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Working Capital : Working Capital What is working capital? What are it’s components? What
factors influence working capital? How is working capital projected? What are the strategies as
regards it’s financing? What is aggressive/moderate and conservative policy as regards working
capital? Double edge characteristic. What is operating cycle? How it is calculated? Why is
working capital important? Working capital financing in India-various committees. Receivables
management-credit period decision evaluation-reports-control-credit policy. Creditors
management-report-payment terms-prompt payment discount evaluation. Inventory management
(EOQs, ABC analysis, slow moving-non moving, slump sale etc) Cash /liquid resources
management ( transactive /precautionary/speculative motive) Different ways of financing working
capital Some practical hints classification of current assets .
What is working capital?: What is working capital? Once the project is set up and goes on stream,
the portion of capital which gets blocked in current assets and which is essentially required to
keep the business going on. Capital that is needed to keep business entity working round the
clock! Simply it is current assets less current liabilities including bank borrowings.
Working capital cycle: Working capital cycle Suppliers Raw materials WIP Finished goods
overheads cash Accounts receivables
What factors influence working capital? : What factors influence working capital? Nature of
business. ( services-manufacturing ) Seasonality of operations. (ceiling fans?) Production policy.
(ceiling fans?) Market conditions. (competitors) Conditions of supply. (smooth supply/erratic
supply)
Proportion of current assets and fixed assets: Proportion of current assets and fixed assets
Current assets (%) Fixed assets (%) Industries 10-20 80-90 Hotels/Restaurants 20-30 70-80
Electricity generation 30-40 60-70 Aluminium/shipping 40-50 50-60 Steel/chemicals 50-60 40-50
Tea plantation 60-70 30-40 Cotton textile/sugar 70-80 20-30 Edible oils/tobacco 80-90 10-20
Trading/construction
How is working capital projected?: How is working capital projected? Flexible policy or
conservative policy . ( fewer stoppages, quick delivery, stimulates sales due to liberal credit but
this may result in higher carrying costs) Restrictive / aggressive policy ( opposite to above policy)
Optimal Policy. ( trade off between carrying costs and shortages costs
Carrying costs / shortage cost (trade off): Carrying costs / shortage cost (trade off) Carrying
/shortage cost Level of current assets Carrying cost Shortage cost Total cost CA
Strategies for financing: Strategies for financing time Capital requirement Peak requirement
Minimum requirement median
2. What is operating cycle? How it is calculated? : What is operating cycle? How it is calculated?
Operating cycle begins with procurement of raw materials and ends with collection of receivables.
It can be broadly divided into four stages (RM-WIP-FG-Receivables-Collections) Duration of
operating cycle is equal to the sum of the durations of each of these stages less the credit period
allowed by the suppliers. O=R+W+F+D-C R=average stock of raw materials & stores/average
daily consumption W=average WIP/average daily cost of production F=average FG
stock/average daily cost of sales D=average receivables/average daily sales C=average
creditors/average daily credit purchases.
Why is working capital important? : Why is working capital important? Two characteristics make it
special: Short life span Swift transformation in other assets. Decisions relating to working capital
management are repetitive and frequent. The difference between profit and present value is
insignificant. Close interaction among working capital components implies that efficient
management of one component can not be undertaken without simultaneous consideration of
another component. (cash crunch-discount-accumulation of FG-liberal credit) Investment in
current assets involves substantial portion of total investment. Investments in current assets and
the level of current liabilities have to be geared quickly to changes in sales. Although fixed asset
investments and long term financing are also responsive to variation in sales however the
relationship is not as close and direct as it is in the case of working capital components.
Working capital financing in India-various committees.: Working capital financing in India-various
committees. Dahejia Committee ( 1968-69) Reference:the extent to which credit needs are likely
to be inflated and how such trends could be checked. Concluded that short term banking funds
diverted for long term needs. Weak corelation between bank credit and growth of industrial
output. Need for separating permanent portion of working capital to be financed by long term
funds. Tandon Committee ( 1974) Reference: optimum utilization of bank credit. First major
attempt to regulate bank credit. Even today although RBI has given freedom in assesing and
financing working capital to individual banks most of the banks still use norms/methodology laid
down by this committee. Bank credit viewed as tool of resource allocation. It suggested inventory
norms for major 15 industries setting maximum levels. Norms were made applicable to all
including SSI with aggregate limits of more than Rs 10 lakhs. It also suggested deviation from
nborms in case of abnormal circumstances.
