Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital.[16] These policies aim at managing the current assets(generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.  Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.  Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and minimizes reordering costs and hence increases cash flow; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity (EPQ).  Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.  Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

WORKING CAPITAL

1. Concept And Definition Of Working Capital There are two concept of Working Capital : gross and net . a) The term gross working capital , also referred to as working capital , means the total current assets .

b) The net working capital can be defined in two ways : 1. The most common definition of net working capital ( NWC ) is the difference between current assets and current liabilities ; and 2. Alternate definition of NWC is that portion of current assets which is financed with long term funds . The task of financing manager in managing working capital efficiently is to ensure sufficient liquidity in the operations of the enterprise . Net working capital , as a measure of liquidity is not very useful for comparing the performance of different firms , but it is quite

useful for internal control . The NWC helps in comparing the liquidity of the same firm over time . For the purpose of working capital management , therefore , NWC can be said to measure the liquidity of the firm . In the other words , the goal of working capital management is to manage the current assets and liabilities in such a way that an acceptable level of NWC is maintained .

2. Components Of Working Capital

The basic components of working capital are ,

Current Assets : a) Inventories i) Raw Materials and Components ii) Work in Progress iii) Finished Goods iv) Others b) Trade Debtors c) Loans And Advances d) Investments e) Cash And Bank Balance

Current Liabilities:

a) Sundry Creditors b) Trade Advances c) Borrowings d) Commercial Banks e) Provisions

3. Need For Working Capital

Given the objective of financial decision making to maximise the shareholders wealth , it is necessary to generate sufficient profits . The extent to which profits

can be earned will naturally depend , among other things , upon the magnitude of sales . A successful sales program is , in other words , necessary for earning profits by any business enterprise . However , sales do not convert into cash instantly ; there is invariably a time lag between sale of goods and the receipt of cash . There is therefore , a need for working capital in the form of current assets to deal with the problem arising out of the lack of immediate realisation of cash against goods sold . Therefore sufficient working capital is necessary to sustain sales activity . Technically this is referred to s operating cycle . The operating cycle can be

said to be at the heart of the need for the working capital . In other words the operating cycle refers to the length of time necessary to complete the following cycle of events : a) Conversion of cash into raw materials; b) Conversion of raw materials to inventory ; c) Conversion of inventory into receivables ; d) Conversion of receivables into cash . If it were possible to complete the sequences instantaneously , there would be no need for current assets (working capital) . But since it is not possible , the firm is forced to have current assets . Since the cash

inflows and outflows do not match , firms have to necessarily keep cash or invest in short term liquid securities so that they will be in position to meet obligations when they become due . Similarly , firms must have adequate inventory to guard against the possibility of not being able to meet demand for their products . Adequate inventory , therefore, provides a cushion against being out of stock . If firms have to be competitive , they must sell goods to their customer on credit which necessitates the holding of accounts receivables . It is in these ways that an adequate level of working capital is absolutely necessary for smooth

sales activity which , in turn , enhances the owners wealth .

4. Characteristics Of Current Assets In management of working capital two characteristics of current assets must be borne in mind : a) short life span and b) swift transformation into other assets forms . Current assets may have a short life. Cash balance may be held idle for a week or two, account receivables may have a life span of 30 to 60 days , and inventories may be held for 30 days to 100 days . The life span of

current assets depend on the time required in the activities of procurement , production , sales and collection and the degree of synchronisation among them . Each current asset is swiftly transformed into other assets forms : cash is used for acquiring raw materials , raw materials are transformed into finished goods ( this transform may involve several stages of work in progress ) ; finished goods , generally sold on credit , are converted into accounts receivable , and finally account receivables on reliasation , generate cash . These two characteristics has certain implications ,

i)

Decisions relating to working capital management are repetitive and frequent

ii) The difference between profit and present value is insignificant iii) The close interaction among working capital components implies that efficient management of one component cannot be undertaken without simultaneous consideration of other components .

