Appendix 8...

MS-41 : WORKING CAPITAL MANAGEMENT

BLOCK UNIT UNIT TITLE

NOs.

I CONCEPTS AND DETERMINATION OF WORKING CAPITAL

1 Conceptual Framework
2 Operating Environment of Working Capital
3 Determination of Working Capital
4 Theories and Approaches

II MANAGEMENT OF CURRENT ASSETS

5 Management of Receivables
6 Management of Cash
7 Management of Marketable Securities
8 Management of Inventory

III FINANCING OF WORKING CAPITAL NEEDS

9 Bank Credit – Basic Principles and Practices
10 Bank Credit – Methods of Assessment and Appraisal
11 Other Sources of Short Term Finance

IV WORKING CAPITAL MANAGEMENT : AN INTEGRATED VIEW

12 Liquidity vs Profitability
13 Payables Management
14 Short-Term International Financial Transactions
15 Integrating Working Capital and Capital Investment Process

137
 MS-41

Management Programme

ASSIGNMENT
FIRST SEMESTER
(January to June)
2020

MS – 41: Working Capital Management

School of Management Studies

INDIRA GANDHI NATIONAL OPEN UNIVERSITY
MAIDAN GARHI, NEW DELHI – 110 068
 ASSIGNMENT

Course Code : MS-41

Course Title : Working Capital Management
Assignment No. : MS-41/TMA /SEM-I/2020
Coverage : All Blocks

Note : Attempt all questions and submit this assignment to the coordinator of your study center
on or before 30th April, 2020.

1. Explain the meaning of Working Capital. How does inflation affect the size of
working capital, availability of working capital, and various components of working
capital.

2. An Enterprises’ current turnover is Rs. 10 lakh per annum. The enterprise currently
allows a credit period of 40 days to its customers from the date of sale. The
management of this enterprise wishes to adopt a more liberal credit policy, and it is
exploring the following options:

Credit Proposed increase in Expected increase Anticipated default rate

policy collection period (days) in sales (Rs) or rate of bad debt (%)
I 10 40,000 2%
II 20 50,000 2.5%
III 30 70,000 3%
IV 40 90,000 4%

Additional information :-
- Selling price/unit is Rs 5.00
- Average cost/unit is Rs 3.00
- Variable costs/unit is Rs 2.00
- Current default rate is 1.5%
- Required rate of return is 15%
- A year consists of 360 days
You are required to suggest which of the above credit policies should be followed?

3. Taking a suitable example explain how maximum permissible bank finance is

assessed under the three methods of lending suggested by the Tandon Committee.

4. “Capital Investment Module and Working Capital Module use simulation techniques
to represent the interactions among the capital investment and working capital
variables” Discuss.
 Theories and Approaches
UNIT 1 CONCEPTUAL FRAMEWORK
Objectives

The objectives of this unit are to:

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

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

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

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

1.2 DEFINITION OF WORKING CAPITAL

Working capital may be defined in two ways, either as the total of current assets or
as the difference between the total of current assets and total of current liabilities. 1
Concepts and Determination Like, most other financial terms the concept of working capital is used in
of Working Capital different connotations by different writers. Thus, there emerged the following two
concepts of working capital.
i) Gross concept of working capital
ii) Net concept of working capital
Gross concept:
No special distinction is made between the terms total current assets and working
capital by authors like Mehta, Archer, Bogen, Mead and Baker. According to
them working capital is nothing but the total of current assets for the following
reasons:

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

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

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

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

Net concept:
Contrary to the aforesaid point of view, writers like Smith, Guthmann and
Dongall. Howard and Gross, consider working capital as the mere difference
between current assets and current liabilities. According to Keith. V. Smith, a
broader view of working capital would also include current liabilities such as
accounts payable, notes payable and other accruals. In his opinion, working
capital management involves the managing of individual current liabilities and the
managing of all inter-relationships that link current assets with current liabilities
and other balance sheet accounts. The net concept is advocated for the following
reasons:
i) in the long-run what matters is the surplus of current assets over current
liabilities.
ii) it is this concept which helps creditors and investors to judge the financial
soundness of the enterprise.
iii) what can always be relied upon to meet the contingencies is the excess of
current assets over current liabilities, since it is not to be returned; and

iv) this definition helps to find out the correct financial position of companies
having the same amount of current assets.

In general, the gross concept is referred to as the Economics concept, since

assets are employed to derive a rate of return. What rate of return is generated
2 by different assets is more important than the analysed difference between assets
and liabilities. On the contrary, the net concept is said to be the point of view of Theories and Approaches
an accountant. In this sense, working capital is viewed as a liquidation concept.

Therefore, The solvency of the firm is seen from the point of view of this
difference Generally, lenders and creditors view this as the most pertinent
approach to the problem of working capital.

1.3 CONSTITUENTS OF WORKING CAPITAL

No matter how, we define working capital, we should know what constitutes
current assets and current liabilities. Let us refer to the Balance Sheet of Lupin
Laboratories Ltd. for this purpose.
Current Assets: The following are listed by the Company as current assets:
1) Inventories:
a) Raw materials and packing materials
b) Work-in-progress
c) Finished/Traded goods
d) Stores, Spares and fuel
2) Sundry Debtors:
a) Debts outstanding for a period exceeding six months
b) Other debts
3) Cash and Bank balances:
a) With Scheduled Banks
i) in Current accounts
ii) in Deposit accounts
b) With others
i) in Current accounts
4) Loans and advances:
a) Secured Advances
b) Unsecured (considered good)
i) Advances recoverable in cash or kind for value to be
received
ii) Deposits
iii) Balances with customs and excise authorities
Current liabilities: The following items are included under this category.
1) Current Liabilities:
a) Sundry creditors
b) Unclaimed dividend warrants
c) Unclaimed debenture interest warrants
2) Short term credit:
a) Short term loans
b) Cash credit from banks
c) Other short term payables 3
Concepts and Determination 3) Provisions:
of Working Capital
a) For Taxation
b) Proposed Dividend
i) on preference shares
ii) on equity shares
Besides, items like prepaid expenses, certain advance payments are also included
in the list of current assets. Similarly, bills payable, income received in advance
for the services to be rendered are treated as current liabilities. Nevertheless,
there is difference of opinion as to what is current. In the strict sense of the
term, it is related to the, operating cycle, of the firm and current assets are
treated as those that can be converted into cash within the operating cycle. The
period of the operating cycle may be more or less compared to the accounting
period of the firm. In case of some firms the operating cycle period may be
small and in an accounting period there can be more than one cycle. In order to
avoid this confusion, a more general treatment is given to the, currentness, of
assets and liabilities and the accounting period (generally one-year) is taken as
the basis for distinguishing current and non-current assets.

1.4 TYPES OF WORKING CAPITAL

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

Variable Working Capital: This is also known as the circulating or transitory

working capital. This is the amount of investment required to take care of the
fluctuations in the business activity. While permanent working capital is meant to
take care of the minimum investment in various current assets, variable working
capital is expected to care for the peaks in the business activity. While
investment in permanent portion can be predicted with some probability,
investment in variable portion of working capital cannot be predicted easily as
sudden changes in the business activity causes variations in this portion of
working capital.

1.4.1 Working Capital Behaviour

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

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

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

Fig. 1.1: Behaviour of Working Capital

(A) Non-growth, non-seasonal (B) Growing, non-seasonal

non-cyclical firms and non-cyclical firms

g
Working Capital (Rs.)

in
rk
wo
al nt

Permanent
pit ne
Ca rma

W.C
Pe

(C) Growing, seasonal and (D) Growing, seasonal and

non-cyclical firms cyclical firms

Variable
W.C.

.C
nent W
Perma

Variable W.C.

Activity 1.1 Time (years)

Mention the points of differentiation between
i) Gross concept and Net concept
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
....................................................................................................................... 5
Concepts and Determination ii) Permanent working capital & Variable working capital
of Working Capital
.......................................................................................................................

.......................................................................................................................

.......................................................................................................................

.......................................................................................................................

1.5 CYCLICAL FLOW AND CHARACTERISTICS OF

WORKING CAPITAL
For every business enterprise there will be a natural cycle of activity. Due to the
interaction of the various forces affecting the working capital, it transforms and
moves from one to the other. The role of the financial manager then, is to ensure
that the flow proceeds through different working capital stages at an effective
rate and at the appropriate time. However, the successive movements in this
cycle will be different from one enterprise to another, based on the nature of the
enterprises. For example:
i) If the enterprise is a manufacturing concern, the cycle will run something
like: Cash→(buying)→Raw Materials→(production)→Finished Goods→(sales
on credit) Accounts Receivable→(Collections)→Cash.
ii) If the enterprise is purely a Retailing Company and one, which has no
manufacturing problem the cycle is shortened as:
Cash→(buying)→Merchandise→(Sales)→Accounts
Receivables→(Collections) → Cash.
iii) If the enterprise is a purely financing enterprise, the cycle is still shorter and
it can be shown as:
Cash→(sanction of loans)→Debtors→(collections)→Cash.
But in real business situations, the cyclical flow of working capital is not simple
and smooth going, as one may be tempted to conclude from these simple flows.
This cyclical process is repeated again and again and so do the values keep on
changing as they move through the cash to cash path. In other words the cash
flows arising from cash sales and collections from debtors will either exceed or
be lower than cash outflows represented by the amounts spent on materials,
labour and other expenses. An excess cash outflow over cash inflow is a clear
indication of the enterprise having suffered a loss. Thus it is apparent, that the
amount of working capital required and its level at any particular time will be
governed directly by the frequency with which this cash cycle can be sustained
and repeated. The faster the cycle the lesser will be the investment needed in
working capital.
Form the aforesaid discussion, one can easily identify three important
characteristics of working capital, namely, short life span, swift transformation and
inter–related asset forms and synchronization of activity levels.
1. Short-life Span
Components of working capital are short-lived. Typically their life span does not
exceed one year. In practice, however, some assets that violate this criterion are
still classified as current assets.
2. Swift Transformation and Inter-related Asset Forms
In addition to their short span of life, each component of the current assets is
6 swiftly transformed into the other asset. Thus cash is utilised to replenish
inventories. Inventories are diminished when sales occur that augment accounts Theories and Approaches
receivable and collection of accounts receivable increases cash balances. Thus a
natural corollary of this quick transformation is the frequent and repetitive
decisions that affect the level of working capital and the close interaction that
exists among the members of the family of working capital. The latter entails the
assumption that efficient management of one asset cannot be undertaken without
simultaneous consideration of other assets.

3. Assets Forms and Synchronization of Activity Levels

A third characteristic of working capital components is that their life span

depends upon the extent to which the basic activities like production, distribution
and collection are non-instantaneous and unsynchronized. If these three activities
are only instantaneous and synchronized, the management of working capital
would obviously be a trivial problem. If production and sales are synchronized
there would be no need to have inventories. Similarly, when all customers pay
cash, management of accounts receivable would become unnecessary.

1.6 PLANNING FOR WORKING CAPITAL

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

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

1.6.1 Tools of Planning for Working Capital

It should be interesting to know how to identify the relevant tools for completing
the planning exercise. Treating the planning for working capital as part of
financial planning. We can note down the following tools of analysis with respect
to time- frame.
a) Short term planning – Cash Budgeting
b) Medium term planning – Determination of appropriate levels of working
capital items
c) Long term planning –Projected pay outs and returns to shareholders in
terms of CVP and funds flow analysis.
Cash budget: In the short term cash budgeting is considered a handy device for
planning working capital. The use of cash budget technique as a means of
determining the size of the cash flows is considered superior to the use of
proforma balance sheets or judging by the past experience. A cash budget is a
7
Concepts and Determination comparision of estimated cash inflows and outflows for a particular period such
of Working Capital as a day, a week, a month, a quarter or year. Typically Cash budget is designed
to cover one–year period and the period covered is sub-divided into intervals. It
can be prepared in various ways like the one based on cash receipts and
disbursements method, or the adjusted net income method, or the working capital
differential method.

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

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

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

Of the several methods of preparing the cash budget, Receipts and Payments
method is popular among many undertakings. Moreso the preparation of cash
budgets in the organisations was an integral part of the budgetary process, since
the whole of the budgetary structure was divided into revenue budgets,
expenditure budgets and cash budgets. Cash budget was prepared by the
organisations by borrowing figures from various other budgets which they
prepared such as the:
i) Production budgets.
ii) Sales budget.
iii) Cost of production estimates with its necessary subdivisions for example.
a) materials purchase estimates:
b) labour and personnel estimates:
c) plant maintenance estimates: etc.
iv) Manpower budget.
v) Township and welfare estimates
vi) Profit and loss estimates.
vii) Capital expenditure budget.
Thus, cash budget is prepared as a means of identifying the past cash flows and
determine the future course of action. Cash budgets, generally are prepared by
all enterprises on yearly basis having monthly break–ups.
Medium term planning : In the medium term determining appropriate level of
working capital is considered a focal point. In unit 3 of this course on
‘Determination of working Capital’, we have discussed in detail the following
three approaches to determine optimum investment in working capital.
1) Industry Norm Approach
8
2) Economic Modelling Approach Theories and Approaches

3) Strategic Choice Approach

Therefore, students are advised to refer to that particular unit and hence
discussion on them is not repeated here.

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

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

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

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

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

1.7 WORKING CAPITAL AND INFLATION

Inflation, which is commonly indicated by the rise in prices of goods and services,
is so rampant in the world that no economy is far off from its deleterious
effects. Inflation has been experienced by almost all the countries in the world
irrespective of their political system and the stage of industrialisation. The fact is
that, over the last two decades, annual rates of inflation in excess of two to
three percent have become common all over the world.
9
Concepts and Determination In India, the rate of inflation was more grievous than in many other countries,
of Working Capital and the wholesale prices rose by almost 32 percent during 1956-61, by slightly
less than 30 percent during 1961-66, and 25 percent during the Annual Plan
periods (1966-69). Besides fluctuations the annual rate of rise in the wholesale
price was exceptionally high and in 1974-75, almost alarming. Inflation rate based
on Wholesale Price Index (WPI) averaged around 9 per cent during 1970-71 to
1990-91. Again it touched the highest level of the decade in 1991-92 at 16.7
percent, when the economic activity was at its lowest ebb. Consequent upon the
reforms, there has been some recovery in the economy and the rate of inflation
has come down to even 2 percent during 1998-99, threatening the regime of
deflation. Nevertheless, there is no consistency in the performance of the
economy. Again the rate of inflation is moving towards an average of 4-5
percent. Alongside these indices there are some hidden inflationary potentials
which are not apparent. Prominent among these are generous subsidies, changing
international prices of crude oil and petroleum products and the administered
prices for certain other products. The combined impact of these factors is
definitely seen on the inflation. The impact of inflation on working capital be
understood in the following manner.

1.7.1 Size of Working Capital

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

1.7.2 Availability of Working Capital

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

As pointed out earlier, during inflation the availability of internal sources gets
reduced because of the maintenance of records on historical cost basis. On the
other hand, the position with regard to external sources of funds is equally
10
disheartening. The rapid increase in inflation has given rise to the formulation of Theories and Approaches
tight money policy by the Reserve Bank of India with a view to restricting the
flow of credit in the economy. Consequently, the extension of credit facilities
from banks have become extremely limited. Further, the diversion of bank funds
to priority sectors, after nationalisation has made it more difficult to raise funds
from banks.

Till recently, companies depended heavily on public deposits for meeting their
working capital requirements. Their availability however was reduced due to the
restrictions imposed by the RBI on the companies for the mobilisation of deposits
from public, particularly since 1978. Further the advent of Government companies
into the capital market for accepting public deposits made it more difficult to
attract funds from the public.

Coming to the trade credit, one must note that it may not be available for long
periods, and the suppliers of goods tighten the credit facilities during inflationary
period. The issue of long term loans may also be slackened, as the investors
would be less attracted by investments offering a fixed return like debentures and
preference shares. This is so because in terms of purchasing power the principal
amount of investment as well as the interest would dwindle. Thus, these
restrictions and limitations on the availability of working capital from internal and
external sources makes it difficult for the finance manager to raise funds during
inflation.

1.7.3 Components of Working Capital

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

Inventory

Not many understand fully the impact of inflation on the management of

inventory. Inflation affects the decisions in respect of inventory in many ways,
namely;

i) It leads to over-investment in inventory.

ii) It results in shortages.
iii) It affects valuation of inventories; and
iv) It renders the traditional inventory control techniques ineffective.

During the periods of inflation when the prices rise rapidly, companies will have
an incentive to invest more heavily in inventory than is indicated by the minimum
cost calculation. If the management believes the price of an item will increase by
10 per cent in the next month, substantially more of that item may be ordered
than normal, of course, due to increase in inventory the company may get
speculative gain, but this speculative gain may be off-set by the increase in taxes
due to higher profit figures, reported in times of inflation and higher carrying
costs.

Another difficulty that the company is required to face is the material shortages
in the periods of inflation. It is not known whether inflationary escalations result
in shortages or shortages occur because of instability caused by inflation.
Whatever be the real source of the problem, companies should be conscious of
the price trends and accordingly re-evaluate their internal purchasing and
organisational systems.
11
Concepts and Determination Very few firms realise the impact of inflation on the valuation of inventory and
of Working Capital the extent to which it contributes to unrealised profits. In other words, inflation
affects the valuation of inventories, affecting thereby the amount of profits
reported in the financial statements.

Not only inflation affects the inventory, but inflation itself is also increased due to
the inefficient management of inventory. Delivering the keynote address at a
National Convention on the subject of, ‘Curbing Inflation through Effective
Materials Management’, Shri P.J.Fernandes put forward the following five
propositions to show the impact of inflation on the materials management.

a) The stocks which are held by the enterprises have a direct and immediate
relationship to general price levels.
b) The price level in any country is to a great extent determined by the cost of
production. The cost of production is to a great extent determined by the
cost of inputs. Hence, if the cost of inputs goes up, the cost of production as
well as the price level also goes up.
c) An effective system of materials management must necessarily result in an
increase in production.
d) The materials manager can have a total and absolute impact on production
outside his unit, and
e) It is the materials management, which can reduce the crushing burden of
credit expansion, and the money supply, which again will have a direct and
absolute impact on inflationary tendency.

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

Assumptions

1) Annual consumption Rs. 1,00,000

2) Economic Ordering Quantity Rs. 3,125
3) No of orders per year 32
4) Ordering cost Rs. 20 per order
5) Carrying cost Rs. 25 per cent
6) Lead time constant
7) Price rise 5 per cent per
month.
The ordering and carrying costs would be as follows:

a) Ordering costs = 32 × 20 = Rs 640

3125 25
b) Carrying costs = ——— × —— = Rs 390.63
2 100
c) Total costs = Rs. 640 + 390.63 = Rs 1030.63

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

12
 Theories and Approaches

Total Material Cost

No. of months No. of orders Material cost
.
1st Month 2 3125 × 2 × 1.00 = 6,250.00
2nd Month 3 3125 × 3 × 1.05 = 9,843.75
3rd Month 3 3125 × 3 × 1.10 = 10,312.50
4th Month 2 3125 × 2 × 1.15 = 7,187.50
5th Month 3 3125 × 3 × 1.20 = 11,250.00
th
6 Month 3 3125 × 3 × 1.25 = 11,718.75
7th Month 3 3125 × 3 × 1.30 = 12,187.50
8th Month 2 3125 × 2 × 1.35 = 8,437.50
9th Month 3 3125 × 3 × 1.40 = 13,125.00
th
10 Month 3 3125 × 3 × 1.45 = 13,593.75
11th Month 3 3125 × 3 × 1.50 = 14,062.50
12th Month 2 3125 × 2 × 1.55 = 9,687.50
32 1,27,656.25

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

Receivables

The effect of inflation on the receivables is felt through the size of investment in
receivables. The amount of investment in receivables varies depending upon the
credit and collection policies of the organisation. Evidently, during the periods of
inflation the higher the amount involved in the receivables the greater would be
the loss to the company, since the debtor would be paying cheaper rupees.
Likewise, the length of the time too makes the firm lose much in the transaction.
For instance, if the firm in the beginning made a credit sale of about Rs. 1,00,000
with an allowed credit period of three months, assuming a 20 percent inflation in
the economy, the amount the company receives in real terms after the allowed
credit period becomes only Rs. 95,000. Here, even considering the same time lag
between delivery and realisation, as between debtors and creditors, sundry
debtors would create bigger problem than the sundry creditors, because the
declining value of sundry debtors would affect adversely the anticipated
13
Concepts and Determination profitability of the enterprise. Thus, the effect of inflation varies in accordance
of Working Capital with the quantum of receivables and the time allowed to repay them.

Cash

Management of cash takes on an added importance during the periods of

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

1.8 TRENDS IN WORKING CAPITAL

In order that we gain a better idea of the working capital, it is also necessary to
go into the working capital in Indian companies, besides having an idea of the
conceptual framework. For the purpose of analysing trends in working capital,
data is culled from the publications of RBI on “Finances of public limited
companies”. The data of RBI covers roughly about one-third of the non-
government, non-financial companies in terms of paid-up capital. Table 1.1 depicts
the period covered from 1992-93 to 2001-02. The trends are analysed for this
period of nine years with a gap of one year (98-99). In view of the variations in
the sample number of companies during the period under consideration, trends are
analysed to a great extent in terms of percentages than in absolutes.

1.8.1 Size of Working Capital

Working capital, if taken, as the total of current assets increased from Rs. 67,558
crores in 1992-93 to Rs. 1,96,426 crores in 2001-02. (as worked out in table 1.3).
In terms of percentages, working capital worked out to about 53 percent of the
total net assets of the Indian companies. Nevertheless, there is a decline in the
percentage to 43 percent in 2001-02 almost 10 percentage points.
The implication of the study of size is that the ratio of current assets to total
assets provides a measure of relative liquidity of the firm’s asset structure. The
higher the ratio the lower would be the profitability and risk. In the sense that
higher investment in current assets not only locks up the funds that can be
gainfully employed elsewhere, but also necessitates the firm to incur additional
costs in the maintenance of such high volume of current assets.
An attempt is made to capture the position among diverse industries. An
examination of this position has revealed that current assets as per cent of total
net assets stood high in the industries such as trading, construction, tobacco,
sugar, cotton, textiles, engineering and rubber (See Table-1.1) It appears that all
traditional industries had higher amounts invested in working capital. A welcome
feature of these trends is that diversified companies (with a wide variety of
product groups) had investment in working capital upto around 42.6 percent only.
Further, the relation between current assets and current liabilities (as depicted
through current ratio) is sending a signal of poor liquidity. Accepting that a 2:1
relation between current assets and current liabilities as comfortable in exhibiting
14 adequate liquidity, the public limited companies have never been closer to this
standard. It was varying between the lowest of 1.23:1 and the highest of 1.52:1 Theories and Approaches
during the period, 1992-98. In case of individual industries too none of them could
achieve this mark except shipping industry. (See Table 1.2).

1.8.2 Constituents of Working Capital

In order to know the significance of each of the items of working capital, it is
better to decompose the total. Such an attempt is made both for current assets
and current liabilities. Among the current assets, loans and advances dominated
the total position. Almost half of the current assets are in the form of debtors
and advances (see Table-1.3). It is heartening to note that the dominant position
of inventories once has come down significantly from around 60 percent to only
just 32 percent now. Receivables always blamed more than half of the current
assets. Debtors can be considered more liquid than inventories. In that sense this
development can be considered a healthy feature of the Indian corporate sector.
Among the current liabilities sundry creditors and other current liabilities have
occupied a prime place (see Table- 1.4), constituting around almost 60 percent.
Bank borrowings for working capital purposes have come down following the
credit discipline exercised by the Reserve Bank, during nineties, but showing up
during 2001-02. These trends give an idea of the behaviour of working capital in
Indian companies.

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

1.10 KEY WORDS

Working capital: Working capital is defined as the total of current assets or as
the difference between current assets and current liabilities.
Current assets: The total of inventories, debtors, loans and advanced, cash and
marketable securities.
Current liabilities: The sum of sundry creditors, unclaimed dividends short term
loans, bank credit and various types of provisions.
Permanent working capital: Minimum level of investment in current assets
required for production.
Variable working capital: Working capital which takes care of the fluctuations
in business activity.
Cash budget: A projection of estimated cash inflows and outflows.
CVP analysis: A measure of long term planning to study the relationship among
cost, volume and profit. 15
Concepts and Determination Funds flow : A tool to underline changes in the movement of funds.
of Working Capital
Inflation: A phenomenon of rising prices.

1.11 SELF ASSESSMENT QUESTIONS

1) Distinguish between gross working capital and net working capital?

2) Why is working capital considered a liquidation concept?
3) Discuss the various types of working capital and trace out the behaviour of
working capital with respect to time?
4) What is the impact of inflation on working capital?
5) How do you plan for the working capital of an organisation? Choose your
own company as an example?
6) Refer to the balance sheets of a company for a few years and analyse the
trends is working capital. What do they mean to the enterprise studied?
Table 1.1 : Current Assets as percentage of total net assets among different industry
groups in public limited companies in India
Sl. Industry 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01 01-02
1) Tea 38.1 34.6 41.2 38.8 36.2 39.5 38.6 36.5 35.6
2) Sugar 62.6 58.9 60.4 56.3 56.2 54.8 55.4 56.8 57.6
3) Tobacco 68.5 66.3 66.7 67.6 61.8 60.0 - - -
4) Cotton Textiles 51.7 53.5 53.5 53.2 51.8 50.7 42.1 41.6 41.8
5) Silk Rayon 50.1 48.4 49.3 35.9 30.8 28.9 - - -
Textiles
6) Engineering 62.2 58.3 58.4 57.3 52.5 49.2 - - -
7) Chemicals 45.0 44.3 42.8 41.5 37.3 36.1 45.5 45.4 46.1
8) Rubber 57.3 56.5 55.6 60.0 58.0 56.8 46.8 47.9 46.3
9) Paper 47.3 43.8 44.7 43.4 34.5 37.6 34.3 35.3 32.7
10) Construction 74.5 71.6 71.7 50.9 66.5 37.1 66.3 64.5 65.5
11) Electricity 23.6 16.1 19.6 23.8 29.4 23.9 61.5 58.7 57.4
12) Trading 79.2 77.7 79.5 80.9 79.1 80.1 82.5 83.5 81.6
13) Shipping 28.6 30.6 38.8 36.9 37.0 36.6 50.4 47.3 45.4
14) Diversified Co. 47.5 45.0 44.3 48.9 43.7 40.8 36.8 43.1 42.6
Source: RBI Bulletins, October 1997, October 1999 and October 2003.

Table 1.2 : Current ratio among different industry groups in public limited companies in India

Sl. Industry 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01 01-02
1) Tea 1.56 1.60 1.96 1.5 1.4 1.7 1.6 1.4 1.4
2) Sugar 1.16 1.32 1.35 1.2 1.1 1.1 1.2 1.1 1.0
3) Tobacco 1.22 1.34 1.30 1.3 1.3 1.3 - - -
4) Cotton Textiles 1.26 1.33 1.35 1.4 1.4 1.3 1.2 1.2 1.0
5) Silk Rayon 1.43 1.64 1.72 1.6 1.0 0.8 - - -
Textiles
6) Engineering 1.35 1.36 1.44 1.3 1.3 1.2 - - -
7) Chemicals 1.41 1.43 1.54 1.5 1.5 1.3 1.3 1.3 1.2
8) Rubber 1.36 1.38 1.54 1.6 1.4 1.4 1.3 1.3 1.2
9) Paper 1.17 1.34 1.52 1.3 1.3 1.2 1.1 1.1 0.8
10) Construction 1.09 1.04 1.09 1.1 1.5 0.9 1.3 1.3 1.1
11) Electricity 1.00 0.98 1.18 1.3 1.1 1.4 1.4 1.3 1.3
12) Trading 1.21 1.29 1.28 1.4 1.5 1.4 1.4 1.4 1.4
13) Shipping 1.28 1.64 2.29 2.1 2.1 1.9 1.4 1.2 1.2
14) Diversified 1.84 1.73 1.82 1.4 1.3 1.2 1.0 1.1 1.2
16
 Companies Theories and Approaches

Source: RBI Bulletins, October,1997; October 1999 and October 2003.

Tabla-1.3 : Constituents of current Assets (in percent )in public limited companies.

Sl. Particulars 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01 01-02

1. Inventories 39.8 33.3 32.5 34.5 32.2 32.0 33.8 33.7 31.8

2. Receivables 50.9 47.5 52.9 53.2 56.3 55.2 53.4 53.7 54.3

3. Quoted Investments 2.6 11.8 7.4 4.9 4.8 3.5 4.9 5.5 5.5

4. Advance of 0.1 0.1 0.2 0.1 0.1 0.1 0.4 0.4 -

Income tax

5. Cash & Bank 6.6 7.3 6.9 7.3 6.6 9.2 7.5 6.7 8.4
Balances

Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00

Current Assets (67558) (82134) (115541) (136469) (148353) (155716) (179159) (189080) (196426)

Source: RBI Bulletins, October, 1997, October 1999 & October 2003.

Note: Figurers in the brackets indicate absolute amounts in crores.

Table 1.4 : Constituents of current liabilities (in per cent) in public limited companies
Particulars 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01 01-02
A. Short term 33.2 28.3 29.5 29.7 29.8 29.3 32.0 37.5 40.0
borrowings
from Banks
B. Unsecured loans 6.5 8.4 9.4 8.9 13.4 15.6 - - -
from Companies
and others
C. Trade dues and 59.7 62.7 60.6 60.7 55.9 54.0 63.1 55.2 53.2
other Current
liabilities
1.Sundry creditors 38.5 39.2 34.2 37.6 35.2 20.2 37.5 33.8 31.7
2.Others 21.2 23.5 26.4 23.1 20.7 31.8 25.6 21.4 21.5
D. Provisions 0.6 0.6 0.5 0.7 1.0 1.0 4.9 5.4 9.8
Total Current Liabilities 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
(48089) (54307) (67618) (96646) (111653) (126555) (133005)(164273) (180165)

Source: RBI Bulletins, October 1997; October.1999 and October 2003.

Note: Figures in the brackets indicate absolute amounts in crore.

1.12 FURTHER READINGS

1) V.K. Bhalla, 2003, Working Capital Management, Amol Publications Pvt.
Ltd., New Delhi-110002.
2) Rao, K.V., 1990, Management of Working Capital, Deep & Deep,New Delhi.
3) Ramamoorthy, V.E., 1976, Working Capital Management,. IFMR, Madras.
4) Dileep R. Mehta., 1974, Working Capital Management, Englewood Cliffs,
Prentice Hall.
5) Park and Gladson, 1963, Working Capital, Macmillan, New York.

17
Concepts and Determination
of Working Capital UNIT 2 OPERATING ENVIRONMENT OF
WORKING CAPITAL
Objectives

The objectives of this unit are to:

• Highlight the significance of scanning, operating environment of any business
• Identify and discuss the operating environment relevant to the making of
working capital decisions.
• Explain the significant aspects of monetary and credit policies.
• Examine the impact of economic liberalisation on industry as a part of
operations environment.
• Survey the changing environment in financial sector.
Structure
2.1 Introduction
2.2 Monetary and Credit Policies
2.3 Financial Markets
2.4 Economic Liberalisation and Industry
2.5 Summary
2.6 Key Words
2.7 Self-Assessment Questions
2.8 Further Readings
Appendix

2.1 INTRODUCTION
In our previous unit an attempt was made to provide you with a conceptual
framework in terms of understanding the definition, nature and components of
working capital. Further, a sketch was provided of the characteristics of working
capital. Tools for planning working capital and the impact of inflation on working
capital were also discussed. This discussion in the previous unit is expected to
provide you a preliminary understanding about the basic concepts.

Now in the present unit we will be dealing with the operating environment of the
working capital as analysed in the context of monetary, credit and financial
policies.

The term environment refers to the ‘surroundings’ or circumstances, which

affect the life of an object or individual. As applied to business establishments,
people talk of various types of environments like micro, macro or mega
environments. Some people also talk of internal and external environments.
Nevertheless, the term environment is meant, to a large extent, to signify the
surroundings or factors that are external to the firm, affecting the ability of the
firm in achieving its desired objective. The nature of the environment is such that
the firm will have no control on the elements constituting the environment. What
the firm can do is to tailor its own policies and practices in such a way so as to
gain from the changes taking place in the environment. These changes may
pertain to economic, legal, social, cultural or ideological aspects. Whatever be the
aspect, the firm has to gear itself to meet the challenges posed by the changing
environment.
22
The significance of scanning the environment of business is trivial. After all, Theories and Approaches
businesses cannot be run in vacuum, they exist in a natural setting surrounded by
various elements in the society. The decisions of a manager are influenced by
the changes in these surroundings caused by the constituting elements. The
customers, the Government, the society within and outside the country will also
have their influence on the business decision-making. The value system of the
society, the rules and regulations laid down by the government, the monetary and
credit policies of the central bank, the trade, industrial and fiscal policies of the
government, the institutional set up available in the country, the attitudes of
foreign investors, NRIs, the ideological beliefs of the political parties, etc., all
constitute the environment system within which a business firm is to operate.

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

the preferences or attitudes of the customers, suppliers, competitors and the
import and export policies. Similarly, the firm may have to restructure its
financing pattern consequent upon the changes in the rates of interest and
conditions in the capital market. Same would be true in case of marketing and
personnel policies. As a matter of fact, several corporates are assuming ‘social
responsibility functions’ on their own, mainly due to the changes in the value
system of the society and the fear of loosing its confidence. Environment, thus,
has profound influence on business decision-making. Students are advised to
refresh themselves by having a glance at the contents of MS-3: Economic and
Social Environment.

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

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

2.2 MONETARY AND CREDIT POLICIES

During seventies after the economies have started experiencing high inflation and
low growth (a phenomenon called ‘stagflation’) economists have turned their
attention to the potentiality of the monetary policy in the economic policy making.
The relative importance of growth and price stability as the objectives of
monetary policy became the focus of attention in both developed and developing
economies. In a way, the objectives of monetary policy can be no different from
the overall objectives of economic policy. While some central banks consider
monetary targeting as operationally meaningful, some others focus on interest
rates. Whatever be the method, growth with stability is attempted as the objective
of monetary and economic policy of India.

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

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

23
Concepts and Determination 2.2.1 Money Supply
of Working Capital
As a part of the policy exercise, monetary growth is targetted every year. Policy
measures are pronounced, so as to take care of this targeting exercise. This is
expected to maintain real growth and contain inflation. In this context, the Central
Bank specifies the order of expansion in broad money (known popularly as M3
and comprises of currency with the public demand and time deposits with
commercial banks, and other deposits with RBI) that would be used as an
intermediate target to realise the ultimate objective of the policy. In the case of
India, both output expansion and price stability are important objectives; but
depending on the specific circumstances of the year, emphasis is placed on either
of the two. Increasingly, it is being recognised that central banks would have to
target price stability since real growth itself would be in jeopardy, if inflation rates
go beyond the margin of tolerance. On a historical basis, the average inflation
rate’ in India (“which had declined from 9.0 percent in 1970s to 8.0 percent in
1980s) went up markedly to a double-digit level of 10.7 per cent during the first
half of 1990s. The focus of monetary policy in recent years has, therefore, been
to bring down the inflation rate to a modest level. Monetary growth is being
moderated in such a way that the credit requirements for productive activities are
adequately met.

For instance, the monetary growth target, for 1996-97 was set at around the
same level as in the previous year (15.5 percent). The monetary policy for 1996-
97 sought to consolidate the gains on the inflation front. It underscored the
imperative need to sustain the lower and stable level of inflation, while ensuring
the availability of adequate bank credit to support the growth of real sector of
the economy. Broad money growth was projected at 15.5 percent to 16 percent,
assuming a 6 percent growth in real GDP. The credit policy for the year has
also been tailored to achieve the above objective. Basing on the past, the
monetary and credit policy for 1997-98 sought to target broad money growth in
the range of 15.0 - 15.5 percent, on the basis of a projected real GDP growth
rate of about 6 percent and an assumed inflation rate of the same order.

To compare the actual achievements, the broad money growth of 17.0 percent
during 1997-98 was higher than that in the previous financial year (16.0 percent).
The lower order of increase in the monetary base in 1996-97 must be viewed in
the context of the significant cut in Cash Reserve Ratio (CRR) from 14 to 10
per cent of the net demand and Time liabilities. The resulting increases in the
lendable resources of the banks (to the tune of Rs.17, 850 crore) meant decrease
in the ratio of reserves to deposits. This was reflected in the increase in broad
money multiplier from 3.1 to 3.5 as on March 31, 1997.

For the year 2002-03, the mid-term Review of Monetary and Credit Policy
released on October 29, 2002 had projected the GDP growth in the range of 5.0
to 5.5 percent taking into account available data on the performance of the
South-West monsoon. The advance estimates for 2002-03 released by the CSO in
January 2003 has placed GDP growth at 4.4 percent, which reflects an
estimated decline in the output from agriculture and allied activities by as much
as 3.1 percent. The earlier projection in the Reserve Bank's mid-term Review of
October 2002 was based on a much lower decline of 1.5 percent in agricultural
output. The overall growth performance of the industrial sector, as per CSO
advance estimates, at 5.8 percent is, however, much higher than that of 3.2
percent in the previous year. The services sector is estimated to grow by 7.1
percent as against 6.5 percent in the earlier year, mainly on account of higher
growth in construction, domestic trade and transport sectors. The CSO has also
placed the growth of financing, real estate and business services sector at 6.5
percent for 2002-03 as compared with 4.5 percent in 2001-02.
24
The annual rate of inflation in 2002-03 as measured by the increase inWPI, on Theories and Approaches
an average basis, for the year as a whole was, howeever, lower than that in the
previous year 3.3 percent as against 3.8 percent a year ago.

Monetary and credit aggregates for the year 2002-03 reflected the impact of
mergers that took place in the banking industry. During 2002-03, the growth in
money supply, was 15.0 percent as against 14.2 percent which was well within
the projected trajectory. Among the components, growth in aggregate deposits of
scheduled commercial banks (SCBs) at 12.2 percent net of mergers (16.1
percent with mergers), was lower than that of 14.6 percent in the previous year.
The expansion in currency with the public was lower at 12.5 percent as againt
15.2 percent in the previous year.

2.2.2 Bank Rate

The Bank Rate has been defined in Section 49 of the Reserve Bank of India
Act, 1934 as the standard rate at which the bank is prepared to buy or
rediscount bills of exchange or other commercial papers eligible for purchase
under the Act. The significance of bank rate is that it indicates the rate at which
the public should be able to obtain accommodation on the specified types of
paper from the commercial banks as well as the Central Bank. This is expected
to curb the tendency towards relatively high interest rates and ensure satisfactory
banking services and reasonable rates to the people. Secondly, bank rate
represents the basis of the rates at which people can obtain credit. Thirdly, bank
rate also has an important psychological value as an instrument of credit
control. In effect, a change in the bank rate is to make the cost of securing
funds from the Central Bank cheaper or more expensive, bring about changes in
the structure of market interest rates and serve as a signal to the money market,
business community and the public of the relaxation or restrain in credit policy.
Nevertheless, the success of bank rate policy depends on the following:
1) That the bank rate of the Central bank should have a prompt and decisive
influence on money rates and credit conditions within its area of operation;
2) That there should be a substantial measure of elasticity on the economic
structure, in order that prices, wages, rents, production and trade might
respond to changes in money rates and credit conditions; and
3) That the international flow of capital should not be hampered by any
arbitrary restrictions and artificial obstacles.
As far as India is concerned, the use of bank rate as an instrument of credit
control is less frequent. During 1951- 74, Bank rate was changed only nine
times; but was revised only thrice during 1975-96. More so, in majority of the
cases, bank rate has been used in conjunction with other instruments of credit
control to realise the needed effectiveness in the control exercise. It is, of late,
the RBI is taking measures to reactivate the Bank Rate and link it to the interest
rates of significance, so as to facilitate its emergence as the ‘reference rate’ for
the entire financial system. With effect from the close of business on April 15,
1997, the Bank Rate was reduced from12 percent to 11 percent and further to
10 percent w.e.f. June 25, 1997. This reduction in the Bank Rate signalled the
beginning of a low interest rate regime, as these downward movements resulted
in similar reductions in lending and deposit rates in the financial markets.
Developments in the external environment leading to speculative activity in the
Exchange market resulted in a change in the direction of interest rate policy.
RBI subsequently reviewed this policy and reduced the rate to 6 percent w.e.f.
April 29, 2003.

25
Concepts and Determination 2.2.3 CRR and SLR
of Working Capital
Variations in the reserve requirements is yet another credit control technique used
by a Central Bank. The Central Bank by this technique can change the amount
of cash reserves of banks and affect their credit creating capacity. It may be
applied on the aggregate outstanding deposits or on the increments after a base
date or even on certain specific categories of deposits. This has a sure and
identifiable impact as compared to Bank Rate changes or open market
operations. The two instruments under this category are:
i) Cash Reserve Ratio (CRR)
ii) Statutory Liquidity Ratio (SLR)
Under section 42(1) of the RBI Act, scheduled commercial banks were
required to maintain with the RBI at the close of business on any day, a
minimum cash reserve on their demand and time liabilities. Similarly, banks were
required under section 24(2A) to maintain a minimum amount of liquid assets
equal to but not less than certain percentage of demand and time liabilities.
Though the RBI did not use CRR and SLR as significant instruments of credit
control during the whole of the sixties, it started varying the ratios since then
actively. The implication of these variations is that when the ratio is brought
down it would release the funds that would have otherwise been locked up for
investment by the commercial banks. Of late, the RBI has removed the reserve
requirements on inter bank liabilities w.e.f. April 26, 1997. This single measure
released Rs.950 crore for investment in trade and industry. Similarly, as a part
of monetary and credit policy for the second half of 1997-98, RBI reduced CRR
by two percentage points from 10.0 percent in eight phases of 0.25 each. The
total addition to liquidity from this was estimated at about Rs. 9,600 crore.
Even though the obligation of banks is to maintain their liquid assets at a
minimum of 25 percent, in the light of the need to restrain the pace of expansion
of bank credit, the RBI has imposed a much higher percentage of minimum liquid
assets and in some cases to the extent of even 35 percent. These measures
have started impounding vast amount of resources of the banks and encouraging
governments [Central and State] to have an easy access to bank credit. It also
led to the shrinkage of resources available for genuine credit purposes. In view
of the strong opposition from the banks and basing on the recommendations of
the committee on “Financial Sector Reforms”, RBI reduced the ceiling to its
original level of 25 percent of the net demand and time liabilities (NDTL). The
banking system already holds government securities of about 39 percent of its net
demand and time liabilities (NDTL) as against the statutory minimum requirement
of 25 percent.

The cash reserve ratio (CRR) remains an important instrument for modulating
liquidity conditions. The medium-term objective is, however, to reduce CRR to the
statutory minimum level of 3.0 percent. Accordingly, on a review of developments
in the international and domestic financial markets, a 75 basis point reduction in
the CRR during June to November, 2002 was followed by a further 25 basis
points cut from June 14, 2003 taking the level of the CRR down to 4.5 percent.
The minimum daily maintenance of CRR was raised to 80 percent of the
average daily requirement for all the days of the reporting fornight with effect
from the fortnight begining November 16, 2002. This was subsequently lowered
to 70 percent with effect from the fortnight begining December 28, 2002. The
payment of interest on eligible CRR balances maintained by banks was changed
from quarterly basis to monthly basis from April 2003. The CRR has been almost
halved since April 2000 resulting in cumulative release of first round resources of
over Rs.33,500 crore (Table 2.1)
26
 Table 2.1 : Cash Reserve Rato Theories and Approaches
(Amount in Rupees Crore)
2003-04 2002-03 2001-02 2000-01
CRR Amount* CRR Amount* CRR Amount* CRR Amount*
(%) (%) (%) (%)
1 2 3 4 5 6 7 8 9
April 4.75 0 5.5 0 8.0 0 8.0 7,200
May 4.75 0 5.5 0 7.5 4,500 8.0 0
June 4.5 3,500 5.0 6,500 7.5 0 8.0 0
July 5.0 0 7.5 0 8.25 -1,900
August 5.0 0 7.5 0 8.5 -1,900
September 5.0 0 7.5 0 8.5 0
October 5.0 0 7.5 0 8.5 0
November 4.75 3,500 5.75 6,000 8.5 0
December 4.75 0 5.5 2,000 8.5 0
January 4.75 0 5.5 0 8.5 0
February 4.75 0 5.5 0 8.25 2,050
March 4.75 0 5.5 0 8.0 2,050
* Amount stands for first round release (+)/impounding (-) of resources through changes in
the cash reserve ratio.

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

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

2.2.4 Interest Rates

Realising the fact that Bank Rate is not functioning as an effective tool of credit
control, RBI started influencing the cost of credit, through the changes in interest
rates. The RBI derived the authority to regulate the interest rates of banks under
sections 21 and 35a of the Banking Regulation Act, 1949. This power covers
both the advances and deposit rates. The rates on loans and advances are
controlled mainly in order to influence the demand for credit and to introduce an
element of discipline in the use of credit. This is generally done by stipulating
minimum rates of interest for extending credit against commodities covered under
selective credit control. Also, concessive or ceiling rates of interest are made
applicable to advances for certain purposes or to certain sectors to reduce the
interest burden and thus facilitiate their development. Further, the objectives
behind fixing the rates on deposits are to avoid unhealthy competition amongst the
banks for deposits, keep the level of deposit rates in alignment with the lending
rates of banks, and aid in deposit mobilisation.

27
Concepts and Determination In addition to RBI, certain other agencies also have the authority to fix rates of
of Working Capital interest for different types of financial activities. For instance, the controller of
capital issues (now abolished) used to fix the ceiling on coupon rates on industrial
debentures and preference shares. The Indian Banks Association (IBA) had been
fixing the ceiling on call rates since 1973, until 1988, when call rates were freed
from the ceiling. The Government of India fixes the rate on treasury bills and
long-term government securities. The Government has significant influence in the
fixation of interest rates on long-term loans of Development Finance Institutions
[DFIs]. This is how the rates of interest are administered in India, leading to a
large variety of multiple and complex interest rates.

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

following the recommendations of the committee to Review the working of
Monetary System (under the Chairmanship of Chakravarty), RBI has started
rationalising the interest rate structure since 1991. One of the objectives of the
present policy appears to be to reduce the multiplicity of interest rates and to
bring about a simplification in their structure. Efforts are being made to eliminate
all criteria, other than the size of loan, while deciding the credit policy. Recent
policy changes in this regard include:
i) Interest rate on domestic term deposits with maturity of 30 days to one year
was linked to the Bank Rate; by stipulating interest rate on these deposits as
‘not exceeding Bank Rate minus 2 percentage points per annum’ from April
16. 1997;
ii) Bringing under the same ceiling the Non-Resident (External) (NRE) Rupee
term deposits with that of domestic term deposits;
iii) Allowing banks to announce a separate Prime Term Lending Rate (PTLR)
for term loans of three years and above;
iv) Making the banks to announce the maximum spread over the PLR for all
advances other than consumer credit.
v) Permitting banks to prescribe separate Prime Lending Rates (PLRs) for loan
and cash credit components and also separate spreads for both the
components.
vi) Permitting banks to provide foreign currency denominated loans to their
customers for meeting either their foreign currency or rupee requirements;
vii) Freedom for banks to decide the rate of interest on post-shipment export
credit on medium and long-term basis.
In recent years, there has been a persistent downward trend in the interest
rate structrue reflecting moderation of inflationary expectations and comfortable
liquidity situation. Changes in policy rates reflected the overall softening of
interest rates as the Bank Rate has been reduced in stages from 8.0 percent in
July 2000 to 6.25 percent by October 2002, which is the lowest rate since May
1973.

2.2.5 Selective Credit Controls

Central banks, generally, have a policy to use qualitative techniques in addition
to quantitative techniques of credit control. The most widely used of the
qualitative techniques are selective credit control and moral suasion. While the
general credit controls operate on the cost and total volume of credit, selective
credit controls relate to tools available with the monetary authority for regulating
the distribution or direction of bank resources to particular sectors of the
economy in accordance with the broad national priorities considered necessary for
achieving the set, developmental goals. These control techniques have special
28
relevance to developing countries owing to the meagre supply of credit and the Theories and Approaches
chance of credit being misutilised for unproductive and speculative purposes. In
exercise of the powers conferred on to it, the RBI may give directions of the
following kind to the banks generally or to any bank or a group of banks in
particular.
a) the purposes for which advances may or may not be made;
b) the margins to be maintained in respect of secured advances;
c) the maximum amount of advances; and
d) the rate of interest and other terms and conditions subject to which
advances may be granted or guarantees may be given.
Almost since the middle of 1956, RBI has started exercising powers vested in it.
A number of commodities and products have been covered at one time or the
other. Some of the commodities, which had been under frequent controls, are
foodgrains, cotton, raw jute, oil seeds, vegetable oils, sugar, cotton yarn and
textiles.

However, the situation has changed recently. After the implementation of new
economic policy in 1991, there has been a phasing out of the selective credit
controls. By the end of 1996, almost all the controls were virtually eliminated.
The only exception being the advances against buffer stock of sugar and
unreleased stock of sugar-to-sugar mills. However, in order to counter temporary
deterioration in price-supply situation, selective credit controls were reimposed
only for a period of three months (from April to July 7, 1997) on bank advances
against stocks of wheat. Further, effective from October 22, 1997,
differential minimum margins of 10 percent and 15 percent were stipulated
for advances against levy and free sale sugar respectively; leaving advances
against buffer stock free from margin.

2.2.6 Flow of Credit

A favourable development during 2002-03 has been a sustained increase in credit
flow to the commercial sector reflecting industrial recovery. During 2002-03, non-
food credit of scheduled commercial banks (SCBs) registered a high growth of
26.2 percent (Rs.1,40,144 crore) and, net of mergers, it rose by 17.8 percent
(Rs.95,599 crore), as agaisnt an increase of 13.6 percent (Rs.64,302 crore) in the
previous year. The incremental non-food credit-deposit ratio during 2002-03 at 79
percent is the highest recorded over the last five years. This is indicative of the
fact that a substantial part of lendable resources of banks has been deployed for
productive purposes. This is also borne out by the strong growth of 10.3 percent
in demand deposits in 2002-03, which is mainly used for working capital
requirements. The increase in total flow of funds from SCBs to the commercial
sector during 2002-03, Including banks' Investments in bonds/debentures/shares of
public sector undertakings and private corporate sector, commercial paper (CP)
etc, was also higher at 24.5 percent (Rs.1,51,569 crore) as against 12.7 percent
(Rs.69,483 crores) in the previous year. The total flow of resources to the
commercial sector, including capital issues, global depository receipts (GDRs) and
borrowings from financial institutions was at Rs 1,88,262 crore as compared with
Rs 1,42,082 crore in the previous year.

In order to introduce an element of discipline in the utilisation of bank credit,

especially by large borrowers, the loan component was raised progressively from
75 percent in April 1995 to 80 percent in April 1997. Further, the instructions
relating to the computation of Maximum Permissible Bank Finance (MPBF) for
working capital requirements have been withdrawn. Banks were permitted to
evolve their own methods for assessing working capital requirements of 29
Concepts and Determination borrowers. In a major departure from the past, banks were permitted to frame
of Working Capital their own ground rules for consortium arrangements. In order to introduce
further flexibility in the credit delivery system, banks were given freedom to form
or not to form a consortium, even if the credit limit of the borrower exceeds Rs.
50 crores.

Keeping in view of the need to support the efforts to revive the capital market,
banks were allowed to extend loans to corporates against shares held by them to
enable such corporates to meet the promoters’ contribution. The margin and the
period of repayment of such loans would be determined by banks. Banks were
also permitted to sanction bridge loans to companies against expected equity
flows for a period not exceeding one year, subject to the guidelines approved
by their respective boards. Taking into account the changing scenario, banks
were asked to review the existing arrangements for financing trade and services.
The RBI directed banks to evolve a suitable method of assessing loan
requirements of borrowers in the service sector and report the arrangements
made in this regard.

It is clear from the foregoing discussion that the changes in the monetary and
credit policies influence working capital decisions in terms of the availability of
credit and cost of credit directly and through the ‘balancing of the economy’
indirectly. For the benefit of students, the salient features of the monetary and
credit policy measures announced by RBI for the year 2003-04 are given in
Appendix-I.

Activity 2.1
Highlight the salient features of the latest monetary and credit policy announced
by RBI.
....................................................................................................................................

....................................................................................................................................

....................................................................................................................................

....................................................................................................................................

2.3 FINANCIAL MARKETS

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

The main organised financial markets in India are:

i) the credit market, which is dominated by commercial banks;
ii) the money market with call money segment forming a sizeable proportion;
iii) equity and term lending market consisting of primary, secondary and term
lending segments;
iv) corporate debt market comprising PSU bonds and corporate debentures;
v) gilt-edged market for Government securities;
vi) housing finance market;
30
vii) hire purchase and leasing finance market, wherein the non-bank financial Theories and Approaches
companies (NBFCs) predominate;
viii) insurance market; and
ix) foreign exchange market.
In addition, there is an unorganised and informal finance market comprising of
money lenders in villages and indigenous bankers in towns/cities. All the agencies
constitute the financial sector of India.

In the recent past (since 1991) government has embarked upon effecting major
changes in the areas of industrial trade and exchange rate policies. These
changes are designed to correct the macro-economic imbalances and effect
structural adjustments with the objective of bringing about a more competitive
system and promoting efficiency in the real sectors of the economy. Economic
reforms in the real sectors of the economy will not produce desired results,
unless the former are supplimented by suitable and effective financial sector
reforms. With this end in view, the Government of India has appointed a
committee on the working of financial system of the country in August 1991
under the chairmanship of M.Narasimham.

The committee was asked, inter alia, to examine the existing structure of the
financial system and its various components and to make recommendations for
improving the efficiency and effectiveness of the system with particular reference
to the economy of operations, accountability and profitability of the commercial
banks and financial institutions. The committee has submitted its report in
November 1991. Since the submission of the report, the Government has taken
several steps on different aspects of the recommendations. The significant steps
that were taken are:
i) A strict criteria was evolved for companies that access securities markets.
The issuers of securities are required to meet certain standards like the
payment of dividend, minimum share-holding requirement, etc.
ii) The Securities and Exchange Board of India (SEBI) took several steps for
widening and deepening different segments of the market for promoting
investor protection and market development;
iii) The safety and integrity of the securities market were strengthened through
the institution of risk management measures, which included a
comprehensive system of margins, intra-day trading and exposure limits,
capital adequacy norms for brokers and setting up of trade/settlement
guarantee funds.
iv) Reforms in the secondary market focused on improving market transperancy,
integrity and infrastructure.
v) FIIs were permitted to invest upto 10 per cent in equity of any company, to
invest in unlisted companies and to invest in debt securities without any
requirement for investment in equity. They were also permitted to invest in
dated government securities within the framework of guidelines on FII
investment in debt instruments.
vi) Government has also initiated measures to deepen and broaden the
government securities market and increase its liquidity.
vii) The earlier restriction that debt instruments of a corporate could be listed only
after its equity had been listed on any exchange was removed.
viii) Investment guidelines regarding the utilisation of funds of LIC were revised.
ix) The Mutual Fund Regulations issued by SEBI in 1993 were further revised
on the basis of a special study commissioned by itself. 31
Concepts and Determination
of Working Capital 2.4 ECONOMIC LIBERALISATION AND INDUSTRY
The economic liberalisation programme initiated by the Government in the early
ninties has changed the face of industry, more particularly the dynamics of
financial environment. There has been a sea change in the organisational
structure and operations of the players in money and capital markets. The
distinction between long term financing and short term financing is slowly on the
wane. Devlopment Banks are now converting themselves into ordinary
commercial banks. Deregulation of interest rates, emergence of a liberalised
capital market and increasing participation of bank in terms of financing have
significantly influenced the operations of devlopment banks.With their fray into the
realm of working capital loans; the traditional divide into the operational domain
of development banks and commercial banks is getting blurred. One of the
implications of this development is that the hitherto privileged access to assured
sources of low cost funds will disappear. There has already been an attempt to
align all the forces to market make the latter decide the equilibrium between
supply of and demand for funds.

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

On the fiscal front, the government expenditure has been cut in real terms. The
burnt has been borne by cuts in investments and expenditure on social sector.
There were large slippages in the fiscal correction. The rising deficits on the
revenue account are often cited as the main cause for the observed phenomenon.
Behind these lie the erosion of excise tax base, mounting interest burden on
public debt, growing subsidies and the rising cost of wages and salaries.

On the external front, following the liberalisation, India devalued its currency
leaving an impact on the exports and imports. With an unsuccessful interlude with
exim scrips and dual exchange rate system; India went in for a unified market
determined exchange rate system. Correcting the exchange rate valuation of the
past was a major event on the reform process. The lower exchange rate
enhances the profitability of existing exports, more importantly, it broadens the
range of eligible exports. It makes imports more costly and provides scope for
import substitution, thus narrowing the range of potential imports. The rupee is
now convertible on current account, subject to exchange rate risk. Some of the
important components of capital account are considerably liberalised.
Another dimension of the liberalisation on the external front is that the gates for
foreign investment were wide open. foreign trade and foreign investment appear
to be mutually influential. Portfolio investments have become very significant in
several developing countries, including India. According to a study conducted by
Business Line (dated 28-03-04) foreign investors control 30 percent of India’s top
companies. In terms of wealth, foreigners now control a third of the market
capitalisation of the Nifty Companies ( 50 in number). A further analysis of the
share-holding patterns suggests that there is an increase in the holding in such
sectors as oil, gas, petro-chemical, power and automobiles. One might wonder, if
East India Company Syndrome – a sort of creeping acquisition of effective
control and wealth – is under way.
32
These developments produce some direct and some indirect effects on the Theories and Approaches
growth and development of Indian industry in the years to come. More
specifically, developments in the financial sector pose serious concerns for the
effective use of working capital by the industry.

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

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

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

need to care for the impact of inflation on business decisions. Inflation
causes a spurt in the prices of input factors like raw materials, labour, fuel and
power. It may also influence the behaviour of business units to go in for
speculative activities. Rapid increase in inflation may force the central bank
to formulate a tight, money policy, thus restricting for flow of credit to the
business. Further, inflation may effect working capital decisions leading to
over-investment in inventory, under or over pricing of inventories, loss to the unit
in the collection of debts due to depreciation in the value of money. Idle cash
flowing through the organisation will add further problems to the unit in terms of
loss in the value of money in real terms.

Financial markets are the agencies that provide necessary funds for all productive
purposes. The stage of development of these markets has profound influence on
the supply and demand for funds. For, the Government has taken up a reform
exercise meant for improving the efficiency and effectiveness of the system.
The sweep of the reforms is wide enough to cover every constituent of the
organised financial system such as the money market, credit market, equity and
debt market, government securities market, insurance market and the foreign
exchange market.

2.6 KEY WORDS

Environment: Surroundings or circumstances, which affect the life of an object.
Broad Money: Sum of money in circulation, demand and time deposits with
commercial works and other deposits with RBI.
Bank Rate : The Rate at which the Central Bank is prepared to buy or
rediscount bills of exchange and other eligible securities of commercial banks.

Cash Reserve Ratio: Minimum reserve maintained by commercial banks with RBI.

Selective Credit Controls: Tools available with the Central Bank to regulate
the flow of credit. 33
Concepts and Determination Statutory liquidity Ratio: Minimum Reserve to be maintained by commercial
of Working Capital banks with themselves, as a percentage of demand and time liabilities.

Financial Market: An agency that helps in the mobilisation of funds for industry
and trade.

Credit Policy: A statement indicating the measures contemplated for ensuring

effective flow of credit to the needy.

2.7 SELF ASSESSMENT QUESTIONS

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

2.8 FURTHER READINGS

1) Reddy, Y.V. ‘Monetary and Credit Policy - Continuity, Context, Change
and Challenges’, RBI Bulletin, Vol.LII, No.6, June 98.
2) Economic Survey. 1997-98.
3) Rangarajan, C, ‘Dimensions of Monetary Policy’, RBI Bulletin, Vol. LI,
No.2, Feb. 97.
4) Bhole, L.M., Financial Institutions and Markets, New Delhi, Tata McGraw
Hill, 1992.
5) Rao, K.V. & Venkataramaiah, B., 1991, Bank Finance to Industries,
Printwell, Jaipur.
6) Report of the Committee on Financial System, 1991.
7) Rao, K.V., 1990, Management of Working Capital in PEs, Deep & Deep,
New Delhi.
8) De Kock, M.H., Central Banking, New Delhi, Universal Book Stall, 1984.
9) RBI, Reserve Bank of India - Functions and Working, Bombay, 1983.
10) Gupta, L.C. (Ed.), 1978, Banking and Working Capital Finance, Macmillan,
Delhi.
11) Chakraborty, S.K. and Others, 1976, Topics in Accounting and Finance,
Oxford University Press, Calcutta

.
34
 Appendix Theories and Approaches

Monetary and Credit policy for the year 2003-04

The statement on monetary and credit policy for the year 2003-04 was declared
by Dr. Bimal Jalan, Governor, RBI on 29th April 2003. The statement consists of
three parts:
1) Review of macroeconomic and monetary development during 2002-03
2) Stance of monetary policy for 2003-04
3) Financial sector reforms and monetary policy measures.
I) Macroeconomics and Monetary Developments: The following are the
major aspects under this section.

1) The growth rate of real GDP in 2001-02 was at 5.6 percent. This was due
to the contribution of individual sectors such as services (6.5), industry (3.2)
and agriculture (5.7). For the year 2002-03 the GDP growth rate was
established to be 4.4 percent.

2) The annual rate of inflation as measured by variations in the wholesale price

Index remained below 4.0 percent upto mid- January 2003 and rose
thereafter to 6.2 percent by end March 2003, mainly due to increase in prices
of non-food articles and mineral oils.

3) The Growth in money supply (M3) was 15 percent.

4) There has been a sustained increase in credit flow to the commercial sector.
During 2002-03, non-food credit of scheduled commercial banks registered a
high growth of 26.2 percent.

5) The Fiscal deficit of the Central Govt. for 2002-03 was Rs. 1,45,466 crores.
The average cost of Govt. borrowings through primary issuances of dated
securites at 7.3 percent during 2002-03, compared to 9.44 percent during the
previous year.

6) The banking system held about 39 percent of its net demand and time
liabilities (NDTL), as against the statutory minimum requirement of 25
percent.

7) Banks have reduced their prime lending rates (PL Rs) from a range of
10-12.5 percent in March 2002 to 9-12.25 percent by March 2003.

8) There has been a persistent downward trend on the interest rate structure,
reflecting moderation of inflationary expectations and comfortable liquidity
situation.

9) Liberalisation in the domestic economy combined with the increasing

integration of the domestic markets with international financial market poses
new challenges for monetary management.

II) Stances of Monetary Policy: The overall stance of the monetary policy is
as follows:

1) Provision of adequate liquidity to meet credit growth and support investment

demand in the economy, while continuing a vigil on movements in the price
level.

35
Concepts and Determination 2) In line with the above, to continue the present rate of interests, including
of Working Capital preference for soft interest rates.

3) To impart greater flexibility to the interest rate structure in the medium term.

III) Monetary Policy Measures: The following are the important policy
measures announced as a part of the present credit policy.
1) The main focus of the policy is on the structural and regulatory measures to
strengthen the financial systems.
2) To reduce bank rate by 0.25 percentage points from 6.25 to 6.0 percent.
3) To reduce cash reserve ratio from 4.75 to 4. 50 percent.
4) To continue extending refinance facility to eligible export credit remaining
outstanding under post-shipment rupee credit beyond 90 days and upto 180
days.
5) To rationalise the multiplicity of rates at which liquidity is absorbed, in order
to increase the efficacy of liquidity adjustment facility (LAF) operations.
6) Commercial banks to decide the lending rates to different borrowers, subject
to announcement of PLR, as approved by their Boards.
7) To provide uniformity in the maturity structure for all types of repatriable
deposits.
8) Liberalisation of credit for drip irrigation / sprinkler irrigation system.
9) Banks will be free to extend direct finance to the housing sector upto Rs 10
lakhs in rural and semi urban areas as part of priority sector lending.
10) To initiate a survey for assessing the impact of Kisan Credit Cards Scheme.
11) Recognition of micro credit institutions and self-help groups as important
vehicles for generation of income and delivery of credit to self-employed
persons.
12. Review of compliance with the reporting requirement to Negotiated Dealing
Systems (NDS).
13) Scheduled commercial banks, financial institutions and primary dealers would
be allowed to buy and sell options. Corporates may also sell options without
being the net receivers of premium.
14) Banks are allowed to invest in commercial papers guaranteed by non bank
entities.
15) To accord general permission to mutual funds for their overseas investments
within limits.
16) Indian corporates and resident individuals will be permitted to invest in rated
bonds/fixed income securities of listed eligible companies abroad, subject to
certain conditions.
17) To exempt both gold loans and small loans up to Rs. 1 lakh from the 90 days
norm for recognition of loan impairment.
18) As a part of customer service, banks have been advised to open certain
currency chest branches on Sundays for providing note exchange facilities
and distribution of coins. Banks are also advised to install note counting / note
sorting machines at currency chests/major bank branches.
36
 Theories and Approaches
UNIT 3 DETERMINATION OF WORKING
CAPITAL
Objectives

The objectives of this unit are to:

• Provide a framework for assessing the working capital requirements of a
firm.
• Explain the concept of operating cycle and its utility in the determination of
working capital requirements.
• Examine the theoretical basis for the determination of Working Capital needs.
• Highlight the recommendations of Tandon committee.
• Discuss the present policy of the commercial banks in determining working
capital requirements of their borrowers.
Structure
3.1 Introduction
3.2 Determination of Working Capital Needs: Different Approaches
3.3 Factors Influencing Determination
3.4 Tandon Committee Norms
3.5 Present Policy of Banks
3.6 Summary
3.7 Key Words
3.8 Self-Assessment Questions
3.9 Further Readings

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

Indian Industries today have value maximization as the major objective & to
achieve it one should be capable of estimating the requirements precisely.
Both excessive and inadequate investment in working capital items may lead to
unnecessary strain on the objective function. Therefore, the finance manager has
to examine all the factors that determine the working capital requirements within
the theoretical and practical points of view. For, the theoretical considerations
sometimes dominate the methodology of assessment; while the firms are
constrained to follow the restrictions imposed by the borrowers. The finance
manager, therefore, should consider all the factors that have a bearing on the
working capital including cash, receivables and inventories. Though certain models
are developed to determine the optimum investment in each of the working
capital items, an aggregate approach is yet to be formulated. In the mean time,
firms are basing their computations on the concept of operating cycle. These and
other related issues are discussed in detail in this unit.

37
Concepts and Determination
of Working Capital 3.2 DETERMINATION OF WORKING CAPITAL
NEEDS : DIFFERENT APPROACHES
The question that what is the adequate amount of working capital required to run
a business, is attempted to be answered in several ways. Theoreticians, by their
natural inclination to construct models, have based their analogy on certain
foundations and constructed models to estimate the optimum investment in
working capital. Whereas, lenders such as banks, financial institutions have based
their decisions on production schedules and industry practices. In between, a new
point of view was developed calling for the adoption of a strategic approach to
the decision-making. Let us now discuss these theoretical issues to further our
understanding of the subject matter.

3.2.1 Industry Norm Approach

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

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

The classification of units into a particular industry is not that easy. Firms
may not be susceptible for such a neat classification; when the units are
multi-product firms.
b) Deciding an average to represent a particular industry is highly difficult. The
norms, thus, developed can be less of a reality and more of a myth.
c) Averages have no meaning to many firms, since the nature of firms differ.
d) Industry norm approach may result in imitative behaviour resulting in damage
to innovation.
e) This approach may also promote ‘hard mentality’, thus limiting the scope for
excellence. For example, if X unit is able to maintain its production schedule
with only one month requirement of raw material, while the industry norm
being 2 months, there is no wisdom as to why X should also keep 2 months.
For the above reasons, industry norm approach is not suggested by many as a
benchmark for making investment in current assets. Nevertheless, this has been a
practice followed by many as a tradition, even the Tandon Committee has
developed norms for maintenance of current assets on industry basis.

3.2.2 Economic Modelling Approach

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

EOQ is given by a simple equation:

√2SO
Q* = ––––––
C
Where Q* = Optimum order quantity
S = Annual usage of material
O = Ordering costs per order
C = Carrying costs per unit
William J. Baumol has attempted to apply this inventory model to the
determination of optimum cash balances that can be held by an enterprise. The
transactions demand for money is sought to be analysed from this point of view.
As per the model, the optimum level of cash is decided by the carrying cost of
holding cash and the cost of transferring marketable securities to cash and vice-
versa.

His equation is as follows:

√2bT
C* = ––––––
i
C * = Optimum cash balance
b = Transaction costs per transaction
T = Total demand for cash
i = Interest rate
Similarly, the decision to sell to a particular account should be based objectively
upon the application of profit maximising model. In this regard, Robert M.
Soldofsky developed a model for Accounts receivable management. He has laid
down the following formula for making a credit decision, leading to optimum
investment in receivables.
Sell, when M – (b + Ti + c/o) > 0
where M = Profit Margin
b = Probability of a credit sale becoming a bad debt
i = Interest rate
c = Costs per order of selling on credit as an implicit function of risk,
o = Order size
T = Time period
Though models are available to decide optimum investment in case of some
important components of working capital, for many other items, no such modeling
is attempted; nor is there an attempt at the aggregate level. Moreover, these
models are subject to certain assumptions and conditions. Their utility comes
under scrutiny for want of these assumptions turning out to be far from reality.
For this and several other reasons, economic modelling is not much popular with
Indian companies.

3.2.3 Strategic Choice Approach

Unlike industry norm approach and economic modelling approach, this is not a
standard method which suggests certain benchmarks to work with. The earlier 39
Concepts and Determination methods suggest the use of certain yardsticks or guidelines, irrespective of the
of Working Capital differences in size of the business units, nature of industry, business structure or
competition. For example, optimum investment in inventory can be had by
applying the equation and it is almost universal for every business unit. Similarly,
industry norm approach suggests the same yardstick for every unit constituting
that industry, in spite of variations in the size, nature of business, terms of sale
and purchase, and competition.

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

practice and advocates the use of ‘strategy’ in taking working capital decisions.
The spirit behind this approach is to prepare the unit to face challenges of
competition and take a strategic position in the market place. The emphasis is on
the strategic behaviour of the business unit. The firm is independent in choosing
its own course of action; not necessarily guided by the rules of the industry. This
makes it obligatory on the part of the firm to set its own targets for achievement
in the area of working capital. For instance, if the firm has set an objective like
increasing market share from the present level of 20 percent to 40 percent, it
can think of devising a suitable credit policy. Such a policy may involve variations
in the terms followed at present such as extending the credit period, enhancing
the credit limit or increasing the percentage of cash discount, etc.

Thus, the strategic choice approach presupposes a highly competitive environment

and the willingness of the management to take risks. The success of the
approach also depends on the ability of the management to set realistic goals and
prepare suitable strategy to achieve them. Any wrong planning will lead the firm
into trouble; much worse than what it was when either of the earlier methods
were being followed.

Activity 3.1

1. Giving reasons indicate the approach suitable for determining optimum

inventory.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................

2. Mention 2/3 points about relevance of strategic choice approach in practical

business decision making.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................

3.3 FACTORS INFLUENCING DETERMINATION

The working capital requirements of a firm depend on a number of factors. It is
a common proposition that the size of working capital is a function of sales.
Sales alone will not determine the size of the working capital, but instead it is
constantly affected by the criss-crossing economic currents flowing in a business.
The nature of the firm’s activities, the industrial health of the country, the
40
availability of materials, the ease or tightness of the money market, are all parts Theories and Approaches
of these shifting forces. Of them, the influence of operating cycle is considered
paramount.

3.3.1 Operating Cycle

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

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

Average inventory of raw materials and stores

r = ————————————————————
Average materials and stores consumption per day

Average trade creditors

c = ————————————
Average purchase per day
Average work in progress
w = ————————————————
Average cost of production per day

Average inventory of finished goods

f = ——————————————————
Average cost of sales per day

Average book debts

b = —————————————
Average sales per day
41
Concepts and Determination The average inventory or book debts level can be arrived at by finding the mean
of Working Capital between the relevant opening and closing balances for the year. The average
consumption or output or cost of sales or sales per day can be obtained by
dividing the respective annual figures by 365.

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

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

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

3.3.2 Determination of Working Capital Using O.C.

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

Illustration 3.1

ABC company plans to achieve annual sales of 1,00,000 units for the year 2005.
The following is the cost structure of the company as per the previous figures.
Materials .. 50%
Labour .. 20%
Overheads .. 10%
The following further particulars are available from the records of the
company.

1) Raw materials are expected to remain in stores for an average period of one
month before issue to production.
2) Finished goods are to stay in the warehouse for two months on an average
before being sold and sent to customers.
3) Each unit of production will be in process for one month on the average.
4) Credit allowed by the suppliers of raw material is one month from the date
of delivery of materials.
5) Debtors are allowed credit for two months from the date of sale of goods.
6) Selling price per unit is Rs.9 per unit.
7) Production and sales follow a consistent pattern and there are no wide
fluctuations.
Determine the quantum of working capital required to finance the activity level of
1,00,000 units for the year 2005.
42
SOLUTION: Theories and Approaches

STATEMENT OF WORKING CAPITAL REQUIRED

Current Assets:
Amount (Rs.)
1 50
1. Raw Material Inventory (1 month) (1,00,000 x 9 x —–– x —–– ) = 37,500
12 100

1 80
2. Work-in-progress Inventory (1 month) (1,00,000 x 9 x —– x —–– ) = 60,000
12 100
2 80
3. Finished goods Inventory (2 months) (1,00,000 x 9 x —–– x —–– ) = 1,20,000
12 100
2 100
4. Debtors (2 months) (1,00,000 x 9 x — x —–– ) = 1,50,000
12 100 –––––––
3,67,500
Less: Current Liabilities:
1 50
1. Creditors (1 month) (1,00,000 x 9 x ––– x ––– ) = 37,500
12 100 –———
Working capital required = 3,30,000
–––––––
Notes: 1) Raw material inventory is expressed in raw material consumption.
2) Work-in-progress inventory is expressed in cost of production
(COP) where, COP is deemed to include materials, labour and
overheads.
3) Finished goods inventory is supposed to have been expressed in
terms of cost of sales. Since separate details are not given, the
figures are worked out on COP.
4) Debtors are expressed in terms of total sales value.
5) Creditors are expressed in terms of raw material consumption,
since separate figures are not available for purchases.
Illustration 3.2
A company plans to achieve annual sales of Rs.1,00,000. What would be its
working capital requirements under the following conditions:
1) The average period during which raw materials are kept in stock before
being issued to factory - 2 months.
2) The length of the production cycle i.e., the period from the date of receipt
of raw materials by factory to the date of completion of goods - or say
stock-in-process - 1/2 month.
3) Average period during which finished goods are stocked pending sale- 1 month.
4) The period of credit allowed to customers - 1 month.
5) The period of credit granted by suppliers of raw materials - 1 month.
6) The analysis of cost as a percentage of sales:
Raw materials.. .. .. .. 45%
Manufacturing expenses including wages & depreciation 30%
Overheads (Excluding depreciation) .. .. 10%
Net Profit .. .. .. 15%
Total .. 100%
7) Cash available in business to meet urgent requirements is Rs.5,000. 43
Concepts and Determination SOLUTION:
of Working Capital Current Assets:
Amount (Rs.)
45 2
1. Raw material inventory (2 months) (1,00,000 x —–– x—––) = 7,500.00
100 12
1 75 1
2. Work-in-progress inventory (— month) (1,00,000 x ––– x —–) = 3,125.00
2 100 24
85 1
3. Finished goods Inventory (1 month) (1,00,000 x —— x ——) = 7,083.33
100 12
100 1
4) Receivables (1 month) (100,000 x —— x ——) = 8,333.33
100 12 ––––––––––
26,041.66
5) Cash available in the firm .... .... = 5,000.00
—————-
31,041.66
Less: Current Liabilities:
45 1
1. Creditors (1 month) (1,00,000 x —— x ——) = 3,750.00
100 12 ––––––––––
Working capital required 27,291.66
––––––––––
Notes: (1) Workings are made as per assumptions given in Illustration- 3.1
excepting that the finished goods inventory is expressed in terms of cost
of sales, which is considered to be inclusive of raw materials,
manufacturing expenses and overheads.

3.3.2 Other Factors

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

Management’s Attitude Towards Risk

Management’s attitude towards risk also influences the size of working capital in
an undertaking. It is, of course, difficult to give a very precise and determinable
meaning to the management’s attitude towards risk, but as suggested by Walker,
the following principles involving risk may serve as the basis of policy
formulation:
i) If working capital is varied relative to sales the amount of risk that firm
assumes also varies and the opportunity for gain or loss is increased;
ii) Capital should be invested in each component of working capital as long as
the equity position of the firm increases;
iii) The type of capital used to finance working capital directly affects the
amount of risk that a firm assumes as well as the opportunity for gain or
44 loss and cost of capital; and
iv) The greater the disparity between the maturities of a firm’s short-term debt Theories and Approaches
instruments and flow of internally generated funds, the greater the risk and
vice-versa.