Tandon Committee (example): Tandon Committee (example) 1 st Method 2 nd Method 3 rd
Method A Current Assets 1000 1000 600 A1 Core Current assets 400 B Creditors & payables 200
200 200 C Working Capital Gap 800 800 800 D Bank Finance 600 (75% of Gap) 550 (gap-25%of
A) 250 (gap-margin) E Net working Capital / Margin Money (long term) 200 (25% of gap) 250
(25% of A) 550 A1+(25%(A-A1)) F Current Assets 1000 1000 1000 G Current liabilities ( including
bank finance) 800 750 450 H Current Ratio 1.25 1.33 2.22
Academic significance: Academic significance Current ratio gradually improves. Margin money /
net working capital improves by way of long term portion. Although RBI has now given freedom to
banks in assessing and financing working capital, these norms and methodology is still followed
by many banks.
Reporting system: Reporting system Chore Committee(1979) Reference: improvements in cash
credit system for better management. Improving inter relationship between credit and production.
Committee’s recommendation of applying 2 nd method of Tandon committee for all borrowers
having credit limits of more than 10 lakhs not accepted by RBI and instead applied to borrowers
having limits of more than Rs 50 lakhs. Shortfall in working capital can be given as WC term loan
repayable in 5 years carrying 2% extra interest. Extra interest suggestion not accepted by RBI.
Separate limits for peak level and normal requirements. Introduced QIS Form 1 quarterly
projection of sales/production etc, Form 2 actual and projection comparison, form 3 half yearly
P7L and fund flow.
3. Special facility-SSI Units ( investment up to Rs1cr in P&M –SSI and from 1-10 cr is SME): Special
facility-SSI Units ( investment up to Rs1cr in P&M –SSI and from 1-10 cr is SME) Nayak
Committee ( 1991) reference: difficulties faced by small scale industries in securing finance. SSI
units are entitled for working capital at minimum 20% of projected sales (applicable for units
having requirements up to Rs 500 lakhs) quantum of working capital bank financing to be 20% of
projected sales subject to promoters’ contribution of 5% of projected sales i.e 20% of total fund
requirement that has been estimated at 25% of projected sales. Collateral security and third party
guarantee can be dispensed with. Two separate categories were made up to Rs 500 lakhs and
above Rs 500 lakhs.
Overview-WC management: Overview-WC management Working capital is synonymous with
current assets. Gross WC is current assets net working capital is current assets less current
liabilities. WC management concerns administration of firm’s current assets along with financing
(especially current liabilities) needed to support current assets. In determining optimum level of
current assets management has to consider trade off between profitability and risk. Higher level
will lead to liquidity but will lead to the risk of lower profitability. Profitability varies inversely with
liquidity but moves together with risk. WC has different components but it can be also classified
by time permanent or temporary. Permanent WC is the amount of current assets required to meet
a firm’s long term minimum need. Temporary on the other hand is the amount that varies with
seasonal needs. When we adopt hedging approach to financing, each asset would be offset with
financing instrument of approx same maturity. Short term seasonal variations would be financed
with short term debts whereas permanent portion with long term debt or equity. Longer the
composite maturity schedule of financing, less risky is the financing but longer the maturity
schedule financing is likely to be costly and hence less profitable. The two key facets of WC
management are-what level to maintain and how to finance them. These both facets are
interdependent.
Inventory Management: Inventory Management Object: to maintain quantities of stocks at a level
which optimises some predetermined management criteria which could be- a) minimising costs
incurred as whole, as the result of holding stocks. b) maximising profit. c) maintain certain level of
customer service. d) guard against likely abnormal situations, if any.
Disadvantages of low stocks: Disadvantages of low stocks Unable to meet delivery schedules
thereby causing loss of existing customers as well as future business. In order to fulfil
commitments to important customers costly emergency purchases ( special production runs) may
become necessary to maintain goodwill. Lower reordering level may result into higher reorder
costs.
