WORKING CAPITAL IN BUSINESS

WHEELS

OF INDUSTRY RUN SMOOTH WITH ADEQAUTE

WORKING CAPITAL

WORKING CAPITAL AND ITS ASSESSMENT

IN ANY BUSINESS CURRENT ASSETS DRIVE THE USE OF

FIXED ASSETS FOR PRODUCTION OF GOODS AND SERVICES. COMPONENTS OF CURRENT ASSETS OR GROSSS WORKING CAPITAL ARE MAINLY INVENTORY, RECEIVABLES AND CASH BALANCES. CURRENT ASSETS GET CONVERTED TO CASH WITHIN AN OPERATING CYCLE. THREE CAB BE NO INCOME GRENERATION WITHOUT FUNDS DEVELOPMENT IN CURRENT ASSETS.
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IMPORTANCE OF WORKING CAPITAL

WITHOUT ADEQUATE

WORKING CAPITAL BUSINESS

WILL RUN INTO DIFFICULTIES. LACK OF ADEQUATE WORKING CAPITAL IS AN INDICATOR OF POTENTIAL PROBLEMS. ADEQUATE WORKING CAPITAL CAN HELP GROWTH.

HOW MUCH CURRENT ASSETS?

EXCESS WORKING CAPITAL IS A DRAG ON PROFITABILITY

SHORTAGE OF WORKING CAPITAL LEADS TO REDUCTION IN ACTIVITY LEVEL AND HENCE PROFITS. HOLDING OF INVENTORY DEPENDS ON MANY FACTORS. RECEIVABLES LEVEL DEPENDS ON CREDIT PERIOD GIVEN TO BUYERS. THIS IS DETERMINED BY INDUSTRY PRACTICE, RELATIVE STRENGHTS OF BUYER AND SELLER, MATERIAL AVAILABILITY AND RISK PERCEPTIONS.

INVENTORY HOLDING
LEVEL OF HOLDING RAW MATERIALS IS DEPENDENT ON

MANY FACTORS-IMPROVED OR INDIGENOUS, AVAILABILITY-SEASONAL OR ROUND THE YEAR, MINIMUM PURCHASE QUANTITY, TIME TAKEN FOR SUPPLY ETC.
SEMI FINISHED/WORK IN PROCESS LEVEL IS DEPENDENT ON PROCESS TIME. MINIMUM DESPATCH QUANTITY, INSPECTION TIME, AVAILABILITY OF SHIPPING SPACE FOR EXPORTS, ETC DETERMINE THE FINISHED GOODS HOLDING.
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INVENTORY MANAGEMENT PRINCIPLES

THESE RELATE MAINLY TO RAW MATERIALS, STORES ETC

WHICH ARE PURCHASED REGULARLY. CARRYING INVENTORY HAS A COST; FUNDS ARE INVESTED IN INVENTORY AND EXCESS INVENTORY WILL RESULT IN HIGHER COSTS. EVERY PURCHASE HAS AN ORDERING COST. HOLDING LOW INVENTORY MAY REDUCE COST OF CARRYING INVENTORY BUT WITH INCREASE IN THE FREQUENCY OF PURCHASE, ORDERING COSTS GO UP.
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INVENTORY MANAGEMENT
STOCK

OUT COST IS THE INCURRED DUE TO LOSS IN PRODUCTION DUE TO NON AVAILABILITY OF MATERAILS. STOCK OUT COST CAN ALSO ARISE DUE TO NOT HAVING STOCKS OF FINISHED GOODS FOR READY SALE. THE STOCK OUT OF FINISHED GOODS RESULTS IN LOSS OF IMMEDIATE SALE AND THE POTENTIAL LOSS OF FUTURE SALES IS ALSO HIGH.

THE OBJECTIVE OF INVENTORY MANAGEMENT IS TO MINIMISE THE TOTAL COST COSTS OF CARRY AND ORDERING COST WHILE AT THE SAME TIME ELIMINATE STOCK OUT COSTS.
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BASICS OF INVENTORY MANAGEMENT

ECONOMIC

ORDER QUANTITY (EOQ) IS THE MINIMUM ORDER QUANTITY PER ORDER WHICH WILL MIMIMISE TOTAL COST.

EOQ = (2AC/H), WHERE A = ANNUAL USAGE C = ORDERING COST AND H = INVENTORY CARRYING COST. REORDER LEVEL IS THE TIME AT WHICH THE ORDER FOR EOQ IS TO BE PLACED REORDER LEVEL = MAXIMUM USAGE X MAXIMUM LEAD TIME. MINIMUM STOCK LEVEL = REORDER LEVEL AVARAGE USAGE X AVERAGE LEAD TIME. MAXIMUM STOCK LEVEL = REPRORDER LEVEL (MIN. USAGE X 8 MIN. LEAD TIME) + ORDER QUANTITY.

