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Financial Management LESSON-1 NATURE OF FINANCIAL MANAGEMENT Learning Objectives After reading this lesson you should be able

to : Know the meaning of financial management. Identify the changes in the concept of finance. Understand the goals of financial management. Detail the scope of finance function. Explain the functions of Finance Manager. Lesson Outline Financial Management as a branch of management Evolutionary changes in the concept of Finance Definitions of Financial Management Goals of Financial Management Scope of Finance Function Functions of Treasurer and Controller Routine Duties of Financial. Manager Social Responsibility of Financial Manager Finance is to business what blood is to the human body. Thus it is the lifeblood of business. Fortunately for the human body there is an automatic regulation of the quantity and quality of blood required. No such auto control is available in the case of a business firm. Hence the necessity to manage finances of that the firm may have at its disposal adequate funds of various types but at the same time avoiding idleness of funds. There was a time when it was thought that financial management consisted merely of providing funds required by the various departments or divisions of the firm. This has now changed completely and it is accepted that proper financial management consists of a dynamic approach towards the achievement of firms objectives. Financial Management as a Branch of Management Of all the branches of management, financial management is of the highest importance. The primary purpose of a business firm is to produce and distribute goods and services to the society in which it exists. We need finance for the production of the goods and services as well as their distribution. The efficiency

of production, personnel and marketing operations is directly influenced by the manner in which the finance function of the enterprise is performed by the finance personnel. Thus it may be stated that all the functions or activities of the business are ultimately related to finance function. The success of the business depends on how best all these functions can be co-ordinated. A tree keeps itself green and growing as long as its roots sap the life juice from the soil and distribute the same among the branches and leaves. The activities of an organisation also keep going smoothly a long as finance flows through its veins. Any and every business activity will ultimately be reflected through its finance the mirror and also the barometer of the enterprise functions.. Finance and Other Functional Areas of Management Financial Management and Research and Development : The R & D manager has to justify the money spent on research by coming up with new products and process which would help to reduce costs and increase revenue. If the R & D department is like a bottomless pit only swallowing more and more money but not giving any positive results in return, then the management would have no choice but to close it. No commercial entity runs a R & D department for conducting infructuous basic research. For instance, until 5 years ago, 80% of the R & D efforts of Bush India, the 45year old consumer electronics company, well known for its audio systems, was in TVs and only 20% was in audio. But the fact that a 15-year stint in the TV market starting from 1981 when the company shifted its interest from the audio line to TV manufacture, led the companys decline to near oblivion, pushing the oncefamous. Bush brand name to near anonymity, called for a change in production and re-orientation of R&D, strategy. The company has also identified and shut down some of its non-productive divisions and trimmed its workforce. At the beginning of 1992, Bush had 872 employees, by the end this was cut down to 550, The company had to further cut it down to 450 by the end of 1993. Financial Management and Materials Management: Likewise the materials manager should be aware that inventory of different items in stores is nothing but money in the shape of inventory. He should make efforts to reduce inventory so that the funds released could be put to more productive use. At the same time, he should also ensure that inventory of materials does not reach such a low level as to interrupt the production process. He has to achieve the right balance between too much inventory and too little inventory. This is called the liquidity - profitability trade-off about which you will read more in the lessons on Working Capital Management. The same is true with regard to every activity in an organisation. The results of all activities in an organisation are reflected in the financial statements in rupees. Financial Management and Production Management : In any manufacturing firm, the Production Manager controls a major part of the

investment in the form of equipment, materials and men. He should so organise his department that the equipment under his control are used most productively, the inventory of work-in-process or unfinished goods and stores and spares is optimised and the idle time and work stoppages are minimised. If the Production Manager can achieve this, he would be holding the cost of the output under control and thereby help in maximising profits. He has to appreciate the fact that whereas the price at which the output can be sold is largely determined by factors external to the firm like competition, government regulations, etc., the cost of production is more amenable to his control. Similarly, he would have to make decisions regarding make or buy, buy or lease etc., for which he has to evaluate the financial implications before arriving at a decision Financial Management and Marketing Management: Marketing is one of the most important areas on which the success or failure of the firm depends to a very great extent. The philosophy and approach to the pricing policy are critical elements in the companys marketing effort image and sales level. Determination of the appropriate price for the firms products is importance both to the marketing and the financial managers and, therefore, should be a joint decision of both. The marketing manager provides information as to how different prices will affect the demand for the companys products in the market and triefirms competitive position while the finance manager can supply information about costs, change in costs at different level of production and the profit margins required to carry on the business. Thus, the finance manager contributes substantially towards formulation of the pricing policies of the firm. Financial Management and Personnel Management : The recruitment, training and placement of staff is the responsibility of the Personnel Department. However, all this requires finances and, therefore, the decisions regarding these aspects cannot be taken by the Personnel Department in an isolation of the Finance Department. Thus, it will be seen that the financial management is closely linked with all other areas of management. As a matter of fact, the financial manager has a grasp over all areas of the firm because of his key position. Moreover, the attitude of the firm towards other management areas is largely governed by its financial position. A firm facing a critical financial position will devise its recruitment, production and marketing strategies keeping the overall financial position in view. While a firm having a comfortable financial position may give flexibility to the other management functions, such as, personnel, materials, purchase, production, marketing and other policies. Evolutionary Change in the Concept of Finance The word finance has been interpreted differently by different authorities. More significantly, the concept of finance has changed markedly from time to time. For the convenience of analysis different viewpoints on finance have been categorised into three major groups.

1. Finance means Cash only : Starting from the early part of the present century, finance was described to mean cash only. The emphasis under this approach is only on liquidity and financing of the firm. Since nearly every business transaction involves cash, directly or indirectly, finance is concerned with everything that takes place in the conduct of the business. However, it must be noted that this meaning of finance is too broad to be meaningful. 2. Finance is raising of funds: The second grouping, also called the traditional approach, is concerned with raising funds used in an enterprise. It covers, (a) instruments, institutions, practices through which funds are raised and (b) the legal and accounting relationships between a company and its sources of funds, including the redistribution of income and assets among these sources. This concept of finance is, of course, broader than the first as it is concerned with raising of funds. Finance, during the forties through the early fifties, was dominated by this traditional approach. However, it could not last for long because of some shortcomings. First, this approach emphasised the perspective of an outsider lender. It only analysed the firm and did not emphasis decision-making within the firm. Second, this approach laid heavy emphasis on areas of external sources of longterm finance. However, short-term finance, i.e.. working capital is equally important. Third, the function of efficient employment of resources was totally ignored. 3. Finance is raising and utilisation of funds : The third grouping is called the Integrated Approach or Modern Approach. According to this approach, the concept of finance is concerned not only with the optimum way of raising of funds but also their proper utilisation too in time and low cost in a manner that each rupee is made to work at its optimum without endangering the financial solvency of the firm. This approach to finance is concerned with (a)determining the total amount of funds required in the firm, (b) allocating these funds efficiently to the various assets, (c) obtaining the best mix of financing-type and amount of corporate securities, (d) use of financial tools to ensure proper and efficient use of funds. Definitions of Financial Management In general, finance may be defined as the provision of money at the time it is wanted. However, as a management function it has a special meaning. Finance function may be defined as the procurement of funds and their effective utilisation. Some of the authoritative definitions are as follows: According to Ezra Solomon, Financial management is concerned with the

efficient use of an important economic resource, namely, Capital Funds. In the words of Howard and Upton, Finance may be defined as that administrative area or set of administrative functions in an organisation which relate with the arrangement of cash and credit so that the organisation may have the means to carry out its objectives as satisfactorily as possible. Phillippatushas given a more elaborate definition of the term financial management. According to him Financial management is concerned with the managerial decisions that result in the acquisition and financing of long-term and short-term credits for the firm. As such it deals with the situations that require selection of specific assets (or combination of assets), the selection of specific liability (or combination of liabilities) as well as the problem of size and growth of an enterprise. The analysis of these decisions is based on the expected inflow and outflow of funds and their effects upon managerial objectives. Financial Management may also be defined as planning, organising, direction and control of financial resources with the objectives of ensuring optimum utilisation of such resources and providing, insurance against losses through financial deadlock. This definition clearly explains four broad elements viz., planning, organising, direction and control. The details under these elements are as follows: a) Ascertainment of need b) Determination of sources Planning c) Collection of funds d) Allocation of funds Organising e) Communication of planned objective (Direction Rarssolomon : The Theory of Financial Management New York, Columbia University Press, 1963) f) Monitoring of funds(through financial disciplinein respect of funds utilisation). g) Knowing performance actuals h) Judging performance against Control norms, standards, targets etc. i) Taking corrective action which in turn involves removal of snags as well as revision of targets. While the functions under planning and organising are mostly of discrete nature(undertaken from time to time and very often independently), those under control area are continuous' in nature. All the principles, steps and weapons of managerial control are applicable in proper control of financial resources and their utilisation. Hence, it is rightly said by Howard and Upton that financial management is an application of general managerial principles to the area of financial decision making viz., Funds requirement decision, Investment decision, Financing decision and Dividend decision. Hunt, William and Donaldson have rightly called it as Resource Management Financial management is intimately interwoven into the fabric of management itself. Not only is this because the results of management's actions are expressed

in financial terms, but also principally because the central role of financial management is concerned with the same objectives as those of management itself and with the way in which the resources of the business are employed and how it is financed. Because it is about making profits and profits will be determined by the way in which the resources of the business in terms of people, physical resources, capital, and any other specific talents are organised. Financial management is concerned with identifying sources of profit and the factors which affects profit. That is to say with operating activities in the way in which the assets are used, and from a longer term point of view, the process of allocating funds to use within the business. In these activities, financial managers form part of a management team applying their specialist advice and processing and marshalling the data upon which decisions are based. Goals of Financial Management The goal of the financial management should be to achieve the objective of the business owners, who are the suppliers of capital. In the case of company, the owners are shareholders. The financial managers function is not to fulfill his own objectives, which may include higher salaries earning reputation or maintaining and advancing his personal power and prestige. It is, rather to manager is successful in this endeavour, he will also achieve his personal objectives. It is generally agreed that the financial objective of the firm should be the maximisation of owners wealth. However, there is disagreement as to how the economic welfare of owners can be maximised. Two well known and widely discussed criteria which are put forth for this purpose are: (a) profit maximisation, and (b) wealth maximisation. (a) Profit Maximisation : Traditionally, the business has been considered as an economic institution and profit has come to be accepted as a rationally valid criterion of measuring efficiency. As a goal, however, profit maximisation suffers from certain basic weaknesses: (1) it is vague, (2) it is a short-run point of view, (3) it ignores risk, and (4) it ignores the timing of returns.

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An unambiguous meaning of the profit maximisation objective is neither available nor possible. It is rather very difficult to know about the following: Does it mean short-term profits or long-term profits? Does it refer to profit before or after tax? Does it refer to total profits or profit per share? Besides it is being ambiguous, the profit maximisation objective takes a short-run point of view. Prof. Drucker and Prof.Galbraith contradict the theory of profit maximisation

and observe that exclusive attention on profit maximisation misdirects managers to the point where they may endanger the survival of the business. Prof.Galbraith gives the following points to argue his line of reasoning: (1) it undermines the future for todays profit; (2) it shortchanges research promotion and other investments; (3) it may shy away from any capital expenditure that may increase the invested capital base against which profits are based, and the result is dangerous obsolescence of equipment. In other words, the managers are directed into the worst practices of management. Risk and timing factors are also ignored by this objective. The streams of benefits may possess different degrees of certainty and uncertainty. Two firms may have same total expected earnings, but if the earnings of one firm fluctuate considerably as compared to the other, it will be more risky. Also, it does not make a difference between returns received in different time periods i.e., it gives no consideration to the time value of money and value benefits received today and benefits after six months or one year. For the reasons given above the profit maximisation objective cannot be taken as the objective of financial management. (b) Wealth Maximisation : The maximisation of wealth is a more viable objective of financial management. The same objective, if expressed in other terms, would convey the idea of net present worth maximisation. Any financial action which creates wealth or which has a net present worth is a desirable one and should be undertaken. Wealth of the firm is reflected in the maximisation o f the present value of the firm i.e., the present worth of the firm. This value may be readily measured if the company has shares that are held by the public, because the market price of the share is indicative of the value of the company. And to a shareholder, the term wealth is reflected in the amount of his current dividends and the market price of share. Ezra Solomon has defined wealth maximisation objective in the following manner: The gross present worth of a course of action is equal to the capitalised value of the flow of future expected benefits, discounted (or capitalised)at a rate which reflects the certainty or uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits. From the above clarification, one thing is certain that the wealth maximisation is a long-term strategy that emphasises raising the present value of the owners investment in a company and the implementation of projects that will increase the market value of the firms securities. This criterion, if applied, meets the objections raised against earlier criterion of profit maximisation. The financial manager also deals with the problem of uncertainty by taking into account the trade-off between the various returns and associated levels of risks. It also takes

into account the payment of dividends to shareholders. All these ingredients of the wealth maximisation objective are the result of the investment, financing and dividend decisions of the firm. SCOPE OF FINANCE FUNCTION The question of scope of finance function' determines the-decisions or functions to be carried out by the financial manager in pursuit of achieving the objective of wealth maximisation. The various functions of the financial manager relate to the estimation of financial requirements, investment of funds in long-term and shortterm assets, determining the appropriate capital structure, identification of the various sources of finance, decision regarding retention of earnings and distribution of dividend, and administering proper financial controls. In the following discussion, these decisions have been categorised into two broad grouping. (1) Long-term financial decisions : (i) investment decision (capital allocation for fixed and current assets), (ii) financing decision (capital sourcing), and (iii) dividend decision (2) Short-term financial decisions : (Working capital management): (i) cash, (ii) investments(marketable securities), (iii) receivables, and (iv) inventory. A brief description of these financial decisions is given below. 1. Long-Term Financial Decisions : The long term financial decisions pursued by the financial manager have significant long term effects on the value of the firm. The results of these decisions are not confined to a few months but extend over several years and these decisions are mostly irreversible. It is, therefore, necessary that before committing the scarce resources of the firm a careful exercise is done with regard to the likely costs and benefits of the various decisions. Investment Decision: Investment decision (also known as Capital-budgeting decision) is concerned with the allocation of given amount of capital to fixed assets of the business. The important characteristic of fixed assets is that their benefits are realised in the future(generally after one year). Thus, capital-budgeting decision adds to the total fixed assets of the concern by selecting and investing in new irrvestments.lt must be properly understood at this stage that because the future benefits are not known with certainty, investment proposals necessarily involve risk. Consequently, they must be evaluated in relation to their expected income and risk they add to the function as a whole. Obviously, the management will select investments adding something to the value of the firm. The criteria of judging the

profitability of projects is the difference between the cost of the investment proposals and its expected earnings. The important methods employed to judge the profitability of the investment proposals and its expected earnings. The important methods employed to judge the profitability of the investment proposals are: (a)Payback method, (b) Average rate of return method, (c) Internal-rate of return method, and (d) Net present value method. A careful employment of these methods helps in determining the contribution of investment projects to owners wealth. Financing Decision : Financing decision(also known as Capital Structure decision) is intimately tied with the investment decision. To undertake investment decision the firm needs proper finance. The solution to the question of raising finance is solved by financing decision. There are number of sources from which funds can be raised. The most important sources of financing are equity capital and debt capital. The central tasks before the financial manager is to determine the proportion of equity capital and debt capital. He must endeavour to obtain that financing mix or optimal capital structure for the firm where overall cost of capital is the minimum or the value of the firm is maximum. In taking this decision, the financial manager must bear in -mind the likely effects on shareholders and the firm. The use of debt capital, for instance, affects the return and risk of the shareholders. The return on equity will not only increase, but also the risk. A proper balance will have to be struck between return and risk. When the shareholders return is maximised with minimum risk, the market value per share will be maximised and firms capital structure would be optimum. Once the financial manager is able to determine the best combination of debt and equity, he must raise this appropriate amount through best available sources.

Fig. 1.1 Decisions, Return, Risk, and Market Value Dividend Decision : The next crucial financial decision is the dividend decision. This decision is the basis of dividends payment policy, reserves policy,

etc. The dividends are generally paid as some percentage of earnings on the paidup capital. However, the policy pursued by management concerning dividends payment is generally stable in character. Stable dividends policy implies the payment of same earnings percentage with only small variations depending upon the pattern of earnings. The stable dividends policy among other things, increases the market value of the share. The amount of undistributed profits is called retained earnings. In other words, dividends payout ratio determines the amount of earnings retained in the firm.The amount of earnings or profit to be kept undistributed with the firm must be evaluated in the light of the objective of maximising shareholders wealth. (2) Short-Term Financial Decisions: The job of the financial manager is not just limited to the long-term financial decisions, but also extends to the short-term financial decisions aiming at safeguarding the firm against illiquidity or insolvency. Surveys indicate that the largest portion of a financial managers time is devoted to the day to day internal operations of the firm; this may be appropriately subsumed under the heading Working Capital management. Working capital management requires the understanding and proper appreciation of its two concepts-grow and net working capital. Gross working capital refers to the firms investment in current assets such as cash, short-term securities, debtors, bills receivable and inventories. Current assets have the distinctive characteristics of being convertible into cash within an accounting year. Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include trade creditors, bills payable, bank overdraft and outstanding expenses. For the financial manager both these concepts of gross and net working capital are relevant. Investment in current assets affects firms profitability, liquidity and solvency. In order to ensure the neither insufficient nor unnecessary funds are invested in current assets, the financial manager should develop sound techniques of managing current assets. He should estimate firms working capital needs and make sure that funds -would be made available when needed. The cost of capital acts as the core in the framework for financial management decision making. In has a two-way effect on the investment, financing and dividend decisions. It influences and is in turn influenced by them. The cost of capital leads to the acceptance or rejection of projects, as it is the cut-off criterion in investment decisions. In turn, the profitability of projects raises or lowers the cost of capital. The financing decisions affect the cost of capital because it is the weighted average of the cost of different sources of capital. The need to raise or lower the cost of capital, in turn, influences the financing decisions. The dividend decisions try to meet the expectations of the investors raise or lower the cost of capital. The following figure explains the components of finance functions and their interrelation.

