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ADVANCED FINANCIAL

MANAGEMENT

MOD-1

Working Capital Management

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Difference between long term financialmanagement and short term financialmanagement is timing of cash

Long term financial decisions like buyingcapital equipment or issue of debenturesinvolve cashflow over 5 to 15 years

Short term financial decisions involve cashflows within an year or within operatingcycle of firm

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Two concepts of working capital: 1. gross working capital is the total of all current

assets

2. net working capital is the difference between

current assets and current liabilities Working capital management is very

important because:

1. current assets form substantial portion of total

investment 2. investment in CA and level of Current

Liabilities have to be quickly geared to changesin sales

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Constituents of CA

Inventories

RM and components

Work in process Finished goods

Others

trade debtors

loans and advances

Cash & bank balances

Constituents of CL

Sundry creditors

Trade advances

Borrowings Commercial banks

others

Provisions

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Characteristics of current assets:

1. Short life span

Current Assents have short life span: cash balance aweek or two, accounts receivables 30 to 60 days,

inventories 1 to 60 days The life span depends on time required in activities likeprocurement, production, sales and collection. Inaddition degree of synchronisation among them

2. Swift transformation in to other asset form

Each current asset is swiftly transformed into otherform of assets: cash to raw material (RM), RM tofinished goods (FG), FG is sold on credit (accountsreceivables), Account receivables to cash

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Current assets cycle

Finished goods

Accounts

Receivables

Work in process

Wages, salaries,

Factory O/H

Raw materials

Cash Suppliers

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Implications of short life span of WC

1. decisions relating to WC are repetitive andfrequent

2. the difference between profit and present

value is insignificant 3. close interaction of WC components implies

that efficient management of one componentcannot be undertaken without simultaneous

consideration of other components Ex. 1.If firm has more FG it may offer liberal

credit or show laxity in collection, 2.if a firm hasliquidity crunch it may offer generous discounts

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Factors influencing working capitalrequirements:

Important factors:

1. nature of business

2. seasonality of operations

3. production policy

4. market conditions

5. conditions of supply

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Nature of business:

1. WC is closely related with nature of firmsbusiness

2. Ex. Electricity firm or transport corpn whichhas short operating cycle and which sellspredominantly on cash basis has modest WCrequirement

Ex. A mfg. co. like machine tools unit has longoperating cycle and which sells largely on credithas substantial WC requirement

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Proportions of Current Assets and Fixed assets

CA % FA% Industries

10-20 80-90 Hotels and restaurants

20-30 70-80 Electricity T & D

30-40 60-70 Aluminum & shipping

40-50 50-60 Iron & steel, industrialChemicals

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 & constn

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Seasonality of operations:firms which

have marked seasonality in their

operations have highly fluctuating working

capital requirements.

Ex. Firm mfg. ceiling fans have peak sales

in summer and therefore high working

capital requirement. A bulb mfg. co. hasstable working capital requirement

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Production policy:

a firm marked by pronounced seasonalfluctuations in its sales may pursue a

production policy to reduce sharpvariations in WC requirements

Ex. Firm mfg. fans can maintain a steady

production throughout the year. Suchproduction policy may dampen fluctuationsin WC requirements

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Market conditions: Degree of competition in market place hasimportant bearing on WC needs

When competition is keen, larger inventory is to

be maintained to service the demand ofcustomer who may not be ready to wait, asother competitors are ready to meet their needs

Further generous credit terms are offered to

attract customers in highly competitive market Thus WC requirement will be high because of

higher investment in finished goods andaccounts receivables.

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If market is strong and competition isweak, firm can manage with smallerinventory of finished goods, as customers

can be served with delay In such a situation firm can insist on cash

payment and avoid lock up of funds inaccounts receivables

Firm can also ask for advance payments-partial or total

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Conditions of supply: The inventory of RM, spares, and stores

depends on conditions of supply

If supply is prompt and adequate, firm can

manage with small inventory If supply is unpredictable and scant, to

ensure continuity in production, firm has tocarry higher inventory.

