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I take this opportunity to present this project on ASSESSMENT ON WORKING CAPITAL MANAGEMENT REQUIREMENT. I would like to thank Welingkar Institute of Management for giving me opportunity to present this project. It is really a matter of great pleasure to acknowledge the invaluable support to my parents and friends who helped me in the successful completion of the project. I HAVE BEEN IMMENSELY BENEFITTED BY THIS PROJECT.



I hereby declare that the project entitled ASSESSMENT ON WORKING CAPITAL REQUIREMENT is an original project done by me and no part of the project is taken from any other project or materials published or submitted earlier to any other college or university.

Signature of student




Sl. no 1 2 3 Executive summary Introduction Research design


Page no 7 8-9 10-12

Statement of the problem Objective of the study Tools used for project Limitation of the study Data collection technique

4 5 6 7 8 9 10 11 12 13

Literature Review Working capital (Definition) permanent and temporary working capital Working capital needs of a business Working capital cycle Factor determining the working capital requirement Consequences of under assessment on working capital Consequences of over assessment on working capital Impact of inflation on working capital requirement Impact of double shift working capital requirement

13-25 26-27 28-29 30 31-34 35-36 37 38 39 40

14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32

Zero working capital Adequate working capital Working capital leverage Approaches to working capital finance Financing working capital Committee recommendation of working capital finance Method for estimating working capital requirement Inventory management Objective of inventory management Inventory management techniques Receivable management Receivable collection policy Process of receivable management Cash management Effects of cash deficits Cash budget Method of cash flow budgeting Cash management model Analysis and interpretation Types of ratio

41 42 43 44-46 47 48-49 50 51 52-53 54-55 56-57 58 58 59 60 61-62 62 63-64

65-75 76-77 78-80

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Classification of costs Proforma of cost sheet

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Annexure Conclusion Recommendation Bibliography

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Working capital is one of the most difficult financial concepts to understand for the smallbusiness owner. In fact, the term means a lot of different things to a lot of different people. By definition, working capital is the amount by which current assets exceed current liabilities. However, if you simply run this calculation each period to try to analyze working capital, you wont accomplish much in figuring out what your working capital needs are and how to meet them. Small businesses are an essential element of a healthy and vibrant economy. They are seen as vital to the promotion of an enterprise culture and to the creation of jobs within the economy. Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital that is commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. Working Capital = Current Assets Net Working Capital = Current Assets Current Liabilities All the analysis identified in this project have been used for efficient working capital management in an organisation. This project is not just theory but these are ideas that can be applied to any practical business.


Working Capital is life blood and nerve centre of a business. Just as circulation of blood is essential for the survival of the human being similarly working capital is necessary for the survival of every business organization, whether it is a small organization or a big organization. Every business needs funds for two purposes-for the establishment and to carry out its day to day operations. Long terms funds are required to create production facilities through purchase of fixed assets such as plant & machinery, land & building, furniture & fixtures etc. Investments in these assets the present that part of the firms capital, which is blocked on a permanent or fixed basis and is called fixed capital. Funds are also needed for short-term purposes as for the purchase of raw material, payment of wages & other day to day expenses etc. these funds are known as working capital.


Statement of the problem Working capital management is concerned with the problem arise in attempting to manage the current assets, current liabilities and interrelation between both. Its operational goal is to manage the smooth functioning of day-to- day operation of an organization. Objectives of working capital: Every business needs some amount of working capital. It is needed for following purposes For the purchase of raw materials, components and spares. To pay wages and salaries. To incur day to day expenses and overhead costs such as fuel, power, and office expenses etc. To provide credit facilities to customers etc. TOOLS USED FOR PROJECT While making the project file various tools were used. These tools helped in doing the work. These are: Microsoft Excel Microsoft Word Various analysis tools like Bar Graphs, Pie Graphs, tables

Limitations of the study Following limitations were encountered while preparing this project: 1) Limited data: - This project constitutes one part of data collection i.e. secondary. There were limitations for primary data collection because of confidentiality. 2) Limited period: Conclusions and recommendations are based on such limited data. 3) Limited area: - Also it was difficult to gain practical knowledge as the data was collected through secondary sources only.



No field work Secondary data:

Books, Journals, Magazines and various articles. Websites



Review of Literature
Studies on Working Capital Management Studies on Working Capital Management in India Studies on Determinants of Inventory Investment

The purpose of this chapter is to present a review of literature relating to the working capital management. Although working capital is an important ingredient in the smooth working of business entities, it has not attracted much attention of scholars. Whatever studies have conducted, those have exercised profound influence on the understanding of working capital management good number of these studies which pioneered work in this area have been conducted abroad, following which, Indian scholars have also conducted research studies exploring various aspects of working capital. Special studies have been undertaken, mostly economists, to study the dynamics of inventory investment which often represented largest component of total working capital. As such the previous studies may be grouped into three broad classes (1) Studies conducted abroad, (2) Studies conducted in India, (3) Studies relating to determine of inventory investment.

Studies on Working Capital Management Studies adopting a new approach towards working capital management are reviewed here. Sagan in his paper (1955), perhaps the first theoretical paper on the theory of working capital management, emphasized the need for management of working capital accounts and warned that it could vitally affect the health of the company. He realized the need to build up a theory of working capital management. He discussed mainly the role and functions of money manager inefficient working capital management. Sagan pointed out the money managers operations were primarily in the area of cash flows generated in the course of business transactions. However, money manager must be familiar with what is being done with the control of inventories, receivables and payables because all these accounts affect cash position. Thus, Sagan concentrated mainly on cash component of working capital. Sagan indicated that the task of money manager was to provide funds as and when needed and to invest temporarily surplus funds as profitably as possible in view of his particular


requirements of safety and liquidity of funds by examining the risk and return of various investment opportunities. He suggested that money manager should take his decisions on the basis of cash budget and total current assets position rather than on the basis of traditional working capital ratios. This is important because efficient money manager can avoid borrowing from outside even when his net working capital position is low. The study pointed out that there was a need to improve the collection of funds but it remained silent about the method of doing it. Moreover, this study is descriptive without any empirical support. Realising the dearth of pertinent literature on working capital management, Walker in his study (1964) made a pioneering effort to develop a theory of working capital management by empirically testing, though partially, three propositions based on risk-return trade-off of working capital management. Walker studied the effect of the change in the level of working capital on the rate of return in nine industries for the year 1961 and found the relationship between the level of working capital and the rate of return to be negative. On the basis of this observation, Walker formulated three following propositions: Proposition I If the amount of working capital is to fixed capital, the amount of risk the firm assumes is also varied and the opportunities for gain or loss are increased. Walker further stated that if a firm wished to reduce its risk to the minimum, it should employ only equity capital for financing of working capital; however by doing so, the firm reduced its opportunities for higher gains on equity capital as it would not be taking advantage of leverage. In fact, the problem is not whether to use debt capital but how much debt capital to use, which would depend on management attitude towards risk and return. On the basis of this, he developed his second proposition. Proposition II The type of capital (debt or equity) used to finance working capital directly affects the amount of risk that a firm assumes as well as the opportunities for gain or loss. Walker again suggested that not only the debt-equity ratio, but also the maturity period of debt would affect the risk-return trade-off. The longer the period of debt, the lower be the risk. For, management would have enough opportunity to acquire funds from operations to meet the debt obligations. But at the same time, long-term debt is costlier. On the basis of this, he developed his third proposition:


Proposition III The greater the disparity between the maturities of a firms debt instruments and its flow of internally generated funds, the greater the risk and vice-versa. Thus, Walker tried to build-up a theory of working capital management by developing three prepositions. However, Walker tested empirically the first proposition only. Walkers Study would have been more useful had he attempted to test all the three propositions. Weston and Brigham (1972) further extended the second proposition suggested by Walker by dividing debt into long-term debt and short-term debt. They suggested that short-term debt should be used in place of long-term debt whenever their use would lower the average cost of capital to the firm. They suggested that a business would hold short-term marketable securities only if there were excess funds after meeting short-term debt obligations. They further suggested that current assets holding should be expanded to the point where marginal returns on increase in these assets would just equal the cost of capital required to finance such increases. Vanhorne in his study (1969), recognizing working capital management as an area largely lacking in theoretical perspective, attempted to develop a framework in terms of probabilistic cash budget for evaluating decisions concerning the level of liquid assets and the maturity composition of debt involving risk-return trade-off. He proposed calculation of different forecasted liquid asset requirements along with their subjective probabilities under different possible assumptions of sales, receivables, payables and other related receipts and disbursements. He suggested preparing a schedule showing, under each alternative of debt maturity, probability distributions of liquid asset balances for future periods, opportunity cost, maximum probability of running out of cash and number of future periods in which there was a chance of cash stock-out. Once the risk and opportunity cost for different alternatives were estimated, the form could determine the best alternative by balancing the risk of running out of cash against the cost of providing a solution to avoid such a possibility depending on managements risk tolerance limits. Thus, Vanhorne study presented a risk-return trade-off of working capital management in entirely new perspective by considering some of the variables probabilistically. However, the usefulness of the framework suggested by Vanhorne is limited because of the difficulties in obtaining information about the probability .0distributions of liquid-asset balances, the opportunity cgost and the probability of running out of cash for different alternative of debt maturities. Welter, in his study (1970), stated that working capital originated because of the global delay between the moment expenditure for purchase of raw material was made and the moment when payment were received for the sale of finished product. Delay centres are located throughout the production and marketing functions. The study requires specifying the delay centres and working capital tied up in each delay centre with the help of information regarding average delay and added value. He recognized that by more rapid and precise