Financial Controls: The long-term and short-term decisions, together, determine the value of the firm to its shareholders. In order to maximise this value, the firm should strive for optimal combination of these decisions. In an endeavour to make optimal decisions, the financial manager makes use of certain tools in the analysis, planning and control activities of the firm.

Organisation for Finance Function: Almost anything in the financial realm falls within such a committees realm, including questions of financing, budgets, expenditures, dividend policy, and future planning. Such is the power of financial committee that in most cases their recommendations are approved as a matter of course by the full board of directors. On the operational level, the financial management team may be headed up by a financial Vice-President. This is a recent development, the financial VicePresident answers directly to the president. Serving under him are a treasurer and a controller. An illustrative organisation chart of finance function of management in a large organisation is given below:

The above chart shows that the Vice-President (Finance) exercises his function through his two deputies known as : 1. Controller - concerned with internal matters, 2. Treasurer - basically handles external financial matters.

The controller is concerned with the management and control of the firms assets. His duties include providing information for formulating the accounting and financial policies, preparation of financial reports, direction of internal auditing, budgeting, inventory control, taxes, etc. While the treasurer is mainly concerned with management of the firms funds, his duties include the following : Forecasting the financial needs; administering the flow of cash; managing credit; floating securities; maintaining relations with financial institutions and protecting funds and securities. A brief description of the functions of the Controller and the Treasurer, as given by the Controllers Institute of America, is given below. Functions of Controller 1. Planning and Control: To establish, coordinate and administer, as part of management, a plan for the control of operations. This plan would provide to the extent required in the business, profit planning, programmes for capital investing and for financing, sales forecasts and expense budgets. 2. Reporting and Interpreting : To compare actual performance with operating plans and standards, and to report and interpret the results of operations to all levels of management and to the owners of business. To consult with the management about the financial implications of its actions. 3. Tax Administration :

To establish and administer tax policies and procedures. 4. Government Reporting : To supervise or co-ordinate the preparation of report to government agencies. 5. Protection of Assets : To ensure protection of business assets through internal control, internal auditing and assuring proper insurance coverage. 6. Economic Appraisal : To appraise economic and social forces and government influences and interpret their effect upon business. Functions of Treasurer 1. Provision of Finance : To establish and execute programmes for tl: provision of the finance required by the business, including negotiating its procurement and maintaining the required financial arrangements. 2. Investor Relations : To establish and maintain adequate market for the companys securities and to maintain adequate contact with the investment community. 3. Short-term Financing : To maintain adequate sources for the companys current borrowings from the money market. 4. Banking and Custody: To maintain banking arrangements, to receive, have custody of and disburse the companys moneys and securities and to be responsible for the financial assets of real estate transactions. 5. Credit and Collections : To direct the granting of credit and the collection of accounts receivables of the company. 6. Investments :

To invest the companys funds as required and to establish and coordinate policies for investment in pension and other similar trusts. 7. Insurance : To provide insurance coverage as may be required. Another way of looking at these functions is this : The controller function generally concentrates on the asset side* of the balance sheet, while the treasurer function concentrates on the claims side i.e., identifying the best sources of finance to utilise in the business and timing the acquisition of funds. Controllers and Treasurers Functions in the Indian Context The terms controller and treasurer are essentially used in U.S.A. However, this pattern is not popular in India. Some companies do use the term Controller for the official who performs the functions of the chief accountant or the management accountant. However, in most cases, in case of Indian companies, the term General Manager (Finance) or Chief Finance Manager is more popular. Some of the functions of the Controller and the Treasurer such as government reporting, insurance coverage, etc., are taken care of by the Secretary of the company. The function of the treasurer of maintaining relations with its investors is also not much relevant in the Indian context since by and large Indian investors/shareholders are indifferent towards attending the general meetings. The finance manager in Indian companies is mainly concerned with the management of the firms financial resources. His duties are not compounded with other duties generally in large companies. It is a healthy sign since the management of finances is an important business activity requiring extraordinary skill and attention. He has to ensure that the scarce financial resources are put to the optimum use keeping in view various constraints. It is, therefore, necessary that the finance manager devotes his full time attention and energies only in raising and utilising the financial resources of the firm. Routine Duties of Financial Manager Apart from the three broad functions of financial management mentioned above, the financial manager has to perform certain routine or recurring functions. These are stated below: (i) Keeping track of actual and projected cash outflows and making adequate provision in time for any shortfall that may arise. (ii) Managing of cash centrally and supplying the needs of various divisions and departments without keeping idle cash at many points. (iii) Negotiations and relations with banks and other financial institutions, (iv) Investment of funds available and free for a short period. (v) Keeping track of stock exchange prices in general and prices of the companys

shares in particular. (vi) Maintenance of liaison with production and sales departments for seeing that working capital position is not upset because of inventories, book debts, etc. (vii) Keeping management informed of the financial implication of various developments in and around the company . Non-Routine Duties : The non-recurring duties of the financial executive may . involve preparation of financial plan at the time of company promotion, expansion diversification, readjustments in times of liquidity crisis, valuation of the enterprise at the time of acquisition and merger thereof, etc. Today s financial manager has to deal with a variety of developments that affect the firms liquidity and profitability, including : (a) High financial cost identified with risk-bearing investments in a capitalintensive environment; (b) Diversification by firms in to differing businesses, markets, and product lines; (c) High rates of inflation that significantly affect planning and forecasting the firms operations; (d) Emphasis on growth, with its requirements for new sources of funds and improved uses of existing funds; (e) High rates of change in technology, with an accompanying need for expenditures on research and development; (f) Speedy dissemination of information, employing high speed computers and nationwide and worldwide networks for transmitting financial and operating data. Social Responsibility of Financial Manager Another point that deserves consideration is social responsibility : should businesses operate strictly in the stockholders best interest, or are firms also partly responsible for the welfare of society at large? In tackling this question, consider first the firms whose rates of return on investment are close to normal, that is, close to the average for all firms. If such companies attempt to be socially responsible, thereby increasing their costs over what they otherwise would have been, and if the other business in the industry do not follow suit, then the socially oriented firms will probably be forced to abandon their efforts. Thus , any socially responsible acts that raise costs will be difficult, if not impossible, in industries subject to keen competition. What about firms with profits above normal levels - can they not devote resources to social projects? Undoubtedly they can many large, successful firms do engage in community projects, employee benefit programmes, and the like to a greater degree than would appear to be called for by pure profit or wealth maximisation. Still, publicly owned firms are constrained in such actions by capital market factors. Suppose a saver who has funds to

invest is considering two alternative firms. One firm devotes a substantial part of its resources to social actions, while the other concentrates on profits and stock prices. Most investors are likely to shun the socially oriented firm, which will put it to a disadvantage in the capital market. After all, why should the stockholders of one corporation subsidise society to a greater extent than stockholders of other businesses? Thus, even highly profitable firms (unless they are closely held rather than publicly owned) are generally constrained against taking unilateral cost increasing social action. Does all this mean that firms should not exercise social responsibility? Not at all it simply means that most cost-increasing actions may have to be put on a mandatory rather than a voluntary basis, at least initially, to insure that the burden of such action falls uniformly across all businesses. Thus, fair hiring practices, minority training programmes, product safety, pollution abatement, antitrust actions, and are more likely to be effective if realistic rules are established initially and enforced by government agencies. It is critical that industry and government cooperate in establishing the rules of corporate behavior and that firms follow the spirit as well as the letter of the law in their actions. Thus, the rules of the game become constraints, and firms should strive to maximise stock prices subject to these constraints. REVIEW QUESTIONS 1. Finance is the oil of wheel, marrow of bones and spirit of trade, commerce and industry-Elucidate. 2. Discuss the role and significance of financial management in the functional areas of modern management. 3. Some of the early concerns of financial management are related to preservation of capital, maintenance of liquidity and reorganisation. Do you think these topics are still important in our current unpredictable economic environment? 4. Who discharges the finance function and what are his specific responsibilities? 5. Contrast profit maximisation and value maximisation as criteria for financial management decisions in practice. 6. Why is it inappropriate to seek profit maximisation as the goals of financial decision making? How do you justify the adoption of present value maximisation as an apt substitute for it? 7. The operative objective of financial management is to maximise wealth or net present worth-Ezra Solomon. Explain the statement and explain the finance function performed by a Finance Manager to achieve this goal. 8. Explain the scope of finance function and suggest an organisational structure

that you consider suitable for an effective financial control of a large manufacturing concern. 9. Discuss the respective roles of Treasurer and Controller in the financial setup of a large corporation. Out of these two finance officers who is more important in the modern contest and why? 10. As a Financial Manager of a company, how would you reconcile between financial goals and social objectives of the concern? SUGGESTED READINGS 1. Chandra, Prasanna : Fundamentals of Financial Management, New Delhi, Tata McGraw Hill Co. 2. Hampton, J.J. : Financial Decision Making, New Delhi, Prentice Hall of India. 3. Pandey, I.M. : Financial Management, New Delhi, Vikas Publishing House. 4. Van Home, James C : Financial Management and Policy, New Delhi, Prentice Hall of India. LESSON - 2 WORKING CAPITAL MANAGEMENT Learning Objectives After reading this lesson you should be able to: Understand the concept of working capital Classify the different types of working capital Recognise the element of working capital Assess the requirements of working capital Identify the strength and weakness of inadequate or excess working capital. Lesson Outline Concept of Working Capital Classification of Working Capital Elements of Working Capital Assessment of Working Capital Requirements Problems of Inadequacy of Working Capital Reasons for inadequacy of Working Capital Excessive Working Capital Principles of Working Capital

Proper management of working capital is very important for the success of an enterprise. It aims at protecting the purchasing power of assets and maximising the return on investment. Constant management is required to maintain appropriate levels in the various working capital components. Sales expansion, dividend declaration, plant expansion, new product line, increased salaries and wages, rising price levels etc.,put added strain on working capital maintenance. Failure of business is undoubtedly due to poor management and absence of a management skill. Shortage of working capital, so often advanced as the main cause for failure of concerns, is nothing but the clearest evidence of mismanagement which is so common.
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It has been found that the major portion of a financial managers time is utilised in the management of working capital. Current assets account for a very large portion of the total investment of a firm. In some of the industrial current assets on an average represent over three-fifth of the total assets. In the case of trading concerns they account for about 80 per cent. A firm may, sometimes, be able to reduce the investment in fixed assets by renting or leasing plant and machinery. But it cannot avoid investment in cash, accounts receivable and inventory. The management of working capital also helps the management in evaluating various existing or proposed financial constraints and financial offerings. All these factors clearly indicate the importance of working capital management in a firm. Concepts of Working Capital There are two concepts regarding the meaning of Working Capital. Net working Capital and Gross Working Capital. According to one School of thought (supported by distinguished authorities like Lincoln, Doris, Stevens and Saliers) Working Capital is the excess of current assets over current liabilities, as designated in the following equation: Working Capital = Current Assets Current Liabilities According to the other School of thought (supported by authorities like Mead Baker, Mallot and Field), Working Capital represents only the current (capital) assets. There is basis for both these contentions. To understand them, correct conception of current assets and liabilities is essential. Current Assets are those assets that in the ordinary course of business can be or will be turned into cash within a brief period -(not exceeding one year, normally) without undergoing diminution of value and without disrupting the organisation. Examples of current assets are given below: (i)Cash in hand and in bank; (ii) Accounts receivable from customers (less reserve); (iii) Promissory Notes and Bills receivable from customers (less reserve); (iv)Inventories comprising of raw materials, work-inprogress, finished goods (of manufactures) (v) Marketable securities held as temporary investment; (vi) Prepaid expenses; (vii) Maintenance materials; (viii) Accrued income.

Current Liabilities are those liabilities intended at their inception to be paid in ordinary course of business within a reasonable short time (normally within a year)out of the current assets or by creating another current liability or the income of the business. Its examples : (i) Accounts payable to creditors; (ii) Notes or Bills payable; (iii) Accrued expenses, such as accrued taxes, salaries and interest; (iv) Bank over draft, cash credit; (v) Bonds to be paid within one year; (vi) Dividends declared and payable. The arguments of the first school of thought in regarding working capital as the excess of current assets over current liabilities are as follows: (1) It is an established definition of working capital which is in use since long; (2) This concept of working capital enables the shareholders to judge the financial soundness of the concern and the extent of protection afforded to them. It is particularly because with an increase in short-term borrowings the working capital does not increase; it will increase only by following the policy of ploughing back of profits or conversion of fixed assets into liquid assets or by procuring fresh capital from shareholders; (3) Any concern with an excess of current liabilities can successfully tide over periods of emergency, e.g., depression; (4) Further, there is no obligation on the part of the company to return the amount invested by the shareholders; (5) Such a definition is of great use in ascertaining the true financial position of companies having current assets of similar amount. Those who regard working capital and current assets as synonymous advance the following arguments in support of their contention: (1) Earnings in each enterprise are the outcome of both fixed as well as current assets. Individually these assets have no significance. The points of similarity in these assets are that both are borrowed and they yield profit much more than the interest cost. But the distinction in the two lies in the fact that fixed assets constitute the fixed capital of a company, whereas current assets are of a circulating nature. Hence, logic demands that current assets should be considered as the working capital of the company; (2) This definition takes into consideration the fact that there would be an automatic increase in the working capital with every increase in the funds of the company; but it is not so according to the net concept of working capital; (3) Every management is interested in the total current assets out of which the operation of an enterprise is made possible, rather than in the sources from where the capital is procured; (4) The former concept of working capital may hold good only in the case of sole trader or partnership organisation; but under the modern age of company organisation, where mere is divorce between ownership, management and control, the ownership of current or fixed assets is of little significance. Classification of Working Capital Generally speaking, the amount of funds required for operating needs varies from time to time in every business. But a certain amount of assets in the form of working capital are always required, if a business has to carry out its functions

efficiently and without a break. These two types of requirements permanent and variable are the basis for a convenient classification of working capital:

1. Permanent or Fixed Working Capital: As is apparent from the adjective permanent it is that part of the capital which is permanently locked up in the circulation of current assets and in keeping it moving. For example, every manufacturing concern has to maintain stock of raw materials, works-in-progress (work-in-process), finished products, loose tools and spare parts. It also requires money for the payment of wages and salaries throughout the year. The permanent or fixed working capital can again be subdivided into(i)Regular Working Capital and (ii)Reserve Margin or Cushion Working Capital. It is the minimum amount of liquid capital needed to keep up the circulation of the capital from cash to inventories to receivables and back again to cash. -This would include a sufficient cash balance in the bank to discount all bills, maintain an adequate supply of raw materials for processing, carry a sufficient stock of finished goods to give prompt delivery and effect the lowest manufacturing costs, and enough cash to carry the necessary accounts receivables for the type of business engaged in. Reserve margin or cushion working capital is the excess over the need for regular working capital that should be provided for contingencies that arise at unstated periods. The contingencies included (a) raising prices, which may make it necessary to have more money to carry inventories and receivables, or may make it advisable to increase inventories; (b)business depressions, which may raise the amount of cash required to ride out of usually stagnant periods; (c)strikes, fires and unexpectedly severe competition, which use up extra supplies of cash; and (d)special operations, such as experiments with new products, or with new method of distribution, war contracts, contractors to supply new businesses, and the like, which can be undertaken only if sufficient funds are available, and which in many cases mean the survival of a business. 2.Variable Working Capital: The variable working capital changes with the volume of business. It may be subdivided into (i)Seasonal and (ii)Special Working Capital. In many lines of

business(e.g.,Gur or sugar and Fur industry operations are highly seasonal and, as a result, working capital requirements vary greatly during the year. The capital required to meet the seasonal needs of industry is termed as Seasonal Working Capital. On the other hand, Special Working Capital is that part of the variable working capital which is required for financing special operations, such as the inauguration of extensive marketing campaigns, experiments with new products or with new methods of distribution, carrying put of special jobs and similar to the operations that are outside the usual business of buying, fabricating and selling. This distinction between permanent and variable working capital is of great significance particularly in arranging the finance for an enterprise. Regular or fixed working capital should be raised in the same way as fixed capital is procured, through a permanent investment of the owner or through long-term borrowing. As business expands, this regular capital will necessarily expand. If the cash returning from sales includes a large enough profit to take care of expanding operations and growing inventories, the necessary additional working capital may be provided by the earned surplus of the business. Variable needs can, however, be financed out of short-term borrowings from the Bank or from public in the form of deposits. The position with regard to the fixed working capital and variable working capital ' can be shown with the help of the following figures: Fig. 2.1 Steady Firms working capital

requirement From the above figure it should not be presumed that permanent working capital shall remain fixed throughout the life of the concern. As the size of the business grows, permanent working capital too is bound to grow. The position can be depicted with the help of the following figure:

