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ASSIGNMENT REFERENCE MATERIAL

Course Code : MS - 41
Course Title : Working Capital Management
Assignment Code : MS-41/SEM - I /2011
Coverage : All Blocks
Note: Answer all the questions and send them to the Coordinator of the Study Centre you are
attached with.
1. What are the various forms of working capital finance available from banks?
Working capital financing comes in many forms, each of which has unique terms and offers
certain advantages and disadvantages to the borrower.
Line of Credit
A line of credit is an open-ended loan with a borrowing limit that the business can draw
against or repay at any time during the loan period. This arrangement allows a company
flexibility to borrow funds when the need arises for the exact amount required. Interest is
paid only on the amount borrowed, typically on a monthly basis. A line of credit can be
either unsecured, if no specific collateral is pledged for repayment, or secured by specific
assets such as accounts receivable or inventory.
First, it allows a company to minimize the principal borrowed and the resulting interest
payments. Second, it is simpler to establish and entails fewer transaction and legal costs,
particularly when it is unsecured. The disadvantages of a line of credit include the potential
for higher borrowing costs when a large compensating balance is required and its limitation
to financing cyclical working capital needs. With full repayment required each year and
annual extensions subject to lender approval, a line of credit cannot finance medium-term or
long-term working capital investments.
Accounts Receivable Financing
Some businesses lack the credit quality to borrow on an unsecured basis and must instead
pledge collateral to obtain a loan. Loans secured by accounts receivable are a common form
of debt used to finance working capital. Under accounts receivable debt, the maximum loan
amount is tied to a percentage of the borrower’s accounts receivable. When accounts
receivable increase, the allowable loan principal also rises.
The bank receives a copy of all invoices along with an assignment that gives it the legal right
to collect payment and apply it to the loan. In some accounts receivable loans, customers
make payments directly to a bank-controlled account (a lock box). Firms gain several
benefits with accounts receivable financing. With the loan limit tied to total accounts
receivable, borrowing capacity grows automatically as sales grow. This automatic matching
of credit increases to sales growth provides a ready means to finance expanded sales, which
is especially valuable to fast-growing firms. It also provides a good borrowing alternative for
businesses without the financial strength to obtain an unsecured line of credit. Accounts
receivable financing allows small businesses with creditworthy customers to use the stronger
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credit of their customers to help borrow funds. One disadvantage of accounts receivable
financing is the higher costs associated with managing the collateral, for which lenders may
charge a higher interest rate or fees. Since accounts receivable financing requires pledging
collateral, it limits a firm’s ability to use this collateral for any other borrowing. This may be
a concern if accounts receivable are the firm’s primary asset.
Factoring
Factoring entails the sale of accounts receivable to another firm, called the factor, who then
collects payment from the customer. Through factoring, a business can shift the costs of
collection and the risk of nonpayment to a third party. In a factoring arrangement, a company
and the factor work out a credit limit and average collection period for each customer.
Factoring has several advantages for a firm over straight accounts receivable financing. First,
it saves the cost of establishing and administering its own collection system. Second, a factor
can often collect accounts receivable at a lower cost than a small business, due to economies
of scale, and transfer some of these savings to the company. Third, factoring is a form of
collection insurance that provides an enterprise with more predictable cash flow from sales.
On the other hand, factoring costs may be higher than a direct loan, especially when the
firm’s customers have poor credit that lead the factor to charge a high fee. Furthermore, once
the collection function shifts to a third party, the business loses control over this part of the
customer relationship, which may affect overall customer relations, especially when the
factor’s collection practices differ from those of the company
Inventory Financing
As with accounts receivable loans, inventory financing is a secured loan, in this case with
inventory as collateral. However, inventory financing is more difficult to secure since
inventory is riskier collateral than accounts receivable. Some inventory becomes obsolete and
loses value quickly, and other types of inventory, like partially manufactured goods, have
little or no resale value. Firms with an inventory of standardized goods with predictable
prices, such as automobiles or appliances, will be more successful at securing inventory
financing than businesses with a large amount of work in process or highly seasonal or
perishable goods. Lenders need to control the inventory pledged as collateral to ensure that it
is not sold before their loan is repaid. Two primary methods are used to obtain this control:
(1) warehouse storage; and (2) direct assignment by product serial or identification numbers.
Under one warehouse arrangement, pledged inventory is stored in a public warehouse and
controlled by an independent party (the warehouse operator). A warehouse receipt is issued
when the inventory is stored, and the goods are released only upon the instructions of the
receipt-holder.
Term Loan
Term loans have a fixed repayment schedule that can take several forms. Level principal
payments over the loan term are most common. In this case, the company pays the same
principal amount each month plus interest on the outstanding loan balance. A second option