information through computers and improved professional ability of management, saving through reduction of working capital could be possible by reducing the length of global delay by rescuing and/or favourable redistribution of this global delay among the different delay centres. However, better information and improved staff involve cost. Therefore, savings through reduction of working capital should be tried till these saving are greater or equal to the cost of these savings. Thus, this study is concerned only with return aspect of working capital management ignoring risk. Enterprises, following this approach, can adversely affect its short-term liquidity position in an attempt to achieve saving through reduction of working capital. Thus, firms should be conscious of the effect of law current assets on its ability to pay-off current liabilities. Moreover, this approach concentrated only on total amount of current assets ignoring the interactions between current assets and current liabilities. Lambrix and Singhvi (1979) adopting the working capital cycle approach to the working capital management, also suggested that investment in working capital could be optimized and cash flows could be improved by reducing the time frame of the physical flow from receipt of raw material to shipment of finished goods, i.e. inventory management, and by improving the terms on which firm sells goods as well as receipt of cash. However, the further suggested that working capital investment could be optimized also (1) by improving the terms on which firms bought goods i.e. creditors and payment of cash, and (2) by eliminating the administrative delays i.e. the deficiencies of paper-work flow which tended to extend the time-frame of the movement of goods and cash. Warren and Shelton (1971) applied financial simulation to simulate future financial statements of a firm, based on a set of simultaneous equations. Financial simulation approach makes it possible to incorporate both the uncertainty of the future and the many interrelationships between current assets, current liabilities and other balance sheet accounts. The strength of simulation as a tool of analysis is that it permits the financial manager to incorporate in his planning both the most likely value of an activity and the margin of error associated with this estimate. Warren and Shelton presented a model in which twenty simultaneous equations were used to forecast future balance sheet of the firm including forecasted current assets and forecasted current liabilities. Current assets and current liabilities were forecasted in aggregate by directly relating to firm sales. However, individual working capital accounts can also be forecasted in a larger simulation system. Moreover, future financial statements can be simulated over a range of different assumptions to portray inherent uncertainty of the future. Cohn and Pringle in their study (1973) illustrated the extension of Capital Asset Pricing Model (CAPM) for working capital management decisions. They tried to interrelate long-term investment and financing decisions and working capital management decisions through CAPM. They emphasized that an active working capital management policy based on CAPM could be employed to keep the firms shares in a


given risk class. By risk, he meant unsystematic risk, the only risk deemed relevant by CAPM. Owing to the lumpy nature for long-term financial decisions, the firm is continually subject to shifts in the risk of its equity. The fluid nature of working capital, on the other hand, can be exploited so as to offset or moderate such swings. For example they suggested that a policy using CAPM could be adopted for the management of marketable securities portfolio such that the appropriate risk level at any point in time was that which maintains the risk of the companys common stock at a constant level. Similarly, Copeland and Khoury (1980) applied CAPM to develop a theory of credit expansion. They argued that credit should be extended only if the expected rate of return on credit is greater than or equal to market determined required rate of return. They used CAPM to determine the required rate of return for the firm with its new risk, arising from uncertainty regarding collection due to the extension of credit. Thus, these studies show how CAPM can be used for decisions involved in working capital management. One more approach, used mainly in empirical studies, towards working capital management has been to apply regression analysis to determine the factors influencing investment in working capital. Different studies in the past have considered different explanatory variables to explain the investment in inventory. A brief review of these studies is important as regression equation of investment in working capital, in the present study, would be formulated on the basis of works on investment in inventory. In inventory investment literature, there is basically one school of thought according to which firms aim at an optimum or desired stock of inventories in relation to a given level of output/sales. This is known as acceleration principle. Pioneering work in this field has been done by Metzler (1941). However, his work was mainly on simple acceleration principle which postulated that firms liked to maintain inventories in proportions to output/sales and they succeeded in achieving the desired level of inventories in a unit time-period. That is to say, any discrepancy between the actual level and desired level of inventories is adjusted within the same time-period. Needless to say, that such an instantaneous adjustment is not a realistic assumption to make. Modifications, therefore, have been introduced in the literature to provide for partial adjustment. Goodwin (1948) assumed that firms attempted only a partial adjustment of the discrepancy between the desired stocks as determined by the level of output and the existing stock. Similarly, Darling and Lovell (1965) modified Metzlers formulation based on simple acceleration principle and obtained, the relationship based on flexible accelerator principle. There are several reasons physical, financial and technical those motivate partial adjustment. Among the physical factors, mention may be made of procurement lags between orders and deliveries. The length of such lags is connected with the source of supply, foreign or domestic availability. Import licensing procedures on account of foreign exchange scarcity could cause further delays in adjustment. Among the financial


factors, cost advantages associated with bulk buying and higher procurement costs for speedy delivery are also mentioned. Uncertainties in the market for raw materials and in the demand for final product also play a role in influencing the speed of adjustment. Technically, firms like to make sure that changes in demand are of a permanent character before making full adjustment. The acceleration principle has great relevance in inventory analysis than in the analysis of fixed investment, as there are limits to liquidate fixed capital in the face of declining demand. Other variables influencing inventories have been introduced in the literature in the context of accelerator model. Rate of interest is used as a proxy for the opportunity cost of carrying stocks or as a measure of the cost of funds needed to hold inventories. It has been found significant in the studies of Hilton (1976) and Irwin (1981). Time-trend is expected to be important because inventories generally accumulate with the expansion of economic activities of the company. Anticipated price changes, measured by changes in wholesale price index of inventories, are taken as an explanatory variable to capture speculative element in inventory. This suggests a positive relationship between price changes and inventory. An increase in sales is expected to increase the demand for stocks to meet orders regularly. An increase in capacity utilization is also expected to increase the demand for stock by increasing the demand for raw materials and increasing the inventories of finished goods. Thus, the variable, capacity utilization, is postulated to have a positive coefficient in the equation. Abramovitz (1950) and Modigliani (1957) highlighted the impact of capacity utilization on inventory investment. Existing stock of inventories is expected to take account of adjustment process to the desired levels. Thus the variable, existing stock of inventories, is postulated to be negatively related with the desired stock. The ratio of inventory to sales may affect inventory investment positively because a high ratio of stocks to sales in the past suggests the maintenance of high levels of inventories in the past and thus also calling for high investment in inventories in the current period. The studies of Metzler (1941) and Hilton (1976) have found this variable, inventory-sales ratio, to be statistically significant. Fixed investment is generally expected to affect inventory investment inversely because of competing demand for the limited funds. However, in case of an expanding firm, the two components may be complementary. Besides, availability of funds from retained earnings and external sources, may affect investment decision by providing funds for financing inventory investment. Therefore, retained earnings and flow of debt are postulated to have positive coefficients. The studies described so far, are the important studies conducted abroad. A number of studies on working capital management have been conducted in India also. The following discussion describes Indian studies.


Studies on Working Capital Management in India This part briefly reviews the studies conducted in India in respect of working capital management in Indian industries. The first, small but fine piece of work is the study conducted by National Council of Applied Economic Research (NCAER) in 1966 with reference to working capital management in three industries namely cement, fertilizer and sugar. This was the first study on nature and norms of working capital management in countries with scarcity of investible resources. This study was mainly devoted to the ratio analysis of composition, utilization and financing of working capital for the period 1959 to 1963. This study classified these three industries into private and public sector for comparing their performance as regards the working capital management. The study revealed that inventory constituted a major portion of working capital i.e. 74.06 per cent in the sugar industry followed by cement industry (63.1%) and fertilizer industry (59.58%). The study observed that the control of inventory had not received proper attention. The inventory control was mainly confirmed to materials management leading to the neglect of stores and spares. So far as the utilization of working capital was concerned, cement and fertilizer industry had a more efficient utilization of working capital. The sugar industry had inefficient utilization of working capital largely due to the accumulation of stock with the factories. As regards financing of working capital, the study showed that internal sources had contributed very little towards the financing of working capital. It was 11.87 per cent in the cement industry, 15.03 per cent in sugar and 31.25 per cent in fertilizer industry, 17.78 per cent being the average. However, this study failed to put into sharp focus the various problems involved in the management of specific working capital accounts. Appavadhanulu (1971) recognizing the lack of attention being given to investment in working capital, analysed working capital management by examining the impact of method of production on investment in working capital. He emphasized that different production techniques require different amount of working capital by affecting goods-in-process because different techniques have differences in the length of production period, the rate of output flow per unit of time and time pattern of value addition. Different techniques would also affect the stock of raw materials and finished goods, by affecting lead-time, optimum lot size and marketing lag of output disposals. He, therefore, hypothesised that choice of production technique could reduce the working capital needs. He estimated the ratio of work-in-progress and working capital to gross output and net output in textile weaving done during 1960, on the basis of detailed discussions with the producers and not on the basis of balance sheets which might include speculative figures. His study could not show significant relationship between choice of technique and working capital. However, he pointed out that the idea


