Working Capital Management

Learning Objectives
Overtrading Symptoms of poor W. C. management W.C. management Strategies Tondon committee /Chore Committee Recommendations Latest trend in W.C. finance R.B.I guidelines on W.C. finance

Introduction
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All businesses need cash to survive Cash is needed to: Invest in fixed assets Pay suppliers and employees Fund overheads and other fixed costs Pay tax due to the Government Nearly all businesses use much of their cash resources to finance investment in working capital Managing working capital effectively is, therefore, a vital part of making sure the business has enough cash to continue

What is Working Capital?

Working capital management is a significant in financial management due to the fact that it plays important role in running of an business enterprise. y Lack of efficient and effective utilisation of working capital leads to earn low rate of return on capital employed . y A firm invests a part of its permanent capital in fixed assets and keeps part of it for working capital.
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The requirement of working capital varies from firm to firm depending upon the nature of business ,production policy,market conditions. y A company invests its funds for long term purposes and for short term operations.A portion of companys capital invested in short term or current assets to carry on its day to day operations is called as working capital. y Working capital refers to firms investment in short term assets such as cash,amount receivables,inventory,work in progress,finished goods etc minus current liabilities.
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The efficient working capital management is necessary to maintain a balance of liquidity and profitability.

Objectives of working capital management

By optimising the investment in current assets and by reducing level of current liabilities ,the company can reduce the locking up of funds in working capital,thus it can improve return on capital employed. y Company should be always in such a position that it should meet the current obligations which should be properly supported by current assets. y The firm should manage its current assets in such a way that return on investment in these assets is not less than cost of capital employed to finance current assets.
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Gross working capital-The term gross working capital refers to the firms investment in current assets.According to this concept amount of current liabilities is not deducted from total amount of current assets. y Net working capital-The term net working capital refers to the excess of current assets over current liabilities i.e difference between current assets and current liabilities.Net working capital indicates the liquidity position of the firm.
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Permanent working capital-The amount of investment in working capital may increase or decrease over a period of time according to level of production. but there is a need for minimum level of working capital to carry its business irrespective of change in the level of production, such minimum level of working capital is called permanent working capital or regular WC. y Temporary working capital-It is also called as fluctuating working capital. It depends upon the changes in the production or sales. It is the extra working required to support the changing business activities.
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Factors determining working capital requirement

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Nature of business-If we look at any trading organization ,major part of resources are deployed on current assets e.g. stock in trade, whereas in case of transport organization major part of funds are locked in fixed assets like motor vehicles. Any service provider firm will require even lesser working capital. Therefore the requirement of working capital depends upon nature of business.

Manufacturing cycle-Time span required for conversion of raw materials into finished goods is a block period, this cycle determine the need of working capital. In case of industries with long manufacturing process or production cycle more funds are required for working capital. The industries which convert quickly raw materials in to finished goods requires lesser amount of working capital.
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Business Cycle-Economic boom or recession have their influence on transactions and consequently on the amount of working capital required. More working capital is needed during peak or boom conditions but in case of economic recession company requires less working capital. Seasonal variations-for example mustard or oil seeds are rabbi crops, so these are needed to be purchased in a season to ensure continuous operation of oil plant. Manufacturing operations continue for whole year and result into blockage of funds in raw materials which are seasonally available

Scale of operations-Higher the scale of operation higher is the requirement of working capital. Sales turnover is also another factor ,quick turnover means lesser investment in inventory while low turnover rate results in large investment . y Inventory policy-Traditional production systems generate more stocks of finished goods and raw materials., in such cases more WC is required but adoption of JIT drastically reduce the levels of raw materials,WIP,finished goods. therefore less amount of funds invested in inventory
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Credit policy-Amount of money locked up in account receivables has its impact on working capital.The liberal credit period will increase the investment in debtors balances and thus increase WC requirement. y Business standing-In case of newly established concerns the materials are required to be purchased in cash and the sales are to be made on credit basis ,such new concerns require high WC ,but the established companies can negotiate for credit terms with suppliers and sell the products at lesser credit period to customers
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Supply situation-In easy and stable supply situation precautionary steps in inventory investment can be avoided ,but in case of supply uncertainties lead time may be longer resulting into higher carrying cost and higher need of WC.

