PROJECT FINAL REPORT

ON

“LENDING POLICIES OF COMMERCIAL BANK ( OVERDRAFT,CASH

CREDIT, WORKING CAPITAL & BILL DISCOUNTING)”

BY
DEEP BHANUSHALI
(TY B.COM )
6TH SEMESTER

K . J. SAOMAIYA COLLEGE OF SCIENCE AND COMMERCE

(Batch of 2010)
 ACKNOWLEDGEMENT

A work is never a work of an individual. I owe a sense of gratitude to

the intelligence and co-operation of those people who had been so
easy to let me understand what I needed from time to time for
completion of this exclusive project.

I am greatly indebted to my guides Prof……… ,faculty guide for

Finance (summer internship), Accman Institute Of Management &
Mr………., Manager ,

I am also grateful to Prof. ……., CRIC Chief and Mr……….., DIRECTOR,

Accman Institute of Management, for permitting me to undertake this
study.

Last but not the least, I would like to forward my gratitude to my

friends & other faculty members who always endured me and stood
with me and without whom I could not have completed the project.

DEEP
BHANUSHALI
 DECLARATION

I do hereby declare that this piece of project report entitled “ ……….”

for partial fulfillment of the requirements for the award of the degree
of “…………………..” is a record of original work done by me under the
supervision and guidance of Prof…………….., Accman Institute Of
Management .This project work is my own and has neither been
submitted nor published elsewhere.

PLACE:
SIGNATURE OF THE STUDENT

DATE:
 CERTIFICATE

This is to satisfy that the summer project work of ………………….Titled

Working capital management is an original work and this work has not
been submitted elsewhere in any form. The indebtness to other
works/publications has been duly acknowledged at the relevant places.
The project work was carried out during 02.05.2009 to 02.07.2009 in
………………..

Date:
 TABLE OF CONTENTS

Sr. No. Contents Page No.

12 Conclusion 63

13 Bibliography 64
 Commercial Bank

An institution which accepts deposits, makes business loans,

and offers related services. Commercial banks also allow for a variety
of deposit accounts, such as checking,savings, andtime deposit.
These institutions are run to make a profit and owned by a group
of individuals, yet some may be members of the Federal Reserve
System. While commercial banks offer services to individuals,
they are primarily concerned with receiving deposits and lending
to businesses.

Commercial Banks in India are broadly categorized into

Scheduled Commercial Banks and Unscheduled Commercial
Banks. The Scheduled Commercial Banks have been listed under
the Second Schedule of the Reserve Bank of India Act, 1934. The
selection measure for listing a bank under the Second Schedule
was provided in section 42 (60 of the Reserve Bank of India Act,
1934.
Activities of Commercial Banks

The modern Commercial Banks in India cater to the financial needs of

different sectors. The main functions of the commercial banks
comprise:

• transfer of funds

• acceptance of deposits

• offering those deposits as loans for the establishment of

industries

• purchase of houses, equipments, capital investment purposes

etc.

• The banks are allowed to act as trustees. On account of the

knowledge of the financial market of India the financial
companies are attracted towards them to act as trustees to take
the responsibility of the security for the financial instrument like
a debenture.

• The Indian Government presently hires the commercial banks for

various purposes like tax collection and refunds, payment of
pensions etc.

Functions of Commercial Banks

The functions of a commercial banks are divided into two

categories:

i) Primary functions, and

ii) Secondary functions including agency functions.

i) Primary functions:
The primary functions of a commercial bank include:

a) accepting deposits; and

b) granting loans and advances;

a) Accepting deposits

The most important activity of a commercial bank is to mobilise

deposits from the public. People who have surplus income and savings
find it convenient to deposit the amounts with banks. Depending upon
the nature of deposits, funds deposited with bank also earn interest.
Thus, deposits with the bank grow along with the interest earned. If the
rate of interest is higher, public are motivated to deposit more funds
with the bank. There is also safety of funds deposited with the bank.

b) Grant of loans and advances

The second important function of a commercial bank is to grant loans

and advances. Such loans and advances are given to members of the
public and to the business community at a higher rate of interest than
allowed by banks on various deposit accounts. The rate of interest
charged on loans and advances varies depending upon the purpose,
period and the mode of repayment. The difference between the rate of
interest allowed on deposits and the rate charged on the Loans is the
main source of a bank’s income.

i) Loans

A loan is granted for a specific time period. Generally, commercial

banks grant short-term loans. But term loans, that is, loan for more
than a year, may also be granted. The borrower may withdraw the
entire amount in lumpsum or in instalments. However, interest is
charged on the full amount of loan. Loans are generally granted
against the security of certain assets. A loan may be repaid either in
lumpsum or in instalments.

ii) Advances

An advance is a credit facility provided by the bank to its customers. It

differs from loan in the sense that loans may be granted for longer
period, but advances are normally granted for a short period of time.
Further the purpose of granting advances is to meet the day to day
requirements of business. The rate of interest charged on advances
varies from bank to bank. Interest is charged only on the amount
withdrawn and not on the sanctioned amount.

Modes of short-term financial assistance

Banks grant short-term financial assistance by way of cash credit,

overdraft and bill discounting.

a) Cash Credit

Cash credit is an arrangement whereby the bank allows the

borrower to draw amounts upto a specified limit. The amount is
credited to the account of the customer. The customer can
withdraw this amount as and when he requires. Interest is
charged on the amount actually withdrawn. Cash Credit is
granted as per agreed terms and conditions with the customers.

b) Overdraft

Overdraft is also a credit facility granted by bank. A customer

who has a current account with the bank is allowed to withdraw
more than the amount of credit balance in his account. It is a
temporary arrangement. Overdraft facility with a specified limit
is allowed either on the security of assets, or on personal
security, or both.

c) Discounting of Bills

Banks provide short-term finance by discounting bills, that is,

making payment of the amount before the due date of the bills
after deducting a certain rate of discount. The party gets the
funds without waiting for the date of maturity of the bills. In
case any bill is dishonoured on the due date, the bank can
recover the amount from the customer.

ii) Secondary functions

Besides the primary functions of accepting deposits and lending

money, banks perform a number of other functions which are
called secondary functions. These are as follows -

a) Issuing letters of credit, travellers cheques,

circular notes etc.

b) Undertaking safe custody of valuables, important

documents, and securities by providing safe deposit vaults or
lockers;
c) Providing customers with facilities of foreign
exchange.

d) Transferring money from one place to another; and from

one branch to another branch of the bank.

e) Standing guarantee on behalf of its customers, for making

payments for purchase of goods, machinery, vehicles etc.
f) Collecting and supplying business information;
g) Issuing demand drafts and pay orders; and,
h) Providing reports on the credit worthiness of
customers.

Different methods of Granting Loans by Bank

The basic function of a commercial bank is to make loans and

advances out of the money which is received from the public by
way of deposits. The loans are particularly granted to
businessmen and members of the public against personal
security, gold and silver and other movable and immovable
assets. Commercial bank generally lend money in the following
form:

i) Cash credit

ii) Loans

iii) Bank overdraft, and

iv) Discounting of Bills

i) Cash Credit :

A cash credit is an arrangement whereby the bank agrees to lend

money to the borrower upto a certain limit. The bank puts this amount
of money to the credit of the borrower. The borrower draws the
moneyas and when he needs. Interest is charged only on the amount
actually drawn and not on the amount placed to the credit of
borrower’s account. Cash credit is generally granted on a bond of
credit or certain other securities. This a very popular method of lending
in our country.

ii) Loans :

A specified amount sanctioned by a bank to the customer is called a

‘loan’. It is granted for a fixed period, say six months, or a year. The
specified amount is put on the credit of the borrower’s account. He can
withdraw this amount in lump sum or can draw cheques against this
sum for any amount. Interest is charged on the full amount even if the
borrower does not utilise it. The rate of interest is lower on loans in
comparison to cash credit. A loan is generally granted against the
security of property or personal security. The loan may be repaid in
lump sum or in instalments. Every bank has its own procedure of
granting loans. Hence a bank is at liberty to grant loan depending on
its own resources.

The loan can be granted as:

a) Demand loan, or

b) Term loan

a) Demand loan

Demand loan is repayable on demand. In other words it is repayable at

short notice. The entire amount of demand loan is disbursed at one
time and the borrower has to pay interest on it. The borrower can
repay the loan either in lumpsum (one time) or as agreed with the
bank. Loans are normally granted by the bank against tangible
securities including securities like N.S.C., Kisan Vikas Patra, Life
Insurance policies and U.T.I. certificates.

b) Term loans

Medium and long term loans are called ‘Term loans’. Term loans are
granted for more than one year and repayment of such loans is spread
over a longer period. The repayment is generally made in suitable
instalments of fixed amount. These loans are repayable over a period
of 5 years and maximum upto 15 years.

Term loan is required for the purpose of setting up of new business

activity, renovation, modernisation, expansion/extension

of existing units, purchase of plant and machinery, vehicles, land for

setting up a factory, construction of factory building or purchase of
other immovable assets. These loans are generally secured against the
mortgage of land, plant and machinery, building and other securities.
The normal rate of interest charged for such loans is generally quite
high.

iii) Bank Overdraft

Overdraft facility is more or less similar to cash credit facility.

Overdraft facility is the result of an agreement with the bank by which
a current account holder is allowed to withdraw a specified amount
over and above the credit balance in his/her account. It is a short term
facility. This facility is made available to current account holders who
operate their account through cheques. The customer is permitted to
withdraw the amount as and when he/she needs it and to repay it
through deposits in his account as and when it is convenient to
him/her.

Overdraft facility is generally granted by bank on the basis of a written

request by the customer. Some times, banks also insist on either a
promissory note from the borrower or personal security to ensure
safety of funds. Interest is charged on actual amount withdrawn by the
customer. The interest rate on overdraft is higher than that of the rate
on loan.
iv) Discounting of Bills

Apart from granting cash credit, loans and overdraft,banks also grant
financial assistance to customers by discounting bills of exchange.
Banks purchase the bills at face value minus interest at current rate of
interest for the period of the bill. This is known as ‘discounting of bills’.
Bills of exchange are negotiable instruments and enable the debtors to
discharge their obligations towards their creditors. Such bills of
exchange arise out of commercial transactions both in internal trade
and external trade. By discounting these bills before they are due for a
nominal amount, the banks help the business community. Of course,
the banks recover the full amount of these bills from the persons liable
to make payment.
PRINCIPLES OF BANK LENDING POLICIES---------------

The main business of banking company is to grant loans and advances

to traders as well as commercial and industrial institutes.

The most important use of banks money is lending. Yet, there are risks
in lending.

So the banks follow certain principles to minimize the risk:

1. Safety

2. Liquidity

3. Profitability

4. Purpose of loan

5. Principle of diversification of risks

Term Loans and Leases

◆ Term Loans
◆ Provisions of Loan Agreements
◆ Equipment Financing
◆ Lease Financing
◆ Evaluating Lease Financing in Relation to Debt Financing
◆ Term Loan -- Debt originally scheduled for repayment in more
than 1 year, but generally in less than 10 years.
◆ Credit is extended under a formal loan arrangement.

◆ Usually payments that cover both interest and principal are

made quarterly, semiannually, or annually.
◆ The repayment schedule is geared to the borrower’s cash-flow
ability and may be amortized or have a balloon payment.

Costs of a Term Loan

ii) The interest rate is higher than on a short-term loan to the same
borrower (25 to 50 basis points on a low risk borrower).
iii) Interest rates are either (1) fixed or (2) variable depending on
changing market conditions -- possibly with a floor or ceiling.
iv) Borrower is also required to pay legal expenses (loan agreement)
and a commitment fee (25 to 75 basis points) may be imposed on
the unused portion.

