W.C. Mgmt Project

8/9/2019 W.C. Mgmt Project

http://slidepdf.com/reader/full/wc-mgmt-project 1/81

A PROJECT REPORT ON

WORKING CAPITAL MANAGEMENT

SUBMITTED BY

SHRI PRAKASH PANDEY T.Y.B.M.S. [Semester VI]

BHAVAN’S C OLLEGE ANDHERI (W ), M UMBAI - 400 058

SUBMITTED TO UNIVERSITY OF MUMBAI

ACADEMIC YEAR 2007 - 2008

PROJECT GUIDE

MR. KUTTY



A PROJECT REPORT ON

WORKING CAPITAL MANAGEMENT

SUBMITTED BY

SHRI PRAKASH PANDEY T.Y.B.M.S. [Semester VI]

BHAVAN’S C OLLEGE ANDHERI (W ), M UMBAI - 400 058

SUBMITTED TO UNIVERSITY OF MUMBAI

ACADEMIC YEAR 2007 - 2008

PROJECT GUIDE

MR. KUTTY



D E C L A R AT I O N

I, Mr. Shri Prakash Pandey of Bhavan’s

college of TYBMS (SEM VI) here declare that I have completed this project on Working Capital

Management in the academic year 2007-08. This

information submitted is true and original to

the best of my knowledge.

Signature

(Mr. Shri Prakash Pandey)



C E RT I F I C AT E

I, Prof. Mr Kutty hereby certifies that Mr.

Shri Prakash Pandey of Bhavan’s college of

TYBMS (SEM VI) has completed project on

Working Capital Management in the academic

year 2007-08. This information submitted is true

and original to the best of my knowledge.

Signature Signature

(Principal) (Project co-ordinator)

( Dr. V. Katchi ) Mr. Kutty



Executive Summary

It is said “The taller the building, the more deep the foundation has to be laid”. It is a

simple logic, a strong foundation will more efficiently support the structure of building.

Working Capital acts as a foundation for a strong, successful company. If the

working capital is efficiently managed by the company, it yields rewards like higher

Return on investment, better the company’s creditability.

Improper management of working capital has been the cause of business failures.

New firms wind up for the want of capital, even giants tumble like pack of cards through

drying up working capital reservoirs.

This project is made with a view to give a peek view of how to manage working

capital effectively and what components have to be handled to ensure so.



T A B L E O F C O N T E N T S

Title Page Nos.

S e c t i o n – I

Working Capital Management 1

S e c t i o n – I I

Components of Working Capital Management

Cash Management 29

Credit Management 38

Inventory Management 50

Working Capital Financing 58

Conclusion 73

Bibliography 74



Working Capital Management P a g e | 1

What is Working Capital?

Working capital is a measurement of an entity’s current assets, after subtracting itsliabilities. Sometimes referred to as operating capital, it is a valuation of the amount of

liquidity a business or organization has for the running and building of the business.

Generally speaking, companies with higher amounts of working capital are better

positioned for success. They have the liquid assets needed to expand their business

operations as desired.

Sometimes, a company will have a large amount of assets, but have very little with

which to build the business and improve processes. Even a profitable company mayhave this problem. This can occur when a company has assets that are not easy to

convert into cash.

Working capital can be expressed as a positive or negative number. When a

company has more debts than current assets, it has negative working capital. When

current assets outweigh debts, a company has positive working capital.

Changes in working capital will impact a business’ cash flow. When working capital

increases, the effect on cash flow is negative. This is often caused by the liquidation of

inventory or the drawing of money from accounts that are due to be paid by the

business. On the other hand, a decrease in working capital translates into less money to

settle short-term debts.

Working capital is among the many important things that contribute to the success of

a business. Without it, a business may cease to function properly or at all. Not only does

a lack of working capital render a company unable to build and grow, but it may also

leave a company with too little cash to pay its short-term obligations. Simply put, a

company with a very low amount of working capital may be at risk of running out of

money.

When a company has too little working capital, it can face financial difficulties and

may even be forced toward bankruptcy. This is true of both very small companies and




billion-dollar organizations. A company with this problem may pay creditors late or even

skip payments. It may borrow money in an attempt to remain afloat. If late payments

have affected the company’s credit rating, it may have difficulty obtaining a loan at an

affordable interest rate.

In some types of businesses, it isn’t as much of a problem to have a lower amount of

working capital. Companies that are operated on as cash basis, have fast inventory

turnovers, and can generate cash quickly don’t necessarily need as much working

capital. For example, a grocery store might meet these requirements and do well with

less working capital.

Working Capital is the easiest of all the balance sheet calculations. Here's theformula:

Current Assets - Current Liabilities = Working Capital




What is Working Capital Management?

Working capital management involves the relationship between a firm's short-termassets and its short-term liabilities. The goal of working capital management is to

ensure that a firm is able to continue its operations and that it has sufficient ability to

satisfy both maturing short-term debt and upcoming operational expenses. The

management of working capital involves managing inventories, accounts receivable and

payable, and cash.

OBJECTIVES OF WORKING CAPITAL MANAGEMENT

a) Facilitate and further the cause of Corporate Financial Objective of :

Maximize Value of the Firm (Maximize Market Price of the shares).

Maximize Earning Per Share (EPS).

Any Other.

b) Balance Risks and Returns.

c) Balance Liquidity and Profitability – Liquidity and Profitability tend to be at

loggerheads.




C L A S S I F I C AT I O N O F W O R K I N G C A P I T A L

Classification of Working Capital

Quantitative Basis Time Basis Measurement Basis Accounting Basis

Gross Net Permanent Temporary Postive Negative Cash Net

Initial Regular Seasonal Special

Gross and Net Working Capital

Gross and Net Working Capital are the two basic and fundamental concepts of working capital.

Gross Working Capital

Gross Working Capital is equal to total Current assets only. It is identified with

Current assets alone. It is the value of non-fixed assets of an enterprise and includes

inventories (raw materials. work-in-progress, finished goods, spares and consumable

stores), receivables, short-term Investments, advances to suppliers, loans, tender

deposits, sundry deposits with excise and customs, cash and bank balances. prepaid

expenses, incomes receivable, etc.

Gross Working Capital Indicates the quantum of Working capital available to meet

Current liabilities. This is very useful for routine planning of business activities in normal

course.




Thus:-

Gross Working Capital = Total Current Assets

Net Working Capital

Net Working Capital is the excess of current assets over current liabilities, i.e.

current assets less current liabilities.

This concept of working capital is widely accepted in financial management and

normally for granting finance banks consider net working capital concept.

Net Working Capital = T.CA - T.C.L.

However, this does not reflect the exact position of working capital due to the

following factors:

a) Valuation of inventories may include write-offs;

b) Debtors include the profit element;

c) Debts outstanding for more than a year likewise debtors which are doubtful if

not provided for, are included as assets are also placed under the head

'current assets;

d) Non-moving and slow-moving items of inventories are also included in

inventories if not written off and;

e) Write-offs and the profits do not involve cash outflow;

To assess the real strength of working capital position, it is necessary to exclude

the non-moving and obsolete items from inventories. Working Capita1 thus, arrived at is




Permanent Working Capital

This represents the quantum of current assets required on a continuing basis for an

entire year. It is the minimum aggregate of cash, inventory and debtors maintained tocarry on business operations smoothly at any time during an accounting period.

Permanent working capital is locked in the business as long as it continues to exist. The

quantum of permanent working capital will vary according to the level of business

activities from time to time.

Permanent working capital is of two types:

a) Initial Working Capital AND

b) Regular Working Capital.

a) Initial Working Capital:

This is the amount of working capital required at the inception of an

organisation. In the initial stages, when the revenues are not regular, it may be

difficult for a company to obtain credit from the banks and at the same time it may

be required to grant credit to its customers. In such a case adequate workingcapital is required to activate the circulation of capital and keep it moving till the

collection from debtors and other cash receipts exceed the payment.

b) Regular Working Capital:

This is the amount of working capital required for the continuous operations of

an enterprise. It refers to the excess of current assets over current liabilities. Any

organisation has to maintain a minimum stock of materials, finished goods and

cash to ensure its smooth working and to meet its immediate obligations.

Thus, permanent working capital is the quantum of funds required permanently for

the production of goods and services on a continuing basis 10 satisfy the demands of

customers.




Permanent working capital has certain essential features. They are:

a) Permanent working capital is different from fixed assets which are sunk in the

business operations and retain their form for a long period.

b) Permanent working capital is constantly changing. They change from one

current asset to another as in the case of raw materials. Raw materials, as they

are in process, become semi-finished goods, then finished goods and when they

are sold become debtors, debtors when realized become cash and so on.

c) The value represented by permanent working capital never leaves the business

operations. That is why financial managers resort to long-term borrowings like

debentures to meet their company's permanent working capital requirements.

d) The size of permanent working capital will increase as long as the business is

growing and expanding.

Temporary or Variable Working Capital

Temporary working capital is also called as 'circulating Working capital.' It is

influenced by seasonal fluctuations of the business concerning Variable working capital

may be:

(a) Seasonal Working Capital OR

(b) Specific Working Capital

a) Seasonal Working Capital:

This is the amount of Working Capital required at stated intervals to meetthe changing seasonal requirement When the season approaches, business

needs more funds to meet the seasonal pressure of demand.