Similar policy is followed when RM isavailable seasonally and productioncarried round the year

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Levels of current assets: An important WC policy decision is concerned

with level of investment in current assets(CA) Under flexible policy/conservative policy

investment in CA is high

That means firms maintain huge cash balance

and marketable securities, carries large amounts

of inventories, grants generous credit terms to

customers leading to high level of debtors

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Under restrictive policy/ aggressive policy

the investment in CA is low

That means firms keep small balance of

cash, small balance of cash in marketable

securities, manages with small amount of

inventories and offers stiff terms of credit

leading to low level debtors

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What are consequences of flexible andrestrictive policies?

1. broadly flexible policy results in fewer

production stoppages, ensures quick deliveriesto customers, stimulates sales because of liberalcredit. All these at higher investment in currentassets

2. restrictive policy may lead to frequentproduction stoppages, delayed delivery tocustomers, and loss of sales. All these are to beborne by the firm to keep low investments in CA

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Determining the optimal level of CA is trade offbetween costs that rise with CA and cost that fallwith CA

The costs that rise is called carrying costs and

the costs that fall are called shortage costs Carrying costs are mainly financing cost ofhigher inventory

Shortage costs are mainly disruption of

production schedule, loss of sales and customergoodwill.

The optimal level of current asset is denoted byCA* in the graph(often cost curve is fairly flat around optimal level. Managershould be satisfied if CA level is close to optimal point)

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Carrying cost and

Shortage cost

total cost

carrying cost

shortage cost

CA* level of current assets (CA)

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Current assets financing policy: After establishing level of current assets, firm

has to determine how to finance CA.

What mix of long term capital and short term

debt to be employed?

Total assets and hence the capital requirement

of a firm changes over time as depicted in thegraph

(Mainly, Level of CA changes over time)

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Capital requirement and their financing

Capital requirement fluctuating CA requirement A

B

C permanent current

asset requirement

fixed asset

requirement

Time

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Working Capital Management For the sake of simplicity assets are divided into

two classes viz. fixed assets and current assets

Fixed assets are assumed to grow at a constantrate which reflects the secular (long term) rate of

growth in sales Current assets are also expected to grow at thesame long term rate of growth

However they exhibit substantial variation

around the trend line, thanks to the seasonalpatterns in sales or purchases

Several strategies to finance capital requirementof a firm.

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Three important strategies are illustrated

by line A , B and C in the graph

Strategy A:long term financing is used to

meet fixed asset requirement and peak

working capital requirement

When working capital requirement is less

than peak level, the surplus is invested in

liquid assets (cash & marketable securities)

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Strategy B: long term financing is used to

meet fixed asset requirement, permanent

working capital requirement and a portion

of fluctuating working capital requirements.

During seasonal upswings, short term

financing is used: during seasonal down

swing surplus is invested in liquid assets.

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The rationale for matching principle is, if a firmfinances a long term asset with short term debt(say commercial paper), it will have toperiodically refinance the asset.

Whenever short term debt falls due the firm hasto refinance the asset which is risky andinconvenient

Hence it makes sense to ensure that thematurity of assets and sources of financing areproperly matched

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Operating and cash cycle

Order placed stock arrives finished goods sold cash received

inventory period Accounts receivables period

Account payable

period

firm receives cash paid for

invoice materials

Operating cycle

cash cycle

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The firm begins with the purchase of raw

materials which are paid for after a delay

of which represents accounts payable

period

the firm converts the raw materials into

finished goods and then sell the same

The time lag betwn. the purchase of RM

and sale of FG is inventory period

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Customers pay their bills some time after sales

The period that elapses between date of salesand the date of collection of receivables is theaccounts receivable period

The time that elapses between the purchase ofRM and the collection cash for sales is calledoperating cycle

the time length between the payment of RMpurchase and collection of cash for sales iscalled as cash cycle

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The operating cycle is the sum of theinventory period and accounts payableperiod

The cash cycle is equal to operating cycleless the accounts payable period

From financial statements of the firm the

inventory period, the accounts receivableperiod and accounts payable period canbe estimated.

