assessment of working capital requirement - dpgd-ja10-0008 (2)

7/30/2019 Assessment of Working Capital Requirement - DPGD-JA10-0008 (2)

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ASSESSMENT OF WORKING CAPITAL REQUIREMENT

SMITA CHANDRAKANT SURVE

DPGD/JA10/0008

SPECIALIZATION: FINANCE

WELINGKAR INSTITUTE OF MANAGEMENT DEVELOPMENT & RESEARCH November 2011

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ACKNOWLEDGMENT

I would like to express my gratitude to all those who gave me the opportunity to complete

this project, I want to thank the Welingkar Institute of Management Development & Research

for giving me this opportunity. This project has been a tremendous learning experience for

me.

A special thanks to the authors mentioned in the bibliography page. Further, I want to express

my deep regards and sincere gratitude to my Project Guide, Mr. Charu Sharma, (Head of

Operations, SMERA) whose valuable suggestions supported me in this report.

Most especially to my family, and friends; words alone cannot express what I owe them for

their encouragement and whose patient love enabled me to complete this project. Lastly, I

would like to thank everyone who directly and indirectly helped me with the project.


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EXECUTIVE SUMMARY

In todays world it becomes very much important for a company to have a good working

capital management of its current asset and liability. So that in daily operation of the business

firm should perform well. Working capital management also put an emphasis on cash

forecasting so that it can be know the future what it is the requirement of the firm and how it

could arrange to finance it either from Long term source or Short Term Source.

Working Capital (WC) deal with the Short term financial decision typically involves cash

flow within a year or within the operating cycle of the firm. The importance of working

capital assessment is reflected in the fact that financial managers spend a great deal of time in

managing current asset and current liabilities. Arranging Short Term Financing, negotiating

favorable working terms, controlling the movement of cash , administering accounts

receivable and monitoring the investment in inventories consume a great deal of time of

financial managers.

To get the best possible returns firms should not keep unproductive assets and should finance

with the cheapest available finds. It is advantageous for the firm invest in short term assets

and to finance with short term liabilities. For a firm there is uncertainty of demand, price, and

quality, availability of its own products and those of suppliers. There are transaction costs of

purchasing selling goods. Firms have limitations on production capacity and technology that

it can use. The strategies using working capital accounts are the ways firms can address many

of the problems that result from the imperfect and constrained world in which they deal. In

addition to its use as a means of handling uncertainty, the assessment of working capital

requirements plays an important role in maintaining the financial health of the firm during

normal course of business.


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CERTIFICATE FROM THE GUIDE

This is to certify that the Project work titled Assessment of Working Capital Requirement is

a bonafide work carried out by SMITA CHANDRAKANT SURVE

(Admission No. DPGD/JA10/0008)

a candidate for the Post Graduate Diploma examination of the Welingkar Institute of

Management under my guidance and direction.

SIGNATURE OF GUIDE:

NAME: Mr. Charu Dutt Sharma

DESIGNATION: Head Operations

ADDRESS:

SME Rating Agency of India Limited (SMERA)Unit No. 102, 1st Floor, Sumer Plaza,Marol Maroshi Road, Marol,Andheri (East),

Mumbai 400 059Maharashtra

STAMP/SEAL OF THE ORGANIZATION

DATE:

PLACE: Mumbai


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TABLE OF CONTENTS

Sr.

No.Particulars Page No.

Executive Summary -

Certificate from the Guide -

1 Definition of Working Capital 7

2 Constituent of Working Capital 8

3 Types of working capital 10

4 Working Capital Behavior 14

5 Principles Of Working Capital Management Policy 15

6 Factors Determining The Working Capital Requirement 17

7Bank Credit As A Source Of Meeting Working Capital

Requirements23

8 Working Capital Finance 28

9 Working Capital Needs Of A Business 30

10 Assessment Of Working Capital 31

11 Procedure For Working Capital Finance 37

12 Cash Management 41

13 Sources Of Working Capital & Working Capital Cycle 44

14 Breaking Down The Cycle 48

15 Formulas For Calculating Working Capital Ratios 49

16 Level Of Working Capital 53

17 Asset Management 59

18 Sources Of Additional Working Capital 64


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Definition Of Working Capital

Working capital may be defined in two ways, either as the total of current assets or as the

difference between the total of current assets and total of current liabilities.

Working capital is the name given to the difference between the current assets and current

liabilities. Working capital is alternatively known as "Net Current Assets" or "Net Working

Capital". Gross Working Capital is the total of current assets. Manage

Working capital assessment is concerned with the management of short term assets Capital

and liabilities. Assets included here are cash, marketable securities, accounts receivable,inventory, prepaid expenses and other current assets and liabilities such as accounts payable,

wages payable, and accruals. Working capital management is the process of planning,

monitoring, controlling the mix of current assets and liabilities in a firm. In addition, it also

involves deciding how the current assets are to be financed. Financing choices could include

the mix of current as well as long term liabilities. This, unit explains the meaning,

significance and types of working capital, factor affecting and ascertaining working capital

requirement, ways of financing working capital, role of money market and working capitalcontrol and banking policy.

The management is more concerned with the total current assets as they constitute the total

funds available for operating purposes than with the sources from which the funds came.

With every increase in funds, the gross working capital will increase while according to the

net concept of working capital there will be no change in the funds available for the operating

manager.


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Besides, items like prepaid expenses; certain advance payments are also included in the list of

current assets. Similarly, bills payable, income received in advance for the services to be

rendered are treated as current liabilities. Nevertheless, there is difference of opinion as to

what is current. In the strict sense of the term, it is related to the, operating cycle, of the firm

and current assets are treated as those that can be converted into cash within the operating

cycle. The period of the operating cycle may be more or less compared to the accounting

period of the firm. In case of some firms the operating cycle period may be small and in an

accounting period there can be more than one cycle. In order to avoid this confusion, a more

general treatment is given to the, current nature, of assets and liabilities and the accounting

period (generally one-year) is taken as the basis for distinguishing current and non-current

assets.


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Chapter 3:

TYPES OF WORKING CAPITAL


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Temporary or

Variable WorkingCapital

Kinds of Working Capital

On the basis of concept On the basis of time

Gross Working

Capital

Net Working

Capital

Permanent or

Fixed Working

Capital

Regular

Working Capital

Reserve Working

Capital

Seasonal Working

Capital

Special Working

Capital


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Working capital may be classified in two ways:

On the basis of concept

On the basis of time

On the basis of concept, working capital is classified as:

Gross working capital

Net working capital.

The classification is important from the point of view of the financial manager.

On the basis of time, working capital may be classified as:

Permanent or Fixed working capital

Temporary or Variable working capital

Gross Working Capital

Total or gross working capital is that working capital which is used for all the current assets.

Total value of current assets will equal to gross working capital.

Net Working Capital

Net working capital is the excess of current assets over current liabilities.

Net Working Capital = Total Current Assets Total Current Liabilities

This amount shows that if we deduct total current liabilities from total current assets, then

balance amount can be used for repayment of long term debts at any time.