Example: A textile dealer would require large amount of funds a few months

before Diwali.




b) Special Working Capital:

This is the amount of working capital required to meet unforeseen

eventualities that may arise during the course of operations. Any organisationmust have additional funds to meet such contingencies.

Example: Sudden increase in demand, strikes, fire, floods, drastic rise in taxes,

etc.

The concept of permanent and variable working capital is illustrated through the

following diagram:




Permanent and Temporary Working Capital - distinguished

Permanent Working Capital Temporary Working Capital

This is required as long as the business

continues as a going concern.

This is required for a temporary period,

as for example, during seasons.

Permanent working capital never leaves

the business

Temporary working capital disappears

from the business process once purpose

is served.

The size of permanent working capital

Increases with the growth of business.

The size of temporary working capital we

need not necessarily Increase with

growth of business.

Positive and Negative Working Capital

Ω Positive working capital:

The company’s current assets are greater than their current liabilities.

Ω Negative working capital:

Working capital is simply current assets minus current liabilities and can be

positive or negative. Working capital is basically an expression of how much in

liquid assets the company currently has to build its business, fund its growth, and

produce shareholder value. If a company has ample positive working capital,then it is in good shape, with plenty of cash on hand to pay for everything it might

need to buy. If a company has negative working capital, then its current liabilities

are actually greater than their current assets, so the company lacks the ability to

spend with the same aggressive nature as a working capital positive peer. All




other things being equal, a company with positive working capital will always

outperform a company with negative working capital.

Some companies can generate cash so quickly they actually have a negative working capital. This is generally true of companies in the restaurant business

(McDonalds had a negative working capital of $698.5 million between 1999 and

2000). Amazon.com is another example. This happens because customers pay

upfront and so rapidly, the business has no problems raising cash. In these

companies, products are delivered and sold to the customer before the company

ever pays for them.

The operating cycles of companies with negative working capital are suchthat, thanks to a favorable timing mismatch, they collect funds prior to disbursing

certain payments. There are two basic scenarios: 1) supplier credit is much

greater than inventory turnover (see days’ inventory ratio), while at the same

time, customers pay quickly, in some cases in cash; 2) customers pay in

advance. A low or negative working capital is a boon to a company looking to

expand without recourse to external capital. Efficient companies, in particular in

mass-market retailing, all benefit from low or negative working capital.

The bottom line: A negative working capital is a sign of managerial efficiency

in a business with low inventory and accounts receivable (which means they

operate on an almost strictly cash basis). In any other situation, it is a sign a

company may be facing bankruptcy or serious financial trouble.

In short terms negative working capital usually means that on the balance

sheet the company’s current liabilities are greater than their current assets.

Usually mean that a company is borrowing or in overdraft to maintain its day today activities.

From companies point of view




That negative working capital isn't always a problem but certainly is not ideal.

Many of the large organization for example HLL operate with negative working

capital because they use creditors money to partially finance the business.

From suppliers point of view

Suppliers of any company will like to have positive working capital because

they believe that they have less risk in dealing with those companies as

compared to those who have negative working capital.

This works as follows: - They agree 60 day or 90 day terms with their

suppliers. They turn the purchased merchandise into cash in one or two weeks

and can then use the cash for other purposes, paying the staff and so forth. This

continues on a rolling cycle.

Ω Zero Working Capital

Working capital is the comparison of current assets to current liabilities. For

most organizations, current assets exceed current liabilities and working capital

therefore represents the liquid reserves for meeting current obligations. Creditors

prefer high levels of working capital since they are concerned about receivingpayment. However, management prefers low levels of working capital since

working capital earns an extremely low rate of return. Some companies are now

driving working capital to record low levels, so-called Zero Working Capital. By

keeping working capital at zero, funds are released for many other

opportunities.

Zero Working Capital requires major changes in how an organization

functions. One way to implement Zero Working Capital is to have a demand-

based organization. Demand-based organizations do everything only as they are

demanded: Fill customer orders, receive supplies, manufacture products, and

other functions are done only as needed. The production facilities run 24 hours a

day non-stop according to the demands within the marketplace. There are no

inventories; everything is supplied immediately as needed. The end result of this




demand driven organization is that little, if any, working capital is necessary to

run the business.

Companies like GE (General Electric) and Campbell Soup have made ZeroWorking Capital a major strategic objective for the organization. As more and

more businesses find faster ways of servicing customers, the concept of Zero

Working Capital will become more mainstream.

Cash and Net Liquid Assets Concept of Working Capital

Cash Working Capital is that part of gross working capital which is essentially in liquid

form. It is available in cash or cash resources. It is calculated from the items appearing

in the Balance Sheet. It shows the real flow of money at a particular time. It is

considered to be the most realistic approach Working Capital Management. It indicates

the adequacy of the cash flow.

But, net working capital or net current assets concept of working capital emphasis

the significance of the amount obtained by deducting liquid liabilities from liquid assests.




ASSESSMENT OF WORKING CAPITAL

At times, business needs to estimate the requirement of working capital in advance

for proper control and management. The factors discussed above influence thequantum of working capital in the business. The assessment of working capital

requirement is made keeping these factors in view. Each constituent of working capital

retains its form for a certain period and that holding period is determined by the factors

discussed above. So for correct assessment of the working capital requirement, the

duration at various stages of the working capital cycle is estimated. Thereafter, proper

value is assigned to the respective current assets, depending on its level of completion.

The basis for assigning value to each component is given below:

Each constituent of the working capital is valued on the basis of valuation

enumerated above for the holding period estimated. The total of all such valuation

becomes the total estimated working capital requirement.

The assessment of the working capital should be accurate even in the case of smalland micro enterprises where business operation is not very large. We know that working

capital has a very close relationship with day-to-day operations of a business.

Negligence in proper assessment of the working capital, therefore, can affect the day-

to-day operations severely. It may lead to cash crisis and ultimately to liquidation. An




inaccurate assessment of the working capital may cause either under-assessment or

over-assessment of the working capital and both of them are dangerous.

CONSEQUENCES OF UNDER- ASSESSMENT OF WORKING CAPITAL

ال Growth may be stunted. It may become difficult for the enterprise to undertake

profitable projects due to non-availability of working capital.

ال Implementation of operating plans may become difficult and consequently the

profit goals may not be achieved.

ال Cash crisis may emerge due to paucity of working funds.

ال Optimum capacity utilisation of fixed assets may not be achieved due to non-

availability of the working capital.

ال The business may fail to honour its commitment in time, thereby adversely

affecting its credibility. This situation may lead to business closure.

ال The business may be compelled to buy raw materials on credit and sell finished

goods on cash. In the process it may end up with increasing cost of purchases

and reducing selling prices by offering discounts. Both these situations wouldaffect profitability adversely.

ال Non-availability of stocks due to non-availability of funds may result in production

stoppage.

CONSEQUENCES OF OVER ASSESSMENT OF WORKING CAPITAL

ال Excess of working capital may result in unnecessary accumulation of

inventories.

ال It may lead to offer too liberal credit terms to buyers and very poor recovery

system and cash management.

ال It may make management complacent leading to its inefficiency.




ال Over-investment in working capital makes capital less productive and may

reduce return on investment. Working capital is very essential for success of a

business and, therefore, needs efficient management and control. Each of the

components of the working capital needs proper management to optimise profit.

Working capital is very essential for success of a business and, therefore, needs

efficient management and control. Each of the components of the working capital needs

proper management to optimize profit.

There are two methods of projection of Working Capital, these are:

(a) Conventional Method.(b) Operating Cycle Method.

(a) Conventional Method:

According to this method cash inflows and outflows are matched with each other.

Greater emphasis is laid on liquidity of a business.

(b) Operating Cycle Method:

This method is more dynamic. It refers to working capital in a realistic way.

Working capital is decided on the basis of length of the operating cycle. It is calculated

by dividing operating expenditure by the number of operating cycles.




a) Level of Activity:

The process of estimation of working capital begins with the level of activity.

Based on past experience, installed and utilised capacity of the factory and likely

demand the finance manager has to ascertain the required quantum of

production in advance.

b) Raw Materials:

Based on the level of activity, the quantity and the cost of raw materials

required have to be estimated. The length of time raw materials will remain in

store before they are issued for production have to be taken into consideration.

Longer the period of stay of stock of raw materials in stores, greater will be the

requirement of working capital. Month by requirement of raw materials based on

production budgets have also to considered. The raw material stock must be

valued at cost.

c) Labour and Overheads:Cost to be incurred on wages and overheads, besides raw materials have to

be ascertained from cost records.

d) Work-In-Progress or Work-In-Process :

The ‘period of processing’ or ‘time of production cycle’ has to be considered.

Longer the production cycle, greater will be the working capital requirement. For

this period wages has to take into consideration, the amount needed for rawmaterial and overheads having regard to the estimated volume of production.

Method of Production is also important because in some industries entire lot

of raw materials is introduced in the first step of production period and on it

wages and overheads costs are spread over production eye for e.g. edible oil




processing industry.

In other method, all raw materials, wages and overheads are introduced in

various steps and processes of production cycle for e.g. motor car manufacturing.

If wages and overheads accrue evenly during the time the process of

manufacture is in progress, then on an average the total cost of labour and

overheads outstanding will only be for half the time:

e) Finished Goods:

The period for which the finished goods have to remain in the warehousebefore sale has to be taken into account. This depends on seasonality, the sales

forecast, etc. For Example, if the sales are seasonal but production is throughout

the year, working capital requirements would be heavier during the slack season.

