Working Capital Management


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Working Capital Management

  2. 2. Working capital refers to be a part of firm’s capital which is required for financing short term or current assets such as cash, marketable securities, debtors and inventories etc. It is also known as resolving or circulating capital or short-term capital. It refers to the funds, which company must posses to meet its day to day expenses. MEANING OF WORKING CAPITAL
  3. 3. In the words of Shubin, “Working capital is the amount of funds necessary to cost of operating the expenses”. According to Genestenberg, “Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another. For example, from cash to inventories, inventories to receivables, receivables into cash”. DEFINITION
  4. 4. There are two concepts of working capital: (A)Balance Sheet Concept (B)Operating cycle or Circular Flow Concept CONCEPTS OF WORKING CAPITAL
  5. 5. (A)Balance Sheet Concept There are two interpretation of working capital under the balance sheet concept: (i) Gross Working Capital • is the amount invested in total current assets of the enterprise. • is the firm’s investment in short term assets such as cash, short term securities, account receivables and inventories. • The concept helps in making optimum investment in current assets and their financing.
  6. 6. (ii)Net working capital • is the excess of current assets over current liabilities. • It can be positive or negative. • Net working capital = current assets – current liabilities. • Net working capital refers to the portion of firm’s current assets, which financed with long term funds.
  7. 7. (B) Operating cycle or Circular Flow of concept
  8. 8. CLASSIFICATION OF WORKING CAPITAL WORKING CAPITAL BASIS OF CONCEPT BASIS OF TIME Gross Working Capital Net Working Capital Permanent / Fixed WC Temporary / Variable WC Regular WC Reserve WC Special WC Seasonal WC
  9. 9. Permanent or fixed working capital is the minimum investment kept in the form of inventory or raw materials, work in progress etc to facilitate uninterrupted operation in the firm. It also grow with the size of the firm. It could be financed out of long term funds. Permanent working capital
  10. 10. Temporary or Variable working capital is the amount of working capital which is required to meet the seasonal demands and some special exigencies. Variable working capital can be further classified into Seasonal and Special working capital. The capital required to meet the seasonal needs of the enterprise is called seasonal working capital. Special working capital is that part of working capital which is required to meet special situations such as launching of extensive marketing, campaign for conducting research etc. Temporary working capital
  11. 11. Difference between permanent & temporary working capital Amount Variable Working Capital of Working Capital Permanent Working Capital Time
  12. 12. Variable Working Capital Amount of Working Capital Permanent Working Capital Time Permanent & Temporary Working Capital
  13. 13. 1. Solvency of the firm. 2. Goodwill. 3. Easy Loan. 4. Cash discount. 5. Regular supply of raw materials. 6. Regular payment of salaries, wages and other day-to-day commitments. 7. Ability to faces crisis 8. High morale. IMPORTANCE OF ADEQUATE WORKING CAPITAL
  14. 14. • Excess of working capital represents idle funds which earn no profits for the business and hence the business cannot earn a proper rate of return on its investments. • Low rate of return • Unnecessary purchase inventories: • Defective Credit Policy • Speculative transaction: His working capitals in excess give rise to speculative DANGER OF EXCESS WORKING CAPITAL
  15. 15.  Loss reputation  Lowers credit worthless  Cash Discount  Irregularity payment of day-to- day  Low Rate of Return DANGER OF INADEQUATE WORKING CAPITAL
  16. 16. 1. Nature of the business. 2. Size of the business. 3. Production policy. 4. Production cycle process. 5. Seasonal variation 6. Working capital cycle FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS
  17. 17. 8. Business Cycle 9. Rate of growth of business 10.Price level changes
  19. 19. INTRODUCTION Definition: Scientific method of finding out how much stock should be maintained in order to meet the production demands and be able to provide right type of material at right time, in right quantities and at competitive prices. 06 July 2012 KLE College of Pharmacy, Nipani. 19
  20. 20. Introduction (Cont’d) • Inventory is actually money, which is available in the shape of materials (raw materials, in- process and finished products), equipment, storage space, work-time etc. 06 July 2012 20 Input Material Management department Inventory (money) Goods in stores Work-in-progress Finished products Equipment etc. Output Production department Basic inventory model
  21. 21. OBJECTIVES The specific objectives of inventory management are as follow: a) Utilizing of scare resources (capital) and investment judiciously. b) Keeping the production on as on-going basis. c) Preventing idleness of men, machine and morale. 21
  22. 22. Objectives (Cont’d) d) Avoiding risk of loss of life (moral & social). e) Reducing administrative workload. f) Giving satisfaction to customers in terms of quality-care, competitive price and prompt delivery. g) Inducing confidence in customers and to create trust and faith. 22
  23. 23. Motives for holding inventories • Transaction motive- to facilitate smooth production and sales operations. • Precautionary motive – to guard against the risk of unpredictable changes in demand and supply / other forces. • Speculative motive – influences the decision to increase or reduce inventory level to take advantage of price fluctuations.