RECEIVABLES MANAGEMENT
RECEIVABLES ARISE

OUT OF CREDIT SALES; MANAGEMENT HAS TO DECIDE TO WHOM TO GIVE CREDIT AND TO WHAT EXTENT.

A LAX RECIVABLE MANAGEMENT WILL LEAD TO HIGHER WORKING CAPITAL REQUIREMNT AND INCREASED COSTS AND MORE BAD DEBTS, TOO. A VERY CONSERATIVE APPROACH TO SELLING ON CREDIT MAY RESULT IN LOSS OF COMPETITIVENESS AND LOWER SALES. COLLECTION OF RECEIVABLES IN TIME IS AN ESSENTIAL PART OF RECEIVABLES MANAGEMENT.
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CASH AND BANK BALANCES

CASH

IS AN IDLE RESOURCE; BANK BALANCES TOO DO NOT YIELD ANY RETURN.

IN THE CASE OF COMPANIES WITH OFFICES AT MANY LOCATIONS, THE REQUIREMENT OF CASH & BANK BALANCES AT VARIOUS CENTRES WILL POSE CHALLENGES TO REDUCE IDLE ASSTES. CASH MANAGEMNT SERVICES PROVIDED BY BANKS OPTIMISE THIS ITEM OF CURRENT ASSETS. THE MINIMUM HOLDING OF CASH & BANK WILL DEPEND ON CIRCUMSTANCES.
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SOURCES OF WORKING CAPITAL FINANCE

ACCOUNTS

PAYABLE + OWN FUNDS + BANK FINANCE CONSTITUTE THE SOURCES FOR THE DEVELOPMENT IN CURRENT ASSETS.

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NET WORKING CAPITAL

OWNERS CONTRIBUTION

TO MEET PART OF DEVELOPMENT IN CURRENT ASSETS IS KNOWN AS NET WORKING CAPITAL.

NWC = EXCESS OF LONG TERM SOURCES LONG TERM USES = CURRENT ASSETS CURRENT LIABILITIES. BANK FINANCE IS RESTRICTED GENERALLY TO VALUE OF CHARGEABLE CURRENT ASEETS MARGIN (USUALLY 25%). CHARGEABLE CURRENT ASSETS ARE INVENTORY & RECEIVABLES.
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WORKING CAPITAL LEVERAGE

WORKING

CAPITAL LEVERAGE IS DEFINED AS THE RATIO OF CHANGE IN RETURN ON INVESTMENT ( ROI) TO CHANGE IN GROSS WORKING CAPITAL ( CA).

WORKING CAPITAL LEVERAGE = CA /(TA- CA) FOR DECREASE IN LEVEL OF CURRENT ASSETS. LEVERAGE = CA /(TA + CA) FOR INCREASE, WHERE TA = TOTAL ASSETS = FIXED ASSETS + CURRENT ASSETS.

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METHODS OF ASSESSMENT
TURNOVER

METHOD.

BANK FINANCE = 20% OF ESTIMATED GROSS SALES. THE LEVEL OF GROSS WORKING CAPITAL IS 25% OF GROSS SALES OR 3 MONTHS SALES.

MINIMUM NET WORKING CAPITAL OR MARGIN IS 5%.

SO, BANK FINANCE IS (25%-5%) EQUAL TO 20% OF ESTIMATED GROSS SALES. A SMALL UNIT HAS GROSS SALES OF Rs. 50 LAKHS PER ANNUM AND ESTIMATES GROWTH AT 30% THIS YEAR. WHAT IS THE PERMISSIBLE BANK FINANCE UNDER TURNOVER METHOD.

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OPERATING CYCLE METHOD

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OPERATING CYCLE METHOD (CONTD)

THE

METHOD CONSIDERS THE AMOUNT OF BLOCKAGE OF FUNDS AT THE VARIOUS STAGES OF OPERATING CYCLE.

BANK FINANCE = FUNDS BLOCKED IN OPERATING CYCLE LESS TRADE CREDIT LESS NWC. WEIGHTED OPERATING CYCLE TIME IS THE WEIGHTED SUM OF THE DURATIONS OF EACH COMPONENT OF THE OPETAING CYCLE.

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WEIGHTED OPERATING CYCLE

IF

DRM IS THE DURATION OF RAW MATERIAL STAGE, THIS IS WEIGHTED BY WRM = COST OF RAW MATERIAL/ SELLING PRICE.

WIP DURATION IS WEIGHTED BY WRM = COST OF PRODUCTION/SELLING PRICE. DURATION OF FINISHED GOODS WEIGHTED BY WFG = COST OF SALES/SELLING PRICE. WEIGHTED OPERATING CYCLE = DRM *WRM + DWIP *WWIP + DFG * WFG + DAR *WAR. WORKING CAPITAL REQUIREMENT = SALES PER DAY * WEIGHTED OPERATING CYCLE + MINIUM CASH BALANCE REQUIRED. BANK FINANCE = WORKING CAPITAL REQUIREMENT TRADE 17 CREDITORS NWC.

