role of banks in working capital management

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Role of Banks in working capital management

Executive Summery

The project is about role of banks in working capital management to

know that how a bank is plays a major role in the managing the working

capital of their clients (Business firms) to meat their day-to-day

expenditure and other business requirements.

The project also covers various credit facilities given by the banks to its

clients, it functions and different aspects in working capital financing.

The project includes case-study on Icici bank which would help to

understand the concept of working capital financing.

Maintaining of working capital at par level with the efficient and

effective level the bank plays a vital role in that.

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Objectives of the study

The objective of undertaking a project on Role of Banks in Working

Capital Management is to have in-depth knowledge about the Strategy of Banks

to lend the money to the business firms to run the business and mate the day to

day expenses of business firms.

To know about the functions, organizational structure and objective of

Banks lending policies to business firms.

To understand the elements of working Capital and its functions.

To have a broader view on nature of Working Capital which is current

assets & current liabilities and to know what are its components.

To know what are the RBI guidelines formulated for Working Capital

financing.

To know the future scope involved in Working Capital finances & role of

information technology in Working Capital financing.

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Introduction

Working capital management is a significant in financial management

due to the fact that it plays a pivotal (important) role in keeping the

wheels of a business enterprise running. Working capital management is

concerned with short term financial decisions. Shortage of funds for

working capital has caused many businesses to fail and in many cases,

has retarded their growth. Lack of efficient and effective utilization of

working capital leads to earn low rate of return on capital employed or

even compels to sustain losses. The need for skilled working capital

management has thus become grater in recent years.

A firm invests a part of its permanent capital in fixed assets and keeps a

part of it for working capital I.e., for meeting the day today requirements.

We will hardly find a firm which does not requires any amount of

working capital for its normal operations. The requirement of working

capital varies from firms to firms depending upon the nature of business,

production policy, market conditions, seasonality of operations,

conditions of supply etc. Working capital to a company is like the blood

to human body. It is the most vital ingredient of a business. Working

capital management if carried out effectively, efficiently and consistently,

will assure the health of an organization.

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Definition of Working Capital

Working capital is defined as the excess of current assets over current

liabilities. Current assets are those assets which will be converted into

cash within the current accounting period or within the next year as a

result of the ordinary operations of the business. They are cash or near

cash resources. These include:

Cash and Bank balances

Receivables

Inventory

- Raw materials, stores and spares

- Work-in-progress

- Finished goods

Prepaid expenses

Short term advances

Temporary investments

The value represented by these assets circulates among several items.

Cash is used to buy raw-materials, to pay wages and to meet other

manufacturing expenses. Finished goods are produced. These are sold,

accounts receivables are created. The collection of accounts receivable

brings cash into the firm. The cycle starts again. This is shown in below

mention diagram.

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Cash

Inventories

Receivables

Current liabilities are the debts of the firms that have to be paid during the

current accounting period or within a year. These include:

Creditors for goods purchased

Outstanding expenses i.e., expenses due but not paid

Short term borrowings

Advance received against sales

Taxes and dividends payable

Other liabilities maturing within a year.

Working capital is also known as circulating capital, fluctuating capital

and revolving capital. The magnitude and composition keep on

changing continuously in the course of business.

Accounts receivables:

Trade credit creates book debts or accounts receivable. It is used as a

marketing tool to maintain or expends the firms sales. A firms

investment in accounts receivable depends on volume of credit sales

collection period. The financial manager can influence volume of credit

terms, and collection efforts. Credit standards are criteria to decide to

whom credit sales can be made and how much. If the firm has soft

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standards and sells to almost all customers, its sales may increase but its

costs in the form of bad-debt losses and credit administration will also

increase. Therefore, the firm will have to consider the impact in terms of

increase in profits and increase in costs of a change in credit standards or

any other policy variable. The incremental return which a firm may gain

by changing its credit policy should be compared with the cost of funds

invested in receivables. The firms credit policy will be considered

optimum at the point where incremental rate of return equals the cost of

funds. The cost of funds is related to risk; it increases with risk. Thus, the

goal of credit policy is to maximize the shareholders wealth; it is neither

maximization of sales nor minimizations of bad-debt losses.

The conditions for extending credit sales are called credit terms and they

include the credit period and cash discount. Cash discounts are given for

receiving payments before than the normal credit period. All customers

do not pay within the credit period. Therefore, a firm has to make efforts

to collect payments from customers. Collection efforts of the firm aim at

accelerating collections from slow-payers and reducing bad-debt losses.

The firm should in fact thoroughly investigate each account before

extending credit. It should gather information about each customer,

analyze it and then determine the credit limit. Depending on the financial

condition and past experience with a customer, the firm should decide

about its collection tactics and procedures.There are three methods to monitor receivables. The average collection

period and again schedule are based on aggregate data for showing the

payment patterns, and therefore, do not provide meaning information for

controlling receivables. The third approach which uses disaggregated data

is the collection experience matrix. Receivables outstanding for a period

are related to credit sales of the same period. This approach is better than

the two traditional method of monitoring receivables.

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Inventory Management:

Inventories constitute about 60% (per cent) of current assets of public

limited companies in India. The manufacturing companies hold

inventories in the form of raw materials, work-in-process and finished

goods. There are at last three motives for holding inventories.

1. To facilitate smooth production and sales operation (transaction

motive).

2. To guard against the risk of unpredictable changes in usage rate

and delivery time (precautionary motive).

3. To take advantages of price fluctuations (speculative motive).

Inventories represent investment of a firms funds. The objective of the

inventory management should be the maximization of the value of the

firm. The firm should therefore consider:

a. Costs,

b. Return, and

c. Risk factors in establishing its inventory policy.

Two types of costs are involved in the inventory maintenance:

1. Ordering costs: requisition. Placing of order, transportation

receiving, inspecting and storing and clerical and staff services.

Ordering costs are fixed per order. Therefore, they decline as the

order size increases.

2. Carrying costs: warehousing, handling, clerical and staff services,insurance and taxes. Carrying costs vary with inventory holding.

As order size increases, average inventory holding increases and

therefore, the carrying costs increase.

The firm should minimize the total cost (ordering plus carrying). The

economic order quantity (EOQ) of inventory will occur at a point where

the total cost is minimum.

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Cash Management:

Cash is required to meet a firms transactions and precautionary needs. A

firm needs cash to make payments for acquisition of resources and

services for the normal conduct of business. It keeps additional funds to

meet any emergency situation. Some firms any also maintain cash for

taking advantages of speculative changes in prices of input and output.

Management of cash involves three things:

(a) Managing cash flows into and out of the firm,

(b) Managing cash flows within the firms, and

(c) Financing deficit or investing surplus cash and thus, controlling

cash balance at a point of time. It is an important function in

practice because it is difficult to predict cash flows and there is

hardly any synchronization between inflows and outflows.

Firms prepare cash budget to plan for and control cash flows. Cash

budget is generally prepared for short periods such as weekly, monthly,

quarterly, half-yearly or yearly. For making forecasts of cash receipts and

payments, two approaches are used in practice:

i. The receipt and disbursements method, and

ii. The adjusted income method.

The individual items of receipts and payments are identified and

analyzed. Cash inflows could be categorized as:

i. operatingii. non operating, and

iii. Financial.