So unlike a static concern, the fixed working capital of a growing concern will increase with the growth in its size. Elements of Working Capital (i) Cash : Management of cash is very important from firms point of view. There must be balance between the twin objectives of liquidity and cost while managing cash.There must be adequate cash to meet the requirements of all segments of the organisation. Excess cash may be costly for the concern as it will increase the cost in terms of interest. Less cash may also be harmful to the concern as it will not be able to meet the liabilities as the appropriate time. Thus the requirements of the cash must be estimated properly either by preparing cash flow statements or cash budgets. This will help the management to invest the idle funds remuneratively and shortages, if any, may be met timely by making different arrangements. Therefore, it is necessary that every segment of the organisation must have adequate cash in order to meet the requirements of that segment without having surplus balances. Cash management is highly centralised whereby cash inflows and outflows are centrally controlled but in multi-divisional companies it may be possible to decentralise cash requirements so that every company may have cash for its requirements. (ii) Marketable(Temporary)Investments: Firms hold temporary investments for surplus cash flows arising either during seasonal operations or out of sale of long term securities. In most cases the securities are held primarily for precautionary purposesmost firms prefer to rely on bank credit to meet temporary transactions or speculative needs, but to hold some liquid assets to guard against a possible shortage of bank credit. The cash forecast may indicate whether excess cash available is temporary or not. If it is found that excess liquidity will be temporary, the cash should then be invested in marketable but temporary investments. It should be remembered that even if a substantial part of idle cash is invested even though for a short period, the interest earned thereon is significant. (iii) Receivables: Management of receivables involves a trade off between the gains due to additional sales on account of liberal credit facilities and additional cost of

recovering those debts. If liberal credit facilities are given to the customers, sales will definitely increase. But on the other hand bad debts, collection expenses and interest charge will increase. Similarly if the credit policy is strict, the sales will be less and customers may go to the competitors where liberal credit facilities are available. This will result in loss of profit because of less sales but there will be saving because of less bad debts, collection and interest charges. Management of debtors also covers analysis of the risks associated with advancing credit to a particular customer. Follow up of debtors and credit collection are the remaining aspects of receivables management. (iv) Inventories : Inventories include all investments in raw materials, workin-progress, stores, spare parts and finished goods; they constitute an important part of the current assets. The purchase of inventory involves investment which must be properly controlled. There are many issues of inventory management which must be taken into consideration as fixation of minimum and maximum level, deciding the issue of pricing policy, setting up the procedures for receipts and inspection, determining the economic ordering quantity, providing proper storage facilities, keeping control on obsolescence and setting up an effective information system with reference to inventories. Inventory management requires the attention of stores manager, production manager and financial manager. There must be adequate inventories in order to avoid the disadvantages of both inadequate and excessive inventories. (v) Creditors: Management of creditorsis very important aspect of working capital. If the payment of creditors is delayed there is a possibility of saving of some interest but it can be very costly because it will spoil the goodwill of the concern in the market, As far as possible, the credit manager should try to get the liberal credit terms so that payment may be made at the stipulated time. Assessment of Working Capital Requirements The following factors are considered for a proper assessment of the quantum of working capital requirements: (i) The Production Cycle: There is bound to be time span in raw materials input in manufacturing process and the resultant output as finished product. To sustain such production activities the requirement of investment in the form of working capital is obvious. The lesser the production cycle (or the operating cycle) the lesser will be the requirements of working capital. There are enterprises due to their nature of business will have shorter cycle than others. Further, even within the same group of industries, the more the application of technological advances in, will result in shortening the operating cycle. In this context the choice of product requiring shorter or greater operating cycle will have a direct impact on the working capital requirements. This is a factor of paramount importance irrespective of whether a new industry is venturing production of the first time or an on-going business. Hence it can be said that the time span for each stage of the process of

manufacture if geared to improve upon will lead to better efficiency and utilisation of working capital. (ii) Work-in-Process : A close attention is to be given to the accumulation of work-in-progress or workin-process. Unless the sequences of production process leading to conversion into finished product is kept under close observation to achieve better production and productivity, more and more working capital funds will be tied up. In this context, proper production planning and control is vital. (iii) Terms of Credit from Suppliers of Materials and Services: The more the terms of credit is favourable i.e., the more the time allowed by the creditors to pay them, the lesser will be the requirement of working capital. Hence, the negotiation with the suppliers in respect of price and the credit period is an important aspect in working capital management. In this process the impact of the requirement of finance is shared by the creditors for goods and services. (iv) Realisation from Sundry Debtors : The lesser the time span between selling the product and the realisation the more will be the quicker inflow of cash. This, in turn, will reduce the finance required for working capital purposes. A realistic credit control will reduce locking up of finance in the form of sundry debtors. The impact of better realisation will not only help in reducing the working capital fund requirement but also can boost up the finance needed for other operational needs. The important factors in credit control will be: (a) Volume of credit sales desired; (b) terms of sales and (c) collection policy (v) Control on Inventories: The decision to maintain appropriate minimum inventories either in the form of raw material, stores materials, work-in-process or finished products is an important factor in controlling finance locked up. The better the control on inventories the lesser will be the requirements of working capital. The. following vital factors involved in inventory management are to be considered for an effective inventory control: (a)volume of sales, (b) seasonal variation in sales, (c)selling off the shelf, (d) stocking to gain from higher price under inflationary conditions, (e) the operating cycle, i.e., the time interval between manufacturing, selling and realisation, and (f) safety or buffer stock. A minimum policy levels of stock may have to be maintained to seize the opportunity of selling when there is spark in demand for the product. (vi) Liquidity versus Profitability : The management dilemma as to the optimal balancing between liquidity (or solvency) and the profitability is another factor of great importance on the determination of the level of working capital requirement. In other words, the level of liquidity and the profitability to be maintained according to the goals of financial management.

(vii) Competitive Conditions : The whole question of cash inflow depends as to the quickness in selling the products and the realisation thereof. In this context, the nature of business and the product will be the two important contributory factor as to the policy on the quantum of working capital requirements. (viii) Inflation and the Price Level Changes : In an inflationary trend, the impact on working capital is that more finance is needed for the same volume of activity i.e., one has to pay more price for the purchase of same quantity of materials or services to be obtained; Such raising impact of prices can be fully or partly compensated by increasing the selling price of the product. All business may not be in a position to do so due to their nature of product, competitive market or Governments regulatory price. (ix) Seasonal Fluctuation and Market Share of Product: There are products which are mostly in demand in certain periods of the year. In other words, there may not be any sale or only a fraction of the total sale in offseason due to seasonal nature of demand for the product. There may be shifting of demand due to better substitute of the product available. This means the company affected by this economics, attempts to plan diversification to sustain profit, expansion and growth of the business. In certain businesses, demands for products are of seasonal in nature and for certain businesses, the raw materials buying have to be done during certain seasonal timings. Naturally the working capital requirement will be more ill certain periods than in others.

(x) Management Policy, on Profits, Retained Profit, Tax Planning and Dividend Policy: The adequacy of profit will lead to strengthen the financial position of the business through cash generation which will be ploughed back as internal source of financing. Tax planning is an integral part of working capital planning. It is not only the question of quantum of cash availability for tax payment at the appropriate time but also through tax planning the impact of tax payable can be reduced. Dividend Policy considers the percentage of dividend to be paid to the shareholders as interim and/or final dividend. There must be cash available at the appropriate time after the dividend is declared. This way he dividend payment is connected with working capital management. (xi) Terms of Agreement: It refers to the terms and conditions of agreement to repay loans taken from bankers and financial institutions and acceptance of fixed deposits from public. The question of fund arrangement whether for working capital needs or to long term loans is to be decided after taking into account the repaymt.it ability. The cash flow projection will have to be made accordingly.

(xii) Cash (Flow) Budget: In order to meet certain cash contingencies it may be necessary to have liquidity in form of marketable securities as cash reservoir. This extra cash reserve may remain as an idle fund. This type of cash reserve is necessary to meet emergency disbursements. (xiii) Overall Financial and Operational Efficiency : A professionally managed company always applies appropriate tools and techniques to achieve efficiency and utilisation of working capital fund. Adequacy of assessment and control of business will lead to improve the working capital turnover. Management also will have-to keep itself abreast of the environmental, technological and other changes affecting the business so that an effective and efficient financial management can play a vital role in reducing the problems of working capital management. (xiv) Urgency of Cash : In order to avoid product becoming obsolete or to undercut the competitors to hold the market share or in case of emergency for cash funds, it may be necessary to sell out products at a cheaper rate or at a discount or allowing cash rebate for early realisation from sundry debtors (customers). This situation may boost up the cash availability. However, this sort of critical situation should be avoided as this results in reducing profit. (xv) Importance of Labour Mechanisation : Capital intensive industries, i.e.,mechanised and automated industries, will require lower working capital, while labour intensive industries such as small scale and cottage industries will require larger working capital. (xvi) Proportion of Raw Material to Total Costs : If the raw materials are costly, the firm may require larger working capital while if raw materials are cheaper and constitute a small part of the total cost of production, lower working capital is required. (xvii) Seasonal variation: During the busy season, a business requires larger working capital while during the slack season a company requires lower working capital. In sugar industry the season is November to June, while in the woollen industry the season is during the winter. Usually the seasonal or variable needs of working capital are financed by temporary borrowing. (xviii) Banking Connections: If the corporation has good banking connections and bank credit facilities, it may have minimum margin of regular working capital over current liabilities. But in the absence of the availability of bank finance, it should have relatively larger among of net working capital.

(xix) Growth and Expansion : For normal rate of expansion in the volume of business, one may have greater proportion of retained profits to provide for more working capital; but fast growing concerns require larger amount of working capital. A plan of working capital should be formulated with an eye to the future as well as present needs of a corporation. Problem of Inadequacy of Working Capital In case of inadequacy of working capital, a business may have to face the following problems: (i) Production Facilities: It may not be possible to have the full utilisation of the production facilities to the optimum level due to the inability of buying sufficient raw material and/or major renovation of the plant and machinery. (ii) Raw Material Purchases : Advantage of buying at cash discount or on favourable terms may not be possible due to paucity of funds.. (iii) Credit Rating : When financial .crisis continues.the credit worthiness of the company may be lost, resulting in poor credit rating. (iv) Seizing Business Opportunities : In case of boom for the products and for the business, the company may not be in a position to produce more to earn opportunity profit' as there may be inadequacy of finished products availability. (v) Proper Maintenance of Plant and Machinery : If the business is on financial crisis, adequate sums may not be available for regular repair and maintenance, renovation or modernisation of plant to boost up production and to reduce per unit cost. (vi) Dividend Policy: In the absence of fund availability it may not be possible to maintain a steady dividend policy. Under such financial constraint, whatever surplus is available will be kept in general reserve account to strengthen the financial soundness of the business. (vii) Reduced Selling :

Due to the constraint in working capital, the company may not be in a position to increase credit sales to boost up the sales revenue. (viii) Loan Arrangement : Due to the emergency for working capital the company may have to pay higher rate of interest for arranging either short-term or long-term loans. (ix) Liquidity versus Profitability : The lower liquidity position may also result in lower profitability. (x) Liquidation of the Business : If the liquidity position continues to remain weak the business may run into liquidation. To remedy the situation of working capital crisis, the following steps are required: (a) An appraisal and review is to be conducted to minimise the operating cycle. (b) Adequate credit control measures are to be adopted for early and prompt realisation form the debtors. (c) Proper planning and control of cash management through cash flow forecasting. (d) Whether more credit periods can be obtained for buying is to be explored. Reasons for Inadequacy of Working Capital Inadequacy or shortage of working capital may arise for various reasons, of which, the main reasons are the following: (i) Operating losses : This may arise when the cost of production and other related costs are more than the sales revenue, reduction in sales, falling prices, increased depreciation,etc. It is obvious that a company facing losses will not have any cash generation' to sustain its on-going business. (ii) Extraordinary Losses: There may be exceptional losses due to fall in price of finished product stocks, government action, obsolescence or otherwise. The effect of such a loss will be a reduction in current assets or increase in current liabilities without any corresponding favourable change in the working capital composition. (iii) Expansion of Business : The company during the profitable years might have invested substantially in fixed capital assets, increased production and increased credit sales to make the sales volume grow rapidly. Against those activities, the pitfalls of over-trading may show its ugly- face subsequently. That is why a balancing judgment between investment, liquidity and profitability is to be drawn and projected to save the business falling into financial crisis. Thus the continuity and growth of the business may be jeopardised. Along with the increased sales there may be increase in inventories and higher sundry debtors. Such excessive build-up of

inventories an| receivables may amount to alarming figures. (iv) Payment of Dividend and Interest : The payment of interest from borrowings will have to be made as per terms of agreement. Similarly, the payment of dividend may have to be arranged to keep up the business prestige to the public and to the shareholders. There may be profit to declare dividend but there may not be adequate cash to disburse dividend. In case of insufficient funds to meet the aforesaid liabilities, the mobilising of funds will be necessary. Excessive Working Capital The following are the major disadvantages of having or holding excessive working capital. (i) Overtrading: A time may come when overtrading will engulf the financial soundness of the business. (ii) Excessive Inventories : The inventories holding may become excessive under the influence of excessive funds availability. (iii) Liquidity versus Profitability : The situation of liquidity and the profitability may be imbalanced. (iv) Inefficient Operation: Availability of excessive production facilities may result in higher production but sales may not be anticipated to match goods produced. (v) Lower Return on Capital Employed : There may be reduced profit in relation to total capital employed resulting in lower rate of return on capital employed. (vi) Increased Fixed Capital Expenditure: As enough fund is available there may be boost-up in acquiring plant and machinery to enhance production facilities. In case there is not enough sales potentiality with adequate margin of profit such fixed investment may not be worthwhile for fund employment. Principles of Working Capital Management 1. Principle of Risk Variation : If working capital is varied relative to sales, the amount of risk that a firm assumes is also varied and the opportunity for gain or loss is increased. This principle implies that a definite relation exists between the degree of risk that

management assumes and the rate of return. That is, the more risk that a firm assumes, the greater is the opportunity for gain or loss. It should be noted that while the gain resulting from each decrease in working capital is measurable, the losses that may occur cannot be measured. It is believed that while the potential loss, the exactly opposite occurs if management continues to decrease working capital that is to say, potential losses are small at first for each decrease in working capital but increase sharply if it continues to be reduced. It should be the goal of management to find that point of level of Working Capital at which the incremental loss associated with a decrease in Working Capital investment becomes greater than the incremental gain associated with that investment. Since most of the managers do not know what the future holds, they tend to maintain an investment in working capital that exceeds the ideal level. It is this excess that concerns since the size of the investment determines firms rate of return on investment. The obvious conclusion is that managers should determine whether they operate in business that react favourably to changes in working capital levels, if not, the gains realised may not be adequate in comparison to the risk that must be assumed when working capital investment is decreased. 2. Principle of Equity Position : Capital should be invested in each components of working capital as long as the equity position of the firm increases. It follows from the above that the management is faced with the problem of determining the ideal level of working capital. The concept that each rupee invested in fixed or variable working capital should contribute to the net worth of the firm should serve as a basis for such a principle. 3. Principle of Cost of Capital: The type of capital used to finance working capital directly affects the amount of risk that a firm assumes as well as the opportunity for gain or loss and cost of capital. Whereas the first principle dealt with the risk associated with the the amount of working capital employed in relation to sales, the third principle is concerned with the risk resulting from the type of capital used to finance current assets. It has been observed that return to equity capital increases directly with the amount of risk assumed by management. This is true but only to a certain point. When excessive risk is assumed, a firms opportunity for loss will eventually over shadow its opportunity for gain, and at this point return to equity is threatened. When this occurs, the firm stands to suffer losses. Unlike rate of return, cost of capital moves inversely with risk; that is, as additional risk capital is employed by management, cost of capital declines. This relationship prevails until the firms optimum capital structure is achieved; thereafter, the cost of capital increases.

4. Principle of Maturity of Payment: A company should make every effort to relate maturities of payment to its flow of internally generated funds. There should be the least disparity between the maturities of the firms short term debt instrument and its flow of internally generated funds because a greater risk is generated with greater disparity. A margin of safety should, however,be provided for short term debt payments. 5. Principle of Negotiation: The risk is not only associated with the amount of debt used relative to equity, it is also related to the nature of the contracts negotiated by the borrower. Some of the clauses of the contracts such as restrictive clauses and dates of maturity directly affect a firms operation. Lenders of short term funds are particularly conscious of this problem and they ask for cash flow statements. Lenders realize that a firms ability to repay short term loan directly related to cash flow and not to earnings and, therefore,a firm should make every effort to tie maturities to its flow of internally generated funds. This concept serves as the basis for the final hypothesis of this presentation. Specifically, it may be stated as follows:The greater the disparity between the maturities of firms short term debt instrument and its flow of internally generated funds, the greater the risk and vice-versa. One can see that it is possible for a firm to face insolvency or embarrassment even though it might be making a profit. It is extremely difficult to predict accurately a firms cash flow in an economy such as ours.Therefore,a margin of safety should be included in every short term debt contract; That is, adequate time should be allowed between the time the funds are generated and the date of maturity. Steps Involved in Efficient Management of Working Capital 1. Proper financial set up with appropriate authority and responsibility. 2. Coordination between the following functional areas in the organization: Production planning and control Sales credit control Material management. Optimal utilisation of fixed plant and machinery together with other facilities.

