Dividend
Total of Financing Plan

A variety of cash reports designed for specific needs of individual companies

are in vogue for checking cash flows and ensuring constant availability of
adequate cash. For example, if the firm has only a few large customers, the
top management would like to have customer-wise cash collection
reporting to speed up the process of collection at the highest level. The
information collected from these statements is useful to fix responsible
centres for variance and initiate corrective steps, which are essential steps in
control exercise. The corrective steps include short-term efforts such as
speeding up the collections by chasing a few large customers and long-
term policy changes such as revising credit period or credit-granting
decision.

5.9 SUMMARY
Availability of cash is crucial for the operation of business. However, cash
is the least productive asset of the firm and thus managers take every
effort to minimise the cash holding. Despite the least productive nature of
the asset, firms hold large cash. There are several motives behind holding
cash. Cash is required to settle dues of the firm. Since cash inflows are
uncertain and outflows are certain, firms keep additional cash. Cash kept
for these two purposes are called transaction motive and precautionary
motive. Cash is also kept to overcome the mismatch of inflows and
outflows, cyclical behaviour of cash flow pattern and exploit short-term
opportunities, like rising prices and aquisition of control.
Cash flows are affected by internal factors such as operating and financial
policies and external factors such as monetary and fiscal policies and
practices of industry. An understanding on factors that affect the cash flows
is useful to forecast future cash flows, which is core aspect of cash
management. There are several methods of forecasting cash flows and
often different methods are employed to forecast individual cash flow
items. Cash forecasting is converted into cash budgets and cash budget is
broken into quarterly, monthly and weekly cash budgets. Budgets are
prepared to understand whether cash inflows and outflows match with each
other and if not, to know the period in which the mismatch arises. Managers
plan to deal with such mismatches by initiating action in advance.

124
Despite careful planning, actual cash flows often deviate from the budgets Management of
Cash
due to inherent uncertainty associated with cash flow variables. There are
several tools such as sensitivity analysis, simulation, etc., available to
evaluate the impact of uncertainty on cash flows. The uncertainty associated
with the cash flows is managed by holding additional cash, negotiating
stand-by borrowing facility and interest rate derivatives. Management of
cash includes dealing with surplus cash and cash-in-transit. Surplus cash is
to be invested in short-term securities after conducting cost-benefit analysis.
In view of the advancement in Banking Technology, funds transfer has
turned instantaneous. RTGS/NEFT transfer have made the flow of cash easy
and to some extent less costly also. Therefore, all these developments have
potential significance to cash planning and execution.

While planning and decision-making are essential for any management

system, the system completes only when appropriate control mechanism is
built into the system. Management information system assumes importance
in this context in cash management system. Periodical reporting on cash
flows and variance analysis of such flows is essential to effectively manage
the cash flows. The objective of the entire exercise is to ensure availability
of cash to conduct t h e b u s i n es s smoothly and effectively.

5.10 KEY WORDS

Transaction Motive: C ash balances required to meet the expenses
towards day to day operations of a business.

Precautionary Motive: Cash balances required to take care of the

contingencies that arise due to unplanned activity.

Speculative Motive: Cash balances kept by a business unit to take advantage

of increasing prices of raw materials, services, etc.
Discretionary Expenses: Expenses that are not directly related to the
manufacturing process, but have some amount of flexibility in timing the
expenditure.

Cash Forecast: An estimate of cash inflows and outflows for a specified

period.

Simulation Analysis: A method of making forecasts by generating a large

number of probable estimates (generally with the help of a computer) of cash
inflows and outflows and compare the position for their effect on ending
balance in a reference period.
Sensitivity Analysis: A method of studying the impact of changes in cash
flow variables on cash balance.

Electronic Funds Transfer: A mechanism by which receipts and payments

are handled through electronic machines.

Cash Budget: A forecast of cash inflows and outflows for a period.

125
Management of
Current Assets
5.11 SELF-ASSESSMENT QUESTIONS
1. Explain the objective of Cash Management System. How do you deal
with the conflicting nature of the objectives?
2. What are the principal motives of holding cash in a business?
3. Discuss internal and external determinants that affect the flow of
cash.
4. Why is it important to forecast the cash flows in managing the cash?
5. How do you measure the uncertainty associated with cash flows?
Discuss the methods available to manage the uncertainty of cash
flows?
6. Discuss the importance of cash flow reporting in the management of
cash?
7. Digital Electronics Ltd. is preparing cash budget for the next quarter
in order to negotiate with the bankers for additional credit. The sales
department informs that March sales was Rs. 220 lakhs and the
expected sales for the next four months are Rs. 120 lakhs, Rs. 160
lakhs, Rs. 220 lakhs and Rs. 160 lakhs respectively. The company
sells 30% of sales through cash and the balance on credit basis with
one month as credit period. The bad debts level is negligible. Cash
outflows consist of payment to creditors, salary and wages, other
operating expenses, purchase of fixed assets and taxes. The material and
labour costs constitute 30% and 45% respectively of the sales. While
raw materials are purchased in one-month credit, wages are paid in
the same month. Other operating expenses cost Rs.50 lakhs and are
paid in the same month. Other non-operating cash flow items are Rs.
150 lakhs in May (fixed assets), Rs. 120 lakhs in June (fixed assets),
Rs. 160 lakhs in June (corporate tax) Rs. 140 lakhs in April (interest
and instalment of loan) and Rs. 100 lakhs in May (dividend). The cash
at the beginning of the quarter was Rs. 150 lakhs and the company’s cash
policy is to hold 5% of total cash expenses of the next month as
minimum closing balance of the current month. Prepare a monthly cash
flow statement for the quarter and highlight the surplus/deficit for each
month.
8. Kidcat is a leading manufacturer of toys and sports items for kids. The
industry is facing severe competition from unorganised sector, which
imitate the Kidcat products immediately. The sales of the firm during
the last two years show significant volatility. The firm decides to use
simulation this time while preparing cash budget. The firm has sold
Rs. 100 lakhs worth of toys during the month of March and expects
the following possible ranges of sales between April to June of the
next year.
Sales (Rs. in lakhs) 40 80 120 160
Probability 20% 30% 30% 20%

The customers generally pay within a month of sales. The material cost
126 associated with the product works out to 40%, which are paid after a
 month and fixed cost including labour cost of the firm per month is Management of
Cash
Rs. 30 lakhs.

Fixed costs are paid in the same month. Conduct a simulation

exercise of 100 trails using random numbers and find the cash balance
at the end of each month and their distribution. (Hint: Use of Spreadsheet
is recommended to conduct simulation exercise).
9. The internal analysis of cash flows of a large textile manufacturing
company shows a wide variation in cash balances during the next
year. The minimum cash balance expected during the second quarter of
the year was -Rs. 340 lakhs (negative balance indicating shortage of
cash) and the maximum value of Rs. 120 lakhs during the month of
February. The above figures are estimates and likely to see significant
volatility. The firm presently enjoys over draft limit of Rs. 300 lakhs
and contemplating to increase the limit to Rs. 400 lakhs to meet the
additional cash need and also uncertainty associated with cash flows.

The bank is willing to provide the additional loan at 14% interest rate
but insists the firm to accept a commitment charge of 0.25% per
month on the additional borrowing limit. The commitment charge has
to be paid on unused part of the overdraft facility. For instance, if a
firm draws Rs. 340 lakhs in August, it has to pay interest at the rate
of 14% on Rs. 340 lakhs and 0.25% on Rs. 60 lakhs. If the firm
decides not to accept the offer, it will be exposed to cash out position
and emergency borrowing would cost 2% interest per month. The firm
expects a maximum emergency borrowing of Rs. 200 lakhs at
different points of time during the year. Advice the firm on accepting
the additional loan with a commitment charge of 0.25%.

5.12 FURTHER READINGS

Brealey, Richard A and Myers, Stewart C., Principles of Corporate
Finance, Tata-McGraw Hill, New Delhi
Frederick C. Scherr, Modern Working Capital Management: Text and Cases,
Prentice Hall, Englewood Cliffs, NJ.
Joshi, R.N. Cash Management: Perspectives, Principles & Practice, New
Age International (P) Ltd. New Delhi.
Keith V. Smith, Guide to Working Capital Management, McGraw-Hill
Book Company, New York
Pandey, I.M., Financial Management, Vikas Publishing House, New Delhi
Prasanna Chandra, Financial Management, Tata-McGraw Hill, New
Delhi
Ramamoorthy, V.E. Working Capital Management, Institute for Financial
Management and Research, Madras.
John Tennet, Guide to Cash Management: How to Avoid a Business Credit
Crunch, Wiley, 2012.
Joshi, R. N., (2019), Cash Management, New Age International Publishers.
127
Management of
Current Assets UNIT 6 MANAGEMENT OF MARKETABLE
SECURITIES

Objectives
The objectives of this unit are to:
• Highlight the need of investments in marketable securities.
• Explain different types of securities available for investments.
• Provide an overview of markets for securities.
• Explain models to optimize the cost and opportunity income.
• Provide a guideline to develop strategies in the management of
securities.

Structure
6.1 Introduction
6.2 Need for Investments in Securities
6.3 Types of Marketable Securities
6.4 Market for Short-term Securities
6.5 Optimisation Models
6.6 Strategies for Managing Securities
6.7 Summary
6.8 Key Words
6.9 Self-Assessment Questions
6.10 Further Reading

6.1 INTRODUCTION
Cash and marketable securities are normally treated as one item in any
analysis of current assets. Holding cash in excess of immediate requirement
means the firm is missing out an opportunity income. Excess cash thus is
normally invested in marketable securities, which serves two purposes
namely, provide liquidity and also earn a return. Marketable securities form a
major component of cash and marketable securities.
Investing surplus cash in marketable securities is normally a part of overall
cash management. It becomes a separate activity of the firm, if the
investments in marketable securities form a major part of the current assets.
Many firms in India today are very active in money and capital markets,
where marketable securities are traded. A cursory look at the investments by
some of the companies makes us believe that they are very active in the
securities market. For example, Reliance Industries has investment in
securities to the tune of Rs.3,47,285 crore, which is 58.33 per cent of the total
assets. As can be seen from the data incorporated in Table-6.1., companies
like ONGC, Vedanta, Tata Steel, Bharti Airtel, IOC, Larsen, Maruti Suzuki,
128 Grasim, etc., have significant amounts invested in securities.
 Management of
Table 6.1: Investment in Securities by Select Companies by 2-04-2022
Cash
(Rs. in Crore)

S. No. Name of the Company Investments % of Total

Assets
1. Reliance 3,47,285 58.33
2. ONGC 81,376 47.19
3. Vedanta 62,903 69.08
4. Tata Steel 57,471 50.65
5. Bharti Airtel 52,273 41.10
6. IOC 48,619 24.95
7. Larsen 47,024 146.95
8. Maruti Suzuki 41,787 88.14
9. Grasim 33,640 75.00
10. Hindalco 31,731 48.02
11. TCS 31,667 49.87
12. NTPC 28,626 12.16
13. Infosys 28,336 61.52
14. ITC 26,997 48.64
15. Oil India 26,414 72.02
16. Tata Power 26,368 80.19
17. Wipro 25,701 60.74
18. Mah Scooters 24,654 107.93
19. M&M 24,065 66.76
20. Bajaj Auto 23,819 99.99
21. Adani Ports 21,694 43.81
22. Adani Power 19,358 86.09
23. Tata Motors 17,693 56.60
24. TML-D 17,693 56.60
25. BPCL 17,684 24.91
26. Ultra Tech Cement 17,569 34.22
27. Sun Pharma 16,999 61.93
28. Tech Mahindra 16,552 86.22
29. Hind Zinc 15,052 42.50
30. HPCL 14,992 20.56
31. Reliance Power 14,107 102.45
32. Bajaj Holdings 14,020 100.95
33. GMR Infra 13,795 111.61
34. JSW Holdings 13,450 107.57
35. Coal India 13,225 160.39
36. JSW Steel 12,458 15.59
129
Management of 37. Ambuja Cements 11,796 57.84
Current Assets
38. HCL Tech 11,096 27.70
39. Shree Cements 11,050 72.19
40. Cipla 9,725 53.58
41. GAIL 9,723 20.22
42. Lupin 9,563 54.90
43. Tata Chemicals 9,337 76.83
44. JSW Energy 8,211 74.40
45. Tata Steel Long 8,093 53.86
46. Reliance Infra 7,655 109.68
Source: BSE data (www.moneycontrol.com)

Though this gives a positive outlook for investing in marketable securities,

there are many companies, which have lost heavily by investing in
marketable securities.

If we look at the international financial markets, companies such as Procter &

Gamble (US), Gibson Greetings (US), Showa Shell (Japan), Mettalgesells
chaft (Germany), Allied Lyons (UK), Orange Country (US), British Councils
(UK), etc., have lost millions of dollars heavily by entering into financial
transactions of wrong types. In the domestic markets too, several firms have
incurred huge loss during the last few years and many of them have taken a
public stand in the company’s annual general body meeting that they will not
excessively deal in the securities market. Nevertheless, many companies are
willing to deal in marketable securities at different levels. While some of
them have an active treasury management and willing to take risk, others
have restricted themselves in investing their short-term surplus money for a
limited period.

Managers need to acquire some basic knowledge on the nature of marketable

securities, operation of markets where such securities are traded and finally
the models used in recognising short-term surplus and managing such surplus
to improve overall profitability of the firm.

6.2 NEED FOR INVESTMENT IN SECURITIES

Marketable securities result from investment decisions that really are not the
main part of the firm’s business. But marketable securities cannot be ignored,
as they constitute a part of the value of the firm that is entrusted to
management.

Another prominent reason for holding marketable securities is on account of

mismatch between the borrowing and investment programme. Companies in
the field of infrastructure, which are presently executing several projects, are
constant borrowers of money in both domestic and international markets.
These projects are executed over a period oftime. It is often difficult to
borrow money exactly for the requirement of the year or month since the cost
of borrowing, sentiment of the market and regulatory requirements are to be
130
taken into account in deciding the amount to be borrowed. Companies thus Management of
Cash
borrow more than their current requirement. It not only applies to borrowing
but also applies to equity financing. Money raised in the form of debt or
equity has a cost and it cannot be immediately put into use for any long-term
purpose. They are invested in short-term securities with an intention to
recover at least a part of the cost of borrowing.
Many companies, which adopted the profit centre concepts, have made the
finance department as one of the profit centres. It means the finance
department has to add revenue to the firm. Top management wants financial
department to show how they helped the company to improve the bottomline.
By dealing with marketable securities in the form of securities and foreign
exchange derivatives, financial managers’ ought to demonstrate their ability
to cut down the cost or increase the benefit. Investments in marketable
securities also depend on the aggressiveness of the financial managers’ in
dealing with such assets.
Many companies today have a separate treasury division that operates in
marketable securities and other financial products. But aggressive dealings in
marketable securities will increase the risk of financial operations.
The task of financial managers, who become involved with marketable
securities either full-time or part-time, consists of three issues. First,
managers must understand the detailed characteristics of different short-term
investment opportunities. Second, managers must understand the markets in
which those investment opportunities are bought and sold. Third, managers
must develop a strategy for deciding when to buy and sell marketable
securities, which securities to hold, and how much to buy or sell in each
transaction. We will discuss these issues in the next few sections.

Activity 6.1
i) What are the major reasons for deciding to invest “excess” cash balances
in marketable securities?
…………………………………………………………………………
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ii) What characteristics should an investment have to qualify as an
acceptable marketable security?
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Management of iii) Give an account of the activity of marketable securities of a company
Current Assets
you are aware of.
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6.3 TYPES OF MARKETABLE SECURITIES

Marketable securities available for investments can be grouped in several
ways. They can be classified under three broad heads namely debt securities,
equity securities and contingent claim securities, which in turn can be
grouped under several heads. We will give an overview of these securities
below.

A) Debt Securities
All debt securities represent a promise to pay a specific amount of money
(the principal amount) to the holder of the security on a specific date (the
maturity date). In exchange for investing in security, the investor or holder of
the security, receives interest. This interest may be paid upon maturity of the
security (as with most short term debt instruments) or in periodic instalments
(as with most long term debt instruments). Different types of debt securities
are discussed below.

a) Money market instruments

The market for debt securities of relatively short maturity (generally one year
or less) is called money market. The money market gives a considerable
amount of liquidity to all participants in financial market. Companies and
government entities that find themselves temporarily short of cash can raise
funds quickly by issuing money market instruments. Investors who have cash
to invest for short periods of time can invest in money market instruments
that will provide them with a return while not committing their funds for long
periods.

i) Call money
The demand and time liabilities (DTL) of a bank are evaluated every
fortnight on a Friday called the ‘Reporting Friday’. During the first fortnight
following the Reporting Friday, the bank is expected to maintain daily 4% of
its DTLs (as on the Reporting Friday) in cash with RBI. This is known as
cash reserve ratio CRR. The banks are expected to maintain this balance in
such a way that the average daily balance is within the stipulated
requirement. The market that arises as a result of borrowing and lending by
banks in order to maintain their CRR is known as the call market.
Theoretically call money is money that is literally on call, i.e., it can be called
back at short notice. In the case of interbank market, the notice period can be
132 as short as one day.
 Management of
ii) Certificates of Deposit
Cash
A certificate of deposit (CD) is an instrument issued by a bank or other
depository institution representing funds placed on deposit at the bank for a
certain period of time. They are called negotiable certificates of deposit.
Negotiable CDs are generally not redeemable before maturity, but an investor
who purchases, for example, a six-month CD may sell it to another investor
one month later rather than wait until the CD matures. The interest on CDs is
calculated on the face amount of the CD. It is a Non-discount instrument and
pays the face amount plus accrued interest at maturity. The rates available to
investors in CDs are typically somewhat higher (averaging about 1 percent
higher) than those on T-bills of equal maturity. This yield differential can be
attributed to several factors: a) the somewhat thinner market for CDs, b) the
tax differential, c) the risk factor of the issuing financial institution.
iii) Commercial paper
Commercial paper (CP) is the term, for the short-term promissory notes
issued by large corporations with high credit ratings. Commercial paper
usually carries no stated interest rate and sells at a discount from its face
value as T-bills. The objective of the RBI introducing CP as an instrument
to finance working capital needs was to reduce the dependence of corporates
on banks. Also, by pricing the CP at market rates, the financial efficiency of
corporates was coveted to increase. Also, this instrument securitises the
working capital limits. CPs can be issued to individuals, banking companies,
corporate bodies, whether located in India or outside India, including NRIs
and FIIs. The companies can now issue CP for a maturity period ranging
from 3 months to less than a year. Minimum net worth of issuer is also
reduced from Rs. 5 crores to Rs. 4 crores and the minimum working capital
(fund-based) limit is also being reduced from Rs. 5 crores to Rs. 4 crores.
And the borrowable account of the company is classified as the Standard
Asset by the Banks. CPs now can be issued in multiples of Rs. 5 lakhs.
(iv) Bankers Acceptances
Bankers’ Acceptances are time drafts drawn on a commercial bank for which
the bank guarantees payment of the face value upon maturity. They are
commonly used to finance international transactions for the short term. For
e.g., a jewellery retailer in India might purchase watches from a manufacturer
in Switzerland, paying for the goods by sending a time draft (a draft payable
at some future date) drawn upon the jeweller’s bank. When the bank accepts
the draft, it stamps “accepted” on the reverse side of the draft, meaning that
the bank guarantees payment of the draft upon maturity. In effect, the bank is
guaranteeing the credit of the jeweller. Since the credit behind the draft is
now on the bank, the draft can be traded in the money market along with
other short-term debt instruments. Although bankers’ acceptances are
available to individual investors, they are typically most popular with
commercial banks and foreign investors.
(v) Government Securities or Securities Guaranteed by the Government
Government securities are public debt instruments issued by the Government
of India, State Governments or Financial Institutions, Electricity boards,
Municipal Corporation, etc. guaranteed by the governments to finance their
133
Management of projects. The default risk of these securities is perceived to be lower than that
Current Assets
of corporate bonds or equity shares since they are issued on account of
Sovereign risk. These securities are therefore termed as Gilt-edged securities.
Government securities traded in the money markets fall within 5 distinct
categories.
a) Treasury Bills
b) Central Loans
c) State Loans
d) Central Guaranteed loans
e) State Guaranteed loans

The order of these securities ranges from most liquid to less liquid and also
safest to less safe. All these securities are of different maturities and coupon
rates. Currently, the coupon rates of government securities range from lowest
of 5 per cent to the highest of 11 per cent.

You may refer money market page of economic dailies such as The
Economic Times or The Hindu Business Line, Business Standard, Financial
Express. Where you get indicative rates for many of these securities for
different maturity periods. Exhibit-6.1 shows some of the inputs, which you
normally see in a money market page of economic dailies.

Treasury bills have of late started attracting good response, especially since
the introduction of 364 days T Bill in April 1992. Presently, there are 3
maturities - 91 days, 182 days and 364 days. Government securities are one
of the lowest yielding securities that one can invest in. Most investments in
these securities are made due to regulatory reasons. Generally, Banks and
Financial Institutions buy these T-Bills from out of the funds, they are
supposed to maintain as part of SLR.

b) Capital Market Debt Instruments

The capital market supplies long-term funds to corporations, government
entities and other users of capital. The general type of debt instrument of the
capital market is the bond. Bonds usually pay interest to the holder once
every six months (semi-annually) and pay the principal or face amount upon
maturity. Although the face amounts of bonds do vary, the typical bond has a
face value of Rs. 1000. The market value of the bond, the price for which it
trades in the market, can be greater or less than par depending on interest
rates and other market factors.

(i) Government B onds

In India both Central Government and various State Governments are issuing
bonds for diverse purposes with varying maturity periods. These Bonds are
issued by the Governments to support various infrastructure and
developmental activities. Issuing bonds for large infrastructure projects such
as Construction of Roads, Air Ports, Sea Ports, Development of Industrial
Parks has become common now. These are called ‘Government Securities.
They are being issued for periods ranging from 5 to 40 years. In these Bonds,
134 primarily, there are two varieties, viz., fixed rate bonds and floating rate
bonds. While the former carries a fixed rate of interest throughout the period Management of
Cash
of its life, the interest rate in the case of latter type of bonds, would be
varying and the same is indicated before hand. Generally, of late the Central
Government through RBI has started issuing Sovereign Gold Bonds (SGBs),
linking to the prices of Gold; which carry an interest of 2.5 per cent per
annum. The intention is to prevent the people from purchase of physical gold
and invest in Bonds. These SGBs have a fixed maturity period of 8 years; but
can be traded in the stock market.

(ii) Municipal Bonds

Municipal bonds are those issued by Municipal Authorities. Like the Central
and State Governments, Municipal Corporations and other Local Bodies are
permitted to raise loans for their development. As per the Constitution of
India, these are called Local Self Governments. Subject to certain restrictions,
they are independent in designing their own activities. For financing their
development, they can issue bonds or raise loans. The Securities and
Exchange Board of India has formulated guidelines for the issue of these
bonds in 2015. The list of corporations that issued Bonds in India included
Lucknow, Bhopal, Surat, Kanpur, Varanasi, Ghaziabad, etc. For instance, the
Lucknow Municipal Corporation has raised Rs.200 crore through Bonds,
which also got listed on BSE.

(iii) Public Sector Undertaking (PSU) Bonds

PSU bonds are issued to finance projects of various public sector
undertakings like NTPC (National Thermal Power Corporation), IRFC
(Indian Railways Finance Corporation), etc. There are two kinds of bonds
Tax free with a coupon of 9% or 10% or 10.5%, and taxable with a coupon of
13% to18%. The public sector undertakings have been raising resources from
the capital markets, through the issue of bonds, termed as PSU bonds since a
long time. In the recent past, National Highways Authority of India is
mobilizing funds through bonds in a large measure. The face value of these
bonds is varying from as low as Rs.1000 to as high as Rs.10 lakhs. The
Interest rates are varying between 5 to 10 per cent. Of late, IOC has issued 5-
year Bonds with maturity by February 2027 at an interest rate of 6.14%.

c) Corporate Bonds
Debt securities of corporations with maturity of longer than one year are
corporate bonds. The usual par value of a corporate bond is Rs. 100 and
sometimes Rs. 10,000, and maturities range from about 2 years to as many as
30 years. In recent years, however, corporate bond issues have been of
shorter maturities as inflation and economic uncertainties have caused
investors to be less willing to commit their funds for longer periods of time.

B) Equity Investments
Equity securities represent the residual ownership of the firm. Residual
ownership means that the debt holders must first be paid off, before the
company belongs completely to the equity holders. The two types of equity
securities are common stock and preferred stock.
135
Management of a) Common Stock
Current Assets
The common stockholders are the risk takers; they own a portion of the firm
that is not guaranteed, and they are last in line with claims on the company’s
assets in the event of a bankruptcy. In return for taking this risk, they share in
the growth of the firm because the growth in the value of the company
accrues to the common shareholders. The company may make a periodic cash
payment called a cash dividend to the common stockholders. Cash dividends
are commonly paid to shareholders on a quarterly basis, but they may be paid
annually, irregularly, or even not at all. The common shareholder has no
guarantee of receiving a dividend payment. Common stockholders usually
have voting rights that allow them to vote on the corporation’s board of
directors. Since the board of directors hires the top management of the
company, the stockholders indirectly determine the company’s management.

b) Preferred Stock
Preferred stock is technically an equity interest in the company, but its
characteristics are more like those of bonds. Preferred means that this type of
stock has a stated par value that represents a claim against corporate assets
that supersedes the claims of the common stockholders, but is subordinate to
the claims of bondholders. Preferred stock also carries a fixed cash dividend
to the common shareholders. Like debt, preferred stock is often
systematically retired through a sinking fund. It also does not represent true
residual ownership because preferred shareholders usually do not participate
in earnings growth by receiving higher dividends, as common shareholders
do.

C) Contingent Claim Securities

Contingent claim securities are securities that give the holder a claim upon
another asset, contingent upon the holder’s meeting certain contract
conditions. Although there are many types of contingent claim securities, the
three most popular kinds of investments today are options, warrants, and
convertible securities.

(a) Options

An option is a contract giving its holder the right to buy or sell an asset or
security at a fixed price. All options are valid only for a specified time period,
after which they expire. A call option gives its holder the right to buy the
underlying asset and thereby guarantees the purchase price of the asset for the
duration of the option. A put option carries the right to sell and guarantees the
selling price of the underlying security.

(b) Warrants

Warrants are like call options that are issued by the corporation. They give
their holders the right to purchase the common stock from the corporation
at a fixed price. Warrants usually have longer life than options (typically
five to seven years), although a few perpetual warrants do exist. Corporations
usually issue warrants in conjunction with another issue of securities and
offer a “package deal.” For example, the purchase of one share of preferred
136
stock might entitle the investor to receive one warrant to purchase common Management of
Cash
stock of the company. Companies offer such packages to sweeten the deal
and make the other security easier to sell.

(c) Convertible securities

Convertible securities are securities that may be converted into common

stock. A convertible bond is a bond that the holder may exchange for
common stock of the corporation. The other common type of convertible
security is the convertible preferred stock, which is simply a preferred stock
that the holder can exchange for a certain number of shares of common stock
of the corporation.

(d) Futures contracts

A contract that arranges for delivery and payment of an asset at a future

date is a futures contract. Futures contracts are traded publicly on the futures
exchanges, and these exchanges have developed contracts on a number of
assets, such as corn, wheat, soybeans, and frozen pork bellies. These
contracts, often called commodity futures because of the nature of the
underlying asset, allow producers and consumers of the commodities to plan
their production and sales in advance as well as allow speculators to enter the
market. A second group of futures, on such assets as U.S. Treasury bills,
negotiable CDs, and stock markets indexes, is called financial futures. These
futures allow investors in such securities to spread some of the risk to
speculators and aid in the investment process.

There is still one more security in the list, called units of mutual funds,
which is not a separate security on its own but backed by an investment in the
above securities. Indian companies traditionally prefer mutual funds units,
particularly Unit-64 of Unit Trust of India, to invest their surplus money for
short period because of reasonable return, high liquidity and tax concession
(tax provisions governing mutual funds investments have seen significant
changes during the last few years). Since many private sector mutual funds
have also started offering a reasonable return in their debt-oriented schemes,
corporate attention is slowly moving towards the units of private sector
funds. Another instrument similar to mutual funds units that is likely to
emerge in the future is the unit arising out of securitisation process. These
are units backed by mortgages of housing loan or any other receivables. A
few securitisation deals have already taken place in the Indian market but
they were restricted to financial institutions. This market is the second largest
segment of the market, immediately next to government securities market,
and is also very active.

Activity 6.2
i) List out the different kinds of instruments in the money market.
…………………………………………………………………………
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………………………………………………………………………… 137
Management of ii) What is call money market?
Current Assets
…………………………………………………………………………
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iii) Trace out the trends in the Indian Debt Market?
…………………………………………………………………………
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6.4 MARKET FOR SECURITIES

Securities market can be broadly classified into short-term securities market
(also called money market) and long-term securities market. These markets
along with banking and financial institutions are called capital markets,
where different needs for money are exchanged. Financial managers, though
interested in investing their surplus assets for a short period, are not bound to
restrict their investments in short-term securities. What is important, is
liquidity of investments. It is quite possible to invest in long-term securities
such as 20-year government bond and sell it after a week, which is essentially
a short-term investment in a long-term bond. Similarly investment can be
made for a short period in equity or derivative securities. An understanding of
different markets is important for the financial managers in this context. We
will discuss some of the major characteristics of the market under three broad
heads namely money market, market for long-term capital and market for
derivative securities.

(a) Money Market

Money market is a place where borrower meets the lender to trade in money
and other liquid assets that are close substitutes for money. A developed
money market will have large number of instruments, both in terms of variety
and volume, presence of large number of traders and existence of requisite
infrastructure to facilitate efficient settlement of transactions. Till 1991,
money market in India was in a dormant state. It was operating in a closely
regulated environment, where interest rates are fixed and regulated. The
operations were also restricted in a few securities involving commercial
banks. The conditions of the money market improved after the Reserve Bank
of India initiated many changes on the basis of the recommendation of the
Vaghul Committee, which recommended deregulation of interest rates,
introduction of new instruments and increase in the number of participants.
As a result, India now has fairly developed money market with a number of
138 instruments and active trading. The establishment of institutions like,
Discount and Finance House of India Ltd. (DFHL), SBI Guilt, etc., and Management of
Cash
arrival of several wholesale dealers has provided liquidity to the market.
Mutual funds have also started actively investing in short- term securities
along with banks and other institutional investors.

Investing short-term surplus in short-term securities has an advantage over

other securities because short-term securities will reflect the interest accrued
on a day-to-day basis. For instance, if a company has Rs. 50 lakhs surplus
money for a short period, it can invest in a commercial paper or treasury bill
or a long-term government bond. If the prices of all the three instruments are
observed at the end of the week, the first two securities will reflect the
interest earned and thus move upward whereas there is no guarantee that the
prices of long-term securities reflect the interest earned part for such small
interval. Also, the short- term securities are less affected by the interest rate
changes (called interest rate risk). For example, if the central bank increases
the interest rate during the week, the prices of long-term bond will decline
more than short-term bonds.

Before investing in money market securities, it is better to look into yield

curve of securities traded in the market. A yield curve is the one, which
shows the return available for securities having different maturities. This
curve is useful to managers to trade-off between return and interest rate risk.
Further, the yield curve will show the expectation of the market on the future
interest rate scenario, which is a vital input for any treasury managers.
Interest rate is the one which affects almost every aspect of the economy like
business performance, stock market, money market, foreign exchange market
and derivatives market.

(b) Market for long-term Securities

Market for long-term securities is a place where the borrowers raise capital
for longer term. Due to active secondary market for many of the long-term
securities, there is no need that only investors having long-term surplus alone
enter into the market. For instance, a significant percentage of volume of
trading (more than 75%) in stocks, which are long-term instruments, are
settled within a trading cycle of five days. Now ‘T + 1’ trading is going on in
the market. Long- term securities - debt, equity and other types of securities -
are actively traded in the stock exchanges like National Stock Exchange,
Mumbai Stock Exchange. These exchanges deal in corporate securities,
government securities PSU securities and units of mutual funds, etc. Stock
exchanges are more organised than the money market, due to volume of
operations and huge participation of players.

The objective of investing in marketable securities need not always be for

short- term purpose. If the surplus money is available for fairly longer period,
investment in long-term securities can be considered because the return will
be more. Due to active secondary market, there is no liquidity risk in the
event of sudden need of funds. Of course, investment in equity oriented
securities has some amount of investment risk. Investing in portfolio of
stocks or investing through mutual funds can reduce a part of investment risk.

139
Management of (c) Market for Derivative Securities
Current Assets
Derivatives market in India is relatively new and started developing since
2000, when NSE and BSE commenced trading in equity derivatives. Since
then derivatives market in India has grown by leaps and bonds. Actually,
there are four types of derivatives that can be traded in the Indian Stock
Exchanges. They are: Equities, Bonds, Currencies and Commodities. While
the market for equities, bonds and commodities has evolved, the derivative
market for currencies growing now. The following are the usual types of
derivatives traded in India. (a) Forward contracts, (b) Future contracts, (c)
Option contracts, (d) Swap contracts. Though the market for derivatives is of
recent origin, it has recorded phenomenal growths over the years. During the
last 10 years (2011-2021) daily turnover of derivatives grew by 4.2 times
from Rs. 33,305 crore in 2011 to Rs.1,41,267 crore by 2021. Dealings in cash
derivatives also grew by 6.2 times from Rs.11,187 crore to Rs. 69,644 crore
in the same period. In this trade, NSE has emerged the top global Exchange
with about 17.3 billion turnover in 2021 alone.

Activity 6.3
i) What are the reasons for the corporate sector in accessing the capital
markets? List down the various instruments used in capital markets?
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
ii) Describe briefly the market for the Government Securities?
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
iii) Briefly explain the role played by Debt Instruments in the investment of
surplus funds?
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
iv) How far derivatives can serve as a market for surplus cash?
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………

140 …………………………………………………………………………
 Management of
6.5 OPTIMISATION MODELS Cash

At the beginning of this unit, we have observed that holding cash in excess of
immediate requirement means missing out an opportunity to earn an income.
However, it is necessary to find the cost associated with investing activity
before taking investment decision. For example, if Rs. 5,00,000 is surplus
available for one-week and it can earn an interest income of Rs. 750 for one
week, the interest income is to be compared with cost associated with buying
and selling of securities. Suppose, the security dealer charges 0.1%
commission. The firm will incur Rs. 500 when it buys the security and
another Rs.500 when it sells the security. The total cost of Rs. 1000 is greater
than Rs. 750 and thus, the net effect of the investment is loss. The investment
decision is feasible, if the surplus money is available for two weeks or more.
Thus, the decision on investing surplus money needs a careful analysis of
cost and benefit. A few models are available to balance the cost and benefit
and five of such models are discussed below:

Bierman - McAdams Model: This model is different from other models

because it assumes that the investment in marketable securities is on account
of raising excess funds from long-term sources. The reason for raising excess
capital from long-term sources is due to high cost of raising capital from the
long-term sources and thus, the cost is to be optimised. An example will be
useful to understand the concept. Suppose a firm requires Rs.10,00,000 every
year from long-term resources for next four years for certain capital
expenditure. The interest cost prevailing for long-term funds is 14% and
flotation cost (cost of brokerage or processing and legal fee paid to bankers or
financial institutions, stamp duty, etc.) is Rs. 50,000. The flotation cost is one
time cost and not always proportional to amount raised. It is a fixed cost at
least for a range of capital raised from the market. Assume if the firm raises
more than Rs.10 lakhs, the excess amount can be invested at 11.5% in
marketable securities. With this set of information, assess the impact of the
following two alternatives.
1. Rs.10 lakhs every year and;
2. Rs. 20 lakhs in the first year and another Rs. 20 lakhs in the third year.
In the Table given below, the yearly cash outflow under the two conditions is
given.

Year Loan Flotation Cost Interest Outflow Interest Income Netcost

(A) Interest Outflow in Option 1 (Raising Rs. 10 lakhs every year)

0 1000000 50000 0 0 50000

1 1000000 50000 140000 0 190000

2 1000000 50000 280000 0 330000

3 1000000 50000 420000 0 470000

4 0 0 560000 0 560000

141
Management of (B) Interest Outflow in Option 2 (Raising Rs. 20 lakhs Year 1 and Year 3)
Current Assets
0 2000000 50000 0 0 50000

1 0 0 280000 115000 165000

2 2000000 50000 280000 0 330000

3 0 0 560000 115000 445000

4 0 0 560000 0 560000

(C) Comparison of Interest Outflow under Two Options

Net Cost in Option 1 Net Cost in Option 2 Difference

0 50000 50000 0

1 190000 165000 25000

2 330000 330000 0

3 470000 445000 25000

4 560000 560000 0

Option 2 is preferable because Net Cost is lower than Option1

The net interest outflow in Option 2 is lower than the interest outflow of
Option 1. Thus, the firm benefits by raising Rs. 20 lakhs at the beginning of
year 1 (Year 0 in the Table), spends Rs. 10 lakhs and invests the balance in
marketable securities at 11.5% for a year. The marketable securities are sold
at the end of year 1 and the value is used for capital expenditure of year 2.
There is no need to raise fresh funds in year 2 because the required amount is
already raised. The process is repeated again in year 3. This strategy leads to
reduction of overall cost of funds because the total amount spent on flotation
is only Rs.1,00,000 against Rs. 2,00,000 under Option 1. What about other
options like raising Rs. 30 lakhs in year 1 and Rs. 10 lakhs in Year 4 or Rs. 40
lakhs in year 1? None of these options give you a lower cost than raising
Rs.20 lakhs in year 1 and Rs. 20 lakhs in year 3. Bierman and McAdams
showed the way to get the optimal financing through the following equation.

Q= 2FD i Y
Where F = the fixed flotation cost of obtaining new financing
D = the firm’s total net outlay of cash for the next period
i = the percentage of interest rate on new financing
Y= the percentage yield on marketable securities
Substituting the value of funds required (Rs. 10 lakhs), flotation cost of Rs.
50000, interest rate of 14% on new financing and 11.5% interest income on
marketable securities in the above equation, we get the following:

Q= 2 50000 1000000 0.14 0.115 Rs.20,00, 000

142
The model basically optimise the flotation cost with the difference between Management of
Cash
interest outflow and interest income on marketable securities. This model
helps the financial managers to decide on how much to be raised from the
market given the requirement of funds and how much to be invested in
marketable securities. On the other hand, the remaining four models guide the
finance managers on how to switch funds from marketable securities to cash
and vice versa.

Baumol Model: This model assumes that the demand for cash is continuous
and frequent withdrawal of cash from investment will cost more. Thus, the
model gives an approach to find the optimal withdrawal of cash from
investments. An example will be useful to understand the concept. Colleges
or Universities like IGNOU collect fee from the students at the beginning of
the year or term. Assume the receipt for the year is Rs. 12 lakhs. There is no
major cash inflow during the year or term. However, the institution requires
cash continuously to meet various operational expenses during the year or
term. Assume the total demand for the cash during the year is Rs. 10 lakhs.
Suppose the initial receipt of Rs. 12,00,000 is invested in marketable
securities. The issue before us is how much worth of marketable securities is
to be sold and cash be realised. If there is no transaction cost of selling
securities, the amount could be as low as possible. If the cost of each
transaction is Rs. 575, how much money is to be withdrawn every time. The
cost affects our decision because if we withdraw too many times, it will cost
more. At the same time if we withdraw a large amount, then the cash is idle
and we lose an opportunity to earn a return. Baumol resolves the problem
using the following equation, which gives an optimal withdrawal quantity.

C= 2bD /Y
Where b = cost of each transaction
D = total amount required during the period
Y = the percentage of yield on marketable securities

Substituting the value of funds required (Rs.10 lakhs), transaction cost (Rs.
575) and interest on marketable securities (11.5%) in the above equation, we
get the following:

C= 2 575 1000000 / .115 Rs.1, 00, 000

The institution has to sell securities worth of Rs. 1,00,000 every time to
optimise the transaction cost and interest income on marketable securities.
That means, the sale will be effected at the end of every fifth week.

Beranek Model: Beranek’s model is similar to Baumol’s model but the

assumption here is different. Beranek’s model assume that the firms
disbursement takes place periodically whereas the inflows are continuous.
Since buying of the securities also costs the firm, it is not desirable to invest
on daily basis. The inflows are accumulated to a level and then invested with
an objective of minimising the cost of buying of the securities. Since any
delay in investment will affect the opportunity income, the two are to be
balanced. We will give a different example to illustrate this model. Suppose,
143
Management of a supermarket requires cash at the end of every month to pay salaries, rent
Current Assets
and settle the dues of suppliers. The firm on the other hand receives the cash
of Rs. 1 lakh daily from the sale of provision and other items and the total
amount collected during the month is Rs. 30 lakhs. Assume the entire
collection is required at the end of month. That means whatever purchases
has been made during the month in marketable securities, they have to be
liquidated at the end of the month. The interest on marketable securities per
month and transaction cost of purchasing securities are 0.95833% (11.5% per
year) and Rs. 255 respectively. The issue before the finance manager of the
super market is whether the investment is to be done on daily basis or the
receipts are accumulated upto a point before investment. Substituting the
values in the Baumol’s equation, we get the optimal investment as
approximately Rs. 4.00 lakhs. That means, funds are to be accumulated for
four days before buying marketable securities and optimal ordering lot is Rs.
4.00 lakhs. We will see similar concepts in the next unit also when we deal
with inventory management.

Miller and Orr Model: The earlier two models assume that one of the two
cash flow variables namely cash inflow or cash outflow is constant and thus
come out with a solution on optimal withdrawal value or investment value. In
a situation where both inflow and outflow are not constant, Miller and Orr
model is useful. The model is based on control-limit approach. According to
the approach, the optimum level is first derived based on certain assumptions
and this optimum level needs to be disturbed only when the assumptions are
violated. Miller and Orr model using the interest rate on marketable
securities, transaction cost and minimum desired level of cash, derive the
optimal cash holding for the firm with the use of following equation

Z = [(4bσ2) / (4 Y)] ˄ 1/3 + L

Where Z = Optimum cash holding
b = the fixed transaction cost per transfer
Y = the daily yield on marketable securities
σ2 = Variance of daily changes in the cash balance
L = Minimum desirable cash prescribed by the management

Using the minimum desirable cash limit called Lower Limit (L), Miller and
Orr model gives the Upper Limit of cash holding (H), which is equal to

H = 3 Z – 2L

As long as cash is within upper limit (H) and lower limit (L), no action is
required. The moment the cash balance breached one of these two limits, an
action is required. If the cash balance touched the upper limit (H), then all the
excess cash above the optimal holding (Z) is invested in marketable
securities. Similarly, if the cash balance touched the lower limit (L), the firm
sells marketable securities to an extent that brings the cash balance back to
optimal cash holding (Z). The following example shows how the three values
given in the Miller and Orr model are derived.

144
The Treasurer of Blue Diamond Hotel wants to develop a cash management Management of
Cash
model for investing surplus cash in marketable securities. Since the cash
flows show a volatile behaviour, the treasurer feels the Miller and Orr model
is the most suitable for the situation. An analysis of last three-year daily cash
flows shows a standard deviation of Rs. 12,200. Investment in marketable
securities currently offers a return of 12% per annum. The transaction cost
per transaction is Rs.300. The Treasurer believes the hotel should have
minimum cash balance of Rs. 20,000. What is the optimal cash holding?
When an investment or disinvestment action is to be taken?

Substituting the above values in the Miller and Orr model, we get the
following:

Z = [(4×300×122002)/(4×(.12/365))] ^ 1/3 + 20000 = 46702

H = (3 × 46702) – (2 × 20000) = 100107
L = 20000

Thus, the cash management policy is when the cash balance goes below Rs.
20,000, marketable securities are sold and cash balance is brought back to Rs.
46,702. If the cash balance exceeds Rs. 1,00,107, the cash value above Rs.
46,702 is invested in marketable securities. The cash balance is allowed to
move between Rs. 20,000 and Rs.1,00,107 and occasionally brought down to
the optimum level.

Stone Model: Bernell Stone suggested that instead of mechanically taking

action on the basis of Miller and Orr model whenever the cash balance is
breached the upper or lower limit, the treasurer can forecast the behaviour of
future cash flows of two or more days and use this information in taking
investment decision. Under this model, the firm sets out two inner limits. For
instance, in the above example, if the firm sets an inner limit for minimum
balance at Rs. 30,000 and another inner limit for maximum balance at Rs.
90,000, the treasurer evaluates the cash flows for the next two days whenever
the cash balance hits the previously defined Miller and Orr model. Assume
the cash balance touched Rs. 20,000. The firm evaluates whether the next two
days inflows will bring back the cash position at Rs. 30,000 or more. If the
forecast fails to show such an improvement, the securities are sold and cash
balance is brought towards the optimum level. On the other hand, if the cash
balance is likely to move above Rs. 30,000 no action is required at this stage.
Investment in marketable securities will also be taken on the same line. The
two inner limits are provided mainly to avoid unwanted transaction.

Activity 6.4
i) What is the essential theme of Bierman-McAdams Model?
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
145
Management of ii) Do you believe that the Cash Management Models have any appeal to
Current Assets
the Cash Managers? Comment.
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………

6.6 STRATEGIES FOR MANAGING

SECURITIES
As indicated at the beginning of this unit, the financial managers need to have
an understanding on different types of securities and the markets in which the
securities are traded before venturing into investments in securities. In
addition to giving a fair amount of overview on the above two, we have also
discussed different models useful in taking decision on investments in
marketable securities. Using this set of information and knowledge, the
financial manager has to design a strategy in managing securities. In
developing a strategy, the first and foremost issue is an understanding of the
firm’s cash flow behaviour. This is essential because the model, which is
useful for managing the securities, depends on the cash flow behaviour. An
analysis of historical cash flows and volatility measures such as variance or
cash out positions will be useful to set control limits. In other words, the first
set of actions in developing a strategy is to come out with a reasonable cash
management model for the firm.

The second step in the process of designing the strategy is the extent to which
the firm should take risk while investing in securities. In other words, in stage
one, we have identified the amount available for investments but we haven’t
specified the nature of investments. A set of guidelines needs to be developed
that will direct the operational managers while taking investment decisions.
For instance, many banks have a clearly defined investment policy that lists
the kind of securities where the surplus cash can be invested. It is advisable to
prescribe the proportion of investments in different securities like
government securities 60%, corporate securities 20%, etc. The firm should
have a clear mechanism to get the risk of the portfolio and this information
should be made available to chief of treasury operations. If the level of
operation is very high, it is worth to implement the concepts like Value-at-
Risk (VAR) to avoid major losses on such transactions.

The last step is to develop systems in continuous monitoring of this activity

and improving the reporting system. Many companies during the securities
scam period that occurred occasionally in India have suffered because of lack
146 of monitoring and faulty system. If the companies are cautious and
understand the trends in the money and capital markets, there would be no Management of
Cash
need to repent later.

Activity 6.5
i) Imagine yourself as the finance manager of a leading firm. What are the
basic criteria you would follow in making optimum investment decisions
on a portfolio of securities with the surplus cash available with the firm?
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………

6.7 SUMMARY
Firms invest surplus cash in marketable securities because it enables firms to
earn a return or at least recover a part of the cost of funds. Since the risk,
return and liquidity of marketable securities are different, an understanding of
them is essential before the selection of securities. An understanding of the
markets in which such securities are traded is also useful. Since firms incur a
cost in buying and selling of securities, the opportunity return needs to be
compared with the cost before deciding the investment decision. There are
different models that enable the managers to optimise the cost and decide the
quantum of investments. What is more important in managing marketable
securities is developing a system that enables the managers not only to take
investment decisions but also monitoring the investments in securities. In the
process of earning an opportunity income, the firms should not incur a loss
by investing wrongly or giving an opportunity for operational managers to
make personal gains. Studying the behaviour of cash flows is important,
before devising a strategy. Each firm should develop its own strategy. The
companies in India have compiled a very rich experience in managing their
cash balances and investing them intelligently in Indian and global securities.
Indian companies are no longer at the receiving end now. They have turned
transnational and are able to dictate global stock markets.

6.8 KEY WORDS

Marketable Securities: Those instruments that can be bought and sold in a
market, which imply adequate liquidity.
Call money: Call money is that amount lent for very short periods and the
borrower may be asked to payback the money in that short period. This short
period can be as short as one day also.
147
Management of Certificates of deposit: is an instrument issued by a bank or any other
Current Assets
depository institution representing funds placed on deposit at the bank for a
certain period of time.
Commercial paper: is a short-term promissory note issued by large
corporations having high creditworthiness.
Options: are contracts giving their holders right to buy or sell an asset or a
security at a fixed price.
Warrants: these are like options, which give their holders the right to
purchase the common stock from the company at a fixed price.
Convertible securities: these are securities that will be converted into
common stock at agreed price and at agreed date.
Money Market: is a place where borrower meets the lender to trade in
money and other liquid assets that are close substitutes for money.
Derivatives: Derivative is the one derived from another. In Finance
Literature, it is referred to a financial contract, whose value depends upon the
value of the underlying asset or group of assets. Derivatives are traded either
through stock exchanges or through over-the counter (OTC) mode.

6.9 SELF-ASSESSMENT QUESTIONS

1. Explain the objective of management of marketable securities system.
How do you deal with the conflicting nature of the objectives?

2. What is the primary cause of interest rate risk?

3. Discuss the important features of the Miller-Orr model.

4. Trace out the trends in Bond Market?

5. What are the advantages and disadvantages of floating rate securities for
both issuer and the investor?

6. What are liquid assets? Why do firms hold cash and cash equivalents?

7. What are commonly used money market instruments? Discuss.

8. In the money market, there is a well-established relationship among

yields of different types of instruments. What does it reflect?

9. Describe the Baumol and Miller-Orr cash management models and

explain how they differ from each other.

10. What are the options available to a firm for investing surplus cash?
Discuss strategies that a company employ to gain from the market?

11. Alpha Trading Corporation requires Rs 2.5 mn in cash for meeting its
transaction needs over the next 6 months. It currently has the amount in
the form of marketable securities. The cash payments will be made
evenly over the 6-month planning period. It earns 10% annual yield on
148 the marketable securities. The conversion of marketable securities into
 Management of
cash entails a fixed cost of Rs 1200 per transaction. What is the optimal Cash
conversion size as per the Baumol Model?