Cash outflows could be categorized as:

i. operating

ii. capital expenditure

iii. contractual, and

iv. Discretionary.

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Such categorization helps in determining avoidable or postponable

expenditures. The adjusted income method uses proforma income

statement (profit and loss statement) and balance sheet to work out cash

flows (by deriving proforma cash flow statement). As cash flows are

difficult to predict, a financial manager does not base his forecasts only

on one set of assumptions. He or she considers possible and pessimistic

scenarios can be worked out.

Cash budget will serve its purpose only if the firm can accelerate its

collection and postpone its payments within allowed limits. The main

concerns in collection are:

a. to obtain payment from customers within the credit

period,

b. To minimize the lag between the times a customer pays

the bill and the time cheque etc. are collected.

A number of methods such as concentration banking and lock-box system

can be followed to expedite conversion of an instrument (e.g. cheque,

draft, bills, etc.) into cash. The financial manager should be aware of the

instruments of payments, and choose the most convenient and least costly

mode of receiving payment. Disbursements or payment can be delayed to

solve a firms working capital problem. But this involves cost which, in

the long run, may prove to be highly detrimental. Therefore, a firm

should follow the norms of the business.A firm should hold an optimum balance of cash, and invest any

temporary excess amount in short-term (marketable) securities. In

choosing these securities, the firm must keep in mind safety, maturity and

marketability of its investment.

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Objectives of Working capital management

The basic objectives of working capital management are as follows:

By optimizing the investment in current assets and by reducing the

level of current liabilities, the company can reduce the locking up

of funds in working capital thereby; it can improve the return on

capital employed in business.

The second important objective of working capital management is

that the company should always be in a position to meet its current

obligations which should properly be supported by the current

assets available with the firm. But maintaining excess funds in

working capital means locking of funds without return.

The firm should manage its current assets in such a way that the

marginal return on investment in these assets is not less than the

cost of capital employed to finance the current assets.

Gross and Net Working Capital

Generally the working capital has its significance in two perspectives

Gross working capital and Net working capital, the term Gross

working capital refers to the firms investment in current assets. The

term Net working capital refers to the excess of current assets over

current liabilities. These gross working capital and net working capital

are called Balance sheet approach of working capital.

Permanent and Temporary Working Capital

Considering time as the basis of classification, there are two types of

working capital viz, Permanent and Temporary. Permanent working

capital represent the assets required on continuing basis over the entire

year, whereas temporary working capital represents additional assets

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required at different items during the short term debt financing. For

example, in peak seasons, more raw materials to be purchased, more

manufacturing expenses to be incurred, more funds will be locked in

debtors balance etc. In such times excess requirement of working capital

would be financed from short-term financing sources.

The permanent component current assets which are required through the

year will generally be financed from long term debt and equity. Tendon

committee has referred to this type of working capital as Core Current

Assets. Core Current Assets are those required by the firm to ensure the

continuity of operations which represents the minimum levels of various

items current assets viz., stock of raw materials, stock of work in

progress, stock of finished goods, debtors balances, cash and bank etc.

This minimum level of current assets will be financed by the long-term

sources and any fluctuation over the minimum level of current assets will

be financed by the short-term financing. This is shown below. Some time

core current assets are also referred to as hard core working capital.

Short termFinancing

Long term+

Equity capitalFixed Assets

Permanent current assets

Temporary current asset

Rs.

0 Times

The management of working capital is concerned with maximizing the

return to shareholders within the accepted risk constraints carried by the

participants in the company. Just as excessive long-term debt puts a

company at risk, so an inordinate quantity of short-term debt also

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increases the risk to a company by straining its solvency. The suppliers of

permanent working capital look for immediate return and the cost of such

financing will also be costlier than the cost of permanent funds for

working capital.

Disadvantages of Insufficient Working Capital

The disadvantages suffered by a company with insufficient working

capital are as follows:

The company is unable to take advantage of new opportunities or

adopt to changes.

Trade discounts are lost. A company with ample working capital is

able to finance large stocks and can therefore place large orders.

Cash discounts are lost. Some companies will try to persuade their

debtors to pay early by offering them a cash discount off the price

owed.

The advantages of being able to offer a credit line to customers are

foregone.

Financial reputation is lost result in non-cooperation from trade

creditors in times of difficulty.

There may be concerted action by creditors and will apply to court

for winding up.

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Operating Cycle Concept

A new concept which is gaining more and more importance in recent

years is the Operating Cycle Concept of Working Capital. The

operating cycle refers to the average time elapses between the acquisition

of raw materials and the final cash realisation.

Cash is used to buy raw materials and other stores, so cash is converted

into raw materials and stores inventory. Then the raw materials and stores

are issued to production department. Wages are paid and other expenses

are incurred in the process and work-in-process comes into existence.

Work-in-process becomes finished goods. Finished goods are sold to

customers on credit. In the course of time, these customers pay cash for

the goods purchased by them. Cash is retrieved and the cycle is

completed. Thus, operating cycle consists of four stages:

The raw materials and stores inventory stage

The work-in-process stage

The finished goods inventory stage

The receivable stage

The operating cycle of working capital is shown below:

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Cash

Raw materialinventory

Finishedgoods

AccountsReceivables

Work-in-process

Purchase ofRaw materials

Issue of materials of productionand incurring expenses

S a l e s

Collection ofreceivables

The operating cycle being with the arrival of the stock, and ends when

the cash is received. The cash cycle beings when cash is paid for

materials, and ends when cash is collected from receivables.

RawMaterialPurchasedOrderPlaced

StockArrived

Work-in-process Inventory Period

FinishedGoods Sold

Accounts Receivables Period

CashReceivables

Accounts Payable PeriodCash Paid ForMaterials

Operating Cycle

Cash Cycle

InvoiceReceived

Time

Importance of Operating Cycle ConceptThe application of operating cycle concept is mainly useful to ascertain

the requirement of cash working capital to meet the operating expenses of

a going concern. This concept is based on the continuity of the flow of

value in a business operation. This is a important concept because the

longer the operating cycle, the more working capital funds needs.

Management must ensure that this cycle does not become too long. This

concept more precisely measures the working capital fund requirements,

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traces its changes and determines the optimum level of working capital

level of working capital requirements.

Reasons for prolonged Operating Cycle

The following could be the reasons for longer operating cycle period:

- Purchase of materials in excess / short of requirements

- Buying inferior, defective materials

- Failure to get trade discount, cash discount

- Inability to purchase during seasons

- Defective inventory policy

- Use of protracted manufacturing cycle

- Lack of production planning, coordination and control

- Mismatch between production policy and demand

- Use of outdated machinery, technology

- Poor maintenance and upkeep of plant, equipment and

infrastructural facilities

- Defective credit policy and slack collection policy

- Inability to get credit from suppliers, employees

- Lack of proper monitoring of external environment etc.

How to reduce Operating Cycle?

The aim of every management should be to reduce the length of operating

cycle or the number of operating cycle in a year. Only then the need forworking capital decreases. The following a few remedies may become

handy in contrasting the length of operating cycle period.

Purchase management

The purchase manager owes a responsibility in ensuring availability of

right type of materials in right quantity of right price on right time andat right place. These six Rs contribute greatly in the improvement of

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length of operating cycle. Further, streamlining of credit from supplier

and inventory policy also help the management.

