AFM Mod 01

ADVANCED FINANCIAL MANAGEMENT
MOD-1 Working Capital Management
Working Capital Management

Difference between long term financial management and short term financial management is timing of cash Long term financial decisions like buying capital equipment or issue of debentures involve cashflow over 5 to 15 years Short term financial decisions involve cash flows within an year or within operating cycle of firm

Two concepts of working capital: 1. gross working capital is the total of all current assets 2. net working capital is the difference between current assets and current liabilities Working capital management is very important because: 1. current assets form substantial portion of total investment 2. investment in CA and level of Current Liabilities have to be quickly geared to changes in sales

Constituents of CA
Inventories RM and components Work in process Finished goods Others trade debtors loans and advances Cash & bank balances
Constituents of CL
Sundry creditors Trade advances Borrowings Commercial banks others Provisions

1. 2. Characteristics of current assets: Short life span Current Assents have short life span: cash balance a week or two, accounts receivables 30 to 60 days, inventories 1 to 60 days The life span depends on time required in activities like procurement, production, sales and collection. In addition degree of synchronisation among them Swift transformation in to other asset form Each current asset is swiftly transformed into other form of assets: cash to raw material (RM), RM to finished goods (FG), FG is sold on credit (accounts receivables), Account receivables to cash

Current assets cycle
Finished goods Accounts Receivables Work in process
Wages, salaries, Factory O/H

Raw materials
Cash
Suppliers

Implications of short life span of WC 1. decisions relating to WC are repetitive and frequent 2. the difference between profit and present value is insignificant 3. close interaction of WC components implies that efficient management of one component cannot be undertaken without simultaneous consideration of other components Ex. 1.If firm has more FG it may offer liberal credit or show laxity in collection, 2.if a firm has liquidity crunch it may offer generous discounts

Factors influencing working capital requirements: Important factors: 1. nature of business 2. seasonality of operations 3. production policy 4. market conditions 5. conditions of supply

Nature of business: 1. WC is closely related with nature of firms business 2. Ex. Electricity firm or transport corpn which has short operating cycle and which sells predominantly on cash basis has modest WC requirement Ex. A mfg. co. like machine tools unit has long operating cycle and which sells largely on credit has substantial WC requirement

Proportions of Current Assets and Fixed assets CA % 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 FA% 80-90 70-80 60-70 50-60 40-50 30-40 20-30 10-20 Industries Hotels and restaurants Electricity T & D Aluminum & shipping
Iron & steel, industrial Chemicals
Tea plantation Cotton, textile, sugar Edible oils, tobacco Trading & constn

Seasonality of operations: firms which have marked seasonality in their operations have highly fluctuating working capital requirements. Ex. Firm mfg. ceiling fans have peak sales in summer and therefore high working capital requirement. A bulb mfg. co. has stable working capital requirement

Production policy: a firm marked by pronounced seasonal fluctuations in its sales may pursue a production policy to reduce sharp variations in WC requirements Ex. Firm mfg. fans can maintain a steady production throughout the year. Such production policy may dampen fluctuations in WC requirements

Market conditions: Degree of competition in market place has important bearing on WC needs When competition is keen, larger inventory is to be maintained to service the demand of customer who may not be ready to wait, as other competitors are ready to meet their needs Further generous credit terms are offered to attract customers in highly competitive market Thus WC requirement will be high because of higher investment in finished goods and accounts receivables.

If market is strong and competition is weak, firm can manage with smaller inventory of finished goods, as customers can be served with delay In such a situation firm can insist on cash payment and avoid lock up of funds in accounts receivables Firm can also ask for advance paymentspartial or total

Conditions of supply: The inventory of RM, spares, and stores depends on conditions of supply If supply is prompt and adequate, firm can manage with small inventory If supply is unpredictable and scant, to ensure continuity in production, firm has to carry higher inventory. Similar policy is followed when RM is available seasonally and production carried round the year
Levels of current assets:

An important WC policy decision is concerned with level of investment in current assets(CA) Under flexible policy/conservative policy investment in CA is high That means firms maintain huge cash balance and marketable securities, carries large amounts of inventories, grants generous credit terms to customers leading to high level of debtors

Under restrictive policy/ aggressive policy the investment in CA is low That means firms keep small balance of cash, small balance of cash in marketable securities, manages with small amount of inventories and offers stiff terms of credit leading to low level debtors

