UNIT 1 NOTES

WORKING CAPITAL MGT

-Working Capital is the amount of Capital that a Business has available to meet the
day-to-day cash requirements of its operations
-Working Capital is the difference between resources in cash or readily convertible
into cash (Current Assets) and organizational commitments for which cash will
soon be required (Current Liabilities) .It refers to the amount of Current Assets
that exceeds Current Liabilities (i.e. CA - CL)
- 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
Concepts of Working Capital:-
There are two concepts of working capital-
(1) Gross Working Capital Concept
(2) Net Working Capital Concept.
(1) Gross working capital:
Gross working capital; refers to firm's investment in currentassets.Current assets
are the assets which can be converted into cash within an accounting year and
include cash, short-term securities, debtors, bill receivables and stock.
According to this concept, working capital means Gross working Capital which
is the total of all current assets of a business. It can be represented by the
following equation:
Gross Working Capital = Total Current Assets
Definitions favoring this concept are:-
According to Mead, Mallot and Field:
"Working Capital means total of Current Assets".
(2) Net Working Capital Concept:
Net working capital refers to the difference between current assets and current
liabilities. Current liabilities are those claims of outsiders
which  are  expected  to  mature  for  payment  within  an accounting  year  and  
include creditors,  bills  payables,  and  outstanding  expenses.
 Net  working  capital  can  be
positive  or  negative.  A  positive  net  working  capital  will  arise  when curren
t  assets exceed current liabilities. A negative Net working capital occurs when
current liabilities are in excess of current assets.
Net Working Capital = Current Assets - Current Liabilities
Definitions Favoring Net Working Capital Concept:-
According to C.W.Gestenbergh
"It has ordinarily been defined as the excess of current assets over current
liabilities".
According to Lawrence. J. Gitmen
" The most common definition of net working capital is the difference of firm's
current assets and current liabilities".
Classification of Working Capital
 (1) On the Basis of Concept: -
              (i) Gross Working Capital
              (ii) Net Working Capital
(2) On the Basis of time or Need:-
 (i) Permanent Working Capital
(ii) Temporary Working Capital
II. On the basis of time or need
(1) Permanent or Fixed Working Capital:-
The need for working capital fluctuates from time to
time.  However,  to  carry  on  day-to-day  operations of  the  business  without  
any obstacles, a certain minimum level of raw materials, work-in-progress,
finished goods and cash must be maintained on a continuous basis. The amount
needed to maintain current assets on this minimum level is called permanent or
regular working capital.
The  amount  involved as
permanent  working  capital  has  to  be  meet  from  long-term sources of
finance, e.g.
(i) Capital
(ii) Debentures
(iii) Long-term loans.
  (2) Temporary or Variable or Fluctuating Working  Capital:-
Depending upon the changes in production and sales, the need for working
capital, over and above the permanent level of working capital is called
temporary, fluctuating or variable working capital.  It may be two types:-
 (a)Seasonal-Due to seasonal changes, level of business activities is higher than
normal during some months of year and therefore additional working capital
will be required along with the permanent working capital.  It is so because
during peak season, demand rises and more stock is to be maintained to meet
the demand .
(b) Special- Additional doses of working capital may be required to face cut
throat competition in the market or other contingencies like strikes, lock outs,
theft etc.
ADEQUATE WORKING CAPITAL:
The firm should maintain a sound working capital
position.  It  should  have  adequate  working  capital  to run  its  business  opera
tions.  Both excessive as well as inadequate working capital positions are
dangerous from firm's point of view. Excessive working capital means holding
costs and idle funds which earn no profit for the firm. Paucity of working
capital not only impairs the firm's profitability but also results in production
interruptions and inefficiencies and sales disruption
Importance/Need/Advantage of Adequate Working Capital:
(1) Availability of Raw Materials Regularly:-
Adequacy  of  working  capital  makes  it possible  for a  firm
to  pay  the  suppliers  of raw  materials  on time. As  a  result it will
continue  to  receive  regular  supplies  of  raw  materials  and  thus  there  will  
be no disruption in production process.
(2) Full Utilization of Fixed Assets:-
Adequacy of working capital makes it possible for a firm to utilize its fixed
assets fully and continuously. For example, if there is inadequate stock of raw
material, the machines will not be utilized in full and their productivity will be
reduced.
(3) Cash Discount:-
A  firm  having  the  adequate  working  capital  can  avail  the  cash discount by
purchasing the goods for cash or by making the payment before the due date.
(4) Increase in Credit Rating:-
Paying its short-term obligations in time leads to a strong credit rating which
enables the firm to purchase goods on credit on favorable terms and to maintain
its line of credit with banks etc. it facilities the taking of loan in case of need.
5) Exploitation of Favorable Market conditions:-
Whenever  there  are
chances  of  increase  in  prices  of  raw  materials,  the  firm  can  purchase  suff
icient quantity if it has adequate of working capital. Similarly, if a firm receives
a bulk order for
the  supply  of goods  it  can  take  advantage  of  such  opportunity  if  it  has  s
ufficient working capital.
(6) Facility in Obtaining Bank Loans:-
Banks do not hesitate to advance even the unsecured loan to a firm which has
the sufficient working capital. This is because the excess of current assets over
current liabilities itself is a good security.
(7) Increase in Efficiency of Management:-
Adequacy of working capital has a favorable psychological effect on the
managers. This is because no obstacle arises in the day-to-day business
operations. Creditors, wages and all other expenses are paid on time and hence
it keeps the morale of manager’s high
(8) Ability to face crisis:-
Adequate working capital enables a concern to face business crisis in
emergencies such as depression. Because during such periods, generally, there
is much pressure on working capital.
(9) Solvency of the business:-
Adequate working capital helps in maintaining solvency of the business by
providing uninterrupted flow of production.
(10) Good will
Sufficient working capital enables a business concern to male prompt payments
and hence helps in creating and maintaining good will.
EXCESSIVE AND INADEQUATE WORKING CAPITAL:
A business enterprise should maintain adequate working capital according to the
needs of its business operations. The amount of working capital should neither
be excessive nor inadequate. If the working capital is in excess if its
requirements it means idle funds adding to the cost of capital but which earn
nom profits for the firm.  On the contrary, if the working capital is short of its
requirements, it will result in production interruptions and reduction of sales
and, in turn, will affect the profitability of the business adversely.
Disadvantage of Excessive Working Capital:-
(1) Excessive Inventory:-
Excessive working capital results in unnecessary accumulation of large
inventory. It increases the chances of misuse, waste, theft etc.
(2) Excessive Debtors:-
Excessive working capital will results  in  liberal  credit  policy which, in turn,
will results in higher amount tied up in debtors and higher incidence of bad
debts.
(3) Adverse Effect on Profitability:-
Excessive working capital means idle funds in the business which adds to the
cost of capital but earns no profits for the firm. Hence it has a bad effect on
profitability of the firm.
(4) Inefficiency of Management:-
Management becomes careless due to excessive resources at their command.  It
results in laxity of control on expenses and cash resources.
Disadvantage of Inadequate Working Capital:
(1) Difficulty in Availability of Raw-Material:-
Adequacy of working capital results in non-payment of creditors on time.  As a
result the credit purchase of goods on favorable terms becomes increasingly
difficult. Also, the firm cannot avail the cash discount.
(2) Full Utilization of Fixed Assets not Possible:
Due to the frequent interruption in the supply of raw materials and paucity of
stock, the firm cannot make full utilization of its machines etc.
(3) Difficulty  in  the  Maintenance  of  Machinery:
Due  to  the  inadequacy  of  working capital, machines are not cared and
maintained properly which results in the closure of production on many
occasions.
(4) Decrease in Credit Rating:
Because of inadequacy of working capital, firm is unable to pay its short-term
obligations on time. It decays the firm's relations with its bankers and it
becomes difficult for the firm to borrow in case of need.
 (5) Non Utilization of Favorable Opportunities:
For example, a firm cannot purchase sufficient quantity of raw materials in case
of sudden decrease in the prices. Similarly, if the firm receives a big order, it
cannot execute it due to shortage of working capital.
(6) Decrease  in  Sales:
Due  to  the  shortage  of  working  capital,  the  firm  cannot  keep sufficient
stock of finished goods. It results in the decrease in sales. Also, the firm will be
forced to restrict its credit sales. This will further reduce the sales.
(7) Difficulty in the Distribution of Dividends:
Because of paucity of cash resources, firm will not be able to pay the dividend
to its shareholders.
(8) Decrease in the Efficiency of Management:
It will become increasingly difficult for the management to pay its creditors on
time and pay its day-to-day expenses. It will also be difficult to pay the wages
regularly which will  have an adverse effect  on the morale of managers.
DETERMINANTS OF WORKING CAPITAL:
A firm should have neither too much nor too little working capital. A large
number of factors, each has a different importance, influencing working capital
needs of firms. The importance of factors also changes for a firm over time.
Therefore,  an  analysis  of  relevant  factors  should  be  made  in  order  to  det
ermine  total investment in working  capital.  The  following is the  description
of  factors  which generally influence the working capital requirements. The
working capital requirement is determined by  a  large  number of  factors
but,  in  general,  the  following  factors  influence  the  working capital needs of
an enterprise:
(1) Nature  of  Business  :-
Working  capital  requirements  of  an  enterprise  are  largely influenced by the
nature of its business. For instance, public utilities such as railways, transport,
water, electricity etc. have a very limited need for working capital because they
have invested fairly large amounts in fixed assets. Their working capital need is
minimal because they get immediate  payment for  their services and  do not
have to
maintain  big  inventories.  On  the  other  extreme  are  the trading  and  financi
al enterprises which have to invest fewer amounts in fixed assets and a large
amount in working capital. This is so because the nature of their business is
such that they have
to  maintain  a  sufficient  amount  of cash,  inventories  and  debtors.  Working  
capital needs of most of the manufacturing enterprises fall between these two
extremes, that is, between public utilities and trading concerns.
(2) Size of Business:-
Larger the size of the business enterprise, greater would be the need for working
capital. The size of a business may be measured in terms of scale of its business
operations.
(3) Growth and Expansion:-
As a business enterprise grows, it is logical to expect that a larger  amount
of  working  capital  will be  required. Growing  industries  require  more
working capital than those that are static.
(4) Production cycle:-
Production cycle means the time-span between the purchase of raw materials
and its conversion into finished goods. The longer the production cycle, the
larger will be the need for working capital because the funds will be tied up for
a longer period in work in process. If the production cycle is small, the need for
working capital will also be small.
(5) Business Fluctuations:-
Business fluctuations may be in the direction of boom and depression. During
boom period the firm will have to operate at full capacity to meet the increased
demand which in turn, leads to increase in the level of inventories and
book  debts.  Hence,  the  need  for  working  capital  in  boom  conditions  is  b
ound  to
increase.  The  depression phase  of  business  fluctuations  has  exactly  an  opp
osite effect on the level of working capital requirement.
(6) Production Policy:-
The need for working capital is also determined by production policy. The
demand for certain products (such as woolen garments) is seasonal. Two types
of production policies may be adopted for such products. Firstly, the goods may
be produced  in  the  months of  demand  and  secondly,  the goods  may
be  produces throughout the year. If the second alternative is adopted, the stock
of finished goods
will  accumulate  progressively  upto  the  season  of demand  which  requires  a
n increasing amount of working capital that remains tied up in the stock of
finished goods for some months.
(7) Credit  Policy Relating  to Sales:-
If a firm adopts liberal  credit  policy  in respect of sales, the amount tied up in
debtors will also be higher. Obviously, higher book debts mean more working
capital. On the other hand, if the firm follows tight credit policy, the magnitude
of working capital will decrease
(8) Credit Policy Relating to Purchase:-
If a firm purchases more goods on credit, the requirement for working capital
will be less. In other words, if liberal credit terms are
available  from  the  suppliers  of  goods  (i.e.,  creditors),  the  requirement  for  
working capital will be reduced and vice versa.
(9) Availability  of Raw  Material:-
If  the  raw  material  required  by  the  firm  is available easily on a continuous
basis, there will be no need to keep a large inventory of such materials and
hence the requirement of working capital will be less. On the other hand,  if the
supply of raw material is irregular, the firm will be compelled to keep an
excessive inventory of such raw materials which will result in high level of
working capital. Also, some raw materials are available only during a particular
season such as  oil seeds, cotton, etc. They would have to be necessarily
purchased in that season and have to be kept in stock for a period
when  supplies are  lean. This will require more working capital.
(10) Availability of Credit from Banks:-
If a firm can get easy bank facility in case of need,
it  will  operate  with  less  working  capital.  On  the  other  hand, if  such  facili
ty  is  not available, it will have to keep large amount of working capital.
(11) Volume of Profit:-
The net profit is a source of working capital to the extent it has been
earned  in  cash.  Higher  net  profit  would generate  more  internal  funds  there
by contributing the working capital pool.
(12) Level of Taxes:-
Full amount of cash profit is not available for working capital purpose. Taxes
have to be paid out of profits. Higher the amount of taxes less will be the profits
for working capital.
(13) Dividend Policy:-
Dividend policy is a significant element in determining the level of
working  capital  in  an  enterprise.  The  payment of  dividend  reduces  the  cas
h  and thereby, affects the working capital to that extent. On the contrary, if the
company does
not  pay  dividend  but  retains  the  profits,  more  would  be  the  contribution  
of  profits towards capital pool.
(14) Depreciation Policy:-
Although  depreciation  does  not  result  in  outflow  of  cash,  it affects the
working capital indirectly. In the first place, since depreciation is allowable
expenditure in  calculating  net profits, it  affects  the  tax liability.
In  the second  place, higher depreciation also means lower disposable profits
and, in turn, a lower dividend payment. Thus, outgo of cash is restricted to that
extent.
(15) Price  Level  Changes:-
Changes  in  price  level  also  affect  the  working  capital requirements. If the
price level is rising, more funds will be required to maintain the
existing  level  of  production.  Same  level  of  current  assets  will  need  increa
sed investment when  prices  are increasing.  However,  companies that
can  immediately their product prices with rising price levels will not face a
severe working capital problem. Thus, it is possible that some companies may
not be affected by rising prices while others may be badly hit.
(16) Efficiency of Management:-
Efficiency of management is also a significant factor to determine the level of
working capital. Management can reduce the need for working capital by the
efficient utilization of resources. It can accelerate the pace of cash cycle and
thereby use the same amount working capital again and again very quickly.

