Working Capital Management Unit - IV

WORKING CAPITAL MANAGEMENT
Unit Structure
1. Introduction
2. Learning Objectives
3. Section Title
3.1 Significance of Working Capital
3.2 Operating Ccle
3.3 Concepts of Working Capital
3.! "inds of Working Capital
3.# Co$ponents of Working Capital
3.% I$portance of Working Capital &anage$ent
3.' (eter$inants of Working Capital )eeds
3.* +pproac,es to &anaging Working Capital
3.- &easuring Working Capital
3.1. Working Capital &anage$ent under Inflation
3.11 /fficienc Criteria
3.12 0uestions
3.13 Su$$ar
3.1! /1ercises
3.1# 2urt,er 3eadings
WORKING CAPITAL MANAGEMENT
1. INTRODUCTION
/ffective financial $anage$ent is t,e4outco$e5 a$ong ot,er t,ings5 of proper
$anage$ent of invest$ent of funds in business. 2unds can be invested for per$anent or
long4ter$ purposes suc, as ac6uisition of fi1ed assets5 diversification and e1pansion of
business5 renovation or $oderni7ation of plants and $ac,iner5 and researc, and
develop$ent.
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2unds are also needed for s,ort4te$ purposes5 t,at is5 for current operations of t,e
business. 2or e1a$ple5 if ou are $anaging a $anufacturing unit ou 8ill ,ave to arrange
for procure$ent of ra8 $aterial5 pa$ent of 8ages to our 8ork$en and for $eeting
routine e1penses. +ll t,e goods 8,ic, are $anufactured in a given ti$e period $a not be
sold in t,at period. 9ence5 so$e goods re$ain in stock5 e.g. ra8 $aterial5 se$i4finis,ed
:$anufacturing4in4process; goods and finis,ed $arketable goods. 2unds are t,us blocked
in different tpes of inventor. +gain5 t,e 8,ole of t,e stock of finis,ed goods $a not be
sold against read cas,< so$e of it $a be sold on 4 credit. T,e credit sales also involve
blocking of funds 8it, debtors till cas, is received or t,e bills are cleared.
Working Capital refers to a fir$=s invest$ent in s,ort4ter$ assets> vi7. cas,5 ?
s,ort4ter$ securities5 a$ount receivables :debtors; and inventories of ra8 $aterials5 8ork4
in4process and finis,ed goods. It can also be regarded as t,at portion of t,e fir$=s total
capital 8,ic, is e$ploed in s,ort4ter$ operations. It refers to all aspects of current assets
and current liabilities. In si$ple 8ords5 8e can sa t,at 8orking capital is t,e invest$ent
needed for carring out da to da operations of t,e business s$oot,l. T,e $anage$ent of
8orking capital is no less i$portant t,an t,e $anage$ent of lone4ter$ financial
invest$ent.
2. LEARNING OBJECTIVES
T,e objectives of t,is unit are to fa$iliari7e ou 8it, t,e>
@ concepts and co$ponents of 8orking capital
@ significance of and need for 8orking capital
@ deter$inants of t,e si7e of 8orking capital
@ criteria for efficienc in $anaging 8orking capital
. SECTION TITLE
.1 SIGNI!ICANCE O! WORKING CAPITAL
Aou 8ill ,ardl find a running business fir$ 8,ic, does not re6uire so$e a$ount
of 8orking capital. /ven a full e6uipped $anufacturing fir$ is sure to collapse 8it,out :a;
an ade6uate suppl of ra8 $aterials to process5 :b; cas, to $eet t,e 8age bill5 :c; t,e
capacit to 8ait for t,e $arket for its finis,ed products5 and :d; t,e abilit to grant credit to
its custo$ers. Si$ilarl5 a co$$ercial enterprise is virtuall good for not,ing 8it,out
$erc,andise to sell. Working capital5 t,us5 is t,e life4blood of a business. +s a $atter of
2
fact5 an organi7ation5 8,et,er profit4oriented or ot,er8ise5 8ill not be able to carr on da
to da activities 8it,out ade6uate 8orking capital.
.2 OPERATING C"CLE
T,e ti$e bet8een purc,ase of inventor ite$s :ra8 $aterial or $erc,andise; and
t,eir conversion into cas, is kno8n as operating ccle or 8orking capital ccle. T,e
successive events 8,ic, are tpicall involved in an operating ccle are depicted in 2igure
I. + perusal of t,e operating ccle 8ould reveal t,at t,e funds invested in operations are re4
ccled back into cas,. T,e ccle5 of course5 takes so$e ti$e to co$plete. T,e longer t,e
period of t,is conversion t,e longer is t,e operating ccle. + standard operating ccle $a
be for an ti$e period but does not generall e1ceed a financial ear. Obviousl5 t,e s,orter
t,e operating ccle5 t,e larger 8ill be t,e turnover of funds invested for various purposes.
T,e c,annels of t,e invest$ent are called current assets. So$eti$es t,e available funds
$a be in e1cess of t,e needs for invest$ent in t,ese assets5 e.g. inventor5 receivables and
$ini$u$ essential cas, balance. +n surplus $a be invested in govern$ent securities
rat,er t,an being retained as idle cas, balance.
. CONCEPTS O! WORKING CAPITAL
T,ere are t8o concepts of 8orking capital5 na$el Bross and )et concept.
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Gr#$$ W#r%in& C'(it')
+ccording to t,is concept5 8orking capital refers to t,e fir$=s invest$ent in current
assets< T,e a$ount of current liabilities is not deducted fro$ t,e total of current assets. T,is
concept vie8s Working Capital and aggregate of Current +ssets as t8o inter4c,angeable
ter$s. T,is concept is also referred to as CCurrent Capital= or CCirculating Capital=.
T,e proponents of t,e gross 8orking capital concept advocate t,is for t,e follo8ing
reasons>
i; Drofits are earned 8it, t,e ,elp of assets 8,ic, are partl fi1ed and partl current. To a
certain degree5 si$ilarit can be observed in fi1ed and current assets so far as bot, are
partl financed b borro8ed funds5 and are e1pected to ield earnings over and above t,e
interest costs. Logic t,en de$ands t,at t,e aggregate of current assets s,ould be taken to
$ean t,e 8orking capital.
ii; &anage$ent is $ore concerned 8it, t,e total current assets as t,e constitute t,e total
funds available for operating purposes t,an 8it, t,e sources fro$ 8,ic, t,e funds co$e.
iii; +n increase in t,e overall invest$ent in t,e enterprise also brings about an increase in
t,e 8orking capital.
Net W#r%in& C'(it')
T,e net 8orking capital refers to t,e difference bet8een current assets and current
liabilities. Current liabilities are t,ose clai$s of outsiders 8,ic, are e1pected to $ature for
pa$ent 8it,in an accounting ear and include creditors= dues5 bills paable5 bank
overdraft and outstanding e1penses. )et 8orking capital can be positive or negative. +
positive net 8orking capital 8ill arise 8,en current assets e1ceed current liabilities. +
negative net 8orking capital occurs 8,en current liabilities are in e1cess of current assets.
EW,enever 8orking capital is $entioned it brings to $ind current assets and current
liabilities 8it, a general understanding t,at 8orking capital is t,e difference bet8een t,e
t8oF.
C)et 8orking capital= is a 6ualitative concept 8,ic, indicates t,e li6uidit position
of t,e fir$ and t,e e1tent to 8,ic, 8orking capital needs $a be financed b per$anent
sources of funds. T,is needs so$e e1planation.
Current assets s,ould be sufficientl in e1cess of current liabilities to constitute a
$argin or buffer for obligations $aturing 8it,in t,e ordinar operating ccle of a business.
!
+ 8eak li6uidit position poses a t,reat to t,e solvenc of t,e co$pan and $akes it
unsafe. /1cessive li6uidit is also bad. It $a be due to $is$anage$ent of current assets.
T,erefore5 pro$pt and ti$el action s,ould be taken b $anage$ent to i$prove and
correct t,e i$balance in t,e li6uidit position of t,e fir$.
T,e net 8orking capital concept also covers t,e 6uestion of a judicious $i1 of long4
ter$ and s,ort4ter$ funds for financing current assets. /ver fir$ ,as a $ini$u$ a$ount
of net 8orking capital 8,ic, is per$anent. T,erefore5 t,is portion of t,e 8orking capital
s,ould be financed 8it, per$anent sources of funds suc, as o8ners= capital5 debentures5
long4ter$ debt5 preference capital and retained earnings. &anage$ent $ust decide t,e
e1tent to 8,ic, current assets s,ould be financed 8it, e6uit capital andGor borro8ed
capital. 4
Several econo$ists up,old t,e net 8orking capital concept. In support of t,eir
stand5 t,e state t,at>
In t,e long run 8,at $atters is t,e surplus of current assets over current liabilities.
It is t,is concept 8,ic, ,elps creditors and investors to judge t,e financial
soundness of t,e enterprise.
It is t,e e1cess of current assets over current liabilities 8,ic, can be relied upon to
$eet contingencies since t,is a$ount is not liable to be returned.
It ,elps to ascertain t,e correct co$parative financial position of co$panies ,aving
t,e sa$e a$ount of current assets.
It $a be stated t,at gross and net concepts of 8orking capital are t8o i$portant
facets of 8orking capital $anage$ent. Hot, t,e concepts ,ave operational significance for
t,e $anage$ent and t,erefore neit,er can be ignored. W,ile t,e net concept of 8orking
capital e$p,asi7es t,e 6ualitative aspect5 t,e gross concept. underscores t,e 6uantitative.
.* KINDS O! WORKING CAPITAL
Ordinaril5 8orking capital is classified into t8o categories>
2i1ed5 3egular or Der$anent Working Capital< and
Iariable5 2luctuating5 Seasonal5 Te$porar or Special Working Capital.
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!i+e, W#r%in& C'(it')
T,e need for current assets is associated 8it, t,e operating ccle 8,ic,5 as ou kno85 is
a continuous process. +s suc,5 t,e need for current assets is felt constantl. T,e $agnitude
of invest$ent in current assets ,o8ever $a not al8as be t,e sa$e. T,e need for
invest$ent in current assets $a increase or decrease over a period of ti$e according to t,e
level of production. )evert,eless5 t,ere is al8as a certain $ini$u$ level of current assets
8,ic, is essential for t,e fir$ to carr on its business irrespective of t,e level of operations.
T,is is t,e irreducible $ini$u$ a$ount necessar for $aintaining t,e circulation of t,e
current assets. T,is $ini$u$ level of invest$ent in current assets is per$anentl locked up
in business and is t,erefore referred to as per$anent or fi1ed or regular 8orking capital. It
is per$anent in t,e sa$e 8a as invest$ent in t,e fir$=s fi1ed assets is.
!)uctu'tin& W#r%in& C'(it')
(epending upon t,e c,anges in production and sales5 t,e need for 8orking capital5 over
and above t,e per$anent 8orking capital5 8ill fluctuate. T,e need for 8orking capital $a
also var on account of seasonal c,anges or abnor$al or unanticipated conditions. 2or
e1a$ple5 a rise in t,e price level $a lead to an increase in t,e a$ount of funds invested in
stock of ra8 $aterials as 8ell as finis,ed goods. +dditional doses of 8orking capital $a
be re6uired to face cut4t,roat co$petition in t,e $arket or ot,er contingencies like strikes
and lock4outs. +n special advertising ca$paigns organi7ed for increasing sales or ot,er
pro$otional activities $a ,ave to be financed b additional 8orking capital. T,e e1tra
8orking capital needed to support t,e c,anging business activities is called t,e fluctuating
:variable5 seasonal5 te$porar or special; 8orking capital.
2igures II and III give an idea about fi1ed and fluctuating 8orking capital.
2igure II> 2i1ed 8orking capital re$aining constant over ti$e
%
It is s,o8n in 2igure II t,at fi1ed 8orking capital is stable overti$e5 8,ile variable
&anage$ent of Working capital is fluctuating?so$eti$es increasing and so$eti$es
decreasing. T,e per$anent 8orking capital line5 ,o8ever5 $a not al8as be
,ori7ontal. 2or a gro8ing fir$5 per$anent 8orking capital $a also keep on increasing
over ti$e as ,as been s,o8n in 2igure III.
Hot, t,ese kinds of 8orking capital?per$anent and te$porar?are re6uired to
facilitate production and sales t,roug, t,e operating ccle5 but te$porar 8orking capital is
arranged b t,e fir$ to $eet li6uidit re6uire$ents t,at are e1pected to be te$porar.