Permanent Working Capital (Fixed Part)

Permanent working capital is that amount of capital which must be in cash or current assetsfor continuing the activities of business. This indicates the amount of minimum working

capital, which is required to be maintained by every business at any point of time, in order to

carry on the business on permanent and uninterrupted basis.


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Temporary or Variable working capital (Fluctuating Part)

Sometime, it may possible that we have to pay fixed liabilities, at that time we need working

capital which is more than permanent working capital, then this excess amount will be

temporary working capital. In normal working of business, we dont need such capital. Thisindicates that amount of working capital required by the business which is over and above

fixed or permanent or core working capital. This need of the working capital may vary

depending upon the fluctuations in demand as a result of changes in production or sales.

As far as financing of the fixed or permanent needs of working capital are concerned, these

needs should be met out of the long term sources of funds, Own generation of funds, out of

the profits earned, shares or debentures. As far as financing of the variable or temporary

needs of working capital are concerned, these needs can be met from the various sources such

as suppliers of material or services and delayed payment of expenses, profits earned shares,

debentures and other long term borrowings, public deposits etc.

The fixed part is probably defined in amount as the minimum working capital requirement for

the year. It is widely advocated that the firm should be funded in the way shown in the

diagram below:


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Chapter 4:

WORKING CAPITAL BEHAVIOR

One of the implications of the division of working capital into two types is to understand its

behavior over a period of time. Investment in working capital is related to sales volume. A

variation in sales volume over time would consequently 5 bring about a change in the

investment of working capital. This is said to vary Theories and Approaches depending upon

the type of working capital. These variations with respect to different types of firms are

presumed to vary as indicated in Fig.


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The principle is concerned with planning the total investments in current assets. According to

this principle, the amount of working capital invested in each component should be

adequately justified by a firms equity position. Every rupee invested in current assets should

contribute to the net worth of the firm. The level of current assets may be measured with the

help of two ratios:

i. Current assets as a percentage of total assets and

ii. Current assets as a percentage of total sales

While deciding about the composition of current assets, the financial manager may consider

the relevant industrial averages.

PRINCIPLES OF MATURITY OF PAYMENT:

The principle is concerned with planning the source of finance for working capital.

According to the principles, a firm should make every effort to relate maturities of payment

to its flow of internally generated funds. Maturity pattern of various current obligations is an

important factor in risk assumptions and risk assessments. Generally shorter the maturity

schedule of current liabilities in relation to expected cash inflows, the greater the inability to

meet its obligations in time.


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Chapter 6:

FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENT

The working capital requirements of a concern depend upon a large number of factors such as

nature and size of the business, the characteristics of their operations, the length of production

cycle, the rate of stock turnover and the state of economic situation. However the following

are the important factors generally influencing the working capital requirements.

Nature of business: The amount of working capital is basically related to the nature and

volume of the business. In concerns where the cost of raw materials to be used in the

manufacture of a product is very large in proportion to its total cost of manufacture, the

requirements of working capital will be large. On the contrary, concerns having large

investments in fixed assets require lesser amount of working capital.

Size of the business unit: Size of the business unit is also a determining factor in

estimating the total amount of working capital. The general principle in this regard is that

the bigger the size, the larger will be the amount of working capital required since the

larger business units are required to maintain larger inventories for the flow of the

business.

Nature of raw material used: The nature of Raw Material used in the manufacture of

finished goods greatly influences the quantum of Raw Material Inventory. For example, if

the raw Material is an agricultural product whose availability is pronouncedly seasonal in

character, the proportion of Raw Material Inventory to Finished Goods Inventory will be

quite high. Similarly companies using Imported Raw Materials with long lead time tend

to have a high proportion of Raw Material Inventory. In the case of Capital Goods

Manufacturing Company the demand for whose product is growing over time, the

tendency will be to have high Inventory of Raw Material and Components.


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Seasonal Variations: Strong seasonal movements create special problems of working

capital in controlling the financial swings. A great many companies have to carry out

seasonal business such as sugar mills, oil mills or woolen mills, etc. and therefore they

require larger amount of working capital in the season to purchase the raw materials in

large quantities and utilize them throughout the year.

Time Consumed in Manufacture: The average time taken in the process of manufacture

is also an important factor in determining the amount of working capital. The longer the

period of manufacture, the larger the inventory required. Though capital goods industries

manage to minimize their investment in inventories or working capital by asking

advances from the customers as work proceeds on their orders.

Turnover of Circulating Capital: Turnover means the ratio of gross annual sales to

average working assets. In simple words, it means the speed with which circulating

capital completes its rounds or the number of times the amount invested in working assets

have been converted into cash by sale of the finished goods and re-invested in working

assets during a year. The faster the sales, the larger the turnover. Conversely, the greater

the turnover, the larger the volume of business to be done with given working capital.

Process Technology Used: In case the Raw Material has to go through several stages

during the process of production, the Work-in-Progress Inventory is likely to be much

higher than any other item of the Current Assets thereby increasing the need of Working

Capital.

Degree of Competition in the Market: When the Degree of Competition in the market

for finished goods in an industry is high, then companies belonging to the Industry may

have to resort to an increased credit period to its customers, partially lowering credit

standards and similar other practices to push their products. These practices are likely to

result in a high proportion for Accounts Receivables thereby increasing the need for

Working Capital.


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The time between purchase of inventory items (raw material or merchandise) and their

conversion into cash is known as operating cycle or working capital cycle. The longer the

period of conversion the longer will be the period of operating cycle. A standard operating

cycle may be for any time period but does not generally exceed a financial year.

Obviously, the shorter the operating cycle larger will be the turnover of the fund invested for

various purposes. The channels of investment are called current assets.


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Operating Cycle


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WarehousingofFinishedGoods

Manufacturingoperation: wages &

salaries, fuel,power, etc

Office, selling,distribution andother expenses

Cash

Receipt fromDebtors

Creation ofreceivables(Debtors)

Sales ofFinishedGoods

Payments tocreditors

Purchase ofraw material,Components

Creation ofA/c payable(Creditors)


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Chapter 7:

BANK CREDIT AS A SOURCE OF MEETING WORKING CAPITAL

REQUIREMENTS

While bank credit is considered as a major source of meeting the working capital requirement

of the industry, the banks have to consider the following factors before meeting their

requirements.

a) What should be the amount of working capital assistance?

b) What should be the form in which working capital assistance may be extended?

c) What should be the security that should be obtained for extending the working capital

assistance?

Amount of Assistance:

To obtain the bank credit for meeting the working capital requirements, the company will be

required to estimate the working capital requirements and will be required to approach the

banks along with the necessary supporting data. On the basis of the estimates submitted by

the company, the bank may decide the amount of assistance which may be extended, after

considering the margin requirements. This margin is to provide the cushion against the

reduction in the value of security. If the company fails to fulfill its obligations, the bank may

be required to realize the security for recovering the dues.

Margin money is meant to take care of the possible reduction in the value of security. The

percentage of margin money may depend upon the credit standing of the company,

fluctuations in the price of security or the directives of Reserve Bank of India from time to

time.