What are consequences of flexible and restrictive policies? 1. broadly flexible policy results in fewer production stoppages, ensures quick deliveries to customers, stimulates sales because of liberal credit. All these at higher investment in current assets 2. restrictive policy may lead to frequent production stoppages, delayed delivery to customers, and loss of sales. All these are to be borne by the firm to keep low investments in CA

Determining the optimal level of CA is trade off between costs that rise with CA and cost that fall with CA The costs that rise is called carrying costs and the costs that fall are called shortage costs Carrying costs are mainly financing cost of higher inventory Shortage costs are mainly disruption of production schedule, loss of sales and customer goodwill. The optimal level of current asset is denoted by CA* in the graph(often cost curve is fairly flat around optimal level. Manager
should be satisfied if CA level is close to optimal point)

Carrying cost and Shortage cost
total cost
carrying cost
shortage cost
CA* level of current assets (CA)

Current assets financing policy:
After establishing level of current assets, firm has to determine how to finance CA. What mix of long term capital and short term debt to be employed? Total assets and hence the capital requirement of a firm changes over time as depicted in the graph (Mainly, Level of CA changes over time)

Capital requirement and their financing Capital requirement fluctuating CA requirement

A B C permanent current asset requirement
fixed asset requirement
Time

For the sake of simplicity assets are divided into two classes viz. fixed assets and current assets Fixed assets are assumed to grow at a constant rate which reflects the secular (long term) rate of growth in sales Current assets are also expected to grow at the same long term rate of growth However they exhibit substantial variation around the trend line, thanks to the seasonal patterns in sales or purchases Several strategies to finance capital requirement of a firm.

Three important strategies are illustrated by line A , B and C in the graph Strategy A: long term financing is used to meet fixed asset requirement and peak working capital requirement When working capital requirement is less than peak level, the surplus is invested in liquid assets (cash & marketable securities)

Strategy B: long term financing is used to meet fixed asset requirement, permanent working capital requirement and a portion of fluctuating working capital requirements. During seasonal upswings, short term financing is used: during seasonal down swing surplus is invested in liquid assets.

Strategy C: long term financing is used to meet fixed asset requirements and permanent working capital requirements. Short term financing is used to meet fluctuating working capital requirements. The matching principle: according to this principle, the maturity of the sources of financing should match the maturity of the assets being financed. This means that fixed assets and permanent assets should be supported by long term sources of finance, whereas fluctuating CA must financed by short term source of finance.

The rationale for matching principle is, if a firm finances a long term asset with short term debt (say commercial paper), it will have to periodically refinance the asset. Whenever short term debt falls due the firm has to refinance the asset which is risky and inconvenient Hence it makes sense to ensure that the maturity of assets and sources of financing are properly matched
Operating and cycle and cash cycle The investment in working capital is influenced by the following events in the operating cycle of the firm: 1. purchase of raw materials 2. payment for raw materials 3. manufacture of goods 4. sale of finished goods 5. collection of cash for sales
Operating and cash cycle