Unit 2

Working capital finance:-Working capital finance is business finance designed

to boost the working capital available to a business. It's often used for specific
growth projects, such as taking on a bigger contract or investing in a new
market.

Different businesses use working capital finance for a variety of purposes, but
the general idea is that using working capital finance frees up cash for growing
the business which will be recouped in the short- to medium-term.
There are many different types of lending that could be considered working
capital finance. Some are explicitly designed to help working capital (whatever
industry you’re in), while others are useful for specific sectors or requirements.
Here are some of the more common types of working capital finance.
ADVANTAGES OF WORKING CAPITAL FINANCE:-

1.Working Capital Importance

Working capital indicates how well you positioned your company to meet its
near-term cash needs. When your company has significantly more cash on hand
or receivables that readily convert to cash than you have debt principal
payments or payments to vendors, your risk of ceasing operations due to an
inability to pay your bills plummets. Working capital financing can eliminate
any gap between cash flowing into operations and cash flowing out.
2.Speed and Flexibility
One advantage of working capital financing is that most eligible companies can
obtain short-term loans, including accounts receivable credit lines, inventory
loans or bank lines of credit, in a short period of time. The loan amounts are
typically a fraction of revenues and are tied to assets that quickly convert to
cash. Working capital financing is generally flexible, with varying interest rates
and repayment terms. This flexibility can help companies with seasonal or
periodic fluctuations smooth out cash flow.
3.Short-Term Options
Accounts receivable credit lines and factoring, which occurs when your
company sells its receivables to a third party at a discount, directly tie to your
company's accounts receivables. As your company's revenues and associated
receivables grow, the credit line increases. As your company needs more
money, these working capital options make those funds available. These also
provide a viable choice for smaller or newer companies without the operational
history or balance sheet strength to qualify for a bank term loan or unsecured
line of credit.
4.Medium-Term Options
Your company can also finance working capital with a term loan. Short-term
working capital financing addresses cyclical needs throughout the fiscal year.
Mid-term working capital financing provides the funds to purchase additional
inventory and generate the receivables that increase working capital. For
companies with growth prospects over the next few years, this option provides
access to a steady stream of capital to cover gaps created by growth-related
expences.
SOURCE OF FINANCE

1.Accrued Expenses:
Accrued expenses are the expenses which have been incurred but not yet due
and hence not yet paid also. These simply represent a liability that a firm has to
pay for the services already received by it. The most important items of accruals
are wages and salaries, interest, and taxes.

Wages and salaries are usually paid on monthly, fortnightly or weekly basis for
the services already rendered by employees. The longer the payment-period, the
greater is the amount of liability towards employees or the funds provided by
them. In the same manner, accrued interest and taxes also constitute a short-
term source of finance.

Taxes are paid after collection and in the intervening period serve as a good
source of finance. Even income-tax is paid periodically much after the profits
have been earned. Like taxes, interest is also paid periodically while the funds
are used continuously by a firm. Thus, all accrued expenses can be used as a
source of finance.

The amount of accruals varies with the change in the level of activity of a firm.
When the activity level expands, accruals also increase and hence they provide
a spontaneous source of finance. Further, as no interest is payable on accrued
expenses, they represent a free source of financing.

However, it must be noted that it may not be desirable or even possible to

postpone these expenses for a long period. The payment period of wages and
salaries is determined by provisions of law and practice in industry.
Similarly, the payment dates of taxes are governed by law and delays may
attract penalties. Thus, we may conclude that frequency and magnitude of
accruals is beyond the control of managements. Even then, they serve as a
spontaneous, interest free, limited source of short-term financing.

2.Trade credit and terms:-Trade credit is a short-term credit facility extended

by suppliers of raw materials and other suppliers in the normal course of
business. It is a common and important source of financing. Either open account
credit or acceptance credit may be adopted. In the former as per business
custom credit is extended to the buyer, the buyer is not signing any debt
instrument as such. The invoice is the basic document. In the acceptance credit
system, a bill of exchange is drawn on the buyer who accepts and returns the
same. The bill of exchange evidences the debt. Trade credit is an informal and
readily available credit facility. It is unsecured. It is also flexible in the sense
that advance retirement or extension of credit period can be negotiated.
But trade credit may be costlier as the supplier may inflate the price to account
for the loss of interest for delayed payments, although this method of credit does
not involve explicit interest charge. If the company has liquidity difficulties, it
may be able to stretch accounts payable; however the company will be required
to give up any cash discount offered and accept a lower credit rating.

Example: 
A company buys $2,000 merchandise on terms of 2/10, net/30. It fails to take
the discount and pays the bill on the last due date. The cost of discount is: 

   Discount     X               360 days 
(1-Discount)     (credit period � discount period) 

=    0.02       X      360     =    0.367 or 36.7% 
    (1 - 0.02)     (30 - 10)
The company would be better off taking the discount even if it needed to
borrow the money from the bank, since the opportunity cost is 36.7%. The
interest rate on a bank loan would be far less.

The smaller the difference between the payment day and the end of the discount
period, the larger is the annual interest/cost of trade credit. To sum up, as the
cost of trade credit is generally very high beyond the discount period, firms
should avail of the discount on prompt payment. If, however, they are unable
to avail of the discount, the payment of trade credit should be delayed till the
last due date.

Features of Trade Credit:

The features of trade credit are given below:

1. There are no formal legal instruments/acknowledgements of debt.

2. It is an internal arrangement between the buyer and seller.

3. It is a spontaneous source of financing.

4. It is an expensive source of finance, if payment is not made within the

discount period.

Advantages of Trade Credit:

The advantages of trade credits are:

1. It is easy and automatic source of short-term finance.

2. It reduces the capital requirement.

3. It helps the business focus on core activities.

4. It does not require any negotiation or formal agreement.

5.Increased sales: A customer will buy more of a supplier's products if they
don't have to pay cash immediately for their purchases.
6.Customer loyalty: The extension of credit terms tells the buyer that the seller
considers them trustworthy and has confidence that they will pay their bills
when they're due. The buyer rewards the seller's vote of confidence by
continuing to make purchases.
7.Competitive advantage: A seller who is able to offer trade credit to buyers
has an advantage over his competitors, if they are not able to offer credit terms.
This makes sense. Naturally, a buyer wouldprefer to purchase on credit terms
than to pay cash for all of his purchases.

Disadvantages of Trade Credit:

1. Trade credit is available only to those companies that have a good track
record of repayment in the past.
2. For a new business, it is very difficult to finance working capital through
trade credit.
3. It is very expensive, if payment is not made on the due date.
4. Negative effect on cash flow: The most immediate effect of trade credit
is that sellers do not receive cash immediately for sales. Sellers have their
own bills to pay and extending credit terms to buyers creates a hole in
their companies' cash flow.
5. Must investigate creditworthiness of customers: Just like a bank, a
vendor who extends credit to customers needs to analyze their credit
ratings. This takes money and time. Obtaining business credit reports,
such as Dun & Bradstreet, cost money, and making calls to check on
references takes time. A vendor may need to hire an additional person
who has credit analysis skills to help make the decisions about extending
terms of payment.
6. Monitoring accounts receivable: Extending credit creates more
outstanding accounts receivable, and someone needs to monitor these
customers to make sure that they are paying on time. A company that is
making its sales in cash does not have this problem.
7. Financing accounts receivable: The extension of credit terms to buyers
means that the seller has to finance these receivables. A seller may have
to lean on his own suppliers to receive trade credit, borrow on his bank
 line of credit or use the company's accumulated retained earnings. All of
these methods have an inherent cost of capital.
8. Possibility of bad debts: Inevitably, the extension of trade credit will
lead to some buyers not paying their debts. When this happens, an
employee needs to spend time making collection calls to the late payers,
and, eventually, the seller may need to write off the unpaid receivables
and take a loss.

9. CASH FLOW MISMATCH AS THERE IS NO GUARANTEE OF

TIMELY PAYMENT
When a supplier provides credit to the buyer, the ball goes to the buyer’s court.
The supplier is completely dependent on the buyer’s willingness to pay. In
case the buyer delays the payment, the supplier may face cash flow mismatch
problems.

10.THE COST OF FUNDS INVESTED IN BOOK DEBTS /

ACCOUNTS PAYABLE
All suppliers invest their working capital into their debtors/ book debts/
accounts payable. The working capital extended by the bank is not free of cost.

11.THE COST OF CASH DISCOUNT

As part of encouragement to buyers for early payment, suppliers offer a
discount for early payment. This reduces their margins on the sales.

12.RUNNING SPECIAL DEPARTMENTS

Expenses for running special departments to manage trade credit say sales,
collection, legal etc are a cost to the supplier which would otherwise not take
place.

We conclude that there is a cost of trade credit and it should be quantified and to

our surprise, it can be quantified also.

TERMS OF PAYMENT / TRADE CREDIT POLICY

Terms of trade credit also known as terms of payment or trade credit policy.
Whatever name they are called with, but the terms should be followed
judiciously by both (creditors and buyers) to enjoy smooth workings and long
term relations. Buyers should release payment within the period specified and
creditors should encourage the buyer to abide by the agreed terms.

There are three main terms of trade credit viz

MAXIMUM CREDIT LIMIT

It is the maximum amount of credit which a customer is allowed. Suppose,
$5,000 is the limit and if the buyer has got one bill of $3,000, he will not be
allowed another bill of more than $2,000 without clearing dues in the previous
bill. The limit is determined by the creditor based on the credibility of the
customer, volume of its transactions, past payment track records, nature of
business etc.

CREDIT PERIOD
The credit cannot be allowed for an infinite time period. It is the maximum
period of time before which a buyer is expected to make payment. Beyond this
period, the creditor may ask for interest on the amount at the rate mentioned in
the terms of payment. The no. of days of credit is also determined in the similar
fashion like the limit of credit amount.

CASH DISCOUNT
It is the percentage of discount allowed by the creditor to the buyer to encourage
him to pay as early as possible. It is specified like ‘5%/10 net 30’. This means
1% discount is allowed till 10 days i.e. on a bill of $100, the buyer can pay $95
if pays within 10 days. He can pay a net amount of $100 till the 30 th day. If the
payment is made after 30 days, the creditor will charge interest on agreed rate.
STARTING DATE
The starting date is the date from which the credit period is started. It can be the
billing date, dispatch date, goods received date or any other agreed date. If a
buyer is given 45 days of credit, the days will be counted beginning from the
starting date.

3.Working Capital Finance by Commercial Banks:

Commercial banks are the most important source of short-term capital. The
major portion of working capital loans are provided by commercial banks. They
provide a wide variety of loans tailored to meet the specific requirements of a
concern.

The different forms in which the banks normally provide loans and
advances are as follows:
(a) Loans

(b) Cash Credits

(c) Overdrafts
(d) Purchasing and discounting of bills.

(a) Loans:
When a bank makes an advance in lump-sum against some security it is called a
loan. In case of a loan, a specified amount is sanctioned by the bank to the
customer. The entire loan amount is paid to the borrower either in cash or by
credit to his account. The borrower is required to pay interest on the entire
amount of the loan from the date of the sanction.

A loan may be repayable in lump sum or installments. Interest on loans is

calculated at quarterly rests and where repayments are stipulated in installments,
the interest is calculated at quarterly rests on the reduced balances. Commercial
banks generally provide short-term loans up to one year for meeting working
capital requirements. But now-a-days term loans exceeding one year are also
provided by banks. The term loans may be either medium-term or long- term
loans.

(b) Cash Credits:
A cash credit is an arrangement by which a bank allows his customer to borrow
money up to a certain limit against some tangible securities or guarantees. The
customer can withdraw from his cash credit limit according to his needs and he
can also deposit any surplus amount with him.

The interest in case of cash credit is charged on the daily balance and not on the
entire amount of the account. For these reasons, it is the most favourite mode of
borrowing by industrial and commercial concerns. The Reserve Bank of India
issued a directive to all scheduled commercial banks on 28th March 1970,
prescribing a commitment charge which banks should levy on the unutilized
portion of the credit limits.