Production Management

The production manager affects the length of operating cycle by

managing and controlling manufacturing cycle, which is a part of

operating cycle and influences directly. Longer the manufacturing

cycle, longer will be the operating cycle and higher will be the firms

working capital requirements. The following measures may be taken:

- Proper maintenance of plant, machinery and other

infrastructural facilities.

- Proper planning and coordination at all levels of activity.

- Up-gradation of manufacturing system, technology.

- Selection of the shortest manufacturing cycle out of

various alternative etc.

Marketing Management

The sale and production policies should be synchronized as far as

possible. Lack of matching increase the operating cycle period.

Production of Qualitative products at lower costs enhances sales of

the firm and reduces finish goods storage period. Effective

advertisement, sales promotion activities, efficient salesmanship, use

of appropriate distribution channel etc., reduces the storage period of

the finished products.

Sound Credit and Collection Policies

Sound credit and collection policies enable the Finance Manager in

minimizing investment in working capital in the form of book debts.

The firm should be discretionary in granting credit them to its

customers. In order to see that the receivables conversion period is

not increased, the firm should follow a rationalized credit policy

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based on the credit standing of customer are other relevant facts. The

firm should be prompt in making collections. Slack collection

policies will tie up funds for long period, increasing length of

operating cycle.

Proper Monitoring of External Environment

The length of operating cycle is equally influenced by external

environment. Abrupt changes in basic conditions would affect the

length of operating cycle. Fluctuation in demand, competitors,

production and sales policies. Government fiscal and monetary

policies, changes on import and export front, price fluctuations, etc.,

should be evaluated carefully by the management to minimize their

adverse impact on the length of operating cycle.

Other Suggestions

The personnel manager by framing should recruitment, selection,

training, placement, promotion, transfer, wages, incentives and

appraisal policies can contract the length of operating cycle. Use of

Human Resources Development technique in the organization

enhances the morale and zeal of employees thereby reduces the length

of operating cycle. Proper maintenance of plant, machinery,

infrastructural facilities, timely replacement, renewals, overhauling

etc., will contribute towards the control of operating cycle.

These measures, if adhered properly, would go a long way in minimizing

not only the length of operating cycle period but also the firms working

capital requirements.

Gross and Net Operating Cycle -

In a manufacturing firm, the operating cycle for element of cost, say

direct material, starts with the purchase of materials. Materials are not

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consumed immediately. There involves Raw Materials conversion

period (RCMP).

Once materials are issued to production, it again involves time gap

between issue of materials and production of finished product. This time

gap is called as Work-in-process conversion period (WIPCP).

Industries produce the output in the expectation of demand or for the

purpose of assembly. Till the demand for finished product materializes,

the product would remain in the store. This period is termed as Finished

goods conversion period (FGCP).

The enterprise due to competitive reason and other reasons extended

credit facilities to customers. This time gap between sale and realisation

of cash is known as Book Debt conversion period (BDCP).

Business enterprises receive credit in the purchase of raw materials from

the suppliers. This period is called as Payment deferral period (PDP).

This payment period reduced the length of operating cycle of business

firm.

The length of operating cycle of manufacturing firm in Direct material

can be calculated with the help of following formulae.

Similar conclusion can also be drawn for other elements of cost i.e., forDirect wages and overheads. In the case of Direct wages overheads, the

operating cycle starts with the Work-in-progress Conversion Period

(WIPCP) as there will be Raw materials Conversion Period (RMCP).

The chart below shows the operating cycle for these elements of cost with

hypothetical figures.

Particulars DirectMaterials

DirectWages

Overheads

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Gross Operating Cycle = RMCP + WIPCP + FGCP + BDCP

Net Operating Cycle = Gross Operating Cycle PDP

Or = RMCP + WIPCP + FGCP PDP


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Raw materials conversion period

(RMCP)

Work-in-progress conversion period

(RMPCP)

Finished goods conversion period

(FGCP)

Book debts conversion period (BDCP)

Gross operating cycle

Less : Payment deferral period (PDP)

Net operating cycle

2

3

1

2

-

3

1

2

-

3

1

2

8

1

6

6

-

7 5 6

Practical utility of Operating Cycle Concept

The net operating cycle represents the net time gap between investment

of cash and its recovery of sales revenue. If depreciation is excluded from

expenses in the computations of operating cycle, the net operating cycle

also represents the cash conversion cycle. It is the net time interval

between cash collection from sale of product and cash payments for

resources acquired by the firm.

It is the task of Finance Manager the operating cycle effectively and

efficiently. The length of operating cycle is the indicator of operating

management performance. The net operating cycle represents the time

interval for which the firm has to negotiate for working capital from itsBankers. It enables to determine accurately the amount of working capital

needed for the continuous operation of its activities. The operating cycle

calls for proper monitoring of external environment of the business.

Changes in Government policies like taxation, import restrictions, credit

policy of Central Bank, price trend, technological advancement etc., have

their own impact on the length of operating cycle.

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Role of Banks in Working Capital Management

Banks are the main institutional sources of working capital finance in

India. After trade credit, bank credit is the most important source of

financing working capital requirements of firms in India. A bank

considers a firms sales and production plans and the desirable levels of

current assets in determining its working capital requirements. The

amount approved by the bank for the firms working capital is called

credit limit. Credit limit is the maximum funds which a firm can obtain

from the banking system. In the case of firms with seasonal business,

banks may fix separate limits for the peak limit credit requirement and

normal non-peak level credit requirement indicating the periods during

which the separate limits will be utilized by the borrower. In practice,

banks do not lend 100 per cent of the credit limit; they deduct margin

money. Margin requirement is based on the principle of conservatism and

is meant to ensure security. If the margin requirement is 30 per cent, bank

will lend only upto 70 per cent of the value of the asset. This implies that

the security of banks lending should be maintained even if the assets

value falls by 30 per cent.

Till the mid 1970s the principles of commercial banks lending in India

was predominantly security oriented. It was more or less net worth based,

collateralized financing. Major Banks were nationalized in 1969 and with

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that, approach to lending also changed in 1974, a study group under the

chairmanship of P.L.Tandon was formed to examine the existing methods

of lending and suggest changes. The group submitted its report in August

1975, which came to be popularly known as Tandon committees report.

It was a Landmark in the history of bank lending in India. With the

acceptance of major recommendations by RBI a new era of lending being

in India.

Tandon Committee recommendations:

Introduction:-

With the nationalization of major commercial banks in 1969, the

emphasis in bank lending shifted from security to purpose with a bias for

production. The demand for bank credit also registered a phenomenal

growth. While small industries, self-employed and agricultural sectors

and public sector required an increasing share in bank credit, a sizable

share thereof continued to flow into large and medium industries.

Along with increasing demand for bank credit (making it scarce

everyday), there was an ever-increasing inflation calling for control of

bank credit. During 1973-74, inflation touched a level of 31%. Reserve

Bank of India took both monetary and fiscal measures to curb the

inflation.