Order placed
stock arrives finished goods sold cash received
inventory period
Accounts receivables period
Account payable period firm receives invoice cash paid for materials Operating cycle cash cycle
The firm begins with the purchase of raw materials which are paid for after a delay of which represents accounts payable period the firm converts the raw materials into finished goods and then sell the same The time lag betwn. the purchase of RM and sale of FG is inventory period
Customers pay their bills some time after sales The period that elapses between date of sales and the date of collection of receivables is the accounts receivable period The time that elapses between the purchase of RM and the collection cash for sales is called operating cycle the time length between the payment of RM purchase and collection of cash for sales is called as cash cycle
The operating cycle is the sum of the inventory period and accounts payable period The cash cycle is equal to operating cycle less the accounts payable period From financial statements of the firm the inventory period, the accounts receivable period and accounts payable period can be estimated.
Ex. Financial info. of Horizon ltd is given: Balance sheet data P&L Begining End
A/C data of year 2009 of 2009 Sales 800 Inventory 96 102 Cost of goods 720 Acts. Receivable 86 90 sold Acts. Payable 56 60
Inventory period = =Av. Inventory/Annual cost of goods sold/365 Inventory period= (96+102)/2 / (720/365) = 50.1 days Accounts receivable period= Average accounts receivable / annual sales/365 Accts. receivable period= (86+90)/2 / 800/365 Accounts receivable period= 40.2 days
Accounts payable period= = average accounts payable / annual cost of goods sold/365 Accounts payable period= (56+60)/2 / 720/365 Accounts payable period= 29.4 days Operating cycle = inventory period + accounts receivable period= = 50.1+40.2= 90.3 days Cash cycle= operating cycle accounts payable period= =90.3 -29.4 = 60.9 days
It is helpful to monitor the behaviour of overall operating cycle and its individual components For this purpose time series analysis can be done In time series analysis, the duration of the operating cycle and its individual components is compared over a period of time for the same firm In cross-section analysis, the duration of the operating cycle and its individual components is compared with that of other firms of a comparable nature
Cash requirement for working capital Financial manager can follow a two step procedure to find out the cash requirement of his firm: Step-1. estimate the cash cost of various current assets required by the firm The cash cost of a current asset is : value of the CA profit element if any included in the value non-ash charges like depreciation if any included in the value
Ex. Value of sundry debtors Rs.10 mln as per balance sheet, Profit margin is 25%, depreciation element in the cost of goods sold corresponding to sundry debtors is Rs.0.5mln. The cash cost of sundry debtors is=
Value in balance sheet Rs. 10 mln Profit margin 25% Rs. 2.5 mln Cost of goods sold Rs. 7.5 mln Depreciation element Rs. 0.5 mln Cash cost of sundry debtors Rs. 7.0 mln
Step-2: deduct the spontaneous current liabilities from the cash cost of current assets. A portion of the cash cost of CA is supported by trade credit and accruals of wages and expenses, which are referred to as spontaneous current liabilities The balance left after such deductions has to be arranged from other sources
Ex. Max ltd sells goods at a profit margin of 25%, counting depreciation as part of cost of manufacture. Its annual figures are: Rs. mln Sales (2 months credit is given) 240 Material cost (3 months credit) 72 Wages (paid one month arrears) 48 Mfg. expenses outstanding at the end of year (cash exp. Paid 1 month arrears) 4 Admn. & sales expenses 30 (paid as incurred)
Max ltd keeps two months stock of RM and one months stock of FG. It needs a cash balance of Rs. 5mln Estimate the requirement of working capital on cash cost basis, assuming 10% safety margin. Ignore work in process
Working notes: Rs. mln 1. manufacturing expenses sales 240 less Gross profit(25%) 60 Total mfg. cost 180 less material 72 wages 48 120 Manufacturing expenses 60 2. cash mfg. exp (4mln x 12) 48 3. Depreciation (1) (2) 12
Total cash cost: Total manufacturing cost Less depreciation cash manufacturing cost Add admn and selling exp. Total cash cost
180 12 168 30 198
The requirement of working capital cash cost basis is: A: Current Assets Item Calculation Amount Debtors Total cash cost x2/12 198 x 2/12 33.00 RM stock Mat. Stock x 2 /12 72 x 2/12 12.00 FG stock Cash mfg.cost x 1/12 168 X1/12 14.00 Cash balance 5.00 Total current assets 64.00
Item
B: Current liabilities Calculation
Amount
18
Sundry creditors: mat.cost x3/ 12 72 x 3 /12 Mfg. exp outstanding: 1 months cash mfg.exp. Wages outstanding: 1 month wages Total current liabilities:B
4 4 26 38.00 3.80 41.80
Working capital (A-B) (64-26) Add 10% safety margin Working capital required
Negative cash cycle: Internet based amazon.com turns its inventory over 26 times a year making its inventory period very short It charges its customers credit card when it ships a book and gets paid by the credit card usually in a day Finally, it takes about 46 days to the suppliers. All this means that Amazon.com has a negative cash cycle
Concept of zero working capital: Many leading companies seek to have a zero (or even ve) working capital This happens when inventories and receivables are supported by the credit provided by suppliers and the advances given by customers On average, working capital to sales ratio is about 0.2 Reducing working capital has two financial benefits:
1. every rupee released by reduced working capital makes a one-time contribution to cash flow 2. periodically, the cost of money locked in working capital is saved Apart from the financial benefits, reducing working capital forces a company to serve its customers quickly, lessens warehousing needs, and reduces obsolescence costs.