(c) Overdrafts:
Overdraft means an agreement with a bank by which a current account-holder is
allowed to withdraw more than the balance to his credit up to a certain limit.
There are no restrictions for operation of overdraft limits. The interest is
charged on daily overdrawn balances. The main difference between cash credit
and overdraft is that overdraft is allowed for a short period and is a temporary
accommodation whereas the cash credit is allowed for a longer period.
Overdraft accounts can either be clean overdrafts, partly secured or fully
secured.

(d) Purchasing and Discounting of Bills:

Purchasing and discounting of bills is the most important form in which a bank
lends without any collateral security. Present day commerce is built upon credit.
The seller draws a bill of exchange on the buyer of goods on credit. Such a bill
may be either a clean bill or a documentary bill which is accompanied by
documents of title to goods such as a railway receipt.

The bank purchases the bills payable on demand and credits the customer’s
account with the amount of bill less discount. At the maturity of the bills, bank
presents the bill to its acceptor for payment. In case the bill discounted is
dishonoured by non-payment, the bank recovers the full amount of the bill from
the customer along with expenses in that connection. In addition to the above
mentioned forms of direct finance, commercial banks help their customers in
obtaining credit from their suppliers through the letter of credit arrangement.

Letter of Credit:
A letter of credit popularly known as L/c is an undertaking by a bank to honour
the obligations of its customer up to a specified amount, should the customer
fail to do so. It helps its customers to obtain credit from suppliers because it
ensures that there is no risk of non-payment. L/c is simply a guarantee by the
bank to the suppliers that their bills up to a specified amount would be
honoured. In case the customer fails to pay the amount, on the due date, to its
suppliers, the bank assumes the liability of its customer for the purchases made
under the letter of credit arrangement.

A letter of credit may be of many types, such as:

(i) Clean Letter of Credit:
It is a guarantee for the acceptance and payment of bills without any conditions.

(ii) Documentary Letter of Credit:

It requires that the exporter’s bill of exchange be accompanied by certain
documents evidencing title to the goods.

(iii) Revocable Letter of Credit:

It is one which can be withdrawn by the issuing bank without the prior consent
of the exporter.

(iv) Irrevocable Letter of Credit:

It cannot be withdrawn without the consent of the beneficiary.

(v) Revolving Letter of Credit:

In such type of letter of credit the amount of credit it automatically reversed to
the original amount after such an amount has once been paid as per defined
conditions of the business transaction. There is no need for further application
for another letter of credit to be issued provided the conditions specified in the
first credit are fulfilled.

(vi) Fixed Letter of Credit:

It fixes the amount of financial obligation of the issuing bank either in one bill
or in several bills put together.

Features of Bank Loans:

Bank loans have the following characteristics:
1. It is a short-term source of finance.

2. A bank loan may be either secured or unsecured depending upon the

circumstances.

3. The interest charged by the bank on such a loan may be either fixed or
variable.

4. If mortgage loan is to be obtained, the borrower has to pay a number of fees

such as title searching fees, application fees, inspection fees, etc.

Advantages of Bank Loans:

Bank loans offers the following advantages:
1. They can be easily procured.

2. They can be used for short-term as well as medium-term financing.

3. Interest paid on a bank loan is a tax deductible expenditure.

Disadvantages of Bank Loans:

i. Some bank loans carry prepayment penalty.

ii. Borrowing too much as a bank loan can lead to decreased cash flow.

iii. In most cases, the bank does not disburse the whole amount of loan applied
for, it pays cash lower than the loan demanded.

Regulation of Bank Finance

The regulation of bank finance was developed in order to cope with the
problems that came up due to over borrowing of working capital by a particular
business sector while the other sector was being deprived. This happened
mainly because the working capital for the finance was readily available and it
was convenient for the firms to go for the loan.
As a result of which one segment of the industry used to avail the cash more
frequently than the other segments. The market was facing the problem of
disproportionate allocation of capital. In order to bring a discipline among the
borrowers, it was necessary to come up with some regulations from the central
bank.
Since the mid 1960s, the Reserve Bank of India (RBI) has been trying to
formulate some regulations so that the credit allocation can be done on the basis
of priority sectors. On the basis of the recommendations made by various
committees, the RBI developed a number of directives and guidelines on the
regulation of bank finance.
But now when the country is going through financial liberalization, the RBI has
provided much free hand to the commercial banks on the working capital
financing.
The grounds on which the RBI has announced a number of guidelines and
regulations are: 
Maximum Permissible Finance by Bank
The three methods for calculating the maximum permissible bank finance
(MPBF) given by the RBI are
Method 1:
MPBF = 0.75 (CA – CL)
Method 2:
MPBF = 0.75 CA – CL
Method 3:
MPBF = 0.75 (CA – CCA) – CL
Where
CA means current asset according to the given norms
CL means non-bank current liabilities
CCA means core current assets .

Receivables and Inventory Norms

The RBI suggested some norms for the fifteen prime industries of the country.
These norms give the measure of maximum level of holding receivables or
inventory in a certain period.

Reporting and Information System

The reporting and information system was given in order to strengthen the
banker and borrower partnership and also giving the bankers a fair knowledge
on the borrower’s requirements.
Forms of Assistance
Traditionally the bank credit system is based on cash credit. Hence the banks
need to maintain cash management responsibility because the borrowers can
withdraw cash within the bank’s cash credit limit. In 1995 a system on the bank
credit delivery was introduced. According to this, the banks have to restrict the
cash credit limit sanction of the borrowers.
Credit Monitoring
According to this, the RBI carries out the scrutiny of the sanctioned loan when
the banks provide the loan beyond the specified cut off level of working capital
limit.

4.Public Deposits:- One of the important sources of finance to trading and

manufacturing companies in India has been public deposits. Generally
companies opt for this method of financing rather than debenture or debt
financing since they offer attractive rates of interest.
Investors show more interest in public deposits rather than depositing their
funds in commercial banks as borrowing from banks requires strict compliance
of certain conditions and formalities etc. Sufficient securities should also be
offered. The rate of interest is also high. These complications are not there in
case of public deposits.

Advantages of Public Deposits

1. Lower Rate of Interest

Public deposits are beneficial to the company as it receives funds at a lower rate
of interest when compared to the rates charged by commercial banks and
financial institutions.

2. Low Administration Costs

Cost of administering public deposits is lower when compared to the issue of
debentures. The company has to fulfill fewer formalities and follow a simple
procedure. It receives money and issues only a deposit receipt to every
depositor and nothing more.

3. Facilitates trading on Equity

Public deposits help in trading on equity if the company is earning more than
the rate of interest paid on the deposits. The excess profit shall go to the equity
holders. At the same time, their control over the company is also not diluted.

4. Unsecured
Public deposits are generally unsecured. The company need not create any
charge over its assets. Hence, its borrowing capacity is not affected.

5. Flexible
Public deposits facilitates flexibility in the financial planning. The deposits can
be paid back any time, when there is no further need for retaining the fund.
Thus, it is a convenient method to avoid over capitalization.
6. No legal formalities:
This system of raising finance is simple as it does not involve legal formalities
which are required in the issue of shares and debentures.

7. Economical:
It is economical because the interest paid on deposits is usually less than the
interest rate charged by banks and special financial institutions in advancing
money. Moreover deposits are returned whenever their need is not felt.

8. Higher dividends:
The company can adopt the policy of trading on equity, if the company is
earning more than the rate of interest to its public deposits. The company can
pay higher dividend to its shareholders and create better reputation in the
market.

9. No charge on the assets of the company:The public deposits are not secured
by any charge on the assets of the company. The company can use its assets as
security for raising loans from other sources like commercial banks and
financial institutions.
10. No loss of control:
The company can go ahead with its expansion plans, as depositors have no right
to interfere in the affairs of the company.

11. Method of Using the Funds:

Deposits are generally used for the purposes for which the companies cannot get
credit from elsewhere i.e. either from the commercial banks or from financial
institutions. Besides no questions are asked about their use.

12. Elasticity in the capital structure:

The capital structure of a company can be kept flexible. If a company is over-
capitalised, a part of the deposits can be returned. Similarly, when the need
arises, additional finance can also be raised without any difficulty.

Disadvantages of Public Deposits

1. Unreliable Source:- This method is not reliable because it is difficult to
predict whether the company can procure such deposits to the desired level.
Such deposits are termed “Fair weather friend” The depositors may not respond
favorably when the conditions of the company are not satisfactory. Similarly,
new companies cannot depend on this source of finance.

2. Interest of the Investors

The interest of the depositors is not fully protected. These depositors are
unsecured and no charge is created over the assets of company. Moreover, the
management very often uses these funds for non-productive purposes. In the
event of failure of the company, the depositors have no assurance of getting
their money back.

3. Threat to Bank Resources

An uncontrollable growth of company deposits should be viewed with great
concern. It diverts the bank resources to the non-banking sector. It also poses a
threat not only to bank deposits but also to the credit planning and effective
monetary policy.
In fact, the RBI has substantially failed to implement its general policy of credit
restraint and enforcement of selective credit control only due to the sudden spurt
of the company deposits.

4. Distortion of Plan Priorities

These deposits even distort the plan priorities for credit allocation and blunt the
edge of monetary policy specially the dear money policy. They frustrate even
the very object of reducing the sectoral and regional imbalances and also
develop disparities between sectors and regions.

5. Unhealthy Trend in the Capital Market

Such deposits also create unhealthy trends in the capital market. There are
numerous rates of interest offered by different companies. This is detrimental to
the development of the capital market.

6. Fair-Weather Friends:
Public deposits are termed as fair-weather friends. They are quite uncertain in
periods of depression. Depositors may withdraw their funds when they
visualise, even on false grounds, the shaking position of the company. It may
cause great inconvenience to the companies.

7. Heavy Risk of Depositors:

The depositors pay the money to the firm only on its credit and goodwill. There
is neither any backing nor security against the amount advanced. We find that in
many cases the firms go in liquidation 01 declare themselves insolvent with the
result that the depositors find themselves unable to get back their money.

8. Encourages Speculation:
People who are the in charge of concern with the help of surplus deposits begin
to indulge in speculative business. They tempt the management to indulge in
overtrading which may endanger the savings of the investors.

9. Effects on Credit Policy:

Public debts very adversely affect the credit policy of Reserve Bank of India.
The Reserve Bank of India, in consultation with the Government formulates
certain credit policies, which it is felt, will be in the overall interest of the
country. But when credit is available through public debts, this credit policy as
formulated by the Government or Reserve Bank of India is adversely affected.

10. Difficulty in Repayment:

When companies utilise the deposits to finance their capital expenditure, the
money is blocked up and it becomes very difficult for the company to repay it
for a long period.

5.Inter-corporate Deposits (ICDs)?

Inter Corporate Deposits indicates unsecured short term funding raised by one
company from another company. They are dependent on personal contacts.
Inter-company deposit is the deposit made by a company that has surplus funds,
to another company for a maximum of 6 months. It is a source of short-term
financing.

Following are their main characteristics:

1) They are for a very short period of time i.e 3 months or 6 months.

2) They are unsecured source for raising funds.

3) They are not regulated by any law.

4) It is a relationship based borrowing made by the company.

5) They involve high risk and high returns

6) Useful in solving temporary capital crisis.

7) It is a popular source of short-term finance.

8). Procurement procedure is simple.

9). The rate of interest on such deposits is not fixed. It depends upon the amount
involved and the tenure of lending.

10). It is uncertain source of finance, as deposit can be withdrawn any time—so

it is risky also.

Types:
1. Call Deposit:
Such a type of deposit is withdrawn by the lender by giving a notice of one day.
However, in practice, a lender has to wait for at least 3 days.

2. Three-month Deposit:
As the name suggests, such type of a deposit provides funds for three months to
meet up short-term cash inadequacy.

3. Six-month Deposit:
The lending company provides funds to another company for a period of six
months.

Advantages of Inter-company Deposits:

i. Surplus funds can be effectively utilized by the lender company.

ii. Such deposits are secured in nature.

iii. Inter-corporate deposits can be easily procured.

Disadvantages of Inter-company Deposits:

i. A company cannot lend more than 10 per cent of its net worth to a single
company and cannot lend beyond 30 per cent of its net worth in total.
ii. The market for such source of financing is not structured.

6.Rights Debenture for Working Capital

Akin to promissory notes, debentures are instruments for raising long term debt
capital. Debentures holders are the creditors of the company. The obligation of
the company towards its debenture holders is similar to that of a borrower who
promises to pay interest and capital at specified times.

Features
1.Trustee:- When a debenture issue is sold to the investing public, a trustee is
appointed through a deed. The trustee is usually a bank or an insurance
company or a reputable firm of attorneys. Entrusted with the role of protecting
the interest of debenture holders, the trustee is responsible to ensure that the
borrowing firm fulfills its contractual obligations.
2.Security Debentures :-are typically secured by a charge on the immovable
properties, both present and future, of the company by way of an equitable
mortgage, which is effected by deposit of the title deeds relating to mortgaged
assets in favour of the trustees. Debentures not protected by any security are
called unsecured or naked debentures.
3.Redemption Debentures are generally redeemable-perpetual debentures are
very rare. The redemption takes place in a pre specified manner. Typically, it
occurs between the 5th year and the 9th year. Companies are now required to
create a debenture redemption reserve to facilitate timely redemption. A major
requirement is that the company should create a Debenture Redemption Reserve
equivalent to 50 per cent of the amount of debenture issue before debenture
redemption commences.
4.Interest payment on debentures:
The interest payment on debentures is a fixed obligation, irrespective of the
financial situation of the issuing firm. Typically payable semi-annually, it is a
tax-deductible expense.