Benefits of a Term Loan

c) The borrower can tailor a loan to their specific needs

through direct negotiation with the lender.
d) Flexibility in terms of changing needs allows the borrower to
revise the loan more quickly and more easily.
Term loan financing is more readily available over time
making it a more dependable source ofRevolving
Credit
Agreements
 Revolving Credit Agreement -- A formal, legal commitment to
extend credit up to some maximum amount over a stated period
of time.
ii) Agreements are frequently for three years.

iii) The actual notes are usually 90 days, but the company can
renew them per the agreement.
iv) Most useful when funding needs are uncertain.

v) Many are set up so at maturity the borrower has the option of

converting into a term loan.
-6
Insurance
Company Term Loans

c) These term loans usually have final

maturities in excess of seven years.
d) These companies do not have compensating balances to
generate additional revenue and usually have a prepayment
penalty.
e) Loans must yield a return commensurate with the risks and
costs involved in making the loan.
f) As such, the rate is typically higher than
what a bank would charge, but the term is

Medium-Term Note

Medium- Term Note (MTN) -- A corporate or government debt

instrument that is offered to investors on a continuous basis.
d) Maturities range from 9 months to 30 years (or more).

e) Shelf registration makes it practical for corporate issuers to offer

small amounts of MTNs to the public.
f) Issuers include finance companies, banks or bank holding
companies, and industrial companies.
 Euro MTN -- An MTN issue sold internationally outside the country in
whose currency the MTN is denominated.

Equipment Financing

3. Loans are usually extended for more than 1 year.

4. The lender evaluates the marketability and quality of equipment
to determine the loanable percentage.
5. Repayment schedules are designed by the lender so that the
market value is expected to exceed the loan balance by a given
safety margin.
6. Trucking equipment is highly marketable, and the lender may
advance as much as 80% of market value, while a limited use
lathe might provide only a 40% advance or a specific use item
cannot be used as collateral.

The loan may be repaid monthly, quarterly, semi-annually or

annually.

The Bank provides a grace period for investment-related agricultural

loans.

BILL OF EXCHANGE

BILL OF EXCHANGE, a form of negotiable instrument, defined below,

the history of which, though somewhat obscure, was ably summed up
by Lord Chief Justice Cockburn in his judgment in Goodwin v. Robarts
(1875), L.R. io Ex. pp. 346-358. Bills of exchange were probably
invented by Florentine Jews. They were well known in England in the
middle ages, though there is no reported decision on a bill of exchange
before the year 1603. At first their use seems to have been confined to
foreign bills between English and foreign merchants. It was afterwards
extended to domestic bills between traders, and finally to bills of all
persons, whether traders or not. But for some time after they had
come into general employment, bills were always alleged in legal
proceedings to be drawn secundum usum et consuetudinem
mercatorum. The foundations of modern English law were laid by Lord
Mansfield with the aid of juries of London merchants. No better tribunal
of commerce could have been devised. Subsequent judicial decisions
have developed and systematized the principles thus laid down.
Promissory notes are of more modern origin than bills of exchange,
and their validity as negotiable instruments was doubtful until it was
confirmed by a statute of Anne 0704). Cheques are the creation of the
modern system of banking.
Before 1882 the English law was to be found in 17 statutes dealing
with isolated points, and about 2600 cases scattered over some 300
volumes of reports. The Bills of Exchange Act 1882 codifies for the
United Kingdom the law relating to bills of exchange, promissory notes
and cheques. One peculiar Scottish rule is preserved, but in other
respects uniform rules are laid down for England, Scotland and Ireland.
After glancing briefly at the history of these instruments, it will
probably be convenient to discuss the subject in the order followed by
the act, namely, first, to treat of a bill of exchange, which is the original
and typical negotiable instrument, and then to refer to the special
provisions which apply to promissory notes and cheques. Two salient
characteristics distinguish negotiable instruments from other
engagements to pay money. In the first place, the assignee of a
negotiable instrument, to whom it is transferred by indorsement or
delivery according to its tenor, can sue thereon in his own name; and,
secondly, he holds it by an independent title. If he takes it in good faith
and for value, he takes it free from "all equities," that is to say, all
defects of title or grounds of defence which may have attached to it in
the hands of any previous party. These characteristic privileges were
conferred by the law merchant, which is part of the common law, and
are now confirmed by statute.

Definition

By § 3 of the act a bill of exchange is defined to be "an unconditional

order in writing, addressed by one person to another, signed by the
person giving it, requiring the person to whom it is addressed to pay
on demand or at a fixed or determinable future time a sum certain in
money to or to the order of a specified person, or to bearer."' The
person who gives the order is called the drawer. The person thereby
required to pay is called the drawee. If he assents to the order, he is
then called 1 This is also the definition given in the United States, by §
126 of the general act relating to negotiable instruments, prepared by
the conference of state commissioners on uniform legislation, and it
has been adopted in the leading states.
the acceptor. An acceptance must be in writing and must be signed
by the drawee. The mere signature of the drawee is sufficient (§17).
The person to whom the money is payable is called the payee. The
person to whom a bill is transferred by indorsement is called the
indorsee. The generic term "holder" includes any person in
possession of a bill who holds it either as payee, indorsee or bearer. A
bill which in its origin is payable to order becomes payable to bearer
if it is indorsed in blank. If the payee is a fictitious person the
bill may be treated as payable to bearer (§ 7).
The following is a specimen of an ordinary form of a bill of exchange:
£I 00 London, 1st January 1901. Three months after date pay to the
order of Mr J. Jones the sum of one hundred pounds for value
received.
To Messrs. Smith & Sons, Liverpool.
The scope of the definition given above may be realized by comparing
it with the definition given by Sir John Comyns' Digest in the early part
of the 18th century: - "A bill of exchange is when a man takes money
in one country or city upon exchange, and draws a bill whereby he
directs another person in another country or city to pay so much to A,
or order, for value received of B, and subscribes it." Comyns' definition
illustrates the original theory of a bill of exchange. A bill in its origin
was a device to avoid the transmission of cash from place to place to
settle trade debts. Now a bill of exchange is a substitute for money. It
is immaterial whether it is payable in the place where it is drawn or
not. It is immaterial whether it is stated to be given for value received
or not, for the law itself raises a presumption that it was given for
value. But though bills are a substitute for cash payment, and though
they constitute the commercial currency of the country, they must not
be confounded with money. No man is bound to take a bill in payment
of debt unless he has agreed to do so. If he does take a bill, the
instrument ordinarily operates as conditional, and not as absolute
payment. If the bill is dishonoured the debt revives. Under the laws of
some continental countries, a creditor, as such, is entitled to draw on
his debtor for the amount of his debt, but in England the obligation to
accept or pay a bill rests solely on actual agreement. A bill of exchange
must be an unconditional order to pay. If an instrument is made
payable on a contingency, or out of a particular fund, so that its
payment is dependent on the continued existence of that fund, it is
invalid as a bill, though it may, of course,
avail as an agreement or equitable assignment. In Scotland it has
long been the law that a bill may operate as an assignment of funds
in the hands of the drawee, and § 53 of the act preserves this rule.

Stamp

Bills of exchange must be stamped, but the act of 1882 does not
regulate the stamp. It merely saves the operation of the stamp laws,
which necessarily vary from time to time according to the fluctuating
needs and policy of the exchequer. Under the Stamp Act 1891, bills
payable on demand are subject to a fixed stamp duty of one penny,
and by the Finance Act 1899, a similar privilege is extended to bills
expressed to be payable not more than three days after sight or date.
The stamp may be impressed or adhesive. All other bills are liable to
an ad valorem duty. Inland bills must be drawn on stamped paper, but
foreign bills, of course, can be stamped with adhesive stamps. As a
matter of policy, English law does not concern itself with foreign
revenue laws. For English purposes, therefore, it is immaterial whether
a bill drawn abroad is stamped in accordance with the law of its place
of origin or not. On arrival in England it has to conform to the English
stamp laws.

Maturity

A bill of exchange is payable on demand when it is expressed to be

payable on demand, or at sight, or on presentation or when notice for
payment is expressed. In calculating the maturity of bills payable at a
future time, three days, called days of grace, must be added to the
nominal due date of the bill. For instance, if a bill payable one month
after sight is accepted on the 1st of January, it is really payable on the
4th of February, and not on the 1st of February as its tenor indicates.
On the continent generally days of grace have been
abolished as anomalous and misleading. Their abolition has been
proposed in England, but it has been opposed on the ground that it
would curtail the credit of small traders who are accustomed to bills
drawn at certain fixed periods of currency. When the last day of grace
is a nonbusiness day some complicated rules come into play (§ 14).
Speaking generally, when the last day of grace falls on Sunday or a
common law holiday the bill is payable on the preceding day, but when
it falls on a bank holiday the bill is payable on the succeeding day.
Complications arise when Sunday is preceded by a bank holiday; and,
to add to the confusion, Christmas day is a bank holiday in Scotland,
but a common law holiday in England. When the code was in
committee an attempt was made to remove these anomalies, but it
was successfully resisted by the bankers on alleged grounds of
practical convenience.

Acceptance

By the acceptance of a bill the drawee becomes the principal debtor on

the instrument and the party primarily liable to pay it. The acceptor of
a bill "by accepting it engages that he will pay it according to the tenor
of his acceptance," and is precluded from denying the drawer's right to
draw or the genuineness of his signature (§ 54). The acceptance may
be either general or qualified. As a qualified acceptance is so far a
disregard of the drawer's order, the holder is not obliged to take it; and
if he chooses to take it he must give notice to antecedent parties,
acting at his own risk if they dissent (§§ 19 and 44). The drawer and
indorsers of a bill are in the nature of sureties. They engage that the
bill shall be duly accepted and paid according to its tenor, and that if it
is dishonoured by non-acceptance or non-payment, as the case may
be, they will compensate the holder provided that the requisite
proceedings on dishonour are duly taken. Any indorser who is
compelled to pay the bill has the like remedy as
the holder against any antecedent party (§ 55).
A person who is not the holder of a bill, but who backs it with his
signature, thereby incurs the liability of an indorser to a holder in due
course (§ 56). An indorser may by express term either restrict or
charge his ordinary liability as stated above. Prima facie every
signature to a bill is presumed to have been given for valuable
consideration. But sometimes this is not the case. For friendship, or
other reasons, a man may be willing to lend his name and credit to
another in a bill transaction. Hence arise what are called
accommodation bills. Ordinarily the acceptor gives his acceptance to
accommodate the drawer. But occasionally both drawer and acceptor
sign to accommodate the payee, or even a person who is not a party to
the bill at all. The criterion of an accommodation bill is the fact that the
principal debtor according to the instrument has lent his name and is
in substance a surety for some one else. The holder for value of an
accommodation bill may enforce it exactly as if it was an ordinary bill,
for that is the presumable intention of the parties. But if the bill is
dishonoured the law takes cognizance of the true relations of the
parties, and many of the rules relating to principal and surety come
into play. Suppose a bill is accepted for the accommodation of the
drawer. It is the drawer's duty to provide the acceptor with funds to
meet the bill at maturity. If he fails to do so, he cannot rely on the
defence that the bill was not duly presented for payment or that he did
not receive due notice of dishonour. If the holder, with notice of the
real state of the facts, agrees to give time to the drawer to pay, he
may thereby discharge the acceptor.