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Ex. Financial info. of Horizon ltd is given:

Balance sheet data

P & L Begining End A/C data of year 2009 of 2009 Sales 800 Inventory 96 102

Cost of goods 720 Acts. Receivable 86 90

sold Acts. Payable 56 60

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Inventory period=

=Av. Inventory/Annual cost of goods sold/365

Inventory period= (96+102)/2 / (720/365)

= 50.1 days

Accounts receivable period=

Average accounts receivable / annual sales/365

Accts. receivable period= (86+90)/2 / 800/365

Accounts receivable period= 40.2 days

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Accounts payable period= =average accounts payable / annual cost of goods sold/365

Accounts payable period= (56+60)/2 / 720/365

Accounts payable period= 29.4 days

Operating cycle=

inventory period + accounts receivable period== 50.1+40.2= 90.3 days

Cash cycle= operating cycleaccounts payable period==90.3 -29.4 = 60.9 days

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It is helpful to monitor the behaviour ofoverall operating cycle and its individualcomponents

For this purpose time series analysis canbe done

In time series analysis, the duration of theoperating cycle and its individualcomponents is compared over a period oftime for the same firm

In cross-section analysis, the duration ofthe operating cycle and its individualcomponents is compared with that of otherfirms of a comparable nature

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Cash requirement for working capital Financial manager can follow a two step

procedure to find out the cash requirement of hisfirm:

Step-1. estimate the cash cost of various currentassets required by the firm

The cash cost of a current asset is :

value of the CA -

profit element if any included in the valuenon-ash charges like depreciation if any

included in the value

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Ex. Value of sundry debtors Rs.10 mln as per

balance sheet, Profit margin is 25%,

depreciation element in the cost of goods sold

corresponding to sundry debtors is Rs.0.5mln. The cash cost of sundry debtors is=

Value in balance sheet Rs. 10 mln

Profit margin 25% Rs. 2.5 mln

Cost of goods sold Rs. 7.5 mln

Depreciation element Rs. 0.5 mln

Cash cost of sundry debtors Rs. 7.0 mln

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Step-2: deduct the spontaneous currentliabilities from the cash cost of currentassets.

A portion of the cash cost of CA issupported by trade credit and accruals ofwages and expenses, which are referredto as spontaneous current liabilities

The balance left after such deductions hasto be arranged from other sources

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Ex. Max ltd sells goods at a profit margin of25%, counting depreciation as part of cost ofmanufacture. Its annual figures are:

Rs. mln

Sales (2 months credit is given) 240 Material cost (3 months credit) 72

Wages (paid one month arrears) 48

Mfg. expenses outstanding at the end of year

(cash exp. Paid 1 month arrears) 4 Admn. & sales expenses 30

(paid as incurred)

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Max ltd keeps two months stock of RM

and one months stock of FG.

It needs a cash balance of Rs. 5mln

Estimate the requirement of working

capital on cash cost basis, assuming 10%

safety margin. Ignore work in process

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Working notes: Rs. mln

1. manufacturing expenses sales 240

less Gross profit(25%) 60

Total mfg. cost 180less material 72

wages 48 120

Manufacturing expenses 60

2. cash mfg. exp (4mln x 12) 48

3. Depreciation (1)(2) 12

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Total cash cost:-

Total manufacturing cost 180

Less depreciation 12cash manufacturing cost 168

Add admn and selling exp. 30

Total cash cost 198

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The requirement of working capital cash cost basis is:

A: Current Assets

Item Calculation Amount

Debtors Total cash cost x2/12

198 x 2/12 33.00

RM stock Mat. Stock x 2 /12

72 x 2/12 12.00

FG stock Cash mfg.cost x 1/12

168 X1/12 14.00

Cash balance 5.00

Total current assets 64.00

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B: Current l iabi l i t ies Item Calculation Amount Sundry creditors: mat.cost x3/ 12

72 x 3 /12 18

Mfg. exp outstanding: 1 months cash mfg.exp. 4

Wages outstanding: 1 month wages 4

Total current liabilities:B 26

Working capital (A-B) (64-26) 38.00

Add 10% safety margin 3.80

Working capital required 41.80

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Negative cash cycle:Internet based

amazon.com turns its inventory over 26 times a

year making its inventory period very short

It charges its customers credit card when itships a book and gets paid by the credit card

usually in a day

Finally, it takes about 46 days to the suppliers.

All this means that Amazon.com has a negative

cash cycle

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Concept of zero working capital:

Many leading companies seek to have a zero(or evenve) working capital

This happens when inventories and receivablesare supported by the credit provided bysuppliers and the advances given by customers

On average, working capital to sales ratio is

about 0.2 Reducing working capital has two financial

benefits:

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1. every rupee released by reduced working

capital makes a one-time contribution to cash

flow

2. periodically, the cost of money locked inworking capital is saved

Apart from the financial benefits, reducing

working capital forces a company to serve its

customers quickly, lessens warehousing needs,and reduces obsolescence costs.