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 working capital requirements. The key guidelines applicable to such
debentures are as follows
 The amount of the debenture issue should not exceed (a) 20 percent of the
gross current assets, loans and advances minus the long-term funds
presently available for financing working capital, or (b) 20 per cent of the
paid-up share capital, including preference capital and free reserves,
whichever is the lower of the two.
 The debt: equity ratio, including the proposed debenture issue, should not
exceed 1:1.
 The debentures shall first be offered to the existing Indian resident
shareholders of the company on a pro rata basis.

7.Commercial Paper:
Commercial paper represents unsecured promissory notes issued by firms to
raise short-term funds. It is an important money market instrument in advanced
countries like U.S.A. In India, the Reserve Bank of India introduced
commercial paper in the Indian money market on the recommendations of the
Working Group on Money Market (Vaghul Committee).

But only large companies enjoying high credit rating and sound financial health
can issue commercial paper to raise short-term funds. The Reserve Bank of
 India has laid down a number of conditions to determine eligibility of a
company for the issue of commercial paper. Only a company which is listed on
the stock exchange, has a net worth of at least Rs 10 crores and a maximum
permissible bank finance of Rs 25 crores can issue commercial paper not
exceeding 30 per cent of its working capital limit.

The maturity period of commercial paper, in India, mostly ranges from 91 to

180 days. It is sold at a discount from its face value and redeemed at face value
on its maturity. Hence, the cost of raising funds, through this source, is a
function of the amount of discount and the period of maturity and no interest
rate is provided by the Reserve Bank of India for this purpose.

Commercial paper is usually bought by investors including banks, insurance

companies, unit trusts and firms to invest surplus funds for a short-period. A
credit rating agency, called CRISIL, has been set up in India by ICICI and UTI
to rate commercial papers.

Commercial paper is a cheaper source of raising short-term finance as compared

to the bank credit and proves to be effective even during period of tight bank
credit. However, it can be used as a source of finance only by large companies
enjoying high credit rating and sound financial health. Another disadvantage of
commercial paper is that it cannot be redeemed before the maturity date even if
the issuing firm has surplus funds to pay back.

Features of Commercial Paper

1. Commercial paper is a short-term money market instrument comprising

usince promissory note with a fixed maturity.
2. It is a certificate evidencing an unsecured corporate debt of short term
maturity.
3. Commercial paper is issued at a discount to face value basis but it can be
issued in interest bearing form.
4. The issuer promises to pay the buyer some fixed amount on some future
period but pledge no assets, only his liquidity and established earning power,
to guarantee that promise.
5. . It is a negotiable instrument.
6. . It is an unsecured instrument as it is not backed by any assets of the
company.
7. . It can be sold by the issuing company, directly to the investors.

Advantages of Commercial Paper

 Simplicity: The advantage of commercial paper lies in its simplicity. It

involves hardly any documentation between the issuer and investor.
 Flexibility: The issuer can issue commercial paper with the maturities
tailored to match the cash flow of the company.
 Easy To Raise Long Term Capital: The companies which are able to
raise funds through commercial paper become better known in the financial
world and are thereby placed in a more favorable position for rising such long
them capital as they may, form time to time,  as require. Thus there is in
inbuilt incentive for companies to remain financially strong.
 High Returns: The commercial paper provides investors with higher
returns than they could get from the banking system.
 Movement of Funds: Commercial paper facilities securitization of loans
resulting in creation of a secondary market for the paper and efficient
movement of funds providing cash surplus to cash deficit entities.

1) It is quick and cost effective way of raising working capital.

2) Best way to the company to take the advantage of short term interest
fluctuations in the market

3) It provides the exit option to the investors to quit the investment.

4) They are cheaper than a bank loan.

5) As commercial papers are required to be rated, good rating reduces the cost
of capital for the company.

6) It is unsecured and thus does not create any liens on assets of the company.

7) It has a wide range of maturity

8) It is exempt from federal SEC and State securities registration requirements.

Disadvantages of commercial papers:

1) It is available only to a few selected blue chip and profitable companies.

2) By issuing commercial paper, the credit available from the banks may get
reduced.

3) Issue of commercial paper is very closely regulated by the RBI guidelines.

4)Only financially secure and highly rated organizations can raise money
through commercial papers. New and moderately rated organizations are not in a
position to raise funds by this method.

5)The amount of money that we can raise through commercial paper is limited
to the deductible liquidity available with the suppliers of funds at a particular
time.

6)Commercial paper is an odd method of financing. As such if a firm is not in a

position to redeem its paper due to financial difficulties, extending the duration
of commercial paper is not possible.

Objectives of issue of Commercial Papers :

1) To enable highly rated corporate borrowers to diversify their sources of
short-term borrowings.

2) To provide an additional instrument to investors.

They can be issued by Corporates, primary dealers and the All India Financial
Institutions.

All companies are not allowed to issue these papers. Those corporate bodies
which can meet the following criteria may issue CP :

A) The tangible net worth of the company, as per the latest audited balance
sheet, is not less than Rs. 4 crores.

B) company has been sanctioned working capital limit by banks or All-India

financial institutions

C) the borrowal account of the company is classified as a Standard Asset by the

financing banks or institutions.

Who can invest ?

1)Individuals
2)Banking companies

3)Other corporate bodies registered/incorporated in India

4)Unincorporated bodies

5)Non-resident Indians (NRIs)

6) Foreign institutional investors (FIIs) within overall limit set by SEBI

y banks or All-India financial institutions

C) the borrowal account of the company is classified as a Standard Asset by the

financing banks or institutions.

8.WHAT IS FACTORING?
Factoring is a financial arrangement which involves sale of accounts
receivable of a business to another party (called ‘factor’) at a discount. It
facilitates the seller to have immediate cash flows which would have otherwise
occurred to him at a later date. There are various advantages and
disadvantages of factoring which are listed below: Factoring or Accounts
Receivable Credit:
Another method of raising short-term finance is through accounts receivable
credit offered by commercial banks and factors. A commercial bank may
provide finance by discounting the bills or invoices of its customers.

Thus, a firm gets immediate payment for sales made on credit. A factor is a
financial institution which offers services relating to management and financing
of debts arising out of credit sales. Factoring is becoming popular all over the
world on account of various services offered by the institutions engaged in it.

Factors render services varying from bill discounting facilities offered by

commercial banks to a total takeover of administration of credit sales including
maintenance of sales ledger, collection of accounts receivables, credit control
and protection from bad debts, provision of finance and rendering of advisory
services to their clients. Factoring may be on a recourse basis, where the risk of
bad debts is borne by the client, or on a non-recourse basis, where the risk of
credit is borne by the factor. At present, factoring in India is rendered by only a
few financial institutions on a recourse basis. However, the Report of the
Working Group on Money Market (Vaghul Committee) constituted by the
Reserve

Bank of India has recommended that banks should be encouraged to set up

factoring divisions to provide speedy finance to the corporate entities.

In-spite of many services offered by factoring, it suffers from certain

limitations. The most critical fall outs of factoring include;

(i) The high cost of factoring as compared to other sources of short-term

finance,

(ii) The perception of financial weakness about the firm availing factoring
services, and

(iii) Adverse impact of tough stance taken by factor, against a defaulting buyer,
upon the borrower resulting into reduced future sales.

Salient Features of Factoring:

(i) Credit Cover:
The factor takes over the risk burden of the client and thereby the client’s credit
is covered through advances.

(ii) Case advances:

The factor makes cash advances to the client within 24 hours of receiving the
documents.

(iii) Sales ledgering:

As many documents are exchanged, all details pertaining to the transaction are
automatically computerized and stored.

(iv) Collection Service:

The factor, buys the receivables from the client, they become the factor’s debts
and the collection of cheques and other follow-up procedures are done by the
factor in its own interest.

(v) Provide Valuable advice:

The factors also provide valuable advice on country-wise and customer-wise
risks. This is because the factor is in a position to know the companies of its
country better than the exporter clients.

ADVANTAGES OF FACTORING

1.IMMEDIATE CASH INFLOW

This type of finance shortens the cash collection cycle. It provides swift
realization of cash by selling the receivables to a factor. Availability of liquid
cash sometimes becomes a deciding factor for grabbing an opportunity or losing
it. The cash boost provided by factoring is readily available for capital
expenditures, securing a new order or meeting an unforeseen condition.

2.ATTENTION TOWARDS BUSINESS OPERATIONS AND GROWTH

By selling off invoices, business managers can feel stress-free of the task of
collection from the customers. Resources employed in the receivables
department can be directed towards business operations, financial planning, and
future growth.

3.EVASION OF BAD DEBTS

Factoring is of two types – with recourse and without recourse. Under
without recourse factoring, in case of bad debts, the loss is borne by the factor.
Hence, the seller is under no obligation to the factor once it sells off its
receivables.
4.SPEEDY ARRANGEMENT OF FINANCE
Factors provide funds more rapidly than banking companies. Factoring
companies offer quicker application, lesser documentation and swifter
realization of funds as compared to other financial institutions.
5.NO REQUIREMENT OF COLLATERAL
The advances are extended on the basis of the strength of accounts receivables
and their credit healthiness. Unlike cash credit & overdraft, factors do not
require any collateral security to be pledged/hypothecated. New businesses,
startups can easily avail the advances provided they have strong receivables.
6.SALE NOT LOAN
Factoring transaction is a transaction of sale, not a loan. Unlike other types of
finances, factoring does not result in an increase in liabilities of the business.
Hence, there are no adverse impacts on the financial ratios as well. It just
involves the conversion of book debts into liquid cash.

7.CUSTOMER ANALYSIS
Factors provide valuable advice and insights to the seller regarding the credit
strength of the party from whom receivables are pending. It helps in negotiating
better terms between the parties in future contracts.

DISADVANTAGES OF FACTORING

1.REDUCTION OF PROFIT
The factor deducts a certain discount from the value of accounts receivable as
fees for the services offered. Moreover, in certain cases, the factor also charges
interest on the advance made. Consequently, profit of an entity is reduced by a
significant margin.

2.RELIABILITY OF CUSTOMER’S CREDIT

The factor assesses and evaluates credit wellness of the party who owes bills
receivables. This is a critical factor which is outside the control of the seller. A
factor may refuse to extend advances due to poor credit ratings of the concerned
party.

3.EXHAUSTING OF COLLATERAL SECURITY

Factoring exhaust bills receivables of an entity as the entity is no longer entitled
to receive payments from them. The seller is no longer holding any control over
the book debts. Hence, they can not be provided as collateral security while
obtaining any other type of finance.

4.PRESENCE OF CONTINGENT LIABILITY

The liability of the seller is not completely waived in case of with recourse
factoring. If a party fails to pay its debts to the factor, the factor is legally
entitled to recover it from the seller. Thus, the seller is contingently liable to the
factor for paying the debts in future in case of default. This situation would
impact business operations and financial plans which are under execution.

5.HIGHER FINANCE CHARGES

Factors usually deduct 2% to 4% of the total amount involved as their fees for
the duration of 45-60 days. Computing it annually, the cost of finance turns out
to be around 18% to 24% p.a. which is very higher than other sources of
finance.
6.LOSS OF PERSONAL TOUCH
The buyer may not be willing to deal with a factor because of their professional
nature and stringent methods. Factoring agencies even send notices at regular
intervals to the buyer as a reminder of the debt. The buyer may develop a
negative image of the seller through factoring. Loss of personal touch may lead
him to consider switching vendors.

Types of Factoring:
The types of factoring are discussed below:
(i) Recourse Factoring

(ii) Non-Recourse Factoring

(iii) Advance Factoring

(iv) Confidential and Undisclosed Factoring

(v) Maturity Factoring.

(vi) Supplier Guarantee Factoring

(vii) Bank Participation Factoring

The detail about the Types of Factoring is as follows:

(i) In Recourse factoring the credit risk remains with the client though the debt
is assigned to the factor, i.e., the factor can have recourse to the client in the
event of non-payment by the customer.

(ii) The Non-Recourse Factoring also called as ‘Old-line factoring’. It is an

arrangement whereby he factor has no recourse to the client when the bill
remains unpaid by the customer. Thus, the risk of bad debt is absorbed by the
factor.
(iii) Where the payment is made by the factor immediately is called Advance
Factoring Under this type of factoring, the factor provides financial
accommodation apart from non-financial services rendered by him.

(IV) In confidential and undisclosed factoring the arrangement between the

factor and the client are left un-notified to the customers and the client collects
the bills from the customers without intimating them to the factoring
arrangements.

(v) In maturity factoring method, the factor may agree to pay an amount to
the client for the bills purchased by him either immediately or on maturity. The
later refers to a date agreed upon on which the factor pays the client.

(vi) Supplier Guarantee Factoring is also known as ‘drop shipment factoring’.