The finished goods must be valued at cost.

f) Sundry Debtors:

The length of the period of credit allowed to debtors is to be taken intoconsideration. This is known as the "time-lag in payments by debtors". If the

period of credit allowed to debtors is longer. The working capital required will be

higher in the absence of similar time-lags in payments to creditors or suppliers.

Some analysts, while calculating the time-lag in payments by debtors

estimate the book debts less the profit element in them while other analysts take

debtors at book values inclusive of the profit element.

However, debtors valued at sales price is always appropriate in working

capital estimation.




g) Cash and Bank Balances:

Every businessman is supposed to know on the basis of past experience the

amount of cash float or bank balance necessary to meet the day-to-daypayments. This amount is to be added to the working capital required.

h) Sundry Creditors:

The length of credit period available from trade creditors is another important

factor that has to be taken into consideration while estimating the working capital

requirements.

The time-lag in payments to creditors and the rate of purchases or

consumption of raw materials are the data required for this purpose.

Longer the period of credit from suppliers, lower will be the working

requirements.

i) Creditors for Expenses :

Time-lag in payments of wages and overheads also decide the amount of

working capital. If there is no time-lag required in payments of wages and

overheads, more working capital will be required and less, if there is a time-lag in

payments of wages and overheads.

j) Contingencies:

After determining the amount of working capital required, a provision for

contingencies may be made to allowances for likely variations or for unforeseen

expenses. This is a sort of cushion against uncertainties involved in estimating

Working capital requirements.




WORKING CAPITAL OPERATING CYCLE

The operating cycle represents the flow of enterprise values through the firm. The

flow of enterprise values, in a dynamic setting with fast changing events, needs to be

monitored on a moment-to-moment basis.

TYPICAL CYCLES:

SHORTEST CYCLE

TRADING CONCERN – OPERATING CYCLE




This type of operating cycle is experienced by the companies/firms engaged in

trading activities.

The cash is utilized for procurement of a product/finished good, this good undergoesa certain value addition process (i.e. Packaging for exports). These are then sold to the

customers who make part payments. After the expiration of credit period, the cash is

received and this is again put back for purchases. This the cycle continues.

Manufacturing Concern: Operating Cycle

This cycle is modeled by the manufacturing concerns. The cash is utilized to pay for

Raw materials (purchases may be made on credit basis). This Raw material is

Processed through the manufacturing procedure (Sometimes, these goods have to be

stocked cause unavailability of machines, thus WIP). The Finished goods are sold to

customers, cash received and paid to the suppliers of raw material.




FACTORS DETERMINING WORKING CAPITAL

There are a number of factors which determine the working capital requirements of afirm. These factors are of different importance. The influence of an individual factor may

also change for a firm over time. Analysis of the relevant factors has to be made in

order to determine total investment in working capital. The following is a brief

description of important factors which determine the working capital requirements of a

firm:-

1. Nature of Business:

The working capital requirements are significantly influenced by the nature of the business carried on by the firm. Public utility undertakings like road-transport

corporations or electricity supply undertaking need very small working capital

because they offer were services rather than products and offer mostly cash

sales with the result that very small amount of capital remains invested in

inventory, and receivables. In manufacturing enterprises, the working capital

requirements are fairly large. The requirements differ from industry to industry.

For example the working capital requirements of an edible oil mill. The workingcapital requirements of trading and financial enterprises are the maximum as

they have to maintain a sufficiently large amount of cash, inventories and

receivable.

2. Size of Business:

Larger the size of business, the greater will be the working capital

requirements of the firm as more funds will be locked up in inventories and

receivables to meet the demand of bigger size of business.

3.. Manufacturing Cycle:

Manufacturing cycle refers to the time-span between the purchase of raw

materials and their conversion into finished goods by means of manufacturing




process. Funds remain tied up in semi-finished goods during the manufacturing

process. Longer the manufacturing cycle the larger the working capital needed

and vice versa. For example, a distillery requires heavy investment in inventories

because it has an ageing process. On the other hand, in a bakery, raw materials

are soon converted into finished goods and not much funds are looked up

inventories.

4.. Production Policy:

In certain industries, there are wide seasonal changes in demand for the

product manufactured by the firm. In such a case, if the firm adopts a steady

production policy, inventories of finished goods will accumulate during the off-season period requiring a higher amount of working capital. If the firm opts to

vary its production schedules in accordance with changing demand, there may

be serious production problems. During the slack season, the firm will have to

maintain its working force and fixed assets without adequate production and sale.

During the peak period, it will have to operate at full capacity. This arrangement

may be a costly affair. One has to manufacture some other product during the

off-season and concentrate on the main line during the season of the main

product. But it may not be feasible in all the cases.

5. Business Cycles:

There are business cycles resulting in marked variations in business

conditions. There is an upward swing of business conditions leading to a boom

when the business activities are at their peak. It is followed by a downward phase

called recession when business activities decline. The downward phase ends in

a depression, completing the business cycle. Then again, there is a recovery tostart a new business cycle. During the recovery, the working capital requirement

decrease.




6. Conditions of Supply of Raw Material:

In an industry where raw material is available only in a particular season and

the firm has to buy raw material in bulk in that reason to ensure uninterruptedproduction of finished goods, the working capital requirements will be more.

When in cases where the supply of raw material is unpredictable, the firm may

have to accumulate stock of raw material requiring more working capital.

7. Terms of Credit to Customers:

The terms of credit granted to customers normally depend upon the norms

followed in the industry in which the firm is engages. But the firm has some

flexibility within the norms. Ideally, the firm should be use discretion in granting

credit to its customers. Different terms of credit should be offered to different

types of customers. A liberal credit policy without caring much for the

creditworthiness of the customers will land the firm in trouble and the

requirements of working capital will also unnecessarily increase.

8. Credit from Suppliers:

If the firm is able to procure liberal terms of credit from suppliers of rawmaterial, its net working capital requirements will be reduced.

9. Stock Turnover Ratio:

Stock turnover ratio refers to the speed with which finished goods are

converted into sales. If a firm has a high stock turnover ratio as in the case of a

bakery, its working capital requirements will be less. On the other hand, if a firm

has a low stock turnover ratio as in the case of fancy jewellery shop; its workingcapital requirements will be high.

10. Price Level Changes:

Price level changes also affect the working capital requirements. In times of

rising prices, a firm will require a larger amount of working capital to maintain the




same quantity of inventory and credit sales. But the effect will be different for

different firms. If the firm increases the price of its products promptly, the

requirements of working capital will not be high.

11. Income Tax:

Out of the profits, income tax has to be paid. Mostly, advance payment of

income-tax has to be made on the estimated income of the current year. The

management has no discretion in the matter. If level of income-tax is increased

by the government, the working capital requirement will increase.

12. Operating Efficiency:

The working capital requirement can be reduced by management by means

of operating efficiency. Management can ensure the efficient utilization of

resources by minimizing wastages, improving co ordinations and accelerating the

pace of cash cycle.




STRATEGIES IN WORKING CAPITAL MANAGEMENT

There are two strategies of working capital management:

1. Conservative Working Capital Strategy

It suggests high level of current assets in relation to sales. Surplus current

assets enable the firm to absorb the variations in sales, production plans, and

procurement time without any disturbance of the production plans. Higher level of

liquidity reduces the risk of insolvency. But this leads to higher interest and

carrying costs. It ensures continuous flow of operation. It will also help to absorbthe day to day business risks. Excess cash is invested in short term marketable

securities. In case of need, the securities invest old out to meet the urgent

requirement of working capital.

2. Aggressive Working Capital Strategy

As per this strategy current assets are maintained just to meet the liabilities

without keeping any margin. The core working capital is financed by long-termsources and the seasonal variations are met through short term borrowings. This

strategy will minimize the investment in net working capital and it will lower the

cost of financing working capital. However, it requires frequent financing. It also

Increases the risk of sudden shocks.

Working Capital Leverage

It refers to the Impact of level of working capital on the profitability of acompany. The management should improve the productivity of Investment in

current assets. It will ultimately increase the return on capital employed. Higher

level of Investment in current assets than required will mean Increase In the cost

of Interest charges. This will bring down the return on capital employed. Working




C A S H M A N A G E M E N T

CASH:-

Cash is the lifeblood of a business.

Without sufficient cash, a business will be unable to pay the wages of it's

employees, buy the fixed assets required to operate a business, pay for product

development or pay for advertising and promotion to attract new customers and

build a customer list.

If the management of a business doesn't manage cash properly, they aresetting themselves up for emotional distress and the business may not survive.

Cash is like manure- you reap the benefits only if it is spread effectively in the

businesses.

CASH MANAGEMENT:-

Cash management is the component of treasury management that deals with

tracking and adjusting a company’s cash position. The objective in cash

management should be to "keep the investment in cash as low as possible while

still operating the firm’s activities efficiently and effectively. This involves

balancing the costs (forgone interest) of holding cash against the benefits of

saving the time and transaction costs associated with selling securities or other

assets every time cash is needed.

Cash management often is defined to involve not only pursuing optimal cash

balances but also implementing policies and processes to speed the collection

and delay the disbursement of cash. These endeavors are collectively known as

Float Management.

Cash management is the movement of funds through financial institutions to

optimize liquidity. It is the management of corporate funds to increase interest




income earned by maximizing investments and/or reducing interest paid by

minimizing borrowings.