Holder in due Course

The holder of a bill has special rights and special duties. He is the
mercantile owner of the bill, but in order to establish his ownership he
must show a mercantile title. The bill must be negotiated to him, that
is to say, it must be transferred to him according to the forms
prescribed by mercantile law. If the bill is payable to order, he must
not only get possession of the bill, but he must also obtain the
indorsement of the previous holder. If the bill is payable to bearer it is
transferable by mere delivery. A bill is payable to bearer which is
expressed to be so payable, or on which the only or last indorsement
is an indorsement in blank. If a man lawfully obtains possession of a
bill payable to order without the necessary indorsement, he may
obtain some common law rights in respect Brown & Co.
of it, but he is not the mercantile owner, and he is not technically the
holder or bearer. But to get the full advantages of mercantile
ownership the holder must be a "holder in due course" - that is to say,
he must satisfy three business conditions. First, he must have given
value, or claim through some holder who has given value. Secondly,
when he takes the bill, it must be regular on the face of it. In particular,
the bill must not be overdue or known to be dishonoured. An overdue
bill, or a bill which has been dishonoured, is still negotiable, but in a
restricted sense. The transferee cannot acquire a better title than the
party from whom he took it had (§ 36). Thirdly, he must take the bill
honestly and without notice of any defect in the title of the transferor, -
as, for instance, that the bill or acceptance had been obtained by
fraud, or threats or for an illegal consideration. If he satisfies these
conditions he obtains an indefeasible title, and can enforce the bill
against all parties thereto. The act substitutes the expression "holder
in due course" for the somewhat cumbrous older expression "bona fide
holder for value without notice." The statutory term has the advantage
of being positive instead of negative. The French equivalent "tiers
porteur de bonne foi" is expressive. Forgery, of course, stands on a
different footing from a mere defect of title. A forged signature, as a
general rule, is a nullity.
A person who claims through a forged signature has no title himself,
and cannot give a title to any one else (§ 24). Two exceptions to this
general rule require to be noted. First, a banker who in the ordinary
course of business pays a demand draft held under a forged
indorsement is protected (§ 60). Secondly, if a bill be issued with
material blanks in it, any person in possession of it has prima facie
authority to fill them up, and if the instrument when complete gets
into the hands of a holder in due course the presumption becomes
absolute. As between the immediate parties the transaction may
amount to forgery, but the holder in due course is protected (§ 20).
Dishonour
The holder of a bill has special duties which he must fulfil in order to
preserve his rights against the drawers and indorsers. They are not
absolute duties; they are duties to use reasonable diligence. When a
bill is payable after sight, presentment for acceptance is necessary in
order to fix the maturity of the bill. Accordingly the bill must be
presented for acceptance within a reasonable time. When a bill is
payable on demand it must be presented for payment within a
reasonable time. When it is payable at a future time it must be
presented on the day that it is due. If the bill is dishonoured the holder
must notify promptly the fact of dishonour to any drawer and indorser
he wishes to charge. If, for example, the holder only gives notice of
dishonour to the last indorser, he could not sue the drawer unless the
last indorser or some other party liable has duly sent notice to the
drawer. When a foreign bill is dishonoured the holder must cause it to
be protested by a notary public. The bill must be noted for protest on
the day of its dishonour. If this be duly done, the protest, i.e. the formal
notarial certificate attesting the dishonour, can be drawn up at any
time as of the date of the noting. A dishonoured inland bill may be
noted, and the holder can recover the expenses of noting, but no legal
consequences attach thereto. In practice, however, noting is
usually accepted as showing that a bill has been duly presented and
has been dishonoured. Sometimes the drawer or indorser has reason
to expect that the bill may be dishonoured by the drawee. In that case
he may insert the name of a "referee in case of need." But whether he
does so or not, when a bill has been duly noted for protest, any person
may, with the consent of the holder, intervene for the honour of any
party liable on the bill. If the bill has been dishonoured by
nonacceptance it may be "accepted for honour supra protest." If it has
been dishonoured by non-payment it may be paid supra protest. When
a bill is thus paid and the proper formalities are complied with, the
person who pays becomes invested with the rights and duties of the
holder so far as regards the party for whose honour he has paid the
bill, and all parties antecedent to him (§§ 65 to 68)
Discharge

Normally a bill is discharged by payment in due course, that is to say,

by payment by the drawee or acceptor to the holder at or after
maturity. But it may also be discharged in other ways, as for example
by coincidence of right and liability (§ 61), voluntary renunciation (§
62), cancellation (§ 63), or material alteration (§ 64).

WORKING CAPITAL - Meaning of Working Capital

Capital required for a business can be classified under two main

categories via,

1) Fixed Capital

2) Working Capital

Every business needs funds for two purposes for its establishment
and to carry out its day- to-day operations. Long terms funds are
required to create production facilities through purchase of fixed
assets such as p&m, land, building, furniture, etc. Investments in these
assets represent that part of firm’s capital which is blocked on
permanent or fixed basis and is called fixed capital. Funds are also
needed for short-term purposes for the purchase of raw material,
payment of wages and other day – to- day expenses etc.

These funds are known as working capital. In simple words, working

capital refers to that part of the firm’s capital which is required for
financing short- term or current assets such as cash, marketable
securities, debtors & inventories. Funds, thus, invested in current assts
keep revolving fast and are being constantly converted in to cash and
this cash flows out again in exchange for other current assets. Hence,
it is also known as revolving or circulating capital or short term capital.

CONCEPT OF WORKING CAPITAL

There are two concepts of working capital:

1. Gross working capital

2. Net working capital

The gross working capital is the capital invested in the total current
assets of the enterprises current assets are those

Assets which can convert in to cash within a short period normally one
accounting year.

CONSTITUENTS OF CURRENT ASSETS

1) Cash in hand and cash at bank

2) Bills receivables

3) Sundry debtors

4) Short term loans and advances.

5) Inventories of stock as:

a. Raw material

b. Work in process

c. Stores and spares

d. Finished goods

6. Temporary investment of surplus funds.

7. Prepaid expenses

8. Accrued incomes.

9. Marketable securities.

In a narrow sense, the term working capital refers to the net working.
Net working capital is the excess of current assets over current
liability, or, say:

NET WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES.

Net working capital can be positive or negative. When the current

assets exceeds the current liabilities are more than the current assets.
Current liabilities are those liabilities, which are intended to be paid in
the ordinary course of business within a short period of normally one
accounting year out of the current assts or the income business.

CONSTITUENTS OF CURRENT LIABILITIES

1. Accrued or outstanding expenses.

2. Short term loans, advances and deposits.

3. Dividends payable.

4. Bank overdraft.

5. Provision for taxation , if it does not amt. to app. Of profit.

6. Bills payable.

7. Sundry creditors.

The gross working capital concept is financial or going concern concept

whereas net working capital is an accounting concept of working
capital. Both the concepts have their own merits.

The gross concept is sometimes preferred to the concept of working

capital for the following reasons:

1. It enables the enterprise to provide correct amount of working

capital at correct time.

2. Every management is more interested in total current assets with

which it has to operate then the source from where it is made
available.

3. It take into consideration of the fact every increase in the funds of

the enterprise would increase its working capital.

4. This concept is also useful in determining the rate of return on

investments in working capital. The net working capital concept,
however, is also important for following reasons:

• It is qualitative concept, which indicates the firm’s ability to meet

to its operating expenses and short-term liabilities.

• IT indicates the margin of protection available to the short term

creditors.

• It is an indicator of the financial soundness of enterprises.

• It suggests the need of financing a part of working capital

requirement out of the permanent sources of funds.
CLASSIFICATION OF WORKING CAPITAL

Working capital may be classified in to ways:

o On the basis of concept.

o On the basis of time.

On the basis of concept working capital can be classified as gross

working capital and net working capital. On the basis of time, working
capital may be classified as:

¬ Permanent or fixed working capital.

¬ Temporary or variable working capital

PERMANENT OR FIXED WORKING CAPITAL

Permanent or fixed working capital is minimum amount which is

required to ensure effective utilization of fixed facilities and for
maintaining the circulation of current assets. Every firm has to
maintain a minimum level of raw material, work- in-process, finished
goods and cash balance. This minimum level of current assts is called
permanent or fixed working capital as this part of working is
permanently blocked in current assets. As the business grow the
requirements of working capital also increases due to increase in
current assets.

TEMPORARY OR VARIABLE WORKING CAPITAL

Temporary or variable working capital is the amount of working capital

which is required to meet the seasonal demands and some special
exigencies. Variable working capital can further be classified as
seasonal working capital and special working capital. The capital
required to meet the seasonal need of the enterprise is called seasonal
working capital. Special working capital is that part of working capital
which is required to meet special exigencies such as launching of
extensive marketing for conducting research, etc.

Temporary working capital differs from permanent working capital in

the sense that is required for short periods and cannot be permanently
employed gainfully in the business.

IMPORTANCE OR ADVANTAGE OF ADEQUATE WORKING CAPITAL

¬ SOLVENCY OF THE BUSINESS: Adequate working capital helps in

maintaining the solvency of the business by providing uninterrupted of
production.

¬ Goodwill: Sufficient amount of working capital enables a firm to

make prompt payments and makes and maintain the goodwill.

¬ Easy loans: Adequate working capital leads to high solvency and

credit standing can arrange loans from banks and other on easy and
favorable terms.

¬ Cash Discounts: Adequate working capital also enables a concern

to avail cash discounts on the purchases and hence reduces cost.

¬ Regular Supply of Raw Material: Sufficient working capital ensures

regular supply of raw material and continuous production.

¬ Regular Payment Of Salaries, Wages And Other Day TO Day

Commitments: It leads to the satisfaction of the employees and raises
the morale of its employees, increases their efficiency, reduces
wastage and costs and enhances production and profits.

¬ Exploitation Of Favorable Market Conditions: If a firm is having

adequate working capital then it can exploit the favorable market
conditions such as purchasing its requirements in bulk when the prices
are lower and holdings its inventories for higher prices.

¬ Ability To Face Crises: A concern can face the situation during the
depression.

¬ Quick And Regular Return On Investments: Sufficient working

capital enables a concern to pay quick and regular of dividends to its
investors and gains confidence of the investors and can raise more
funds in future.

¬ High Morale: Adequate working capital brings an environment of

securities, confidence, high morale which results in overall efficiency in
a business.

EXCESS OR INADEQUATE WORKING CAPITAL

Every business concern should have adequate amount of working

capital to run its business operations. It should have neither redundant
or excess working capital nor inadequate nor shortages of working
capital. Both excess as well as short working capital positions are bad
for any business. However, it is the inadequate working capital which is
more dangerous from the point of view of the firm.

DISADVANTAGES OF REDUNDANT OR EXCESSIVE WORKING CAPITAL

1. Excessive working capital means ideal funds which earn no profit

for the firm and business cannot earn the required rate of return on its
investments.

2. Redundant working capital leads to unnecessary purchasing and

accumulation of inventories.

3. Excessive working capital implies excessive debtors and defective

credit policy which causes higher incidence of bad debts.
4. It may reduce the overall efficiency of the business.

5. If a firm is having excessive working capital then the relations

with banks and other financial institution may not be maintained.

6. Due to lower rate of return n investments, the values of shares

may also fall.

7. The redundant working capital gives rise to speculative

transactions

DISADVANTAGES OF INADEQUATE WORKING CAPITAL

Every business needs some amounts of working capital. The need for
working capital arises due to the time gap between production and
realization of cash from sales. There is an operating cycle involved in
sales and realization of cash. There are time gaps in purchase of raw
material and production; production and sales; and realization of cash.

Thus working capital is needed for the following purposes:

• For the purpose of raw material, components and spares.

• To pay wages and salaries

• To incur day-to-day expenses and overload costs such as office

expenses.

• To meet the selling costs as packing, advertising, etc.

• To provide credit facilities to the customer.

• To maintain the inventories of the raw material, work-in-progress,

stores and spares and finished stock.

For studying the need of working capital in a business, one has to

study the business under varying circumstances such as a new
concern requires a lot of funds to meet its initial requirements such as
promotion and formation etc. These expenses are called preliminary
expenses and are capitalized. The amount needed for working capital
depends upon the size of the company and ambitions of its promoters.
Greater the size of the business unit, generally larger will be the
requirements of the working capital.

The requirement of the working capital goes on increasing with the

growth and expensing of the business till it gains maturity. At maturity
the amount of working capital required is called normal working
capital.

There are others factors also influence the need of working capital in a
business.

FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS

1. NATURE OF BUSINESS: The requirements of working is very limited

in public utility undertakings such as electricity, water supply and
railways because they offer cash sale only and supply services not
products, and no funds are tied up in inventories and receivables. On
the other hand the trading and financial firms requires less investment
in fixed assets but have to invest large amt. of working capital along
with fixed investments.