could be tested in some other industries like machine tools, ship building etc. by taking more appropriate ratios representing production technique correctly. Chakraborty (1973) approached working capital as a segment of capital employed rather than a mere cover for creditors. He emphasized that working capital is the fund to pay all the operating expenses of running a business. He pointed out that return on capital employed, an aggregate measure of overall efficiency in running a business, would be adversely affected by excessive working capital. Similarly, too little working capital might reduce the earning capacity of the fixed capital employed over the succeeding periods. For knowing the appropriateness of working capital amount, he applied Operating Cycle (OC) Concept. He calculated required cash working capital by applying OC concept and compared it with cash from balance sheet data to find out the adequacy of working capital in Union Carbide Ltd. and Madura Mills Co. Ltd. for the years 1970 and 1971. He extended the analysis to four companies over the period 1965-69 in 1974 study. The study revealed that cash working capital requirement were less than average working capital as per balance sheet for Hindustan Lever Ltd. and Guest, Keen and Williams Ltd. indicating the need for effective management of current assets. Cash working capital requirements of Dunlop and Madura Mills were more than average balance sheet working capital for all years efficient employment of resources. For Union Carbide Ltd., cash working capital requirements were more in beginning years and then started reducing in the later years as compared to conventional working capital indicating the attempts to better manage the working capital. Chakraborty emphasized the usefulness of OC concept in the determination of future cash requirements on the basis of estimated sales and costs by internal staff of the firm. OC concept can also be successfully employed by banks to assess the working capital needs of the borrowers. Misra (1975) studied the problems of working capital with special reference to six selected public sector undertakings in India over the period 1960-61 to 1967-68. Analysis of financial ratios and responses to a questionnaire revealed somewhat the same results as those of NCAER study with respect to composition and utilization of working capital. In all the selected enterprises, inventory constituted the more important element of working capital. The study further revealed the overstocking of inventory in regard to its each component, very low receivables turnover and more cash than warranted by operational requirements and thus total mismanagement of working capital in public sector undertakings. Agarwal (1983) also studied working capital management on the basis of sample of 34 large manufacturing and trading public limited companies in ten industries in private sector for the period 1966-67 to 1976-77. Applying the same techniques of ratio analysis, responses to questionnaire and interview, the study concluded the although the working capital per rupee of sales showed a declining trend over the years but still there appeared a sufficient scope


for reduction in investment in almost all the segments of working capital. An upward trend in cash to current assets ratio and a downward trend in cash turnover showed the accumulation of idle cash in these industries. Almost all the industries had overstocking of raw materials shown by increase in the share of raw material to total inventory while share of semi-finished and finished goods came down. It also revealed that long-term funds as a percentage of total working capital registered an upward trend, which was mainly due to restricted flow of bank credit to the industries. Kamta Prasad Singh, Anil Kumar Sinha and Subas Chandra Singh (1986) examined various aspects of working capital management in fertilizer industry in India during the period 1978-79 to 1982-93. Sample included public sector unit, Fertilizer Corporation of India Ltd. (FCI) and its daughter units namely Hindustan Fertilizers Corporation Ltd., the National Fertilizer Ltd., Rashtriya Chemicals and Fertilizers Ltd. and Fertilizer (Projects and Development) India Ltd. and comparing their working capital management results with 63 Gujarat State Fertilizer Company Limited in joint sector. On the basis of ratio-analysis and responses to a questionnaire, study revealed that inefficient management of working capital was to a great extent responsible for the losses incurred by the FCI and its daughter units, as turnover of its current assets had been low. FCI and its daughter units had high overstocking of inventory in respect of each of its components particularly stores and spares. Similarly, quantum of receivables had been excessive and their turnover very low. However, cash and liquid resources held by FCI and its daughter units had been much lower in relation to operation requirements. So far as financing of working capital was concerned, long-term funds had been financing a low proportion of current assets due to rapid increase of current liabilities. The profitability providing an internal base for financing of working capital, had been very low in these undertakings. Verma (1989) evaluated working capital management in iron and steel industry by taking a sample of selected units in both private and public sectors over the period 1978-79 to 198586. Sample included Tata Iron and Steel Company Ltd. (TISCO) in private sector and Steel Authority of India Ltd. (SAIL) and Indian Iron and Steel Company, a wholly owned subsidiary of SAIL, in public sector. By using the techniques of ratio analysis, growth rates and simple linear regression analysis, the study revealed that private sector had certainly an edge over public sector in respect of working capital management. Simple regression results revealed that working capital and sales were functionally related concepts. The study further showed that all the firms in the industry had made excessive use of bank borrowings to meet their working capital requirement vis--vis the norms suggested by Tandon Committee. Vijaykumar and Venkatachalam (1995) studied the impact of working capital on profitability in sugar industry in Tamil Nadu by selecting a sample of 13 companies; 6 companies in cooperative sector and 7 companies in private sector over the period 1982-83 to 1991-92. They


applied simple correlation and multiple regression analysis on working capital and profitability ratios. They concluded through correlation and regression analysis that liquid ratio inventory turnover ratio, receivables turnover ratio and cash turnover ratio influenced the profitability of sugar industry in Tamil Nadu. They also estimated the demand functions of working capital and its components i.e. cash, receivables, inventory, gross working capital and net working capital, by applying regression analysis. They showed the impact of sales and interest rate on working capital and its components. When only sales was taken as independent variable, coefficient of sales was more than unity in all the equations of working capital and its components showing more than unity sales elasticity and diseconomies of scale. When sales and interest rate were taken as independent variable, sales elasticity was again more than unity in demand functions of working capital and its components except cash. So far as capital costs were concerned, these had negative signs in all the equations but significant only in inventory, gross working capital and net working capital showing negative impact of interest rates on investment in working capital and its components. Thus study showed that demand for working capital and its components was a function of both sales and carrying costs. Studies on Determinants of Inventory Investment Inventory, in most industries, accounts for largest proportion of gross working capital. A number of studies, therefore, have been conducted to find the determinants of investment in inventories. The following discussion provides a brief review of studies, dealing with factors influencing investments in inventory in India. Econometric studies to analyse the factors that influence inventory accumulation in India, are based on time series and pooling of cross section of time series date pertaining to manufacturers inventories. Krishnamurtys study (1964) was aggregative and dealt with inventories in the private sector of the Indian Economy as a whole for the period 1948-61. this study used sales to represent demand for the product and suggested the importance of accelerator. Short-term rate of interest had also been found to be significant. Sastrys study (1966) was a cross section analysis of total inventories of companies across several heterogeneous industries for the period 1955-60 using balance sheet data of public limited companies in the private sector. The study brought out the importance of accelerator represented by change in sales. It also showed negative influence of fixed inventory investment. Krishnamurty and Sastrys study in 1970 was perhaps the most comprehensive study on manufacturers inventories. They used CMI data and the consolidated balance sheet data of public limited companies published by RBI, to analyse each of the major components i.e. raw material, goods-in-process and finished goods for 21 industries over the period 1946-62. It was a time series study but some inter-industry cross section analysis had also been done.


Accelerator represented by change in sales, bank finance and short-term interest rate were found to be important determinants. Utilisation of productive capacity and price anticipations had been found to be of some relevance. Another study conducted by them in 1975 analysed inventory investment in the context of flexible accelerator with financial variables. Both RBI and Stock Exchange, Official Directory, Mumbai data for seven important industries had been taken for the period of 1956-69. Their study of pooled cross section was in current prices whereas time series analysis based on RBI data was a constant prices. OLS results showed the important influence of accelerator, internal and external funds flow and fixed investment on inventory investment. The study by Vinod Prakash (1970) was a time series analysis with mostly undeflated data taken from CMI and Annual Survey of Industries (ASI) for the period 1946-63. It examined the influence of structural changes in manufacturing activity on the relative size and composition of inventory in the large scale-manufacturing sector in India. Three different models for industry groups and for six important individual industries had been tried. Output/sales, capacity utilization, short-term rate of interest, money supply, foreign exchange availability, price index, size and time trend were taken as explanatory variable. The simple accelerator model with output gave better results for industrial groups, whereas the ratio model seemed to perform better in the analysis of individual industry. The flexible accelerator models were found to be inferior. The impact of price index was found to be generally insignificant, while the impact of foreign exchange and money supply was absent. The rate of interest showed a perverse impact. Time trend appeared to be important than the size of establishment. The role of availability of funds was completely ignored in this study. The study by George (1972) was cross section analysis of balance sheet data of 52 public limited companies for the period 1967-70. Accelerator, internal and external finance variables were considered in the equations for raw materials including goods-in-process and total inventories. However, equations for finished goods inventories considered only output variable. Accelerator and external finance variables were found to be important. The analysis by Seamy and Rao (1975) of the flow of funds of public limited companies had an equation for aggregate inventory investment. RBI data for the period 1954- 70 had been used. The explanatory variables considered were accelerator, flow of bank borrowings, an index of man-days lost, capacity by the call rate. Accelerator, bank finance and fixed investment were found to be significant. The study by R.N. Agarwal (1982)estimated total inventory investment equation for individual firms in automobile manufacturing industry, which was divided into two sectors car-sector and non car-sector. His study was based on the data for 1959-60 through 197879. Official Directory of Mumbai Stock Exchange had been the basic source of data. Analysis of two sector revealed that sales and stock-sales ratio were important explanatory variables.