  24. 24. Why We Want to Hold Inventories? • Improve customer service. • Reduce certain costs such as – ordering costs – stock out costs – acquisition costs – start-up quality costs • Contribute to the efficient and effective operation of the production system. 24
  25. 25. TYPES OF DEMAND • Independent demand • Dependent demand
  26. 26. Independent Demand Inventory Systems • Demand for an item is independent of the demand for any other item in inventory. • Finished goods inventory is an example. • Demands are estimated from forecasts and/or customer orders. 26
  27. 27. Dependent Demand Inventory Systems • Demand of item depends on the demands for other items. • For example, the demand for raw materials and components. • The systems used to manage these inventories are different. 27
  28. 28. Independent Demand A B C D E D F Dependent Demand Independent demand is uncertain. Dependent demand is certain. 28
  29. 29. Risks and costs associated with inventories Risks of holding inventories can be put as follows: (i) Price decline (ii) Product deterioration (iii) Obsolescence.
  30. 30. Costs of holding inventories (i) Materials cost – cost of purchasing the goods, transportation and handling charges, less discount allowed by the supplier of goods. (ii) Ordering costs – variable cost associated with placing an order for the goods. (iii)Carrying costs – expenses for storing the goods. It comprises storage costs, insurance costs, spoilage costs, cost of funds tied up in inventories etc.
  31. 31. TOOLS AND TECHNIQUES OF INVENTORY MANAGEMENT 1. ABC Analysis 2. Economic Order Quantity (EOQ) 3. Order Point Problem (a) minimum level (b) maximum level (c) average stock level (d) reorder level (e) safety level 4. Two –bin technique
  32. 32. 5. VED classification 6.SDE classification 7.Just In Time classification
  33. 33. 33 1. ABC Analysis It is efficient control of stores requires greater in case of costlier items.
  34. 34. 34 Continued…. Item Quality Quantity order Checking A Costlier Less Regular system to see that there is no overstocking as well as that there is no danger of production being interrupted for unwanted material. B Less costlier Order may be on review basis. Position being viewed in each month C Economical Larger Order in large quantity so that cost can be avoided
  35. 35. 2. EOQ What is EOQ? 35 EOQ = mathematical device for arriving at the purchase quantity of an item that will minimize the cost. total cost = holding costs + ordering costs
  36. 36. EOQ (Cont’d) So…What does that mean? 36 Basically, EOQ helps you identify the most economical way to replenish your inventory by showing you the best order quantity.