2. SIZE OF THE BUSINESS: Greater the size of the business, greater is

the requirement of working capital.

3. PRODUCTION POLICY: If the policy is to keep production steady by

accumulating inventories it will require higher working capital.

4. LENTH OF PRDUCTION CYCLE: The longer the manufacturing time

the raw material and other supplies have to be carried for a longer in
the process with progressive increment of labor and service costs
before the final product is obtained. So working capital is directly
proportional to the length of the manufacturing process.

5. SEASONALS VARIATIONS: Generally, during the busy season, a firm

requires larger working capital than in slack season.

6. WORKING CAPITAL CYCLE: The speed with which the working cycle
completes one cycle determines the requirements of working capital.
Longer the cycle larger is the requirement of working capital.

DEBTORS

CASH FINISHED GOODS

RAW MATERIAL WORK IN PROGRESS

7. RATE OF STOCK TURNOVER: There is an inverse co-relationship

between the question of working capital and the velocity or speed with
which the sales are affected. A firm having a high rate of stock
turnover wuill needs lower amt. of working capital as compared to a
firm having a low rate of turnover.

8. CREDIT POLICY: A concern that purchases its requirements on

credit and sales its product / services on cash requires lesser amt. of
working capital and vice-versa.

9. BUSINESS CYCLE: In period of boom, when the business is

prosperous, there is need for larger amt. of working capital due to rise
in sales, rise in prices, optimistic expansion of business, etc. On the
contrary in time of depression, the business contracts, sales decline,
difficulties are faced in collection from debtor and the firm may have a
large amt. of working capital.

10. RATE OF GROWTH OF BUSINESS: In faster growing concern, we

shall require large amt. of working capital.

11. EARNING CAPACITY AND DIVIDEND POLICY: Some firms have more
earning capacity than other due to quality of their products, monopoly
conditions, etc. Such firms may generate cash profits from operations
and contribute to their working capital. The dividend policy also affects
the requirement of working capital. A firm maintaining a steady high
rate of cash dividend irrespective of its profits needs working capital
than the firm that retains larger part of its profits and does not pay so
high rate of cash dividend.

12. PRICE LEVEL CHANGES: Changes in the price level also affect the
working capital requirements. Generally rise in prices leads to increase
in working capital.

Others FACTORS: These are:

 Operating efficiency.

 Management ability.

 Irregularities of supply.

 Import policy.

 Asset structure.

 Importance of labor.

 Banking facilities, etc.

MANAGEMENT OF WORKING CAPITAL

Management of working capital is concerned with the problem

that arises in attempting to manage the current assets, current
liabilities. The basic goal of working capital management is to
manage the current assets and current liabilities of a firm in such
a way that a satisfactory level of working capital is maintained,
i.e. it is neither adequate nor excessive as both the situations are
bad for any firm. There should be no shortage of funds and also
no working capital should be ideal. WORKING CAPITAL
MANAGEMENT POLICES of a firm has a great on its probability,
liquidity and structural health of the organization. So working
capital management is three dimensional in nature as

1. It concerned with the formulation of policies with regard to

profitability, liquidity and risk.

2. It is concerned with the decision about the composition and

level of current assets.

3. It is concerned with the decision about the composition and

level of current liabilities.

WORKING CAPITAL ANALYSIS

As we know working capital is the life blood and the centre of a

business. Adequate amount of working capital is very much
essential for the smooth running of the business. And the most
important part is the efficient management of working capital in
right time. The liquidity position of the firm is totally effected by
the management of working capital. So, a study of changes in
the uses and sources of working capital is necessary to evaluate
the efficiency with which the working capital is employed in a
business. This involves the need of working capital analysis.

The analysis of working capital can be conducted through a

number of devices, such as:

1. Ratio analysis.

2. Fund flow analysis.

3. Budgeting.

ANALYSIS OF FINANCIAL STATEMENTS

FINANCIAL STATEMENTS:

Financial statement is a collection of data organized according to

logical and consistent accounting procedure to convey an under-
standing of some financial aspects of a business firm. It may
show position at a moment in time, as in the case of balance
sheet or may reveal a series of activities over a given period of
time, as in the case of an income statement. Thus, the term
‘financial statements’ generally refers to the two statements

(1) The position statement or Balance sheet.

(2) The income statement or the profit and loss Account.

OBJECTIVES OF FINANCIAL STATEMENTS:

According to accounting Principal Board of America (APB) states

The following objectives of financial statements: -

1. To provide reliable financial information about economic

resources and obligation of a business firm.

2. To provide other needed information about charges in such

economic resources and obligation.

3. To provide reliable information about change in net resources

(recourses less obligations) missing out of business activities.

4. To provide financial information that assets in estimating the

learning potential of the business.

LIMITATIONS OF FINANCIAL STATEMENTS:

Though financial statements are relevant and useful for a

concern, still they do not present a final picture a final picture of
a concern. The utility of these statements is dependent upon a
number of factors. The analysis and interpretation of these
statements must be done carefully otherwise misleading
conclusion may be drawn.

Financial statements suffer from the following limitations: -

1. Financial statements do not given a final picture of the

concern. The data given in these statements is only
approximate. The actual value can only be determined when the
business is sold or liquidated.

2. Financial statements have been prepared for different

accounting periods, generally one year, during the life of a
concern. The costs and incomes are apportioned to different
periods with a view to determine profits etc. The allocation of
expenses and income depends upon the personal judgment of
the accountant. The existence of contingent assets and liabilities
also make the statements imprecise. So financial statement are
at the most interim reports rather than the final picture of the
firm.

3. The financial statements are expressed in monetary value, so

they appear to give final and accurate position. The value of
fixed assets in the balance sheet neither represent the value for
which fixed assets can be sold nor the amount which will be
required to replace these assets. The balance sheet is prepared
on the presumption of a going concern. The concern is expected
to continue in future. So fixed assets are shown at cost less
accumulated deprecation. Moreover, there are certain assets in
the balance sheet which will realize nothing at the time of
liquidation but they are shown in the balance sheets.

4. The financial statements are prepared on the basis of

historical costs Or original costs. The value of assets decreases
with the passage of time current price changes are not taken
into account. The statement are not prepared with the keeping in
view the economic conditions. the balance sheet loses the
significance of being an index of current economics realities.
Similarly, the profitability shown by the income statements may
be represent the earning capacity of the concern.

5. There are certain factors which have a bearing on the financial

position and operating result of the business but they do not
become a part of these statements because they cannot be
measured in monetary terms. The basic limitation of the
traditional financial statements comprising the balance sheet,
profit & loss A/c is that they do not give all the information
regarding the financial operation of the firm. Nevertheless, they
provide some extremely useful information to the extent the
balance sheet mirrors the financial position on a particular data
in lines of the structure of assets, liabilities etc. and the profit &
loss A/c shows the result of operation during a certain period in
terms revenue obtained and cost incurred during the year. Thus,
the financial position and operation of the firm.
V. WORKING CAPITAL

Working capital management is management for the short-term

current assets and current liabilities, which is of critical
importance to a firm. Lack of efficient and effective utilization of
working capital leads to earn low rate of return on capital
employed. The requirement of working capital varies from firm to
firm depending upon the nature of business, production policy,
market conditions, seasonality of operations, conditions of
supply, etc.

Working capital management entails short term decisions -

generally, relating to the next one year period - which are
"reversible". These decisions are therefore not taken on the
same basis as Capital Investment Decisions (NPV or related, as
above) rather they will be based on cash flows and / or
profitability.

One measure of cash flow is provided by the cash conversion cycle

- the net number of days from the outlay of cash for raw material
to receiving payment from the customer. As a management tool,
this metric makes explicit the inter-relatedness of decisions
relating to inventories, accounts receivable and payable, and
cash. Because this number effectively corresponds to the time
that the firm's cash is tied up in operations and unavailable for
other activities, management generally aims at a low net count.

In this context, the most useful measure of profitability is Return

on capital (ROC). The result is shown as a percentage, determined
by dividing relevant income for the 12 months by capital
employed; Return on equity (ROE) shows this result for the firm's
shareholders. Firm value is enhanced when, and if, the return on
capital, which results from working capital management,
exceeds the cost of capital, which results from capital investment
decisions as above. ROC measures are therefore useful as a
management tool, in that they link short-term policy with long-
term decision making.

Management of working capital:

Guided by the above criteria, management will use a
combination of policies and techniques for the management of
working capital. These policies aim at managing the current
assets (generally cash and cash equivalents, inventories and
debtors) and the short term financing, such that cash flows and
returns are acceptable. It simply refers to management of the
working capital, or in more precise terms, the management of
current assets. A firms working capital consist of its investment
in current asset which include short term asset such as cash and
bank balance, inventories, receivables, and marketable
securities.

Cash management: Identify the cash balance which allows for the
business to meet day to day expenses, but reduces cash holding
costs.

Inventory management: Identify the level of inventory which

allows for uninterrupted production but reduces the investment
in raw materials - and minimizes reordering costs - and hence
increases cash flow, supply chain management ; Just In Time (JIT);
Economic order quantity (EOQ); Economic production quantity (EPQ).

Debtors management: Identify the appropriate credit policy, i.e.

credit terms which will attract customers, such that any impact
on cash flows and the cash conversion cycle will be offset by
increased revenue and hence Return on Capital (or vice versa);
Discounts and allowances.

Short term financing: Identify the appropriate source of

financing, given the cash conversion cycle: the inventory is
ideally financed by credit granted by the supplier; however, it
may be necessary to utilize a bank loan (or overdraft), or to
"convert debtors to cash" through "factoring".

The term working capital may be used in two different ways:

1. Gross working capital: The gross working capital refers to

the firm’s investment in all current assets taken together.

2. Net working capital: The term net working capital may be

defined as the excess of total current assets over total current
liabilities.

A firm should maintain an optimum level of gross working capital. This

will help avoiding the unnecessarily stoppage of work or liquidation
due to insufficient working capital. Effect on profitability because over
flowing working capital implies cost. Therefore, a firm should have just
adequate level of total current assets. The gross working capital also
gives an idea of total funds required for maintaining current assets.

On other hand, net working capital refers to amount of funds that must
be invested by the firm, more or less regularly in current assets. The
net working capital also denotes the net liquidity being maintained by
the firm. This also gives an idea of buffer available to the current
liability.

Need for adequate working capital:

Every firm must maintain a sound working capital position otherwise;

its business activities may be adversely affected.

The excess working capital, i.e. when the investment in working capital
is more than the required level, it may result in unnecessary
accumulation of inventories resulting in waste, theft, damage etc.
Delay in collection of receivables resulting in more liberal credit terms
to customers than warranted by the market conditions. Adverse
influence on the performance of the management.

On the other hand, inadequate working capital is not good for the firm.
It may result in the following:

 The fixed asset may not be optimally used.

 Firm growth may stagnate.
 Interruptions in production schedule may occur ultimately
resulting in lowering of the profit of the firm.
 The firm may not be able to take benefit of an opportunity.
 Firm goodwill in the market is affected if it is not in a position to
meet its liabilities on time.

Working Capital Needs:

A business’ need for working capital can come as a result of several

reasons that include the following:

 Increasing sales growth or seasonal growth.

 Customers paying slower.
 Need to increase inventory to support sales growth and/or
adding product lines.
 Desire to take discounts on purchases from vendors.
 Recent operating losses have reduced your cash reserves.
 Increased expenses due to additional marketing efforts, new
employees, office relocation, etc.
Factors determining working capital requirement:

Though there is no set of universally applicable rules to ascertain

working capital needs, the following factors may be considered:

Nature of business:

The Working capital requirement depends upon the nature of business

carried on by the organization. In a manufacturing firm the
requirement is generally high, but it also depends on the type and
nature of the product. The proportion of current asset to total assets
measures the relative requirements of working capital of various
industries.