Cost of capital and trend were important in only car sector while fixed investment and flows of external funds were significant in non-car sector. Existing stock of inventories was statistically significant in both the sector but contrary to expectations, it possessed negative coefficient. Several other variables as dividends, capacity utilization and liquidity ratio were found to be of no importance in explaining inventory investment behaviour. N.C. Gupta study (1987) examined the determinants of total inventory investment in aluminium and non-ferrous semi firms in private sector. The data had been taken from Stock Exchange, Official Directory, Mumbai for 9 years 1966-67 to 1974-75. variables considered were current sales change, one-lagged sales change, inventory stock at the beginning, gross fixed investment during the year, flow of net debt (external finance) and profits net of dividends and taxes but gross of depreciation provision (retained earnings or internal finance). The equation also provided for firm dummies and year dummies. Analysis was based on pooling of time series of cross section data. Demand factor and external finance turned out to be significant determinants in aluminium. Both retained earnings and external finance were important determinants in case of non-ferrous semis. Competition for investment funds between fixed and inventory investment was suggested both in aluminium and non-ferrous semis. Adesh Sharma (1994) applied accelerator model with financial variables to determine the factors influencing investment in inventories in pesticides industry in India. Data had been taken from the Stock Exchange Official Directory, Mumbai for the period 1978-1992 in respect of 18 firms in this industry. The coefficients of the accelerator and financial variables were found to be significant and positive. The coefficient of inventory of inventory stock was significant and negative. The above brief review of studies in Indian context shows that no attempts has been made to analyse working capital management in Hotel industry in India. Secondly, there have been many studies exploring the determinants of inventory investment, no attempt has been made to study the factors influencing investment in total working capital. On the basis of previous studies, the present study aims at filling both these gaps.


Definition of working capital The Capital required to run the day-to-day operation of an organization is known as Working Capital. It can be either gross working capital or net working Capital. Gross working capital means the total of the all current assets whereas Net working capital means the difference between the total Current assets and Current liabilities. WORKING CAPITAL = CURRENT ASSETS CURRENT LIABILITIES Current assets are those assets which will be converted in to cash within the current accounting period or within the next year as a result of the ordinary operation of the business. They are cash or near cash resources. These include: Cash and Bank balances Receivables Pre-Paid expenses Short-term advances Temporary advance Inventory Raw materials, stores and spares Work-in-Progress Finished goods The value represented by these assets circulates among several items. Cash is to buy raw materials, to pay wages to meet others manufacturing expenses. Finished goods are produced. These are held as inventories. When these are sold, accounts receivables are created. The collections of accounts receivable bring cash into the firm. The cycle starts again Cash




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 Advances 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. Every business needs adequate liquid resources in order to maintain day-to-day cash flow. It needs enough cash to pay wages and salaries as they fall due and to pay creditors to keep its workforce and ensure its supplies. Maintaining adequate working capital is not just important in the short-term. Sufficient liquidity must be maintained in order to ensure the survival of the business in the long-term as well. Even a profitable business may fail if it does not have adequate cash flow to meet its liabilities as they fall due. Therefore, when businesses make investment decisions they must not only consider the financial outlay involved with acquiring the new machine or the new building etc, but must also take an account of the additional current assets that are usually involved with any expansion of activity. Increased production need to hold more stock of raw material and work-in-progress. Increased sales usually mean that the level of debtors will increase. A general increase in the firms scale of operations tends to imply a need for greater levels of cash.


Permanent and Temporary Working Capital

There are two types of working capital viz, Permanent and Temporary working capital. Permanent working capital represents the assets required on continuing basis over the entire year, whereas temporary working capital represents additional assets required at different times during the year. A firm will finance its seasonal and current fluctuation business operation through short-term debt financing. For example: in Peak season, more raw material 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 will be financed from short term financing sources. The permanent components current assets which are required throughout the year will generally be financed from long-term debt and equity. Tandon Committee has referred to these types of working capital as Core Current Assets. Core current Assets are those required by the firm to ensure of operations which represents the minimum levels of various items of current assets viz., stock of raw material, stock of work-in-process, stock of finished goods, debtors balance, cash and bank etc. This minimum level of current assets will be financed by the long term sources and any fluctuation etc. This minimum level of current assets will be financed by long term sources and any fluctuation over the level of the current assets will be financed by the short-term financing. Sometimes core current assets are also referred to as Hard core working capital



short term Current Financing

assets Rs. = Long-term

Debt + Equity Capital 0 Time F.A

The management of working capital is concern with maximising the return to shareholder within the accepted risk constraints carried by the participants in the company.



Different industries have different optimum working capital profiles, reflecting their method of doing business and what they are selling. Business with a lot of cash sales and few credit sales should have minimal trade debtors. Supermarkets are good examples of such businesses. Business that exists to trade in completed products will only have finished goods in stock. Manufactures will also have to maintain stock of raw material and work-inprogress. Some finished goods, notably foodstuffs, have to be sold within a limited period because of their perishable nature. Larger companies may be able to use their bargaining strength as customers to obtain more favourable, extended credit terms from suppliers. By contrast, smaller companies, particularly those that have recently started trading (and do not have a record of accomplishment of credit worthiness) may be required to pay their suppliers immediately. Some business will receive their monies at certain times of the year, although they may incur expenses thorough out the year at a consistent level. This is often known as seasonality of the cash flow. For example, travel agents have peak sales in the weeks immediately following Christmas.



Introduction The working capital cycle can be defined as: The period of time, which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from customer? Cash is used to buy raw material and other stores, so cash is converted into raw material and stores inventory. Then the raw material and stores are issued to the production department. Wages are paid and other expenses are incurred in the process and work-inprocess comes into existence. Workin-process becomes finished goods. Finished goods are sold to customer on credit. In the course of time these customer pay cash for the goods purchase by them. Cash is retrieved and the cycle is completed. Thus, working capital cycle consists of four stages. The raw material and stores inventory stage The work-in-progress stage The finished goods inventory stage The receivable.


The diagram below illustrates the working capital cycle for a manufacturing firm.

Work-In- progress

Raw material stock

Finished goods stock

Wages & overheads


Trade creditors Selling expenses

Trade debtors




Fixed assets Lease payment

loan Creditors

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


stock, and it will become part of the firms work in progress( WIP) Work will continue on the WIP until it eventually emerges as the finished product. As production progresses, labour costs and overheads will need to be met. Of course, at some stage trade creditors will need to be paid When the finished goods are sold on credit, debtors are increased They will eventually pay, so that cash will be injected into the firm Each of the areas stocks (raw material, work in progress and finished goods), trade debtors, cash (positive or negative) and trade creditors-can be viewed as tanks into and from which funds flow. Working capital is clearly not only aspect of a business but that affects the amount of cash: The business will have to make payments to government for taxation Fixed assets will be purchased and sold Lesser of fixed assets will be paid their rent. Shareholders (existing or new) may provide new funds in the form of cash. Some shares may be redeemed for cash. Dividends may be paid. Long term loan creditors (existing or new) may provide loan finance ,loan will need to be repaid from time to time , and Interest obligation will have to be met in the business. Unlike movement in the working capital items, most of this non- working capital cash transaction is not every day events. Some of them are annual events (e.g. tax payments, lease payment, dividends, interest and possibly, fixed assets purchase and sales). Others (e.g. new equity and loan finance and redemption of old equity and loan finance would typically be rarer events. Working capital cycle involves conversions and rotation of various constituents of the working capital. Initially cash converted into raw materials. Subsequently ,with the usages of fixed assets resulting in value additions ,the raw material get converted into work in process and then into finished goods. When sold on credit, the finished goods assume the form of debtors who give the business cash on due date. Thus, cash assumes its original form against at the end of one such working capital cycle but in the course it passes through various other forms of current assets too. This is how various components of current assets keep on changing their forms due to value addition.


As a result, they rotate and business operation continues. Thus, the working capital cycle involves rotation of various constituents of the working capital. While managing the working capital, two characteristics of current assets should be kept in mind viz. 1. Short life span

2. Swift transformation into other form of current assets. Each constituent of current assets has comparatively very short life span. Investment remains in a particular form of current assets for a short period. The life span of current assets depends upon the time required in the activities of procurement, production, sales and collection and degree of synchronisation among them. A very short life span of current assets results into swift transformation into other form of current assets for a running business. These characteristics have certain implicationi. Decision regarding management of the working capital has to be taken frequently and on regular basis. ii. The various components of the working capital are closely related and mismanagement of any one component adversely affects the other components too. iii. The difference between the present value and the book value of profit is not significant. The working capital has the following components, which are in several form of current assets: 1. Stock of cash

2. Stock of raw material 3. Stock of finished goods 4. Value of debtors 5. Miscellaneous current assets like short term investment loans & advance


Factors Determining Working Capital Requirement

This is not a set of universally applicable rules to ascertain working capital needs of a business organisation. The factors which influence the need level are discussed below. Nature of Enterprise:The nature and the working capital requirement of an enterprise are interlinked. While a manufacturing industry has a long cycle of operation of the working capital, the same would be short in an enterprise involved in providing service. The amount required also varies as per the nature; an enterprise involved in production would required more working capital than a service sector enterprise. Manufacturing / Production Policy: Each enterprise in the manufacturing sectors has its own production policy, some follow the policy of uniform production even if the demand varies from time to time, and others may follow the principle of demand-based production in which production is based on the demand during that particular phase of time. Accordingly, the working capital requirement varies for both of them. Operation: The requirement of working capital fluctuates for seasonal business. The working capital needs of such businesses may increase considerably during the busy season and decrease during the slack season. Ice creams and cold drinks have great demand during summers; while winter the sales are negligible. Market Condition:If there is high competition in the chosen product category, then one shall need to offer sops like credit, immediate delivery of goods etc, for which the working capital requirement will be high. Otherwise, if there is no competition or less competition in the market then the working capital requirement will be low. Availability of Raw material:If raw material is readily then one need not maintain a large stock of the same, thereby reducing the working capital investment in raw material stock. On the other hand, if raw material is not readily available then a large inventory/ stock needs to be maintained, thereby calling for substantial investment in the same. Growth and Expansion:Growth and expansion in the volume of business result in enhancement of the working capital requirement. As business grows and expands, it needs a larger


amount of working capital. Normally the need for increased working capital funds precedes growth in business activities.

