1048 File

Working Capital Management
MBA Second Year

(Financial Management)
Paper No. 2.4
School of Distance Education

Bharathiar University, Coimbatore - 641 046
Author: B Muralikrishna
Copyright © 2008, Bharathiar University

All Rights Reserved
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CONTENTS
Page No.
UNIT I
Lesson 1 Working Capital Management: An Introduction 7
Lesson 2 Cash Flows Forecasting and Budgeting 39
UNIT II
Lesson 3 Financing of Working Capital-I 61
Lesson 4 Financing of Working Capital-II 71
Lesson 5 Managing Corporate Liquidity and Financial Flexibility 86
UNIT III
Lesson 6 Receivables Management 99
Lesson 7 Cash Management Systems 112
Lesson 8 Inventory Management 143
UNIT IV
Lesson 9 Instruments of the International Money Market 165
Lesson 10 Floating Rate Notes 171
UNIT V
Lesson 11 Working Capital Control and Banking Policy 183
Lesson 12 Appraisal and Assessment of the Working Capital 198
Model Question Paper 209

WORKING CAPITAL MANAGEMENT
SYLLABUS
UNIT I
Working Capital Management - Theories and approaches - Ratio Analysis - Fund
Flow and Cash Flow Analysis - Cash flow forecasting and Budgeting.
UNIT II
Financing of working capital - Money market instruments - Bank Finance-
Assessment and Appraisal - Managing corporate liquidity and financial flexibility
UNIT III
Receivables Management - Cash Management - Inventory Management
UNIT IV
Instruments of international money market - Euro notes - Euro commercial paper -
MTNs and FRNs.
UNIT V
Working Capital Control and Banking policy - Committee recommendations on
working capital - New system of assessment of working capital finance.
5
Working Capital Management:
An Introduction
UNIT 1
UNIT I
6
7
LESSON Working Capital Management:
An Introduction
1
WORKING CAPITAL MANAGEMENT:
AN INTRODUCTION
CONTENTS
1.0 Aims and Objectives
1.1 Introduction
1.2 Concept of Working Capital
1.2.1 Balance Sheet Concept
1.2.2 Operating Cycle Concept
1.3 Importance of Working Capital
1.4 Factors Influencing Working Capital Requirement
1.5 Levels of Working Capital Investment
1.6 Profitability vs. Risk trade-off
1.7 Optimal Level of Working Capital Investment
1.7.1 Proportions of Short-term Financing
1.7.2 Cost of Short-term vs. Long-term Debt
1.7.3 Risk of Long-term vs. Short-term Debt
1.8 Theories and Approaches to Working Capital
1.8.1 The Hedging or Matching Approach
1.8.2 The Conservative Approach
1.8.3 The Aggressive Approach
1.9 The Statement of Changes in Financial Position
1.9.1 Basic Approach
1.9.2 Working Capital Approach
1.10 Analysis of Funds Flow Statement
1.10.1 Meaning and Definition of Funds Flow Statement
1.10.2 Funds Flow Statement, Income Statement and Balance-Sheet
1.10.3 Uses, Significance and Importance of Funds Flow Statement
1.10.4 Limitations of Funds Flow Statement
1.10.5 Procedure for Preparing a Funds Flow Statement
1.10.6 Statement of Sources and Application of Funds
1.11 Application or Uses of Funds
1.12 Cash Flow Statement
1.12.1 Cash Flow from Operations
1.12.2 Cash Disbursements for Expenses
1.13 Let us Sum up
1.14 Lesson End Activity
1.15 Keywords
1.16 Questions for Discussion
1.17 Suggested Readings
8
Working Capital Management 1.0 AIMS AND OBJECTIVES
After studying this lesson, you should be able to understand:
z The concept of working capital
z Types of the working capital
z The levels of working capital
z The factors responsible for requirement of working capital
1.1 INTRODUCTION
Working capital typically means the firm’s holdings of current, or short-term, assets
such as cash, receivables, inventory, and marketable securities. Much academic
literature is directed towards gross working capital, i.e., total current or circulating
assets. In a retail establishment, cash is initially employed to purchase inventory
which is in turn sold on credit and results in accounts receivables. Once the
receivables are collected, they become cash-part of which is reinvested in additional
inventory and part (i.e., the amount above cost) going to profit or cash.
Corporate executives devote a considerable amount of attention to the management of
working capital. Net working capital (current assets minus current liabilities) provides
an accurate assessment of the liquidity position of firm with the liquidity-profitability
dilemma solidly authenticated in the financial scheme of obligations which mature
within a twelve-month period. Management must always ensure the solvency and
viability of the firm.
An examination of the components of components of working capital is helpful at this
point because of the preoccupation of management with the proper combination of
assets and acquired funds. First, short-term, or current, liabilities constitute the portion
of funds witch have been planned for and raised. Since management must be
concerned with proper financial structure, these and other funds must be raised
judiciously. Short-term or current assets constitute a part of the asset-investment
decision and require diligent review by the firm’s executives.
Although careful maintenance of the proper asset and funds-acquired mixes is
subjected to close scrutiny, it must be noted that there exists a close correlation
between sales fluctuations and invested amounts in current assets. For example,
assume a hypothetical increase and in the firm’s sales. This increase will necessitate
more inventory, more credit sales and resulting accounts receivable, and perhaps more
cash. Although current liabilities must be financed---frequently from short-term funds,
the larger the percentage of funds obtained from short-term funds, the more aggressive
(and risky) is firm’s working capital policy and vice-versa. Although short-term debt
is less expensive than long-term, short-term funds may only be renewable at much
higher rats of interest. Conversely, long-term funds involve a rather lengthy
commitment at fixed rates of interest. It should also be realized that heavy reliance on
low-cost, current funds may jeopardize the solvency of the firm. The risk/return trade-
off is very much in evidence in the firm’s working capital-management approach. As
a further illustration of the trade-off, management usually elects to prescribe levels for
current assets, despite the fact that sales dictate some fluctuation in short-term are
generally not considered to be the earning assets of the firm. The yield from
short-term assets is usually low, while returns from long-term, more permanent assets
are usually quite high. So management may also be considered as an aggressive or
conservative according to its investments in current versus long-term assets.
9
1.2 CONCEPT OF WORKING CAPITAL Working Capital Management:
An Introduction
There are two possible interpretations of working capital concept:
1. Balance Sheet Concept
2. Operating Cycle Concept
It goes without saying that the pattern of management will be very largely influenced
by the approach taken in defining it. Therefore the two concepts are discussed
separately in a nutshell.
1.2.1 Balance Sheet Concept

There are two interpretations of working capital under the balance sheet concept. It is
represented by the excess of current assets over current liabilities and is the amount
normally available to finance current operations. But, some-times working capital is
also used as a synonym for gross or total current assets. In that case, the excess of
current assets over current liabilities is called the net working capital or net current
assets. Economists like Mead, Malott, Baket and Field support the latter view of
working capital. They feel that current assets should be considered as working capital
as the whole of it helps to earn profits; and the management is more concerned with
the total current assets as they constitute the total funds available for operational
purposes. On the other hand, economists like Lincoln and Salvers uphold the former
view. They argue that (a) in the long run what matters is the surplus of current asserts
over current liabilities (b) it is this concept which helps creditors and investors to
judge the financial soundness of the enterprise; (c) what can always be relied upon to
meet the contingencies, is the excess of current assets over the current liabilities since
this amount is not to be returned; and (d) this definition helps to find out the correct
financial position of companies having the same amount of current assets. Institute of
Chartered Accountants of India, while suggesting a vertical form of balance sheet,
also endorsed the former view of working capital when it described net current assets
as the difference between current assets and current liabilities.
The conventional definition of working capital in terms of the difference between the
current assets and the current liabilities is somewhat confusing. Working capital is
really what a part of long-term finance is locked in and used for supporting current
activities. Consequently, the larger the amount of working capital so derived, greater
the proportion of long –term capital sources siphoned off to short-term activities. It is
about tight working capital situation, the logic of the above definition would perhaps
indicate diversion to bring in cash, under the conventional method, working capital
would evidently remain unchanged. Liquidation of debtors and inventory into cash
would also keep the level of working capital unchanged. A relatively large amount of
working capital according to this definition may produce a false sense of security at a
time when cash resources may be negligible, or when these may be provided
increasingly by long-term fund sources in the absence of adequate profits. Again,
under the conventional method cash enters into the computation of working capital.
But it may have been more appropriate to exclude cash from such calculations
because one compares cash requirements with current assets less current liabilities.
The implication of this in conventional working capital computations is that during
the financial period current assets get converted into cash which, after paying off the
current liabilities, can be used to meet other operational expenses. The paradox,
however, is that such current assets as are relied upon to yield cash must themselves to
be supported by long-term funds until are converted into cash.
At least, three points seem to emerge from the above. First, the balance sheet
definition of working capital is perhaps not so meaningful, except as an indication of
the firm’s current solvency in repaying its creditors. Secondly, when firms speak of
shortage of working capital, they in fact possible imply scarcity of cash resources.
10 Thirdly, in fund flow analysis an increase in working capital, as conventionally
defined, represents employment or application of funds.
1.2.2 Operating Cycle Concept

A company’s operating cycle typically consists of thee primary activities; purchasing
resources, producing the product, and distributing (selling) the product. These
activities create funds flows that are both unsynchronized because cash disbursements
(for example, payments for resource purchases) usually take place before cash receipts
(foe example, collection of receivables). They are uncertain because future sales and
costs, which generate the respective receipts and disbursements, cannot be forecasted
with complete accuracy. If the firm is to maintain a cash balance to pay the bills as
they come due. In addition, the company must invest in inventories to fill customer
orders promptly. And, finally, the company invests in accounts receivable to extend
credit to its customers.
Figure 1.1 illustrates the operating cycle of a typical firm. The operating cycle is equal
to the length of the inventory and receivables conversion periods:
Operating cycle = inventory conversion period + Receivables conversion period
The inventory conversion period is the length of time required to produce and sell the
product. ET is defined as follows:
Average inventory
Inventory conversion period =
Cost of sales / 365
The payables deferral period is the length of time the firm is able to defer payment on
its various resource purchases (for example, materials, wages, and taxes).
Payables deferral period
Accountspayble + slaries, benefits, and Payroll taxes payble
=
(Cost of sales + sellin, general and Ad min istrative exp ense) / 365
Finally, the cash conversion cycle represents the net time interval between the
collection of cash receipts from product sales and the cash payments for the
company’s various resource purchases. It is calculated as follows:
Cash conversion cycle = operating cycle – payable deferral period
Inventory Receivables
conversion period conversion
period
Payables Defer Cash

period conversion
cycle
Operating cycle
Figure 1.1: Operating cycle of typical company cash

The cash conversion cycle shows the time interval over which additional no
spontaneous sources of working capital financing must be obtained to carry out the
firm’s activities. An increase in the length of the operating cycle, without a
corresponding increase in the payables deferral period, lengthens the cash conversion
cycle and creates further working capital financing needs for the company.
11
1.3 IMPORTANCE OF WORKING CAPITAL Working Capital Management:
An Introduction
Working capital is the life blood and nerve centre of a business. Just as circulation of
blood is essential in the human body for marinating life, working capital is very
essential to maintain the smooth running of a business. No business can run
successfully without an adequate amount of working capital. The main advantages of
maintaining adequate amount of working capital are as follows:
1. Solvency of the business: Adequate working capital helps in maintaining
solvency of the business by providing uninterrupted flow of production.
2. Good will: Sufficient working capital enables a business concern to make prompt
payments and hence helps in creating and maintaining goodwill.
3. Easy Loans: A concern having adequate working capital, high solvency and good
credit standing can arrange loans from banks and other on easy and favourable
terms.
4. Cash Discounts: Adequate working capital also enables a concern to avail cash
discounts on the purchases and hence it reduces costs.
5. Regular supply of raw materials: Sufficient working capital ensures regular
supply of raw materials and continuous production.
6. Regular payment of salaries, wages and other day-to-day commitments: A
company which has ample working capital can make regular payment of salaries,
wages and other day-to-day commitments which raises the morale of its
employees, increases their efficiency, reduces wastages and costs and enhances
production and profits.
7. Exploitation of favourable market condition: Only concern with adequate
working capital can exploit favourable market conditions such as purchasing its
requirements in bulk when the prices are lower and by holding its inventories for
higher prices.
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. Quick and regular return on investments: Every investor wants a quick and
regular return on his investments. Sufficiency of working capital enables a
concern to pay quick and regular dividends to its investors as there may not be
much pressure to plough back profits. This gains the confidence of its investors
and creates a favourable market to raise additional funds in the future.
10. High Morale: Adequacy of working capital creates an environment of security,
confidence, and high morale and creates overall efficiency in a business.
Check Your Progress 1

1. Describe the balance sheet concept.
…………………………………………………………………………….
…………………………………………………………………………….
2. What does cash conversion cycle represent?
…………………………………………………………………………….
…………………………………………………………………………….
12
Working Capital Management 1.4 FACTORS INFLUENCING WORKING CAPITAL
REQUIREMENT
The working capital requirement of a concern depend upon a large numbers of factors
such as nature and size of business, the character of their operations, the length of
production cycles, the rate of stock turnover and the state of economic situation. It is
not possible to rank them because all such factors of different importance and the
influence of individual factors changes for a firm overtime. However the following are
important factors generally influencing the working capital requirement.
1. Nature or Character of Business: The working capital requirement of a firm
basically depends upon the nature of this business. Public utility undertakings like
electricity water supply and railways need very limited working capital because
they offer cash sales only and supply services, not products and as such no funds
are tied up in inventories and receivables. Generally speaking it may be said that
public utility undertakings require small amount of working capital, trading and
financial firms require relatively very large amount, whereas manufacturing
undertakings require sizable working capital between these two extremes.
2. Size of Business/Scale of Operations: The working capital requirement of a
concern is directly influenced by the size of its business which may be measured
in terms of scale of operations.
3. Production Policy: In certain industries the demand is subject to wide fluctuations
due to seasonal variations. The requirements of working capital in such cases
depend upon the production policy.
4. Manufacturing process/Length of production cycle: In manufacturing business
the requirement of working capital increases in direct proportion of length of
manufacturing process. Longer the process period of manufacture, larger is the
amount of working capital required.
5. Seasonal Variation: In certain industries raw material is not available through out
the year. They have to buy raw materials in bulk during the season to ensure and
uninterrupted flow and process them during the entire year.
6. Rate of stock turnover: There is a high degree of inverse co-relationship between
the quantum of working capital; and the velocity or speed with which the sales are
affected. A firm having a high rate of stock turnover will need lower amount of
working capital as compared to affirm, having a low rate of turnover.
7. Credit policy: The credit policy of a concern in it s dealing with debtors and
creditors influence considerably the requirement of working capital. A concern
that purchases its requirement on credit and sell its products/ services on cash
require lesser amount of working capital.
8. Business Cycle: Business cycle refers to alternate expansion and contraction in
general business activity. In a period of boom i.e., when the business is
prosperous, there is a need of larger amount of working capital due to increase in
sales, rise in prices, optimistic expansion of business contracts sales decline,
difficulties are faced in collection from debtors and firms may have a large
amount of working capital lying idle.
9. Rate of growth of business: The working capital requirement of a concern
increase with the growth and expansion of its business activities. Although it is
difficulties to determine the relationship between the growth in the volume of
business and the growth in the working capital of a business, yet it may be
concluded that of normal rate of expansion in the volume of business, we may
have retained profits to provide for more working capital but in fast growth in
concern, we shall require larger amount of working capital.
10. Price Level Changes: Changes in the price level also effect the working capital 13
requirement. Generally the rising prices will require the firm to maintain larger An Introduction
amount of working capital as more funds will be required to maintain the same
current assets.
1.5 LEVELS OF WORKING CAPITAL INVESTMENT

In a “perfect” world, there would be no necessity for working capital assets and
liabilities. In such a world, there would be no uncertainty, no transaction costs,
information search costs, scheduling costs, or production and technology constraints.
The unit cost of producing goods would not vary with the amount produced. Firms
would borrow and lend at the same interest rate. Capital, labor, and product markets
would reflect all available information and would be perfectly competitive. In such a
world, it can be shown that there would be no advantage for invest or finance in the
short-term.
But the world in which real firms function is not perfect. It is characterized by the
firm’s considerable uncertainty regarding the demand, market price, quality, and
availability of its own products and those of suppliers. There are transaction costs for
purchasing or selling goods or securities. Information is faced with limits on the
production capacity and technology that it can employ. There are spreads between the
borrowing and lending rates for investments and financings of equal risk. Information
is not equally distributed and may not be fully reflected in the prices in product and
labor markets, and these markets may not be perfectly competitive.
These real-world circumstances introduce problems with which the firm must deal.
While the firm has many strategies available to address these circumstances, strategies
that utilize investment or financing with working capital accounts often offer a
substantial advantage over other techniques. For example, assume that the firm is
faced with uncertainty regarding the level of its future cash flows and will incur
substantial costs if it has insufficient cash to meet expenses. Several strategies may be
formulated to address this uncertainty and the costs that it may engender. Among
these strategies are some that involve working capital investment or financing such as
holding additional cash balances beyond expected needs, holding a reserve of
short-term borrowing capacity. One of these strategies (or a combination of them)
may well be the least costly approach to the problem. Similarly, the existence of fixed
set-up costs in the production of goods may be addressed in several ways, but one
possible alternative is hold inventory.
By these examples, we see that strategies using working capital accounts are some of
the possible ways firms can respond to many of the problems engendered by the
imperfect and constrained world in which they deal. One of the major features of this
world is uncertainty (risk), and it is this feature that gives rise to many of the strategies
involving working capital accounts. Moreover, a firm’s net working capital position
not only is important from an internal standpoint; it also is widely used as one
measure of the firm’s risk, Risk, as used in this context, deals with the probability that
a firm will encounter financial difficulties, such as the inability to pay bills on time.
All other things being equal, the more net working capital a firm has, the more likely
that it will be able to meet current financial obligations. Because vet working capital is
one debt financing. Many loan agreements with commercial banks and other lending
institutions contain provision requiring the firm on maintain a minimum net working
capital position. Likewise, bond indentures also often contain such provisions. The
overall policy considers both the level of working capital investment and its financing.
In practice, the firm has to determine the joint impact of these two decisions upon its
profitability and risk. However, to permit a better understanding of working capital
policy, the working capital financing decision is discussed in the following section. In
the final section of the chapter, the two decisions are considered together.
14 The size and nature of a firm’s investment in current assets is a function of a number
of different factors, including the following:
1. The type of products manufactured.
2. The length of the operating cycle.
3. The sales level (because higher sales require more investment in inventories and
receivables).
4. Inventory policies (for example, the amount of safety stocks maintained; that is,
inventories needed to meet higher than expected demand or unanticipated delays
in obtaining new inventories).
5. Credit policies.
6. How efficiently the firm manages current assets. (Obviously, the more effectively
management.
7. economizes on the amount of cash, marketable securities, inventories, and
receivables employed, the smaller the working capital requirements).
For the purposes of discussion and analysis, these factors are held constant for the
remainder of this lesson. Instead of focusing these factors, this section examines the
risk-return tradeoffs associated with alternative levels of working capital investments.

1. Define production policy.
…………………………………………………………………………….
…………………………………………………………………………….
2. Discuss business cycle.
…………………………………………………………………………….
…………………………………………………………………………….
1.6 PROFITABILITY VS. RISK TRADE-OFF

Before deciding on an appropriate level of working capital investment, a firm’s
management has to evaluate the tradeoff between expected profitability and the risk
that it may be unable to meet its financial obligations. Profitability is measured by the
rate of (operating) return on total assets; that is, EBIT/ total assets. The risk that the
firm will encounter financial difficulties is related to the firm’s net working capital
poison.
Policies C represent a conservative approach to working capital management. Under
this policy the company holds a relatively large proportion of its total assets in the
form of current assets. Because the rate of return on current assets normally is
assumed to be less than the rate of return on fixed assets, this policy results in a lower
expected profitability as measured by the rate of return on the company’s total assets.
Assuming that current liabilities remain constant, this type of policy also increases the
company’s net working capital position, resulting in a lower risk that the firm will
encounter difficulties.
In contrast to policy C policy A represent an aggressive approach. Under this policy
the company holds a relatively small proportion of its total assets in the form of lower
yielding current assets and thus has relatively less net working capital. As a result, this
policy yields a higher expected profitability and a higher risk that the company will
encounter financial difficulties.
Finally, policy B represents a moderate approach, because expected profitability and 15
risk levels fall between those of policy C and policy A. An Introduction
Using net working capital as a measure of risk, the aggressive policy is most risky,
and the conservative policy is the least risky. The current ratio is another measure of
working capital policies.
A firm’s ability to meet financial obligations is as they come due. The aggressive
policy would yield the lowest current ratio, and the conservative would yield the
highest current ratio.
1.7 OPTIMAL LEVEL OF

WORKING CAPITAL INVESTMENT
The optimal level of working capital investment is the level expected to maximize
shareholder wealth. It is a function of several factors, including the variability of sales
and cash flows and the degree of operating and financial leverage employed by the
firm. therefore no single working capital investment policy is necessarily optimal for
all firms.
1.7.1 Proportions of Short-term Financing

Not only dose a firm have to be concerned about the level of current assets; it also has
to determine the proportions of short-and long-term debt to use in financing use in
these assets. The decision also involves tradeoffs between profitability and risk.
Sources of debt financing are classified according to their maturities. Specifically,
they can be categorized as being either short-term or long-term, with short-term
sources having maturities of 1 year or less and long-term sources having maturities of
greater than 1 year
1.7.2 Cost of Short-term vs. Long-term Debt

Historically long-term interest rates normally exceeds short-term rate because of the
reduce flexibility of long–term borrowing relative to short-term borrowing. Infect, the
effective cost of long-term debt, even went short-term interest rates are equal to or
greater then long-term rates. With long-term debt, a firm incurs the interest expense
even during times went it has no immediate need for the funds, such as during
seasonal or cyclical downturns. With short –term debt, in contrast, the firm can avoid
the interest costs on unneeded funds by playing of (or not renewing) the debt.
therefore, the cost of long-term debt generally is higher then the cost of short-term
debt.
1.7.3 Risk of Long-term vs. Short-term Debt

Borrowing companies have different attitudes toward the relative risk of long-term
versus short-term debt then lenders. Whereas lenders normally fee that risk increases
with maturity, borrowing feel that there is more risk associated with short-term debt.
The reasons for this are two-fold.
First, there is always the chance that a firm will not be able to refund its short-term
debt. When a firm’s debt matures, it either pays off the debt as part of a debt reduction
program or arranges new financing. At the time of maturity, however, the form could
faced with financial problems resulting from such events as strikes, natural disasters,
or recessions that cause sales and cash inflows to decline. Under these circumstances
the form may find it very difficult or even impossible to obtain the needed funds. This
could lead to operating and financial difficulties. The more frequently affirm must
refinance debt, the greater is the risk of its not being able to obtain the necessary
financing.
16 Second, short-term interest rates tend to fluctuate more over time than long-term
interest rates. As a result, a firm’s interest expenses and expected earnings after
interest and taxes are subject to more variation (risk) over time with short-term debt
than with long-term debt.
1.8 THEORIES AND APPROACHES TO WORKING

CAPITAL
There are three basic approaches for determining an appropriate working capital
financing mix.
Approaches to Financing Mix
The Hedging or The Conservative The Aggressive

Matching Approach Approach Approach
Figure 1.2: Working Capital Financing Mix

The term ‘hedging’ usually refers to two off-setting transactions of a simultaneous but
opposite nature which counterbalance the effect of each other. With reference to
financing mix, the term hedging refers to ‘a process of matching maturities of debt
with the maturities of financial needs’. According to this approach, the maturity of
sources of funds should match the nature of assets to be financed. This approach is,
therefore, also known as ‘matching approach’. This approach classifies the
requirements of total working capital into two categories:
(i) Permanent or fixed working capital which is the minimum amount required to
carry out the normal business operations. It does not vary over time.
(ii) Temporary or seasonal working capital which is required to meet special
exigencies. It fluctuates over time.
The hedging approach suggests that the permanent working capital requirements
should be financed with funds from long-term sources while the temporary or
seasonal working capital requirements should be financed with short-term funds. The
following example explains this approach.
Table 1.1: Estimated Total Investment in Current Assets of
Company X for the Year 2000
Month Investments in Permanent or Temporary or
Current Assets Fixed Investments Seasonal Invest
(Rs.) (Rs.) (Rs.)
January 50,400 45,000 5,400
February 50,000 45,000 5,000
March 48,700 45,000 3,700
April 48,000 45,000 3,000
May 46,000 45,000 1,000
June 45,000 45,000 ……….
July 47,500 45,000 2,500
August 48,000 45,000 3,000
September 49,500 45,000 4,500
October 50,700 45,000 5,700
November 52,000 45,000 7,000
December 48,500 45,000 3,500
Total 44,300
According to hedging approach the permanent portion of current assets required 17
(Rs. 45,000) should be financed with long-term sources and temporary or seasonal An Introduction
requirements in different months (Rs. 5,400; Rs. 5,000 and so on) should be financed
from short-term sources.
1.8.2 Conservative Approach

This approach suggests that the entire estimated investments in current assets should
be financed from long-term sources and the short-term sources should be used only
for emergency requirements. According to this approach, the entire estimated
requirements of Rs. 52,000 in the month of November (in the above given example)
will be financed from long-term sources. The short-term funds will be used only to
meet emergencies. The distinct features of this approach are:
(i) Liquidity is severally greater;
(ii) Risk is minimized; and
(iii) The cost of financing is relatively more as interest has to be paid even on
seasonal requirements for the entire period.
Trade-off between the Hedging and Conservative Approaches

The hedging approach implies low cost, high profit and high risk while the
conservative approach leads to high cost, low profits and low risk. Both the
approaches are the two extremes and neither of them serves the purpose of efficient
working capital management. A trade off between the two will then be an acceptable
approach. The level of trade off may differ from case to case depending upon the
perception of risk by the persons involved in financial decision-making. However, one
way of determining the trade off is by finding the average of maximum and the
minimum requirements of current assets or working capital. The average requirements
so calculated may be financed out of long-term funds and the excess over the average
from the short-term funds. Thus, in the above given example the average requirements
of Rs. 48,500, i.e. 45,000+52,000 may be financed from long-term. While the excess
capital required during various months from short-term sources.
1.8.3 Aggressive Approach

The aggressive approach suggests that the entire estimated requirements of currents
asset should be financed from short-term sources and even apart of fixed assets
investments be financed from short-term sources. This approach makes the
finance-mix more risky, less costly and more profitable.
Illustration 1
Excel Industries Ltd. is considering its current assets policy. Fixed assets are
estimated at Rs. 40,00,000 and the firm plans to maintain a 50 per cent debt to asset
ratio. The interest rate is 14 per cent on all debt. Three alternative current asset
policies are under consideration; 40,50 and 60 percent of projected sales.
The company expects to earn 50 percent before interest and tax on sales of
Rs. 2,00,00,000. The corporate tax rate is 35 percent. Calculate the expected return on
equity under alternative.
18
Working Capital Management Table 1.2: Alternative Balance Sheets of Excel Industries Ltd.
Current Assets Policies

Conservative Moderate Aggressive
40% of Sales) (50% of Sales) (60% of Sales)
Rs. in lacs Rs. in lacs Rs. in lacs
Current Assets 80.00 100.00 120.00

Fixed Assets 40.00 40.00 40.00
Total Assets 120.00 140.00 160.00
Debt (50% of Total Assets) 60.00 70.00 80.00
Equity 60.00 70.00 80.00
Total Liabilities and Equity 120.00 140.00 160.00
Table 1.3: Alternative Income Statements: Effects of

Alternative Current Assets Policies
Conservative (40%) Moderate (50%) Aggressive (60%)

Rs. in lacs, Rs. in lacs Rs. in lacs
Sales 200.00 200.00 200.00

Earnings Before Interest
and Tax (20%) 40.00 40.00 40.00
Interest on Debt (14%) 8.40 9.80 11.20
Earnings Before Tax (EBT) 31.60 30.20 28.80
Tax (35%) 11.06 10.57 10.08
Earnings After Tax (EAT) 20.54 19.63 18.72
Return on Equity
(EAT/Equity) 34.23% 28.04% 23.40%
Illustration 2
The following are the summarized balance sheets of X Ltd. and Y Ltd. as on
31st March, 2003:
Table 1.4
X Ltd. Y Ltd.
(Rs. in lacs) (Rs. in lacs)
Current Assets 100.00 60.00

Fixed Assets 100.00 140.00
Total Assets 200.00 200.00
Current Liabilities 20.00 80.00
Long-term Debt 80.00 20.00
Equity Share Capital 70.00 30.00
Retained Earnings 30.00 70.00
200.00 200.00
Earnings before interest and tax for both the companies are Rs. 50 lacs each. The 19
corporate tax rate is 35 percent. An Introduction
(i) What is the return on equity (ROE) for each company if the interest rate on
current liabilities is 10 per cent and 12 per cent on long-term debt?
(ii) Assuming that the rate of interest on current liabilities rises to 15 percent, while it
remains unchanged for ling-term debt, would be its effect on return on equity for
each company.
Solution:
Table 1.5: Calculation of Return on Equity
(Rs. in lacs)
X Ltd. Y Ltd.
(a) (b) (a) (b)
Earnings Before Interest and Tax 50.00 50.00 50.00 50.00
Interest on Current and
Long-term Debt 11.60 12.60 10.40 14.40
Earnings Before Tax (EBT) 38.40 37.40 39.60 35.60
Tax (35%) 13.44 13.09 13.86 12.46
Earnings After Tax (EAT) 24.96 24.31 25.74 23.14
Equity (Eq. Share Capital
+ Retained Earnings 100.00 100.00 100.00 100.00
Return on Equity (EAT/Equity) 24.96% 24.31% 25.74% 23.14%
1.9 THE STATEMENT OF CHANGES IN

FINANCIAL POSITION
Historically, financial reporting requirements have included a balance sheet, a profit
or loss statement, and a statement of changes in financial position. If only one
financial statement is to be presented for a business, that statement would have to be
the Balance Sheet. For the Balance Sheet reports the irreducible minimum of modern
double-entry accounting, namely the resources of a firm and the various liabilities and
other equity interests in those resources. All other financial statements report
particular aspects of assets and equities. If, however, the most important statement
were to be selected, the choice would probably be the income statement in the
majority of cases. Earnings are the real basis of asset and enterprise values, the best
test of managerial effectiveness in the business world, and therefore, a leading
criterion in business decisions. Still, as earning power is a rate of return, dependent
well as income statements are necessary even when the emphasis is primarily on
earnings. Thus, the accountants report on the results of operations and on the current
Balance Sheet and the income statement. However, because of inherent limitations in
the Balance Sheet and income statements, the two basic statements are supplemented
in corporate annual reports by a third statement, the Statement of Changes in Financial
Position. And by footnotes which explain and amplify the reported numerical data. It
did exist in the past with some minor differences in the forms and under different
titles, such as the Statement of Sources and Uses ( or Applications ) of Funds; Funds
Statements or Funds flow Statement, Statement of Funds provided and Applied and
so on.
The purpose of this financial statement is to present an analysis of the changes in the
financial position-the changes in the Balance Sheet of a company from the beginning
20 of an accounting person to the end of the period. The statement of changes in financial
position assist the user in assessing the causes of changes in the Balance Sheet. Some
of the types of questions that can be answered by an analysis of the statement are:
1. What were the sources of funds-either cash or working capital that became
available to the company during the period? Where funds obtained from net
income, borrowing, and investments by owners or sale of assets?
2. Why did cash or working capital decr4ese during the period in which the
company earned a profit?
3. How were funds used? Were they used from expansion, payment of debt, payment
of dividends, and so on?
4. How were assets acquisition financed—by long-term borrowings, by short-term
debt, from working capital, or investments by owners?
1.9.1 Basic Approach

An analysis of the flow of resources-funds flow-through a business enterprise has long
been viewed as a useful technique for analyzing the effectiveness of the enterprise’s
financial activities and for assisting in the prediction of its financial success or failure.
The term funds has a particular meaning in this context. However in everyday usage,
the term funds usually means cash. Therefore, it might appear that a statement of
changes in financial position would provide a summary of the firm’s cash receipts and
disbursements for the period. Using this definition of funds, the statement is
essentially an analysis of cash flow.
In financial reporting, the term “funds” has usually been defined as working capital, or
the excess of current assets over current liabilities. According to this concept, the
statements report financing and investing activities as a summary of the sources and
uses of working capital for the period. Thus, the purpose of the statements is to
indicate the source of working capital inflow into the firm and the uses which were
made of working capital during the period.
The working capital concept for “funds” is the more commonly used method for
preparing a statement of changes in financial position. Since it is more often used, and
is usually easier to apply, we will first discuss this method and then cover the cash
“funds” approach.
1.9.2 Working Capital Approach

Working capital is defined as current assets minus current liabilities. It is a broader
definition of “funds” than just cash, but bear in mind that cash is one component of
working capital. Since working capital is the difference between current assets and
current liabilities, a change in either or both results in a changes in working capital.
The statement of changes in financial position is prepared to present an analysis of the
change in working capital from the beginning to the end of an accounting period.
The statement of changes in financial position on a working capital basis includes
information relating to the changes in working capital based on the various sources
and uses of funds. The statement of sources and uses of capital gives a picture of
management’s handling of circulating capital. It is, therefore, a “window” through
which the analyst can closely examine on phase of management’s planning and
decision-making. The statement provides answers to several questions which cannot
be supplied by the conventional statements, such as those listed below that may be
raised by management, shareholders, creditors, and others.
1. What has caused the change in the working capital position?
2. How much working capital was provided by current operations, and what
disposition was made of it?
3. What was the amount of capital derived from the sale of capital stock or through 21
long-term borrowing, and what use was made of these funds? An Introduction
4. Did company dispose of any of the non-current assets, and if so, what were the
proceeds?
5. What additional plant and equipment or other non-current assets were acquired by
using working capital?
Sources and Uses of Working Capital

The statement of changes in financial position is divided into two major segments:
funds that the firm has obtained during the period (sources of funds), and the outflow
of funds which has occurred (use of funds). The “sources of funds” section
summarizes all transactions of the business that caused a decrease in working capital
during the period.
Sources of Funds
Transactions that increase working capital are sources of funds. The primary sources
of working capital of a firm include:
Funds generated from operations: The earnings of a business represent on of the
principal “sources of funds”. The amount of funds generated from operations is not
the net income shown on the income statement, however, because some of the
expenses, principally depreciation and amortization, do not involve the expenditure of
funds. In order to determine working capital provided by operations, it is necessary to
deduct from revenues only those expense which required an expenditure of funds and
therefore caused a decrease in working capital. A convenient way of determining
working capital from operations is simply to add back to net income all those
expenses which did not a source of funds in and of itself, but instead is simply a
means of determining the amount of working capital generated by operations.
Certain items included in the income statement decrease expenses (there by increasing
income) without increasing working capital. For example, the amortization of
premium on bonds payable cause interest expenses to be less than the amount of the
cash paid. Therefore, these items should be deducted from net income in computing
the amount of working capital provided by operations.
The computation of the working capital fund provided by operations may be
summarized as follows:
Net Income + Items Reducing Net Income Which Do Not Affect Working Capital +
Non-operating Loses – Non-operating Gains – Items Increasing Net Income Which
Do Not Affect Working Capital .
Working Capital Provided by Operations

Increase in long-term liabilities: A second source of funds is long-term borrowing.
The change in the amount of funds from long-term borrowing can be calculated by
subtracting the balance at the end of the period from the balance at the beginning of
the period. If the difference is appositive number (i.e., liabilities have increased), it is
a source of funds; if long-term liabilities have decreased, it is a use of funds.
Increase in share capital: If a business has issued share capital during a period, the
amount for which the shares were sold is a source of funds.
Sale of non-current assets: The sale of non-current assets will be another source of
funds equal to the net proceeds form the sales. (Notice that profit or loss from the sale
of non-current assets is neither a source nor use of funds).
22 Uses of Funds
Transactions that decrease working capital are classified as uses of funds. Typical uses
of working capital include:
Purchase of non-current assets: One of the major use of funds is the purchase of
non-current assets, principally land buildings, machinery investments, and intangible
assets. The amount of funds used to purchase machinery, building etc. cannot be
calculated by taking the difference between net value at the beginning and end of the
year. Non-current asset accounts are affected not only by purchases, but also by the
amount of depreciation taken during the year and the sale or disposition of assets dung
the year. Consequently, it is necessary to have information on all of these three items.
Dividends: The declaration of a cash dividend to be paid at a later date is also a use of
funds. Working capital is reduced at the time the declaration is made because a current
liability, dividends payable, is incurred and recorded at that time. The subsequent
payments of the cash dividend does not affect working capital because cash, a current
asset, and dividends payable, a current liability are reduced by equal amounts.
Decrease in long-term liabilities: Funds may be used to pay-off long-term liabilities.
The amount of funds used for the purpose can be calculated by subtracting the balance
of the long-term liabilities at the beginning of the period from the balance at the end
of the period. A decrease in long-term liabilities is a use of funds. An increase in long-
term liabilities is a source of funds. If there are different types of long-term liabilities
and the amounts arte significant, it is usual to show each type as a separate item.
Changes in Working Capital
An increase in a current assets balance causes an increase in working capital. This
increase in working capital may be reflected in cash and marketable securities or in
receivables and inventories which might be slow of collection and low of turnover,
respectively. The increase may be a result of one or a combination of such
transactions as the following:
1. Issuance of debentures in exchange for current liabilities.
2. Working capital provided by current operations (income before deducting
depreciation, depletion, and amortization charges, i.e. revenue less charges against
revenue which required the use of working capital).
3. Payment of current dividends.
4. Sale of long-term assets.
5. Issuance of fresh share capital.
A different interpretation would be made of the increase in working capital depending
upon the relative importance of the various sources, if the entire increase was a result
of current operations (less reasonable dividends), a more favorable position would
obtain than if the source were primarily from the issuance of long-term debt
obligations. A less factorable impression of the increase would be created if dividend
payments exceeded the net income or if a loss were incurred and long-term debt
obligations has been issued.
In determining changes in working capital we are concerned only with those in
determining working capital and the accounts not included in working capital
(i.e., non-working capital accounts) at the same time. Transactions that involve only
working capital accounts or non-working capital may be ignored in determining the
changes in working capital. For example, if a cash payment is made or creditors,
working capital is not affected because cash (and current assets) and creditors
(and current liabilities) decrease by equal amounts. Likewise, if shares are exchanged
for a machine, working capital does not change because on working capital accounts
are involved in the exchange.
Changes in non-current accounts: One the change in working capital has been 23
calculated, the next step is to examine the changes in the financial position of An Introduction
non-working capital amount, i.e., non-current assets, non-current liabilities, and
shareholders’ equity. The purpose of this examination is to identify those transactions
that may have equity. The purpose of this examination is to identify those transactions
that may have affected working capital.
The first change encountered in the non-working capital account on the Balance Sheet
is the change in equipment. It is important to note that this is a net change; that is, the
result of an increase that is partially offset by a decrease in the equipment account, on
the Balance Sheet, the next change in a non-current accounts is the change in bills
payable. The liquidation of long-term liabilities is assumed to be the result of a cash
payment unless otherwise noted, it is reported on the statement of changes in financial
position as an application of working capital. Change in debentures indicates that a
company has incurred additional debt during the period. Unless otherwise noted, it is
assumed that the company borrowed cash. This transaction is presented on the
statement of change in financial position under other sources of working capital.
Change in equity capital and paid-up capital along with retained earnings are also
provided under the other sources of working capital. Other non-working capital
revenue and expenses items that may appear in given situation are the amortization of
premiums and discounts on long-term investments in bonds and bonds payable.
Changes in working capital due to flood damage and dividends declared are also
recorded under other sources of working capital.
The first change encountered in the non-working capital account on the Balance Sheet
is the change in equipment. It is important to note that this is a net change; that is, the
result of an increase that is partially offset by a decrease in the equipment account, on
the Balance Sheet, the next change in a non-current accounts is the change in bills
payable. The liquidation of long-term liabilities is assumed to be the result of a cash
payment unless otherwise noted, it is reported on the statement of changes in financial
position as an application of working capital. Change in debentures indicates that a
company has incurred additional debt during the period. Unless otherwise noted, it is
assumed that the company borrowed cash. This transaction is presented on the
statement of change in financial position under other sources of working capital.
Change in equity capital and paid-up capital along with retained earnings are also
provided under the other sources of working capital. Other non-working capital
revenue and expenses items that may appear in given situation are the amortization of
premiums and discounts on long-term investments in bonds and bonds payable.
Changes in working capital due to flood damage and dividends declared are also
recorded under other sources of working capital.

Define working capital.
…………………………………………………………………………….
…………………………………………………………………………….
1.10 ANALYSIS OF FUNDS FLOW STATEMENT

1.10.1 Meaning and Definition of Funds Flow Statement
Funds Flow Statements is a method by which we study changes in the financial
position of a business enterprise between beginning and ending financial statements
dates. It is a statement showing sources and uses of funds for a period of time.
24 Foulke defines these statements as:
“A statement of sources and application of funds is a technical device designed to
analyse the changes in the financial condition of a business enterprise between two
dates.”
In the words of Anthony, “The funds flow statement describes the sources from which
additional funds were derived and the use to which these sources were put.”
I.C.W.A in Glossary of Management Accounting terms defines Funds Flow Statement
as “a Statement either prospective or retrospective, setting out the sources and
applications of the funds of an enterprise. The purpose of the statement is to indicate
clearly the requirement of funds and how they are proposed to be raised and the
efficient utilization and application of the same.”
Thus, funds flow statement is statement which indicates various means by which the
funds have been obtained during certain period and the ways to which these funds
have been used during that period. The term ‘funds’ used here means working capital,
i.e., the excess of current assets over current liabilities.
Funds flow statement is called by various names such as Sources and Application of
Funds; Statement of Changes in Financial Position; Sources and Uses of Funds;
Summary of Financial Operations: Where came in and Where gone out Statement;
Where got, Where gone Statement; Movement of Working Capital Statement;
Movement of Funds Statement; Funds Received and Disbursed Statement; Funds
Generated and Expended Statement; Sources of Increase and Application of Decrease;
Funds Statement, etc.
1.10.2 Funds Flow Statement, Income Statement and Balance Sheet

Funds flow statement is not a substitute of an income statement, i.e., a profit and loss
account, and a balance sheet. The Profit and Loss Account is a document which
indicates the extent of success achieved by a business in earning profits. It reports the
results of business activities and indicates the reasons for the profitability or lack
thereof. The Profit and Loss Account does not highlight the changes in the financial
position of a business. It does not reveal the inflows and outflows of funds in business
during a particular period.
A balance sheet is statement of financial position or status of business on a given date.
It is prepared at the end of accounting period. The balance sheet depicts various
resources of an undertaking and the deployment of these resources in various assets on
a particular date. As it indicates the financial condition on a particular date, it is static
in nature; while funds flow statement is a dynamic one. Funds statement tells us many
financial facts which a balance sheet cannot tell. Balance Sheet does not disclose the
causes for changes in the assets and liabilities between two different points of time.
Again, while balance sheet is the end result exercise, it is prepared (Funds Statements)
to show various sources from which the funds came into business and various
applications where they have been used.
Hence, funds flow statement is not competitive but complementary to financial
statements. The funds statement provides additional information as regards changes in
working capital, derived from financial statements at two points of time. It is a tool of
management for financial analysis and helps in making decisions.
25
Difference Between Funds Flow Statement and Income Statement Working Capital Management:
An Introduction
Funds Flow Statement Income statement
1. It highlights the changes in the financial 1. It does not reveal the inflows and outflows
position of a business and indicates the of funds but depicts the items of expenses
various means by which funds were and incomes arrive at the figure of profit or
obtained during a particular period and the loss.
ways to which these funds were employed.
2. It is complementary to income statement. 2. Income statement is not prepared from
Income statement helps the preparation of Funds Flow Statement.
Funds Flow Statement.
3. While preparing Funds Statement both 3. Only revenue items are considered.
capital and revenue items are considered.
4. There is no prescribed format for preparing 4. It is prepared in prescribed format.
a Funds Flow Statement.
Difference between Funds Flow Statement and Balance Sheet
Funds Flow Statement Balance Sheet

1. It is statement of changes in financial 1. It is a statement of financial position on a
position and hence is dynamic in nature. particular date and hence is static in nature.
2. It shows the sources and uses of funds in a 2. It depicts the assets and liabilities at a
particular period of time. particular point of time.
3. It is a tool of management for financial 3. It is not of much help to management in
analysis and helps in making decisions. making decisions.
4. Usually, Schedule of Changes in Working 4. No such schedule of Changes in Working
Capital has to be prepared before preparing Capital is required. Rather Profit and Loss
Funds Flows Statement. Account is prepared.
1.10.3 Uses, Significance and Importance of Funds Flow Statement

A funds flow statement is an essential tool for the financial analysis and is of primary
importance to the financial management. Now-a-days, it is being widely used by the
financial analysts, credit granting institutions and financial managers. The basic
purpose of a funds flow statement is to reveal the changes in the working capital on
the two balance sheet dates. It also describes the sources from which additional
working capital has been financed and the uses to which working capital has been
applied. Such a statement is particularly useful in assessing the growth of the firm, its
resulting financial needs and in determining the best way of financing these needs. By
making use of projected funds flow statements, the management can come to know
the adequacy or inadequacy of working capital even in advance. One can plan the
intermediate and long-term financing of the firm, repayment of long-term debts,
expansion of the business, allocation of resources, etc. The significance or importance
of funds flow statement can be well followed from its various uses given below:
1. It helps in the analysis of financial operations. The financial statements reveal the
net effect of various transactions on the operational and financial position of a
concern. The balance sheet gives a static view of the resources of a business and
the uses to which these resources have been put at a certain point of time. But it
does not disclose the causes for changes in the assets and liabilities between two
different points of time. The funds flow statement explains causes for such
changes and also the effect of these changes on the liquidity position of the
company. Sometimes a concern may operate profitably and yet its cash position
may become more and more worse. The funds flow statement gives a clear answer
to such a situation explaining what has happened to the profits of the firm.
26 2. It throws light on many perplexing questions of general interest which otherwise
may be difficult to be answered, such as:
a) Why were the net current assets lesser in spite of higher profits and vice-
versa?
b) Why more dividends could not be declared in spite of available profits?
c) How was it possible to distribute more dividends than the present earnings?
d) What happened to the net profit? Where did they go?
e) What happened to the proceeds of sale of fixed assets or issue of shares,
debentures, etc.?
f) What are the sources of the repayment of debt?
g) How was the increase in working capital financed and how will it be financed
in future?
3. It helps in the formation of a realistic dividend policy. Sometimes a firm has
sufficient profits available for distribution as dividend but yet it may not be
advisable to distribute dividend for lack of liquid or cash resources. In such cases,
a funds flow statement helps in the formation of a realistic dividend policy.
4. 4. It helps in the proper allocation of resources. The resources of a concern are
always limited and it wants to make the best use of these resources. A projected
funds flow statement constructed for the future helps in making managerial
decisions. The firm can plan the deployment of its resources and allocate them
among various applications.
5. It acts as a future guide. A projected funds flow statement also acts as a guide for
future to the management. The management can come to know the various
problems it is going to face in near future for want of funds. The firm’s future
needs of funds can be projected well in advance and also the timing of these
needs. The firm can arrange to finance these needs more effectively and avoid
future problems.
6. It helps in appraising the use of working capital. A funds flow statement helps in
explaining how efficiently the management has used its working capital and also
suggests ways to improve working capital position of the firm.
7. It helps knowing the overall creditworthiness of firm. The financial institutions
and banks such as State Financial Institutions. Industrial Development
Corporation. Industrial Finance Corporation of India, Industrial Development
Bank of India, etc. all ask for funds flow statement constructed for a number of
years before granting loans to know the creditworthiness and paying capacity of
the firm. Hence, a firm seeking financial assistance from these institutions has no
alternative but to prepare funds flow statements.
1.10.4 Limitations of Funds Flow Statement

The funds flow statement has a number of uses, however, it has certain limitations
also, which are listed below:
1. It should be remembered that a funds statement is not a substitute of an income
statement or a balance sheet. It provides only some additional information as
regards changes in working capital.
2. It cannot reveal continuous changes.
3. It is not an original statement but simply are-arrangement of data given in the
financial statements.
4. It is essentially historic in nature and projected funds flow statement cannot be 27
prepared with much accuracy. An Introduction
5. Changes in cash are more important and relevant for financial management than
the working capital.
1.10.5 Procedure for Preparing a Funds Flow Statement

Funds Flow statement is a method by which we study changes in the financial position
of business enterprise between beginning and ending financial statements dates.
Hence, the funds flow statement is prepared by comparing two balance sheets and
with the help of such other information derived from the accounts as may be needed.
Broadly speaking, the preparation of a funds flow statement consists of two parts:
1. Statement or Schedule of Charges in Working Capital.
2. Statement of Sources and Application of Funds.
1. Statement or Schedule of Changes in Working Capital

Working Capital means the excess of current assets over current liabilities. Statement
of changes in working capital is prepared to show the changes in the working capital
between the two balance sheet dates. This statement is prepared with the help of
current assets and current liabilities derived from the two balance sheets.
As. Working Capital = Current Assets-Current Liabilities.
So, (i) An increase in current assets increases working capital.