Manufacturing cycle:

Time span required for the conversion of raw materials into finished
goods is a block period. The period in reality extends a little before and
after the work-in-progress. The manufacturing cycle and the fund
requirements vary in direct proportion. The funds blocked in
manufacturing cycle vary from industry to industry. Further, even
within the same group of industries, the operating cycle may be
different due to technological considerations.

Business cycle:

Business fluctuations lead to cyclical and seasonal changes, which, in

turn, cause a shift in working capital position particularly for working
capital requirement. The variations in business conditions may be in
two directions: Upward phase when boom conditions prevail, and
Downswing phase when economic activity is marked by a decline.
During the upswing of business activity, the need for working capital is
likely to grow and during the downswing phase the working capital
requirement is likely to be less. The decline in economy is associated
with a fall in the volume of sales, which, in turn, leads to a fall in the
level of inventories and book debts.

Seasonal variation:

Variation apart, seasonally factor creates production or even shortage

problem. This is the reason as to why manufacturing concerns
producing seasonal products purchase their raw material throughout
the year and carry on the manufacturing activity. For example woolen
garments have a demand during winter. But the manufacturing
operation for the same has to be conducted during the whole year
resulting in working capital blockage during off-season.

Production policy:

While working capital requirements vary because of seasonal factors,

the impact can be minimized by suitably gearing the production
schedule. There are two choices- either the production is periodically
adjusted to meet the seasonal requirements or a steady level of
production is maintained throughout, consequently allowing the
inventories to build up in the off-season.
Scale of operations:

Operational level determines the working capital demand during a

particular period. Higher the scale, higher will be the need for working
capital. However, pace of sales turnover is another factor. Quick
turnover calls for lesser investment for inventory while low turnover
rate necessitates larger investments.

Credit policy:
The credit policy influences the requirement of working capital in two
ways:

 Through credit terms granted by the firm to its

customers/buyers of goods.
 Credit terms available to the firm from its creditors.

Growth and expansion:

It is, of course difficult to determine precisely the relationship between
the growth and volume of business and the increase in working capital.
The composition of working capital also shifts with economic
circumstances and corporate practices. However, it is to be noted that
the need for increased working capital funds does not follow the
growth in business activity but precedes it.

Dividend policy:
The payment of dividend consumes cash resources and, thereby,
effects working capital to that extent. However, if the firm does not
pay dividend but retains the profit, working capital increases. There
are wide variations in industry practices as regards the inter
relationship between working capital requirement and dividend
payment. In some cases, shortage of working capital is sometimes a
powerful reason for reducing or even skipping dividends in cash
(resolved by payment of bonus shares).

Depreciation policy:
There is an indirect effect of depreciation policy on working capital.
Enhanced rates of depreciation lower the profits and tax liability and,
thus, more cash profits. Higher depreciation means lower disposable
profits and a smaller dividend payment. Thus cash is preserved. If the
current capital expenditure falls short of the depreciation provision, the
working capital position is strengthened and there may be no need for
short-term borrowing. If the current capital expenditure exceeds the
depreciation provision, either outside borrowing will have to be
resorted to or a restriction on dividend payment coupled with retention
of profits will have to be adopted to prevent working capital position
from being adversely affected.

Price level changes:

Rising prices necessitate the use of more funds for maintaining an
existing level of activity. However, the implications of rising price levels
on working capital position may vary from company to company
depending on the nature of its operation, its standing in the market
and other relevant considerations.

Operating efficiency:
The efficient utilization of resources by eliminating waste, improved
coordination and full utilization of existing resources would increase
the operating efficiency. Efficiency of operations accelerates the pace
of cash cycle and improves the working capital turnover. It releases the
pressure on working capital by improving profitability and improving
the internal generation of funds.

Sources of working capital finance:

Working Capital Finance - Gives your business the money it needs to

grow.

Working capital finance makes it possible for the business to obtain

capital if the business has been denied for a bank loan, or if it has little
cash flow. Traditional funding through a standard bank can be difficult
to obtain, but they also don't satisfy the needs of expanding
companies. Without capital a business will have to slow down their
growth, which can hurt a business. Working capital finance makes it
possible for any business to have access to the cash it needs, when it
needs it.

Working capital finance allows a company to turn their income streams

into instant capital. They can turn their accounts receivables into cash
by selling them to a lender who specializes in accounts receivable
factoring. Another method for obtaining working capital is to lease
equipment or to obtain credit from a company (for eg. Companies like
Office Depot or Lowes in US) that sells items that the business needs.
Obtaining lines of credit from a company are easier than going after a
bank loan. If at all possible obtain a line of credit from a company that
will report your business credit scores to the major business credit
bureaus. This will help build your business credit scores, so it is easier
to qualify for large bank loans.
Another popular method of working capital finance is utilizing asset-
based financing. That means that the company would use assets from
their own business to secure loans. They could pledge any commercial
real estate their business owns, business vehicles, equipment, etc.
Lending institutions approve asset-based loans quicker because the
risk isn't as high. Small companies often can obtain more cash with an
asset-based loan.

Commercial banks are the largest financing source for external

business debt including working capital loans, and they offer a large
range of debt products. With banking consolidation, commercial banks
are multistate institutions that increasingly focus on lending to small
business with large borrowing needs that pose limited risks.

Consequently, alternate sources of working capital debt become more

important. Savings banks and thrift lenders are increasingly providing
small business loans, and, in some regions, they are important small
business and commercial real estate lenders. Although savings banks
offer fewer products and may be less familiar with unconventional
economic development loans, they are more likely to provide smaller
loans and more personalized service.

Commercial finance companies are important working capital lenders

since, as non -regulated financial institutions, they can make higher
risk loans. Some finance companies specialize in serving specific
industries, which allows them to better assess risk and
creditworthiness, and extend loans that more general lenders would
not make.

Another approach used by finance companies is asset-based lending

in which a lender carefully evaluates and lends against asset collateral
value, placing less emphasis on the firm’s overall balance sheet and
financial ratios. An asset-based lending approach can improve loan
availability and terms for small firms with good quality assets but
weaker overall credit. Commercial finance companies also are more
likely to offer factoring than banks.

Trade credit extended by vendors is a fourth alternative for small

firms. While trade credit does not finance permanent or long-term
working capital, it helps address short-term borrowing needs.
Extending payment periods and increasing credit limits with major
suppliers is a fast and cost-effective way to finance some working
capital needs that can be part of a firm’s overall plan to manage
seasonal borrowing needs.

Other working capital finance options exist beyond these three

conventional credit sources. Business development corporations
(BDCs) are a second alternative source for working capital loans. BDCs
are high-risk lending arms of the banking industry that exist in almost
every state. They borrow funds from a large base of member banks
and specialize in providing subordinate debt and lending to higher-risk
businesses. While BDCs rely heavily on bank loan officers for referrals,
economic development practitioners need to understand their debt
products and build good working relationships with their staffs.
Venture capital firms also finance working capital, especially
permanent working capital to support rapid growth. While venture
capitalists typically provide equity financing, some also provide debt
capital. A growing set of mezzanine funds,7 often managed by venture
capitalists, supply medium-term subordinate debt and take warrants
that increase their potential returns. This type of financing is
appropriate to finance long-term working capital needs and is a lower-
cost alternative to raising equity.

However, the availability of venture capital and mezzanine debt is

limited to fast-growing firms, often in industries and markets viewed as
offering the potential for high returns. Government and nonprofit
revolving loan funds also supply working capital loans. While small in
total capital, these funds help firms access conventional bank debt by
providing subordinate loans, offering smaller loans, and serving firms
that do not qualify for conventional working capital credit.

Many entrepreneurs and small firms also rely on personal credit

sources to finance working capital, especially credit cards and second
mortgage loans on the business owner’s home. These sources are easy
to come by and involve few transaction costs, but they have certain
limits. First, they provide only modest amounts of capital. Second,
credit card debt is expensive with interest rates of 18% or higher,
which reduces cash flow for other business purposes.

Third, personal credit links the business owner’s personal assets to the
firm’s success, putting important household assets, such as the
owner’s home, at risk. Finally, credit cards and second mortgage loans
are not viable for entrepreneurs who do not own a home or lack a
formal credit history.

Immigrant or low-income business owners, in particular, are least able

to use personal credit to finance a business. Given these many
limitations, it is desirable to move entrepreneurs from informal and
personal credit sources into formal business working capital loans that
are structured to address the credit needs of their firms.
Working capital finance may be classified into the following:

Spontaneous source of finance:

Finance that naturally arises in the course of business is called as

spontaneous financing. For example: Trade creditors, credit from
employees, credit from suppliers of services etc.

Negotiated financing:
Financing which has to be negotiated with lenders (commercial banks,
financial institutions, and general public) is called as negotiated
financing. This kind of financing may short term or long term in nature.

Between spontaneous and negotiated sources of finance, the latter is

more expensive and inconvenient to raise. Spontaneous source of
finance reduces the amount of negotiated financing.

The working capital may be financed in either of the following ways,

keeping in view of accessibility to different sources as well as the cost
factor-

Hedging Approach to Working Capital Financing:

Under hedging approach to financing working capital requirements of a

firm each asset in the balance sheet asset side would be off set with
a financing instrument of the same approximate maturity. The basic
approach of this method of financing is that the permanent component
of current assets and fixed assets would be met with long-term funds
and the short term or seasonal variation in current assets would be
financed with short-term debt. If the long-term funds are used for
short-term needs of the firm, it can identify and take steps to correct
the mismatch in financing.

Trade credit:

Trade credit refers to the credit extended by suppliers of goods and

services in the normal course of transaction/ business/ sales. It is an
informal spontaneous source of finance. Not requiring negotiation and
formal agreement trade credit is free from the restrictions associated
with formal/negotiated source of finance/ credit. It does not involve
any explicit interest charge, however there is an implicit cost of trade
credit. As, the cost of trade credit is generally very high beyond the
discount period; the firms should avail of the discount on prompt
payment.

Bank Credit:

It is the primary institutional source of working capital finance in India.

Banks in five ways provide working capital finance:

Cash credit/ Overdraft:

Under cash credit/ overdraft form the banks specify, a pre-determined

borrowing/ credit limit. The borrower can draw/ borrow upto the
stipulated credit/ overdraft limit. This form of bank financing of working
capital is highly attractive to the borrowers because, firstly, it is flexible
in that although the borrowed funds are repayable on demand, banks
usually do not recall cash advances/ roll them over and, secondly the
borrower has the freedom to draw the amount in advance as and when
required, while the interest liability is only on the amount actually
outstanding. With the emergence of new banking since the mid
nineties, cash credit cannot, at present exceed 20 % of maximum
permissible bank finance/ credit limit to any borrower.

Loans:

Under this arrangement the entire amount of borrowing is credited to

the current account of the borrower or released in cash. The borrower
has to pay interest on the total amount. The loans are repayable on
demand or in periodic installments. They can also be renewed form
time to time. As a form of financing, loans imply a financial discipline
on the part of the borrowers. From the modest beginning in the early
nineties, at least 80 % of MPBF/ credit limit must be in the form of
loans in India.

Bills purchased/ discounted:

Under this arrangement, a bill arises out of a trade sale-purchase

transaction on credit. The seller of goods draws the bill on the
purchaser of goods, payable on demand or after a usance period, not
exceeding 90 days. On acceptance of bill by the purchaser, the seller
offers it to the bank for discount/ purchase. On discounting the bill, the
bank releases the funds to the seller. The bill is presented by the bank
to the purchaser / acceptor of the bill on due date for payment. The
bills can also be rediscounted with the other banks / RBI.
Term loans:

Under this arrangement the banks advance loans for three to seven
years repayable in yearly or half yearly installments.

Letter of credit:

It is an indirect form of working capital financing and banks assume

only the risk, the credit being provided by the supplier himself. The
purchaser of goods on credit obtains a letter of credit from a bank. The
bank undertakes the responsibility to make the payment to the
supplier in case the buyer fails to meet his obligation.