Overtrading
Overtrading represents an imbalance between the orders a business accepts and the means it has to fulfill them. y Overtrading happens when a business takes on customer orders, but does not have enough current assets, or working capital, to meet these demands y Overtrading is particularly common in young, rapidly expanding businesses. It can be extremely serious, even fatal to the business
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Impact of overtrading on WC
Overtrading arise when a business expands beyond the level of funds available. y Overtrading means an attempt to finance a certain volume of production with inadequate WC. y If the company does not have enough funds of its own to finance stock and if it wishes to expand then it is forced to borrow from creditors and from bank in the form of overdraft.
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Sooner or later such expansion ,financed completely by the funds of others will lead to a chronic imbalance in WC ratio. y A firm should always maintain adequate WC to support its sales activity. y Overtrading is a situation where a firm attempts to increase the sales level without having support of adequate WC. y The overtrading situation lead to higher pressure on liquidity and the firm will find difficult to pay to creditors in given credit period.
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This in turn would lead to difficulty in procurement of raw materials in time, this will adversely affect the production process and the firm will be forced to slow down its activity. y WC position is adversely affected and leads to negative profitability of the firm ,therefore overtrading should be detected in time and remedial action should be taken either to increase the WC to match the increased sales level or the firm should slow down its activity level to match the WC available with the firm.
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Symptoms of poor working capital management

Excessive carriage of inventory over the normal levels required for the business will result in more balance in trade creditors account .More creditors balances will cause strain on management of cash. y Working capital problems will arise when there is a slow down in collection of debtors. y Sometimes capital goods will be purchased from the funds available for working capital,this will result in shortage of funds for WC.
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Unplanned production schedules will cause excessive stocks of finished goods or failure in meeting dispatch schedules. More funds kept in the form of cash will not generate any profit for the business. Inefficiency in using potential trade credit require more funds for financing WC Overtrading will cause shortage of WC and its ultimate effect is on the operation of the company Dependance on short term sources of financing permanent WC causes lesser profitability and will increase strain on the management of WC.

Inefficiency in cash management y Inability to get working capital limits will cause serious concern to the company and sometimes may turn out to be sick.
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Strategies in WC Management
Conservative Approach y Aggressive Approach y Matching Approach y Zero working capital approach y Working capital policies
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Conservative Approach
Conservative approach suggests not to take any risk in working capital management and to carry high levels of current assets in relation to sales. y Surplus current assets enable the firm to absorb sudden variation in sales and production plan. y It requires to maintain a high level of working capital and it should be financed by long term funds like share capital or long term loan.
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Availability of sufficient working capital will enable the smooth operational activities of the firm and there would be no stoppages of production for want of raw materials . y In this approach sufficient stocks of finished goods are maintained to meet market fluctuations. y Conservative policy will enable a firm to absorb day to day business risk and ensures continuous flow of operations
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Under this approach Long term funds= Fixed assets + total permanent current assets + Part of temporary current assets Short term funds= Part of temporary current assets

Aggressive approach y Under this approach current assets are maintained just to meet the current liabilities without any cushion for variation in working capital needs. y The core working capital is financed by long term sources and seasonal variations are met through short term borrowings. y Adoption of this strategy will minimise the investment in net working capital. y In this approach short term financing is used to finance current assets.
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Financing strategy y Long term funds=Fixed assets + part of permanent current assets y Short term funds=Part of permanent current assets + total temporary current assets.
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Matching Approachy The basic objective of this method of financing is that permanent component of current assets and fixed assets is financed by long term funds and short term or seasonal variations is met through short term debt. y Financing strategy y Long term funds=Fixed assets + total permanent current assets y Short term funds=Total temporary current assets
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Zero working capital approachy This is one of the latest trends in working capital management. y According to this approach at all the times current assets shall be equal to current liabilities. Excess investment in current assets is avoided and firm meets its current liabilities through current assets. y By this approach the firm saves opportunity cost on excess investment in current assets
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There is a self imposed financial discipline on the firm to manage their activities within their current liabilities and current assets and there is not a tendency to over borrow and divert funds. y Zero working capital also ensure a smooth and uninterrupted working capital cycle. y Total current assets=Total current liabilities.
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Working capital policies-In practice business concern follows three forms of working capital policies y Restricted policy-In this policy rigid estimate of working capital is done and it is forced to adhere to that estimate. Deviation from estimate are not allowed and estimate does not provide any contingencies to the WC. y Relaxed Policy-It involves the allowing of sufficient cushion for fluctuations in funds requirements for financing various items of working capital.The estimate is made after taking in to account the provisions for contingencies.
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Moderate policy-The working capital level estimated in between the two extremes i.e restricted and relaxed policies.The relationship of sales and corresponding levels of investment in current assets .