(ii) A decrease in current assets decreases, working capital.
(iii) An increase in current liabilities decreases working capital; and
(iv) A decrease in current liabilities increases working capital.
The change in the amount of any current asset or current liability in the current
balance sheet as compared to that of the previous balance sheet either results in
increase or decrease in working capital. The difference is recorded for each individual
current asset and current liability. In case a current asset in the current period is more
than in the previous period, the effect is an increase in working capital and it is
recorded in the increase column. But if a current liability in the current period is more
than in the previous period, the effect is decrease in working capital and it is recorded
in the decrease column or vice versa. The total increase and the total decrease are
compared and the difference shows the net increase or net decrease in working capital.
It is worth noting that schedule of changes in working capital is prepared only from
current assets and current liabilities and the other information is not of any use for
preparing this statement. A typical form of statement or schedule of changes in
working capital is as follows:
28 Statement of Schedule of Changes in Working Capital
Particulars Previous Current Effect on Working Capital
Year Year Increase/Decrease
Current Assets:
Cash in hand
Cash at bank
Bills Receivable
Sundry Debtors
Temporary Investments
Stocks/Inventories
Prepaid Expenses
Accrued Incomes
Total Current Assets
Current Liabilities:
Bills Payable
Sundry Creditors
Outstanding Expenses
Bank Overdraft
Short-term advances
Dividends Payable
Proposed dividends
Provision for taxation
Total Current Liabilities
Working Capital (CA-CL)
Net Increase or Decrease in
Working Capital
Illustration 3
Prepare a Statement of changes in Working Capital from the following Balance Sheets
of Manjit and Company Limited.
Balance Sheets
as at December 31
Liabilities 2001 2002 Assets 2001 2002

Rs. Rs. Rs. Rs.
Equity Capital 5,00,000 5,00,000 Fixed Assets 6,00,000 7,00,000

Debentures 3,70,000 4,50,000 Long-term
Investment 2,00,000 1,00,000
Tax Payable 77,000 43,000
Accounts Payable 96,000 1,92,000 Work-in-progress 80,000 90,000
Interest Payable 37,000 45,000 stock-in-trade 1,50,000 2,25,000
Dividend Payable 50,000 35,000 Accounts Receivable 70,000 1,40,000
Cash 30,000 10,000
11,30,000 12,65,000 11,30,000 12,65,000
Solution: 29
Statement of Schedule of changes in Working Capital An Introduction
Particulars 2001 2002 Effect on Working Capital

Rs. Rs. Increase Decrease
Rs. Rs.
Current Assets:
Cash 30,000 10,000 20,000
Accounts Receivable 70,000 1,40,000 70,000
Stock-in-trade 1,50,000 2,25,000 75,000
Work-in-progress 80,000 90,000 10,000
3,30,000 4,65,000
Current Liabilities:
Tax payable 77,000 43,000 34,000
Account payable 96,000 1,92,000 96,000
Interest payable 37,000 45,000 8,000
Dividend payable 50,000 35,000 15,000
2,60,000 3,15,000
Working Capital (CA-CL) 70,000 1,50,000
Net Increase in Working 80,000 80,000
Capital 1,50,000 1,50,000 2,04,000 2,04,000
1.10.6 Statement of Sources and Application of Funds

Funds flow statement is a statement which indicates various sources from which funds
(working capital) have been obtained during a certain period and the uses or
applications to which these funds have been put during that period. Generally, this
statement is prepared in two formats:
a) Report Form
b) T Form or An Account Form or Self Balancing Type.
Specimen of Report Form of Funds Flow Statement
Sources of Funds: Rs.
Funds from Operations
Issue of Share Capital
Raising of long-term loans
Receipts from partly paid shares, called up
Sales of non current (fixed) assets
Non-trading receipts, such as dividends received
Sale of Investments (long-term)
Decrease in Working Capital (as per schedule of changes
In Working Capital)
Total
Applications or Uses of Funds:
Funds Lost in Operations
Redemption of Preference Share Capital
Redemption of Debentures
Repayment of long-term loan
Purchase of non-current (fixed) assets
Purchase of long-term Investments
Non-trading payments
Payments of dividends
Contd…
30
Payment of tax
Increase in Working Capital (as per schedule of changes in
Working Capital)
Total
T Form an Account Form or Self Balancing Type Funds Flow Statement
(For the year ended………….)
Source Rs. Applications Rs.
Funds from Operations Funds lost in Operations
Issue of Share Capital Redemption of Preference Share Capital
Issue of Debentures Redemption of Debentures
Raising of long-term loans Repayment of long-term loans
Receipts from partly paid shares, called up Purchase of non-current (fixed) assets
Sale of non-current (fixed) assets Purchase of long-term investments
Non-trading receipts such as dividends Non-trading payments
Sale of long-term Investments Payment of Dividends
Net Decrease in Working Payment of tax
Net Increase in Working Capital
Note: Payment of dividend and tax will appear as an application of funds only when these items are appropriations of
profits and not current liabilities.
Sources of Funds
The following are the sources from which funds generally flow (come), into the
business:
1. Funds from Operations or Trading Profits: Trading profits or the profits from
operations of the business are the most important and major source of funds. Sales
are the main source of inflow of funds into the business as they increase current
assets (cash, debtors or bills receivable) but at the same time funds flow out of
business for expenses and cost of goods sold. Thus, the net effect of operations
will be a source of funds if inflow from sales exceeds the outflow for expenses
and cost of goods sold and vice-versa. But it must be remembered that funds from
operations do not necessarily mean the profit as shown by the profit and loss
account of a firm, because there are many non-fund or non-operating items which
may have been either debited or credited to profit and loss account. The examples
of such items on the debit side of a profit and loss account are: amortization of
fictitious and intangible assets such as goodwill, Preliminary expenses and
Discount on issue of shares and debentures written off; Appropriation of Retained
Earnings, such as Transfers to Reserves, etc., Depreciation and depletion; Loss on
sale of fixed assets; Payment of dividend, etc. The non-fund items are those which
may be operational expenses but they do not affect funds of the business, e.g., for
depreciation charged to profit and loss account, funds really do not move out of
business. Non-operating items are those which although may result in the outflow
of funds but are not related to the trading operations of the business, such as loss
on sale of machinery or payment of dividends. The methods of calculating funds
from operations have been discussed in the following pages.
Basically, there are two methods of calculating funds from operations:
a) The first method is to prepare the profit and loss account afresh by taking into
consideration only fund and operational items which involve funds and are
related to the normal operations of the business. The balancing figure in this
case will be either funds generated from operations or funds lost in operations
depending upon whether the income or credit side of profit and loss account
exceeds the expense or debit side of profit and loss account or vice-versa.
b) The second method (which is generally used) is to proceed from the figure of 31
net profit or net loss as arrived at from the profit and loss account already An Introduction
prepared. Funds from operations by this method can be calculated as under:
(a) Calculation of Funds From Operation Rs.

Closing Balance of P & L A/c or Retained Earnings (as given in the balance sheet)
Add: Non-fund and Non-operating items which have been already debited to P & L A/c:
(i) Depreciation and Depletion
(ii) Amortization of fictitious and Intangible Assets such as:
(a) Good will
(b) Patents
(c) Trade Marks
(d) Preliminary Expenses
(e) Discount on Issue of Shares, etc.
(iii) Appropriation of Retained Earnings, such as:
(a) Transfer to General Reserve
(b) Dividend Equalization Fund
(c) Transfer to Sinking Fund
(d) Contingency Reserve, etc.
(iv) Loss on Sale of any non-current (fixed) assets such as:
(a) Loss on sale of land and building
(b) Loss on sale of machinery
(c) Loss on sale of furniture
(d) Loss on sale of long-term investments, etc.
(v) Dividends including:
(a) Interim Dividend
(b) Proposed Dividend (if it is an appropriation of profits and not taken as current liability
(vi) Provision for Taxation (if it is not taken as current liability)
(vii) Any other non-fund/non-operating items which have been debited to P/L A/c
Total (A)
Less Non-fund or Non-operating items which have already been credited to P & L A/c
(i) Profit or Gain from the sale of non-current (fixed) assets such as:
(a) Profit on sale of land and building
(b) Profit on sale of plant & machinery
(c) Profit on sale of long-term investments, etc.
(ii) Appreciation in the value of fixed assets, such as increase in the value of land if it has been
Credited to P/L A/c
(iii) Dividends Received
(iv) Excess Provision retransferred to P/L A/c or written off
(v) Any other non-operating item which has been credited to P/L A/c
(vi) Opening balance of P & L A/c or Retained Earnings (as given in the balance sheet)
Total (B)
Total(A)-Total(B) = Funds generated by operations

32 Illustration 4
B.M. Company presents the following information and you are required to calculate
funds from operations:
Profit and Loss Account
Rs. Rs.
To Expenses: By Gross Profit 2,00,000
Operation 1,00,000 By Gain on Sale Plant 20,000
Depreciation 40,000
To Advertisement Suspense A/c 5,000
To Discount (allowed to customers) 500
To Discount on Issue of Shares
Written off 500
To Good will 12,000
To Net Profit 52,000
To Loss on Sale of building 10,000
2,20,000 2,20,000
Solution:
Calculation of Funds from Operations:

Rs.
Net Profit (as given) 52,000
Add: Non-fund or non-operating items
which have been debited to P/L A/c:
Depreciation 40,000
Loss on sale of building 10,000
Advertisement written off 5,000
Discount on issue of shares written off 500
Goodwill written off 12,000
67,500
Alternatively:
Adjusted Profit and Loss account
Rs. Rs.
To depreciation 40,000 By Opening balance --
To Loss on sale of building 10,000 By Gain on sale of plant 20,000
To Advertisement Suspense A/c 5,000 By Funds from Operations
To Discount on issue of shares 500 (balancing figure) 99,500
To Goodwill 12,000
To Closing balance 52,000
1,19,500 1,19,500
33
Adjusted Profit and Loss Account An Introduction
Rs. Rs.
To Depreciation & Depletion or amortization By Opening Balance (of P & L A/c
of fictitious and intangible assets. Such as: By Transfers from excess provisions
Good will, patents, Trade Marks, By Appreciation in the value of
Preliminary Expenses etc. fixed assets
To Appropriation of Retained Earnings, such as: By Dividends received
Transfers to General Reserve, Dividend By Profit on sale of fixed or
Equalisation Fund, Sinking Fund, etc. non-current assets
To Loss on sales of any non-current or fixed asset By Funds from Operations
To Dividends (including interim dividend) (balancing figure in case debit
To Proposed Dividend (if not taken as a current side exceeds credit side)
Liability)
To Provision for taxation (if not taken as a current
Liability)
To Closing balance (of P & L A/c)
To Funds lost in Operations (balancing figure, in
Case credit side exceeds the debit side)
Illustration 5
Calculate Funds from Operation from the following Income Statement.
Income Statement
Rs. Rs.
To Rent paid 25,000 By Gross Income 5,00,000
To Salaries paid 1,00,000 By Profit on sale of vehicle 3,000
To provision for depreciation 50,000 By Refund of tax 2,000
To Commission paid 5,000 By dividend received 10,000
To Provision for taxation 1,50,000
To General reserve 3,000
To Loss on sale of investments 10,000
To Cost of issue of shares
written off 2,000
To Provision for legal damages 5,000
To Net Income 1,65,000
5,15,000 5,15,000
Solution:
[Funds from Operation = Rs. 3,70,000]
1.11 APPLICATION OR USES OF FUNDS

1. Funds lost in operations. Sometimes the result of trading in a certain year is a loss
and some funds are lost during that period in trading operations. Such loss of
funds in trading amounts to an outflow of funds and is treated as an application of
funds.
2. Redemption of preference share capital. If during the year any preference shares
are redeemed, it will result in the outflow of funds and is taken as an application
of funds. When the shares are redeemed at premium or discount, it is the net
34 amount paid (including premium or excluding discount, as the case may be).
However, if shares are redeemed in exchanges of some other type of shares or
debentures, it does not constitute an outflow of funds as no current account is
involved in that case.
3. Repayment of loans or redemption of debentures, etc. In the same way as
redemption of preference share capital, redemption of debentures or repayment of
loans also constitute an application of funds.
4. Purchase of any non-current or fixed asset: When any fixed or non-current asset
like land, building, plant and machinery, furniture, long-term investments, etc, are
purchased, funds outflow from the business. However, if fixed assets are
purchased for a consideration of issue of shares or debentures or if some fixed
asset is exchanged for another, it does not involve any funds and hence not an
application of funds.
5. Payments of dividends and tax. Payments of dividends and tax are also
applications of funds. It is the actual payment of dividend (may be interim
dividend) and tax which should be taken as an outflow of funds and not the mere
declaration of dividend or creating of provision for taxation.
6. Any other non-trading payment. Any payment or expense not related to the
trading operations of the business amounts to outflow of funds and is taken as an
application of funds.
Fill in the blanks:
1. Working capital is equals to _______________________.
2. Sales- cost of sales is equals to ____________________.
3. Working capital is categorized into _______________ concepts.
1.12 CASH FLOW STATEMENT

There are changes in financial position that do not affect funds flow, yet should be
included in the funds flow statement. These changes result from such transactions as
exchanges of debentures or share capital for bounds. For example, assume that a
company needed money to expand its physical facilities and whished to borrow the
money. One procedure would be to sell bonds (a source of funds) and use the funds to
purchase the physical equipment ( a use of fund). If, instead, the company exchanged
the bonds directly with the owner of the acquired facilities, the net result would be
precisely the same. Yet, in this instance, there would have been no funds flow because
the bonds were never sold for cash. In cases like this, we assume an implicit funds
flow. As a general rule, any time long-term debt or share capital is exchange, it should
appear on the funds flow statement.
If funds are defined as cash, the statement of changes in financial position disclose
individual sources and use of cash. The analysis of cash flow is very similar to the
analysis which was described for the working capital concept of funds. Additional
adjustments, however, are necessary to convert the net income for the period to the
amount of cash which was provided by operations.
1.12.1 Cash Flow from Operations

Several adjustments are required to convert a firm’s net income to cash flow
operations. As illustrated previously, a non-fund expens4, such as depreciation, is an
allocation of a past cost and thus does not result in an outlay of cash during the current
period. Therefore, non-fund expenses must be added back to net income in
determining cash provided by operations. The calculation of cash generated by 35
operations of the business can be better understood with the help of below. An Introduction
Computation of Cash from Operations
Net income as per Income statement (P and L A/c)

Add: Non-fund expenses
Depreciation
Amortization/write off of patents, preliminary Expenses or loss on sale
of fixed assets
Deduct: Profit on sale of fixed assets
Net Working capital or funds provided by operation (a)
Add: Decrease in current assets
Increase in current liabilities
Deduct: Increase in current assets
Decrease in current liabilities
Net change (b)
Cash generated by operation (a) + (b)
Cash received from Customers: since many firms make sales on a credit basis, cash
receipts depend on the collection from customers. If the sundry debtors balance
increases during the period, credit sales must have exceeded collections from
customers. Similarly, a decrease in accounts receivable during the year indicates that
cash collected form customers exceeded net credit sales by the amount of the decrease
in accounts receivable. Therefore, cash received from customers may be computed
thus:
+ Decrease in debtors
Sales or = Cash Receipts from Sales
– Increase in debtors
Cash Disbursement Associated with Cost of Goods Sold: The initial step in computing
the cash disbursements associated with cost of goods sold is determining purchases
for the period. Purchases will differ from cost of goods sold if the inventory balance
increases or decreases during the year. If inventories decreased, then a part of the cost
of goods sold came from the reduction of the beginning inventory and did not
represent goods purchased during the year. Similarly, if inventories increased,
purchases exceeded the cost of goods sold by the amount of the increase in the
inventory balance.
+ Increase in Inventory
Cost of goods sold or = Purchases
– Decrease in Inventory
since purchases are often made on a credit basis, purchases for a period may differ
from cash disbursements if the creditors balance increas4d or decreased during the
year. For example, if a firm increases its creditors, it paid out less cash than the
amount of its purchases for the period.
Thus, the procedure for computing cash disbursements for purchases is as follows:
+ Decrease in creditors
Purchases or = Cash Disbursements for purchases
– Increase in creditors
36
1.12.2 Cash Disbursements for Expenses
Expenses incurred during the current period may differ from cash outlays because of
changes in either prepaid expenses or accrued liability balances.
If an accrued liability related to an expense increased during the year, then only a
portion of the expense represented as expenditure of cash during the period. Thus, if
an expense has a related accrued liability account, the cash disbursement associated
with the expense may be determined as follows:
+ Decrease in Accrued Liability
Expense or = Cash Disbursement for expense
– Increase in Accrued Liability
Similarly, if an expense has a related prepaid expense account an increase in the
prepaid account indicates that the cash outlay exceeded the amount of the expenses.
The cash outlay is computed as follows:
+ Increase in Prepaid Expense Account
Expense or = Cash Disbursement for expenses
– Decrease in Prepaid Expense Account
Cash used for Dividends: The computation of the cash used for dividends may also
differ if there was a change in the dividends payable account from the beginning to the
ends of the year. The declaration of dividends would constitute a decrease in working
capital because a current liability; dividends payable, is increased. The use of cash,
however, would occur during the following year when the dividends are actually paid.
1.13 LET US SUM UP

Until now this lesson has analyzed the working capital the working capital investment
and financing decisions independent of one another in order to examine the
profitability–risk tradeoffs associated with each, assuming that all other factors are
held constant. Effective working capital, policy, however, also requires the
consideration of the joint impact of these decisions on the firm’s profitability and risk.
1.14 LESSON END ACTIVITY

“Uncertainty makes it difficult for a financial manager to predict the company’s
requirements for short-term funds”. Discuss. What steps can the financial manager
take to minimize the resulting risks to the company?
1.15 KEYWORDS
Working capital: It means the firm’s holdings of current or short-term asset.
Balance Sheet Concept: It is represented by the excess of current assets over current
liabilities and is the amount normally available to finance current operations.
1.16 QUESTIONS FOR DISCUSSION

1. Define and describe the difference between the operating cycle and cash
conversion cycle for a typical manufacturing company.
2. Discuss the profitability versus risk tradeoffs associated with alternative levels of
working capital investment.
3. Describe the difference between pertinent current assets and fluctuating current
assets.
4. Why is it possible for the effective cost of long-term debt to exceed the cost of 37
short-term debt, even when short-term interest rates are higher than long-term An Introduction
rates?
5. Describe the matching approach for meeting the financing needs of a company.
What is the primary difficulty in implementing this approach?
6. Discuss the profitability versus risk tradeoffs associated with alternative
combinations of short-term and long-term debt used in financing a company’s
assets.
7. As the difference between the costs of short-and long-term debt becomes smaller,
which financing plan, aggressive or conservative, becomes more attractive?
8. Why is no single working capital investment and financing policy necessarily
optimal for all firms? What additional factors need to be considered in
establishing a working capital policy?
9. Define and contrast the terms working capital and net working capital.
10. Why is working capital management considered so important by shareholders,
creditors, and the firm’s financial manager? What is the definition of net working
capital?
11. Given that a firm’s net working capital is sometimes defined as the portion of
current assets financed with long-term funds, can you show diagrammatically why
this definition is valid?
12. How can the differences between the returns on current and fixed assets and the
cost of current liabilities and long-term funds be used to determine how best to
change a firm’s net working capital?
Check Your Progress: Model Answers
CYP 1
1. There are two interpretations of working capital under the balance sheet
concept. It is represented by the excess of current assets over current
liabilities and is the amount normally available to finance current
operations. But, some-times working capital is also used as a synonym for
gross or total current assets.
2. Cash conversion cycle represents the net time interval between the
collection of cash receipts from product sales and the cash payments for
the company’s various resource purchases.
CYP 2
1. In certain industries the demand is subject to wide fluctuations due to
seasonal variations. The requirements of working capital in such cases
depend upon the production policy.
2. Business cycle refers to alternate expansion and contraction in general
business activity. In a period of boom i.e., when the business is
prosperous, there is a need of larger amount of working capital due to
increase in sales, rise in prices, optimistic expansion of business contracts
sales decline, difficulties are faced in collection from debtors and firms
may have a large amount of working capital lying idle.
CYP 3
Working capital is defined as current assets minus current liabilities. It is a
broader definition of “funds” than just cash, but bear in mind that cash is one
component of working capital. Since working capital is the difference
Contd…
38 between current assets and current liabilities, a change in either or both results
in a changes in working capital.
CYP 4
1. CA-CL
2. Gross profit
3. Two
1.17 SUGGESTED READINGS

P. Gopala Krishan and M.S. Sandilya, Inventory Management, McMillan, 1978.
D.R. Mehta, Working Capital Management, Prentice-Hall Inc., 1974.
K.V. Smith, Management of Working Capital, McGraw-Hill, New York.
E.S. Buffa, Modern Production/Operation Management, Wiley, 1980.
39
LESSON Cash Flows Forecasting
and Budgeting
2
CASH FLOWS FORECASTING AND BUDGETING
CONTENTS
2.1 Introduction
2.2 The Need to Focus on Cash
2.3 Cash Forecasting Horizons
2.3.1 Long Range Forecasts
2.3.2 Medium-Range Forecasts
2.3.3 Daily Cash Forecasts
2.4 Objectives of Cash Forecasting
2.5 Methods of Financial Forecasting
2.5.1 Spot Method
2.5.2 Proportion of another Account
2.5.3 Compounded Growth
2.5.4 Multiple Dependencies
2.6 Forecasting Daily Cash Flows
2.7 Sources of Uncertainty in Cash Forecasting
2.7.1 Estimating Uncertainty in Cash Forecasts
2.8 Hedging Cash Balance Uncertainties
2.8.1 Holding a Stock of Extra Cash
2.9 Let us Sum up
2.10 Keywords
2.0 AIMS AND OBJECTIVES

z Objective of cash management
z Motive of holding cash
z Methods of cash forecasting
z Hedging and options
40
Working Capital Management 2.1 INTRODUCTION
The cash forecast is an estimation of the flows in and out of the firm's cash account
over a particular period of time, usually a quarter, month, week, or day. The cash
forecast is primarily intended to produce a very useful piece of information: an
estimation of the firm's borrowing and lending needs and the uncertainties regarding
these needs during various future periods.
Cash forecasting is extremely important to most firms. It enables them to anticipate
periods of surplus cash and periods where financing will be necessary. This
anticipation is the reason that cash forecasts are generated. Anticipation enables the
firm to plan much more effectively for investment and financing, and via this
planning, produce superior returns.
This lesson highlights design issues relating to forecasting short-term cash flows. We
consider both medium-term monthly and quarterly forecasts and daily cash forecasts.
We first discuss the benefits and costs of forecasting and then introduce some of the
techniques used in cash forecasting systems.
2.2 THE NEED TO FOCUS ON CASH

In this lesson we focus forecasting efforts on cash flow. Because of the availability of
accounting data, managers are sometimes tempted to focus on earnings.
Unfortunately, earnings are not very useful numbers for cash management. Earnings
represent an important accounting concept that attempts to match revenues with the
expenses that generated them. The matching concepts requires that cash outflows be
stored up (in inventory or other assets) until a matching revenue occurs, at which time
an expense is realised. Revenues, in turn, are often recognised on accounting
statements before a cash inflow actually occurs (as in credit sales, which result in
accounts receivable). The result of following generally accepted accounting principles
is a number called earnings cannot be spent. They cannot be paid out in dividends.
They cannot be invested. The only thing management can do with earnings is report
them!
To obtain cash flows from earnings, we must unravel all of the effects of accrual
accounting. Alternatively, we can start with cash flows in the first place and avoid the
confusing effects of accounting. We use both approaches in this lesson.
2.3 CASH FORECASTING HORIZONS

Cash forecasting may be divided into roughly three sub problems. Depending on the
horizon the forecaster wishes to consider. Different techniques and purposes are
associated with each horizon.
2.3.1 Long Range Forecasts

Cash forecasts of 1 or more years into the future are needed primarily to assess the
viability of the firm's long-range financing and operating policies. Long-range
forecasts give planners an idea of how much cash the firm needs to raise through debt
or equity issues, internally generated cash, or other cash sources. These forecasts also
assist managers in establishing dividend policies, determining capital investments, and
planning a mergers and acquisitions (or divestitures) programme. It is typical for a
firm to have a 5 or 10-year forecast that is updated annually.
Long-range forecasts are generally based on accounting projections and typically
involved the generation of various scenarios for future economic and technological
environments. Such forecasts are considered strategic in the sense that possible major
changes are examined.
2.3.2 Medium-Range Forecasts 41
Cash Flows Forecasting
We consider medium-range forecasts to be those that cover cash flows during the next and Budgeting
12 months. A firm may have, for example, a forecast of quarterly cash flows over the
next 4 quarters, with monthly detail over the next 3 months. Medium-range cash
forecasting usually takes the firm'-S existing technology and long-range financing as
given. Hence, this kind of forecast is considered tactical rather than strategic.
Although it can be accounting based, adjustments are made to focus on cash flows
rather than earnings. It is sometimes called cash budgeting.
The purpose of medium-range forecasting is to determine the firms need for short-
term cash from credit lines, commercial paper sales, or credit and payables policies. It
also helps firms to determining the makeup of their short-term investment portfolio.
When a firm performs the task called budgeting, it generally designates the most
likely (or most desirable) scenario of the medium-range forecasts as the budget. The
budget is used to compare actual performance during the course of the year.
2.3.3 Daily Cash Forecasts

Daily cash forecasts attempt to project cash inflows and outflows on a daily basis 1 or
more days into the future. This is perhaps the most difficult forecasting to perform
accurately. Even though a firm may know precisely its revenues for the month, it may
have difficulty determining specific cash inflows for given days of the month. For
some firms, A daily forecast several months into the future is possible. For most,
however, a forecast even 2 days into the future is difficult.
The purposes of daily forecasting are to assist management in scheduling transfer in
cash concentration, funding disbursement accounts, controlling field deposits, and
making short-term investing and borrowing decisions.

1. Define cash forecast.
…………………………………………………………………………….
…………………………………………………………………………….
2. What is the use of long-range forecasts?
…………………………………………………………………………….
…………………………………………………………………………….
2.4 OBJECTIVES OF CASH FORECASTING

As with the other short-term financial systems, it is helpful to outline an objective
function for cash forecasting. Such an objective function might include the following
factors:
1. Interest costs and Income: One major purpose of forecasting is to increase the
firm's yield on its investment portfolio or depending on the firm's financial
position, to decrease interest costs on its borrowing. Lack of an accurate forecast
may force management either to invest in very short-term securities (thereby often
earning the lowest yields) or to borrow unexpectedly at higher than usual interest
rates.
2. Excess Balances: This may be considered a corollary to the first factor. Accurate
daily cash forecasts enable management to reduce balances in disbursement
and/or deposit accounts and thereby move otherwise non-interest- earning cash
into other areas of the firm.
42 3. Administrative Costs Benefits: Forecasting may require extensive administrative
efforts to collect and digest data. On the other hand, forecasting may provide
administrative benefits in the form of better planning and more timely
management reports.
4. Control: Daily cash budgets often provide a standard against which deposit
reports from the field can be compared. If actual deposit vary from project
deposits, inquiries may be warranted.
5. Forecast System Costs: There costs are associated directly with developing,
maintaining, and running the forecasting model and associated data bases. Some
forecast systems require extensive computer time and information. Others are
simple and inexpensive.
Designing forecasting systems requires that management make trade off among these
five cost factors. For example, an extensive, accurate forecasting system may be
costly to build and maintain and may require strong administrative effort. But such a
system may enable the firm to achieve better returns on its short-term investments,
reduce borrowing costs, and exert better control over cash flows. To determine
whether such a system is worth the cost, a detailed study would be conducted to
qualify the five factors. We next discuss medium-range cash forecasting, which
involves primarily a projection of accounting statements. We then introduce daily
cash forecasting methods requiring more refined information sources. In the final
section, we survey quantitative forecasting tools.
2.5 METHODS OF FINANCIAL FORECASTING

Financial forecasting is the estimation of the future level of a financial variable, often
a cash flow, asset level, or liability level. It is usually assumed that the relationship
between the financial variable and other variables is linear. The general linear model
can then be used.
Yt = aa + a1X1 +a2X2…….. anXn (1)
Here, Y is the financial variable (Y) to be forecast in period t. This X’s are the
explanatory variables, they are assumed to cause the level of Y in period t. The a term
represents a constant unaffected by the X's. The other a terms are the estimated
Coefficients of the explanatory X variables. There are n terms with X's in them. This
general methodology will be clearer as examples are presented. It is understood that
any forecast made in this way is subject to some prediction error because of
uncertainty about the exact relationship between the explanatory variables (the X's)
and the outcome variable (the Y; that is, uncertainty about the a coefficients). There
are four common approaches to forecasting financial variables, but they are all special
cases of the general linear model. These four methods are discussed below:
2.5.1 Spot Method

Here it is assumed that the variable to be forecast is independent of all other variables,
or alternatively, is predetermined. The variable is forecast by using its expected or
predetermined level. All other explanatory variables are presumed to be irrelevant and
the formula used is
Y1 = a0 (2)
where a is the expected or predetermined level of Y. For example, if we are doing a
cash forecast and we know that the level of particular types of disbursement (such as
rental payments) will be Rs. 12,000 in every month because of the firm's lease
agreement, it would be reasonable to use the spot method to estimate rental payments
as Rs. 12,000 per month.
2.5.2 Proportion of another Account 43
This technique is used to project financial variables that are expected to vary directly and Budgeting
with the level of another variable. The formula used is:
Y1 = a1 X1 (3)
where X1 is the other variable to which Y is related and a1 is the constant of
proportionality between the two. The "percent of sales" method is a variation of this
technique, wherein X1 is sales for a particular period and a1 is the percent. The
"proportion of another account" method is widely used, when there is a causal link
from the explanatory variable to the variable to be forecast. For example, if sales
volume (units sold) increases, it is natural that more units will have to be produced to
replenish inventory. It is then reasonable to project certain direct costs of production,
such as direct materials, as a percent of sales In this circumstance, if costs of direct
materials have historically been 50 percent of sales, and sales for a particular period
have been forecast as Rs. 1,00,000, the firm would normally project direct material
purchases at Rs. 50,000 for that period.
2.5.3 Compounded Growth

This method is used when a particular financial variable is expected to grow at a
steady growth rate over time. The formula is the same as equation (3), but the
explanatory variable X1 is the prior period's level of Y, and a is one plus the expected
growth rate. That is:
Yt = (1+g)Yt-1 (4)
Where g is the period's growth rate. For example, if it is expected that a firm's level of
selling expenses will grow at 10 percent per year, and this year's selling expenses are
Rs. 10,00,000, we would project next year's selling expenses as Rs, 1,00,000.
2.5.4 Multiple Dependencies

Here the variable is thought to depend on more than one factor; not just sales or some
other variable but a combination of several variables. The general linear model as
expressed in equation (1) is used, and the statistical technique of linear regression is
often employed with historic data to estimate which explanatory variables are
significant in determining Y and to estimate the coefficients of these variables. A
classic example of multiple dependency is inventory level. Finns often keep a "base
level" or "safety stock" of inventory to hedge uncertainty and vary the remaining
portion of inventory in response to demand. In such a system, there are two
appropriate variables associated with inventory level:
Yt = a0 +a1X1 (5)
There a0 term represents the base inventory level, the Xt the square root of the sales
level, and at the proportionality constant. If the firm's base level of inventory is
Rs. 50,000, the proportionality constant is 15 and sales are expected to be
Rs. 5,00,000, we could estimate inventory as:
Yt = 50,000 + (15) ((500,000)1/2) = Rs. 60,607
In deciding which of these methods to use to forecast a particular variable, a primary
consideration is the term of the forecast: how far into the future are we projecting? To
see this, the concepts of the short run and the long run from economics can be
employed. In the short run, most things are predetermined or preplanned; very little
can be changed. In the long run, almost everything is variable. In terms of financial
forecasting, this means that in short-term forecasts, many things will result from plans
and events that are already in place (contracts, capital budgets, long-range financing
plans, and so forth). But in the long run, most things can vary and are dependent on
outside influences such as the firm's long-term growth rate. Since cash forecasts deal
44 mostly with the near future, many of the items on the cash forecast are estimated by
some variation of the spot method. The bases for these spot estimates are usually the
firm's other financial plans. Remaining estimates are mostly in a "proportion of
another account" basis, with this "other account" often being a particular period's
scales; the other two methods are employed less frequently. This is quite unlike
longer-term forecasting. Where compounded growth and multiple dependency
methodologies play a more important role.,'

1. Define daily cash forecasts.
…………………………………………………………………………….
…………………………………………………………………………….
2. Forecast system costs.
…………………………………………………………………………….
…………………………………………………………………………….
2.6 FORECASTING DAILY CASH FLOWS

Forecasters typically use scheduling for daily cash forecasts, especially for short
horizons. Statistical tools can be helpful for the recurrent, non-major elements in the
forecast, however. Many smaller and some medium-sized companies do not even
forecast on a daily basis, relying on funding from investments or credit lines to cover
shortfalls. The uncertainty of cheque clearing is managed with controlled
disbursement accounts. As the opportunity cost for suboptimal investing increases due
to increasing interest rates. More companies find it profitable to do daily forecasts.
For most companies doing daily forecasting, the immediate day's flows are simply
gathered from balance-reporting systems. For the next day and up to two weeks in the
future, historical collection and payment patterns can be used in connection with sales
and purchases to project cash flows.
The shorter the horizon, the more detail shown in the cash forecast. Ideally, the format
will include columns for the forecast, the actual amount (as it materialises), the
budgeted amount, and variances. Typically, actual-versus-forecast and actual-versus-
budget variances will be calculated. Explanations of likely causes and corrective
actions will accompany the numbers.
With the requirement to present a Statement of Cash Flows, some companies are
finding it fruitful to prepare their cash forecasts with separate subtotals for operating,
financing, and investing cash flows. While the Statement of Cash Flows format might
be more appropriate for a monthly forecast, it can be used for daily forecasts as well,
The major differences when it comes to modeling the daily cash flow are a and greater
reliance on bank-supplied deposit and cleaning data, an emphasis on scheduling the
upcoming cash flows via the receipts and disbursements technique, and a lesser
reliance on statistical forecasting techniques. Scheduling upcoming cash receipts and
disbursements requires close contact with any corporate personnel having
responsibility for or knowledge of impending cash flows. Cash managers who have
not yet discovered computers have been known to write these flows down on their
desk calendars!
One area where statistics have been instrumental in achieving accuracy is for
spreading out (distributing) cheque clearing or receivable cash effects throughout the
days of the week and month. Here regression analysis has been very useful, in that the
day-of-the week and even day-of-the month effects can be modeled by assigning each 45
a separate regression coefficient. The regression-based distribution method also has and Budgeting
been used to model the cash disbursements related to how many business days have
elapsed since payroll cheque have been issued. In general, distribution simply refers to
spreading out the month's cash forecast into daily flows, thereby showing the
intramonth cash flow pattern. We can illustrate this in the disbursements context by
assuming that October's total disbursement is forecast to be Rs. 40,00,000 We can
forecast the disbursements for Friday, October 13, which is the eleventh work day of
the month.
CD11 = (d11 + w5) x MDF
where
CD11 = cash disbursement forecast for the eleventh work day of the month
d11 = coefficient for eleventh work day (from regression model)
w5 = coefficient for fifth day of work, Friday (from regression model)
MDF = month's disbursement forecast (from cash budget)
If we assume that d11 is (.04, w5 is .015 and MDF is Rs. 40,00,000,
we have: CD11 = (.04 + .015) × (Rs. 40,00,000)
= (.055) × (Rs. 40,00,000)
= Rs. 2,20,000
One can think of the work-day coefficient as the effect of the day-of-the-month effect,
holding constant the day-of-the-week, and the day-of-week coefficient as to that day's
effect holding constant the day-of-the-month.
2.7 SOURCES OF UNCERTAINTY IN

CASH FORECASTING
Given the short-fun nature of the cash forecast, with most things occurring in the near
future and the forecast period typically being a year, one would tend to think that most
financial transaction, over this period could be forecast very accurately.
Unfortunately, this is far from true. Even with this short period there are numerous
sources of risk. Among the sources are sales uncertainty; collection rate uncertainty,
production cost uncertainty, and capital outflow uncertainty. Let us look at each one
of these in turn.
Sales uncertainty refers to the risk regarding the firm's future levels of sales. Most
firms try to forecast accurately enough to hold errors in short-run sales forecasts to
less than 10 percent, but are often unsuccessful in these efforts. Sales-projections are a
product of two other projections, units to be sold and price per unit. Both are often
quite uncertain and depend on economic and competitive conditions. 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
(and therefore disbursements).
Collection rate uncertainty is the uncertainty regarding the firm's actual future
collection patterns of receivables. The firm may historically have collected an average
of a certain percent of its outstanding receivables from a particular period in another
particular period, but this average contains considerable variability. Further, changing
market and economic conditions may make for chancy extrapolation of post historic
data into future period. Because of this and the uncertainties in forecasting sales,
forecasts of the collection of future receivables contain at least three sources of
uncertainty; uncertainly regarding the number of units that will be sold, uncertainty
46 regarding the price at which these units will be sold, and uncertainty regarding the
patterns with which the receivables generated by these sales will be collected.
Production cost uncertainty has to do with the risk of the actual labour and material
costs that go into the making of a product of service. Labour productivity may be
more or less than expected, making labour costs uncertain. The cost of materials used
may vary due to unexpected changes in price or in the amount of materials necessary
to produce products and services.
Capital outflow uncertainty is one of the biggest sources of surprises in cash flow
forecasting. This is the uncertainty regarding the timing of cash disbursements related
to the firm's major capital expenditure and construction programmes. The uncertainty
arises from the nature of payments made for new construction. When the firm
undertakes to build a new plant or other project of this sort. The total price (subject to
specified revisions) is generally agreed upon in advance. The construction firm then
starts the project. After a certain percent of the project is done, the construction firm
submits a "progress report" to the firm and is paid for what has been completed, less a
retainage. For example, assume that the firm has contracted to have built a Rs. 10
crore building with a 10 percent retainage. Once the construction firm completes the
first 20 percent of the project, a payment of Rs. 1.8 crore will be due (Rs. 10 crore
times 20 percent times 90 percent). Such payments are subject to at least two
uncertainties. First, the weather, a very risky variable, plays a significant part in the
rate of construction completion. Second construction firms are notorious for filing late
progress reports and then expecting immediate payment. While only a small percent
of the firm's total bills are from capital construction programmes, the amounts
involved are usually very large. One unexpected item of this sort can destroy a
carefully planned cash flow management strategy.
2.7.1 Estimating Uncertainty in Cash Forecasts

There are two basic approaches to the assessment of risk in cash forecasting. First, we
could assess the effects of individual sources of uncertainty on important individual
outcome variables. Second, we could assess the effect of all the uncertainties in all the
risky estimated variables on all the important outcome variables with all the
uncertainties allowed to vary simultaneously Both of these methodologies are very
useful. The first requires sensitivity analysis; the second requires simulation.
Sensitivity Analysis of the Cash Forecast: We know that there are uncertainties in the
estimation of sales, collection rates, production and other cost amounts, and the timing
and amount of capital disbursements, at the least. Using sensitivity analysis. We can
assess some of the effects of these individual sources of uncertainty. For example,
recall that the direct labour payments were estimated as 34 percent of sales for the last
three months because of a new wage scale. If this new wage scale was the result of a
new labour contact that is yet to be negotiated when the forecast is made, the actual
wage rate would be subject to uncertainty. Let us assess the effects of variation in the
direct labour payments as a percent of sales on the projected surpluses and deficits in
October, November, and-December. This is done by changing the input variable and
observing changes in the output variable. The first step might be to estimate the
surpluses and deficits with direct labour at 36 percent of sales.
The results are presented in Table 2.1. The projected surplus in October drops from
Rs. 12,300 to Rs. 7,800, the surplus in November drops from Rs. 1,01,400 to
Rs. 93,000 and the project deficit in December increases from Rs. 3,600 to Rs. 15,000.
47
Table 2.1: Sensitivity Analysis of Cash Forecast Cash Flows Forecasting
and Budgeting
(Direct Labour for October through December changed to 36 percent of Sales)
Another uncertain variable is the timing of payments for new construction. The
weather pays a significant part in the rate of progress of construction. It is possible
that the weather may be good and that the firm's construction company may progress
ahead of schedule; instead of Rs. 54,000 being due in August. October, and
December, this could result in Rs. 81,000 being due in August and October and
nothing due in December. The results are presented in Table 2.2. Other variations in
the timing of construction payments could also be investigated.
This kind of analysis provides very useful information about the amounts of possible
surpluses and deficits in various future periods. With regard to the construction
payments example, the expected amounts of surpluses and borrowings in the
beginning and ending months are unaffected, but the pattern from September to
November is significantly altered. The maximum amount of the firm's necessary
borrowings are now Rs. 59,100, not Rs. 32,100 in the original calculation. If there is a
significant chance that this speedup of construction may occur, the firm should make
far different financing arrangements than were originally anticipated.
48 Table 2.2: Sensitivity Analysis of Cash Forecast: New Construction
Payment Accelerates (in Rs.)
Simulation Analysis of the Cash Forecast: While sensitivity analysis methodologies

give useful information, it is generally the overall variation from the means of the
monthly cash deficits and surpluses that concerns management for planning purposes.
This information on the probability distributions of cash surpluses and deficits is
necessary to plan advantageous strategies. To estimate these probability distributions,
a simulation of the overall uncertainty in the ending cash balances for cash of the
period within the forecast is needed. To get these, the methods of simulation analysis
are used. First, probability distributions for each of the major uncertain variables are
developed. For a cash forecast, the variables involved would include sales, collection
rates, production costs, and capital expenditures. Statistical estimation procedures or
management estimates could be used; discrete or continuous distributions are possible.
Then, large number of trials are run. From these trial results, frequency histograms of
the important outcome variables would be developed and these compared to known
probability distributions via goodness-of-fit methods.
To apply simulation analysis in estimating the total uncertainty in a cash forecast, one
of the uncertainties that must be quantified is that of the collection rates on accounts
receivable. Uncertainty in the collection rates of receivables is an important
component in the overall uncertainty of the cash forecast. The usual method of
estimating these rates is to compute individual collection rates on various period's
sales using historic data. Another approach to the problem aids an quantifying the 49
multivariate uncertainty in these rates. The approach estimates all the collection rates and Budgeting
simultaneously by regressing past sales figures against past collections. The estimated
collection of the sales figures in the regression can be interpreted as the collection
proportions and the standard errors of the estimated regression collection as the
uncertainty inherent in the estimation of these collection proportion.

Define sales uncertainty.
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2.8 HEDGING CASH BALANCE UNCERTAINTIES

The point is that, without some kind of hedge against the uncertainties of future cash
flows, the firm incurs costs that could be avoided by the use of a hedging strategy. Of
course, there is a trade-off between the cost of the hedge and the expected costs that it
avoids. It would not be cost-effective to hedge against all possible future costs if their
probability of occurrence was very small. Because of this trade-off, it is necessary to
understand the relative costs and other characteristics of the various methods
commonly used to hedge the uncertainty of the firm's cash flows. Some of the
possible hedging methods and their costs are discussed below:
2.8.1 Holding a Stock of Extra Cash

We refer here to a stock of cash kept by the firm beyond that needed for transactions.
Cash is the most flexible but the most costly hedge available to the firm. It is the most
flexible in that it can hedge a shortage in any circumstances, at any time, with no
transaction costs. If the firm holds a stock of extra the temporary investment. Interest
rate futures and options can also be used to hedge interest rate risks that do not arise as
the result of uncertainties in the firm's cash flow, but instead occur solely because of
changing interest rates between the time of the forecast and the planned investment of
financing.
Illustration 1
Global Recreation Centers is attempting to forecast cash receipts from its Eastern
Division. Cash is deposited into two field banks on a daily basis. The cash manager
has found that deposits follow a fairly strong day-of-week pattern. She used historical
data to determine the fraction of each week's total revenues deposited by day-of-week
by district. Combined with weekly revenue estimates the fractions help her estimate
daily deposits from Eastern Division. The parameters obtained from the past 3
months' deposit data follow:
Day of Week District 1 using Deposit District 2 using Deposit
Bank 1 Bank 2
Monday 36.0 % 31.0%
Tuesday 13.0 15.0
Wednesday 17.0 17.0
Thursday 15.0 20.0
Friday 19.0 17.0
100.0% 100.0%
50 Weekly revenue estimates from the sales department were also obtained:
Day of Week District 1 District 2
Week 1 Rs. 68,000 Rs. 52,000
Week 2 Rs. 39,000 Rs. 44,000
Solution:
To forecast daily deposits into each bank, we simply multiply the weekly revenue by
the day-of-week percentage and sum across the two districts.
Table 2.3
HP Apples Company has a seasonal pattern of its business. It borrows under a line of
credit from Central Bank at 1.50 per cent over prime. Its total asset requirements was
(at year end) and estimated requirement for the coming year are:
Now 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Amount Rs. 90 cr. Rs. 96 cr. Rs. 110 cr. Rs. 118 cr. Rs. 100 cr.
The prime rate at present is 10.50 per cent, and the company expects no change in this
rate for the next year, H.P. Apples Company is also considering issuing intermediate
term debt at an interest rate of 14.00 per cent. In this regard three alternative amounts
are under consideration: Zero, Rs. 10 crore, and Rs. 20 crore. All additional funds
requirements will be borrowed under the company's bank line of credit.
(a) Determine the total borrowing costs for short-and intermediate-term debt under
each of the three alternatives for the coming year, assuming there are no changes
in current liabilities other than borrowings. Which is lowest?
(b) Are there other consideration in addition to expected cost?
Solution: 51
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Total and Budgeting
Alternative 1: Rs. 6 crore Rs. 20 crore Rs. 28 crore Rs. 10 crore
incremental borrowings Rs. 18 crore Rs. 60 crore Rs. 84 crore Rs. 30 crore Rs. 1.92
crore
Bank loan cost crore
(10.5% + !%)/ 4 = 3% per
quarter
Alternative 2:
Term loan cost (Rs. 20 crore at 14%) Rs. 1.40
crore
incremental borrowings Rs. 10 crore Rs. 18 crore
Bank loan cost crore Rs. 30 crore Rs. 54 crore Rs. 84 crore
Rs. 2.24
crore
Alternative 3:
Term loan cost Rs. 2.80
(Rs. 20 crore at 14%) crore
incremental borrowings Rs. 8 crore 0

Bank loan cost Rs. 24 crore Rs. 24 crore
Rs. 3.04
crore
(a) Alternative is lowest in cost because the company borrows at a lower rate, 12 per
cent versus 14 per cent, and because it does not pay interest on funds employed
when they are not needed.
(b) While alternative I is cheapest it entails financing the expected build up in
permanent funds requirements (Rs. 10 crore) on a short-term basis. There is a risk
consideration in that if things turn bad the company is dependent on its back for
continuing support. There is risk of renewal and of interest rates changing.
Alternative 2 involves borrowing the expected increase in permanent funds
requirements on a term basis. As a result, only the expected seasonal component
of total needs would be financed with short-term debt. Alternative 3, the most
conservative financing plan of the three, involves financing on a term basis more
than the expected building-up in permanent funds requirements. In all three cases,
there is the risk that actual total funds requirements will differ from those that are
expected.
Problems
1. Ashok Sood has the following financial statements for the year ending December
31, 1996 (all figures are in crores);
Income Statement for the Year ending December-31, 1996 (crores)
Sales Rs. 14.0
Cost of gold 9.0
Gross profit 5.0
Expenses
Depreciation 1.0
Other fixed costs 2.0
Operating profit 2.0
Taxes (40%) 0.8
Net income after taxes Rs. 1.2
52 Balance Sheet, December 31, 1996 (crores}
Liabilities and Equity Assets
Account payable Rs. 4.0 Cash and mkt. sec Rs. 1.0
Long-term debt 2.0 Accounts receivable 5.0
Retained earnings 9.0 Inventories 7.0
Equity shares Rs. 20.0 Net fixed assets Rs. 22.0
Because of a change in credit policy, sales are expected to increase by 50% next
year, Sood feels that certain accounts will remain in the same proportion to sales
as in the past: cost of goods sold, inventories, and accounts payable. Because of
the liberalised credit policy, the accounts receivable collection period is expected
to double. No addition to fixed assets is expected. Other fixed costs are expected
to increase by Rs. 1.5 crore. Long-term debt is expected to remain at Rs. 2 crore
and no new equity offering are planned. Cash and marketable securities should be
at least Rs. 4 crore. No dividends are to be paid.
a. Project the income statement for Sood for 1997.
b. Project the balance sheet for December 31, 1997, using a short-term bank loan
as the balancing amount.
c. Starting with sales, make appropriate cash flow adjustments to show how the
net cash flow is equal to the short-term debt plug figure of part (b).
2. It is June 30 and the treasurer of the ABC Toy Company is trying to forecast cash
inflows for the last 6 months of the year. The following credit sales information
(in crore of rupees) is available:
Apr Rs. 30 May Rs. 35 Jun Rs. 30 Actual
Jul 45 Aug 70 Sep 150
Oct 200 Nov 125 Dec 45 Forecast
From prior studies, the treasurer has determined that approximately 85% of the
sales for any month are uncollected at the end of the month of the sale, 60% are
still uncollected 1 month after the sale, and 10% are uncollected 2 months after
the sale. That last 10%, with the exception of bad debts, which average 2% of
sales, are collected in the third month after the sale.
a) Forecast the case inflows, by months, for July through December for ABC
Toys.
b) Forecast the accounts receivable at the end of each month for July through
December, (Assume that bad debts are written off in the third month
following the sale rather than through an allowance for doubtful accounts at
the time the sale is made.)
3. It is January and the XYZ Company wishes to prepare a monthly cash forecast
over the next four months. Sales for December were Rs. 11,00,000. Expected
sales for the next four months are:
Month January February March April
Expected sales Rs. 6,00,000 Rs. 8,00,000 Rs. 11,00,000 Rs. 8,00,000
a) Thirty percent of the firm's sales are for cash; the remainder are collected in
the month following the sale (there are no bad debts). Disbursements consist
of payments for raw materials, direct labour, other operating expenses,
purchases of fixed assets, and taxes. Costs of sales are 75 percent of sales. Of
these costs of sales, 38 percent are raw material costs and 62 percent are
direct labour costs. Direct labour costs are paid in the month incurred, while 53
raw materials are purchased on net 30-day terms. Other operating expenses and Budgeting
total Rs. 1,50,000 per month. Expenditures for fixed assets of Rs.75,000 are
to be made in February and April and tax payments of Rs.1,10,000 are to be
made in January and March. As of January 1 .there are no surpluses or
deficits and the firm's cash balance is Rs.83,000. The firm keeps a cash
balance equal to 10 percent of the month's cost of sales. Generate a monthly
cash forecast for the upcoming four months.
4. A firm makes monthly cash forecasts and distributes these forecasts to a daily
basis. For the upcoming month, anticipated cash inflows are Rs. 10,00,000. Each
of the first two weeks has five working days. Twenty percent of the month's total
cash receipts are expected to be received during the first week and 28 percent are
expected to be received during the second week.
Within each week, receipts are expected to be received as follows:
Day Monday Tuesday Wednesday Thursday Friday
Proportion 0.20 0.23 0.07 0.20 0.30
The firm writes cheques on Tuesday for the entire week's expenses, except for
taxes. Ten percent of these cheques are cashed on Tuesday, 5 percent on
Wednesday, 60 percent on Thursday, and remainder on Friday. Cheques totaling
Rs. 2,50,000 are to be written on Tuesday of the first week, and cheques totaling
2,00,000 are to be written on Tuesday of the second week. A tax payment in the
amount Rs. 1,00,000 will be made on Wednesday of the second week via mail
transfer. Beginning cash is Rs, 50,000; this is also the desired cash at all times
during the first two weeks of the month. Generate the distributed daily cash
forecast for the first two weeks of the upcoming months.
5. A firm has generated a cash forecast that shows the following pattern of surpluses
over the next four months:
Month March April May June
Surplus Rs. 25,00,000 Rs. 17,00,000 Rs. 20,00,000 Rs. 0
The yield curve is upsloping and has the following rates and maturities:
Time of Maturity Uncompounded Yearly Rate
1 month 9.00%
2 month 9.60%
3 month 10.00%
Generate a bar chart of the surpluses over time. Using this bar chart, formulate an
investment strategy for the investment of surplus funds. In formulating this
investment strategy, assume that the firm has hedged the cash stockout risk; the
surplus amounts can thus be treated as certain. Ignoring transaction costs,
calculate the interest income from your investment strategy.
6. A firm has performed a simulation of its cash budget, with the following results:
Month Expected Surplus Or (Deficit) Standard Deviation of Expected
Surplus or (Deficit)
1 (Rs. 80,000) Rs. 1,00,000

2 (Rs. 20,000) Rs. 1,50,000
3 Rs. 70,000 Rs. 2,00,000
4 Rs. 20,000 Rs. 2,50,000
54 The firm keeps two hedges against cash flow uncertainty: excess borrowing
capacity with its bank and a Rs. 50,000 cash reserve. It must commit to its
maximum level of borrowing over the next four months, at a commitment fee of
0.2 percent of the maximum amount of borrowing arranged. The opportunity cost
of holding the cash hedge is 10 percent per year (3.33 percent for the upcoming
four months). The firm wishes to limit its probability of running out of cash (of
exceeding the total available hedge) to a maximum of 5 percent in any month.
Calculate the amount of borrowing capacity that the firm should arrange for with
its bank and the total cost of its hedges of cash flow uncertainty, assuming that the
probability distributions of surpluses and deficits are normal and serially
uncorrelated. (Hint: The maximum amount of borrowing required will be the
maximum needed for hedging and for expected borrowings less that needed for
expected borrowings only.)
7. Desai Enterprises currently sells on term of 2/10, net 40, with bad debt losses
running at 2 percent of gross sales. Of the 98 per cent of the customers who pay,
60 per cent take the discount and pay on Day 10, while 40 per cent pay on Day
40. The firm's gross sales are currently, Rs. 10,00,000 per year, with variable
costs amounting to 60 per cent of sales. The firm finances its receivables with 10
per cent line of credit, and there are sufficient fixed assets to support the doubling
of sales.
The firm finance manager has proposed the credit terms be changed to 2/20, net
60, and he estimates that this change would increase sales to Rs. 11,00,000,
However, bad debt losses at the new sales level would be 3 per cent, compared
with only 2 per cent at the old sales level. It is expected that 75 per cent of the
paying customers would take the discount under the new terms, paying on Day
20, while 25 per cent would now pay on Day 60.
a) What are the old and new day’s sales outstanding?
b) Find change in investment (A I) in receivables.
c) Find the incremental change in profits before tax (A PBT) if the change in
credit terms be adopted.
d) Assume that the firm's competitions immediately react to the change in credit
terms by easing their own term. This causes Desai to gain no new customers,
however, of the existing buyers who pay (2 per cent continue as bad debt
losses), 75 per cent now take the discount and pay on Day 20, with 25 per
cent pay on Day 60. What is the effect on the firm's profits before tax?
e) The responsiveness of sales to a proposed change in credit terms is, of
course, uncertain. Suppose that the firm implemented the finance manager's
policy, but the sales may rise to Rs. 10,50,000 or may fall to Rs. 10,25,000.
What change in profits before tax will generate? Assuming that all other
aspects of his forecast actually occur.
f) Considering the firm's original terms, collection experience, and level of
sales, if the finance manager decides to shorten the collection period by
tightening the credit term to 2/10 not 30. If bad debt losses remain 2 per cent
of gross sales and collection percentages are expected to .remain at 60 and 40
per cent but the gross sales decline to Rs. 9,00,000. Would this decision be
advisable?
Ans: (a) 22 days, 30 days; (b) Al = Rs. 27222; (c) APBT = Rs. 20,033; (d) AI =
Rs. 22,222; APBT = -Rs. 5,162; (e) = Rs. 6,251, Rs. 2,510; (f) Dl = -Rs. 13,667;
APBT = -Rs. 35,457
8. R.D. Vasu, manager of the Royal Sports Club, is considering to lower the usage 55
fee for the play ground. He estimates that this will result in an immediate and Budgeting
(one-time) cash flow of Rs. 18,00,000 from new membership fees. On the other
hand, the annual net cash flow from usage fees is expected to fall by Rs. 3,00,000
indefinitely (because of the lower fees).
a) Should Vasu lower the usage fee if his discount ratio for this project in 20%?
(I)) At what discount rate would he be indifferent to lowering the usage fee?
Ans: (a) NPV = Rs. 3,00,000; (b) 16.67%
9. S.B. Mukherjee is considering the acquisition of personal computer and
associated software to improve the efficiency of its inventory and accounts
receivable management. Mukherjee estimates that the initiate cash outflow for the
computer and software will be Rs. 1,50,000 and the associated net cash savings
will be Rs. 30,000 annually.
a) If Mukherjee's discount rate for the cash flows associated with the project is
12 per cent and Rs, 30,000 savings will occur for only ten years (at which
time the computer and software will be valueless), should he buy the
computer?
b) What if the project last ten years but the discount rate is 16 per cent?
c) What if the project lasts forever and the discount rat is 12 per cent?
d) What if the project last forever and the discount is 16 per cent?
Ans. (a)NPV = Rs. 19506; (b) NPV = -Rs. 5004; (c) NPV = Rs. 10,000; (d)
NPV= Rs. 37,500.
Fill up the blanks:
1. A combination of assets is known as _________________.
2. NPV stands for ___________________.
3. The rate of return that can be earned on the best alternative investment is
known as______________.
2.9 LET US SUM UP

The cash forecast is an estimation of the flows in and out of the firm's cash account
over a particular period of time, usually a quarter, month, week, or day.
Long-range forecasts are generally based on accounting projections and typically
involved the generation of various scenarios for future economic and technological
environments. The purposes of daily forecasting are to assist management in
scheduling transfer in cash concentration, funding disbursement accounts, controlling
field deposits, and making short-term investing and borrowing decisions.
While sensitivity analysis methodologies give useful information, it is generally the
overall variation from the means of the monthly cash deficits and surpluses that
concerns management for planning purposes. This information on the probability
distributions of cash surpluses and deficits is necessary to plan advantageous
strategies. To estimate these probability distributions, a simulation of the overall
uncertainty in the ending cash balances for cash of the period within the forecast is
needed. To get these, the methods of simulation analysis are used.
56
Working Capital Management 2.10 KEYWORDS
Operating Cycle: The operating cycle of firm begins with the acquisition of raw
materials and ends with the collection of receivables.
Opportunity Cost: The rate of return that can be earned on the best alternative
investment.
Portfolio: A combination of assets.