Commercial paper:

Commercial paper is a debt instrument used for short term financing

that enables highly rated corporate borrowers to diversify their sources
of short-term borrowings and provide an additional financial instrument
to investors to a freely negotiable interest rate. The maturity period
ranges from three months to one year. Since it is short-term debt, the
issuing company is required to meet dealers’ fees, rating agency fees,
and any other relevant charges. It is a short term unsecured
promissory note issued by corporations with high credit ratings.

Inter corporate loans and deposits:

In the present corporate world, it is a common practice that the

company with surplus cash will lend other period for short period
normally ranging from 60 to 180 days. The rate of interest will be
higher than the bank rate of interest and depending on the financial
soundness of the Borrower Company. This source of finance reduces
the intermediation of funds in financing.

Public Deposits:

The period of public deposits is usually restricted to a maximum of 5

years at a time. Thus, this source can provide finance only for short
term to medium term, which could be useful for meeting working
capital needs of the company. It is therefore advisable to use the
amounts of public deposits for acquiring assets of long-term nature
unless its pay back period is very short.

Funds generated from operations:

Funds generated from operations during an accounting period increase

working capital by an equivalent amount. The two main components of
funds generated from operations are profits and depreciation. Working
capital will increase by the extent of funds generated from operations.

Deferred tax payment:

Under this arrangement the tax authorities supply the credit. This is
created by the interval that elapses between the earning of the profits
of the company and the payment of the taxes due on them.

Accrued Expenses:

For most firms accrued expenses act as a spontaneous source of short-

term finance. One such example would be that of employee’s accrued
wages. For large firms, the accrued wages held by the firm constitute
an important source of financing. In case of Raymond Limited, this
would amount to wages and salaries of about 6000 employees and
workers.
 Term Loan
It is a long term debt provided by commercial banks and / or
financial institutions mainly to acquire fixed assets for a project
Features of Term Loan
It is a type of debt financing ‡ FIs provides Rupee TL and foreign
currency TL ‡ Mainly for investment in fixed assets ‡ Also for
getting technical know how, preliminary expenses and margin
money for working capital ‡ Foreign currency term loan for
import of plant and machinery

Features of Term Loan

‡ Assets which are financed with TL is the prime security ‡ Other
assets of the firm can be collateral ‡ Repayable in equal half
yearly or quarterly installment ‡ Interest rate charged is as per
credit risk of the project ‡ In case of default of payment penal
interest is charged

Features of Term Loan

‡ In a typical term loan, principle amount remains constant, but
interest burden declines over a period of time ‡ Various
restrictive clause may be applied on borrower
± Refrain from undertaking any new project without approval of
the FI ± Refrain from additional borrowings without consent of FI
± Nominee Director on the board
Term Loan procedure
‡ Submission of loan application with Project Report ‡ Project
Report contains
± ± ± ± ± ± ± ± Promoters¶ background Particulars of the firm
Particulars of the project Cost of the project Means of financing
Marketing and selling arrangements Profitability and cash flow
Government consent

Term Loan procedure

‡ Initial processing of loan application
± Additional information may be asked

‡ Detailed appraisal of proposed project

± Marketing, technical, financial, managerial and economic
appraisal

‡ Issue of letter of sanction ‡ Acceptance of terms and conditions

by the borrower
± By passing appropriate resolution
Term Loan procedure
‡ Execution of loan agreement
± FI sends the draft agreement to the borrower which is to be
signed and stamped by the borrower

‡ Creation of charge over security

± Creation of mortgage, deposit of title deeds and hypothecation
of movable property
Term Loan procedure
‡ Disbursement of loans. Borrower is required to submit following
information
± Physical progress of the project ± Financial status of the
project ± Contribution made by promoters ± Projected fund flow
statement ± Compliance of statutory requirements

‡ Based on such information disbursement of loan amount is

decided

Term Loan procedure

‡ Monitoring of Loan
± It is done at two stages, implementation stage and operational
stage

‡ Implementation stage monitoring

± Regular reports from promoters ± Periodic site visit ± Progress
report submitted by nominee director

‡ Operational stage monitoring

± Quarterly progress report ± Periodic site visit ± Progress
report submitted by nominee director
WORKING CAPITAL
Working Capital management is the management of assets that are
current in nature. Current assets, by accounting definition are the
assets normally converted in to cash in a period of one year. Hence
working capital management can be considered as the management of
cash, market securities receivable, inventories and current liabilities. In
fact, the management of current assets is similar to that of fixed assets
the sense that is both in cases the firm analyses their effect on its
profitability and risk factors, hence they differ on three major aspects:

1. In managing fixed assets, time is an important factor discounting

and compounding aspects of time play an important role in
capital budgeting and a minor part in the management of current
assets.

2. The large holdings of current assets, especially cash, may

strengthen the firm’s liquidity position, but is bound to reduce
profitability of the firm as ideal car yield nothing.

3. The level of fixed assets as well as current assets depends upon

the expected sales, but it is only current assets that add
fluctuation in the short run to a business.

To understand working capital better we should have basic knowledge

about the various aspects of working capital. To start with, there are
two concepts of working capital:

 Gross Working Capital

 Net working Capital

Gross Working Capital: Gross working capital, which is also simply

known as working capital, refers to the firm’s investment in current
assets: Another aspect of gross working capital points out the need of
arranging funds to finance the current assets. The gross working
capital concept focuses attention on two aspects of current assets
management, firstly optimum investment in current assets and
secondly in financing the current assets. These two aspects will help in
remaining away from the two danger points of excessive or inadequate
investment in current assets. Whenever a need of working capital
funds arises due to increase in level of business activity or for any
other reason the arrangement should be made quickly, and similarly if
some surpluses are available, they should not be allowed to lie ideal
but should be put to some effective use.

Net Working Capital: The term net working capital refers to the
difference between the current assets and current liabilities. Net
working capital can be positive as well as negative. Positive working
capital refers to the situation where current assets exceed current
liabilities and negative working capital refers to the situation where
current liabilities exceed current assets. The net working capital helps
in comparing the liquidity of the same firm over time. For purposes of
the working capital management, therefore Working Capital can be
said to measure the liquidity of the firm. In other words, the goal of
working capital management is to manage the current assets and
liabilities in such a way that a acceptable level of net working capital is
maintained.

Importance of working capital management:

Management of working capital is very much important for the success

of the business. It has been emphasized that a business should
maintain sound working capital position and also that there should not
be an excessive level of investment in the working capital components.
As pointed out by Ralph Kennedy and Stewart MC Muller, “the
inadequacy or mis-management of working capital is one of a few
leading causes of business failure.

Current assets, in fact, account for a very large portion of the total
investment of the firm.

It can be visualized from the table that in the first year of our study i.e.
2004 it was 31% which was reduced to 26% in the next year and in
2006 it is 35% shows fluctuating trend.

Determinants of Working Capital:

There is no specific method to determine working capital requirement

for a business. There are a number of factors affecting the working
capital requirement. These factors have different importance in
different businesses and at different times. So a thorough analysis of
all these factors should be made before trying to estimate the amount
of working capital needed. Some of the different factors are mentioned
here below:-

1. Nature of business: Nature of business is an important factor in

determining the working capital requirements. There are some
businesses which require a very nominal amount to be invested
in fixed assets but a large chunk of the total investment is in the
form of working capital. There businesses, for example, are of
the trading and financing type. There are businesses which
require large investment in fixed assets and normal investment
in the form of working capital.
2. Size of business: It is another important factor in determining the
working capital requirements of a business. Size is usually
measured in terms of scale of operating cycle. The amount of
working capital needed is directly proportional to the scale of
operating cycle i.e. the larger the scale of operating cycle the
large will be the amount working capital and vice versa.
3. Business Fluctuations: Most business experience cyclical and
seasonal fluctuations in demand for their goods and services.
These fluctuations affect the business with respect to working
capital because during the time of boom, due to an increase in
business activity the amount of working capital requirement
increases and the reverse is true in the case of recession.
Financial arrangement for seasonal working capital requirements
are to be made in advance.
4. Production Policy: As stated above, every business has to cope
with different types of fluctuations. Hence it is but obvious that
production policy has to be planned well in advance with respect
to fluctuation. No two companies can have similar production
policy in all respects because it depends upon the circumstances
of an individual company.
 5. Firm’s Credit Policy: The credit policy of a firm affects working
capital by influencing the level of book debts. The credit term is
fairly constant in an industry but individuals also have their role
in framing their credit policy. A liberal credit policy will lead to
more amount being committed to working capital requirements
whereas a stern credit policy may decrease the amount of
working capital requirement appreciably but the repercussions of
the two are not simple. Hence a firm should always frame a
rational credit policy based on the credit worthiness of the
customer.
6. Availability of Credit: The terms on which a company is able to
avail credit from its suppliers of goods and devices credit/also
affects the working capital requirement. If a company in a
position to get credit on liberal terms and in a short span of time
then it will be in a position to work with less amount of working
capital. Hence the amount of working capital needed will depend
upon the terms a firm is granted credit by its creditors.
7. Growth and Expansion activities: The working capital needs of a
firm increases as it grows in term of sale or fixed assets. There is
no precise way to determine the relation between the amount of
sales and working capital requirement but one thing is sure that
an increase in sales never precedes the increase in working
capital but it is always the other way round. So in case of growth
or expansion the aspect of working capital needs to be planned
in advance.
8. Price Level Changes: Generally increase in price level makes the
commodities dearer. Hence with increase in price level the working
capital requirements also increases.
CONCEPT OF WORKING CAPITAL

There are two concepts of working capital:

1. Gross working capital

2. Net working capital

The gross working capital is the capital invested in the total current
assets of the enterprises current assets are those

Assets which can convert in to cash within a short period normally

one accounting year.

CONSTITUENTS OF CURRENT ASSETS

1) Cash in hand and cash at bank

2) Bills receivables

3) Sundry debtors

4) Short term loans and advances.

5) Inventories of stock as:

a. Raw material

b. Work in process

c. Stores and spares

d. Finished goods

6. Temporary investment of surplus funds.

7. Prepaid expenses

8. Accrued incomes.

9. Marketable securities.

In a narrow sense, the term working capital refers to the net

 working. Net working capital is the excess of current assets
over current liability, or, say:

NET WORKING CAPITAL = CURRENT ASSETS – CURRENT

LIABILITIES.

Net working capital can be positive or negative. When the

current assets exceeds the current liabilities are more than the
current assets. Current liabilities are those liabilities, which are
intended to be paid in the ordinary course of business within a
short period of normally one accounting year out of the current
assts or the income business.

CONSTITUENTS OF CURRENT LIABILITIES

1. Accrued or outstanding expenses.

2. Short term loans, advances and deposits.

3. Dividends payable.

4. Bank overdraft.

5. Provision for taxation , if it does not amt. to app. Of profit.

6. Bills payable.

7. Sundry creditors.

The gross working capital concept is financial or going concern concept

whereas net working capital is an accounting concept of working
capital. Both the concepts have their own merits.

The gross concept is sometimes preferred to the concept of working

capital for the following reasons:

1. It enables the enterprise to provide correct amount of working

capital at correct time.
2. Every management is more interested in total current assets
with which it has to operate then the source from where it is
made available.

3. It take into consideration of the fact every increase in the

funds of the enterprise would increase its working capital.

4. This concept is also useful in determining the rate of return on

investments in working capital. The net working capital concept,
however, is also important for following reasons:

 It is qualitative concept, which indicates the firm’s

ability to meet to its operating expenses and short-term
liabilities.

 IT indicates the margin of protection available to the

short term creditors.

 It is an indicator of the financial soundness of

enterprises.

 It suggests the need of financing a part of working

capital requirement out of the permanent sources of funds.
CLASSIFICATION OF WORKING CAPITAL

Working capital may be classified in to ways:

o On the basis of concept.

o On the basis of time.