5. Factors Affecting Working Capital

The working capital needs of a firm are influenced by numerous factors . The important ones are i) Nature of business : The working capital requirement of a firm is closely related to the nature of business . A service firm , like electricity undertaking or a transport corporation which has a short operating cycle and which sells predominantly on cash basis , has a modest working capital requirement . On the other hand , manufacturing concern like a machine tools unit , which has a long operating cycle and

which sells largely on credit has a very substantial working capital requirement . ii) Seasonality of Operation : Firms which have marked seasonality in there operations usually have highly fluctuating working capital requirement . For example , consider a firm manufacturing air conditioners . The sale of air conditioners reaches the peak during summer months and drops sharply during winter season . The working capital need of such a firm is likely to increase considerably in summer months and decrease significantly during winter period . On

the other hand , a firm manufacturing consumer goods like soaps , oil , tooth pastes etc. which have fairly even sale round the year , tends to have a stable working capital need . iii) Production Policy : A firm marked by pronounced seasonal fluctuation in its sale may pursue a production policy which may reduce the sharp variations in working capital requirements . For example a manufacturer of air conditioners may maintain steady production through out the year rather than intensify the production activity during the peak business season . Such

decision may dampen the fluctuations in working capital requirements . iv) Market Conditions : When competition is keen , larger inventory of finished goods is required to promptly serve the customers who may not be inclined to wait because other manufacturers are ready to meet their needs . Further generous credit terms may have to be offered to attract customers in highly competitive market . Thus , working capital needs tend to be high because of greater investment in finished goods inventory and accounts receivable .

If the market is strong and competition is weak , a firm can manage with smaller inventory of finished goods because customers can be served with delay . Further in such situation the firm can insist on cash payment and avoid lock up of funds in accounts receivables it can even ask for advance payment , partial or total . v) Conditions of Supply : The inventory of raw material , spares and stores depends on the conditions of supply . If supply is prompt and adequate , the firm can manage with small inventories . However if the supply is unpredictable and scant then the firm , to ensure

continuity of production , would have to acquire stocks as and when they are available and carry large inventories on an average . A similar policy may have to be followed when the raw material is available only seasonally and production operations are carried out round the year .

6. Operating Cycle Analysis

The Operating cycle of the firm begins with the acquisition of raw materials and ends with the collection of receivables . It may be divided into four

stages a) raw material and stores storage stage , b) work-in-progress stage , c) finished goods inventory stage and d) debtors collection stage .

Duration of operating cycle : The duration of operating cycle is equal to the sum of the duration of

each of these stages less the credit period allowed by the suppliers to the firms . It can be given as O=R+W+F+DC Where O = Duration of operating cycle R = Raw material and stores storage period W = Work-in-progress period F = Finished goods storage period D = debtors collection period C = Creditors payment period

The components of Operating cycle may be calculated as follows ;

R = Average stock of raw materials and stores Average raw material and stores consumption per day

W = Average Work-in-progress inventory Average cost of production per day

F = Average Finished Goods Inventory Average cost of goods sold per day

D = Average books debts

Average credit sales pert day

C = Average trade creditors Average credit purchase Types of working capital

The type, kinds of a thing are depending upon the different utilization of working capital. It prominently works in the direction of performing different functions in different situation and in the context of divergent variables. So following are some important types of working capital.

Net Working Capital Negative Working Capital Types of Working Capital Cash Working Capital

Gross Working Capital

Permanent Working capital

Balance Sheet Working Capital

Temporary Working Capital

1) Net Working Capital: Term Net working capital can be define in two way i) ii) It is the difference between current assets and current liabilities. Amount left for operational requirement.

2) Gross Working Capital: Gross working capital means the total current assets. 3) Permanent Working Capital: It is the minimum amount of the current assets, which are needs to conduct the business even during the dullest season of the year. This amount varies from year to year depending upon the growth of a company and stage of the business cycle in which it operates. It is the amount of funds required to produce the goods and services, which are necessary to satisfy demand at a particular point. It represents the current assets, which are required on a continuing basis over the year. It is maintain as the medium to carry on operation at any time. Permanent working capital has following features: i) ii) iii) It is classified on the basis of the time factor. Its size increase with the growth of the business. It constantly shifted from one assets o another and continues to remain in the business process. 4) Temporary Working Capital: It represents the additional assets, which are required at different times during the operating year. Seasonal working capital is the additional amount of current assets particularly cash, receivables, and inventory which is required during the more active