Cash management uses the knowledge of funds movement through thebanking system, coupled with banking services and other financial products, to

optimize liquidity. It is the scheduled gathering of information about a company’s

cash flow, its receipts, disbursements, and balances. This information is used to

manage these elements of working capital.

Effective cash management ensures the timely provision of cash resources

necessary to support the company’s operations. With the use of basic cash

management tools and techniques, cash becomes a corporate asset thatcontributes directly to the bottom line. Whether a company is flush with cash or

experiencing a shortfall of funds, good cash management is critical to the

success of every company.

Cash management is a financial discipline that uses the same principles,

regardless of the type of business, size or age of an enterprise. Cash

management is not an accounting function. The accountant records and reports

transactions historically; the cash manager plans and executes these financialtransactions. Cash managers use techniques, products and services to efficiently

manage cash resources and satisfactorily resolve cash shortages or surpluses.

The major elements of cash management are:

♦ Deposits: Receiving funds and depositing receipts into the bank account

as quickly as possible, while collecting adequate information to correctly

identify the source of the payment.

♦ Concentration: Moving funds to a central location from which they are

more efficiently managed for investing and disbursing.

♦ Disbursement: Paying funds by check or electronically to vendors,

employees, investors, and others.




♦ Information gathering, analysis and control: Reporting funds

information, including: current cash position, forecasted shortages andsurpluses, cost-benefit of proposed changes in cash management

operations or outsourced services, interest rate or foreign currency risk

exposure, and many other monetary circumstances which affect corporate

resources.

CASH MANAGEMENT OBJECTIVES:- (from the business owner’s point of view)

♦ Maintaining Liquidity : Liquidity refers to a company’s ability to meet current and

future financial obligations in a timely and cost-effective manner.

♦ Optimizing Cash Resources: Cash management system reduces holdings of

non-earning cash balances to minimum levels while still providing adequate

liquidity. Any excess cash balances are either invested to generate additional

income or used to reduce interest expense through the repayment of debt.

♦ Financing: Cash management assist in obtaining both short and long-term

borrowed funds in a timely manner and at an acceptable cost. These credit

facilities are used to fund a company’s cash shortages.

♦ Managing Risk: Cash management help in the monitoring and controlling of a

company’s exposure to interest rate, foreign exchange and other financial risks.

♦ Coordinating Financial Functions: Cash management help managers ensure

that managers in other areas of the company understand and implement policies

that are consistent with cash management objectives.




WHAT IS THE BASIC CASH MANAGEMENT PROCESS?

Every successful company has a pool of cash that sustains the day-to-day activities

of business. It grows with receipts from sales and contributions and shrinks with

expenditures for inventory, marketing, labor and other expenses. The uncertainty of

cash inflows and outflows creates the challenge of ensuring that sufficient funds are

available at all times to support the operating cycle. Cash flows of both types must be

closely managed. There are a variety of cash management tools and techniques to

assist in this process, which will be discussed later.

Borrowing becomes necessary when cash flow falls short of covering

disbursements. When incoming funds exceed the outflow, cash is used to repay

borrowings or purchase short-term investments until the cash is needed to cover future

expenses.

Financial officers need timely information to properly control and use their funds

throughout the cash flow cycle. The Basic Cash Management Process provides that

timely information. The cash flow timeline includes the total time interval beginning with

the first phase of the operating cycle, when resources are purchased, until the last step

when receipts are collected.

It consists of the following steps:

Material purchases. Acquisition of raw materials or merchandise for resale

includes negotiation of the method of payment, credits terms and trade and

payment discounts.

Payment for resources. All resources required to support sales, including

labor, marketing and overhead expenses, incur financing costs until cash is

collected for sales made. By managing the timing of disbursements, the cash

manager can minimize implicit financing expenses.

Sale of inventory or services. Merchandise and other sales are most

frequently accomplished by extending credit to customers. The timing of




accounts receivable collection is a major focus in cash management.

Collection of receipts. Only when the customer has provided good funds

for the merchandise or service does the cash flow cycle conclude for thattransaction.

The cash flow and operating cycles are similar. The cash manager focuses on the

timing of the cash flows related to accounts payable, accounts receivable and inventory

turnover. Operations managers concentrate on the timely availability of materials and

resources and on sales volumes, relying on the cash manager to ensure adequate

liquidity to support operations. Cash forecasting is based on understanding both the

Operating and the Cash Flow cycles.

Cash flow versus business operations cycles




EXCESS CASH MANAGEMENT

Cash management in a corporate environment is an exciting and challenging issue.The technique usually used to understand cash flows is a cash budget, which maps out

the periodic – daily, weekly or monthly cash inflows and cash outflows. If the cash

inflows are greater than cash outflows, it is referred to as excess cash and vice versa.

Cash flows are also presented in terms of point of origination and end use viz

operations, investment and financing. The respective categories are evaluated for their

contribution or toll on the cash flows. Surfeit or deficit cash compels management to

identify options to tackle the situation. Deficit cash is easier to handle than surplus cash.

Deficit cash requires prudent deployment of payments and alertness to recoveries. It

also encourages parsimony and usually attracts an embargo on superfluous and

unaffordable luxuries. Last but not the least it motivates identification of timely

procurement of funds – right time, right amount, right lender, right rate, right country and

currency, right covenants regarding amortization - interest and loan installments. In a

boundary less world options for an entrepreneur, transcend beyond the national

frontiers into markets and currencies of other countries.

However surfeit cash is a big problem. If not handled in time with skill and dexterity,

it can lead to idle cash or liquid assets earning returns comparable to gilt edged returns

or even lower, thus depressing the overall return on capital or assets employed in the

business. If the assets employed in the core business are earning an overall return of

15% and the gilt edged returns on liquid assets is 8% the overall return on assets (core

business plus liquid assets) is depressed to the extent of the gap between efficiency of

capital in core assets vis-à-vis liquid assets. There are other issues too. If a large chunk

of reserves are blocked in liquid assets in lieu of plant and machinery (core business

assets) the question of taxes come into picture. Substantial amounts of depreciation

and possibly other incentives can and do provide tax shelter which protects the

operating excellence. Infact tax management plays a key role in facilitating the

transmission of operating excellence to the shareholders. However, this exercise is




rendered defunct if there are liquid funds blocked in assets of non-core businesses. This

may happen either because of lack of adequate reinvestment opportunities or

excellence in management, which generates a lot of free reserves matched by cash or

both. Thus the rate at which cash flows come into the business is far greater than the

rate at which new opportunities can absorb cash to create assets in core businesses or

even new diversified business ventures providing returns higher than liquid assets.

Hence surfeit cash is a serious problem – at best a blessing in disguise and at worst a

value destroyer if not laid to rest in time through right reinvestment opportunities.

Globally Singapore Airlines (SQ) provides an excellent case study of a company with

excess cash from time to time. it makes half a billion USD net profit with a double digit

profit margin for a very long time – year on year basis. Infact in the mid nineties it was

said that SQ had a very difficult reputation with the banking fraternity because it didn’t

borrow money. SQ had to turn down bankers proposals to provide loans at competitive

interest rates. SQ was flushed with cash and was looking for profitable avenues to

deploy the surplus cash. As a policy SQ use to replace their aircrafts in five years (the

shortest useful life in the air line business). At one time in the late nineties SQ placed an

order for 77 triple sevens with a plea that they will pay cash on an upfront basis. Each

aircraft was around 140mn USD. Though this order did not actually go through it wasthe largest purchase order in aviation history at that point of time. Thus strategies to

deploy cash included accelerated depreciation policy through short useful life and an

active replacement, modernization and expansion policy. Of course accelerated

depreciation and short useful life have their own externalities of operating a modern and

new fleet and also reaping the bonanza of high realizable value of the aircrafts on sale

at the end of useful life of 5 years. Pending purchase of assets for the core business

and also investing in airline related business the airline had to identify profitable short-

term investment opportunities to absorb the bulging, surfeit, cash. Economic history is

replete with instances of several occasions, across the globe, where as and when

supply exceeds demand the excess has to be destroyed. In fact this goes well with the

fundamental tenets of economic management of capitalist societies viz mass

production, mass consumption and as and when need be mass destruction. Agricultural




production, from time to time, is a case in point. As and when excess production

emerges there is destruction to support the farm price policies and protect the farmers.

In the same vein as and when the supply of loanable funds exceeds the demand for the

same, interest rates get depressed. Infact Switzerland is a classic example where

interest rates move into a negative level – customers who keep money in the bank have

to pay interest and withdrawals of cash are entitled to an interest payment. Thus though

text books say interest rate cannot be negative, in Switzerland cash of all colours flow in

from different parts of the world throughout the year creating a massive surfeit of cash

to push interest rate to negative levels. India Inc is now facing, in some quarters, a

serious problem of cash surpluses lying idle and anxiously awaiting profitable

deployment.

IMPLICATIONS:

Cash rich companies have a profile, which is worth understanding. A cash rich

company would have piles of cash either in the Current Asset section (cash or near

cash assets like marketable securities). If the cash is already deployed in investments,

then investments are another important item to reckon with. Such companies would also

have limited or no need for employing leverage i.e. debt in the capital structure.