On the basis of concept working capital can be classified as

gross working capital and net working capital. On the basis of
time, working capital may be classified as:

 Permanent or fixed working capital.

 Temporary or variable working capital

PERMANENT OR FIXED WORKING CAPITAL

Permanent or fixed working capital is minimum amount which is

required to ensure effective utilization of fixed facilities and for
maintaining the circulation of current assets. Every firm has to
maintain a minimum level of raw material, work- in-process, finished
goods and cash balance. This minimum level of current assts is called
permanent or fixed working capital as this part of working is
permanently blocked in current assets. As the business grow the
requirements of working capital also increases due to increase in
current assets.

TEMPORARY OR VARIABLE WORKING CAPITAL

Temporary or variable working capital is the amount of working capital

which is required to meet the seasonal demands and some special
exigencies. Variable working capital can further be classified as
seasonal working capital and special working capital. The capital
required to meet the seasonal need of the enterprise is called seasonal
working capital. Special working capital is that part of working capital
which is required to meet special exigencies such as launching of
extensive marketing for conducting research, etc.

Temporary working capital differs from permanent working capital in

the sense that is required for short periods and cannot be permanently
employed gainfully in the business.

IMPORTANCE OR ADVANTAGE OF ADEQUATE WORKING CAPITAL

 SOLVENCY OF THE BUSINESS: Adequate working capital helps in

maintaining the solvency of the business by providing
uninterrupted of production.

 Goodwill: Sufficient amount of working capital enables a firm to

make prompt payments and makes and maintain the goodwill.

 Easy loans: Adequate working capital leads to high solvency

and credit standing can arrange loans from banks and other on
easy and favorable terms.

 Cash Discounts: Adequate working capital also enables a

concern to avail cash discounts on the purchases and hence
reduces cost.

 Regular Supply of Raw Material: Sufficient working capital

ensures regular supply of raw material and continuous
production.

 Regular Payment Of Salaries, Wages And Other Day TO Day

Commitments: It leads to the satisfaction of the employees and
raises the morale of its employees, increases their efficiency,
reduces wastage and costs and enhances production and profits.
 Exploitation Of Favorable Market Conditions: If a firm is having
adequate working capital then it can exploit the favorable
market conditions such as purchasing its requirements in bulk
when the prices are lower and holdings its inventories for higher
prices.

 Ability To Face Crises: A concern can face the situation during

the depression.

 Quick And Regular Return On Investments: Sufficient working

capital enables a concern to pay quick and regular of dividends
to its investors and gains confidence of the investors and can
raise more funds in future.

 High Morale: Adequate working capital brings an environment

of securities, confidence, high morale which results in overall
efficiency in a business.

EXCESS OR INADEQUATE WORKING CAPITAL

Every business concern should have adequate amount of working

capital to run its business operations. It should have neither
redundant or excess working capital nor inadequate nor shortages
of working capital. Both excess as well as short working capital
positions are bad for any business. However, it is the inadequate
working capital which is more dangerous from the point of view of
the firm.

DISADVANTAGES OF REDUNDANT OR EXCESSIVE WORKING CAPITAL

1. Excessive working capital means ideal funds which earn no

profit for the firm and business cannot earn the required rate
of return on its investments.

2. Redundant working capital leads to unnecessary purchasing

 and accumulation of inventories.

3. Excessive working capital implies excessive debtors and

defective credit policy which causes higher incidence of bad
debts.

4. It may reduce the overall efficiency of the business.

5. If a firm is having excessive working capital then the

relations with banks and other financial institution may not be
maintained.

6. Due to lower rate of return n investments, the values of

shares may also fall.

7. The redundant working capital gives rise to speculative

transactions

DISADVANTAGES OF INADEQUATE WORKING CAPITAL

Every business needs some amounts of working capital. The need for
working capital arises due to the time gap between production and
realization of cash from sales. There is an operating cycle involved in
sales and realization of cash. There are time gaps in purchase of raw
material and production; production and sales; and realization of cash.

Thus working capital is needed for the following purposes:

 For the purpose of raw material, components and spares.

 To pay wages and salaries

 To incur day-to-day expenses and overload costs such as

office expenses.
 To meet the selling costs as packing, advertising, etc.

 To provide credit facilities to the customer.

 To maintain the inventories of the raw material, work-in-

progress, stores and spares and finished stock.

For studying the need of working capital in a business, one has to

study the business under varying circumstances such as a new
concern requires a lot of funds to meet its initial requirements such
as promotion and formation etc. These expenses are called
preliminary expenses and are capitalized. The amount needed for
working capital depends upon the size of the company and
ambitions of its promoters. Greater the size of the business unit,
generally larger will be the requirements of the working capital.

The requirement of the working capital goes on increasing with the

growth and expensing of the business till it gains maturity. At
maturity the amount of working capital required is called normal
working capital.

There are others factors also influence the need of working capital
in a business.

FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS

1. NATURE OF BUSINESS: The requirements of working is very

limited in public utility undertakings such as electricity, water
supply and railways because they offer cash sale only and
supply services not products, and no funds are tied up in
inventories and receivables. On the other hand the trading
and financial firms requires less investment in fixed assets but
have to invest large amt. of working capital along with fixed
investments.
 2. SIZE OF THE BUSINESS: Greater the size of the business,
greater is the requirement of working capital.

3. PRODUCTION POLICY: If the policy is to keep production

steady by accumulating inventories it will require higher
working capital.

4. LENTH OF PRDUCTION CYCLE: The longer the manufacturing

time the raw material and other supplies have to be carried
for a longer in the process with progressive increment of labor
and service costs before the final product is obtained. So
working capital is directly proportional to the length of the
manufacturing process.

5. SEASONALS VARIATIONS: Generally, during the busy season,

a firm requires larger working capital than in slack season.

6. WORKING CAPITAL CYCLE: The speed with which the working

cycle completes one cycle determines the requirements of
working capital. Longer the cycle larger is the requirement of
working capital.

DEBTORS

CASH FINISHED GOODS

RAW MATERIAL WORK IN PROGRESS

7. RATE OF STOCK TURNOVER: There is an inverse co-

relationship between the question of working capital and the
 velocity or speed with which the sales are affected. A firm
having a high rate of stock turnover wuill needs lower amt. of
working capital as compared to a firm having a low rate of
turnover.

8. CREDIT POLICY: A concern that purchases its requirements

on credit and sales its product / services on cash requires
lesser amt. of working capital and vice-versa.

9. BUSINESS CYCLE: In period of boom, when the business is

prosperous, there is need for larger amt. of working capital
due to rise in sales, rise in prices, optimistic expansion of
business, etc. On the contrary in time of depression, the
business contracts, sales decline, difficulties are faced in
collection from debtor and the firm may have a large amt. of
working capital.

10. RATE OF GROWTH OF BUSINESS: In faster growing concern,

we shall require large amt. of working capital.

11. EARNING CAPACITY AND DIVIDEND POLICY: Some firms have

more earning capacity than other due to quality of their
products, monopoly conditions, etc. Such firms may generate
cash profits from operations and contribute to their working
capital. The dividend policy also affects the requirement of
working capital. A firm maintaining a steady high rate of cash
dividend irrespective of its profits needs working capital than
the firm that retains larger part of its profits and does not pay
so high rate of cash dividend.

12. PRICE LEVEL CHANGES: Changes in the price level also affect
the working capital requirements. Generally rise in prices
leads to increase in working capital.
 Others FACTORS: These are:

FINANCIAL STATEMENT ANALYSIS

It is the process of identifying the financial strength and weakness of a

firm from the available accounting data and financial statements. The
analysis is done
CALCULATIONS OF RATIOS
Ratios are relationship expressed in mathematical terms between
figures, which are connected with each other in some manner.

CLASSIFICATION OF RATIOS
Ratios can be classified in to different categories depending upon the
basis of classification

The traditional classification has been on the basis of the financial

statement to which the determination of ratios belongs.

These are:-

 Profit & Loss account ratios

 Balance Sheet ratio

 Important Terms

Working Capital Cycle

Cash flows in a cycle into, around and out of a business. It is the

business's life blood and every manager's primary task is to help keep
it flowing and to use the cash flow to generate profits. If a business is
operating profitably, then it should, in theory, generate cash surpluses.
If it doesn't generate surpluses, the business will eventually run out of
cash and expire.

The faster a business expands , the more cash it will need for working
capital and investment. The cheapest and best sources of cash exist as
working capital right within business. Good management of working
capital will generate cash will help improve profits and reduce risks.
Bear in mind that the cost of providing credit to customers and holding
stocks can represent a substantial proportion of a firm's total profits.

There are two elements in the business cycle that absorb cash -
Inventory (stocks and work-in-progress) and Receivables (debtors
owing you money). The main sources of cash are Payables (your
creditors) and Equity and Loans.
Each component of working capital (namely inventory, receivables and
payables) has two dimensions ........TIME ......... and MONEY. When it
comes to managing working capital - TIME IS MONEY. If you can get
money to move faster around the cycle (e.g. collect monies due from
debtors more quickly) or reduce the amount of money tied up (e.g.
reduce inventory levels relative to sales), the business will generate
more cash or it will need to borrow less money to fund working capital.
As a consequence, you could reduce the cost of bank interest or you'll
have additional free money available to support additional sales
growth or investment. Similarly, if you can negotiate improved terms
with suppliers e.g. get longer credit or an increased credit limit; you
effectively create free finance to help fund future sales.

If you....... Then......

Collect receivables (debtors) faster You release cash

from the cycle

Collect receivables (debtors) slower Your receivables

soak up cash

Get better credit (in terms of You increase your

duration or amount) from cash resources
suppliers

Shift inventory (stocks) faster You free up cash

 Move inventory (stocks) slower You consume
more cash

It can be tempting to pay cash, if available, for fixed assets e.g.

computers, plant, vehicles etc. If you do pay cash, remember that this
is now longer available for working capital. Therefore, if cash is tight,
consider other ways of financing capital investment - loans, equity,
leasing etc. Similarly, if you pay dividends or increase drawings, these
are cash outflows and, like water flowing downs a plug hole, they
remove liquidity from the business.
More businesses fail for lack of cash than for want of
profit.

Sources of Additional Working Capital

Sources of additional working capital include the following:

• Existing cash reserves

• Profits (when you secure it as cash!)

• Payables (credit from suppliers)

• New equity or loans from shareholders

• Bank overdrafts or lines of credit

• Long-term loans

If you have insufficient working capital and try to increase sales, you
can easily over-stretch the financial resources of the business.

This is called overtrading. Early warning signs include:

o Pressure on existing cash

o Exceptional cash generating activities e.g. offering high

discounts for early cash payment

o Bank overdraft exceeds authorized limit

 o Seeking greater overdrafts or lines of credit

o Part-paying suppliers or other creditors

o Paying bills in cash to secure additional supplies

o Management pre-occupation with surviving rather than

managing

Frequent short-term emergency requests to the bank (to help pay

wages, pending receipt of a cheque).

Handling Receivables (Debtors)

Cash flow can be significantly enhanced if the amounts owing to a

business are collected faster. Every business needs to know.... who
owes them money.... how much is owed.... how long it is owing.... for
what it is owed.

Late payments erode profits and can lead to bad

debts.

Slow payment has a crippling effect on business; in particular on small

businesses who can least afford it. If you don't manage debtors, they
will begin to manage your business as you will gradually lose control
due to reduced cash flow and, of course, you could experience an
increased incidence of bad debt.

The following measures will help manage your debtors:

1. Have the right mental attitude to the control of credit and make
sure that it gets the priority it deserves.

2. Establish clear credit practices as a matter of company policy.

3. Make sure that these practices are clearly understood by staff,

suppliers and customers.

4. Be professional when accepting new accounts, and especially

 larger ones.

5. Check out each customer thoroughly before you offer credit. Use
credit agencies, bank references, industry sources etc.