business seasons of the year. It is the temporary investment in the current assets and possesses he following features: a) It is not always gainfully employed, though is May also shift from one asset to another as permanent working capital does. b) It is particularly suited to business of seasonal on cyclical nature. 5) Balance Sheet Working Capital: The balance sheet working capital is one, which is calculated from the items appearing in the balance sheet. Gross working capital, which is represented by the excess of current assets over current liabilities, is example of the balance sheet working capital. 6) Cash Working Capital: It is one, which is calculated from the items appearing in he Profit and Loss Account. It shows the real flow of money or value at a particular time and considered to be most realistic approach in working capital management. It is the basic of he operation cycle concept, which has assumed a great importance in financial management in recent year. The reason is that the cash working capital indicates he adequacy of he cash flow which is an essential pre requisite of a business. 7) Negative Working Capital: It emerges when current liabilities exceeds current assets, such a situation is absolutely theoretical and occurs when a firm is nearing a crisis of some magnitude.

Principles of Working Capital Management:

There are some principles of sound working capital management policy. They are as follows: 1) Principle of Risk Variation: Risk here refers to inability of a firm to meet its obligation when they become due for payment. Large investment in current assets with less dependence on a short term borrowing increase liquidity, reduces dependence on short term borrowing increases liquidity, reduces risk. On the other hand less investment in current assets and greater dependence on debt increase the risk, reduces liquidity and increases profitability. In other word these is a definite inverse relationship between he degree of risk and profitability. A conservative management prefers to minimize risk by maintaining a higher level of current assets or working capital while a liberal management should be to establish a suitable trade off between profitability and risk. 2) Principle of Cost of Capital: The various sources of rising of working capital finance have different cost of capital and the degree of risk involved. Generally higher the risk lower is the cost and lower the risk higher is the cost. A sound working capital management should always try to achieve a proper balance between these two. 3) Principle of Equity position: According this principle, the amount of working capital invested in each component should be adequately justified by a firms equity position. Every rupee invested in the current assets should contribute to he net worth of he firm. 4) Principle of Maturity of Payment:

This principle is concerned with planning he sources of finance for working capital. According to this principle, a firm should make every efforts o related maturity of payment to its flow of internally generated funds. Maturity pattern of various current obligations is an impotent factor in risk assumptions and risk assessment.

Factors determining working capital

1) Nature or character of Business: The working capital requirement of a firm basically depends upon he nature of its business. Public utility undertaking 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. On the other hand trading and financial firms require less investment in fixed assets but they have to invest large amount in current assets like inventories, receivables and cash. So they need large amount of working capital. 2) Production cycle: Another factor, which has a bearing on the quantum of working capital, is the production cycle. The term production or manufacturing cycle refers to the time involved in the manufacturing of goods. It covers the time span between the procurement of raw material and the completion of the manufacturing process leading to the production of finished goods. In other words, there is sometime gap before raw material becomes finished goods. To sustain such activities that need for working capital is obvious. The longer time span (production cycle) the large will be the tied up funds and therefore, larger is working capital need and vise versa.

3) Production Policy: In certain industry the demand is subject to wide fluctuations due to seasonal variations. The requirement of working capital in such case, depend upon the production policy. The production can be either kept steady by accumulating inventories during slack period with a view to meet high demand during peak season of the production could be curtailed during the slack season and increased during the peak season. If policy is to keep production steady by accumulating inventories it will require higher working capital. 4) Credit Policy: The credit terms granted to customers have a bearing in the magnitude of working capital by determining the level of book debts. The credit sales result in higher book debs. Higher book debts mean more working capital. On the other hand, if liberal credit terms are available from the supplies of goods trade needs less working capital. The working capital requirement of a business are thus, affected by term of purchase and sale, and the ole given to credit by a company in its dealing with creditors and debtors. 5) Growth and Expansion: The working capital requirement of concern increase with the growth and expansion of its business activities. Although, It is difficult 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 for normal rate of expansion in the volume of business. We may have retained profits to provide for me working capital but in fast growing concern, we shall require lager amount of working capital. 6) Seasonal Variation:

In certain industry raw material is no available throughout the year. They have to buy raw material in bulk during the season to ensure uninterrupted flow and process them during the entire year. So a huge amount is blocked in form of row material during the peak season, which gives more requirements for working capital and less requirement during the slack season. 7) Earning Capacity: Some firm have more earning capacity than others due to quality of the products, monopoly condition etc. Such firms with high earning capacity may generate cash profits from operations and contribute to their working capital. 8) Dividend Policy: The dividend policy of a concern influence on the requirement of the working capital. A firm that maintains a steady high rate of cash dividend irrespective of its profits level needs more working capital than the firm that retains large part of its profits and does not pay at high rate of cash dividend. 9) Other Factors: Certain other factors such as operating efficiency, management ability, irregularities in supply, import policy, assets structure, importance of labour, banking facilities etc, also influence the requirement of working capital.

