Working Capital Management MBA Second Year (Financial Management) Paper No 2.4 School of Distance Education Bharathiar University, Coimbatore - 641 046 Author: B Muralikrishna Copyright © 2008, Bharathiar University All Rights Reserved Produced and Printed by EXCEL BOOKS PRIVATE LIMITED A-45, Naraina, Phase-I, New Delhi-110028 for SCHOOL OF DISTANCE EDUCATION Bharathiar University Coimbatore-641046 CONTENTS Page No UNIT I Lesson Working Capital Management: An Introduction Lesson Cash Flows Forecasting and Budgeting 39 UNIT II Lesson Financing of Working Capital-I 61 Lesson Financing of Working Capital-II 71 Lesson Managing Corporate Liquidity and Financial Flexibility 86 UNIT III Lesson Receivables Management 99 Lesson Cash Management Systems 112 Lesson Inventory Management 143 UNIT IV Lesson Instruments of the International Money Market 165 Lesson 10 Floating Rate Notes 171 UNIT V Lesson 11 Working Capital Control and Banking Policy 183 Lesson 12 Appraisal and Assessment of the Working Capital 198 Model Question Paper 209 WORKING CAPITAL MANAGEMENT SYLLABUS UNIT I Working Capital Management - Theories and approaches - Ratio Analysis - Fund Flow and Cash Flow Analysis - Cash flow forecasting and Budgeting UNIT II Financing of working capital - Money market instruments - Bank FinanceAssessment and Appraisal - Managing corporate liquidity and financial flexibility UNIT III Receivables Management - Cash Management - Inventory Management UNIT IV Instruments of international money market - Euro notes - Euro commercial paper MTNs and FRNs UNIT V Working Capital Control and Banking policy - Committee recommendations on working capital - New system of assessment of working capital finance Working Capital Management: An Introduction UNIT UNIT I Working Capital Management Working Capital Management: An Introduction LESSON WORKING CAPITAL MANAGEMENT: AN INTRODUCTION CONTENTS 1.0 Aims and Objectives 1.1 Introduction 1.2 Concept of Working Capital 1.2.1 Balance Sheet Concept 1.2.2 Operating Cycle Concept 1.3 Importance of Working Capital 1.4 Factors Influencing Working Capital Requirement 1.5 Levels of Working Capital Investment 1.6 Profitability vs Risk trade-off 1.7 Optimal Level of Working Capital Investment 1.8 1.9 1.10 1.7.1 Proportions of Short-term Financing 1.7.2 Cost of Short-term vs Long-term Debt 1.7.3 Risk of Long-term vs Short-term Debt Theories and Approaches to Working Capital 1.8.1 The Hedging or Matching Approach 1.8.2 The Conservative Approach 1.8.3 The Aggressive Approach The Statement of Changes in Financial Position 1.9.1 Basic Approach 1.9.2 Working Capital Approach Analysis of Funds Flow Statement 1.10.1 Meaning and Definition of Funds Flow Statement 1.10.2 Funds Flow Statement, Income Statement and Balance-Sheet 1.10.3 Uses, Significance and Importance of Funds Flow Statement 1.10.4 Limitations of Funds Flow Statement 1.10.5 Procedure for Preparing a Funds Flow Statement 1.10.6 Statement of Sources and Application of Funds 1.11 Application or Uses of Funds 1.12 Cash Flow Statement 1.12.1 Cash Flow from Operations 1.12.2 Cash Disbursements for Expenses 1.13 Let us Sum up 1.14 Lesson End Activity 1.15 Keywords 1.16 Questions for Discussion 1.17 Suggested Readings Working Capital Management 1.0 AIMS AND OBJECTIVES After studying this lesson, you should be able to understand: z The concept of working capital z Types of the working capital z The levels of working capital z The factors responsible for requirement of working capital 1.1 INTRODUCTION Working capital typically means the firm’s holdings of current, or short-term, assets such as cash, receivables, inventory, and marketable securities Much academic literature is directed towards gross working capital, i.e., total current or circulating assets In a retail establishment, cash is initially employed to purchase inventory which is in turn sold on credit and results in accounts receivables Once the receivables are collected, they become cash-part of which is reinvested in additional inventory and part (i.e., the amount above cost) going to profit or cash Corporate executives devote a considerable amount of attention to the management of working capital Net working capital (current assets minus current liabilities) provides an accurate assessment of the liquidity position of firm with the liquidity-profitability dilemma solidly authenticated in the financial scheme of obligations which mature within a twelve-month period Management must always ensure the solvency and viability of the firm An examination of the components of components of working capital is helpful at this point because of the preoccupation of management with the proper combination of assets and acquired funds First, short-term, or current, liabilities constitute the portion of funds witch have been planned for and raised Since management must be concerned with proper financial structure, these and other funds must be raised judiciously Short-term or current assets constitute a part of the asset-investment decision and require diligent review by the firm’s executives Although careful maintenance of the proper asset and funds-acquired mixes is subjected to close scrutiny, it must be noted that there exists a close correlation between sales fluctuations and invested amounts in current assets For example, assume a hypothetical increase and in the firm’s sales This increase will necessitate more inventory, more credit sales and resulting accounts receivable, and perhaps more cash Although current liabilities must be financed -frequently from short-term funds, the larger the percentage of funds obtained from short-term funds, the more aggressive (and risky) is firm’s working capital policy and vice-versa Although short-term debt is less expensive than long-term, short-term funds may only be renewable at much higher rats of interest Conversely, long-term funds involve a rather lengthy commitment at fixed rates of interest It should also be realized that heavy reliance on low-cost, current funds may jeopardize the solvency of the firm The risk/return tradeoff is very much in evidence in the firm’s working capital-management approach As a further illustration of the trade-off, management usually elects to prescribe levels for current assets, despite the fact that sales dictate some