Consequently the company would bear a very low interest burden. By implication the

debt equity ratio is very low and the cover ratio, redundantly very high. The opportunity

to boost return on equity via leverage is non-existent for such companies. Cash rich

companies fully backed by reserves tend to be overcapitalized. Further the domination

of net worth in the sources of fund tends to make capital structures relatively more

expensive than leverage structures. The composite cost of capital of over-capitalized

companies tends to be high casting a higher responsibility on management.

Added to this is the woe of lower overall return on assets. The composite profit is a

combine of returns from assets in core business plus returns from assets in non-core

business financial assets and other investments. The efficiency of capital invested in the

core business is usually higher than other options particularly the financial assets,




gilt/non-gilt as the case may be. Thus the overall returns are depressed due to the

limited, rather low productivity of capital invested in the non-core business. And the

latter investments are a compulsion stemming from surfeit cash. The bottom line is as

follows cash rich companies face economic value dilution due to the limited

opportunities to use capital productivity and the increased cost of capital due to the high

role of equity capital in the capital structure. Hence the caveat surfeit cash is a rather

dangerous position – a double-edged razor.

There is one more point.

Cash rich companies trying to deploy surplus cash into financial assets/investments,

pending long term business opportunities, are bugged by higher taxation. Other incomes arising out of returns on temporary investments are usually exposed to taxation

without major deductions like depreciation. This tends to expose greater amounts of

incomes to taxation. Invariably investment decisions are tax driven. And tax incentive

embedded in depreciation is denied to the cash rich companies because of the absence

of asset formation that can attract the benefits of Section 32 of IT Act.

The important messages which come out of the above:

1) Liquidity and profitability are at loggerheads

2) Cash rich companies have severe problems in identifying profitable

investment opportunities.

3) Cash rich companies are saddled with an unduly high current ratio.

However, they are benefit of borrowings because they do not need

lenders in view of net worth being back up by adequate liquid assets.

4) Cash rich companies tend to be over capitalize with a very high ration of net worth to capital employed (net worth plus long term borrowings).




C R E D I T M A N A G E M E N T

While business firms would like to sell on cash, the pressure of competition and theforce of custom persuades them to sell on credit. Firms grant credit to facilitate sales. It

is valuable to customers as it augments their resources-it is particularly appealing to

those customers who cannot borrow from other sources or find it very expensive or

inconvenient to do so.

The credit period extended by business firms usually ranges from 15 days to 60

days. When goods are sold on credit, finished goods get converted into accounts

receivable (trade debtors) in the books of the seller. In the books of the buyer, theobligation arising from credit purchase is represented as accounts payable (trade

creditors).

A firm's investment in accounts receivable depends on how much it sells on credit

and how long it takes to collect receivables. For example, if a firm sells Rs 1 million

worth of goods on credit a day and its average collection period is 40 days, its accounts

receivable will be Rs 40 million. Accounts receivable (or sundry debtors as they are

referred to in India) constitute the third most important asset category for businessfirms, after plant and equipment and inventories. Hence it behooves a firm to manage

its credit well.

TERMS OF PAYMENT

Terms of payment vary widely in practice. At one end, if the seller has financial

sinews it may extend liberal credit to the buyer till it converts goods bought into cash. Atthe other end, the buyer may pay cash in advance to the seller and finance the entire

trade cycle. Most commonly, however, some in-between arrangement is chosen

wherein the trade cycle is financed partly by the seller, partly by the buyer, and partly by

some financial intermediary. The major terms of payment are discussed below.




Cash Terms

When goods are sold on cash terms, the payment is received either before the

goods are shipped (cash in advance) or when the goods are delivered (cash on

delivery).

Cash in advance is generally insisted upon when goods are made to order. In

such a case, the seller would like to finance production and eliminate marketing

risks. Cash on delivery is often demanded by the seller if it is in a strong bargaining

position and / or the customer is perceived to be risky.

Open Account

Credit sales are generally on open account. This means that the seller first ships

the goods and then sends the invoice (bill). The credit terms (credit period, cash

discount for prompt payment, the period of discount, and so on) are stated in the

invoice which is acknowledged by the buyer. There is no formal acknowledgement of

indebtedness by the buyer.

Credit Period:

The credit period refers to the length of time the customer is allowed to pay

for its purchases. It is usually mentioned in days from the date of invoice. If a firm

allows 30 days, say, of credit with no discount for early payment, its credit terms

are stated as 'net 30'.

Cash Discount:

Firms generally offer cash discount to induce customers to make prompt pay-

ment. For example, credit terms of 2/10, net 30 mean that a discount of 2 per

cent is offered if the payment is made by the tenth day; otherwise, the full

payment is due by the thirtieth day.




Billings:

To streamline billings, it is a common practice to send a single bill every

month. For example at the end of every month, the customer may be sent a

consolidated bill for the purchases made from the 26th of the previous month to

the 25th of the current month.

Consignment

When goods are sent on consignment, they are merely shipped but not sold to

the consignee. The consignee acts as the agent of the seller (consignor). The title of

the goods is retained by the seller till they are sold by the consignee to a third party.

Periodically, sales proceeds are remitted by the consignee to the seller.

Bill of Exchange

Whether goods are shipped on open account or consignment, the seller does not

have strong evidence of the buyer's obligation. So, a more secure arrangement,

usually in the form of a bill of exchange, is sought. It represents an unconditionalorder issued by the seller asking the buyer to pay on demand or at a certain future

date, the amount specified on it. It is typically accompanied by shipping documents

that are delivered to the drawee when he pays or accepts it. When the drawee

accepts a bill of exchange it becomes a trade acceptance. The seller may hold it till it

matures or get it discounted.

The bill of exchange performs three useful functions: (i) It serves as a written

evidence of a definite obligation. (ii) It helps in reducing the cost of financing tosome extent. (iii) It represents a negotiable instrument.




Letter of Credit

Commonly used in international trade, the letter of credit is now used in domestic

trade as well. A letter of credit, or L/C, is issued by a bank on behalf of its customer

(buyer) to the seller. As per this document, the bank agrees to honour drafts drawn

on it for the supplies made to the customer if the seller fulfills the conditions laid

down in the L/C.

The L/C serves several useful functions: (i) It virtually eliminates credit risk, if the

bank has a good standing. (ii) It reduces uncertainty as the seller knows the

conditions that should be fulfilled to receive payment. (iii) It offers safety to the buyer

who wants to ensure that payment is made only in conformity with the conditions of

the L/C.

CREDIT POLICY VARIABLES

The important dimensions of a firm's credit policy are:

. Credit standards

. Credit period

. Cash discount

. Collection effort

These variables are related and have a bearing on the level of sales, bad debt loss,

discounts taken by customers, and collection expenses. For purposes of expository

convenience \

Credit Standards

A pivotal question in the credit policy of a firm is: What standard should be

applied in accepting or rejecting an account for credit granting? A firm has a wide

range of choice in this respect. At one end of the spectrum, it may decide not to




extend credit to any customer, however strong his credit rating may be. At the

other end, it may decide to grant credit to all customers irrespective of their credit

rating. Between these two extreme positions lie several possibilities, often the

more practical ones.

In general, liberal credit standards tend to push sales up by attracting more

customers. This is, however, accompanied by a higher incidence of bad debt loss,

a larger investment in receivables, and a higher cost of collection. Stiff credit

standards have the opposite effects. They tend to depress sales, reduce the

incidence of bad debt loss, decrease the investment in receivables, and lower the

collection cost.

Credit Period

The credit period refers to the length of time customers are allowed to pay for

their purchases. It generally varies from 15 days to 60 days. When a firm does not

extend any credit, the credit period would obviously be zero. If a firm allows 30 days,

say, of credit, with no discount to induce early payments, its credit terms are stated

as 'net 30'.

Lengthening of the credit period pushes sales up by inducing existing customers

to purchase more and attracting additional customers. This is, however,

accompanied by a larger investment in debtors and a higher incidence of bad debt

loss. Shortening of the credit period would have opposite influences: It tends to

lower sales, decrease investment in debtors, and reduce the incidence of bad debt

loss.

Cash Discount

Firms generally offer cash discounts to induce customers to make prompt

payments. The percentage discount and the period during which it is available are

reflected in the credit terms. For example, credit terms of 2/10, net 30 mean that a

discount of 2 per cent is offered if the payment is made by the tenth day; otherwise




the full payment is due by the thirtieth day.

Liberalising the cash discount policy may mean that the discount percentage is

increased and/or the discount period is lengthened. Such an action tends toenhance sales (because the discount is regarded as price reduction), reduce the

average collection period (as customers pay promptly), and increase the cost of

discount.

Collection Effort

The collection programme of the firm, aimed at timely collection of receivables,

may consist of the following:

1. Monitoring the state of receivables.

2. Despatch of letters to customers whose due date is approaching.

3. Telegraphic and telephonic advice to customers around the due date.

4. Threat of legal action to overdue accounts.

5. Legal action against overdue accounts.

A rigorous collection programme tends to decrease sales, shorten the average

collection period, reduce bad debt percentage, and increase the collection expense.

A lax collection programme, on the other hand, would push sales up/ lengthen the

average collection period, increase the bad debt percentage, and perhaps reduce

the collection expense.

CREDIT EVALUATION

Proper assessment of credit risks is an important element of credit management.

It helps in establishing credit limits. In assessing credit risks, two types of errors

occur:




Type I error A good customer is misclassified as a poor credit risk.

Type II error A bad customer is misclassified as a good credit risk.