Sources of Working Capital

Mainly there are two sources of working capital: i. Permanent or Fixed working capital ii. Temporary or variables working capital

In any concern, a part of the working capital investments are as investment in fixed assets. This is so because there is always a minimum level of current assets, which are copiously required by the enterprise to carry out its day-to-day business operation and this minimum, cannot be expected to reduce at any time. This minimum level of current assets need long term working capital, which is permanently blocked. 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 gives rise to short term working capital which is required for day to day transaction also. The fixed proportion of working capital should be generally financed from the fixed capital sources while the temporary or variable working capital equipment may be met from the short term sources of capital.

Sources of Working Capital

Long term Sources

1) Shares 2) Debentures 3) Public Deposits 4) Ploughing back of Profits 5) Loans from Financial institution

Short Term sources

1) Commercial Banks 2) Indigenous Banks 3) Trade Creditors 4) Installment Credit 5) Advances 6) Account receivable 7) Credit 8) Accrued Expenses

9) Differed Income Methods of Calculation of Required Working Capital 10) Commercial Paper The methods of calculation of required working capital are as follows:

Working Capital Cycle:

The working capital cycle is also known as operating cycle. It refers to the duration between the firms payment of cash for raw material, entering into production and inflow of cash from debtors and realization of receivables. Simply speaking, operating cycle is the duration between the outflow of cash and inflow of cash and this may be evidenced from the following working capital cycle.

Receivables

Cash

Finished Goods

Raw Material

Work In Process

The above and network diagram may offer a clear picture of a complete working capital i.e. it is a cash phenomenon. In the diagram, raw material, stock refers to material only. In work in process, components involve are raw material, wages, and overhead more specifically manufacturing overheads. Finished stock consists components of material, wages and overheads inclusive of factory, office and administration and selling and distribution. Debtors include material, wages, overheads and profits. Credit involves for the components of raw material, etc. something a contingency margin is also given while estimating the working capital requirement. The operating cycle consists of him following events, which continues throughout his life of a firm remaining engaged in commercial activities.

Avg. Stock of Raw Material 1) Raw Material Holding Period = Avg. Cost of Consumption per day Avg. Stock of Work in Process 2) Work in Process Holding Period = Avg. Cost of Production per day Avg. Stock of Finished Goods 3) Finished Goods Holding Period = Avg. Cost of Goods Sold per day Avg. Book Debt 4) Receivables Collection Period = Avg. Credit Sales per day Avg. Trade Creditors 5) Creditors Collection Period = Avg. Credit Purchased per day In the form of a simple equation working capital cycle or operating cycle can be represented as bellow:

O = R+W+F+D-C
Where, O = Operating Cycle (In Days) R = Raw Materials Holding Period W = Work in Process Holding Period F = Finished Goods Holding Period D = Receivables Collection Period C = Creditors Collection Period.

Total Operating Cost Working Capital Required = Number of Operating Cycle

Components of Working Capital:

Current Assets:
i) ii) Stock of Raw Material (formonth consumption) Work In Process (forMonth) a) Raw Materials b) Direct Labour c) Overheads Stock of Finished Goods (formonth sales) Sundry Debtors or Receivables (formonth sales) Payments in Advance (if any) Balance of Cash (required to meet day-to-day Expenses) Any Other (if any)

Amount
-----------

iii) iv) v) vi) vii)

--------------------------

Less: Current Liabilities:

i) ii) iii) Creditors (formonth purchase of raw materials) Outstanding Expenses (for month) Others (if any) --------------------------------------

Working Capital (CA CL) Add: Provision/ Margin for contingencies Net Working Capital Required

Management of working capital:

Working capital, in general practice, refers to him excess of current assets over current liabilities. Management of working capital therefore, is concerned with problems that arise in attempting to mange him current assets, current liabilities, and interrelationship that exists between them. In other word it refers to all aspects of administration of both current assets and current liabilities. The basic goal of working capital management is to manage the current assets and current liabilities of a firm in such way that a satisfactory level of working capital is maintained, i.e. neither inadequate nor excessive. This is so because both inadequate as well as excessive working capital position is bad for the business. Inadequacy of working capital, may lead the firm insolvency and excessive working capital implies idle funds, which earn no profit for the business. Working capital management policies of the firm have a great effect on its profitability, liquidity and structural health of the organization. In this context, working capital management is three-dimensional nature: 1) Dimension I is concerned with the formulation of he policy with regard to Profitability, risk and liquidity. 2) Dimension II is concerned with the decision about his composition and level of current assets.

