Ebook MS41
Ebook MS41
Ebook MS41
8...
12 Liquidity vs Profitability
13 Payables Management
14 Short-Term International Financial Transactions
15 Integrating Working Capital and Capital Investment Process
137
MS-41
Management Programme
ASSIGNMENT
FIRST SEMESTER
(January to June)
2020
Note : Attempt all questions and submit this assignment to the coordinator of your study center
on or before 30th April, 2020.
1. Explain the meaning of Working Capital. How does inflation affect the size of
working capital, availability of working capital, and various components of working
capital.
2. An Enterprises’ current turnover is Rs. 10 lakh per annum. The enterprise currently
allows a credit period of 40 days to its customers from the date of sale. The
management of this enterprise wishes to adopt a more liberal credit policy, and it is
exploring the following options:
Additional information :-
- Selling price/unit is Rs 5.00
- Average cost/unit is Rs 3.00
- Variable costs/unit is Rs 2.00
- Current default rate is 1.5%
- Required rate of return is 15%
- A year consists of 360 days
You are required to suggest which of the above credit policies should be followed?
4. “Capital Investment Module and Working Capital Module use simulation techniques
to represent the interactions among the capital investment and working capital
variables” Discuss.
Theories and
UNIT 1 CONCEPTUAL FRAMEWORK Approaches
Objectives
Structure
1.1 Introduction
1.2 Definition of Working Capital
1.3 Constituents of Working Capital
1.4 Types of Working Capital
1.5 Cyclical Flow and Characteristics of Working Capital
1.6 Planning for Working Capital
1.7 Working Capital and Inflation
1.8 Trends in Working Capital
1.9 Summary
1.10 Key Words
1.11 Self Assessment Questions
1.12 Further Readings
1.1 INTRODUCTION
Financial management can be divided into two broad areas of responsibility as the
management of long-term capital and the management of short-term funds or
working capital. The management of working capital which constitutes a major
area of decision-making for financial managers is a continuous function which
involves the control of the every ebb and flow of financial resources circulating
in the enterprise in one form or another. It also refers to the management of
current assets and current liabilities. Efficient management of working capital is
an essential pre-requisite for the successful operation of a business enterprise
and improving its rate of return on the capital invested in short-term assets.
Virtually every business enterprise requires working capital to pay-off its short-
term obligations. Moreover, every firm needs working capital because it’s not
possible that production, sales, cash receipts and payments are all instantaneous and
synchronised. There elapses certain time for converting raw materials into finished
goods: finished goods into sales and finally realisation of sale proceeds. Hence,
funds are required to support all such activities in the firm. A number of terms like
working funds, circulating capital, temporary funds are used
synonymously for working capital. However, the expression, Working Capital, is
preferred by many due to its popularity and simplicity.
i) Profits are earned with the help of the assets which are partly fixed and
partly current. To a certain degree, similarity can be observed in fixed and
current assets in that both are partly borrowed and yield profit over and
above the interest costs. Logic then demands that current assets should be
taken to mean the working capital of the corporation.
ii) With every increase in funds, the gross working capital will increase while
according to the net concept of working capital there will be no change in
the funds available for the operating manager.
iii) The management is more concerned with the total current assets as they
constitute the total funds available for operating purposes than with the
sources from which the funds came, and that
iv) The net concept of working capital had relevance when the form of
organisation was single entrepreneurship or partnership. In other words a
close contact was involved between the ownership, management and control of
the enterprise and consequently the ownership of current and fixed assets is not
given so much importance as in the past.
Net concept:
Contrary to the aforesaid point of view, writers like Smith, Guthmann and
Dongall. Howard and Gross, consider working capital as the mere difference
between current assets and current liabilities. According to Keith. V. Smith, a
broader view of working capital would also include current liabilities such as
accounts payable, notes payable and other accruals. In his opinion, working
capital management involves the managing of individual current liabilities and the
managing of all inter-relationships that link current assets with current liabilities
and other balance sheet accounts. The net concept is advocated for the following
reasons:
i) in the long-run what matters is the surplus of current assets over current
liabilities.
ii) it is this concept which helps creditors and investors to judge the financial
soundness of the enterprise.
iii) what can always be relied upon to meet the contingencies is the excess of
current assets over current liabilities, since it is not to be returned; and
iv) this definition helps to find out the correct financial position of companies
having the same amount of current assets.
Therefore, The solvency of the firm is seen from the point of view of this
difference Generally, lenders and creditors view this as the most pertinent
approach to the problem of working capital.
Figure 1.1 exemplifies the behaviour of different types of working capital in diverse
firms affected by seasonal and cyclical variations in production or sales. In case of
non-growth non-seasonal and non-cyclical firms, all the working capital can be
considered permanent as shown in (A). Similarly, growing firms require more
working capital over a period of time, but fluctuations are not assumed to occur. As
such, in this case also, no variable portion of working capital is
present. In the third case (growing seasonal and non-cyclical firms), there are two
types of working capital. On the contrary, in case of growing, seasonal and cyclical
firms, all the working capital is assumed to be of varying type.
Permanent
W.C
Variable
W.C.
Variable W.C.
5
Concepts and Determination ii) Permanent working capital & Variable working
capital of Working Capital
Components of working capital are short-lived. Typically their life span does not
exceed one year. In practice, however, some assets that violate this criterion are
still classified as current assets.
In addition to their short span of life, each component of the current assets is
6 swiftly transformed into the other asset. Thus cash is utilised to replenish
inventories. Inventories are diminished when sales occur that augment accounts Theories and
Approaches
receivable and collection of accounts receivable increases cash balances. Thus a
natural corollary of this quick transformation is the frequent and repetitive
decisions that affect the level of working capital and the close interaction that exists
among the members of the family of working capital. The latter entails the
assumption that efficient management of one asset cannot be undertaken without
simultaneous consideration of other assets.
A third characteristic of working capital components is that their life span depends
upon the extent to which the basic activities like production, distribution and
collection are non-instantaneous and unsynchronized. If these three activities are
only instantaneous and synchronized, the management of working capital would
obviously be a trivial problem. If production and sales are synchronized there would
be no need to have inventories. Similarly, when all customers pay cash, management
of accounts receivable would become unnecessary.
While planning should logically begin at the top of the organisational hierarchy,
responsibility for planning exists at all levels within the organisation. While
working capital planning is a part of financial planning the responsibility permeats
among different managers within the organisation responsible for managing
different components of working capital. At the level of planning for individual
components of working capital persons like materials manager, credit manager
and cash manager are involved. However, the overall responsibility for co-
ordinating the planning of working capital typically rests with the top
management.
The budgeting process begins with the beginning balance to which are added
expected receipts. This amount is reached by multiplying expected cash receipts
by the probability distribution that the management budgetary will prevail during
the budgetary period. If outlays exceed the beginning balance plus anticipated
receipts the difference must be financed from external sources. If an excess
exist, management must make a decision regarding its disposal either in terms of
investing in short-term securities, repaying the existing debts or returning the
funds to the share-holders.
Of the several methods of preparing the cash budget, Receipts and Payments
method is popular among many undertakings. Moreso the preparation of cash
budgets in the organisations was an integral part of the budgetary process, since the
whole of the budgetary structure was divided into revenue budgets,
expenditure budgets and cash budgets. Cash budget was prepared by the
organisations by borrowing figures from various other budgets which they
prepared such as the:
i) Production budgets.
ii) Sales budget.
iii) Cost of production estimates with its necessary subdivisions for example.
a) materials purchase estimates:
b) labour and personnel estimates:
c) plant maintenance estimates: etc. iv)
Manpower budget.
v) Township and welfare estimates vi)
Profit and loss estimates.
vii) Capital expenditure budget.
Thus, cash budget is prepared as a means of identifying the past cash flows and
determine the future course of action. Cash budgets, generally are prepared by all
enterprises on yearly basis having monthly break-ups.
Medium term planning : In the medium term determining appropriate level of
working capital is considered a focal point. In unit 3 of this course on
‘Determination of working Capital’, we have discussed in detail the following
three approaches to determine optimum investment in working capital.
1) Industry Norm Approach
8
2) Economic Modelling Approach Theories and
Approaches
3) Strategic Choice Approach
Therefore, students are advised to refer to that particular unit and hence
discussion on them is not repeated here.
CVP Analysis: As a measure of long term planning, macro- level techniques like
C-V-P and funds flow are considered helpful in making an effective planning.
These are helpful not only for working capital planning but also for the entire
financial planning. At the level of working capital planning, we are required to
establish relationships between costs, volume and profits. Though the regular
break-even point is used to determine that level of sales or production which
equals total costs, in the area of working capital, we can be cautious about the
costs and revenues akin to working capital items such as inventory, receivables
and cash. Firms often face a dilemma of whether to place an order to keep a
particular level of inventory or not and whether a customer be provided credit or
not. These matters can be effectively dealt with orientation towards the C-V-P
relationships.
In this context, a distinction may be made between cash break even point and
profit break-even point, which represents liquidity and profitability respectively.
Cash break-even point, which is defined as that level of sales per period for
which sales revenue just equals the cash outlays associated with the product or
business. This kind of an analysis helps in focusing on the areas of cash deficit
and cash surplus leading to better liquidity management. When we appreciate the
fact that working capital is a liquidation concept, the utility of CVP concept in
making better exercise in planning for working capital needs no special emphasis.
Funds Flow: Funds flow is yet another tool used in the long run to analyse the
financial position of a company. Though the term funds can be understood to
include all financial resources, preparation of funds flow statements on working
capital basis are more common in finance. The preparation of such flow
statements gives an idea as to the movement of funds in the organisation. The
particulars relating to the funds generated from operations and changes in net
working capital position are highly relevant in this analysis. A firm’s capacity to
pay off its current debts depends mainly on its ability to secure funds from
operations. The prime objective of funds flow statement (prepared on the basis of
working capital movements) is to show the ebb and flow of funds through
working capital and to shed light on factors contributing to the movements. As a
matter of fact the internal movement of wealth (to a large extent) usually takes
place among working capital items. An analysis of these movements therefore
would provide an understanding of the efficiency of working capital management.
Whereas the schedule of working capital is designed to measure, the flow of funds
through working capital. For that matter, one has to ascertain changes in current
assets and current liabilities during the two balance sheet dates and
record variations in working capital. This would help in identifying the net
changes. i.e., increases and decreases in working capital position.
As pointed out earlier, during inflation the availability of internal sources gets
reduced because of the maintenance of records on historical cost basis. On the
other hand, the position with regard to external sources of funds is equally
10
disheartening. The rapid increase in inflation has given rise to the formulation of Theories and
Approaches
tight money policy by the Reserve Bank of India with a view to restricting the flow
of credit in the economy. Consequently, the extension of credit facilities
from banks have become extremely limited. Further, the diversion of bank funds to
priority sectors, after nationalisation has made it more difficult to raise funds from
banks.
Till recently, companies depended heavily on public deposits for meeting their
working capital requirements. Their availability however was reduced due to the
restrictions imposed by the RBI on the companies for the mobilisation of deposits
from public, particularly since 1978. Further the advent of Government companies
into the capital market for accepting public deposits made it more difficult to
attract funds from the public.
Coming to the trade credit, one must note that it may not be available for long
periods, and the suppliers of goods tighten the credit facilities during inflationary
period. The issue of long term loans may also be slackened, as the investors
would be less attracted by investments offering a fixed return like debentures and
preference shares. This is so because in terms of purchasing power the principal
amount of investment as well as the interest would dwindle. Thus, these
restrictions and limitations on the availability of working capital from internal and
external sources makes it difficult for the finance manager to raise funds during
inflation.
Inventory
During the periods of inflation when the prices rise rapidly, companies will have
an incentive to invest more heavily in inventory than is indicated by the minimum
cost calculation. If the management believes the price of an item will increase by
10 per cent in the next month, substantially more of that item may be ordered
than normal, of course, due to increase in inventory the company may get
speculative gain, but this speculative gain may be off-set by the increase in taxes due
to higher profit figures, reported in times of inflation and higher carrying
costs.
Another difficulty that the company is required to face is the material shortages in
the periods of inflation. It is not known whether inflationary escalations result in
shortages or shortages occur because of instability caused by inflation.
Whatever be the real source of the problem, companies should be conscious of the
price trends and accordingly re-evaluate their internal purchasing and
organisational systems.
11
Concepts and Very few firms realise the impact of inflation on the valuation of inventory and the
Determination of Working extent to which it contributes to unrealised profits. In other words, inflation affects
Capital
the valuation of inventories, affecting thereby the amount of profits
reported in the financial statements.
Not only inflation affects the inventory, but inflation itself is also increased due to the
inefficient management of inventory. Delivering the keynote address at a
National Convention on the subject of, ‘Curbing Inflation through Effective
Materials Management’, Shri P.J.Fernandes put forward the following five
propositions to show the impact of inflation on the materials management.
a) The stocks which are held by the enterprises have a direct and immediate
relationship to general price levels.
b) The price level in any country is to a great extent determined by the cost of
production. The cost of production is to a great extent determined by the
cost of inputs. Hence, if the cost of inputs goes up, the cost of production as well
as the price level also goes up.
c) An effective system of materials management must necessarily result in an
increase in production.
d) The materials manager can have a total and absolute impact on production
outside his unit, and
e) It is the materials management, which can reduce the crushing burden of
credit expansion, and the money supply, which again will have a direct and
absolute impact on inflationary tendency.
Finally, it may be considered with the help of the following illustration how
inflation renders the traditional inventory control techniques ineffective.
Assumptions
3125 25
b) Carrying costs = ——— × —— = Rs 390.63
2 100
c) Total costs = Rs. 640 + 390.63 = Rs 1030.63
If 32 orders are placed in a year, the distribution of the same in each month and
the material cost month-wise would be as given below.
12
Theories and
Approaches
Based on the EOQ formula, if one places orders as shown in the example, the
total material cost comes to Rs. 1,27,656.25 (i.e., Material Cost + Ordering Costs
+ Inventory Carrying Costs). In contrast, If the firm in question does not apply
the EOQ technique and simply resorts to buying at the single stretch or lot
buying, the total material cost would be only Rs. 1,12,520/- as worked out below:
Receivables
The effect of inflation on the receivables is felt through the size of investment in
receivables. The amount of investment in receivables varies depending upon the
credit and collection policies of the organisation. Evidently, during the periods of
inflation the higher the amount involved in the receivables the greater would be
the loss to the company, since the debtor would be paying cheaper rupees.
Likewise, the length of the time too makes the firm lose much in the transaction.
For instance, if the firm in the beginning made a credit sale of about Rs. 1,00,000
with an allowed credit period of three months, assuming a 20 percent inflation in
the economy, the amount the company receives in real terms after the allowed
credit period becomes only Rs. 95,000. Here, even considering the same time lag
between delivery and realisation, as between debtors and creditors, sundry
debtors would create bigger problem than the sundry creditors, because the
declining value of sundry debtors would affect adversely the anticipated
13
Concepts and profitability of the enterprise. Thus, the effect of inflation varies in accordance
Determination of Working with the quantum of receivables and the time allowed to repay them.
Capital
Cash
1.9 SUMMARY
This unit has aimed at providing a conceptual understanding of the issues involved
in working capital. Thus, it started with the discussion on definition and ended
with the trends in working capital in Indian companies. There is a clear
difference in the understanding of the concept of working capital among
accountants and economists. This unit has attempted to highlight this aspect.
Similarly, what constitutes working capital is discussed to enhance the
understanding of the readers. Though there is a broad consensus, there are a few
differences in identifying the constituents, particularly in the area of
investments and advance payments. Attempt has also been made to highlight the
significant characteristics of working capital. Working capital planning is
considered yet another issue, which engages the attention of corporate managers.
The discussion is further strengthened to incorporate matters on inflation and
trends. At the end, a synoptic view is presented of the working capital trends, as
compiled from the data of RBI.
Tab le 1.1 : Current ssets tage otal assets mong indu try
A as of t net a differ s
groups perce ompa ia ent
Sl. in 1992- n nies in 1997- 01-
93 public 1994- Ind 1996- 98 00- 02
1) Industry limite 95 97 99- 01
38.1 d c 1995- 39.5 00 35.6
2) Tea 41.2 96 36.2 36.5
62.6 1993- 54.8 38.6 57.6
3)
Sugar 68.5 94 60.4 38.8 56.2 60.0 56.8
4) 55.4 -
Tobacco 51.7 66.7 61.8 50.7 -
5) 34.6 56.3 - 41.8
Cotton Textiles 50.1 53.5 51.8 28.9 41.6
67.6 -
58.9 42.1
Silk Rayon 49.3 30.8 -
6) 66.3 53.2 -
Textiles 62.2 49.2
7) 35.9 -
Engineering 53.5 58.4 52.5 -
45.0 36.1 46.1
8) 48.4 -
Chemicals 57.3 42.8 37.3 56.8 45.4
9) 57.3 46.3
45.5
Rubber 47.3 55.6 58.0 37.6 47.9
10) 41.5 46.8 32.7
Paper 58.3 44.7 34.5 35.3
74.5 60.0 37.1 65.5
11) 44.3 34.3
Construction 23.6 71.7 66.5 23.9 64.5
12) Trading 79.2 77.7 79.5 43.4
80.9 79.1 80.1 82.5 83.5 57.4
81.6
13) Shipping 28.6 30.6 38.8 36.9 37.0 36.6 50.4 47.3 45.4
14) Diversified Co. 47.5 45.0 44.3 48.9 43.7 40.8 36.8 43.1 42.6
Source: 1997, 1999 Octobe 200
Sl. Particulars 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-0101-02
1. Inventories 39.8 33.3 32.5 34.5 32.2 32.0 33.8 33.7 31.8
2. Receivables 50.9 47.5 52.9 53.2 56.3 55.2 53.4 53.7 54.3
3. Quoted Investments 2.6 11.8 7.4 4.9 4.8 3.5 4.9 5.5 5.5
5. Cash & Bank 6.6 7.3 6.9 7.3 6.6 9.2 7.5 6.7 8.4
Balances
Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00
Current Assets (67558) (82134) (115541) (136469) (148353) (155716) (179159) (189080) (196426)
Source: RBI Bulletins, October, 1997, October 1999 & October 2003.
17
Concepts and
Determination of Working UNIT 2 OPERATING ENVIRONMENT OF
Capital
WORKING CAPITAL
Objectives
2.1 INTRODUCTION
In our previous unit an attempt was made to provide you with a conceptual
framework in terms of understanding the definition, nature and components of
working capital. Further, a sketch was provided of the characteristics of working
capital. Tools for planning working capital and the impact of inflation on working
capital were also discussed. This discussion in the previous unit is expected to
provide you a preliminary understanding about the basic concepts.
Now in the present unit we will be dealing with the operating environment of the
working capital as analysed in the context of monetary, credit and financial
policies.
22
The significance of scanning the environment of business is trivial. After all, Theories and
businesses cannot be run in vacuum, they exist in a natural setting surrounded by Approaches
various elements in the society. The decisions of a manager are influenced by
the changes in these surroundings caused by the constituting elements. The
customers, the Government, the society within and outside the country will also
have their influence on the business decision-making. The value system of the
society, the rules and regulations laid down by the government, the monetary and
credit policies of the central bank, the trade, industrial and fiscal policies of the
government, the institutional set up available in the country, the attitudes of
foreign investors, NRIs, the ideological beliefs of the political parties, etc., all
constitute the environment system within which a business firm is to operate.
The production schedules of the firm are to be restated if there is a change in the
preferences or attitudes of the customers, suppliers, competitors and the import
and export policies. Similarly, the firm may have to restructure its
financing pattern consequent upon the changes in the rates of interest and
conditions in the capital market. Same would be true in case of marketing and
personnel policies. As a matter of fact, several corporates are assuming ‘social
responsibility functions’ on their own, mainly due to the changes in the value
system of the society and the fear of loosing its confidence. Environment, thus,
has profound influence on business decision-making. Students are advised to
refresh themselves by having a glance at the contents of MS-3: Economic and
Social Environment.
a) Money Supply
b) Bank Rate
c) CRR & SLR
d) Interest Rates
e) Selective Credit Controls
f) Flow of Credit
23
Concepts and 2.2.1 Money Supply
Determination of Working
Capital
As a part of the policy exercise, monetary growth is targetted every year. Policy
measures are pronounced, so as to take care of this targeting exercise. This is
expected to maintain real growth and contain inflation. In this context, the Central
Bank specifies the order of expansion in broad money (known popularly as M 3 and
comprises of currency with the public demand and time deposits with
commercial banks, and other deposits with RBI) that would be used as an
intermediate target to realise the ultimate objective of the policy. In the case of
India, both output expansion and price stability are important objectives; but
depending on the specific circumstances of the year, emphasis is placed on either
of the two. Increasingly, it is being recognised that central banks would have to
target price stability since real growth itself would be in jeopardy, if inflation rates
go beyond the margin of tolerance. On a historical basis, the average inflation
rate’ in India (“which had declined from 9.0 percent in 1970s to 8.0 percent in
1980s) went up markedly to a double-digit level of 10.7 per cent during the first
half of 1990s. The focus of monetary policy in recent years has, therefore, been
to bring down the inflation rate to a modest level. Monetary growth is being
moderated in such a way that the credit requirements for productive activities are
adequately met.
For instance, the monetary growth target, for 1996-97 was set at around the
same level as in the previous year (15.5 percent). The monetary policy for 1996-
97 sought to consolidate the gains on the inflation front. It underscored the
imperative need to sustain the lower and stable level of inflation, while ensuring
the availability of adequate bank credit to support the growth of real sector of
the economy. Broad money growth was projected at 15.5 percent to 16 percent,
assuming a 6 percent growth in real GDP. The credit policy for the year has also
been tailored to achieve the above objective. Basing on the past, the
monetary and credit policy for 1997-98 sought to target broad money growth in the
range of 15.0 - 15.5 percent, on the basis of a projected real GDP growth rate of
about 6 percent and an assumed inflation rate of the same order.
To compare the actual achievements, the broad money growth of 17.0 percent
during 1997-98 was higher than that in the previous financial year (16.0 percent).
The lower order of increase in the monetary base in 1996-97 must be viewed in
the context of the significant cut in Cash Reserve Ratio (CRR) from 14 to 10
per cent of the net demand and Time liabilities. The resulting increases in the
lendable resources of the banks (to the tune of Rs.17, 850 crore) meant decrease in the
ratio of reserves to deposits. This was reflected in the increase in broad money
multiplier from 3.1 to 3.5 as on March 31, 1997.
For the year 2002-03, the mid-term Review of Monetary and Credit Policy
released on October 29, 2002 had projected the GDP growth in the range of 5.0 to
5.5 percent taking into account available data on the performance of the
South-West monsoon. The advance estimates for 2002-03 released by the CSO in
January 2003 has placed GDP growth at 4.4 percent, which reflects an
estimated decline in the output from agriculture and allied activities by as much as
3.1 percent. The earlier projection in the Reserve Bank's mid-term Review of
October 2002 was based on a much lower decline of 1.5 percent in agricultural
output. The overall growth performance of the industrial sector, as per CSO
advance estimates, at 5.8 percent is, however, much higher than that of 3.2
percent in the previous year. The services sector is estimated to grow by 7.1
percent as against 6.5 percent in the earlier year, mainly on account of higher
growth in construction, domestic trade and transport sectors. The CSO has also
placed the growth of financing, real estate and business services sector at 6.5
percent for 2002-03 as compared with 4.5 percent in 2001-02.
24
The annual rate of inflation in 2002-03 as measured by the increase inWPI, on an Theories and
average basis, for the year as a whole was, howeever, lower than that in the Approaches
previous year 3.3 percent as against 3.8 percent a year ago.
Monetary and credit aggregates for the year 2002-03 reflected the impact of
mergers that took place in the banking industry. During 2002-03, the growth in
money supply, was 15.0 percent as against 14.2 percent which was well within
the projected trajectory. Among the components, growth in aggregate deposits of
scheduled commercial banks (SCBs) at 12.2 percent net of mergers (16.1
percent with mergers), was lower than that of 14.6 percent in the previous year.
The expansion in currency with the public was lower at 12.5 percent as againt
15.2 percent in the previous year.
25
Concepts and 2.2.3 CRR and SLR
Determination of Working
Capital
Variations in the reserve requirements is yet another credit control technique used by
a Central Bank. The Central Bank by this technique can change the amount of cash
reserves of banks and affect their credit creating capacity. It may be
applied on the aggregate outstanding deposits or on the increments after a base
date or even on certain specific categories of deposits. This has a sure and
identifiable impact as compared to Bank Rate changes or open market
operations. The two instruments under this category are:
i) Cash Reserve Ratio (CRR)
ii) Statutory Liquidity Ratio (SLR)
Under section 42(1) of the RBI Act, scheduled commercial banks were
required to maintain with the RBI at the close of business on any day, a
minimum cash reserve on their demand and time liabilities. Similarly, banks were
required under section 24(2A) to maintain a minimum amount of liquid assets
equal to but not less than certain percentage of demand and time liabilities.
Though the RBI did not use CRR and SLR as significant instruments of credit
control during the whole of the sixties, it started varying the ratios since then
actively. The implication of these variations is that when the ratio is brought
down it would release the funds that would have otherwise been locked up for
investment by the commercial banks. Of late, the RBI has removed the reserve
requirements on inter bank liabilities w.e.f. April 26, 1997. This single measure
released Rs.950 crore for investment in trade and industry. Similarly, as a part
of monetary and credit policy for the second half of 1997-98, RBI reduced CRR
by two percentage points from 10.0 percent in eight phases of 0.25 each. The
total addition to liquidity from this was estimated at about Rs. 9,600 crore.
Even though the obligation of banks is to maintain their liquid assets at a
minimum of 25 percent, in the light of the need to restrain the pace of expansion
of bank credit, the RBI has imposed a much higher percentage of minimum liquid
assets and in some cases to the extent of even 35 percent. These measures
have started impounding vast amount of resources of the banks and encouraging
governments [Central and State] to have an easy access to bank credit. It also
led to the shrinkage of resources available for genuine credit purposes. In view
of the strong opposition from the banks and basing on the recommendations of
the committee on “Financial Sector Reforms”, RBI reduced the ceiling to its
original level of 25 percent of the net demand and time liabilities (NDTL). The
banking system already holds government securities of about 39 percent of its net
demand and time liabilities (NDTL) as against the statutory minimum requirement
of 25 percent.
The cash reserve ratio (CRR) remains an important instrument for modulating
liquidity conditions. The medium-term objective is, however, to reduce CRR to the
statutory minimum level of 3.0 percent. Accordingly, on a review of developments
in the international and domestic financial markets, a 75 basis point reduction in
the CRR during June to November, 2002 was followed by a further 25 basis
points cut from June 14, 2003 taking the level of the CRR down to 4.5 percent.
The minimum daily maintenance of CRR was raised to 80 percent of the
average daily requirement for all the days of the reporting fornight with effect
from the fortnight begining November 16, 2002. This was subsequently lowered
to 70 percent with effect from the fortnight begining December 28, 2002. The
payment of interest on eligible CRR balances maintained by banks was changed
from quarterly basis to monthly basis from April 2003. The CRR has been almost
halved since April 2000 resulting in cumulative release of first round resources of
over Rs.33,500 crore (Table 2.1)
26
Table 2.1 : Cash Reserve Rato Theories and
Approaches
(Amount in Rupees Crore)
2003-04 2002-03 2001-02 2000-01
CRR Amount CRR Amount CRR Amount CRR Amount*
(%) * (%) * * (%)
(%)
1 2 3 4 5 6 7 8 9
April 4.75 0 5.5 0 8.0 0 8.0 7,200
May 4.75 0 5.5 0 7.5 4,500 8.0 0
June 4.5 3,500 5.0 6,500 7.5 0 8.0 0
July 5.0 0 7.5 0 8.25 -1,900
August 5.0 0 7.5 0 8.5 -1,900
September 5.0 0 7.5 0 8.5 0
October 5.0 0 7.5 0 8.5 0
November 4.75 3,500 5.75 6,000 8.5 0
December 4.75 0 5.5 2,000 8.5 0
January 4.75 0 5.5 0 8.5 0
February 4.75 0 5.5 0 8.25 2,050
March 4.75 0 5.5 0 8.0 2,050
* Amount stands for first round release (+)/impounding (-) of resources through
changes in the cash reserve ratio.
27
Concepts and In addition to RBI, certain other agencies also have the authority to fix rates of
Determination of Working interest for different types of financial activities. For instance, the controller of
Capital
capital issues (now abolished) used to fix the ceiling on coupon rates on industrial
debentures and preference shares. The Indian Banks Association (IBA) had been
fixing the ceiling on call rates since 1973, until 1988, when call rates were freed
from the ceiling. The Government of India fixes the rate on treasury bills and long-
term government securities. The Government has significant influence in the fixation
of interest rates on long-term loans of Development Finance Institutions [DFIs].
This is how the rates of interest are administered in India, leading to a large variety
of multiple and complex interest rates.
28
relevance to developing countries owing to the meagre supply of credit and the Theories and
chance of credit being misutilised for unproductive and speculative purposes. In Approaches
exercise of the powers conferred on to it, the RBI may give directions of the
following kind to the banks generally or to any bank or a group of banks in
particular.
a) the purposes for which advances may or may not be made;
b) the margins to be maintained in respect of secured advances;
c) the maximum amount of advances; and
d) the rate of interest and other terms and conditions subject to which
advances may be granted or guarantees may be given.
Almost since the middle of 1956, RBI has started exercising powers vested in it. A
number of commodities and products have been covered at one time or the other.
Some of the commodities, which had been under frequent controls, are foodgrains,
cotton, raw jute, oil seeds, vegetable oils, sugar, cotton yarn and
textiles.
However, the situation has changed recently. After the implementation of new
economic policy in 1991, there has been a phasing out of the selective credit
controls. By the end of 1996, almost all the controls were virtually eliminated.
The only exception being the advances against buffer stock of sugar and
unreleased stock of sugar-to-sugar mills. However, in order to counter temporary
deterioration in price-supply situation, selective credit controls were reimposed
only for a period of three months (from April to July 7, 1997) on bank advances
against stocks of wheat. Further, effective from October 22, 1997,
differential minimum margins of 10 percent and 15 percent were stipulated for
advances against levy and free sale sugar respectively; leaving advances against
buffer stock free from margin.
Keeping in view of the need to support the efforts to revive the capital market,
banks were allowed to extend loans to corporates against shares held by them to
enable such corporates to meet the promoters’ contribution. The margin and the
period of repayment of such loans would be determined by banks. Banks were
also permitted to sanction bridge loans to companies against expected equity
flows for a period not exceeding one year, subject to the guidelines approved
by their respective boards. Taking into account the changing scenario, banks
were asked to review the existing arrangements for financing trade and services.
The RBI directed banks to evolve a suitable method of assessing loan
requirements of borrowers in the service sector and report the arrangements
made in this regard.
It is clear from the foregoing discussion that the changes in the monetary and
credit policies influence working capital decisions in terms of the availability of
credit and cost of credit directly and through the ‘balancing of the economy’
indirectly. For the benefit of students, the salient features of the monetary and
credit policy measures announced by RBI for the year 2003-04 are given in
Appendix-I.
Activity 2.1
Highlight the salient features of the latest monetary and credit policy announced by
RBI.
In the recent past (since 1991) government has embarked upon effecting major
changes in the areas of industrial trade and exchange rate policies. These
changes are designed to correct the macro-economic imbalances and effect
structural adjustments with the objective of bringing about a more competitive
system and promoting efficiency in the real sectors of the economy. Economic
reforms in the real sectors of the economy will not produce desired results, unless
the former are supplimented by suitable and effective financial sector reforms.
With this end in view, the Government of India has appointed a committee on
the working of financial system of the country in August 1991 under the
chairmanship of M.Narasimham.
The committee was asked, inter alia, to examine the existing structure of the
financial system and its various components and to make recommendations for
improving the efficiency and effectiveness of the system with particular reference to
the economy of operations, accountability and profitability of the commercial
banks and financial institutions. The committee has submitted its report in
November 1991. Since the submission of the report, the Government has taken
several steps on different aspects of the recommendations. The significant steps that
were taken are:
i) A strict criteria was evolved for companies that access securities markets.
The issuers of securities are required to meet certain standards like the
payment of dividend, minimum share-holding requirement, etc.
ii) The Securities and Exchange Board of India (SEBI) took several steps for
widening and deepening different segments of the market for promoting
investor protection and market development;
iii) The safety and integrity of the securities market were strengthened through
the institution of risk management measures, which included a
comprehensive system of margins, intra-day trading and exposure limits,
capital adequacy norms for brokers and setting up of trade/settlement
guarantee funds.
iv) Reforms in the secondary market focused on improving market transperancy,
integrity and infrastructure.
v) FIIs were permitted to invest upto 10 per cent in equity of any company, to
invest in unlisted companies and to invest in debt securities without any
requirement for investment in equity. They were also permitted to invest in
dated government securities within the framework of guidelines on FII
investment in debt instruments.
vi) Government has also initiated measures to deepen and broaden the
government securities market and increase its liquidity.
vii) The earlier restriction that debt instruments of a corporate could be listed only
after its equity had been listed on any exchange was removed.
viii)Investment guidelines regarding the utilisation of funds of LIC were revised. ix)
The Mutual Fund Regulations issued by SEBI in 1993 were further revised
on the basis of a special study commissioned by itself.
31
Concepts and Determination
of Working Capital 2.4 ECONOMIC LIBERALISATION AND INDUSTRY
The economic liberalisation programme initiated by the Government in the early
ninties has changed the face of industry, more particularly the dynamics of
financial environment. There has been a sea change in the organisational
structure and operations of the players in money and capital markets. The
distinction between long term financing and short term financing is slowly on the
wane. Devlopment Banks are now converting themselves into ordinary
commercial banks. Deregulation of interest rates, emergence of a liberalised
capital market and increasing participation of bank in terms of financing have
significantly influenced the operations of devlopment banks.With their fray into the
realm of working capital loans; the traditional divide into the operational domain
of development banks and commercial banks is getting blurred. One of the
implications of this development is that the hitherto privileged access to assured
sources of low cost funds will disappear. There has already been an attempt to
align all the forces to market make the latter decide the equilibrium between
supply of and demand for funds.
The monetary policy framework has undergone changes over the recent period in
response to reforms in the financial sector and the growing external orientation of
the economy. The endeavour of the policy has been to enhance the allocative
efficiency of the financial sector, preserve financial stability and improve the
transmission mechanism of monetary policy by moving from direct to indirect
instruments. The stance of the monetary policy has been to ensure provision of
adequate liquidity to meet credit growth and suggest investment demand in the
economy, while continuing a vigil on the movements in the price level and to
continue with the present policy of interest rate structure in the medium term.
On the fiscal front, the government expenditure has been cut in real terms. The
burnt has been borne by cuts in investments and expenditure on social sector.
There were large slippages in the fiscal correction. The rising deficits on the
revenue account are often cited as the main cause for the observed phenomenon.
Behind these lie the erosion of excise tax base, mounting interest burden on
public debt, growing subsidies and the rising cost of wages and salaries.
On the external front, following the liberalisation, India devalued its currency
leaving an impact on the exports and imports. With an unsuccessful interlude with
exim scrips and dual exchange rate system; India went in for a unified market
determined exchange rate system. Correcting the exchange rate valuation of the
past was a major event on the reform process. The lower exchange rate
enhances the profitability of existing exports, more importantly, it broadens the
range of eligible exports. It makes imports more costly and provides scope for
import substitution, thus narrowing the range of potential imports. The rupee is
now convertible on current account, subject to exchange rate risk. Some of the
important components of capital account are considerably liberalised.
Another dimension of the liberalisation on the external front is that the gates for
foreign investment were wide open. foreign trade and foreign investment appear
to be mutually influential. Portfolio investments have become very significant in
several developing countries, including India. According to a study conducted by
Business Line (dated 28-03-04) foreign investors control 30 percent of India’s top
companies. In terms of wealth, foreigners now control a third of the market
capitalisation of the Nifty Companies ( 50 in number). A further analysis of the
share-holding patterns suggests that there is an increase in the holding in such
sectors as oil, gas, petro-chemical, power and automobiles. One might wonder, if
East India Company Syndrome - a sort of creeping acquisition of effective
control and wealth - is under way.
32
These developments produce some direct and some indirect effects on the Theories and
growth and development of Indian industry in the years to come. More Approaches
specifically, developments in the financial sector pose serious concerns for the
effective use of working capital by the industry.
2.5 SUMMARY
It is important that every business unit understands its environment. The nature of
environment is such that the business units, will have no control on the
elements constituting the environment. Change in the environment may necessitate
the unit to tailor its own business policies so as to suit to the environment. The
customers, the government, the society will exert their influence on the decision
making process of the business. Changes in the value system,
sometimes, may even force firms to pursue distant goals like ‘social
responsibility’.
This unit considers changes in monetary and credit policies, inflation and financial
markets as pertinent for their influence on working capital decisions. Monetary and
credit policies consisting of variables like money supply, bank rate, CRR,
SLR, Interest rates, selective credit controls are decided by the central bank of
the country, having significant influence on business decisions. More specifically,
these are expected to influence the availability and cost of business credit.
Financial markets are the agencies that provide necessary funds for all productive
purposes. The stage of development of these markets has profound influence on
the supply and demand for funds. For, the Government has taken up a reform
exercise meant for improving the efficiency and effectiveness of the system.
The sweep of the reforms is wide enough to cover every constituent of the
organised financial system such as the money market, credit market, equity and
debt market, government securities market, insurance market and the foreign
exchange market.
Cash Reserve Ratio: Minimum reserve maintained by commercial banks with RBI.
Selective Credit Controls: Tools available with the Central Bank to regulate
the flow of credit.
33
Concepts and Statutory liquidity Ratio: Minimum Reserve to be maintained by
Determination of Working commercial banks with themselves, as a percentage of demand and time liabilities.
Capital
Financial Market: An agency that helps in the mobilisation of funds for industry
and trade.
34
Appendix Theories and
Approaches
The statement on monetary and credit policy for the year 2003-04 was declared by
Dr. Bimal Jalan, Governor, RBI on 29 th April 2003. The statement consists of three
parts:
1) Review of macroeconomic and monetary development during 2002-03 2)
Stance of monetary policy for 2003-04
3) Financial sector reforms and monetary policy measures.
I) Macroeconomics and Monetary Developments: The following are the
major aspects under this section.
1) The growth rate of real GDP in 2001-02 was at 5.6 percent. This was due
to the contribution of individual sectors such as services (6.5), industry (3.2)
and agriculture (5.7). For the year 2002-03 the GDP growth rate was
established to be 4.4 percent.
4) There has been a sustained increase in credit flow to the commercial sector.
During 2002-03, non-food credit of scheduled commercial banks registered a
high growth of 26.2 percent.
5) The Fiscal deficit of the Central Govt. for 2002-03 was Rs. 1,45,466 crores.
The average cost of Govt. borrowings through primary issuances of dated
securites at 7.3 percent during 2002-03, compared to 9.44 percent during the
previous year.
6) The banking system held about 39 percent of its net demand and time
liabilities (NDTL), as against the statutory minimum requirement of 25
percent.
7) Banks have reduced their prime lending rates (PL Rs) from a range of
10-12.5 percent in March 2002 to 9-12.25 percent by March 2003.
8) There has been a persistent downward trend on the interest rate structure,
reflecting moderation of inflationary expectations and comfortable liquidity
situation.
II) Stances of Monetary Policy: The overall stance of the monetary policy is
as follows:
35
Concepts and 2) In line with the above, to continue the present rate of interests, including
Determination of Working preference for soft interest rates.
Capital
3) To impart greater flexibility to the interest rate structure in the medium term.
III) Monetary Policy Measures: The following are the important policy
measures announced as a part of the present credit policy.
1) The main focus of the policy is on the structural and regulatory measures to
strengthen the financial systems.
2) To reduce bank rate by 0.25 percentage points from 6.25 to 6.0 percent. 3)
To reduce cash reserve ratio from 4.75 to 4. 50 percent.
36
Theories and
UNIT 3 DETERMINATION OF WORKING Approaches
CAPITAL
Objectives
3.1 INTRODUCTION
In the previous unit, we have learnt about the crucial issues affecting the
working capital decisions. A survey of the policy aspects pertaining to
monetary and credit policies has been attempted. These developments are
considered to affect the quantum and availability of working capital in the
country. More particularly, the recent changes in the economic liberalization of the
country are expected to produce a tremendous impact on the working of Indian
industries.
Indian Industries today have value maximization as the major objective & to
achieve it one should be capable of estimating the requirements precisely.
Both excessive and inadequate investment in working capital items may lead to
unnecessary strain on the objective function. Therefore, the finance manager has to
examine all the factors that determine the working capital requirements within the
theoretical and practical points of view. For, the theoretical considerations
sometimes dominate the methodology of assessment; while the firms are
constrained to follow the restrictions imposed by the borrowers. The finance
manager, therefore, should consider all the factors that have a bearing on the
working capital including cash, receivables and inventories. Though certain models
are developed to determine the optimum investment in each of the working
capital items, an aggregate approach is yet to be formulated. In the mean time, firms
are basing their computations on the concept of operating cycle. These and other
related issues are discussed in detail in this unit.
37
Concepts and Determination
of Working Capital 3.2 DETERMINATION OF WORKING CAPITAL
NEEDS : DIFFERENT APPROACHES
The question that what is the adequate amount of working capital required to run a
business, is attempted to be answered in several ways. Theoreticians, by their
natural inclination to construct models, have based their analogy on certain
foundations and constructed models to estimate the optimum investment in
working capital. Whereas, lenders such as banks, financial institutions have based
their decisions on production schedules and industry practices. In between, a new
point of view was developed calling for the adoption of a strategic approach to the
decision-making. Let us now discuss these theoretical issues to further our
understanding of the subject matter.
√2SO
Q* = ------
C
Where Q* = Optimum order quantity
S = Annual usage of material
O = Ordering costs per order C =
Carrying costs per unit
William J. Baumol has attempted to apply this inventory model to the
determination of optimum cash balances that can be held by an enterprise. The
transactions demand for money is sought to be analysed from this point of view.
As per the model, the optimum level of cash is decided by the carrying cost of
holding cash and the cost of transferring marketable securities to cash and vice-
versa.
√2bT
C* = ------
i
C * = Optimum cash balance
b = Transaction costs per transaction
T = Total demand for cash
i = Interest rate
Similarly, the decision to sell to a particular account should be based objectively
upon the application of profit maximising model. In this regard, Robert M.
Soldofsky developed a model for Accounts receivable management. He has laid
down the following formula for making a credit decision, leading to optimum
investment in receivables.
Sell, when M - (b + Ti + c/o) > 0
where M = Profit Margin
b = Probability of a credit sale becoming a bad debt
i = Interest rate
c = Costs per order of selling on credit as an implicit function of risk,
o = Order size
T = Time period
Though models are available to decide optimum investment in case of some
important components of working capital, for many other items, no such modeling
is attempted; nor is there an attempt at the aggregate level. Moreover, these
models are subject to certain assumptions and conditions. Their utility comes
under scrutiny for want of these assumptions turning out to be far from reality.
For this and several other reasons, economic modelling is not much popular with
Indian companies.
Thus, the strategic choice approach presupposes a highly competitive environment and
the willingness of the management to take risks. The success of the
approach also depends on the ability of the management to set realistic goals and
prepare suitable strategy to achieve them. Any wrong planning will lead the firm into
trouble; much worse than what it was when either of the earlier methods
were being followed.
Activity 3.1
40
availability of materials, the ease or tightness of the money market, are all parts of Theories and
these shifting forces. Of them, the influence of operating cycle is considered Approaches
paramount.
The term operating cycle can be understood to represent the length of time
required for the completion of each of the stages of operation involved in respect of
working capital items. This helps portray different stages of manufacturing activity in
its various manifestations, such as peaks and troughs, along with the required
supporting level of investment at each stage in working capital. The sum of these
stage-wise investments is the total amount of working capital required to support the
manufacturing activity at different stages of the cycle. The four
important stages of that can be identified as:
1) Raw materials and stores inventory stage
2) Work-in-progress stage
3) Finished goods inventory stage
4) Book Debts stage
The following is the formula used to arrive at the OC period in an enterprise. ‘t’
= (r-c) + w + f + b, where
‘t’ = stands for the total period of the operating cycle in number of days;
‘r’ = the number of days of raw materials and stores consumption requirements
held in raw materials and stores inventory;
‘c’ = the number of days purchases, included in trade creditors;
‘w’ = the number of days of cost of production held in work-in-progress; ‘f’
= the number of days cost of sales included in finished goods; and ‘b’ = the
number of days sales in book debts.
The computations involved are:
Instead they used the term ‘natural business year’ within which an activity
cycle is completed. Later, the accounting principles board of the American
Institute of the Certified Public Accountants while defining working capital used
this concept.
Illustration 3.1
ABC company plans to achieve annual sales of 1,00,000 units for the year 2005.
The following is the cost structure of the company as per the previous figures.
Materials .. 50%
Labour 20%
Overheads .. 10%
The following further particulars are available from the records of the
company.
1) Raw materials are expected to remain in stores for an average period of one
month before issue to production.
2) Finished goods are to stay in the warehouse for two months on an average
before being sold and sent to customers.
3) Each unit of production will be in process for one month on the average.
4) Credit allowed by the suppliers of raw material is one month from the date
of delivery of materials.
5) Debtors are allowed credit for two months from the date of sale of goods.
6) Selling price per unit is Rs.9 per unit.
7) Production and sales follow a consistent pattern and there are no wide
fluctuations.
Determine the quantum of working capital required to finance the activity level of
1,00,000 units for the year 2005.
42
SOLUTION: Theories and
Approaches
1 80
2. Work-in-progress Inventory (1 month) (1,00,000 x 9 x —- x —-- ) = 60,000
12 100
2 80
3. Finished goods Inventory (2 months) (1,00,000 x 9 x —-- x —-- ) = 1,20,000
12 100
2 100
4. Debtors (2 months) (1,00,000 x 9 x — x —-- ) = 1,50,000
12 100 -------
3,67,500
Less: Current Liabilities:
1 50
1. Creditors (1 month) (1,00,000 x 9 x --- x --- ) =
37,500
12 100 -———
Working capital required = 3,30,000
-------
Notes: 1) Raw material inventory is expressed in raw material consumption.
2) Work-in-progress inventory is expressed in cost of production
(COP) where, COP is deemed to include materials, labour and
overheads.
3) Finished goods inventory is supposed to have been expressed in
terms of cost of sales. Since separate details are not given, the
figures are worked out on COP.
4) Debtors are expressed in terms of total sales value.
5) Creditors are expressed in terms of raw material consumption,
since separate figures are not available for purchases.