Sale of uneconomical fixed assets Acquiring plant and machinery to augment production. Cost reduction programme 3. Financial planning and control for achieving increased profitability to have adequate cash generation and plough back' of profits so that there is adequate internal source of finance. 4. Proper cash management through projection of cash flow and source and application of funds flow statement. 5. Establishing appropriate Information and Reporting System. REVIEW QUESTIONS 1. Discuss the importance of working capital for a manufacturing concern. 2. Explain the various determinants of working capital of a concern. 3. What are the advantages of having ample working capital funds? 4. Differentiate between fixed working capital and variable working capital. 5. What are the different principles of working capital management? 6. Summarise the causes for and changes in working capital of a firm. SUGGESTED READINGS 1. Agarwal, N.K. : Working Capital Management,New Delhi, Sterling Publications (P) Ltd. 2. Khan, M.Y. and : Financial Management,Jain, P.K. New Delhi, Tata McGraw Hill Co., 3. Ramamoorthy, V.E. : Working Capital Management,Madras, Institute for Financial Management and Research.

LESSON - 3 WORKING CAPITAL FORECASTING TECHNIQUES

Learning Objectives After reading this lesson you should be able to: Know the concept of working capital cycle Identify the working capital gap Explain the working capital forecasting techniques Chapter Outline Per cent-of-sales method Regression analysis method The working capital cycle method Illustrative Examples Working capital requirements can be determined mainly in three ways: Per centof-sales method, Regression analysis method, and The working capital cycle method (1) Per cent-of-Sales Method : It is a traditional and simple method of determining the volume of working capital and its components, sales being a dominant factor. In this method, working capital is determined as a per cent of forecasted sales. It is decided on the basis of past observations. If over the year, relationship between sales and working capital is found to be stable, then this relationship may be taken as a standard for the determination of working capital in future also. This relationship between sales and working capital and its various components may be expressed in three ways: (i)as number of days of sales, (ii)as turnover, and (iii) as percentage of sales. The per cent-of-sales method of determining working capital is simple and easy to understand and is useful in forecasting of working capital requirements, particularly in the short term. However, the greatest drawback of this method is the assumption of linear relationship between sales and working capital. Therefore, this method cannot be recommended for universal application. It may be found suitable by individual companies in specific situations.

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(2) Regression Analysis Method : As stated earlier the regression analysis method is a very useful statistical technique of forecasting. In the sphere of working capital management it helps in making projection after establishing the average relationship in the past years between sales and working capital (current assets)and its various components. The analysis can be carried out through the graphic portrayals (scatter diagrams)or through mathematical formula. The relationship between sales and working capital or various components may be simple and direct indicating complete linearity between the two or may be complex in differing degree involving simple linear regressions or simple curvilinear regression, and multiple regressions situations. This method, with a range of techniques suitable for simple as well as complex situations, is an undisputed refinement on traditional approaches of forecasting and determining working capital requirements. It is particularly suitable for longterm forecasting. (3) The Working Capital Cycle Method : The working capital cycle refers to the period that a business enterprise takes in converting cash back into cash. As an example, a manufacturing firm uses cash to acquire inventory of materials that is converted into semi finished goods and then into finished goods. When finished goods are disposed of to customers on credit, accounts receivable are generated. When cash is collected from customers, we again have cash. At this stage one operating cycle is completed. Thus a circle from cash-back-to-cash is called the working capital cycle. This concept is also be termed as Pipe Line Theory as popularly known. Fig. 3.1 Working Capital Cycle

Thus we see that a working capital cycle, generally, has the following four distinct stages: 1. The raw materials and stores inventory stage;

2. The semi-finished goods or work-in-progress stage; 3. The finished goods inventory stage; and 4. The accounts receivable or book debts stage. Each of the above working capital cycle stage is expressed in terms of number of days of relevant activity and requires a level of investment to support it. The sum total of these stage-wise investments will be the total amount of working capital of the firm. A series of such operating cycle recur one after another and chain continues till the end of the operating period. In this way the entire operating period has a number of operating cycles. It is important to note that the velocity or speed of this cycle should not slacken at any stage, otherwise the normal duration of the cycle will be lengthened, resulting in an increased need for working fund. The faster the speed of the operating cycle, shorter will be its duration and larger will be the number of total operating cycles in a year (operating period) which in turn would be instrumental in giving the maximum level of turnover with comparatively lower level of working fund. The four steps involved in this method are : (i) computing the duration of the operating cycle, (ii) calculating the number of operating cycles in the operating period, (iii) estimating the total amount of annual operating expenses, and (iv) ascertaining the total working capital requirements. Each step is discussed with some detail in the following paragraphs. (i) Duration of Operating Cycle : The duration is computed in days by adding together the average storage period of raw materials, works-in-progress, finished goods and the average collection period and then deducting from the total the average payment period. The formula to express the framework of the operating cycle is: O = (R + W + F + D)C where : O = Duration of operating cycle R = Raw material average storage period W = Average period of work-in-progress F = Finished goods average storage period D = Debtors collection period C = Creditors payment period The average inventory, trade creditors, work-in-progress, finished goods arid book debts can be computed by adding the opening and closing balances at the end of the year in the respective accounts and dividing the same by two. The average per day figures can be obtained by dividing the concerned annual figures by 365 or the number of days in the given period. (ii) Number of Operating Cycle in Operating Period :

This is found out by dividing the total number of days in the operating period by number of days in the operating cycle as shown below : N = P/O where :N = Number of operating cycle in operating period P = Number of days in the operating period O = Duration of operating cycle (in days) Suppose the operating period is one year (365 days) and the duration of operating cycle is 73 days then the number of operating cycles in the operating period will be : N = 365 /73 = 5 cycles (iii) Total amount of Annual Operating Expenses : These expenses include purchase of raw materials, direct labour costs and the overhead costs-calculated on the basis of average storage period of raw materials and the time-lag involved in the payment of various items of expenses. The aggregate of such separate average amounts will represent the annual operating expenses. (iv) Estimating the Working Capital Requirement : This is calculated by dividing the total annual operating expenses by the number of operating cycles in the operating period as shown below : N = E/N where :R = Requirement of Working Capital (Estimated) E = Annual Operating Expenses N = Number of operating cycles in the operating period The amount of working capital thus estimated is increased by a fixed percentage so as to provide for contingencies and the aggregate figure gives the total estimate of working capital requirements. The operational cycle method of determining working capital requirements gives only an average figure. The fluctuations in the intervening period due to seasonal or other factors and their impact on the working capital requirements cannot be judged in this method. To identify these impacts, continuous short-run detailed forecasting and budget exercises are necessary. Illustration 1 The following data have been extracted from the financial records of Prabhakar Enterprises Limited : Raw Materials Rs. 8 per unit, Direct Labour, Rs. 4 per unit, and Overheads

Rs.80,000 Additional information i. The company sells annually 25,000 units @ Rs. 20 per unit. All the goods produced are sold in the market. ii. The average storage period for raw materials is 40 days and for finished goods it is 18 days. iii. The suppliers give 60 days credit facility to the firm for purchases. The firm also sells goods on 60 days credit to its customers. iv. The duration of the production cycle is 1 5 days and raw material is issued at the beginning of each production cycle. v. 25% of the average working capital is kept as cash for contingencies. On the basis of the above information, estimate the total working capital requirements of the firm under Operating Cycle Method.

Number of Operating Cycles in a year : Total Number of Days in a year divided by Duration of Operating Cycle = -rr- = 5 Cycles in a year.

Illustration 2 Messrs Senthil Industries Ltd. are engaged in large scale retailing. From the following information, you are required to forecast their working capital requirements of this trading concern. Projected annual sales Percentage of Net Profit on cost of sales Average credit allowed to Debtors Average credit allowed by Creditors 4 weeks Average stock carrying (in terms of sales requirement) Add 10% to computed figures to allow for contingencies. Solution Statement of Working Capital Requirements Rs. 65 lakhs 25% 10 weeks 8 weeks

Note : It has been assumed that the creditors include those for both goods and expenses and that all such creditors allow one month credit on average. Interpretation of Results : The amount of working capital fund above is to be interpreted as the amount to be blocked up in inventory, debtors (minus creditors)at any time during the period(year)in view, in order that the anticipated activity (sales primarily)can go on smoothly. The amount is not for a period of time but at any point of time. It represents the maximum(or the highest) quantum of locking up at any time during the period. Illustration 3

Ramaraj Brothers Private Limited sells goods on a gross profit of 25%. Depreciation is taken into account as a part of cost of production. The following are the annual figures given to you:

The company keeps one months stock each of raw materials and finished goods. It also keeps Rs. 1,00,000 in cash. You are required to estimate the working capital requirements of the company on cash basis assuming 15% safety margin. Solution

REVIEW QUESTIONS 1. What are the different methods of forecasting working capital requirements? 2. Explain:, (a) Core current assets (b) Working Capital Gap (c) Working capital cycle PRACTICAL PROBLEMS 1. The Board of Directors of Guru Nanak Engineering Company Private Ltd, requests you to prepare a statement showing the Working Capital Requirements Forecast for a level of activity of 1,56,000 units of production. The following information.is available for your calculation:

B. (i) Raw materials are in stock on average one month, (ii) Materials are in process, on average two weeks, (iii) Finished goods are in stock, on average one month (iv) Credit allowed by suppliers one month (v) Time lag in payment from debtors 2 months (vi) Lag in payment of wages 11/2 weeks. (vii) Lag in payment of overheads is one month 20% of the output is sold against cash. Cash in hand and at Bank is expected to be Rs.60,000. It is to be assumed that production is carried on evenly throughout the year, wages and overheads accrue similarly and a time period of 4 weeks is equivalent to a month.

[Ans: Working Capital Required Rs.74,13,000] Notes(i) Since wages and overheads accrue evenly on average, half the wages and. overhead would be included in working progress. Alternatively if it to assumed that the direct labour and overhead are introduced at the beginning.full wages and overhead would be included. 2. A proforma cost sheet of a company provides the following particulars: Elements of Cost (c) Finished goods are required to be in stock on average period of 8 weeks (d) Credit period allowed to debtors, on average 10 weeks. (e) Lag in payment of wages 4 weeks (f) Credit period allowed by creditors 4 weeks (g) Selling price is Rs.50 per unit . You are required to prepare an estimate of working capital requirements adding 10% margin for contingencies for a level of activity of 1,30,000 units of production. [Ans:Working Capital Required=Rs.25,2,5000] 3. From the following information extracted from the books of a manufacturing concern, compute the operating cycle in days Period covered : 365 days. Average period of credit allowed by suppliers : 16 days.

SUGGESTED READINGS 1. Agarwal, N.K. : Working Capital Management, New Delhi, Sterling Publications (P) Ltd. 2. Kulshrestha, R.S. : Financial Management, Agra, Sahitya Bhavan. 3. Ramamoorthy, V.E. : Working Capital Management, Madras, Institute for Financial Management and Research. LESSON - 4 WORKING CAPITAL FINANCING POLICY

Learning Objectives After reading this lesson you should be able to: - Assess the need for working capital policy. - Identify the different approaches to working capital policy. - Understand the implications of conservative policy. - Evaluate the Risk - Return in Aggressive policy. - Arrive at a Moderate or Balanced approach to the problem of financing of current assets.

Lesson Outline

Matching (Moderate) Approach Aggressive Approach Conservative Approach Balanced Policy Illustrative Examples The current assets financing plan may be readily related to the broader issue of the financing plan for all the firms assets. The firm has a wide variety of financing policies it may choose, and the fact that short-term financing usually is less costly but involves more risk than long-term financing plays an important part in describing the degree of aggressiveness or conservatism of the firms financing policy. In comparing financing plans we should distinguish between three different kinds of financing; (i) permanent source of financing, (ii) temporary source of financing and (iii) the spontaneous short-term financing. A firms investment is namely financed by the some of its spontaneous, temporary and permanent sources of financing. (i) A permanent investment in an asset is one that the firm expects to hold for period longer than one year. Permanent investments are made in the firms minimum level of current assets as well as in its fixed assets. Permanent sources of financing include intermediate and long-term debt, preference share and equity share. (ii) Temporary investments are comprised of the firms investments in current assets, which will be liquidated and not replaced within the current year. For example, a seasonal increase in the level of inventory is a temporary investment as the holding up in inventories will be eliminated when it is no longer needed. Temporary source of financing is a current liability. Thus, temporary financing consists of the various sources of short-term debt including secured and unsecured bank loans, commercial paper, factoring of accounts receivables, and public deposits. (iii) Besides permanent and temporary sources of financing, there also exist spontaneous sources. Spontaneous sources consist of the trade credit and other accounts payable that arise spontaneously in the firms day-to-day operations. Examples include wages and salaries payable, accrued interest, and accrued taxes. These expenses generally arise in direct conjunction with the firms ongoing operations, they are referred to as spontaneous. Popular example of a spontaneous source of financing involves the use of trade credit. As the firm

acquires materials for its inventories, credit is often made available spontaneously or on demand by the firms suppliers. Trade credit appears on the firms balance sheet as accounts payable. The size of the accounts payable balance varies directly with the firms purchases of inventory items, which in turn are related to the firms anticipated sales. Thus, a part of the financing needs by the firm is spontaneously provided by its use of trade credit. The long term working capital can be conveniently financed by(a)owners equity e.g.shares and retained earnings, b)lenders 'equity e.g..debentures, and(c)fixed assets reduction e.g., sale of assets, depreciation on fixed assets etc. This capital can be preferably obtained from owners equity as they do not carry with them any fixed charges in the form of interest or dividend and so do not throw any burden on the company. Intermediate working capital funds are ordinarily raised for a period varying from 3 to 5 years through loans which are repayable in installments e.g., working capital term-loans from the commercial banks or from finance corporations.

Matching (or Moderate) Approach Matching approach is also called Hedging principle. It involves matching the cash flow generating characteristics of a firms assets with the maturity of the source of financing used. The rationale for matching is that since the purpose of financing is to pay for assets, when the asset is expected to be relinquished so should the financing be relinquished. Obtaining the needed funds from a long-term source (longer than one year) would mean that the firm would still have the funds after the inventories has been sold. In this case the firm would have excess liquidity, which they either hold in cash or invest in low yielding marketable securities. This would result in an overall lowering of firm profits. Similarly arranging finance for shorter periods that the assets require is also costly in that there will be extra transaction costs involved in continually arranging new short-term financing. Also, there is always the risk that new financing cannot be obtained in times of economic difficulty. The firms permanent investment in assets is financed by the use of either permanent source of financing (intermediate-and long-term debt, preference shares, and equity shares) or spontaneous source (trade credit and other accounts payable,), its temporary investment in assets is financed with temporary (shortterm debt) and/or spontaneous sources of financing. Note the matching approach has been modified to state: Asset needs of the firm, not financed by spontaneous sources, should be financed in accordance with the rule: permanent asset investments financed with permanent sources and temporary investments financed with temporary sources. Since total assets must always equal to the sum of spontaneous, temporary, and

permanent sources of financing, the hedging approach provides the financial manager with the basis for determining the sources of financing to use at any point in time.

Aggressive Approach: The firms financing plan is said to be aggressive if the firm uses more short-term negotiated financing than is needed under a matching approach. The firm is no longer financing all its permanent assets with long-term financing. Such plans are said to be aggressive because they involve a relatively heavy use of (riskier) shortterm financing. The more short-term financing used relative to long-term financing, the more aggressive is the financing plan. Some firms are even financing part of their long-term assets with short-term debt, which would be a highly aggressive plan. Conservative Approach: Conservative financing plans are those plans that use more long-term financing than is needed under a matching approach. The firm is financing a portion of its temporary current assets requirements with long-term financing. Also, in periods when the firm has no temporary current assets the firm has excess (unneeded) financing available that will be invested in marketable securities. These plans are called conservative because they involve relatively heavy use of (less risky) longterm financing. Comparison of Conservative, Hedging and Aggressive Approaches: These approaches to working capital financing can be compared on the basis of (a) cost considerations, (b) profitability considerations, and (c) risk considerations (probability of technical insolvency). The following statement gives a comparative evaluation. Comparative Evaluation of Financing Approaches

Because of the impracticalities in implementing the matching policy and the extreme nature of the other two policies, most financial managers opt for a compromise position. Such a position is the balanced policy. As its name implies, management adopting this policy balances the trade-off between risk and profitability in a manner consistent with its attitude toward bearing risk. The long-term financing is used to support permanent current assets and part of the temporary current assets. Thus short-term credit is used to cover the refraining working capital needs during seasonal remaining. This implies that as any seasonal borrowings are repaid, surplus funds are invested in marketable securities. This policy has the desirable attribute of providing a margin of safety not found in the other policies. If temporary needs for current assets exceed managements expectations, the firm will still be able to use unused short-term lines of credit to fund them. Similarly, if the contraction of current assets is less than expected, short-term loan payments can still be met, but less surplus cash will be available for investment in marketable securities. In contrast to the other working capital policies, a balanced policy will demand more management time and effort. Under the policy, the financial manager will not only have to arrange and maintain short-term sources of financing but must be prepared to manage the investment of excess funds. The Appropriate Working Capital Policy The analysis so far has offered insights into the risk-profitability trade-off inherent in a variety of different policies. Just as there is no optimal capital structure that all firms should adopt, there is no one optimal working capital policy that all firms should employ. Which particular policy is chosen by a firm will depend on the uncertainty regarding the magnitude and timing of cash flow associated with sales; the greater this uncertainty, the higher the level of working capital necessary. In addition, the cash conversion cycle will influence a firms working policy; the longer the time required to convert current assets into cash, the greater the risk of illiquidity. Finally, in practice, the more risk averse management is the greater will be the net working capital position. The

management of working capital is an ongoing responsibility that involves many interrelated and simultaneous decisions about the level and financing of current assets. The considerations and general guidelines offered in this lesson should be useful in establishing an overall net working capital policy.