3) Dimension III is concerned with the decision about his composition and level of current liabilities.

This dimension aspect of his working capital has been more clearly and precisely Explains by the following diagram. Profitability, Risk & Liquidity Dimension I

Dimension III

Dimension II Composition & Level of current assets

Composition & level Of current Liabilities

Evaluation of working capital

The working capital management needs attention of all the finance head/ working capital management is important for avoiding unnecessary blockage of fund. Like that liquidity is important at it refer to the short-term financial strength of company. It is very important to have proper balance in regard to the liquidity of the firm.
FINANCING WORKING CAPITAL FINANCING WORKING CAPITAL

After determining the level of Working Capital, the firm has to decide how it is to be financed. The need for finance arises mainly because the investment in working capital/current assets, that is, raw material, work-in-progress, finished goods and receivables typically fluctuates during the year. Although long-term funds partly finance current assets and provide the margin money for working capital, such working capitals are virtually exclusively supported by short term sources. The main sources of working capital financing are namely, Trade credits, Bank credits and commercial bankers.

1. Trade Credit

Trade credit refers to the credit extended by the supplier of goods and services in the normal course of business of the firm. According to trade practices, cash is not paid immediately for purchases but after an agreed period of time. Thus, trade credit represents a source of finance for credit purchases. There is no formal/specific negotiation for trade credit. It is an informal agreement between the buyer and the seller. Such credit appears in the books of buyer as sundry creditors/accounts payable. The most of the trade credit is on open account as accounts payable, the supplier of goods does not extend credits indiscriminately. Their decision as well as the quantum is based on a consideration of factors such as earnings record over a period of time, liquidity position of the firm and past record of payment.

Advantages
i) ii) It is easily, almost automatically available. It is flexible and spontaneous source of finance.

iii) iv) v)

The availability and the magnitude of trade credit is related to the size of operation of the firm in terms of sales/purchases. It is also an informal, spontaneous source of finance. Trade credit is free from restrictions associated with formal/negotiated source of finance/credit.

2. Bank Credit

Bank credit is primarily institutional source of working capital finance in India. In fact, it represents the most important source for financing of current assets. Working Capital finance is provided by banks in five ways : (a) Cash Credit / Overdrafts : Under cash credit/ overdraft agreement of bank finance, the bank specifies a predetermine borrowing/credit limit. The burrower can burrow upto the stipulated credit. Within the specified limit, any number of drawings are possible to the extent of his requirements periodically. Similarly, repayment can be made whenever desired during the period. The interest is determined on the basis of the running balance/amount actually utilized by the burrower and not on the sanctioned limit. However, a minimum charge may be payable on the unutilized balance irrespective of the level of borrowing for availing of the facility. This type of financing is highly attractive to the burrowers because, firstly, it is flexible in that although borrowed funds are repayable on demand, and, secondly, the burrower has the freedom to draw the amount in advance as an when required while the interest liability is only on the amount actually outstanding. However, cash credit/overdraft is inconvenient to the banks and hampers credit planning. It was the most popular method of bank financing of working capital in India till the early nineties. With the emergence of the new banking since mid-nineties, cash credit cannot at present exceed 20% of the maximum permissible bank finance (MPBF)/credit limit to any borrower. (b) Loans : under this arrangement, the entire amount of borrowing is credited to the current account of the borrower or released in cash. The borrower has to pay interest on the total amount. The loans are repayable on demand or in periodic installments. They can also be renewed from time to time. As a form of financing, loans imply a financial discipline on the part of the borrowers. From a modest