.- COMPONENTS O! WORKING CAPITAL
Aou ,ave alread noted t,at 8orking capital ,as t8o co$ponents> Current assets
and Current liabilities. Current assets co$prise several ite$s. T,e tpical ite$s are>
i; Cas, to $eet e1penses as and 8,en t,e occur.
ii; +ccounts 3eceivables or sundr trade debtors.
iii; Inventor of>
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a; 3a8 $aterials5 stores5 supplies and spares5
b; Work4in4process5 and
c; 2inis,ed goods.
iv;+dvance pa$ents to8ards e1penses or purc,ases5 and ot,er s,ort4ter$ advances 8,ic,
are recoverable.
v; Te$porar invest$ent of surplus funds 8,ic, could be converted into cas, 8,enever
needed.
+part of t,e need for funds to finance t,e current assets $a be $et fro$ suppl of
goods on credit5 and defer$ent5 on account of custo$5 usage or arrange$ent5 of pa$ent
for e1penses. T,e re$aining part of t,e need for 8orking capital $a be $et fro$ s,ort4
ter$ borro8ing fro$ financiers like banks. T,ese ite$s arc collectivel called current
liabilities. Tpical ite$s of current liabilities are>
i; Boods purc,ased on credit I
ii; /1penses incurred in t,e course of t,e business of t,e organi7ation :e.g. 8ages or
salaries5 rent5 electricit bills5 interest etc.; 8,ic, are not et paid for.
iii; Te$porar or s,ort4ter$ borro8ings fro$ banks5 financial institutions or ot,er parties.
iv; +dvances received fro$ parties against goods to be sold or delivered5 or as s,ort4ter$
deposits.
v; Ot,er current liabilities suc, as ta1 and dividends paable.
Acti.it/ 1
a; List so$e $ain ite$s of 8orking capital in our organi7ation5 e.g. inventor of ra8
$aterial supplies5 stores etc. :under t,eir various ,eads;.
JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ
JJJJJJJJJJJJJJJ
b;. List so$e of t,e $ajor ite$s of operating e1penses in our organi7ation suc, as
Wages and salaries of staff.
JJJJJJJJJJJJJJJ
*
c; W,at is t,e a$ount of revolving fund or 8orking capital t,at organi7ation $aintains to
pa for t,e operating e1pensesK
JJJJJJJJJJJJJJJ
.0 IMPORTANCE O! WORKING CAPITAL
MANAGEMENT
Hecause of its close relations,ip 8it, da to da operations of a business5 a stud of
8orking capital and its $anage$ent is of $ajor i$portance to internal5 as 8ell as e1ternal
analsts. It is being increasingl reali7ed t,at inade6uac or $is$anage$ent of 8orking
capital is t,e leading cause of business failures. We $ust not lose sig,t of t,e fact t,at
$anage$ent of 8orking capital is an integral part of t,e overall financial $anage$ent and5
ulti$atel5 of t,e overall corporate $anage$ent. Working capital $anage$ent t,us t,ro8s
a c,allenge and s,ould be a 8elco$e opportunit for a financial $anager 8,o is read to
pla a pivotal role in ,is organi7ation.
)eglect of $anage$ent of 8orking capital $a result in tec,nical insolvenc and even
li6uidation of a business unit. Wit, receivables and inventories tending to gro8 and 8it,
increasing de$and for bank credit in t,e 8ake of strict regulation of credit in India b t,e
Central Hank5 $anagers need to develop a long4ter$ perspective for $anaging 8orking
capital. Inefficient 8orking capital $anage$ent $a cause eit,er inade6uate or e1cessive
8orking capital 8,ic, is dangerous.
+ fir$ $a ,ave to face t,e follo8ing adverse conse6uences fro$ inade6uate 8orking
capital>
1 Bro8t, $a be stunted. It $a beco$e difficult for t,e fir$ to undertake profitable
projects due to non4availabilit of funds.
2 I$ple$entation of operating plans $a beco$e difficult and conse6uentl t,e fir$=s
profit goals $a not be ac,ieved.
3 Operating inefficiencies $a creep in due to difficulties in $eeting even da to da
co$$it$ents.
! 2i1ed assets $a not be efficientl utili7ed due to lack of 8orking funds5 t,us lo8ering
t,e rate of return on invest$ents in t,e process.
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# +ttractive credit opportunities $a ,ave to be lost due to paucit of 8orking capital.
% T,e fir$ loses its reputation 8,en it is not in a position to ,onour its s,ort4ter$.
obligations. +s a result5 t,e fir$ is likel to face tig,t credit ter$s.
On t,e ot,er ,and5 e1cessive 8orking capital $a pose t,e follo8ing dangers>
1 /1cess of 8orking capital $a result in unnecessar accu$ulation of inventories5
increasing t,e c,ances of inventor $is,andling5 8aste5 and t,eft.
2 It $a provide an undue incentive for adopting too liberal a credit polic and slackening
of collection of receivables5 causing a ,ig,er incidence of bad debts. T,is ,as an adverse
effect on profits.
3 /1cessive 8orking capital $a $ake $anage$ent co$placent5 leading eventuall to
$anagerial inefficienc!
! It $a encourage t,e tendenc to accu$ulate inventories for $aking speculative profits5
causing a liberal dividend polic 8,ic, beco$es difficult to $aintain 8,en t,e fir$ is
unable to $ake speculative profits.
+n enlig,tened $anage$ent5 t,erefore5 s,ould $aintain t,e rig,t a$ount of 8orking
capital on a continuous basis. 2inancial and statistical tec,ni6ues can be ,elpful in
predicting t,e 6uantu$ of 8orking capital needed at different points of ti$e.
.1 DETERMINANTS O! WORKING CAPITAL NEEDS
T,ere are no set rules or for$ulas to deter$ine t,e 8orking capital re6uire$ents of a
fir$. T,e corporate $anage$ent ,as to consider a nu$ber of factors to deter$ine t,e Level
of 8orking capital. T,e a$ount of 8orking capital t,at a fir$ 8ould need is
affected not onl b t,e factors associated 8,en t,e fir$ itself but is also affected b
econo$ic5 $onetar and general business environ$ent. +$ong t,e various factors t,e
follo8ing are i$portant ones.
N'ture 'n, Si2e #3 Bu$ine$$
T,e 8orking capital needs of a fir$ are basicall influenced b t,e nature of its
business. Trading and financial fir$s generall ,ave a lo8 invest$ent in fi1ed assets5 but
re6uire a large invest$ent in 8orking capital. 3etail stores5 for e1a$ple5 $ust carr large
stocks of a variet of $erc,andise to satisf t,e varied de$and of t,eir custo$ers. So$e
$anufacturing businesses like tobacco5 and construction fir$s also ,ave to invest
1.
substantiall in 8orking capital but onl a no$inal a$ount in fi1ed assets. In contrast5
public utilities ,ave a li$ited need for 8orking capital and ,ave to invest abundantl in
fi1ed assets. T,eir 8orking capital re6uire$ents are no$inal because t,e ,ave cas, sales
onl and t,e suppl services5 not products. T,us5 t,e a$ount of funds tied up 8it, debtors
or in stocks is eit,er nil or ver s$all. T,e 8orking capital needs of $ost of t,e
$anufacturing concerns fall bet8een t,e t8o e1tre$e re6uire$ents of trading fir$s and
public utilities.
T,e si7e of business also ,as an i$portant i$pact on its 8orking capital needs. Si7e
$a be $easured in ter$s of t,e scale of operations. + fir$ 8it, larger scale of operations
8ill need $ore 8orking capital t,an a s$all fir$. T,e ,a7ards and contingencies in,erent
in a particular tpe of business also ,ave an influence in deciding t,e $agnitude of 8orking
capital in ter$s of keeping li6uid resources.
M'nu3'cturin& C/c)e
T,e $anufacturing ccle starts 8it, t,e purc,ase of ra8 $aterials and is co$pleted
8it, t,e production of finis,ed goods. If t,e $anufacturing ccle involves a longer period
t,e need for 8orking capital 8ill be $ore5 because an e1tended $anufacturing ti$e span
$eans a larger tie4up of funds in inventories. +n dela at an stage of $anufacturing
process 8ill result in accu$ulation of 8ork4in4process and 8ill en,ance t,e re6uire$ent of
8orking capital. Aou $a ,ave observed t,at fir$s $aking ,eav $ac,iner or ot,er suc,
products5 involving long $anufacturing ccle5 atte$pt to $ini$ise t,eir invest$ent in
inventories :and t,ereb in 8orking capital; b seeking advance or periodic pa$ents fro$
custo$ers.
Bu$ine$$ !)uctu'ti#n$
Seasonal and cclical fluctuations in de$and for a product affect t,e 8orking capital
re6uire$ent considerabl5 especiall te$porar 8orking capital re6uire$ents of t,e fir$.
+n up8ard s8ing in t,e econo$ leads to increased sales5 resulting in an increase in t,e
fir$=s invest$ent in inventor and receivables or book debts. On t,e ot,er ,and5 a decline
in t,e econo$ $a register a fall in sales and5 conse6uentl5 a fall in t,e levels of stocks
and book debts.
Seasonal fluctuations $a also create production proble$s. Increase in production level
$a be e1pensive during peak periods. + fir$ $a follo8 a polic of stead production in
all seasons to utili7e its resources to t,e fullest e1tent. T,is 8ill $ean accu$ulation of
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inventories in off4season and t,eir 6uick disposal in peak season. T,erefore5 financial
arrange$ents for seasonal 8orking capital re6uire$ent s,ould be $ade in advance. T,e
financial plan s,ould be fle1ible enoug, to take care of an seasonal fluctuations>
Pr#,ucti#n P#)ic/
If a fir$ follo8s stead production polic5 even 8,en t,e de$and is seasonal5 inventor
8ill accu$ulate during off4season periods and t,ere 8ill be ,ig,er inventor costs and
risks. If t,e costs and risks of $aintaining a constant production sc,edule are ,ig,5 t,e fir$
$a adopt t,e polic of varing its production sc,edule in accordance 8it, t,e c,anges in
de$and. 2ir$s 8,ose p,sical facilities can be utili7ed for $anufacturing a variet of
products can ,ave t,e advantage of diversified activities. Suc, fir$s $anufacture t,eir
$ain products during t,e season and ot,er products during off4season. T,us5 production
policies $a differ fro$ fir$ to fir$5 depending upon t,e circu$stances. +ccordingl5 t,e
need for 8orking capital 8ill also var.
Turn4#.er #3 Circu)'tin& C'(it')
T,e speed 8it, 8,ic, t,e operating ccle co$pletes its round :i.e. cas, ra8
$aterials finis,ed product accounts receivables cas,; plas a
decisive role in influencing t,e 8orking capital needs. :3efer to 2igure 1 on operating
ccle;
Cre,it Ter5$
T,e credit polic of t,e fir$ affects t,e si7e of 8orking capital b influencing t,e level
of book debts. T,oug, t,e credit ter$s granted to custo$ers5 in a large $easure depend
upon t,e nor$s and practices of t,e industr or trade to 8,ic, t,e fun belongs5 et it $a
endeavour to s,ape its credit polic 8it,in suc, constrains. + long collection period 8ill
generall $ean ting of larger funds in book debts. Slave collection procedures $a even
increase t,e c,ances of bad debts.
T,e 8orking capital re6uire$ents of a fir$ are also affected b credit ter$s ranted b
its creditors. + fir$ enjoing liberal credit ter$s 8ill need less 8orking capital.
Gr#6t7 'n, E+('n$i#n Acti.itie$
+s a co$pan gro8s5 logicall5 larger a$ount of 8orking capital 8ill be needed.
T,oug, it is difficult to state an fir$ rules regarding t,e relations,ip bet8een gro8t, in
t,e volu$e of a fir$=s business and its 8orking capital needs. T,e fact to recogni7e is t,at
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t,e need for increased 8orking capital funds $a precede t,e gro8t, ii business activities5
rat,er t,an follo8ing it. T,e s,ift in co$position of 8orking capital in a co$pan $a be
observed 8it, c,anges in econo$ic circu$stances and corporate crate practices. Bro8ing
industries re6uire $ore 8orking capital t,an t,ose t,at r static.
O(er'tin& E33icienc/
Operating efficienc $eans opti$u$ utili7ation of resources. T,e fir$ can $ini$ise its
need for 8orking capital b efficientl controlling its operating costs. Wit, increased
operating efficienc t,e use of 8orking capital is i$proved and pace of cas, ccle is
accelerated. Hetter utili7ation of resources i$proves profitabilit and ,elps in relieving t,e
pressure on 8orking capital.