Additional Information (i) The firm earns, on an average, approximately 6% on investments in current assets and 18% on investments in fixed assets. (ii) Average cost of current liabilities is 5% and average cost of long-term funds is 12%. Compute the costs and returns under any three different approaches, and comment on the policies.

1. Computation of Costs under Conservative, Matching & Aggressive Approaches.

Comments (i) Cost of financing is highest being Rs. 9,250 in conservative approach, and lowest (Rs. 7,850) in aggressive approach (the total funds being the same, i.e., Rs. 80,000). (ii) Return on investment (net) is lowest in conservative approach being Rs.950 and highest in aggressive approach being Rs. 2,350. (iii) Risk is measured by the amount of net working capital. The larger the net working capital, the lesser will be the degree of technical insolvency or the lesser will be the inability to meet obligations on maturity dates. In other words, larger net working capital means less risk. The net working capital is comparatively larger in conservative approach and therefore, the degree of risk is low. The net working capital is comparatively lower in aggressive approach, and, therefore, the degree of risk is high. Risk is also measured by the degree of liquidity. The larger the degree of liquidity, the lesser will be the degree of risk. One of the measurements of degree of liquidity is current ratio; it is also known as Working Capital Ratio: This ratio signifies the firms ability to meet its current obligations. The larger the ratio, the greater the liquidity, and the lesser the risk. In conservative approach, current ratio is the highest being 7:1, and in aggressive approach, this ratio is lowest being 1.4 : 1. Therefore, there is low risk in conservative approach. The aforementioned analysis leads to the following conclusions : (i) In conservative approach, cost is high, risk is low, and return is low. (ii) In aggressive approach, cost is low, risk is high, and return is high. (iii) Hedging approach has moderate cost, risk and return. It aims at trade-off between profitability and risk. REVIEW QUESTIONS 1. Evaluate the following statement: A firm can reduce its risk of illiquidity with higher current-asset investments, but the return on capital goes down. 2. What are the risk-return trade-offs involved in choosing a mix of short-and long-term financing? 3. There are four different policies that managers must consider in designing their working capital policy. Explain the salient features of each policy. What are the advantages and

disadvantages of each such policy? PRACTICAL PROBLEMS 1. The management of Jayant Electrical Ltd. is faced with various alternatives for managing its current assets. The company is producing 1,00,000 units of electrical heaters. This is its maximum installed capacity. Its selling price per unit is Rs.50. The entire output is sold in the market. Fixed assets of the company are valued at Rs. 20 lakhs. The company earns 10% on sales before interest and taxes. The management is faced with three alternatives about the size of investment in current assets. (i) To operate with current assets of Rs. 20 lakhs, or (ii) To operate with current assets of Rs. 15 lakhs, or (iii) To operate with current assets of Rs 10 lakhs. You are required to show the effect of the above three alternative current assets management policies on the degree of profitability of the company. [Ans.: (i) Conservative Policy (ii) Moderate Policy (iii) Aggressive Policy]

2. (a) Total investments : In Fixed Assets Rs. 1,20,000 In Current Assets 80,000 2,00,000 (b) Earning (EBIT) is 25%. (c) Debt-ratio is 60%. (d) Rs. 80,000 being (40% assets) financed by the equity shareholder, i.e., longterm sources. (e) Cost of short-term debt and long-term debt is 14% and 16% respectively. (f) Assume Income-tax @ 50%. As a result of the financing policy, ascertain the return on equity shares. [Ans : Return on equity is highest in aggressive policy]

SUGGESTED READINGS 1. Agarwal, N.K : Working Capital Management, New Delhi, Sterling Publications (P) Ltd. 1983. 2. Pandey, I.M. : Financial Management, New Delhi, Vikas Publishing House. 3. Ramamoorthy, V.E : Working Capital Management,. Madras, Institute for Financial Management and Research, 1978

LESSON - 5 SOURCES OF WORKING CAPITAL FINANCE Learning Objectives After reading this lesson you should be able to: Identify the various sources of working capital finance Know the cost of trade credit Understand the regulation of bank credit Evaluate the significance of Public Deposits and inter-corporate loans/deposits Recognise the emergence of new instruments like Commercial Papers, Convertible Warrants, etc. Lesson Outline Trade Credit - Customers Advances Commercial Bank Credit - Cash Credit/Discounting Regulation of Bank Credit - Tandon Committee - Chore Committee -Marathe Committee Commercial Papers Inter Company Deposits/Loans Public Deposit

One of the important tasks of the finance manager is to select an assortment of appropriate sources to finance the current assets. A business firm has various sources to meet its financial requirements. Normally, the current assets are supported by a combination of long term and short term sources of financing. In selecting a particular source a firm has to consider the merits and demerits of each source in the context of prevailing constraints. The following is a snapshot of various sources of working capital available to a concern : Sources of Working Capital: Long term sources , Medium & Short term sources

The long term working capital can be conveniently financed by (a) owners equity e.g. shares and retained earnings, (b) preferred equity, (c) lenders equity e.g., debentures, and (d) fixed assets reduction e.g., sale of assets, depreciation on fixed assets etc. This capital can be preferably obtained from owners equity as they do not carry with them any fixed charges in the form of interest or dividend and so do not throw any burden on the company. Intermediate working capital funds are ordinarily raised for a period varying from 3 to 5 years through loans which are repayable in installments e.g., termloans from the commercial banks or from finance corporations. Short term working capital funds can be obtained for financing day-to-day business requirements through trade credit, bank credit, discounting bills and factoring of account receivables. Factoring is a method of financing through accounts receivable under which a business firm sells its accounts to financial institution,

called the Factor.

Sources of short-term finance :In choosing a source of short term financing, the finance manager is concerned with the following five aspects of each financing arrangement. (i) Cost : Generally the finance manager will seek to minimise the cost of financing, which usually can be expressed as an annual interest rate. Therefore, the financing source with the lowest interest-rate will be chosen. However, there are other factors which may be important in particular situations. (ii) Impact on credit rating : Use of some sources may affect the firms credit rating more than use of others. A poor credit rating limits the availability, and increases the cost of additional financing. (iii) Reliability : Some sources are more reliable than others in that funds are more likely to be available when they are needed. (iv) Restrictions : Some creditors are more apt to impose restrictions on the firm than others. Restrictions might include rupee limits on dividends, management salaries, and capital expenditures. (v) Flexibility : Some sources are more flexible than others in that the firm can increase or decrease the amount of funds provided very easily. All these factors must usually be considered before making the decision as to the sources of financing. Trade Credit Trade credit represents credit granted by manufacturers, wholesalers, etc., as an incident of sale. The usual duration of credit is 30 to 90 days. It is granted to the company on open account, without any security except that of the goodwill and

financial standing of purchaser. No interest is expressly charged for this, only the price is a little higher than the cash price. The use of trade credit depends upon the buyers need for it and the willingness of the supplier to extend it. The willingness of a supplier to grant credit depends upon: (i) the financial resources of the supplier; (ii) his eagerness to dispose of his stock; (iii) degree of competition in the market; (iv) the credit worthiness of the firm; (v) nature of the product; (vi) size of discount offered; (vii) the degree of risk associated with customers. The length of the credit period depends upon : (a)Customers marketing period (b) Nature of the product (long credit for new, seasonal goods and short credit on perishable goods and low-margin goods) and (c) Customer location (long distance evidencing the amount that he owes to the seller.) Cost of Trade Credit: The trade credit as a source of financing is not without cost. The cost of trade credit is clearly determined by its terms. However, the terms of trade credit vary industry to industry and from company to company. However, regardless of the industry, the two factors that must be considered while analysing the terms and the cost of trade credit are : (i) the length of time the purchaser of goods has before the bill must be paid and (ii) the discount, if any that is offered for prompt payment. For instance, a concern purchases goods worth Rs. 10,000 on terms Rs. 10,000/2/10, net 30 days. It means if the payment is made within ten days the firm will be entitled for 2% cash rebate; otherwise the payment is to be made within 30 days in full. If the concern wants to use Rs. 9,800 for 20 days at a cost of Rs. 200 and then its actual cost works to 2.049. Advantages of Trade Credit:

Trade credit, as a form of short term financing , has the following advantages: (i) Ready availability : There is no need to arrange financing formally. (ii) Flexible means of financing : Trade credit is a more flexible means of financing. The firm does not have to sign a Promissory Note, pledge collateral, or adhere to-a strict payment schedule on the Note. (iii) Economic means of financing : Generally, during periods of tight money large firms obtain credit more easily than small firms do. However, trade credit as a source of financing is still more easily accessible by small firms even during the periods of tight money. Customers Advances Depending upon the competitive condition of the market and customs of trade, a company can meet its short-term requirements at least partly through customer/dealers advances. Such advances represent part of the price and carry no interest. The period of such credit will depend upon the time taken to deliver the goods. This type of finance is available only to those firms which can dictate terms to their customers since their product is in great demand as compared to the products of the other competitive firms. COMMERCIAL BANK: BILL DISCOUNTING AND CASH CREDIT Bank credit is the primary institutional source for working capital finance. Banks offer both unsecured as well as secured loans to business firms. At one time banks confined their lending policies to such loans only. Banks, now, provide a variety of business loans, tailored to the specific needs of the borrowers. Still, short term loans are an important source of business financing such as seasonal build ups in accounts receivable, and inventories. The different forms in which unsecured and secured short-term loans may be extended are discounting of bills of exchange, overdraft, cash credit, loans and

advances. Banks provide credit on the basis of the security. A loan may either be secured by tangible assets or by personal security. Tangible assets may be charged as security by any one of the following modes, viz., lien, pledge, hypothecation, mortgage, charge, etc.

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Discounting and Purchase of Bills : Under the Bill Market scheme, the Reserve Bank of India envisages the progressive use of bills as an instrument of credit as against the current practice of using the widely prevalent cash credit arrangement for financing working capital. To popularise the scheme, the discount rates are fixed at lower rates than those of cash credit, the difference being about 1 to 1.5 per cent. Cash Credits : Banks in India normally make loans and advances in three forms viz., cash credits, overdrafts and loans. Cash credit is an arrangement by which a banker allows the customer to borrow money up to a certain limit (called cash credit limit) against some tangible security or on the basis of a promissory- note signed and fixes the limit annually or quarterly after taking into account several material levels, etc. The banker keeps adequate cash balances so as to meet the customers demand as and when demand arises. Once the cash credit arrangement is made, the customer need not take the whole advance at once but may draw out or utilise the bank credit at any time without keeping a credit balance. Further, the borrower can put back any surplus amount which he may find with him for the time being. The bank can also withdraw the credit at any time in case the financial position of the borrower goes down. Generally the borrower is charged interest on the actual amount utilised by him and for the period of actual utilisation only; interest is charged by the bank on daily debit balance. Overdrafts : When a customer having a current account requires a temporary financial accommodation, he is allowed to overdraw (to draw more than his credit balance) his current account up to an agreed limit. Overdraft accounts can either be secured or unsecured, usually, security is insisted upon for an overdraft arrangement. The customer is allowed to withdraw the amount by cheques as and when he needs it and repay it by means of deposits into his account as and when it is feasible for him. Interest is charged on the daily debit balance i.e.,the exact amount overdrawn by the customer and for the period of actual utilisation. This is more advantageous to the customer-borrower in the sense that the interest is

charged only on the amount drawn by him. But the banker is comparatively at a disadvantage because he has to keep himself in readiness with the full amount of the overdraft and he can charge interest on the amount actually drawn. An overdraft, is different from a cash credit in that the former is supposed to be for a comparatively short time where as the latter is not so. Loans: When an advance to a customer is made in a lump sum against security or otherwise, without liberty to him of repaying, with a view to making a subsequent withdrawal it is called a loan. The entire loan amount is paid to the borrower in cash or is credited to his current account and interest is charged on the full amount of the loan from quarterly rests from the date of sanction. Where the loan is repayable in installments the interest is charged only on the reduced balance. A loan once repaid in full or in part cannot be withdrawn again by the borrower, unless the banker grants a fresh loan which will be treated as a separate transaction. In this respect a loan account differs from a cash credit or an overdraft account. A banker prefers to make an advance in the form of a loan because he can charge interest on than overdraft or cash credit because in the latter case there is continuity and magnitude of operation. Critical Evaluation of Bank Finance : Bank credit offers the following advantages to the borrowing companies: (1) Timely Assistance : Banks assist the borrowing companies by providing timely assistance to meet the working capital requirements. A company can usually rely upon the bank for amounts of loan up to an agreed limit sanctioned by bank in advance. (2) Flexibility: Bank assistance is flexible to the company. The accommodation can easily be got extended and may be used when it is urgently needed. It helps the company in maintaining goodwill in the market. Also, if the amount of loan or a part of it is no more required it can be repaid and interest on it be saved. (3) Economy : Bank assistance entails the payment of only interest and does not involve the kind of costs which are to be incurred in the issue of securities such as commission on underwriting etc. Moreover, the rate of interest is not very high. The interest is

payable only for the period the loan remains unpaid. Thus it reduces the cost of borrowings. (4) No permanent burden : The borrowings can be repaid if it is no mere required. In this way, it is not a permanent burden to the concern. (5) No interference with company management: The loan provided by the bank is simply a loan and no string is attached to it. Generally banks do not interfere with the management of the borrowing com panies, till bank is assured of the repayment of loans. (6) Secrecy : This is by far the greatest advantage of bank finance. Any information supplied to bank regarding financial position of the borrowing company is not made public in any way by the bank. Drawback of Bank Finance : Bank accommodation and loans suffer from the following drawbacks: (1) Burden of mortgage or hypothecation : The stock of raw material, finished or semi finished goods are to be kept in a godowns under bank control and can be used only with the permission of bank or after paying the amount of loan. (2) Short-duration of assistance : Banks provide only short-term assistance generally for the period less than a year and its renewal or extension is quite uncertain depending upon the discretion of banks authorities. (3) Cumbersome terms : Banks grant assistance generally, to the extent of 50 to 75% of the cost of security pledged or hypothecated, thus having a margin of 25% to 50%. In addition, banks press the borrowing companies to have the goods in their godowns. Minimum interest is paid on a certain specific amount whether it is drawn or not and

repayment of loan is strictly enforced as per the agreement entered into between the company and the bank. Thus, the terms of borrowings are too harsh. It also increases the cost of new borrowings and of the production.