Management of cashy Management of cash protects the financial condition of the firm by developing a projected cash statement from a forecast of expected cash inflows and outflows for a given period. y Advantages of management of cash y The life or death of any business enterprise depends upon the availability of cash.A business firm incurring losses can still survive because of sufficiency of cash.
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A efficient cash planning through cash budget may enable a firm to obtain optimum WC and can ease strain on cash shortage. y Cash is said to be life blood of business,it must be kept circulating round the arteries of business because if the circulation gets clogged ,sickness or death may occur. y The first priority of any business is survival and this happens only when company remains both liquid and solvent.
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Account Receivable managementProblem of management of receivable arises when goods are sold on credit,if the company makes all sales in cash,there would be no account receivables and therefore the question of account receivable does not arise y Although concession like price discount are granted to customers to make immediate cash payments. y If the firm decides to sell on cash it will save the cost of carrying receivables,but in this case the firm may lose its previous customers who will turn to its rival firms who are givibg credit facilities.
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The firm can not survive in the business by pursuing the policy of cash sales,when other firms are giving liberal credit policy. y Account receivables is a major component of current assets ,this account emerges because of existence of credit sales. y Credit sales no doubt increases turnover and profit of business but carrying the account receivables permanently involves greater risk,hence there is a need for better management of account receivables.
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Inventory management- Inventories represent a very significant proportion of total assets . y For any manufacturing firm it is necessary to have inventory of raw materials,goods in process and inventory of finished goods. y How much funds a firm would require to carry different kinds of inventories to ensure continuous production and to meet customers demands without any delay should be determined by finance manager. y So if the firm maintains excess inventory ,it will incur additional cost of holding that inventory.
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Likewise if the firm keeps the inventory which is less than the required will adversely affect the rate of return as absence of adequate raw materials, production is likely to be hampered .

Latest trends in WC Finance

Working capital finance generally refers to debt raised for a period less than a year from commercial banks,term lending institutions. y Working capital finance can be fund based or non fund based.
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Cash credit- Cash credit refers to a system of financing where a borrower is provided a credit limit. The limits are decided on the total operating cycle and the gap between payment to be received and to be made. y Working capital loan-The firm can take loan to finance the working capital. The loan component covers the permanent part of working capital need and cash credit component covers the fluctuating part of WC.
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Overdrafts-An overdraft is a temporary accomodation by bank by which borrower is allowed to overdraw his current account up to a fixed limit, this system operates exactly on similar lines to that of cash credits,the only difference between the two is that overdraft can be used temporarily ,whereas cash credit is used regularly and for long periods.

Commercial papers-Commercial Paper is a money-market security issued (sold) by large banks and corporations to get money to meet short term debt obligations and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and carries higher interest repayment.

Factoring-Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business.

Export financing- This financial intrument is offered in case of goods exported from the country because of lower interest rates abroad, In order to offset the disadvantage of higher interest rates in india ,banks extend concessional financing for exports, y The export financing can be broadly classified in to two types y Pre-shipment credit y Post-shipment credit
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Pre shipment credit-Preshipment finance is issued by a financial institution when the seller want the payment of the goods before shipment. the main objective behind preshipment finance is to enable exporter to, y Procure raw materials y Carry out manufacturing process y Process and pack the goods y Ship the goods to the buyer
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Pre shipment credit is only issued to that exporter who has the export order in his own name, still there is an exception to this, financial institution can also grant credit to a third party manufacturer or suppliers of goods who does not who does not have export orders in their own name.