It was also thought that time was ripe to have a complete review of bank

credit so as to gear it to the development role expected of banks in the

economy. Reserve Bank of India, thus appointed in 1974 a study group

with Sri P.L.Tandon, then chairman, Punjab National Bank as the

chairman. This study group for Framing Guidelines for the following up

of Bank Credit came to be popularly known as the Tandon Committee.

The Reserve Bank of India has accepted the major recommendations and

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banks have to implement them. The major areas covered by the

recommendations are:

Norms for holding inventory and receivables;

Maximum permissible bank finance;

Style of credit; and

Follow up and supervision of credit

Norms for Inventory receivables

The Committee has given itself to the study of those items against whichbank advance is made. In term of the production requirements, the

committee has worked out the level of current assets which each

industrial unit cash hold. These are called the norms. Norms are the

maximum level of these assets that a unit cab hold. Norms are expressed

in terms in terms of periods for which the assets can be held. The assets

for which norms have been prescribed and the terms in which they areexpressed are given below:

Raw material - So many cost of raw materials consumed

Work-in-Progress - So many months cost of production

Finished goods - So many months cost of sales

Receivables - So many months sales

Norms in the beginning were prescribed for 15 selected industries, which

together accounted for about 50% of the total bank credit to the industry.

Further, they are applicable only to these units have working capital

limits aggregating to Rs. 10 lakhs and above in the entire banking system.

The banks are expected to apply the spirit of the recommendations to

accounts having smaller limits also.

The following factors may be noted while dealing with the norms:

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Norms are the maximum level of current assets that a unit can hold.

They are not the optimum levels. Therefore, if a unit is having

current assets at levels less that the norms, it should continue to

hold at the same level.

Norms have been prescribed separately for 49 different industries.

If few cases, different norms are given for different regions for the

same industry. The norms appropriate to the unit in question should

be applied.

Norms have been prescribed separately for individual current asset.

The unit should satisfy the requirement of norms for individual

component separately. For instance, for pharmaceutical industry,

norms for raw materials and work-in-progress are 2 months and

month respectively. The unit cannot have 2 months of raw

materials and 1 month of work-in-progress. But in certain cases, a

combined norm for finished goods and receivable is given. In such

cases, the holding of finished goods and receivables can vary

within the overall ceiling prescribed. It should be noted that the

combined norms is 2 months, finished goods can be for 1 month

and receivables for 1 months finished goods and 2 months

receivable.

No Norms is fixed for export receivables, imported raw materials

and other current assets. For these items, the banker has to go by

the past level of holding.

The level of spares not normally exceeds 5% of the total inventory.

The tendency is to consider spares as current assets only upto the

level of 5% of the total current assets and treat the balance as

miscellaneous assets.

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Maximum Permissible Bank Finance:

The committee has suggested three methods of working out of the

maximum amount that a unit may expect from the bank. The extent of

bank finance will be more in the first method, less in the second method

and the least in third method. The three alternatives may be illustrated by

the following example taken from the report of the committee. The

borrowers financial position projected as at the end of the next year are

as under.

(Rs. Lakh)

Current Liabilities Current Assets

Creditors for purchases

Other current liabilities

Bank borrowings,

including discount withbankers

100

50

Raw material

Stock in process

Finished goods

Receivables, including

bills discounted withbankers

Other Current Assets

200

20

90

20010

150

50

350 370

As per suggested norms or past practice, whichever is lower in relation to

projected production level for the next year.

(Rs. Lakh)

1st

method 2nd

method 3rd

methodTotal Current

assets

Less:

Current

liabilities

(other than

long-term

370

150

Total Current

assets

Less:

25% of above

from long-

term sources

370

92

Total current

assets

Less:

Core current

Assets

From long-

term sources

370

95

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borrowings) real current

assets

25% of above

from long-

term sources

Less:

Current

Liabilities

(other than

bank

borrowings)

25% of above

form long-term

sources

220

55

Less:

Current

liabilities

(other than

long-term

borrowings)

278

150

275

69

206

150

MPBF* 165 MPBF*

128

MPBF* 56

Working

capital gap

(370-150)

Excess

borrowing

Current ratio

220

35

1.71:1

220

72

1.33:1

220

144

1.79:1

MPBF* = Maximum Permissible Bank Finance.

Initially, all units were placed under method 1. It was expected that over

year the units would progress and could be placed in successive methods.

Accepting the recommendations of Tandon committee, the Reserve Bank

has directed the banks in December 1980 that Method 2 should be applied

for all accounts where the total working capital limit is Rs. 50 lakhs and

above.

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The minimum current ratio under method 1 works out to 1.71:1 and to

1.33:1 under method 2.

Deviation from norms

Norms prescribed by the Tandon committee are not rigid. Deviation from

norms can be allowed for agreed short periods and in situation

satisfactory to the bankers. In the following cases deviation are usually

allowed:

Bunched receipt of raw material including imports.

Power-cuts, strikes and other unavoidable interruptions in the

process of production, transport delays and bottlenecks.

Accumulating of finished goods due to non-availability of shipping

space for exports or other disruptions in sales (but not under

circumstance where sale stimulation is needed through reduction in

prices).

Build up of stocks of finished goods such as machinery due to

failure (on the part of purchasers for whom those were specifically

manufactured) take delivery.

Need to cover full or substantial requirement of raw materials for

specific export contract of short duration.

Slip Back

A unit whose current ratio is better than the minimum required under the

first method should not be allowed so slip back or worsen it. There were,

however, many representations from industry and Reserve Bank has

allowed the slip back subject the condition that the relaxation does not

result in the contribution of the unit to the working capital gap going

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below a minimum of 25%. The relaxation is allowed in the following

cases:

- Fro undertaking either an expansion of existing capacity

or for diversification.

- Fro fuller utilization of existing plant capacity.

- For meeting a substantial increase in the units working

capital requirement on account of abnormal price rise.

- For bringing about a reduction in the level of deposits

accepted from the public for complying with statutory

requirements.

- Fro repayment of the installments due; under foreign

currency loans and other term loans.

Style of credit and flow of information:

The recommendation of the Tandon committee with regard to the above

since been modified by the recommendation of the chore committee.

Chore Committee recommendations:

Introduction:-

On reviewing the monetary and credit trends for the busy session of

1978-79, the RBI felt that the extensive use of cash credit system was a

deterrent factor in implementing the credit regulatory measures by the

banks. The Tandon committee had recommended bifurcations of credit

limits into a deemed loan and a fluctuating cash credit component. But

implementation of this recommendation was very slow. The Reserve

Bank, therefore, though that this problem needed a deep study and

decision was taken to entrust the work to a working group. Accordingly a

Working Group to review the system of cash credit was constituted in

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April 1979 under the chairmanship of Sri.K.B.Chore, Chief Officer,

DBCOD, Reserve Bank of India.

Recommendations:

The Committee submitted its final report in August 1979. The major

areas covered by the recommendations are:

Use of different types of advances, cash credit, loan and bills-all

types to continue.

Bifurcation of cash credit limit into demand loan and fluctuating

cash credit portions not favored because:

1. For seasonal industries the different is too much; for sales

season period the account may be in credit in which case the

loan portion should be nil.

2. For non-seasonal industries the difference is too marrow to

be of any help to the banker.

Separate limits to be granted for peak level and normal non-peak

level credit requirements.