This happens when the client is a mediator between supplier and customer.
When the client is a distributor, the factor guarantees the supplier against the
invoices raised by the supplier upon the client and the goods may be delivered
to the customer. The client thereafter raises bills on the customer and assigns
them to the factor. The factor thus enables the client to make a gross profit with
no financial involvement at all.

(vii) In bank participation factoring the bank takes a floating charge on the
client’s equity i.e., the amount payable by the factor to the client in .respect of
his receivables. On this basis, the bank lends to the client and enables him to
have double financing.

Steps Involved in Factoring:

The steps involved in factoring are discussed below:
Step I. The customer places an order with the seller (the client).
 Step II. The factor and the seller enter into a factoring agreement about the
various terms of factoring.

Step III. Sale contract is entered into with the buyer and the goods are delivered.
The invoice with the notice to pay the factor is sent along with.

Step IV. The copy of invoice covering the above sale is sent to the factors, who
maintain the sales ledger.

Step V. The factor prepays 80% of the invoice value.

Step VI. Monthly Statements are sent by the factor to the buyer.

Step VII. If there are any unpaid invoices follow up action is initiated.

Step VIII. The buyer settles the invoices on expiry of credit period allowed.

Step IX. The balance 20% less the cost of factoring is paid by the factor to the
client.

Tandon Committee
The next committee was appointed Tandon Committee 1975, in an intention of
granting loans and advances to the industry on the need basis through the study
of the development proceeds only in order to improve the weaker section of the
people.

Findings of the Committee

1. The bank should not reveal this much only to lent to the requirements of
the firm in accordance with lending policy, in spite of that the banks were
expected to lend to the tune of firm's requirement.
2. It should be treated as supplementary source of finance but not as major
source of finance
3. Loans were lent only in accordance on the basis of the securities
produced by the borrower but not on basis of level of operations
4. Security compliance wont provide any safety to the banks but the
periodical follow up only should facilitate the banker to get back the amount
of loans and advances lent
Recommendations: It reached the land mark in studying the need of the
industries towards the requirements of the working capital. The committee has
submitted its report on 9th Aug, 1975 by studying the lending policies.
1. Necessary information about the future operations are to be supplied
2. The supporting current assets should be shown to the banker at the
moment of borrowing
3. The bank should understand that the bank credit is only for the purposes
to meet out the needs of the borrower but not for any other.

Tandon Committee Report:

Reserve Bank of India set up a committee under the chairmanship of Shri P.L.
Tandon in July 1974. The terms of reference of the Committee were:
(1) To suggest guidelines for commercial banks to follow up and supervise
credit from the point of view of ensuring proper end use of funds and keeping a
watch on the safety of advances;

(2) To suggest the type of operational data and other information that may be
obtained by banks periodically from the borrowers and by the Reserve Bank of
India from the leading banks;

(3) To make suggestions for prescribing inventory norms for the different
industries, both in the private and public sectors and indicate the broad criteria
for deviating from these norms ;

(4) To make recommendations regarding resources for financing the minimum

working capital requirements;

(5) To suggest criteria regarding satisfactory capital structure and sound

financial basis in relation to borrowings;
(6) To make recommendations as to whether the existing pattern of financing
working capital requirements by cash credit/overdraft system etc., requires to be
modified, if so, to suggest suitable modifications.

The committee was of the opinion that:

(i) Bank credit is extended on the amount of security available and not
according to the level of operations of the customer,

(ii) Bank credit instead of being taken as a supplementary to other sources of

finance is treated as the first source of finance.

Although the Committee recommended the continuation of the existing cash

credit system, it suggested certain modifications so as to control the bank
finance. The banks should get the information regarding the operational plans of
the customer in advance so as to carry a realistic appraisal of such plans and the
banks should also know the end-use of bank credit so that the finances are used
only for purposes for which they are lent.

The recommendations of the committee regarding lending norms have been

suggested under three alternatives. According to the first method, the borrower
will have to contribute a minimum of 25% of the working capital gap from
long-term funds, i.e., owned funds and term borrowing; this will give a
minimum current ratio of 1.17: 1.

Under the second method the borrower will have to provide a minimum of 25%
of the total current assets from long-term funds; this will give a minimum
current ratio of 1.33: 1. In the third method, the borrower’s contribution from
long-term funds will be to the extent of the entire core current assets and a
minimum of 25% of the balance current assets, thus strengthening the current
ratio further.
 Chore Committee Report 1979
This committee especially constituted only for the purpose to study the
sanctionable limits of the banker and the extent of the loan amount utilization of
the borrower. The another purpose of the committee to appoint that to provide
the alternate ways and means to afford credit facility to the industries to
enhance the productive activities in the country.
1. Continuance of the existing three system of credits by the banker viz
cash credit, loans and bills
2. No need to bifurcate the cash credit accounts of the borrower for the
implementation of the differential rate of interest
3. According to the specifications of the borrower, the banker should come
to one conclusion which in normal peak level and non peak level of
operations only to the tune of operations
4. No frequent sanction of ad hoc limits of borrowing from the banker
5. The overdependence on the bank credit should be lessened among the
practices of the industrialists through emphasizing the need of term finance.

Chore Committee Report:

The Reserve Bank of India in March, 1979 appointed another committee under
the chairmanship of Shri K.B. Chore to review the working of cash credit
system in recent years with particular reference to the gap between sanctioned
limits and the extent of their utilization and also to suggest alternative type of
credit facilities which should ensure greater credit discipline.

The important recommendations of the Committee are as follows:

(i) The banks should obtain quarterly statements in the prescribed format from
all borrowers having working capital credit limits of Rs 50 lacs and above.

(ii) The banks should undertake a periodical review of limits of Rs 10 lacs and
above.

(iii) The banks should not bifurcate cash credit accounts into demand loan and
cash credit components.

(iv) If a borrower does not submit the quarterly returns in time the banks may
charge penal interest of one per cent on the total amount outstanding for the
period of default.

(v) Banks should discourage sanction of temporary limits by charging additional

one per cent interest over the normal rate on these limits.

(vi) The banks should fix separate credit limits for peak level and non-peak
level, wherever possible.

(vii) Banks should take steps to convert cash credit limits into bill limits for
financing sales.

1980 were as under:

(a) Annual Revenue of Accounts:
Bearing in mind the information that the system of cash credit cannot be totally
replaced by any other lending system, the RBI felt the necessity of streamlining
the system with regular periodical reviews of limits in order to verify the
continued viability of borrowers and for assessing the need-based character of
their limits.
All scheduled banks are required to review accounts of the borrowers having
working capital limits of Rs 10 lakhs and over at least once in a year. If the
borrowers’ limit exceeds by Rs. 50 lakhs and over, they are required to submit
quarterly statement for the purpose.

(b) Bifurcation of Accounts Discontinued:

The RBI withdrew its past directives which were issued to the scheduled banks
requiring them to bifurcate the cash credit accounts into demand loan, cash
credit components and charging differential interest rates. If the accounts are
already bifurcated, the differential rates are to be abolished as an immediate
effect.

The RBI indicated the following four measures that are applicable on all the
borrowers having total working capital limits of Rs. 50 lakhs and over.

(i) Peak Level and Non-Peak Level Limits:

Banks are to fix separate credit limits for the borrowers according to the normal
peak level and non-peak level as far as possible which are to be selected on the
basis of past performances of the borrowers and the utilization of such limits. At
the same time, the period for which the borrowings are to be utilized is to be
specified.

For agriculture based industries and consumer goods industries, separate limits
are to be fixed since they have seasonal demand of their products and for others,
only one limit is to be fixed by the banks

(ii) Withdrawals of Funds:

After sanctioning the credit limit, the borrower must indicate, before the com-
mencement of each quarter, his expected requirements of funds in the said
quarter. Such limits are known as operating limit. It is expected that borrower
must withdraw funds from bank within the operating limit in that particular
quarter subject to a tolerance limit of 10% either way.

That is, if a borrower withdraws any amount which is more than or less than
that tolerance limit, the same is considered as irregularity in the account and as
a consequence, bank should take corrective steps in order to avoid such
repetition of irregularity of funds in future which is actually the product of
defective planning of the borrower.

(iii) Temporary Limits:

Banks must be very careful about the request made by the borrower for ad hoc/
temporary limits in excess of the sanctioned limits in order to meet unforeseen
contingencies. Such limits should be allowed for pre-determined short-durations
and in the form of a demand loan or ‘non-operable’ cash credit account for
which an additional interest of 1% over and above the normal rate is to be
charged.

But if the borrower is unable to provide corresponding additional contributions

for this purpose, bank will simply refuse.

(iv) Contribution of the Borrowers:

The RBI stressed the need in order to reduce the over-dependence on bank
credit by medium and large borrowers. Borrowers must increase their
contribution towards working capital. Bank must assess the maximum
permissible bank finance by applying the second method of lending which was
recommended by Tandon Committee.

That is, under this method, borrowers must have to contribute from (i) his
owned funds and (ii) term loans an amount which must be at least 25% of total
current assets. In short, the contribution of the borrowers towards working
capital should be increased from 25% of the working capital gap (under 1st
Method) to 25% of the total current assets which result in a current ratio of 1.3:
1 instead of a 1: 1 current ratio.

Arrangement during Transition Period:

If it is found that the borrower fails to comply with the above requirements,
immediately bank may segregate the excess borrowing and may treat the same
as Working Capital Term Loan (WCTL). This loan must be repaid by the
borrowers in half-yearly installments within a period not exceeding 5 years.

Of course, banks may charge a higher rate of interest for this purpose which
must not exceed the ceiling for encouraging early payments. Bank also may
charge a penal rate if there is any default in repayment of the said loans.

Additional Credit Limits:

Banks are permitted to grant additional credit limits to the borrowers, if such
limits are necessary for increased production. But Bank must insist on (i) the
incremental current ratio of 1.33: 1 and (ii) WCTL component must not be
increased.
Exemption:
However, the RBI exempted the following categories of borrowers from the
compliance of this requirement:
(a) New companies floated prior to December 8, 1980.

(b) Companies showing signs of incipient sickness.

(c) Companies having finalized modernization or expansion programme before

the Chore Committee recommendation.

(d) Borrowers who have failed to pay the installment/interest due to term
lending institutions, if the efforts to re-schedule the installments do not succeed.

In the above categories of borrowers, the RBI has advised the scheduled banks
to examine carefully the financial position on the basis of cash flow/fund flow
statements and other relevant information.

If they are satisfied, they may assess the credit requirement of the borrowers
without applying the second method of lending recommended by Tandon
Committee which is permitted only for a period of 3 years and bank, in these
cases, should impress upon the borrowers the usefulness of changing-over to
second method.

The RBI has also clarified that the above measures are not applicable in those
cases that enjoy aggregate working capital limits below Rs. 50 lakhs but exceed
this level due to sanctioning additional credit limits for the temporary periods.

RBI also has advised to adopt a flexible approach in case of exporters who are
unable to bring in additional contribution for additional credit limits sanctioned
for specific export transactions.

If any borrower exports a substantial part of his production and the WCTL has
to be carved out of the existing paking credit limit, bank may identify the
WCTL on a national basis. That is, the amount of excess borrowings may be
identified but not transferred to a separate account for concessionary rate of
interest.

The borrower must contribute the required amount within a period of 5 years.

Marathe Committee Report:

The Reserve Bank of India, in 1982, appointed a committee under the
chairmanship of Marathe to review the working of Credit Authorisation Scheme
(CAS) and suggest measures for giving meaningful directions to the credit
management function of the Reserve Bank. The recommendations of the
committee have been accepted by the Reserve Bank of India with minor
modifications.

The principal recommendations of the Marathe Committee include:

(i) The committee has declared the Third Method of Lending as suggested by
the Tanden Committee to be dropped. Hence, in future, the banks would
provide credit for working capital according to the Second Method of Lending.

(ii) The committee has suggested the introduction of the ‘Fast Track Scheme’ to
improve the quality of credit appraisal in banks. It recommended that
commercial banks can release without prior approval of the Reserve Bank 50%
of the additional credit required by the borrowers (75% in case of export
oriented manufacturing units) where the following requirements are fulfilled:

(a) The estimates/projections in regard to production, sales, chargeable current

assets, other current assets, current liabilities other than bank borrowings, and
net working capital are reasonable in terms of the past trends and assumptions
regarding most likely trends during the future projected period.

(b) The classification of assets and liabilities as ‘current’ and ‘non-current’ is in

conformity with the guidelines issued by the Reserve Bank of India.

(c) The projected current ratio is not below 1.33 : 1.

(d) The borrower has been submitting quarterly information and operating
statements (Form I, II and III) for the past six months within the prescribed time
and undertakes to do the same in future also.
(e) The borrower undertakes to submit to the bank his annual account regularly
and promptly, further, the bank is required to review the borrower’s facilities at
least once in a year even if the

The fundamental characteristic of CMA is noted below:

(a) A post-sanction scrutiny of term loans and working capital limits which
were provided by commercial banks, will be made by the RBI. It is the duty of
the commercial bank to submit the necessary paper to the RBI within 15 days
from such transactions.

(b) The commercial banks must mention whether the minimum prescribed level
made by RBI relating to finance for credit transactions by drawing and
accepting trade bills in each and every case and steps must be taken if RBI
norms is not followed.

borrower does not need enhancement in credit facilities.