  37. 37. Assumptions of the EOQ Model 1. Demand is known and constant 2. Lead time is known and constant 3. Receipt of inventory is instantaneous 4. Quantity discounts are not available 5. Variable costs are limited to: ordering cost and carrying (or holding) cost 6. If orders are placed at the right time, stockouts can be avoided
  38. 38. Ordering cost may be referred to as the “cost of acquiring while the carrying cost as the “cost of holding” inventory. EOQ formula- Q = Economic order quantity A = Annual demand in units O = Ordering cost per unit C = Carrying cost per unit Q = 2AO C
  39. 39. EOQ – GRAPHICAL APPROACH Ordering Cost Order Size QEOQ Minimum Total Costs
  40. 40. 40 Maximum stock level • Quantity of inventory above which should not be allowed to be kept. This quantity is fixed keeping in view the disadvantages of overstocking; Factors to be considered: • Amount of capital available. • Godown space available. • Possibility of loss.
  41. 41. 41 Continue…. • Cost of maintaining stores; • Likely fluctuation in prices; • Seasonal nature of supply of material; • Restriction imposed by Govt.; • Possibility of change in fashion and habit.
  42. 42. 42 Minimum stock level • This represents the quantity below which stocks should not be allowed to fall . • The level is fixed for all items of stores and the following factors are taken into account: 1.Lead time- 2. Rate of consumption of the material during the lead time.
  43. 43. 43 Re-ordering level • It is the point at which if stock of the material in store approaches, the store keeper should initiate the purchase requisition for fresh supply of material. • This level is fixed some where between maximum and minimum level.
  44. 44. Safety Stock • Safety stock (SS) is extra inventory held to help prevent stockouts • Frequently demand is subject to random variability (uncertainty) • If demand is unusually high during lead time, a stockout will occur if there is no safety stock
  45. 45. 4. Two - bin system of inventory control-suited for small firms: • Under this system the company maintains two bins. • Once the inventory contained in the first bin gets exhausted, stock is ordered while inventory in the second bin becomes available for consumption/sale
  46. 46. 5. V-E-D Classification (Cont’d) • V-Vital : Items without which the activities will come to a halt. • E-Essential : Items which are likely to cause disruption of the normal activity. • D-Desirable : In the absence of which the hospital work does not get hampered. 46
  47. 47. 6. S-D-E Classification • Based on the lead-time analysis and availability. S – Scarce : longer lead time D – Difficult : long lead time E – Easy : reasonable lead time
  48. 48. 7. Just In Time(JIT) Inventory System • JIT inventory system means all inventories-raw materials- work in progress- and finished goods are received in time. • Raw materials are received just in time to go into production • Manufactured parts are completed just in time to be assembled into products. • Products are completed just in time to be shipped to customers. The flow of goods is controlled by a “pull approach”.
  49. 49. Benefits of JIT System • Inventories of all types can be reduced significantly. His results in saving of costs. • Storage space used for inventories can be made available for more productive uses. • Total Quality Control results in production of quality products. • It helps to increase the productivity of workers.
  50. 50. Cash Management
  51. 51. • Cash management is one of the key areas of working capital management as cash is both beginning and the end of working capital cycle- cash, inventories, receivables and cash. • It is the most liquid asset and the basic input required to keep the business running on a continuous basis.
  52. 52. Nature of cash In cash management the term cash has been used in two senses: • Narrow sense Under this cash covers currency and generally accepted equivalents of cash,cheques,demand drafts and demand deposits. • Broad sense Cash includes not only the above stated but also cash assets.
  53. 53. Motives of holding cash • Transaction Motive This motive arises due to the necessity of having cash for various disbursements like purchase of raw materials, payment of business expenses, payment of tax, payment of dividend etc.. • Precautionary Motive Firm may require cash for payment of unexpected disbursements like flood, strikes, increase in cost of raw materials etc.. • Speculative Motive Holding cash relates for investing in profitable opportunities as and when they arise.
  54. 54. Objectives of Cash Management • To meet cash payment needs. The primary objective of cash management is to meet various cash payment needed to pay in business operations. The payment are like payment to supplier of raw materials ,payment of wages and salary etc.. • To maintain minimum cash balance Firm should not maintain excess cash balance.