1. Why should a financial manager focus on cash flow rather than earnings?
2. What are some of the purposes of long-term, medium-term, and daily cash flow
forecasts?
3. What are the elements of the firm's objective function related to cash forecasting?
4. What is a driving variable, and why is it crucial to cash forecasting?
5. Outline the procedures for medium-range cash forecasting, starting with the
generation of a scenario. What is a cash budget?

CYP 1
1. The cash forecast is an estimation of the flows in and out of the firm's
cash account over a particular period of time, usually a quarter, month,
week, or day. The cash forecast is primarily intended to produce a very
useful piece of information: an estimation of the firm's borrowing and
lending needs and the uncertainties regarding these needs during various
future periods.
2. Long-range forecasts give planners an idea of how much cash the firm
needs to raise through debt or equity issues, internally generated cash, or
other cash sources. These forecasts also assist managers in establishing
dividend policies, determining capital investments, and planning a
mergers and acquisitions (or divestitures) programme.
CYP 2
1. Daily cash forecasts attempt to project cash inflows and outflows on a
daily basis 1 or more days into the future. This is perhaps the most
difficult forecasting to perform accurately. Even though a firm may know
precisely its revenues for the month, it may have difficulty determining
specific cash inflows for given days of the month. For some firms,
A daily forecast several months into the future is possible.
2. There costs are associated directly with developing, maintaining, and
running the forecasting model and associated data bases. Some forecast
systems require extensive computer time and information.
CYP 3
3. Sales uncertainty refers to the risk regarding the firm's future levels of
sales. Most firms try to forecast accurately enough to hold errors in short-
run sales forecasts to less than 10 percent, but are often unsuccessful in
these efforts.
Contd…
CYP 4 57
1. Portfolio and Budgeting
2. Net Present Value

3. Opportunity cost

V.K. Bhalla, Working Capital Management, Text and Cases, Sixth Edition, Anmol
Publications.
Prasanna Chandra, Financial Management, Theory and Practice, Tata McGraw Hill.
Pandey, Financial Management, Vikas Annex.54.J.3 -MBA - Finance - SDE Page 20 of 2.
Khan and Jain, Financial Management, Tata McGraw Hill.
59
Financing of Working Capital-I
UNIT 1
UNIT II
60
61
LESSON Financing of Working Capital-I
3
FINANCING OF WORKING CAPITAL-I
CONTENTS
3.1 Introduction
3.2 Sources of Working Capital
3.2.1 Financing of Temporary or Variable or Short-term Working Capital
3.3 Bank Finance
3.4 Factoring
3.4.1 Features of Factoring
3.4.2 Advantages
3.4.3 Limitations
3.5 Let us Sum up
3.7 Keywords

Sources of financing working capital
Concept of factoring
Regulations imposed by banks
Various suggestions given in the reports
3.1 INTRODUCTION
Once, estimation of working capital required is completed, then the next step is
financing of working capital. Statement of working capital gives clear picture about
the components, (raw materials, work-in-process, finished goods and receivables) and
required investment in these components of working capital. Generally investment in
these components varies a great deal during the course of the year. Financing of
current assets is the responsibility of finance manager who may require spending lot
of time for raising finance.
3.2 SOURCES OF WORKING CAPITAL

As we have seen earlier discussion, there are two types of working capital (a)
permanent or fixed and (b) temporary or variable working capital. In simple words,
62 working capital should be financed by suitable and optimal mix of short-term source
of funds and long-term source of funds.
3.2.1 Financing of Temporary or Variable or Short-term Working Capital

Sources of short-term funds have to be used (exclusively) for meeting the working
capital requirements only and not far financing fixed assets and for meeting the
margin money for working capital loans.
The various sources of short-term financing are as follows:
1. Trade Credit: Trade credit refers to the credit extended by the supplier of goods
or services to his/her customer in the normal course of business. Trade credit
occupies very important position in short-term financing due to the competition.
Almost all the traders and manufacturers are required to extend credit facility (a
portion), without which there is no possibility of staying back in the business.
Trade credit is a spontaneous source of finance that arises in the normal business
transactions of the firm without specific negotiations (automatic source of
finance). In order to get this source of finance, the buyer should have acceptable
and dependable credit worthiness and reputation in the market. Trade credit
generally extended in the format open account or bills of exchange. Open account
is the form of trade credit, where supplier sends goods to the buyer for the
payment to be received in future as per terms of the sales invoice. As such trade
credit constitutes a very important source of finance; it represents 25 per cent to
50 per cent of the total short-term sources for financing working capital
requirements.
Getting trade credit may be easy to the well-established or well-reputed firm, but
for a new or the firm with financial problems will generally face problem in
getting trade credit. Generally suppliers look for earning record, liquidity position
and payment record which is extending credit. Building confidence in suppliers is
possible only when the buyer discussing his/ her financial condition future plans
and payment record. Trade credit involves some benefits and costs.
Advantages of Trade Credit: The main advantages are:
Easy availability when compared to other sources of finance (except
financially weak companies).
Flexibility is another benefit, as the credit increases with the growth of the
firm's sales.
Informality as we have already seen that it is an automatic finance.
The above discussion on trade credit reveals two things. One, cost of trade credit
is very-high beyond the cash discount period, company should not have cash
discount for prompt payment and Second, if the company is not able to avail cash
discount it should pay only at the end of last day of credit period, even if it can
delay by one or two days, it does not affect the credit standing.
2. Accruals: Accrued expenses are those expenses which the company owes to the
other persons or organisations, but not yet due and not yet paid the amount. In
other words, accruals represent a liability that a firm has to pay for the services or
goods, which it has already received. It is spontaneous and interest-free sources of
financing. Salaries, wages, interest and taxes are the major constituents of
accruals. Salaries and wages are usually paid on monthly and weekly basis
respectively. The amounts of salaries and wages have owed but not yet paid and
shown them as accrued salaries and wages on the balance sheet at the end of
financial year. Longer the time lag in payment of these expenses, the greater is the
amount of funds provided by the employees. Similarly, interest and tax are other
accruals, as source of short-term finance. Tax will be paid on earnings. Income tax
is paid to the government on quarterly basis and some other taxes may be payable 63
half-yearly or annually. Amount of taxes due as on the date of the balance sheet Financing of Working Capital-I
but not paid till then and they are showed as accrued taxes on the balance sheet.
Like taxes, interest is paid periodically in the year but the funds are used
continuously by a firm. All other such items of expenses can be used as a source
of short-term finance but shown on the balance sheet. The amount of accrual
varies with the level of activities of a firm. When the level of activity expands,
accruals increase, they automatically act as a source of finance, and Accruals are
treated as "cost free" source or finance, since it does not involve any payment of
interest. But in actual terms, it may not be true, since payment of salaries and
wages is determined by provisions of law and industry practice, similarly, tax
payment governed by laws and delay in payment of tax leads to pay penalty.
Hence, a firm must be noted that use of accruals as a source of working capital or
it may not be possible to delay in payment of these items of expenses.
3. Deferred Income: Deferred incomes are incomes received in advance by the firm
for supply of goods or services in future period. These income receipts increase
the firm's liquidity and constitute an important source of short-term source
finance. These payments are not showed as revenue till the supply of goods or
services, but showed in the balance sheet as income received in advance. Advance
payment can be demanded by only firms having monopoly power, great demand
for its products and services and if the firm is manufacturing a special product on
a special order.
4. Commercial Papers (CPs): Commercial paper represents a short-term unsecured
promissory note issued by firms that have a fairly high credit (standing) rating. It
was first introduced in USA and it was an important money market instruments.
In India, Reserve Bank of India introduced CP on the recommendations of the
Vaghul Working Group on money market. CP is a source of short-term finance to
only large firms with sound financial position.
Features of CP
The maturity period of CP ranges from, 15 to 365 days (but in India it ranges
between 91 to 180 days).
It is sold at a discount from its face value and redeemed at its face value.
Return on CP is the difference between par value and redeemable value. It
may be sold directly to investors or indirectly (through) dealers.
There is no developed secondary market for CP.
"Eligibility" Criteria for issuing CP:
CP is unsecured promissory note, the issue of CP is being regulated by the
Reserve Bank of India. RBI has laid down the following conditions to
determine the eligibility of a company that wishes to raise funds through the
issue of CPs.
The Tangible Net worth (TNW) of the company, as per latest audited balance
sheet should not be less than Rs. 4 crore.
The company should have been sanctioned as a fund based limit for bank(s)
finance and / or the All India Financial Institutions.
Company can issue CFs amounting to 75% of the permitted bank (working
capital limit) credit.
Company's CPs receives a minimum rating of (P2 form CRISIL, A-2 form
ICRA). The minimum size of each CP is Rs. 5 lakhs or multiples thereof.
The size of any single issue should not be less than Rs. I crore.
64 The CP is in the form of usance promissory note negotiable by endorsement
and delivery.
Advantages of CP
It is an alternative source of finance and proves to be helpful during the period
of tight bank credit.
It is a cheaper source of short-term finance when compared to the bank credit.
Disadvantages of CP
It is available only for large and financially sound companies.
It cannot be redeemed before the maturity date.
5. Public Deposits: Public deposits or term deposits are in the nature of unsecured
deposits, have been solicited by the firms (both large and small) from general
public primarily for the purpose of financing their working capital requirements.
Regulations
Fixed deposits accepted by companies are governed by the Companies
(Acceptance of Deposits) Amendment Rules 1978. The main features of this
regulation are:
A firm cannot issue public deposits for more than 25 per cent of its share
capital and free reserves.
The public deposits can be issued for a period ranging from a minimum
6 months to maximum 3 years. Public deposits for a period of three months,
however, can as well be issued, but only for an amount up to 10% of the
company's share capital and free reserves. Maximum period of 5 years is
allowed for non-banking financial corporation (NBFC's).
The company that had raised funds by way of issue of public deposits is
required to set aside, a deposit and / or investment, by the 30th April each
year an amount equal to 10 per cent of the maturity deposits by the 31st
March of the next year. The amount, so set aside can be used only for
repairing the amount of deposits.
Finally, a company's and accepting the public deposits is required to disclose
some true, fair, vital and relevant facts in regards to its financial position and
performance.
Advantages
Advantages of public deposit can be studied from two different views.
a) Company point of view
Simple procedure involved in issuing public deposits.
No restrictive covenants are involved.
No security is offered against public deposits.
Cheaper (post-tax cost is fairly reasonable).
b) Investors point of view
Higher interest rates when compared to other investment avenues.
Short maturity period.
These also can, be studied from two different points: 65
a) Company point of view
Limited amount of funds can be raised. Funds available only for a short
period.
b) Investor point of view
Risk since there is no security against PL1.
Income received (interest) is taxable.
6. Inter-Corporate Deposits (ICDs: A deposit made by one firm with another firm is
known as inter-corporate deposits (ICDs). Generally, these deposits are usually
made for a period up to six months. Such deposits may be of three types:
Call Deposits: Deposits are expected to be payable on call. In other words,
whenever its repayment is demanded on just one days notice. But, in actual
practice, the lender has to wait for at least 2 or 3 days to get back the amount.
Inter corporate deposits generally have 12 per cent interest per annum.
Three Months Deposits: These deposits are more popular among companies
for investing the surplus funds. The borrower takes this type of deposits for
tiding over a short-term cash inadequacy. The interest rate on these types Q-f
deposits is around 14 per cent per annum.
Six-month Deposits: Generally, the inter-corporate deposits are made for a
maximum period of six months. These types of deposits are usually given to
'A' category borrowers only and they carry an interest rate of around 16% per
annum.
Features of ICDs
There are no legal regulations, which make an ICD transaction very convenient.
Inter-corporate deposits are given and taken in secrecy,
Inter-corporate deposits are given based on borrower’s financial sound, but in
practice lender lends money based on personal contacts.

1. Define public deposits.
…………………………………………………………………………….
…………………………………………………………………………….
2. Define commercial papers.
…………………………………………………………………………….
…………………………………………………………………………….
3.3 BANK FINANCE

Commercial banks are the major source of working capital finance to industries and
commerce. Granting loan to business is one of their primary functions. Getting bank
loan is not an easy task since the lending bank office may ask number of questions
about the prospective borrower's financial position and. its plans for the future. At the
same time bank will want to monitor of the borrower's business progress. But there is
a good side to this that borrower's share price tends to rise, because investor know that
convince banks is very difficult.
66 Forms of Bank Finances: Banks provide different types of tailored made loans that
are suitable for specific needs of a firm. The different types of forms of loans are:
(1) Loans, (2) Overdrafts, (3) Cash credits, (4) Purchase or discounting of bills, and
(5) Letter of Credit.
1. Loans: Loan in an advance is him: sum given to borrower against some security.
Loan amount is paid to the applicant in the form of cash or by credit to his/her
account. In practice the loan amount is paid to the customer by crediting his/her
account. Interest will be charged on the entire loan amount from the date the loan
is sanctioned. Borrower can repay the loan either in lump sum or in installments
depending on conditions. If the loan is repayable in installment basis interest will
be calculated on quarterly and on reduced balances. Generally, working capital
loans will be granted for one-year period.
2. Overdrafts: Overdraft facility is an agreement between the borrower and the
banker, where the borrower is allowed to "withdraw funds in excess of the
balance in his/her current accounts up to a certain limit during a specified period.
It is flexible from the borrower’s point of view because the borrower can
withdraw and repay the cash whenever he/she wants within the given stipulations.
Interest is charged on daily ewer drawn balances and not on the overdraft limit
given by the bank. But bank charges some minimum charges,
3. Cash Credit: It is the most: popular source of working capital finance in India. A
cash credit facility is an arrangement where a bank permits a borrower to
withdraw money up to a sanctioned credit limit against tangible security or
guarantees. Borrower does not require to withdraw the total sanctioned credit at a
time, rather, he can withdraw according to his/her requirements and he can also
repay the surplus cash in his cash credit account. Interest is chargeable on actually
used amount and there is no commitment charge. Cash credit is a flexible source
of working capital from borrower's point of view.
4. Purchasing or Discounting of Bills: Bills receivable arises out of sales
transaction, where the seller of goods draws the bill on the purchaser. The bill
may be documentary or clean bill. Once the bill is accepted by the purchaser, then
the drawer (seller) of the bill can go to bank for discount or sale. The credit
worthiness of the drawer (seller) is satisfactory, then bank purchases or discounts
the bill and reduces funds by way of crediting to customers account. The credited
amount will be less than the bill amount. At the end of maturity period of the bill,
bank presents the bill to drawee (acceptor) for payment. If the bill is discounted
and dishonored by the drawee, then the customer (seller) is liable to pay the bill
amount and any other expenses incurred to bank.
5. Letter of Credit [L/C]: There are two non-hind based sources of working capital,
viz., letter of credit (L/Cs) and Bank Guarantees (B/Gs). These are also known as
quasi-credit facilities, due to non-payment of amount immediately. A Letter of
Credit (L/C) is a written document issued by the Buyer's Banker (BB) at the
request of the buyer's, in favour of the seller, where by the Buyers Banker gives
an undertaking to the seller, that the bank pay the obligations of its customer up to
a specified amount, if the customer fails to pay the value of goods purchased. It
helps to bank's customer to obtain credit from the seller (supplier), which is
possible by assurance of the payment. Thereby, it allows the supplier to extend
credit, since the risk of non-payment is transferred to the BB. Letter of credit
facility is available from bank only for the companies that are financially sound
and Bank charges the customer for providing this facility.
Check Your Progress 2 67
1. Fill in the blanks with appropriate word(s):
a) ___________ and ___________ working capital the two types of
working capital.
b) Trade credit is a ____________ source of short-term finance.
c) CPs are sold at ____________ and redeemed at ____________.
d) A firm cannot issue public deposits for more than ____________ of
its share capital and free reserves.
e) ____________ interest rate ceiling on public deposits.
f) There are no commitment charges for ____________.
g) ____________ letter of credit is one that can be withdrawn by the
issuing banker any time after it is issued.
h) ____________ is a financial institution, which render services
relating to the management of and financing of sundry debtors that
arises from credit sale.
2. State whether each of the following statement is true of false:
a) Minimum size of CP is Rs. 6 lakhs.
b) Pubic deposits are governed by the companies (Acceptance of
deposits) Amendment Rules 1978.
c) There are three types of inter-corporate deposits.
d) In India, the factoring services are providing by four financial
institutions
e) Factor charges a commission ranging between 1% and 2%.
3.4 FACTORING
Banks have been given more freedom of borrowing and lending both internally and
externally, and facilitated the free functioning of the banks in lending and investment
operations. From 1994 banks are allowed to enter directly leasing, hire purchasing and
factoring services, instead through their subsidiaries. In other words, Banks are free to
enter or exit in any field depending on their profitability, but subject to some RBI
guidelines.
Banks provide, working capital finance through financing receivables. A "Factor" is a
financial institution, which renders services relating to the management and financing
of sundry debtors that arises from credit sales. Factoring is a popular mechanism of
managing, financing and collecting receivables in developed countries like USA and
UK, and it has spread over to a number of countries in recent past including India. In
India, factoring service started in April 1994, after setting up of subsidiaries. It is yet
at the formative stage. In India, there are only four public sector banks that offer
factoring related service in the respective regions of the country (authorized by RBI)
viz., State Bank of India {subsidiary State Bank of India Factoring and Commercial
Services Limited), Canara Bank (Canara Bank factoring Limited), Allahabad Bank
and Punjab National Bank to cater to the needs of the Western, Southern, Eastern and
Northern regions, respectively.
68
3.4.1 Features of Factoring
The following arc the salient features of the factoring arrangement:
Factor selects the accounts of the receivables of his client and set up a credit limit,
for each account of receivables depending on safety, financial stability and credit
worthiness.
The factor takes the responsibility for collecting the accounts receivables selected
by it.
Factor advances money to the client against selected accounts that may be
not-yet collected and not-yet-due debts. Generally the amount of money as
advances to 70 per cent to 80 per cent of the amount of the bills (debt). But factor
charges interest on advances, that usually is equal to or slight higher than the
landing rate of commercial banks.
3.4.2 Advantages
The following advantages relating to the facility of factor:
Factor ensures certain pattern of cash-in-flows from credit sales.
Elimination of debt collection department, if it is continuous goes factoring.
3.4.3 Limitations
Apart from the services observe by factor, the arrangement suffers from some
limitations:
Services would be provided on selective accounts basis and not for all accounts
(debts):
The cost of factoring is higher and compared to other sources of short-term
working capital finance.
Factoring of debt may be perceived as an indication of financial weakness.
Reduces future sales due to strict collection policy of factor.
3.5 LET US SUM UP

Estimation of working capital required is completed, then the next step is financing of
working capital. Statement of working capital gives clear picture about the
components, (raw materials, work-in-process, finished goods and receivables) and
required investment in these components of working capital. Financing of current
assets is the responsibility of finance manager who may require spending lot of time
for raising finance.
Working capital should be financed by suitable and optimal mix of short-term source
of funds and long-term source of funds.
Sources of short-term financing funds are: trade credit, accruals, differed incomes,
Commercial Papers (CPs), Public Deposits (PDs), Inter Corporate Deposits (ICDs),
and commercial banks.
Trade credit refers to the credit extended by the supplier of goods or services to his
customer in the normal course of business. Trade credit is a spontaneous source of
finance that it arises in the normal business transactions of the firm without specific
negotiations (automatic source of finance).
Accrued expenses arc those expenses which the company owes to the other persons or
organisations, but not yet due to pay the amount.
Deferred Incomes are income received in advance by the firm for supply of goods or 69
services in future period. Financing of Working Capital-I
Commercial Papers (CPs) represents a short-term unsecured promissory notes issued

by firms that have a fairly high credit (standing) rating. CP is an alternative source of
finance and proves to be helpful during the period of tight bank credit, it is a cheaper
source of short-term finance when compared to the bank credit. But CP is available
only for large and financially sound companies, and it cannot be redeemed before the
maturity date.
Public Deposits or term deposits are in the nature of unsecured deposits, have been
solicited by the firms (both large and small) from general public primarily for the
purpose of financing their working capital requirements. But fixed deposits accepted
by companies are governed by the Companies (Acceptance of Deposits) Amendment
Rules of 1978. Benefits of public deposits are simple procedures involved in issuing
public deposits, no restrictive covenants are involved, no security is offered against
public deposits, and its cheaper (post-tax cost is fairly reasonable). But it has some
disadvantages they are: limited amount of funds can be raised, and funds available
only for a short period.
Inter-Corporate Deposits (ICDs): A deposit made by one firm with another firm is
known as Inter-Corporate Deposits (ICDs). Generally, these deposits are usually made
for a period up to six months. Such deposits may be of three types: call deposits, (its
repayment is demanded on just one days notice), three months deposits, and six-
months deposits. These types of deposits are usually given to 'A' category borrowers
only and they carry an interest rate of around 16% per annum.
Commercial banks are the major source of working capital finance to industries and
commerce. The loaning of funds to business is one of their primary functions. Forms
of Bank Finance are: (1) Loans, (2) Overdrafts, (3) Cash credits, (4) Purchase or
discounting of bills and (5) Letter of Credit.
Bank finance is available on providing adequate security. The modes of security
required by a bank are: (a) hypothecation, (b) pledge, and (c) mortgage.
Factoring service may be offered to the client in two ways: (a) with recourse to the
drawer(s) and (b) without recourse to the drawer(s). Advantages relating to the facility
factors which ensure certain pattern of cash in flows from credit sales, and elimination
of debt collection department, if it continuously goes in for factoring. Apart from the
services observed by factor, the arrangement suffers from some limitations they are:
services would be provided on selective accounts basis and not for all accounts
(debts). The cost of factoring is higher and compared to other sources of short-term
working capital finance, Factoring of debt may be perceived as an indication of
financial weakness, and reduces future sales due to strict collection policy of factor.
Net working capital should be financed by long-term sources of finance. The sources
of long-term working capital are: retained earnings, issue of shares (ordinary or equity
shares and preference shares), debentures, public deposits, loan from financial
institutions, Life Insurance Corporation of India (LIC), General Insurance Corporation
(GIC), Unit Trust of India (UTI), State Financial Corporations (SFCs), Industrial
Development Bank of India (IDBI), etc.

List out the important forms of working capital advance given by banks. Discuss the
modes security required by banks in this context.
70
Working Capital Management 3.7 KEYWORDS
Acid Test Ratio: A liquidity measure which is defined as current liabilities.
Accounts Receivable: Money owed to a firm by its suppliers.

1. Name the sources of short-term working capital.
2. What is factoring?
3. What is CP?
4. What do you mean by L/C?
5. How do you compute cost of trade credits?

CYP 1
1. Commercial paper represents a short-term unsecured promissory note
issued by firms that have a fairly high credit (standing) rating. It was first
introduced in USA and it was an important money market instruments. In
India, Reserve Bank of India introduced CP on the recommendations of
the Vaghul Working Group on money market.
2. Public deposits or term deposits are in the nature of unsecured deposits,
have been solicited by the firms (both large and small) from. general
public primarily for the purpose of financing their working capital
requirements.
CYP 2
1. [(a) Permanent, variable; (b) Spontaneous; (c) Discount, face value;
(d) 25 %; (e) 15 %; (f) Cash credit account; (g) Revocable; (h) Factor].
2. [(a) False; (b) True; (c) True; (d) True; (e) True].

P. Gopala Krishan and M.S. Sandilya, Inventory Management, McMillan, 1978.
K.V. Smith, Management of Working Capital, McGraw-Hill, New York.
E.S. Buffa, Modern Production /Operation Management, Wiley, 1980.
71
LESSON Financing of Working Capital-II
4
FINANCING OF WORKING CAPITAL-II
CONTENTS
4.1 Introduction
4.2 Working Capital Requirements
4.2.1 Financing of Permanent/Fixed or Long-term Working Capital/Money
Market Instruments
4.2.2 Financing of Temporary, Variable or Short-term Working Capital
4.3 Determining the Working Capital Financing Mix
4.4 Appraisal and Assessment of Working Capital
4.5 Let us Sum up
4.7 Keywords

z The concept of working capital finance
z The financing forms
z The working capital
z The appraisal and assessment methods
4.1 INTRODUCTION
The working on extra shift basis (double shift or triple shift) usually, does not affect
the requirements of fixed capital in a business as further investment in fixed assets
may not be required. However, the following shall be the effect of extra shift working
on working capital:
1. Increased volume of stocks will be required. But the same may not be
proportionate to the increase in production as the minimum level of stocks may
not increase in the same proportion.
2. Fixed overheads will remain the same and thus fixed overheads cost per unit will
decrease.
72 3. Variable overheads will increase proportionately. However, there may be some
saving in purchase cost of materials because of large orders. Similarly, the wage
rate may also be higher for second or third shift workers.
4. There may be change in the amount of work-in-process because of higher wage
rates, etc.
5. The overall requirements of working capital will increase under extra shift
working.
4.2 WORKING CAPITAL REQUIREMENTS

The working capital requirements of concern can be classified as:
1. Permanent or Fixed working capital requirements.
2. Temporary or Variable working capital requirements.
In any concern, a part of the working capital investments are as permanent
investments in fixed assets. This is so because there is always a minimum level of
current assets which are continuously required by the enterprise to carry out its day-to-
day business operations and this minimum cannot be expected to reduce at any time.
This minimum level of current assets gives rise to permanent or fixed working capital
as this part of working capital is permanently blocked in current assets.
Similarly, some amount of working capital may be required to meet the seasonal
demands and some special exigencies such as rise in prices, strikes, etc. this
proportion of working capital gives rise to temporary or variable working capital
which cannot be permanently employed gainfully in business.
The fixed proportion of working capital should be generally financed from the fixed
capital sources while the temporary or variable working capital requirements of
concern may be met from the short term sources of capital.
The various sources for the financing of working capital are as follows:
Sources of Working Capital
Permanent or Fixed Temporary or Variable
1. Shares 1. Commercial Banks

2. Debentures 2. Indigenous Bankers
3. Public deposits 3. Trade Creditors
4. Ploughing back of profits 4. Installment Credit
5. Loans from Financial Institutions. 5. Advances
6. Account Receivable-Credit/Factoring
7. Accrued Expenses
8. Commercial Paper
Figure 4.1

What will be the effect of extra shift working on working capital?
…………………………………………………………………………….
…………………………………………………………………………….
4.2.1 Financing of Permanent/Fixed or Long-term Working Capital/ 73
Financing of Working Capital-II
Money Market Instruments
Permanent working capital should be financed in such a manner that the enterprise
may have its uninterrupted use for a sufficiently long period, There are five important
sources of permanent or long-term working capital.
1. Shares: Issue of shares is the most important source for raising the permanent or
long-term capital. A company can issue various types of shares as equity shares,
preference shares and deferred shares. According to the Companies Act, 1956,
however, a public company cannot issue deferred shares. Preference shares carry
preferential rights in respect of dividend at a fixed rate and in regard to the
repayment of capital at the time of winding up the company. Equity shares do not
have any fixed commitment charge and the dividend on these shares is to be paid
subject to the availability of sufficient profits. As far as possible, a company
should raise the maximum amount of permanent capital by the issue of shares.
2. Debentures: A debenture is an instrument issued by the company acknowledging
its debt to its holder. It is also an important method of raising long-term or
permanent working capital. The debenture-holders are the creditors of the
company. A fixed rate of interest is paid on debentures. The interest on debentures
is a charge against profit and loss account. The debentures are generally given
floating charge on the assets of the company. When the debentures are secured
they are paid on priority to other creditors. The debentures may be of various
kinds such as simple, naked or unsecured debentures, secured or mortgaged
debentures, redeemable debentures irredeemable debentures, convertible
debentures and non-convertible debentures. The debentures as a source of finance
have a number of advantages both to the investors and the company. Since interest
on debentures have to be paid on certain predetermined intervals at a fixed rate
and also debentures get priority on repayment at the time of liquidation, they are
very well suited to cautious investors. The firm issuing debentures also enjoys a
number of benefits such as trading on equity, retention of control, tax
benefits, etc.
3. Public Deposits: Public deposits are the fixed deposits accepted by a business
enterprise directly from the public. This source of raising short term and medium-
term finance was very popular in the absence of banking facilities. In the past,
generally, public deposits were accepted by textile industries in Ahmedabad and
Bombay for periods of 6 months to 1 year. But now-a-days even long-term
deposits for 5 to 7 years are accepted by the business houses. Public deposits as a
source of finance have a large number of advantages such as very simple and
convenient source of finance, taxation benefits, trading on equity, no need of
securities and an inexpensive source of finance, But it is not free from certain
dangers such as, it is uncertain, unreliable, unsound and inelastic source of
finance. The Reserve Bank of India has also laid down certain limits on public
deposits. Non-banking concerns cannot borrow by way of public deposits more
than 25% of its paid-up capital and free reserves.
4. Ploughing Back of Profits: Ploughing back of profits means the reinvestments
by concern of its surplus earnings in its business. It is an internal source of finance
and is most suitable for an established firm for its expansion, modernization and
replacement etc. This method of finance has a number of advantages as it is the
cheapest rather cost-free source of finance; there is no need to keep securities;
there is no dilution of control; it ensures stable dividend policy and gains
confidence of the public. But excessive resort to ploughing back of profits may
lead to monopolies, misuse of funds, over capitalization and speculation, etc.
5. Loans from Financial Institutions: Financial institutions such as Commercial
Banks, Life Insurance, Development Corporations, Industrial Development Bank
74 of India, etc. also provide short-term, medium-term and long-term loans. This
source of finance is more suitable to meet the medium-term demands of working
capital. Interest is charged on such loans at a fixed rate and the amount of the loan
is to be repaid by way of installments in a number of years.
4.2.2 Financing of Temporary, Variable or Short-term Working Capital

The main sources of short-term working capital are as follows:
1. Indigenous Bankers
2. Trade Credit
3. Installment Credit
4. Advances
5. Accounts Receivable Credit or Factoring
6. Accrued Expenses
7. Deferred Incomes
8. Commercial Paper
9. Commercial Banks
Indigenous Bankers
Private money-lenders and other country bankers used to be the only source of finance
prior to the establishment of commercial banks. They used to charge very high rates of
interest and exploited the customers to the largest extent possible. Now-a-days with
the development of commercial banks they have lost their monopoly. But even today
some business houses have to depend upon indigenous bankers for obtaining loans to
meet their working capital requirements.
Trade Credit
Trade credit refers to the credit extended by the suppliers of goods in the normal
course of business. As present day commerce is built upon credit, the trade credit
arrangement of a firm with its suppliers is an important source of short-term finance.
The credit-worthiness of a firm and the confidence of its suppliers are the main basis
of securing trade credit. It is mostly granted on an open account basis whereby
supplier sends goods to the buyer for the payment to be received in future as per terms
of the sales invoice. It may also take the form of bills payable whereby the buyer signs
a bill of exchange payable on a specified future date.
When a firm delays the payment beyond the due date as per the terms of sales invoice,
it is called stretching accounts payable, A firm may generate additional short-term
finances by stretching accounts payable, but it may have to pay penal interest charges
as well as to forgo cash discount. If a firm delays the payment frequently, it adversely
affects the credit worthiness of the firm and it may not be allowed such credit facilities
in future.
The main advantages of trade credit as a source of short-term finance include:
z It is an easy and convenient method of finance.
z It is flexible as the credit increases with the growth of the firm.
z It is informal and spontaneous source of finance.
However, the biggest disadvantage of this method of finance is charging of higher
prices by the suppliers and loss of cash discount.
Installment Credit 75
This is another method by which the assets are purchased and the possession of goods
is taken immediately but the payment is made in installments over a pre-determined
period of time. Generally, interest is charged on the unpaid price or it may be adjusted
in the price. But, in any case, it provides funds for sometime and is used as a source of
short-term working capital by many business houses which have difficult fund
position.
Advances
Some business houses get advances from their customers and agents against orders
and this source is a short-term source of finance for them. It is a cheap source of
finance and in order to minimize their investment in working capital, some firms
having long production cycle, specially the firms manufacturing industrial products
prefer to take advances from their customers.
Accounts Receivable Credit or Factoring

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 take over 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 o 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.
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. Taxes are paid after collection and in the
intervening period serve as a good source of finance. Even income-tax is paid
76 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.
Deferred Incomes
Deferred incomes are incomes received in advance before supplying goods or
services. They represent funds received by a firm for which it has to supply goods or
services in future. These funds increase the liquidity of a firm and constitute an
important source of sort-term finance. However, firms having great demand for its
products and services, and those having good reputation in the market can demand
deferred incomes.
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 company for the issue of commercial paper. Only a company which is listed on the
stork exchange has a net worth of at least Rs. 10 crores and 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 and no interest rate is provided this source, is an action 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 id the issuing firm has
surplus funds to pay back.
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 concern. The
different forms in which the banks normally provide loans and advances are as 77
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
instalments. 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. These 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
78 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:
a) Clean Letter of Credit. It is a guarantee for the acceptance and payment of bills
without any conditions.
b) Documentary Letter of Credit. It requires that the exporter’s bill of exchange be
accompanied by certain documents evidencing title to the goods.
c) Revocable Letter of Credit. It is one which can be withdrawn by the issuing bank
without the prior consent of the exporter.
d) Irrevocable Letter of Credit. It cannot be withdrawn without the consent of the
beneficiary.
e) 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 deed for
further application for another letter of credit to be issued provided the conditions
specified in the first credit are fulfilled.
f) 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.
Security Required in Bank Finance

Banks usually do not provide working capital finance without obtaining adequate
security. The following are the most important modes of security required by a bank:
1. Hypothecation: Under this arrangement, bank provides working capital finance
against the security of movable property, usually inventories. The borrower does
not give possession of the property to the bank. It remains with the borrower and
hypothecation is merely a charge against property for the amount of debt. If the
borrower fails to pay his dues to the bank, the banker may file a case to realize his
dues by sale of the goods/property hypothecated.
2. Pledge: Under this arrangement, the borrower is required to transfer the physical
possession of the property or goods to bank as security. The bank will have the
right of lien and can retain the possession of goods unless the claim of the bank is
met. In case of default, the bank can even sell the goods after giving due notice.
3. Mortgage: In addition to the hypothecation or pledge, banks usually ask for
mortgages as collateral or additional security. Mortgage is the transfer of a legal
or equitable interest in a specific immovable property for the payment of a debt.
Although, the possession of the property remains with the borrower, the full legal
title is transferred to the lender. In case of default, the bank can obtain decree
from the court to sell the immovable property mortgaged so as to realize its dues.

1. Define shares.
…………………………………………………………………………….
…………………………………………………………………………….
2. What do you mean by Public deposits?
…………………………………………………………………………….
…………………………………………………………………………….
79
4.3 DETERMINING THE WORKING CAPITAL Financing of Working Capital-II
FINANCING MIX
Broadly speaking, there are two sources of financing working capital requirements :
(i) Long-term sources such as share capital, debentures, public deposits, ploughing
back of profits, loans from financial institutions, and (ii) short-term sources such as
commercial banks, indigenous bankers, trade credits, installment credit, advances,
accounts receivables and so on. Therefore, a question arises as to what portion of
working capital (current assets) should be financed by long-term sources and how
much by short-term sources?
There are three basic approaches for determining an appropriate working capital
financing mix.
Approaches to Financing Mix
The Hedging or The Conservative The Aggressive

Matching Approach Approach
Approach
Figure 4.2: Approaches to Financing Mix

The term ‘hedging’ usually refers to two off-selling transactions of a simultaneous but
opposite nature which counterbalance the effect of each other. With reference to
financing mix, the term hedging refers to ‘a process of matching maturities of debt
with the maturities of financial needs’. According to this approach, the maturity of
sources of funds should match the nature of assets to be financed. This approach is,
therefore, also known as ‘matching approach’. This approach classifies the
requirements of total working capital into two categories:
z Permanent or fixed working capital which is the minimum amount required to
carry out the normal business operations. It does not vary over time.
z Temporary or seasonal working capital which is required to meet special
exigencies. It fluctuates over time.
The hedging approach suggests that the permanent working capital requirements
should be financed with funds from long-term sources while the temporary or
seasonal working capital requirements should be financed with short-term funds. The
following example explains this approach.
80
Estimated Total Investment in Current Assets of Company X For the Year 2000
Month Investments in Permanent or Temporary or
Current Assets Fixed Investments Seasonal Invest,
(Rs.) (Rs.) (Rs.)
January 50,400 45,000 5,400
February 50,000 45,000 5,000
March 48,700 45,000 3,700
April 48,000 45,000 3,000
May 46,000 45,000 1,000
June 45,000 45,000 -------
July 47,500 45,000 2,500
August 48,000 45,000 3,000
September 49,500 45,000 4,500
October 50,700 45,000 5,700
November 52,000 45,000 7,000
December 48,500 45,000 3,500
Total 44,300
According to hedging approach the permanent portion of current assets required

(Rs. 45,000) should be financed with long-term sources and temporary or seasonal
requirements in different months (Rs. 5,400; Rs. 5,000 and so on) should be financed
from short-term sources.

This approach suggests that the entire estimated investments in current assets should
be financed from long-term sources and the short-term sources should be used only
for emergency requirements. According to this approach, the entire estimated
requirements of Rs. 52,000 in the month of November (in the above given example)
will be financed from long-term sources. The short-term sources. The short-term
funds will be used only to meet emergencies. The distinct features of this approach
are:
(i) Liquidity is severally greater;
(ii) Risk is minimized; and
(iii) The cost of financing is relatively more as interest has to be paid even on seasonal
requirements for the entire period.
Trade-off between the Hedging and Conservative Approaches

The hedging approach implies low cost, high profit and high risk while the
conservative approach leads to high cost, low profits and low risk. Both the
approaches are the two extremes and neither of them serves the purpose of efficient
working capital management. A trade off between the two will then be an acceptable
approach. The level of trade off may differ from case to case depending upon the
perception of risk by the persons involved in financial decision-making. However, one
way of determining the trade off is by finding the average of maximum and the
minimum requirements of current assets or working capital. The average requirements
so calculated may be financed out of long-term funds and the excess over the average
from the short-term funds. Thus, in the above given example the average requirements
45,000 + 52,000 81
of Rs. 48,500, i.e. may be financed from long-term while the excess Financing of Working Capital-II
2
capital required during various months from short-term sources.

The aggressive approach suggests that the entire estimated requirements of currents
asset should be financed from short-term sources and even apart of fixed assets
investments be financed from short-term sources. This approach makes the finance-
mix more risky, less costly and more profitable.
Illustration 1:
Excel Industries Ltd. is considering its current assets policy. Fixed assets are
estimated at Rs. 40,00,000 and the firm plans to maintain a 50 per cent debt to asset
ratio. The interest rate is 14 per cent on all debt. Three alternative current asset
policies are under consideration; 40,50 and 60 percent of projected sales. The
company expects to earn 50 percent before interest and tax on sales of
Rs. 2,00,00,000. The corporate tax rate is 35 percent. Calculate the expected return on
equity under alternative.
Alternative Balance Sheets of Excel Industries Ltd.
Conservative Moderate Aggressive

(40% of Sales) (50% of Sales) (60% of Sales)
Rs. in lacs Rs. in lacs Rs. in lacs
Current Assets 80.00 100.00 120.00

Fixed Assets 40.00 40.00 40.00
Total Assets 120.00 140.00 160.00
Debt (50% of Total Assets) 60.00 70.00 80.00
Equity 60.00 70.00 80.00
Total Liabilities and Equity 120.00 140.00 160.00
Alternative Income Statements: Effects of Alternative Current Assets Policies
Conservative (40%), Moderate (50%) Aggressive (60%)

Rs. in lacs, Rs. in lacs Rs. in lacs
Sales 200.00 200.00 200.00

Earnings Before Interest and Tax (20%) 40.00 40.00 40.00
Interest on Debt (14%) 8.40 9.80 11.20
Earnings Before Tax (EBT) 31.60 30.20 28.80
Tax (35%) 11.06 10.57 10.08
Earnings After Tax (EAT) 20.54 19.63 18.72
Return on Equity (EAT/Equity) 34.23% 28.04% 23.40%
82 Illustration 2
The following are the summarized balance sheets of X Ltd. and Y Ltd. as on 31st
March, 2003:
X Ltd. Y Ltd.
(Rs. in lacs) (Rs. in lacs)
Current Assets 100.00 60.00

Fixed Assets 100.00 140.00
Total Assets 200.00 200.00
Current Liabilities 20.00 80.00
Long-term Debt 80.00 20.00
Equity Share Capital 70.00 30.00
Retained Earnings 30.00 70.00
200.00 200.00
Earnings before interest and tax for both the companies are Rs. 50 lacs each. The
corporate tax rate is 35 percent.
a) What is the return on equity (ROE) for each company if the interest rate on
current liabilities is 10 per cent and 12 per cent on long-term debt?
b) Assuming that the rate of interest on current liabilities rises to 15 percent, while it
remains unchanged for ling-term debt, would be its effect on return on equity for
each company?
Solution:
Calculation of Return on Equity
(Rs. in lacs)
X Ltd. Y Ltd
(a) (b) (a) (b)
Earnings Before Interest and Tax 50.00 50.00 50.00 50.00

Interest on Current and Long-term Debt 11.60 12.60 10.40 14.40
Earnings Before Tax (EBT) 38.40 37.40 39.60 35.60
Tax (35%) 13.44 13.09 13.86 12.46
Earnings After Tax (EAT) 24.96 24.31 25.74 23.14
Equity (Eq. Share Capital+Retained Earnings 100.00 100.00 100.00 100.00
Return on Equity (EAT/Equity) 24.96% 24.31% 25.74% 23.14%

Fill in the blanks:
1. A budget is a financial and/or quantitative expression of business plans
and policies to be pursued in the ____________ period of time.
2. The technique of ratio analysis can be employed for measuring
______________ liquidity or working capital position of a firm.
3. _______________ is the transfer of a legal or equitable interest in a
specific immovable property for the payment of a debt.
83
4.4 APPRAISAL AND ASSESSMENT OF Financing of Working Capital-II
WORKING CAPITAL
We have already studied in this chapter that working capital is the life blood and nerve
centre of a business. Just as circulation of blood is essential in the human body for
maintaining life, working capital is very essential to maintain the smooth running of a
business. No business can run successfully without an adequate amount of working
capital. However, it must also be noted that working capital is a means to run the
business smoothly and profitably, and not an end. Thus, concept of working capital is
a means to run importance in a going concern. A going concern, usually, has a
positive balance of working capital has its own excess of current assets over current
liabilities, but sometimes the uses of working capital may be more than the sources
resulting into a negative value of working capital. This negative balance is generally
offset soon by gains in the following periods. A study of changes in the uses and
sources of working capital is necessary to evaluate the efficiency with which the
working capital is employed in a business. This involves the need of working capital
analysis.
The analysis of working capital can be conducted through a number of devices,
such as:
1. Ratio Analysis
2. Funds Flow Analysis
3. Budgeting
1. Ratio Analysis: A ratio is a simple arithmetical expression of the relationship of
one number to another. The technique of ratio analysis can be employed for
measuring short-term liquidity or working capital position of a firm. The
following ratios may be calculated for this purpose:
Current Ratio
Acid Test Ratio
Absolute Liquid Ratio or Cash Position Ratio
Inventory Turnover Ratio
Receivables Turnover Ratio
Payables Turnover Ratio
Working Capital Turnover Ratio
Working Capital Leverage
Ratio of Current Liabilities to Tangible Net Worth
2. Funds Flow Analysis: Funds flow analysis is a technical device designated to
study the sources from which additional funds were derived and the use to which
these sources were put. It is an effective management tool to study changes in the
financial position (working capital) of business enterprise between beginning and
ending financial statements dates. The funds flow analysis consists of: (i)
preparing schedule of changes in working capital, and (ii) statement of sources
and application of funds.
This technique of measuring working capital has been discussed at length in the
chapter relating to ‘Funds Flow Statement’.
84 3. Working Capital Budget: A budget is a financial and/or quantitative expression
of business plans and policies to be pursued in the future period of time. Working
capital budget, as a part of total budgeting process of business, is prepared
estimating future long-term and short-term working capital needs and the sources
to finance them, and then comparing the budgeted figures with the actual
performance for calculating variances, if any, so that corrective actions may be
taken in the future. The objective of a working capital budget is to ensure
availability of funds as and when needed, and to ensure effective utilization of
these resources. The successful implementation of working capital budget
involves the preparing of separate budgets for various elements of working
capital, such as, cash, inventories and receivables, etc.
4.5 LET US SUM UP

We have already studied in this chapter that working capital is the life blood and nerve
centre of a business. Just as circulation of blood is essential in the human body for
maintaining life, working capital is very essential to maintain the smooth running of a
business. No business can run successfully without an adequate amount of working
capital. However, it must also be noted that working capital is a means to run the
business smoothly and profitably, and not an end. Thus, concept of working capital is
a means to run importance in a going concern. A going concern, usually, has a
positive balance of working capital has its own excess of current assets over current
liabilities, but sometimes the uses of working capital may be more than the sources
resulting into a negative value of working capital. This negative balance is generally
offset soon by gains in the following periods. A study of changes in the uses and
sources of working capital is necessary to evaluate the efficiency with which the
working capital is employed in a business. This involves the need of working capital
analysis.