All borrowers (except sick units) with working capital requirement

of Rs. 10 Lakh and above to be placed under second method of

lending recommended by Tandon Committee.

The flow of information from borrower to banks to be simplified.

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Bank to take up financing a portion of raw material by way of

drawee bills.

Implementation of recommendations:

The recommendations of the committee have been accepted by the RBI

subject to certain modifications. The directives of the RBI on

implementing the recommendations were issued to the banks in

December 1980.

1. Working capital advances of Rs. 10 Lakhs and over (aggregate

working capital advances per borrower)

Banks should review all borrowal accounts to verify the

continued viability and also to assess the need based

character of the advance.

Bifurcation of cash credit accounts into demand loan

component and cash credit portion charging different rates of

interest is withdrawn. If already bifurcated steps should be

taken to abolish the different interest rate with immediate

effect.

2. Working capital advances of Rs. 50 Lakhs and over (aggregate

working capital advance per borrower)

While assessing the credit requirement of borrowers

wherever feasible, the banks should sanction separate limits

for peak level requirement and normal non-peak level

requirements.

Within the limits sanctioned withdrawals from the

account are to be regulated through quarterly statements.

Before the commencement of a quarter the borrower should

indicate his requirements for the quarter by submitting the

quarterly statement (Form I) giving estimates of current

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assets, current liabilities, bank borrowing, production and

sales. This set operating limit for the quarter.

Ad hoc or temporary limits may be sanctioned in

exceptional cases for predetermined short periods to meet

unforeseen contingencies. Such facilities should be in the

form of a separate demand loan or a non-operable cash credit

account. Except in exceptional cases like natural calamities

and in the case of accounts under nursing programmer banks

are to charge interest at 1% more than the normal rate.

Enhancement of borrowers contribution is to be

enforced through placing them under second method of

lending recommended by Tandon committee. According to

this working capital to the extent of at least 25% of the

current assets should be financed by term finance and

contribution from owned funds. This would give a minimum

current ratio of1.33:1.0.

Discounting bills should be encouraged in place of

cash credit against book debts for financing sales. Wherever

possible existing cash credit against book debts should be

converted into bill limits.

Drawee bill financing should be encouraged for

financing raw material under bill system. Under this, the

seller draws a bill on the buyer. The bank accepts the bill

thus enabling the seller to discount the bill with bank or any

other bank may itself pay the bill amount to the seller. At

least 50% of the cash credit limit against raw materials

sanctioned to manufacturing units should be by way of

drawee bill limits. For example, if the party has been

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sanctioned a total limit Rs. 200 Lakhs the individual limit

would be as follows:

Cash credit (margin 50%) Rs. 100 Lakhs

Drawee bill discounting Rs. 100 Lakhs

The stock statement may reveal the following particulars:

Stock paid for Rs. 100 Lakhs

Stock received under bill discounting Rs. 75 Lakhs

Unpaid stock Rs. 25 Lakhs

Drawing limits would be determined as under:

Cash credit (Rs. 100 Lakhs less 50% margin) Rs. 50 Lakhs

Bill discounting Rs. 75 Lakhs

When the bill is met by borrower, the stock would be taken under cash

credit. Then it would subject to margin requirements.

Nayak Committee Recommendations:

Considering the contribution of SS! Sector to overall industrial

production, exports and employment and al s orecognizing the need to give

a fillip to this sector, RBI has accepted the recommendations of Kayak

committee ("Committee to examine the adequacy of Institutions Credit to

SSI sector and related aspects headed by Sri. P.R. Nayak). The salient

features of the committee's recommendations are:-

To give preference to village industries, tiny industries and other

small scale units in that order while meeting the credit

requirements of small scale sector.

For the credit requirements of village industries, tiny industries and

other SSI units upto aggregate fund based working capital credit

limits upto Rs. 50 lakhs from the banking system, the norms for

inventory and receivables as also the methods of lending as per

Tandon Committee will not apply. Instead, for such units the

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working capital limit will be computed at 20% of their projected

annual turn over (for both new as well as existing units). These SSI

units will be required to bring in 5% of their annual turnover as

margin money. In other words, 25% of the output value should be

computed as working capital requirement, of which at least 4/5th

should be provided by Banking Sector, the remaining 1/5th

representing borrower's contribution towards margin money for the

working capital. Branches have to satisfy themselves about the

reasonableness of projected annual turnover of the applicants.

Preparation of annual Budget in respect of Working Capital

requirements of SSI sector on "bottom up" basis.

Sick SSI unit redefined.

Banks are advised to adopt "Single Financing Approach "for

meeting both Term Loan and working capital requirements of SSI sector.

The "Single Window Scheme "(SWS) of SIDBI enables commercial

banks to provide term loans and working capital to SSI units have a

project outlay upto Rs. 20 lakhs and working capital requirement upto

Rs. 10 lakhs.

Banks to set up effective grievance cells to enable SSI borrowers to

approach in case of difficulties.

SSI loan applications should be disposed off within time frame laid

down as follows:

In case of credit upto Rs. 25,000 within 15 days

In all other case 8 to 9 weeks

To help eliminate delay in sanction of limits to SSI units, Banks

should adopt a system of committee approach, in which decisions

are taken by the competent authority after a structured discussion

with the Branch Manager and also the authorities at the interveninglevel.

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Rejection/curtailment of limits by sanctioning authority

should be referred to the next higher authority should be referred to

next higher authority for confirmation.

Branches should not insist on deposit mobilization of

stipulated amounts as a precondition to the sanction of credit.

However, they can enlist the co-operation of these customers for

deposit mobilization.

Branch level officials should have the right aptitude, skills

and orientation with respect of financing SSI sector.

Vaz Committee Recommendations:

The Vaz committee has extended the concept of Nayak committee to all

business enterprises, which also has been accepted and implemented. The

borrower has to bring in a margin of 5% of the projected turnover from

long-term sources as his contribution and 20% would be provided by the

financing bank. Thus, the working capital limits have no relation to the

current assets which is a total departure from Tandon and Chore

Committees.

In arriving at 25% of the projected turnover as the working capital

requirement, the committee has assumed an average of four working

capital cycles in a year. This method of determining the working capital

has understandably made the small entrepreneur happy as he is assured of

a working capital facility from his bankers bearing a direct relationship to

his expected turnover.

Further, he is also able to determine for himself his eligibility for a

working capital limits, but banks, in spite of stiff instructions from the33


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RBI to abide by the new guidelines, still stick to the traditional method.

Bank policy to lend the working capital

The following approaches are generally followed by the banks in

financing working capital needs of the business firms:

Maximum Permissible Bank Finance (MPBF) - Under MPBF

approach, thecapital finance limits of a firm at either 75 per centof the companys current assets or the different between 75 per

cent of current assets and non-bank current liabilities. The

inherent concept of the approach is that scarce credit must be

rationed.Under this method, the minimum acceptable current ratio was

specified, thus fixing the minimumcontribution of the corporateto funding working capital gap. At the same time, the maximum

current assets levels were prescribed through a series of

inventories and receivables norms.

Current Ratio Financing - The liquidity of the

firm is said to be satisfactory if it is able to meet itsobligations inthe short - run. The measure of liquidity is the ratio of current

assets to current liabilities. Hence current ratio is used by the

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bankers in estimating and financing the working capital needs of

the firms. The acceptable current ratio is, therefore, the ratio of

bank funds to own funds. This ratio is fixed through negotiation

between the Corporate and the Banker.