  55. 55. Phases of cash management 1.Cash planning 2.Cash flows management 3.Determination of optimum cash balance 4.Investment of surplus cash
  56. 56. 1.Cash Planning • Cash planning is required to estimate the cash surplus or deficit for each planning period. Estimation of cash surplus can be arrived by preparation of cash budget. • Cash budget is an important tool for the flow of cash in any firm over a future period of time.
  57. 57. 2. Cash Flow Management • Cash flow means cash inflows and outflows. The cash flows should be properly managed that the cash inflows should be accelerated.(collected as early as possible) and cash outflows should be decelerated(cash payments should be delayed without affecting firm name). • Accelerating cash collection 1. Prompt Payment of customers 2. Early conversion of payment into cash 3.Concentration Banking 4. Lock box system
  58. 58. • Slowing down cash payments 1.Paying on last date. 2.Centralised payment
  59. 59. 3.Determination of optimum cash balance • Optimum cash balance is that balance at which the cost of excess cash and danger of cash deficiency will match. • Firms have to determine the optimum cash balance. • The most important models are: 1.Baumol model 2.Miller and Orr Model
  60. 60. 1.Baumol Model • This model was developed by William J. Baumol. • According to this model optimum cash level is that level of cash where the carrying costs and transaction costs are the minimum
  61. 61. William J. Baumol's Model Total Cost Opportunity Cost Transaction Cost Optimum Cash Balance (Baumol’s Model : Tradeoff Between Holding cost and transaction cost) Cost
  62. 62. The formula for determining Optimum cash balance can be put as follows: ____ Where C= √ 2 cT K C = Optimum cash balance c = Average fixed cost of securing cash (transaction cost) T = Total cash needed during the year. K =opportunity cost of holding cash balance
  63. 63. Assumptions • Cash needs of the firm is known with certainty • Cash Disbursement over a period of time is known with certainty • Opportunity cost of holding cash is known and remains constant • Transaction cost of converting securities into cash is known and remains constant
  64. 64. Evaluation of the model • Helpful in determining optimum level of Cash holding • Facilitates the finance manager to minimize Carrying cost and Maintain Cash • Indicates idle cash Balance Gainful employment • Applicable only in a situation of certainty in other words this model is deterministic model
  65. 65. 2.Miller and Orr Model • This model was developed by M. H. Miller and Daniel Orr • The Miller and Orr model of cash management is one of the various cash management models in operation. It is an important cash management model as well. It helps the present day companies to manage their cash while taking into consideration the fluctuations in daily cash flow. • As per the Miller and Orr model of cash management the companies let their cash balance move within two limits a) Upper Control limit b) Lower Control Limit
  66. 66. M. H. Miller and Daniel Orr’s Stochastic Model Upper Control Limit : Buy Security Curve representing Cash Balance Purchase Market Security Sale of market security Return Point Lower Control Limit : Buy Security Cash h Z O
  67. 67. Computation of Miller – Orr Model of Cash Management Z = (3/4 * Transaction cost *Variance of Cash Flow) Z = (3/4*c /i) Upper limit =lower limit +3 Z Return point = lower limit + Z Average cash balance = lower limit + 4/3 Z 1/3 Interest per day 2 1/3
  68. 68. Evaluation • The stochastic model can be employed even in extreme uncertain situation. • But when the cash flows fluctuate violently in short period , it will not give optimal results. • It is advisable to the finance manager to apply this model in highly unpredictable situation.
  69. 69. 4.Investment of surplus fund • Whenever there is surplus cash it should be properly invested in marketable securities to earn profits. • Firms should not invest in long term securities they cannot be converted into cash within a short period
  71. 71. MANAGEMENT OF RECEIVABLES • Management of accounts receivables may be defined as the process of making decisions relating to the investment of funds in this asset which will result in the maximizing the overall return on the investment of the firm. • Receivables management is also referred to as Trade Credit management.