Both the errors are costly. Type I error leads to loss of 'profit on sales to good

customers who are denied credit. Type II error results in bad-debt losses on credit

sales made to risky customers.

While misclassification errors cannot be eliminated wholly, a firm can mitigate

their occurrence by doing proper credit evaluation. Three broad approaches are

used for credit evaluation, viz. traditional credit analysis, numerical credit scoring,

and discriminant analysis.

Traditional Credit Analysis

The traditional approach to credit analysis calls for assessing a prospective

customer in terms of the "five C's of credit".

1. Character: The willingness of the customer to honour his obligations. It

reflects integrity, a moral attribute that is considered very important by credit

managers.

2. Capacity: The ability of the customer to meet credit obligations from the

operating cash flows.

3. Capital: The financial reserves of the customer. If the customer has difficulty

in meeting his credit obligations from its operating cash flow, the focus shifts to

its capital.4. Collateral: The security offered by the customer in the form of pledged

assets.

5. Conditions: The general economic conditions that affect the customer.




To get information on the five Cs, a firm may rely on the following:

1. Financial Statements:

Financial statements contain a wealth of information. A searching

analysis of the customer's financial statements can provide useful insights

into the creditworthiness of the customer. The following ratios seem

particularly helpful in this context: current ratio, acid-test ratio, debt-equity

ratio, EBIT to total assets ratio, and return on equity. (Chapter 30 discusses

these ratios).

2. Bank Reference:The banker of the prospective customer may be another source of

information. To ensure a higher degree of candour, the customer's banker

may be approached indirectly through the bank of the firm granting credit.

3. Experience of the Firm:

Consulting one's own experience is very important. If the firm had

previous dealings with the customer, then it is worth asking: How prompt hasthe customer been in making payments? How well has the customer

honored his word in the past? Where the customer is being approached for

the first time, the impression of the company's sales personnel is useful.

4. Prices and Yields on Securities:

For listed companies, valuable inferences can be derived from stock

market data. Higher the price-earnings multiple and lower the yield on bonds,

other things being equal, lower will be the credit risk.

Sequential Credit Analysis

The full logic of the flowchart may be redundant for certain customers. For




example, if the character of a customer is found to be weak, it may be pointless to

conduct the credit investigation further. Hence, sequential credit analysis is a more

efficient method. In this analysis, investigation is carried further if the benefit of such

analysis outweighs it cost. To illustrate, consider three stages of credit analysis:

review of the past payment record, detailed internal analysis, and credit investigation

by an external agency. The credit analyst proceeds from stage one to stage two only

if there is no past payment history and hence a detailed internal credit analysis is

warranted. Likewise, the credit analyst goes from stage two to stage three only if

internal credit analysis suggests that the customer poses a medium risk and hence

there is a need for external credit analysis.

Capacity

Capital Capital

Doubtful

Risk

Dangerous

Risk

Capacity

Capital Capital

Excellent

Risk

Fair Risk

How much

credit be

granted?

Should

credit be

granted?

Character




Numerical Credit Scoring

In traditional credit analysis, customers are assigned to various risk classes

somewhat judgmentally on the basis of the five C's of credit. Credit analysts may,

however, want to use a more systematic numerical credit scoring system. Such a

system may involve the following steps:

1. Identify factors relevant for credit evaluation.

2. Assign weights to these factors that reflect their relative importance.

3. Rate the customer on various factors, using a suitable rating scale (usually

as-point scale or a 7-point scale is used).

4. For each factor, multiply the factor rating with the factor weight to get the

factor score.

5. Add all the factor scores to get the overall customer rating index.

6. Based on the rating index, classify the customer.




Risk Classification Scheme

On the basis of information and analysis in the credit investigation process,

customers may be classified into various risk categories. A simple risk classification

scheme is shown below.

Factor Factor Weight

Rating Factor

score5 4 3 2 1

Past payment 0.30 1.20

Net profit margin 0.20 0.80

Current ratio 0.20 0.60

Debt-equity ratio 0.10 0.40

Return on Equity 0.20 1.00

Rating Index 4.00




Rank Class Description

1 Customers with no risk of default

2 Customers with negligible risk of default (default rate less than 2 per cent)

3Customers with little risk of default (default rate between 2 per cent and 5

per cent)

4Customers with some risk of default (default rate between 5 per cent and

10 per cent)

5Customers with significant risk of default (default rate in excess of 10 per

cent)




I N V E N T O RY M A N A G E M E N T

Just In Time (JIT)

It is an inventory strategy implemented to improve the return on investment of a

business by reducing in-process inventory and its associated costs. The process is

driven by a series of signals, which can be Kanban ( Kanban ? ), that tell production

processes when to make the next part. Kanban are usually 'tickets' but can be simple

visual signals, such as the presence or absence of a part on a shelf. When implemented

correctly, JIT can lead to dramatic improvements in a manufacturing organization's

return on investment, quality, and efficiency. Some have suggested that "Just on Time"

would be a more appropriate name since it emphasises that production should create

items that arrive when needed and neither earlier nor later.

Quick communication of the consumption of old stock which triggers New stock to be

ordered is key to JIT and inventory reduction. This saves warehouse space and costs.

However since stock levels are determined by historical demand any sudden demand

rises above the historical average demand, the firm will deplete inventory faster than

usual and cause customer service issues. Some have suggested that recycling Kanban

faster can also help flex the system by as much as 10-30%. In recent years

manufacturers have touted a trailing 13 week average as a better predictor for JIT

planning than most forecastors could provide.

Philosophy

The philosophy of JIT is simple - Inventory is defined to be waste. Just-in-time (JIT)

inventory systems expose the hidden causes of inventory keeping and are therefore nota simple solution that a company can adopt; there is a whole new way of working that

the company must follow in order to manage its consequences. The ideas in this way of

working come from many different disciplines including statistics, industrial engineering,

production management and behavioral science. In the JIT inventory philosophy there




are views with respect to how inventory is looked upon, what it says about the

management within the company, and the main principle behind JIT.

Inventory is seen as incurring costs, or waste, instead of adding value, contrary totraditional accounting. This does not mean to say that JIT is implemented without an

awareness that removing inventory exposes pre-existing manufacturing issues. Under

this way of working, businesses are encouraged to eliminate inventory that doesn’t

compensate for manufacturing issues, and then to constantly improve processes so that

less inventory can be kept. Secondly, allowing any stock habituates the management to

stock keeping and it can then be a bit like a narcotic. Management are then tempted to

keep stock there to hide problems within the production system. These problems

include backups at work centres, machine reliability, process variability, lack of flexibility

of employees and equipment, and inadequate capacity among other things.

In short, the just-in-time inventory system is all about having “the right material, at

the right time, at the right place, and in the exact amount” without the safety net of

Inventory, the implications of which are broad for the implementors.

Stocks

JIT emphasises inventory as one of the seven wastes, and as such its practice

involves the philosophical aim of reducing input buffer inventory to zero. Zero buffer

inventory means that production is not protected from exogenous (external) shocks. As

a result, exogenous shocks reducing the supply of input can easily slow or stop

production with significant negative consequences. For example as noted in Liker

(2003) Toyota suffered a major supplier failure as a result of the 1997 Aisin fire which

rendered one of its suppliers incapable of fulfilling Toyota's orders. In the US the 1992

railway strikes resulted in General Motors having to shut down a 75,000 worker plant

temporarily as they had no inputs flowing in to the factory.




Transaction Cost Approach

JIT reduces inventory in a firm, however unless it is used throughout the supply

chain, then it can be proposed that firms are simply outsourcing their input inventory tosuppliers (Naj 1993). This effect was investigated by Newman (1993) who found that on

average suppliers in Japan charged JIT customers a 5% price premium.

Environmental concerns

During the birth of JIT multiple daily deliveries were often made by human powered

bicycle, however with increases in scale has come the adoption of vans and lorries for

these deliveries. Cusumano (1994) has highlighted the potential and actual problems

this causes with regard to gridlock and the burning of fossil fuels. This violates three JIT

wastes:

1) Time; wasted in traffic jams

2) Inventory; specifically pipeline (in transport) inventory and

3) Scrap; with respect to petrol or diesel burned while not physically moving.

Price volatility JIT implicitly assumes a level of input price stability such that it is desirable to

inventory inputs at today's prices. Where input prices are expected to rise storing inputs

may be desirable.

Quality volatility

JIT implicitly assumes that the quality of available inputs remains constant over time.

If not firms may benefit from hoarding high quality inputs.




Demand stability

Karmarker (1989) highlights the importance of relatively stable demand which can

help ensure efficient capital utilisation rates. Karmarker argues that without a significantstable component of demand, JIT becomes untenable in high capital cost production.

Kaizen

Kaizen ( , Japanese for "change for the better" or "improvement"; the common

English usage is "continuous improvement" or "continual improvement").

Kaizen is a daily activity whose purpose goes beyond simple productivity

improvement. It is also a process that, when done correctly, humanizes the workplace,

eliminates overly hard work (both mental and physical) "muri", and teaches people how

to perform experiments on their work using the scientific method and how to learn to

spot and eliminate waste in business processes.

To be most effective kaizen must operate with three principles in place:

1. Consider the process and the results (not results-only) so that actions to

achieve effects are surfaced;2. Systemic thinking of the whole process and not just that immediately in view

(i.e. big picture, not solely the narrow view) in order to avoid creating problems

elsewhere in the process; and

3. A learning, non-judgmental, non-blaming (because blaming is wasteful)

approach and intent will allow the re-examination of the assumptions that

resulted in the current process.