fluctuation in short-term are generally not considered to be the earning assets of the firm The yield from short-term assets is usually low, while returns from long-term, more permanent assets are usually quite high So management may also be considered as an aggressive or conservative according to its investments in current versus long-term assets 1.2 CONCEPT OF WORKING CAPITAL There are two possible interpretations of working capital concept: Balance Sheet Concept Operating Cycle Concept It goes without saying that the pattern of management will be very largely influenced by the approach taken in defining it Therefore the two concepts are discussed separately in a nutshell 1.2.1 Balance Sheet Concept There are two interpretations of working capital under the balance sheet concept It is represented by the excess of current assets over current liabilities and is the amount normally available to finance current operations But, some-times working capital is also used as a synonym for gross or total current assets In that case, the excess of current assets over current liabilities is called the net working capital or net current assets Economists like Mead, Malott, Baket and Field support the latter view of working capital They feel that current assets should be considered as working capital as the whole of it helps to earn profits; and the management is more concerned with the total current assets as they constitute the total funds available for operational purposes On the other hand, economists like Lincoln and Salvers uphold the former view They argue that (a) in the long run what matters is the surplus of current asserts over current liabilities (b) it is this concept which helps creditors and investors to judge the financial soundness of the enterprise; (c) what can always be relied upon to meet the contingencies, is the excess of current assets over the current liabilities since this amount is not to be returned; and (d) this definition helps to find out the correct financial position of companies having the same amount of current assets Institute of Chartered Accountants of India, while suggesting a vertical form of balance sheet, also endorsed the former view of working capital when it described net current assets as the difference between current assets and current liabilities The conventional definition of working capital in terms of the difference between the current assets and the current liabilities is somewhat confusing Working capital is really what a part of long-term finance is locked in and used for supporting current activities Consequently, the larger the amount of working capital so derived, greater the proportion of long –term capital sources siphoned off to short-term activities It is about tight working capital situation, the logic of the above definition would perhaps indicate diversion to bring in cash, under the conventional method, working capital would evidently remain unchanged Liquidation of debtors and inventory into cash would also keep the level of working capital unchanged A relatively large amount of working capital according to this definition may produce a false sense of security at a time when cash resources may be negligible, or when these may be provided increasingly by long-term fund sources in the absence of adequate profits Again, under the conventional method cash enters into the computation of working capital But it may have been more appropriate to exclude cash from such calculations because one compares cash requirements with current assets less current liabilities The implication of this in conventional working capital computations is that during the financial period current assets get converted into cash which, after paying off the current liabilities, can be used to meet other operational expenses The paradox, however, is that such current assets as are relied upon to yield cash must themselves to be supported by long-term funds until are converted into cash At least, three points seem to emerge from the above First, the balance sheet definition of working capital is perhaps not so meaningful, except as an indication of the firm’s current solvency in repaying its creditors Secondly, when firms speak of shortage of working capital, they in fact possible imply scarcity of cash resources Working Capital Management: An Introduction 10 Working Capital Management Thirdly, in fund flow analysis an increase in working capital, as conventionally defined, represents employment or application of funds 1.2.2 Operating Cycle Concept A company’s operating cycle typically consists of thee primary activities; purchasing resources, producing the product, and distributing (selling) the product These activities create funds flows that are both unsynchronized because cash disbursements (for example, payments for resource purchases) usually take place before cash receipts (foe example, collection of receivables) They are uncertain because future sales and costs, which generate the respective receipts and disbursements, cannot be forecasted with complete accuracy If the firm is to maintain a cash balance to pay the bills as they come due In addition, the company must invest in inventories to fill customer orders promptly And, finally, the company invests in accounts receivable to extend credit to its customers Figure 1.1 illustrates the operating cycle of a typical firm The operating cycle is equal to the length of the inventory and receivables conversion periods: Operating cycle = inventory conversion period + Receivables conversion period The inventory conversion period is the length of time required to produce and sell the product ET is defined as follows: Inventory conversion period = Average inventory Cost of sales / 365 The payables deferral period is the length of time the firm is able to defer payment on its various resource purchases (for example, materials, wages, and taxes) Payables deferral period = Accountspayble + slaries, benefits, and Payroll taxes payble (Cost of sales + sellin, general and Ad istrative exp ense) / 365 Finally, the cash conversion cycle represents the net time interval between the collection of cash receipts from product sales and the cash payments for the company’s various resource purchases It is calculated as follows: Cash conversion