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

Growth and Expansion of Business

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

Product Policies

Depending upon the kind of items manufactured by adjusting its production

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

Position of the Business Cycle

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

Terms of Purchase and Sale

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

Miscellaneous
Apart from the above mentioned factors some others like the operating efficiency,
profit levels, management’s policies towards dividends, depreciation and other
reserves, price level changes, shifts in demand for products competitive
45
Concepts and Determination conditions, vagaries in supply of raw materials, import policy of the government,
of Working Capital hazards and contingencies in the nature of business, etc., also determine the
amount of working capital required by an undertaking.

Activity 3.2
1. Highlight few important factors on which the working capital requirement of
your organisation depends.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
2. Give your views on the method of assessment being used in your organisation
for working capital determination
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

3.4 TANDON COMMITTEE NORMS

Since mid-sixties, the issue of financing working capital has been engaging the
attention of industry and the policy makers. The measures taken by the Reserve
Bank of India included the introduction of Credit Authorisation Scheme in
November 1965, Constitution of the Dahejia Committee in October 1968, Tandon
Committee in July 1974 and the Chore Committee in March 1979. Over the
years, attempt has been made to streamline the flow of credit from the banking
sector to the industry. The link between financing of working capital and the
recommendations of various committees is that the latter tried to make out a
case for fixing norms for the maintenance of various current assets; thus leading
to the determination of optimum working capital.
In this regard, Tandon Committee, for the first time, made an attempt to
prescribe norms for holding diverse current asset items. The committee wanted
the commercial banks to quantify the desirable level of net working capital and
the maximum permissible lending by the banks. In its approach to the methods of
lending, the Committee sought to identify the ‘Reasonable level of current assets’
as the basis of its calculation of different methods. In other words, the total of
current assets is based on the norms suggested by them rather than the actual
current assets held by the undertakings. For this purpose, the Committee
suggested norms for carrying raw materials, work-in-progress, finished goods, and
receivables in respect of 15 major industries. The norms for the four kinds of
assets are related in the following manner:
Type of Asset Relation to
1. Raw Materials Month’s consumption of raw materials
2. Work-in-progress Month’s cost of production
3. Finished goods Month’s cost of sales
4. Receivables Month’s sales
The norms represent the maximum levels of inventories and receivables in each
type of industry. It is further laid down that, if the holding of any kind of asset is
higher than the level fixed by the relative norms, the surplus would be treated
‘excess’ holding to be shed off, failing which an amount equal to the value
thereof would be treated as excess borrowing and a levy of penal rate of interest
is suggested on such excess borrowing. Again, it is not permitted to set off such
excess against any shortfall in the holding of other current assets, as the norms
46 represent the maximum permissible levels of holdings. The list of fifteen industries
included cotton textiles, synthetic textiles, jute, pharmaceuticals, rubber, fertilisers, Theories and Approaches
vanaspati, paper and engineering. This system of lending continued with little
variations almost upto the beginning of the present decade. But there is no
change in the basic philosophy as to the assessment of working capital norms,
based on the industry norm approach.

3.5 PRESENT POLICY OF BANKS

After the implementation of a phased liberation programme since 1991, the RBI
decided to allow full operational freedom to the banks in assessing the working
capital requirements of the borrowers. All the instructions relating to Maximum
Permissible Bank Finance (MPBF) have been withdrawn. As an alternative, a
revised system of assessing working capital limits has been evolved. Accordingly,
one of the following three methods has been suggested for adoption by the
commercial banks.
a) Turnover method
b) Eligible working capital limit method
c) Cash-flow method
Under the ‘Turnover method’, working capital requirements of all the borrowers
enjoying aggregate fund based working capital limits up to Rs.2 crore from the
banking system are being assessed on the basis of a minimum of 25% of their
projected annual turnover. Of this, 5% of the annual turnover should be brought
by way of promoter’s contribution. Thus, the remaining 20 % is only financed by
the banks.

As is evident, this calls for a change in the approach of the RBI in assessing
working capital needs of the industrial units. The industry norm approach followed
so far yields a place to the simple turnover method and norms have no role to
play. Higher the turnover, higher would be the credit facility available. In the
earlier system, (industry norm approach), maintenance of a high level of current
assets or any other assets has no significance to the computation of working
capital needs, excepting the industry norms fixed on some practical basis. On the
contrary, units having higher turnover are permitted to hold higher current assets,
though as per norms it is excess. Moreover, this type of a practice encourages
firms to stock materials and finished goods with lax inventory control. Small firms
lag in competition to large firms, as there is an inherent advantage to the latter.

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

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

3.5.1 Revised Policy Guidelines for Assessment of Working

Capital - A Case Study
In this section, an attempt has been made to provide readers with the insight of
actual guidelines under operation in one of the nationalised banks.
47
Concepts and Determination A. Methodology
of Working Capital
The following methods shall be adopted hereafter, depending on the quantum of
finance requested for assessing working capital requirements of the borrowers.

Quantum of limits requested (Rs. in lacs) Method

i) Upto Rs.200.00 lacs from the Banking system Turnover Method
ii) Rs.200.00 lacs and above from the banking Eligible Working Capital
system but upto & inclusive of Rs.2000.00 lacs Limit (EWCL) Method
from the Bank.
iii) For limits above Rs.2000.00 lacs EWCL or Cash Budget
Method as may be
decided by the Bank.
B. TURNOVER METHOD:

In the case of SSI borrowers who are seeking fund-based limits upto Rs.200.00
lacs from the banking system, it is made mandatory by the RBI to assess the
working capital limits as under:
a) Projected Gross Sales .. Rs..............
b) Working Capital requirements at 25% of A .. Rs..............
c) Margin to be provided by the borrower at 5% of A
(Corresponding to a Current ratio of 1.25) or the actual
net working capital available, whichever is higher Rs..............
d) Eligible Working Capital finance (b–c) Rs..............
In the case of Non-SSI borrowers, seeking fund based limits up to Rs.200.00
lacs from the banking system, the assessment methodology, remains the same as
in the case of SSI borrowers except that minimum margin to be brought in by
the borrower shall be 6.25% of the Projected Gross Sales which corresponds to
a Current Ratio of 1.33, which can be relaxed upto 5% of the Projected Gross
Turnover which corresponds to a current ratio of 1.25 subject to other Financial
Parameters being satisfactory.

While arriving at Eligible Working Capital Finance under the Turnover Method,
for SSI and Non-SSI borrowers, if the available NWC is higher than the required
minimum, the higher available NWC shall be reckoned with. Also, the unpaid
stocks in excess of unfinanced eligible receivables shall not be taken into account
for the purpose of computation of drawing power. The inventory margin
requirement shall be 20% in the case of SSI borrowers and 20% to 25% in the
case of Non-SSI borrowers depending on the stipulated current ratio. While the
limit shall be assessed and sanctioned on the basis of 25% of projected gross
sales less prescribed margin to be provided by the borrower, the actual release
under the sanctioned limit shall be on the basis of drawing power.

Like SSI borrowers, in the case of non-SSI borrowers also, if any borrower
requests for working capital limits higher than what he would have been eligible
if assessed under the Turnover Method, his requirements can be assessed under
EWCL method and limits to the extent he is eligible under EWCL method may
be made available.

In the case of borrowers seeking fund based working capital limits less than
Rs.10.00 lacs from the Bank, the need based requirement for credit facilities may
48
be arrived at adopting a holistic approach, instead of Turnover Method, taking into Theories and Approaches
account the applicant’s business potential, business plans, past dealings, credit-
worthiness, market standing, collateral wherever available and ability to repay, etc.

The limits assessed through simplified procedure shall be secured by current

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

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

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

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

C. ELIGIBLE WORKING CAPITAL LIMIT METHOD (EWCL):

EWCL method, a suitably relaxed form of the erstwhile Maximum Permissible

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

a) Total Current Assets .. .. Rs…………

b) Less: Current Liabilities other than bank borrowings .. Rs…………
v) Working Capital Gap (a–b) Rs…………
d) Less: 25% (bench-mark) of Current Assets as
Net Working Capital (NWC) or
Projected NWC, whichever is higher .. Rs…………
E) Eligible Working Capital Limit (c–d) .. Rs…………

49
Concepts and Determination The identification/treatment of Current Assets and Current Liabilities shall
of Working Capital continue to be as before when the MPBF Method was practiced. The 25% of
current assets as margin (NWC) corresponds to a Current Ratio of 1.33, which
would be a benchmark current Ratio under this method of assessment. However,
relaxation of current ratio under EWCL method may be allowed upto 1.1
selectively provided other basic financial parameters are satisfactory. To arrive at
the current ratio, the term loan instalments falling due in next 12 months shall be
reckoned with but the same to be excluded as a component of current liability to
arrive at working capital gap under EWCL method. Similarly the export
receivables shall continue to be excluded from the current assets to determine the
required NWC.

D. CASH BUDGET METHOD

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

The assessment methodology under Cash Budget Method is as under:

Heads Quarterly details

I. Cash Flow from Business Operations:

i) All inflows (receipts)
ii) All outflows (payments)
II. Cash Flow from Non-business operations:
i) All inflows
ii) All outflows
III. Cash Flow from Capital Accounts:
(i) All inflows
(ii) All outflows
IV. Cash Flow from sundry items:
(i) All inflows
(ii) All outflows
V. Assessment of bank finance:
(i) Cash Gap in the business-operations {I(ii) – I (i)}

LESS:(ii) Amount brought/proposed to be brought from other

sources i.e. cash surplus under II, III & IV above.

(iii) Net Cash Gap {V(i) – V (ii)}

The Highest (Peak) Cash Gap during the period under assessment is to be
extended by way of eligible working capital limit. The following prerequisites are
advised for the borrowers to be assessed under Cash Budget system. The
borrower should:
50
a) Preferably be a company under the Indian Companies Act, listed and quoted Theories and Approaches
at one or more of the Stock Exchanges in India. This however may not be a
restrictive parameter and if the Bank is satisfied on financial strengths, the
partnership and proprietorship concerns may also be allowed under the
system. The preference to listed/quoted companies is only with an intent to
have access to their published data.

b) Have in place a data base and system for doing the financial planning on
cash budget basis.

c) Have Inventory and Receivable management on the professional lines,

adhering to Stock Audit norms with stores management, shop floor control
and costing norms as provided in the industry. The Cash Budget method shall
continue to be used in the case of seasonal industries like Sugar, Tea and
others, and also in construction industry as before irrespective of the quantum
of working capital finance sought.

Since the requirements of working capital finance is directly related to the levels
of activity under production and sales and the inputs required to achieve these
levels, it is necessary to obtain the above requirements in addition to the detailed
Cash Budget. While the assessment to arrive at quantum of finance should be
carried out on the basis of cash budget obtained from the borrower, the financial
statements. CMA data with fund flows also are to be taken into account to
ascertain the level of business activity for which the working capital finance is
sought by the borrower. It may be also necessary to conduct a sensitivity
analysis based on variance of major financial assumptions for a proper risk
perception.

3.6 SUMMARY
Determination of adequate amount of working capital required for a business is
of great significance in its prudent management. Value maximisation implies
optimum investment in all types of assets. There are three approaches to decide
the optimum investment in working capital. They are: industry norm approach,
economic modeling approach, and the strategic choice approach. Under the first
one, certain norms have been worked out taking the nature of operations into
account. Each unit’s requirements are assessed with respect to such ‘industry
bench mark’ norm. Economic models are pressed into service to make certain
projections, current asset items are projected on the basis of these models and an
optimum quantum is arrived at. Under the strategic choice approach, business
forms are advised to follow their own ‘unique’ approach basing on the
circumstances prevailing; they need not be guided by the industry practices.

As against these theoretical considerations, operating cycle concept is widely

followed in practice. Working capital requirements are assessed basing on this
methodology. Various other factors such as nature of business, management’s
attitude towards risk, growth and expansion of business, product policies, position
of the business cycle, terms of purchase and sale and operating efficiency also
exert their influence on the determination of working capital. The methodology
suggested by the Tandon Committee has particular relevance to the assessment
of working capital requirements. Against this background, the approach followed
by the commercial banks is also highlighted. The present policy of the banks is to
fix up working capital limits basing on the three methods, viz., turnover method,
eligible working capital limit method and the cash flow method. The effectiveness
of these methods will be known in due course, as they are relatively new in
implementation.
51
Concepts and Determination
of Working Capital 3.7 KEY WORDS
Operating cycle: Length of time required for the completion of each of the
stages involved in the manufacturing process, covering working capital items.
Turnover method: It is a method of calculation of working capital requirements,
basing on sales turnover.
Cash budget method: It is a method of calculation of working capital
requirements using cash budget.
Industry norm: It is a method of taking industry practices into account while
deciding working capital requirements.
Economic modelling: This refers to the use of quantitative techniques for
assessing working capital requirements.
Strategic choice: It is a need based approach taking into account the
circumstances prevailing in the industry to decide the optimum amount of working
capital.

3.8 SELF ASSESSMENT QUESTIONS

1) Explain different approaches to the determination of working capital. As a
new entrepreneur, which of the three broad approaches would you prefer and
why?
2) What are the various factors influencing the determination of working capital?
3) Illustrate, using hypothetical data, how working capital requirements are
assessed using operating cycle concept.
4) How is the methodology formulated by the Tandon Committee useful in
determining working capital requirements?
5) Distinguish between turnover method and cash budget method which of them
do you suggest to a banker?
6) Management of Infotech Limited seeks your assistance on assessing the
working capital requirements for an activity level of 1,00,000 units of output
for the year 2004. The cost details of the product are as follows:
Particulars Cost per Unit (Rs.)
Raw materials .. 20
Direct labour .. 5
Overheads .. 15
Total cost .. 40
Profit .. .. 10
Selling price .. 50
The other details are:
1) In order to ensure smooth flow of production 2 months raw material
inventory is to be held in the stores.
2) Finished goods remain in stores for one month.
3) Credit allowed for purchase of raw material is one month.
4) Credit allowed to customers is 2 months.
5) Cash Balance to be maintained is Rs.25,000.
6) Assuming that the product process is uninterrupted and even, compute
the amount of working capital required for the given level of activity.
52
 7) The following information has been extracted from the accounts of Lupin Theories and Approaches
Laboratories Ltd., for the year 1998-99.
Statement of Cost Structure
S.No. Particulars (Rs. in crores)
1. Raw materials stock (opening) 33.89
2. Purchases 377.34
3. Raw materials stock (closing) 39.76
4. Raw Materials consumed (1+2–3) 371.47
5. Personnel Expenses 45.32
6. Other manufacturing Expenses 132.03
7. Depreciation 11.92
8. Total cost (4+5+6+7) 560.74
9. Work-in-progress inventory (opening) 55.56
10. Work-in-progress inventory (closing) 67.69
11. Cost of production (8+9–10) 548.61
12. Finished goods inventory (opening) 37.37
(including stores and spares)
13. Finished goods inventory (closing) 42.02
14. Cost of Goods sold (11+12–13) 543.96
15. Selling Expenses 8.71
16. Cost of Sales (14+15) 552.67

The following additional information is as given:

Particulars (Rs. in crores)
Accounts receivables (opening) 193.07
Accounts receivables (closing) 199.40
Accounts payable (opening) 127.72
Accounts payable (closing) 139.43
Sales (assumed to be credit sales) 715.73
Interest 51.58
PBT 26.80
PAT 25.30
Net Block 218.16

Using the above information compute operating cycle.

Hint: Use a 360-day year.
Ans: Q.6: Working capital required is Rs.44.00 lacs.
Ans: Q.7: Operating cycle = 107 days

3.9 FURTHER READINGS

1) V. K. Bhalla, 2003, Working capital Management; Anmol Publications, New
Delhi
2) Pandey, I.M. Eigth Edition 1999, Financial Management, Vikas Publication
house, New Delhi.
3) Weston, Fred J. & Brigham, E.F., 1978, Managerial Finance, Hinsade, The
Dryden Press.
4) Smith, Keith, V., 1977, Guide to Working Capital Management, Mc.Graw
Hill Book Co., New York.
5) Michael Firth, 1976, Management of Working Capital, The Macmillan 53
Press, London.
Concepts and Determination
of Working Capital UNIT 4 THEORIES AND APPROACHES
Objectives

The objectives of this unit are:

• To provide you an understanding as to the policy making in the area of
working capital management.
• To examine the different approaches to working capital management.
• To highlight the impact of different choices of investment and financing on
working capital policy.
Structure
4.1 Introduction
4.2 Creation of Value through Working Capital Management
4.3 Approaches to Working Capital Investment
4.4 Approach to Financing Working Capital
4.5 Effect of Choice of Financing on ROI
4.6 Summary
4.7 Key Words
4.8 Self-Assessment Questions
4.9 Further Readings

4.1 INTRODUCTION
In the previous unit, we have discussed about the concept of operating cycle and
various methods for determining working capital requirements. The present unit
focuses on the theoretical issues governing the determination and also the
practices followed by banks and other financial institutions. This is expected to
help the Student come closer to the reality. There has been little difficulty in
segregating the issues under this block into individual units due to their
overlapping content. Therefore, an attempt has been made in this unit to cover all
those issues that could not be covered under the earlier three units, yet focussing
on the theme of the present unit. As you could observe from the structure of the
lesson presented above, enough care has been taken to include only pertinent
matters in the discussion that follows. Major concentration has been on the
following:
a) What is the objective function in taking working capital decisions?
b) How to create value through working capital?
c) Is there any scope to lay down time-tested principles of working capital
policy?
d) How do risk-return relationships operate in the area of working capital
decision making?

4.2 CREATION OF VALUE THROUGH WORKING

CAPITAL MANAGEMENT
Creation of value has been said to be the objective of a company. In the realm
of finance it turns out to be the function of firm’s investment, financing and
dividend decisions. In addition to long term investment decisions, companies face
many decisions involving investment in current assets. Quite often, maximisation
54
of profits is regarded as the proper objective of the firm. but it is not as inclusive Theories and Approaches
as that of maximising shareholders’ value. A right kind of approach to decisions
of investment and financing of working capital can contribute to the achievement
of the objective function.

Value maximisation is considered consistent with the interests of various groups

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

Be that as it may, how should one proceed to create value through working
capital management. The answer is: invest in an asset, if its net present value is
positive. The fact is that the basic principles of long term asset investment
decisions should apply equally well to short term asset investment decisions.
Therefore, it is useful to examine this criterion more closely in terms of current
asset investment decisions.

The general formula for finding net present value of a project is:
A1 A2 A3 An
NPV= ————— 1
+ ————— 2
+ ————— 3
+ ------- + ———— – C
(1+K) (1+K) (1+K) (1+K)n
Where A1 to An represent annual cash inflows on an after tax basis. ‘K’ is the
discount factor, which is generally taken as the cost of capital. ‘C’ represents the
initial outflow.

This equation can be used to decide the choice of investment in current assets
taking into account their shorter life span. Accepting one year life as standard to
categorise assets into fixed and current, NPV has to be calculated for each year.
For this purpose, the above equation can be modified as follows to elicit NPV.
A1 A2 A3 An
NPV =—— + ——— + ——— + ------- + ——— – C
K K K K
Like the decisions in capital budgeting, the problem remains as that of
determination of risk and thus the appropriate discount rate to apply.

Sometimes, practitioners tend to use net profit criterion to decide the investment
in current assets; which they consider is a simple modification of the concept of
NPV as shown below:
r
Net profit per period = Annuity = NPV [———— ]
1–(1+ r)–n
Example 4.1

There is an investment proposal involving Rs.5000 initial investment and

generating Rs.500 per year, so long as we keep the investment intact. The NPV
in this case depends on the discount rate and time period assumed. We may also
calculate an annuity that has a present value equal to the NPV of above
investment using the above equation. Assuming that the discount rate is 8%. Net
profit per period will be Rs.100. See the following derivation:
r
Net Profit = Annuity = NPV (—————)
per period 1- (1+r)–n

55
Concepts and Determination 500 500 5000 r
of Working Capital = [–5000 + ———— + ———— n
+ ————— n
] [—————]
(1+ r) (1+ r) (1+ r) 1–(1+ r)–n

1–(1+ r)–n
r
= 500 (—————) (——————)
r
1-(1+ r)–n

r
– [ 5000 – 5000 (1+r)–n ] (—————)
1–(1+r)–n

1-(1+ r)–n 1/r

But ——————— = —————————.
r
1–(1+ r)–n
r
So Net Profit = 500 – 5000 [1– (1+ r )–n ] (——————)
1–(1+ r)–n
= 500 – 5000 (r)
= 500 – 5000 (8%)
= 500 – 400 = 100
The Rs.400 is the annual capital cost of Rs.5,000 investment at an 8 per cent
rate of interest, and the annual net profit of Rs. 100 does not depend on when
the investment is reversed. The result is that we can use net profit per period as
a criterion for choosing among alternative reversible investments. The investment
with the highest value of net profit per period is also the investment with the
highest net present value, regardless of when the investment is reversed.
Investments with positive NPVs will have positive net profits, investments with
zero NPVs will have zero net profits, and investments with negative NPVs will
have negative net profit. Thus, net profit per period, instead of NPV can be used
as a decision criterion for working capital management.

Many current asset decisions, particularly inventory decisions, can be made on

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

4.3 APPROACHES TO WORKING CAPITAL

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

4.3.1 Walker’s Approach

Early in 1964 Ernest W. Walker has developed a four-part theory of working
capital. He has laid down that a firm’s profitability is determined in part by the
way its working capital is managed. When the working capital is varied relative
to sales without a corresponding change in production, the profit position is
56
affected. If the flow of funds created by the movement of working capital is Theories and Approaches
interrupted, the turnover of working capital is decreased, as is the rate of
return on investment. In this regard. Walker has laid down the following four
principles with respect to working capital investment.

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

Table 4.1: XYZ Manufacturing Company

1 2 3
Level of working capital (Rs.) 50,000.00 90,000.00 1,20,000.00
Fixed capital (Rs.) 10,000.00 10,000.00 10,000.00
Liabilities 30,000.00 30,000.00 30,000.00
Net Worth 30,000.00 70,000.00 1,00,000.00
Sales 1,00,000.00 1,00,000.00 1,00,000.00
Fixed Capital Turnover 10.00 10.00 10.00
Working Capital Turnover 2.00 1.1 0.8333
Total Capital Turnover 1.66 1.00 0.761
Earnings (as Percent of Sales) 10.00 10.00 10.00
Rate of Return (Percent) 16.60 10.00 7.60
————————————————————————————————
It can be seen from the data that the return on investment has increased from
7.6 percent to 16.6 per cent when working capital fell from Rs. 1,20,000 to
Rs.50,000. Moreover, it is believed that while the potential gain resulting from
each decrease in working capital is greater in the beginning than potential loss,
exactly opposite occurs, if the management continues to decrease working
capital (see-Figure 4.1).

Fig. 4.1: Working Capital Relative to Sales

Gain
Rate of Raturn

0
Loss

Decreasing Level of Working Capital per Unit of Sales 57

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

Second principle: Capital should be invested in each component of working

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

Third principle: The type of capital used to finance working capital directly
affects the amount of risk that a firm assumes as well as the opportunity for
gain or loss and cost of capital. It is indisputable that different types of capital
possess varying degrees of risk. Investors relate the price for which they are
willing to sell their capital to this risk. They may charge less for debt than equity,
since debt capital possesses less risk. Thus risk is related to the return. Higher
risk may imply a higher return too. Unlike rate of return, cost of capital moves
inversely with risk. As additional risk capital is employed by management, cost of
capital declines. This relationship prevails until the firm’s optimum capital structure
is achieved.

Fourth principle: The greater the disparity between the maturities of a firm’s
short-term debt instruments and its flow of internally generated funds, the greater
the risk and vice-versa. This principle is based on the analogy that the use of
debt is recommended and the amount to be used is determined by the level of
risk, management wishes to assume. It should be noted that risk is not only
associated with the amount of debt used relative to equity, it is also related to the
nature of the contracts negotiated by the borrower. Some of the more important
characteristics of debt contracts directly affecting a firm’s operation are
restrictive clauses of the contracts and dates of maturity.

Lenders of short-term funds are particularly conscious of this problem, and in an

effort to protect them selves by reducing the risk associated with improper
maturity dates, they are requiring firms to produce documents depicting cash
flows. These documents when properly prepared, not only show the level of
loans necessary to support sales but also indicate when the loans can be repaid.
In other words, lenders realize that a firm’s ability to repay short-term loans is
directly related to cash flow and not to earnings, and therefore, a firm should
make every effort to the maturities to its flow of internally generated funds.

4.3.2 Trade off Approach

It is evident from the study of Walker’s principles that working capital decisions
involve a trade-off between risk and return. The same is sought to be further
examined in this section.

All decisions of the financial manager are assumed to be geared to maximisation

of shareholders wealth, and working capital decisions are no exception.
Accordingly. risk-return trade-off characterises each of the working capital
decision. There are two types of risks inherent in working capital management,
namely, liquidity risk and opportunity loss risk. Liquidity risk is the non-availability
of cash to pay a liability that falls due. Even though it may happen only on
certain days, it can cause, not only a loss of reputation but also make the work
condition unfavourable for getting the best terms on transaction with the trade
58
creditors. The other risk involved in working capital management is the risk of Theories and Approaches
opportunity loss i.e. risk of having too little inventory to maintain production and
sales, or the risk of not granting adequate credit for realising the achievable level
of sales. In other words, it is the risk of not being able to produce more or sell
more or both, and therefore, not being able to earn the potential profit, because
there are not enough funds to support higher inventory and book debts. Thus, it
would not be out of place to mention that it is only theoretical that the current
assets could all take zero values. Indeed, it is neither practicable nor advisable. In
practice, all current assets take positive values, because firms seek to reduce
working capital risks.

The risk-return trade-off involved in managing the firm’s liquidity via investing in
marketable securities is illustrated in the following example. Firms A and B are
identical in every respect but one. Firm B has invested Rs.5,000 in marketable
securities which has been financed with equity. That is, the firm sold equity
shares and raised Rs.5,000.00. The balance sheets and net incomes of the two
firms are shown in Table 4.2. Note that Firm A has a current ratio of 2.5
(reflecting net working capital of Rs. 15,000) and earns a 10 percent return on
its total assets. Firm B, with its larger investment in marketable securities has a
current ratio of 3 and has net working capital of Rs.20,000. Since the marketable
securities earn a return of only 9 percent before taxes (4.5 percent after taxes
with a 50 percent tax rate). Firm B earns only 9.7 percent on its total
investment. Thus, investing in current assets and in particular in marketable
securities, does have a favourable effect on firms liquidity but it also has an
unfavourable effect on the firm's rate of return earned on invested funds. The
risk-return trade-off involved in holding more cash and marketable securities,
therefore, is one of added liquidity versus reduced profitability.

Table 4.2 : The Effects of Investing in Current Assets on Liquidity and Profitability

Balance Sheets A B

Cash Rs 500 Rs 500

Marketable securities ——- 5,000
Accounts receivable 9,500 9,500
Inventories 15,000 15,000
Current assets 25,000 30,000
Net fixed assets 50,000 50,000
Total 75,000 80,000
Current liabilities 10,000 10,000
Long-term debt 15,000 15,000
Capital Equity 50,000 55,000
Total 75,000 80,000
Net Income 7,500 7,725*
Current ratio 25,000 30,000
(Current assets/ ———— = 2.5 times ————— =3.0 times
Current liabilities) 10,000 10,000
Net working capital 15,000 20,000
(Current assets-Current liabilities) 7,500 = 10% 7,725 = 9.7%
Return on total assets 75,000 80,000
(net income/total assets)
*During the year Firm B held Rs.5,000 in marketable securities, which earned a 9 percent return
or Rs.450 for the year. After paying taxes at a rate of 50 percent, the firm netted a Rs.225 return
on this investment.

59
Concepts and Determination Activity 4.1
of Working Capital
Give points of distinction between the Walker's Approach and Trade off
Approach.
..............................................................................................................................

..............................................................................................................................

..............................................................................................................................

..............................................................................................................................

..............................................................................................................................

4.4 APPROACH TO FINANCING WORKING

CAPITAL
Financing the firm’s working capital requirements has been shown to involve
simultaneous and inter-related decisions regarding the firm’s investment in current
assets. Fortunately, there exists a principle, which can be used as a guide to
firm’s working capital financing decisions. This is the hedging principle or
matching principle.

Simply speaking, the hedging principle involves matching the cash flow generating
characteristics of an asset with the maturity of the source of financing used to
finance its acquisition. For example, a seasonal expansion in inventories, according
to the hedging principle, should be financed with a short-term loan or current
liability. The rationale underlying the rule is straightforward. Funds are needed for
a limited period of time, and when that time has passed, the cash needed to
repay the loan will be generated by the sale of the extra inventory items.
Obtaining the needed funds from a long-term source (longer than one year)
would mean that the firm would still have the funds after the inventories (they
helped finance) have been sold. In this case the firm would have “excess”
liquidity, which they either hold in cash or invest in low yielding marketable
securities until the seasonal increase in inventories occurs again and the funds are
needed. This would result in an over-all lowering of firm profits, as we saw
earlier in the example presented in Table 4.2.

Let us take another example in which a firm purchases a new packing machine,
which is expected to produce cash saving to the firm by eliminating the need for
two labourers and, consequently their salaries. This amounts to an annual savings
of Rs.20,000. while the new machine costs Rs. 1,00,000 to install and will last 10
years. If the firm chooses to finance this asset with a one-year loan, then it will
not be able to repay the loan from the cash flow generated by the asset. Hence,
in accordance with the hedging principle, the firm should finance the asset with a
source of financing that more nearly matches the expected life and cash flow
generating characteristics of the asset. In this case a 7 to 10-year loan would be
more appropriate than a one-year loan.

To put it very succinctly the hedging principle states that the firm’s assets not
financed by spontaneous sources should be financed in accordance with the rule:
permanent assets (including permanent working capital needs) financed with long-
term sources and temporary assets (viz. fluctuating working capital need) with
short-term sources of finance towards the liquidity risk.

We may graphically illustrate the hedging principle as depicted in Figure 4.2A

60
 Figure: 4.2A : Hedging Financing strategy Theories and Approaches

Temporary Current Short Term

Assets Financing
Investment

Assets
Current
Per manent
Long Term
Financing
Fixed Assets

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

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

across certain modifications of this strict hedging strategy. Figure 4.2B and 4.2C
depict two modifications.
Figure: 4.2B
Conservative financing strategy: Long term financing exceeds permanent assets

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e n t C u rrent A
Perman
Long Term
Financing
Fixed Assets

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

Figure: 4.2C : Aggressive Financing strategy: Permanent Reliance on Short Term Financing

Temporary CAS
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ts
C u r r e nt Asse
ent
Perman Long Terms
Financing
Fixed Assets

Shaded area reflects the firm’s continuous use of short-term financing to support its
permanent asset needs. 61
Concepts and Determination In Figure 4.2B the firm follows a more cautious plan, whereby long-term sources
of Working Capital of financing exceed permanent assets in trough period such that excess cash is
available (which must be invested in marketable securities). Note that the firm
actually has excess liquidity during the low ebb of its asset cycle and thus faces
a lower risk of being caught short of cash than a firm that follows the pure
hedging approach. However, the firm also increases its investment in relatively
low-yielding assets such that its return on investment is diminished (recall the
example from Table 1.2).

In contrast, Figure 4.2C depicts a firm that continually finances a part of its
permanent asset needs with short term funds and thus follows a more aggressive
strategy in managing its working capital. It can be seen that even when its
investment in asset needs is lowest the firm must still rely on short-term
financing. Such a firm would be subjected to increased risks of cash shortfall, in
that it must depend on a continual rollover or replacement of its short-term debt
with more short-term debt. The benefit derived from following such a policy
relates to the possible savings resulting from the use of lower-cost short-term
debt as opposed to long-term debt.

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

4.5 EFFECT OF CHOICE OF FINANCING ON ROI

It would be now pertinent to examine the impact of the choice of financing on,
return on investment. Consider the following Data in Table-4.3
Table 4.3 : Effect of choice of financing on ROI

Balance Sheet Firm X Firm Y

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

62
Income Statement Firm X Firm Y Theories and Approaches
Net operating Income (EBIT) 64,800 64,800
Less Interest 4,800 3,000
–––––––– ––––––––
Taxable Income 60,000 61,800
Taxes @ 50% 30,000 30,900
–––––––– ––––––––
PAT (Net Income) 30,000 30,900
–––––––– ––––––––
Measures of Liquidity
(a) Current Ratio 4:1 1:1
(b) Net working capital 30,000 0
Measures of profitability
(a) ROl 37.5% 38.6%
(b)EPS Rs 3.00 Rs 3.09
It is evident from the data contained in Table 4.3 that the Firm (X) using long
term debt has a current ratio of 4 times and Rs.30,000 in net working capital,
whereas Firm Y’s current ratio is only 1 time, which represents zero net working
capital. Because of lower interest rates on short-term debt (bank credit in this
case) Firm ‘Y’ was able to earn a ROI of 38.6 percent compared to that of ‘X’,
which could earn only 37.5 percent. Thus a firm can reduce its risk of illiquidity
through the use of long term debt at the expense of a reduction of its return on
investment funds. Once again we see that the risk-return trade-off involves an
increased risk of illiquidity versus increased profitability.

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

4.7 KEY WORDS

Aggressive financing Strategy: A portion of permanent assets financed with
short-term sources.
Considervative financing strategy : A portion of the temporary assets financed
with long term sources.
Hedging principle: The firm’s assets not financed by spontaneous sources
should be financed in accordance with the rule: permanent assets financed with
long-term sources and temporary assets with short-term sources.
63
Concepts and Determination Reversible investment: An investment, the cash flow related to which could
of Working Capital be readily reversed.

Spontaneous finance: Credit, which arises in direct conjunction with the day-to-
day operations of the firm.

Creation of value: The process of maximising the market price of the

company’s common stock. This occurs when the finance manager does
something that shareholder cannot do for themselves.

Net present value: The difference between the present value of inflows
generated by a project minus the initial investment made in that project.

4.8 SELF-ASSESSMENT QUESTIONS

1) Distinguish between Fixed asset management and current asset management.
2) How is value created through working capital management?
3) ‘Merely increasing the level of investment in current assets does not reduce
the working capital risks of a firm’ - comment.
4) ‘Working capital, like other financial management decisions involves risk-
return trade-off: yet the same is unique’. Elaborate with suitable examples.

5) Examine with suitable examples the principles of Walker.

6) Illustrate, using hypothetical data, the risks-return trade-off involved in current

asset investment and financing decisions.

7) Distinguish matching, conservative and aggressive working capital financing

strategies. Under the present capital and money market conditions, which of
these would you recommend to a consumer durable manufacturing firm?
Why? List out your assumptions, if any.

8) The balance sheet of the Cooptex Manufacturing Company is presented

below for the year ended December 31, 2003.

Cooptex Manufacturing Co.

Balance sheet as on Dec. 31, 2003

Current Liabilities Rs 30,000 Net Fixed Assets Rs 50,000
Long-Term Liabilities Rs 20,000 Current Assets:
Equity Capital Rs 50,000 Cash 5,000
Inventories 25,000
Accounts Receivable 20,000 Rs 50,000
––––––––– –––––– –––––––
1,00,000 1,00,000
––––––––– –––––––
During 2003 the firm earned net income after taxes of Rs. 10,000 based on net
sales of Rs.2,00,000.
a) Calculate Cooptex’s current ratio, net working capital and return on total
assets ratio (net income/total assets) using the above information.

b) The General Manager (Finance) of Cooptex is considering a Plan for

enhancing the firm’s liquidity. The plan involves raising Rs.l0,000 by issuing
equity shares and investing in marketable securities that will earn 10 percent
before taxes and 5 per cent after taxes. Calculate Cooptex’s current ratio,
64
 Management of Inventory
UNIT 5 MANAGEMENT OF RECEIVABLES
Objectives

The objectives of this unit are to:

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

Structure
5.1 Introduction
5.2 Credit Policy
5.3 Credit Evaluation Models
5.4 Monitoring Receivables
5.5 Collecting Receivables
5.6 Strategic Issues in Receivables Management
5.7 Summary
5.8 Key Words
5.9 Self Assessment Questions
5.10 Further Readings

5.1 INTRODUCTION
“Buy now, pay later” philosophy is increasingly gaining importance in the way
of living of the Indian Families. In other words, consumer credit has become a
major selling factor. When consumers expect credit, business units in turn expect
credit form their suppliers to match their investment in credit extended to
consumers. If you ask a practising manager why her/his firm offers credit for the
purchases, the manager is likely to be perplexed. The use of credit in the
purchase of goods and services is so common that it is taken for granted. The
granting of credit from one business firm to another, for purchase of goods and
services popularly known as trade credit, has been part of the business scene for
several years. Trade credit provided the major means of obtaining debt financing
by businesses before the existence of banks. Though commercial banks provide a
significant part of requirements for working capital, trade credit continues to be a
major source of funds for firms and accounts receivables that result from
granting trade credit are major investment for the firm. The importance of
accounts receivables can be seen from Table 5.1, which presents investments in
accounts receivables for different industries over the years. This is expected to
provide an idea of the size of investment in receivables in the Indian Industry.

1
Management of Current Table 5.1 : Industry-wise Investments in Trade Credit Receivables
Assets Rupees in Crores

Industry 1999 2000 2001 2002 2003

Chemicals 3502.22 3561.63 3412.65 3768.37 3614.45

Food & beverages 7171.87 7195.32 7369.03 7172.42 6046.75

Machinery 21101.05 27928.26 28818.50 28980.45 28796.07

Metals & metal products 3513.62 3885.98 4252.64 4606.84 3907.31

Non-metallic mineral products 12944.11 13147.85 13456.84 12196.30 11923.14

Textiles 21912.86 24989.77 28720.10 29095.38 28889.75

Transport equipment 7003.26 7304.55 7652.69 7622.18 7199.14

Diversified 5888.22 6631.51 6945.93 8620.85 8891.48

Miscellaneous manufacturing 2146.93 2478.04 2751.78 2953.06 2745.85

All Manufacturing 85184.14 97122.91 103380.16 105015.85 102013.94

Two important conclusions emerge from the analysis of Table 5.1:

Investment in accounts receivable is high and shows a positive growth over
the years; and

Value of accounts receivable differs significantly between industries even
after adjusting the differences in number of companies between industries.
The investment in accounts receivable is an important aspect which requires
careful managment. Besides the cost of investment, there are two types of risks
which are associated with the accounts receivable management. One is the risk
of OPPORTUNITY LOSS and the other LIQUIDITY risk. The firm has to
extend credit to its customers to generate enough sales. The grant of credit is an
important tool to realize the operating plans and budgets of the company. But at
the same time management has to see that the company has not extended too
much of credit to its customers which has resulted in high degree of liquidity risk.
By liquidity risk we mean the ability to collect back the amounts due from the
customers. This would happen if the company extends the credit to customers
whose financial position is doubtful or week and subsequently the funds tied up
with them are recovered after a long period or they are not at all realised. If this
happens it would result in the companies ability to meet its own obligations and
thus affecting short term and long term solvency of the company. The decision to
extend the credit to its customers also determines the timing and amount of cash
flows accruing to the company.

At the same time minimisation of liquidity risk would imply the risk of opportunity
loss. The opportunity loss here means loss of sales by refusing the credits to its
potential customers. This would further affect the loss of revenue and the loss of
profits. Thus the objective of accounts receivable management is to arrive at an
optimum balance of these two risks and help the company to realize its operating
plans. This balancing is not a static but a dynamic one. To arrive at the balancing
of these two risk, the company would frequently require to adjust their credit
standards, credit terms and credit policies. Management of the company would
also be required to consider general economic conditions while making such
adjustments.

2
 Management of Inventory

While high investments in accounts receivable warrant efficient management,

significant differences between industries call for proper structuring of credit
policy that match the industry norms. These two are essential issues in
management of receivables. The receivables management system thus involves
the following:

Terms of credit

Assessing customers’ credit worthiness to grant credit

Monitoring the level of accounts receivables and improving collection efficiency.
Setting of terms of credit is first step in the receivables management. It is a
corporate policy and thus has a close interrelationship with other corporate
policies. For example, if a company pursues a policy of market leadership, then it
requires aggressive credit policy to achieve maximum sales volume. Terms of
credit requires management to decide period of credit, a broad guideline on the
eligibility of credit, credit limit for different customers and discount rate offered to
customers who settles the bill within a predetermined period. Credit policy is
determined by trading off risk associated with granting credit and additional
revenue available from granting credit. The credit policy once determined is fixed
in the short-run and may warrant periodic adjustment depending on the changes
in environment and corporate policies.

Determining creditworthiness of customers, first, requires a system to collect

basic information about the customers and then fit the data into a Model that
determines the suitability of the customer in granting credit and other credit
terms. Once credit is granted, the focus is shifted to collection of dues in time.
The efficiency of receivables management is measured by comparing the extent
to which collection flows are in line with credit terms.

The objectives that drive the above issues of receivables management are:
1) Obtain maximum (optimum) volume of sales.
2) Maintain proper control over the quantum or amount of investment in debtors.
3) Exercise control over the cost of credit and collections.
Activity 5.1

1) Why companies sell/provide goods/services on credit basis?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) How does the decision on granting credits affect the finance of the company?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

……………………………………………………………………………………. 3
Management of Current …………………………………………………………………………………….
Assets

5.2 CREDIT POLICY

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

Decision on credit period is determined by several factors. It is important to

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

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

Cost of Extending Credit Period

Lengthening credit period delays the cash inflows. For example, suppose a firm
increases the credit period from 30 days to 90 days. Customers, old as well as
4
new, will now pay at the end of 90 days and the cash inflows from these sales Management of Inventory
would occur further into the future. That means, the firm has to delay in settling
its dues to others or resort to short-term borrowing if the payments cannot be
delayed. The interest cost of short-term borrowing arises mainly on account of
extending the credit period.

Example 5.1

Flysafe Travels is one of the large air-ticket sellers in the city. It offers one-
month credit for the air-tickets booked through the firm. Since it also gets one-
month credit from the air-lines, the payables and receivables are by and large
matched and there is no need of additional investment. The present annual
turnover of the firm is around Rs.40 crores. The firm is now contemplating to
increase the credit period from one-month to two-months and this is expected to
increase the volume by 40% and nearly 80% of the customers (old and new) are
expected to avail the new credit facility. The firm has just concluded a credit
proposal with a nationalised bank to meet payment liability at 15%. How much
more it costs for Flysafe Travels to meet the increased credit volume.
Revised Sales Rs. 40 cr. × 1.40 = Rs. 56.00 cr.
Customers, who are expected to use additional
credit period = 80%
Sales which are likely to be collected at the end of
second month = Rs. 56 x 0.80 = 44.80 cr.
Total Credit Period = 2 months
Less: Credit given by Air-line operators = 1 month
Funds required for additional credit period of 1 month
Interest cost per year = 15%
Additional interest cost to sustain 1 month credit = Rs. 44.80 x 15%
= Rs. 6.72 cr.
The cost of Rs. 6.72 cr. is compared with the additional profit generated by the
new sales to decide whether it is desirable to increase the credit period or not.

Changes in credit period also affect the cost of carrying inventory. This arises
mainly on account of increased volume attracted by the extended credit period,
which in turn requires more inventory to support increased volume. For example,
if expected additional sales is Rs. 5 cr. and the firm’s present operating cycle
requires an inventory at 20% of its sales value, the additional inventory
requirement is Rs. 1 cr. Again, inventory is a idle investment and consumes cost
in the form of cost of storage and cost of carrying inventory. If the two costs
together amount to 17%, the changes in credit policy has caused an additional
cost of Rs. 17 lakhs.

Another cost associated with extending credit term and increase in sales volume
on account of extended credit term is discount and bad debts expenses.
Increase in credit sales and period would prompt firms to announce attractive
discount policy for prompt payment. Similarly, bad debts will also go up due to
increased volume of credit sales.

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

Example 5.2
5
Management of Current Suppose the cost of collection for the Flysafe Travels is 1% and bad debts are
Assets
likely to increase from 0.50% to 0.75% due to increased credit period. These
costs are to be added along with interest cost on additional investments in
receivables arising out of changes in credit period. These two costs are
computed as follows:

Cost of Collection
Case Sales (Rs.) Cost of Collection (Rs.)
Present 56.00 cr. 0.56 cr.
Previous 40.00 cr. 0.40 cr.
Difference 16.00 cr. 0.16 cr.

Cost of Bad Debts

If we follow the methodology adopted earlier in computing cost of collection, then
the additional bad debts works out to Rs. 0.22 cr. (i.e., 0.75% of Rs. 56 cr. less
0.50% of Rs. 40 cr.). However, the entire value of additional bad debts is not
on account of change in credit period. A part of it is on account of increase in
sales. The actual impact of increase in bad debts can be computed in two stages
as follows:
Increased cost of bad debts for existing sales of Rs. 40 cr.
Bad debts as per revised percentage of bad debts, 0.75% of Rs. 40 cr.= 0.30 cr.
Bad debts as per earlier percentage of bad debts, 0.50% of Rs. 40 cr. = 0.20 cr.
Increased value of bad debts attributable to new credit policy = 0.10 cr.
Increased cost of bad debts for additional sales of Rs. 16 cr.
Bad debts as per revised percentage of bad debts, 0.75% of Rs. 16 cr.= 0.12 cr.
Bad debts as per existing percentage of bad debts, 0.50% of Rs. 16 cr.= 0.08 cr.
Increased value of bad debts attributable to new credit policy = 0.04 cr.
Total value of bad debts attributable to new credit policy (0.10+0.04) = Rs. 0.14 cr.
The balance of Rs.0.08 cr. is on account of increase in sales.
b) Discount
When a firm pursues aggressive credit policy, it affects cash flows in the form of
delayed collection and bad debts. Discounts are offered to the customers, who
purchased the goods on credit, as an incentive to give up the credit period and
pay much earlier. For example, suppose the terms of credit is “3/10 net 60”. It
means if the customer, who gets 60 days credit period can pay within 10 days
from the date of purchase and get a discount of 3% on the value of order.
Since the customer uses the opportunity cost of funds and availability of cash in
taking decision, the cash discount should be set attractive. The discount quantum
should be greater than interest rate of short-term borrowings.
Example 5.3

Excel Industries is presently offering a credit period of 60 days to some of their

customers. It now intends to introduce a discount policy of “3/10 net 60”. We
will now see how a customer would evaluate the discount policy here. If a
customer bought goods worth of Rs. 1 lakh, the amount due at the end of 60
days is Rs. 1 lakh and if he pays within 10 days, it costs Rs. 97,000. The customer
evaluates the interest cost of Rs.97,000 for 50 days to take a decision on availing
the discount and advancing the payment. Suppose the interest cost is 15%, then
6
cost of interest for 50 days on Rs.97,000 is Rs. 97,000 x 0.15 x (50/365), which Management of Inventory
works out to Rs. 1,993.15. Since the discount value is greater than the cost, it is
profitable for the customer to pay the money earlier within 10 days and avail the
discount. In other words, if the customer borrows money for 50 days at 15%
interest cost in the short-term market or bank and uses the money to settle the
account within 10 days, the loan amount due at the end of two months is Rs.
98,993.15, which is lower than Rs. 1,00,000 due at the end of the period in the
normal course. If the cost of borrowing is 24%, the customer would take a
different decision. The interest cost of borrowing for 50 days in this case is
Rs.3189, which is greater than the discount benefit. Of course, the customer will
look into the availability of funds and other options available to the firm before
deciding whether to accept the offer or not.

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

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

Example 5.4

Royal Textiles is contemplating to increase the credit period from 30 days to 60

days. This is expected to increase the sales from Rs. 20 cr. to Rs. 23 cr. but
the bad debts is also expected to go up from 0.5% on sales to 1% on sales.
Marketing Director felt that by giving 3% discount for payment within 10 days
would prompt several customers to avail the facility and thus would bring back
the bad debts value to 0.5% on sales. The interest cost of short-term borrowing
is 15% and nearly 40% worth of sales are expected to be collected at the end
of 10 days. Is it desirable to introduce the discount policy?

As far as interest cost component is concerned, our earlier working on Excel

Industries shows the interest cost of 15% is higher than the discount value of
3%. We will work out the interest cost and discount value again. The 40% sales,
which is expected to be collected at the end of 10 days works out to Rs. 9.20
cr. (23 x 0.4). The discount to be given on this value at 3% is Rs.0.276 cr. or
Rs. 27,60,000 (i.e. 9.2 x 0.03). The net collection is Rs. 8.924 cr. (i.e. 9.2 -
0.276). If the company is in a position to borrow this money at 15%, the
interest cost for 50 days would be Rs. 18,33,700 (i.e. 8.924 x .15 x (50/365).
Since the discount value is greater than cost of borrowing, 3% discount is not
economical if interest cost alone is considered. However, it is not correct to
ignore the impact of discount policy on bad debts.

The discount policy will bring down the value of bad debts from 1% to 0.50%.
The savings in terms of values is Rs. 11,50,000 i.e. 23,00,00,000 x (1% - 0.50%).
If this saving is deducted from the discount value of Rs. 27,60,000, the net
discount cost is Rs. 16,10,000. When the net discount cost of Rs. 16,10,000 is
compared with the interest cost of Rs. 18,33,700, then offering 3% discount for
payment within 10 days is economical. (However, before implementing this new
7
Management of Current credit policy, the overall impact of the policy on profit is to be assessed and this
Assets
will be discussed later).

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

Example 5.5: Cost-Benefit Analysis

American Pharama is a multinational pharmaceutical company selling certain

premium tablets in the domestic market for the last three years. The company
has not offered any credit on sales and the annual turnover for the year was Rs.
10 cr. Due to increased competition, the company is now evaluating new credit
policy, which it intends to introduce. As per the policy, the company will offer 30
days credit and a discount of 2% if the amount is paid within a day (i.e., 2/1 net
30). Without this new credit policy, the sales are expected to increase to Rs. 12
crore and with the new policy, the sales will be Rs. 15 cr. It is estimated that
40% of the customers would avail the discount. The contribution margin for its
sales is 30% and the company is operating above break-even point. The new
credit policy will cause additional costs in terms of collection charges at 1% and
bad debts at 0.5%. The interest cost is 16%. Evaluate the credit policy and its
implication on profit.
Increase in sales on account of credit policy (Rs.15 cr. less Rs. 12 cr.): Rs. 3.00 cr.
Contribution from increased sales (30% on Rs. 3 cr.) : Rs. 0.90 cr.
Cost associated with credit policy
1. Collection charges @ 1% on Rs. 15 cr. Rs. 0.150 cr.
2. Bad debts at 0.5% on Rs. 15 cr. Rs. 0.075 cr.
3. Discount at 2% on 40% of Rs. 15 cr. Rs. 0.120 cr.
4. Interest cost on receivables @ 16%
Sales not likely to take discount: Rs. 9 cr.
Investments on 30 days receivable
Rs. 9 cr. x (30/365) = Rs. 0.74 cr.
Interest on Rs. 0.74 cr. at 16% Rs. 0.118 cr. Rs. 0.463 cr.
Net benefit before tax
Rs. 0.437 cr.
c) Credit Eligibility

Having designed credit period and discount rate, the next logical step is to define
the customers, who are eligible for the credit terms. The credit-granting decision
is critical for the seller since credit-granting has economic value to buyers and
buyers decision on purchase is directly affected by this policy. For instance, if the
credit eligibility terms reject a particular customer and requires the customer to
make cash purchase, the customer may not buy the product from the company
8
and may look forward to someone who is agreeable to grant credit. Nevertheless, Management of Inventory
it may not be desirable to grant credit to all customers. It may instead analyse
each potential buyer before deciding whether to grant credit or not based on the
attributes of that particular buyer. While the earlier two terms of credit policy
viz. credit period and discount rate are not changed frequently in order to
maintain consistency in the policy, credit eligibility is periodically reviewed. For
instance, an entry of new customer would warrant a review of credit eligibility of
existing customers.

The decision whether a particular customer is eligible for credit terms generally
involves a detailed analysis of some of the attributes of the customer. Credit
analysts normally group the attributes in order to assess the credit worthiness of
customers. One traditional way of organising the information is by characterising
the applicant along five dimensions namely, Capital, Character, Collateral, Capacity
and Conditions. These five dimensions are also popularly called Five Cs of credit
analysis.

Capital: The term capital here refers to financial position of the applicant firm.
It requires an analysis of financial strength and weakness of the firm in relation
to other firms in the industry to assess the credit worthiness of the firm.
Financial information is normally derived from the financial statements of the firm
and analysed through ratio analysis. The liquidity ratios like current ratio, debt-
service coverage ratio, etc. are often used to get a preliminary idea on the
financial strength of the firm. Further analysis includes trend analysis and
comparison with the other industry norm or other firms in the industry.

Character: A prospective customer may have high liquidity but delay payment to
their suppliers. The character thus relates to willingness to pay the debts.
Some relevant questions relating to character are:
• What is the applicant’s history of payments to the trade?
• Has the firm defaulted to other trade suppliers?
• Does the applicant’s management make a good-faith effort to honour
debts as they become due?
Information on these areas are useful to assess the applicant’s character.
Collateral: If a debt is supported by collateral, then the debt enjoys lower risk
because in the event of default, the debt holder can liquidate the collateral to
recover the dues. The collateral causes hardship to other debt holders. Thus,
the analysts should look into both the availability of collateral for the debt and the
amount of collateral the firm has given to others. In computing the liquidity of
the firm, the analysts should remove the assets used for collateral and take into
account only the free assets. The credit worthiness improves if the customer is
willing to offer collateral assets or the value of collateral asset backed loan is
low.
Capacity: The capacity has two dimension - management’s capacity to run the
business and applicant firm’s plant capacity. The future of the firm depends on
the management’s ability to meet the challenges. Similarly, the facility should
exist to exploit the opportunity. Since the assessment of capacity is a
judgement on the part of analysts, a lot of care should be taken in assessing this
feature.
Conditions: These are the economic conditions in the applicant’s industry and in
the economy in general. Scope for failure and default is high when the industry
and economy are in contraction phase. Credit policy is required to be modified
when the conditions are not favourable. The policy changes include liberal
discount for payment within a stipulated period and imposing lower credit limit. 9
Management of Current The information collected under five Cs can be analysed in general to decide
Assets
whether the customer is eligible for credit or fit into a statistical model to get an
unbiased credit rating of the customer. Discussion on credit evaluation model is
presented in the next section.
d) Credit Limit
If a customer falls within the desired limit of credit worthiness, the next issue is
fixing the credit amount. This is some thing similar to banks fixing overdraft limit
for the account holders. If a customer is new, normally the credit limit is fixed
at the lowest level initially and expanded over the period based on the
performance of the customer in meeting the liability. Credit limit may undergo a
change depending on the changes in the credit worthiness of the customer and
changes in the performance of customer’s industry.

Example 5.6

Alpha Electronics is presently grouping its customers into three categories. It

offers unlimited credit to first group, a maximum credit of Rs. 1 cr. to second
group and Rs. 5 lakhs for third group. It is presently doing a turnover of Rs. 50
cr. at 60% production capacity. One of the proposals received to increase the
capacity utilisation during the annual review meeting is increasing the credit limit
for second and third groups of customers. Instead of relaxing credit limit to all
groups, the Marketing Chief felt it is desirable to upgrade some of the customers
based on their past performance by relaxing the review procedure. The
Marketing Chief felt this will also give a right signal to their customers. After
completing the upgrading exercise, the marketing manager projected that the sales
will go up by another Rs. 10 cr. Based on the average collection period of 40
days, the Finance Manager estimated the revised investments in receivables at
Rs. 6.58 cr. against the earlier figure of Rs. 5.48 cr. The interest cost on short-
term borrowing is 14%. No major change is expected in collection and bad
debts values on account of this regrouping. The firm presently has a contribution
margin of 20% and operating above break-even level.

The additional contribution on account of increase in sales works out to Rs. 2 cr.
(20% of Rs. 10 cr.). The investment in receivables has gone up by Rs. 1.10 cr.
and it costs additional interest burden of Rs. 0.154 cr. per year. Since additional
contribution of Rs. 2 cr. is higher than the additional cost of Rs. 0.154 cr., the
revision is profitable to the firm.

There are several reasons for limiting the credit facility to the customers. Some
of the important reasons are:
• reduce the impact of deficiencies in credit-granting decision;
• reduce the scope for overbuying by the customers;
• rationally allocate the limited funds available for investment in bills
receivable; and
• mitigate agency problem
The last reason, mitigating agency problem, requires further discussion. Agency
problem arises on account of conflict of interest between the managers (agents)
and equity shareholders (owners or principal). Agents will always try to
maximise their return even if it is at the cost of principal. Two types of agency
problems arise in credit-granting decision. Firstly, managers may collude with
some of the customers and grant credit even to undesirable customers. Credit
limit puts a cap on the potential loss. Secondly, managers may hesitate to give
credit to even creditworthy customers when the performance of the managers is
10
assessed on the basis of collection efficiency. Recently, many public sector
banks were criticised for not granting fresh loan despite comfortable monetary Management of Inventory
position and funds are simply used to buy government securities. The fear of
default and delay in collection would prevent in granting credit even to good
customers and thus, take away the opportunity to maximise the profit. Credit
limit would to some extent take away this fear of managers since default is
restricted and thus would encourage them to accept credit proposals. The
situation will improve further if credit limits are built into the system of
performance evaluation and managers are not penalised as long as they have
restricted the credit.

Activity 5.2

1) What are the major components of credit policy?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) List out important factors that are used in assessing credit worthiness.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

3) How do you evaluate alternative credit policies? Identify the principle to be

used in evaluating credit policies.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

5.3 CREDIT EVALUATION MODELS

In the previous section, how the credit analysts collect the information required
for processing credit application under five Cs was discussed. Credit
evaluation models are useful for the analysts to process the information to
decide credit worthiness of the customer. It is possible to structure credit
evaluation model in different ways. An experienced credit analyst can
evaluate the credit worthiness by simply scanning the information received or
collected for the credit proposal. When the credit transactions increase or
number of customer increases, it may be difficult to apply this methodology. It
11
Management of Current will also cause delay in processing credit proposals and lead to inconsistent
Assets
decision. Thus, it is always useful to create a credit evaluation system and
standardise the appraisal. Decision-tree model and multivariate statistical model
are generally used to create credit evaluation system

Decision Tree Model: Under decision-tree model, credit applications are rated
under different parameters. For instance, if a company uses five Cs factors, the
analysts rate the credit applicant under each of the five Cs. Decision-tree is
initially created for all possible routes and decisions at the end of each route are
indicated. Figure 5.1 illustrates decision-tree model using three credit information
namely capital, character and collateral. If a character, capital and collateral are
strong, then the applicant firm is granted large amount of credit. On the other

Fig.5.1 : Decision Tree Credit Evalution Model

Should
Credit
be
granted?

Character

Strong Weak

Capital Capital

Strong Strong Weak

Weak

Collateral Collateral Collateral Collateral

Strong
Strong Strong/ Strong/ Weak
Weak Weak

Excellent Risk Fair Risk Dangerous

Fair Risk
Risk

Large Credit Limited Credit Limited to No Credit

Limit Collateral Limit

12
hand, if the first two are strong but the collateral is weak, a limited credit could Management of Inventory
be granted.

If character is weak but capital and collateral are strong, then credit is limited to
collateral value. On the other hand, if all the three are weak, it is a dangerous
credit proposal and hence to be rejected. In Figure 5.1, we have taken two
broad ratings, which can be further divided into three or five scale rating.
Increasing the credit variable and rating scale will lead to more branches and
credit limit can be prescribed for each branch separately.

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

credit evaluation has to be conducted. For example, if character, capacity and
conditions are good but capacity and collateral are weak, it may require a
detailed credit evaluation. That means, the information collected is inadequate and
a rigorous analysis is required.

Multivariate Statistical Model: Many firms have started using sophisticated

statistical techniques in conducting their credit analysis. Multiple Discriminant
Analysis (MDA) employs a series of variables to categorise people or objects
into two or more distinct groups. A credit scoring system utilises multiple
discriminant analysis to categorise potential credit customers into two groups:
good credit risk and bad credit risk. An important advantage of credit scoring
system is that all of the variables are considered simultaneously, rather than
individually as in the decision tree analysis. The model is capable of handling both
numerical measures such as debt-equity ratio, current ratio, profit margin, etc., as
well as non-numerical measures like character of the customer as good, bad,
average. When a credit scoring model is constructed with historical data of a
few customers, the model would produce a equation as given below:
MDA Score Y = b1X1 + b2X2 + b3X3 + ……. + bnXn
where, b1, b2, b3,.. bn are co-efficient values of variables X1, X2, X3 … Xn.
X1, X2, etc. are variables such as debt-equity, current ratio, etc.

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

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

Rating Methodologies of Credit Rating Institutions

13
Management of Current Credit rating has become one of the professionalised services in the recent past.
Assets
Though rating is more common with different securities offered by industrial units,
there is also focus on the rating of individuals and institutions as credit applicants.
For instance, CRISIL's rating methodology includes the following key factors for
deciding the credit worthiness of a borrowing company.
A. Business Analysis
• Industry Risk (nature and basis of competition, key sucess factors, demand
supply position, structure of industry, cyclical/seasonal factors. Goverment
policies etc.)
• Market position of the company within the industry (market share, competitive
advantages, selling and distrbution arrangements product and customer
diversity, etc.).
• Operating efficiency of the company (locational advantages, labour
relationships, cost structure, technological advantages and manufacturing
efficiency as compared to those of competitors etc.)
• Legal position (terms of prospectus, trustees and their responsiblities: systems
for timely payment and for protection against forgery/fraud; etc.)
B . Financial Analysis
• Accounting quality (overstatement/understatement of profits; auditors
qualifications; method of income recognition; inventory valuation and
depreciation policies; off balance sheet liabilities; etc.)
• Earnings protection (sources of future earnings growth; profitability ratios;
earnings in relation to fixed income charges; etc.)
• Adequacy of cash flows (in relation to debt and fixed and working capital
needs; sustainability of cash flow; capital spending flexibility; working capital
managment etc.)
• Financial flexibility (alternative financing plans in times of stress; ability to
raise funds; asset redeployment potential; etc.)
C. Management Evaluation
• Track record of the management; planning and control systems; depth of
managerial talent; succession plans.
• Evaluation of capacity to overcome adverse situations
• Goals, philosophy and strategies
The above factors are considered for companies with manufacturing activities.
The assessment of finance companies lays emphasis on the following factors
in addition to the financial analysis and management evaluation as outlined
above.
D. Regulatory and Competitive Environment
• Strucutre and regulatory framework of the financial system

• Trends in regulation/deregulation and their impact on the company.

E. Fundamental Analysis
• Capital Adequacy (assessment of true net worth of the company, its
adequacy in relation to the volume of business and the risk profile of the
assets.)
• Asset Quality (quality of the company's credit-risk management systems for
14
 monitoring credit; sector risk; exposure to individual borrowers; management Management of Inventory
of problem credits; etc.)
• Liquidity Management (capital structure; term matching of assets and
liabilities; policy on liquid assets in relation to financing commitments and
maturing deposits.)
• Profitability and Financial Position (historic profits; spreads on fund
deployment; revenues on non-fund based services; accretion to reserves; etc.)
• Interest and Tax Sensitivity (exposure to interest rate changes; tax law
changes and hedge against interest rate; etc.)
Individual Credit Rating: As indicated earlier, credit rating has become more
popular now, with financial instruments than individuals. Nevertheless, there are
now costing institutions like the Onida Individual credit Rating Agency
(ONICRA), developing specific methodology to help in rating individuals as
consumers. The ONICRA model considers the following three parametres as
important:
I. Individual Considerations
i) Personal strenghts - Qualification Occupation.
ii) Stability - Job Tenure
Duration of stay in personal
place of residence
iii) Capability - Income
Future Job Prospects
iv) Strenghts - Financial aspects
Discipline
Willingness to pay
II. Transaction Considerations
i) Risk - Security
Ownership of the asset
Control over end use of the product
colleteral
Exposure
ii) Modalities of payment - Direct deduction from salary
Advance post dated cheques
Automated debiting of bank account
Payment on due date
Payment on demand
III. Environmental Considerations- Economy
Activity 5.3

1) Why do we need models to evaluate credit proposals?

…………………………………………………………………………………….

…………………………………………………………………………………….
15
Management of Current …………………………………………………………………………………….
Assets
2) List down some of the important inputs required in evaluating credit proposals.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

3) Briefly explain multivariate discriminant model of credit evaluation.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

5.4 MONITORING RECEIVABLES

Managing receivables does not end with granting of credit as dictated by the
credit policy. It is necessary to ensure that customers make payment as per the
credit term and in the event of any deviation, corrective actions are required.
Thus, monitoring the payment behaviour of the customers assumes importance.
There are several possible reasons for customers to deviate from the payment
terms. Three of these possible reasons and their implications in credit
management are discussed below:

Changing Customer Business Characteristics: The customers, who have

earlier agreed to make payment within a certain period of time, may deviate from
their acceptance and delay the payment. For example, economic slow down or
slow down in the industry of the customers business may force the customers to
delay the payment. In fact, the bills payable become discretionary cash outflow
item in economic recession. Thus, a close watch on the performance of
customer’s industry is required.

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

Improper Policy Implementation: Often wide deviation is noticed in practice

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

Monitoring provides signals of deviation from expectations. There are several

16
monitoring techniques available to the credit managers. The monitoring system Management of Inventory
begins with aggregate analysis and then move down to account-specific analysis.

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

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

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

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

Accounts Receivable
Collection Period = ––––––––––––––––––––––
Credit Sales per day

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

Period 1: 120/1 = 120 days Period 2: 140/1.33 =105 days

The collection period shows a decline and thus improved performance, which was
not visible earlier in simple comparison. If the sales value for the second period
is Rs. 100 lakhs instead of 120 lakhs, then average credit sales per day is Rs.
1.11 lakh and collection period is 126 days. The collection performance in this
case has marginally come down. The collection period of manufacturing
companies in BSE-30 index (Sensex) for the last five years is given in Table 5.2.
The Table shows the average collection period for companies such as Hindustan
Petroleum, Nestle, Hindustan Lever, Bajaj Auto, Gujarat Ambuja Cements, ACC,
and Colgate are low whereas BHEL, L&T, Telco, Tisco, Grasim, etc., have
experienced longer days for collection.

If customers are granted different credit periods, then customers of similar nature
are to be grouped separately and then sales, receivables and collection period
relating to each group of customers are to be computed separately. Otherwise, it
will give a distorted figure. In addition to comparing collection period of one
period with other periods, they are also compared with credit terms. Any
abnormal deviation warrants customer-wise analysis. That is, all these three
17
Management of Current values for two periods can be computed for each customer to know the trends in
Assets
collection period of different customers. Such an analysis will help to narrow
down the customers who take longer time for paying the dues.

Table 5.2 : Average Collection Days of Manufacturing Companies in BSE-30 Index

Company Name 1999 2000 2001 2002 2003

Associated Cement Cos. Ltd. 44.64 40.75 24.63 27.67 23.60

Bajaj Auto Ltd. 25.78 21.51 14.43 19.88 14.42

Bharat Heavy Electricals Ltd. 194.87 231.53 249.48 240.67 209.65

Cipla Ltd. 36.25 41.88 55.63 72.35 88.92

Dr. Reddy’s Laboratories Ltd. 137.37 107.27 113.40 99.74 97.09

Grasim Industries Ltd. 62.47 53.19 50.43 41.54 34.01

Gujarat Ambuja Cements Ltd. 8.37 9.30 11.26 9.62 10.30

Hero Honda Motors Ltd. 6.32 5.22 4.87 8.15 10.13

Hindalco Industries Ltd. 33.83 33.31 32.95 42.74 41.09

Hindustan Lever Ltd. 7.47 8.43 9.12 14.58 13.44

Hindustan Petroleum Corpn. Ltd. 6.64 7.30 4.53 7.08 6.36

I T C Ltd. 35.03 10.91 9.17 14.07 13.64

Infosys Technologies Ltd. 60.76 56.27 58.13 47.28 51.68

Larsen & Toubro Ltd. 52.51 67.63 71.29 69.09 82.16

Mahanagar Telephone Nigam Ltd. 40.63 42.77 36.20 67.69 65.97

Oil & Natural Gas Corpn. Ltd. 38.76 36.64 30.24 40.92 49.85

Ranbaxy Laboratories Ltd. 107.22 98.14 80.00 83.00 76.33

Reliance Energy Ltd. 109.72 112.03 140.27 118.62 73.58

Reliance Industries Ltd. 13.30 17.32 16.36 18.58 18.02

Satyam Computer Services Ltd. 100.64 117.04 112.33 83.53 86.70

Tata Iron & Steel Co. Ltd. 75.53 64.70 61.95 53.33 37.18

Tata Motors Ltd. 103.42 43.79 33.60 41.93 42.49

Tata Power Co. Ltd. 48.91 77.59 63.59 76.55 78.32

Wipro Ltd. 64.98 71.91 74.06 68.28 72.63

18 Zee Telefilms Ltd. 159.26 167.21 162.35 246.44 236.62

 Management of Inventory

Ageing Schedule or Age Analysis: Public limited companies in their annual

report disclose debtors outstanding more than six month separately. The
receivables outstanding more than six months as a percentage of total receivables
of manufacturing companies in BSE-30 index (Sensex) for the last five years are
given in Table 5.4. The outstanding receivables for more than six months as a
percentage of total receivables is negligible in companies such as Bajaj Auto,
Colgate, Hindalco, Nestle and Ranbaxy. The percentage is high in many of the
commodity and engineering companies. While the above figures gives some
insight on the nature of receivables, a more detailed analysis is normally done
internally. Such analysis involves preparing an ageing schedule as shown below:
Table 5.3 : Ageing Schedule for Four Quarters (Rs. in thousands)
Accounts Receivable
Interval Quarter 1 Quarter 2 Quarter 3 Quarter 4

0 to 30 days 4340.00 5880.00 9100.00 13720.00

(in ) 52.69 56.62 51.89 55.97

31-60 days 2884.00 3430.00 5950.00 8232.00

(in ) 35.01 33.03 33.93 33.58

61-90 days 840.00 840.00 2240.00 2002.00

(in ) 10.20 8.09 12.77 8.17

91-120 days 168.00 224.00 238.00 546.00

(in ) 2.04 2.16 1.36 2.23

Above 120 days 5.60 11.20 8.40 14.00

(in ) 0.07 0.11 0.05 0.06

Total 8238.00 10385.00 17536.00 24514.00

The above analysis shows that while debtors for 0 to 90 days is more or less in line
with previous quarters values, debtors for 91-120 days have gone up to the highest
level. Further investigation in the form of break-up details would help to initiate
corrective steps. While feeding this type of information to top management, the
names and other details of the customers for the last two categories are also given.

Table 5.4 : Receivables Outstanding more than 6 months as a percentage of Total Receivables

Company 1999 2000 2001 2002 2003

Associated Cement Cos. Ltd. 28.15 23.08 21.01 22.09 34.14
ACC 35.15% 42.29% 27.47% 43.42% 46.74%
Bajaj Auto 0.40% 0.61% 0.84% 0.96% 0.74%
BHEL 39.16% 38.60% 41.86% 44.07% 37.60%
Cipla 16.04% 13.98% 7.94% 7.61% 8.77%
Dr. Reddy’S Laboratories 28.12% 18.16% 12.52% 5.05% 3.16%
Grasim Industries 15.65% 15.08% 14.49% 11.74% 8.00%
Gujarat Ambuja Cements 6.72% 10.16% 6.95% 11.48% 10.56%
Hero Honda 0.53% 0.68% 0.50% 1.04% 0.59%
19
Management of Current Hindalco Industries 4.55% 8.39% 9.81% 2.52% 5.05%
Assets
Hindustan Lever 7.58% 4.58% 2.90% 1.84% 2.09%
HPCL 10.15% 8.75% 12.68% 5.24% 2.25%
ITC 5.15% 7.59% 7.27% 9.83% 6.69%
Infosys Technologies 0.00% 1.62% 0.00% 0.00% 0.00%
Larsen & Toubro 25.51% 33.34% 36.22% 34.77% 30.61%
MTNL 47.78% 47.30% 49.05% 61.69% 66.81%
ONGC 9.01% 7.24% 8.63% 9.41% 5.36%
Ranbaxy Laboratories 9.24% 9.66% 12.78% 8.67% 0.23%
Reliance Energy 24.85% 24.42% 26.82% 43.46% 48.56%
Reliance Industries 12.78% 7.24% 11.41% 4.12% 0.52%
Satyam Computer Services 0.00% 1.50% 6.43% 2.46% 3.01%
Tata Iron & Steel 25.06% 20.64% 22.12% 17.41% 12.99%
Tata Motors 13.06% 14.75% 22.72% 56.25% 67.06%
Tata Power 13.07% 20.50% 34.00% 33.96% 41.71%
Wipro 12.46% 5.79% 7.27% 10.54% 7.88%
Zee Telefilms 18.17% 12.63% 4.49% 44.79% 21.83%

The above two measures namely, average collection period and ageing schedule
may give misleading picture when the sales are seasonal. Suppose the average
sales per month of a quarter is Rs. 10 lakhs. The sales figures for the three
months are Rs.10 lakhs, Rs.15 lakhs and Rs.5 lakhs. Suppose the collection
pattern shows that 50 per cent of the sales is collected in the same month, 25
in the following month and the remaining 25 in the third month. If there is no
outstanding receivables at the beginning of the quarter, then the receivables
values at the end of each month are Rs. 5 lakhs, Rs.10 lakhs and Rs.12.5 lakhs.
The average collection period for the last month will be very high compared to
other months though there is no change in the payment pattern of the customers.
In order to overcome this problem, particularly in a seasonal sales pattern, the
following alternatives are suggested:
• Ratio of receivables outstanding to original sales, and
• Sales-weighted Collection Period.
Both the above measures require decomposing receivable outstanding at the end
of each month to trace the receivables with original sales. Such a decomposition
will be useful even for a non-seasonal firms.
Decomposing Receivables Outstanding at the End of Month: Another way to
spot changes in customer behaviour is to decompose outstanding receivables at
the end of each month. This is achieved by preparing a schedule of the
percentage portions of each month’s sales that are still outstanding at the end of
successive months. An illustrative table is given below:
Table 5.5 Percentage of Receivables Outstanding at the end of month
Percentage outstanding after January February March
Current Month 94 98 96
1 month 70 80 78
2 months 21 28 32
3 months 6 9 12
4 months and above 1 1 2

The following example will help you to understand the figures in the above Table.
20 Suppose Rs. 40 lakhs is outstanding receivables at the end of January, this
consists of 94% of January’s sales, 70% of December's sales, 21% of Management of Inventory
November’s salary, 6% of October's sales and 1% of September's sales. If the
credit period is 30 days, the above analysis shows that a significant part of the
debtors takes more than one month in settling dues. While a significant part of
the customers settle down their dues by the end of second month, outstanding
beyond 2 months is also high and more importantly growing. Receivables
outstanding more than two months have gone up from 21% to 32%. The growing
trend in non-collection of dues continues for other two months too. This clearly
shows the customers have slowed down in settling their dues and thus requires
more careful analysis. If this Table 5.5 is supplemented with the names of
customers along with their dues for the second, third and fourth months, it is
helpful for follow up and appropriate action.