Unit 3

Cash management refers to a broad area of finance involving the collection,

handling, and usage of cash.

It involves assessing market liquidity, cash flow, and investments.In banking,

cash management, or treasury management, is a marketing term for certain
services relatedto cash flow offered primarily to larger business customers. It
may be used to describe all bank accounts (such as checking accounts) provided
to businesses of a certain size, but it is more often used to describespecific
services such as cash concentration, zero balance accounting, and clearing
house facilities.Sometimes, private banking customers are given cash
management services.Financial instruments involved in cash management
include money market funds, treasury bills, andcertificates of deposit

Motives for Holding Cash

Definition: The Motives for Holding Cash is simple, the cash inflows and
outflows are not well synchronized, i.e. sometimes the cash inflows are more
than the cash outflows while at other times thecash outflows could be more.
Hence, the cash is held by the firms to meet the certain as well asuncertain
situations.

Motives of holding cash

Transaction Motive: The transaction motive refers to the cash required by a

firm to meet the day to dayneeds of its business operations. In an ordinary
course of business, the firm requires cash to make thepayments in the form of
salaries, wages, interests, dividends, goods purchased, etc.

Likewise, it also receives cash from its sales, debtors, investments. Often the
firm’s cash inflows andoutflows do not match, and hence, the cash is held up to
meet its routine commitments.

Precautionary Motive: The precautionary motive refers to the tendency of a

firm to hold cash, to meetthe contingencies or unforeseen circumstances arising
in the course of business.Since the future is uncertain, a firm may have to face
contingencies such as an increase in the price ofraw materials, labor strike,
lockouts, change in the demand, etc. Thus, in order to meet with
theseuncertainties, the cash is held by the firms to have an uninterrupted
business operations.

Speculative Motive: The firms hold cash for the speculative purposes to avail
the benefit of bargainpurchases that may arise in the future. For example, if the
firm feels the prices of raw material are likelyto fall in the future, it will hold
cash and wait till the prices actually fall.Thus, a firm holds cash to exploit the
possible opportunities that are out of the normal course ofbusiness. These
opportunities could be in the form of the low-interest rate charged on the
borrowedfunds, expected fall in the raw material prices or favorable change in
the government policies.Thus, the cash is the most significant and liquid asset
that the firm holds. It is significant as it is used topay off the firm’s obligations
and helps in the expansion of business operations.

Marketable Securities

Marketable securities are liquid financial instruments that can be quickly

converted into cash at areasonable price. The liquidity of marketable securities
comes from the fact that the maturities tend tobe less than one year, and that the
rates at which they can be bought or sold have little effect on prices.Marketable
securities are defined as any unrestricted financial instrument that can be bought
or sold ona public stock exchange or a public bond exchange. Therefore,
marketable securities are classified aseither a marketable equity security or a
marketable debt security.Examples of marketable securities include common
stock, commercial paper, banker's

acceptances,Treasury bills, and other money market instruments.

Commercial Paper'

Commercial paper is an unsecured, short-term debt instrument issued by a

corporation, typically for the

financing of accounts payable and inventories, and meeting short-term

liabilities. Maturities on

commercial paper rarely range longer than 270 days. Commercial paper is
usually issued at a discount

from face value and reflects prevailing market interest rates.

What is a 'Treasury Bill - T-Bill'

A Treasury Bill (T-Bill) is a short-term debt obligation backed by the Treasury

Department of the U.S.

government with a maturity of less than one year, sold in denominations of

$1,000 up to a maximum

purchase of $5 million on noncompetitive bids. T-bills have various maturities

and are issued at a

discount from par.

When an investor purchases a T-Bill, the U.S. government effectively writes

investors an IOU. They do

not receive regular interest payments as with a coupon bond, but a T-Bill does
include interest, reflected

in the amount it pays when it matures.

What is a 'Certificate Of Deposit - CD'

A certificate of deposit (CD) is a savings certificate with a fixed maturity date,

specified fixed interest
rate and can be issued in any denomination aside from minimum investment
requirements. A CD

restricts access to the funds until the maturity date of the investment. CDs are
generally issued by

commercial banks and are insured by the FDIC up to $250,000 per individual.

This article throws light upon the seven main factors influencing cash
requirements of a firm. The factors

are:

1. Terms of Purchase and Sale

2. Collection Period of Receivables

3. Credit Position of the Firm

4. Production Policy of the Firm

5. Nature of Demand of Firm’s Products

6. Sale-Asset Relationship

7. Amount of Current Liabilities and their Maturity Period.

Factor # 1. Terms of Purchase and Sale:

Terms on which goods are bought and sold decide, to a large extent, the amount
of cash reserve that a
firm will have to hold. If a business firm can manage to buy materials on credit
terms but sell its

products on cash, it can run its affairs with a little cash balance. The reverse
tendency will be found

where the firm makes purchases on cash basis but it has to sell its productions to
customers on credit

terms.

Factor # 2. Collection Period of Receivables:

If speed of collection of accounts receivable in a firm, is quick the firm need not
carry large cash balance.

However, owing to liberal credit and collection policies, poor collection

machinery and other factors, the

firm will have to maintain relatively substantial reserve of cash to meet normal
business expenses.

Factor # 3. Credit Position of the Firm:

A firm having established good image in the market circle can carry its affairs
with little cash balance
obviously because the firm gets liberal credit facilities from other business
enterprises.

Factor # 4. Production Policy of the Firm:

Production policy is also an important determinant of normal cash requirements.

If management of an

enterprise decides to hold inventory worth 3 months production requirements to

maintain fairly steady

production throughout the year, it will require larger amount of cash to finance
the inventory

requirements than one following hand to mouth policy of carrying inventories.

Factor # 5. Nature of Demand of Firm’s Products:

Where demand of firm’s products is highly susceptible to changes in economic

conditions, the firm will

have to hold large cash balance to strengthen its liquidity position. This
tendency is usually observed in

undertakings engaged in luxurious products. However, public utility concerns

need not maintain large

cash reserve because of the constant flow of cash in the firm resulting from the
regularity of their
services.

Factor # 6. Sale-Asset Relationship:

Sale-asset relationship must be examined minutely while assessing cash

requirements for normal

transaction purposes. A firm having larger amount of sales in relation to fixed

assets will have to carry

substantially large cash balance to meet inventory and receivables.

In this connection it may be argued that increase in quantum of sales brings in

increased cash to the firm

which could be used to finance additional inventory and receivable

requirements. There are no two

opinions about this. However, it should be remembered that amount of cash

inflow does not increase in

proportion to the increase in sales. As a matter of fact, risk in sales results in

increase in cash at

diminishing rate.

Factor # 7. Amount of Current Liabilities and their Maturity Period:

A firm with larger amount of current liabilities will have to hold larger cash
reserve than one with small
amount of current liabilities. Furthermore, maturity period of these liabilities
should also be considered

while deciding the level of cash holding.

It would be desirable on the part of the management to provide for sufficiently

large amount of cash to

avoid illiquidity crisis if it finds that the firm’s current liabilities are mostly of
one month’s duration or

less than that.

Factor # 8. Nature of business:

The working capital requirement of a firm is closely related to the nature of its
business. A service firm,

like an electricity undertaking or a transport corporation which has a short

operating cycle and which

sells predominantly on cash basis, has a modest working capital requirement.

On the other hand, a

manufacturing concern likes a machine tools unit, which has a long operating
cycle and which sells

largely on credit, has a very substantial working capital requirement.

Factor #. 9. Seasonality of operations:

Firms which have marked seasonality in their operations usually have highly
fluctuating working capital

requirements. To illustrate, consider a firm manufacturing ceiling fans. The sale

of ceiling fans reaches a

peak during the summer months and drops sharply during the winter period.
The working capital need

of such firm is likely to increase considerably in summer months and decrease

significantly during the

winter period. On the other hand, a firm manufacturing product like lamps,
which have even sales round

the year, tends to have stable working capital needs.

Factor #. 10. Production policy:

A firm marked by pronounced seasonal fluctuation in its sales may pursue a

production policy which

may reduce the sharp variations in working capital requirements. For example, a
manufacturer of ceiling

fans may maintain a steady production throughout the year rather than intensify
the production activity

during the peak business season. Such a production policy may dampen the
fluctuations in working
capital requirements.

Factor # 11. Market conditions:

The degree of competition prevailing in the market has an important bearing on

working capital needs.

When competition is keen, a larger inventory of finished is required to promptly

serve customers who

may not be inclined to wait because other manufacturers are ready to meet their
needs.

Further, generous credit terms may have to be offered to attract customers in a

highly competitive

market. Thus, working capital needs tend to be high because of greater

investment in finished goods

inventory and accounts receivable.

If the market is strong and competition weak, a firm can manage with a smaller
inventory of finished

goods because customers can be served with some delay. Further, in such a
situation the firm can insist

on cash payment and avoid lock-ups of funds in accounts receivable –it can
even ask for advance
payment, partial or total.

Factor #. 12. Conditions of supply:

The inventory of raw materials, spares, and stores on the conditions of supply. If
the supply is prompt

and adequate, the firm can manage with small inventory. However, if the supply
is unpredictable and

scant, then the firm, to ensure continuity of production, would have to acquire
stocks as and when they

are available and carry large inventory on an average. A similar policy may
have to be followed when the

raw material is available only seasonally and production operations are carried
out round the year.

What is a cash system?

Cash accounting is an accounting method in which payment receipts are

recorded during the period

they are received, and expenses are recorded in the period in which they are
actually paid.

MANAGING THE CASH FLOWS

1. Monitor your cash flow regularly.

Online accounting software such as QuickBooks Online makes it simple to

reconcile your accounts,generate reports and more. Because your information is
secure in the cloud, you can easily stay on topof your cash flow wherever you
are.

2. Cut costs.

Focus on recurring monthly, quarterly or annual expenses. Can you cut back on
utilities, rent or payroll?Are you spending money on subscriptions or services
you’re not using or insurance you no longer need .Can you renegotiate the terms
of outstanding loans or leases?

3. Cash in on assets.

Do you have equipment you no longer use or inventory that’s becoming

obsolete? Consider selling it togenerate quick cash.

4. Get a business line of credit before you need one.

A business line of credit is a good insurance policy against cash flow problems.
You may be able to get aline of credit for a percentage of your accounts
receivable or inventory if you use them as collateral.

5. Lease equipment instead of buying it.

By leasing vehicles, computers and other business equipment, you get access to
the latest features and
avoid tying up cash—but you still get to expense the lease costs on your
business taxes.

6. Stay on top of invoicing.

Send invoices when the work's completed or products are delivered—why

wait? Find out the specificperson, job title and address to send your invoices to
so they don’t get lost in a shuffle from departmentto department. Design your
invoices so they’re straightforward and easy to read, with key areas like
duedate, amount due, where to send payment and payment methods highlighted.
Speed things up furtherby emailing invoices instead of mailing them.

7. Don’t let travel slow your invoicing.

If you’re on the road and in a pinch, try the free instant invoice creators Invoice-
o-matic and invoiceto.me. They’re so simple, you don’t even have to register—
just input your info into a template,then generate a PDF you can email to your
customer.

8. Get paid faster by using mobile payment solutions.

If you sell products or provide services at customers’ homes or offices, get paid
on the spot with mobileapps that use your smartphone or tablet to accept
payment by credit and debit card. Check out five coolmobile payment tools in
"5 Mobile Payment Apps That Get You Paid Faster."

9. Speed payments by offering deals.

Consider offering your customers incentives, such as a percentage off the total,
for early payments. Dothe math beforehand to ensure the tradeoff (getting paid
early) is worth the loss (less money in the longrun).

10. Ask for deposits or partial payments on large orders or long-term

contracts.For example, a building contractor or website developer might charge
a 10 percent deposit upfrontbefore beginning to draw up plans for the project,
then charge half the remaining amount when workbegins, and the balance upon
completion. Charging this way, the company generates enough cash tofinance
the materials and pay the workers needed for the job.

11. Delay payments to your vendors.Unless there’s a worthwhile incentive for

you to pay early, figure out how late you can pay your vendorswithout risking
late fees or harming your relationship. This keeps the cash in your account and
out ofyour vendor’s until it absolutely has to be there.

12. Get business credit cards to cushion your cash flow.

Look for cards with rewards such as points you can use toward travel or
business purchases. In additionto providing a cushion for lean times, business
credit cards also categorize your purchases, so it’s easierto track
expenses.Staying on top of your cash flow is key to your business success.
Don't let a few cash flow missteps putyou in a money crunch. All it takes
are a few smart moves to keep your company in the black.

Cash Collection system :- Cash management is intimately connected with

realization from debtors. Prompt collection fromdebtors is preferred for that
involves less money being locked-up in accounts receivables, less baddebts,
etc.How can collections be prompted?We can give cash discount to prompt
collections. Besides a system of decentralized collection issuggested for prompt
collections.