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In some cases, interests of purchasing company are also to be protected. Suppose that

Company A which manufactures capital goods takes some advance from the purchasing

Company B. If Company A fails to fulfill its part of contract to supply the capital goods to

Company B, their needs to be to be some protection available to Company B. In such

circumstances, Bank C which is the banker of Company A opens a Bank Guarantee in Favour

of Company B in which it undertakes that if Company A fails to fulfill its part of the contract,

it will reimburse any losses incurred by Company B due to this non fulfillment of contractual

obligations. Such Bank Guarantee is technically referred to as performance Bank Guarantee

and it ideally found in the buyers market.

ii) Letter of Credit:

The non-fund based lending in the form of letter of credit is very regularly found in the

international trade. In case the exporter and the importer are unknown to each other.

Under these circumstances, exporter is worried about getting the payment from the importer

and importer is worried as to whether he will get the goods or not. In this case, the importer

applies to his bank in his country to open a letter of credit in favour of the exporter whereby

the importers bank undertakes to pay the exporter or accept the bills or drafts drawn by the

exporter on the exporter fulfilling the terms and conditions specified in the letter of credit.

B. Fund Based Lending

In case of Fund Based Lending, the lending bank commits the physical outflow of funds.

As such, the funds position of the lending bank gets affected. The Fund Based Lending can

be made by the banks in the following forms-

i) Loan:

In this case, the entire amount of assistance is disbursed at one time only, either in cash or by

transfer to the companys account. It is a single advance. The loan may be repaid in

installments, the interests will be charged on outstanding balance.

ii) Overdraft:


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Chapter 8:

WORKING CAPITAL FINANCE

A manufacturing concern needs finance not only for acquisition of fixed assets but also for its

day-to-day operations. It has to obtain raw materials for processing, pay wage bills & other

manufacturing expenses, store finished goods for marketing & grant credit to the customers.

It may have to pass through the following stages to complete its operating cycle-

i. Conversion of cash into raw materials raw material procured on credit, cash may

have to be paid after a certain period.

ii. Conversion of raw materials into stock in process.

iii. Conversion of stock in process into finished goods.

iv. Conversion of finished goods into receivables/debtors or cash.

v. Conversion of receivables/debtors into cash.

A non-manufacturing trading concern may not require raw material for their processing, but it

also needs finance for storing goods & providing credit to its customers.

Similarly a concern engaged in providing services, it may not have to keep inventories but it

may have to provide credit facility to its customers. Thus all enterprises engaged in

manufacturing or trading or providing services require finance for their day-to-day

operations, the amount required to finance day-to-day operation is called working capital &

the assets & liabilities are created during the operating cycle are called current assets &

current liabilities. The total of all the current assets is called gross working capital & the

excess of current assets over current liabilities is called net working capital.

When entrepreneurs for financing working capital requirements approach the banks, the bank

has to examine the viability of the project before agreeing to provide working capital for it.

Financial institutions & bank while providing term loan finance to unit for acquisition of

fixed assets does a detailed viability study. They have to ensure that the project will generate

sufficient return on the resources invested in it. The viability of a project depends on

technical feasibility, marketability of the products, at a profitable price, availability of

financial resources in time & proper management of the unit. In brief the project should

satisfy the tests of technical, commercial, financial & managerial feasibility.


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Proper co-ordination amongst banks & financial institution is necessary to judge the viability

of a project & to provide working capital at appropriate time without any delay. If a unit

approaches banks only for working capital requirement & no viability study has been done

earlier which is done at the time of providing term loans, a detailed viability study is

necessary before agreeing to provide working capital finance.

In the view of scarcity of bank credit, its increasing demand from various sectors of economy

& its importance in the development of economy, bank should provide working capital

finance according to production requirements. Therefore it is necessary to make a proper

assessment of total requirement of the working capital, which depends on the nature of the

activities of an enterprise & the duration of its operating cycle. It has to be ensured that the

unit will have regular supply of raw material to facilitate uninterrupted production. The unit

should be able to maintain adequate stock of finished goods for smooth sales operation. The

requirement of trade credit, facilities to be given by the unit to its customers should also be

assessed on the basis of practice prevailing in the particular industry/trade which assessing

above requirements, it should also be ensured that carrying cost of inventories & duration of

credit to customers are minimized.

After assessing the total requirement of working capital, a part of working capital

requirement should be financed for the long term & partly by determining maximum

permissible bank finance.


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Chapter 9:

WORKING CAPITAL NEEDS OF A BUSINESS

Different industries have different optimum working capital profiles, reflecting their methods

of doing business and what they are selling.

Businesses with a lot of cash sales and few credit sales should have minimal trade

debtors. Supermarkets are good examples of such businesses

Businesses that exist to trade in completed products will only have finished goods in

stock. Compare this with manufacturers who will also have to maintain stocks of raw

materials and work-in-progress.

Some finished goods, notably foodstuffs, have to be sold within a limited period because

of their perishable nature.

Larger companies may be able to use their bargaining strength as customers to obtain

more favorable, extended credit terms from suppliers. By contrast, smaller companies,

particularly those that have recently started trading (and do not have a track record of

credit worthiness) may be required to pay their suppliers immediately.

Some businesses will receive their monies at certain times of the year, although they may

incur expenses throughout the year at a fairly consistent level. This is often known as

seasonality of cash flow. For example, travel agents have peak sales in the weeks

immediately following Christmas.

The amount of funds tied up in working capital would not typically be a constant figure

throughout the year. Only in the most unusual of businesses would there be a constant

need for working capital funding. For most businesses there would be weekly

fluctuations. Many businesses operate in industries that have seasonal changes in demand.

This means that sales, stocks, debtors, etc. would be at higher levels at some predictable

times of the year than at others.


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Chapter 10:

ASSESSMENT OF WORKING CAPITAL

A unit needs working capital funds mainly to carry current assets required for its operations.

Proper assessment of funds required for working capital is essential not only in the interest of

the concerned unit but also in the national interest to use the scare credit according to

production requirements. Inadequate levels of working capital may result in under-utilization

of capacity and serious financial difficulties. Similarly excessive levels may lead to

unproductive use of credit and unnecessary interest Burdon on the unit.

Proper assessment of working capital requirement may be done as under-

I. NORMS FOR INVENTORY AND RECEIVABLES:

If the bank credit is to be linked with production requirements, it is necessary to assess the

requirements on the basis of certain norms. The study group to frame guidelines to follow-up

of bank credit (Tandon Study Group) appointed by Reserve Bank of India had suggested the

norms for inventory and receivables regarding 1: major industries on the basis of company

finance studies made by Reserve Bank process periods in the different industries, discussions

with the industry experts and feed-back received on the interim report. The norms suggested

by Tandon Study Group are being reviewed from time to time by the Committee of Direction

constituted by the Reserve Bank to keep a constant view on working capital requirements.