12. Excel Enterprises expects its cashflows to behave in a random manner,

as assumed by the Miller Orr model. Excel wants you to establish the
“Upper Control Limit (UCL)” and the “return point”. It provides the
following information as required by you-
♦ The fixed cost of effecting a marketable securities transaction is
Rs.1500.
♦ The standard deviation of the change in daily cash balances is Rs.6000.
♦ The minimum cash balance maintained is Rs.100,000.
13. Pheonix Electronics has used the Baumol to estimate its optimal cash
balance to be Rs 10 lakhs. Its opportunity cost is 10% and there is a cost
of Rs. 250 every time the marketable securities have to be converted into
cash. Estimate the weekly cash usage rate?
14. The financial manager of a large multinational company Jax Ltd., is
studying the firm’s cash management. He knows that it costs an average
of Rs. 1000 per transaction to sell marketable securities. Short term
Treasury bills are currently yielding 6%. In studying the firm’s cash
flows, he determines that the standard deviation of daily cash balance is
Rs. 5 lakhs. The firm must maintain a minimum balance of Rs. 50 lakhs
to comply with compensating balances requirements. He sees no reasons
to hold more than this amount in cash.
(a) Using the Miller-Orr model, what is the cash return point for the Jax
Ltd?
(b) What is the Upper Control Limit?
(c) Using the values, explain how the firm will manage cash and
marketable securities balances. At what point will the firm sell
marketable securities and how much will it sell?
(d) How will the firm’s holdings of cash be affected by a) an increase in
the opportunity cost of holding cash, b) an increase in the daily
variance of cash balances, c) a decrease in the transaction cost
associated with selling marketable securities

6.10 FURTHER READINGS

Brealey, Richard A and Myers, Stewart C., Principles of Corporate Finance,
Tata-McGraw Hill, New Delhi

Frederick C. Scherr, Modern Working Capital Management: Text and Cases,

Prentice Hall, Englewood Cliffs, NJ.

Joshi, R.N. Cash Management: Perspectives, Principles &Practice, New

Age International (P) Ltd. New Delhi.
149
Management of Keith V. Smith, Guide to Working Capital Management, McGraw-Hill Book
Current Assets
Company, New York

Pandey, I.M., Financial Management, Vikas Publishing house, New Delhi

Prasanna Chandra, Financial Management, Tata-McGraw Hill, New Delhi

Ramesh, K. S. Rao, Fundamentals of Financial Management, Prentice Hall

International.

150
 Management of
Exhibit 6.1: Money Market Operations as on May 2, 2022
Cash
(Amount in Crore, Rate in Per cent)

MONEY MARKETS@ Volume (One Weighted Range

Leg) Average
Rate
A. Overnight Segment (I+II+III+IV) 4,55,953.51 3.75 2.00-5.70
I. Call Money 9,524.38 3.65 2.30-3.90
II. Triparty Repo 3,14,234.60 3.76 3.65-3.83
III. Market Repo 1,32,089.53 3.73 2.00-3.90
IV. Repo in Corporate Bond 105.00 5.70 5.70-5.70
B. Term Segment
I. Notice Money** 326.25 3.50 3.05-3.75
II. Term Money@@ 192.00 - 3.65-3.95
III. Triparty Repo 2,530.00 3.81 3.75-3.90
IV. Market Repo 300.00 3.15 3.15-3.15
V. Repo in Corporate Bond 0.00 - -
RBI OPERATIONS@ AuctionDate Tenor Maturity Amount Current
(Days) Date Rate/Cut
off Rate
C. Liquidity Adjustment Facility (LAF), Marginal Standing Facility (MSF) & Standing
Deposit Facility (SDF)
I Today's Operations
1. Fixed Rate
2. Variable Rate&
(I) Main Operation
(a) Reverse Repo
(II) Fine Tuning Operations
(a) Repo
(b) Reverse Repo
3. MSF Mon, 2 Wed, 0.00 4.25
02/05/2022 04/05/2022
4. SDFΔ Mon, 2 Wed, 1,38,634.00 3.75
02/05/2022 04/05/2022
5. Net liquidity injected -
from today's 1,38,634.00
operations [injection
(+)/absorption (-)]*
II Outstanding Operations
1. Fixed Rate
2. Variable Rate&
(I) Main Operation
(a) Reverse Repo Fri, 14 Fri, 4,51,901.00 3.99
22/04/2022 06/05/2022
(II) Fine Tuning Operations
(a) Repo
(b) Reverse Repo Tue, 28 Tue, 50,010.00 3.99
19/04/2022 17/05/2022
3. MSF
151
Management of 4. SDFΔ
Current Assets
5. Long-Term Repo Mon, 1095 Thu, 499.00 5.15
Operations# 17/02/2020 16/02/2023
Mon, 1094 Wed, 253.00 5.15
02/03/2020 01/03/2023
Mon, 1093 Tue, 484.00 5.15
09/03/2020 07/03/2023
Wed, 1094 Fri, 294.00 5.15
18/03/2020 17/03/2023
6. Targeted Long Term Fri, 1092 Fri, 11,987.00 4.40
Repo Operations^ 27/03/2020 24/03/2023
Fri, 1095 Mon, 16,423.00 4.40
03/04/2020 03/04/2023
Thu, 1093 Fri, 17,512.00 4.40
09/04/2020 07/04/2023
Fri, 1091 Thu, 19,746.00 4.40
17/04/2020 13/04/2023
7. Targeted Long Term Thu, 1093 Fri, 7,450.00 4.40
Repo 23/04/2020 21/04/2023
Operations 2.0^
8. On Tap Targeted Long Mon, 1095 Thu, 5,000.00 4.00
Term Repo Operations€ 22/03/2021 21/03/2024
Mon, 1096 Fri, 320.00 4.00
14/06/2021 14/06/2024
Mon, 1095 Thu, 50.00 4.00
30/08/2021 29/08/2024
Mon, 1095 Thu, 200.00 4.00
13/09/2021 12/09/2024
Mon, 1095 Thu, 600.00 4.00
27/09/2021 26/09/2024
Mon, 1095 Thu, 350.00 4.00
04/10/2021 03/10/2024
Mon, 1095 Thu, 250.00 4.00
15/11/2021 14/11/2024
Mon, 1095 Thu, 2,275.00 4.00
27/12/2021 26/12/2024
9. Special Long-Term Repo Mon, 1095 Thu, 400.00 4.00
Operations (SLTRO) for 17/05/2021 16/05/2024
Small Finance Banks
(SFBs)£
Tue, 1095 Fri, 490.00 4.00
15/06/2021 14/06/2024
Thu, 1093 Fri, 750.00 4.00
15/07/2021 12/07/2024
Tue, 1095 Fri, 250.00 4.00
17/08/2021 16/08/2024
Wed, 1094 Fri, 150.00 4.00
15/09/2021 13/09/2024
Mon, 1095 Thu, 105.00 4.00
15/11/2021 14/11/2024
Mon, 1095 Thu, 100.00 4.00
22/11/2021 21/11/2024
Mon, 1095 Thu, 305.00 4.00
29/11/2021 28/11/2024
152
 Mon, 1095 Thu, 150.00 4.00 Management of
13/12/2021 12/12/2024 Cash

Mon, 1095 Thu, 100.00 4.00

20/12/2021 19/12/2024
Mon, 1095 Thu, 255.00 4.00
27/12/2021 26/12/2024
D. Standing Liquidity Facility (SLF) Availed 26,521.23
from RBI$
E. Net liquidity injected from outstanding -
operations 3,88,641.77
[injection (+)/absorption (-)]*
F. Net liquidity injected (outstanding -
including today's 5,27,275.77
operations) [injection (+)/absorption (-)]*

RESERVE POSITION

G. Cash Reserves Position of Scheduled Commercial

Banks
(i) Cash balances with RBI as on May 02, 2022 6,83,134.67
(ii) Average daily cash reserve requirement for the May 06, 2022 6,76,950.00
fortnight ending
H. Government of India Surplus Cash Balance May 02, 2022 0.00
Reckoned for Auction as on¥
I. Net durable liquidity [surplus (+)/deficit (-)] as on April 08, 2022 7,20,395.00

Source: RBI Press Release on Money Market Operations as on May 02, 2022

153
Management of
Current Assets UNIT 7 MANAGEMENT OF INVENTORY

Objectives
The objectives of this unit are to:
• Explain importance of holding different components of inventory in
manufacturing and distribution.
• Explain the need for investments in inventory.
• Define the inventory system and the costs associated with the inventory
system.
• Explain inventory models that balance the cost and benefit of holding
inventory under certainty and uncertainty.
• Explain inventory control methods to ensure continuous inventory
control.
• Discuss some of the emerging ideas in inventory management.

Structure
7.1 Introduction
7.2 Components of Inventory
7.3 Need for Inventory
7.4 Inventory System
7.5 Costs in Inventory System
7.6 Optimising Inventory Cost
7.7 Selective Inventory Control Models
7.8 Inventory Management Under Uncertainty
7.9 Emerging Trends in Inventory Management
7.10 Summary
7.11 Key Words
7.12 Self-Assessment Questions
7.13 Further Readings

7.1 INTRODUCTION
Three things will come to top of your mind when you think of a
manufacturing unit - machines, men and materials. Men using machines and
tools convert the materials into finished goods. The success of a business unit
depends on the extent to which these are efficiently managed. In this unit, we
will discuss how to manage the inventory, which consists of not only material
but also work-in- progress and finished goods. The general concepts of
management namely, planning, decision-making and controlling equally
apply to inventory management. In fact, this is one area in which companies
in the real life spend a lot of resources, both in terms of monetary value and
154
managers’ time. Table-7.1 shows the investments in inventory in different Management of
Inventory
companies and its value as a percentage of current assets.
Table 7.1: Top Companies in India by the Size of Inventory Holdings by
the Financial Year 2020-21
(Rs. in Crore)
S. No. Name of the Company Inventory % of Current
Holding Assets
1. IOC 78,188 83.8
2. Reliance 37,437 79.4
3. HPCL 28,592 80.1
4. BPCL 26,757 64.3
5. Macrotech Developers 23,762 96.8
6. SAIL 19,508 71.4
7. Hindustan Aeron 16,560 56.4
8. Hindalco 15,989 85.9
9. Jaypee Infra 11,720 95.8
10. JSW Steel 10,692 41.5
11. DLF 9,804 92.6
12. ITC 9,471 60.9
13. NTPC 9,179 36.4
14. Tata Steel 8,604 60.9
15. ONGC 8,474 51.1
16. Titan Co. 7,984 90.8
17. BHEL 7,191 40.1
18. Prestige Estate 6,880 73.1
19. Sobha 6,752 94.5
20. MRPL 6,610 72.8
21. Mazagon Dock 5,889 39.6
22. PC Jeweller 5,794 50.4
23. Vedanta 5,555 50.4
24. Bharat Ele. 4,955 30.0
25. Zee Entertain 4,944 67.4
26. Aurobindo Pharma 4,841 43.4
27. Jindal Steel 4,592 37.5
28. Jai Prakash Associate 4,568 66.7
29. Tata Motors 4,552 41.5
30. TML – D 4,552 41.5
31. Chennai Petro 4,509 95.7
32. Kalyan Jeweller 4,388 82.9
33. Puravankara 4,057 94.0
Source: BSE Data (www.moneycontrol.com/stocks/marketinfo/inventory/bse/index/html)
155
Management of It is evident from the Table-7.1 that inventory is the major component of
Current Assets current assets. In majority of the companies, it is constituting as high as 90
per cent. The trend is that those companies in the business of Steel, Heavy
Machinery, Infrastructure are having the large size of inventory with them.
To name a few of them Macrotech Developers, Jaypee Infra, Sobha,
Purevankara, DLF are in the list.
The value of inventory differs between industries because several factors like
technology, nature of materials, production process, etc. determines the value
of inventory. The composition of inventory is high in food and beverages
because the technology is fairly simple and hence the requirement of fixed
assets is low. The inventory requirement is high because of seasonal factor
and the need for wider retail distribution network. For instance, if each shop
in the country stores twenty pockets of Maggi Noodles or Milkmaid, think of
the total volume of finished goods stored in millions of shops distributed all
over the country. The composition of inventory is low in heavy industries or
hi-tech industries because of high value of fixed assets. Another interesting
finding is declining trend in the composition of inventories as a percentage of
total assets during the period, which partly attributes to successful
implementation of new techniques such as Materials Resource Planning
(MRP) and Just-in-Time (JIT). We will discuss these issues later under the
heading of emerging trends in inventory management.
There are few basic differences between managing inventory and other
components of assets. Unlike machine and men, the inventories are
continuously planned on day-to-day basis based on the customers’ demand
and production schedule. Frequent decision-making and continuous
controlling are thus required. Unlike other components of current assets,
there are number of people/ departments involved in managing the inventory.
While stores department manages the materials and components, it is the
production department’s responsibility in managing work-in-progress.
Finished goods are managed either by the warehouse or sales department.
In addition to the involvement of different divisions, each division requires
input from others in planning and controlling the inventory. For instance,
stores department, which manages the raw material, needs to closely interact
with production-planning and purchase departments to manage the raw
materials effectively. Again, the production-planning department needs input
from marketing or sales department to plan for the production schedule. The
complexity of managing inventory could be seen with diverse objectives
pursued by each of these departments. Production planning department wants
to ensure timely availability of material to allow smooth functioning of
production flow and thus insists that materials are purchased or drawn in
advance. On the other hand, material planning and stores department would
like to procure the material only when it is required and thus reduce their stay
in the stores. Similarly, marketing department wants to ensure adequate
stocks with the retailers or dealers or distributors. They may also insist the
company to produce more variety to fulfil different tastes of the customers
and thus forcing the firm to increase the Quantity as well as the number of
materials and components. The larger issue or strategic role of inventory
management is to synchronise different objectives of the departments and
efficiently manage the inventory.

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 Management of
Activity 7.1
Inventory
i) How managing inventory is different from that of managing machines
and men?
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ii) Explain the need for external input in the management of different
components of inventory?
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iii) Visit any of the Manufacturing Unit nearby, and write down a brief on
your observations relating to Inventory Management there.
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7.2 COMPONENTS OF INVENTORY

Inventory is an asset to the organisation like other components of current
assets but the difference is, it can be seen and counted. It is also bit complex
because there are different types of inventory, as well as different sizes,
shapes, forms and substances. It is a group of assets with different
characteristics. There are four major components of inventory namely raw
materials, stores and spares, work-in-process and finished goods.

Raw materials: Raw materials are the input that are used in the
manufacturing process to be converted to finished goods. Examples of raw
materials are iron-ore, crude oil, salt, wood, etc. However, what is considered
to be the finished goods for one firm could be the raw materials for the
others. For example steel flat or tubes are finished goods for Tata Iron and
Steel Company (TISCO) but the same is raw material for automobile
companies such as Maruti Udyog or Hindustan Motors or machinery
manufacturing companies such as BHEL or Thermax. Similarly,
petrochemicals produces manufactured by Reliance Industries are used as
raw materials by several detergent manufacturers, polyester textile units,
tyres manufacturers, etc. Raw materials are not only important in the
manufacturing process but also play a crucial role in deciding the location of 157
Management of plant. Several cement factories are located close to areas where limestone and
Current Assets
coal are available. Sugar factories are located close to sugarcane growing
areas and power plants are located close to waterfalls (hydroelectric units)
and coal belts.

Stores and Spare parts: Stores or otherwise called as purchased components

are another important input in the manufacturing process. This is a major
component of working capital for many assembly type of units. For instance,
manufacturers of colour television such as Videocon or Sony, Samsung and
LG buy components like picture tubes, printed circuit boards, tuner, speakers,
etc., and assemble them. Many of the computer hardware companies would
be using assemblers to assemble Computers to cut down the cost. Many
companies are also trying to achieve a concept called lean organisation to
meet competition and in this process out sourcing several items, which were
internally manufactured. The concept of ‘supply chain management’ has, of
late, emerged as the key practice in the efficient management of inventory
and sales. We will discuss the same in detail later in this lesson.

Spare parts and tools are also accounted for as part of total inventory. But
these do not directly contribute in the final output of the product but are
necessary to support in the smooth flow of the production process. Often
machinery suppliers, particularly for imported ones, send critical spare parts
required for the machines in the event of breakdown. Tools like spare parts
are primary equipments used in the machines or independently to produce a
product. However, they are treated as inventory due to their short life and
stored along with materials. As they are also issued and accounted like
materials, they are treated as a part of inventory.

Work-in-process: These are items, which are partially assembled or

processed. The complexity of production process and time required to
complete production cycle determines the value of work-in-process. The
value of work-in-process is high for the manufacturers of passenger aircraft
or railway engines or heavy machinery because of complexity and long time
required to complete a unit. The value of work-in- process is relatively low in
pharmaceutical or paint companies since its primarily mixing of chemicals.
To gain better understanding you may compare the production process in the
construction of a steam or electric turbine and a dairy unit.

Finished goods: The last stage in the inventory processing is the finished
goods. These are the final output in any manufacturing process and are ready
to be sold to the customers. Why do firms keep finished goods in the factory
or warehouse before they are sold to the customers? It is not necessary and
firms can sell whatever they have produced immediately or can produce only
to the extent demanded by the customers like Tata Power and NTPC, BHEL,
which will have no finished goods. However, it is not practical for many
other firms because of the nature of production process and consumption
practices of the users.

For instance, Maruti Automobiles, Parrys Confectionary, Britania and Nestle,

which manufacture many brands of toffees and biscuits cannot produce all of
them on a daily basis to the expected consumption of their products. They
158
 have to necessarily produce them in batches of few days or weeks Management of
Inventory
requirements by using more or less same machines. Otherwise, the
requirement of machinery will be huge and production becomes
economically nonviable. They may also have to establish a large number of
plants all over the country to meet the local demands. Finished goods may be
relatively low for high value equipments like aircraft or ships, which are
often manufactured on the basis of orders. It can be reduced for firms, which
are supplying to industrial customers because firms can schedule their
production according to the production schedule of customers. The finished
goods component has to be necessarily high for firms that produce products
like food products, consumer durable, etc., which are directly consumed by
the public, and distribution network also need to be large.

Activity 7.2
i) List out the various components of inventory? Identify major raw
materials, purchased components, finished goods for any one firm which
is familiar to you.
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ii) List down a few reasons for the differences in the level of inventory
values.
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7.3 NEED FOR INVENTORY

In the course of discussion on different components of inventory, we have
indicated that some amount of inventory is necessary. However, holding
excessive inventory will block the funds and costs more to the firm. There are
several other associated costs of holding excessive inventory, which we will
discuss later. How do managers assess the level of inventory? They need to
first understand different needs of holding inventory and accordingly quantify
its requirement. For instance, a television manufacturer can quantify the
159
Management of finished goods inventory by identifying the number of dealers the firm has
Current Assets
appointed and the minimum number of pieces of each brand that need to be
stored with each dealer for the customers to come and see the product. The
following are some of the primary reasons or the motives for holding
inventories that applies to different components of inventory.

Transaction Motive: It is possible for a hotel to buy vegetables and other

food ingredients required for the day and serve the food such that there is no
inventory at the end of day. If you have kitchen garden in your house, you,
your mother or sister or wife will be picking up the vegetables when it is
required for cooking. It is bit difficult for other large-scale manufacturing
units to synchronise the arrival of materials and their use. Inventory is also
required to supply to dealers and retailers on continuous basis to meet
demand. Thus, an important motive for holding inventory is to perform
smooth transaction in the production process and serving the customers’
demand. It makes production and delivery scheduling a lot more easier.

Precautionary Motive: There is a risk of planning inventory exactly to the

requirement unless the supplier is next to your firm or the product or
component is internally produced. If a firm buys material from outside, there
are several factors that govern the smooth flow of completing the purchase
orders. Similarly, there is also a risk that the plant suddenly breaks down and
is not in a position to replenish the finished goods. Some amount of excess
inventory, often called as buffer stock, is maintained as a precaution. The
precautionary motive plays a vital role in decision making relating to spares
and other critical items required for the production. Many of us carry Stepney
(extra tyre) with our scooters and four wheelers as a precaution.

Speculative Motive: Though firms may not speculate in buying and selling
raw materials, there is nothing wrong in exploiting the opportunity that arises
occasionally due to uneven demand and supply. A refinery could buy or
enter into a contract for the purchase of the crude oil when the price is cheap
because of sudden increase in the supply of oil. We have mentioned earlier,
textile companies find it useful to buy cotton when the prices are low since
the price behaviour is volatile. It is true for most of the seasonal products. It
is also possible to buy extra materials because the suppliers offer discount
beyond certain quantity. Many of the Agro-based industries like Jute, Cotton,
Sugar, Tobacco, confectionery have to buy their entire requirement as and
when the crop is available. These units are forced to buy their requirements
much in advance, though not for speculative purposes. Price fluctuations in
Agricultural products are also very wide, making it necessary for these firms
to buy at any price to remain in production. We often buy extra garments
during clearance sale or festival period, when firms offer discount.

The above discussion presents general reasons for holding different types of
inventory. Given below are a few specific reasons that apply to individual
components of inventory.

160
 Management of
Raw Materials and Stores
Inventory
• To make production process easier
• To ensure price stability
• To hedge against supply shortages
• To take advantage of quantity discounts
Work-In-Process
• To achieve flexibility in manufacturing
• To ensure economies of production
Finished Goods
• To ensure smooth delivery schedule
• To provide immediate supply
• To achieve economies of scale
• To allow batch processing in a multiple product situation and optimize
the utilization of machine and other resources

Though the above said factors could influence the firms in maintaining the
inventories, each firm has its own policies in deciding the quantum of the
inventory to be maintained. To understand the need for inventory one should
understand the flow of the inventory components in the manufacturing
process. Raw materials are needed as input in the initial stages of the
manufacturing cycle. The raw material requirements vary as per the nature of
the industry.
Similarly the companies have to maintain sufficient stockings of the finished
goods as the output produced are not always sold at the factory gate. These
goods have to be distributed when the goods are to reach the customers
spread out geographically. This requires overcoming the challenges faced in
the competitive world. When the firm defaults to supply the goods at the
right time in the right place to the right customers, there is fear of losing the
sales to the competitors.

In a similar way, inventory is required to maintain a balance between the

investment in inventory and customer-service, in that lower the inventory,
higher the stock-out and higher the inventory better the customer service.
Inventory is also required to minimise the ordering costs and transportation
costs by reducing frequent ordering and by moving materials in bulk
respectively.

Activity 7.3
i) Why do the firms maintain inventory? Identify three best reasons for
holding inventory by a company.
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Management of ii) List any two speculative reasons for holding excess inventory.
Current Assets
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7.4 INVENTORY SYSTEM

An understanding of inventory system is essential before making any attempt
to manage different components of inventory. A system in simple terms is
defined as how things are organised together with their inter-relationships
among different components of systems. We can define inventory system as
the one, which consists of three components namely inventory customers,
inventory storage points and inventory sources. Inventory customers are
primary cause for investments in inventory. Inventory customers includes
end-customers, marketing department or dealers, production centres and any
one, who demands inventory to be stored for their ready consumption. The
customers demand inventory because of their production process and
consumption pattern. A firm, which is doing job orders, can purchase the
required items after it receives the job order. On the other hand, sugar or
power plant cannot buy their daily requirements on daily basis because the
process is continuous and any delay in the arrival of material will force the
unit to shut down. Similarly, industrial consumer would buy in quantities
sufficient to ensure their production process to run smoothly whereas retail
consumers will expect the shops to keep ready the stocks to allow them to
buy whenever the product is required. For example, individuals buy soaps,
detergents, toothpaste, health drinks and other consumables only for a
month’s requirement. An analysis of the inventory customers and their
consumption behavior is essential for inventory management.
The second component of an inventory system is inventory storage or
inventory stocking points. It might be a warehouse, a distribution centre, a
storage bin or any other physical location where inventory is stored for a brief
period of time. Stocking points are required because transportation in bulk
quantity to these points is easy and cheaper and stocks are redistributed in
smaller quantity to retail outlets. In the case of raw materials also
convenience and low cost, require materials to be bought in bulk and stored
inside the factory. Analysis of stocks in stores and removing transportation
bottleneck are key to reduce the investments in stocks. The slow moving and
non-moving items not only increase the cost of carrying the inventory but
also incur an opportunity cost of denying storing space for fast moving items.
162
The last component of an inventory system is sources of inventory. It could Management of
Inventory
be a supplier from whom the firm purchases materials or internal division
from which the products are transferred. This factor affects inventory
management in several ways. For instance, the number of inventory sources
affects the decision on inventory holding. If an item is manufactured by
several units and the quality is comparable, then lead time for procuring the
material is low and the availability of material is high. On the other hand, if
the number of suppliers is few or the quality is not consistent, the inventory
holding is high. The production process of suppliers again determines their
ability to supply in small quantity.

In inventory system, where the number of customers, stocking points and

suppliers are few, the system is relatively easy to manage. Many companies
are trying to achieve this by doing customer profit analysis, warehousing
analysis and supply chain analysis. The system becomes complex to manage,
if the number of customers, stocking points and sources increases. As the
customer’s demands are satisfied by supplying stocks from the stock points,
the core issue of inventory management is how to replenish the stocking
points from different sources in such a way as to minimise the total of all
associated costs and thereby enhance the profitability of the organisation. The
next issue before us is to understand the costs associated with inventory
before attempting to reduce them.

Activity 7.4
i) How do you define an inventory system? List down three important
components of inventory system.
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ii) List down few industries in which the demand for inventory is (a)
continuous and (b) discrete.
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163
Management of iii) List down any three ideas to make the inventory system simpler so that
Current Assets
its management is easier?
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7.5 COSTS IN INVENTORY SYSTEM

Managing costs is one of the primary responsibilities of any manager. The
focus is not to eliminate or minimise the cost but it is a comparison of cost
and benefit. The focus is to minimise the cost per unit of benefit. Thus,
modern inventory management shifted the focus from eliminating inventory
to optimising the level of holding inventory. For instance, one of the key
success factors in cotton spinning and textile units is buying quality cotton
during the season, when the prices are cheap. In all industries, which are
exposed to price volatility, inventory holding is essential. Thus, cost of
holding inventory needs to be compared to the benefit before judging the
level of holding. We will first list out different costs associated with inventory
in this section before comparing the cost with the benefits.

There are five different costs to the firm that holds inventory. The first
category of costs is the value of inventory itself. It is the purchase cost of
inventory of materials and components. For internally manufactured parts or
work-in-progress or finished goods, the cost associated with producing the
product, includes cost of material, labour and other production overheads.
The second component of inventory cost is cost of acquiring inventory. For
materials and purchased parts or components, it is the cost of purchasing,
freight, inspection, etc. This component of cost goes up when the materials
are purchased in small lot because it requires frequent ordering,
transportation, and inspection. The set-up costs can be viewed as cost of
acquiring finished goods since in terms of behaviour it is similar to
acquisition cost of raw material. If finished goods are produced in small
quantity, then the number of set-ups increases causing more set-up costs.
The third cost of inventory, which is important among different components
of costs, is cost of holding inventory. There are different items that go into
this cost component, some of them are fixed in nature whereas many others
are variable. The cost of maintaining and managing stores, warehouses and
other storing facilities are part of cost of holding inventory. The losses such
as spoilage, theft or obsolescence that might occur in holding the inventory
are also included in the cost of holding inventory. The most important cost of
holding inventory is interest or opportunity costs associated with locking of
firm’s funds for inventory. The cost of holding inventory declines if the
materials are procured in small quantity because it reduces the level of
inventory.

164
The fourth cost of inventory is invisible and hence often ignored in formal Management of
Inventory
analysis. This relates to cost of inventory shortage. In many ways, this is the
most difficult category to estimate even though it is a very important cost to
the firm. Its difficulty is mainly due to changes in the magnitude of the costs
in different situations. For instance, if a firm is unable to supply the goods in
time, it may have different consequences. It is possible to supply the goods
with a minor delay and the buyer would perfectly accept the delayed supply.
In a different situation, the customer would refuse to take delivery because of
delay and thus the firm will lose profit on this sale. If the customer decides
not to buy the product henceforth from the firm, then it is a loss of customer,
which takes away all potential profits of the future. In the worst scenario, the
news spreads to others' and many customers move to other competitors. The
cost of shortage relates to material and other components which are
associated with stopping and starting the production. If the entire factory is
shut down due to shortage of material, then cost is very high.

The last component of cost related to inventory is cost of managing the

inventory system. The cost of developing inventory information system,
computer hardware and software and people associated with managing the
inventory system. The cost is high in a multi-product and multi-locational
firm whereas is it is relatively low for a single product ‘company produced’
at a single location.

The above costs in inventory system can also be classified as follows:

• Cost directly proportional to amount of inventory held such as storage
cost, financial cost of carrying inventory, etc.
• Cost not directly proportional to amount of inventory held, which can be
again classified into the following two categories:
• Cost directly proportional to the period of holding inventory such as
spoilage, obsolescence, interest cost, etc.
• Cost directly proportional to number of orders such as ordering cost,
set-up cost, freight, payment process, etc.
• Stock out cost

The objective before us is to manage these components of inventory cost

such that the value derived from inventory is maximised. The optimisation
can be achieved with zero inventory or high inventory, ordering frequently
and procuring from several sources or storing in bulk and taking huge or zero
risk of stock-out position.

Activity 7.5
i) Explain different cost components of inventory in a manufacturing unit?

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165
Management of ii) Give an example on the relevance of cost of shortage in inventory
Current Assets
management.
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iii) List down fixed and variable components of costs of inventory. How do
you use this information in managing inventory?
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7.6 OPTIMISING INVENTORY COST

Inventory holding is desirable because it meets several objectives and needs
as described in Section 7.3. But excessive inventory is undesirable as it costs
a lot to a firm. The issue before us is balancing the cost and benefit and get an
optimum level of inventory holding. This optimisation is achieved in two
stages. First, the optimum ordering level (also called the Reorder Level) is
computed by using the time required to place the order and receive the goods
and demand from production centres. Second, the optimum ordering quantity
also known as the Reordering quantity or Economic Order Quantity (EOQ) is
computed using inputs such as ordering cost and inventory carrying costs. In
simple terms, two questions namely, (a) how much should be ordered and (b)
when should the stocks be ordered? are to be answered.

The issue of quantity to be ordered is determined by two costs namely

ordering cost and cost of carrying inventory, which are inversely related. If
every time, the firm orders more quantity, it can definitely cut down the cost
of ordering, but has to carry more inventory and thus incur more cost of
carrying inventory. Frequent ordering increases the cost of ordering but
reduces cost of holding inventory. How these two costs are balanced to
achieve optimum ordering quantity? There are two ways by which this could
be achieved. One is by determining the EOQ and the other is by adopting the
trial and error approach. This can be worked out with simple examples. But
we do this with certain assumptions that both the annual demand and the
materials usage is known with certainty. Also, the carrying cost per unit and
ordering cost per order are constant. We will list down the assumptions once
again because we will be discussing different other models in Section 7.7 by
removing some of these assumptions.
1) The annual demand is known with certainty.
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2) The annual consumption is even throughout the period. Management of
Inventory
3) The material usage per unit is known with certainty, and is uniform
throughout the years.
4) The carrying cost per unit and ordering cost per unit is constant
regardless of the size of the order.
5) The carrying cost is at a fixed percentage on the average value of the
inventory held.
6) Inventory orders can be replenished immediately.

Trial and Error Approach has intuitive appeal as this resolves the problem
through logical steps. Let us work out this with a simple problem. For this we
take following data into consideration:
Annual consumption forecasted (C) : 24,000 units
Purchase price per unit (P) : Rs.15.00
Cost per order (O) : Rs.45.00
Carrying cost (I) :10% on the purchase price.

There are number of alternatives available to the firm to manage the

inventory cost. The firm may either purchase the entire lot in one order or it
may purchase in small lots by making multiple orders. If the firm chooses to
purchase the entire in one single lot of 24000 units, then an amount of
Rs.180000{(24000+0)/ 2*15}is invested throughout the period. On the other
hand, if the firm chooses to purchase each month by ordering twelve times of
2000 units, then the average investment in inventory is Rs. 15000{(2000 + 0)
/2*15}. Investment values differ according to the size of order. If the firm has
to decide whether to go for the single order or multiple order system, it
depends on various factors like the scarcity of materials, the production
cycle, the demand for the materials, the availability of the materials, suppliers
and buyers bargaining power, etc. If the firm focuses on reduction in the
investment in inventory, then the firm would favour multiple orders. To
further substantiate this, we find the total carrying and ordering cost involved
in the various alternatives. Table 7.3 gives the details.

Table 7.3: Total cost of various alternatives

No. of orders (C/Q) 1 2 3 4 6 10 12 20 24
Order Size (Q) 24000 12000 8000 6000 4000 2400 2000 1200 1000
Avg inv (Q/2) 12000 6000 4000 3000 2000 1200 1000 600 500
Carrying cost 18000 9000 6000 4500 3000 1800 1500 900 750
(A/Q*I)
Ordering cost 45 90 135 180 270 450 540 900 1080
(A/Q*O)
Total Cost 18045 9090 6135 4680 3270 2250 2040 1800 1830

We find that the total cost gets reduced upto a point when the inventory level
reaches 1200 units (Rs. 1800) of order size and after which, the cost starts to
increase. Hence we call this level as the optimum level. There is an
alternative way to find precisely the optimum quantity to be ordered. The
Economic Order Quantity model is discussed in the next section. 167
Management of Economic Order Quantity (EOQ)
Current Assets
Since the trial and error approach involves too tedious calculation, one simple
Method is the use of the formula for calculating the Economic Order
Quantity. We will show the derivation of the model before applying it to our
above Example. Let us first describe the variables used in the equation as
follows:

Annual consumption forecasted =C

Purchase price per unit =P
Cost per order =O
Carrying cost =I
Quantity per order =Q
Number of orders = C/Q
Average Inventory carried = Q/2
The total cost of inventory is equal to purchase value of inventory (C x P)
plus cost of ordering (C/Q x O) plus cost of holding or carrying inventory
(Q/2xI). That is,

TC = CP + (C/Q) O + (Q/2) I
To minimise the total cost of inventory, we need to take the first derivative of
the equation with respect to Quantity and set it to zero and then check
whether the second derivative is positive.
dTC/dQ = -OCQ-2 + I/2 =0
2
OC/Q = I/2
2
Q I = 2OC
2
Q = 2OC/I
Q or EOQ = 2OC / I

The second derivative (2OCQ-3) is greater than zero because all the elements
are positive. Substituting the values of the previous problem in the above
equation, we get

2 45 24000 / 1.5 1200 Units

The relationship between order size and different component of cost is given
in the following graph. The total cost is low at the intersection point of
ordering cost and carrying cost. The order size at this intersection is
economic order quantity.

7.6.1 Analysis of Quantity Discounts

There are occasions when a firm is able to take advantage of quantity
discounts provided the order size reaches a certain level. It is possible to
analyse and decide on such cases.

For instance, in the preceding example we found that the usage per year is
168 2000 units, the holding cost per unit per year is Rs.10 and the ordering cost is
Rs. 100, let us now consider what would be the solution if it was known that Management of
Inventory
a quantity discount of 10% in price is available if the order size is raised to
250 units.

Whether or not the quantity discount should be availed of, depends on an

assessment of the costs and benefits involved.

The savings resulting from the quantity discount = (Re.1) (0.10) (2000) =
Rs.200.
The cost is the additional holding cost minus savings in ordering cost
stemming from fewer orders being placed.
While the cost was cQ*/2 = 10 (200)/2 = Rs.1000
The cost would now be, cQ#/2 = 10 (250)/2 = Rs. 1250;
where, Q# = New Order Size
There would be a difference of Rs.250
The savings in ordering cost can be arrived at as follows:
Total ordering cost when 200 units are ordered each time
= 2000 (100)/200) = 1000
Total ordering cost when 250 units are ordered each time
= 2000 (100)/250 = Rs.800
The saving in ordering cost would be Rs. 200.

Thus while the savings in ordering cost would be Rs.200, the escalation in
holding cost would be Rs.250, that is to say that the net increase in cost
would be Rs.50.

In this particular instance it would be advisable to avail of the quantity

discount option because the saving of Rs.200 exceeds the net increase in cost
of Rs.50

7.6.2 Buffer Stock Decision

As was noted earlier in this unit, most firms maintain some margin of safety
or buffer stock. If they did not do so they would run the risk of being unable
to meet the demand for an item of inventory at a particular point in time. The
cost of incurring shortages is the opportunity cost that one must take into
account. When finished goods are in short supply customers get irritated and
a loss of business may result therefrom. When raw materials or in-transit
inventories are in short supply, stoppage in production and resulting
inefficiencies may crop up.

To decide on the level of buffer stock to be carried a firm must balance the
cost of stock outs with the cost of carrying additional inventory. One can
assess this balance if the probability distribution of future usage is known.

Suppose the usage of an inventory item over a week is expected to be as

follows:

169
Management of
Current Assets
Usage (in Units) Probability
50 0.04
100 0.08
150 0.20
200 0.36
250 0.20
300 0.08
350 0.04
1.00

Let us also assume an economic order quantity of 200 units per week, steady
usage, 200 units in hand at the beginning of the period and three days' lead
time required to procure inventories. We may further assume that since this
lead time is known with certainty, orders are placed on the fifth day for
delivery on the eighth day or the first day of the next seven-day-week. Even
if the firm carries no buffer stock there will be no stock outs as long as the
usage is 200 units or less. When usage exceeds 200 units there will be stock
outs. When we know the cost per unit of stock out we are in a position to
calculate the expected cost of stock outs and compare this with the cost of
carrying additional inventory. Naturally, the stock out cost includes the loss
of profit arising from the order not being fulfilled, a valuation of the loss of
business reputation and goodwill. Let us say we reckon that the stock out cost
is Rs.6 per unit and the average carrying cost per week is Re.1 per unit then
we are in a position to figure out the expected costs associated with various
levels of safety stocks.

Safety Stock Stock Probability Expected Carrying Total

Stock out out Stock out Cost Cost
Cost Cost (Rs.) (Rs.) (Rs.)
(Rs.)
150 0 0 0 0 150 150
Units
100 50 300 0.04
Units
150 units 0 0 0 0 100 150
100 units 50 300 0.04 12 100 112
50 units 100 600 0.04 24
50 300 0.08 24 50 98
0 units 150 900 0.04 26
100 600 0.08 48
50 300 0.20 60 0 144

From the above table it can be clearly seen that the optimal safety stock is 50
170 units, since at that level the total cost is at its lowest.
However, some firms simply decide on a probability level of stock out Management of
Inventory
acceptable to them and then decide on the level of safety stock. For example,
if this firm had decided on accepting a probability of 10% stock out then it
will maintain a safety stock of 50 units only. If, however, the firm wished to
accept a probability of only 5% stock out, then it will maintain a safety stock
of 100 units. When it maintains a safety stock of 100 units it will be able to
meet all situations except the one where there is 4% probability of the usage
being 350 units.

Activity 7.6
i) How do firms arrive at the optimum cost?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
ii) What are the major costs that are taken into consideration in optimising
the inventory cost?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

7.6 SELECTIVE INVENTORY CONTROL

MODELS
The economic order quantity ensures the cost of carrying inventory and cost
of ordering inventory are balanced and an optimum cost level is reached.
However, it fails to ensure stock-out situation and the cost associated with the
stock-out situation. In other words, if there is any uncertainty in replenishing
the stock, it will lead to stock-out situation. Thus, in addition to ordering
quantity, the time at which the order is to be placed is worked out after taking
the uncertainty of replenishing the stocks into consideration. The various
stock-levels that are mostly fixed are as follows:

Stock-Levels
Re-order Level: The storekeeper starts to make the purchases when the
inventory in stores reaches this level. The re-order level is fixed taking into
consideration leadtime and unusual delays or interruptions. This is calculated
as follows:
Re-order Level = Maximum consumption x Maximum Re-order Period.

171
Management of Minimum Level: Inventories are not allowed to fall below this level. These
Current Assets
are otherwise called as safety stocks in the event of emergency. If the
inventory level falls below this level there is a greater chance of stock-out.
This generally happens when the consumption increases the standard
requirements. This is calculated as follows

Minimum Level = Re-order Level - (Normal consumption x Normal Re-order

Period)

Maximum Level: This is considered to be the highest level beyond which

holding of inventories implies blocking of funds unnecessarily. The good
inventory control technique should keep a constant check to see that the
inventory level does not rise beyond this level. The maximum level is fixed
taking into consideration the Re-order quantity, carrying costs, and the
availability of capital, government policy and the nature of the materials.

Maximum Level= Re-order Level + 0.5(Re-order quantity) –

(Minimum consumption x Minimum Re-order Period)
Danger Level: This level is fixed even below the minimum level as a
disastrous signal when the inventory level touches this level. This has to be
solved by exercising greater efforts in purchasing to bring the inventory to
the required level.
Re-order Point: When the question of maintaining inventory at optimum
cost is raised one should not only focus on how much to order but the firm
should also concentrate on when the order has to be placed. Arriving at the
re-order point solves this. This is the level at which the orders should be
placed to replenish the inventory. It takes into consideration the lead-time
required to receive the inventory and the average usage. This should be a
level over and above the minimum level or safety stock. Re-order point is
calculated as follows:
Re-order point = Safety stock + (Average consumption x lead time.)

The determination of economic order quantity and different order levels are
basically a planning exercise. The inventory management does not end with
planning and what is more important is its implementation and continuous
control on inventory. The following techniques, which follow selective
control, are useful to exercise control on inventory.

ABC Analysis
ABC works on the mechanism namely Always Better Control. Vilfredo
Pareto, called nineteenth century Renaissance man, was the first to document
the Management Principle for Materiality, which formed the basis of ABC
analysis discussed here. As per Pareto, the ABC principle involves:
1) Classifying the inventory on the basis of importance on a relative basis to
the total inventory value.

172
2) Establishing different management controls for different classification Management of
Inventory
with the degree of control being commensurate with the importance of
the classification.

3) Hence this follows the criteria of concentrating the attention on most

critical items and pay less concern for less critical items, something
equivalent to the management by exception rule one could have come
across in the basic management textbooks. For this purpose the
management have to be careful in classifying the inventories into high,
moderate and less critical goods. How is this done? The usual
methodology is to use the Rupee volume as the criteria to classify them
into categories, but there are several other factors that determine the
importance of the item. These include:

Annual Rupee volume of the items.

a. Unit cost
b. Scarcity of material used in producing an item.
c. Availability of resources, manpower and facilities to produce an item.
d. Lead-time.
e. Storage requirements for an item.
f. Pilferage risks, shelf life and other critical attributes.
g. Cost of stock-out.
h. Engineering design volatility
Using value of items as the basis for such classification, if on an average the
15% of the items account for nearly 65% of the total inventory value, this
falls under the most critical category which is usually named as the ‘A’
category. Similarly if 30% of the items account for 25% of the total inventory
value, this falls under the next category named as ‘B’ category. The balance
55% of the items that account for nearly 10% of the total inventory value fall
under the least category named as ‘C’ category.

Control Levels: In the case of ‘A’ category item, close controls are required
to avoid stock-out costs. Arranging the supply with large number of vendors
rather than depending only on a few suppliers might do this. Stock levels as
discussed above are strictly maintained. Moreover holding buffer stocks
would be more useful in managing the stock-out. In the case of B category
item the stock-out costs could be somewhere between moderate to low.
Hence appropriate computer-based system, with periodic reviews by the
management is utmost necessary. In addition buffer stocks could be adequate
control mechanism. On the other hand, routine control is sufficient for stocks
falling under the C category. Action is taken only if the stock level falls
below the re-order point. A periodic review at longer interval may also be
sufficient.

VED Analysis
VED stands for Vital, Essential and Desirable. This technique is primarily
used for the control of the spare parts inventory. As the name goes the spare
173
Management of parts are subdivided into vital, essential and desirable categories, based on
Current Assets
their critical nature. The criticality is determined by the importance of its
usage. If the event of stock-out in an item stops the production, then it is
classified under the ‘vital’ category. Those spares the absence of which is not
tolerated for even few hours or a day, the loss of, which is considerably high,
falls under the 'essential' category. Desirable spares are those, the absence of
which is not expected to create havoc for a week or so and necessarily would
not result in the stoppage of the production. Hence one could find that the
VED analysis adopts almost the similar mechanism of the ABC analysis in
that the former is used for the control of spare parts.

F-S-N Analysis
Inventory items are also classified and controlled on the basis of fast-moving,
slow-moving and non-moving items (F-S-N analysis). The non-moving items
are critically examined for their needs and items, which are not critical, are
disposed off in a suitable manner. They may be used in the production
process with modifications or sold in the market. The order levels and
economic order quantity for slow-moving items are reviewed to check,
whether they can be further reduced without affecting the production process.
The above three analysis are not mutually exclusive and in fact, by
combining the analyses, the management can get a better picture on the
inventory. For example, items, which are fast-moving, vital and “A” class,
may require very close monitoring because excess holding will cause
additional cost and at the same time stock-out will also cause equal loss.
Inventory policy can be designed by combining the three analyses.

Activity 7.7
i) How do you think the existence of an inventory control system in the
organisation would help in the inventory management?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
ii) What is Economic Order Quantity?
……………………………………………………………………………
……………………………………………………………………………
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……………………………………………………………………………
……………………………………………………………………………

174
iii) What are the various aspects that are to be considered in fitting an Management of
Inventory
inventory control system in any organisation?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

7.8 INVENTORY MANAGEMENT UNDER

UNCERTAINTY
In our discussion on optimising inventory cost, we have discussed economic
order quantity based on the assumption that the firm knows with certainty the
demand for inventory and cost of ordering and carrying inventory. Since
this certainty assumption may go wrong, we have developed different stock
levels to handle stock-out situation caused by uneven demand for inventory
and order processing time. In this section, we will discuss some of the new
techniques in handling the uncertainty. First, we will define the problem of
uncertainty in simple terms with an example. Suppose a television dealer
expects the demand for the product in the next twelve months to be 12000
televisions. Based on the ordering cost and cost of carrying inventory, the
dealer works out 2000 units as the economic order quantity with a reorder
level of 500 units. The methodology given in Section 7.6 would be adequate
to get these figures. Suppose the actual demand for televisions suddenly
increases to 20,000 units. If the manufacturer is not in a position to accept the
demand for additional televisions, the dealer has to forego the opportunity
income. On the other hand, if the demand declines to 5,000, the dealer will be
carrying excess stock for atleast certain part of the year. The issue is how to
address this uncertainty in demand while deciding optimum level of
inventory. We will discuss a few models available to address the issue.

Option Pricing Model: Option is a contract that gives the holder a right to
acquire or sell certain things at a predetermined price without any obligation.
This type of contract is prevalent in commodities and financial assets. Since it
is one- sided contract that offers only a benefit, the valuation methodology
needs to differ from conventional models of valuing contracts or assets.
There are different models available to value options and discussion on these
models are beyond the scope of this unit. The basic option pricing approach
finds application in several financial management issues such as capital
budgeting, capital structuring and dividend policy. The model is also useful to
address the uncertainty problem of inventory management.

We will first explain an option type called put option and then show how it is
similar to the situation we have described in television dealers example. A
put option gives a right to the holder to sell an asset at a predetermined price.
The holder of the option gains if the value of underlying asset goes down
because the holder can buy the asset at a lower price and sell at a higher
predetermined price. The holder is not going to sustain any additional loss if
175
Management of the price of the asset goes up. Of course, the holder will incur a loss to the
Current Assets
extent of initial price (called option premium) paid to the other party of the
contract to accept the one-sided contract. Thus, the value of contract is
inversely related to the price behaviour of underlying asset with a cap on
maximum loss. With this brief on options, let us go back to the television
dealer example and compare the condition with the option model.
If the dealer decides to acquire additional inventory under the expectation
that the demand will go up, there is an additional cost of carrying the
inventory. At the same time, the dealer has acquired the right to sell the
product and realise the profit if the demand picks up. This is similar to
acquiring a put option on financial assets or commodity by paying upfront
premium. The variable, which determines the profit of the financial or
commodity option is the price of the product and in the case of inventory
option, it is the demand for the product. As the demand goes up, the dealer
starts initially getting back the cost and if the demand still goes up, gets
profit. On the other hand, if there is no change in the demand, the product
stays more time before it finds a buyer and this cost is initially determined as
the cost of buying the option. The issue before the dealer is whether this cost
is worth to incur to get a potential future benefit. This is similar to whether it
is worth to buy a put option at a given price considering the likely benefit the
option offers to the holder. Of course, in the television example, the value of
the option directly moves with the demand for the product unlike the inverse
relationship between the price of the asset and put option benefit. To know
whether it is worth to carry additional inventory by incurring a cost, the
dealer has to get a distribution of demand with associated probability. The
easiest methodology to decide on this issue is Binomial Option Pricing
Model. If the option value is more than the cost of carrying the inventory,
then the decision is in favour of holding larger inventory. The readers are
advised to consult standard text books on option pricing models to know
more about valuation of options.
Frederic C. Scherrhas explained the use of Black-Scholes Option Pricing
Model to resolve inventory problem by relating the impact of various demand
levels on stock prices of the company.

Risk-Adjusted Discounted Cash Flow (DCF) Model: The model requires

the managers to convert the inventory problem into a capital budgeting
problem. Once this is done, it is possible to apply all the techniques that are
used for resolving uncertainty in capital budgeting decisions. We will
continue the television dealer example to show the similarity between the
inventory problem and capital budgeting decisions. Suppose the dealer
decides to hold additional inventory on the expectation that the demand will
be more than 1000 television per month. The additional inventory holding
has a cost and this is similar to the cost incurred for the purchase of
equipment in capital budgeting exercise. The only difference is the inventory
holding cost (cash outflow) is spread overtime whereas in the case of
purchase of equipment, it is normally incurred at the beginning of the project
period. Of course, there are projects, where investment is spread over time.
The project offers certain benefit/cash inflows over the years. The benefit of
176 holding larger inventory is the additional profit if the demand picks up. It
may be a one-time benefit or spread over the period. If you think of oil- Management of
Inventory
drilling as a project, you can see several common features between our
inventory problem and oil-drilling project. In an oil-drilling project, the cash
outflow is incurred over a period, till the pipes reach the oil-bed. Once the oil
is struck, there is no major additional expense and oil starts pouring for
certain period. The project gets cash inflow. The only uncertainty is when we
are going to strike oil and how long the flow will be there. There is no other
way except to develop a probability distribution of the time and oil reserve.
In the same manner, the television dealer also needs to estimate the
probability distribution of future demand. As we have converted our
inventory problem into a normal capital budgeting problem, risk- adjusted
DCF model can be applied to resolve the uncertainty.