REGULATION OF BANK CREDIT SINCE 1965 During the last 25 years the availability of bank credit to industry has been the subject matter of regulation and control with a view to ensure equitable distribution of bank credit to various sectors of the economy as per planning priorities. The following are of special significance in this respect: (i) Credit Authorisation Scheme, 1965, (ii) Dehejia Committee, 1969, (iii) Tandon Committee Report, 1975, (iv) Chore Committee Report, 1979, (v) Marathe Committee 1,1992, and (vi) Nayak Committee. Credit Authorisation Scheme : The Credit Authorisation Scheme (CAS) was introduced by the Reserve Bank of India in November 1965 as a measure to regulate bank credit in accordance with plan priorities i.e., purpose-oriented. Under this Scheme, the scheduled commercial banks are required to obtain Reserve Banks prior authorisation before granting fresh credit limits (including commercial bill discounts and termloans) of Rs.l crore or more to any single party or any limit that would take the total limits enjoyed by such party from the banking system as a whole to Rs. 1 crore or more on secured or unsecured basis. If the existing credit limits exceed Rs. 1 crore such prior authorisation is also required for grant of any further credit facilities. New procedures for Quicker Release of Funds under CAS, based on Marathe Committee 1982 : The Reserve Bank of India (RBI) had issued guidelines under which banks can release funds to their borrowers up to 50 per cent of the additional limits under the modified Credit Authorisation Scheme (CAS) which come into force from April 1, 1984 without waiting for prior authorisation from the RBI subject to the five requirements. The five requirement under this Fast Track Procedure are :

1. Reasonableness of the estimates and projections of production, sales, current assets, etc, given by the client. 2. Proper classification of current assets and liabilities. 3. Maintenance of minimum current ratio of 1.33:1 4. Prompt submission of quarterly operating statements as also annual accounts by borrowers, and 5. Regular annual review of the credit facilities by the banks. The proposals should be certified by an authorised senior officer of the bank regarding the fulfillment of these requirements:All proposals seeking the benefit of the Fast Track Procedure simultaneously go through the normal process of scrutiny by the RBI. If it is found that the credit limits sanctioned by the commercial banks are not need-based or were excessive, corrective action will be taken. In such cases the RBI may stipulate that until further notice, credit proposals from these borrowers should be referred to it for its prior authorisation. With effect from April 1, 1984, banks may grant facilities on an ad hoc basis for a period not exceeding three months to any of CAS borrowers under exceptional circumstances up to 25 per cent of the existing packing credit limit or 10 per cent of the existing working capital limit subject to an overall ceiling of Rs. 75 lakhs against Rs, 50 lakhs now. Prior authorisation from the RBI will not be necessary for letters of credit (L.C.) facilities subject to the following conditions:Banks should not open letters of credit for amounts out of proportion to the borrowers genuine needs and without ensuring that the borrowers have made adequate arrangement for retiring the bills received under the letters of credit out of their own resources or from the existing borrowing arrangements. Tandon Committee Recommendations The Reserve Bank of India (RBI) constituted in July 1974 a study group to frame guidelines for follow-up of bank credit under the chairmanship of P.L.Tandon. The report submitted by the committee in August 1975 is popularly referred to as the Tandon Committee Report. The recommendations of this committee are given below: 1. Norms for Inventory and Receivables : The Committee has come out with a set of norms that represent the maximum levels for holding inventory and receivables in each of 15 major industries,

covering about 50 per cent of industrial advances of banks. As norms cannot be rigid, deviations from norms can be permitted under extenuating circumstances such as bunched receipt of raw materials including imports, power-cuts, strikes, transport bottlenecks etc., for usually short periods. Once normalcy is restored, the norms should become applicable. The norms should be applied to all industrial borrowers with aggregate limits from the banking system in excess of Rs. 10 lakhs and extend to smaller borrowers progressively. 2. Approach to Lending : (i) As a lender the bank should only supplement the borrowers resources in carrying a reasonable level of current assets in relation to his production requirements. (ii) The difference between total current assets and current liabilities other than bank borrowing is termed as working capital gap. The bank should finance a part of the working capital gap and the balance should be financed through long-term sources comprising equity and long-term borrowings. (iii) Three alternative methods have been suggested for calculating the maximum permissible bank borrowing. The methods will progressively reduce the maximum permissible bank borrowing. These three methods are explained by means of a numerical example which indicates the projected financial position as at the end of the next year. Method 1 : Under this method, 75% of the working capital gap may be provided by banks and the customer should provide the balance 25% from long-term funds like owned funds or term-loans. Method 2 : According to this method, the borrower should be required to provide through long-term resources 25% the gross current assets while the balance could be provided by trade creditors and current liabilities as also the banks. Method 3 : This method is similar to Method 2, but it further requires that even out of the gross current assets, the core current assets should be determined and separately funded from long-term resources. The Committee did not lay down any mode for the determination of the core current assets and left it to the lending banks to find out method for such determination. The Committee recommended that if in any borrowers case, the limit under the

particular method in its case had been exceeded, the excess should be converted into a funded debt and liquidated within an agreed period. It was also suggested that the change over should be gradual, viz., a borrower may first be brought into the base provided under Method 1, and then he should be carried towards Method 2, and thereafter to Method 3. In fact, till now, Method 3 has not been applied. Example : Let us try to apply these methods to a company which has the following current assets and current liabilities position.

The current assets have been worked out on the basis of suggested norms or past practices, whichever is lower.

3. Reporting System regarding Bank Credit: The Committee suggested that in order that the lending bank could follow up the position of a borrower, certain periodical statements (in addition to the audited Balance Sheet) should be submitted by the borrower to the lending bank, e.g. (i) Quarterly Profit & Loss Account. (ii) Quarterly Statement of Current Assets & Current Laibilities. (iii) Quarterly Funds Flow Statement. (iv) Half-yearly Proforma Balance Sheet and |&rit & Loss Account. (v) Monthly Stock Statements in a revised form. The Committee suggested that the above information system should be introduced initially with borrowers whose limits aggregated rupees one crore and above within a period of 6 months, and then progressively extended to borrowers with limits of rupees fifty lakhs and above, and then to borrowers with credit limits of rupees ten lakhs and above. According to the committee, the banker

should be guided by the borrowers total operations and not merely by the value of the current assets. The credit that should be allowed must be entirely needbased and the borrowers requirement should be planned in advance with the assistance of the banker. A financial analysis of the borrowers operating results along with inter-firm comparison should be carried out by the banker so that the efficiency and performance of the borrower can be judged, and a time-bound programme can be laid down as corrective measure. 4. Inter-firm Studies : To facilitate inter-firm and industry-wise comparisons for assessing efficiency, it would be of advantage if companies in the same industry could be grouped under three or four categories, say, according to size of sales and the group-wise financial ratios compiled by the RBI for furnishing to banks. 5. Classification of Borrowers: For the purpose of better control, there should be a system of borrower classification in each bank. This will facilitate easy identification of the borrowers whose affairs require to be watched with more than ordinary care and will also provide a rational base for the purposes of fixing rates of interest for the respective borrowers. 6. Bank credit for Trade : While financing trade, banks should keep in view, among other things, the extent of owned funds of the borrower in relation to the credit limits granted, the annual turnover, possible diversion to other units or uses and how much is being ploughed back from profit into the business. They should avoid financing of goods which have already been obtained on credit. 7. Norms for Capital Structure: In discussing the norms for capital structure we have to keep in mind both the relationships long-term debt to equity and total Outside liabilities to equity. Where a company's loan-term debt/net worth and outside liabilities, net worth ratios are worse than the medians, the banker should try to persuade the borrower to strengthen his equity base as early as possible. 8. The committee favoured the retention of the basic elements of the existing system because (i) it provides more flexibility to borrowers.

(ii) it is cheaper to borrowers, and (iii) it leaves abundant discretion and judgment to the bankers operate in a realistic manner given daily developments. Central to existing system is the cash credit arrangements with its three elements of annual credit limits, drawing accounts and drawing power based on security stipulations. 9. The Committee also suggested that within the over-all eligibility, a part of the borrowers requirements should be met by the banker by way of a bills limit apart from the loan or other cash credit arrangements. This, however, should be only a sort of interim arrangement. In most cases, the bankers apply Method 1 advocated by the Committee for determining the maximum limit of borrowals to be allowed to a borrower. In some cases only, Method 2 is applied, while Method 3 has not yet been applied in any case. The Committees Report has been subsequently modified to some extent by the Chore Committee Report of 1979. Chore Committee The RBI constituted in April 1979 a six-member working group under the chairmanship of K.B. Chore, Chief Officer, Department of Banking Operations and Developments, RBI to review mainly the system of cash credit and credit management policy by banks. Recommendations : The highlights of the Chore Committee report as considered by the RBI are as follows: 1. Enhancement on borrowers contribution : The net surplus cash generation of an established industrial unit should be utilised partly at least for reducing borrowing for working capital purpose. In assessing the maximum permissible bank finance,banks should adopt the second method of lending recommended by the Tandon Committee, according to which, the borrowers contribution from owned funds and term finance to meet the working capital requirement should be equal to at least 25 per cent of the total current assets. In cases where the borrowers may not be in a position to comply with this requirement immediately, the excess borrowing should be segregated and treated as Working Capital Term Loan (WCTL) which could be made repayable in half-yearly installments within a definite period which should not exceed five years in any case. The WCTL should carry a rate of interest which should, in no case, be less than the rate sanctioned for the relative cash credit limit and banks may in their discretion, with a view to encouraging an early liquidation of the WCTL, charge a higher rate of interest, not exceeding the

ceiling. Provisions should be made for charging of penal rate of interest in the event of any default in the timely repayment of WCTL. 2. Lending System : The existing system of three types of lending (cash credit, loans and bills) should continue but wherever possible the use of cash credit should be supplemented by loans and bills. However, there should be scrutiny of the operations of the Cash Credit Accounts by at least reviewing large working capital limits once in a year. The discipline relating to the submission of quarterly statements to be obtained from the borrowers under the information system is also-to be strictly enforced in respect of all borrowers having working capital limits of Rs.50 lakhs and over from the banking system.

3. Bifurcation of Cash Credit : The RBFs earlier instructions to banks to bifurcate the cash credit accounts (as recommended by the Tandon Committee) in demand loan for corporation and fluctuating cash credit component and to maintain a differential interest rate between these two components are withdrawn. In cases where the cash credit accounts have already been bifurcated, steps should be taken to abolish the differential interest rates with immediate effect. 4. Separate limits for peak level and normal non-peak level period : Banks should appraise and fix separate limits for the normal non-peak level as also for the peak level credit requirements for all borrowers in excess of Rs. 10 lakhs indicating the relevant periods. 5. Drawals of fund to be regulated through Quarterly Statement: Within the sanctioned limits for peak and non-peak periods, the borrower should indicate in advance his need for funds during the quarter. Excess of underutilisation against this operative limit beyond tolerance of 10 per cent should be deemed to be an irregularity and appropriate corrective action should be taken. 6. Ad hoc or temporary limits : Borrowers should be discouraged from frequently seeking ad hoc or temporary limits in excess of sanctioned limits to meet unforeseen contingencies. Additional interest of 1 per cent per annum should normally be charged for such limits.

7. Encouragement for bill finance : Advances against book debts should be converted to bills wherever possible and at least 50 per cent of the cash credit limit utilised for financing purchase of raw material inventory should also be changed to this bill system. The RBI tentatively accepted a few major recommendations of Chore Committee on cash credit system for reshaping and reforming the existing system and asked the commercial banks to submit their opinion on the feasibility of implementing the recommendations and their possible future impact. The Chore Committees recommendations will pre-empt all internal accruals towards augmenting working capital, leaving nothing for modernisation and expansion. COMMERCIAL PAPERS Commercial Papers (CPs) are short-term use promissory notes with a fixed maturity period, issued mostly by the leading, reputed, well-established, large corporations who have a very high credit rating. It can be issued by body corporates whether financial companies or non-financial companies. Hence, it is also referred to as Corporate Paper. Features of a Commercial Paper (i) They are unsecured and backed only by the credit standing of the issuing company. (ii) They are negotiable by endorsement and delivery like pro-notes and hence are highly flexible instruments. (iii) Since Commercial Papers are issued by companies with good credit-rating, they are regarded as safe and liquid instruments. In India, as per the RBI guidelines, any private or public sector company can issue Commercial Papers provided (a) its minimum tangible net worth (paid up share capital plus reserves and surplus) is equal to Rs.4 crores and it has a minimum current ratio of 1.33:1 as per the latest audited balance sheet. (b) it enjoys a working capital limit of Rs. 4 crores or more. (c) it is listed on one or more of the stock exchanges, and

(d) it obtains every 6 months an excellent credit rating (Pi or AI) from a rating agency approved by RBI like CRISIL, ICRA, CARE, etc. (iv) Commercial Papers are normally issued at a discount and are in large denominations. (v) Issues of Commercial Papers may be made through banks, merchant banks, dealers, brokers, open market, or through direct placement through lenders or investors. (vi) Commercial Papers normally have a buy-back facility; the issuers or dealers can buy back Commercial Papers if needed. (vii) The maturity period of Commercial Papers may vary from 3 to 6 months. (viii) The minimum denomination of a Commercial Paper is to be Rs.5 lakhs and the maximum amount of Commercial Paper finance that a company can raise is limited to 20% f the maximum permissible bank finance. (ix) No prior approval of RBI is needed to make Commercial Paper issues and underwriting of the issue is not mandatory. (x) The minimum size of a commercial paper issue is Rs. 25 lakhs. Commercial Papers are mostly used to finance current transactions of a company and to meet its seasonal needs for funds. They are rarely used to finance the fixed assets or the permanent portion of working capital. The rise and popularity of Commercial Papers in other countries like USA, UK, France, Canada and Australia, has been a matter of spontaneous response by the large companies to the limitations and difficulties they experienced in obtaining funds from banks. Commercial Papers in India The introduction of Commercial Papers in India is a result of the suggestions of the Working Group (known as Vaghul Committee) on Money Market in 1987. Subsequently, in 1989, the RBI announced its decision to introduce a scheme by which certain categories of borrowers could issue Commercial Papers in the Indian Money Market. This was followed by RBI Guidelines on issue of Commercial Papers in January 1990, further revised in April 1991. These guidelines apply to all Non-Banking Finance and Non-Finance Companies. Some

recent issues of Commercial Papers by Indian Companies and their CRISIL Ratings are shown below .

Note : PI : Highest Safety - This rating indicates that the degree of safety regarding timely payment on the instrument is very strong. CRISIL may apply + (plus) or - (minus) signs for ratings to reflect comparative standings within categories. INTER-CORPORATE DEPOSITS A deposit made by one company with another, normally for a period up to six months, is referred to as an inter-corporate deposit. Such deposits are of three types: Call Deposits: In theory, a call deposit is withdrawable by the lender on giving a days notice. In practice, however, the lender has to wait for at least three days. The interest rate on such deposits may be around 14 per cent per annum. Three months Deposits : More popular in practice, these deposits are taken by borrowers to tide over a short-term cash inadequacy that may be caused by one or more of the following factors: disruption in production, excessive imports of raw material, tax payment, delay in collection, dividend payment, and unplanned capital expenditure. The interest rate on such deposits is around 16 per cent annum. Six-months Deposits : Normally, lending companies do not extend deposits beyond this time-frame.

Such deposits, usually made with first-class borrowers, carry an interest rate of around 18 per cent per annum. Growth of Inter-Corporate Deposit Market: Traditionally, some prosperous companies in the fold of big business houses such as Birlas and Goenkas carried substantial liquid funds meant primarily to exploit investment opportunities in the form of corporate acquisitions and takeovers. Until such opportunities arose, the liquid funds were deposited with other companies with an understanding that they would be withdrawn at short notice. From the early seventies (more particularly from 1973), the inter-corporate deposit market grew significantly in the wake of the following development: (i) Substantial excise duty provisions made by the companies ever since the Bombay High Court made a ruling that excise duty was not payable on postmanufacturing expenses. (ii) Curbs on working capital financing imposed by the Reserve Bank of India after the first oil shock of 1973. (iii) Imposition of restrictions on acceptance of public deposits (this was perhaps caused largely by the failure of W.G. Forge and Company Limited). (iv) Burgeoning liquidity of scooter companies (little Bajaj, Honda etc.) and, of late, of car companies (like Maruti Udhyog), which have received massive booking deposits from their customers. Characteristics of the Inter-Corporate Deposit Market Lack of Regulation : While Section 58 A of the Companies Act, 1956, specifies borrowing limits for inter-corporate loans of a long-term nature, inter-corporate deposits of a shortterm nature are virtually exempt from any legal regulation. The lack of legal hassles and bureaucratic red tape makes an inter-corporate deposit transaction very convenient. In a business environment otherwise characterised by a plethora of rules and regulations, the evolution of the inter-corporate deposit market is an example of the ability of the corporate sector to organise itself in a reasonably orderly manner. Secrecy : The inter-corporate deposit market is shrouded in secrecy. Brokers regard their lists of borrowers and lenders as guarded secrets. Tightlipped and circumspect, they are somewhat reluctant to talk about their business. Such disclosures, they apprehend, would result in unwelcome competition and undercutting of rates.

Importance of Personal Contacts : Brokers and lenders argue that they are guided by a reasonably objective analysis of the financial situation of the borrowers. However, the truth is that lending decisions in the inter-corporate deposit markets are based on personal contacts and market information which may lack reliability. PUBLIC DEPOSITS Public deposits constitute an important source of industrial finance in some of the Indian industries, particularly in sugar, cotton textiles, engineering, chemicals, and electricity concerns. Although public deposits are principally a form of short-term finance, but have since long been utilised to provide long and medium term finance by cotton mills of Bombay, Ahmedabad and Sholapur and tea gardens of Bengal and Assam. The system is a legacy from the old past when the banking system had not developed adequately and the money was kept for safe custody with the mahajans. In Bombay and Ahmedabad the men who established the mill companies were either merchants or shroffs in whom the public

LESSON - 6 CASH MANAGEMENT Learning Objectives After reading this lesson you should be able to: Understand the nature of cash Identify issues in cash management Appreciate the motives for holding cash. Detail the factors influencing the level of cash balance to hold. Examine the strength and weakness of cash surplus/deficit. Explain and evaluate the techniques of expediting collections.

Lesson Outline Nature of Cash. Motives for Holding Cash. Cash Planning - Cash Budget. Factors Influencing the Level of Cash Balance. Advantages of Maintaining Ample Cash. Cash Deficit/Surplus. Techniques of Expediting Cash Collections. Evaluation of Cash Management. Illustrative Examples. Cash means and includes actual cash (in hand and at bank). Cash is like blood stream in the human body gives vitality and strength to a business enterprise. The steady and healthy circulation of cash throughout the entire business operation is the basis of business solvency.