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Working capital financing: Typically current assets are supported by long

term and short term sources of finance.

Long term finance provide the margin money for

working capital

Short term sources of finance more or less

exclusively support the current assets. discussion on sources of finance are divided

into ten sections.

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Accrua ls :the major accrual items are wagesand taxes, which the firm owes to its employeesand government

Wages are paid weekly, fortnightly or monthlybasis; the amounts owed not yet paid are shownas accrued wages in balance sheet

Income tax is payable quarterly, and other taxesmay be payable half yearly or annually. In theinterim, taxes owed but not paid may be shownas accrued taxes on the balance sheet

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Accrual vary with the level of activity of the firm

When activity expands accruals increase anddecrease when activity contracts

As accruals respond automatically to changes inactivity they are treated as part of spontaneousfinancing

As interest is not paid on accruals by the firm

accruals are regarded as free source offinancing. However closer examination showthat it is not so.

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That is when payment cycle is longer, wagesmay be higher. An employee earning Rs.5000per week may ask for slightly highercompensation if payment is made on monthly

basis Likewise tax authorities may also raise the tax

rate

However the facts remain that, betweenestablished payment dates accruals do not carryany explicit interest burden

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While accruals are welcome source offinancing, they are not amenable to controlby management

Payment period to employees aredetermined by the practice of the industryand the provisions of law

Similarly tax payment dates are given bylaw and postponement of paymentnormally results in penalties

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Trade credit :represents the creditextended by the suppliers of goods and

services

it is a spontaneous source of financearising in normal transactions of the firm

without any negotiations provided the firm

is considered as creditworthy by suppliers

It is an important source of financing

representing 25 to 50% of short term

financing

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Obtaining trade credit: the confidence ofsuppliers is key to securing trade credit.

Suppliers consider: Earnings over a period of time: if the firm has good

earnings record and with a portion ploughed back intothe business, it is looked upon favourably

Liquidity position of the firm: suppliers naturally lookat the ability of the firm to meet its obligation in theshort run, which is measured by current ratio and acid

test ratio Record of payment: if firm has been prompt andregular in paying bulk of its suppliers in the past, it isdeemed as creditworthy


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Working Capital Management Cultivating good supplier relationships:

New firm or firm with financial problem will havedifficulty in obtaining trade credit

Confidence of suppliers can be earned bydiscussing the financial situation, by showing

realistic plans, and more importantly honouringthe commitments

Broken promises erode confidence than poorresults.

Better to make modest commitments which maynot be fully satisfying to the supplier and honorthem, instead of breaking a tall promise whichwould gratify the supplier and fail to honor them.

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Cost of trade credit: the cost of trade credit depends onthe credit offered by the supplier.

If the terms are say, 30 day net, then trade credit is cost-free because the amount payable is the same whether

payment is made on the day of purchase or on 30th

day However if supplier offers discount for prompt payment

and terms are say 2/10, net 30, there is cost associatedwith trade credit availed beyond discount period into twoparts:

10 days/discount period: 20 days/non discount period The cost of trade credit during discount period is nil and

cost of trade credit during non discount period is:

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[Discount/1-discount ]x[360/credit period-discount period]

In the example it works out to:

[0.02/1-0.02] x 360/(30-10) =36.7%

The cost of trade credit for several credit terms is as below:

credit terms cost of trade credit

1/10, net 20 36.4%

2/10, net 45 21.0%

3/10, net 60 22.3%

2/15, net 45 24.5%

Generally cost of trade credit is very high. Unless firm ishard pressed financially, it should not forego discount.

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What happens if the firm fails to pay with in discountperiod but pays before the end of net period?

Naturally the annual interest cost of trade credit ishigher, the longer the difference between the day ofpayment and end of the discount period. From theforegoing two things are clear;

1. cost of trade credit is very high beyond discountperiod. Unless the firm is hard pressed financially itshould not forego the discount for prompt payment

2. if the firm is unable to avail the discount forprompt payment, it should delay the payment till thelast day of the net period, and even beyond if suchan action does not impair creditworthyness of thefirm

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Working capital advance by commercial

banks:

Working capital advance by commercial banks

represents most important source for financingcurrent assets.