Illustration 3.2
i) If working capital is varied relative to sales the amount of risk that firm
assumes also varies and the opportunity for gain or loss is increased;
ii) Capital should be invested in each component of working capital as long as
the equity position of the firm increases;
iii) The type of capital used to finance working capital directly affects the
amount of risk that a firm assumes as well as the opportunity for gain or
44 loss and cost of capital; and
iv) The greater the disparity between the maturities of a firm’s short-term debt Theories and
instruments and flow of internally generated funds, the greater the risk and Approaches
vice-versa.
Briefly, these principles imply that the policies governing the size of the working
capital are determined by the amount of risk, which the management is prepared to
undertake.
Product Policies
Miscellaneous
Apart from the above mentioned factors some others like the operating efficiency,
profit levels, management’s policies towards dividends, depreciation and other
reserves, price level changes, shifts in demand for products competitive
45
Concepts and conditions, vagaries in supply of raw materials, import policy of the government,
Determination of Working hazards and contingencies in the nature of business, etc., also determine the
Capital
amount of working capital required by an undertaking.
Activity 3.2
1. Highlight few important factors on which the working capital requirement of
your organisation depends.
2. Give your views on the method of assessment being used in your organisation
for working capital determination
As is evident, this calls for a change in the approach of the RBI in assessing
working capital needs of the industrial units. The industry norm approach followed
so far yields a place to the simple turnover method and norms have no role to
play. Higher the turnover, higher would be the credit facility available. In the
earlier system, (industry norm approach), maintenance of a high level of current
assets or any other assets has no significance to the computation of working
capital needs, excepting the industry norms fixed on some practical basis. On the
contrary, units having higher turnover are permitted to hold higher current assets,
though as per norms it is excess. Moreover, this type of a practice encourages
firms to stock materials and finished goods with lax inventory control. Small firms
lag in competition to large firms, as there is an inherent advantage to the latter.
Alternatively banks may also follow ‘Cash-flow method’ to finance the working
capital needs of the industrial units. Under this method, banks will meet the
deficit if any due to payments being higher than the receipts in that month. For
this purpose, borrowers are instructed to prepare monthly cash flow statements
and impose certain control measures to ensure smooth operation of the system.
This method too abandons the industry norm approach in assessing working
capital needs. This method takes into account only the difference between
receipts and payments. This difference may arise for several reasons and may not
be entirely due to changes in working capital items. Though care is expected to be
taken by the industrial units in preparing cash flow statements,
implementation of the method in practice will only highlight its suitability.
In the case of SSI borrowers who are seeking fund-based limits upto Rs.200.00
lacs from the banking system, it is made mandatory by the RBI to assess the
working capital limits as under:
While arriving at Eligible Working Capital Finance under the Turnover Method,
for SSI and Non-SSI borrowers, if the available NWC is higher than the required
minimum, the higher available NWC shall be reckoned with. Also, the unpaid
stocks in excess of unfinanced eligible receivables shall not be taken into account
for the purpose of computation of drawing power. The inventory margin
requirement shall be 20% in the case of SSI borrowers and 20% to 25% in the
case of Non-SSI borrowers depending on the stipulated current ratio. While the
limit shall be assessed and sanctioned on the basis of 25% of projected gross
sales less prescribed margin to be provided by the borrower, the actual release
under the sanctioned limit shall be on the basis of drawing power.
Like SSI borrowers, in the case of non-SSI borrowers also, if any borrower
requests for working capital limits higher than what he would have been eligible
if assessed under the Turnover Method, his requirements can be assessed under
EWCL method and limits to the extent he is eligible under EWCL method may
be made available.
In the case of borrowers seeking fund based working capital limits less than
Rs.10.00 lacs from the Bank, the need based requirement for credit facilities may
48
be arrived at adopting a holistic approach, instead of Turnover Method, taking into Theories and
account the applicant’s business potential, business plans, past dealings, credit- Approaches
worthiness, market standing, collateral wherever available and ability to repay, etc.
The Working Capital limits less than Rs.10.00 lacs may also be extended by way of
short term loan of not more than one year maturity. This short term loan
repayable in instalments (i.e., balloon form) or in one lump sum (i.e. bullet form). is
available for renewal/rollover at the end of expiry, if the sanctioning authority, after
a review is satisfied to continue the advance. The short term loan is
permitted to be arranged for the part amount of the limit assessed while the
balance is permitted to be extended by way of overdraft.
To ensure continued use in the case of short term loans extended as above, the
stock statement shall be obtained at the end of every calendar quarter, within 7
days from the end of the quarter and for any drawings beyond the drawing
Power (DP), penal interest as in force shall be recovered on the drawings
beyond the DP. The drawings beyond the DP shall not be recovered immediately
but the loan shall be allowed to be repaid as per repayment programme specified.
The SSI borrowers seeking working capital limits less than Rs.10.00 lacs shall be
assessed under Turnover Method but they will be eligible to avail the advance by way
of short term loan as above and/or overdraft. The short term loans as above will be
eligible for 0.5% p.a. less interest (net of tax) subject to a minimum of PLR, as
compared to the interest chargeable on overdraft.
EWCL method, a suitably relaxed form of the erstwhile Maximum Permissible Bank
Finance (MPBF) Method, shall be applied in the case of borrowers seeking fund
based working capital limits of Rs.200.00 lacs and above (from the banking system)
but upto (and inclusive of) Rs.2000.00 lacs from the Bank and the
assessment shall be carried out as under:
Projections for ensuing year
49
Concepts and The identification/treatment of Current Assets and Current Liabilities shall
Determination of Working continue to be as before when the MPBF Method was practiced. The 25% of
Capital
current assets as margin (NWC) corresponds to a Current Ratio of 1.33, which
would be a benchmark current Ratio under this method of assessment. However,
relaxation of current ratio under EWCL method may be allowed upto 1.1
selectively provided other basic financial parameters are satisfactory. To arrive at
the current ratio, the term loan instalments falling due in next 12 months shall be
reckoned with but the same to be excluded as a component of current liability to
arrive at working capital gap under EWCL method. Similarly the export
receivables shall continue to be excluded from the current assets to determine the
required NWC.
The working capital requirements of the borrowers seeking fund based limits of
above Rs.2000.00 lacs shall be assessed either under CASH BUDGET Method
or the EWCL Method discussed earlier, as may be decided by the Bank. The
corporate borrowers whose management of finance is cash budget driven and the
existing clients of the Bank who have a consistently good track record of
fulfilling the specified norms/covenants - financial and performance related - can
opt for assessment under Cash Budget Method.
The Highest (Peak) Cash Gap during the period under assessment is to be
extended by way of eligible working capital limit. The following prerequisites are
advised for the borrowers to be assessed under Cash Budget system. The
borrower should:
50
a) Preferably be a company under the Indian Companies Act, listed and quoted Theories and
at one or more of the Stock Exchanges in India. This however may not be a Approaches
restrictive parameter and if the Bank is satisfied on financial strengths, the
partnership and proprietorship concerns may also be allowed under the
system. The preference to listed/quoted companies is only with an intent to
have access to their published data.
b) Have in place a data base and system for doing the financial planning on
cash budget basis.
Since the requirements of working capital finance is directly related to the levels
of activity under production and sales and the inputs required to achieve these
levels, it is necessary to obtain the above requirements in addition to the detailed
Cash Budget. While the assessment to arrive at quantum of finance should be
carried out on the basis of cash budget obtained from the borrower, the financial
statements. CMA data with fund flows also are to be taken into account to
ascertain the level of business activity for which the working capital finance is
sought by the borrower. It may be also necessary to conduct a sensitivity
analysis based on variance of major financial assumptions for a proper risk
perception.
3.6 SUMMARY
Determination of adequate amount of working capital required for a business is of
great significance in its prudent management. Value maximisation implies
optimum investment in all types of assets. There are three approaches to decide
the optimum investment in working capital. They are: industry norm approach,
economic modeling approach, and the strategic choice approach. Under the first
one, certain norms have been worked out taking the nature of operations into
account. Each unit’s requirements are assessed with respect to such ‘industry
bench mark’ norm. Economic models are pressed into service to make certain
projections, current asset items are projected on the basis of these models and an
optimum quantum is arrived at. Under the strategic choice approach, business
forms are advised to follow their own ‘unique’ approach basing on the
circumstances prevailing; they need not be guided by the industry practices.
51
Concepts and Determination
of Working Capital 3.7 KEY WORDS
Operating cycle: Length of time required for the completion of each of the
stages involved in the manufacturing process, covering working capital items.
Turnover method: It is a method of calculation of working capital requirements,
basing on sales turnover.
Cash budget method: It is a method of calculation of working capital
requirements using cash budget.
Industry norm: It is a method of taking industry practices into account while
deciding working capital requirements.
Economic modelling: This refers to the use of quantitative techniques for
assessing working capital requirements.
Strategic choice: It is a need based approach taking into account the
circumstances prevailing in the industry to decide the optimum amount of working
capital.
4.1 INTRODUCTION
In the previous unit, we have discussed about the concept of operating cycle and
various methods for determining working capital requirements. The present unit
focuses on the theoretical issues governing the determination and also the
practices followed by banks and other financial institutions. This is expected to
help the Student come closer to the reality. There has been little difficulty in
segregating the issues under this block into individual units due to their
overlapping content. Therefore, an attempt has been made in this unit to cover all
those issues that could not be covered under the earlier three units, yet focussing on
the theme of the present unit. As you could observe from the structure of the lesson
presented above, enough care has been taken to include only pertinent
matters in the discussion that follows. Major concentration has been on the
following:
a) What is the objective function in taking working capital decisions?
b) How to create value through working capital?
c) Is there any scope to lay down time-tested principles of working capital
policy?
d) How do risk-return relationships operate in the area of working capital
decision making?
54
of profits is regarded as the proper objective of the firm. but it is not as inclusive as Theories and
that of maximising shareholders’ value. A right kind of approach to decisions of Approaches
investment and financing of working capital can contribute to the achievement of the
objective function.
Be that as it may, how should one proceed to create value through working
capital management. The answer is: invest in an asset, if its net present value is
positive. The fact is that the basic principles of long term asset investment
decisions should apply equally well to short term asset investment decisions.
Therefore, it is useful to examine this criterion more closely in terms of current
asset investment decisions.
The general formula for finding net present value of a project is:
A1 A2 A3 An
NPV= ————— + ————— + ————— + ------- + ———— - C
(1+K) 1
(1+K) 2
(1+K) 3
(1+K)n
Where A1 to An represent annual cash inflows on an after tax basis. ‘K’ is the
discount factor, which is generally taken as the cost of capital. ‘C’ represents the
initial outflow.
This equation can be used to decide the choice of investment in current assets
taking into account their shorter life span. Accepting one year life as standard to
categorise assets into fixed and current, NPV has to be calculated for each year.
For this purpose, the above equation can be modified as follows to elicit NPV.
A1 A2 A3 An
NPV =—— + ——— + ——— + ------- + ——— - C
K K K K
Like the decisions in capital budgeting, the problem remains as that of
determination of risk and thus the appropriate discount rate to apply.
Sometimes, practitioners tend to use net profit criterion to decide the investment in
current assets; which they consider is a simple modification of the concept of NPV
as shown below:
r
Net profit per period = Annuity = NPV [———— ]
1-(1+ r)-n
Example 4.1
55
Concepts and Determination 500 500 5000 r
of Working Capital = [-5000 + ———— + ———— + ————— ] [—————]
(1+ r) (1+ r) n
(1+ r) n
1-(1+ r)-n
1-(1+ r)-n
= 500 (—————) r
r (——————)
1-(1+ r)-n
r
- [ 5000 - 5000 (1+r) ] (—————)
-n
1-(1+r)-n
1-(1+ r)-n 1/r
But ——————— = —————————.
r 1-(1+ r)-n
r
So Net Profit = 500 - 5000 [1- (1+ r )-n ] (——————)
1-(1+ r)-n
= 500 - 5000 (r)
= 500 - 5000 (8%)
= 500 - 400 = 100
The Rs.400 is the annual capital cost of Rs.5,000 investment at an 8 per cent
rate of interest, and the annual net profit of Rs. 100 does not depend on when
the investment is reversed. The result is that we can use net profit per period as
a criterion for choosing among alternative reversible investments. The investment
with the highest value of net profit per period is also the investment with the
highest net present value, regardless of when the investment is reversed.
Investments with positive NPVs will have positive net profits, investments with
zero NPVs will have zero net profits, and investments with negative NPVs will
have negative net profit. Thus, net profit per period, instead of NPV can be used
as a decision criterion for working capital management.
i) Walker’s approach
ii) Trade off approach
First principle: This is concerned with the relation between the levels of
working capital and sales. His principle is that: if working capital is varied
relative to sales, the amount of risk that a firm assumes is also varied and the
opportunity for gain or loss is increased. This implies that a definite relation
exists between the degree of risk that management assumes and the rate of
return. The more the risk that a firm assumes, the greater is the opportunity for
gain or loss. Consider the following data:
1 2 3
Level of working capital (Rs.) 50,000.00 90,000.00 1,20,000.00
Fixed capital (Rs.) 10,000.00 10,000.00 10,000.00
Liabilities 30,000.00 30,000.00 30,000.00
Net Worth 30,000.00 70,000.00 1,00,000.00
Sales 1,00,000.00 1,00,000.00 1,00,000.00
Fixed Capital Turnover 10.00 10.00 10.00
Working Capital Turnover 2.00 1.1 0.8333
Total Capital Turnover 1.66 1.00 0.761
Earnings (as Percent of Sales) 10.00 10.00 10.00
Rate of Return (Percent) 16.60 10.00 7.60
————————————————————————————————
It can be seen from the data that the return on investment has increased from
7.6 percent to 16.6 per cent when working capital fell from Rs. 1,20,000 to
Rs.50,000. Moreover, it is believed that while the potential gain resulting from
each decrease in working capital is greater in the beginning than potential loss,
exactly opposite occurs, if the management continues to decrease working
capital (see-Figure 4.1).
0
Loss
Third principle: The type of capital used to finance working capital directly
affects the amount of risk that a firm assumes as well as the opportunity for
gain or loss and cost of capital. It is indisputable that different types of capital
possess varying degrees of risk. Investors relate the price for which they are
willing to sell their capital to this risk. They may charge less for debt than equity,
since debt capital possesses less risk. Thus risk is related to the return. Higher
risk may imply a higher return too. Unlike rate of return, cost of capital moves
inversely with risk. As additional risk capital is employed by management, cost of
capital declines. This relationship prevails until the firm’s optimum capital structure
is achieved.
Fourth principle: The greater the disparity between the maturities of a firm’s
short-term debt instruments and its flow of internally generated funds, the greater
the risk and vice-versa. This principle is based on the analogy that the use of
debt is recommended and the amount to be used is determined by the level of
risk, management wishes to assume. It should be noted that risk is not only
associated with the amount of debt used relative to equity, it is also related to the
nature of the contracts negotiated by the borrower. Some of the more important
characteristics of debt contracts directly affecting a firm’s operation are
restrictive clauses of the contracts and dates of maturity.
The risk-return trade-off involved in managing the firm’s liquidity via investing in
marketable securities is illustrated in the following example. Firms A and B are
identical in every respect but one. Firm B has invested Rs.5,000 in marketable
securities which has been financed with equity. That is, the firm sold equity
shares and raised Rs.5,000.00. The balance sheets and net incomes of the two
firms are shown in Table 4.2. Note that Firm A has a current ratio of 2.5
(reflecting net working capital of Rs. 15,000) and earns a 10 percent return on its
total assets. Firm B, with its larger investment in marketable securities has a current
ratio of 3 and has net working capital of Rs.20,000. Since the marketable securities
earn a return of only 9 percent before taxes (4.5 percent after taxes with a 50
percent tax rate). Firm B earns only 9.7 percent on its total
investment. Thus, investing in current assets and in particular in marketable
securities, does have a favourable effect on firms liquidity but it also has an
unfavourable effect on the firm's rate of return earned on invested funds. The
risk-return trade-off involved in holding more cash and marketable securities,
therefore, is one of added liquidity versus reduced profitability.
Balance Sheets A B
59
Concepts and Activity 4.1
Determination of Working
Capital Give points of distinction between the Walker's Approach and Trade off
Approach.
Simply speaking, the hedging principle involves matching the cash flow generating
characteristics of an asset with the maturity of the source of financing used to
finance its acquisition. For example, a seasonal expansion in inventories, according to
the hedging principle, should be financed with a short-term loan or current
liability. The rationale underlying the rule is straightforward. Funds are needed for a
limited period of time, and when that time has passed, the cash needed to
repay the loan will be generated by the sale of the extra inventory items.
Obtaining the needed funds from a long-term source (longer than one year)
would mean that the firm would still have the funds after the inventories (they
helped finance) have been sold. In this case the firm would have “excess”
liquidity, which they either hold in cash or invest in low yielding marketable
securities until the seasonal increase in inventories occurs again and the funds are
needed. This would result in an over-all lowering of firm profits, as we saw earlier
in the example presented in Table 4.2.
Let us take another example in which a firm purchases a new packing machine,
which is expected to produce cash saving to the firm by eliminating the need for
two labourers and, consequently their salaries. This amounts to an annual savings
of Rs.20,000. while the new machine costs Rs. 1,00,000 to install and will last 10
years. If the firm chooses to finance this asset with a one-year loan, then it will
not be able to repay the loan from the cash flow generated by the asset. Hence,
in accordance with the hedging principle, the firm should finance the asset with a
source of financing that more nearly matches the expected life and cash flow
generating characteristics of the asset. In this case a 7 to 10-year loan would be
more appropriate than a one-year loan.
To put it very succinctly the hedging principle states that the firm’s assets not
financed by spontaneous sources should be financed in accordance with the rule:
permanent assets (including permanent working capital needs) financed with long-
term sources and temporary assets (viz. fluctuating working capital need) with short-
term sources of finance towards the liquidity risk.
60
Figure: 4.2A : Hedging Financing Theories and
strategy Approaches
Long Term
Financing
Fixed Assets
Note that permanent asset needs are matched exactly with spontaneous plus long-term sources of
financing while temporary current assets are financed with short-term sources of financing.
901 34567890123456789
456789012345678901234
234567890123456789
2345678901234
23456789
Long Term
Financing
Fixed Assets
Shaded area represents the firm’s use of long-term plus spontaneous financing in excess of
the firm’s permanent asset financing needs.
Figure: 4.2C : Aggressive Financing strategy: Permanent Reliance on Short Term Financing
Temporary CAS
67
1234567 Short Terms
678901234567
123456789012345 Financing
678901234567890
123456789012345
890121234567890
345678901212345
890123456789012
Investment
345678901234567
890123456789012
345678901234567
123456789012
1234567
Long Terms
Financing
Fixed Assets
Shaded area reflects the firm’s continuous use of short-term financing to support its
permanent asset needs. 61
Concepts and In Figure 4.2B the firm follows a more cautious plan, whereby long-term sources
Determination of Working of financing exceed permanent assets in trough period such that excess cash is
Capital
available (which must be invested in marketable securities). Note that the firm
actually has excess liquidity during the low ebb of its asset cycle and thus faces
a lower risk of being caught short of cash than a firm that follows the pure
hedging approach. However, the firm also increases its investment in relatively
low-yielding assets such that its return on investment is diminished (recall the
example from Table 1.2).
In contrast, Figure 4.2C depicts a firm that continually finances a part of its
permanent asset needs with short term funds and thus follows a more aggressive
strategy in managing its working capital. It can be seen that even when its
investment in asset needs is lowest the firm must still rely on short-term
financing. Such a firm would be subjected to increased risks of cash shortfall, in
that it must depend on a continual rollover or replacement of its short-term debt
with more short-term debt. The benefit derived from following such a policy
relates to the possible savings resulting from the use of lower-cost short-term
debt as opposed to long-term debt.
Most firms will not exclusively follow any one of the three strategies outlined
above in determining their reliance on short-term credit. Instead, a firm will at
times find itself overly reliant on long term financing and thus holding excess
cash and at other times it may have to rely on short-term financing throughout an
entire operating cycle. The hedging principle does, however; provide an important
guide regarding the appropriate use of short-term credit for working capital
financing.
Rs. Rs.
Current Assets 40,000 40,000
Fixed Assets 80,000 80,000
–------- --------
Total Assets 1,20,000 1,20,000
–------- --------
Accounts payable 10,000 10,000
Bank credit (10%) 0 30,000
–------- --------
Current liabilities 10,000 40,000
–------- --------
Long Term Debt (16%) 30,000 0
Equity 80,000 80,000
–------- --------
Total Liabilities 1,20,000 1,20,000
–------- --------
62
Income Statement Firm X Firm Y Theories and
Approaches
Net operating Income (EBIT) 64,800 64,800
Less Interest 4,800 3,000
–------- --------
Taxable Income 60,000 61,800
Taxes @ 50% 30,000 30,900
–------- --------
PAT (Net Income) 30,000 30,900
–------- --------
Measures of Liquidity
(a) Current Ratio 4:1 1:1
(b) Net working capital 30,000 0
Measures of profitability
(a) ROl 37.5% 38.6%
(b)EPS Rs 3.00 Rs 3.09
It is evident from the data contained in Table 4.3 that the Firm (X) using long
term debt has a current ratio of 4 times and Rs.30,000 in net working capital,
whereas Firm Y’s current ratio is only 1 time, which represents zero net working
capital. Because of lower interest rates on short-term debt (bank credit in this case)
Firm ‘Y’ was able to earn a ROI of 38.6 percent compared to that of ‘X’, which
could earn only 37.5 percent. Thus a firm can reduce its risk of illiquidity through the
use of long term debt at the expense of a reduction of its return on investment
funds. Once again we see that the risk-return trade-off involves an increased risk of
illiquidity versus increased profitability.
4.6 SUMMARY
It has been noted in this unit that value is created by virtue of investment in both
fixed and current assets. It is also found that the same criterion of selection of
projects used for fixed investment holds good for investments in working capital;
though the inter-related nature of current assets and current liabilities makes the
job of managing working capital difficult. To attain this objective function,
different approaches have been suggested. The early contribution of Walker is
found to be of immense use in this regard. The principles laid down by him need
to be tested in practice and deviations to be examined. It is further highlighted
that working capital decisions involve trade-off between risk and return. This
operates within the investment and financing areas. Different approaches have
been examined in this unit with suitable examples to highlight the impact of the
variables on the working capital decision-making. Against these theoretical
foundations, the students are expected to compare their practices and enrich the
existing knowledge base.
Net present value: The difference between the present value of inflows
generated by a project minus the initial investment made in that project.
2003
Current Liabilities Rs 30,000 Net Fixed Assets Rs 50,000
Long-Term Liabilities Rs 20,000 Current Assets:
Equity Capital Rs 50,000 Cash 5,000
Inventories 25,000
Accounts Receivable 20,000 Rs 50,000
–-------- ------ -------
1,00,000 1,00,000
–-------- -------
During 2003 the firm earned net income after taxes of Rs. 10,000 based on net
sales of Rs.2,00,000.
a) Calculate Cooptex’s current ratio, net working capital and return on total
assets ratio (net income/total assets) using the above information.
Objectives
Structure
5.1 Introduction
5.2 Credit Policy
5.3 Credit Evaluation Models
5.4 Monitoring Receivables
5.5 Collecting Receivables
5.6 Strategic Issues in Receivables Management
5.7 Summary
5.8 Key Words
5.9 Self Assessment Questions
5.10 Further Readings
5.1 INTRODUCTION
“Buy now, pay later” philosophy is increasingly gaining importance in the way
of living of the Indian Families. In other words, consumer credit has become a
major selling factor. When consumers expect credit, business units in turn expect
credit form their suppliers to match their investment in credit extended to
consumers. If you ask a practising manager why her/his firm offers credit for the
purchases, the manager is likely to be perplexed. The use of credit in the
purchase of goods and services is so common that it is taken for granted. The
granting of credit from one business firm to another, for purchase of goods and
services popularly known as trade credit, has been part of the business scene for
several years. Trade credit provided the major means of obtaining debt financing
by businesses before the existence of banks. Though commercial banks provide a
significant part of requirements for working capital, trade credit continues to be a
major source of funds for firms and accounts receivables that result from
granting trade credit are major investment for the firm. The importance of
accounts receivables can be seen from Table 5.1, which presents investments in
accounts receivables for different industries over the years. This is expected to
provide an idea of the size of investment in receivables in the Indian Industry.
1
Management of Current Table 5.1 : Industry-wise Investments in Trade Credit Receivables
Assets Rupees in
Crores
At the same time minimisation of liquidity risk would imply the risk of opportunity
loss. The opportunity loss here means loss of sales by refusing the credits to its
potential customers. This would further affect the loss of revenue and the loss of
profits. Thus the objective of accounts receivable management is to arrive at an
optimum balance of these two risks and help the company to realize its operating
plans. This balancing is not a static but a dynamic one. To arrive at the balancing
of these two risk, the company would frequently require to adjust their credit
standards, credit terms and credit policies. Management of the company would
also be required to consider general economic conditions while making such
adjustments.
2
Management of Inventory
The objectives that drive the above issues of receivables management are:
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
2) How does the decision on granting credits affect the finance of the company?
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
……………………………………………………………………………………. 3
Management of …………………………………………………………………………………….
Current
Assets
5.2 CREDIT POLICY
Designing credit policy is the first step in receivables management. In designing
credit policy, the management can follow two broad approaches. Firstly, the
policy can be designed under the assumption of unlimited production/sales and
funds available for investment in receivables. If credit policy is designed under
this assumption and subsequently some constraints are experienced on sales or
funds available for receivables, then managers have to restrict the credit at the
time of implementing the credit policy. But this may cause certain difficulties to
customers because of deviation from the announced credit policy. For example, if a
company announces that credit will be unlimited to certain categories of
customers based on unlimited funds assumption and subsequently refuse to grant
credit due to limited funds available for investment in receivables, it will create
hardship to the customer. Under the second approach, the credit policy could be
designed keeping in mind the limitations on production/sales volume and funds
available for investment in receivables. This is aimed to achieve optimum
utilisation of production capacity and funds available for receivables. It also
ensures consistency of credit policy.
The credit policy consists of the following components:
• Credit Period
• Discount
• Credit Eligibility
• Credit Limit
a) Credit Period
The time that the buyer gets before payment is due, is one of the dimensions of
the product (like quality, service, etc.) which determine the attractiveness of the
product. Like other aspects of price, the firm’s terms of credit affect its volume.
All other things being equal, longer credit period and more liberal credit-granting
policies increase sales, while shorter credit period and more stringent credit-
granting policies decrease sales. These policies also affect the level and timing of
certain costs. Evaluation of credit policy changes must compare with the
changes in sales and additional revenues generated by the sales as a result of this
policy change and costs effects. While additional volume and revenue
associated with such additional volume are clear and measurable, the cost effects
require further analysis.
Lengthening credit period delays the cash inflows. For example, suppose a firm
increases the credit period from 30 days to 90 days. Customers, old as well as
4
new, will now pay at the end of 90 days and the cash inflows from these sales Management of
Inventory
would occur further into the future. That means, the firm has to delay in settling its
dues to others or resort to short-term borrowing if the payments cannot be
delayed. The interest cost of short-term borrowing arises mainly on account of
extending the credit period.
Example 5.1
Flysafe Travels is one of the large air-ticket sellers in the city. It offers one-
month credit for the air-tickets booked through the firm. Since it also gets one-
month credit from the air-lines, the payables and receivables are by and large
matched and there is no need of additional investment. The present annual
turnover of the firm is around Rs.40 crores. The firm is now contemplating to
increase the credit period from one-month to two-months and this is expected to
increase the volume by 40% and nearly 80% of the customers (old and new) are
expected to avail the new credit facility. The firm has just concluded a credit
proposal with a nationalised bank to meet payment liability at 15%. How much
more it costs for Flysafe Travels to meet the increased credit volume.
Revised Sales Rs. 40 cr. × 1.40 = Rs. 56.00 cr.
Customers, who are expected to use additional
credit period = 80%
Sales which are likely to be collected at the end of
second month = Rs. 56 x 0.80 = 44.80 cr.
Total Credit Period = 2 months
Less: Credit given by Air-line operators Funds = 1 month
required for additional credit period of Interest 1 month
cost per year = 15%
Additional interest cost to sustain 1 month credit = Rs. 44.80 x 15% =
Rs. 6.72 cr.
The cost of Rs. 6.72 cr. is compared with the additional profit generated by the
new sales to decide whether it is desirable to increase the credit period or not.
Changes in credit period also affect the cost of carrying inventory. This
arises
mainly on account of increased volume attracted by the extended credit period,
which in turn requires more inventory to support increased volume. For example,
if expected additional sales is Rs. 5 cr. and the firm’s present operating cycle
requires an inventory at 20% of its sales value, the additional inventory
requirement is Rs. 1 cr. Again, inventory is a idle investment and consumes cost
in the form of cost of storage and cost of carrying inventory. If the two costs
together amount to 17%, the changes in credit policy has caused an additional
cost of Rs. 17 lakhs.
Another cost associated with extending credit term and increase in sales volume on
account of extended credit term is discount and bad debts expenses.
Increase in credit sales and period would prompt firms to announce attractive
discount policy for prompt payment. Similarly, bad debts will also go up due to
increased volume of credit sales.
The cost of collection also goes up when the credit period is increased and
more credit volume is done. The cost of collection includes cost of maintaining
records of credit sales, telephone calls, letters, personal visits to customers, etc.
These costs tend to show an uptrend with increased volume and credit sales.
Example 5.2
5
Management of Suppose the cost of collection for the Flysafe Travels is 1% and bad debts are
Current
likely to increase from 0.50% to 0.75% due to increased credit period. These
Assets
costs are to be added along with interest cost on additional investments in
receivables arising out of changes in credit period. These two costs are
computed as follows:
Cost of Collection
Case Sales (Rs.) Cost of Collection (Rs.)
Present 56.00 cr. 0.56 cr.
Previous 40.00 cr. 0.40 cr.
Difference 16.00 cr. 0.16 cr.
b) Discount
When a firm pursues aggressive credit policy, it affects cash flows in the form of
delayed collection and bad debts. Discounts are offered to the customers, who
purchased the goods on credit, as an incentive to give up the credit period and
pay much earlier. For example, suppose the terms of credit is “3/10 net 60”. It
means if the customer, who gets 60 days credit period can pay within 10 days
from the date of purchase and get a discount of 3% on the value of order.
Since the customer uses the opportunity cost of funds and availability of cash in
taking decision, the cash discount should be set attractive. The discount quantum
should be greater than interest rate of short-term borrowings.
Example 5.3
Example 5.4
The discount policy will bring down the value of bad debts from 1% to 0.50%. The
savings in terms of values is Rs. 11,50,000 i.e. 23,00,00,000 x (1% - 0.50%). If this
saving is deducted from the discount value of Rs. 27,60,000, the net
discount cost is Rs. 16,10,000. When the net discount cost of Rs. 16,10,000 is
compared with the interest cost of Rs. 18,33,700, then offering 3% discount for
payment within 10 days is economical. (However, before implementing this new
7
Management of credit policy, the overall impact of the policy on profit is to be assessed and this
Current
will be discussed later).
Assets
The above analysis also highlights the factors that are involved in evaluating the
discount policy. The discount policy is judged on the basis of discount percent
(3%), discount period (10 days), percentage of customers expected to avail the
discount term (40%), and interest cost (15%). For example, if 80% of the
customers are likely to avail this facility, then the discount value and interest cost
will double to Rs. 55,20,000 and Rs. 36,67,400 respectively. If there is no
change in reduction of bad debts value, then the cost (Rs.55.20 - 11.50 lakhs)
exceeds benefit (Rs.36.674 lakhs) and thus, the discount policy is uneconomical.
To make the policy economical, the company has to reduce the discount rate from
3% to lower level, which will cut down the discount cost as well as
percentage of customers using the discount offer.
Having designed credit period and discount rate, the next logical step is to define
the customers, who are eligible for the credit terms. The credit-granting decision
is critical for the seller since credit-granting has economic value to buyers and
buyers decision on purchase is directly affected by this policy. For instance, if the
credit eligibility terms reject a particular customer and requires the customer to
make cash purchase, the customer may not buy the product from the company
8
and may look forward to someone who is agreeable to grant credit. Nevertheless, Management of
Inventory
it may not be desirable to grant credit to all customers. It may instead analyse
each potential buyer before deciding whether to grant credit or not based on the
attributes of that particular buyer. While the earlier two terms of credit policy
viz. credit period and discount rate are not changed frequently in order to
maintain consistency in the policy, credit eligibility is periodically reviewed. For
instance, an entry of new customer would warrant a review of credit eligibility of
existing customers.
The decision whether a particular customer is eligible for credit terms generally
involves a detailed analysis of some of the attributes of the customer. Credit
analysts normally group the attributes in order to assess the credit worthiness of
customers. One traditional way of organising the information is by characterising
the applicant along five dimensions namely, Capital, Character, Collateral, Capacity
and Conditions. These five dimensions are also popularly called Five Cs of credit
analysis.
Capital: The term capital here refers to financial position of the applicant firm. It
requires an analysis of financial strength and weakness of the firm in relation to
other firms in the industry to assess the credit worthiness of the firm.
Financial information is normally derived from the financial statements of the firm
and analysed through ratio analysis. The liquidity ratios like current ratio, debt-
service coverage ratio, etc. are often used to get a preliminary idea on the
financial strength of the firm. Further analysis includes trend analysis and
comparison with the other industry norm or other firms in the industry.
Character: A prospective customer may have high liquidity but delay payment to
their suppliers. The character thus relates to willingness to pay the debts.
Some relevant questions relating to character are:
• What is the applicant’s history of payments to the trade?
• Has the firm defaulted to other trade suppliers?
• Does the applicant’s management make a good-faith effort to honour
debts as they become due?
Information on these areas are useful to assess the applicant’s character.
Collateral: If a debt is supported by collateral, then the debt enjoys lower risk
because in the event of default, the debt holder can liquidate the collateral to
recover the dues. The collateral causes hardship to other debt holders. Thus,
the analysts should look into both the availability of collateral for the debt and the
amount of collateral the firm has given to others. In computing the liquidity of
the firm, the analysts should remove the assets used for collateral and take into
account only the free assets. The credit worthiness improves if the customer is
willing to offer collateral assets or the value of collateral asset backed loan is
low.
Capacity: The capacity has two dimension - management’s capacity to run the
business and applicant firm’s plant capacity. The future of the firm depends on the
management’s ability to meet the challenges. Similarly, the facility should exist to
exploit the opportunity. Since the assessment of capacity is a
judgement on the part of analysts, a lot of care should be taken in assessing this
feature.
Conditions: These are the economic conditions in the applicant’s industry and in
the economy in general. Scope for failure and default is high when the industry and
economy are in contraction phase. Credit policy is required to be modified when the
conditions are not favourable. The policy changes include liberal
discount for payment within a stipulated period and imposing lower credit limit.
9
Management of The information collected under five Cs can be analysed in general to decide
Current
whether the customer is eligible for credit or fit into a statistical model to get an
Assets
unbiased credit rating of the customer. Discussion on credit evaluation model is
presented in the next section.
d) Credit Limit
If a customer falls within the desired limit of credit worthiness, the next issue is
fixing the credit amount. This is some thing similar to banks fixing overdraft limit for
the account holders. If a customer is new, normally the credit limit is fixed at the
lowest level initially and expanded over the period based on the
performance of the customer in meeting the liability. Credit limit may undergo a
change depending on the changes in the credit worthiness of the customer and
changes in the performance of customer’s industry.
Example 5.6
The additional contribution on account of increase in sales works out to Rs. 2 cr.
(20% of Rs. 10 cr.). The investment in receivables has gone up by Rs. 1.10 cr. and
it costs additional interest burden of Rs. 0.154 cr. per year. Since additional
contribution of Rs. 2 cr. is higher than the additional cost of Rs. 0.154 cr., the
revision is profitable to the firm.
There are several reasons for limiting the credit facility to the customers. Some of
the important reasons are:
• reduce the impact of deficiencies in credit-granting decision;
• reduce the scope for overbuying by the customers;
• rationally allocate the limited funds available for investment in bills
receivable; and
• mitigate agency problem
The last reason, mitigating agency problem, requires further discussion. Agency
problem arises on account of conflict of interest between the managers (agents) and
equity shareholders (owners or principal). Agents will always try to
maximise their return even if it is at the cost of principal. Two types of agency
problems arise in credit-granting decision. Firstly, managers may collude with
some of the customers and grant credit even to undesirable customers. Credit limit
puts a cap on the potential loss. Secondly, managers may hesitate to give credit to
even creditworthy customers when the performance of the managers is assessed on
the basis of collection efficiency. Recently, many public sector
10
banks were criticised for not granting fresh loan despite comfortable monetary Management of
Inventory
position and funds are simply used to buy government securities. The fear of
default and delay in collection would prevent in granting credit even to good
customers and thus, take away the opportunity to maximise the profit. Credit
limit would to some extent take away this fear of managers since default is
restricted and thus would encourage them to accept credit proposals. The
situation will improve further if credit limits are built into the system of
performance evaluation and managers are not penalised as long as they have
restricted the credit.
Activity 5.2
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
……………………………………………………………………………………. 2)
List out important factors that are used in assessing credit worthiness.
…………………………………………………………………………………….
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…………………………………………………………………………………….
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…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
Decision Tree Model: Under decision-tree model, credit applications are rated
under different parameters. For instance, if a company uses five Cs factors, the
analysts rate the credit applicant under each of the five Cs. Decision-tree is
initially created for all possible routes and decisions at the end of each route are
indicated. Figure 5.1 illustrates decision-tree model using three credit information
namely capital, character and collateral. If a character, capital and collateral are
strong, then the applicant firm is granted large amount of credit. On the other
Should
Credit
be
granted?
Character
Strong Weak
Capital Capital
Strong
Strong Strong/ Strong/ Weak
Weak Weak
12
hand, if the first two are strong but the collateral is weak, a limited credit could be Management of
Inventory
granted.
If character is weak but capital and collateral are strong, then credit is limited to
collateral value. On the other hand, if all the three are weak, it is a dangerous
credit proposal and hence to be rejected. In Figure 5.1, we have taken two
broad ratings, which can be further divided into three or five scale rating.
Increasing the credit variable and rating scale will lead to more branches and
credit limit can be prescribed for each branch separately.
The model produces the coefficient values and when a new application is
received for credit scoring, the values of Xs are to be measured and substituted in
the model equation to get the discriminant score. The discriminant is then
compared with the point of separation to place the applicant in one of the two
groups. For example, if the point of separation is 3.80, when the applicant’s
score is above 3.80, then the applicant is placed in fair or excellent risk group. If the
score is below 3.80, then it is risky proposal. Thus, it is possible to evaluate where a
particular customer stands in terms of credit worthiness. No difficulty is felt when
the scores are much above or below the separation point but credit
worthiness of customers, whose scores are close to separation point, are difficult to
assess. In such cases, further analysis is made to understand the credit
worthiness of the customers. It is also possible to outsource credit rating
evaluation from specialised credit rating agencies.
Credit scoring models are periodically updated to take into account changes in the
environment and also reassess the credit worthiness of the customers. An outdated
model may wrongly classify the customers and lead to heavy losses. Further, while
developing the system, it is necessary to ensure good sample for developing the
model. It is equally important that the model is validated before employing it. Many
foreign banks and credit card agencies extensively use credit rating schemes and
found them useful in taking credit decision.
…………………………………………………………………………………….
…………………………………………………………………………………….
15
Management of Current …………………………………………………………………………………….
Assets
2) List down some of the important inputs required in evaluating credit proposals.
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
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…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
Inaccurate Policy Forecasts: A wide deviation from the credit terms and
actual flow of cash flows show inaccurate forecast and defective credit policy. It is
quiet possible that a firm uses defective credit rating model or wrongly assesses the
credit variable. For example, it is quiet possible to overestimate the collateral value
and then lend more credit. If this is the reason for wide deviation, it
requires updating the model or training the employees.
Accounts Receivable
Collection Period = ----------------------
Credit Sales per day
Credit sales per day is computed by dividing the total credit sale of the period by the
number of days of the period. If the sales value given above are related to quarterly
sales value, then sales per day for the two quarters are Rs. 1 lakh
(Rs.90 lakhs/90 days) and Rs. 1.33 lakh (Rs.120 lakhs/90 days) respectively.
The collection period for the two quarters are:
The collection period shows a decline and thus improved performance, which was not
visible earlier in simple comparison. If the sales value for the second period is Rs.
100 lakhs instead of 120 lakhs, then average credit sales per day is Rs.
1.11 lakh and collection period is 126 days. The collection performance in this
case has marginally come down. The collection period of manufacturing
companies in BSE-30 index (Sensex) for the last five years is given in Table 5.2.
The Table shows the average collection period for companies such as Hindustan
Petroleum, Nestle, Hindustan Lever, Bajaj Auto, Gujarat Ambuja Cements, ACC,
and Colgate are low whereas BHEL, L&T, Telco, Tisco, Grasim, etc., have
experienced longer days for collection.
If customers are granted different credit periods, then customers of similar nature are
to be grouped separately and then sales, receivables and collection period
relating to each group of customers are to be computed separately. Otherwise, it will
give a distorted figure. In addition to comparing collection period of one
period with other periods, they are also compared with credit terms. Any
abnormal deviation warrants customer-wise analysis. That is, all these three
17
Management of values for two periods can be computed for each customer to know the trends in
Current
collection period of different customers. Such an analysis will help to narrow
Assets
Oil & Natural Gas Corpn. Ltd. 38.76 36.64 30.24 40.92 49.85
Tata Iron & Steel Co. Ltd. 75.53 64.70 61.95 53.33 37.18
Table 5.4 : Receivables Outstanding more than 6 months as a percentage of Total Receivables
The above two measures namely, average collection period and ageing schedule
may give misleading picture when the sales are seasonal. Suppose the average
sales per month of a quarter is Rs. 10 lakhs. The sales figures for the three
months are Rs.10 lakhs, Rs.15 lakhs and Rs.5 lakhs. Suppose the collection
pattern shows that 50 per cent of the sales is collected in the same month, 25
in the following month and the remaining 25 in the third month. If there is no
outstanding receivables at the beginning of the quarter, then the receivables
values at the end of each month are Rs. 5 lakhs, Rs.10 lakhs and Rs.12.5 lakhs.
The average collection period for the last month will be very high compared to
other months though there is no change in the payment pattern of the customers. In
order to overcome this problem, particularly in a seasonal sales pattern, the
following alternatives are suggested:
• Ratio of receivables outstanding to original sales, and
• Sales-weighted Collection Period.
Both the above measures require decomposing receivable outstanding at the end of
each month to trace the receivables with original sales. Such a decomposition will
be useful even for a non-seasonal firms.
The following example will help you to understand the figures in the above Table.
20 Suppose Rs. 40 lakhs is outstanding receivables at the end of January, this
consists of 94% of January’s sales, 70% of December's sales, 21% of Management of
Inventory
November’s salary, 6% of October's sales and 1% of September's sales. If the
credit period is 30 days, the above analysis shows that a significant part of the
debtors takes more than one month in settling dues. While a significant part of the
customers settle down their dues by the end of second month, outstanding
beyond 2 months is also high and more importantly growing. Receivables
outstanding more than two months have gone up from 21% to 32%. The growing
trend in non-collection of dues continues for other two months too. This clearly
shows the customers have slowed down in settling their dues and thus requires more
careful analysis. If this Table 5.5 is supplemented with the names of
customers along with their dues for the second, third and fourth months, it is
helpful for follow up and appropriate action.
n
Sales-weighted Collection Period =Σ (ARt/St) × 30 days
t=0
A similar table prepared for each customer will be useful to evaluate the
behaviour of each customer in settling the dues. An analysis of this behaviour for a
year can be used to assign ranks to the customers and such ranking can be used
while taking credit policy or credit decision. Instead of using outstanding
receivables values, some organisations use the payment values. However, both
should lead to same conclusion.
Month Credit
Sales
(Rs.) Jan Feb Mar Apr May June July Aug Sept
Total Collection 10,000 51,000 76,000 1,19,500 1,26,500 1,53,500 1,46,000 97,000 40,500
It may be observed from the above data that our Hypothetical company, making
a sale of Rs. 1 lakh could collect only 10% in the same month and around 50%
after two months. The above represents a case of deteriorating collection
efficiency.
Activity 5.4
…………………………………………………………………………………….
…………………………………………………………………………………….
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22
3) How do you set right the seasonal variation in sales affecting some of the Management of
Inventory
indicators used in receivables analysis?
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
The above discussion assumes that the firm takes the responsibility of collection.
Two alternatives are available to firms in collecting the receivables. The first one
called factoring enables the firm to transfer the receivables to factoring agent,
who takes the responsibility of collection. Some factoring agents takes the credit
risk (i.e. the factoring agents bear the loss on account of bad debts) and others
accept factoring without credit risk. In India, we have factoring subsidiaries of
Canara Bank, SBI, etc. and Exim Bank does the factoring service relating to
export bills. The second one is called receivables securitisation. Securitisation is
somewhat similar to factoring but here the securitising agent sells the units of
receivables to investors in the market. Though the concept of securitisation is
popular in finance related receivables like housing loans, credit cards receivables,
lease rentals, etc., the concept is slowly spreading to other types of receivables. A
few securitisation deals have already been completed in India and the market will
witness more such transactions in the near future.
Firms pursuing strategies to acquire cost leadership need a suitable credit policy to
support their strategies. For instance, if a firm is trying to achieve cost
leadership through economies of scale of production, then it has to generate a
large volume of sales. Since credit term is an economic variable in buying
decision, the credit terms should be supportive to sell large volume. That means, the
firm may have to offer more days of credit particularly for those who buy in large
quantity. Of course, the cost of investment in receivables will go up initially but
without a liberal credit policy, the assets created to achieve economics of sale will be
idle. In fact, the additional cost of investments in receivables need to be considered
while computing the benefit arising out of economies of scale.
Credit policy can also be used to change the product life cycle and investment
pattern. For instance, the life cycle of a product X is 10 years, which is worked out
on the basis of existing credit terms and volume of turnover. Assume the
total sales during the period is 2,50,000 units. The volume achieved is initially low,
then it increases to reach a peak at the end of 4 th year and then declines over the
remaining 6 years. Based on different capacity options, it is found that a
capacity of 20,000 units for six-year period is optimum and offers highest net
present value. The firm now found that by increasing the credit period, it can
sell more units and thus can go for a capacity of 30,000 units and achieve same
NPV in four-year period. The second option may be suitable on account of
increased uncertainty on the product as the product moves into the latter part of the
life cycle and also getting economies of scale, which was not possible with lower
turnover in the first case. Shortening product life cycle has certain
advantages as well as disadvantages. The advantages are obvious. It increases
NPV and removes uncertainty. At the same time, it requires more R&D to
come out with a new and improved product and additional investment much
earlier than originally visualised. If competitors are able to come out with better
product version, the firm has to suffer higher loss because of higher capacity. The
firm has to develop various scenarios and study their impact on the overall
organisation goal.