Working capital financing:
Typically current assets are supported by long term and short term sources of finance. Long term finance provide the margin money for working capital Short term sources of finance more or less exclusively support the current assets. discussion on sources of finance are divided into ten sections.

They are: 1. accruals 2. trade credit 3. working capital advances by commercial banks 4. regulation of bank finance 5. Public deposit 6. Inter-corporate deposits 7. short-term loans from Financial institutions 8. rights debentures for working capital 9. commercial paper 10. factoring

Accruals: the major accrual items are wages and taxes, which the firm owes to its employees and government Wages are paid weekly, fortnightly or monthly basis; the amounts owed not yet paid are shown as accrued wages in balance sheet Income tax is payable quarterly, and other taxes may be payable half yearly or annually. In the interim, taxes owed but not paid may be shown as accrued taxes on the balance sheet

Accrual vary with the level of activity of the firm When activity expands accruals increase and decrease when activity contracts As accruals respond automatically to changes in activity they are treated as part of spontaneous financing As interest is not paid on accruals by the firm accruals are regarded as free source of financing. However closer examination show that it is not so.

That is when payment cycle is longer, wages may be higher. An employee earning Rs.5000 per week may ask for slightly higher compensation if payment is made on monthly basis Likewise tax authorities may also raise the tax rate However the facts remain that, between established payment dates accruals do not carry any explicit interest burden

While accruals are welcome source of financing, they are not amenable to control by management Payment period to employees are determined by the practice of the industry and the provisions of law Similarly tax payment dates are given by law and postponement of payment normally results in penalties

Trade credit: represents the credit extended by the suppliers of goods and services it is a spontaneous source of finance arising in normal transactions of the firm without any negotiations provided the firm is considered as creditworthy by suppliers It is an important source of financing representing 25 to 50% of short term financing

Obtaining trade credit: the confidence of suppliers is key to securing trade credit. Suppliers consider:
Earnings over a period of time: if the firm has good earnings record and with a portion ploughed back into the business, it is looked upon favourably Liquidity position of the firm: suppliers naturally look at the ability of the firm to meet its obligation in the short run, which is measured by current ratio and acid test ratio Record of payment: if firm has been prompt and regular in paying bulk of its suppliers in the past, it is deemed as creditworthy

Cultivating good supplier relationships: New firm or firm with financial problem will have difficulty in obtaining trade credit Confidence of suppliers can be earned by discussing the financial situation, by showing realistic plans, and more importantly honouring the commitments Broken promises erode confidence than poor results. Better to make modest commitments which may not be fully satisfying to the supplier and honor them, instead of breaking a tall promise which would gratify the supplier and fail to honor them.

Cost of trade credit: the cost of trade credit depends on the credit offered by the supplier. If the terms are say, 30 day net, then trade credit is costfree because the amount payable is the same whether payment is made on the day of purchase or on 30th day However if supplier offers discount for prompt payment and terms are say 2/10, net 30, there is cost associated with trade credit availed beyond discount period into two parts: 10 days/discount period: 20 days/non discount period The cost of trade credit during discount period is nil and cost of trade credit during non discount period is:

[Discount/1-discount ]x[360/credit period-discount period] In the example it works out to: [0.02/1-0.02] x 360/(30-10) =36.7% The cost of trade credit for several credit terms is as below: credit terms cost of trade credit 1/10, net 20 36.4% 2/10, net 45 21.0% 3/10, net 60 22.3% 2/15, net 45 24.5% Generally cost of trade credit is very high. Unless firm is hard pressed financially, it should not forego discount.

What happens if the firm fails to pay with in discount period but pays before the end of net period? Naturally the annual interest cost of trade credit is higher, the longer the difference between the day of payment and end of the discount period. From the foregoing two things are clear; 1. cost of trade credit is very high beyond discount period. Unless the firm is hard pressed financially it should not forego the discount for prompt payment 2. if the firm is unable to avail the discount for prompt payment, it should delay the payment till the last day of the net period, and even beyond if such an action does not impair creditworthyness of the firm

Working capital advance by commercial banks: Working capital advance by commercial banks represents most important source for financing current assets. The following aspects needs examination: 1. application processing, 2. sanction and terms and condition, 3. forms of bank finance, 4. nature of security, 5. margin amount

