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working capital management

Working capital is the employment of current assets...
3. To meet overhead cost, factory cost, office and administration cost, taxes,
selling distribu...
In case of gross working capital, it is the concept that focus attention of two
aspects of curr...
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working capital management

  1. 1. WORKING CAPITAL MANAGEMENT CHAPTER – 1 INTRODUCTION OF WORKING CAPITAL Working capital is the employment of current assets and current liabilities in such a way as to increase short-term liquidity. Working capital management is a significant fact of financial management due to the fact that it plays a crucial role in keeping the wheels of business enterprise running. Working capital management is concerned with the short-term financial decisions, which have been comparatively neglected in the literature of finance. Shortage of funds for working capital has caused many businesses to fail. Lack of efficient and effective utilization of working capital leads to low rate of returns on capital employed or even compels to sustain loses. The need for skilled working capital has become greater in recent years. A firm usually invests a part of its permanent capital in fixed assets and keeps a part of it for working capital, for example meeting day-to-day requirements. The requirement of working capital varies from firm to firm, depending on the nature of business, production policy, market conditions, seasonality of operation, condition of supply etc. Working capital to a company is like a blood of human body. It is the most vital ingredient of business. Working capital if carried out effectively and efficiently and consistently, will assure the health of an organization. Every organization has to arrange for adequate funds for meeting day-to-day expenditure, apart from investment from fixed assets. Working capital is the flow of ready funds necessary for the working of the enterprise. It consists of funds invested in current asset of that asset, which in the ordinary course of business, can be turned into cash within a brief period without undergoing reduction in value and without disruption of organization. Current liabilities are those indented to be paid in ordinary course of business within a short period of time. Working capital serves the fallowing purposes: - 1. To meet the cost of inventories, raw materials purchases, work in progress, finished goods etc. 2. To pay wages and salaries. 1
  2. 2. WORKING CAPITAL MANAGEMENT 3. To meet overhead cost, factory cost, office and administration cost, taxes, selling distribution expense, packing, advertisements etc. FIG 1.1 CIRCULATION OF CURRENT ASSET CHAPTER – 2 DEFINITION OF WORKING CAPITAL 2 INVENTORIES CASH RECEIVABLES
  3. 3. WORKING CAPITAL MANAGEMENT In case of gross working capital, it is the concept that focus attention of two aspects of current asset management: 1. Optimum investment in current asset. 2. Financing of current assets. Following definitions of working capital place emphasis on gross working capital. 1. According to Mead, Mallot & Field. “Working capital means current assets”. 2. According to Bonneville. “Working capital is any acquisition of funds which increase the current asset, increases working capital, for they are one and the same.” 3. According to J.S Mills. “The sum of current asset is the working capital of the firm”. Now let us look at the definitions of net working capital. It reflects the modern concept of working capital, which is also most commonly used. According to the new concept of working capital it refers to the difference between current asset and current liability. It is the excess of current asset over current liability. Current liabilities refer to the claims of outsiders, which are expected to mature for payment within an accounting year. It includes creditors for goods, bills payable, bank overdraft etc. The concept may be better understood in the fallowing equation: - WORKING CAPITAL = CURRENT ASSET – CURRENT LIABILITY. The net working capital (a) indicate the liquidity position of the firm and (b) suggest the extend to which working capital needs to be financed by permanent sources of fund. Both the net and gross concept of working capital is the two facets of working capital management. 3
  4. 4. WORKING CAPITAL MANAGEMENT Net working capital may be of the fallowing type: Positive and quantitive net working capital: - It arises when current asset exceeds current liability. Negative or quantities net working capital: - It occurs when current liabilities are in excess of current asset. CHAPTER – 3 CLASSIFICATION OF WORKING CAPITAL Working capital may be classified on the fallowing basis: 1. On the basis of concept: 4
  5. 5. WORKING CAPITAL MANAGEMENT I. Gross working capital (represented by the total current asset). II. Net working capital (excess of current asset over current liabilities). 2. On the basis of periodicity of requirements: I. Fixed or permanent working capital: It represents that part of capital permanently locked up in the current asset to carry out the business smoothly. This investment in current asset increase as the size of business expands. Examples of such investment are those required to maintain the minimum stock of raw material, work in progress, finished products, loose tools and equipments. This arrangement requires minimum cash balance to be kept in reserve for payment of wages salaries and all other current expenditure throughout the year. The permanent fixed working capital may again be subdivided into fallowing: (A) Regular working capital: It is the minimum amount of liquid capital required to keep up the circulation of the capital from cash to inventories; to receivables and again to cash. This includes sufficient minimum cash balance to discount all bills and to maintain adequate supply of raw material etc. (B) Reserve margin or cushion working capital: It is the excess capital over the needs of regular working capital, that should be kept in reserve for contingencies, that may arise at any time. These contingencies include rising price, strikes, business decompressions, special operation such as experiment with new product etc. II. Variable working capital: Variable working capital changes with the increase or decrease in the volume of business. It may be subdivided into fallowing: - {A} Seasonal variable working capital: The working capital required to meet the seasonal liquidity of business is seasonal variable working capital. 5
  6. 6. WORKING CAPITAL MANAGEMENT {B} Special variable working capital: It is that part of variable working capital, which is required for financing special operation such as extensive marketing campaigns, experiment with product or methods of production, carrying of special jobs etc. CHAPTER – 4 ADEQUACY OF WORKING CAPITAL Working capital or investment in current asset is a must for meeting the day- to-day expenditure on salaries, wages rent, advertising etc and for maintaining the fixed asset. Large-scale capital in fixed asset is often determined by relatively small amount of current asset. The heart of industry, working capital, if weak the business cannot prosper and survive, although there may be a large investment of fixed 6
  7. 7. WORKING CAPITAL MANAGEMENT assets. Inadequate as well as superfluous working capital is dangerous for the health of the industry.”Inedequate working capital is disastrous, whereas superfluous working capital is a criminal waste”. Both situations are unwarranted in a sound business organization. Adequacy of working capital is the lifeblood and controlling nerve center of a business. Some of the uses of adequate working capital are: 1) CASH DISCOUNT: By adequate working capital the business can avail the advantage of cash discount by paying cash for the purpose of raw material and merchandise. If proper cash balance is maintained, this will reduce the cost of production. 2) SENSE OF SECURITY AND CONFIDENCE: Adequate working capital create a sense of security, confidence and loyalty throughout the business and also among its consumers, creditors and business associates .The proprietor, official or manager of a concern are carefree, if they have proper capital arrangements because they need not worry for the payment of business expenditure or creditors. 3) SOLVENCY AND CONTINUOUS PRODUCTION: In order to maintain the solvency of business, it is essential that sufficient amount of funds are available to make all the payments in time as and when they are due. In the absence of working capital, production will suffer in the era of cutthroat competition and business can never flourish in the absence of adequate working capital. 4) SOUND GOODWILL AND INCREASED DEBT CAPACITY: Promptness of payment in business creates goodwill and increases the debt capacity of the firm. If the investors and borrowers are confident that they will get their due interest and payment of principle in time, a firm can raise funds from market, purchase goods on credit and borrow short term loans from bank etc. 7
  8. 8. WORKING CAPITAL MANAGEMENT 5) EASY LOANS FROM THE BANK: An adequate working capital helps the company to borrow unsecured loans from the bank, because the excess provides a good security to the unsecured loans. If the business has a good credit standing and trade reputation, bank favors in granting seasonal loans. 6) DISTRIBUTION OF DIVIDEND: Short of working capital, a company cannot distribute dividend to its shareholders in spite of sufficient profits. To make up for the deficiency of working capital, profits are to be retained in business. On the other hand ample dividend can be declared and distributed to the market value of share and increase by sufficient working capital. 7) EXPLOITATION OF GOOD OPPORTUNITIES: Good opportunity can be exploited through adequacy of capital in a concern. For example – A company may make off seasons purchase, resulting in substantial saving or it can fetch big supply orders resulting in good profits. 8) MEETING UNSEEN CONTINGENCY: As stock piling of finished goods becomes necessary, depression shoots up the working demand of capital. If a company maintain adequate working capital, unseen contingencies such as financial crisis due to heavy loses, business oscillation etc can easily be overcome. 9) INCREASE IN EFFICIENCY OF FIXED ASSETS: Proper maintainces and adequate working capital increase the efficiency of fixed asset of business. It has been rightly said,” the fate of large scale investment in fixed capital is often determined by a relatively small amount of current asset.” 10)HIGH MORALE: The provision of adequate working capital improves the morale of the executive as they get an environment of security, certainty and confidence, which is a great psychological factor in improving the overall efficiency of business and of the person who is at the helm of affair in the company. 8
  9. 9. WORKING CAPITAL MANAGEMENT 11)INCREASE PRODUCTION EFFICIENCY: A continuous supply of raw material, research programs, innovation and technical development and expansion programs are successfully carried out if adequate capital is maintained in the business. It increases production capacity, which increase the efficiency and morale of the employees. CHAPTER – 5 EVILS OF INADEQUATE WORKING CAPITAL Some of the evils of not having adequate working capital in a business firm or a company are as fallows: 1) LOSS OF CREDIT WORTHINESS AND GOODWILL: A firm losses its credit worthiness and goodwill if it fails to honors its current liability. It finds it difficult to procure the required funds for its business operation on easy terms. This leads to reduced profitability and production interruption. 9