cycle = operating cycle – payable deferral period Inventory conversion period Receivables conversion period Cash conversion cycle Payables Defer period Operating cycle Figure 1.1: Operating cycle of typical company cash The cash conversion cycle shows the time interval over which additional no spontaneous sources of working capital financing must be obtained to carry out the firm’s activities An increase in the length of the operating cycle, without a corresponding increase in the payables deferral period, lengthens the cash conversion cycle and creates further working capital financing needs for the company 194 Working Capital Management Reducing Over-dependence on Bank Borrowings The need for reducing the over-dependence of the medium and large borrowers—both in the private and public sectors-on bank finance for their production/trading purposes is recognized The net surplus cash generation of an established industrial unit should be utilized partly as least for reducing borrowing for working capital purposes Peak level and Normal Non-peak Level Limits to be Separate While assessing the credit requirements, the bank should appraise and fix separate limits for the ‘normal non-peak level’ as well as for the ‘peak level’ credit requirements indicating the periods during which the separate limits would be utilized by the borrower This procedure would be extended to all borrowers having working capital limits of Rs.10 lakhs and above One of the important criteria for deciding such limits should be the borrowers’ utilization of credit limits in the past Financing Temporary Requirements through Loan If any ad-hoc or temporary accommodation is required in excess of the sanctioned limit to meet unforeseen contingencies the additional finance should be given, where necessary, through a separate demand loan account or a separate ‘non-operatable cash credit account’ There should a stiff penalty for such demand loan or non-operatable cash credit portion, at least two per cent above the normal rate, unless Reserve Bank exempts such penalty This discipline may be made applicable in cases involving working capital limits or Rs.10 lakhs and above Penal Interest The borrower should be asked to give his quarterly requirement of funds before the commencement of the quarter on the basis of his budget, the actual requirement being within the sanctioned limit for the particular peak level/non peak level periods Drawing less than or in excess of the operative limits so fixed (with a tolerance of 10% either way) but not exceeding sanctioned limit would be subject to a penalty to be fixed by the Reserve Bank from time to time For the time being the penalty may be fixed at 2% per annum The borrower would be required to submit his budgeted requirements in triplicate and a copy each would be sent immediately by the branch to the controlling office for record The penalty will be applicable only in respect of parties enjoying credit limits of Rs.10 lakhs and above, subject to certain exemptions Information System The non-submission of the returns in time is partly due to certain features in the forms themselves To get over this difficulty, simplified forms have been proposed As the quarterly information systems, is part and parcel of the revised style of lending thunder the cash credit system, if the borrower does not submit the return within the prescribed time, he should be penalized by charging the whole outstanding in the account at a penal rate of interest, 10% per annum more than the contracted rate for the advance from the due date of the return till the date of its actual submission Relaxation from Norms Requests for relaxation of inventory norms and for ad-hoc increase in limits would be subjected by banks to close scrutiny and agreed to only in exceptional circumstances Toning Up-Assessment Technique The banks should devise their own check lists in the light of the instructions issued by the Reserve Bank for the scrutiny of data the operational level Delays in Sanction Delays on the part of banks in sanctioning credit limits could be reduced in cases where the borrowers cooperate in giving the necessary information about their past performance and future projections in time Bill System As on of the reasons for the slow growth of the bill system is the stamp duty on usance bills and difficulty in obtaining the required denominations of stamps, these questions may have to be taken up with the state governments Sales Bill Bank should review the system of financing book debts though cash credit and insist on the conversion of such cash credit limits into bill limits Drawee Bill System A stage has come to enforce the use of drawee bills in the lending system by making it compulsory for banks to extend at least 50% of the cash credit limit against raw materials to manufacturing units whether in the public or private sector by way of drawee bills To start with, this discipline should be confined to borrowers having aggregate working capital limits of Rs.50lakhs and above from the banking system Segregation of Dues of Small Scale Industries Bank should insist on the public sector undertakings/large borrowers to maintain control accounts in their books to give precise data regarding their dues to the small units and furnish such data in their quarterly information system This would enable the banks to take suitable measures for ensuring payment of the du4s to small units by a definite period by stipulating, if necessary, that a portion of limits for bills acceptance (drawee bills) should be utilized only for drawee bills of small scale units Discount House To encourage the bill system of financing and to facilitate cal money operations an autonomous financial institution on the lines of the Discount House in UK may be set up Correlation between Production and Bank Finance No conclusive data are available to establish the degree of correlation between production and quantum of credit at the industry level As this issue is obviously of great concern to the monetary authorities the Reserve bank may undertake a detailed scientific study in this regard Communication of Credit Control Measures to Branches and Follow-up Credit control measures to be affective will have to be immediately communicated to the operational level and followed