Price Le.e) C7'n&e$
Benerall5 rising price level re6uires a ,ig,er invest$ent in 8orking capital. Increasing
prices at t,e sa$e levels of current assets need en,anced invest$ent .9o8ever5 fir$s 8,ic,
can i$$ediatel revise prices of t,eir products up8ards $a not face a severe 8orking
capital proble$ in periods of rising price levels. T,e effects of increasing price level $a5
,o8ever5 be felt differentl b different fir$s are to variations in individual prices. It is
possible t,at so$e co$panies $a not be affected b t,e rising prices5 8,ereas ot,ers $a
be badl ,it b it.
Ot7er !'ct#r$
T,ere are so$e ot,er factors 8,ic, affect t,e deter$ination of t,e need for 8orking
capital. + ,ig, net profit $argin contributes to8ards t,e 8orking capital. T,e net profit is a
source of 8orking capital to t,e e1tent it ,as been earned in cast. T,e cas, inflo8 can be
calculated b adjusting non4cas, ite$s suc, as depreciation. outstanding e1penses5 losses
8ritten off5 etc. fro$ t,e net profit.
T,e fir$=s appropriation polic5 t,at is5 t,e polic to retain or distribute profit use ,as a
bearing on 8orking capital. Da$ent of dividend consu$es cas, recourse and t,us reduces
t,e fir$=s 8orking capital to t,at e1tent. If t,e profits are retainL in t,e business5 t,e fir$=s
8orking capital position 8ill be strengt,ened.
In general5 8orking capital needs also depend upon t,e $eans of transport and
co$$unication. If t,e are not 8ell developed5 t,e industries 8ill ,ave to keep ,uge stocks
13
of ra8 $aterials5 spares5 finis,ed goods5 etc. at places of production. as 8ell as at
distribution outlets.
.8 APPROAC9ES TO MANAGING WORKING CAPITAL
T8o approac,es are generall follo8ed for t,e $anage$ent of 8orking capital :i; t,e
conventional approac,5 and :ii; t,e operating ccle approac,.
T7e C#n.enti#n') A((r#'c7
T,is approac, i$plies $anaging t,e individual co$ponents of 8orking capital :ii; t,e
inventor5 receivables5 paables5 etc.; efficientl and econo$icall so t,at t,ere are neit,er
idle funds nor paucit of funds. Tec,ni6ues ,ave been evolved for t,e &anage$ent of eac,
of t,ese co$ponents. In India5 $ore e$p,asis is given to t,e &anage$ent of debtors
because t,e generall constitute t,e largest s,are of t,e invest$ent in 8orking capital. On
t,e ot,er ,and5 inventor control ,as not et been practiced on a 8ide scale per,aps due to
scarcit of goods :or co$$odities; and ever rising prices.
T7e O(er'tin& C/c)e A((r#'c7
T,is approac, vie8s 8orking capital as a function of t,e volu$e of operating e1penses.
Mnder t,is approac, t,e 8orking capital is deter$ined b t,e duration of t,e operating
ccle and t,e operating e1penses needed for co$pleting t,e ccle. T,e duration of t,e
operating ccle is t,e nu$ber of das involved in t,e various stages5 co$$encing 8it,
ac6uisition of ra8 $aterials to t,e reali7ation of proceeds fro$ debtors. T,e credit period
allo8ed b creditors 8ill ,ave to be set off in t,e process. T,e opti$u$ level of 8orking
capital 8ill be t,e re6uire$ent of operating e1penses for an operating ccle5 calculated on
t,e basis of operating e1penses re6uired for a ear.
In India5 $ost of t,e organisations used to follo8 t,e conventional approac, earlier5 but
no8 t,e practice is s,ifting in favour of t,e operating ccle approac,. T,e banks 4 usuall
appl t,is approac, 8,ile granting credit facilities to t,eir clients.
.: ENSURING WORKING CAPITAL
T,e factors discussed in t,e preceding section influence t,e 6uantu$ of 8orking capital
in a business enterprise. 9o8 to deter$ine or $easure t,e a$ount of 8orking capital t,at
an enterprise 8ould need 8as discussed to so$e e1tent in Mnit % dealing 8it, funds flo8
analsis. Let us atte$pt to detennine!,e a$ount of 8orking capital needed b taking up an
illustration.
1!
I))u$tr'ti#n I
(eter$ine t,e $agnitude of 8orking capital :8it, t,e ,elp of t,e follo8ing particulars;
for Bujarat Triccles Li$ited5 a ne8l set up enterprise>
a; T,e profor$a cost s,eet s,o8s t,at t,e various ele$ents of cost bear t,e
under $entioned relations,ip to t,e selling price>
&aterials5 parts and co$ponents !.N
Labour 3.N
Over,ead 1.N
b; Droduction in 1-O* is esti$ated to be %5... triccles.
c; 3a8 $aterial5 parts and co$ponents are e1pected to re$ain in t,e stores for an
average period of one $ont, before issue to production.
d; 2inis,ed goods are likel to sta in t,e 8are,ouse for t8o $ont,s on an average before
being sold and delivered to custo$ers.
e; /ac, unit of production 8ill be in4process for ,alf a $ont, on an average>
f; 9alf of t,e sales are likel to be on credit. T,e debtors 8ill be allo8ed t8o $ont,s credit
fro$ t,e date of sale.
g; Credit period allo8ed b suppliers of ra8 $aterial5 parts and co$ponents is one $ont,.
,; T,e lag of pa$ent to labour is one $ont,.#.N of t,e over,ead consists of salaries
of non4production staff.
i; Selling price 8ill be 3s 2.. per triccle
j; +ssu$e t,at sales and production follo8 a consistent pattern.
k; +llo8 2.N to our co$puted figure for buffer cas, and contingencies.
Hefore 8e atte$pt to calculate t,e 8orking capital5 it 8ill be ,elpful to 8ork out t,e
follo8ing basic data>
a; T,e earl production is %5... triccles. 9ence5 $ont,l production 8ill be #..
triccles.
1#
b; T,e selling price per triccle is 3s. 2... T,e various ele$ents of cost :i.e. ra8 $aterial5
parts and co$ponents5 labour and over,eads; co$prise *.N :!.N P3.NP 1.N; of t,e
selling price. 9ence5 cost of production is 3s. 1%.
i.e. :2..1
1..
*.
;.
Gu;'r't Tric/c)e$ Li5ite,
St'te5ent #3 6#r%in& c'(it') re<uire5ent$
Current A$$et$=
Stock of ra8 $aterial5 parts and co$ponents 4 :in t,ousand 3s.;
:l &ont,; !.
Stock of finis,ed goods
:2 &ont,s;
#..11%.12 15%.
Work 4in4 Drocess
:1G2 &ont,;
#O1%.O1
1G2
!.
(ebtors :#.N of sales;
:2 $ont,s credit;
#..11G211%.1 *. 352.
Le$$ current )i'>i)itie$
Creditors :one $ont,; !.
Wages and Salaries>
Wages 3.
Salaries :Over,eads; # '#
25!#
+dd 2.N for buffer cas,
and contingencies !- !-
1%
+verage 8orking capital re6uired 25-!
T,e various figures ,ave been 8orked out as follo8s> 4
Cost of ra8 $aterial etc.
&ont,l production #.. Mnits
cost of $aterial etc.
per unit 3s*.
Deriod for 8,ic, stock
re6uired 1 $ont,
9ence a$ount locked up
#..1*.11 3s.!.5...
Cost of finis,ed goods
&ont,l Droduction #.. Mnits
Cost of production per unit 3s1%.4 :*.P%.P2.;
re6uired 2 $ont,s
9ence a$ount locked up #..1 1%.12 3s.15%.5...
W#r%4in4Pr#ce$$ St#c%
Cost of production per unit 3s. 1%.
re6uired
1G2
&ont,
9ence a$ount locked up
#..1 1%.
1G2
3s. !.5...
De>t#r$
Sales per $ont, #.. Mnits
Droportion of credit sales
1'
Cost of production per unit #. per cent
Deriod of credit 3s 1%.
9ence a$ount locked up 2 $ont,s
#..1
1G2
1%.12 3s.*.....
Creditors &anage$ent of
&ont,l production #.. Mnits
Cost of production per unit 3s. 1%.
Cost of ra8 $aterial etc. being 4
one ,alf 3s. *.
Deriod :or 8,ic, credit available 1 $ont,
9ence5 Working Capital unlocked
#..1*.11 3s.!.5...
W'&e$ 'n, S')'rie$
I; Wages
&ont,l production . #.. Mnits
Labour cost per unit 3s. %.
Lag period for pa$ent I $ont,
9ence5 Working Capital unlocked
#..1%.11 3s.3.5...
II? S')'rie$
Dortion of Salaries in over,eads
1G2
Over,ead cost per unit 3s. 2.
Lag period for pa$ent 1 &ont,
9ence5 8orking capital unlocked
#..12.1
1G2
11 3s.#5...
1*
.1@ WORKING CAPITAL MANAGEMENT UNDER IN!LATION
It is desirable to c,eck t,e increasing de$and for capital for $aintaining t,e e1isting
level of activit. Suc, a control ac6uires even $ore significance in ti$es of inflation. In
order to control 8orking capital needs in periods of inflation5 t,e follo8ing $easures $a
be applied.
Breater disciplines on all seg$ents of t,e production front $a be atte$pted as under>
a; T,e possibilit of using substitute ra8 $aterials 8it,out affecting 6ualit $ust be
e1plored in all seriousness. 3esearc, activities in t,is regard $a be undertaken5 8it,
financial assistance provided b t,e Bovern$ent and t,e corporate sector5 if an.
b; +tte$pts $ust be $ade to increase t,e productivit of t,e 8ork force b proper
$otivational strategies. Hore going in for an incentive sc,e$e5 t,e cost involved $ust be
8eig,ed against t,e benefit to be derived. T,oug, 8ages in accounting are considered a
variable cost5 t,e ,ave tended to beco$e partl fi1ed in nature due to t,e influence of
various legislative $easures adopted b t,e Central or State Bovern$ents in recent ti$es.
Increased productivit results in an increase in value added and t,is ,as t,e effect of
reducing labour cost per unit.
T,e $anaged costs s,ould be properl scrutini7ed in ter$s of t,eir costs and benefits.
Suc, costs include office decorating e1penses5 advertising5 $anagerial salaries and
pa$ents5 etc. &anaged costs are $ore or less fi1ed costs and once co$$itted t,e are
difficult to retreat. In order to $ini$ise t,e cost i$pact of suc, ite$s5 t,e $a1i$u$
possible use of facilities alread created $ust be ensured. 2urt,er t,e $anage$ent s,ould
be vigilant in sanctioning an ne8 e1penditure belonging to t,is cost area
T,e increasing pressure to aug$ent 8orking capital 8ill5 to so$e e1tent5 be neutrali7ed
if t,e span of t,e operating ccle can be i4educed. Breater turnover 8it, s,orter intervals
and 6uicker reali7ation of debtors 8ill go a long 8a in easing t,e situation.
Onl 8,en t,ere is a pressure on 8orking capital does t,e $anage$ent beco$e conscious
of t,e e1istence of slo84$oving and obsolete stock. T,e $anage$ent tends to adopt ad ,oc
$easures 8,ic, are grossl inade6uate. .T,erefore5 a clear cut polic regarding t,e disposal
of slo84$oving and obsolete stocks $ust be for$ulated and ad,ered to. In addition to t,is5
t,ere s,ould be an efficient $anage$ent infor$ation sste$ reflecting t,e stock position
fro$ various standpoints.
1-
T,e pa$ent to creditors in ti$e leads to building up of good reputation and conse6uentl
it increases t,e bargaining po8er of t,e fir$ regarding period of credit for pa$ent and
ot,er conditions. Drojections of cas, flo8s s,ould be $ade to see t,at cas, inflo8s and
outflo8s $atc, 8it, eac, ot,er. If t,e do not5 eit,er so$e pa$ents ,ave to be postponed
or purc,ase of so$e avoidable ite$s ,as to be deferred.
.11 E!!ICIENC" CRITERIA
I$proved profitabilit of S fir$5 to a great e1tent5 depends on its efficienc in
$anaging 8orking capital. + single criterion 8ould not be sufficient to judge or evaluate
t,e efficienc in a dna$ic area like 8orking capital.