Nature of Cash : Cash is the common purchasing power or medium of exchange. Cash forms the method of collecting revenues and paying various costs and expenses of the business. As such, it forms the most important component of working capital. Not only that, it largely upholds, under given conditions, the quantum of other ingredients of working capital viz., inventories and debtors, that may be, needed for a given scale and type of operation. Approximately 1.5 to 2 per cent of the average industrial firms' assets are held in the form of cash. However, cash balances vary widely not only among industries but also among the firms within a given industry, depending on the individual firms specific conditions and on their owners and managers aversion to risk. Cash as a Liquid Asset: Cash is the most liquid asset that a business owns. Liquidity refers to commonly accepted medium for acquiring the things, discharging the liabilities,etc. The

main preoccupation of a businessman should be cash, which is the starting point and the finishing point. It is the sole asset at the commencement and the termination of a business. It should be remembered that a want of cash is more likely to cause the demise of a business than any single factor. Credit standing of the firm with sufficient stock as cash is the strengthened. A strong credit position of the firm helps it to secure from banks and other sources generous amount of loans on softer terms and to procure the supplies on easy terms. Cash as a Sterile Asset: Cash itself is a barren or sterile asset and in nature until and unless human beings apply their head and hand. That is cash itself can not earn any profit or interest or yield unless; it is invested in the form of near-cash or non-cash assets. Cash as a Working Asset: While cash is a factor contributing to the liquidity position of the enterprise, fixed assets are real producer of earnings; on planning it would be the objective of management to maintain in each asset group the appropriate amount of resources to easy but on efficient production and to meet the requirements of the future. Should an excess cash balance be is covered, it would be non-working asset and should be employed elsewhere to produce some income. Cash as a Strange Asset: A firm seeks to receive it in the shortest possible time but to hold as little as possible. It is more efficient to maintain good credit sources than to hold extra cash or low interest bearing market instruments against unexpected use. Clearly, it is preferable, whenever possible to hold income-earning marketable investment in lieu of cash and to use short-term borrowing to meet peak seasonal needs. Issues in Cash Management In a business enterprise, ultimately, a transaction results in either an outflow or an inflow of cash. Its shortage may degenerate a firm into a state of technical insolvency and even to liquidation. Though idle cash is sterile, its retention is not without cost. Holding of cash balance has an implicit cost in the firm of opportunity cost. It varies directly with the quantity of cash held. The higher the amount of idle cash, the greater is the cost of holding it in the form of loss of interest which could have been earned either by investing it in some interest bearing securities or by reducing the burden of interest charges by paying off the past loans, especially in the present era of ever increasing cost of borrowing. Hence, a finance manager has to adhere to the five Rs of financial management, viz

(i) the right quality of finance for liquidity considerations; (ii) the right quantity whether owned or borrowed; (iii)the right time to preserve solvency; (iv) the right source; and (v) the right cost of capital the organisation can afford to pay. In order to, resolve the uncertainty about cash flow prediction, lack of synchronisation between cash receipts and payments, the organisation should develop some strategies for cash management. The organisation should evolve strategies regarding the following areas and facets of cash management. (i) Determining the organisation s objective of keeping cash, (ii) Cash planning and forecasting (iii) Determination of optimum level of cash balance holding in the company. (iv) Controlling flow of cash by maximising the availability of cash i.e., economising cash by accelerating cash inflows or decelerating cash outflows. (v) Financing of cash shortage and cost of running out of cash. (vi) Investing idle or surplus cash. Motives for Holding Cash According to John Maynard Keynes, the famous economist, there are three motives that both individuals and businessmen hold cash. They are (i)the Transaction motive. (ii) the Precautionary motive. (iii) the Speculative motive. Yet another motive which has been added as the fourth one by the modern

writers on financial management is Compensation motive Thus, there are altogether four primary motives for maintaining cash balances. Transactions Motive : This motive requires a firm to hold cash to conduct its business in the ordinary course. The firm needs cash primarily to make payments for purchases, wages, operating expenses, taxes, dividends, etc. The need to hold cash would not arise, if there were perfect synchronisation between cash receipts and cash payments, i.e. enough cash is received when the payment has to be made. But cash receipts and payments are not perfectly synchronised. Sometimes cash receipts exceed cash payments, while at other times cash payments are more than cash receipts; hence, the firm should maintain some cash balance to make the required payments. For transaction purposes, a firm may invest its cash in marketable securities. Usually, the firm will purchase the securities whose maturity corresponds with some aniticipated payments, such as dividend, taxes etc., in future. However, the transactions motive mainly refers to holding cash to meet anticipated payments whose timing is not perfectly matched with cash receipts. Precautionary Motive : According to this motive, a firm should maintain sufficient cash to act as a cushion against unexpected events. Even though, by the use of budgets, the financial needs of a firm, can be estimated, yet inaccuracies are likely to occur in predicting the cash flows which require the attention of the management. These inaccuracies may be caused by (a) floods, strikes and failure of an important customer to pay in time, (b) bills may be presented for settlement earlier than expected, (c) unexpected slow down in collection amounts receivables, (d) cancelation of some order for goods as the customer is not satisfied,(e)sharp increase in cost of raw materials. That is why it is necessary to maintain higher cash balances. The size of the cash balance to be maintained also depends upon the ability of the firm to borrow funds at short notice. If the firm has the ability to borrow funds at short notice, it is not necessary to maintain higher cash balances. If the management is not prepared to take the risk the precautionary balances will be larger than it would be if the management is prepared to take the risk. To compensate the loss of return on these balances, the firm will invest a large part of the balances in short-term (marketable) securities, so that they can be converted into cash immediately. The amount of income that a firm is willing to forego by holding precautionary balances will be criterion for the upper limit for investment in cash. Speculative Motive : It refers to the desire ,of a firm to take advantage of opportunities which present themselves at unexpected moments and which are typically outside the normal course of business. While the precautionary motive is defensive in nature, in that

firm must make provisions to tide over unexpected contingencies, the speculative motive represents a positive and aggressive approach. Firms aim to exploit profitable opportunities and keep cash in reserve to do so. Compensation Motive : Yet another motive to hold cash balance is to compensate banks for providing certain services and loans. Banks provide a variety of services banks charge a commission or fee, for others they seek indirect compensation. Usually clients are required to maintain a minimum balance of cash at the bank. Since this balance cannot be utilised by the firms for transaction purposes.the banks themselves can use the amount to earn a return. To be compensated for their services indirectly in this form, they require the clients to always keep a bank balance sufficient to earn a return equal to the cost of services. Such balances are compensating balances. Compensating balances are also required by some loan agreements between a bank and its customers. During periods when the supply of credit is restricted and interest rates are rising, banks require a borrower to maintain a minimum balance in his account as a condition precedent to the grant of loan. This is presumably to compensate the bank for a rise in the interest rate during the period when the loan will be pending. Cash Planning : Cash Planning involves the formulation of cash policies resulting from normal and abnormal requirements. Normal cash requirements are those which are predictable and occur as a result of routine operations and include cash of such items as raw materials, supplies, interest, wages and salaries, replacement of fixed assets which are wornout through use, dividends,and taxes. Abnormal requirements, which cannot be anticipated in the routine of the business process, include cash for fixed assets which are replaced for reasons other than normal depreciation, purchases resulting from price declines, and interruption of cash flow which reduce cash receipts without a corresponding reduction in cash disbursement. The main purpose of cash planning is low synchronise cash receipts with cash outgo. In most firms perfect synchronisation is difficult to achieve mainly because the inflow and outflow is effected by several factors. Tools of Cash Planning (i) Net Cash Forecast through Projected Cash flow Statements which give the estimated receipts and disbursements on a month by month basis. (ii) Cash Budgetas a tool of cash planning and control.

(iii) Statement of Working Capital Forecast (iv) Cash Ratioslike Acid Test Ratio, Turnover of cash etc. (v) Cash Reports: A cash report showing the monthly position can supplement the cash budget in the task of controlling the cash. The management must try to maintain a balance between cash receipts and payments and cash reporting helps very much in this direction. (vi) Proforma Statements : In addition to the above tools, Cash Planning requires two additional statements viz.,(a) Proforma Balance Sheet and (b)Proforma Profit and Loss Statement. The proforma balance sheet establishes a connection between planning for the use of assets. The proforma profit and loss statement reveals the management planning regarding sales (revenue), expenses and net profit. Cash Budget as a Tool of Cash Planning and Control: The cash budget may be used either as a simple forecasting device or as a means of aggressive strategy or planning. When used as a forecasting device, operating projections are made; cash inflows and outflows are matched, deficiencies are provided for and surplus funds invested. Aggressive planning involves estimating different levels of operations and judging the inflows and outflows to obtain the mix that makes the greatest contribution to the profitability of the enterprise without entailing too much risk. Cash budget is a formalised structure for estimating cash in come and cash expenditure over some period of time. The net cash position of the enterprise as it moves from one budgeting sub-period to another, is highlighted. The cash budget includes only cash flow, non-cash items such as depreciation, loss in sale of fixed assets etc., are excluded. The period of time covered by the cash budget may be a year, six months, three months or some other period. The sub-periods may be a day, a week, a month or a quarter, depending upon the needs of the enterprise. If the firms flow of funds is dependable and it has a large cash balance, a cash budget covering a period of one year divided into three-month intervals may be appropriate. Where substantial uncertainty is associated with the flow of funds a quarterly cash budget broken into monthly intervals may be the most suitable. The cash budget since, it shows the size of cash balance at the end of each subperiod as well as the amount and term of financing required, is the key to arranging for needed funds at the most favourable terms available. Adequate time is available to study the needs. Factors Influencing the Level of Cash Balance to Hold 1. Credit Position :

If a firm enjoys a sound credit position, it is not necessary for it to keep heavy cash balances. If a firm wants to purchase its inventories on trade credit, it can keep only small cash balances. It will not be possible in such a case for a firm to synchronise the credit it allows and the credit it avails. 2. Position of Accounts Receivable : The amount of cash required is affected by the time factor viz.,the time required for converting the accounts receivable into cash. If the credit term of the firm is longer, the turnover also will be slow. Therefore when the outflow and the turnover could not synchronise, it becomes necessary for a firm to maintain larger cash balance required to meet its requirements. 3. Nature of the Product/Business : Nature of the business has also great i influence on the cash requirements. If one business was to carry larger inventory as compared to that of similar business,it becomes necessary, for the firm to invest additional funds in inventory. Further, cash requirement is influenced by the firms demand. If the firms demand is volatile, larger cash will be required. 4. Sales in relation to Assets : Another factor affecting the cash requirement is the volume of sales in relation to assets. In the case of firms with larger sales, as huge sums are invested in inventories and accounts receivable they should carry heavy cash balances. When sales increase cash requirements do not increase in the same proportion but there is definite increase in cash. 5. Managements Attitude : Cash requirement of a firm is influenced by the attitude of the management also. If the management is of conservative type it will hold larger cash than that which is less conservative. The demands of such a firm will be more of liquid nature. But a firm which plans its requirements effectively is less conservative. By planning, a firm will be able to predict its requirements accurately. 6. Distribution Channel : Distribution channel refers to the number of middlemen in the process of distribution of service or product. If the distribution channel is long and the credit policy is liberal the level of cash may be higher. If goods and services are

sold through departmental stores or chain stores the cash holdings will differ substantially. 7. Size and Area of Operation : Area of operation refers to the geographical area in w hich the organisation is working. If the organisation working on large scale it is possible that organisation must have to keep higher cash level. 8. Duration of Production Cycle: It refers to the time period taken by the raw material to become finished product. In case of long production cycle the level of cash holding is likely to be high and vice-versa. Advantages of Maintaining Ample Cash (1) A shield for Technical Inefficiency : The provision of ample cash funds can prove to be a shield for technical inefficiency of a management. (2) Maintenance of Goodwill: The goodwill and reputation of a business firm depends to a large extent on this fact that the firm retires all the obligations and meets the payments as and when they mature. It can be possible only when the firm maintains a good cash balance ascertained carefully for normal operations and adjustment for abnormal contingencies.. (3) Cash Discounts can be Availed : If a firm has sufficient cash, it can avail cash discounts offered by the suppliers. It will lower down the raw material cost and finally the cost of production. (4) Good Bank Relations : Commercial banks like to maintain good relations with such firms having high liquidity in funds. Large companies maintaining large liquid balances of cash in excess of their immediate needs, need to borrow very little if at all, on current account. (5) Exploitation of Business Opportunities:

Firms having good cash position can exploit the business opportunities very well. They can take risk of entering into new ventures. (6) Encourage to new Investments : Firm having good cash position can maintain a sound (cash) dividend policy. It encourages the new investment in the shares of such firm because shareholders like cash dividend more. (7) Increase in Efficiency: Unless there is an adequate supply of cash to bridge the gap a stringency develops. Operations are slowed, if not paralysed. Creditors press for their payments. Inpayments can not be made in time bankruptcy and failure follow. (8) Overcoming Abnormal Situations : Such firms can overcome abnormal financial conditions also with cash and without causing loss to the interest of existing shareholders. (9) Other Advantages : Cash is often the primary factor deciding the course of business destiny. The decision to expand the business, the decision to add any new product in the product line of the company, etc., are decided by the cash position of the firm. Utilisation of Cash Surplus : A cash surplus is obviously a more acceptable proposition for a firm than a cash deficit. However, a cash surplus is idle cash and, therefore, unproductive. This surplus may be deployed for the greater benefit of the firm. If it is available permanently, it may be utilised for the purchase of additional equipment, for expansion, for the introduction of a new product, etc. However, it should not be recklessly squandered on hare brained loss-making schemes simply because it happens to be available. Cash surplus should be utilised in the following ways: (i) If it is available permanently, it should be deployed profitably in the business by a planned phase of re-equipments, expansion, etc. (ii) If it is available for a short period, it may be invested in several short-term

investments like Certificates of Deposit, Commercial Papers, Money Market Mutual Funds etc. However, short-term cash surpluses should not be used in speculative investments. (iii) Short-term surplus may be used to qualify for the benefit of discounts from suppliers by prompt payment or by negotiating concessional prices with the suppliers. (iv) If the cash surplus is permanent, it may be utilised (a) for the repayment of capital borrowed at exorbitant rates of interest; (b) for the extension of loans to subsidiaries; (c) for the investment of funds through mergers and acquisitions; (d) for new plant facilities in order earn a higher rate of return; (e) for the purchase of own securities to be used in acquisitions, stock option plans or other payments; (f) for the investment in the development of a products or the improvement of the old ones, etc. It is not always desirable for a company or group of companies to build up a reserve or surplus cash funds in order to make a more effective use of money. The group may already have borrowed; it is therefore, far betterand more cost effective to reduce such borrowings than to place surplus cash funds in the money market.

Avoiding Cash Deficit or Cash Insolvency Cash deficit, as stated earlier, presents a more difficult problem. A firm may reduce its cash deficit by a closer internal control rather than by resorting to external financing. A cash deficit may be dealt with in the following ways: (i) The collections from customers and sundry debtors should be accelerated. (ii). Liquidating marketable securities held by the firm. (iii) Accounts receivable should be discounted with a bank. (iv) Factoring the receivables (v) Redundant assets should be sold out.