Disadvantages of high stock: Disadvantages of high stock High storage & holding costs-chances
of deterioration. Loss due to capital tied up. Locking of capital may result in to losing it’s
alternative better uses. Losses due to market price fluctuations on lower side.
Cost of holding stocks: Cost of holding stocks Purchase price Cost of capital tied up. Insurance
Deterioration Obsolescence Damage / pilferage Store up keep Labour & administrative costs.
Reorder cost Shortage cost Systems cost
Some of the best practices: Some of the best practices Reordering levels. EOQ. Standardisation.
Insurance spares. ABC analysis. Reports generation- actual-norms. Corrective actions.
Responsibility fixing. Preventive maintenance schedule. Vendor development / sourcing. Supply
chain management. Market feedback. Effective coordination amongst departments. Logistics
services. Outsourcing some of the activities. Sub contracting. Reengineering aimed at reducing
the production process time / lead time. Control over slow moving / non moving stocks.
Production planning. Method of inventory valuation. Removing bottlenecks in production,
4. Reducing change over time. Adequate down stream facilities / balancing facilities.
Credit management: Credit management Always remember, as creditors provide you the source
of working capital your credit to customers is also partially funding his working capital.
Aspects of credit management: Aspects of credit management Terms of payment. Credit policy
variables . (conflict-cross functional teams involving marketing & finance) Credit evaluation. Credit
granting decision. Review of credit. Customer weightages. Control of accounts receivables.
Latest trends in credit management (outsourcing).
Extremes in terms of payment: Extremes in terms of payment Liberal credit till buyer converts
goods into cash and then pays. Buyer pays 100% advance and finances the entire trade cycle.
Actual practice the scene is in between the above two.
Payment terms: Payment terms Cash. Open credit. (max outstanding at any point of time) Line of
credit ( upper ceiling) Revolving credit. Open / revolving credit with prompt payment discount.
Documentary credit.-demand bills - usance bills Letter of credit
Credit policy variables.: Credit policy variables. Credit standards ( customer category) Credit
period-fixed / variable to category. Cash discount Collection efforts - monitoring state of
receivables - follow up for payment - legal action Nature of business
Credit evaluation: Credit evaluation Willingness of customer to honour obligation. ( character)
Ability to meet obligation based on operating cash flow. ( capacity) Financial reserves ( capital)
Security offered ( collaterals) General economic condition ( condition) Sources to get above-bank
references, financial statements, experience, stock prices , DGs& D registration etc
Should credit be granted?: Should credit be granted? Credit Risk analysis character capacity
capacity weak strong capital capital weak strong Dangerous risk Doubtful risk weak strong weak
Fair risk strong Excellent risk capital capital weak strong strong weak weak strong Credit Period?
Credit granting decision: Credit granting decision Evaluate business potential. Chances of repeat
order. Chances of approved supplier. Chances of continuous annual open order.
Control of receivables: Control of receivables Periodic reports Review & follow up. Ageing of
receivables-flags Collection matrix-to study trend. Expert agencies ( credit rating) Collection
agents? Pit falls Incentives. Clear cut responsibility fixing.
Payables management: Payables management It is the source of capital for business. Should be
given equal importance as receivables. Involves: Negotiations Volumes Price revisions
Escalations Annual review. Prompt payment discounts. Deferred credit
Cash management: Cash management Cash budgeting Long term cash forecasting Reports for
control Cash collections & disbursements Optimal cash balance Investment of surplus cash Cash
management models
Cash budgeting: Cash budgeting Estimating cash requirements Planning short term financing
Scheduling capex Developing credit policies Checking accuracy of long term forecast
Investment portfolio: Investment portfolio Segments: ready cash – controllable cash- free cash.
Criteria: safety-liquidity-yield-maturity. Options: term deposits with banks-treasury bills-mutual
funds-commercial paper-ICD
5. Cash & short term investment: Cash & short term investment Corporates hold cash to meet
transactions, as well as for speculative and precautionary motives. Cash management involves
efficient collection and payments and investments out of temporary surpluses. Efficient cash
management consists of speedy collections and slowing down of payments. Collections can be
accelerated with the help of computerised billing, automatic debits, lockboxes, electronic
transfers, electronic commerce etc. Disbursements can be controlled through separate
disbursement accounts, zero balance accounts, Use of outsourcing wherever practical and
feasible especially billing, collections, disbursements, short term investments etc. Optimum cash
balance will be based on transactions balances or minimum balance requirements of the bank
whichever is higher. Short term investments can be based on ready cash segment, controllable
cash segments (taxes ,dividends etc) and free cash segments. Principles of safety, marketability,
yield and maturity will be deciding factors for portfolio. ( trade off between risk & returns).