is a level loan payment in which the total payment amount is the same every month but the
share allocated to interest and principle varies with each payment. Finally, some term loans
are partially amortizing and have a balloon payment at maturity. Term loans can be either
unsecured or secured; a business with a strong balance sheet and a good profit and cash flow
history might obtain an unsecured term loan, but many small firms will be required to pledge
assets.
2. Identify and explain those elements of business environment which are going to
impact working capital.
Working capital is the difference between current assets and current liabilities and it is the
amount of liquefiable capital available to a company to build itself. It doesn’t mean that working
capital will always be positive, there are times when it can be negative and this happens when the
current assets are more than the current liabilities. More importantly a company needs working
capital for its day-to-day activities like those of paying wages, paying for raw material and bills.
When a company finds itself short of working capital it uses its current assets to get money. We
have already understood the fact that working capital is essential for a business, in fact in some
cases, working capital is the essence on the basis of which the business functions. But why is
working capital so essential? Basically it is needed for the smooth functioning of the business. A
business in fact requires just the right amount of working capital; too much and too little working
capital is detrimental to the business.
Elements of Working Capital
Working capital has certain elements and for a business to function smoothly, it needs to be
aware of these elements of working capital. These are:
Cash – this is probably the most essential element or component of working capital. Without
cash a business cannot run smoothly. But cash in the business needs to be monitored careful
along with proper budgeting and forecasting. Cash inflow and cash outflow need to be monitored
properly.
Accounts receivable – every business has some debtors, people or other businesses that owe
them money, these in accounts lingo are called accounts receivable. Simply put these are
amounts that are yet to be received from debtors. Accounts receivable have to be monitored
properly and checked.
Inventory or Stock - the inventory in a company is half of its currents assets and hence needs
more monitoring than everything else. The level of the inventory or stock needs to be at a
particular level, the rate of turnover also needs to be monitored closely. All this is an important
aspect of the working capital.
Accounts payable – like every company has debtors, people who owe you money, similarly
every company has creditors to whom they owe money. Its normal for businesses to owe money
to their suppliers and other businesses, this is because sometimes the amounts to be paid are
large and will need some time to be paid off. It is important to track these payable amounts also
called accounts payable for the purpose of working capital but also for goodwill reasons.
Outstanding expenses and payable taxes – these are certain outstanding that the company has and
that will reflect on the working capital.
Each company has different working capital requirements, this requirement depends on different
factors, and these are:
• Type of Business.
• Size of business.
• Production policy.
• Process of manufacturing.
• Changes in seasons.
• Working capital cycle.
• Turnover rate of inventory.
• Policy for credit.
• Business cycles.
• Rate at which business grows.
• Changes in pricing.
• Dividend policy and capacity of earning.
Working capital affected will be the fixed assets that wont be able to function properly because
of lack of working capital. There is always the risk of dissolving the company because it cannot
sustain on the lack of working capital. The credibility of the company will also be affected; all
these will just result in bad losses and like mentioned before the liquidation of the business to
cope with these losses.
3. How do cash flow problem arise? Explain the cost of liquidity and illiquidity.
Cash flow is the movement of cash into or out of a business, project, or financial product. (Note
that "cash" is used here in the broader sense of the term, where it includes bank deposits.) It is
usually measured during a specified, finite period of time. Measurement of cash flow can be used
for calculating other parameters that give information on the companies' value and situation.
Cash flow can e.g. be used for calculating parameters:
• to determine a project's rate of return or value. The time of cash flows into and out of
projects are used as inputs in financial models such as internal rate of return, and net
present value.
• to determine problems with a business's liquidity. Being profitable does not necessarily
mean being liquid. A company can fail because of a shortage of cash, even while
profitable.
• as an alternate measure of a business's profits when it is believed that accrual accounting
concepts do not represent economic realities. For example, a company may be notionally
profitable but generating little operational cash (as may be the case for a company that
barters its products rather than selling for cash). In such a case, the company may be
deriving additional operating cash by issuing shares, or raising additional debt finance.
• Cash flow can be used to evaluate the 'quality' of Income generated by accrual
accounting. When Net Income is composed of large non-cash items it is considered low
quality.
• to evaluate the risks within a financial product, e.g. matching cash requirements,
evaluating default risk, re-investment requirements, etc.
Cash flow is a generic term used differently depending on the context. It may be defined by users
for their own purposes. It can refer to actual past flows, or to projected future flows. It can refer
to the total of all the flows involved or to only a subset of those flows. Subset terms include 'net
cash flow', operating cash flow and free cash flow.
Common ways by which cash flow problem arises:
• Sales - Sell the receivables to a factor for instant cash. (leading)