Cash flow Financing - The need for working

capital arises essentially because of uneven and uncertain

nature of cash flows. This is because cash outflows to meet

production expenses do not occur at the same time as cash

proceeds from sales are realised. They are uncertain because

sales and costs are not known in advance. By projecting future

cash receipts and disbursements, the cash budget enables the

corporate to determine its cash needs, and plan their financing

accordingly. Under this approach, bank finance~ based on the

submission of periodic say, quarterly, cash flow statements

that would fit smoothly into a firms cash cycle. To determine

the quantum of bank finance, banks must evaluate cash-flow

risks, forcing them to be more involved in day to day

operations of the borrower. Once the bank has appraised the

cash budget, ad hoc requests for more funds will not be

entertained. This will demand sound resource planning&

receivable management, purchase planning and management

of inventory.

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Different kinds of working capital

financing

The main source of working capital financing, namely, Trade credit,

Bank credit, Factoring and Commercial papers.TRADE CREDIT:

Trade credit refers to the credit that a customer gets from suppliers of

goods in the normal course of business. In practice, the buying firms do

not have to pay cash immediately for the purchases made. This deferral of

payments is a short-term financing called trade credit. It is major source

of financing for firms. In India, it contributes to about one-third of the

short-term financing. Particularly, small firms are heavily dependent on

trade credit as a source of finance since they find it difficult to raise funds

from banks or other sources in the capital markets.

Trade credit is mostly an informal arrangement, and is granted on an open

account basis. A supplier sends goods to buyer on credit which the buyer

accepts, and thus, in effect, aggress to as a debt: he does not sign any

legal instrument. Once the trade links have been established between

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routine activities which may be periodically reviewed by the supplier.

Open account trade credit appears as sundry creditors (known as accounts

payable in USA) on the buyers balance sheet.

Trade credit may also take the form of bills payable. When the buyer

signs a bill - a negotiable instrument to obtain trade credit, it appears on

the buyers balance sheet as bills payable. The bill has a specified future

date, and is usually used when the supplier is less sure about the buyers

willingness and ability to pay, or when the supplier wants cash by

discounting the bill from a bank. A bill is formal acknowledgement of an

obligation to repay the outstanding amount. In USA, promissory notes a

formal acknowledgement of an obligation with promise to pay on a

specified date are used an alternative to the open account, and they

appears as note payable in the buyers balance sheet.

Credit Terms

Credit terms refer to the conditions under which the supplier sells on

credit to the buyer, and the buyer is required to repay the credit. These

conditions include the due date and the cash discount (if any) given for

prompt payment. Due date (also called net date) is the date by which the

supplier discount is the concession offered to the buyer by the supplier to

encourage him to make payment promptly. The cash discount can be

availed by the buyer if he pays by a certain date which is quite earlier

than the due date. The typical way of expressing credit terms is, forexample, as follows; 3/1.5, net 45. This implies that a 3 per cent discount

is available if the credit is repaid on the 15th day, and in case the discount

is not taken, the payment is due by the 45th day.

Benefits and Cost of Trade Credit:

As stated earlier, trade credit is normally available to a firm: therefore, it

is a spontaneous source of financing. As the volume of the firms

purchase increases, trade credit also expands. Suppose that a firm

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increases its purchases from Rs.50, 000 per day to Rs. 60,000 per day.

Assume that these purchases are made on credit terms of net 45, and the

firm makes payment on the 45th day. The average accounts payable

outstanding (trade credit finance) will expand to Rs 27 lakh (Rs. 60,000 x

45) from Rs. 22.50 lakh (Rs. 50,000 x 45).

Advantages of trade credit:

Easy availability: Unlink other sources of finance, trade

credit is relatively easy to obtain. Except in the case of financially

very unsound firms, it is almost automatic and does not require any

negotiations. The easy availability is particularly important to small

firms. Which generally face difficulty in raising funds from the

capital markets.

Flexibility: Flexibility is another advantage of trade credit.

Trade credit grows with the growth in firms sales. The expansion

in the firms sales causes its purchases of goods and services to

increase which is automatically financed by trade credit. In

contrast, if the firms sales contract, purchases will decline and

consequently trade credit will also decline.

Informality: Trade credit is an informal, spontaneous source

of finance. It does not require any negotiation and formal

agreement. It does not have the restrictions which are usually parts

of negotiated sources of finance.

Bank credit: Bank credit is the primary institutional source of working

capital finance in India; in fact, it represents the most important source

of financing of current assets.

Form of Credit:

Working capital finance is provided by banks in five ways:

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Cash Credit/Overdrafts:

Under cash credits, the bank specifies a predetermined borrowing/ credit

limit. The borrows can draw/borrow up to the stipulated credit/overdraft

limit. Similarly repayments can be made whenever desired during the

period. The interest is determined on the basis of the running

balance/amount actually utilized by the borrower and not on the

sanctioned limit.

Loans:

Under the arrangement the entire amount of borrowing is credited to the

current account of the borrower or the released in cash. The borrower has

to pay interest on the total amount.

Bills purchased/discounted:

The amount made available under this arrangement is covered by the cash

credit and overdraft limit. Before discounting the bill, the bank satisfied

itself about the credit-worthiness of the drawer and the genuineness of the

bill. To popularize the scheme, the discounting banker asks the drawer of

the bill (i.e. seller of goods) to have his bill accepted by the drawee

(buyers) bank before discounting is latter grants acceptance against the

cash credit limit, earlier fixed by it on the basis of the borrowing value ofstocks therefore, the buyer who byes goods on credit cannot use the same

goods as source of obtaining additional bank credit.

Term loans for working capital:

Under this arrangement, banks advance loans for 3-7 years repayable in

yearly or half yearly installments.

Letter of credit:

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While the other forms of bank credit are direct forms of financing in

which banks provide funds as well as bear risk, letter of credit is an

indirect form of working capital financing and banks assume only the

risk, the credit being provided by the supplier himself.

Mode of Security for Bank credit:

Banks provide credit on the following modes of security:

Hypothecation:

Under this method of security, the banks provide credit to borrowers

against the security of movable property, usually inventory of goods.

Pledge:

Pledge, as mode of security is different from hypothecation in that in the

former, unlike in the latter the goods which are offered as security are

transferred to the physical possession of the lender.

Lien:

The term Lien refers to the right of the party to retain goods belonging

to another party until a debt due to him is paid.

Mortgage:

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It is the transfer of the legal stock equitable interest in specific immovable

property for securing the payment of debts.

Charge:

Where immovable property of one person is, by the act of parties or by

the operation of law, made security for the payment of money to another

and the transaction does not amount to mortgage, the later person is paid

to have a charge on the property and all provisions of simple mortgage

will apply to such a charge.

COMMERCIAL PAPERS:

Meaning:

Commercial paper (CP), an important short term money market

instruments made its debut in India in the beginning of 1990. It was,

while adumbrating the credit policy for the first half of 1989, that the RBI

Governor announced the introduction of CPs, "with a view to enabling

highly rated corporate borrowers to diversifying their sources of short

term borrowing and also providing an additional instrument to investors."