AN EXAMPLE OF OPERATING CYCLE METHOD

INDIAN MOTOR PARTS MANUFACTURING LTD HAS A WEIGHTED OPERATING CYCLE TIME OF 58 DAYS AND ITS MINIMUM CASH BALANCE IS RS 15 LAKHS. SALES PER DAY IS RS 40 LAKHS. ESTIMATE BANK FNANCE IF TRADE CREDITRORS ARE RS 255 LAKHS AND NWC OF COMPANY IS 880 LAKHS. WORKING CAPITAL REQUIREMENT = 58*40+15=2335. BANK FINANCE = 2335-255-880=1200 LAKHS.

DRAW BACK IN THIS METHOD IS THE ESTIMATION OF WORKING CAPITAL CYCLE FOR DIFFERENT PRODUCTS.

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PROJECTED BALANCE SHEET METHOD (PBS)

UNDER

PBS, THE PROJECTED OPERATING STATEMENT AND BALANCE SHEET FOR THE CURRENT YEAR AND THE NEXT YEARS PER CMA FORMAT ARE OBTAINED AND THE LEVEL OF CURRENT ASSETS AND CURRENT LIABILITIES OTHER THAN BANK ARE CHECKED FOR VARIATION FROM PAST HOLDING LEVELS.

IF HOLDING LEVELS ARE FOUND TO BE ACCEPTABLE, THE ASSESSMENT OF BANK FINANCE IS MADE AS BELOW:

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PROJECTED BALANCE SHEET METHOD

WORKING

CAPITAL GAP(WCG) = CURRENT ASSETS LESS CURRENT LIABILITIES OTHER THAN BANK BORROWINGS.

BANK FINANCE = WCG NET WORKING CAPITAL. UNDER 1ST METHOD OF LENDING, NWC = 25% OF WCG. UNDER 2ND METHOD OF LENDING, NWC = 25% OF CA. THE 3RD METHOD STIPULATES THAT THE NWZ = CORE CURRENT ASSETS; BUT THIS METHOD HAS NOT BEEN IMPLEMENTED IN VIEW OF DIFFICULTY IN ASCERTAINING CORE CURRENT ASSETS.
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SECOND METHOD OF LENDING

FOR

WORKING CAPITAL LIMIST ABOVE Rs. 10 LAKHS, MINIMUM NWC IS 25% OF CURRENT ASSETS.

BANK FINANCE = WORKING CAPITAL GAP 25% OF CA. THE TANDON STUDY GROUP CONSTITUTED BY RBI, STIPULATED THE NORMS OF INVENTORY AND RECEIVABLES HOLDINGS FOR VARIOUS INDUSTRIES AND ALSO RECOMMENDED THE THREE METHODS OF LENDING. RBI ACCEPTED THE RECOMMENDATIONS AND INSTRUCTED BANKS TO IMPLEMENT THE MAXIMUM PERMISSIABLE BANK FINANCE (MPBF) USING THE NORMS FOR INVENTORY AND RECEIVABLE AND NWC AS PER SECOND METHOD OF LENDING. 21

POST REFORMS SCENARIO IN BANK FINANCE

BANKS ARE

FREE TO DETERMINE THE HOLDING LEVELS OF INVENTORY AND RECEIVABLES.

CURRENT RATIO OF 1.33 IS NOT MANDATORY. BIFURCATION OF WORKING CAPITAL LIMITS TO WORKING CAPITAL DEMEND LOAN AND OPERATIVE CASH CREDIT PORTION FOR LIMITS OVER RS. 20 CRORE IN THE RATION OF 80:20. WHAT IS THE RATIONALE IN BIFURCATION TO WCDL & C/C?

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CASH BUDGET METHOD

CASH

BUDGET METHOD FOR ASSESSING WORKING CAPITAL REQUIREMENTS IS USED IN SEASONAL INDUSTRIES AND CONSTRUCTION PROJECTS.

IT IS ALSO BE USED FOR SHORT TERM ADDITIONAL REQUIREMNETS FOR EXECUTION OF SPECIFIC ORDERS. THE MONTHWISE RECEIPTS AND PAYMENTS ARE PROJECTED FOR THE NEXT 12 MONTHS AND THE CASH DEFICIT IS FINANCED. THE METHOD ALSO TAKES INTO ACCOUNT THE FINANCIAL STRENGHT OF BORROWER.
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COMMERCIAL PAPER
COMMERCIAL

PAPER IS A STAND ALONE MONEY MARKET BORROWING REGULATED BY RBI.

CP CAN BE ISSUED BY A COMPANY HAVING A MINIMUM NET WORTH OF RS 4 CRORE.