Credit policy and its terms assume strategic importance if a firm is primarily
supplying its products or services to select firms. Suppose company R is one of
the ten customers of Company L. Company R is now going for massive
expansion and found it difficult to borrow to meet the normal credit terms of
24
Company R since the debt-capacity remaining is not adequate. If Company L has Management of
Inventory
reasonable borrowing capacity or internal generation, it can extend the terms of
credit. L&T had come out with a major issue some years back to provide
suppliers credit to Reliance Industries for their expansion projects. Such kind of
suppliers credit may also be feasible when the interest cost of a domestic firm is
much higher than the interest cost of supplier firm located in a different country.
A firm dealing with a large number of customers may find it difficult to manage the
receivables within the existing organisational set up. If a few other group
companies also face similar problems, it may start a separate subsidiary to
manage the receivables of all group companies. Many companies have started
their subsidiary to manage share transfer jobs of group companies. It is also
equally possible to centralise the credit rating service of the customers through
subsidiaries. Instead of starting their own subsidiaries, it is also possible to go in for
factoring services and credit rating agencies to outsource these services.
Many foreign banks outsource the services not directly related to their core
activities in order to keep the organisation lean. It is a way to convert many of the
fixed costs into variable costs. All these decisions have strategic implications and
thus, it is difficult to visualise the receivables management as a operational issues of
management in the modern business environment.
Activity 5.5
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5.7 SUMMARY
The use of credit in the purchase of goods and services is so common that it is
taken for granted. Selling goods or providing services on credit basis lead to
accounts receivables. Though a lot of discussion is going on in the Indian industry on
how to cut down the investments in inventories through concepts such as
Just-in-Time (JIT), MRP, etc., investments in receivables have gone up and firms are
demanding more credit from banks and specialised institutions to deal with
receivables. Since investment in receivables has a cost, managing receivables
assumes importance. Receivables management starts with designing appropriate
25
Management of credit policy. Credit policy involves fixing credit period, discount to be offered in
Current
the event of early payment, conditions to be fulfilled to grant credit and fixing credit
Assets
limit for different types of customers. It is essential for the operating
managers to strictly follow the credit policy in evaluating credit proposals and
granting credit. To evaluate the credit proposal, it is necessary to know the
credit worthiness of the customers. Credit worthiness is assessed by collecting
information about the customers and then fitting the values into credit evaluation
models. There are number of credit evaluation models which range from simple
decision tree analysis to sophisticated multivariate statistical models. The firm
has to develop a suitable model, test the model with historical data to validate the
model and use it for credit evaluation. Models also need to be periodically
updated. Once the credit is granted, then it should be monitored for collection.
Different methodologies are available to get a macro picture on collection
efficiency. Micro analysis in the form of individual customer analysis is done
wherever there is a deviation from the expectation. It is equally important in
dealing with delinquent customers. There are several options, simple reminders to
legal action, available before the credit managers in dealing with such default
accounts and appropriate method is to be selected with an objective of benefit
exceeding cost. The use of credit policy and credit analysis is not restricted to the
operational managers in dealing with day-to-day activities of the firm. In the
competitive world, credit policy and analysis provide a lot of strategic inputs.
Credit policy of an organisation is in line with the desired strategy that the
organisation wants to pursue to gain certain competitive advantages.
Credit Policy : Decision of the firm to grant or not to grant credit. It consists
of the components such as credit period, discount, credit eligibility and credit limit.
Credit Period : Refers to the minimum and maximum time limits for which
credit is granted.
Decision Tree : Is a model indicating decision points and chance events for
taking a decision.
Why do we need a credit policy? How do you evaluate credit policy? 3. How
4. Discuss a few important financial ratios and analysis used in managing receivables.
5. Assume a customer, who used to pay the dues in time earlier, has suddenly
defaulted. A couple of reminders sent to him fail to get any response. As a
credit manager, you have two issues to decide. You have to first decide
whether to continue the supply to the customer on credit basis. The second
issue is how to deal with the customer to recover the dues. In the normal
course, you have to initiate legal process to recover the dues but this may
strain your firm’s relationship with the customer. You can’t also be silent
since the money involved is quiet high and your firm is incurring interest cost on
this credit. How do you deal with this customer and decide the two
issues?
7. Regal Industries found that a very few debtors avail the discount, which is
“1.5/10 net 60”. The firm is presently borrowing at 15%. Since finance for
receivables is limited, it is turning down many credit proposals and thus loose
the opportunity to increase the sales. The firm now wants to revise the
discount policy and make it attractive to motivate some of the existing
customers to avail the discount. The funds released could be used for
accepting new customers. The additional details available to you are:
Contribution margin is 20%; Average collection period is 60 days; Sales could
be increased to any level. With these additional details evaluate the proposed
discount policy of “4/10 net 60”. Compute the impact of new policy on
profitability of the firm.
8. The proposed credit policy of R.K. mills would cut down the bad debts from
4% to 2%. It will also improve the collection period from 60 days to 30
days. The firms current sale of Rs. 80 lakhs will decline by 20% on account of
this new policy. If the contribution margin cost of borrowing are 15% and 14%
respectively, how the new credit policy affect the profit of the firm.
9. Your firm is following a credit rating model developed internally to assess the
credit worthiness of customers. The cut-off score is 4.8 points. Your analysis
of historical behaviour of customers with different points shows the
27
Management of Inventory
UNIT 6 MANAGEMENT OF CASH
Objectives
6.1 INTRODUCTION
Cash is basic input to start a business unit. Cash in initially invested in fixed
assets like plant and machinery, which enable the firm to produce products and
generate cash by selling them. Cash is also required and invested in working
capital. Investments in working capital are required because firms have to store
certain quantity of raw materials and finished goods and provide credit terms to
the customers. The cash invested in raw materials at the beginning of working
capital cycle goes through several stages (work-in-progress, finished goods and
sundry debtors) and gets released at the end of cycle to the fund fresh
investment needs of raw materials. The firm needs additional cash during its life
whenever it needs to buy more fixed assets, increase the level of operations and
any change in working capital cycle such as extending credit period to the
customers. In other words, the demand for cash is affected by several factors
and some of them are within the control of the managers and others are outside
the control of the managers. Cash management thus, in a broader sense is
managing the entire business.
Note: Figures in brackets indicate the number of companies of the industry used to
compile industry aggregates.
Thus, while structuring cash management policy, the firm has to consider the
internal business process and external environment. The important issues relating
to management of cash are:
• Understanding the motives behind holding the cash;
• Quantifying the cash needs of the firms to achieve the above motives; and
• Developing a cash management model to enable operating managers to take
decisions on investing surplus cash and selling investment to fund shortage.
Activity 6.1
1) How do you relate cash management in a broader sense? What is its focus in
the context of working capital management?
…………………………………………………………………………………….
2
…………………………………………………………………………………….
2) Why do we need to manage cash? Management of Inventory
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
3) Collect the cash and marketable securities data of your company or any one
company you are familiar with from published accounts for the last three or
five years. Examine the trend and its relationship with level of operation.
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
Transaction Motive: Money is required to settle customers’ bills, pay salary and
wages to workers, pay duties and taxes, etc. Some cash balance is to be
maintained to complete these transactions. The amount to be maintained for the
transaction motive depends on the cash inflows and outflows. Often, firms
prepare a cash budget by incorporating the estimates of inflows and outflows to
know whether the cash balance would be adequate to meet the transactions.
Speculative Motive: If the firm intends to exploit the opportunities that may
arise in the future suddenly, it has to keep some cash balance. The term
“speculative motive” to some extent is a misnomer since cash is not kept to
conduct any speculation but merely to exploit opportunity. This is particularly
relevant in commodity sector, where the prices of material fluctuate widely in
different periods and the firm's business success depends on its the ability to 3
source the material at the right time. Some of the materials, whose prices show
Assets
significant volatility, are cotton, aluminium, steel, chemicals, etc. Surplus cash is
also used for taking over of other firms. Firms that intend to take advantage on
the above counts keep large cash balances with them, though the same are not
required either for transactions or as a precaution.
Management of Current
Managing uneven supply and demand for cash: Firms generally
experience
some seasonality in sales, which leads to excess cash flows in certain period of
the year. This is not permanent surplus and cash is required at different points
of time. One possible solution to address this mismatch of cash flows is to pay
off bank loans whenever there is excess cash and negotiate fresh loan to meet
the subsequent demands. Since firms are exposed to some amount of
uncertainty in getting the loan proposal sanctioned in time, the surplus cash is
retained and invested in short-term securities.
In a competitive environment, firms also felt the desire of holding cash to get
flexibility in meeting competition. For instance, when a competitor suddenly
resort to massive advertisement and other product promotion, it forces other firms
to increase advertisement cost or some other sales promotion such as “free gift”
for every purchase or lottery scheme, etc. Amount held in the form of cash and
marketable securities of twenty manufacturing companies of BSE-30 Index
(Sensex) firms has increased from Rs. 20827.76 cr. in 1999 to Rs. 20094.91 in
2003 (Table 6.2).
Table 6.2 :Investments in Cash & Marketable Securities of Manufacturing
Companies in
Sensex
(Rupees in Crores)
Company 1999 200 2001 2002 2003
Oil & Natural Gas Corpn. 2393.83 0
3878.12 50326.59 25706.20 2488.52
Bajaj Auto 1150.11 2223.90 5525.18 4183.43 2331.03
Bharat Heavy Electricals 537.43 1807.72 9722.93 8276.70 2020.30
Hindustan Petroleum Corpn. 672.22 4770.76 15203.81 9784.78 1743.80
Hindalco Industries 928.75 1461.26 7660.84 2658.63 1475.62
Grasim Industries 446.21 1326.67 6247.97 2991.17 1217.34
Tata Power Co. 660.62 1491.27 8431.65 3457.94 1088.82
Larsen & Toubro 291.52 7675.29 15561.74 10016.02 1075.50
Hindustan Lever 1030.38 2378.12 6767.00 3873.85 917.38
HDFC 1623.57 3341.00 20213.30 2622.43 883.78
Wipro 37.12 191.03 2585.45 1673.09 848.84
Tata Motors 877.38 2191.60 9299.45 3068.67 750.64
Mahanagar Telephone Nigam 1356.42 265.08 16888.20 7994.18 698.41
Reliance Industries 6425.93 8055.17 36959.51 6825.49 648.33
Tata Iron & Steel Co. 735.70 1763.74 12889.90 3576.49 628.80
Reliance Energy 519.87 1479.14 4612.13 2114.79 465.55
Gujarat Ambuja Cements 272.15 383.50 2988.98 618.90 209.07
Cipla 94.55 407.18 1047.85 637.02 145.88
Zee Telefilms 18.10 3505.76 4570.49 796.41 145.42
Associated Cement Cos. 80.06 466.20 3476.45 901.24 114.13
ITC 445.73 1946.49 6376.15 2538.60 105.80
Ranbaxy Laboratories 50.41 647.86 2389.91 1327.16 44.70
Dr. Reddy’S Laboratories 44.01 211.10 1066.85 550.40 22.92
Hero Honda Motors 83.56 337.31 1163.95 674.47 13.58
Satyam Computer Services 38.28 56.48 1146.54 674.65 10.75
Bharti Tele-Ventures 13.85 324.96 1865.38 600.89 0.00
Total 20827.76 52586.71 254988.20 108143.60 20094.91
4
Activity 6.2 Management of Inventory
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
2) Why companies maintain huge cash and marketable securities despite they
being least productive assets? List down a few industries, where the demand for
cash for speculative motive would be more.
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
3) Analyse the data given in Table 6.2. Why do you feel that in some
companies the cash balance has gone up over the years whereas in a few
cases, it remains same or has gone down?
..………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
Internal Factors
Payment Polices: The ability to get credit terms for purchases of materials and
other products and services also affects the cash flow. If the firm maintains
creditworthiness, it could always find it easy to source material and other items
on credit basis. On the other hand, if materials and other items are to be bought
on cash basis or only limited credit period is available, the demand for cash
increases.
External Factors
External factors can be broadly classified into monetary and fiscal factors and
industry-related factors. These are discussed below.
Monetary and Fiscal Factors: The central bank (Reserve Bank of India)
periodically spells out monetary policies and through which influences the
availability of money. The monetary policy in turn is affected by the fiscal factors
of the country. In a liberal monetary policy regime, it will not be difficult to get
credit from banks as well as from suppliers of material and services. Thus, the
need for holding cash is thus limited to transaction motive. Cash required for
precautionary and speculative motives can be easily raised. Unit-2 on 'Operating
Environment of Workimg Capital' contains more discussion on monetary
policy
issues.
form of practices followed by other firms in the industry on terms of sale and
nature of material and services required. Cash flow will be positive in retail
industry. Cash flow will be cyclical for industries such as plantation and agro-
based products. Cash flow is volatile in certain industries like entertainment and
hospitality industry. Cash flow is generally negative for manufacturing industries.
Depending on the nature of cash flow relating to the industry, the demand for
holding cash is determined.
6
Activity 6.3 Management of Inventory
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
2) List down the factors that affect the cash flows of the firm.
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3) Name any three industries in which you expect a positive or negative cash flow.
…………………………………………………………………………………….
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…………………………………………………………………………………….
Types of Cash Forecast: The cash forecasts generated by the firms can be
broadly differentiated under two dimensions: the length of periods included within
the cash forecast and the approaches to cash flows used in the cash forecast.
Cash forecasts are normally prepared for one-year period but the forecast is
broken down to several smaller periods like, quarterly, monthly or weekly cash
forecasts. The choice of particular periodicity depends on the volume of cash 7
flows, nature of cash flows and the desirability of the management. Firms broadly
Assets
follow two approaches in the preparation of cash forecast. Under the direct
approach, firms forecast various receipts and payments items for different periods
and consolidate the forecasts into cash budget. Under indirect approach, firms start
with forecast of earnings and then add back all non-cash expenses and
deduct all non-cash
Management revenues, to get cash forecast. This is similar to preparation of
of Current
funds flow/cash flow statement, which is normally prepared using historical
accounting information as a part of financial statement analysis.
The format of monthly cash budget is illustrated in Table 6.3. It lists out major
cash inflow and outflow that arise in the normal operation of business. The
example also shows how the cash deficit and cash surplus are dealt with to
maintain the minimum balance.
Table 6.3 : Monthly Cash Budget
Cash Flow Item January February March Total for
the
Beginning cash balance 60000 66078 61320 Quarter
60000
Collection from sales/receivables 415488 373392 368280 1157160
Total 475488 439470 429600 1217160
Disbursements
Suppliers 68648 60960 56957 186565
Payment of Salaries & Wages 49202.4 42150 44670 136022.4
Other Overhead Expenses 30160 28290 29130 87580
S&A Expenses 51400 48850 50130 150380
Total 199410 180250 180887 560547
Excess / -Inadequacy 276078 259220 248713 656613
Minimum Balance 60000 60000 60000 60000
Cash Available / -Needed (A) 216078 199220 188713 596613
Financing
Borrowing/ -Repayments 0 0 0 0
Fresh Equity Issue 0 0 0 0
Sell/ -Acquire Investments -210000 30000 60000 -120000
Payment to Fixed Assets -230000 -230000
Receive/ -pay interest 2100 1800 3900
Dividend -250000 -250000
Total of Financing Plan (B) -210000 -197900 -188200 -596100
Closing Cash Balance (A - B) 66078 61320 60513 60513
Methods of Cash Flow Forecasting: The above Table gives the output as
a
result of forecasting exercise. However, each item in the above Table requires
several computations and assumptions. While a few cash flow items are
independent, several others are dependent on many other variables. Forecasting
method depends on the nature of cash flows. Some of the common methods of
forecasting are explained below:
2. Dependent Cash Flow Items: Many cash flow items are dependent
on
other financial variables. For instance, cash collection from sundry debtors
depends on sales of the previous months, credit terms and collection pattern.
An understanding of the relationship between the cash flow variables is
important in forecasting the cash flows. If only one variable is associated
with cash flow items, then estimation is not difficult. On the other hand, if
several variables are associated with a cash flow item, econometric models
are used to get the value. For instance, if customers take more than two
8
months credit period to pay the amount, it is possible to construct a multiple ry
regression model to measure the proportion of amount collected from various
months’ sales. The model uses cash collection of the month as dependent
variable and previous months sales values as independent variables.
3. Growth in Cash Flow Items: As business grows, the cash flow items
also
see a positive growth. Suppose the total sales grow at five percent every
quarter and credit (60 days) sales is eighty percent of the sales. If forty
percent of the customers pay at the end of two months in time, another 40
percent pays at the end of three months and the balance 20 percent pays at
the end of fourth month the amount collected from the customers is also
expected to show an uptrend due to growth in sales.
The most usual approach to cash forecasting is the Receipts and Payments methods as
accepted in Table-6.3. After the firm has determined what types of receipts and
payments are important in its overall cash flow, an important question is how to
forecast the future level of inflows and outflows. There are four common techniques
of forecasting these items of receipt and payment.
Since cash forecasts deal mostly with the near future, many of the items on the cash
forecast are usually estimated by some variation of the spot method. The bases of
these spot estimates are usually the firm’s other financial plans. Remaining estimates
are mostly on a proportion of another account’ basis, the another account often being
a particular period’s sales. The other two methods are employed less frequently.
Ct = 0.754 St - 1 + 0.241St - 2
(0.250) (0.087)
The figures in parentheses below the estimated collection rates are the standard
errors of these collection rates. In this equation, Ct is the collection from receivable in
period t, St - 1 is the sales in period t -1 (say, previous month), and S t - 2 is the sales in
period t-2 (say, two months previously). Assume also that these were the only
statistically significant explanatory variables (the variables like S t - 3, St - 4, etc. and
dummy variables to assess seasonality, were not significant), and that the overall
estimated equation was highly significant. We may now interpret the regression
results in the following way. The estimated collection rates are 75.4 per cent
(regression coefficient on St - 1) of the previous month’s sales and 24.1 per cent
(regression coefficient on St - 2) of the sales from two months previously. The implied
bad debt rate is 0.5 per cent, equal to one minus the sum of the collection rates. The
standard error figures are used to test the statistical significance of the estimated
regression coefficients.
Simulation Approach
Upper/Lower Estimates
With the information of this type in hand, finance manager can now address the
formulation of appropriate investement and financing strategies. Let us now proceed
with some examples to illustrate the point.
Consider our hypothetical simulation results and assume that the costs of having
insufficient cash and the costs of hedges (i.e. financial arrangement to fall back upon
in case of shortage of cash) are such that the firm desires to incur, at maximum, a 5
per cent chance of having insufficient cash to cover expenses. What is the maximum
amount for which the firm should secure a line of credit? The maximum expected
deficit is in the month of June, with a mean of Rs. 12,21,000 and a standard deviation
of Rs. 3,53,000. The Z statistic for 95 per cent confidence interval is 1.645; and 1.645
times of Rs. 3,53,000 is Rs.5,80,685. The maximum amount that the firm should
arrange to borrow is Rs. 12,21,000 plus. Rs. 5,80,685 or Rs. 18,01,685. There is a 5
per cent chance that the actual borrowing needs in June will be greater than this and
a 95 per cent chance that the requirements will be less than this.
Let us now consider that the firm is contemplating how much of the estimated surplus
in September to invest in a 60-day investment. How much can the firm invest and
have only 10 per cent chance of having to resell the investment in September? Z
statistic for 90 per cent confidence interval is 1.28; times of Rs. 4,21,000 is
Rs.5,38,880; Rs. 5,91,000 less Rs. 5,38,880 is Rs.52,120. There is 10 per cent chance
that cash surplus in September will be less than Rs. 52,120. So, the firm can invest the
amount in the 60-days investment and have a 10 per cent chance that they will have to
liquidate the investment prior to maturity.
The above exmaples are intended to illustrate the mechanics of manipulating means,
standard deviations, and probabilites of cash balances rather than to present realistic
hedging strategies. In practice, the array of possible hedging strategies is quite a bit
more complicated. One is required to consider various alternatives and the assoicated
costs and risk in hedging strategies.
Activity 6.4
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11
2) Collect cash flow statement given in the annual report of a large listed
Asset
s company for the last five years. Comment on the trend in the component.
…………………………………………………………………………………….
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Management of Current
………………………………………………………………………….………….
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Scenario Analysis: Here cash flows are forecasted under different assumptions
and cash requirement under different scenarios is worked out. Depending on the
level of risk taking capability, firm selects a scenario and uses it for cash
management
the user defines possible scenarios and the computer generates the cash forecast.
In simulation, the computer is allowed to generate various scenarios based on
random numbers. Since a large number of scenarios are generated, it is possible
12
to define the distribution of cash flow forecast and uncertainty associated with tory
the forecast.This is discussed in more detail in the previous section.
Extra Borrowing Capacity: If the uncertainty analysis model helps to figure out
the period in which the firm is likely to face serious problem of cash
management, then it is worth to negotiate with bankers or other financing
agencies well in advance for additional temporary credit. It is possible to have a
standby arrangement with the bank or financial intermediaries.
Activity 6.5
1) Why the actual cash flows show significant variation from the forecast?
…………………………………………………………………………………….
…………………………………………………………………………………….
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2) How do you recognise and measure the uncertainty associated with cash flows?
…………………………………………………………………………………….
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Use of Lockboxes: The lockbox is a post office box number to which some
or all the customers would be requested to mail their cheques. The lockbox will
be opened in several cities and the local branches of the bank are authorised to
open the box and clear the cheques. The amount collected under lockbox is
transferred to the notified account. This concept is popular in the US and other
developed countries but not prevalent in India.
…………………………………………………………………………………….
…………………………………………………………………………………….
2) What are different options available before the firm in improving collection
efficiency of cash-in-transit?
…………………………………………………………………………………….
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…………………………………………………………………………………….
3) Draw an activity chart that speeds up the process of depositing the cheque in
the bank account from the time of receipt?
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The daily cash report is the best vehicle for obtaining a running comparison
between the forecast and actual cash flows. Daily cash reporting is useful even
if cash budget and forecast are not available on daily basis. It helps the
managers to understand the flow of cash on daily basis and a comparison of
cumulative figures with the budget indicates the target still to be achieved to keep
the budget in force. In addition, the reporting on daily basis to top management
forces the operating people to work efficiently. This is very useful since
accounting profit cannot be computed on daily basis and available only at the end
of quarter.
Meaningful analysis can be done by consolidating cash flows on daily basis into
two documents namely Cash Flow Budget-Actual Variance Analysis and
Cumulative Cash Flow Statement for the year to date. The formats for the two
reporting documents are given below.
Table 6.5 : Cash Flow Budget-Actual Variance Analysis from …….. to
……….
Total
Disbursements
Suppliers
S&A Expenses
Total
Excess / -Inadequacy
Minimum Balance
Financing
Borrowing/ -Repayments
Dividend
6.9 SUMMARY
Availability of cash is crucial for the operation of business. However, cash is the
least productive asset of the firm and thus managers take every effort to
minimise the cash holding. Despite the least productive nature of the asset, firms
hold large cash. There are several motives behind holding cash. Cash is required
to settle dues of the firm. Since cash inflows are uncertain and outflows are
certain, firms keep additional cash. Cash kept for these two purposes are called
transaction motive and precautionary motive. Cash is also kept to overcome the
mismatch of inflows and outflows, cyclical behaviour of cash flow pattern and
exploit short-term opportunities, like rising prices and aquisition of control.
Cash flows are affected by internal factors such as operating and financial
policies and external factors such as monetary and fiscal policies and practices of
industry. An understanding on factors that affect the cash flows is useful to
forecast future cash flows, which is core aspect of cash management. There are
several methods of forecasting cash flows and often different methods are
employed to forecast individual cash flow items. Cash forecasting is converted
18
into cash budgets and cash budget is broken into quarterly, monthly and weekly ory
cash budgets. Budgets are prepared to understand whether cash inflows and
outflows match with each other and if not, to know the period in which the
mismatch arises. Managers plan to deal with such mismatches by initiating action
in advance.
Despite careful planning, actual cash flows often deviate from the budgets due to
inherent uncertainty associated with cash flow variables. There are several tools
such as sensitivity analysis, simulation, etc., available to evaluate the impact of
uncertainty on cash flows. The uncertainty associated with the cash flows is
managed by holding additional cash, negotiating stand-by borrowing facility and
interest rate derivatives. Management of cash includes dealing with surplus cash
and cash-in-transit. While surplus cash is to be invested in short-term securities
after conducting cost-benefit analysis, cash-in-transit are managed by taking
efforts to reduce the float and float amount.
While planning and decision-making are essential for any management system, the
system completes only when appropriate control mechanism is built into the
system. Management information system assumes importance in this context in
cash management system. Periodical reporting on cash flows and variance
analysis of such flows is essential to effectively manage the cash flows. The
objective of the entire exercise is to ensure availability of cash to conduct smooth
business and at the same time to minimise the investments in this least productive
asset.
Cash Forecast: An estimate of cash inflows and outflows for a specified period.
Float: Refers to cash in transit, which can be utilised by the paying form till it is
actually withdrawn
19
Management of Current
6.11 SELF-ASSESSMENT QUESTIONS
1.
Explain the objective of cash management system. How do you deal with the
conflicting nature of the objectives?
2.
Assets
What are the principal motives of holding cash in a business despite its
unproductive nature?
3.
Discuss internal and external determinants that affect the flow of cash.
4.
Why is it important to forecast the cash flows in managing the cash?
5.
How do you measure the uncertainty associated with cash flows? Discuss the
products available to manage the uncertainty of cash flows?
6.
What is flotation? How do you cut down the flotation time?
7.
Discuss the importance of cash flow reporting in the management of cash?
8.
Digital Electronics Ltd. is preparing cash budget for the next quarter in order to
negotiate with the bankers for additional credit. The sales department
informs that March sales was Rs. 220 lakhs and the expected sales for the
next four months are Rs. 120 lakhs, Rs. 160 lakhs, Rs. 220 lakhs and Rs.
160 lakhs respectively. The company sells 30% of sales through cash and
the balance on credit basis with one month as credit period. The bad debts
level is negligible. Cash outflows consist of payment to creditors, salary and
wages, other operating expenses, purchase of fixed assets and taxes. The
material and labour costs constitute 30% and 45% respectively of the sales.
While raw materials are purchased in one-month credit, wages are paid in
the same month. Other operating expenses cost Rs.50 lakhs and are paid in
the same month. Other non-operating cash flow items are Rs. 150 lakhs in
May (fixed assets), Rs. 120 lakhs in June (fixed assets), Rs. 160 lakhs in
June (corporate tax) Rs. 140 lakhs in April (interest and instalment of loan)
and Rs. 100 lakhs in May (dividend). The cash at the beginning of the
quarter was Rs. 150 lakhs and the company’s cash policy is to hold 5% of total
cash expenses of the next month as minimum closing balance of the current
month. Prepare a monthly cash flow statement for the quarter and highlight
the surplus/deficit for each month.
9.
Kidcat is a leading manufacturer of toys and sports items for kids. The
industry is facing severe competition from unorganised sector, which imitate
the Kidcat products immediately. The sales of the firm during the last two
years show significant volatility. The firm decides to use simulation this time
while preparing cash budget. The firm has sold Rs. 100 lakhs worth of toys
during the month of March and expects the following possible ranges of sales
between April to June of the next year.
The customers generally pay within a month of sales. The material cost
associated with the product works out to 40%, which are paid after a month and
fixed cost including labour cost of the firm per month is Rs. 30 lakhs. Fixed
costs are paid in the same month. Conduct a simulation exercise of 100 trails
using random numbers and find the cash balance at the end of each month and
their distribution. (Hint: Use of Spreadsheet is recommended to conduct
20
simulation exercise).
10. The internal analysis of cash flows of a large textile manufacturing company y
shows a wide variation in cash balances during the next year. The minimum
cash balance expected during the second quarter of the year was -Rs. 340
lakhs (negative balance indicating shortage of cash) and the maximum value
of Rs. 120 lakhs during the month of February. The above figures are
estimates and likely to see significant volatility. The firm presently enjoys over
draft limit of Rs. 300 lakhs and contemplating to increase the limit to Rs. 400
lakhs to meet the additional cash need and also uncertainty associated with
cash flows. The bank is willing to provide the additional loan at 14% interest
rate but insists the firm to accept a commitment charge of 0.25% per month
on the additional borrowing limit. The commitment charge has to be paid on
unused part of the overdraft facility. For instance, if a firm draws Rs. 340
lakhs in August, it has to pay interest at the rate of 14% on Rs. 340 lakhs
and 0.25% on Rs. 60 lakhs. If the firm decides not to accept the offer, it
will be exposed to cash out position and emergency borrowing would cost
2% interest per month. The firm expects a maximum emergency borrowing
of Rs. 200 lakhs at different points of time during the year. Advice the firm
on accepting the additional loan with a commitment charge of 0.25%.
Delhi
Delhi
21
Management of
UNIT 7 MANAGEMENT OF MARKETABLE Inventory
SECURITIES
Objectives
Structure
7.1 Introduction
7.2 Need for Investments in Securities
7.3 Types of Marketable Securities
7.4 Market for Short-term Securities
7.5 Optimisation Models
7.6 Strategies for Managing Securities
7.7 Summary
7.8 Key Words
7.9 Self Assessment Questions
7.10 Further Reading
7.1 INTRODUCTION
Cash and marketable securities are normally treated as one item in any analysis
of current assets. For this reason, in Table 6.1 of Unit 6 (Management of
Cash), cash and marketable securities were combined together. Holding cash in
excess of immediate requirement means the firm is missing out an opportunity
income. Excess cash thus is normally invested in marketable securities, which
serves two purposes namely, provide liquidity and also earn a return. Marketable
securities form a major component of cash and marketable securities. In
Table 7.1, the investment in marketable securities of different industries along
with its composition as a percentage of cash and marketable securities is given.
The table shows that the marketable securities constitute around 50% of the total,
and ranges from 25% to 81% in certain industries. Because of this importance,
the management of marketable securities is discussed separately in this unit.
In the international financial markets, companies such as Procter & Gamble (US),
Gibson Greetings (US), Showa Shell (Japan), Mettalgesellschaft (Germany), Allied
Lyons (UK), Orange Country (US), British Councils (UK), etc., have lost millions
of dollars heavily by entering into financial transactions of wrong types. In the
domestic markets too, several firms have incurred huge loss during the last few
years and many of them have taken a public stand in the companies annual
general body meeting that they will not excessively deal in the securities market.
In 1992 securities scam, many companies, particularly public sector companies
had incurred huge loss in their dealings in government securities. Nevertheless,
many companies are willing to deal in marketable securities at different levels.
While some of them have an active treasury management and willing to take
risk, others have restricted themselves in investing their short-term surplus money
for a limited period.
Table 7.1: Investments in Marketable Securities
Industry 1999 2000 2001 2003 200
3
Food & Beverages 1008.18 1031.91 1243.27 1328.16 1436.88
(% of cash & market securities) 43.7% 42.6% 52.4% 51.4% 47.7%
Textile 1383.2 784.79 1417.11 1171.42 1430.52
(% of cash & market securities) 56.2% 41.6% 56.9% 46.7% 54.5%
Chemicals 4879.7 5499.95 6166.91 9143.7 10968.15
(% of cash & market securities) 39.7% 41.2% 45.3% 52.2% 59.8%
Non-metallic Minerals 424.55 380.4 526.92 577 611.39
(% of cash & market securities) 32.9% 33.5% 38.5% 42.8% 42.2%
Metals & Products 2104.04 1931.48 3126.04 2965.45 3249.91
(% of cash & market securities) 40.9% 37.2% 49.1% 49.0% 44.4%
Machinery 3098.35 1961.95 2321.46 4496.66 5075.51
(% of cash & market securities) 34.7% 19.6% 19.8% 29.3% 27.9%
Transport Equipment 2725.89 2988.6 2530.94 2943.1 3719.29
(% of cash & market securities) 45.4% 55.1% 44.1% 50.1% 46.9%
Diversified 3415.51 6602.6 5764.81 3776.73 4591.72
(% of cash & market securities) 34.7% 71.4% 80.0% 50.6% 67.0%
Miscellaneous 168.78 358.43 215.75 254.71 606.53
(% of cash & market securities) 23.4% 34.5% 22.7% 26.7% 37.5%
Total 19208.2 21540.11 23313.21 26656.93 31689.9
(% of cash & market securities) 39.2% 43.4% 45.0% 44.7% 47.1%
There are several reasons for such difference in the investments in marketable
securities between the firms and between the years. For instance, companies
like Lakshmi Machine Works Ltd. (LMW) and NEPC Micon, leading
manufacturers of textile machinery and windmill power equipments, used to have
an order booking for one to three years. Companies, which place the order with
LMW and NEPC pay advances along with the order. Most companies in the
auto-cars segment like Maruti Udyog Ltd (MUL) and Telco that entered the
small car segment collects advances when they launch new models. However
they cannot use these short-term surplus cash flows for any long-term purposes.
Surplus cash is thus invested in marketable securities primarily
to earn an
income, which otherwise remains idle within the firm. Companies
may not
always have an opportunity to demand advances from the customers. For
instance, the recession in textile industry and general economic recession has
affected the order flow of LMW and NEPC. Intensive competition between the
car manufacturers forces many of them to sell the cars without demanding any
initial amount from the customers. Thus, companies, which were flushed with
money at one point of time and investing heavily in marketable securities, may
issue short-term securities to others and borrow money at another point of time.
Many companies, which adopted the profit centre concepts, have made the
finance department as one of the profit centres. It means the finance
department has to add revenue to the firm. Top management wants financial
department to show how they helped the company to improve the bottomline.
By dealing with marketable securities in the form of securities and foreign
exchange derivatives, financial managers’ ought to demonstrate their ability to cut
down the cost or increase the benefit. Investments in marketable
securities
also depend on the aggressiveness of the financial managers’ in
dealing
with such assets.
The task of financial managers, who become involved with marketable securities
either full-time or part-time, consists of three issues. First, managers must
understand the detailed characteristics of different short-term investment
opportunities. Second, managers must understand the markets in which those
investment opportunities are bought and sold. Third, managers must develop a
strategy for deciding when to buy and sell marketable securities, which securities
to hold, and how much to buy or sell in each transaction. We will discuss these
issues in the next few sections.
Activity 7.1
1) What are the major criteria managers use for deciding where to invest “excess”
cash balances?
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56
3) Give an account of the activity of marketable securities of a company you are Management of
Inventory
aware of.
……………………………………………………………………………….
………………………………………………………………………………
………………………………………………………………………………..
A) Debt Securities
All debt securities represent a promise to pay a specific amount of money (the
principal amount) to the holder of the security on a specific date (the maturity
date). In exchange for investing in security, the investor or holder of the security,
receives interest. This interest may be paid upon maturity of the security (as with
most short term debt instruments) or in periodic instalments (as with most long
term debt instruments). Different types of debt securities are discussed below.
The market for debt securities of relatively short maturity (generally one year or
less) is called money market. The money market gives a considerable amount of
liquidity to all participants in financial market. Companies and government entities
that find themselves temporarily short of cash can raise funds quickly by issuing
money market instruments. Investors who have cash to invest for short periods
of time can invest in money market instruments that will provide them with a
return while not committing their funds for long periods.
i) Call money
The demand and time liabilities (DTL) of a bank are evaluated every
fortnight on a Friday called the ‘Reporting Friday’. During the first fortnight
following the Reporting Friday, the bank is expected to maintain daily 15 % of
its DTLs (as on the Reporting Friday) in cash with RBI. This is known as cash
reserve ratio CRR. The banks are expected to maintain this
balance in such a way that the average daily balances is within the
stipulated requirement. The market that arises as a result of borrowing and
lending by banks in order to maintain their CRR is known as the call
market. Theoretically call money is money that is literally on call, i.e., it can be
called back at short notice. In the case of inter bank market, the notice period
can be as short as one day.
Commercial paper (CP) is the term, for the short-term promissory notes
issued by large corporations with high credit ratings. Commercial paper
usually carries no stated interest rate and sells at a discount from its face
value as T-bills. The objective of the RBI introducing CP as an instrument to
finance working capital needs was to reduce the dependence of
corporates on banks. Also, by pricing the CP at market rates, the financial
efficiency of corporates was coveted to increase. Also, this instrument
securitises the working capital limits. The companies can now issue CP for a
maturity period ranging from 3 months to less than a year. Minimum
networth of issuer is also reduced from Rs. 5 crores to Rs.4 crores and the
minimum working capital (fund-based) limit is also being reduced from Rs. 5
crores to Rs. 4 crores.
Bankers’ Acceptances are time drafts drawn on a commercial bank for which
the bank guarantees payment of the face value upon maturity. They are
commonly used to finance international transactions for the short term. For
e.g., a jewellery retailer in India might purchase watches from a
manufacturer in Switzerland, paying for the goods by sending a time draft (a
draft payable at some future date) drawn upon the jeweller’s bank.
When the bank accepts the draft, it stamps “accepted” on the reverse side of
the draft, meaning that the bank guarantees payment of the draft upon
maturity. In effect, the bank is guaranteeing the credit of the jeweller. Since the
credit behind the draft is now on the bank, the draft can be traded in the
money market along with other short-term debt instruments. Although
bankers’ acceptances are available to individual investors, they are typically
most popular with commercial banks and foreign investors.
Treasury bills have of late started attracting good response, especially since the
introduction of 364 days T Bill in April 1992. Presently, there are 2 maturities -
91 days and 364 days. A third category of T-Bills that was for 182 days has
been withdrawn since April 1993. Government securities are one of the lowest
yielding securities that one can invest in. Most investments in these securities are
made due to regulatory reasons. During the second fortnight following the
Reporting Friday, the banks have to maintain 34.5 % of DTL up to 17/09/93 and
25 % on incremental DTL since that date, in Government securities. This is
known as Statutory Liquidity Ratio (SLR).
The long-term bond issues of the treasury that are available to investors are
the Treasury notes and the Treasury bonds. Treasury notes have
original fixed maturities of not less than one and not more than ten years
from the date of issue. They are available in denominations as small as $
1000, except that the T.notes of less than four years are usually not issued
for less than $ 5000. Treasury bonds are like notes in every respect in that
their original maturities are from more than ten years to come as long as
thirty years.
Municipal bond, in spite of the word municipal, includes all bond issues of
states, countries, cities, and other political subdivisions of the United States.
An important distinguishing feature of municipal bonds is that all interest
payments are exempt from U.S. income taxes. They are also exempt from
any state or city income taxes within the issuing municipality. Though
couple of corporations in the states of Gujarat and Maharashtra, have
issued bonds of this kind, this market is less active in India.
c) Corporate Bonds
Debt securities of corporations with maturity of longer than one year are
corporate bonds. The usual par value of a corporate bond is Rs. 100 and
sometimes Rs. 10,000, and maturities range from about two to as many as
thirty years. In recent years, however, corporate bond issues have been of
shorter maturities as inflation and economic uncertainties have caused
investors to be less willing to commit their funds for longer periods of time.
B) Equity Investments
Equity securities represent the residual ownership of the firm. Residual ownership
means that the debt holders must first be paid off, before the company belongs
completely to the equity holders. The two types of equity securities are common
stock and preferred stock.
a) Common Stock
The common stockholders are the risk takers; they own a portion of the firm
that is not guaranteed, and they are last in line with claims on the company’s
assets in the event of a bankruptcy. In return for taking this risk, they share in
the growth of the firm because the growth in the value of the company
accrues to the common shareholders. The company may make a periodic cash
payment called a cash dividend to the common stockholders. Cash dividends
are commonly paid to shareholders on a quarterly basis, but they may be paid
annually, irregularly, or even not at all. The common shareholder has no
guarantee of receiving a dividend payment. Common stockholders usually have
voting rights that allow them to vote on the corporation’s board of directors.
Since the board of directors hires the top management of the company, the
stockholders indirectly determine the company’s management.
b) Preferred Stock
Contingent claim securities are securities that give the holder a claim upon
another asset, contingent upon the holder’s meeting certain contract conditions.
Although there are many types of contingent claim securities, the three most
popular kinds of investments today are options, warrants, and convertible
securities.
60
(a) Options Management of
Inventory
An option is a contract giving its holder the right to buy or sell an asset or
security at a fixed price. All options are valid only for a specified time
period, after which they expire. A call option gives its holder the right to buy
the underlying asset and thereby guarantees the purchase price of the asset
for the duration of the option. A put option carries the right to sell and
guarantees the selling price of the underlying security.
(b) Warrants
Warrants are like call options that are issued by the corporation. They give
their holders the right to purchase the common stock from the corporation at a
fixed price. Warrants usually have longer life than options (typically five to
seven years), although a few perpetual warrants do exist.
Corporations usually issue warrants in conjunction with another issue of
securities and offer a “package deal.” For example, the purchase of one
share of preferred stock might entitle the investor to receive one warrant to
purchase common stock of the company. Companies offer such
packages to sweeten the deal and make the other security easier to sell.
There is still one more security in the list, called units of mutual funds, which is
not a separate security on its own but backed by an investment in the above
securities. Indian companies traditionally prefer mutual funds units, particularly
Unit-64 of Unit Trust of India, to invest their surplus money for short period
because of reasonable return, high liquidity and tax concession (tax provisions
governing mutual funds investments have seen significant changes during the last
few years). Since many private sector mutual funds have also started offering a
reasonable return in their debt-oriented schemes, corporate attention is slowly
moving towards the units of private sector funds. Another instrument similar to
mutual funds units that is likely to emerge in the future is the unit arising out of
securitisation process. These are units backed by mortgages of housing loan or any
other receivables. A few securitisation deals have already taken place in the Indian
market but they were restricted to financial institutions. This market is the second
largest segment of the market, immediately next to government securities market, and
is also very active. 61
Management of Current Activity 7.2
Assets
1) List out the different kinds of instruments in the money market.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
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………………………………………………………………………………….
………………………………………………………………………………….
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Money market is a place where borrower meets the lender to trade in money
and other liquid assets that are close substitutes for money. A developed money
market will have large number of instruments, both in terms of variety and
volume, presence of large number of traders and existence of requisite
infrastructure to facilitate efficient settlement of transactions. Till 1991, money
market in India was in a dormant state. It was operating in a closely regulated
environment, where interest rates are fixed and regulated. The operations were
also restricted in a few securities involving commercial banks. The conditions of
the money market improved after the Reserve Bank of India initiated many
changes on the basis of the recommendation of the Vaghul Committee, which
recommended deregulation of interest rates, introduction of new instruments and
increase in the number of participants. As a result, India now has fairly
developed money market with a number of instruments and active trading. The
establishment of institutions like, Discount and Finance House of India Ltd.
62 (DFHL), SBI Guilt, etc., and arrival of several whole sale dealers has provided
liquidity to the market. Mutual funds have also started actively investing in short- Management of
Inventory
term securities along with banks and other institutional investors.
Before investing in money market securities, it is better to look into yield curve of
securities traded in the market. A yield curve is the one, which shows the return
available for securities having different maturities. This curve is useful to managers
to trade-off between return and interest rate risk. Further, the yield curve will
show the expectation of the market on the future interest rate
scenario, which is a vital input for any treasury managers. Interest rate is the one
which affects almost every aspect of the economy like business
performance, stock market, money market, foreign exchange market and derivatives
market. The yield-curve of securities as appeared on September 24, 1999 is given
in Exhibit-7.2
Market for long-term securities is a place where the borrowers raise capital for
longer term. Due to active secondary market for many of the long-term
securities, there is no need that only investors having long-term surplus alone
enter into the market. For instance, a significant percentage of volume of trading
(more than 75%) in stocks, which are long-term instruments, are settled within a
trading cycle of five days. Now ‘T + 2’ trading is going on in the market. Long-
term securities - debt, equity and other types of securities - are actively traded in
the stock exchanges like National Stock Exchange, Mumbai Stock Exchange.
These exchanges deal in corporate securities, government securities PSU
securities and units of mutual funds,. Stock exchanges are more organised than
the money market, which primarily operates over phones. Now trading is mostly
on-line.
The objective of investing in marketable securities need not always be for short-
term purpose. If the surplus money is available for fairly longer period,
investment in long-term securities can be considered because the return will be
more. Due to active secondary market, there is no liquidity risk in the event of
sudden need of funds. Of course, investment in equity oriented securities has
some amount of investment risk. Investing in portfolio of stocks or investing
through mutual funds can reduce a part of investment risk.
Activity 7.3
1) What are the reasons for the corporate sector in accessing the capital
markets? List down the various instruments used in capital markets?
………………………………………………………………………………….
………………………………………………………………………………….
…………………………………………………………………………………. 2)
………………………………………………………………………………….
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………………………………………………………………………………….
3) What is the role played by the Discount and Finance House of India
(DFHI)?
………………………………………………………………………………….
………………………………………………………………………………….
…………………………………………………………………………………. 4)
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
The model basically optimise the flotation cost with the difference between
interest outflow and interest income on marketable securities. This model helps
the financial managers to decide on how much to be raised from the market
given the requirement of funds and how much to be invested in marketable
securities. On the other hand, the remaining four models guide the finance
managers on how to switch funds from marketable securities to cash and vice
versa.
Baumol Model: This model assumes that the demand for cash is continuous and
frequent withdrawal of cash from investment will cost more. Thus, the model
gives an approach to find the optimal withdrawal of cash from investments. An
example will be useful to understand the concept. Colleges or Universities like
IGNOU collect fee from the students at the beginning of the year or term.
Assume the receipt for the year is Rs. 12 lakhs. There is no major cash inflow
during the year or term. However, the institution requires cash continuously to meet
various operational expenses during the year or term. Assume the total
demand for the cash during the year is Rs. 10 lakhs. Suppose the initial receipt of
Rs. 12,00,000 is invested in marketable securities. The issue before us is how much
worth of marketable securities is to be sold and cash be realised. If there is no
transaction cost of selling securities, the amount could be as low as
possible. If the cost of each transaction is Rs. 575, how much money is to be
withdrawn every time. The cost affects our decision because if we withdraw
too many times, it will cost more. At the same time if we withdraw a large
amount, then the cash is idle and we lose an opportunity to earn a return.
Baumol resolves the problem using the following equation, which gives an optimal
withdrawal quantity.
C = √ (2 b D)/Y
The institution has to sell securities worth of Rs. 1,00,000 every time to optimise the
transaction cost and interest income on marketable securities. That means, the sale
will be effected at the end of every fifth week.