  10. 10. WORKING CAPITAL MANAGEMENT 2) NO BENEFIT FROM FAVORABLE OPPORTUNITY: With inadequate working capital a firm fails to undertake profitable projects. It prevents the firm from availing the benefit of available opportunity and stagnate its growth. 3) FAILURE TO AVAIL CREDIT OPPORTUNITY: Due to inadequate working capital a firm fail to avail attractive credit opportunities. 4) OPERATING INEFFICIENCIES: Inadequate working capital leads to operating inefficiencies, as day-to-day commitment cannot be met. 5) LOW RATE OF RETURN ON FIXED ASSET: Inadequate working capital leads to a lowering down of rate of returns of fixed asset, as it cannot be efficiently utilized or maintained due to inadequacy of working capital. 6) INCREASE IN BUSINESS RISKS: Inadequate working capital increases the business risk of the firm. Unable to discharge its current liability it is liable to be declared as insolvent. Thus inadequate working capital posses a serious threat to the working and survival of the firm. 7) CANNOT ACHIEVE PROFIT TARGET: Due to inadequate working capital the firm cannot achieve its profit target, as it cannot put into operation, its operating plans due to shortage of working capital. 8) LOW MORALE OF BUSINESS EXECUTIVES: Inadequate working capital adversely lowers the morale of the firm’s executive, as they do not have an environment of certainty safety and confidence, which is necessary psychological factor in improving the overall efficiency of a business firm. 9) WEAKENING OF FINANCIAL CAPACITY: Inadequate working capital weakens the shock absorbing capacity of the firm, as it cannot meet the contingencies arising from business fluctuation, financial loses etc. 10
  11. 11. WORKING CAPITAL MANAGEMENT CHAPTER – 6 EVILS OF EXCESSIVE WORKING CAPITAL Now let us look at some of the evils of having excessive or redundant working capital: 1. IDLE FUNDS: Excessive and redundant working capital implies the presence of idle funds, which earn no profits for the firm. A firm with excessive working capital cannot earn proper rate of return on its total investments, as profits are distributed on the whole of its capital. This brings down the rate of return to the shareholders. Lower dividend reduce the market value of shares and causes capital losses to the shareholders. 2. DECLINE IN OPERATING EFFICIENCY: Companies often adopt some objectionable devices to inflate profits to maintain or increase the rate of 11
  12. 12. WORKING CAPITAL MANAGEMENT dividend. Sometimes unearned dividends are paid out of company’s capital to keep the show of prosperity by window dressing of accounts. In order to make up the deficiency of reduced earnings, certain provision, such as the provision for depreciation, repairs and renewals are not made. This leads to decline in operating efficiency and fall in profits. 3. LOSS OF CONFIDENCE AND GOODWILL: Excessive working capital leads to lower rate of returns on company’s total investments. Lower dividend leads to reduction of market value of companies share much less than the book value. The shareholders losses confidence in the company and the goodwill or the credit of the company suffers a serious setback. Thus the financial stability of the company is jeopoderzied. 4. MISAPPLICATION OF FUNDS: Companies with excessive working capital do not utilize the resources prudently. The company purchases excessive inventories and fixed assets, which do not add to the profitability and increase its maintaince cost and losses due to theft, waste and mishandling. 5. EVILS OF OVERCAPITALIZATION: Excessive working capital leads to over capitalization, which is disastrous to the smooth working and survival of the company and effect the interest of those associated with the company. 6. INEFFICIENT MANAGEMENT: Excessive working capital indicates that the management is not interested in expanding the business; otherwise the excessive capital might have been utilized for this purpose. 7. DESTRUCTION IN TURNOVER RATIO: Superfluous working capital destroys the control of turnover ratio, which is commonly used in conduct of an efficient business. It eradicates all other guide and signpost commonly used and employed in conducting and operating a business. Thus a company must have working capital adequate to its requirements. It must neither be excessive or inadequate. While inadequate working capital 12
  13. 13. WORKING CAPITAL MANAGEMENT adversely affects the business operation and profitability, excessive working capital keep it idle and earn no profits. CHAPTER – 7 WORKING CAPITAL MANAGEMENT Working capital is the money used to make goods and attract sales. The less working capital is used to attract sale, the higher is it likely to be the return of investment. Working capital management is about the commercial and financial aspect of inventory, credit, marketing, royalty and investment policy. The higher the profit margin, lower is it likely to be the level of working capital tied up in creating and selling titles. The faster that we create and sell the books the higher is it likely to be the return on investment. Now let us look at some of the definitions of working capital management: 13
  14. 14. WORKING CAPITAL MANAGEMENT PROF K V SMITH: “Working capital management is concerned with problems that arise in attempting to manage the current asset, the current liability and the interrelation that exist between them”. WESTON AND BRIGHAM: “Working capital management refer to all aspect of administration of both current asset and current liability”. JAMES C VAN HORNE: “Current asset, by definition are asset normally converted into cash within one year. Working capital management is concerned with the administration of these asset-namely cash and marketable securities”. Now let us look at some of the main and important objective of working capital management: 1. To decide upon the optimum level of investment in various current asset I.e. determining the size of working capital. 2. By optimizing the investment in current asset and by reducing the level of current liability, the company can reduce the locking up of funds in working capital and thereby it can improve the return on capital employed in the business. 3. To decide upon the optimum mix of short-term funds in relation to long-term capital. 4. The company should always be in a position to meet its current obligation, which should be properly supported by current assets available with the firm. Maintaining excess fund in working capital means locking of funds without any returns. 14
  15. 15. WORKING CAPITAL MANAGEMENT 5. To locate appropriate source of short term financing. 6. Maintaining working capital at appropriate levels. 7. Availability of sufficient funds at time of need. 8. The Firm should manage its current asset in such a way that marginal returns on investment in current asset is not less than the cost of capital employed to finance the current assets. CHAPTER – 8 IMPORTANCE OF WORKING CAPITAL MANAGEMENT According to Husband and Hockery,”the prime object of management is to make a profit, either or not this is accomplished, depend on the manner in which working capital is accomplished”. The primary object of working capital is management is to manage the firm’s current asset and current liability in such a manner that a satisfactory level of working capital is maintained. The firm may become insolvent if it cannot maintain a satisfactory level of working capital. Working capital assist in increasing the profitability of the concern. The working capital position decide the various policies in the business with receipt to general operation viz importance of working capital. Positive correlation between sale and current assets: There is a positive correlation between the sale of the product of the firm and its current assets. 15
  16. 16. WORKING CAPITAL MANAGEMENT Increase in the sale of the product requires a corresponding increase in current assets. Therefore, the current asset must be managed properly. Investment in current asset: Generally more than half of the total capacity of the firm is invested in current assets. Thus less than half of the capital is blocked in fixed asset. Therefore management of working capital attracts the attention of the management. No alternative for current asset: While fixed capital can be acquired on lease in emergency, there is no alternative for current asset. Investment in current asset cannot be avoided without substantial losses. Important for small unit: The management of working capital is more important for small unit because they do not relay on long term capital market and have easy access to short term finance source such as trade credit, short term bank loans etc. CHAPTER – 9 FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS Now let us look at the various factors determining the working capital requirement in a business firm: (A) Nature of businesses: The amount of working capital is related to the nature of business. It concerns, where the cost of raw material used in manufacture of a product is very large in production to its total cost of manufacture, the requirement of working capital will be very large. For instance a cotton or sugar mills require a large amount of working capital. On the other hand firms requiring large amount of investment in fixed asset require less working capital. Public utility concern like Indian Railways, require a lesser amount of working capital as compared to trading or manufacturing concern, partly because of cash nature of their business and partly 16
  17. 17. WORKING CAPITAL MANAGEMENT because, they are selling service instead of a commodity and there is no need of maintaining inventories. (B) Size of business unit: The general principle in this regard is that the bigger the size of business, the larger will be the amount of working capital required, because the larger business unit are required to maintain big inventories for the flow of the business and to spend more in carrying out the business operation smoothly. (C) Seasonal variation: Strong seasonal variation create special problem of working capital in controlling the internal financial swings in many companies such as sugar mills, oil mills, woolen mills etc. These require larger amount of working capital in the season to purchase the raw material in large quantity and utilize them throughout the year. They adjust their production schedule and maintain a steady rate of production in off seasons. Thus they require larger amount of working capital during season. (D) Time consumed in manufacture: The average time taken in the process of manufacture is also an important factor in determining the amount of working capital. The larger the period of manufacture the larger will be the working capital required. Capital goods industries managed to minimize their investment in working capital by asking advances from consumers as work proceeds in their orders. (E) Turnover of circulating capital: Turnover means ratio of annual gross sales to average working asset. It means the speed with which circulating capital complete its round, or number of times the amount invested in working asset has been converted into cash by sale of finished goods and reinvested in working asset during the year. The faster the sales the larger the turnover. Conversely greater the turnover, larger the volume of business to be done with given working capital. It require lesser amount of working capital in spite of larger sale because of great turnover. (F) Labor intensive versus capital intensive industries: In labor intensive industries, larger working capital is required because of regular payment of heavy wage bills and more time taken in completing the manufacturing process. On the other hand the capital intensive industry requires require lesser amount of working 17