The following aspects needs examination:

1. application processing, 2. sanction and terms

and condition, 3. forms of bank finance, 4.

nature of security, 5. margin amount

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Application and processing: customers seekingan advance should submit appropriateapplication form. There are different types offorms for different categories of advances

The information required include name andaddress of borrower & his establishment, detailsof his business, nature and security offered.

Application form has to be supported by variousancillary statements like financial statementsand financial projections of the company

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The application is processed by branch manageror his field staff.

This primarily involves examination of:

1. ability, integrity and experience of theborrower in the particular business, 2. general

prospects of the business, 3. purpose of

advance, 4. requirement of the borrower and its

reasonableness, 5. adequacy of margin, 6.provision of security, 7. period of repayment

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Sanction and terms and conditions: once the

application is processed it is put up for sanction

to appropriate authority

The sanctioning powers of various officials likeBranch Manager, Regional Manager, General

Manager etc., are defined by the virtue of the

position they occupy

If the loan is sanctioned, it specifies the termsand conditions applicable to advance

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These usually cover the following, 1. amount of loan or maximum limit of advance,

2.nature of advance, 3. period for which loan isvalid, 4. rate of interest applicable to advance, 5.primary security to be charged, 6. insurance of thesecurity, 7. details of collateral security if any to beprovided, 8. margin to be maintained, 9. otherrestrictions or obligation of borrower if any

It is common practice to incorporate terms and

conditions on a stamped security document This helps bank to create required charge on thesecurity offered and also obligates the borrower toobserve stipulated terms and conditions

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Forms of bank finance: Working capital advance isprovided by commercial bank in three primary ways: 1.cash credits/ overdrafts, 2.loans, 3. purchase/ discountof bills

Cash credits/ overdrafts: under this arrangement a

predetermined limit for borrowing is specified by thebank. Borrower can draw as often as required providedout standings do not exceed the cash credit / overdraftlimit

Borrower also enjoys the facility of repaying the amount

partially or fully as and when he desires Interest is charged on running balance not on limitsanctioned.

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A minimum charge may be payable

irrespective of the level of borrowing, for

availing this facility.

This form of advance is highly attractive asthe borrower has freedom of drawing

amount in installments as and when

required and interest is payable on actualamount outstanding

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Working Capital Management Loans: these are advances of fixed amounts

which are credited to the current account of theborrower or released to him in cash.

The borrower is charged with interest on theentire loan amount, irrespective of how much hedraws

Loans are payable on demand or in periodicalinstallments

When payable on demand, loans are supportedby demand promissory note executed byborrower.

There is possibility of renewing the loan

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Purchase/ discount of bill: A bill arise out of atrade transaction.

The seller of the goods draws the bill on thepurchaser

The bill may be either clean or documentary andpayable on demand or after a period which doesnot exceed 90 days

(A documentary bill is supported by a documentof title of goods like railway receipt or bill oflanding)

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On acceptance of the bill by purchaser, theseller offers it to the bank for discount/ purchase

When the bank discounts / purchases the bill it

releases the funds to the seller The bank presents the bill to the purchaser on

the due date and gets its payment

The RBI launched the new bill market scheme in

1970 to encourage the use of the bills as an

instrument of credit

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The objective was to reduce the reliance oncash credit which was amenable tomisuse/abuse

The new bills scheme sought to promote an

active market for bills as a negotiable instrumentso that the lending activities of a bank could beshared by other banks

It was envisaged that a bank, when short offunds can sell or rediscount the bills that it haspurchased or discounted

Likewise a bank with surplus funds would investin bills

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For such a system to work, there has to be

a lender of last resort which can come to

help the banking system

RBI took this role and rediscounts bills ofcommercial banks to a certain limit

In spite of the support of RBI bill market

scheme has not functioned successfully

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Ex. A bank opens a LC in favour of A for some purchasethat A plans to make from B.

If A does not make payment with in the credit periodoffered by B, the bank assumes the liability of A for thepurchase covered under LC

Naturally B will not hesitate to extend credit to A whenbank opens LC in favour of A

Under LC arrangement supplier provides the credit,but bank assumes the risk

This is an indirect form of financing as against OD, CC,

loans and bill discounting which are direct form offinancing

Note that bank assumes risk as well as financing indirect financing

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Working Capital Management Security:

Hypothecation: the owner of the goods borrowsmoney against security of movable property,usually inventories

Owner does not part with the property

Rights of lender depends on agreementbetween the lender and the borrower.