S#5e #3 t7e ('r'5eter$ 3#r ;u,&in& t7e e33icienc/ in 5'n'&in& 6#r%in& c'(it') 're=
a; W,et,er t,ere is enoug, assurance for t,e creditors about t,e abilit of t,e co$pan to
$eet its s,ort4ter$ co$$it$ents on ti$e. 9ence5 a reliable inde1 is 8,et,er a co$pan
can settle t,e bills on due dates. T,e finance depart$ent ,as to plan in advance to $aintain
sufficient li6uidit to $eet $aturing liabilities.
b; W,et,er $a1i$u$ possible inventor turnover is ac,ieved. T,e adverse effect of
ineffective inventor $anage$ent $a not be offset even b t,e $ost efficient
$anage$ent of ot,er co$ponents of 8orking capital.
c; W,et,er reasonable credit is e1tended to custo$ers. T,is po8erful instru$ent to
pro$ote sales s,ould not be $isused. T,e ot,er side of t,e sa$e coin is receiving credit.
Hot, depend upon a co$pan=s strengt, as a seller and as a buer.
d; W,et,er ade6uate credit is obtained fro$ suppliers. It depends upon t,e co$pan=s
position in relation to its suppliers and t,e nature of suppl $arket i.e. 8,et,er t,ere is a
single supplier or an oligarc, or a large nu$ber of suppliers. Wit, coordination of efforts
buers can be in a position to negotiate co$petitive credit ter$s even if t,ere is a single
supplier and ,is abilit to control t,e $arket. +t ti$es t,e supplier i$poses t,e credit ter$s
as 1..N advance i.e. negative trade credit.
e; W,et,er t,ere are ade6uate safeguards to ensure t,at neit,er overtrading nor 4 under
trading takes place.
T,e follo8ing indices can be used for $easuring t,e efficienc in $anaging 8orking
capital>
Current R'ti# ACR?
2.
C3 Q Current +ssets G Current Liabilities
It indicates t,e abilit of a co$pan to $anage t,e current affairs of business. It is
useful to stud t,e trend of 8orking capital over a period of ti$e.
T,oug, t,e current ratio of 2>1 is considered ideal5 t,is $a ,ave to be $odified
depending on t,e peculiar conditions prevailing in a particular trade or industr.
It is not onl t,e 6uantu$ of current ratio t,at is i$portant but also its 6ualit. i.e.
e1tent to 8,ic, assets and liabilities are reall current.
Buic% R'ti# ABR?
03QLi6uid +ssetsGCurrent Liabilities
Li6uid assets $ean current assets $inus t,ose 8,ic, are not 6uickl realisable.
Inventor and stick debts are generall treated as non46uick assets.
T,e relations,ip of 1>1 bet8een 6uick assets and current liabilities is considered ideal5
but5 like current ratio5 it also varies fro$ industr to industr5 depending on t,e peculiar
conditions of a particular industr.
C'$7 t# Current A$$et$
If cas, alone is a $ajor ite$ of current assets t,en it $a be a good indicator of t,e
profitabilit of t,e organisation as cas, b itself does not earn an profit5 t,e proportion
s,ould usuall be kept lo8.
S')e$ t# C'$7 R'ti#
Sales to Cas, 3atioQSalesG+verage cas, balance during t,e period.
Cas, s,ould turned over as $an ti$es as possible5 in order ac,ieve $a1i$u$ sales 8it,
$ini$u$ cas, on ,and.
A.er'&e C#))ecti#n Peri#,
:(ebtorsGCredit Sales; O 3%#
T,is ratio e1plains ,o8 $an das of credit a co$pan is allo8ing to its custo$ers to
settle t,eir bills.
A.er'&e P'/5ent Peri#,
21
+verage pa$ent periodQ:CreditorsGCredit purc,ases; 1 3%#
It indicates ,o8 $an das of credit is being enjoed b t,e co$pan fro$ its
suppliers.
In.ent#r/ Turn#.er R'ti# AITR?
IT3QSalesG+verage Inventor
It s,o8s ,o8 $an ti$es inventor ,as turned over to ac,ieve t,e sales. Inventor
s,ould be $aintained at a level 8,ic, balances production facilities and sales needs.
W#r%in& C'(it') t# S')e$
Msuall e1pressed in ter$s of percentage5 it signifies t,at for an a$ount of sales a
relative a$ount of 8orking capital is needed. If an increase in sales is conte$plated it ,as
to be seen t,at 8orking capital is ade6uate. T,erefore5 t,is ratio ,elps $anage$ent in
$aintaining 8orking capital 8,ic, is ade6uate for t,e planned gro8t, in sales.
W#r%in& C'(it') t# Net W#rt7
Working CapitalG)et 8ort,
T,is ratio s,o8s t,e relations,ip bet8een 8orking capital and t,e funds belonging to
t,e o8ners. W,en t,is ratio is not carefull 8atc,ed5 it $a lead to>
a; Overtrading 8,en t,e conditions are in t,e ups8ing. Its s$pto$s being :I; 9ig,
Inventor Turnover 3atio :ii; Lo8 Current 3atio< or
>? Un,ertr',in& 67en t7e c#n,iti#n$ #3 5'r%et 're n#t &##,. It$ 5';#r $/5(t#5$ 're=
i; Lo8 Inventor Turnover 3atio
ii; 9ig, Current 3atio.
/fficient 8orking capital $anage$ent s,ould5 t,erefore5 avoid bot, overtrading and
undertrading.
Acti.it/ 2
&eet an +ccounting or 2inance /1ecutive of a business enterprise5 8,et,er in t,e Dublic
or t,e Drivate Sector5 and talk to ,i$ regarding t,e $anage$ent of 8orking capital in ,is
enterprise. Dlease tr to gat,er infor$ation on t,e follo8ing 6uestions>
a; W,at $et,ods does t,e enterprise e$plo for efficient $anage$ent of 8orking capitalK
22
JJJJJJ.
b; (o t,e $et,ods under :a; above include 3atio +nalsisK W,at ratios are being co$puted
and 8,K
JJJJJJ
c; W,at steps t,e organisation ,as taken in t,e recent past to i$prove t,e $anage$ent of
8orking capitalK
JJJJJJ
d; W,at are t,e $ajor proble$s faced b t,e enterprise regarding $anage$ent of 8orking
capitalK
JJJJJJ
.12 BUESTIONS !OR UNDERSTANDING
1 (iscuss t,e concept of 8orking capital. +re t,e gross and net concepts of 8orking capital
e1clusiveK /1plain.
2 (istinguis, bet8een fi1ed and fluctuating 8orking capitals. W,at is t,e significance of
suc, distinction in financing 8orking needs of an enterpriseK
23
3 (iscuss t,e significance of 8orking capital $anage$ent in a business enterprise. W,at
s,all be t,e repercussions if a fir$ ,as :a; s,ortage of 8orking capital and :b; e1cess
8orking capitalK
! + fir$ desires to finance its current assets entirel 8it, s,ort4ter$ loans. (o ou t,ink
t,is pattern of financing 8ould be in t,e interest of t,e fir$K Support our ans8er 8it,
cogent argu$ent.
# W,at factors a financial $anager 8ould ordinaril take into consideration 8,ile
esti$ating 8orking capital needs of ,is fir$K
% W,at is an operating ccle and ,o8 a close stud of t,e operating ccle is ,elpfulK
' 9o8 8ould ou as a 2inance &anager control t,e need of increased 8orking capital on
account of inflationar pressuresK )arrate so$e real4life e1a$ples ou $ig,t ,ave co$e
across.
* 9o8 8ould ou judge t,e efficienc of t,e $anage$ent of 8orking capital in a business
enterpriseK /1plain 8it, t,e ,elp of ,pot,etical data.
.1 SUMMAR"
+n enterprise needs funds to operate profitabl. T,e 8orking capital of a business
reflects t,e s,ort4ter$ uses of funds. +part fro$ t,e invest$ent in t,e long4ter$ assets suc,
as buildings5 plant and e6uip$ent5 funds are also needed for $eeting da to da operating
e1penses and for a$ounts ,eld in current assets. Wit,in t,e ti$e span of one ear t,ere is a
continuing ccle or turnover of t,ese assets. Cas, is used to ac6uire stock 8,ic, on being
sold results in an inflo8 of cas,5 eit,er i$$ediatel or after a ti$e lag in case t,e sales are
on credit. T,e rate of turnover of current assets in relation to total sales of a given ti$e
period is of critical i$portance to t,e total funds e$ploed in t,ose assets.
T,e a$ount needed to be invested in current assets is affected b $an factors and $a
fluctuate over a period of ti$e. &anufacturing ccle5 production policies5 credit ter$s5
gro8t, and e1pansion needs5 and inventor turnover are so$e of t,e i$portant factors
influencing t,e deter$ination of 8orking capital.
Inflation $agnifies t,e need for 8orking capital. T,e constant rise in t,e cost of inputs5
if not acco$panied 8it, corresponding increase in output prices5 puts an additional strain
on t,e $anage$ent. 9o8ever5 b taking several $easures on production front and b
keeping a strict 8atc, on $anaged costs and e1pediting collection of credit sales5 etc. t,e
2!
$anage$ent can contain or atleast $ini$ise t,e up8ard t,rusts for additional 8orking
capital.
T,e $anage$ent s,ould ensure t,e ade6uac and efficienc in t,e utilisation of 8orking
capital. 2or t,is purpose various ratios can be periodicall co$puted and co$pared against
t,e nor$s establis,ed in t,is regard.
.1* ECERCISES
1. +ssa$ Ti$ber Ltd.5 a ne8l founded co$pan5 ,as applied for a s,ort4ter$ loan to a
co$$ercial bank for financing its 8orking capital re6uire$ent. Aou are re6uested b t,e
bank to prepare a state$ent on t,e re6uire$ent for 8orking capita; for t,at co$pan. Aou
$a add 1.N to our esti$ated figure to cover for unforeseen contingencies. T,e projected
profit and loss account of t,e co$pan is as under
Sales 2#5......
Cost of goods sold 1*5..5...
Bross Drofit '5..5...
+dditional e1penses 15*.5...
Selling e1penses 15#.5... 353.5...
Drofit before ta1 35'.5...
Drovision for ta1 152.5...
Drofit after ta1 25#.5...
Cost of goods sold ,as been derived as follo8s>
&aterial sold -5%.5...
Wages R $anufacturing e1penses '5!.5...
(epreciation 35%.5...
2.5..5...
Less Stock of finis,ed goods
esti$ated at 1.N of production 25..5...
1*5..5...
2#
T,e figures above relate to t,e goods t,at 8ould be finis,ed :or co$pleted; and not to
8ork in process. Boods e6ual of 2.N of t,e ear=s production in ter$s of p,sical units are
e1pected to be in progress on an average5 re6uiring full $aterials but onl #. per cent of
ot,er e1penses. T,e co$pan intends to keep t8o $ont,s consu$ption of $aterial in stock.
+ll t,e e1penses 8ill be paid one $ont, in arrears. Suppliers of $aterial 8ould e1tend
one $ont, credit. Si1t per cent of t,e sales are esti$ated on cas, basis 8,ile t,e rest are
on t8o $ont,s credit. Sevent per cent of t,e inco$e ta1 ,as to be paid in advance in
6uarterl instal$ents. T,e co$pan 8ill re6uire 3s. #.5... cas, to $eet da4to4da needs
of business. 2or t,e purpose of t,e 6uestion ou $a ignore profit as a source of 8orking
capital.
An$6er t# t7e (r#>)e5$ E+erci$e
: TOTAL INVESTMENT IN
CURRENT ASSETS
'5'.5...
i; Less current liabilities>
*-51%'
Lag in pa$ent of e1penses Creditors *.5... 15%-51%'
+dd 1.N for contingencies %5..5*33
%.5.*3
Total 8orking capital re6uired %5%.5-1%
ii; (epreciation is not a cas, e1pense and ,ence it ,as been e1cluded fro$ cost of goods
sold for t,e purpose of deter$ining invest$ent in debtors. Si$ilarl5 depreciation ,as not
been taken into account in deter$ining invest$ent in
8ork4in4process and stock of finis,ed goods. 4
iii; 2or t,e purpose of deter$ining invest$ent in 8ork4in4process5 advertising and selling
e1penses are not relevant. 9ence5 t,e ,ave not to be taken into account.
iv; 2or t,e purpose of t,is 6uestion profit is to be ignored as a source of 8orking capital. +s
suc, inco$e ta1 ,as also been disregarded since inco$e ta1 is paid out of profit..