  18. 18. WORKING CAPITAL MANAGEMENT capital because of heavy investment in fixed asset and shorter period in many acquiring processes. (G) Need to stockpile raw material and finished goods: The industry, where it is necessary to stockpile the raw material and finished goods increase the amount of working capital, which is tied up in stock and stores. In some line of business where the materials are bulky and best purchased in large quantity such as cements, stockpiling of raw material is very usual and used. In companies where labor strike is very frequent like public utility concern, stockpiling of raw material is advisable. In certain industries which are seasonal in nature, finished goods stock have to be in large quantity which require large working capital. (H) Terms of purchase and sale: Cash or credit terms of purchase and sale also affect the amount of working capital .If a company purchase all goods in cash and sells its finished product on credit, it will require a large amount of working capital .On the other hand a concern having credit facility and allows no credit to its customers will require less amount of working capital. Terms and conditions of purchase and sale are generally governed by prevailing trade practice and by changing economic conditions. (I) Conversion of current asset into cash: The need of having cash in hand to meet the day to day requirement like payment of wage and salary, rent etc has an important bearing in deciding the adequate amount of working capital. The greater the cash requirement, higher will be the need of working capital. A company has ample stock of liquid current asset will require lesser amount of working capital because it can encash its assets immediately in open market. (J) Growth and extension of business: Growing concern requires more working capital than that which is static. It is logical to except larger amount of working capital in a going concern to meet its growing need of funds and for its expansion programs through it varies with economic condition and corporate practice. 18
  19. 19. WORKING CAPITAL MANAGEMENT (K) Business cycle fluctuation: Business cycle affect the requirement of working capital At times, when the prices are going up and boom condition prevail, the management seek to pile up big stock of raw material to have an advantage of lower price and maintain a big stock of finished goods with an expectation to earn more profit by selling it at higher price in future. The expansion of business unit caused by the inflationary condition creates demand for more and more working capital. Depression involves the locking up of big amount in working capital as the inventories remain unsolved and book debts uncollected. The reduction in the volume of business may result in increasing the cash position because of reduction in inventories and receivable that usually accompanies decline in sale and shortening in capital expenditure. In such case shortage of working capital develops. (L) Profit margin and profit appropriation: Some firms enjoy a leading position in the market due to quality product and good marketing management or monopoly power in the market and thereby earn huge profits. It contributes towards working capital, provided it is earned in cash. Cash profit can be found by adjusting the non- cash item like depreciation, outstanding expense, accumulated losses and expense written off in net profit. But in practice the whole cash inflows are not considered as cash available for use as cash is used up to increase the other asset like, book debts and fixed asset stock etc. In a growing concern working capital requirement will be estimated on how the cash available is rightfully used. Even if the net profit is earned in cash, whole of it is not available for working capital purpose. The contribution towards working capital is effected by the way in which profit are appropriated and affected by tax action, dividend, depreciation and reserve policy. (M) Price level changes: The financial manager should predict the effect of price level changes on working capital requirement of the firm. Rising price level will require a higher level of working capital to maintain the same level of current asset, as it will require higher investments. However if companies reverse their product prices, they will not face a severe working capital problem. Thus the effect of rising price will be different for different firm depending upon their price policy and its nature. 19
  20. 20. WORKING CAPITAL MANAGEMENT (N) Dividend policies: There is a well-established relationship between dividend and working capital in companies where successive dividend policy is followed. The changes in working capital position bring about an adjustment in dividend policy. In order to maintain an established dividend policy, the management gives due consideration to its effect on cash requirements. Storage of cash may induce the management to reduce cash dividend. Strong cash position may justify the cash dividend, even if earnings are not sufficient to cover the payments. Shortage of cash is one of the reasons for issue of stock dividend. On the other hand if the company follow the policy of retention of profit in business, the working capital position will be quite adequate, alternatively, if the whole of the profit are distributed among the shareholders, companies working capital position will suffer. (O) Close coordination between production and distribution policy: This will reduce the demand of working capital. (P) An absence of specialization in the distribution of products: This will require more working capital as such concerns will have to maintain its own marketing organization. (Q) If the means of transporting and communication are less developed: More working capital is required in such areas to store the material and finished goods. (R) Hazards in a particular business also decide the magnitude of working capital required. 20
  21. 21. WORKING CAPITAL MANAGEMENT CHAPTER – 10 WORKING CAPITAL FINANCING The main source of working capital financing, namely, trade credit, bank credit, RBI framework/regulation of bank credit/finance/advances, factoring and commercial papers will be discussed in this chapter. 1. TRADE CREDIT: Trade credit refers to the credit extended by the suppliers of goods and service in normal course of transaction/business/sale of the firm. According to trade practice, cash is not paid immediately for purchase but after an agreed period of time. There is however, no formal/specific negotiation of trade credit It is an informal arrangement between buyer and seller. There is no legal instrument of acknowledgement of debt, which is granted on an open account basis. (a) ADVANTAGES: - Trade credit as a source of short-term working capital finance has certain advantages. It is easily available. Moreover it is flexible and spontaneous source of finance. The availability and 21
  22. 22. WORKING CAPITAL MANAGEMENT magnitude of trade credits is related to the size of operation of a firm in relation to sales/purchase. If the credit purchase of goods decline, availability of credit will also decline. Trade credit is also an informal, spoteganous source of finance. Not requiring negotiation and formal agreement, trade credit is free from the restriction associated with formal/negotiated source of finance/credit. (b) COST: Trade credit does not involve any explicit interest charged. However there is an implicit cost of trade credit. It depends on trade credit offered by suppliers of goods. The smaller the difference between the payment day and the end of the discount period, the larger is the annual interest/cost of trade credit. 2. BANK CREDITS: It is the primary institutional source of working capital finance in India. In fact it represent the most important source of financing of credit asset. It can be provided by banks in five ways (a) Cash/credit overdrafts: Under cash credits, the bank specifies a predetermined borrowing/credit limit. The borrowers can draw/borrow up to the stipulated credit/overdraft limit. Similarly repayment can be made wherever desired during the period. The interest is determined on the basis of the running balance/amount actually utilized by borrower and not on the sanctioned amount. (b) Loans: Under the arrangement the entire amount of borrowing is credited to the current account of the borrower .The borrower has to pay interest on the total amount. (c) Bills purchased/discounted: -The amount made available under this arrangement is covered by the cash credit and the overdraft limit. Before discounting the bill the bank satisfies itself with the credit worthiness of the drawer and the genuineness of the bill. To 22
  23. 23. WORKING CAPITAL MANAGEMENT popularize the scheme, the discounting banker asks the drawer of the bill (i.e. the seller of the goods) to have his bills accepted by the drawee bank. (d) Term loans for working capital: Under this arrangement, banks advance loans for three to seven years repayable in yearly and half yearly installments. (e) Letter of credit: While the other forms of bank credit are direct forms of financing in which banks provide funds as well as bears risk, letter of credit is an indirect form of working capital financing and bank assume only the risk, the credit being provided by the supplier. MODES OF SECURITY Banks provide credit on the fallowing modes of security: 1. Hypothecation: Under this mode of security the bank provide credit to borrowers against the security of movable property, usually inventory of goods. 2. Pledge: Pledge, as a mode of security is different from hypocatation in that in the former unlike the later goods, which are offered as security is transferred to the physical possession of the lender. 3. Lien: The term lien refers to the right of the party to retain goods belonging to other party until a debt due to him is paid. 4. Mortgage: It is the transfer of legal stock equitable interest in specific immovable property for securing the payment of debt. 23
  24. 24. WORKING CAPITAL MANAGEMENT CHAPTER – 11 RESERVE BANK OF INDIA FRAMEWORK FOR REGULATION OF BANK CREDIT Till the mid sixties, the notable feature of bank financing of working capital of corporate industrial borrowers were (a) easy access/over-reliance, i.e. in excess of legimate requirement and (b) pre ponderance of cash credit arrangement/device through which his finance was provided. In order to secure arrangement of a bank credit with planning priorities and ensures equitable distribution to various sectors of Indian economy, the RBI initiated several policy measures measure to direct bank credit to priority sectors and enforce a measure of financial discipline among industrial borrowers. However the basic character of bank financing and industry namely, over borrowing and domination of cash credit system did not materially alter. To reorient bank lending to industry to the two emerging reality of the Indian economy in terms of the crucial factors of regulating controlling it, the RBI constitute from time to time a number of expert groups to examine the various aspect of banking policy relating to industrial financing, the notable being Dehejia committee of 1969,Marathe committee of 1974,Chore committee of 1980 and Marathe committee of 1984.The recommendation of these groups ( refer to annexure) shaped the framework/regulation of industrial finance by banks after mid 1970s.After mid 1990 24
  25. 25. WORKING CAPITAL MANAGEMENT the framework have been relaxed permitting banks greater flexibility in tune with the emergence of new banking in the country, focusing on viability and profitability in contrast with earlier trust on social/development banking .The main element of the framework and the subsequent relaxation are discussed. CHAPTER – 12 FIXATION OF NORMS A notable feature of the framework /regulation to the fixation of norms for bank lending to industry fall under two category: 1. Inventory and receivable norms: The norms refer to the maximum level for holding inventory and receivable in each industry. Initially, the inventory and receivable norms were applied in respect to 15 major industries accounting for about one half of the industrial advance of the bank. The norms pertained to (a) raw material including stores and other item used in the process of manufacture: (b) stocks in process (c) finished goods and receivables and bills purchased and discounted. The norms were based on time elements 2. Lending norms: The lending norms are the basic element of the framework of bank lending to have far-reaching implications. According to lending norms a part of the current asset should be financed by trade credit and other current liabilities. The remaining part of the current asset, termed, as working capital gap should be partly financed by owner’s funds and long-term borrowing and partly by short-term 25