People at all levels of an organization can participate in kaizen, from the CEO down,

as well as external stakeholders when applicable. The format for kaizen can be

individual, suggestion system, small group, or large group. In Toyota it is usually a local

improvement within a workstation or local area and involves a small group in improving




their own work environment and productivity. This group is often guided through the

kaizen process by a line supervisor; sometimes this is the line supervisor's key role.

While kaizen (in Toyota) usually delivers small improvements, the culture of continual aligned small improvements and standardization yields large results in the

form of compound productivity improvement. Hence the English usage of "kaizen" can

be: "continuous improvement" or "continual improvement."

This philosophy differs from the "command-and-control" improvement programs of

the mid-twentieth century. Kaizen methodology includes making changes and

monitoring results, then adjusting. Large-scale pre-planning and extensive project

scheduling are replaced by smaller experiments, which can be rapidly adapted as newimprovements are suggested.

Translation

The original kanji characters for this word are:

In Japanese this is pronounced 'kaizen'.

('kai') KAI means 'change' or 'the action to correct'.

('zen') ZEN means 'good'.

In Chinese this is pronounced 'gai shan':

('gǎ i shàn') means 'change for the better' or 'improve'.

('gǎ i') means 'change' or 'the action to correct'.

('shàn') means 'good' or 'benefit'. 'Benefit' is more related to the Taoist or

Buddhist philosophy, which gives the definition as the action that 'benefits' thesociety but not one particular individual (i.e. multilateral improvement). In other

words, one cannot benefit at another's expense. The quality of benefit that is

involved here should be sustained forever, in other words the 'shan' is an act that

truly benefits others.




The foundation of the Kaizen method consists of 5 founding elements:

1. Teamwork,

2. Personal Discipline,

3. Improved Morale,

4. Quality circles, and

5. Suggestions for improvement.

Out of this foundation three key factors in Kaizen . arise:1. Elimination of waste (muda) and inefficiency

2. The Kaizen five-S framework for good housekeeping

a. Seiri - Tidiness

b. Seiton - Orderliness

c. Seiso - Cleanliness

d. Seiketsu - Standardized clean-up

e. Shitsuke – Discipline

3. Standardization.

Material Requirements Planning (MRP)

It is a software based production planning and inventory control system used tomanage manufacturing processes. Although it is not common nowadays, it is possible

to conduct MRP by hand as well.

An MRP system is intended to simultaneously meet three objectives:




A. Ensure materials and products are available for production and delivery to

customers.

B. Maintain the lowest possible level of inventory.

C. Plan manufacturing activities, delivery schedules and purchasing activities

The scope of MRP in manufacturing

Manufacturing organizations, whatever their products, face the same daily practical

problem - that customers want products to be available in a shorter time than it takes to

make them. This means that some level of planning is required.

Companies need to control the types and quantities of materials they purchase, plan

which products are to be produced and in what quantities and ensure that they are able

to meet current and future customer demand, all at the lowest possible cost. Making a

bad decision in any of these areas will make the company lose money. A few examples

are given below:

I. If a company purchases insufficient quantities of an item used in

manufacturing, or the wrong item, they may be unable to meet contracts tosupply products by the agreed date.

II. If a company purchases excessive quantities of an item, money is being

wasted - the excess quantity ties up cash while it remains as stock and may

never even be used at all. This is a particularly severe problem for food

manufacturers and companies with very short product life cycles. However,

some purchased items will have a minimum quantity that must be met,

therefore, purchasing excess is necessary.III. Beginning production of an order at the wrong time can cause customer

deadlines to be missed.

MRP is a tool to deal with these problems. It provides answers for several questions:




WHAT items are required?

HOW MANY are required?

WHEN are they required?

MRP can be applied both to items that are purchased from outside suppliers and to

sub-assemblies, produced internally, that are components of more complex items.

The data that must be considered include:

a. The END ITEM (or items) being created. This is sometimes called

Independent Demand, or Level "O" on BOM.

b. How much is required at a time.

c. When the quantities are required to meet demand.

d. Shelf life of stored materials.

e. Inventory status records. Records of NET materials AVAILABLE for use

already in stock (on hand) and materials on order from suppliers.

f. Bills of materials. Details of the materials, components and subassemblies

required to make each product.

g. Planning Data. This includes all the restraints and directions to produce the

end items. This includes such items as: Routings, Labor and Machine Standards,

Quality and Testing Standards, Pull/Work Cell and Push commands, Lot sizing

techniques (i.e. Fixed Lot Size, Lot-For-Lot, Economic Order Quantity), Scrap

Percentages, and other inputs.




W O R K I N G C A P I TA L F I N A N C I N G

The investment in raw materials, stock-in-process, finished goods, and receivables(the principal constituents of current assets) often varies a great deal during the

course of the year. Hence, the financial manager generally spends a good chunk of

his time in finding money to finance current assets.

Typically, current assets are supported by a combination of long-term and short-

term sources of finance. Long-term sources of finance, discussed elsewhere in this

book, primarily support fixed assets and secondarily provide the margin money for

working capital. Short-term sources of finance, the subject matter of this chapter, moreor less exclusively support the current assets.

i. Accruals

ii. Trade credit

iii. Working capital advance by commercial banks

iv. Regulation of bank finance

v. Public deposits

vi. Inter-corporate deposits

vii. Short-term loans from financial institutions

viii. Rights debentures for working capital

ix. Commercial paper

x. Factoring




ACCRUALS

The major accrual items are wages and taxes. These are simply what the firm

owes to its employees and to the government. Wages are usually paid on a weekly,fortnightly, or monthly basis-between payment's, the amounts owed but not yet paid

is shown as accrued wages on the balance sheet Income tax is payable quarterly

and other taxes may be payable half-yearly or annually. In the interim, taxes owed

but not paid may be shown as accrued taxes on the balance sheet.

Accruals vary with the level of activity of the firm. When the activity level

expands, accrual increases and when the activity level contracts accruals decrease.

As they respond more or less automatically to changes in the level of activity,accruals are treated as part of spontaneous financing.

Since no interest is paid by the firm on its accruals, they are often regarded as a

'free' Source of financing. However, a closer examination would reveal that this may

not be so. When the payment cycle is longer, wages may be higher. For example,

an employee earning Rs 500 per week and receiving weekly payment may ask for a

slightly higher compensation ii the payment is made monthly. Likewise when the

payment period is longer, tax authorities may raise the tax rates to some extent.Even when such adjustments are made, the fact remains that between established

payment dates accruals do not carry any explicit interest burden.

While accruals are a welcome source of financing, they are typically not

amenable to control by management. The payment period for employees is

determined by the practice in industry and provisions of law. Similarly, tax payment

dates are given by law and postponement of payment normally results in penalties.

TRADE CREDIT

Trade credit represents the credit extended by the supplier of goods and

services. It is a spontaneous source of finance in the sense that it arises in the




normal transactions of the firm without specific negotiations, provided the firm is

considered creditworthy by its surplus. It is an important source of finance

representing 25 per cent to 50 per cent of short term financing. .

Obtaining Trade Credit

The confidence of suppliers is the key to securing trade credit. What do

suppliers look for in granting trade credit? Among the things that suppliers

consider are:

ه Earnings record over a period of time:

If the firm has a fairly good earnings record with a portion of it

ploughed back in the business, it is looked upon favorably.

ه Liquidity position of the firm:

Suppliers naturally look at the ability of the firm to meet its obligations

in the short run. Such ability is usually measured by the current ratio and

the acid test ratio.

ه Record of payment:

If the firm has been prompt and regular in paying the bulk of the

suppliers in the past, it is deemed to be creditworthy.




Cultivating Good Supplier Relationships

While a well-established, successful enterprise may have no difficulty in

obtaining trade credit, a new company or one with financial problems willprobably face difficulty in obtaining it. The confidence of suppliers, a pre-

condition for obtaining trade credit, can be earned by discussing the financial

situation, by showing realistic plans, and, more important, by honouring

commitments. The last point, namely, honouring commitments, is very important.

Broken promises erode confidence more than poor operating results. It is better

to make modest commitments which may not be fully satisfying to the supplier

and honour them rather than make tall promises, that gratify the supplier, and fail

to honour them.

WORKING CAPITAL ADVANCE BY COMMERCIAL BANKS

Forms of Bank Finance

Working capital advance is provided by commercial banks in three primary ways:

(i) Cash credits/ overdrafts,

(ii) Loans, and

(iii) Purchase/discount of bills.

In addition to these forms of direct finance, commercial banks help their

customers in obtaining credit from other sources through the letter of credit

arrangement.i) Cash Credits/Overdrafts:

Under a cash credit or overdraft arrangement, a pre-determined limit for

borrowing is specified by the bank. The borrower can draw as often as

required provided the outstanding do not exceed the cash credit/ overdraft




limit. The borrower also enjoys the facility of repaying the amount, partially or

fully, as and when he desires. Interest is charged only on the running

balance, not on the limit sanctioned. A minimum charge may be payable,

irrespective of the level of borrowing, for availing this facility. This form of

advantage is highly attractive from the borrower's point of view because while

the borrower has the freedom of drawing the amount in instalments as and

when required, interest is payable only on the amount actually outstanding.

ii) Loans:

These are advances of fixed amounts which are credited to the current

account of the borrower or released to him in cash. The borrower is charged

with interest on the entire loan amount, irrespective of how much he draws. In

this respect this system differs markedly from the overdraft or cash credit

arrangement wherein interest is payable only on the amount actually utilised.