Discuss, in detail, the short-term financing of working capital for a business
organization.
4.7 KEYWORDS
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.
Funds flow analysis: A technical device designated to study the sources from which
additional funds were derived and the use to which these sources were put.
Hedging: The term ‘hedging’ usually refers to two off-selling transactions of a
simultaneous but opposite nature which counterbalance the effect of each other.

1. What are the different modes for financing the working capital?
2. What are the money market instruments?
3. Explain the process of working capital appraisal and assessment.
85
Check Your Progress: Model Answers Financing of Working Capital-II
CYP 1
The following shall be the effect of extra shift working on working capital:
1. Increased volume of stocks will be required. But the same may not be
proportionate to the increase in production as the minimum level of stocks
may not increase in the same proportion.
2. Fixed overheads will remain the same and thus fixed overheads cost per
unit will decrease.
CYP 2
1. A company can issue various types of shares as equity shares, preference
shares and deferred shares. According to the Companies Act, 1956,
however, a public company cannot issue deferred shares. Preference
shares carry preferential rights in respect of dividend at a fixed rate and in
regard to the repayment of capital at the time of winding up the company.
2. Public deposits are the fixed deposits accepted by a business enterprise
directly from the public. This source of raising short-term and medium-
term finance was very popular in the absence of banking facilities.
CYP 3
1. Future
2. Short-term
3. Mortgage

Publications.
Prasanna Chandra, Financial Management, Theory and Practice, Tata McGraw-Hill.
Khan and Jain, Financial Management, Tata McGraw-Hill.
86
LESSON
5
MANAGING CORPORATE LIQUIDITY
AND FINANCIAL FLEXIBILITY
CONTENTS
5.1 Introduction
5.2 Traditional Measures of the Liquidity
5.3 Liquidity Ratio
5.3.1 Current Ratio
5.3.2 Quick (Acid Test) Ratio
5.4 Activity Ratios
5.4.1 Receivable Turnover
5.4.2 Inventory Turnover Ratio
5.5 Net Working Capital
5.5.1 Net Liquid Balance
5.6 Working Capital Requirements
5.7 Let us Sum up
5.9 Keywords

z The concept of corporate liquidity
z The traditional measure of liquidity
z The liquidity ratio
z The working capital requirement
5.1 INTRODUCTION
The term liquidity probably brings to mind the relationship of current assets to current
liabilities. However, the concept of liquidity should encompass much more than
simply these two balance sheet accounts. The overall financial structure of a firm
influences liquidity, as do countless other aspects of the operation of the firm, such as
the firm’s product line, expertise of its management, and its industry’s vitality.
Liquidity has three basis ingredients: time, amount, and cost.
An essential component of liquidity is the time an asset takes to be converted into cash
or the time it takes to pay a current liability. More simply, this may be stated as the
ability of the firm to pay its bills on time. This approach to liquidity analysis takes a
flow perspective and is very short-run in nature, relating to the firm’s operating or 87
Managing Corporate Liquidity
cash cycle as discussed. and Financial Flexibility
Contrast this flow perspective with traditional measure of liquidity that use balance
sheet accounts such as the current ratio or net working capital. Such measures really
address the solvency of the firm. Solvency exists when the value of a firm’s asset
exceeds the value of its liabilities.
Liquidity may also be viewed as the ability of the firm to augment its future cash
flows to over any unforeseen needs or to take advantage of any unforeseen
opportunities. This concept of liquidity has been referred to as financial flexibility.
This viewpoint is much broader and would consider such things as the firm’s stability
of earnings, its relative debt/equity position (which may affect its access to external
financing sources), and the availability of credit lines. Traditional method of analyzing
financial statements—ratio analysis—is considered a weak tool for monitoring
liquidity. It may be safe to say that it is not ratio analysis itself that is a weak tool but
rather that rations have yet to be developed that effectively measure the liquidity
aspect of a business operation.
To properly measure and monitor the liquidity, standards and approaches used in the
past must be discarded and a new framework must be developed. Infect, the liquidity
analysis should include the amount and trend of internal cash flow; the aggregate lines
of credit and degree of line usage; the attractiveness to investors of the firm’s
commercial paper, long-term bonds, and equity; and overall expertise of management.
Since liquidity is a fairly complex issue and the analysis of liquidity involves much
more than computing the relationship between current assets and current liabilities.
Liquidity analysis should consider the overall framework of management’s ability to
monitor and control the firm’s ability to generate operating cash flow.
5.2 TRADITIONAL MEASURES OF THE LIQUIDITY

Although the ratios presented in this section are generally referred to as liquidity
ratios, most of them, especially the current and quick ratios, really measure the
solvency of the firm. As discussed earlier, a firm is considered solvent when its total
assets exceed its total liabilities. These balance sheet ratios generally measure the
relationship between some measure of current assets and some measure of current
liabilities. In some respects, these balance sheet ratios demonstrate the degree by
which current liabilities are covered in the event of liquidation. Table 5.1 presents the
finances statements of Shiva Pharma Company. We will use these financial statements
to demonstrate the calculation and interpretation of the liquidity, solvency, and
financial flexibility ratios that will be presented.
Table 5.1: Shiva Pharma Company
Income Statement for the year ended December 31, 1996
Sales Rs.80,00,000
Cost of goods sold 44,50,000
Grass Profit Rs.35,50,000
Operating expense:
Selling expense Rs.16,00,000
Administrative expense 9,00,000
Interest expense 40,000
Total expense Rs.25,00,000
Net income before tax Rs.10,10,000
Tax expenses 4,00,000
Net income Rs.6,10,000
Earnings per share (5,00,000 equity shares) Rs.1.22
88
Working Capital Management Balance Sheet
As on December 31, 1996
Liabilities and Owners’ Equity Assets
Share capital (Rs.10.00 par Fixed Assets:
Value, 5,00,000 shares Equipment Rs.60,00,000
authorize, issued and
Less: Accumulated outstanding) Rs.50,00,000 depreciation 18,00,000
Retained earnings 22,70,000 Rs.42,00,000
Long-term liabilities: Investments 5,00,000
Bonds payable (due 2003) 15,00,000 Current Assets
Current Liabilities and Cash 9,00,000
Provisions:
Sundry debtors-Sundry creditors 9,60,000 (net) 6,00,000
Bills payable 5,20,000 Inventory 40,00,000
Accrued wages payable 1,00,000 Prepaid expenses 1,50,000
Rs.1,03,50,000 Rs.1,03,50,000
Other Data for 1996
Cash Dividends per share = Rs.20
Selected Data from the previous year’s financial statement
Total assets = Rs.93,50,000
Total shareholders equity = Rs.70,60,000
Total number of shares of equity outstanding = 5,00,000
Net sundry debtors = Rs.5,60,000
Shares
Inventory = Rs.32,00,000
5.3 LIQUIDITY RATIO

Liquidity and short-term solvency ratios are used to judge the firm’s ability to meet
such current obligations as its accounts payable and the current position of its long
term debt. By interpreting such ratios we can determine the degree to which assets
which are quickly convertible to cash exceed the liabilities which require almost
immediate cash payment. Liquidity ratios are generally useful to all financial
statement users, but are particularly useful to short-term creditors. The most
frequently ratios in this category are the current and the quick (acid test) ratios.
5.3.1 Current Ratio

The current ratio is the traditional ratio used to measure a company’s liquidity and is
calculated by dividing the total current assets by the total current liabilities. Its use
dates back to the last century, and it is still accepted as the best measure of the
company’s short-term solvency. The current ratio for the Shiva Pharma Company is:
Total current assets
Current Ratio =
Total current liabilities
Rs.56,50,000
=
Rs.15,80,000
= 3.6
This ratio is designed to assist the decision maker in determining a firm’s ability to
pay its current liabilities. The higher the ratio, the greater the ability of the company to
meet its immediate financial obligations. However, the higher this ratio, the greater
the proportion of the company’s resources that is tied up in relatively unproductive 89
assets, which have an adverse effect on profitability. Therefore, regardless of the and Financial Flexibility
magnitude of the current ratio, management still bars to make the decision as to the
appropriate balance between profitability and liquidity.
5.3.2 Quick (Acid Test) Ratio

A supplementary test of the ability of a business to meet its current obligations is the
quick or the acid rest ratio. The quick ratio is calculated by dividing the total current
assets less inventories by the total current liabilities less bank overdraft. The reason
for deducting inventories are regarded as the best liquid of all current assets, and so,
this will prove the most difficult to realize at short notice, consequently, these items
are excluded from the computation of quick ratio. It is guided better than the current
ratio as measure of the company’s ability to meet its financial obligations if they
become payable in the very short-term.
Cash Marketable sec urities + Interests receivable
Quick ratio =
Current liabilities
Total current assets − Inventories
=
Current liabilites
Rs.9,00,000 + 0 + Rs.6,00,000
=
Rs.15,80,000
= 0.95
The current ratio and the quick ratio serve as a measure of a company’s liquidity
position and to have particular application to cash management. The usefulness of
these ratios to management has already been questioned, although empirical studies
have produced evidence that these4 and other ratios may assist external parties in
estimating the possibility of the future failure of a company. It has also been suggested
that a study of the company’s future cash flows would be a more suitable method of
ascertaining a company’s liquidity position than other based on financial ratios.
Regardless of other criticisms of these ratios, there are serious doubts that they can
measure a company’s ability to meet its immediate financial obligations. The current
ratio is calculated simply by dividing the book value of current liabilities. This does
not rake into account either the relative liquidity of the various current assets or the
relative urgency for repayment of the current liabilities. It is not useful to know that
the company has a current ratio of two, if all the liabilities are due to be paid within a
week and most of the assets cannot be realized within few months, a further limitation
of the current ratio is that it includes inventory valued at historical cost. As it is
assumed that inventory can generate liquidity to meet financial obligations, then it
may be argued that inventory should be valued at net realizable value, which better
represents the asset’s contribution to liquidity. Finally, the numerical value of these
ratios can be manipulated by management so that the resulting figure will be
acceptable to interested parties, this can be easily achieved by delaying purchases or
paying off a large amount of the company’s current liabilities just prior to the end of
the financial year.

1. Define current ratio.
…………………………………………………………………………….
…………………………………………………………………………….
2. What is the use of liquidity ratio?
…………………………………………………………………………….
…………………………………………………………………………….
90
Working Capital Management 5.4 ACTIVITY RATIOS
Activity ratios reflect the intensity with which the firm uses assets in generating sales.
These ratios indicate whether the firm’s investments in current and long-term assets
are too small or too large. If investment in an asset is too large, it could be that the
funds tied up in that asset should be used for more immediate productive purposes.
For example, the firm may have unused plant capacity which it could sell and then use
the proceeds in some profitable way. It investment is too small, the firm may be
providing poor service to customers or inefficiently, producing its product. Some of
the activity ratios, which are also refereed to as efficiency or turnover are discussed
below.

Both the current and the acid test ratio presume that sundry debtors can be converted
into cash within enough time to allow the payment of current debits. In the
management of assets, a balance must be struck in the creation of sundry debtors. If a
firm grants too little credit, it may lose sales as result. On the other hand, if the firm is
too generous in the extension of credit, it will soon have much of its short-term assets
tied up in slow or uncollectible accounts.
The sundry debtor’s turnover is a measure of the number of times on the average that
receivables turnover each year. This ratio is computed by dividing net credit sales by
the average receivable outstanding during the year. Average sundry debtors balances.
Total net sales or credit sales
Debtors turnover =
Average net debtors
Rs. 80,000,000
= = 13.8times
(Rs. 5,60,000 + 6,00,000)
This ratio indicates that debtors for the Shiva Pharma Company turnover 13.8 times
per year. The average period of time required to collect debtors is obtained by
dividing the turnover ratio (13.8) into the number of days in a year (360-day is used
for simplicity).
Number of days in year
Average collection period =
Debtors turnover ratio
= 360/13.8
= 26.1 days.
On average, Shiva Pharma Company collects its receivables every 26.1 days. This
means that Shiva Pharma is providing credit to customers fro less than a month. If the
terms of credit in this industry call for payment within 30 days of sale, a 26 days
collection period may be viewed as a positive one. Comparison with an industry
average would help in evaluating these results. A relatively short collection period
suggests that most receivables are collectible.
5.4.2 Inventory Turnover Ratio

Another important liquidity ratio is the inventory turnover ratio. Inventory turnover is
a measure of the number of times the average inventory has been sold during the year.
It is computed by dividing the cost of goods sold by the average inventory balance:
Cost of good sold
Inventory turnover ratio =
Average inventory
Rs. 44,50,000
=
(Rs. 32,00,000 + Rs. 40,00,000)/2
The amount of time required to sell the average inventory can be determined by 91
dividing the inventory turnover ratio into the number of days in the year (360 days). and Financial Flexibility
Number of days in the year
Average inventory turnover days =
Inventory turnover ratio
= 360/1.236 = 291.26
The greater the number of times per year that inventory turns over, the more
efficiently it is being used. The smaller the inventory in relation to annual sales, the
greater the sales activity that the inventory is able to support, ideally, average
inventory should be based on a 12-month average; otherwise the average may be
distorted by seasonal fluctuations. Indeed a company may intentionally choose to end
its fiscal year in a month when inventories are at a yearly low in order to facilitate its
physical movement. In addition, this ratio is distorted by comparing sales with
inventory holdings valued at historical cost. As a result, it is preferable to use cost of
goods sold in the numerator.
Before proper use can be made of this ratio it is necessary for the company to specify
an “ideal” ratio at which it can aim. The higher this ratio, the lower will be the amount
of funds that the company has tried up in inventory at a particular times, but the more
times the company will have to place orders for times of inventory. However, it is
unlikely that an ideal inventory turnover ratio can be estimated which will lead to an
optimal inventory policy. The reverse is more likely to be true, that is, an optimal
policy for each inventory item will result in an optimum turnover ratio.
5.5 NET WORKING CAPITAL

Another common liquidity measure is net working capital. Net working capital is the
difference between current assets and current liabilities. This liquidity measure reports
the amount of long-term funds used to finance current assets if net working capital is
positive, or reports the dollar amount of current liabilities financing fixed or long-term
assets if net working capital is negative. It is generally agreed that the greater the
current assets relative to the level of current liabilities, the more liquid the company.
Shiva Pharma’s net working capital follows:
Net working capital = Current assets – Current liabilities

Net working capital = Rs.61,50,000 – Rs.15,80,000
= Rs.45,70,000
5.5.1 Net Liquid Balance

Shulman and Cox refined the concept of net working capital as a liquidity measure by
adding new interpretations to various working capital relationships. First they
observed that the traditional definition of net working capital (NWC), i.e., current
assets minus current liabilities, was not reflective of its real impact on liquidity. They
offered an alternative interpretation that equated NWC to the difference between
permanent capital (long-term liabilities and net worth) and net fixed assets. From this
viewpoint, the amount of positive net working capital measures that portion of current
assets financed with permanent funds. A negative level of net working capital
indicates that portion of current liabilities financing net fixed assets.
To further expand their analysis, they created two new definitions. First, they defined
working capital requirements, WCR, as the difference between current operating
assets (consisting of prepaid, inventory, and receivables) and current operating
liabilities (defined as accounts payable and accruals). These accounts represent
spontaneous uses and sources of funds over the firm’s operating cycle.
92 They then defined net liquid balance, NLB, as the difference between current financial
assets such as cash and marketable securities and current discretionary or no
spontaneous financial liabilities such as notes payable and current maturing debt. One
should note the relationship between WCR, NLB, and NWC, specifically, NWC =
WCR + NLB.
The NLB serves as Shulman and Cox’s proposed measure of liquidity. To see how
NLB measures liquidity, remember the interpretation of a positive level of net
working capital (NWC): the amount of current assets financed by permanent capita.
Over the operating cycle of the firm, the amount of positive working capital
requirements, which is a component of NWC, will expand as sales expand (increasing
receivables and inventory) and contract as a sales contract (selling off inventory and
collecting receivables). During the upswing, the expanding amount of WCR must
either be financed by drawing down the net liquid balance (NLB), adding to
permanent capital by acquiring new long-term debt or equity financing, or both.
Therefore, the more positive the net liquid balance, the greater the amount of liquid
resources the firm has to finance its working capital requirements if the incr5ease in
WCR is seasonal, then drawing down the net liquid balance is appropriate. However,
if the increase in WCR is permanent because of a new higher level of operations, then
the increase in WCR should be financed with a permanent source of funds in order to
maintain the firm’s level of liquidity
The Relationship between Net Working Capital, Net Liquid Balance, and Working
Capital Requirements.
Net Working Capital

Current Current
Assets Liabilities
NWC = CA - CL
Cash
Marketable Accounts
Securities Payable
Accounts Notes
Receivable Payable
Inventory Current
Pre-Paid Maturities of Long-
term debt
Working Capital Requirements
Current Current
Assets Liabilities
WCR = A/R + INV + Pre – A/p
Cash
Marketable Accounts
Securities Payable
Accounts Notes
Receivable Payable
Inventory Current
Pre-Paid Maturities of Long-
term debt
Net Liquid Balance 93
Current Current and Financial Flexibility
Assets Liabilities
NLB = Cash + Mkt Sec – N/P - CMLTD
Cash
Marketable Accounts
Securities Payable
Accounts Notes
Receivable Payable
Inventory Current
Pre-Paid Maturities of Long-term debt
NWC = WCR + NLB
The absolute NLB balance may be used as a measure of a firm’s liquidity. If the
measure is negative, it indicates a dependence on outside financing and is indicative
of the minimum borrowing line required. While a negative NLB does not by itself
suggest that the firm is going to default on its debt obligations, it does imply that the
firm has a reduced level of financial flexibility.
Fill in the blanks:
1. ___________________ turnover is a measure of the number of times the
average inventory has been sold during the year.
2. __________________ is the difference between current assets and current
liabilities.
5.6 WORKING CAPITAL REQUIREMENTS

The working capital requirements approach is useful because the traditional net
working capital figure includes accounts that are not directly related to the operating
cycle. For example, the cash account, the marketable securities account, and the notes
payable balance should be viewed as balances that result from internal financial
decisions or policies, not balances resulting from the operating cycle of the firm. They
should therefore by excluded from consideration. This approach is consistent with the
decomposition of net working capital into net liquid balance and working capital
requirements.
The standardized working capital requirements divide it by sales for developing a
working capital requirements to sales ratio WCR/S. This ratio, statistically different
across industry categories, indicates that industries have significantly different
working capital needs. All other factors constant, the greater this ratio, the greater
reliance a company will have on external funds given a change in sales. Thus, the
larger the WCR/S ratio, the less financial flexibility and less liquidity the firm will
have because its operating cycle will require a significant investment of funds. In
those cases where WCR is negative, the firm’s operating cycle becomes a permanent
source of financial and the positive impact on liquidity will be significant.
5.7 LET US SUM UP

Liquidity may also be viewed as the ability of the firm to augment its future cash
flows to over any unforeseen needs or to take advantage of any unforeseen
opportunities. This concept of liquidity has been referred to as financial flexibility.
This viewpoint is much broader and would consider such things as the firm’s stability
of earnings, its relative debt/equity position (which may affect its access to external
financing sources), and the availability of credit lines. Traditional method of analyzing
financial statements–ratio analysis–is considered a weak tool for monitoring liquidity.
94 It may be safe to say that it is not ratio analysis itself that is a weak tool but rather that
rations have yet to be developed that effectively measure the liquidity aspect of a
business operation.
To properly measure and monitor liquidity, the standards and approaches used in the
past must be discarded and a new framework must be developed. Infect, the liquidity
analysis should include the amount and trend of internal cash flow; the aggregate lines
of credit and degree of line usage; the attractiveness to investors of the firm’s
commercial paper, long-term bonds, and equity; and overall expertise of management.
Since liquidity is a fairly complex issue and the analysis of liquidity involves much
more than computing the relationship between current assets and current liabilities.
Liquidity analysis should consider the overall framework of management’s ability to
monitor and control the firm’s ability to generate operating cash flow.

“Liquidity and short-term solvency ratios are used to judge the firm’s ability to meet
such current obligations as its accounts payable and the current position of its long
term debt”. Discuss.
5.9 KEYWORDS
Sundry Debtor’s Turnover: A measure of the number of times on the average that
receivables turnover each year.
Liquidity: The ability of the firm to augment its future cash flows to over any
unforeseen needs or to take advantage of any unforeseen opportunities.
Inventory Turnover: A measure of the number of times the average inventory has
been sold during the year.
Net working capital: The difference between current assets and current liabilities.

1. What is liquidity?
2. How do you measure the requirement of liquidity?
3. Discuss the different types of liquidity ratio.
4. Describe net liquidity balance.

CYP 1
1. The current ratio is the traditional ratio used to measure a company’s
liquidity and is calculated by dividing the total current assets by the total
current liabilities. Its use dates back to the last century, and it is still
accepted as the best measure of the company’s short-term solvency.
2. Liquidity and short-term solvency ratios are used to judge the firm’s
ability to meet such current obligations as its accounts payable and the
current position of its long term debt. By interpreting such ratios we can
determine the degree to which assets which are quickly convertible to
cash exceed the liabilities which require almost immediate cash payment.
Liquidity ratios are generally useful to all financial statement users, but
are particularly useful to short-term creditors.
Contd….
CYP 2 95
1. Inventory and Financial Flexibility
2. Net working capital

Publications.
97
Receivables Management
UNIT 1
UNIT III
98
LESSON 99
Receivables Management
6
RECEIVABLES MANAGEMENT
CONTENTS
6.1 Introduction
6.2 Objectives of Account Receivables Management
6.3 Costs of Accounts Receivables Management
6.4 Benefits of Accounts Receivables Management
6.5 Credit Policy
6.5.1 Lenient Credit Policy
6.5.2 Stringent Credit Policy
6.5.3 Credit Policy Variables
6.6 Credit Evaluation of the Credit Applicant
6.7 Credit Terms
6.8 Collections from Accounts Receivables
6.8.2 Average Collection Period (ACP)
6.8.3 Aging Schedule
6.8.4 Collection Matrix
6.9 Let us Sum up
6.11 Keywords

z Concept of Accounts Receivable
z Account Receivable Objectives
z Modes of Accounts Receivable Collections
z Credit evaluation procedure
6.1 INTRODUCTION
Account Receivables occupy an important position in the structure of current assets of
a firm. They are the outcome of rapid growth of credit sales granted by the firms to
their customers. Credit sales are reflected in the value of Sundry Debtors [SD’s in
India]. It is also known as Trade Debtors (TD’s), Accounts Receivable (BR’s) on the
asset side of balance sheet. Trade credit is most prominent force of modern business.
100 It is considered as a marketing tool acting as a bridge between production and Baja to
customers. Firm grants credit to protect its sales from the competitors and attract the
potential customers. It sis not possible to increase sales without credit facility,
increase in sales also increases profits. But investment on accounts receivables
involves certain costs and risks. Therefore, a great deal of attention is normally paid to
the effective and efficient management of accounts receivable.
The term receivable is defined as “debt owed to the firm by customers arising from
sale of goods or services in the ordinary course of business”. When the firm sells it
products services on credit, and it does not receive cash for it immediately, but would
be collected in near future. Till collection they form as current assets.
6.2 OBJECTIVES OF ACCOUNT RECEIVABLES

MANAGEMENT
The following are the main objectives of accounts receivables management:
1. Maximizing the Value of the Firm: The basic objective of debtors’ management
is to maximize the value of the firm by achieving a trade off between liquidity
(risk) and return. The main purpose of receivables management is to minimize the
risk of bad debts and not maximization of order. Efficient management of
receivables expands sales by retaining old customers and attracting new
customers.
2. Optimum Investment in Sundry Debtors: Credit sales expand, but they involve
block of funds, that have an opportunity cost, which can be reduced by optimum
investment in receivables. Providing liberal credit increases sales consequently
profits will increases, but increasing investment in receivables results in increased
costs.
3. Control and Cost of Trade Credit: When there are zero credit sales, there will not
be any trade credit cost. But credit sales increases profits. It is possible only when
the firm is able to keep the costs at minimum.
6.3 COSTS OF ACCOUNTS RECEIVABLES

MANAGEMENT
Management of accounts receivables is not cost free. The following are the main costs
associate with accounts receivables management:
1. Opportunity Cost/Capital Cost: Providing goods or services on credit involves
block of firm’s funds. In other words, the increased level of accounts receivables
is an investment in current assets. These blocked funds or investment in
receivables need to be financed, by shareholders funds or from short-term
borrowings. They involve some cost. If receivables are financed by shareholder
funds, there involves opportunity cost to shareholders. If they are financed by
borrowed funds, it involves payments of interest, which is also a cost.
2. Collection Cost: Collection of receivable is on of the tasks of receivables
management. Collection costs are those costs that are increased in collecting the
debts from the customers to whom the credit sales have been granted. The
collection cost may include, staff, records, stationary, postage they are related to
maintenance credit department, and exposes details involved in collecting
information about prospective customer, from specialized agencies, for evaluation
of prospective customer before going to grant credit.
3. Bad Debts: Some times customer may not be able to honor the dues to the firm
because of the inability to pay. Such costs are referred as bad debts, and they have
to be written of, because they cannot be collected. These cost can be reduced to
some extent, if the firm properly evaluates customer before granting credit, but 101
complete avoidance is not possible. Receivables Management
6.4 BENEFITS OF ACCOUNTS

RECEIVABLES MANAGEMENT
Accounts receivables management involves not only costs but also benefits. The
benefits are:
1. Increased Sales: Providing goods or services on credit expands sales, by retaining
old customers and attraction of prospective customers.
2. Market Share Increase: when the firm’s able to retain old customer and attract
new customer automatically market share will be increased to the extent of new
sales.
3. Increase in Profits: Increased sales, leads to increase in profits, because, it need
to produce more products with a given fixed cost and sales of products with a
given sales network, in both cost per unit comes down and the profit will be
increased.

1. Define account receivables.
…………………………………………………………………………….
…………………………………………………………………………….
2. What do you understand by the term receivables?
…………………………………………………………………………….
…………………………………………………………………………….
6.5 CREDIT POLICY

A firm’s credit policy is regarding its credit standards, credit period, cash discounts,
and collection procedures. The credit policy may be lenient or stringent (tight).
6.5.1 Lenient Credit Policy

It is that policy where the seller sells goods on very liberal credit terms and standards.
In other words, goods are sold to the customers whose creditworthiness is not up to
the standards or whose financial position is doubtful.
Advantages of Liberal Credit Policy

z Increase in Sales: Lenient credit policy expands sales because of the liberal credit
terms and favorable incentives granted to customers.
z Higher Profits: Increase in sales leads to increase in profits, because higher level
of production and sales reduces permit cost.
Disadvantages of Lenient Credit Policy

z Bad Debt Loss: A firm that follows lenient credit policy may suffer from bad
debts losses that arise due to the non-payment credit sales.
z Liquidity Problem: Lenient credit policy not only increases bad debt losses but
also creates liquidity problem because when the firm is not able to receive the
payment at a due date, it may became difficult to pay currently maturing
obligations.
102
6.5.2 Stringent Credit Policy
Stringent credit policy seller sells goods on credit on a highly selective basis only i.e.,
the customers who have proven credit worthiness and financially sound.
Advantages of Stringent Credit Policy

z Less Bad Losses: A firm that adopts stringent credit policy will have minimum
bad debts losses, because it had granted credit only the customers who are
creditworthy.
z Sound Liquidity Position: The firm that follows stringent credit policy will have
sound liquidity position, due to the receipt of all payments from customers on due
date, the firm can easily pay the currently maturing obligations.
Disadvantages of Stringent Credit Policy

z Less Sales: Stringent credit policy restricts sales, because it is not extending credit
to average credit worthiness customers.
z Less Profits: Less sales automatically reduces profits, because firm may not be
able to produce goods economically, and it may not be able to use resource
efficiently that leads increase in production cost per unit.
6.5.3 Credit Policy Variables

As we have seen in the credit policy that majority of firms follow a credit policy is
one, which maximizes firm’s operating profit. For establishing optimum credit policy,
the financial manager must consider the important decision variables, which have
bearing on the level of receivables. In other words, the credit policy variables have
bearing on level of sales, bad debts loss, discounts taken by customers, and the
collection expenses. The major credit policy variable includes the following:
(a) Credit Standards, (b) Credit Terms, and (c) Collection Policy and Procedures.
a) Credit Standards: Firm has to select some customers for extension of credit. For
this firm has to evaluate the customer. In evaluation of customers what standards
should be applied? Credit stands refer to the minimum criteria for the extension of
credit to a customer. Credit ratings, credit references, average payment periods.
And certain financial rations provide a quantitative basis for establishing and
enforcing credit standards. The firm’s decision, to accept or reject a customer, and
to extend credit depends on credit standards. Firms may have more number of
standards in this respect, but at one point it may decide not extend credit to any
customer, even though his/her credit rating is strong. On the other point, firm may
decide to provide goods on credit to all customers irrespective of their credit
creditworthiness. Practical ones lies between these two points.
b) Credit terms: The second decision criteria in receivables management are the
credit terms. Credit terms mean the stipulations under which goods or services are
sold on credit. Once the credit terms have been established and the credit
worthiness of the customers has been assessed, the financial managers has to
decide the terms and conditions on which credit is extended to customer and the
discount, if any, given for early payment. Credit terms have three components
such as: (i) credit period, (ii) cash discount, and (iii) cash discount period.
Credit Period: The period of time, for which credit is allowed to a customer
to economic value of purchases. It is generally expressed in terms of a net
data [i.e., if a firm’s credit terms are not 60”], it is understandable that
payment will be made within 60 days from the date to credit sales. Generally
the credit period is decided with the consideration of industry norms and
depending on the firm’s ability to manage receivables. A decision regarding
lengthening of credit period increases sales by increases sales by inducing 103
existing customers to purchase more and attracting new customers. But it also Receivables Management
increases investment in receivables and lowers the quality of trade credit. In

other words, it increases investment in receivables and bad debt loss. On the
other hand, shortening of the credit period (existing) will lead to lower sales,
decrease investment in debtors, and reduce the bad debt loss. A firm should
finalize the decision relating to credit period [either lengthening or shortening
credit period] only after cost, benefit analysis. If the change in net profit is
positive, it is better to go for credit period and vice versa.
Cash Discount: The second part of credit terms is cash discount. Cash
discount represents a percent reduction in sales or purchase price allowed for
early payment of invoices. It is an incentive for credit customers to pay
invoices in a timely fashion. In other words, it encourages the customers to
pay credit obligations within a specified period of time, which will be less
than the normal credit period. It is generally stated, as percentage of sales.
Cash discount terms specify, the repayment terms required of all credit
customers, which involve rate of cash discount. For example, ‘2/20 net 60’,
which means creditor (sells) grants 2 per cent discount, if debtor (buyer) pays
his/her accounts with 20 days after beginning of the credit period. Financial
managers before going to offer cash discount, he/she is suppose to estimate
the change in net profit, it is positive, then he can go for providing cash
discount and vice versa.
Cash Discount Period: It refers to the duration in which the discount can be
availed from collection of receivable and is influenced by the cash discount
period. Extension of cash discount period may prompt some more customer to
avail discount and more payments, which will release additional funds. But
extension of cash discount period will result in late collection of funds,
because the customer who are able to pay will have less cash discount thus
now they may delay their payments. It will increase collection period of the
firm. Hence, financial manager has to match the effect on collection period of
the firm. Hence, financial manager has to match the effect on collection
period with the increased cost associated with additional customers availing
the discount.
c) Collection Policy: This is the third aspect in receivables management. The
collection of a firm is the procedures passed to collect amount receivables, when
they become due. It is needed because all customers do not ay the bill receivables
in time collection procedures includes monitoring the state of receivables,
dispatch of letters to customers whose due date is approaching, electronic and
telephonic advice to customers around the due date, thereat of legal action to
overdue customers, and legal action against overdue accounts. Customers may be
divided into two categories such as slow payer and non-payers. Hence, there is a
need for accelerating collections from slow payers and reduce bad debt losses.
Collection policies may be divided in to two categories. (i) strict/ rigorous, and (ii)
lenient/tax collection policy. Adoption of strict collection policy tends to decrease
sales, reduces average collection period, bad debt percentage, and increases the
collection expenses. On the other hand, lenient collection policy will increase
sales average collection period, bad debt losses, and reduce collection expenses.
Financial manager has to see the benefits and costs from adopting one credit
policy, if the change in net profit is positive, he/she has to go with new credit
policy and vice versa.
104
Working Capital Management 6.6 CREDIT EVALUATION OF THE CREDIT APPLICANT
Receivables management requires a lot of decision making exercises, setting
standards, identifying credit terms (credit period and cash discount), collection policy,
evaluation of individual accounts. Evaluation of individual accounts is the prime
activity, which affects firm’s profitability. In this, firm should develop procedures for
evaluating credit applicants and consider the possibilities of bad debt or slow
payment. Mere determination of appropriate credit policy will not serve the purpose of
minimizing investment in receivables and reducing bad debt losses, without credit
evaluation of individual accounts and identification of there credit worthiness. In other
words, the firm has to evaluate the customers before extension of credit. The credit
evaluation procedure involves three related steps:
(i) Obtaining credit information,
(ii) Analyzing the information, and
(iii) Making the credit decision.
z Obtaining Credit Information: Credit should be granted to those customers who
have ability to make payment on time. To ensure this, a firm should evaluate an
individual’s accounts properly, for which it require information. Hence, there is a
need to obtain information. Collection of credit information involves some cost.
Some accounts, small account. In addition, the cost, the firm must consider the
time factor in collecting information. The decision to grant credit to customer
cannot be delayed unnecessarily due to long time involved in collecting
information. Hence, while collecting information there is a need to consider cost
an time. Depending on these two factors, the credit analyst may use one or more
of the following sources of information. The information may be divided into two
sources, such as (a) Internal source (b) External source. The following secondary
sources are available for the collection of credit information.
Internal Sources: Internal source is that is available with in an organization
and it provides information free of cost. This type of source is useful only
while evaluating existing customers. A particular customer may have enjoyed
credit facility in the past. Now for extension of credit period or cash discount
firm may ask the internal receivable department to provide this past record,
based on which firm may make decision.
External Sources: External sources of information are very important when a
firm is planning to evaluate a new customer. Secondary source of information
is available based on the development of institutional agencies facilities and
industry practices. India, has little progress in the matter of developing the
sources of credit information in the name of secrecy and confidentiality. But
in advanced countries, there are number of independent information agencies,
banks, fellow business undertakings and associates, competitors, suppliers etc.
based on the availability, the following are the secondary sources information
that can be used to obtain information:
Financial Statement or Annual Reports: financial statements are the profit &
loss account and balance sheet that give the prospective customer’s financial
condition in terms of financial viability, liquidity, profitability and debt
capacity. They are dumb figures, proper analysis provides vivid stories of the
prospective customer, which is very much helpful in determining the credit
standing position of the prospective customer. There are difficulties in
obtaining financial statements of partnership firms or individuals and small
private firms.
Bank References: This is another secondary source to credit information.
Bank references means collection of information about prospective customer
from the bank where the customer is maintaining account. Here the firm is
required to write a letter to the bank requesting for a credit report on the 105
prospective customer, the bank may, at its sole discretion, decide to send a Receivables Management
report and oblige the firm (seller). Information collected from bank may not
be useful, because banker’s written report may not provide much of the
desired clue, or even a small clue, due to the use of certain self-terminologies,
which may have different bases and connotations. These may vary from bank
to bank. Some times, they give information favorable to its customers, it
cannot be relied upon in granting credit. Firm may require more information
from other sources, which may be supplemented. In advanced countries like
USA, many banks have separate credit departments that provide detailed
information required by the firm that can be believed and can take base for
credit granting.
Trade References: Trade reference it the source of information from firm’s
with whom the prospective customer has dealings. Firms magnify the
applicant to give the names of references. This is useful and cost free source.
If the firm feels that the information given by the applicant is misleading then
the firm may need to got to trade references, where all the relevant
information may be obtained. Firm should examine honesty and seriousness
of the references and may insist on furnishing the references of reputed
people.
Credit Rating Agencies: This is the suitable source of information, when the
customer insists to give products on credit immediately. Then financial
managers cannot spend much time in collection of financial statements. At
that time reports of credit rating agencies can be collected and can relieve
upon them. In India, there are three important credit rating agencies, such as
CRISIL, ICRA, and CARE. But in developed counties like USA, Credit
Bureau Reports are an important source of information.
z Analysis of Information/Credit Analysis: After having collected the required
information about applicant from different sources, the information should be
analyzed to determine the credit worthiness of the prospective customers. There
are no tailored made procedures to analyze the credit information that are suitable
to one. The analysis should cover two aspects. (a) Quantitative, and (b)
Qualitative.
Quantitative: This type of assessment is very much useful, which is done on
the basis of financial statements, and firm’s past records. Preparation of aging
schedule is the prime one. Aging schedule is statement showing ate-wise
distribution of receivables (Bills). It gives a clear picture about the past
payment patterns of the applicant. Next the firm can go for ratio analysis,
where it can study, liquidity, profitability and debt capacity of the perspective
customer. Calculated ratios must be compared with industry ratios
(standards).
Qualitative: Evaluation of prospective customer from the quantitative analysis
point, some times it should be fortified by qualitative analysis for conclusion
to be drawn.
The above mentioned are the two, methods of evaluation. But in traditional credit
analysis takes 6C’s into consideration.
Character: It is the prime C’ in as much as it means the moral integrity and
noble intentions and willingness in the part of the prospective buyers to honor
the obligation of making the full payments on the due date because, there may
be cases, where the buyer may be able to pay but may not have the good
intention to do so.
Capacity: It means the ability of prospective customers to pay. In other
words, customer’s capacity as the financial capability to make the payment on
106 the due date. It may be ascertained from the net cash position, after assessing
the cash inflows and cash out flows.
Capital: It refers to the capital base and capital structure of the company. If
the applicant is a person then capital refers the personal assets value of
financial reserve value of the customer. In any case, the value should be more
than the goods are going to be sold on credit. It may be required when the
customer has difficulties in meeting obligations out of the current generation
of surplus, it may offered to make the payment out of its resources and
surplus, till its present financed position improves.
Collateral: It means offering assets as a pledge against providing credit. It
acts as a cushion, when the above three C’s are not sufficient to take decision.
The assets generally may be security deposits of bank sureties, these are
movable.
Conditions: The term ‘condition’ here refers to the economic conditions and
climate providing at the material time, which may have favorable or
unfavorable impact on the financial position and prospects of the prospective
customer.
Case History [past expense]: If the credit extension decision to a existing
customer than these is a need to go back to old needs and check customs
record. The past date may be reliable for decision-making.
z Making Credit Decision: The prime objective of evaluation of prospective
customer credit worthiness is to asset whether he/she is worthy of granting the
credit or not. Actual credit worthiness is compared with the predetermined
standards, if the actual are up to the standards or above to the standards, goods
would be provided on credit, and vice versa. Credit decision is difficult to make
when the credit worthiness is marginal. Decision can be taken only, after
comparing the benefits of credit extension with likely bad debt losses. In case,
where customer’s credit worthiness is less than the standards, firm may not reject
the customer, but it may give some alternative facilities. Customer may be asked
to pay after delivery of goods, or invoices may be sent through bank and it may
release after collecting dues on basis of a third party guarantee. This will help to
the firm to retain the present or old customs and continuation delays may help in
receiving their requests ( credit facilities at a future date).
6.7 CREDIT TERMS

The second decision area in accounts receivable management is the credit terms. After
the credit standards have been established and the creditworthiness of the customers
has been assessed, the management of a firm must determine the terms and conditions
on which trade credit will be made available. The stipulations under which goods are
sold on credit are referred to as credit terms. These relate to the repayment of the
amount under the credit sale. Thus, credit terms specify the repayment terms of
receivables.
Credit terms have three components:
1. Credit period: in terms of the duration of time fro which trade credit is extended-
during this period the overdue amount must be paid by the customer?
2. Cash Discount: If any, which the customer can take advantage of, that is, the
overdue amount will be reduced by this amount.
3. Cash Discount Period: Which refers to the duration during which the discount
can be availed of? These terms are usually written in abbreviations, for instance,
‘2/10 net 30’. The three numerals are explained below:
2 signify the rate of cash discount (2 per cent), which will be available to the
customers if they pay the overdue within the stipulated time.
10 represents the time duration (10 days) within which a customer must pay to 107
be entitled to the discount. Receivables Management
30 means the maximum period for which credit is available and the amount
must be paid in any case before the expiry of 30 days.
In order words, the abbreviation 2/10 net 30 means that the customer is entitled to 2
per cent cash discount (discount rate) if he pays within 10 days (discount period) after
the beginning of the credit period (30 days). If, however, he does not want to take
advantage of the discount, he may pay within 30 days. If the payment is not made
within a maximum period of 30 days, the customer would be deemed to have
defaulted.
The credit terms, like the credit standards, affect the profitability as well as the cost of
a firm. A firm should determine the credit terms on the basis of cost-benefit trade-off.
We illustrate below how the three components of credit terms, namely, rate of
discount, period of discount and the credit period, affect the trade-off. It should be
noted that our focus in analyzing the credit terms is from the view point of suppliers
of trade credit and not the recipients for whom it is a source of financing.
Cash Discount
The cash discount has implications from the sales volume, average collection
period/average investment in receivables, bad debt expenses and profit per unit. In
taking a decision regarding the grant of cash discount, the management has to see
what happens to these factors if it initiates increase, or decrease in the discount rate.
The changes in the discount rate would have both positive and negative effects. The
implications of increasing or initiating cash discount are as follows:
z The sales volume will increase. The grant of discount implies reduced prices. If
the demand for the products is elastic, reduction in prices will result in higher
sales volume.
z Since the customers, to take advantage of the discount, would like to pay within
the discount period, the average collection period would be reduced. The
reduction in the collection period would lead to a reduction in the investment in
receivables as also the cost. The decrease in the average collection period would
also cause a fall in bad debt expenses. As a result, profits would increase.
z The discount would have a negative effect on the profits. This is because the
decrease in prices would affect the profit margin per unit of sales.
A Case Study
Dream Well Company’s present annual sales are Rs. 5,00,000, cost of capital is 15 % and
the company is in the 40% tax bracket. Company categorized its customers into four
categories, viz., C1, C2, C3 and C4 (C1 customer have the highest credit standing and
those in C4 have lowest credit standing). At present Company has provided unlimited
credit to categories C1 and C2, where as limited credit facility to Category C3 and no credit
to Category C4, since their credit standing (rating) is very low. Due to the present credit
standards the company foregoing sales to the extent of Rs. 50,000 to the customers in
category C3 and Rs. 40,000 to the C4 category customers. To grab the foregoing sales to
the C3 and C4 category customers, company is considering to relax, credit standards, under
that category C3 customers would be provided unlimited credit facility and customers in
C4 category would be provided limited credit facility. As a result of relaxation in credit
standards the sales are expected to increase by Rs.75,000 and it involves 12 per cent bad
debt loss on increased sales. The estimated contribution margin ration is 25 per cent and
average collection period if 50 days.
Determine the change in net profit and suggest whether the company consider the
relaxation of credit standards or not.
108 Solution:
Calculation of Change in Net Profit
Particulars Amount (Rs.)
Increased Sales 75,000

Less: Variable Cost (Rs.75,000 × 0.75) 56,250
Contribution 18,750
Less: Bad debt loss on new sales 9,000
(Rs.75,000 × 0.12)
Earnings Before Tax (EBT) 9,750
Less: Tax at 40 % 3,900

Earnings After Tax (EAT) 5,850
Less: Opportunity cost (See Note) 1,156
Increase in Net Profit 4,694

Note: Calculation of Opportunity Cost: Increase in Investment X Cost of Capital
Increase in Sales
------------------ Avg. Collection Period X Ratio of Variable Cost to Sales X Cost of Capital
365
(75,000 × 365) 50 × 0.75 × 0.15 = Rs.1,156
Suggestion: The firm can relax its credit standards since

the change in net profit is positive

Define credit policy.
………………………………………………………………………………….
………………………………………………………………………………….
6.8 COLLECTIONS FROM ACCOUNTS RECEIVABLES

Just evaluation of individual accounts does not help in efficient accounts receivables
management without continuous monitoring and control of receivables. In other words
success of collection effort depends on mp/monitoring and controlling receivables.
Then how to monitor and control receivables? There are traditional techniques
available for monitoring accounts receivables. They are (a) Receivables turnover, (b)
Average Collection period, (c) Aging Schedule and (d) Collection Matrix.

Receivables turnover provides relationship between credit sales and debtors
(receivables) of a firm. It indicates how quickly receivables or debtors are converted
into cash. Ramamurthy observes “collection of debtors is the concluding stage for
process of sales transaction”. The liquidity of receivables is therefore, is measured
through the receivables (debtors) turnover rate.
Debtors or Receivable Turnover Rate =Credit Sales ÷Average Debtors or receivables
Debtor’s turnover rate is expressed in terms of times. Analyst may not be able to 109
access credit sales information, average debtors and bills receivables. Receivables Management
To avoid of non-availability of the above information and to evaluate receivables

turnover there is another method available for analyst.
Debtors or Receivables Turnover Rate= Total Net Sales ÷ Average Debtors
6.8.2 Average Collection Period (ACP)

Turnover rate converted into average collection period is a significant, measure of
how long it takes from the time sales is made to the time to cash is collected from the
customers.
ACP = 365 ÷ Debtors or Receivables turnover.
6.8.3 Aging Schedule

As we have seen in the above average collection period measures quality of
receivables in an aggregate manner, which is the limitation of ACP. This can be
overcome by preparing aging schedule. Aging schedule is a statement that shows age
wise grouping of debtors. In other words, it breaks, down debtors according to the
length of time for which they have been outstanding. A hypothetical aging schedule is
as follows:
Age Group Amount Outstanding Percentage of Debtors
(in days) (Rs.) to total Debtors
Less than 30 40,00,000 40

31-45 20,00,000 20
46-60 30,00,000 30
Above 60 10,00,000 10
Total 1,00,00,000 100
Aging schedule is helpful for identifying slow pay debtors, with which firm may have
to encounter a stringent collection policy. The actual aging schedule of the firm is
compared with industry standard aging schedule or with bench mark aging schedule
for deciding whether the debtors are in control or not.
6.8.4 Collection Matrix

Traditional methods (debtor’s turnover rate, average collection period) of receivables
management are very popular, but they have limitations, that they are on aggregate
data and fail to relate the outstanding accounts receivables of a period with credit sales
of the same period. The problem of aggregating data can be eliminated by preparing
and analyzing collection matrix. Collection matrix is a method (statement) showing
percentage of receivables collected during the month of sales and subsequent months.
It helps in studying the efficiency of collections whether they are improving or
deteriorating. Following table show hypothetical collection matrix.
Percentage of receivables collected during April May June July August
the
Sales ( Rs.Lakhs) 350 340 320 300 250
Month of Sales 10 12 14 11 08
First month following 30 38 40 30 34
Second month following 25 24 22 20 21
third month following 20 26 22 19 18
Fourth month following 15 10 02 15 20
Fifth month following - - - 05 09
110 From the above table, it may be read for April sales are Rs. 350 lakhs. The patterns of
collections are 10 per cent in the same month (April), 30 per cent of sales in May, 25
per cent of sales in June, 20 per cent of sales in July and the remaining 15 per cent in
the August.
6.9 LET US SUM UP

Account Receivables occupy an important position in the structure of current assets of
a firm. They are the outcome of rapid growth of credit sales granted by the firms to
their customers. Credit sales are reflected in the value of Sundry Debtors [SD’s in
India]. It is also known as trade Debtors (TD’s), Accounts Receivable (BR’s) on the
asset side of balance sheet. Trade credit is most prominent force of modern business.
It is considered as a marketing tool acting as a bridge between production and Baja to
customers. Firm grants credit to protect its sales from the competitors and attract the
potential customers. It is not possible to increase sales without credit facility, increase
in sales also increases profits. But investment on accounts receivables involves certain
costs and risks. Therefore, a great deal of attention is normally paid to the effective
and efficient management of accounts receivable.

What are the traditional techniques available for monitoring accounts receivables?
Discuss each in detail.
6.11 KEYWORDS
Time Value: A Diagram specifying the timing of cash flows.
Yield to Maturity: The rate of return earned on a security if it is held till maturity.

1. Explain the objectives of Account receivable Management.
2. What are the benefits of Accounts receivable Management.
3. Write about the credit evaluation of the credit applicants.

CYP 1
1. Account Receivables occupy an important position in the structure of
current assets of a firm. They are the outcome of rapid growth of credit
sales granted by the firms to their customers.
2. The term receivable is defined as “debt owed to the firm by customers
arising from sale of goods or services in the ordinary course of business”.
When the firm sells it products services on credit, and it does not receive
cash for it immediately, but would be collected in near future.
CYP 2
A firm’s credit policy is regarding its credit standards, credit period, cash
discounts, and collection procedures. The credit policy may be lenient or
stringent (tight).
111
6.13 SUGGESTED READINGS Receivables Management
J. McN Stancill, The Management of Working Capital, Intext, 1971.