Application and processing: customers seeking an advance should submit appropriate application form. There are different types of forms for different categories of advances The information required include name and address of borrower & his establishment, details of his business, nature and security offered. Application form has to be supported by various ancillary statements like financial statements and financial projections of the company

The application is processed by branch manager or his field staff. This primarily involves examination of: 1. ability, integrity and experience of the borrower in the particular business, 2. general prospects of the business, 3. purpose of advance, 4. requirement of the borrower and its reasonableness, 5. adequacy of margin, 6. provision of security, 7. period of repayment

Sanction and terms and conditions: once the application is processed it is put up for sanction to appropriate authority The sanctioning powers of various officials like Branch Manager, Regional Manager, General Manager etc., are defined by the virtue of the position they occupy If the loan is sanctioned, it specifies the terms and conditions applicable to advance

These usually cover the following, 1. amount of loan or maximum limit of advance, 2.nature of advance, 3. period for which loan is valid, 4. rate of interest applicable to advance, 5. primary security to be charged, 6. insurance of the security, 7. details of collateral security if any to be provided, 8. margin to be maintained, 9. other restrictions or obligation of borrower if any It is common practice to incorporate terms and conditions on a stamped security document This helps bank to create required charge on the security offered and also obligates the borrower to observe stipulated terms and conditions

Forms of bank finance: Working capital advance is provided by commercial bank in three primary ways: 1. cash credits/ overdrafts, 2.loans, 3. purchase/ discount of bills Cash credits/ overdrafts: under this arrangement a predetermined limit for borrowing is specified by the bank. Borrower can draw as often as required provided out standings do not exceed the cash credit / overdraft limit Borrower also enjoys the facility of repaying the amount partially or fully as and when he desires Interest is charged on running balance not on limit sanctioned.

A minimum charge may be payable irrespective of the level of borrowing, for availing this facility. This form of advance is highly attractive as the borrower has freedom of drawing amount in installments as and when required and interest is payable on actual amount outstanding

Loans: these are advances of fixed amounts which are credited to the current account of the borrower or released to him in cash. The borrower is charged with interest on the entire loan amount, irrespective of how much he draws Loans are payable on demand or in periodical installments When payable on demand, loans are supported by demand promissory note executed by borrower. There is possibility of renewing the loan

Purchase/ discount of bill: A bill arise out of a trade transaction. The seller of the goods draws the bill on the purchaser The bill may be either clean or documentary and payable on demand or after a period which does not exceed 90 days (A documentary bill is supported by a document of title of goods like railway receipt or bill of landing)

On acceptance of the bill by purchaser, the seller offers it to the bank for discount/ purchase When the bank discounts / purchases the bill it releases the funds to the seller The bank presents the bill to the purchaser on the due date and gets its payment The RBI launched the new bill market scheme in 1970 to encourage the use of the bills as an instrument of credit

The objective was to reduce the reliance on cash credit which was amenable to misuse/abuse The new bills scheme sought to promote an active market for bills as a negotiable instrument so that the lending activities of a bank could be shared by other banks It was envisaged that a bank, when short of funds can sell or rediscount the bills that it has purchased or discounted Likewise a bank with surplus funds would invest in bills

For such a system to work, there has to be a lender of last resort which can come to help the banking system RBI took this role and rediscounts bills of commercial banks to a certain limit In spite of the support of RBI bill market scheme has not functioned successfully

Letter of credit (LC): A letter of credit is an arrangement whereby a bank helps its customers to obtain credit from its suppliers When a bank opens a LC in favour of its customer for some specific purchases, the bank undertakes the responsibility to honour the obligation of its customer, should the customer fail to do so.

Ex. A bank opens a LC in favour of A for some purchase that A plans to make from B. If A does not make payment with in the credit period offered by B, the bank assumes the liability of A for the purchase covered under LC Naturally B will not hesitate to extend credit to A when bank opens LC in favour of A Under LC arrangement supplier provides the credit, but bank assumes the risk This is an indirect form of financing as against OD, CC, loans and bill discounting which are direct form of financing Note that bank assumes risk as well as financing in direct financing

Security: Hypothecation: the owner of the goods borrows money against security of movable property, usually inventories Owner does not part with the property Rights of lender depends on agreement between the lender and the borrower. Should the borrower default in paying his dues, the lender can file a suit and realise his dues by selling goods hypothecated