The committee has representatives from a few banks and it generally once in a quarter. It also

consults the representatives from industry and trade. It keeps a watch on the various issues

relating to working capital requirements and gives various suggestions to suit the changing

requirements of the industry and trade.

Banks make their own assessment of credit requirements of borrowers based on a total study

of borrowers business operations and they can also decide the levels of holding each item of

inventory as also of receivables which in their view would represent a reasonable built up of

current assets for being supported by banks finance. Banks may also consider suitable

internal guidelines for accepting the projections made by the borrowers regarding sundry

creditors as sundry creditors are taken as a source of financing current assets (inventories,

receivables, etc.), it is necessary to project them correctly while calculating need of bank

finance for working capital requirements.

II. COMPUTATION OF MAXIMUM PERMISSIBLE BANK FINANCE (MPBF):


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The Tandon Study group had suggested the following alternatives for working out the

maximum permissible bank finance:-

a. Bank can work out the working capital gap. i. e. total current assets less current liabilities

other than bank borrowings and finance a maximum of 75 per cent of the gap; the balance

to come out of long-term funds, i.e. owned funds and term borrowings

b. Borrower should provide for a minimum of 25 per cent of total current assets out of long-

term funds, i.e. owned funds and long term borrowings. A certain level of credit for

purchases and other current liabilities inclusive of bank borrowings will not exceed 75 per

cent of current assets.

It may be observed from the above that borrowers contribution from long term funds would

be 25 per cent of the working capital gap under the first method of lending and 25 per cent of

total current assets under the second method of lending. The above minimum contribution of

long-term funds is called minimum stipulated Net Working Capital (NWC) which comes

from owned funds and term borrowings.

III. CLASSIFICATION OF CURRENT ASSETS & CURRENT LIABILITIES:

In order to calculate net working capital & maximum permissible bank finance, it is

necessary to have proper classification of various items of current assets & current liabilities.

All illustrative lists of current assets & current liabilities for the purpose of assessment of

working capital are furnished below;

Current assets: -

a. Cash and bank balances

b. Investments

c. Receivables arising out of sales other than deferred receivables (including bills purchased

& discounted by bankers)

d. Installments by deferred receivables due within one year

e. Raw materials & components used in the process of manufactured including those in

transit

f. Stock in process including semi finished goods

g. Finished goods including goods in transit

h. Other consumable spares

i. Advance payment for tax


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j. Prepaid expenses

k. Advances for purchases of raw materials, components & consumable stores

l. Payment to be received from contracted sale of fixed assets during the next 12 months

Current Liabilities:

a. Short-term borrowings (including bills purchased & discounted) from Banks and Others

b. Unsecured loans

c. Public deposits maturing within one year

d. Sundry creditors (trade) for raw material & consumer stores & spares

e. Interest & other charges accrued but no due for payments

f. Advances/progress payments from customers

g. Deposits from dealers selling agents, etc.

h. Statutory liabilities

Provident fund dues

Provision for taxation

Sales-tax, excise, etc.

Obligation towards workers considered as statutory

i. Miscellaneous current liabilities

Dividends

Liabilities for expenses

Gratuity payable within one year

Any other payments due within one year


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IV. INFORMATION/DATA REQUIRED FOR ASSESSMENT OF WORKING

CAPITAL:

In order to assess the requirements of working capital on the basis of production needs, it is

necessary to get the data from the borrowers regarding their past/projected production, sales,

cost of production, cost of sales, operating profit, etc. in order to ascertain the financial

position of the borrowers & the amount of working capital needs to be financed by banks, it

is necessary to call for the data from the borrowers regarding their net worth, long term

liabilities, current liabilities, fixed assets, current assets, etc. the Reserve Bank prescribed the

forms in 1975 to submit the necessary details regarding the assessment of working capital

under its credit authorization scheme. The scheme of credit authorization was changed into

credit monitoring arrangement in 1988. The forms used under the credit authorization scheme

for submitting necessary information have also been simplified in 1991 for reporting the

credit sanctioned by banks above the cut-off point to reserve bank under its scheme of credit

monitoring arrangement.

As the traders and merchant exporters who do not have manufacturing activities are not

required to submit the data regarding raw materials, consumable stores, goods- in-process,

power and fuel, etc., a separate set of forms has been designed for traders and merchant

exporters. In view of the peculiar nature of leasing and the hire purchase concerns, a separate

set of forms has also designed for them.

In addition to the information/data in the prescribed forms, bank may also call for additional

information required by them depending on the nature of the borrowers activities & their

financial position. The data is collected from the borrowers in the following six forms: -

a. Particulars of the existing/proposed limits from the banking system (form I)

Particulars of the existing credit from the entire banking system as also the term loan

facilities availed of from the term lending institutions/banks are furnished in this form.

Maximum & minimum utilization of the limits during the last 12 months outstanding

balances as on a recent date are also given so that a comparison can be made with the limits

now requested & the limits actually utilized during the last 12 months.

b. Operating Statement (Form II)


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The data relating to last sales, net sales, cost of raw material, power & fuel, direct

labour, depreciation, selling, general expenses, interest, etc. are furnished in this form.

It also covers information on operating profit & net profit after deducting total expenditure

from total sale proceeds.

c. Analysis of Balance Sheet (Form III)

A complete analysis various items of last years balance sheet, current years estimate &

following years projections is given, in this form. The details of current liabilities, term

liabilities, net worth, current assets, other non-current assets, etc. are given in this form as per

the classification accepted by banks.

d. Comparative statement of current assets & current liabilities (Form IV)

This form gives the details of various items of current assets and current liabilities as per

classification accepted by banks. The figures given in this form should tally with the figures

given in the form III where details of all the liabilities & assets are given. In case of

inventory, receivables and sundry creditors; the holding/levels are given not only in absolute

amount but also in terms of number of month so that a comparative study may be done with

prescribed norms/past trends. They are indicated in terms of numbers of months in bracket

below their amounts.

e. Computation of Maximum Permissible Bank Finance (Form V)

On the basis of details of current assets & liabilities given in form IV, Maximum

Permissible Bank Finance is calculated in this form to find out credit limits to be allowed to

the borrowers.

f. Fund Flow Statement (Form VI)

In this form, fund flow of long term sources & uses is given to indicate whether long term

funds are sufficient for meeting the long term requirements. In addition to long term sources

and uses, increase/decrease in current assets is also indicated in this form.

V. CHECK LIST FOR VERIFICATION OF THE INFORMATION/DATA:


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Bank should verify not only the arithmetical accuracy of the data furnished by the borrowers

but also the logic behind various assumptions based on which the projections have been

made. For this purpose, bank officials should hold discussions with the borrowers on

projected sales, level of operations, level of inventory, receivables, etc. if necessary, a visit to

the factory may also be made to have a clear idea of products and processes.