Sales-weighted Collection Period: In the above Table 5.5, percentages of

receivables outstanding to original sales are given. To compute sales-weighted
collection period, the values are to be summed up for each month and then
multiplied by 30. The sales-weighted collection period for January, February and
March are 57.60 days (1.92 x 30), 64.80 days (2.16 x 30) and 66 days (2.20 x
30) respectively. The general equation is:

n
Sales-weighted Collection Period =Σ (ARt/St) × 30 days
t=0

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

St is Sales of the month ‘t’

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

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

month are patterned as per their collection. This shows how the credit sales of a
month are collected in the subsequent months. This reveals the laxity or
otherwise of the collection department. Look at the following conversion matrix to
judge whether the collection pattern is improving, stable or deteriorating.
Conversion Matrix

Month Credit
Sales
(Rs.) Jan Feb Mar Apr May June July Aug Sept

Jan 1,00,000 10,000 40,000 30,000 20,000

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

Feb 80,000 11,000 28,000 32,000 9,000

(14%) (35%) (21%) (24%)

Mar 1,20,000 18,000 48,000 25,000 29,000

(15%) (40%) (21%) (24%)

Apr 1,60,000 19,500 72,500 38,000 30,000

(12%) (45%) (24%) (19%)

21
Management of Current May 2,00,000 20,000 72,000 60,000 48,000
Assets
(10%) (36%) (30%) (24%)

June 1,60,000 14,500 56,000 49,00040,500

(9%) (35%) (31%) (25%)

Total Collection 10,000 51,000 76,000 1,19,500 1,26,500 1,53,500 1,46,000 97,000 40,500

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

Receivables Variance Analysis: Receivables budget can be prepared from sales

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

Other simple measures of receivables management are ratio of credit sales to

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

Activity 5.4

1) Why customers often fail to adhere the credit terms?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) List down various indicators used in macro-analysis of receivables.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

22
3) How do you set right the seasonal variation in sales affecting some of the Management of Inventory
indicators used in receivables analysis?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

5.5 COLLECTING RECEIVABLES

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

Inexpensive procedures include periodical mailing of duplicate bills reminding the

customers that the account is not settled or sending a formal letter informing non-
payment of bill and requesting the customer to pay immediately. Written follow-up
on an overdue account is referred to as dunning. If a customer fails to respond
to these reminders, then expensive procedures are initiated. Personal telephone
calls and reminder through registered post are initially tried. Even if these steps
fail to deliver the desired results, a personal visit by the credit manager or
representative to sort out the issue would be useful. If the credit manager
realises that the customer is wilfully defaulting or is in deep trouble and hence
unlikely to pay the dues, a formal legal action is initiated either to recover the
dues or file a liquidation petition before the court to recover the dues. It is
difficult to prescribe exactly as to which and when these collection procedures
should be adopted. If collection policy is strict, then it would reduce the
outstanding receivables but at the same time frightened many potential customers
from doing business. On the other hand, a liberal collection policy would invite
many wilful defaulters to do business with the company.

The above discussion assumes that the firm takes the responsibility of collection.
Two alternatives are available to firms in collecting the receivables. The first one
called factoring enables the firm to transfer the receivables to factoring agent,
who takes the responsibility of collection. Some factoring agents takes the credit
risk (i.e. the factoring agents bear the loss on account of bad debts) and others
accept factoring without credit risk. In India, we have factoring subsidiaries of
Canara Bank, SBI, etc. and Exim Bank does the factoring service relating to
export bills. The second one is called receivables securitisation. Securitisation is
somewhat similar to factoring but here the securitising agent sells the units of
receivables to investors in the market. Though the concept of securitisation is
popular in finance related receivables like housing loans, credit cards receivables,
lease rentals, etc., the concept is slowly spreading to other types of receivables.
A few securitisation deals have already been completed in India and the market
will witness more such transactions in the near future.

5.6 STRATEGIC ISSUES IN RECEIVABLES

MANAGEMENT
Business management today involves continuous formulation of strategies and
23
Management of Current also, to develop and carry out tactics to implement the strategies to gain
Assets
competitive advantage. The discussion on receivables management so far focused
on operational issues such as how changes in credit policy affects investments in
receivables, how to monitor collection pattern, what are the options available in
dealing with delinquent customers, etc. Receivables management, however, can
support the strategies being pursued by the organisation to gain certain
competitive strength.

Firms pursuing strategies to acquire cost leadership need a suitable credit policy
to support their strategies. For instance, if a firm is trying to achieve cost
leadership through economies of scale of production, then it has to generate a
large volume of sales. Since credit term is an economic variable in buying
decision, the credit terms should be supportive to sell large volume. That means,
the firm may have to offer more days of credit particularly for those who buy in
large quantity. Of course, the cost of investment in receivables will go up initially
but without a liberal credit policy, the assets created to achieve economics of sale
will be idle. In fact, the additional cost of investments in receivables need to be
considered while computing the benefit arising out of economies of scale.

Firms pursuing strategies to acquire product differentiation have limited customer

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

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

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

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

Activity 5.5

1) List down a few inexpensive and expensive methods of credit follow-up.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) A firm in high-growth industry would like to build up more market share.

What type of credit policy is suitable to be consistent with this strategy?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

3) How credit policy affects investment decisions?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

5.7 SUMMARY
The use of credit in the purchase of goods and services is so common that it is
taken for granted. Selling goods or providing services on credit basis lead to
accounts receivables. Though a lot of discussion is going on in the Indian industry
on how to cut down the investments in inventories through concepts such as
Just-in-Time (JIT), MRP, etc., investments in receivables have gone up and firms
are demanding more credit from banks and specialised institutions to deal with
receivables. Since investment in receivables has a cost, managing receivables
assumes importance. Receivables management starts with designing appropriate
25
Management of Current credit policy. Credit policy involves fixing credit period, discount to be offered in
Assets
the event of early payment, conditions to be fulfilled to grant credit and fixing
credit limit for different types of customers. It is essential for the operating
managers to strictly follow the credit policy in evaluating credit proposals and
granting credit. To evaluate the credit proposal, it is necessary to know the
credit worthiness of the customers. Credit worthiness is assessed by collecting
information about the customers and then fitting the values into credit evaluation
models. There are number of credit evaluation models which range from simple
decision tree analysis to sophisticated multivariate statistical models. The firm
has to develop a suitable model, test the model with historical data to validate the
model and use it for credit evaluation. Models also need to be periodically
updated. Once the credit is granted, then it should be monitored for collection.
Different methodologies are available to get a macro picture on collection
efficiency. Micro analysis in the form of individual customer analysis is done
wherever there is a deviation from the expectation. It is equally important in
dealing with delinquent customers. There are several options, simple reminders to
legal action, available before the credit managers in dealing with such default
accounts and appropriate method is to be selected with an objective of benefit
exceeding cost. The use of credit policy and credit analysis is not restricted to
the operational managers in dealing with day-to-day activities of the firm. In the
competitive world, credit policy and analysis provide a lot of strategic inputs.
Credit policy of an organisation is in line with the desired strategy that the
organisation wants to pursue to gain certain competitive advantages.

5.8 Key Words

Terms of Credit : These refer to eligibility conditions and payment details for
granting credit by the company to a customer.

Creditworthiness : Capacity of the customer to meet payment obligations.

Credit Policy : Decision of the firm to grant or not to grant credit. It consists
of the components such as credit period, discount, credit eligibility and credit limit.

Credit Period : Refers to the minimum and maximum time limits for which
credit is granted.

Credit limit : Is the limit upto which credit is granted

Decision Tree : Is a model indicating decision points and chance events for
taking a decision.

Credit Scoring System : A system which attempts to rank customers as good, bad
or average by a scoring mechanism.

Business Analysis : An examination of risk factors influencing business

prospects in terms of competition, demand and supply position, structure of
industry, cost structure, labour relations, etc.

Financial Analysis : An examination of financial performance and ability of a

business unit to generate income.

Fundamental Analysis : Refers to capital adequacy asset quality, liquidity

management and interest over tax sensitivity.

Collection Period : Indicates the time taken by the collection department in

collecting its book debts. A comparison of collection period with credit period tells
us whether the debts were collected within the stipulated time or not.
26
Ageing Schedule : A method of classifying debts according to the number of Management of Inventory
days the debt remained outstanding.

Conversion matrix: Sequencing of debts in the order of their collection.

Variance Analysis : A comparison of Budgeted figures with Actuals to note

down deviations.

9.9 SELF-ASSESSMENT QUESTIONS

1. Explain important components of receivables management system?

2. Why do we need a credit policy? How do you evaluate credit policy?

3. How do you assess the credit worthiness of customers?

4. Discuss a few important financial ratios and analysis used in managing receivables.

5. Assume a customer, who used to pay the dues in time earlier, has suddenly
defaulted. A couple of reminders sent to him fail to get any response. As a
credit manager, you have two issues to decide. You have to first decide
whether to continue the supply to the customer on credit basis. The second
issue is how to deal with the customer to recover the dues. In the normal
course, you have to initiate legal process to recover the dues but this may
strain your firm’s relationship with the customer. You can’t also be silent
since the money involved is quiet high and your firm is incurring interest cost
on this credit. How do you deal with this customer and decide the two
issues?

6. Hindustan Automobiles is manufacturing heavy vehicles and presently offering

a credit period of 45 days. In order to increase the sales from its current
level of Rs. 400 crore., it is contemplating to increase the credit period to 60
days. This is expected to bring additional sales of Rs. 40 crore. There is
no change in the collection and bad debts cost. The company is likely to earn
a contribution margin of 20%. The short-term borrowing cost is 15%.
Evaluate the new credit period and its impact on profitability.

7. Regal Industries found that a very few debtors avail the discount, which is
“1.5/10 net 60”. The firm is presently borrowing at 15%. Since finance for
receivables is limited, it is turning down many credit proposals and thus loose
the opportunity to increase the sales. The firm now wants to revise the
discount policy and make it attractive to motivate some of the existing
customers to avail the discount. The funds released could be used for
accepting new customers. The additional details available to you are:
Contribution margin is 20%; Average collection period is 60 days; Sales could
be increased to any level. With these additional details evaluate the proposed
discount policy of “4/10 net 60”. Compute the impact of new policy on
profitability of the firm.

8. The proposed credit policy of R.K. mills would cut down the bad debts from
4% to 2%. It will also improve the collection period from 60 days to 30
days. The firms current sale of Rs. 80 lakhs will decline by 20% on account
of this new policy. If the contribution margin cost of borrowing are 15% and
14% respectively, how the new credit policy affect the profit of the firm.

9. Your firm is following a credit rating model developed internally to assess the
credit worthiness of customers. The cut-off score is 4.8 points. Your analysis
of historical behaviour of customers with different points shows the
27
 Management of Inventory
UNIT 6 MANAGEMENT OF CASH
Objectives

The objectives of this unit are to:

• Highlight the role of cash in the operation of business.
• Explain different motives behind holding the cash.
• Discuss various determinants that affect and create uncertainty in the cash flows.
• Stress the importance of cash forecasting and techniques of forecasting.
• Discuss the importance of managing cash surplus and cash-in-transit.
• Explain the need for good management information system in cash management.
Structure
6.1 Introduction
6.2 Motives of holding cash
6.3 Determinants of Cash Flows
6.4 Cash Forecasting
6.5 Managing Uncertainty In Cash Flow Forecast
6.6 Managing Surplus Cash
6.7 Managing Cash-in-transit
6.8 MIS in Cash Management
6.9 Summary
6.10 Key Words
6.11 Self Assessment Questions
6.12 Further Readings

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

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

optimising the benefits and costs associated with holding cash. As described
earlier, unless the cash is put into use, there is no benefit derived out just by
holding it. Further, holding cash without a purpose also costs firm either directly
in the form of interest or opportunity income that could be earned out of the
cash. At the same time, it is not possible to operate the business without holding
cash. Many of us take cash while going to office though we have bought the
tickets earlier and taking lunch with us or have a credit facility to take lunch.
1
Management
Though of Current
no major demand for cash is expected, we feel uncertain without cash.
Assets
Firms also feel uncertain without holding cash for various reasons. For instance,
any delay in collection will force the firm to delay the salary to employees or
payment to creditors or bankers which in turn affects long-term relationship with
them. Firms, which are experiencing volatile price behaviour in some of the
critical raw materials, would like to have more cash to buy the material,
whenever the price is low. There are several other motives of holding cash and
we will shortly discuss these motives in detail.

The objective of cash management is to balance the cost associated with holding
cash and benefits derived out of holding the cash. The objective is best achieved
by speeding up the working capital cycle, particularly the collection process and
investing surplus cash in short-term assets in most profitable avenues. The term
‘cash’ under cash management thus refers to both cash and credit balance in the
bank and short-term investments in marketable securities. Table 6.1 shows total
amount invested in cash and marketable securities of few industries. The figures
in the Table shows that investment in cash and marketable securities is huge and
has gone up several times in reflection to growth of operations. Investments in
cash and marketable securities also show significant differences between
industries even after taking into account the differences in the number of firms in
different industries.
Table 6.1: Investments in Cash and Marketable Securities of Manufacturing Industries
(Rupees in Crores)
Industry 1999 2000 2001 2002 2003
Food & Beverages 2306.34 2424.03 2372.82 2585.53 3014.78
Textile 2460.09 1884.74 2489.38 2506.74 2625.73
Chemicals 12287.85 13337.33 13618.50 17504.49 18334.49
Non-metallic Minerals Products 1289.58 1135.09 1369.33 1349.02 1449.67
Metals & Products 5143.03 5188.58 6362.79 6050.11 7325.18
Machinery 8926.23 9986.02 11714.53 15334.53 18197.25
Transport Equipment 5998.40 5419.28 5744.91 5871.66 7933.06
Diversified 9852.56 9242.45 7208.94 7467.43 6849.64
Miscellaneous 721.01 1040.25 948.77 953.74 1617.11
Total 48985.09 49657.77 51829.97 59623.25 67346.91

Note: Figures in brackets indicate the number of companies of the industry used
to compile industry aggregates.
Thus, while structuring cash management policy, the firm has to consider the
internal business process and external environment. The important issues relating
to management of cash are:
• Understanding the motives behind holding the cash;
• Quantifying the cash needs of the firms to achieve the above motives; and
• Developing a cash management model to enable operating managers to take
decisions on investing surplus cash and selling investment to fund shortage.
Activity 6.1

1) How do you relate cash management in a broader sense? What is its focus in
the context of working capital management?

…………………………………………………………………………………….
2
…………………………………………………………………………………….
2) Why do we need to manage cash? Management of Inventory

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

3) Collect the cash and marketable securities data of your company or any one
company you are familiar with from published accounts for the last three or
five years. Examine the trend and its relationship with level of operation.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

6.2 MOTIVES OF HOLDING CASH

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

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

Precautionary or Hedging Motive: The transaction motive takes into account

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

Speculative Motive: If the firm intends to exploit the opportunities that may
arise in the future suddenly, it has to keep some cash balance. The term
“speculative motive” to some extent is a misnomer since cash is not kept to
conduct any speculation but merely to exploit opportunity. This is particularly
relevant in commodity sector, where the prices of material fluctuate widely in
different periods and the firm's business success depends on its the ability to 3
Management
source of Current
the material at the right time. Some of the materials, whose prices show
Assets
significant volatility, are cotton, aluminium, steel, chemicals, etc. Surplus cash is
also used for taking over of other firms. Firms that intend to take advantage on
the above counts keep large cash balances with them, though the same are not
required either for transactions or as a precaution.

Managing uneven supply and demand for cash: Firms generally experience
some seasonality in sales, which leads to excess cash flows in certain period of
the year. This is not permanent surplus and cash is required at different points
of time. One possible solution to address this mismatch of cash flows is to pay
off bank loans whenever there is excess cash and negotiate fresh loan to meet
the subsequent demands. Since firms are exposed to some amount of
uncertainty in getting the loan proposal sanctioned in time, the surplus cash is
retained and invested in short-term securities.

In a competitive environment, firms also felt the desire of holding cash to get
flexibility in meeting competition. For instance, when a competitor suddenly
resort to massive advertisement and other product promotion, it forces other firms
to increase advertisement cost or some other sales promotion such as “free gift”
for every purchase or lottery scheme, etc. Amount held in the form of cash and
marketable securities of twenty manufacturing companies of BSE-30 Index
(Sensex) firms has increased from Rs. 20827.76 cr. in 1999 to Rs. 20094.91 in
2003 (Table 6.2).
Table 6.2 :Investments in Cash & Marketable Securities of Manufacturing Companies in
Sensex
(Rupees in Crores)
Company 1999 2000 2001 2002 2003
Oil & Natural Gas Corpn. 2393.83 3878.12 50326.59 25706.20 2488.52
Bajaj Auto 1150.11 2223.90 5525.18 4183.43 2331.03
Bharat Heavy Electricals 537.43 1807.72 9722.93 8276.70 2020.30
Hindustan Petroleum Corpn. 672.22 4770.76 15203.81 9784.78 1743.80
Hindalco Industries 928.75 1461.26 7660.84 2658.63 1475.62
Grasim Industries 446.21 1326.67 6247.97 2991.17 1217.34
Tata Power Co. 660.62 1491.27 8431.65 3457.94 1088.82
Larsen & Toubro 291.52 7675.29 15561.74 10016.02 1075.50
Hindustan Lever 1030.38 2378.12 6767.00 3873.85 917.38
HDFC 1623.57 3341.00 20213.30 2622.43 883.78
Wipro 37.12 191.03 2585.45 1673.09 848.84
Tata Motors 877.38 2191.60 9299.45 3068.67 750.64
Mahanagar Telephone Nigam 1356.42 265.08 16888.20 7994.18 698.41
Reliance Industries 6425.93 8055.17 36959.51 6825.49 648.33
Tata Iron & Steel Co. 735.70 1763.74 12889.90 3576.49 628.80
Reliance Energy 519.87 1479.14 4612.13 2114.79 465.55
Gujarat Ambuja Cements 272.15 383.50 2988.98 618.90 209.07
Cipla 94.55 407.18 1047.85 637.02 145.88
Zee Telefilms 18.10 3505.76 4570.49 796.41 145.42
Associated Cement Cos. 80.06 466.20 3476.45 901.24 114.13
ITC 445.73 1946.49 6376.15 2538.60 105.80
Ranbaxy Laboratories 50.41 647.86 2389.91 1327.16 44.70
Dr. Reddy’S Laboratories 44.01 211.10 1066.85 550.40 22.92
Hero Honda Motors 83.56 337.31 1163.95 674.47 13.58
Satyam Computer Services 38.28 56.48 1146.54 674.65 10.75
Bharti Tele-Ventures 13.85 324.96 1865.38 600.89 0.00
Total 20827.76 52586.71 254988.20 108143.60 20094.91
4
Activity 6.2 Management of Inventory

1) Can we consider investments in cash and marketable securities as least

productive?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) Why companies maintain huge cash and marketable securities despite they
being least productive assets? List down a few industries, where the demand
for cash for speculative motive would be more.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

3) Analyse the data given in Table 6.2. Why do you feel that in some
companies the cash balance has gone up over the years whereas in a few
cases, it remains same or has gone down?

..………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

6.3 DETERMINANTS OF CASH FLOWS

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

Internal Factors

Internal factors relate to policies of management relating to working capital

components and future growth plan. These factors are determined by the firm
and arising out of management decisions. The internal factors that affect the
cash flows of firms are discussed below.

Production-related policies: Production-related policies determine production plan,

which in turn affect, purchase of material and other components and level of
finished goods. For example, firms that follow production policy of manufacturing
for inventory and then selling the product in the market will normally carry high
volume of material and other inventory in order to ensure smooth production
process. The increase in purchase activity will demand more cash compared to
other firms, which follow order-based production policy. Similarly, if production
process is automated, then the demand for cash to pay wages to workers will
5
Management
come down of Current
significantly. Firms following JIT, MRP, FMS, etc., could reduce the
Assets
general level of inventory and they also favourably contribute to the demand for
cash.

Policies on Discretionary Expenses: Expenses not directly connected to the

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

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

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

Financial Policies: Firms, which pursue active capital expenditure programme in

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

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

External Factors

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

Monetary and Fiscal Factors: The central bank (Reserve Bank of India)
periodically spells out monetary policies and through which influences the
availability of money. The monetary policy in turn is affected by the fiscal factors
of the country. In a liberal monetary policy regime, it will not be difficult to get
credit from banks as well as from suppliers of material and services. Thus, the
need for holding cash is thus limited to transaction motive. Cash required for
precautionary and speculative motives can be easily raised. Unit-2 on 'Operating
Environment of Workimg Capital' contains more discussion on monetary policy
issues.

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

form of practices followed by other firms in the industry on terms of sale and
nature of material and services required. Cash flow will be positive in retail
industry. Cash flow will be cyclical for industries such as plantation and agro-
based products. Cash flow is volatile in certain industries like entertainment and
hospitality industry. Cash flow is generally negative for manufacturing industries.
Depending on the nature of cash flow relating to the industry, the demand for
holding cash is determined.
6
Activity 6.3 Management of Inventory

1) Why do we need to analyse the cash flows to determine the balance to be

maintained in the form of cash and marketable securities?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) List down the factors that affect the cash flows of the firm.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

3) Name any three industries in which you expect a positive or negative cash flow.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

6.4 CASH FORECASTING

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

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

independently. The determinants are many as seen in the previous section and
also highly inter-related with other budgets. Cash forecast/budget integrates
several other forecasts.

Types of Cash Forecast: The cash forecasts generated by the firms can be
broadly differentiated under two dimensions: the length of periods included within
the cash forecast and the approaches to cash flows used in the cash forecast.
Cash forecasts are normally prepared for one-year period but the forecast is
broken down to several smaller periods like, quarterly, monthly or weekly cash
forecasts. The choice of particular periodicity depends on the volume of cash 7
Management
flows, natureof of
Current
cash flows and the desirability of the management. Firms broadly
Assets
follow two approaches in the preparation of cash forecast. Under the direct
approach, firms forecast various receipts and payments items for different periods
and consolidate the forecasts into cash budget. Under indirect approach, firms
start with forecast of earnings and then add back all non-cash expenses and
deduct all non-cash revenues, to get cash forecast. This is similar to preparation
of funds flow/cash flow statement, which is normally prepared using historical
accounting information as a part of financial statement analysis.

The format of monthly cash budget is illustrated in Table 6.3. It lists out major
cash inflow and outflow that arise in the normal operation of business. The
example also shows how the cash deficit and cash surplus are dealt with to
maintain the minimum balance.
Table 6.3 : Monthly Cash Budget
Cash Flow Item January February March Total for
the Quarter
Beginning cash balance 60000 66078 61320 60000
Collection from sales/receivables 415488 373392 368280 1157160
Total 475488 439470 429600 1217160
Disbursements
Suppliers 68648 60960 56957 186565
Payment of Salaries & Wages 49202.4 42150 44670 136022.4
Other Overhead Expenses 30160 28290 29130 87580
S&A Expenses 51400 48850 50130 150380
Total 199410 180250 180887 560547
Excess / -Inadequacy 276078 259220 248713 656613
Minimum Balance 60000 60000 60000 60000
Cash Available / -Needed (A) 216078 199220 188713 596613
Financing

Borrowing/ -Repayments 0 0 0 0
Fresh Equity Issue 0 0 0 0
Sell/ -Acquire Investments -210000 30000 60000 -120000
Payment to Fixed Assets -230000 -230000
Receive/ -pay interest 2100 1800 3900
Dividend -250000 -250000
Total of Financing Plan (B) -210000 -197900 -188200 -596100
Closing Cash Balance (A - B) 66078 61320 60513 60513

Methods of Cash Flow Forecasting: The above Table gives the output as a
result of forecasting exercise. However, each item in the above Table requires
several computations and assumptions. While a few cash flow items are
independent, several others are dependent on many other variables. Forecasting
method depends on the nature of cash flows. Some of the common methods of
forecasting are explained below:

1. Independent Cash Flow Items: These cash flow items are independent of
other factors or predetermined. Lease rent for office building, property tax,
insurance premium, etc., are few items which are determined independently.

2. Dependent Cash Flow Items: Many cash flow items are dependent on
other financial variables. For instance, cash collection from sundry debtors
depends on sales of the previous months, credit terms and collection pattern.
An understanding of the relationship between the cash flow variables is
important in forecasting the cash flows. If only one variable is associated
with cash flow items, then estimation is not difficult. On the other hand, if
several variables are associated with a cash flow item, econometric models
are used to get the value. For instance, if customers take more than two
8
 months credit period to pay the amount, it is possible toManagement
construct a ofmultiple
Inventory
regression model to measure the proportion of amount collected from various
months’ sales. The model uses cash collection of the month as dependent
variable and previous months sales values as independent variables.

3. Growth in Cash Flow Items: As business grows, the cash flow items also
see a positive growth. Suppose the total sales grow at five percent every
quarter and credit (60 days) sales is eighty percent of the sales. If forty
percent of the customers pay at the end of two months in time, another 40
percent pays at the end of three months and the balance 20 percent pays at
the end of fourth month the amount collected from the customers is also
expected to show an uptrend due to growth in sales.

The most usual approach to cash forecasting is the Receipts and Payments methods
as accepted in Table-6.3. After the firm has determined what types of receipts and
payments are important in its overall cash flow, an important question is how to
forecast the future level of inflows and outflows. There are four common techniques
of forecasting these items of receipt and payment.

a) Direct Method – In using this technique, it is assumed that the variable to be

forecast is independent of all other variables, or alternatively, is predetermined.
The variables (e.g.lease rental) is forecast by using its expected or
predetermined level.

b) Proportion of Another Account – This technique is used to project financial

variables that are expected to vary directly with the level of another variable. For
example, if sales volume increases, it is natural that more units will have to be
produced to replenish inventory. It is then reasonable to project certain direct
costs of production, such as direct materials, as a per cent of sales.

c) Compounded Growth – This method is used when a particular financial

variable is expected to grow at a steady growth rate over time. The formula used
is:
Yt = (1 + g) Y t-1
Where Yt-1 is the prior period’s level of y and g is the growth rate.
d) Multiple Dependencies : Under this technique the variable is considered to be
influenced by more than one factor. The statistical technique of linear
regression is often employed with historical data to determine which
explanatory variables are significant in explaining the dependent variable.
We will see the application of regression technique after a while.

Since cash forecasts deal mostly with the near future, many of the items on the cash
forecast are usually estimated by some variation of the spot method. The bases of
these spot estimates are usually the firm’s other financial plans. Remaining estimates
are mostly on a proportion of another account’ basis, the another account often being
a particular period’s sales. The other two methods are employed less frequently.

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

receipts, because the cash manager can rely on internal information and knowledge
of payment policy in order to determine what needs to be paid and when. Besides, he
has the knowledge of firm’s other plans (or budgets) and can make use of the
forecasting techniques described above. However, a major challenge for him comes
in estimating the receipts from the collection of the firm’s receivables. In this
regard, an useful forecasting method is to analyse the historical payment patterns to
determine the proportion of credit sales that are collected at various times after the
date of sale, and then to use this information (along with the estimates of future sales)
to project future receipts. This has been illustrated in the unit 14 of MS-4 (under the 9
Management
head of Current
‘Sales Work Sheet’). We may, however, adopt a better and a more sophisticated
Assets
approach. In this all collection rates are estimated simultaneously by regressing past
sales figures against past collections. The estimated coefficients of the sales figures
in the regression can be interpreted as the collection proportions, and the standard
errors of the estimated regression coefficients as the uncertainty inherent in the
estimation of these collection proportions.

Let us take an example. Suppose that a firm has regressed its monthly collections for
past months against the appropriate past monthly sales figures and has obtained the
following results:
Ct = 0.754 St – 1 + 0.241St – 2
(0.250) (0.087)

The figures in parentheses below the estimated collection rates are the standard
errors of these collection rates. In this equation, Ct is the collection from receivable in
period t, St – 1 is the sales in period t –1 (say, previous month), and St – 2 is the sales in
period t-2 (say, two months previously). Assume also that these were the only
statistically significant explanatory variables (the variables like St – 3, St – 4, etc. and
dummy variables to assess seasonality, were not significant), and that the overall
estimated equation was highly significant. We may now interpret the regression
results in the following way. The estimated collection rates are 75.4 per cent
(regression coefficient on St – 1) of the previous month’s sales and 24.1 per cent
(regression coefficient on St – 2) of the sales from two months previously. The implied
bad debt rate is 0.5 per cent, equal to one minus the sum of the collection rates. The
standard error figures are used to test the statistical significance of the estimated
regression coefficients.

Simulation Approach

Simulation analysis permits the financial manager to incorporate in his forecasting

both most likely value of ending cash balances (surplus/deficits) for each of the
forecast periods (say, for each month over the next quarter) and the margin of error
assoicated with this estimate. It involves the following steps: First, probability
distributions for each of the major uncertain variables are developed. The variables
would generally include sales, selling price, proportion of cash and credit sales,
collection rates, production costs, and capital expenditures. Some of these variables
have the greatest influence upon cash balances. Clearly, more time and effort should
be spent in obtaining probability distributions of these variables. Second, values are
drawn at random for the variables from their respective probability distributions, and
using these values each balances are estimated. Third, the process is repeated
several times (say, 100 times). Needless to say, such tedious and cumbersome
computations are done on computer. From the trial results, information of the kind as
shown in table 6.4 would be generated.

Table 6.4 : Hypothetical Simulation Results

Month Average Cash Balance Standard Deviation

(Rs. in '000) (Rs. in '000)

April 3,104 334

May 1,258 375

June -1,221 353

July -1,104 402

August -363 403

September 591 421

10
How can the finance manager use the results of the simulation? Management of Inventory
The usefulness of
the results as shown in Table 6.4 lies in the fact that summary statistics (i.e. average
cash balances and standard deviation) can be used to determine upper/lower
estimates of cash surplus or deflcit for each month, with a probability of say 95
per cent that cash balance will remain within the estimated range. Assuming that the
distribution of month-ending cash balances is normal, we can obtain the upper/lower
estimates by applying the following formula.

Upper/Lower Estimates

= Average Cash Balance + Z × Standard Deviation

where Z is the standard normal variate.

With the information of this type in hand, finance manager can now address the
formulation of appropriate investement and financing strategies. Let us now proceed
with some examples to illustrate the point.

Consider our hypothetical simulation results and assume that the costs of having
insufficient cash and the costs of hedges (i.e. financial arrangement to fall back upon
in case of shortage of cash) are such that the firm desires to incur, at maximum, a 5
per cent chance of having insufficient cash to cover expenses. What is the maximum
amount for which the firm should secure a line of credit? The maximum expected
deficit is in the month of June, with a mean of Rs. 12,21,000 and a standard deviation
of Rs. 3,53,000. The Z statistic for 95 per cent confidence interval is 1.645; and 1.645
times of Rs. 3,53,000 is Rs.5,80,685. The maximum amount that the firm should
arrange to borrow is Rs. 12,21,000 plus. Rs. 5,80,685 or Rs. 18,01,685. There is a 5
per cent chance that the actual borrowing needs in June will be greater than this and
a 95 per cent chance that the requirements will be less than this.

Let us now consider that the firm is contemplating how much of the estimated surplus
in September to invest in a 60-day investment. How much can the firm invest and
have only 10 per cent chance of having to resell the investment in September? Z
statistic for 90 per cent confidence interval is 1.28; times of Rs. 4,21,000 is
Rs.5,38,880; Rs. 5,91,000 less Rs. 5,38,880 is Rs.52,120. There is 10 per cent chance
that cash surplus in September will be less than Rs. 52,120. So, the firm can invest
the amount in the 60-days investment and have a 10 per cent chance that they will
have to liquidate the investment prior to maturity.

The above exmaples are intended to illustrate the mechanics of manipulating means,
standard deviations, and probabilites of cash balances rather than to present realistic
hedging strategies. In practice, the array of possible hedging strategies is quite a bit
more complicated. One is required to consider various alternatives and the assoicated
costs and risk in hedging strategies.

Activity 6.4

1) Why do we need to forecast cash flows while managing the cash?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….
11
Management
2) of Current
Collect cash flow statement given in the annual report of a large listed
Assets
company for the last five years. Comment on the trend in the component.

…………………………………………………………………………………….

…………………………………………………………………………………….

………………………………………………………………………….………….

………………………………………………………………………….………….

………………………………………………………………………….………….

3) How does simulation approach help in cash forecasting?

…………………………………………………………………………………….

…………………………………………………………………………………….

……………………………………………………………………………………

………………………………………………………………………….………….

………………………………………………………………………….………….

6.5 MANAGING UNCERTAINTY IN CASH FLOW

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

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

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

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

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

the user defines possible scenarios and the computer generates the cash forecast.
In simulation, the computer is allowed to generate various scenarios based on
random numbers. Since a large number of scenarios are generated, it is possible
12
 Management
to define the distribution of cash flow forecast and uncertainty of Inventory
associated with
the forecast.This is discussed in more detail in the previous section.

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

solution to manage the uncertainty associated with the forecasting of cash flow.
This is relied upon when the level of uncertainty is high.

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

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

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

Activity 6.5

1) Why the actual cash flows show significant variation from the forecast?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) How do you recognise and measure the uncertainty associated with cash flows?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

3) List down important techniques in managing the uncertain cash flows?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

6.6 MANAGING SURPLUS CASH

Profit making firms have to generate surplus cash at the end of operating cycle
since the cash collected from debtors is greater than cash invested initially.
However, in reality, many profit making firms see the pressure of negative flow
of cash. There are several reasons for this situation. The mismatch of inflows
and outflows and diversion of short-term funds for long-term needs are two
major reasons for this condition. Though it is not desirable to divert the short-
term funds for long-term needs, often firms resort to this diversion if there is
13
Management
some delay of
in Current
getting long-term funds. The situation is set right once the firm
Assets
receives the long-term funds. In other words, profit-making firms periodically
generate cash surplus even though they face pressure on cash flows in other
times. The issue is how to deal with such surplus cash. Excess cash balance is
the least productive asset of the firm and thus should be minimised.

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

securities to earn some return. The firm has to decide on two issues at this
juncture. First, it should decide on investment avenues and products. The amount
to be invested is the next important decision.

The investment product is typically short-term, highly liquid government securities.

The Indian money market is not fully developed and generally restricted to banks
and other institutional investors. The investment widely used by the Indian
corporate sector to place short-term capital in Unit-64 scheme of Unit Trust of
India. Earlier, investment in Unit-64 enjoyed certain tax benefit also for the
corporate sector. Since many private sector mutual funds have floated open-
ended debt-based schemes, the demand for this source of investment has
increased in recent times. Certificate of deposits, commercial paper and inter-
corporate deposits are other popular schemes in which short-term funds are
placed. After liberalisation of the economy, money and capital markets have
become active and the volume and variety in the instruments traded has
increased. The advent of money market mutual funds has broaden the scope for
surplus cash investment.

The amount to be invested depends on transaction cost associated with

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

6.7 MANAGING CASH-IN-TRANSIT

The discussion covered so far generally relates to forecasting of future cash
flows and managing the surplus or deficit cash flows. A related issue of cash
management is improving collection efficiency, particularly speeding up the
conversion of cash-in-transit to cash. The concept is explained with simple
example. Suppose a firm in New Delhi sold Rs.10 lakhs worth of goods to
another firm located in town near Madurai. At the end of credit period, when the
selling firm made an enquiry over phone about the payment, the customer
informed that they have posted the cheque on that day and gave the payment
details. The postal department will take about four to five days to deliver the
post to the seller firm. The seller firm may take about a day or two to process
the receipt and the cheque will be deposited on sixth or seventh day in the bank
account. Since it is outstation cheque, the bank will take about another one to
two weeks to collect the money since the collection bank again has to send the
cheque by post to issuer’s bank and get the collection details by post. In other
words, it will take about two to three weeks to complete the whole exercise. The
buyer in this process enjoyed another two-three week credit, which is called
''Float'. On a Rs. 10 lakhs, the interest cost for three weeks is around Rs.
10000 (1%). The electronic clearing system that reduces the collection time at
the bank end is not available at all places. The issue is how the selling firm
speeds up the collection process. Though a simple solution is to request the
customer to pay through demand draft and send the draft by speed-post or
courier
14
after deducting the cost of DD and courier charges, customers may not
 Management
agree to the proposal since they loose the float Thus, we need to look of Inventory
into our
collection system for improvement.

Selection of Banks with Accelerated Clearing Facilities: An analysis of the

time delay in the collection process, particularly collection of outstation cheques,
shows that a significant part of delay is at banks end. If a firm is having
customers through out the country, then it is necessary to select a bank, which
gives accelerated clearing facilities. Banks may be atleast insisted to process the
clearing through speed post to cut down the delay arising on account of postal
transaction.

Maintaining Accounts in Several Branches: To cut down the time delay in

clearing outstation cheques, the firm can open accounts in important cities, where
the number of clients are more and deposit the cheque in the branches to get
local clearing facility. Funds collected may be electronically transferred to the
head office.

Acceleration of Cheque Processing at the Firm: This is within the control of

the firm. Often, the sales person, who collects the cheque from the customer will
first show the collection to his/her boss before sending the cheque to accounts
department. If the boss is not available or in a meeting, the cheque will be in his
table for a day or two before it moves to accounts department. The person,
who receives the cheque in the accounts department, will first identify the
relevant bill. If there is any shortfall in the value, this will be discussed with the
sales department. After reconciling the cheque amount with the bill, the accounts
department prepares receipt and makes an entry in the cash-book. The cheque
now moves to the person who is preparing challan for depositing into the bank.
If the cheque is deposited beyond certain hours, this will not be taken up for the
day’s clearing and the cheque has to wait for one more day for collection. All
these activities can be done after noting down the relevant cheque details and
directly handing over the cheque to the employee who is looking after the bank
transaction. It requires simplification of procedure involved in processing of
collection.

Use of Lockboxes: The lockbox is a post office box number to which some or
all the customers would be requested to mail their cheques. The lockbox will be
opened in several cities and the local branches of the bank are authorised to
open the box and clear the cheques. The amount collected under lockbox is
transferred to the notified account. This concept is popular in the US and other
developed countries but not prevalent in India.

Electronic Funds Transfer and Anywhere banking: The advent of banking

technology and the spread of internet facilities has changed the face of corporate
cash management. The more towards paperless economy reduces many of the
difficulties in dealing with cheques/drafts. It should be clear from the prior
discussion that the time necessary for transmittal of cash from one firm to
another revolves largely around the passing from one hand to another of a piece
of paper, ie., the cheque. if we can eliminate this paper there will be a major
saving in the time and cost.

The system of electronic remittances introduced by many foreign and Indian

banks has almost achieved the objective of cheque-less payment mechanisum.
Added to this, the concept of 'Anywhere Banking' practised by many banks also
is helping speedy flow of remittances. with these developments, it should not be
difficult for the firms to eliminats the 'Float. unfortunately, many corporates in
India are not much in favour of the' Electronic Funds Transfer System' mainly
because of their habit of delaying the the payments. It may however, be hoped,
15
Management
that of Current
the collection process in the near future will be fully automatic, as far as the
Assets
banking operations are concerned.

Activity 6.6

1) Why is it important to manage the cash-in-transit?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) What are different options available before the firm in improving collection
efficiency of cash-in-transit?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

3) Draw an activity chart that speeds up the process of depositing the cheque in
the bank account from the time of receipt?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

4) Outline the impact of internet banking on corporate cash menagement.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

6.8 MIS IN CASH MANAGEMENT

The preparation of cash budget based on forecast of cash flows is only the
starting point of cash management. It is the planning part of cash management.
The forecast of cash flows and budget exercises help the management to locate
cash deficient and surplus periods. Managers decide on dealing with the deficit
and surplus, which is decision-making part of cash management. The exercise is
completed, if the control element is also brought into the cash management
system. The control element is required since the operations of the business
enterprise may often deviate from the plan. It is very common that wide
deviation arises between planned and actual cash flows, which keeps the financial
managers always under severe pressure. Often, attention of the managers is
drawn after the problem developed to a full level. Thus, the crucial issue in cash
management is continuous information on actual cash flows and reporting of
deviation. Minor deviation can be tackled by postponing certain discretionary
payments or speedy collection of book debts by offering cash discounts. If the
deviation is expanding, it requires major corrections in the form of negotiating
fresh loan with bankers and improving the collection mechanism. Such corrective
16
 Management
actions are possible by developing a good reporting system that of Inventory
highlights such
deviations without loss of time.

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

Meaningful analysis can be done by consolidating cash flows on daily basis into
two documents namely Cash Flow Budget-Actual Variance Analysis and
Cumulative Cash Flow Statement for the year to date. The formats for the two
reporting documents are given below.
Table 6.5 : Cash Flow Budget-Actual Variance Analysis from …….. to ……….

Cash Flow Item Budget Actual Variance Remarks

Beginning cash balance

Collection from sales/receivables

Total

Disbursements

Suppliers

Payment of Salaries & Wages

Other Overhead expenses

S&A Expenses

Total

Excess / -Inadequacy

Minimum Balance

Cash Available / -Needed (A)

Financing

Borrowing/ -Repayments

Fresh Equity Issue

Sell/ -Acquire Investments

Payment to Fixed Assets

Receive/ -pay interest

Dividend

Total of Financing Plan (B)

Closing Cash Balance (A - B)

Table 6.6 : Cumulative Cash Flow Statement For the Year-to -Date
17
Management of Current
Assets
Cash Flow Item Budget for Performance Target for
the Year till Date the Remaining
Period
Collection from sales/receivables
Total
Disbursements
Suppliers
Payment of Salaries & Wages
Other Overhead expenses
S&A Expenses
Total
Excess / -Inadequacy
Financing
Borrowing/ -Repayments
Fresh Equity Issue
Sell/ -Acquire Investments
Payment to Fixed Assets
Receive/ -pay interest
Dividend
Total of Financing Plan

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

6.9 SUMMARY
Availability of cash is crucial for the operation of business. However, cash is the
least productive asset of the firm and thus managers take every effort to
minimise the cash holding. Despite the least productive nature of the asset, firms
hold large cash. There are several motives behind holding cash. Cash is required
to settle dues of the firm. Since cash inflows are uncertain and outflows are
certain, firms keep additional cash. Cash kept for these two purposes are called
transaction motive and precautionary motive. Cash is also kept to overcome the
mismatch of inflows and outflows, cyclical behaviour of cash flow pattern and
exploit short-term opportunities, like rising prices and aquisition of control.

Cash flows are affected by internal factors such as operating and financial
policies and external factors such as monetary and fiscal policies and practices of
industry. An understanding on factors that affect the cash flows is useful to
forecast future cash flows, which is core aspect of cash management. There are
several methods of forecasting cash flows and often different methods are
employed
18
to forecast individual cash flow items. Cash forecasting is converted
into cash budgets and cash budget is broken into quarterly, Management
monthly andofweekly
Inventory
cash budgets. Budgets are prepared to understand whether cash inflows and
outflows match with each other and if not, to know the period in which the
mismatch arises. Managers plan to deal with such mismatches by initiating action
in advance.

Despite careful planning, actual cash flows often deviate from the budgets due to
inherent uncertainty associated with cash flow variables. There are several tools
such as sensitivity analysis, simulation, etc., available to evaluate the impact of
uncertainty on cash flows. The uncertainty associated with the cash flows is
managed by holding additional cash, negotiating stand-by borrowing facility and
interest rate derivatives. Management of cash includes dealing with surplus cash
and cash-in-transit. While surplus cash is to be invested in short-term securities
after conducting cost-benefit analysis, cash-in-transit are managed by taking
efforts to reduce the float and float amount.

While planning and decision-making are essential for any management system, the
system completes only when appropriate control mechanism is built into the
system. Management information system assumes importance in this context in
cash management system. Periodical reporting on cash flows and variance
analysis of such flows is essential to effectively manage the cash flows. The
objective of the entire exercise is to ensure availability of cash to conduct smooth
business and at the same time to minimise the investments in this least productive
asset.

6.10 KEY WORDS

Transaction Notice : cash balances required to meet the expenses towards day to
day operations of a business.

Precautionary Motive: Cash balances required to take care of the contingencies

that arise due to unplanned activity.

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

increasing prices of raw materials, services, etc.

Discretionary Expenses: Expenses that are not directly related to the manufacturing
process, but have some amount of flexibility in timing the expenditure.

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

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

of probable estimates (generally with the help of a computer) of cash inflows and
outflows and compare the position for their effect on ending balance in a reference
period.

Sensitivity Analysis: A method of studying the impact of changes in cash flow

variables on cash balance.

Float: Refers to cash in transit, which can be utilised by the paying form till it is
actually withdrawn

Electronic Funds Transfer: A mechanism by which receipts payments are handled

through electronic machines.

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

19
Management of Current
6.11
Assets SELF-ASSESSMENT QUESTIONS
1. Explain the objective of cash management system. How do you deal with
the conflicting nature of the objectives?

2. What are the principal motives of holding cash in a business despite its
unproductive nature?

3. Discuss internal and external determinants that affect the flow of cash.

4. Why is it important to forecast the cash flows in managing the cash?

5. How do you measure the uncertainty associated with cash flows? Discuss
the products available to manage the uncertainty of cash flows?

6. What is flotation? How do you cut down the flotation time?

7. Discuss the importance of cash flow reporting in the management of cash?

8. Digital Electronics Ltd. is preparing cash budget for the next quarter in order
to negotiate with the bankers for additional credit. The sales department
informs that March sales was Rs. 220 lakhs and the expected sales for the
next four months are Rs. 120 lakhs, Rs. 160 lakhs, Rs. 220 lakhs and Rs.
160 lakhs respectively. The company sells 30% of sales through cash and
the balance on credit basis with one month as credit period. The bad debts
level is negligible. Cash outflows consist of payment to creditors, salary and
wages, other operating expenses, purchase of fixed assets and taxes. The
material and labour costs constitute 30% and 45% respectively of the sales.
While raw materials are purchased in one-month credit, wages are paid in
the same month. Other operating expenses cost Rs.50 lakhs and are paid in
the same month. Other non-operating cash flow items are Rs. 150 lakhs in
May (fixed assets), Rs. 120 lakhs in June (fixed assets), Rs. 160 lakhs in
June (corporate tax) Rs. 140 lakhs in April (interest and instalment of loan)
and Rs. 100 lakhs in May (dividend). The cash at the beginning of the
quarter was Rs. 150 lakhs and the company’s cash policy is to hold 5% of
total cash expenses of the next month as minimum closing balance of the
current month. Prepare a monthly cash flow statement for the quarter and
highlight the surplus/deficit for each month.

9. Kidcat is a leading manufacturer of toys and sports items for kids. The
industry is facing severe competition from unorganised sector, which imitate
the Kidcat products immediately. The sales of the firm during the last two
years show significant volatility. The firm decides to use simulation this time
while preparing cash budget. The firm has sold Rs. 100 lakhs worth of toys
during the month of March and expects the following possible ranges of sales
between April to June of the next year.

Sales (Rs. in lakhs) 40 80 120 160

Probability 20% 30% 30% 20%

The customers generally pay within a month of sales. The material cost
associated with the product works out to 40%, which are paid after a month
and fixed cost including labour cost of the firm per month is Rs. 30 lakhs.
Fixed costs are paid in the same month. Conduct a simulation exercise of
100 trails using random numbers and find the cash balance at the end of
each month and their distribution. (Hint: Use of Spreadsheet is recommended
to conduct simulation exercise).
20
 Management ofcompany
10. The internal analysis of cash flows of a large textile manufacturing Inventory
shows a wide variation in cash balances during the next year. The minimum
cash balance expected during the second quarter of the year was -Rs. 340
lakhs (negative balance indicating shortage of cash) and the maximum value
of Rs. 120 lakhs during the month of February. The above figures are
estimates and likely to see significant volatility. The firm presently enjoys over
draft limit of Rs. 300 lakhs and contemplating to increase the limit to Rs. 400
lakhs to meet the additional cash need and also uncertainty associated with
cash flows. The bank is willing to provide the additional loan at 14% interest
rate but insists the firm to accept a commitment charge of 0.25% per month
on the additional borrowing limit. The commitment charge has to be paid on
unused part of the overdraft facility. For instance, if a firm draws Rs. 340
lakhs in August, it has to pay interest at the rate of 14% on Rs. 340 lakhs
and 0.25% on Rs. 60 lakhs. If the firm decides not to accept the offer, it
will be exposed to cash out position and emergency borrowing would cost
2% interest per month. The firm expects a maximum emergency borrowing
of Rs. 200 lakhs at different points of time during the year. Advice the firm
on accepting the additional loan with a commitment charge of 0.25%.

6.12 FURTHER READINGS

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

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

Prentice Hall, Englewood Cliffs, NJ.

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

International (P) Ltd. New Delhi.

Keith V. Smith, Guide to Working Capital Management, McGraw-Hill Book

Company, New York

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

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

Ramamoorthy, V.E. Working Capital Management, Institute for Financial

Management and Research, Madras.

21
 Management of Inventory
UNIT 7 MANAGEMENT OF MARKETABLE
SECURITIES
Objectives

The objectives of this unit are to:

• Highlight the need of investments in marketable securities.
• Explain different types of securities available for investments.
• Provide an overview of markets for securities.
• Explain models to optimise the cost and opportunity income.
• Provide a guideline to develop strategies in the management of securities.

Structure
7.1 Introduction
7.2 Need for Investments in Securities
7.3 Types of Marketable Securities
7.4 Market for Short-term Securities
7.5 Optimisation Models
7.6 Strategies for Managing Securities
7.7 Summary
7.8 Key Words
7.9 Self Assessment Questions
7.10 Further Reading

7.1 INTRODUCTION
Cash and marketable securities are normally treated as one item in any analysis
of current assets. For this reason, in Table 6.1 of Unit 6 (Management of
Cash), cash and marketable securities were combined together. Holding cash in
excess of immediate requirement means the firm is missing out an opportunity
income. Excess cash thus is normally invested in marketable securities, which
serves two purposes namely, provide liquidity and also earn a return. Marketable
securities form a major component of cash and marketable securities. In
Table 7.1, the investment in marketable securities of different industries along
with its composition as a percentage of cash and marketable securities is given.
The table shows that the marketable securities constitute around 50% of the total,
and ranges from 25% to 81% in certain industries. Because of this importance,
the management of marketable securities is discussed separately in this unit.

Investing surplus cash in marketable securities is normally a part of overall cash

management. It becomes a separate activity of the firm, if the investments in
marketable securities form a major part of the current assets. Many firms in
India today are very active in money and capital markets, where marketable
securities are traded. An analysis of investments in marketable securities by 92
non-financial companies of BSE-100 index companies shows an investment of
Rs.9754.73 cr. as on March 31, 1998. These companies have earned an income
of Rs. 3622.89 cr. through dividend, interest and profit from sale of investments
for the year, which is approximately equal to 19% of the profit before tax of
these companies. In several companies of the group like Ashok Leyland, MRPL,
SAIL, ACC, etc. the income from market activities for the year 1997-98 was
more than income for operations. Though this gives a positive outlook for
53
Management of Current investing in marketable securities, there are many companies, which have lost
Assets
heavily by investing in marketable securities.

In the international financial markets, companies such as Procter & Gamble (US),
Gibson Greetings (US), Showa Shell (Japan), Mettalgesellschaft (Germany), Allied
Lyons (UK), Orange Country (US), British Councils (UK), etc., have lost millions
of dollars heavily by entering into financial transactions of wrong types. In the
domestic markets too, several firms have incurred huge loss during the last few
years and many of them have taken a public stand in the companies annual
general body meeting that they will not excessively deal in the securities market.
In 1992 securities scam, many companies, particularly public sector companies
had incurred huge loss in their dealings in government securities. Nevertheless,
many companies are willing to deal in marketable securities at different levels.
While some of them have an active treasury management and willing to take
risk, others have restricted themselves in investing their short-term surplus money
for a limited period.
Table 7.1: Investments in Marketable Securities
Industry 1999 2000 2001 2003 2003
Food & Beverages 1008.18 1031.91 1243.27 1328.16 1436.88
(% of cash & market securities) 43.7% 42.6% 52.4% 51.4% 47.7%
Textile 1383.2 784.79 1417.11 1171.42 1430.52
(% of cash & market securities) 56.2% 41.6% 56.9% 46.7% 54.5%
Chemicals 4879.7 5499.95 6166.91 9143.7 10968.15
(% of cash & market securities) 39.7% 41.2% 45.3% 52.2% 59.8%
Non-metallic Minerals 424.55 380.4 526.92 577 611.39
(% of cash & market securities) 32.9% 33.5% 38.5% 42.8% 42.2%
Metals & Products 2104.04 1931.48 3126.04 2965.45 3249.91
(% of cash & market securities) 40.9% 37.2% 49.1% 49.0% 44.4%
Machinery 3098.35 1961.95 2321.46 4496.66 5075.51
(% of cash & market securities) 34.7% 19.6% 19.8% 29.3% 27.9%
Transport Equipment 2725.89 2988.6 2530.94 2943.1 3719.29
(% of cash & market securities) 45.4% 55.1% 44.1% 50.1% 46.9%
Diversified 3415.51 6602.6 5764.81 3776.73 4591.72
(% of cash & market securities) 34.7% 71.4% 80.0% 50.6% 67.0%
Miscellaneous 168.78 358.43 215.75 254.71 606.53
(% of cash & market securities) 23.4% 34.5% 22.7% 26.7% 37.5%
Total 19208.2 21540.11 23313.21 26656.93 31689.9
(% of cash & market securities) 39.2% 43.4% 45.0% 44.7% 47.1%

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

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

7.2 NEED FOR INVESTMENT IN SECURITIES

Marketable securities result from investment decisions that really are not the main
part of the firm’s business. But marketable securities cannot be ignored, as they
constitute a part of the value of the firm that is entrusted to management. For
54
some firms, investments in marketable securities extend to lakhs or even crores Management of Inventory
of rupees. Table 7.2, gives the investments in marketable securities of few well
known companies in India. The firms were chosen because of their familiarity
and also because of the differences between them. Investments in marketable
securities of these ten sample firms show not only a wide variation among them
but also wide variation between the two points of time. Reliance Industries
maintained the top position in both years. Marketable securities share in the
current assets has also gone up from 29.6% to 41.8% whereas on the total
assets, the percentage shows a marginal change. A similar change is also seen in
the case of Bajaj Auto and Hindalco Industries. In case of HPCL and Tata Iron
& Steel Industries, the Investments in marketable securities as a percentage of
current assets remained stable. The share of Wipro and Grasim industries, which
was very low in 1998-99 has gone up steeply by 2002 - 2003. In Tata Power the
trend was reverse over the five year period.

Table 7.2: Holding in Marketable Securities of Select Indian Companies

Companies For theYear Ending 1998-99 For the Ending 2002-03
Holding %Current %Total Holding% Current %Total
Rs. in Cr. Assets Assets Rs.inCr. Assets Assets

Bajaj Auto 1096.03 36.98% 23.93% 2329.13 54.97% 36.91%

Hindalco Industries 820.52 56.11% 13.94% 1468.74 53.85% 14.26%
Grasim Industries 417.04 25.93% 7.30% 1158.91 47.09% 17.54%
Gujarat Ambuja Cem. 144.85 27.64% 6.41% 205.23 42.19% 5.32%
Tata Power 530.01 56.29% 16.02% 828.71 31.10% 9.45%
Wipro 0.38 0.06% 0.03% 781.34 28.97% 19.16%
Hindustan Lever 370.50 13.46% 8.44% 909.56 22.16% 12.07%
HPCL 633.52 18.04% 6.85% 1702.71 17.51% 9.77%
Tata Iron & Steel 399.51 12.38% 3.33% 441.87 11.77% 3.33%
Tata Motors 435.41 11.96% 4.25% 278.39 9.29% 3.36%

There are several reasons for such difference in the investments in marketable
securities between the firms and between the years. For instance, companies
like Lakshmi Machine Works Ltd. (LMW) and NEPC Micon, leading
manufacturers of textile machinery and windmill power equipments, used to have
an order booking for one to three years. Companies, which place the order with
LMW and NEPC pay advances along with the order. Most companies in the
auto-cars segment like Maruti Udyog Ltd (MUL) and Telco that entered the
small car segment collects advances when they launch new models. However
they cannot use these short-term surplus cash flows for any long-term purposes.
Surplus cash is thus invested in marketable securities primarily to earn an
income, which otherwise remains idle within the firm. Companies may not
always have an opportunity to demand advances from the customers. For
instance, the recession in textile industry and general economic recession has
affected the order flow of LMW and NEPC. Intensive competition between the
car manufacturers forces many of them to sell the cars without demanding any
initial amount from the customers. Thus, companies, which were flushed with
money at one point of time and investing heavily in marketable securities, may
issue short-term securities to others and borrow money at another point of time.

Another prominent reason for holding marketable securities is on account of

mismatch between the borrowing and investment programme. Companies like
Reliance Industries, which are presently executing several projects, are constant
borrowers of money in both domestic and international markets. These projects
are executed over a period of time. It is often difficult to borrow money exactly 55
Management of Current for the requirement of the year or month since the cost of borrowing, sentiment
Assets
of the market and regulatory requirements are to be taken into account in
deciding the amount to be borrowed. Companies thus borrow more than their
current requirement. It not only applies to borrowing but also applies to equity
financing. Money raised in the form of debt or equity has a cost and it cannot
be immediately put into use for any long-term purpose. They are invested in
short-term securities with an intention to recover atleast a part of the cost of
borrowing.

Many companies, which adopted the profit centre concepts, have made the
finance department as one of the profit centres. It means the finance
department has to add revenue to the firm. Top management wants financial
department to show how they helped the company to improve the bottomline.
By dealing with marketable securities in the form of securities and foreign
exchange derivatives, financial managers’ ought to demonstrate their ability to cut
down the cost or increase the benefit. Investments in marketable securities
also depend on the aggressiveness of the financial managers’ in dealing
with such assets.

Many companies today have a separate treasury division that operates in

marketable securities and other financial products. But aggressive dealings in
marketable securities will increase the risk of financial operations. For instance,
Procter and Gamble (US), which bought leveraged interest rate swaps for $ 200
million from Bankers Trust in 1994, to cut down the interest cost of their
commercial paper borrowing, had finally incurred a loss of $100 million.

The task of financial managers, who become involved with marketable securities
either full-time or part-time, consists of three issues. First, managers must
understand the detailed characteristics of different short-term investment
opportunities. Second, managers must understand the markets in which those
investment opportunities are bought and sold. Third, managers must develop a
strategy for deciding when to buy and sell marketable securities, which securities
to hold, and how much to buy or sell in each transaction. We will discuss these
issues in the next few sections.

Activity 7.1

1) What are the major criteria managers use for deciding where to invest “excess”
cash balances?

………………………………………………………………………………..

………………………………………………………………………………..

………………………………………………………………………………..

………………………………………………………………………………..

2) What characteristics should an investment have to qualify as an acceptable

marketable security?

………………………………………………………………………………..

………………………………………………………………………………..

………………………………………………………………………………..

………………………………………………………………………………..
56
3) Give an account of the activity of marketable securities of a company you are Management of Inventory
aware of.

……………………………………………………………………………….

………………………………………………………………………………

………………………………………………………………………………..

7.3 TYPES OF MARKETABLE SECURITIES

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

A) Debt Securities

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

a) Money market instruments

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

i) Call money

The demand and time liabilities (DTL) of a bank are evaluated every
fortnight on a Friday called the ‘Reporting Friday’. During the first fortnight
following the Reporting Friday, the bank is expected to maintain daily 15 %
of its DTLs (as on the Reporting Friday) in cash with RBI. This is known
as cash reserve ratio CRR. The banks are expected to maintain this
balance in such a way that the average daily balances is within the
stipulated requirement. The market that arises as a result of borrowing and
lending by banks in order to maintain their CRR is known as the call
market. Theoretically call money is money that is literally on call, i.e., it can
be called back at short notice. In the case of inter bank market, the notice
period can be as short as one day.

ii) Certificates of Deposit

A certificate of deposit (CD) is an instrument issued by a bank or other

depository institution representing funds placed on deposit at the bank for a
certain period of time. They are called negotiable certificates of deposit.
Negotiable CDs are generally not redeemable before maturity, but an
investor who purchases, for example, a six-month CD may sell it to another
investor one month later rather than wait until the CD matures. The
interest on CDs is calculated on the face amount of the CD. It is a 57
Management of Current nondiscount instrument and pays the face amount plus accrued interest at
Assets
maturity. The rates available to investors in CDs are typically somewhat
higher (averaging about 1 percent higher) than those on T-bills of equal
maturity. This yield differential can be attributed to several factors: a) the
somewhat thinner market for CDs, b) the tax differential, c) the risk factor
of the issuing financial institution.

iii) Commercial paper

Commercial paper (CP) is the term, for the short-term promissory notes
issued by large corporations with high credit ratings. Commercial paper
usually carries no stated interest rate and sells at a discount from its face
value as T-bills. The objective of the RBI introducing CP as an instrument
to finance working capital needs was to reduce the dependence of
corporates on banks. Also, by pricing the CP at market rates, the financial
efficiency of corporates was coveted to increase. Also, this instrument
securitises the working capital limits. The companies can now issue CP for
a maturity period ranging from 3 months to less than a year. Minimum
networth of issuer is also reduced from Rs. 5 crores to Rs.4 crores and
the minimum working capital (fund-based) limit is also being reduced from
Rs. 5 crores to Rs. 4 crores.

(iv) Bankers Acceptances

Bankers’ Acceptances are time drafts drawn on a commercial bank for

which the bank guarantees payment of the face value upon maturity. They
are commonly used to finance international transactions for the short term.
For e.g., a jewellery retailer in India might purchase watches from a
manufacturer in Switzerland, paying for the goods by sending a time draft
(a draft payable at some future date) drawn upon the jeweller’s bank.
When the bank accepts the draft, it stamps “accepted” on the reverse side
of the draft, meaning that the bank guarantees payment of the draft upon
maturity. In effect, the bank is guaranteeing the credit of the jeweller. Since
the credit behind the draft is now on the bank, the draft can be traded in
the money market along with other short-term debt instruments. Although
bankers’ acceptances are available to individual investors, they are typically
most popular with commercial banks and foreign investors.

(v) Government Securities or Securities Guaranteed by the Government

Government securities are public debt instruments issued by the

Government of India, State Governments or Financial Institutions, Electricity
boards, Municipal Corporation etc. guaranteed by the governments to
finance their projects. The default risk of these securities is perceived to be
lower than that of corporate bonds or equity shares since they are issued
on account of Sovereign risk. These securities are therefore termed as Gilt-
edged securities. Government securities traded in the money markets fall
within 5 distinct categories.
a) Treasury Bills
b) Central Loans
c) State Loans
d) Central Guaranteed loans
e) State Guaranteed loans
The order of these securities ranges from most liquid to less liquid and also
safest to less safe. All these securities are of different maturities and coupon
rates. Currently, the highest coupon rate of a government security is 13.40 % (in
58
State loan 13.50 %). The longest maturity available is 21 years. You may refer Management of Inventory
money market page of economic dailies such as The Economic Times or The
Hindu Business Line, where you get indicative rates for many of these securities
for different maturity periods. Exhibit-7.1 shows some of the inputs, which you
normally see in a money market page of economic dailies.

Treasury bills have of late started attracting good response, especially since the
introduction of 364 days T Bill in April 1992. Presently, there are 2 maturities -
91 days and 364 days. A third category of T-Bills that was for 182 days has
been withdrawn since April 1993. Government securities are one of the lowest
yielding securities that one can invest in. Most investments in these securities are
made due to regulatory reasons. During the second fortnight following the
Reporting Friday, the banks have to maintain 34.5 % of DTL up to 17/09/93 and
25 % on incremental DTL since that date, in Government securities. This is
known as Statutory Liquidity Ratio (SLR).

b) Capital Market Debt Instruments

The capital market supplies long-term funds to corporations, government entities

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

(i) Treasury notes and treasury bonds

The long-term bond issues of the treasury that are available to investors
are the Treasury notes and the Treasury bonds. Treasury notes have
original fixed maturities of not less than one and not more than ten years
from the date of issue. They are available in denominations as small as $
1000, except that the T.notes of less than four years are usually not issued
for less than $ 5000. Treasury bonds are like notes in every respect in that
their original maturities are from more than ten years to come as long as
thirty years.

(ii) Municipal Bonds

Municipal bond, in spite of the word municipal, includes all bond issues of
states, countries, cities, and other political subdivisions of the United States.
An important distinguishing feature of municipal bonds is that all interest
payments are exempt from U.S. income taxes. They are also exempt from
any state or city income taxes within the issuing municipality. Though
couple of corporations in the states of Gujarat and Maharashtra, have
issued bonds of this kind, this market is less active in India.

(iii) Public Sector Undertaking (PSU) Bonds

PSU bonds are issued to finance projects of various public sector

undertakings like NTPC (National Thermal Power Corporation), IRFC
(Indian Railways Finance Corporation), etc. There are two kinds of
bonds Tax free with a coupon of 9 % or 10 % or 10.5 %, and taxable
with a coupon of 13 % to 18 %. Since 1985-86, the public sector
undertakings have been raising resources from the capital markets, through
the issue of bonds, termed as PSU bonds. With just Rs. 354 crores in
1985-86, the amount of bonds issued has increased to Rs. 4,625 crores in
59
Management of Current 1991-92. This was inevitable, as the gilt-edged market could not be
Assets
enlarged further, without putting up the SLR ratio. Also, the dependence of
the PSUs on central and state budgets could be progressively reduced.
With the divestiture programme somewhat going slow, the reliance of PSUs
on bond segment will increase.

c) Corporate Bonds

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

B) Equity Investments

Equity securities represent the residual ownership of the firm. Residual ownership
means that the debt holders must first be paid off, before the company belongs
completely to the equity holders. The two types of equity securities are common
stock and preferred stock.

a) Common Stock

The common stockholders are the risk takers; they own a portion of the firm
that is not guaranteed, and they are last in line with claims on the company’s
assets in the event of a bankruptcy. In return for taking this risk, they share in
the growth of the firm because the growth in the value of the company
accrues to the common shareholders. The company may make a periodic cash
payment called a cash dividend to the common stockholders. Cash dividends
are commonly paid to shareholders on a quarterly basis, but they may be paid
annually, irregularly, or even not at all. The common shareholder has no
guarantee of receiving a dividend payment. Common stockholders usually have
voting rights that allow them to vote on the corporation’s board of directors.
Since the board of directors hires the top management of the company, the
stockholders indirectly determine the company’s management.

b) Preferred Stock

Preferred stock is technically an equity interest in the company, but its

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

C) Contingent Claim Securities

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

60
 (a) Options Management of Inventory

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

(b) Warrants

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

(c) Convertible securities

Convertible securities are securities that may be converted into common

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

(d) Futures contracts

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

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

There is still one more security in the list, called units of mutual funds, which is
not a separate security on its own but backed by an investment in the above
securities. Indian companies traditionally prefer mutual funds units, particularly
Unit-64 of Unit Trust of India, to invest their surplus money for short period
because of reasonable return, high liquidity and tax concession (tax provisions
governing mutual funds investments have seen significant changes during the last
few years). Since many private sector mutual funds have also started offering a
reasonable return in their debt-oriented schemes, corporate attention is slowly
moving towards the units of private sector funds. Another instrument similar to
mutual funds units that is likely to emerge in the future is the unit arising out of
securitisation process. These are units backed by mortgages of housing loan or
any other receivables. A few securitisation deals have already taken place in the
Indian market but they were restricted to financial institutions. This market is the
second largest segment of the market, immediately next to government securities
61
market, and is also very active.
Management of Current Activity 7.2
Assets
1) List out the different kinds of instruments in the money market.

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

2) What is call money market?

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

3) What are options and futures? Describe the various kinds?

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

7.4 MARKET FOR SECURITIES

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

(a) Money Market

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

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

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

Before investing in money market securities, it is better to look into yield curve
of securities traded in the market. A yield curve is the one, which shows the
return available for securities having different maturities. This curve is useful to
managers to trade-off between return and interest rate risk. Further, the yield
curve will show the expectation of the market on the future interest rate
scenario, which is a vital input for any treasury managers. Interest rate is the
one which affects almost every aspect of the economy like business
performance, stock market, money market, foreign exchange market and
derivatives market. The yield-curve of securities as appeared on September 24,
1999 is given in Exhibit-7.2

(b) Market for long-term Securities

Market for long-term securities is a place where the borrowers raise capital for
longer term. Due to active secondary market for many of the long-term
securities, there is no need that only investors having long-term surplus alone
enter into the market. For instance, a significant percentage of volume of trading
(more than 75%) in stocks, which are long-term instruments, are settled within a
trading cycle of five days. Now ‘T + 2’ trading is going on in the market. Long-
term securities - debt, equity and other types of securities - are actively traded in
the stock exchanges like National Stock Exchange, Mumbai Stock Exchange.
These exchanges deal in corporate securities, government securities PSU
securities and units of mutual funds,. Stock exchanges are more organised than
the money market, which primarily operates over phones. Now trading is mostly
on-line.

The objective of investing in marketable securities need not always be for short-
term purpose. If the surplus money is available for fairly longer period,
investment in long-term securities can be considered because the return will be
more. Due to active secondary market, there is no liquidity risk in the event of
sudden need of funds. Of course, investment in equity oriented securities has
some amount of investment risk. Investing in portfolio of stocks or investing
through mutual funds can reduce a part of investment risk.

(c) Market for Derivative Securities

Market for derivative securities is less developed in India. A few commodity

futures exchanges like Pepper and Coffee exchanges have been established.
Banks are allowed to offer foreign exchange related derivative products.
Derivative trading is taking place now on Indian stock exchanges in a limited
way. Since all derivatives are also marketable securities, traded actively in the
secondary market, they qualify for investing surplus cash. Derivatives are
available for different levels of risk takers. It is possible by entering into two
63
Management of Current transactions - one in the normal market and the other in derivative market, it is
Assets
possible to create a low risk investment. Since derivative transactions require
only margin, which is normally 5% to 20% depending on the nature of underlying
assets, it is possible to create a leverage (borrowing through the market) and
attempt to maximise the return provided the company is willing to assume the
additional risk.

Activity 7.3

1) What are the reasons for the corporate sector in accessing the capital
markets? List down the various instruments used in capital markets?

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

2) Describe briefly the capital market for the Government Securities?

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

3) What is the role played by the Discount and Finance House of India
(DFHI)?

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

4) How far derivatives can serve as a market for surplus cash?

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

7.5 OPTIMISATION MODELS

At the beginning of this unit, we have observed that holding cash in excess of
immediate requirement means missing out an opportunity to earn an income.
However, it is necessary to find the cost associated with investing activity before
taking investment decision. For example, if Rs. 5,00,000 is surplus available for
one-week and it can earn an interest income of Rs. 750 for one week, the
interest income is to be compared with cost associated with buying and selling of
securities. Suppose, the security dealer charges 0.1% commission. The firm will
incur Rs. 500 when it buys the security and another Rs.500 when it sells the
security. The total cost of Rs. 1000 is greater than Rs. 750 and thus, the net
effect of the investment is loss. The investment decision is feasible, if the
surplus money is available for two weeks or more. Thus, the decision on
investing surplus money needs a careful analysis of cost and benefit. A few
models are available to balance the cost and benefit and five of such models are
discussed below:
64
Bierman - McAdams Model: This model is different from other models Management of Inventory
because it assumes that the investment in marketable securities is on account of
raising excess funds from long-term sources. The reason for raising excess
capital from long-term sources is due to high cost of raising capital from the
long-term sources and thus, the cost is to be optimised. An example will be
useful to understand the concept. Suppose a firm requires Rs. 10,00,000 every
year from long-term resources for next four years for certain capital expenditure.
The interest cost prevailing for long-term funds is 14% and flotation cost (cost of
brokerage or processing and legal fee paid to bankers or financial institutions,
stamp duty, etc.) is Rs. 50000. The flotation cost is one time cost and not
always proportional to amount raised. It is a fixed cost at least for a range of
capital raised from the market. Assume if the firm raises more than Rs. 10
lakhs, the excess amount can be invested at 11.5% in marketable securities.
With this set of information, assess the impact of the following two alternatives.
1. Rs. 10 lakhs every year and;
2. Rs. 20.00 lakhs in the first year and another Rs. 20 lakhs in the third year.
In the Table given below, the yearly cash outflow under the two conditions is given.
Year Loan Flotation Cost Interest Outflow Interest Income Net cost
(A) Interest Outflow in Option 1 (Raising Rs. 10 lakhs every year)
0 1000000 50000 0 0 50000
1 1000000 50000 140000 0 190000
2 1000000 50000 280000 0 330000
3 1000000 50000 420000 0 470000
4 0 0 560000 0 560000
(B) Interest Outflow in Option 2 (Raising Rs. 20 lakhs Year 1 and Year 3)
0 2000000 50000 0 0 50000
1 0 0 280000 115000 165000
2 2000000 50000 280000 0 330000
3 0 0 560000 115000 445000
4 0 0 560000 0 560000
(C) Comparison of Interest Outflow under Two Options
Net Cost in Option 1 Net Cost in Option 2 Difference
0 50000 50000 0
1 190000 165000 25000
2 330000 330000 0
3 470000 445000 25000
4 560000 560000 0

Option 2 is preferable because Net Cost is lower than Option 1

The net interest outflow in Option 2 is lower than the interest outflow of
Option 1. Thus, the firm benefits by raising Rs. 20 lakhs at the beginning of year
1 (Year 0 in the Table), spends Rs. 10 lakhs and invests the balance in
marketable securities at 11.5% for a year. The marketable securities are sold at
the end of year 1 and the value is used for capital expenditure of year 2. There
is no need to raise fresh funds in year 2 because the required amount is already
raised. The process is repeated again in year 3. This strategy leads to reduction
of overall cost of funds because the total amount spent on flotation is only Rs.
1,00,000 against Rs. 2,00,000 under Option 1. What about other options like
raising Rs. 30 lakhs in year 1 and Rs. 10 lakhs in Year 4 or Rs. 40 lakhs in year
1? None of these options give you a lower cost than raising Rs. 20 lakhs in
year 1 and Rs. 20 lakhs in year 3. Bierman and McAdams showed the way to
get the optimal financing through the following equation. 65
Management of Current
Assets Q = √ (2 F D)/(i -Y)
Where F = the fixed flotation cost of obtaining new financing
D = the firm’s total net outlay of cash for the next period
i = the percentage of interest rate on new financing
Y = the percentage yield on marketable securities
Substituting the value of funds required (Rs. 10 lakhs), flotation cost of Rs.
50000, interest rate of 14% on new financing and 11.5% interest income on
marketable securities in the above equation, we get the following:

Q =√ (2 × 50000 × 1000000)/(0.14 - 0.115) = Rs. 20,00,000

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

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

C = √ (2 b D)/Y

Where b = cost of each transaction

D = total amount required during the period
Y = the percentage of yield on marketable securities
Substituting the value of funds required (Rs.10 lakhs), transaction cost (Rs.575) and
interest on marketable securities (11.5%) in the above equation, we get the following:

C = √ (2 x 575 x 1000000)/.115 = Rs. 1,00,000

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

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

assumption here is different. Beranek’s model assume that the firms
66
disbursement takes place periodically whereas the inflows are continuous. Since Management of Inventory
buying of the securities has also costs the firm, it is not desirable to invest on
daily basis. The inflows are accumulated to a level and then invested with an
objective of minimising the cost of buying of the securities. Since any delay in
investment will affect the opportunity income, the two are to be balanced. We
will give a different example to illustrate this model. Suppose a supermarket
requires cash at the end of every month to pay salaries, rent and settle the dues
of suppliers. The firm on the other hand receives the cash of Rs. 1 lakh daily
from the sale of provision and other items and the total amount collected during
the month is Rs. 30 lakhs. Assume the entire collection is required at the end of
month. That means whatever purchases has been made during the month in
marketable securities, they have to be liquidated at the end of the month. The
interest on marketable securities per month and transaction cost of purchasing
securities are 0.95833% (11.5% per year) and Rs. 255 respectively. The issue
before the finance manager of the super market is whether the investment is to
be done on daily basis or the receipts are accumulated upto a point before
investment. Substituting the values in the Baumol’s equation, we get the optimal
investment as approximately Rs. 4.00 lakhs. That means, funds are to be
accumulated for four days before buying marketable securities and optimal
ordering lot is Rs. 4.00 lakhs. We will see similar concepts in the next unit also
when we deal with inventory management.

Miller and Orr Model: The earlier two models assume that one of the two
cash flow variables namely cash inflow or cash outflow is constant and thus
come out with a solution on optimal withdrawal value or investment value. In a
situation where both inflow and outflow are not constant, Miller and Orr model is
useful. The model is based on control-limit approach. According to the approach,
the optimum level is first derived based on certain assumptions and this optimum
level needs to disturbed only when the assumptions are violated. Miller and Orr
model using the interest rate on marketable securities, transaction cost and
minimum desired level of cash, derive the optimal cash holding for the firm with
the use of following equation
2 1/3
Z = [(4 b σ )/(4 Y)] ^ +L

Where Z = Optimum cash holding

b = the fixed transaction cost per transfer

Y = the daily yield on marketable securities

σ2 =
Variance of daily changes in the cash balance

L = Minimum desirable cash prescribed by the management

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

H = 3 Z - 2 L

As long as cash is within upper limit (H) and lower limit (L), no action is
required. The moment the cash balance breached one of these two limits, an
action is required. If the cash balance touched the upper limit (H), then all the
excess cash above the optimal holding (Z) is invested in marketable securities.
Similarly, if the cash balance touched the lower limit (L), the firm sells
marketable securities to an extent that brings the cash balance back to optimal
cash holding (Z). The following example shows how the three values given in
the Miller and Orr model are derived. 67
Management of Current The Treasurer of Blue Diamond Hotel wants to develop a cash management
Assets
model for investing surplus cash in marketable securities. Since the cash flows
show a volatile behaviour, the Treasurer feels the Miller and Orr model is the
most suitable for the situation. An analysis of last three-year daily cash flows
shows a standard deviation of Rs. 12,200. Investment in marketable securities
currently offers a return of 12% per annum. The transaction cost per transaction
is Rs.300. The Treasurer believes the hotel should have minimum cash balance
of Rs. 20,000. What is the optimal cash holding? When an investment or
disinvestment action is to be taken?