The next step in the application of risk-adjusted DCF model is to measure the
cash inflow (profit) under different demand levels. It is also useful to estimate
the cash inflows values for different levels of inventory holding i.e. 1000
units, 1500 units, 2000 units, etc. The cash flows are multiplied by the
respective probability values of demand forecast. The next step is to use the
risk-adjusted discount rate (often, it is cost of capital of the firm derived
using Capital Asset Pricing Model) to get the present value of cash inflows.
The expected value of cash inflows is computed by summing up all the
present values of cash flows for different demand levels. If we repeat this
process for different inventory holdings, then we get a series of expected
values of cash inflows for different inventory holdings. The optimum
inventory holding is the one where the difference between the risk-adjusted
expected value of cash inflows is greater than the risk-adjusted cash outflows
(cost of holding inventory).

Dynamic Inventory Model: In the above two models, we have limited the
scope of uncertainty to expected demand and also restricted the period of
analysis. If we desire to include uncertainty associated with many inventory
variables such as demand, delivery period, interest cost of holding inventory,
storage cost, cost of stock out, etc., we need a complex optimisation model. It
is possible to use simulation technique to include multiple variables, which
are exposed to uncertainty. The model requires identification of uncertain
variables, estimation of probabilities associated with different uncertain
variables and how the variables together affect the cost and benefit of holding
a particular level of inventory. For example, given a delivery period of 30
days, interest cost of 14%, demand of 1500 units per month, and storage cost
of 2% per month, the impact of placing an order quantity of 2000 units with
a reorder level of 500 units on the cost and benefit of holding inventory are to
be estimated. With this set of information, it is possible to simulate a large
number of trials using random numbers. The simulation will give expected
profit or loss estimation for each order quantity and reorder level and you
may select the combination, which offers maximum profit. The decision
making is easier and to an extent reliable because each profit estimation is
based on a large number of simulated trials.

Though we have used finished goods example to explain different models of

uncertainty, it equally applies to raw materials as well as work-in-process. All
the uncertain variables affecting inventory like demand from production 177
Management of centre, interest cost, storage cost, ordering cost, stock out cost, etc. are
Current Assets
common to other types of inventory.

Activity 7.8
i) Why do we need to consider uncertainty in inventory management?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
ii) How do you evaluate the decision of holding additional inventory in an
uncertain environment?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
iii) List down the steps involved in conducting simulation exercise to deal
with uncertainty.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

7.9 EMERGING TRENDS IN INVENTORY

MANAGEMENT
So far, we have assumed that inventory holding is inescapable necessity and
thus finding ways to optimise the inventory holding through several models.
This very basic assumption is questioned that leads to several interesting
alternative inventory management techniques. Two important reasons for
holding raw materials are to avoid price fluctuations and ensure that the delay
in the arrival of materials does not affect the production process. Alternative
strategies to holding raw materials to mitigate the price volatility include
entering into a long-term supply contract at a fixed price or taking up position
in futures market. The objective of ensuring smooth production process can
be achieved by dealing with multiple supply sources, built-in strict penalty
clauses in the purchase orders to compensate the loss sustained for
emergency buying and adopting just-in-time (JIT) system.

178
The reasons for holding inventory in the form of work-in-process are Management of
Inventory
complex production process, economic batch processing upto a stage of
production and insure against sudden breakdown in the manufacturing
process. It is not possible to overcome all the technology related problems but
attempt can be made to bring a new technology that speeds up the production
process or changes the production process. Some of the components can be
outsourced so that there is no need to produce the quantity in bulk to achieve
economies of scale. Another Japanese technique called Kanbans is useful to
cut down the work-in-process since under this system, a production
department produces the required product only when demand is made by the
user system. Investments in plant and machinery and improving maintenance
system would take away the need for holding stocks against sudden
breakdown.

Finished goods inventory is maintained to ensure immediate delivery of the

product. It may be difficult to make customers wait or require them to give an
advanced schedule of consumption for many consumer products. However,
this can be attempted in industrial goods and high value consumer goods.
For example, companies like BPL have a system of taking advance from the
customers to supply television after certain period and customers are suitably
compensated for waiting period. Promoting internet based ordering system
would definitely give a lead time to the manufacturer and thus avoid holding
finished goods inventory. Industrial customers can be motivated to enter into
a long-term purchase order by offering discounts or better credit terms. It is
possible to access the production schedule of the industrial customers on a
continuous basis and produce accordingly. The concepts such as vendor
development, supply chain, etc. are emerging techniques that allow exchange
of information between the suppliers and users with an objective of bringing
down overall cost of inventory and at the same time ensuring smooth
production process.
Many of the concepts we have discussed so far are likely to become outdated
soon if the current growth rate in the information technology is maintained.
The expansion of internet services and e-commerce will definitely create a
new business world in which we may not have shops or malls. Most of the
agencies dealing between customers and producers may not exist. Producers
may also offer product with individual preferences and bargain for a leadtime
to deliver the product. Industrial marketing is also likely to see major changes
and at some point of time JIT, Kanbans, supply-chain, vendor development,
etc. will become basic techniques for businesses. A sure way of tackling
uncertainty is free exchange of information on online basis, which is not only
feasible but will also become a norm in the near future.

Activity 7.9
i) List down some of the alternatives to hold raw material inventory.
……………………………………………………………………………
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179
Management of
Current Assets
7.9 SUMMARY
Inventory, which consists of raw materials, components and other
consumables, work-in-process and finished goods, is an important component
of current assets. There are several factors like nature of industry, availability
of material, technology, business practices, price fluctuation, etc., that
determine the amount of inventory holding. Some of the broad objectives of
holding inventory are ensuring smooth production process, price stability and
immediate delivery to customers.
The inventory holding is also affected by the demand of the customers of
inventory, suppliers and storage facility. Since inventory is like any other
form of assets, holding inventory has a cost. The cost includes opportunity
cost of funds blocked in inventory, storage cost, stock out cost, etc. The
benefits that come from holding inventory should exceed the cost to justify a
particular level of inventory.

Inventory optimising techniques such as EOQ help us to balance the cost and
benefit to achieve a desirable level of inventory. It is not adequate to just
plan for inventory holding. They need to be periodically monitored or
controlled. Techniques such as ABC or VED are useful for continuous
monitoring of inventory. Inventory planning can be done taking into account
the uncertainty associated with inventory variables. Models such as option
pricing model, risk- adjusted DCF model and dynamic inventory model are
useful to handle the problem of uncertainty.

Recent developments in the manufacturing system and adoption of

techniques such as JIT, Kanban, vendor development and supply chain
management have contributed a lot in improving inventory management. The
information sharing within the organisation as well as with the suppliers and
consumers has allowed firms to operate with lower inventory and at the same
time ensuring several objectives of holding inventory. The future is still
exciting because of development in information technology and spread of
internet and e-commerce. These developments allow a direct interaction
between customers and producers and also synchronise material buying,
production and consumption.

7.11 KEY WORDS

Raw materials: These are inputs used in the manufacturing process.
Work-in-progress: Material in the pipe line
Finished Goods: Completed products, ready for sale.
Stores and Spares: Consumables and components used in the manufacturing
process.
Transaction motive: Material kept for running the production process.
Precautionary motive: Material kept for meeting contingency requirements
like Irregular supply, excess demand, etc.

180 Speculative motive: purchasing material to take advantage of rising prices.

Economic ordering quantity: optimum quantity which minimises the costs Management of
Inventory
of inventory.
Buffer stock: also known as safety stock, which is maintained to meet
contingent requirements for material.
Re-order level: The stock level at which a fresh order for stock is made.
This is fixed taking into account leadtime and consumption.
Minimum Level: The stock level below which inventories are not allowed to
deplete
Maximum Level: The stock level, which is the highest in terms of
holding inventory
ABC Analysis: A method of classification of inventory items basing on their
consumption value. It is technique of management by exception.
Option Pricing Model: A mechanism of price determination in contracts
that give the holder a right to acquire or sell certain things at a predetermined
price without any obligation.
Just-in-Time: is an inventory management technique which helps companies
to align raw material supplies with production schedules.
Kanban: is a technique used to limit the pile up of excess inventory in the
production process by putting quantity restrictions at each point.

7.12 SELF ASSESSMENT QUESTIONS

1) Why do firms hold inventory? Illustrate with Examples.

2) Explain different components of an inventory system? Why do the

inventory components vary from firm to firm? Compare your company’s
inventory components with that of some other company but in a different
industry?

3) How do the factors that govern the inventory requirement of a firm that
manufactures goods for direct consumption differ from another firm,
which manufactures intermediary goods for industrial consumption?

4) What are different costs associated with holing inventory? How are they
related?

5) What is Economic Order Quantity? How is it useful for the firms in

inventory management? Under what conditions, EOQ model fails to hold
good?

6) Briefly discuss philosophy of different types of inventory control

systems.
7) How does uncertainty affect inventory management? Explain different
models of inventory management under the condition of uncertainty.

8) If a firm adopts world-class manufacturing system, how does it affect

inventory management?
181
Management of 9) How JIT and Kanbans help to cut-down the inventory in work-in-
Current Assets
process? Will it be possible to implement these techniques in Indian
Environment?

10) Describe the kind of impact the developments in IT is likely to cause on

the inventory management of your industry.

11) The contention is that the ABC analysis is no longer appropriate as the
developments in the IT technology can maintain tight control on all items.
Comment.

12) Do you think that the Japanese Inventory Management Techniques have
any relevance to the Indian Environment?

13) Sun Corporation estimates the monthly requirements of one of its

inventory items to be as 1800 units. The cost of processing the order per
unit is Rs.10.00.

The supplier agrees to offer quantity discounts as follows-

Lot size (Units) Discount (%)

Upto 400 units 0
401-600 6
601-800 9
801-1000 15
Above 1000 20

The lead-time for the supply is found to be 2 days and the company wishes to
keep a safety stock equivalent of 50% of the usage in the lead-time.

a) Find EOQ assuming no discount being offered.

b) Calculate Re-order point (for convenience take one month as 30days).

c) Tabulate various costs incurred taking into account the discount offered
for various order sizes of 1,2,3 to7 orders a month and indicate the EOQ.

11. The ABC Corporation carries Rs 25 million of inventory. The financial

manager is considering whether to recommend a reduction in inventory
and has estimated the impact of lowering inventory from Rs.25 million
to Rs.23 million and to Rs. 21 million on costs and sales. The details are
given below:

Costs/Inventory Level Rs.25mn Rs. 23mn Rs. 21mn

Storage costs 7,50,000 7,25,000 7,10,000
Spoilage costs 4,00,000 3,75,000 3,67,000
Daily sales 1,20,000 1,19,000 1,14,500

182
The company earns a contribution margin of 10% on sales. Would it be Management of
Inventory
profitable for the firm to reduce the inventory from Rs. 25mn to Rs 23mn or
to Rs 21mn.? Work out the possibilities.

12. A manufacturer of cameras has forecasted the demand for a component

as follows:

Month 1 2 3 4 5 6
Demand(units) 100 130 125 200 210 185
Month 7 8 9 10 11 12
Demand(units) 175 190 200 251 270 255

The ordering cost for the component is Rs.50.00 per order. Purchase
price per unit is Rs. 5.00 for a lot size of less than 500 units and Rs. 4.80
for lot size of 500 or more units. The annual carrying cost per unit of
inventory is expected to be 30 percent of the unit purchase price. The
lead-time is expected to be one week. The entire order for the component
is delivered at one time.
The department has three alternatives for ordering. The order quantity
should be equal to – (a) one-month supply, (b) two-month supply,
(c) three-month supply.
Which one of these proposals would you suggest being more economical
on the basis of an annual cost comparison?
13. An engineering unit uses a component at a uniform rate of 900 units per
week. Minimum inventory is 100 units. The cost of placing and receiving
an order is Rs. 200. Purchase price per unit is Rs. 40 per unit. Carrying
cost is 15% of the purchase price per unit. The lead-time is two weeks.

You are required:

a. To ascertain the value of the economic order quantity for the firm.
b. With the use of the data and calculated EOQ as above determine:
xi. Reorder point.
xii. Maximum inventory.
xiii. Average inventory.
xiv. Average number of orders per week.
xv. Average order cost per week.
xvi. Average carrying cost per week.
xvii. Relevant total average cost per week.
xviii. Relevant total average cost per year.
14. ABC company buys an item costing Rs.125 each in lots of 500 boxes
which is a 3 months supply and the ordering cost is Rs.150. The
inventory carrying cost is estimated to be 20% of unit value, what is the
total annual cost of the existing inventory policy? How much money
could be saved by employing EOQ model?
183
Management of 15. The experience of a firm being out of stock is summarized below:
Current Assets
Stock out No. of times
(No. of units) (%)
500 1
400 2
250 3
100 4
50 10
0 80
Stock out costs are estimated to be Rs. 40 per unit and carrying costs per unit
is Rs. 20. Determine the optimum level of Inventory?

7.13 FURTHER READINGS

Brealey, Richard A and Myers Stewart C. Principles of Corporate Finance,
Tata Mc Graw Hill, New Delhi.

Kaen, Fred R., Corporate Finance-Concepts and Policies, Blackwell

Business Publishers, Oxford.

Keith V. Smith, Guide to Working Capital Management, Mc Graw Hill Book

Company, New York.

184
 Management of
Inventory

BLOCK 3
FINANCING OF WORKING CAPITAL

185
Management of
Current Assets BLOCK 3 FINANCING OF WORKING
CAPITAL
The previous block has focused on the management of the components of
working capital. Prudent management implies management of every
constituent in the most efficient manner. Units 4-7 of Block-II provide the
reader with such understanding and also guide him through the relevant
techniques that need to be employed for better management of working
capital. The present block focuses on the theoretical issues governing the
determination and also the practices followed by banks and other financial
institutions.

After estimating the funds needed for working capital purposes of a firm, the
next task is to decide the sources from which such funds are to be raised. As
already noted, Gross Working Capital denotes the total amount of funds
which are required for investment in current assets. A part of such assets is
financed through trade credit which is an autonomous source of finance. Rest
of the current assets are financed through other sources both short term and
long term. The permanent portion of the working capital always remains
blocked up in business and hence must be financed from long term sources
like share capital, debentures and term loans. This is the reason why a part of
the permanent Working Capital is included in the cost of the project as
margin money for working capital and is raised from long term sources.

Unit -8 attempt to highlight the theories and approaches to working capital

management. It also discusses the impact of different choices of investment
and financing on working capital policy. Unit-9 deals with the payables
management. It explains the significance of payables as a source of finance.
The unit also makes an incisive analysis of the nature of trade credit, its
determinants and costs. Normally, trade credit is considered spontaneous
financing. But it carries with it several other costs, if not tackled properly.
Finally, it also deals with the methods of effective management of payables.
Unit-10 discusses the basic concepts and practices relating to borrowings
from banks, as they prevail in India. It also deals with the methods of
assessment of working capital needs which are adopted by banks and other
related methods. The concluding unit of this block (unit-11) highlights other
sources of short term finance used to finance the working capital needs of a
firm.

186
 Theories and
UNIT 8 THEORIES AND APPROACHES Approaches

Objectives
The objectives of this unit are:
• To provide you an understanding as to the policy making in the area
of working capital management.
• To examine the different approaches to working capital management.
• To highlight the impact of different choices of investment and financing on
working capital policy.

Structure
8.1 Introduction
8.2 Creation of Value through Working Capital Management
8.3 Approaches to Working Capital Investment
8.4 Approach to Financing Working Capital
8.5 Effect of Choice of Financing on ROI
8.6 Summary
8.7 Key Words
8.8 Self-Assessment Questions
8.9 Further Readings

8.1 INTRODUCTION
In the previous two Blocks, we have discussed about the concept of
Working Capital and various methods for determining working capital
requirements and the management of various components. The present block
focuses on the theoretical issues governing the determination and also the
practices followed by banks and other financial institutions. This is
expected to help the student come closer to the reality. There has been little
difficulty in segregating the issues under this block into individual units due
to their overlapping content. Therefore, an attempt has been made in this
unit to cover all those issues that could not be covered under the earlier
Blocks, yet focusing on the theme of the present Block. As you could
observe from the structure of the lesson presented above, enough care has
been taken to include only pertinent matters in the discussion that follows.
Major concentration has been on the following:
a) What is the objective function in taking working capital decisions?
b) How to create value through working capital?
c) Is there any scope to lay down time-tested principles of working
capital policy?
d) How do risk-return relationships operate in the area of working capital
decision making?
187
Financing of
Working Capital
8.2 CREATION OF VALUE THROUGH
WORKING CAPITAL MANAGEMENT
Creation of value has been said to be the objective of a company. In the
realm of finance it turns out to be the function of firm’s investment,
financing and dividend decisions. In addition to long term investment
decisions, companies face many decisions involving investment in current
assets. Quite often, maximisation of profits is regarded as the proper
objective of the firm. but it is not as inclusive as that of maximising
shareholders’ value. A right kind of approach to decisions of investment
and financing of working capital can contribute to the achievement of the
objective function.

Value maximisation is considered consistent with the interests of various

groups that interact with the business. Take for instance shareholders;
businesses can often do what individuals cannot do on their own. Business
houses pool up resources and engage in mass production, which is beyond
the capacity of an individual as shareholder. Perpetual succession ensures
enough confidence to a creditor. The point of view of society is well taken
care of, since there is a realisation on the company that it cannot pursue
profit maximisation as a goal. A framework is thus created for analysing the
financial decisions from the standpoint of maximising value.

Be that as it may, how should one proceed to create value through working
capital management. The answer is: invest in an asset, if its net present
value is positive. The fact is that the basic principles of long term asset
investment decisions should apply equally well to short term asset
investment decisions. Therefore, it is useful to examine this criterion more
closely in terms of current asset investment decisions.
The general formula for finding net present value of a project is:
A1 A2 A3 An
NPV = 1 2 3 ...... n C
1 K 1 K 1 K 1 K

Where A1 to An represent annual cash inflows on an after tax basis. ‘K’ is the
discount factor, which is generally taken as the cost of capital. ‘C’
represents the initial outflow.

This equation can be used to decide the choice of investment in current

assets taking into account their shorter life span. Accepting one year life
as standard to categorise assets into fixed and current, NPV has to be
calculated for each year. For this purpose, the above equation can be
modified as follows to elicit NPV.
A1 A2 A3 An
NPV = ......... C
K K K K

Like the decisions in capital budgeting, the problem remains as that of

determination of risk and thus the appropriate discount rate to apply.

188
Sometimes, practitioners tend to use net profit criterion to decide the Theories and
Approaches
investment in current assets; which they consider is a simple modification of
the concept of NPV as shown below:

r
Net profit per period = Annuity = NPV n
1 1 r

Example 8.1
There is an investment proposal involving Rs.5000 initial investment and
generating Rs.500 per year, so long as we keep the investment intact. The
NPV in this case depends on the discount rate and time period assumed.
We may also calculate an annuity that has a present value equal to the NPV
of above investment using the above equation. Assuming that the discount
rate is 8%. Net profit per period will be Rs.100. See the following
derivation:

r
Net profit per period = Annuity = NPV n
1 1 r

500 500 5000 r

5000 n n n
1 r 1 r 1 r 1 1 r

n
1 1 r r
500 n
r 1 1 r

n r
= – 5000 5000 1 r n
1 1 r

1 1 r
n 1
But r
n
r 1 1 r

r
So Net Profit = 500 – 5000 [1– (1+ r )–n ] n
1 1 r

= 500 – 5000 (r)

= 500 – 5000 (8%)
= 500 – 400 = 100

The Rs. 400 is the annual capital cost of Rs.5,000 investment at an 8 per
cent rate of interest, and the annual net profit of Rs. 100 does not depend
on when the investment is reversed. The result is that we can use net
profit per period as a criterion for choosing among alternative reversible
investments. The investment with the highest value of net profit per period
is also the investment with the highest net present value, regardless of
when the investment is reversed. Investments with positive NPVs will have
positive net profits, investments with zero NPVs will have zero net profits,
and investments with negative NPVs will have negative net profit. Thus, 189
Financing of net profit per period instead of NPV, can be used as a decision criterion
Working Capital
for working capital management.

While the above sounds logical theoretically, in practice, firms are choosing
innovative approaches to create value through current assets management.
For instance, firms are very active in commodity markets to buy raw
materials while they are in full supply. They are not minding the size and cost
of investment in this asset. More so, firms are also adopting risk management
techniques like options, hedging, etc. Like any usual trader in the stock
market, they are watchful of the trends in both stock and commodity markets.
Similarly, idle cash is now intelligently invested in various markets such as
Money Market, Mutual Funds and finally equities. Gone are the days when
companies used to focus on their core activities of operations; they are now
exploring ways to maximize value through every means. Mergers, takeovers
and acquisitions are the best examples of utilizing surplus cash and every
cash-rich firm got benefitted by these choices.

Many current asset decisions, particularly inventory decisions, can be

made on the basis of minimising cost. There also, instead of minimising
the net present value of costs. One may minimise total annual cost where
the annual capital cost of the investment is the discount rate times the
amount invested. In sum the current assets may be treated as reversible
and investment policies may be selected that maximise net profit or
minimise total cost per period. The choice between the profit or cost
criterion will of course depend on the particular problem being analysed.

8.3 APPROACHES TO WORKING CAPITAL

INVESTMENT
Every business enterprise needs to pay particular attention towards the
planning and control of working capital. Different approaches have been
suggested for this purpose. Of them, let us focus our attention on the
following two approaches:
i) Walker’s approach
ii) Trade off approach

8.3.1 Walker’s Approach

Early in 1964 Ernest W. Walker has developed a four-part theory of
working capital. He has laid down that a firm’s profitability is determined
in part by the way its working capital is managed. When the working
capital is varied relative to sales without a corresponding change in
production, the profit position is affected.
If the flow of funds created by the movement of working capital is
interrupted, the turnover of working capital is decreased, as is the rate of
return on investment. In this regard, Walker has laid down the following
four principles with respect to working capital investment.

190
First principle: This is concerned with the relation between the levels of Theories and
Approaches
working capital and sales. His principle is that: if working capital is varied
relative to sales, the amount of risk that a firm assumes is also varied and
the opportunity for gain or loss is increased. This implies that a definite
relation exists between the degree of risk that management assumes and
the rate of return. The more the risk that a firm assumes, the greater is
the opportunity for gain or loss. Consider the following data:

Table 8 .1: XYZ Manufacturing Company

1 2 3
Level of working capital (Rs.) 50,000.00 90,000.00 1,20,000.00
Fixed capital (Rs.) 10,000.00 10,000.00 10,000.00
Liabilities 30,000.00 30,000.00 30,000.00
Net Worth 30,000.00 70,000.00 1,00,000.00
Sales 1,00,000.00 1,00,000.00 1,00,000.00
Fixed Capital Turnover 10.00 10.00 10.00
Working Capital Turnover 2.00 1.1 0.8333
Total Capital Turnover 1.66 1.00 0.761
Earnings (as Percent of Sales) 10.00 10.00 10.00
Rate of Return (Percent) 16.60 10.00 7.60

It can be seen from the data that the return on investment has increased
from 7.6 percent to 16.6 per cent when working capital fell from Rs.
1,20,000 to Rs.50,000. Moreover, it is believed that while the potential gain
resulting from each decrease in working capital is greater in the beginning
than potential loss, exactly opposite occurs, if the management continues to
decrease working capital (see-Figure 8 .1).

Fig. 8.1: Working Capital Relative to Sales

Gain
Rate of Raturn
0
Loss

Decreasing Level of Working Capital per Unit of Sales

191
Financing of It is also presumed that by analysing correctly the factors determining the
Working Capital
amount of the various components of working capital as well as
predictions of the state of the economy, management can determine the
ideal level of working capital that will equilibrate its rate of return with its
ability to assume risk. However, since most managers do not know what
the future holds, they tend to maintain an investment in working capital
that exceeds the ideal level. It is this excess that concerns us, since the
size of the investment determines a firm’s rate of return on investment.

Second principle: Capital should be invested in each component of

working capital as long as the equity position of the firm increases. This
principle is based on the concept that each rupee invested in fixed or
working capital should contribute to the net worth of the firm.

Third principle: The type of capital used to finance working capital

directly affects the amount of risk that a firm assumes as well as the
opportunity for gain or loss and cost of capital. It is indisputable that
different types of capital possess varying degrees of risk. Investors relate the
price for which they are willing to sell their capital to this risk. They may
charge less for debt than equity, since debt capital possesses less risk. Thus
risk is related to the return. Higher risk may imply a higher return too.
Unlike rate of return, cost of capital moves inversely with risk. As
additional risk capital is employed by management, cost of capital declines.
This relationship prevails until the firm’s optimum capital structure is
achieved.
Fourth principle: The greater the disparity between the maturities of a
firm’s short-term debt instruments and its flow of internally generated
funds, the greater the risk and vice-versa. This principle is based on the
analogy that the use of debt is recommended and the amount to be used
is determined by the level of risk, management wishes to assume. It should
be noted that risk is not only associated with the amount of debt used
relative to equity, it is also related to the nature of the contracts negotiated
by the borrower. Some of the more important characteristics of debt
contracts directly affecting a firm’s operation are restrictive clauses of
the contracts and dates of maturity.
Lenders of short-term funds are particularly conscious of this problem, and
in an effort to protect themselves by reducing the risk associated with
improper maturity dates, they are requiring firms to produce documents
depicting cash flows. These documents when properly prepared, not only
show the level of loans necessary to support sales but also indicate when
the loans can be repaid. In other words, lenders realize that a firm’s ability
to repay short-term loans is directly related to cash flow and not to
earnings, and therefore, a firm should make every effort to the maturities
to its flow of internally generated funds.

8.3.2 Trade off Approach

It is evident from the study of Walker’s principles that working capital
decisions involve a trade-off between risk and return. The same is sought
192 to be further examined in this section.
All decisions of the financial manager are assumed to be geared to Theories and
Approaches
maximisation of shareholders wealth, and working capital decisions are no
exception. Accordingly, risk-return trade-off characterises each of the
working capital decision. There are two types of risks inherent in working
capital management, namely, liquidity risk and opportunity loss risk.
Liquidity risk is the non-availability of cash to pay a liability that falls due.
Even though it may happen only on certain days, it can cause, not only a
loss of reputation but also make the work condition unfavourable for
getting the best terms on transaction with the trade creditors. The other risk
involved in working capital management is the risk of opportunity loss i.e.
risk of having too little inventory to maintain production and sales, or the
risk of not granting adequate credit for realising the achievable level of
sales. In other words, it is the risk of not being able to produce more or
sell more or both, and therefore, not being able to earn the potential profit,
because there are not enough funds to support higher inventory and book
debts. Thus, it would not be out of place to mention that it is only theoretical
that the current assets could all take zero values. Indeed, it is neither
practicable nor advisable. In practice, all current assets take positive values,
because firms seek to reduce working capital risks.

As a matter of fact, there are many studies carried out to establish the link
between the profitability (return) and the investment in various components
of working capital (risk factors). In an interesting study conducted by Majid
Imdad Akash and others (2011) examined the risk-return relationships with
the empirical evidence drawn from Textile Sector of Pakistan. The authors
started with a hypothesis that working capital management has effect on
profitability and there exist a tradeoff between risk and return. Through this
study, they found that there existed significant relationship between
profitability and average college period in a negative manner. However, the
study proved that there was positive relationship between profitability and
other variables like: (a) average collection period, (b) inventory turnover in
days, (c) sales, (d) debt to total assets. The regression results of the study had
clearly indicated the strong relationship between profitability and the
important variables of working capital.

In another study, Daniel Kaman and Amos Ayuo (2014) investigated the
relationship between working capital management and organizational
performance among a sample of 13 manufacturing firms in Kenya through
both quantitative and qualitative dimensions found that the working capital
management is negatively correlated with Return on Assets (ROA) and
Return on Equity (ROE), indicating the “R’ values of -0.148 and -0.231
respectively. Likewise, many studies conducted in this area, have clearly
established the fact that there existed a clear tradeoff between the risk and
return.

The risk-return trade-off involved in managing the firm’s liquidity via

investing in marketable securities is illustrated in the following example.
Firms A and B are identical in every respect but one. Firm B has invested
Rs. 5,000 in marketable securities which has been financed with equity. That
is, the firm sold equity shares and raised Rs.5,000.00. The balance sheets
and net incomes of the two firms are shown in Table 8.2. Note that Firm A 193
Financing of has a current ratio of 2.5 (reflecting net working capital of Rs. 15,000)
Working Capital
and earns a 10 percent return on its total assets. Firm B, with its larger
investment in marketable securities has a current ratio of 3 and has net
working capital of Rs. 20,000. Since the marketable securities earn a return
of only 9 percent before taxes (4.5 percent after taxes with a 50 percent
tax rate). Firm B earns only 9.7 percent on its total investment. Thus,
investing in current assets and in particular in marketable securities, does
have a favourable effect on firms liquidity but it also has an unfavourable
effect on the firm's rate of return earned on invested funds. The risk-return
trade-off involved in holding more cash and marketable securities, therefore,
is one of added liquidity versus reduced profitability.

Table 8.2 : The Effects of Investing in Current Assets on Liquidity and

Profitability

Balance Sheets A (Rs.) B (Rs.)

Cash 500 500
Marketable securities 5,000
Accounts receivable 9,500 9,500
Inventories 15,000 15,000
Current assets 25,000 30,000
Net fixed assets 50,000 50,000
Total 75,000 80,000
Current liabilities 10,000 10,000
Long-term debt 15,000 15,000
Capital Equity 50,000 55,000
Total 75,000 80,000
Net Income 7,500 7,725*

Current ratio (Current assets/Current liabilities)

25, 000 30,000
2.5 times 3.0 times
10, 000 10, 000

Net working capital 15,000 20,000

(Current assets – Current liabilities)

Return on total assets (net income/total assets)

7,500 7, 725
10% 9.7%
75, 000 80,000
*During the year Firm B held Rs.5,000 in marketable securities, which earned a 9
percent return or Rs.450 for the year. After paying taxes at a rate of 50 percent, the
firm netted a Rs.225 return on this investment.

Activity 8.1
i) Give points of distinction between the Walker's Approach and Trade
off Approach.
…………………………………………………………………………….
…………………………………………………………………………….
194
 ……………………………………………………………………………. Theories and
Approaches
…………………………………………………………………………….
…………………………………………………………………………….

ii) What do you think are the possible ways by which Value Maximisation
would be possible through Current Assets Management
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

8.4 APPROACH TO FINANCING WORKING

CAPITAL
Financing the firm’s working capital requirements has been shown to involve
simultaneous and inter-related decisions regarding the firm’s investment in
current assets. Fortunately, there exists a principle, which can be used as a
guide to firm’s working capital financing decisions. This is the hedging
principle or matching principle.
Simply speaking, the hedging principle involves matching the cash flow
generating characteristics of an asset with the maturity of the source of
financing used to finance its acquisition. For example, a seasonal expansion
in inventories, according to the hedging principle, should be financed with a
short-term loan or current liability. The rationale underlying the rule is
straight forward. Funds are needed for a limited period of time, and when
that time has passed, the cash needed to repay the loan will be generated
by the sale of the extra inventory items. Obtaining the needed funds from a
long-term source (longer than one year) would mean that the firm would
still have the funds after the inventories (they helped finance) have been
sold. In this case the firm would have “excess” liquidity, which they either
hold in cash or invest in low yielding marketable securities until the
seasonal increase in inventories occurs again and the funds are needed.
This would result in an over-all lowering of firms profits, as we saw
earlier in the example presented in Table 8 .2.

Let us take another example in which a firm purchases a new packing

machine, which is expected to produce cash saving to the firm by
eliminating the need for two labourers and, consequently their salaries.
This amounts to an annual savings of Rs.20,000. While the new machine
costs Rs. 1,00,000 to install and will last 10 years. If the firm chooses to
finance this asset with a one-year loan, then it will not be able to repay
the loan from the cash flow generated by the asset. Hence, in accordance
with the hedging principle, the firm should finance the asset with a source
of financing that more nearly matches the expected life and cash flow
generating characteristics of the asset. In this case a 7 to 10-year loan
would be more appropriate than a one-year loan. 195
Financing of To put it very succinctly the hedging principle states that the firm’s assets
Working Capital
not financed by spontaneous sources should be financed in accordance
with the rule: permanent assets (including permanent working capital
needs) financed with long- term sources and temporary assets (viz.
fluctuating working capital need) with short-term sources of finance towards
the liquidity risk.
We may graphically illustrate the hedging principle as depicted in Figure 8.2A

Figure: 8.2A: Hedging Financing strategy

Note that permanent asset needs are matched exactly with spontaneous plus long-term
sources of financing while temporary current assets are financed with short-term sources
of financing.

This may be termed as hedging financing strategy. In practice we may

come across certain modifications of this strict hedging strategy. Figure
8 .2B and 8.2Cdepict two modifications.

Figure 8.2B: Conservative financing strategy: Long term financing exceeds permanent assets

Shaded area represents the firm’s use of long-term plus spontaneous financing in excess
of the firm’s permanent asset financing needs.

196
 Theories and
Approaches

Figure 8.2 C: Aggressive Financing strategy: Permanent Reliance on Short Term

Financing

Shaded area reflects the firm’s continuous use of short-term financing to support its
permanent asset needs.

In Figure 8.2 B the firm follows a more cautious plan, whereby long-term
sources of financing exceed permanent assets in trough period such that
excess cash is available (which must be invested in marketable securities).
Note that the firm actually has excess liquidity during the low ebb of its
asset cycle and thus faces a lower risk of being caught short of cash than a
firm that follows the pure hedging approach. However, the firm also
increases its investment in relatively low-yielding assets such that its return
on investment is diminished.

In contrast, Figure 8.2 C depicts a firm that continually finances a part of its
permanent asset needs with short term funds and thus follows a more
aggressive strategy in managing its working capital. It can be seen that even
when its investment in asset needs is lowest the firm must still rely on
short-term financing. Such a firm would be subjected to increased risks of
cash shortfall, in that it must depend on a continual rollover or
replacement of its short-term debt with more short-term debt. The benefit
derived from following such a policy relates to the possible savings
resulting from the use of lower-cost short-term debt as opposed to long-
term debt.

Most firms will not exclusively follow any one of the three strategies outlined
above in determining their reliance on short-term credit. Instead, a firm will
at times find itself overly reliant on long term financing and thus holding
excess cash and at other times it may have to rely on short-term financing
throughout an entire operating cycle. The hedging principle does, however;
provide an important guide regarding the appropriate use of short-term credit
for working capital financing.

Going by the trends in the interest rate structure prevailing in the money and
capital markets, the distinction between short-term and long-term finance
seems rarely relevant. Take for instance, the State Bank of India offers 5.20
per cent on a Fixed Deposits of 1-2 years (as on 30-04-2022); whereas it
offers just 5.40 per cent on a deposit made for the duration between 5 and 10
years. See how thin the margin between short-term and long-term finance.
197
Financing of Same is true in case of many other banks; excepting the fact that private
Working Capital
banks offering little higher rates over PSBs. Whereas the yield on
Government Securities per year stood at 6.779 per cent over the period
between May 1996 and January 2019; as per the data compiled by Census
and Economic Information Center. And whereas, Money Market instruments
like Treasury Bills are yielding 4.41 per cent on an average (2021-22 data),
Long-term Government Bonds (of 5 – 10 years) also are yielding about 4.81
per cent. These examples clearly indicate that the divergence between short
and long has become very thin and fading.

8.5 EFFECT OF CHOICE OF FINANCING ON

ROI
It would be now pertinent to examine the impact of the choice of financing on,
return on investment. Consider the following Data in Table-8.3

Table 8 .3: Effect of choice of financing on ROI

Balance Sheet Firm X Firm Y

Rs. Rs.
Current Assets 40,000 40,000
Fixed Assets 80,000 80,000
Total Assets 1,20,000 1,20,000
Accounts payable 10,000 10,000
Bank credit (10%) 0 30,000
Current liabilities 10,000 40,000
Long Term Debt (16%) 30,000 0
Equity 80,000 80,000
Total Liabilities 1,20,000 1,20,000

Income Statement Firm X Firm Y

Net operating Income (EBIT) 64,800 64,800
Less Interest 4,800 3,000
Taxable Income 60,000 61,800
Taxes @ 50% 30,000 30,900
PAT (Net Income) 30,000 30,900
Measures of Liquidity
(a) Current Ratio 4:1 1:1
(b) Net working capital 30,000 0
Measures of profitability
(a) ROl 37.5% 38.6%
(b) EPS Rs 3.00 Rs 3.09

198
It is evident from the data contained in Table 8.3 that the Firm (X) using Theories and
Approaches
long term debt has a current ratio of 4 times and Rs.30,000 in net working
capital, whereas Firm Y’s current ratio is only 1 time, which represents
zero net working capital. Because of lower interest rates on short-term debt
(bank credit in this case) Firm ‘Y’ was able to earn a ROI of 38.6
percent compared to that of ‘X’, which could earn only 37.5 percent. Thus
a firm can reduce its risk of illiquidity through the use of long term debt
at the expense of a reduction of its return on investment funds. Once again
we see that the risk-return trade-off involves an increased risk of illiquidity
versus increased profitability.

8.6 SUMMARY
It has been noted in this unit that value is created by virtue of investment
in both fixed and current assets. It is also found that the same criterion of
selection of projects used for fixed investment holds good for investments
in working capital; though the inter-related nature of current assets and
current liabilities makes the job of managing working capital difficult. To
attain this objective function, different approaches have been suggested. The
early contribution of Walker is found to be of immense use in this regard.
The principles laid down by him need to be tested in practice and
deviations to be examined. It is further highlighted that working capital
decisions involve trade-off between risk and return. This operates within the
investment and financing areas. Different approaches have been examined
in this unit with suitable examples to highlight the impact of the variables
on the working capital decision-making. Against these theoretical
foundations, the students are expected to compare the practices followed in
their organisations and enrich the existing knowledge base.

8.7 KEY WORDS

Aggressive financing Strategy: A portion of permanent assets financed
with short-term sources.
Conservative financing strategy: A portion of the temporary assets
financed with long term sources.
Hedging principle: The firm’s assets not financed by spontaneous sources
should be financed in accordance with the rule: permanent assets financed
with long-term sources and temporary assets with short-term sources.
Reversible investment: An investment, the cash flow related to which
could be readily reversed.
Spontaneous finance: Credit, which arises in direct conjunction with the
day-to-day operations of the firm.
Creation of value: The process of maximising the market price of the
company’s common stock. This occurs when the finance manager does
something that shareholder cannot do for themselves.
Net present value: The difference between the present value of inflows
generated by a project minus the initial investment made in that project.
199
Financing of
Working Capital
8.8 SELF-ASSESSMENT QUESTIONS
1) Distinguish between Fixed asset management and current asset
management.
2) How is value created through working capital management?
3) ‘Merely increasing the level of investment in current assets does not
reduce the working capital risks of a firm’ - comment.
4) ‘Working capital, like other financial management decisions involves
risk-return trade-off: yet the same is unique’. Elaborate with suitable
examples.
5) Examine with suitable examples the principles of Walker.
6) Illustrate, using hypothetical data, the risks-return trade-off involved in
current asset investment and financing decisions.
7) Distinguish matching, conservative and aggressive working capital
financing strategies. Under the present capital and money market
conditions, which of these would you recommend to a consumer durable
manufacturing firm? Why? List out your assumptions, if any.
8) The balance sheet of the Cooptex Manufacturing Company is presented
below for the year ended December 31, 2021.
Cooptex Manufacturing Co.
Balance sheet as on Dec. 31, 2021
Current Liabilities Rs 30,000 Net Fixed Assets Rs 50,000
Long-Term Liabilities Rs 20,000 Current Assets:
Equity Capital Rs 50,000 Cash 5,000
Inventories 25,000
Accounts Receivable 20,000 Rs 50,000
1,00,000 1,00,000

During 2003 the firm earned net income after taxes of Rs. 10,000 based
on net sales of Rs.2,00,000.
a) Calculate Cooptex current ratio, net working capital and return on total
assets ratio (net income/total assets) using the above information.
b) The General Manager (Finance) of Cooptex is considering a Plan for
enhancing the firm’s liquidity. The plan involves raising Rs.l0,000 by
issuing equity shares and investing in marketable securities that will
earn 10 percent before taxes and 5 per cent after taxes. Calculate
Cooptex’s current ratio, net working capital and return on total assets
after the plan has been implemented.
(Hint: Net Income will now become Rs 10,000 plus .05 times Rs. 10,000
or Rs 1,05,000)
c) In what manner will the plan proposed in part (b) affect the firm’s
liquidity and profitability? Explain.
9) The manager of farm supply store is evaluating two alternative levels of
investment in sand inventory. A & B. The relevant data for the two
alternatives are shown below:
200
 A B Theories and
Approaches
Average Monthly Investment Rs. 2000 Rs. 4000
Monthly Cash Revenues Rs. 1200 Rs. 1600
Monthly Cash Costs Rs. 400 Rs. 780

The discount rate for the investment is 1 per cent per month. The Income Tax
rate is 40 per cent. In six month’s time, inventories of this item will be
reduced to zero. The Manager expects to realize the amount invested at that
time.
a) Calculate the monthly net profit for the two alternatives.
b) Calculate the net present value for the two alternatives.
c) Which alternative is better? Does it matter whether net profit per month
or net present value is used to decide on the alternative?
Answers:
9 (a): A= Rs. 444 B= Rs. 438
9 (b): A=Rs.2661 B= Rs. 2627

8.9 FURTHER READINGS

1) Hrishikes Bhattacharya, Working Capital Management, Strategies and
Techniques, Prentice Hall.

2) Gup Benton E., Principles of Financial Management, John Wiley &

Sons, New York.
3) Walker, Ernest W., Essentials of Financial Management, Prentice Hall.

4) Weston, Fred J. & Brigham, E.F., Managerial Finance, The Dryden

Oress, Illinois.

201
Financing of
Working Capital UNIT 9 PAYABLES MANAGEMENT

Objectives
The objectives of this unit are to:
• Explain the significance of payables as a source of finance
• Identify the factors that influence the payables quantum and duration
• Highlight the advantages of payable and provide hints for effective
management of payables.

Structure
9.1 Introduction
9.2 Payables: Their Significance
9.3 Types of Trade Credit
9.4 Determinants of Trade Credit
9.5 Cost of Credit
9.6 Advantages of Payables
9.7 Effective Management of Payables
9.8 Summary
9.9 Key Words
9.10 Self-Assessment Questions
9.11 Further Readings

9.1 INTRODUCTION
A substantial part of purchases of goods and services in business are on
credit terms rather than against cash payment. While the supplier of goods
and services tend to perceive credit as a lever for enhancing sales or as a
form of non-price instrument of competition, the buyer tends to look upon it
as a loaning of goods or inventory. The supplier’s credit is referred to as
Accounts Payable, Trade Credit, Trade Bill, Trade Acceptance, Commercial
Draft or Bills Payable depending on the nature of credit provided. The extent
to which this ‘buy-now, pay-later’ facility is provided will depend upon a
variety of factors such as the nature, quality and volume of items to be
purchased, the prevalent practices in the trade, the degree of competition and
the financial status of the parties concerned. Trade credits or Payables
constitute a major segment of current liabilities in many business enterprises.
And they primarily finance inventories which form a major component of
current assets in many cases.

9.2 PAYABLES: THEIR SIGNIFICANCE

Payables constitute a current or short term liability representing the buyer’s
obligation to pay a certain amount on a date in the near future for value of
202
goods or services received. They are short term deferments of cash payments Theories and
Approaches
that the buyer of goods and services is allowed by the seller. Trade credit is
extended in connection with goods purchased for resale or for processing and
resale, and hence excludes consumer credit provided to individuals for
purchasing goods for ultimate use and instalment credit provided for
purchase of equipment for production purposes. Trade credits or payables
serve as non-interest bearing source of funds in most cases. They provide a
spontaneous source of capital that flows in naturally in the course of business
in keeping with established commercial practices or formal understandings.

9.3 TYPES OF TRADE CREDIT

Trade Credits or Payables could be of three types: Open Accounts,
Promissory Notes and Bills Payable.

Open Account or open credit operates as an informal arrangement wherein

the supplier, after satisfying himself about the credit-worthiness of the buyer,
despatches the goods as required by the buyer and sends the invoice with
particulars of quantity despatched, the rate and total price payable and the
payment terms. The buyer records his liability to the supplier in his books of
accounts and this is shown as payables on open account. The buyer is then
expected to meet his obligation on the due date.
The Promissory note is a formal document signed by the buyer promising to
pay the amount to the seller at a fixed or determinable future time. Where the
client fails to meet his obligation as per open credit on the due date, the
supplier may require a formal acknowledgement of debt and a commitment of
payment by a fixed date. The promissory note is thus an instrument of
acknowledgement of debt and a promise to pay. The supplier may even
stipulate an interest payment for the delay involved in payment.

Bills Payable or Commercial Drafts are instruments drawn by the seller and
accepted by the buyer for payment on the expiry of the specified duration. The
bill or draft will indicate the banker to whom the amount is to be paid on the
due date, and the goods will be delivered to the buyer against acceptance of
the bill. The seller may either retain the bill and present it for payment on the
due date or may raise funds immediately thereon by discounting it with the
banker. The buyer will then pay the amount of the bill to the banker on the
due date.

Activity 9 .1.
Try to ascertain from a Finance Manager:

i) What forms of credit is the firm obtaining?

…………………………………………………………………………….
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…………………………………………………………………………….
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……………………………………………………………………………. 203
Financing of ii) Which of these forms is most economical from the purchasing firm’s
Working Capital
point of view and why?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

iii) How does the company organize itself to negotiate effectively with the
suppliers for obtaining the best possible credit terms?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

9.4 DETERMINANTS OF TRADE CREDIT

Size of the Firm
Smaller firms have increasing dependence on trade credit as they find it
difficult to obtain alternative sources of finance as easily as medium or large
sized firms. At the same time, larger firms that are less vulnerable to adverse
turns in business can command prompt credit facility from the supplier, while
smaller firms may find it difficult to sustain credit worthiness during periods
of financial strain and may have reduced access to credit due to weak
financial position.

Industrial Categories
Different categories of industries or Commercial enterprises show varying
degrees of dependence on trade credit. In certain lines of business the
prevailing commercial practices may stipulate purchases against payment in
most cases. Monopoly firms may insist upon Cash on delivery. There could
be instances where the firm’s inventory, turns over every fortnight but the
firm enjoys thirty days credit from suppliers, whereby the trade credit not
only finances the firm’s inventory but also provides part of the operating
funds or additional working capital.

Nature of Product
Products that sell faster or which have higher turnover may need shorter term
credit. Products with slower turnover take longer to generate cash flows and
will need extended credit terms.

Financial Position of Seller

The financial position of the seller will influence the quantities and period of
204 credit he wishes to extend. Financially weak suppliers will have to be strict
and operate on higher credit terms to buyers. Financially stronger suppliers, Theories and
Approaches
on the other hand, can dictate stringent credit terms but may prefer to extend
liberal credit so long as the transactions provide benefits in excess of the
costs of extending credit. They can afford to extend credits to smaller firms
and assume higher risks. Suppliers with working capital crunch will be
willing to offer higher cash discounts to encourage early payments.

Financial Position of the Buyer

Buyer’s creditworthiness is an important factor in determining the credit
quantum and period. It may be logical to expect large buyers not to insist on
extended credit terms from small suppliers with weak bargaining power.
Where goods are supplied on a consignment basis, the supplier provides extra
finance for the merchandise and pays commission to the consignee for the
goods sold. Small retailers are thus enabled to carry much larger levels of
stocks than they will be able to finance by themselves. Slow paying or
delinquent accounts may be compelled to accept stricter credit terms or higher
prices for products, to cover risk.

Terms of Sale
The magnitude of trade credit is influenced by the terms of sale. When a
product is sold, the seller sends the buyer an invoice that specifies the goods
or services, the price, the total amount due and the terms of the sale. These
terms fall into several broad categories according to the net period within
which payment is expected. When the terms of sale are only on cash basis,
there can be two situations, viz., Cash On Delivery (COD) and Cash Before
Delivery (CBD). Under these two situations, the seller does not extend any
credit.

Cash Discount
Cash discount influences the effective length of credit. Failure to take
advantage of the cash discount could result in the buyer using the funds at an
effective rate of interest higher than that of alternative sources of finance
available. By providing cash discounts and inducing good credit risks to pay
within the discount period, the supplier will also save on the costs of
administration connected with keeping records of dues and collecting overdue
accounts.

Degree of Risk
Estimate of credit risk associated with the buyer will indicate what credit
policy is to be adopted. The risk may be with reference to buyer’s financial
standing or with reference to the nature of the business the buyer is in.

Nature and Extent of Competition

Monopoly status facilitates imposition of tight credit term whereas intense
competition will promote the tendency to liberalise credit. Newly established
companies in competitive fields may more readily resort to liberal trade credit
for promoting sales than established firms which are more formal in deciding
on credit policies.
205
Financing of Datings
Working Capital
In seasonal industries, sellers frequently use datings to encourage customers
to place their orders before a heavy selling period. For many consumer
durables, the demand will be of this type. The need for an air-conditioner is
felt in the summer, leading to heavy ordering at a particular point of time.
This has double advantages. For manufacturer, he can schedule production
more conveniently and reduce the inventory levels. Whereas, the buyer has
the advantage of not having to pay for the goods until the peak, of the selling
period. Under this arrangement, credit is extended for a longer period than
normal.

9.5 COST OF CREDIT

Billing methods can vary. The payment of invoices may be stipulated as a
number of days after the date of the invoice or after the receipt of the goods.
In instances of seasonal business, when the supplier wishes to induce
customers to acquire and hold inventories in advance of the peak sales period,
he may resort to dating. The supplier, under this arrangement, extends longer
duration credit to the buyer and allows him to pay for the goods when the
peak period sales pick up. In some cases, a series of despatches effected
during a period, say, a month, are bunched together for invoicing and the
credit term is reckoned from the invoice date.

When the credit does not cover cash discount for early payment, the trade
credit is considered to be a cost free source of financing for the buyer. It is
not uncommon for some of the buyers to delay payments beyond the due
date, thus extending the period of use of costless trade credit.

Trade credit is a built-in source of financing that is normally linked to the

production cycle of the purchasing firm. If payments are made strictly in
accordance with credit terms, trade credit can be regarded as a cost free, non-
discretionary source of financing. But where the buyer takes the privilege of
delaying payment beyond the due date, it assumes the form of discretionary
financing and if this becomes a regular feature resulting in delinquency, trade
credit will cease to be cost free. The supplier may stop credit or may charge a
higher price for the product, to cover the risk.

The supplier may offer cash discount for payment within a specified number
of days after the invoice or after the receipt of goods. Generally such
concessions for expedited settlement are given to select customers on
informal basis. Where the aim is to induce earlier payment wherever possible,
cash discounts are provided for in the credit terms. The quantum of discount
offered will vary for different categories of business and clients.