K.V. Smith, Readings in the Management of Working Capital, West Publishing Company,
1980.
P. Gopalakrishnan and M.S. Sandilya, Inventory Management, Macmillan, 1978.
112
LESSON
7
CASH MANAGEMENT SYSTEMS
CONTENTS
7.1 Introduction
7.2 Motives for Holding Cash and Marketable Securities
7.2.1 Cash for Transactions
7.2.2 Cash and Near-cash Assets as Hedges
7.2.3 Temporary Investments
7.3 Factors Determining the Cash Balance
7.4 Managing the Cash
7.5 Managing Cash Flows
7.5.1 Methods of Accelerating Cash Inflows
7.5.2 Methods of Slowing Cash Outflows
7.6 Objective of a Collection System
7.7 Design of a Collective System
7.7.1 Collection Float
7.7.2 Float Measurement
7.7.3 Individual Item Float
7.8 Types of Collection Systems
7.8.1 Basic Components
7.8.2 System Design
7.8.3 System Optimisation
7.8.4 Electronic Funds Transfer System
7.9 Mailed Payments Collection System
7.10 Lockbox Systems
7.10.1 Some Warnings about Lockbox Location Decisions
7.11 Cash Concentration Strategies
7.11.1 Advantages of Concentration
7.11.2 Objective Function of Cash Concentration
7.11.3 Field vs. Lockbox Concentration Systems
7.11.4 Reducing Information, Processing and Clearing Delays
7.12 Disbursement Tools
7.12.1 Zero-balance Accounts
7.12.2 Controlled Disbursing
Contd…
113
7.13 Investment in Marketable Securities Cash Management Systems
7.14 Types of Marketable Securities

7.15 Let us Sum up
7.17 Keywords

z Motive of holding cash
z Determination of cash balance
z Adoption of cash system
z Investment of cash in securities
z Types of marketable securities
7.1 INTRODUCTION
Cash is the lifeblood of a business firm; it is needed to acquire supplies, resources,
equipment, and other assets used in generating the products and services provided by
the firm. It is also needed to pay wages and salaries to workers and managers, taxes to
governments, interest and principal to creditors, and dividends to shareholders. More
fundamentally, cash is the medium of exchange which allows management to carry on
the various activities of the business firm from day to day. As long as the firm has the
cash to meet these obligations, financial failure is improbable. Without cash, or at
least access to it, bankruptcy becomes a grim possibility. Such is the emerging view of
modern corporate cash management. On the other hand, marketable securities come in
many forms and will be discussed later, but their main characteristic is that they
represent "near cash" in that they may be readily sold. Hence marketable securities
serve as a back up pool of liquidity that provides cash quickly when needed.
Marketable security also provides a short-term investment outlet for excess cash and
is also useful for meeting planned outflows of funds.
In the previous chapter we introduced the general concepts associated with managing
the firm's current assets and liability positions. In this chapter we look in more detail
at the problem involved with managing two very important components of current
assets; cash and marketable securities.
7.2 MOTIVES FOR HOLDING CASH AND

MARKETABLE SECURITIES
Cash and short-term, interest-bearing investments, (marketable securities) are the
firm's least productive assets. They are not required in producing goods or services,
unlike the firm's fixed assets, they are not part of the process of selling as are
inventory and accounts receivable. When firms hold cash in currency or in non-
interest-bearing accounts, they obtain no direct return on their investment. Even if the
cash is temporarily invested in marketable securities, its return is much less than the
return on other assets held by the firm. So why hold cash or marketable securities at
all? Couldn't the firm's resources be better deployed elsewhere.
114 Despite the seemingly low returns, there are several good reasons why firms hold cash
and marketable securities. It is useful to think of the firm's portfolio of cash and
marketable securities as comprised of three parts with each part addressing a
particular reason for holding these assets.
7.2.1 Cash for Transactions

One very important reason for holding cash in the form of non-interest-bearing
currency and deposits is transactions demand. Since debts are settled via the exchange
of cash, the firm must hold some cash in the bank to pay suppliers and some currency
to make change if it makes sales for cash.
7.2.2 Cash and Near-cash Assets as Hedges

Unfortunately, the firm's future cash needs for transactions purposes are often quite
uncertain; emergencies may arise for which the firm needs immediate cash. The firm
must hedge against the possibility of these unexpected needs. Several types of hedges
are possible. For example, the firm can arrange to be able to borrow from its bank on
short notice should funds suddenly be needed. Another approach is to hold extra cash
and near-cash assets beyond what would be needed for transactions purposes. By
"near-cash assets," we mean interest-earning marketable assets that have very short
maturities (a few days or less), and thus can be liquidated to provide funds on short
notice with very little risk of loss.
Clearly, the more of this total hedging reserve held in near-cash assets and the less
held in cash, the greater the interest earned. However, there is a trade-off between this
interest revenue and the transactions costs involved in purchasing and selling such
near-cash assets. These transactions costs have a fixed cost component; the firm bears
these fixed costs when it buys or sells these assets regardless of the size of investment.
Thus, whether it is economical to invest part or all of the hedging reserve in near-cash
assets depends on the amount of the reserve. Firms that keep smaller reserves
(because their transactions needs are either smaller or more certain) are more likely to
hold these reserves in cash, while firms with larger reserves keep them in near-cash
assets.
7.2.3 Temporary Investments

Many firms experience some seasonality in sales. Often, there will be times during the
year when such firms have excess cash that will be needed later in the year. Firms in
this situation have several choices. One alternative is to pay out the excess cash to its
security holders when this cash is available, and then issue new securities, later in the
year when funding is needed. However, the costs of issuing new securities usually
make this a disadvantageous strategy. More commonly, firms will temporarily invest
the cash in interest-earning marketable securities from the time the cash is available
until the time it is needed. Proper planning and investment selection for this strategy
can yield a reasonable return on such temporary investment.
All of these are valid reasons for holding cash and marketable securities in response to
the needs and uncertainties faced by the firm. In fact, firms generally hold a
surprisingly large portion of their assets in these forms, despite the disadvantage of
low returns.
115
7.3 FACTORS DETERMINING THE CASH BALANCE Cash Management Systems
A firm has to maintain a minimum amount of cash for settling the dues in time. The
cash is needed to purchase raw materials. A creditors, day to day expenses, dividend,
etc. the test of liquidity of the firm is that it is able to meet various obligations in time.
Some cash will be needed for transaction needs an amount may be kept as a safety
stock. An appropriate amount of cash balance to be maintained should be determined
on the basis of past experience and future expectations. If a firm maintains less cash
balance then its liquidity position will be weak. If higher cash balance is maintained
then an opportunity to earn is lost. Thus a firm should maintain an optimum cash
balance, neither a small nor a large cash balance. For this purpose the transaction costs
and risk of too small a balance should be matched with the opportunity costs of too
large a balance.
7.4 MANAGING THE CASH

Cash management has assumed importance because it is the most significant of all
current assets. it is required to meet business obligations and it is unproductive when
not used.
Cash management deals with the following:
z Cash inflows and outflows
z Cash flows within the firm
z Cash balances held by the firm at a point of time.

1. Define cash for transactions.
…………………………………………………………………………….
…………………………………………………………………………….
2. Define Temporary Investments.
…………………………………………………………………………….
…………………………………………………………………………….
7.5 MANAGING CASH FLOWS

After estimating the cash flows, efforts should be made to adhere to the estimates of
receipts and payments of cash. Cash management will be successful only if cash
collections are accelerated and cash disbursement, as far as possible, are delayed. The
following methods of cash management will help:
7.5.1 Methods of Accelerating Cash Inflows

1. Prompt Payment by Customer.
2. Quick Conversion of payment into cash.
3. Decentralized Collection.
4. Lock Box System.
7.5.2 Methods of Slowing Cash Outflows

1. Paying on Last Date.
2. Payment through Drafts.
116 3. Adjusting Payroll Funds.
4. Centralization of Payments.
5. Inter-bank transfer.
6. Making use of float.
7.6 OBJECTIVE OF A COLLECTION SYSTEM

When a selling firm transfers value to a buyer through the provision of goods or
services. There is an opportunity cost incurred if value is not promptly received in
return. A primary objective of a collection system is to receive value from the buyer
as quickly as possible. A second objective is to receive and process information
associated with the payment. A third related factor to consider in designing a
collection system is the relationship the firm has with those making payments.
Collection procedures have the potential to harm payer-payee relationships. Collection
system design must also consider costs associated with receiving payments and the
accompanying information. These costs may be associated directly with transaction
processing, such as bank costs, postage costs, etc., or may be more administrative in
nature. An additional cost factor primarily relates to systems in which coin and
currency is the predominant payment vehicle, costs of losses from theft or fraud. With
these factors in mind, the objective function may be stated in more formal terms as
follow:
Minimize Costs of Collection Float
– Value of payment information
– Value of relationship with payers
+ Collection system costs
+ Cost of losses through theft/fraud
Since three key factors in the objective factors in the objective functions are costs, we
state it as a minimization problem. Since the value of information and value of the
relationship with payers are benefits, they have negative signs in the objective
function.
Cost of Collection Float

One of the most important factors in the objective function is the value of collection
float. To illustrate, assume a company is losing approximately 6 calendar days of
interest on Rs. 20,00,000 each week. The annual cost of this float at 12% opportunity
cost is:
Rs. 20,00,000 × 6 days × .12/365 × 52 = Rs. 2,05,150 per year.
Value of Payment Information

Information accompanying the payment is vital to the firm's accounts receivable
function. If payment is received quickly but remittance information is delayed,
missing, or garbled, accounts receivable may not be able to post payments to accounts
in a timely or accurate manner. In the example, it is important for the company to
know which customers' costs are being covered by the weekly payment.
Value of Relationship with Power

If there are problems in posting payment information to a customer's account, the
relationship between the firm and customer may be harmed. For example, suppose the
collection system receives a customer's payment very quickly but fails to credit the
customer's account for several days. Suppose that an order is held until notice is
received from accounts receivable that last month's payment has been made. The 117
delay in posting could cause delay in release of goods and may irreparably harm Cash Management Systems
relations with the customer. What may have been gained in float may be offset many
fold by lost business.
Collection System Costs

A collection system incurs costs in processing payments. Some of these costs are
direct, such as bank charges for cheque processing or wire transfers. Other costs are
indirect, such as administrative effort in managing the collection system. Collection
system cost must be traded off with other factors in the objective function. The cost
differential must be traded off with the collection float difference.
Costs of Losses from Fraud and Theft

In systems that collect payments primarily through cash, there is a potential for loss
due to theft and fraud. It takes only a small number of losses through theft or fraud to
counteract an otherwise very efficiently designed collection system to minimise
collection float but that fails to deal with security problems.
7.7 DESIGN OF A COLLECTIVE SYSTEM

A collection system moves payments from payors to available deposits in the banking
system as efficiently as possible. There are five major elements in this system: (1) the
number of collection points. (2) location of the collection points, (3) internal or
external operation of the collection points, (4) assignment of individual payors to
collection points, and (5) capture and movement of information about the payment to
appropriate users in the system.
7.7.1 Collection Float

The term collection float refers to the total time lag between the mailing of the
payment by the payor and the availability of cash in the bank. As shown in Figure 7.1
the components of collection float are due to the sources of delay in the collection
process. Mail float results from the time that elapse from the mailing of the until is
receipt. Processing float is due to the processing time before the cheque is deposited in
the banking system. The last component of collection float is availability float, which
is a result of the firm's not being granted immediate availability on all deposit items.
These last two elements of collection float were referred as deposit float. They
represent the difference between the cash that is recorded as a deposit on the
company's books and the increase in the available balance at the bank.
Figure 7.1: Cash Flow Timeline for a General Collection System

118
7.7.2 Float Measurement
The measurement of float is a function both of the time lag and of the amount
involved. Float is usually measured in amount days, which are calculated by
multiplying the time lag in days by the amount being delayed. Float can be measured
either on each item that is processed or on an average daily basis.
7.7.3 Individual Item Float

The float on each item is found by multiplying the amount of the payment by the
number of days of delay for that payment. It-is the product of these two quantities, and
not either one individually, that is important in measuring float. We can see from the
calculation of collection float in Exhibit-1 that the float on a Rs. 10,000-item that is
delayed for 6 days is identical to the float on a Rs. 20,000 item that is delayed for
3 days.

1. Define Collection Systems Costs.
…………………………………………………………………………….
…………………………………………………………………………….
2. What are the objectives of a Collection System?
…………………………………………………………………………….
…………………………………………………………………………….
7.8 TYPES OF COLLECTION SYSTEMS

The first specialized collection system that we describe is an over the counter
collection system, where the payment is received in a face-to-face meeting with the
customer. Most retail or consumer businesses receive at least some of their payments
on an over-the-counter basis. Since payments are not mailed, an over the counter
system does not contain mail float. The cash how timeline for an over-the counter
system is shown in Figure 7.2.
Figure 7.2: Cash Flow Timeline for an Over-the Counter Collection System
7.8.1 Basic Components

The basic components of an over-the-counter collection system include the field unit
at which the payment is received, a local deposit bank that serves as the entry point for
the firm's banking system, and an input into the firm's central information system. A
schematic diagram of the components of an over-the-counter collection system is
given in Figure 7.3.
119
Cash Management Systems
Figure 7.3: Components of a Collection System or Over-the-Counter Receipts
7.8.2 System Design

In designing an over-the-counter collection system, the issues addressed use the
location of the field units, the type of payment accepted, location and compensation of
deposit banks, and the reporting system. Some of these elements are solely the
function of management decisions, whereas others may be influenced by competition
and the institutional arrangements that are available.
1. Field Office Location: Field units are generally locations where the firm delivers
goods or services to the customer and collects payments. In many retail
establishments (such as a restaurant) the payments are received when the
merchandise or service is delivered to the customer. In most cases, the location of
field units is dictated by marketing concerns (an attractive location, good traffic
patterns, proximity to competitors, availability of adequate facilities, etc.) and is
not an element in collection system design.
2. Type of Payment Accepted: Over-the-counter payment can be made by cash
cheque or third-party credit (debit) card finance. Each form of payment has
unique advantages and disadvantages. Cash is often immediately available, is
convenient for small purchase amounts, has small handling costs for small
quantities, and involves link risk that the payment is invalid. The disadvantages
are that it is inconvenient for large payments, requires tight controls in processing,
and requires security in handling because it is easy to divert and difficult to trace.
A cheque is convenient for large purchase, and security problems are less. The
disadvantages are that there is a processing delay (cheques must be deposited
before the cash is usable), there may be availability delay before value is received,
and there is a risk that the cheque will not be honoured when presented for
payment. Third-party credit (debt) cards are convenient, have low security risks,
and have a certainty of payment if proper procedures are followed. The
disadvantages are the cost, in the form of a discount from the face value, and a
possible delay in receipt of value for the payment.
3. Selection of Deposit Banks: For convenience and safety in handling cash,
geographical proximity is a major factor in the choice of banks for deposit of
over-the-counter payments. Where regional or statewide branch banking is
available, there may be a tradeoff between geographical proximity of a particular
branch and administrative and concentration costs of dealing with fewer banks.
120 4. Bank Compensation: In addition to acting as an input for deposits into the
banking system, some banks, may provide services such as cash replenishment,
they must be fairly compensated for these services. Price charged for services,
flexibility to pay in balances of in fees, availability on deferred items, and
compatibility with the concentration system affect the contribution of the
collection system to the net present value of the firm.
5. Information Gathering: The finance manager must know the amount of deposits
and their availability before the money can be put to use. It is usually desirable to
have dual reporting of the information for control purposes. One report generally
comes from the field manager, containing the amount of receipts and the deposit.
Another comes from the deposit bank, containing deposit and availability
information. The bank report from small deposit banks is frequently in the form of
a monthly statement so it may not be timely enough for the needs. A simple
reporting system for timely deposit information is for the manager of the field unit
to call headquarters or a third-party information processor and report the deposit
information prior to going to the bank to make the deposit.
In a more sophisticated reporting system, the field manager enters the amount of
the deposit into a point-of-sale computer that records sales, inventory, and other
information. Periodically, perhaps after hours, these data are transmitted directly
to the information system at headquarters or to a service bureau for further
processing. If the system is set up to gather and transmit information overnight,
the treasurer knows exactly how much is available in each bank at the start of the
day and the identity of any non-reporting field units.
7.8.3 System Optimisation

Since the number and location of collection points in an over-the-counter collection
system are chosen for reasons other than collection system design, the primary areas
for enhancing present value are processing float, availability float, and processing and
administrative costs. The nature of the payments virtually requires that the firm does
its own processing of the payments for deposit. Efficient company procedures are
important, with "deposits made as soon as possible after receipt of payment and with
careful consideration of availability cutoff times.
7.8.4 Electronic Funds Transfer System

RBI’s Electronic Funds Transfer (EFT) system facilitates inter-bank and intra-bank
fund transfers among our 15 notified centers. EFT transfers are soon coming to
replace demand drafts because they are faster, less expensive, and more secure. SBH
levies nominal service charges for such transfers. The funds are transferred to the
beneficiary’s account either on the same day or on the next working day.
You can transfer a maximum of Rs.2 crore in a single transaction. To make an EFT
transfer, you need to fill up and submit an EFT request form. You can submit the form
either online or at the branch where you hold an account. Provide the following
information in the EFT form:
z The name of the beneficiary
z The name of your bank and branch name
z Your account number
z The amount to be remitted
121
7.9 MAILED PAYMENTS COLLECTION SYSTEM Cash Management Systems
For many companies, payments, almost always cheques are mailed by the customer in
response to an invoice. A mailed payments system contains all three components of
collection float: mail float, processing float, and availability float.
Basic Components
The mailed payments collection system consists of collection centers, deposit banks,
and an information system. A schematic diagram of the components is given in
Figure 7.4. Payments are mailed by customers to a designated collection center
operated either by the company or by an outside agent. Payments are processed at the
collection center; cheques are encoded, the deposit is prepared and made, and data are
transmitted to the company's information system. The cash flow timeline for a mailed
payments collection system has all of the elements shown in the generalised timeline
in Figure 7.1.
System Design
Number of Collection Points: The number of collection points needed is a function of
the number of payments, the average size of payments, the average size of payments,
and the geographical dispersion of customers. For a firm receiving many small
payments, processing costs may be more important than float costs. Such a firm will
Payment
mailed
Figure 7.4: Components of a Mailed Payments Collection System

likely use an automated processing system at one or two sites. For a firm receiving
large payments, float costs represent a large portion of the total costs of the collection
system. Locating collection sites close to the customers to reduce mailing time and
availability float costs becomes important. Such a firm is likely to use a relatively
larger number of collection points.
122 Collection Point Location: The optimal location of the collection points is a function
of many factors, including:
1. The geographical locations of the payer's mail points and hence, mailing times
between mail points and collection points.
2. Availability time at collection points for the payor's drawee banks, i.e., the banks
on which the cheques are drawn.
3. Processing efficiency of collection banks.
4. Number of cheques processed.
5. Amount of cheques processed
6. The firm's opportunity cost or interest rate.
7. Variable and fixed costs imposed by collection points in addition to administrative
costs of managing the collection system.
In-house vs. External Operation: The firm has the choice of operating its own
collection points or contracting for outside operation. A typical procedure for a
company-operated collection center is to have mail delivered to the processing center.
Employees open the envelopes, remove the cheques, process the deposit, and take it to
the bank. Some firms encode cheques before depositing, After the deposit is made,
administrative processing continues, with updates to the information system. When in
house processing is used, the company maintains total control over the operation. It is
easier to make changes in the system and the information is geared to the company's
needs. If an outside contractor (usually a bank operating a lockbox) is used, the agent
intercepts the mail, removes and makes a copy of the cheque, processes the deposit,
captures information accompanying the remittance, and sends of transmits the data to
the company. The advantages of contracting out may include:
1. Lower processing costs because of economies of scale,
2. The contractor may be located closer to customer mail points and therefore may
be able to reduce mail float.
3. The contractor may be able to operate in the early hours of the day. when mail
tends to arrive in central post offices. Earlier processing means that more
availability cut off times can be met.
Payer Assignment: In Figure 7.4 the company's payer base is divided into five
groups, but there are only two collection points. As part of the determination of an
efficient collection system, each customer group is assigned to a collection point that
results in the lowest total cost for that payment group. A company can increase the
probability of" having the payments sent to the correct collection location by
including addressed return envelopes,
Type of Payer: The characteristics of the payers that remit payments to a firm
influence the type of collection system that is established. Corporate payors generally
make payments in response to specific invoices, but the payments are frequently for
an amount different from the invoice amount because of adjustments made for
discounts, returns, or allowances. Manual processing may be required to handle these
alterations. In addition, the cheques tend to be for large amounts. The primary
emphasis of the collection system is on float reduction and timely handling of
information related to the invoices being paid. On the other hand, retail payors,
consumers or small businesses, generally make payments for a small amount,
frequently use installment or recurring payments for an ongoing credit or service and
generally pay the amount on the bill. The emphasis is on automation to hold down
processing costs.
Other Collection Systems 123
Several other types of collection systems are used. Many of them use electronics and
advanced communication systems. Although not widely used at present, they are
growing in importance as electronic communications and transactions gain greater
acceptance.
We have seen that although the goal of any collection system is to speed inflows, the
type of collection system that a firm uses is a function of the characteristics of the
customer base and the method of the delivery of the product or service. The closer the
payment is tied to the delivery of the product or service, the less flexibility there is in
the design of the collection system.
Preauthorised Payments
Preauthorised cheques (PACs), preauthorized drafts (PADs) etc. are sometimes used
when the payment amount (or range) and the payment date are specified in advance.
On the agreed date, the pay initiates the value transfer from the prayer through the
banking system, with no need for further action on the part of the payer. Preauthorised
payments eliminate mail float, reduce processing and availability float, and improve
both parties' forecasting ability.
Electronic Collection Procedures: It should be clear from the prior discussion that the
time necessary for transmittal of cash from one firm to another revolves largely
around the passing from one hand to another of a piece of paper—the remitting firm's
cheque. One alternative to this process is to substitute an electronic message of
payment for the cheque. This eliminates the need for the paper and thus the various
floats associated with taking the paper from one place to another.
The major experiment in the development of a system for electronic remittances, was
the corporate trade payments (CTP) system. However the system has not attracted a
significant volume of transactions. Several causes of this failure are commonly cited,
such as the costs of converting to electronic payments, the absence of adequate
marketing efforts, and the difficulty in sending proper advice as to what the remittance
is supposed to pay. The major problem with electronic payments, however, does not
relate to these factors, but to the relative benefits and costs of the system to the paying
and receiving firms. To see this, it is first necessary to recognise that the elimination
of float on cheques benefits the receiving firm but extracts the same costs from the
paying firm, and that paying firms must agree to remit electronically. While outgoing
cheques in non-electronic systems remain uncollected, the paying firm retains the cash
which it can then use. But in electronic systems, this float is eliminated, to the
advantage of the receiving firm but to the disadvantage of the paying firm. This
disparity in benefits has led to considerable reluctance by paying firms to participate
in electronic payment systems. The remaining advantages of electronic payments,
such as the reduction in printing costs for cheques and the reduction in charges to the
receiving firm by its bank for processing these cheques, are not large enough to offset
the initial costs of instituting an electronic payments system. Unless these economics
change, electronic trade payments will continue to be unattractive to remitting firms.
7.10 LOCKBOX SYSTEMS

A "lockbox" is a post office box number to which some or all of the firm's customers
are instructed to send their cheques. The firm grants permission to its bank to take
these cheques and immediately start them in the clearing process. In fact, the mail
addressed to this "post office box" is actually delivered directly to the firm's lockbox
bank. In this way, at firm float is eliminated. Judicious placement of lockboxes and
instructions to customers on where to send their cheques can also serve to reduce mail
and clearing float substantially.
124 While lockboxes are very useful, not all firms will find them of advantage. Their use
entails giving customers two mailing addresses for the firm: the lockbox (for cheques)
and the firm's usual business address (for all other documents). This inevitably leads
to the misrouting of some documents to the lockbox that the firm would prefer to go
directly to its business. A consequent delay in the delivery of these documents to the
firm occurs, since banks often do not forward items received at the lockbox until the
next day. This entails costs to the firm. For example, misrouted purchase orders from
customers, which the firm would like to process as soon as possible, are delayed.
Further, lockbox cheque processing systems at banks are oriented toward the rapid
processing of routine cheques, not extraordinary items (such as postdated cheques,
unsigned cheques, and promissory notes). While lockbox personnel are instructed to
look for these items and not to sent them on through the banking system, errors occur
rather frequently, with consequent inconvenience for the firm, while lockboxes are not
a problem-free panacea for flotation problems, their proper use can reduce all the
types of flotation on incoming cheques. The important decisions in the formulation of
a lockbox strategy are:
z Where should the firm locate its lockboxes?
z To which lockboxes should each of the firm's customers send their cheques?
The best solutions to the lockbox problem require that these questions be answered
simultaneously.
The lockbox location problem is a cost minimisation problem. The firm seeks to
minimise the sum of (1) the opportunity cost of the float on incoming cash, and (2) the
costs of the lockbox system. The opportunity cost of the incoming cash is the total
float in the amount times the firm's required return. The costs of the lockbox system
include the fixed costs that banks charge to provide lockbox service (regardless of the
number of cheques processed), the pre-cheque processing charges,, and any charges
necessary to gather up the cash from the lockbox banks after it is collected. There is a
trade-off between these two sets of costs. As the firm increases the number of
lockboxes (properly placed}, the opportunity cost of float will be reduced. However,
each additional lockbox adds another fixed. charge to the costs of the lockbox system.
Eventually, the addition of another lockbox increases rather than decreases total costs.
This relationship is portrayed in Figure 7.5.
To solve the lockbox location problem, the firm must collect four sets of data:
1. The mail and clearing times for sending cheques from each part of the firm's
geographic sales area to each possible lockbox
Figure 7.5: Costs in Lockbox Systems vs. Number of Lockboxes

2. The total amount of daily funds and number of cheques received by the firm from 125
each part of the sales area. This is usually collected by an examination of the Cash Management Systems
postmarks on a sample of the firm's incoming cheques. A stratified sample of

high-value cheques may be used to reduce collection costs for these data.
3. The required rate of return (for computing opportunity costs).
4. The variable and fixed costs of each proposed lockbox site. To speed clearing
times, lockboxes are usually located in cities.
With these data in hand, it is relatively simple to calculate the one best lockbox if the
firm is constrained to have only one. This optimal solution to the one-lockbox
problem is simply the lockbox which has the lowest total cost, defined again as the
sum of the opportunity cost of float and the costs of the lockbox. Beyond this, it is
rarely clear whether a group of lockboxes would do a better job (in the sense of lower
total costs) than this single best lockbox.
There may be several lockbox location and customer assignment routines in the cash
management. Some of these will always find the optimum (least cost) combination of
lockboxes and assignments while others will not. In general, the routines that always
lead to optimum solutions are more difficult to calculate (particularly by hand) than
those which may not lead to optimums. The trade-off has been between case of
computation versus the guarantee of an optimum solution. However, one of the
mathematical approaches, that will always lead to an optimum-solution—integer
programming, now commonly available as a user-friendly microcomputer software
package, Thus, there no longer seems any need to compromise on technique in
illustrating lockbox location decisions because of computational difficulty
considerations.
7.10.1 Some Warnings about Lockbox Location Decisions

The integer programming approach to lockbox location analysis should seem a
relatively straightforward approach to a rather complex problem. However, there are
difficulties associated with both the collection of the necessary data and with the
lockbox location algorithm. These difficulties do not invalidate this approach to the
lockbox location problem, but they do limit its accuracy. They should be kept in mind
when the firm is considering, analyzing, and implementing a lockbox strategy.
1. Determining Customer Zones: Because the opportunity cost of float is computed
as the sum of the mail and clearing floats, the customer zones must be defined
such that these should be as homogenous as possible within the zone. Otherwise,
non-optimal strategies may result.
2. Obtaining Bank Cost Data: Estimating the least-cost placement of lockboxes
requires data on the fixed costs of opening a lockbox at a particular location and
the variable cost of processing cheques at the location. The logical approach to
collecting this data is to conduct a telephone or mail survey of potential bank
lockbox sites, inquiring as to these costs. However, such surveys do not
necessarily produce accurate results. Banks seem prone to offer their services in
packages, with the costs of individual services tied to the size of the package. For
example, a firm requesting only a lockbox service might pay more for that service
than would a firm requesting a package of a lockbox service and a borrowing
arrangement. Thus, the cost of a lockbox service might depend on the amount of
other services that the firm is willing to purchase from the lockbox bank.
The criticality of this bank cost data depends on the average size of the cheques
received by the firm. If" the firm receives many cheques for relatively small
amounts, data on bank charges (particularly processing costs) are very important,
as these will be an important fraction of the total costs associated with the
lockbox. If the average size of the cheques received by the firm is relatively large,
126 bank cost data will be a good deal less important, as the dominant cost will be the
opportunity cost of float and not cheque processing cost.
3. Obtaining a Representative Sample of Cheque Volume and Origination: Since a
one-month sample of the receiving firm's incoming cheques is usually used for
this purpose, the firm must be very careful that this sample is representative of the
entire year's patterns. If the firm has seasonality in its sales, or if receipts are
concentrated from a few remaining firms that pay frequently, a small sample may
not adequately represent the total pattern of receipts. Further, the very redesign of
the firm's cash receipt system may cause changes in this pattern of receipts if
some of the firm's customers practice "disbursement management."
4. The Costing of Float: In most lockbox location analysis systems, the opportunity
cost of float is determined by multiplying the total float in amount times the
required rate of return. This approach is intended to account for the time value of
money, but it is exactly equivalent to net present value only when the future cash
flow stream is perpetuity. When there is growth in the future cash flows, the
opportunity cost approach will misstate the time cost of funds relative to their
proper discounted value.
5. Interaction with the Availability of Borrowing Capacity: As noted previously,
banks are prone to provide services in packages. Thus, the location of a lockbox at
a bank may make the bank more likely to lend to the firm, possibly at favourable
rates. This borrowing availability and lower cost have a value to the firm. In such
a case, the cash cost of the lockbox overstates the disadvantage to the firm of
having a lockbox at a particular bank.
What is a lock box?
…………………………………………………………………………………….
…………………………………………………………………………………….
7.11 CASH CONCENTRATION STRATEGIES

Concentration is sometimes a neglected part of cash management because firm tend to
think that when the cash is in their banking system, the battle is over. Nevertheless
there are significant managerial decisions that must still be made to insure that cash is
moved efficiently to accounts where it can benefit the firm. Once the remittance from
the firm's customers have been received and cleared, the resulting cash balances are
available in the firm's lockbox (depository) banks. It is useful for the firm to gather
these balances from the lockbox banks into a central bank account. The process of
collecting funds is called cash concentration. There are two reasons why cash
concentration is advantageous. First, the collection process results in a larger pool of
funds. The larger pool makes any temporary interest-earning investments more
economical because it reduces the transaction costs on investment. For example, if the
firm gathers Rs. 10,000 from each of 10 accounts, the firm will have Rs. 1,00,000 to
invest, resulting in one purchase of securities rather than 10. Also, the larger amount
of funds may enable the firm to take advantage of higher-interest investments that
require a larger minimum purchase. Second, with all the cash in a central location,
keeping track of the cash (controlling the cash) is considerably simplified.
In concentrating cash, firms channel collected funds from the depository banks to the
central concentration bank sometimes through regional concentration banks. As
illustrated in Figure 7.6 concentration system consists of deposit banks, which feed
cash into a concentration bank and disbursement banks, which draw cash from a
concentration bank. In addition, the concentration bank is tied to a portfolio of
short-term investments and borrowings. This portfolio is used to balance out any
excesses or deficiencies in the concentration account. A concentration bank is simply 127
a bank designated by the firm to perform three main tasks: (1) receive deposits from Cash Management Systems
banks in the firm's collection system (2) transfer funds to the firm's disbursement
banks, and (3) serve as the focal point for short-term credit and investment
transactions. To perform the last function, cash in the concentration bank is
monitored. When the level becomes too high, extra cash is moved into short-term
investments or used to pay off credit lines. When the level dips too low, needed cash
is supplied by the sale of short-term investments or from a draw on short-term
borrowing sources. This process is called aggregate cash position, management.
Though any bank can theoretically serve as a concentration bank, most firms use a
large commercial bank for this purpose. The reason is that a concentration bank often
serves additional functions besides the three mentioned. First, it may provide a
balance-reporting function. Such reporting services gather information from the firm's
banking system and provide a daily report of the firm's deposits, disbursements, and
balances. Second, a concentration bank often serves as a source of short-term security
investments and short-term liquidity in the form of credit lines. Third, it provides
assistance in preparing concentrating transfers. Small banks generally cannot perform
all of these functions. Although it is possible to receive these services from parties
other than the concentration bank, administration is simplified, it is argued, if the
concentration bank provides them all as a package.
7.11.1 Advantages of Concentration

Cash concentration simplifies short-term borrowing and investing decisions. If
deposits are more or less routinely transferred to the concentration bank, the finance
manager need only make decisions about what to do with cash balances.
Figure 7.6: Cash Concentration System

128 Concentrating cash into a central cash pool also facilities investment in short-term
securities. Money market securities that give the highest rates are sold in large
demonstrations. Accumulating cash in a concentration account provides the quantities
needed to purchase such securities.
Short term forecasting is usually simpler for a concentrated account than for
individual deposit and disbursement accounts. There is because forecast errors in
smaller accounts often offset each other when summed over the firm's banking
system. This is important in forecasting credit line needs. It is much easier to have one
large credit line tied to a concentration account than many small credit lines tied to
cash bank in the firm's system.
7.11.2 Objective Function of Cash Concentration

Cash concentration costs arise from several sources: (1) opportunity costs of holding
excess balances in deposit banks, (2) transaction costs of moving cash into the
concentration bank, (3) the value of dual balances (in which the same cash is counted
in both the deposit bank and the concentration bank at the same time). (4)
administrative costs of managing the concentration system, and (5) control costs
associated with the risks of cash losses encountered in some concentration systems.
Each of these cost factors center expressed qualitatively in an objective function as
follows:
Minimise Opportunity Costs of Excess Balances
+ transaction costs
– interest on dual balances
+ administrative costs
+ control costs.
The dual-balance factor has a negative sign because as dual balances increase, costs
are reduced.
The dual-balance cost does not exist for the collection portion of the cash flow
timeline, but it may be present in certain concentration systems. Dual balances arise in
concentration systems because of inefficiencies in the transfer clearing mechanism.
Such balances generally occur when a deposit into the concentration bank receives
availability at the concentration bank before the transfer clears the field bank. During
the time of the overlap, the firm "owns" the same cash at two different banks.
7.11.3 Field vs. Lockbox Concentration Systems

There are two basic types of concentration systems, each associated with a potentially
different set of problems and practices. The first is a field banking system, which
collects cash and other over-the counter deposits. The second is a lockbox banking
system, which collects mailed deposits.
We now discuss techniques for reducing cash concentration costs. Although each
technique seeks to reduce one or more cost factors, we must keep in mind the other
factors may be adversely affected at the same time. The goal is to realise an overall
reduction in the objective function.
7.11.4 Reducing Information, Processing and Clearing Delays

Excess balances are caused primarily by delays in gathering and processing deposit
information and by clearing transfers back to the deposit bank.
Table 7.1 129
Feature Field System Lockbox System
Number of banks Usually many Fewer than 10
Bank size Usually small Usually large
Source of deposit Over the counter Bank must be near Mailed in Bank can be anywhere
Geographical constraints a cash collection point
Deposit size Type of Relatively small Cash and cheques Often large Cheques only Often
deposit Availability Usually immediate delayed by availability schedule
Information from bank Monthly statement Monthly statement Daily balance and
deposit report
Account analysis Services Generally none Coin and cash Customary Wide variety; sometimes
deposit and transfer credit
7.12 DISBURSEMENT TOOLS

Commercial banks and other providers offer a number of tools and assist managers in
designing efficient disbursement systems.
7.12.1 Zero-balance Accounts

Zero-balance accounts are a very common strategy for funding disbursements as the
cheques are presented. In this strategy, an account for disbursement is first established
at a bank. For the zero-balance system to be effective, the participating bank must be
one on which most disbursements are made via the clearance system (which presents
disbursements to banks early in the morning), and not a bank where disbursements
occur throughout the day. Consequently, the banks used in zero-balance strategies are
usually branches of major banks and not their main locations.
The once-a-morning disbursement requirement is critical to the zero balance system.
As implied by the name, the disbursing firm does not keep any permanent stock of
cash in the disbursing account. Instead, the participating banks agrees that when the
morning disbursements for the firm are presented to it, the bank will advise the firm of
the amount of the cash required to cover these disbursements. The money will then be
wire-transferred into the zero-balance account and the cheques honoured. In this way,
the disbursing firms' cheques are honored as presented, but the firm does not tie up
cash while the cheques are in the mail and while they are clearing.
7.12.2 Controlled Disbursing

If the zero-balance system is not feasible, another (though less attractive) is the use of
controlled disbursing, which is often used when the firm's disbursing bank receives
cheques throughout the day. In this system, the firm projects the amount of cheques to
arrive each day at the disbursement bank (based on the cheques written in previous
days and historic statistics on disbursement float) and transfers the amount of the
expected cheques to the account on that day or just before. Of course, the firm does
not know exactly what outstanding cheques will be presented on any particular day:
the forecasting procedure is subject to error because the disbursement float figures are
uncertain. To hedge this uncertainty, firms keep a safety stock of cash in the
disbursement account. The amount of this safety stock may be calculated if the
probability distribution of disbursements is known. For example, suppose that the
probability distribution of disbursements is normal, that the firm wishes to have only a
1.0 percent chance that the initial cash will be insufficient to cover the presented
cheques, and that for a particular day the expected presentments are Rs, 5,00,000 with
a standard deviation of Rs. 50,000. Since the Z-score for 1.0 percent of he normal
distribution is 2.72, the firm will need to start with an additional Rs. 1,36,000
(2.72 times Rs. 50,000) in its disbursement account, above the expected requirement
of Rs. 50,000, to have only a 1.0 percent chance of having insufficient funds.
130 Thus, the firm should arrange to have Rs. 6,36,000 in its account to cover
disbursements for that day. The additional Rs. 1,36,000 is a hedge, and its carrying
cost is the result of uncertainty regarding the firm's disbursement figure for that day.
7.13 INVESTMENT IN MARKETABLE SECURITIES

The management of the investment in marketable securities is an important financial
management responsibility because of the close relationship between cash and
marketable securities. One important aspect of this responsibility is determining the
amount of marketable securities to hold. Another major aspect of the problem of
investment in marketing securities is deciding which securities should the firm invest
in ? That is, what should be the composition of the firm's portfolio of securities. A
vast array of types and maturities is available, and the financial manager must choose
among these alternatives,
General Selection Criteria

An assessment of certain criteria can provide the financial manager with a useful
framework for selecting a portfolio of marketable securities. The firm will be
particularly interested in the safety of the securities, their marketability, and their
maturity. Differences in these features are the primary determinants of the yield
differences among securities and differences in these features also explain why firms
select certain kinds of securities for short-term investments.
Safety: Other things equal, the firm would like to receive as high a yield on its
investment in marketable securities as possible. However, seeking higher rates of
return leads to accepting larger amounts of risk. Since the firm keeps marketable
securities for the precautionary reasons and to men known, scheduled outflows of
cash, the firm will tend to invest in very safe marketable securities. Firms tend to buy
the highest yielding marketable securities they can find subject to the constraints that
the securities have an acceptable risk level. Risk in this context refers to risk of
failure. However, failure can have more than one meaning here. At one extreme, a
security could default. The issuer fails to redeem the security as per the contract. In a
less severe sense the price of the security could fall at a time when the firm needs to
liquidate the security (perhaps to replenish the cash account). If the firm sells the
security for less than the needed amount, this term is a kind of failure. To minimise
the possibilities firm tend to restrict their marketable securities investments to certain
"safe" financial instruments, accepting the relatively low yields that accompany such
investments as an unavoidable consequences.
Maturity: The lower the maturity of a security,-the more possibility is for price
fluctuations prior to its maturity. Since downside price fluctuations are undesirable for
safety reasons, the firm will prefer short-lived securities. At the long end of the
maturity spectrum, firms prefer marketable securities whose remaining life is no
longer than six to nine months. At the short end of the spectrum, firms can and do
invest funds overnight.
Marketability: In the present context of managing the marketability of securities
portfolio, marketability refers to the ability to transform a security into cash. Should
an unforeseen event require that a significant amount of cash be immediate available,
than a sizeable portion of the portfolio might have to be sold? The financial manager
will want to cash quickly, and he will not want to accept a large concession in order to
convert the securities. Thus, in the formation of preferences for the inclusion of
particular instruments in the portfolio, consideration will be given to the time period
needed to sell the security and the likelihood that the security can be sold at or near its
prevailing market price. The latter element, here means that 'thin' markets, where
relatively few transactions take place, or where trades are accomplished only with
large price changes between transactions, will be avoided.
Check Your Progress 4 131
Sadhan Nitro Company currently maintains a centralized billing system at its
home office to handle average daily collections of Rs. 4,50,000. The total
time for mailing, processing, and clearing has been estimated at 4 days.
a) If the company's opportunity cost on short-term funds is 15%, how much
this time lag of 4 days costing the company?
……………………………………………………………………………...
……………………………………………………………………………...
b) If management has designed a system of lock-boxes with regional banks
that would have reduced the float by 1 and 1/2 days and home office
credit department expense by Rs. 52,000 annually, what is the largest total
amount of required compensating balance that the firm should be willing
to accept with the lockbox arrangement ?
……………………………………………………………………………...
……………………………………………………………………………...
7.14 TYPES OF MARKETABLE SECURITIES

This section presents a brief description of the most commonly held marketable
securities. Attention is focused on the types of marketable securities held for
transactions and safety motives. Securities held for a speculative motive are often
long-term, less marketable issues that will not be discussed here. The securities most
commonly held as part of the marketable securities portfolio are divided into two
groups : (1) governmental issues and (2) nongovernmental issues.
The short-term obligations issued by the central government and available as
marketable security are treasury bills, Government securities could have maturities of
more or less than one year, at the time of issue. The securities with a maturity of
between three to twelve months, at the time of issues, are called treasury bills. The
sales are carried out by the RBI, on behalf of the Central Government, to raise short-
term finance for the Government and observe excess liquidity in the market.
The firm can deposit its excess cash with the commercial banks for some fixed
maturity. Deposit scheme are tailored suiting to the needs of the depositors. By
various combinations of Demand, Term and Recurring Deposits, banks have brought
spectrum of deposit schemes. Bank deposits are very popular due to their safe
character. An individual depositor gets protection to the extent of Rs. 20,000 from the
Deposit Insurance Corporation. Besides, the RBI also exercises a strict surveillance
over the banking system which also ensures safety of deposits.
Illustration 1
A firm is currently disbursing from its concentration bank at a cost of Rs. 25 per
month for account maintenance and Re. JO per cheque processed. The controlled
disbursement bank will charge Rs. 75 per month for account maintenance and Re.15
per cheque processed. The controlled disbursement account will add 1/2-day float to
the disbursements. The company issues 100 cheques of average face amount of Rs.
2,500 per day. The treasurer maintains an overnight portfolio of about Rs. 10,00,000,
on which she currently earns about 6% per annum. She estimates that she could earn
an additional 25 basis points on the investments if she could invest earlier in the day.
Transfers to the controlled disbursement account could be done at a cost of Re. 1 per
transfer. Determine the annual net benefit, or cost, of using the controlled
disbursement account instead of the current system.
132 Solution:
The net benefits consists of the float benefits plus the gain on the earlier investment
less the additional costs connected with the controlled disbursing account less the
transfer costs.
Float benefits are:
annual disbursement × float gain × investment rate
(Rs, 2,500 per day × 100 × 250 days) × (.5 days) × (.06/365) = Rs. 5,137
Additional investment benefits are:
Amount of the investment portfolio x incremental rate (Rs. 10,00,000) × (.0025)
= Rs. 2,500.
Incremental bank charges are:
Incremental account maintenance costs + incremental per item charges (Rs. 75
– Rs. 25) × 12 + (Re. .15 × Re. .10) × 100 × 250 = Rs. 1,850
Transfer costs are: Rs. 1 × 250 = Rs, 250.
The net benefits are:
Float benefits + investment benefits – additional costs – transfer costs
Rs. 5,137 + Rs, 2,500 – Rs. 1,850 – Rs. 250 = Rs. 5,537
Total reduced costs = Rs, 1 ,01 ,250 + Rs. 52,000 = Rs. 1,53,250 Maximum
acceptable compensating balance = Rs, 1,53,250/0.15 = Rs. 10,21,666.60
Illustration 2
The XYZ Company currently makes payments by cheques. The ABC Company, a
supplier, has requested that XYZ allow ABC to debit their account 1 0 days after the
invoice date. XYZ currently pays ABC with a cheque mailed 30 days after the invoice
date. It takes an average of 5 days for the cheque to the cleared through XYZ account.
The average payment to ABC is' Rs. 500. It costs XYZ an average of Rs. 10 to
process the invoice through their accounts payables department and to issue a cheque.
These costs would be eliminated by the proposed procedure. The opportunity costs of
funds to XYZ is 10%,
a) Should XYZ accept ABC's offer?
b) XYZ has received a similar offer from TNK Company. Payments to TNK
company average Rs. 5,000. All other information is unchanged from the
involving ABC. Should XYZ accept TNK's offer?
Solution:
a) Under the current system XYZ loses value from its account on day 35. They also
incur internal costs of Rs. 10. (For simplicity assume these costs are incurred on
day 35 when the payment is made.) Under the proposed payment terms XYZ will
lose value of Rs. 500 on day 10. To compare these two we take the present value
(on day 10) of the payment on day 35. This is Rs. 5107 (l + l × 25/365)
= Rs. 506.53. Under the proposed payment terms they with lose value of Rs. 500
on day 10. Since they will be better off by Rs. 6.53 with the payment terms. XYZ
should accept ABC's offer,
b) The present value on day 10 for the payment to TNK under the system is
Rs.5,010/( 1 +. 1 × 25/365) = Rs. 4,975.92. If XYZ accepts TNK's payment terms
it will lose value of Rs, 5,000 on day 10. Since XYZ will be worse off by
Rs. 24.08, it should reject TNK's offer of the new payment terms.
Illustration 3 133
The Mobile Company receives the following cheques during January. Calculate the
amount of opportunity costs for January for Mobile if the opportunity cost rate is 12%
per annum.
Face Amount Days Delay
Rs. 1,00,000 4
1,50,000 5
50,000 3
75,000 6
Solution
To determine the average float for the month we find the total Rs.-days of float by
multiplying the face amount times the number of days delay and taking the total.
Face Amount Days Delay Amount × Delay Rs.
1,00,000 4 Rs. 1,00,000-days
1,50,000 5 Rs. 7,50,000-days
50,000 3 Rs. 1,50,000-days
75,000 6 Rs. 4,50,000-days
Total Rs. 17,50,000-days
The next step is to divide the total by the number of days in the month to determine
the average float over the month. Since January has 3! days, the average float is
Rs. 56,451.61. Multiplying this by the opportunity cost for the month gives
Rs. 56,451.61 × .12 × 31 /365 = Rs. 575.34. Note that we could have also just taken
the total Rs.-days of float for the month of 17,50,000 and multiplied by the daily
opportunity costs rate of ,12/365 and obtained Rs. 575.34.
Illustration 4
Assume that a cash manager discovers that his firm is paying off its accounts payable
at an average of two days early. If the firm changes this practice and pays the accounts
on their due date, what is the effect on the disbursement float if credit purchases are
Rs. 9.125 crore annually? If the available cash released can be invested in short-term
securities at 10 per cent and the firm's tax rate is 40 per cent, what is the net benefit to
the firm? Assume a 365-day year.
Solution
The average increase in disbursement float is:
⎛ Rs. 9.125 ⎞
⎜ × 2 days ⎟
⎝ 365 ⎠
= Rs. 5,00,000
And the NPV is:
(Rs. 5,00,000) (.10 )(.60 )
NPV = Rs. 3,00,000
.10
134 Illustration 5
R.J. Mahajan, financial manager of the AMC Services, has been keeping the firm's
fund in the First Growth Fund (FGF) a money market fund that pays 8 percent on
deposits and has no charge for withdrawals. Mahajan has found another Fund, Grand
Growth fund that pay 10.5 per cent on deposits but has a Rs. 200 fee for withdrawal of
any size, AMC Services has annual cash disbursements of Rs. 4 crore. Mahajan is
considering establishing an account with GGF, transferring funds to FGF only
occasionally, and using the FGF account to handle daily transaction.
a) Using a 360-day year, find the daily disbursement of funds.
b) When Mahajan makes a transfer, what the size of transfer be?
c) How often should Mahajan make transfers?
d) If Mahajan does not change to the GGF, what will be his average balance in the
FGF (assuming the Rs. 4 crore for disbursements is available at the beginning of
the year)? What annual interest will this account earn.
e) If Mahajan establishes the GGF account, what will be his average balance and
annual interest from FGF?
f) What will be the average balance and the annual interest from GGF?
g) What is the marginal value of establishing the GGF account?
Solution
a) AMC Services daily disbursement of funds Rs. 4crore/360=Rs. 1.31,111
b) Size of transfer
V(2) (Rs. 200) (Rs. 4 crore)/(.105 – .08) = Rs. 8,00,000
c) (c) No. of transfers to be made
= Rs. 4 crore/Rs. 8,00.000
= 50 times per year or every 7 days.
d) Average balance
= (Rs. 4 crore + Re. 0)/2 = Rs. 2 crore
Interest = 0.08 (Rs. 2 crore) = Rs. 16,00,000
e) Average balance:
= (Rs. 8,00,000 +Re. 0)/2
= Rs. 4,00,000
Interest:
= .08 (Rs. 4,00,000)
= Rs. 32,000
f) Average balance:
[(Rs. 4 crore - Rs. 8,00,000) + Re. OJ/2]
= Rs, 1.96 crore
g) Interest:
(Rs. 1.96 crore) (0.105) Rs. 20,58,000
Marginal Value= [(Rs. 20,58,000 + Rs. 32,000 - Rs. 49 (Rs. 200)]
– Rs 16,00,000 = Rs. 4,80,200. = Rs. 4,80,200
Illustration 6 135
A firm has an annual opportunity cost of 12 per cent is contemplating installation of a
lock box system at an annual cost of Rs. 2,60,000, The system is expected to reduce
mailing time by 3 days and reduce cheque clearing time by 2 days. If the firm collects
Rs. 5,00,000 per day, would you recommend the system? Explain:
Solution
Time reduction:
Mailing time - 3 days
Clearing time - 2 days
Total time reduction - 5 days Float reduction;
5 days × Rs. 5,00,000/day = 25,00,000 Gross annual profit of float reduction;
0.12 × Rs. 25,00,000 « Rs. 3,00,000
Since the annual earnings from the float reduction of Rs. 3,00,000 exceed the annual
cost of Rs. 2,60,000, the proposed lock-box system should be implemented. It will
result in a net annual savings of Rs, 40,000 (Rs. 3,00,000 - Rs, 2,60,000 cost).
Illustration 7
The credit terms for each of three suppliers are as follows:
Supplier Credit term
XYZ 1/10 net 46 EOM
ABC 1/10 net 30 EOM
YON 1/10 net 60 EOM
a) Determine the approximate cost of giving up the case discount from each,
supplier.
Cash Management System>n.\
b) Assume that the firm needs short-term financing, recommend whether it would be
better to give up the cash discount and borrow from a bank at 15 per cent annual
interest. Evaluate each supplier separately, using your findings in a.
c) What impact, if any, would the fact that the firm could stretch its accounts payable
(net period) by 20 days from supplier YON have on your answer in h relative this
supplier?
Solution
a) Approximate Cost of Saving up Cash Discount
XY7 ABC YON
b) Recommendation
XYZ 10% cost of giving up discount < 15% interest cost from bank; therefore
take discount and borrow from bank.
ABC 18% cost of giving up discount > 15% interest cost from bank; therefore
YOU 18% Cost of giving up discount > 15% interest cost from bank; therefore,
136 c) Stretching an accounts payable for supplier YON would change the cost of giving
up the cash discount to:
2% × [360/{(60+ 20)-20}]
In this case, in view of the 15 percent interest cost from the bank, the
recommended strategy in b would be to give up the discount, since the 12 per cent
cost of giving up the discount would be less than the 15 per cent bank interest
cost.
7.15 LET US SUM UP

Cash is the lifeblood of a business firm; it is needed to acquire supplies, resources,
equipment, and other assets used in generating the products and services provided by
the firm. It is also needed to pay wages and salaries to workers and managers, taxes to
governments, interest and principal to creditors, and dividends to shareholders. More
fundamentally, cash is the medium of exchange which allows management to carry on
the various activities of the business firm from day to day. As long as the firm has the
cash to meet these obligations, financial failure is improbable. Without cash, or at
least access to it, bankruptcy becomes a grim possibility. Such is the emerging view of
modern corporate cash management. On the other hand, marketable securities come in
many forms and will be discussed later, but their main characteristic is that they
represent "near cash" in that they may be readily sold. Hence marketable securities
serve as a back up pool of liquidity that provides cash quickly when needed.
Marketable security also provides a short-term investment outlet for excess cash and
is also useful for meeting planned outflows of funds.