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

Z = [(4x300x122002)/(4x(.12/365))] ^ 1/3
+ 20000 = 46702

H = (3 x 46702) - (2 x 20000) = 100107

L = 20000

Thus, the cash management policy is when the cash balance goes below Rs.
20,000, marketable securities are sold and cash balance is brought back to
Rs.46702. If the cash balance exceeds Rs. 100107, the cash value above Rs.
46702 is invested in marketable securities. The cash balance is allowed to move
between Rs. 20000 and Rs.100107 and occasionally brought down to the optimum
level.

Stone Model: Bernell Stone suggested that instead of mechanically taking action
on the basis of Miller and Orr model whenever the cash balance is breached the
upper or lower limit, the treasurer can forecast the behaviour of future cash
flows of two or more days and use this information in taking investment decision.
Under this model, the firm sets out two inner limits. For instance in the above
example, if the firm sets an inner limit for minimum balance at Rs. 30,000 and
another inner limit for maximum balance at Rs. 90,000, the treasurer evaluates
the cash flows for the next two days whenever the cash balance hits the
previously defined Miller and Orr model. Assume the cash balance touched Rs.
20000. The firm evaluates whether the next two days inflows will bring back the
cash position at Rs. 30000 or more. If the forecast fails to show such an
improvement, the securities are sold and cash balance is brought towards the
optimum level. On the other hand, if the cash balance is likely to move above
Rs. 30000, no action is required at this stage. Investment in marketable
securities will also be taken on the same line. The two inner limits are provided
mainly to avoid unwanted transaction.

The behaviour of cash flows in the four different models is given in Exhibit-7.3.

Activity 7.4

1. Describe the Baumol and Miller-Orr cash management models and explain how
they differ from each other.

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….
68
2. What does the term liquidity mean? Management of Inventory

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

3. What is the essential theme of Bierman - McAdams Model.

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

7.6 STRATEGIES FOR MANAGING SECURITIES

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

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

The last step is to develop systems in continuous monitoring of this activity and
improving the reporting system. Many companies during the securities scam
period have suffered because of lack of monitoring and faulty system.

Activity 7.5

1. What are the options available to a firm for investing surplus cash?

…………………………………………………………………………………..

…………………………………………………………………………………..

………………………………………………………………………………….. 69
Management of Current 2. Explain the strategies available to a firm for investing surplus cash?
Assets
…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

3. Imagine yourself as the financial manager of a leading firm. What are the
basic criteria you would follow in making optimum investment decisions on a
portfolio of securities with the surplus cash available with the firm.
…………………………………………………………………………………..
…………………………………………………………………………………..
…………………………………………………………………………………..

7.7 SUMMARY
Firms invest surplus cash in marketable securities because it enables firms to
earn a return or at least recover a part of the cost of funds. Since the risk,
return and liquidity of marketable securities are different, an understanding of
them is essential before the selection of securities. An understanding of the
markets in which such securities are traded is also useful. Since firms incur a
cost in buying and selling of securities, the opportunity return needs to be
compared with the cost before deciding the investment decision. There are
different models that enable the managers to optimise the cost and decide the
quantum of investments. What is more important in managing marketable
securities is developing a system that enables the managers not only to take
investment decisions but also monitoring the investments in securities. In the
process of earning an opportunity income, the firms should not incur a loss by
investing wrongly or giving an opportunity for operational managers to make
personal gains. Studying the behaviour of cash flows is important, before
devising a strategy. Each firm should develop its own strategy. The experience of
many Indian companies, which have lost money during the securities scam, will
be useful to the managers in avoiding such mistakes in the future.

7.8 KEY WORDS

Marketable Securities: Those instruments that can be bought and sold in a
market, which imply adequate liquidity.
Call money: Call money is that amount lent for very short periods and the
borrower may be asked to payback the money in that short period. This short
period can be as short as one day also.
Certificates of deposit: is an instrument issued by a bank or any other
depository institution representing funds placed on deposit at the bank for a
certain period of time.
Commercial paper: is a short term promissory note issued by large corporations
having high creditworthiness.
Options: are contracts giving their holders right to buy or sell an asset or a
serurity at a fixed price.
Warrants: these are like options, which give their holders the right to purchase the
common stock from the company at a fixed price.
Convertible securities: these are securities that will be converted into common
stock at agreed price and at agreed date.
Money Market: is a place where borrower meets the lender to trade in money
and other liquid assets that are close substitutes for money.
70
 Management of Inventory
7.9 SELF-ASSESSMENT QUESTIONS
1. Explain the objective of management of marketable securities system. How
do you deal with the conflicting nature of the objectives?

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

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

4. What are bond call provision and why are they used?

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

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

7. What are commonly used money market instruments?

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

different types of instruments. What does it reflect?

9. Alpha Trading Corporation requires Rs 2.5 mn in cash for meeting its

transaction needs over the next 6 months. It currently has the amount in the
form of marketable securities. The cash payments will be made evenly over
the 6-month planning period. It earns 10% annual yield on the marketable
securities. The conversion of marketable securities into cash entails a fixed
cost of Rs 1200 per transaction. What is the optimal conversion size as per
the Baumol Model?

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

assumed by the Miller-Orr model. Excel wants you to establish the “Upper
Control Limit (UCL)” and the “return point”. It provides the following
information as required by you-

♦ The fixed cost of effecting a marketable securities transaction is Rs.1500.

♦ The standard deviation of the change in daily cash balances is Rs.6000.

♦ The minimum cash balance maintained is Rs.100,000.

11. Pheonix Electronics has used the Baumol to estimate its optimal cash balance
to be Rs 10 lakhs. Its opportunity cost is 10% and there is a cost of Rs.
250 every time the marketable securities have to be converted into cash.
Estimate the weekly cash usage rate?

12. The financial manager of a large multinational company Jax Ltd., is studying
the firm’s cash management. He knows that it costs an average of Rs.
1000 per transaction to sell marketable securities. Short term Treasury bills
are currently yielding 6%. In studying the firm’s cash flows, he determines
that the standard deviation of daily cash balance is Rs. 5 lakhs. The firm
must maintain a minimum balance of Rs.50 lakhs to comply with
compensating balances requirements. He sees no reasons to hold more than
this amount in cash.

(a) Using the Miller-Orr model, what is the cash return point for the Jax Ltd?

(b) What is the Upper Control Limit?

71
Management of Current (c) Using the values, explain how the firm will manage cash and marketable
Assets
securities balances. At what point will the firm sell marketable securities
and how much will it sell?

(d) How will the firm’s holdings of cash be affected by a) an increase in the
opportunity cost of holding cash, b) an increase in the daily variance of
cash balances, c) a decrease in the transaction cost associated with selling
marketable securities?

7.10 FURTHER READINGS

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

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

Prentice Hall, Englewood Cliffs, NJ.

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

International (P) Ltd. New Delhi.

Keith V. Smith, Guide to Working Capital Management, McGraw-Hill Book

Company, New York

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

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

Ramamoorthy, V.E. Working Capital Management, Institute for Financial

Management and Research, Madras.

72
 Exhibit 7.1: Reading the Money Market Page Management of Inventory
(A) NSE Debt Market Deals
Market as on 24 September, 1999
Sec. Security Issue Trade No. of Trade Low Price High Price Last Traded Weighted Yield
Type Name Type Trade Value(Rs.
in Lakhs)

GC GC2001 11.75% NR 2 10.00 101.9000 101.9000 101.9000 10.5920

GC GC2000 11.64% NR 3 30.00 100.8800 100.8800 100.8800 10.4272

GC GC2001 11.55% NR 6 40.00 101.4500 101.4800 101.4500 10.5666

GC GC2002 11.00% NR 3 20.00 100.6700 100.6700 100.6700 10.6720

GC GC2002 11.15% NR 9 65.00 101.0300 101.0500 101.0400 10.7274

GC GC2002 11.68% NR 1 5.00 102.3100 102.3100 102.3100 10.6840

GC GC2004 11.50% NR 2 10.00 101.9800 101.9850 101.9800 10.9235

GC GC2004 11.95% NR 3 15.00 103.6000 103.6300 103.6300 10.9437

GC GC2004 11.98% NR 3 20.00 103.8100 103.8300 103.8300 10.9653

GC GC2005 11.19% NR 2 20.00 100.6000 100.6100 100.6000 11.0265

GC GC2007 11.90% NR 7 65.00 103.8100 103.8300 103.8300 10.9653

GC GC2008 11.50% NR 6 75.00 100.6000 100.6100 100.6000 11.0265

GC GC2008 12.00% NR 2 15.00 102.9700 102.9750 102.9700 11.2952

GC GC2008 12.25% NR 3 25.00 100.2200 100.3300 100.3300 11.4358

GC GC2009 11.50% NR 8 145.00 102.9600 102.9700 102.9700 11.4357

GC GC2009 11.99% NR 13 70.00 104.3600 104.3700 104.3650 11.4600

GC GC2010 12.29% NR 8 60.00 99.6500 99.7700 99.7200 11.5448

GC GC2011 12.00% NR 3 50.00 102.4400 102.4700 102.4700 11.5553

GC GC2011 12.32% NR 15 90.00 103.7400 103.8000 103.7900 11.6388

GC GC2013 12.40% NR 3 20.00 101.4400 101.4400 101.4400 11.7690

GC GC2018 12.60% NR 1 5.00 103.5300 103.5750 103.5750 11.8600

ID ICICO3C 13.75% NR 1 15.00 104.4200 104.4200 104.4200 11.9940

ID ICICIO5B14.25% NR 1 2.00 106.7000 106.7000 106.7000 12.4940

PF IRFC04 10.50% NR 1 10.00 105.6000 105.6000 105.6000 9.0090

SG MAH09 12.25% NR 2 6.00 102.4400 102.7000 102.7000 11.8045

TS NCRP06 13.50% NR 1 1.00 103.0100 103.0100 103.0100 12.7150

ZF IRFC03F 10.50% NR 1 0.05 101.7500 101.7500 101.7500 9.8970

ZT APWR04 15.50% NR 1 0.50 102.2500 102.2500 102.2500 14.8020

Total 111 889.55

DEBENTURE ACTIVITY ON N.S.E.

Description Year No. of Traded Traded
Trade Quantity Value Open High Low Close Yield
(Rs.lacs)
ESSAROIL 14% 2003 7 1700 0.8990 53.00 53.00 52.00 53.00
MRPL 16% 2002 3 5150 3.0779 60.50 60.50 59.75 59.80 14.34%
NIRMA SPN 0% 2003 2 70 0.2245 322.00 322.00 320.00 320.00
NIRMA 17% 2003 1 25 0.0525 210.00 210.00 210.00 210.00 14.39%
Total 13 6945 4.2539
73
Management of Current (B) BID-OFFER Rates of Government Securities and Treasury Bills
Assets
Security Securities Trading SBI Gilts Ltd. Gilt Securities Trading
Corporation of India Ltd. Corporation Ltd.

Bid Offer Bid Offer Bid Offer

ZCB GOI 13/7/2000 92.27 92.30 - - - -

11.55% GOI 2001 - - - - 101.45 101.50

11.00% GOI 2002 - - - - 100.65 100.70

11.15% GOI 2002 - - - - 101.06 101.10

11.99% GOI 2009 102.44 102.47 102.43 102.50 - -

12.29% GOI 2010 103.74 103.78 - - - -

12.40% GOI 2013 103.53 103.56 103.52 103.58 - -

12.30% GOI 2013 - - - - 102.56 102.595

91 DTB 30/11/1999 - - 9.50% 8.75% - -

91 DTB 20/11/1999 - - - - 10.00% 9.40%

91 DTB 27/11/1999 - - 9.75% 9.00% - -

364 DTB 11/12/2000 10.25% 10.05% - - - -

364 DTB 13/07/2000 10.45% 10.35% - - - -

364 DTB 21/09/2000 - - 10.50% 10.30% - -

364 DTB 24/03/2000 - - - - 10.60% 10.00%

Source: The Economic Time, Saturday, 25 September 1999 - page 8

Exhibit 7.1: Reading the Money Market Page

(C) GOVERNMENT SECURITIES - Quotes Appeared in REUTERS
Interest Year Indicative Price Maturity Date Yield to Maturity Current Yield Years to
% Bid/Offer % Approximate Maturity
Range

0.00 2000 92.28/92.31 13-07-2000 10.26/10.22 0.00 0.81

11.55 2001 101.47/101.52 02-07-2001 10.60/10.56 11.38 1.78
11.75 2001 101.89/101.93 25-08-2002 10.61/10.59 11.53 1.93
11.15 2002 101.05/101.07 01-09-2002 10.72/10.71 11.03 2.94
12.50 2004 105.35/105.40 23-04-2004 10.97/10.95 11.87 4.50
11.98 2004 103.83/103.86 08-09-2004 10.95/10.94 11.54 4.96
11.68 2006 102.31/102.36 10-04-2006 11.17/11.16 11.42 6.55
11.90 2007 102.97/103.03 28-05-2007 11.29/11.28 11.56 7.68
11.99 2009 102.48/102.52 07-04-2009 11.55/11.54 11.70 9.55
12.29 2010 103.75/103.80 29-01-2010 11.67/11.66 11.85 10.36
12.32 2011 103.50/103.54 29-01-2011 11.75/11.74 11.90 11.36
12.40 2013 103.55/103.60 20-08-2013 11.87/11.86 11.97 13.92
12.60 2018 104.45/104.50 23-11-2018 12.00/11.99 12.06 19.18

Note: These rates are based on a consensus of rates being offered by leading banks. Yield to
maturity is based on the CRISIL-IDBI Bond Tables.
Source: The Hindu Business Line, Saturday, September 25 1999 - page 10.
74
(D) MUMBAI MONEY MARKET-Indicative Market Rates Appeared in Management of Inventory
REUTERS
Instrument Period Rates (%) Instrument Period Rates (%)

Call Money (Closing) 7.75-8.00 T-Bill Maturing On 06/01/2000 9.95-9.80

Mumbai Inter-Bank Overnight 7.39-7.86 T-Bill Maturing On 14/01/2000 10.00-9.85

Bid/Offer Rate

14-day 9.00-9.63 T-Bill Maturing On 20/01/2000 10.05-9.90

1 Month 9.51-10.18 T-Bill Maturing On 28/01/2000 10.05-9.90

3 Months 9.93-10.69 T-Bill Maturing On 03/02/2000 10.10-9.95

Reuters 10-year Gilt 11.55 T-Bill Maturing On 11/02/2000 10.15-10.00

Treasury Bills (T.Bill) 91-day 9.60-9.40 T-Bill Maturing On 17/02/2000 10.20-10.10

364-day 10.60-10.40 T-Bill Maturing On 25/02/2000 10.25-10.15

T-Bill Maturing On 02/10/99 9.35-9.15 T-Bill Maturing On 10/03/2000 10.30-10.20

T-Bill Maturing On 09/10/99 9.45-9.20 T-Bill Maturing On 24/03/2000 10.30-10.25

T-Bill Maturing On 16/10/99 9.50-9.25 T-Bill Maturing On 07/04/2000 10.35-10.25

T-Bill Maturing On 23/10/99 9.55-9.30 T-Bill Maturing On 05/05/2000 10.40-10.30

T-Bill Maturing On 20/11/99 9.60-9.40 T-Bill Maturing On 19/05/2000 10.45-10.35

T-Bill Maturing On 25/11/99 9.65-9.45 T-Bill Maturing On 01/06/2000 10.45-10.35

T-Bill Maturing On 09/12/99 9.75-9.50 T-Bill Maturing On 15/06/2000 10.50-10.40

T-Bill Maturing On 17/12/99 9.80-9.55 T-Bill Maturing On 29/06/2000 10.55-10.45

T-Bill Maturing On 23/12/99 9.85-9.70 T-Bill Maturing On 13/07/2000 10.60/10.40

T-Bill Maturing On 31/12/99 9.90-9.75 T-Bill Maturing On 27/07/2000 10.60-10.40

Note: These rates are based on a consensus of rates being offered by leading banks

Source: The Hindu Business Line, Saturday, September 25 1999 - page 10.

75
Management of Current Exhibit 7.2: Yield Curve of Government Securities (Gilt) and Corporate Securities
Assets

Gilt Yield Curve

12.00

11.00
Percentage

10.00

9.00

8.00
3 1 5 10
M Y Y Y
Period

Corporate and Gilt Yields

13.00

Per 12.00
cent
age 11.00

10.00

9.00
3M 1Y 5Y

Period
Guilt Corporate

76
 Management of Inventory
Exhibit 7.3 : Behaviour of Cash Balances in Different Models
(A) Baumol Model
Cash Balance

Optimal Cash Withdrawal

Time

(B) Beranek Model

Cash Balance

Optimal Cash Disbursement

Time
(C) Miller and Orr Model
Cash Balance
Upper Limit (H)

Target (Z)

Lower Limit (L)

Time

(D) Stone Model

Cash Balance

UCL2

UCL1
Return Point (Z)
LCL1
LCL2

Time

77
 Management of Inventory

UNIT 8 MANAGEMENT OF INVENTORY

Objectives

The objectives of this unit are to: 1

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

Structure
8.1 Introduction
8.2 Components of Inventory
8.3 Need for Inventory
8.4 Inventory System
8.5 Costs in Inventory System
8.6 Optimising Inventory Cost
8.7 Selective Inventory Control Models
8.8 Inventory Management Under Uncertainty
8.9 Emerging Trends in Inventory Management
8.10 Summary
8.11 Key Words
8.12 Self Assessment Questions
8.13 Further Readings

8.1 INTRODUCTION
Three things will come to top of your mind when you think of a manufacturing
unit - machines, men and materials. Men using machines and tools convert the
materials into finished goods. The success of a business unit depends on the
extent to which these are efficiently managed. In this unit, we will discuss how
to manage the inventory, which consists of not only material but also work-in-
progress and finished goods. The general concepts of management namely,
planning, decision-making and controlling equally apply to inventory management.
In fact, this is one area in which companies in the real life spend a lot of
resources, both in terms of monetary value and managers’ time. Table 8.1
shows the investments in inventory in different industries and its value as a
percentage of total assets.

The value of inventory differs between industries because several factors like
technology, nature of materials, production process, etc. determines the value of
inventory. The composition of inventory is high in food and beverages because
the technology is fairly simple and hence the requirement of fixed assets is low.
The inventory requirement is high because of seasonal factor and the need for
wider retail distribution net work. For instance, if each shop in the country
stores twenty pockets of Maggi Noodles or Milkmaid, think of the total volume
of finished goods stored in millions of shops distributed all over the country. The
composition of inventory is low in heavy industries or hi-tech industries because
of high value of fixed assets. Another interesting finding is declining trend in the
composition of inventories as a percentage of total assets during the period,
which partly attributes to successful implementation of new techniques such as
MRP and JIT. We will discuss these issues later under the heading of emerging
2
trends in inventory management. Management of Inventory

Table 8.1 : Industry-wise distribution of Inventories

Industry 1999 2000 2001 2002 2003
Food & Beverages 8241.83 9016.35 10852.72 10551.56 9945.68
(as a % on total assets) 21.83% 22.15% 24.56% 22.49% 21.57%
Textile 8972.92 9443.55 9535.15 8960.25 9244.79
(as a % on total assets) 14.16% 14.24% 14.89% 13.80% 14.90%
Chemicals 28229.60 45422.63 44959.80 39629.90 47864.00
(as a % on total assets) 12.88% 17.46% 16.51% 15.60% 18.17%
Non-metallic Mineral Prod. 4163.02 4801.02 5521.85 5512.75 4836.06
(as a % on total assets) 14.22% 15.14% 15.69% 14.22% 13.96%
Metals & Products 15201.63 16527.79 17245.87 15470.12 15797.83
(as a % on total assets) 17.56% 16.43% 14.23% 12.27% 11.81%
Machinery 18519.83 16903.70 17238.67 15564.91 15789.51
(as a % on total assets) 13.17% 12.18% 11.96% 11.16% 10.87%
Transport Equipment 10806.51 10357.13 9905.66 8046.69 8284.38
(as a % on total assets) 18.78% 17.22% 16.31% 14.01% 14.66%
Diversified 14260.79 14325.40 15385.96 17412.10 21278.23
(as a % on total assets) 17.39% 17.81% 18.35% 15.50% 17.50%
Miscellaneous 2750.59 2942.90 3336.91 3093.38 2981.25
(as a % on total assets) 14.49% 13.31% 13.54% 13.14% 12.78%
Total 111146.72 129740.47 133982.59 124241.66 136021.73
(as a % on total assets) 15.12% 16.20% 15.76% 14.39% 15.34%

There are few basic differences between managing inventory and other
components of assets. Unlike machine and men, the inventories are continuously
planned on day-to-day basis based on the customers’ demand and production
schedule. Frequent decision-making and continuous controlling are thus required.
Unlike other components of current assets, there are number of people/
departments involved in managing the inventory. While stores department
manages the materials and components, it is the production department’s
responsibility in managing work-in-progress. Finished goods are managed either by
the warehouse or sales department.

In addition to the involvement of different divisions, each division requires input

from others in planning and controlling the inventory. For instance, stores
department, which manages the raw material, needs to closely interact with
production-planning and purchase departments to manage the raw materials
effectively. Again, the production-planning department needs input from marketing
or sales department to plan for the production schedule. The complexity of
managing inventory could be seen with diverse objectives pursued by each of
these departments. Production planning department wants to ensure timely
availability of material to allow smooth functioning of production flow and thus
insists that materials are purchased or drawn in advance. On the other hand,
material planning and stores department would like to procure the material only
when it is required and thus reduce their stay in the stores. Similarly, marketing
department wants to ensure adequate stocks with the retailers or dealers or
distributors. They may also insist the company to produce more variety to fulfil
different tastes of the customers and thus forcing the firm to increase the
3
Management
quantity of Current
as well as the number of materials and components. The larger issue or
Assets
strategic role of inventory management is to synchronise different objectives of
the departments and efficiently manage the inventory.

Activity 8.1
1) How managing inventory is different from that of managing machines and men?
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
2) Explain the need for external input in the management of different components
of inventory?
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
3) As an inventory manager, how do you set your goals or objectives?
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….

8.2 COMPONENTS OF INVENTORY

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

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

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

are another important input in the manufacturing process. This is a major
component of working capital for many assembly type of units. For instance,
manufacturers of colour television such as Videocon or BPL buy components like
picture tubes, printed circuit boards, tuner, speakers, etc., and assemble them.
Many of your companies would be using computer assemblers to assemble
4
computers to cut down the cost. Many companies are also Management of Inventory
trying to achieve a
concept called lean organisation to meet competition and in this process
outsourcing several items, which were internally manufactured.
Spare parts and tools are also accounted for as part of total inventory. But
these do not directly contribute in the final output of the product but are
necessary to support in the smooth flow of the production process. Often
machinery suppliers, particularly for imported ones, send critical spare parts
required for the machines in the event of breakdown. Tools like spare parts are
primary equipments used in the machines or independently to produce a product.
However, they are treated as inventory due to their short life and stored along
with materials. As they are also issued and accounted like materials, they are
treated as a part of inventory.
Work-in-process: These are items, which are partially assembled or processed.
The complexity of production process and time required to complete production
cycle determines the value of work-in-process. The value of work-in-process is
high for the manufacturers of passenger aircraft or railway engines because of
complexity and long time required to complete a unit. The value of work-in-
process is relatively low in pharmaceutical or paint companies since its primarily
mixing of chemicals. Could you guess the value of work-in-process for
electricity manufacturers like Tata Power or NTPC?
Finished goods: The last stage in the inventory processing is the finished goods.
These are the final output in any manufacturing process and are ready to be sold
to the customers. Why do firms keep finished goods in the factory or
warehouse before they are sold to the customers? It is not necessary and firms
can sell whatever they have produced immediately or can produce only to the
extent demanded by the customers like Tata Power and NTPC, which have no
finished goods. However, it is not practical for many other firms because of the
nature of production process and consumption practices of the users. For
instance, Parrys Confectionary, Britania and Nestle, which manufacture many
brands of toffees and biscuits cannot produce all of them on a daily basis to the
expected consumption of their products. They have to necessarily produce them
in batches of few days or weeks requirements by using more or less same
machines. Otherwise, the requirement of machinery will be huge and production
becomes economically nonviable. They may also have to establish a large number
of plants all over the country to meet the local demands. Finished goods may be
relatively low for high value equipments like aircraft or ships, which are often
manufactured on the basis of orders. It can be reduced for firms, which are
supplying to industrial customers because firms can schedule their production
according to the production schedule of customers. The finished goods component
has to be necessarily high for firms that produce products like food products,
consumer durable, etc., which are directly consumed by the public and distribution
network also need to be large.
Table 8.2 gives the various components of inventory for different industries for
five years i.e., from 1999 to 12003. The figures reflect many of the points,
which we have discussed so far. You can observe wide variation in the values
of inventory and its components because the nature of industry is the most
important factor that decides the level of inventory. For instance in the case of
chemical industry the raw materials are held at a higher level compared to the
other industries. Similarly work-in-process component is found to be at higher
level in the case of the machinery industry where sub-assemblies are supposed to
be more than the other industries. It is low for food products, chemicals and
minerals. Similarly, the finished goods are found to be high in the case of food
products and chemicals reflecting the nature of the industry.
Table 8.2 : Industry-wise Components of Working Capital
5
Management
Industry of Current 1999 2000 2001 2002 2003
Assets
Food & Beverages
Raw Materials & Stores 2676.50 2761.02 3191.26 1735.79 3862.37
Work-in-progress 388.13 403.48 432.66 183.38 700.02
Finished Goods 5032.50 5723.40 7162.75 2984.22 7612.08
Textile
Raw Materials & Stores 3743.79 4104.39 4045.05 3079.24 5035.12
Work-in-progress 1381.29 1507.19 1459.43 1035.62 1668.02
Finished Goods 3606.32 3665.30 3807.26 2185.11 4557.19
Chemicals
Raw Materials & Stores 12180.95 17507.52 17006.60 11731.72 20764.78
Work-in-progress 2455.79 4011.15 4341.74 2062.92 5419.00
Finished Goods 13473.50 23603.87 23251.28 9927.93 28615.13
Non-metalic Minerals
Raw Materials & Stores 2172.90 2276.44 2537.17 1557.61 3026.00
Work-in-progress 574.52 644.45 713.02 361.80 720.91
Finished Goods 1366.19 1818.78 2219.27 851.93 2270.35
Metals & Products
Raw Materials & Stores 7416.16 7615.14 7362.71 6462.56 8964.97
Work-in-progress 2413.26 2111.88 2406.20 1404.26 2511.17
Finished Goods 8536.29 7020.42 7358.29 7261.27 6213.45
Machinery
Raw Materials & Stores 6452.96 6931.79 6912.79 6322.18 7369.58
Work-in-progress 4266.97 4575.12 5032.30 3707.79 5230.62
Finished Goods 4060.56 4394.32 4733.20 3168.70 5190.63
Transport Equipment
Raw Materials & Stores 4428.79 4747.74 4430.00 5317.47 3920.73
Work-in-progress 4678.79 3218.87 2737.36 2713.00 3375.34
Finished Goods 1586.27 2096.66 2397.63 1351.73 2518.37
Diversified
Raw Materials & Stores 3834.10 3746.32 3822.38 3661.35 6324.28
Work-in-progress 1371.07 1576.11 1818.08 4272.04 1764.16
Finished Goods 3186.02 3622.17 4134.26 2463.28 6237.21
Miscellaneous
Raw Materials & Stores 1488.70 1637.20 1878.41 1089.32 2263.94
Work-in-progress 299.32 339.81 289.59 183.36 411.59
Finished Goods 952.56 948.98 1120.95 713.56 1092.01
Total
Raw Materials & Stores 44394.85 51327.56 51186.37 40957.24 61531.77
Work-in-progress 17829.14 18388.06 19230.38 15924.17 21800.83
Finished Goods 41800.21 52893.90 56184.89 30907.73 64306.42

Activity 8.2

1) List out the various components of inventory? Identify major raw materials,
purchased components, finished goods for any one firm which is familiar to
you.
6
 Management of Inventory
…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

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

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

3) Pick up any two or three industries from Table 8.2. List down a few
reasons for the differences in the level of inventory values.

…………………………………………………………………………………...

…………………………………………………………………………………….

…………………………………………………………………………………….

8.3 NEED FOR INVENTORY

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

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

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

requirement unless the supplier is next to your firm or the product or component
is internally produced. If a firm buys material from outside, there are several
factors that govern the smooth flow of completing the purchase orders. Similarly,
there is also a risk that the plant suddenly breaks down and is not in a position
to replenish the finished goods. Some amount of excess inventory, often called as
buffer stock, is maintained as a precaution. The precautionary motive plays a
7
Management
vital role in ofdecision
Current making relating to spares and other critical items required for
Assets
the production. Many of us carry Stepney (extra tyre) with our scooters and four
wheelers as a precaution.

Speculative Motive: Though firms may not speculate in buying and selling raw
materials, there is nothing wrong in exploiting the opportunity that arises
occasionally due to uneven demand and supply. A refinery could buy or enter
into a contract for the purchase of the crude oil when the price is cheap because
of sudden increase in the supply of oil. We have mentioned earlier, textile
companies find it useful to buy cotton when the prices are low since the price
behaviour is volatile. It is true for most of the seasonal products. It is also
possible to buy extra materials because the suppliers offer discount beyond
certain quantity. We often buy extra garments during clearance sale or festival
period, when firms offer discount.

The above discussion presents general reasons for holding different types of
inventory. Given below are a few specific reasons that apply to individual
components of inventory.
Raw Materials and Stores
• To make production process easier
• To ensure price stability
• To hedge against supply shortages
• To take advantage of quantity discounts
Work-In-Process
• To achieve flexibility in manufacturing
• To ensure economies of production
Finished Goods
• To ensure smooth delivery schedule
• To provide immediate supply
• To achieve economies of scale
• To allow batch processing in a multiple product situation and
optimise the utilisation of machine and other resources
Though the above said factors could influence the firms in maintaining the
inventories, each firm has its own policies in deciding the quantum of the
inventory to be maintained. To understand the need for inventory one should
understand the flow of the inventory components in the manufacturing process.
Raw materials are needed as input in the initial stages of the manufacturing
cycle. The raw material requirements vary as per the nature of the industry.

Similarly the companies have to maintain sufficient stockings of the finished goods
as the output produced are not always sold at the factory gate. These goods
have to be distributed when the goods are to reach the customers spread out
geographically. This requires overcoming the challenges faced in the competitive
world. When the firm defaults to supply the goods at the right time in the right
place to the right customers, there is fear of losing the sales to the competitors.

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

investment in inventory and customer-service, in that lower the inventory higher
the stock-out and higher the inventory better the customer service. Inventory is
also required to minimise the ordering costs and transportation costs by reducing
frequent ordering and by moving materials in bulk respectively.
8
Activity 8.3 Management of Inventory

1) Why do the firms maintain inventory? Identify three best reasons for holding
inventory by a company.

…………………………………………………………………...................

…………………………………………………………………...................

…………………………………………………………………...................

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

…………………………………………………………………...................

…………………………………………………………………...................

…………………………………………………………………...................

3) List any two speculative reasons for holding excess inventory.

…………………………………………………………………...................

…………………………………………………………………...................

…………………………………………………………………...................

8.4 INVENTORY SYSTEM

An understanding of inventory system is essential before making any attempt to
manage different components of inventory. A system in simple terms is defined
as how things are organised together with their inter-relationships among different
components of systems. We can define inventory system as the one, which
consists of three components namely inventory customers, inventory storage
points and inventory sources. Inventory customers are primary cause for
investments in inventory. Inventory customers includes end-customers, marketing
department or dealers, production centres and any one, who demands inventory to
be stored for their ready consumption. The customers demand inventory because
of their production process and consumption pattern. A firm, which is doing job
orders, can purchase the required items after it receives the job order. On the
other hand, sugar or power plant cannot buy their daily requirements on daily
basis because the process is continuous and any delay in the arrival of material
will force the unit to shut down. Similarly, industrial consumer would buy in
quantities sufficient to ensure their production process to run smoothly whereas
retail consumers will expect the shops to keep ready the stocks to allow them to
buy whenever the product is required. For example, individuals buy soaps,
detergents, toothpaste, health drinks and other consumables only for a month’s
requirement. An analysis of the inventory customers and their consumption
behaviour is essential for inventory management.

The second component of an inventory system is inventory storage or inventory

stocking points. It might be a warehouse, a distribution centre, a storage bin or
any other physical location where inventory is stored for a brief period of time.
Stocking points are required because transportation in bulk quantity to these points
9
Management
is easy and of Currentand stocks are redistributed in smaller quantity to retail
cheaper
Assets
outlets. In the case of raw materials also convenience and low cost require
materials to be bought in bulk and stored inside the factory. Analysis of stocks
in stores and removing transportation bottleneck are key to reduce the
investments in stocks. The slow moving and non-moving items not only increase
the cost of carrying the inventory but also incur an opportunity cost of denying
storing space for fast moving items.

The last component of an inventory system is sources of inventory. It could be

a supplier from whom the firm purchases materials or internal division from
which the products are transferred. This factor affects inventory management in
several ways. For instance, the number of inventory sources affects the decision
on inventory holding. If an item is manufactured by several units and the quality
is comparable, then lead time for procuring the material is low and the availability
of material is high. On the other hand, if the number of suppliers is few or the
quality is not consistent, the inventory holding is high. The production process of
suppliers again determines their ability to supply in small quantity.

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

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

Activity 8.4

1) How do you define an inventory system? List down three important

components of inventory system.

…………………………………………………………………………………...

…………………………………………………………………………………...

…………………………………………………………………………………...

…………………………………………………………………………………...

2) List down few industries in which the demand for inventory is (a) continuous
and (b) discrete.

…………………………………………………………………………………...

…………………………………………………………………………………...

…………………………………………………………………………………...

…………………………………………………………………………………...

…………………………………………………………………………………...

3) List down any three ideas to make the inventory system simpler so that its
management is easier?
10
 Management of Inventory
…………………………………………………………………………………...

…………………………………………………………………………………...

…………………………………………………………………………………...

…………………………………………………………………………………...

8.5 COSTS IN INVENTORY SYSTEM

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

There are five different costs to the firm that holds inventory. The first category
of costs is the value of inventory itself. It is the purchase cost of inventory of
materials and components. For internally manufactured parts or work-in-progress
or finished goods, the cost associated with producing the product, includes cost of
material, labour and other production overheads. The second component of
inventory cost is cost of acquiring inventory. For materials and purchased parts or
components, it is the cost of purchasing, freight, inspection, etc. This component
of cost goes up when the materials are purchased in small lot because it requires
frequent ordering, transportation, and inspection. The set-up costs can be viewed
as cost of acquiring finished goods since in terms of behaviour it is similar to
acquisition cost of raw material. If finished goods are produced in small quantity,
then the number of set-ups increases causing more set-up costs.

The third cost of inventory, which is important among different components of

costs, is cost of holding inventory. There are different items that go into this cost
component, some of them are fixed in nature whereas many others are variable.
The cost of maintaining and managing stores, warehouses and other storing
facilities are part of cost of holding inventory. The losses such as spoilage, theft
or obsolescence that might occur in holding the inventory are also included in the
cost of holding inventory. The most important cost of holding inventory is interest
or opportunity costs associated with locking of firm’s funds for inventory. The
cost of holding inventory declines if the materials are procured in small quantity
because it reduces the level of inventory.

The fourth cost of inventory is invisible and hence often ignored in formal
analysis. This relates to cost of inventory shortage. In many ways, this is the
most difficult category to estimate even though it is a very important cost to the
firm. Its difficulty is mainly due to changes in the magnitude of the costs in
different situations. For instance, if a firm is unable to supply the goods in time, it
may have different consequences. It is possible to supply the goods with a
minor delay and the buyer would perfectly accept the delayed supply. In a
different situation, the customer would refuse to take delivery because of delay
and thus the firm will lose profit on this sale. If the customer decides not to buy
the product henceforth from the firm, then it is a loss of customer, which takes
away all potential profits of the future. In the worst scenario, the news spreads
to others' and many customers move to other competitors. The cost of shortage
relates to material and other components which are associated with stopping and11
Management of Current
starting
Assets the production. If the entire factory is shut down due to shortage of
material, then cost is very high.

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

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

• Cost directly proportional to amount of inventory held such as storage cost,
financial cost of carrying inventory, etc.
• Cost not directly proportional to amount of inventory held, which can be again
classified into the following two categories:

Cost directly proportional to the period of holding inventory such as
spoilage, obsolescence, interest cost, etc.

Cost directly proportional to number of orders such as ordering cost, set-up
cost, freight, payment process, etc.
• Stock out cost
The objective before us is to manage these components of inventory cost such
that the value derived from inventory is maximised. The optimisation can be
achieved with zero inventory or high inventory, ordering frequently and procuring
from several sources or storing in bulk and taking huge or zero risk of stock-out
position.

Activity 8.5

1) Explain different cost components of inventory with respect to cement industry?

…………………………………………………………………………………....

…………………………………………………………………………………....

…………………………………………………………………………………....

2) Give an example on the relevance of cost of shortage in inventory management?

…………………………………………………………………………………....

…………………………………………………………………………………....

…………………………………………………………………………………....

3) List down fixed and variable component of costs of inventory. How do you
use this information in managing inventory?

…………………………………………………………………………………....

…………………………………………………………………………………....

…………………………………………………………………………………....

8.6 OPTIMISING INVENTORY COST

Inventory holding is desirable because it meets several objectives and needs as
12
 Management
described in Section 8.3. But excessive inventory is undesirable becauseof itInventory
costs
a lot to a firm. The issue before us is balancing the cost and benefit and get an
optimum level of inventory holding. This optimisation is achieved in two stages.
First, the optimum ordering level (also called the Reorder Level) is computed by
using the time required to place the order and receive the goods and demand
from production centres. Second, the optimum ordering quantity also known as
the Reordering quantity or Economic Order Quantity (EOQ) is computed using
inputs such as ordering cost and inventory carrying costs. In simple terms, two
questions namely, (a) how much should be ordered and (b) when should the
stocks be ordered ? are to be answered.

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

cost and cost of carrying inventory, which are inversely related. If every time,
the firm orders more quantity, it can definitely cut down the cost of ordering, but
has to carry more inventory and thus incur more cost of carrying inventory.
Frequent ordering increases the cost of ordering but reduces cost of holding
inventory. How these two costs are balanced to achieve optimum ordering
quantity? There are two ways by which this could be achieved. One is by
determining the EOQ and the other is by adopting the trial and error approach.
This can be worked out with simple examples. But we do this with certain
assumptions that both the annual demand and the materials usage is known with
certainty. Also, the carrying cost per unit and ordering cost per order are
constant. We will list down the assumptions once again because we will be
discussing different other models in Section 8.8 by removing some of these
assumptions.

1) The annual demand is known with certainty.

2) The annual consumption is even throughout the period.

3) The material usage per unit is known with certainty, and is uniform through out
the years.

4) The carrying cost per unit and ordering cost per unit is constant regardless of the
size of the order.

5) The carrying cost is at a fixed percentage on the average value of the inventory
held.

6) Inventory orders can be replenished immediately.

Trial and Error Approach

Trial and Error Approach has intuitive appeal as this resolves the problem through
logical steps. Let us work out this with a simple problem. For this we take following
data into consideration:

Annual consumption forecasted (C) : 24,000 units

Purchase price per unit (P) : Rs. 15.00
Cost per order (O) : Rs. 45.00
Carrying cost (I) : 10% on the purchase price.

There are number of alternatives available to the firm to manage the inventory
cost. The firm may either purchase the entire lot in one order or it may purchase
in small lots by making multiple orders. If the firm chooses to purchase the entire
13
Management
in one singleof lot
Current
of 24000 units, then an amount of Rs. 180000 {(24000 + 0) /
Assets
2*15} is invested throughout the period. On the other hand, if the firm chooses
to purchase each month by ordering twelve times of 2000 units, then the average
investment in inventory is Rs. 15000{(2000 + 0) /2*15}. Investment values differ
according to the size of order. If the firm has to decide whether to go for the
single order or multiple order system, it depends on various factors like the
scarcity of materials, the production cycle, the demand for the materials, the
availability of the materials, suppliers and buyers bargaining power, etc. If the
firm focuses on reduction in the investment in inventory, then the firm would
favour multiple orders. To further substantiate this, we find the total carrying and
ordering cost involved in the various alternatives. Table 8.3 gives the details.

Table 8.3: Total cost of various alternatives

No. of orders (C/Q) 1 2 3 4 6 10 12 20 24

Order Size (Q) 24000 12000 8000 6000 4000 2400 2000 1200 1000
Avg inv (Q/2) 12000 6000 4000 3000 2000 1200 1000 600 500
Carrying cost (Q/2*I) 18000 9000 6000 4500 3000 1800 1500 900 750
EOQ Size and Cost Relations
Ordering cost (A/Q*O) 45 90 135 180 270
450 540 900 1080
6000
Total cost 18045 9090 6135 4680 3270 2250 2040 1800 1830
5000
Cost
(Rs.) 4000
We find that3000
the total cost gets reduced upto a point when the inventory level
reaches 12002000
units (Rs. 1800) of order size and after which, the cost starts to
increase. Hence
1000 we call this level as the optimum level. There is an alternative
way to find precisely the optimum quantity to be ordered. The Economic Order
0
Quantity model is discussed in the next section.
100 200 300 400 500 600
Economic Order Quantity (EOQ)
Order Size (No
Since the trial and error approach involves too tedious calculation, one simple
method is the use of the formula for calculating the Economic Order Quantity.
Ordering Cost Holding
We will show the derivation of the model before applying it to our above
example. Let us first describe the variables used in the equation as follows:
Annual consumption forecasted = C
Purchase price per unit = P
Cost per order = O
Carrying cost = I
Quantity per order = Q
Number of orders = C/Q
Average Inventory carried = Q/2
The total cost of inventory is equal to purchase value of inventory (C x P) plus cost
of ordering (C/Q x O) plus cost of holding or carrying inventory (Q/2 x I). That is,

TC = CP + (C/Q) O + (Q/2) I

To minimise the total cost of inventory, we need to take the first derivative of the
equation with respect to Quantity and set it to zero and then check whether the
second derivative is positive.
-2
dTC/dQ = -OCQ + I/2 = 0
2
OC/Q = I/2
14
 2 Management
Q I = 2OC of Inventory
2
Q = 2OC/I
Q or EOQ = √2OC / I
-3
The second derivative (2OCQ ) is greater than zero because all the elements
are positive. Substituting the values of the previous problem in the above
equation, we get

√2x45x24000/1.5 = 1200 units

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

8.6.1 Analysis of Quantity Discounts

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

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

Whether or not the quanity discount should be availed of, depends on an assessment
of the costs and benefits involved.

The savings resulting from the quantity discount = (Re.1) (0.10)(2000) = Rs.200.

The cost is the additional holding cost minus savings in ordering cost stemming from
fewer orders being placed.
While the cost was cQ*/2 = 10 (200)/2 = Rs.1000
The cost would now be, cQ#/2 = 10 (250)/2 = Rs. 1250; where, Q# = New Order Size
There would be a difference of Rs.250
The savings in ordering cost can be arrived at as follows:
Total ordering cost when 200 units are ordered each time 15
Management of Current
= 2000(100)/200) = Rs. 1000
Assets
Total ordering cost when 250 units are ordered each time
= 2000 (100)/250 = Rs.800
The saving in ordering cost would be Rs.200.
Thus while the savings in ordering cost would be Rs.200, the escalation in holding
cost would be Rs.250, that is to say that the net increase in cost would be Rs.50.

In this particular instance it would be advisable to avail of the quantity discount option
because the saving of Rs.200 exceeds the net increase in cost of Rs.50

8.6.2 Buffer Stock Decision

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

To decide on the level of buffer stock to be carried a firm must balance the cost of
stock outs with the cost of carrying additional inventory. One can assess this balance
if the probability distribution of future usage is known.
Suppose the usage of an inventory item over a week is expected to be as follows:
Usage (in Units) Probability
50 0.04
100 0.08
150 0.20
200 0.36
250 0.20
300 0.08
350 0.04
1.00
Let us also assume an economic order quantity of 200 units per week, steady usage,
200 units in hand at the beginning of the period and three days' lead time required to
procure inventories. We may further assume that since this lead time is known with
certainty, orders are placed on the fifth day for delivery on the eighth day or the first
day of the next seven-day-week. Even if the firm carries no buffer stock there will
be no stock outs as long as the usage is 200 units or less. When usage exceeds 200
units there will be stock outs. When we know the cost per unit of stock out we are in
a position to calculate the expected cost of stock outs and compare this with the cost
of carrying additional inventory. Naturally, the stock out cost includes the loss of profit
arising from the order not being fulfilled, a valuation of the loss of business reputation
and goodwill. Let us say we reckon that the stock out cost is Rs.6 per unit and the
average carrying cost per week is Re.1 per unit then we are in a position to figure out
the expected costs associated with various levels of safety stocks.
Safety Stock out Stock out Probability Expected Carrying Total
Stock Cost Stock out Cost Cost
16 (Rs.) Cost (Rs.) (Rs.) (Rs.)
150 units 0 0 0 0 Management
150 of Inventory
150
100 units 50 300 0.04 12 100 112
50 units 100 600 0.04 24
50 300 0.08 24 50 98
0 units 150 900 0.04 26
100 600 0.08 48
50 300 0.20 60 0 144
From the above table it can be clearly seen that the optimal safety stock is 50 units,
since at that level the total cost is at its lowest.

However, some firms simply decide on a probability level of stock out acceptable to
them and then decide on the level of safety stock. For example, if this firm had
decided on accepting a probability of 10% stock out then it will maintain a safety
stock of 50 units only. If, however, the firm wished to accept a probability of only 5%
stock out, then it will maintain a safety stock of 100 units. When it maintains a safety
stock of 100 units it will be able to meet all situations except the one where there is
4% probability of the usage being 350 units.

Activity 8.6

1) How do firms arrive at the optimum cost?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) What is economic order quantity? How is it useful for the firms in the inventory
management?

………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

3) What are the major costs that are taken into consideration in optimising the
inventory cost?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

8.7 SELECTIVE INVENTORY CONTROL MODELS

The economic order quantity ensures the cost of carrying inventory and cost of
ordering inventory are balanced and an optimum cost level is reached. However,
it fails to ensure stock-out situation and the cost associated with the stock-out
situation. In other words, if there is any uncertainty in replenishing the stock, it
will lead to stock-out situation. Thus, in addition to ordering quantity, the time at
which the order is to be placed is worked out after taking the uncertainty of
replenishing the stocks into consideration. The various stock-levels that are mostly
17
Management
fixed are as offollows:
Current
Assets
Stock-Levels

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

Re-order Level = Maximum consumption x Maximum Re-order Period.

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

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

Normal Re-order Period)

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

holding of inventories implies blocking of funds unnecessarily. The good inventory
control technique should keep a constant check to see that the inventory level
does not rise beyond this level. The maximum level is fixed taking into
consideration the Re-order quantity, carrying costs, the availability of capital,
government policy and the nature of the materials.
Maximum Level = Re-order Level + .5 (Re-order quantity) -
(Minimum consumption x Minimum Re-order
Period)

Danger Level: This level is fixed even below the minimum level as a disastrous
signal when the inventory level touches this level. This has to be solved by
exercising greater efforts in purchasing to bring the inventory to the required
level.

Re-order Point: When the question of maintaining inventory at optimum cost is

raised one should not only focus on how much to order but the firm should also
concentrate on when the order has to be placed. Arriving at the re-order point
solves this. This is the level at which the orders should be placed to replenish
the inventory. It takes into consideration the lead-time required to receive the
inventory and the average usage. This should be a level over and above the
minimum level or safety stock. Re-order point is calculated as follows:
Re-order point = Safety stock + (Average consumption x lead time.)
The determination of economic order quantity and different order levels are
basically a planning exercise. The inventory management does not end with
planning and what is more important is its implementation and continuous control
on inventory. The following techniques, which follow selective control, are useful
to exercise control on inventory.

ABC Analysis

ABC works on the mechanism namely Always Better Control. Vilfredo Pareto,
called nineteenth century Renaissance man, was the first to document the
Management Principle for Materiality, which formed the basis of ABC analysis
discussed here. As per Pareto, the ABC principle involves:

1)
18 Classifying the inventory on the basis of importance on a relative basis to the
 total inventory value. Management of Inventory

2) Establishing different management controls for different classification with the

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

Annual Rupee volume of the items.

Unit cost

Scarcity of material used in producing an item.

Availability of resources, manpower, and facilities to produce an item.

Lead-time.

Storage requirements for an item.

Pilferage risks, shelf life, and other critical attributes.

Cost of stock-out.

Engineering design volatility
Using value of items as the basis for such classification, if on an average the
15% of the items account for nearly 65% of the total inventory value, this falls
under the most critical category which is usually named as the ‘A’ category.
Similarly if 30% of the items account for 25% of the total inventory value, this
falls under the next category named as ‘B’ category. The balance 55% of the
items that account for nearly 10% of the total inventory value fall under the least
category named as ‘C’ category.

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

VED Analysis

VED stands for Vital, Essential and Desirable. This technique is primarily used
for the control of the spare parts inventory. As the name goes the spare parts
are subdivided into vital, essential and desirable categories, based on their critical
nature. The criticality is determined by the importance of its usage. If the event
of stock-out in an item stops the production, then it is classified under the ‘vital’
category. Those spares the absence of which is not tolerated for even few
hours or a day, the loss of, which is considerably high, falls under the 'essential'
category. Desirable spares are those, the absence of which is not expected to
create havoc for a week or so and necessarily would not result in the stoppage
of the production. Hence one could find that the VED analysis adopts almost
the similar mechanism of the ABC analysis in that the former is used for the 19
Management
control of Current
of spare parts.
Assets
F-S-N Analysis

Inventory items are also classified and controlled on the basis of fast-moving,
slow-moving and non-moving items (F-S-N analysis). The non-moving items are
critically examined for their needs and items, which are not critical, are disposed
off in a suitable manner. They may be used in the production process with
modifications or sold in the market. The order levels and economic order
quantity for slow-moving items are reviewed to check, whether they can be
further reduced without affecting the production process.

The above three analysis are not mutually exclusive and in fact, by combining the
analyses, the management can get a better picture on the inventory. For
example, items, which are fast-moving, vital and “A” class, may require very
close monitoring because excess holding will cause additional cost and at the
same time stock-out will also cause equal loss. Inventory policy can be designed
by combining the three analyses.

Activity 8.7

1) How do you think the existence of an inventory control system in the organisation
would help in the inventory management?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) What is Economic Order Quantity? How is it useful to achieve some of the

objectives of inventory management?

…………………………………………………………………………………...

…………………………………………………………………………………….

…………………………………………………………………………………….

3) What are the various aspects that are to be considered in fitting an inventory
control system in any organisation?.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

8.8 INVENTORY MANAGEMENT UNDER

UNCERTAINTY
In our discussion on optimising inventory cost, we have discussed economic order
quantity based on the assumption that the firm knows with certainty the demand
for inventory and cost of ordering and carrying inventory. Since this certainty
assumption may go wrong, we have developed different stock levels to handle
stock-out situation caused by uneven demand for inventory and order processing
time. In this section, we will discuss some of the new techniques in handling the
uncertainty. First, we will define the problem of uncertainty in simple terms with
20
an example. Suppose a television dealer expects the demand for the product in
the next twelve months to be 12000 televisions. Based on Management
the orderingofcost
Inventory
and
cost of carrying inventory, the dealer works out 2000 units as the economic order
quantity with a reorder level of 500 units. The methodology given in Section 8.6
would be adequate to get these figures. Suppose the actual demand for
televisions suddenly increases to 2000 units. If the manufacturer is not in a
position to accept the demand for additional televisions, the dealer has to forego
the opportunity income. On the other hand, if the demand declines to 500, the
dealer will be carrying excess stock for atleast certain part of the year. The
issue is how to address this uncertainty in demand while deciding optimum level
of inventory. We will discuss a few models available to address the issue.

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

We will first explain an option type called put option and then show how it is
similar to the situation we have described in television dealers example. A put
option gives a right to the holder to sell an asset at a predetermined price. The
holder of the option gains if the value of underlying asset goes down because the
holder can buy the asset at a lower price and sell at a higher predetermined
price. The holder is not going to sustain any additional loss if the price of the
asset goes up. Of course, the holder will incur a loss to the extent of initial
price (called option premium) paid to the other party of the contract to accept
the one-sided contract. Thus, the value of contract is inversely related to the
price behaviour of underlying asset with a cap on maximum loss. With this brief
on options, let us go back to the television dealer example and compare the
condition with the option model.

If the dealer decides to acquire additional inventory under the expectation that the
demand will go up, there is an additional cost of carrying the inventory. At the
same time, the dealer has acquired the right to sell the product and realise the
profit if the demand picks up. This is similar to acquiring a put option on
financial assets or commodity by paying upfront premium. The variable, which
determines the profit of the financial or commodity option is the price of the
product and in the case of inventory option, it is the demand for the product. As
the demand goes up, the dealer starts initially getting back the cost and if the
demand still goes up, gets profit. On the other hand, if there is no change in the
demand, the product stays more time before it finds a buyer and this cost is
initially determined as the cost of buying the option. The issue before the dealer
is whether this cost is worth to incur to get a potential future benefit. This is
similar to whether it is worth to buy a put option at a given price considering the
likely benefit the option offers to the holder. Of course, in the television example,
the value of the option directly moves with the demand for the product unlike the
inverse relationship between the price of the asset and put option benefit. To
know whether it is worth to carry additional inventory by incurring a cost, the
dealer has to get a distribution of demand with associated probability. The easiest
methodology to decide on this issue is Binomial Option Pricing Model. If the
option value is more than the cost of carrying the inventory, then the decision is
in favour of holding larger inventory. The readers are advised to consult standard
textbooks on option pricing models to know more about valuation of options.
21
Management
Frederic C. of Current
Scherr has explained the use of Black-Scholes Option Pricing Model
Assets
to resolve inventory problem by relating the impact of various demand levels on
stock prices of the company.

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

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

Dynamic Inventory Model: In the above two models, we have limited the
scope of uncertainty to expected demand and also restricted the period of
analysis. If we desire to include uncertainty associated with many inventory
variables such as demand, delivery period, interest cost of holding inventory,
storage cost, cost of stock out, etc., we need a complex optimisation model. It is
possible to use simulation technique to include multiple variables, which are
exposed to uncertainty. The model requires identification of uncertain variables,
estimation of probabilities associated with different uncertain variables and how
the variables together affect the cost and benefit of holding a particular level of
inventory. For example, given a delivery period of 30 days, interest cost of 14%,
demand of 1500 units per month, and storage cost of 2% per month, the impact
of placing an order quantity of 2000 units with a reorder level of 500 units on the
cost and benefit of holding inventory are to be estimated. With this set of
22
information, it is possible to simulate a large number of trialsManagement of Inventory
using random
numbers. The simulation will give expected profit or loss estimation for each
order quantity and reorder level and you may select the combination, which offers
maximum profit. The decision making is easier and to an extent reliable because
each profit estimation is based on a large number of simulated trials.

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

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

Activity 8.8

1) Why do we need to consider uncertainty in inventory management?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) How do you evaluate the decision of holding additional inventory in an uncertain

environment?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

3) List down the steps involved in conducting simulation exercise to deal with
uncertainty.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………...

8.9 EMERGING TRENDS IN INVENTORY

MANAGEMENT
So far, we have assumed that inventory holding is inescapable necessity and thus
finding ways to optimise the inventory holding through several models. This very
basic assumption is questioned that leads to several interesting alternative
inventory management techniques. Two important reasons for holding raw
materials are to avoid price fluctuations and ensure that the delay in the arrival of
materials does not affect the production process. Alternative strategies to holding
raw materials to mitigate the price volatility include entering into a long-term
supply contract at a fixed price or taking up position in futures market. The
objective of ensuring smooth production process can be achieved by dealing with
multiple supply sources, built-in strict penalty clauses in the purchase orders to
compensate the loss sustained for emergency buying and adopting just-in-time 23
Management
(JIT) of Current
system.
Assets
The reasons for holding inventory in the form of work-in-process are complex
production process, economic batch processing upto a stage of production and
insure against sudden breakdown in the manufacturing process. It is not possible
to overcome all the technology related problems but attempt can be made to
bring a new technology that speeds up the production process or changes the
production process. Some of the components can be outsourced so that there is
no need to produce the quantity in bulk to achieve economies of scale. Another
Japanese technique called Kanbans is useful to cut down the work-in-process
since under this system, a production department produces the required product
only when demand is made by the user system. Investments in plant and
machinery and improving maintenance system would take away the need for
holding stocks against sudden breakdown.

Finished goods inventory is maintained to ensure immediate delivery of the

product. It may be difficult to make customers wait or require them to give an
advanced schedule of consumption for many consumer products. However, this
can be attempted in industrial goods and high value consumer goods. For
example, companies like BPL have a system of taking advance from the
customers to supply television after certain period and customers are suitably
compensated for waiting period. Promoting internet based ordering system would
definitely give a lead time to the manufacturer and thus avoid holding finished
goods inventory. Industrial customers can be motivated to enter into a long-term
purchase order by offering discounts or better credit terms. It is possible to
access the production schedule of the industrial customers on a continuous basis
and produce accordingly. The concepts such as vendor development, supply chain,
etc. are emerging techniques that allow exchange of information between the
suppliers and users with an objective of bringing down overall cost of inventory
and at the same time ensuring smooth production process.

Many of the concepts we have discussed so far are likely to become outdated
soon if the current growth rate in the information technology is maintained. The
expansion of internet services and e-commerce will definitely create a new
business world in which we may not have shops or malls. Most of the agencies
dealing between customers and producers may not exist. Producers may also
offer product with individual preferences and bargain for a leadtime to deliver the
product. Industrial marketing is also likely to see major changes and at some
point of time JIT, Kanbans, supply-chain, vendor development, etc. will become
basic techniques for businesses. A sure way of tackling uncertainty is free
exchange of information on online basis, which is not only feasible but will also
become a norm in the near future.

Activity 8.9

1) List down some of the alternatives to holding raw material inventory?

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

2) How JIT and Kanbans help to cut-down the inventory in work-in-process?

24 …………………………………………………………………………………….
 Management of Inventory
…………………………………………………………………………………….

…………………………………………………………………………………….

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

inventory management of your industry.

…………………………………………………………………………………….

…………………………………………………………………………………….

…………………………………………………………………………………….

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

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

Recent developments in the manufacturing system and adoption of techniques

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

8.11 KEY WORDS

Raw materials : These are inputs used in the manufacturing process.
Work-in-progress : material in the pipe line.
Finished goods : completed products, ready for sale.
Stores and spares: consumables and components used in the manufacturing
process.
Transaction motive : material kept for running the production process.
25
Management of Current
Precautionry motive : material kept for meeting contingency
Assets
requirements like irregular supply, excess demand etc.
Speculative motive : purchasing material to take advantage of rising prices.
Economic ordering quantity : optimum quantity which minimises the costs of
inventory.
Buffer stock : also known as safety stock, which is maintained to meet
contingent requirements for material.
Re-order level : The stock level at which a fresh order for stock is made.
This is fixed taking into account lead time and consumption.
Minimum Level : The stock level below which inventories are not allowed
to deplete.
Maximum Level : The stock level, which is the highest in terms of holding
inventory.
ABC Analysis : A method of classification of inventory items basing on their
consumption value. It is technique of management by exception.
Option Pricing Model : A mechanism of price determination in contracts
that give the holder a right to acquire or sell certain things at a predetermined
price without any obligation.

8.12 SELF ASSESSMENT QUESTIONS

1) Why do firms hold inventory? Illustrate with Examples.
2) Explain different components of an inventory system?
3) What are different costs associated with holing inventory? How are they related?
4) Under what conditions, EOQ model fails to hold good?
5) Briefly discuss philosophy of different types of inventory control systems.
6) How does uncertainty affect inventory management? Explain different models of
inventory management under the condition of uncertainty.
7) If a firm adopts world-class manufacturing system, how does it affect inventory
management?
8) The contention is that the ABC analysis is no longer appropriate as the
developments in the IT technology can maintain tight control on all items. Comment.
9) Sun Corporation estimates the monthly requirements of one of its inventory items
to be as 1800 units. The cost of processing the order per unit is Rs.10.00. The
supplier agrees to offer quantity discounts as follows-
Lot size (Units) Discount (%)
Upto 400 units 0
401-600 6
601-800 9
801-1000 15
Above 1000 20

The leadtime for the supply is found to be 2 days and the company wishes to
keep a safety stock equivalent of 50% of the usage in the leadtime.
26
 a) Find EOQ assuming no discount being offered. Management of Inventory

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

c) Tabulate various costs incurred taking into account the discount offered for
various order sizes of 1, 2, 3, to 7 orders a month and indicate the EOQ.
10. The ABC Corporation carries Rs 25 million of inventory. The financial manager
is considering whether to recommend a reduction in inventory and has estimated
the impact of lowering inventory from Rs. 25 million to Rs. 23 million and to Rs.
21 million on costs and sales. The details are given below:
Costs/Inventory Level Rs.25mn Rs. 23mn Rs. 21mn
Storage costs 7,50,000 7,25,000 7,10,000
Spoilage costs 4,00,000 3,75,000 3,67,000
Daily sales 1,20,000 1,19,000 1,14,500
The company earns a contribution margin of 10% on sales. Would it be profitable
for the firm to reduce the inventory from Rs. 25mn to Rs 23mn or to Rs 21mn.?
Work out the possibilities.

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

follows:
Month 1 2 3 4 5 6
Demand(units) 100 130 125 200 210 185
Month 7 8 9 10 11 12
Demand(units) 175 190 200 251 270 255
The ordering cost for the component is Rs.50.00 per order. Purchase price per
unit is Rs.5.00 for a lot size of less than 500 units and Rs.4.80 for lot size of
500 or more units. The annual carrying cost per unit of inventory is expected to
be 30 percent of the unit purchase price. The lead-time is expected to be one
week. The entire order for the component is delivered at one time.

The department has three alternatives for ordering. The order quantity should be
equal to – (a) one-month supply, (b) two-month supply, (c) three-month supply.
Which one of these proposals would you suggest being more economical on the
basis of an annual cost comparison?

12. An engineering unit uses a component at a uniform rate of 900 units per
week. Minimum inventory is 100 units. The cost of placing and receiving an
order is Rs.200.00. Purchase price per unit is Rs. 40.00 per unit. Carrying
cost is 15% of the purchase price per unit. The leadtime is two weeks.
You are required:
a. To ascertain the value of the economic order quantity for the firm.
b. With the use of the data and calculated EOQ as above determine:
i) Reorder point.
ii) Maximum inventory.
iii) Average inventory.
iv) Average number of orders per week.
v) Average order cost per week.
vi) Average carrying cost per week.
vii) Relevant total average cost per week.
viii) Relevant total average cost per year.
13. ABC company buys an item costing Rs.125 each in lots of 500 boxes which27
is a 3 months supply and the ordering cost is Rs.150. The inventory carrying
cost is estimated to be 20% of unit value, what is the total annual cost of the
existing inventory policy? How much money could be saved by employing
EOQ model?
14. The experience of a firm being out of stock is summarised below:
Stock out No. of times
(No. of units) (%)
UNIT 9 BANK CREDIT - PRINCIPLES AND
PRACTICES
Objectives
The objectives of this unit are to explain:
• The basic principles of sound lending
• The style of Credit — their merits and demerits
• The types of security required and the modes of creating charge, and
• The methods of credit investigation
Structure
9.1 Introduction
9.2 Principles of Bank Lending
9.3 Style of Credit
9.4 Classification of Advances According to Security
9.5 Modes of Creating Charge Over Assets
9.6 Secured Advances
9.7 Purchase & Discounting of Bills
9.8 Non Fund Based Facilities
9.9 Credit Worthiness of Borrowers
9.10 Summary
9.11 Key Words
9.12 Self Assestment Questions
9.13 Further Readings
Appendix : Observations of RBI on working capital cycles and Demand for bank
credit

9.1 INTRODUCTION
Bank credit constitutes one of the major sources of Working Capital for trade and
industry. With the growth of banking institutions and the phenomenal rise in their
deposit resources, their importance as the suppliers of Working Capital has
significantly increased. Of the total gross bank credit outstanding as at the end of
August 22, 2003, of Rs.6,63,122 crore, Rs.2,78,408 crore is advanced to industry. This
works out to around 41.98 percent. More particularly, there has been significant rise
in the credit towards industry in the recent past. In this unit, first we shall examine
the basic principles of bank credit, followed by a detailed account of the various
types of credit facilities offered by banks and the securities required by them.

9.2 PRINCIPLES OF BANK LENDING

While granting loans and advances commercial banks follow the three cardinal
principles of lending. These are the principles of safety, liquidity and profitability,
which have been explained below:

1) Principle of Safety : The most important principle of lending is to ensure the

safety of the funds lent. It means that the borrower repays the amount of the
loan with interest as per the loan contract. The ability to repay the loan depends
upon the borrower’s capacity to pay as well as his willingness to repay. To
ensure the former, the banker depends upon his tangible assets and the viability
of his business to earn profits. Borrower’s willingness depends upon his honesty
and character. Banker, therefore, takes into account both the above mentioned 1
Financing Working aspects to determine the credit - worthiness of the borrower and to ensure
Capital Needs safety of the funds lent.

2) Principle of Liquidity : Banks mobilize funds through deposits which are

repayable on demand or over short to medium periods. The banker therefore
lends his funds for short period and for Working Capital purposes. These loans
are largely repayable on demand and are granted on the basis of securities
which are easily marketable so that he may realise his dues by selling the
securities.

3) Principle of Profitability: Banks are profit earning institutions. They lend their
funds to earn income out of which they pay interest to depositors, incur
operational expenses and earn profit for distribution to owners. They charge
different rates of interest according to the risk involved in lending funds to
various borrowers. However, they do not have to sacrifice safety or liquidity for
the sake of higher profitability.

Following the above principles banks pursue the practice of diversifying risk by
spreading advances over a reasonably wide area, distributed amongst a good number
of customers belonging to different trades and industries. Loans are not granted for
speculative and unproductive purposes

9.3 STYLE OF CREDIT

Commercial banks provide finance for working capital purposes through a variety of
methods. The main systems or style of credit, prevalent in India are depicted in the
following diagram.
Bank Credit

Loans and advances Discounting of bills

Overdrafts Cash Credit Loans

Short term Medium & Bridge Composite

Personal
Loans Long term loans loans
loans
loans
The terms and conditions, the rights and privileges of the borrower and the banker
differ in each case. We shall discuss below these methods of granting bank credit.

9.3.1 Overdrafts
This facility is allowed to the current account holders for a short period. Under this
facility, the current account holder is permitted by the banker to draw from his
2
account more than what stands to his credit. The excess amount drawn by him is
deemed as an advance taken from the bank. Interest on the exact amount
overdrawn by the account-holder is charged for the period of actual utilisation. The
banker may grant such an advance either on the basis of collateral security or on the
personal security of the borrower. Overdraft facility is granted by a bank on an
application made by the borrower. He is also required to sign a promissory note.
Therefore, the customer is allowed the amount, upto the sanctioned limit of overdraft
as and when he needs it. He is permitted to repay the loan as per his convenience
and ability to do so.

9.3.2 Cash Credit System

Cash Credit System accounts for the major portion of bank credit in India. The
salient features of this system are as follows:
1) Under this system, the banker prescribes a limit, called the Cash Credit limit,
upto which the customer- borrower is permitted to borrow against the security
of tangible assets or guarantees.
2) The banker fixes the Cash Credit limit after considering various aspects of the
working of the borrowing concern i.e production, sales ,inventory levels, past
utilisation of such limit, etc.
3) The borrower is permitted to withdraw from his Cash Credit account, amount as
and when he needs them. Surplus funds with him are allowed to be deposited
with the banker any time. The Cash Credit account is thus a running account,
wherein withdrawals and deposits may be made frequently any number of times.
4) As the borrower withdraws from Cash Credit account he is required to provide
security of tangible assets. A charge is created on the movable assets of the
borrower in favour of the banker.
5) When the borrower repays the borrowed amount in full or in part, security is
released to him in the same proportion in which the amount is refunded.
6) The banker charges interest on the actual amount utilised by him and for the
actual period of utilisation.
7) Though the advance made under Cash Credit System is repayable on demand
and there is no specific date of repayment, in practice the advance is rolled over
a period of time i.e. the debit balance is hardly fully wiped out and the loan
continues from one period to another.
8) Under this system, the banker keeps adequate cash balance to meet the
demand of his customers as and when it arises, but interest is charged on the
actual amount of loan availed of. Thus, to neutralize the loss caused to the
banker, the latter imposes a commitment charge at a normal rate of 1% or so, on
the unutilised portion of the cash credit limit.

Merits of Cash Credit System

The Cash Credit System has the following merits:

1) The borrower need not keep surplus funds idle with himself. He can deposit the
surplus funds with the banker, reduce his debit balance, and thus minimise the
interest burden. On the other hand he can withdraw funds at any time to meet
his needs.

2) Banks maintain one account for all transactions of a customer. As documents

are required only once in a year the costs of repetitive documentation is avoided.
3
Financing Working Demerits of Cash Credit System
Capital Needs
The Cash Credit System, on the other hand, suffers from the following demerits:
1) Cash Credit limits are prescribed only once in a year and hence they are fixed
keeping in view the maximum amount that can be required within a year.
Consequently, a portion remains unutilised for part of the year during which bank
funds remain unemployed.

2) The banker remains unable to verify the end use of funds borrowed by the
customer. Such funds may be diverted to unapproved purposes.

3) The banker remains unable to plan the utilisation of his funds as the level of
advances depends upon the borrower’s decision to borrow at any time.

4) As the volume of cash transactions increases significantly under the cash

credit system as against the loan system, the cost of handling cash, honouring
cheques, taking and giving delivery of securities increases the transactions cost
of banks.

5) As there is only commitment charge of 1% or less, there will be a tendency on

the part of companies to negotiate for a higher limit.

9.3.3 Loan System

Under the loan system, a definite amount is lent at a time for a specific period and a
definite purpose. It is withdrawn by the borrower once and interest is payable for the
entire period for which it is granted. It may be repayable in instalments or in lump
sum. If the borrower needs funds again , or wants to renew an existing loan, a fresh
proposal is placed before the banker. The banker will make a fresh decision
depending upon the availability of cash resources. Even if the full loan amount is not
utilised the borrower has to pay the full interest.

Advantages of the Loan System

The loan system has the following advantages over the Cash Credit System:

1) This system imposes greater financial discipline on the borrowers, as they are
bound to repay the entire loan or its instalments on the due date/ dates fixed in
advance.

2) At the time of granting a new loan or renewing an existing loan, the banker
reviews the loan account. Thus unsatisfactory loan accounts may be
discontinued at his discretion.

3) As the banker is entitled to charge interest on the entire amount of loan, his
income from interest is higher and his profitability also increases because of
lower transaction cost.

Short Term Loans

Short term loans are granted by banks to meet the Working Capital requirements of
the borrowers. Such loans are usually granted for a period upto one year and are
secured by the tangible movable assets of the borrowers like goods and commodities,
shares, debentures etc. Such goods and securities are pledged or hypothecated with
the banker.

As we shall study in the next unit. Reserve Bank of India has exercised compulsion
on banks since 1995 to grant 80% of the bank credit permissible to borrowers with
credit of Rs 10 crore or more in the form of short term loans which may be for
4
various maturities. Reserve Bank has also permitted the banks to roll over such
loans i.e. to renew the loan for another period at the expiry of the period of the first
loan.

Medium and Long Term Loans

Such loans are generally called ‘Term Loans’ and are granted by banks with All
India Financial institutions like Industrial Development Bank of India, Industrial
Finance Corporation of India, Industrial Credit and Investment Corporation of India
Ltd. Term loans are granted for medium and long terms, generally above 3 years
and are meant for purchase of capital assets for the establishment of new units and
for expansion or diversification of an existing unit . At the time of setting up of a new
industrial unit, term loans constitute a part of the project finance which the
entrepreneurs are required to raise from different sources. These loans are usually
secured by the tangible assets like land, building, plant and machinery etc. In October
1997 Reserve Bank of India permitted the banks to announce separate prime
lending rate for term loans of 3 years and above. In April 1999 Reserve bank of
India also permitted the banks to offer fixed rate loans for project financing. Reserve
Bank of India has encouraged the banks to lend for project finance as well. In
September, 1997 ceiling on the quantum of the term loans granted by banks
individually or in consortia/syndicate for a single project was abolished. Banks now
have the discretion to sanction term loans to all projects within the overall ceiling of
the prudential exposure norms prescribed by Reserve bank. ( Fully discussed in the
next unit). The period of term loans will also be decided by banks themselves.

Though term loans are meant for meeting the project cost but as project cost
includes margin for Working Capital , a part of term loans essentially goes to meet
the needs of Working Capital.

Bridge Loans
Bridge loans are in fact short term loans which are granted to industrial undertakings
to enable them to meet their urgent and essential needs. Such loans are granted
under the following circumstances:

1) When a term loan has been sanctioned by banks and/ or financial institutions, but
its actual disbursement will take time as necessary formalities are yet to be
completed.

2) When the company is taking necessary steps to raise the funds from the Capital
market by issue of equities/debt instruments.

Bridge loans are provided by banks or by the financial institutions which have
granted term loans. Such loans are automatically repaid out of the amount of term
loan when it is disbursed or out of the funds raised from the Capital Market.

Reserve Bank of India has allowed the banks to grant such loans within the ceiling
of 5% of incremental deposits of the previous year prescribed for individual banks’
investment in Shares/ Convertible debentures. Bridge loans may be granted for a
maximum period of one year.

Composite Loans

Composite loans are those loans which are granted for both, investment in capital
assets as well as for working capital purposes. Such loans are usually granted to
small borrowers, such as artisans, farmers, small industries etc. Under the
composite loan scheme, both term loans and Working Capital are provided through
a single window. The limit for composite loans has recently (in Feb., 2000) been
increased from Rs. 5 lakhs to Rs.10 lakhs for small borrowers.
5
Financing Working Personal Loans
Capital Needs
These loans are granted by banks to individuals specially the salary-earners and
others with regular income, to purchase consumer durable goods like refrigerators,
T.Vs., cars etc. Personal loans are also granted for purchase/construction of houses.
Generally the amount of loans is fixed as a multiple of the borrower’s income and a
repayment schedule is prepared as per his capacity to save.
Activity 9.1
1) What do you understand by Margin money for Working Capital? How is it
financed?
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Explain three important demerits of the Cash Credit System
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) What do you understand by Term Loans? For what purposes are they granted
by banks? What is Reserve Bank’s directive to banks in this regard?
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................
4) What is meant by Bridge Loan? What is the necessity for granting such loans.
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................
5) Elucidate the principles of Bank lending.
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................

9.4 CLASSIFICATION OF ADVANCES ACCORDING

TO SECURITY
Banks attach great importance to the safety of the funds, lent as loans and
advances. For this purpose, they ask the borrowers to create a charge on their
6
tangible assets in their favour. In some cases, the banks secure their interest by
asking for a guarantee given by a third party. Besides the tangible assets or a
guarantee, banks rely upon the personal security of the borrower and grant loans
which are called unsecured advances’ or ‘clean loans’. In the balance sheet, banks
classify advances as follows:

Advances

Secured by Covered by Unsecured

Tangible Assets Bank /Govt. Guarantees

Secured Advances

According to Banking Regulation Act 1949, a secured loan or advance means “a

loan or advance made on the security of assets, the market value of which is not at
any time less than the amount of such loan or advances”. An unsecured loan or
advance means a loan or advance not so secured.

The main features of a secured loan are:

1) The advance is made on the basis of security of tangible assets like goods and
commodities, life insurance policies, corporate and government securities etc.

2) A charge is created on such security in favour of the banker.

3) The market value of such security is not less than the amount of loan. If the
former is less than the latter, it becomes a partly secured loan.

Unsecured Advances

Unsecured advances are granted without asking the borrower to create a charge on
his assets in favour of the banker. In such cases the security happens to be the
personal obligation of the borrower regarding repayment of the loan. Such loans are
granted to parties enjoying high reputation and sound financial position.

The legal status of the banker in case of a secured advance is that of a secured
creditor. He possesses absolute right to recover his dues from the borrower out of
the sale proceeds of the assets over which a charge is created in his favour. In case
of an unsecured advance, a banker remains an unsecured creditor and stand at par
with other unsecured creditors of the borrower, if the latter defaults.