• Inventory - Don't pay your suppliers for an additional few weeks at period end. (lagging)
• Sales Commissions - Management can form a separate (but unrelated) company and act
as its agent. The book of business can then be purchased quarterly as an investment.
• Wages - Remunerate with stock options.
• Maintenance - Contract with the predecessor company that you prepay five years worth
for them to continue doing the work
• Equipment Leases - Buy it
• Rent - Buy the property (sale and lease back, for example).
• Oil Exploration costs - Replace reserves by buying another company's.
• Research & Development - Wait for the product to be proven by a start-up lab; then buy
the lab.
• Consulting Fees - Pay in shares from treasury since usually to related parties
• Interest - Issue convertible debt where the conversion rate changes with the unpaid
interest.
• Taxes - Buy shelf companies with TaxLossCarryForward's. Or gussy up the purchase by
buying a lab or O&G explore co. with the same TLCF
Cost of liquidity and illiquidity
An act of exchange of a less liquid asset with a more liquid asset is called Cost of liquidation.
Liquidity also refers both to a business's ability to meet its payment obligations, in terms of
possessing sufficient liquid assets, and to such assets themselves.
A liquid asset has some or more of the following features. It can be sold rapidly, with minimal
loss of value, any time within market hours. The essential characteristic of a liquid market is that
there are ready and willing buyers and sellers at all times. Another elegant definition of liquidity
is the probability that the next trade is executed at a price equal to the last one. A market may be
considered deeply liquid if there are ready and willing buyers and sellers in large quantities. This
is related to the concept of market depth that can be measured as the units that can be sold or
bought for a given price impact. The opposite concept is that of market breadth measured as the
price impact per unit of liquidity.
Liquidity is the ability to meet obligations when they come due without incurring unacceptable
losses. Managing liquidity is a daily process requiring bankers to monitor and project cash flows
to ensure adequate liquidity is maintained. Maintaining a balance between short-term assets and
short-term liabilities is critical. For an individual bank, clients' deposits are its primary liabilities
(in the sense that the bank is meant to give back all client deposits on demand), whereas reserves
and loans are its primary assets (in the sense that these loans are owed to the bank, not by the
bank). The investment portfolio represents a smaller portion of assets, and serves as the primary
source of liquidity. Investment securities can be liquidated to satisfy deposit withdrawals and
increased loan demand. Banks have several additional options for generating liquidity, such as
selling loans, borrowing from other banks, borrowing from a central bank, such as the US
Federal Reserve bank, and raising additional capital. In a worst case scenario, depositors may
demand their funds when the bank is unable to generate adequate cash without incurring
substantial financial losses. In severe cases, this may result in a bank run. Most banks are subject
to legally-mandated requirements intended to help banks avoid a crisis. Speculators and market
makers are key contributors to the liquidity of a market, or asset. Speculators and market makers
are individuals or institutions that seek to profit from anticipated increases or decreases in a
particular market price. By doing this, they provide the capital needed to facilitate the liquidity.
The risk of illiquidity need not apply only to individual investments: whole portfolios are subject
to market risk. Financial institutions and asset managers that oversee portfolios are subject to
what is called "structural" and "contingent" liquidity risk. Structural liquidity risk, sometimes
called funding liquidity risk, is the risk associated with funding asset portfolios in the normal
course of business. Contingent liquidity risk is the risk associated with finding additional funds
or replacing maturing liabilities under potential, future stressed market conditions. When a
central bank tries to influence the liquidity (supply) of money, this process is known as open
market operations.
An illiquid asset is an asset which is not readily saleable due to uncertainty about its value or the
lack of a market in which it is regularly traded. The mortgage-related assets which resulted in the
subprime mortgage crisis are examples of illiquid assets, as their value is not readily
determinable despite being secured by real property. Another example is an asset such as a large
block of stock, the sale of which affects the market value
Naturally the market will demand a liquidity premium when valuing illiquid investments.
Investors value flexibility; this is the basis of real option theory. In real options theory, one
explicitly values the optionality associated with decision-making flexibility. In essence, with
illiquidity, a portfolio is short real options, and the investor gives up the flexibility of being able
to readily liquidate their investments.
The illiquidity can arise from the contracts an investor enters into, which may have one year or
longer lock-ups, or can arise from the type of investments that a hedge fund specializes in. A
hedge fund’s investments may include over-the-counter derivatives instruments, which may be
difficult to value, or small-capitalization stocks, which may trade infrequently, and so on.
4. Apart from bank and trade credit what are the other sources of short term
finance?
Ans:
Customers’ Advances
Sometimes businessmen insist on their customers to make some advance payment. It is generally
asked when the value of order is quite large or things ordered are very costly. Customers’
advance represents a part of the payment towards price on the product (s) which will be delivered
at a later date. Customers generally agree to make advances when such goods are not easily
available in the market or there is an urgent need of goods. A firm can meet its short-term
requirements with the help of customers’ advances.
Merits and Demerits of Customers’ advances as a source of Short-term Finance