Ashok Kapoor, the finance manager of the Vadhera Shoes, currently, keeps Vadhera's
funds in a demand deposit account yield 12 per cent compounded annually. Vadhera's
annual disbursements total Rs. 32.60 crore. This sum is deposited in the account at the
beginning of the year and is to pay bills as they come due. Kapoor is considering
inventory the money in short-term securities with an annual yield of 14.5 per cent,
selling them as necessary to replenish the demand deposit account. Suppose that it
costs Rs. 22 to sell any amount short-term securities, (a) What is the current average
balance in the demand deposit account? What is the amount of annual interest that this
account earns? (b) If Kapoor decides to buy the short-term securities, what amount of
short-term securities should he sell whenever he replenishes the demand deposit
account? What are the average balance and annual interest in the demand deposit
account? (c) What is the average balance in the short-term securities account? what is
the annual interest earned from the short-term securities? (d) Should Kapoor make this
switch? What is the marginal value of this decision?
7.17 KEYWORDS
Current Ratio: A liquidity measure defined as current assets divided by current
liabilities.
EPS: Earning Per Share.
Financial Risk: The risk which arises from the use of debt capital.

1. What is the objective of the financial manager in cash management? What
conditions must be satisfied in meeting this objective?
2. Discuss the motives that a company may have for holding liquid assets. Explain 137
the costs and benefits associated with holding liquid assets. Cash Management Systems
3. What is a firm's cash cycle? How are the cash cycle and cash Turnover ratio
firm related? What should a firm's objectives with respect to its cash cycle and
cash turnover be?
4. What is meant when we say "A money market instrument is highly liquid"?
5. What action can a financial manager take to reduce a company's cash
requirements?
6. How does the lock-box system differ from concentration banking? What is the
overall objective of both these arrangements?
7. Amar Dye has an inventory turnover ratio of 12, accounts receivable turnover of
8, and an accounts payable turnover ratio of 9. The firm spends Rs. 10,00,000 per
year. Assuming a 360-day, calculate the firm's cash cycle.
8. A firm currently has a weekly payroll of Rs. 80,000. Thus on the average, they
have the use of Rs. 40,000 in accrued wages (Rs. 80,000/2). If the firm changes to
payment every two weeks, and can earn an annual rate of 12% on other
investments, what savings if any, could be obtained? Explain.
9. Amba Manufacturing Company pays accounts payable on the 10th after purchase.
The average age of accounts receivable is 30 days and the average inventory is 40
days. Annual cash outlays are approximately Rs. 1,80,00,000 The firm is
considering a plan which would stretch its accounts payable by 20 days. If the
firm can earn 7% on its investments, what annual savings can it realise by this
plan, assume no discount for early payment of trade credit and a 360-day year.
10. Sagar Markets, Inc., a national food chain, is trying to convert as many of its
transfers to wire transfers as possible. Presently. Sagar is using draft at cost of Rs.
12 per transfer. A wire transfer would cost Rs. 16.5 and would accelerate
collections by 2 days. Excess funds are investable in commercial paper with an
average yield of 6.4%. Calculate the minimum amount of a transfer for which the
use of a wire would be economically acceptable.
11. Royal Products Limited has a credit and collection management policy that calls
for centralised billing to and collection from customers. The billing and collection
system is costing Royal Rs. 10,00,000 annually in equipment rental and employee
expenses. Royal is considering going to a lock-box system that would
substantially reduce collection activities at the present location. It is expected that
without centralized billings, some personnel and equipment could be assigned to
other corporate units, resulting in a saving of Rs. 40,000 annually. The lock-box
system that Royal is evaluating would cost Rs. 1,10,000 annually to operate. It
would, on the average, reduce by 2 days the amount of time it takes for payments
received to become available for investments. Excess funds released through the
use of the- lock-box system would be temporarily invested in bankers'
acceptances with an annualised yield of 6.45% Royal has been averaging
payments of Rs. 7,20,000 daily. Calculate the amount of funds released from
using the lock-box system.
12. Vikrant Paints, which can earn 7% on money-market instrument currently, has a
lock-box arrangement with a bank for its northern customers. The bank handles
Rs. 3,00,000 a day in return for a compensating balance of Rs. 2,00,000.
a) Vikrant has discovered that it could divided the northern region into a
northeastern region (with Rs. 1,00,000 a day in collections, which could In-
handled by Bank of Baroda for a Rs. 1,00,000 compensating balance) and a
northwestern region (with Rs. 2,00,000 a day in collections, which could be
138 handled by Punjab National Bank for a Rs. 2,00,000 compensating balance).
In each case, collections would be one-half day quicker than with the Hank of
India arrangement. What would be the annual savings (or cost) of dividing the
northern region?
b) In an effort to retain the business, the Bank of India has offered to handle the
collections strictly on a fee basis (no compensating balance). What would be
the maximum fee the Bank of India could charge and still retain Vikrant's
business?
13. Ambica Mills purchases Rs. 7,50,000 of raw material each year on terms of net
30. The purchasing agent currently is paying each invoice 20 working days after
its date to make sure that payment is received by suppliers in 30 days. A study
shows that payment could be delayed until the 25th day of working and still leave
enough time for receipt by the 30th day. How much would the company save
annually by making this change, assuming a 12% cost of funds?
14. The Novex Company receives the average deposit as shown in the table below.
The company has agreed to maintain an average balance of Rs. 20,000 in the
deposit bank. The treasurer is planning on initiating a transfer that will remove the
total deposits for the week Friday.
a) Determine the amount of the transfer that should be made each week.
b) Determine the beginning balance for Monday that the treasurer should
establish to achieve an average balance of Rs. 20,000 for the weak.
Mon Tue Wed Thu Fri Sat Sun
Deposits 15,000 4,000 5,000 5,000 6,000 0 0
15. The assistant treasurer for Bazaz Textiles wants to establish a transfer schedule
that will achieve the desired average balance at the deposit bank, will transfer the
total deposits for the week, and will have a transfer that moves money from the
deposit bank on Monday and Friday. She has decided the Monday transfer should
be Rs. 25,000. Determine the amount of the beginning balance that is required on
monday so that the average balance will be equal to the desired balance to
Rs. 10,000. The average daily deposit is as follows:
Mon Tue Wed Thu Fri Sat Sun
Deposits 32,000 5,000 7,000 8,000 9,000 0 0
16. A firm has measured the various segments of the cash outflow timeline in its
disbursement system. The average calendar-day delays are as follows:
Time Segment Calendar Days
Invoice, processing 35 days
Mail to vendor 5
Clearing to disbursement bank 3
Total 43 days
Disbursements average Rs. 2,50,00,000 per month. If the firm were to extend
invoice processing by 3 days and clearing time by 1 day, how much would the
firm save per year? Assume an opportunity cost of 10%. What must your answer
assume about the cost of ill will?
17. Disbursements for one firm are processed on a daily basis, Monday through 139
Friday. A typical pattern for disbursements is as follows: Cash Management Systems
Day Cheques Mailed (Rs.)

Monday 1,00,000
Tuesday 2,00,000
Wednesday 2,00,000
Thursday 3,00,000
Friday 4,00,000
Under a new automate system, disbursements would be batch-processed once a

week. The firm has decided to move all payments in one week to the following
Monday. In other words, the Rs. 1,00,000 payment in the preceding table would
be delayed one full week. The Tuesday disbursements would also be delayed until
the following Monday (6 days), and so on. Considering only the time value cost
opportunity cost 10%), compute the gain (loss) to the firm by adopting the new
system.
18. Under its current disbursement system at a large regional bank, XYZ Company
has had to keep an average balance of about Rs. 1,00,000 in its disbursement
account to protect against possible overdrafts. This is necessary because cheques
are frequently presented over the counter by local vendors late in the afternoon.
Management does not want to endanger the firm's banking relations by frequent
overdrafts. The balance earn no credits, since company has excess credits in other
accounts. The treasurer of cheques has been studying the possibility of using a
controlled disbursing bank that is affiliated with the large regional bank. The
controlled disbursing point would extend the clearing time by about .5 calendar
days but would cost an extra Rs. 500 per month. Cash flow through the disbursing
account averages Rs, 2,50,000 per calendar day. XYZ considers its cost of funds
to be 11%. Compute the savings (or loss) that the controlled disbursing system
would provide.
19. WSJ, Inc., located in Karnal, Haryana, initiates payment against invoices on
average 35 days after the invoice date. They currently issue their disbursement on
their concentration bank in Chandigarh. The cheques take an average of 5 days
before they are presented for payment. Disbursement average Rs. 10,00,000 per
month. The opportunity cost of WSJ is 12%. WSJ has received a proposal to use a
bank in Delhi, for disbursement. The use of this bank would extend the clearing
time by one day. What would be the monthly benefit of accepting the use of the
Delhi bank for disbursement?
20. Liston Industries currently handles all disbursements out of their concentration
bank. Sunil, the treasure, estimates there is a delay of 6 days from the time the
cheques are written until they are presented for payment. A representative of the
National Bank has suggested that they use a controlled disbursing account. The
controlled disbursing account would give Sunil information on cheques presented
for payment earlier in the day and would also result in a delay on average of 7.5
days from the time the cheques are written until they are presented for payment.
Liston has an opportunity cost of .03% per day, and writes an average of Rs.
20,00,000 cheques per day. Sunil estimates that transfer costs would be about 300
per month to transfer funds from the concentration account to the controlled
disbursement account at the National Bank. The Bank would charge a fee of
approximately Rs. 1500 per month to operate the controlled disbursement
account. How much will Liston save by using the controlled disbursing system, if
only directly identifiable financial costs are considered?
140 21. KDR Industries wants to maintain a balance in its demand deposit accounts that
results in approximately a 2.5% probability of overdraft. The treasurer has
estimated the standard deviation of daily cash flows for the demand deposit
accounts as shown in the accompanying table. The opportunity cost to KDR is
12% per annum. KDR has inquired about using zero-balance accounts for the
three disbursing activities shown below. The bank charges for the zero-balance
account system would average Rs. 750 per month more than the charges for the
current system.
Account Standard Deviation (Rs.)
Vendor disbursing 25,000
Hourly payroll 10,000
Salary payroll 15,000
a) How much does KDR currently have to carry to provide the level of
overdraft protection desired?
b) Assume that the presentments to the three disbursing account are
independent, normal distributions and that the presentments are proportional
to the standard deviations given above. How much would KDR have to carry
in the master account to provide the same level of overdraft protection?
Should KDR adopt the zero-balance account system?
c) Assume the presentments are perfectly correlated. How would you answers
to (b) change?
22. Bahadur Construction Company has credit sales of Rs. 10 crore per year. It is
currently running an excess cash balance and believes that any additional cash
should be invested in marketable securities earning 10 per cent. If the collection
float can be reduced by two days, what pretax change in annual earnings will
result? Use a 365-day year.
23. Suppose that Triveni Blast knows that the cost of each cash transaction is Rs, 25,
opportunity cost is 15 per cent per year, an that the standard deviation of daily
cash flows is Rs. 10,000. Also suppose that management has set the lower control
limit at Rs. 1,00,000. Compute the target cash balance, the upper control limit,
and the average cash balance for Triveni Blast.
24. Firm sometimes actually use messengers to deliver and collect payment. You;
firm must make a payment of Rs. 5,00,000 in five days and interest rates are 10
per cent. There are two ways of making the payment. First you could mail, but
because mail times are uncertain you must mail it today to be sure it is there on
time, however, you expect it to be there in two days. Second, you could wait four
days and send it by overnight delivery for Rs. 20. Which would you choose? What
is the expected saving of your alternative?
25. Your firm owes Rs. 10 crore to a supplier. You would pay it now or you could
wait for 15 days. If interest rates are 12 per cent per year, what is the value of
waiting?
26. Assume that your firm collects Rs. 10 crore per year and that interest rates are 6
per cent. A bank is trying to sell you a cash-management system. A lock-box
system will cost Rs. 2,00,000 per year, but should speed your accounts receivable
by three days on average. What would be the savings (or extra cost) of adopting
two lock box system?
27. Interest rates are 15 per cent per year, and you have an account with a
Rs. 5,00,000 balance that earns no interest. Your banker waits to talk to you about
a zero balance account instead. What is the largest fee per year that you would
consider for such an account?
28. Smart Suitings is headquartered in Baroda but has customers in Delhi, Mumbai, 141
Calcutta, Banglore, and Indore as well. Chaman Bhai Patel, the collection Cash Management Systems
manager, is planning to open collection offices in these cities to speed up the

collection process. The amount of collections, the annual cost of running the
collection center and the reduction in float time for each city are as follows:
City Annual Collection Annual Cost of center Reduction in Float Time
(Rs.) (Rs.) (days)
Delhi 300 crore 8,00,000 1
Mumbai 160 7.60,00 2
Kolkata 120 7,50,000 3
Bangalore 220 7,80,00 2
Indore 150 8,00,000 2
Suppose that the fate earned on these accounts is 8 per cent. In which cities
(if any) Should Patel open collection centers?
29. National Plastic Ltd., a Delhi based company, is considering using a lockbox for
its North East sales of Rs. 90 crore. Sales occur evenly throughout the year, and it
is estimated that float could be reduced by 4 days using a lockbox. The cost to the
firm would be Rs. 6,240 per year. Assume a 365-day year. Released funds would
be invested at 10 per cent, (a) Should the firm use the lockbox? (b) Assuming all
estimates are correct, what is the maximum National Plastic should pay for a
lockbox service?
30. Rally Chemicals, a Ludhiana based company, is evaluating a cash management
system proposal submitted by a private bank, Thakur Bank. The proposal includes
establishment of lockboxes in Ambala, Nagpur, Kanpur, and Cuttack, which will
serve as decentralised collection locations. Good funds in these accounts will be
wired daily to the concentration bank in Ludhiana. The concentration bank will
perform all posting of accounts receivable and will furnish a daily listing of all
receivables transactions. The cost to the company for these services includes
Rs. 1,02,000 for the four lockbox locations plus Rs. 25,000 for accounts
receivable posting. It is believed that the system will reduce collection float by
two days on annual credit sales of Rs. 25 crore. Excess funds can be invested to
earn 11 percent. Should the company use the cash management system? Use a
365-day year.
31. Jindal Departmental Store (JDS) has annual sales of Rs. 2.70 crore. Hari Om
Tiwari, the collection manager, has estimated that it takes six days for a mailed
department to be credited to JDS's account and that this time can be cut to three
days if Jindal opens a lockbox account with a local bank. The account in which
the cheques are placed earns 8 per cent annually. The lockbox agreement calls for
a monthly payment of Rs. 500 and in addition, a charge of Rs. 0.03 per cheque.
Jindal currently processes 45,000 cheques monthly. Assume these expenses if
they occur at the beginning of the year and a year of 360 days, (a) What are
Jindal's daily sales? (b) By how much will Jindal's average bank balance increase
if it uses a lockbox? (c) Should Tiwari use a lockbox? (d) Suppose that JDS has
found that a regular 20 per cent of its customers account for 80 percent of its
credit sales, should Tiwari use a lockbox for only this 20 per cent of the
customers?
32. Your boss, the owner of the Surat Gems and Jewellery, has asked you to see
whether you can improve his cash management. You easily determine that the
firm makes Rs. 325 crore in credit purchases. You then find out that the owner has
always believed in paying his bills as soon as they are received. This practice
results in the firm's paying its payable 18 days before they are due. If the firm paid
142 its payables only when due and the available cash reduced was invested in
marketable securities earning 9 per cent, what would be the net benefit to
the firm?

CYP 1
1. One very important reason for holding cash in the form of non-interest-
bearing currency and deposits is transactions demand. Since debts are
settled via the exchange of cash, the firm must hold some cash in the bank
to pay suppliers and some currency to make change if it makes sales for
cash.
2. Many firms experience some seasonality in sales. Often, there will be
times during the year when such firms have excess cash that will be
needed later in the year. Firms in this situation have several choices and;
one alternative is to pay out the excess cash to its security holders when
this cash is available, and then issue new securities, later in the year when
funding is needed. However, the costs of issuing new securities usually
make this a disadvantageous strategy. More commonly, firms will
temporarily invest the cash in interest-earning marketable securities from
the time the cash is available until the time it is needed and; proper
planning and investment selection for this strategy can yield a reasonable
return on such temporary investment.
CYP 2
1. A collection system incurs costs in processing payments. Some of these
costs are direct, such as bank charges for cheque processing or wire
transfers.
2. A primary objective of a collection system is to receive value from the
buyer as quickly as possible. A second objective is to receive and process
information associated with the payment. A third related factor to
consider in designing a collection system is the relationship the firm has
with those making payments.
CYP 3
A "lockbox" is a post office box number to which some or all of the firm's
customers are instructed to send their cheques. The-firm grants permission to
its bank to take these cheques and immediately start them in the clearing
process. In fact, the mail addressed to this "post office box" is actually
delivered directly to the firm's lockbox bank.
CYP 4
a) Total float = Rs. 4,50.000 (4 days) = Rs. 18,00,000
b) Cost = .15 (Rs. 18,00,000) = Rs. 2,70,000 per year.

J. McN Stancill, The Management of Working Capital, Intext, 1971.
K.V. Smith, Readings in the Management of Working Capital, West Publishing
Company, 1980.
P. Gopalakrishnan and M.S. Sandilya, Inventory Management, Macmillan, 1978.
143
LESSON Inventory Management
8
INVENTORY MANAGEMENT
CONTENTS
8.1 Introduction
8.2 Cost of Holding Inventories
8.2.1 Ordering Costs
8.2.2 Carrying Costs
8.2.3 Stock Out Costs
8.3 Type of Control Required
8.3.1 Explosion Process
8.3.2 Past-usage Methods
8.3.3 Value-volume Analysis
8.3.4 ABC Approach
8.3.5 HML Classification
8.3.6 XYZ Classification
8.3.7 VED Classification
8.3.8 FSN Classification
8.3.9 SDF and GOLF Classifications
8.3.10 SOS Classification
8.4 Inventory Control Responsibility
8.5 Other Control Devices
8.5.1 Control Account
8.5.2 Physical Counting
8.5.3 Visual Review
8.5.4 Two-bin System
8.5.5 Minimum-maximum System
8.5.6 Periodic Order System
8.6 Inventory Management and Evaluation
8.6.1 Average Cost Method
8.6.2 First-In, First-Out (FIFO) Inventory Method
8.6.3 Base Stock Method
8.6.4 Last-In, First-Out (LIFO) Inventory Method
8.7 Inventory Control Models
8.7.1 Basic EOQ Model
Contd…
144
8.7.2 Extensions of the Basic EOQ Model
8.7.3 Non-zero Lead Time
8.7.4 Quantity Discounts
8.7.5 Probabilistic Inventory Control Models
8.8 Let us Sum up
8.10 Keywords

z Inventory management
z Types of controls required
z Methods followed for evaluation
z Inventory control models
8.1 INTRODUCTION
Inventory management is concerned with keeping enough product on hand to avoid
running out while at the same time maintaining a small enough inventory balance to
allow for a reasonable return on investment. Proper inventory management is
important to the financial health of the corporation; being out of stock forces
customers to turn to competitors or results in a loss of sales. Excessive level of
inventory, however, results in large inventory carrying costs, including the cost of the
capital tied up in inventory warehouse fees, insurance etc.
A major problem with managing inventory is that the demand for a corporation’s
product is to a degree uncertain. The supply of the raw materials used in its production
process is also somewhat uncertain. In addition, the corporation’s own production
contain some degree of uncertainty due to possible equipment breakdowns and labour
difficulties. Because of these possibilities, inventory acts as a shock absorber between
product demand and product supply. If product demand is greater than expected,
inventory can be depleted without losing sales until production can be stepped up
enough to select the unexpected demand. However, inventory is difficult to manage
because it crosses so many lines of responsibility. The purchasing manager is
responsible for uninterrupted production and wants to have enough raw materials and
work-in process inventory on hand to avoid disruption in the production process. The
marketing manager is responsible for selling the product and wants to minimize the
chances of running out of inventory. The financial manager is concerned about
achieving an appropriate overall rate of return. Funds invested in inventory are idle
and do not earn a return.
This lesson will discuss the impact that the management of inventory has on the cash
cycle of the corporation. It will develop some basic techniques that can be used by the
finance manager to effectively manage this important component of the cash cycle.
Poor inventory management results in an illiquid corporation-one that must the
turnover of the inventory releases cash in a timely manner, and this cash flow is then
used to make payment on payables as they come due.
145
8.2 COST OF HOLDING INVENTORIES Inventory Management
The determination of inventory costs is essentially an income measurement problem, a

means whereby there is a rational, orderly, systematic interpretation of the effect on
the economic progress of the company of expenditures involved in acquiring goods of
in maintaining and operating productive facilities. Ability to quantify and develop
rigours models of most managerial problems is dependent on the determination of the
behaviour of relevant costs. The practical application of such models is also dependent
on ability to obtain the cost data. Relevant inventory costs which change with the level
of inventory are listed below.
8.2.1 Ordering Costs

Every time an order is placed for stock replenishment, certain costs are involved. The
ordering cost may vary, dependent upon the type of item. However, an estimate of
ordering cost can be obtained for a given range of items. This cost of ordering
includes:
1. Paper work costs, typing and dispatching an order.
2. Follow-up costs-the follow-up required to ensure timely supplies include the
travel cost for purchase follow-up, telex and postal bills.
3. Cost involved in receiving the order inspection, checking, and handling to the
stores;
4. Any set up cost of machines if charged by the supplier, either directly indicated in
quotations or assessed through quotations for various quantities.
5. The salaries and wages to the purchase department are relevant for consideration
if the purchasing function is carried out at the same level with the existing staff. If
the level of purchasing activity decreases significantly, obviously a proportional
amount of personnel will be transferred to other departments.
There are certain costs which remain the same regardless of the size of the lot
purchased or requisitioned. This would be true for the retailer ordering from the
distributor, from the distributor ordering from a factory warehouse, for the factory
warehouse ordering a new production run from the factory, and for the factory
ordering raw materials from vendors. These kinds of costs are called preparation or
set up costs. If we are ordering to replenish supplies at one stock point from another
stock point, our interest is in the incremental clerical costs of preparing orders,
following up these orders, expediting them when necessary, etc. we must take care
however, to be sure that we obtain true incremental cost or order preparation. It is not
correct to derive the figure by simply dividing the total cost of the ordering
preparation. It is not correct to average number of orders processed. A large segment
of the total costs of the ordering function are fixed, regardless of the number of order
issued. There is, however, a variable component, and this is the pertinent figure for
use. Even then it may be difficult to determine satisfactorily the incremental cost
which results from placing one more order. Quantity discounts and handling and
transport costs are other factors which vary with lot sizes.
When the order to be placed is on the factory, then the equipment decision is in
determining the size of the production run. In this instance the preparation costs are
the incremental costs of planning production, writing production orders, setting up
machines and controlling the flow of order through the factory. Material handling
costs in the plant have an effect on production lot sizes in much the same way that
freight costs may affect purchase lot sizes.
Besides the preparation costs of production, there are some other production costs
which can have a direct bearing on inventory models, however. These are overtime
146 premiums and the incremental costs of changing production levels, such as hiring,
training and separation costs.
8.2.2 Carrying Costs

Carrying costs constitute all the costs of holding items in inventory for a given period
of time. They are expressed either in rupees per unit per period or as a percentage of
the value per period. Components of this cost include the following:
z Storage and handling costs.
z Obsolescence and deterioration costs.
z Insurance.
z Taxes.
z The cost of the funds invested in inventories.
Storage and handling costs include the cost of warehouse space. If a company owns
the warehouse, this cost is equal to the value of the space in its next-best alternative
use. These costs also include depreciation on the inventory handling equipment, such
as conveyors and forklift trucks, and the wages and salaries paid to warehouse and
supervisors.
Inventories are valuable only if they can be sold. Obsolescence costs represent the
decline in inventory value caused by technological or style changes that make the
existing product less salable. Deterioration costs represent the decline in value caused
by changes in the physical quality of the inventory, such as spoilage and breakage.
Another element of the carrying cost is the cost of insuring the inventory against
losses due to theft, fire, and natural disaster. In addition, a company must pay any
personal property taxes and business taxes required by local and state governments on
the value of its inventories.
The cost of funds invested in inventories is measured by the inventory rate of return
on theses funds. Because inventory investments are likely to be of “average risk”, the
overall weighted cost of capital should be used to measure the cost of these funds. If it
is felt that inventories constitute an investment with either above-average or below-
average risk, some adjustment in the weighted cost of capital may be necessary to
account for this difference in risk.
Some firms incorrectly use the rate of interest on borrowed funds as a measure of this
cost. This tends to understate the true cost, because a given amount of lower-cost debt
must be balanced with additional higher-cost equity financing. Inventory investment
cost constitutes an opportunity cost in that it represents the return a firm foregoes as a
result of deciding to invest its limited funds in inventories rather than in some other
asset. Therefore for most inventory decisions, the appropriate opportunity cost is the
firm’s weighted cost of capital.
Like ordering costs, inventory carrying costs both fixed and variable components.
Most carrying costs vary with the inventory level, but a certain portion of them-such
as warehouse rent and depreciation on inventory handling equipment are relatively
fixed over the short run. Most of the simple inventory control models, such as the
EOQ model, treat the entire carrying cost as variable.
8.2.3 Stock Out Costs

Stock out costs are incurred whenever a business is unable to fill orders because the
demand for an item is greater than the amount currently available in inventory. When
a stock in raw materials occurs, for example, stock out costs include the expenses of
placing special orders and expediting incoming orders, in addition to the costs of any
resulting production delays. A stock out in work-in-progress inventory results in
additional costs of rescheduling and speeding production within the plant, and it also 147
Inventory Management
may result in lost production costs if work stoppage occur. Finally, a stock out in
finished goods inventory may result in the immediate loss of profits if customers
decide to purchase decide to purchase the product from a competitor, and potential
long-term losses if customers decide to order from other companies in the future.

1. Define inventory management.
…………………………………………………………………………….
…………………………………………………………………………….
2. What is ordering cost?
…………………………………………………………………………….
…………………………………………………………………………….
8.3 TYPE OF CONTROL REQUIRED

The ultimate goal of an inventory control programme is to provide maximum
customer service at a minimum cost. For this time and are in use today. For
determining material requirements, the methods used are:
8.3.1 Explosion Process

In many manufacturing organizations, production requirements are based directly on
the sales forecast. For each of its products, the company prepares a bill of materials- a
list of the parts needed for various products. To determine overall material
requirements, each sub-assembly or part on the bill of materials is extended or
multiplied by the planned number of finished products. This yields the total
requirement for each time listed.
The explosion process is greatly simplified if electronics data-processing equipment is
available. After the production level is set, cards are punched to initiate a
manufacturing order for each product. It is possible to obtain, in very short-order,
cards representing each part or sub-assembly necessary to complete the order. These
requirements can then be extended mechanically to find the amount of each material
or item needed to fill the overall requirement.
8.3.2 Past-usage Methods

The other method used for determining production requirements relies on past usage,
rather than on the sales forecast. If a certain item, was used at a rate of 100 units per
month during the past year – or during some other representative period-it is likely to
be used at the same rate in future. If the production rate is expected to be higher or
lower than in the past period, the past usage figure may be altered accordingly by an
application of a factor that represents the anticipated percentage of change.
In general, the past-usage method is not as accurate as the explosion method. Changes
in product mix or product design may adversely affect the results of the past usage
method. In addition, it does not sufficient account of shifting production levels.
8.3.3 Value-volume Analysis

Many firms use the value-volume analysis to determine which inventory accounts
should be controlled by the explosion method and which should be controlled by the
past-usage method. In value-volume analysis the number of each item used in the past
year is multiplied by its unit to find the find the annual activity for the item. In most
cases, the volume analysis reveals that a relatively small percentage of the items in
148 inventory account for a large percentage of annual activity. Typically, most of the cost
of inventory is concentrated in a few high activity inventory accounts.
This is an important concept, because those items with a high level of activity must be
more closely controlled than the ones with relatively low activity levels. Their
requirements must be determined by the more accurate explosion process while
requirements for the low activity items can be determined by the less accurate, and
less costly past-usage method. The high activity items are generally few in number but
they represent most of the activity; they are the ones, therefore, that most directly
affect inventory values. These items should be ordered and to increase the turnover
rate. Since expediting expense, if necessary, is usually justified, lead times should be
controlled by the most effective recording systems.
8.3.4 ABC Approach

One of the most widely recognized concepts of inventory management is refereed to
as ABC inventory control. The maintaining appropriate control according to the
potential savings associated with a proper level of such control. For example an item
having in inventory cost of Rs 10,000 has a much greater potential for saving of
expenses related to maintaining inventories than an item, into these classes “A”, “B”
and ”C” according to the potential amount to be controlled. When item have been
classified., appropriate control techniques are develop classified, appropriate control
techniques are developed for each class of inventory. “A” items justify the use of
piece control techniques, where “C” items should be controlled by mean of general
control techniques.
The primary criteria for classifying items into “A” and “C” categories is the annual
rupees usage of each item. This is accomplished by multiplying the annual unit usage
of each inventories item by its unit cost and then listing all items in descending order
according to annual rupees usage. This listing should also include C column to show
the cumulative annual rupees usage. Such a listing reflects the distribution of annual
rupees usage. A typical distribution in a manufacturing operation shows that the
top15% of the line items, in terms of annual rupees usage, represent 80% of the total
annual rupees usages and are designated as “B” items. The “C’ items represent the
remaining 70 percent of the items in inventory and account for only 5% of the total
rupees usage. In some cases the ABC classification will be developed independently
for different types of inventory such as finished goods, raw materials and service
parts.
In addition to annual rupees usage, several other factors need to be considered in
developing criteria for analyzing items into “A”,”B” and “C” categories. In this
regard, a ‘truth table can be used to facilitate the classification process. A typical
“truth table” is shown below. The question included in such a table, and the parameter
associated with the questions, will vary according to the specific inventory being
analysed.
Table 8.1: “Truth” Table for ABC Classification
Questions Yes Part Numbers
Answer 1 2 3 4 5
Is annual usage
More than RS 10,000? A 1 0 0 0 0
Is annual usage between B 0 1 0 0 0
Rs 1,000 and 10,000?
Is annual usage less

than Rs 1,000? C 0 0 1 1 1
Is the unit cost over
Rs. 100? B 1 0 0 0 0
Contd…
149
Does the physical B 0 0 0 0 1 Inventory Management
Nature of the item
Cause special storage
Problems
Would a stock out B 0 0 0 1 0

Result in excessive
Costs? A B C B B B
Classification
In this table six questions are asked regarding each inventoried item. A “yes” answer
is indicated by a one in the appropriate column under the part number; a “no” answer
is reflected by a zero. The column next to the question provides the question provides
the key to the classification by indicating the inventory class associated with a “yes”
answer to each question. When there is more than one “yes” answer per item, the
highest classification and inventoried sub-assemblies are found in the “A” category.
Small metal stamping with moderate usage are frequently “B” items, “C” items are
typically hardware items such as small nuts, bolts, and screws.
ABC inventory classification and related control techniques were developed originally
for mutual systems prior to the widespread use of automated inventory record
keeping. ABC control placed emphasis on reducing record-keeping requirements,
redirecting clerical and review effort, and implementing stratified or varying inventory
control techniques. These concepts also are generally applicable to automated
systems. They can be used in structuring exception reports, determining safety stocks,
cycling counting programmes and in numerous other aspects of inventory
management and control. Besides the ABC there are number of other classification
emphasizing on particular aspects. These are:
8.3.5 HML Classification

The HML(high, medium, low) classification is similar to ABC classification, but in
this case instead of the assumption value of item, the unit value of the item is
considered. The cut off points will depend on the individual units. For example,
kerosene would be a m low value item for a jeweler and a high- value item for a small
shopkeeper. The focus here is directed to control the purchase prices.
8.3.6 XYZ Classification

While the ABC classification has the value of the basic, the XYZ classification has the
value of inventory stored as the basis of differentiation. This study is usually
undertaken once a year during the annual stock checking exercise. X items are those
whose inventory value are high while Z items are those whose value are low. This
classification, therefore, helps in identifying the items which are being extensively
stocked. If the management is not alert, one can except C items to be in the X
category. Therefore, the XYZ and ABC classification are used in conjunctions and
controls can be effected on the items according to whether they are AX, BY, CZ and
so on.
8.3.7 VED Classification

The VED (vital, essential desirable) classification is applicable largely to spare parts.
Stocking of space parts is based on strategies different from those of raw materials
because their consumption pattern in different. While consumption of raw material
depends directly on the market demand for spare for spares follow the poisson
distribution and therefore, spares are classified as vital, essential and desirable. This
implies that vital class of spares have to be stocked adequately and so on. Also ABC
and VED classifications can be combined to advantage. A combination of XYZ and
150 VED methods can give an idea of what are the items that can be disposed off to train
the inventory.
8.3.8 FSN Classification

Movement analysis forms the basis for FSN (fast moving, slow moving and
non-moving) classification and the items are classified according to their assumption
pattern. If there is a paid change in technology, this classification will have to be up
dated more often. FSN analysis is specially useful to combat obsolete items. Cut-off
points in the previous few years.
8.3.9 SDF and GOLF Classifications

If should not be overlooked that inventory levels also dependent on the source a scare
item with a long lead time will have a higher safety stock for the same consumption
level. The SDF (scarce, difficult, easy to obtain) classification and the GOLF
(government, ordinary, local, foreign sources) classification are systems where
classification is done on the basis of general availability and the source of suppliers.
8.3.10 SOS Classification

Raw materials specially agriculture inputs are generally classified by the SOS
(seasonal, off-seasonal) system since the season would generally be lower.
8.4 INVENTORY CONTROL RESPONSIBILITY

The responsibility for inventory management or control is not wholly assignable to
any one group of people, any one department or any one function. In plants with a
store department or section, the inventory control function is more or less centralized.
But the constant flow of material into stores and then into production and out again
making inventory control a joint responsibility of many departments. Purchasing
naturally has a vested interest in inventories, even to the extent that the purchasing and
stores functions are often combined. Production could look after work in progress, no
other arrangement would be satisfactory. Quality control is concerned with the
condition of incoming materials, since all purchased items must meet quality
specifications. Where there are much sections, traffic and receiving play an important
inventory control role. The economic importance of inventories causes more than a
passing interest on the part of accounting and finance. The fact that parts and materials
must be moved from one plant location to another to be properly utilized brings in the
material handling function into play, both to exercise control and to physically move
parts and material.
With so many people from so many different plants areas exercising direct and
indirect control over inventories, it is essential that the right hand always know that
the left hand is doing. This requires continuous communication, which, in turn,
requires standard procedures forms and other control devices. All these are essential to
inventory control. These problems are eased somewhat in plants that use data
processing systems inventory accounting but they are not eliminated. The complexity
of any inventory control system is directly proportional to the number of items carried
in stock and the number of interdepartmental transactions necessary to keep track of
material movement and disposition.
8.5 OTHER CONTROL DEVICES

8.5.1 Control Account
The control account is maintained in the general ledger by accounting. All material
purchases are charged against and all insurance are credited to it. The balance of the
control account should always equal the sum of the balances of stores forms.
The control account is frequently maintained by a purchased card system, cards are 151
maintained for every transaction that affects the inventory receipts, insurances and
adjustments. The cards are then collected by part number and the information on each
card is mechanically transferred to ledger sheets.
8.5.2 Physical Counting

All companies take a periodic inventory at least one each year. Physical counting of
stock on hand necessary for tax and cost accounting functions and as a means of
verifying the balances showed on perpetual inventory records and in the control
account maintained by accounting. Physical inventories may be taken periodically
(usually annually), continuously or by sampling.
8.5.3 Visual Review

A highly subjective method of determining when to recorder is a visual reviews of
stock in the old time general store, the owner would inspect his inventory and
determine what should be ordered. This techniques still has limited application where
the cost of the inventory is low and the cost of control needed to be minimised control
is based upon the judgment of the individual ordering and periodic review of the item
being ordered.
8.5.4 Two-bin System

As the name implies, the two-bin system divides each item of inventory into two
groups or bins. In the first, a sufficient supply is kept to meet current demand over a
designed period of time, in the second, enough additional items are available to meet
the demand during the load time necessary to fill the order.
The advantages of this form of control are minimum control expenses and positive
physical recognition of reorder points. The principal disadvantages are the limited
information available regarding inventory status of items, lack of monthly usage dates
and reliance on storeroom personnel.
8.5.5 Minimum-maximum System

The minimum-maximum(min-max) system is frequently used in connection with
manual inventory control systems. The minimum quantity is established in the same
way as any reorder point. The maximum is the minimum quantity plus the optimum
order lot size. In practice, a requisition is initiated when a withdrawal reduces the
inventory below the minimum level. The order quantity is the maximum minus the
inventory status after the withdrawal. If the final withdrawal reduces the stock level
substantially below the minimum level, the order quantity will-be larger than the
calculated optimum order lot quantity.
The effectiveness of min-max system is determined by the method and precision with
which the minimum and maximum parameters are established. If these parameters re
based upon arbitrary judgements with a limited factual basis, the system will be
limited in its effectiveness. If the minimums are based on an objective rational basis,
the system can be very effective.
8.5.6 Periodic Order System

Under the periodic order system, the stock levels for all inventory accounts are
reviewed at established intervals, and orders are placed to bring all accounts up to
their maximum levels. The length of review period often varies for different accounts
and for different classes of items, thereby permitting higher or lower turnover rates as
required. Since, orders are automatically placed, at the end of the review periods the
system greatly simplifies the ordering process. The advantage may, however,
152 sometimes be a disadvantage because of the heavy paperwork burden it places
periodically on the purchasing department.
8.6 INVENTORY MANAGEMENT AND EVALUATION

Decision about the desired level of inventory are difficult to relate the goal of
shareholder wealth maximization. Presumably maintenance of inadequate inventories
could reduce profitability and create additional uncertainty about shareholders returns.
Whether such added risk can be diversified away is open to question but some
tendency to raise risk premiums contained in the cost of capital and to reduce the
value of equity shares may be present. In the other direction, excessive inventory
levels may reduce risk of production disruptions as well as risk premiums in the cost
of capital may also raise carrying costs more than enough to offset such gains. The
precise optimum point, in a valuation sense is by no means clear. However, in
determining valuation method to use, consideration is given to the size and turnover of
inventories, the price outlook, tax laws, and prevailing practices in the field. The
financial manager’s influence will be felt practically in establishing underlying
policies, while the expert in the different areas play important roles in evaluating the
implication different procedures from the view point of their specialties.
The evaluation of inventory is significant from the stand-point both the balance sheet
and the income statement. In the former, the inventory valuation influences the current
assets, the total assets, the ratio between current assets and current liabilities and the
retained earnings. In the later the inventory evaluation may influence the cost of goods
sold and the net profits.
Under the normal circumstances, financial statements reflecting the results of the
operation of a business enterprise during a particular period are preferred on a going
concern basis. Consistent with this concept of continuing operations, their will always
be goods on hand available for sale. The goods owned at the end of an accounting
period will seldom be exactly comparable to the goods in which the opening
inventory, but the purpose of inventory will be the same; to make possible
uninterrupted realization of income through sales.
8.6.1 Average Cost Method

The exact amount of the computed cost for an individual item is generally of little
significance. In fact, in the determination of cost for inventory purpose no one
prescribed procedure can be used. For determining the valuation of inventories
consistency from year is of prime importance and for this using average costs rather
than specifically identified costs seems to be more appropriate. The averaging process
is in one sense a concept of a flow of costs, but it can also be viewed as merely a
compilation of the actual cost for a group of similar items under circumstances where
the amount paid for each item has no significance. The entire group of items is
considered as single entity; and when particular items are separated, they are treated
as merely a proportionate part of the whole.
In this method normally weighted average prices are taken, purchase of each type of
material in stock are taken together and an average price completed. If the price
fluctuate considerably, many calculations will be involved. It is usual to calculate a
new average after each delivery. The pricing book, if issued, and the stores ledger will
require frequent amendment.
Since average prices are charged and, therefore whether the charges to production
represent current replacement costs depends on the turnover of the stocks. In a period
of rising prices slow turnover will tend to mean that costs which are lower than
present day costs will be charged. In these statements there is an over statement of
profit. In appropriate circumstances the use of the average cost will have a stabilizing
effect of price used for issues and therefore profits.
Computations of income which attempt to reflect the actual flow of goods are not 153
necessarily the most meaningful to business management, investors or creditors. Each
of these group is normally more concerned with what the future earning of the
business enterprise will be than with the amount which could be realized from the
inventory if it were liquidated completely and the activity discontinued.
8.6.2 First-In, First-Out (FIFO) Inventory Method

Under FIFO method, cost is computed on the assumption that goods sold or consumed
are those which have been longest on hand and that those remaining the stock present
the least purchases or production.
Items received first are assumed to be used first and therefore prices charged are those
paid for the early purchases. Prices charged are actual prices and therefore there is no
question of having to re-calculate a new price each time a new purchase in received.
Care has to be taken to ensure that each quantity is issued at the correct prices.
If prices are rising, costs of products will be understand and therefore profit will tend
to over stand. On the other hand, stock valuations should approximate current
replacement values.
8.6.3 Base Stock Method

Under the base stock method the minimum quantity of raw materials or other goods
without which management considers the operations cannot be continued, except for
limited periods. Is treated as being a fixed asset subject to constant renewal. The base
quantity is carried forward at the cost of the original stock. If a quantity of goods
larger than the base stock owned at the end of any period, the excess will be carried at
its identified cost or at the cost determined under FIFO method. This is considered a
temporary condition.
If a quantity of goods less than the base stock is owned at the end of any period, this
condition is similarly considered temporary. In order not inflate the income of the
period during which the base stock was deflected a reserve is set up equal to the
excess of the replacement cost over the amount at which the goods would have been
includes in the base stock inventory. Even if there serve for replacement is not
provided for out of income of the year in which the base stock is depleted, the
originally established cost is assigned to the replacement goods in the subsequent
inventories when the base stock quantities are actually on hand.
The quantity of material included in the base stock is actually a some what flexible
minimum amount necessary to permit orderly operations. Within reasonable limits.
The process must be able to accept goods tendered by the suppliers with whom he has
continuing relations, and similarly his customer’s demands must be met, not only the
anticipated demands for which the customer gives order for future delivery but also
the orders for immediate delivery resulting from unforeseen circumstances.
If base stock quantity is properly established, this method should result in income
being fairly reflected. The cost of acquiring an equal volume of goods will be charged
against revenues derived from sales. Earnings will not be affected by increases or
decreases in the cost or market value of the base stock.
Income is not realized from merely replacing inventory quantities, and it can be
argued that these should be deducted from the revenue derived from selling the goods
previously owned whatever expenditure are necessary to restore the company to a
position of being able to continue operations.
Issues are priced at actual cost but base stock is carried forward at the end of each year
at the original price paid when the business commenced to operate, which may have
been years ago.
154
8.6.4 Last-In, First-Out (LIFO) Inventory Method
Under LIFO it is assumed that the stocks sold or consumed in any period are those
most recently acquired or made. As a consequence of this assumption the stocks to be
carried forwards as the inventory are considered as if they were those earliest acquired
or made. The result at the LIFO method is to change current revenues with amounts
approximating current replacement costs. To the goods owned at the end of any period
are assigned costs applicable to items purchased or made in earlier periods.
It is more obvious with respect to LIFO to FIFO although true under both inventory
methods that the concepts are as to the flow of goods sold.
Reporting on profits by application LIFO under ideal conditions is simple. As here
used, conditions are ‘ideal’ when closing inventory equals opening inventory and the
goods sold are equivalent to the purchases for each accounting period. Since such
conditions are rarely found in practice, an accounting system must be sufficiently
flexible to reflect the facts, whatever they may be.
If at the end of n interim accounting period, the inventory of any LIFO group is below
the opening inventory, an estimate should be charged with the cost of goods
purchased plus an estimated amount to cover the cost to be incurred in making good
the temporary decrease in inventory, and an account should be established for the
differences between the estimated replacement cost and the LIFO inventory cost of
the quantities to the interim date.
An indication of the extent to which inventory is composed of raw materials, work in
process, and finished goods may be significant for balance sheet.
The artificiality of paper profits resulting from assigning a larger amount to a closing
inventory merely because market prices have increased-when from the standpoint of
physical attributes the opening and the closing inventories are comparable-has
particular practical significance when tax rates are high only the income remaining
after paying taxes can be used to replace inventories, expand the plant, pay dividends
and so forth. The higher the taxes the lower is the rate of earnings, and the greater is
the proportion of the year’s earnings needed to maintain inventories during a period of
rising prices.
Assuming no additional capital is invested for this purchase, the portion of net
earnings of business needed to maintain the inventory required for continuing
operations during a period of rising X costs can be expressed as a formula. If
Cost of inventory at the beginning of the year
Turnover rate for the inventory investment
R - Rate of earnings stated as the percentage which the net
income after tax is of the total cost of goods for the year.
Net Earnings=(I)(T)(R)
If ‘i’ is the percentage increase in the replacement cost of inventory and ‘e’ represents
the fraction of the year’s earnings needed to maintain same physical volume of
inventory. Then
iI =e.I.T.R
e=i/TR
Income tax rates are significant in the analysis of the consequence of increases in
inventory cost because of their effect on the amount of net earnings. Every increase in
income tax rate cause a reduction in the rate of earnings and results in a larger portion
of the net earnings being required to maintain the inventory during a period of rising
costs.
Costing an inventory by references to LIFO assumption to the flow of the costs will 155
not alter the amount required to maintain or the intrinsic value of the inventory, but its
use will tend to keep the increase in cost out of the computed income from operations.
Also, any reduction in the amount of income taxes payable by a business will result in
more case being available to maintain the inventory and for other needs of the
enterprise.
The following information relating to inventory in WTS Ltd. is made available to

you. The company wants to introduce the scheme of ordering only the economic
order quantity.
Annual demand : 480 units; Price per unit : Rs.4
Carrying cost : 40 paise per unit; Cost per order : Rs. 5 per unit
Determine the economic order quantity. Also determine the number of orders per
year and frequency of purchases.
8.7 INVENTORY CONTROL MODELS

Given the significance of the benefits and costs associated with holding inventories, it
is important that the firm efficiently control the level of inventory investments. A
number of inventory control models are available that can help in determining the
optimal inventory level of each item. These models range from the relatively simple to
the extremely complex. Their degree of complexity depends primarily on the
assumptions made about the demand or use for the item and the lead time required to
secure additional stock.
In the “classic” inventory models, which includes both the simpler deterministic
models and the more complex probabilistic models, it is assumed that demand is
either uniform or dispersed and independent over time. In other words, demand is
assumed either to be constant or to fluctuate overtime due to random elements. These
types of demand situations are common in retailing and some services operations.
The simper deterministic inventory control models, such as the economic order
quantity (EOQ) model, assume that both demand and lead times are constant and
known with certainty. The more complex probabilistic inventory control models
assume that demand, lead time, or both are random variables with known probability
distributions.
8.7.1 Basic EOQ Model

In its simplest form the EOQ model assumes the annual demand or usage for a
particular items is known with certainty. It also assumes that this demand is stationary
or uniform throughout the year. In other words, seasonal fluctuations in the rate of
demand are ruled out. Finally, the model assumes that orders to replenish the
inventory of an item are filled instantaneously. Given a known demand and a zero
lead time for replenishing inventories, there is no need for a company to maintain
additional inventories, or safety stocks, to protect itself against stock outs.
The assumption of the EOQ model yield the saw-toothed inventory pattern shown in
fig. The vertical line at the 0, T1, T2, and T3 points in time represent the instantaneous
replenishment of the amount of the order quantity, Q, and the negatively sloped lines
between the replenishment points represent the use of the item. Because the inventory
level varies between 0 and the order quantity, average inventory is equal to one-half of
the order quantity, or Q/2.
156
Avg inventory=Q/2
T1 T2 T3
Time
Figure 8.1: Certainty Case of The Inventory Cycle
This model assumes that the costs of placing and receiving an order are the same for
each order and independent of the number of units ordered. It also assumes that the
annual cost of carrying 1 unit of the item in inventory is constant regardless of the
inventory level. Total annual inventory cost, then, are the sum of ordering costs and
carrying costs. The primary objective of the EOQ model is to find the order quantity
Q that minimizes total annual inventory cost.
Algebraic Solution: In developing the algebraic form of the EOQ model, the
following variables are defined
Q= The order quantity, in units
D= The annual demand for the item, in units
S= The Cost of placing and receiving an order, or set-up cost
C= The annual cost of carrying 1 unit of the item in inventory
Ordering costs are equal to the number of orders per year
Is equal to annual demand, D, divided by order quantity, Q, Carrying costs are equal
to average inventory, Q/2, multiplied by the annual carrying cost per unit, C.
The total annual cost equation is as follows:
Total cost = Ordering cost + carrying cost
By substituting the variable just defined into equation-1, the following expression is
obtained:
Total costs = (Number of orders per year
X cost per order) + Average inventory
X annual carrying cost per unit)
Or, in algebraic terms,
Total cost = ( D/Q X S )+(Q/2XC)
The EOQ is the value of Q that minimizes the total costs given in equation-3. the
standard procedure for finding this value of Q involves calculus. The optimal solution,
or EOQ, is equal to the following:
2
Q* = SD / c
Another item of information that sometimes is useful for planning purposes is the
optimal length of one inventory cycle; that is, the time between placements of orders
for the item. The optimal length of one inventory cycle, T*, measured in days, is equal
to the economic order quantity, Q*, divided by the average daily demand, 157
D/365(assuming 365 days per year), as follows:
T*=Q*/D/365
This equation can be rewritten as follows:
T*=365XQ*/D
Graphic Solution
The order quantity that minimizes total annual inventory costs can be determined
graphically by plotting inventory costs (vertical axis) as a function of the order
quantity (horizontal axis). As can be seen in the figure, annual ordering costs, DS/Q,
vary inversely with the order quantity, Q, because the number of orde5rs placed per
year, D/Q, decreases as the size of the order quantity increases. Carrying costs, CQ/2,
vary directly with the order quantity, Q because the average inventory, Q/2, increases
as the size of the order quantity increase
Total cost
Carrying Cost=CQ/2
Cost (Rs.)
Ordering Cost=DS/Q
O Q Q Units
Figure 8.2: Graphic Solution of the EOQ Model