Loans are payable either on demand or in periodical instalments. When

payable on demand, loans are supported by a demand promissory note

executed by the borrower. There is often a possibility of renewing the loan.

iii) Purchase/Discount of Bills:

A bill arises out of a trade transaction. The seller of goods draws the bill

on the purchaser. The bill may be either clean or documentary (a

documentary bill is supported by a document of title to goods like a railway

receipt or a bill of lading) and may be payable on demand or after a usance

period which does not exceed 90 days. On acceptance of the bill by the

purchaser, the seller offers it to the bank for discount/purchase. When thebank discounts/purchases the bill it releases the funds to the seller. The bank

presents the bill to the purchaser (the acceptor of the bill) on the due date and

gets its payment.

The Reserve Bank of India launched the new bill market scheme in 1970




to encourage the use of bills as an instrument of credit. The objective was to

reduce the reliance on the cash credit arrangement because of its amenability

to abuse. The new bill market scheme sought to promote an active market for

bills as a negotiable instrument so that the lending activities of a bank could

be shared by other banks. It was envisaged that a bank, when short of funds,

would sell or rediscount the bills that it has purchased or discounted.

Likewise, a bank which has surplus funds would invest in bills. Obviously for

such a system to work, there has to be a lender of last resort which can come

to the succour of the banking system as a whole. This role naturally has been

assumed by the Reserve Bank of India which rediscounts bills of commercial

banks up to a certain limit. Despite the blessings and support of the Reserve

Bank of India, the new bill market scheme has not functioned very

successfully in practice.

iv) Letter of Credit:

A letter of credit is an arrangement whereby a bank helps its customer to

obtain credit from its (customer's) suppliers. When a bank opens a letter of

credit in favour of its customer for some specific purchases, the bankundertakes the responsibility to honour the obligation of its customer, should

the customer fail to do so. To illustrate, suppose a bank opens a letter of

credit in favour of A for some purchases that A plans to make from B. If A

does not make payment to B within the credit period offered by B, the bank

assumes the liability of A for the purchases covered by the letter of credit

arrangement. Naturally, B would hardly have any hesitation to extend credit to

A when a bank opens a letter of credit in favour of A. It is clear from the

preceding discussion that under a letter of credit arrangement the credit is

provided by the supplier but the risk is assumed by the bank which opens the

letter of credit. Hence, this is an indirect form of financing as against

overdraft, cash credit, loans, and bill purchasing/discounting which are direct

forms of financing. Note that in direct financing the bank assumes risk as well




as provides financing.

Security

For working capital advances, commercial banks seek security either in the

form of hypothecation or in the form of pledge.

♦ Hypothecation:

Under this arrangement, the owner of the goods borrows money

against the security of movable property, usually inventories. The owner

does not part with the possession of property. The rights of the lender

(hypothecatee) depend upon the agreement between the lender and the

borrower. Should the borrower default in paying his dues, the lender

(hypothecatee) can file a suit to realise his dues by selling the goods

hypothecated.

♦ Pledge:

In a pledge arrangement, the owner of the goods (pledgor) deposits

the goods with the lender (pledgee) as security for the borrowing. Transfer

of possession of goods is a precondition for pledge. The lender (pledgee)

is expected to take reasonable care of goods pledged with him. The

pledge contract gives the lender (pledgee) the right to sell goods and

recover dues, should the borrower (pledgor) default in paying debt.

Margin Amount

Banks do not provide hundred per cent finance. They insist that the customer

should bring a portion of the required finance from other sources. This portion isknown as the margin amount. How is the margin amount established? While

there is no fixed formula for determining the margin amount, the following

guideline is broadly observed: "The margin is kept lowest for raw materials and

highest for accounts receivable."




three types:

1. Call Deposits:

In theory, a call deposit is withdrawable by the lender on giving a day's

notice. In practice, however, the lender has to wait for at least three days.

The interest rate on such deposits may be around 12 per cent annum.

2. Three-months:

Deposits More popular in practice, these deposits are taken by

borrowers to tide over a short-term cash inadequacy that may be caused by

one or more of the following factors: disruption in production, excessive

imports of raw material, tax payment, delay in collection, dividend payment,

and unplanned capital expenditure. The interest rate on such deposits is

around 14 per cent annum.

3. Six-months:

Deposits Normally, lending companies do not extend deposits beyond

this time frame. Such deposits, usually made with first-class borrowers, carryan interest rate of around 16 per cent per annum.

Characteristics of the Inter-Corporate Deposit Market

It may be of interest to note the following characteristics of the inter-corporate

deposit market.

Lack of Regulation:

The lack of legal hassles and bureaucratic red tape makes an inter-

corporate deposit transaction very convenient. In a business environment

otherwise characterised by a plethora of rules and regulations, the

evolution of the intercorporate deposit market js an example of the ability

of the corporate sector to organise itself in a reasonably orderly manner.




Secrecy:

The inter-corporate deposit market is shrouded in secrecy. Brokers

regard their lists of borrowers and lenders as guarded secrets. Tightlipped

and circumspect, they are somewhat reluctant to talk about their business.

Such disclosures, they apprehend, would result in unwelcome competition

and undercutting of rates.

Importance of Personal Contacts:

Brokers and lenders argue that they are guided by a reasonably

objective analysis of the financial situation of the borrowers. However, thetruth is that lending decisions in the inter-corporate deposit markets are

based on personal contacts and market information which may lack

reliability. Given the secrecy that shrouds this operation and the non-

availability of hard data, can it be otherwise?

SHORT-TERM LOANS FROM FINANCIAL INSTITUTIONS

The Life Insurance Corporation of India, the General Insurance Corporation of

India, and the Unit Trust of India provide short-term loans to manufacturing

companies with an excellent track record.

Eligibility

A company to be eligible for such loans should satisfy the following conditions:

It should have declared an annual dividend of not less than 6 per cent for

the past five years. (In certain cases, however, this condition is relaxed

provided the company has paid an annual dividend of at least 10 per cent

over the last three years.)

The debt-equity ratio of the company should not exceed 1:5:1.




The current ratio of the company should be at least 1:33.

The average of the interest cover ratios for the past three years shouldbe at least 2:1.

Features

The short-term loans provided by financial institutions have the following features:

o They are totally unsecured and are given on the strength of a demand

promissory note.

o The loan is given for a period of 1 year and can be renewed for two

consecutive year provided the original eligibility criteria are satisfied.

o After a loan is repaid, the company will have to wait for at least 6 months

before availing of a fresh loan.

o The loans carry an interest rate of 18 per cent per annum with a quarterly

rest, which works out to an effective rate of 19.29 per cent per annum.

However, there is a rebate of 1 per cent for prompt payment, in which case

the effective rate comes down accordingly.

RIGHTS DEBENTURES FOR WORKING CAPITAL

Public limited companies can issue "rights" debentures to their shareholders with

the object of augmenting the long-term resources of the company for working capital

requirements. The key guidelines applicable to such debentures are as follows:

¥ The amount of the debenture issue should not exceed:

(a) 20 per cent of the gross current assets, loans, and advances minus the




long-term funds presently available for financing working capital, or

(b) 20 per cent of the paid-up share capital, including preference capital and

free reserves, whichever is the lower of the two.

¥ The debt: equity ratio, including the proposed debenture issue, should not

exceed 1:1. . The debentures shall first be offered to the existing Indian

resident shareholders of the company on a pro rata basis.

COMMERCIAL PAPER

Commercial paper represents short-term unsecured promissory notes issued by

firms which enjoy a fairly high credit rating. Generally, large firms with considerable

financial strength are able to issue commercial paper. The important features of

commerical paper are as follows:

1. The maturity period of commercial paper ranges from 90 to 180 days.

2. Commercial paper is sold at a discount from its face value and redeemed

at its face value. Hence the implicit interest rate is a function of the size of the

discount and the period of maturity.

3. Commercial paper is either directly placed v,rith investors or sold through

dealers.

4. Commercial paper is usually bought by investors who intend holding it till

its maturity. Hence there is no well developed secondary market for

commercial paper.

FACTORING

A 'factor' is a financial institution which offers services relating to management




(i) Factoring ensures a definite pattern of cash inflows from credit sales.

(ii) Continuous factoring may virtually eliminate the need for the credit and

collection department.

As against these advantages, the limitations of factoring are:

(i) The cost of factoring tends to be higher than the cost of other forms of

short-term borrowing.

(ii) Factoring of debt may be perceived as a sign of financial weakness




Conclusion

Thus, to ensure short term survival of the company, efficient working capital

management has to be undertaken. To achieve this end, the company can employ theexpertise of professionals or consultants, depending upon the financial capacity of the

company.

There are a number of sources from where the working capital can be financed, but

it should be noted that the specific cost of financing has to be worked out so as to better

the benefit from the activity.




Bibliography

Books:

Financial Management :- Prasanna Chandra

Financial Management :- Sheth Publishers

Internet:

http://www.ediindia.org

http://ezinearticles.com

http://www.valuebasedmanagement.com

http://www.wikipedia.com

http://www.investopedia.com

http://www.studyfinance.com

W.C. Mgmt Project

Documents

Transcript of W.C. Mgmt Project