  72. 72. RECEIVABLES  What are receivables? • Receivables are sales made on credit basis.  Why do we need receivables? • Achieving growth in sales potential • Increasing profits • Meeting competition  Understanding Receivables • As a part of the operating cycle • Time lag b/w sales and receivables creates need for working capital
  73. 73. Types of Costs Associated with Receivables Management  COLLECTION COST: Administrative costs incurred in collecting the accounts receivable.  CAPITAL COST: Cost incurred for arranging additional funds to support credit sales.  DELINQUENCY COST: Cost which arises if customers fail to meet their obligations.  DEFAULT COST: Amounts which have to written off as bad debts.
  74. 74. Factors affecting the size of receivables • Level of sales • Credit Policies • Terms of trade • Credit period • Cash discount
  75. 75. Receivables Management Policies These policies relate to: (i) Credit standards (ii) Credit terms (iii) Collection procedures
  76. 76. CREDIT STANDARDS • The term credit standards represent the basic criteria for extension of credit to customers. • The levels of sales and receivables are likely to be high ,if the credit standards are relatively loose. • The firm’s credit standards are generally determined by the five C’s – character, capacity, capital , collateral and conditions.
  77. 77. “Five Cs” of Credit Analysis The “Five Cs” of credit analysis used to decide whether or not to extend credit to a particular customer are : 1. Character: moral integrity of credit applicant and whether borrower is likely to give his/her best efforts to honoring credit obligation 2. Capacity: whether borrowing form has financial capacity to meet required account payments 3. Capital: general financial condition of firm as judged by analysis of financial statements 4. Collateral: existence of assets (i.e. inventory, accounts receivable) that may be pledged by borrowing firm as security for credit extended 5. Conditions: operating and financial condition of firm
  78. 78. CREDIT TERMS It refers to the terms under which a firm sells goods on credit to its customers. The two components of credit terms are: (a) Credit period (b) Cash discount
  79. 79. (a) Credit Period • Credit Terms – Specify the length of time over which credit is extended to a customer and the discount, if any, given for early payment. For example, “2/10, net 30.” • Credit Period – The total length of time over which credit is extended to a customer to pay a bill. For example, “net 30” requires full payment to the firm within 30 days from the invoice date.
  80. 80. Optimal Credit Period Extending credit period stimulates sales but increases the cost on account of more tying up of funds in receivables. Shortening the credit period reduces the profit on account of reduced sales, but also reduces the cost of tying up of funds in receivables. Determining the optimal credit period, therefore involves locating the period where the marginal profits on increased sales are exactly offset by the cost of carrying the higher amount of accounts receivable.
  81. 81. (b) Cash Discount Attractive cash discount terms reduce the average collection period resulting in reduced investment in accounts receivable. Optimal discount is established at that point where the cost and benefit are exactly offsetting.
  82. 82. Cash Discount Period • Cash Discount Period – The period of time during which a cash discount can be taken for early payment. For example, “2/10” allows a cash discount in the first 10 days from the invoice date. Cash Discount – A percent (%) reduction in sales or purchase price allowed for early payment of invoices. For example, “2/10” allows the customer to take a 2% cash discount during the cash discount period.
  83. 83. Types of Policies • Liberal credit policy :  Profitability increases on account of higher sales Increased investment in receivables Increased chances of debts  More collection costs Total investment in receivables increases and thus the problem of liquidity is created
  84. 84. (contd…..) • Stringent credit policy : Reduces the profitability but increases the liquidity of the firm. Optimum credit policy occurs at a point where there is a trade off between liquidity and profitability.
  85. 85. Optimum size of receivables Profitability Liquidity Tight Credit policy Loose Costs & Benefits
  86. 86. Collection Procedures • Letters • Phone calls • Personal visits • Legal action The firm should increase collection expenditures until the marginal reduction in bad-debt losses equals the marginal outlay to collect.