1.Concentration Banking : It is a technique of decentralized or prompt

collection. Concentrationbanking system works this way:(i) there is
decentralized billing of customers, so that immediate dispatch of goods,
invoices are madeand dispatched,(ii) customers are directed to send the
remittances to corresponding regional offices,(iii) regional offices on receipt of
remittances send them to banks for collection,(iv) After collection is effected,
after retaining a minimum sum, the regional office sends the balance onaccount
to the head-office bank account.As all such cash balance remittances get
concentrated in the head-office bank account, the method isknown
‘concentration banking’.This system involves quick dispatch of invoices, quick
receipt of remittances, quick posting of entries,quick forwarding of remittances
to banks for collection, quick collection by banks and lump-sum transferto the
concentration bank of collections from debtors.As a result, collection float, that
is, total time between mailing of a cheque by a consumer and theavailability of
cash to the receiving firm, is reduced.

2.Lock-box System. :. It is another method of prompt collection. Here

(i) the regional branch offices send invoices to credit customers in respective
branch areas and direct

them to send remittances to specified post-boxes hired from post-office under

an arrangement

(ii) the bankers of the company clear the post boxes several times a day and
process for collection andalso inform the firm’s branch office of the remittance
(iii) after keeping a minimum balance, the rest of funds is remitted onward to
the firm’s main bankaccount.Lock box system is an improvement over the
concentration system. In lock-box system the bankers clearthe remittances from
post-boxes instead of remittances being sent to branch offices and branch
officessending the cheques and bills to the bankers for collection. Thus one
more interim step is skipped tospeedup the collection.

3.Pre authorised debit : It is another method of prompt collection. He the

transfer of funds frompayer’s bank to payee’s bank is preauthorised triggered,
by the payee with payer’s advanceauthorization.Now-a-days cash transfer is
also done electronically. Electronic Fund Transfer (EFT) is used to
instantlytransfer funds from payer’s bank to the payee’s bank.

Cash concentration :. It is the transfer of funds from diverse accounts into a

central account toimprove the efficiency of cash management. The
consolidation of cash into a single account allows acompany to maintain smaller
cash balances overall, and to identify excess cash available for short
terminvestments. The cash available in different bank accounts are pooled into a
master account.

The advantages of cash concentration are

1) Cash control

2) Cash visibility

Cash Concentration & Disbursement (CCD)

corporate electronic payment used in business to business and intracompany

transfers of funds.Vendors, including numerous federal agencies, have used the
CCD payment format, an electronicpayment record developed by the National
Automated Clearing House Association, to make singleinvoice payments to
suppliers. Funds are cleared on an overnight basis through the
nationwideAutomate Clearing House.

Disbursement Tools

1. ACH Services

 Safely and efficiently move money through the Automated Clearing House
(ACH)—same dayorigination available

 Eliminates the expense and hassle of paper checks and wire transfers

 ensures secure and accurate processing of each file received

 Transmit files easily through Lake City Bank Business Online

2. BizNOW

 Manage your company budget, funding outflows and expense tracking from
a single app*

 Receive real-time funding requests, spend notifications, uploaded receipts,

purchase

descriptions and expense categorization in seconds.

 Approve or reject requests for funds or send additional money to your

employees in real time.

 Instantly view uploaded transaction receipts, employee categorization and

memos.
 Issue and assign cards to additional or new employees at any time from the
BizNOW app.

 Link your authorized business accounts to transfer funds, then replenish your
BizNOW accountany time.

 For more information and to get started, visit biznowcard.com/lakecitybank.

When you sign up,use “Lake City Bank” as your invite code.

3. Business Online Bill Pay

 Easily disburse funds without writing checks

4. Business Online Payroll

 Easily access payroll records and take fewer trips to the bank

 Comply with payroll tax — it’s accurate and guaranteed

 Use our free, downloadable labor law posters for your business to help stay
in compliance withgovernment regulations

 Adjust employee hours and pay rates every pay period

 Provide free direct deposit and employee access to online pay stubs

 Take advantage of our comprehensive federal, state and local tax filing
service

 Get unlimited support from U.S.-based payroll experts.

5. Controlled Disbursement
 Receive check clearing information the day a check posts to better calculate
your daily cashposition or take advantage of investment opportunities

 Checks are drawn on a separate routing and transit number associated with
Lake City Bank togive you an early sneak peek

 Controlled Disbursement intercepts check information before posting and

delivers it via

Business Online by 12pm EST.

6. Zero Balance Account

 Lake City Bank’s Zero Balance Account is a stand-alone checking account

that is tied to yourmaster account that holds all funds.

 The Zero Balance Account is maintained at a set balance that you determine.

 As checks clear the Zero Balance Account, collected funds move from your
master account tothe zero Balance Account so that you have peace of mind that
your checks will clear.

INVESTING IN MARKETABLE SECURITIES

Rather than let their cash reserves build up in excess of daily cash requirements,
many firms

invest in interest -bearing short -term marketable securities. Determining the

level of liquid

assets that should be invested in marketable securities depends on several

factors, including:
 The interest to be earned over the expected holding period

 The transaction costs involved in buying and selling the securities

 The variability of the firm’s cash flows.

Choosing Marketable Securities

A firm may choose among many different types of securities when deciding
where to invest

excess cash reserves. In determining which securities to include in its portfolio,

the firm

should consider a number of criteria, including the following:

 Default risk

 Marketability

 Maturity date

 Rate of return.

1 . Default risk : Most firms invest only in marketable securities that have little
or no default risk (therisk that a borrower will fail to make interest and/or
principal payments on a loan).

2. Marketability. :. A firm usually buys marketable securities that can be sold

on short notice withouta significant price concession. Thus, there are two
dimensions to a security’s marketability: the timerequired to sell the security
and the price realized from the sale relative to the last quoted price.
3. Maturity Date : Firms usually limit their marketable securities purchases to
issues that haverelatively short maturities. Recall that prices of debt securities
decrease when interest rates rise andincrease when interest rates fall.

4. Rate of Return : Although the rate of return, or yield, is also given

consideration in

securities for inclusion in a firm’s portfolio, it is less important than the other
three criteria justdescribed.

Types of Marketable Securities

Firms normally confine their marketable securities investments to “money

market” instruments, that is,those high-grade (low default risk), short-term debt
instruments having original maturities of 1 year orless.Money market
instruments that are suitable for inclusion in a firm’s marketable securities
portfolioinclude

 Treasury issues or bill

 Govt. securities

 negotiable certificates of deposit

 commercial paper

 repurchase agreements

 bankers’ acceptances

 Eurodollar deposits
 auction rate preferred stocks

 money market mutual funds

 bank money market accounts.

(In some cases, firms will also use long-term bonds having 1 year or less
remaining to maturity as“marketable” securities and treat them as money market
instruments.)

Treasury Issues or bills :. Treasury bills are the most popular marketable
securities. They aresold at weekly auctions through Federal Reserve Banks and
their branches and have standard maturitiesof 91 days, 182 days, and 1 year.
Treasury bills are issued at a discount and then redeemed for the fullface
amount at maturity. Once they are issued, Treasury bills can be bought and sold
in the secondarymarkets through approximately 40 government securities
dealers. There is a large and active market forTreasury bills, which means that a
firm can easily dispose of them when it needs cash. The smallestdenomination
of Treasury bills is $10,000 of maturity value.

The advantages of Treasury issues include short maturities, a virtually default-

free status, and readymarketability. Their primary is advantage lies in the fact
that their yields normally are the lowest of anymarketable security.

Govt. Securities : State and local governments and their agencies issue various
types of interest-bearing securities. Short-term issues are suitable for inclusion
in a firm’s marketable securities portfolio.The yields on these securities vary
with the creditworthiness of the issuer. The pretax yields on thesesecurities are
generally lower than the yields on Treasury bills because the interest is exempt
fromfederal (and some state) income taxes. The secondary market for municipal
issues is not as strong asthat for Treasury and other federal agency
issues.Municipal (tax-exempt) money market mutual fundsare also available.

Negotiable Certificates of Deposit : Commercial banks are permitted to issue

certificates ofdeposit (CDs), which entitle the holder to receive the amount
deposited plus accrued interest on aspecified date. At the time of issue,
maturities on these instruments range from 7 days to 18 months ormore. Once
issued, CDs become negotiable, meaning they can be bought and sold in the
secondarymarkets. Because CDs of the largest banks are handled by
government securities dealers, they arereadily marketable and thus are suitable
for inclusion in a firm’s marketable securities portfolio. Yieldson CDs are
generally above the rates on federal agency issues having similar maturities.

Commercial Paper ;: Commercial paper consists of short-term unsecured

promissory notesissued by large, well-known corporations and finance
companies with strong credit ratings.

Repurchase Agreements : A repurchase agreement, or “repo,” is an

arrangement with a bankor securities dealer in which the investor acquires
certain short-term securities sub- ject to acommitment from the bank or dealer
to repurchase the securities on a specified date. Securities used inthis agreement
can be government securities, CDs, or commercial paper. Their maturities tend
to berelatively short, ranging from 1 day to several months, and are designed to
meet the needs of theinvestor.

Bankers’ Acceptances :. A bankers’ acceptance is a short-term debt instrument

issued by a firmas part of a commercial transaction. Payment is guaranteed by a
commercial bank. Bankers’ acceptancesare commonly used financial
instruments in international trade, as well as in certain lines of domestictrade.
Eurodollar Deposits. :. Eurodollar deposits are dollar-denominated deposits in
banks or bank brancheslocated outside the United States. These deposits usually
have slightly higher yields than oncorresponding deposits in domestic banks
because of the additional risks. Eurodollar CDs issued byLondon banks are
negotiable, and a secondary market is developing for them.

Auction rate preferred stock. :. which is a suitable short-term investment for

excess corporatefunds. The dividend yield on this type of security is adjusted
every 49 days through an auction process,where investors can exchange their
stock for cash.

Money Market Mutual Funds. :. Many of the higher-yielding marketable

securities described earlier areavailable only in relatively large denominations.

Bank Money Market Accounts. :. Banks are permitted to offer checking

accounts with yieldscomparable to those on money market mutual accounts
with limited check-writing privileges. Theseaccounts provide yields that are
comparable to those on money market mutual funds.

Definition of cash flow forecast.

A cash flow forecast is a plan that shows how much money a business expects
to receive in, and payout, over a given period of time. ... Check out our article
on how to make a cash flow forecast for moreinformation on the process and
benefits of financial forecasting for small businesses.In other words , A cash
flow forecast is an estimate of the amount of money you expect to flow in
andout of your business. It includes all your projected income and expenses and
usually covers the nextyear, though it can also cover a shorter period such as a
week or month.Financial forecasting techniques consist of two broadly
categorized methods:

1. Qualitative techniques

2. Quantitative techniques

Qualitative Financial Forecasting Techniques

1. Executive Opinions

In this method, management makes decisions based on opinions shared by

various department headsand key personnel of various departments in an
enterprise, such as sales, production, purchasing,operations and so forth.
Management does its calculations and estimations based on inputs from
theseimportant members.

2. Reference Class Forecasting

In this method, enterprises make decisions based on reference cases or similar

scenarios in a differenttimeframe. This forecasting method is completely based
on human judgment.

3. Delphi Method

In this method, a questionnaire is provided to experts who share their answers in

isolation. Onceresponses are in place, a second questionnaire is shared with
them to re-evaluate their responses to thefirst one. This process goes on until the
responses are narrowed down to a short list of importantopinions.

4. Sales Force Inputs

Sales representatives are closest to the customers. They are in a better position
to share insights about acustomer’s behavior. In this method, based on inputs
shared by sales representatives, managementprepares estimates.

5. Consumer Feedback

Inputs in the form of consumer feedback or customer surveys help enterprises to

define and derivefinancial forecasts. This feedback can be taken in the form of
telephonic conversations and personalinterviews.

Quantitative Financial Forecasting Techniques

1. Proforma Statements

Proforma statements are financial statements that consist of data related to sales
figures and costs fromthe last two to three years. This forecasting method is
generally used in mergers and acquisitions, orwhen a new company is to be
formed and statements need to be presented in front of the investors.

2. Cause-Effect Method

In this method, enterprises conduct a comparative study of variable factors such

as consumers’disposable income, interest rate, consumer confidence and even
unemployment level. This is comparedover a period of time, and then estimates
are drawn.

3.Time-series forecasting,where businesses gather financial data over a period

of time to identify patterns and trends and forecastbased on these patterns.
Financial forecasting is a very challenging task, and it is critical to select the
right forecasting techniqueto derive the right forecasts. The technique that is
chosen for one objective may be different for anotherone.

Source of uncertainty in cash forecasting

 Sales uncertainty

 Collection rate

 Production Cost

 Capital outflows

Accurate cash flow forecasting hinges on the forecaster’s ability to reduce the
amount if observed errorbetween forecast values and actual values that have
occurred. Given the short-run nature of the cashforecast, with most things
occurring in the near future, one would tent to think that
mostfinancialtransaction could be forecast very accurately. This is far from true.

 In practice few firms, if any are able to forecast their inflows and outflows
accurately.

 Sales forecasts are notoriously unreliable, for actual sales depend in part
upon factors

that lie outside the control of the firm.

 Changes in the marketing of competitive products.

 changes in general economic conditions, can lead to large forecasting errors.

We may further note that any errors in sales forecasts have multiple impacts on
the firm’s cash flows;

they impact on receivable levels (and therefore collections) and also on

production expenses (andtherefore disbursements).Working capital is the cash
available to finance a company's short-term operational needs.
However,sometimes a company does not have the adequate cash on hand or
asset liquidity to cover daily . operational expenses and, thus, will secure a loan
for this purpose. Working capital loans are simplycorporate debt borrowings
that are used by a company to finance its daily operations.Many companies do
not have stable or predictable revenue throughout the year.