Cash discount is to be distinguished from the other categories of discount that

may be offered by the seller, namely, the trade discount and the quantity
discount. The trade discount is a reduction from the invoice or list price
offered to the dealer or trader in the channel of distribution. Quantity
discounts are given when purchases are made insizeable lots.

206
When the cash discount is allowed for payment within a specified period, we Theories and
Approaches
can compute the cost of credit. For instance, if 30 days’ credit is offered with
the stipulation of a 2 per cent cash discount for payment within 10 days, it
means that the cost of deferring payment by 20 days is 2 per cent. If payment
is made 20 days earlier than the due date, 2 per cent of the amount due can be
saved, which amounts to an attractive annual saving rate of 36 per cent.
If cash discount is not availed, the effective rate of interest of the funds held
will work out to 36.7 per cent. The interest is Rs. 2 on Rs. 98 for a period of
20 days, and the rate of interest will be:
2/98 × 360/20 = 36.7 per cent.

If 60 days’ credit is extended, with a cash discount of 2 per cent for payment
within 10 days, there is a saving of Rs. 2 for paying 50 days ahead. The
effective rate of interest is 2/98 × 360/50 = 14.7 per cent. For 90 days’ credit,
with 2 per cent cash discount for payment within 10 days, the effective
interest works out to 9.2 per cent. Thus the more liberal the credit terms, the
saving from cash discount declines and so does the effective rate of interest
for using the funds till the due date. If, however, the discounts are not taken
and the settlement is made earlier than the due date, the effective rate of
interest will vary. For a firm that resists from taking the cash discount, its
cost of trade credit declines the longer it is able to delay payment.

The rationale for availing trade credit should be its savings in cost over the
forms of short term financing, its flexibility and convenience. Stretching
trade credit or accounts payable results in two types of costs to the buyer.
One is the cost of cash discount foregone and the other is the consequence of
a poor credit rating.
The contention that there is no explicit cost to trade credit if the payment is
made during the discount period or if the payment is made on the due date
when no cash discount is offered, is not totally tenable. The supplier who is
denied the use of funds during the credit period may bear the cost fully or
pass on part of it to the buyer through higher prices. This will depend on the
nature of demand for the product. If the demand is elastic, the supplier may
opt to bear the cost himself and refrain from charging higher prices to recover
part of it. The buyer should satisfy himself that the burden of trade credit is
not unduly loaded on him through disguised price revisions.

Repeated delinquency and deterioration in credit reputation do involve an

opportunity cost though it is difficult to measure. Some suppliers may be more
tolerant to delayed payments at some times than on other occasions. A policy
of delayed payments is bad business practice and in the long run can prove
very expensive or may even lead to freezing of credit source. Credit
reputation is a precious asset that needs to be preserved with utmost care. The
long run policy should be to avail discounts, if offered, utilize credit periods
to the full and discharge obligations on schedule.

The following formula can be used for determining the effective rate of
return: R = C (360)/D (100-C), where

R = Annual interest rate for the use of funds C = Cash discount 207
Financing of D = Number of extra days the customer has the use of supplier’s funds.
Working Capital
Let us take an illustration.

A firm wants to hold additional inventory but does not have the cash to
finance it. If the credit term is 2 per cent discount for payment within 10 days
with 60 days credit period, and the bank rate is 9 per cent, should the firm
take the discount?

If the discount is not taken by the 10th day, the effective rate of interest on
the funds held and utilized for the remaining 50 days will be:

2/98 × 360/50 = 14.7 per cent.

The bank rate is 9 per cent only. Therefore it is advisable to take the discount
offered, even if it involves utilizing bank borrowing for effecting early
payment for availing the cash discount.

Stretching Accounts Payable

It is normally assumed that the payment to the supplier is made at the end of
due date. However, a firm may postpone payment beyond this period. This
type of postponement is called stretching or Leaning on the trade. The cost of
stretching accounts payable is two fold : the cost of cash discount foregone
and the possible deterioration in the credit rating. If a firm stretches its
payables excessively, so that its payables are significantly delinquent, its credit
rating will suffer. Suppliers will view the firm with apprehension and may
insist on rather strict terms of sale. Although it is difficult to measure, there is
certainly an opportunity cost to a deterioration in the firms quality of
payment.

Activity 9 .2
i) Do the suppliers change their trade credit policy from time to time or are
they consistent irrespective of customer’s shifting fortunes?
…………………………………………………………………………….
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ii) Compare Manufacturing companies against Service Firms in terms of

Credit Policies.
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…………………………………………………………………………….

208
 Theories and
9.6 ADVANTAGES OF PAYABLES Approaches

Easy to obtain
Payable or Trade Credit is readily obtainable, in most cases, without extended
procedural formalities. During periods of credit crunch or paucity of working
capital, trade credit from large suppliers can be a boon to small buyers.

Suppliers assume the risk

Where the suppliers have the advantage of high gross margins on their
products, they would be able to assume greater risks and extend more liberal
credit.

Informality
In trade credit, there is no rigidity in the matter of repayment on scheduled
dates, occasional delays are not frowned upon. It serves as an extendable,
convenient source of unsecured credit.

Continuous Financing
Even as the current dues are paid, fresh credit flows in, as further purchases
are made. It is a continuous source of finance. With a steady credit term and
the expectation of continuous circulation of trade credit-backing up repeat
purchases, trade credit does in effect, operate as long term source.

9.7 EFFECTIVE MANAGEMENT OF PAYABLES

The salient points to be noted on effective management of payables are:

• Negotiate and obtain the most favourable credit terms consistent with the
prevailing commercial practice pertaining to the concerned product line.
• Where cash discount is offered for prompt payment, take advantage of
the offer and derive the savings there from.
• Where cash discount is not provided, settle the payable on its date of
maturity and not earlier. It pays to avail the full credit term.
• Do not stretch payables beyond due date, except in inescapable
situations, as such delays in meeting obligations have adverse effects on
buyer’s credibility and may result in more stringent credit terms, denial of
credit or higher prices on goods and services procured.
• Sustain healthy financial status and a good track record of past dealings
with the supplier so that it would maintain his confidence. The quantum
and the terms of credit are mainly influenced by suppliers’ assessment of
buyer’s financial health and ability to meet maturing obligations promptly.
• In highly competitive situations, suppliers may be willing to stretch credit
limits and period. Assess your bargaining strength and get the best
possible deal.
• Avoid the tendency to divert payables. Maintain the self-liquidating
character of payables and do not use the funds obtained there from for
209
Financing of acquiring fixed assets. Payables are meant to flow through current assets
Working Capital
and speedily get converted into cash through sales for meeting maturing
short term obligations.
• Provide full information to suppliers and concerned credit agencies to
facilitate a frank and fair assessment of financial status and associated
problems. With fuller appreciation of client’s initiatives to honor his
obligations and the occasional financial strains which he might be
subjected to for a variety of reasons, the supplier will be more
considerate and flexible in the matter of credit extension.
• Keep a constant check on incidence of delinquency. Delays in settlement
of payables with reference to due dates can be classified into age groups
to identify delays exceeding one month, two months, three months, etc.
Once overdue payables are given priority of attention for payment, the
delinquencyrate can be minimized or eliminated altogether.
• Managers shall not think that payables management is a back-office
function. In view of the competing uses for materials, advancements in
the technology and the growing significance of Supply Chain
Management (SCM), this function also needs to be viewed as priority.
• Coordination between the Purchase department and Accounts department
is very much necessary.
• In the light of the EFTS and RTGS practices becoming widespread and
moving towards paperless processing, the issue shall be not about
delaying the payments, but it is about effective ‘scheduling of purchase
orders and payments’. Continuous monitoring of suppliers portals may
help schedule them properly and efficiently.
• Finally, it is the command of the company on the Data Flow about
suppliers, shortages, market trends that would greatly contribute in
designing newer and innovative ways in the management of payables.

In an interesting study done on ‘Accounts Payable Optimisation’, the

Institute of Finance and Management (IOFM), Geneva, Switzerland has
identified 17 ways to optimize investment in payables. They are:
• Self-Service Web Portal for vendors.
• Travel & Expense (T&E) Automation.
• Spend Analysis for Vendor Consolidation.
• Electronic Data Interchange (EDI).
• Automated Clearing House (ACH).
• Migrating Suppliers to e-invoicing.
• Document imaging as and when invoices are received (Front-end
processing).
• Automated Workflows for invoice approval.
• Automated workflows for Exceptions handling.
• Automated Data Capture (ADC).
210 • Cash forecasting with payables data.
• Recovery Audits. Theories and
Approaches
• Outsourcing/Off-shoring.
• P-cards (purchasing/procurement cards).
• Evaluated Receipt Settlement (ERS).
• Web Invoicing.
• Dynamic Discounting.

After having surveyed the practices of firms, the study found that the
following three methods are very popular among the companies:
a) Automated Clearing House.
b) P-cards.
c) Document Imaging and e-invoicing.

Advancements in the technology have really changed the way the corporate
affairs are handled across the globe. Many multinational companies like
ABB, Canon, Oracle, etc., are increasingly adopting many of the above
methods.

9.8 SUMMARY
Payables or trade credit is a self liquidating, easy-to-obtain, flexible source of
short term finance. Buyer’s credit reputation, as reflected in evidences of his
willingness and ability to meet maturing obligations will determine the
quantum and period of credit he can command. Factors like competition,
nature of the product and size of the supplier’s firm also influence terms of
credit, besides relevant commercial practices or conventions. It will be
prudent to take advantage of cash discount facilities when available and avoid
over-stretching payables by frequent delays in payments. If good credit
relations are maintained with suppliers, payables can be a ready and
expanding source of short term finance that will correspond to the needs of a
growing firm.

Payables are not altogether cost-free but if managed well, the costs can be
substantially lower than the alternative sources of short term finance.

9.9 KEY WORDS

Accounts Payable: is a liability arising from the purchase of goods or
services on credit.
Trade Acceptance: is a bill or instrument drawn by the seller on the buyer,
the amount which the buyer accepts to pay at an agreed future date.
Promissory Note: is a formal document signed by the buyer promising to
pay the amount thereof to the seller on demand or at a certain future date.
Delinquency: is the failure to meet the obligation on the due date.
Datings: A practice of encouraging buyers to place orders before a heavy
selling period.
211
Financing of Stretching : Postponement of payment beyond due date.
Working Capital

9.9 SELF ASSESSMENT QUESTIONS

1) Why is trade credit used extensively by firms?
2) What are the different forms of trade credit? Explain.
3) Trade credit is regarded as a spontaneous source of short term finance.
Comment.
4) Distinguish between trade discount, quantity discount and cash discount.
5) What are the factors that influence the availability of trade credit?
6) What are the principal advantages of trade credit or payables?
7) Over extension of trade credit is a major factor in the financial difficulties
of most companies that fail. Explain.
8) A company has regularly been obtaining 90 days’ credit, with a cash
discount of 2 per cent for payment within 10 days and has found that it
can let the account slide for an extra 30 days without injuring its credit
rating or losing its source of supply. Will it pay the firm to borrow from a
finance agency at a rate of 7 per cent to take advantage of cash discount?
9) Compute the cost of not availing the following discounts on a purchase of
Rs. 10lakh a year.
a) 2/10, net 30
b) 3/10, net 40
c) 2/5, net 25
d) 1/10, net 46

10) You receive a bill from a supplier with the term 2/15, net 45.

a) If you can borrow funds from your bank at 12% per annum, should
you avail discount?
b) Suppose the terms are 1/5, net 15, and you can borrow at 12%, should
you avail discount?

9.10 FURTHER READINGS

Satish B. Mathur, 2002, Working Capital Management and Control, New
Age International (P) Ltd., New Delhi.

R.M. Srivastava, 1986, Essentials of Business Finance, Himalaya Publishing

House, Bombay (Chapter 20),
Van Horne, James C, 1985, Fundamentals of Financial Management,
Prentice Hall of India, New Delhi.

212
 Bank Credit -
UNIT 10 BANK CREDIT - PRINCIPLES Principles a nd
Practices
AND PRACTICES
Objectives
The objectives of this unit are to explain:
• The basic principles of sound lending
• The style of Credit — their merits and demerits
• The types of security required and the modes of creating charge, and
• The methods of credit investigation

Structure
10.1 Introduction
10.2 Principles of Bank Lending
10.3 Style of Credit
10.4 Classification of Advances According to Security
10.5 Modes of Creating Charge Over Assets
10.6 Secured Advances
10.7 Purchase & Discounting of Bills
10.8 Non Fund Based Facilities
10.9 Credit Worthiness of Borrowers
10.10 Summary
10.11 Key Words
10.12 Self Assessment Questions
10.13 Further Readings

10.1 INTRODUCTION
Bank credit constitutes one of the major sources of Working Capital for trade
and industry. With the growth of banking institutions and the phenomenal
rise in their deposit resources, their importance as the suppliers of Working
Capital has significantly increased. Of the total gross bank credit outstanding
as at the end of February 2022 of Rs.116,27,008 crore, an amount of
Rs.31,35,271 crore is advanced to industry; which included all types of Micro,
Small, Medium and large industries. This works out to around 27.0 per cent. If we
also take into consideration the service industry, wholesale and retail trade
this percentage goes up very significantly to 52.5 per cent. Individually,
service industry alone accounted for about 25.5 per cent of the total gross
bank credit outstanding at Rs.29,66,593 crore. More particularly, there has
been significant rise in the credit towards industry in the recent past. In this
unit, first we shall examine the basic principles of bank credit, followed by a
detailed account of the various types of credit facilities offered by banks and
the securities required by them.
213
Financing of
Working Capital
10.2 PRINCIPLES OF BANK LENDING
While granting loans and advances commercial banks follow the three
cardinal principles of lending. These are the principles of safety, liquidity and
profitability, which have been explained below:
1) Principle of Safety: The most important principle of lending is to ensure
the safety of the funds lent. It means that the borrower repays the
amount of the loan with interest as per the loan contract. The ability to
repay the loan depends upon the borrower’s capacity to pay as well as his
willingness to repay. To ensure the former, the banker depends upon his
tangible assets and the viabilityof his business to earn profits. Borrower’s
willingness depends upon his honesty and character. Banker, therefore,
takes into account both the above mentioned aspects to determine the
credit - worthiness of the borrower and to ensure safety of the funds lent.
2) Principle of Liquidity: Banks mobilize funds through deposits which
are repayable on demand or over short to medium periods. The banker
therefore lends his funds for short period and for Working Capital
purposes. These loans are largely repayable on demand and are granted
on the basis of securities which are easily marketable so that they may
realise their dues by selling the securities.
3) Principle of Profitability: Banks are profit earning institutions. They
lend their funds to earn income out of which they pay interest to
depositors, incur operational expenses and earn profit for distribution to
owners. They charge different rates of interest according to the risk
involved in lending funds to various borrowers. However, they do not
have to sacrifice safety or liquidity forthe sake of higher profitability.
Following the above principles, banks pursue the practice of diversifying
risk by spreading advances over a reasonably wide area, distributed
amongst a good number of customers belonging to different trades and
industries. Loans are not granted for speculative and unproductive
purposes

10.3 STYLE OF CREDIT

Commercial banks provide finance for working capital purposes through a
variety of methods. The main systems or style of credit, prevalent in India are
depicted in the following diagram.
Bank Credit

Loans and advances Discounting of bills

Overdrafts Cash Credit Loans

Short-term Personal Medium & Bridge Composite Others/ including credit cards/
Loans Loans Long-term Loans Loans Education Loans/Housing
Loans, etc.
214
The terms and conditions, the rights and privileges of the borrower and the Bank Credit -
Principles a nd
banker differ in each case. We shall discuss below some of these methods of Practices
granting bank credit.

10.3.1 Overdrafts
This facility is allowed to the current account holders for a short period.
Under this facility, the current account holder is permitted by the banker to
draw from his account more than what stands to his credit. The excess
amount drawn by him is deemed as an advance taken from the bank. Interest
on the exact amount overdrawn by the account-holder is charged for the
period of actual utilisation. The banker may grant such an advance either on
the basis of collateral security or on the personal security of the borrower.
Overdraft facility is granted by a bank on an application made by the
borrower. He is also required to sign a promissory note. Therefore, the
customer is allowed the amount, upto the sanctioned limit of overdraft as and
when he needs it. He is permitted to repay the loan as per his convenience
and ability to do so.

10.3.2 Cash Credit System

Cash Credit System accounts for the major portion of bank credit in India.
Thesalient features of this system are as follows:
1) Under this system, the banker prescribes a limit, called the Cash Credit
limit, upto which the customer- borrower is permitted to borrow against
the securityof tangible assets or guarantees.
2) The banker fixes the Cash Credit limit after considering various aspects
of the working of the borrowing concern i.e production, sales, inventory
levels, past utilisation of such limit, etc.
3) The borrower is permitted to withdraw from his Cash Credit account,
amount as and when he needs them. Surplus funds with him are allowed
to be deposited with the banker any time. The Cash Credit account is
thus a running account, wherein withdrawals and deposits may be made
frequently any number of times.
4) As the borrower withdraws from Cash Credit account he is required to
provide security of tangible assets. A charge is created on the movable
assets of the borrower in favour of the banker.
5) When the borrower repays the borrowed amount in full or in part,
security is released to him in the same proportion in which the amount is
refunded.
6) The banker charges interest on the actual amount utilised by him and for
the actual period of utilisation.
7) Though the advance made under Cash Credit System is repayable on
demand and there is no specific date of repayment, in practice the
advance is rolled over a period of time i.e. the debit balance is hardly
fully wiped out and the loan continues from one period to another.
215
Financing of 8) Under this system, the banker keeps adequate cash balance to meet the
Working Capital
demand of his customers as and when it arises, but interest is charged on
the actual amount of loan availed of. Thus, to neutralize the loss caused
to the banker, the latter imposes a commitment charge at a normal rate of
1% or so, on the unutilised portion of the cash credit limit.

Merits of Cash Credit System

The Cash Credit System has the following merits:
1) The borrower need not keep surplus funds idle with himself. He can
deposit the surplus funds with the banker, reduce his debit balance, and
thus minimise the interest burden. On the other hand he can withdraw
funds at any time to meet his needs.
2) Banks maintain one account for all transactions of a customer. As
documents are required only once in a year the costs of repetitive
documentation is avoided.

Demerits of Cash Credit System

The Cash Credit System, on the other hand, suffers from the following
demerits:
1) Cash Credit limits are prescribed only once in a year and hence they are
fixed keeping in view the maximum amount that can be required within a
year. Consequently, a portion remains unutilised for part of the year
during which bank funds remain unemployed.
2) The banker remains unable to verify the end use of funds borrowed by
the customer. Such funds may be diverted to unapproved purposes.
3) The banker remains unable to plan the utilisation of his funds as the level
of advances depends upon the borrower’s decision to borrow at any time.
4) As the volume of cash transactions increases significantly under the
cash credit system as against the loan system, the cost of handling cash,
honouring cheques, taking and giving delivery of securities increases the
transactions cost of banks.
5) As there is only commitment charge of 1% or less, there will be a
tendency on the part of companies to negotiate for a higher limit.

10.3 LOAN SYSTEM

Under the loan system, a definite amount is lent at a time for a specific period
and a definite purpose. It is withdrawn by the borrower once and interest is
payable for the entire period for which it is granted. It may be repayable in
installments or in lump sum. If the borrower needs funds again, or wants to
renew an existing loan, a fresh proposal is placed before the banker. The
banker will make a fresh decision depending upon the availability of cash
resources. Even if the full loan amount is not utilised the borrower has to pay
the full interest.
216
 Bank Credit -
Advantages of the Loan System Principles a nd
Practices
The loan system has the following advantages over the Cash Credit System:
1) This system imposes greater financial discipline on the borrowers, as
they are bound to repay the entire loan or its installments on the due
date/ dates fixed in advance.
2) At the time of granting a new loan or renewing an existing loan, the
banker reviews the loan account. Thus unsatisfactory loan accounts may
be discontinued at his discretion.
3) As the banker is entitled to charge interest on the entire amount of loan,
his income from interest is higher and his profitability also increases
because of lower transaction cost.

Short Term Loans

Short term loans are granted by banks to meet the Working Capital
requirements of the borrowers. Such loans are usually granted for a period
upto one year and are secured by the tangible movable assets of the borrowers
like goods and commodities, shares, debentures, etc. Such goods and
securities are pledged or hypothecated with the banker.

As we shall study in the next unit. Reserve Bank of India has exercised
compulsion on banks since 1995 to grant 80% of the bank credit permissible
to borrowers with credit of Rs 10 crore or more in the form of short term
loans which may be for various maturities. Reserve Bank has also permitted
the banks to roll over such loans i.e. to renew the loan for another period at
the expiry of the period of the first loan.

As per the Master Circular issued by the Reserve Bank of India on the
‘Management of Advances’ dated April 8, 2022, Banks are free to assess the
working capital requirements of the borrowers either on the basis of turnover
or the old method based on the Tandon Committee methodology. Whatever
be the method followed, borrowers are required to bring in their own
resources to the extent of 5 per cent and the banks share the remaining 20 per
cent. Similarly, the total working capital finance is required to be divided
between Term-loan and cash credit. Of the total amount agreed upon, 80 per
cent should be in the form of Term Loan (WCTM) and the remaining could
be the cash credit portion.

In order to meet the special requirements, Banks may also grant Ad-
hoc/additional credit limits, subject to proper scrutiny and in complete
satisfaction of the requirement. Further banks are permitted to fix separate
lending rates for loan component and cash credit component.

Medium and Long Term Loans

Such loans are generally called ‘Term Loans’ and are granted by banks with
All India Financial Institutions like Industrial Development Bank of India,
Industrial Finance Corporation of India, Industrial Credit and Investment
Corporation of India Ltd. Term loans are granted for medium and long
terms, generally above 3 years and are meant for purchase of capital assets 217
Financing of for the establishment of new units and for expansion or diversification of an
Working Capital
existing unit. At the time of setting up of a new industrial unit, term loans
constitute a part of the project finance which the entrepreneurs are required to
raise from different sources. These loans are usually secured by the tangible
assets like land, building, plant and machinery etc. Banks now have the
discretion to sanction term loans to all projects within the overall ceiling of
the prudential exposure norms prescribed by Reserve bank. The period of
term loans will also be decided by banks themselves.

Though term loans are meant for meeting the project cost but as project cost
includes margin for Working Capital , a part of term loans essentially goes to
meet the needs of Working Capital.

Bridge Loans
Bridge loans also called swing loans, interim funding, gap financing, are in fact
short term loans which are granted to industrial undertakings to enable them
to meet their urgent and essential needs. Such loans are granted under the
following circumstances:
1) When a term loan has been sanctioned by banks and/ or financial
institutions, but its actual disbursement will take time as necessary
formalities are yet to be completed.
2) When the company is taking necessary steps to raise the funds from the
Capital market by issue of equities/debt instruments.

Bridge loans are provided by banks or by the financial institutions which

have granted term loans. Such loans are automatically repaid out of the
amount of term loan when it is disbursed or out of the funds raised from the
Capital Market.
Reserve Bank of India has allowed the banks to grant such loans within the
ceiling of 5% of incremental deposits of the previous year prescribed for
individual banks’ investment in Shares/ Convertible debentures. Bridge loans
may be granted for a maximum period of one year. Normally, the interest
rates on these loans are high.

Composite Loans
Composite loans are those loans which are granted for both, investment in
capital assets as well as for working capital purposes. Such loans are usually
granted to small borrowers, such as artisans, farmers, small industries etc.
Under the composite loan scheme, both term loans and Working Capital are
provided through a single window. The limit for composite loans has been
increased from Rs.10 lakh to Rs.1.00 crore now for MSME units. These
loans are sanctioned to encourage small borrowers to meet all kinds of
requirements and make the loans sanction process hassle-free.

Cluster Financing:
Cluster based financing is devised by the banks to provide a full service
approach to cater to the diverse needs of small borrowers. This approach is
218 said to help in: (a) dealing with well defined and recognized groups,
(b) information risk management; (c) feedback mechanism, and (d) cost Bank Credit -
Principles a nd
reduction. The Government of India has been advising Banks to adopt at least Practices
one cluster on each district.

Personal Loans
These loans are granted by banks to individuals specially the salary-earners
and others with regular income, to purchase consumer durable goods like
refrigerators, T.V.s, cars etc. Personal loans are also granted for
purchase/construction of houses. Generally the amount of loans is fixed as a
multiple of the borrower’s income and a repayment schedule is prepared as
per his capacity to save.

Activity 1 0 .1
i) What are the Basic Principles that guide banks in lending?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) What is meant by Bridge Loan? What is the necessity for granting such
loans?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

iii) Have an informal chat with a Bank Manager and try to understand the
merits and demerits of various types of loans sanctioned by him/her.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

10.4 CLASSIFICATION OF ADVANCES

ACCORDING TO SECURITY
Banks attach great importance to the safety of the funds, lent as loans and
advances. For this purpose, they ask the borrowers to create a charge on their
tangible assets in their favour. In some cases, the banks secure their interest
by asking for a guarantee given by a third party. Besides the tangible assets
or a guarantee, banks rely upon the personal security of the borrower and
grant loans which are called unsecured advances’ or ‘clean loans’. In the
219
Financing of balance sheet, banks classify advances as follows:
Working Capital
Advances

Secured by Covered by Unsecured

Tangible Bank /Govt.
Assets Guarantees

Secured Advances
According to Banking Regulation Act 1949, a secured loan or advance means
“a loan or advance made on the security of assets, the market value of which
is not at any time less than the amount of such loan or advances”. An
unsecured loan or advance means a loan or advance not so secured.
The main features of a secured loan are:

• The advance is made on the basis of security of tangible assets like goods
and commodities, life insurance policies, corporate and government
securities etc.

• A charge is created on such security in favour of the banker.

• The market value of such security is not less than the amount of loan. If
the former is less than the latter, it becomes a partly secured loan.

Unsecured Advances
Unsecured advances are granted without asking the borrower to create a
charge on his assets in favour of the banker. In such cases the security
happens to be the personal obligation of the borrower regarding repayment of
the loan. Such loans are granted to parties enjoying high reputation and sound
financial position.

The legal status of the banker in case of a secured advance is that of a

secured creditor. He possesses absolute right to recover his dues from the
borrower out of the sale proceeds of the assets over which a charge is created
in his favour. In case of an unsecured advance, a banker remains an
unsecured creditor and stand at par with other unsecured creditors of the
borrower, if the latter defaults.

Guaranteed Advances
The banker often safeguards his interest by asking the borrower to provide a
guarantee by a third party may be an individual, a bank or Government.
According to the Indian Contract Act, 1872, a contract of guarantee is
defined as “a contract to perform the promise or discharge the liability of
third person is case of his default”. The person who undertakes this
obligation to discharge the liability of another person is called the guarantor
or the surety. Thus a guaranted advance is, in fact, also an unsecured
advance i.e. without any specific charge being created on any asset, in
220
favour of the banker. A guarantee carries a personal security of two persons Bank Credit -
Principles a nd
i.e. the principal debtor and the surety to perform the promise of the Practices
principal debtor. If the latter fails to fulfill his promise, liability of the surety
arises immediately and automatically. The surety therefore, must be a reliable
person considered good for the amount for which he has stood as surety. The
guarantee given by banks, financial institutions and the government are
therefore considered valuable.

10.5 MODES OF CREATING CHARGE

OVER ASSETS
As we have noted above, in case of secured advance, a charge is created
over an asset of the borrower in favour of the lender. By creation of charge it
is meant that the banker gets certain rights in the tangible assets of the
borrower. The borrower still remains the owner of the asset, but the banker
gets the right of realizing his dues out of the sale proceeds of the asset. Thus
banker’s interest is safeguarded.
There are several methods of creating charge over the borrower’s assets as
shown below:

Modes of creating charge

Pledge Hypothecation Mortgage Lien Assignment

10.5.1 Pledge
Pledge is the most popular method of creating charge over the movable
assets. Indian Contract Act, 1872, defines pledge as ‘bailment of goods as
security of payment of a debt or performance of a promise”. The person
who offers the security is called the pledger and the person to whom the
goods are entrusted is called the ‘pledgee’. Thus bailment of goods is the
essence of a pledge. Indian Contract Act defines bailment as “delivery of
goods from one person to another for some purpose upon the contract that the
goods be returned back when the purpose is accomplished or otherwise
disposed of according to the instructions of the bailor”.
Thus when the borrower pledges his goods with the banker, he delivers the
goods to the banker to be retained by him as security for the amount of the
loan. Delivery of goods may be either (i) physical delivery or (ii) constructive
or symbolic delivery. The latter does not involve physical delivery of the
goods. The handing over of the keys of the godown storing the goods, or even
handing over the documents of the title to goods like warehouse receipts, duly
endorsed in favour of the banker amounts to constructive delivery.

It is also essential that the banker must return the same goods to the borrower
after he repays the amount of loan along with interest and other charges. The
pledgee (banker) is entitled to certain rights, which are conferred upon him
221
Financing of by the Indian Contract Act. The foremost right is that he can retain the goods
Working Capital
pledged for the payment of debt and interest and other charges payable by
the borrower. In case the pledger defaults, the pledgee has the right to sell the
goods after giving pledger reasonable notice of sale or to file a suit for the
amount due from him.

10.5.2 Hypothecation
Hypothecation is another method of creating charge over the movable assets
of the borrower. It is preferred in circumstances in which transfer of
possession over such assets is either inconvenient or is impracticable. For
example, if the borrower wants to borrow on the security of raw materials or
goods in process, which are to be converted into finished products, transfer of
possession is not possible/practicable because his business will be impeded in
case of such transfer. Similarly a transporter needs the vehicle for plying on
the road and hence cannot give its possession to the banker for taking a loan.
In such circumstances a charge is created by way of hypothecation.

Under hypothecation, neither ownership nor possession over the asset is

transferred to the creditor. Only an equitable charge is created in favour of
the banker. The asset remains in the possession of the borrower who
promises to give possession thereof to the banker, whenever the latter
requires him to do so. The charge of hypothecation is thus converted into that
of a pledge. The banker enjoys the rights and powers of a pledgee. The
borrower uses the asset in any manner he likes, viz he may take out the stock,
sell it and replenish it by a new one. Thus a charge is created on the movable
asset of the borrower. The borrower is deemed to hold possession over the
goods as an agent of the creditor. To enforce the security, the banker should
take possession of the hypothecated asset on his own or through the court.

10.5.3 Mortgage
A charge on immovable property like land & building is created by means of
a mortgage. Transfer of Property Act 1882 defines mortgage as” the
transfer of an interest in specific immovable property for the purpose of
securing the payment of money, advanced or to be advanced by way of
loan, an existing or future debt or the performance of an engagement
which give rise to a pecuniary liability”. The transferor is called the
‘mortgagor’ and the transferee ‘mortgagee’.

The owner transfers some of the rights of ownership to the mortgagee and
retains the remaining with himself. The object of transfer of interest in the
property must be to secure a loan or to ensure the performance of an
engagement which results in monetary obligation. It is not necessary that
actual possession of the property be passed on to the mortgagee. The
mortgagee, however, gets the right to recover the amount of the loan out of
the sale proceeds of the mortgaged property. The mortgagor gets back the
interest in the mortgaged property on repayment of the amount of the loan
along with interest and other charges.

222
 Bank Credit -
Kinds of Mortgages Principles a nd
Practices
Though Transfer of Property Act specifies seven kinds of mortgages, but
from the point of view of transfer of title to the mortgaged property,
mortgages are divided into-
a) Legal mortgages and
b) Equitable mortgages
In case of Legal Mortgage, the mortgagor transfers legal title to the property
in favour of the mortgagee by executing the Mortgage deed. When the
mortgage money is repaid, the legal title to the mortgaged property is re-
transferred to the mortgagor. Thus in this type of mortgage, expenses are
incurred in the form of stamp duty and registration charges.
In case of an equitable mortgage the mortgagor hands over the documents of
title to the property to the mortgagee and thus creates an equitable interest of
the mortgagee in the mortgaged property. The legal title to the property is not
passed on to the mortgagee but the mortgagor undertakes through a
Memorandum of Deposit to execute a legal mortgage in case he fails to pay
the mortgaged money. In such situation the mortgagee is empowered to apply
to the court to convert the equitable mortgage into legal mortgage.
Equitable Mortgage has several advantages over Legal Mortgage. It is not
necessary to register the Memorandum of Deposit or the covering letter sent
along with the Documents of title. Actual handing over by a borrower to the
lender of documents of title to immovable property with the intention to
constitute them as security is sufficient. As registration is not mandatory,
information regarding mortgage remains confidential and the mortgagor’s
reputation is not affected. When the debt is repaid documents are returned
back to the borrower, who may re-deposit the same for taking another loan
against the same documents. But the banker should be very careful in
retaining the documents in his possession, because if the equitable mortgagee
is negligent or mis-represents to another person, who advances money on the
security of the mortgaged property, the right of the latter will have first
priority.

10.5.4 Assignment
The borrower may provide security to the banker by assigning any of his
rights, properties or debts to the banker. The transferor is called the
‘assignor’ and the transferee the ‘assignee’. The borrowers generally assign
the actionable claims to the banker under section 130 of the Transfer of
Property Act 1882. Actionable claim is defined as a claim to any debt, other
than a debt secured by mortgage of immovable property or by hypothecation
or pledge of movable property or to any beneficial interest in movable
property not in the possession of the claimant.

A borrower may assign to the banker (i) the book debts, (ii) money due from
a government department or semi-government organisation and (iii) life
insurance policies.

Assignment may be either a legal assignment or an equitable assignment. In

case of legal assignment, there is absolute transfer of actionable claim which
must be in writing. The debtor of the assignor is informed about the 223
Financing of assignment. In the absence of the above the assignment is called equitable
Working Capital
assignment.

10.5.5 Lien
The Indian Contract Act confers upon the banker the right of general lien.
The banker is empowered to retain all securities of the customer, in respect of
the general balance due from him. The banker gets the right to retain the
securities handed over to him in his capacity as a banker till his dues are paid
by the borrower. It is deemed as implied pledge.

Activity 10.2
i) Distinguish between a secured advance and a guaranteed advance.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
ii) Distinguish between pledge and hypothecation. Which provides better
securityto the banker and why?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

iii) What do you understand by Equitable Mortgage? What are its

advantages vis-a-vis legal mortgage?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

10.6 SECURED ADVANCES

Secured advances account for significant portion of total advances granted by
banks. As we have seen, in case of secured advances, a charge is created on
the assets of the borrowers in favour of the banker, which enables him to
realise his dues out of the sale proceeds of the assets. Banks grant advances
against a variety of assets as shown below:
224
 Bank Credit -
Securities for Advances Principles a nd
Practices

Goods & Documents Real Estates Book Supply

Commodities Debts Bills

Documents of Stock Exchange Life Insurance Fixed Deposit

Title to goods Securities Policies Receipts

Let us first study the general principle of secured advances:

1) Marketability of Securities: The banker grants advances on the basis of
those securities which are easily marketable without loss of time and
money, because in case of non-payment by the borrower, the banker
shall have to dispose off the security to realise his dues.
2) Adequacy of Margin : Banker also maintains a difference between the
value of the security and the amount lent. This is called ‘margin’.
Suppose a banker grants a loan of Rs. 100 /- on the security valued at Rs.
200/- the difference between the two (i.e. Rs. 200 - Rs. 100 = Rs. 100) is
called margin. Margin is necessary to safeguard the interest of the
banker as the market value of the security may fall in future and /or
interest and other charges become payable by the borrower, thus
increasing the liability of the borrower towards the banker. Different
margins are prescribed in case of different securities.
3) Documentation: Banker also requires the borrower to execute the
necessary documents e.g. Agreement of pledge, Mortgage Deed,
Promissory notes etc. to safeguard his interest.
Goods and Commodities
Bulk of the advances granted by banks are secured by goods and
commodities, raw material and finished goods etc., which constitute the
stock-in-trade of business houses. However, agricultural commodities are
likely to deteriorate in quality over a period of time. Hence banks grant short
term loans only against such commodities. The problem of valuation of stock
pledged with the bank is not a difficult one, as daily quotations are easily
available. Banker usually prefers those commodities which have steady
demand and a wider market. Such goods are required to be insured against
fire and other risks. Such goods either pledged or hypothecated to the banker
are released to the borrower in proportion to the amount of loan repaid.

Agro-based commodities such as food grains, sugar, pulses, oilseeds, cotton

are sensitive to the market forces of demand and supply, and prices. As our
country has faced seasonal shortages in several of these commodities, the
Reserve Bank of India under the authority vested in it by the Banking
Regulation Act, issues directives known as Selective Credit Control (SCC) to
scheduled commercial banks during the commencement of each busy season
which is, in practical terms, the commencement of the Kharif or the Rabi
season each year. In order to ensure that speculation in these sensitive
commodities does not take place, the Reserve Bank of India in its busy 225
Financing of season policy issues direction to control the credit for commodities by:
Working Capital
Fixing an overall ceiling for credit to sensitive commodities for each bank as
whole. For example, total credit against these commodities in a particular year
may be restricted to 80% of the previous year’s level;

i) Fixing margins and rates of interest that can be levied by banks in their
credit against the selected commodities; and
ii) Banning the flow of bank credit towards financing one or more of these
selected commodities.

Each bank takes into consideration the RBI’s policy on selective credit control
while determining its own credit policy. The Head Offices of banks advise
their branches on the terms and conditions applicable to SCC commodities.

Documents of Title to Goods

These documents represent actual goods in the possession of some other
person. Hence, they are proof of possession or control over the goods. For
example, warehouse receipts, railway receipts, Bill of lading etc. are
documents of title to goods. When the owner of goods represented by these
documents wants to take a loan from the banker, he endorses such documents
in favour of the banker and delivers them to him. The banker is thus entitled
to receive the delivery of such goods, if the advance is not repaid. However,
there remains the risk of forgery in such documents and dishonesty on the
part of the borrower.

Stock Exchange Securities

Stock Exchange Securities comprise of the securities issued by the Central
and State governments, semi-govt. organisations, like Port Trust &
Improvement Trust, Shares and Debentures of companies and Units of the
Mutual Funds listed on the Stock Exchanges. The Govt. securities are
accepted by banks because of their easy liquidity, stability in prices, regular
accrual of income and easy transferability.

In case of corporate securities banks prefer debentures of companies vis-à-

vis shares because the debenture holder generally happens to be secured
creditor and there is a contractual obligation on the company to pay interest
thereon regularly. Amongst the shares, banks prefer preference shares,
because of the preferential rights enjoyed by the preference shareholders
over equity shareholders. Banks accept equity shares of those companies
which they approve after thorough screening and examination of all aspects
of their working. A charge over such securities is created in favour of the
banker.

Reserve Bank of India has permitted the banks to grant advances against
shares to individuals upto Rs. 20 lakhs w.e.f. April 29, 1998 if the advances
are secured by dematerialized Securities. The minimum margin against such
dematerialized shares was also reduced to 25%. Advances can also be
granted to investment companies, shares & stock brokers, after making a
careful assessment of their requirements.
226
 Bank Credit -
Life Insurance Policies Principles a nd
Practices
A life insurance policy is considered a suitable security by a banker as
repayment of loan is ensured to the banker either at the time policy matures
or at the time of death of the insured. Moreover, the policy has a surrender
value which is paid by the insurance company, if the policy is discontinued
after a minimum period has lapsed. The policy can be legally assigned to the
banker and the assignment may be registered in the books of the insurance
company. Banks prefer endowment policies as compared to the whole life
policies and insist that the premium is paid regularly by the insured.
Fixed Deposit Receipts
A Fixed Deposit Receipt issued by the same bank is the safest security for
granting an advance because the receipt represents a debt due from the
banker to the customer. At the time of taking a loan against fixed deposit
receipt the depositor hands over the receipt to the banker duly discharged,
along with a memorandum of pledge. The banker is thus authorised by the
depositor to appropriate the amount of the FDR towards the repayment of
loan taken from the banker.
Real Estate
Real Estate i.e immovable property like land and building are generally not
regarded suitable security for granting loans for working capital. It is difficult
to ascertain that the legal title of the owner is free from any encumbrance.
Moreover, their valuation is a difficult task and they are not readily realizable
assets. Preparation of mortgage deed and its registration takes time and is
expensive also. Real Estates are, therefore, taken as security for term loans
only.
Book Debts
Sometimes the debts which the borrower has to realise from his debtors are
assigned to the banker in order to secure a loan taken from the banker. Such
debts have either become due or will accrue due in the near future. The
assignor must execute an instrument in writing for this purpose, clearly
expressing his intention to pass on his interest in the debt to the assigner
(banker). He may also pass an order to his debtor to pay the assigned debt to
the banker.

Supply Bills
Banks also grant advance on the security of supply bills. These bills are
offered as security by persons who supply goods, articles or materials to
various Govt. departments, semi-govt bodies and companies, and by the
contractors who undertake government contract work. After the goods are
supplied by the suppliers to the govt. department and s/he obtains an
inspection note or Receipted Challan from the Department, s/he prepares a
bill for the goods supplied and gives it to the bank for collection and seeks an
advance against such supply bills. Such bills are paid by the purchaser at the
expiry of the stipulated period.

Security for bank credit could be in the form of a direct security or an indirect
security. Direct security includes the stocks and receivables of the customers 227
Financing of on which a charge is created by the bank through various security documents.
Working Capital
If in the view of the bank, the primary or direct security is not considered
adequate or is risk- prone, that is, subject to heavy fluctuations in prices,
quality etc. the bank may require additional security either from the customer
or from a third party on behalf of the customer. The additional security so
obtained is known as Indirect or “Collateral Security”. The term collateral
means running parallel or together and collateral security is an additional and
separate security for repayment of money borrowed.

In case the customer is unable to provide additional security when required

by the bank, he may be required to provide collateral security from a third
party. The common form of the third party collateral security is a guarantee
given by a person on behalf of the customer to the bank. The third party
collateral security in turn may be unsecured or secured. For example, where
the guarantor has executed a guarantee agreement only. The collateral
security is unsecured. However, if he lodges along with the guarantee
agreement, security such as title deeds to his property creating mortgage by
deposit of title deeds with the bank, a secured collateral security is created.

10.7 PURCHASE AND DISCOUNTING OF BILLS

Purchase and discounting of bills of exchange is another way banks provide
credit to business entities. Bills of exchange and promissory notes are
negotiable instruments which arise out of commercial transactions both in
inland trade and foreign trade and enable the debtors to discharge their
obligations towards their creditors.
On the basis of maturity period, bills are classified into (i) demand bills and
(ii) usance bills. When a bill is payable ‘at sight’ ‘on demand’ or on
presentment, it is called a demand bill. If it matures for payment after a
certain period of time say 30, 60, 90 days, after date or sight, it is called a
usance bill. No stamp duty is required in case of demand bills and on usance
bills, if they (i) arise out of the bonafide commercial transactions , (ii) are
payable not more than 3 months after date or sight and (iii) are drawn on or
made by or in favour of a commercial or cooperative bank.

When the drawer of a bill encloses with the bill, documents of title to goods
such as the railway receipt or motor transport receipt, to be delivered to the
drawee, such bills are called documentary bills. When no such documents are
attached the bill is called a clean bill. In case of documentary bills, the
documents may be delivered on accepting the bill or on making its payment.
In the former case it is called Documents against Acceptance (D/A) basis,
and in the latter case Documents against Payment (D/P) basis. In case of a
clean bill, the relevant documents of title to goods are sent directly to the
drawee.

Procedure for Discounting of Bills

When the seller of the goods draws a bill of exchange on the buyer (debtor),
he has two options to deal with the bill.

228 a) to send the bill to a bank for collection, or

b) to sell it to, or discount it with, a bank Bank Credit -
Principles a nd
Practices
When the bill is sent to the bank for collection the banker acts as the agent of
the drawer and makes its payment to him only on the realisation of the bill
from the drawee. The banker sends it to its branch at the drawee’s place,
which presents it before the drawee, collects the amount and remits it to the
collecting banker, who credits the same to the drawer’s account. In case of
collection of bills, the bank acts as an agent of the drawer of the bill and does
not lend his funds by giving credit before actual realisation of the bill.
The business of purchasing and discounting of bills differs from that of
collection of bills. In case of purchase/discounting of bills, the bank credits
the amount of the bill to the drawer’s account before its actual realisation
from the drawee. The banker thus lends his own funds to the drawer of the
bill. Bills purchased or discounted are therefore, shown under the head
‘Loans and Advances’ in the Balance Sheet of a bank.
The practice adopted in case of demand bills is known as purchase of bills.
As demand bills are payable on demand, and there is no maturity, the banker is
entitled to demand its payment immediately on its presentation before the
drawee. Thus the money credited to the drawer’s account, after deducting
charges/discount, is realised by the banker within a few days.
In case of a usance bill maturing after a period of time generally 30, 60, or 90
days, therefore banker discounts the bill i.e credits the amount of the bill, less
the amount of discount, to the drawer’s account. Thereafter, the bill is sent to
the bank’s branch at the drawee’s place which presents it to the drawee for
acceptance. Documents of title to goods, if enclosed with the bills, are
released to him on accepting the bill. The bill is thereafter retained by the
banker till maturity, when it is presented to the acceptor of the bill for
payment.

Advantages of Discounting of Bills

A banker derives the following advantages by discounting the bills of
exchange:

1) Safety of funds lent

Though the banker does not get charge over any tangible asset of the
borrower in case of discounting of bills, his interest is safeguarded by the fact
that the bills of exchange contain’s signatures of two parties - the drawer and
the drawee (acceptor), who are responsible to make payment of the bill. If the
acceptor fails to make payment of the bill the banker can claim the whole
amount from his customer, the drawer of the bill. The banker can debit the
customer’s account and recover the money on the due date. The banker is
able to recover the amount as he discounts the bills drawn by parties of
standing and good reputation.

2) Certainty of payment
Every usance bill matures on a certain date. Three days of grace are allowed
to the acceptor to make payment. Thus, the amount lent to the customer by
229
Financing of discounting the bills is definitely recovered by the banker on its due date.
Working Capital
The banker knows the date of payment of the bills and hence can plan the
utilisation of his funds well in advance and with profit.

3) Facility of re-discounting of bills

The banker can augment his funds, if need arises, by re-discounting the bills,
already discounted by him, with the Reserve Bank of India, other banks and
financial institutions and the Discount and Finance House of India Ltd.
Reserve Bank of India can also grant loans to the banks on the basis of the
bills held by them.

4) Stability in the value of bills

The value of the bills remain fixed and unchanged while the value of all other
goods, commodities and securities fluctuate over a period of time.

5) Profitability
In case of discounting of bills, the amount of interest (called discount) is
deducted in advance from the amount of the bill. Hence the effective yield is
higher than loans and advances where interest is payable quarterly/half
yearly.

Derivative Usance Promissory Notes

As noted above, banks may re-discount the discounted bills of exchange with
other banks and financial institutions. For this purpose, under the normal
procedure, the bills are endorsed in favour of the re-discounting bank
/institution and delivered to it. At the time of maturity reverse process is
required.

To simplify the procedure of re-discounting, Reserve Bank of India has

dispensed with the necessity of physical lodgment of the discounted bills.
Instead, banks are permitted, on the basis of such discounted bills, to prepare
derivative usance promissory notes for suitable amounts like Rs. 5 lakhs or
Rs. 10 lakhs and for suitable maturities like 60 days or 90 days. These
derivative usance promissory notes are re- discounted with the re-discounting
bank or institution. The essential condition is that the derivative promissory
note should be backed by unencumbered bills of exchange of atleast equal
value till the date of maturity. In the meanwhile, any maturing bill may be
replaced by another bill for equal amount. No stamp duty is required on such
derivative usance promissory notes.

Compulsion on the Use of Bills

To encourage the use of bills of exchange by corporate borrowers, the
Reserve Bank of India had directed the commercial banks to advice their
corporate borrowers to finance their domestic credit purchases from small
scale industrial units as well as from others at least to the extent of 25 percent
by way of acceptance of bills drawn upon them by their suppliers. This was
to be stipulated as a condition for sanctioning working capital credit limits.
Banks were also authorized to charge an additional interest from those
230 borrowers who did not comply with this requirement in any quarter. In
October 1999 Reserve bank of India permitted the banks to charge interest Bank Credit -
Principles a nd
rate on discounting of bills without reference to Prime Lending Rate. They Practices
are now free to offer competitive rate of interest on the bill discounting
facility. The above-mentioned compulsion was also withdrawn.
Revised Guidelines of RBI on Discounting of Bills
• Banks may sanction working capital limits as also bills limits to borrowers
after proper appraisal of their credit needs and in accordance with the
loan policy as approved by their Board of Directors.
• Banks are required to open Letters of Credit (LCs) and purchase
/discount/ negotiate bills under LCs only in respect of genuine
commercial and trade transactions of their borrower constituents who
have been sanctioned regular credit facilities by them.
• For the purpose of credit exposure, bills purchased discounted/negotiated
under LCs or otherwise would be reckoned as exposure on the bank’s
borrower constituent. Accordingly, the exposure should attract a risk-
weight appropriate to the borrower constituent (viz.100 per cent for firms,
individuals, corporates) for capital adequacy purposes.
• Banks have been permitted to exercise their commercial judgment in
discounting of bills of services sector. Banks would need to ensure that
actual services are rendered and accommodation bills are not discounted.
Services sector bills should not be eligible for rediscounting.

10.8 BANK CREDIT ON CAPITAL MARKETS

INSTRUMENTS
There has been a representation from the industry and borrowers that banks
shall also extend loans on the security of capital market instruments, which
may include Equity, Debt Instruments, Mutual Fund Investments, Venture
Capital Investments, etc. based on this, the RBI has formulated certain
guidelines permitting banks to expose themselves to the capital market by
way of advancing loans on these instruments. The guidelines included the
following:

• The aggregate exposure of a bank shall not exceed to 40 per cent of its
net worth on a solo and consolidated basis.
• Subject to the above ceiling, Banks are permitted to directly invest in
capital market securities upto 20 per cent of their net worth.