Customers’ advance refers to advance made by the customer against the value of order placed. It
is, thus, a part payment of the value of goods to be supplied later.
Merits
(a) Interest free: Amount offered as advance is interest free. Hence funds are available without
involving financial burden.
(b) No tangible security: The seller is not required to deposit any tangible security while
seeking advance from the customer. Thus assets remain free of charge.
(c) No repayment obligation: Money received as advance is not to be refunded. Hence there are
no repayment obligations.
Demerits
(a) Limited amount: The amount advanced by the customer is subject to the value of the order.
Borrowers’ need may be more than the a amount of advance.
(b) Limited period : The period of customers’ advance is only upto the delivery goods. It can
not be reviewed or renewed.
(c) Penalty in case of non-delivery of goods : Generally advances are subject to the condition
that in case goods are not delivered on time, the order would be cancelled and the advance would
have to be refunded along with interest.
5. Installment credit
Installment credit is now-a-days a popular source of finance for consumer goods like television,
refrigerators as well as for industrial goods. You might be aware of this system. Only a small
amount of money is paid at the time of delivery of such articles. The balance is paid in a number
of installments. The supplier charges interest for extending credit. The amount of interest is
included while deciding on the amount of installment. Another comparable system is the hire
purchase system under which the purchaser becomes owner of the goods after the payment of
last installment. Sometimes commercial banks also grant installment credit if they have suitable
arrangements with the suppliers.
Advantages and Disadvantages of Installment credit as a source of Short-term Finance

Advantages
(i) Immediate possession of assets: Delivery of assets is assured immediately on payment of
initial installment (down payment).
(ii) Convenient payment for assets and equipments: Costly assets and equipments which
cannot be purchased due to inadequacy of long-term funds can be conveniently purchased on
payment by installments.
(iii) Saving of one time investment: If the value of asset or equipment is very high, funds of the
business are likely to be blocked if lumpsum payment is made. Installment credit leads to saving
on one time investment.
(iv) Facilitates expansion and modernization of business and office
Business firms can afford to buy necessary equipments and machines when the facility of
payment in installments is available. Thus, expansion and modernization of business and office
are facilitated by installment credit.
Disadvantages
(i) Committed expenditure: Payment of installment is a commitment to pay irrespective of
profit or loss in the business.
(ii) Obligation to pay interest: Under installment credit system payment of interest of
obligatory. Generally sellers charge a high rate of interest.
(iii) Additional burden in case of default: Sellers sometimes impose stringent conditions in the
form of penalty or additional interest, if the buyer fails to pay the installment amount.
(iv) Cash does not flow: Like trade credit, installment credit facilitates the purchase of asset or
equipment. It does not make cash available which can be utilised for all needful purposes.
5. Loans from Co-operative Banks