Manufacturing Cycle :The manufacturing cycle starts with the purchase of raw material and is completed with the production of finished goods. If the manufacturing cycle involves a longer period, the need for working capital would be more. At times, business needs to estimate the requirement of working capital in advance for proper control and management. The factor discussed above influence the quantum of working capital in the business. The assessment of working capital requirement is made keeping these factors in view. Each constituent of working capital retains its form for a certain period and that holding period is determined by the factors discussed above. So for correct assessment of the working capital cycle requirement, the duration at various stages of the working capital estimated. Thereafter, proper value is assigned to the respective current assets, depending on its level of completion. Each constituent of the working capital is valued on the basis of valuation enumerated above for the holding period estimated. The total of all such valuation becomes the total estimated working capital requirement. The assessment of the working capital should be accurate even in the case of small and micro enterprise where business operation is not very large. We know that working capital has a very close relationship with day-to-day operation of a business. Negligence in proper assessment of the working capital, therefore, cans affect the day-to day operation severely. It may lead to cash crisis and ultimately to liquidation. An inaccurate assessment of the working capital may cause either under-assessment or over assessment of the working capital and both of them are dangerous.



Due to lack of funds, payment of salaries may become irregular. Inadequate working capital may lead to non-payment of creditors amount in time. It will not allow the organization to produce the demanded number of items. Growth may be stunted. It may become difficult for the enterprise to undertake profitable project due to non-availability of working capital. Implementation of operating plans may become difficult and consequently the profit goals may be achieved. Cash crisis may emerge due to paucity of working funds. Optimum capacity utilisation of fixed assets may not achieved due to non availability of the working capital. The business may fail to honour its commitment in time, thereby adversely affecting its credibility. This situation may lead to business closure. The business may be compelled to buy raw material on credit and sell finished goods on cash. In the process it may end up with increasing cost of purchase and reducing selling by offering discounts. Both these situation would affect profitability adversely. Non-availability of stock due to non- availability of funds may result in production stoppage. While under assessment of working capital has disastrous implication on business, over assessment of working capital also has its own drawbacks.



Idle funds which will earn no profit. It may lead to unnecessary purchase. It may allow the change of misuse of funds. It reduces the overall efficiency of the organization.

Excess of working capital may result in unnecessary accumulation of inventory. It may lead to offer too liberal credit terms to buyers and very poor recovery system and cash management. It may make management complacent leading to its inefficiency. Over-investment in working capital makes capital less productive and reduces return on investment. Working capital is very essential for success of a business and, therefore, needs efficient management and control. Each of the components of the working capital needs proper management to optimise profit.



When the inflation rate is high, it will have its direct impact on the requirement of the working capital as explained below: 1. Inflation will cause to show the turnover figure at higher level even if there is no increase in the quantity of sales. The higher the sales mean the higher level of balance in receivables. 2. Inflation will result in increase of raw material prices and hike in payment for expenses and as a result, increase in balance of trade creditors and creditors for expenses. 3. Increase in valuation of closing stocks result in showing higher profit but without its realisation into cash causing the firm to pay higher tax, dividends and bonus. Thus will lead the firm in serious problem of fund shortage and firm may unable to meet its short-term and long term obligation. 4. Increase in investment is current assets means the increase in requirement of working capital without corresponding increase in sales or profitability of the firm.

5. Keeping in view of the above, the finance manager should be very careful about the impact of inflation in assessment of working capital requirement and its management.



Working capital in double shift means requirement of raw material will be doubled and other variable expenses will also increase drastically. With the increase in raw materials requirement and expenses, the raw material inventory and work-in- progress will increase simultaneously the creditors for goods and creditors for expenses balances will also increase. Increase in production to meet the increased demand which will also increase the stock of finished goods. The increase in sales means increase in debtors balance. Increase in production will result in increased requirement of working capital. The fixed expenses will increase with the working capital on double shift basis.


Zero working capital

The idea is to have zero working capital i.e. at all times the current assets shall equal the current liabilities. Excess investment in current assets is avoided and firm meets its current liabilities out of the matching current assets. As current assets ratio 1 and the quick ratio below 1, there may be apprehension about the liquidity, but if all current assets are performing and are accounted at their realisable values, these fears are misplaced. The firm saves opportunity cost on excess investment current assets and as bank cash credit limits are linked to the inventory levels, interest costs are also saved. There would be self-imposed financial discipline on the firm to manage their activities within their current liabilities and current assets and there may not be tendency to over borrow or divert funds.


Adequate Working Capital

Working capital is the lifeblood of the organization. Without working capital, the functioning of an organization will come to a halt. No business can run successfully without adequate amount of working capital. The main advantages of adequate working capital are as follows:Solvency of the business Adequate working capital helps in smooth running of the business. The generates revenue and maintains the solvency of the organization. Goodwill Sufficient working capital helps to makes prompt payments to the creditors, which maintain the goodwill of the organization. Easy Loan Organizations having adequate working capital are viewed by the banks as good candidates to offer the loan facilities. Cash Discounts Companies can make use of the discount facilities that come along with the repayment of the credit. Regular supply of Raw Material Adequate working capital helps to make regular payment to the supplier. Regular payment of Salaries It helps to make regular payments of salaries to the employees, thereby keeping their moral high.


Working Capital Leverage

One of the important objectives of the working capital management is by maintaining the optimum levels of the investment in current assets and reducing the level of current liabilities, the company can minimise the investment in working capital thereby improvement in Return on Capital employed is achieved. The term working capital leverage refers to the impact of level of working capital on companys profitability. The working capital management should improve the productivity of investment in current assets and ultimately it will increase the return on capital employed. Higher levels of investment in current assets than is actually required mean increase in the cost of interest charges on the short-term loans and working capital finance raised from banks etc, and will result in lower return on capital employed and vice versa. Working capital leverage measures the responsiveness of ROCE for charges in current assets. It is measured by applying the following formula. Working Capital leverage = C. A T.A Where, C.A = Current assets T.A = Total assets (i.e., Net fixed assets + Current assets) C.A = Change in Current assets C.A


Approaches to working Capital Finance

Every organization requires financing its working capital requirement. Generally, there are two source of finance. One is long- term source and the other is short-term source. Long term is considered less risky as the period is high and the amount repayment period is high and the amount of interest is low. The short-term sources are considered risky as they have to be repaying within a very short period and the interest rate is very high. 1. Conservative working capital Approach A conservative approach suggests carrying high levels of current assets in relation to sales. Surplus current assets enable the firm to absorb sudden variations in sales, production plans and procurement time without disrupting production plans. Additionally, the higher liquidity levels reduce the risk of insolvency. But lower risk translates into lower return. Larger investment in current assets leads to higher interest and carrying costs and encouragement for inefficient. But conservative policy will enable the firm to absorb day to day business risk. Under this approach long term financings covers more than the total requirement for working capital. The excess cash is invested in short term marketable securities and in need, theses securities are sold off in the market to meet the urgent requirement of working capital.


Secular Growth Rs.

Long-Term Financing

Seasonal Variations Investment Marketable securities Time

2. Aggressive working capital Approach Under the approach current assets are maintained just to meet the current liabilities without keeping any cushion for the variation in working capital needs. The core working capitals financed by long-term sources of capital and seasonal variations are met through short-term borrowings. Adoption of this strategy will minimise the investment in net working capital and ultimately it lower the cost of financing working capital. The main drawback of this approach is that it necessitates frequent financing and also increase risk as the vulnerable to sudden shocks.


Rs. Seasonal Variation Short term Financing

Secular growth

Long- term Financing


3. Matching working Capital approach Under this approaches, manager undertake only the required amount of risk. The fixed portion of working capital is financed from long-tem sources. Here the source of financing is matched with the components of working capital.