  26. 26. WORKING CAPITAL MANAGEMENT credit. There are three alternative methods for working out the maximum permissible level of bank borrowing/finance, each successive method reducing the involvement of short-term bank credit to support current assets. CHAPTER –13 HOW “PUBLISHERS” CAN MAKING MORE EFFICIENT USE OF WORKING CAPITAL The table below lists items, which influence working capital levels favorably and adversely for Publishers Items that reduce working capital levels Items that increase working capital levels -- Customers who pay promptly -- Advance payment by customers -- Long print runs expect where all the books are required on publication e.g. schools and university textbooks. -- Increased profit margins -- Lower profit margins -- Inventory which is sold and paid for quickly by customers and publication -- Lower inventory level by reducing print quantities and working with printers who will delivery quickly and produce low print runs economically -- Slow authors whom deliver late and whose manuscript require substantial editing. -- Holding paper stock unless market condition demand and the saving are large -- Slow schedules for development of new titles 26
  27. 27. WORKING CAPITAL MANAGEMENT -- Successful promotion that speed up the rate of sale. -- Licensing -- Paying suppliers on completion with credit -- Making advance payment to printers -- Seasonal sales except where the publishers print only for the season CHAPTER – 14 ASSESSMENT OF WORKING CAPITAL REQUIREMENT IN SEASONAL INDUSTRY In the seasonal industries the level of working capital requirement will not be similar all the year. In times of off-season, the working capital requirements and therefore, the level of investment in current asset and liability are very low. But during seasons, the firm requirement of working capital is at peak level. Now let us look at the sugar industry. The crushing season in the year will remain for five to six month’s time. During the season the plant is expected to work at full capacity, with triple shift working and the requirement of stock is very high resulting in increased sugar stock. The requirement for payment of labor, expense and maintenance is also very high. There will not be immediate sale of sugar and finished stock inventory will be much higher. After the completion of crushing season the plants will stop and only upkeep and maintenance of plant will be incurred and the level of current asset and the current liabilities will come down and the working capital requirement will be very low. For efficient management of working capital the finance manager should be able to properly estimate the season and off season requirement of working capital. For this the fallowing precaution are taken: 27
  28. 28. WORKING CAPITAL MANAGEMENT 1. Preparation of projected cash flow statement showing the cash flow for peak season, normal season and off-season requirement. 2. Make proper arrangement with the banks and other source of finance to meet the short-term need of season 3. Make proper arrangement for meeting contingencies of higher-level requirements than the projected level of requirement. 4. Proper and careful assessment of working capital requirement for the season and off-season requirement. 5. Care to be taken to reduce the level of investment in current asset after the season is completed. CHAPTER – 15 METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENT Now let us look at some of the ways used by a business firm in estimating the working capital requirement: Operating cycle method: Operating cycle is a period that a business enterprise takes in converting cash back into cash. It has the fallowing four stages. (a) The raw material and stores inventory stage. (b) The semi finished goods or work in progress stage (c) The finished goods inventory stage. (d) The accounts receivable and book debt stage. Each of he above stage is expressed in terms of days of relevant activity. Each requires a level of investment to support it. The sum of these stage wise investments will be total amount of working capital of the firm. The fallowing formulae can be used to express the framework of the operating cycle. T = (S * C) + W + F + B Where T Stands for the total period of operating cycle in number of days R Stands for the number of days of raw material and stores 28
  29. 29. WORKING CAPITAL MANAGEMENT Consumption requirement held in raw material and store Inventory C The number of days of purchase in trade creditors W The number of days of cost of production held in W.I.P F The number of days of cost of sales held in finished goods B The number of days of sale in book debt The consumption may be made as under: Average inventory of raw material and stores R = Average per day of consumption of raw materials and stores Average trade creditors C = Average credit purchase per day Average work in progress W = Average cost of production per day Average inventory of finished goods F = Average cost of sale per day Average book debts B = Average sales per day The average inventory, trade creditors, working progress, finished goods and book debts can be computed by adding the opening and closing balance at the end of the year in the respective accounts and dividing the concerned annual figures by 365 or the number of days in a given period. The operational cycle method of determining working capital requirements gives only an average figure. In this method the fluctuations in the intervening period due to seasonal and other factors and their impact on working capital cannot be judged. Continuous short run detailed forecasting and budgeting exercise are necessary to identify these impacts. 29
  30. 30. WORKING CAPITAL MANAGEMENT The new concept that is gaining more and more importance in recent years is this style of working capital method. The operating cycle refer to the average time elapsed between the acquisition of raw material and the final cash realization. Cash is used to buy the raw materials and other stores, so cash is converted into raw materials and stores inventories. Then the raw materials and stores are issued to the production department. Wages are paid and other expense are incurred in the process and work in progress comes into existence. Work in progress becomes finished goods. Finished goods are sold to costumers on credit. In the course of time these costumers pay cash for the goods purchased by them. Cash is retrieved and cycle is completed. The operating cycle of working capital is shown below: CASH ACCOUNTS RECEIVABLE PURCHASE OF RAW MATERIAL INVENTORY FINISHED GOODS W.I.P FIG 15.1 OPERATING CYCLE OF WORKING CAPITAL Percent of sales method: It assumes that certain balance sheet items vary directly with sales. Thus the ratio of the given balance sheet item to sales remains constant. The firms need in terms of percentage of annual sales envisaged in each individual balance sheet items are expressed in the following three ways: As number of days of sale As turnover As percent of sales 30
  31. 31. WORKING CAPITAL MANAGEMENT Regression analysis method: This is a very useful statical technique of working capital forecasting which helps in making projection after establishing the relationship in the past years between sales and working capital and its various components. This analysis may be carried out through the graphic portrayals or through mathematical formulae. The relationship between the sales and working capital of various components may be simple and direct indicating linearly between the two. It may be complex involving simpler linear regression or simple curvilinear regression and multiple regression situations. This method is particularly suitable for long term forecasting. CHAPTER – 16 WORKING CAPITAL REPORT A sensible finance manager is always vigilant for avoiding the financial embarrassment likely to be caused to the firm due to inadequacy of working capital. He always takes utmost care so as to keep himself well informed of the working capital position, its present aspect and its future prospects. Working capital report varies according to the requirement of individual firms and circumstances. Some of the types of working capital report are: Inventory report: It gives in detail a comparative analysis of composition of closing stock of raw material and finished products. It may be prepared weekly, monthly or quarterly. It brings into light the fact whether working capital is unnecessarily blocked up in the inventory. Fallowing is an example of monthly inventory report. Sr no Item Cod e no Max Stock Limit Min Stock Limit Order size Op Bal Receive d During The Month Issued during the Month Balance 1 001 *** *** *** *** *** *** *** *** 2 002 *** *** *** *** *** *** *** *** 31
  32. 32. WORKING CAPITAL MANAGEMENT 3 003 *** *** *** *** *** *** *** *** 4 004 *** *** *** *** *** *** *** *** 5 005 *** *** *** *** *** *** *** *** 6 006 *** *** *** *** *** *** *** *** 7 007 *** *** *** *** *** *** *** *** Cash report: It reflects the net liquidity position of the concern. It is prepared on daily basis. It shows the summary of daily cash receipt, cash disbursements and the cash balance. Fallowing is the Performa of a cash report. Receivables report: These help in studying up the efficiency of the collection policies and the desirability of credit policies. Detailed report may be made to depict the reserve for bad and doubtful debts position. Some companies prepare aging report in respect of debtors and receivables. A Performa of receivable report is given below Particulars Current a/c Letter of credit a/c Fixed deposit a/c Cash in chest Total Previous week A REVENUE X *** *** *** *** *** *** Y *** *** *** *** *** *** Z *** *** *** *** *** *** B CAPITAL X *** *** *** *** *** *** Y *** *** *** *** *** *** Z *** *** *** *** *** *** TOTAL ****** ****** ****** ****** ****** ****** 32
  34. 34. WORKING CAPITAL MANAGEMENT CHAPTER - 17 RECEIVABLES MANAGEMENT The receivables represent an important component of current asset of a firm. The purpose of this chapter is to analyze the importance of efficient management of receivables, within the framework of a firm’s objective of value maximizing. The first section of this chapter discusses the objective of receivables management. This is followed by an indebt analysis of three crucial aspect of management of receivables. Before understanding the objectives of receivables management let us first understand the two concepts, which forms an important part in receivables management, namely debtors and creditors. 34
  35. 35. WORKING CAPITAL MANAGEMENT Debtors: Debtors (Accounts Receivable) are customers who have not yet made payment for goods or services, which the firm has provided. The objective of debtor management is to minimize the time-lapse between completion of sales and receipt of payment. The costs of having debtors are: 1. Opportunity costs (cash is not available for other purposes); 2. Bad debts. Debtor management includes both pre-sale and debt collection strategies. Pre-sale strategies include: 1. Offering cash discounts for early payment and/or imposing penalties for late payment; 2. Agreeing payment terms in advance; 3. Requiring cash before delivery; 4. Setting credit limits; 5. Setting criteria for obtaining credit; 6. Billing as early as possible; 7. Requiring deposits and/or progress payments. Post-sale strategies include: 1. Placing the responsibility for collecting the debt upon the center that made the sale; 2. Identifying long overdue balances and doubtful debts by regular analytical reviews; 3. Having an established procedure for late collections, such as - A reminder; - a letter; - cancellation of further credit; - telephone calls; 35
  36. 36. WORKING CAPITAL MANAGEMENT - use of a collection agency; - legal action. Creditors; Creditors (Accounts Payable) are suppliers whose invoices for goods or services have been processed but who have not yet been paid. Organizations often regard the amount owing to creditors as a source of free credit. However, creditor administration systems are expensive and time- consuming to run. The over-riding concern in this area should be to minimize costs with simple procedures. While it is unnecessary to pay accounts before they fall due, it is usually not worthwhile to delay all payments until the latest possible date. Regular weekly or fortnightly payment of all due accounts is the simplest technique for creditor management. Electronic payments (direct credits) are cheaper than cheque payments, considering that transaction fees and overheads more than balance the advantage of delayed presentation. Some suppliers are unenthusiastic to receive payments by this method, but in view of the significant cost advantage (and the advantages to the suppliers themselves) departments may wish to encourage suppliers to accept this option. However, electronic payments are likely to be used in combination with, rather than as a replacement for, cheque payments. Objectives of receivables management: The term receivables are defined as debts owed to the firm by customers arising from sale of goods or service in the ordinary course of business. When a firm makes an ordinary sale of goods or service and does not receive payment the firm grant credit and credits account receivable. Receivables management is also known as trade credit management and thus, account receivables represent an extension of credits to customers, allowing them a reasonable period of time in which to pay the goods received. 36