Should the borrower default in paying his dues,

the lender can file a suit and realise his dues byselling goods hypothecated

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Pledge: owner of the goods(pledgor) depositsthe goods with the lendor (pledgee) as security

for the borrowing

Transfer of possession of goods is aprecondition for pledge. Lendor is expected to

take reasonable care of goods pledged with him

Pledge contract gives lender right to sell goods

and recover dues, should the borrower default inpaying debt

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Margin amount: banks do not provide 100%finance.

They insist that the customer should bring a

portion of the required finance from othersources

This portion is known as margin amount

There is no fixed formula to determine the

margin amount. The guideline is:

When margin is low bankss risk high, vice versa

C

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Regulation of bank finance: Traditionally industrial borrowers enjoyed

easy access to bank finance to meet their

WC needs

The CC facility is advantageous to borrowers

Observers felt that there was over borrowing

of readily available finance by the industrialborrowers, depriving other sectors.

W ki C i l M

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Concerned about the distortion, since1960 RBI had been issuing guidelines tobring in discipline among industrial

borrowers and to redirect funds to prioritysector.

The guidelines and directives stemmedfrom recommendations of groups like,

Dahejia committee, Tandon committee,Chore committee and Marathe committee.

W ki C it l M t

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From 1970s the regulation of bank financewas based mainly on Tandon committee

In spite of financial liberalisation since

1990s, giving freedom to banks relating toWC financing, most of the banks are stillinfluenced by Tandon committeerecommendations

The key elements of the same is givenbelow:

W ki C it l M t

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Tandon committee recommendations:

the key recommendations relate to: 1. norms for

CA, 2. the maximum permissible bank finance

(MPBF), 3. emphasis on loan system and, 4.periodic information and reporting system.

Norms of CA: Tandon committee defined the

norms for RM, Stock in process, FG and

receivables for 15 major industries.Subsequently more industries were covered

W ki C it l M t

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MPBF: following three methods weresuggested:

Method 1: MPBF=0.75(CA-CL)

Method 2: MPBF=0.75(CA)-CL

Method 3: MPBF=0.75(CA-CCA)-CL

CA=current assets; CL=current liabilities;

CCA=core current assets, representing

permanent component of WC

W ki C it l M t

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Ex:Ambex Company Current assets Current liabilities

1. RM 18 1. Trade creditors 12

2. WIP 5 2. other CL 3

3. FG 10 3. Bank borrowings

4. Receivables (incl. bills discounted) 25 (incl.bills discounted) 15

5. Other 2

Total 50 40

MPBF Computation:

Method 1= 0.75(CA-CL)=0.75(50-15)=Rs.26.25Cr

Method 2=0.75(CA)-CL=0.75(50)-15=Rs.22.5Cr

Method 3=0.75(CA-CCA)-CL=0.75(50-20*)-15=Rs.7.5 Cr

*Assume core current asset- Rs.20 Cr

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In the above three methods, second method hasbeen adopted.

Note the that under this method minimum

current ratio works out to be 1.33 =50/(22.5+15) Ex. For a xyz co. CA=100 and CL=50(excl. bank finance)

Under method 2: MPBF=0.75(100)-50=25

This means that CL including MPBF=50+25=75

hence current ratio= 100/75=1.33

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Emphasis on loan system: traditionally bankcredit to industry was in the form of cash credit(which was introduced by scottish bankers)

Under CC system bank bears the responsibility

of cash management because borrowersdetermine their drawls with in the CC limitprovided by the bank

Tandon committee recommended that only a

portion of MPBF must be in the form of CC andbalance must be in the form of working capitaldemand loan

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Periodic information and reporting system: Tandon committee recommendation on this issue was

further improved by Chore committee. The Keycomponents are:

1. Quarterly information systemform-I: this gives i.estimates of production and sales of current year andensuing quarter, ii. the estimates of current assets andliabilities for the ensuing quarter

2. quarterly information systemform-II: this gives i.

actual production and sales during current year and forlatest completed year, ii. The actual current assets andcurrent liabilities for the latest completed quarter

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3. Half yearly operating statement-form-III:this gives the actual operating

performance for the half year ended

against the estimates for the same 4. Half yearly funds flow statement- form-

IIIB: this gives the sources and uses of

funds for the half-year ended against theestimates for the same

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Present practice:

1. assessment of WC requirements: banks use

following methods:

Projected balance sheet method: WC requirementsassessed on the basis of projected values of assets

and liabilities

Cash budget method: the WC requirements are

assessed on the basis of projected cash flows

Turnover method: the WC requirements are assessed

on the basis of projected annual turnover

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Current ratio norm: under Tandon committeereport the minimum current ratio of 1.33 wasrequired. At present 1.33 is regarded asbenchmark and banks accept lower current ratiodepending on circumstances.