Post shipment credit-Post shipment finance Postshipment finance is a loan or advance granted by a bank to an exporter of goods from India. This facility is available to an exporter subsequent to the date of shipment of goods up to the date of realization of export proceeds. y Some key features of post-shipment finance are as follows: y Finance is extended to either the exporter (seller's credit) or the overseas buyer of the goods (buyer's credit). y Finance is extended against evidence of shipping documents. Concessive rate of interest is available for a maximum period of 180 days, starting from the date of submission of documents
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Non fund based or documentary credit instruments

These are commercial documents guaranteeing payment by the bank to the beneficiary. y Letter of credit-A letter of credit is a promise to pay. Banks issue letters of credit as a way to ensure sellers that they will get paid as long as they do what they've agreed to do. Letters of credit are common in international trade because the bank acts as an uninterested party between buyer and seller. For example, importers and exporters might use letters of credit to protect themselves.
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Letter of guarantee- A type of contract issued by a bank on behalf of a customer who has entered a contract to purchase goods from a supplier and promises to meet any financial obligations to the supplier in the event of default.

Deferred payment guarantee- In case of equipment financing,the manufacturer offers credit to the buyers of the equipment at attractive terms to generate additional demands for its products .DPG is a bank facility where the bank extends a guarantee to the equipment manufacturer on behalf of its client .

RBI Guidelines for WC finance

RBI has appointed various committees for prescribing the guidelines for working capital finance,such as Tondon committee and Chore committee.The various recommendations prescribed by these committees are regarded as ideal guidelines for working capital finance. y RBI is going to restrict the corporates from taking external commercial borrowings (ECB) for working capital loans.
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Tondon & Chore Committee Recommendations

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Like many other activities of the banks, method and quantum of short-term finance that can be granted to a corporate was mandated by the Reserve Bank of India till 1994. This control was exercised on the lines suggested by the recommendations of a study group headed by Shri Prakash Tandon

The study group headed by Shri Prakash Tandon, the then Chairman of Punjab National Bank, was constituted by the RBI in July 1974 with eminent personalities drawn from leading banks, financial institutions and a wide crosssection of the Industry with a view to study the entire gamut of Bank's finance for working capital and suggest ways for optimum utilisation of Bank credit

As per the recommendations of Tandon Committee, the corporates should be discouraged from accumulating too much of stocks of current assets and should move towards very lean inventories and receivable levels. y The committee even suggested the maximum levels of Raw Material, Stock-in-process and Finished Goods which a corporate operating in an industry should be allowed to accumulate .
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These levels were termed as inventory and receivable norms. Depending on the size of credit required, the funding of these current assets (working capital needs) of the corporates could be met by one of the following methods:

First Method of Lending: Banks can work out the working capital gap, i.e. total current assets less current liabilities other than bank borrowings (called Maximum Permissible Bank Finance or MPBF) and finance a maximum of 75 per cent of the gap; the balance to come out of long-term funds, i.e., owned funds and term borrowings. This approach was considered suitable only for very small borrowers i.e. where the requirements of credit were less than Rs.10 lacs

Second Method of Lending: Under this method, it was thought that the borrower should provide for a minimum of 25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for purchases and other current liabilities will be available to fund the build up of current assets and the bank will provide the balance (MPBF).

Consequently, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets. RBI stipulated that the working capital needs of all borrowers enjoying fund based credit facilities of more than Rs. 10 lacs should be appraised (calculated) under this method.

Third Method of Lending: Under this method, the borrower's contribution from long term funds will be to the extent of the entire CORE CURRENT ASSETS, which has been defined by the Study Group as representing the absolute minimum level of raw materials, process stock, finished goods and stores which are in the pipeline to ensure continuity of production and a minimum of 25% of the balance current assets should be financed out of the long term funds plus term borrowings.