up There should be a ‘Cell’ attached to the Chairman’s office at the Central Office of each bank to attend to such matters The Central Offices of banks should take a second look at the credit budget as soon as changes in credit policy are announced by the Reserve Bank and revise their plan of action in the light of the new policy and communicate the corrective measures to the operational levels as quickly as possible Monitoring of Key Branches and Critical Accounts The banks should continuously monitor the credit portfolio of the ‘key’ branches irrespective of the fact whether there is a change in credit policy or not For effective credit monitoring, the number of critical accounts should be kept under a close watch over the utilization of limits and inventory build up 195 Working Capital Control and Banking Policy 196 Working Capital Management Delay in Collection of Bills/Cheques To reduce the delay in collection of bills and cheques, return of documents by the collecting branches, etc, the Group suggested to tone up the communication channels and systems and procedures within the banking system Bill Facilities and Current Accounts with other Banks Although banks usually object to their borrower’s dealing with other banks without their consent, some of the borrowers still maintain current accounts and arrange bill facilities with other banks Apart from diluting the control over the advance by the main banker, this practice often enables the borrower to divert sales proceeds for unapproved purposes without the knowledge of his main banker Banks should be suitably advised in this matter by the Reserve Bank to check this unhealthy practice 11.4 LET US SUM UP The norms of working capital finance followed by bank since mid-70's were mainly based on the recommendations of the Tandon Committee The Chore Committee made further recommendations to strengthen the procedures and norms for working capital finance by banks The norms based on the recommendations of these committees are discussed below In the deregulated economic environment in India recently, banks have considerably relaxed their criteria of lending In fact, each bank can develop its own criteria for the working capital finance 11.5 LESSON END ACTIVITY Discuss the various procedures and norms for working capital finance by banks in India What are the issues related to bank finance in India? 11.6 KEYWORDS Letter of Credit: A letter of credit popularly known as L/C is an undertaking by a bank to honour the obligations of its customer up to a specified amount Funds flow analysis: A technical device designated to study the sources from which additional funds were derived and the use to which these sources were put Hedging: The term ‘hedging’ usually refers to two off-selling transactions of a simultaneous but opposite nature which counterbalance the effect of each other 11.7 QUESTIONS FOR DISCUSSION What are the various recommendations made by different committees? Explain the suggestions given various committees Check Your Progress: Model Answers CYP 1 Tandon Committee, was appointed by the Reserve Bank of India in July 1974 to suggest guidelines for the rational allocation and optimum use of bank credit RBI, through its guidelines, issued from time to time CYP 1969 Double or multiple Tandon 11.8 SUGGESTED READINGS V.K Bhalla, Working Capital Management, Text and Cases, Sixth Edition, Anmol Publications Prasanna Chandra, Financial Management, Theory and Practice, Tata McGraw-Hill Pandey, Financial Management, Vikas Annex.54.J.3 -MBA - Finance - SDE Page 20 of 23 Khan and Jain, Financial Management, Tata McGraw-Hill 197 Working Capital Control and Banking Policy 198 Working Capital Management LESSON 12 APPRAISAL AND ASSESSMENT OF THE WORKING CAPITAL CONTENTS 12.0 Aims and Objectives 12.1 Introduction 12.2 Analysis of Working Capital 12.3 12.4 12.2.1 Ratio Analysis 12.2.2 Funds Flow Analysis 12.2.3 Working Capital Budget Operating Cycle Analysis 12.3.1 Operating Cycle 12.3.2 Operating Cycle Analysis Estimation of Working Capital Requirements 12.4.1 Main Factors Considered in the Estimation of Working Capital Requirement 12.4.2 Steps Involved in Arriving at the Level of Working Capital Requirement 12.4.3 Standard Formulae for Determination of Working Capital 12.4.4 Computation of Working Capital Requirement 12.4.5 Working Capital and Small Scale Industries 12.4.6 Working Capital through Formula–Boon or Bane? 12.4.7 Cash Flow Based Computation of Working Capital 12.5 Let us Sum up 12.6 Lesson End Activity 12.7 Keywords 12.8 Questions for Discussion 12.9 Suggested Readings 12.0 AIMS AND OBJECTIVES After studying this lesson, you should be able to understand: z The concept of working capital and its assessment methods z The analysis procedure of working capital 12.1 INTRODUCTION Working capital is the life blood and nerve centre of a business Just as circulation of blood is essential in the human body for maintaining life, working capital is very essential to maintain the smooth running of a business No business can run successfully without an adequate amount of working capital However, it must also be noted that working capital is a means to run the business smoothly and profitably, and not an end Thus, concept of working capital is a means to run importance in a going concern A going concern, usually, has a positive balance of working capital has its own excess of current assets over current liabilities, but sometimes the uses of working capital may be more than the sources resulting into a negative value of working capital This negative balance is generally offset soon by gains in the following periods A study of changes in the uses and sources of working capital is necessary to evaluate the efficiency with which the working capital is employed in a business This involves the need of working capital analysis 12.2 ANALYSIS OF WORKING CAPITAL Ratio Analysis Funds Flow Analysis Budgeting 12.2.1 Ratio Analysis A ratio is a simple arithmetical expression of the relationship of one number to another The technique of ratio analysis can be employed for measuring short-term liquidity or working capital position of a firm The following ratios may be calculated for this purpose: a) Current Ratio b) Acid Test Ratio c) Absolute Liquid Ratio or Cash Position Ratio d) Inventory Turnover Ratio e) Receivables Turnover Ratio f) Payables Turnover Ratio g) Working Capital Turnover Ratio h) Working Capital Leverage i) Ratio of Current Liabilities to Tangible Net Worth All the above mentioned ratios have been discussed in detail in the ‘Lesson relating to Ratio Analysis.’ 