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Chapter 11:

PROCEDURE FOR WORKING CAPITAL FINANCE

CREDIT SANCTION PROCESS

The revised credit process is introduced with a view of reducing the time lag in the sanction

of credit besides clearly delineating the areas of responsibilities of various functionaries. As

per this the revised process is divide into two components that is Pre sanctioning and Post

sanctioning

In the pre sanctioning it is the only time that the bank can take due assessment and

precautions to make sure that the investments are done for the benefit of the bank. The post

sanctioning is the follow of the payment. In case the payment defaults then the account will

go into NPA in stages and the bank is then said to scrutinize the said account.

PRE SANCTION PROCESS: -

Obtain loan application

When a customer required loan he is required to complete application form and submit the

same to the bank also the borrower has to be submit the required information along with the

application form.


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APPRAISAL &

RECOMMANDATION

PRE SANCTIONPROCESS

SANCTIONING

ASSESSMENT


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Estimated working capital gap W.R.T acceptable buildup of

inventory/receivables/other current assets and bank borrowing patterns.

Assess MPBF determine facilities required

Assess requirement of off balance sheet facilities viz. contingent liabilities, bankguarantees, etc.

Management quality, competence, track records

Companys structure and system

Market shares of the units under comparison.

Unique feature

Profitability factors

Inventory/Receivable level

Capacity utilization

Capital market perception.


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POST SANCTION PROCESS

Supervision and follow up: -

Sanction credit limit of working capital requirement after proper assessment of proposal is

alone not sufficient. Close supervision and follow up are equally essential for safety of bank

credit and to ensure utilization of fund lend. A timely action is possible only close

supervision and followed up by using following techniques.

Monthly stock statement

Inspection of stock

Scrutiny of operation in the account

Quarterly/half quarterly statements.

Under information system

Annual audited report


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POST SANCTIONPROCESS

FOLLOW UP MONITORING &CONTROL

SUPERVISION


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e) Payment Polices:

The ability to get credit terms for purchases of materials and other products and services also

affects the cash flow. If the firm maintains creditworthiness, it could always find it easy to

source material and other items on credit basis. On the other hand, if materials and other

items are to be bought on cash basis or only limited credit period is available, the demand for

cash increases.

External Factors:

External factors can be broadly classified into monetary and fiscal factors and industry

related factors. These are discussed below.

a) Monetary and Fiscal Factors:

The central bank (Reserve Bank of India) periodically spells out monetary policies and

through which influences the availability of money. The monetary policy in turn is affected

by the fiscal factors of the country. In a liberal monetary policy regime, it will not be difficult

to get credit from banks as well as from suppliers of material and services. Thus, the need for

holding cash is thus limited to transaction motive..

b) Industry-related factors:

Industry-related factors affect the cash flow in the form of practices followed by other firms

in the industry on terms of sale and nature of material and services required. Cash flow will

be positive in retail industry. Cash flow will be cyclical for industries such as plantation and

agro based products. Cash flow is volatile in certain industries like entertainment and

hospitality industry. Cash flow is generally negative for manufacturing industries. Depending

on the nature of cash flow relating to the industry, the demand for holding cash is determined


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Chapter 13:

SOURCES OF WORKING CAPITAL & WORKING CAPITAL CYCLE

The sources of working capital are:

1. Public Deposits

2. Commercial Paper

3. Inter-Corporate Loans

4. Bonds and Debentures

5. Factoring of Receivables

The working capital cycle can be defined as:

The period of time which elapses between the point at which cash begins to be expended on

the production of a product and the collection of cash from a customer.

The diagram below illustrates the working capital cycle for a manufacturing firm


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The upper portion of the diagram above shows in a simplified form the chain of events in a

manufacturing firm. Each of the boxes in the upper part of the diagram can be seen as a tank

through which funds flow. These tanks, which are concerned with day-to-day activities, have

funds constantly flowing into and out of them.

The chain starts with the firm buying raw materials on credit.

In due course this stock will be used in production, work will be carried out on the

stock, and it will become part of the firms work in progress (WIP)

Work will continue on the WIP until it eventually emerges as the finished product

As production progresses, labour costs and overheads will need to be met

Of course at some stage trade creditors will need to be paid

When the finished goods are sold on credit, debtors are increased

They will eventually pay, so that cash will be injected into the firm. Each of the areas

stocks (raw materials, work in progress and finished goods), trade debtors, cash

(positive or negative) and trade creditors can be viewed as tanks into and from

which funds flow.

Working capital is clearly not the only aspect of a business that affects the amount of cash:

The business will have to make payments to government for taxation

Fixed assets will be purchased and sold

Lessors of fixed assets will be paid their rent

Shareholders (existing or new) may provide new funds in the form of cash

Some shares may be redeemed for cash

Dividends may be paid

Long-term loan creditors (existing or new) may provide loan finance, loans will need

to be repaid from time to time, and

Interest obligations will have to be met by the business.


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Unlike movements in the working capital items, most of these non-working capital cash

transactions are not every day events. Some of them are annual events (e.g. tax payments,

lease payments, dividends, interest and, possibly, fixed asset purchases and sales). Others

(e.g. new equity and loan finance and redemption of old equity and loan finance) would

typically be rarer events.

Cash flows in a cycle into, around and out of a business. It is the business's life blood and

every manager's primary task is to help keep it flowing and to use the cash flow to generate

profits. If a business is operating profitably, then it should, in theory, generate cash surpluses.

If it doesn't generate surpluses, the business will eventually run out of cash and expire. Click

here for more information about the vital distinction between profits and cash flow.

The faster a business expands the more cash it will need for working capital and investment.

The cheapest and best sources of cash exist as working capital right within business. Good

management of working capital will generate cash will help improve profits and reduce risks.

Bear in mind that the cost of providing credit to customers and holding stocks can represent a

substantial proportion of a firm's total profits.

There are two elements in the business cycle that absorb cash - Inventory (stocks and work-

in-progress) and Receivables (debtors owing you money). The main sources of cash are

Payables (your creditors) and Equity and Loans.

Each component of working capital (namely inventory, receivables and payables) has two

dimensions TIME and MONEY. When it comes to managing working capital - TIME IS

MONEY. If you can get money to move faster around the cycle (e.g. collect monies due from

debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory levels

relative to sales), the business will generate more cash or it will need to borrow less money to

fund working capital. As a consequence, you could reduce the cost of bank interest or you'll

have additional free money available to support additional sales growth or investment.

Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an

increased credit limit; you effectively create free finance to help fund future sales.

It can be tempting to pay cash, if available, for fixed assets e.g. computers, plant, vehicles etc.

If you do pay cash, remember that this is now longer available for working capital. Therefore,


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Chapter 14:

BREAKING DOWN THE CYCLE

The entire process starts with the receipt of raw materials. If they are purchased on credit,

there is a commitment, in terms of accounts payable, but a cash disbursement has not yet

been made. So in effect, the time from when a purchase commitment is made until the time

the supplier is paid is really financing that the business is gaining, and serves to reduce the

need for other sources of financing.

If production is not started immediately, there will be a period of time when raw materials are

in inventory. Once production starts, the raw materials will enter the next phase - the work-

in-process inventory, where additional costs such as labor and utilities will be added. The

work-in process period ends when the products are completed and the production cycle ends

with the finished goods inventory.