Commercial paper is a short term financial instrument used by

accompany for raising funds from the money markets. Thus, it is a moneymarket instrument which is issued in the form of unsecured promissory

note in bearer form with a maturity period of one year or even less. The

issue of CP is expected to bring in financial discipline in the working

capital management of an issuer company as it has to ensure its

creditability in the money market by proper utilization of funds to finance

the current or short term transactions and honoring payment of CP on the

maturity date. CP can be issued either through direct placements or

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through agents like banks, merchant bankers and financial institutions.

CP is freely negotiable by endorsement and delivery.

Advantages

A CP has several advantages for both the issuer and investors. It is a

simple instrument and hardly involves any documentation. It is

additionally flexible in terms of maturities which can be tailored to march

the cash flow of the issuer. Companies which are able to raise funds

through CP's have better financial standing. The CP's are unsecured and

there are no limitations on the end use of funds raised to them.

FACTORING:

Factoring provides resources to finance receivables as well as facilitates

the collection of receivables. Although such services constitute a critical

segment of the financial services scenario in the developed countries,

they appeared in the Indian financial scene only in early nineties as a

result of RBI initiatives. There are two bank sponsored organizations

which provide such services: (i) SBI factors and commercial services ltd.,

and (ii) can bank factors. The first private sector factoring company,

foremost factors ltd. Started operations since the beginning of 1997.

Definition and Mechanism:

Definition: Definition factoring can broadly be defined as an agreement

in which receivables arising out of sale of goods/services are sold by a

firm (client) to the 'factors' (a financial intermediary) as a result of which

the title of the goods/services represented by the said receivables passes

on the factor. Hence forth, the factor becomes responsible for all credit

control, sales accounting and debt collection from the buyers.

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Mechanism: Credit sales generate the factoring business in the ordinary

course of business dealing. Realisation of credit sales is the main function

of factoring services. Once the sales transaction is completed, the factors

steps into realize the sales. Thus the factor works between the seller and

the buyer and sometimes with the sellers banks together.

Function of a Factor:

Depending on the type/form of factoring, the main functions of a factor,

in general terms can be classified into following categories:

1. Financing facility trade debts.

2. Maintenance/administration of sales ledger.

3. Collection facility of accounts receivables.

4. Assumption of credit risk/credit control and credit restriction: and

next provision of advisory services.

Cost of Services

It is the factors provide various services at a charge. The charge for

collection and sales ledger administration is in the form of a commission

expressed as value of debt purchase. It is collected up-front/in advance.

The commission for short term financing as advance part-payment is inthe form of interest charged for the period between the date of advance

payment and the date of collection guaranteed payment date. It is also

known as discount charge.

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Methods for Estimating Working Capital Requirements

There are three methods for estimating the working capital requirements

of a firm:

(i) Percentage of sales method (ii) Regression analysis method (iii)Operating cycle method.

Percentage of Sales Method - It is a traditional and simple method of

determining the level of working capital and its components. In this

method, working capital is determined on the basis of past experience. if,

over the years, the relationship between sales and working capital is

found to be stable, then this relationship may be taken as a base for

determining the working capital for future.

This method is simple, easy to understand and useful for projecting

relatively short term changes in working capital. However, this

method cannot be recommended for universal application because the

assumption of linear relationship between sales and working capital

may not hold good in all cases.

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Regression Analysis Method - It is a useful statistical technique

applied for forecasting working capital requirements. It helps in

making working capital requirement projection after establishing the

average relationship between sales and working capital and its

various components in the past year. The method of least squares is

used in this regard.

Operating Cycle Method In this method the requirement of

working capital is estimating through the operating cycle period. It

varies from firm to firm and industry to industry. If the enterprise is

trading firm than it does not have operating cycle because, they are

directly buying goods from other and selling to others. If the

enterprise is manufacturing firm than their operating cycle depends

on their process of converting raw material into finished goods,

availability of raw material, power, fuel and other required thing to

manufacture.

Individual component approach

Detailed estimation is made using the individual components of the

operating cycle.

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Factors determining Working Capital Requirement

There is no set of universally applicable rules to ascertain working capital

needs of a business organization. The factors which influence the need

level are as below:-

Nature of Business:

If we look at the Balance sheet of any trading organization, we find

major parts of the resources are deployed on current assets,

particularly stock-in-trade. Whereas in case of transport organization

major part of funds would be looked up in fixed assets like motor

vehicle, spares and work shed etc. and the working capital component

would be negligible. The service organization or public utilities need

lesser working capital than trading and financial organizations.

Therefore, the requirement of working capital depends upon the nature

of business carried by the organization.

Manufacturing Cycle:

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Time span required for conversion of raw materials into finished

goods is a block period. The period in reality extends a little before

and after the work-in-progress. This cycle determines the need of

working capital.

Business Cycle Fluctuation:

This is another factor which determines the need level. Barring

exceptional cases, there are variations in the demand for

goods/services handled by any organization. Economic boom or

recession etc., have their influence on the transactions and

consequently on the quantum of working capital required.

Seasonal Variations:

Variation apart, seasonality factor creates production or even storage

problem. Muster and many other oil seeds are Rabi crops. There are to

be purchased in a season o ensure continuous operation of oil plant.

Further there are woolen garments which have demand during winter

only. But manufacturing operation has to be conducted during the

whole year resulting in working capital blockage during off season.

Scale of Operations:

Operational level determines working capital demand during a given

period. Higher the scale, higher will be the need for working capital.

However, pace of sales turnover (Quick or slow) is another factor.

Quick turnover calls for lesser investment in inventory while low

turnover rate necessitates larger investment.

Credit Policy:

Credit policy of the business organization includes to whom, when

and to what extent credit may be allowed. Amount of money locked

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up in account receivables has its impact on working capital. In

good many cases, account receivables are sterile and sticky and

thereby they have forfeited the right to be classified as current assets.

In view of such situation in ascertaining quick ratio instead of

deducting stock-in-trade we find it worth while to deduct sundry

debtors. The other component is credit policy of the suppliers, their

terms and conditions of credit. Trade credit has its historical presence

in the trading world. Availability of normal credit supplies as well as

trade credit facilities working capital supply and reduce the need for

bank finance.

Accessibility to Credit:

Creditworthiness is the precondition for assured accessibility to credit.

Accessibility in banks depends on the flow of credit i.e., the level of

working capital.

Growth and Diversification of Business:

Growth and diversification of business call for larger volume of

working fund. The need for increased working capital does not follow

the growth of business operations but precedes it. Working capital

need is in fact assessed in advance in reference to the business plan.

Supply Situation:

In easy and stable supply situation, no contingency plan is necessary

and precautionary steps in inventory investment can be avoided. But

in case of supply uncertainties, lead time may be longer necessitating

larger basic inventory, higher carrying cost and working capital need

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for the purpose. No aggressive approach can gain foothold in such

situation.

Environment Factors:

Political stability in its wake brings in stability in money market and

trading world. Things mostly go smooth. Risk ventures are possible

with enhanced need for working capital finance. Similarly, availability

of local infrastructural facilities road, transport, storage and market

etc., influence business and working capital need as well.