12.2.2 Funds Flow Analysis Funds flow analysis is a technical device designated to study the sources from which additional funds were derived and the use to which these sources were put It is an effective management tool to study changes in the financial position (working capital) of business enterprise between beginning and ending financial statements dates The funds flow analysis consists of: (i) preparing schedule of changes in working capital, and (ii) statement of sources and application of funds This technique of measuring working capital has been discussed at length in the chapter relating to ‘Funds Flow Statement’ 12.2.3 Working Capital Budget A budget is a financial and/or quantitative expression of business plans and policies to be pursued in the future period of time Working capital budget, as a part of total budgeting process of business, is prepared estimating future long-term and short-term working capital needs and the sources to finance them, and then comparing the 199 Appraisal and Assessment of the Working Capital 200 Working Capital Management budgeted figures with the actual performance for calculating variances, if any, so that corrective actions may be taken in the future The objective of a working capital budget is to ensure availability of funds as and when needed, and to ensure effective utilization of these resources The successful implementation of working capital budget involves the preparing of separate budgets for various elements of working capital, such as, cash, inventories and receivables, etc Check Your Progress Fill in the blanks: Working capital is the _ of a business The objective of a working capital budget is to as and when needed, and to ensure effective utilization of these resources A ratio is a simple arithmetical expression of the relationship of _ 12.3 OPERATING CYCLE ANALYSIS 12.3.1 Operating Cycle Operating cycle is the average time between the acquisition of materials or services and the final cash realization from that acquisition It is the average length of time between when a company purchases items for inventory and when it receives payment for sale of the items The operating cycle is the number of days from cash to inventory to accounts receivable to cash The operating cycle reveals how long cash is tied up in receivables and inventory A long operating cycle means that less cash is available to meet short-term obligations A long operating cycle tends to harm profitability by increasing borrowing requirements and interest expense 12.3.2 Operating Cycle Analysis Working capital is one of the most difficult financial concepts to understand for the small-business owner In fact, the term means a lot of different things to a lot of different people By definition, working capital is the amount by which current assets exceed current liabilities However, if you simply run this calculation each period to try to analyze working capital, you won't accomplish much in figuring out what your working capital needs are and how to meet them A useful tool for the small-business owner is the operating cycle The operating cycle analyzes the accounts receivable, inventory and accounts payable cycles in terms of days In other words, accounts receivable are analyzed by the average number of days it takes to collect an account Inventory is analyzed by the average number of days it takes to turn over the sale of a product (from the point it comes in your door to the point it is converted to cash or an account receivable) Accounts payable are analyzed by the average number of days it takes to pay a supplier invoice Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone Consequently, working capital financing is needed This shortfall is typically covered by the net profits generated internally or by externally borrowed funds or by a combination of the two Most businesses need short-term working capital at some point in their operations For instance, retailers must find working capital to fund seasonal inventory buildup between September and November for Christmas sales But even a business that is not seasonal occasionally experiences peak months when orders are unusually high This creates a need for working capital to fund the resulting inventory and accounts receivable buildup Some small businesses have enough cash reserves to fund seasonal working capital needs However, this is very rare for a new business If your new venture experiences a need for short-term working capital during its first few years of operation, you will have several potential sources of funding The important thing is to plan ahead If you get caught off guard, you might miss out on the one big order that could have put your business over the hump Here are the five most common sources of short-term working capital financing: z Equity: If your business is in its first year of operation and has not yet become profitable, then you might have to rely on equity funds for short-term working capital needs These funds might be injected from your own personal resources or from a family member, friend or third-party investor z Trade Creditors: If you have a particularly good relationship established with your trade creditors, you might be able to solicit their help in providing short-term working capital If you have paid on time in the past, a trade creditor may be willing to extend terms to enable you to meet a big order For instance, if you receive a big order that you can fulfill, ship out and collect in 60 days, you could obtain 60-day terms from your supplier if 30-day terms are normally given The trade creditor will want proof of the order and may want to file a lien on it as security, but if it enables you to proceed, that shouldn't be a problem z Factoring: Factoring is another resource for short-term working capital financing Once you have filled an order, a factoring company buys your account receivable and then handles the collection This type of financing is more expensive than conventional bank