Pledge: owner of the goods(pledgor) deposits the goods with the lendor (pledgee) as security for the borrowing Transfer of possession of goods is a precondition for pledge. Lendor is expected to take reasonable care of goods pledged with him Pledge contract gives lender right to sell goods and recover dues, should the borrower default in paying debt

Margin amount: banks do not provide 100% finance. They insist that the customer should bring a portion of the required finance from other sources This portion is known as margin amount There is no fixed formula to determine the margin amount. The guideline is: When margin is low bankss risk high, vice versa

Regulation of bank finance:
Traditionally industrial borrowers enjoyed easy access to bank finance to meet their WC needs The CC facility is advantageous to borrowers Observers felt that there was over borrowing of readily available finance by the industrial borrowers, depriving other sectors.

Concerned about the distortion, since 1960 RBI had been issuing guidelines to bring in discipline among industrial borrowers and to redirect funds to priority sector. The guidelines and directives stemmed from recommendations of groups like, Dahejia committee, Tandon committee, Chore committee and Marathe committee.

From 1970s the regulation of bank finance was based mainly on Tandon committee In spite of financial liberalisation since 1990s, giving freedom to banks relating to WC financing, most of the banks are still influenced by Tandon committee recommendations The key elements of the same is given below:

Tandon committee recommendations: the key recommendations relate to: 1. norms for CA, 2. the maximum permissible bank finance (MPBF), 3. emphasis on loan system and, 4. periodic information and reporting system. Norms of CA: Tandon committee defined the norms for RM, Stock in process, FG and receivables for 15 major industries. Subsequently more industries were covered

MPBF: following three methods were suggested: Method 1: MPBF=0.75(CA-CL) Method 2: MPBF=0.75(CA)-CL Method 3: MPBF=0.75(CA-CCA)-CL CA=current assets; CL=current liabilities; CCA=core current assets, representing permanent component of WC

Ex:Ambex Company Current assets Current liabilities 1. RM 18 1. Trade creditors 2. WIP 5 2. other CL 3. FG 10 3. Bank borrowings 4. Receivables (incl. bills discounted) 25 (incl.bills discounted) 15 5. Other 2 Total 50 MPBF Computation: Method 1= 0.75(CA-CL)=0.75(50-15)=Rs.26.25Cr Method 2=0.75(CA)-CL=0.75(50)-15=Rs.22.5Cr Method 3=0.75(CA-CCA)-CL=0.75(50-20*)-15=Rs.7.5 Cr *Assume core current asset- Rs.20 Cr
12 3
40

In the above three methods, second method has been adopted. Note the that under this method minimum current ratio works out to be 1.33 =50/(22.5+15) Ex. For a xyz co. CA=100 and CL=50(excl. bank finance) Under method 2: MPBF=0.75(100)-50=25 This means that CL including MPBF=50+25=75 hence current ratio= 100/75=1.33

Emphasis on loan system: traditionally bank credit to industry was in the form of cash credit (which was introduced by scottish bankers) Under CC system bank bears the responsibility of cash management because borrowers determine their drawls with in the CC limit provided by the bank Tandon committee recommended that only a portion of MPBF must be in the form of CC and balance must be in the form of working capital demand loan

Periodic information and reporting system: Tandon committee recommendation on this issue was further improved by Chore committee. The Key components are: 1. Quarterly information system- form-I: this gives i. estimates of production and sales of current year and ensuing quarter, ii. the estimates of current assets and liabilities for the ensuing quarter 2. quarterly information system form-II: this gives i. actual production and sales during current year and for latest completed year, ii. The actual current assets and current liabilities for the latest completed quarter

3. Half yearly operating statement-form-III: this gives the actual operating performance for the half year ended against the estimates for the same 4. Half yearly funds flow statement- formIIIB: this gives the sources and uses of funds for the half-year ended against the estimates for the same

Present practice: 1. assessment of WC requirements: banks use following methods:
Projected balance sheet method: WC requirements assessed on the basis of projected values of assets and liabilities Cash budget method: the WC requirements are assessed on the basis of projected cash flows Turnover method: the WC requirements are assessed on the basis of projected annual turnover