The total inventory cost curve is found by vertically summing the heights of the
ordering cost and carrying cost functions. The order quantity corresponding to the
lowest point on the total cost curve is the optimal solution-that is, the economic order
quantity, Q*.
8.7.2 Extensions of the Basic EOQ Model
The basic EOQ model just described makes a number of simplifying assumptions,
including those pertaining to the demand for the item, replenishment lead time, the
behaviour of ordering and carrying costs, and quantity discounts. In practical
applications of inventory control models, however, some of these assumptions may
not be valid. Thus, it is important to understand how different assumptions affect the
analysis and the optimal order quantity. The following discussion examines what
occurs when some of these assumptions are altered.
158
8.7.3 Non-zero Lead Time
The basic EOQ model assumes that orders to replenish the inventory of an item are
filled instantaneously; that is, the lead time is zero. In practice, however, some time
usually elapses between when a purchase order is placed and when the item actually is
received in inventory. This lead time consists of the time it takes to manufacture the
item, the time it takes to package and ship the item, or both.
If the lead time is constant and known with certainty, the optimal order quantity, Q*,
is not affected. Although the time when an order should be placed is specially a
company, that should not wait to reorder unit the end of the inventory cycle, when the
inventory level reaches zero-such as at points T1 T2, and T3, in figure. Instead, it
should place an order n days prior to the end of each cycle, n being equal to the
replenishment lead time measured in days. The reorder point is defined as the
inventory level at which an order should be placed for replenishment of an item.
Assuming that demand is constant over time, the reorder point, Q1, is equal to the lead
time, n (measured in days), multiplied by daily demand:
Qr = n×D/365
Where D/365 is daily demand (based on 365 days per year)
Order quantity Q
Re order point
Q1
T1 n T1 T2 n T2 T3 n T3 Time
Figure 8.3: Nozed Replenishment Lead Case of an Inventory Cycle
8.7.4 Quantity Discounts

Large orders often permit a company to realize substantial per-unit savings (that is,
economies of scale) in manufacturing, order processing, and transport. Many
companies encourage their customers to place large orders by passing on to them a
portion of these savings in the form of quantity discounts. With a quantity discount,
the cost per unit to the customer is variable and depends on the quantity discount on
the optimal order quantity.
First, the EOQ is determined, using equation next, the annual net returns when the
order quantity is increased from the EOQ level up to the size necessary to receive the
discount are calculated. The annual net returns are equal to the discount savings on the
annual demand less any increase in annual inventory costs, as defined in equation, if
the annual net returns are positive, the optimal order quantity is the order size
necessary to receive the discount: if they are not, the optimal order quantity is the
smaller EOQ value.
8.7.5 Probabilistic Inventory Control Models

The far the analysis has assumed that demand or usage is uniform throughout time and
known with certainty, as well as the lead time necessary to procure additional
inventory is also fixed, known value. However, in most practical inventory
management problems either (or both) of these assumptions may not be strictly
correct. Typically, demand fluctuates over time due to seasonal, cyclical, and
“random” influences, and imprecise forecasts of future demands often are all that can
be made. Similarly, lead times are subject to uncertainty because of such factors as 159
transportation delays, strikes, and natural disasters. Under these conditions, the
possibility of stock outs exists. To minimize the possibility of stock outs and the
associated stock out costs, most companies use a standard approach of adding a safety
stock to their inventory. A safety stock is maintained to meet unexpectedly high
demand during the lead, unanticipated delays in the lead time, or both.
Figure shows the inventory pattern characterized by these more realistic assumptions.
During the first inventory cycle (0-T2), an order to replenish the inventory is placed at
T1, when the inventory level reaches the predetermined order point. The order then is
received at T2. The second (T2-T4) is similar to the first, except that demand exceeds
the normal inventory of the item, and part of the safety stock is consumed during the
lead time prior to receipt of the order at T4. During cycle 3(T4-T6), demand exceeds
the normal inventory plus the safety and, as a result, a stock out occurs during the lead
time prior to receipt of the order at T6.
Determining the optimal safety stock and order quantities under these more realistic
conditions is a fairly complex process. However, the factors that have to be considered
in this type of analyzing can be identified briefly. All other things being equal, the
optimal safety stock increases as the uncertainty associated with the demand forecasts
and lead times increases. Likewise, all other things being equal, the optimal safety
stock increases as the cost of stock outs increases. Determining the optimal safety
stock involves balancing the expected costs of stock outs against the cost of carrying
the additional inventory.
Illustration 1
Determine reorder level, minimum level, maximum level, and average stock level.
Normal usage – 100 units per week; Lead-time – 4 to 6 weeks
Minimum usage – 50 units per week; Maximum usage – 150 per week
Re-order quantity - 600 units
Solution:
Reorder Level = Maximum usage × Maximum delivery time
= 150 units × 6 weeks = 900 units
Minimum Level = Re-order level – (Normal Usage × Average delivery time)
= 900 units – (100 units × 5 weeks) = 400 units
Maximum Level = Reorder level + reorder quantity – (minimum usage x minimum
delivery time)
= 900 units + 600 units – (50 units × 4 weeks) = 1,300 units
Average Stock Level = Minimum level + (reorder quantity ÷ 2)
= 400 units + (600 units ÷ 2) = 700 units
Illustration 2
A company purchases a component of a product at the rate of Rs. 50 per piece. The
annual consumption of that component is 25,000 pieces. if the ordering cost is Rs.230
per order and carrying cost is 20 per cent per annum, what would be the EOQ?
Solution
Annual usage – 25,000 units; Cost of placing and receiving one order - Rs. 230
Cost of materials – Rs. 50 per unit; Annual carrying cost of one unit – 20 per of
inventory value
EOQ = 2AO ÷ CCEOQ = (2 x 25,000 x 230) ÷ (50 × 20/100) = 1,072 units.
160 Illustration 3
Hindustan Engineering Factory consumes 75,000 units of a component per year. The
ordering, receiving and handling costs are Rs. 6 per order while transportation cost is
Rs.24 per order. Depreciation and obsolescence cost Re. 0.008 per unit per year;
interest cost Re. 0.12 per unit per year; storage cost Rs. 2,000 per year for 75,000
units. Calculate EOQ.
Solution
Annual usage – 75,000 units; Cost of raw materials – Rs. 8 per unit
Ordering cost = (Ordering cost + Transportation cost ) = (Rs. 6 + Rs. 24) = Rs. 30
Carrying cost of one unit: Re

Interest cost 0.12
Deterioration and obsolescence cost 0.008
Storage cost (2,000 ÷ 75,000) 0.026
Total carrying cost 0.154
EOQ = (2 × 75,000 × 30) ÷ 0.154 = 5, 406 units
8.8 LET US SUM UP

Inventory management is concerned with keeping enough product on hand to avoid
running out while at the same time maintaining a small enough inventory balance to
allow for a reasonable return on investment. Proper inventory management is
important to the financial health of the corporation; being out of stock forces
customers to turn to competitors or results in a loss of sales. Excessive level of
inventory, however, results in large inventory carrying costs, including the cost of the
capital tied up in inventory warehouse fees, insurance etc.
A major problem with managing inventory is that the demand for a corporation’s
product is to a degree uncertain. The supply of the raw materials used in its production
process is also somewhat uncertain. In addition, the corporation’s own production
contain some degree of uncertainty due to possible equipment breakdowns and labour
difficulties. Because of these possibilities, inventory acts as a shock absorber between
product demand and product supply. If product demand is greater than expected,
inventory can be depleted without losing sales until production can be stepped up
enough to select the unexpected demand. However, inventory is difficult to manage
because it crosses so many lines of responsibility. The purchasing manager is
responsible for uninterrupted production and wants to have enough raw materials and
work-in process inventory on hand to avoid disruption in the production process. The
marketing manager is responsible for selling the product and wants to minimize the
chances of running out of inventory. The financial manager is concerned about
achieving an appropriate overall rate of return. Funds invested in inventory are idle
and do not earn a return.

AIM Company Ltd. uses quarterly 50,000 units of raw materials. Cost of raw
materials is Rs.100 per unit, Cost of placing an order is Rs. 120 and carrying cost is 9
per cent per year. Calculate EOQ.
161
8.10 KEYWORDS Inventory Management
Time line: A diagram specifying the timing of cash flows.

Terminal value: The value of an asset at some point of time in future.
Tombstone: An advertisement that announces a public offering.

1. Discuss the concept of inventory management and explain its importance.
2. What are the different controls required for inventory management?
3. Discuss the different models of inventory controls.

CYP 1
1. Inventory management is concerned with keeping enough product on
hand to avoid running out while at the same time maintaining a small
enough inventory balance to allow for a reasonable return on investment.
Proper inventory management is important to the financial health of the
corporation; being out of stock forces customers to turn to competitors or
results in a loss of sales.
2. Every time an order is placed for stock replenishment, certain costs are
involved. The ordering cost may vary, dependent upon the type of item.
However, an estimate of ordering cost can be obtained for a given range
of items. This cost of ordering includes: Paper work costs, typing and
dispatching an order.
CYP 2
1. EOQ = (2 × 480 x 5) ÷ 0.40 = 109.54 or 110 units
2. No. of orders per year = Demand per year ÷ EOQ size = 480 ÷ 110 = 4.36
orders.
3. Frequency of purchase = No. of months in a year ÷ No. of orders per year
= 12 ÷ 4 = 3 months.

P. Gopala Krishnan and M.S. Sandilya, Inventory Management, Macmillan,1978.
J. Mc N Stancill, The Management of Working Capital, Intext, 1971.
K.V. Smith, Readings in the Management of Working Capital, West Publishing Company,
1980.
163
Instruments of
the International Money Market
UNIT 1
UNIT IV
164
LESSON 165
Instruments of
the International Money Market
9
INSTRUMENTS OF
THE INTERNATIONAL MONEY MARKET
CONTENTS
9.1 Introduction
9.2 The Role of the International Market
9.3 Selected Instruments of the International Money Market
9.3.1 Eurocurrency Time Deposits and Certificates of Deposit
9.3.2 Banker’s Acceptances and Letters of Credit
9.3.3 Euronotes and Eurocommercial Paper
9.3.4 Medium-term Notes and Deposit Notes
9.4 Let us Sum up
9.6 Keywords

z The concept of international market instruments.
z The role of the international market
z The selected instruments of international market
9.1 INTRODUCTION
The international money market can be regarded as the market for short-term
financing and investment instruments that are issued or traded internationally. Such
instruments include short-term bank loans, Treasury bills, bank certificates of deposit,
commercial paper, bankers’ acceptances and repurchase agreements, and other short-
term asset-backed claims. The core of this market is the Eurocurrency market, where
bank deposits are issued and traded outside the country that issued the currency.
However, each of the instruments is a substitute to a degree for each of the other
instrument, and the yield and price of each is sensitive to many of the same influences,
so we may feel justified in lumping them together in something called a market. The
fact that many of the other instruments of the international money market are priced
off LIBOR, the interest rate on Eurodollar deposits, suggests that market participants
themselves regard the different instruments as having a common frame of reference.
166
Working Capital Management 9.2 THE ROLE OF THE INTERNATIONAL MARKET
As a key element of the financial system of a country, the money market plays a
crucial economic role: that of reconciling the cash needs of so-called deficit units with
the investment needs of surplus units. Holding or borrowing liquid claims is more
productive than holding cash balances. A smoothly functioning money market can
perform these functions very efficiently if borrowing-lending spreads (or bid-offer
spreads for traded instruments) are small (operational efficiency), and if funds are lent
to those who can make the most productive use of them (allocation efficiency). Both
borrowers and lender prefer to meet their short-term needs without bearing the
liquidity risk or interest-rate risk that characterizes longer-term instruments, and
money-market instrument allow this. In addition, money-market investors instruments
are generally characterized by a high degree of safety of principal. Instruments are
generally characterized by a high degree of safety of principal. Thus the money
markets sets a market interest rate that balances cash management needs, and sets
different rates for different uses that balance their risks and potential for productive
use. Unlike stock or futures markets, the money markets of the major industrial
countries have no central location.
Check Your Progress
Fill in the blanks:
1. The international money market can be regarded as the market for

______________ financing and investment instruments that are issued or
traded internationally.
2. Deposit notes are simply ______________ issued internationally.
3. Both Euro notes and Euro commercial papers are ______________

instruments.
9.3 SELECTED INSTRUMENTS OF THE INTERNATIONAL

MONEY MARKET
9.3.1 Eurocurrency Time Deposits and Certificates of Deposit
The overwhelming majority of bank deposits in the Eurocurrency market takes the
form of non-negotiable time deposits. To illustrate, consider an investor who puts
money in London branch, today; he gets is back, plus interest, in three months’ time.
Canceling a time deposit is awkward and expensive, so the investor sacrifices
liquidity. Those who want greater liquidity invest in shorter maturities. A very high
proportion of Eurodollar time deposits, especially in the inter bank market, mature in
one week or less.
Alternatively, the investor can buy a negotiable Euro certificate of deposit (Euro CD),
which is simply a time deposit that is transferable and thus has the elements of a
security. Some banks are a little reluctant to issue CDs, because they would prefer not
to have their paper traded in a secondary market, especially at times when the bank
might be seeking additional short-term funding. The secondary paper might compete
with the primary paper being offered. Others will issue CDs readily if investors prefer
them, perhaps paying 1/8 per cent of more below their equivalent time-deposit rate to
reflect the additional liquidity and the some what greater documentary inconvenience
of CDs.
Other banks (particularly if they wish to have their names better known in the market)
might deliberately undertake a funding a program using Euro CDs. In this
circumstance, the CDs, are to be distributed like securities, so as to increase awareness 167
Instruments of
of the issuer’s name and rise a longer volume of funds for longer maturities than the International Money Market
might be possible in the conventional Euro deposit market.
9.3.2 Banker’s Acceptances and Letters of Credit

Banker’s acceptances are money market instruments arising, typically, from
international trade transactions that are financed by banks. The banker’s acceptance
(BA) itself represents an obligation by a specific bank to pay a certain amount on a
certain date in the future. To simplify a bit, it is a claim on the bank that differs little
from other short-term claims such as CDs. Indeed BAs, when they are traded in a
secondary market, trade at a return that seldom deviates much from comparable CDs
issued by the same bank. Letter of credit (L/C) are documents issued by banks in
which the bank promises to pay a certain amount on a certain date, if and only if
documents are presented to the bank as specified in the terms of the credit. A letter of
credit is generally regarded as a very strong legal commitment on the part of a bank to
pay if the conditions of trade documents are fulfilled.
In a typical export transaction, the exporter will want to be paid one the goods arrive
(and are what they are supposed to be) in the foreign port. So the exporter asks for
acceptance by the importer’s bank of a time draft (essentially an invoice that requests
a money-market instrument. Banker’s acceptances are sold at discount from face
value, like treasury bills and commercial paper, and yield are quote3d as discount
yields. Why should the bank pay the exporter? The reason is that it has promised the
exporter that it will do so upon presentation of documents conveying title to the
goods. That promise is called the letter of credit.
Standby letters of credit are related instruments entailing a commitment to pay on the
part of a bank, but they normally do not involve the direct letter of credit says
unconditionally that “I’ll pay your X dollars on Y date if and your receive the money.
Standby letters of credit are used to support bid and performance bonds, advance-
payment guarantees, and other financial commitments. Nowadays, they are also
widely used as a sort of guarantee, or more precisely a substitute for someone else’s
obligation. For example, a relatively unknown Japanese bank, Hokkaido Trust, might
wish to issue a CD in the U.S. market. In exchange for a fee and perhaps the pledging
of CD with a letter of credit. Sanwa has, in effect, substituted its own liability for that
of Hokkaido Trust, investors prefer in L/C to a guarantee, which obligates the
guarantor to pay only if the original obligor fails to do so. The letter of credit, in
contrast, is unconditional: it is payable by the issuer of the L/C simply against a draft.
9.3.3 Euronotes and Eurocommercial Paper

Both Euro notes and Euro commercial papers are short-term instruments, unsecured
promissory notes issued by corporations and banks. Euro notes, the more general
term, encompasses note-issuance facilities, those that are underwritten, as well as
those that are not underwritten. The term Euro commercial paper is generally taken
to mean notes that are issued without being backed by an underwriting facility—that
is, without the support of a medium-term commitment by a group of banks to provide
funds in the event that the borrower is unable to roll over its Euro notes on acceptable
terms. Most actual issuance in the Euro note market takes the form of non
underwritten Euro commercial paper (ECP), so the actual paper that an investor will
find available for investment is likely to be ECP.
Like U.S. commercial paper, Euro notes and ECP are traded by convention on a
discount basis, and interest is calculated as “actual/360,” meaning that the price is set
as 100 minus the discount interest rate multiplied by the actual number of days to
maturity, over 360.
168
9.3.4 Medium-term Notes and Deposit Notes
The role of international banks in arranging and managing Euro commercial paper
facilities in the international credit market has evolved from one of providing loans, to
include the underwriting of syndicated facilities and perhaps trading the participations,
and finally to being the auctioneer in the distribution of corporate paper. The latter
role has carried over into an offshoot of the commercial-paper market, the medium-
term note (MTN) market, Deposit notes are simply MTNs issued by international
banks. International institutions such as the World Bank are prominent issues.
Medium-term notes are in many respects simply fixed-rate corporate bonds but of a
generally shorter maturity than Euro bonds or domestic bonds. As an investment
vehicle, the MTN is often regarded by institutional investors as a temporary
investment that can be designed to suit the particular investor’s requirements. The
reason is that MTNs, unlike conventional bonds, are offered on a continuous basis in
smaller amounts—as little as $2 to $5 million at a time—rather than in single large
issues. An investor such as a pension fund might have $7 million to invest for 11
months in a good corporate name. he will call several MTN dealers to see what
companies are borrowing, and when he makes his choice the note will be issued
specifically for the investor. This specificity explains why MTN financing
programmes are often described as “investor driven.” In effect, the distribution
process in the MTN market resembles a commercial-paper-issuance programme,
although without the backstop lines of credit that commercial paper programmes
typically have. Under a comprehensive MTN issuance programmes, an issuer can
raise funds by issuing fixed-rate, floating-rate, or deep-discount paper in any of a
number of currencies. Liquidity is provided by either one or a number of “committed”
dealers.
The MTN and its offshoots have turned-out to be one of the most important
developments in longer-term funding in the 1980s. the MTN is a commercial-paper-
like instrument that has a maturity rivaling that of a corporate bond. Indeed medium-
term notes are issued today with maturities ranging from 9 months to as much as 30
years—a lost longer than is available in the Euro bond market. The notes are typically
unsecured but need not be. They pay interest on a 30/360—day basis, unlike deposits
that pay on actual/360 terms. Some have floating rates based on an index such as
LIBOR, just like floating-rate notes. Unlike corporate bonds, few are callable. Like
commercial paper, most domestic MTNs are rated, whereas most Euro-MTNs are
unrated. Their most significant distinguishing feature is a subtle one—the fact that
their issuance and even maturity is largely investor determined. Not issuer determined.
Corporate bonds are issued infrequently and often entail relatively heavy issuance
costs, so the borrower wants to do the issue in large amounts as a known cost and get
it distributed as widely as possible. This means that there must be an underwriting
syndicate. Not so with MTNs or deposit notes; paper is issued through dealers at the
time, in the amount, and for the maturity that the investor wants. MTNs and deposit
notes issued by to-name banks have achieved the status of a commodity; very few
Euro bonds have.
In the primary market, MTNs by their nature lack the magnitude of placing power of
identical bonds issued in a big corporate bonds issued in a big corporate bonds issue,
but they have borrowed so many of the successful features of the commercial paper
market—such as broker-sponsored programmes, continuous offerings of primary
paper, and good market-marker support—that they have replaced underwritten Euro
bonds and domestic bonds as the preferred source of longer-term funds for major
international banks.
In the secondary market, one potential problem with MTNs from the investor’s point
of view is that if each note is tailored to a specific investor’s needs, then it is
somewhat unique and hence is likely to lack liquidity. To be able to price a security
and to buy or sell it without difficulty, there should be a reasonable amount of the 169
Instruments of
same or closely comparable securities outstanding in the market. Two approaches the International Money Market
have been taken to help improve liquidity, at the expense of some flexibility:
1. Use multitranche tap notes: Under this structure, the borrower must issue a
minimum amount of paper, such as $50 million, in each tranche. Beyond the
minimum the issue can be expanded to satisfy demand; but the minimum ensures
that there is always a reasonable quantity of paper outstanding with identical
characteristics.
2. Insist upon standard annual or semiannual coupon dates, irrespective of the
note’s issuance and maturity dates. Normally a bond issued on April 1 would have
its first annual coupon paid a year later, on March 31.
The yield on a MTN is calculated in the same way as a bond yield. That is, it is the
internal rate of return that gives the cash flows a present value equal to the total price
of the instrument.
9.4 LET US SUM UP

The international money market can be regarded as the market for short-term
financing and investment instruments that are issued or traded internationally. Such
instruments include short-term bank loans, Treasury bills, bank certificates of deposit,
commercial paper, bankers’ acceptances and repurchase agreements, and other short-
term asset-backed claims. The core of this market is the Eurocurrency market, where
bank deposits are issued and traded outside the country that issued the currency.
However, each of the instruments is a substitute to a degree for each of the other
instrument, and the yield and price of each is sensitive to many of the same influences,
so we may feel justified in lumping them together in something called a market. The
fact that many of the other instruments of the international money market are priced
off LIBOR, the interest rate on Eurodollar deposits, suggests that market participants
themselves regard the different instruments as having a common frame of reference.

“The overwhelming majority of bank deposits in the Eurocurrency market takes the
form of non-negotiable time deposits.” Discuss with examples.
9.6 KEYWORDS
Euro Notes and EC: Like U.S. commercial paper, Euro notes and ECP are traded by
convention on a discount basis, and interest is calculated as “actual/360” meaning that
the price is set as 100 minus the discount interest rate multiplied by the actual number
of days to maturity, over 360.
Banker’s acceptances: These are money market instruments arising, typically, from
international trade transactions that are financed by banks.
Money Market Instruments: Such instruments include short-term bank loans,
Treasury bills, bank certificates of deposit, commercial paper, bankers’ acceptances
and repurchase agreements, and other short-term asset-backed claims.

1. What is the role of the international markets?
2. Explain the some of the selected market instrument of the international money
market.
170
1. Short-term;
2. MTNs;
3. Short-term.

Publications.
Prasanna Chandra, Financial Management, Theory and Practice, Tata McGraw Hill.
Khan and Jain, Financial Management, Tata McGraw Hill.
171
LESSON Floating Rate Notes
10
FLOATING RATE NOTES
CONTENTS
10.1 Introduction
10.2 Features of FRNs
10.3 Pricing FRNs
10.3.1 The Discount Margin and the Neutral Price
10.3.2 Caps, Floors, Calls and Puts in FRNs
10.4 Returns on Money-market Instruments
10.5 Let us Sum up
10.7 Keywords
10.8 Questions of Discussion

z The concept of FRNs
z The features of FRNs
z The various pricing systems
z The returns from FRNs
10.1 INTRODUCTION
The floating-rate note is, as the name implies, an instrument whose interest rate floats
with prevailing market rates. Like Euro dollar deposits, it pays a three—or six-month
interest rate set above, at, or below LIBOR. Like international loans, this interest rate
is reset every three or six months to a new level based on the prevailing LIBOR level
at the reset date. More precisely, floating-rate notes issued outside of the country of
the currency of denomination n are issued in the form of Euro bonds, which makes
them in some respects as much a capital-market instrument as a money-market
instrument. But the frame work we use place pricing at the center of what defines an
instrument, and FRNs are priced in part like money-market instruments and in part
like conventional fixed-rate bonds.
The floating-rate note has grown up with the Euro market as a whole. The instrument
was introduced in the early 1970s after many investors had gotten their fingers burned
by dabbling in the fixed-rate Euro bond market, in which prices fell as inflation drove
172 interest rates up to historically high levels. Investment bankers though that they would
have a ready demand for floating-rate notes among those investor who wanted loner-
maturity instruments than bank deposits, ones that would maintain their value in the
face of higher interest rates. It turned out that the biggest buyers of floating rate notes
among those investors who wanted longer-maturity instruments than bank deposits,
ones that would maintain their value in the face of higher interest rates. It turned out
that the biggest buyer of floating-rate notes were not banks’ customers, but banks
themselves. Some saw them as another trading instrument: buy today, sell later at a
profit. Most, however, bought them as medium-term substitutes for loans. Some, with
a low cost of funds but a dearth of prime borrower customers, were looking for a way
to earn a spread with little risk or effort. Other banks preferred them to bank loans
because they were treated by the regulators as securities, a treatment that improved the
liquidity of the banks’ asset portfolios. Whatever the reason, the bulk of FRNs are
today held by financial institutions whose cost of funds varies with short-term rates,
because an FRN pays a rate that is tied to changes in short-term interest rates.
10.2 FEATURES OF FRNS

All floating-rate notes have a coupon that is reset at fixed intervals in accordance with
some preset formula, but there are many variations on this theme. Most FRNs can be
characterized by the following features:
z The reference rate: The reference rate is the interest rate to which the coupon
payment is linked. This is normally a short-term rate, so that some see FRNs as a
substitute for money-market instruments. In the Euro markets, the reference rate is
usually LIBOR, although a few FRNs have used other reference rate (such as
LIBID, LIMEAN, or the U.S.-Treasury-bill rate). The rate is normally reset at the
beginning of each coupon period, and interest is paid in arrears.
z The margin: The margin is the spread between the coupon payment and LIBOR.
Coupon payment on FRNs are generally LIBOR plus (or minus) some fixed
amount. This spread reflects the differential risk at the time of issue between
investing in the FRN and investing in a bank deposit paying LIBOR. LIBOR itself
is usually about 1/8 per cent higher than prime banks’ bid rate in the inter bank
market, reflecting the risk of the bank with which funds would be deposited, and
perhaps a discount for illiquidity. An FRN carries the default risk of the issuer
over the life of the note and the liquidity risk of a tradable, but not necessarily
traded, security.
z The reference-rate period: The reference-rate period is the maturity of the
security to which the FRN’s coupon is linked, such as three—or six-month Euro
dollar deposits. And FRN coupon is quoted as the LIBOR—period rate and the
margin—for example, six-month LIBOR plus 3/16 per cent.
z Frequency of reset: Reset frequency is the period between coupon-reset dates and
normally coincides with the reference-rate period.
z Coupon-payment frequency: This is the interval between coupon payments, and
normally coincides with the coupon-reset periods.
z Maturity: The date on which the principal on an FRN will be redeemed is the
maturity date. Many FRNs have call features—that is, the issuer may, at its
option, redeem the FRN at certain prespecified dates prior to maturity.
A “plan vanilla” FRN is a fixed-maturity bond whose reference-rate period, frequency
to reset, and coupon-payment period are of different lengths. The rate is reset monthly
but paid semiannually. The coupon is the arithmetic mean of the six one-month
interest periods within the six-month coupon period.
Each FRN has a specific method for calculating the LIBOR rate to be used as a 173
reference rate to reset coupons. The method is usually as follows: Floating Rate Notes

1. What is floating rate note?
…………………………………………………………………………….
…………………………………………………………………………….
2. What is reference rate?
…………………………………………………………………………….
…………………………………………………………………………….
10.3 PRICING FRNS

In some respects, an FRN is like a short-term money-market instrument. The rate on
the FRN at issue is set high enough that the note is worth 100. at each reset period, the
rate is raised or lowered to match the prevailing market rate. So, credit-risk changes
aside, its price should return to 100. that means you could buy it today (a reset date)
and sell it six months later at par, collecting your six-month coupon—just like a Euro
dollar CD. Even if the investor made some other assumption about the rollover price
(the price at the next reset date), he could use this approach to calculate the money-
market return.
This is somewhat naïve approach the money-market method. It is helpful to those
who wish to compare the yield on an FRN held as a short-term investment in lieu of
another money-market instrument, and the fact that the rate is reset to market offers
some comfort to such investors, but not much: FRNs are medium—or long-term
bonds, and their prices at reset dates can deviated, and have deviated, far from par, for
reasons associated with general FRN market conditions as well as the credit
worthiness of the specific issue. Thus we can identify three distinct influences on the
price of an FRN:
1. Credit condition of the issuer: The price at the reset date will fall below par if the
promised margin relative to LIBOR is perceived as insufficient reward for an
issuer’s deteriorated credit condition. The most direct measure is the issue’s credit
rating. A note issued as a AA may be downgraded to A or worse for reasons
specific to the issuer.
2. Market perceptions of FRNs in general: Changes in investors’ perceptions of the
FRN market as a whole or of a particular segment of the market may cause a
particular issuer’s FRN to trade above or below par on reset dates. In the early
days of the market, many issues were seen as generously priced and trade above
100. then in the late 1980s, the opposite happened. Subordinated bank debt was
priced in much the same way as unsubordinated debt until the Bank of England
changed its rules concerning the investment by one bank in the debt of another
bank. After the change, the market reassessed the relative risk of subordinated to
unsubordinated FRNs. This reassessment resulted in a sharp widening of required
margins and a fall in bid prices on subordinated debt relative to unsubordinated
debt of the same issuers. The most visible and devastating effect was on the price
of perpetual FRNs.
3. Money-market rate: The FRN price will be affected by changes in short-term
rates—specifically, the level of LIBOR between now and the next coupon reset
date. A change in this rate will change the FRN’s valued as if it were a money-
market instrument maturing on the reset date.
174 The method used for pricing and comparing FRNS reflects the fact that they are, in
some respects, bond instruments and, in some respects, money-market instruments.
When comparing two straight bonds, the standard approach is to consider the yield to
maturity of each bond and the liquidity and credit risk of the bonds. They yield is
sometimes expressed as a spread over “ benchmark” U.S. treasury yields, but because
the FRN’s coupon rate fluctuates, the standard yield measures are useless. From this
reason, and because so many FRNs are held by those seeking a spread over their
short-term cost of funds, the market has developed a measure of an FRNs effective
spread over LIBOR: To get the effective spread over the instrument’s remaining life.
We adjust the quoted margin by amortising the premium or discount at which the
FRN is trading. The discount-margin approach is the industry standard for
comparing FRN spreads.
10.3.1 The Discount Margin and the Neutral Price

The discount margin is a measure of the effective spread, relative to LIBOR, that an
investor would earn if he bought the FRN at some price today and held it to maturity.
It is the margin relative to LIBOR that is necessary to discount the cash flows from an
FRN so that the sum of the present value of the flows is equal to the gross price of the
note. It is calculated in a manner similar to the yield to maturity of a fixed-rate bond.
Because the coupon stream is uncertain, it is necessary to make some assumption
about average LIBOR from the next coupon date until maturity, although fortunately,
the discount margin is not very sensitive to the assumption made. Naturally, nobody
can be sure what rates will prevail over the life of the FRN, but one acceptable method
is to use the implied forward rate for the remaining life fro the yield curve for is
preferable because, an FRN can be converted into the equivalent of a fixed-rate
instruments. Better still, use the swap yield curve: this is preferable because, an FRN
can be converted into the equivalent of a fixed-rate bond using and interest-rate swap.
FRN prices are conventionally quoted clean—that is, not including accrued interest.
Accrued interest is calculated on a money market actual/360-day basis by using the
formula A= (LIBOR + Quoted margin)(Days/360). The variable Days is the actual
number of days from, and including, the date of the last coupon up to, but excluding,
the settlement date. The gross price is the clean price plus accrued interest—that is,
the total price paid.
The discount margin (DM) is found by solving, by iteration, the following equation
for DM:
( L + QM ) / m
P+A=
Ls + DM Ds
1+ .
100 360
⎛ ⎞
⎜ 1 ⎟
⎜ ⎟
⎜⎜ 1 + Ls + DM . Ds ⎟⎟
⎝ 100 360 ⎠
⎛ ⎞
⎜ ( La + QM ) / m 100 ⎟
⎜∑ + ⎟
⎜ ( L a + QM ) / m ( La + QM ) / m ⎟
⎜ 1+ 1+ ⎟
⎝ 100 100 ⎠
where
P = today’s price
A = Accrued interest, (LIBOR + Quoted margin)
(Days since last coupon/360)
QM= Quoted margin 175
Floating Rate Notes
DM= Discount margin
L = Current LIBOR in effect, so that L + QM is the current coupon
Ls = LIBOR for time between settlement and next coupon date
La = Assumed average LIBOR rate over remaining life of FRN
(using the swap rate)
Ds = Days from settlement to next coupon date
m = Number of coupon periods per year
n = Number of coupon periods to maturity
This formula looks complicated but it’s really not. It simply discounts the note’s cash
flows as in a fixed-rate bond. The equation is having three parts:
Total price paid equals present value of next coupon plus sum of present values of
all subsequent coupons plus present value of final principal repayment.
For some investors it is useful to abstract from the money-market aspect of a FRN to
gauge the extent to which changes in risk, rather than in short-term rates, have
affected the note’s price. This analysis can be done by waiting until a coupon date to
see whether the FRN trad4es at on a coupon date to ensure that the investor the FRN
would have to trade at on a coupon date to ensure that the investor receives the
discounted margin. This price is known as the neutral price; it may be considered the
price at which a new issue with the same quoted margin as the FRN would be set in
order to give a return equal to the discounted margin.
The discounted margin neutral price is the price of the floating-rate more on the next
coupon date that gives a return over the period from the settlement to the next coupon
equal to the rate plus the discounted margin:
⎛ ⎞
⎜ 1 ⎟
⎜ ⎟ − coupon
⎜⎜ Ls + DM . Ds ⎟⎟
⎝ 100 360 ⎠
Where
P = Today’s price
A = Accrued interest
DM= Discounted margin
Ls = LIBOR for the time from settlement to the first coupon
Ds = Days from settlement to first coupon date.
The neutral price will move toward par as the time to maturity decreases.
10.3.2 Caps, Floors, Calls and Puts in FRNs

Many floating-rate notes have option features. Most, in fact, have a minimum coupon
level; this is called a floor. Some have a maximum coupon level, called a cap. An
FRN that has both a floor and a cap is said to be collared.
From the investor’s viewpoint, buying a floored FRN may be regarded as purchasing
a plain FRN plus a strip of European call options on LIBOR with strike prices equal to
the floor level minus the margin. On each coupon date, the investor receives LIBOR
plus the margin, plus the intrinsic value of the option, if any. In the early 1990s, many
176 FRNs were issued with both caps and floors. In effect, the investor sold a cap with
sufficient value to pay for the floor.
A “cap floater” may be considered as an uncapped FRN, plus a strip of European puts
on LIBOR that the investor has sold, with a strike price equal to the cap level minus
the margin. The number of puts equals the number of reset periods in the note’s
remaining life. The investor is paid in the form of a higher stated margin or a lower
price than plain-vanilla FRNs—in other words, with a higher discounted margin.
Credit considerations aside, the neutral price of a capped or floored FRN will depend
on the volatility of inertest rates, the level of interest rates, and the shape of the yield
curve. How a cap or a floor affects an FRN’s price depends on the value of the
embedded options: for a floor, the strip of long calls; for a cap, the strip of short puts.
The value of both caps and floors depends on the forward rates implied in today’s
LIBOR yield curve. With an upward-sloping yield curve and steeply rising implied
forward rates, the strip of calls embedded in a floor may be much further out-of-the-
money than on would guess by simply comparing the floor level with today’s LIBOR
rate. The reverse is true for a cap; with an upward-sloping yield curve, the high
forward rates place the cap further into-the-money (or closet to being in-the-money).
As the yield curve moves upward and steepens, caps become relatively expensive,
hurting the investor and lowering the capped FRN’s neutral price.
This and other effects of caps and floors on FRN’s prices of changing interest rates are
summarized below:
Effect on Neutral Effect on Neutral
Price of Capped FRN Price of Floored FRN
Interest-Rate Volatility Falling Increases Decreases
Rising Decreases Increases
Interest-Rate Level Falling Increases Increases
Rising Decreases Decreases
Shape of Yield Curve Flattening Increases Increases
Steepening Decreases Decreases
Many floating-rate notes are callable by the issuer, others are puttable by the investor,
and some are both, in all cases the call or put provisions are exercisable only on
coupon reset dates. As a result the call or put decision is influenced only by credit-risk
considerations and not by interest rates. This is in sharp contrast to similar provision is
fixed-rate bonds. FRNs tend to be called when the issuer can refinance at a cheaper
spread (as indicated by the discount margin) and put when the investor can get a better
spread for the same credit risk, irrespective of the level of rates. Investors find that
how callable FRNs trade depends on the note’s neutral price compared to the call
price (which is normally the issue price.) callable FRNs with a neutral price
significantly above the call price will tend to trade as if the call date were the
redemption date. If a call date is approaching, the discount margin, measured to the
call date, will be similar to the spread the borrower pays on its floating-rate note is
similar to that in a note-issuance facility: it is the right, but not the obligation, to
borrow at a preset spread.
177
Check Your Progress 2 Floating Rate Notes
Fill in the blanks:
1. _____________________is the rate that equates the present value of all
future interest and principal payments with the market price of the
instrument.
2. The _____________ is the interest rate to which the coupon payment is
linked.
3. The coupon is the _____________ of the six one-month interest periods
within the six-month coupon period.
10.4 RETURNS ON MONEY-MARKET INSTRUMENTS

The finance manger consider the alternative money-market instruments by comparing
their returns, risks, and other characteristics. In principle, the range includes all the
instruments in two dozen or so domestic money-markets open to international
investors. Realistically, though, one would normally limit one’s attention to a few
major currencies and to the more liquid instruments.
The basic idea of a return is the investor who invests a sum of money today expects
more to get back at a later date. The increases, expressed as an annualized percentage
of the original investment, is typically how we measure return. Thus if you invest
Rs.100 today and you receive Rs.114 in one year the return is 114 per cent. In practice
this idea takes three different forms: (1) the bank discount rate, (2) the add-on yield,
and (3) the yield to maturity, known in the Euro markets as the bond-equivalent yield.
1. The bank-discount-rate method is a formula devised to make calculations easy to
do by hand, but its use persists in these days of financial calculators and
computers, for money-market instruments such as Treasury bills, banker’s
acceptances, and commercial paper. These carry no coupon but are sold on a
discount basis from a face-principal value of 100. the yield quoted on such
instruments is calculated as follows:
Discount 360
Bank discount rare = ×
100 Days
Where Discount is the dollar amount of discount from the face value of $100 and
Days is the actual number of days to maturity.
For example if the discount on $100 of commercial paper were $1.50 and it has 92
days to maturity, its yield on a discount rate basis would be
1.50 360
× = 5.87per cent
100 92
Not only is the percentage return based on the maturity value rather than the
amount invested, but also the formula assumes 360 rather than 365 days in the
year. This convention may be summarized as discount basis, actual/360.
2. The add-on yield is used in Euro dollar and Euro currency-deposit calculation,
because these are typically issued at a price of 100 and the coupon added on at the
end. The formula changes to:
Interest payment 360
Add-on yield = ×
100 Days
178 where
Interest payment is the dollar amount of payment made at maturity on an
investment of $100 days are the number of days to maturity.
For example, if the interest payment on a 90-day Eurodollar deposit is V2.50, then
the add-on yield is 10 per cent.
The trouble with the add-on yield is that it ignores compounding, which can be
important because a one-year Euro deposit that pays interest semiannually is more
desirable than one that pays annually. To take compounding into account we need
the yield to maturity or the bond-equivalent yield.
3. The bond-equivalent yield or yield to maturity is the rate that equates the present
value of all future interest and principal payments with the market price of the
instrument. If as in the Euro bond market, interest is paid annually, we can solve
the following equation for r, the yield to maturity.
1 1 1 FV
P= + + ... + =
1 + r (1 + r) 2
(1 + r) 2
(1 + r 2 )
where
PV = the present market price of the instrument
I = the annual coupon payment
n is the number of year to maturity
FV is the face value of the instrument (usually 100)
For a portion of a year we use the 30/360 convention, which assumes that each
month has 30 days and each year 360 days.
To find the yield to maturity when interest is paid m times per year, we find r such
that:
I/m I/m I/m FV
PV = + + ... + +
1 + r / m ( I + r / m) 2
( I + r / m ) (1 + r / m )
mn mn
The first mn terms form a geometric progression, so PV can be simplified to
I / m ⎡1 − (1 + r / m ) ⎤
− mn
PV = ⎣ ⎦+ FV
(1 + r / m )
mn
r/m
which is more convenient formula because it can be calculated in one cell of a

spreadsheet.
The frequency of payment will make a difference to the effective yield to maturity.
The more frequent the payment, the greater the effective yield, because it is always
nicer to get money sooner. A common way of comparing apples with apples in the
Euro market is to convert everything to its annual-pay equivalent. The formula for
interest conversions of this kind is (1+i/m)m-1, where m is the frequency of payments
per year. For example, converting a 9 per cent rate paid semiannually to its annual
equivalent would yield (1+ .09/2) 2 -1 = 9.20 per cent.
Some instruments have interest calculated on the basis of the actual number of days to
maturity—that is, from settlement (delivery) date to maturity date—the number of
days, counting the settlement date but not counting the maturity date—while others
make the simplifying assumption that there are only 30 days in every month. And in
some cases, the year is assumed to have 360 days, in other 365. in the U.S. and
Japanese markets, coupons are paid semiannually, and in the Euro deposit and
floating-rate-note markets, interest may be paid semiannually or quarterly.
179
10.5 LET US SUM UP Floating Rate Notes
The floating-rate note is, as the name implies, an instrument whose interest rate floats
with prevailing market rates. Like Euro dollar deposits, it pays a three—or six-month
interest rate set above, at, or below LIBOR. Like international loans, this interest rate
is reset every three or six months to a new level based on the prevailing LIBOR level
at the reset date. More precisely, floating-rate notes issued outside of the country of
the currency of denomination n are issued in the form of Euro bonds, which makes
them in some respects as much a capital-market instrument as a money-market
instrument. But the frame work we use place pricing at the center of what defines an
instrument, and FRNs are priced in part like money-market instruments and in part
like conventional fixed-rate bonds.

Discuss the terms Caps, Floors, Calls, and Puts in the context of flexible rate notes
(FRNs).
10.7 KEYWORDS
Add-on Yield: The add-on yield is used in Euro dollar and Euro currency-deposit
calculation, because these are typically issued at a price of 100 and the coupon added
on at the end.
Bond-equivalent: The bond-equivalent yield or yield to maturity is the rate that
equates the present value of all future interest and principal payments with the market
price of the instrument.
10.8 QUESTIONS OF DISCUSSION

1. Explain the features of FRNs.
2. What are the different pricings of FRNs?
3. What are the different returns from money market instruments?
CYP 1
1. The floating-rate note is, as the name implies, an instrument whose
interest rate floats with prevailing market rates.
2. The reference rate is the interest rate to which the coupon payment is
linked.
CYP 2
1. The bond-equivalent yield or yield to maturity
2. Reference rate
3. Arithmetic mean

Publications.
Pandey, Financial Management, Vikas Annex.54.J.3 -MBA - Finance - SDE Page 20 of 23
181
Working Capital Control and
Banking Policy
UNIT 1
UNIT V
182
LESSON 183
Banking Policy
11
WORKING CAPITAL CONTROL AND BANKING POLICY
CONTENTS
11.1 Introduction to Policies and Control of Bank Finance
11.2 Guidelines for Bank Finance: Historical Perspective
11.3 Various Committees’ Recommendations on Working Capital
11.3.1 Dehejia Study Group
11.3.2 Tandon Study Group
11.3.3 Chore Committee
11.4 Let us Sum up
11.6 Keywords

z The concept of international market instruments.
z The role of the international market
z The selected instruments of international market
11.1 INTRODUCTION TO POLICIES AND CONTROL OF

BANK FINANCE
Banks have been following certain norms in granting working capital finance to
companies. These norms have been greatly influenced by the recommendations of
various committees appointed by the Reserve Bank of India from time to time. The
norms of working capital finance followed by bank since mid-70's were mainly based
on the recommendations of the Tandon Committee. The Chore Committee made
further recommendations to strengthen the procedures and norms for working capital
finance by banks. The norms based on the recommendations of these committees are
discussed below. In the deregulated economic environment in India recently, banks
have considerably relaxed their criteria of lending. In fact, each bank can develop its
own criteria for the working capital finance.
184
Working Capital Management 11.2 GUIDELINES FOR BANK FINANCE: HISTORICAL
PERSPECTIVE
A study group, popularly known as the Tandon Committee, was appointed by the
Reserve Bank of India in July 1974 to suggest guidelines for the rational allocation and
optimum use of bank credit. This was done on the presumption that the existing system
of bank lending had a number of weaknesses. The existing system has served its
primary objective of financing trade quite efficiently in the past, when the industrial
structure was simple. Industries in India, however, grew rapidly in the last three decades
and, as a result, the industrial system became very complex. One can also witness a shift
in the bank's role from trade financing to industrial financing during this period. But
the commercial bank's lending practices and style remained almost the same.
Because of the easy availability of bank credit, industries in the past did not use it
properly arid efficiently. Still today industries are not using banks funds skillfully and
for appropriate purposes. A majority of the companies in India are not cash, or resource,
conscious; their techniques of managing funds at times, are unscientific and non-
professional. A number of companies, even among the largest industrial units, have yet
to learn the methods of reducing costs, optimising use of inputs per unit of output,
conserving resources, improving and developing product, orienting their
marketing practices and policies to customers and so on. If they fail in using these
techniques of modem management, industries in the country may become a national
burden. Already a number of units have become sick and the number of such units is on
the increase. To an extent, the abnormal conditions are the cause for this, but,
perhaps, mismanagement of resources is far more responsible for the present state of
industries.
Background Bank credit is a scare resource; hence it should be optimally utilised
under all circumstances. For industrial units, it has become scarcer. There are many
other contenders for bank credit: agriculture, small-scale industry, farmers, small
man and many others. Public enterprises also approach commercial bank for their
working capital requirements,
In view of the growing demand on bank funds from all sectors, industrial companies have
no option but to use bank funds in the most efficient way. In the past, they misused or
mismanaged the bank funds. Bank credit primarily meant for working capital finance
was found to be used for long-term purposes and to finance subsidiaries and associated
companies. Not only this, cheap credit available from banks has been used to build-up
disproportionate stocks of materials to realise trading profits.
In fact, the misuse of bank funds was made possible by the existing system of bank
lending, based on cash credit system. The practice was to lend generally to the extent
of 75 per cent of the value of inventory and receivables, the remaining 25 per cent
being the margin. The value of inventory included purchases of materials on credit.
Thus, this amounted to double financing—from creditors as well as banks. Bank
lending, under the cash credit system, was directly related to security in the form of
inventory and receivables, irrespective of borrower's operations. So long as the
borrower continued to provide the required margin, the banker considered his
advance to be safe and liquid, and did not bother about the way in which advance was
being utilised. The borrower's limit was generally increased, without much questioning
about his operations, whenever inventory and receivable levels went up. The banker
never took a closer look into the affairs of the customer.
One important drawback of the system was that the banker sanctioned a maximum
limit within which the borrower could draw at his will. Under this procedure, the level
of advances in a bank is determined not by how much a banker can lend at a particular
point of time but the borrower's decision to borrow at that time. Under a tight situation,
such a system would put banks to considerable strain. The cash credit system makes 185
credit planning by banks very difficult. Banking Policy
The existing practice in fixing limit was to value inventory at the market prices for
fixing limit. For this reason and because of the availability of credit from creditors, a
borrower was able to borrow more than his current assets requirements. Accordingly, it
was possible for the borrower to divert banks' funds to acquire fixed assets, including
investment stand make advances to subsidiaries and associated concerns.
In the early years, bank lending in India was mostly directed to financing of
movement of agricultural produce from the grower to the trader, the task of financing
foreign trade being handled mostly be foreign banks. Advances were sanctioned
against the security of stocks pledged or hypothecated to the banks. Based on English
banking practice, the purpose of commercial bank lending in India has traditionally
been seen as the provision of short-term finance for business.
With the growth of industrialization, the same system of bank lending continued with
minor changes, and the banker saw his function as meeting also the industry’s need
for short-term funds. Working capital finance was made available ostensibly for
acquisition of current assets and as the advances were made available in cash credit
accounts, repayable on demand, they were considered short-term in nature and self-
liquidating in character. As industrialization in India was largely promoted by an
earnest of good management, in addition to the security of the current assets of the
borrowing company; security-cum-guarantee advances thus became the pattern of
lending to industry. The security–oriented system tended to favor borrowers with
strong financial resources, irrespective of their economic function.
With the advent of planning for economic development and a growing social
awareness of the role of bank credit in the economy, it was felt that the prevailing
commercial bank lending system had little social control and that it aided
concentration of economic power. It was felt too that system was unresponsive to
needs of the weaker sectors of the economy, small industry and agriculture and
concentrated instead on security-cum-guaranteed-oriented lending to large customers.
The security-cum-guarantee system of lending was found inadequate also with the
termination of the managing agency system. With the de-linking in of industrial units
from the managing agency houses, the erstwhile guarantors sought termination of the
guarantee obligations, the entry of new entrepreneurs into industry, with technical
knowledge but lacking financial backing and managerial background, also called for a
new approach to lending by banks.
It was against this background, the Reserve Bank of India appointed different study
groups from time to time.