financing but is often used by new businesses z Line of credit: Lines of credit are not often given by banks to new businesses However, if your new business is well-capitalized by equity and you have good collateral, your business might qualify for one A line of credit allows you to borrow funds for short-term needs when they arise The funds are repaid once you collect the accounts receivable that resulted from the short-term sales peak Lines of credit typically are made for one year at a time and are expected to be paid off for 30 to 60 consecutive days sometime during the year to ensure that the funds are used for short-term needs only z Short-term loan: While your new business may not qualify for a line of credit from a bank, you might have success in obtaining a one-time short-term loan (less than a year) to finance your temporary working capital needs If you have established a good banking relationship with a banker, he or she might be willing to provide a short-term note for one order or for a seasonal inventory and/or accounts receivable buildup In addition to analyzing the average number of days it takes to make a product (inventory days) and collect on an account (account receivable days) vs the number of days financed by accounts payable, the operating cycle analysis provides one other important analysis From the operating cycle, a computation can be made of the dollars required to support one day of accounts receivable and inventory and the dollars provided by a day of accounts payable 201 Appraisal and Assessment of the Working Capital 202 Working Capital Management Working capital has a direct impact on cash flow in a business Since cash flow is the name of the game for all business owners, a good understanding of working capital is imperative to make any venture successful 12.4 ESTIMATION OF WORKING CAPITAL REQUIREMENTS It is important to have an analytical estimation of the working capital requirements of a medium-sized undertaking The concept of estimation of working capital requirements helps the user understand the concept of an operating cycle, concept of cash conversion cycle, impact of cycle time on working capital requirements, approaches for estimation of working capital, and methods of determining working capital Sometimes your industry may be suffering because of inadequate working capital Lack of adequate working capital is often stated as one of the major reasons for sickness in industry (especially in case of SMEs) The counter arguments from the banks have been that most firms face problems of inadequate working capital due to credit indiscipline (diversion of working capital to meet long term requirements or to acquire other assets) In this context it would be pertinent to understand the method adopted by banks in computing the working capital requirement of the business and the quantum of bank financing to be provided by the bank 12.4.1 Main Factors Considered in the Estimation of Working Capital Requirement z The Nature of Business and Sector-Wise Norms: Factors such as seasonality of raw materials or of demand may require a high level of inventory being maintained by the company Similarly, industry norms of credit allowed to buyers determine the level of debtors of the company in the normal course of business z The Level of Activity of the Business: Inventories and receivables are normally expressed as a multiple of a day’s production or sale Hence, higher the level of activity, higher the quantum of inventory, receivables and thereby working capital requirement of the business So in order to arrive at the working capital requirement of the business for the year, it is essential to determine the level of production that the business would achieve In case of well-established businesses, the previous year’s actual and the management projections for the year provide good indicators The problems arise mainly in the case of determining the limit for the first time or in the initial few years of the business Banks often adopt industry standard norms for capacity utilization in the initial years 12.4.2 Steps Involved in Arriving at the Level of Working Capital Requirement z Based on the level of activity decided and the unit cost and sales price projections, the banks calculate at the annual sales and cost of production z The quantum of current assets (CA) in the form of Raw Materials, Work-inprogress, Finished goods and Receivables is estimated as a multiple of the average daily turnover The multiple for each of the current assets is determined generally based on the industry norms z The current liabilities (CL) in the form of credit availed by the business from its creditors or on its manufacturing expenses are deducted from the current assets (CA) to arrive at the Working Capital Requirement (WCR) 12.4.3 Standard Formulae for Determination of Working Capital The issue of computation of working capital requirement has aroused considerable debate and attention in this country over the past few decades A directed credit approach was adopted by the Reserve Bank of ensuring the flow of credit to the priority sectors for fulfillment of the growth objectives laid down by the planners Consequently, the quantum of bank credit required for achieving the requisite growth in Industry was to be assessed Various committees such as the Tandon Committee and the Chore Committee were constituted and studied the problem at length Norms were fixed regarding the quantum of various current assets for different industries (as multiples of the average daily output) and the Maximum Permissible Bank Financing (MPBF) was capped at a certain percentage of the working capital requirement thus arrived at Working Capital assessment on the formula prescribed by the Tandon Committee Working Capital Requirement (WCR) = [Current assets i.e CA (as per industry norms) – Current Liabilities i.e CL] Permissible Bank Financing [PBF] = WCR – Promoter’s Margin Money i.e PMM (to be brought in by the promoter) As per Formula 1: PMM = 25% of [CA – CL] and thereby PBF = 75% of [CA – CL] As per Formula 2: PMM = 25% of CA and thereby PBF = 75% [CA] – CL As is apparent Formula requires a higher level of PMM as compared to Formula Formula is generally adopted in case of bank financing In cases of sick units where the