  87. 87. Monitoring Receivables • 1. Use of Ratios • DAILY SALES OUTSTANDING (DSO) DSO = Accounts Receivable Avg. Daily Sales • AGEING SCHEDULE Classifies the outstanding accounts receivables at a given point of time into different age brackets. Ex. Age Group (days) % of receivables 0-30 30 31-60 40 61-90 25 >=90 5
  88. 88. Control of receivables Management • ABC Analysis of Receivables A – Represents a small proportion of accounts of debtors representing a large value B – Represents moderate value C – Represents a large number of accounts of debtors but representing a small amount
  89. 89. Working capital financing
  90. 90. Working capital is the fund invested in current assets and is needed for meeting day to day expenses . It is an operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital.
  91. 91. The working capital requirements of a firm is classified into 2 a) Permanent or long term or fixed working capital requirement b) Temporary or variable or short term working capital requirement
  92. 92. Fixed working capital • Fixed working capital is that portion of the total capital that is required to be maintained in the business on the permanent basis or uninterrupted basis. This working capital is required to invest in fixed assets. The requirement of this type of working capital is unaffected due to the changes in the level of activity.
  93. 93. Variable working capital • Variable working capital is that portion of the total capital that is required over and above the fixed working capital. This working capital is required to meet the seasonal needs and some contingencies. The requirement of this type of working capital changes with the changes in the level of activity.
  94. 94. Sources of working capital Permanent or fixed Temporary or variable 1.Shares 1.commercial banks 2. Debentures 2.indigeneous bankers 3.Public deposits creditors 4.retained profits 4.instalment creditors 5.Loans from financial 5.advances institutions 6.accrued expences 7. commercial paper 8. commercial banks
  96. 96. Spontaneous Liabilities 1. Spontaneous liabilities arise from the normal course of business. 2. The two major sources of spontaneous liabilities are accounts payable and accruals. 3. As a firm’s sales increases, accounts payable and accruals increases in response to the increased purchases, wages, and taxes. 4. There is normally no explicit cost attached to either of these current liabilities.
  97. 97. Management of Accounts Payable • Accounts payable are the major source of unsecured short-term financing for business firms. The underlying objective of accounts payable is to slow down payments process as much possible as possible. • The delay in accounts payable may result in saving of some interest costs but it may result in loss of credit in the market.
  98. 98. Average payment period • The average payment period has two parts: – The time from the purchase of raw materials until the firm mails the payment. – Payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn funds from the firm’s account. • The finance manager has, therefore, to ensure that payments to the creditors are made at the stipulated time periods after obtaining the best credit terms possible.
  99. 99. Spontaneous Liabilities- Analyzing Credit Terms A. Credit terms offered by suppliers allow a firm to delay payment for its purchases. B. However, the supplier probably imputes the cost of offering terms in its selling price. C. Therefore, the firm should analyze credit terms to determine its best credit strategy. D. If a cash discount is offered, the firm has two options—to take the cash discount or to give it up.
  100. 100. Analyzing credit terms (contd…..) • Taking the Cash Discount – If a firm intends to take a cash discount, it should pay on the last day of the discount period. – There is no cost associated with taking a cash discount • Giving Up the Cash Discount – If a firm chooses to give up the cash discount, it should pay on the final day of the credit period. – The cost of giving up a cash discount is the implied rate of interest paid to delay payment of an account payable for an additional number of days.
  101. 101. Spontaneous Liabilities: Effects of Stretching Accounts Payable • Stretching accounts payable simply involves paying bills as late as possible without damaging credit rating. • This can reduce the cost of giving up the discount.