2%
.1- RE!ERENCES
Ian 9o$e5 Sa$es C.5 1-*#. 2unda$entals of 2inancial &anage$ent5 Drentice49all of
India> )e8 (el,i.
"ulkarni5 D.I.5 1-*#. 2inancial &anage$ent5 9i$alaa Dublis,ing> Ho$ba.
"uc,,al5 S.C.5 1-*#. 2inancial &anage$ent5 C,aitana Dublis,ing> +lla,abad.
SOURCESS O! WORKING CAPITAL
SOURCES O! WORKING CAPITAL
Sources of 8orking capital are $an. T,ere are bot, e1ternal or internal sources.
T,e e1ternal sources are bot, s,ort4ter$ and long4ter$. Trade credit5 co$$ercial banks5
finance co$panies5 indigenous bankers5 public deposits5 advances fro$ custo$ers5 accrual
accounts5 loans and advances fro$ directors and group co$panies etc. are e1ternal s,ort4
ter$ sources. Co$panies can also issue debentures and invite public deposits for 8orking
capital 8,ic, re e1ternal long ter$ sources. /6uit funds $a also be used for 8orking
capital. + brief discussion of eac, source is atte$pted belo8.
Trade credit is a s,ort ter$ credit facilit e1tended b suppliers of ra8 $aterials and
ot,er suppliers. It is a co$$on source. It is an i$portant source. /it,er open account credit
or acceptance credit $a be adopted. In t,e for$er as per business custo$ credit is
e1tended to t,e buer5 t,e buer is not goring an debt instru$ent as suc,. T,e invoice is
t,e basic docu$ent. In t,e credit sste$ a bill of e1c,ange is dra8n on t,e buer 8,o
accepts and returns t,e sa$e. T,e bill of e1c,ange evidences t,e debt. Trade credit is an
infor$al and readil available credit facilit. It is unsecured. It is fle1ible too< t,at is
advance retire$ent or e1tension of credit period can be negotiated. Trade credit $ig,t be
costlier as t,e supplier $a inflate t,e price to account for t,e loss of interest for delaed
pa$ent.
C#55erci') >'n%$ are t,e ne1t i$portant source of 8orking capital finance
co$$ercial banking sste$ in t,e countr is broad based and fairl developed. Straig,t
loans5 cas, credits5 ,pot,ecation loans5 pledge loans5 overdrafts and bill purc,ase and
discounting are t,e principal for$s of 8orking capital finance provided b co$$ercial
banks. Straig,t loans are given 8it, or 8it,out securit. + one ti$e lu$p4su$ pa$ent is
$ade5 8,ile repa$ents $a be periodical or one ti$e. Cas, credit is an arrange$ent b
8,ic, t,e custo$ers :business concerns; are given borro8ing facilit upto certain li$it5 t,e
2'
li$it being subjected to e1a$ination and revision ear after ear. Interest is c,arged on
actual borro8ings5 t,oug, a co$$it$ent c,arge for utili7ation $a be c,arged.
9pot,ecation advance is granted on t,e ,pot,ecation of stock or ot,er asset. It is a
secured loan. T,e borro8er can deal 8it, t,e goods. Dledge loans are $ade against p,sical
deposit of securit in t,e bank=s custod. 9ere t,e borro8er cannot deal 8it, t,e goods
until t,e loan is settled. Overdraft facilit is given to current account ,olding custo$ers tn
overdra8 t,e account upto certain li$it. It is a ver co$$on for$ of e1tending 8orking
capital assistance. Hill financing b purc,asing or discounting bills of e1c,ange is anot,er
co$$on for$ of financing. 9ere5 t,e seller of goods on credit dra8s a bill on t,e buer and
t,e latter accepts t,e sa$e. T,e bill is discounted per cas, 8ill t,e banker. T,is is a popular
for$.
!in'nce c#5('nie$ '>#un, in t7e c#untr/. +bout #.... co$panies e1ist at
present. T,e provide services al$ost si$ilar to banks5 t,oug, not t,e are banks. T,e
provide need based loans and so$eti$es arrange loans fro$ ot,ers for custo$ers. Interest
rate is ,ig,er. Hut ti$el assistance $a be obtained.
In,i&en#u$ >'n%er$ also abound and provide financial assistance. to s$all business
and trades. T,e c,ange e1orbitant rates of interest b ver $uc, understanding.
Pu>)ic ,e(#$it$ are unsecured deposits raised b businesses for periods e1ceeding a
ear but not $ore t,an 3 ears b $anufacturing concerns and not $ore t,an S ears b
non4banking finance co$panies. T,e 3HT is regulating deposit taking b t,ese co$panies
in order to protect t,e depositors. 0uantit restriction is placed at 2#N of paid up capital P
free services for deposits solicited fro$ public is prescribed for non4banking $anufacturing
concerns. T,e rate of interest ceiling is also fi1ed. T,is for$ of 8orking capital financing is
resorted to b 8ell establis,ed co$panies.
A,.'nce$ 3r#5 cu$t#5er$ are nor$all de$anded b producers of costl goods at
t,e ti$e of accepting orders for suppl of goods. Contractors $ig,t also de$and advance
fro$ custo$ers. W,ere sellers= $arket prevail advances fro$ custo$ers $a be insisted. In
certain cases to ensure perfor$ance of contract in advance $a be insisted.
Accru') 'cc#unt$ are si$pl outstanding suppliers of over,ead service
re6uire$ents and t,e like ta1es due5 dividend provision5 etc.
L#'n$ 3r#5 ,irect#r$5 loans fro$ group co$panies etc. constitute anot,er source
of 8orking capital. Cas, ric, co$panies lend to li6uidit crunc, co$panies of t,e group.
2*
C#55erci') ('(er$ are usance pro$issor notes negotiable b endorse$ent and
deliver. Since 1--. CDs ca$e to be introduced. T,ere are restrictive conditions as to issue
of co$$ercial paperR CDs are privatel placed after 3HI=s approval 8it, an fir$5
incorporated or not5 an bank or financial institution. Hig and sound co$panies generall
float CDs.
De>enture$ 'n, e<uit/ 3un, can be issued to finance 8orking capital so t,at t,e
per$anent 8orking capital can be $atc,ingl financed t,roug, long ter$ funds.
.0 TANDON COMMITTEE RECOMMENDATIONS
Tandon co$$ittee 8as appointed b 3HI in Sul 1-'! under t,e
c,airpersons,ip of S,ri. D.L. Tandon 8,o 8as t,e C,air$an of D)H t,en. ,e ter$s of
references of t,e co$$ittee 8ere>
i. To suggest guidelines for co$$ercial banks to follo8 up and supervise credit
fro$ t,e point of vie8 of ensuring proper use of funds and keeping a 8atc, on t,e
safet of advances.
ii. To suggest t,e tpe of operational data and ot,er infor$ation t,at $a be obtained
b banks periodicall fro$ t,e borro8ers and b t,e 3eserve bank fro$ t,e
lending banks.
iii. To $ake suggestions for prescribing inventor nor$s for different industries bot,
in t,e private and public sectors and indicate t,e broad criteria for deviating fro$
t,ese nor$s.
iv. To suggest criteria regarding satisfactor capital structure and sound financial
basis in relation to borro8ing.
v. To $ake reco$$endations regarding resources for financing t,e $ini$u$
8orking capital re6uire$ents.
vi. To suggest 8,et,er t,e e1isting pattern of financing 8orking capital re6uire$ents
b cas, credit G overdraft re6uires to be $odified5 if so5
vii. Suggest suitable $odification.
2indings of t,e co$$ittee> T,e co$$ittee studied t,e e1isting sste$ of e1tending
8orking capital finance to industr and identified follo8ing as its $ajor 8eaknesses>
2-
i. It is t,e borro8er 8,o decides ,o8 $uc, ,e 8ould borro8. T,e banker cannot do
an credit planning since ,e does not decide ,o8 $uc, ,e 8ould lend.
ii. ii; Hank credit5 instead of being taken as a supple$entar to ot,er source finance5
is treated as t,e first source of finance.
iii. iii; Hank credit is e1tended on t,e account of securit available and not according
to t,e level of operations of t,e borro8er5
iv. iv; T,ere is a 8rong notion t,at securit b itself ensures t,e safet of bank funds.
+s a $atter of fact5 safet essentiall lies in efficient follo84up of t,e industrial
operations of t,e borro8er.
Co$$it$ent 3eco$$endations> T,e report sub$itted b t,e Tandon co$$ittee
introduced $ajor c,anges in financing of 8orking capital b co$$ercial banks in India.
T,e report 8as sub$itted on -t, +ugust 1-'#.
!i+'ti#n #3 n#r5$. +n i$portant feature of t,e Tandon Co$$ittee=s
reco$$endations relate of fi1ation of nor$s for bank tending to industr.
W#r%in& c'(it') &'(
i. In order to reduce t,e dependence of businesses on banks fo< 8orking capital5
ceiling on bank credit to individual fir$s ,as been prescribed. +ccordingl5
businesses ,ave to co$pute t,e current assets re6uire$ent on t,e basis of
stipulations as to si7e. So5 flabb inventor5 speculative inventor cannot be
carried on 8it, bank finance. )or$al current liabilities5 ot,er t,an bank finance5
are also 8orked out considering industr and geograp,ical features and factors.
Working capital gap is t,e e1cess of current assets as per stipulations over nor$al
current liabilities :ot,er t,an bank assistance;. Hank assistance for 8orking capital
s,all be based on t,e 8orking capital gap5 instead of t,e current assets need of a
business. T,is tpe of financing assistance b banks 8as introduced on t,e basis
of reco$$endations of Tandon Co$$ittee.
ii. In.ent#r/ 'n, Recei.'>)e$ n#r5$= T,e co$$ittee ,as suggested nor$s rot 1#
$ajor industries.
3.
T,e nor$s proposed represent t,e $a1i$u$ level for ,olding ventures and
receivables. T,e pertain to t,e follo8ing>
i. 3a8 $aterials including stores and ot,er ite$s used in t,e process of $anufacture
ii; Stock in process
iii; 2inis,ed goods
iv; 3eceivables and bills discounted and purc,ased.
3a8 $aterials are e1pressed so $an $ont,s= cost of production.
Stock in process is e1pressed as so $an $ont,s= cost of production. 2inis,ed goods and
receivables are e1pressed as so $an $ont,s cost of sales and sales respectivel.
iii? Len,in& n#r5$> T,e lending nor$s ,ave been suggested in vie8 of t,e
reali7ation t,at t,e banker=s role as a lender is onl to supple$ent t,e borro8er=s resources.
T,e co$$ittee ,as suggested t,ree alternative $et,ods for 8orking out t,e $a1i$u$
per$issible level of bank borro8ings. /ac, successive $et,od reduces t,e involve$ent of
s,ort4ter$ credit to finance t,e current assets5 and increases t,e use of long ter$ funds.
T,e first $et,od provided for a $a1i$u$ '#N of bank funding of t,e 8orking
capital gap. T,at is5 at least 2#N of 8orking capital gap $ust be financed t,roug, long
ter$ fluids. T,e second $et,od provided for full bank
financing of 8orking capital gap based on '#N of current assets onl. T,at is5 2#N of
current assets s,ould be financed t,roug, long ter$ ,ind. 2#N of current assets is greater
t,an 2#N of 8orking capital gap. 9ence 2F $et,od $eant $ore non4bank finance for
8orking capital. T,e t,ird $et,od provided for long4ter$ fund financing of 8,ole
per$anent current asset and 2#N of varing current assets. T,at is bank financing 8ill be
li$ited to 8orking capital gap co$puted taking '#N of varing current assets onl.
T,e t,ree $et,ods are discussed belo8 to s,o8 per$itted bank funding of 8orking
capital>
31
Toda5 Tandon co$$ittee reco$$endations are not relevant. )o8= banks are
flus,ed 8it, fluids. Hut good borro8ers aren=t $an. Tandon co$$ittee reco$$endations
8ere relevant 8,en controlled econo$ prepared. Toda5 it open econo$. Hesides5 t,ese
reco$$endations 8ere relevant in t,ese ears 8,en $one $arket 8as tig,t and capital
rationing 8as needed. Toda5 t,e 8,ole environ$ent ,as c,anged. )o8 banks 8ant to
32
provide long4ter$ loans 8ell. +ctuall fro$ +pril 1#5 1--'5 all instructions relating to
$a1i$u$ per$issible bank finance :&DH2; 8ere 8it, dra8n.