  37. 37. WORKING CAPITAL MANAGEMENT The sale of goods on credit is an essential part of modern competitive economic systems. Infact, credit sales and therefore receivables are treated as marketing tools to aid the sale of goods. The objective of receivable management is to promote the sale and profits until that point is reached where the return on investment in further funding receivable is less than the cost of funds raised to finance that additional credit (i.e.) cost of capital. Now let us see some costs in receivable management: 1. Collection cost: Collection costs are administrative costs incurred in collecting the receivables from the customers to whom credit sale have been made. 2. Capital cost: The increased level of account receivable is an investment in asset. They have to be financed thereby incurring a cost. The cost on the use of additional capital, to support the credit sale, which alternatively, profitably employed is therefore a part of the cost of receivables. 3. Delinquency cost: These cost arise out of the failure of customers to meet their obligation when payment on credit sale becomes dew after the expiry of credit period. Such cost is called delinquency cost. 4. Default cost: Finally the firm may not be able to recover the overdue because the inability of the customers to pay. Such that are treated as bad debts and have to be written off, as they cannot be realized is called default cost. Benefits: The benefits are increased sales and anticipated profits because of a more liberal policy. When firms extend trade credits, that is, invest in receivables; they intend to increase the sales. The impact of liberal trade credit policy is likely two take two forms. First it is oriented to sales expansion. In other words a firm may grant trade credit to increase sale to existing customers. Secondly the firm gives trade credit to protect its current sales against competitions. 37
  38. 38. WORKING CAPITAL MANAGEMENT Credit policies: The credit policy of the firm provides a framework to determine (a) whether or not to extend credit to a costumer (b) how much credit to extend. The credit policy decision of a firm has two broad dimensions 1. Credit standards 2. Credit analysis CHAPTER – 18 WORKING CAPITAL RATIO Working capital ratios indicate the ability of a business concern in meeting its current obligation as well as its efficiency in managing the current asset in the generation of sales. These ratios are applied to evaluate the efficiency with which the firm manages and make use of its current assets. The fallowing three categories of ratio are used for efficient management of working capital (a) efficiency ratios (b) Liquidity ratios (c) Structural health ratios. Efficiency ratio: This ratio is computed by dividing the working capital by sale. This ratio helps to measure the efficiency of utilization of networking capital. It signifies for an amount of sale a relative amount of working capital is needed. If any 38
  39. 39. WORKING CAPITAL MANAGEMENT increase in sale is contemplated, working capital should be adequate and thus this ratio is useful for maintaining adequate level of working capital. Inventory turnover ratio: This ratio indicate the effectiveness and efficiency of the inventory management .The formulae is as fallows INVENTORY TURNOVER RATIO = SALES / CURRENT ASSET This ratio shows how speedily the inventory is turned into accounts receivable through sales. The lower the inventory of sales ratio, the more efficiently the inventory is said to manage and vice versa. Current assets turnover ratio: This ratio formula is: CURRENT ASSET TURNOVER RATIO = SALES / CURRENT ASSETS This ratio indicates the efficiency with which the current asset turn into sales. The lower the current asset to sales ratio, it implies a more efficient use of funds. Thus, a high turnover rate indicates reduced lock up of funds in current assets. An analysis of this ratio over a period of time reflects working capital management of a firm. Liquidity ratio: This ratio indicate the extend of soundness of the current financial position of an undertaking and the degree of safety provided to the creditors. The higher the current ratio, the larger amount of rupee available, per rupee for current liability, the more the firms ability to meet current obligation and the greater safety of funds of short term creditors. The liquidity ratio formulae is LIQUIDITY RATIO = CURRENT ASSET, LOANS, ADVANCES/ CURRENT LIABILITY Current assets are those assets, which can be converted into cash within an accounting year. Current liability and provisions are those liability that are payable within a year. A current ratio of 2: 1 indicates a highly solvent position. Banks consider a current ratio of 1: 3: 1 as minimum acceptable level for providing working capital finance. The constituents of the current asset are as important as current asset themselves for evaluation of companies solvency position. 39
  40. 40. WORKING CAPITAL MANAGEMENT Quick ratio: This ratio is a more refined tool to measure the liquidity of an organization. It is a better test of financial strength than the current ratio, because it excludes very slow moving inventories and the item of current asset, which cannot be converted into cash easily. This ratio shows the extend of cushion of protection provided from the quick assets to the current creditors. A quick ratio of 1: 1 is usually considered satisfactorily through it is again a rule of the thumb only. Structural health ratio: This ratio explains the relationship between current asset and total investment in current asset. A business enterprise should use its current asset effectively and economically because it is out of the management of these assets that profits accrue. A business will end up in losses if there is any lacuna in managing assets to the advantage of business. Investment in fixed assets being inelastic in nature there is no elbowroom to make an amendment in this sphere and its impact on profitability remains minimal. This structural ratio can be indicated as S.H.R = NET ASSETS / CURRENT ASSET An analysis of current assets composition enable one to examine in which components the working capital funds are locked up. Large tie up of funds in inventories effect profitability of the business adversely owing to carry over cost .in addition losses are likely to occur by the way of depreciation, decay, obsolesce, evaporation and so on. Receivable constitute another component of current assets If the major portion of current assets are made of cash alone the profitability will be decreased because cash is a non earning asset. If the portion of cash balance is excessive then it can be said that management is not efficient to employ surplus cash. Debtor turnover ratio: This ratio shows the extend of trade credit granted and the efficiency in the collection of debts and thus it is an indicative of trade credit management. The lower the debtor to sale ratio the better the trade credit management and better the quality of debtors. The lower debtor means prompt payment by customers. An excessive long collection period on the other hand indicates a very liberal ineffective inefficient credit and collection policy. DEBTOR TURNOVER RATIO = SALES / DEBTORS 40
  41. 41. WORKING CAPITAL MANAGEMENT Average collection period measures how long it takes to collect amounts from debtors. The actual collection period can be compared with the stated credit terms of the company. If it is longer than those terms, this indicate some insufficiency in the procedure of collecting debts Bad debts to sale ratio: This ratio indicates the efficiency of the controlled procedure of the company. The actual ratio is compared with the target of norms to decide whether or not it is acceptable. Creditor turnover period: The measurement of creditor turnover period shows the average time taken to pay for goods and service by the company. In general the longer the credit period achieved the better, because delay in payments means that the operation of the company is financed interest free by suppliers funds. But there will be point beyond which if they are operating in a sellers market, may harm the company. If too long a period is taken to pay creditors, the credit rating of the company may suffer, thereby making it more difficult to obtain supplier in future. CREDIT TURNOVER PERIOD = CREDITORS * 365 / PURCHASES CHAPTER – 19 WORKING CAPITAL LEVERAGES One of the important objectives of working capital management is by maintaining the optimum level of investment in current asset and by reducing the current liability .The company can minimize the investment in working capital and thereby improve the return of capital employed. The term working capital leverages refer to the impact of level of working capital on company’s profitability. The working capital management should improve the productivity of investment and current asset and ultimately it will increase the return on capital employed. Higher level of investment in current asset than is required means increase in the cost of interest charged on short term loans and working capital finance raised from banks and will resulting the lover return on capital employed and vice versa. Working capital leverages measures the responsiveness of ROCE for changes in current asset. It is measured by applying the fallowing formulae 41
  42. 42. WORKING CAPITAL MANAGEMENT Working capital leverages = C.A / T.A - ‫טּ‬C.A Where: C.A = CURRENT ASSET T.A = TOTAL ASSETS (net fixed asset = current asset ) ‫טּ‬C.A = CHANGE IN CURRENT ASSET IMPACT OF INFLATION ON WORKING CAPITAL REQUIREMENT When the inflation rate is high, it will have a direct impact on the requirement of working capital as explained below 1. Inflation will cause the slow turnover figure at higher level even if there is no increase in the quantity of sale. The higher the sale means the higher level of balance in receivables. 2. Inflation will result in the increase of raw material price and hike in the payment for expenses and as a result increase in balance of trade creditors and creditors for expense. 3. Increase in the valuation of closing stock will result in showing higher profits but without its realization into cash cause the firm to pay higher tax dividend and bonus. This will lead the firm in serious problem in fund shortage and the firm may enable to meet its short term and long-term obligation. 4. Increase in investment in current asset means the increase in the requirement of working capital without corresponding increase in sale or profitability of a firm. Keeping in view of the above stated points the finance manager should be very careful about the impact of inflation in assessment of working capital requirement and its management. 42
  43. 43. WORKING CAPITAL MANAGEMENT IMPACT OF DOUBLE SHIFT WORKING ON WORKING CAPITAL REQUIREMENT If the firm, which is presently running in single shift, plans to go for working in double shift, the fallowing factors should be considered in assessing the working capital requirement of the firm. 1. Working in double shift means requirement of raw materials will be doubled and another variable expense will also increase drastically. 2. With the increase in the raw material requirement and expenses, the raw material inventory and work in progress will increase simutanunsly. The creditors for goods and creditors for expense balance will also increase. 3. Increase in production to meet the increased demand, which will also increase the stock of finished goods. The increase in sales means increase in debtor balance. 4. Increased in production will result in increased requirement of working capital 5. The fixed expense will increase with the working on double shift basis. The finance manager should reassess the working capital requirement if the change is contemplated from single shift operation to double shift operation. 43