Current ratio norm: under Tandon committee report the minimum current ratio of 1.33 was required. At present 1.33 is regarded as benchmark and banks accept lower current ratio depending on circumstances. Thus presently banks follow more flexible approach in determining Assessed Bank Finance (in place of MPBF) Banks take into account variety of factors like duration and nature of operating cycle, projected build up of CA and CL, projected turnover, profitability and liquidity

Emphasis on the loan system: there is change in style of lending. Today bulk of WC limit is in the form of WC demand loan, only a small portion in the form of cash credit component Financial follow-up reports: some public sector banks have designed financial follow-up reports FFR-I and FFR-II FFR-I; is simplified form of Form-II of Tandon committee, to be submitted on quarterly basis FFR-II: is modified version of Form-III of Tandon committee, to be submitted on half yearly basis.

Public deposits:
Many large & small firms have solicited unsecured deposits from public in recent years to finance their WC requirements. Cost: interest payable on public deposit was subject to ceiling till mid 1996, just before its withdrawl it was 15% Companies offer an interest rate of 6-7%for one year, 7-8% for two years and 9-10% on three year deposits

Regulation: the Companies (acceptance of Deposits) Amendment Rules 1978 governs fixed deposits. The main features are: 1. public deposit cannot exceed 25% of share capital and free reserves 2. the maximum maturity period allowed is 3 years and minimum is 6 months. For NBFCs maximum period is 5 years 3. a company has to set aside an amount equall to 10% of the deposits maturing by 31st march of the following year. The amount set aside to be used only repay the public deposit falling due 4. a company inviting deposit should disclose certain facts about its financial performance and position
Evaluation: from the companys view; 1. the procedure obtaining public deposit is fairly simple. 2. no restrictive covenants (conditions) are involved 3. no security is offered against public deposit. Hence mortgageable assets are conserved 4. post tax cost is fairly reasonable Demerits: 1. quantum of funds that can be raised by way of public deposit is limited 2. maturity period is relatively short

From investors view, the advantages: 1. the rate of interest is higher than alternative forms of financial investment 2. the maturity period is fairly short- one to three years Disadvantages: 1.there is no security offered by the firm 2. the interest on public deposit is not exempt from taxation

Inter-corporate deposits:
the deposit made by one company with another, normally for a period upto six months is referred to as an inter-corporate deposit. Three types 1. call deposit: in theory, call deposit is withdrawable by the lender on giving a days notice. In practice lender has to wait 3 days. The interest rate may be around 12%

2. three months deposit: more popular, these deposits are taken to tide over short term cash inadequacy which may be due to one or more of the following; 1. disruption in production, excessive imports of RM, tax payment, delay in collection, dividend payment, and unplanned capital expenditure. The interest rate is around 15% per annum 3. six-months deposit: normally lending companies do not extend deposits beyond this time frame. Interest rate is 18% per annum.

Characteristics of the inter-corporate deposit market: 1. lack of regulation: the lack of legal hassles and bureaucratic red tape makes an inter-corporate deposit transaction very convenient. With plethora of regulations in business environment, this is an example of the ability of corporate sector to organise itself in a reasonably orderly manner. 2. secrecy: the inter-corporate market is shrouded with secrecy. Brokers regard their list of borrowers and lenders as guarded secret. Tightlipped about their business apprehend, may result in unwelcome competition and undercutting of rates

Importance of personal contacts: brokers and lenders argue that they are guided by a reasonably objective analysis of the financial situation of the borrowers. However truth is inter-corporate deposit markets are based on personal contacts and market information which may lack reliability. Given the secrecy of operation and nonavailability of hard data, can it be otherwise?

Short term loans from financial institutions:
Insurance companies provide short term loans to manufacturing companies with excellent track record. Eligibility: the borrowing company should satisfy the following conditions: 1. it should have declared dividend of not less than 6%for the past 5 years (relaxed in certain cases at least 10% from last 3 years)

2. the debt equity ratio should not exceed 2:1 3. The current ratio should be at least 1:1 4. the average of interest cover ratios for the past three years should be at least 2:1 Features: short term loans provided by FI have following features: 1. they are totally unsecured and given on demand promissory note 2. the loan is given for a period of one year and can be renewed for two consecutive years provided the original eligibility criteria are satisfied 3. after repaying the loan company has to wait 6 months for availing fresh loan 4.interest payable at quarterly rests.