Guaranteed Advances

The banker often safeguards his interest by asking the borrower to provide a
guarantee by a third party may be an individual, a bank or Government. According
to the Indian Contract Act, 1872, a contract of guarantee is defined as “a contract to
perform the promise or discharge the liability of third person is case of his
default”. The person who undertakes this obligation to discharge the liability of
another person is called the guarantor or the surety. Thus a guaranted advance is, in
fact, also an unsecured advance i.e. without any specific charge being created on
any asset, in favour of the banker. A guarantee carries a personal security of two
persons i.e. the principal debtor and the surety to perform the promise of the
principal debtor. If the latter fails to fulfill his promise, liability of the surety arises
immediately and automatically. The surety therefore, must be a reliable person
considered good for the amount for which he has stood as surety. The guarantee
given by banks, financial institutions and the government are therefore considered 7
Financing Working valuable.
Capital Needs

9.5 MODES OF CREATING CHARGE OVER

ASSETS
As we have noted above, in case of secured advance, a charge is created over an
asset of the borrower in favour of the lender. By creation of charge it is meant that
the banker gets certain rights in the tangible assets of the borrower. The borrower
still remains the owner of the asset, but the banker gets the right of realizing his dues
out of the sale proceeds of the asset. Thus banker’s interest is safeguarded.

There are several methods of creating charge over the borrower’s assets as shown
below:
Modes of Creating charge

Pledge Hypothecation Mortgage Lien Assignment

9.5.1 Pledge
Pledge is the most popular method of creating charge over the movable assets.
Indian Contract Act, 1872, defines pledge as ‘bailment of goods as security of
payment of a debt or performance of a promise”. The person who offers the
security is called the pledger and the person to whom the goods are entrusted is
called the ‘pledgee’ . Thus bailment of goods is the essence of a pledge. Indian
Contract Act defines bailment as “delivery of goods from one person to another for
some purpose upon the contract that the goods be returned back when the purpose is
accomplished or otherwise disposed of according to the instructions of the bailor”.

Thus when the borrower pledges his goods with the banker, he delivers the goods to
the banker to be retained by him as security for the amount of the loan. Delivery of
goods may be either (i) physical delivery or (ii) constructive or symbolic delivery.
The latter does not involve physical delivery of the goods. The handing over of the
keys of the godown storing the goods, or even handing over the documents of the title
to goods like warehouse receipts, duly endorsed in favour of the banker amounts to
constructive delivery.

It is also essential that the banker must return the same goods to the borrower after
he repays the amount of loan along with interest and other charges. The pledgee
(banker) is entitled to certain rights, which are conferred upon him by the Indian
Contract Act. The foremost right is that he can retain the goods pledged for the
payment of debt and interest and other charges payable by the borrower. In case the
pledger defaults, the pledgee has the right to sell the goods after giving pledger
reasonable notice of sale or to file a suit for the amount due from him.

9.5.2 Hypothecation
Hypothecation is another method of creating charge over the movable assets of the
borrower. It is preferred in circumstances in which transfer of possession over
such assets is either inconvenient or is impracticable. For example, if the borrower
wants to borrow on the security of raw materials or goods in process, which are to be
converted into finished products, transfer of possession is not possible/practicable
8
because his business will be impeded in case of such transfer. Similarly a transporter
needs the vehicle for plying on the road and hence cannot give its possession to the
banker for taking a loan. In such circumstances a charge is created by way of
hypothecation.

Under hypothecation, neither ownership nor possession over the asset is transferred
to the creditor. Only an equitable charge is created in favour of the banker. The
asset remains in the possession of the borrower who promises to give possession
thereof to the banker, whenever the latter requires him to do so. The charge of
hypothecation is thus converted into that of a pledge. The banker enjoys the rights
and powers of a pledgee. The borrower uses the asset in any manner he likes, viz he
may take out the stock, sell it and replenish it by a new one. Thus a charge is
created on the movable asset of the borrower. The borrower is deemed to hold
possession over the goods as an agent of the creditor. To enforce the security, the
banker should take possession of the hypothecated asset on his own or through the
court.

9.5.3 Mortgage
A charge on immovable property like land & building is created by means of a
mortgage. Transfer of Property Act 1882 defines mortgage as” the transfer of an
interest in specific immovable property for the purpose of securing the payment
of money, advanced or to be advanced by way of loan, an existing or future
debt or the performance of an engagement which give rise to a pecuniary
liability”. The transferor is called the ‘mortgagor’ and the transferee ‘mortgagee’.

The owner transfers some of the rights of ownership to the mortgagee and retains
the remaining with himself. The object of transfer of interest in the property must
be to secure a loan or to ensure the performance of an engagement which results in
monetary obligation. It is not necessary that actual possession of the property be
passed on to the mortgagee. The mortgagee, however, gets the right to recover the
amount of the loan out of the sale proceeds of the mortgaged property. The
mortgagor gets back the interest in the mortgaged property on repayment of the
amount of the loan along with interest and other charges.

Kinds of Mortgages

Though Transfer of Property Act specifies seven kinds of mortgages, but from the
point of view of transfer of title to the mortgaged property, mortgages are divided
into-
a) Legal mortgages and
b) Equitable mortgages
In case of Legal Mortgage, the mortgagor transfers legal title to the property in
favour of the mortgagee by executing the Mortgage deed. When the mortgage
money is repaid, the legal title to the mortgaged property is re-transferred to the
mortgagor. Thus in this type of mortgage expenses are incurred in the form of stamp
duty and registration charges.

In case of an equitable mortgage the mortgagor hands over the documents of title to
the property to the mortgagee and thus creates an equitable interest of the mortgagee
in the mortgaged property. The legal title to the property is not passed on to the
mortgagee but the mortgagor undertakes through a Memorandum of Deposit to
execute a legal mortgage in case he fails to pay the mortgaged money. In such
situation the mortgagee is empowered to apply to the court to convert the equitable
mortgage into legal mortgage.

Equitable Mortgage has several advantages over Legal Mortgage. It is not 9

Financing Working necessary to register the Memorandum of Deposit or the covering letter sent along
Capital Needs with the Documents of title. Actual handing over by a borrower to the lender of
documents of title to immovable property with the intention to constitute them as
security is sufficient. As registration is not mandatory, information regarding
mortgage remains confidential and the mortgagor’s reputation is not affected. When
the debt is repaid documents are returned back to the borrower, who may re-deposit
the same for taking another loan against the same documents. But the banker should
be very careful in retaining the documents in his possession, because if the equitable
mortgagee is negligent or mis-represents to another person, who advances money on
the security of the mortgaged property, the right of the latter will have first priority.

9.5.4 Assignment
The borrower may provide security to the banker by assigning any of his rights,
properties or debts to the banker. The transferor is called the ‘assignor’ and the
transferee the ‘assignee’. The borrowers generally assign the actionable claims to
the banker under section 130 of the Transfer of Property Act 1882. Actionable claim
is defined as a claim to any debt, other than a debt secured by mortgage of
immovable property or by hypothecation or pledge of movable property or to any
beneficial interest in movable property not in the possession of the claimant.
A borrower may assign to the banker(i)the book debts, (ii) money due from a
government department or semi-government organisation and (iii)life insurance
policies.
Assignment may be either a legal assignment or an equitable assignment. In case of
legal assignment, there is absolute transfer of actionable claim which must be in
writing. The debtor of the assignor is informed about the assignment. In the
absence of the above the assignment is called equitable assignment.

9.5.5 Lien
The Indian Contract Act confers upon the banker the right of general lien. The
banker is empowered to retain all securities of the customer, in respect of the general
balance due from him. The banker gets the right to retain the securities handed over
to him in his capacity as a banker till his dues are paid by the borrower. It is deemed
as implied pledge.

Activity 9.2
1) Distinguish between a secured advance and a guaranteed advance.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
2) Distinguish between pledge and hypothecation. Which provides better security
to the banker and why?
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
3) What do you understand by Equitable Mortgage? What are its advantages
vis-a-vis legal mortgage?

10
.......................................................................................................................
 .......................................................................................................................
.......................................................................................................................
.......................................................................................................................

9.6 SECURED ADVANCES

Secured advances account for significant portion of total advances granted by banks.
As we have seen, in case of secured advances, a charge is created on the assets of
the borrowers in favour of the banker, which enables him to realise his dues out of
the sale proceeds of the assets. Banks grant advances against a variety of assets as
shown below:
Securities for Advances

Goods & Documents Real Estates Book Supply

Commodities Debts Bills

Documents of Stock Exchange Life Insurance Fixed Deposit

Title to goods Securities Policies Receipts

Let us first study the general principle of secured advances:

1) Marketability of Securities: The banker grants advances on the basis of those

securities which are easily marketable without loss of time and money, because
in case of non-payment by the borrower, the banker shall have to dispose off the
security to realise his dues.

2) Adequacy of Margin : Banker also maintains a difference between the value

of the security and the amount lent. This is called ‘ margin’. Suppose a banker
grants a loan of Rs. 100 /- on the security valued at Rs. 200/- the difference
between the two (i.e. Rs. 200 - Rs. 100 = Rs. 100) is called margin. Margin is
necessary to safeguard the interest of the banker as the market value of the
security may fall in future and /or interest and other charges become payable by
the borrower , thus increasing the liability of the borrower towards the banker.
Different margins are prescribed in case of different securities.

3) Documentation: Banker also requires the borrower to execute the necessary

documents e.g. Agreement of pledge, Mortgage Deed, Promissory notes etc. to
safeguard his interest.

Goods and Commodities

Bulk of the advances granted by banks are secured by goods and commodities, raw
material and finished goods etc., which constitute the stock-in-trade of business
houses. However, agricultural commodities are likely to deteriorate in quality over a
period of time. Hence banks grant short term loans only against such commodities .
The problem of valuation of stock pledged with the bank is not a difficult one, as
daily quotations are easily available. Banker usually prefers those commodities which
have steady demand and a wider market. Such goods are required to be insured
against fire and other risks. Such goods either pledged or hypothecated to the banker
are released to the borrower in proportion to the amount of loan repaid.

Agro-based commodities such as foodgrains, sugar, pulses, oilseeds, cotton are

11
Financing Working sensitive to the market forces of demand and supply and prices. As our country has
Capital Needs faced seasonal shortages in several of these commodities, the reserve bank of India
under the authority vested in it by the Banking Regulation Act, issues directives
known as Selective Credit Control (SCC) to scheduled commercial banks during the
commencement of each busy season which is, in practical terms, the commencement
of the Kharif or the Rabi season each year. In order to ensure that speculation in
these sensitive commodities does not take place, the Reserve Bank of India in its
busy season policy issues direction to control the credit for commodities by:
i) Fixing an overall ceiling for credit to sensitive commodities for each bank as
whole. For example, total credit against these commodities in a particular year
may be restricted to 80% of the previous year’s level;
ii) Fixing margins and rates of interest that can be levied by banks in their credit
against the selected commodities; and
iii) Banning the flow of bank credit towards financing one or more of these selected
commodities.
Each bank takes into consideration the RBI’s policy on selective credit control while
determining its own credit policy. The Head Offices of banks advise their branches
on the terms and conditions applicable to SCC commodities.
Documents of Title to Goods

These documents represent actual goods in the possession of some other person.
Hence they are proof of possession or control over the goods. For example,
warehouse receipts, railway receipts, Bill of lading etc. are documents of title to
goods. When the owner of goods represented by these documents wants to take a
loan from the banker, he endorses such documents in favour of the banker and
delivers them to him. The banker is thus entitled to receive the delivery of such
goods, if the advance is not repaid. However, there remains the risk of forgery in
such documents and dishonesty on the part of the borrower.

Stock Exchange Securities

Stock Exchange Securities comprise of the securities issued by the Central and State
governments, semi-govt. orgaisations, like Port Trust & Improvement Trust, Shares
and Debentures of companies and Units of the Mutual Funds listed on the Stock
Exchanges. The Govt. securities are accepted by banks because of their easy
liquidity, stability in prices, regular accrual of income and easy transferability.
In case of corporate securities banks prefer debentures of companies vis-à-vis shares
because the debenture holder generally happens to be secured creditor and there is a
contractual obligation on the company to pay interest thereon regularly. Amongst the
shares, banks prefer preference shares, because of the preferential rights enjoyed
by the preference shareholders over equity shareholders. Banks accept equity
shares of those companies which they approve after thorough screening and
examination of all aspects of their working. A charge over such securities is created
in favour of the banker.

Reserve Bank of India has permitted the banks to grant advances against shares to
individuals upto Rs. 20 lakhs w.e.f. April 29, 1998 if the advances are secured by
dematerialized Securities. The minimum margin against such dematerialized shares
was also reduced to 25%. Advances can also be granted to investment companies,
shares & stock brokers, after making a careful assessment of their requirements.

Life Insurance Policies

A life insurance policy is considered a suitable security by a banker as repayment of

12 loan is ensured to the banker either at the time policy matures or at the time of death
of the insured. Moreover, the policy has a surrender value which is paid by the
insurance company, if the policy is discontinued after a minimum period has lapsed.
The policy can be legally assigned to the banker and the assignment may be
registered in the books of the insurance company. Banks prefer endowment policies
as compared to the whole life policies and insist that the premium is paid regularly
by the insured.

Fixed Deposit Receipts

A Fixed Deposit Receipt issued by the same bank is the safest security for granting
an advance because the receipt represent a debt due from the banker to the
customer. At the time of taking a loan against fixed deposit receipt the depositor
hands over the receipt to the banker duly discharged, along with a memorandum of
pledge. The banker is thus authorised by the depositor to appropriate the amount of
the FDR towards the repayment of loan taken from the banker.

Real Estate
Real Estate i.e. immovable property like land and building are generally not regarded
suitable security for granting loans for working capital. It is difficult to ascertain that
the legal title of the owner is free from any encumbrance. Moreover, their valuation
is a difficult task and they are not readily realizable assets. Preparation of mortgage
deed and its registration takes time and is expensive also. Real Estates are,
therefore, taken as security for term loans only.

Book Debts
Sometimes the debts which the borrower has to realise from his debtors are assigned
to the banker in order to secure a loan taken from the banker. Such debts have either
become due or will accure due in the near future. The assignor must execute an
instrument in writing for this purpose, clearly expressing his intention to pass on his
interest in the debt to the assigner (banker). He may also pass an order to his debtor
to pay the assigned debt to the banker.

Supply Bills
Banks also grant advance on the security of supply bills. These bills are offered as
security by persons who supply goods, articles or materials to various Govt.
departments, semi-govt. bodies and companies, and by the contractors who undertake
govt. contract work. After the goods are supplied by the suppliers to the govt.
department and he obtains an inspection note or Receipted Challan from the Deptt.,
he prepares a bill for the goods supplied and gives it to the bank for collection and
seeks an advance against such supply bills. Such bills are paid by the purchaser at
the expiry of the stipulated period.

Security for bank credit could be in the form of a direct security or an indirect
security. Direct security includes the stocks and receivables of the customers on
which a charge is created by the bank through various security documents. If in the
view of the bank, the primary or direct security is not considered adequate or is risk-
prone, that is, subject to heavy fluctuations in prices, quality etc., the bank may
require additional security either from the customer or from a third party on
behalf of the customer. The additional security so obtained is known as Indirect or
“Collateral Security”. The term collateral means running parallel or together and
collateral security is an additional and separate security for repayment of money
borrowed.

In case the customer is unable to provide additional security when required by the
bank, he may be required to provide collateral security from a third party. The
common form of the third party collateral security is a guarantee given by a person
on behalf of the customer to the bank. The third party collateral security in turn may
13
Financing Working be unsecured or secured. For example, where the guarantor has executed a guaran-
Capital Needs tee agreement only, The collateral security is unsecured. However, if he lodges along
with the guarantee agreement, security such as title deeds to his property creating
mortgage by deposit of title deeds with the bank, a secured collateral security is
created.

9.7 PURCHASE AND DISCOUNTING OF BILLS

Purchase and discounting of bills of exchange is another way banks provide credit to
business entities. Bills of exchange and promissory notes are negotiable instruments
which arise out of commercial transactions both in inland trade and foreign trade and
enable the debtors to discharge their obligations towards their creditors.

On the basis of maturity period , bills are classified into (i) demand bills and (ii)
usance bills. When a bill is payable ‘at sight’ ‘on demand’ or on presentment, it is
called a demand bill. If it matures for payment after a certain period of time say
30,60,90 days , after date or sight, it is called a usance bill. No stamp duty is required
in case of demand bills and on usance bills, if they (i) arise out of the bona fide
commercial transactions , (ii) are payable not more than 3 months after date or sight
and (iii) are drawn on or made by or in favour of a commercial or cooperative bank.

When the drawer of a bill encloses with the bill documents of title to goods, such as
the railway receipt or motor transport receipt, to be delivered to the drawee , such
bills are called documentary bills. When no such documents are attached the bill is
called a clean bill. In case of documentary bills, the documents may be delivered on
accepting the bill or on making its payment. In the former case it is called
Documents against Acceptance (D/A) basis, and in the latter case Documents
against Payment (D/P) basis. In case of a clean bill, the relevant documents of title
to goods are sent directly to the drawee.

Procedure for Discounting of Bills

When the seller of the goods draws a bill of exchange on the buyer (debtor), he has
two options to deal with the bill.
a) to send the bill to a bank for collection, or
b) to sell it to, or discount it with, a bank
When the bill is sent to the bank for collection the banker acts as the agent of the
drawer and makes its payment to him only on the realisation of the bill from the
drawee. The banker sends it to its branch at the drawee’s place, which presents it
before the drawee, collects the amount and remits it to the collecting banker, who
credits the same to the drawer’s account. In case of collection of bills, the bank acts
as an agent of the drawer of the bill and does not lend his funds by giving credit
before actual realisation of the bill.

The business of purchasing and discounting of bills differs from that of collection of
bills. In case of purchase/discounting of bills, the bank credits the amount of the bill
to the drawer’s account before its actual realisation from the drawee. The banker
thus lends his own funds to the drawer of the bill. Bills purchased or discounted are
therefore, shown under the head ‘ Loans and Advances’ in the Balance Sheet of a
bank.

The practice adopted in case of demand bills is known as purchase of bills. As

demand bills are payable on demand, and there is no maturity, the banker is entitled to
demand its payment immediately on its presentation before the drawee. Thus the
money credited to the drawer’s account, after deducting charges/discount, is realised
by the banker within a few days.
14
In case of a usance bill maturing after a period of time generally 30,60,or 90 days,
therefore, banker discounts the bill i.e. credits the amount of the bill, less the amount
of discount, to the drawer’s account. Thereafter, the bill is sent to the bank’s branch
at the drawee’s place which presents it to the drawee for acceptance. Documents
of title to goods, if enclosed with the bills, are released to him on accepting the bill.
The bill is thereafter retained by the banker till maturity, when it is presented to the
acceptor of the bill for payment.

Advantages of Discounting of Bills

A banker derives the following advantages by discounting the bills of exchange:

1) Safety of funds lent

Though the banker does not get charge over any tangible asset of the borrower in
case of discounting of bills, his interest is safeguarded by the fact that the bills of
exchange contains signatures of two parties—the drawer and the drawee
(acceptor)— who are responsible to make payment of the bill. If the acceptor fails
to make payment of the bill the banker can claim the whole amount from his
customer, the drawer of the bill. The banker can debit the customer’s account and
recover the money on the due date. The banker is able to recover the amount as he
discounts the bills drawn by parties of standing and good reputation.

2) Certainty of payment

Every usance bill matures on a certain date. Three days of grace are allowed to the
acceptor to make payment. Thus, the amount lent to the customer by discounting the
bills is definitely recovered by the banker on its due date. The banker knows the date
of payment of the bills and hence can plan the utilisation of his funds well in
advance and with profit.

3) Facility of re-discounting of bills

The banker can augment his funds, if need arises, by re-discounting the bills, already
discounted by him, with the Reserve Bank of India, other banks and financial
institutions and the Discount and Finance House of India Ltd. Reserve Bank of
India can also grant loans to the banks on the basis of the bills held by them.

4) Stability in the value of bills

The value of the bills remains fixed and unchanged while the value of all other goods,
commodities and securities fluctuate over period of time.

5) Profitability

In case of discounting of bills, the amount of interest (called discount) is deducted in

advance from the amount of the bill. Hence the effective yield is higher than loans
and advances where interest is payable quarterly/half yearly.

Derivative Usance Promissory Notes

As noted above, banks may re-discount the discounted bills of exchange with other
banks and financial institutions. For this purpose, under the normal procedure, the
bills are endorsed in favour of the re-discounting bank /institution and delivered to it.
At the time of maturity reverse process is required.

To simplify the procedure of re-discounting, Reserve Bank of India has dispensed

with the necessity of physical lodgment of the discounted bills. Instead, banks are
permitted, on the basis of such discounted bills, to prepare derivative usance
15
Financing Working promissory notes for suitable amounts like Rs. 5 lakh or Rs. 10 lakh and for suitable
Capital Needs maturities like 60 days or 90 days. These derivative usance promissory notes are re-
discounted with the re-discounting bank or institution. The essential condition is that
the derivative promissory note should be backed by unencumbered bills of exchange
of atleast equal value till the date of maturity. In the meanwhile, any maturing bill
may be replaced by another bill for equal amount. No stamp duty is required on such
derivative usuance promissory notes.

Compulsion on the Use of Bills

To encourage the use of bills of exchange by corporate borrowers, the Reserve Bank
of India had directed the commercial banks to advice their corporate borrowers to
finance their domestic credit purchases from small scale industrial units as well as
from others at least to the extent of 25 percent by way of acceptance of bills drawn
upon them by their suppliers. This was to be stipulated as a condition for sanctioning
working capital credit limits. Banks were also authorized to charge an additional
interest from those borrowers who did not comply with this requirements in any
quarter. In October 1999 Reserve bank of India permitted the banks to charge
interest rate on discounting of bills without reference to Prime Lending Rate. They
are now free to offer competitive rate of interest on the bill discounting facility. The
above-mentioned compulsion was also withdrawn.
Revised Guidelines of RBI on Discounting of Bills
• Banks may sanction working capital limits as also bills limits to borrowers after
proper appraisal of their credit needs and in accordance with the loan policy as
approved by their Board of Directors.
• Banks are required to open letters of credit (LCs) and purchase /discount/
negotiate bills under LCs only in respect of genuine commercial and trade
transactions of their borrower constituents who have been sanctioned regular
credit facilities by them.
• For the purpose of credit exposure, bills purchased discounted/negotiated under
LCs or otherwise would be reckoned as exposure on the bank’s borrower
constituent. Accordingly, the exposure should attract a risk-weight appropriate to
the borrower constituent (viz.,100 per cent for firms, individuals, corporates) for
capital adequacy purposes.
• Banks have been permitted to exercise their commercial judgment in discounting
of bills of services sector. Banks would need to ensure that actual services are
rendered and accommodation bills are not discounted. Services sector bills should
not be eligible for rediscounting.
Bank Credit Through Debt Instruments

During recent years, banks have resorted to granting large credit to the corporate
sector and the public sector undertakings by investing in their debt instruments like
bonds, debentures and commercial paper. Banks find excess liquidity with them in
the midst of low off take of credit, by the corporate sector. Taking advantage of such
a situation, companies prefer to raise funds by way of private placement of their
bonds, debentures and commercial paper. During 1998-99 roughly Rs. 35, 000 crore
was raised from debt instruments only through private placements. Most of this
was subscribed by the banks. Their outstanding investment in debt paper was Rs.
41,458 crore as at the end March, 1999 as against Rs. 28,378 crore a year earlier.
Investment in C.P.s stood at Rs. 4,033 crore at the end of March 1999. Thus
corporates have been able to raise funds from the investors (including banks) at
rates lower than the prime lending rates of banks.

Moreover, investment in debt instruments is not reckoned as bank credit and hence
16
does not entail bank’s obligation to grant advances to priority sectors based thereon.
Further, the relaxation granted by Reserve Bank of India in April 1997 to the banks to
invest in the bonds and debentures of private corporate sector without any limit, has
also contributed to the greater flow of bank credit through debt instruments.

9.8 NON FUND BASED FACILITIES

The credit facilities explained above are fund based facilities wherein funds are
provided to the borrower for meeting their working capital needs. Banks also provide
non-fund based facilities to the customers. Such facilities include ( i ) letters of credit
and (ii) bank guarantees. Under these facilities, banks do not immediately provide
credit to the customers, but take upon themselves the liability to make payment in
case the borrower defaults in making payment or performing the promise undertaken
by him.

Letter of Credit

A letter of Credit(L/C) is a written undertaking given by a bank on behalf of its

customer, who is a buyer , to the seller of goods, promising to pay a certain sum of
money provided the seller complies with the terms and conditions given in the L/C. A
Letter of Credit is generally required when the seller of goods and services deals
with unknown parties or otherwise feels the necessity to safeguard his interest.
Under such circumstances, he asks the buyer to arrange a letter of credit from his
banker. The banker issuing the L/C commits to make payment of the amount
mentioned therein to the seller of the goods, provided the latter supplies the specified
goods within the specified period and comply with other terms and conditions.

Thus by issuing Letter of Credit on behalf of their customers, banks help them in
buying goods on credit from sellers who are quite unknown to them. The banker
issuing L/C undertakes an unconditional obligation upon himself, and charge a fee
for the same. L/Cs may be revocable or irrevocable. In the latter case, the
undertaking given by the banker cannot be revoked or withdrawn.

Bank Guarantee

Banks issue guarantees to third parties on behalf of their customers. These

guarantees are classified into (i) Financial guarantee, and (ii) Performance
guarantee. In case of the financial guarantees, the banker guarantees the repayment
of money on default by the customer or the payment of money when the customer
purchases the capital goods on deferred payment basis.

A bank guarantee which guarantees the satisfactory performance of an act, say

completion of a construction work undertaken by the customer, failing which the bank
will make good the loss suffered by the beneficiary is known as a performance
guarantee.

9.9 CREDIT WORTHINESS OF BORROWERS

The business of granting advances is a risky one. It is more risky specially in case of
unsecured advances. The safety of the advance depends upon the honesty and
integrity of the borrower, apart from the worth of his tangible assets. The banker
has, therefore, to investigate into the borrower’s ability to pay as well as his
willingness to pay the debt taken. Such an exercise is called credit investigation.
Its aim is to determine the amount for which a person is considered creditworthy.
Credit worthiness is judged by a banker on the basis of borrower’s ( i ) character, (ii)
capacity and (iii) capital.
17
Financing Working 1) Character includes a number of personal characteristics of a person e.g his
Capital Needs honesty, integrity, promptness in fulfilling his promises and repaying the dues,
sense of responsibility, reputation and goodwill enjoyed by him. A person having
all these qualities, without any doubt in the minds of others , possesses, an
excellent character and hence his creditworthiness is considered high.

2) Capacity If the borrower possesses necessary technical skill, managerial ability

and experience to run a particular business or industry, success of such an
enterprise is taken for granted except in some unforeseen circumstances, Such a
person is considered creditworthy by the banker.

3) Capital The borrower is also expected to have financial stake in the business,
because in case the business fails, the banker will be able to realise his money
out of the capital put in by the borrower. It is a sound principle of finance that
debt must be supported by sufficient equity.

The relative importance of the above factors differs from banker to banker and from
borrower to borrower. Banks are granting advances to technically qualified and
experienced entrepreneurs but they are required to put in a small amount as their own
capital. Reserve Bank of India has recently directed the banks to dispense with the
collateral requirement for loans upto Rs. 1 lakh. This limit has recently been further
increased to Rs. 5 lakh for the tiny sector.
Determination of credit worthiness of a borrower has become now a more scientific
exercise. Special institutions like rating companies such as CRISIL, ICRA, CARE,
have come on to the field and each of them has developed a methodology of its own.
This was discussed in earlier Block under Receivables Management in more detail.
Activity 9.3
1) Why do banks prefer Govt. and semi-govt. securities vis-à-vis Corporate
Securities for granting credit? Amongst the Corporate Securities why do they
prefer debt instruments?
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) What are the advantages of discounting of bills to the banks? Is it compulsory
for corporate borrowers to use bills of Exchange?
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) What do you understand by credit-worthiness of a borrower? What factors are
taken into account by the banker to determine credit-worthiness?
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................

9.10 SUMMARY
18
In this unit we have discussed the basic concepts, principles and practices of bank
credit as a source of working capital. Various forms in which bank credit is granted
viz. Overdrafts, loans, cash credit and discounting of bills etc. are discussed with
their merits and demerits. Different types of loans, and their classification on the
basis of security and guarantee have been explained. After explaining the various
modes of creating charge over the borrower’s assets, we have discussed merits and
demerits of different types of securities taken by banks. Purchase and discounting of
bills as a method of granting credit has been duly explained. Concept of credit
worthiness of the borrower has been clarified. In the end, the two important non-
fund based facilities such as letter of credit and guarantee given by banks have been
explained.

9.11 KEY WORDS

Overdrafts : This is a facility allowed to a current account holder for a short
period. Under this facility, the account holder is allowed to draw from his account
more than what stands to his credit, either on the personal security of the borrower or
on the basis of collateral security.

Cash Credit System: This is a method of granting credit by banks. Under this
method the bank prescribes a limit, called the Cash Credit limit, upto which the
customer is permitted to borrow against the security of tangible assets or guarantee.
The borrower may withdraw from the account as and when he needs money.
Surplus funds with him may be deposited with the banker any time. Thus, it is
running a/c with the banker, wherein withdrawals and deposits may be made
frequently in any number of times.

Loan: Under the Loan System of granting credit a definite amount is lent for a
specified period.

Bridge Loan: Bridge Loan is a short term loan which is usually granted to industrial
undertakings to enable them to meet their urgent needs. It is granted when a term
loan has already been sanctioned by a bank/financial institution, but its disbursement
takes some time or when the company is taking steps to raise funds for the capital
market. It is a type of interim finance.

Composite Loan: Those loans that are granted for both investment in capital
assets and for working capital purposes, are called composite loans.

Secured Loans: A secured loan is a loan made on the security of any tangible asset
of the borrower. It means that a charge or right is created on the assets of the
borrower in favour of the lender. The value of the security must be equal to the
amount of the loan. If the former is less than the latter, it is called partly secured
loan. An advance without such security is called unsecured advance. In case of
secured loan the lender gets the right to realise his dues from the sale proceeds of the
security, if the borrower defaults.

Pledge: Pledge is a method of creating a charge over the movable assets of the
borrower in favour of the lender. Under the pledge , the movable assets of the
borrower are delivered to the banker as a security, which he will return back to the
borrower, after he repays the amount due from him in respect of principal and
interest.

Hypothecation: It is another method of creating charge over the movable assets.

Under hypothecation the possession over such assets is not transferred to the
banker. Only an equitable charge is created in favour of banker. The assets remain
in the possession of the borrower, who promises to give possession of the same to the
19
Financing Working banker , whenever he is requested to do so.
Capital Needs
Mortgage: It is a method of creating charge over the immovable property like
land and building. Under Mortgage the borrower transfers some of the rights of
ownership to the banker (or mortgagee) and retains the remaining rights with
himself. The objective is to secure a loan taken from the banker. Actual possession
over the property is not passed on to the mortgage in all cases.

Equitable Mortgage: In this type of mortgage the mortgagor hands over the
documents of title to the property to the mortgagee and thus an equitable interest of
the mortgagee is created in the property. If the mortgagor fails to repay the amount
of the loan, he may be asked to execute a legal mortgage in favour of the lender.

Assignment: It is a method whereby the borrower provides security to the banker

by assigning (transferring or parting with) any of his rights, properties or debts to the
banker.

Lien: Lien is the right of the banker to retain all securities of the customer, until the
general balance due from him is not repaid.

Documents of title to goods: These are the documents which represent the goods
in the possession of some other person. For example a warehouse receipt or a
railway receipt. By endorsing such documents in favour of the banker, the borrower
entitles the banker to take delivery of the goods from the warehouse or railway, if he
does not repay the advance.

Credit worthiness: Creditworthiness indicates the quality of the borrower. It

denotes the amount for which a borrower is considered worthy for borrowing from a
bank. It depends upon his ability and willingness and is judged on the basis of
character, capacity and capital of the borrower.

9.12 SELF ASSESMENT QUESTIONS

1. Why does a bank as a general rule not lend on long term basis ?
2. What are the common securities against which a bank may lend for working
capital purposes ? Can a bank extend an unsecured loan or advance ?
3. Does a bank need to be satisfied about the creditworthiness of a customer
before extending non – fund facilities to him ? If so why ? Would a bank
guarantee issued in favour of Customs Authorities guaranteeing payment of
customs duty be classified as a performance or financial one ?
4. What are the different types of ventures that a bank can finance ? Does it
include a handcart operator selling vegetables ?
5. Discuss the different ways by which banks provide credit to business entities?

9.13 FURTHER READINGS

1. Tannan’s Banking Law and Practice (19th Edition)
2. P. N. Varshney- Banking Law & Practice
3. P. N. Varshney- Indian Financial System and Commercial Banking.
4. S. Srinivasan 1999; Cash and Working Capital Management, Vikas Publishing
house, New Delhi.

20
 Appendix

Observation of RBI on Working Capital Cycles and Demand for Bank Credit

Working capital is critical for daily management of cash flows to settle bills, wages
and other variable costs. The working capital cycle is 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 sale of the product to its customers.
Typically, the cycle begins with the injection of cash which is utillised for making
payments to the suppliers of raw materials, workers, etc. Between each stage of this
working capital cycle, there is a time lag. The amplitude of the working capital cycle
depends on the type of activity. In general, careful management of working capital is
vital for any firm, particularly where the gestation lag between the production
process and realisation of the receivables is substantial in a situation when the firm
has incurred all expenditure associated with production but has not realised the value
of its product, it is imperative that the firm manages its cash flow carefully to stay
liquid and operational.

Working capital requirements can be financed from both internally generated re-
sources (selling current assets) and externally acquired alternatives (borrowing or
securing current assets). Mostly firms borrow on the strength of their current assets
and the major sources of funds include trade credits, accruals, short-term bank loans,
collateral papers, commercial papers and factoring accounts receivable. In a bank-
based financial system, the loan from the bank by a corporate takes form of line of
credit or overdraft. This is an arrangement between the bank and its customers with
respect to the maximum amount of unsecured credit the bank will permit the bor-
rower firm. Besides this arrangement, there are other forms of short-term financing
by raising resources directly from the market through issue of commercial paper.

In the Indian context, a major part of the working capital requirements are met by
bank credit. Typically, periods of spurt in industrial activity are associated with surges
in non-food bank credit, albeit, with some lag. These lags are more prolonged in a
production based business rather than in service providing firms. Commercial paper
(CP)has emerged as an important source of funding working capital needs; however
it is restricted to a few large companies with triple-A corporate ratings and does not
enjoy wider market acceptability. Thus, bank credit in the form of cash credit (CC)
and working capital demand loan (WCDL)continues to remain the principal source of
working capital requirements. An analysis of the data for large borrowers showed
that working capital credit which constituted nearly 65 per cent of the total bank
credit in mid-1990s, came down to nearly 55 per cent in 2002.

The CC arrangement in India is a unique system, which is highly advantageous to the

borrowers as the task of cash managment of the borrowers is passed on to the
lending banks. Since the borrowers are free to draw from the cash credit account at
any time depending on their cash requirements, it results in uncertainty in the utilisa-
tion of the cash credit limit. As such, banks are required to maintain large cash/liquid
assets or resort to borrowal from the call money market to meet the sudden demand
for withdrawal by the borrowers. In April 1995, under the 'Loan System' of delivery
of bank credit, the CC component was restricted to a maximum of 75 percent of the
Maximum Permissible Borrowerd Fund (MPBF) in respect of cases where the
21
prescribed at 80 percent in respect of borrowers with working captial credit limit of
Rs.10 crore and above. In view of the improved environment of short-term invest-
ment opportunities available to both corporates and banks and the banks having put in
place suitable risk management systems for covering liquidity and interest rate risks,
banks were allowed to increase the CC component beyond 20 percent in October
2001. Banks are expected to appropriately price each of the two components of
working capital finance, taking into account the impact of such decisions on their cash
and liquidity management.
Source: RBI's Annual Report, 2002-2003.

1
Financing Working
UNIT 10 BANK CREDIT - METHODS OF
Capital Needs

ASSESSMENT AND APPRAISAL

Objectives
The objectives of this unit are:
• To explain the methods permitted by Reserve Bank of India for banks to assess
the credit needs of the large borrowers.
• To explain the Maximum Permissible Bank Finance Method as evolved on the
basis of Tandon Committee and Chore Study Group’s Reports and the
alternatives suggested by the Reserve Bank.
• To describe the system of compulsory loan component in bank credit, as
enforced by the Reserve Bank of India.
• To discuss present system of interest rates, and
• To discuss the methodology of financing large borrowers by banks
Structure
10.1 Introduction
10.2 Brief Historical Background
10.3 Maximum Permissible Bank Finance System
10.4 The Turnover Method
10.5 The Cash Budget Method
10.6 Compulsory Loan Component in Bank Credit
10.7 Interest Rates on Bank Advances
10.8 Tax on Bank Interest
10.9 Prudential Norms for Exposure Limits
10.10 Consortium Advances
10.11 Syndication of Credit
10.12 Summary
10.13 Key Words
10.14 Self Assessment Questions
10.15 Further Readings

10.1 INTRODUCTION
In Unit 9, we have studied the principles of bank lending, the style of credit and the
securities taken by a banker from his customers. The basic task before the banker
remains how to assess the needs of a customer for bank credit, particularly for
meeting working capital needs. The need for bank credit depends upon a borrower’s
operating cycle i.e the period between the time of payment for purchase of raw
material and the time sale proceeds are realised in cash. In addition, it also depends
upon the level of inventories held by the borrowers in different forms-raw materials,
semi-manufactured goods and the finished goods. The credit terms offered by the
borrower to his customers and the collection efforts made by him also affect the
working capital needs. In short, a careful assessment of all these aspects is required
to be made by the banker to assess the working capital requirements of a customer.

10.2 BRIEF HISTORICAL BACKGROUND

In India, traditionally the Cash Credit System has been in vogue for a very long time
and
2 to a larger extent. There are two main defects in this system. First, the level of
advances in a bank is determined not by how much a banker can lend at a particular
point of time but by the borrower’s decision to borrow at that time.
Secondly, the Cash Credit advances, though repayable on demand by the banker, are
generally rolled over and thus never fall below a certain level during the course of a
year. Thus the business concerns employ bank funds on a quasi-permanent basis.

Realising these drawbacks in the Cash Credit System, Reserve Bank of India
appointed a study group, under the chairmanship of Shri P.L. Tandon to frame
guidelines for the follow up of bank credit. Accepting the recommendations of
Tandon Study Group, Reserve Bank of India advised the banks in 1975 to follow a
reformed system of Cash Credit, which is known as ‘ Maximum Permissible Bank
Finance System’. In 1980, necessary modifications were made in the above in the
light of the recommendations of another working group known as ‘Chore
Committee’. The Maximum Permissible Bank Finance System (MPBF) was
substantially liberalized in 1993. Ultimately, in April 1997, the MPBF System was
made optional to the banks. Reserve Bank of India has permitted the banks to
follow any of the following methods for assessing the working capital requirements of
the borrower:
1) The Turnover Method for small borrowers, already enforced, may be continued
for this category of borrowers,
2) The Cash Budget System may be followed by banks for large borrowers who
prepare Cash Budget,
3) The existing Maximum Permissible Bank Finance System, may be retained , if
necessary, with modifications.
4) Any other system.
Thus sufficient operational flexibility has been given to the banks in their efforts to
assess working capital needs. But, on the other hand, compulsion has been enforced
on banks to introduce a compulsory loan component in bank credit and exposure
norms have been prescribed. In case of large borrowers flexibility is allowed to form
consortium or to go for syndication.

10.3 MAXIMUM PERMISSIBLE BANK FINANCE

SYSTEM
As noted in the previous section, the Maximum Permissible Bank Finance System
was introduced in India in 1975. Initially, it was made obligatory for all borrowers
with credit limits of Rs. 10 lakh and above. The Tandon Committee, while suggesting
this system, made a significant attempt towards modernising the methodology of
credit appraisal. The Chore Committee, strengthened the System further. In the
wake of liberalisation policy, the MPBF System was substantially liberalised in the
year 1993. In April 1997, it ceased to be mandatory and banks were permitted to
adopt this system with modification, if any, or to adopt any other system of credit
appraisal. As the MPBF System is still relevant in India, we shall study its salient
features as modified /amended in 1993.
1) Norms for Inventories and Receivables
The main thrust of this system is on assessing the credit needs of a borrower on the
basis of holding of current assets, as per the prescribed norms. Initially, the
Committee suggested norms for holding various current assets for 15 industries.
Later on, almost all industries were covered. The norms were prescribed for various
current assets as follows:
1) For raw materials expressed as so many months’ consumption. Raw materials
include store and other items used in the process of manufacture. 3
Financing
2) Working
For stock-in-process, expressed as so many months’ cost of production
Capital Needs
3) For finished goods, expressed as so many months’ cost of sales,
4) For receivables, expressed as so many months’ sales.
These norms were to be treated as the maximum quantity of current assets to be held
by a borrower. If a borrower had managed with less quantity in the past, he should
continue to do so. The norms were for the average level of holding of a particular
current asset and not for a particular item of a current asset. For most of the
industries a combined norm was prescribed for finished goods and receivables.

The objective of laying down the norms of inventories was to ensure that banks
assess the credit needs of a borrower on the basis of reasonable level of inventories
held as per the norms. Thus the credit granted was intended to be need- based.
However, the Reserve Bank permitted the banks to deviate from the norms in
specified circumstances.

In 1993, Reserve bank of India provided more flexibility to the banks in this regard.
Banks were permitted to make their own assessment of credit requirements of
borrowers based on their own study of the borrowers’ business operations i.e taking
into account the production/processing cycle of the industry as well as the financial
and other relevant parameters of the borrowers. Banks are now allowed to decide
the levels of holding of each item of inventory and receivables, which in their view
would represent a reasonable build up of current assets for being supported by bank
finance.

Reserve Bank of India now does not prescribe norms for each item of inventory and
receivables. Its role is now confined to advising the overall levels of inventories and
receivables of different industries for the guidance of the banks. The above guidelines
were made applicable to all borrowers enjoying aggregate fund-based working
capital limit of Rs. 2 crore and above from the banking system. (instead of Rs. 10
lakhs earlier) All borrowers enjoying aggregate fund based credit limits of up to Rs.
2 crore from the banking system were exempted from the above guidelines. Their
working capital needs are now assessed on the basis of projected Turnover Method
(which has been explained in a subsequent section in this unit) which was earlier
applicable to village and tiny industries and other small scale industries enjoying fund-
based working capital limits up to Rs. 50 lakhs.

2) Methods of Lending

The MPBF system permits the banks to finance only a portion of the borrowers’
working capital requirements from bank credit. The borrower is expected to depend
less and less on banks to finance his working capital needs. The Tandon Committee
suggested the following three methods of lending for determining the permissible level
of bank borrowing. It is to be noted that each successive method is intended to
increase progressively the involvement of long term funds comprising borrower’s
owned funds and term borrowings to support current assets. The three methods of
lending are as follows:
First Method of Lending: Under this method, banks have to work out the working
capital gap by deducting current liabilities other than bank borrowings from the
current assets. Bank can provide a maximum credit upto 75 percent of working
capital gap. The balance is to be met by the own funds of the borrower and term
loans.
Second Method of Lending: Under this method, the borrower has to provide for a
minimum of 25 percent of the total current assets out of long term funds i.e. own
funds plus term borrowings. After deducting current liabilities other than bank
borrowings from the rest of the current assets, the balance of current assets are to be
4
financed through bank borrowings. Thus the total current liabilities inclusive of bank
borrowing will not exceed 75 percent of current assets.
Third method of Lending: This is the same as the second method except one
difference. The core current assets, i.e. the permanent current assets which should
be financed from long term funds are deducted from the total current assets. Of the
balance of current assets, 25% are financed from long term sources and the rest out
of current liabilities including bank borrowings.

It is to be noted that the first method gives a minimum current ratio 1.17:1, while the
second method gives 1.3:1 and the third method 1.79:1

You can understand well calculation of the maximum permissible bank finance under
the three methods of lending from the following illustration:

Projected Balance sheet of a borrower is as follows:

Current liabilities Current Assets
Creditors for purchases 100 Raw material 200
Other Current liabilities 50 Stock-in process 20
————
150 Finalised 90
————
Bank borrowings 200 Receivables
(including bills discounted) (including bills discounted) 50
Other current assets 10
—— ———
350 370
——- ———
st nd rd
1 Method 2 Method 3 Method
Total Current Assets 370 Total Current Assets 370 Total Current Assets 370
Less Current liabilities 25% of above from Less Core Current Asset
Other than bank long term sources 92 (assumed) financed
Borrowings 150 from long term sources 95
Working Capital
Gap 220 278 Rest of Current Assets 275
25% of the above Less Current liabilities
from long term other than bank 25% of above from
sources 55 borrowing 150 long term sources 69
206
Less Current liabilities
other than bank
borrowings 150
Maximum bank Maximum bank
Borrowing borrowing Maximum bank
Permissible 165 permissible 128 borrowing permissible 56
Actual bank Actual bank
Borrowings 200 borrowings 200 Actual bank borrowing 200
Excess borrowings 35 Excess borrowing 72 Excess borrowing 144
Current Ratio 1.17:1 Current Ratio 1.33:1 Current Ratio 1.79:1

You will note that the current ratio is higher in case of Method II as against Method I,
and still higher in case of Method III as against Method II.

Till 1993, Reserve Bank of India required the banks to follow the first method of
lending in case of borrowers enjoying fund-based working capital limits of Rs. 10
lakh and above and upto Rs. 50 lakh. For borrowers with high fund-based working
capital limits method II was to be applied.

In 1993, Method II was made applicable to all borrowers with aggregate fund based
working capital limits above Rs. 2 crore from the banking system. Borrowers with
5
Financing
credit limitWorking
upto Rs. 2 crore were to be sanctioned credit limits according to Projected
Capital Needs
Turnover Method (discussed ahead)

The following credit facilities have been exempted from the application of Second
Method of lending:
a) Borrowing units engaged in export activities.
b) Additional credit needs of exporters arising out of firm orders/confirmed letters
of credit.
c) Borrowing units marketing/trading exclusively the products and merchandise
st
manufactured by village, tiny & small scale industrial units will be subject to 1
Method provided dues are settled by them within 30 days of supply.
d) Sick/weak units under rehabilitation.
3) Style of Credit

On the recommendation of the Tandon Committee, the Reserve Bank of India

prescribed at the time of introduction of MPBF System that banks should bifurcate
accommodation into (1) loan comprising the minimum level of borrowing which the
borrower expects to use throughout the year and (2) a demand cash credit to
meet the fluctuating requirements of credit. A slightly higher rate of interest on
demand Cash Credit component than for loan component was also suggested.
Reserve Bank of India directed the banks that the interest rate on demand Cash
Credit should be higher by one percent over the rate of interest on the loan
component.

The above directive was withdrawn by Reserve Bank of India in 1980. Subsequently
in 1995 Reserve Bank of India introduced a compulsory loan component in the
delivery of bank credit (which has been discussed in a subsequent section in this
unit).

Peak Level and Non Peak Level Limits

The Chore Committee suggested significant modification in the MPBF System, which
were enforced by the Reserve Bank of India in December 1980. Hitherto credit
limits were sanctioned on the basis of peak level requirements of the borrowers, but
a portion of the same remained unutilized during the non-peak season. The MPBF
System was, therefore, modified so as to require the banks to fix credit limits for the
normal peak level and non-peak level requirements of the borrower separately.
These limits are to be fixed on the basis of the utilisation of such limits in the past.
The period during which they have to be utilised is also required to be specified.
Seasonal limits are required to be fixed in case of all agro-based industries and
consumer goods industries having seasonal demand. For other industries only one
limit is to be fixed.

Withdrawal of Funds

After the peak level and non- peak level credit limits are sanctioned by the banks as
stated above, the borrower is required to indicate, before the commencement of each
quarter, his expected requirements of funds in that quarter. Such requirements are
called the ‘operating limits’. Borrower is expected to withdraw funds from the
banks as per his requirements within the operating limit in that quarter subject to a
tolerance of 10% either way. Banks also require the borrower to submit monthly
stock statements to determine his drawing power within the operating limit. Hence
the actual amount availed of as bank credit will be the operating limit or the drawing
power, whichever is lower. If a borrower draws more than or less than these
tolerance limits, it must be considered as an irregularity in the account. In such
6
situation banks should take necessary corrective steps to avoid the repetition of such
irregularity in future.

Submission of Quarterly Statements

Each borrower enjoying fund-based working capital limit of Rs. 2 crore or more is
required to submit to the banker the following two quarterly statements:
1) Statement giving estimates of production, sales, stock position and current
liabilities. (This statement is to be submitted in the week preceding the
commencement of the quarter to which it relates).
2) Statement showing actual performance in the quarter. This statement is to be
submitted within six weeks from the end of the quarter. In addition to these, the
borrowers are also required to submit half yearly operating statement and funds
flow statement, along with a half yearly balance sheet within 2 months from the
close of the half year.
Reserve Bank of India has also prescribed penalties for non-submission of the above
statements within the prescribed period as follows:
1) banks are permitted to invariably charge penal interest of at least 1 percent per
annum for a period of one quarter on the outstandings under various working
capital limits sanctioned to a borrower.
2) If the default is of a serious nature or persists for two consecutive quarters,
banks may consider charging a rate of interest higher than the normal lending
rate determined for a borrower on his entire outstanding, under the working
capital limits sanctioned, until such time as the position relating to timely
submission of various statements is regularised.
3) In case of continuous/persisting defaults, banks may further consider freezing
the operations in the account after giving due notice to the borrower.
4) Sick units which remain closed, and borrowers affected by political disturbances,
riots, natural calamities are excluded from the requirements of submission of
statements.
Commitment Charge
Banks are permitted to levy a minimum commitment charge of 1 percent per annum
on the unutilised portion of the working capital limits, subject to tolerance level of 15
percent of such limits. This is applicable incase of borrowing units with aggregate
fund-based working capital credit limits of Rs. 1 crore and above from the banking
system. The commitment charge will be exclusive of overall ceiling of 2 percent of
penal additional interest, as stipulated by the Reserve Bank of India.
The commitment charge will not apply to-
a) Drawing in excess of the operating limit
b) Working Capital limits sanctioned to sick/weak units
c) Limits sanctioned for export credit as well as against export incentives
d) Inland Bill limit
e) Credit limit granted to commercial banks, financial institutions and cooperative
banks.
Ad-hoc Credit Limits

Since 1993 banks are permitted to decide the quantum as also period of any ad-hoc
credit facilities based on their commercial judgement and merits of individual cases.
Banks will also have the discretion to decide about charging of interest for
sanctioning ad-hoc credit limits. 7
Financing 10.1
Activity Working
Capital Needs
1. As per Tandon Committee, the norms for stocks and receivables have been
as:
a) Raw material as so many months’ ----------
b) Stock in process as so many months’ ----------
c) Finished goods as so many months’ ----------
d) Receivables as so many months’ ----------
2. Under the First Method of Lending the MPBF is equal to……….percent of…….
whereas under the Second Method it is …………of…………….
3. Give details of the two Quarterly Statements required to be submitted under
MPBF Method?
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
4) Work out the MPBF under three methods taking a live example.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

10.4 THE TURNOVER METHOD

The Turnover Method of assessing working capital needs was introduced by Reserve
Bank of India in 1991 in case of village and tiny industries and other small scale
industries having aggregate fund-based working capital credit limits up to Rs. 50 lakh
from the banking system. In 1993 it was extended to non-small scale industries
borrowers also, having aggregate credit limit upto Rs. 1 crore. Later, banks were
advised to follow this method for small borrowers with credit limit up to Rs. 4 crore in
case of small industries and up to Rs. 2 corer in case of other borrowers. In the
budget of 1999-2000 this limit has been raised to Rs. 5 crore in case of small scale
industries.

The turnover method ensures adequate and timely flow of credit to the borrowers.
Under this method, norms of inventory and receivables and the first method of
lending are not applicable to the borrower. On the other hand, credit needs of the
borrower are assessed on the basis of their projected annual turnover(PAR), which
means projected gross scales inclusive of the excise duty. The following are the
steps to be followed under this method:
1) First, the projected sales of the borrower for the whole year are assessed. The
projection should be justified, reasonable, achievable and falling in line with the
past trend in the industry concerned. It can be ascertained by scrutinizing
annual statement of accounts, various returns filed, orders on hand and the
installed capacity of the unit, etc.
2) Banks should work out working capital requirements at a minimum level of
25% of the accepted turnover, assuming an average production/processing cycle
8 of 3 months.
3) Borrower should contribute 5% of the turnover as his margin or as Net Working
Capital

4) The remaining 20% of the turnover should be considered as the working

capital credit limits by the bank. If the borrower is having margin, greater than
5% of the turnover, the same is to be considered for arriving at the credit limits,
which can be scaled down below 20% of the turnover. Hence the word
‘minimum’ is intended for the working capital gap and not for the limits to be
sanctioned. The facilities intended under this method should be need-based and
not based on eligibility. Assessment under this method is done as shown in the
table below:
ASSESSMENT OF WORKING CAPITAL BY TURNOVER METHOD
Rs.
a) Total projected sales ——
b) 25% of projected sales (i.e of a) ——
c) Margin at 5% of turnover ——
d) Limit 20% of ‘a’ a ——
e) Margin available in System (NWC) ——
f) Higher of ‘c’ or e (margin) ——
g) Credit Limit Permissible (b-f) ——-
Evaluation: The Turnover Method is a simple method of assessing the working
capital requirements. But the assessment does not take into account the funds flow
of the borrower with the result that the working capital limits may remain
underutilized in case of borrower with regular and sufficient cash flows. Funds may
be diverted to some other uses if not required in the business.

10.5 THE CASH BUDGET METHOD

As already noted, the Reserve Bank of India has permitted the banks to choose Cash
Budget Method, as one of the alternatives to MPBF method, in case of large
borrowers. This method endeavors to assess the credit requirements of a borrower
on the basis of his projected cash inflows and outflows during a specific period of
time.

One of the important drawbacks of MPBF method is that the working capital limit is
limited to the accepted level of current assets, and not much significance is attached
to the cash flows of the borrowers. Sometimes the receivables remain unrealized
for longer period of time or inventories are accumulated for a longer period due to
peculiar nature of demand. Thus the borrowers face the liquidity problem which is
turn affects their production as need-based working capital limits taking into account
their cash flows, are not made available to them.

Under the Cash Budget Method, the entire funds requirements of a borrower are
taken into account. Payments which are not inevitable and which may be incurred
upon the availability of funds are not included. For example, payment of dividends,
unrelated investments, diversion for creation of fixed assets for forward/backward
integration are excluded from the total outflows. The Cash budget method thus helps
in arriving at need-based working capital limits. Thus this method avoids
accumulation of larger current assets than actual requirements, diversion of funds
because of availability of surplus funds and also prevents sickness of the business
units due to inadequate working capital funds. As the current assets are taken as
prime security for working capital limits, banks can restrict their exposure to the
extent of availability of the security. 9
Financing Working
The calculation of eligible bank finance under Cash Budget System is shown in the
Capital Needs
chart below:

On the basis of the Cash Projections, quarterly Working Capital limits may be fixed.
For monitoring of the utilisation of credit limits, the bank may call for data periodically
i.e monthly, quarterly or half yearly, in addition to the balance sheet. If in a quarter
excess finance has been availed of, explanation may be called from the borrower
and a penal interest may be charged on the excess amount for the entire previous
quarter to enforce financial discipline.

CALCULATION OF ELIGIBLE BANK FINANCE UNDER CASH

BUDGET METHOD
Quarterly Projections

I II III
IV

1) Consumption of raw materials, consumable stores and spares,

2) Factory salaries and wages
3) Other manufacturing expenses (excluding Depreciation)

Sub total
Add opening stock —————-
Less closing stock —————-

_______

Sub total

–––––––
Add
1) Administrative and selling expenses Other overheads

2) Interest

3) Tax/Statutory dues payable

4) Repayment of Deposits/Debentures/Instalment of term loans.

5) Margin required for letters of credit/Bank guarantees

6) Others:

a) Advances for RM/Stores & spares etc.

b) Deposit with Govt. Departments

c) Loans to employees

d) Payment to Trade Creditors

e) L.C. Payment

f) Contingencies
10
7) Outstanding Receivables
Total Fund Required Grand Total (A)

Sources of Funds
(Other than bank finance) Quarterly Projection
I II
III IV
1) Cash sales
2) Realisation from Receivables
(Previous Receivables plus credit sales)
minus outstanding Receivables)
3) Unsecured/Corporate loans taken
4) Public Deposits
5) Credit Purchases of Raw materials
Consumable stores and spares
6) Advances received from customers
7) Deposit from Dealers/selling agents
8) Incentives
1) Sales Tax
2) Export
3) Subsidy
4) Other Deferred payments
9) Other Incomes
a) Interest, commission
b) Sale of Scrap Assets
Total Funds Available Grand Total (B)
c.) Working Capital Gap (A-B)
d.) Minimum Margin
(25% of Working Capital Gap)
e) Net Working Capital
(Long term sources less Long Term uses)
f) Maximum Eligible Bank Finance
(c-d) or (c-e) whichever is less

Activity 10.2

1. Under the Turnover Method of assessing Working Capital needs, the credit limits
are fixed at ..................... percent of....................

2. What types of payments are excluded from total Outflows under the Cash
Budget Method?
........................................................................................................................

........................................................................................................................
11
Financing Working
........................................................................................................................
Capital Needs
........................................................................................................................

........................................................................................................................

3. How is maximum eligible bank finance determined under the Cash Budget
Method?

........................................................................................................................

........................................................................................................................

........................................................................................................................

........................................................................................................................

10.6 COMPULSORY LOAN COMPONENT IN BANK

CREDIT
In April 1995, Reserve Bank of India introduced a reform of far reaching significance
in the delivery system of bank credit. Reserve Bank introduced a compulsory loan
component in the credit granted by banks to large borrowers and issued guidelines to
the banks in this regard . The salient features of these guidelines as amended upto
date are as follows:

1) Initially in April 1995, the loan component was made compulsory in case of
borrowers with maximum permissible bank finance of Rs. 20 crore and above.
In April 1996 it was extended to all borrowers with MPBF of Rs. 10 crore and
above. Since October 1997 the loan component for all borrowers having MPBF
of Rs. 10 crore and above has been uniformly prescribed at 80 percent of
MPBF. The cash credit portion has consequently been reduced to 20 percent. It
is mandatory for banks/ consortia/syndicate to restrict the cash credit component
as specified above.

2) For borrowers with working capital credit limits of less than Rs. 10 crore, the
Reserve Bank of India has permitted the banks to settle with their customers the
levels of loan and cash credit components. Such borrowers may like to avail of
bank credit in the form of loans because of lower rate of interest applicable on
loan component.

3) Reserve Bank has also permitted the banks to identify the business activities
which may be exempted from the loan system of delivery of bank credit on the
ground that such business activities are cyclical and seasonal in nature or have
inherent volatility and hence application of loan component may create
difficulties.

4) The minimum period of the loan for working capital purposes is to be fixed by
banks in consultation with the borrowers. Banks are also permitted to split the
loan component according to the needs of the borrowers with different maturities
for each segments and allow roll over of loans.
5) banks are permitted to fix their prime lending rate and spread over the prime
lending rate separately for loan component and cash credit component.
6) Reserve Bank of India has permitted that a borrower can avail of the loan
component for working capital purpose , at more than the specified level of
80% of MPBF. In such cases the cash credit component shall stand reduced. A
12 borrower can also draw the loan component first.
7) An ad hoc limit may be sanctioned only after the borrower has fully utilised the
cash credit and the loan components.
8) In case of consortium/syndicate, member banks should share the cash credit
component and the loan component on a pro rata basis depending upon their
individual share in MPBF.
9) Bill limit for inland bills should be carved out of the loan component.
10) The Reserve Bank has allowed the banks to permit the borrowers to invest their
short term/temporary surplus in short term money market instruments like
commercial paper, certificate of deposits and in term deposits with banks.
11) Export credit limit (both post-shipment and pre-shipment) are to be excluded
from MPBF for the purpose of bifurcation of credit limits into loan and cash
credit components.

12) The loan component would be applicable to borrowal accounts classified as

standard and sub-standard.

The basic objective behind the bifurcation of credit limits into loan component and
Cash Credit component is to bring about discipline in the utilisation of bank credit
and to gain better control over the flow of credit. As you already know, there is no
financial discipline on the borrower in case of cash credit system —he may borrow
any amount within the operating limit at any time and may repay the same as per his
choice and convenience. The banker, therefore, remains unable to plan the
utilisation of his resources in advance and his earnings are affected, as he earns
interest on the actual amount utilised by the borrower. By introducing a compulsory
loan component which now accounts for the major part of bank credit, banks can
ensure that their resources are utilised for the full period of the loan and thus their
earnings are enhanced. Such a system will also compel the borrowers to resort to
planning in utilizing the funds.

10.7 INTEREST RATES ON BANK ADVANCES

Interest rates charged by banks on their advances were, to a great extent regulated
by the Reserve Bank of India for over two decades (1971-1991). The Narasimham
Committee 1991 recommended deregulation of interest rates on advances in a phased
manner. Accepting its recommendation, Reserve Bank of India abolished the
minimum lending rate on advances of Rs. 2 lakh in October 1994 and asked the
banks to fix their own prime lending rate which will be their minimum lending rate.
Concessional interest rate of 12% was prescribed for advances upto Rs. 25,000 and
a higher rate of 13.5% was prescribed for advances over Rs. 25,000 and upto Rs. 2
lakh. In October 1996, Reserve Bank of India asked the banks to announce the
maximum spread over the Prime Lending rate for all advances other than the
consumer credit. Banks have also been permitted to prescribe different Prime
Lending Rates for the loan component and the cash credit component in order to
encourage the borrowers to prefer the loan component because of lower spread.

Banks were allowed to fix their Prime Lending Rates and spread after taking into
consideration their cost of funds, transaction cost and minimum spread.

In April 1998, Reserve Bank further extended the process of deregulation by

permitting the banks to charge interest on advances below Rs. 2 lakh at a rate not
exceeding their Prime Lending Rate, which is available to the best borrowers of the
bank concerned.

The lending rates of banks are at present completely deregulated. Banks prescribe
their own Prime Lending Rate for their best borrowers and a spread thereon. The
13
Financing Working
Prime Lending Rate happens to be the maximum rate for borrowers up to Rs. 2 lakh
Capital Needs
each, whereas it is the minimum rate for all other borrowers. Since October 1997
banks have been permitted by the Reserve Bank of India to prescribe their Prime
Lending Rate for term loans of 3 years and above. In April 1999 banks have been
granted further freedom to operate different Prime Lending Rates for different
maturities. Banks are also permitted to offer fixed rate loans for project finance.

Though the Reserve bank has granted freedom to the commercial banks to prescribe
their own Prime Leading Rates, the changes in the Bank Rate announced by the
Reserve Bank of India from time to time do exert their influence on the bank’s
decisions on their Prime Lending Rates. For instance, the reduction of Bank Rate by
Reserve Bank of India by one percentage point from 9% to 8% effective March 1,
1999 was immediately followed by similar reduction in the Prime Lending Rate of
State bank of India and all other commercial banks. The Reserve Bank of India has
thus made the bank rate a reference rate for other interest rates.

10.8 TAX ON BANK INTEREST

The Government of India re-introduced interest tax on income from interest accuring
to the financial institutions with effect from October 1, 1991 and has withdrawn it in
the budget for 2000-2001. Interest Tax was payable on gross interest income of
banks and credit institutions like cooperative societies engaged in the business of
banking (excluding cooperative societies providing credit facilities to farmers and
village artisans), public financial institutions, state financial corporations and finance
companies.

Interest Tax was charged @ 2% on the gross amount of interest earned by banks,
including the commitment charges and discount on promissory notes and bills of
exchange. Interest earned on Cash Reserves maintained with Reserve Bank of
India, discount on Treasury bills and interest on loans to other credit institutions was
not included in the income from interest for this purpose. Banks were permitted to
re-imburse themselves by making necessary adjustments in the interest charges.
Hence the real burden of this tax was borne by the borrowers themselves as credit
became costlier to them by the amount of interest tax.

10.9 PRUDENTIAL NORMS FOR EXPOSURE LIMITS

Credit requirements of large business houses are invariably large. Banks follow the
policy of diversifying their risks by spreading their lending over different borrowers
who are engaged in different types of trades and industries, in order to minimise their
risks. They do not commit large resources to a single borrower or a group of
borrowers for better risk management. Reserve Bank of India has laid down
prudential norms for banks, for exposure to a single borrower or group of borrowers
as follows:

1) The overall exposure to a single borrower shall not exceed 20% of the net
worth of the bank. The exposure ceiling has been reduced from 25% to 20%
effective April 1,2000. In case it exceeds 20% of capital funds as on
October 31, 1999, banks are expected to reduce it to 20% by end of October
2001, and

2) The overall exposure to a group of borrowers shall not exceed 50% of the net
worth of the bank.

For determining exposure to a single borrower/ group, credit facilities will include the
following:
14
a) Advances by way of loans, cash credit, overdrafts
b) Bill purchased/discounted
c) Investment in debentures,
d) Guarantees, letters of credit, co-acceptances, underwriting etc.
e) Investment in Commercial Paper
The non-fund based facilities shall be counted @ 50% of sanctioned limit and added
to total fund based limits.

While the Reserve Bank of India has granted flexibility to the banks to assess the
credit requirements of the borrowers as already noted, the above prudential norms
are to be invariably complied by the banks.

10.10 CONSORTIUM ADVANCES

Credit needs of large borrowers may be met by banks in any of the following ways:
a) By sole bank
b) By multiple banks
c) On consortium basis
d) On syndication basis
Sole banking i.e lending by a single bank to a large borrower, subject to the
resources available with it and limited to the exposure limits imposed by the
Reserve Bank of India. When the credit requirements of a borrower are beyond the
capacity of a single bank, the borrower may resort to multiple banking i.e borrowing
from a number of banks simultaneously and independent of each other, under
separate loan agreements with each of them. Securities are charged to them
separately.

Consortium lending, also called joint financing or participation financing, is also

undertaken by a number of banks but against a common security which remains
charged to all the banks for the total advance. Usually, in case of consortium lending
one of the banks acts as a consortium leader and takes a leading part in the
processing of the loan proposal, its documentation, recovery etc. The participating
banks enter into an agreement setting out the terms and conditions of such
participation arrangement.

Reserve Bank Directives

Consortium lending by banks in India commenced in 1974 when Reserve Bank of

India issued guidelines to the banks in this regard. In 1978 formation of consortium
was made obligatory where the aggregate credit limits sanctioned to a single
borrower amounted to Rs. 5 crore or more. In October 1993, this threshold limit for
formation of consortium was raised to Rs. 50 crore and the guidelines were also
suitably revised.

Following the policy of liberalisation and deregulation in the financial sector, the
Reserve Bank of India decided in October 1996, that whenever a consortium is
formed either on a voluntary basis or on obligatory basis, the ground rules of the
consortium arrangement would be framed by the participating banks in the
consortium. These rules may relate to the following:
i) Number of participating banks
ii) Minimum share of each bank
15
Financing
iii) EntryWorking
into/exit from a consortium
Capital Needs
iv) Sanction of additional/ad hoc limit in emergency situation/contingencies by lead
bank/other banks
v) The fee to be charged by the lead bank for the services rendered by it
vi) Grant of any facility to the borrower by a non-member bank
vii) Deciding time frame for sanctions/ renewals.
In April 1997, Reserve Bank of India withdrew the mandatory requirements on
formation of consortium for working capital requirements under multiple banking
arrangement. Reserve bank has advised the banks to evolve an appropriate
mechanism for adoption of a sole bank/multiple bank/consortium or syndication
approach by framing necessary ground rules on operational basis. While the aforesaid
flexibility has been granted to the banks, they are required not to exceed the single
borrower/group exposure limits laid down by the Reserve Bank. Banks have been
advised to ensure to have an effective system for appraisal, flow of information on
the borrower among the participating banks, commonality in approach and sharing of
lending resources, under the single window concept. Banks have also been permitted
to adopt the syndication route, if the arrangement suits the borrower and the financing
banks.

10.11 SYNDICATION OF CREDIT

As you have noted in the previous section, Reserve Bank of India has permitted the
banks to adopt syndication route to provide credit in lieu of consortium advance. A
syndicated credit differs from consortium advance in certain aspects. The salient
features of a syndicated credit are as follows:

1) It is an agreement between two or more banks to provide a borrower a credit

facility using common loan documentation.

2) The prospective borrower gives a mandate to a bank, commonly referred to a

‘Lead Manager, to arrange credit on his behalf. The mandate gives the
commercial terms of the credit and the prerogatives of the mandated bank in
resolving contentious issues in the course of the transaction.

3) The mandated bank prepares an Information Memorandum about the borrower

in consultation with the latter and distributes the same amongst the prospective
lenders, inviting them to participate in the credit.

4) On the basis of the Information Memorandum each bank makes its own
independent economic and financial evaluation of the borrower. It may collect
additional information from other sources also.

5) Thereafter, a meeting of the participating banks is convened by the mandated

bank to discuss the syndication strategy relating to coordination, communication
and control within the syndication process and to finalise the deal timings,
charges for management, cost of credit, share of each participating bank in the
credit etc.

6) A loan agreement is signed by all the participating banks

7) The borrower is required to give prior notice to the Lead Manager or his agent
for drawing the loan amount so that the latter may tie up disbursement with the
other lending banks.

8) Under the system, the borrower has the freedom in terms of competitive pricing.
16
 Discipline is also imposed through a fixed repayment period under syndicated
credit.

Activity 10.3
1) Fill in the blanks:
a) Loan Component has now been made compulsory for Credit limits of Rs.
...................... crore and above.
b) Prime lending rate is the............................. rate for borrower upto
Rs......................
c) Interest tax was not charged on income from interest earned by banks
on.............................
2) State whether it is true or false:
a) Formation of Consortium of banks for working capital requirement is now
mandatory?
b) Investment in Commercial paper is excluded for the purpose of exposure
limits.
c) Under the Syndication of Credit the borrower gives mandate to a bank to
arrange credit on his behalf.

10.12 SUMMARY
In this unit we have dealt with the methods followed by banks for assessing the credit
needs of their borrowers for Working Capital. We have explained in detail the up-
dated version of the Maximum Permissible Bank Finance System (MPBF System)
as it prevailed as a mandatory prescription for banks till 1997. Since then they are
permitted to follow the alternative methods also. The Turnover Method and the
Cash Budget Method, as suggested by the Reserve Bank have been explained.

This unit also deals with the measures introduced by Reserve Bank of India to
discipline the big borrowers and to reduce the risks of the lending bankers.
Compulsory bifurcation of credit limits into loans and Cash Credit and introduction of
Prudential Norms for Exposure limits have been duly explained. Banks have also
been granted flexibility in forming consortium and syndicate to finance the credit
needs of big borrowers. The unit explains in detail these new dimensions in granting
bank credit.

10.13 KEY WORDS

Maximum Permissible Bank Finance System: This system of assessing the
working capital needs was introduced by Reserve Bank of India in 1975. In this
method the norms for holding the main types of current assets for different
industries have been laid down. On the basis of such norms, the working capital
gap is estimated. A portion of this gap is required to be met by owned funds and
long term sources and the rest may be provided by banks. This forms the maximum
limit on bank finance permissible.
Turnover Method: This method of assessing the working capital needs has been
introduced for small borrowers upto Rs. 5 crore. Under this method, the projected
annual turnover inclusive of the excise duty are assessed. Working Capital
requirements are worked out at a minimum level of 25% of the accepted turnover.
Banks, are permitted to provide 20% of turnover as working capital limits.

Cash Budget Method: This method of assessing working capital needs has
been suggested for those large borrowers who prepare Cash Budget. Under this 17
Financing Working
method, the credit requirements of a borrower are assessed on the basis of his
Capital Needs
projected cash inflows and outflows during a specific period of time.

Prudential Norms for Exposure Limits: In case of large borrowers, credit

requirements are also large and lending large funds is not without risks. Hence to
ensure that banks do not commit large resources to a single borrower or a group of
borrowers. Reserve Bank of India has prescribed the limits upto which they may
lend to them. These exposure limits are linked to the net worth of the bank
concerned.
Consortium Advances: When the credit needs of a large borrower are met
by a number of banks together, it is called consortium lending. Under it, a common
security remains charged to all the banks for the total advance. One of the banks
acts as consortium leader and takes a leading part in the processing of the loan
proposal, its documentation, recovery etc. Participating banks enter into an
agreement amongst themselves.

Syndication of Loans: It is also a method of financing large borrowers. Under it

the borrower gives a mandate to a bank to arrange credit on his behalf. The
mandated bank distributes an Information Memorandum about the borrower amongst
prospective lenders, inviting them to participate. A loan agreement is signed by all the
participating banks. The borrower gives notice to lead Manager for drawing the
amount so that the latter may tie up disbursement with other lending banks.

Commitment Charge: It is a charge at a nominal rate, say ½% or 1%, which the

banks impose on the unutilized portion of Cash Credit Limit.

10.14 SELF ASSESSMENT QUESTIONS

1. Why has the Reserve Bank of India made it compulsory for the banks to
introduce loan component in the credit granted to big borrowers?
2. What do you understand by Prime Lending Rate ? How is it determined? Are
banks free to determine more than one Prime Lending Rate? How is the spread
over Prime Lending Rate determined?
3. What do you understand by Prudential Norms for Exposure Limits? Why have
they been prescribed by Reserve Bank of India?
4. What do you understand by Consortium Lending? How does it differ from
syndication of loans?
5. Explain how can the permissible bank finance be assessed under the Second
Method of Lending. How does it differ from the First Method of Lending?
6. What do you understand by operating limits? How is it determined?
7. Explain how the credit needs of a borrower are assessed under the Turnover
Method?
8. What are the advantages of Cash Budget Method of assessing working capital
needs.

10.15 FURTHER READINGS

1) V.K. Bhalla, 2003, Working Capital Management Anmol Publications Pvt. Ltd.,
New Delhi.
2) P.N. Varshney, 1999, “Banking Law &Practice “, Sultan Chand & Sons, New
Delhi.
3) Hrishikes Bhattacharya, 1998, “Banking Strategy, Credit Appraisal and
18 Lending Decisions” Oxford University Press.
4) Reserve Bank of India - Report of the Working Group to Review the System
of Cash Credit. (Chairman: K.B. Chore) 1979.
5) Reserve Bank of India, - Report of the Study group to frame Guidelines for
Follow-up of Bank credit (Chairman: Prakash Tandon), 1975
6) “How to Borrow from Financial and Banking Institutions” A Nabhi
Publication.

UNIT 11 OTHER SOURCES OF SHORT

TERM FINANCE
Objectives
The objectives of this Unit are:
• To discuss the sources of short term finance, other than bank credit and trade
credit, to meet the working capital needs, and
• To highlight the framework of rules and regulations prescribed by the authorities
regarding these non-bank sources of finance.
Structure
11.1 Introduction
11.2 Public Deposits
11.3 Commercial Paper
11.4 Inter-Corporate Loans
11.5 Bonds and Debentures
11.6 Factoring of Receivables
11.7 Summary
11.8 Key Words
11.9 Self Assessment Questions
11.10 Further Readings

11.1 INTRODUCTION
Trade credit and commercial bank credit have been two important sources of
funds for financing working capital needs of companies in India, apart from the long
term source like equity shares. However, more stringent credit policies followed by
banks, tightening financial discipline imposed by them, and their higher cost, led the
companies to go in for new and innovative sources of finance. As the new equities
market has remained in a subdued condition and investor interest in the equities has
almost vanished during recent years, corporates have raised larger resources
through debt instruments, some of them being for as short a period as 18 months.
The situation has turned bouyant for corporates during 2002 and after for any type of
finance.

Raising short term and medium term debt by inviting and accepting deposits from the
investing public has become an established practice with a large number of
companies both in the private and public sectors. This is the outcome of the process
of dis-intermediation that is taking place in Indian economy. Similarly, issuance of
Commercial Paper by high net-worth Corporates enables them to raise short-term
funds directly from the investors at cheaper rates as compared to bank credit. In
practice, however, commercial banks have been the major investors in Commercial
Paper in India, implying thereby that bank credit flows to the corporate sector
19
Financing Working
through the route of CPs. Inter-Corporate loans and investments enable the cash
Capital Needs
rich corporations to lend their surplus resources to those who need them for their
working capital purpose. Factoring of receivables is a relatively recent innovation
which enables the corporates to convert their receivables into liquidity within a
short period of time. In this unit we shall discuss the salient features of various
sources of non-bank finance and the regulatory framework evolved in respect of
them.

11.2 PUBLIC DEPOSITS

Public deposits are unsecured deposits accepted by companies for specific periods
and at specific rates of interest. These deposits have acquired prominence as a
source of finance for the companies, as it is more convenient and cheaper to mobilise
short term finance through such deposits. Public deposits provide a fine example of
dis-intermediation, as the borrower directly accepts the deposits from the lenders, of
course with the help of brokers.