promoter is unable to bring in PMM to the extent required under Formula 2, the difference in PMM between Formulae and may be provided as a Working Capital Term Loan repayable in installments over a period of time Illustrative Example: Turnover of a manufacturing unit: Rs 750 lakh p.a (assumed uniform across the year) Assumed value addition norm: 50% (i.e cost of raw material = 50% of Realisation) Promoter Projections Current Assets Current Liabilities - Raw materials Rs 50 lakh - Payables - Work in progress Rs 25 lakh - Finished Goods Rs 60 lakh - Receivables Rs 125 lakh Rs 35 lakh Requirement assessed as per norms applicable for the industry: Industry Norm Amount as per Norm Promoter Projection Applicable norm (a) (b) (c) (d) Current Asset - Raw material month Rs 31.25 lakh Rs 50 lakh Rs 31.25 lakh - Work in Progress (assumed at 50% complete) 10 days Rs 15.62 lakh Rs 25 lakh Rs 15.62 lakh - Finished Goods 15 days Rs 31.25 lakh Rs 60 lakh Rs 31.25 lakh Contd… 203 Appraisal and Assessment of the Working Capital 204 Working Capital Management - Receivables 1.5 months Rs 112.50 lakh Rs 125 lakh Rs 112.50 lakh Rs 190.62 lakh Rs 260.0 lakh Rs 190.62 lakh Rs 18.80 lakh Rs 35 lakh Rs 18.80 lakh Rs 171.82 lakh Rs 225.0 lakh Rs 171.82 lakh Current Liabilities - Payables Working Capital Requirement 15 days Notes: z Assumptions here include: No export turnover, uniform working capital requirement throughout the year z Industry norms have been specified in the Tandon Committee Report for all important industry categories z Raw materials have been valued at cost of raw material (assumed at 50% of realization) z Work in progress has been valued at 50% complete basis z Applicable norm (d) is the more conservative of (b) or (c) from the bank’s point of view 12.4.4 Computation of Working Capital Requirement Working Capital Requirement arrived at therefore is Rs 171.82 lakh Formula PMM (Promoter Margin Money) as per formula = 25% of 171.82 lakh = Rs 42.95 lakh–Rs 43 lakh Hence, Permissible Bank Finance = Rs 129 lakh Formula PMM as per formula 2=25% of Rs 190.6 lakh = Rs 47.65 lakh Permissible Bank Financing as per formula = [75% of 190.6 lakh – Rs 18.8 lakh ] = Rs 124.1 lakh The difference between the methods is Rs 4.90 lakh (which maybe extended as a Working Capital Term Loan in case of sick units Thus the PMM while being at 25% of the Working Capital requirement could actually translate to as high as Rs 225 lakh – Rs 124 lakh i.e Rs 101 lakh assuming that the promoter projections really reflect his genuine need for working capital It should however be understood by the entrepreneur that he ought to keep his working capital requirements to the minimum (whether or not bank financing is available) to ensure that his interest burden and capital blocked is kept to the minimum The following further points maybe worth mentioning here: z In case of export financing sought by the entrepreneur, the quantum of bank financing for the Working Capital build up for this purpose would normally be at a higher percentage z Within the overall limits, there could be sub-limits for bills financing (in case of receivables) with the result that such limits might not be fully available to the business z The Bank Financing Limit arrived above is the Overall limit for the year The actual quantum of bank financing that could be availed by the unit at a given point in time depends upon its drawing power based on its periodical returns filed to the banker 12.4.5 Working Capital and Small Scale Industries Small scale industries have a distinct set of characteristics such as low bargaining power leading to problems of receivables and lower credit on purchases, poor financial strength, high level of variability due to dependence on local factors, etc Consequently, it has been rightly argued that the industry norms on different current assets cannot be adopted The P.R Nayak Committee that was appointed to devise norms for assessing the working capital requirement of small-scale industries arrived at simplified norm pegging the Working Capital bank financing at 20% of the projected annual turnover However, in case of units which are non-capital intensive such as hotels, etc banks often assess requirements both on the Nayak Committee norms as well as the working cycle norms and take the lower of the two figures Eligibility and Norms for bank financing of SSIs as per Nayak Committee: (a) Applicability: In case of SSIs, with working capital requirement of less than Rs crores In case of other industries, with working capital requirement of less than Rs crore (b) Quantum of Working Capital bank financing: 20% of the projected annual turnover (c) Subject to a Promoter bringing in a margin of: 5% of the projected annual turnover (i.e 20% of the total fund requirement that has been estimated at 25% of the projected annual turnover) 12.4.6 Working Capital through Formula – Boon or Bane? The formula driven computation of working capital requirement have been subjected to much debate over the past few decades The advantage of such computation has been that it removes discretion from the officials of banks (which are largely from the Public Sector) The uniformity thus reduces the scope for accusation of bias However, the strongest argument against the MPBF based lending has been that it does not take into account the variations arising out of location, relative bargaining of the enterprise and other reasons, which could vary its need for working capital Even though the banker could understand the problem, it was not possible to act on it due to the norms Further, the “One Size fits all” theory ensured that banks never needed to develop credit appraisal skills and lent to all and sundry based on their seeming adherence to norms on paper The method has also been criticized as being more appropriate for the era where credit was rationed out Banks today are capable of undertaking better assessment of the requirements and welcome the idea of offering higher limits (larger exposures) to established clients if required in order to retain their business in the face of competition from other banks In 1997, the RBI permitted banks to evolve their own norms for assessment of the Working Capital requirements of their clients 12.4.7 Cash Flow Based Computation of Working