  44. 44. WORKING CAPITAL MANAGEMENT CHAPTER – 20 ZERO WORKING CAPITAL This is one of the newest trends in working capital management. The idea is to have zero working capital .For e.g. at all times the current asset shall be equal to current liability. Excess investment in current asset is avoided and firms meet its current liability out of the matching current asset. As current ratio is 1 and quick ratio below 1,there may be appreansation about the liquidity, but if all current assets are performing and are accounted at their realizable values, these fears are misplaced. The firm saves opportunity cost on excess investments in current assets and as bank cash credit limit are limits are linked to inventory levels, interest cost is also sold. There would be a self-imposed financial disciple on the firm to manage their activity within their current liability and current asset and there may not be attendance to over borrow or divert funds. 44
  45. 45. WORKING CAPITAL MANAGEMENT Zero working capital also ensures a smooth and uninterrupted working capital cycle, and it will pressurize the financial manager to improve the quality of current asset at all times, to keep them 100 percent realizable. There will also be a constant displacement in current liability and the possibility of having overdue may diminish. The tendency to postpone current liability payment has to be curbed and working capital always maintained at zero. Zero working capital will also call for a fine balancing act in financial management, and the success in this endeavor would get reflected in healthier bottom lines. CHAPTER – 21 OVERTRADING Overtrading arises when a business expands beyond the level of funds available. Overtrading an attempt to finance a certain volume of production and sales with inadequate working capital .If the company does not have enough funds of its own to finance stock and debtors it is forced, if it wish to expand, to borrow from creditors and from banks on overdraft sooner or later and such expansion financed completely by funds of others, will lead to a chronic imbalance in the working capital ratio. Expansion is advantageous so long as the business has funds available to finance stock and debtors involved. Overtrading begins at a point where the business relies on extra trade credit and increased turnover are financed by taking longer period of credit from suppliers and/or negotiating an extension of overdraft limits with the banks. 45
  46. 46. WORKING CAPITAL MANAGEMENT Over dependence on outside finance is a sign of weakness, unless the expansion is curtailed, suppliers may refuse credit beyond certain limit, and the banks may call for the reduction in overdrafts. If this happens the business may be insolvent in that it does not have sufficient liquid resource to pay for current operation or to repay current liability until customers pay for sale made on credit terms, or unless the stock is sold for a loss for immediate cash payments. Using the fallowing ratios it will be possible to analyze the situation properly 1. Working capital = current asset: current liability 2. Acid test = quick asset: current liability 3. Stock turnover = stock: cost of sale 4. Debtor’s turnover = debtors: credit purchases The object of using these ratios is to detect a disorientation of liquidity position of a firm and increase reliance upon trade creditors and overdraft facilities. CHAPTER – 22 OVERCAPITALIZATION AND UNDER CAPITALIZATION OF WORKING CAPITAL If there are excessive stock, debtors and cash and very few creditors, there will be an over investment in current asset. The inefficiency of managing working capital will cause this excessive working capital resulting in lower returns in working capital employed. and long-term funds will be unnecessarily tied up when they could be invested to earn profit. This situation is known as overcapitalization of working capital. Under capitalization is a situation where a company does not have funds sufficient to run the normal operation smoothly. This may happen, due to inefficient working capital or diversion of working capital funds to finance capital items. If the company faces the situation of undrecapitalization, then it will face difficulty in meeting current obligation, procurement of raw material, meeting day-to-day running expense etc. The result will ultimately be reduced profitability, and reduced turnover. The finance manager must take immediate and proper step to overcome the 46
  47. 47. WORKING CAPITAL MANAGEMENT situation by making arrangements for sufficient working capital. For this purpose he should prepare the realistic cash flow and fund flow statement of the company. Some of the symptoms of poor working capital management are: 1. Excessive carriage of inventory over the normal levels required for business will result in more balance in trade creditors account. More creditors balance will cause strain on the management in management of cash. 2. Working capital problem will arise when there is a show down in collection of debtors. 3. Sometimes capital goods will be purchased from the funds available for working capital. This will result in the working capital and its impact on the operation of the company. 4. Unplanned production schedule will cause excessive stock of finished goods or failure in meeting dispatch shedadule. More funds kept in the form of cash will not generate any profit for the business. 5. Inefficiency in using potential trade credit require more funds for financing working capital. 6. Overtrading will cause shortage of working capital and its ultimate effect is on the operation of the company. 7. Dependence in short term source of finance for financing permanent working capital causes less profitability and will increase strain on management in managing working capital. 8. Inefficiency in cash management will cause embezzlement of cash. 47
  48. 48. WORKING CAPITAL MANAGEMENT CHAPTER – 23 INVENTORY MANAGEMENT Inventories symbolize the second largest asset categories for manufacturing companies, next only to plant and equipments. The proportion of inventories to total asset varies between fifteen to thirty percent. Inventories are stocks of the product a company is manufacturing for sale and component that make up the product. There are three types of inventories: raw materials, work in progress and finished goods. Raw materials are materials and components that are inputs in making the final product. The work in progress, also called stock in progress, refer to goods in intermediate stage of production. Finished goods consist of the final products that are ready for sale. While manufacturing firms generally hold all three types of inventories, distribution firms hold mostly finished goods. As inventory management has important financial implication, the financial manager has the responsibility to ensure that the inventory properly monitored and controlled. The three general motives for holding the inventories are: 1. The transaction motives that emphasis the need to maintain inventories to facilitate smooth production and sales operation. 48
  49. 49. WORKING CAPITAL MANAGEMENT 2. The precautionary motive that necessitates holding of inventories to guard against the risk of unpredictable change in demand and supply force and other factors. 3. The speculative motive which influence the decision to increase and reduce the inventory level to take advantage of price fluctuations. The objectives of holding inventory are: 1. To maintain a large size of inventory for efficient and smooth production and sales operation. 2. To maintain a minimum investment in inventories to maximize profitability. The objective of inventory management should be to determine and maintain optimum level of inventory investment. The firm should always avoid a situation of over investment or under investment in inventories. If there is over investment in investment then it would result in unnecessary tie up of firm’s funds, loss of profit, excessive carrying cost and risk of liquidity. Maintaining an inadequate level of inventories is also dangerous. The consequence of under investment in inventories will lead to production hold up and failure to meet delivery commitments. The aim of inventory management thus should be to avoid excessive and inadequate level of inventories and to maintain sufficient inventories for smooth production and sales operation. Efforts should be made to place an order at the right time and with the right source to acquire the right quantity at he right place and quality. An effective inventory management should: 1. Ensure a continuous supply of materials to facilitate uninterrupted production. 2. Maintain sufficient stock of raw material in periods of short supply and anticipate price change. 3. Maintain sufficient finished goods inventory for smooth sales operation, and efficient customer service. 4. Minimize the carrying cost and time. 5. Control investment in inventories and keep it at an optimal level. ECONOMIC ORDER QUANTITY: 49
  50. 50. WORKING CAPITAL MANAGEMENT There are two basic questions that should be considered in inventory management namely (a) What should be the size of order? (b) At what level should the order be placed? This includes three types of cost: 1. Ordering cost: It relates to purchased items that include expense on fallowing: requisitioning, preparation of purchase order, expediting, transport and receiving and placing in storage. 2. Carrying cost: It includes expenses on interest on capital locked up in inventory, storage, and insurance, obsolesce and taxes. Carrying cost generally are 25% of the value of inventory held. 3. Storage cost: It arises when inventories are short of requirement for meeting the need of production or demand of customers. Inventory shortage may result in high cost, less efficient and uneconomic production schedules, customer dissatisfaction and loss of sale. Thus when a firm order in large quantities, in a bid to reduce the total ordering cost, the average inventory, other things being equal, tends to be high thereby increasing the carrying costs. In view of such relationship, minimization of overall inventory management would require a consideration of trade off among these costs. For determining Economic Order Quantity formula the fallowing symbols are used: U Annual usage/demand Q Quantity ordered F Cost per order C Percent carrying cost P Price per unit TC Total cost of ordering and carrying T.C = U * F * Q * P * C 50
  51. 51. WORKING CAPITAL MANAGEMENT The total cost of ordering and carrying cost is minimized when Q = √ 2 FU / PC CHAPTER – 24 MONITORING AND CONTROLLING OF INVENTORIES This includes the tools of ABC (Always Better Control) analysis, the various measures for judging the effectiveness of inventories, the concept of just in time inventory control and the steps that may be taken to maintain control over inventories. ABC analysis: In most inventories a small proportion of items account for a very substantial usage (in terms of monetary value of annual consumption) and a very large proportion of items account for a very small usage (in terms of monetary value of annual usage). ABC analysis, based on this empirical reality, advocates in essence, a selective approach to inventory control, which calls for greater concentration of efforts on inventory items accounting for the bulk usage value. This approaches calls for classifying inventories into three broad categories namely A, B and C categories. Category A represent the most important items, which generally consist of 15 to 25 % of inventory items and constitute for 60 –70 % of annual usage value. Category B, represent items of moderate importance, generally consist of 20 to 30 % of inventory items and account for 20 to 30 % of annual usage value. Category C represent items of least importance, generally consisting of forty to sixty percent of inventory items and accounts for 10 to 15 % of annual usage value. 51