.1 C9ORE COMMIT!EE RECOMMENDATIONS
2ollo8ing t,e Tandon Co$$ittee t,e C,ore Co$$ittee under t,e
C,air$ans,ip of S,ri. C.H. C,ore5 of 3HI5 8as constituted in +pril 1-'-. T,e ter$s of
reference 8ere>
I. to revie8 t,e 8orking of cas, credit sste$
II. to stud t,e gap bet8een sanctioned and utili7ed cas, credit levels
III. to suggest $easures to ensure better credit discipline
II. to suggest $easures to enable banks to relate credit li$its 8it, output levels.
T,e reco$$endations of t,e co$$ittee 8ere>
I. To continue t,e present sste$ of 8orking capital financing5 vi7.5 credit5 bill finance
and loan
II. If possible supple$ent cas, credit sste$ b bill and loan financing
III. To periodicall revie8 cas, credit levels
II. )o need to bifurcate cas, credit accounts into de$and loan and cas, credit
co$ponents.
I. To fi1 peak level and non4peak level li$its of bank assistance 8,erever5 seasonal
factors significantl affect level of business activit.
II. Horro8ers to indicate before co$$ence$ent re6uire$ent of bank credit 8it,in peak
and sanctioned. + variation of 1.N is to be tolerated.
III. /1cess or under utili7ation beond 1.N tolerance level is to be considered as
irregularit and corrective actions b3 taken up.
IIII. 0uarterl state$ent of budget and perfor$ance be sub$itted b all borro8ers ,aving
3s.#. lak, 8orking capital li$it fro$ t,e 8,ole of banking sste$.
IO. To discourage borro8ers depending on ad ,oc assistances over and above sanctioned
levels.
33
O. T,e second $et,od of financing of 8orking capital as suggested b t,e Tandon
co$$ittee be unifor$l adopted b banks.
OI. To treat as 8orking capital ter$ loan t,e e1cess of bank funding 8,en t,e s8itc, over
to t,e second $et,od bank financing is adopted and t,e borro8er is not able to repa
t,e e1cess loan.
MARAT9E COMMTTEE RECOMMENDATIONS
Later &arat,e Co$$ittee 8as appointed to suggest $eaningful credit &anage$ent
function of t,e 3HI. T,e reco$$endations are>
I. t,e second $et,od of financing Tandon co$$ittee s,ould be follo8ed
II. fast4track sste$ of advance releasing upto #.N of additional credit re6uired b
borro8ers pending 3HI=s approval of suc, en,anced credit aut,ori7ation
III. t,e bank s,ould ensure t,e reasonableness of projections as to sales5 current assets5
current liabilit5 net 8orking capital b looking into past perfor$ance and
assu$ptions of t,e future trend
II. t,e current assets and liabilities to be classified in confor$it 8it, t,e guidelines
issued b t,e 3HI. 2or instance current liabilit s,ould include an liabilit t,at needs
to be retired 8it,in 12 $ont,s fro$ t,e date of previous balance s,eet
I. a $ini$u$ of 1.33 current ratio s,ould be $aintained. T,at is5 2#N current assets
s,ould be financed fro$ long ter$ funds
II. a 6uarterl infor$ation sste$ :0ISO giving details as to project level of current
assets and current liabilities be evolved suc, t,at t,e infor$ation is given to t,e
banker in t,e 8eek preceding co$$ence$ent of t,e 6uarter to 8,ic, t,e data are
related5 adopted
III. a 6uarterl perfor$ance reporting sste$ giving data on perfor$ance 8it,in % 8eeks
follo8ing t,e end of t,e 6uarter to 8,ic, t,e data an related be adopted
IIII. a ,alf earl operating and fund flo8 state$ent to be sub$itted 8it, 2 $ont,s fro$
t,e close of t,e ,alf4ear
IO. t,e banker s,ould revie8 t,e borro8er=s accounts at least once a ear
3!
.: VAD COMMITTEE RECOMMENDATIONS
+s per I+U co$$ittee reco$$endations 8orking re6uire$ent is taken as 2#N of
annual turnover5 and t,e borro8er ,as to #N of projected turnover fro$ long4ter$ sources
as ,is contribution and 2.N of projected turnover 8ill be provided b t,e financing bank.
t,us bank finance for 8orking capital is totall de4linked fro$ current assets level. 9ence
t,e total departure fro$ Tandon and C,ore co$$ittee reco$$endations. Since 1#4!41--'5
banks 8ere instructed to evolve t,eir o8n $et,od suc, of turnover $et,od5 t,e cas, budget
sste$ or an ot,er sste$ including erst8,ile 8orking capital gap sste$5 for assessing
t,e 8orking capital needs of businesses.
.1@ BUESTIONS
1. (efine 8orking capital and describe its co$ponents
2. Hring out t,e kinds and concepts of 8orking capital and t,e nature and significance
eac, tpe of 8orking capital
3. W,at do ou $ean b 8orking capital $anage$entK W,at approac,es 8ould ou
adopt to ensure effectivenessK
!. (iscuss clearl t,e factors affecting t,e si7e and co$position of 8orking capital.
#. /1plain ,o8 8ould ou plan t,e 8orking capital re6uire$ents of a $anufacturing
undertaking.
%. W,at is operating ccleK /1plain its significance in t,e conte1t of esti$ation of
8orking capital and ensuring efficient $anage$ent of 8orking capital.
'. /1plain t,e different sources of 8orking capital finance.
*. (iscuss t,e ter$s of reference and reco$$endations of t,e Tandon Co$$ittee.
Bive t,e i$pact on financing of 8orking capital.
-. W,at are t,e reco$$endations of C,ore Co$$itteeK /1plain t,e$.
1.. T,e cost structure for a fir$ is> 3a8 $aterials 3s.1. per unit< labour 3s.* per unit<
over,ead 3s.l. per unit< profit 3s.' per unit. Credit allo8ed b creditors is 2 $ont,s
and allo8ed to debtors is 3 $ont,s. Ti$e lag in pa$ent of e1penses 1 $ont,.
Droduction and consu$ption are e6ual and even. 2or an e6ual production of
15*.5... units prepare 8orking capital budget. Cas, balance re6uired is 3s.S.5...
and provision for contingenc is re6uired at #N.
3#
11. + business ,as projected its turnover as 3s.12 crs. +s per Ia7 co$$ittee find its
8orking capital need and e1tent of bank finance.
12. )o8 bank finance for 8orking capital is de4linked fro$ current asserts. /1a$ine
i$plications of suc, a polic.
13. + fir$=s cost of goods sold is e1pected to be 3s.% crores. /1pected operating ccle
is -. das. It 8ants to keep a cas, balance of 1N of cost of goods sold. 2ind its
e1pected 8orking capital taking 3%. das in t,e ear.
.11 SUMMAR"
Working capital is t,e life sustaining sste$ of businesses. T,ere are different tpes
and concepts of 8orking capital. Der$anent 8orking capital5 te$porar 8orking capital5
gross 8orking capital and net 8orking capital are different tpes. T,ere are aggressive5
$atc,ing and conservative approac,es to financing 8orking capital. Trade credit5 bank
finance5 internal accruals5 debt and e6uit finances are used to finance 8orking capital.
.12 RE!ERENCES
1. 2inancial &anage$ent and Dolic 4 Ian 9o$e
2. 2inancial (ecision &aking ? 9a$pton
3. &anage$ent of 2inance 4 Weston and Hrig,a$
!. 2inancial &anage$ent 4 D.C,andra
#. 2inancial &anage$ent ? 3avi &. "is,ore
CAS9 MANAGEMENT
Unit Structure
1. Introduction
2. Learning Objectives
3. Section Title
3.1 W, is Cas, )eededK 4
3.2 (eter$ining Opti$al Cas, Halance
3.! Cas, &anage$ent
3.# Cas, Hudgeting
3%
3.# 9ave ou understand 6uestion
3.% Su$$ar
3.' /1ercises
3.* 2urt,er 3eadings
1. INTRODUCTION
In t,e previous unit5 various issues regarding $anage$ent of 8orking capital 8ere
discussed. it 8as e1plained t,at current assets for$ an i$portant aspect of 8orking
capital $anage$ent. In fact5 eac, current asset re6uires a detailed treat$ent to
understand t,e issues related to t,e need and $et,od of its $anage$ent. In t,is unit 8e
s,all discuss t,e planning and $anaging of cas, needs. It is needless to i$press upon
ou t,at cas,5 like blood strea$ in ,u$an bod5 is vital for a business. Cas, denotes t,e
li6uidit of a business enterprise and plas an i$portant role in nurturing and i$proving
t,e profitabilit of an organisation. It is5 t,erefore5 essential to $ake a proper esti$ate
of t,e cas, needs and plan for it so as to avoid tec,nical or legal insolvenc. 9ence5
effective $anage$ent ensuring ade6uate cas, is necessar. T,e cas, available 8it, t,e
organisation s,ould neit,er be s,ort nor too e1cessive.
2. LEARNING OBJECTIVES
T,e objectives of t,is unit are to ac6uaint ou 8it, t,e>
i$portance of $aintaining ade6uate li6uidit
concept of opti$u$ cas, balance
i$portance of cas, $anage$ent and t,e usefulness of cas, budgeting as a
tec,ni6ue of li6uidit planning
. SECTION TITLE
.1 W9" IS CAS9 NEEDEDE
T,e de$and for li6uid assets like cas,5 8,et,er b individuals or fir$s5 is nor$all
attributed to t,ree be,avioral $otives5 vi7.5 t,e transaction $otive5 t,e precautionar
$otive and t,e speculative $otive.
T,e transaction $otive for ,olding cas, is ,elpful in t,e conduct of everda
ordinar business suc, as $aking of purc,ases and sales. T,e a$ount of cas, needed5
3'
,o8ever5 differs fro$ business to business and fro$ fir$ to fir$ depending on t,e
fre6uenc of cas, transactions. 3etail trade5 for e1a$ple5 re6uires a ,ig,er ratio of cas,
to sales and of cas, to total assets. 2ir$s ,aving seasonal business 8ill need greater
a$ount of cas, during t,e season.
T,e precautionar $otive is concerned 8it, predictabilit of cas, inflo8s and
outflo8s. 9ig,er t,e predictabilit of cas,5 lo8er is t,e a$ount needed against
e$ergencies or contingencies. T,is $otive for ,olding cas, is also influenced b t,e
abilit of t,e fir$ to obtain additional cas, on s,ort notice t,roug, s,ort4ter$
borro8ings. + $ini$u$ reservoir of cas, $ust al8as be kept in ,and to $eet t,e
une1pected pa$ents and ot,er contingencies.
T,e speculative $otive for ,olding cas, is concerned 8it, availing t,e
opportunities arising fro$ une1pected develop$ents5 e.g. an abnor$al increase in
prices. 9o8ever5 keeping additional cas, for speculative purpose is not co$$on in
business.
.2 DETERMINING OPTIMAL CAS9 BALANCE
9olding of e1cessive cas, is a non4profitable proposition as idle cas, does not earn
an inco$e. Si$ilarl s,ortage of cas, $a deprive t,e business unit of availing t,e
benefits of cas, discounts5 and of taking advantage of ot,er favourable opportunities. It
$a even lead to loss of credit48ort,iness on account of default in paing liabilities
8,en t,e sa$e beco$e due. 9ence5 ever organisation5 irrespective of its si7e and
nature5 ,as to deter$ine t,e appropriate or opti$u$ cas, balance t,at it 8ould need.
+ fir$=s cas, balance5 generall5 $a not be constant overti$e. It 8ould t,erefore
be 8ort,8,ile to investigate t,e $a1i$u$5 $ini$u$ and average cas, needs over a
designated period of ti$e.
Aou are a8are t,at cas, is needed for various transactions of t,e organisation.
&aintenance of a cas, balance ,o8ever ,as an opportunit cost in t,e follo8ing 8as>
a; Cas, can be invested in ac6uiring assets suc, as inventor5 or for purc,asing
securities. Opportunities for suc, invest$ents $a ,ave to be lost if a certain $ini$u$
cas, balance is ,eld.
b; 9olding of cas, $eans t,at it cannot be used to offset financial risks fro$ t,e s,ort4
ter$ debts.
3*
c; /1cessive reliance on internall generated li6uidit can isolate t,e fir$ fro$ t,e
s,ort4ter$ financial $arket.