It may turn out that products are not sold immediately upon completion, so there is a period

when finished products remain in inventory pending their sale. And when sales are made,

there may be a delivery period involved, and the sales may be on credit terms, so the process

enters the final period in which accounts receivable are pending payment. Once collection is

made and payment is received from the customer, the cycle is complete.

So, the overall business cycle can be broken down as follows:

Number of days raw materials are in inventory

Minus number of days of accounts payable to suppliers

Plus number of days in work-in-process

Plus number of days products are in finished goods inventory

Plus collection period from customers

Equals cash conversion period.


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Once these periods are defined, calculations can be made to begin to develop an estimate of

working capital needs.


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Current Ratio

Total Current Assets/Total Current Liabilities = x times

Current Assets are assets that you can readily turn in to cash or will do so within 12 months

in the course of business. Current Liabilities are amount you are due to pay within the coming

12 months. For example, 1.5 times means that you should be able to lay your hands on $1.50

for every $1.00 you owe. Less than 1 times e.g. 0.75 means that you could have liquidity

problems and be under pressure to generate sufficient cash to meet oncoming demands.

Quick Ratio

(Total Current Assets - Inventory)/Total Current Liabilities = x times

Similar to the Current Ratio but takes account of the fact that it may take time to convert

inventory into cash.

Working Capital Ratio

(Inventory + Receivables - Payables)/Sales= (As % Sales)

A high percentage means that working capital needs are high relative to your sales.

Other working capital measures include the following:

Bad debts expressed as a percentage of sales.

Cost of bank loans, lines of credit, invoice discounting etc.

Debtor concentration - degree of dependency on a limited number of customers.

Once ratios have been established for your business, it is important to track them over time

and to compare them with ratios for other comparable businesses or industry sectors.

When planning the development of a business, it is critical that the impact of working capital

be fully assessed when making cash flow forecasts. Our financial planning software packages

Ex. Plan and Cash flow Plan - can facilitate this task as they provide for the setting of targets

for receivables, payables and inventory.


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Terms with Suppliers and Customers

The other periods involved in the cycle are the average payment terms with suppliers for

purchases of materials, the average payment period for other expenses, and the average credit

terms with customers for sales. With this information, the first stage of calculating working

capital needs based on days of sales to finance is complete. The next stage involves

assigning values to these periods.

Number of Days

Based on the above calculations, an example could be generated, as follows:

Days of raw materials inventory = 5

Days of work-in-process inventory = 15

Days of finished goods inventory = 10

Payment terms with suppliers = 30

Payment terms for other expenses = 10

Credit terms with customers = 45

This information may be available from historical records on production, or based on

personal experience in the business with help of above formulas. Or it may be based on

contractual terms, such as payment terms with suppliers and credit terms with customers.

Percentage Components of Sales Price

The next step is to express the final sales price of the product in terms of its component parts;

that is, what part of the sales price is represented by raw materials and other expenses. If it is

assumed for purposes of this example that raw materials represent 20% of the final sales price

and other expenses represent 50%, these percentages can then be applied to the number of

days involved in each stage of the cycle, as previously determined, to calculate the number of

days of sales that need to be financed. For purposes of the example, it is assumed that work-

in-process contains both the 20% component for raw materials and the 50% component for

other expenses. In practice, the costs invested in work-in-process depend on the stage of


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completion of the products in inventory. It may be necessary to refine this aspect, based on

the particular business and the level of information available.

Calculating Days Based on Percentage Components

Based on the foregoing information, the number of days involved in each separate period of

the process times their corresponding percentage components of the sale price are as follows:

Raw materials: 5 days x 20% = 1 day

Work-in-process: 15 days x 70% = 10.5 days

Finished goods: 10 days x 70% = 7 days

Suppliers: 30 days x 20% = 6 days (this number is subtracted)

Other expenses: 10 days x 50% = 5 days

Customers: 45 days x 70% = 31.5 days

Equals total number of days of sales to finance: 49 days

Calculating Days of Sales to Finance

The next step is to take the total estimated annual sales and express them in terms of sales per

day. For example:

Total annual sales of $500,000 / 365 days = $1,370 per dayThe number of days of sales to finance (49 days) times sales of $1,370 per day equals an

estimated working capital requirement of $67,130.

The above example outlines the general steps involved in estimating working capital

requirements using this methodology, and by refining the date a closer approximation can be

obtained.


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Chapter 16:

LEVEL OF WORKING CAPITAL

I. Optimum level of Working capital

High amount of working capital will decrease the return on investment and low amount of

working capital will increase the risk of business. So, it is very important decision to get

optimum level of working capital where both profitability and risk will be balanced. For

achieving optimum level of working capital, finance manager should also study the factors

which affect the requirement of working capital and different elements of current assets. If he

will manage cash, debtor and inventory, then working capital will automatically optimize.

Optimal level of working capital is that level where company is capable to pay day to day

expenses and company has enough cash to buy the stocks in case if it does not receive money

from debtors on the time. We all know that both low level and over level of working capital

is harmful for development of business. If company has not enough cash to repay its liability,

it will create the risk of solvency and liquidity and company may go for liquidation. In case,

company has over working capital, it will be misuse of money because that money is not

gaining any earning and its opportunity cost will suffer by shareholders and ultimately it will

decrease the value of share in share market. So, as finance manager, you should try to create

equilibrium or optimal or optimum level of working capital.


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CASE OF CAMEROON DEVELOPMENT CORPORATION (CDC)

The issue of working capital is very important to the operations of the Cameroon

Development Corporation (CDC) Net working capital (i.e. the excess of liquid current assets

over current liabilities) is an indispensable component of any business organization's capital

structure. For any company to make profit in order to enhance growth depends on the size of

working capital and its proper assessment. The mismatch of working capital and fixed capital

will always bring problems to the financial operations of the company. There must be an

optimum size of working capital is a dangerous to an organization's working life as too little

working capital

This coupled with sound working capital always forces management to go into an overtrading

situation (negative working capital) Looking the case of CDC there is an overtrading

situation. This case is used to examine the causes and consequences of overtrading. The paper

concludes that organizations must properly manage their working capital in order to achieve

growth. To achieve the main objective of this study (i.e. determining the optimum size of

working in order to achieve the main objectives of this study (i.e. determining the optimum

size of working capital) data was collected and analyzed from CDC This is because CDC is a

very large corporation and working capital problems are likely. The study found that CDC is

a very large corporation and working capital problems are very likely. The study found that

CDC has acute working capital problems resulting in losses. These problems stem from poor

working capital management approaches employed over the years. Every organization must

seek a point of balance in its working capital in order to avoid a loss-making situation.


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It becomes impossible to utilize efficiently the fixed assets due to non-availability of

liquid funds thus the firms profitability would deteriorate.

The rate of return on investments also falls with the shortage of WC.

Operating inefficiency creeps in and it becomes difficult to implement operating plans

and achieve the firms profit targets.