  102. 102. Spontaneous Liabilities- Accruals • Accruals are liabilities for services received for which payment has yet to be made. • The most common items accrued by a firm are wages and taxes. • While payments to the government cannot be manipulated, payments to employees can. • This is accomplished by delaying payment of wages, or stretching the payment of wages for as long as possible
  103. 103. Unsecured Sources of Short-Term Loans: Bank Loans • The major type of loan made by banks to businesses is the short-term, self-liquidating loan which are intended to carry firms through seasonal peaks in financing needs. • These loans are generally obtained as companies build up inventory and experience growth in accounts receivable. • As receivables and inventories are converted into cash, the loans are then retired. • These loans come in three basic forms:(i) single- payment notes, (ii) lines of credit, and (iii) revolving credit agreements.
  104. 104. (i) Single Payment Notes – A single-payment note is a short-term, one-time loan payable as a single amount at its maturity. – The “note” states the terms of the loan, which include the length of the loan as well as the interest rate. – The maturity period of most of these loans vary from 30 days to 9 or more months. – The interest may be either fixed or floating.
  105. 105. (ii)Line of Credit (LOC) – A Line of Credit is an agreement between a commercial bank and a business specifying the amount of unsecured short-term borrowing the bank will make available to the firm over a given period of time. – It is usually made for a period of 1 year and often places various constraints on borrowers. – Although not guaranteed, the amount of a LOC is the maximum amount the firm can owe the bank at any point in time.
  106. 106. In order to obtain the LOC, the borrower may be required to submit a number of documents including a cash budget, and recent (and pro forma) financial statements. The interest rate on a LOC is normally floating . In addition, banks may impose operating restrictions giving it the right to revoke the LOC if the firm’s financial condition changes. Both LOCs and revolving credit agreements often require the borrower to maintain compensating balances. A compensating balance is simply a certain checking account balance equal to a certain percentage of the amount borrowed (typically 10 to 20 percent). This requirement effectively increases the cost of the loan to the borrower.
  107. 107. (iii)Revolving Credit Agreement (RCA) – RCA is nothing more than a guaranteed line of credit. – Because the bank guarantees the funds will be available, they usually charge a commitment fee which applies to the unused portion of the borrowers credit line. – A fee is around 0.5% of the average unused portion of the funds. – Although more expensive than the LOC, the RCA is less risky from the borrowers perspective.
  108. 108. Money Market
  109. 109. • Money Market is the part of financial market where instruments with high liquidity and very short-term maturities are traded. It's the place where large financial institutions, dealers and government participate and meet out their short-term cash needs. They usually borrow and lend money with the help of instruments or securities to generate liquidity. Due to highly liquid nature of securities and their short-term maturities, money market is treated as safe place. • Role of Reserve Bank of India: The Reserve Bank of India (RBI) plays a key role of regulator and controller of money market. The intervention of RBI is varied – curbing crisis situations by reducing key policy rates or curbing inflationary situations by rising key policy rates such as Repo, Reverse Repo, CRR etc.
  110. 110. Money Market Instruments Money Market Instruments provide the tools by which one can operate in the money market. Money market instrument meets short term requirements of the borrowers and provides liquidity to the lenders. The most common money market instruments are Treasury Bills, Certificate of Deposits, Commercial Papers, Repurchase Agreements and Banker's Acceptance,Money Market Mutual Funds.