Financing working capital

Now let us understand the means to finance the working capital. Working capital or current assets are those assets, which unlike fixed assets change their form rapidly. Due to this nature, they need to be finance through short-term funds is also called current liabilities. The following are the also called current liabilities. The following are the major sources of raising short-term funds. 1. Suppliers Credit At times, business gets raw material on credit from the suppliers. The cost of raw material is paid after some time, i.e. upon completion of the credit period. Thus without having an outflow of cash the business is in position to use raw material and continue the activities. The credit given by the suppliers of raw material is for a short period and is considered

current liabilities. These funds should be used for creating current assets like stock of raw material, work in process, finished goods, etc. A. Bank Loan This is a major source for raising short-term funds. Banks extend loans to business to help them create necessary current assets so as to achieve the required business level. The loans are available for creating the following current assets. Stock of raw materials Stock of work in process Stock of finished goods Debtors.

Banks give short-term loans against these assets, keeping some security margin. The advances given by banks against current assets are short term in nature and banks have the right to ask for immediate repayment if they consider doing so. Thus, bank loans for creation of current assets are also current liabilities.

B. Promoters Fund It is advisable to finance a portion of current assets from the promoters funds. They are long term funds and therefore do not require immediate repayment. These funds increase the liquidity of the business.


Committee Recommendation for working capital finance.

1. Tandon committee recommendation The committee has three method of working out 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 least in the third method. First Method:Total Current assets (-) Current Liabilities (Other than long-term Borrowing) 25% of above from Long-term sources Balance MPBF ::****** ***** ::***** *****

MPBF: - Maximum Permissible Bank Finance

Second Method Total Current assets (-) 25% of above from Long-term sources :****** :*****

(-) Current Liabilities (Other than long-term Borrowing) Balance MPBF






Third Method

Total Current assets (-) Core Current assets From long-term source Real current assets (-) 25% of above from Long-term sources


***** *****



(-) Current Liabilities (Other than long-term Borrowing) Balance MPBF





*MPBF Maximum Bank Finance 2. Chore Committee recommendation. 3. Vaz Committee recommendation. 4. Nayak Committee recommendation: To give preference to village industries, tiny industries and other small scale units . For the credit requirement of village industries ,tiny industries and other SSI units up to aggregate funds based working capital credit limits up to Rs. 50 lacs from banking system, the norms for inventory and receivable as also the method of lending as per Tandon Committee will not apply . instead ,for such units the working capital limit will be computed at 20% of their projected annual turnover (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 provide by banking sectors, the remaining 1/5th representing borrowers contribution towards margin money for the working capital.


Method for estimating working capital requirement.

There are three methods for estimating the working capital requirement of a firm: 1. Percentage of Sales Method:It is traditional and simple method of determining the level of working capital and its components. In the 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. 2. 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 years. The method of least square is used in this regard. 3. Operating cycle method:The following methods are used in operating cycle approach: Total operating cycle Duration Approach Working capital requirement is estimated using the following formula Estimated cost of goods sold x Operating Cycle + desired cash 365 Estimated working capital Estimated cost of goods sold x Operating Cycle + desired cash 360 Individual component approach Detailed estimation is made using the individual component of the operating cycle. balance balance


Inventory Management
Introduction: Inventory includes all types of stocks. For effective working capital management, inventory needs to be managed effectively. The level of inventory should be such that the total cost of ordering and holding cost inventory is the least. Simultaneously, stock out costs should also be minimised. Business, therefore, should fix the minimum safety stock level, re-order level and ordering quantity so that the inventory cost is reduced and its management becomes efficient. Every organisation required to maintain inventory for smooth running of its activities. The investment in inventories constitutes the major proportion of the current assets. Therefore, it is essential to have proper control and management of inventories. The purpose of inventory management is to insure availability of material in right quality, in right time and at right place. Purpose of Following Inventory i. Transaction Motive:In order to have smooth and continuous operation, the organizations maintain inventory. ii. Precautionary Motive :In order to satisfy the fluctuating demands and supply as well as some emergency like strikes, etc., inventory is maintained. iii.Speculative Motive :In order to take advantage of the price changes, organizations sometimes maintain inventory to make profit.


Objective of Inventory Management:

In the context of inventory management, the firm can face the problem of meeting two conflicting needs: To maintain a large size of inventories of raw material and work-in-progress for efficient and smooth production and of finished goods for uninterrupted sales operation. To maintain a minimum investment in inventory to maximize profitability.

Both excessive and inadequate inventories are not desirable. These are two danger points, which the firm should avoid. The objective of inventory management should be to determine and maintain optimum level of inventory investment. The optimum level of inventory will lie between the two danger points of excessive and inadequate inventories. The firm should always avoid a situation of over investment and under investment in inventories. The major dangers of over investment are: Unnecessary tie up of the firms funds Excessive carrying cost Risk of liquidity

The excessive level of inventories consumes funds of the firm, which cannot be use for any other purpose, and thus, it involves an insurance, recording and inspection increase in proportion to the volume of inventory. These costs will impair the firms profitability further. Excessive inventories carried for long period increase chances of loss of liquidity. It may not be possible to sell inventories in time and full value. Raw materials are generally difficult to sell as the holding period increases. There are exceptional circumstances where it may pay to the company to hold stock of raw materials. This is possible under the conditions of inflation and scarcity. Another danger of carrying inventory is the physical deterioration of inventories in storage. An effective inventory management should in case of certain goods of raw material, deterioration occurs with the passage of time, or it may be due to mishandling and improper shortage facilities. Maintaining an inadequate level of inventories is also dangerous. The consequences of under- investment in inventories are: a. Production hold-ups, and


b. Failure to meet delivery commitments. Inadequate raw material and work-in-progress inventories will result in frequent production interruption; similarly, if finished goods are not sufficient to meet the demand of customer regularly, they may shift to competitors, which will amount to a permanent loss to the firm. The aim of inventory management, thus, should be to avoid excessive and inadequate levels of inventories and to maintain sufficient inventory for the smooth and sales operation effort should. Ensure a continuous supply of raw material to facilitate uninterrupted production. Maintain sufficient stock of raw material in period of short supply and anticipate price changes. Maintain sufficient finished goods inventory for smooth sales operation and efficient customer service. Control investment in inventories and keep it at an optimum level.


Inventory Management Techniques

Economic Order QuantityEOQ = (2AB) 2 (CS) 2 Where, EOQ = Economic Order Quantity. A B C S = Annual Consumption = Buying cost per order = Cost per unit = Storage and other inventory carrying cost

Fixation of Inventory LevelsThe following levels of inventory are fixed for efficient management of inventory: Re-Order Level: - Re-order level is the level of the stock availability when a new order should be raised. Re-Order level = Maximum usage X Maximum lead time

Minimum Stock Level: - Minimum stock level is the lower limit which the stock of any stock items should not normally be allowed to fall. Their level is also called safety stock or buffer stock level Minimum stock Level = Re-order level (Average or Normal Usage X average lead time)

Maximum Stock Level: - Maximum stock levels represent the upper limit beyond which the quantity of any item is not normally allowed to rise. Maximum level = Re-order level + EOQ (Minimum usage X Minimum lead time)

Danger level: - Danger level of stock is fixed below the minimum stock level and if stock reaches below this level. Danger Level = Average consumption X Lead time emergency Period.


VED Analysis ( Vital, Essential, & Desirable) FNSD Analysis ( Fast moving items, Normal moving items, Slow moving items & Dead stock)

Pareto Analysis ( 80 : 20 Rule) ABC Analysis Two Bin system Perpetual Inventory system Continuous stock taking Periodic stock taking system Input-Output Ratio Stock Turnover Ratio


Receivables Management
Given a choice, every business would prefer selling its produce on cash basis. However due to factors like trade policies, prevailing marketing conditions etc., businesses are compelled to sell their goods on credit. In certain circumstances, business may deliberately extend credit as a strategy of increasing sales. Extending credit means creating current assets in the form of Debtors or Accounts Receivable. Investment in this type of current assets needs proper and effective management as it to cost such as: a. Carrying cost :This cost includes the interest on capital blocked in the debtors balance the administration costs associated with the credit decision making and controlling of debtors balances, cost of keeping the records of credit sales and payment ,cost of collection of payments from customers , opportunity cost of cost of capital that can be employed elsewhere than in debtors balances.


Default risk:There are also costs associated with the risk of default a certain portion of debtors will never pay, and will become Bad debts which has to be written off of the profits of the firm. Thus the objective of any management policy pertaining to account receivable would be ensure that the benefit arising due to the receivables are more than the cost incurred for receivable and the gap between benefit and cost increases profit. An effective control of receivables helps a great deal in properly managing it. Each business should, therefore ,try to find out average credit extended to its client using the below given formula. Average credit = Extended (in days) Total amount of receivables Average credit sales per day

Each business should project expected sales and expected investment in receivables based on various factors, which influence the working capital requirement. Form this it would be possible to find out the average credit days using the above given formula. A business should continuously try to monitor the credit days and see that the average credit offered to clients is not crossing the budgeted period. Otherwise, the requirement of


investment in the working capital would increase and, as a result, activities may get squeezed. This may lead to cash crisis. Cash discount Cash discounts are offered by the seller to the customer to encourage early payment. This is to encourage payment before the end of the credit period cash discounts are cost to the seller and benefit to the buyer. Credit Rating Customer For credit rating customer the following information will be collected and processed, depending upon which the individual limits and the term will be fixed to each individual credit limits and the terms will be fixed each individual customer. The experience of sales force Financial statement of the customer Bank checking Companys own experience Statistical data available with credit rating agencies.