)o8 t,e financial $anager s,ould understand t,e benefits and t,e opportunit costs
for ,olding cas,. T,ereafter5 ,e $ust proceed to 8ork out a $odeT for deter$ining t,e
opti$al a$ount of cas,. 2irst of allK critical $ini$u$ cas, balance s,ould be
conceived belo8 8,ic, t,e fir$ 8ill incur definite and $easurable costs. +part fro$
risk aversion t,e e1istence of t,e $ini$u$ balance is justified b institutional
re6uire$ents suc, as credit ratings5 c,ecking accounts5 lines of credit.
T,e violation of $aintaining a $ini$u$ cas, balance 8ill create s,ortage costs
8,ic, 8ill be deter$ined b t,e actions of creditors on account of postponing t,eir
pa$ents or non availing of cas, discounts.
+t an point of ti$e a fir$=s :ending; cas, balance can be represented as follo8s>
/nding balance4Heginning Halance P 3eceipts ? (isburse$ents
If receipts and disburse$ents are e6ual for an unit of ti$e5 no proble$ is involved.
Ordinaril5 ,o8ever5 receipts $a be $ore t,an disburse$ents or vice versa5 ,ence5 t,e
ending balance 8ill keep on fluctuating . In actual practice receipts and disburse$ents
do var5 particularl in case of fir$s ,aving seasonal activities.
Suppose5 t,e receipts and disburse$ents are not snc,ronised but t,e variation is
predictable5 t,en t,e $ain proble$ 8ill be t,at of $ini$ising total costs. In case ou set
t,e balance too lo8 ou 8ill incur ,ig, transaction costs. If ou set t,e balance too ,ig,
ou 8ill lose interest 8,ic, ou can earn b investing cas, in $arketable
!i&ure 1= T7e O(ti5') W#r%in& C'$7 B')'nce
3-
securities. T,e deter$ination of opti$al cas, balance under t,ese conditions of kno8n
certaint is si$ilar to t,e inventor proble$. T,e costs of too little cas, :transaction costs;
can be balanced against t,e costs of too $uc, cas, :opportunit costs;. 2igure I clarifies
t,is position.
Doint C in 2igure I denotes t,e point 8,ere t,e su$ of t8o costs :opportunit and
transaction costs; is $ini$u$. /fficient $anage$ent s,ould tr to locate t,is point for
deter$ining t,e opti$al cas, balance. & is t,e point 8,ere 8orking cas, balance is
opti$al.
It is seldo$ t,at receipts and disburse$ents are co$pletel predictable. 2or a
$o$ent let us take one e1tre$e case 8,ere receipts and disburse$ents are co$pletel
rando$. + $odel can be developed using t,e Control T,eor and fi1 $a1i$u$ and
$ini$u$ opti$al balances as illustrated in t,e 2igure II. 2igure II> Cas, Halance Control
Li$its
Aou can observe fro$ 2igure II t,at t,e fluctuating cas, balance is on account of
rando$ receipts and disburse$ents. +t ti$e t1 t,e balance touc,es t,e upper control point.
+t t,is point t,e e1cess of cas, is invested in $arketable securities. T,e balance falls to
7ero point at ti$e t2 and at t,is stage $arketable securities ,ave to be sold to create cas,
balances. T,ese t8o control points la onl t,e $a1i$u$ and $ini$u$ balance. We can
conclude t,at 8,ere cas, flo8s :receipts and disburse$ents; are uncertain t,e principle 8ill
be> t,e greater t,e variabilit t,e ,ig,er t,e $ini$u$ cas, balance.
Acti.it/ 1
W7't 're t7e 5'in &r#u($ #3 e+(en,iture 3#r 67ic7 c'$7 i$ nee,e, in /#ur
#r&'ni$'ti#n=
!.
i; :a; on dail basis
JJJ...
:b; on $ont,l basis
:c; at irregular intervals
JJJ...
:d; at regular intervals5 ot,er t,an dail or $ont,l basis
JJJ...
ii; W,at are t,e $ain sources of cas, and 8,at arrange$ents e1ist for collection5 4
accounting and banking of cas, receipts.
JJJ...
. CAS9 MANAGEMENT
Cas, being a sensitive asset5 it ,as to be regulated according to needs. +n deficits
:or inade6uacies; s,ould be rectified and an e1cess a$ount be gainfull invested. Cas,
&anage$ent involves t8o $ain 6uestions
9o8 s,ould t,e storage5 collection and disburse$ent of cas, balances be $anagedK
9o8 s,ould t,e appropriate cas, balance be deter$ined5 and ,o8 s,ould an
te$poraril idle cas, be invested in interest earning assetsK
M'n'&in& C#))ecti#n$ 'n, Di$>ur$e5ent$
!1
T,e Cas, Ccle> In order to deal 8it, t,e proble$ of cas, $anage$ent 8e $ust
,ave an idea about t,e flo8 of cas, t,roug, a fir$=s accounts. T,e entire process of t,is
cas, flo8 is kno8n as Cas, Ccle. T,is ,as been illustrated in 2igures III and II. Cas, is
used to purc,ase $aterials fro$ 8,ic, goods are produced. Droduction of t,ese goods
involves use of funds for paing 8ages and $eeting ot,er e1penses. Boods produced are
sold eit,er on cas, or credit. In t,e latter case t,e pending bills are received at a later date.
T,e fir$ t,us receives cas, i$$ediatel or later for t,e goods sold b it. T,e ccle
continues repeating itself.
!2
T,e diagra$ in 2igure III onl gives a general idea about t,e c,annels of flo8 of cas,
&anaging Cas, in a business. T,e $agnitude of t,e flo8 in ter$s of ti$e is depicted in t,e
diagra$ given in 2igure II. T,e follo8ing infor$ation is reflected b 2igure II>
a; 3a8 $aterial for production is received 1. das after place$ent of order.
b; T,e $aterial is converted into goods for sale in 3' das :1#P2P2.; fro$ point H to /.
c; T,e pa$ent for $aterial purc,ased can be deferred to 1' das :1#P2; after it is received
:i.e. t,e distance of ti$e bet8een points H to (;5 assu$ing t,at it takes 2 das for collection
of pa$ent of t,e c,e6ue.
d; T,e a$ount of t,e bill for goods sold is received 3% das :32P2P2; after t,e sale of
goods as is depicted b duration of ti$e bet8een point 2 to 9.
e; T,e recover of cas, spent till point ( is $ade after #% das :2.P3.P2P2P2; as s,o8n
bet8een points ( to 9.
Acti.it/ 2
&eet a responsible e1ecutive of +ccounting and 2inance (epart$ent of a
$anufacturing organisation regarding t,e follo8ing> 4
a; W,at is t,e lengt, of its Cas, CcleK
Cas, Ccle is appro1i$atel of JJJJJJJJJJJJJJJJJJ.das.
b; (ra8 t,e se6uence of Cas, Ccle s,o8ing its successive events 8it, t,e respective
nu$ber of das.
JJJJ.
c; In6uire 8,et,er or not t,e organisation is satisfied 8it, its lengt, of cas, ccle. W,at
steps it proposes to take for reducing t,e Cas, CcleK
!3
d; 9o8 does t,e top $anage$ent judge t,e efficienc about cas, $anage$entK
e; (oes t,e organisation ,ave an i$prest sste$ of cas,K W,at are t,e $ajor
objectives and procedures of t,e sste$K .
S(ee,in& u( C#))ecti#n$
In order to $ini$ise t,e si7e of cas, ,olding5 t,e ti$e gap bet8een sale of goods and t,eir
cas, collection s,ould be reduced and t,e flo8 be controlled. )or$all5 certain factors
creating ti$e lags are beond t,e control of $anage$ent. Aet5 in order to i$prove t,e
efficienc5 attention s,ould be paid to t,e follo8ing.
+ll cas, collected s,ould be directl deposited in one account. If t,ere are $ore t,an one
collection centers5 all cas, receipts s,ould be re$itted to t,e $ain account 8it,. top speed.
Co$pared to a single collection centre5 t,e aggregate re6uire$ent for cas, 8ill be $ore
8,en t,ere are several centers. Concentration of collections at one place 8ill t,us per$it
t,e fir$ to store its cas, $ore efficientl.
T,e ti$e lag bet8een t,e dispatc, of c,e6ue b t,e custo$er and its credit to our
account 8it, t,e bank s,ould be reduced. So$e fir$s 8it, large collection transactions
introduce lock bo1 sste$. In t,is sste$ t,e post bo1es are ,ired at different centers 8,ere
cas,Gc,e6ues can be dropped in. T,e local banker can dail collect t,e sa$e fro$ t,e
lockers. T,e collecting bank is paid service c,arges. In order to $ini$ise ti$e5 banks $a
be asked to devise $et,ods for speeding up t,e collection of cas,.
Rec#.erin& Due$
+fter sale of goods on credit5 eit,er on account of convention or for pro$oting
sales5 receivables are created. It $a ,o8ever be useful to reduce t,e a$ount block in
receivables b seeing to it t,at t,e do not beco$e overdue accounts. Incentive in t,e for$
of discounts for earl pa$ent $a be given. &ore i$portant t,an ant,ing else is a
constant follo84up action for t,e recover of dues. T,is 8ill i$prove position of cas,
balance.
!!
C#ntr#))in& Di$>ur$e5ent$
)eedless to assert t,at speeding up of collections ,elps conversion of receivables
into cas, and t,us reduces t,e financing re6uire$ents of t,e fir$. Si$ilar kind of benefit
can be derived b delaing disburse$ents. Trade credit is a costless source of funds for it
allo8s us to pa t,e creditors onl after t,e period of credit agreed upon. T,e dues can be
8it,,eld till t,e last date. T,is 8ill reduce t,e re6uire$ent for ,olding large cas, balances.
So$e fir$s $a like to take advantage of c,e6ue book float 8,ic, is t,e ti$e gap bet8een
t,e date of issue of a c,e6ue and t,e actual date 8,en it is presented for pa$ent directl or
t,roug, t,e bank.
In.e$t5ent #3 I,)e C'$7 B')'nce$
T8o ot,er i$portant aspects in cas, $anage$ent are ,o8 to deter$ine appropriate
cas, balance and ,o8 to invest te$poraril idle cas, in interest earning assets or securities.
T,e first part relating to t,e t,eor of deter$ining appropriate cas, balance ,as alread
been discussed earlier. )o8 8e s,all discuss t,e invest$ent of idle cas, balances on
te$porar basis. Cas, b itself ields no inco$e. If 8e kno8 t,at so$e cas, 8ill be in
e1cess of our need for a s,ort period of ti$e5 8e $ust invest it for earning inco$e 8it,out
depriving ourselves of t,e benefit of li6uidit of funds. W,ile doing t,is5 8e $ust 8eig,
t,e advantages of carring e1tra cas, :i.e. $ore t,an t,e nor$al re6uire$ent; and t,e
disadvantages of not carring it. T,e carring of e1tra cas, $a be necessitated due to its
re6uire$ent in future5 8,et,er predictable or unpredictable. T,e e1perience indicates t,at
cas, flo8s cannot be predicted 8it, co$plete accurac. Co$petition5 tec,nological
c,anges5 une1pected failure of products5 strikes and variations in econo$ic conditions
$ake it difficult to predict cas, needs accuratel.
In.e$t5ent Criteri'
W,en it is realised t,at t,e e1cess cas, 8ill re$ain idle5 it s,ould be invested in
suc, a 8a t,at it 8ould generate inco$e and at t,e sa$e ti$e ensure 6uick re4conversion
of invest$ent in cas,. W,ile c,oosing t,e c,annels for invest$ent of an idle cas, balance
for a s,ort period5 it s,ould be seen t,at :i; t,e invest$ent is free fro$ default risk5 t,at is5
t,e risk involved due to t,e possibilit of default in ti$el pa$ent of interest and
repa$ent of principal a$ount< :ii; t,e invest$ent s,all $ature in s,ort
span of ti$e< and :iii; t,e invest$ent ,as ade6uate $arketabilit. &arketabilit refers to t,e
ease 8it, 8,ic, an asset can be converted back into cas,. &arketabilit ,as t8o
!#
di$ensions44price and ti$e48,ic, are inter4related. If an asset can be sold 6uickl in large
a$ounts at a price deter$inable in advance t,e asset 8ill be regarded as ,ig,l $arketable
and ,ig,l li6uid. T,e assets 8,ic, largel satisf t,e aforesaid criteria are> Bovern$ent
Securities5 Hankers= +cceptances and Co$$ercial Daper.