Unit 4

INVENTORY CONTROL SYSTEM OR CONTROL DEVICES

Inventory control systems are technology solutions that integrate all aspects of
an organization’s inventory tasks, including shipping, purchasing, receiving,
warehouse storage, turnover, tracking, and reordering. While there is
some debate about the differences between inventory management and
inventory control, the truth is that a good inventory control system does it all by
taking a holistic approach to inventory and empowering organizations to utilize
lean practices to optimize productivity and efficiency along the supply chain
while having the right inventory at the right locations to meet customer
expectations.
That being said, there are two different types of inventory control systems
available today: perpetual inventory systems and periodic inventory systems.
Within those systems, two main types of inventory management systems –
barcode systems and radio frequency identification (RFID) systems – used to
support the overall inventory control process:

Main Inventory Control System Types:

 Perpetual Inventory System
 Periodic Inventory System
Types of Inventory Management Systems within Inventory Control Systems:
 Barcode System
 Radio Frequency Identification (RFID) System
Inventory control systems help you track inventory and provide you with the
data you need to control and manage it. No matter which type of inventory
control system you choose, make sure that it includes a system for identifying
inventory items and their information including barcode labels or asset tags;
hardware tools for scanning barcode labels or RFID tags; a central database for
all inventory in addition to the ability to analyze data, generate reports, and
forecast demand; and processes for labeling, documenting, and reporting
inventory along with a proven inventory methodology like just-in-time, ABC
analysis, first-in, or first out (FIFO), or last-in-first-out (LIFO). Read on to learn
more about the four types of inventory control systems.
1.Perpetual Inventory System
When you use a perpetual inventory system, it continually updates inventory
records and accounts for additions and subtractions when inventory items are
received, sold from stock, moved from one location to another, picked from
inventory, and scrapped. Some organizations prefer perpetual inventory systems
because they deliver up-to-date inventory information and better handle
minimal physical inventory counts. Perpetual inventory systems also are
preferred for tracking inventory because they deliver accurate results on a
continual basis when managed properly. This type of inventory control system
works best when used in conjunction with a database of inventory quantities and
bin locations updated in real time by warehouse workers using barcode
scanners.
There are some challenges associated with perpetual inventory systems. First,
these systems cannot be maintained manually and require specialized equipment
and software that results in a higher cost of implementation, especially for
businesses with multiple locations or warehouses. Periodic maintenance and
upgrades are necessary for periodic inventory systems, which also can become
costly. Another challenge of using a perpetual inventory system is that recorded
inventory may not reflect actual inventory as time goes by because they do not
use regular physical inventory counts. The result is that errors, stolen items, and
improperly scanned items impact the recorded inventory records and cause them
not to match actual inventory counts.
2.Periodic Inventory System
Periodic inventory systems do not track inventory on a daily basis; rather, they
allow organizations to know the beginning and ending inventory levels during a
certain period of time. These types of inventory control systems track inventory
using physical inventory counts. When physical inventory is complete, the
balance in the purchases account shifts into the inventory account and is
adjusted to match the cost of the ending inventory. Organizations may choose
whether to calculate the cost of ending inventory using LIFO or FIFO inventory
accounting methods or another method; keep in mind that beginning inventory
is the previous period’s ending inventory.
There are a few disadvantages of using a periodic inventory system. First, when
physical inventory counts are being completed, normal business activities nearly
become suspended. As a result, workers may hurry through their physical
counts because of time constraints. Errors and fraud may be more prevalent
when you implement a periodic inventory system because there is no
continuous control over inventory. It also becomes more difficult to identify
where discrepancies in inventory counts occur when using a periodic inventory
control system because so much time passes between counts. The amount of
labour that is required for periodic inventory control systems make them better
suited to smaller businesses.
3.Barcode Inventory Systems
Inventory management systems using barcode technology are more accurate
and efficient than those using manual processes. When used as part of an overall
inventory control system, barcode systems update inventory levels
automatically when workers scan them with a barcode scanner or mobile
device. The benefits of using barcoding in your inventory management
processes are numerous and include:
 Accurate records of all inventory transactions
 Eliminating time-consuming data errors that occur frequently with
manual or paper systems
 Eliminating manual data entry mistakes
 Ease and speed of scanning
 Updates on-hand inventory automatically
 Record transaction histories and easily determine minimum levels and
reorder quantities
 Streamline documentation and reporting
 Rapid return on investment (ROI)
 Facilitate the movement of inventory within warehouses and between
multiple locations and from receiving to picking, packing, and shipping

4.Radio Frequency Identification (RFID) Inventory Systems

Radio frequency identification (RFID) inventory systems use active and passive
technology to manage inventory movements. Active RFID technology uses
fixed tag readers throughout the warehouse; RFID tags pass the reader, and the
movement is recorded in the inventory management software. For this reason,
active systems work best for organizations that require real-time inventory
tracking or where inventory security has been an issue. Passive RFID
technology, on the other hand, requires the use of handheld readers to monitor
inventory movement. When a tag is read, the data is recorded by the inventory
management software. RFID technology has a reading range of approximately
40 feet with passive technology and 300 feet with active technology.

RFID inventory management systems have some associated challenges. First,

RFID tags are far more expensive than barcode labels; thus, they typically are
used for higher value goods. RFID tags also have been known to have
interference issues, especially when tags are used in environments with a lot of
metal or liquids. It also costs a great deal to transition to RFID equipment, and
your suppliers, customers, and transportation companies need to have the
required equipment as well. Additionally, RFID tags carry more data than
barcode labels, which means your system and servers can become bogged down
with too much information.
When choosing an inventory control system for your organization, you first
should decide whether a perpetual inventory system or periodic inventory
system is best suited to your needs. Then, choose a barcode system or RFID
system to use in conjunction with your inventory control system for a complete
solution that will enable you to have visibility into your inventory for improved
accuracy in scanning, tracking, recording, and reporting inventory movement.

INENTORY CONTROL MODELS

The forms of inventories existing in a manufacturing enterprise can be

classified into three categories:
(i) Raw Materials:
These are those goods which have been purchased and stored for future
productions. These are the goods which have not yet been committed to
production at all.

(ii) Work-in-Progress:
These are the goods which have been committed to production but the finished
goods have not yet been produced. In other words, work-in-progress inventories
refer to ‘semi-manufactured products.’
(iii) Finished Goods:
These are the goods after production process is complete. Say, these are the
final products of the production process ready for sale. In case of wholesaler or
retailer, inventories are generally referred to as ‘merchandise inventories.’ Some
firms also maintain the fourth type of inventories called ‘supplies.’ Examples of
supplies are office and plant cleaning materials, oil, fuel, light bulbs and the
like.

Needless to mention, maintaining the required size of inventory is necessary for

the smooth and effective functioning of production activity. Holding required
inventories provides certain advantages to the entrepreneur. For example, it
helps in avoiding losses of sales, reducing ordering costs, and achieving
efficient production run.

However, against these benefits are some costs as well associated with
inventories? It is said that every noble acquisition is attended with risk; he who
fears to encounter the one must not expect to obtain the other. This is true of
inventories also.

There are broadly two costs involved in holding inventories:

(i) Ordering Costs:

These include costs which are associated with placing of orders to purchase raw
materials and components. Clerical and administrative salaries, rent for the
space occupied, postage, telegrams, bills, stationery, etc. are the examples of
ordering costs. The more the orders, the more will be the ordering costs and vice
versa.

(ii) Carrying Costs:

These include costs involved in holding or carrying inventories like insurance
charges for covering risks, rent for the floor space occupied, wages of labourers,
wastages, obsolescence, or deterioration, thefts, pilferages, etc. These also
include ‘opportunity costs.’ This simply means had the money blocked in
inventories been invested elsewhere in the business, it would have earned a
certain return. Hence, the loss of such return may be considered as an
‘opportunity costs.’

Models of Inventory Management:

While it is very necessary to maintain the optimum level of inventory, it is not
so easy as well. Nonetheless, some models or methods have been developed in
the recent past for determining the optimum level of inventories to be
maintained in the enterprise.

All models are classified into two major types:

(i) Deterministic Models, and

(ii) Probabilistic Models.

In brief, the deterministic models are built on the assumption that there is no
uncertainty associated with demand and replenishment of inventories. On the
contrary, the probabilistic models take cognizance of the fact that there is
always some degree of uncertainty associated with the demand pattern and lead
time of inventories.

Usually, the following three deterministic models are in use:

1. Economic Ordering Quantity (EOQ) Model,

2. ABC Analysis,

3. Inventory Turnover Ratio,

Let us discuss these one by one.

1. Economic Ordering Quantity (EOQ) Model:
One of the important decisions to be taken by a firm in inventory management
is how much inventory to buy at a time.

This is called ‘Economic Ordering Quantity (EOQ). EOQ also gives

solutions to other problems like:
(i) How frequently to buy?

(ii) When to buy?

(iii) What should be the reserve stock?

Assumptions:
Like other economic models, EOQ Model is also based on certain
assumptions:
1. That the firm knows with certainty how much items of particular inventories
will be used or demanded for within a specific period of time.

2. That the use of inventories or sales made by the firm remains constant or
unchanged throughout the period.

3. That the moment inventories reach to the zero level, the order of the
replenishment of inventory is placed without delay.

The above assumptions are also called as limitations of the EOQ Model.

Determination of EOQ:
EOQ Model is based on Baumol’s cash management model. How much to
buy at a time, or say, how much will be EOQ is to be decided on the basis of
the two costs:
(i) Ordering Costs, and
(ii) Carrying Costs.

These are just discussed. Hence are not repeated again. The above two costs are
inversely associated. If holding inventory cost increases, ordering cost decreases
and vice versa. A balance is, therefore, struck between the two opposing costs
and economic ordering quantity is determined at a level for which the aggregate
of two costs is the minimum.

The various components of ordering costs and carrying costs are shown in
the following Table 27.3:
Table 27.3: Components of Ordering Costs and Carrying Costs:

Ordering Costs Carrying Costs

Requisitioning Warehousing

Order Placing Handling

Transportation Administrative

Storing Insurance

Administrative Deterioration and Obsolesce

EOQ can be determined by applying the following commonly used

formula:
Q = 2UxP/S

Where:

Q = Economic Ordering Quantity (EOQ)

U = Quantity purchased in a year or month

P = Cost of placing an order

S = Annual or monthly cost of storage of one unit known as ‘carrying cost.’

Let us illustrate this with an imaginary example:

Let us assume the following data for a firm:

Annual requirements 800 units

Ordering Cost (per order) Rs. 50

Carrying Cost (per unit) Rs. 100

Now, using the EOQ formula, EOQ quantity will be as follows:

EOQ = 2 x 800 x 50/2

= 80,000/2

= 40,000

= 200 Units

2. ABC Analysis:
This is also called ‘Selective Inventory Control.’ The ABC analysis of selective
inventory is based on the logic that in any large number, we usually have
‘significant few’ and ‘insignificant many.’ This holds true in case of inventories
also. A firm maintaining several types of inventories does not need to exercise
the same degree of control on all the items.

The firm adopts selective approach to control investments in various types of

inventories. This selective approach is called the ABC Analysis. The items with
highest value are classified as ‘A Items’. The items with relatively low value as
‘B Items’ and the items least valuable are classified as ‘C Items.’ Since the
ABC analysis concentrates on important items, hence, it is also known as
‘Control by Importance and Exception (CIE).’

The composition of these items in terms of quantity and value is lopsided.

In a study conducted sometimes ago, the shares of various items, viz. A, B
and C in total number and value of an automobile company were found as
follows:

Items % of Numbers % of Value

A 9 57

B 10 18

C 81 25

Total 100 100

In case of ABC Analysis, stringent control is imposed on ‘A Items’ maintaining

bare minimum necessary level of inventories of these. While ‘B Items’ will be
kept under reasonable control, ‘C Items’ will be under simple control.

The FSN analysis classifying goods into Fast-Moving, Slow-Moving, and Non-
Moving and VED analysis classifying goods into Vital, Essential, and Desirable
are similar to ABC Analysis in principle.

3. Inventory Turnover Ratio:

Inventory can also be managed by using accounting ratios like Inventory
Turnover Ratio. Inventory ratio establishes relationship between average
inventory and cost of inventory consumed or sold during the particular period.
This is calculated with the help of the following formula:
Cost of Good Consumed or Sold during the year/Average Inventory during the
year.

A comparison of current year’s inventory ratio with those of previous years

will unfold the following points relating to inventories:
Fast-Moving Items:
This is indicated by a high inventory ratio. This also means that such items of
inventory enjoy high demand. Obviously, in order to have smooth production,
adequate inventories of these items should be maintained. Otherwise, both
production and sales will be adversely affected through uninterrupted supply of
these items.

Slow-Moving Items:
That some items are slowly moving is indicated by a low turnover ratio. These
items are, therefore, needed to be maintained at a minimum level.

Dormant or Obsolete Items:

These refer to items having no demand. These should be disposed of as early as
possible to curb further losses caused by them.