• Individual ceilings are also suggested to be followed by Banks while

exposing them to diverse instruments. For instance, the ceiling against
loans sanctioned on shares to an individual shall be below Rs.10 lakh.
Likewise, separate limits are fixed for lending on employees, stock
brokers, joint holders, venture capitalists, etc.
While the above guidelines are indicative and suggestive, Banks following
robust risk management practices can approach RBI requesting for relaxation
in the ceiling limit.
231
Financing of
Working Capital
10.9 CONSORTIUM ADVANCES
Credit needs of large borrowers may be met by banks in any of the following
ways:
a) By sole bank
b) By multiple banks
c) On consortium basis
d) On syndication basis

Sole banking: lending by a single bank to a large borrower, subject to the

resources available with it and limited to the exposure limits imposed by the
Reserve Bank of India. When the credit requirements of a borrower are
beyond the capacity of a single bank, the borrower may resort to multiple
banking i.e borrowing from a number of banks simultaneously and
independent of each other, under separate loan agreements with each of
them. Securities are charged to them separately.
Consortium lending: also called joint financing or participation financing, is
also undertaken by a number of banks but against a common security which
remains charged to all the banks for the total advance. Usually, in case of
consortium lending one of the banks acts as a consortium leader and takes a
leading part in the processing of the loan proposal, its documentation,
recovery etc. The participating banks enter into an agreement setting out the
terms and conditions of such participation arrangement.

Reserve Bank Directives

Consortium lending by banks in India commenced in 1974 when Reserve
Bank of India issued guidelines to the banks in this regard. In 1978 formation
of consortium was made obligatory where the aggregate credit limits
sanctioned to a single borrower amounted to Rs. 5 crore or more. In later
years, this limit was revised upwards to Rs.50 crore. But now, there is no
mandatory requirement for formation of consortium.

Following the policy of liberalisation and deregulation in the financial sector,

the Reserve Bank of India decided, that whenever a consortium is formed
either on a voluntary basis or on obligatory basis, the ground rules of the
consortium arrangement would be framed by the participating banks in the
consortium. These rules may relate to the following:
i) Number of participating banks
ii) Minimum share of each bank
iii) Entry to exit from a consortium
iv) Sanction of additional/ad hoc limit in emergency situation/contingencies
by lead bank/other banks
v) The fee to be charged by the lead bank for the services rendered by it
vi) Grant of any facility to the borrower by a non-member bank
vii) Deciding time frame for sanctions/ renewals.
232
Basing on the above, Reserve bank has advised the banks to evolve an Bank Credit -
Principles a nd
appropriate mechanism for adoption of a sole bank/multiple bank/consortium Practices
or syndication approach by framing necessary ground rules on operational
basis. While the aforesaid flexibility has been granted to the banks, they are
required not to exceed the single borrower/group exposure limits laid down
by the Reserve Bank. Banks have been advised to ensure to have an effective
system for appraisal, flow of information on the borrower among the
participating banks, commonality in approach and sharing of lending
resources, under the single window concept. Banks have also been permitted
to adopt the syndication route, if the arrangement suits the borrower and the
financing banks.

10.10 SYNDICATION OF CREDIT

As you have noted in the previous section, Reserve Bank of India has
permitted the banks to adopt syndication route to provide credit in lieu of
consortium advance. A syndicated credit differs from consortium advance in
certain aspects. The salient features of a syndicated credit are as follows:
1) It is an agreement between two or more banks to provide a borrower a
credit facility using common loan documentation.
2) The prospective borrower gives a mandate to a bank, commonly referred
to a ‘Lead Manager, to arrange credit on his behalf. The mandate gives
the commercial terms of the credit and the prerogatives of the mandated
bank in resolving contentious issues in the course of the transaction.
3) The mandated bank prepares an Information Memorandum about the
borrower in consultation with the latter and distributes the same amongst
the prospective lenders, inviting them to participate in the credit.
4) On the basis of the Information Memorandum each bank makes its own
independent economic and financial evaluation of the borrower. It may
collect additional information from other sources also.
5) Thereafter, a meeting of the participating banks is convened by the
mandated bank to discuss the syndication strategy relating to coordination,
communication and control within the syndication process and to finalise
the deal timings, charges for management, cost of credit, share of each
participating bank in the credit etc.
6) A loan agreement is signed by all the participating banks
7) The borrower is required to give prior notice to the Lead Manager or his
agent for drawing the loan amount so that the latter may tie up
disbursement with the other lending banks.
8) Under the system, the borrower has the freedom in terms of competitive
pricing.

As per the existing guidelines of RBI, Banks are free to adopt syndication
route, irrespective of the quantum of credit involved, upon mutual agreement
between the borrowing company and the Bank.
233
Financing of
Working Capital
10.11 NON-FUND BASED FACILITIES
The credit facilities explained above are fund based facilities wherein funds
are provided to the borrower for meeting their working capital needs. Banks
also provide non-fund based facilities to the customers. Such facilities
include (i) letters of credit and (ii) bank guarantees. Under these facilities,
banks do not immediately provide credit to the customers, but take upon
themselves the liability to make payment in case the borrower defaults in
making payment or performing the promise undertaken by him.

Letter of Credit
A letter of Credit (L/C) is a written undertaking given by a bank on behalf of
its customer, who is a buyer, to the seller of goods, promising to pay a certain
sum of money provided the seller complies with the terms and conditions
given in the L/C. A Letter of Credit is generally required when the seller of
goods and services deals with unknown parties or otherwise feels the
necessity to safeguard his interest. Under such circumstances, he asks the
buyer to arrange a letter of credit from his banker. The banker issuing the
L/C commits to make payment of the amount mentioned therein to the seller
of the goods, provided the latter supplies the specified goods within the
specified period and comply with other terms and conditions.
Thus by issuing Letter of Credit on behalf of their customers, banks help
them in buying goods on credit from sellers who are quite unknown to them.
The banker issuing L/C undertakes an unconditional obligation upon himself,
and charge a fee for the same. L/Cs may be revocable or irrevocable. In the
latter case, the undertaking given by the banker cannot be revoked or
withdrawn.

Bank Guarantee
Banks issue guarantees to third parties on behalf of their customers. These
guarantees are classified into (i) Financial guarantee, and (ii) Performance
guarantee. In case of the financial guarantee, the banker guarantees the
repayment of money on default by the customer or the payment of money
when the customer purchases the capital goods on deferred payment basis.

A bank guarantee which guarantees the satisfactory performance of an act,

say completion of a construction work undertaken by the customer, failing
which the bank will make good the loss suffered by the beneficiary is known
as a performance guarantee.

10.12 CREDIT WORTHINESS OF BORROWERS

The business of granting advances is a risky one. It is more risky specially in
case of unsecured advances. The safety of the advance depends upon the
honesty and integrity of the borrower, apart from the worth of his tangible
assets. The banker has, therefore, to investigate into the borrower’s ability to
pay as well as his willingness to pay the debt taken. Such an exercise is
called credit investigation. Its aim is to determine the amount for which a
234
person is considered creditworthy. Credit worthiness is judged by a banker on Bank Credit -
Principles a nd
the basis of borrower’s ( i ) character, (ii) capacity and (iii) capital. Practices

1) Character includes a number of personal characteristics of a person, e.g.

his honesty, integrity, promptness in fulfilling his promises and repaying
the dues, sense of responsibility, reputation and goodwill enjoyed by him.
A person having all these qualities, without any doubt in the minds of
others, possesses, an excellent character and hence his creditworthiness is
considered high.
2) Capacity If the borrower possesses necessary technical skill, managerial
ability and experience to run a particular business or industry, success of
such an enterprise is taken for granted except in some unforeseen
circumstances. Such a person is considered creditworthy by the banker.
3) Capital The borrower is also expected to have financial stake in the
business, because in case the business fails, the banker will be able to
realise his money out of the capital put in by the borrower. It is a sound
principle of finance that debt must be supported by sufficient equity.

The relative importance of the above factors differs from banker to banker
and from borrower to borrower. Banks are granting advances to technically
qualified and experienced entrepreneurs but they are required to put in a
small amount as their own capital. Reserve Bank of India has recently
directed the banks to dispense with the collateral requirement for loans upto
Rs. 1 lakh. This limit has recently been further increased to Rs. 5 lakh for the
tiny sector.
Determination of credit worthiness of a borrower has become now a more
scientific exercise. Special institutions like rating companies such as CRISIL,
ICRA, CARE, have come on to the field and each of them has developed a
methodology of its own.

Students are advised to take special interest in these rating processes.

Activity 10.3
i) Why do banks prefer Govt. and semi-govt. securities vis-à-vis Corporate
Securities for granting credit? Amongst the Corporate Securities why do
they prefer debt instruments?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) How do Banks judge credit worthiness of a borrower?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
235
Financing of
Working Capital
10.13 SUMMARY
In this unit we have discussed the basic concepts, principles and practices of
bank credit as a source of working capital. Various forms in which bank
credit is granted viz. Overdrafts, loans, cash credit and discounting of bills
etc. are discussed with their merits and demerits. Different types of loans, and
their classification on the basis of security and guarantee have been
explained. After explaining the various modes of creating charge over the
borrower’s assets, we have discussed merits and demerits of different types
of securities taken by banks. Purchase and discounting of bills as a method of
granting credit has been duly explained. Concept of credit worthiness of the
borrower has been clarified. In the end, the two important non- fund based
facilities such as letter of credit and guarantee given by banks have also been
dealt with. Attention of the students is also drawn towards the
regulations/guidelines of RBI in the management of their Advances.

10.14 KEY WORDS

Overdrafts: This is a facility allowed to a current account holder for a short
period. Under this facility, the account holder is allowed to draw from his
account more than what stands to his credit, either on the personal security of
the borrower or on the basis of collateral security.
Cash Credit System: This is a method of granting credit by banks. Under
this method the bank prescribes a limit, called the Cash Credit limit, upto
which the customer is permitted to borrow against the security of tangible
assets or guarantee. The borrower may withdraw from the account as and
when he needs money. Surplus funds with him may be deposited with the
banker any time. Thus, it is running a/c with the banker, wherein withdrawals
and deposits may be made frequently in any number of times.
Loan: Under the Loan System of granting credit, a definite amount is lent
for a specified period.
Bridge Loan: Bridge Loan is a short term loan which is usually granted to
industrial undertakings to enable them to meet their urgent needs. It is
granted when a term loan has already been sanctioned by a bank/financial
institution, but its disbursement takes some time or when the company is
taking steps to raise funds for the capital market. It is a type of interim
finance.
Composite Loan: Those loans that are granted for both investment in
capital assets and for working capital purposes, are called composite loans.
Secured Loans: A secured loan is a loan made on the security of any
tangible asset of the borrower. It means that a charge or right is created on
the assets of the borrower in favour of the lender. The value of the security
must be equal to the amount of the loan. If the former is less than the latter, it
is called partly secured loan. An advance without such security is called
unsecured advance. In case of secured loan the lender gets the right to realise
his dues from the sale proceeds of the security, if the borrower defaults.
236
Pledge: Pledge is a method of creating a charge over the movable assets of Bank Credit -
Principles a nd
the borrower in favour of the lender. Under the pledge, the movable assets of Practices
the borrower are delivered to the banker as a security, which he will return
back to the borrower, after he repays the amount due from him in respect of
principal and interest.
Hypothecation: It is another method of creating charge over the movable
assets. Under hypothecation the possession over such assets is not
transferred to the banker. Only an equitable charge is created in favour of
banker. The assets remain in the possession of the borrower, who promises to
give possession of the same to the banker, whenever he is requested to do so.
Mortgage: It is a method of creating charge over the immovable property
like land and building. Under Mortgage the borrower transfers some of the
rights of ownership to the banker (or mortgagee) and retains the remaining
rights with himself. The objective is to secure a loan taken from the banker.
Actual possession over the property is not passed on to the mortgage in all
cases.

Equitable Mortgage: In this type of mortgage the mortgagor hands over the
documents of title to the property to the mortgagee and thus an equitable
interest of the mortgagee is created in the property. If the mortgagor fails to
repay the amount of the loan, he may be asked to execute a legal mortgage in
favour of the lender.
Assignment: It is a method whereby the borrower provides security to the
banker by assigning (transferring or parting with) any of his rights, properties
or debts to the banker.
Lien: Lien is the right of the banker to retain all securities of the customer,
until the general balance due from him is not repaid.
Documents of title to goods: These are the documents which represent the
goods in the possession of some other person. For example a warehouse
receipt or a railway receipt. By endorsing such documents in favour of the
banker, the borrower entitles the banker to take delivery of the goods from
the warehouse or railway, if he does not repay the advance.

Credit worthiness: Creditworthiness indicates the quality of the borrower. It

denotes the amount for which a borrower is considered worthy for borrowing
from a bank. It depends upon his ability and willingness and is judged on the
basis of character, capacity and capital of the borrower.

10.15 SELF ASSESMENT QUESTIONS

1) Explain briefly the nature of Bank lending.
2) What are the common securities against which a bank may lend for
working capital purposes? Can a bank extend an unsecured loan or
advance?
3) Explain the merits and demerits of the Cash Credit System.

237
Financing of 4) What do you understand by Term Loans? For what purposes are they
Working Capital
granted by banks? What is Reserve Bank’s directive to banks in this
regard?
5) What are the different types of ventures that a bank can finance? Does it
include a handcart operator selling vegetables?
6) What are the advantages of discounting of bills to the banks? Is it
compulsory for corporate borrowers to use bills of Exchange?
7) What do you understand by credit-worthiness of a borrower? What
factors are taken into account by the banker to determine credit-
worthiness? Can you suggest anything beyond?
8) Discuss the different ways by which banks provide credit to business
entities?
9) Do you think that banks should lend on Equities? Argue for and against.

10.16 FURTHER READINGS

1) Taxman’s Banking Law and Practice.
2) P. N. Varshney- Banking Law & Practice
3) P. N. Varshney- Indian Financial System and Commercial Banking.
4) S. Srinivasan 1999; Cash and Working Capital Management, Vikas
Publishing house, New Delhi.
5) Master Circulars of RBI on ‘Advances by Commercial Banks’.

238
 Other Sources of
UNIT 11 OTHER SOURCES OF SHORT ShortTerm
Finance
TERM FINANCE

Objectives
The objectives of this Unit are:
• To discuss the sources of short term finance, other than bank credit and
trade credit, to meet the working capital needs, and
• To highlight the framework of rules and regulations prescribed by the
authorities regarding these non-bank sources of finance.

Structure
11.1 Introduction
11.2 Public Deposits
11.3 Commercial Paper
11.4 Inter-Corporate Loans
11.5 Bonds and Debentures
11.6 Factoring of Receivables
11.7 Summary
11.8 Key Words
11.9 Self-Assessment Questions
11.10 Further Readings

11.1 INTRODUCTION
Trade credit and commercial bank credit have been two important sources of
funds for financing working capital needs of companies in India, apart from
the long term source like equity shares. However, more stringent credit
policies followed by banks, tightening financial discipline imposed by them,
and their higher cost, led the companies to go in for new and innovative
sources of finance. As the new equities market has remained in a subdued
condition and investor interest in the equities has almost vanished during
recent years, corporates have raised larger resources through debt
instruments, some of them being for as short a period as 18 months. The
situation has turned buoyant for corporates during the 21st Century for any
type of finance.

Raising short term and medium term debt by inviting and accepting deposits
from the investing public has become an established practice with a large
number of companies both in the private and public sectors. This is the
outcome of the process of dis-intermediation that is taking place in Indian
economy. Similarly, issuance of Commercial Paper by high net-worth
Corporates enables them to raise short-term funds directly from the investors
at cheaper rates as compared to bank credit. In practice, however,
commercial banks have been the major investors in Commercial Paper in 239
Financing of India, implying thereby that bank credit flows to the corporate sector through
Working Capital
the route of CPs. Inter-Corporate loans and investments enable the cash rich
corporations to lend their surplus resources to those who need them for their
working capital purpose. Factoring of receivables is a relatively new
innovation which enables the corporates to convert their receivables into
liquidity within a short period of time. In this unit, we shall discuss the salient
features of various sources of non-bank finance and the regulatory framework
evolved in respect of them.

11.2 PUBLIC DEPOSITS

Public deposits are unsecured deposits accepted by companies for specific
periods and at specific rates of interest. These deposits have acquired
prominence as a source of finance for the companies, as it is more convenient
and cheaper to mobilise short term finance through such deposits. Public
deposits provide a fine example of dis-intermediation, as the borrower
directly accepts the deposits from the lenders, of course with the help of
brokers.
In India, acceptance of deposits from the public is regulated by sections 58A
and 58B of the Companies Act 1956, and the Companies (Acceptance of
Deposits) Rules, 1975. The above sections were inserted in the Companies
Act in 1974 with the objective to safeguard the interests of the depositors.
The regulatory framework in this regard is contained in the Companies Act
and the Rules.

This legal position has changed with the passage of New Companies Act,
2013. The position was revamped to a great extent. The New Sections in the
Companies Act that pertain to ‘deposits’ are 73 to 76 (corresponding to
Sections 58A and 58B). Many of the deposits which were considered as such
in the previous situation, are not accepted as deposits now. There have been
stringent restrictions in accepting deposits from the public now. The
following are the pertinent aspects relating to this issue:

• No company shall invite or accept deposits from public unless the

company meets a specified criteria. As at present, a public company
having net worth of Rs.100 crore or turnover of not less than Rs.500
crore will only be eligible to accept deposits from public.

• The public company shall obtain credit rating every year from a rating
agency and publish it properly.

• It shall create a charge on the assets equal to the amount of issue.

• All other companies can accept deposits only from their Members.

The Ministry of Corporate Affairs, through the Notification dated 31-03-

2014, issued ‘Companies (Acceptance of Deposits) Rules, 2014,
incorporating rules on the following:
• Terms and conditions of acceptance of deposits by companies.
• Form and particulars of Advertisements or circulars.
240
• Manner and extent of deposit insurance. Other Sources of
ShortTerm
• Creation of security. Finance

• Appointment of Trustee for depositors and their duties.

• Meeting of depositors.
• Form of Application for deposits.
• Maintenance of liquid assets and creation of deposits repayment reserve
account.
• Register of deposits.

Maintenance of Liquid Assets

Every company accepting public deposit is required to deposit or invest
before 30th April of each year, an amount which shall not be less than 15% of
the amount of its deposits which will mature during the next financial year
ending 31st March in any one or more of the following:
a) in a current or other deposit account with any scheduled bank, free from
charge or lien,

b) in unencumbered securities of the central or state governments,

c) in unencumbered securities in which Trust funds may be invested under

the Indian Trust Act, 1882; or

d) in unencumbered bonds issued by Housing Development Finance

Corporation Ltd.

The securities referred to in clauses (b) or (c) shall be reckoned at their

market value. The amount deposited or invested as aforesaid shall not be
utilised for any other purpose than the repayment of deposits maturing during
the year.

Rates of Interest and Brokerage

The Rules prescribe the maximum rate of interest payable on such deposits.
At present companies are allowed to pay interest not exceeding 15% per
annum at rates which shall not be shorter than monthly rests.
Companies are permitted to pay brokerage to any broker at the rate of 1% of
the deposits for a period of upto 1 year, 1½ % for a period more than 1 year
but upto 2 years and 2% for a period exceeding 2 years. Such payment shall
be on one time basis.

Advertisement
Every company intending to invite or accept deposits from the public must
issue an advertisement for that purpose in a leading English Newspaper and in
one vernacular newspaper circulating in the state in which the registered
office of the company is situated.

The advertisement must be issued on the authority and in the name of the
Board of Directors of the company. The advertisement must contain the
conditions subject to which deposits shall be accepted by the company and 241
Financing of the date on which the Board of Directors has approved the text of the
Working Capital
advertisement. In addition, the advertisement must contain the following
information, namely:
a) Name of the company,

b) The date of incorporation of the company,

c) The business carried on by the company and its subsidiaries with the
details of branches of units, if any,
d) Brief particulars of the management of the company

e) Names, addresses and occupations of the directors,

f) Profits of the company, before and after making provision for tax, for the
three financial years immediately preceding the date of advertisement,

g) Dividends declared by the company in respect of the said years.

h) A summarised financial position of the company as in the two audited

balance sheets immediately preceding the date of advertisement in the
prescribed form.
i) The amount which the company can raise by way of deposits under these
rules and the aggregate of deposits actually held on the last day of the
immediately preceding financial year.

j) A statement to the effect that on the day of the advertisement, the

company has no overdue deposits, other than the unclaimed deposits, or
a statement showing the amount of such overdue deposits, as the case
may be, and

k) A declaration as prescribed under the Rules.

The advertisement shall be valid until the expiry of six months from the date
of closure of the financial year in which it is issued or until the date on which
the balance sheet is laid before the company at its general meeting, or where
Annual General Meeting for any year has not been held, the latest day on
which that meeting should have been held as per the Companies Act,
whichever is earlier. A fresh advertisement is required to be made in each
succeeding financial year.

Before issuing an advertisement, a copy of such advertisement shall have to

be delivered to the Registrar for registration. Such advertisement should be
signed bythe majority of the Directors of the company or their duly authorised
agents.

The above provision regarding mandatory publication of an advertisement is

necessary in case the company invites public deposits. But if the company
intends to accept deposits without inviting the same, it is not required to issue
an advertisement but a statement in lieu of such advertisement shall have to
be delivered to the Registrar for registration, before accepting deposits. The
contents of the statement and its validity period shall be the same as in the
case of an advertisement.
242
 Other Sources of
Procedure for Accepting Deposits ShortTerm
Finance
Every company intending to accept public deposits is required to supply to
the investors, forms which shall be accompanied by a statement by the
company containing all the particulars specified for advertisements. The
application must also contain a declaration by the depositor stating that the
amount is not being deposited out of the funds acquired by him by borrowing
or accepting deposits from any other person.

On accepting a deposit or renewing an existing deposit, every company shall

furnish to the depositor or his agent a receipt for the amount received by the
company within a period of eight weeks from the date of receipt of money or
realisation of cheques. The receipt must be signed by an officer of the
company duly authorised by it. The company shall not have the right to alter
to the disadvantage of the depositor, the terms and conditions of the deposit
after it is accepted.

Register of Deposits
Every company accepting deposits is required to keep as its registered office
one or more registers in which the following particulars about each depositor
are to be entered:
a) Name and address of the depositors,
b) Date and amount of each deposit
c) Duration of the deposit and the date on which each deposit is repayable
d) Rate of interest
e) Date or dates on which payment of interest will be made.
f) Any other particulars relating to the deposit.

These registers shall be preserved by the company in good order for a period
of not less than eight years from the end of the financial year in which the
latest entry is made in the Register.

Repayment of Deposits
Deposits are accepted by companies for specified period say 12 months, 18
months, 24 months, etc. Companies prescribe different rates of interest for
deposits for different periods. Other terms and conditions are also prescribed
by the companies and interest is paid at the stipulated rate at the time of
maturity of the deposit.

But, if a depositor desires repayment of the deposit, before the period

stipulated in the Receipt, companies are permitted to do so, but interest is to
be paid at a lower rate. Rules prescribe that if a company makes repayment
of a deposit after the expiry of a period of six months from the date of such
deposit, but before the expiry of the period for which such deposit was
accepted by the company, the rate of interest payable by the company shall
be determined by reducing one percent from the rate which the company
would have paid had the deposit been accepted for the period for which the
deposit had run.
243
Financing of The rules also provide that if a company permits a depositor to renew the
Working Capital
deposit, before the expiry of the period for which such deposit was accepted
by the company, for availing of benefit of higher rate of interest, the company
shall pay interest to such depositor at higher rate, if
a) such deposit is renewed for a period longer than the unexpired period of
the deposit, and

b) the rate of interest as stipulated at the time of acceptance or renewal of

a deposit is reduced by one percent for the expired period of the deposit
and is paid or adjusted or recovered.

The Rules also stipulate that if the period for which the deposit had run
contains any part of a year, then if such part is less than six months, it shall be
excluded and if part is six months or more, it shall be reckoned as one year.

Return of Deposits
Every company accepting deposits is required to file with the Registrar every
year before 30th June, a return in the prescribed form and giving information
as on 31st. March of the year. It should be duly certified by the auditor of the
company. A copy of the same shall also be filed with the Reserve Bank of
India.

Penalties
The Rules, 2014 also provided machinery for repayment of deposits on
maturity and also prescribes penalties for defaulting companies. If a company
fails to repay any deposit or part thereof in accordance with the terms and
conditions of such deposit, the Company Law Board may, if it is satisfied,
direct the company to make repayment of such deposit forthwith or within
such time or subject to such conditions as may be specified in its order. The
Company Law Board may issue such order on its own or on the application
of the depositor and shall give a reasonable opportunity of being heard to the
company and to other concerned persons. Further, the company shall pay
penal interest at the rate of 18 per cent, if the deposits remain unpaid after
due date.

If any company contravenes these rules, the company and every officer of the
company, who is in default, shall be punishable with fine which may extend
to five thousand rupees and the contravention is continuing, the company and
every officer shall be liable with a further fine which may extend to Rs.500
per day.

Deduction of Tax at Source

According to section 194 A of the Income Tax Act, 1961, the companies
accepting public deposits are required to deduct income tax at source at 10%,
if the aggregate interest paid or credited during a financial year exceeds Rs.
40,000.

244
 Other Sources of
Activity 11.1 ShortTerm
Finance
i) Can a company repay a deposit before the period stipulated in the
Receipt? Will the depositor suffer in such a case?

…………………………………………………………………………….

…………………………………………………………………………….
…………………………………………………………………………….

…………………………………………………………………………….

ii) What penalty is imposed on the company if it accepts deposit in excess of

the prescribed limits?

…………………………………………………………………………….

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

11.3 COMMERCIAL PAPER

Commercial paper (C.P) is another source of raising short term funds by
highly rated corporate borrowers for working capital purposes. A
commercial paper at the same time provides an opportunity to cash rich
investors to park their short term funds. The Reserve Bank of India permitted
companies to issue Commercial paper in 1989 and issued guidelines entitled
“Non banking Companies (Acceptance of Deposits through Commercial
Paper) Directions 1989,” to regulate the issuance of C.Ps. The guidelines have
been significantly relaxed and modified from time to time. The salient features
of these guidelines (as amended to date) are as follows:

Eligibility to Issue CPs

Companies (except the banking companies) which fulfil the following
requirements are permitted to issue CPs in the money market:
i) The minimum tangible net worth of the company is Rs. 4 crore as per the
latest audited balance sheet.

ii) The company has fund-based working capital limits of not less than Rs. 4
crore.
iii) The shares of the company are listed at one or more stock exchanges.
Closely held companies whose shares are not listed on any stock
exchange are also permitted to issue CPs provided all other conditions
are fulfilled.

iv) The company has obtained minimum credit rating from a Credit rating
agency i.e. CP2 from Credit Rating Information Services of India Ltd.,
A2 from Investment Information & Credit Rating Agency or PR2 from
Credit Analysis and Research. 245
Financing of Terms of Commercial Paper
Working Capital
The Commercial paper may be issued by the companies on the following
terms and conditions:
a) The minimum period of maturity should be 15 days (It was reduced from
30 days effective May 25, 1998) and the maximum period less than one
year.
b) The minimum amount for which a CP is to be issued to a single investor
in the primary market should be Rs. 25 lakhs and thereafter in multiple of
Rs. 5 lakhs.
c) CPs are to be issued in the form of usance promissory notes which are
freely transferable by endorsement and delivery.
d) CPs are to be issued at a discount to face value. The rate of discount is
freely determined by the issuing company and the investors.
e) The issuing company shall bear the dealers fee, rating agencies fee, and
other charges. Stamp duty shall also be applicable on CPs.

f) CPs may be issued to any person, corporate body incorporated in India,

or even unincorporated bodies. CPs may be issued to Non-resident
Indians only on non- repatriation basis and such CPs shall not be
transferable.
g) The issue of CP will not be underwritten or co-accepted by any individual
or institution.

h) There will be no grace period for payment. The holder of the CP shall
present the instrument for payment to the issuing company.

Ceiling on the amount of issue of Commercial Paper

The amount for which the companies issue Commercial Paper is to be carved
out of the fund based working capital limit enjoyed by the company with its
banker. The maximum amount that can be raised through issue of
commercial paper is equal to 100 percent of the fund based working capital
limit. The latter is reduced pro-tanto on the issuance of CP by the company.
Effective October 19, 1996 the amount of CP is permitted to be adjusted out
of the loans or cash credit or both as per the arrangement between the issuer
of the CP and the concerned bank.

Standby facility withdrawn

As stated above, the amount of CP is carved out of the borrower’s working
capital limit. Till October 1994 commercial banks were permitted to provide
standby facility to the issuers of CPs. It ensured the borrowers to draw on
their cash credit limit in case there was no roll-over of CP. Thus the
repayment of the CP was ensured automatically.

In October 1994 Reserve bank of India prohibited the banks to grant such
stand-by- facility. Accordingly, banks reduce the cash credit limit when CP is
issued. If subsequently, the issuer requires a higher cash credit limit, he shall
246
have to approach the bank for a fresh assessment of his requirement for the Other Sources of
ShortTerm
enhancement of credit limit. Banks do not automatically restore the limit and Finance
consider the sanction of higher limit afresh. In November 1997, Reserve Bank
of India permitted the banks to decide the manner in which restoration of
working capital limit is to be done on repayment of the CP if the corporate
requests for restoration of such limit.

Procedure for Issuing Commercial Paper

1) The company which intends to issue CP should submit an application in
the prescribed form to its bankers or leader of the consortium of banks,
together with a certificate from an approved credit rating agency. The
rating should not be more than 2 months old.
2) The banker will scrutinize the proposal and if it finds the proposal
satisfying all eligibility criteria and conditions, shall take the proposal on
record.
3) Thereafter, the company will make arrangement for privately placing the
issue within a period of 2 weeks.
4) Within 3 days of the completion of the issue, the company shall advice
the Reserve Bank through its bankers the amount actually raised through
CP.
5) The investors shall pay the discounted value of the CP through a cheque
to the account of the issuing company with the banker.
6) Thereafter, the fund-based working capital limit of the company will be
reduced correspondingly.

Commercial Paper in India

The Vagul Committee suggested the introduction of commercial paper in
India to enable the high worth corporates to raise short term funds cheaper as
compared to bank credit. On the other hand, the investors in CPs were
expected to earn a better return because of the absence of intermediaries
between them and the borrowers. As the issuer bears the cost of issuing the
CPs, his total cost is higher by 1% point or so over the discount rate on the
CPs issued by him.

Commercial paper is being issued by corporates in India for about three

decades now. During this period the quantum of outstanding CPs has
gradually increased. In the recent past, the issue of CPs is picking up very
fast. As per the latest (June 2021) data of RBI monthly fresh issues of CP is
growing by about 37 per cent every year and touched a record of 1.71 lakh
crore by June 2021. Whereas the size of outstanding CP amount stood at
Rs.3.89 lakh crore by May 2021. The highest touched in this regard stood at
Rs.5.04 lakh crore in the First Quarter of the Financial Year 2020-21. It is
also to be noted that the number of corporate tapping the CP market are
growing year after year. And about 70 corporates and about 50 NBFCs or
HCFs have raised resources through this mechanism.

247
Financing of The Reserve Bank of India has issued revised draft guidelines on August 10,
Working Capital
2017 for the issuance of commercial paper. The important changes proposed
were:
i) Companies willing to issue CP and having fund based credit facility,
should have been classified as ‘Standard Asset’.
ii) Entities like Co-operatives, Government entities, Trusts, LLPs, etc.,
should have a net worth of Rs.100 crore or more.
iii) The exact purpose for which CP are proposed to be issued should be
declared.
iv) Shall obtain credit rating from at least two agencies, if their issue size
crosses Rs.1000 crore.
v) CP shall be issued as a ‘Stand-alone’ product.
vi) The settlement cycle for trading in CPs shall be T+0 or T+1.
vii) The Buyback of the CP must be at the prevailing market price only.
viii) Every company intending to issue CP shall appoint a Issuing and Paying
Agent (IPA) and comply with all the requirements specified by the IPA.
ix) The company shall inform Credit Rating Agency (CRA) and IPA about
the delay/default in the CP related payments. If the issuer has defaulted,
the entity shall not be allowed to access the CP market for six months,
after the due are cleared.

11.4 INTER-CORPORATE LOANS

Short term finance for working capital requirements of a company may be
raised through accepting inter-corporate loans or deposits. Some companies,
which may have surplus idle cash due to seasonal nature of their operations
or otherwise would like to lend such resources for such period when they are
not needed by them. On the other hand, some other companies face financial
stringency and need cash resources to meet their immediate liquidity needs.
The former lend their surplus resources to the latter through brokers, who
charge for their services. Inter- corporate loans facilitate such lending and
borrowings for short periods of time. The rate of interest and other terms and
conditions of such loans are determined by negotiations between the lending
and borrowing companies. The prevailing market conditions do exert their
influence on the determination of interest rates.

Statutory Provisions Prior to January 1999

The Inter-corporate loans were, till 1999 were governed by the provisions of
section 370 of the Companies Act, 1956 and the Rules framed thereunder.
This section provided that no company shall (a) make any loan to or (b) give
any guarantee or provide any security in connection with a loan given to any
body corporate unless such loan or guarantee has been previously authorised
by a special resolution of the lending company. But such special resolution
was not required in case of loans made to other bodies corporate not under
the same management as the lending company where the aggregate of such
248
loans did not exceed thirty percent of the aggregate of the subscribed capital Other Sources of
ShortTerm
of the lending company and its free reserves.’ Finance

Further the aggregate of the loans made by the lending company to all other
bodies corporate shall not, except with the prior approval of the Central
Government, exceed.
a) Thirty percent of the aggregate of the subscribed capital of the lending
company and its free reserves, where all such other bodies are not under
the same management as the lending company.

b) Thirty percent of the aggregate of the subscribed capital of the lending

company and its free reserves, where all such corporates are under the
same management as the lending company.

Section 372 of the Companies Act laid down the limits for investment by a
company in the shares of another body corporate. Rules framed there under
laid down that the Board of Directors of a company shall be entitled to
invest in the shares of any other body corporate upto thirty percent of the
subscribed equity share capital or the aggregate of the paid up equity and
preference share capital of such other body corporate whichever is less.
Permission of the Central Government was also required in case the
investment made by the Board of Directors in all other bodies corporate
exceed thirty percent of the aggregate of the subscribed capital and reserves
of the investing company.

Later, the Government brought out Companies (Amendment) Ordinance

1999, the provisions of sections 370 and 372 were made ineffective and
instead a new section 372A was inserted to govern both inter-corporate loans
and investments. According to the new section 372 A, a company shall,
directly or indirectly.
a) make any loan to any other body corporate,
b) give any guarantee, or provide security in connection with a loan made by
anyother person to anybody corporate, and
c) acquire, by way of subscription, purchase or otherwise, the securities of
any other body corporate upto 60% of its paid up capital and free
reserves or 100% of the free reserves, whichever is more.

The loan, investment, guarantee or security can be given to any company

irrespective of whether it is subsidiary company or otherwise. If the
aggregate of all such loans and investments exceed the above limit the
company would have to secure the permission of shareholders through a
special resolution which should specify the particulars of the company in
which investment is to be made or loan, security or guarantee is proposed to
be given. It should also specify the purpose of the investment, loan, security
or guarantee and the specific sources of funding. The resolution should be
passed at the meeting of the Board with the consent of all directors present at
the meeting and the prior approval of the public financial institutions where
any term loan is subsisting, is obtained. But no prior approval of the public
financial institution is necessary, if there is no default in payment of loan
249
Financing of installment or repayment of interest thereon as per the terms and conditions
Working Capital
of the loan.

The above provisions of Section 372 A will not apply to any loan made by a
holding company to its wholly owned subsidiary or any guarantee given by
the former in respect of loan made to the latter or acquisition of securities of
the subsidiary by the holding company. Section 372 A Shall not apply to any
loan, guarantee or investment made by a banking company, an insurance
company or a housing finance company or a company whose principal
business is the acquisition of shares, stocks, debentures etc or which has the
object of financing industrial enterprises or of providing infrastructural
facilities.

The loan to anybody corporate shall be made at a rate of interest not lower
than the Bank rate. A company which has defaulted in complying with the
provisions of the section 58A of the Companies Act, 1956 shall not be
permitted to make inter- corporate loans and investment till such default
continues.

Companies making inter- corporate loans/ investment are required to keep a

Register showing the prescribed details of such loans/investments/guarantees.
Such Register shall be open for inspection and extracts may be taken
therefrom. The provisions of the new section are not applicable to loans made
by banking, insurance/housing finance/investment company and a private
company, unless it is subsidiary of a public company.
If a default is made in complying with the provisions of section 372A, the
company and every officer of the company who is in default shall be
punishable with improvement upto 2 years or with fine upto Rs. 50,000/-.

Present Statutory Provisions as per Companies Act, 2013:

Under the New Companies Act, 2013, Inter-corporate loans are governed by
the provisions incorporated in section 186. According to this, a company can
extend loans or guarantees, acquire securities or make investments in any
other company upto 60% of the paid-up capital, or upto 100% of the share
premium or free reserves, whichever is higher. The other salient aspects in
this regard are:

• If the company wants to grant loans/guarantees above the prescribed

limit, there must be a special resolution passed by the company.
• Inter-corporate investments can be made above the threshold limit, if the
same are proposed to be extended to wholly-owned subsidiary, or Joint
Venture.
• The ceilings also do not apply to the companies registered under section
12 of the SEBI Act, 1992.
• No company can extend these loans at a rate lower than the prevailing
yield of the similar term.
• The company shall follow all disclosure norms and follow the procedure
as specified in the section 186 (2) of the Act.
250
• There are also penalties specified for contravention of the above rules. A Other Sources of
ShortTerm
penalty of not less than Rs.25,000 and upto Rs.5.00 lakhs may be Finance
imposed. The Directors of the company are also liable for imprisonment
for a term not exceeding 2 years and penalty of not less than Rs.25,000
and upto Rs.1.00 lakh.

Activity 11.2
i) Fill in the blanks:
a) The minimum period of maturity of CP. should be……….. days
b) The CP must have………………………………… Rating from
Credit Rating Information Services Ltd.
c) The loans by a company to another company shall carry a rate of
interest which is not less than .....................................

ii) Explain what do you understand by Standby facility?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
iii) State the latest provisions regarding Inter-corporate Loans.

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

11.5 BONDS AND DEBENTURES

Bonds and debentures are another form of raising debt for augmenting funds
for long term purposes as well as for working capital. It has gained popularity
during recent years because of the depressed conditions in the new equities
market and the permission given to the banks to invest their funds in such
bonds and debentures. These debentures may be fully convertible, partly
convertible, or non-convertible into equity shares.
The salient points of the Guidelines issued by Securities and Exchange Board
of India (SEBI) in this regard are as follows:
1) Issue of fully convertible debentures having a conversion period more
than 36 months will not be permissible unless conversion is made optional
with “put” and “call” options.
2) Compulsory credit rating is required, if conversion of fully convertible
debentures is made after 18 months. If the issue size is above Rs.1000
crore, two ratings are necessary. 251
Financing of 3) Premium amount on conversion, and time of conversion in stages, if any,
Working Capital
shall be predetermined and stated in the prospectus. The rate of interest
shall be freely determined by the issuer.
4) Companies issuing debentures with maturity upto 18 months are not
required to appoint debentures trustees or to create Debentures
Redemption Reserves. In other cases the names of debentures trustee
must be stated in the prospectus. The trust deed must be executed within
6 months of the closure of the issue.
5) Any conversion in part or whole of the debentures will be optional at the
hands of the debenture holders, if the conversion takes places at or after
18 months from the date of allotment but before 36 months.
6) In case of Non-Convertible Debentures and Partly convertible
debentures, credit rating is compulsory.
7) Premium amount at the time of conversion of Partly convertible
debentures shall be pre-determined and stated in the Prospectus. It must
also state the redemption amount, period of maturity, yield on redemption
for Non-convertible/ Partly Convertible Debentures.
8) The discount on the non-convertible portion of the Partly convertible
debentures, in case they are traded and procedure for their purchase on
spot trading basis, must be disclosed in the prospectus.
9) In case, the non-convertible portions of partly Convertible Debentures or
Non- Convertible Debentures are to be rolled over without change in the
interest rate, a compulsory option should be given to those debenture
holders who want to withdraw and encash their debentures. Positive
consent of the debenture holders must be obtained for all-over.
10) Before the rollover, fresh credit rating shall be obtained within a period
of six months prior to the due date of redemption and must be
communicated to the debenture holders before the rollover. Fresh Trust
Deed must be made in case of rollover.
11) The letter of information regarding rollover shall be vetted by SEBI.
12) The disclosure relating to raising of debenture will contain amongst other
things
a) The existing and future equity and long term debt ratio,
b) Servicing behaviour of existing debentures,
c) Payment of interest due on due dates on term loans and debentures
d) Certificate from a financial institution or bankers about their no
objection for a second or pari passu charge being created in favour
of the trustees to the proposed debenture issue.
13) Companies which issue debt instruments through an offer document can
issue the same without submitting the prospectus or letter of offer for
vetting to SEBI or obtaining an acknowledgement card from SEBI in
respect of the said issue, provided the:
252
 a) Company’s securities are already listed on any stock exchange Other Sources of
ShortTerm
Finance
b) Company has obtained atleast an ‘adequately safe’ credit rating for
its issue of debt instrument from a credit rating agency.
c) The debt instrument is not convertible, is not issued along with any
other security or, without any warrant with an option to convert into
equity shares.
14) In such cases a category I Merchant bank shall be appointed to manage
the issue and to submit the offer document to SEBI. The Merchant
banker acting as Lead Manager should ensure that the document for the
issue of debt instrument contains the required disclosure and gives a true,
correct and fair view of the state of affairs of the company. The merchant
banker will also submit a due diligence certificate to SEBI.
15) The debentures of a company can be listed at a Stock Exchange, even if
its equity shares are not listed.
16) The trustees to the Debenture issue shall have the power to protect the
interest of debenture holders. They can appoint a nominee director on the
Board of the company in consultation with institutional debenture holders.
17) The lead bank will monitor the utilisation of funds raised through
debentures for working capital purposes. In case the debentures are
issued for capital investment purpose, this task of monitoring will be
performed by lead Institution/ Investment Institution.
18) In case of debentures for working capital, institutional debenture holders
and trustees should obtain a certificate from the company’s auditors
regarding utilisation of funds at the end of each accounting year.
19) Company should not issue debentures for acquisition of shares or for
providing loans to any company belonging to the same group. This
restriction does not apply to the issue of fully convertible debentures
provided conversion is allowed within a period of 18 months.
20) Companies are required to file with SEBI certificate from their bankers
that the assets on which security is to be created are free from any
encumbrances and necessary permission to mortgage the assets have
been obtained or a No objection from the financial institutions/ banks for
a second or pari passu charge has been obtained, where the assets are
encumbered.
21) SEBI permits the issue of Debt instruments only when the instrument
carries minimum “A’ Grade rating.
22) The face value of the debenture/debt instrument shall be Rs.100 and shall
be listed in one or more Stock Exchanges.
23) A premium of 5% is only allowed in case of Non-convertible debentures.
24) The Redemption of the instrument shall not start before 7 years.
25) The issue of debentures should not exceed more than 20% of the gross
current assets, including loans and advances.
253
Financing of 26) The debt-equity ratio of the company shall not be above 2:1. However,
Working Capital
this shall not apply to capital intensive projects.

11.6 FACTORING OF RECEIVABLES

Factoring of receivables is another source of raising working capital by a
business entity. Factoring is an agreement under which the receivables
arising out of the sale of goods/services are sold by a firm (called the client)
to the factor (a financial intermediary). The factor thereafter becomes
responsible for the collection of the receivables. In case of credit sale, the
purchaser promises to pay the sale proceeds after a period of time. The seller
has to wait for that period for realising his claims from the buyer. His cash
cycle is thus prolonged and he needs larger working capital. Factoring of
receivables is a device to sell the receivables to a factor, who pays the whole
or a major part of dues from the buyer immediately to the seller, thereby
reducing his cash cycle and the requirements of working capital. The factor
realizes the amount from the buyers on the due date.
Factoring is of recent origin in India. Government of India notified factoring
as a permissible activity for the banks in July 1990. They have been
permitted to set up separate subsidiaries for this purpose or invest in the
factoring companies jointly with other banks. Two factoring companies have
been set up by banks jointly with Small Industries Development Bank of
India. SBI Factors and Commercial Services Ltd. has been promoted by State
Bank of India, Union Bank of India and the Small Industries Development
Bank of India. Canbank Factors Ltd. is another factoring company promoted
jointly by Canara Bank, Andhra Bank and SIDBI. The Foremost Factors
Ltd. is the first private sector company which has commenced its operations
in 1997. One other private sector company is Bibby Financial Services
(India) Pvt. Ltd., SBI also floated SBI Global Factors Ltd.

With Recourse and Without Recourse Factoring

Factoring business may be undertaken on ‘with recourse’ or ‘without
recourse’ basis. Under with recourse factoring, the factor has recourse to the
client if the receivable purchased turn out to be irrecoverable. In other words,
the credit risk is borne by the client and not the factor. The factor is entitled
to recover the amount from the client the amount paid in advance, interest for
the period and any other expenses incurred by him.
In case of, without recourse factoring, the factor does not possess the above
right of recourse. He has to bear the loss arising out of non-payment of dues
by the buyer. The factor, therefore, charges higher commission for bearing
this credit risk.
Mechanism of Factoring
1) An agreement is entered into between the seller and the factor for
rendering factoring services.
2) After selling the goods to the buyer, the seller sends copy of invoice,
delivery challan, instructions to make payment to the factor, to the buyer
and also to the factor.
254
3) The factor makes payment of 80% or more of the amount of receivable Other Sources of
ShortTerm
to the seller. Finance

4) The seller should also execute a deed of assignment in favour of the

factor to enable him to recover amount from the buyer.
5) The seller should also obtain a letter of waiver from the banker in favour
of the factor, if the bank has charge over the asset sold to the buyer.
6) The seller should give a letter of confirmation that all conditions of the
sale transactions have been completed.
7) The seller should also confirm in writing that all payments receivable
from the debtor are free from any encumbrances, charge, right of set off
or counter claim from another person, etc.
8) The facility of factoring in India is available to all forms of business
organisations in manufacturing, service and trading. Sole proprietary
concerns, partnership firms and companies can avail of the services of
factors, but a ceiling on the credit which they can avail of in terms of the
value of the invoice to be purchased is generally fixed for each client in
medium and small scale sectors. Generally the period for which
receivables are factored ranges between 30 and 90 days.
9) The factor evaluates the client on the basis of various criteria e.g. level of
receivables turnover, the quality of receivables, growth in sales, etc. The
factor charges a service fee and a discount. The service fee is charged in
advance and depends upon the invoice value for different categories of
clients. It ranges between 0.5–2% of the invoice value.
Moreover, the factor also charges a discount on the pre-payment made to the
client. It is payable in arrears and is generally linked to the bank lending rate.
In case of high worth clients, the discount rate is presently one percentage
point lower than the rate charged under the cash credit system.

The cost of funds under, without recourse, factoring is much higher than,
with recourse, factoring due to the credit risk borne by the factor. However,
the service fee and discount charge depends upon the cost of funds and the
operational cost.

RBI Regulations on Factoring Services:

The Government of India has originally issued Factoring Regulations in
2011. The same were amended in 2022. As per these regulations, all the
existing NBFC Investment and Credit Companies with asset size of Rs.1000
crore and above are permitted to undertake factoring services. Based on this
norm, there are about 182 firms that would be eligible to do this business.
While all other conditions of Regulations, 2011 are in force. As per these,
every firm intending to start this business shall register with the Reserve
Bank of India. Similarly, the procedure to conduct this business shall be as
specified in these regulations. RBI in this regard has the power to give
directions and collect information from factors registered.
Though the service was started with huge expectation, it did not meet with
any success. The total factoring business stood at 1625 million Euros; of this 255
Financing of domestic turnover remained at 1450 million Euros. As a matter of fact, till
Working Capital
recently (2015), the number of factoring companies stagnated at 8 only. After
the 2022 amendment, it is now expected that the number would grow to 182.
It remains to be seen to what extent the factoring business would also grow at
the same pace.

Activity 11.3
i) Fill in the blanks:
a) The Credit Rating required for debentures ………………………..
b) The names of Debenture Trustees must be disclosed in
..........................
c) In case of ‘with recourse factoring’, the loss arising out of non-
payment ofthe dues by the buyer is borne by........................
ii) Explain the mechanism of factoring of receivables.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

11.7 SUMMARY
In this unit, we have discussed various sources of short term funds, other than
bank credit and trade credit which are used by business and industrial houses
in India to finance their working capital needs. The unit covers public
deposits, commercial paper, inter-corporate loans, bonds and debentures and
factoring of receivables. The statutory framework, along with rules and
regulations concerning these sources have been explained in detail. Relative
significance of these sources has also been explained by citing relevant facts
and figures. Though these sources are deemed as non-bank sources of
finance, involvement of commercial banks in providing such finance is
evident, specially, in case of commercial paper, bonds and debentures and
factoring of receivables.

11.8 KEY WORDS

Public Deposits: Public deposits are deposits of money accepted by
companies in India from the public for specified period ranging between 12
months and 36 months. These deposit are accepted within the limit and
subject to terms prescribed under Companies (Acceptance of Deposits) Rule,
2014.
256
Commercial Paper: Commercial paper is an unsecured instrument through Other Sources of
ShortTerm
which high net worth corporates borrow funds from any person, corporate or Finance
unincorporated body. It is issued in the form of usance promissory note;
which is freely transferable by endorsement and delivery. Its minimum
period of maturity should be 15 days and maximum period less than a year,
It is issued at a discount to face value.
Inter-Corporate Loans: These are loans made by a company to another
company, whether its own subsidiary or otherwise. These loans and
investments in the securities of another company should be upto the limits
specified in section 186 of the Companies Act, 2013.

Convertible Bonds: These are bonds issued by the companies to the

investors, which are convertible either fully or partly into the equity shares of
the company within a specified period of time at the option of the investor.

Put and Call Options: The debt instruments like bonds and debentures are
issued for a fixed period of time-i.e. they are redeemable at the expiry of a
fixed period say 5 or 7 years. But sometimes the issuer includes the ‘put’
or/and ‘call’ options in the terms of issue. ‘Put’ option means that the investor
may, if he so desires ask for the redemption of the bond after a specified
period is over but before the period of maturity. If the issuer reserves this
right to himself to redeem the bond after a specific minimum period but
before the date of maturity, such right is called ‘call’ option.
Credit Rating: Credit Rating is an opinion expressed by a Credit Rating
Agency about the ability of the issuer of a debt instrument to make timely
payment of principal and interest thereon. It is expressed in alphabetical
symbols. All types of debt instruments may be rated. Rating is given for
each instrument and not for the issuer as such.

Factoring of Receivables: Factoring is an agreement under which the

receivables arising out of the sale of goods/services are sold by a firm (called
the client) to the factor (a financial intermediary), who becomes responsible
for the collection of the receivable on the due date.
With Recourse and without Recourse Factoring: When the factor bears
the loss arising out of non-payment of the dues by the buyer, it is called
without recourse factoring. In case of ‘With Recourse Factoring’ he can
recover the loss from the client (seller).