In India, acceptance of deposits from the public is regulated by sections 58A and
58B of the Companies Act 1956, and the Companies (Acceptance of Deposits)
Rules, 1975. The above sections were inserted in the Companies Act in 1974 with
the objective to safeguard the interests of the depositors. The regulatory framework
in this regard is contained in the Companies Act and the Rules. Their important
provisions are stated below:

Sections 58A (1) empowers the Central Government, in consultation with the
Reserve Bank of India , to prescribe the limits up to which, the manner in which and
the conditions subject to which deposits may be invited or accepted by a company
either from the public or from its members. Such deposits are to be invited in
accordance with the rules made under this section and after insertion of an
advertisement issued by the company.

Section 58 (2) (c) which was inserted with effect from March 1, 1997 prohibits a
company which is in default in the repayment of any deposit or part thereof or any
interest thereupon, from accepting any further deposit.

Categories of Deposits and Statutory limits

Rule 3 lays down that the period for which such deposits may be accepted by a
company should not be less than 3 months and not more than 36 months from the
date of acceptance or renewal of deposit. Companies are not permitted to accept
deposits repayable on demand or on notice. Deposits accepted by companies are
divided into the following two categories and separate limits have been prescribed for
each of them:

i) Deposits received from specified sources:

Deposits against unsecured debentures
Deposits from shareholders
Deposits guaranteed by directors
The maximum limit upto which such deposits are allowed is 10% of the aggregate
paid up share capital and free reserves.

ii) Deposit received from the general public:

This category of deposits may be accepted to the extent of 25% of the aggregate
paid up capital and free reserves of the company.

20
For government companies, there is only one single limit of 35% of paid up capital
and free reserves for all such deposits.

Companies are, however, permitted to accept or renew deposit from depositors

falling in category (i) above for periods below 6 months but not less than 3 months
for the purpose of meeting any short term requirements of funds provided such
deposits do not exceed 10% of the aggregate of paid up share capital and free
reserves of the company.

Maintenance of Liquid Assets

th
Every company accepting public deposit is required to deposit or invest before 30
April of each year, an amount which shall not be less than 15% of the amount of its
st
deposits which will mature during the next financial year ending 31 March in any
one or more of the following:
a) in a current or other deposit account with any scheduled bank, free from charge
or lien,
b) in unencumbered securities of the central or state governments,
c) in unencumbered securities in which Trust funds may be invested under the
Indian Trust Act, 1882; or
d) in unencumbered bonds issued by Housing Development Finance Corporation
Ltd.
The securities referred to in clauses (b) or (c) shall be reckoned at their market
value. The amount deposited or invested as aforesaid shall not be utilised for any
other purpose than the repayment of deposits maturing during the year.

Rates of Interest and Brokerage

The Rules prescribe the maximum rate of interest payable on such deposits. At
present companies are allowed to pay interest not exceeding 15% per annum at
rates which shall not be shorter than monthly rests.

Companies are permitted to pay brokerage to any broker at the rate of 1% of the
deposits for a period of upto 1 year, 1½ % for a period more than 1 year but upto 2
years and 2% for a period exceeding 2 years. Such payment shall be on one time
basis.

Advertisement

Every company intending to invite or accept deposits from the public must issue an
advertisement for that purpose in a leading English newspaper and in one vernacular
newspaper circulating in the state in which the registered office of the company is
situated.

The advertisement must be issued on the authority and in the name of the Board of
Directors of the company. The advertisement must contain the conditions subject to
which deposits shall be accepted by the company and the date on which the Board
of Directors has approved the text of the advertisement. In addition, the
advertisement must contain the following information, namely:
a) Name of the company,
b) The date of incorporation of the company,
c) The business carried on by the company and its subsidiaries with the details of
branches of units, if any,
d) Brief particulars of the management of the company
21
Financing
e) Names,Working
addresses and occupations of the directors,
Capital Needs
f) Profits of the company, before and after making provision for tax, for the three
financial years immediately preceding the date of advertisement,
g) Dividends declared by the company in respect of the said years.
h) A summarised financial position of the company as in the two audited balance
sheets immediately preceding the date of advertisement in the prescribed form,
i) The amount which the company can raise by way of deposits under these rules
and the aggregate of deposits actually held on the last day of the immediately
preceding financial year.
j) A statement to the effect that on the day of the advertisement, the company has
no overdue deposits, other than the unclaimed deposits, or a statement showing
the amount of such overdue deposits, as the case may be, and
k) A declaration as prescribed under the Rules.
The advertisement shall be valid until the expiry of six months from the date of
closure of the financial year in which it is issued or until the date on which the
balance sheet is laid before the company at its general meeting, or where Annual
General Meeting for any year has not been held, the latest day on which that meeting
should have been held as per the Companies Act, whichever is earlier. A fresh
advertisement is required to be made in each succeeding financial year.

Before issuing an advertisement, a copy of such advertisement shall have to be

delivered to the Registrar for registration. Such advertisement should be signed by
the majority of the Directors of the company or their duly authorised agents.

The above provision regarding mandatory publication of an advertisement is

necessary in case the company invites public deposits. But if the company intends to
accept deposits without inviting the same, it is not required to issue an advertisement
but a statement in lieu of such advertisement shall have to be delivered to the
Registrar for registration, before accepting deposits. The contents of the statement
and its validity period shall be the same as in the case of an advertisement.

Procedure for Accepting Deposits

Every company intending to accept public deposits is required to supply to the
investors forms, which shall be accompanied by a statement by the company
containing all the particulars specified for advertisements. The application must also
contain a declaration by the depositor stating that the amount is not being deposited
out of the funds acquired by him by borrowing or accepting deposits from any other
person.

On accepting a deposit or renewing an existing deposit, every company shall furnish

to the depositor or his agent a receipt for the amount received by the company within
a period of eight weeks from the date of receipt of money or realisation of cheques.
The receipt must be signed by an officer of the company duly authorised by it. The
company shall not have the right to alter to the disadvantage of the depositor, the
terms and conditions of the deposit after it is accepted.

Register of Deposits
Every company accepting deposits is required to keep as its registered office one or
more registers in which the following particulars about each depositor are to be
entered:
a) Name and address of the depositors,
b) Date and amount of each deposit
22
c) Duration of the deposit and the date on which each deposit is repayable
d) Rate of interest
e) Date or dates on which payment of interest will be made.
f) Any other particulars relating to the deposit.
These registers shall be preserved by the company in good order for a period of not
less than eight years from the end of the financial year in which the latest entry is
made in the Register.

Repayment of Deposits
Deposits are accepted by companies for specified period say 12 months, 18 months,
24 months, etc. Companies prescribe different rates of interest for deposits for
different periods. Other terms and conditions are also prescribed by the companies
and interest is paid at the stipulated rate at the time of maturity of the deposit.

But, if a depositor desires repayment of the deposit, before the period stipulated in the
Receipt, companies are permitted to do so, but interest is to be paid at a lower rate.
Rules prescribe that if a company makes repayment of a deposit after the expiry of a
period of six months from the date of such deposit, but before the expiry of the period
for which such deposit was accepted by the company, the rate of interest payable by
the company shall be determined by reducing one percent from the rate which the
company would have paid had the deposit been accepted for the period for which the
deposit had run.

The rules also provide that if a company permits a depositor to renew the deposit,
before the expiry of the period for which such deposit was accepted by the company,
for availing of benefit of higher rate of interest, the company shall pay interest to
such depositor at higher rate, if
a) such deposit is renewed for a period longer than the unexpired period of the
deposit, and
b) the rate of interest as stipulated at the time of acceptance or renewal of a
deposit is reduced by one percent for the expired period of the deposit and is paid
or adjusted or recovered.
The Rules also stipulate that if the period for which the deposit had run contains any
part of a year, then if such part is less than six months, it shall be excluded and if part
is six months or more, it shall be reckoned as one year.

Return of Deposits
Every company accepting deposits is required to file with the Registrar every year
th st
before 30 June, a return in the prescribed form and giving information as on 31
March of the year. It should be duly certified by the auditor of the company. A copy
of the same shall also be filed with the Reserve Bank of India.

Penalties
st
Sub-section 9 and 10 of section 58 A, which were inserted with effect from 1
September 1989, provide a machinery for repayment of deposits on maturity and also
prescribes penalties for defaulting companies. According to sub-section (9), if a
company fails to repay any deposit or part thereof in accordance with the terms and
conditions of such deposit, the Company Law Board may, if it is satisfied, direct the
company to make repayment of such deposit forthwith or within such time or subject
to such conditions as may be specified in its order. The Company Law Board may
issue such order on its own or on the application of the depositor and shall give a
reasonable opportunity of being heard to the company and to other concerned
23
Financing Working
persons.
Capital Needs
Sub-section 10 prescribes penalty for non-compliance with the above order of the
Board. Whoever fails to comply with its order shall be punishable with imprisonment
which may extend to 3 years and shall also be liable to a fine of not less than Rs. 50
for every day during which such non-compliance continues.

The above rule shall not apply to those categories of amounts which may be specified
in consultation with Reserve Bank of India.
Section 58 A (6) stipulates penalties for accepting deposits in excess of the specified
limits. Where a company accepts deposits in excess of the limits prescribed or in
contravention of the manner or condition prescribed, the company shall be
punishable:
a) Where such contravention relates to the acceptance of any deposit, with fine
which shall not be less than an amount equal to the amount of the deposit
accepted,
b) Where such contravention relates to the invitation of any deposit, with fine which
may extend to Rs. 1 lakh, but not less than Rs. 5000.

Every officer of the company who is in default shall be punishable with imprisonment
for a term which may extend to 5 years and shall also be liable to fine.

Deduction of Tax At Source

According to section 194 A of the Income Tax Act, 1961, the companies accepting
public deposits are required to deduct income tax at source at the prescribed rates if
the aggregate interest paid or credited during a financial year exceeds Rs. 5000.
This limit has been recently (May 2000) raised from Rs. 2500 to Rs. 5000.

Public Deposits with Companies in India

Public Deposits constitute an important source of working capital for corporates in
India. According to the data published by the Reserve Bank of India, the total
amount of Public deposits with the companies as at the end of March 1997 was Rs.
357, 153 crores, out of which 62.7% was held by the Non-finance companies and
the rest by finance companies and other Non-banking Companies.
Companies attract deposits because of higher rates of interest vis-à-vis the banks.
One year coupon rate of leading manufacturing companies at present ranges from
11% to 15% . Moreover, most of the companies provide incentive ranging from 0.25
to 1% to the depositors. For the guidance of the depositors the fixed deposits of the
companies are rated also by the Credit Rating agencies and the credit ratings are
published by the companies to solicit deposits. The rate of interest varies with the
credit rating assigned to it. Higher credit rating carries lower rate of interest and
vice-versa.
Public deposits with the companies are unsecured deposits and do not carry the cover
of deposit insurance while bank deposits are insured by Deposit Insurance and Credit
Guarantee Corporation of India to the extent of Rs. 1 lakh in each account. Many
companies default in the repayment of the deposits along with interest. In many
cases, the District Consumers Disputes Redressal Fora have penalised the
companies for not paying their depositors’ money. The Fora have held the
companies guilty for deficiency of service and maintained that a depositor was a
consumer within the meaning of the Consumer Protection Act., 1986 Nevertheless,
reputed companies do attract deposits from the public, because of their sound
financial position and reputation.
Activity 11.1
24
1) Fill in the blanks:
a) A company which ………………………………………………….. is
prohibited from accepting any further deposit.
b) The maximum period for which a company may accept deposit is
………….months.
c) The advertisement for deposit must give the profits of the company and
dividends declared during…………………………………financial years
immediately preceding the date of advertisement.
2) Can a company repay a deposit before the period stipulated in the Receipt?
Will the depositor suffer in such a case?
.................................................................................................................
.................................................................................................................
.................................................................................................................
.................................................................................................................
3) What penalty is imposed on the company if it accepts deposit in excess of
the prescribed limits?
.................................................................................................................
.................................................................................................................
.................................................................................................................
.................................................................................................................

11.3 COMMERCIAL PAPER

Commercial paper (C.P) is another source of raising short term funds by highly rated
corporate borrowers for working capital purposes. A commercial paper at the same
time provides an opportunity to cash rich investors to park their short term funds.
The Reserve Bank of India permitted companies to issue Commercial paper in 1989
and issued guidelines entitled “Non banking Companies (Acceptance of Deposits
through Commercial Paper) Directions 1989,” to regulate the issuance of C.Ps. The
guidelines have been significantly relaxed and modified from time to time. The salient
features of these guidelines (as amended to date) are as follows:

Eligibility to Issue CPs

Companies (except the banking companies) which fulfil the following requirements
are permitted to issue CPs in the money market:
i) The minimum tangible net worth of the company is Rs. 4 crore as per the latest
audited balance sheet.
ii) The company has fund-based working capital limits of not less than Rs. 4 crore.
iii) The shares of the company are listed at one or more stock exchanges. Closely
held companies whose shares are not listed on any stock exchange are also
permitted to issue CPs provided all other conditions are fulfilled.
iv) The company has obtained minimum credit rating from a Credit rating agency
i.e. CP2 from Credit Rating Information Services of India Ltd., A2 from
Investment Information & Credit Rating Agency or PR2 from Credit Analysis
and Research.
Terms of Commercial Paper
The Commercial paper may be issued by the companies on the following terms and
25
Financing Working
conditions:
Capital Needs
a) The minimum period of maturity should be 15 days (It was reduced from 30 days
effective May 25, 1998) and the maximum period less than one year.
b) The minimum amount for which a CP is to be issued to a single investor in the
primary market should be Rs. 25 lakh and thereafter in multiple of Rs. 5 lakh.
c) CPs are to be issued in the form of usance promissory notes which are freely
transferable by endorsement and delivery.
d) CPs are to be issued at a discount to face value. The rate of discount is freely
determined by the issuing company and the investors.
e) The issuing company shall bear the dealers fee, rating agencies fee, and other
charges. Stamp duty shall also be applicable on CPs.
f) CPs may be issued to any person, corporate body incorporated in India, or even
unincorporated bodies. CPs may be issued to Non-resident Indians only on non-
repatriation basis and such CPs shall not be transferable.
g) The issue of CP will not be underwritten or co-accepted by any individual or
institution.
h) There will be no grace period for payment. The holder of the CP shall present
the instrument for payment to the issuing company.
Ceiling on the amount of issue of Commercial Paper

The amount for which the companies issue Commercial Paper is to be carved out of
the fund based working capital limit enjoyed by the company with its banker. The
maximum amount that can be raised through issue of commercial paper is equal to
100 percent of the fund based working capital limit. The latter is reduced pro-tanto
on the issuance of CP by the company. Effective October 19, 1996 the amount of
CP is permitted to be adjusted out of the loans or cash credit or both as per the
arrangement between the issuer of the CP and the concerned bank.

Standby facility withdrawn

As stated above, the amount of CP is carved out of the borrower’s working capital
limit. Till October 1994 commercial banks were permitted to provide standby facility
to the issuers of CPs. It ensured the borrowers to draw on their cash credit limit in
case there was no roll-over of CP. Thus the repayment of the CP was ensured
automatically.

In October 1994 Reserve bank of India prohibited the banks to grant such stand-by-
facility. Accordingly, banks reduce the cash credit limit when CP is issued. If
subsequently, the issuer requires a higher cash credit limit, he shall have to approach
the bank for a fresh assessment of his requirement for the enhancement of credit
limit. Banks do not automatically restore the limit and consider the sanction of higher
limit afresh. In November 1997, Reserve Bank of India permitted the banks to
decide the manner in which restoration of working capital limit is to be done on
repayment of the CP if the corporate requests for restoration of such limit.

Procedure for Issuing Commercial Paper

1) The company which intends to issue CP should submit an application in the
prescribed form to its bankers or leader of the consortium of banks, together
with a certificate from an approved credit rating agency. The rating should not
be more than 2 months old.
2) The banker will scrutinize the proposal and if it finds the proposal satisfying all
eligibility criteria and conditions, shall take the proposal on record.
3)
26 Thereafter, the company will make arrangement for privately placing the issue
 within a period of 2 weeks.
4) Within 3 days of the completion of the issue, the company shall advice the
Reserve Bank through its bankers the amount actually raised through CP.
5) The investors shall pay the discounted value of the CP through a cheque to the
account of the issuing company with the banker.
6) Thereafter, the fund-based working capital limit of the company will be reduced
correspondingly.
Commercial Paper in India
The Vagul Committee suggested the introduction of commercial paper in India to
enable the high worth corporates to raise short term funds cheaper as compared to
bank credit. On the other hand, the investors in CPs were expected to earn a better
return because of the absence of intermediaries between them and the borrowers.
As the issuer bears the cost of issuing the CPs, his total cost is higher by 1% point or
so over the discount rate on the CPs issued by him.

Commercial paper is being issued by corporates in India for about a decade now.
During this period the quantum of outstanding CPs has gradually increased. Till May
1997 the outstanding amount of CPs remained below the level of Rs. 1000 crore and
the rate of discount ranged above 11%. But since May 1997 the outstanding amount
has gradually increased and the discount rate remained much below 10%. During
the year 1998, Rs. 5249 crore were raised during the first fortnight of January 1998
and again in the second fortnight of August 1998 when discount rate ranged between
8.5 and 11%. Since May 1998, the level of outstanding CPs has gradually risen and
has touched the mark of Rs. 11153 crore in December 1998. Discount rate touched
the low range of 8.5 to 9% during this period. By the end of July 31, 2003, the
outstanding CPs stood at Rs.7,557 crore and the typical effective rates of discount
varied between 4.99% to 8.25%. Thus the corporates find the CP route far cheaper
than normal bank credit.

Banks continue to be the major investors in CPs as they find CPs of top-rated
companies very attractive, because of the excess liquidity situation they are presently
placed in. As on February 28, 1999, the outstanding investment by scheduled
commercial banks in CP amounted to Rs. 5367 crore with an effective discount rate
in the range of 10.2% to 13%. Outstanding investments in CPs steadily increased to
Rs. 7658 crore as on September 30.1999 due to easy liquidity.

The Reserve Bank of India has issued revised draft guidelines on July 6,2000 for the
issuance of commercial paper. The important changes proposed were:
i) Corporates are permitted to issue CP upto 50% of their working capital (fund-
based) under the automatic route, i.e. without prior clearance from the banks.
ii) CPs can be issued for wide range of maturities from 15 days to 1 year and can
be in denominations of Rs. 5 lakh or multiple there of.
iii) Financial Institutions may also issue CPs.
iv) Foreign instutional investors may invest in CPs. Within 30% limit set for their
investments in debt instruments
v) Credit rating again will decide the period of validity of the issue.

11.4 INTER-CORPORATE LOANS

Short term finance for working capital requirements of a company may be raised
through accepting inter-corporate loans or deposits. Some companies, which may
have surplus idle cash due to seasonal nature of their operations or otherwise would
27
Financing Working
like to lend such resources for such period when they are not needed by them. On
Capital Needs
the other hand, some other companies face financial stringency and need cash
resources to meet their immediate liquidity needs. The former lend their surplus
resources to the latter through brokers, who charge for their services. Inter-
corporate loans facilitate such lending and borrowings for short periods of time. The
rate of interest and other terms and conditions of such loans are determined by
negotiations between the lending and borrowing companies. The prevailing market
conditions do exert their influence on the determination of interest rates.

Statutory Provisions Prior to January 1999

The Inter-corporate loans were, till recently, governed by the provisions of section
370 of the Companies Act, 1956 and the Rules framed thereunder. This section
provided that no company shall (a) make any loan to or (b) give any guarantee or
provide any security in connection with a loan given to any body corporate unless
such loan or guarantee has been previously authorised by a special resolution of the
lending company. But such special resolution was not required in case of loans
made to other bodies corporate not under the same management as the lending
company where the aggregate of such loans did not exceed thirty percent of the
aggregate of the subscribed capital of the lending company and its free reserves.’

Further the aggregate of the loans made by the lending company to all other bodies
corporate shall not, except with the prior approval of the Central Government,
exceed.
a) Thirty percent of the aggregate of the subscribed capital of the lending company
and its free reserves, where all such other bodies are not under the same
management as the lending company.
b) Thirty percent of the aggregate of the subscribed capital of the lending company
and its free reserves, where all such corporates are under the same management
as the lending company.

Section 372 of the Companies Act laid down the limits for investment by a company
in the shares of another body corporate. Rules framed thereunder laid down that the
Board of Directors of a company shall be entitled to invest in the shares of any
other body corporate upto thirty percent of the subscribed equity share capital or the
aggregate of the paid up equity and preference share capital of such other body
corporate whichever is less. Permission of the Central Government was also
required in case the investment made by the Board of Directors in all other bodies
corporate exceed thirty percent of the aggregate of the subscribed capital and
reserves of the investing company.

Present Statutory Provisions

After the promulgation of Companies (Amendment) Ordinance 1999 in January 1999
the provisions of sections 370 and 372 were made ineffective and instead a new
section 372A was inserted to govern both inter-corporate loans and investments.
According to the new section 372 A, a company shall, directly or indirectly.
a) make any loan to any other body corporate,
b) give any guarantee, or provide security in connection with a loan made by any
other person to any body corporate, and
c) acquire, by way of subscription, purchase or otherwise, the securities of any
other body corporate upto 60% of its paid up capital and free reserves or 100%
of the free reserves, whichever is more.
The loan, investment, guarantee or security can be given to any company irrespective
of whether it is subsidiary company or otherwise. If the aggregate of all such loans
28
and investments exceed the above limit the company would have to secure the
permission of shareholders through a special resolution which should specify the
particulars of the company in which investment is to be made or loan, security or
guarantee is proposed to be given. It should also specify the purpose of the
investment, loan, security or guarantee and the specific sources of funding. The
resolution should be passed at the meeting of the Board with the consent of all
directors present at the meeting and the prior approval of the public financial
institutions where any term loan is subsisting, is obtained. But no prior approval of
the public financial institution is necessary , if there is no default in payment of loan
instalment or repayment of interest thereon as per the terms and conditions of the
loan.
The above provisions of Section 372 A will not apply to any loan made by a Holding
company to its wholly owned subsidiary or any guarantee given by the former in
respect of loan made to the latter or acquisition of securities of the subsidiary by the
holding company. Section 372 A Shall not apply to any loan, guarantee or investment
made by a banking company, an insurance company or a housing finance company or
a company whose principal business is the acquisition of shares, stocks, debentures
etc or which has the object of financing industrial enterprises or of providing infra
structural facilities.
The loan to any body corporate shall be made at a rate of interest not lower than the
Bank rate. A company which has defaulted in complying with the provisions of the
section 58A of the Companies Act, 1956 shall not be permitted to make inter-
corporate loans and investment till such default continues.
Companies making inter- corporate loans/ investment are required to keep a Register
showing the prescribed details of such loans/investments/guarantees. Such Register
shall be open for inspection and extracts may be taken therefrom. The provision of
the new section are not applicable to loans made by banking, insurance/housing
finance/investment company and a private company, unless it is subsidiary of a public
company.

If a default is made in complying with the provisions of section 372A, the company
and every officer of the company who is in default shall be punishable with
improvement upto 2 years or with fine upto Rs. 50,000/-.

Activity 11.2
1) Fill in the blanks:
a) The minimum period of maturity of CP. should be ………………..days
b) The CP must have………………………. Rating from Credit Rating
Information Services Ltd.
c) The loans by a company to another company shall carry a rate of interest
which is not less than .....................................
2) Explain what do you understand by Standby facility?
.....................................................................................................................

.....................................................................................................................

.....................................................................................................................

.....................................................................................................................
3) Provision of Section 372 A are not applicable to certain companies. Specify
them.
.....................................................................................................................29
Financing Working
.....................................................................................................................
Capital Needs
.....................................................................................................................

.....................................................................................................................

11.5 BONDS AND DEBENTURES

Bonds and debentures are another form of raising debt for augmenting funds for long
term purposes as well as for working capital. It has gained popularity during recent
years because of the depressed conditions in the new equities market and the
permission given to the banks to invest their funds in such bonds and debentures.
These debentures may be fully convertible, partly convertible, or non-convertible into
equity shares.

The salient points of the Guidelines issued by Securities and Exchange Board of
India (SEBI) in this regard are as follows:
1) Issue of fully convertible debentures having a conversion period more than 36
months will not be permissible unless conversion is made optional with “put” and
“call” options.
2) Compulsory credit rating is required, if conversion of fully convertible debentures
is made after 18 months.
3) Premium amount on conversion, and time of conversion in stages, if any, shall be
predetermined and stated in the prospectus. The rate of interest shall be freely
determined by the issuer.
4) Companies issuing debentures with maturity upto 18 months are not required to
appoint Debentures Trustees or to create Debentures Redemption Reserves. In
other cases the names of debentures trustee must be stated in the prospectus.
The trust deed must be executed within 6 months of the closure of the issue.
5) Any conversion in part or whole of the debentures will be optional at the hands
of the debenture holders, if the conversion takes places at or after 18 months
from the date of allotment but before 36 months.
6) In case of Non-Convertible Debentures and Partly convertible debentures, credit
rating is compulsory if maturity exceeds 18 months.
7) Premium amount at the time of conversion of Partly convertible debentures shall
be pre-determined and stated in the Prospectus. It must also state the
redemption amount, period of maturity, yield on redemption for Non-convertible/
Partly Convertible Debentures.
8) The discount on the non-convertible portion of the Partly convertible debentures,
in case they are traded and procedure for their purchase on spot trading basis,
must be disclosed in the propectus.
9) In case, the non-convertible portions of partly Convertible Debentures or Non-
Convertible Debentures are to be rolled over without change in the interest rate,
a compulsory option should be given to those debenture holders who want to
withdraw and encash their debentures. Positive consent of the debenture
holders must be obtained for all-over.
10) Before the rollover, fresh credit rating shall be obtained within a period of six
months prior to the due date of redemption and must be communicated to the
debenture holders before the rollover. Fresh Trust Deed must be made in case
of rollover.
11) The letter of information regarding rollover shall be vetted by SEBI.
30
12) The disclosure relating to raising of debenture will contain amongst other things
a) The existing and future equity and long term debt ratio,
b) Servicing behaviour of existing debentures,
c) Payment of interest due on due dates on term loans and debentures
d) Certificate from a financial institution or bankers about their no objection for a
second or pari passu charge being created in favour of the trustees to the
proposed debenture issue.
13) Companies which issue debt instruments through an offer document can issue
the same without submitting the prospectus or letter of offer for vetting to SEBI
or obtaining an acknowledgement card from SEBI in respect of the said issue,
provided the:
a) Company’s securities are already listed on any stock exchange
b) Company has obtained atleast an ‘adequately safe’ credit rating for its
issue of debt instrument from a credit rating agency.
c) The debt instrument is not convertible, is not issued along with any other
security or, without any warrant with an option to convert into equity
shares.
14) In such cases a category I Merchant bank shall be appointed to manage the
issue and to submit the offer document to SEBI. The Merchant banker acting as
Lead Manager should ensure that the document for the issue of debt instrument
contains the required disclosure and gives a true, correct and fair view of the
state of affairs of the company. The merchant banker will also submit a due
diligence certificate to SEBI.
15) The debentures of a company can be listed at a Stock Exchange, even if its
equity shares are not listed.
16) The trustees to the Debenture issue shall have the power to protect the interest
of debenture holders. They can appoint a nominee director on the Board of the
company in consultation with institutional debenture holders.
17) The lead bank will monitor the utilisation of funds raised through debentures for
working capital purposes. In case the debentures are issued for capital
investment purpose, this task of monitoring will be performed by lead Institution/
Investment Institution.
18) In case of debentures for working capital, institutional debenture holders and
trustees should obtain a certificate from the company’s auditors regarding
utilisation of funds at the end of each accounting year.
19) Company should not issue debentures for acquisition of shares or for providing
loans to any company belonging to the same group. This restriction does not
apply to the issue of fully convertible debentures provided conversion is allowed
within a period of 18 months.
20) Companies are required to file with SEBI certificate from their bankers that the
assets on which security is to be created are free from any encumbrances and
necessary permission to mortgage the assets have been obtained or a No
objection from the financial institutions/ banks for a second or pari passu charge
has been obtained, where the assets are encumbered.

11.6 FACTORING OF RECEIVABLES

Factoring of receivables is another source of raising working capital by a business
entity. Factoring is an agreement under which the receivables arising out of the sale
of goods/services are sold by a firm(called the client) to the factor (a financial
31
Financing Working
intermediary). The factor thereafter becomes responsible for the collection of the
Capital Needs
receivables. In case of credit sale, the purchaser promises to pay the sale proceeds
after a period of time. The seller has to wait for that period for realising his claims
from the buyer. His cash cycle is thus prolonged and he needs larger working
capital. Factoring of receivables is a device to sell the receivables to a factor, who
pays the whole or a major part of dues from the buyer immediately to the seller,
thereby reducing his cash cycle and the requirements of working capital. The factor
realises the amount from the buyers on the due date.

Factoring is of recent origin in India. Government of India notified factoring as a

permissible activity for the banks in July 1990. They have been permitted to set up
separate subsidiaries for this purpose or invest in the factoring companies jointly with
other banks. Two factoring companies have been set up by banks jointly with Small
Industries Development Bank of India. SBI Factors and Commercial Services Ltd.
has been promoted by State Bank of India, Union, Bank of India and the Small
Industries Development Bank of India. Canbank Factors Ltd. is another factoring
company promoted jointly by Canara Bank, Andhra Bank and SIDBI. The
Foremost Factors Ltd. is the first private sector company which has commenced its
operations in 1997.
With Recourse and Without Recourse Factoring
Factoring business may be undertaken on ‘with recourse’ or ‘without recourse’
basis. Under with recourse factoring, the factor has recourse to the client if the
receivable purchased turn out to be irrecoverable. In other words, the credit risk is
borne by the client and not the factor. The factor is entitled to recover the amount
from the client the amount paid in advance, interest for the period and any other
expenses incurred by him.
In case of, without recourse factoring, the factor does not possess the above right of
recourse. He has to bear the loss arising out of non-payment of dues by the buyer.
The factor, therefore, charges higher commission for bearing this credit risk.
Mechanism of Factoring
1) An agreement is entered into between the seller and the factor for rendering
factoring services.
2) After selling the goods to the buyer, the seller sends copy of invoice, delivery
challen, instructions to make payment to the factor, to the buyer and also to the
factor.
3) The factor makes payment of 80% or more of the amount of receivable to the
seller.
4) The seller should also execute a deed of assignment in favour of the factor to
enable him to recover amount from the buyer.
5) The seller should also obtain a letter of waiver from the banker in favour of the
factor, if the bank has charge over the asset sold to the buyer.
6) The seller should give a letter of confirmation that all conditions of the sale
transactions have been completed.
7) The seller should also confirm in writing that all payments receivable from the
debtor are free from any encumbrances, charge, right of set off or counter claim
from another person, etc.
8) The facility of factoring in India is available to all forms of business organisations
in manufacturing, service and trading. Sole proprietary concerns, partnership
firms and companies can avail of the services of factors, but a ceiling on the
credit which they can avail of in terms of the value of the invoice to be
purchased is generally fixed for each client in medium and small scale sectors.
32 Generally the period for which receivables are factored ranges between 30 and
 90 days.
9) The factor evaluates the client on the basis of various criteria e.g. level of
receivables turnover, the quality of receivables, growth in sales, etc. The factor
charges a service fee and a discount. The service fee is charged in advance and
depends upon the invoice value for different categories of clients. It ranges
between 0.5-.2% of the invoice value.
Moreover, the factor also charges a discount on the pre-payment made to the client.
It is payable in arrears and is generally linked to the bank lending rate. In case of
high worth clients, the discount rate is presently one percent point lower than the rate
charged under the cash credit system.

The cost of funds under, without recourse, factoring is much higher than, with
recourse, factoring due to the credit risk borne by the factor. However, the service
fee and discount charge depends upon the cost of funds and the operational cost.

Activity 11.3

1) Fill in the blanks:

a) Credit Rating is compulsory if the fully convertible debentures are convertible

after................... months.

b) The names of Debenture Trustees must be disclosed in ..........................

c) In case of ‘with recourse factoring’, the loss arising out of non-payment of

the dues by the buyer is borne by........................
2) State the conditions under which it is not necessary for a company to issue debt
instruments without submitting proposals or letter of offer to SEBI.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Explain the mechanism of factoring of receivables.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

11.7 SUMMARY
In this unit, we have discussed various sources of short term funds, other than bank
credit and trade credit which are used by business and industrial houses in India to
finance their working capital needs. The unit covers public deposits, commercial
paper, inter-corporate loans, bonds and debentures and factoring of receivables. The
statutory framework, along with rules and regulations concerning these sources have
been explained in detail. Relative significance of these sources has also been
explained by citing relevant facts and figures. Though these sources are deemed as
non-bank sources of finance, involvement of commercial banks in providing such
finance is evident, specially in case of commercial paper, bonds and debentures and
factoring of receivables.

33
Financing Working
11.8 KEY WORDS
Capital Needs

Public Deposits: Public deposits are deposits of money accepted by

companies in India from the public for specified period ranging between 3 months and
36 months. These deposit are accepted within the limit and subject to terms
prescribed under Companies( Acceptance of Deposits) Rule , 1975.

Commercial Paper: Commercial paper is an unsecured instrument through which

high net worth corporates borrow funds from any person, corporate or
unincorporated body. It is issued in the form of usance promissory note; which is
freely transferable by endorsement and delivery. Its minimum period of maturity
should be 15 days and maximum period less then a year, It is issued at a discount
to face value.

Inter-Corporate Loans : These are loans made by a company to another

company, whether its own subsidiary or otherwise. These loans and investments in
the securities of another company should be upto the limits specified in section 372 A
of the Companies Act.

Convertible Bonds: These are bonds issued by the companies to the investors,
which are convertible either fully or partly into the equity shares of the company
within a specified period of time at the option of the investor.

Put and Call Options: The debt instruments like bonds and debentures are issued
for a fixed period of time-i.e. they are redeemable at the expiry of a fixed period
say 5 or 7 years. But sometimes the issuer includes the ‘put’ or/and ‘call’ options
in the terms of issue. ‘Put’ option means that the investor may, if he so desires ask
for the redemption of the bond after a specified period is over but before the period
of maturity. If the issuer reserves this right to himself to redeem the bond after a
specific minimum period but before the date of maturity, such right is called ‘call’
option.

Credit Rating: Credit Rating is an opinion expressed by a Credit Rating Agency

about the ability of the issuer of a debt instrument to make timely payment of
principal and interest thereon. It is expressed in alphabetical symbols. All types of
debt instruments may be rated. Rating is given for each instrument and not for the
issuer as such.

Factoring of Receivables: Factoring is an agreement under which the receivables

arising out of the sale of goods/services are sold by a firm (called the client) to the
factor (a financial intermediary), who becomes responsible for the collection of the
receivable on the due date.

With Recourse and without Recourse Factoring : When the factor bears the
loss arising out of non-payment of the dues by the buyer, it is called without recourse
factoring. In case of ‘With Recourse Factoring’ he can recover the loss from the
client (seller).

11.9 SELF ASSESSMENT QUESTIONS

1) State the two broad categories of deposits which non-banking companies can
accept to meet their working capital needs.
2) State the existing guidelines regarding maintenance of liquid assets prescribed for
a company accepting deposits from the public.
3) What remedy is available to the depositor, if the company fails to repay the
deposit as per the terms and conditions of the deposit?
4) Describe the eligibility conditions prescribed for issuing the Commercial Paper.
34
5) Describe five important terms and conditions for issuing Commercial Paper.
6) Why are banks major investors in Commercial Paper?
7) Explain the provisions of newly inserted section 372 A regarding inter-corporate
loans and investments.
8) Describe the guidelines issued by SEBI for the conversion of debentures into
equity.
9) What do you understand by factoring? Discuss With Recourse and Without
Recourse factoring.
10) Write a short note on ‘company deposits’ as a source of working capital finance
for industry in India.
11) As the ceiling on the issue of the Commercial Paper has been removed and the
banks are the major investors in CPs, do you think that CPs will replace bank
credit all together? Give reasons.

11.10 FURTHER READINGS

1) Reserve Bank of India: Report of the study group on Examining the
Introduction of factoring Services in India. ( chairman: E.S. Kalyana
sundaram)

2) Reserve Bank of India: Repon of the working Group on Money Market.

(Chairman: N. Vaghul).

3) Jain A. P.: Company Deposit: Law and Procedure. Chapters 1,2,3.

4) Taxman’s Companies Act with SEBI Rules/Regulations and Guidelines, 1998.

35
 Indira Gandhi National Open University MS-41
School of Management Studies
Working Capital
Management

FINANCING WORKING CAPITAL NEEDS 3

UNIT 11 OTHER SOURCES OF SHORT
TERM FINANCE
Objectives
The objectives of this Unit are:
• To discuss the sources of short term finance, other than bank credit and trade
credit, to meet the working capital needs, and
• To highlight the framework of rules and regulations prescribed by the authorities
regarding these non-bank sources of finance.
Structure
11.1 Introduction
11.2 Public Deposits
11.3 Commercial Paper
11.4 Inter-Corporate Loans
11.5 Bonds and Debentures
11.6 Factoring of Receivables
11.7 Summary
11.8 Key Words
11.9 Self Assessment Questions
11.10 Further Readings

11.1 INTRODUCTION
Trade credit and commercial bank credit have been two important sources of
funds for financing working capital needs of companies in India, apart from the long
term source like equity shares. However, more stringent credit policies followed by
banks, tightening financial discipline imposed by them, and their higher cost, led the
companies to go in for new and innovative sources of finance. As the new equities
market has remained in a subdued condition and investor interest in the equities has
almost vanished during recent years, corporates have raised larger resources
through debt instruments, some of them being for as short a period as 18 months.
The situation has turned bouyant for corporates during 2002 and after for any type of
finance.

Raising short term and medium term debt by inviting and accepting deposits from the
investing public has become an established practice with a large number of
companies both in the private and public sectors. This is the outcome of the process
of dis-intermediation that is taking place in Indian economy. Similarly, issuance of
Commercial Paper by high net-worth Corporates enables them to raise short-term
funds directly from the investors at cheaper rates as compared to bank credit. In
practice, however, commercial banks have been the major investors in Commercial
Paper in India, implying thereby that bank credit flows to the corporate sector
through the route of CPs. Inter-Corporate loans and investments enable the cash
rich corporations to lend their surplus resources to those who need them for their
working capital purpose. Factoring of receivables is a relatively recent innovation
which enables the corporates to convert their receivables into liquidity within a
short period of time. In this unit we shall discuss the salient features of various
sources of non-bank finance and the regulatory framework evolved in respect of
them.

1
Financing Working
11.2 PUBLIC DEPOSITS
Capital Needs

Public deposits are unsecured deposits accepted by companies for specific periods
and at specific rates of interest. These deposits have acquired prominence as a
source of finance for the companies, as it is more convenient and cheaper to mobilise
short term finance through such deposits. Public deposits provide a fine example of
dis-intermediation, as the borrower directly accepts the deposits from the lenders, of
course with the help of brokers.

In India, acceptance of deposits from the public is regulated by sections 58A and
58B of the Companies Act 1956, and the Companies (Acceptance of Deposits)
Rules, 1975. The above sections were inserted in the Companies Act in 1974 with
the objective to safeguard the interests of the depositors. The regulatory framework
in this regard is contained in the Companies Act and the Rules. Their important
provisions are stated below:

Sections 58A (1) empowers the Central Government, in consultation with the
Reserve Bank of India , to prescribe the limits up to which, the manner in which and
the conditions subject to which deposits may be invited or accepted by a company
either from the public or from its members. Such deposits are to be invited in
accordance with the rules made under this section and after insertion of an
advertisement issued by the company.

Section 58 (2) (c) which was inserted with effect from March 1, 1997 prohibits a
company which is in default in the repayment of any deposit or part thereof or any
interest thereupon, from accepting any further deposit.

Categories of Deposits and Statutory limits

Rule 3 lays down that the period for which such deposits may be accepted by a
company should not be less than 3 months and not more than 36 months from the
date of acceptance or renewal of deposit. Companies are not permitted to accept
deposits repayable on demand or on notice. Deposits accepted by companies are
divided into the following two categories and separate limits have been prescribed for
each of them:

i) Deposits received from specified sources:

Deposits against unsecured debentures
Deposits from shareholders
Deposits guaranteed by directors
The maximum limit upto which such deposits are allowed is 10% of the aggregate
paid up share capital and free reserves.

ii) Deposit received from the general public:

This category of deposits may be accepted to the extent of 25% of the aggregate
paid up capital and free reserves of the company.

For government companies, there is only one single limit of 35% of paid up capital
and free reserves for all such deposits.

Companies are, however, permitted to accept or renew deposit from depositors

falling in category (i) above for periods below 6 months but not less than 3 months
for the purpose of meeting any short term requirements of funds provided such
deposits do not exceed 10% of the aggregate of paid up share capital and free
reserves of the company.
2
Maintenance of Liquid Assets
th
Every company accepting public deposit is required to deposit or invest before 30
April of each year, an amount which shall not be less than 15% of the amount of its
st
deposits which will mature during the next financial year ending 31 March in any
one or more of the following:
a) in a current or other deposit account with any scheduled bank, free from charge
or lien,
b) in unencumbered securities of the central or state governments,
c) in unencumbered securities in which Trust funds may be invested under the
Indian Trust Act, 1882; or
d) in unencumbered bonds issued by Housing Development Finance Corporation
Ltd.
The securities referred to in clauses (b) or (c) shall be reckoned at their market
value. The amount deposited or invested as aforesaid shall not be utilised for any
other purpose than the repayment of deposits maturing during the year.

Rates of Interest and Brokerage

The Rules prescribe the maximum rate of interest payable on such deposits. At
present companies are allowed to pay interest not exceeding 15% per annum at
rates which shall not be shorter than monthly rests.

Companies are permitted to pay brokerage to any broker at the rate of 1% of the
deposits for a period of upto 1 year, 1½ % for a period more than 1 year but upto 2
years and 2% for a period exceeding 2 years. Such payment shall be on one time
basis.

Advertisement

Every company intending to invite or accept deposits from the public must issue an
advertisement for that purpose in a leading English newspaper and in one vernacular
newspaper circulating in the state in which the registered office of the company is
situated.

The advertisement must be issued on the authority and in the name of the Board of
Directors of the company. The advertisement must contain the conditions subject to
which deposits shall be accepted by the company and the date on which the Board
of Directors has approved the text of the advertisement. In addition, the
advertisement must contain the following information, namely:
a) Name of the company,
b) The date of incorporation of the company,
c) The business carried on by the company and its subsidiaries with the details of
branches of units, if any,
d) Brief particulars of the management of the company
e) Names, addresses and occupations of the directors,
f) Profits of the company, before and after making provision for tax, for the three
financial years immediately preceding the date of advertisement,
g) Dividends declared by the company in respect of the said years.
h) A summarised financial position of the company as in the two audited balance
sheets immediately preceding the date of advertisement in the prescribed form,
3
Financing
i) Workingwhich the company can raise by way of deposits under these rules
The amount
Capital Needs
and the aggregate of deposits actually held on the last day of the immediately
preceding financial year.
j) A statement to the effect that on the day of the advertisement, the company has
no overdue deposits, other than the unclaimed deposits, or a statement showing
the amount of such overdue deposits, as the case may be, and
k) A declaration as prescribed under the Rules.
The advertisement shall be valid until the expiry of six months from the date of
closure of the financial year in which it is issued or until the date on which the
balance sheet is laid before the company at its general meeting, or where Annual
General Meeting for any year has not been held, the latest day on which that meeting
should have been held as per the Companies Act, whichever is earlier. A fresh
advertisement is required to be made in each succeeding financial year.

Before issuing an advertisement, a copy of such advertisement shall have to be

delivered to the Registrar for registration. Such advertisement should be signed by
the majority of the Directors of the company or their duly authorised agents.

The above provision regarding mandatory publication of an advertisement is

necessary in case the company invites public deposits. But if the company intends to
accept deposits without inviting the same, it is not required to issue an advertisement
but a statement in lieu of such advertisement shall have to be delivered to the
Registrar for registration, before accepting deposits. The contents of the statement
and its validity period shall be the same as in the case of an advertisement.

Procedure for Accepting Deposits

Every company intending to accept public deposits is required to supply to the
investors forms, which shall be accompanied by a statement by the company
containing all the particulars specified for advertisements. The application must also
contain a declaration by the depositor stating that the amount is not being deposited
out of the funds acquired by him by borrowing or accepting deposits from any other
person.

On accepting a deposit or renewing an existing deposit, every company shall furnish

to the depositor or his agent a receipt for the amount received by the company within
a period of eight weeks from the date of receipt of money or realisation of cheques.
The receipt must be signed by an officer of the company duly authorised by it. The
company shall not have the right to alter to the disadvantage of the depositor, the
terms and conditions of the deposit after it is accepted.

Register of Deposits
Every company accepting deposits is required to keep as its registered office one or
more registers in which the following particulars about each depositor are to be
entered:
a) Name and address of the depositors,
b) Date and amount of each deposit
c) Duration of the deposit and the date on which each deposit is repayable
d) Rate of interest
e) Date or dates on which payment of interest will be made.
f) Any other particulars relating to the deposit.
These registers shall be preserved by the company in good order for a period of not
4
less than eight years from the end of the financial year in which the latest entry is
made in the Register.

Repayment of Deposits
Deposits are accepted by companies for specified period say 12 months, 18 months,
24 months, etc. Companies prescribe different rates of interest for deposits for
different periods. Other terms and conditions are also prescribed by the companies
and interest is paid at the stipulated rate at the time of maturity of the deposit.

But, if a depositor desires repayment of the deposit, before the period stipulated in the
Receipt, companies are permitted to do so, but interest is to be paid at a lower rate.
Rules prescribe that if a company makes repayment of a deposit after the expiry of a
period of six months from the date of such deposit, but before the expiry of the period
for which such deposit was accepted by the company, the rate of interest payable by
the company shall be determined by reducing one percent from the rate which the
company would have paid had the deposit been accepted for the period for which the
deposit had run.

The rules also provide that if a company permits a depositor to renew the deposit,
before the expiry of the period for which such deposit was accepted by the company,
for availing of benefit of higher rate of interest, the company shall pay interest to
such depositor at higher rate, if
a) such deposit is renewed for a period longer than the unexpired period of the
deposit, and
b) the rate of interest as stipulated at the time of acceptance or renewal of a
deposit is reduced by one percent for the expired period of the deposit and is paid
or adjusted or recovered.
The Rules also stipulate that if the period for which the deposit had run contains any
part of a year, then if such part is less than six months, it shall be excluded and if part
is six months or more, it shall be reckoned as one year.

Return of Deposits
Every company accepting deposits is required to file with the Registrar every year
th st
before 30 June, a return in the prescribed form and giving information as on 31
March of the year. It should be duly certified by the auditor of the company. A copy
of the same shall also be filed with the Reserve Bank of India.

Penalties
st
Sub-section 9 and 10 of section 58 A, which were inserted with effect from 1
September 1989, provide a machinery for repayment of deposits on maturity and also
prescribes penalties for defaulting companies. According to sub-section (9), if a
company fails to repay any deposit or part thereof in accordance with the terms and
conditions of such deposit, the Company Law Board may, if it is satisfied, direct the
company to make repayment of such deposit forthwith or within such time or subject
to such conditions as may be specified in its order. The Company Law Board may
issue such order on its own or on the application of the depositor and shall give a
reasonable opportunity of being heard to the company and to other concerned
persons.

Sub-section 10 prescribes penalty for non-compliance with the above order of the
Board. Whoever fails to comply with its order shall be punishable with imprisonment
which may extend to 3 years and shall also be liable to a fine of not less than Rs. 50
for every day during which such non-compliance continues.
5
Financing
The aboveWorking
rule shall not apply to those categories of amounts which may be specified
Capital Needs
in consultation with Reserve Bank of India.
Section 58 A (6) stipulates penalties for accepting deposits in excess of the specified
limits. Where a company accepts deposits in excess of the limits prescribed or in
contravention of the manner or condition prescribed, the company shall be
punishable:
a) Where such contravention relates to the acceptance of any deposit, with fine
which shall not be less than an amount equal to the amount of the deposit
accepted,
b) Where such contravention relates to the invitation of any deposit, with fine which
may extend to Rs. 1 lakh, but not less than Rs. 5000.

Every officer of the company who is in default shall be punishable with imprisonment
for a term which may extend to 5 years and shall also be liable to fine.

Deduction of Tax At Source

According to section 194 A of the Income Tax Act, 1961, the companies accepting
public deposits are required to deduct income tax at source at the prescribed rates if
the aggregate interest paid or credited during a financial year exceeds Rs. 5000.
This limit has been recently (May 2000) raised from Rs. 2500 to Rs. 5000.

Public Deposits with Companies in India

Public Deposits constitute an important source of working capital for corporates in
India. According to the data published by the Reserve Bank of India, the total
amount of Public deposits with the companies as at the end of March 1997 was Rs.
357, 153 crores, out of which 62.7% was held by the Non-finance companies and
the rest by finance companies and other Non-banking Companies.
Companies attract deposits because of higher rates of interest vis-à-vis the banks.
One year coupon rate of leading manufacturing companies at present ranges from
11% to 15% . Moreover, most of the companies provide incentive ranging from 0.25
to 1% to the depositors. For the guidance of the depositors the fixed deposits of the
companies are rated also by the Credit Rating agencies and the credit ratings are
published by the companies to solicit deposits. The rate of interest varies with the
credit rating assigned to it. Higher credit rating carries lower rate of interest and
vice-versa.
Public deposits with the companies are unsecured deposits and do not carry the cover
of deposit insurance while bank deposits are insured by Deposit Insurance and Credit
Guarantee Corporation of India to the extent of Rs. 1 lakh in each account. Many
companies default in the repayment of the deposits along with interest. In many
cases, the District Consumers Disputes Redressal Fora have penalised the
companies for not paying their depositors’ money. The Fora have held the
companies guilty for deficiency of service and maintained that a depositor was a
consumer within the meaning of the Consumer Protection Act., 1986 Nevertheless,
reputed companies do attract deposits from the public, because of their sound
financial position and reputation.
Activity 11.1
1) Fill in the blanks:
a) A company which ………………………………………………….. is
prohibited from accepting any further deposit.
b) The maximum period for which a company may accept deposit is
………….months.
6
 c) The advertisement for deposit must give the profits of the company and
dividends declared during…………………………………financial years
immediately preceding the date of advertisement.
2) Can a company repay a deposit before the period stipulated in the Receipt?
Will the depositor suffer in such a case?
.................................................................................................................
.................................................................................................................
.................................................................................................................
.................................................................................................................
3) What penalty is imposed on the company if it accepts deposit in excess of
the prescribed limits?
.................................................................................................................
.................................................................................................................
.................................................................................................................
.................................................................................................................

11.3 COMMERCIAL PAPER

Commercial paper (C.P) is another source of raising short term funds by highly rated
corporate borrowers for working capital purposes. A commercial paper at the same
time provides an opportunity to cash rich investors to park their short term funds.
The Reserve Bank of India permitted companies to issue Commercial paper in 1989
and issued guidelines entitled “Non banking Companies (Acceptance of Deposits
through Commercial Paper) Directions 1989,” to regulate the issuance of C.Ps. The
guidelines have been significantly relaxed and modified from time to time. The salient
features of these guidelines (as amended to date) are as follows:

Eligibility to Issue CPs

Companies (except the banking companies) which fulfil the following requirements
are permitted to issue CPs in the money market:
i) The minimum tangible net worth of the company is Rs. 4 crore as per the latest
audited balance sheet.
ii) The company has fund-based working capital limits of not less than Rs. 4 crore.
iii) The shares of the company are listed at one or more stock exchanges. Closely
held companies whose shares are not listed on any stock exchange are also
permitted to issue CPs provided all other conditions are fulfilled.
iv) The company has obtained minimum credit rating from a Credit rating agency
i.e. CP2 from Credit Rating Information Services of India Ltd., A2 from
Investment Information & Credit Rating Agency or PR2 from Credit Analysis
and Research.
Terms of Commercial Paper
The Commercial paper may be issued by the companies on the following terms and
conditions:
a) The minimum period of maturity should be 15 days (It was reduced from 30 days
effective May 25, 1998) and the maximum period less than one year.
b) The minimum amount for which a CP is to be issued to a single investor in the
primary market should be Rs. 25 lakh and thereafter in multiple of Rs. 5 lakh.

7
Financing
c) Working
CPs are to be issued in the form of usance promissory notes which are freely
Capital Needs
transferable by endorsement and delivery.
d) CPs are to be issued at a discount to face value. The rate of discount is freely
determined by the issuing company and the investors.
e) The issuing company shall bear the dealers fee, rating agencies fee, and other
charges. Stamp duty shall also be applicable on CPs.
f) CPs may be issued to any person, corporate body incorporated in India, or even
unincorporated bodies. CPs may be issued to Non-resident Indians only on non-
repatriation basis and such CPs shall not be transferable.
g) The issue of CP will not be underwritten or co-accepted by any individual or
institution.
h) There will be no grace period for payment. The holder of the CP shall present
the instrument for payment to the issuing company.
Ceiling on the amount of issue of Commercial Paper

The amount for which the companies issue Commercial Paper is to be carved out of
the fund based working capital limit enjoyed by the company with its banker. The
maximum amount that can be raised through issue of commercial paper is equal to
100 percent of the fund based working capital limit. The latter is reduced pro-tanto
on the issuance of CP by the company. Effective October 19, 1996 the amount of
CP is permitted to be adjusted out of the loans or cash credit or both as per the
arrangement between the issuer of the CP and the concerned bank.

Standby facility withdrawn

As stated above, the amount of CP is carved out of the borrower’s working capital
limit. Till October 1994 commercial banks were permitted to provide standby facility
to the issuers of CPs. It ensured the borrowers to draw on their cash credit limit in
case there was no roll-over of CP. Thus the repayment of the CP was ensured
automatically.

In October 1994 Reserve bank of India prohibited the banks to grant such stand-by-
facility. Accordingly, banks reduce the cash credit limit when CP is issued. If
subsequently, the issuer requires a higher cash credit limit, he shall have to approach
the bank for a fresh assessment of his requirement for the enhancement of credit
limit. Banks do not automatically restore the limit and consider the sanction of higher
limit afresh. In November 1997, Reserve Bank of India permitted the banks to
decide the manner in which restoration of working capital limit is to be done on
repayment of the CP if the corporate requests for restoration of such limit.

Procedure for Issuing Commercial Paper

1) The company which intends to issue CP should submit an application in the
prescribed form to its bankers or leader of the consortium of banks, together
with a certificate from an approved credit rating agency. The rating should not
be more than 2 months old.
2) The banker will scrutinize the proposal and if it finds the proposal satisfying all
eligibility criteria and conditions, shall take the proposal on record.
3) Thereafter, the company will make arrangement for privately placing the issue
within a period of 2 weeks.
4) Within 3 days of the completion of the issue, the company shall advice the
Reserve Bank through its bankers the amount actually raised through CP.
5) The investors shall pay the discounted value of the CP through a cheque to the
account of the issuing company with the banker.
8
6) Thereafter, the fund-based working capital limit of the company will be reduced
correspondingly.
Commercial Paper in India
The Vagul Committee suggested the introduction of commercial paper in India to
enable the high worth corporates to raise short term funds cheaper as compared to
bank credit. On the other hand, the investors in CPs were expected to earn a better
return because of the absence of intermediaries between them and the borrowers.
As the issuer bears the cost of issuing the CPs, his total cost is higher by 1% point or
so over the discount rate on the CPs issued by him.

Commercial paper is being issued by corporates in India for about a decade now.
During this period the quantum of outstanding CPs has gradually increased. Till May
1997 the outstanding amount of CPs remained below the level of Rs. 1000 crore and
the rate of discount ranged above 11%. But since May 1997 the outstanding amount
has gradually increased and the discount rate remained much below 10%. During
the year 1998, Rs. 5249 crore were raised during the first fortnight of January 1998
and again in the second fortnight of August 1998 when discount rate ranged between
8.5 and 11%. Since May 1998, the level of outstanding CPs has gradually risen and
has touched the mark of Rs. 11153 crore in December 1998. Discount rate touched
the low range of 8.5 to 9% during this period. By the end of July 31, 2003, the
outstanding CPs stood at Rs.7,557 crore and the typical effective rates of discount
varied between 4.99% to 8.25%. Thus the corporates find the CP route far cheaper
than normal bank credit.

Banks continue to be the major investors in CPs as they find CPs of top-rated
companies very attractive, because of the excess liquidity situation they are presently
placed in. As on February 28, 1999, the outstanding investment by scheduled
commercial banks in CP amounted to Rs. 5367 crore with an effective discount rate
in the range of 10.2% to 13%. Outstanding investments in CPs steadily increased to
Rs. 7658 crore as on September 30.1999 due to easy liquidity.

The Reserve Bank of India has issued revised draft guidelines on July 6,2000 for the
issuance of commercial paper. The important changes proposed were:
i) Corporates are permitted to issue CP upto 50% of their working capital (fund-
based) under the automatic route, i.e. without prior clearance from the banks.
ii) CPs can be issued for wide range of maturities from 15 days to 1 year and can
be in denominations of Rs. 5 lakh or multiple there of.
iii) Financial Institutions may also issue CPs.
iv) Foreign instutional investors may invest in CPs. Within 30% limit set for their
investments in debt instruments
v) Credit rating again will decide the period of validity of the issue.

11.4 INTER-CORPORATE LOANS

Short term finance for working capital requirements of a company may be raised
through accepting inter-corporate loans or deposits. Some companies, which may
have surplus idle cash due to seasonal nature of their operations or otherwise would
like to lend such resources for such period when they are not needed by them. On
the other hand, some other companies face financial stringency and need cash
resources to meet their immediate liquidity needs. The former lend their surplus
resources to the latter through brokers, who charge for their services. Inter-
corporate loans facilitate such lending and borrowings for short periods of time. The
rate of interest and other terms and conditions of such loans are determined by
9
Financing Working
negotiations between the lending and borrowing companies. The prevailing market
Capital Needs
conditions do exert their influence on the determination of interest rates.

Statutory Provisions Prior to January 1999

The Inter-corporate loans were, till recently, governed by the provisions of section
370 of the Companies Act, 1956 and the Rules framed thereunder. This section
provided that no company shall (a) make any loan to or (b) give any guarantee or
provide any security in connection with a loan given to any body corporate unless
such loan or guarantee has been previously authorised by a special resolution of the
lending company. But such special resolution was not required in case of loans
made to other bodies corporate not under the same management as the lending
company where the aggregate of such loans did not exceed thirty percent of the
aggregate of the subscribed capital of the lending company and its free reserves.’

Further the aggregate of the loans made by the lending company to all other bodies
corporate shall not, except with the prior approval of the Central Government,
exceed.
a) Thirty percent of the aggregate of the subscribed capital of the lending company
and its free reserves, where all such other bodies are not under the same
management as the lending company.
b) Thirty percent of the aggregate of the subscribed capital of the lending company
and its free reserves, where all such corporates are under the same management
as the lending company.

Section 372 of the Companies Act laid down the limits for investment by a company
in the shares of another body corporate. Rules framed thereunder laid down that the
Board of Directors of a company shall be entitled to invest in the shares of any
other body corporate upto thirty percent of the subscribed equity share capital or the
aggregate of the paid up equity and preference share capital of such other body
corporate whichever is less. Permission of the Central Government was also
required in case the investment made by the Board of Directors in all other bodies
corporate exceed thirty percent of the aggregate of the subscribed capital and
reserves of the investing company.

Present Statutory Provisions

After the promulgation of Companies (Amendment) Ordinance 1999 in January 1999
the provisions of sections 370 and 372 were made ineffective and instead a new
section 372A was inserted to govern both inter-corporate loans and investments.
According to the new section 372 A, a company shall, directly or indirectly.
a) make any loan to any other body corporate,
b) give any guarantee, or provide security in connection with a loan made by any
other person to any body corporate, and
c) acquire, by way of subscription, purchase or otherwise, the securities of any
other body corporate upto 60% of its paid up capital and free reserves or 100%
of the free reserves, whichever is more.
The loan, investment, guarantee or security can be given to any company irrespective
of whether it is subsidiary company or otherwise. If the aggregate of all such loans
and investments exceed the above limit the company would have to secure the
permission of shareholders through a special resolution which should specify the
particulars of the company in which investment is to be made or loan, security or
guarantee is proposed to be given. It should also specify the purpose of the
investment, loan, security or guarantee and the specific sources of funding. The
resolution should be passed at the meeting of the Board with the consent of all
10
directors present at the meeting and the prior approval of the public financial
institutions where any term loan is subsisting, is obtained. But no prior approval of
the public financial institution is necessary , if there is no default in payment of loan
instalment or repayment of interest thereon as per the terms and conditions of the
loan.
The above provisions of Section 372 A will not apply to any loan made by a Holding
company to its wholly owned subsidiary or any guarantee given by the former in
respect of loan made to the latter or acquisition of securities of the subsidiary by the
holding company. Section 372 A Shall not apply to any loan, guarantee or investment
made by a banking company, an insurance company or a housing finance company or
a company whose principal business is the acquisition of shares, stocks, debentures
etc or which has the object of financing industrial enterprises or of providing infra
structural facilities.
The loan to any body corporate shall be made at a rate of interest not lower than the
Bank rate. A company which has defaulted in complying with the provisions of the
section 58A of the Companies Act, 1956 shall not be permitted to make inter-
corporate loans and investment till such default continues.
Companies making inter- corporate loans/ investment are required to keep a Register
showing the prescribed details of such loans/investments/guarantees. Such Register
shall be open for inspection and extracts may be taken therefrom. The provision of
the new section are not applicable to loans made by banking, insurance/housing
finance/investment company and a private company, unless it is subsidiary of a public
company.

If a default is made in complying with the provisions of section 372A, the company
and every officer of the company who is in default shall be punishable with
improvement upto 2 years or with fine upto Rs. 50,000/-.

Activity 11.2
1) Fill in the blanks:
a) The minimum period of maturity of CP. should be ………………..days
b) The CP must have………………………. Rating from Credit Rating
Information Services Ltd.
c) The loans by a company to another company shall carry a rate of interest
which is not less than .....................................
2) Explain what do you understand by Standby facility?
.....................................................................................................................

.....................................................................................................................

.....................................................................................................................

.....................................................................................................................
3) Provision of Section 372 A are not applicable to certain companies. Specify
them.
.....................................................................................................................

.....................................................................................................................

.....................................................................................................................

.....................................................................................................................
11
Financing Working
11.5 BONDS AND DEBENTURES
Capital Needs

Bonds and debentures are another form of raising debt for augmenting funds for long
term purposes as well as for working capital. It has gained popularity during recent
years because of the depressed conditions in the new equities market and the
permission given to the banks to invest their funds in such bonds and debentures.
These debentures may be fully convertible, partly convertible, or non-convertible into
equity shares.

The salient points of the Guidelines issued by Securities and Exchange Board of
India (SEBI) in this regard are as follows:
1) Issue of fully convertible debentures having a conversion period more than 36
months will not be permissible unless conversion is made optional with “put” and
“call” options.
2) Compulsory credit rating is required, if conversion of fully convertible debentures
is made after 18 months.
3) Premium amount on conversion, and time of conversion in stages, if any, shall be
predetermined and stated in the prospectus. The rate of interest shall be freely
determined by the issuer.
4) Companies issuing debentures with maturity upto 18 months are not required to
appoint Debentures Trustees or to create Debentures Redemption Reserves. In
other cases the names of debentures trustee must be stated in the prospectus.
The trust deed must be executed within 6 months of the closure of the issue.
5) Any conversion in part or whole of the debentures will be optional at the hands
of the debenture holders, if the conversion takes places at or after 18 months
from the date of allotment but before 36 months.
6) In case of Non-Convertible Debentures and Partly convertible debentures, credit
rating is compulsory if maturity exceeds 18 months.
7) Premium amount at the time of conversion of Partly convertible debentures shall
be pre-determined and stated in the Prospectus. It must also state the
redemption amount, period of maturity, yield on redemption for Non-convertible/
Partly Convertible Debentures.
8) The discount on the non-convertible portion of the Partly convertible debentures,
in case they are traded and procedure for their purchase on spot trading basis,
must be disclosed in the propectus.
9) In case, the non-convertible portions of partly Convertible Debentures or Non-
Convertible Debentures are to be rolled over without change in the interest rate,
a compulsory option should be given to those debenture holders who want to
withdraw and encash their debentures. Positive consent of the debenture
holders must be obtained for all-over.
10) Before the rollover, fresh credit rating shall be obtained within a period of six
months prior to the due date of redemption and must be communicated to the
debenture holders before the rollover. Fresh Trust Deed must be made in case
of rollover.
11) The letter of information regarding rollover shall be vetted by SEBI.
12) The disclosure relating to raising of debenture will contain amongst other things
a) The existing and future equity and long term debt ratio,
b) Servicing behaviour of existing debentures,
c) Payment of interest due on due dates on term loans and debentures
12
d) Certificate from a financial institution or bankers about their no objection for a
second or pari passu charge being created in favour of the trustees to the
proposed debenture issue.
13) Companies which issue debt instruments through an offer document can issue
the same without submitting the prospectus or letter of offer for vetting to SEBI
or obtaining an acknowledgement card from SEBI in respect of the said issue,
provided the:
a) Company’s securities are already listed on any stock exchange
b) Company has obtained atleast an ‘adequately safe’ credit rating for its
issue of debt instrument from a credit rating agency.
c) The debt instrument is not convertible, is not issued along with any other
security or, without any warrant with an option to convert into equity
shares.
14) In such cases a category I Merchant bank shall be appointed to manage the
issue and to submit the offer document to SEBI. The Merchant banker acting as
Lead Manager should ensure that the document for the issue of debt instrument
contains the required disclosure and gives a true, correct and fair view of the
state of affairs of the company. The merchant banker will also submit a due
diligence certificate to SEBI.
15) The debentures of a company can be listed at a Stock Exchange, even if its
equity shares are not listed.
16) The trustees to the Debenture issue shall have the power to protect the interest
of debenture holders. They can appoint a nominee director on the Board of the
company in consultation with institutional debenture holders.
17) The lead bank will monitor the utilisation of funds raised through debentures for
working capital purposes. In case the debentures are issued for capital
investment purpose, this task of monitoring will be performed by lead Institution/
Investment Institution.
18) In case of debentures for working capital, institutional debenture holders and
trustees should obtain a certificate from the company’s auditors regarding
utilisation of funds at the end of each accounting year.
19) Company should not issue debentures for acquisition of shares or for providing
loans to any company belonging to the same group. This restriction does not
apply to the issue of fully convertible debentures provided conversion is allowed
within a period of 18 months.
20) Companies are required to file with SEBI certificate from their bankers that the
assets on which security is to be created are free from any encumbrances and
necessary permission to mortgage the assets have been obtained or a No
objection from the financial institutions/ banks for a second or pari passu charge
has been obtained, where the assets are encumbered.

11.6 FACTORING OF RECEIVABLES

Factoring of receivables is another source of raising working capital by a business
entity. Factoring is an agreement under which the receivables arising out of the sale
of goods/services are sold by a firm(called the client) to the factor (a financial
intermediary). The factor thereafter becomes responsible for the collection of the
receivables. In case of credit sale, the purchaser promises to pay the sale proceeds
after a period of time. The seller has to wait for that period for realising his claims
from the buyer. His cash cycle is thus prolonged and he needs larger working
capital. Factoring of receivables is a device to sell the receivables to a factor, who
pays the whole or a major part of dues from the buyer immediately to the seller,
13
Financing Workinghis cash cycle and the requirements of working capital. The factor
thereby reducing
Capital Needs
realises the amount from the buyers on the due date.

Factoring is of recent origin in India. Government of India notified factoring as a

permissible activity for the banks in July 1990. They have been permitted to set up
separate subsidiaries for this purpose or invest in the factoring companies jointly with
other banks. Two factoring companies have been set up by banks jointly with Small
Industries Development Bank of India. SBI Factors and Commercial Services Ltd.
has been promoted by State Bank of India, Union, Bank of India and the Small
Industries Development Bank of India. Canbank Factors Ltd. is another factoring
company promoted jointly by Canara Bank, Andhra Bank and SIDBI. The
Foremost Factors Ltd. is the first private sector company which has commenced its
operations in 1997.
With Recourse and Without Recourse Factoring
Factoring business may be undertaken on ‘with recourse’ or ‘without recourse’
basis. Under with recourse factoring, the factor has recourse to the client if the
receivable purchased turn out to be irrecoverable. In other words, the credit risk is
borne by the client and not the factor. The factor is entitled to recover the amount
from the client the amount paid in advance, interest for the period and any other
expenses incurred by him.
In case of, without recourse factoring, the factor does not possess the above right of
recourse. He has to bear the loss arising out of non-payment of dues by the buyer.
The factor, therefore, charges higher commission for bearing this credit risk.
Mechanism of Factoring
1) An agreement is entered into between the seller and the factor for rendering
factoring services.
2) After selling the goods to the buyer, the seller sends copy of invoice, delivery
challen, instructions to make payment to the factor, to the buyer and also to the
factor.
3) The factor makes payment of 80% or more of the amount of receivable to the
seller.
4) The seller should also execute a deed of assignment in favour of the factor to
enable him to recover amount from the buyer.
5) The seller should also obtain a letter of waiver from the banker in favour of the
factor, if the bank has charge over the asset sold to the buyer.
6) The seller should give a letter of confirmation that all conditions of the sale
transactions have been completed.
7) The seller should also confirm in writing that all payments receivable from the
debtor are free from any encumbrances, charge, right of set off or counter claim
from another person, etc.
8) The facility of factoring in India is available to all forms of business organisations
in manufacturing, service and trading. Sole proprietary concerns, partnership
firms and companies can avail of the services of factors, but a ceiling on the
credit which they can avail of in terms of the value of the invoice to be
purchased is generally fixed for each client in medium and small scale sectors.
Generally the period for which receivables are factored ranges between 30 and
90 days.
9) The factor evaluates the client on the basis of various criteria e.g. level of
receivables turnover, the quality of receivables, growth in sales, etc. The factor
charges a service fee and a discount. The service fee is charged in advance and
depends upon the invoice value for different categories of clients. It ranges
14 between 0.5-.2% of the invoice value.
Moreover, the factor also charges a discount on the pre-payment made to the client.
It is payable in arrears and is generally linked to the bank lending rate. In case of
high worth clients, the discount rate is presently one percent point lower than the rate
charged under the cash credit system.

The cost of funds under, without recourse, factoring is much higher than, with
recourse, factoring due to the credit risk borne by the factor. However, the service
fee and discount charge depends upon the cost of funds and the operational cost.

Activity 11.3

1) Fill in the blanks:

a) Credit Rating is compulsory if the fully convertible debentures are convertible

after................... months.

b) The names of Debenture Trustees must be disclosed in ..........................

c) In case of ‘with recourse factoring’, the loss arising out of non-payment of

the dues by the buyer is borne by........................
2) State the conditions under which it is not necessary for a company to issue debt
instruments without submitting proposals or letter of offer to SEBI.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Explain the mechanism of factoring of receivables.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

11.7 SUMMARY
In this unit, we have discussed various sources of short term funds, other than bank
credit and trade credit which are used by business and industrial houses in India to
finance their working capital needs. The unit covers public deposits, commercial
paper, inter-corporate loans, bonds and debentures and factoring of receivables. The
statutory framework, along with rules and regulations concerning these sources have
been explained in detail. Relative significance of these sources has also been
explained by citing relevant facts and figures. Though these sources are deemed as
non-bank sources of finance, involvement of commercial banks in providing such
finance is evident, specially in case of commercial paper, bonds and debentures and
factoring of receivables.

11.8 KEY WORDS

Public Deposits: Public deposits are deposits of money accepted by
companies in India from the public for specified period ranging between 3 months and
36 months. These deposit are accepted within the limit and subject to terms
prescribed under Companies( Acceptance of Deposits) Rule , 1975.

15
Financing
Commercial Working
Paper: Commercial paper is an unsecured instrument through which
Capital Needs
high net worth corporates borrow funds from any person, corporate or
unincorporated body. It is issued in the form of usance promissory note; which is
freely transferable by endorsement and delivery. Its minimum period of maturity
should be 15 days and maximum period less then a year, It is issued at a discount
to face value.

Inter-Corporate Loans : These are loans made by a company to another

company, whether its own subsidiary or otherwise. These loans and investments in
the securities of another company should be upto the limits specified in section 372 A
of the Companies Act.

Convertible Bonds: These are bonds issued by the companies to the investors,
which are convertible either fully or partly into the equity shares of the company
within a specified period of time at the option of the investor.

Put and Call Options: The debt instruments like bonds and debentures are issued
for a fixed period of time-i.e. they are redeemable at the expiry of a fixed period
say 5 or 7 years. But sometimes the issuer includes the ‘put’ or/and ‘call’ options
in the terms of issue. ‘Put’ option means that the investor may, if he so desires ask
for the redemption of the bond after a specified period is over but before the period
of maturity. If the issuer reserves this right to himself to redeem the bond after a
specific minimum period but before the date of maturity, such right is called ‘call’
option.

Credit Rating: Credit Rating is an opinion expressed by a Credit Rating Agency

about the ability of the issuer of a debt instrument to make timely payment of
principal and interest thereon. It is expressed in alphabetical symbols. All types of
debt instruments may be rated. Rating is given for each instrument and not for the
issuer as such.

Factoring of Receivables: Factoring is an agreement under which the receivables

arising out of the sale of goods/services are sold by a firm (called the client) to the
factor (a financial intermediary), who becomes responsible for the collection of the
receivable on the due date.

With Recourse and without Recourse Factoring : When the factor bears the
loss arising out of non-payment of the dues by the buyer, it is called without recourse
factoring. In case of ‘With Recourse Factoring’ he can recover the loss from the
client (seller).

11.9 SELF ASSESSMENT QUESTIONS

1) State the two broad categories of deposits which non-banking companies can
accept to meet their working capital needs.
2) State the existing guidelines regarding maintenance of liquid assets prescribed for
a company accepting deposits from the public.
3) What remedy is available to the depositor, if the company fails to repay the
deposit as per the terms and conditions of the deposit?
4) Describe the eligibility conditions prescribed for issuing the Commercial Paper.
5) Describe five important terms and conditions for issuing Commercial Paper.
6) Why are banks major investors in Commercial Paper?
7) Explain the provisions of newly inserted section 372 A regarding inter-corporate
loans and investments.
8) Describe the guidelines issued by SEBI for the conversion of debentures into
equity.
16
 Integrating Working Capital
UNIT 12 LIQUIDITY Vs PROFITABILITY and Capital Investment
Processes
Objectives
The objectives of this unit are to:
• Explain the concepts of liquidity and profitability
• Discuss the measures of liquidity and profitability
• Highlight the relation between profitability and working capital
• Examine the significance of liquidity and profitability in taking working capital
decisions.
Structure
12.1 Introduction
12.2 Concept of Liquidity
12.3 Measurement of Liquidity
12.4 Determinants of Liquidity
12.5 Effects of Liquidity
12.6 Concept of Profit
12.7 Measurement of Profitability
12.8 Profitability and Working Capital
12.9 Liquidity Vs Profitability in Working Capital Decisions
12.10 Summary
12.11 Key Words
12.12 Self Assessment Questions
12.13 Further Readings

12.1 INTRODUCTION
As per the accountants, working capital is a liquidation concept. Whether the firm
will be able to pay off its debts using its cash flows is more important than what level
of current or non-current assets it maintains. Viewed thus, the difference between
current assets and current liabilities is more important than the size of investment
either in current assets or current liabilities. The efficiency of working capital
management finally depends upon the liquidity that is maintained by the firm. Though
several other factors may decide the liquidity of a firm, changes in the cash flows
consequent upon the changes in working capital items are highly pertinent. If cash
flows were certain, less working capital would be required, usually, the problem stems
from the difficulty in forecasting inflows, vis-à-vis outflows.

12.2 CONCEPT OF LIQUIDITY

By the term ‘liquidity’ it is meant the debt-repaying capacity of an undertaking. It
refers to the firm’s ability to meet the claims of suppliers of goods, services and
capital. According to Archer and D’Ambrosio, liquidity means cash and cash
availability, and it is from current operations and previous accumulations that cash is
available, to take care of the claims of both the short-term suppliers of capital and the
long-term ones. It has two dimensions; the short-term and the long-term liquidity.