  52. 52. WORKING CAPITAL MANAGEMENT To illustrate the use of ABC analysis, let the information on usage and price of 20 items used by Control System Limited be CLASS NUMBER OF ITEMS % OF ITEMS % OF USAGE VALUES A 5 25 68.3 B 5 25 21.4 C 10 50 10.2 The procedure for numerical calculation of ABC analysis will be (1) Rank the items of inventory on the basis of usage value (2) Record the cumulative usage in value (3) Show the cumulative percent of the usage item. Now a days many large manufacturers operate on just in time basis whereby all the components to be assembled on a particular day arrive at the factory early that morning, no earlier-no later. This helps to minimize manufacturing costs as JIT stock take up a little space, minimize stock holding and virtually eliminate the risk of obsolete and damaged stock. Because JIT manufacturers hold stock for a short time, they are able to conserve substantial cash. IT is a good model to strive for, as it embraces all the principle of sensible stock management. The key issue for a business is to identify the fast and slow stock movers with the objective of establishing optimum stock level for each category and thereby minimize the cash tied up in stock. Factors to be considered when determining optimum stock level include (a) what are the projected sales of each product? (b) How widely available are the raw materials, components etc? (c) How long does it take for delivery by suppliers? (d) Can you remove slow movers from your product range without compromising best sellers? Remember that stock sitting on shelves for long period of time ties up money that is not working for you. For better stock control a firm should try the fallowing (a) Review the effectiveness of existing purchases and inventory system? (b) Know the stock turn for all major item of inventory (c) apply tight control to significant few items and simplify controls for trivial many. (d) Sell off 52
  53. 53. WORKING CAPITAL MANAGEMENT outdated or slow moving merchandise—It gets more difficult to sell the longer you keep it. (e) Consider having part of your product outsourced to another manufacturer rather than making it yourself (f) Review your security procedure to ensure that no stock “is going out the back door”! Higher than necessary stock levels tie up cash and cost more in insurance, accommodation costs and interest charges. CHAPTER – 25 STRATEGIES IN WORKING CAPITAL MANAGEMENT At present more finance option are available to the finance manager to see the operation of his firm go smoothly. Depending on the risks of business strategies is evolved to manage the working capital. Conservative working capital strategy: A conservative strategy suggests carrying high levels of current asset in relation to sales. Surplus current asset enable the firm to absorb sudden variation in sales, production plans, and procurement time without destructing production plans. Additionally the higher liquidity level reduces the risk of insolvency. But lower risk translates into lower returns. Large investment in current asset lead to higher interest and carrying cost and encouragement for efficiency. But conservative policy will enable the firm to absorb day o day risk. It assures continuous flow of operation and illuminates worry about recurring obligation. Under this strategy, long term financing covers more than the total requirement of capital. The excess cash is invested in short-term marketable securities and in need these securities are sold off in the market to meet the urgent requirement of working capital. Aggressive working capital strategy: Under this approach current asset are maintained just to meet the current liability without keeping cushions for the variation in working capital needs. The companies working capital is financed by long-term source of capital and seasonal variation are met through short-term borrowing. Adoption of this strategy will minimize the investment in net working 53
  54. 54. WORKING CAPITAL MANAGEMENT capital and ultimately it lowers the cost financing working capital needs. The main drawback of this strategy is that it necessitates frequent financing and also increase, as the firm is variable to sudden shocks. A conservative current asset financing strategy would go for more long- term finance, which reduces the risk of uncertainty associated with frequent refinancing. The price of this strategy is higher financing cost since long-term rates will normally exceed short-term rates. But when aggressive strategy is adopted, some time the firm runs into mismatches and defaults. It is a cardinal principle of corporate finance that long term source and short-term assets should finance long term asset by a mix of long and short-term source. Efficient working capital management techniques are those that compressed operating cycle. The length of operating cycle is equal to the sum of the length of the inventory period and the receivable period. Just in time inventory management techniques reduce carrying cost by slashing the time that goods are parked as inventories. To shorten the receivables period without necessary reducing the credit period, corporate can offer trade discount for prompt payment. Rs SECULAR GROWTH LONG TERM FINANCING SEASONAL INVESTMENT IN VARIATION MARKETABLE SECURITY 54
  55. 55. WORKING CAPITAL MANAGEMENT Time FIG 25.1 CONSERVATION WORKING CAPITAL STRATEGY Rs Seasonal variation Short term financing Secular growth Long term financing Time FIG 25.2 AGGRESSIVE WORKING CAPITAL STRATEGY 55
  56. 56. WORKING CAPITAL MANAGEMENT CHAPTER – 26 ROLE OF CASH AND BANK IN WORKING CAPITAL MANAGEMENT Good cash management can have a major impact on overall working capital management. The key elements of cash management are: 1. Cash forecasting; 2. Balance management; 3. Administration; 4. Internal control. Cash Forecasting. Good cash management requires regular forecasts. In order for these to be essentially accurate, they must be based on information provided by those managers responsible for the amounts and timing of expenditure. Capital expenditure and operating expenditure must be taken into account. It is also necessary to collect information about impending cash transactions from other financial systems, such as creditors and payroll. Balance Management. Those responsible for balance management must make decisions about how much cash should at any time be on call in the Bank Account and how much should be on term deposit at the various terms available. There are various types of mathematical model that can be used. One type is analogous to the ERQ inventory model. Linear programming models have been 56
  57. 57. WORKING CAPITAL MANAGEMENT developed for cash management, subject to certain constraints. There are also more complicated techniques. Administration. Cash receipts should be processed and banked as quickly as possible because: 1. They cannot earn interest or reduce overdraft until they are banked; 2. Information about the existence and amounts of cash receipts is usually not available until they are processed. Where possible, cash floats (mainly petty cash and advances) should be avoided. If, on review, the only reason that can be put forward for their existence is that "we've always had them", they should be discontinued. There may be situations where they are useful, however. For example, it may be desirable for minor parts of departments to meet urgent local needs from cash floats rather than local bank accounts. Internal Control. Cash and cash management is part of a department's overall internal control system. The main internal cash control is invariably the bank reconciliation. This provides assurance that the cash balances recorded in the accounting systems are consistent with the actual bank balances. It requires regular clearing of reconciling items. 57
  58. 58. WORKING CAPITAL MANAGEMENT CHAPTER – 27 CONCLUSIONS In conclusion, good management of working capital is part of good financial management. Effective use of working capital will add to the operational efficiency of a department; optimal use will help to generate maximum returns. Ratio analysis discussed in the beginning, can be used to identify working capital areas, which require closer management. Various techniques and strategies, discussed above are available for managing specific working capital items. Debtors, creditors, cash and in some cases inventories are the areas most likely to be relevant to a firm. 58
  59. 59. WORKING CAPITAL MANAGEMENT CHAPTER –28 ANALYSES 1 GUJARAT AMBUJA CEMENTS L.T.D Gujarat Ambuja cements was set up in 1986.In the last decade the company has grown tenfold. With the commencement of commercial production of its 2 mn tones plant in Chandrapur, Maharashtra, Ambuja will become India’s third largest cement company with a capacity of 12.5 mn tones and revenue in excess of 2500 crores. Its plants are one of the most efficient in the world with environment protection measures that are on par with the finest in the developed world. Ambuja fallows a unique home grown philosophy of giving people the authority to set their own targets, and the freedom to achieve their goals. This simple vision has created an environment where there are no limits to excellence, no limits to efficiency and has proved to be a powerful engine of growth for the company. Ambuja, believes that an asset is worth only as much as the people who use it. The people’s efforts to constantly raise efficiency have not only raised the bar at Ambuja, but across the industry as well. Thus their people continue to achieve ever-high efficiency and productivity at all their plants. 59
  60. 60. WORKING CAPITAL MANAGEMENT Over 40 % of the production cost of cement is power. Ambuja realized that to run a profitable company, they need to keep power cost to minimum. So they set up a captive power plant at a substantially lower cost than the national grid. They sourced a cheaper and a higher quality coal from South Africa. They also brought better furnace oil from the Middle East. The result is that today hey are in a position to sell their excess power to the local government. Their sea borne bulk cement transportation facility has brought many costal markets within easy reach. It also made Ambuja India’s largest exporter of cement consistently for the last five years. As a result Ambuja is the most profitable cement company in India, and the lowest cost producer of cement in the world. Ambuja has received the highest quality award – The national quality award and the only current company to do so. It was also the first to receive ISO 9002 quality certification. Performance highlights of Gujarat Ambuja cements Ltd for the years 2001 – 2002 and 2002 – 2003 PARTICULARS 2002 – 2003 (Rs in cores) 2001 -2002 (Rs in cores) Sales 1592 1474 (-) Expenditure 1126 1010 PBDIT 466 464 (-) Depreciation & Amortization 138 129 PBIT/Operating profit 328 335 (-) Interest/Financial charges 97 134 PBT 231 201 (-) Provision for tax 45 14 PAT 186 187 60
  61. 61. WORKING CAPITAL MANAGEMENT STATEMENT SHOWING WORKING CAPITAL OF GUJAART AMBUJA CEMENT LTD Particulars 2002 – 2003 Rs in lacks 2001 – 2002 Rs in lacks CURRENT ASSETS: Inventories 20837 16143 Sundry debtors 3901 3344 Cash and Bank balance 5072 2861 Other current asset 2371 2435 Loans and advances 15055 15278 TOTAL CURRENT ASSET (A) 47236 40061 CURRENT LIABILITY Current liability 18821 22060 Provisions 3430 8313 TOTAL CURRENT LIABILITY (B) 22251 30373 NET WORKING CAPITAL (A-B) 24985 9668 Statement indicating short-term ratio: 1. Liquid ratios: RATIO FORMULAE 2002 - 2003 2001 - 2002 A) Current ratio Current 47236 / 22251 40061 / 30373 = 61
  62. 62. WORKING CAPITAL MANAGEMENT asset/current liability =2.12 1.32 B) Quick ratio (Current asset – inventories) / current liability 26399 / 22251 = 1.86 23918 / 30373 = 0.79 C) Cash ratio Cash + marketable securities / current liability 5072 / 22251 = 0.23 2861 / 30373 = 0.09 2. Turnover ratios: C) Stores and consumables turnover ratio Cost of goods sold / Closing consumables 433.99 / 143.98 = 3.01 days 406.90 / 97.93 = 4.16 days RATIO FORMULAE 2002 - 2003 2001 - 2002 A) Debtor turnover ratio Net credit sales / Closing debtors 1592 / 39.01 = 1474 / 33 = Debtor collection period 365 days / DTR 365 / 40.81 = 9 365 / 44 =14 B) Stock in trade ratio Cost of goods sold / Closing stock in trade 964.5 / 64.30 = 15 898 / 63 =8 Stock holding period 365 days STR 365 / 15 = 24 365 / 14 =26 62