Miller and Orr Model: The earlier two models assume that one of the two
cash flow variables namely cash inflow or cash outflow is constant and thus
come out with a solution on optimal withdrawal value or investment value. In a
situation where both inflow and outflow are not constant, Miller and Orr model is
useful. The model is based on control-limit approach. According to the approach, the
optimum level is first derived based on certain assumptions and this optimum level
needs to disturbed only when the assumptions are violated. Miller and Orr model
using the interest rate on marketable securities, transaction cost and
minimum desired level of cash, derive the optimal cash holding for the firm with
the use of following equation
2 1/3 + L
Z = [(4 b σ )/(4 Y)] ^
Using the minimum desirable cash limit called Lower Limit (L), Miller and Orr model
gives the Upper Limit of cash holding (H), which is equal to
H = 3Z-2L
As long as cash is within upper limit (H) and lower limit (L), no action is
required. The moment the cash balance breached one of these two limits, an
action is required. If the cash balance touched the upper limit (H), then all the
excess cash above the optimal holding (Z) is invested in marketable securities.
Similarly, if the cash balance touched the lower limit (L), the firm sells
marketable securities to an extent that brings the cash balance back to optimal
cash holding (Z). The following example shows how the three values given in the
Miller and Orr model are derived.
67
Management of Current The Treasurer of Blue Diamond Hotel wants to develop a cash management
Assets model for investing surplus cash in marketable securities. Since the cash flows
show a volatile behaviour, the Treasurer feels the Miller and Orr model is the
most suitable for the situation. An analysis of last three-year daily cash flows
shows a standard deviation of Rs. 12,200. Investment in marketable securities
currently offers a return of 12% per annum. The transaction cost per transaction
is Rs.300. The Treasurer believes the hotel should have minimum cash balance
of Rs. 20,000. What is the optimal cash holding? When an investment or
disinvestment action is to be taken?
Substituting the above values in the Miller and Orr model, we get the following:
L = 20000
Thus, the cash management policy is when the cash balance goes below Rs.
20,000, marketable securities are sold and cash balance is brought back to
Rs.46702. If the cash balance exceeds Rs. 100107, the cash value above Rs.
46702 is invested in marketable securities. The cash balance is allowed to move
between Rs. 20000 and Rs.100107 and occasionally brought down to the optimum
level.
Stone Model: Bernell Stone suggested that instead of mechanically taking action
on the basis of Miller and Orr model whenever the cash balance is breached the
upper or lower limit, the treasurer can forecast the behaviour of future cash
flows of two or more days and use this information in taking investment decision.
Under this model, the firm sets out two inner limits. For instance in the above
example, if the firm sets an inner limit for minimum balance at Rs. 30,000 and
another inner limit for maximum balance at Rs. 90,000, the treasurer evaluates
the cash flows for the next two days whenever the cash balance hits the
previously defined Miller and Orr model. Assume the cash balance touched Rs.
20000. The firm evaluates whether the next two days inflows will bring back the
cash position at Rs. 30000 or more. If the forecast fails to show such an
improvement, the securities are sold and cash balance is brought towards the
optimum level. On the other hand, if the cash balance is likely to move above
Rs. 30000, no action is required at this stage. Investment in marketable
securities will also be taken on the same line. The two inner limits are provided
mainly to avoid unwanted transaction.
The behaviour of cash flows in the four different models is given in Exhibit-7.3.
Activity 7.4
1. Describe the Baumol and Miller-Orr cash management models and explain how
they differ from each other.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
68
2. What does the term liquidity mean? Management of
Inventory
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
The second step in the process of designing the strategy is the extent to which
the firm should take risk while investing in securities. In other words, in stage
one, we have identified the amount available for investments but we haven’t
specified the nature of investments. A set of guidelines needs to be developed
that will direct the operational managers while taking investment decisions. For
instance, many banks have a clearly defined investment policy that lists the kind of
securities where the surplus cash can be invested. It is advisable to prescribe the
proportion of investments in different securities like government securities
60%, corporate securities 20%, etc. The firm should have a clear mechanism to get
the risk of the portfolio and this information should be made available to chief of
treasury operations. If the level of operation is very high, it is worth to
implement the concepts like Value-at-Risk (VAR) to avoid major losses on such
transactions.
The last step is to develop systems in continuous monitoring of this activity and
improving the reporting system. Many companies during the securities scam
period have suffered because of lack of monitoring and faulty system.
Activity 7.5
1. What are the options available to a firm for investing surplus cash?
…………………………………………………………………………………..
…………………………………………………………………………………..
…………………………………………………………………………………..
69
Management of 2. Explain the strategies available to a firm for investing surplus cash?
Current
Assets
…………………………………………………………………………………..
…………………………………………………………………………………..
…………………………………………………………………………………..
3. Imagine yourself as the financial manager of a leading firm. What are the
basic criteria you would follow in making optimum investment decisions on a
portfolio of securities with the surplus cash available with the firm.
…………………………………………………………………………………..
…………………………………………………………………………………..
…………………………………………………………………………………..
7.7 SUMMARY
Firms invest surplus cash in marketable securities because it enables firms to
earn a return or at least recover a part of the cost of funds. Since the risk,
return and liquidity of marketable securities are different, an understanding of
them is essential before the selection of securities. An understanding of the
markets in which such securities are traded is also useful. Since firms incur a
cost in buying and selling of securities, the opportunity return needs to be
compared with the cost before deciding the investment decision. There are
different models that enable the managers to optimise the cost and decide the
quantum of investments. What is more important in managing marketable
securities is developing a system that enables the managers not only to take
investment decisions but also monitoring the investments in securities. In the
process of earning an opportunity income, the firms should not incur a loss by
investing wrongly or giving an opportunity for operational managers to make
personal gains. Studying the behaviour of cash flows is important, before
devising a strategy. Each firm should develop its own strategy. The experience of
many Indian companies, which have lost money during the securities scam, will be
useful to the managers in avoiding such mistakes in the future.
4. What are bond call provision and why are they used?
5. What are the advantages and disadvantages of floating rate securities for
both issuer and the investor?
6. What are liquid assets? Why do firms hold cash and cash equivalents? 7.
The standard deviation of the change in daily cash balances is Rs.6000. ♦ The
11. Pheonix Electronics has used the Baumol to estimate its optimal cash balance
to be Rs 10 lakhs. Its opportunity cost is 10% and there is a cost of Rs.
250 every time the marketable securities have to be converted into cash.
Estimate the weekly cash usage rate?
12. The financial manager of a large multinational company Jax Ltd., is studying
the firm’s cash management. He knows that it costs an average of Rs.
1000 per transaction to sell marketable securities. Short term Treasury bills
are currently yielding 6%. In studying the firm’s cash flows, he determines
that the standard deviation of daily cash balance is Rs. 5 lakhs. The firm
must maintain a minimum balance of Rs.50 lakhs to comply with
compensating balances requirements. He sees no reasons to hold more than
this amount in cash.
(a) Using the Miller-Orr model, what is the cash return point for the Jax Ltd?
71
Management of Current (c) Using the values, explain how the firm will manage cash and marketable
Assets securities balances. At what point will the firm sell marketable securities
and how much will it sell?
(d) How will the firm’s holdings of cash be affected by a) an increase in the
opportunity cost of holding cash, b) an increase in the daily variance of
cash balances, c) a decrease in the transaction cost associated with selling
marketable securities?
Delhi
72
Exhibit 7.1: Reading the Money Market Page Management of Inventory
(A) NSE Debt Market Deals
Market as on 24 September, 1999
Sec. Security Issue Trade No. of Trade Low Price High Price Last Traded Weighted Yield
Type Name Type Trade Value(Rs.
in Lakhs)
Note: These rates are based on a consensus of rates being offered by leading banks. Yield to
maturity is based on the CRISIL-IDBI Bond Tables.
Source: The Hindu Business Line, Saturday, September 25 1999 - page 10.
74
(D) MUMBAI MONEY MARKET-Indicative Market Rates Appeared in Management of Inventory
REUTERS
Instrument Period Rates Instrument Period Rates (%)
(%)
Call Money (Closing) 7.75-8.00 T-Bill Maturing On 06/01/2000 9.95-9.80
Bid/Offer Rate
Note: These rates are based on a consensus of rates being offered by leading banks
Source: The Hindu Business Line, Saturday, September 25 1999 - page 10.
75
Management of Current Exhibit 7.2: Yield Curve of Government Securities (Gilt) and Corporate
Securities
Assets
12.00
11.00
Percentage
10.00
9.00
8.00
3 1 5 10
M Y Y Y
Period
Per 12.00
cent
age
11.00
10.00
9.00
3M 1Y 5Y
Period
Guilt Corporate
76
Management of
Exhibit 7.3 : Behaviour of Cash Balances in Different Models Inventory
(A) Baumol Model
Cash Balance
Time
Time
(C) Miller and Orr Model
Cash Balance
Upper Limit (H)
Target (Z)
Time
Cash Balance
UCL2
UCL1
Return Point (Z)
LCL1
LCL2
Time
77
Management of Inventory
Structure
8.1 Introduction ntory
8.2 Components of Inve
8.3 Need for Inventory
8.4 Inventory System
8.5 Costs in Inventory y Cost
8.6 Optimising Inventor
8.7 Selective Inventory ty
8.8 Inventory Managem Inventory
8.9 Emerging Trends in
8.10 Summary
8.11 Key Words estions
8.12 Self Assessment Qu
8.13 Further Readings
8.1 INTRODUCT
n you thi nk of a ma
aterials. M as in
Three things will come to inventory
t s. The suc man business
erging ide anaged. ent unit
unit - machines, men and System
odels machines depend work-in-
m Control M Uncertain In this un
t
progress and finished goods. The general concepts of management namely,
planning, decision-making and controlling equally apply to inventory management.
In fact, this is one area in which companies in the real life spend a lot of
resources, both in terms of monetary value and managers’ time. Table 8.1
shows the investments in inventory in different industries and its value as a
percentage of total assets.
The value of inventory differs between industries because several factors like
technology, nature of materials, production process, etc. determines the value of
inventory. The composition of inventory is high in food and beverages because
the technology is fairly simple and hence the requirement of fixed assets is low.
The inventory requirement is high because of seasonal factor and the need for
wider retail distribution net work. For instance, if each shop in the country
stores twenty pockets of Maggi Noodles or Milkmaid, think of the total
volume
of finished goods stored in millions of shops distributed all over the country. The
composition of inventory is low in heavy industries or hi-tech industries because
of high value of fixed assets. Another interesting finding is declining trend in the
composition of inventories as a percentage of total assets during the period,
which partly attributes to successful implementation of new techniques such as
MRP and JIT. We will discuss these issues later under the heading of emerging
2
trends in inventory management. Management of Inventory
There are few basic differences between managing inventory and other
components of assets. Unlike machine and men, the inventories are continuously
planned on day-to-day basis based on the customers’ demand and production
schedule. Frequent decision-making and continuous controlling are thus required.
Unlike other components of current assets, there are number of people/
departments involved in managing the inventory. While stores department
manages the materials and components, it is the production department’s
responsibility in managing work-in-progress. Finished goods are managed either by
the warehouse or sales department.
Raw materials: Raw materials are the input that are used in the manufacturing
process to be converted to finished goods. Examples of raw materials are iron-
ore, crude oil, salt, wood, etc. However, what is considered to be the finished
goods for one firm could be the raw materials for the others. For example steel
flat or tubes are finished goods for Tata Iron and Steel Company (TISCo) but
the same is raw material for automobile companies such as Maruti Udyog or
Hindustan Motors or machinery manufacturing companies such as BHEL or
Thermax. Similarly, petrochemicals produces manufactured by Reliance Industries
are used as raw materials by several detergent manufacturers, polyester textile
units, tyres manufacturers, etc. Raw materials are not only important in the
manufacturing process but also play a crucial role in deciding the location of
plant. Several cement factories are located close to areas where limestone and
coal are available. Sugar factories are located close to sugarcane growing areas
and power plants are located close to waterfalls (hydroelectric units) and coal
belts.
i
i
r
f
i
l
5
Industry 1999 2000 2001 2002 2003
Assets
Food & Beverages
Raw Materials & Stores 2676.50 2761.02 3191.26 1735.79 3862.37
Work-in-progress 388.13 403.48 432.66 183.38 700.02
Finished Goods
Management of Current 5032.50 5723.40 7162.75 2984.22 7612.08
Textile
Raw Materials & Stores 3743.79 4104.39 4045.05 3079.24 5035.12
Work-in-progress 1381.29 1507.19 1459.43 1035.62 1668.02
Finished Goods 3606.32 3665.30 3807.26 2185.11 4557.19
Chemicals
Raw Materials & Stores 12180.95 17507.52 17006.60 11731.72 20764.78
Work-in-progress 2455.79 4011.15 4341.74 2062.92 5419.00
Finished Goods 13473.50 23603.87 23251.28 9927.93 28615.13
Non-metalic Minerals
Raw Materials & Stores 2172.90 2276.44 2537.17 1557.61 3026.00
Work-in-progress 574.52 644.45 713.02 361.80 720.91
Finished Goods 1366.19 1818.78 2219.27 851.93 2270.35
Metals & Products
Raw Materials & Stores 7416.16 7615.14 7362.71 6462.56 8964.97
Work-in-progress 2413.26 2111.88 2406.20 1404.26 2511.17
Finished Goods 8536.29 7020.42 7358.29 7261.27 6213.45
Machinery
Raw Materials & Stores 6452.96 6931.79 6912.79 6322.18 7369.58
Work-in-progress 4266.97 4575.12 5032.30 3707.79 5230.62
Finished Goods 4060.56 4394.32 4733.20 3168.70 5190.63
Transport Equipment
Raw Materials & Stores 4428.79 4747.74 4430.00 5317.47 3920.73
Work-in-progress 4678.79 3218.87 2737.36 2713.00 3375.34
Finished Goods 1586.27 2096.66 2397.63 1351.73 2518.37
Diversified
Raw Materials & Stores 3834.10 3746.32 3822.38 3661.35 6324.28
Work-in-progress 1371.07 1576.11 1818.08 4272.04 1764.16
Finished Goods 3186.02 3622.17 4134.26 2463.28 6237.21
Miscellaneous
Raw Materials & Stores 1488.70 1637.20 1878.41 1089.32 2263.94
Work-in-progress 299.32 339.81 289.59 183.36 411.59
Finished Goods 952.56 948.98 1120.95 713.56 1092.01
Total
Raw Materials & Stores 44394.85 51327.56 51186.37 40957.24 61531.77
Work-in-progress 17829.14 18388.06 19230.38 15924.17 21800.83
Finished Goods 41800.21 52893.90 56184.89 30907.73 64306.42
Activity 8.2
1) List out the various components of inventory? Identify major raw materials,
purchased components, finished goods for any one firm which is familiar to
6 you.
……………………………………………………………………………………
…………………………………………………………………………………….
…………………………………………………………………………………….
2) Why do the inventory components vary from firm to firm? Compare your
company’s inventory components with that of some other company but in a
different industry?
…………………………………………………………………………………….
…………………………………………………………………………………….
…………………………………………………………………………………….
3) Pick up any two or three industries from Table 8.2. List down a few
reasons for the differences in the level of inventory values.
…………………………………………………………………………………...
…………………………………………………………………………………….
…………………………………………………………………………………….
Transaction Motive: It is possible for a hotel to buy vegetables and other food
ingredients required for the day and serve the food such that there is no
inventory at the end of day. If you have kitchen garden in your house, you, your
mother or sister or wife will be picking up the vegetables when it is required for
cooking. It is bit difficult for other large-scale manufacturing units to synchronise
the arrival of materials and their use. Inventory is also required to supply to
dealers and retailers on continuous basis to meet demand. Thus, an important
motive for holding inventory is to perform smooth transaction in the production
process and serving the customers’ demand. It makes production and delivery
scheduling a lot more easier.
The above discussion presents general reasons for holding different types of
inventory. Given below are a few specific reasons that apply to individual
components of inventory.
Similarly the companies have to maintain sufficient stockings of the finished goods
as the output produced are not always sold at the factory gate. These goods
have to be distributed when the goods are to reach the customers spread out
geographically. This requires overcoming the challenges faced in the competitive
world. When the firm defaults to supply the goods at the right time in the right
place to the right customers, there is fear of losing the sales to the competitors.
1) Why do the firms maintain inventory? Identify three best reasons for holding
inventory by a company.
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2) How do the factors that govern the inventory requirement of a firm that
manufactures goods for direct consumption differ from another firm, which
manufactures intermediary goods for industrial consumption?
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Activity 8.4
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2) List down few industries in which the demand for inventory is (a) continuous
and (b) discrete.
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3) List down any three ideas to make the inventory system simpler so that its
management is easier?
10
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There are five different costs to the firm that holds inventory. The first category
of costs is the value of inventory itself. It is the purchase cost of inventory of
materials and components. For internally manufactured parts or work-in-progress
or finished goods, the cost associated with producing the product, includes cost of
material, labour and other production overheads. The second component of
inventory cost is cost of acquiring inventory. For materials and purchased parts or
components, it is the cost of purchasing, freight, inspection, etc. This component
of cost goes up when the materials are purchased in small lot because it requires
frequent ordering, transportation, and inspection. The set-up costs can be viewed
as cost of acquiring finished goods since in terms of behaviour it is similar to
acquisition cost of raw material. If finished goods are produced in small quantity,
then the number of set-ups increases causing more set-up costs.
The fourth cost of inventory is invisible and hence often ignored in formal
analysis. This relates to cost of inventory shortage. In many ways, this is the
most difficult category to estimate even though it is a very important cost to the
firm. Its difficulty is mainly due to changes in the magnitude of the costs in
different situations. For instance, if a firm is unable to supply the goods in time, it
may have different consequences. It is possible to supply the goods with a
minor delay and the buyer would perfectly accept the delayed supply. In a
different situation, the customer would refuse to take delivery because of delay
and thus the firm will lose profit on this sale. If the customer decides not to buy
the product henceforth from the firm, then it is a loss of customer, which takes
away all potential profits of the future. In the worst scenario, the news spreads
to others' and many customers move to other competitors. The cost of shortage
relates to material and other components which are associated with stopping and 11
Management of Current
starting the production. If the entire factory is shut down due to shortage of
material, then cost is very high.
The last component of cost related to inventory is cost of managing the inventory
system. The cost of developing inventory information system, computer hardware
and software and people associated with managing the inventory system. The cost is
Assets
high in a multi-product and multi-locational firm whereas is it is relatively low for a
single product company produced at a single location.
Activity 8.5
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3) List down fixed and variable component of costs of inventory. How do you
use this information in managing inventory?
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3) The material usage per unit is known with certainty, and is uniform through out
the years.
4) The carrying cost per unit and ordering cost per unit is constant regardless of the
size of the order.
5) The carrying cost is at a fixed percentage on the average value of the inventory
held.
Trial and Error Approach has intuitive appeal as this resolves the problem through
logical steps. Let us work out this with a simple problem. For this we take following
data into consideration:
There are number of alternatives available to the firm to manage the inventory
cost. The firm may either purchase the entire lot in one order or it may purchase
in small lots by making multiple orders. If the firm chooses to purchase the entire
13
in one single lot of 24000 units, then an amount of Rs. 180000 {(24000 + 0) /
Assets
2*15} is invested throughout the period. On the other hand, if the firm chooses
to purchase each month by ordering twelve times of 2000 units, then the average
investment in inventory is Rs. 15000{(2000 + 0) /2*15}. Investment values differ
according to the size of order. If the firm has to decide whether to go for the
Management
single order orofmultiple
Currentorder system, it depends on various factors like the
scarcity of materials, the production cycle, the demand for the materials, the
availability of the materials, suppliers and buyers bargaining power, etc. If the
firm focuses on reduction in the investment in inventory, then the firm would
favour multiple orders. To further substantiate this, we find the total carrying and
ordering cost involved in the various alternatives. Table 8.3 gives the details.
Table 8.3: Total cost of various alternatives
TC = CP + (C/Q) O + (Q/2) I
To minimise the total cost of inventory, we need to take the first derivative of the
equation with respect to Quantity and set it to zero and then check whether the
second derivative is positive.
-2
dTC/dQ = -OCQ + I/2 = 0
2
OC/Q = I/2
14
Q2 I Man= 2OC of Inventory
2
Q = 2OC/I
Q or EOQ = √2OC / I
-3
The second derivative (2OCQ ) is greater than zero because all the elements are
positive. Substituting the values of the previous problem in the above
equation, we get
For instance, in the preceding example we found that the usage per year is 2000
units, the holding cost per unit per year is Rs.10 and the ordering cost is Rs. 100, let us
now consider what would be the solution if it was known that a quanity discount of
10% in price is available if the order size is raised to 250 units.
Whether or not the quanity discount should be availed of, depends on an assessment
of the costs and benefits involved.
The savings resulting from the quantity discount = (Re.1) (0.10)(2000) = Rs.200.
The cost is the additional holding cost minus savings in ordering cost stemming from
fewer orders being placed.
To decide on the level of buffer stock to be carried a firm must balance the cost of
stock outs with the cost of carrying additional inventory. One can assess this balance
if the probability distribution of future usage is known.
Suppose the usage of an inventory item over a week is expected to be as follows:
Usage (in Units) Probability
50 0.04
100 0.08
150 0.20
200 0.36
250 0.20
300 0.08
350 0.04
1.00
Let us also assume an economic order quantity of 200 units per week, steady usage,
200 units in hand at the beginning of the period and three days' lead time required to
procure inventories. We may further assume that since this lead time is known with
certainty, orders are placed on the fifth day for delivery on the eighth day or the first
day of the next seven-day-week. Even if the firm carries no buffer stock there will
be no stock outs as long as the usage is 200 units or less. When usage exceeds 200
units there will be stock outs. When we know the cost per unit of stock out we are in
a position to calculate the expected cost of stock outs and compare this with the cost
of carrying additional inventory. Naturally, the stock out cost includes the loss of profit
arising from the order not being fulfilled, a valuation of the loss of business reputation
and goodwill. Let us say we reckon that the stock out cost is Rs.6 per unit and the
average carrying cost per week is Re.1 per unit then we are in a position to figure out
the expected costs associated with various levels of safety stocks.
However, some firms simply decide on a probability level of stock out acceptable to
them and then decide on the level of safety stock. For example, if this firm had
decided on accepting a probability of 10% stock out then it will maintain a safety
stock of 50 units only. If, however, the firm wished to accept a probability of only 5%
stock out, then it will maintain a safety stock of 100 units. When it maintains a safety
stock of 100 units it will be able to meet all situations except the one where there is
4% probability of the usage being 350 units.
Activity 8.6
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2) What is economic order quantity? How is it useful for the firms in the inventory
management?
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3) What are the major costs that are taken into consideration in optimising the
inventory cost?
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Re-order Level: The storekeeper starts to make the purchases when the
inventory in stores reaches this level. The re-order level is fixed taking into
Management of Current
consideration leadtime and unusual delays or interruptions. This is calculated as
follows:
Minimum Level: Inventories are not allowed to fall below this level. These are
otherwise called as safety stocks in the event of emergency. If the inventory
level falls below this level there is a greater chance of stock-out. This generally
happens when the consumption increases the standard requirements. This is
calculated as follows
Danger Level: This level is fixed even below the minimum level as a disastrous
signal when the inventory level touches this level. This has to be solved by
exercising greater efforts in purchasing to bring the inventory to the required
level.
ABC Analysis
ABC works on the mechanism namely Always Better Control. Vilfredo Pareto,
called nineteenth century Renaissance man, was the first to document the
Management Principle for Materiality, which formed the basis of ABC analysis
discussed here. As per Pareto, the ABC principle involves:
3) Hence this follows the criteria of concentrating the attention on most critical
items and pay less concern for less critical items, something equivalent to the
management by exception rule one could have come across in the basic
management textbooks. For this purpose the management have to be careful in
classifying the inventories into high, moderate and less critical goods. How is
this done? The usual methodology is to use the Rupee volume as the
criteria to classify them into categories, but there are several other factors that
determine the importance of the item. These include:
Annual Rupee volume of the items.
Unit cost
Scarcity of material used in producing an item.
Availability of resources, manpower, and facilities to produce an item.
Lead-time.
Storage requirements for an item.
Pilferage risks, shelf life, and other critical attributes.
Cost of stock-out.
Engineering design volatility
Using value of items as the basis for such classification, if on an average the
15% of the items account for nearly 65% of the total inventory value, this falls
under the most critical category which is usually named as the ‘A’ category.
Similarly if 30% of the items account for 25% of the total inventory value, this
falls under the next category named as ‘B’ category. The balance 55% of the
items that account for nearly 10% of the total inventory value fall under the least
category named as ‘C’ category.
Control Levels: In the case of A category item, close controls are required to
avoid stock-out costs. Arranging the supply with large number of vendors rather
than depending only on a few suppliers might do this. Stock levels as discussed
above are strictly maintained. Moreover holding buffer stocks would be more
useful in managing the stock-out. In the case of B category item the stock-out
costs could be somewhere between moderate to low. Hence appropriate
computer-based system, with periodic reviews by the management is utmost
necessary. In addition buffer stocks could be adequate control mechanism. On
the other hand, routine control is sufficient for stocks falling under the C
category. Action is taken only if the stock level falls below the re-order point. A
periodic review at longer interval may also be sufficient.
VED Analysis
VED stands for Vital, Essential and Desirable. This technique is primarily used
for the control of the spare parts inventory. As the name goes the spare parts
are subdivided into vital, essential and desirable categories, based on their critical
nature. The criticality is determined by the importance of its usage. If the event
of stock-out in an item stops the production, then it is classified under the ‘vital’
category. Those spares the absence of which is not tolerated for even few
hours or a day, the loss of, which is considerably high, falls under the 'essential'
category. Desirable spares are those, the absence of which is not expected to
create havoc for a week or so and necessarily would not result in the stoppage
of the production. Hence one could find that the VED analysis adopts almost
the similar mechanism of the ABC analysis in that the former is used for the 19
control of spare parts.
Assets
F-S-N Analysis
Inventory items are also classified and controlled on the basis of fast-moving,
slow-moving and non-moving items (F-S-N analysis). The non-moving items are
Management of Current
critically examined for their needs and items, which are not critical, are disposed off
in a suitable manner. They may be used in the production process with
modifications or sold in the market. The order levels and economic order
quantity for slow-moving items are reviewed to check, whether they can be further
reduced without affecting the production process.
The above three analysis are not mutually exclusive and in fact, by combining the
analyses, the management can get a better picture on the inventory. For
example, items, which are fast-moving, vital and “A” class, may require very
close monitoring because excess holding will cause additional cost and at the
same time stock-out will also cause equal loss. Inventory policy can be designed
by combining the three analyses.
Activity 8.7
1) How do you think the existence of an inventory control system in the organisation
would help in the inventory management?
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3) What are the various aspects that are to be considered in fitting an inventory
control system in any organisation?.
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Option Pricing Model: Option is a contract that gives the holder a right to
acquire or sell certain things at a predetermined price without any obligation. This
type of contract is prevalent in commodities and financial assets. Since it is one-
sided contract that offers only a benefit, the valuation methodology needs to
differ from conventional models of valuing contracts or assets. There are
different models available to value options and discussion on these models are
beyond the scope of this unit. The basic option pricing approach finds application
in several financial management issues such as capital budgeting, capital
structuring and dividend policy. The model is also useful to address the
uncertainty problem of inventory management.
We will first explain an option type called put option and then show how it is
similar to the situation we have described in television dealers example. A put
option gives a right to the holder to sell an asset at a predetermined price. The
holder of the option gains if the value of underlying asset goes down because the
holder can buy the asset at a lower price and sell at a higher predetermined
price. The holder is not going to sustain any additional loss if the price of the
asset goes up. Of course, the holder will incur a loss to the extent of initial
price (called option premium) paid to the other party of the contract to accept
the one-sided contract. Thus, the value of contract is inversely related to the
price behaviour of underlying asset with a cap on maximum loss. With this brief
on options, let us go back to the television dealer example and compare the
condition with the option model.
If the dealer decides to acquire additional inventory under the expectation that the
demand will go up, there is an additional cost of carrying the inventory. At the
same time, the dealer has acquired the right to sell the product and realise the
profit if the demand picks up. This is similar to acquiring a put option on
financial assets or commodity by paying upfront premium. The variable, which
determines the profit of the financial or commodity option is the price of the
product and in the case of inventory option, it is the demand for the product. As
the demand goes up, the dealer starts initially getting back the cost and if the
demand still goes up, gets profit. On the other hand, if there is no change in the
demand, the product stays more time before it finds a buyer and this cost is
initially determined as the cost of buying the option. The issue before the dealer
is whether this cost is worth to incur to get a potential future benefit. This is
similar to whether it is worth to buy a put option at a given price considering the
likely benefit the option offers to the holder. Of course, in the television example,
the value of the option directly moves with the demand for the product unlike the
inverse relationship between the price of the asset and put option benefit. To
know whether it is worth to carry additional inventory by incurring a cost, the
dealer has to get a distribution of demand with associated probability. The easiest
methodology to decide on this issue is Binomial Option Pricing Model. If the
option value is more than the cost of carrying the inventory, then the decision is
in favour of holding larger inventory. The readers are advised to consult standard
textbooks on option pricing models to know more about valuation of options.
21
Frederic C. Scherr has explained the use of Black-Scholes Option Pricing Model
Assets
to resolve inventory problem by relating the impact of various demand levels on
stock prices of the company.
Risk-Adjusted Discounted Cash Flow (DCF) Model: The model requires
the
Management of Current
managers to convert the inventory problem into a capital budgeting problem. Once
this is done, it is possible to apply all the techniques that are used for resolving
uncertainty in capital budgeting decisions. We will continue the television dealer
example to show the similarity between the inventory problem and capital
budgeting decision. Suppose the dealer decides to hold additional inventory on the
expectation that the demand will be more than 1000 television per month. The
additional inventory holding has a cost and this is similar to the cost incurred for
the purchase of equipment in capital budgeting exercise. The only difference is
the inventory holding cost (cash outflow) is spread over time whereas in the
case of purchase of equipment, it is normally incurred at the beginning of the
project period. Of course, there are projects where investment is spread over
time. The project offers certain benefit/cash inflows over the years. The benefit
of holding larger inventory is the additional profit if the demand picks up. It may
be a one-time benefit or spread over the period. If you think of oil-drilling as a
project, you can see several common features between our inventory problem and
oil-drilling project. In an oil-drilling project, the cash outflow is incurred over a
period, till the pipes reach the oil-bed. Once the oil is struck, there is no major
additional expense and oil starts pouring for certain period. The project gets cash
inflow. The only uncertainty is when are we going to strike oil and how long the
flow will be there. There is no other way except to develop a probability
distribution of the time and oil reserve. In the same manner, the television dealer
also needs to estimate the probability distribution of future demand. As we have
converted our inventory problem into a normal capital budgeting problem, risk-
adjusted DCF model can be applied to resolve the uncertainty.
The next step in the application of risk-adjusted DCF model is to measure the
cash inflow (profit) under different demand levels. It is also useful to estimate
the cash inflows values for different levels of inventory holding i.e. 1000 units,
1500 units, 2000 units, etc. The cash flows are multiplied by the respective
probability values of demand forecast. The next step is to use the risk-adjusted
discount rate (often, it is cost of capital of the firm derived using Capital Asset
Pricing Model) to get the present value of cash inflows. The expected value of
cash inflows is computed by summing up all the present values of cash flows for
different demand levels. If we repeat this process for different inventory holdings,
then we get a series of expected values of cash inflows for different inventory
holdings. The optimum inventory holding is the one where the difference between
the risk-adjusted expected value of cash inflows is greater than the risk-adjusted
cash outflows (cost of holding inventory).
Dynamic Inventory Model: In the above two models, we have limited the
scope of uncertainty to expected demand and also restricted the period of
analysis. If we desire to include uncertainty associated with many inventory
variables such as demand, delivery period, interest cost of holding inventory,
storage cost, cost of stock out, etc., we need a complex optimisation model. It is
possible to use simulation technique to include multiple variables, which are
exposed to uncertainty. The model requires identification of uncertain variables,
estimation of probabilities associated with different uncertain variables and how
the variables together affect the cost and benefit of holding a particular level of
inventory. For example, given a delivery period of 30 days, interest cost of 14%,
demand of 1500 units per month, and storage cost of 2% per month, the impact
of placing an order quantity of 2000 units with a reorder level of 500 units on the
cost and benefit of holding inventory are to be estimated. With this set of
22
information, it is possible to simulate a large number of trials using random nventory
numbers. The simulation will give expected profit or loss estimation for each
order quantity and reorder level and you may select the combination, which offers
maximum profit. The decision making is easier and to an extent reliable because
each profit estimation is based on a large number of simulated trials.
Activity 8.8
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3) List down the steps involved in conducting simulation exercise to deal with
uncertainty.
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Many of the concepts we have discussed so far are likely to become outdated
soon if the current growth rate in the information technology is maintained. The
expansion of internet services and e-commerce will definitely create a new
business world in which we may not have shops or malls. Most of the agencies
dealing between customers and producers may not exist. Producers may also
offer product with individual preferences and bargain for a leadtime to deliver the
product. Industrial marketing is also likely to see major changes and at some
point of time JIT, Kanbans, supply-chain, vendor development, etc. will become
basic techniques for businesses. A sure way of tackling uncertainty is free
exchange of information on online basis, which is not only feasible but will also
become a norm in the near future.
Activity 8.9
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24 …………………………………………………………………………………….
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8.10 SUMMARY
Inventory, which consists of raw materials, components and other consumables,
work-in-process and finished goods, is an important component of current assets.
There are several factors like nature of industry, availability of material,
technology, business practices, price fluctuation, etc., that determine the amount of
inventory holding. Some of the broad objectives of holding inventory are ensuring
smooth production process, price stability and immediate delivery to customers.
The inventory holding is also affected by the demand of the customers of
inventory, suppliers and storage facility. Since inventory is like any other form of
assets, holding inventory has a cost. The cost includes opportunity cost of funds
blocked in inventory, storage cost, stock out cost, etc. The benefits that come
from holding inventory should exceed the cost to justify a particular level of
inventory.
Inventory optimising techniques such as EOQ help us to balance the cost and
benefit to achieve a desirable level of inventory. It is not adequate to just plan
for inventory holding. They need to be periodically monitored or controlled.
Techniques such as ABC or VED are useful for continuous monitoring of
inventory. Inventory planning can be done taking into account the uncertainty
associated with inventory variables. Models such as option pricing model, risk-
adjusted DCF model and dynamic inventory model are useful to handle the
problem of uncertainty.
The leadtime for the supply is found to be 2 days and the company wishes to
keep a safety stock equivalent of 50% of the usage in the leadtime.
26
a) Find EOQ assuming no discount being offered. Management of Inventory
Month 1 2 3 4 5 6
Demand(units) 100 130 125 200 210 185
Month 7 8 9 10 11 12
Demand(units) 175 190 200 251 270 255
The ordering cost for the component is Rs.50.00 per order. Purchase price per
unit is Rs.5.00 for a lot size of less than 500 units and Rs.4.80 for lot size of
500 or more units. The annual carrying cost per unit of inventory is expected to
be 30 percent of the unit purchase price. The lead-time is expected to be one
week. The entire order for the component is delivered at one time.
The department has three alternatives for ordering. The order quantity should be
equal to - (a) one-month supply, (b) two-month supply, (c) three-month supply.
Which one of these proposals would you suggest being more economical on the
basis of an annual cost comparison?
12. An engineering unit uses a component at a uniform rate of 900 units per
week. Minimum inventory is 100 units. The cost of placing and receiving an
order is Rs.200.00. Purchase price per unit is Rs. 40.00 per unit. Carrying
cost is 15% of the purchase price per unit. The leadtime is two weeks.
You are required:
a. To ascertain the value of the economic order quantity for the firm.
b. With the use of the data and calculated EOQ as above determine:
i) Reorder point.
ii) Maximum inventory.
iii) Average inventory.
iv) Average number of orders per week.
v) Average order cost per week.
vi) Average carrying cost per week.
vii) Relevant total average cost per week.
viii) Relevant total average cost per year.
13. ABC company buys an item costing Rs.125 each in lots of 500 boxes which 27
is a 3 months supply and the ordering cost is Rs.150. The inventory carrying
cost is estimated to be 20% of unit value, what is the total annual cost of the
existing inventory policy? How much money could be saved by employing
EOQ model?
9.1 INTRODUCTION
Bank credit constitutes one of the major sources of Working Capital for trade and
industry. With the growth of banking institutions and the phenomenal rise in their
deposit resources, their importance as the suppliers of Working Capital has
significantly increased. Of the total gross bank credit outstanding as at the end of
August 22, 2003, of Rs.6,63,122 crore, Rs.2,78,408 crore is advanced to industry. This
works out to around 41.98 percent. More particularly, there has been significant rise
in the credit towards industry in the recent past. In this unit, first we shall examine
the basic principles of bank credit, followed by a detailed account of the various
types of credit facilities offered by banks and the securities required by them.
Following the above principles banks pursue the practice of diversifying risk by
spreading advances over a reasonably wide area, distributed amongst a good number of
customers belonging to different trades and industries. Loans are not granted for
speculative and unproductive purposes
9.3.1 Overdrafts
This facility is allowed to the current account holders for a short period. Under this
facility, the current account holder is permitted by the banker to draw from his
2
account more than what stands to his credit. The excess amount drawn by him is
deemed as an advance taken from the bank. Interest on the exact amount
overdrawn by the account-holder is charged for the period of actual utilisation. The
banker may grant such an advance either on the basis of collateral security or on the
personal security of the borrower. Overdraft facility is granted by a bank on an
application made by the borrower. He is also required to sign a promissory note.
Therefore, the customer is allowed the amount, upto the sanctioned limit of overdraft
as and when he needs it. He is permitted to repay the loan as per his convenience
and ability to do so.
1) Under this system, the banker prescribes a limit, called the Cash Credit limit,
upto which the customer- borrower is permitted to borrow against the security
of tangible assets or guarantees.
2) The banker fixes the Cash Credit limit after considering various aspects of the
working of the borrowing concern i.e production, sales ,inventory levels, past
utilisation of such limit, etc.
3) The borrower is permitted to withdraw from his Cash Credit account, amount as
and when he needs them. Surplus funds with him are allowed to be deposited
with the banker any time. The Cash Credit account is thus a running account,
wherein withdrawals and deposits may be made frequently any number of times.
5) When the borrower repays the borrowed amount in full or in part, security is
released to him in the same proportion in which the amount is refunded.
6) The banker charges interest on the actual amount utilised by him and for the
actual period of utilisation.
7) Though the advance made under Cash Credit System is repayable on demand
and there is no specific date of repayment, in practice the advance is rolled over a
period of time i.e. the debit balance is hardly fully wiped out and the loan
continues from one period to another.
8) Under this system, the banker keeps adequate cash balance to meet the
demand of his customers as and when it arises, but interest is charged on the
actual amount of loan availed of. Thus, to neutralize the loss caused to the
banker, the latter imposes a commitment charge at a normal rate of 1% or so, on
the unutilised portion of the cash credit limit.
2) The banker remains unable to verify the end use of funds borrowed by the
customer. Such funds may be diverted to unapproved purposes.
3) The banker remains unable to plan the utilisation of his funds as the level of
advances depends upon the borrower’s decision to borrow at any time.
The loan system has the following advantages over the Cash Credit System:
1) This system imposes greater financial discipline on the borrowers, as they are
bound to repay the entire loan or its instalments on the due date/ dates fixed in
advance.
2) At the time of granting a new loan or renewing an existing loan, the banker
reviews the loan account. Thus unsatisfactory loan accounts may be
discontinued at his discretion.
3) As the banker is entitled to charge interest on the entire amount of loan, his
income from interest is higher and his profitability also increases because of
lower transaction cost.
Short term loans are granted by banks to meet the Working Capital requirements of
the borrowers. Such loans are usually granted for a period upto one year and are
secured by the tangible movable assets of the borrowers like goods and commodities,
shares, debentures etc. Such goods and securities are pledged or hypothecated with
the banker.
As we shall study in the next unit. Reserve Bank of India has exercised compulsion
on banks since 1995 to grant 80% of the bank credit permissible to borrowers with
credit of Rs 10 crore or more in the form of short term loans which may be for
4
various maturities. Reserve Bank has also permitted the banks to roll over such
loans i.e. to renew the loan for another period at the expiry of the period of the first
loan.
Such loans are generally called ‘Term Loans’ and are granted by banks with All
India Financial institutions like Industrial Development Bank of India, Industrial
Finance Corporation of India, Industrial Credit and Investment Corporation of India
Ltd. Term loans are granted for medium and long terms, generally above 3 years
and are meant for purchase of capital assets for the establishment of new units and
for expansion or diversification of an existing unit . At the time of setting up of a new
industrial unit, term loans constitute a part of the project finance which the
entrepreneurs are required to raise from different sources. These loans are usually
secured by the tangible assets like land, building, plant and machinery etc. In October
1997 Reserve Bank of India permitted the banks to announce separate prime
lending rate for term loans of 3 years and above. In April 1999 Reserve bank of
India also permitted the banks to offer fixed rate loans for project financing. Reserve
Bank of India has encouraged the banks to lend for project finance as well. In
September, 1997 ceiling on the quantum of the term loans granted by banks
individually or in consortia/syndicate for a single project was abolished. Banks now
have the discretion to sanction term loans to all projects within the overall ceiling of
the prudential exposure norms prescribed by Reserve bank. ( Fully discussed in the
next unit). The period of term loans will also be decided by banks themselves.
Though term loans are meant for meeting the project cost but as project cost
includes margin for Working Capital , a part of term loans essentially goes to meet
the needs of Working Capital.
Bridge Loans
Bridge loans are in fact short term loans which are granted to industrial undertakings
to enable them to meet their urgent and essential needs. Such loans are granted under
the following circumstances:
1) When a term loan has been sanctioned by banks and/ or financial institutions, but
its actual disbursement will take time as necessary formalities are yet to be
completed.
2) When the company is taking necessary steps to raise the funds from the Capital
market by issue of equities/debt instruments.
Bridge loans are provided by banks or by the financial institutions which have
granted term loans. Such loans are automatically repaid out of the amount of term
loan when it is disbursed or out of the funds raised from the Capital Market.
Reserve Bank of India has allowed the banks to grant such loans within the ceiling
of 5% of incremental deposits of the previous year prescribed for individual banks’
investment in Shares/ Convertible debentures. Bridge loans may be granted for a
maximum period of one year.
Composite Loans
Composite loans are those loans which are granted for both, investment in capital
assets as well as for working capital purposes. Such loans are usually granted to
small borrowers, such as artisans, farmers, small industries etc. Under the
composite loan scheme, both term loans and Working Capital are provided through
a single window. The limit for composite loans has recently (in Feb., 2000) been
increased from Rs. 5 lakhs to Rs.10 lakhs for small borrowers.
5
Financing Personal Loans
Working Capital
Needs These loans are granted by banks to individuals specially the salary-earners and
others with regular income, to purchase consumer durable goods like refrigerators,
T.Vs., cars etc. Personal loans are also granted for purchase/construction of houses.
Generally the amount of loans is fixed as a multiple of the borrower’s income and a
repayment schedule is prepared as per his capacity to save.
Activity 9.1
1) What do you understand by Margin money for Working Capital? How is it
financed?
3) What do you understand by Term Loans? For what purposes are they granted
by banks? What is Reserve Bank’s directive to banks in this regard?
4) What is meant by Bridge Loan? What is the necessity for granting such loans.
Advances
Secured Advances
1) The advance is made on the basis of security of tangible assets like goods and
commodities, life insurance policies, corporate and government securities etc.
3) The market value of such security is not less than the amount of loan. If the
former is less than the latter, it becomes a partly secured loan.
Unsecured Advances
Unsecured advances are granted without asking the borrower to create a charge on
his assets in favour of the banker. In such cases the security happens to be the
personal obligation of the borrower regarding repayment of the loan. Such loans are
granted to parties enjoying high reputation and sound financial position.
The legal status of the banker in case of a secured advance is that of a secured
creditor. He possesses absolute right to recover his dues from the borrower out of the
sale proceeds of the assets over which a charge is created in his favour. In case of an
unsecured advance, a banker remains an unsecured creditor and stand at par with
other unsecured creditors of the borrower, if the latter defaults.
Guaranteed Advances
The banker often safeguards his interest by asking the borrower to provide a
guarantee by a third party may be an individual, a bank or Government. According
to the Indian Contract Act, 1872, a contract of guarantee is defined as “a contract
to
perform the promise or discharge the liability of third person is
case of his
default”. The person who undertakes this obligation to discharge the liability of
another person is called the guarantor or the surety. Thus a guaranted advance is, in
fact, also an unsecured advance i.e. without any specific charge being created on
any asset, in favour of the banker. A guarantee carries a personal security of two
persons i.e. the principal debtor and the surety to perform the promise of the
principal debtor. If the latter fails to fulfill his promise, liability of the surety arises
immediately and automatically. The surety therefore, must be a reliable person
considered good for the amount for which he has stood as surety. The guarantee
given by banks, financial institutions and the government are therefore considered 7
Financing Working valuable.
Capital Needs
There are several methods of creating charge over the borrower’s assets as shown
below:
Modes of Creating charge
9.5.1 Pledge
Pledge is the most popular method of creating charge over the movable assets.
Indian Contract Act, 1872, defines pledge as ‘bailment of goods as security
of
payment of a debt or performance of a promise”. The person who
offers the
security is called the pledger and the person to whom the goods are entrusted is
called the ‘pledgee’ . Thus bailment of goods is the essence of a pledge. Indian
Contract Act defines bailment as “delivery of goods from one person to another for
some purpose upon the contract that the goods be returned back when the purpose is
accomplished or otherwise disposed of according to the instructions of the bailor”.
Thus when the borrower pledges his goods with the banker, he delivers the goods to
the banker to be retained by him as security for the amount of the loan. Delivery of
goods may be either (i) physical delivery or (ii) constructive or symbolic delivery.
The latter does not involve physical delivery of the goods. The handing over of the
keys of the godown storing the goods, or even handing over the documents of the title
to goods like warehouse receipts, duly endorsed in favour of the banker amounts to
constructive delivery.
It is also essential that the banker must return the same goods to the borrower after
he repays the amount of loan along with interest and other charges. The pledgee
(banker) is entitled to certain rights, which are conferred upon him by the Indian
Contract Act. The foremost right is that he can retain the goods pledged for the
payment of debt and interest and other charges payable by the borrower. In case the
pledger defaults, the pledgee has the right to sell the goods after giving pledger
reasonable notice of sale or to file a suit for the amount due from him.
9.5.2 Hypothecation
Hypothecation is another method of creating charge over the movable assets of the
borrower. It is preferred in circumstances in which transfer of possession over
such assets is either inconvenient or is impracticable. For example, if the borrower
wants to borrow on the security of raw materials or goods in process, which are to be
converted into finished products, transfer of possession is not possible/practicable
8
because his business will be impeded in case of such transfer. Similarly a transporter
needs the vehicle for plying on the road and hence cannot give its possession to the
banker for taking a loan. In such circumstances a charge is created by way of
hypothecation.