Example: Energy Industry Faces Higher Levels of Working Capital

The degree of working capital tied up by the oil and gas industry has grown

substantially over the past six years, according to Ernst & Young's report, Cash in the

Barrel: Benchmarking and analysis of working capital management in the oil and gas

industry.

Ernst & Young reports that working capital among oil and gas companies in terms of

cash-to-cash (C2C) grew from 24.9 to 32.0 days, an increase of 7.1 days or 29 percent

between 2003 and 2009. While the expansion of the industry-wide C2C cycle was

driven by 20 of the 34 companies surveyed, the difference between the best

performers and laggard performers is considerable.

Working capital, the measure of a company's current assets after subtracting its

liabilities, can negatively impact a company's cash flow when it increases. "There is a

growing awareness throughout the industry of just how much value is being left on

the table as a result of too little focus on working capital management," Ernst &

Young said. However, issues such as price volatility and, in particular, any interval of

relatively higher oil and gas prices tend to draw attention away from sound working

capital management.

Ernst & Young noted that a key factor in the deterioration of the industry's C2C

performance is inventory levels, which grew substantially from 2003 to 2009. While

the meaning behind such a decline may not be immediately apparent, in general, this

reflects the impact of much stronger oil prices on the value and composition of total

inventories, as well as higher levels of physical stocks.


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"Moreover, the apparent paradox of holding more physical inventories when oil prices

are high can be explained today by the current combination of low interest rates and

significant price volatility," Ernst & Young said. "Low interest rates reduce the cost

of storage. Meanwhile, volatility creates a significant price differential between spot

and forward prices. As such, firms can afford to hold on to crude for longer intervals,

delivering stock into more lucrative forward markets."

Ernst & Young notes that wide variations exist in working capital management

performance in the oil and gas industry, often due to variations in business models,

customers, levels of vertical integration, nature of supply contracts and production

and distribution infrastructure.

However, the size of disparities in performance indicates that there are fundamental

differences in the degree of management focus on cash and process effectiveness.

"Huge opportunities for improvement exist within areas such as inventory

management, demand forecasting, supply chain planning, billing, collection,

commercial terms, contractor management and sourcing," Ernst & Young said.

Ernst & Young found that exploration and production (E&P) firms carry the lowest

level of working capital across the industry, seven days, reflecting a combination of

low inventory and high payables levels. By comparison, refining and marketing and

integrated firms show significantly longer C2C cycles of 32 days and 30 days

respectively.

Oilfield service companies carry much higher working capital levels, 97 days, than

other segments of the industry. "This reflects the complex, sometimes long-cycle

nature of the segment's operating model, with certain long-term contracts carrying

significant down payment and progress billing terms."

Overall C2C performance was also positively impacted, to a small degree, by changes

in the industry sales mix, and as more companies focus on E&P and dispose of

refining, marketing and chemical interests, their relative capital working performance

should begin to improve. "However, companies should be careful not to use such

passive gains as an excuse to put off more substantive steps to improve working

capital management."


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III. CONSEQUENCES OF UNDER ASSESMENT OF WORKING CAPITAL:

Growth may be stunted. It may become difficult for the enterprises to undertake

profitable projects due to non availability of working capital.

Implementations of operating plans may brome difficult and consequently the profitgoals may not be achieved.

Cash crisis may emerge due to paucity of working funds.

Optimum capacity utilization of fixed assets may not be achieved due to non

availability of the working capital.

The business may fail to honour its commitment in time thereby adversely affecting its

creditability. This situation may lead to business closure.

The business may be compelled to by raw materials on credit and sell finished goods on cash.

In the process it may end up with increasing cost of purchase and reducing selling price by

offering discounts. Both the situation would affect profitable adversely.

Now avaibility of stocks due to non availability of funds may result in production stoppage.

While underassessment of working capital has disastrous implications on business over

assessments of working capital also has its own dangerous.

IV. CONSEQUENCES OF OUR OWN ASSESMNET OF WORKING CAPITAL:

Excess of working capital may result in unnecessary accumulation of inventories.

It may lead to offer too liberal credit terms to buyers and very poor recovery system &

cash management.

It may make management complacent leading to its inefficiency.

Over investment in working capital makes capital less productive and may reduce

return on investment.

Working Capital is very essential for success of business & therefore needs efficient

management and control. Each of the components of working capital needs proper

management to optimize profit.


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Chapter 17:

ASSET MANAGEMENT

Inventory Management:

Inventory includes all type of stocks. For effective working capital management, inventory

needs to be managed effectively. The level of inventory should be such that the total cost of

ordering and holding inventory is the least. Simultaneously stock out costs should be

minimized. Business therefore should fix the minimum safety stock level reorder level of

ordering quantity so that the inventory costs is reduced and outs management become

efficient.

The value of inventory differs between industries because several factors like technology,

nature of materials, production process, etc. determines the value of inventory. The

composition of inventory is high in food and beverages because the technology is fairly

simple and hence the requirement of fixed assets is low. The inventory requirement is high

because of seasonal factor and the need for wider retail distribution net work. For instance, if

each shop in the country stores twenty pockets of Maggi Noodles or Milkmaid, think of the

total volume of finished goods stored in millions of shops distributed all over the country.

The composition of inventory is low in heavy industries or hi-tech industries because of high

value of fixed assets. Another interesting finding is declining trend in the composition of

inventories as a percentage of total assets during the period, which partly attributes to

successful implementation of new techniques such as MRP and JIT.


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Components Of Inventory

There are four major components of inventory namely raw materials, stores and spares,

Work-in-process and finished goods.

Inventory System

We can define inventory system as the one, which consists of three components namely

inventory customers, inventory storage points and inventory sources. Inventory customers are

primary cause for investments in inventory. Inventory customers include end-customers,

marketing department or dealers, production centers and any one, who demands inventory to

be stored for their ready consumption. The customers demand inventory because of their

production process and consumption pattern. A firm, which is doing job orders, can purchase

the required items after it receives the job order. On the other hand, sugar or power plant

cannot buy their daily requirements on daily basis because the process is continuous and any

delay in the arrival of material will force the unit to shut down. Similarly, industrial consumer

would buy in quantities sufficient to ensure their production process to run smoothly whereas

retail consumers will expect. The shops to keep ready the stocks to allow them to buy

whenever the product is required. For example, individuals buy soaps, detergents, toothpaste,

health drinks and other consumables only for a months requirement. An analysis of the

inventory customers and their consumption behavior is essential for inventory management.

The second component of an inventory system is inventory storage or inventory stocking

points. It might be a warehouse, a distribution centre, a storage bin or any other physical

location where inventory is stored for a brief period of time. Stocking points are required

because transportation in bulk quantity to these points is easy and cheaper and stocks are

redistributed in smaller quantity to retail outlets. In the case of raw materials also

convenience and low cost require materials to be bought in bulk and stored inside the factory.

Analysis of stocks in stores and removing transportation bottleneck are key to reduce the

investments in stocks. The slow moving and non-moving items not only increase the cost of

carrying the inventory but also incur an opportunity cost of denying storing space for fast

moving items.