Relaxation in Assessment of Working Capital by Banks

In order to provide greater freedom is assessing the working capital

requirements of borrowers, effective from April 15, 1997, all

instructions relating to MPBF were withdrawn. Banks were

instructed to evolve their own method such as turnover method, the

cash budget system, the MPBF system with necessary modifications

or any other system of assessing working capital requirements. The

loan policy in respect of each broad category of industry is, however,

required to be laid down by each bank with the approval of the

respective Board.

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Ratios for the Working Capital

Working Capital ratio includes the ability of business concern in

meeting its current obligations as well its efficiency in managing its

current assets in generation of sales. These ratios are applied to

evaluate efficiency with the firm manages and utilizes its current

assets. The following three categories of ratios are used for efficient

working capital management.

1. Effective ratios

2. Liquidity ratios

3. Structural health ratios.

Effective ratios:-

Working capital to sales ratio = sales

Working capital

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Inventory turnover ratio = sales

Inventory

Current Asset turnover ratio = sales

Current Assets

Liquid ratios:-

Current ratio = Current Assets, Loans, Advances

Current liabilities and Provisions

Quick ratio = Current assets, Loans and Advances Inventories

Current liabilities and Provisions Bank overdraft

Structural health ratios:-

Total Assets to total net assets = Net Asset

Current Assets

Debtors turnover ratio = Sales

Debtors

Average collection period (in days) = Creditors x 365

SalesBad debts to Sales = Creditors x 365

Purchases

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CASH STUDY

Steel Authority of India Limited.

Balance sheet for the year ended 31.3.2008

(Amounts in crore)

Particulars Sch no. Amount

Sources of funds

Shareholders fund

Share capital 1.1 4160.40Reserves and surplus 1.2 18933.17 23063.57

Loan fund

Secured loans 1.3 925.31

Unsecured loans 1.4 2119.93 3045.24

Deferred tax liability (net) 1568.60

27677.41

Application of funds

Fixed assets 1.5

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Gross block 30922.73

Less: Deprecation 19351.42

Net block 11571.31

Capital work-in-progress 1.6 2389.55 13960.86Investments 1.7 538.20

Current assets, loans and advances

Inventories 1.8 6857.23

Sundry debtors 1.9 3048.12

Cash and Bank balance 1.10 13759.44

Other current assets 1.11 273.08

Loans and Advances 1.12 2379.75

26317.62Less: Current liability & Provisions

Current liability 1.13 6400.92

Provisions 1.14 6797.83

13198.75

Net Current Assets 13118.87

Miscellaneous Expenditure 1.15 59.48

(to the extend of not written off or

adjusted)

27677.41

Profit & Loss Account for the year ended 31.3.2008

(Amount in crore)

Particulars Sch No, Amount

Income

Sales 2.1 45555.34

Less: Excise duty 6046.89 39508.45

Finished products internally

consumed

490.81

Interest earned 2.2 1184.76

Other revenue 2.3 646.27

Provisions no longer required

written back

2.4 60.62

41890.91

Expenditure

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Accretion (-) to stocks 2.5 -339.30

Raw materials consumed 2.6 13960.14

Purchases of finished / semi-

finished goods

3.63

Employees remuneration &

Benefits

2.7 7919.02

Stores & spares consumed 3293.90

Power & fuel 2.8 2825.56

Repairs & Maintenance 2.9 552.15

Freight outward 717.85

Other expenses 2.10 1836.32

Interest & finance charges 2.11 250.94

Deprecation 1235.48

Total 32255.69

Less: Inter Account Adjustments 2.12 1832.22 30423.47

11467.44

Adjustments pertaining to earlier

years

2.13 1.29

11468.73Profit before tax

Less: Provision for taxation (3931.95)

Profit after tax 7536.78

Transfer to reserves 86.39

Bal b/d from last year 10811.65

Amount for Appropriation 18434.82

Less: Appropriation 2557.16

Balance c/d to balance sheet 18434.82Efficient ratios:-

W.C to sales ratio = Sales

W.C

= 39508.45

19916.7

= 1.983

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Inventory turnover ratio = Sales

Inventory

= 39508.45

-339.30

= 39169.15

Current asset turnover ratio = Sales

W.C

= 39508.45

19916.7

= 1.983

Liquid ratios:-

Current ratio = C.A, Loans and Advances

C.L, Provisions Bank O/D

= 26317.62

13198.75

= 1.993: 1

Quick ratio = Q.A

Q.L

= C.A, Loans and Advances - Inventories

C.L, and Provisions Bank O/D

= 26317.62 6857.23

13198.75 nil

= 19460.39

13198.45

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= 1.47:1

Structural health ratios:-

C.A to total net assets = Net assets

C.A

= 27079.73

26317.62

= 1.028

Debtors turnover ratio = Sales

Debtors

= 39508.34

3048.12

= 12.96

Average collection period (in days) = Debtors x 365

Sales

= 3048.12 x365

39508.34

= 1112563.8

39508.34

= 28.16 days

Approx = 28 daysBad debts to sales = Bad debts

Sales

= 216.69

39508.48

= 0.005

Creditors turnover ratio = Creditors x 365

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Purchases

= 2981.55

13960.14

= 0.2135

Conclusion

Working capital management is concerned with short term financial

decisions which have been relatively neglected in the literature of finance

shortage of funds for working capital has caused many businesses to fail

and in many cases, has recorded there growth, Lack of efficient and

effective utilization of working capital leads to earn low rate of return on

capital employed or even compels to sustain losses. The need for skilled

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working capital management has thus become greater in recent years;

every enterprise has to arrange for adequate funds for meeting day-to-day

expenditure apart from investments in fixed assets. Working capital is the

flow of ready funds necessary working of the enterprise. It consists of

funds invested in current assets or those assets which in the ordinary

course of business can be turned into cash within a brief period without

undergoing diminution in value and without disruption of the

organization.

Concept of working capital is difference between current asset and

current liabilities. It is the excess of current asset over current liabilities.The blood to the business enterprise working capital, if weak, the

business cannot prosper and survive, although there may be a large

investment of fixed assets. Inadequate as well as redundant working

capital is dangerous for the health of industry. In other words Over and

under working capital is the dangerous for the any business enterprise.

A company must have working capital adequate to its requirements

neither excessive nor inadequate. While inadequate working capital

adversely affects the business operations and profitability, excessive

working capital keeps idle and earns no profit.

The primary objective of working capital management is to manage the

firm's current assets and current liabilities in such a way that a

satisfactorily level of working capital is maintained. The firm may

become insolvent if it cannot maintain a satisfactory level of workingcapital. Working capitals assist in increasing the profitability of the

concern. The working capital position decides the various policies in the

business with receipt to general operations viz., importance of working

capital management.

To manage working capital at par level to meet with the day-to-day

expenditure of the firm, the Banks role is very important as the bank

lends the money to the firm to run the business and day-to-day business

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activities. In this lending banks lending the advances to the business

firms in various forms. Such as,

Bank credit:-

Cash credit / Bank overdraft

Loans

Bill purchased & discount

Term loan for working capital

Letter of credit discounting

Commercial paper

FactoringBy providing such kind of advances to the business firm, Banks plays the

important role to managing the working capital of the business firm.

role of banks in working capital management

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