11.9 SELF ASSESSMENT QUESTIONS

1) State the broad categories of deposits which non-banking companies can
accept to meet their working capital needs.
2) State the existing guidelines regarding maintenance of liquid assets
prescribed for a company accepting deposits from the public.
3) What remedy is available to the depositor, if the company fails to repay
the deposit as per the terms and conditions of the deposit?
4) Describe the eligibility conditions prescribed for issuing the Commercial
Paper. 257
Financing of 5) Describe five important terms and conditions for issuing Commercial
Working Capital
Paper.
6) Why are banks major investors in Commercial Paper?
7) Explain the provisions of section 186 regarding inter-corporate loans and
investments.
8) Describe the guidelines issued by SEBI for the conversion of debentures
into equity.
9) What do you understand by factoring? Discuss With Recourse and
Without Recourse factoring?
10) Write a short note on ‘company deposits’ as a source of working capital
finance for industry in India.

11.10 FURTHER READINGS

1) Reserve Bank of India: Report of the Study Group on Examining the
Introduction of Factoring Services in India (Chairman: E.S. Kalyana
Sundaram).
2) Reserve Bank of India: Report of the Working Group on Money Market
(Chairman: N. Vaghul).
3) Jain, A.P., Company Deposit: Law and Procedure, Chapters 1, 2 & 3.
4) Taxman’s Companies Act with SEBI Rules/Regulations and Guidelines.
5) Aswath Damodaran, Corporate Finance: Theory and Practice, Wiley
Estern, 2020.
6) Jaswant Saini, Corporate Finance, University Book House Pvt. Ltd.,
2021.

258
 Other Sources of
ShortTerm
Finance

BLOCK 4
WORKING CAPITAL MANAGEMENT:
ISSUES AND PRACTICES

259
Financing of
Working Capital BLOCK 4 WORKING CAPITAL
MANAGEMENT: ISSUES AND
PRACTICES
This block contains four units, the first unit discusses the role and
contribution of SMEs in India, and the scope, and functions of financial
management in SMEs. Besides it also presents the issues relating to the
working capital management for small and medium enterprises. The second
unit explains the financing options of large and small businesses, besides the
differences between the small and large firms working capital management.
Further, it also highlights the important factors that affect the working capital
needs of large companies. In the end, it discusses the impact of COVID-19 on
large companies working capital management.

The working capital management in MNCs is presented in the next unit to

understand the international environment under which MNCs carry out their
operations; along with developing an idea of how-to diverse risks associated
with the management of working capital and to know the issues involved in
the transfer of funds from the host country to home country and vice-versa.
At the end it examines the policies and practices followed by the MNCs in
managing individual components of working capital, viz., inventory
receivables and cash. Further, it also covers the diverse sources of working
capital available to MNCs. The last unit in this block focuses attention on the
case studies on the working capital components in different organizations to
gain knowledge on how to manage the working capital in practical situations.

260
 Working Capital
UNIT 12 WORKING CAPITAL Management in
SMES
MANAGEMENT IN SMES
Objectives
The objectives of this unit are to familiarise you:
• with the scope and functions of financial management
• role and contribution of SMEs in India
• working capital management for small business organizations
• managing working capital in small and medium enterprises.

Structure
12.1 Introduction
12.2 Small & Medium Enterprises Vs. Large Companies
12.3 Role of Small and Medium Enterprises in India
12.4 Working Capital Management for SMEs – Differential Features
12.5 Working Capital Cycle
12.6 Objectives of Working Capital Management in SMEs
12.7 Managing Working Capital
12.8 Determinants of Working Capital in SMEs
12.9 Components of Working Capital Management
12.10 Effective Working Capital Management for SMEs
12.12 Strategic Planning - Strengthen Working Capital Performance
12.13 Summary
12.14 Key Words
12.15 Self-Assessment Questions/Exercises
12.16 Further Readings

12.1 INTRODUCTION
To define Small and Medium Enterprises (SMEs), academics and policy
makers employed a range of criteria, including total worth, relative size
within the industry, number of employees, product value, yearly sales, or
receipts. The benchmarks, on the other hand, differ significantly from country
to country, and classification can be based on a company's assets, several
employees, or yearly sales. The nature of the unpredictability that SMEs
encounter sets them apart from their larger counterparts. Smaller businesses
are more likely to be reliant on a small number of consumers and have a
restricted product selection; they are therefore more vulnerable to market
instability.

261
Working Capital
Management: 12.2 SMALL & MEDIUM ENTERPRISES Vs.
Issues and Practices
LARGE COMPANIES
There are several analysts who argued that SMEs have many advantages over
their large-scale competitors because of their modern technologies, which
allow them to adjust more easily to market situations. They claim that SMEs
can withstand unfavorable economic situations because of their flexibility.
They are more labour-intensive than larger firms and therefore, they have a
relatively low cost of capital associated with job creation.
Small firms are similar to large well-established corporations, but they have a
lesser market presence. On the other hand, the larger firms must deal with a
plethora of rules and regulations that they have imposed on themselves. As a
small business owner, you'll have a lot more leeway when it comes to making
adjustments to business processes. Taking working capital management
seriously and paying attention to the intricacies of how cash flows are
handled can make the company more lucrative. This, when paired with social
networking, e-commerce, and data science, can be extremely beneficial to
small businesses.

A small or large business must be able to earn enough cash to meet its
immediate obligations and hence continue to trade. The failure of small and
medium businesses is caused by ineffective working capital decisions and
insufficient accounting information that has been cited regularly. Many
experts agree that “the smaller they are, the less efficient they tend to be.”
Although little study has been done on the SMEs sector, articles on working
capital management claim that the following distinctions in working capital
management techniques exist:
• For short-term finance, there is a growing reliance on trade credit and
bank overdrafts.
• willingness to extend overly generous credit terms to win business,
especially from large corporations
• Weak control procedures and a lack of a clear working capital
management policy.

The manufacturing and retailing firms generally hold more than half of their
total assets as current assets, even though the level of working capital varies
greatly by industry. As current assets are held in the form of inventory,
accounts receivables, bank and cash balances the percentage is even higher in
the case of SMEs, many of whom do not have long-term assets such as a
building or a vehicle of their own.

The small firms most typically pursue finance in the form of standard small
business loans. While these loans are excellent for beginning a firm,
producing an initial cash flow, and developing working capital, they can be
challenging to maintain over time. As a result, small firms’ investments can
take many different forms. In addition to standard small business loans,
they may be able to obtain funding through personal loans, such as home
equity loans. Small businesses can also fund their endeavors through their
262
vendors, such as financing equipment or using a pay-by-the-hour option, Working Capital
Management in
such as "buy now, pay later." Finally, small firms may be eligible for SMES
venture financing or government incentives under certain conditions.

12.3 ROLE OF SMALL AND MEDIUM

ENTERPRISES IN INDIA
Small and medium enterprises contribute significantly to the creation of jobs
and the gross domestic product of all countries across the world (GDP).
These in general, engage in a wide range of economic activities and are often
regarded as the backbone of economic growth and development in both
emerging and established economies. Small and medium-sized businesses are
one of the most active development engines, accounting for about 80 percent
of worldwide economic development. SMEs account for more than 90
percent of businesses in developing nations, except agricultural businesses,
and they contribute significantly to GDP. As a result, practically every
country considers SMEs to be a priority.

In India, this industry contributes considerably to the socio-economic

development of the country. Furthermore, compared to larger corporations, it
offers a big number of job prospects at a minimal capital cost. Small
businesses are predicted to have a four-fold higher employment intensity than
large businesses. As supplementary units, these small businesses are also
beneficial to larger industries. Because of their effective, efficient, adaptable,
and innovative entrepreneurial nature, they also contribute to the
development of the home economy. Furthermore, they aid in the reduction of
regional imbalances by assisting in the industrialization of rural and
backward areas. Similarly, the SME sector ensures that national income and
wealth are distributed more evenly. Small businesses have succeeded in
achieving the socialist objective of delivering equal growth, even though
huge corporations generally generated the islands of affluence in an ocean of
poverty.

MSMEs in India are defined differently for businesses that manufacture,

produce or process items vs those that provide or deliver services.
Manufacturing businesses are classified by their investment in plants and
machinery, whereas service businesses are classified by their investment in
equipment, according to the MSMED Act of 2006. Table-12.1 provides the
classification of MSMEs as per MSMED Act, 2006.

Table-12.1 Classification of MSMEs

Manufacturing Sector
Categories Investment in Plant & Machinery
Micro Enterprises Does not exceed Rs. 25 lakhs
Small Enterprises More than Rs. 25 lakhs but does not exceed Rs. 5
crores.
Medium Enterprises More than Rs. 5 crores but does not exceed Rs. 10
crores.
263
Working Capital
Management:
Service Sector
Issues and Practices Categories Investment in Equipment
Micro Enterprises Does not exceed Rs. 10 lakhs.
Small Enterprises More than Rs. 10 lakhs but does not exceed Rs. 2
crores.
Medium Enterprises More than Rs. 2 crores but does not exceed Rs. 5
crores.
Source: The Micro, Small and Medium Enterprises Development Act, 2006

12.4 WORKING CAPITAL MANAGEMENT IN

SMEs - UNIQUE CHARACTERISTICS
Any firm can have multiple sources of revenue, and effective management of
such sources can help the business run smoothly. While beginning money
and fixed assets are often long-term investments, an effective cash flow
structure is essential for the day-to-day operations of any organization. In
light of this working capital becomes increasingly important for small
business owners. Furthermore, many small businesses run their operations
without keeping track of how their working capital is being used.

In reality, small business owners cannot afford to ignore the working capital
management process. Furthermore, many small businesses do not maintain
accounting records for their operations. As a result, without proper
accounting records and information, SMEs have a difficult time
distinguishing between their working capital and earnings. As a result of this
issue, SMEs frequently fail a few years after they are founded. As a result,
the goal of working capital management is to keep net capital at a level that
maximizes the wealth of the firm's owner. Apart from that, there are several
other problems to consider when it comes to working capital management:

i) Effective working capital management ensures that the firm has

sufficient liquidity to meet its short-term obligations when they become
due as well as carry out its usual day-to-day activities. There have been
multiple instances where small businesses have failed due to a lack of
liquidity, despite increasing revenues.

ii) Many SMEs struggle to manage their working capital because they lack
the resources to adequately manage their trade debtors. Small businesses
frequently operate without a credit control department. As a result, both
knowledge and the information needed to make smart decisions about
sales terms and other matters may be unavailable.
iii) SMEs lack effective debt procedures, such as timely invoicing and
regular statement distribution. Where there is a sole concern for
expansion, this tends to increase the chances of late payment and
defaulting debtors. To boost sales, SMEs may be willing to lend credit to
consumers who pose a high risk of default. While this type of issue can
occur in any size business, it is more common in smaller businesses.

264
iv) When negotiating financing terms with bigger businesses, SMEs will Working Capital
Management in
frequently find themselves in a disadvantaged position. Furthermore, SMES
when a major customer exceeds the conditions of the credit, the small
supplier may be hesitant to pursue payment from the consumer for fear
of losing future sales. SMEs appear to have a substantially higher
proportion of past-due loans than bigger corporations.
v) The SME owners and managers are not always aware of the expenses of
keeping too much stock as well as the costs of holding too little stock.
Because an effective inventory management system necessitates efficient
planning and budgeting processes, accurate sales projections or budgets
should be provided for stock ordering purposes.

vi) It was also found that cash balance was generally proportionately higher
for SMEs than for large businesses. Again, more than half of the SMEs
had regular surplus cash balances. Although finance, and specifically
working capital, has been highlighted as one of the key impediments to
small business growth, current understanding does not address the
specific difficulties or intricacies of the obstacles that small business
owners have in managing working capital.

Activity 12.1
You are required to approach a small business firm of your choice and
discuss the policies and procedures followed in the sphere of working capital
management.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

12.5 WORKING CAPITAL CYCLE

Moreover, half of the SMEs had regular cash surpluses. Even though finance,
and specifically working capital management, has been highlighted as one of
the key limitations to small business growth, current understanding does not
address the specific difficulties or intricacies of the obstacles small business
owners have in managing working capital. Figure-12.1 shows that several
elements of working capital are interconnected and can be considered as
sections of a cycle. The net time delay between real cash expenditure on a
firm's purchases and the ultimate recovery of cash proceeds from sales is
reflected by the working capital cycle, which is also known as the operational
cycle.

There are three phases to the operation cycle. Cash is transformed into
inventory in phase one, which comprises purchasing raw materials, 265
Working Capital converting raw materials into work-in-progress, and finished goods, and
Management:
Issues and Practices finally transferring items to stock after the production process. This phase is
shorter in trading companies that are usually modest in size since there is no
manufacturing activity and cash is directly converted into inventory.

Inventory is transformed into receivables in phase two of the cycle as credit

sales are made to customers. Businesses that do not sell on credit do not have
phase two of the operational cycle, which is especially true for small and
medium businesses. The collection of receivables is represented by the final
phase. This phase completes the operating cycle, requiring businesses to
transition from cash to inventories, receivables, and then back to cash.

Figure-12.1: Working Capital (Operating) Cycle

Credit for suppliers

Price level
Changes
Business
Fluctuatio Cash
n

Accounts Accounts
Receivable Payable
Production

Finished Raw Material

Goods Inventory
Nature of Inventory
Business

Production Policy Growth & Expansion

Determining working capital using Operating cycle is discussed in detail in

unit-3 of this course.

12.6 WORKING CAPITAL MANAGEMENT

GOALS FOR SMEs
The basic goal of working capital management, whether small or large, is to
maintain a level of working capital that maximizes the value of the firm's
owners/shareholders. In addition, the following are some of the goals of
working capital management:

i) Working capital and the liquidity of the company are inextricably linked.
As a result, good working capital management ensures that the company
266
 has enough cash on hand to meet its short-term obligations and run its Working Capital
Management in
day-to-day operations. SMES

ii) There should be a link between profitability and working capital as well.
Because of the cost of financing the firm's current assets, the amount of
capital has an impact on its profitability and working capital.

iii) There is evidence that many SMEs are poor at managing their working
capital, which has been highlighted as a primary reason for their high
failure rate when compared to bigger enterprises.

12.4 WORKING CAPITAL MANAGEMENT

As previously stated, there is a link between working capital investment, cash
availability, and other cash uses and sources. If a company invests too much
money in working capital, the quantity of money available for other business
needs may be lowered. Because it does not have enough cash to invest in
long-term assets that can provide higher returns, this could have an impact on
future profits. Capital issues, debt, or the sale of current assets, which are
usually costly for the company, can all be used to raise cash. The best
strategy to fund the working capital required is to use the cash generated from
operating activities. This will ensure that you have enough cash to pay your
tax and dividend obligations.

As a result, working capital is one of the few remaining areas where a

shareholder's value can be influenced without the help of a huge restructuring
firm. In a recovering economy, funding working capital also needs strategic
planning and oversight. Companies have the problem of expanding output
while keeping working capital under control, which has had a significant
impact on revenue, operating margin, asset efficiency, and future
expectations, as well as the components of working capital. This is depicted
in Figure-12.2 as follows:

Figure-12.2: Interlinking of Shareholder Value and Working Capital Management

There are no fixed norms or criteria for calculating a company's working

capital. To assess the level of working capital, the company must evaluate a
variety of elements. The amount of working capital required by a company is
influenced not only by the company's internal characteristics, but also by its
economic, monetary, trading, and working capital regulations. Among the
various factors, the following are important ones. 267
Working Capital
Management:
12.7.1 Nature of Business
Issues and Practices
The type and size of working capital are influenced by the characteristics of
the firm within the industry. A retailing unit has a specific inventory, such as
finished items. These are things that were purchased on credit; however, the
majority of the sales were made in cash. The stock level of items is typically
high, and some merchants have just-in-time relationships with suppliers,
allowing them to lower the cost of inventory keeping. Raw materials, work-
in-progress, finished goods, and consumables are the four categories of
inventories found in a manufacturing company. Keeping inventory, costs a
lot of money, thus these companies commonly buy and sell on credit.
Manufacturing companies, on the other hand, typically have a high amount of
trade receivables and trade credits from suppliers.

12.7.2 Working Capital Policy

Because less cash is tied up in current assets, a more aggressive working
capital program will boost profitability. The risk will also rise if the
likelihood of cash shortages or inventory shortages increases. Maintaining a
greater cash position, possibly even investing in short-term securities,
offering more generous credit terms to consumers, and storing higher
quantities of inventory are all connected with a conservative and more
flexible working capital policy for a given level of turnover. This policy will
result in lower risk, but at the cost of lesser profitability.
A moderate policy would strike a balance between aggressive and
conservative policies. By comparing a company's working capital policies to
the working capital policies of similar companies, it may be determined
whether the company's working capital policies are aggressive, moderate, or
conservative. Despite the lack of a precise definition of what constitutes
aggressive behavior, these classifications are useful for studying how
different companies approach working capital operational management.
Figure-12.3 depicts a more detailed picture of the working capital cycle, with
arrows showing cash movement.

Working Capital
Requirement

Figure-12.3 Cash Movement in the Working Capital Cycle.

Source: Singh & Kumar (2014)
268
 Working Capital
12.7.3 Financing of Working Capital Management in
SMES
The risk-return trade-off that happens in policy decisions about current asset
investments is also important in policy decisions about other items on the
balance sheet, such as the choice between short-term and long-term funds to
finance working capital. We can divide a company's assets into three
categories to help with working capital financing policy decisions: non-
current assets, permanent current assets, and fluctuating current assets. Non-
current assets are long-term assets that a company expects to benefit from
over a lengthy period, such as factory buildings and production machines.
Permanent current assets, on the other hand, reflect the core level of working
capital required to maintain the typical level of ongoing business or trading
activity, such as inventory and trade receivables investment. The fluctuating
current assets reflect changes in the level of current assets as a result of
typical business operations.

A fair financing policy allocates short-term funds to fluctuating current assets

and long-term funds to permanent current assets and non-current assets. The
funds' maturity corresponds to the maturity of the various types of assets.
Long-term funds are used to finance non-current and permanent current
assets in a conservative financing approach. The risk of conservative working
capital management is lower since there is less reliance on short-term
financing, but the higher cost of long-term funding reduces profitability.
Short-term funds are used to finance not only fluctuating current assets, but
also some permanent current assets, under an aggressive financing policy.
This policy is more risky in terms of solvency, but it also has the highest
profitability and boosts shareholder value. Due to their greater sustainability
in various business scenarios, SMEs are more susceptible to these varied
ways of financing working capital than bigger enterprises.

12.7.4 Optimization of Working Capital.

The following are the various barriers to optimizing the working capital in
small and medium enterprises:

Customer and Fear of compromising relationships and revenue by

Rivalry pursuing customers for payment too aggressively. There's a
chance you'll lose clients to the competition.
Fear of drop-in customer service if inventory levels aren't
kept high. Customers are granted payment discounts even if
they do not pay on time. Longer payment terms are being
offered due to competition.
Concerns about how suppliers will react and the potential of
Suppliers disruption to supply as a result of a unilateral move to
extend payment terms.
Negative media impact on the organization's reputation if
payment terms are extended, especially for minor supplies.

269
Working Capital
Management: Control and The importance of cash is not reflected in individual or
Issues and Practices Accountability organizational performance measurements.
Working capital is a complex topic with multiple functional
areas to which no single person can be assigned authority.
Are there any advantages? We will be unable to run the
Advantages firm on a day-to-day basis if we restrict liquidity.
Are the advantages long-term? It can control working
capital levels after the fiscal year, but they quickly climb
again.

12.7.5 Small and Medium Enterprises - Overtrading

Overtrading is one of the issues that many businesses, particularly small and
medium-sized businesses, face. Over-trading occurs when a firm expands too
quickly and does not have enough long-term funds to support the increasing
asset level. When a company's revenues expand, so does the quantity of
working capital it has. In the absence of this additional funding, the company
may put pressure on its debtors and creditors. This could indicate that the
corporation is behind on payments to creditors or is putting pressure on
existing debtors to pay up sooner. Because the rise in inventory and trade
receivables exceed the growth in trade payables, a resource requirement must
be met. If no action is done, the firm's overdraft will be increased, generating
liquidity problems.

Many prosperous or growing businesses may be forced to close, due to a

liquidity problem. Over-trading can cause problems for even the most
experienced companies striving to expand quickly. Indeed, any company
looking to expand should factor in the need for long-term working capital
investments throughout the initial decision-making process. When a small
business receives substantial orders from a significant market player, it must
purchase new equipment, purchase additional raw materials, and recruit
additional personnel. For any of these, the company may seek an overdraft
from the bank or lease equipment.
It may be tough for a small supplier to put pressure on a buyer to pay early or
even within an acceptable time frame. Larger companies frequently wield
more power in commercial relationships. This situation becomes more acute
when trading internationally. As a result, when the economy emerges from a
recession, over-trading can be an issue for many businesses. When demand
increases, the company may boost inventory levels. This could be the most
fundamental scenario in which over-trading occurs. Business firms want to
take advantage of rising demand by attempting to complete all requests, but
they lack the financial resources to do so.

12.7.6 Overtrading Impact Reduced

To mitigate the impact of over-trading, it is recommended that the company
maintain, its growth strategy and take steps to secure the appropriate long-
term finance. The corporation can sell non-current assets for cash to finance
270
working capital if they do not create enough income and aren't crucial to the Working Capital
Management in
firm. The working capital policy should be reviewed to reduce trade SMES
receivables and inventory holding periods while simultaneously increasing
trade payable periods without affecting the prices/discounts agreed upon with
suppliers. The company must reassess its growth strategy, and if it expands
too quickly with insufficient financial resources, it may face financial
difficulties.

12.8 DETERMINANTS OF WORKING CAPITAL

MANAGEMENT IN SME
Corporate finance advocates that a variety of firm-specific elements influence
managerial decision-making, particularly small business working capital
performance. The level of working capital is determined by fundamental
elements such as a firm's size, working capital practices of enterprises, and a
variety of other considerations. They observed discrepancies in small and
large firm financial procedures, as well as greater and lower profitable firm
working capital methods. Managerial decisions are influenced by a variety of
characteristics, including business size, performance, industry, firm age,
manager gender, and management education. According to the above, the
size of SMEs' working capital practices is controlled by the following
characteristics, which are separated into three categories: firm-specific,
owner-specific, and behavioral bias. They are explained as follows:

12.8.1 Firm-Specific Factors

i) Firm Age: In the case of small company businesses, the firm's age has
been used as a proxy for the length of the relationship between suppliers
and customers, as well as the creditworthiness to support suppliers. It is
stated that age has a favorable impact on working capital requirements,
which could be explained by the fact that small businesses can obtain
loans more quickly with better terms and closeness to their financiers,
resulting in cheaper funding costs. In the case of SMEs, it is assumed
that there will be a positive link between the firm's age and the amount of
money necessary for working capital procurement.
ii) Firm Size: Another factor that influences the volume of working capital
funds is size, which has a positive link with the cash conversion cycle
and has shown that the working capital needs grow with size. This could
be because the cost of cash needed to invest in current assets, falls as the
size of the company grows, as smaller companies have more information
asymmetries and more informational capacity, which analysts can
exploit. In brief, because the cost of cash invested in current assets is
higher for smaller businesses, their accounts receivable and inventory
may be lower. Furthermore, as previously said, these companies use
greater trade credit from their suppliers. Thus, it can be seen that the size
of a company has a beneficial impact on the cash conversion cycle it
maintains.

271
Working Capital iii) Financial Leverage: Firms with more physical assets may have lower
Management:
Issues and Practices expenses when raising capital to invest in current assets, which may
increase the cash conversion cycle in small businesses. As a result, in
small businesses, physical asset investment is positively connected with
working capital size. Because of lower funding costs due to greater
physical assets, they may be able to invest more in working capital.

Firm Specific Factors Owner Specific Factors

• Age of the Firm • Gender
• Size of the Firm • Education
• Financial Leverage • Experience
• Foreign Sales

Working Capital Management Process

• Cash Management Practices
• Inventory Management Practices
• Receivable Management Practices
• Payable Management Practices

Behavioural Biases
• Self-Attribution Biases
• Overconfidence Biases
• Loss Aversion Biases
• Anchoring Biases

Figure-12.4: Determinants of Size of Working Capital in SMEs

iv) Foreign Sales: When compared to enterprises without foreign sales,

companies with overseas sales place a greater emphasis on working
capital. SME owners' financing preferences are also influenced by these
sales. The export-oriented businesses find it easier to obtain bank
funding because they have a higher likelihood of payback than non-
exporting businesses due to better production and profit. Furthermore,
factors such as the currency exchange rate and the degree of inflation
have a greater impact on cash management in companies that sell
internationally than in companies that do not. Furthermore, export-
oriented businesses pay more attention to currency exchange rates
because fluctuations in the rate affect the price of exported items and, as
a result, cash flows. The enterprises with foreign sales are more
formalized and use advanced procedures in inventory management than
firms without international sales.

272
 Working Capital
12.8.2 Owner Specific Factors Management in
SMES
i) Gender of Manager: It is a well-known truth that human attitudes and
behavior influence financial decision-making. Furthermore, due to their
attitudinal differences, males and females have dramatically different
risk-taking capacities. Females were discovered to be more risk-averse
than their male counterparts, who have higher risk tolerance. Males and
females have different risk perceptions, which influences their decision-
making. Female business managers are also more likely than male
business managers to experience financial difficulties.
ii) Education of Manager: Highly educated persons are thought to make
more informed decisions and make decisions based on analytical
reasoning. Managerial education is considered a critical component for
increasing productivity in a fast-changing environment. People with
higher education have stronger problem-solving skills and are more
adaptable to change than those with lower education. In terms of
working capital size, it has been discovered that SME owners/managers
with higher education are better equipped to manage their working
capital. In addition, skilled SME managers can effectively control
inventory levels using computerized accounting systems.

iii) Experience of Manager: A manager's work experience is an equally

essential factor in improving a company's performance. Further, more
work experience reduces the likelihood of decision-making errors. As a
result, the manager's experience has been regarded as a significant
element affecting many elements of SME enterprises. More experienced
SME managers, are expected to be, better at negotiating credit terms with
suppliers and customers. Skilled SME managers can control inventory
levels using the most up-to-date technologies in their systems.

12.8.3 Behavioural Biases

According to classical finance theories, individuals are rational and make
decisions based on predicted utility maximization. However, in real-life
situations where people are not completely logical, the truth does not match
these expectations. It has been shown in the field of experimental psychology
that humans generally depart from the classic rationality paradigm. Moods,
emotions, personality traits, and other behavioral aspects influence their
decision-making. Over time, extensive research on behavioral biases has been
conducted, and they have identified a long list of biases that influence
managers' behavior on working capital management, particularly in SMEs,
including representativeness, overconfidence, anchoring, loss aversion, self-
attribution, mental accounting, overreaction, herding, and so on.

12.9 COMPONENTS OF WORKING CAPITAL

MANAGEMENT
A typical manufacturing or distribution firm’s current assets account for more
than half of its overall assets. As a result, these businesses must efficiently
manage their current accounts to achieve the necessary balance of 273
Working Capital profitability and risk. Thus, it is a critical component of a company's overall
Management:
Issues and Practices strategy for increasing shareholder value. This, in turn, entails managing and
controlling current assets and liabilities in a way that removes the danger of
failing to pay short-term commitments', due dates and avoids overinvesting in
these assets.

12.9.1 Inventory Management

The corporation should aim to strike a balance between the cost of retaining
inventory and the risk of missing out on sales. The goal is to lower the
company's total cost. This can be accomplished if there is a good line of
communication between the marketing and sales departments, the production
and purchasing departments, and the store managers. Indeed, the company
should select an inventory management system that is appropriate for its
industry and product features.

i) Potential Consequences of Stock-Out: The impact of a stock-out

would have an impact on the amount of inventory held by a corporation.
Inventory holding is a smart investment, but it also comes at a cost to the
company. Without incurring holding costs, the corporation can earn by
saving interest in the bank or investing in higher-yielding investments.
As a result, the cost of financing inventory will be influenced by the
company's ability to finance the additional expenditure. If the demand
for the company's goods is known with reasonable certainty, or if a
predictable pattern exists, the company can predict the inventory level.
Because the company has a good relationship with its suppliers and the
distribution route is functional, it may reduce inventory holding and save
money by receiving the product soon.

When a company runs out of inventory, it risks losing sales and losing
money that could have been generated through sales. If the company's
product is specialized, the consumer may have to wait for it, which is
less serious. If a company's products are homogeneous, buyers can
simply locate them elsewhere, which causes the company to lose clients
to its competitors. When the company is in a slump, however, it may be
difficult to acquire another customer, resulting in a higher economic
impact. If it is a manufacturing company, a shortage of raw materials
will disrupt production, resulting in idle time and overheads that aren't
incorporated into the product.

ii) Economic Order Quantity: By combining the expenses of storing

inventory with the expenses of acquiring the goods, this inventory
management method determines the optimal order size. A minimum-cost
procurement approach is based on this ideal order size. The economic
order quantity model presupposes, that costs and demand are stable and
certain for the period under discussion.

iii) Just-In-Time Inventory Policies: In recent years, several businesses

have cut inventory expenditures by reducing inventory levels. The goal
of a just-in-time (JIT) purchasing policy is to reduce or eliminate the
period between inventory delivery and use. Such strategies have been
274 used in a wide range of commercial operations and necessitate a close
 interaction between the raw material provider and the purchaser of other Working Capital
Management in
consumable components. To avoid production interruptions, the buyer SMES
seeks guarantees from the provider on both quality and delivery
reliability. In exchange for these pledges, the supplier might expect long-
term purchase agreements from a firm that uses the JIT purchasing
strategy, which focuses on working with suppliers that can provide goods
of the requisite quality on time. This can be accomplished by changing
the factory layout to reduce work-in-progress queues and so lower the
size of production batches, in addition to creating stronger ties with
suppliers. A good production plan is also necessary for the success of the
JIT policy to achieve this.

Activity 12.2

You are approached by an owner/manager of a small business and

inquire about the inventory management procedures employed by his or
her company. In this context, try to collect data on the following:
i) What are the main types of inventories which is used and what procedure
followed to procure the stocks needed in his/her organization?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) Identify the type of inventory costs being incurred and assess the cost of
carrying inventory to obtain the optimal inventory.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

12.9.2 Credit Management

Information on a firm is essential for making an informed decision about
whether or not to trade with it. If the creditworthiness of new clients is
rigorously analyzed before credit is issued and is evaluated regularly, the risk
of bad debts can be reduced. A variety of sources can be used to gather the
necessary credit information. The published information, such as a
prospective customer's audited annual report and accounts, may also provide
a good indication of trustworthiness. The amount of probable regular sales
could be used as a reference to define the level of the credit investigation,
keeping in mind the cost of analyzing creditworthiness in mind.
275
Working Capital After the customer's creditworthiness has been assessed and a credit limit
Management:
Issues and Practices agreed upon, the company should take steps to guarantee that the credit limit
and terms of trade are adhered to. The customer accounts should also be kept
within the agreed-upon credit limit, and credit extended should be reviewed
regularly to ensure that it is still appropriate. To encourage fast payment, bills
and statements should be double-checked for accuracy and sent out as soon
as possible.

i) Influence
The following Table-12.2 shows how trade receivables management
strategies affect a company's commercial activities:

Table-12.2: Influence of Company Activities on Receivable Management

Policies
Marketing strategy and strategic Industry influence
growth

When a firm's products are highly In general, businesses strive

specialized and in high demand, the to conform to industry
marketing strategy might concentrate on standards. A firm that offers
these characteristics. lengthier loan terms than the
industry standard can usually
In a market with homogeneous products,
charge more.
the term of sale becomes significant, and
discounts and credit periods are regarded If the firm's credit period is
as key marketing tools. cut shorter than the industry
norm, it may lose sales or
When long credit periods are granted,
have to lower prices. It would
trade credit costs and hazards rise. The
be necessary to assess the
firm will strike a balance between this and
additional costs of
the benefits of more profitable sales.
discounting vs the benefits of
Allowing for a longer credit period will
lowering loan costs.
assist the organization in getting rid of
slow-moving or obsolescent inventory.

ii) Receivables Collection System: A corporation should do an aged trade

receivables analysis regularly and pursue late payers. Establishing
explicit procedures for pursuing late payers is beneficial, to set out the
circumstances under which credit control staff should send out reminders
and initiate legal proceedings. Depending on the expected response of
customers, charging interest on late accounts could be considered a way
to encourage timely payment. The three stages of trade receivable
management are as follows:

Credit Policy → Credit Monitoring → Credit Collection →

ii) Protection Against Bad Debt: Senior managers should evaluate the
administrative costs of debt collection, how the policy could be
implemented efficiently, and the costs and impacts of loosening credit
276 when formulating a trade receivables management policy. Longer
 lending periods may boost turnover, but they also raise the chance of bad Working Capital
Management in
debts. In most cases, the cost of rising bad debts, as well as any SMES
additional working capital necessary, should be less than the increased
profits earned by increasing turnover. Many small businesses have failed
as a result of late payments from consumers. However, a solid credit
management system can help a company lower the risk of bad debts.
There is bad debt insurance available, which can be acquired through brokers
or intermediaries. The full turnover insurance will protect any debt that is less
than the agreed-upon amount from non-payment. Specific account insurance,
on the other hand, allows a corporation to protect essential accounts from
default and can be utilized for significant clients. Furthermore, cash discounts
may encourage early payment, but their cost must be lower than the total
finance savings resulting from lower trade receivables balances, any
administrative or financing savings resulting from shorter trade receivables
collection periods, and any benefits from lower bad debts.

Activity 12.3

You should contact the owner/manager of a small firm of your choice to

examine the credit management strategy that s/he uses to maximize the
sales while minimizing bad debts. In this context, try to collect data on
the following topics:
i) Terms of credit the firm has adopted, and how do they determine those
terms of credit in the business enterprise?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) The techniques the firm has been following to minimize the bad debts on
its credit sales?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

12.9.3 Cash Management

The trade-off between liquidity’s benefits and costs is an important aspect of
cash management. Making the cash collection and disbursement system as
efficient as possible is the other half. Because cash is a non-profitable asset,
277
Working Capital the purpose of cash management is to keep the quantity of cash on hand to a
Management:
Issues and Practices minimum. As a result, the pressure placed on financial managers is to decide
an acceptable level of assets to be paid for everyday business activities such
as payroll, dividend payment, prepaid taxes, and other costs. The financial
managers can defer payments for purchase invoices rather than paying them
early, but they must maintain their credit status and reduce the financial
penalties of late payment.

In today's global and computerized society, managing currency is becoming

increasingly sophisticated. As financial managers aim to squeeze every last
dollar of profit out of cash management methods, one of the most essential
areas of small business. It allows management to carry out the various
activities of the company, which is especially significant for several reasons:

i) For starters, small enterprises do not have as much access to financing

markets as major corporations. Banks are the most common source of
capital funds for SMEs. Bankers demand that borrowers produce a
detailed analysis of their expected cash needs, for which the company
must have a well-functioning cash management system.
ii) Second, due to a small firm's limited access to capital, resolving a cash
shortage situation is more complex and expensive for small businesses
than it is for large businesses.

iii) Finally, many small businesses are fast expanding and are at risk of
running out of funds. Increase in inventories and accounts receivable are
required to meet rising sales, depleting the company's cash reserves.

Influence
The internal and external influences on a company’s cash balance are now
detailed in the following Table-12.3.

Table-12.3: Cash Balances – Influence of Internal and External Factors

Internal Factors External Factors

Type of business: Some businesses The economy: The state of the
have a consistent demand for their economy has an indirect impact on
products throughout the year, while cash holdings. If the economy is
others have to change degrees of weak, the company may have
demand and seasonal or cyclical difficulty obtaining the necessary
revenues. Firms with cyclical/seasonal funds, causing the cash-out
cash flow, on the other hand, require problem to worsen. This condition
effective cash management. may be manageable and not
especially harmful during boom
times.

278
 Working Capital
Profitability: Companies with excess Inflation: Working capital Management in
cash must maximize the return on their requirements will be increased SMES
cash investments. Cash management at during periods of high inflation.
a loss-making company focuses on This is especially true when a
balancing liquidity and does not have company is profitable, as the cost
to worry about liquidity issues until of replacing a capital, expenses,
cash flows are positive. and assets may outpace the cash
Strategy: A growing company generated by the sale of older
demands capital at all times, which has things.
implications for cash flow. When the
expansion is not properly financed and
liquidity is a significant concern, the
company is said to be overtrading. The
capital structure chosen will have a
financial impact. Interest must be paid
on the debt capital, as well as capital
redemption. How capital is repaid is
determined by the type of debt.

Activity 12.4

You must contact the owner/manager of a small & medium enterprise of

your choice and discuss the cash management strategies that s/he has
used to maximize the amount of cash in the business. In this context, try
to collect data on the following:
i) The kinds of expenses for which cash is spent in the business enterprise.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) The main sources and types of income and the procedures that are
followed for their accounting, collection, and deposits of cash receipts?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
279
Working Capital
Management: 12.10 EFFECTIVE WORKING CAPITAL
Issues and Practices
MANAGEMENT FOR SMEs
Many SMEs owners/managers, in reality, run their businesses through trial
and error. They frequently focus on innovation and sales, but they are less
strict when it comes to financial management, particularly working capital
management. They believe that making money is the most important thing,
but this is not always the case. During the growth phase, they may run out of
funds needed to fund operations, activities such as payroll, rent, and payable
accounts.

12.10.1 Reduce Inventory

The control on inventory has a substantial positive impact on working capital.
The company can negotiate with its supplier to have the goods stocked in the
warehouse but not paid for until the company sells them. This policy, as well
as careful planning and controlling stock levels to accommodate demand
peaks and troughs, decreases costs while increasing revenues. More
specifically, the following lines show how the organization can reduce
inventory across the value chain:
i) Enhanced forecast accuracy and demand planning: A far more
reliable planning procedure resulted from improved forecast accuracy
and regular updates on customer demand. This policy will assist
businesses in reducing inventory and improving delivery capability.
ii) Improved delivery and logistics concepts: Many companies use
innovative and demand-driven logistic strategies with their suppliers to
maintain stocks as low as feasible. For instance, vendor-managed
inventory and just-in-time delivery or just in sequence and work with
their suppliers in terms of a holistic supply chain management with
mutual benefits.
iii) Optimized production processes: Redesigning manufacturing
processes to eliminate non-value-adding time and surplus inventory
between production phases is one technique to reduce work-in-progress
inventory.
iv) Variance management: One technique to reorganize and narrow the
assortment and focus on the most selling products is to reduce product
complexity and carefully track the demand of product variants to find the
low-turning products. Customization of items should be done as late as
possible in the manufacturing process.

12.9.2 Secure Good Credit Terms

Credit terms must be handled properly by the business entity with its
consumers and suppliers. Before extending credit, sales and marketing
departments must identify and thoroughly assess the customer's position. This
policy ensures that debts are paid on time, so that customer relationships and
280 bussiness are not harmed. Furthermore, the company must carefully negotiate
 Working Capital
payment terms with its suppliers to ensure that it receives the largest payment Management in
term possible without jeopardizing its ties with them. SMES

• Avoidance of early payments: Companies should not pay anything

before the deadline. After the due date, the payments should be
completed with the next payment run. Changing from ex-ante to ex-post
payments is a typical practice that involves a simple lever for boosting
payables.
• Payment conditions: Renegotiating with suppliers is an excellent
approach for finalizing the payment terms and conditions. The best
strategy is to first gain a comprehensive review of all payment terms in
use before defining a clear set of payment terms for the future. The
renegotiations with suppliers are based on these terms, which consider
the suppliers' circumstances. The focus should be on prices for suppliers
with little liquidity, while payment terms can typically be extended for
suppliers with ample liquidity.

• Back-to-back agreements: Matching the due dates of receivables and

payables accounts can assist organizations to avoid excessive supplier
pre-financing and maintaining a positive cash balance.

12.11 IMPACT OF PANDEMIC ON SMALL

BUSINESSES
While there is a significant disparity in working capital performance between
small, medium, and big businesses, COVID has had an even greater impact
on small businesses' working capital management. The pandemic had a
smaller impact on major businesses' working capital than it did on small
firms. These businesses have more negotiating power and stronger processes
and procedures, allowing them to track and handle cash and working capital
more effectively. During lockdowns, there is a build-up of inventory,
particularly for non-essential items, due to lower demand for goods, as
companies take time to re-adjust their production levels to the changing
demand scenario.
During the time, the majority of industries had a decline in Days Inventory
Outstanding (DIO). Some industries have seen an increase in DIO, indicating
increasing inventory holdings paired with slower turnover. Increased
inventory levels may result in higher holding costs and the risk of obsolete
inventory. Some of the levers that organizations may utilize for effective
inventory management include adjusting product portfolios to customer
demand, generating dynamic scenario planning, and establishing excess
inventory campaigns.

12.12 STRATEGIC PLANNING - WORKING

CAPITAL PERFORMANCE
We will not know exactly what happened after the COVID-19 disaster, but
we do know that similar trends are now guiding divestment strategy. Lenders
281
Working Capital and investors are more cautious about lending money to tiny businesses since
Management:
Issues and Practices the risks are higher than with established large businesses. Small businesses
may face higher borrowing rates as a result of this, which will limit their
ability to recruit outside investors and access capital markets, forcing them to
rely more on owner financing or trade credit.
As a result, it is critical for small and medium businesses to effectively
manage their cash conversion cycle. It is also possible to argue that poor
working capital management and insufficient finances are two main causes of
small businesses failure. It is frequently set up such that a buyer has a
specified amount of time to pay off their debt in full. This helps corporations
to cut costs by paying directly, and it also allows struggling enterprises to
essentially "borrow" money from their suppliers by waiting for the full credit
period.
The firms with long-standing connections with their clients, need not provide
extended trade credit because their counterparties know what to expect from
them. The same is true for large, well-known companies, which are more
likely to have a solid track record that guarantees quality, even if the
consumer in question is not one of them.

12.13 SUMMARY
Small businesses frequently rely on a small number of customers and have a
restricted product selection; as a result, they are more vulnerable to market
volatility. In India, this sector contributes significantly to socio-economic
development and provides a big number of jobs at a low capital cost as
compared to the larger ones. The inability of SMEs to efficiently manage
their working capital is the primary cause of high failure rates. Using various
working capital management tactics in conjunction with technological
solutions would undoubtedly increase the profitability of these small
businesses.
Though there has always been a significant variation in working capital
performance between small, medium, and big businesses, the COVID-19 has
had an even greater impact on small businesses' working capital
management. The small businesses' cash-to-cash cycle deteriorated as a result
of the epidemic, even though they lengthened their payables cycle to protect
liquidity.

12.14 KEY WORDS

Small and Medium Enterprise: (i) A small business with a plant and
machinery or equipment investment of less than ten crore rupees and a
turnover of less than fifty crore rupees; (ii) A medium-sized business with an
investment in plant and machinery or equipment of not more than fifty crore
rupees and a turnover of not more than 250 crore rupees.
Aggressive Policy: It entails costing as little as possible to produce goods,
transfer inventory, and provide services. Money is saved, and your
organization is partly protected from risk when you take a conservative
strategy.
282
Working Capital Cycle: It is the time it taken by an organization's net Working Capital
Management in
current assets and current liabilities to be converted into cash. It demonstrates SMES
the organization's capacity and efficiency in managing its short-term liquidity
position.

Stock-Out: It is when there aren't any things of a certain type available for
purchase. Overstocks, in which too much merchandise is kept on hand, are
the polar opposite of stockouts.
Just-in-Time: It is a management method that connects raw-material orders
from suppliers with production schedules directly. This method is used by
commercial enterprises to boost efficiency and reduce waste by obtaining
products only as needed for the production process, lowering inventory
expenses.

Inflation: It refers to price increases in everyday products and services such

as food, clothing, housing, recreation, transportation, consumer essentials,
and so on. Inflation is measured as a percentage change in the average price
of a basket of goods and services over time.
Credit Terms: These are the conditions that specify when payment is due for
credit sales, as well as any relevant discounts, interest, and late payment
costs.
Pandemic: A pandemic is an epidemic that spreads globally, or over a large
area, and crosses international borders, hurting business in a variety of ways
and having a significant economic impact on the country.

12.15 SELF-ASSESSMENT QUESTIONS

1) Explain the role of small and medium enterprises in India.
2) Explain the objectives of working capital management in SMEs.
3) What factors a financial manager would ordinarily take into
consideration while estimating the working capital needs of a small
business firm?
4) How the working capital management in SMEs is different from large
firms?
5) What are the inventory management strategies followed by SMEs?
6) Discuss the factors that influenced cash management in SMEs.
7) Describe the bills receivables collection system in SMEs.
8) How do you manage the working capital effectively in SMEs?

12.16 FURTHER READINGS

Brigham, E.F, Gapenski, L.C and Ehrhardt, M.C (1999) Financial
Management: Theory and Practice. New York: Harcourt College Publishers.
Chandra, P. (2015), Financial Management: Theory and Practice” 9th
Edition, Tata McGraw-Hill Education. 283
Working Capital Grablowisky, B.T, and Rowell, D.R. (1980) Small Business Financial
Management:
Issues and Practices Management: Theory and Practice, Norfolk: Old Dominion University.
Srinivasan S. (1999). Cash and Working Capital Management, Vikas
Publishing House Pvt. Ltd., Mumbai.
Van Horne, J.C. and Wachowicz, Jr., J.M. (2009) Fundamentals of Financial
Management, 13th Edition, Harlow: FT Prentice Hall.

284
 Working Capital
UNIT 13 WORKING CAPITAL Management in
Large Companies
MANAGEMENT IN LARGE
COMPANIES

Objectives
The objectives of this unit are to familiarise you:
• with the financing options of large and small businesses.
• differences in small and large firms working capital management.
• factors affecting the working capital needs of large companies.
• impact of COVID-19 on large companies working capital management.

Structure
13.1 Introduction
13.2 Significance of Working Capital Management
13.3 Large and Small Firms - Financing Options
13.4 Differences in SMEs and Large Companies Working Capital
13.5 Factors Affecting Large Companies Working Capital Needs
13.6 Impact of COID-19 Pandemic
13.7 Working Capital Efficiency Improvement– During Pandemic
13.8 Strengthening Operational Agility – Strategic Partnerships
13.9 Summary
13.10 Key Words
13.11 Self-Assessment Questions/Exercises
13.12 Further Readings

13.1 INTRODUCTION
Working capital management is one of the most critical aspects of day-to-day
business management. Working capital management is a fictional area of
finance that encompasses the firm's entire current account. It is concerned
with the link between a company's short-term assets and obligations. The
purpose of working capital management is to ensure that a company can
continue to operate and that it has enough cash on hand to pay down short-
term debt and cover upcoming operating needs.
Some multinational corporations have negative working capital, meaning that
their short-term liabilities exceed their liquid assets. Behemoth firms with
great brand recognition and strong selling power are typically the only
entities capable of remaining solvent in these conditions. Such businesses can
easily raise additional funds by repurposing monies from other operational
silos or obtaining long-term debt. Even if their assets are locked up in long-
term investments, houses, or equipment rents, these companies can readily
satisfy short-term expenses.
285
Working Capital Though most firms seek to keep their working capital positive all of the time,
Management:
Issues and Practices high working capital can signal that a company isn't investing its excess cash
wisely, or that it's sacrificing development possibilities in favor of liquidity.
To put it in another way, a corporation that does not invest its cash wisely
may be doing itself a disservice. Excessively high networking capital could
indicate that the company is investing more in inventory or that it is slow to
collect its debts, both of which indicate diminishing revenues and/or
operational inefficiencies.
As working capital volume can fluctuate significantly over time and differ
from one firm to another firm, it is critical to consider this metric in a
broader, more holistic context. When evaluating financial stability based on
networking capital levels, the industry, firm size, growth stage, and
operational model of the particular business must all be considered. In some
businesses, such as retail, a large amount of working capital is required to
keep operations running smoothly throughout the year. Others, if they have
consistently steady revenues and expenditure, as well as dependable business
strategies, can run well with relatively modest working capital.
Working capital management is a collection of activities carried out by a firm
to ensure that it has adequate resources to cover day-to-day operational
expenses while also ensuring that resources are invested productively. It is
significant because the company has sufficient resources for its everyday
operations, ensuring that the company's existence is protected and that it can
continue to operate as a continuing concern. Due to lack of cash, unregulated
commercial credit rules, or limited access to short-term financing, the
company may need to be restructured, assets sold or even liquidated.
Working capital management is critical for all businesses, whether small,
medium, or big, and has a significant impact on their performance. This
working capital management consists of management of liquidity, inventory,
bills receivables, accounts payables, and short-term debt management as
shown under:

Figure-13.1: Management of Working Capital and its Sub-Components.

286
 Working Capital
13.2 SIGNIFICANCE OF WORKING CAPITAL Management in
MANAGEMENT Large Companies

In general, the chief financial officer of working capital is responsible in

assuring the organization's ability to fund various current assets with current
liabilities to a considerable extent. However, a comprehensive approach
should be taken, encompassing all company activities relating to both short
and long-term assets. In practice, working capital management has become
one of the most critical concerns in any firm, with many finance executives
attempting to find working capital ruminants and the basic deter optimum
working capital levels.
Understanding the role and factors of working capital, can help a company
organization achieve its aim of working capital management by reducing risk
and improving overall performance. The manager of working capital
management is responsible for maintaining an appropriate balance between
each of the working capital components to achieve this. The ability of
financial executives to efficiently handle inventory, receivables, cash, and
payables is critical to a company's performance. Business enterprises can
lower their financial costs while increasing the amount of money invested in
short-term assets. The majority of a financial manager's time and effort is
spent bringing current assets and liabilities back to acceptable levels.

In general, current assets are one of the most essential components of a

company's total assets. Renting or leasing plants and machinery may allow a
company to lower its overall asset investment, but this approach cannot be
applied to the components of working capital. The high level of current
assets, the risk of liquidity associated with money that could have been put in
long-term assets, and the opportunity cost of funds that could have been
invested in long-term assets. As a result, effective working capital
management is a key condition for a corporation's successful operation, as it
decreases business failures and instills a sense of stability and trust in
employees in the organization, and ensures the solvency of the organization.
When it comes to working capital, size matters - and it is getting more
essential. The widely accepted belief is that big businesses achieve good
working capital performance by squeezing their smaller suppliers with their
purchasing power and market clout. While there is some truth to this,
statistics demonstrate that small businesses have far longer payables cycles
than big businesses.