Cash management cycle: Cash management cycle cash collections disbursements Short term
investments Control by reporting Funds flow Information flow With timely information reporting it
is possible to generate significant Income by properly managing collections, disbursements &
investments.
Collection float: Collection float Customer Mails check Receipt of check Check deposit Actual
credit Mail float Processing float Clearing float Total float
Reducing collection float : Reducing collection float Collection float is important because we have
to wait until a check mailed by the customer finally clears the banking system before cash
becomes available. To turn mailed checks into cash more quickly collection float need to be
reduced as much as possible. What are the different ways to do this?
Reducing collection float: Reducing collection float Quicker invoicing : either send with shipment ,
by fax, by e-mail,should be computerised, or claim payment based on proforma. Eliminate billing :
preauthorised debits (ECS) Lockbox system : post box maintained by bank to receive checks.
This can be single location or multiple location. Evaluate financial implications. Take benefit of
multiple city checks at par. Insist on payments by drafts or wire transfer . Cash concentration
through concentration banking. (Air India) Prepare for paperless payments over a period of last
10 years paper based payment options such as checks have fallen from 81% of consumer
spending to just 60%. Stored value or prepaid cards. Credit cards / debit cards.
Slowing down payments: Slowing down payments Playing the float: checks in transit, difference
in book balance and bank balance. Zero balance account linked to master account ( Ashok
Leyland) Policy to issue checks only on weekends. Standing instructions to the bank to encash
deposits kept in multiples internally. Remote bank branch disbursements. Renegotiate quick
payment discount such to beat the cost of borrowing. Outsourcing certain operations.
Integrated Financial Management System: Integrated Financial Management System Essentials
of an effective IFMS -integration of budgeting-accounting-receivables-payables-inventory-cash
management modules. - timely reports. - analysing reports -corrective actions -follow up.
Financing working capital: Financing working capital Spontaneous financing ( creditors / accrued
expenses) Bank overdraft Cash credit. Bill discounting Letters of credit Factoring Packing credit
Commercial paper Advance against book debts.
Credit Rating system & Credit Risk Assessment.: Credit Rating system & Credit Risk
Assessment. Earlier banks were scoring only two financial parameters depicting operating
efficiency / strength of borrowing unit and few subjective aspects of the functioning of the unit.
The total score used to be graded against scale and the pricing was decided on that basis. CRS
has now been replaced by CRA
6. Credit Rating system & Credit Risk Assessment.: Credit Rating system & Credit Risk
Assessment. The earlier system relied on only two parameters Current ratio and debt equity ratio
and other factors to depict adherence to financial discipline. Certain other areas used to be
commented upon like extent of irregularity ( drawing in excess, default in payment etc)
submission of QIS etc Stress was more on compliance aspect and not on inherent risk in the
proposal / venture. CRS was more a loan classification system. In today’s deregulated financial
regime performance as well as risk perception in respect of borrowing unit is considerably
influenced by external factors like industry scenario, Govt regulations, national / global economic
scenario etc. Risk factors need to be factored to arrive at credit sanction pricing thereof.
Credit Rating system & Credit Risk Assessment: Credit Rating system & Credit Risk Assessment
Risk elements ( financial, industrial, management) Financial Risk a) latest financials of the unit b)
average financials over a period of time (better, at par, worse) c) comparison of latest financial
with industry average. (better, at par, worse) d) other risks-off balance sheet items ( contingent
liabilities, disputes, guarantees, tax claims, accounting policies, auditor’s remarks etc) impact on
profitability, interest coverage is done with sensitivity / probability approach. Qualifying remarks of
auditors like non provisioning, recognising of income are also impacted. Financial ratios will
include Current ratio, Debt equity, PBDIT/Interest, PAT/sales, ROCE or ROA,
Inventory+Receivable/ net sales in days. Weightages- 25%, 25%, 10%,10%, 10% 20%.