MINIMUM PERIOD 7 DAYS TO A MAX OF ONE YEAR. CP INSTRUMENT MUST BE RATED BY AN APPROVED CREDIT RATING AGENCY AND MINIMUM RATING IS P2. ISSUED IN DEMATERIALISED FORM THROUGH BANK WHICH ACTS AS ISSUING AND PAYING AGENT. CP IS AN ADDITIONAL SOURCE OF SHORT TERM FINANCE FOR HIGHLY RATED CORPORATES AT MARKET RELATED INTEREST 24 RATE.

CLASSIFICATION OF WORKING CAPITAL FINANCE

STAGE PRE SALE PRODUCTS CASH CREDIT / OVERDRAFT

(PRESHIPMENT)
POST SALE (POST SHIPMENT)

LOANS PACKING CREDIT

IMPORT TRUST LOAN CASH CREDIT / OVERDRAFT BILLS PURCHASE FACTORING / FORFAITING ADVANCE AGAINST BILLS

FINANCE MAY BE MADE AVAILABLE IN FOREIGN CURRENCY FOR EXPORTS WHAT IS THE ADVANTAGE IN AVAILING PCFC OR PSFC?

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NON FUND FACILITIES

MOST

COMMONLY USED FACILITIES LETTERS OF CREDIT AND GUARANTEES.

FROM THE FINANCIAL STATEMENTS OF A PUBLIC SECTOR, A PRIVATE SECTOR AND FOREIGN BANK, (SAY, SBI, ICICI BANK AND CITIBAK), COMPARE THE LEVELS OF L/C, AND GUARANTEE OBLIGATIONS OUTSTANDING IN ABSOLUTE TERMS AS ALSO AS PERCENTAGE OF TOTAL ASSETS. WHAT ARE THE ADVANTAGES THAT FOREIGN BANKS HAVE IN NON FUND BUSINESS?

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L/C PROCESS FLOW

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LETTER OF CREDIT
HOW

DOES L/C MECHANISM REDUCE PAYMENT RISKS IN TRADE?

WHAT IS THE RISK THAT L/C DOES NOT COVER? DIFFERENT TYPES OF L/C
- IRREVOCABLE, CONFIRMED - REVOCABLE - INLAND AND FOREIGN - DOCUMENTS AGAINST PAYMENT, DOCUMENTS AGAINST ACCEPTANCE AND CLEAN L/CS - RED CLAUSE L/C AND GREEN CLAUSE L/C - REVOLVING L/C - STAND BY L/C

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L/Cs & GUARANTEES

BOTH

L/CS AND GUARANTEES ARE PAYMENT GUARANTEES. L/C GUARANTEES PAYMENT TO CUSTOMER IF THERE IS PERFOMANCE AS PER TERMS OF L/C WHILE PAYMENT IS MADE TO BENEFICIARY UNDER GUARANTEE IF THERE IS NON PERFORMANCE BY THE CONTRACTOR (Customer). THERE IS NO OUTLAY OF FUNDS AT THE TIME OF ISSUE. BANK EARNS COMMISSION FOR L/C AND GTY. L/Cs ARE GOVERNED BY PROVISIONS OF UCPDC FORMULATED BY ICC. GUARANTEES ARE GOVERNED BY LOCAL LAWS.
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GUARANTEES
TYPES

OF GUARANTEES

- FINANCIAL - PERFORMANCE

BID

BOND, ADVANCE PAYMENT GUARANTEE, GUARANTEE IN LIEU OF DEPOSIT (SECURTY DEPOASIT) ETC ARE FINANCIAL GUARANTEES WHERE BANK GUARANTEE SUBSTITUTES PAYMENT OF MONEY BY CUSTOMER TO BENEFICIARY.

PERFORMANCE GUARANTEES ARE FOR PAYMENT OF DAMAGES INCASE OF UNSATISFACTORY PERFORMANCE OF CONTRACT.

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RBI GUIDELINES ON ASSESSMENT OF NFB LIMITS

LETTERS

OF CREDIT AND GUARANTEES CAN BE ISSUED ONLY ON BEHALF OF A CUSTOMER.

ASSESSMENT OF NON FUND LIMITS IS TO BE DONE WITH THE SAME DILIGENCE AS FOR FUND BASED LIMITS.

PERFORMANACE GUARANTEES SHOULD BE GIVEN ONLY ON BEHALF OF CUSTOMERS WITH GOOD TRACK RECORD AND PROVEN EXPERTISE IN LINE OF BUSINESS.
L/CS AND GUARANTEES ARE TO BE OPENED ONLY AFTER ASCERTAINING THAT THE CUSTOMER HAS THE ABILITY TO PAY IN CASE OF DEFAULT RESULTING IN L/C DEVELOPMENT OR GTV INVOKATION.
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