13.3 LARGE AND SMALL FIRMS - FINANCING

OPTIONS
From the managements stand point, the method of financing working
capital of various sizes of business firms is a topic of debate. There is a
wide range of financing options accessible to a business, each with its own
set of advantages and limitations. The size of a company has an impact on
the floating of money in general and working capital in particular. Large
companies, unlike small entities, may raise funds in capital markets at a 287
Working Capital minimal cost due to their size and reputation. Furthermore, with bigger
Management:
Issues and Practices companies, the sort of security and methods for raising funds is more
amicable. Now, in the following paragraphs, the various funding choices and
their characteristics for large and small businesses will be discussed.

13.3.1 Business Financing

Business funding serves a variety of functions, it could be to start a business
or for working capital, such as to buy raw materials or to cover everyday
requirements. Alternatively, a company may need funding to develop or
grow, as well as to purchase equipment or land. The basic fact is that every
business, at some point or another, will require funding periodically
throughout the life of the business. However, a company can pick from a
variety of financing options, the availability of which is usually determined
by the size of the company, whether it is small or large.

13.3.2 Types of Funding

Large firms have the same alternatives as small ones, but they have a much
wider range of possibilities. They may turn to business loans, such as those
given by large banks and other financial organizations, to meet their
financial demands. They can also use accounts receivable factoring or take
loans against their existing purchase orders. Furthermore, larger
organizations typically have more assets than smaller enterprises, which
they can utilize to receive a secured business loan or line of credit. Finally,
larger companies may be able to raise funds by selling stock to the general
public.

Activity 13.1
You are required to approach two business organizations of your choice; one
is large and another one is small and lists out their differential sources of
working capital finance.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

13.4 DIFFERENCES IN SMEs AND LARGE

COMPANIES WORKING CAPITAL
The contrasts between large companies and small and medium businesses
are now explored in the next section. For numerous reasons, larger
businesses have different access to finance than smaller firms.

Funds Arrangement
i) Larger companies indeed have greater assets. While those assets might
288 be used as collateral, which is certainly a significant benefit, they can
 also be sold in a crisis. As a result, a financier understands that if a firm Working Capital
Management in
has a lot of assets, it may simply sell one of them to receive the money Large Companies
it needs.

ii) Larger organizations have a longer and more extensive company

history. Any type of financial investments, such as lending money to a
company or purchasing shares in the firm, is dependent on the firm's
history and projections about the firm's future performance based on
that history. Risk is the probability that such assumptions are right, and
the smaller the risk, the better the terms for the company being invested
in. As a result, larger organizations have a long history and thus these
benefits.

iii) The larger corporations have a stronger reputation than the majority of
smaller corporations. In this scenario, just having a good reputation can
be enough of a guarantee. Few individuals would disagree, for
example, that Coca-Cola or Shell Oil stock is a lousy investment, at
least in the near run. The reason for this is that these companies have
reputations strong enough that it would be difficult to imagine them not
performing well. Smaller businesses, such as Ron's Home
Improvement, do not have access to this benefit.
iv) Another significant distinction between large and small business
funding choices is that larger firms can be more discriminating. Not
only will a larger company be seen as a good candidate for a variety of
funding solutions — and will receive several offers to that end. They
can, however, take several financing choices, working with one bank
for one purpose and another for another.
v) Because larger companies have less perceived risk and greater proof of
their financial status, they will be able to acquire funding at a cheaper
rate than their smaller competitors.
vi) Small business entrepreneurs frequently require some type of capital to
start their business, expand it, or even keep it afloat when times are
rough. While funding is frequently required, it can be difficult to secure
and can put them in a financial bind. Unlike major corporations, small
businesses face a variety of risks when it comes to funding.

Size of Debt
If you borrow more money to start a business, you may find it challenging
to honor the interest payments. You may not have enough finances for
marketing or supplies since the monthly installments required to repay the
loan are so high. Small investors, rather than large ones, may find a high
debt level unappealing.

Relinquishing Control
Some types of financing may require you to give up some influence over
your activities. For example, if we choose to go with equity financing,
which involves taking a loan in exchange for a share of the company's
ownership and giving the investors a role in how the company is run. This 289
Working Capital can negate the purpose of starting a firm in the first place for small business
Management:
Issues and Practices owners.

Reluctance to Retire
Those who start a small business later in life may be forced to spend cash
set aside for retirement to meet the needs of the firm. If the firm fails, it will
loose not just the business but also the chance to retire at a certain age. As a
result, individuals may be obliged to work much beyond the typical
retirement age or beyond their time of retirement.

Personal Relationships
The aspiring small firms indeed borrow money from relatives or friends to
get a low-interest rate or as a last resort. If these firms collapse or their
owners fall behind on payments, their connections may be in dispute. Even
if a bank loan is arranged, the stress of having to repay the loan may cause
affect personal relationships.

Losing Assets
When we apply for a small business loan from a bank, we are typically
required to put up some form of collateral, such as a car or even our home,
to secure the loan. If the company fails to make it, it will also risk losing
some of the personal property of the owners of the small firms. Whether a
firm is large or small, finance is critical to its growth, expansion, and
adoption of new organizational techniques. To choose which source of
financing best meets the business needs, it is necessary to have adequate
knowledge about the numerous sources of finance.

Resources of Individuals
Using personal funds to finance a business is a direct approach to doing so.
This can be done by putting savings toward business expenses, taking up a
line of credit, cashing out retirement assets, or borrowing money from
friends or relatives. In case of small businesses, the majority of new
enterprises are self-funded. This option of finance is highly beneficial
for a company since it has more control over the repayment alternatives.
For example, paying a relative back can be negotiated, whereas borrowing
money from a financial institution is subject to its payback terms.

Many people dislike the word debt, although it is a completely typical way
to fund the purchase of assets or to utilize as a backup for short-term cash
flow problems in business. In some ways, debt financing is superior to
equity financing because you do not have to give up any ownership when
you borrow money rather than take it from an investor. Small firms,
particularly young enterprises, have fewer debt funding possibilities than
larger or more established organizations.

Borrowing
A business loan is often the most obvious source of debt financing. Small
290 business owners frequently borrow money from friends and family, but if
you have collateral to put up for the loan, commercial lenders are a choice. Working Capital
Management in
If you are just starting, you may have to put your assets, such as your home, Large Companies
on the line. Once the business is established, you may be able to pledge the
assets of the company itself.
Installment Purchases
A business firm that takes a mortgage on a building buys a vehicle with a
car loan, or purchases equipment with dealer financing is doing nothing
more than acquiring debt financing. Someone - a bank, a loan firm, or the
asset's actual seller - is putting money upfront for you to buy the assets. The
capacity of new businesses to purchase assets with debt may be influenced
by the owner's credit rating. A mature company with a credit rating is more
likely to be able to obtain funding without the help of the owner.
Trade Credit
Your vendors are the ones who will provide debt financing, even if it is just
for a short period, using trade-credit — "buy now, pay later" contracts with
suppliers. You have a month's worth of debt financing for the cost of
inventory if you receive an order with a 30-day payment period. A small
business that is just getting started may not be able to get trade credit right
away. It will always have to pay in advance or on delivery until it can show
suppliers that it has the funds to satisfy its obligations.
Bonds
Small firms do not consider using bonds to raise funds for long-term
investment. Even so, it is something to keep in mind when the company is
well-established and needs funding for expansion. The municipal bonds can
be sold to fund the small business ventures, and the money created by those
initiatives can be used to repay the bonds. While some small businesses
acquire funds by selling bonds themselves, such bonds often have to pay a
high rate of interest and are labeled "junk bonds" due to the risk involved.

13.5 FACTORS AFFECTING LARGE

COMPANIES' WORKING CAPITAL NEEDS
All firms have different working capital requirements. The level of working
capital needs is determined by the nature, size, structure, age, and
management structure of the company. The volume of business operations,
i.e., small, and large business firms, has a significant impact on working
capital requirements. There are two types of factors that can influence
working capital requirements: endogenous and exogenous. The size,
structure, and strategy of a company are all endogenous elements. Whereas
the exogenous elements include banking access and availability, interest
rates, industry and products or services sold, economic conditions, and the
size, quantity, and strategy of the company's competitors. When it comes to
arranging working capital funds for large businesses, all of these elements
have a greater impact than when it comes to arranging money for smaller
businesses. The components of working capital, which are significant in the
case of large enterprises, are where these variances can be observed.
291
Working Capital The following are the major elements of working capital that have an
Management:
Issues and Practices impact on the performance of large business firms' working capital
management. To manage the working capital effectively, one has to
understand the various components of working capital and the working
strategy of the executives of the larger companies.

Managing Liquidity
Liquidity management guarantees that the organization has enough cash on
hand for both routine operations and unforeseen expenses of an acceptable
magnitude. It is also significant since it influences a company's
creditworthiness, which can decide the future of a corporation. Other factors
being equal, the lesser a company's liquidity, the more probable it is to
encounter financial difficulties. On the other hand, too much capital parked
in low or non-earning assets may indicate poor resource allocation. As a
result, adequate liquidity management manifests itself in an acceptable level
of cash and/or an organization's ability to generate cash resources swiftly
and efficiently to finance its business demands.

Taking Care of Receivables

A firm should provide its clients with the appropriate level of flexibility or
commercial credit while ensuring that the appropriate quantity of cash flows
through activities. A company will select the credit conditions to offer
depending on the customer's financial strength, the industry's policies, and
the real policies of competitors. Ordinary credit terms are those in which the
customer is given a specified number of days to pay the invoice (generally
between 30 and 90). Different terms, such as cash before delivery, cash on
delivery, bill-to-bill, or recurring billing, may be required depending on the
company's regulations and the discretion of the manager.

Inventory Control
Inventory management seeks to ensure that the company maintains an
acceptable inventory size to deal with normal operations and demand
fluctuations without overinvesting in the assets. An excessive volume of
inventory implies a large quantity of capital is invested in it. It also raises
the possibility of unsold inventory and probable obsolescence diminishing
inventory value. Inventory shortages should also be avoided, as they will
result in lost revenue for the organization.

Managing Short-Term Debt

Short-term financing management, like liquidity management, should focus
on ensuring that the company has enough liquidity to finance short-term
activities without taking on undue risk. The efficient administration of
short-term financing necessitates the selection of appropriate financing
instruments as well as the size of funds accessed through each instrument.
Regular credit lines, unbound lines, revolving credit agreements,
collateralized loans, discounted receivables, and factoring are all prominent
methods of funding. A corporation should ensure that it has enough
292 liquidity to deal with peak cash requirements. For example, to meet
unanticipated cash needs, a corporation can set up a revolving credit Working Capital
Management in
agreement well above normal demands. Large Companies

Accounts Payable Management

Accounts payable is a result of trade credit issued by a company's suppliers,
which is usually done as part of normal business operations. It is important
to strike the correct balance between early payments and commercial debt.
The early payments may unnecessarily diminish available liquidity, which
could otherwise be put to better use. The late payments can harm a
company's reputation and business ties, while a large amount of commercial
debt can hurt its creditworthiness.

Activity 13.2
i) List out the items of working capital in a large organization, e.g.,
inventory of raw material supplies, stores, etc.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) Identify the terms of credit of sales in your selected large firm, and the
procedure that has been followed in the collection of bills, its accounting,
and deposit of bills in banks.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

iii) What is the amount of revolving fund or working capital that the selected
organization maintains to pay for the operating expenses?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

13.6 IMPACT OF COVID-19 PANDEMIC

With the advent of the pandemic situation, the necessity for working capital
efficiency has grown even more. Covid-19 has caused major disruption in the
293
Working Capital supply chain, posing a variety of issues in terms of working capital
Management:
Issues and Practices management. As a result, amid such exceptional circumstances, the
importance of saving currency has become crucial.

The epidemic has hurt working capital cycles in a variety of industries around
the world, and India is showing a similar pattern. On a year-over-year basis,
firms in India saw their cash-to-cash cycle deteriorate by six days in the year
ending 30 April 2021. The decline was fueled by declining receivables and
inventories. To preserve liquidity, a huge number of companies have
proactively extended their payables cycle. Numerous levers may be used to
optimize working capital, freeing up cash to manage the disruption and
assisting organizations in recovering quickly from the crisis.

The business firms have attempted to balance their working capital

requirements by raising payables to offset higher inventory holdings and
lower collections. When compared to the previous 12-month period, about 70
percent of the businesses raised their payables cycle during the last year
ended 30th April 2021, according to the available statistics. While stretching
payables can help with short-term liquidity, it is not always the most effective
technique. The lengthening payables cycle stifles the supplier relationships
and can put suppliers in a financial bind, further exacerbating supply chain
risk. Furthermore, the business may lose any purchase discounts granted for
on-time or early payments, making this a costly tactic. As a result,
organizations must optimize receivables and inventory, reducing the need to
manage liquidity by extending payables and achieving long-term working
capital improvement.

Activity 13.3
You are required to meet the finance manager of a large company and
discuss the impact of the COVID-19 Pandemic on its working capital
management.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

Proactive Management of Working Capital Management

While most businesses struggled to manage their working capital successfully
throughout the pandemic, other industries were able to make proactive
adjustments to their operations to save working capital and increase liquidity.
Early on, corporations in the Automotive Sector reconfigured their
production levels in response to the lockdown demand, which enabled them
to maintain control over their working capital cycle.

294
The Chemical firms benefited from a diverse product portfolio and skills, Working Capital
Management in
which allowed them to manage inventory more effectively. Further, the Large Companies
Cement and Building products firms made deliberate decisions to avoid
selling items on credit and instead focus on collection activities, which
helped them mitigate the pandemic's impact on their working capital. In
addition, the disruption caused by the pandemic led to an increased demand
for technology solutions, such as collaborative and digital tools. This led to
an increase in the revenues for the Technology sector, hence improving the
cash-to-cash cycle for the majority of the companies.

13.7 WORKING CAPITAL EFFICIENCY

IMPROVEMENT— DURING PANDEMIC
India Inc's cash, liquidity, and working capital have all suffered as a result of
the pandemic. While certain industries have developed targeted strategies to
address working capital issues, there is still a substantial need for Indian
enterprises to enhance their working capital processes. Furthermore, every
organization must take a unique and systematic approach to working capital
management. To drive business choices and maximize overall cash and
working capital, firms must combine emerging technology and data analytics
with appropriate governance mechanisms.
By automating internal procedures, preparing accurate cash-flow forecasts,
and enhancing real-time access to information, innovative technology
solutions can assist in optimizing cash flows. As a result, working capital
management should be considered as a holistic approach to increasing
efficiency and profitability across the firm, rather than just a financial best
practice.
With the outbreak of the Covid-19 epidemic, the importance of working
capital has risen dramatically. It has impacted organizations’ working capital
cycles in a variety of industries. The cash-to-cash cycle in Indian businesses
has increased during the last year. India Inc. has the potential to release up to
Rs. 5.2 trillion in operating capital, which might help businesses recover
quickly from the crisis.
Executives must immediately begin planning for the future in light of the
COVID-19 outbreak. More than half of Indian businesses believe the
pandemic will require them to borrow money, while two-thirds want to
reduce their debt levels. However, when corporations face increasingly
challenging capital allocation decisions, they must be willing to act. To
future-proof the firm, capital investments in technology, automation, and
supply chains are likely to be necessary right now.
There is evidence that taking aggressive action now could pay off - the most
resilient and successful companies will be those that have demonstrated
portfolio transformation discipline and focus. There is little doubt that the
financial and economic effects of the crisis have generated shifts in
divestment viewpoints in recent months. As a result, in the final year of 2020,
it reopened the topic to reassess the pulse of corporate executives.
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Working Capital The following are the insights of the executives of the business organizations:
Management:
Issues and Practices
Those who emerge stronger from the current crisis's next phase will be
reinventing not only their portfolios but the fundamental foundation of their
businesses right now. As a result, though corporations may not always sell in
the short term, they recognize the importance of planning ahead of time to act
when necessary. More than half of the corporations said they would begin
their next divestment within the following 12 months. As a result, there will
be a long-term focus on the portfolio's highest-growth features, with three-
quarters of the company aiming to reinvest divestment proceeds in core
businesses.
The divestment proceeds can be used to improve cash reserves and strengthen
balance sheets. It will also hasten the technological agenda, as the crisis has
heightened the demand for greater investments in automation. While the
epidemic has shown flaws in certain companies' abilities to support remote
workers, the rapidly shifting needs of customers are a far more pressing
concern. Forecasting value drivers beyond crises will prompt new ways of
thinking now, such as the creation of new ecosystems of partnerships and
alliances that position organizations as disruptors rather than disrupted. As a
result, more than two-thirds of corporations said they will be more inclined to
divest in the coming 12 months to fund new technology expenditures.

13.8 STRENGTHENING OPERATIONAL

AGILITY - STRATEGIC PARTNERSHIPS
Companies are re-evaluating their ownership of non-core assets as part of
portfolio optimization and divestiture strategy and considering shifting to an
ecosystem of strategic partners. These partners, who are often considered
better owners or managers of such assets, can assist in the move from fixed to
variable expenses, enhance the company’s agility, shift the resources to focus
on critical capabilities, and achieve higher shareholder returns. As a result,
the pandemic has put a lot of strain on balance sheets, resulting in a cash
constraint and a liquidity crisis.
With relatively easy measures, larger organizations could secure long-term
collaboration. Is it fair, however, for trade credit to exist to such a vast
extent? In a market, a society where product trading is based on credit loans
can have serious economic consequences. The financial crisis of 2008, when
the real-estate market crashed, is a recent example. This is one issue that
requires a larger view.
The larger firms, on the other hand, are less reliant on trade credit financing.
The benefits of size, like diversification and reputational strength, can result
in less expensive access to alternative financial sources. A well-known,
worldwide corporation is more likely to receive an acceptable rate than a tiny,
local company. Furthermore, transaction costs are lower in proportion to
larger businesses.

Investing extra cash in securities with a week's or even a day's maturity is

likely to cost smaller businesses more than the benefit it provides. When you
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factor in the additional costs of employing a treasury department to handle Working Capital
Management in
this type of working capital management, the net gain is drastically Large Companies
decreased. Larger companies have a greater incentive to pursue such a
strategy because they profit from economies of scale. As a result, smaller
businesses may profit more by reducing their cash conversion cycle as much
as possible.
It is true that as a firm grows, additional traits are required to run it, such as
managerial abilities rather than entrepreneurial abilities. There is also
evidence that publicly traded corporations are more concerned with short-
term results, such as using earnings management to manipulate margins, due
to increased investor pressure. Given these considerations and the fact that
working capital management is a short-term activity, it is reasonable to infer
that public companies place a greater emphasis on it.

The non-listed companies, on the other hand, have a higher cost of capital for
financing their activities. It is realistic to anticipate that non-listed companies
benefit more from a stronger focus on working capital management. As a
result, it is thought that listed companies are more efficient in their working
capital management, whereas non-listed enterprises benefit more from better
working capital management.
As a result of the Covid-19 outbreak, businesses in a range of industries have
experienced a slew of working capital challenges. Economic instability
lingers in, forcing businesses to discover new ways to fund working capital to
stay afloat. Firms that focus on inventories, payables, receivables, and short-
term commitments are best positioned to manage proper cash flow.

13.9 SUMMARY
Cash, trade receivables, trade payables, short-term finance, and inventory are
all part of working capital management, which ensures that a company has
enough resources to function efficiently. Cash levels should be sufficient to
meet routine or modest, unanticipated demands, but not so high as to cause a
wasteful capital allocation. Similarly, credit should be handled wisely to
strike a balance between the requirement to continue sales and the need to
retain positive client relationships.
Managing short-term debt and accounts payable should allow the company to
attain sufficient liquidity for both routine operations and unforeseen needs
without putting the company at undue risk. Furthermore, inventory
management should ensure that there are sufficient products to sell as well as
materials for the company's manufacturing processes while preventing
excessive buildup and obsolescence. As a result, large firms have a huge
opportunity and need to enhance their working capital operations, which may
help them increase profitability and efficiency across the board.
Covid-19 has caused significant disruption in working capital management,
resulting in several issues in working capital management. As a result, amid
such exceptional circumstances, the importance of saving currency has
become crucial. In light of the COVID-19 epidemic, executives must begin
297
Working Capital planning for the future immediately. As a result, organizations must be
Management:
Issues and Practices willing to act as they face progressively more difficult financial decisions for
which technology, automation, and other methods can be used to increase
working capital efficiency.

13.10 KEY WORDS

Accounts Payable: These are the outstanding balances owed to vendors or
suppliers for goods or services that are yet to be paid. The accounts payable
balance on the balance sheet is the total of all outstanding monies owing to
vendors.
Bonds: Bonds are tradeable assets that are units of corporate debt issued by
firms. It is classified as a fixed-income asset.

Credit Terms: These are the conditions of payment specified on the invoice
at the time of purchase. It is an agreement between the buyer and the seller
regarding the timing and payment of products purchased on credit.
Cash Conversion Cycle: The cash conversion cycle (CCC) is a metric that
measures how long it takes a company to convert its inventory and other
resources into cash flows from sales (measured in days).
Endogenous: Endogenous factors are those factors that affect a single
product. Many businesses have trade cycles, with stronger demand at certain
times and reduced demand at others. As the market demand grows, prices
may rise as well. As a result, these factors influence business output,
efficiency, growth, profitability, and so on.
Exogeneous: Exogenous elements are external elements that have an impact
on the business. These include external business shocks, such as the
economy, federal taxes, interest rates, foreign policies, and so on.
Liquidity Management: It refers to a company's ability to meet financial
obligations via cash flow, funding operations, and capital management in
general. It can be difficult because income and cost-generating activities,
capital and dividend plans, and tax strategies all have an impact.
Trade Credit: It is a sort of business financing in which a customer can buy
products or services now and pay the supplier at a later time. Businesses can
use trade credit to free up cash flow and finance short-term expansion.
Trade Receivables: The sum due to a business by its customers following
the sale of products or services on credit is known as trade receivables.
They're also known as accounts receivable, and they're listed on the balance
sheet as current assets.

13.11 SELF-ASSESSMENT QUESTIONS

1. What factors are considered while estimating the working capital needs
of a large company?
2. How are the working capital activities in large companies different from
SMEs?
298
3. What are the inventory management strategies followed by the large Working Capital
Management in
companies? Large Companies
4. Discuss the factors that influenced cash management in a large business
firm.
5. Describe the bills receivables collection system in large business
enterprises.
6. Discuss the impact of the COVID-19 Pandemic on the working capital
management of large firms.

13.12 FURTHER READINGS

Brigham, E.F, Gapenski, L.C and Ehrhardt, M.C (1999) Financial
Management: Theory and Practice. New York: Harcourt College Publishers.

Chandra, P. (2015), Financial Management: Theory and Practice” 9th

Edition, Tata McGraw-Hill Education.

Grablowisky, B.T, and Rowell, D.R. (1980) Small Business Financial

Management: Theory and Practice, Norfolk: Old Dominion University.

Khan M.Y., Jain P.K., 2002. Cost Accounting and Financial Management,
Tata McGraw Hill (Chapters 11-16).
Srinivasan S. (1999). Cash and Working Capital Management, Vikas
Publishing House Pvt. Ltd., Mumbai.
Van Horne, J.C. and Wachowicz, Jr., J.M. (2009) Fundamentals of Financial
Management, 13th Edition, Harlow: FT Prentice Hall.
Audio/Video Programs
Videos on: Working Capital Management, & Unique Enterprises: A Case
Study

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Working Capital
Management: UNIT 14 WORKING CAPITAL
Issues and Practices
MANAGEMENT IN MNCS

Objectives
After going through this Unit, you will be able to:
• Understand the International Environment under which MNCs carry out
their operations.
• Develop an idea as to diverse risks associated with the management of
working capital.
• Know the issues involved in the transfer of funds from the host country
to the home country and vice-versa.
• Examine the policies and practices followed by the MNCs in managing
individual components of working capital, viz., inventory receivables,
and cash.
• Gain an understanding of the diverse sources of working capital
available to MNCs.

Structure
14.1 Introduction
14.2 Special Issues of concern: Operational Environment
14.3 Cash Management
14.4 Receivables Management
14.5 Inventory Management
14.6 Summary
14.7 Key Words
14.8 Self-Assessment Questions
14.9 Further Readings

14.1 INTRODUCTION
After the setting in of the New International Economic Order (NIEO) with
the signing of the new General Agreement on Tariffs and Trade (GAAT) by a
majority of the countries in the world and the funding of the World Trade
Organisation and the permission accorded to China to Global Trade, there
had been a sea change in the international business environment. The number
of companies carrying on their business beyond the home country has been
on the rise constantly. At the beginning of the latter half of the previous
century, companies incorporated in countries such as USA, UK, Germany,
and Japan used to set up manufacturing and trading facilities outside their
country of origin. Thus companies like Unilever, Coca-Cola, Johnson &
Johnson, L & T, etc., had business locations in many countries in Asia,
including India. The scenario got dramatically altered with the entry of
companies from South Korea, Singapore and China. China’s growth story is
300
very envious. It has become a global power in scale with varying degrees of Working Capital
Management in
integration. With just 2 percent of the share of Global GDP in 1990, China MNCS
got it expanded to about 16 percent now. It took over USA, to become the
world’s largest economy in terms of the Purchasing Power Parity (PPP) terms
(2014). China’s GDP is 66 percent of the USA in 2018. As per the study
conducted by McKinsey Global Institute on “China and the World: Inside the
Dynamics of a Changing Relationship” (July 2019), China occupied 11
percent of global trade in goods and 6 percent in services; having 110
companies on the list of Fortune 500. These companies earn about 20 percent
of their revenues from abroad. China is now one of the top 3 in terms of
capital flows across the world. It is the second in terms of its spending on
Research and Development, next only to the USA. It has 802 million Internet
users, with about 20 percent of USA-cross-border data flows. It is no surprise
to learn that more than 30 percent of smartphones used in India, Malaysia,
and Africa are made in China. Even countries like South Korea, Singapore,
and Malaysia could make rapid strides in terms of expanding their global
operations. The products manufactured by Korean companies like Samsung,
Hyundai, L G, and Kia are very popular in India. The same is true in respect
of many other companies originating from nearby Asian countries.

As far as the Indian position is concerned, companies incorporated in India

are also slowly evolving and becoming global. As per the information of the
Confederation of Indian Industry (CII), there are about 165 companies that
have some kind of presence at the global level in terms of having
manufacturing locations or trade relations. Notable among them are Tata
Group Companies including Tata Motors, TCS, Tata Chemicals, Bajaj Auto,
Dr. Reddy’s Labs, Infosys, Bharti Airtel, Bharat Forge, L & T, IOC, Wipro,
and Vedanta Enterprises. Till around January 2021, Indian Companies have
bagged 11 places in the list of 500 Most Valuable Global 500. They included
Reliance Industries (54th Rank), TCS (73 Rank), HDFC Bank (105),
Hindustan Lever (190), Infosys (201), HDFC (249), Kotak Mahindra Bank
(284), ICICI Bank (316), Bharti Airtel (440), Bajaj Finance (451) and ITC
(480). Again, as per the latest Study Report of the CII (January 16, 2020), as
many as 155 companies have invested $22 billion in the USA, creating nearly
125,000 jobs in that country.

While it was common during the Nineteen Seventies and Eighties to acquire
Indian firms by the MNCs of Foreign Origin. Indian companies too have
started foraying into the advanced countries through collaborations and
acquisitions. Indian companies having huge cash surpluses and strong bottom
lines are now eyeing foreign companies for acquisition. During the period of
six years from 2015 to 2020. There were 910 outbound acquisitions by Indian
companies (the highest of 183 recorded in 2018) involving a deal value of
$33.5 billion. Most of these deals have happened in the sectors like
Pharmaceuticals, Chemicals, and IT Services. The most notable among these
deals are: (1) Haldia Petrochemicals and Rhone Capital LLC acquiring
Lummus Tech for $2,725 million; (2) HCL Technologies taking over DWS at
$137.5 million; (3) Tech Mahindra acquiring Zen 3 Info solutions Inc at $64
million; (4) Mastek gaining Evolutionary Systems Arabia-West Asia Biz at
$65 million and (5) Infosys taking over Kaleidoscope Innovation at $42
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Working Capital million. These developments emphasize the fact that things are going global
Management:
Issues and Practices and even Indian companies are coming off age and are stabilizing,
necessitation the need to improve operational efficiency by focusing attention
on the working capital and fixed capital management.

14.2 SPECIAL ISSUES OF CONCERN:

OPERATIONAL ENVIRONMENT
Although the basic principles of Working Capital Management are common
to national and international enterprises, there are certain special issues of
concern that need to be cared for by the companies operating in the
international environment. These issues exhort the companies to be extra
careful in managing their working capital. The operational environment of
the MNCs is impacted by these factors. They are:
 The policies and practices regarding trade and industry of the home
country and host countries will be at variance. The restrictions prevailing
in the host country will impact the operational efficiency of the MNC.

 Currency risks are attendant to the variations in the Exchange Rates. For
a variety of reasons, the currency values of the countries will be
changing. Such reasons may include economic slowdown, political
instability, aggression from outside, etc. Moreover, currencies of a few
countries are only accepted as ‘International Currencies’ like the Dollar
(USA), Euro (Europe), Yen (Japan), and Yuan (China). It has become
customary to express prices of goods and services for sale in other
countries in US $. This is true in the case of India also.

 The procedures and practices regarding imports and exports of Raw

Materials, Equipment, Stores, and Spares will impact the operational
efficiency of working capital. In some cases, there will be tie-up
practices followed by the companies. Developing countries follow the
practice of encouraging ‘Indigenous materials and methods’. In such
cases, there may be restrictions on the import or export of certain goods
and services. For example in India, there is a condition that 100% Export
Oriented Units shall export a minimum of 75% of their production
outside India to get concessions available for such category of units.
They are not supposed to sell their output within India.
 Restrictions on the ‘flow of funds between countries would limit the
investments in Fixed and Working Capital. If we take the case of India;
remittances by Foreign companies from India are subject to the
provisions incorporated in the Foreign Exchange Management Act,
1999. Specifically, Sections IIC.1 to IIC.5 of the Act condition the
Remittance of Profits by Foreign Companies (other than Banks) subject
to certain guidelines. Every Foreign company is required to comply with
such guidelines and procedures. To ensure a proper balance of Foreign
Currencies and Assets, every country will have such rules and
regulations in place.

302
 Tax policies and procedures are yet another important issue that needs to Working Capital
Management in
be taken into consideration by companies. These are akin to an MNCS
individual country. Taxation is one regulatory tool that is handy to the
Governments in regulating the inflow and outflow of funds.

 Trade restrictions like tariffs, quotas, and pricing have larger

implications for international trade. Though free trade is encouraged at
the global scale, regional trade agreements (RTAs) have not ceased to
operate. Still, there are a wide variety of Bi-lateral treaties, impinging on
the Free Trade. All these restrictions imply MNC operations.
 Finally, there is the issue of ‘Transfer Pricing’. Usually, the MNC will
have business locations at several places, but manufacturing or service
locations will be at a few places. Due to this, the value of the goods and
services varies depending on the country of sale. The MNC has to decide
the base price which is to be taken as common and add taxes of the
buying country and other duties. Transfer pricing is one of the most
difficult aspects in the case of an MNC.

14.3 CASH MANAGEMENT

With the advancements in technology, there have been tremendous changes
in the method and practice of Cash Management by companies within and
outside the countries. Cash Flows have become instantaneous with the
introduction of Electronic Funds Transfer System (EFTs). It has turned quite
common to domestic and MNCs to maintain multi-currency accounts, multi-
bank transfers, and multi-bank reporting. All these activities are designed to
help the company operate in an international environment to enhance its
capability in handling cash flows. Banks are increasingly becoming members
of the Society for Worldwide Interbank Financial Telecommunications
(SWIFT) networks to ensure quick, accurate, and secure payment
mechanisms. It is reported that about 11,000 member institutions are joining
this network conducting approximately 33.6 million transactions per day. The
counterpart in India is the National Electronic Fund Transfer (NEFT) system
introduced by the Reserve Bank of India. In addition, RBI has also
introduced a quick settlement mechanism in the name of Realtime Gross
Settlement (RTS) for quick and effective transfer of money between
accounts. Some of the services that are offered through these networks
include:
• ATM transfers
• Direct Depositing of Money
• Direct Debit/Credit Services
• Transfers through Credit Card Services
• Wire transfers via SWIFT
• Online Bill Payment Services

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Working Capital • Services involving private currencies, if required and subject to home
Management:
Issues and Practices country and host country regulations.
• Instant Payment Services

14.3.1 Issues in International Cash Management

It is already indicated in the preceding section the various issues that are
relevant in the context of operating in an international environment. In this
section, we will know more about the issues that are directly having relation
to Cash Management by MNCs. The following are a few such issues that
need to be taken care of by the Cash Management of an MNC:

 There are differences in the banking practices followed by banks in

different countries. Usually, Banks in any country are supervised and
regulated by the Central Bank of the country. There is going to be a
stated procedure to be followed by each bank in dealing with overseas
transactions. The transaction fees and range of services vary widely from
country to country. For example, interest is not paid on Current Accounts
in India. But in some countries, interest is allowed even on
Demand/Savings Accounts also. This will shoot up the cost of funds to
the Banks and help companies realize some income. Some Central Banks
put restrictions on the Foreign Institutional Investors (FIIs) and are
always skeptical about the foreign flows.

 Differing economic and monetary environments also make cash

management more complex for the Manager. In addition to the risk
associated with the fluctuations in the values of the currencies due to
vagaries in the economy, the exchange rates also prove to be unkind.
This is particularly timely in the case of currencies of Low-income
countries.

 We have noticed in the earlier discussion that technical advancements

have revolutionized payment mechanisms. But the impact of the
changing technology will not be uniform. Some countries may be more
forward in adopting these technology changes and are swift in action.
Yet others may be slow runners. The Internet and Communication
networks may not have spread widely and there may be areas still
unattended. In some parts of the world, the continuous supply of
electricity itself is an issue. All these naturally limit the speed of the
transactions. The use of electronic networks also should be taken into
consideration. For example, the use of the Internet by people is only to
the extent of around 65 per cent of the total world population. Whereas,
China has a 63.33 percent of people using the internet, as against 55.40
percent of people in India. While there are countries like the USA
(96.26%), Japan (90.87%), Iran (94.06%), and South Korea (95.26%)
with above 90 percent usage of the Internet, there are countries like
Ghana (14.10%), Tanzania (16%), Kenya (17.83%) etc. with a very low
percentage of internet usage.

 Another important issue for consideration is the legal barriers imposed

on the movement of cash or transactions happening through Banks and
304
 other Financial Institutions. We are aware that the flow of funds from Working Capital
Management in
NRIs is also regulated in India. Such restrictions may be imposed for MNCS
want of ensuring cross-border liquidity or to fide over some external
exigencies. Sometimes, secrecy is maintained for security reasons.

 It is also interesting to know that cultural issues have a role to play in

payment preferences. It is known in India that individuals and companies
avoid payments on certain days. In some “small talk” or entertainment
programs.
 Times Zones are another issue of concern to a cash manager of MNCs.
The overlapping of timings and Days and Nights leave an impact on the
business hours. Companies need to schedule their activities in such a
way to adjust to those time differences. For example, the USA has six
time zones. Though the zoning system is not followed in some countries,
time differences are a reality. For example, there is about a one-hour
time difference between the East and the West in India, although India
has only a one-time zone.

14.3.2 Managing Inflows

The objectives of Cash Management either in the context of domestic
companies or international companies will be the same. Economists have
identified three primary motives for holding cash by individuals or
institutions. They are: (i) Transactional Motives, (ii) Precautionary Motives,
and (iii) Speculative Motives. Of these three, the first two appear to be more
relevant. Yet we cannot ignore the speculative transactions carried out by the
companies, especially in times of emergency, uncertainties, and rising prices.
Companies having surplus cash balances do hunt for avenues for parking
such funds; with the hope of making gains in the uncertain future. This also is
understood as business acumen and not speculation.

To realize these objectives, companies need to regulate both the cash inflows
and outflows. Increasing the cash inflows by an MNC involves setting up a
proper method of collection of sale proceeds. In the case of domestic
companies, it is said that the ‘thumb rule should be to follow the system of
decentralized collection mechanism. In the case of an MNC, it would be
through its subsidiaries and affiliates. Each unit in the host country is
independent. And the ‘terms of trade’ are governed by the industry practices
of that country. The MNC may be hard in a position to alter them
significantly. Changing values of the currency due to fluctuations in the
Exchange Rates are to be taken into consideration. A few issues that need to
be cared for are:
• The MNC may permit to hold the cash in the currency of the Host
Country and also make investments for the same from time to time.

• The firm may decide to centralize all investment decisions and thus
instruct every subsidiary unit to transfer the surplus to the home country.
However, the transfer of income/surplus will be subject to the host
country’s Foreign Exchange Management guidelines.
305
Working Capital • Minimisation of transaction costs involved in the currency conversions,
Management:
Issues and Practices calls for holding adequate cash balances in the currency of the host
country for immediate and future payments.

• Yet another problem in managing the cash inflows by an MNC is in the

proper estimate of cash follows. This all depends on the turnover
expected from the host country. While it is possible to some extent to
estimate the rates that would be happening in the host country; it would
be beyond comprehension in respect of currency appreciation and
depreciation. The values of the currency of the host country fluctuate for
a variety of reasons. To a great extent, a majority of them are beyond the
expectations of the company. A small change in the policy of the host
country like FDI permission may cause a big difference in currency
valuations. The usual practice is that currency appreciations would
encourage host country domestic companies to export more and import
less when the converse is true.

• Finally, there is the issue of host country guidelines blocking the

movement of cash from their country. Several developing nations
promote investments and employment in their countries, but certain
restrictions on the size of the transfer of funds. In such cases, the MNCs
are required to devise ways to tackle the situation with due care and
diligence. A few ways, usually suggested by the Cash Managers of
MNCs are: (1) to incur expenditure towards R & D activities, (2) to take
loans from local banks and pay interest in their currency; instead of
taking loan from the bank of the host country, (iii) to incur expenditure
on the Corporate Social Responsibility (CSR) activities, to promote
goodwill among the locals.

14.3.3 Managing Outflows

In this regard, the usual technique suggested by many is “to centralize all
payments”. There will indeed be greater control over the cash situation, but it
may not be possible in present-day circumstances. Centralized systems were
suggested in those days when the Negotiable Investments like Cheque, and
Bills of Exchange were popular. Nowadays, all payments are done through
the electronic mechanism. Therefore, delaying the payments will not be
possible through centralization.

A centralized system of Cash Management indeed has the advantage of

holding overall cash balances to the minimum. This would also enable the
company to make full utilization of the cash available and avoid idle cash
balances, thus securing a return on the cash holdings. The following are the
two systems that are widely followed by MNCs.

1) Multilateral Netting: This is a payment mechanism, where two or more

parties join together, to sum up, the transactions that happened in a
specified period. This could be applied to units or branches of the
organization, or can be arranged with outside parties. The implication is
that the netting activity is centralized in one place, avoiding the need to
prepare and raise multiple invoices for setting payments. Therefore, it is
306 taken as the tool to pool up funds for making payments from that pool.
 The key aspects of this process are as follows: Working Capital
Management in
MNCS
• All the Customers/Branch Managers/Unit Heads forward all their
payment advice to one netting center.
• Several transactions are bundled together rather than being treated
individually.

Multi-lateral Netting is said to offer diverse benefits to the MNCs

operating in this model; like the following:
• Saving time and bank charges.
• Effective handling of cash balance. Since there will be a reduction in
the inter-company cash flows.
• Better Invoice reconciliation among the subsidiaries and parent
company.
• Informed decision-making about the inter-company flows, subject to
the laws of the land in vogue.
• Helping with the introduction of better accounting procedures.
• Better bargaining capacity with Banks and Financial Institutions for
getting loans and the payment of interest.
• Since this mechanism operated through a networking mechanism
and is based on the Membership model, the risk of default will be
less.

The only thing that Netting proves ineffective is when there are frequent and
multiple changes in the current rules of the host countries and failure of the
law and order and the ruling Government due to internal or external
disturbances.
To take an example, suppose XYZ Ltd., sells $100 million worth of goods to
its subsidiary, ABC Ltd. This subsidiary sells the same to another subsidiary
PQR Ltd. This PQR sells the same to the parent XYZ Ltd. If this is the
network of transactions, under the multi-lateral netting system, the inter-
company transfers get eliminated, as shown below:

XYZ Ltd.

$100 Million $100 Million

ABC Ltd. PQR Ltd.

$100 Million

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Working Capital Under the netting system, a matrix of receivables and payables is prepared to
Management:
Issues and Practices arrive at the net receipts or payments. Suppose a USA parent company has
subsidiaries in France, Germany, UK, and Italy. For the netting purpose, the
transactions that happened among all these affiliates are converted into
common currency, say US Dollar, and then the netting process is followed.
Imagine the following transactions:

Table –14.1: Transactions Matrix (In US $ Thousands)

Paying Affiliate
France Germany UK Italy Total
France -- 20 30 50 100
Germany 30 -- 20 40 90
Receiving
UK 40 30 -- 35 105
Affiliate
Italy 50 15 30 -- 95
Total 120 65 80 125 390

In the above example, without netting, the total payments amount to $390
thousand. With netting, this amount would come down to just $50. See Table
14.3 given below:

Table – 14.2: Netting Schedule (In US $ Thousands)

Affiliate Receipt Payment Net Net

Receipt Payment
France 100 120 -- 20
Germany 90 65 25 --
UK 105 80 25 --
Italy 95 125 -- 30
Total 390 390 50 50

2) Physical and Notional Cash Pooling

Yet another method of centralized Cash Management is to resort to cash
pooling in both physical and natural forms. Usually, nobody would prefer to
opt for physical pooling due to various restrictions imposed by the countries
in the handling and movement of hard currencies. But the Covid-19
pandemic has led many MNCs to hold large cash balances to maintain a
liquidity position in those difficult times.

In the case of physical pooling, an attempt is made to transfer the cash

balances of all accounts to one Pool Account or Major Account daily
withdrawals, or anything is done through this pooled account only. Further,
these pool accounts are maintained on a currency-by-currency basis. No
exchange or conversion is undertaken. For accounting purposes, interest on
the cash balances is also paid to the transferring unit/branch, and
reconciliation and further investment activity are taken care of by the holding
unit/entity.
308
In the case of Notional Pooling, a similar procedure is followed by creating a Working Capital
Management in
shadow or notional position resulting from an aggregate of all the accounts; MNCS
which may be held in multiple currencies. There will be no actual movement
or lending of currencies. The holding unit or entity (maybe banks also);
which is maintaining the pool provides an interesting statement, reflecting the
net offset (notional), which would have been achieved in physical pooling.
Since there is no physical movement of currency, intercompany loans are not
required to account for the offset. But one limitation with this method is that
there is complexity arising out of legal and tax issues emanating from host
countries.

14.3.4 Investing Excess/Idle Cash

This is one of the important functions of the Cash Manager. During business,
surpluses do generate and there would be situations that prompt the Manager
to look for avenues to invest these surpluses. These would be available only
from a few days to a few months at times. Being a corporate, the Cash
Manager has to take every measure to realize the most mileage of the
investment. Keeping in banks as deposits, investing in treasury bills,
commercial paper, and certain other money market funds can be explored.
Surely, there will be divergence in the sources available for investment in
domestic markets and global markets.

The biggest question for the Cash Manager of an international firm is to

invest the surplus in the country, where it is generated in the same currency
or to transfer the surpluses, following the rules of the host country and then
opt for centralized investment choices. Each of these has its own merits and
demerits. Instead of being momentary, an MNC can design a policy of its
own in this regard.

In addition to the traditional investments like Bank Deposits, Treasury Bills,

and Commercial Paper, MNCs can also think of Global Depository Receipts
(GDRs) and American Depository Receipts (ADRs). These Depository
Receipts have become popular in the recent past and are used both for
financing and investment whatever the means of investment selected, it
should have the recourse of yield, risk, financial strength, purpose and
duration, flexibility, and creditworthiness. Considering a numerical example
for better clarity, the effective yield on a foreign deposits general equation:
= (1 + if) (1 + ef) – 1

Where = effective yield on a foreign deposit

if = percentage of interest quoted on the foreign currency
ef = percentage change (appreciation or depreciation) in the value of
the currency from the date of deposit to the date of withdrawal.

Suppose that an MNC X of the US has surplus cash of $2,000,000. It can

invest in a one-year domestic bank deposit @ 6 percent. The company finds
that a one-year deposit in an Australian bank would fetch 9 percent. The
exchange rate of the Australian dollar at the time of investment is $0.68. Due
to the higher interest rate X decided to invest in Australia. The U.S. Dollars
309
Working Capital are, therefore, converted to Aus $2,941,176 and then deposited in a bank.
Management:
Issues and Practices After one year, X receives Aus $3,205,882 (equivalent to the initial deposit
plus 9 percent interest on the deposit). X then converts it into U.S. dollars.
Assume that the exchange rate at this time is $72 (an appreciation of 5.88%).
The funds are covert to $2,308,236. Thus, the yield on this investment to X
is:
= (1 + .09) (1 + .0588) – 1
= 1541, or 15.41%
Now assume that the Australian dollar depreciated from $0.68 to $0.65 or by
4.41%, the effective yield will be:
= (1 +0.09f) (1 + 0.0441) – 1
= .0419, or 4.19%

The effective yield could be negative if the currency denominating the

deposit depreciates to an extent that more than offsets the higher interest
accrued from the deposit.

Activity-14.2
i) Try to trace the cash flows of any MNC you are aware of.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

14.4 RECEIVABLES MANAGEMENT

It is known to the captains of the industry that the size of receivables depends
on the credit and collection policies of the company. Both of these are the
influencing factors in boosting the sales of the company. It would be the
choice of the company either to follow stringent credit policies or liberal
policies. It is also true that the practices prevailing in the world lay down a
set of standard practices and the firms may be left with little choice but to
vary such terms, going against the already followed practices. In the case of
an MNC, these practices would be quite diverse and it may have to formulate
the policies and practices for each country and vary them as and when
necessitated.

The gamut of additional variables that need to be taken into account by the
MNC includes currency fluctuation, exchange rate variations, restrictions on
the flow of funds beyond the boundaries of the host countries, inflation rates,
and other economic and non-economic factors. In the case of MNC, unit
receivables mainly arise due to the transit period between countries. When
the consignment is shipped to a foreign destination, there will be sometime
elapsing between the shipment and receipt. The bills drawn on the importer
can be discounted or wait for payment. Usually, the importer is advised to
open a Letter of Credit (LC) against which payment is received by the
exporter.
310
One of the services that emerged in recent times is the factoring of Working Capital
Management in
receivables. Factoring is a financial service extended by an agency (called a MNCS
factor) that buys the receivables from the seller (means the company selling
goods or services) and pays a certain amount (generally about 80 to 90
percent) of the sale amount. The factor would collect the invoice and after
deducting his agreed commission, pay the remaining amount to the company.
Factoring encourages the exporter to quote more competitive terms or to ship
goods on an open account rather than insisting on cash payment or shipment
against the letter of credit. One advantage to the exporter is that he can save
on the cost of a credit investigation, currency risks, collection risks, and
political risks also. As the agency involved in factoring is the one having the
necessary expertise in assessing all these risks, to that extent the exporter is in
a better position. Nevertheless, it is for the exporter or the MNC to decide on
hiring the services of a Factor. It has to weigh the cost of waiting for payment
from the importer and the commission to be paid to the Factor. The following
Equation is usually employed to weigh these costs:
i × n CF
CB =
(2 X r)

Where CB = Cash Balance

n CF = Average negative cash flow in a given period
i = Discount rate (Factoring Cost)
r = Rate of return on the firm’s assets.

Factoring service has evolved over the years. A separate Accounting

Standard is also formulated to deal with the threat of ‘factoring cost’ under
Generally Accepted Accounting Principles (GAAP) and the United States of
America and in other countries. Based on the growth in the Factoring
Services and using the advancements in technology. Some of the Factoring
agencies have also diversified into fields like real estate, construction,
medical, haulage, etc.

As we have noticed in the cost of Cash Management, technology has been

bringing about, in a company, significant and more lasting changes in the
Management. Receivable Management is the point of the same. Some of the
technology like the following would contain by contributing to the efficient
management of receivables by both the domestic and international
companies.
• Developing a Mobile App
• Resorting to RTGS / NEFT
• Designing specific Templates for handling receivables
• creating a Dashboard kind of mechanism
• Automated Reminder
• Role-based /system generated notifications and escalations

The MNC will have the advantage of knowing better the local practices and
tailoring the method to suit their taste
311
Working Capital
Management: 14.5 INVENTORY MANAGEMENT
Issues and Practices
There was an age-old saying that ‘inventions are the grave end of business’.
This turns out to be true in case of domestic companies as well as
international companies. Some of the finance managers have linked
inventories to that industry’s cancer. Therefore, if the inventories are not
properly handled, they leave a deleterious effect on the bottom lines of the
companies. The inventory management techniques such as EOQ, Re-order
level, ABC, etc., are akin to both types of companies. Yet, the companies
operating in more than one country need extra caution about the purchasing
policies of the host countries, changing prices, currency fluctuations,
disruptions in the supplies, changing lead times, and finally political stability
too.

Whatever the techniques that the parent company is conversant with or

following in the country of origin may not be suitable in the host country or
the environment may not be so ripe to adopt such practices there. The supply
chains or stock replenishments may not be that instantaneous, as is the
situation in the home country. We are aware of the fact that Japanese
companies are highly popular in following inventory management practices
like Just-in-Time (JIT), Kaizen, Kanban, etc. But their adaptability to a
country like Tanzania is not so easy. For various internal and external
reasons, even Japanese companies also may be required to go for “Stock
Pilings”. Frequent changes in the tariffs, import controls, and quota
restrictions would necessitate the MNCs to change their strategy. Further,
countries like India follow an incentive mechanism, whereby 100% export-
oriented units are provided with certain flexibilities in imports and exports.
Such measures usually help MNC units operate with lesser inventories.
Since MNCs usually depend on their home countries for imports, and there is
always some amount of lead time, maintaining a certain quantity of ‘safety
stock, becomes imminent. Not only raw material supplies but also stores and
spares of the machines deployed in the production process are all imported.
Many MNCs follow this practice to ensure the quality of their products and
to ensure the economy of operation. How the MNC companies face the
difficulties in their supplies is far to imagine. For instance, the movement of
cargo in the ‘Suez Canal’ got stuck in the past for a week due to a large ship
named ‘Ever Given’, and the entire movement of the Fleet in the canal got
stopped abruptly and about 320 vessels were waiting for clearance. Such
incidents may happen anywhere in the world, destabilizing the management
practices and stock pilings.