Short-term liquidity implies the capacity of the undertaking, to repay the short-term
debt, which means the same as the ability of the firm in meeting the currently
maturing obligations form out of the current assets. The purpose of the short-term
analysis is to derive a picture of the capacity of the firm to meet its short-term
5
Working Capital obligations out of its short-term resources, that is, to estimate the risk of supplying
Management: An short-term capital to the firm.
Integrated View
Analysis of the firm’s long-term position has for its rationale, the delineation of the
ability of a firm to meet its long-term financial obligations such as interest and
dividend payment and repayment of principal. Long-term liquidity refers to the ability
of the firm to retire long-term debt and interest and other long-run obligations. When
relationships are established along these lines, it is assumed that in the long-run assets
could be liquidated to meet the financial claims of the firm. Quite often the
expression ‘liquidity’ is used to mean short-term liquidity of the companies.

In the present study, liquidity is taken to mean the short-term liquidity which refers to
the ability of the undertakings to pay of current liabilities. This is chosen because the
study is related to the management of short-term assets and liabilities. Further, the
concept of short-term liquidity is more suited to enterprises that have a remote
possibility of becoming insolvent. In other words, the long-run success of an
undertaking lies in its ability to survive in the immediate future. Further, a company
may have tremendous potential for profitability in the long-run, but may languish due
to inadequate liquidity. It is, therefore, short-term liquidity that has been considered
crucial to the very existence of an enterprise.

12.3 MEASUREMENT OF LIQUIDITY

Liquidity of an enterprise can be studied in two ways, namely (i) Technical liquidity,
and (ii) operational liquidity. The difference between the two methods of liquidity
measurement depends upon whether one assumes the ‘liquidation concept’ of
business as in case of the technical liquidity or the ‘going concern concept’ of
business as in the case of the operational liquidity.

The first method of computation of liquidity is based on the assumption that the firm
might become insolvent at any time and whether, in such an event, the current assets
held by the undertakings would be sufficient to pay-off the current liabilities. On the
other hand, the computation of ‘operational liquidity’ attempts the measurement of the
firm’s potential to meet the current obligations on the basis of net cash flows
originating from out of its own operations; with the view that a manufacturing
enterprise cannot pay off current liabilities from it current assets when it is in the run.
It is assumed under this approach the firms are going firms and hence the liabilities
are met through the net cash flows arising out of their operations.

Technical Liquidity: Technical liquidity is normally evaluated on the basis of the

following ratios in a business enterprise.
Current Ratio
Current ratio expresses the precise relation between current assets and current
liabilities. It is calculated by dividing current assets with current liabilities.
Current Ratio = Current assets/Current liabilities.
It indicates the availability of current assets in rupees for every one rupee of current
liabilities. A high ratio means that the firm has more investment in current assets.
While a low ratio indicates that the firm in question is unable to retire its current
liabilities, In fact, a satisfactory current ratio for any given firm is difficult to judge.
For most manufacturing undertakings, a ratio of 2 : 1 is traditionally considered a
bench-mark of adequate liquidity. However, in some of the undertakings like public
utilities and service firms, this standard ratio is not particularly useful as they carry no
inventories for sale.

6
Current ratio is equally useful to both the outsiders and the management. To an Integrating Working Capital
outsider, it is a measure of the firm’s ability to meet its short-term claims. So far as and Capital Investment
Processes
the management is concerned, the ratio discloses the magnitude of the current assets
that the firm carries in relation to its current liabilities. As regards the outsider, the
larger the ratio, the more liquid is the firm. But, from the management point of view,
a larger ratio indicates excess investment in less profit-generating assets. On the
contrary, a low current ratio or downward trend in the ratio indicates the inefficient
management of working capital.

Nevertheless, the current ratio is a crude and quick measure of the firm’s liquidity as
it is only a test of the quantity and not the quality. The limitation of this ratio as an
indicator of liquidity lies in the size of the inventory of the enterprise. If inventory
forms a high proportion of current assets, the 2:1 ratio might not be adequate, as a
meaningful measure of liquidity.
Quick or Acid-test Ratio
Recognising that inventory might not be very liquid or slow moving, this ratio takes
the quickly realisable assets and measures them against current liabilities. This is a
more refined of somewhat conservative estimate of the firm’s liquidity, since it
establishes a relation between quick or liquid assets and current liabilities. To be
precise, a quick asset is one that can be converted into cash immediately or
reasonably soon without loss of value, for instance, cash is the most liquid of all
assets. The other assets which are considered to be relatively liquid and included in
the quick category are accounts and bills receivable and marketable securities.
Inventory and period expenses are considered to be less liquid. Inventories normally
require some time for realising into cash. The quick ratio is, then, expressed as a
relation between quick assets and current liabilities, as:
Quick Ratio = Quick assets/Current liabilities ; or
__
= Current assets Inventories/Current liabilities.
Conventionally, a quick ratio of 1 : 1 is considered to be a more satisfactory measure
of liquidity position of an enterprise. In fact, this ratio does not entirely supplant the
current ratio; rather, it partially supplements current ratio and when used in
conjunction with it, tends to give a better picture of the firm’s ability to meet its claims
out of short-term assets.
Absolute Liquidity Ratio
Absolute liquidity ratio is the refinement of the concept of eliminating inventory as
liquid asset in the acid-test ratio, because of their uncertain value at the time of
liquidation. Although receivables are generally much more liquid in nature than
inventories, some doubt may exist concerning their liquidity as well. So, by
eliminating receivables and inventories from the current assets, another measure of
liquidity is derived by relating the sum of cash and marketable securities to the
current liabilities. Generally, an absolute liquidity ratio of 0.5 : 1 is considered
appropriate in evaluating liquidity.
Operational Liquidity
Operational liquidity which is based on the going concern concept of business, is
determined by expressing cash flows as a percentage of current liabilities. It is
verified here whether the enterprises included in the study would be able to discharge
its current liabilities from the cash flows generated from the operations.

7
Working Capital
Management: An 12.4 DETERMINANTS OF LIQUIDITY
Integrated View
The measurement of liquidity was accomplished by comparing current assets with
current liabilities. But, focus has not been thrown on the factors that determine
liquidity. Several factors influence the liquidity position of an undertaking. Significant
among them are:
a) the nature and volume of business;
b) the size and composition of current assets and current liabilities:
c) the method of financing current assets;
d) the level of investment in fixed assets in relation to the total long-term funds; and
e) the control over current assets and current liabilities.
Firstly, the nature and volume of business influence the liquidity of an enterprise.
Depending upon the nature of the units, some firms require more of working capital
than others. For some of the concerns like public utilities, less proportion of working
capital is needed, vis-à-vis, manufacturing organizations. Besides, an increasing
volume of business also enhances the funds needed to finance current assets. In
these situations, if the firm does not divert some funds form the long-term sources,
the liquidity ratios would be adversely affected.

Secondly, the size and the composition of current assets and current liabilities were
the basic factors that determine the liquidity of an enterprise. If a higher investment
is made in the current assets in relation to current liabilities, there would be a
corresponding rise in the current ratio. While quick and other ratios depend on the
composition of current assets.

Thirdly, the method of financing current assets causes changes in the liquidity ratios.
If greater part of the current assets is financed form long-term sources, greater also
would be the current ratio. On the other hand, if the concern depends much on the
outside sources for financing current assets, the ratio would fall.

Fourthly, the absorption of funds by fixed assets is one of the major causes of low
liquidity. As more and more of the firm’s total funds are absorbed in this process,
there will be little left to finance short-term needs and therefore liquidity ratios fall.
Hence, the degree of liquidity is determined by the attitude of the management in the
allocation of permanent funds between fixed and current assets.

Finally, stringent control over the current items causes fluctuations in the liquidity
ratios. If investment in current assets is not taken care of properly, the firm may
accumulate excess liquidity, which may adversely affect the profitability. On the
contrary, unduly strict control of the investment in all types of current assets may
eventually endanger the existence of the firm; owing to noncompliance of claims
because of the shortage of funds. Similarly, control over current liabilities also plays
an important role in determining liquidity of an enterprise by requiring the firm to
contribute necessary funds from long-term sources to keep up the liquidity position.

12.5 EFFECTS OF LIQUIDITY

Liquidity of a business is one of the key factors determining its propensity to succeed
or fail. Both excess and shortage of liquidity affect the interests of the firm. By
excess liquidity in a business enterprise, it is meant that it is carrying higher current
assets than are warranted by the requirements of production. Hence, it indicates the
blocking up of funds in current assets without any return. Besides, the firm has to
incur costs to carry them overtime. Further, the value of such assets would
8
depreciate in times of inflation, if they are left idle. Owing to the cornering of capital, Integrating Working Capital
the firm may have to resort to additional borrowing even at a fancy price. and Capital Investment
Processes
On the other hand, the impact of inadequate liquidity is more severe. The losses due
to insufficient liquidity would be many. Production may have to be curtailed or
stopped for want of necessary funds. As the firm will not be in a position to pay off
the debts, the credit worthiness of the firm is badly affected. In general, the smaller
the amount of default, the higher would be the damage done to the image of the unit.
In addition, the firm will not be able to secure funds from outside sources, and the
existing creditors may even force the firm into bankruptcy. Further, insufficient funds
will not allow the concern to launch any profitable project or earn attractive rates of
return on the existing investment.

Between the excess and inadequate liquidity, the latter is considered to be more
detrimental, since the lack of liquidity may endanger the very existence of the
business enterprise. Besides, both the excess and inadequate liquidity adversaly
affect the profitability. If the firm is earning very low rates of return or incurring
losses, there would be no funds generated by the operations of the company, which
are essential to retire the debts. In fact, there is a tangle between liquidity and
profitability, which eventually determines the optimum level of investment in current
assets. Of the liquidity and profitability, the former assumes further importance since
profits could be earned with ease in subsequent periods, once the image of the unit is
maintained. But, if the firm losses its face in the market for want of liquidity, it
requires Qerculean efforts to restore its position. Instances are not lacking of great
industrial giants, with comfortable book profits coming to grief for want of liquidity.

12.6 CONCEPT OF PROFIT

Profits are essential for the working of a private free-enterprise economy.
Unfortunately, there is no general agreement about the meaning of the term
‘corporate profits’, and this has led to diversity of opinions on the subject of profits.
The controversy seems to be prevailing in respect of what constitutes ‘profit’; how
profit should be measured and how profit contributes towards a healthy and vigorous
economy. As such it is not surprising to find people coming up with different
interpretations of profits while analyzing the same set of financial data. These
differences may arise simply because people apply different values to the data or
bring different insights into their interpretations. One of the examples of this problem
is the difference in the concept of the profits as per economists and accountants.
The differences get manifested in their concern for future and the past while viewing
the profits. Like wise, the business manager and the trade union leader quite
obviously emphasize interpretations of profits that represent their best interests.
Academicians differ among themselves about theoretical concepts of profits and the
process of decision-making. The term ‘profits’ can also be used by any of these
people with respect to a single firm and to the aggregate of many firms.

The meaning attributed to the word ‘profit’ ranges form the view point that it is the
entire return received by the business to the view that ‘pure’ profit is residual in
nature as it is arrived at after deductions are made form total income for wages,
interest and rent. Clark argued that profit results exclusively from dynamic change
e.g., inventions, which yield temporary profit to entrepreneurs. Hawley holds that
risk bearing is the essential function of the entrepreneur and is the basis for profit.
While differing in their views about the causes of profits, proponents of both these
views regard profit as residual. It is to be recalled that profit has been connected by
F.H. Knight with uncertainity, by Schumpeter with innovations, by Hawley with risk-
bearing, and by Mrs. Robinson, Chamberlin and Kalecki with the degree of monopoly
power.
9
Working Capital The relationship between business, profit and economic growth is basically very
Management: An simple. Profit determines investment and investment is essential to growth. Thus, a
Integrated View
steep and continuing decline in profit is likely to mean a serious drop in the investment
stances, higher profit would mean higher investment and faster growth. Further, it is
by no accident that business profits, business investment, and unemployment form
three important economic indicators that depict the level of economic activity. More
business investment is needed to provide more jobs for the rapidly growing labour
force and one of the very dependable ways to get more investment is to plough back
adequately from the profits.

The decline in profits during the postwar period has in fact been accompanied by a
short decline in the business investment in many countries in the world. The idea that
profit is good’ is unacceptable to many people. The idea that higher profits are even
better is still unpalatable. What the critics of profit erroneously perceive is that
businessmen aim not at developing economic activities but on profiteering and
fleecing the consumers. Probably their intention tells them that one man’s profit is
another man’s loss and, as such the obvious conclusion is that profit means
exploitation. But experience is a better guide than instinct and experience teaches
that in a competitive economy business profit must accrue to those ventures that best
serve the general economic welfare. The targets of private business are private
profits. The great virtue of a free and competitive economy is that it stabilizes
organic link between profits and economic welfare and therefore undermining one
results in the undermining of both.

Profits may be increased by reducing corporate taxes. But tax cut is not a panacea
and does not guarantee that profit will rise or the investment will continue to rise, Its
benefits could be lost if rising business costs lead either to inflation or to the reduction
of profits or both. Conversly, the benefit of tax reduction can be greatly enhanced if
business costs can be reduced.

The responsibility for controlling the increase in the business costs rests on various
agencies. It rests in part with the business management; in part with government,
state and local; in part with employees and their unions and in part with the public.
Thus it must certainly be recognized that the profits are one of the principal engines
of economic growth, and it must be seen that the prospect for profits is bright enough
in this country to assure continued economic expansion.

The profitability of an industry has obviously a direct bearing on its growth. This is
principally due to the psychological incentives and the financial resources that the
profitability provides. High profitability makes possible to plough back substantial
resources, helps to raise equity capital in the investment market; and make it possible
to raise loans. Thus, it is business confidence in the level of profitability which is the
primary determinant of the decision to invest. Despite the vilification of profit by
forces on the extreme left, a mixed economy will not undertake productive
investment in plant and machinery unless management in reasonably assured of
earning a rate of return at least commensurate with the risks involved.

12.7 MEASUREMENT OF PROFITABILITY

Profit is considered an indicator of operational efficiency of the firm. Profitability of
a firm is measured on the following two bases:
1) Based on Sales
2) Based on Investment
Basing on sales, the following three ratios can be considered important in judging the
profitability of an enterprise.
10
i) Gross profit ratio Integrating Working Capital
and Capital Investment
ii) Operating profit ratio Processes
iii) Net profit ratio
Gross Profit Ratio: This is calculated by comparing the Gross profit (sales - cost of
goods sold) with the Net Sales of a firm

. Gross Profit
_______________
. . Gross Profit ratio = × 100
Net Sales

This ratio indicates the profit generated by a firm for every one rupee of sale made.
For example, a Gross profit ratio of 25 per cent indicates that for every one rupee
sales, the firm makes a profit of 25 paise. Gross profit ratio depends upon the
relationship between the selling price and the cost of production including direct
expenses. The gross profit ratio reflects the efficiency with which the firm
produces/purchases the goods. Given the constant level of selling price, cost price
and raw material consumption per unit, the gross profit ratio would also remain same
from one year to another. If there is a change in the gross profit ratio from one year
to another then reasons must be looked for. If the efficiency of the firm is same then
the change in gross profit ratio may result because of change in selling price or cost
price or raw material consumption per unit.

The gross profit ratio should be analyzed and studied as a time series. For a single
year, the gross profit ratio may not indicate much about the efficiency level of the
firm. However, when studied as a time series, it may give the increasing or
decreasing trend and hence an idea of the level of operating efficiency of the firm. A
high gross profit ratio or a low gross profit ratio for a particular period does not have
any meaning unless compared with some other firm operating in the same industry or
compared with the industry average.

Operating Profit Ratio (OP Ratio): The operating profit refers to the pure
operating profit of the firm i.e. the profit generated by the operation of the firm and
hence is calculated before considering any financial charge (such as interest
payment), non-operating income/loss and tax liability, etc. The operating profit is also
termed as the Earnings Before Interest and Taxes (EBIT). The OP ratio may be
calculated as follows:
EBIT
________________
OP Ratio = × 100
Net Sales

The OP ratio shows the percentage of pure profit earned on every 1 rupee of sales
made. The OP ratio will be less than the GP ratio as the indirect expenses such as
general and administrative expenses, selling expenses and depreciation charge, etc.
are deducted from the gross profit to arrive at the operating profits i.e. EBIT. Thus
the OP ratio measures the efficiency with which the firm not only manufactures/
purchases the goods but also sells the goods. The OP ratio in conjunction with the
GP ratio can depict whether changes in the profitability of the firm are caused by
change in manufacturing efficiency or administrative efficiency. It can help to
identify the corrective measures to improve the profitability.

Net Profit Ratio (NP Ratio): The NP ratio establishes the relationship between the
net profit (after tax) of the firm and the net sales and may be calculated as follows:
Profit (After Tax)
___________________
NP Ratio = × 100
Net Sales
The NP ratio measures the efficiency of the management in generating additional
revenue over and above the total cost of operations. The NP ratio shows the overall
efficiency in manufacturing, administration, selling and distribution of the product.
This ratio also shows the net contributions made by every 1 rupee of sales to the 11
Working Capital owners funds. The NP ratio indicates the proportion of sales revenue available to the
Management: An owners of the firm and the extent to which the sales revenue can decrease or the
Integrated View
cost can increase without inflicting a loss on the owners. So, the NP ratio shows the
firm’s capacity to face the adverse economic situations.

The NP ratio can be meaningfully employed to study the profitability of the firm when
this ratio is used together with the GP ratio and the OP ratio. A time series analysis
of the GP ratio, OP ratio and the NP ratio can help to identify the reasons for
variations in the profitability. Since the difference between the operating profit and
the net profit arises only because of financial charges and the taxes, an insight into
their comparison may show as to how efficiently the firm is financed and how well
the finance manager is able to hold down taxes.

Basing on Investment, the following TWO ratios may be considered significant.

i) Return on Assets
ii) Return on Capital Employed
Return on Assets (ROA): This ratio measures the profitability of the firm in terms
of assets employed in the firm. The ROA is calculated by establishing the
relationship between the profits and the assets employed to earn that profit. Usually
the profit of the firm is measured in terms of the net profit after tax and the assets
are measured in term of total assets or total tangible assets or total fixed assets.
Conceptually, the ROA is measured as follows:
Net Profit After Taxes
_____________________
ROA = × 100
Average Total Assets

There are many other versions of the ROA to how much is the profit earned by the
firm per rupee of assets used. Sometimes, the amount of financial charges (interest,
etc.) is added back to the net profit figure to relate the net operating profit with the
operating assets of the firm. By separating the financing effect form the operating
effect, the ROA provides a cleaner measure of the profitability of these assets. In
such a case, the ROA can be calculated as follows:
EBIT – Interest
_________________
ROA = × 100
Total Assets

Thus, the ROA measures the overall efficiency of the management in generating
profits for a given level of assets. The ROA essentially relates the profits to the size
of the firm (which is measured in terms of the assets). If a firm increases its size but
is unable to increase its profits proportionately, then the ROA will decrease. In such
a case increasing the size of the assets i.e. the size of the firm will not by itself
advance the financial welfare of the owners. The ROA of a particular firm should
be compared with the industry average as the amount of assets required depends
upon the nature and characteristics of the industry.

Return on Capital Employed (RCE): The profitability of the firm can also be
analyzed from the point of view of the total funds employed in the firm. The term
funds employed or the capital employed refers to the total long term sources of funds.
It means that the capital employed comprises of shareholders funds plus long term
debts. Alternatively, it can also be defined as fixed assets plus net working capital.

This ratio may be calculated as shown below:

Net Profit After Taxes

______________________
RCE = × 100
Average Capital Employed

12
 Integrating Working Capital
12.8 PROFITABILITY AND WORKING CAPITAL and Capital Investment
Processes
There has been an attempt made to highlight the nexus between liquidity, profitability
and working capital. A further examination can be thought of with the following
indicators.

i) Net Working Capital: As a general rule, current obligations or current liabilities

are paid off by reducing current assets, which are assets that can be converted
into cash on short notice. The arithmetic difference between current assets and
current liabilities is called net working capital and it represents a cushion for
creditors. Although this measure is not a ratio, it is commonly included in the
liquidity ratios while analysing companies. It is widely used by creditors and
credit rating agencies as a measure of liquidity. More working capital is
preferred to less. In other words, creditors like a ‘big’ cushion to protect their
interest. However, too much working capital can act to the detriment of the
company because they may not be utilizing the funds effectively.

It has been found that in some cases, the net working capital turned out to be
negative in some years. This implies the mobilization of more current liabilities
compared to current assets. Judged from this point of view, the liquidity position
and the consequent efficiency can be stated to be very low.

ii) Working Capital Turnover: The turnover of working capital, which indicates
the frequency at which they were rotating is another measure of the efficiency
of working capital management. Like any other turnover or activity ratio, a low
ratio reflects a slow movement of the current assets, thereby implying a sub-
optimum utilization of working capital.
iii) Rate of Return on Current Assets: The return on current assets is yet
another useful economic indicator of the profitability of the enterprises and thus
indicates the efficiency or otherwise with which the current assets are put to
use. The rate of net profit to current assets is calculated to under line the
efficiency. In case where current assets form more than half, this ratio becomes
significant.
iv) PAT as Percentage of Sales: One of the important profitability ratios
calculated for the purpose of measuring management’s efficiency is the profits
after tax as percentage of sales. This is the overall measure of firms ability to
turn each rupee of sales into profit. If the net margin is inadequate, the firm will
fail to achieve satisfactory return on owners equity. This ratio also indicates the
firms capacity to withstand adverse economic conditions. A firm with a high net
margin ratio would be in an advantageous position to survive in the face of falling
sales, prices, rising cost of production, or declining demand for the product. It
would really be difficult for a low net margin firm to withstand these adversities.
Similarly, a firm with high net profit margin can make better use of favorable
conditions, such as rising sales prices, falling costs of production, or increasing
demand for the product. Such a firm will be able to accelerate its profits at a
faster rate than a firm with low net profit margin.
v) Assets Turnover: Usually the turnover ratios are employed to determine the
efficiency with which a particular asset is managed and also to consider the
relationship between sales and various items of assets for this purpose. These
ratios which are called activity ratios, indicate the speed with which the
investment in the assets is getting rotated or converted into sales. A proper
balance between sales and assets generally reflects that assets are managed
well. Although fixed assets may not maintain close relation with sales, they are
taken as important because of their contribution to production. Hence total
assets turnover is taken as an indicator to measure the extent of sales generated
13
for one rupee investment in assets.
Working Capital vi) Collection Period: Another indicator which is considered to be important in
Management: An judging the working capital efficiency is the collection period. This ratio indicates
Integrated View
the total number of days that was taken by the firms in collecting their debts. A
comparison of the norms fixed with the results obtained would show the positive
or negative tendencies.

vii) Interest as Percentage of Profits before Interest and Tax: One of the
ratios that is used to determine the debt capacity of a firm is this coverage ratio.
This ratio reveals the ability of the company in servicing the debt undertaken. A
high ratio speaks about the interest burden of the company and consequently the
adverse impact of the same on profitability. In the same way, a high ratio
enhances the financial risk of the firm.

12.9 LIQUIDITY Vs. PROFITABILITY IN WORKING

CAPITAL DECISIONS
All decisions of the financial manager are assumed to be geared to maximization of
shareholders wealth, and working capital decisions are no exception. Accordingly,
risk-return trade-off characterizes each of the working capital decision. There are
two types of risks inherent in working capital management, namely, liquidity risk and
opportunity loss risk. Liquidity risk is the non-availability of cash to pay a liability that
falls due. It may happen only on certain days. Even so, it can cause not only a loss
of reputation but also make the work condition unfavorable for getting the best terms
on transaction with the trade creditors. The other risk involved in working capital
management is the risk of opportunity loss i.e. risk of having too little inventory to
maintain production and sales, or the risk of not granting adequate credit for realizing
the achievable level of sales. In other words, it is the risk of not being able to
produce more or sell more or both, and, therefore, not being able to earn the potential
profit, because there were not enough funds to support higher inventory and book
debts. Thus, it would not be out of place to mention that it is only theoretical that the
current assets could all take zero values. Indeed, it is neither practicable nor
advisable. In practice, all current assets take positive values because firms seek to
reduce working capital risks. However, if more funds are deployed in current assets,
the higher would be the cost of funds employed, and therefore, lesser the profit.

If liquidity goes up, profitability goes down. The risk-return trade-off involved in
managing the firm’s liquidity via investing in marketable securities is illustrated in the
following example. Firms A and B are identical in every respect but one Firm B has
invested Rs. 5,000 in marketable securities, which has been financed with equity.
That is, the firm sold equity shares and raised Rs.5,000. The balance sheets and net
incomes of the two firms are shown in Table 12.1. Note that Firm A has a current
ratio of 2.5 (reflecting net working capital of Rs. 15.000) and earns a 10 per cent
return on its total assets. Firm B, with its larger investment in marketable securities
has a current ratio of 3 and has net working capital of Rs. 20,000. Since the
marketable securities earn a return of only 9 per cent before taxes (4.5 per cent after
taxes with a 50 per cent tax rate), Firm B earns only 9.7 per cent on its total
investment. Thus, investing in current assets and in particular in marketable
securities, does have a favorable effect on firms liquidity but it also has an
unfavorable effect on the firm’s rate of return earned on invested funds. The risk-
return trade-off involved in holding more cash and marketable securities, therefore, is
one of added liquidity versus reduced profitability.

In the use of current versus long-term debt for financing working capital needs also
the firm faces a risk-return trade-off. Other things remaining the same, the greater
its reliance upon short-term debt or current liabilities in financing its current asset
investments, the lower will be its liquidity. On the other hand, the use of current
14
liabilities offers some very real advantages to the user in that they can be less costly Integrating Working Capital
than long-term financing as they provide the firm with a flexible means of financing and Capital Investment
Processes
its fluctuating needs for current assets.

Table 12.1 : The Effects of Investing in Current Assets on Liquidity and Profitability
____________________________________________________________________________________________________
Balance Sheets A B
____________________________________________________________________________________________________

Cash Rs. 500 Rs.500

Marketable securities - 5,000
Accounts receivable 9,500 9,500
Inventories 15,000 15,000
_________ _________

Current assets 25,000 30,000

Net fixed assets 50,000 50,000
_________ _________

Total 75,000 80,000

_________ _________

Current liabilities 10,000 10,000

Long-term debt 15,000 15,000
Capital Equity 50,000 55,000
_________ _________
Total 75,000 80,000
_________ _________

Net Income 7,500 7,725

Current ratio 25,000
_________ 30,000
______
= 2.5 times = 3.0 times
(Current assets/current liabilities) 10,000 10,000
Net working capital
__
(Current assets current liabilities) 15,000 20,000
Return on total assets 7,500
_______ 7,725
_______
= 10 % = 9.7 %
(net income/total assets) 75,000 80,000
____________________________________________________________________________________________________

* During the year Firm B held Rs. 5,000 in marketable securities, which earned a
9 per cent return or Rs.450 for the year. After paying taxes at a rate of 50 per
cent, the firm netted a Rs. 225 return on this investment.
If for example, a firm needs funds for a three-month period during each year to
financé a seasonal expansion in inventories, then a three-month loan can provide
substantial cost saving over a long-term loan (even if the interest rate on short-term
financing should be higher). This results from the fact that the use of long term debt
in this situation involves borrowing for the entire year rather than for the three month
period when the funds are needed; this increases the interest cost for the firm. There
exists a possibility for further saving because in general, interest rates on short-term
debt are lower than on long-term debt for a given borrower. We may demonstrate
the risk-return trade-off associated with the use of current versus long term liabilities
with the help of an example given below:

Consider the risk-return characteristics of Firm X and Firm Y, whose balance sheets
and income statements are given in Table 12.2. Both firms had the same seasonal
15
Working Capital needs for financing throughout the past year. In December, they each required
Management: An Rs.20,000 to finance a seasonal expansion in accounts receivable. In addition, during
Integrated View
the four-month period beginning with August and extending through November both
firms needed Rs. 10,000 to support a seasonal buildup in inventories. Firm X
financed its seasonal financing requirements using Rs. 20,000 in long-term debt
carrying an annual interest rate of 10 per cent. Firm Y, on the other hand, satisfied its
seasonal financing needs using short-term borrowing on which it paid 9 per cent
interest. Since Firm Y borrowed only when it needed the funds and did so at the
lower rate of interest on short-term debt, its interest expense for the year was only
Rs.450, whereas Firm X incurred Rs. 2,000 as annual interest expense.

The end result of the two firms financing policies is evidenced in their current ratio,
net working capital, and return on total assets which appear at the bottom of Table
12.2. Firm X using long-term rather than short-term debt, has a current ratio of 3
times and Rs.20,000 in net working capital. Whereas Firm Y’s current ratio is only 1,
which represents zero net working capital. However, owing to its lower interest
expense, Firm Y was able to earn 10.8 per cent on its invested funds, whereas Firm
X produced a 10 per cent return. Thus, a firm can reduce its risk of illiquidity through
the use of long-term debt at the expense of a reduction of its return on invested
funds. Once again we see that the risk-return trade-off involves an increased risk of
illiquidity versus increased profitability.
Table 12.2
____________________________________________________________________________________________________
Balance Sheets
____________________________________________________________________________________________________

Firm X Firm Y
Rs. Rs.
Current assets 30,000 30,000
Net fixed assets 70,000 70,000
____________ ___________
Total 1,00,000 1,00,000
Accounts payable 10,000 10,000
Notes payable —- 20,000
____________ ___________
Current liabilities 10,000 30,000
____________ ___________
Long-term debt 20,000 0
Equity Capital 70,000 70,000
____________ ___________
1,00,000 1,00,000
____________ ___________
____________________________________________________________________________________________________
Income Statements
____________________________________________________________________________________________________

Firm X Firm Y
Rs. Rs.
Net operating income 22,000 22,000
Less: Interest expense 2,000* 450**
_________ __________

Earnings before taxes 20,000 21,550

Less: Taxes (50%) 10,000 10,775
_________ __________

Net income 10,000 10,775

_________ __________
16
 current assets = ________
___________ 30,000 30,000
________ Integrating Working Capital
Current ratio = = 3 times =1 times and Capital Investment
current liabilities 10,000 30,000
Processes
Net working capital
(current assets – current liabilities) 20,000 Rs. 0
Net income 10,000 10,775
__________ = _______ ______
Return on total assets = = 10% = 10.8%
Total assets 1,00,000 1,00,000
____________________________________________________________________________________________________
* Firm X paid interest during the entire year on 20,000 on long-term debt at a rate
of 10 per cent. Its interest expenses for the year was 10% x 20,000 = 2,000.
** Firm Y paid interest on 20,000 for one month and on 10,000 for four months at
9 per cent interest during the year. Thus, Firm Y’s interest expense for the
year equals 20,000 X .09 X 1/12 plus 10,000 X .09 X 4/12 or 150+300 = 450.

12.10 SUMMARY
Attempt has been made in this unit to focus on the issues of liquidity and profitability.
The dimensions of both the concepts are discussed in a great detail. There has been
a realization that working per se as a liquidation concept. Whether the firm will be
able to pay off its debts using cash flows is more important than what level of current
assets or current liabilities, it maintains. The concepts of technical and operational
liquidity are analysed for their significance. In the same way, the concept of profit
was analysed to go deep into its mechanics. It may be rather obnoxious to mean
profit as an engine of economic growth. But fair chance must be provided to an
entrepreneur to compensate for his risks. At the end, the trade-off between liquidity
and profitability is discussed with adequate numerical illustrations.

12.11 KEY WORDS

Liquidity means the short term debt repaying capacity of firm

Current ratio is the relationship between current assets and current liabilities

Technical liquidity is a measure of firm’s capacity to meet current liabilities from its
current assets

Operational liquidity is a measure of firm’s ability to meet its obligations from its
cash flows

Profitability is an indicator of efficiency of firm. Profitability of a firm can be

measured with the help of sales or investment.

12.12 SELF ASSESSMENT QUESTIONS

1) Explain the concepts of Liquidity and Profitability
2) Bring out the effects of liquidity on the survival of a firm
3) Is profit equivalent to exploitation? Argue
4) Profitability and working capital are related in many ways; what are they?
5) Illustrate with examples the tradeoff between liquidity and profitability
6) The Balance Sheet of Cooptex Manufacturing Company is presented below for
the year ended December 31, 2003.

17
Working Capital Cooptex manufacturing Co.
Management: An
Integrated View Balance Sheet as on December 31, 2003.
____________________________________________________________________________________________________

Current Liabilities Rs. 30,000 Net Fixed Assets Rs. 50,000

Long-Term Liabilities Rs. 20,000 Current Assets:
Equity Capital Rs. 50,000 Cash 5,000
Inventories 25,000
Accounts Receivable 20,000 Rs. 50,000
_________ _________
1,00,000 1,00,000
_________ _________
During 2003, the firm earned net income after taxes of Rs. 10,000 based on net sales
of Rs. 2,00,000.

a) Calculate Cooptex’s current ratio, net working capital and return on total assets
ratio (net income/total assets) using the above information.

b) The General Manager (Finance) of Coopetex is considering a Plan for enhancing

the firm’s liquidity. The plan involves raising Rs. 10,000 by issuing equity shares
and investing in marketable securities that will earn 10 per cent before taxes and
5 per cent after taxes. Calculate Cooptex’s current ratio, net working capital and
return on total assets after the plan has been implemented.

(Hint: net income will now become Rs. 10,000 plus, 05 times Rs. 10,000 or Rs.
10,500.)

c) In what manner will the plan proposed in part b affect the firm’s liquidity and
profitability? Explain.

12.13 FURTHER READINGS

1. Van Horne, James C., 2002, Financial Management and Policy, Indian Reprint,
Pearson, Delhi.
2. Rustagi, R.P., 1999, Financial Management, Galgotia, New Delhi.
3. Prasanna Chandra, 1988, Financial Management, Tata Mc Graw Hill, New
Delhi.
4. Schall, L.D and Haley, C,W., 1986, Introduction to Financial management,
New York, Mc.Graw hill.

18
 Integrating Working Capital
UNIT 13 PAYABLES MANAGEMENT and Capital Investment
Processes
Objectives
The objectives of this unit are to:
• Explain the significance of payables as a source of finance
• Identify the factors that influence the payables quantum and duration
• Highlight the advantages of payable and provide hints for effective management
of payables.
Structure
13.1 Introduction
13.2 Payables: Their Significance
13.3 Types of Trade Credit
13.4 Determinants of Trade Credit
13.5 Cost of Credit
13.6 Advantages of Payables
13.7 Effective Management of Payables
13.8 Summary
13.9 Key Words
13.10 Self-Assessment Questions
13.11 Further Readings

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

13.2 PAYABLES: THEIR SIGNIFICANCE

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

19
Working Capital
Management: An 13.3 TYPES OF TRADE CREDIT
Integrated View
Trade Credits or Payables could be of three types: Open Accounts, Promissory
Notes and Bills Payable.

Open Account or open credit operates as an informal arrangement wherein the

supplier, after satisfying himself about the credit-worthiness of the buyer, despatches
the goods as required by the buyer and sends the invoice with particulars of quantity
despatched, the rate and total price payable and the payment terms. The buyer
records his liability to the supplier in his books of accounts and this is shown as
payables on open account. The buyer is then expected to meet his obligation on the
due date.

The Promissory note is a formal document signed by the buyer promising to pay the
amount to the seller at a fixed or determinable future time. Where the client fails to
meet his obligation as per open credit on the due date, the supplier may require a
formal acknowledgement of debt and a commitment of payment by a fixed date. The
promissory note is thus an instrument of acknowledgement of debt and a promise to
pay. The supplier may even stipulate an interest payment for the delay involved in
payment.

Bills Payable or Commercial Drafts are instruments drawn by the seller and accepted
by the buyer for payment on the expiry of the specified duration. The bill or draft will
indicate the banker to whom the amount is to be paid on the due date, and the goods
will be delivered to the buyer against acceptance of the bill. The seller may either
retain the bill and present it for payment on the due date or may raise funds
immediately thereon by discounting it with the banker. The buyer will then pay the
amount of the bill to the banker on the due date.
Activity 13.1
You arrange to meet the Finance Executive of an enterprise that procures a wide
range of materials from different sources and ascertain.

a) What forms of credit is the firm obtaining?

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

b) Which of these forms is most economical from the purchasing firm’s point of
view and why?

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

20
c) How does the company organize itself to negotiate effectively with the suppliers Integrating Working Capital
for obtaining the best possible credit terms? and Capital Investment
Processes
…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

13.4 DETERMINANTS OF TRADE CREDIT

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

Industrial Categories
Different categories of industries or Commercial enterprises show varying degrees of
dependence on trade credit. In certain lines of business the prevailing commercial
practices may stipulate purchases against payment in most cases. Monopoly firms
may insist upon Cash on delivery. There could be instances where the firm’s
inventory, turns over every fortnight but the firm enjoys thirty days credit from
suppliers, whereby the trade credit not only finances the firm’s inventory but also
provides part of the operating funds or additional working capital.
Nature of Product
Products that sell faster or which have higher turnover may need shorter term credit.
Products with slower turnover take longer to generate cash flows and will need
extended credit terms.

Financial Position of Seller

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

Financial Position of the Buyer

Buyer’s creditworthiness is an important factor in determining the credit quantum and
period. It may be logical to expect large buyers not to insist on extended credit terms
from small suppliers with weak bargaining power. Where goods are supplied on a
consignment basis, the supplier provides extra finance for the merchandise and pays
commission to the consignee for the goods sold. Small retailers are thus enabled to
carry much larger levels of stocks than they will be able to finance by themselves.
Slow paying or delinquent accounts may be compelled to accept stricter credit terms
or higher prices for products, to cover risk. 21
Working Capital Terms of Sale
Management: An
Integrated View The magnitude of trade credit is influenced by the terms of sale. When a product is
sold, the seller sends the buyer an invoice that specifies the goods or services, the
price, the total amount due and the terms of the sale. These terms fall into several
broad categories according to the net period within which payment is expected.
When the terms of sale are only on cash basis, there can be two situations, viz., Cash
On Delivery (COD) and Cash Before Delivery (CBD). Under these two situations,
the seller does not extend any credit.

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

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

Nature and Extent of Competition

Monopoly status facilitates imposition of tight credit term whereas intense
competition will promote the tendency to liberalise credit. Newly established
companies in competitive fields may more readily resort to liberal trade credit for
promoting sales than established firms which are more formal in deciding on credit
policies.

Datings
In seasonable industries, sellers frequently use datings to encourage customers to
place their orders before a heavy selling period. For many consumer durables, the
demand will be of this type. The need for an air-conditioner is felt in the summer,
leading to heavy ordering at a particular point of time. This has double advantages.
For manufacturer, he can schedule production more conveniently and reduce the
inventory levels. Whereas, the buyer has the advantage of not having to pay for the
goods until the peak, of the selling period. Under this arrangement, credit is extended
for a longer period than normal.

13.5 COST OF CREDIT

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

When the credit does not cover cash discount for early payment, the trade credit is
considered to be a cost free source of financing for the buyer. It is not uncommon for
some of the buyers to delay payments beyond the due date, thus extending the period
of use of costless trade credit.
22
Trade credit is a built-in source of financing that is normally linked to the production Integrating Working Capital
cycle of the purchasing firm. If payments are made strictly in accordance with credit and Capital Investment
Processes
terms, trade credit can be regarded as a cost free, non-discretionary source of
financing. But where the buyer takes the privilege of delaying payment beyond the
due date, it assumes the form of discretionary financing and if this becomes a regular
feature resulting in delinquency, trade credit will cease to be cost free. The supplier
may stop credit or may charge a higher price for the product, to cover the risk.

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

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

When the cash discount is allowed for payment within a specified period, we can
compute the cost of credit. For instance, if 30 days’ credit is offered with the
stipulation of a 2 per cent cash discount for payment within 10 days, it means that the
cost of deferring payment by 20 days is 2 per cent. If payment is made 20 days
earlier than the due date, 2 per cent of the amount due can be saved, which amounts
to an attractive annual saving rate of 36 per cent.

If cash discount is not availed, the effective rate of interest of the funds held will
work out to 36.7 per cent. The interest is Rs. 2 on Rs. 98 for a period of 20 days, and
the rate of interest will be:
2/98 × 360/20 = 36.7 per cent.
If 60 days’ credit is extended, with a cash discount of 2 per cent for payment within
10 days, there is a saving of Rs. 2 for paying 50 days ahead. The effective rate of
interest is 2/98 × 360/50 = 14.7 per cent. For 90 days’ credit, with 2 per cent cash
discount for payment within 10 days, the effective interest works out to 9.2 per cent.
Thus the more liberal the credit terms, the saving from cash discount declines and so
does the effective rate of interest for using the funds till the due date. If, however, the
discounts are not taken and the settlement is made earlier than the due date, the
effective rate of interest will vary. For a firm that resists from taking the cash
discount, its cost of trade credit declines the longer it is able to delay payment.

The rationale for availing trade credit should be its savings in cost over the forms of
short term financing, its flexibility and convenience. Stretching trade credit or
accounts payable results in two types of costs to the buyer. One is the cost of cash
discount foregone and the other is the consequence of a poor credit rating.

The contention that there is no explicit cost to trade credit if the payment is made
during the discount period or if the payment is made on the due date when no cash
discount is offered, is not totally tenable. The supplier who is denied the use of funds
during the credit period may bear the cost fully or pass on part of it to the buyer
through higher prices. This will depend on the nature of demand for the product. If
the demand is elastic, the supplier may opt to bear the cost himself and refrain from
charging higher prices to recover part of it. The buyer should satisfy himself that the
burden of trade credit is not unduly loaded on him through disguised price revisions.

23
Working Capital Repeated delinquency and deterioration in credit reputation do involve an opportunity
Management: An cost though it is difficult to measure. Some suppliers may be more tolerant to delayed
Integrated View
payments at some times than on other occasions. A policy of delayed payments is
bad business practice and in the long run can prove very expensive or may even lead
to freezing of credit source. Credit reputation is a precious asset that needs to be
preserved with utmost care. The long run policy should be to avail discounts, if
offered, utilize credit periods to the full and discharge obligations on schedule.
The following formula can be used for determining the effective rate of return:
R = C (360)/D (100-C), where
R = Annual interest rate for the use of funds
C = Cash discount
D = Number of extra days the customer has the use of supplier’s funds.
Let us take an illustration.
A firm wants to hold additional inventory but does not have the cash to finance it. If
the credit term is 2 per cent discount for payment within 10 days with 60 days credit
period, and the bank rate is 9 per cent, should the firm take the discount?

If the discount is not taken by the 10th day, the effective rate of interest on the funds
held and utilized for the remaining 50 days will be:
2/98 × 360/50 = 14.7 per cent.
The bank rate is 9 per cent only. Therefore it is advisable to take the discount
offered, even if it involves utilizing bank borrowing for effecting early payment for
availing the cash discount.
Stretching Accounts Payable
It is normally assumed that the payment to the supplier is made at the end of due
date. However, a firm may postpone payment beyond this period. This type of
postponement is called stretching or Leaning on the trade. The cost of stretching
accounts payable is two fold : the cost of cash discount foregone and the possible
deterioration in the credit rating. If a firm stretches its payables excessively, so that
its payables are significantly delinquent, its credit rating will suffer. Suppliers will view
the firm with apprehension and may insist on rather strict terms of sale. Although it is
difficult to measure, there is certainly an opportunity cost to a deterioration in the
firms quality of payment.
Activity 13.2
Meet the Finance Executive of a large enterprise that has been growing at a fast
pace and enjoying substantial credit facilities from different suppliers and also meet
the Finance Executive of another large firm which has been under financial strain for
some time but is yet getting trade credit from suppliers, and get responses from them
on following aspects.

a) Do the suppliers change their trade credit policy from time to time or are they
consistent irrespective of customer’s shifting fortunes?

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........
24
b) How do the two companies that you contacted evaluate the credit terms offered Integrating Working Capital
by suppliers? Do they reckon the cost of credit and. if so, what initiatives do they and Capital Investment
Processes
take to keep the cost of credit to the minimum?

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

…………………………………………………………………………….........

13.6 ADVANTAGES OF PAYABLES

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

Suppliers assume the risk

Where the suppliers have the advantage of high gross margins on their products, they
would be able to assume greater risks and extend more liberal credit.

Informality
In trade credit, there is no rigidity in the matter of repayment on scheduled dates,
occasional delays are not frowned upon. It serves as an extendable, convenient
source of unsecured credit.

Continuous Financing
Even as the current dues are paid, fresh credit flows in, as further purchases are
made. It is a continuous source of finance. With a steady credit term and the
expectation of continuous circulation of trade credit-backing up repeat purchases,
trade credit does in effect, operate as long term source.

13.7 EFFECTIVE MANAGEMENT OF PAYABLES

The salient points to be noted on effective management of payables are:
• Negotiate and obtain the most favourable credit terms consistent with the
prevailing commercial practice pertaining to the concerned product line.
• Where cash discount is offered for prompt payment, take advantage of the offer
and derive the savings there from.
• Where cash discount is not provided, settle the payable on its date of maturity
and not earlier. It pays to avail the full credit term.
• Do not stretch payables beyond due date, except in inescapable situations, as
such delays in meeting obligations have adverse effects on buyer’s credibility
and may result in more stringent credit terms, denial of credit or higher prices on
goods and services procured.
• Sustain healthy financial status and a good track record of past dealings with the
supplier so that it would maintain his confidence. The quantum and the terms of
credit are mainly influenced by suppliers’ assessment of buyer’s financial health
and ability to meet maturing obligations promptly.
25
Working Capital • In highly competitive situations, suppliers may be willing to stretch credit limits
Management: An and period. Assess your bargaining strength and get the best possible deal.
Integrated View
• Avoid the tendency to divert payables. Maintain the self liquidating character of
payables and do not use the funds obtained there from for acquiring fixed
assets. Payables are meant to flow through current assets and speedily get
converted into cash through sales for meeting maturing short term obligations.
• Provide full information to suppliers and concerned credit agencies to facilitate a
frank and fair assessment of financial status and associated problems. With
fuller appreciation of client’s initiatives to honor his obligations and the
occasional financial strains which he might be subjected to for a variety of
reasons, the supplier will be more considerate and flexible in the matter of credit
extension.
• Keep a constant check on incidence of delinquency. Delays in settlement of
payables with references to due dates can be classified into age groups to
identify delays exceeding one month, two months, three months, etc. Once
overdue payables are given priority of attention for payment, the delinquency
rate can be minimized or eliminated altogether.

13.8 SUMMARY
Payables or trade credit is a self liquidating, easy-to-obtain, flexible source of short
term finance. Buyer’s credit reputation, as reflected in evidences of his willingness
and ability to meet maturing obligations will determine the quantum and period of
credit he can command. Factors like competition, nature of the product and size of
the supplier’s firm also influence terms of credit, besides relevant commercial
practices or conventions. It will be prudent to take advantage of cash discount
facilities when available and avoid over-stretching payables by frequent delays in
payments. If good credit relations are maintained with suppliers, payables can be a
ready and expanding source of short term finance that will correspond to the needs of
a growing firm.

Payables are not altogether cost-free but if managed well, the costs can be
substantially lower than the alternative sources of short term finance.

13.9 KEY WORDS

Accounts Payable: is a liability arising from the purchase of goods or services on
credit.
Trade Acceptance: is a bill or instrument drawn by the seller on the buyer, the
amount which the buyer accepts to pay at an agreed future date.
Promissory Note: is a formal document signed by the buyer promising to pay the
amount thereof to the seller on demand or at a certain future date.
Delinquency: is the failure to meet the obligation on the due date.
Datings : A practice of encouraging buyers to place orders before a heavy selling
period.
Stretching : Postponement of payment beyond due date.

13.10 SELF ASSESSMENT QUESTIONS

1) Why is trade credit used extensively by firms?
2) What are the different forms of trade credit? Explain.
3) Trade credit is regarded as a spontaneous source of short term finance.
26 Comment.
4) Distinguish between trade discount, quantity discount and cash discount. Integrating Working Capital
and Capital Investment
5) What are the factors that influence the availability of trade credit? Processes
6) What are the principal advantages of trade credit or payables?
7) Over extension of trade credit is a major factor in the financial difficulties of most
companies that fail. Explain.
8) A company has regularly been obtaining 90 days’ credit, with a cash discount of
2 per cent for payment within 10 days and has found that it can let the account
slide for an extra 30 days without injuring its credit rating or losing its source of
supply. Will it pay the firm to borrow from a finance agency at a rate of 7 per
cent to take advantage of cash discount?
9) Compute the cost of not availing the following discounts on a purchase of Rs. 10
lakhs a year.
a) 2/10, net 30
b) 3/10, net 40
c) 2/5, net 25
d) 1/10, net 46
10) You receive a bill from a supplier with the term 2/15, net 45.
a) If you can borrow funds from your bank at 12% per annum, should you avail
discount ?
b) Suppose the terms are 1/5, net 15, and you can borrow at 12%, should you
avail discount ?

13.11 FURTHER READINGS

Satish B. Mathur, 2002, Working Capital Management and Control,New Age
International (P) Ltd., New Delhi.

R.M. Srivastava, 1986, Essentials of Business Finance, Himalaya Publishing

House, Bombay (Chapter 20),

Van Horne, James C, 1985, Fundamentals of Financial Management, Prentice

Hall of India, New Delhi.

27
 Integrating Working Capital
UNIT 14 SHORT- TERM INTERNATIONAL
and Capital Investment
Processes
FINANCIAL TRANSACTIONS
Objectives
The objectives of this unit are to:
• Survey the situation prevailing in the international short-term market.
• Highlight the implications of foreign exchange market.
• Provide a mechanism for managing exchange rate fluctuations.
• Create awareness of the techniques employed to deal with foreign currency
exposure.
• Finally, explain the genesis and operations of Euromarkets.
Structure
14.1 Introduction
14.2 Markets and Market Participants
14.3 Quoting Foreign Exchange Rates
14.4 Economic Forces in Exchange Markets
14.5 Managing Exchange Rate Gyrations
14.6 Foreign Financial Markets
14.7 Euromarkets and their Linkages
14.8 Creation of Euromoney
14.9 Growth of Euromarkets
14.10 Summary
14.11 Key Words
14.12 Self Assessment Questions
14.13 Further Readings

14.1 INTRODUCTION
When finance goes international, problems multiply. The common thread of
international aspects of financial management is found in the following: What aspects
of the issue are peculiarly international , and what opportunities does a firm have by
virtue of its being international? The clues to an answer lie in the basic
understanding of the management of the cross border financial assets and liabilities
and cash flows. From a corporate perspective, the most important theoretical
development in international financial management can be captured by concentrating
on the following areas:
• Foreign Exchange Markets
• Foreign Financial Markets
• Euromarkets
What is foreign exchange? Foreign exchange is simply a payment made in some
national currency (or artificial currency) that is exchanged for a payment received in
another currency . Thus any money can become foreign exchange by surprise and
the moment after it has been exchanged it forgets it was foreign exchange. Once
more, it is national money.

Unlike the money and capital markets, the foreign exchange market deals not in
credit but in means of payment. This brings one to a fundamental point. While
foreign exchange deals frequently take place between residents of different
countries, the money being traded never actually leaves the country of the currency.
1
Working
Thus when Capital
West German deutsche marks are exchanged for U.S. dollars in London,
Management: An
the deutsche markets and dollars stay in West Germany and the United States
Integrated View
respectively. The act of trading only effects a change of ownership of the money.
The money itself , in the form of bank deposits, merely gets shifted from one deposit
to another through the country’s inter bank payments system.

14.2 MARKETS AND MARKET PARTICIPANTS

Participants in foreign exchange markets are diverse. At the bottom, or at the first
level, are such traditional users (tourists, importers, exporters and investors, who
exchange domestic for foreign currencies to pay for their international transactions)
as well as traders and specialists (individuals, investment managers, and corporate
treasurers who trade currencies seeking short-term profits by betting on the direction
of changes in their relative price). At the next, or second, level are the commercial
banks, which act as clearing houses between users and earners of foreign exchange.
At third level are foreign exchange brokers, through whom the nation’s commercial
banks even out their foreign exchange inflows and outflows among themselves (the
so-called inter-bank or wholesale market). Finally, at the fourth and highest level is
the nation’s central bank, which acts as the seller or buyer of last resort when the
nation’s total foreign exchange earnings and expenditures are required. When the
market rate of the currency reaches the upper lines (“upper intervention point”) of
the band , the central bank of that country must increase sales of its currency in
exchange for other currencies. Similarly , the central bank must sell foreign
exchange and buy its own currency when the market rate reaches the “lower
intervention point”. Thus, the central bank either draws down its foreign exchange
or adds to them.

14.3 QUOTING FOREIGN EXCHANGE RATES

Foreign exchange rates can be quoted in one of the followings two ways. The first
way, the indirect quote, is to quote one unit of local currency as equal to ‘n’ units of
the foreign currency. The second way, the direct quote , is to quote n units of local
currency as equal to one unit or 100 units of the foreign currency. London invariably
uses the first method of quotation.
In London (indirect quote)
$ 1.7172/ pound
DM 2. 8451/Pound
* In New York (Direct quote)
100 Deutsche Marks are worth 60. 56 US dollars
We see that the quotation is $/DM and is the domestic currency at New York, is a
direct quote. Similarly , 100 Japanese Yen are worth 1.0052 Us dollars.

Care must be taken when reading off exchange rates to see which method is being
employed. To make explicit the role of each currency in an exchange quote, it is
helpful to write down the names of each currency in its appropriate position. The
currency used as a unit of account is placed in front of the quote. The unit of
currency being priced follows the quote. For example, in the following quote of:
$ 0.60/DM
The unit of account if the U.S. dollar and the unit of currency being priced is one
mark. A foreign exchange dealer will usually quote two rates to a potential customer
a bid and an offer rate. The dealer is willing to buy at the bid rate and sell at the
offer or ask rate. In either case, the currency for which the end or offer price is
given is the unit of item price. When he makes the quotation, he does not know
2
whether the customer is a buyer or a seller of currency. ForIntegrating Working
instance, in Capital
the example
and Capital Investment
quoted in Table 14.1, the foreign exchange dealer is quoting a spread Rs. 31. 2514
Processes
to Rs. 31. 3219 to the dollar . This means that he is prepared to sell Rs. 31.2514 to
the dollar and buy them at Rs. 31. 3219 to the U.S. dollar. Conversely, he will buy
dollars at Rs. 31. 2514 to the dollar and sell dollars at Rs. 31.3219 to the dollar.

Table 14.1 : Bid Offer Rates Quoted by Foreign Exchange Dealer

LS1
Bid Offer
Rs. 31.2514 31.3219 $
Rs. 50.0013 51.2006 Pound
Rs. 22.4056 22.9058 DM
Rs. 27.0543 27.6009 Sw. Fr.
Rs. 35.6086 36.3095 Yen*
*per 100 units.

The most common type of foreign exchange transaction involves the payment and
receipt of the foreign exchange within two business days after the day the
transaction is agreed upon. The two – day period gives adequate time for the parties
to send instructions to debit and credit the appropriate bank accounts at home and
abroad. This type of transaction is called a spot transaction, and the exchange rate
at which the transaction takes place is called the spot rate. Besides spot
transaction, there are forward transactions. A forward transaction involves an
agreement today to buy or sell a specified amount of a foreign currency at a specified
future date at a rate agreed upon today (the forward rate). The typical forward
contract is for one month; three months; or six months, with three months the most
common. Forward contracts for longer periods are not as common because of the
great uncertainties involved. However, forward contract can be renegotiated for one
or more periods when they become due.

The equilibrium forward rate is determined at the intersection of the market demand
and supply curves of foreign exchange for future delivery. The demand for and
supply of forward foreign exchange arises in the course of hedging, from foreign
exchange speculation and from covered interest arbitrate.

The question for forward rate can be made in two ways. They can be made in
terms of the amount of local currency. At which the quoter will buy and sell a unit of
foreign currency. This is called the outright rate and is used by the traders in
prompting to customers. The forward rates can also be quoted in terms of prints,
called the swap rate, and used in inter-bank quotations. The points are added to the
spot price if the foreign currency is traded at forward premium; if trading at a
forward discount, the forward quotations are subtracted from the spot price. The
resulting number is the outright forward rate. In other words, the outright rate is the
spot rate adjusted by the swap rate.

How to read the foreign exchange quotation? If the forward quote (the led or buying
figure) is smaller than the forward rate ( the offer or setting figure), then in a
premium, i.e. , the swap rates are added to the spot rate. Conversely, if the first
quote is larger than the second, it is a discount. In case the first quote is equal to the
second, a quote would require a further specification as to whether it is a premium or
a discount. The procedure assures that the buying price is lower than the selling
price, and the trader profits from the spread between the two prices. To illustrate,
suppose you have called your foreign exchange trader and asked for quotations on
the U.S. dollar spot, one month, three month, and six-month.
3
Working
The Capital
trader has reported with the following:
Management: An
$Integrated
0. 0.032122/8
View 8/10 7/5
In outright terms these quotes would be expressed as follows:
Table 14.2
Maturity Bid offer
Spot 0.032122 0.032128
1-month 0.032130 0.032138
3-month 0.32115 0.32123
6-month 0.032132 0.032140
It shows that the one-month and six- month forward are at premium whereas the
three-month forward is at discount.

The value of a currency is often expressed as a single figure, i.e, $ 0.032125 (US)
worth Re.1, rather than being quoted as both a bid and offer rate. The single rate is
the middle rate arrived at by adding the bid and offer rate together and dividing by
two. In the example, give the dollar bid rate is 0.032122 and the dollar offer rate
0.032128, so the middle rate is (0.032122 +0.032128)/2=0.32125

The difference between the bid price and the offer price is known as the spread and
it makes the profit. Spreads in the forward market are a function of both the breadth
of the market (the volume of transactions/in a given currency and the risk associated
with forward contracts). The risks, in turn, are based on the variability of future spot
rates. Even if the spot market is stable, there is no guarantee that further rates will
remain invariant. This uncertainty will be reflected in the forward markets.

In a foreign exchange market, dealers quote the forward rate only at a discount from,
or a premium on, the spot rate. If the forward rate is below the present spot rate,
the foreign currency is said to be at a forward discount with respect to the domestic
currency. On the other hand, if the forward rate is above the present spot rate, the
foreign currency is said to be at a foreign premium. To illustrate, if the spot rate is
Rs. 50/ pound and three-month forward rate is Rs. 48/ per pound, we say that the
pound is at a three month forward discount of Rs. 2 or 4 per cent (or at a 16 per cent
forward discount per year) with respect to the pound. On the other hand, if the spot
rate is still Rs. 50/- per pound but the three-month forward rate is Rs. 52 per pound,
the pound is said to be a forward premium of Rs. 2 or 4 per cent for three months, or
16 percent per year.
Forward discounts or premiums are usually expressed as percentages per year from
the corresponding spot rate and can be calculated formally with the following
formula:
(Forward Rate – Spot Rate) 12× 100
Forward Premium = –––––––––––––––––––––– × ––––––––––––––––––
–––
Spot Rate Forward contract
length
in months
Thus, when the spot rate of the rupee/pound is Rs. 50 per pound and the forward rate
is Rs. 48 per pound , we get:

Rs. 48 - Rs. 50 12 –2
—————— × –— × 100 = —–– × 4 × 100 = –16% p.a.
Rs. 50 3 50
the same as found earlier without the formula. Similarly if Rs. 52 /pound:

Rs. 52-Rs. 50 12
—————— × —— × 100–2 = —— × 4 ×100 = +16% p.a.
Rs. 50 3 50
So far we have dealt with only two currencies for simplicity, in reality there are
4
numerous exchange rates, one between any pair of currencies. Integrating Working Capital
The exchange rate
and Capital Investment
between two currencies can be obtained from the rates of these two currencies in
Processes
terms of a third currency. This is called the cross-rate. For example, if the exchange
rate is between the Indian Rupee and the British pound and between the U.S. dollar
and the British pound, then the exchange rate between the rupee and the dollar is
31.25 (i.e, it takes Rs. 31.25 to purchase one dollar).

Specifically:
Rs. Rs. value of pound
50
Exchange Rate ————— = —————————— = —— 31.2
$ $ value of pound
16

Since over time a currency can depreciate with respect to some currencies and
appreciate against others, an effective exchange rate is calculated. This is a
weighted average of the exchange rates between the domestic currency and the
nation’s most important trade partners, with weights given by the relative importance
of the nation’s trade with each of these trade partners.

14.4 ECONOMIC FORCES IN EXCHANGE

MARKETS
Geographical Spatial or Arbitrage: The exchange rate between any two
currencies is kept the same in different monetary centres by arbitrage. This refers to
the purchase of a currency in the monetary center where it is cheaper, for immediate
resale in the monetary center where it is more expensive, in order to make a profit.

For example, assume that the quotes of the rupee against the pound sterling in
Bombay and London are as follows:
Bombay London
Rs. 50. 021511 Rs. 50. 021523
The rupee commands a higher price against the pound sterling in Bombay than in
London. It will attract arbitrageurs. They will purchase pounds with rupees in
Bombay and convert pound in rupees in London to make profit. As arbitrage takes
place, the purchase of pound in Bombay will tend to increase the price of the pound
against the rupee in that market. In London, reverse will happen with the sale of
pound sterling and hence the fall in the price of the pound against rupee. This
arbitrage process tends to equalise the exchange rate between the two currencies in
both the markets.

When only two currencies and two monetary centres are involved in arbitrage, we
have two-point arbitrage, when three currencies and three monetary centres are
involved, we have triangular, or three-point arbitrage. While triangular arbitrage is
not very common, it operates in the same manner to ensure consistent indirect, or
cross, exchange rates between the three currencies in the three monetary centers.
For example, if a foreign exchange dealer quotes on April 1, 1995, the DM was
quoted $ 0.708707/DM and the Indian rupee was quoted Rs. 32.425325/$ in Bombay.
If on the same date New York was quoting Rs. 22.915265/DM and
Rs. 32. 425325/$, what are the incentives for arbitrage?

Summary table of calculations is given below:

New York Bombay
32,425325/$ Rs. 32.425325/$
In terms of Re/$
5
Working $/DM
a) Capital 0.708707/DM 0.706707/DM
Management: An
b) Re/DM
Integrated View 22.980055/DM 22.915265/DM

a) To find Re/DM in New York :

We know $/Re = 0.03084
Then $/Re = 1/32.425325 = $ 0.03084
b) In New York :
We know Re/$ = Rs. 32.425325/$
Re/DM = Rs. 22.915265/DM
Then DM/Re = 1/22.915265 = DM 0.043639/R

$/Re 0.3084
SO $/DM = ———— = ———— = .70
DM/Re .04639
c) In Bombay:
$/DM = 0.708707/DM
1
Then DM = —————( 0.708707 )/ $
DM = 1.410203/$
Re/$ = Rs. 32.425325/$; therefore,
DM 1.4110203/$ = Rs. 32.425325/$

Re/$ 32.425325
Re/DM = ———— = ————— = Rs. 22980055
DM/$ 1.4110203

By reading various quotes in two markets , we can say:

i) The DM in terms of dollar is cheaper in New York than in Bombay.
ii) The dollar and the rupee are at parity in both markets;
iii) The DM in terms of rupee is cheaper in Bombay than in New York.
Therefore, buy DMs against dollars in New York; sell DMs against Rs. in Bombay;
and convert Rs. in dollars in either Bombay or New York.

As in the case of two-point arbitrage, triangular arbitrage increases the demand for
the currency in the monetary centres when the currency is cheaper, increases the
supply of the currency in the monetary centres where the currency is more
expensive, and quickly eliminates inconsistent gross rates and the profitability of
further arbitrage. As a result, arbitrage quickly equalises exchange rates for each
pair of currencies and results in consistent gross rates among all pairs of currencies,
thus unifying all international monetary centres into a single market.

Interest arbitrage refers to the international flow of short-term liquid capital to earn
high returns abroad. Since the transfer of funds abroad to take advantage of higher
interest rates in foreign monetary centers involves the conversion of the domestic to
the foreign currency to make the investment, and the subsequent recon version of the
funds (plus the interest earned) from the foreign currency to the domestic currency at
the time of maturity, a foreign exchange risk is involved due to the possible
depreciation of the foreign currency during the period of the investment. Suppose
that the interest on risk free security XYZ, is 5 per cent per annum in Singapore
and 9 per cent in India on risk-free security ABC. It may then pay for a Singapore
investor to exchange dollars for rupees at the current spot rate and invest in India
to earn the extra 4 per cent on free interest 1% for the security , XYZ. When the
6
Indian risk-free security, ABC matures, the Singapore investorIntegrating
may wantWorking Capital
to exchange
and Capital Investment
the rupees he invested plus the interest he earned back into dollars. However, by that
Processes
time the rupee may have depreciated so that he would get back fewer dollars for
rupee than he paid, if the rupee depreciates by ½ of the 1 per cent during the
maturity period, say of 3-months, of the investment, the Singapore investor nets only
about ½ on 1 percent from his foreign investment (the extra 1 percent interest he
earns minus the ½ of 1 percent that he losses for the depreciation of the rupee). If
the rupee depreciates by 1 percent during the three months, the Singapore investor
loses, of course, if the rupee appreciates the Singapore investor gains nothing, and if
the rupee depreciates by more than 1 percent, the Singapore investor loses, of course,
if the rupee appreciates the Singapore investor gains both from the extra interest he
earns and from the appreciation of the rupee. This is a case of uncovered interest
arbitrate. But as the investors of short-term funds abroad generally want to avoid the
foreign exchange risk. Hence, interest arbitrage is usually covered.

Covered interest arbitrage refers to the spot purchase of the foreign currency to
make the investment and the offsetting simultaneous forward sale (swap) of the
foreign currency to cover the foreign exchange risk. When the risk-free security, say
treasury bills, mature, the investor can then get the domestic currency equivalent of
the foreign investment plus the interest earned without a foreign exchange risk.
Since the currency with the higher interest rate is usually at a forward discount, the
net return on investment is roughly equal to the positive interest differential earned
abroad minus the forward discount on the foreign currency. This reduction in
earnings is the cost of insurance against the foreign exchange risk.

In general, under covered interest arbitrage, there is an incentive to invest in the

higher-interest currency to the point where the discount of that currency in the
forward market is less than the interest differential. If the discount on the forward
market of the currency with the higher interest rate becomes larger than the interest
differential, then it pays to invest in the lower-interest currency and take advantage of
the excessive forward premium on this currency.

In the real world, significant covered interest arbitrage margins are often observed
for long periods. The reason for this is not necessarily that covered interest
arbitrage does not work. Rather, it is likely to be the result of other forces at work
not accounted for by the pure theory of covered interest arbitrage. Some of these
other forces are the different real growth rates among nations; differential growth in
their money suppliers; and differences in expectation, in liquidity preferences, in
inflation rates, and in fiscal and trade policies. Lack of adequate information and
government restrictions on short-term international capital flows can also sometimes
account for the persistence of wide covered interest arbitrage margins.

Finally, it must be remembered that behind the demand and supply curves of foreign
exchange are not only traders and investors, but also hedgers, speculators, and
interest arbitrageurs. Governments also operate in foreign exchange markets, both
in their normal function of making and receiving foreign payments and in their effort
to affect the level and the movement of exchange rates. It is all of these forces
together that determine exchange rates at the intersection of the nation’s aggregate
demand and supply curves for each foreign currency under a flexible exchange rate
system.

14.5 MANAGING EXCHANGE RATE GYRATIONS

AND CORPORATE SECTOR
Globalisation of financial markets and gyrations in exchange markets have
complicated transnational corporate exposure management. It is complex largely
7
Working
because ofCapital
(a) the increasing size and variety of exposures which companies incur
Management: Aninternationally and (b) the increasing volatility of the foreign
as they develop
Integrated View
exchange markets. Given this complexity, a logical and structured approach is
needed to formulate company’s foreign exchange risk management programme. The
starting point in such a programme must be to decide exactly which is at risk.

All corporate exposure management strategies must address two questions. Firstly,
which definition (s) of exposure is the company concerned with? If the answer
embodies more than one definition then priorities and the trade-off between the
alternatives should be clearly defined, for example, how much cash are the
companies willing to spend to protect against a given unrealized translation loss?
Secondly, given alternative definitions of foreign exchange risk, what is corporate
attitude towards risk? Is it to maximise foreign exchange gains or minimize exchange
losses? Also, what time frame is the company considering does it want to smooth
short-term results at the expense of longer term fundamentals, or vice-versa? The
time frame consideration is also relevant to the first strategy question, since short-
term profit priorities will tend to induce companies to emphasize accounting rather
than cash flow exposure.

At micro economic level, transnational companies face varying degrees of business

structural and financial structural risks. Their need for information relevant to
exposure identification differs. Therefore, as with other areas of corporate exposure
management, no single exposure information system will be right for all companies.
The appropriate system must be firm-specific; it must take into account the size of
the company and its constituent units, the exposure objectives and strategy of the
company, its operating and organisational characteristics, personnel strength and so
on. There are, however, five basic elements which should be present in all exposure
information systems: (1) the information should be anticipatory; (2) the reporting
frequency must be adequate; (3) the information flow should be direct to the
company; (4) the rationale of the information requirement must be understandable;
and (5) finally, the degree of information required should be subsidiary specific.
These general reporting principles should be the basis of all exposure information
systems.

For analytical purposes, these systems can be categorized into two functional
components: the exposure identification system, which requires information on the
accounting and /or cash flow exposures generated by group companies; and the
exposure management information system, which provides details of decision
parameters and constraints to be considered in deciding what exposure management
action is required. Analytically, at least, two fundamental exchange risk management
strategies may be considered, namely, ‘aggressive’ and ‘defensive’. A key factor in
the company’s choice between these two strategies will be its ability to accurately
forecast exchange rates specifically its ability to outpredict the forward rate. In
contrast to the Bretton Wood’s era, in the existing flexible exchange rate
environment, such forecasting is very difficult. At present, there are large and
perhaps confusing variety of techniques used in corporate exchange risk
management.

To understand the rationale underlying their use, they may be classified into internal
and external techniques according to their basic origin. Internal techniques are
mainly used as a part of a company’s regulatory financial management aimed at
minimizing its continuing exposure to exchange risk. They are basically aimed at
reducing or preventing an exposed position from arising. The external techniques are
used to ensure against the possibility that exchange losses will result from the
exposed position which the internal measures have not been able to eliminate;
consisting basically the contractual measures to ensure against an exchange loss
(realized or unrealized which may arise from an existing translation or exposed
8
position. Integrating Working Capital
and Capital Investment
Processes

A) Exposure Management: Internal Techniques

1) Netting
Netting simply means offsetting exposures in one currency with exposure in the same
or another currency, where exchange rates are expected to move in such a way that
losses (gains) on the first exposed position should be offset by gains(losses) on the
secured currency exposure. In the simplest kind of scheme, known as bilateral
netting, each pair of subsidiaries nets out their own positions, with each other.
Flows are reduced by the lower of each company’s purchases from or sales to its
netting partner. There is no attempt to introduce the net position of other group
companies.

Multilateral netting, a complex form of netting, can take place when affiliates both
import from and export to companies within the same corporate groups. Flows are
reduced by the lower of each company’s total purchase from/sale to affiliates. The
focal point in a multilateral netting scheme is the central information point.
Participating units must report an inter company position at the end of a given period,
and the center then advises the units of the net amount which they are to pay or
receive at a certain date. Multilateral netting, therefore, requires a centralized
communication system and a lot of discipline on the part of participating units. In this
process of multilateral netting, the three most common constraints are: (a) prior
approval for netting may be required; (b) trading (rather than financial) transactions
only may be netted; and (c) inter company (rather than third party) transactions only
may be netted.

The major benefits of netting are reduced banking costs and increased control of
inter-company settlements. The reduced number and total amount of payments
produces savings in the form of lower flow and lower exchange costs (i.e the buy/sell
spread in the spot and forward markets plus the elimination of bank charges, if any).
No simple savings percentages can be universally applied to the amount netted since
savings will be determined by prevailing buy/sell spreads and the structure of the
payment flows eliminated. In addition, the introduction of a netting system does
create opportunities for exposure and liquidity management and tax planning. A
quick and easy decision format can be evolved to produce an inter company
settlement pattern which will help to achieve the company’s liquidity and exposure
management objectives.
2) Matching
The terms ‘netting’ and ‘matching’ are often used interchangeably. But the term
netting is typically used only for inter company flows to the netting out of groups,
receipts and payments. As such it is applicable only to the operations of a
multinational company rather than the exporter or importer. In contrast, matching can
be applied to both third party as well as inter- company cash flows, and it can be used
by the exporter/importer as well as the multinational company. It is a process
whereby a company matches its currency inflows with its currency outflows with
respect to amount and (to an appropriate degree) timing. Receipts in a particular
currency may then be used to make payments in that currency so that the need to go
through the exchanges (spot and forward) is limited to the unmatched portion of
foreign currency cash flows. The aggressive company may decide to take forward
cover on its currency payables and leave the currency receivables exposed to
exchange risk; if it takes the view that the forward rate looks cheaper than the
expected spot rate.
9
Working
The basicCapital
requirement for a matching operation, then, is a two-way cash flow in the
Management:
same foreign Ancurrency. This kind of operation is sometimes called ‘natural’ matching.
Integrated View
There is a further possibility, however, which we will call ‘parallel’ matching. Here
the match involves two currencies whose movements are expected to run closely
parallel’. In a parallel matching situation, gains in one foreign currency are expected
to be offset by losses in another. Needless to say, with parallel matching there is
always the risk that the exchange rates will move contrary to expectations, so that
both sides of the parallel match lead to exchange losses (or gains).

The major practical problem in implementing matching is the timing of third party
receipts and payments. Unexpected delays can cause the mistiming of a match and
may consequently leave both receivable and payable exposed to exchange risk.
Success requires accurate prediction of the amount of settlement and, more
particularly, the timing of settlement dates. Where exchange controls allow, the
timing problem can be overcome by the utilisation of foreign currency accounts,
which allow the retiming of currency conversions to facilitate matching. The cost of
neutralizing exposures in this way is represented by the effective interest rate
differential (including the deposit/borrowing rate spread) between the foreign and
domestic currency.
3) Leading and Lagging
This simply refers to the adjustment of inter-company credit terms, ‘leading’ meaning
a prepayment of a trade obligation and ‘lagging’ a delayed payment. This is primarily
an inter company technique between buyer and seller. Whilst netting and matching
are purely defensive measures, intercompany leading and lagging can be used as part
of either a risk-minimising strategy (to facilitate matching) or an aggressive strategy
(to maximise expected exchange gains). In either case a central information and
decision point is usually required, to ensure that the timing of inter-company
settlement is effective from a group point of view rather than purely a local one.

As with other schemes involving central decision making, leading and lagging requires
a lot of discipline on the part of participating subsidiaries. Apart from the exposure
impacts, such operations can seriously affect the liquidity and hence profitability of
each subsidiary. To overcome the consequent evaluation problem, multinational,
companies which make extensive use of leading and lagging may either evaluate
subsidiary performance on a pre-interest basis or impute interest charges and credits
where appropriate.

One very important complicating factor, however, is the existence of local minority
interests. If there are powerful local share holders in the “losing” subsidiary there will
be strong objections because of the added interest cost / lower profitability resulting
from the consequent local borrowing. In such cases of leading and lagging the
interests of the minority shareholders are subordinated to those of the majority
shareholders (the parent company) . Host governments , via credit and exchange
controls , may well restrict such operations.
4) Pricing policy
For exposure management purposes, there are two kinds of pricing tactics: price
variation and currency-of invoicing policy. ( In effect , the latter tactic is a subtle
variant of the former ) . For each of these it is necessary to distinguish between
external and inter-company trading, since each kind of trading gives rise to a different
set of problems and opportunities .
Price Variation : External Trade. One obvious way for a company to protect itself
against exchange risk is to raise selling prices to offset the adverse effects of
exchange rate fluctuations . But the question which always arises with the pricing
option , of course, is that if the company is able to raise prices then why has it not
10
done so already, irrespective of exposure considerations ? Integrating Working Capital
and Capital Investment
Processes
Given an adverse exchange rate change ( or trend ), how quickly can local selling
prices be increased to bring the parent currency equivalent of the foreign operation’s
cash flows back to the pre-depreciation level ? The determination of this lag requires
an analysis of the following questions.

Competitive situation : what sector of the market are the firms in ? A firm selling
in the import or import – competing sectors is likely to have greater pricing flexibility
than one in the purely domestic sector . The question of timing is also important : is
there any scope for anticipatory price increases , given an expectation of an adverse
currency movement .

Customer credibility : when did the company last increase its prices and will there
be customer resistance to another price rise ?

Price controls : are these in existence or likely to be introduced in the near future ?
Given the existence of such controls , to what extent do they allow the adverse
impact of an exchange rate change to be recouped by subsequent price increases,
and how quickly ?

Internal delays : what are the administrative lags involved in raising prices ?
Foreign currency price lists can be the source of significant delays , depending on
how regularly they are reviewed and how lengthy is the review process. For a price
list involving thousands of items such delays can be serious .