Rights debentures for working capital: public limited companies can issue
rights debentures to their share holders with the object of augmenting the long term resources of the company for WC requirements. The guidelines to such debentures are as follows: 1. the amount of debenture issue should not exceed, i. 20% of the gross CA, loans and advances minus the long term funds presently available for financing WC, or ii. 20% of the paid up share capital, including preference capital and free reserves, whichever is lower of the two

2. the debt equity ratio including proposed debenture issue should not exceed 1:1 3. the debentures shall first be offered to the existing Indian resident share holders of the company on a pro rata basis Commercial paper:commercial paper represents short term unsecured promissory notes issued by firms which enjoy high credit rating. Large firms with considerable financial strength issue commercial paper. Important features are:

1. the maturity period of commercial paper ranges from 90 to 180 days 2. commercial paper is sold at a discount from its face value and redeemed at its face value. Hence the implicit interest rate is a function of the size of the discount and the period of maturity 3. commercial paper is directly placed with investors who intend holding it till its maturity. Hence there is no well developed secondary market for commercial paper

Regulation: since commercial paper represents unsecured instrument of financing, RBI has stipulated conditions meant to ensure only financially strong companies can issue commercial paper. These conditions are: 1. company has net worth at least Rs.50 milllion 2. its MPBF is at least RS.100million 3. the face value of commercial paper does not exceed 30 % of the its WC limit 4. its equity is listed on a stock exchange

5. the commercial paper receives a minimum rating of P1 from CRISIL or equivalent thereof 6. it has minimum current ratio of 1.33 7. it enjoys health code No.1 status 8. the minimum size of commercial paper issue is Rs.2.5 million and the denomination of each commercial paper note is half a million rupees or multiple thereof

Effective cost: commercial paper is sold at a discount from its face value and redeemed at its face value. Hence effective cost of commercial paper is:
{[face value net amount realised]/net amount realised} x {360/maturity period}
Ex. Face value :RS.500,000 Maturity period :180 days Net amount realised :RS.480,000 The pretax effective cost of commercial paper is = {(500000-480000)/480000} x {360/180}=8.33%

Factoring:
A factor is financial institution which offers services relating to management and financing of debts arising from credit sales. RBI has authorised four PSU banks to do factoring (still nascent stage) in India SBI (SBI factoring and commercial services ltd.), canara bank (canbank factoring ltd), PNB and Bank of Allahabad have been allowed to do factoring in western, southern, northern and eastern regions respectively

Features of factoring arrangement: 1. the factor selects the accounts of the client that would be handled by it and establishes, along with the client, the credit limit applicable to the selected accounts 2. the factor assumes responsibility for collecting debt of accounts handled by it. For each account, the factor pays to the client at the end of credit period or the account is collected, whichever comes earlier

3. the factor advances money to the client against notyet-collected and not-yet-due debts. Typically the amount advanced is 70 to 80% of the face value of the debt and carries interest rate which may be equal to or marginally higher than the lending rate of commercial banks 4. factoring may be on recourse basis (means that the credit risk is borne by the client) or on a non-recourse basis ( means that the credit risk is borne by the factor). Presently factoring is done on recourse basis 5. besides interest on advances against debt, the factor charges a commission which may 1 to 2 % of the face value of debt factored.

Mechanics of factoring

Client (seller)
1. places order 3. Delivers goods and invoice with notice to pay the factor
Customer (buyer)
4.sends 8. pays invoice balance copy amount 2. Fixes 5.prepays Customer upto Limit 80%
6.follows up 7.pays
Factor

Evaluation: advantages 1. factoring ensures a definite pattern of cash inflows from credit sales 2. Continuous factoring may virtually eliminate the need for the credit and collection department Disadvantages: 1. cost of factoring tends to be higher than other forms of short-term borrowing 2. factoring of debt may be perceived as a sign of financial weakness

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ADVANCED FINANCIAL MANAGEMENT

MOD-1 Working Capital Management

Working Capital Management

Working Capital Management

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Wages, salaries, Factory O/H

Working Capital Management

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Levels of current assets:

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Capital requirement and their financing Capital requirement fluctuating CA requirement

fixed asset requirement

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Operating and cash cycle

Accounts receivables period

180 12 168 30 198

B: Current liabilities Calculation

4 4 26 38.00 3.80 41.80

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