  111. 111. Instrument of Money Market • A variety of instrument are available in a developed money market • In India till 1986, only a few instrument were available Treasury bills Commercial Bills Money at call Promissory notes
  112. 112. Money Market Instruments Money Market Commercial Papers Certificate of deposit Repo instrument Repurchase Agreement Banker's Acceptance Mutual Fund
  113. 113. Commercial paper (CP) It is a short term unsecured loan issued by a corporation typically financing day to day operation  It is very safe investment because the financial situation of a company can easily be predicted over a few months  Only company with high credit rating issues CPs
  114. 114. Treasury Bills (T-Bills)  (T-bills) are the most marketable money market security  They are issued with three-month, six-month and one-year maturities  T-bills are purchased for a price that is less than their par(face) value; when they mature, the government pays the holder the full par value  T-Bills are so popular among money market instruments because of affordability to the individual investors
  115. 115. Certificate of deposit (CD)  A CD is a time deposit with a bank  Like most time deposit, funds can not withdrawn before maturity without paying a penalty  CDs have specific maturity date, interest rate and it can be issued in any denomination  The main advantage of CD is their safety  Anyone can earn more than a saving account interest
  116. 116. Repurchase agreement (Repos)  Repo is a form of overnight borrowing and is used by those who deal in government securities  They are usually very short term repurchases agreement, from overnight to 30 days of more  The short term maturity and government backing usually mean that Repos provide lenders with extremely low risk  Repos are safe collateral for loans
  117. 117. Banker's Acceptance  A banker’s acceptance (BA) is a short-term credit investment created by a non-financial firm  BAs are guaranteed by a bank to make payment  Acceptances are traded at discounts from face value in the secondary market  BA acts as a negotiable time draft for financing imports, exports or other transactions in goods  This is especially useful when the credit worthiness of a foreign trade partner is unknown
  118. 118. Mutual Funds • A money market fund (also known as money market mutual fund) is an open- ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are widely (though not necessarily accurately) regarded as being as safe as bank deposits yet providing a higher yield. Regulated in the US under the Investment Company Act of 1940, money market funds are important providers of liquidity to financial intermediaries.
  120. 120. One of the most important functions of banks is to finance working capital requirement of firms. Working capital advances forms major part of advance portfolio of banks. In determining working capital requirements of a firm, the bank takes into account its sales and production plans and desirable level of current assets. The amount approved by the bank for the firm’s working capital requirement is called credit limit . Thus, it is maximum fund which a firm can obtain from the bank.
  122. 122. • Cash Credit – Under this facility, the bank specifies apredetermined limit and the borrower is allowed to withdraw funds from the bank up to that sanctioned credit limit against a bond or other security. • Overdraft – Under this arrangement, the borrower is allowed to withdraw funds in excess of the actual credit balance in his current account up to a certain specified limit during a stipulated period against a security. •Loans – Under this system, the total amount of borrowing is credited to the current account of the borrower or released to him in cash. The borrower has to pay interest on the total amount of loan, irrespective of how much he draws.
  123. 123. • Bills Financing – This facility enables a borrower to obtain credit from a bank against its bills. The bank purchases or discounts the bills of exchange and promisory notes of the borrower and credits the amount in his account after deducting discount. • Letter of Credit – While the other forms of credit are direct forms of financing in which the banks provide funds as well as bears the risk, letter of credit is an indirect form of working capital financing in which banks assumes only the risk and the supplier himself provide the funds.
  124. 124. •Working Capital Loan – Sometimes a borrower may require additional credit in excess of sanctioned credit limit to meet unforeseen contingencies. Banks provide such credit through a Working Capital Demand Loan (WCDL) account or a separate ‘non–operable’ cash credit account. This arrangement is presently applicable to borrowers having working capital requirement of Rs.10 crores or above.
  126. 126. •Hypothecation – Under this mode of security, the banks provide working capital finance to the borrower against the security of movable property, generally inventories. It is a charge against property for the amount of debt where neither ownership nor possession is passed to the creditor. In the case of default the bank has the legal right to sell the property to realise the amount of debt. • Pledge – A pledge is bailment of goods as security for the repayment of a debt or fulfillment of a promise. Under this mode, the possession of goods offered as security passes into the hands of the bank
  127. 127. •Lien – Lien means right of the lender to retain property belonging to the borrower until he repays the debt •Mortgage – Mortgage is the transfer of a legal or equitable interest in a specific immovable property for the payment of a debt. •Charge – Where immovable property of one person is made security for the payment of money to another and the transaction does not amount to mortgage, the latter person is said to have a charge on the property and all the provisions of simple mortgage will apply to such a charge.