beginning in the early nineties, at least 80% of MPBF must be in form of loans in India. (c) Bills Purchased/Discounted : This arrangement is of relatively recent origin in India. With introduction of the New Bill Market Scheme in 1970 by RBI, bank credit is being made available through discounting of usance bills by banks. The RBI envisaged the progressive use of bills as an instrument of credit as against the prevailing practice of using the widely-prevalent cash credit arrangement for financing working capital. The cash credit arrangement gave rise to unhealthy practices. As the availability of bank credit was unrelated to production needs, borrower enjoyed facilities in excess of their legitimate needs. Moreover, it led to double financing. This was possible because credit was taken form different agencies for financing the same activity. This was done, for example, by buying goods on credit from suppliers and raising cash credit b hypothecating the same goods. The bill financing is intended to link credit with sale and purchase of goods and, thus eliminate the scope for misuse or diversion of credit to other purposes.Before discounting he bill, the bank satisfies itself about the credit worthiness of the drawer and the genuineness of the bill. To popularize the scheme, the discount rates are fixed at lower rates than those of cash credit. The discounting banker asks the drawer of the bill to have his bill accepted by the drawee bank before discounting it. The later grants acceptance against the cash credit limit, earlier fixed by it, on the basis of the borrowing value of stocks. Therefore, the buyer who buys goods on credit cannot use the same goods as a source of obtaining additional bank credit.

The modus operandi of bill finance as a source of working capital financing is that a bill that arises out of a trade sale-purchase transaction on credit. The seller of goods draws the bill on the purchaser of goods, payable on demand or after a usance period not exceeding 90 days. On acceptance of the bill by the purchaser, the seller offers it to the bank for discount/purchase. On discounting the bill, the bank releases the funds to the seller. The bill is presented by the bank to the purchaser/acceptor of the bill on due date for payment. The bills can be rediscounted with the other banks/RBI. However, this form of financing is not popular in the country. d) Term Loans for Working Capital : Under this arrangement, banks advance loans for 37 years payable in yearly or half-yearly installments. e) Letter of Credit : While the other forms of bank credit are direct forms of financing in which banks provide funds as well as bear risk, letter of credit is an indirect form of working capital financing and banks assume only the risk, the credit being provided by the suppliers himself. The purchaser of goods on credit obtains a letter of credit from a bank. The bank undertakes the responsibility to make payment to the supplier in case the buyer fails to meet his obligations. Thus , the modus operandi of letter of credit is that the supplier sells goods on credit/extends credit to the purchaser, the bank gives a guarantee and bears risk only in case of default by the purchaser. 3. Mode of Security a) Hypothecation : Under this mode of security, the banks provide credit to borrowers against the security of movable property, usually inventory of goods. The goods hypothecated, however, continue to be in the possession of the owner of these goods (i.e. the borrower ). The rights of the lending bank (hypothecate) depend upon the terms of the contract between the borrower and the lender. Although the bank does not have physical possession of the goods, it has the legal right to sell the goods to realize the outstanding loan. Hypothecation facility is normally is not available to new borrowers. b) Pledge : Pledge, as a mode of security, is different from hypothecation in that in the former, unlike in the later, the goods which are offered as security are transferred to the physical possession of the lender. An, essential perquisite of pledge, therefore, is that the goods are in the custody of the bank. The borrower who offer the security is, called a

pawnor (pledgor), while the bank is called the pawnee (pledgee). The lodging of goods by the pledgor to the pledgee is a kind of bailment. Therefore, pledge creates some liabilities for the bank. It must take reasonable care of goods pledged with it. In case of non-payment of the loans, the bank enjoys the right to sell the goods. c) Lien : The term lien refers to the right of a part to retain goods belonging to another party until a debt due to him is paid. Lien can be of two types: (i) particular lien, and (ii) general lien. Particular lien is a right to retain goods until a claim pertaining to theses goods is fully paid. On the other hand, general lien can be applied till all dues of the claimant are paid. Banks usually enjoy general lien. d) Mortgage : It is the transfer of a legal/equitable interest in specific immovable property for securing the payment of debt. The person who parts with the interest in the property is called mortgagor and the bank in whose favour the transfer takes place is the mortagagee. The instrument of transfer is called the mortgage deed. Mortgage is, thus, conveyance of interest in the mortgaged property. The mortgage interest in the property is terminated as soon as the debt is paid. Mortgage are taken as an additional security for working capital credit b banks. e) Charge : Where immovable property of one person is, by the act of parties or by the operation of law, made security for the payment of money to another and the transaction does not amount to mortgage, the latter person is said to have a charge on the property and all the provisions of simple mortgage will apply to such a charge. The provision are as follows: y A charge is not the transfer of interest in the property though it is security for payment. But mortgage is a transfer of interest in the property. y A charge may be created by the act of parties or by the operation of law. But a mortgage can be created only by the act of parties. y y A charge need not be made in writing but a mortgage deed must be attested. Generally, a charge cannot be enforced against the transferee for consideration without notice. In a mortgage, the transferee of the mortgage property can acquire the remaining interest in the property, if any is left. 4. Reserve Bank of India Framework for Regulation of Bank Credit