Capital Cash flow is the most realistic means of assessing the operations of an enterprise Drawing up cash flow statements (monthly or quarterly) for the past few years clearly indicate the seasonal and secular trend in utilization of working capital The projections drawn up by the entrepreneur may then be jointly discussed with the banker as modified in light of the past performance and the banker’s opinions The peak cash deficit is ascertained from the cash budgets The promoter’s share (margin money) for such requirement maybe mutually arrived at by the banker and the borrower with the balance requirement forming the Bank financed part of Working Capital 205 Appraisal and Assessment of the Working Capital 206 Working Capital Management Cash flow based computation of working capital requirement has been recommended by the RBI for assessment of working capital requirement permitting the banks to evolve their own norms for such assessment The reason for this has been that Cash flow factors in the past trends, takes into account the company specific factors and is based on mutual discussion between the banker and the borrower thereby increasing its acceptability Also, large companies have adopted cash budgeting systems for managing their cash flows and hence such a system does not impose additional requirements on the corporates Cash flow system is extremely relevant in case of the seasonal industries to assess the peak credit requirement and in case of large companies (working capital requirements above Rs 10 crores) However the reluctance to provide the cash budgets thereby revealing additional information to the banks, has led to even larger companies shying away from Cash Budget method of assessing Working Capital Consequently Cash Budget method is currently prevalent mainly in case of seasonal industries, construction sector as well as other entities whose operations are linked to projects Bank financing based on cash budgets works well and is a good step form for the system A big failure in the working capital system hitherto followed by our banks has been that the Drawing Power (within the PBF limit) is based on post facto stock statements and these are reset typically on a monthly basis This means: z The borrowing unit is putting its money upfront and the Drawing Power is a form of reimbursement z Responsiveness to sudden surges in demand/ seasonality/ other short term boom conditions is non-existent, putting a burden on the company to finance this at exorbitant rates from private financiers Finally, a growing company will always be playing “catch-up” and its Permissible Bank Financing will be lagging its cash requirements by at least one year 12.5 LET US SUM UP No business can run successfully without an adequate amount of working capital However, it must also be noted that working capital is a means to run the business smoothly and profitably, and not an end Thus, concept of working capital is a means to run importance in a going concern A going concern, usually, has a positive balance of working capital has its own excess of current assets over current liabilities, but sometimes the uses of working capital may be more than the sources resulting into a negative value of working capital This negative balance is generally offset soon by gains in the following periods A study of changes in the uses and sources of working capital is necessary to evaluate the efficiency with which the working capital is employed in a business This involves the need of working capital analysis 12.6 LESSON END ACTIVITY “The objective of a working capital budget is to ensure availability of funds as and when needed, and to ensure effective utilization of these resources” Discuss 12.7 KEYWORDS Working capital: It means the firm’s holdings of current or short-term asset Funds flow analysis: A technical device designated to study the sources from which additional funds were derived and the use to which these sources were put Liquidity: The ability of the firm to augment its future cash flows to over any unforeseen needs or to take advantage of any unforeseen opportunities 12.8 QUESTIONS FOR DISCUSSION Explain about the various tools available to appraise and assess the working capital Discuss the analysis methods of working capital What you understand by operating cycle analysis? Discuss the estimation of working capital requirements Check Your Progress: Model Answers Life blood and nerve center Ensure availability of funds One number to another 12.9 SUGGESTED READINGS V.K Bhalla, Working Capital Management, Text and Cases, Sixth Edition, Anmol Publications Prasanna Chandra, Financial Management, Theory and Practice, Tata McGraw-Hill Pandey, Financial Management, Vikas Annex.54.J.3 -MBA - Finance - SDE Page 20 of 23 Khan and Jain, Financial Management, Tata McGraw-Hill 207 Appraisal and Assessment of the Working Capital 209 Model Question Paper MODEL QUESTION PAPER MBA Second Year Sub: Working Capital Management Time: hours Total Marks: 100 Direction: There are total eight questions, each carrying 20 marks You have to attempt any five questions Explain about the various tools available to appraise and assess the working capital Discuss the analysis methods of working capital What are the different pricings of FRNs? What are the different returns from money market instruments? What is a driving variable, and why is it crucial to cash forecasting? Outline the procedures for medium-range cash forecasting, starting with the generation of a scenario What is a cash budget? What is meant when we say, "A money market instrument is highly liquid"? What action can a financial manager take to reduce a company's cash requirements? 209 ... recommendations on working capital - New system of assessment of working capital finance 5 Working Capital Management: An Introduction UNIT UNIT I Working Capital Management Working Capital Management: ... in working capital is as follows: 27 Working Capital Management: An Introduction 28 Working Capital Management Statement of Schedule of Changes in Working Capital Previous Current Effect on Working. .. 21 Working Capital Management: An Introduction 22 Working Capital Management Uses of Funds Transactions that decrease working capital are classified as uses of funds Typical uses of working capital