+ctivit 3
(iscuss 8it, t,e C,ief /1ecutive of +ccounting and 2inance depart$ent of our
organisation regarding t,e broad policies and procedures follo8ed in t,e sp,ere of cas,
$anage$entK
.* CAS9 BUDGETING
Dlanning cas, and controlling its use are ver i$portant tasks. If t,e future cas,
flo8s are not properl anticipated5 it is likel t,at idle cas, balances $a be created 8,ic,
$a result into unnecessar tosses. It $a also result in cas, deficits and conse6uent
proble$s. T,e financial $anager s,ould5 t,erefore5 plan t,e cas, needs and uses. Hudget is
a useful device for t,is purpose.
Cas, budget basicall incorporates esti$ates of future inflo8s and outflo8s of cas,
over a projected s,ort period of tine 8,ic, $a usuall be a ear5 a 6uarter or a ,alf4ear.
/ffective cas, $anage$ent is facilitated if t,e cas, budget is furt,er broken do8n into
$ont,5 8eek or even dail basis.
Pre('rin& ' C'$7 Bu,&et
T,ere are t8o co$ponents of a cas, budget?cas, inflo8s and cas, outflo8s. In
bot, t,ese co$ponents t,ere are t8o tpes of flo8s5 vi7. operating cas, flo8s and financial
cas, flo8s. So$e co$$on ele$ents of eac, are as follo8s>
Cas, Inflo8s 4 :a; Operating> cas, sales5 receivable collections.
:b; 2inancial> interest receipts5 sale of $arketable securities5
issue of ne8 securities.
Cas, Outflo8s 4 :a; Operating> 8age pa$ents5 pa$ents of bills and
accounts paable5 and capital e1penditure
:b; 2inancial> dividend pa$ents5 interest pa$ents5
rede$ption of securities5 loan repa$ents5 purc,ase of
$arketable securities5 ta1 pa$ents.
!%
S')e$ W#r% S7eet
Sales bring in a $ajor part of cas, inflo8s. +ll sales $a not be against cas,< credit
sales are 6uite co$$on. /ac, business establis,$ent ,as its o8n credit polic for
pro$oting sales. /ven 8,en care is taken to ensure t,at credit sales do not e1ceed t,e
per$itted percentage of total sales and t,at debtors do not default in paing bills in ti$e5 it
is a co$$on e1perience t,at t,e total a$ount of sales is recovered over a period of ti$e.
Let us take an e1a$ple. In a business5 1. per cent of t,e sales value in a5 $ont, is
realised in cas, during t,e sa$e $ont,< #. per cent is received in t,e ne1t $ont,< and t,e
re$aining !. per cent in t,e $ont, after t,at. We can find out t,e esti$ated cas, inflo8
due to sales for ever $ont, 8it, t,e ,elp of t,e data on past and future sales.
In a si$ilar $anner5 a Durc,ase Work S,eet can also be prepared to find out t,e
esti$ated total cas, disburse$ents for purc,ases. 2or e1a$ple5 #. per cent of current
$ont,=s purc,ases $abe paid for in t,e current $ont,5 !. per cent in t,e ne1t $ont, and
t,e re$aining 1. per cent in t,e $ont, after t,at.
+ profor$a Cas, Hudget 8it, ,pot,etical figures is presented in Table 1
T'>)e I=
Pr#3#r5' 3#r C'$7 Bu,&et
!'
I ))u$tr'ti#n 1
Aou are appointed as t,e 2inance &anager of Orissa Dol$ers Li$ited. Drepare a
cas, budget for si1 $ont,s of 1-1* 8it, t,e ,elp of t,e follo8ing infor$ation>
a; Sales on credit5 cost of $aterial and 8ages are budgeted as follo8s :figures for
)ove$ber and (ece$ber of t,e previous ear are t,e actual figures for t,ose 4
$ont,s;.
&ont,s Credit sales Cost of $aterial Wages
)ov 325... #5... 1.5...
(ec. 325... %5... 125...
San. 2*5... #5... 1.5...
2eb. 315... '5... 115...
&arc,. 3!5... *5... 125...
+pril 2-5... #5... -5...
!*
&a 3.5... %5... 115...
Sune 3%5... '5... 125...
b; 2i1ed over,eads a$ount to 3s. 1.5... per $ont,.
c; Dreference dividend of 3s. *5... for t,e ,alf ear 8ill be due in Sune.
d; Inco$e ta1 a$ount of 3s. 1.5... is paable in Sanuar.
e; Drogress pa$ents under a building contract are due as follo8s>
&arc, 31 3s. 125...
&a 31 3s. 1#5...
f; Boods are sold on ter$s> )et cas, in t,e follo8ing $ont,. /1perience indicates t,at
*.N of debtors pa 8it,in t,e period of credit and t,e re$ainder do not pa until t,e
follo8ing $ont,.
g; Cost of $aterial is paable in t,e $ont, follo8ing t,e $ont, in 8,ic, t,e cost is
incurred. 9alf of t,e purc,ases are subject to a 2N discount and t,e re$aining are
paable net.
,; T,e co$pan pas all its accounts pro$ptl.
!-
C'$7 Bu,&et
It 8ill be seen t,at deficienc of cas, occurs in t,e $ont,s of Sanuar5 &arc,5
&a and Sune5 $ainl because so$e unusual pa$ents like preference dividend5
advance inco$e4ta1 and progress pa$ents under building contract are to be $ade in
t,ose $ont,s. Wit, t,e ,elp of t,e cas, budget5 t,e co$pan 8ill be able to plan its
s,ort4ter$ financing. One of t,e courses is to obtain overdraft facilities fro$ its
bankers.
T,e net cas, position in a particular period $a s,o8 deficit. 9ence5
arrange$ents s,ould be $ade in advance to fill t,is gap b borro8ing or b ot,er
$eans. In case t,ere is a surplus balance5 t,e desirabilit of investing it in govern$ent
or ot,er s,ort4ter$ securities s,ould be e1a$ined. +n surplus s,ould be invested in
#.
safe securities5 provided t,e surplus is fairl considerable and t,e period of invest$ent
is s,ort so as to ensure 6uick conversion of securities in cas, 8it,out loss of value.
Acti.it/ *
+rrange a $eeting 8it, an accounting e1ecutive of our organisation and
ascertain if cas, budgeting is being practisedK Obtain a profor$a of cas, budget for
our record. W,at are t,e $ajor sources of cas, inflo8s and t,e $ain uses of cas,
outflo8sK In 8,at 8a our organisation $anages an deficit or surplus of cas,
revealed b t,e cas, budgetK
JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ
.- BUESTIONS
1 W,at are t,e t,ree $otivations be,ind ,olding cas,K /1plain briefl.
2 EIn $anaging cas, t,e 2inance &anager faces t,e proble$ of co$pro$ising t,e
conflicting goals of li6uidit and profitabilitF. Co$$ent. W,at strateg s,ould t,e
2inance &anagers develop to solve t,is proble$K
3 W,at is opti$u$ cas, balance and ,o8 can it be arrived atK
! W,at is cas, ccle and ,o8 can it be reducedK
# If a fir$ esti$ates t,at it 8ill ,ave so$e idle cas, balances fro$ ti$e to ti$e5 8,at
advice 8ould ou render to t,e fir$K
% W,at is a cas, budget and in 8,at 8a can it be ,elpful in li6uidit planningK
' 9o8 8ould ou judge t,e efficienc of cas, $anage$ent of a co$panK
.0 SUMMAR"
+n ade6uate a$ount of cas, is re6uired for $eeting liabilities and da4to4da
operating e1penses of t,e business. Cas, is also needed as a reserve for $eeting an
unforeseen contingencies. T,e $anage$ent of cas, is as i$portant as t,e $anage$ent
of ot,er ite$s of current assets like receivables and inventories. Too little cas, $a
place t,e fir$ in an illi6uid position 8,ic, $a force t,e creditors and ot,er clai$ants
to stop transacting 8it, t,e fir$. Too $uc, cas, results in funds ling idle5 t,ereb
lo8ering t,e overall return on capital e$ploed belo8 t,e acceptable level. T,e fir$
#1
$ust plan its cas, re6uire$ents on a s,ort run basis. Cas, budgeting is a useful tool for
forecasting cas, inflo8s and outflo8s. 2or t,is purpose t,e fir$ $ust identif t,e
sources and ti$ings of all receipts and ti$ings and uses of all pa$ents. T,e cas,
budget indicates t,e s,ortages or e1cesses of cas, at particular points of ti$e. Steps can
t,en be taken to arrange for additional financing for filling t,e gap or investing an
surplus funds so as to generate additional inco$e.
T,e close $onitoring of cas, position i$plies an efficient and regular data
collection and reporting sste$ t,at ,ig,lig,ts t,e likel s,ortfalls 8ell in advance.
T,is enables corrective action to be taken b e1pediting receipts5 curtailing e1penses
and resc,eduling e1penditure. If li6uidit position of t,e fir$ is insisted upon as an
inde1 of $anagerial perfor$ance5 it 8ill reduce occurrence of cas, s,ortages and 8ill
,elp to instill an inbuilt li6uidit discipline.
.1 ECERCISES
1. West Hengal La$ps Li$ited 8is,es to arrange over4draft facilities 8it, its banker
during t,e period +pril4Sune of a particular ear. It intends to $anufacture $ostl for
stock. Drepare a cas, budget 8it, t,e ,elp of t,e follo8ing data5 indicating t,e e1tent of
bank facilities t,e co$pan 8ould re6uire at t,e end of eac, $ont,>
'? S')e$F (urc7'$e 'n, 6'&e$ 6i)) >e '$ 3#))#6$=
M#nt7 S')e$ Purc7'$e$ W'&e$
2ebruar 25..5... 153.5... 1#5...
&arc, 252.5... 15#.5... 1%5...
+pril 15%.5... 25#.5... 135...
&a 15*.5... 25%.5... 125...
Sune 15#.5... 25*.5... 1%5...
b; '#N of t,e credit sales are realised in t,e $ont, follo8ing t,e sales and t,e
re$aining in t,e second $ont, follo8ing.
c; Creditors are paid in t,e $ont, follo8ing t,e purc,ases.
d; Cas, at bank on 1st +pril is esti$ated at 3s. 3.5....
e; Da$ent for purc,ases are $ade in t,e $ont, follo8ing.
#2
f; Wages are paable in t,e sa$e $ont,.
T,e follo8ing data pertain to Travancore Traders. Drepare a cas, budget for t,e first
6uarter of t,e ear 8it, t,e infor$ation given belo8>
a; T,e o8ner ,as $ade sales forecasts for t,e first five $ont,s of t,e co$ing ear>
&ont, 3s
Sanuar #.5...
2ebruar %.5...
&arc, %.5...
+pril '.5...
&a *.5...
b; (ebtors= and creditor=s balances at t,e beginning of t,e ear are /s. 3.5... and 3s.
2#5... respectivel
T,e balances of ot,er assets and liabilities are>
Cas, Halance 3s. *5...
Stock 3s. %.5...
+ccrued Sales
Co$$ission 3s. !5...
c; #.N of sales are on cas, basis. Credit sales are collected in t,e 8ing $ont,
of sales.
d; Cost of sales is '#N of sales. 4
e; T,e onl ot,er variable cost is a #N co$$ission to sales agents 8,o are paid in t,e
follo8ing $ont, 8it, a ti$e lag of nearl 3. das. '#N of sales are subject to
co$$ission.
f; Trade creditors are paid in t,e follo8ing $ont, after purc,ase.
g; 2i1ed costs are 3s. %5... per $ont, including Its. 15... depreciation.
An$6er$ t# Se)34'$$e$$5ent Bue$ti#n$GE+erci$e$
#3
+pril &a Sune
*. Total Cas, Inflo8s 251#5... 15'#5... 15'#5...
Total Cas, Outflo8s 15%35... 25%25... 25'%5...
Sanuar 2ebruar &arc,
-. Total Cas, 3eceipts ##5... ##5... %.5...
Total Cas, Da$ents 3!5... !'!53'# #-5'#.
/nding Halance 2-5... 1.53'# 1.5%2#
.8 RE!ERENCES
Solo$on5 /7ra and Dringle So,n5 1-'*. +n Introduction to 2inancial &anage$ent5
Drentice49all of India> )e8 (el,i.
"uc,,al5 S.C.5 1-*#. 2inancial &anage$ent5 C,aitana Dublis,ing> +lla,abad.
"ulkanii5 DS.5 1-*#. 2inancial &anage$ent5 9i$alaa Dublis,ing> Ho$ba.
#!

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