Thus presently banks follow more flexibleapproach in determining Assessed BankFinance (in place of MPBF)

Banks take into account variety of factors like

duration and nature of operating cycle, projectedbuild up of CA and CL, projected turnover,profitability and liquidity

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Emphasis on the loan system: there is change instyle of lending. Today bulk of WC limit is in theform of WC demand loan, only a small portion inthe form of cash credit component

Financial follow-up reports: some public sectorbanks have designed financial follow-up reportsFFR-I and FFR-II

FFR-I; is simplified form of Form-II of Tandoncommittee, to be submitted on quarterly basis

FFR-II: is modified version of Form-III of Tandoncommittee, to be submitted on half yearly basis.


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Public deposits: Many large & small firms have solicited

unsecured deposits from public in recent yearsto finance their WC requirements.

Cost: interest payable on public deposit wassubject to ceiling till mid 1996, just before itswithdrawl it was 15%

Companies offer an interest rate of 6-7%for oneyear, 7-8% for two years and 9-10% on threeyear deposits

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Working Capital Management Evaluation: from the companys view;

1. the procedure obtaining public deposit is fairlysimple.

2. no restrictive covenants (conditions) areinvolved

3. no security is offered against public deposit.Hence mortgageable assets are conserved

4. post tax cost is fairly reasonable

Demerits:

1. quantum of funds that can be raised by way ofpublic deposit is limited

2. maturity period is relatively short


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From investors view, the advantages: 1. the rate of interest is higher than

alternative forms of financial investment

2. the maturity period is fairly short- one tothree years

Disadvantages:

1.there is no security offered by the firm 2. the interest on public deposit is not

exempt from taxation


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Inter-corporate deposits: the deposit made by one company with another,

normally for a period upto six months is referred

to as an inter-corporate deposit. Three types 1. call deposit: in theory, call deposit is

withdrawable by the lender on giving a days

notice. In practice lender has to wait 3 days. The

interest rate may be around 12%


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2. three months deposit: more popular, thesedeposits are taken to tide over short term cashinadequacy which may be due to one or more ofthe following; 1. disruption in production,

excessive imports of RM, tax payment, delay incollection, dividend payment, and unplannedcapital expenditure. The interest rate is around15% per annum

3. six-months deposit: normally lendingcompanies do not extend deposits beyond thistime frame. Interest rate is 18% per annum.


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Characteristics of the inter-corporate deposit market: 1. lack of regulation: the lack of legal hassles and

bureaucratic red tape makes an inter-corporate deposittransaction very convenient. With plethora of regulationsin business environment, this is an example of the abilityof corporate sector to organise itself in a reasonablyorderly manner.

2. secrecy: the inter-corporate market is shrouded withsecrecy. Brokers regard their list of borrowers and

lenders as guarded secret. Tightlipped about theirbusiness apprehend, may result in unwelcomecompetition and undercutting of rates


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Importance of personal contacts: brokers andlenders argue that they are guided by a

reasonably objective analysis of the financial

situation of the borrowers.

However truth is inter-corporate deposit markets

are based on personal contacts and market

information which may lack reliability.

Given the secrecy of operation and non-availability of hard data, can it be otherwise?


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Short term loans from financialinstitutions:

Insurance companies provide short term loans

to manufacturing companies with excellent trackrecord.

Eligibility: the borrowing company should satisfythe following conditions:

1. it should have declared dividend of not lessthan 6%for the past 5 years (relaxed in certaincases at least 10% from last 3 years)


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2. the debt equity ratio should not exceed 2:1 3. The current ratio should be at least 1:1

4. the average of interest cover ratios for the past threeyears should be at least 2:1

Features: short term loans provided by FI have following

features: 1. they are totally unsecured and given on demand

promissory note

2. the loan is given for a period of one year and can berenewed for two consecutive years provided the original

eligibility criteria are satisfied 3. after repaying the loan company has to wait 6 months

for availing fresh loan

4.interest payable at quarterly rests.