The credit manager should check the following five Cs CharacterCapacityCapitalCollateralConditionrelates to the customers willingness to pay The customer should have ability to pay his dues. The customer should have sufficient funds to pay the dues. The security available with the customer in paying the debt. The economic position of the customer.

Credit Policy- A firm establish its own credit policy for proper management of debtors, otherwise it will lead more outstanding balance in debtors account and the risk of bad debts will also arise.


Receivable collection policy

Sometimes a customer fails to pay on the due date. The following procedure will help in efficient collection of overdue debtors. A reminder A personal letter Several telephone calls Personal visit of salesman A telegram A visit from salesman responsible to customer A reminder to the sales person that commission is based on cash received not invoice sales. Restriction of credit. Use of collection agencies. Legal action : as a resort

Process of Receivables Management

The Following process will help in efficient management of the receivable. Take the opinion of the sales force and internal staff Frame the credit terms for the customer if credit is sanctioned. Established the initial creditworthiness. Check the credit before the despatch of consignment. Close monitoring of the credit terms and customer compliance. Develop the report for internal appraisal of the customer.


Cash Management
Cash represent the liquid form of assets in an organization. A business should also maintain adequate amount of cash to met its obligation . any shortage of cash will leads to disruption of operation. If excess cash is maintained then it does not earn any profit for the organisation . so maintaining adequate amount of cash , cash management is an important function of the organization. Cash is required to meet the business obligation and it is unproductive when it is not used. The following are the various aspects of cash management: a) Cash inflow and outflow

b) Cash flow within the firm c) Cash balance held by the firm

Following are the tools used by the organization: a) Cash Planning it is the technique to plan and control the use of cash. A projected cash flow statement is prepared showing the future payment and receipts of cash b) Cash forecast and budgeting: Cash budget is the most important tool in the hands of an organization to manage cash. It can be prepared on a daily basis, weekly basis or monthly basis. A cash budget typically shows the receipt of cash and the payment of cash during a future period. At the end, cash budget shows the cash balance for the period. Either it can be deficit or surplus cash balance. Cash is the liquid current assets. It is of vital importance to the daily operation of business. While the proportion of assets helps in the form of cash is very small, its efficient management is crucial to the solvency of the business. Therefore, planing cash and controlling its use are very important tasks. Cash budgeting is a useful device for this purpose.


Effects of cash Deficits

The cash balance shortage can result in the making of sub-optimal investment decision and sub-optimal financing decisions: Sub optimal investment decision :

This decision would include the disposal of profitable lines of division, inability profitable investment project, failure to maintain an adequate level of working capital. Sub optimal financing decision: These decisions would include the taking out of very expensive loans and being granted overdraft facilities subject to restrictive convents which could include personal guarantees from directors, restrictions on investment, and restriction on additional finance


Cash Budget
Cash budget incorporates estimate of future inflow and outflows of cash over a projected short period, which may usually be a year, a half or a quarter year. Effective cash management is facilitated if the cash budget is further broken down into month, week or even on daily basis. There are two component of cash budget: (1) (2) Cash Inflows and Cash outflows

The main sources for these flows are given hereunder: Cash inflow: (a) (b) (c) (d) (e) Cash sales Cash received from debtors Cash received from loans, deposit, etc. Cash receipt of the revenue income Cash received from sale of investment or assets.

Cash Outflows: (a) (b) (c) (d) (e) (f) Cash purchase Cash payment to creditors Cash payment for other revenue expenditure Cash payment for assets creation Cash payment for withdrawals, taxes Repayment of loan, etc.

In preparation of cash flow budgets the following points are considered: Credit period allowed to debtors Credit period allowed by creditors to the company for goods and services. Payments of dividends, taxation and capital expenditure etc., and the month when cash payments are expected to be made. Non- consideration of transaction which have no impact on cash flow e.g. Deprecation. The bank overdraft limits allowed. Dealing with the surplus cash e.g. Putting in marketable securities. Dealing with the cash deficit. Trends of sales.


Period of debt payment. Raising long-term funds during the course of cash budget etc.

Method of cash flow budgeting Cash flow budget is a detailed budget of income and cash expenditure incorporating both revenue and capital items. The cash flow budget can be prepared in the following ways:


Receipts and payment method :

In this method all the expected receipt and payment for budget period are considered. All the cash inflow and out flow of all functional budget including capital expenditure budget are considered. Accruals and adjustments in account will not affect the cash budget. 2. Adjusted Income Method:

In the method the annual cash flow are calculated by adjusted the sales revenues and cost figures for delays in receipts and payment and eliminating non-cash items such as deprecation. 3. Adjusted Balance sheet method:

In this method, the budgeted balance sheet is predicted by expressing each type of asset and short-term m liabilities as percentage of the expected sales.


Cash Management Models

The following method is useful in management of cash. Baumes Model:-

Baumols (1952) suggested that cash may be managed in the same way as any other inventory and that the inventory model reasonably reflect the cost- volume relationship as well as the cash flows. In the model, the carrying cost of holding cash-namely the interest forgone on marketable securities is balance against the fixed cost of transferring marketable securities to each, or vice-versa. The Banmols model find a correct balance by combining holding cost and transaction cost so as to minimise the total cost of holding cash. Baumols model assumes that the rate of cash usage is constant and known with certainty. The optimal level of C is found to be: C = (2BT)2 (I)2 Where, C B T I = optimal transaction size = fixed cost per transaction = Estimed cash payment during the period = interest on marketable securities p.a


This model can be applied only when the payment position can be reasonably Degree of uncertainty is high in predicting the cash flow transaction The model merely suggests only the optimal balance under a set of assumption

Miller-Orr Model: The Miller Orr-model (1966) specifies the following two control limit. H O Z Upper control Limit Lower control Limit The return point for cash balance

















CURRENT RATIOS 12 10 8 6 4 2 0 2006-07 2007-08 11.2 6.71 CURRENT RATIOS

Interpretation: A relatively high current ratio is an indication that the firm is liquid and has ability to pay its current obligations in time as and when they become due. On the other hand, a relatively low current ratio represents that the liquidity position of the firm is not good and the firm shall not be able to pay its current liabilities in time without facing difficulties. Current ratio has moved down from 11.2 to 6.71, which indicates that there has been deterioration in the liquidity position.







1,153237,069.61 (431570480)

1,076,464808.72 (825491821.69)






LIQUID RATIO 5 4 3 2 1 0 2006-07 2007-08 4.19 1.56 LIQUID RATIO



Usually, a high acid test ratio is an indication that the firm is liquid and has the ability to meet its current or liquid liabilities in time and on the other hand a low quick ratio represents that the firms liquidity position is not good. As a rule of thumb or as a convention quick ratio of 1:1 is considered satisfactory. Liquidity ratio is falling from 4.19 to 1.56 which means low quick ratio may have a good liquidity position if it has fast moving inventories.














ABSOLUTE LIQUID RATIO 0.05 0.04 0.03 0.02 0.01 0 2006-07 2007-08 0.045 0.029 ABSOLUTE LIQUID RATIO


Although receivables, debtors and bill receivables are generally more liquid than inventories, yet there may be doubts regarding their realization into cash immediately or in time. Here the company acid test ratio decreased and its is low than the thumb rule










767334308 4.46

773579205 4.76



STOCK TURNOVER RATIO 4.8 4.7 4.6 4.5 4.4 4.3 2006-07 2007-08 4.46 4.76 STOCK TURNOVER RATIO

Interpretation: Inventory turnover ratio measures the velocity of conversion of stock into sales. Usually, a high inventory turnover indicates efficient management of inventory because more frequently the stocks are sold; the lesser amount of money is required to finance the inventory. A low inventory turnover implies an inefficient management of inventory. We can clearly view that stock turnover ratio has improved.








3424503526 289844033 11.81

3682682347.11 146774094 25.09

DEBTORS TURNOVER RATIO 30 25 20 15 10 5 0

25.09 11.81 2006-07 2007-08


Interpretation: Debtors velocity indicates the number of times the debtors are turned during the year. Generally, the higher the value of debtors turnover the more efficient is the management of debtors/sales or more liquid are the debtors. Similarly, low debtors turnover implies inefficient management of debtors/sales and less liquid debtors. We can see debtors turnover ratio 25.09 is very high which may imply a firms inability due to lack of resources to sell on credit thereby losing sales and profits








365 11.81

365 25.09





15 2006-07 2007-08 31



The average collection period ratio represents the average number of days for which a firm has to wait before its receivables are converted into cash. It measures the quality of debtors. VARDHMANS average collection period is short as compared to last financial year. This implies better quality of debtors as short collection period implies quick payment by debtors.















14.9 12.77 2006-07 2007-08


Interpretation: The ratio indicates the velocity with which the creditors are turned over in relation to purchases. Generally, higher the creditors velocity better it is or otherwise lower the creditors velocity, less favorable are the results







365 12.77

365 14.9






24 29

2006-07 2007-08

Interpretation: The average payment period ratio represents the average number of days taken by the firm to pay its creditors. lower the ratio the better the liquidity position of the firm.

