Trading/financing pattern : if a firm does not have pricing flexibility for any of the
above reasons , does it have a trading pattern or can one be created in which adverse
currency impacts in one area of the business will be offset by positive effects
elsewhere ? For example , a foreign subsidiary which imports raw materials and sells
locally is exposed to a local currency depreciation . To the extent that it can shift its
sourcing (to domestic suppliers) or its selling (to foreign customers), this economic
exposure may be reduced .

Price Variation : Inter company Trade. Inter-company ( or transfer ) price

variation refers to the arbitrary pricing of inter company transfers of goods and
services at a higher or lower figure than the ‘fair’ or ‘arm’s length ‘ price ( the
market price if there is an established market or the price which would be charged to
a third party customer if there is not ) . However , multinational companies must
always not set inter-company prices on an arm ‘s length basis , as generally required
by tax and exchange control authorities. In establishing international transfer prices,
they try to satisfy a number of objectives not relevant to domestic transfer pricing.
For example , the firm wants to minimise taxes and at the same time win approval
from the government of the host country. Yet the basic objectives of profit
maximisation and performance evaluation also are important . often it is not possible
to satisfy all these objectives simultaneously, so a company must decide which
objectives are the most important . As a result, a particular transfer price, rather then
evolving from a transfer pricing technique , may be established arbitrarily to fulfil an
objective involving international considerations .

Currency-of- Invoicing : External Trade. Currency-of- Invoicing tactics can be

either aggressive or defensive. As aggressive strategy would be to try to invoice
exports in relatively strong currencies relative to the exporter’s home currency
(HC) and imports in relatively weak currencies. Here the company is increasing its
exposure to exchange risk in the expectation that this exposure will produce
exchange gains rather than losses.

For the strong currency exporter the defensive approach is the only one available for
11
Working Capital since the HC is probably also the strongest currency acceptable to
export invoicing
Management:
the customer An. For the weak currency exporter, however, there may be significant
Integrated View
opportunity gains from an aggressive currency – of- invoicing policy. In such
circumstances foreign currency invoicing may be attractive to the exporter, in the
expectations that the HC equivalent sales proceeds would be increased by a foreign
currency appreciation over the credit period. It should be added, however, that there
are risks involved in switching from a weak currency to a supposedly stronger one.
The relative strengths of the two currencies could reverse themselves in the future
and , once having changed to foreign currency billing , companies will find it difficult
to switch back to HC-involving if the currency situation alters . In any case ,
currency-of-invoicing cannot be changed regularly quite apart from customers
objections and the loss of customer credibility, there is the problem of price list
adjustment lags. Currency-of-invoicing changes will also have to be ‘sold’ to
subsidiary management as well as to customers. Indeed, resistance at operating unit
level may present major problems to a corporate treasury trying to make the initial
switch to foreign currency invoicing. Subsidiaries may be reluctant to give up the
perceived marketing advantages of weak currency invoicing, particularly since if
corporate exposure management is to be centralised (often a corollary of the switch
to foreign currency invoicing) the benefits of foreign currency billing may accrue at
corporate treasury.

Currency -of- Invoicing : Inter-company Trade. On a pre-tax basis, the

distinction between aggressive and defensive approaches to currency-of- invoicing
disappears in the context of inter-company trade , since what is one subsidiary’ s
benefit ( higher profit or lower risk ) is another subsidiary ‘s loss .On an after-tax
basis, however ,there is scope for an aggressive inter company currency-of-invoicing
policy. As an extreme example, if subsidiaries A and B trade with each other and A
pays a higher tax rate, then A might be directed to invoice B in a weak currency and
B to invoice A in a strong currency. After – tax group income may be increased,
although such an approach can also create internal (motivation and evaluation) and
external (tax) problems .
5) Asset and Liability Management
Asset and liability management techniques can be used to manage balance sheet,
income statement and cash flow exposures. They can also be used aggressively or
defensively . The aggressive approach is to increase exposed assets, revenues, and
cash inflows denominated in strong currencies and to increase exposed liabilities,
expenses, and cash outflows in weak currencies. In contrast, the defensive firm will
seek to minimise foreign exchange gains and losses by matching the currency
denomination of assets / liabilities, revenues / expenses , and cash inflows / outflows,
irrespective of the distinction between strong and weak currencies .

In analysing how these objections can be achieved, it is useful to make the distinction
between operating variables (trade receivables and payables, inventory, fixed assets)
and financial variables (cash, short-term investments and debt).

The currency denomination of operating variables is largely determined by intrinsic

business conditions, such as production and marketing factors. Nevertheless, some
fine tuning of existing exposures is often possible. Consider the case of a foreign
subsidiary located in a weak currency/country. If the ‘all-current’ method of
translation is used then operating variables will tend to generate positive balance
sheet exposures. Hence, the aim of asset/liability management here might be to
reduce the subsidiary’s local currency(LC) asset exposures and increase LC
liabilities. LC receivables could be reduced by shortening the length of credit terms,
offering special discounts and discounting or factoring – all of which involve costs
(lower sales, high cash discounts or factoring charges) which may well outweigh the
potential benefits. Similarly, local inventories could be run down to lower levels. The
12
 Integrating
reverse process is applied on the liability side. Trade payables Working Capital
can be increased by
and Capital Investment
deferring payment, which may mean missing trade discounts and a loss of goodwill if
Processes
applied to third party suppliers. Such costs must be compared with the perceived
benefits of reducing the net asset exposure in a given currency.

The next step is to consider how financial variables can be manipulated for exposure
management purposes, and it is here that corporate financial management has most
discretion over currency denomination. Let us revert to the case of the positive
balance sheet exposure of a foreign subsidiary located in a weak currency country.
The treasury management objective here would normally be to reduce net exposed
financial assets, which means reducing local currency(LC) cash/near cash balance
and increasing LC denominated debt. The scarcity of weak currency finance is often
a major constraint here but, subject to availability, the parent company would typically
borrow the weak currency long term, whilst the subsidiary is usually restricted to
local bank (short term) borrowing. This is because (a) most subsidiaries are not
individually listed on a stock exchange, so that the public issue of debt instruments is
very difficult (hence the bulk of long term loans taken out by foreign subsidiaries are
private placements); (b) many foreign subsidiaries are relatively small and not well
known to the local financial community; and (c) host governments may be reluctant
to allow long-term borrowing by expatriate subsidiaries, arguing that – for balance of
payments reasons – long-term funds should be supplied by the parent company.

In the context of cash flow exposure management, the distinction between aggressive
and defensive currency-of-financing policies is an important one. With an aggressive
financial management strategy the aim of currency-of-financing policy is simply to
borrow in those currencies which have the cheapest effective interest cost, after tax.
For the defensive firm the aim of international financial management should be to
arrange the financing pattern of the company so that the detrimental effects of
currency movements are minimised, whatever the exchange rate scenario. This can
be done by structuring the group’s liabilities in such a way that any change in cash
inflows (operating revenues) induced by a currency movement is offset as much as
possible by a countervailing change in cash outflows (effective interest costs).
B) Exposure Management : External Techniques
In contrast to internal exposure management methods, the complete range of external
techniques can be used by both exporters and Importers as well as by multinational
companies. Further, the costs of the external exposure management methods are
fixed and predetermined. The main external exposure management techniques are
examined below:
1) Forward Exchange Contracts
By covering forward the currency commitment, exporter/importer need no longer
worry about the exchange risk element in the foreign transactions. What price has
been paid for this protectionism is clearly an important question since, in deciding
between various covering techniques it is the least-cost alternative which should be
chosen. There is, however, some disagreement on how to calculate the cost of
forward cover, mainly because there are two kinds of ‘cost’ involved : an ex ante
cost and an ex post (opportunity) cost.
2) Short-Term Borrowing
An alternative to covering or hedging on the forward market is the short-term
borrowing technique. A company can borrow either dollar (or some other foreign
currency) or the local currency. Through short-term borrowing techniques, the
settlement dates and the continuing stream of foreign currency exposure, two main
practical transactions’ exposure management difficulties, can be handled quite easily.
Indeed, short-term borrowing has some advantages here, over forward cover. The
13
Working Capital
expose cost of short-term borrowing cover is the home currency (HC) amount which
Management: An received if the expose receivable had been left measured (i.e. the
would have been
Integrated View
foreign currency converted into HC at the settlement date), less the HC amount
which the short-term borrowing technique yielded. Again, a company may cover a
continuing stream of foreign currency exposures by arranging a borrowing facility, as
an alternative to entering into ‘bulk’ forward option contracts, either in the currency
of invoicing (in the case of exporter) or the home currency (for the importer). This
technique can be used to simultaneously handle the problems of continuing foreign
currency exposures and uncertain settlement dates.
3) Discounting
Unlike the first two techniques, discounting can be used to cover only export
receivables. It cannot be used to cover foreign currency payable or to hedge a
translation exposure. Where an exports receivable is to be settled by bill of exchange
the exporter can discount the bill and thereby receive payment before the receivable
settlement date. The bill may be discounted either with a foreign bank in the
customer’s country, in which case the foreign currency proceeds can be repatriated
immediately, at the current spot rate; or it can be discounted with a bank in the
exporter’s country/ (HC). Either way the exporter is covered against exchange risk,
the explicit cost being the discount rate charged by the bank.

The discounting technique for covering receivables exposures is very similar to the
alternative of short-term borrowing except here the ex ante cost is the effective
discount rate less the HC deposit rate, rather than the foreign currency borrowing
rate less the HC deposit rate. With both techniques, of course, the basic aim is to
convert the proceeds from the foreign currency receivable into the HC as soon as
possible. As with straight borrowing operations, discounting is a non-sequitur in many
exchange-controlled countries since foreign currency borrowing of any sort is
permitted only under certain conditions.
4) Factoring
Like discounting, factoring can only be used as a means of covering export
receivables. When the export receivable is to be settled on open account, rather than
by bill of exchange, the receivables can be assigned as collateral for selected bank
financing. Under which circumstances such a service will give protection against
exchange rate changes, though during unsettled periods in the foreign exchange
markets, appropriate variations may be made in the factoring agreement.

For the exporter the technique is very straight forward. He simply sells his export
receivables to the factor and receives HC in return. The costs involved include both
credit risks (the customer may default) and the cost of financing (if the exporter
wants to receive payment before the receivable maturity date), as well as the cost of
covering the exchange risk (the forward discount/premium). Factoring therefore
tends to be a high-priced means of covering exposure, although there may be
offsetting benefits and credit collection costs (the exporter may simply hand over the
invoices against payment, the book-keeping and credit collection being done by the
factor).
5) Government Exchange Risk Guarantees
To encourage exports, government agencies in many countries offer their exporters,
insurance against export credit risk and special export financing schemes. In recent
years a few of these agencies have begun to offer exchange risk insurance to their
exporters, as well as the usual export credit guarantees. Typically, the exporter will
pay a small premium on his export sales and, for this premium, the government
agency will absorb all exchange losses (and gains) beyond a certain threshold level.

14
 Integrating
Initially, such exchange risk guarantee schemes were introduced to aid Working Capital
capital goods’,
and Capital
exporters, where receivable exposure terms can be of a very long-term nature. Investment
Processes
More, recently however, some schemes have been extended to cover the exchange
risk arising on consumer as well as capital goods’ export. Government exchange risk
guarantees are also given to cover foreign currency borrowing by public bodies.

It may be noted that the various exposure management techniques described above
are not available in all circumstances. This is mainly because of limitations imposed
by the market-place (as forward market exists in many of the ‘exotic’ currencies of
the developing countries) and by regulation (the hedging of translation exposures on
the forward markets is not allowed in many countries). Similarly, the availability of
internal techniques is largely a function of the international involvement of each
company.

14.6 FOREIGN FINANCIAL MARKETS

Most of the savings and investments of a country take place in that country’s
domestic financial market. However, many financial markets have extensive links
abroad. Domestic investors purchase foreign securities and invest funds in foreign
financial institutions. Conversely, domestic banks can lend to foreign residents, and
foreign residents can issue securities in the national market or deposit funds with
resident financial intermediaries. These are the traditional foreign markets for
international financial transactions.

The significant aspect of such traditional foreign lending and borrowing is that all
transactions take place under the rules, nuances, and institutional arrangements
prevailing in the respective national market. Most important, all these transactions
are directly subject to public policy governing foreign transactions in a particular
market. To illustrate, when savers purchase securities in a foreign market, they do so
according to the rules, market practices, and regulatory precepts that govern such
transactions in that particular market. The same applies to those who invest their
funds with foreign financial intermediaries.

Likewise, foreign borrowers who wish to issue securities in a national market must
follow the rules and regulations of that market. Frequently these rules are
discriminatory and restrictive. The same is true with respect to financial
intermediaries; the borrower who approaches a foreign financial institution for a loan
obtains funds at rates and conditions imposed by the financial institutions of the
foreign country and is directly affected by the authorities’ policy towards lending to
foreign residents.

14.7 EUROMARKETS AND THEIR LINKAGES

Euro currencies which are neither currencies (they are deposits, loans, or securities)
nor are they necessarily connected with Europe-represent the separation of currency
of denomination from the country of jurisdiction.

The Eurocurrency markets constitute the short-to-medium term debt part of the
international capital flow structure. The market is made by banks and other financial
institutions that accept time deposits and make loans in a currency or currencies other
than that of the country in which they are located. The latter characteristic defines
the Eurocurrency market — it is a non domestic financial intermediary. In the light of
the rapid growth of similar institutions in Hong Kong and Singapore (and to a lesser
extent in the Middle East) the market is new worldwide and is more appropriately
called the “offshore” or “external” money market.

15
Working
Growth of Capital
this network of intermediaries has been spectacular. The Eurocurrency
Management: An
market is extremely large and has grown rapidly in a short interval. It has received a
Integrated View
bad press from central banks, which continue to call it a major cause of inflation and
an obstacle to their control of domestic monetary systems. A number of basic
questions and issues crop up soon as one looks at the offshore capital markets. First,
what separates them from domestic markets? Second, why were they needed and
how could they grow so fast when sophisticated domestic capital markets already
existed? Third, is there a process of offshore money creation analogous to money
creation in a domestic banking system and what effect does this have on world
inflation?

14.8 THE CREATION OF EUROMONEY

There are no offshore currencies but only national currencies of different countries.
A national currency deposit becomes part of the offshore currency market when it is
transferred to a bank outside the controlled national monetary system. This usually
means transferred to a bank outside the nation in question. Offshore deposits can be
created in two ways:

1. One can take the physical currency of a country and deposit it in a bank in
another country. Banks do hold currency of other countries but mainly for the
convenience of travellers. And large quantities of currency have been smuggled
out from time to time in recent years. However, this is usually done with the
expectations of a depreciation of the currency being smuggled, and the receiving
banks quickly convert these balances into some hard currency. So this method is
in general of trivial importance as a creator of deposits.

2. One can transfer deposits from within the country whose currency is in question
to an offshore bank. This may well be an overseas subsidiary of the very same
bank with which the original deposit was held.

If we confine our attention to domestic money supplies, the offshore currency

markets could only cause inflationary pressure if they could lower statutory reserves
against deposits by allowing transformation of deposits from one category to another
(and if there were different reserve requirements against the different categories of
deposits). This actually happened in the United States in the late 1960s. While there
were reserve requirements against ordinary deposits, there were none against banks’
borrowings from foreign branches. When domestic rates came to exceed the CD
ceilings, then in effect, funds from domestic U.S. CDs were transferred to London
branches of American banks (which faced no interest rate ceilings) and were then
loaned to the parent banks. Since there were no reserve requirements, the same
volume of CDs supported more loans than before.

Of course, once offshore banking systems exist in tandem with domestic banking
systems it is no longer particularly meaningful to measure money supplies according
to the domestic banking system exclusively. What are you interested in when you
measure the money supply? What purpose do these measurements serve? If our
interest is inflation, we are concerned with the demand for and the supply of money
balances for transactions purposes. To the extent that they are negotiable, Euro
market CDs are probably used as transactions balances. Analysis of problems
involving the money supply should, therefore, embrace a money supply consisting of
the domestic monetary aggregates plus the negotiable part of offshore deposits in the
currency concerned. If the relevant domestic monetary aggregate includes time
deposits, then one should include also Eurotime deposits of the same maturity.

The offshore banking system is outside the control of the central banks whose
currencies it uses. We should consider briefly whether this is good or bad, or even,
16
 Integrating
for some purposes, true. Let us consider first the question of whether Working Capital
the central
and Capital Investment
banks have now lost control of the money supply and therefore of inflation. Since
Processes
every Eurocurrency unit has its origin in a domestic currency deposit or cash unit, this
cannot be true. Just as in a system of purely domestic banking, the central bank
controls the monetary base and so controls the money supply, up to the vagaries of
the money multiplier. The monetary base is multiplied to create the money supply,
because deposits are relent except for the portion held as reserves plus the portion
held as cash by the public. The offshore currency markets might make the multiplier
different in size, or they might make it more variable. A multiplier different in size
from that in a purely domestic banking system does not affect the monetary control
of the central bank. The latter body must simply know that it is working with a
multiplier of size x rather than size y. Hence problems in monetary control arise from
variability of the size of the multiplier.

For practical purposes we have one short-term CD cum time deposit market, and
whatever practical problems there are in the conception and implementation of
monetary policy cannot be sensibly described as more severe in one part of this
whole than in another part.

If this is so, we must explain the hostility central bankers often voice towards the
offshore markets. A number of factors are important here. First, while the central
banks have as much control as they ever had on creation of money, they have no
control over allocation of credit in the offshore capital market. Second, as the
Euromarkets are still viewed by the press and the public as mysterious and
omnipotent, they make convenient scapegoats for failures of nerves in the handling of
domestic monetary policy. Finally, the European central banks made fools of
themselves in the 1960s in their Euromarket dealings in a way which they would
rather forget, but which is instructive for us to examine.

In the 1960s the European central banks were pegging exchange rates, and absorbing
growing dollar deficits. In the early 1960s these dollar deficits, which became dollar
reserves of the absorbing central banks, were matched by growth of U.S. official
obligations to foreign central banks in the U.S. balance of payments accounts.
However, in the late 1960s the European central banks were surprised to observe a
growing discrepancy between the change in U.S. official obligations to foreign central
banks and their own record of dollar reserves held. The central bankers kept getting
more and more dollars than the United States seemed to be losing on the official
settlements definition of the balance of payments. The well-known economist Fritz
Machulp said of them, “Most magicians who pull rabbits out of their hats know full
well that they put them there before the beginning of the show. The magicians in
(this) story, however, are more naïve, they are just as surprised as the audience by
the emergence of the rabbits from their hats.”

What happened? Commonly when central banks undervalued their countries’

currencies against the dollar they would take the dollars they received in pegging the
price and buy U.S. Treasury Bills with them. From an accounting viewpoint, the
U.S. deficit with Germany, say, equaled in dollar value the German surplus with the
United States. A U.S. deficit with Germany meant that more dollar checks were
written to purchase DM and DM checks were written to purchase dollars. The
Bundesbank became the owner of the excess U.S. demand deposits, which it used to
purchase Treasury Bills. Thus the U.S. deficit was represented by these excess
demand deposits but entered the official settlements balance only when the demand
deposits were converted to bills.

Now suppose a foreign central bank decided to earn higher interest on its reserves by
converting its acquired U.S. demand deposits to Eurodollar CDs rather than Treasury
Bills. As we have seen, such an action transfers the ownership of the U.S. demand
deposits representing the new foreign reserves to some private, offshore bank. 17
Working Capital
Originally, these U.S. deposits were turned into foreign exchange to create the capital
Management: An European central bank absorbed. Subsequently they became the
outflow that the
Integrated View
property of the private foreign bank. This was not recorded on the official settlements
part of the balance of payments accounts though it certainly constituted foreign
reserves created by the deficit, just as before. This explains part of the mystery, but
the best part is yet to come.

Consider what might have happened to the Eurodollar deposits owned by the foreign
central banks. Under the fixed exchange rate system there were periodic exchange
crises, during which people would try to switch other currencies into DM or Swiss
francs in anticipation of appreciation. Frequently the offshore banks would lend the
dollar deposits of the Swiss and German central banks to speculators who converted
them into DM or Swiss francs. Under their exchange pegging policies, these
tendered dollars had to be absorbed by the central banks, who re-deposited in the
offshore markets, so that they could be lent again ! This is the rabbit in the hat trick
of which Machlup was speaking. The central banks came to own very large
Eurodollar claims by this circular process, but these large claims were not on the
United States but rather (indirectly) on the speculators.

14.9 EXPLANATION FOR THE GROWTH OF THE

EUROMARKETS
The Euro markets are not a bogeyman but an unregulated financial intermediary.
They bring together borrowers and lenders, frequently from the same country. They
deal only in the currencies of individual countries and are thus a substitute for the
domestic banking system. The incredibly rapid growth of the Euro-markets show
that they were a strongly preferred substitute. But why ? The question has an
obvious answer. An offshore credit market will not exist unless :
• Depositors receive better terms than they can receive onshore, and
• Borrowers can borrow more, possibly at lower rates, then they can onshore.
That is, banks in the offshore market must operate with a lower spread between the
interest rates they charge to borrowers and the ones they pay to lenders.

The rapid emergence in the 1960s of a world-wide Eurocurrency market that

coexists and competes with traditional foreign exchange banking resulted from the
peculiarly stringent and detailed official regulations governing residents operating with
their own national currencies. These regulations contrast sharply with the relatively
great freedom of non-residents to make deposits or borrow foreign currencies from
these same constrained national banking systems. On an international scale, offshore
unregulated financial markets compete with onshore regulated ones.

The differences in national regulatory regimes and the internationalisation of finance

brought the birth of the Eurodollar markets. From basic factors that contributed to
the rise of the Eurodollar markets are :
i) U.S. financial regulation played a very major role in the creation of the
Eurodollar markets, especially Regulation Q. (Restriction on currency
convertibility prevented the commercial exploitation of U.S. dollar held in Europe,
while low interest rates in the U.S. enforced by Regulation Q depressed the
returns. This was reinforced by Interest Equalisation Tax in 1963. These
conditions were in part responsible for the Eurodollar market centred in London).
ii) The U.S. balance of payments deficits and to the accumulation of dollars stride
the U.S.
iii) The U.S. dollar was the key international currency for trading and for reserve
18
 purposes, Integrating Working Capital
and Capital Investment
iv) No receive ratios were required in many of the countries, therefore, off-balance
Processes
sheet funding outside the regulatory controls was possible enabling the
establishment of Eurodollar markets.
Within the turbulent environment the inter-bank (Eurodollar) market soon became the
central mechanism to channel international flows of funds amongst banks. This truly
international market linked the various components of the international financial
system to the corresponding domestic market.

The internationalisation of finance placed international and national regulatory

systems era under further stress to liberalise financial markets and remove the long
standing barriers to trade in financial services. This trend enveloped several related
developments, most notably: some countries allowed foreign institutions a larger role
in domestic financial markets ; the erosion of domestic restrictions on capital markets;
and the increasing integration of domestic and international markets.

These changes initiated national policies of liberalisation and deregulation which were
designed to attract capital to its financial markets. Furthermore, they have been
characterised by a trend toward a breakdown in the segmentation of financial
markets. Distinctions among services offered by different financial institutions are
blurring in many countries, and national markets are becoming increasingly integrated
internationally. The nature and extent of these changes differ across countries, but
almost everywhere competition in financial markets has intensified.

14.10 SUMMARY
It is common that when finance goes international, problems multiply. One has to
focus on the operation of exchange markets, financial and euro markets. When
companies operate across nations, they face political, tax, foreign exchange and the
economic constraints. A clear understanding of the issues is all that is desired in an
international context. The basic issues pertain to the quotings and factors that
influence the exchange markets. Managing exchange rate fluctuations is also highly
important. The present unit focuses on both the internal and external techniques to
deal with this phenomenon. The internal techniques include: Netting, Matching,
Leading and Lagging, Pricing and Asset-liability management [ALBM]. External
techniques include: Forward exchange contracts, short-term borrowing, discounting,
factoring and guarantees. Finally, the developments in the Euro-markets need to be
closely studied for their effects on the company borrowing and financing programme.
Getting more mileage out of the funds involves a clear understanding of the
implications of change in the national and international contexts.

14.11 KEY WORDS

Foreign Exchange : Payment made in other country’s currency

Bid-Ask Rates : The prices quoted by the sellers and buyers for their dealings in
foreign exchange.

Interest Arbitrage : Investment of funds in other countries for securing high

interest income.

Netting : Offsetting exposures in one currency with exposure in the same or another
currency.

Factoring : Selling of export receivables to a third party 19

Working Capital : Money maintained outside the country of origin; mainly in the form
Euromoney
Management:
of deposits inAn
the off-shore banks..
Integrated View

14.12 SELF ASSESMENT QUESTIONS

1. Explain the principle of covered interest arbitrage and interest parity theory.
2. The following quotations and expectations exist for the German Mark:
Present Spot Rate $ 0.5000
90 days Forward Rate 0.5200
Your expectation of the Spot Rate 90 days hence 0.5500
a) What is the premium or discount on the forward G.M.
(b) If your expectation proves correct, what would be your dollar profit or loss
from investing $ 4,000 in the spot market? How much capital do you need
now to carry out this operation? What are the major risks associated with this
speculation?
c) If your expectation is correct what would be your dollar profit or loss from
investing $ 4,000 in the forward market?
3. Mr. Morales a trader at one of the major banks in New York has received
information from the economic research department of his bank that short-term
interest rates in the United States are bound to increase by 100 basis points within
a month. (100 basis points equal 1 %).
1-year interest rates:
United States 6.45%
Canada 4.46%
Spot rate: $ 0.996899/Canadian dollar
Forward rate :
1 year $ 1.016636
1 month$ 0.998453
i) What is the premium or discount on the Canadian dollar?
ii) What does the new information mean in terms of future rates? If Mr.
Morales is bound by the rule ‘buy equals sell, ‘ what opportunities does he
have to profit from the information given to him by his economic research
department?
iii) What are the costs or gains of such alternatives,
1) If the U.S. interest rate increases to 7.45% within a month?
2) If interest rates remain constant ?
3) If Spot Canadian dollars on day 30 were $ 0.9500?
iv) What course of action would you advise the trader to follow?
4) The spot Danish krone is selling for $ 0.17400 and the 3-month forward is selling
for $0.17440. The three-month inter bank rate for the U.S. dollar is 11.60% and
for the Danish krone is 11.25%.
i) Are the forward rates and interest rates in equilibrium? Why?
ii) If not, what would you do to take advantage of the situation?
20
 iii) If a large number of individuals take similar actions,Integrating Working
what rate trends willCapital
appear in the market? and Capital Investment
Processes
5) A foreign exchange trader gives the following quotes for the Belgian franc spot,
one month, three-months and six-months to a U.S. based treasurer.
$ 0.0247 8/80 4/6 9/8 14/11
i) Calculate the outright quotes for one, three and six months forward.
ii) If the treasurer wished to buy Belgain francs three months forward, how
much would he pay in dollars?
iii) If he wished to purchase U.S. dollars one month forward. How much would
he have to pay in Belgian francs?
iv) Assuming that Belgian francs are being bought, what is the premium or
discount, for the one, three, and six month forward rates in annual percentage
terms?
6) The Eurocurrency market is often commented upon for its apparent ability to
create vast amounts of credit. Explain how this credit creation process takes
place with the help of an example. Also explain how the interest rates work in
the Eurocurrency market.

7) “With the growth in availability of Eurodollars, Euro-banks have begun to extend

medium term Eurodollar loans for multinational companies to finance their
medium-term needs. Although the Eurobound market is of a more recent
vantage, it is of a parallel development of importance to Multinational financial
management.” Discuss.

8) Under what circumstances would a financial manager of an MNC consider using

Euro-Currency markets? What advantages or special features can these
markets offer compared to borrowing from domestic markets? Are these
drawbacks? Explain.

9) What is the difference between a Eurocurrency loan and a Eurobound? Explain

some factors accounting for the existence and growth of the Eurodollar market.

10) What is meant by “Covered-Interest-Arbitrage and Interest parity”? Why is

interest parity more realistically represented by a band rather than a line? Explain
with the help of an example.

11) How does speculation in the forward exchange market differ from speculation in
the spot market? What is meant by going ‘long’ or ‘short’ in the currency
market? Under what conditions would you sell a certain currency forward?

12) Explain the mechanism of an Interest rate swap with the help of an example.

13) What is the difference between the Eurodollar market and the Eurobond market?
In this context explain the rationale of the Eurodollar market.

14) Explain how the Eurocurrency, Euro-credit, and Eurobond markets differ from
one another.

14.13 FURTHER READINGS

1. Van Horne, James C., 2002, Financial Management and Policy, Indian Reprint,
Peortron, Delhi.
2. Shapiro, Alan C., 2001, Multinational Financial Management, John wiley &
Sons, New York.
21
3. Madhu Vij, 2001, Multinational Financial Management, Excell Books, New Integrating Working Capital
Delhi. and Capital Investment
Processes
4. Bhalla, V.K., 2001, International Financial Management, Anmol, New Delhi.

UNIT 15 INTEGRATING WORKING

CAPITAL AND CAPITAL
INVESTMENT PROCESSES
Objectives
The objectives of this unit are to:
• Emphasise the need for intergrating the working capital and capital investment
processes
• Highlight how working capital per se becomes an investment proposition.
• Discuss models suitable for integrating the processes of working capital and
capital budgeting
• Examine the operational validity of the integration exercise.
Structure
15.1 Introduction
15.2 Working Capital as an Investment
15.3 Models for Integration
15.4 Summary
15.5 Key Words
15.6 Self Assessment Questions
15.7 Further Readings

15.1 INTRODUCTION
Capital investment creates the need for additional investment in inventory, accounts
receivable and cash, through-out the life of the plant and equipment. It is normally
assumed that an investment in working capital assets also causes a comparable
expansion in current liabilities. The theoretical models for evaluating capital
investment alternatives implicitly assumes the costs resulting from changes in the
working capital components or the cash benefits following from these components
are imbedded in the cash flow of the investment. The implicit inclusion of working
capital components in the capital investment model is correct theoretically, but having
the capability to measure the explicit contribution of working capital components to
cash inflows and outflows provides a powerful tool for management.

There are several reasons for identifying the costs and benefits created by the
working capital components and linking them explicitly into the total investment
planning process. More than likely in the early life of an investment it is operating
below capacity; while later in the life cycle, there is often an increase in operating
capacity. Thus, throughout the life of an investment, there is often a continuing
growth of investment in working capital. Furthermore, the discounted cash outflows
related to cash, receivables and inventories can range from a modest to a major
proportion of the total cost of an investment. Also the source of financing for these
current assets, either long or short-term, can affect the cash flow patterns of an
investment. The need for additional investment in working capital is dependent on
1
Working Capital the type and size of investment’ the size and growth of the market, the growth of the
Management: An relative market share and length of the planning horizon. Additionally, the impact of
Integrated View
inflation can create a drag on cash flows if the price increases related to Labour and
materials are always leading the price increase for the products sold by a significant
margin. Finally, within many corporations the management of the working capital
components is usually separate from the capital investment and long-run financial
planning systems. Continuous communication between operating and strategic
management are vital to the long-term success of a firm, but communications are
often infrequent or nonexistent. These observations indicate the need for a planning
model that explicitly integrates the working capital components into the capital
investment decision-making process.

15.2 WORKING CAPITAL AS AN INVESTMENT

Working capital is well recognized as an important decision area within the firm. Yet
working capital does not seem to occupy a very prominent place within the academic
field of finance. While a gap between theory and practice persists in many areas of
management decision-making, it would seem, especially so, for working capital
management.

The gap between theory and practice may not be so serious, if working capital is
given appropriate decision-making context. Specifically, if the working capital is
viewed as an investment, and that changes in working capital policies are included in
the capital budgeting process of the firm.

In view of the relative size of working capital changes, and also the finding that many
firms do indeed view such changes as investment projects, it is well to consider more
closely the relationship of working capital decisions to other financial decisions made
by the firm. This relationship is found in financial control. While control is well
known to be one of the key functions of management, it would appear to have
received considerably less treatment than planning, at least in the financial literature.
But just as control without adequate planning will likely be futile, planning without
adequate control will prove frustrating.

A first dimension of financial control that has been well documented is to monitor the
financial progress of the firm over time. This usually takes the form of tracking
selected financial ratios, and thereby assessing both the current status and likely
future prospects of the organisation. If attention is limited to single ratios for just
profitability and liquidity, then financial control is relatively straight forward. If,
instead, management tracks a larger number of financial ratios, then financial
control is more complex as tradeoffs must be made. In general, if there are N
measures being tracked any investment project or change in policy will result in 2N
possible changes in the status of the firm, Obviously, the number 2N –2 quickly gets
large as N is increased. One way to handle the complexity of multiple ratios is with
composite measures such as the Dupont System or the Altman Bankruptcy model.

A second dimension of financial control is to consider corrective actions that can be

taken when firms progress departs from firms plans. For example, if the liquidity
position of the organisation appears to be worsening, management may decide to
issue either bonds or equity in order to reduce short-term financial obligations.
Alternatively, management may decide to reduce inventory levels and/or expand
credit if the probability goal of the firm is not being achieved. Many possible
corrective actions pertain to the current assets and current liabilities of the firm, and
thus working capital adjustments can be an important part of overall financial control
within the organisation.

A logical extension of this idea is to view corrective actions as investments made by

2
the firm. Just as investments are routinely made by the firm in capital project, so too Integrating Working Capital
should the firm routinely consider changes in working capital as investment projects. and Capital Investment
Processes
Viewed in this way, each investment in working capital is an attempt to move the firm
closer to its expressed goals. This view, it should be noted, is different than just
including working capital implications with each capital project being considered. It
is also a view that is consistent, with the theory of the firm, the theory of finance, and
apparently the current practices of many large industrial firms.

A list of possible corrective actions having to do with working capital is presented in

Exhibit-15.1. The list, which is representative rather than exhaustive, is organised
into six groups that correspond to certain current assets and current liabilities
normally found on the balance sheet.

Exhibit- 15.1
Possible Corrective Actions Involving Working Capital
—————————————————————————————————
Cash
1. Change collection network
2. Change disbursement network
3. Change size of operating cash balance
Marketable Securities
4. Change method of investing surplus cash
5. Change method of transferring funds between cash account and marketable
securities portfolio.
Accounts Receivable
6. Change cutoff score for credit applications
7. Change discounts offered to customers
8. Change frequency of follow-up payment notice
Inventory
9. Change inventory valuation methods
10. Change inventory order quantities
11. Change inventory safety stocks
12. Change distribution network
Payables and Accruals
13. Change suppliers used
14. Change response to suppliers discounts
15 Change payroll procedures
Short-term Borrowing
16. Change lenders used
17. Change payment methods
18. Change collateral arrangements
—————————————————————————————————

Not all of the corrective actions in Exhibit-15.1 would be feasible, let alone desirable,
for a given firm at a particular point in time. For each corrective action that is
feasible, financial managers should identify the expected benefits and costs towards
3
Working Capital evaluating whether it would help the firm move towards its expressed goals.
Management: An Corrective action #7, for example, is a change in the cash discounts which the firm
Integrated View
offers to its customers. A cash discount tantamounts to a reduction in price. Suppose
the discount is increased, to the extent that customers take advantage of the larger
discount by paying their bills sooner, the firm’s investment in accounts receivable is
reduced. The expected benefit of corrective action 7, therefore, should reflect the
extent of the discount that is offered to the proportion of credit customers that are
expected to take the discount and the resulting decrease in the receivables
investment. The expected cost of corrective action # 7 is the reduced profit to the
firm as a result of credit customers that avail themselves of the larger discount.

Based on past experiences with customer response to changing credit terms, the
credit manager ought to be able to make reasonable estimates of the expected
benefits and cost to the firm of offering customers a larger cash discount. Expected
benefit and cost can then be combined in order to calculate a “return-on-investment”
for the corrective action. If a similar procedure is also followed for each corrective
action being considered (such as those in Exhibit-15.1) , then each corrective action
can be viewed as a proposed investment project by the firm-and evaluated within the
context of the capital budgeting process. Again, this would seem to be consistent
with both the theory and current management practice.

15.3 MODELS FOR INTEGRATION

There have been many valuable theoretical and operational contributions in managing
each component of working capital linking them with one another. Linear
programming (LP) models have been used to introduce the dynamic features of the
working capital process. Two large scale LP models were designed to link the
sources of short term credit to short term uses and to integrate the variables involved
in managing short-term cash flow in this chapter. The Goal programming as a tool
for the management of working capital has been applied.

Though the need for integrating the working capital processes into the long run
financial planning processes has been recognized and a variety of theoretical
linkages have been suggested, many of the models have not incorporated the
dynamics of uncertainty involved in the short- run investment. None of these models
are really integrated into the capital investment and long-run financing processes of
the firm. The primary objective of this chapter is to offer an integrated model
designed for management decision making and to provide a model for testing “ What
if” policy questions concerning the impact of working capital variables on the total
profitability of capital investment alternative.

The model is divided into two parts, viz the Capital Investment (CI) module and the
Working Capital (WC) module.

15.3.1 Capital Invest Module

The financial planning process is composed of many variables and occurs in an
uncertain and dynamic environment, therefore, this model will use simulation
techniques to represent the interactions among the capital investment and working
capital variables. The Hertz model is revised to simulate the capital investment
process. The variables are divided into three major categories viz, market,
investment and cost. The market analysis variables are market size, growth rate of
market size related to the life cycle of the product and market share related to the
price of the product. The investment analysis variables are life of the investment, on
line time, initial and future investment costs excluding working capital costs. The
cost analysis variables are the variable and fixed costs.
4
Each variable is assumed to be stochastic and independent. However, it is assumed Integrating Working Capital
that the parameters are specified for each variable by the decision makers, reflecting and Capital Investment
Processes
their perception of the interrelationships among the variables. If there are well

Exhibit 15.2
Simulation of the working capital-capital investment process

5
Working Capital
Management: An
Integrated View

established relationships among variables, these functional relationship can be easily

inserted into the model. The variables involved in the capital investment module are
presented in Exhibit-15.2 and the actual operation of the CI module is presented in
the exhibit.

The programme randomly selects in a sequential order a value from the specified
distribution for each variable. The uncertain and dynamic characteristics of the CI
process are reflected in this random interaction of the variables. The selected values
are used in the calculation of a net present value (NPV) , internal rate of return
(IRR), and a benefit/cost ratio (B/C) for each simulation. This process including the
working capital module is repeated 100 times and the final outcomes are profitability
profiles or cumulative frequency distributions of NPV, IRR, and B/C.

15.3.2 Working Capital Module: An Overview

The module simulates the integration of working capital components into the capital
investment (CI) process. Forecasting errors and inflation are introduced into the
total investment planning process because they are the primary causes of working
capital management problems. The objectives of the module are: (1) to identify and
measure the benefits and costs of investments in working capital components; (2) to
identify the impact of forecasting errors and inflation on cash, inventory receivables,
payables and short-term borrowing; and (3) to measure the sensitivity of net present
value (NPV) and internal rate of return (IRR) profiles to changes in WC strategies
designed to offset forecasting errors and inflationary conditions.

Historically, working capital (WC) activities are frequently revised, relatively routine
and occur in a relatively short time period. Also the WC process is usually
considered to be independent of the CI planning process. The management of short-
run cash flows is a continous and dynamic process occurring in an uncertain
environment. However, because the CI model operates on an annual basis it is
assumed, for convenience, that the strategic planning of the WC cycle also operates
on a one year horizon. A shorter time period could be programmed to accommodate
the needs of decision makers.
Cash Flow Crises
A cash flow crises often occurs when unexpected events arise, e.g., actual short-run
expenditures being greater than forecasted and /or actual short-run cash inflows
being less than forecasted. Surprise outflows can be related to a large price increase
for raw materials. An unexpected decline in inflows arises when actual sales are
less than forecasted or if there is an extension of the normal trade credit payment
pattern. In both cases total cash outflows are frequently greater than total cash
inflows plus existing cash items.

The standard approach to investment planning is to assume that the forecasted cash
flows actually occur. For example, in solving for the net present value (NPV) or
internal rate of return (IRR) of an investment it is assumed the forecasted
distributions of revenues and costs actually occurred. By assuming the profitability
profiles generated from the forecasted inputs actually happen, the analysis misses the
effect a short-run financial crises has on cash flows. Because cash flow crises
often arise when forecasting errors occur, the analysis of investment opportunities
6
requires an additional step. A dual simulation process is introduced with one Integrating Working Capital
assumed to represent the forecasted results and the other the actual outcomes. In and Capital Investment
Processes
simulating these two sets of conditions, the model assumes sales are the key
mechanism. It is assumed that actual sales (s) are generated by the CI programme
and a supportive forecast of sales (SF) is produced by the WC module. Simulating
sales conditions where the actual sales are randomly different from forecasted
sales, captures the essences of forecasting errors, which incorporates the major
cause of WC problems.

If the forecasted sales exceed actual sales there will be a cash flow shortfall. To
offset the short-fall current asset and current liability components are adjusted by
management. The cash flow shortfall is the heart of the problem related to a WC
crises. The model provides management a variety of short-run policy alternatives to
offset the cash flow shortfall.

New Variables

In the WC module two new sets of probabilistic variables are introduced and
combined with the variables in the CI module. One set represents three WC
variables. These variables inject the uncertainty existing in the WC system into the
total financial planning process. These three probabilistic variables are: (1) sales
forecast (SF) in year 1, (2) an annual growth rate of forecasted sales (G) related
to the life cycle of the product, and (3) trade credit/sales (TC) ratio that is related to
the quantity of production.

The second set of probabilistic variables represent the inflation dimension as its
impact on the firm. There are four separate rates of inflation. The stochastic
inflationary variables serve as an adjustment to the values selected for price (P),
interest (ib,iL), total purchases (PUR), total Labour costs (LC), and fixed costs
(FC).

Additionally, management determines a single value for each of the following

variables.
Cash
Beginning cash
Minimum cash
Maximum cash (minimum cash plus marketable securities)
Receivables
Beginning receivables
Bad debt allowance
Inventory
Beginning inventory
Required ending inventory
Maximum inventory cushion
Cost of excess inventory
Operating
Gross margin for purchases
Percent of marginal sales achieved
Marginal labour cost on marginal sales
Interest
7
Working Capital Short term borrowing rate
Management: An
Integrated View Short term lending rate
The working capital module is divided into three additional parts beyond the
investment information presented in the CI module. The first module comprises the
cost and income components. Also, inflation adjustments occur in this module. The
second module involves the processes related to production and inventory. Finally,
the module that links the total process together is the cash and trade credit system.

Operation of the WC Module

The objectives of each module and an explanation of its operation are presented in
the following sections. A numerical example with accompanying comments
concerning the operation of the module are found in Table 15.1. The example of the
model in Table 15.1 integrates all of the modules in the total working capital-capital
investment process (WC-CI). The following presentation is an explanation of the
sequential operation of the WC module and is based on the data in Table-15.1.

Investment Information

The first operation of the model is the determination of actual and forecasted sales in
both rupees and units. The initial price is provided by the user, which is Rs. 12.50 in
our example in Table-15.1. A random market size of 45.4 lakh units is selected for
year 1. Also, a market share of 17.92 per cent is selected at random. Sales demand is
8,62,219 units and is determined by multiplying the random market size (1) times the
market share. Sales of Rs. 1.077 crore are calculated by multiplying price times
sales demanded in units. Sales forecasted in rupees is randomly drawn from a
distribution and sales forecast in units is calculated by dividing by price.

The difference between sales demand (s) and sales forecast (SF) reflect the
forecasting error and is a critical value in the working capital management process.
If forecasted sales are greater than the actual sales (SFt > St), the firm did not
achieve its sales forecast. Therefore, the sales demanded (Q) become the actual
sales (AS). However, if sales demand is greater than forecasted sales (St > SFt),
unforecasted or potential sales arise and it is assumed management will try to
produce as much as possible to close this gap and meet these potential marginal
sales. In example in Table 15.1 management assumed 40 per cent of potential
marginal sales would be produced. Whenever St > SFt, the marginal sales achieved
are added to the sales demand to give actual sales (AS). The final operation of this
module is the calculation of forecasted production (FPQ). Table 15.1 shows FPQ is
calculated by adding the change in the amount of required ending inventory (units)
to the sales forecast in units.

Each of the variables in this module make an important contribution to the total
module. It is apparent the gap between St and SFt is the primary reason for
financial planning. The gap between S and SF introduces uncertainity into the
investment planning process.

Previously capital investment theory has assumed that St = SFt. The contribution of
the (WC-CI) model is to include a sales forecast variable and build in the assumptions
that (1) St SFt, for t =1, … n, (2) if St > SF all marginal sales may not be
achievable and there might be a cost premium for marginal sales that should be
added to total costs of the investment, (3) also, when marginal sales are achieved,
they generate cash in-flows that were not anticipated when it was assumed St = SFt,
(4) if SFt > St, there can be a cost of carrying additional inventory that should be
added to the total cost of the investment, and cash inflows will be smaller than
planned under conditions when St = SFt.
8
Cost and Income Module Integrating Working Capital
and Capital Investment
Processes
There are several key operations involved in the costs and income module. The three
primary operating costs are : purchases (PUR), labour (LC) and fixed (FC). It is
assumed that these variables are closely related to the forecasted production, i.e.
quantity of goods produced. When St > SFtt, it is possible to have marginal
production above the original forecasted level. When this condition occurs, the
marginal cost of purchases and labour are calculated separately and added to their
respective forecasted costs for purchase and labour.

Increases in cost as a result of inflationary conditions are introduced in this module.

The programme randomly selects an inflation rate for purchases and this rate is
applied to total purchases. The model also randomly selects and applies an
adjustment to labour and fixed costs. Additionally, a random inflationary rate is
injected into the price of the product. Thus, as shown in Table 15.1, actual sales are
computed by multiplying the production quantity with the price which has been
adjusted for inflationary pressures. When actual sales and costs are calculated, the
model calculates the remaining components of the income statements.

The major cost items are calculated in this module and Table 15.1 provides an
example of these calculations. First , for period 1, labour cost per unit of 2.52 was
randomly chosen, and multiplied with forecasted production. The labour costs are
increased for inflation, which was 5.35 per cent in year 1. In this model inflation is
assumed to be a random variable. When marginal sales are achieved, marginal
labour costs are calculated in units of marginal sales. In Table 15.1, the marginal
labour costs (MLCX) are 10 per cent. Thus on the additional marginal sales
achieved, the cost of labour was 10 per cent higher than under normal operating
conditions.

Fixed costs are assumed to be a random variable that is related to the sales
demanded. The fixed costs are also increased by a separate inflation rate, 4.45 per
cent, that was selected randomly.

Purchase costs are calculated by multiplying the gross margin (.5) times the value of
forecasted production. The gross margin is a key input variable determined by the
user. When St > SFt, there are marginal purchases made to accommodate the
marginal sales determined earlier. Normally, the gross margin for marginal sales
(GMMP) should be greater than the gross margin. It is .6 in Table 15.1.
Additionally all purchase costs are adjusted by a randomly selected inflation value of
5.35 per cent.

In year 1 the initial investment cost of Rs. 7.72 million is randomly selected, and an
annual straight line depreciation schedule of Rs. 857,778 is determined for nine year
horizon with all receipts and costs determined, earnings before interest and taxes
(EBIT) of Rs. 758,065 are calculated. Next it is assumed that the interest cost on
short-term debt is paid the following year. Thus, in year 1, there is no interest cost,
and earnings before taxes (EBT) is equal to EBIT. The assumed tax rate is 40
percent. Table 15.1 shows the calculation of Rs. 303,226 in taxes, and net income
equals Rs. 454,839.

Production – Inventory System

The module focuses on the production-inventory process. Management has at its

discretion a set of variables that may be used for controlling inventory limits. In this
module management establishes single point estimates for each of the following
production –inventory decision variables. (1) An estimate of the beginning inventory
quantity (BIQ); (2) A required ending inventory (REI) value which is an estimate of
management’s desired ratio of ending inventory(units)/ sales forecast (units). The
9
Working Capital
Management: An
Integrated View
level of REI is related to the units of production in period t. (3) A maximum
inventory cushion (MIC) that management expresses as a percent, above the
required ending inventory quantity (REI). If the actual ending inventory (AEIOT) is
greater than the maximum ending inventory MEIOt), there will be excess inventory
(EXINV). (4) The cost of carrying excess inventory is cost that arises when
SF > S, thereby causing a cash cost for holding inventory in excess of the forecasted
inventory needs. The cost of carrying excess inventory is assumed to be the cost of
capital. As shown in Table 15.1, it is multiplied with the cost of excees inventory to
determine the cost of holding excess inventory.

Cash-trade Credit System

This module ties together receivables and the cash operation including short-term
borrowing or investing in marketable securities. The module collects which serve as
inputs for calculating the net present value of the investment.

The primary decision variables available to management in controlling levels of cash

and accounts receivable are: (1) The beginning value of cash (BC) and accounts
receivables (AR); (2) A minimum cash level (CLOW) is determined as a ratio of
cash/sales forecast (CMIN), which depends on the levels of production; (3) A
maximum cash level (MAXCASH) that is expressed as a per cent above the
minimum cash balance(CLOW) . MAXCASH is a discretionary variable that can
range from zero to a large whole number. If ending cash (EC) falls between
CLOWt and, the difference between Ect and CLOWt is invested in marketable
securities (MAXCASHt); (4) The sum of minimum cash balances (CLOWt) and
invested in marketable securites (MSt) equals the maximum cash position in a
specific time period (CMAX). There are three interest rate variables in the model;
(5) Interest rate on short term borrowed funds (ib); (6) Interest rate on lending (iL)
(7) Cost of capital (k) . The cost of capital is the discount rate in the present value
equation.

The model assumes that there is a controlled stochastic relationship between

receivables and sales and between payables and sales. The ratios of receivables/
sales (ARS) and payables/sales (AP/S) serve as proxies for these two relationships.
These two distributions are crucial management inputs in establishing trade credit
Table policy.
15.1 : Integration of Working
It is assumed Capital
that the and Capital
management Investment
perceives Modules - An
a probability Example of
distribution
AR/S and AP/S ratios, and it wishes to control the level of each one within a
Year
specified range of sales. The difference between these two trade credit variables
Variables (AR/S – AP/S)1 is the input 2 used to calculate theComments
net for accounts receivable. In
Price (P)
Table 15.1, a trade
(Rs.)
credit/sale
12.50
(TC/S) ratio
13.44
of .3535 was randomly chosen for year 1.
P1 is an initial input;
Multiplying it with actual sales (AS1) gives accounts receivables
P2 = P1 (1 +PA2),= of PA2Rs. 3.7 million.
= .0750
After
Market Size (MSIZE)
deducting
(u)
for bad debts,
48,11,491
cash receipts
51,50,954
(CR) are determined by
MSIZEO is a randomly Selected
adding to
actual sales to the change in accounts receivableVariable between period
= 4540000; t and t-1. CR1 is
equal to Rs. 6.78 million. MSIZE1 = MSIZEO ( 1+MSIZE1 );
GMSIZE1 = .0598
GMISZE2 = .0612.
Market share (MSHR) (%) 179200 220267 Randomly selected.
Sales Demand* (Q) (u) 8,62,219 11,24,671 Qt = MSIZEt (MSHRt)
Sales Demand (S) (Rs.) 1,07,77,737 1,51,15,577 St = Pt × Qt
Sales Forecast * (SFQ) (u) 8,23,750 9,21,711 SFQ1 is a randomly selected
Value. SFQ2 = Q1 ( 1+g2 )
Where g2 - .0690; g2,…………,
gn are randomly selected
Variables.
Sales Forecast (SF) (Rs.) 1,02,96,875 1,23,87,798 SFt = SFQt (Pt)
Pot Marg Sales (PS) (Rs.) 4,80,860 37,27,779 PSt = (St - SFt); if SFt > St: PSt = 0.

10
Marg Sales Achieve (Rs.) 1,93,344 10,91,111 If SF > S: MSA = 0; Integrating Working Capital
If S > SF : MSA = PSt and Capital Investment
(PSAt); Processes
PSA2 = .4 PSA =
Potential
Sales Achieved.
Marg Sales Achieve (Rs.) 15,388 81,184 MSAQt = MSAt/Pt
(MSAQ)
Actual Sales (AS) (Rs.) 1,04,89,218 1,34,78,909 If SF > S: ASt = St;
If St > SFt;
ASt = (SFQt + MSAQt) Pt
Actual Sales* (ASQ) (u) 8,39,137 10,02,985 ASQt = ASt/Pt
Forecast Prod (FPQ (u) 9,22,600 8,22,861 FPQt = SFQt + (REIQt -
AEIQt -1);
Where REIQ is required ending
Inventory and AEIQt -1
Is actual required ending
:Inventory given below.
These concepts are presented in
the inventory module.
COST AND INCOME MODULE
Labour Cost (LC) (Rs.) 23,24,951 18,76,123 LC1 = LC1 Per Unit ( FPQ 1);
Where LC1 = 2.52; where
LC2 = 2.2799 AND BIQ =
beginning inventory =98,850 (u);
LCt for future years follows
the second equation.
Infl Adj Lab Cost (Rs.) 24,49,334 19,90,566 PALCt = LCt (1 + PALt); where
(PALC) PAL is inflation rate for
labour costs; PAL 1 = .0535;
PAL2 = .061
Marg Labour Cost (Rs.) 42, 654 2 , 03 , 609 If St > SFt : MLCt = MSAQt (LCt
(MLC) Per unit x 1 + MLCX) =
Marginal labour cost per unit
Above LC per Unit. MLCX =.10.
If St > . SFt : MLC = 0.
Infl Adjust (PAMLC) (Rs.) 44,936 2,16,029 If St < SFt : PAMLCt = 0;
If St > SFt:
PAMLC = MLCt (1 + PALt)
Fixed Cost (FC) (Rs.) 1,75,000 2,15,000 FCt = related to SFt.
Infl Adjust (PAFC) (Rs.) 1,82,787 2,16,029 PAFCt = FCt (1 + PAFt);
Where PAFt is inflation
rate for fixed cost.
PAF1 = .0445; PAF2 = .064.
Purchase Cost (PUR) (Rs.) 57,66,248 55,76,087 PURt = GM (FPQt × Pt)
where
GM is gross margin. GM = .5.
Infl Adjust (PAPUR) (Rs.) 60,74,737 60,19,381 PAPURt = PURt (1 + PAPt);
Where PAPt is inflation
rate for purchases.
PAP1 = .0535; PAP2 = .0795.
Marg Purch Cost (Rs.) 1,15,406 6,54,667 If St > SFt : MPUR =
(MPUR) (MSAQt x Pt) GMMP;
GMMP = .6, Gross
Margin for marginal purchases.
If SFt > St: MPUR = 0.
Infl Adj (PAMPUR) (Rs.) 1,21,580 70,76, 712 PAMPURt = MPURt ×
(1 + PAP).
Operating Income (OI) (Rs.) 16,15,843 43,17,355 Iot = ASt - PALCt - PAMLCt
- PAFCt - PAPURt - PAMPURt.
Investment Cost (IC) (Rs.) 77 , 20 , 000 0 IC0 is a randomly
selected variable.
11
Working Capital Deprec (DEP) (Rs.) 8,57,77 8,57,778 DEP1 is straight line
Management: An depreciation; DEPt = IVt /N;
Integrated View Where N = 9 Years.
Book Value (BV) (Rs.) 68,62,222 60,04,444 BV1 = ICO - DEP1;
BV2 = BV1 + DEP2.
EBIT (Rs.) 7,58,065 34,59,477 EBITt = OIt - DEPt.
Interest (ZNT) (Rs) 0 2,41,050 INTt = ib (cumulative S/T
borrowingt-1) ; ib is borrowing rate
of interest,
TIbl = .08; for t2, …, tn,
TIbt = ibt-1 (Pat); cumulative
S/T borrowing - 1
given on last page.
EBT (Rs.) 7,58,065 32,18,526 EBTt = EBITt = INTt
Taxes (T) (Rs.) 3,03,226 12,87,410 Tt TR (EBT); where TR
Ts tax rate. TR =.4.
Net Income (NI) (Rs.) 4,54,839 15,31,116 NIt = EBTt - Tt
Production-Inventory Module
Required Ending (u) 98,850 92,171 REIQt = REIt (SRF);
Inventory (REIQ) REI1 = .12; REI2 =.10.
Begin Inventory (BIQ) (u) 0 98,850 BIQ1 = O; BIQt = AEIQt - 1
For tt2, …… , tn
Actual Production (u) 9,37,987 9, 96,266 PRODQt = SFQt - BIOt
(ORIDQ) + MSAQt + REIQt
Actual Ending Inv (u) 98,850 92,171 If St > SFt; AEIQt = REIQt;
(AEIQ) If SFt > St: AEIQt = PRODQT
- ASQt + BIt
MAX Ending Inv (u) 1,18,620 1,10,605 MEIQt = REIQt (1 + MIC);
(MEIQ) MIC = .2
Excess Inv (ExINVQ) (u) 0 0 If MEIQt > AEIQt : ExINVQt = 0;
If AIEQt > MEIQt:
ExINVQt = AEIQt - MEIQt
Carrying Cost (Rs.) 0 0 CEXNVt = ExINVQt (GM)
(CEXINV) GM = Gross Margin = .5;
K= Cost of carrying
Inventory = .1
Cash-Trade Credit System
Trade Credit/Sales (%) .3535 .331 TCt is a random variation
(TC) and proxies for (AR/S - AP/St).
Net Act. Rec. Bal. (AR) (Rs.) 37,07,937 44,61,517 ARt = STt (BDA): BDAt
Bad Debt Allowance (Rs.) 3,70,794 4,46,152 BADt = ARt (ADA); BDA = (BDA)
Cash Receipts (CR) (Rs.) 67,81,281 1,23,54,531 CRt = ASt + ARt-1 - BADt
Begin Cash + MS Bal (Rs.) 0 6,17,812 BC1 = 0; BCt = Ect-1,(BC)
For T2,…….., tn
Cash Available (CBAL) (Rs. ) 67,81,281 1,29,72,343 CBALt = CRt + BCt + BEXC -
FUTCOSTt, BECX is
est from S/T investment
Is Zero in years 1 and
FUTCOST = 0 future investment
Cost.
Total Cash Pay (CPAY) (Rs.) 91,76,000 1,12,24,972 CPAYt = PALCt + PAMLCt
+ PAFCt + PAPURt + PAMPt
+ Tt + CEXINVt + INTt - 1
End Cash + MS Bal (Rs.) 6,17,812 6,19,390 ECt = SEt (CMINt) + MSt;
(EC) CMIN1 = .06; CMIN2 = .0
*****
Cash Lower Bound (Rs.) 6,17,812 6,19,390 CLOWt = SFt (CMINt)
(CLOW)
Max Cash + MS Level (Rs.) 7,41,374 7,43,268 CMAXt = CLOWt (1+ MAXCA
(CMAX) MAXCASH = .2
12
Short Term Debt (STD) (Rs.) 30,131,31 0 If (CBALt - CPAYt) > Integrating Working Capital
CLOWt; and Capital Investment
STDt = 0; If (CBALt - CPAYt) Processes
<
CLOW: STDt = CPAYt -
CBALt)
+ CLOW. See Appendix 1
for additional conditions.
Payment S/T/debt (Rs.) 0 11,27,981 If (CBALt - CPAYT) >
CLOWt:
(PAY) PAYt = (CBALt - CPAYt) -
If (CBALt - CPAYt) <
CLOWt:
PAYt = 0. See Appendix 1.
Cum S/T/ Debt (Rs.) 30,13,131 18,85,150 SUMCXt = SUMCXt-1 - PAYt
(SUMCX) + STDt
Interest Cost (INT) (Rs.) 2,41,050 1,61,180 INTt = SUMCXt (Tb); Tb =
borrowing rate = .08
S/T LEND (Mkt Sec) (Rs.) 0 0 If SUMCXt > 1, MS = 0.
(MS) See Appendix 1.
Interest Benefits (Rs.) 0 0 BEXCt = MSt (iL); iL = lending
(BEXC) rate = .07
Cash CT MAX Cash + (Rs.) 0 0 CEXt=CBALt CPAYt- SUMCXt
MS (CEX) - CMAXt
Cash Flow (CF) (Rs.) 23,95,320 12,74,186 CFt = CRt - PALCt - PAMLCt
- PAPURt - PAMPURt - PAFCt
- T*t
Revised Cash Flow (Rs.) 0 0
RCFt = CFt = T*t - Tt +
(RCF) BEXCt - 1
- INTt-1 - (Ect - Ect -1)
+ (SUMCXt - SUMCXt - 1) -
CEXINVt
cost of Capital (k) (%) .10 .1055 kt = kt-1 + PAt - PAt-1)
———————————————————————————————————————————

In Table 15.1 cash equals zero at the beginning of year 1. For subsequent years
beginning casht equals ending cash (-1), which includes cash plus marketable
securities. The total cash available for meeting cash payments equals cash receipts
(CRt) plus beginning casht (BCt) plus interest earned on marketable securities
(INT) minus any capital investment costs (FUTCOST).

Total cash payments equals the sum of all cash outflows which are shown in
Table 15.1. All outflows occur in the year. If cash payments are greater than cash
available, the company will have to borrow (short-term) to meet the total cash
payment. Under these conditions, ending cash equals lower boundary (CLOW)
prescribed by management. Table 15.1 shows this was the case in year 1. Ending
cash is a complex variable that is explored further in the next few paragraphs.

If cash payments were greater than cash available (CBAL1) , it is necessary to

borrow enough short-term funds to cover the cash shortfall plus maintaining the
13
Working Capital minimum levels of cash. In the case where CPALt >CPAYt, and there is short term
Management: An (S/T) debt outstanding the difference between CBALt – CPAYt, is used to retire
Integrated View
debt and also maintain the minimum cash balance. The model will continue to retire
debt in future years when ABAL > CPAY. Once the ST debt is retired the model
will invest, the idle cash balances that exist above the cash lower boundary. Thus,
the model assumes the investment is either borrowing or lending in any given period.
Of course, it is possible that neither could occur, but it is highly unlikely. The model
will invest up to CMAX in any year. Any cash above CMAX is included in cash
receipts and is assumed to be earning the cost of capital.

When there is cumulative ST debt outstanding, an interest cost is incurred at the short
term rate (ib). The interest costs become a cash outflow the following period. If
there are investments in marketable securities, they earn at the lending rate (iL) . Any
cash earned on marketable securities becomes cash available in the following period.
Traditional analysis assumes investment is financed by long term sources and,
furthermore, it assumes the debt/ equity mix is relatively stable in the long-run. It
does not explicitly allow for a cash flow shortfall which results in an increase in short
term debt. If a prolonged working capital crisis was financed by short run financing,
one serious outcome could be a radical change in a company’s debt/equity mix. The
chances of short-term debt surge is quite plausible in an inflationary environment or a
period of high interest rates. Finally, the traditional approach does not consider a
cash overflow, where liquid assets would earn less than the cost of capital. Thus
explicitly introducing interest cost of short term borrowing and interest earned on
marketable securities is an addition to traditional investment analysis.

15.3.3 Present Value Module

Traditional Analysis:: In traditional analysis cash receipts were equal to the inflow
of funds from actual sales, and cash payments included initial and future investment
costs, price adjusted labour cost, total purchases and fixed costs, plus taxes. In
equation form, the net present value (NPV) of an investment proposal is:
NPV(A) = - 1Co + AS,-TC, +AS2-TCO2 +————————+ASn – TCOn + SVn
———— ————— —————————
(1+K) (1+K)2 (1+K)n

Where
ICO = Investment cost at the beginning of the period

ASt = total cash Inflow from actual sales or cash inflow

In each period
TCO t = total cash outflows in each period which
included
The following:
TLC t = total price adjusted labour costs, or PALCt
TPC t = total price adjusted purchases, or PARt + PAM
PAFCt = Price adjusted fixed costs;
Tt = taxes;
FUTCOSTt = future investment costs;
Other variables included are:
SVN = salvage value of the investment
k = cost of capital

Revised Analysis : An objective of this model is to provide a more comprehensive

investment analysis framework by explicitly integrating the working capital operations
into the capital investment process. Forecasting errors and inflation may cause cash
flows from the revised model to vary markedly from flows generated by the
14
traditional model. Short-term borrowing and /or the sale of marketable securities Integrating Working Capital
are used to offset a cash flow shortfall or the retirement of debt. Marketable and Capital Investment
Processes
securities absorb an overflow of cash above the minimum level but below the
maximum level. Also changing inventory levels, minimum cash levels or payment
patterns of receivables and payables can alter shortfalls or overflows. Thus an
objective of the revised model is to measure the size and sign of the cash flows and
thereby make it possible to highlight the cost and benefits related to the working
capital strategies. The significance of these working capital strategies on the net
present value of an investment are explained in the following paragraphs.

First, declining business conditions or a prolonged inflationary environment can

change payment behaviour and dramatically alter the inflow of funds from
receivables. Thus a lengthening of payments on receivables that was not forecast
can result in a significant cumulative shortfall in the actual cash inflows from an
investment. During this period if the delays in receivables payments are not offset
by a stretching of payable, the net cash flows will be further reduced. If cash flows
are negative short-term borrowing will occur after cash and marketable securities
are reduced to their minimums. The borrowing costs are determined in the revised
model and are reflected as a cash outflow. Alternatively an acceleration of
receivable inflows without a change in the payment of payables can expand the net
cash flow during that period. Excess idle cash balances are invested and generate
cash benefits for the investment.

Second, an adjustment in taxes is required because in the traditional models, short-

term interests cost or benefits were not permitted. Thus, EBIT is increased when
interest income is received, which makes EBT higher than in the traditional case.
Also , in the revised model, interest costs cause EBT to be lower than in the
traditional model. Thus, tax outflows in the revised model differ from taxes in the
traditional model. Third, carrying excess inventory produces a holding cost. This cost
enters the revised NPV equation as a cash outflow. This cost only occurs when
inventory exceeds the upper control limit. Fourth, another big factor in the revised
model relates to cash management policies and operations. The change in the ending
cash account (ECt) between period t and t-1, can produce a substantive change in
cash inflow or outflow. When ECt > ECt-1, it indicates an increase in the level of
cash held and a reduction in cash available for meeting cash payments, which
results in a lower net cash flow. The opposite effect occurs if ECt < ECt-1. There
are several refinements related to ending cash and they are presented in Table 15.2.

Finally, positive cash flows are used to retire accumulated short-term borrowing
(SUMCXt) thereby reducing cash flows available for reinvestment, as shown in
table 15.2. When negative cash flows happen, short-term borrowing will occur after
liquid assets are reduced to a minimum. The result is that accumulated short term
borrowing. Table 15.2 presents the logic of these two cases.

In comparing the revised cash flow (RCF) model to the traditional cash flow (CF)
approach, it is necessary to refer to the equation for each one of Table 15.1. The
RCFs differ from the CFs for the following reasons. First, the contribution of trade
credit policies and bad debts are reflected in cash receipts. Additionally, forecasting
errors and inflation cause change in the level of cash (ECt = ECt –1 ) and short-
term borrowing (SUMCXt – SUMCXt –1) . These two terms are algebraically
added to the revised cash flows. Also the cost of carrying excess inventory because
of forecasting errors enter the NPV equation as an outflow. The interest return
from marketable securities and the interest cost of short-run borrowing are
appropriately included in the revised cash flows.

If the sum of the costs are greater than the receipts, and liquid assets are at a
minimum, short term borrowing is employed to offset the amount of the negative
15
Working Capital cash flow. The rationale for this modeling assumption is that after the initial
Management: An investment costs (IC) are incurred, any additional costs are related to an investment
Integrated View
in working capital components or delayed capital expenditures (FUTCOSTt)
Increases in the level of short –term borrowing (SUMCXt=SUMCXt-1) to offset a
shortfall are included in the RCF equation as an inflow, therefore when outflow >
inflow additions to STDt equal the shortfall and the RCF is recorded as a zero.
Table 15.1 illustrates this concept. In the traditional model a cash flow (CF) shortfall
is recorded as a negative value, e.g., year 1 in Table 15.1.

By making the working capital components explicit and introducing forecasting errors,
the revised model can identify and measure the cost of the shortfall, which was not
previously accomplished. When a positive cash flow exists, short-term borrowing is
paid off before may positive cash flows are available for discounting. Thus, when
borrowing occurs, the RCFs are limited on the down side to zero and when positive
flows occur the RCFs are limited on the top side by the retirement of debt. In
conclusion, the RCFs will operate in a more narrow band than the CF from the
traditional model.

For comparative purposes the model calculates the traditional (CFt) and revised cash
flow (RCFt) for each period in the life of the investment. This provides management
an invaluable source of information to compare the CF to the RCFt. Because of the
large number of possible combinations and permutations, interpretation of these data
should be done with care. The size of the gap between CFt and RCFt profiles
reflects the effect working capital components and strategies have on the profitability
of an investment. For example, when the CF profile is positive and greater than the
RCF profile, a narrow gap shows working capital components have a limited affect
on the value of the investment. However, a large gap indicates the importance of
working capital components and strategies in determining the value of the investment.
An analysis of these wide differences can aid management in re-evaluating the
forecasted inputs, the forecasting errors and the working capital strategy that is
creating the gap. There are many possible combinations of inputs that cause a gap.
The model produces the necessary data to identify the variable(s) causing the
problem.

Table 15.2 : Determining Net Cash Flow From Investment after adjusting
for ending Cash and S/T Debt Retirement or Addition

Legend

CBAL = Total cash inflow

CPAY = Total cash outflow

CEX = Net Cash flow in excess of cash minimums

UNDISX= Net cash flow from investment after adjusting for ending
cash and S/T/ debt retirement or addition
EC = Ending cash plus m.s. balance
BEXC = Interest benefit from S/T/ investment
INT = Interest cost on S/T debt
CMAX = CMINX * (1.0 MAXCASH)
Cr = Cash receipts
FUTCOST = Any future investment cost
CEINV = Cost of excess inventory
CLOW = Minimum cash balance
SUMCX= Cumulative S/T/ debt
CBALt = CRt - FUTCOSTt + Ect -1 + BEXCT -1
16
CPAYt = fixed costt + labour cost + purchase cost + Taxestt + CEINVt Integrating Working Capital
and Capital Investment
+ INTt - 1
Processes
CEXt = CBALt - CPAYt - CPATt - CMAXT
If CBALt - CPAYt < CMAXt, CEX = 0
When CBALt = CPAYt < CNAXt, UNDISXt = 0
UNDISXt = CBALt - CPAYt - ECt + SUMCXt - 1 - SUMCXt)
Case 1.
When CBALt - CPAYt < CLOWt
ECt = CLOWt
SUMCXt = SUMCXt -1 + CLOWt - (CBALt - CPAYt)
ECt + SUMCXt - 1 - SUMCXt = CBALt - CPAYt
Therefore UNDISXt = 0
Case 2.
When Clowt < (CBALt - CPAYt) < CMAXt
and CABALt - (CBALt < SUMCXt - 1
EC = CLOWt
SUMCXt = SUMCXt-1 - (CBALt - CPAYt - CLOWt)
SUMCXt - 1 - SUMCXt = CBALt - CPAYt - CLOWt
ECt + SUMCXt SUMCXt = CBALt - CPAYt
Therefore UNDISXt + 0
Case 3.
When CLOWt < (CBALt - CPAYt) < CMAXt
and SUMCXt - 1 < CBALt < - CPAYt
SUMCXt = 0

ECt = CBALt - CPAYt - SUMCXt - 1

ECt + SUMCXt - 1 - SUMCXt = CBALt - CPAYt
Therefore UNDISXt - 0
Case 4.
When CMAXt < CBALt - CPAYt,
UNDISXt = CBALt - CPAYt - CMAXt = CEXt, AND
When CMAX < CBALt - CPAYt and SUMCXt -1 < CBALt - CPAYt:
ECt = CMAXt SUMCXt = 0 SUMCXt-1 =0
CTt + SUMCXt - 1 - SUMCXt = CTt
There UNDISXt + CBALt = CPAYt - CMAXt + CEXt

15.3.4 Cost of Capital

In this model, it is assumed that the management prefers to use a single value for
the initial cost of capital (Ko). However, the impact of inflation must be included in
the cost of capital , kt. The cash inflows and outflows in the numerator of the NPV
equation are adjusted for inflation. The price of the goods sold in period 2 (P2) is
calculated in the following manner as shown in Table 15.1: P2 =P1 (L + PA2),
where PA is a randomly selected value for inflation drawn from a distribution
perceived for inflation between the current and most recent time periods, PAT –
PAt-1. This adjustment for inflation is presented below in equation form, which
reflects the real cost of capital(t):

(1+k)=(1+Kt) (1+IF)

Where IF = PAt – PAt-1

Using the change in the perceived rate of inflation between periods, more closely
17
Working Capital approximates the behaviour of financial markets, than an expected rate of inflation
Management: An for a long time horizon. The essence of the adjustment assumes, a positive change
Integrated View
in the rate of inflation will increase the cost of capital from the preceding period;
however, if the rate of inflation decreases, the cost of capital will subsequently
decrease. This would not occur if the adjustment process assumed a constant rising
mean perceived rate of inflation.

By allowing the cost of capital to change each year, the inflation adjusted net cash
flows in the numerator are discounted with a different k in each period. In this
simulation model, the cost of capital is a probability distribution, and a cost of capital
profile is created. The task of evaluating the profile of NPVs of an investment is
complicated by not having a common cost of capital. Management must interpret
the statistical properties of the NPVs , especially the mean, standard deviation,
skewness and kurtosis when comparing separate simulation of the same alternatives
or different alternatives. Furthermore, there is no longer a single cost of capital to
serve as a benchmark for which the internal rates of return (IRR) can be compared.
Previously if IRR>.k the investment was acceptable or rejected if IRR < k. In this
simulation model, the profile of 100 IRR’s are compared to the profile of the 100 k’s
and the judgement of the user is needed to determine if the investment is
acceptable.

The WC-CI model extends the traditional capital investment model and provides
management a tool to test the sensitivity of an investment’s profitability to changes in
working capital strategies. Forecasting errors and inflationary conditions are shown
to be the primary causes of working capital problems. These Working Capital
Strategies are designed to offset forecasting errors and inflation. The model aids
management in finding the best possible mix of strategies to generate the highest
possible values of an investment.

15.4 SUMMARY
A firm is run with both fixed capital and working capital. These capitals change their
rates due to swift transformation taking place in each of them. Working capital gets
converted into fixed capital and via-versa. Thus, there is a need to integrate working
capital and capital investment processees. This is based on the realisation that
changes in the policies of working capital bring about changes on the capital
budgeting process of the firm. An attempt is made in this unit to highlight the
significance of this integration process and the models to do it. Discussion in this unit
is confined mainly to the what if techniques. It focuses on both the capital investment
module and working capital module. The capital investment module takes into
considention the variables such as market, investment and cost. Each variable is
assumed to be stcheffic and independent. The uncertain and dynamic characteristics
of the capital investment module are reflected in the random interaction of the
variables.

Whereas the working capital module attempts to simulate the integration of working
capital components into the capital investment process. More specifically, it attempts
to measure the sensitivity of the NPV and IRR to changes in working capital strate-
gies designed to offset the forecasting error and inflactorary conditions. The models
have highlighted the fact that forecosting errors and inflationary conditions are shown
to be the primary causes of working capital problems.

15.5 KEY WORDS

Simulation : A technique to study the interrelationships among the variables of a set,
with the help of probabilities.
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Investment Information : Information that is crucial for deciding investment in a Integrating Working Capital
project. and Capital Investment
Processes
Cost Project Module : A combination of purchase cost, labour cost and fixed cost.
Cash flow crisis : An unexpected happening resulting in the shortage of cash.

15.6 SELF ASSESSMENT QUESTIONS

1) How can computer simulation be used as a tool for improving business
decisions? In view of the many techniques now available to the financial
theorists, what judicial advantages are to be derived from simulation? IIIustrate
your decisions with specific examples.

2) “In simulating financial decision, the strategy that produces the best simulated
result is not necessarily the optimal financing strategy”. Do you agree with this
statement? Why or Why not?
3) “If one is in possession of a basic single Sequence or independent observations of
some random variable with known intrivation function, then one can construct a
sequence of such observations of any other random variable whose distribution is
known”. Explain
4) Define Working Capital. What are the two critical decisions in Working Capital
management? In what important ways do these decisions differ from those
concerned with the management of the fixed capital of a business? Explain why
these difference exists.
5) Explain the sequential process of :
a) Capital Investment Module
b) Working Capital Module.

15.7 FURTHER READINGS

1) Bhalla, V. K., 2002, Working Capital Management- Test and Cases New
Delhi.

2) Walker, EW., 1071, Essentials of Financial Management, Prentice Hall, New

Delhi.

3) Orgler Y.E, 1970, Cash Management, Wadworth Publishing, Belmont.

4) Berenek, William, 1963, Analysis for Financial Decisions, Homewood, Richard

D. Irwin.

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