Under hypothecation, neither ownership nor possession over the asset is transferred
to the creditor. Only an equitable charge is created in favour of the banker. The
asset remains in the possession of the borrower who promises to give possession
thereof to the banker, whenever the latter requires him to do so. The charge of
hypothecation is thus converted into that of a pledge. The banker enjoys the rights
and powers of a pledgee. The borrower uses the asset in any manner he likes, viz he
may take out the stock, sell it and replenish it by a new one. Thus a charge is
created on the movable asset of the borrower. The borrower is deemed to hold
possession over the goods as an agent of the creditor. To enforce the security, the
banker should take possession of the hypothecated asset on his own or through the
court.
9.5.3 Mortgage
A charge on immovable property like land & building is created by means of a
mortgage. Transfer of Property Act 1882 defines mortgage as” the transfer of
an
interest in specific immovable property for the purpose of
securing the payment
of money, advanced or to be advanced by way of loan, an
existing or future
debt or the performance of an engagement which give rise to a
pecuniary
liability”. The transferor is called the ‘mortgagor’ and the transferee ‘mortgagee’.
The owner transfers some of the rights of ownership to the mortgagee and retains the
remaining with himself. The object of transfer of interest in the property must be to
secure a loan or to ensure the performance of an engagement which results in
monetary obligation. It is not necessary that actual possession of the property be
passed on to the mortgagee. The mortgagee, however, gets the right to recover the
amount of the loan out of the sale proceeds of the mortgaged property. The
mortgagor gets back the interest in the mortgaged property on repayment of the
amount of the loan along with interest and other charges.
Kinds of Mortgages
Though Transfer of Property Act specifies seven kinds of mortgages, but from the
point of view of transfer of title to the mortgaged property, mortgages are divided
into-
a) Legal mortgages and
b) Equitable mortgages
In case of Legal Mortgage, the mortgagor transfers legal title to the property in
favour of the mortgagee by executing the Mortgage deed. When the mortgage
money is repaid, the legal title to the mortgaged property is re-transferred to the
mortgagor. Thus in this type of mortgage expenses are incurred in the form of stamp
duty and registration charges.
In case of an equitable mortgage the mortgagor hands over the documents of title to
the property to the mortgagee and thus creates an equitable interest of the mortgagee
in the mortgaged property. The legal title to the property is not passed on to the
mortgagee but the mortgagor undertakes through a Memorandum of Deposit to
execute a legal mortgage in case he fails to pay the mortgaged money. In such
situation the mortgagee is empowered to apply to the court to convert the equitable
mortgage into legal mortgage.
9.5.4 Assignment
The borrower may provide security to the banker by assigning any of his rights,
properties or debts to the banker. The transferor is called the ‘assignor’ and the
transferee the ‘assignee’. The borrowers generally assign the actionable claims to
the banker under section 130 of the Transfer of Property Act 1882. Actionable claim is
defined as a claim to any debt, other than a debt secured by mortgage of
immovable property or by hypothecation or pledge of movable property or to any
beneficial interest in movable property not in the possession of the claimant.
A borrower may assign to the banker(i)the book debts, (ii) money due from a
government department or semi-government organisation and (iii)life insurance
policies.
Assignment may be either a legal assignment or an equitable assignment. In case of
legal assignment, there is absolute transfer of actionable claim which must be in
writing. The debtor of the assignor is informed about the assignment. In the
absence of the above the assignment is called equitable assignment.
9.5.5 Lien
The Indian Contract Act confers upon the banker the right of general lien. The
banker is empowered to retain all securities of the customer, in respect of the general
balance due from him. The banker gets the right to retain the securities handed over to
him in his capacity as a banker till his dues are paid by the borrower. It is deemed as
implied pledge.
Activity 9.2
1) Distinguish between a secured advance and a guaranteed advance.
10
9.6 SECURED ADVANCES
Secured advances account for significant portion of total advances granted by banks.
As we have seen, in case of secured advances, a charge is created on the assets of
the borrowers in favour of the banker, which enables him to realise his dues out of
the sale proceeds of the assets. Banks grant advances against a variety of assets as
shown below:
Securities for Advances
Bulk of the advances granted by banks are secured by goods and commodities, raw
material and finished goods etc., which constitute the stock-in-trade of business
houses. However, agricultural commodities are likely to deteriorate in quality over a
period of time. Hence banks grant short term loans only against such commodities .
The problem of valuation of stock pledged with the bank is not a difficult one, as
daily quotations are easily available. Banker usually prefers those commodities which
have steady demand and a wider market. Such goods are required to be insured
against fire and other risks. Such goods either pledged or hypothecated to the banker
are released to the borrower in proportion to the amount of loan repaid.
These documents represent actual goods in the possession of some other person.
Hence they are proof of possession or control over the goods. For example,
warehouse receipts, railway receipts, Bill of lading etc. are documents of title to
goods. When the owner of goods represented by these documents wants to take a
loan from the banker, he endorses such documents in favour of the banker and
delivers them to him. The banker is thus entitled to receive the delivery of such
goods, if the advance is not repaid. However, there remains the risk of forgery in
such documents and dishonesty on the part of the borrower.
Reserve Bank of India has permitted the banks to grant advances against shares to
individuals upto Rs. 20 lakhs w.e.f. April 29, 1998 if the advances are secured by
dematerialized Securities. The minimum margin against such dematerialized shares
was also reduced to 25%. Advances can also be granted to investment companies,
shares & stock brokers, after making a careful assessment of their requirements.
Real Estate
Real Estate i.e. immovable property like land and building are generally not regarded
suitable security for granting loans for working capital. It is difficult to ascertain that
the legal title of the owner is free from any encumbrance. Moreover, their valuation is
a difficult task and they are not readily realizable assets. Preparation of mortgage
deed and its registration takes time and is expensive also. Real Estates are,
therefore, taken as security for term loans only.
Book Debts
Sometimes the debts which the borrower has to realise from his debtors are assigned to
the banker in order to secure a loan taken from the banker. Such debts have either
become due or will accure due in the near future. The assignor must execute an
instrument in writing for this purpose, clearly expressing his intention to pass on his
interest in the debt to the assigner (banker). He may also pass an order to his debtor to
pay the assigned debt to the banker.
Supply Bills
Banks also grant advance on the security of supply bills. These bills are offered as
security by persons who supply goods, articles or materials to various Govt.
departments, semi-govt. bodies and companies, and by the contractors who undertake
govt. contract work. After the goods are supplied by the suppliers to the govt.
department and he obtains an inspection note or Receipted Challan from the Deptt.,
he prepares a bill for the goods supplied and gives it to the bank for collection and
seeks an advance against such supply bills. Such bills are paid by the purchaser at
the expiry of the stipulated period.
Security for bank credit could be in the form of a direct security or an indirect
security. Direct security includes the stocks and receivables of the customers on
which a charge is created by the bank through various security documents. If in the
view of the bank, the primary or direct security is not considered adequate or is risk-
prone, that is, subject to heavy fluctuations in prices, quality etc., the bank may
require additional security either from the customer or from a third party on
behalf of the customer. The additional security so obtained is known as Indirect or
“Collateral Security”. The term collateral means running parallel or together and
collateral security is an additional and separate security for repayment of money
borrowed.
In case the customer is unable to provide additional security when required by the
bank, he may be required to provide collateral security from a third party. The
common form of the third party collateral security is a guarantee given by a person
on behalf of the customer to the bank. The third party collateral security in turn may
13
Financing be unsecured or secured. For example, where the guarantor has executed a guaran-
Working Capital tee agreement only, The collateral security is unsecured. However, if he lodges along
Needs
with the guarantee agreement, security such as title deeds to his property creating
mortgage by deposit of title deeds with the bank, a secured collateral security is
created.
On the basis of maturity period , bills are classified into (i) demand bills and (ii)
usance bills. When a bill is payable ‘at sight’ ‘on demand’ or on presentment, it is
called a demand bill. If it matures for payment after a certain period of time say
30,60,90 days , after date or sight, it is called a usance bill. No stamp duty is required in
case of demand bills and on usance bills, if they (i) arise out of the bona fide
commercial transactions , (ii) are payable not more than 3 months after date or sight
and (iii) are drawn on or made by or in favour of a commercial or cooperative bank.
When the drawer of a bill encloses with the bill documents of title to goods, such as
the railway receipt or motor transport receipt, to be delivered to the drawee , such
bills are called documentary bills. When no such documents are attached the bill is
called a clean bill. In case of documentary bills, the documents may be delivered on
accepting the bill or on making its payment. In the former case it is called
Documents against Acceptance (D/A) basis, and in the latter case Documents
against Payment (D/P) basis. In case of a clean bill, the relevant documents of title to
goods are sent directly to the drawee.
The business of purchasing and discounting of bills differs from that of collection of
bills. In case of purchase/discounting of bills, the bank credits the amount of the bill
to the drawer’s account before its actual realisation from the drawee. The banker
thus lends his own funds to the drawer of the bill. Bills purchased or discounted are
therefore, shown under the head ‘ Loans and Advances’ in the Balance Sheet of a
bank.
Though the banker does not get charge over any tangible asset of the borrower in
case of discounting of bills, his interest is safeguarded by the fact that the bills of
exchange contains signatures of two parties—the drawer and the drawee
(acceptor)— who are responsible to make payment of the bill. If the acceptor fails
to make payment of the bill the banker can claim the whole amount from his
customer, the drawer of the bill. The banker can debit the customer’s account and
recover the money on the due date. The banker is able to recover the amount as he
discounts the bills drawn by parties of standing and good reputation.
2) Certainty of payment
Every usance bill matures on a certain date. Three days of grace are allowed to the
acceptor to make payment. Thus, the amount lent to the customer by discounting the
bills is definitely recovered by the banker on its due date. The banker knows the date
of payment of the bills and hence can plan the utilisation of his funds well in
advance and with profit.
The banker can augment his funds, if need arises, by re-discounting the bills, already
discounted by him, with the Reserve Bank of India, other banks and financial
institutions and the Discount and Finance House of India Ltd. Reserve Bank of
India can also grant loans to the banks on the basis of the bills held by them.
The value of the bills remains fixed and unchanged while the value of all other goods,
commodities and securities fluctuate over period of time.
5) Profitability
As noted above, banks may re-discount the discounted bills of exchange with other
banks and financial institutions. For this purpose, under the normal procedure, the
bills are endorsed in favour of the re-discounting bank /institution and delivered to it.
At the time of maturity reverse process is required.
To encourage the use of bills of exchange by corporate borrowers, the Reserve Bank of
India had directed the commercial banks to advice their corporate borrowers to
finance their domestic credit purchases from small scale industrial units as well as
from others at least to the extent of 25 percent by way of acceptance of bills drawn
upon them by their suppliers. This was to be stipulated as a condition for sanctioning
working capital credit limits. Banks were also authorized to charge an additional
interest from those borrowers who did not comply with this requirements in any
quarter. In October 1999 Reserve bank of India permitted the banks to charge
interest rate on discounting of bills without reference to Prime Lending Rate. They
are now free to offer competitive rate of interest on the bill discounting facility. The
above-mentioned compulsion was also withdrawn.
Revised Guidelines of RBI on Discounting of Bills
• Banks may sanction working capital limits as also bills limits to borrowers after
proper appraisal of their credit needs and in accordance with the loan policy as
approved by their Board of Directors.
• Banks are required to open letters of credit (LCs) and purchase /discount/
negotiate bills under LCs only in respect of genuine commercial and trade
transactions of their borrower constituents who have been sanctioned regular
credit facilities by them.
• For the purpose of credit exposure, bills purchased discounted/negotiated under
LCs or otherwise would be reckoned as exposure on the bank’s borrower
constituent. Accordingly, the exposure should attract a risk-weight appropriate to the
borrower constituent (viz.,100 per cent for firms, individuals, corporates) for capital
adequacy purposes.
• Banks have been permitted to exercise their commercial judgment in discounting
of bills of services sector. Banks would need to ensure that actual services are
rendered and accommodation bills are not discounted. Services sector bills should not
be eligible for rediscounting.
Bank Credit Through Debt Instruments
During recent years, banks have resorted to granting large credit to the corporate
sector and the public sector undertakings by investing in their debt instruments like
bonds, debentures and commercial paper. Banks find excess liquidity with them in
the midst of low off take of credit, by the corporate sector. Taking advantage of such a
situation, companies prefer to raise funds by way of private placement of their
bonds, debentures and commercial paper. During 1998-99 roughly Rs. 35, 000 crore
was raised from debt instruments only through private placements. Most of this was
subscribed by the banks. Their outstanding investment in debt paper was Rs. 41,458
crore as at the end March, 1999 as against Rs. 28,378 crore a year earlier. Investment
in C.P.s stood at Rs. 4,033 crore at the end of March 1999. Thus
corporates have been able to raise funds from the investors (including banks) at
rates lower than the prime lending rates of banks.
Moreover, investment in debt instruments is not reckoned as bank credit and hence
16
does not entail bank’s obligation to grant advances to priority sectors based thereon.
Further, the relaxation granted by Reserve Bank of India in April 1997 to the banks to
invest in the bonds and debentures of private corporate sector without any limit, has
also contributed to the greater flow of bank credit through debt instruments.
Letter of Credit
Thus by issuing Letter of Credit on behalf of their customers, banks help them in
buying goods on credit from sellers who are quite unknown to them. The banker
issuing L/C undertakes an unconditional obligation upon himself, and charge a fee
for the same. L/Cs may be revocable or irrevocable. In the latter case, the
undertaking given by the banker cannot be revoked or withdrawn.
Bank Guarantee
3) Capital The borrower is also expected to have financial stake in the business,
because in case the business fails, the banker will be able to realise his money
out of the capital put in by the borrower. It is a sound principle of finance that
debt must be supported by sufficient equity.
The relative importance of the above factors differs from banker to banker and from
borrower to borrower. Banks are granting advances to technically qualified and
experienced entrepreneurs but they are required to put in a small amount as their own
capital. Reserve Bank of India has recently directed the banks to dispense with the
collateral requirement for loans upto Rs. 1 lakh. This limit has recently been further
increased to Rs. 5 lakh for the tiny sector.
Determination of credit worthiness of a borrower has become now a more scientific
exercise. Special institutions like rating companies such as CRISIL, ICRA, CARE,
have come on to the field and each of them has developed a methodology of its own.
This was discussed in earlier Block under Receivables Management in more detail.
Activity 9.3
1) Why do banks prefer Govt. and semi-govt. securities vis-à-vis Corporate
Securities for granting credit? Amongst the Corporate Securities why do they
prefer debt instruments?
9.10 SUMMARY
18
In this unit we have discussed the basic concepts, principles and practices of bank
credit as a source of working capital. Various forms in which bank credit is granted
viz. Overdrafts, loans, cash credit and discounting of bills etc. are discussed with
their merits and demerits. Different types of loans, and their classification on the
basis of security and guarantee have been explained. After explaining the various
modes of creating charge over the borrower’s assets, we have discussed merits and
demerits of different types of securities taken by banks. Purchase and discounting of
bills as a method of granting credit has been duly explained. Concept of credit
worthiness of the borrower has been clarified. In the end, the two important non-
fund based facilities such as letter of credit and guarantee given by banks have been
explained.
Cash Credit System: This is a method of granting credit by banks. Under this
method the bank prescribes a limit, called the Cash Credit limit, upto which the
customer is permitted to borrow against the security of tangible assets or guarantee.
The borrower may withdraw from the account as and when he needs money.
Surplus funds with him may be deposited with the banker any time. Thus, it is
running a/c with the banker, wherein withdrawals and deposits may be made
frequently in any number of times.
Loan: Under the Loan System of granting credit a definite amount is lent for a
specified period.
Bridge Loan: Bridge Loan is a short term loan which is usually granted to
industrial undertakings to enable them to meet their urgent needs. It is granted when
a term loan has already been sanctioned by a bank/financial institution, but its
disbursement takes some time or when the company is taking steps to raise funds for
the capital market. It is a type of interim finance.
Composite Loan: Those loans that are granted for both investment in capital
assets and for working capital purposes, are called composite loans.
Secured Loans: A secured loan is a loan made on the security of any tangible
asset
of the borrower. It means that a charge or right is created on the assets of the
borrower in favour of the lender. The value of the security must be equal to the
amount of the loan. If the former is less than the latter, it is called partly secured
loan. An advance without such security is called unsecured advance. In case of
secured loan the lender gets the right to realise his dues from the sale proceeds of the
security, if the borrower defaults.
Pledge: Pledge is a method of creating a charge over the movable assets of the
borrower in favour of the lender. Under the pledge , the movable assets of the
borrower are delivered to the banker as a security, which he will return back to the
borrower, after he repays the amount due from him in respect of principal and
interest.
Equitable Mortgage: In this type of mortgage the mortgagor hands over the
documents of title to the property to the mortgagee and thus an equitable interest of
the mortgagee is created in the property. If the mortgagor fails to repay the amount
of the loan, he may be asked to execute a legal mortgage in favour of the lender.
Lien: Lien is the right of the banker to retain all securities of the customer, until the
general balance due from him is not repaid.
Documents of title to goods: These are the documents which represent the
goods in the possession of some other person. For example a warehouse receipt or a
railway receipt. By endorsing such documents in favour of the banker, the borrower
entitles the banker to take delivery of the goods from the warehouse or railway, if he
does not repay the advance.
4. What are the different types of ventures that a bank can finance ? Does it
include a handcart operator selling vegetables ?
5. Discuss the different ways by which banks provide credit to business entities?
20
Appendix
Observation of RBI on Working Capital Cycles and Demand for Bank Credit
Working capital is critical for daily management of cash flows to settle bills, wages
and other variable costs. The working capital cycle is the period of time which
elapses between the point at which cash begins to be expended on the production of
a product and the collection of cash from sale of the product to its customers.
Typically, the cycle begins with the injection of cash which is utillised for making
payments to the suppliers of raw materials, workers, etc. Between each stage of this
working capital cycle, there is a time lag. The amplitude of the working capital cycle
depends on the type of activity. In general, careful management of working capital is
vital for any firm, particularly where the gestation lag between the production
process and realisation of the receivables is substantial in a situation when the firm
has incurred all expenditure associated with production but has not realised the value
of its product, it is imperative that the firm manages its cash flow carefully to stay
liquid and operational.
Working capital requirements can be financed from both internally generated re-
sources (selling current assets) and externally acquired alternatives (borrowing or
securing current assets). Mostly firms borrow on the strength of their current assets
and the major sources of funds include trade credits, accruals, short-term bank loans,
collateral papers, commercial papers and factoring accounts receivable. In a bank-
based financial system, the loan from the bank by a corporate takes form of line of
credit or overdraft. This is an arrangement between the bank and its customers with
respect to the maximum amount of unsecured credit the bank will permit the bor-
rower firm. Besides this arrangement, there are other forms of short-term financing
by raising resources directly from the market through issue of commercial paper.
In the Indian context, a major part of the working capital requirements are met by
bank credit. Typically, periods of spurt in industrial activity are associated with surges
in non-food bank credit, albeit, with some lag. These lags are more prolonged in a
production based business rather than in service providing firms. Commercial paper
(CP)has emerged as an important source of funding working capital needs; however
it is restricted to a few large companies with triple-A corporate ratings and does not
enjoy wider market acceptability. Thus, bank credit in the form of cash credit (CC)
and working capital demand loan (WCDL)continues to remain the principal source of
working capital requirements. An analysis of the data for large borrowers showed
that working capital credit which constituted nearly 65 per cent of the total bank
credit in mid-1990s, came down to nearly 55 per cent in 2002.
1
Financing Working
10.1 INTRODUCTION
In Unit 9, we have studied the principles of bank lending, the style of credit and the
securities taken by a banker from his customers. The basic task before the banker
remains how to assess the needs of a customer for bank credit, particularly for
meeting working capital needs. The need for bank credit depends upon a borrower’s
operating cycle i.e the period between the time of payment for purchase of raw
material and the time sale proceeds are realised in cash. In addition, it also depends
upon the level of inventories held by the borrowers in different forms-raw materials,
semi-manufactured goods and the finished goods. The credit terms offered by the
borrower to his customers and the collection efforts made by him also affect the
working capital needs. In short, a careful assessment of all these aspects is required
to be made by the banker to assess the working capital requirements of a customer.
Realising these drawbacks in the Cash Credit System, Reserve Bank of India
appointed a study group, under the chairmanship of Shri P.L. Tandon to frame
guidelines for the follow up of bank credit. Accepting the recommendations of
Tandon Study Group, Reserve Bank of India advised the banks in 1975 to follow a
reformed system of Cash Credit, which is known as ‘ Maximum Permissible Bank
Finance System’. In 1980, necessary modifications were made in the above in the
light of the recommendations of another working group known as ‘Chore
Committee’. The Maximum Permissible Bank Finance System (MPBF) was
substantially liberalized in 1993. Ultimately, in April 1997, the MPBF System was
made optional to the banks. Reserve Bank of India has permitted the banks to
follow any of the following methods for assessing the working capital requirements of
the borrower:
1) The Turnover Method for small borrowers, already enforced, may be continued
for this category of borrowers,
2) The Cash Budget System may be followed by banks for large borrowers who
prepare Cash Budget,
3) The existing Maximum Permissible Bank Finance System, may be retained , if
necessary, with modifications.
4) Any other system.
Thus sufficient operational flexibility has been given to the banks in their efforts to
assess working capital needs. But, on the other hand, compulsion has been enforced
on banks to introduce a compulsory loan component in bank credit and exposure
norms have been prescribed. In case of large borrowers flexibility is allowed to form
consortium or to go for syndication.
The main thrust of this system is on assessing the credit needs of a borrower on the
basis of holding of current assets, as per the prescribed norms. Initially, the
Committee suggested norms for holding various current assets for 15 industries.
Later on, almost all industries were covered. The norms were prescribed for various
current assets as follows:
These norms were to be treated as the maximum quantity of current assets to be held
Financing
by Working
a borrower. If a borrower had managed with less quantity in the past, he should
continue to do so. The norms were for the average level of holding of a particular
current asset and not for a particular item of a current asset. For most of the
industries a combined norm was prescribed for finished goods and receivables.
The objective of laying down the norms of inventories was to ensure that banks
assess the credit needs of a borrower on the basis of reasonable level of inventories
held as per the norms. Thus the credit granted was intended to be need- based.
However, the Reserve Bank permitted the banks to deviate from the norms in
specified circumstances.
In 1993, Reserve bank of India provided more flexibility to the banks in this regard.
Banks were permitted to make their own assessment of credit requirements of
borrowers based on their own study of the borrowers’ business operations i.e taking
into account the production/processing cycle of the industry as well as the financial
and other relevant parameters of the borrowers. Banks are now allowed to decide
the levels of holding of each item of inventory and receivables, which in their view
would represent a reasonable build up of current assets for being supported by bank
finance.
Reserve Bank of India now does not prescribe norms for each item of inventory and
receivables. Its role is now confined to advising the overall levels of inventories and
receivables of different industries for the guidance of the banks. The above guidelines
were made applicable to all borrowers enjoying aggregate fund-based working
capital limit of Rs. 2 crore and above from the banking system. (instead of Rs. 10
lakhs earlier) All borrowers enjoying aggregate fund based credit limits of up to Rs.
2 crore from the banking system were exempted from the above guidelines. Their
working capital needs are now assessed on the basis of projected Turnover Method
(which has been explained in a subsequent section in this unit) which was earlier
applicable to village and tiny industries and other small scale industries enjoying
fundbased working capital limits up to Rs. 50 lakhs.
2) Methods of Lending
The MPBF system permits the banks to finance only a portion of the borrowers’
working capital requirements from bank credit. The borrower is expected to depend
less and less on banks to finance his working capital needs. The Tandon Committee
suggested the following three methods of lending for determining the permissible level
of bank borrowing. It is to be noted that each successive method is intended to
increase progressively the involvement of long term funds comprising borrower’s
owned funds and term borrowings to support current assets. The three methods of
lending are as follows:
First Method of Lending: Under this method, banks have to work out the
working
capital gap by deducting current liabilities other than bank borrowings from the
current assets. Bank can provide a maximum credit upto 75 percent of working
capital gap. The balance is to be met by the own funds of the borrower and term
loans.
Second Method of Lending: Under this method, the borrower has to provide for
a
minimum of 25 percent of the total current assets out of long term funds i.e. own
funds plus term borrowings. After deducting current liabilities other than bank
borrowings from the rest of the current assets, the balance of current assets are to be
4
financed through bank borrowings. Thus the total current liabilities inclusive of bank
borrowing will not exceed 75 percent of current assets.
Third method of Lending: This is the same as the second method except one
difference. The core current assets, i.e. the permanent current assets which should
be financed from long term funds are deducted from the total current assets. Of the
balance of current assets, 25% are financed from long term sources and the rest out
of current liabilities including bank borrowings.
It is to be noted that the first method gives a minimum current ratio 1.17:1, while the
second method gives 1.3:1 and the third method 1.79:1
You can understand well calculation of the maximum permissible bank finance under
the three methods of lending from the following illustration:
You will note that the current ratio is higher in case of Method II as against Method I,
and still higher in case of Method III as against Method II.
Till 1993, Reserve Bank of India required the banks to follow the first method of
lending in case of borrowers enjoying fund-based working capital limits of Rs. 10
lakh and above and upto Rs. 50 lakh. For borrowers with high fund-based working
capital limits method II was to be applied.
In 1993, Method II was made applicable to all borrowers with aggregate fund based
working capital limits above Rs. 2 crore from the banking system. Borrowers with
5
credit limit upto Rs. 2 crore were to be sanctioned credit limits according to Projected
Turnover Method (discussed ahead)
The following credit facilities have been exempted from the application of Second
Method of lending:
Financing
a) Working
Borrowing units engaged in export activities.
Capital Needs
b) Additional credit needs of exporters arising out of firm orders/confirmed letters
of credit.
c) Borrowing units marketing/trading exclusively the products and merchandise
st
manufactured by village, tiny & small scale industrial units will be subject to 1
Method provided dues are settled by them within 30 days of supply.
d) Sick/weak units under rehabilitation.
3)
Style of Credit
The above directive was withdrawn by Reserve Bank of India in 1980. Subsequently
in 1995 Reserve Bank of India introduced a compulsory loan component in the
delivery of bank credit (which has been discussed in a subsequent section in this
unit).
The Chore Committee suggested significant modification in the MPBF System, which
were enforced by the Reserve Bank of India in December 1980. Hitherto credit
limits were sanctioned on the basis of peak level requirements of the borrowers, but
a portion of the same remained unutilized during the non-peak season. The MPBF
System was, therefore, modified so as to require the banks to fix credit limits for the
normal peak level and non-peak level requirements of the borrower separately.
These limits are to be fixed on the basis of the utilisation of such limits in the past.
The period during which they have to be utilised is also required to be specified.
Seasonal limits are required to be fixed in case of all agro-based industries and
consumer goods industries having seasonal demand. For other industries only one
limit is to be fixed.
Withdrawal of Funds
After the peak level and non- peak level credit limits are sanctioned by the banks as
stated above, the borrower is required to indicate, before the commencement of each
quarter, his expected requirements of funds in that quarter. Such requirements are
called the ‘operating limits’. Borrower is expected to withdraw funds from the
banks as per his requirements within the operating limit in that quarter subject to a
tolerance of 10% either way. Banks also require the borrower to submit monthly
stock statements to determine his drawing power within the operating limit. Hence
the actual amount availed of as bank credit will be the operating limit or the drawing
power, whichever is lower. If a borrower draws more than or less than these
tolerance limits, it must be considered as an irregularity in the account. In such
6
situation banks should take necessary corrective steps to avoid the repetition of such
irregularity in future.
Each borrower enjoying fund-based working capital limit of Rs. 2 crore or more is
required to submit to the banker the following two quarterly statements:
1) Statement giving estimates of production, sales, stock position and current
liabilities. (This statement is to be submitted in the week preceding the
commencement of the quarter to which it relates).
2) Statement showing actual performance in the quarter. This statement is to be
submitted within six weeks from the end of the quarter. In addition to these, the
borrowers are also required to submit half yearly operating statement and funds
flow statement, along with a half yearly balance sheet within 2 months from the
close of the half year.
Reserve Bank of India has also prescribed penalties for non-submission of the above
statements within the prescribed period as follows:
1) banks are permitted to invariably charge penal interest of at least 1 percent per
annum for a period of one quarter on the outstandings under various working
capital limits sanctioned to a borrower.
2) If the default is of a serious nature or persists for two consecutive quarters,
banks may consider charging a rate of interest higher than the normal lending
rate determined for a borrower on his entire outstanding, under the working
capital limits sanctioned, until such time as the position relating to timely
submission of various statements is regularised.
3) In case of continuous/persisting defaults, banks may further consider freezing
the operations in the account after giving due notice to the borrower.
4) Sick units which remain closed, and borrowers affected by political disturbances,
riots, natural calamities are excluded from the requirements of submission of
statements.
Commitment Charge
Banks are permitted to levy a minimum commitment charge of 1 percent per annum
on the unutilised portion of the working capital limits, subject to tolerance level of 15
percent of such limits. This is applicable incase of borrowing units with aggregate
fund-based working capital credit limits of Rs. 1 crore and above from the banking
system. The commitment charge will be exclusive of overall ceiling of 2 percent of
penal additional interest, as stipulated by the Reserve Bank of India.
The commitment charge will not apply to-
a) Drawing in excess of the operating limit
b) Working Capital limits sanctioned to sick/weak units
c) Limits sanctioned for export credit as well as against export incentives
d) Inland Bill limit
e) Credit limit granted to commercial banks, financial institutions and cooperative
banks.
Since 1993 banks are permitted to decide the quantum as also period of any ad-hoc
credit facilities based on their commercial judgement and merits of individual cases.
Banks will also have the discretion to decide about charging of interest for
sanctioning ad-hoc credit limits. 7
Activity 10.1
Capital Needs
1. As per Tandon Committee, the norms for stocks and receivables have been
as:
a) Raw material as so many months’ ----------
b) Stock
Financing in process
Working as so many months’ ----------
c) Finished goods as so many months’ ----------
d) Receivables as so many months’ ----------
2. Under the First Method of Lending the MPBF is equal to……….percent of…….
whereas under the Second Method it is …………of…………….
3. Give details of the two Quarterly Statements required to be submitted under
MPBF Method?
4) Work out the MPBF under three methods taking a live example.
The turnover method ensures adequate and timely flow of credit to the borrowers.
Under this method, norms of inventory and receivables and the first method of
lending are not applicable to the borrower. On the other hand, credit needs of the
borrower are assessed on the basis of their projected annual turnover(PAR), which
means projected gross scales inclusive of the excise duty. The following are the
steps to be followed under this method:
1) First, the projected sales of the borrower for the whole year are assessed. The
projection should be justified, reasonable, achievable and falling in line with the
past trend in the industry concerned. It can be ascertained by scrutinizing
annual statement of accounts, various returns filed, orders on hand and the
installed capacity of the unit, etc.
2) Banks should work out working capital requirements at a minimum level of
25% of the accepted turnover, assuming an average production/processing cycle
8 of 3 months.
3) Borrower should contribute 5% of the turnover as his margin or as Net Working
Capital
One of the important drawbacks of MPBF method is that the working capital limit is
limited to the accepted level of current assets, and not much significance is attached
to the cash flows of the borrowers. Sometimes the receivables remain unrealized for
longer period of time or inventories are accumulated for a longer period due to
peculiar nature of demand. Thus the borrowers face the liquidity problem which is
turn affects their production as need-based working capital limits taking into account
their cash flows, are not made available to them.
Under the Cash Budget Method, the entire funds requirements of a borrower are
taken into account. Payments which are not inevitable and which may be incurred
upon the availability of funds are not included. For example, payment of dividends,
unrelated investments, diversion for creation of fixed assets for forward/backward
integration are excluded from the total outflows. The Cash budget method thus helps
in arriving at need-based working capital limits. Thus this method avoids
accumulation of larger current assets than actual requirements, diversion of funds
because of availability of surplus funds and also prevents sickness of the business
units due to inadequate working capital funds. As the current assets are taken as
prime security for working capital limits, banks can restrict their exposure to the
extent of availability of the security. 9
The calculation of eligible bank finance under Cash Budget System is shown in the
chart below:
On the basis of the Cash Projections, quarterly Working Capital limits may be fixed.
For monitoring of the utilisation of credit limits, the bank may call for data periodically
i.e monthly, quarterly or half yearly, in addition to the balance sheet. If in a quarter
Financing Working
excess
Capitalfinance
Needs has been availed of, explanation may be called from the borrower and
a penal interest may be charged on the excess amount for the entire previous quarter to
enforce financial discipline.
I II III
IV
Sub total
_______
Sub total
-------
Add
2) Interest
6) Others:
c) Loans to employees
e) L.C. Payment
f) Contingencies
10
7) Outstanding Receivables
Total Fund Required Grand Total (A)
Sources of Funds
(Other than bank finance) Quarterly Projection
I II
III IV
1) Cash sales
2) Realisation from Receivables
(Previous Receivables plus credit sales)
minus outstanding Receivables)
3) Unsecured/Corporate loans taken
4) Public Deposits
5) Credit Purchases of Raw materials
Consumable stores and spares
6) Advances received from customers
7) Deposit from Dealers/selling agents
8) Incentives
1) Sales Tax
2) Export
3) Subsidy
4) Other Deferred payments
9) Other Incomes
a) Interest, commission
b) Sale of Scrap Assets
Total Funds Available Grand Total (B)
c.) Working Capital Gap (A-B)
d.) Minimum Margin
(25% of Working Capital Gap)
e) Net Working Capital
(Long term sources less Long Term uses)
f) Maximum Eligible Bank Finance
(c-d) or (c-e) whichever is less
Activity 10.2
1. Under the Turnover Method of assessing Working Capital needs, the credit limits
are fixed at........................ percent of....................
2. What types of payments are excluded from total Outflows under the Cash
Budget Method?
11
Capital Needs
Financing
3. How is Working
maximum eligible bank finance determined under the Cash Budget
Method?
1) Initially in April 1995, the loan component was made compulsory in case of
borrowers with maximum permissible bank finance of Rs. 20 crore and above.
In April 1996 it was extended to all borrowers with MPBF of Rs. 10 crore and
above. Since October 1997 the loan component for all borrowers having MPBF
of Rs. 10 crore and above has been uniformly prescribed at 80 percent of
MPBF. The cash credit portion has consequently been reduced to 20 percent. It
is mandatory for banks/ consortia/syndicate to restrict the cash credit component
as specified above.
2) For borrowers with working capital credit limits of less than Rs. 10 crore, the
Reserve Bank of India has permitted the banks to settle with their customers the
levels of loan and cash credit components. Such borrowers may like to avail of
bank credit in the form of loans because of lower rate of interest applicable on
loan component.
3) Reserve Bank has also permitted the banks to identify the business activities
which may be exempted from the loan system of delivery of bank credit on the
ground that such business activities are cyclical and seasonal in nature or have
inherent volatility and hence application of loan component may create
difficulties.
4) The minimum period of the loan for working capital purposes is to be fixed by
banks in consultation with the borrowers. Banks are also permitted to split the
loan component according to the needs of the borrowers with different maturities
for each segments and allow roll over of loans.
5) banks are permitted to fix their prime lending rate and spread over the prime
lending rate separately for loan component and cash credit component.
6) Reserve Bank of India has permitted that a borrower can avail of the loan
component for working capital purpose , at more than the specified level of
80% of MPBF. In such cases the cash credit component shall stand reduced. A
12 borrower can also draw the loan component first.
7) An ad hoc limit may be sanctioned only after the borrower has fully utilised the
cash credit and the loan components.
8) In case of consortium/syndicate, member banks should share the cash credit
component and the loan component on a pro rata basis depending upon their
individual share in MPBF.
9) Bill limit for inland bills should be carved out of the loan component.
10) The Reserve Bank has allowed the banks to permit the borrowers to invest their
short term/temporary surplus in short term money market instruments like
commercial paper, certificate of deposits and in term deposits with banks.
11) Export credit limit (both post-shipment and pre-shipment) are to be excluded
from MPBF for the purpose of bifurcation of credit limits into loan and cash
credit components.
The basic objective behind the bifurcation of credit limits into loan component
and
Cash Credit component is to bring about discipline in the utilisation of bank
credit
and to gain better control over the flow of credit. As you already know, there is no
financial discipline on the borrower in case of cash credit system —he may borrow
any amount within the operating limit at any time and may repay the same as per his
choice and convenience. The banker, therefore, remains unable to plan the
utilisation of his resources in advance and his earnings are affected, as he earns
interest on the actual amount utilised by the borrower. By introducing a compulsory
loan component which now accounts for the major part of bank credit, banks can
ensure that their resources are utilised for the full period of the loan and thus their
earnings are enhanced. Such a system will also compel the borrowers to resort to
planning in utilizing the funds.
Banks were allowed to fix their Prime Lending Rates and spread after taking into
consideration their cost of funds, transaction cost and minimum spread.
The lending rates of banks are at present completely deregulated. Banks prescribe
their own Prime Lending Rate for their best borrowers and a spread thereon. The
13
Prime Lending Rate happens to be the maximum rate for borrowers up to Rs. 2 lakh
each, whereas it is the minimum rate for all other borrowers. Since October 1997
banks have been permitted by the Reserve Bank of India to prescribe their Prime
Lending Rate for term loans of 3 years and above. In April 1999 banks have been
granted further freedom to operate different Prime Lending Rates for different
maturities. Banks are also permitted to offer fixed rate loans for project finance.
Financing Working
Capital Needs
Though the Reserve bank has granted freedom to the commercial banks to prescribe
their own Prime Leading Rates, the changes in the Bank Rate announced by the
Reserve Bank of India from time to time do exert their influence on the bank’s
decisions on their Prime Lending Rates. For instance, the reduction of Bank Rate by
Reserve Bank of India by one percentage point from 9% to 8% effective March 1,
1999 was immediately followed by similar reduction in the Prime Lending Rate of
State bank of India and all other commercial banks. The Reserve Bank of India has
thus made the bank rate a reference rate for other interest rates.
Interest Tax was charged @ 2% on the gross amount of interest earned by banks,
including the commitment charges and discount on promissory notes and bills of
exchange. Interest earned on Cash Reserves maintained with Reserve Bank of
India, discount on Treasury bills and interest on loans to other credit institutions was
not included in the income from interest for this purpose. Banks were permitted to
re-imburse themselves by making necessary adjustments in the interest charges.
Hence the real burden of this tax was borne by the borrowers themselves as credit
became costlier to them by the amount of interest tax.
1) The overall exposure to a single borrower shall not exceed 20% of the net
worth of the bank. The exposure ceiling has been reduced from 25% to 20%
effective April 1,2000. In case it exceeds 20% of capital funds as on
October 31, 1999, banks are expected to reduce it to 20% by end of October
2001, and
2) The overall exposure to a group of borrowers shall not exceed 50% of the net
worth of the bank.
For determining exposure to a single borrower/ group, credit facilities will include the
following:
14
a) Advances by way of loans, cash credit, overdrafts
b) Bill purchased/discounted
c) Investment in debentures,
d) Guarantees, letters of credit, co-acceptances, underwriting etc.
e) Investment in Commercial Paper
The non-fund based facilities shall be counted @ 50% of sanctioned limit and added
to total fund based limits.
While the Reserve Bank of India has granted flexibility to the banks to assess the
credit requirements of the borrowers as already noted, the above prudential norms
are to be invariably complied by the banks.
Sole banking i.e lending by a single bank to a large borrower, subject to the
resources available with it and limited to the exposure limits imposed by the
Reserve Bank of India. When the credit requirements of a borrower are beyond the
capacity of a single bank, the borrower may resort to multiple banking i.e borrowing
from a number of banks simultaneously and independent of each other, under
separate loan agreements with each of them. Securities are charged to them
separately.
Following the policy of liberalisation and deregulation in the financial sector, the
Reserve Bank of India decided in October 1996, that whenever a consortium is
formed either on a voluntary basis or on obligatory basis, the ground rules of the
consortium arrangement would be framed by the participating banks in the
consortium. These rules may relate to the following:
i) Number of participating banks
ii) Minimum share of each bank
15
iii) Entry into/exit from a consortium
Capital Needs
iv) Sanction of additional/ad hoc limit in emergency situation/contingencies by lead
bank/other banks
v) The fee to be charged by the lead bank for the services rendered by it
vi) Grant of
Financing any facility to the borrower by a non-member bank
Working
4) On the basis of the Information Memorandum each bank makes its own
independent economic and financial evaluation of the borrower. It may collect
additional information from other sources also.
7) The borrower is required to give prior notice to the Lead Manager or his agent
for drawing the loan amount so that the latter may tie up disbursement with the
other lending banks.
8) Under the system, the borrower has the freedom in terms of competitive pricing.
16
Discipline is also imposed through a fixed repayment period under syndicated
credit.
Activity 10.3
10.12 SUMMARY
In this unit we have dealt with the methods followed by banks for assessing the credit
needs of their borrowers for Working Capital. We have explained in detail the up-
dated version of the Maximum Permissible Bank Finance System (MPBF System)
as it prevailed as a mandatory prescription for banks till 1997. Since then they are
permitted to follow the alternative methods also. The Turnover Method and the
Cash Budget Method, as suggested by the Reserve Bank have been explained.
This unit also deals with the measures introduced by Reserve Bank of India to
discipline the big borrowers and to reduce the risks of the lending bankers.
Compulsory bifurcation of credit limits into loans and Cash Credit and introduction of
Prudential Norms for Exposure limits have been duly explained. Banks have also
been granted flexibility in forming consortium and syndicate to finance the credit
needs of big borrowers. The unit explains in detail these new dimensions in granting
bank credit.
Cash Budget Method: This method of assessing working capital needs has
been suggested for those large borrowers who prepare Cash Budget. Under this 17
method, the credit requirements of a borrower are assessed on the basis of his
projected cash inflows and outflows during a specific period of time.
Structure
11.1 Introduction
11.2 Public Deposits
11.3 Commercial Paper
11.4 Inter-Corporate Loans
11.5 Bonds and Debentures
11.6 Factoring of Receivables
11.7 Summary
11.8 Key Words
11.9 Self Assessment Questions
11.10 Further Readings
11.1 INTRODUCTION
Trade credit and commercial bank credit have been two important sources of
funds for financing working capital needs of companies in India, apart from the long
term source like equity shares. However, more stringent credit policies followed by
banks, tightening financial discipline imposed by them, and their higher cost, led the
companies to go in for new and innovative sources of finance. As the new equities
market has remained in a subdued condition and investor interest in the equities has
almost vanished during recent years, corporates have raised larger resources
through debt instruments, some of them being for as short a period as 18 months.
The situation has turned bouyant for corporates during 2002 and after for any type of
finance.
Raising short term and medium term debt by inviting and accepting deposits from the
investing public has become an established practice with a large number of
companies both in the private and public sectors. This is the outcome of the process
of dis-intermediation that is taking place in Indian economy. Similarly, issuance of
Commercial Paper by high net-worth Corporates enables them to raise short-term
funds directly from the investors at cheaper rates as compared to bank credit. In
practice, however, commercial banks have been the major investors in Commercial
Paper in India, implying thereby that bank credit flows to the corporate sector
19
through the route of CPs. Inter-Corporate loans and investments enable the cash
rich corporations to lend their surplus resources to those who need them for their
working capital purpose. Factoring of receivables is a relatively recent innovation
which enables the corporates to convert their receivables into liquidity within a
short period of time. In this unit we shall discuss the salient features of various
sources of Working
Financing non-bank finance and the regulatory framework evolved in respect of
them.
Capital Needs
In India, acceptance of deposits from the public is regulated by sections 58A and
58B of the Companies Act 1956, and the Companies (Acceptance of Deposits)
Rules, 1975. The above sections were inserted in the Companies Act in 1974 with
the objective to safeguard the interests of the depositors. The regulatory framework
in this regard is contained in the Companies Act and the Rules. Their important
provisions are stated below:
Sections 58A (1) empowers the Central Government, in consultation with the
Reserve Bank of India , to prescribe the limits up to which, the manner in which and
the conditions subject to which deposits may be invited or accepted by a company
either from the public or from its members. Such deposits are to be invited in
accordance with the rules made under this section and after insertion of an
advertisement issued by the company.
Section 58 (2) (c) which was inserted with effect from March 1, 1997 prohibits a
company which is in default in the repayment of any deposit or part thereof or any
interest thereupon, from accepting any further deposit.
The maximum limit upto which such deposits are allowed is 10% of the aggregate
paid up share capital and free reserves.
This category of deposits may be accepted to the extent of 25% of the aggregate
paid up capital and free reserves of the company.
20
For government companies, there is only one single limit of 35% of paid up capital
and free reserves for all such deposits.
a) in a current or other deposit account with any scheduled bank, free from charge
or lien,
b) in unencumbered securities of the central or state governments,
c) in unencumbered securities in which Trust funds may be invested under the
Indian Trust Act, 1882; or
d) in unencumbered bonds issued by Housing Development Finance Corporation
Ltd.
The securities referred to in clauses (b) or (c) shall be reckoned at their market
value. The amount deposited or invested as aforesaid shall not be utilised for any
other purpose than the repayment of deposits maturing during the year.
The Rules prescribe the maximum rate of interest payable on such deposits. At
present companies are allowed to pay interest not exceeding 15% per annum at
rates which shall not be shorter than monthly rests.
Companies are permitted to pay brokerage to any broker at the rate of 1% of the
deposits for a period of upto 1 year, 1½ % for a period more than 1 year but upto 2
years and 2% for a period exceeding 2 years. Such payment shall be on one time
basis.
Advertisement
Every company intending to invite or accept deposits from the public must issue an
advertisement for that purpose in a leading English newspaper and in one vernacular
newspaper circulating in the state in which the registered office of the company is
situated.
The advertisement must be issued on the authority and in the name of the Board of
Directors of the company. The advertisement must contain the conditions subject to
which deposits shall be accepted by the company and the date on which the Board of
Directors has approved the text of the advertisement. In addition, the
advertisement must contain the following information, namely:
The advertisement shall be valid until the expiry of six months from the date of
closure of the financial year in which it is issued or until the date on which the
balance sheet is laid before the company at its general meeting, or where Annual
General Meeting for any year has not been held, the latest day on which that meeting
should have been held as per the Companies Act, whichever is earlier. A fresh
advertisement is required to be made in each succeeding financial year.
Register of Deposits
Every company accepting deposits is required to keep as its registered office one or
more registers in which the following particulars about each depositor are to be
entered:
These registers shall be preserved by the company in good order for a period of not
less than eight years from the end of the financial year in which the latest entry is
made in the Register.
Repayment of Deposits
Deposits are accepted by companies for specified period say 12 months, 18 months,
24 months, etc. Companies prescribe different rates of interest for deposits for
different periods. Other terms and conditions are also prescribed by the companies
and interest is paid at the stipulated rate at the time of maturity of the deposit.
But, if a depositor desires repayment of the deposit, before the period stipulated in the
Receipt, companies are permitted to do so, but interest is to be paid at a lower rate.