After mid-nineties, the framework for regulation of bank credits has been relaxed permitting banks greater flexibility in tune with the emergence of new banking in the

country, focusing on viability and profitability in contrast to the earlier thrust on social/development banking. The notable features of the framework/regulation related to fixation of norms for bank lending to industry. The norms are: a) Inventory and Receivable Norms : The norms refer to the maximum level for holding inventories and receivables in each industry. Raw materials were expressed as so many months consumptions; WIP as so many months cost of production; finished goods and receivables as so many months of cost of sales and sales respectively. These norms represent the maximum levels of holding inventory and receivables in each industry. Borrowers were not expected to hold more than that level. The fixation of these norms was, thus, intended to reduce the dependency of industry on bank credit. b) Lending Norms/Approach to Lending/MPBF : According to the lending norms, a part of the current assets should be financed by the trade credit and other current liabilities. The remaining part of the current assets, termed as working capital gap, should be partly financed by the owners funds and long term borrowings and partly by short term bank credit. The approach to lending is vitally significant. It takes into account all the current assets requirements of borrowers total operational needs and not merely inventories or receivables; it also takes into account all the other sources of finance at his command. Another merit of the approach is that it invariably ensures a positive current ratio and, thus, keeps under check any tendency to overtrade with borrowed funds. c) Forms of Financing/Style of Credit : In 1995, a mandatory limit on cash credit and a loan system of delivery of bank credit was introduced. The cash-credit limit was initially limited to 60% of the MPBF. The balance 40% could be availed of as short term loans. The cash credit limit sanctions are currently 20% and loan component 80%. d) Information and Reporting System : The main components of the information and reporting system are four, namely, y Quarterly Information System : Form I. Its contents are (i) production and sales estimates for the current and the next quarter, and (ii) current assets and current liabilities estimates for the next quarter. y Quarterly Information System : Form II. It contains (i) actual production and sales during the current year and for the latest completed year, and (ii) actual current assets and current liabilities for the latest completed quarter. y Half-yearly Operating Statement : Form III. The actual operating performance for the half-year ended against the estimates are given in this.

Half-yearly Operating Statement : Form IIIB. The estimates as well as the actual sources and uses of funds for the half-year ended are given.

5. Commercial Papers

Commercial Paper (CP) is a short term unsecured negotiable instrument, consisting of usance promissory notes with a fixed maturity. It is issued on a discount on a face value basis but it can also be issued in interest bearing form. A CP when issued by a company directly to the investor is called a direct paper. The companies announce current rates of CPs of various maturities, and investors can select those maturities which closely approximate their holding period. When CPs are issued by security dealer on behalf of their corporate customers, they are called dealer paper. They buy at a price less than the commission and sell at the highest possible level. The maturities of CPs can be tailored within the range to specific investments.

a) Advantages
CP is a simple instrument and hardly involves any documentation. It is flexible in terms of maturities which can be tailored to match the cash flow of the issuer. A well rated company can diversify its sort-term sources of finance from banks to money market at cheaper cost. The investors can get higher returns than what they can get from the banking system. Companies which are able to raise funds through CPs have better financial standing. The CPs are unsecured and there are no limitations on the end-use of funds raised through them. As negotiable/transferable instruments, they are highly liquid.

b) Framework of Indian CP Market

The CPs emerged as sources of short-term financing in the early nineties. They are regulated by RBI. The main element of present framework are given below. y CPs can be issued for periods ranging between 15 days and one year. Renewal of CPs is treated as fresh issue. y The minimum size of an issue is Rs.25 lakh and the minimum unit of subscription is Rs.5 lakh.

The maximum amount that a company can raise by way of CPs is 100% of the working capital limit.