Some of the usual and most frequently resorted to mistakes by the MNCs can
be said to be the following:
• Holing too much or too little inventory in one location.
• Lack of diverse inventory items.
• An Inadequate number of warehouses.
• Difficulties in the movement of inventory items from one location to
312 another location.
• Lack of coordination among the multiple locations within the same Working Capital
Management in
country and between a parent company and the subsidiaries in host MNCS
countries.

14.5.1 Supply Chains and Inventory Management

A new trend in the management of inventories is towards cultivating supply
chains. Businesses are always in search of new and innovative processes and
the new development in this regard is the Supply Chain Management (SCM).
This combines a wide gamut of activities covering manufacturing operations,
purchasing, transportation, and physical distribution into a unified activity.
The intention is to create a seamless process linking all the players in the
chain. Many of these activities have a direct bearing on inventory control
such as procurement, transportation, warehousing, forecasting, production
planning, scheduling, etc. In a wider sense, the supply chain is said to extend
to all those activities associated with the movement of goods from the raw
material stage through to the end-user. Supply chain integration implies not
only the internal departments but also extends to external agencies, like the
suppliers of raw materials, transporters, warehousing firms, etc. Supply
chains are designed to play an important role in moving goods more quickly
to their destination. It is also important that a common framework is
developed for analyzing the efficiency of the players in the chain at every
level and on each occasion, crucial to the chain.
It has been revealed through many research studies that efficient supply
chains can reduce holding costs to a significant extent. Therefore, there is a
need to design a suitable model for effective inventory management through
these chains. In this context, H. Lee and C. Billington (1992) through their
article (published in Sloan Management Review, Vol.33, No.3, 1992) on
“Managing Supply Chain Inventory: Pitfalls and Opportunities” proposed a
model for Inventory management taking into account decentralized and
discontinuous supply chains. The authors have identified fourteen such
pitfalls in supply chain management and some corresponding opportunities.
They expressed the opinion that the more complex is the network of
suppliers, the more likely is the possibility of operational efficiencies.
Therefore, managing inventory in supply chains required special focus and
consideration at all levels.

14.6 SUMMARY
Because national boundaries are fading out and economies are merging as a
single global village, opportunities for business expansion are growing day
by day. Companies are spreading their business throughout the world and
even small start-up units are also having customers across nations.
Companies are therefore emerging as global entities in more than one
country; perhaps 10-20 countries easily. Under these circumstances,
businesses are also required to adapt themselves to international management
practices and be conversant with the changing environment.
Working Capital Management is one such important area, where companies
are required to be vigilant to improve upon their profitability. Though the 313
Working Capital practices are similar to those practiced in the domestic context, there are a
Management:
Issues and Practices few additional issues that need to be cared for by the firms operating in the
international context. These relate to the changing business and industrial
policies of the host countries. Tax matters, Exchange fluctuations, restrictions
on the movement of goods and services, and finally transfer pricing. Each
component of the working capital such as cash, accounts receivable and
inventory is to be managed properly to realize the competitive advantage in
the international context. It is advised that the firms shall always try to
maximize the inflows and minimize the outflows. In the present days of
Electronic funds transfer, the cash dealings are almost instantaneous.
Therefore, firms should be well aware of the payment mechanisms and take
advantage of the advancements in technology. Cash pooling and multilateral
netting are some of the cash management tools that can be gainfully
employed. Investing idle cash is yet another important task, about which
firms should not be complacent. Firms also shall focus on the receivables and
inventory aspects to carry out the process of production without any
interruption. Some of the techniques useful in the home country may not be
easily deployable in the host countries due to divergence in practices and also
import and export restrictions. Getting the most mileage out of every rupee
invested shall be the motto of the firm dealing in an international context.

14.7 KEY WORDS

Multinational Company (MNC): A company having business
operations/units spread across other nations.

New International Economic Order (NIEO): A set of relations that govern

the trade among nations.

Electronic Funds Transfer Systems (EFTS): A network system that helps

the transfer of funds from one account to another and from one place to
another. These also include various types of electronic gadgets that help the
transfer of funds.

International Cash Management: Cash Management practices followed by

MNCs.

Multilateral Netting: A payment mechanism wherein two or more parties

join together to sum transactions carried out by them in a specific period.

Cash Pooling: A centralized cash management system, whereby all the cash
dealings are pooled at one place or into one account.

Receivables Management: Methods and techniques employed to speed up

the collection of debts.

Inventory Management: Tools and techniques followed to keep the

inventory as low as possible, without impacting the production process and
sales.

314
 Working Capital
14.8 SELF ASSESSMENT QUESTIONS Management in
MNCS
1) How does the Working Capital Management of an MNC differ from a
domestic company?

2) What are the special considerations about which an MNC should be

always cautious?

3) How did Electronic Funds Transfer system bring about changes in the
Cash Management practices?

4) Whether the traditional Cash Management practices followed by a

domestic company have any relevance to the MNC?

5) Distinguish between Netting and Cash Pooling. Illustrate your answer

with a live or Hypothetical case.
6) Investing Idle Cash is an intelligent exercise. What do you think are the
special issues of significance in this regard?
7) “Accounts Receivables Management is not a big deal for an MNC”. Do
you agree?

8) “The so-called much talked about Inventory Management Techniques

like JIT, Kaizen have no big appeal in the International Environment”.
Argue.

9) ‘Supply Chains have freed the suffocation in Inventories’. To what

extent this observation is right?

14.9 FURTHER READINGS

1) Alan C. Shapiro and Peter Moles, (2016), International Financial
Management, Wiley.
2) Bhalla, V.K., (2014), International Financial Management, S. Chand &
Co.
3) Srivastava, R.M., (2008), Multinational Financial Management, Excel
Books.
4) Keneth Kim and Sukkim (2019), Global Corporate Finance, World
Scientific.
5) Hrishik Bhattacharya, (2014), Working Capital Management, PHI
Learning.

315
Working Capital
Management: UNIT 15 CASE STUDIES
Issues and Practices

Objectives
After going through this Unit, you should be able to:
• know how the various components of working capital are managed by
the existing companies.
• get in touch with the nuances of Working Capital Management in terms
of policy and practice.
• understand how companies would be topping and mobilizing funds for
financing working capital.

Structure
15.1 Introduction
15.2 Cash Management in Paytm
15.3 Receivables Management – Case Study of TCS
15.4 Inventory Management – Case Study of Maruti Suzuki India Ltd.
15.5 Financing of Working Capital by Commercial Banks – Case Study of
SBI.

15.1 INTRODUCTION
Working Capital is a matter of great concern to any business. It is said to be
the lifeline of a business. The shorter the operating cycle of a unit, the more
significant it turns out to be. Usually, investment in Fixed Capital is a one-
time affair. Working capital is a continuous requirement which needs the
attention of the Management. It is for this reason, that working capital is also
called ‘circulating capital’. As the blood in the arteries and veins flows in the
body of an individual, working capital circulates in the firm in the same
manner. In the case of manufacturing activities like the production of Sugar,
Cement, Paints, etc., the quantum of working capital would be heavy and
significant. It is only in the case of service industries like Software
development that the working capital assumes low significance. Irrespective
of the size and proportion, working capital will have a paramount influence
on the profitability of the company. Therefore, ignoring the aspect of prudent
management of working capital would be very dangerous.

It would always be interesting to analyze how things are managed in the

actual field. Theoretically, one may propose many principles and stands, but
it is also important to verify to what extent those are appreciable and yield
results. With this intention, an attempt has been made in this unit to discuss
four live cases about all the important components of working capital. Care
has been taken to ensure that the company selected is significant from the
standpoint of the management of that component of working capital.

316
Case Study on Paytm is expected to throw light on the modern state-of-the- Case Studies

art cash management practices and also highlight how the traditional
practices have been going into oblivion, yielding place to the newer ones. In
the present day context, swift practices through Payment Gateway, NEFT,
RTGS, etc., have become the order of the day. In a way, the transfer of funds
across places and accounts has turned out almost instantaneous. The
discussion in this case study would take the student closer to reality.
The case study about receivables management is done on TCS Ltd. TCS is
one of the companies having more receivables. The efficiency of
management of working capital thus depends on this component. As per the
Financial Statements of the company, the size of receivables is varying
between the lowest of Rs.24,000 crores to the highest of Rs. 29,000 crores.
Even a saving of 1 percent would add a significant amount to the profitability
of the company.
The other significant component of working capital is inventory. It is thought
that the Automobile giant M/s Maruti Suzuki would fit as the ad example.
Being a Japanese sponsored company, it could put in place state-of-the-art
Japanese inventory management techniques like JIT, Kaizen, etc., As one can
observe from the case study, the company has laid down its policies and
followed them scrupulously. It is the discipline of the Japanese companies
that takes them to the top.
On the whole, it is also considered appropriate to develop a case study on the
procedures followed by the Commercial Banks in financing working capital.
In this regard, the case study of SBI is thought the ‘best fit’. SBI, being the
biggest institution in the Indian banking industry is a model for other banks
in terms of its lending and other practices. By its sheer size also, it is in a
position to take risks and experiment with new and innovative methods. After
doing away with the implementation of Tandon Committee norms for
financing working capital, banks have a lot of freedom to design their
models. In that context, the SBI case offers interesting reading.

15.2 CASH MANAGEMENT IN PAYTM ORIGIN

AND GROWTH
Paytm is the brand name of the company, 97 Communications Ltd., a start-up
company founded by Mr. Vijay Shekhar Sharma in August 2010. Paytm is a
big success story as an e-commerce payment system. The company is located
in Noida Industrial Area, U.P. India. In addition to payment system services,
it is also extending cash management services through Paytm Mall, Paytm
Money, Gamepind, and Paytm Smart Retail. Initially, the Founder Mr. Vijay
Shekhar Sharma invested $2 Million in subscriptions from others. Started off
as a prepaid mobile and DTH recharge platform, now offers services that
cover digital wallets, data, and payments, online shopping, banking, postpaid
mobile, landline bill payments, etc. Further, extensions included the payment
of college/school fees, electricity bills, metro charges, water bills, and
ticketing for entertainment units like Movie Theatres, Amusement parks, etc.
It also entered into ticket bookings for railways, Airways, etc. Uber and
Indian Railways have added Paytm wallet as the payment option.
317
Working Capital Through these initiatives, the user-base runner of the company has grown
Management:
Issues and Practices substantially. Starting with a base of about 7 million users it has grown to
350 million. Similarly, the business turnover has jumped from just around
$100 million to about $600 million now. In terms of financial strength, its net
income itself is about $350 million. Given the value of about $20 billion.

Shareholding Pattern
Beginning with the small investment of $2 million by the promoter, Mr. V.S.
Sharma, many other venture capital firms, equity firms, and E-Commerce
giants have started evincing interest in the company. These included Sapphire
Ventures, Alibaba Group (through Ant Financial Services), Ratan Tata,
Softbank (a Start-up funding company) and Warren Buffett (through
Berkshire Hathaway).
In turn, Paytm also expanded its business through investments and
acquisitions of related businesses. In 2013, Paytm acquired Plustxt for $2
million, invested $5 million in an auto-rickshaw aggregator, called (Jugnoo),
invested in logistics Start-ups LogiNext and XpressBees in 2016, and
invested in a healthcare start-up called Q or QL, and continued this spree as
and when it found lucrative and necessary for business development.

Over the years, there had been a significant change in the shareholding
pattern of the company, and the founder, who had about 51% at the
incorporation got shrunk to about 15.73%. There was major shuffling in the
holdings by other firms too. At the end of 2020, the following is found to be a
shareholding pattern of Paytm (i.e., One97 Communications Ltd.):

Sl. No. Name of the Holder % of Holding

1. Alibaba 38.19

2. SoftBank 19.69

3. SAIF Partners 19.93

4. Berkshire Hathaway 2.96

5. Media Tek Inc. 0.76

6. One97 Employee Welfare Trust 0.48

7. Mr. V.S. Sharma (Promoter) 15.73

8. Mark Schwartz 0.15

9. Others 2.11

Total 100.00

No. of Shares (Approx) 57,389,217

318
 Case Studies
The Controversies
The runaway success of the firm is not without controversies. There was an
allegation (2018) that the firm had shared the personal details of its users with
the Indian Government, violating the ‘privacy policy. There is also an
apprehension that the promoter and his relatives had nexus with the ruling
party (BJP) and thus involved in politicking through their services. In recent
times, controversy (September 2020) pertains to the violation of Google’s
Play Store Gambling Policy, leading to the removal of its ‘Paytm’ app from
the ‘Google Play Store’. There is also an apprehension that the Chinese E-
Commerce major (Alibaba) is using Paytm as the tool to get personal data of
Indians and thus increased its shareholding to a substantial level of about
40%. Nevertheless, Paytm is not on the list of 118 Apps banned by the
Central Government, on the finding that ‘One97 Communications Ltd.’ is
still an Indian Company.

The Operation of Paytm Services

Paytm is operating a payment Gateway that accepts payments from any
funding source. Besides, payment Gateway, as payment links with diverse
business entities, which include educational institutions, all kinds of business
establishments, professionals, distributors, consultants, etc. It has developed a
portal called ‘Paytm icol collect in acts as a window for receiving payments.
It is also involved in all types of QR codes and monitors and processes
payments of all kinds. Not only on the receipts side, but has I butt also
offered payout services which include Employ Benefits, Enterprise Bill
Payments, and different kinds of EMIs.

It has also developed exclusive cloud services and put in place different kinds
of Apps for dealing with its customers. Business Khata is the exclusive
service extended to its customers. Financial services delivered include
Current Accounts, Salary accounts for Employees, and Credit Card Services.
The Business Model of Paytm includes the appointment of Paytm Service
Agents (PSAs) who wish to work with Paytm as the Service Partner to sell
Paytm Products. Those that intend to tie up with Paytm for its service have to
submit required documents like company proof, Business proof, PAN Card,
Bank Account details, GST details, KYC of the Authorised signatory, and
photos/videos of the place of Business.

Financials of Paytm (One97 Communications Ltd.)

The following are the details ending March 31, 2019:

Consolidated Standalone
(INR in Crore) (INR in Crore)
2018-19 2017-18 2018-19 2017-18
Revenue from Operations 3,232.01 3,052.90 3,049.87 2,982.22
Other Income 347.66 256.71 341.74 247.16
TOTAL REVENUE 3,579.67 3,309.61 3,391.61 3,229.38
Less: Expenses
Employee Benefit Expense 856.22 613.98 627.78 528.66 319
Working Capital
Management:
Finance Cost 16.87 18.88 16.50 18.39
Issues and Practices Depreciation and Amortization 99.51 78.88 75.81 68.92
Expense
Other Expenses 6,757.54 4,152.79 6,534.71 4,082.11
TOTAL EXPENSES 7,730.14 4,864.53 7,254.80 4,698.08
Profit/Loss before sharing (4,150.47) (1,554.92)(3,863.19) (1,468.70)
of the result of
associates and taxation from
continuing operations
Share of result of associates / 14.61 (30.81) - -
joint venture entities
Profit/Loss before exceptional (4,135.86) (1,585.73)(3,863.19) (1,468.70)
items and tax from continuing
operations
Exceptional items (82.52) 3.40 (91.02) (2.30)
Profit/Loss before Tax from (4,218.38) (1,582.33)(3,954.21) (1,471.00)
Continuing Operations
Tax Expense (6.49) 1.53 0.12 (1.01)
Profit/Loss from Continuing (4,211.89) (1,583.86)(3,954.33) (1,469.99)
Operations
Profit/Loss for the (5.31) (20.48) (5.31) (20.48)
period from
discontinued operations
Profit/Loss for the year (4,217.20) (1,604.34)(3,959.64) (1,490.47)
Total Comprehensive (4,221.81) (1,606.05)(3,959.78) (1,491.23)
Income/Loss
Loss attributable to equity (4,167.98) (1,589.46) - -
holders of the parent
Loss attributable to non- (49.22) (14.88) - -
controlling interests
Total Comprehensive (4,172.93) (1,591.17) - -
Income/Loss attributable to
equity holders of the parent
Total Comprehensive (48.88) (14.88) - -
Income/Loss attributable to non-
controlling interests
Basic & Diluted EPS for (742.17) (311.42) (705.02) (291.77)
continuing operations
Basic & Diluted EPS for (0.95) (4.06) (0.95) (4.06)
discontinued
operations
Basic & Diluted EPS for (743.12) (315.48) (705.97) (295.83)
continuing and discontinued
operations

320
Consolidated Balance Sheet of One 97 Communications Limited as of Case Studies
March 31, 2019
(Amount in INR Crore)
Notes As of As of
March 31, March 31,
2019 2018
ASSETS
Non-current assets
Property plant and equipment 1 284.28 161.13
Capital work-in-progress 51.31 18.54
Goodwill 4 293.02 312.21
Other intangible assets 4 73.45 99.02
Intangible assets under development 4.29 1.63
Investment in Joint Venture 5(a) 46.05
Investment in associates 5(b) 200.20 175.57
Financial Assets
Investments 6(b) 105.08 211.59
Loans 6(c) 107.40 32.48
Other Financial Assets 6(d) 137.07 243.64
Current tax assets 464.76 281.26
Deferred tax assets 28 3.04 0.80
Other non-current assets 8 141.04 53.68
Total Non-current Assets 1,910.99 1,591.55

Current Assets
Financial Assets
Investments 6(a) 2,897.88 4,455.09
Trade Receivables 7 258.45 504.78
Cash and Cash Equivalents 9(a) 325.47 331.84
Bank balances other than cash 9(b) 37.26 38.21
and cash equivalents
Loans 6(c) 308.83 12.86
Other Financial Assets 6(d) 1,829.29 1,106.55
Other Current Assets 8 1,413.82 635.77
Total Current Assets 6,671.00 7,085.10

TOTAL ASSETS 8,581.99 8,676.65

EQUITY AND LIABILITIES

EQUITY
Share Capital 10(a) 57.53 55.32
Instruments entirely equity in nature 10(a) --- 173.63
Other Equity 10(b) 5,681.15 7,254.90 321
Working Capital
Management:
Equity attributable to the owner of 5,738.68 7,483.35
Issues and Practices the parent
Non-controlling interests 86.17 135.47
Total Equity 5,824.85 7,619.32

LIABILITIES
Non-current Liabilities
Financial Liabilities
Borrowings 12(a) 26.96 --
Deferred Tax Liability 28 18.47 22.67
Provisions 11 11.55 9.89
Total Non-current Liabilities 56.98 32.56

Current Liabilities
Financial Liabilities
Borrowings 12(a) 695.60 242.12
Trade Payables
(a) Total Outstanding dues of 12(b) 11.26 0.88
micro and small enterprises
(b) Total Outstanding dues other 12(b) 725.39 461.80
than (a) above
Other financial liabilities 12(c) 715.41 235.80
Contract Liabilities 352.87 ---
Other Current Liabilities 13 159.17 53.60
Provisions 11 40.46 30.67

Total Current Liabilities 2,700.16 1024.77

Total Liabilities 2,757.14 1,057.33

TOTAL EQUITY AND 8,581.99 8,676.65

LIABILITIES

Questions for Discussion:

1) How do you analyze the Business Model of Paytm? Do you have any
suggestions?
2) In the light of the stiff competition among the multiple players of
payment Gateways, what kind of Cash Management strategies you can
think of for Paytm.
3) How do you look at the Ratio between Current Assets and Non-Current
Assets of the company?
4) Keeping in view the given Financials, what kind of working capital
policies do you imagine for the company?
322
 Case Studies
15.3 RECEIVABLES MANAGEMENT IN TATA
CONSULTANCY SERVICES LIMITED
Introduction
The Bombay Stock Exchange (BSE) has compiled data on the Top 100
companies listed with it, based on the figures available from their latest
Balance Sheets (see Annexure-I). As per the data compiled, the Tata
Consultancy Services Limited (TCSL) has the highest Sundry Debtors
(Receivables) at Rs.28,660 crore, which is about 86% of the total Current
Assets of the company. Close to it L & T has about Rs.27,913 crore (80.6
percent) in the second place. True, that there are a few companies that had the
highest percentage of receivables such as PTC India (97.01%), NHPC
(88.27%), ITI (86.84%), Sterling & Wilson (88.16%), and McNally Bharat
Engineering (98.37%). But the size of their receivables in absolute terms is
much lower. In this regard, the Economic Times (a Financial Daily of India)
commented that the Indian MSMEs, especially Startups are choked by the
large dues to be received from the large companies, to whom they are
supplying the goods and services.

Case of TCS
Against this background, it is felt that TCS offers itself as a good case study,
in the sphere of ‘Receivables Management. TCS is a big name in the IT
Sector of India. It is the second-largest Indian company in terms of market
capitalization. In 2018, TCS was ranked eleventh on the Fortune India 500
list.

Going into the past, TCS was founded in 1968 by Tata Sons Ltd., the parent
company. Tata Sons owns about 72% of the shareholding in TCS. The
company has 67 subsidiaries and offers a wide range of IT Services to its
customers which include application software development, business process
outsourcing, capital planning, software consultancy, and also educational
services linked to IT. The company website says that ‘TCS is an IT Services,
Consulting and Business Solutions Organisation that has been partnering
with many of the world’s large businesses in their transformation Journeys
for over years. The network of TCS includes over 4.43 lakh trained
consultants in over 46 countries. The revenues of the company stood at US
$22 billion by the end of March 31, 2020. TCS is a company carrying on
excellent work to influence climate change across the world; as evidenced by
a learning place on the ‘Sustainability Indices’ by the Dow Jones, MSCI, and
FTSE.

The Receivables Story

As indicated earlier, trade receivables are occupying a significant place in the
company’s Current Assets. As per the Balance Sheet information (given as
Annexure-II), trade receivables stood at Rs.28,660 crore, in 2019-20
compared to Rs.24,029 crore in 2018-19. In terms of percentages, receivables
formed 36.2 percent of Current Assets in 2019-20, higher by 5.8 percent
compared to the previous year (i.e 3 percent). This amply shows the
323
Working Capital significance of handling receivables effectively. The Accounting Policies
Management:
Issues and Practices concerning countries are stated as follows by the Company:

• Contract assets are classified as unbilled receivables (the other only act
of invoicing is pending); when there is an unconditional right to receive
cash.

• The company provides for the expected credit loss in the collection of
receivables. This is done by taking into account the tagging of
receivables.

• Revenue recognition is done only when the collectability of receivables

is reasonably assured.

• Allowance for delinquent receivables is treated as the operating expense.

• The company recognizes lifetime expected losses for all trade

receivables that do not constitute a financing transaction.

• When the company leases any asset as a lessor, the lease rents are treated
as receivables and the rate of return is computed on the net investment
made in that asset.

Other Issues
• TCS being in the leadership position is facing several challenges from its
Indian competitors like Infosys, HCL, and Wipro.
• The acquisition strategies of the company are needed to be sharpened.
There is an apprehension in the market that its surplus is being
distributed to the shareholders to satisfy them, rather than using them for
acquisition and expansion.

• In the face of future technology changes, how well the company

responds to imbibe and nurture such tech changes is also going to leave a
tremendous impact on its business.

• The other issue is Customer Relationship Management (CRM). It is that

Tata Group Companies are in ideal CRM. This needs to be continued for
better hold in the market.

Questions for Discussion

1) How do you view the significance of Receivables to any company, in
particular to TCS?
2) Do you propose any changes in the Accounting Policies of the company
for better management of Receivables? You can draw a comparison
between the Indian GAAP and IFRS.

3) What ratios do you compute to discern the effectiveness of receivables

management by TCS?

324
 Case Studies
Annexure – I: Sundry Debtors of Top 100 Companies

Sundry % of Current
S. No. Company
Debtors Assets
1 TCS 28,660.00 85.58
2 Larsen 27,912.96 80.62
3 NTPC 15,668.11 54.77
4 Infosys 15,459.00 53.27
5 IOC 12,844.09 16.66
6 Hindustan Aeron 11,583.39 36.97
7 Wipro 9,257.00 46.58
8 SAIL 8,812.39 26.77
9 NFL 7,735.33 85.62
10 HCL Tech 7,504.00 85.19
11 Reliance 7,483.00 13.67
12 BHEL 7,107.62 31.69
13 PTC India 6,787.85 97.01
14 Bharat Elec 6,732.91 55.18
15 NLC India 6,691.83 79.76
16 Tech Mahindra 6,212.00 76.98
17 Sun Pharma 6,168.13 65.23
18 Pharma 5,789.57 56.86
19 Chambal Fert 5,563.11 81.22
20 KEC Intl 5,223.41 88.28
21 BPCL 5,164.34 20.09
22 Power Grid Corp 4,867.90 41.74
23 ONGC 4,777.39 33.38
24 Dr. Reddys Labs 4,638.70 67.54
25 Rashtriya Chem 4,551.23 82.68
26 GAIL 4,546.84 54.71
27 Reliance Infra 4,106.24 94.14
28 Coromandel Int 4,040.57 59.48
29 HPCL 3,922.72 16.93
30 Enterprises 3,846.48 62.47
31 NHPC 3,818.34 88.27
32 Bharti Airtel 3,810.00 52.84
33 Lupin 3,616.33 48.82
34 Cipla 3,560.27 50.11
35 Kalpataru Power 3,517.39 76.57
36 JSW Steel 3,166.00 13.09
325
Working Capital
Management:
37 UP 3,161.00 68.13
Issues and Practices 38 Siemens 3,123.90 31.94
39 M&M 2,998.98 28.20
40 Vodafone Idea 2,919.10 53.53
41 Grasim 2,905.32 51.78
42 Redington 2,805.58 61.78
43 Rajesh Exports 2,790.24 19.17
44 ITI 2,761.14 86.84
45 GSFC 2,722.76 67.89
46 Cadila Health 2,456.70 57.99
47 NCC 2,408.26 74.33
48 United Spirits 2,283.50 54.97
49 MRF 2,257.03 36.31
50 JISL 2,232.57 70.33
51 Jain Irrigation 2,232.57 70.33
52 NMDC 2,223.71 41.65
53 BGR Energy 2,220.57 84.57
54 L&T Infotech 2,176.70 85.42
55 Adani Ports 2,132.67 32.00
56 Maruti Suzuki 2,127.00 39.66
57 Jyoti Structure 2,105.54 96.93
58 Hindalco 2,093.00 12.61
59 ITC 2,092.00 12.33
60 Zee Entertain 2,052.00 29.55
61 Bajaj Electric 2,048.99 72.03
62 Cox & Kings 2,031.32 73.74
63 ISGEC Heavy Eng 1,990.44 75.48
64 TML-D 1,978.06 21.17
65 Tata Motors 1,978.06 21.17
66 ABB India 1,947.54 44.19
67 MMTC Ltd 1,925.36 85.07
68 GE T&D India 1,898.82 72.81
69 UltraTechCement 1,848.28 30.84
70 Glenmark 1,835.24 66.47
71 Hind Constr 1,821.97 83.48
72 Apar Ind 1,803.58 55.91
73 ABB Power Produ 1,792.85 72.47
74 PC Jeweller 1,780.55 24.50
75 Sadbhav Engg 1,743.41 86.57
326
 Case Studies
76 Bajaj Auto 1,725.10 55.70
77 Bharat Forge 1,654.91 57.93
78 Hero Motocorp 1,603.14 54.58
79 Petronet LNG 1,602.57 24.60
80 Alkem Lab 1,555.07 45.56
81 SpiceJet 1,545.82 87.65
82 HFCL 1,545.71 77.34
83 Sterling & Wils 1,539.76 88.16
84 Rattan Power 1,535.22 66.94
85 Divis Labs 1,533.21 45.30
86 Jindal Saw 1,532.57 38.47
87 FEL 1,520.10 55.36
88 Future Ent 1,520.10 55.36
89 BEML 1,510.37 42.65
90 Torrent Pharma 1,508.94 44.28
91 Mangalore Chem 1,446.31 75.21
92 Polycab 1,439.40 39.73
93 Mindtree 1,438.90 71.08
94 JK Tyre & Ind 1,436.03 55.71
95 Voltas 1,429.25 47.66
96 GNFC 1,413.42 55.76
97 Sterlite Techno 1,413.16 75.61
98 Bosch 1,413.00 29.53
99 Mcnally Bh Engg 1,385.32 98.37
100 Simplex Infra 1,382.73 70.02

Source: www.moneycontrol.com

327
Working Capital Annexure-II: Key Items of Working Capital of TCS
Management:
Issues and Practices
(Rs. in Crore)

Sl. Item 2019- 2018- 2017- 2016- 2015-

No. 20 19 18 17 16
1. Current Liabilities
A. Short Term Nil Nil 181 200 113
Borrowings
B. Trade Payables 6784 7632 4775 4198 5376
C. Other Current 15057 11030 8931 6245 5711
Liabilities
D. Short Term Provisions 235 174 171 66 115
Total Current 24026 18896 14058 10701 11309
Liabilities
2. Current Assets
A. Current Investments 25686 28280 35073 40729 21930
B. Inventories 5 10 25 21 9
C. Trade Receivables 28660 24029 18882 16582 19058
D. Cash & Cash 4824 8900 3487 1316 4806
Equivalents
E. Short Term Loans & 7270 7018 2793 2704 2523
Advances
F. Other Current Assets 12749 10795 7962 7090 5051
Total Current Assets 79194 79032 68222 68442 53377
3. Fixed Assets 16903 10495 10678 10708 10720
4. Total Assets 104975 99500 91056 89758 77417
5. Total Income 156949 146463 123104 117966 108646
6. Profit After Tax 32340 31472 25826 26289 24270
Note: Compiled from the Annual Reports of the TCS Ltd., as available from the website.

15.4 INVENTORY MANAGEMENT IN MARUTI

SUZUKI INDIA LIMITED
About the Company
Maruti Suzuki India Limited (MSIL) is a subsidiary of Suzuki Motor
Corporation (SMC) of Japan. Going into history, the Government of India
established an automobile company on 24-02-1981 in the name of Maruti
Udyog Limited (MUL). The MUL was merged with SMC in October 1982.
The first car plant was set up at Gurugram in 1982. The company came to
prominence within a short period because of its very popular brands like
Maruti-800, Alto, Wagon R, Swift, Ertiga, Baleno, Ciaz, Celerio, and many
other models. In 2015, the company launched a new dealership network in
the name of ‘NEXA’ for selling premium cars. It also has entered the pre-
owned car market with its brand name ‘True Value’. MSIL has been the
single largest car manufacturer in India with about 47.4 percent of the market
share by November 2020. The Net Sales Turnover of the company stood at
328 Rs.75,610 crore at the end of Financial Year 2019-20. You can take a glance
at the Chief Financials of the Company in annexure-I (appended to this case Case Studies

study).

Value System and Policies

The core values of the company are stated as follows:
• Customer Obsession
• Openness and Learning
• Networking and Partnership
• Fast, Flexible First Mover
• Innovation and Creativity

In addition, it has put in place a ‘Code of Business Conduct and Ethics’ to be

compiled by every Senior Manager to ensure ethical business operations. It
includes compliance with the laws of the land, honesty, and integrity in
business dealings. This document is circulated among the Directors,
Managers, and all the Senior Personnel and is to be acknowledged properly.

Inventory Management
Being a car manufacturer, materials occupy a significant part of the cost of
production. To affect, effects and gain a competitive advantage among the
players in the market, materials/inventory management assumes paramount
importance. Going by the financials of the company, the cost of raw materials
consumed formed part of 50 percent of the total expenses of the company
during 2019-20. Inventories formed part of 38.1 percent of the total current
assets at Rs.8,427 crore in the same year (see annexure-II). The CIF value of
raw materials imported by the company stood at Rs.2,488 crore during 2019-
20; which is about 77.4 percent of the inventory and 7.2 percent of the
material cost. These figures indicate the critical value of inventories to any
automobile company like the MSIL.

Management Practices of the Company

Japanese companies are known for unique Management Practices from the
beginning like lifetime employment and consensual decision-making. Strong
company philosophy, distinct corporate culture; all put together as Theory-Z
(as theorized by Dr. William Ouchi). These practices were regarded as new to
the Western Management Style and thus gained wide currency and popularity
during the 1980s and since then.

In respect of Inventory Management, Japanese companies are known for

introducing new and innovative techniques like the Just-in-Time (JIT)
inventory system, Kaizen (KAI=Change; ZEN=Good or Better), and Kanban
(Billboard or Taskboard). Besides these, they are also said to be good with
the conventional inventory management practices like FIFO, LIFO, ABC
Analysis, EOQ, etc.

To go into the specifics, MSIL has introduced the following inventory

systems for effective management of its inventories:

329
Working Capital • Bar Codes to reduce processing times, increase the accuracy of data, and
Management:
Issues and Practices speed up the operation.
• Delivery instruction system to reduce lead time and reduce the
requirement for buffer stocks.
• Just-in-Time to align raw material orders issued to suppliers with
production schedules. It is quite surprising to note that it leaves just four
hours for the supply of local items and six days for imported items. The
inventory to sales ratios is also kept low every time.
• Kanban system is put in place to control the supply chains and realize
cost savings. This is a technique designed to reduce idle time in the
production process. The main idea under this model is to deliver the
material item when the process needs it exactly at that time.
• Kaizen is the inventory management practice that the company uses for
continuous and incremental improvement in the system.
• Vendor Management is the most efficient in MSIL. This has a focus on
the suppliers. In respect of Maruti, it is found that about 70% of the
suppliers are within 100 kms radius. Components are supplied directly to
the Assembly Line; thereby reducing the packaging costs. The company
also practices the system of engaging full component suppliers, instead
of individual parts; thus, reducing the ordering costs.
• As indicated earlier, MSIL is a strong believer in localization. Its policy
is to source the maximum components of materials, almost up to 90%
from local sources. It is working relentlessly to substitute local
components in place of imported ones.
Questions for Discussion
1) Taking the MSIL as an example, give your ideas for better inventory
management.
2) Like the Japanese Inventory Management Systems, can you identify
anything of Indian origin?
3) Analyse the Financial Statements of MSIL given in the annexures to note
down Inventory Policies and Practices of MSIL.
4) Can you compare Western and Japanese Management Practices for the
betterment of the performance of a company? Where do Indian
companies stand.

330
 annexure – I: Income Statement of Maruti Suzuki India Case Studies
(Rs. in Crore)
Mar’20 Mar’19 Mar’18 Mar’17 Mar’16
INCOME
Net Sales Turnover 75610.60 86020.30 79762.70 68034.80 57538.10
Other Income 3420.80 2561.00 2045.50 2279.80 1461.00
Total Income 79031.40 88581.30 81808.20 70314.60 58999.10
EXPENSES
Stock Adjustments -238.10 210.80 40.70 -380.10 6.90
Raw Material Consumed 34636.60 45023.90 44941.30 42629.60 35483.90
Power and Fuel .00 .00 .00 .00 .00
Employee Expenses 3383.90 3254.90 2833.80 2331.00 1978.80
Administration and Selling
.00 .00 .00 .00 .00
Expenses
Research and
.00 .00 .00 .00 .00
Development Expenses
Expenses Capitalized .00 .00 .00 .00 .00
Other Expenses 30525.60 26531.40 19885.40 13101.30 11184.10
Provisions Made .00 .00 .00 .00 .00
TOTAL EXPENSES 68308.00 75021.00 67701.20 57681.80 48653.70
Operating Profit 7302.60 10999.30 12061.50 10353.00 8884.40
EBITDA 10723.40 13560.30 14107.00 12632.80 10345.40
Depreciation 3525.70 3018.90 2757.90 2602.10 2820.20
EBIT 7197.70 10541.40 11349.10 10030.70 7525.20
Interest 132.90 75.80 345.70 89.40 81.50
EBT 7064.80 10465.60 11003.40 9941.30 7443.70
Taxes 1414.20 2965.00 3281.60 2603.60 2079.40
Profit and Loss for the
5650.60 7500.60 7721.80 7337.70 5364.30
Year
Extraordinary Items .00 .00 .00 .00 .00
Prior Year Adjustment .00 .00 .00 .00 .00
Other Adjustment .00 .00 .00 .00 .00
Reported PAT 5650.60 7500.60 7721.80 7337.70 5364.30
KEY ITEMS
Reserves Written Back .00 .00 .00 .00 .00
Equity Capital 151.00 151.00 151.00 151.00 151.00
Reserves and Surplus 48286.00 45990.50 41606.30 36280.10 29733.20
Equity Dividend Rate 1200.00 1600.00 1600.00 1500.00 700.00
Agg. Non-Promoter
.00 .00 .00 .00 .00
Share(Lakhs)
Agg. Non-Promoter
.00 .00 .00 .00 .00
Holding(%)
Government Share .00 .00 .00 .00 .00
Capital Adequacy Ratio .00 .00 .00 .00 .00
EPS(Rs.) NaN NaN NaN NaN NaN
Source: https://economictimes.indiatimes.com
331
Working Capital annexure – II: Balance Sheet of Maruti Suzuki India
Management:
Issues and Practices
(Rs. in Crore)

Mar 20 Mar 19 Mar 18 Mar 17 Mar 16

12 mths 12 mths 12 mths 12 mths 12 mths
EQUITIES AND LIABILITIES
SHAREHOLDER'S FUNDS
Equity Share Capital 151.00 151.00 151.00 151.00 151.00
Total Share Capital 151.00 151.00 151.00 151.00 151.00
Reserves and Surplus 48,286.00 45,990.50 41,606.30 36,280.10 29,733.20
Total Reserves and 48,286.00 45,990.50 41,606.30 36,280.10 29,733.20
Surplus
Total Shareholders’ 48,437.00 46,141.50 41,757.30 36,431.10 29,884.20
Funds
NON-CURRENT LIABILITIES
Long Term 0.00 0.00 0.00 0.00 0.00
Borrowings
Deferred Tax 598.40 564.00 558.90 466.20 194.30
Liabilities [Net]
Other Long Term 2,170.30 2,036.50 1,585.30 1,105.00 807.50
Liabilities
Long Term Provisions 51.60 39.50 26.50 21.90 14.80
Total Non-Current 2,820.30 2,640.00 2,170.70 1,593.10 1,016.60
Liabilities
CURRENT LIABILITIES
Short Term 106.30 149.60 110.80 483.60 77.40
Borrowings
Trade Payables 7,494.10 9,633.00 10,497.00 8,367.30 7,407.30
Other Current 3,014.80 3,743.30 4,274.30 3,926.50 3,155.60
Liabilities
Short Term Provisions 679.60 624.40 560.00 449.00 398.90
Total Current 11,294.80 14,150.30 15,442.10 13,226.40 11,039.20
Liabilities
Total Capital And 62,552.10 62,931.80 59,370.10 51,250.60 41,940.00
Liabilities
ASSETS
NON-CURRENT ASSETS
Tangible Assets 15,374.50 14,956.70 13,047.30 12,919.70 12,163.10
Intangible Assets 406.70 451.10 311.70 373.00 346.90
Capital Work-In- 1,337.40 1,600.10 2,125.90 1,252.30 1,006.90
Progress
Other Assets 0.00 0.00 0.00 0.00 0.00
Fixed Assets 17,118.60 17,007.90 15,484.90 14,545.00 13,516.90
Non-Current 35,248.80 31,469.50 34,072.90 26,302.20 18,875.40
Investments
Deferred Tax Assets 0.00 0.00 0.00 0.00 0.00
[Net]
332
 Case Studies
Long Term Loans 0.20 0.20 0.20 0.30 0.40
And Advances
Other Non-Current 1,757.10 2,092.60 1,890.70 1,626.90 1,701.30
Assets
Total Non-Current 54,124.70 50,570.20 51,448.70 42,474.40 34,094.00
Assets
CURRENT ASSETS
Current Investments 1,218.80 5,045.50 1,217.30 2,178.80 1,056.80
Inventories 3,214.90 3,325.70 3,160.80 3,262.20 3,132.10
Trade Receivables 2,127.00 2,310.40 1,461.80 1,199.20 1,322.20
Cash And Cash 21.10 178.90 71.10 13.80 42.20
Equivalents
Short Term Loans 16.90 16.00 3.00 2.50 147.80
And Advances
Other Current Assets 1,828.70 1,485.10 2,007.40 2,119.70 2,144.90
Total Current Assets 8,427.40 12,361.60 7,921.40 8,776.20 7,846.00
Total Assets 62,552.10 62,931.80 59,370.10 51,250.60 41,940.00
OTHER ADDITIONAL INFORMATION
CONTINGENT LIABILITIES, COMMITMENTS
Contingent Liabilities 12,955.50 12,090.30 10,181.20 9,642.10 9,368.70
CIF VALUE OF IMPORTS
Raw Materials 2,487.60 4,396.90 3,887.90 3,725.40 3,363.20
Stores, Spares, And 64.00 58.50 66.10 20.10 62.90
Loose Tools
Trade/Other Goods 64.00 58.50 66.10 20.10 62.90
Capital Goods 917.30 1,331.20 648.30 1,481.80 738.30
EXPENDITURE IN FOREIGN EXCHANGE
Expenditure In 9,099.00 12,802.70 3,872.50 0.00 3,792.60
Foreign Currency
REMITTANCES IN FOREIGN CURRENCIES FOR DIVIDENDS
Dividend Remittance -- -- -- -- 424.50
In Foreign Currency
EARNINGS IN FOREIGN EXCHANGE
FOB Value Of Goods -- -- -- -- 4,735.30
Other Earnings 5,424.60 5,218.60 5,455.90 -- 57.00
BONUS DETAILS
Bonus Equity Share -- -- -- -- --
Capital
NON-CURRENT INVESTMENTS
Non-Current 84.30 1,077.30 337.60 329.00 583.90
Investments Quoted
Market Value
Non-Current 34,775.70 30,609.10 33,041.90 25,606.20 18,404.60
Investments Unquoted
Book Value
CURRENT INVESTMENTS
333
Working Capital Current Investments -- -- -- -- --
Management:
Issues and Practices Quoted Market Value
Current Investments 1,218.80 5,045.50 1,217.30 2,178.80 1,056.80
Unquoted Book Value

Source: https://economictimes.indiatimes.com

15.5 FINANCING OF WORKING CAPITAL BY

COMMERCIAL BANKS: SBI
Introduction
Working Capital requirements of the companies are usually met by the
commercial banks in the form of cash, overdraft, and short-term Loans. There
is a particular method of financing industry by Banks. Way back in the
Nineteen Seventies and Eighties Tandon Committee (1974) and Chore
Committee (1979) and a few other Committees constituted by the RBI have
worked out methodologies in this regard. The same are being followed by the
Banks since then with little modifications. In effect, the extent and procedure
in respect of Financing of Working Capital are conditioned by the Guidelines
issued by the RBI from time to time. Since SBI is the biggest institution in
our banking industry, the case study is considered worth studying.

SBI Policies for Working Capital Finance

State Bank of India provides Working Capital Finance in various forms such
as Cash Credit, Demand Loan, Bill Financing, and Non-funded facilities. The
Bank staff assesses the working capital requirements of the industrial unit,
using all their knowledge, based on the risk profile, and working capital
cycle. Usually, working capital loans are sanctioned for less than a year. Yet
times, ad-hoc or temporary requirements of the borrowers are also taken into
account. Normally working capital loans given by SBI carry a floating rate of
interest linked to Situation, Background, Assessment, and Recommendation
(SBAR). The interest charged is based on the SBI Prime Lending Rate for
working capital finance. Short-term Loans sanctioned by the Bank are linked
to Short-Term Advance Rates (STAR). In addition, SBI also provides
financial assistance towards Bills Discounting, Export Credit, etc. It also
extends non-fund-based facilities such as Letters of Credit (LCs), Guarantees,
and Loans Syndication.

Asset-Based Loan (ABL) is a new facility offered to MSME firms that are
covered under MSMED Act, 2006. The ABLs are provided to all kinds of
Manufacturing and Service Units, covering wholesale, retail, trade
professionals and self-employed. Usually, the period of repayment will be 96
months. There is also a facility called Drop line OD, which can be sanctioned
for periods ranging from 12 months to 18 months – with either equated
reduction in limit or customized reduction in limit. Keeping in view the given
trends in the business and industry, SBI is providing varied types of loans,
which included working capital. A few of them spread to purposes like
Export Packing Credit, Cotton Ginning Plus, Fleet Finance, E-dealer Finance
Scheme, E-Vendor Finance Scheme, PM Mudra Yojana, Lease Rental
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Discounting, SME E-Biz Loan, Simplified Small Business Loan, Stand-up Case Studies

India, SME Smart Score, SME Credit Card, Warehouse Receipt Finance,
Finance to Food Processing Industry, Loans to Business Correspondents, SBI
Exporters’ Gold Card Scheme, etc. SBI’s Portfolio of working capital loans
is so diverse and innovative, reflecting the pooled experience of a large
reservoir of professionals.
The swift actions of the SBI received wide acclaim during Covid-19 times,
for taking measures to process and disburse working capital loans within 5
days. The finance minister has stated, in this regard, that about 45 lakh
industrial units had got benefitted from this measure. SBI has directed the
Branch Managers to release funds in time by taking into account the difficult
times.

The loan portfolios of SBI for MSME include the following:

• Loans under PMMY (MUDRA) and Stand-up India
• Asset-Backed Loan (ABL)
• ABL for Commercial Real Estate
• SBI Open Term Loan
• SME Collateral Free Loan under CGTMSE
• SME Asset – GST Receivables
• Standby Line of Credit
• Simplified Cash Credit

SBI also has the distinction of being the only Bank, having established a
special delivery mechanism for sanction and disbursement of working capital
loans. These included the establishment of a Centralized Processing Cell for a
quick assessment, sanction, and disbursal and appointment of Relationship
Managers for different categories of MSMEs to provide customized products
and services.

Working Capital Finance is a requirement of every business unit, including

large firms. But the manner of providing working capital finance to large
firms would be something different. Generally, these requirements are met by
a consortium of Banks or through Social Banking. Under this process,
usually, there will be a ‘Lead Bank’ and other banks join as associates.
During the Covid-19 times, it is observed that even large companies
approached Banks for meeting their current liabilities like paying for material
purchases, payment of wages, meeting energy requirements, etc. Thus,
working capital finance is the ‘life blood’ for running the wheels of business
and industry.

RBI Guidelines for Working Capital Finance

Regarding the provision of finance by commercial banks for working capital
requirements, RBI has been issuing Advisories to Commercial Banks from
time to time. These are the nature guidelines to be followed by the banks for
ensuring sound banking practices. A major Advisory was issued in 2005 and
got it revised in July 2009. As per these guidelines, banks are required to
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Working Capital follow the procedure mentioned below:
Management:
Issues and Practices  The assessment of working capital requirements is to be made based on
projected annual turnover in the case of Working Capital Limits (WCL)
up to Rs.1.00 crore and up to Rs.5.00 crore for SSI units.
 Based on the above assessment, 20% of the projected turnover is
financed by Banks, and 5% is contributed by the borrower.
 Drawls against the Working Capital Limits (WCL) should be need-based
and properly checked by the Bank.
 Maximum Permissible Bank Finance (MPBF) rules based on the
recommendations of the Tandon Committee were completely withdrawn.
Now Banks are free to follow their procedures in assessing the actual
working capital needs of the firms and accordingly fix Working Capital
Limits.
 Freedom is given to Banks to fix norms for individual Current Assets
holdings and accordingly decide Working Capital Limits.
 Banks may also consider sanctioning Ad-hoc credit limits, if satisfied,
and if the borrower has exhausted the original limits.
 In December 2018, RBI has issued separate guidelines to banks in case
of corporates having Working Capital Limits above Rs.150 crore. These
rules are intended to enhance credit discipline among large borrowers.
 As per the above, these large borrowers have to avail of 40% of their
Working Capital Limits as a Working Capital Demand Loan (WCDL).
The remaining 60% may be in other forms like cash credit, OD, etc. This
demand loan will be for a specified period varying from 7 days to 1 year.

The magnitude of Working Capital Financing

To know the extent of working capital funding extended by the SBI, the latest
balance figures are verified. As per the same by March 31, 2020, the total
capital, and liabilities of SBI stood at Rs.39,51,394 crore. The advances of
the bank stood at Rs.23,25,290 crore. Of these Advances, Cash Credits,
Overdrafts, and Loans repayable on demand accounted for about 30.48
percent at Rs.7,08,726 crore. Similarly, the bills purchased accounted for
about 3.61 percent. Similarly secured loans against inventory, book debts,
etc. also constituted a significant portion at 71.99 percent at Rs.16,73,925
crore. Of course, a majority of them may be against fixed assets which may
include land, buildings, machinery, etc. Nevertheless, the loan portfolio of the
Bank clearly shows the significance of the working Capital Finance Extended
to Trade and Industry (see Annexure-1).

Questions
1) Looking into the Case Study of SBI, what kind of Working Capital
Finance policies and practices do you suggest to other Banks?

2) Should the RBI have any control over Commercial Banks in the matter
of Financing Working Capital?

3) Keeping in view the significance of working capital to industry and the

336 Loan Portfolio of Banks, what financing strategies do you recommend?
 Case Studies
Annexure-1
Advances are given by SBI during Financial Year 2019-20
(000s omitted)
As at As at
31.03.2020 31.03.2019
(Current (Previous
Year)Rs. Year)Rs
A. I. Bills purchased and discounted 84017,46,96 80278,87,21
II. Cash credits, overdrafts, and 708726,92,91 776633,45,81
loans repayable on demand
III. Term loans 1532545,16,20 1328964,58,75
TOTAL 2325289,56,07 2185876,91,77
B. I. Secured by tangible assets 1673925,40,51 1582764,41,50
(includes advances against Book Debts)
II. Covered by Bank/ Government 92117,72,36 80173,16,17
Guarantees
III. Unsecured 559246,43,20 522939,34,10
TOTAL 2325289,56,07 2185876,91,77
C. (I) Advances in India
(i) Priority Sector 526675,87,35 520729,77,60
(ii) Public Sector 287504,28,69 240295,89,39
(iii) Banks 812,52,23 9174,06,50
(iv) Others 1154187,79,39 1114 679,73 ,28
TOTAL 1969180,47,66 1884879,46,77
(II) Advances Outside India
(i) Due from Banks 80372,75,07 69975,74,47
(ii) Due to Others
(a) Bills purchased and discounted 31091,11,08 26740,94,1
(b) Syndicated Loans 172482,45,21 138191,25,40
(c) Others 7 216 2 ,7 7, 0 5 66089,51,02
Total 356109,08,41 300997,45,00
Grand Total [C (I) and C (II)] 2325289,56,07 2185876,91,77

Source: www.sbi.co.in

Annual Report of 2019-20 of SBI

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