Rules prescribe that if a company makes repayment of a deposit after the expiry of a
period of six months from the date of such deposit, but before the expiry of the period
for which such deposit was accepted by the company, the rate of interest payable by
the company shall be determined by reducing one percent from the rate which the
company would have paid had the deposit been accepted for the period for which the
deposit had run.
The rules also provide that if a company permits a depositor to renew the deposit,
before the expiry of the period for which such deposit was accepted by the company,
for availing of benefit of higher rate of interest, the company shall pay interest to such
depositor at higher rate, if
a) such deposit is renewed for a period longer than the unexpired period of the
deposit, and
b) the rate of interest as stipulated at the time of acceptance or renewal of a
deposit is reduced by one percent for the expired period of the deposit and is paid
or adjusted or recovered.
The Rules also stipulate that if the period for which the deposit had run contains any
part of a year, then if such part is less than six months, it shall be excluded and if part
is six months or more, it shall be reckoned as one year.
Return of Deposits
Every company accepting deposits is required to file with the Registrar every year
th st
before 30 June, a return in the prescribed form and giving information as on 31
March of the year. It should be duly certified by the auditor of the company. A copy of the same
shall also be filed with the Reserve Bank of India.
Penalties
st
Sub-section 9 and 10 of section 58 A, which were inserted with effect from 1
September 1989, provide a machinery for repayment of deposits on maturity and also
prescribes penalties for defaulting companies. According to sub-section (9), if a
company fails to repay any deposit or part thereof in accordance with the terms and
conditions of such deposit, the Company Law Board may, if it is satisfied, direct the
company to make repayment of such deposit forthwith or within such time or subject
to such conditions as may be specified in its order. The Company Law Board may
issue such order on its own or on the application of the depositor and shall give a
reasonable opportunity of being heard to the company and to other concerned
23
persons.
Capital Needs
Sub-section 10 prescribes penalty for non-compliance with the above order of the
Board. Whoever fails to comply with its order shall be punishable with imprisonment
which may extend to 3 years and shall also be liable to a fine of not less than Rs. 50
for every day during which such non-compliance continues.
Financing Working
The above rule shall not apply to those categories of amounts which may be specified
in consultation with Reserve Bank of India.
Section 58 A (6) stipulates penalties for accepting deposits in excess of the specified
limits. Where a company accepts deposits in excess of the limits prescribed or in
contravention of the manner or condition prescribed, the company shall be
punishable:
a) Where such contravention relates to the acceptance of any deposit, with fine
which shall not be less than an amount equal to the amount of the deposit
accepted,
b) Where such contravention relates to the invitation of any deposit, with fine which
may extend to Rs. 1 lakh, but not less than Rs. 5000.
Every officer of the company who is in default shall be punishable with imprisonment
for a term which may extend to 5 years and shall also be liable to fine.
According to section 194 A of the Income Tax Act, 1961, the companies accepting
public deposits are required to deduct income tax at source at the prescribed rates if
the aggregate interest paid or credited during a financial year exceeds Rs. 5000.
This limit has been recently (May 2000) raised from Rs. 2500 to Rs. 5000.
Activity 11.1
24
1) Fill in the blanks:
a) A company which ………………………………………………….. is
prohibited from accepting any further deposit.
b) The maximum period for which a company may accept deposit is
………….months.
c) The advertisement for deposit must give the profits of the company and
dividends declared during…………………………………financial years
immediately preceding the date of advertisement.
2) Can a company repay a deposit before the period stipulated in the Receipt?
Will the depositor suffer in such a case?
Companies (except the banking companies) which fulfil the following requirements
are permitted to issue CPs in the money market:
i) The minimum tangible net worth of the company is Rs. 4 crore as per the latest
audited balance sheet.
ii) The company has fund-based working capital limits of not less than Rs. 4 crore.
iii) The shares of the company are listed at one or more stock exchanges. Closely
held companies whose shares are not listed on any stock exchange are also
permitted to issue CPs provided all other conditions are fulfilled.
iv) The company has obtained minimum credit rating from a Credit rating agency
i.e. CP2 from Credit Rating Information Services of India Ltd., A2 from
Investment Information & Credit Rating Agency or PR2 from Credit Analysis
and Research.
Terms of Commercial Paper
The Commercial paper may be issued by the companies on the following terms and
25
conditions:
Capital Needs
a) The minimum period of maturity should be 15 days (It was reduced from 30 days
effective May 25, 1998) and the maximum period less than one year.
b) The minimum amount for which a CP is to be issued to a single investor in the
primary market should be Rs. 25 lakh and thereafter in multiple of Rs. 5 lakh. c)
Financing Working
CPs are to be issued in the form of usance promissory notes which are freely
transferable by endorsement and delivery.
d) CPs are to be issued at a discount to face value. The rate of discount is freely
determined by the issuing company and the investors.
e) The issuing company shall bear the dealers fee, rating agencies fee, and other
charges. Stamp duty shall also be applicable on CPs.
f) CPs may be issued to any person, corporate body incorporated in India, or even
unincorporated bodies. CPs may be issued to Non-resident Indians only on
nonrepatriation basis and such CPs shall not be transferable.
g) The issue of CP will not be underwritten or co-accepted by any individual or
institution.
h) There will be no grace period for payment. The holder of the CP shall present
the instrument for payment to the issuing company.
The amount for which the companies issue Commercial Paper is to be carved out of
the fund based working capital limit enjoyed by the company with its banker. The
maximum amount that can be raised through issue of commercial paper is equal to
100 percent of the fund based working capital limit. The latter is reduced pro-tanto
on the issuance of CP by the company. Effective October 19, 1996 the amount of
CP is permitted to be adjusted out of the loans or cash credit or both as per the
arrangement between the issuer of the CP and the concerned bank.
As stated above, the amount of CP is carved out of the borrower’s working capital
limit. Till October 1994 commercial banks were permitted to provide standby facility
to the issuers of CPs. It ensured the borrowers to draw on their cash credit limit in
case there was no roll-over of CP. Thus the repayment of the CP was ensured
automatically.
In October 1994 Reserve bank of India prohibited the banks to grant such stand-by-
facility. Accordingly, banks reduce the cash credit limit when CP is issued. If
subsequently, the issuer requires a higher cash credit limit, he shall have to approach
the bank for a fresh assessment of his requirement for the enhancement of credit
limit. Banks do not automatically restore the limit and consider the sanction of higher
limit afresh. In November 1997, Reserve Bank of India permitted the banks to
decide the manner in which restoration of working capital limit is to be done on
repayment of the CP if the corporate requests for restoration of such limit.
Commercial paper is being issued by corporates in India for about a decade now.
During this period the quantum of outstanding CPs has gradually increased. Till May
1997 the outstanding amount of CPs remained below the level of Rs. 1000 crore and
the rate of discount ranged above 11%. But since May 1997 the outstanding amount
has gradually increased and the discount rate remained much below 10%. During
the year 1998, Rs. 5249 crore were raised during the first fortnight of January 1998
and again in the second fortnight of August 1998 when discount rate ranged between
8.5 and 11%. Since May 1998, the level of outstanding CPs has gradually risen and
has touched the mark of Rs. 11153 crore in December 1998. Discount rate touched
the low range of 8.5 to 9% during this period. By the end of July 31, 2003, the
outstanding CPs stood at Rs.7,557 crore and the typical effective rates of discount
varied between 4.99% to 8.25%. Thus the corporates find the CP route far cheaper
than normal bank credit.
Banks continue to be the major investors in CPs as they find CPs of top-rated
companies very attractive, because of the excess liquidity situation they are presently
placed in. As on February 28, 1999, the outstanding investment by scheduled
commercial banks in CP amounted to Rs. 5367 crore with an effective discount rate
in the range of 10.2% to 13%. Outstanding investments in CPs steadily increased to
Rs. 7658 crore as on September 30.1999 due to easy liquidity.
The Reserve Bank of India has issued revised draft guidelines on July 6,2000 for the
issuance of commercial paper. The important changes proposed were:
i) Corporates are permitted to issue CP upto 50% of their working capital (fund-
based) under the automatic route, i.e. without prior clearance from the banks.
ii) CPs can be issued for wide range of maturities from 15 days to 1 year and can
be in denominations of Rs. 5 lakh or multiple there of.
iii) Financial Institutions may also issue CPs.
iv) Foreign instutional investors may invest in CPs. Within 30% limit set for their
investments in debt instruments
v) Credit rating again will decide the period of validity of the issue.
Further the aggregate of the loans made by the lending company to all other bodies
corporate shall not, except with the prior approval of the Central Government,
exceed.
a) Thirty percent of the aggregate of the subscribed capital of the lending company
and its free reserves, where all such other bodies are not under the same
management as the lending company.
b) Thirty percent of the aggregate of the subscribed capital of the lending company
and its free reserves, where all such corporates are under the same management
as the lending company.
Section 372 of the Companies Act laid down the limits for investment by a company
in the shares of another body corporate. Rules framed thereunder laid down that the
Board of Directors of a company shall be entitled to invest in the shares of any
other body corporate upto thirty percent of the subscribed equity share capital or the
aggregate of the paid up equity and preference share capital of such other body
corporate whichever is less. Permission of the Central Government was also
required in case the investment made by the Board of Directors in all other bodies
corporate exceed thirty percent of the aggregate of the subscribed capital and
reserves of the investing company.
The above provisions of Section 372 A will not apply to any loan made by a Holding
company to its wholly owned subsidiary or any guarantee given by the former in
respect of loan made to the latter or acquisition of securities of the subsidiary by the
holding company. Section 372 A Shall not apply to any loan, guarantee or investment
made by a banking company, an insurance company or a housing finance company or
a company whose principal business is the acquisition of shares, stocks, debentures
etc or which has the object of financing industrial enterprises or of providing infra
structural facilities.
The loan to any body corporate shall be made at a rate of interest not lower than the
Bank rate. A company which has defaulted in complying with the provisions of the
section 58A of the Companies Act, 1956 shall not be permitted to make inter-
corporate loans and investment till such default continues.
Companies making inter- corporate loans/ investment are required to keep a Register
showing the prescribed details of such loans/investments/guarantees. Such Register
shall be open for inspection and extracts may be taken therefrom. The provision of
the new section are not applicable to loans made by banking, insurance/housing
finance/investment company and a private company, unless it is subsidiary of a public
company.
If a default is made in complying with the provisions of section 372A, the company
and every officer of the company who is in default shall be punishable with
improvement upto 2 years or with fine upto Rs. 50,000/-.
Activity 11.2
29
Capital Needs
Financing Working
11.5 BONDS AND DEBENTURES
Bonds and debentures are another form of raising debt for augmenting funds for long
term purposes as well as for working capital. It has gained popularity during recent
years because of the depressed conditions in the new equities market and the
permission given to the banks to invest their funds in such bonds and debentures.
These debentures may be fully convertible, partly convertible, or non-convertible into
equity shares.
The salient points of the Guidelines issued by Securities and Exchange Board of
India (SEBI) in this regard are as follows:
Mechanism of Factoring
1) An agreement is entered into between the seller and the factor for rendering
factoring services.
2) After selling the goods to the buyer, the seller sends copy of invoice, delivery
challen, instructions to make payment to the factor, to the buyer and also to the
factor.
3) The factor makes payment of 80% or more of the amount of receivable to the
seller.
4) The seller should also execute a deed of assignment in favour of the factor to
enable him to recover amount from the buyer.
5) The seller should also obtain a letter of waiver from the banker in favour of the
factor, if the bank has charge over the asset sold to the buyer.
6) The seller should give a letter of confirmation that all conditions of the sale
transactions have been completed.
7) The seller should also confirm in writing that all payments receivable from the
debtor are free from any encumbrances, charge, right of set off or counter claim
from another person, etc.
8) The facility of factoring in India is available to all forms of business organisations
in manufacturing, service and trading. Sole proprietary concerns, partnership
firms and companies can avail of the services of factors, but a ceiling on the
credit which they can avail of in terms of the value of the invoice to be
purchased is generally fixed for each client in medium and small scale sectors.
32 Generally the period for which receivables are factored ranges between 30 and
90 days.
9) The factor evaluates the client on the basis of various criteria e.g. level of
receivables turnover, the quality of receivables, growth in sales, etc. The factor
charges a service fee and a discount. The service fee is charged in advance and
depends upon the invoice value for different categories of clients. It ranges
between 0.5-.2% of the invoice value.
Moreover, the factor also charges a discount on the pre-payment made to the client. It
is payable in arrears and is generally linked to the bank lending rate. In case of high
worth clients, the discount rate is presently one percent point lower than the rate
charged under the cash credit system.
The cost of funds under, without recourse, factoring is much higher than, with
recourse, factoring due to the credit risk borne by the factor. However, the service
fee and discount charge depends upon the cost of funds and the operational cost.
Activity 11.3
2) State the conditions under which it is not necessary for a company to issue debt
instruments without submitting proposals or letter of offer to SEBI.
11.7 SUMMARY
In this unit, we have discussed various sources of short term funds, other than bank
credit and trade credit which are used by business and industrial houses in India to
finance their working capital needs. The unit covers public deposits, commercial
paper, inter-corporate loans, bonds and debentures and factoring of receivables. The
statutory framework, along with rules and regulations concerning these sources have
been explained in detail. Relative significance of these sources has also been
explained by citing relevant facts and figures. Though these sources are deemed as
non-bank sources of finance, involvement of commercial banks in providing such
finance is evident, specially in case of commercial paper, bonds and debentures and
factoring of receivables.
33
Financing Working
Capital Needs 11.8 KEY WORDS
Public Deposits: Public deposits are deposits of money accepted by
companies in India from the public for specified period ranging between 3 months and
36 months. These deposit are accepted within the limit and subject to terms
prescribed under Companies( Acceptance of Deposits) Rule , 1975.
high net worth corporates borrow funds from any person, corporate or
unincorporated body. It is issued in the form of usance promissory note; which is
freely transferable by endorsement and delivery. Its minimum period of maturity
should be 15 days and maximum period less then a year, It is issued at a discount
to face value.
Put and Call Options: The debt instruments like bonds and debentures are
issued
for a fixed period of time-i.e. they are redeemable at the expiry of a fixed period
say 5 or 7 years. But sometimes the issuer includes the ‘put’ or/and ‘call’ options
in the terms of issue. ‘Put’ option means that the investor may, if he so desires ask
for the redemption of the bond after a specified period is over but before the period
of maturity. If the issuer reserves this right to himself to redeem the bond after a
specific minimum period but before the date of maturity, such right is called ‘call’
option.
With Recourse and without Recourse Factoring : When the factor bears the
loss arising out of non-payment of the dues by the buyer, it is called without recourse
factoring. In case of ‘With Recourse Factoring’ he can recover the loss from the
client (seller).
35
Indira Gandhi National Open University MS-41
School of Management Studies
Working Capital
Management
3
UNIT 11 OTHER SOURCES OF SHORT
TERM FINANCE
Objectives
Structure
11.1 Introduction
11.2 Public Deposits
11.3 Commercial Paper
11.4 Inter-Corporate Loans
11.5 Bonds and Debentures
11.6 Factoring of Receivables
11.7 Summary
11.8 Key Words
11.9 Self Assessment Questions
11.10 Further Readings
11.1 INTRODUCTION
Trade credit and commercial bank credit have been two important sources of
funds for financing working capital needs of companies in India, apart from the long
term source like equity shares. However, more stringent credit policies followed by
banks, tightening financial discipline imposed by them, and their higher cost, led the
companies to go in for new and innovative sources of finance. As the new equities
market has remained in a subdued condition and investor interest in the equities has
almost vanished during recent years, corporates have raised larger resources
through debt instruments, some of them being for as short a period as 18 months.
The situation has turned bouyant for corporates during 2002 and after for any type of
finance.
Raising short term and medium term debt by inviting and accepting deposits from the
investing public has become an established practice with a large number of
companies both in the private and public sectors. This is the outcome of the process
of dis-intermediation that is taking place in Indian economy. Similarly, issuance of
Commercial Paper by high net-worth Corporates enables them to raise short-term
funds directly from the investors at cheaper rates as compared to bank credit. In
practice, however, commercial banks have been the major investors in Commercial
Paper in India, implying thereby that bank credit flows to the corporate sector
through the route of CPs. Inter-Corporate loans and investments enable the cash
rich corporations to lend their surplus resources to those who need them for their
working capital purpose. Factoring of receivables is a relatively recent innovation
which enables the corporates to convert their receivables into liquidity within a
short period of time. In this unit we shall discuss the salient features of various
sources of non-bank finance and the regulatory framework evolved in respect of
them.
1
Financing Working
Capital Needs 11.2 PUBLIC DEPOSITS
Public deposits are unsecured deposits accepted by companies for specific periods
and at specific rates of interest. These deposits have acquired prominence as a
source of finance for the companies, as it is more convenient and cheaper to mobilise
short term finance through such deposits. Public deposits provide a fine example of
dis-intermediation, as the borrower directly accepts the deposits from the lenders, of
course with the help of brokers.
In India, acceptance of deposits from the public is regulated by sections 58A and
58B of the Companies Act 1956, and the Companies (Acceptance of Deposits)
Rules, 1975. The above sections were inserted in the Companies Act in 1974 with
the objective to safeguard the interests of the depositors. The regulatory framework
in this regard is contained in the Companies Act and the Rules. Their important
provisions are stated below:
Sections 58A (1) empowers the Central Government, in consultation with the
Reserve Bank of India , to prescribe the limits up to which, the manner in which and
the conditions subject to which deposits may be invited or accepted by a company
either from the public or from its members. Such deposits are to be invited in
accordance with the rules made under this section and after insertion of an
advertisement issued by the company.
Section 58 (2) (c) which was inserted with effect from March 1, 1997 prohibits a
company which is in default in the repayment of any deposit or part thereof or any
interest thereupon, from accepting any further deposit.
The maximum limit upto which such deposits are allowed is 10% of the aggregate
paid up share capital and free reserves.
This category of deposits may be accepted to the extent of 25% of the aggregate
paid up capital and free reserves of the company.
For government companies, there is only one single limit of 35% of paid up capital
and free reserves for all such deposits.
a) in a current or other deposit account with any scheduled bank, free from charge
or lien,
b) in unencumbered securities of the central or state governments,
c) in unencumbered securities in which Trust funds may be invested under the
Indian Trust Act, 1882; or
d) in unencumbered bonds issued by Housing Development Finance Corporation
Ltd.
The securities referred to in clauses (b) or (c) shall be reckoned at their market
value. The amount deposited or invested as aforesaid shall not be utilised for any
other purpose than the repayment of deposits maturing during the year.
The Rules prescribe the maximum rate of interest payable on such deposits. At
present companies are allowed to pay interest not exceeding 15% per annum at
rates which shall not be shorter than monthly rests.
Companies are permitted to pay brokerage to any broker at the rate of 1% of the
deposits for a period of upto 1 year, 1½ % for a period more than 1 year but upto 2
years and 2% for a period exceeding 2 years. Such payment shall be on one time
basis.
Advertisement
Every company intending to invite or accept deposits from the public must issue an
advertisement for that purpose in a leading English newspaper and in one vernacular
newspaper circulating in the state in which the registered office of the company is
situated.
The advertisement must be issued on the authority and in the name of the Board of
Directors of the company. The advertisement must contain the conditions subject to
which deposits shall be accepted by the company and the date on which the Board of
Directors has approved the text of the advertisement. In addition, the
advertisement must contain the following information, namely:
The advertisement shall be valid until the expiry of six months from the date of
closure of the financial year in which it is issued or until the date on which the
balance sheet is laid before the company at its general meeting, or where Annual
General Meeting for any year has not been held, the latest day on which that meeting
should have been held as per the Companies Act, whichever is earlier. A fresh
advertisement is required to be made in each succeeding financial year.
Register of Deposits
Every company accepting deposits is required to keep as its registered office one or
more registers in which the following particulars about each depositor are to be
entered:
These registers shall be preserved by the company in good order for a period of not
4
less than eight years from the end of the financial year in which the latest entry is
made in the Register.
Repayment of Deposits
Deposits are accepted by companies for specified period say 12 months, 18 months,
24 months, etc. Companies prescribe different rates of interest for deposits for
different periods. Other terms and conditions are also prescribed by the companies
and interest is paid at the stipulated rate at the time of maturity of the deposit.
But, if a depositor desires repayment of the deposit, before the period stipulated in the
Receipt, companies are permitted to do so, but interest is to be paid at a lower rate.
Rules prescribe that if a company makes repayment of a deposit after the expiry of a
period of six months from the date of such deposit, but before the expiry of the period
for which such deposit was accepted by the company, the rate of interest payable by
the company shall be determined by reducing one percent from the rate which the
company would have paid had the deposit been accepted for the period for which the
deposit had run.
The rules also provide that if a company permits a depositor to renew the deposit,
before the expiry of the period for which such deposit was accepted by the company,
for availing of benefit of higher rate of interest, the company shall pay interest to such
depositor at higher rate, if
a) such deposit is renewed for a period longer than the unexpired period of the
deposit, and
b) the rate of interest as stipulated at the time of acceptance or renewal of a
deposit is reduced by one percent for the expired period of the deposit and is paid
or adjusted or recovered.
The Rules also stipulate that if the period for which the deposit had run contains any
part of a year, then if such part is less than six months, it shall be excluded and if part
is six months or more, it shall be reckoned as one year.
Return of Deposits
Every company accepting deposits is required to file with the Registrar every year
th st
before 30 June, a return in the prescribed form and giving information as on 31
March of the year. It should be duly certified by the auditor of the company. A copy of the same
shall also be filed with the Reserve Bank of India.
Penalties
st
Sub-section 9 and 10 of section 58 A, which were inserted with effect from 1
September 1989, provide a machinery for repayment of deposits on maturity and also
prescribes penalties for defaulting companies. According to sub-section (9), if a
company fails to repay any deposit or part thereof in accordance with the terms and
conditions of such deposit, the Company Law Board may, if it is satisfied, direct the
company to make repayment of such deposit forthwith or within such time or subject
to such conditions as may be specified in its order. The Company Law Board may
issue such order on its own or on the application of the depositor and shall give a
reasonable opportunity of being heard to the company and to other concerned
persons.
Sub-section 10 prescribes penalty for non-compliance with the above order of the
Board. Whoever fails to comply with its order shall be punishable with imprisonment which may
extend to 3 years and shall also be liable to a fine of not less than Rs. 50 for every day during
which such non-compliance continues.
5
The above rule shall not apply to those categories of amounts which may be specified
in consultation with Reserve Bank of India.
Section 58 A (6) stipulates penalties for accepting deposits in excess of the specified
limits. Where a company accepts deposits in excess of the limits prescribed or in
contravention of the manner or condition prescribed, the company shall be
Financing Working
punishable:
Capital Needs
a) Where such contravention relates to the acceptance of any deposit, with fine
which shall not be less than an amount equal to the amount of the deposit
accepted,
b) Where such contravention relates to the invitation of any deposit, with fine which
may extend to Rs. 1 lakh, but not less than Rs. 5000.
Every officer of the company who is in default shall be punishable with imprisonment
for a term which may extend to 5 years and shall also be liable to fine.
According to section 194 A of the Income Tax Act, 1961, the companies accepting
public deposits are required to deduct income tax at source at the prescribed rates if
the aggregate interest paid or credited during a financial year exceeds Rs. 5000.
This limit has been recently (May 2000) raised from Rs. 2500 to Rs. 5000.
Activity 11.1
Companies (except the banking companies) which fulfil the following requirements
are permitted to issue CPs in the money market:
i) The minimum tangible net worth of the company is Rs. 4 crore as per the latest
audited balance sheet.
ii) The company has fund-based working capital limits of not less than Rs. 4 crore.
iii) The shares of the company are listed at one or more stock exchanges. Closely
held companies whose shares are not listed on any stock exchange are also
permitted to issue CPs provided all other conditions are fulfilled.
iv) The company has obtained minimum credit rating from a Credit rating agency
i.e. CP2 from Credit Rating Information Services of India Ltd., A2 from
Investment Information & Credit Rating Agency or PR2 from Credit Analysis
and Research.
Terms of Commercial Paper
The Commercial paper may be issued by the companies on the following terms and
conditions:
a) The minimum period of maturity should be 15 days (It was reduced from 30 days
effective May 25, 1998) and the maximum period less than one year.
b) The minimum amount for which a CP is to be issued to a single investor in the
primary market should be Rs. 25 lakh and thereafter in multiple of Rs. 5 lakh.
7
c) CPs are to be issued in the form of usance promissory notes which are freely
transferable by endorsement and delivery.
d) CPs are to be issued at a discount to face value. The rate of discount is freely
determined by the issuing company and the investors.
e) The issuing company shall bear the dealers fee, rating agencies fee, and other
Financing Working
charges.
Capital NeedsStamp duty shall also be applicable on CPs.
f) CPs may be issued to any person, corporate body incorporated in India, or even
unincorporated bodies. CPs may be issued to Non-resident Indians only on non-
repatriation basis and such CPs shall not be transferable.
g) The issue of CP will not be underwritten or co-accepted by any individual or
institution.
h) There will be no grace period for payment. The holder of the CP shall present
the instrument for payment to the issuing company.
The amount for which the companies issue Commercial Paper is to be carved out of
the fund based working capital limit enjoyed by the company with its banker. The
maximum amount that can be raised through issue of commercial paper is equal to
100 percent of the fund based working capital limit. The latter is reduced pro-tanto
on the issuance of CP by the company. Effective October 19, 1996 the amount of
CP is permitted to be adjusted out of the loans or cash credit or both as per the
arrangement between the issuer of the CP and the concerned bank.
As stated above, the amount of CP is carved out of the borrower’s working capital
limit. Till October 1994 commercial banks were permitted to provide standby facility
to the issuers of CPs. It ensured the borrowers to draw on their cash credit limit in
case there was no roll-over of CP. Thus the repayment of the CP was ensured
automatically.
In October 1994 Reserve bank of India prohibited the banks to grant such stand-by-
facility. Accordingly, banks reduce the cash credit limit when CP is issued. If
subsequently, the issuer requires a higher cash credit limit, he shall have to approach
the bank for a fresh assessment of his requirement for the enhancement of credit
limit. Banks do not automatically restore the limit and consider the sanction of higher
limit afresh. In November 1997, Reserve Bank of India permitted the banks to
decide the manner in which restoration of working capital limit is to be done on
repayment of the CP if the corporate requests for restoration of such limit.
Commercial paper is being issued by corporates in India for about a decade now.
During this period the quantum of outstanding CPs has gradually increased. Till May
1997 the outstanding amount of CPs remained below the level of Rs. 1000 crore and
the rate of discount ranged above 11%. But since May 1997 the outstanding amount
has gradually increased and the discount rate remained much below 10%. During
the year 1998, Rs. 5249 crore were raised during the first fortnight of January 1998
and again in the second fortnight of August 1998 when discount rate ranged between
8.5 and 11%. Since May 1998, the level of outstanding CPs has gradually risen and
has touched the mark of Rs. 11153 crore in December 1998. Discount rate touched
the low range of 8.5 to 9% during this period. By the end of July 31, 2003, the
outstanding CPs stood at Rs.7,557 crore and the typical effective rates of discount
varied between 4.99% to 8.25%. Thus the corporates find the CP route far cheaper
than normal bank credit.
Banks continue to be the major investors in CPs as they find CPs of top-rated
companies very attractive, because of the excess liquidity situation they are presently
placed in. As on February 28, 1999, the outstanding investment by scheduled
commercial banks in CP amounted to Rs. 5367 crore with an effective discount rate
in the range of 10.2% to 13%. Outstanding investments in CPs steadily increased to
Rs. 7658 crore as on September 30.1999 due to easy liquidity.
The Reserve Bank of India has issued revised draft guidelines on July 6,2000 for the
issuance of commercial paper. The important changes proposed were:
i) Corporates are permitted to issue CP upto 50% of their working capital (fund-
based) under the automatic route, i.e. without prior clearance from the banks.
ii) CPs can be issued for wide range of maturities from 15 days to 1 year and can
be in denominations of Rs. 5 lakh or multiple there of.
iii) Financial Institutions may also issue CPs.
iv) Foreign instutional investors may invest in CPs. Within 30% limit set for their
investments in debt instruments
v) Credit rating again will decide the period of validity of the issue.
Further the aggregate of the loans made by the lending company to all other bodies
corporate shall not, except with the prior approval of the Central Government,
exceed.
a) Thirty percent of the aggregate of the subscribed capital of the lending company
and its free reserves, where all such other bodies are not under the same
management as the lending company.
b) Thirty percent of the aggregate of the subscribed capital of the lending company
and its free reserves, where all such corporates are under the same management
as the lending company.
Section 372 of the Companies Act laid down the limits for investment by a company
in the shares of another body corporate. Rules framed thereunder laid down that the
Board of Directors of a company shall be entitled to invest in the shares of any
other body corporate upto thirty percent of the subscribed equity share capital or the
aggregate of the paid up equity and preference share capital of such other body
corporate whichever is less. Permission of the Central Government was also
required in case the investment made by the Board of Directors in all other bodies
corporate exceed thirty percent of the aggregate of the subscribed capital and
reserves of the investing company.
The above provisions of Section 372 A will not apply to any loan made by a Holding
company to its wholly owned subsidiary or any guarantee given by the former in
respect of loan made to the latter or acquisition of securities of the subsidiary by the
holding company. Section 372 A Shall not apply to any loan, guarantee or investment
made by a banking company, an insurance company or a housing finance company or
a company whose principal business is the acquisition of shares, stocks, debentures
etc or which has the object of financing industrial enterprises or of providing infra
structural facilities.
The loan to any body corporate shall be made at a rate of interest not lower than the
Bank rate. A company which has defaulted in complying with the provisions of the
section 58A of the Companies Act, 1956 shall not be permitted to make inter-
corporate loans and investment till such default continues.
Companies making inter- corporate loans/ investment are required to keep a Register
showing the prescribed details of such loans/investments/guarantees. Such Register
shall be open for inspection and extracts may be taken therefrom. The provision of
the new section are not applicable to loans made by banking, insurance/housing
finance/investment company and a private company, unless it is subsidiary of a public
company.
If a default is made in complying with the provisions of section 372A, the company
and every officer of the company who is in default shall be punishable with
improvement upto 2 years or with fine upto Rs. 50,000/-.
Activity 11.2
11
Financing Working
Capital Needs 11.5 BONDS AND DEBENTURES
Bonds and debentures are another form of raising debt for augmenting funds for long
term purposes as well as for working capital. It has gained popularity during recent
years because of the depressed conditions in the new equities market and the
permission given to the banks to invest their funds in such bonds and debentures.
These debentures may be fully convertible, partly convertible, or non-convertible into
equity shares.
The salient points of the Guidelines issued by Securities and Exchange Board of
India (SEBI) in this regard are as follows:
12) The disclosure relating to raising of debenture will contain amongst other things
a) The existing and future equity and long term debt ratio,
b) Servicing behaviour of existing debentures,
c) Payment of interest due on due dates on term loans and debentures
12
d) Certificate from a financial institution or bankers about their no objection for a
second or pari passu charge being created in favour of the trustees to the
proposed debenture issue.
13) Companies which issue debt instruments through an offer document can issue
the same without submitting the prospectus or letter of offer for vetting to SEBI
or obtaining an acknowledgement card from SEBI in respect of the said issue,
provided the:
a) Company’s securities are already listed on any stock exchange
b) Company has obtained atleast an ‘adequately safe’ credit rating for its
issue of debt instrument from a credit rating agency.
c) The debt instrument is not convertible, is not issued along with any other
security or, without any warrant with an option to convert into equity
shares.
14) In such cases a category I Merchant bank shall be appointed to manage the
issue and to submit the offer document to SEBI. The Merchant banker acting as
Lead Manager should ensure that the document for the issue of debt instrument
contains the required disclosure and gives a true, correct and fair view of the
state of affairs of the company. The merchant banker will also submit a due
diligence certificate to SEBI.
15) The debentures of a company can be listed at a Stock Exchange, even if its
equity shares are not listed.
16) The trustees to the Debenture issue shall have the power to protect the interest
of debenture holders. They can appoint a nominee director on the Board of the
company in consultation with institutional debenture holders.
17) The lead bank will monitor the utilisation of funds raised through debentures for
working capital purposes. In case the debentures are issued for capital
investment purpose, this task of monitoring will be performed by lead Institution/
Investment Institution.
18) In case of debentures for working capital, institutional debenture holders and
trustees should obtain a certificate from the company’s auditors regarding
utilisation of funds at the end of each accounting year.
19) Company should not issue debentures for acquisition of shares or for providing
loans to any company belonging to the same group. This restriction does not
apply to the issue of fully convertible debentures provided conversion is allowed
within a period of 18 months.
20) Companies are required to file with SEBI certificate from their bankers that the
assets on which security is to be created are free from any encumbrances and
necessary permission to mortgage the assets have been obtained or a No
objection from the financial institutions/ banks for a second or pari passu charge
has been obtained, where the assets are encumbered.
The cost of funds under, without recourse, factoring is much higher than, with
recourse, factoring due to the credit risk borne by the factor. However, the service
fee and discount charge depends upon the cost of funds and the operational cost.
Activity 11.3
2) State the conditions under which it is not necessary for a company to issue debt
instruments without submitting proposals or letter of offer to SEBI.
11.7 SUMMARY
In this unit, we have discussed various sources of short term funds, other than bank
credit and trade credit which are used by business and industrial houses in India to
finance their working capital needs. The unit covers public deposits, commercial
paper, inter-corporate loans, bonds and debentures and factoring of receivables. The
statutory framework, along with rules and regulations concerning these sources have
been explained in detail. Relative significance of these sources has also been
explained by citing relevant facts and figures. Though these sources are deemed as
non-bank sources of finance, involvement of commercial banks in providing such
finance is evident, specially in case of commercial paper, bonds and debentures and
factoring of receivables.
15
Commercial Paper: Commercial paper is an unsecured instrument through which
high net worth corporates borrow funds from any person, corporate or
unincorporated body. It is issued in the form of usance promissory note; which is
freely transferable by endorsement and delivery. Its minimum period of maturity
should be 15 days and maximum period less then a year, It is issued at a discount
Financing Working
to
Capitalvalue.
face Needs
Put and Call Options: The debt instruments like bonds and debentures are
issued
for a fixed period of time-i.e. they are redeemable at the expiry of a fixed period
say 5 or 7 years. But sometimes the issuer includes the ‘put’ or/and ‘call’ options
in the terms of issue. ‘Put’ option means that the investor may, if he so desires ask
for the redemption of the bond after a specified period is over but before the period
of maturity. If the issuer reserves this right to himself to redeem the bond after a
specific minimum period but before the date of maturity, such right is called ‘call’
option.
With Recourse and without Recourse Factoring : When the factor bears the
loss arising out of non-payment of the dues by the buyer, it is called without recourse
factoring. In case of ‘With Recourse Factoring’ he can recover the loss from the
client (seller).
12.1 INTRODUCTION
As per the accountants, working capital is a liquidation concept. Whether the firm
will be able to pay off its debts using its cash flows is more important than what level
of current or non-current assets it maintains. Viewed thus, the difference between
current assets and current liabilities is more important than the size of investment
either in current assets or current liabilities. The efficiency of working capital
management finally depends upon the liquidity that is maintained by the firm. Though
several other factors may decide the liquidity of a firm, changes in the cash flows
consequent upon the changes in working capital items are highly pertinent. If cash
flows were certain, less working capital would be required, usually, the problem stems
from the difficulty in forecasting inflows, vis-à-vis outflows.
Short-term liquidity implies the capacity of the undertaking, to repay the short-term
debt, which means the same as the ability of the firm in meeting the currently
maturing obligations form out of the current assets. The purpose of the short-term
analysis is to derive a picture of the capacity of the firm to meet its short-term
5
Working Capital obligations out of its short-term resources, that is, to estimate the risk of supplying
Management: An short-term capital to the firm.
Integrated View
Analysis of the firm’s long-term position has for its rationale, the delineation of the
ability of a firm to meet its long-term financial obligations such as interest and
dividend payment and repayment of principal. Long-term liquidity refers to the ability
of the firm to retire long-term debt and interest and other long-run obligations. When
relationships are established along these lines, it is assumed that in the long-run assets
could be liquidated to meet the financial claims of the firm. Quite often the
expression ‘liquidity’ is used to mean short-term liquidity of the companies.
In the present study, liquidity is taken to mean the short-term liquidity which refers to
the ability of the undertakings to pay of current liabilities. This is chosen because the
study is related to the management of short-term assets and liabilities. Further, the
concept of short-term liquidity is more suited to enterprises that have a remote
possibility of becoming insolvent. In other words, the long-run success of an
undertaking lies in its ability to survive in the immediate future. Further, a company
may have tremendous potential for profitability in the long-run, but may languish due
to inadequate liquidity. It is, therefore, short-term liquidity that has been considered
crucial to the very existence of an enterprise.
The first method of computation of liquidity is based on the assumption that the firm
might become insolvent at any time and whether, in such an event, the current assets
held by the undertakings would be sufficient to pay-off the current liabilities. On the
other hand, the computation of ‘operational liquidity’ attempts the measurement of the
firm’s potential to meet the current obligations on the basis of net cash flows
originating from out of its own operations; with the view that a manufacturing
enterprise cannot pay off current liabilities from it current assets when it is in the run.
It is assumed under this approach the firms are going firms and hence the liabilities
are met through the net cash flows arising out of their operations.
Current ratio expresses the precise relation between current assets and current
liabilities. It is calculated by dividing current assets with current liabilities.
It indicates the availability of current assets in rupees for every one rupee of current
liabilities. A high ratio means that the firm has more investment in current assets.
While a low ratio indicates that the firm in question is unable to retire its current
liabilities, In fact, a satisfactory current ratio for any given firm is difficult to judge.
For most manufacturing undertakings, a ratio of 2 : 1 is traditionally considered a
bench-mark of adequate liquidity. However, in some of the undertakings like public
utilities and service firms, this standard ratio is not particularly useful as they carry no
inventories for sale.
6
Current ratio is equally useful to both the outsiders and the management. To an Integrating Working
outsider, it is a measure of the firm’s ability to meet its short-term claims. So far as Capital
and Capital
the management is concerned, the ratio discloses the magnitude of the current assets Investment
that the firm carries in relation to its current liabilities. As regards the outsider, the Processe
larger the ratio, the more liquid is the firm. But, from the management point of view, a s
larger ratio indicates excess investment in less profit-generating assets. On the
contrary, a low current ratio or downward trend in the ratio indicates the inefficient
management of working capital.
Nevertheless, the current ratio is a crude and quick measure of the firm’s liquidity as it
is only a test of the quantity and not the quality. The limitation of this ratio as an
indicator of liquidity lies in the size of the inventory of the enterprise. If inventory
forms a high proportion of current assets, the 2:1 ratio might not be adequate, as a
meaningful measure of liquidity.
Quick or Acid-test Ratio
Recognising that inventory might not be very liquid or slow moving, this ratio takes
the quickly realisable assets and measures them against current liabilities. This is a
more refined of somewhat conservative estimate of the firm’s liquidity, since it
establishes a relation between quick or liquid assets and current liabilities. To be
precise, a quick asset is one that can be converted into cash immediately or
reasonably soon without loss of value, for instance, cash is the most liquid of all assets.
The other assets which are considered to be relatively liquid and included in the quick
category are accounts and bills receivable and marketable securities. Inventory and
period expenses are considered to be less liquid. Inventories normally require some
time for realising into cash. The quick ratio is, then, expressed as a relation between
quick assets and current liabilities, as:
Quick Ratio = Quick assets/Current liabilities ; or
__
= Current assets Inventories/Current liabilities.
Conventionally, a quick ratio of 1 : 1 is considered to be a more satisfactory measure of
liquidity position of an enterprise. In fact, this ratio does not entirely supplant the
current ratio; rather, it partially supplements current ratio and when used in
conjunction with it, tends to give a better picture of the firm’s ability to meet its claims
out of short-term assets.
Absolute Liquidity Ratio
Absolute liquidity ratio is the refinement of the concept of eliminating inventory as
liquid asset in the acid-test ratio, because of their uncertain value at the time of
liquidation. Although receivables are generally much more liquid in nature than
inventories, some doubt may exist concerning their liquidity as well. So, by
eliminating receivables and inventories from the current assets, another measure of
liquidity is derived by relating the sum of cash and marketable securities to the
current liabilities. Generally, an absolute liquidity ratio of 0.5 : 1 is considered
appropriate in evaluating liquidity.
Operational Liquidity
Operational liquidity which is based on the going concern concept of business, is
determined by expressing cash flows as a percentage of current liabilities. It is
verified here whether the enterprises included in the study would be able to discharge
its current liabilities from the cash flows generated from the operations.
7
Working Capital
Management: 12.4 DETERMINANTS OF LIQUIDITY
An
Integrated View The measurement of liquidity was accomplished by comparing current assets with
current liabilities. But, focus has not been thrown on the factors that determine
liquidity. Several factors influence the liquidity position of an undertaking. Significant
among them are:
a) the nature and volume of business;
b) the size and composition of current assets and current liabilities:
c) the method of financing current assets;
d) the level of investment in fixed assets in relation to the total long-term funds; and
e) the control over current assets and current liabilities.
Firstly, the nature and volume of business influence the liquidity of an enterprise.
Depending upon the nature of the units, some firms require more of working capital
than others. For some of the concerns like public utilities, less proportion of working
capital is needed, vis-à-vis, manufacturing organizations. Besides, an increasing
volume of business also enhances the funds needed to finance current assets. In
these situations, if the firm does not divert some funds form the long-term sources,
the liquidity ratios would be adversely affected.
Secondly, the size and the composition of current assets and current liabilities were the
basic factors that determine the liquidity of an enterprise. If a higher investment is
made in the current assets in relation to current liabilities, there would be a
corresponding rise in the current ratio. While quick and other ratios depend on the
composition of current assets.
Thirdly, the method of financing current assets causes changes in the liquidity ratios. If
greater part of the current assets is financed form long-term sources, greater also
would be the current ratio. On the other hand, if the concern depends much on the
outside sources for financing current assets, the ratio would fall.
Fourthly, the absorption of funds by fixed assets is one of the major causes of low
liquidity. As more and more of the firm’s total funds are absorbed in this process,
there will be little left to finance short-term needs and therefore liquidity ratios fall.
Hence, the degree of liquidity is determined by the attitude of the management in the
allocation of permanent funds between fixed and current assets.
Finally, stringent control over the current items causes fluctuations in the liquidity
ratios. If investment in current assets is not taken care of properly, the firm may
accumulate excess liquidity, which may adversely affect the profitability. On the
contrary, unduly strict control of the investment in all types of current assets may
eventually endanger the existence of the firm; owing to noncompliance of claims
because of the shortage of funds. Similarly, control over current liabilities also plays
an important role in determining liquidity of an enterprise by requiring the firm to
contribute necessary funds from long-term sources to keep up the liquidity position.
8
depreciate in times of inflation, if they are left idle. Owing to the cornering of capital, Integrating Working
the firm may have to resort to additional borrowing even at a fancy price. Capital
and Capital
Investment
On the other hand, the impact of inadequate liquidity is more severe. The losses due Processe
to insufficient liquidity would be many. Production may have to be curtailed or s
stopped for want of necessary funds. As the firm will not be in a position to pay off
the debts, the credit worthiness of the firm is badly affected. In general, the smaller
the amount of default, the higher would be the damage done to the image of the unit.
In addition, the firm will not be able to secure funds from outside sources, and the
existing creditors may even force the firm into bankruptcy. Further, insufficient funds
will not allow the concern to launch any profitable project or earn attractive rates of
return on the existing investment.
Between the excess and inadequate liquidity, the latter is considered to be more
detrimental, since the lack of liquidity may endanger the very existence of the
business enterprise. Besides, both the excess and inadequate liquidity adversaly
affect the profitability. If the firm is earning very low rates of return or incurring
losses, there would be no funds generated by the operations of the company, which
are essential to retire the debts. In fact, there is a tangle between liquidity and
profitability, which eventually determines the optimum level of investment in current
assets. Of the liquidity and profitability, the former assumes further importance since
profits could be earned with ease in subsequent periods, once the image of the unit is
maintained. But, if the firm losses its face in the market for want of liquidity, it
requires Qerculean efforts to restore its position. Instances are not lacking of great
industrial giants, with comfortable book profits coming to grief for want of liquidity.
The meaning attributed to the word ‘profit’ ranges form the view point that it is the
entire return received by the business to the view that ‘pure’ profit is residual in
nature as it is arrived at after deductions are made form total income for wages,
interest and rent. Clark argued that profit results exclusively from dynamic change
e.g., inventions, which yield temporary profit to entrepreneurs. Hawley holds that
risk bearing is the essential function of the entrepreneur and is the basis for profit.
While differing in their views about the causes of profits, proponents of both these
views regard profit as residual. It is to be recalled that profit has been connected by
F.H. Knight with uncertainity, by Schumpeter with innovations, by Hawley with risk-
bearing, and by Mrs. Robinson, Chamberlin and Kalecki with the degree of monopoly
power.
9
Working Capital The relationship between business, profit and economic growth is basically very
Management: simple. Profit determines investment and investment is essential to growth. Thus, a
An
Integrated View steep and continuing decline in profit is likely to mean a serious drop in the investment
stances, higher profit would mean higher investment and faster growth. Further, it is
by no accident that business profits, business investment, and unemployment form
three important economic indicators that depict the level of economic activity. More
business investment is needed to provide more jobs for the rapidly growing labour
force and one of the very dependable ways to get more investment is to plough back
adequately from the profits.
The decline in profits during the postwar period has in fact been accompanied by a
short decline in the business investment in many countries in the world. The idea that
profit is good’ is unacceptable to many people. The idea that higher profits are even
better is still unpalatable. What the critics of profit erroneously perceive is that
businessmen aim not at developing economic activities but on profiteering and
fleecing the consumers. Probably their intention tells them that one man’s profit is
another man’s loss and, as such the obvious conclusion is that profit means
exploitation. But experience is a better guide than instinct and experience teaches that
in a competitive economy business profit must accrue to those ventures that best serve
the general economic welfare. The targets of private business are private
profits. The great virtue of a free and competitive economy is that it stabilizes
organic link between profits and economic welfare and therefore undermining one
results in the undermining of both.
Profits may be increased by reducing corporate taxes. But tax cut is not a panacea
and does not guarantee that profit will rise or the investment will continue to rise, Its
benefits could be lost if rising business costs lead either to inflation or to the reduction of
profits or both. Conversly, the benefit of tax reduction can be greatly enhanced if
business costs can be reduced.
The responsibility for controlling the increase in the business costs rests on various
agencies. It rests in part with the business management; in part with government, state
and local; in part with employees and their unions and in part with the public. Thus it
must certainly be recognized that the profits are one of the principal engines of
economic growth, and it must be seen that the prospect for profits is bright enough in
this country to assure continued economic expansion.