A company can issue CPs only if it has a minimum tangible net worth of Rs.4 crore, a fund-based working limit of Rs.4 crore or more, at least a credit rating of P2 (Crisil ), A2 ( Icra ), PR-2 ( Care ) and D-2 ( Duff & Phelps ) and its borrowal account is classified as standard asset.

The CPs should be issued in the form of usance promissory notes, negotiable by endorsement and deliver at a discount rate freely determined by the issuer. The rate of discount also includes the cost of stamp duty ( 0.25 to 0.5% ), rating charges (0.1 to 0.2%), dealing bank fee ( 0.25% ) and stand by facility ( 0.25% ).

The participants/investors in CPs can be corporate bodies, banks, mutual funds, UTI, LIC, GIC, NRIs on non-repatriation basis. The Discount and Finance House of India ( DFHI ) also participates by quoting its bid and offer prices.

The holder of CPs would present them for payment to the issuer on maturity.

c) Effective Cost/Interest Yield

As the CPs are issued at discount and redeemed at it face value, their effective pre-tax cost/interest yield = { (Face Value Net amount realised) / (Net amount realised) }x{(360) / (Maturity period) } where net amount realised = Face value discount issuing and paying agent (IPA) charges that is, stamp duty, rating charges, dealing bank fee and fee for stand by facility.

6. Factoring

Factoring provides resources to finance receivables as well as facilitates the collection of receivables. Although such services constitute a critical segment of the financial services scenario in the developed countries, they appeared in the Indian financial scene only in the early nineties as a result of RBI initiatives. There are two bank sponsored organisations which provide such services: (i) SBI Factors and Commercial Services Ltd., and (ii) Canbank Factors Ltd. The first private sector factoring company, Foremost Factors Ltd. Started operations since the beginning of 1997.

a) Definition : Factoring can broadly be defined as an agreement in which receivables arising out of sales or goods/services are sold by a firm ( client ) to the factor ( a financial intermediary ) as a result of which the title of the goods/services represented by the said receivables passes on to the factor. Henceforth, the factor becomes responsible for all credit control, sales accounting and debt collection from the buyer. In a full service factoring concept ( without resource facility ), if any of the debtor fails to pay the dues as a result of his financial inability/insolvency/bankruptcy, the factor has to absorb the losses. b) Mechanism : Credit sales generate the factoring business in the ordinary course of business dealings. Realisation of credit sales is the main function of factoring services. Once a sale transaction is completed, the factor steps in to realise the sales. Thus the factor works between the seller and the buyer and sometimes with the sellers bank together. c) Functions of a Factor : Depending on the type/form of factoring, the main functions of a factor, in general terms, can be classified into five categories: i) Financing facility/trade debts : The unique feature of factoring is that a factor purchases the book debts of his client at a price and the debts are assigned in favour of the factor who is usually willing to grant advances to extent of, say, 80% of the assigned debts. Where the debts are factored with recourse, the finance provided would become refundable by the client in case of non-payment of the buyer. However, where the debts are factored without recourse, the factors obligation to the seller becomes absolute on the due date of the invoice whether or not the buyer makes the payment. ii) Maintenance/administration of sales ledger : The factor maintains the clients sales ledger. In addition, the factor also maintains a customer-wise record of payments spread over a period of time so that any change in the payment pattern can be easily identified. iii) Collection facility of accounts receivable : The factor undertakes to collect the receivables on the behalf of the client relieving him of the problems involved in collection, and enables him to concentrate on other important functional areas of the business. This also enables the client to reduce the cost of collection by way of savings in manpower, time and efforts. iv) Credit Control and Credit Restriction :

The factor in consultation with the client fixes credit limits for approved customers. Within these limits, the factor undertakes to purchase all trade debts of the customer without resource. In other words, the factor assumes the risk of default in payment by the customer. Operationally, the line of credit/credit limit up to which the client can sell to the customer depends on his financial position, his past payment record and value of goods sold by the client to the customer. v) Advisory Services : These services are a spin-off of the close relationship between a factor and a client. By virtue of their specialised knowledge and experience in finance and credit dealings and access to extensive credit information, factors can provide a variety of incidental advisory services to their clients. vi) Cost of Services : The factors provide various services at a charge. The charge for collection and sales ledger administration is in the form of a commission expressed as a value of debt purchased. It is collected in advance. The commission for short term financing as advance part-payment is in the form of interest charge for the period between the date of advance payment and the date of collection date. It is also known as discount charge.