Credit Rating system & Credit Risk Assessment: Credit Rating system & Credit Risk Assessment
Industry Risk: study current trends ( specific activity in particular) and translate perception into
quantifiable terms. This is generally done by value statement of various aspects of the industry
risk parameters. These are: a) competition / market b) industry cyclicality.( long term propects,
stable outlook, stable industry cycle) c) Regulatory (regulatory framework, availability of skilled
labour, environment pollution, labour unrest) d) Technology( kind of technology, state of
maintenance,capacity utilisation) e) Input profile ( rm availability, its price stability, alternate users,
substitutes available) f) User profile ( distinctive product, substitutes available, large buyers, no
complaints)
Value statement example: Value statement example Competition & market risk: ( score of 4 for
following) a) company is one of the lead players or has an exclusive niche market or brand equity,
ancillaries tie up with well known major domestic / multinational company. b) has a market share
growing faster than the industry. c) does not depend on one or few buyers. d) has a large area of
operations. e) has a range of products.
Value statement example: Value statement example Score of 3 for following: Few significant
players in the market. There are some barriers to entry. Company is one of the top three players.
Sufficient orders on hand. Has a established brand which is well received. Has a share which is
steadily growing. Has fairly large area of operations.
Value statement example: Value statement example Score of 2 could be for: a) Competition
heating up but by and large demand still exceeds supply. b)Adequate orders on hand. c)Is one of
the average players. Score of 1 could be for: Market share is declining Depends on few buyers.
Recession in market. Does not have range of products. Score of 0 could be for: Industry has
problem of over supply. Company is insignificant player with no distinguished product line.
Depends on one or very few buyers.
Credit Rating system & Credit Risk Assessment: Credit Rating system & Credit Risk Assessment
Management Risk: perhaps the most important area of risk assessment especially when the
management has not been time tested. These include a) integrity b) track record c) structure &
systems d) Expertise e) Capital market perceptions ( may not be in case of agri, SSi etc)
7. CRA models: CRA models Depending upon market segment and exposure proposed every bank
has different models. For example ABank has following: Regular Model: (based on all risk
parameters) applicable for WC limits of Rs 5 cr and above in C&I, SSI and Agriculture segments,
Rs 2 cr and above in trade segment. Simplified (regular)model: ( based on only financial risk
parameters) applicable for WC limits below Rs 5 cr in C&I, WC limits in the range of 2-5 cr for SSI
& Agri and limits below 2 cr for trade. Simplified liberal model (taking simplified model and again
liberalizing it further) applicable to WC limits of Rs 25 lakhs and above and up to Rs 2 cr in SSI &
Agri for this model NFB is excluded to compute the limits Some delegations and powers given to
CGMs for interpretation
Models-applications: Models-applications situations ( Rs lakhs) I II III IV FBWC 180 210 400 400
NFBWC 50 20 70 120 Total 230 230 470 520 CRA Model Simplified liberal Simplified regular
Simplified regular Regular
Risk & pricing: Risk & pricing Banks generally make a Risk Range Table All the risks are scored
according to the laid down formulae. If some items could not be scored the score is
proportionately reduced. Total score is found out. The relevant gradation is found out. According
to the gradation pricing is done For example for a total risk score of 68 risk gradation could be
AB3 and the corresponding pricing could be 3% above it’s PLR or such other rate fixed.
Risk & pricing: Risk & pricing Some time banks fix the exposure to a particular borrower based of
initial assessment. For example no fresh / additional exposure will be allowed in respect of
proposals which have been assessed at a grade worse than say AB5. Some exceptional
authorities could be given at a level. Some time review of WC limits is done at half yearly or
annual intervals. Some times for deviations for say more than 20% in ratios or default in payment
may attract penal interest. Sometimes additional collaterals will be called for. Sometimes pricing
is done on account value based pricing model which considers volume of business, share of
ancillary business to bank, value of account, price/earning ratio, length of relationship with the
bank. These are quantitative parameters. The qualitative parameters will include threat of loss of
business due to competition, overall image or reputation of the company, perception of long term
benefit to company, perception of group potential for growth and business to bank.
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