  63. 63. WORKING CAPITAL MANAGEMENT Stores and consumables holding period 365 / SCTR 365 / 3.01 = 121 days 365 / 4.16 = 87 days D) Creditor turnover ratio Net credit purchases / Closing Creditors 464.34 / 112.27 = 4.14 days 461.40 / 167.32 = 2.76 days Creditors payment period 365 / CTR 365 / 4.1 = 88 days 365 / 2.76 = 132 days 3. Effect of turn over ratio on working capital: RATIO 2002 – 2003 (IN DAYS) 2001 – 2002 (IN DAYS) Stock holding period 24 26 (ADD) Stores and consumables holding period 121 87 (ADD) Debtors collection period 9 8 (LESS) Creditors payment period 88 132 Total 66 (11) 4. Profitability ratio: RATIO FORMULAE 2002 - 2003 2001 - 2002 Gross profit margin ratio Gross profit / net sales 328 / 1592 = 0.21 =21% 335 / 1474 = 0.23 = 23% ANALYSIS: WORKING CAPITAL OUTLAY: 63
  64. 64. WORKING CAPITAL MANAGEMENT In the cement business where the production and marketing cycle can be long, working capital funds a number of activity: the purchase of raw materials, making advances, availing cash discount on the total billing, maintaining an inventory on production spares, sustaining the production cycle without interruption and sustaining all the usual function within the organization. Working capital accounted for 7.8 percent of the companies total capital employed in 2002 – 2003.The total quantum of working capital was rs 24985 lac in 2002-2003 compared to 9688 lacks in 2001-2002,a 157.9% increase. The company’s turnover to working capital ratio increased from 6.6 times in 2001-2002 to 15.7 times in 2002-2003. LIQUIDITY RATIOS: It implies the firm’s ability to pay its debts in a short run. It involves the relationship between the current asset and current liability. In case of Gujarat Ambuja Cements, the net working capital was Rs 9688 lacks in 2001-2002 has increased to Rs 24985 lacks in the year 2002-2003.It means that the liquidity position of the firm has increased. This is mainly due to increase in inventory holding and cash balances. The current ratio implies the firm’s ability to meet its current obligation. In 2001-2002 the current ratio was 1.32,which is now increased to 2.12 in 2002- 2003,which means that the company has current asset, which are 2.12 times the current liability. This shows that the overall liquidity position of the company has seen an improvement over the previous year. The increase in current ratio in over the earlier period can be attributed towards an increase in inventory holdings and also a noticeable rise in cash holdings over the earlier period. This if further affraimed by quick ratio, which has shown a significant rise from 0.79 in 2001-2002 to 1.86 in 2002-2003.In fact the quick ratio has more than doubled over the previous year. Thus, the company has managed to generate adequate cash surplus to meet its growing business needs. Besides they have also built up good stock levels of coal and other packing materials, probably to take advantage of low price prevailing in the market. 64
  65. 65. WORKING CAPITAL MANAGEMENT SUNDRY DEBTORS: Sundry debtors stood at 3901 lacks in 2002-2003,compared with Rs 3344 lacks in 2001-2002,a 16.66 percent increase. Sales have increased by 9.34 percent in 2002-2003,and average collection period has more or less remained steady from 8 days in 2002 to nine days in 2003.This indicates that the company has succeeded in achieving growth in sales and at the same time, efficiently collected its receivables from the marketplace, as in the previous year. Credit worthiness was appraised on a periodic basis. INVENTORIES: Inventories increased from Rs 16143 lacks in 2001-2002 to Rs 20837 lacks in 2002-2003,a 29% increase over the previous year primarily due to the increase in stock of coal and packing material. Goods and consumables holding period increased from 87 days to 121 days As a result the total inventory-holding period also increased from days in 2001 –2002 to 145 days in 2002-2003. SUNDRY CREDITORS: The sundry creditors decreased from 16732 lacks in 2001-2002 to Rs 11226 lacks in 2002-2003,a 32.9% decrease’s a result creditors payment period decreased from 132 days in 2001-2002 to 88 days in 2002-2003.It seemed that the company has pushed hard its cost cutting drive, and effectively negotiated with its major suppliers to reduce the price of the supplies and compensated the suppliers to a certain extend by accepting a lower credit period. Also, the company seems to have generated enough cash from its operation to pay off the suppliers on a timely basis. The company has strived hard to reduce its liabilities by paying off the creditors, which shows that they have efficiently planned their finance. To summarize one can say that, Gujarat Ambuja Cement has utilized its working capital efficiently. It has been able to process at lower prices by compromising on credit period from its creditors up to 88 days and has efficiently collected from debtors in nine days. But the inventory seem to be slightly on the 65
  66. 66. WORKING CAPITAL MANAGEMENT higher side as compared to the previous year, which may me due to the company availing the benefits of low price of material in the market. PROFITABILITY RATIO: This is the ratio that measures the firm’s activity and the ability to generate profits. The gross profit margin ratio of Gujarat Ambuja Cement has decreased from 23% in 01-02 to 21% in 02-03.On an average it shows that company has made good profit as compared to the earlier year. CHAPTER – 29 ANALYSES 2 SHREE CEMENTS LTD SHREE cements is one of the major energy efficient and productive cement manufacturing in the world. SHREE cements is engaged in manufacture of cement through the dry process route in north India. The company process two plants in Bewar and Rajastan.Shree cements manufacture cements of two varieties – Gray cement and Clinker cement. Its competitive advantage lays in its ability to constituently generate a production in excess of its installed capacity. In 2002 – 2003,Shree Company recorded a turnover of Rs 399.27 crore as against Rs 554.60 crore in 2001 - 2002.This was because 2002 - 2003 comprised 9 66
  67. 67. WORKING CAPITAL MANAGEMENT working months as compared to 12 working months the previous year. In 2002 - 2003 SHREE cements posted a 28% increase in its cash profits i.e. 49.84 crore as compared to the previous year. The vision of SHREE cement is to register a strong consumer surplus through a superior cement quality at affordable prices. And their mission is to strengthen realization through intelligent brand building and to increase he awareness of superior products through a realistic and convincing communication process with consumers. The company is looking forward to make financial accounting module available online for the authorized users. It also plans to get input from Weigh Bridge online to exercise better control on inbound and out bound logistics. In coming days IT is expected to play an even more important role in terms of integrating various activities of business, maintaining Data and providing information. PERFORMANCE HIGHLIGHTS OF SHREE CEMENTS LTD FOR THE YEAR 2001-2002 & 2002-2003 PARTICULARS 2002-2003 (NINE MONTHS) Rs in crores 2001-2002 (TWELVE MONTHS) Rs in crores Sales 397.21 554.60 Other income 0.30 0.28 Increase/Decrease in stock 6.01 (13.31) (-) Expenditure 326.75 445.80 67
  68. 68. WORKING CAPITAL MANAGEMENT PBDIT 76.77 95.77 (-) Interest and financial charges 26.93 44 Gross profit 49.84 51.77 (-) Depreciation and a moralization 43.12 25.64 PBT 6.72 26.13 (-) Provision for tax 3.10 - (-) Provision for deferred tax 2.14 - PAT 1.48 26.13 Statement showing working capital of shree cements ltd PARTICULARS 2002-2003 All rs in crores 2001-2002 All rs in crores Current assets: Inventories 4103 3472 Sundry debtors 3003 4082 Cash and bank balance 553 1891 Loan and advance 6423 6584 Total current assets (A) 14082 16029 Current liabilities Current liability 5840 5488 Provisions 446 599 Total current liability (B) 6286 6087 Net working capital (A-B) 7796 9942 68
  69. 69. WORKING CAPITAL MANAGEMENT Statement indicating Short term ratios Liquidity ratio: RATIO FORMULAE 2002-2003 2001-2002 A) CURRENT RATIO CURRENT ASSETS / CURRENT LIABILITY 14082/6286 = 2.24 16029/6087 = 2.63 B) QUICK RATIO CURRENT ASSETS – INVENTORY /CURRENT LIABILITY 9979/6286 = 1.59 12557/607 = 2.06 C) CASH RATIO CASH + MARKETABLE SECURITIES/CURRENT LIABILITY 553/6286 = 0.08 1891/6087 = 0.31 Turnover ratio: RATIO FORMULAE 2002-2003 2001-2002 A) Inventory turnover ratio Goods sold/closing stock 39722/4103 = 9.68 55460/3472 = 16 Inventory holding period 365 days/ITR 274/9.68 = 28 days 365/16 = 23 days B) Debtor turnover ratio Net credit sales/Closing debtors 39722/3003 = 13 55460/4082 = 14 Debtor collection period 365 days/DTR 274/13 = 21 days 365/14 = 27 days C) Creditor turnover Net credit 14829/3754 20823/3405 = 69
  70. 70. WORKING CAPITAL MANAGEMENT period purchases/Closing creditors =3.95 6.11 Creditor payment period 365/CTR 274/3.96 = 69 days 365/6.11 = 60 days EFFECT OF THE TURNOVER RATIO ON WORKING CAPITAL RATIO 2002-2003 2001-2002 Inventory holding period 28 DAYS 23 DAYS ADD Debtor collection period 21 DAYS 27 DAYS LESS Creditor payment period 69 DAYS 60 DAYS TOTAL (20) (10) PROFITABILITY RATIO RATIO FORMULAE 2002-2003 2001-2002 Gross profit margin ratio Gross profit/Net sales 4984/39722 = 0.13 = 13% 5176/55461 = .09 = 9% ANALYSIS: WORKING CAPITAL OUTLAY: In the cement business where the production and marketing cycle can be long, working capital funds a number of activity: the purchase of raw materials, making advances, availing cash discount on the total billing, maintaining an inventory on production spares, sustaining the production cycle without interruption and sustaining all the usual function within the organization. Working capital accounted for 12 percent of the companies total capital employed in 2002 – 2003.The total quantum of working capital was rs 77crore in 2002-2003 compared to 99.42 crore in 2001-2002,a 21.58% decrease. 70
  71. 71. WORKING CAPITAL MANAGEMENT LIQUIDITY RATIOS: It implies the firms ability to pay its debtors I the short run. It involves the relationship between the current asset and the current liability. In the case of SHREE cements, the net working capital was rs 99.42 crores in 2001-2002 and reduced to RS 77.96 cr in 2002-2003.It means that the liquidity position of the company has decreased. The current ratio implies the firm’s ability to meet its current obligation. In 01- 02 the current ratio was 2.63,which has now come down to 2.24, which means that the company has current asset, which are 2.24 times the current liability. Thus the liquidity position of the company has reduced. The quick ratio implies the firms ability to pay off its liabilities without relaying on the sale of the inventory or its recovery. The quick ratio is reduced from 2.06 in 01-02 to 1.59 in 02-03.,which means the inventories are reduced over a period of time and that liquidity position is good although the current ratio gives a different picture. SUNDRY DEBTORS: Retail sale increased by ten percent in 2002-2003 and sundry debtors decreased by Rs 10.79 crore. This indicates that the companies collets its outstanding faster from the marketplace. Sundry debtors stood at 30.03 crore in 2002-2003 compared with 40.82 crore in 2001-2002, a 26.43% decrease. Debtor’s day decreased from 27 days in 2001-2002 to 21 days in 2002-2003,reflecting prudent debtor management. Credit worthiness was appraised on a periodic basis. Attractive financial incentive scheme were instituted to ensure a quick settlement of outstanding. INVENTORY :Inventories increased from 34.05 crore in 2001-2002 to 37.54 crore in 2002-2003 which is a 10.24% increase. Creditor payment period increased from sixty days in 2001-2002 to sixty nine days in 2002-2003, which shows a prudent credit management. The company has strived hard to push their creditors, which shows they have efficiently planed things. PROFITABILITY RATIO: This is the ratio that measures the firm’s activity and its ability to generate profit. The gross profit margin of SHREE CEMENTS has decreased from thirteen percent to nine percent but on average it shows that the companies has made good profit as compared to the earlier year. 71