The profitability of an industry has obviously a direct bearing on its growth. This is
principally due to the psychological incentives and the financial resources that the
profitability provides. High profitability makes possible to plough back substantial
resources, helps to raise equity capital in the investment market; and make it possible to
raise loans. Thus, it is business confidence in the level of profitability which is the
primary determinant of the decision to invest. Despite the vilification of profit by
forces on the extreme left, a mixed economy will not undertake productive
investment in plant and machinery unless management in reasonably assured of
earning a rate of return at least commensurate with the risks involved.
10
i) Gross profit ratio ii) Integrating Working
Capital
Operating profit ratio iii) and Capital
Net profit ratio Investment
Processe
Gross Profit Ratio: This is calculated by comparing the Gross profit (sales - cost of s
goods sold) with the Net Sales of a firm
. Gross Profit
. . Gross Profit ratio = × 100
Net Sales
This ratio indicates the profit generated by a firm for every one rupee of sale made.
For example, a Gross profit ratio of 25 per cent indicates that for every one rupee
sales, the firm makes a profit of 25 paise. Gross profit ratio depends upon the
relationship between the selling price and the cost of production including direct
expenses. The gross profit ratio reflects the efficiency with which the firm
produces/purchases the goods. Given the constant level of selling price, cost price
and raw material consumption per unit, the gross profit ratio would also remain same
from one year to another. If there is a change in the gross profit ratio from one year
to another then reasons must be looked for. If the efficiency of the firm is same then
the change in gross profit ratio may result because of change in selling price or cost
price or raw material consumption per unit.
The gross profit ratio should be analyzed and studied as a time series. For a single
year, the gross profit ratio may not indicate much about the efficiency level of the
firm. However, when studied as a time series, it may give the increasing or
decreasing trend and hence an idea of the level of operating efficiency of the firm. A
high gross profit ratio or a low gross profit ratio for a particular period does not have
any meaning unless compared with some other firm operating in the same industry or
compared with the industry average.
Operating Profit Ratio (OP Ratio): The operating profit refers to the pure
operating profit of the firm i.e. the profit generated by the operation of the firm and
hence is calculated before considering any financial charge (such as interest
payment), non-operating income/loss and tax liability, etc. The operating profit is also
termed as the Earnings Before Interest and Taxes (EBIT). The OP ratio may be
calculated as follows:
EBIT
OP Ratio = × 100
Net Sales
The OP ratio shows the percentage of pure profit earned on every 1 rupee of sales
made. The OP ratio will be less than the GP ratio as the indirect expenses such as
general and administrative expenses, selling expenses and depreciation charge, etc.
are deducted from the gross profit to arrive at the operating profits i.e. EBIT. Thus
the OP ratio measures the efficiency with which the firm not only manufactures/
purchases the goods but also sells the goods. The OP ratio in conjunction with the
GP ratio can depict whether changes in the profitability of the firm are caused by
change in manufacturing efficiency or administrative efficiency. It can help to
identify the corrective measures to improve the profitability.
Net Profit Ratio (NP Ratio): The NP ratio establishes the relationship between
the
net profit (after tax) of the firm and the net sales and may be calculated as follows:
Profit (After Tax)__
NP Ratio = × 100
Net Sales
The NP ratio measures the efficiency of the management in generating additional
revenue over and above the total cost of operations. The NP ratio shows the overall
efficiency in manufacturing, administration, selling and distribution of the product.
This ratio also shows the net contributions made by every 1 rupee of sales to the 11
Working Capital owners funds. The NP ratio indicates the proportion of sales revenue available to the
Management: owners of the firm and the extent to which the sales revenue can decrease or the
An
Integrated View cost can increase without inflicting a loss on the owners. So, the NP ratio shows the
firm’s capacity to face the adverse economic situations.
The NP ratio can be meaningfully employed to study the profitability of the firm when this
ratio is used together with the GP ratio and the OP ratio. A time series analysis of the
GP ratio, OP ratio and the NP ratio can help to identify the reasons for
variations in the profitability. Since the difference between the operating profit and
the net profit arises only because of financial charges and the taxes, an insight into
their comparison may show as to how efficiently the firm is financed and how well
the finance manager is able to hold down taxes.
EBIT - Interest
ROA = __ × 100
Total Assets
Thus, the ROA measures the overall efficiency of the management in generating
profits for a given level of assets. The ROA essentially relates the profits to the size of the firm
(which is measured in terms of the assets). If a firm increases its size but is unable to increase its
profits proportionately, then the ROA will decrease. In such a case increasing the size of the assets
i.e. the size of the firm will not by itself
advance the financial welfare of the owners. The ROA of a particular firm should be compared
with the industry average as the amount of assets required depends upon the nature and
characteristics of the industry.
Return on Capital Employed (RCE): The profitability of the firm can also be
analyzed from the point of view of the total funds employed in the firm. The term
funds employed or the capital employed refers to the total long term sources of funds.
It means that the capital employed comprises of shareholders funds plus long term
debts. Alternatively, it can also be defined as fixed assets plus net working capital.
12
Integrating Working
12.8 PROFITABILITY AND WORKING CAPITAL Capital
and Capital
There has been an attempt made to highlight the nexus between liquidity, profitability Investment
Processe
and working capital. A further examination can be thought of with the following s
indicators.
It has been found that in some cases, the net working capital turned out to be
negative in some years. This implies the mobilization of more current liabilities
compared to current assets. Judged from this point of view, the liquidity position
and the consequent efficiency can be stated to be very low.
efficiency with which a particular asset is managed and also to consider the
relationship between sales and various items of assets for this purpose. These
ratios which are called activity ratios, indicate the speed with which the
investment in the assets is getting rotated or converted into sales. A proper
balance between sales and assets generally reflects that assets are managed
well. Although fixed assets may not maintain close relation with sales, they are
taken as important because of their contribution to production. Hence total
assets turnover is taken as an indicator to measure the extent of sales generated
for one rupee investment in assets. 13
Working Capital vi) Collection Period: Another indicator which is considered to be important in
Management: judging the working capital efficiency is the collection period. This ratio indicates
An
Integrated View the total number of days that was taken by the firms in collecting their debts. A
comparison of the norms fixed with the results obtained would show the positive
or negative tendencies.
If liquidity goes up, profitability goes down. The risk-return trade-off involved in
managing the firm’s liquidity via investing in marketable securities is illustrated in the
following example. Firms A and B are identical in every respect but one Firm B has
invested Rs. 5,000 in marketable securities, which has been financed with equity.
That is, the firm sold equity shares and raised Rs.5,000. The balance sheets and net
incomes of the two firms are shown in Table 12.1. Note that Firm A has a current
ratio of 2.5 (reflecting net working capital of Rs. 15.000) and earns a 10 per cent
return on its total assets. Firm B, with its larger investment in marketable securities
has a current ratio of 3 and has net working capital of Rs. 20,000. Since the
marketable securities earn a return of only 9 per cent before taxes (4.5 per cent after
taxes with a 50 per cent tax rate), Firm B earns only 9.7 per cent on its total
investment. Thus, investing in current assets and in particular in marketable
securities, does have a favorable effect on firms liquidity but it also has an
unfavorable effect on the firm’s rate of return earned on invested funds. The risk-
return trade-off involved in holding more cash and marketable securities, therefore, is
one of added liquidity versus reduced profitability.
In the use of current versus long-term debt for financing working capital needs also
the firm faces a risk-return trade-off. Other things remaining the same, the greater
its reliance upon short-term debt or current liabilities in financing its current asset
investments, the lower will be its liquidity. On the other hand, the use of current
14
liabilities offers some very real advantages to the user in that they can be less costly Integrating Working
than long-term financing as they provide the firm with a flexible means of financing its Capital
and Capital
fluctuating needs for current assets. Investment
Processe
Table 12.1 : The Effects of Investing in Current Assets on Liquidity and s
Profitability
____________________________________________________________________________________________________
Balance Sheets A B
____________________________________________________________________________________________________
Cash
Rs. 500 Rs.500
Marketable securities
- 5,000
Accounts receivable
9,500 9,500
Inventories
15,000 15,000
_________ _________
Current assets
25,000 30,000
Net fixed assets
50,000 50,000
_________ _________
Total
75,000 80,000
_________ _________
Current liabilities
10,000 10,000
Long-term debt
15,000 15,000
Capital Equity
50,000 55,000
_________ _________
Total
75,000 80,000
_________ _________
Net Income
7,500 7,725
Current ratio
25,000 30,000
= 2.5 times
(Current assets/current liabilities) 10,000 10,000 = 3.0 times
Net working capital
(Current assets __ current liabilities) 15,000 20,000
Return on total assets 7,500 7,725
= 10 % = 9.7 %
(net income/total assets) 75,000 80,000
____________________________________________________________________________________________________
* During the year Firm B held Rs. 5,000 in marketable securities, which earned a
9 per cent return or Rs.450 for the year. After paying taxes at a rate of 50 per
cent, the firm netted a Rs. 225 return on this investment.
If for example, a firm needs funds for a three-month period during each year to
financé a seasonal expansion in inventories, then a three-month loan can provide
substantial cost saving over a long-term loan (even if the interest rate on short-term
financing should be higher). This results from the fact that the use of long term debt
in this situation involves borrowing for the entire year rather than for the three month
period when the funds are needed; this increases the interest cost for the firm. There
exists a possibility for further saving because in general, interest rates on short-term
debt are lower than on long-term debt for a given borrower. We may demonstrate
the risk-return trade-off associated with the use of current versus long term liabilities
with the help of an example given below:
Consider the risk-return characteristics of Firm X and Firm Y, whose balance sheets
and income statements are given in Table 12.2. Both firms had the same seasonal
15
Working Capital needs for financing throughout the past year. In December, they each required
Management: Rs.20,000 to finance a seasonal expansion in accounts receivable. In addition, during the
An
Integrated View four-month period beginning with August and extending through November both firms
needed Rs. 10,000 to support a seasonal buildup in inventories. Firm X
financed its seasonal financing requirements using Rs. 20,000 in long-term debt
carrying an annual interest rate of 10 per cent. Firm Y, on the other hand, satisfied its
seasonal financing needs using short-term borrowing on which it paid 9 per cent
interest. Since Firm Y borrowed only when it needed the funds and did so at the
lower rate of interest on short-term debt, its interest expense for the year was only
Rs.450, whereas Firm X incurred Rs. 2,000 as annual interest expense.
The end result of the two firms financing policies is evidenced in their current ratio,
net working capital, and return on total assets which appear at the bottom of Table
12.2. Firm X using long-term rather than short-term debt, has a current ratio of 3
times and Rs.20,000 in net working capital. Whereas Firm Y’s current ratio is only 1,
which represents zero net working capital. However, owing to its lower interest
expense, Firm Y was able to earn 10.8 per cent on its invested funds, whereas Firm X
produced a 10 per cent return. Thus, a firm can reduce its risk of illiquidity through the
use of long-term debt at the expense of a reduction of its return on invested
funds. Once again we see that the risk-return trade-off involves an increased risk of
illiquidity versus increased profitability.
Table 12.2
____________________________________________________________________________________________________
Balance Sheets
____________________________________________________________________________________________________
Firm X Firm Y
Rs. Rs.
Current assets 30,000 30,000
Net fixed assets 70,000 70,000
____________ ___________
Total 1,00,000 1,00,000
Accounts payable 10,000 10,000
Notes payable —- 20,000
____________ ___________
Current liabilities 10,000 30,000
____________ ___________
Long-term debt 20,000 0
Equity Capital 70,000 70,000
____________ ___________
1,00,000 1,00,000
____________ ___________
____________________________________________________________________________________________________
Income Statements
____________________________________________________________________________________________________
Firm X Firm Y
Rs. Rs.
Net operating income 22,000 22,000
Less: Interest expense 2,000* 450**
_________ __________
Earnings before taxes 20,000 21,550
Less: Taxes (50%) 10,000 10,775
_________ __________
Net income 10,000 10,775
16
_________ __________
current assets 30,000__ 30,000__ Integrating Working
Current ratio =current liabilities=Net = 3 times =1 times Capital
30,000
and Capital
working capital 10,000
Investment
Processe
s
(current assets - current liabilities) 20,000 Rs. 0
Net income 10,000 10,775
_
Return on total assets = _________ = _______ = 10% ______ = 10.8%
Total assets 1,00,000 1,00,000
____________________________________________________________________________________________________
* Firm X paid interest during the entire year on 20,000 on long-term debt at a rate
of 10 per cent. Its interest expenses for the year was 10% x 20,000 = 2,000.
** Firm Y paid interest on 20,000 for one month and on 10,000 for four months at
9 per cent interest during the year. Thus, Firm Y’s interest expense for the
year equals 20,000 X .09 X 1/12 plus 10,000 X .09 X 4/12 or 150+300 = 450.
12.10 SUMMARY
Attempt has been made in this unit to focus on the issues of liquidity and profitability.
The dimensions of both the concepts are discussed in a great detail. There has been
a realization that working per se as a liquidation concept. Whether the firm will be
able to pay off its debts using cash flows is more important than what level of current
assets or current liabilities, it maintains. The concepts of technical and operational
liquidity are analysed for their significance. In the same way, the concept of profit
was analysed to go deep into its mechanics. It may be rather obnoxious to mean
profit as an engine of economic growth. But fair chance must be provided to an
entrepreneur to compensate for his risks. At the end, the trade-off between liquidity
and profitability is discussed with adequate numerical illustrations.
Current ratio is the relationship between current assets and current liabilities
17
Working Capital Cooptex manufacturing Co.
Management:
An Balance Sheet as on December 31, 2003.
Integrated View ____________________________________________________________________________________________________
Current Liabilities Rs. 30,000 Net Fixed Assets Rs. 50,000
Long-Term Liabilities Rs. 20,000 Current Assets:
Equity Capital Rs. 50,000 Cash 5,000
Inventories 25,000
Accounts Receivable 20,000 Rs. 50,000
_________ _________
1,00,000 1,00,000
_________ _________
During 2003, the firm earned net income after taxes of Rs. 10,000 based on net sales of
Rs. 2,00,000.
a) Calculate Cooptex’s current ratio, net working capital and return on total assets
ratio (net income/total assets) using the above information.
(Hint: net income will now become Rs. 10,000 plus, 05 times Rs. 10,000 or Rs.
10,500.)
c) In what manner will the plan proposed in part b affect the firm’s liquidity and
profitability? Explain.
18
Integrating Working
UNIT 13 PAYABLES MANAGEMENT Capital
and Capital
Investment
Objectives Processe
The objectives of this unit are to: s
13.1 INTRODUCTION
A substantial part of purchases of goods and services in business are on credit terms
rather than against cash payment. While the supplier of goods and services tend to
perceive credit as a lever for enhancing sales or as a form of non-price instrument of
competition, the buyer tends to look upon it as a loaning of goods or inventory. The
supplier’s credit is referred to as Accounts Payable, Trade Credit, Trade Bill, Trade
Acceptance, Commercial Draft or Bills Payable depending on the nature of credit
provided. The extent to which this ‘buy-now, pay-later’ facility is provided will
depend upon a variety of factors such as the nature, quality and volume of items to be
purchased, the prevalent practices in the trade, the degree of competition and the
financial status of the parties concerned. Trade credits or Payables constitute a major
segment of current liabilities in many business enterprises. And they primarily finance
inventories which form a major component of current assets in many cases.
19
Working Capital
Management: 13.3 TYPES OF TRADE CREDIT
An
Integrated View Trade Credits or Payables could be of three types: Open Accounts, Promissory
Notes and Bills Payable.
The Promissory note is a formal document signed by the buyer promising to pay the
amount to the seller at a fixed or determinable future time. Where the client fails to
meet his obligation as per open credit on the due date, the supplier may require a
formal acknowledgement of debt and a commitment of payment by a fixed date. The
promissory note is thus an instrument of acknowledgement of debt and a promise to
pay. The supplier may even stipulate an interest payment for the delay involved in
payment.
Bills Payable or Commercial Drafts are instruments drawn by the seller and accepted
by the buyer for payment on the expiry of the specified duration. The bill or draft will
indicate the banker to whom the amount is to be paid on the due date, and the goods
will be delivered to the buyer against acceptance of the bill. The seller may either
retain the bill and present it for payment on the due date or may raise funds
immediately thereon by discounting it with the banker. The buyer will then pay the
amount of the bill to the banker on the due date.
Activity 13.1
You arrange to meet the Finance Executive of an enterprise that procures a wide
range of materials from different sources and ascertain.
……………………………………………………………………………..........
……………………………………………………………………………..........
……………………………………………………………………………..........
……………………………………………………………………………..........
……………………………………………………………………………..........
b) Which of these forms is most economical from the purchasing firm’s point of
view and why?
……………………………………………………………………………..........
……………………………………………………………………………..........
……………………………………………………………………………..........
……………………………………………………………………………..........
……………………………………………………………………………..........
20
c) How does the company organize itself to negotiate effectively with the suppliers Integrating Working
for obtaining the best possible credit terms? Capital
and Capital
Investment
……………………………………………………………………………......... Processe
s
…………………………………………………………………………….........
…………………………………………………………………………….........
…………………………………………………………………………….........
…………………………………………………………………………….........
Industrial Categories
Different categories of industries or Commercial enterprises show varying degrees of
dependence on trade credit. In certain lines of business the prevailing commercial
practices may stipulate purchases against payment in most cases. Monopoly firms
may insist upon Cash on delivery. There could be instances where the firm’s
inventory, turns over every fortnight but the firm enjoys thirty days credit from
suppliers, whereby the trade credit not only finances the firm’s inventory but also
provides part of the operating funds or additional working capital.
Nature of Product
Products that sell faster or which have higher turnover may need shorter term credit.
Products with slower turnover take longer to generate cash flows and will need
extended credit terms.
21
Working Capital Terms of Sale
Management: An
Integrated View The magnitude of trade credit is influenced by the terms of sale. When a product is
sold, the seller sends the buyer an invoice that specifies the goods or services, the
price, the total amount due and the terms of the sale. These terms fall into several
broad categories according to the net period within which payment is expected.
When the terms of sale are only on cash basis, there can be two situations, viz., Cash
On Delivery (COD) and Cash Before Delivery (CBD). Under these two situations,
the seller does not extend any credit.
Cash Discount
Cash discount influences the effective length of credit. Failure to take advantage of
the cash discount could result in the buyer using the funds at an effective rate of
interest higher than that of alternative sources of finance available. By providing cash
discounts and inducing good credit risks to pay within the discount period, the supplier
will also save on the costs of administration connected with keeping records of dues
and collecting overdue accounts.
Degree of Risk
Estimate of credit risk associated with the buyer will indicate what credit policy is to
be adopted. The risk may be with reference to buyer’s financial standing or with
reference to the nature of the business the buyer is in.
Datings
In seasonable industries, sellers frequently use datings to encourage customers to
place their orders before a heavy selling period. For many consumer durables, the
demand will be of this type. The need for an air-conditioner is felt in the summer,
leading to heavy ordering at a particular point of time. This has double advantages.
For manufacturer, he can schedule production more conveniently and reduce the
inventory levels. Whereas, the buyer has the advantage of not having to pay for the
goods until the peak, of the selling period. Under this arrangement, credit is extended
for a longer period than normal.
When the credit does not cover cash discount for early payment, the trade credit is
considered to be a cost free source of financing for the buyer. It is not uncommon for
some of the buyers to delay payments beyond the due date, thus extending the period
of use of costless trade credit.
22
Trade credit is a built-in source of financing that is normally linked to the production Integrating Working
cycle of the purchasing firm. If payments are made strictly in accordance with credit Capital
and Capital
terms, trade credit can be regarded as a cost free, non-discretionary source of Investment
financing. But where the buyer takes the privilege of delaying payment beyond the due Processe
date, it assumes the form of discretionary financing and if this becomes a regular s
feature resulting in delinquency, trade credit will cease to be cost free. The supplier
may stop credit or may charge a higher price for the product, to cover the risk.
The supplier may offer cash discount for payment within a specified number of days
after the invoice or after the receipt of goods. Generally such concessions for
expedited settlement are given to select customers on informal basis. Where the aim is
to induce earlier payment wherever possible, cash discounts are provided for in the
credit terms. The quantum of discount offered will vary for different categories of
business and clients.
Cash discount is to be distinguished from the other categories of discount that may be
offered by the seller, namely, the trade discount and the quantity discount. The trade
discount is a reduction from the invoice or list price offered to the dealer or trader in
the channel of distribution. Quantity discounts are given when purchases are made in
sizeable lots.
When the cash discount is allowed for payment within a specified period, we can
compute the cost of credit. For instance, if 30 days’ credit is offered with the
stipulation of a 2 per cent cash discount for payment within 10 days, it means that the
cost of deferring payment by 20 days is 2 per cent. If payment is made 20 days
earlier than the due date, 2 per cent of the amount due can be saved, which amounts to
an attractive annual saving rate of 36 per cent.
If cash discount is not availed, the effective rate of interest of the funds held will work
out to 36.7 per cent. The interest is Rs. 2 on Rs. 98 for a period of 20 days, and the rate
of interest will be:
2/98 × 360/20 = 36.7 per cent.
If 60 days’ credit is extended, with a cash discount of 2 per cent for payment within
10 days, there is a saving of Rs. 2 for paying 50 days ahead. The effective rate of
interest is 2/98 × 360/50 = 14.7 per cent. For 90 days’ credit, with 2 per cent cash
discount for payment within 10 days, the effective interest works out to 9.2 per cent.
Thus the more liberal the credit terms, the saving from cash discount declines and so
does the effective rate of interest for using the funds till the due date. If, however, the
discounts are not taken and the settlement is made earlier than the due date, the
effective rate of interest will vary. For a firm that resists from taking the cash
discount, its cost of trade credit declines the longer it is able to delay payment.
The rationale for availing trade credit should be its savings in cost over the forms of
short term financing, its flexibility and convenience. Stretching trade credit or
accounts payable results in two types of costs to the buyer. One is the cost of cash
discount foregone and the other is the consequence of a poor credit rating.
The contention that there is no explicit cost to trade credit if the payment is made
during the discount period or if the payment is made on the due date when no cash
discount is offered, is not totally tenable. The supplier who is denied the use of funds
during the credit period may bear the cost fully or pass on part of it to the buyer
through higher prices. This will depend on the nature of demand for the product. If
the demand is elastic, the supplier may opt to bear the cost himself and refrain from
charging higher prices to recover part of it. The buyer should satisfy himself that the
burden of trade credit is not unduly loaded on him through disguised price revisions.
23
Working Capital Repeated delinquency and deterioration in credit reputation do involve an opportunity
Management: cost though it is difficult to measure. Some suppliers may be more tolerant to delayed
An
Integrated View payments at some times than on other occasions. A policy of delayed payments is
bad business practice and in the long run can prove very expensive or may even lead
to freezing of credit source. Credit reputation is a precious asset that needs to be
preserved with utmost care. The long run policy should be to avail discounts, if
offered, utilize credit periods to the full and discharge obligations on schedule.
The following formula can be used for determining the effective rate of return:
R = C (360)/D (100-C), where
R = Annual interest rate for the use of funds C
= Cash discount
D = Number of extra days the customer has the use of supplier’s funds.
Let us take an illustration.
A firm wants to hold additional inventory but does not have the cash to finance it. If
the credit term is 2 per cent discount for payment within 10 days with 60 days credit
period, and the bank rate is 9 per cent, should the firm take the discount?
If the discount is not taken by the 10th day, the effective rate of interest on the funds
held and utilized for the remaining 50 days will be:
2/98 × 360/50 = 14.7 per cent.
The bank rate is 9 per cent only. Therefore it is advisable to take the discount
offered, even if it involves utilizing bank borrowing for effecting early payment for
availing the cash discount.
Stretching Accounts Payable
It is normally assumed that the payment to the supplier is made at the end of due
date. However, a firm may postpone payment beyond this period. This type of
postponement is called stretching or Leaning on the trade. The cost of stretching
accounts payable is two fold : the cost of cash discount foregone and the possible
deterioration in the credit rating. If a firm stretches its payables excessively, so that its
payables are significantly delinquent, its credit rating will suffer. Suppliers will view the
firm with apprehension and may insist on rather strict terms of sale. Although it is
difficult to measure, there is certainly an opportunity cost to a deterioration in the
firms quality of payment.
Activity 13.2
Meet the Finance Executive of a large enterprise that has been growing at a fast
pace and enjoying substantial credit facilities from different suppliers and also meet
the Finance Executive of another large firm which has been under financial strain for
some time but is yet getting trade credit from suppliers, and get responses from them on
following aspects.
a) Do the suppliers change their trade credit policy from time to time or are they
consistent irrespective of customer’s shifting fortunes?
……………………………………………………………………………..........
……………………………………………………………………………..........
……………………………………………………………………………..........
……………………………………………………………………………..........
24
b) How do the two companies that you contacted evaluate the credit terms offered Integrating Working
by suppliers? Do they reckon the cost of credit and. if so, what initiatives do they Capital
and Capital
take to keep the cost of credit to the minimum? Investment
Processe
……………………………………………………………………………......... s
…………………………………………………………………………….........
…………………………………………………………………………….........
…………………………………………………………………………….........
…………………………………………………………………………….........
Informality
In trade credit, there is no rigidity in the matter of repayment on scheduled dates,
occasional delays are not frowned upon. It serves as an extendable, convenient
source of unsecured credit.
Continuous Financing
Even as the current dues are paid, fresh credit flows in, as further purchases are
made. It is a continuous source of finance. With a steady credit term and the
expectation of continuous circulation of trade credit-backing up repeat purchases,
trade credit does in effect, operate as long term source.
25
Working Capital • In highly competitive situations, suppliers may be willing to stretch credit limits
Management: An and period. Assess your bargaining strength and get the best possible deal.
Integrated View
• Avoid the tendency to divert payables. Maintain the self liquidating character of
payables and do not use the funds obtained there from for acquiring fixed
assets. Payables are meant to flow through current assets and speedily get
converted into cash through sales for meeting maturing short term obligations.
• Provide full information to suppliers and concerned credit agencies to facilitate a
frank and fair assessment of financial status and associated problems. With
fuller appreciation of client’s initiatives to honor his obligations and the
occasional financial strains which he might be subjected to for a variety of
reasons, the supplier will be more considerate and flexible in the matter of credit
extension.
• Keep a constant check on incidence of delinquency. Delays in settlement of
payables with references to due dates can be classified into age groups to
identify delays exceeding one month, two months, three months, etc. Once
overdue payables are given priority of attention for payment, the delinquency
rate can be minimized or eliminated altogether.
13.8 SUMMARY
Payables or trade credit is a self liquidating, easy-to-obtain, flexible source of short
term finance. Buyer’s credit reputation, as reflected in evidences of his willingness
and ability to meet maturing obligations will determine the quantum and period of
credit he can command. Factors like competition, nature of the product and size of
the supplier’s firm also influence terms of credit, besides relevant commercial
practices or conventions. It will be prudent to take advantage of cash discount
facilities when available and avoid over-stretching payables by frequent delays in
payments. If good credit relations are maintained with suppliers, payables can be a
ready and expanding source of short term finance that will correspond to the needs of
a growing firm.
Payables are not altogether cost-free but if managed well, the costs can be
substantially lower than the alternative sources of short term finance.
27
Integrating Working
UNIT 14 Capital
SHORT- TERM INTERNATIONALnt
Processes
FINANCIAL TRANSACTIONS
Objectives
The objectives of this unit are to:
• Survey the situation prevailing in the international short-term market.
• Highlight the implications of foreign exchange market.
• Provide a mechanism for managing exchange rate fluctuations.
• Create awareness of the techniques employed to deal with foreign currency
exposure.
• Finally, explain the genesis and operations of Euromarkets.
Structure
14.1 Introduction
14.2 Markets and Market Participants
14.3 Quoting Foreign Exchange Rates
14.4 Economic Forces in Exchange Markets
14.5 Managing Exchange Rate Gyrations
14.6 Foreign Financial Markets
14.7 Euromarkets and their Linkages
14.8 Creation of Euromoney
14.9 Growth of Euromarkets
14.10 Summary
14.11 Key Words
14.12 Self Assessment Questions
14.13 Further Readings
14.1 INTRODUCTION
When finance goes international, problems multiply. The common thread of
international aspects of financial management is found in the following: What aspects
of the issue are peculiarly international , and what opportunities does a firm have by
virtue of its being international? The clues to an answer lie in the basic
understanding of the management of the cross border financial assets and liabilities
and cash flows. From a corporate perspective, the most important theoretical
development in international financial management can be captured by concentrating
on the following areas:
• Foreign Exchange Markets
• Foreign Financial Markets
• Euromarkets
What is foreign exchange? Foreign exchange is simply a payment made in some
national currency (or artificial currency) that is exchanged for a payment received in
another currency . Thus any money can become foreign exchange by surprise and the
moment after it has been exchanged it forgets it was foreign exchange. Once more,
it is national money.
Unlike the money and capital markets, the foreign exchange market deals not in
credit but in means of payment. This brings one to a fundamental point. While
foreign exchange deals frequently take place between residents of different
countries, the money being traded never actually leaves the country of the currency.
1
Thus when West German deutsche marks are exchanged for U.S. dollars in London,
the deutsche markets and dollars stay in West Germany and the United States
Integrated View
respectively. The act of trading only effects a change of ownership of the money.
The money itself , in the form of bank deposits, merely gets shifted from one deposit
to another through the country’s inter bank payments system.
We see that the quotation is $/DM and is the domestic currency at New York, is a
direct quote. Similarly , 100 Japanese Yen are worth 1.0052 Us dollars.
Care must be taken when reading off exchange rates to see which method is being
employed. To make explicit the role of each currency in an exchange quote, it is
helpful to write down the names of each currency in its appropriate position. The
currency used as a unit of account is placed in front of the quote. The unit of
currency being priced follows the quote. For example, in the following quote of:
$ 0.60/DM
The unit of account if the U.S. dollar and the unit of currency being priced is one
mark. A foreign exchange dealer will usually quote two rates to a potential customer
a bid and an offer rate. The dealer is willing to buy at the bid rate and sell at the
offer or ask rate. In either case, the currency for which the end or offer price is
given is the unit of item price. When he makes the quotation, he does not know
2
whether the customer is a buyer or a seller of currency. For instance, in the example l
quoted in Table 14.1, the foreign exchange dealer is quoting a spread Rs. 31. 2514ent
Processes
to Rs. 31. 3219 to the dollar . This means that he is prepared to sell Rs. 31.2514 to
the dollar and buy them at Rs. 31. 3219 to the U.S. dollar. Conversely, he will buy
dollars at Rs. 31. 2514 to the dollar and sell dollars at Rs. 31.3219 to the dollar.
Table 14.1 : Bid Offer Rates Quoted by Foreign Exchange Dealer
LS1
Bid Offer
Rs. 31.2514 31.3219 $
Rs. 50.0013 51.2006 Pound
Rs. 22.4056 22.9058 DM
Rs. 27.0543 27.6009 Sw. Fr.
Rs. 35.6086 36.3095 Yen*
*per 100 units.
The most common type of foreign exchange transaction involves the payment and
receipt of the foreign exchange within two business days after the day the
transaction is agreed upon. The two - day period gives adequate time for the parties
to send instructions to debit and credit the appropriate bank accounts at home and
abroad. This type of transaction is called a spot transaction, and the exchange rate
at which the transaction takes place is called the spot rate. Besides spot
transaction, there are forward transactions. A forward transaction involves an
agreement today to buy or sell a specified amount of a foreign currency at a specified
future date at a rate agreed upon today (the forward rate). The typical forward
contract is for one month; three months; or six months, with three months the most
common. Forward contracts for longer periods are not as common because of the
great uncertainties involved. However, forward contract can be renegotiated for one
or more periods when they become due.
The equilibrium forward rate is determined at the intersection of the market demand
and supply curves of foreign exchange for future delivery. The demand for and
supply of forward foreign exchange arises in the course of hedging, from foreign
exchange speculation and from covered interest arbitrate.
The question for forward rate can be made in two ways. They can be made in
terms of the amount of local currency. At which the quoter will buy and sell a unit of
foreign currency. This is called the outright rate and is used by the traders in
prompting to customers. The forward rates can also be quoted in terms of prints,
called the swap rate, and used in inter-bank quotations. The points are added to the
spot price if the foreign currency is traded at forward premium; if trading at a
forward discount, the forward quotations are subtracted from the spot price. The
resulting number is the outright forward rate. In other words, the outright rate is the
spot rate adjusted by the swap rate.
How to read the foreign exchange quotation? If the forward quote (the led or buying
figure) is smaller than the forward rate ( the offer or setting figure), then in a
premium, i.e. , the swap rates are added to the spot rate. Conversely, if the first
quote is larger than the second, it is a discount. In case the first quote is equal to the
second, a quote would require a further specification as to whether it is a premium or
a discount. The procedure assures that the buying price is lower than the selling
price, and the trader profits from the spread between the two prices. To illustrate,
suppose you have called your foreign exchange trader and asked for quotations on
the U.S. dollar spot, one month, three month, and six-month.
3
The trader haslreported with the following:
Management: An
$ 0. 0.032122/8 8/10 7/5
In outright terms these quotes would be expressed as follows:
Table 14.2
Maturity Bid offer
Spot 0.032122 0.032128
Integrated View
1-month 0.032130 0.032138
3-month 0.32115 0.32123
6-month 0.032132 0.032140
It shows that the one-month and six- month forward are at premium whereas the
three-month forward is at discount.
The value of a currency is often expressed as a single figure, i.e, $ 0.032125 (US)
worth Re.1, rather than being quoted as both a bid and offer rate. The single rate is
the middle rate arrived at by adding the bid and offer rate together and dividing by
two. In the example, give the dollar bid rate is 0.032122 and the dollar offer rate
0.032128, so the middle rate is (0.032122 +0.032128)/2=0.32125
The difference between the bid price and the offer price is known as the spread and
it makes the profit. Spreads in the forward market are a function of both the breadth
of the market (the volume of transactions/in a given currency and the risk associated
with forward contracts). The risks, in turn, are based on the variability of future spot
rates. Even if the spot market is stable, there is no guarantee that further rates will
remain invariant. This uncertainty will be reflected in the forward markets.
In a foreign exchange market, dealers quote the forward rate only at a discount from,
or a premium on, the spot rate. If the forward rate is below the present spot rate,
the foreign currency is said to be at a forward discount with respect to the domestic
currency. On the other hand, if the forward rate is above the present spot rate, the
foreign currency is said to be at a foreign premium. To illustrate, if the spot rate is
Rs. 50/ pound and three-month forward rate is Rs. 48/ per pound, we say that the
pound is at a three month forward discount of Rs. 2 or 4 per cent (or at a 16 per cent
forward discount per year) with respect to the pound. On the other hand, if the spot
rate is still Rs. 50/- per pound but the three-month forward rate is Rs. 52 per pound,
the pound is said to be a forward premium of Rs. 2 or 4 per cent for three months, or
16 percent per year.
Forward discounts or premiums are usually expressed as percentages per year from
the corresponding spot rate and can be calculated formally with the following
formula:
(Forward Rate - Spot Rate) 12× 100
Forward Premium = ---------------------- × ------------------
–-- Spot Rate Forward contract
length
in months
Thus, when the spot rate of the rupee/pound is Rs. 50 per pound and the forward rate
is Rs. 48 per pound , we get:
Rs. 48 - Rs. 50 12 -2
—————— × -— × 100 = —-- × 4 × 100 = -16% p.a.
Rs. 50 3 50
the same as found earlier without the formula. Similarly if Rs. 52 /pound:
Rs. 52-Rs. 50 12 -2
—————— × —— × 100 = —— × 4 ×100 = +16% p.a.
Rs. 50 3 50
So far we have dealt with only two currencies for simplicity, in reality there are
4
numerous exchange rates, one between any pair of currencies. The exchange rate ital
between two currencies can be obtained from the rates of these two currencies in ment
Processes
terms of a third currency. This is called the cross-rate. For example, if the exchange
rate is between the Indian Rupee and the British pound and between the U.S. dollar
and the British pound, then the exchange rate between the rupee and the dollar is
31.25 (i.e, it takes Rs. 31.25 to purchase one dollar).
Specifically:
Rs. Rs. value of pound
50
Exchange Rate ————— = —————————— = —— 31.2
$ $ value of pound
16
Since over time a currency can depreciate with respect to some currencies and
appreciate against others, an effective exchange rate is calculated. This is a
weighted average of the exchange rates between the domestic currency and the
nation’s most important trade partners, with weights given by the relative importance
of the nation’s trade with each of these trade partners.
For example, assume that the quotes of the rupee against the pound sterling in
Bombay and London are as follows:
Bombay London
Rs. 50. 021511 Rs. 50. 021523
The rupee commands a higher price against the pound sterling in Bombay than in
London. It will attract arbitrageurs. They will purchase pounds with rupees in
Bombay and convert pound in rupees in London to make profit. As arbitrage takes
place, the purchase of pound in Bombay will tend to increase the price of the pound
against the rupee in that market. In London, reverse will happen with the sale of
pound sterling and hence the fall in the price of the pound against rupee. This
arbitrage process tends to equalise the exchange rate between the two currencies in
both the markets.
When only two currencies and two monetary centres are involved in arbitrage, we
have two-point arbitrage, when three currencies and three monetary centres are
involved, we have triangular, or three-point arbitrage. While triangular arbitrage is
not very common, it operates in the same manner to ensure consistent indirect, or
cross, exchange rates between the three currencies in the three monetary centers.
For example, if a foreign exchange dealer quotes on April 1, 1995, the DM was
quoted $ 0.708707/DM and the Indian rupee was quoted Rs. 32.425325/$ in Bombay.
If on the same date New York was quoting Rs. 22.915265/DM and
Rs. 32. 425325/$, what are the incentives for arbitrage?
b) In New York :
We know Re/$ = Rs. 32.425325/$
Re/DM = Rs. 22.915265/DM
Then DM/Re = 1/22.915265 = DM 0.043639/R
$/Re 0.3084
SO $/DM = ———— = ———— = .70
DM/Re .04639
c) In Bombay:
$/DM = 0.708707/DM
1
Then DM = (
————
$
0.708707
)/
DM = 1.410203/$
Re/$ = Rs. 32.425325/$; therefore,
DM 1.4110203/$ = Rs. 32.425325/$
Re/$ 32.425325
Re/DM = ———— = ————— = Rs. 22980055
DM/$ 1.4110203
By reading various quotes in two markets , we can say:
i) The DM in terms of dollar is cheaper in New York than in Bombay.
ii) The dollar and the rupee are at parity in both markets;
iii) The DM in terms of rupee is cheaper in Bombay than in New York.
Therefore, buy DMs against dollars in New York; sell DMs against Rs. in Bombay;
and convert Rs. in dollars in either Bombay or New York.
As in the case of two-point arbitrage, triangular arbitrage increases the demand for
the currency in the monetary centres when the currency is cheaper, increases the
supply of the currency in the monetary centres where the currency is more
expensive, and quickly eliminates inconsistent gross rates and the profitability of
further arbitrage. As a result, arbitrage quickly equalises exchange rates for each
pair of currencies and results in consistent gross rates among all pairs of currencies,
thus unifying all international monetary centres into a single market.
In the real world, significant covered interest arbitrage margins are often observed
for long periods. The reason for this is not necessarily that covered interest
arbitrage does not work. Rather, it is likely to be the result of other forces at work
not accounted for by the pure theory of covered interest arbitrage. Some of these
other forces are the different real growth rates among nations; differential growth in
their money suppliers; and differences in expectation, in liquidity preferences, in
inflation rates, and in fiscal and trade policies. Lack of adequate information and
government restrictions on short-term international capital flows can also sometimes
account for the persistence of wide covered interest arbitrage margins.
Finally, it must be remembered that behind the demand and supply curves of foreign
exchange are not only traders and investors, but also hedgers, speculators, and
interest arbitrageurs. Governments also operate in foreign exchange markets, both
in their normal function of making and receiving foreign payments and in their effort
to affect the level and the movement of exchange rates. It is all of these forces
together that determine exchange rates at the intersection of the nation’s aggregate
demand and supply curves for each foreign currency under a flexible exchange rate
system.
For analytical purposes, these systems can be categorized into two functional
components: the exposure identification system, which requires information on the
accounting and /or cash flow exposures generated by group companies; and the
exposure management information system, which provides details of decision
parameters and constraints to be considered in deciding what exposure management
action is required. Analytically, at least, two fundamental exchange risk management
strategies may be considered, namely, ‘aggressive’ and ‘defensive’. A key factor in
the company’s choice between these two strategies will be its ability to accurately
forecast exchange rates specifically its ability to outpredict the forward rate. In
contrast to the Bretton Wood’s era, in the existing flexible exchange rate
environment, such forecasting is very difficult. At present, there are large and
perhaps confusing variety of techniques used in corporate exchange risk
management.
To understand the rationale underlying their use, they may be classified into internal
and external techniques according to their basic origin. Internal techniques are
mainly used as a part of a company’s regulatory financial management aimed at
minimizing its continuing exposure to exchange risk. They are basically aimed at
reducing or preventing an exposed position from arising. The external techniques are
used to ensure against the possibility that exchange losses will result from the
exposed position which the internal measures have not been able to eliminate;
consisting basically the contractual measures to ensure against an exchange loss
(realized or unrealized which may arise from an existing translation or exposed
8
position. Integrating Working
Capital
and Capital
Investment
Processe
A) Exposure Management: Internal s
Techniques
1) Netting
Netting simply means offsetting exposures in one currency with exposure in the same
or another currency, where exchange rates are expected to move in such a way that
losses (gains) on the first exposed position should be offset by gains(losses) on the
secured currency exposure. In the simplest kind of scheme, known as bilateral
netting, each pair of subsidiaries nets out their own positions, with each other.
Flows are reduced by the lower of each company’s purchases from or sales to its
netting partner. There is no attempt to introduce the net position of other group
companies.
Multilateral netting, a complex form of netting, can take place when affiliates both
import from and export to companies within the same corporate groups. Flows are
reduced by the lower of each company’s total purchase from/sale to affiliates. The
focal point in a multilateral netting scheme is the central information point.
Participating units must report an inter company position at the end of a given period,
and the center then advises the units of the net amount which they are to pay or
receive at a certain date. Multilateral netting, therefore, requires a centralized
communication system and a lot of discipline on the part of participating units. In this
process of multilateral netting, the three most common constraints are: (a) prior
approval for netting may be required; (b) trading (rather than financial) transactions
only may be netted; and (c) inter company (rather than third party) transactions only
may be netted.
The major benefits of netting are reduced banking costs and increased control of
inter-company settlements. The reduced number and total amount of payments
produces savings in the form of lower flow and lower exchange costs (i.e the buy/sell
spread in the spot and forward markets plus the elimination of bank charges, if any).
No simple savings percentages can be universally applied to the amount netted since
savings will be determined by prevailing buy/sell spreads and the structure of the
payment flows eliminated. In addition, the introduction of a netting system does
create opportunities for exposure and liquidity management and tax planning. A
quick and easy decision format can be evolved to produce an inter company
settlement pattern which will help to achieve the company’s liquidity and exposure
management objectives.
2) Matching
The terms ‘netting’ and ‘matching’ are often used interchangeably. But the term
netting is typically used only for inter company flows to the netting out of groups,
receipts and payments. As such it is applicable only to the operations of a
multinational company rather than the exporter or importer. In contrast, matching can
be applied to both third party as well as inter- company cash flows, and it can be used
by the exporter/importer as well as the multinational company. It is a process
whereby a company matches its currency inflows with its currency outflows with
respect to amount and (to an appropriate degree) timing. Receipts in a particular
currency may then be used to make payments in that currency so that the need to go
through the exchanges (spot and forward) is limited to the unmatched portion of
foreign currency cash flows. The aggressive company may decide to take forward
cover on its currency payables and leave the currency receivables exposed to
exchange risk; if it takes the view that the forward rate looks cheaper than the
expected spot rate.
9
The basic requirement for a matching operation, then, is a two-way cash flow in the
same foreign currency. This kind of operation is sometimes called ‘natural’ matching.
Integrated View
There is a further possibility, however, which we will call ‘parallel’ matching. Here
the match involves two currencies whose movements are expected to run closely
parallel’. In a parallel matching situation, gains in one foreign currency are expected
to be offset by losses in another. Needless to say, with parallel matching there is
always the risk that the exchange rates will move contrary to expectations, so that
both sides of the parallel match lead to exchange losses (or gains).
The major practical problem in implementing matching is the timing of third party
receipts and payments. Unexpected delays can cause the mistiming of a match and
may consequently leave both receivable and payable exposed to exchange risk.
Success requires accurate prediction of the amount of settlement and, more
particularly, the timing of settlement dates. Where exchange controls allow, the
timing problem can be overcome by the utilisation of foreign currency accounts,
which allow the retiming of currency conversions to facilitate matching. The cost of
neutralizing exposures in this way is represented by the effective interest rate
differential (including the deposit/borrowing rate spread) between the foreign and
domestic currency.
3) Leading and Lagging
This simply refers to the adjustment of inter-company credit terms, ‘leading’ meaning
a prepayment of a trade obligation and ‘lagging’ a delayed payment. This is primarily
an inter company technique between buyer and seller. Whilst netting and matching
are purely defensive measures, intercompany leading and lagging can be used as part
of either a risk-minimising strategy (to facilitate matching) or an aggressive strategy
(to maximise expected exchange gains). In either case a central information and
decision point is usually required, to ensure that the timing of inter-company
settlement is effective from a group point of view rather than purely a local one.
As with other schemes involving central decision making, leading and lagging requires
a lot of discipline on the part of participating subsidiaries. Apart from the exposure
impacts, such operations can seriously affect the liquidity and hence profitability of
each subsidiary. To overcome the consequent evaluation problem, multinational,
companies which make extensive use of leading and lagging may either evaluate
subsidiary performance on a pre-interest basis or impute interest charges and credits
where appropriate.
One very important complicating factor, however, is the existence of local minority
interests. If there are powerful local share holders in the “losing” subsidiary there will
be strong objections because of the added interest cost / lower profitability resulting
from the consequent local borrowing. In such cases of leading and lagging the
interests of the minority shareholders are subordinated to those of the majority
shareholders (the parent company) . Host governments , via credit and exchange
controls , may well restrict such operations.
4) Pricing policy
For exposure management purposes, there are two kinds of pricing tactics: price
variation and currency-of invoicing policy. ( In effect , the latter tactic is a subtle
variant of the former ) . For each of these it is necessary to distinguish between
external and inter-company trading, since each kind of trading gives rise to a different
set of problems and opportunities .