Interpretation: This ratio indicates the number of times the working capital is turned over in the course of year. This ratio measures the efficiency with which the working capital is being used by a firm. A higher ratio indicates efficient utilization and low ratio indicates otherwise. But a very high ratio is not a good situation for any firm and hence care must be taken while interpreting the ratio




* 100


2006-07 221,753,922.93

2007-08 250,477,915.32







NET PROFIT 10.4 10.2 10 9.8 9.6 9.4 2006-07 2007-08 9.78 10.2 NET PROFIT

Interpretation: The ratio is very helpful as if the profit is not sufficient, the firm shall not be able to achieve a satisfactory return on its investment. This ratio also indicates the firm capacity to face












Higher the ratio, the better is the profitability


We first classify costs according to the three elements of cost: a) Materials b) Labour c) Expenses

Product and Period Costs: We also classify costs as either 1 2 Product costs: the costs of manufacturing our products; or Period costs: these are the costs other than product costs that are charged to, debited to, or written off to the income statement each period. The classification of Product Costs: Direct costs: Direct costs are generally seen to be variable costs and they are called direct costs because they are directly associated with manufacturing. In turn, the direct costs can include: Direct materials: plywood, wooden battens, fabric for the seat and the back, nails, screws, glue. Direct labour: sawyers, drillers, assemblers, painters, polishers, upholsterers Direct expense: this is a strange cost that many texts don't include; but (International Accounting Standard) IAS 2, for example, includes it. Direct expenses can include the costs of special designs for one batch, or run, of a particular set of tables and/or chairs, the cost of buying or hiring special machinery to make a limited edition of a set of chairs. Total direct costs are collectively known as Prime Costs and we can see that Product Costs are the sum of Prime costs and Overheads. Indirect Costs: Indirect costs are those costs that are incurred in the factory but that cannot be directly associate with manufacture. Again these costs are classified according to the three elements of cost, materials labour and overheads.


Indirect materials: Some costs that we have included as direct materials would be included here. Indirect labour: Labour costs of people who are only indirectly associated with manufacture: management of a department or area, supervisors, cleaners, maintenance and repair technicians

Indirect expenses: The list in this section could be infinitely long if we were to try to include every possible indirect cost. Essentially, if a cost is a factory cost and it has not been included in any of the other sections, it has to be an indirect expense. Here are some examples include: Depreciation of equipment, machinery, vehicles, buildings Electricity, water,

telephone, rent, Council Tax, insurance Total indirect costs are collectively known as Overheads. Finally, within Product Costs, we have Conversion Costs: these are the costs incurred in the factory that are incurred in the conversion of materials into finished goods. The classification of Period Costs: The scheme shows five sub classifications for Period Costs. When we look at different organisations, we find that they have period costs that might have sub classifications with entirely different names. Unfortunately, this is the nature of the classification of period costs; it can vary so much according to the organisation, the industry and so on. Nevertheless, such a scheme is useful in that it gives us the basic ideas to work on. Administration Costs: Literally the costs of running the administrative aspects of an organisation. Administration costs will include salaries, rent, Council Tax, electricity, water, telephone, depreciation, a potentially infinitely long list. Notice that there are costs here such as rent, Council Tax, that appear in several sub classifications; in such cases, it should be clear that we are paying rent on buildings, for example, that we use for manufacturing and storage and administration and each area of the business must pay for its share of the total cost under review. Without wishing to overly extend this listing now, we can conclude this discussion by saying that the costs of Selling, the costs of Distribution and the costs of Research are all accumulated in a similar way to the way in which Administration Costs are accumulated. Consequently, our task is to look at the selling process and classify the costs of running that process accordingly: advertising, market research, salaries, bonuses,


electricity, and so on. The same applies to all other classifications of period costs that we might use.

COST SHEET Particulars Opening Stock of Raw Material Add: Purchase of Raw materials Add: Purchase Expenses Less: Closing stock of Raw Materials Raw Materials Consumed Direct Wages (Labour) Direct Charges Prime cost (1) Add :- Factory Over Heads: Factory Rent Factory Power Indirect Material Indirect Supervisor Salary Drawing Office Salary Factory Insurance Factory Asset Depreciation *** *** *** Wages *** *** *** *** *** *** Amount *** *** *** *** *** *** *** *** SS Amount

Works cost Incurred


Add: Opening Stock of WIP Less: Closing Stock of WIP Works cost (2) Add:- Administration Over Heads:Office Rent Asset Depreciation General Charges Audit Fees Bank Charges Counting house Salary Other Office Expenses Cost of Production (3) Add: Opening stock of Finished Goods Less: Closing stock of Finished Goods Cost of Goods Sold Add:- Selling and Distribution OH:Sales man Commission Sales man salary Travelling Expenses Advertisement Delivery man expenses Sales Tax Bad Debts Cost of Sales (5)

*** *** ***

*** *** *** *** *** *** *** *** *** *** ***

*** *** *** *** *** *** *** ***


Profit (balancing figure) Sales

*** ***

Notes:1) Factory Over Heads are recovered as a percentage of direct wages 2) Administration Over Heads, Selling and Distribution Overheads are recovered as a percentage of works cost.


The below Annexure is an example for explanation


Balance sheet as on 31st March 2011 (Amount in Rs.) PParticulars SOURCES OF FUNDS 1) SHAREHOLDERS' FUNDS (a) Capital (b) Reserves and Surplus 18,719,280 78,340,733 97,060,013 2) DEFFERED TAX LIABILITY TOTAL APPLICATION OF FUNDS : 1) FIXED ASSETS (a) Gross Block (b) Less: Depreciation (c) Net Block 2) CURRENT ASSETS, LOANS AND ADVANCES (a) Sundry Debtors 80,712,804 37,856,420 31,057,596 16,894,562 14,163,034 29,767,979 14,710,986 15,056,993 2,478,428 99,538,441 18,719,280 37,754,372 56,473,652 2,794,350 59,268,002 2010-2011 2009-2010


(b) Cash and Bank Balances (c) Other Current Assets (d) Loans and Advances

34,043,520 152,228 733,516 115,642,068

51,690,326 857,753 923,709 91,328,208

LESS : CURRENT LIABILITIES AND PROVISIONS (a) Liabilities (b) Provisions 21,596,916 8,669,745 30,266,661 NET CURRENT ASSETS TOTAL 85,375,407 99,538,441 38,591,265 8,525,934 47,117,199 44,211,009 59,268,002


Profit and Loss Account for the period ended on 31 st March 2010 ( Amount in Rs.) Particulars I.INCOME Income from Services 96,654,902 55,550,649 2009-2010 2008-2009

Other Income TOTAL

2,398,220 99,053,122

2,285,896 57,836,545

II.EXPENDITURE Administrative and Other Expenses 81,334,750 75,599,719

Less: Expenditure Reimbursable under Operations TOTAL

49,474,305 31,860,445

49,349,892 26,249,827

III. PROFIT BEFORE DEPRECIATION AND TAXATION Provision for Depreciation IV. PROFIT BEFORE TAXATION Provision for Taxation - Current - Deferred

67,192,677 2,183,576 65,009,101

31,586,718 2,279,917 29,306,801

24,292,000 (315,921)

10,680,440 (67,359)

- Fringe Benefits




V. PROFIT AFTER TAXATION Surplus brought forward from Previous Year

40,586,359 26,699,257

18,259,580 44,951,851

VI. PROFIT AVAIALABLE FOR APPROPRIATIONS Transfer to General Reserve Interim Dividend Provision for Dividend Distribution Tax VII. BALANCE CARRIED TO BALANCE SHEET

67,285,616 NIL NIL NIL 67,285,616

63,211,431 4,495,185 28,078,920 3,938,069 26,699,257



CONCLUSION The study was a fruit giving job. It talks about effective working capital management which

is especially important in todays business environment. In order to survive an organization must be able to compete. In order to compete, firms will need to have cash available for growth, advertising and research and development of new products. In order to have cash available, a company needs to manage its working capital. Managing working capital is a delicate balance. If cash levels are too low a company risks running out of money and not being able to meet its obligations or stay solvent. If cash levels are too high, the company is not utilizing assets efficiently. The failure to effectively utilize assets can cost organizations money in lost opportunity for sales and investment. Additionally, managers who are constantly worried about whether or not bills will be paid on time have little time for innovation. Organization with Good Working Capital Management For Example:- Computer giant Dell is a company that practices good working capital management. Organization with Poor Working Capital Management Businesses that fail do not fail because of poor marketing, sales or inferior products or services. Some of the failed businesses do not succeed because of poor working capital management strategies. So working capital management should be practiced on regular basis for the smooth functioning of an organisation.


The Working Capital Management in the company can be improved to a great extent, if the following steps are undertaken: Introduction of budgetary control module in the ERP system (JD Edwards) for better control. Vendor rationalization for better pricing, delivery and credit terms improving working capital cycle. Regular analysis of slow moving, non-moving and obsolete items reducing inventory improving working capital management.




BIBLIOGRAPHY Books Referred: I M Pandey, Financial Management, Ninth Edition, Vikas Publishing House Pvt. Ltd. Dr.S.N.Maheshwari, Financial Management, Second Edition, Sultan Chand & Sons. Ravi M. Kishore, Cost Accounting,2008 Edition, Taxmann Allied Servises Pvt. Ltd