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The last component of an inventory system is sources of inventory. It could be a supplier

from whom the firm purchases materials or internal division from which the products are

transferred. This factor affects inventory management in several ways. For instance, the

number of inventory sources affects the decision on inventory holding. If an item is

manufactured by several units and the quality is comparable, then lead time for procuring the

material is low and the availability of material is high. On the other hand, if the number of

suppliers is few or the quality is not consistent, the inventory holding is high. The production

process of suppliers again determines their ability to supply in small quantity.

In inventory system, where the number of customers, stocking points and suppliers are few,

the system is relatively easy to manage. Many companies are trying to achieve this by doing

customer profit analysis, warehousing analysis and supply chain analysis. The system

becomes complex to manage, if the number of customers, stocking points and sources

increases. As the customers demands are satisfied by supplying stocks from the stock points,

the core issue of inventory management is how to replenish the stocking points from different

sources in such a way as to minimize the total of all associated costs and thereby enhance the

profitability of the organization. The next issue before us is to understand the costs associated

with inventory before attempting to reduce them.

RECEIVABLE MANAGEMENT:

Given a choice, every business would prefer selling its produce on cash basis. However, due

to factors like trade policies, prevailing market conditions etc. Business are compelled to sells

their goods on credit. In certain circumstances a business may deliberately extend credit as a

strategy of increasing sales. Extending credit means creating current assets in the form of

debtors or account receivables. Investment in the type of current assets needs proper and

effective management as, it gives rise to costs such as:

Cost of carrying receivables

Cost of bad debts losses

Thus the objective of any management policy pertaining to accounts receivables would be to

ensure the benefits arising due to the receivables are more than the costs incurred for the

receivables and the gap between benefit and costs increased resulting in increase profits.

Help a great deal in properly managing it. Each business should therefore try to find out

coverage credit extends to its clients using the below given formula:


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Average Credit = Total amount of receivable

(Extend in days) Average credit sale per day

Each business should project expected sales and expected investments in receivable based on

various factor, which influence the working capital requirement. From this it would be

possible to find out the average credit days using the above given formula. A business should

continuously try to monitor the credit days and see that the average. Credit offer to clients is

not crossing the budgeted period otherwise the requirement of investment in the working

capital would increase and as a result, activities may get squeezed. This may lead to cash

crisis.

CASH BUDGET:

Cash budget basically incorporates estimates of future inflow and outflows of cash cover a

projected short period of time which may usually be a year, a half or a quarter year. Effective

cash management is facilated if the cash budget is further broken down into months, weeks or

even a daily basis.

There are two components of cash budget are:

1. Cash Inflows

2. Cash Outflows


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The main sources for these flows are given here under:

1. CASH INFLOWS:

Cash Sales

Cash received from debtors

Cash received from Loans, deposits etc.

Cash receipts other revenue income

Cash received from sale of investment or assets.

2. CASH OUTFLOWS:

Cash Purchase

Cash payments to Creditors Cash payment for other revenue expenditure

Cash payment for assets creation

Cash payments for withdrawals, taxes.

Repayments of Loan etc.

A suggestive for, at for cash budget is given below:


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MONTHS

PARTICULARS JANUARY FERBUARY MARCHEstimated cash inflows

.

I. Total cash inflows Estimated cash outflows .. .. II. Total cash outflows III. Opening cash balances IV. Add/deduct surplus/deflect during the month (

I-II)

V. Closing cash balances (III -IV) VI. Minimum level of cash balance

VII. Estimated excess or short fall of cash (V-VI)


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Chapter 18:

SOURCES OF ADDITIONAL WORKING CAPITAL

Sources of additional working capital include the following:

Existing cash reserves

Profits (when you secure it as cash!)

Payables (credit from suppliers)

New equity or loans from shareholders

Bank overdrafts or lines of credit

Long-term loans

If you have insufficient working capital and try to increase sales, you can easily over-stretchthe financial resources of the business. This is called overtrading. Early warning signs

include:

Pressure on existing cash

Exceptional cash generating activities e.g. offering high discounts for early cash

payment

Bank overdraft exceeds authorized limit

Seeking greater overdrafts or lines of credit

Part-paying suppliers or other creditors

Paying bills in cash to secure additional supplies

Management pre-occupation with surviving rather than managing

Frequent short-term emergency requests to the bank (to help pay wages, pending

receipt of a cheque).


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Chapter 19:

MAJOR COMPONENTS FOR ASSESSING WORKING CAPITAL

Inventory

Accounts Receivable

Cash & Banks

Payables

Marketable Securities

Advances & prepaid

Inventory

Stocks of materials and spares need to be available to facilitate the smooth functioning of a

project's operations. Stocks of final goods may be held before their sale and distribution.

Other materials and inputs will be tied up in partially completed production outputs. For

some projects, particularly in agro processing or industry, such working capital stocks need to

be allowed for in the estimates of initial project investments and included in the project

statement at financial and economic prices. They are separate from the annual project costs

on operations and maintenance.

Several types of projects involve negligible working capital. For example, irrigation and road

projects require considerable resources for regular operation and maintenance, including

labor. However, they require very small amounts of resources tied up and available as

materials and spares. Other projects may require stocks of materials but not outputs, for

example, power generation from coal that requires coal stocks at power plants but where the

product is not storable.

In the economic analysis of projects, the value of working capital is calculated at constant

prices. If the level of stocks varies over the year, as for many agriculture-based activities,

annual average stock levels are used in the calculations. The project statement for economic

analysis should contain a cost row showing annual increases in working capital in early

project years. The total stocks held as working capital are released at the end of the project

and should be shown as a residual value.


67/94


68/94

The components of Inventory are,

Initial stocks of materials equivalent to two months requirement for the following year's

production level, valued at shadow prices;

Final stocks of outputs equivalent to one month sales in the current year, valued at cost in

shadow prices; and

Work in progress based on a production period of 20 days and a working year of 250

days, at the current year's production level, valued in shadow prices.

Accounts Receivable

Accounts receivable represent money owed by entities to the firm on the sale of products oncredit. In most business entities, accounts receivable is typically executed by generating an

invoice and either mailing or electronically delivering it to the customer, who, in turn, must

pay it within an established timeframe, called credit terms or payment terms. Accounts

receivable departments use the sales ledger.

Accounts receivable management is important to the liquidity of working capital, especially

when a large number of sales are on credit. If there are a significant number of slow-paying

accounts, working capital is impacted in a negative way. A good finance policy for working

capital is either factoring for the slow-paying accounts or getting short-term accounts

receivable loans. Factoring agreements set up with a financial business will enable the receipt

of cash, less a fee, when a sales invoice is issued. This increases the liquidity of the business.

Working Capital funds the cost of the labor & materials that go into the goods you sell or the

services you render (i.e., your Cost of Goods Sold or Cost of Sales) and what you use to pay

for salaries, rent, office supplies, etc (i.e., your operating expenses). In most businesses

(specially where goods are produced), the greater portion of Working Capital goes int

assessment of working capital requirement - dpgd-ja10-0008 (2)

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