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g p g Rights debentures for working

capital:public limited companies can issuerights debentures to their share holders withthe object of augmenting the long termresources of the company for WC requirements.

The guidelines to such debentures are asfollows:

1. the amount of debenture issue should notexceed, i. 20% of the gross CA, loans and

advances minus the long term funds presentlyavailable for financing WC, or ii. 20% of the paidup share capital, including preference capitaland free reserves, whichever is lower of the two


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g p g

2. the debt equity ratio including proposed

debenture issue should not exceed 1:1 3. the debentures shall first be offered to

the existing Indian resident share holdersof the company on a pro rata basis

Commercial paper:commercialpaper represents short term unsecuredpromissory notes issued by firms whichenjoy high credit rating.

Large firms with considerable financialstrength issue commercial paper.Important features are:


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1. the maturity period of commercial paperranges from 90 to 180 days

2. commercial paper is sold at a discount fromits face value and redeemed at its face value.

Hence the implicit interest rate is a function ofthe size of the discount and the period ofmaturity

3. commercial paper is directly placed with

investors who intend holding it till its maturity.Hence there is no well developed secondarymarket for commercial paper


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Regulation: since commercial paper representsunsecured instrument of financing, RBI hasstipulated conditions meant to ensure onlyfinancially strong companies can issue

commercial paper. These conditions are: 1. company has net worth at least Rs.50 milllion

2. its MPBF is at least RS.100million

3. the face value of commercial paper does notexceed 30 % of the its WC limit

4. its equity is listed on a stock exchange


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5. the commercial paper receives a minimumrating of P1 from CRISIL or equivalent thereof

6. it has minimum current ratio of 1.33

7. it enjoys health code No.1 status 8. the minimum size of commercial paper issue

is Rs.2.5 million and the denomination of each

commercial paper note is half a million rupees or

multiple thereof


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Effective cost: commercial paper is sold at adiscount from its face value and redeemed at itsface value. Hence effective cost of commercialpaper is:

{[face valuenet amount realised]/net amount realised} x {360/maturity period}

Ex. Face value :RS.500,000

Maturity period :180 days

Net amount realised :RS.480,000

The pretax effective cost of commercial paper is =

{(500000-480000)/480000} x {360/180}=8.33%


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Factoring: A factor is financial institution which offers

services relating to management and financingof debts arising from credit sales.

RBI has authorised four PSU banks to dofactoring (still nascent stage) in India

SBI (SBI factoring and commercial services ltd.),canara bank (canbank factoring ltd), PNB and

Bank of Allahabad have been allowed to dofactoring in western, southern, northern andeastern regions respectively


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Features of factoring arrangement: 1. the factor selects the accounts of the client

that would be handled by it and establishes,along with the client, the credit limit applicable to

the selected accounts 2. the factor assumes responsibility for collecting

debt of accounts handled by it. For eachaccount, the factor pays to the client at the end

of credit period or the account is collected,whichever comes earlier


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3. the factor advances money to the client against not-yet-collected and not-yet-due debts. Typically theamount advanced is 70 to 80% of the face value of thedebt and carries interest rate which may be equal to ormarginally higher than the lending rate of commercial

banks 4. factoring may be on recourse basis (means that the

credit risk is borne by the client) or on a non-recoursebasis ( means that the credit risk is borne by the factor).Presently factoring is done on recourse basis

5. besides interest on advances against debt, the factorcharges a commission which may 1 to 2 % of the facevalue of debt factored.


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Mechanics of factoring 1. places order

3. Delivers goods and

invoice with notice

to pay the factor

4.sends 8. pays 6.follows

invoice balance up

copy amount 7.pays

2. Fixes 5.prepays

Customer upto Limit 80%

Client

(seller)

Customer

(buyer)

Factor


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Evaluation:advantages 1. factoring ensures a definite pattern of cash

inflows from credit sales

2. Continuous factoring may virtually eliminatethe need for the credit and collection department

Disadvantages:

1. cost of factoring tends to be higher than other

forms of short-term borrowing 2. factoring of debt may be perceived as a signof financial weakness

Date post:	04-Jun-2018
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