(vi) Payments to suppliers may be deferred to the extent possible. The firm may also take advantage of liberal trade credit terms. (vii) Expenditure on wages, salaries, etc., should be brought under control by maintaining the activity at a constant level instead of encouraging cyclical fluctuations. The payment of corporate taxes cannot be avoided. However, a firm may pay on the last day of payment so that early payment and late payment can both be avoided. (viii)Capital investment decisions should be avoided or delayed in order that a firm may be freed for the time being from commitment of funds. (ix) Interest obligations are contractual. To avoid their payment, therefore, amounts to be default. A firm, however, should ensure that the period of interest payment does not coincide with the payment of inventory or other working capital items. (x) Dividend payments may not be made in cash. It would be worthwhile to take stockholders into confidence to explain clearly the exigency of cash deficit. Nonpayment of dividend might otherwise shatter their confidence. (xi) The bank balance should be maintained in such a manner that cash deficit situations do not get out of hand. (xii) Utilising bank credit The ultimate hazard of running out of cash, however, and the one which lurks in the background of every debt decision, is the situation in which cash is so reduced -that legal contracts are defaulted, bankruptcy occurs and normal operations cease. Since no private enterprise has a guaranteed cash inflow, there must always be some risk, however, this event may occur rarely. Consequently, any addition to mandatory cash outflows resulting from new debt or any other act or event must increase that risk. Costs of Being Short of Cash or Short Costs : The Costs of being short of cash come in the form of not being able to take advantage of discounts, and short-lasting special buying opportunities, and that of cost associated with credit impairment are called short costs. Detailed explanation of these costs are given below:

Loss of Discount : Discounts for paying cash promptly are usually very generous and the effective return on capital employed is often well above that earned on any other asset. To take advantage of discount, cash is required to be paid in very short period of time. For instance, aconcern purchases goods worth Rs. 10,000 on terms Rs. 10,000/2/10, net 30 days. It means if the payment is made within ten days the firm will be entitled for 2% cash rebate; otherwise the payment is to be made within 30 days in full. If the concern wants to use Rs.9,800 for 20 days at a cost of Rs.200 and then its actual cost works to 2.04%. Further,taking the discount would mean a lower acquisition price for inventories. Thus, the impact of not being able to take advantage of a cash discount is therefore quite significant. The quantity discount would require a higher purchase order. As a result, the higher carrying costs might outweigh the advantage of quantity discount. But this may not be true in all cases. Cost associated with credit impairment. (i) No credit given all dealings for cash; alternatively, the credit terms could be made less generous; (ii) Creditors could mark-up their prices up in order to compensate for poor payments; (iii) Suppliers may refuse to deal at all; (iv) Suppliers may give slow or unreliable delivery times, if there is an excess of demand for supplies, then the poor paying firm may find that it is the last on the list of priority customers. (v) Short-term and long-term financing will not be easily obtainable reasonable terms. (vi) Banks may charge (a) higher (bank) charges on loans, overdrafts and cash credits (b)penalty rates to meet a short fall in compensating balances. (vii) The attendant decline in sales and profits;

(viii) In some cases the shortage of cash may lead to creditors to petition for a winding up of the firm. This has very adverse publicity effects. The quantification of credit impairment is difficult and will probably have to be subjectively estimated. Apart from the loss of creditors confidence, a strained liquidity position also places pressures on individual mangers. The amount of time spent by senior executives to satisfy creditors when the cash balances are low is likely to be very costly. Transaction Costs : These costs are associated with raising cash to tide over the shortage of cash. This is usually the brokerage incurred in relation to the sale of some short-term nearcash assets such as marketable securities. These represent the fixed costs associated with the transaction. They consist of both explicit and implicit costs. Borrowing Costs : Interest on loan, commitment charges, and other expenses relating to the loan raised to cover the cash deficit are called borrowing costs. The borrowing or financing costs are closely associated with the opportunity cost. Techniques of Expediting Collections Several techniques are employed to reduce the span between the time a customer makes payment and the time such funds are available for use by a firm. The following are the techniques designed to accelerate the collection of accounts receivables: (i) Concentration Banking (ii) Lock-Box System (iii)Playing on the float. Concentration Banking: In this system, large firms which have a large number of branches at different places, selects some of these which are strategically located as collection centres for receiving payment from customers. Instead of all the payments being collected at the head office of the firm, the cheques from a certain geographical

area are collected at a specified local collection centre. Under this arrangement, the customers are required to send their payments(cheques)to the collection centre covering the area in which they live and these are deposited in a local bank account of the concerned collection centre, after meeting local expenses, if any. Funds beyond a predetermined minimum balance are automatically transferred daily by wire transfer or telex, to a central or concentration banks account. A Concentration bank is the Companys head office bank i.e., one with which the firm has a major account usually a disbursement account. Hence this arrangement is referred to as Concentration Banking. On the basis of their daily report of collected funds, the finance manager can use them according to need. However, the Company will have to incur additional cost to man these collection centres. Compensating balances to cover the cost of service are usually maintained with the local or regional banks. An in-depth cost-benefit analysis of each region, where the collection centre is to be set up, should be undertaken by the company. Normally, the establishment of collection centres depends upon the volume of business in the area. Concentration banking, as a system of decentralised billing and multiple collection points, is a useful technique to expedite the collection of accounts receivable. First of all it reduces the time needed in the collection process by reducing the mailing time. Since the collection centres are near the customers, the time involved in the sending the bill to the customer is reduced. Thus,mailing time is saved both in respect of sending the bill to the customers as well as in the receipt of payment. Secondly, the decentralised system hastens the collection of cheques because most of the cheques deposited in the company ;s regional bank are drawn on banks located in that area. Thus, a company can reduce the time a cheque takes to collect. Lastly, concentration banking permits the company to store its cash more efficiently. This is so mainly because by pooling funds for disbursement in a single account, the aggregate requirement for cash balances were maintained at each branch office. Lock-Box System : Under this arrangement firms hire a post office box at important collection centres. The customers are required to remit payments to the lock box. The local banks of the firm, at the respective places, are authorised to open the box and pick up the remittances(cheques)received from the customers. Usually, the authorised banks pick up the cheques several times a day and deposit them in the firm's, accounts. After crediting the account of the firm, the banks send a deposit slip along .with list of payments and other enclosures, if any, to the firm by way of proof and record of collection. Thereafter, depending upon the arrangements made with each regional lock-box bank, funds in excess of balances maintained to cover costs are transferred automatically to company head quarters. The lock-box system is like concentration banking in that the collection is decentralised and is done at branch level. But the main difference between them is that under concentration banking the customer sends the cheque to the collection centres or local branches while he sends them to a post office box under the lock- box

system. In case of concentration banking, cheques are received by a collection centre and after processing, they are deposited in the bank. The lock-box arrangement is an improvement over the concentration banking system since the former eliminates the processing time the receipt and deposit of cheques within the firm. This system, reduces the exposure to credit losses by expediting the time at which data can come to know of dishonoured cheques and weak credit situations sooner. The lock box bank performs the clerical task of handling the remittances prior to deposits, services which the bank may be able to perform at a lower cost and consequently the overhead expenses are lowered. Further, it facilitates control by divorcing remittances from the accounting department. However, the basic limitation of the lock-box system lies in additional cost which the companys bank will charge in lieu of additional services rendered. Since the cost for these services is directly in proportion to the number of cheques handled by the bank, obviously the lock box arrangement will prove useful and economical too when average remittance is large. Concentration banking is the most popular technique employed by business firms in India to intensify cash inflows. Over three fifth of the firms rely on this technique. There is, however, customers resistance to lock-box system and they insist on sending cheques directly to company head quarters, in spite of companys insistence that remittance should be forwarded to the regional lockbox. The customer have been traditionally used to 7-10 days float (previously involved in making a remittance)and often draw and mail cheques against funds that would not be in their bank accounts for one week. The use of the lock-box system meant that they had to have bank balances to cover such remittances in the bank, not later than one day after the cheque had been mailed. Float: The term float refers to the amount of money tied up in cheques that have been written and issued, but have yet to be collected and encashed. Alternatively, float represents the difference between the bank balance and book balance of cash of a firm. The difference between the balance as shown by the firms record and the actual bank balance is due to transit and processing delays. If the financial manager accurately estimate when the cheques issued will be deposited and collected, he can invest the float during the float period to earn a return. Float used in this sense is called cheque kitting. There are three ways of doing it: (a) paying from a distant bank,(b)scientific cheque encashing involving the time-lag in the issue of cheques and their encashment, and (c)the issue of bank draft. If a firms own collection and clearing process is more efficient than that of the recipients of its cheques-and this is generally true of larger, more efficient firms then the firm should show a negative balance on its own records and a positive balance on the books of its bank. Obviously, the firm must be able to forecast its positive and negative clearing accurately in order to make use of float. Cash Management Models.

Baumol Patinkin, Archer, Miller and Orr, and Orgler have developed some interesting models for cash management and to determine the minimum level of cash balances to be held by a business firm. Baumols mathematical model is based on the combination of inventory theory with monetary theory. In his model, cash is taken as an inventory item which flows out at a constant rate and is replenished instantaneously by borrowing or by selling securities. It is assumed that the size and timing of cash inflows are fully controllable to which a fixed cost per order(cost of converting the securities into cash) and a variable carrying cost per rupee (in the form of opportunity cost of holding cash i.e., the return on marketable securities) are attached. Since the cash outflows are known the only cash management decision is to decide about the volume of cash and the frequently at which cash is to be procured. Baumol has concluded that generally some cash should be kept even in a state of no change and that the transaction demand for cash will vary approximately in a proportion with the money value of transactions with the object of minimising total cost. However, since the model is subject to unreal assumptions, it does not provide an applicable tool for cash management. Patinkins model attempts to determine the optimum level of cash balance at the beginning of each period with the object of minimising the probability of cash shortage during the period. This model also assumes that (i) net cash flows in each period are equal to zero; (ii) cash flows cannot be controlled by a financial executive; and iii) all transactions between cash and other assets take place at the beginning of each period. Though this model takes into account both the cash inflows and outflows and is, unlike Baumols model, deterministic in nature, the above assumptions limit the practical application of the model. Mehta observes that as an approach to cash management, the Economic Order Quantity (EOQ)model is less than satisfactory. The assumptions about cash flows create problems. Unlike the physical stock, the cash inflows, will be interspersed with payments and at times receipts may exceed cash outflows. In fact, the cash balance can move in either direction, whereas in the usual inventory model demand' during any period is assumed to be non-negative. Archers simple probabilistic model aims at determining optimum level of cash and marketable securities together to be held by a business firm. About this model, it has been commented that the model is largely based on a financial officers subjective decision. Merlon H.Miller and Daniel Orr developed somewhat different probability model. In this model, unlike Baumols model, cash flows are assumed to fluctuate in a

completely stochastic manner. Transactions can increase as well as decrease cash balance. Their main assumption about the model is that only two forms of assets exist: cash and marketable securities. As regards the optimum level of cash balance. Miller and Orr suggest that there is not only one specific minimum level of ideal cash balance but a range of ideal cash balances. Within this range cash balance be allowed to move upwards as well as downwards and no action is needed. But when the balance reaches the upper limit of the range, it is to be reduced to a predetermined level by purchasing marketable securities and when the cash balance reaches the lower limit, it is toSpireplenished by the sale of marketable securities. Orglers extensive linear programming model deals with cash management of the firm as a whole. The objective function includes payments, short-term financing, and security transaction. The function is maximised subject to managerial and institutional constraints including minimum cash balance requirements. This model also points towards the value of operations research techniques in cash management. Evaluation of Cash Management : In evaluating cash management, the finance manager has to (i) check all receipts and payments against the projections. (ii)compare the actual performance against predetermined plans and objectives. (iii)find out discrepancy, if any, analysing these variations in order to pinpoint the underlying causes, and (iv) finally take remedial steps to correct the anomaly so that the performance conforms to the plans and goals of the economy. This means that there should be continuous budget evaluation of the cash position so as to make continuous control through policy decisions. The following ratios have been used to evaluate different aspects of cash management performance. 1. To test the adequacy of Cash: (a) Liquid ratio or Quick ratio; (b) Net Cash flows to Current Liabilities ratio; (c) Cash in terms of number of days of current obligations. 2. To assess the effective control of Cash flows:

(a) Cash to current assets ratio; (b) Cash turnover in sales ratio; (c) Rate of growth in cash; and (d) Absolute Liquid funds to current liabilities. 3. For productive utilisation of surplus cash: (a) Marketable securities to current assets ratio; and (b) Marketable securities to absolute liquid funds. To test a firms liquidity and solvency, current ratio and liquid ratio are calculated. Traditionally 2:1 for Current ratio and 1:1 Quick ratio are takto as satisfactory standards for these purposes. The computation of cash in terms of number of days of current obligations is another measure to assess the sufficiency of cash. It is not practical to suggest any standard ratio in this regard to determine the adequacy of cash. It is influenced by the firms cash flows pattern, maturity schedule of its current obligations, and its ability to procure extra funds if develops. The average cash to current assets ratio indicates the firms liquidity position. The proportion of cash to total current assets directly affects the profitability of a firm. A downward trend in this ratio over a period indicates tighter control whereas upward trend reveals a slack control over cash resources. Greater cash turnover in sales indicates the effective utilisation of cash resources. If a business can turnover its cash larger number of times, it can finance greater volume of sales with relatively lesser cash resources. This will increase the profitability of a concern. Moreover, such a business would not require proportionate increase in cash resources with the increase in sales volume. The proportion of marketable securities in current assets indicates the firms prudence to invest temporary surplus in such short term investments to augment its over all profitability. Firms in India do not normally purchase marketable securities for the purpose of investing idle cash for short durations for two reasons:

(i) Most of the firms consider it to be a speculative activity not meant for manufacturers and (ii)investment in securities has same element of risk on account of fluctuations in their prices. Illustration 1 The following information is available in respect of a firm: (a) On an average accounts receivable are collected after 80 days; inventories have an average of 100 days and accounts payable are paid approximately 60 days after they arise. (b) The firm spends a total of Rs. 1,81,20,000 annually at a constant rate. (c) It can earn 8% on investments. Calculate: (i) the firms cash cycle and cash turnover assuming 360 days in a year; (ii) minimum amounts of cash to be maintained to meet payments as they become due; (iii)savings by reducing the average age of inventories to 70 days. Solution (i)Cash cycle: 80 days+100-60 = 120 days Cash Turnover= 360 divided by 120 days = 3 times Total operating annual outlay (ii) Minimum operating cash = Cash turnover = Rs. 1,81,20,000 + 3 = Rs.

60,40,000 (iii) Savings by reducing the average age of inventory to 70 days New Cash cycle = 120 days - 10=days New Cash Turnover = 360 = 3.2727 times New Minimum operating cash = Rs.1,81,20,000 / 3.2727 = Rs. 55,36,713 Reduction in investments = (Rs. 60,40,000 - Rs. 55,36,713) = Rs. 5,03,287 Savings = 8% on Rs. 5,03,287 = Rs. 40,263. Illustration 2 A firm uses a continuous billing system that results in an average daily receipt of Rs.40,000.00. It is contemplating the institution of concentration banking, instead of the current system of centralised billing and collection. It is estimated that such a system would reduce the collection period of accounts receivable by 2 days. Concentration banking would cost Rs. 75,000 annually and 8% can be earned by the firm on its investments. It is also found that a lock-box system could reduce its overall collection time by four days and could cost annually Rs. 1,20,000. (i) How much cash would be released with the concentration banking system? (ii) How much money can be saved due to reduction in the collection period by 2 days? Should the firm institute the concentration banking system? (iii) How much cash would be freed by lock-box system? (iv) How much can be saved with lock-box? (v) Between concentration banking and lock-box system which is better? Solution (i) Cash released by the concentration banking system = Rs. 40,00,00 x 2 days = Rs. 80,00,000

(ii) Savings = 8% x Rs.80,00,000 = Rs. 6,40,000. The firm should institute the concentration banking system. It costs only Rs. 75,000 while the savings expected are Rs. 6,40,000. Net savings - 6,40,000 - 75,000 = 5,65,000. (iii) Cash released by the lock-box system = Rs. 40,00,000 x 4 days = Rs. 1,60,00,000. (iv) Savings in lock-box system: 8% on Rs. 1,60,00,000 = Rs. 12,80,000. (v) Lock-box system is better. Its net savings Rs. 11,60,000 (Rs. 12,80,000- Rs. 1,20,000) are higher than that of concentration banking. Net savings = 12,80,000 - 1,20,000 = Rs. 11,60,000 Difference net saving = 11#0,000 - 5,65,000 = 5,95,000 Additional savings Rs. 5,95,000 if lock box system is introduced. Hence it is better to go for lock box system. REVIEW QUESTIONS 1 Explain the nature of cash and state the scope and objectives of cash management. 2. Since cash does not earn can we still call it a working asset? Why? What are the principal motives for holding cash? How do they relate to cash as a working asset. 3. Enumerate the factors that influence the size of cash holdings of company. Discuss the inventory approach to cash management. 4. Discuss the methods accelerating cash inflows and decelerating cash inflows of a company. 5. Describe how a lock-box arrangement may be used to accelerate cash flow. What costs are involved with the use of a lock-box?

6. Discuss the management problems involved in planning and control of cash. Explain the main tools of cash planning and control. 7. What is a firms cash cycle ? How are the each cycle and cash turnover of a firm related? What should a firms objectives with respect to its cash cycle and cash turnover be? 8. Explain the following: (a) Compensating balance (b) Deposit float (c) Lock-box system (d) Cash forecast (e) Cash Budget (f) Cash ratios (g) Cash reports (h) Cash flow statement (i) Payment float (j) Cash losses PRACTICAL PROBLEMS 1. A firm purchases raw-materials on credit of 30 days. All the sales of the firm are made on credit basis and the credit term allowed to its customers is 60 days. However in actual practice the average age of the, firms Accounts Payables is 35 days and that of Accounts Receivables is-70 days. The average age of the firms inventory (that is the time-lag between the purchase of raw-materials and the sale of finished goods.) is 40 days. From the above data calculate (i) The firms cash-cycle and (ii) The firms cash turnover.

2. A group of new customers with 10% risk of non-payment desires to establish business connections with you. This group would require one and a half month of credit and is likely to increase your sales by Rs.60,000 p.a. Production, administrative and selling expenses amount to 80% of sales. You are required to pay income-tax @ 50%. Should you accept the offer if the required rate of return , is 40% (after-tax)? [Ans.: Return 50% This is higher than desired rate of return of 40% and hence the offer should be accepted.]

3. A Companys present credit sales amount of Rs.50lakhs. Its variable cost ratio is 60% of sales and fixed costs amount to Rs.10 lakhs per annum. The company proposes to relax its present credit policy of 1 month to either 2 months or 3 months, as the case may be. The following Information are also available : Policy 2 Average age of debtors Increase in sales Percentage of bad debts 3 months 30% 5.0 1 months -1.0 2 months 20% 2.5 Present Policy Policy I

If the company requires a return on investment of 20% before tax, evaluate the proposals. [Ans.: Policy 1 is more profitable as it gives surplus of Rs.2,13,333 after meeting the required return on investment at 20% before tax.] SUGGESTED READINGS

1. Bhabatosh Banerjee : Cash Management Calcutta, The World Press (P) Ltd., 2. Khan, M.Y. and : Financial Management, Jain, P,K. New Delhi, Tata McGraw Hill Co. 3. Pandey, I.M : Financial Management, New Delhi, Vikas Publishing House 4. Van Home, James C. : Financial Management and Policy, New Delhi, Prentice Hall of India.