1. When was Tandon Committee appointed?
…………………………………………………………………………….
…………………………………………………………………………….
2. Who does control working capital in India?
…………………………………………………………………………….
…………………………………………………………………………….
186
Working Capital Management 11.3 VARIOUS COMMITTEES’ RECOMMENDATIONS ON
WORKING CAPITAL
11.3.1 Dehejia Study Group
The National Credit Council constituted, in October 1968, a study Group under the
Chairmanship of Shri V.T. Dehejia to examine the subjected of the extent to which
credit needs of industry and trade are likely to be inflated and how such trends could
be checked. Since the bulk of bank credit is short-term, the Group’s enquiry was
primarily concerned with the inflation of the short-term bank credit. The credit needs
of industry or trade may be considered to be inflated or either of the two sectors may
be regarded to have received credit in excess of its genuine requirements (i) if, over a
period of years, the rise in short-term credit is found to be substantially higher than the
growth in the value of industrial production; (ii) if the rise in short-term credit in
appreciably higher than the increase in inventories with industry or trade, (iii) if there
is a diversion of short-term bank borrowings of concerns in industry for building up of
fixed assets or other non-current assets such as loans and investments, (iv) if there is
double or multiple financing of the same stock; (v) if the period of credit is unduly
lengthened.
The Group submitted its report in September, 1969.
Major Findings
The major finding of Dehejia study Groups are listed below:
1. Expansion of Bank Credit to Industry in Excess of Output: The Group found
that the bank credit during the period from 1960-61 to 1966-67 expanded at a
higher rate than the rise in industrial output. This finding was supported by the
available data on inventories in relation to short-term bank credit. Between 1961-
62 and 1966-67, the rise in the value of inventories with industry was 80% while
the rise in short-term bank credit was as much as 130%. The ratio of short-term
bank borrowings to inventories went up from 40% in 1961-62 to 52% in 1966-67.
a similar analysis showed that some industries, particularly those in the traditional
group, and several industrial units obtained credit from banks over and above the
rise in their production. The Group therefore came to the conclusion that in the
absence of specific restraint, there was a tendency on the part of the industry
generally to avail itself of short term credit from banks in excess of the amount
based on the growth in production and/or inventories in value terms.
2. Fixing Credit Limits by Banks: The basis on which banks fix credit limits has an
important bearing on the size of bank credit in relation to the requirements of
individual borrowers. For fixing credit limit bans generally took into account
several features of the working of the loaned concerns, such as production, sales,
inventory levels, past utilization etc. the prevalent practices of banks in this regard
were so varied that they were unlikely to prevent the emergence of excess demand
for credit from certain borrowers. By and large, the scheduled banks were inclined
generally to relate their credit limits to the security offered by their constituents
but many do not appear to make any attempt to assess the overall financial
position of the borrowers through a cash flow analysis and in the light of this
study fixed their credit limits.
3. Valuation of Stock and Margin Requirements: Banks did not generally adopt a
uniform method of valuation of stocks. The usual method, for indigenous goods
was based on ‘cost’ or ‘market value’ whichever is lower and for imported goods
on landed cost. Similarly, there was considerable divergence in practice as regards
the prescription of margins by the banks. Some banks stipulated a lower margin or
pledge advances against hypothecation of stocks, while a few others did not make
this distinction. In the opinion of the Group, the varying practice could not be said 187
to constitute an important factor in the emergence of excess credit. Banking Policy
4. Diversion of Short-term Credit to Acquisition of Long-term Assets: A study of
255 companies over the period from 1961-62 to 1966-67 showed a deterioration
in their current ratio and the increase in short-term liabilities was utilized for
financing the gap between long-term assets and long-term liabilities. One-fifth of
the gross-fixed assets of these companies was financed by expansion in short-term
liabilities including the bank loans.
The tendency on the part of a number of industrial units to utilize short-term bank
credit and other current liabilities for acquisition of non-current assets was, in the
Group, due to (a) generally sluggish condition in the capital market since 1962 (b)
the limited nature of the appraisal of application for short-term loans as compared
to medium term loans and (c) stipulation of repayment schedules for medium
loans.
5. Lending System: The Group considered that the lending system, as was prevalent
in India banking, would have appear greatly assisted prevalent in India banking,
would have appear greatly assisted certain units in industry on increased reliance
on short-term debt to finance their non-current investment. The working capital
advances of banks were grated by way of cash credit limits which were only
technically repayable on demand. The system was found convenient in view of
the emphasis placed by banks on the security aspect. These short-term advances
though secured by current assets were not necessarily utilized for short-tem or
self-liquidating in as much as although cash accruals arising from sales were
adjusted in a cash credit account from time to time. The Group found that on a
large number no credit balance emerged or debt balances fully wiped out over a
period of years as the withdrawals were in excess of receipts. The possibility of
heavy reliance on bank credit by industry arose mainly out of the way in which
the system of cash credit—which accounted from about 70% of total bank credit
had been operated.
Suggestions
The Group was of the opinion that unless measures were taken to check the tendency
for diversion of bank credit for acquiring long term assets, it might assume wider
dimensions. The Group made following suggestions for a change in the lending
system:
1. Method of Appraisal of Credit Applications: The appraisal of credit applications
should be made with reference to the total financial situation, existing and
projected, as shown by cash flow analysis and forecasts submitted by borrowers.
This would help a diagnosis of the extent to which current liabilities of industrial
units had bee put to non-current use and the manner in which liabilities and assets
of borrowers were likely to move over a period of time. Initially, advances of , say
Rs.50 lakhs and over should be analyzed this way and then the system may
gradually be extended to borrowers with advances of over Rs.10 lakhs.
2. Segregation of the Credit Market: The out standings in the existing as well as
further cash credit accounts should be distinguished as between (i) ‘the hard core’
which would represent the minimum level of raw materials, finished goods and
stores which the industry was required to hold for maintaining given level of
production and (ii) the strictly short-term component which would be the
fluctuating part of the account. The latter part of the account would represent the
requirements of funds for temporary purchases, e.g. short-term increases in
inventories, tax, dividend and bonus payments etc., the borrowing being adjusted
in a short period out of sales. In the case of financially sound companies, the
Group was of the opinion to segregate the hard ore element in the cash credit
188 borrowings and put on a formal term loan basis and subject to repayment
schedule. But when the borrowers’ financial position was not too good or the size
of the hard core, was so large that repayment could not be expected within 7/10
years, it would be difficult for the banks to continue to carry these liabilities over
along period of time. The possible solutions the promoters and their friends,
additional issue of equity or preference capital, a debenture issue with a long
maturity. When the hard core was to be placed on a formal should contain
covenants in regard to the end-use of the loan, maintenance of minimum financial
ratios, repayment obligations restrictions on investments on shares and
debentures. To determine the hard core element of the cash credit account, the
Group considered that it would be worthwhile to attempt to study of industry-wise
norms for minimum inventory levels.
3. Double or Multiple Financing: Double or multiple financing may result where
credit facilities are granted against receivables either by way of documents against
acceptance bills or drawing against book debts; the purchases is also in position to
obtain bank credit by way of hypothecation/pledge of the stock which have not
been paid for. For eliminating double or multiple financing, the Group suggested
that a customer should generally be required to confine his dealings to one bank
only. In case the credit requirements of borrowers were to be large and could not
be met out of resources of one bank, the Group has commended the adoption of
‘consortia’ arrangement.
4. Period of Trade Credit: To prevent undue stretching of the period of trade credit
and the typing up of resources of banks for unproductive purpose, the group
suggested that the period of trade credit should not normally exceed 60 days and
in special circumstance up to 90 days (excluding sales of capital equipment on
deferred payment term). The undue delay in the settlement of bills by
governments could be discouraged by stipulating that the latter should pay interest
on bills if they were not paid within 90 days after their receipt.
5. Commitment Charges on Unutilised Limits: As a complementary measure to
check the extension of extra credit, the group suggested that a levy of commitment
charge on unutilized limited coupled with, if necessary, a minimum interest
charge could be considered. The commitment levy might be progressively raised
with the size of the unutilized limits. As the initial stages, limits sanctioned upon
Rs.10 lakhs might be exempted from the point of view of administrative
convenience.
6. Need for Greater Recourse to Bill Finance: The Study Group emphasized the
need for greater recourse to bill finance. The Group recommended that
commercial banks, industry and trade should try, where feasible and
administratively convenient, to initiate and develop the practice of issuing usance
bills as this would not only impose financial discipline, on the purchaser out also
help supplier or producer to plan his financial commitments in a realistic manner.
An adequate growth in the volume of usance bills would also facilitate the
development of a genuine bill market in India. With a view to encouraging the
development of such Group to the government. The Group believed that the loss
in revenue following a reduction in stamp duty would be more than made good by
the resultant larger volume of usance bills.
7. Inventory Control: With regard to inventory control, the Group considered that as
an integral part of restraining the demand for bank credit by industry, adequate
attention should be paid to the question of adequacy or otherwise of stocks of
inventories held by various industries and the scope for minimizing the stocks
needed by industry.
8. Implications: Financial discipline implicit in Dehejia Study Group was intended 189
to help the corporate and other borrowers in formulating financial plans, Banking Policy
regulating production on a more rational basis and economizing the demand for
bank credit. As regards banks. A periodical release of the part of the resources
otherwise locked up in ‘roll over’ cash credit/overdraft to industry would enable
them to meet to these extent further demands of priority sectors of the economy
and to diversify their loan transactions. This, in turn, would increase the scope for
mobilization of deposits. Commercial banks would thus be able to play a more
effective role in serving the community and the ends of social justice.
11.3.2 Tandon Study Group

The Reserve Bank of India constituted Study Group to frame guidelines for follow up
of bank credit in July 1974 under the Chairmanship of Shri Prakash Tandon. The
terms of reference of the Group were:
1. To suggest guidelines for commercial bank 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 the advances and to suggest the type of operational data and other
information that may be obtained by banks periodically from such borrowers and
by the Reserve Bank of India from the leading banks.
2. To make recommendations for obtaining periodical forecasts from borrowers of
(a) business/production plants, (b) credit needs,
3. To make suggestions for prescribing inventory norms for different industries both
in the private and public sectors and indicate the broad criteria for deviating from
these norms.
4. To suggest criteria regarding satisfactory capital structure and sound financial
basis in relation to borrowings.
5. To make recommendations regarding the sources for financing the minimum
working capital requirements.
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.
7. To make recommendations on any other related matter as the Group may consider
germane to the subject of enquiry or any other allied matter which may be
specifically referred to it by the Reserve Bank of India.
Observations and Recommendations

The Study Group submitted its report to the RBI in August 1975. the summary of the
Group’s main observations and recommendations is given below:
Supply of and Demand for Funds

Nationalization of the major commercial banks in 1969 raised expectations of a new
sense of direction in bank lending, and indeed advances to new claimants of credit,
and especially to small industry and agriculture had since gone up. The public sector
has emerged is and important user of credit due both to its growing dominance and its
turning increasingly to commercial banks for its working capital finance instead of
relying on government. Another new source of demand was the growing awareness of
the need to achieve and equitable geographical development of industry, and in its
distribution of credit. Though industrial production increased at a slow pace but the
call on bank credit essentially for maintaining inventories even at the same level had
gone up with rising prices. If the growth process is resumed then the volume of
inventory required to maintain a higher level of production will increase and
correspondingly the demand for bank credit.
190 This state of affairs caused no problem in the year when the credit-deposit ratio in the
banking system was low and a sudden spurt in credit demand could easily be taken
care of and access to refinance from the Reserve Bank was easy. With control on
monetary expansion as part of anti-inflationary policy and a rise in demand for
funds—both from the old and the new claimants—the existing system of bank lending
came under considerable strain and the fundamental weakness of the system had been
exposed.
Coverage of the Proposed Approach

The proposed approach to lending and the style of credit may be extended to all
borrowers having credit limits in excess of Rs.10 lakhs from the banking system,
while the information system may be introduced, to start with, in respect of borrowers
with limits of Rs.1 crore and above from the entire banking system. Progressively,
banks should extend this system, first to borrowers with limits of Rs.50 lakhs to Rs.1
crore and next to those enjoying limits of Rs.10 lakhs to Rs.50 lakhs.
Information System
To meet the specific requirement of the new ventures and to ensure the end-use and
safety of bank advance, the borrower is expected to subject himself to the budgeting
and reporting system. The borrower will supply appropriate operational data and
figures relating to financial position at periodical intervals on the prescribed forms
which have been devised for the purpose. The information so furnished by the
borrower will have to be screened thoroughly and speedily and a view taken of his
total activities.
All borrowers with total credit facilities from the Banking System in excess of Rs.10
lakhs should submit (i) Operating Statement (ii) Funds Flow Statements (iii) Peak
Level Balance Sheet and Pro forma Balance Sheet for the ensuing year at the ensuing
year at the time of submitting the loan application (whether for renewal/enhancement
of fresh limits). The borrower with aggregate credit facilities from the Banking
System exceeding Rs. One crore should submit (i) quarterly operating statement (ii)
quarterly funds flow statement and (iii) current assets and current liabilities every
quarter for the purpose of follow-up.
Follow-Up
A bank has to follow-up and supervise the use of credit to verify first whether the
assumptions on which the lending decision was taken continue to hold good, both in
regard to the borrower’s operations and the environment, and second, whether the
end-use in according to the purpose for which the credit was given. From the quarterly
expectations and signs, if any, of significant divergence reading as red signals to both
the banker and the customer. However, variance of say +10% may be treated as
normal. In addition to the quarterly data, the larger borrowers should submit a half
yearly pro forma balance sheet and profit and loss account within two months from
the end of the half year.
Inter-firm Comparison
To facilitate inter-firm and industry-wise comparison for assessing efficiency, it
would be of added advantage if companies in the same industry could be grouped
under three or four categories, say, according to size of sales and the group wise
financial ratios compiled by the Reserve Bank of India, for furnishing to the banks.
Besides examining financial and operating ratios, certain productivity ratios may also
be examined to determine efficiency in use of resources—man, money, machines and
materials. A banker can choose his own criteria, but some useful ones are: labor
efficiency; capital efficiency and fixed assets efficiency.
Classification of Customers 191
For purposes of better control, there should a system of borrower classification in each Banking Policy
bank, within a credit-rating scale. Such a system of classification according to credit-
risk will facilitate easy identification of the borrower whose affairs require to be
watched with more than ordinary care. An incidental advantage of such classification
will be the formulation of a rational base for purpose of fixing the rates of interest for
the respective borrowers.
Norms for Capital Structure

The debt-equity relationship is a relative concept that depends on several factors and
circumstances such as the state of the capital market at any one time, government
policy on created money, the need to maintain current assets at a specified level
(which again is contingent on other factors), marginal efficiency of capital or the
opportunity cost, etc. the experience of other countries in this matter may not be of
much assistance in formulating guidelines in the India context. In discussing norms
for capital structure, the Group kept in mind both the relationships—long-term debt to
equity and total outside liabilities to equity. Where a company’s long-term debt-net
worth and total outside liabilities-net worth ratios are worse than the medians, the
banker would endeavor to persuade the borrower to strengthen his equity base as early
as possible. This would be a more practical approach for the banker than attempting to
legislate absolute standards of long-term debt—net worth and total outside
liabilities—net worth ratios for all industries or even industry by industry.
The impact of taxation in considering this subject is also important for, under the tax
structure, it is advantageous to trade as much as possible on borrowed capital to
maximize earnings per share. The higher the level of borrowings, or the financial
leverage, the greater is the advantage in view of this and coupled with the cheap
money policy, there may be limited incentive to the borrower for efficient
management of funds. Introduction of higher interest rates in the banking system has
changed this position. In fact, the lending banker likes to see as high an equity stake as
possible funds so further. However, on cannot lose sight of the need to promote the
capital market while resolving this dichotomy of interest between the banker and
borrower as the ultimate goal being to assist in maximizing investment and
production. If the end-product of industry has to be sold at a cheaper price and
adequate dividends are also to be given to make equity attractive to the investor, no
company can afford, even if it were possible, to trade entirely on owned funds, nor
rely too heavily on borrowed funds. There has thus to be a balance between the two—
what the company provides and what it borrows.
Problems in Implementing Tandon Committee Report

The Reserve Bank of India in its notification dated August 21, 1975 considered some
of the main recommendations of the Group and advised the banks accordingly. The
scheme was required to be implemented at the micro-level where advances were made
to the borrowers. But a thorough understanding of the scheme required knowledge
about the analysis of financial statements and credit appraisal by the officers at branch
level. This knowledge was slowly spreading and till the officers at the grass root level
were equipped with the basic knowledge of credit appraisal, the implementation was
bound to be quite slow.
Another problem was that of gearing the attitudes of the bank men to this new scheme
being something new as being not in the routine nature of credit appraisal, it was
difficult task to kindle the interest of the staff to study the Tandon Scheme for
enforcing it in the case of big industrial customers. In addition, the new scheme also
called for in-depth knowledge about each industry and various units in each industry
so that the norms could be realistically applied in each case to determine the level of
current assets, working capital gap and the style of credit.
192 It’s not only the bankers but also the customers were required to be trained in
understanding the implications of the norms and the quarterly information system, an
innovation brought in by the Tandon committee. No doubt the big parties had the
qualified staff to give the data in forms prescribed on quarterly basis, but these forms
were not forthcoming in time. If they were submitted each time after the current
quarter or even much later upon reminder, the very purpose of calling for quarterly
data were to be defeated as in that event follow-up supervision and control were
difficult or not possible.
In the case of some of the big parties, it had been found that they were run like family
concerns on partnership or proprietary basis and they did not maintain proper books of
accounts. Such parties were likely to plead inability to furnish the data as per the
Tandon form. To make matter worse or difficult for banks, they maintained account in
regional language too. Even if the forms were coming with lot of persuasion and
understanding form the borrowers it was difficult to convince them in individual cases
to abide by the norms for carrying current assets if they were already above the norms.
No doubt, ultimately it was the banker’s judgment that should prevail in credit
decisions after a dialogue with the parties, but in super-imposing such decisions over
the customers’ judgment, there was likely to be misunderstanding or clash sort of
thing with the borrowers. It was quite possible that aggrieved borrowers getting lesser
limit might perhaps consider higher limits.
Another problem which was no less important could be about the manipulation in the
figures of “other current assets”, other current liabilities” etc. as the permissible bank
finance was based on figure work only. Further it was felt that the calculation of
excess finance poses a realistic problem because while the working capital gap was
computed on the basis of the projected net current assets, the figures of liability were
the existing ones and not the projected levels. For growing higher levels of current
assets, the Committee provided exceptions where under higher holdings might be
permitted. It was feared that each party might argue to be brought within the
exceptions to circumvent the rigors of the norms.
However, in order to improve the operational efficiency and to develop and better
understanding of the new lending system of banks, if all the banks are serious in
implementing the Tandon Scheme and if they are able to get the cooperation from
their customers, the problem areas are nothing and can be ignored. On the other hand,
if unwarranted concessions and deviations are shown by banks against the ethics of
the implementation of the scheme as a whole, the very philosophy of the Tandon
Scheme will be defeated and it will create a situation in which the scrupulous banks
will regret for going the Tandon way.
Fill in the blanks:
1. Nationalization of the major commercial banks was made in the year
_____________.
2. _______________financing may result where credit facilities are granted
against receivables either by way of documents against acceptance bills or
drawing against book debts.
3. The _______________ Committee, was appointed by the Reserve Bank of India
in July 1974 to suggest guidelines for the rational allocation and optimum use
of bank credit.
11.3.3 Chore Committee 193
While reviewing the monetary and credit trends in March 1979, the Governor of the Banking Policy
Reserve Bank of India stressed the need for exercising continued restraint on
expansion of credit. He also indicated in his meeting with bankers the need for
considering certain long-term issues relating to baking operations. In his letter dated
16th March 1979 to all scheduled commercial banks, he indicated:
“I would like to initiate action on certain structural matters which need further
examination. It is necessary to take a fresh look at another major problem faced by
banks in implementing the credit regulatory measures, viz., the extensive use of the
cash credit system. Its drawbacks have been pointed out by the various Committees in
the past including the Tandon Committee, which suggested the bifurcation of credit
limits into a demand loan and a fluctuating cash credit component. Although the
banks were advised to implement this recommendation, I am afraid, the progress
achieved has been very slow. Clearly, this problem needs to be looked into further and
for this purpose I purposes to set up immediately a small Working Group, to report to
me….. on the reforms to be introduced”.
It was in this context that the Reserve Bank of India appointed the Working Group
under the Chairmanship of Shri K.B. Chore to review the system of credit in all
aspects. The term of reference of the Working Group were as follows:
1. To review the operation of the cash credit system with reference to the gap
between sanctioned credit limits and the extent of their utilization;
2. In the light of the review, to suggest:
a) Modification in the system with a view to making the system more amenable
to rational management of funds by commercial banks, and/or
b) Alternative types of credit facilities, which would ensure greater credit
discipline and also enable banks to relate credit limits to increase in output or
other productive activities; and
3. To make recommendations and any other related matter as the Group may
germane to the subject.
The Group made following recommendations in its final report.
Credit System
The advantages of the existing system of extending credit by a combination of the
three types of lending, viz., cash credit, loan and bill should be retained. At the same
time, it is necessary to give some directional changes to ensure that wherever possible
the use of cash credit would be supplanted by loans and bills. It would also be
necessary to introduce necessary corrective measures to remove the impediments in
the use of bill system of finance and also to remove the drawbacks observed in the
cash credit system.
Bifurcation of Credit Limits

Bifurcation of cash credit limit into a demand loan portion and a fluctuating cash
credit component has not found acceptance either on the part of the banks or the
borrowers. Such bifurcation may not serve the purpose of better credit planning by
narrowing the gap between sanctioned limits and the extent of utilization thereof. It is
not likely to be voluntarily accepted and it does not confer enough advantages to make
it compulsory.
194 Reducing Over-dependence on Bank Borrowings
The need for reducing the over-dependence of the medium and large borrowers—both
in the private and public sectors-on bank finance for their production/trading purposes
is recognized. The net surplus cash generation of an established industrial unit should
be utilized partly as least for reducing borrowing for working capital purposes.
Peak level and Normal Non-peak Level Limits to be Separate

While assessing the credit requirements, the bank should appraise and fix separate
limits for the ‘normal non-peak level’ as well as for the ‘peak level’ credit
requirements indicating the periods during which the separate limits would be utilized
by the borrower. This procedure would be extended to all borrowers having working
capital limits of Rs.10 lakhs and above. One of the important criteria for deciding such
limits should be the borrowers’ utilization of credit limits in the past.
Financing Temporary Requirements through Loan

If any ad-hoc or temporary accommodation is required in excess of the sanctioned
limit to meet unforeseen contingencies the additional finance should be given, where
necessary, through a separate demand loan account or a separate ‘non-operatable cash
credit account’. There should a stiff penalty for such demand loan or non-operatable
cash credit portion, at least two per cent above the normal rate, unless Reserve Bank
exempts such penalty. This discipline may be made applicable in cases involving
working capital limits or Rs.10 lakhs and above.
Penal Interest
The borrower should be asked to give his quarterly requirement of funds before the
commencement of the quarter on the basis of his budget, the actual requirement being
within the sanctioned limit for the particular peak level/non peak level periods.
Drawing less than or in excess of the operative limits so fixed (with a tolerance of
10% either way) but not exceeding sanctioned limit would be subject to a penalty to
be fixed by the Reserve Bank from time to time. For the time being the penalty may
be fixed at 2% per annum. The borrower would be required to submit his budgeted
requirements in triplicate and a copy each would be sent immediately by the branch to
the controlling office for record. The penalty will be applicable only in respect of
parties enjoying credit limits of Rs.10 lakhs and above, subject to certain exemptions.
Information System
The non-submission of the returns in time is partly due to certain features in the forms
themselves. To get over this difficulty, simplified forms have been proposed. As the
quarterly information systems, is part and parcel of the revised style of lending
thunder the cash credit system, if the borrower does not submit the return within the
prescribed time, he should be penalized by charging the whole outstanding in the
account at a penal rate of interest, 10% per annum more than the contracted rate for
the advance from the due date of the return till the date of its actual submission.
Relaxation from Norms

Requests for relaxation of inventory norms and for ad-hoc increase in limits would be
subjected by banks to close scrutiny and agreed to only in exceptional circumstances.
Toning Up-Assessment Technique

The banks should devise their own check lists in the light of the instructions issued by
the Reserve Bank for the scrutiny of data the operational level.
Delays in Sanction 195
Delays on the part of banks in sanctioning credit limits could be reduced in cases Banking Policy
where the borrowers cooperate in giving the necessary information about their past
performance and future projections in time.
Bill System
As on of the reasons for the slow growth of the bill system is the stamp duty on
usance bills and difficulty in obtaining the required denominations of stamps, these
questions may have to be taken up with the state governments.
Sales Bill
Bank should review the system of financing book debts though cash credit and insist
on the conversion of such cash credit limits into bill limits.
Drawee Bill System
A stage has come to enforce the use of drawee bills in the lending system by making it
compulsory for banks to extend at least 50% of the cash credit limit against raw
materials to manufacturing units whether in the public or private sector by way of
drawee bills. To start with, this discipline should be confined to borrowers having
aggregate working capital limits of Rs.50lakhs and above from the banking system.
Segregation of Dues of Small Scale Industries
Bank should insist on the public sector undertakings/large borrowers to maintain
control accounts in their books to give precise data regarding their dues to the small
units and furnish such data in their quarterly information system. This would enable
the banks to take suitable measures for ensuring payment of the du4s to small units by
a definite period by stipulating, if necessary, that a portion of limits for bills
acceptance (drawee bills) should be utilized only for drawee bills of small scale units.
Discount House
To encourage the bill system of financing and to facilitate cal money operations an
autonomous financial institution on the lines of the Discount House in UK may be
set up.
Correlation between Production and Bank Finance
No conclusive data are available to establish the degree of correlation between
production and quantum of credit at the industry level. As this issue is obviously of
great concern to the monetary authorities the Reserve bank may undertake a detailed
scientific study in this regard.
Communication of Credit Control Measures to Branches and Follow-up
Credit control measures to be affective will have to be immediately communicated to
the operational level and followed up. There should be a ‘Cell’ attached to the
Chairman’s office at the Central Office of each bank to attend to such matters. The
Central Offices of banks should take a second look at the credit budget as soon as
changes in credit policy are announced by the Reserve Bank and revise their plan of
action in the light of the new policy and communicate the corrective measures to the
operational levels as quickly as possible.
Monitoring of Key Branches and Critical Accounts
The banks should continuously monitor the credit portfolio of the ‘key’ branches
irrespective of the fact whether there is a change in credit policy or not. For effective
credit monitoring, the number of critical accounts should be kept under a close watch
over the utilization of limits and inventory build up.
196 Delay in Collection of Bills/Cheques
To reduce the delay in collection of bills and cheques, return of documents by the
collecting branches, etc, the Group suggested to tone up the communication channels
and systems and procedures within the banking system.
Bill Facilities and Current Accounts with other Banks

Although banks usually object to their borrower’s dealing with other banks without
their consent, some of the borrowers still maintain current accounts and arrange bill
facilities with other banks. Apart from diluting the control over the advance by the
main banker, this practice often enables the borrower to divert sales proceeds for
unapproved purposes without the knowledge of his main banker. Banks should be
suitably advised in this matter by the Reserve Bank to check this unhealthy practice.
11.4 LET US SUM UP

The norms of working capital finance followed by bank since mid-70's were mainly
based on the recommendations of the Tandon Committee. The Chore Committee
made further recommendations to strengthen the procedures and norms for working
capital finance by banks. The norms based on the recommendations of these
committees are discussed below. In the deregulated economic environment in India
recently, banks have considerably relaxed their criteria of lending. In fact, each bank
can develop its own criteria for the working capital finance.

Discuss the various procedures and norms for working capital finance by banks in
India. What are the issues related to bank finance in India?
11.6 KEYWORDS
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.
Hedging: The term ‘hedging’ usually refers to two off-selling transactions of a
simultaneous but opposite nature which counterbalance the effect of each other.

1. What are the various recommendations made by different committees?
2. Explain the suggestions given various committees.

CYP 1
1. Tandon Committee, was appointed by the Reserve Bank of India in July
1974 to suggest guidelines for the rational allocation and optimum use of bank
credit.
2. RBI, through its guidelines, issued from time to time.
CYP 2
1. 1969 2. Double or multiple 3. Tandon
197
11.8 SUGGESTED READINGS Working Capital Control and
Banking Policy
Publications.
198
Working Capital Management LESSON
12
APPRAISAL AND ASSESSMENT OF
THE WORKING CAPITAL
CONTENTS
12.1 Introduction
12.2 Analysis of Working Capital
12.2.1 Ratio Analysis
12.2.2 Funds Flow Analysis
12.2.3 Working Capital Budget
12.3 Operating Cycle Analysis
12.3.1 Operating Cycle
12.3.2 Operating Cycle Analysis
12.4 Estimation of Working Capital Requirements
12.4.1 Main Factors Considered in the Estimation of Working Capital Requirement
12.4.2 Steps Involved in Arriving at the Level of Working Capital Requirement
12.4.3 Standard Formulae for Determination of Working Capital
12.4.4 Computation of Working Capital Requirement
12.4.5 Working Capital and Small Scale Industries
12.4.6 Working Capital through Formula–Boon or Bane?
12.4.7 Cash Flow Based Computation of Working Capital
12.5 Let us Sum up
12.7 Keywords

z The concept of working capital and its assessment methods
z The analysis procedure of working capital
12.1 INTRODUCTION
Working capital is the life blood and nerve centre of a business. Just as circulation of
blood is essential in the human body for maintaining life, working capital is very
essential to maintain the smooth running of a business. No business can run
successfully without an adequate amount of working capital. However, it must also be 199
Appraisal and Assessment of
noted that working capital is a means to run the business smoothly and profitably, and the Working Capital
not an end. Thus, concept of working capital is a means to run importance in a going
concern. A going concern, usually, has a positive balance of working capital has its
own excess of current assets over current liabilities, but sometimes the uses of
working capital may be more than the sources resulting into a negative value of
working capital. This negative balance is generally offset soon by gains in the
following periods. A study of changes in the uses and sources of working capital is
necessary to evaluate the efficiency with which the working capital is employed in a
business. This involves the need of working capital analysis.
12.2 ANALYSIS OF WORKING CAPITAL

1. Ratio Analysis
2. Funds Flow Analysis
3. Budgeting
12.2.1 Ratio Analysis

A ratio is a simple arithmetical expression of the relationship of one number to
another. The technique of ratio analysis can be employed for measuring short-term
liquidity or working capital position of a firm. The following ratios may be calculated
for this purpose:
a) Current Ratio
b) Acid Test Ratio
c) Absolute Liquid Ratio or Cash Position Ratio
d) Inventory Turnover Ratio
e) Receivables Turnover Ratio
f) Payables Turnover Ratio
g) Working Capital Turnover Ratio
h) Working Capital Leverage
i) Ratio of Current Liabilities to Tangible Net Worth
All the above mentioned ratios have been discussed in detail in the ‘Lesson relating to
Ratio Analysis.’
12.2.2 Funds Flow Analysis

Funds flow analysis is a technical device designated to study the sources from which
additional funds were derived and the use to which these sources were put. It is an
effective management tool to study changes in the financial position (working capital)
of business enterprise between beginning and ending financial statements dates. The
funds flow analysis consists of: (i) preparing schedule of changes in working capital,
and (ii) statement of sources and application of funds.
This technique of measuring working capital has been discussed at length in the
chapter relating to ‘Funds Flow Statement’.
12.2.3 Working Capital Budget

A budget is a financial and/or quantitative expression of business plans and policies to
be pursued in the future period of time. Working capital budget, as a part of total
budgeting process of business, is prepared estimating future long-term and short-term
working capital needs and the sources to finance them, and then comparing the
200 budgeted figures with the actual performance for calculating variances, if any, so that
corrective actions may be taken in the future. The objective of a working capital
budget is to ensure availability of funds as and when needed, and to ensure effective
utilization of these resources. The successful implementation of working capital
budget involves the preparing of separate budgets for various elements of working
capital, such as, cash, inventories and receivables, etc.
Check Your Progress
Fill in the blanks:
1. Working capital is the _____________________ of a business.
2. The objective of a working capital budget is to ____________________ as
and when needed, and to ensure effective utilization of these resources.
3. A ratio is a simple arithmetical expression of the relationship of
_______________.
12.3 OPERATING CYCLE ANALYSIS

12.3.1 Operating Cycle
Operating cycle is the average time between the acquisition of materials or services
and the final cash realization from that acquisition. It is the average length of time
between when a company purchases items for inventory and when it receives payment
for sale of the items.
The operating cycle is the number of days from cash to inventory to accounts
receivable to cash.
The operating cycle reveals how long cash is tied up in receivables and inventory.
A long operating cycle means that less cash is available to meet short-term
obligations. A long operating cycle tends to harm profitability by increasing
borrowing requirements and interest expense.
12.3.2 Operating Cycle Analysis

Working capital is one of the most difficult financial concepts to understand for the
small-business owner. In fact, the term means a lot of different things to a lot of
different people. By definition, working capital is the amount by which current assets
exceed current liabilities. However, if you simply run this calculation each period to
try to analyze working capital, you won't accomplish much in figuring out what your
working capital needs are and how to meet them.
A useful tool for the small-business owner is the operating cycle. The operating cycle
analyzes the accounts receivable, inventory and accounts payable cycles in terms of
days. In other words, accounts receivable are analyzed by the average number of days
it takes to collect an account. Inventory is analyzed by the average number of days it
takes to turn over the sale of a product (from the point it comes in your door to the
point it is converted to cash or an account receivable). Accounts payable are analyzed
by the average number of days it takes to pay a supplier invoice.
Most businesses cannot finance the operating cycle (accounts receivable days +
inventory days) with accounts payable financing alone. Consequently, working capital
financing is needed. This shortfall is typically covered by the net profits generated
internally or by externally borrowed funds or by a combination of the two.
Most businesses need short-term working capital at some point in their operations. For 201
instance, retailers must find working capital to fund seasonal inventory buildup the Working Capital
between September and November for Christmas sales. But even a business that is not
seasonal occasionally experiences peak months when orders are unusually high. This
creates a need for working capital to fund the resulting inventory and accounts
receivable buildup.
Some small businesses have enough cash reserves to fund seasonal working capital
needs. However, this is very rare for a new business. If your new venture experiences
a need for short-term working capital during its first few years of operation, you will
have several potential sources of funding. The important thing is to plan ahead. If you
get caught off guard, you might miss out on the one big order that could have put your
business over the hump.
Here are the five most common sources of short-term working capital financing:
z Equity: If your business is in its first year of operation and has not yet become
profitable, then you might have to rely on equity funds for short-term working
capital needs. These funds might be injected from your own personal resources or
from a family member, friend or third-party investor.
z Trade Creditors: If you have a particularly good relationship established with
your trade creditors, you might be able to solicit their help in providing short-term
working capital. If you have paid on time in the past, a trade creditor may be
willing to extend terms to enable you to meet a big order. For instance, if you
receive a big order that you can fulfill, ship out and collect in 60 days, you could
obtain 60-day terms from your supplier if 30-day terms are normally given. The
trade creditor will want proof of the order and may want to file a lien on it as
security, but if it enables you to proceed, that shouldn't be a problem.
z Factoring: Factoring is another resource for short-term working capital financing.
Once you have filled an order, a factoring company buys your account receivable
and then handles the collection. This type of financing is more expensive than
conventional bank financing but is often used by new businesses.
z Line of credit: Lines of credit are not often given by banks to new businesses.
However, if your new business is well-capitalized by equity and you have good
collateral, your business might qualify for one. A line of credit allows you to
borrow funds for short-term needs when they arise. The funds are repaid once you
collect the accounts receivable that resulted from the short-term sales peak. Lines
of credit typically are made for one year at a time and are expected to be paid off
for 30 to 60 consecutive days sometime during the year to ensure that the funds
are used for short-term needs only.
z Short-term loan: While your new business may not qualify for a line of credit
from a bank, you might have success in obtaining a one-time short-term loan (less
than a year) to finance your temporary working capital needs. If you have
established a good banking relationship with a banker, he or she might be willing
to provide a short-term note for one order or for a seasonal inventory and/or
accounts receivable buildup.
In addition to analyzing the average number of days it takes to make a product
(inventory days) and collect on an account (account receivable days) vs. the number
of days financed by accounts payable, the operating cycle analysis provides one other
important analysis.
From the operating cycle, a computation can be made of the dollars required to
support one day of accounts receivable and inventory and the dollars provided by a
day of accounts payable.
202 Working capital has a direct impact on cash flow in a business. Since cash flow is the
name of the game for all business owners, a good understanding of working capital is
imperative to make any venture successful.
12.4 ESTIMATION OF WORKING CAPITAL

REQUIREMENTS
It is important to have an analytical estimation of the working capital requirements of
a medium-sized undertaking. The concept of estimation of working capital
requirements helps the user understand the concept of an operating cycle, concept of
cash conversion cycle, impact of cycle time on working capital requirements,
approaches for estimation of working capital, and methods of determining working
capital.
Sometimes your industry may be suffering because of inadequate working capital.
Lack of adequate working capital is often stated as one of the major reasons for
sickness in industry (especially in case of SMEs). The counter arguments from the
banks have been that most firms face problems of inadequate working capital due to
credit indiscipline (diversion of working capital to meet long term requirements or to
acquire other assets). In this context it would be pertinent to understand the method
adopted by banks in computing the working capital requirement of the business and
the quantum of bank financing to be provided by the bank.
12.4.1 Main Factors Considered in the Estimation of

Working Capital Requirement
z The Nature of Business and Sector-Wise Norms: Factors such as seasonality of
raw materials or of demand may require a high level of inventory being
maintained by the company. Similarly, industry norms of credit allowed to buyers
determine the level of debtors of the company in the normal course of business.
z The Level of Activity of the Business: Inventories and receivables are normally
expressed as a multiple of a day’s production or sale. Hence, higher the level of
activity, higher the quantum of inventory, receivables and thereby working capital
requirement of the business. So in order to arrive at the working capital
requirement of the business for the year, it is essential to determine the level of
production that the business would achieve. In case of well-established
businesses, the previous year’s actual and the management projections for the year
provide good indicators. The problems arise mainly in the case of determining the
limit for the first time or in the initial few years of the business. Banks often adopt
industry standard norms for capacity utilization in the initial years.
12.4.2 Steps Involved in Arriving at the Level of

Working Capital Requirement
z Based on the level of activity decided and the unit cost and sales price
projections, the banks calculate at the annual sales and cost of production.
z The quantum of current assets (CA) in the form of Raw Materials, Work-in-
progress, Finished goods and Receivables is estimated as a multiple of the
average daily turnover. The multiple for each of the current assets is
determined generally based on the industry norms.
z The current liabilities (CL) in the form of credit availed by the business from
its creditors or on its manufacturing expenses are deducted from the current
assets (CA) to arrive at the Working Capital Requirement (WCR).
12.4.3 Standard Formulae for Determination of Working Capital 203
The issue of computation of working capital requirement has aroused considerable the Working Capital
debate and attention in this country over the past few decades. A directed credit
approach was adopted by the Reserve Bank of ensuring the flow of credit to the
priority sectors for fulfillment of the growth objectives laid down by the planners.
Consequently, the quantum of bank credit required for achieving the requisite growth
in Industry was to be assessed. Various committees such as the Tandon Committee
and the Chore Committee were constituted and studied the problem at length.
Norms were fixed regarding the quantum of various current assets for different
industries (as multiples of the average daily output) and the Maximum Permissible
Bank Financing (MPBF) was capped at a certain percentage of the working capital
requirement thus arrived at.
Working Capital assessment on the formula prescribed by the Tandon Committee

Working Capital Requirement (WCR) = [Current assets i.e. CA (as per industry
norms) – Current Liabilities i.e. CL]
Permissible Bank Financing [PBF] = WCR – Promoter’s Margin Money i.e. PMM
(to be brought in by the promoter)
As per Formula 1: PMM = 25% of [CA – CL] and thereby PBF = 75% of [CA – CL]
As per Formula 2: PMM = 25% of CA and thereby PBF = 75% [CA] – CL
As is apparent Formula 2 requires a higher level of PMM as compared to Formula 1.
Formula 2 is generally adopted in case of bank financing. In cases of sick units where
the promoter is unable to bring in PMM to the extent required under Formula 2, the
difference in PMM between Formulae 1 and 2 may be provided as a Working Capital
Term Loan repayable in installments over a period of time.
Illustrative Example:
Turnover of a manufacturing unit: Rs. 750 lakh p.a (assumed uniform across the year)
Assumed value addition norm: 50% (i.e. cost of raw material = 50% of Realisation)
Promoter Projections
Current Assets Current Liabilities
- Raw materials Rs. 50 lakh - Payables Rs. 35 lakh
- Work in progress Rs. 25 lakh
- Finished Goods Rs. 60 lakh
- Receivables Rs. 125 lakh
Requirement assessed as per norms applicable for the industry:

Industry Norm Amount as per Promoter Applicable norm
Norm Projection
(a) (b) (c) (d)
Current Asset
- Raw material 1 month Rs. 31.25 lakh Rs. 50 lakh Rs. 31.25 lakh
- Work in Progress
(assumed at 50% 10 days Rs. 15.62 lakh Rs. 25 lakh Rs. 15.62 lakh
complete)
- Finished Goods 15 days Rs. 31.25 lakh Rs. 60 lakh Rs. 31.25 lakh
Contd….
204 - Receivables
Working Capital Management 1.5 months Rs. 112.50 lakh Rs. 125 lakh Rs. 112.50 lakh
Rs. 190.62 lakh Rs. 260.0 lakh Rs. 190.62 lakh

Current Liabilities
- Payables 15 days Rs. 18.80 lakh Rs. 35 lakh Rs. 18.80 lakh
Working Capital
Rs. 171.82 lakh Rs. 225.0 lakh Rs. 171.82 lakh
Requirement
Notes:
z Assumptions here include: No export turnover, uniform working capital requirement throughout the year.
z Industry norms have been specified in the Tandon Committee Report for all important industry categories.
z Raw materials have been valued at cost of raw material (assumed at 50% of realization).
z Work in progress has been valued at 50% complete basis.
z Applicable norm (d) is the more conservative of (b) or (c) from the bank’s point of view.
12.4.4 Computation of Working Capital Requirement

Working Capital Requirement arrived at therefore is Rs. 171.82 lakh.
Formula 1
PMM (Promoter Margin Money) as per formula 1 = 25% of 171.82 lakh = Rs. 42.95
lakh–Rs. 43 lakh Hence, Permissible Bank Finance 1 = Rs. 129 lakh.
Formula 2
PMM as per formula 2=25% of Rs. 190.6 lakh = Rs. 47.65 lakh
Permissible Bank Financing as per formula 2 = [75% of 190.6 lakh – Rs. 18.8 lakh ] =
Rs. 124.1 lakh.
The difference between the 2 methods is Rs. 4.90 lakh (which maybe extended as a
Working Capital Term Loan in case of sick units.
Thus the PMM while being at 25% of the Working Capital requirement could actually
translate to as high as Rs. 225 lakh – Rs. 124 lakh i.e. Rs. 101 lakh assuming that the
promoter projections really reflect his genuine need for working capital. It should
however be understood by the entrepreneur that he ought to keep his working capital
requirements to the minimum (whether or not bank financing is available) to ensure
that his interest burden and capital blocked is kept to the minimum.
The following further points maybe worth mentioning here:
z In case of export financing sought by the entrepreneur, the quantum of bank
financing for the Working Capital build up for this purpose would normally be at
a higher percentage.
z Within the overall limits, there could be sub-limits for bills financing (in case of
receivables) with the result that such limits might not be fully available to the
business.
z The Bank Financing Limit arrived above is the Overall limit for the year. The
actual quantum of bank financing that could be availed by the unit at a given point
in time depends upon its drawing power based on its periodical returns filed to the
banker.
12.4.5 Working Capital and Small Scale Industries 205
Small scale industries have a distinct set of characteristics such as low bargaining the Working Capital
power leading to problems of receivables and lower credit on purchases, poor
financial strength, high level of variability due to dependence on local factors, etc.
Consequently, it has been rightly argued that the industry norms on different current
assets cannot be adopted.
The P.R. Nayak Committee that was appointed to devise norms for assessing the
working capital requirement of small-scale industries arrived at simplified norm
pegging the Working Capital bank financing at 20% of the projected annual turnover.
However, in case of units which are non-capital intensive such as hotels, etc. banks
often assess requirements both on the Nayak Committee norms as well as the working
cycle norms and take the lower of the two figures.
Eligibility and Norms for bank financing of SSIs as per Nayak Committee:
(a) Applicability: In case of SSIs, with working capital requirement of less than Rs. 5
crores In case of other industries, with working capital requirement of less than
Rs. 1 crore.
(b) Quantum of Working Capital bank financing: 20% of the projected annual
turnover.
(c) Subject to a Promoter bringing in a margin of: 5% of the projected annual
turnover (i.e. 20% of the total fund requirement that has been estimated at 25% of
the projected annual turnover).
12.4.6 Working Capital through Formula – Boon or Bane?

The formula driven computation of working capital requirement have been subjected
to much debate over the past few decades. The advantage of such computation has
been that it removes discretion from the officials of banks (which are largely from the
Public Sector). The uniformity thus reduces the scope for accusation of bias.
However, the strongest argument against the MPBF based lending has been that it
does not take into account the variations arising out of location, relative bargaining of
the enterprise and other reasons, which could vary its need for working capital. Even
though the banker could understand the problem, it was not possible to act on it due to
the norms. Further, the “One Size fits all” theory ensured that banks never needed to
develop credit appraisal skills and lent to all and sundry based on their seeming
adherence to norms on paper.
The method has also been criticized as being more appropriate for the era where credit
was rationed out. Banks today are capable of undertaking better assessment of the
requirements and welcome the idea of offering higher limits (larger exposures) to
established clients if required in order to retain their business in the face of
competition from other banks.
In 1997, the RBI permitted banks to evolve their own norms for assessment of the
Working Capital requirements of their clients.
12.4.7 Cash Flow Based Computation of Working Capital

Cash flow is the most realistic means of assessing the operations of an enterprise.
Drawing up cash flow statements (monthly or quarterly) for the past few years clearly
indicate the seasonal and secular trend in utilization of working capital. The
projections drawn up by the entrepreneur may then be jointly discussed with the
banker as modified in light of the past performance and the banker’s opinions. The
peak cash deficit is ascertained from the cash budgets. The promoter’s share (margin
money) for such requirement maybe mutually arrived at by the banker and the
borrower with the balance requirement forming the Bank financed part of Working
Capital.
206 Cash flow based computation of working capital requirement has been recommended
by the RBI for assessment of working capital requirement permitting the banks to
evolve their own norms for such assessment. The reason for this has been that Cash
flow factors in the past trends, takes into account the company specific factors and is
based on mutual discussion between the banker and the borrower thereby increasing
its acceptability. Also, large companies have adopted cash budgeting systems for
managing their cash flows and hence such a system does not impose additional
requirements on the corporates.
Cash flow system is extremely relevant in case of the seasonal industries to assess the
peak credit requirement and in case of large companies (working capital requirements
above Rs. 10 crores). However the reluctance to provide the cash budgets thereby
revealing additional information to the banks, has led to even larger companies shying
away from Cash Budget method of assessing Working Capital. Consequently Cash
Budget method is currently prevalent mainly in case of seasonal industries,
construction sector as well as other entities whose operations are linked to projects.
Bank financing based on cash budgets works well and is a good step form for the
system.
A big failure in the working capital system hitherto followed by our banks has been
that the Drawing Power (within the PBF limit) is based on post facto stock statements
and these are reset typically on a monthly basis. This means:
z The borrowing unit is putting its money upfront and the Drawing Power is a form
of reimbursement.
z Responsiveness to sudden surges in demand/ seasonality/ other short term boom
conditions is non-existent, putting a burden on the company to finance this at
exorbitant rates from private financiers.
Finally, a growing company will always be playing “catch-up” and its Permissible
Bank Financing will be lagging its cash requirements by at least one year.
12.5 LET US SUM UP

No business can run successfully without an adequate amount of working capital.
However, it must also be noted that working capital is a means to run the business
smoothly and profitably, and not an end. Thus, concept of working capital is a means
to run importance in a going concern. A going concern, usually, has a positive balance
of working capital has its own excess of current assets over current liabilities, but
sometimes the uses of working capital may be more than the sources resulting into a
negative value of working capital. This negative balance is generally offset soon by
gains in the following periods. A study of changes in the uses and sources of working
capital is necessary to evaluate the efficiency with which the working capital is
employed in a business. This involves the need of working capital analysis.

“The objective of a working capital budget is to ensure availability of funds as and
when needed, and to ensure effective utilization of these resources”. Discuss.
12.7 KEYWORDS
Working capital: It means the firm’s holdings of current or short-term asset.
Liquidity: The ability of the firm to augment its future cash flows to over any
unforeseen needs or to take advantage of any unforeseen opportunities.
207
12.8 QUESTIONS FOR DISCUSSION Appraisal and Assessment of
the Working Capital
1. Explain about the various tools available to appraise and assess the working
capital.
2. Discuss the analysis methods of working capital.
3. What do you understand by operating cycle analysis?
4. Discuss the estimation of working capital requirements.

1. Life blood and nerve center
2. Ensure availability of funds
3. One number to another

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Working Capital Management

MBA Second Year

School of Distance Education

Copyright © 2008, Bharathiar University

Produced and Printed

Model Question Paper 209

1.2.1 Balance Sheet Concept

1.2.2 Operating Cycle Concept

Payables Defer Cash

Figure 1.1: Operating cycle of typical company cash

Check Your Progress 1

1.5 LEVELS OF WORKING CAPITAL INVESTMENT

Check Your Progress 2

1.6 PROFITABILITY VS. RISK TRADE-OFF

1.7 OPTIMAL LEVEL OF

1.7.1 Proportions of Short-term Financing

1.7.2 Cost of Short-term vs. Long-term Debt

1.7.3 Risk of Long-term vs. Short-term Debt

1.8 THEORIES AND APPROACHES TO WORKING

Approaches to Financing Mix

The Hedging or The Conservative The Aggressive

Figure 1.2: Working Capital Financing Mix

1.8.1 The Hedging or Matching Approach

1.8.2 Conservative Approach

Trade-off between the Hedging and Conservative Approaches

1.8.3 Aggressive Approach

Current Assets Policies

Current Assets 80.00 100.00 120.00

Table 1.3: Alternative Income Statements: Effects of

Current Assets Policies

Conservative (40%) Moderate (50%) Aggressive (60%)

Sales 200.00 200.00 200.00

Current Assets 100.00 60.00

1.9 THE STATEMENT OF CHANGES IN

1.9.1 Basic Approach

1.9.2 Working Capital Approach

Sources and Uses of Working Capital

Working Capital Provided by Operations

Check Your Progress 3

1.10 ANALYSIS OF FUNDS FLOW STATEMENT

1.10.2 Funds Flow Statement, Income Statement and Balance Sheet

Difference between Funds Flow Statement and Balance Sheet

Funds Flow Statement Balance Sheet

1.10.3 Uses, Significance and Importance of Funds Flow Statement

1.10.4 Limitations of Funds Flow Statement

1.10.5 Procedure for Preparing a Funds Flow Statement

1. Statement or Schedule of Changes in Working Capital

So, (i) An increase in current assets increases working capital.

Liabilities 2001 2002 Assets 2001 2002

Equity Capital 5,00,000 5,00,000 Fixed Assets 6,00,000 7,00,000

Particulars 2001 2002 Effect on Working Capital

1.10.6 Statement of Sources and Application of Funds

(a) Calculation of Funds From Operation Rs.

Total(A)-Total(B) = Funds generated by operations

Calculation of Funds from Operations:

1.11 APPLICATION OR USES OF FUNDS

1.12 CASH FLOW STATEMENT

1.12.1 Cash Flow from Operations

Net income as per Income statement (P and L A/c)

Cost of goods sold or = Purchases

1.13 LET US SUM UP

1.14 LESSON END ACTIVITY

1.16 QUESTIONS FOR DISCUSSION