Co-operative banks are a good source to procure short-term finance. Such banks have been
established at local, district and state levels. District Cooperative Banks are the federation of
Primary credit societies. The State Cooperative Bank finances and controls the District
Cooperative Banks in the state. They are also governed by Reserve Bank of India regulations.
Some of these banks like the Vaish Co-operative Bank was initially established as a co-operative
society and later converted into a bank. These banks grant loans for personal as well as business
purposes. Membership is the primary condition for securing loan. The functions of these banks
are largely comparable to the functions of commercial banks.
Benefits and Drawbacks of Finance from Cooperative Banks Benefits
(i) Loans from co-operative banks are easily available to farmers and small businessmen
involving minimum formalities.
(ii) Co-operative banks provide a convenient means of borrowing. Loans are generally granted at
a lower rate of interest.
(iii) Sometimes co-operative banks organize training programmes for members to familiarize
them with the various avenues of business and regarding proper utilization of loan money.
(iv) Being a member of a cooperative bank, the borrower can participate in the management and
also share in the profits of the society.
(v) Co-operative loans create a sense of thrift and self-reliance among the low income group.
(vi) Loans are generally given for productive purposes and that helps to develop the financial and
social status of the people.
Drawbacks
i) Loan from co-operative banks is available only to members.
ii) Co-operative banks find it difficult to ensure repayment of loan money due to inadequate
information about the need and utilization of funds by the borrower. There is little scrutiny of the
repaying capacity of the loan seeker at the time of granting loan.
iii) Inadequate resources and lack of trained personnel for management have restricted the spread
of co-operative banking facilities.
iv) Co-operative banks depend largely on the support of the Government. Therefore
Government rules and regulations sometime create hurdles for the borrowers.
v) Credit from co-operative banks is available only for limited purposes.
5. Sakthi Traders has a contribution/sales ration of 20% and average book debts of
Rs. 10 lakhs which it collects in an average collection period 24 days. The company
reorganized its ‘Credit Administration’ department recently and introduction a
cash incentive of 5% to speed up collection of outstanding. The incentive is payable
to customers making payment within 10 days. When the company reviewed the
position after a few months it was found that the average collection period has
actually fallen to 20 days only and the average book debts had increased to Rs. 10.50
lakhs mainly as a result of some increase in sales. It was also noticed that only about
half the total sales availed of the cash discount. The company’s cost of raising
additional funds in 20%. Do you recommend continuance of the cash incentive
scheme? Show workings. Assume one year = 360.
Solution:
The decision under consideration will be analyzed in the terms of cost of average book debts and
average collection period. We have to consider the saving of opportunity cost reduced
investment in receivables.
Change in average book debts = Rs.10 lakshs – Rs.10.5 lakshs

= Rs.50 000
Change in average book debts collection period =
Actual book debt
----------------------- x actual collection period -
360
increase in book debt
----------------------- x increase in collection period
360
= 10 10.5
------- x 24 - --------- x 20
360 360
= 66667 - 58333
= Rs.8334
Since the collection period declines the opportunity cost tied in receivable also increases.
credit collection period is reduced and needed because all customers do not pay the firm bills in
time. Some customers are slow payers while some are non payers. The collection efforts should,
therefore aim at accelerating collection of slow payers and reducing bad debts losses.

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ASSIGNMENT REFERENCE MATERIAL

Elements of Working Capital

Common ways by which cash flow problem arises:

• Sales - Sell the receivables to a factor for instant cash. (leading)

Cost of liquidity and illiquidity

Merits and Demerits of Customers’ advances as a source of Short-term Finance

Advantages and Disadvantages of Installment credit as a source of Short-term Finance

5. Loans from Co-operative Banks

Change in average book debts = Rs.10 lakshs – Rs.10.5 lakshs

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