6. Establish credit limits for each customer... and stick to them.

7. Continuously review these limits when you suspect tough times

are coming or if operating in a volatile sector.

8. Keep very close to your larger customers.

9. Invoice promptly and clearly.

10. Consider charging penalties on overdue accounts.

11. Consider accepting credit /debit cards as a payment

option.

12. Monitor your debtor balances and ageing schedules, and

don't let any debts get too large or too old.

Recognize that the longer someone owes you, the greater the chance
you will never get paid. If the average age of your debtors is getting
longer, or is already very long, you may need to look for the following
possible defects:

• weak credit judgement

• poor collection procedures

• lax enforcement of credit terms

• slow issue of invoices or statements

• errors in invoices or statements

• Customer dissatisfaction.

Debtors due over 90 days (unless within agreed credit terms) should
generally demand immediate attention. Look for the warning signs of a
future bad debt. For example.........

o longer credit terms taken with approval, particularly for smaller

orders
 o use of post-dated checks by debtors who normally settle within
agreed terms

o evidence of customers switching to additional suppliers for the

same goods

o new customers who are reluctant to give credit references

o Receiving part payments from debtors.

Profits only come from paid sales.

The act of collecting money is one which most people dislike for many
reasons and therefore put on the long finger because they convince
themselves there is something more urgent or important that demand
their attention now. There is nothing more important than getting paid
for your product or service. A customer who does not pay is not a
customer.

Managing Payables (Creditors)

Creditors are a vital part of effective cash management and should be

managed carefully to enhance the cash position.

Purchasing initiates cash outflows and an over-zealous purchasing

function can create liquidity problems. Consider the following:

o Who authorizes purchasing in your company - is it tightly

managed or spread among a number of (junior) people?

o Are purchase quantities geared to demand forecasts?

o Do you use order quantities which take account of stock-holding

and purchasing costs?

o Do you know the cost to the company of carrying stock?

o Do you have alternative sources of supply? If not, get quotes

from major suppliers and shop around for the best discounts,
credit terms, and reduce dependence on a single supplier.

o How many of your suppliers have a returns policy?

 o Are you in a position to pass on cost increases quickly through
price increases to your customers?

o If a supplier of goods or services lets you down can you charge

back the cost of the delay?

o Can you arrange (with confidence!) to have delivery of supplies

staggered or on a just-in-time basis?

There is an old adage in business that if you can buy well then you can
sell well. Management of your creditors and suppliers is just as
important as the management of your debtors. It is important to look
after your creditors - slow payment by you may create ill-feeling and
can signal that your company is inefficient (or in trouble!).

Remember, a good supplier is someone who will work with you to

enhance the future viability and profitability of your company

Key Working Capital Ratios

The following, easily calculated, ratios are important measures of

working capital utilization.

Ratio Formulae Result Interpretation

On average, you turn over the value of
your entire stock every x days. You
may need to break this down into
Average product groups for effective stock
Stock
Stock * 365/ = x management.
Turnover
Cost of Goods days Obsolete stock, slow moving lines will
(in days)
Sold extend overall stock turnover days.
Faster production, fewer product lines,
just in time ordering will reduce
average days.
Receivabl Debtors * = x It takes you on average x days to
es Ratio 365/ days collect monies due to you. If you’re
(in days) Sales official credit terms are 45 day and it
takes you 65 days... why?
One or more large or slow debts can
drag out the average days. Effective
 debtor management will minimize the
days.

On average, you pay your suppliers

every x days. If you negotiate better
credit terms this will increase. If you
Creditors *
pay earlier, say, to get a discount this
Payables 365/
= x will decline. If you simply defer paying
Ratio Cost of Sales
days your suppliers (without agreement)
(in days) (or
this will also increase - but your
Purchases)
reputation, the quality of service and
any flexibility provided by your
suppliers may suffer.

Current Assets are assets that you can

readily turn in to cash or will do so
within 12 months in the course of
business. Current Liabilities are
amount you are due to pay within the
Total Current
coming 12 months. For example, 1.5
Current Assets/ =x
times means that you should be able
Ratio Total Current times
to lay your hands on $1.50 for every
Liabilities
$1.00 you owe. Less than 1 times e.g.
0.75 means that you could have
liquidity problems and be under
pressure to generate sufficient cash to
meet oncoming demands.
(Total Current
Assets - Similar to the Current Ratio but takes
Quick =x
Inventory)/ account of the fact that it may take
Ratio times
Total Current time to convert inventory into cash.
Liabilities
(Inventory +
Working A high percentage means that working
Receivables - As %
Capital capital needs are high relative to your
Payables)/ Sales
Ratio sales.
Sales

Other working capital measures include the following:

• Bad debts expressed as a percentage of sales.

• Cost of bank loans, lines of credit, invoice discounting etc.

• Debtor concentration - degree of dependency on a limited

 number of customers.

Once ratios have been established for your business, it is important to

track them over time and to compare them with ratios for other
comparable businesses or industry sectors.

Sources of Additional Working Capital

Sources of additional working capital include the following:

• Existing cash reserves
• Profits (when you secure it as cash !)

• Payables (credit from suppliers)

• New equity or loans from shareholders

• Bank overdrafts or lines of credit

• Long-term loans

If you have insufficient working capital and try to increase sales, you
can easily over-stretch the financial resources of the business. This is
called overtrading. Early warning signs include:

• Pressure on existing cash

• Exceptional cash generating activities e.g. offering high

discounts for early cash payment

• Bank overdraft exceeds authorized limit

• Seeking greater overdrafts or lines of credit

• Part-paying suppliers or other creditors

• Paying bills in cash to secure additional supplies

• Management pre-occupation with surviving rather than

managing

• Frequent short-term emergency requests to the bank (to help

pay wages, pending receipt of a cheque).

Here are the five most common sources of short-term working capital
financing:
• Equity: If your business is in its first year of operation and has
not yet become profitable, then you might have to rely on equity
funds for short-term working capital needs. These funds might be
injected from your own personal resources or from a family
member, friend or third-party investor.
• Trade Creditors: If you have a particularly good relationship
established with your trade creditors, you might be able to solicit
their help in providing short-term working capital. If you have
paid on time in the past, a trade creditor may be willing to
extend terms to enable you to meet a big order. For instance, if
you receive a big order that you can fulfill, ship out and collect in
60 days, you could obtain 60-day terms from your supplier if 30-
day terms are normally given. The trade creditor will want proof
of the order and may want to file a lien on it as security, but if it
enables you to proceed, that shouldn't be a problem.
• Factoring: Factoring is another resource for short-term working
capital financing. Once you have filled an order, a factoring
company buys your account receivable and then handles the
collection. This type of financing is more expensive than
conventional bank financing but is often used by new businesses.
• Line of credit: Lines of credit are not often given by banks to new
businesses. However, if your new business is well-capitalized by
equity and you have good collateral, your business might qualify
for one. A line of credit allows you to borrow funds for short-term
needs when they arise. The funds are repaid once you collect the
accounts receivable that resulted from the short-term sales
peak. Lines of credit typically are made for one year at a time
and are expected to be paid off for 30 to 60 consecutive days
sometime during the year to ensure that the funds are used for
short-term needs only.

• Short-term loan: While your new business may not qualify for a
line of credit from a bank, you might have success in obtaining a
one-time short-term loan (less than a year) to finance your
temporary working capital needs. If you have established a good
banking relationship with a banker, he or she might be willing to
provide a short-term note for one order or for a seasonal
inventory and/or accounts receivable buildup.

In addition to analyzing the average number of days it takes to make a

product (inventory days) and collect on an account (account receivable
days) vs. the number of days financed by accounts payable, the
operating cycle analysis provides one other important analysis.

From the operating cycle, a computation can be made of the dollars

required to support one day of accounts receivable and inventory and
the dollars provided by a day of accounts payable.

Working capital has a direct impact on cash flow in a business. Since

cash flow is the name of the game for all business owners, a good
understanding of working capital is imperative to make any venture
successful.
Factors determining working capital requirements
• Size of business

• Stage of development

• Time of production

• Rate of stock turnover ratio

• Buying and selling terms

• Seasonal consumption

• Seasonal product

• profit level

• growth and expansion

• production cycle

• general nature of business

• business cycle

Definiition of Bill Discounting

Business activities across borders are done through letter of credit.
Letter of credit is an instrument issued in the favor of the seller by the
buyer bank assuring that payment will be made after certain timer
frame depending upon the terms and conditions agreed, it could be
either sight, 30 days from the Bill of Lading or 120 days from the date
of bill of lading. Now when the seller receives the letter of credit
through bank, seller prepares documents and presents the same to the
bank.
The most important element in the same is the bill of exchange which
is used to negotiate a letter of credit. Seller discounts that bill of
exchange with the bank and gets money. Discounting bill terminology
is used for this purpose. Now it is seller’s bank responsibility to send
documents and bill of exchange to buyer’s bank for onward forwarding
to the buyer for the acceptance and the buyer finally, accepts bill of
exchange drawn by the seller on buyer’s bank because he has opened
that LC. Buyers bank than get that signed bill of exchange from the
buyer as guarantee and
release payment to the sellers bank and waits for the time span will
buyer will pay the bank against that bill of exchange.

Discounting of bills

Meaning of the word discounting:

•a contract

•source of short-term finance

•the process of calculating the present value of some future amount

Bill Discounting
When a firm holds other drawer’s bills of exchange with distant terms of
payment
and is money short, the amount of the bill shall be subject to a discount.
Discounting is a special form of lending, when a bank buys a bill prior to
maturity
at a price lower then the nominal amount of the bill of exchange (with a
discount).
Discounting bills indicates the operation by means of which a bank, having
previously deducted the interest, advances to its client - the creditor - the
amount
corresponding to the value of one or more bills bearing a future date which
the
client cedes to the bank by endorsement.
The discounting of bills are a widely used source of short-term finance.
Commercial bill discount refers to the service that the holder commercial
acceptance draft transfers his draft to bank for obtaining funds before the
day of
draft maturity.The cash received is posted to the bank account and the bill
of
exchange charges are posted to the appropriate expense account.If the
drawee
does not pay the bill of exchange on the date of maturity, it isprotested.
The grounds for discounting the bill
Bills of exchange are discounted before their maturity date.The grounds for
discounting the bill before its maturity date is Bank’s consent for
discounting,
written request addressed to the chairman of board by the drawer, and the
bill of
exchange itself.
Before the bills can be discounted they are checked for juridical
authenticity and
legitimacy of the drawer (the number of valid endorsements is considered,
though the last endorsement may be the blank endorsement).
Discounting of bills means purchase of bill by the Bank from the drawer
before
the due date.
All discount transactions are performed by the Bank basing on agreement
concluded between the Bank and the drawer. Pricing for bills discounting
is
determined basing on the bill discount rate and is specially agreed with the
drawer for every separate bill. The Bill Discounting operations include
presentation of bills, application of conditions, dispatch of Bills to the
concerned
banks for collection and dispatch of unpaid bills to the notary for protest
Charges
A fee is charged as payment is made before the due date is reached. In
other
words face value minus the fee will be paid. the fees charged by the bank
for
accepting the bill of exchange.The minimum charge for bill discounting
tends to
vary according to the credit-worthiness of the companies.The pricing for
bill
discounting is determined individually.
A discount house buys a bill or security for less than its face value. Rather
than
receiving interest, the discount house waits till the bill matures, and
collects the
money (at the face value). The amount paid for the bill depends on the time
till
maturity and the short-term rate of interest.
Discount Rate: the rate used in calculating the present value of some future
monetary amount.
Discount period: the period between the date of discounting and the future
due
date of the receivable
Discounting fee: the discount fee is the difference between the nominal
value
of bill of exchange bought by the Bank from a client and the sum credited
to theclient's bank account. The difference, made up of the time-
proportionate interestup until the due date plus the risk-based charge,
which varies according to therisk involved, is deducted as the bank's fee
(discount rate).

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