Price Variation : External Trade. One obvious way for a company to protect
itself
against exchange risk is to raise selling prices to offset the adverse effects of
exchange rate fluctuations . But the question which always arises with the pricing
option , of course, is that if the company is able to raise prices then why has it not
10
done so already, irrespective of exposure considerations ? Integrating Working
Capital
and Capital
Investment
Given an adverse exchange rate change ( or trend ), how quickly can local selling esses
prices be increased to bring the parent currency equivalent of the foreign operation’s
cash flows back to the pre-depreciation level ? The determination of this lag requires
an analysis of the following questions.
Competitive situation : what sector of the market are the firms in ? A firm
selling
in the import or import - competing sectors is likely to have greater pricing flexibility
than one in the purely domestic sector . The question of timing is also important : is
there any scope for anticipatory price increases , given an expectation of an adverse
currency movement .
Customer credibility : when did the company last increase its prices and will
there be customer resistance to another price rise ?
Internal delays : what are the administrative lags involved in raising prices ?
Foreign currency price lists can be the source of significant delays , depending on
how regularly they are reviewed and how lengthy is the review process. For a price
list involving thousands of items such delays can be serious .
Trading/financing pattern : if a firm does not have pricing flexibility for any of
the
above reasons , does it have a trading pattern or can one be created in which adverse
currency impacts in one area of the business will be offset by positive effects
elsewhere ? For example , a foreign subsidiary which imports raw materials and sells
locally is exposed to a local currency depreciation . To the extent that it can shift its
sourcing (to domestic suppliers) or its selling (to foreign customers), this economic
exposure may be reduced .
For the strong currency exporter the defensive approach is the only one available for
11
export invoicing since the HC is probably also the strongest currency acceptable to
the customer . For the weak currency exporter, however, there may be significant
Integrated View
opportunity gains from an aggressive currency - of- invoicing policy. In such
circumstances foreign currency invoicing may be attractive to the exporter, in the
expectations that the HC equivalent sales proceeds would be increased by a foreign
currency appreciation over the credit period. It should be added, however, that there
are risks involved in switching from a weak currency to a supposedly stronger one.
The relative strengths of the two currencies could reverse themselves in the future
and , once having changed to foreign currency billing , companies will find it difficult
to switch back to HC-involving if the currency situation alters . In any case ,
currency-of-invoicing cannot be changed regularly quite apart from customers
objections and the loss of customer credibility, there is the problem of price list
adjustment lags. Currency-of-invoicing changes will also have to be ‘sold’ to
subsidiary management as well as to customers. Indeed, resistance at operating unit
level may present major problems to a corporate treasury trying to make the initial
switch to foreign currency invoicing. Subsidiaries may be reluctant to give up the
perceived marketing advantages of weak currency invoicing, particularly since if
corporate exposure management is to be centralised (often a corollary of the switch
to foreign currency invoicing) the benefits of foreign currency billing may accrue at
corporate treasury.
Asset and liability management techniques can be used to manage balance sheet,
income statement and cash flow exposures. They can also be used aggressively or
defensively . The aggressive approach is to increase exposed assets, revenues, and
cash inflows denominated in strong currencies and to increase exposed liabilities,
expenses, and cash outflows in weak currencies. In contrast, the defensive firm will
seek to minimise foreign exchange gains and losses by matching the currency
denomination of assets / liabilities, revenues / expenses , and cash inflows / outflows,
irrespective of the distinction between strong and weak currencies .
In analysing how these objections can be achieved, it is useful to make the distinction
between operating variables (trade receivables and payables, inventory, fixed assets)
and financial variables (cash, short-term investments and debt).
In the context of cash flow exposure management, the distinction between aggressive
and defensive currency-of-financing policies is an important one. With an aggressive
financial management strategy the aim of currency-of-financing policy is simply to
borrow in those currencies which have the cheapest effective interest cost, after tax.
For the defensive firm the aim of international financial management should be to
arrange the financing pattern of the company so that the detrimental effects of
currency movements are minimised, whatever the exchange rate scenario. This can
be done by structuring the group’s liabilities in such a way that any change in cash
inflows (operating revenues) induced by a currency movement is offset as much as
possible by a countervailing change in cash outflows (effective interest costs).
B) Exposure Management : External Techniques
2) Short-Term Borrowing
The discounting technique for covering receivables exposures is very similar to the
alternative of short-term borrowing except here the ex ante cost is the effective
discount rate less the HC deposit rate, rather than the foreign currency borrowing
rate less the HC deposit rate. With both techniques, of course, the basic aim is to
convert the proceeds from the foreign currency receivable into the HC as soon as
possible. As with straight borrowing operations, discounting is a non-sequitur in many
exchange-controlled countries since foreign currency borrowing of any sort is
permitted only under certain conditions.
4) Factoring
For the exporter the technique is very straight forward. He simply sells his export
receivables to the factor and receives HC in return. The costs involved include both
credit risks (the customer may default) and the cost of financing (if the exporter
wants to receive payment before the receivable maturity date), as well as the cost of
covering the exchange risk (the forward discount/premium). Factoring therefore
tends to be a high-priced means of covering exposure, although there may be
offsetting benefits and credit collection costs (the exporter may simply hand over the
invoices against payment, the book-keeping and credit collection being done by the
factor).
14
Initially, such exchange risk guarantee schemes were introduced to aid capital goods’,
exporters, where receivable exposure terms can be of a very long-term nature. estment
Processes
More, recently however, some schemes have been extended to cover the exchange
risk arising on consumer as well as capital goods’ export. Government exchange risk
guarantees are also given to cover foreign currency borrowing by public bodies.
It may be noted that the various exposure management techniques described above
are not available in all circumstances. This is mainly because of limitations imposed
by the market-place (as forward market exists in many of the ‘exotic’ currencies of
the developing countries) and by regulation (the hedging of translation exposures on
the forward markets is not allowed in many countries). Similarly, the availability of
internal techniques is largely a function of the international involvement of each
company.
The significant aspect of such traditional foreign lending and borrowing is that all
transactions take place under the rules, nuances, and institutional arrangements
prevailing in the respective national market. Most important, all these transactions
are directly subject to public policy governing foreign transactions in a particular
market. To illustrate, when savers purchase securities in a foreign market, they do so
according to the rules, market practices, and regulatory precepts that govern such
transactions in that particular market. The same applies to those who invest their
funds with foreign financial intermediaries.
Likewise, foreign borrowers who wish to issue securities in a national market must
follow the rules and regulations of that market. Frequently these rules are
discriminatory and restrictive. The same is true with respect to financial
intermediaries; the borrower who approaches a foreign financial institution for a loan
obtains funds at rates and conditions imposed by the financial institutions of the
foreign country and is directly affected by the authorities’ policy towards lending to
foreign residents.
The Eurocurrency markets constitute the short-to-medium term debt part of the
international capital flow structure. The market is made by banks and other financial
institutions that accept time deposits and make loans in a currency or currencies other
than that of the country in which they are located. The latter characteristic defines
the Eurocurrency market — it is a non domestic financial intermediary. In the light of
the rapid growth of similar institutions in Hong Kong and Singapore (and to a lesser
extent in the Middle East) the market is new worldwide and is more appropriately
called the “offshore” or “external” money market.
15
Growth of this network of intermediaries has been spectacular. The Eurocurrency
market is extremely large and has grown rapidly in a short interval. It has received a
Integrated View
bad press from central banks, which continue to call it a major cause of inflation and
an obstacle to their control of domestic monetary systems. A number of basic
questions and issues crop up soon as one looks at the offshore capital markets. First,
what separates them from domestic markets? Second, why were they needed and
how could they grow so fast when sophisticated domestic capital markets already
existed? Third, is there a process of offshore money creation analogous to money
creation in a domestic banking system and what effect does this have on world
inflation?
1. One can take the physical currency of a country and deposit it in a bank in
another country. Banks do hold currency of other countries but mainly for the
convenience of travellers. And large quantities of currency have been smuggled
out from time to time in recent years. However, this is usually done with the
expectations of a depreciation of the currency being smuggled, and the receiving
banks quickly convert these balances into some hard currency. So this method is
in general of trivial importance as a creator of deposits.
2. One can transfer deposits from within the country whose currency is in question
to an offshore bank. This may well be an overseas subsidiary of the very same
bank with which the original deposit was held.
Of course, once offshore banking systems exist in tandem with domestic banking
systems it is no longer particularly meaningful to measure money supplies according
to the domestic banking system exclusively. What are you interested in when you
measure the money supply? What purpose do these measurements serve? If our
interest is inflation, we are concerned with the demand for and the supply of money
balances for transactions purposes. To the extent that they are negotiable, Euro
market CDs are probably used as transactions balances. Analysis of problems
involving the money supply should, therefore, embrace a money supply consisting of
the domestic monetary aggregates plus the negotiable part of offshore deposits in the
currency concerned. If the relevant domestic monetary aggregate includes time
deposits, then one should include also Eurotime deposits of the same maturity.
The offshore banking system is outside the control of the central banks whose
currencies it uses. We should consider briefly whether this is good or bad, or even,
16
for some purposes, true. Let us consider first the question of whether the central apital
banks have now lost control of the money supply and therefore of inflation. Sincement
Processes
every Eurocurrency unit has its origin in a domestic currency deposit or cash unit, this
cannot be true. Just as in a system of purely domestic banking, the central bank
controls the monetary base and so controls the money supply, up to the vagaries of
the money multiplier. The monetary base is multiplied to create the money supply,
because deposits are relent except for the portion held as reserves plus the portion
held as cash by the public. The offshore currency markets might make the multiplier
different in size, or they might make it more variable. A multiplier different in size
from that in a purely domestic banking system does not affect the monetary control
of the central bank. The latter body must simply know that it is working with a
multiplier of size x rather than size y. Hence problems in monetary control arise from
variability of the size of the multiplier.
For practical purposes we have one short-term CD cum time deposit market, and
whatever practical problems there are in the conception and implementation of
monetary policy cannot be sensibly described as more severe in one part of this
whole than in another part.
If this is so, we must explain the hostility central bankers often voice towards the
offshore markets. A number of factors are important here. First, while the central
banks have as much control as they ever had on creation of money, they have no
control over allocation of credit in the offshore capital market. Second, as the
Euromarkets are still viewed by the press and the public as mysterious and
omnipotent, they make convenient scapegoats for failures of nerves in the handling of
domestic monetary policy. Finally, the European central banks made fools of
themselves in the 1960s in their Euromarket dealings in a way which they would
rather forget, but which is instructive for us to examine.
In the 1960s the European central banks were pegging exchange rates, and absorbing
growing dollar deficits. In the early 1960s these dollar deficits, which became dollar
reserves of the absorbing central banks, were matched by growth of U.S. official
obligations to foreign central banks in the U.S. balance of payments accounts.
However, in the late 1960s the European central banks were surprised to observe a
growing discrepancy between the change in U.S. official obligations to foreign central
banks and their own record of dollar reserves held. The central bankers kept getting
more and more dollars than the United States seemed to be losing on the official
settlements definition of the balance of payments. The well-known economist Fritz
Machulp said of them, “Most magicians who pull rabbits out of their hats know full
well that they put them there before the beginning of the show. The magicians in
(this) story, however, are more naïve, they are just as surprised as the audience by
the emergence of the rabbits from their hats.”
Now suppose a foreign central bank decided to earn higher interest on its reserves by
converting its acquired U.S. demand deposits to Eurodollar CDs rather than Treasury
Bills. As we have seen, such an action transfers the ownership of the U.S. demand
deposits representing the new foreign reserves to some private, offshore bank. 17
Originally, thel se U.S. deposits were turned into foreign exchange to create the capital
outflow that the European central bank absorbed. Subsequently they became the
Integrated View
property of the private foreign bank. This was not recorded on the official settlements
part of the balance of payments accounts though it certainly constituted foreign
reserves created by the deficit, just as before. This explains part of the mystery, but
the best part is yet to come.
Consider what might have happened to the Eurodollar deposits owned by the foreign
central banks. Under the fixed exchange rate system there were periodic exchange
crises, during which people would try to switch other currencies into DM or Swiss
francs in anticipation of appreciation. Frequently the offshore banks would lend the
dollar deposits of the Swiss and German central banks to speculators who converted
them into DM or Swiss francs. Under their exchange pegging policies, these
tendered dollars had to be absorbed by the central banks, who re-deposited in the
offshore markets, so that they could be lent again ! This is the rabbit in the hat trick
of which Machlup was speaking. The central banks came to own very large
Eurodollar claims by this circular process, but these large claims were not on the
United States but rather (indirectly) on the speculators.
That is, banks in the offshore market must operate with a lower spread between the
interest rates they charge to borrowers and the ones they pay to lenders.
These changes initiated national policies of liberalisation and deregulation which were
designed to attract capital to its financial markets. Furthermore, they have been
characterised by a trend toward a breakdown in the segmentation of financial
markets. Distinctions among services offered by different financial institutions are
blurring in many countries, and national markets are becoming increasingly integrated
internationally. The nature and extent of these changes differ across countries, but
almost everywhere competition in financial markets has intensified.
14.10 SUMMARY
It is common that when finance goes international, problems multiply. One has to
focus on the operation of exchange markets, financial and euro markets. When
companies operate across nations, they face political, tax, foreign exchange and the
economic constraints. A clear understanding of the issues is all that is desired in an
international context. The basic issues pertain to the quotings and factors that
influence the exchange markets. Managing exchange rate fluctuations is also highly
important. The present unit focuses on both the internal and external techniques to
deal with this phenomenon. The internal techniques include: Netting, Matching,
Leading and Lagging, Pricing and Asset-liability management [ALBM]. External
techniques include: Forward exchange contracts, short-term borrowing, discounting,
factoring and guarantees. Finally, the developments in the Euro-markets need to be
closely studied for their effects on the company borrowing and financing programme.
Getting more mileage out of the funds involves a clear understanding of the
implications of change in the national and international contexts.
Bid-Ask Rates : The prices quoted by the sellers and buyers for their dealings
in foreign exchange.
Netting : Offsetting exposures in one currency with exposure in the same or another
currency.
6) The Eurocurrency market is often commented upon for its apparent ability to
create vast amounts of credit. Explain how this credit creation process takes
place with the help of an example. Also explain how the interest rates work in
the Eurocurrency market.
11) How does speculation in the forward exchange market differ from speculation in
the spot market? What is meant by going ‘long’ or ‘short’ in the currency
market? Under what conditions would you sell a certain currency forward?
12) Explain the mechanism of an Interest rate swap with the help of an example.
13) What is the difference between the Eurodollar market and the Eurobond market?
In this context explain the rationale of the Eurodollar market.
14) Explain how the Eurocurrency, Euro-credit, and Eurobond markets differ from
one another.
15.1 INTRODUCTION
Capital investment creates the need for additional investment in inventory, accounts
receivable and cash, through-out the life of the plant and equipment. It is normally
assumed that an investment in working capital assets also causes a comparable
expansion in current liabilities. The theoretical models for evaluating capital investment
alternatives implicitly assumes the costs resulting from changes in the working capital
components or the cash benefits following from these components are imbedded in the
cash flow of the investment. The implicit inclusion of working capital components in
the capital investment model is correct theoretically, but having the capability to
measure the explicit contribution of working capital components to cash inflows and
outflows provides a powerful tool for management.
There are several reasons for identifying the costs and benefits created by the
working capital components and linking them explicitly into the total investment
planning process. More than likely in the early life of an investment it is operating
below capacity; while later in the life cycle, there is often an increase in operating
capacity. Thus, throughout the life of an investment, there is often a continuing
growth of investment in working capital. Furthermore, the discounted cash outflows
related to cash, receivables and inventories can range from a modest to a major
proportion of the total cost of an investment. Also the source of financing for these
current assets, either long or short-term, can affect the cash flow patterns of an
investment. The need for additional investment in working capital is dependent on
1
Working Capital the type and size of investment’ the size and growth of the market, the growth of the
Management: relative market share and length of the planning horizon. Additionally, the impact of
An
Integrated View inflation can create a drag on cash flows if the price increases related to Labour and
materials are always leading the price increase for the products sold by a significant
margin. Finally, within many corporations the management of the working capital
components is usually separate from the capital investment and long-run financial
planning systems. Continuous communication between operating and strategic
management are vital to the long-term success of a firm, but communications are
often infrequent or nonexistent. These observations indicate the need for a planning
model that explicitly integrates the working capital components into the capital
investment decision-making process.
The gap between theory and practice may not be so serious, if working capital is
given appropriate decision-making context. Specifically, if the working capital is
viewed as an investment, and that changes in working capital policies are included in the
capital budgeting process of the firm.
In view of the relative size of working capital changes, and also the finding that many
firms do indeed view such changes as investment projects, it is well to consider more
closely the relationship of working capital decisions to other financial decisions made by
the firm. This relationship is found in financial control. While control is well
known to be one of the key functions of management, it would appear to have
received considerably less treatment than planning, at least in the financial literature.
But just as control without adequate planning will likely be futile, planning without
adequate control will prove frustrating.
A first dimension of financial control that has been well documented is to monitor the
financial progress of the firm over time. This usually takes the form of tracking
selected financial ratios, and thereby assessing both the current status and likely
future prospects of the organisation. If attention is limited to single ratios for just
profitability and liquidity, then financial control is relatively straight forward. If,
instead, management tracks a larger number of financial ratios, then financial
control is more complex as tradeoffs must be made. In general, if there are N
measures being tracked any investment project or change in policy will result in 2N
possible changes in the status of the firm, Obviously, the number 2N -2 quickly gets
large as N is increased. One way to handle the complexity of multiple ratios is with
composite measures such as the Dupont System or the Altman Bankruptcy model.
Exhibit- 15.1
Possible Corrective Actions Involving Working Capital
—————————————————————————————————
Cash
1. Change collection network
2. Change disbursement network
3. Change size of operating cash balance
Marketable Securities
4. Change method of investing surplus cash
5. Change method of transferring funds between cash account and marketable
securities portfolio.
Accounts Receivable
6. Change cutoff score for credit applications
7. Change discounts offered to customers
8. Change frequency of follow-up payment notice
Inventory
9. Change inventory valuation methods
10. Change inventory order quantities
11. Change inventory safety stocks
12. Change distribution network
Payables and Accruals
13. Change suppliers used
14. Change response to suppliers discounts
15 Change payroll procedures
Short-term Borrowing
16. Change lenders used
17. Change payment methods
18. Change collateral arrangements
—————————————————————————————————
Not all of the corrective actions in Exhibit-15.1 would be feasible, let alone desirable,
for a given firm at a particular point in time. For each corrective action that is
feasible, financial managers should identify the expected benefits and costs towards
3
Working Capital evaluating whether it would help the firm move towards its expressed goals.
Management: Corrective action #7, for example, is a change in the cash discounts which the firm
An
Integrated View offers to its customers. A cash discount tantamounts to a reduction in price. Suppose
the discount is increased, to the extent that customers take advantage of the larger
discount by paying their bills sooner, the firm’s investment in accounts receivable is
reduced. The expected benefit of corrective action 7, therefore, should reflect the
extent of the discount that is offered to the proportion of credit customers that are
expected to take the discount and the resulting decrease in the receivables
investment. The expected cost of corrective action # 7 is the reduced profit to the
firm as a result of credit customers that avail themselves of the larger discount.
Based on past experiences with customer response to changing credit terms, the
credit manager ought to be able to make reasonable estimates of the expected
benefits and cost to the firm of offering customers a larger cash discount. Expected
benefit and cost can then be combined in order to calculate a “return-on-investment”
for the corrective action. If a similar procedure is also followed for each corrective
action being considered (such as those in Exhibit-15.1) , then each corrective action
can be viewed as a proposed investment project by the firm-and evaluated within the
context of the capital budgeting process. Again, this would seem to be consistent
with both the theory and current management practice.
Though the need for integrating the working capital processes into the long run
financial planning processes has been recognized and a variety of theoretical
linkages have been suggested, many of the models have not incorporated the
dynamics of uncertainty involved in the short- run investment. None of these models
are really integrated into the capital investment and long-run financing processes of the
firm. The primary objective of this chapter is to offer an integrated model
designed for management decision making and to provide a model for testing “ What
if” policy questions concerning the impact of working capital variables on the total
profitability of capital investment alternative.
The model is divided into two parts, viz the Capital Investment (CI) module and the
Working Capital (WC) module.
4
Each variable is assumed to be stochastic and independent. However, it is assumed Integrating Working
Capital
that the parameters are specified for each variable by the decision makers, reflecting and Capital
Investment
their perception of the interrelationships among the variables. If there are well
Processes
Exhibit 15.2
Simulation of the working capital-capital investment
process
5
Working Capital
Management:
An
Integrated View
The programme randomly selects in a sequential order a value from the specified
distribution for each variable. The uncertain and dynamic characteristics of the CI
process are reflected in this random interaction of the variables. The selected values
are used in the calculation of a net present value (NPV) , internal rate of return
(IRR), and a benefit/cost ratio (B/C) for each simulation. This process including the
working capital module is repeated 100 times and the final outcomes are profitability
profiles or cumulative frequency distributions of NPV, IRR, and B/C.
Historically, working capital (WC) activities are frequently revised, relatively routine
and occur in a relatively short time period. Also the WC process is usually
considered to be independent of the CI planning process. The management of short-
run cash flows is a continous and dynamic process occurring in an uncertain
environment. However, because the CI model operates on an annual basis it is
assumed, for convenience, that the strategic planning of the WC cycle also operates
on a one year horizon. A shorter time period could be programmed to accommodate
the needs of decision makers.
Cash Flow Crises
A cash flow crises often occurs when unexpected events arise, e.g., actual short-run
expenditures being greater than forecasted and /or actual short-run cash inflows
being less than forecasted. Surprise outflows can be related to a large price increase
for raw materials. An unexpected decline in inflows arises when actual sales are
less than forecasted or if there is an extension of the normal trade credit payment
pattern. In both cases total cash outflows are frequently greater than total cash
inflows plus existing cash items.
The standard approach to investment planning is to assume that the forecasted cash
flows actually occur. For example, in solving for the net present value (NPV) or
internal rate of return (IRR) of an investment it is assumed the forecasted
distributions of revenues and costs actually occurred. By assuming the profitability
profiles generated from the forecasted inputs actually happen, the analysis misses the
effect a short-run financial crises has on cash flows. Because cash flow crises
often arise when forecasting errors occur, the analysis of investment opportunities
6
requires an additional step. A dual simulation process is introduced with one Integrating Working
assumed to represent the forecasted results and the other the actual outcomes. In Capital
and Capital
simulating these two sets of conditions, the model assumes sales are the key Investment
mechanism. It is assumed that actual sales (s) are generated by the CI programme Processe
and a supportive forecast of sales (SF) is produced by the WC module. Simulating s
sales conditions where the actual sales are randomly different from forecasted
sales, captures the essences of forecasting errors, which incorporates the major
cause of WC problems.
If the forecasted sales exceed actual sales there will be a cash flow shortfall. To
offset the short-fall current asset and current liability components are adjusted by
management. The cash flow shortfall is the heart of the problem related to a WC
crises. The model provides management a variety of short-run policy alternatives to
offset the cash flow shortfall.
New Variables
In the WC module two new sets of probabilistic variables are introduced and
combined with the variables in the CI module. One set represents three WC
variables. These variables inject the uncertainty existing in the WC system into the
total financial planning process. These three probabilistic variables are: (1) sales
forecast (SF) in year 1, (2) an annual growth rate of forecasted sales (G) related to
the life cycle of the product, and (3) trade credit/sales (TC) ratio that is related to the
quantity of production.
The second set of probabilistic variables represent the inflation dimension as its
impact on the firm. There are four separate rates of inflation. The stochastic
inflationary variables serve as an adjustment to the values selected for price (P),
interest (ib,iL), total purchases (PUR), total Labour costs (LC), and fixed costs
(FC).
7
Working Capital Short term borrowing rate
Management: An
Integrated View Short term lending rate
The working capital module is divided into three additional parts beyond the
investment information presented in the CI module. The first module comprises the
cost and income components. Also, inflation adjustments occur in this module. The
second module involves the processes related to production and inventory. Finally,
the module that links the total process together is the cash and trade credit system.
The objectives of each module and an explanation of its operation are presented in
the following sections. A numerical example with accompanying comments
concerning the operation of the module are found in Table 15.1. The example of the
model in Table 15.1 integrates all of the modules in the total working capital-capital
investment process (WC-CI). The following presentation is an explanation of the
sequential operation of the WC module and is based on the data in Table-15.1.
Investment Information
The first operation of the model is the determination of actual and forecasted sales in
both rupees and units. The initial price is provided by the user, which is Rs. 12.50 in
our example in Table-15.1. A random market size of 45.4 lakh units is selected for
year 1. Also, a market share of 17.92 per cent is selected at random. Sales demand is
8,62,219 units and is determined by multiplying the random market size (1) times the
market share. Sales of Rs. 1.077 crore are calculated by multiplying price times
sales demanded in units. Sales forecasted in rupees is randomly drawn from a
distribution and sales forecast in units is calculated by dividing by price.
The difference between sales demand (s) and sales forecast (SF) reflect the
forecasting error and is a critical value in the working capital management process.
If forecasted sales are greater than the actual sales (SFt > St), the firm did not
achieve its sales forecast. Therefore, the sales demanded (Q) become the actual
sales (AS). However, if sales demand is greater than forecasted sales (St > SFt),
unforecasted or potential sales arise and it is assumed management will try to
produce as much as possible to close this gap and meet these potential marginal
sales. In example in Table 15.1 management assumed 40 per cent of potential
marginal sales would be produced. Whenever St > SFt, the marginal sales achieved
are added to the sales demand to give actual sales (AS). The final operation of this
module is the calculation of forecasted production (FPQ). Table 15.1 shows FPQ is
calculated by adding the change in the amount of required ending inventory (units)
to the sales forecast in units.
Each of the variables in this module make an important contribution to the total
module. It is apparent the gap between St and SFt is the primary reason for
financial planning. The gap between S and SF introduces uncertainity into the
investment planning process.
Previously capital investment theory has assumed that St = SFt. The contribution of
the (WC-CI) model is to include a sales forecast variable and build in the assumptions
that (1) St SFt, for t =1, … n, (2) if St > SF all marginal sales may not be
achievable and there might be a cost premium for marginal sales that should be
added to total costs of the investment, (3) also, when marginal sales are achieved,
they generate cash in-flows that were not anticipated when it was assumed St = SFt,
(4) if SFt > St, there can be a cost of carrying additional inventory that should be
added to the total cost of the investment, and cash inflows will be smaller than
planned under conditions when St = SFt.
8
Cost and Income Module Integrating Working
Capital
and Capital
There are several key operations involved in the costs and income module. The three
Investment
primary operating costs are : purchases (PUR), labour (LC) and fixed (FC). It is Processe
assumed that these variables are closely related to the forecasted production, i.e. s
quantity of goods produced. When St > SFtt, it is possible to have marginal
production above the original forecasted level. When this condition occurs, the
marginal cost of purchases and labour are calculated separately and added to their
respective forecasted costs for purchase and labour.
The major cost items are calculated in this module and Table 15.1 provides an
example of these calculations. First , for period 1, labour cost per unit of 2.52 was
randomly chosen, and multiplied with forecasted production. The labour costs are
increased for inflation, which was 5.35 per cent in year 1. In this model inflation is
assumed to be a random variable. When marginal sales are achieved, marginal
labour costs are calculated in units of marginal sales. In Table 15.1, the marginal
labour costs (MLCX) are 10 per cent. Thus on the additional marginal sales
achieved, the cost of labour was 10 per cent higher than under normal operating
conditions.
Fixed costs are assumed to be a random variable that is related to the sales
demanded. The fixed costs are also increased by a separate inflation rate, 4.45 per
cent, that was selected randomly.
Purchase costs are calculated by multiplying the gross margin (.5) times the value of
forecasted production. The gross margin is a key input variable determined by the
user. When St > SFt, there are marginal purchases made to accommodate the
marginal sales determined earlier. Normally, the gross margin for marginal sales
(GMMP) should be greater than the gross margin. It is .6 in Table 15.1.
Additionally all purchase costs are adjusted by a randomly selected inflation value of
5.35 per cent.
In year 1 the initial investment cost of Rs. 7.72 million is randomly selected, and an
annual straight line depreciation schedule of Rs. 857,778 is determined for nine year
horizon with all receipts and costs determined, earnings before interest and taxes
(EBIT) of Rs. 758,065 are calculated. Next it is assumed that the interest cost on
short-term debt is paid the following year. Thus, in year 1, there is no interest cost,
and earnings before taxes (EBT) is equal to EBIT. The assumed tax rate is 40
percent. Table 15.1 shows the calculation of Rs. 303,226 in taxes, and net income
equals Rs. 454,839.
9
Working Capital level of REI is related to the units of production in period t. (3) A maximum
Management: inventory cushion (MIC) that management expresses as a percent, above the
An
Integrated View required ending inventory quantity (REI). If the actual ending inventory (AEIOT) is
greater than the maximum ending inventory MEIOt), there will be excess inventory
(EXINV). (4) The cost of carrying excess inventory is cost that arises when
SF > S, thereby causing a cash cost for holding inventory in excess of the forecasted
inventory needs. The cost of carrying excess inventory is assumed to be the cost of
capital. As shown in Table 15.1, it is multiplied with the cost of excees inventory to
determine the cost of holding excess inventory.
This module ties together receivables and the cash operation including short-term
borrowing or investing in marketable securities. The module collects which serve as
inputs for calculating the net present value of the investment.
10
Marg Sales Achieve (Rs.) 1,93,344 10,91,111 If SF > S: MSA = 0; Integrating Working
If S > SF : MSA = PSt Capital
(PSAt); and Capital
PSA2 = .4 PSA = Investment
Potential Processe
Sales Achieved. s
Marg Sales Achieve (Rs.) 15,388 81,184 MSAQt = MSAt/Pt
(MSAQ)
Actual Sales (AS) (Rs.) 1,04,89,218 1,34,78,909 If SF > S: ASt = St;
If St > SFt;
ASt = (SFQt + MSAQt) Pt
Actual Sales* (ASQ) (u) 8,39,137 10,02,985 ASQt = ASt/Pt
Forecast Prod (FPQ (u) 9,22,600 8,22,861 FPQt = SFQt + (REIQt -
AEIQt -1);
Where REIQ is required ending
Inventory and AEIQt -1
Is actual required ending
:Inventory given below.
These concepts are presented in
the inventory module.
COST AND INCOME MODULE
Labour Cost (LC) (Rs.) 23,24,951 18,76,123 LC1 = LC1 Per Unit ( FPQ 1);
Where LC1 = 2.52; where
LC2 = 2.2799 AND BIQ =
beginning inventory =98,850 (u);
LCt for future years follows
the second equation.
Infl Adj Lab Cost (Rs.) 24,49,334 19,90,566 PALCt = LCt (1 + PALt); where
(PALC) PAL is inflation rate for
labour costs; PAL 1 = .0535;
PAL2 = .061
Marg Labour Cost (Rs.) 42, 654 2 , 03 , 609 If St > SFt : MLCt = MSAQt (LCt
(MLC) Per unit x 1 + MLCX) =
Marginal labour cost per unit
Above LC per Unit. MLCX =.10.
If St > . SFt : MLC = 0.
Infl Adjust (PAMLC) (Rs.) 44,936 2,16,029 If St < SFt : PAMLCt = 0;
If St > SFt:
PAMLC = MLCt (1 + PALt)
Fixed Cost (FC) (Rs.) 1,75,000 2,15,000 FCt = related to SFt.
Infl Adjust (PAFC) (Rs.) 1,82,787 2,16,029 PAFCt = FCt (1 + PAFt);
Where PAFt is inflation
rate for fixed cost.
PAF1 = .0445; PAF2 = .064.
Purchase Cost (PUR) (Rs.) 57,66,248 55,76,087 PURt = GM (FPQt × Pt)
where
GM is gross margin. GM = .5.
Infl Adjust (PAPUR) (Rs.) 60,74,737 60,19,381 PAPURt = PURt (1 + PAPt);
Where PAPt is inflation
rate for purchases.
PAP1 = .0535; PAP2 = .0795.
Marg Purch Cost (Rs.) 1,15,406 6,54,667 If St > SFt : MPUR =
(MPUR) (MSAQt x Pt) GMMP;
GMMP = .6, Gross
Margin for marginal purchases.
If SFt > St: MPUR = 0.
Infl Adj (PAMPUR) (Rs.) 1,21,580 70,76, 712 PAMPURt = MPURt ×
(1 + PAP).
Operating Income (OI) (Rs.) 16,15,843 43,17,355 Iot = ASt - PALCt - PAMLCt
- PAFCt - PAPURt - PAMPURt.
Investment Cost (IC) (Rs.) 77 , 20 , 000 0 IC0 is a randomly
selected variable.
11
Working Capital Deprec (DEP) (Rs.) 8,57,77 8,57,778 DEP1 is straight line
Management: depreciation; DEPt = IVt /N;
An Where N = 9 Years.
Integrated View
Book Value (BV) (Rs.) 68,62,222 60,04,444 BV1 = ICO - DEP1;
BV2 = BV1 + DEP2.
EBIT (Rs.) 7,58,065 34,59,477 EBITt = OIt - DEPt.
Interest (ZNT) (Rs) 0 2,41,050 INTt = ib (cumulative S/T
borrowingt-1) ; ib is borrowing rate
of interest,
TIbl = .08; for t2, …, tn, TIbt
= ibt-1 (Pat); cumulative S/T
borrowing - 1
given on last page.
EBT (Rs.) 7,58,065 32,18,526 EBTt = EBITt = INTt
Taxes (T) (Rs.) 3,03,226 12,87,410 Tt TR (EBT); where TR
Ts tax rate. TR =.4.
Net Income (NI) (Rs.) 4,54,839 15,31,116 NIt = EBTt - Tt
Production-Inventory
Module
Required Ending (u) REIQt = REIt (SRF);
98,850 92,171
Inventory (REIQ) REI1 = .12; REI2 =.10.
Begin Inventory (BIQ) (u) BIQ1 = O; BIQt = AEIQt - 1
0 98,850 For tt2, …… , tn
Actual Production (u) PRODQt = SFQt - BIOt
(ORIDQ) 9,37,987 9, 96,266 + MSAQt + REIQt
Actual Ending Inv (u) If St > SFt; AEIQt = REIQt;
(AEIQ) 98,850 92,171 If SFt > St: AEIQt = PRODQT
- ASQt + BIt
MAX Ending Inv (u) MEIQt = REIQt (1 + MIC);
(MEIQ) 1,18,620 1,10,605 MIC = .2
Excess Inv (ExINVQ) (u) If MEIQt > AEIQt : ExINVQt = 0;
0 0 If AIEQt > MEIQt:
ExINVQt = AEIQt - MEIQt
Carrying Cost (Rs.) CEXNVt = ExINVQt (GM)
(CEXINV) 0 0 GM = Gross Margin = .5;
K= Cost of carrying
Inventory = .1
Cash-Trade Credit
Trade Credit/Sales (%) TCt is a random variation
System
(TC) and proxies for (AR/S - AP/St).
.3535 .331
Net Act. Rec. Bal. (AR) (Rs.) ARt = STt (BDA): BDAt
Bad Debt Allowance (Rs.) BADt = ARt (ADA); BDA = (BDA)
37,07,937 44,61,517
Cash Receipts (CR) (Rs.) CRt = ASt + ARt-1 - BADt
3,70,794 4,46,152
Begin Cash + MS Bal (Rs.) BC1 = 0; BCt = Ect-1,(BC)
67,81,281 1,23,54,531
For T2,…….., tn
0 6,17,812
Cash Available (CBAL) (Rs. ) CBALt = CRt + BCt + BEXC -
FUTCOSTt, BECX is
67,81,281 1,29,72,343 est from S/T investment
Is Zero in years 1 and
FUTCOST = 0 future investment
Cost.
Total Cash Pay (CPAY) (Rs.) CPAYt = PALCt + PAMLCt
+ PAFCt + PAPURt + PAMPt
91,76,000 1,12,24,972 + Tt + CEXINVt + INTt - 1
End Cash + MS Bal (Rs.) ECt = SEt (CMINt) + MSt;
(EC) CMIN1 = .06; CMIN2 = .0
6,17,812 6,19,390 *****
Cash Lower Bound (Rs.) CLOWt = SFt (CMINt)
(CLOW)
6,17,812 6,19,390
Max Cash + MS Level (Rs.) CMAXt = CLOWt (1+ MAXCA
(CMAX) MAXCASH = .2
7,41,374 7,43,268
12
Short Term Debt (STD) (Rs.) 30,131,31 0 If (CBALt - CPAYt) > Integrating Working Capital
CLOWt; and Capital Investment
STDt = 0; If (CBALt - CPAYt) Processes
<
CLOW: STDt = CPAYt -
CBALt)
+ CLOW. See Appendix 1
for additional conditions.
Payment S/T/debt (Rs.) 0 11,27,981 If (CBALt - CPAYT) >
CLOWt:
(PAY) PAYt = (CBALt - CPAYt) -
If (CBALt - CPAYt) <
CLOWt:
PAYt = 0. See Appendix 1.
Cum S/T/ Debt (Rs.) 30,13,131 18,85,150 SUMCXt = SUMCXt-1 - PAYt
(SUMCX) + STDt
Interest Cost (INT) (Rs.) 2,41,050 1,61,180 INTt = SUMCXt (Tb); Tb =
borrowing rate = .08
S/T LEND (Mkt Sec) (Rs.) 0 0 If SUMCXt > 1, MS = 0.
(MS) See Appendix 1.
Interest Benefits (Rs.) 0 0 BEXCt = MSt (iL); iL = lending
(BEXC) rate = .07
Cash CT MAX Cash + (Rs.) 0 0 CEXt=CBALt CPAYt- SUMCXt
MS (CEX) - CMAXt
Cash Flow (CF) (Rs.) 23,95,320 12,74,186 CFt = CRt - PALCt - PAMLCt
- PAPURt - PAMPURt - PAFCt
- T*t
Revised Cash Flow (Rs.) 0 0
RCFt = CFt = T*t - Tt +
(RCF) BEXCt - 1
- INTt-1 - (Ect - Ect -1)
+ (SUMCXt - SUMCXt - 1) -
CEXINVt
cost of Capital (k) (%) .10 .1055 kt = kt-1 + PAt - PAt-1)
———————————————————————————————————————————
In Table 15.1 cash equals zero at the beginning of year 1. For subsequent years
beginning casht equals ending cash (-1), which includes cash plus marketable
securities. The total cash available for meeting cash payments equals cash receipts
(CRt) plus beginning casht (BCt) plus interest earned on marketable securities
(INT) minus any capital investment costs (FUTCOST).
Total cash payments equals the sum of all cash outflows which are shown in
Table 15.1. All outflows occur in the year. If cash payments are greater than cash
available, the company will have to borrow (short-term) to meet the total cash
payment. Under these conditions, ending cash equals lower boundary (CLOW)
prescribed by management. Table 15.1 shows this was the case in year 1. Ending
cash is a complex variable that is explored further in the next few paragraphs.
When there is cumulative ST debt outstanding, an interest cost is incurred at the short
term rate (ib). The interest costs become a cash outflow the following period. If
there are investments in marketable securities, they earn at the lending rate (iL) . Any
cash earned on marketable securities becomes cash available in the following period.
Traditional analysis assumes investment is financed by long term sources and,
furthermore, it assumes the debt/ equity mix is relatively stable in the long-run. It
does not explicitly allow for a cash flow shortfall which results in an increase in short
term debt. If a prolonged working capital crisis was financed by short run financing, one
serious outcome could be a radical change in a company’s debt/equity mix. The
chances of short-term debt surge is quite plausible in an inflationary environment or a
period of high interest rates. Finally, the traditional approach does not consider a
cash overflow, where liquid assets would earn less than the cost of capital. Thus
explicitly introducing interest cost of short term borrowing and interest earned on
marketable securities is an addition to traditional investment analysis.
Where
ICO = Investment cost at the beginning of the period
Finally, positive cash flows are used to retire accumulated short-term borrowing
(SUMCXt) thereby reducing cash flows available for reinvestment, as shown in
table 15.2. When negative cash flows happen, short-term borrowing will occur after
liquid assets are reduced to a minimum. The result is that accumulated short term
borrowing. Table 15.2 presents the logic of these two cases.
In comparing the revised cash flow (RCF) model to the traditional cash flow (CF)
approach, it is necessary to refer to the equation for each one of Table 15.1. The
RCFs differ from the CFs for the following reasons. First, the contribution of trade
credit policies and bad debts are reflected in cash receipts. Additionally, forecasting
errors and inflation cause change in the level of cash (ECt = ECt -1 ) and short-
term borrowing (SUMCXt - SUMCXt -1) . These two terms are algebraically
added to the revised cash flows. Also the cost of carrying excess inventory because of
forecasting errors enter the NPV equation as an outflow. The interest return from
marketable securities and the interest cost of short-run borrowing are
appropriately included in the revised cash flows.
If the sum of the costs are greater than the receipts, and liquid assets are at a
minimum, short term borrowing is employed to offset the amount of the negative
15
Working Capital cash flow. The rationale for this modeling assumption is that after the initial
Management: investment costs (IC) are incurred, any additional costs are related to an investment in
An
Integrated View working capital components or delayed capital expenditures (FUTCOSTt)
Increases in the level of short -term borrowing (SUMCXt=SUMCXt-1) to offset a
shortfall are included in the RCF equation as an inflow, therefore when outflow >
inflow additions to STDt equal the shortfall and the RCF is recorded as a zero. Table
15.1 illustrates this concept. In the traditional model a cash flow (CF) shortfall is
recorded as a negative value, e.g., year 1 in Table 15.1.
By making the working capital components explicit and introducing forecasting errors,
the revised model can identify and measure the cost of the shortfall, which was not
previously accomplished. When a positive cash flow exists, short-term borrowing is
paid off before may positive cash flows are available for discounting. Thus, when
borrowing occurs, the RCFs are limited on the down side to zero and when positive
flows occur the RCFs are limited on the top side by the retirement of debt. In
conclusion, the RCFs will operate in a more narrow band than the CF from the
traditional model.
For comparative purposes the model calculates the traditional (CFt) and revised cash
flow (RCFt) for each period in the life of the investment. This provides management an
invaluable source of information to compare the CF to the RCFt. Because of the large
number of possible combinations and permutations, interpretation of these data should
be done with care. The size of the gap between CFt and RCFt profiles
reflects the effect working capital components and strategies have on the profitability
of an investment. For example, when the CF profile is positive and greater than the
RCF profile, a narrow gap shows working capital components have a limited affect
on the value of the investment. However, a large gap indicates the importance of
working capital components and strategies in determining the value of the investment. An
analysis of these wide differences can aid management in re-evaluating the
forecasted inputs, the forecasting errors and the working capital strategy that is
creating the gap. There are many possible combinations of inputs that cause a gap.
The model produces the necessary data to identify the variable(s) causing the
problem.
Legend
In this model, it is assumed that the management prefers to use a single value for
the initial cost of capital (Ko). However, the impact of inflation must be included in
the cost of capital , kt. The cash inflows and outflows in the numerator of the NPV
equation are adjusted for inflation. The price of the goods sold in period 2 (P2) is
calculated in the following manner as shown in Table 15.1: P2 =P1 (L + PA2),
where PA is a randomly selected value for inflation drawn from a distribution
perceived for inflation between the current and most recent time periods, PAT -
PAt-1. This adjustment for inflation is presented below in equation form, which
reflects the real cost of capital(t):
(1+k)=(1+Kt) (1+IF)
Using the change in the perceived rate of inflation between periods, more closely
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Working Capital approximates the behaviour of financial markets, than an expected rate of inflation
Management: for a long time horizon. The essence of the adjustment assumes, a positive change
An
Integrated View in the rate of inflation will increase the cost of capital from the preceding period;
however, if the rate of inflation decreases, the cost of capital will subsequently
decrease. This would not occur if the adjustment process assumed a constant rising
mean perceived rate of inflation.
By allowing the cost of capital to change each year, the inflation adjusted net cash
flows in the numerator are discounted with a different k in each period. In this
simulation model, the cost of capital is a probability distribution, and a cost of capital
profile is created. The task of evaluating the profile of NPVs of an investment is
complicated by not having a common cost of capital. Management must interpret
the statistical properties of the NPVs , especially the mean, standard deviation,
skewness and kurtosis when comparing separate simulation of the same alternatives or
different alternatives. Furthermore, there is no longer a single cost of capital to serve
as a benchmark for which the internal rates of return (IRR) can be compared.
Previously if IRR>.k the investment was acceptable or rejected if IRR < k. In this
simulation model, the profile of 100 IRR’s are compared to the profile of the 100 k’s
and the judgement of the user is needed to determine if the investment is
acceptable.
The WC-CI model extends the traditional capital investment model and provides
management a tool to test the sensitivity of an investment’s profitability to changes in
working capital strategies. Forecasting errors and inflationary conditions are shown to
be the primary causes of working capital problems. These Working Capital
Strategies are designed to offset forecasting errors and inflation. The model aids
management in finding the best possible mix of strategies to generate the highest
possible values of an investment.
15.4 SUMMARY
A firm is run with both fixed capital and working capital. These capitals change their
rates due to swift transformation taking place in each of them. Working capital gets
converted into fixed capital and via-versa. Thus, there is a need to integrate working
capital and capital investment processees. This is based on the realisation that
changes in the policies of working capital bring about changes on the capital
budgeting process of the firm. An attempt is made in this unit to highlight the
significance of this integration process and the models to do it. Discussion in this unit is
confined mainly to the what if techniques. It focuses on both the capital investment
module and working capital module. The capital investment module takes into
considention the variables such as market, investment and cost. Each variable is
assumed to be stcheffic and independent. The uncertain and dynamic characteristics
of the capital investment module are reflected in the random interaction of the
variables.
Whereas the working capital module attempts to simulate the integration of working
capital components into the capital investment process. More specifically, it attempts to
measure the sensitivity of the NPV and IRR to changes in working capital strate-
gies designed to offset the forecasting error and inflactorary conditions. The models
have highlighted the fact that forecosting errors and inflationary conditions are shown to
be the primary causes of working capital problems.
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Investment Information : Information that is crucial for deciding investment in Integrating Working
a project. Capital
and Capital
Cost Project Module : A combination of purchase cost, labour cost and fixed Investment
Processe
cost. Cash flow crisis : An unexpected happening resulting in the shortage of cash. s
2) “In simulating financial decision, the strategy that produces the best simulated
result is not necessarily the optimal financing strategy”. Do you agree with this
statement? Why or Why not?
3) “If one is in possession of a basic single Sequence or independent observations of
some random variable with known intrivation function, then one can construct a
sequence of such observations of any other random variable whose distribution is
known”. Explain
4) Define Working Capital. What are the two critical decisions in Working Capital
management? In what important ways do these decisions differ from those
concerned with the management of the fixed capital of a business? Explain why
these difference exists.
5) Explain the sequential process of :
a) Capital Investment Module
b) Working Capital Module.
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