Executive Summary

Working capital is a subject which involves detailed knowle

The working capital ratio is a key figure in financial management. It characterizes how much financial funds are required by short term, operating activities. The calculation of working capital functions are as so Inventory + Trade Receivables – Trade Liabilities. The core objective is maintaining the lowest working capital as possible in order to reduce financial responsibility, without endangering the ability to operate the business. Further more the reduced working capital forces efficiency of invested capital, releases cash from balance sheets and improves balance sheet structures.

The working capital goal for each subsidiary which it is obliged to follow. The ratio must be not more than 12.5 % of annual turnover. However, to achieve the goal an active working capital management is required. Therefore an organisation to control should be drawn up and controlling measures to improve the figure must be defined and carried out.

Setting up an organisation for the working capital management is the precondition to control working capital effectively and sustainably. Firstly, it is essential to define who is responsible for the controlling process. The figure must be calculated, planned and improved. Therefore further key ratios must be defined and targets set. In addition, continual target-performance comparisons must be conducted as well as defining measures for improvement. These measures advance the effectiveness of the working capital key processes; the forecast to fulfill process, the order-to-cash process and the purchase-to-pay process.

The concept includes the necessary steps for implementing the organisation for the working capital management and measures for the continuous improvement of the working capital.

INTRODUCTION

Working Capital Management involves managing the balance between firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. The interaction between current assets and current liabilities is, therefore, the main theme of the theory of working capital management.

There are many aspects of working capital management which makes it important function of financial management.

Time: Working capital management requires much of the finance manager’s time.

Investment: Working capital represents a large portion of the total investment in assets.

Credibility: Working capital management has great significance for all firms but it is very critical for small firms. Growth: The need for working capital is directly related to the firm’s growth.

Working capital

Working capital is the capital available for conducting the day-to-day operations of the business and consists of current assets and current liabilities.

Current Assets Current Liabilities

Inventories

Trade Receivables

Cash

Short Term Investment

Trade Payables

Bank Overdrafts

Working capital can be viewed as a whole but interest is usually focussed on the individual components such as inventories or trade receivables. Working capital is effectively the net current assets of a business.

Working capital can either be:

Positive Current assets are greater than Current Liabilities

Negative Current assets are less than Current Liabilities

Working capital management

Working capital management is the administration of current assets and current liabilities. Effective management of working capital ensures that the organisation is maximising the benefits from net current assets by having an optimum level to meet working capital demands.

It is difficult trying to achieve and maintain an optimum level of working capital for the organisation. For example having a large volume of inventories will have two effects, firstly there will never be stock outs, so therefore the customers are always satisfied, but secondly it means that money has been spent on acquiring the inventories, which is not generating any returns (i.e.inventories is a non productive asset), there are also additional costs of holding the inventories (i.e. warehouse space, insurance etc). The important aspect of working capital is to keep the levels of inventories, trade receivables, cash etc at a level which ensures customer goodwill but also keeps costs to the minimum. With trade payables, the longer the period of credit the better as this is a form of free credit, but again the goodwill with the supplier may suffer.

Assessment of working capital

A unit needs finance not only for acquisition of fixed assets but also for its day-to-day operations. A manufacturing concern has to obtain raw material for processing, pay wage bills and other manufacturing expenses, store finished goods for marketing and grant credit to its customers. It may have to pass through the following stages to complete its operating cycle.

1. Conversion of cash into raw materials – raw materials may be procured either on payment of cash or on credit. Even if procured on credit, cash may have to be paid.

2. Conversion of raw materials into stock- in- process and finished goods.3. Conversion of finished goods into receivables / Debtors or cash.4. Conversion of receivables / Debtors into cash.

Working capital cycle (operating/trading/cash cycle)

The working capital cycle measures the time between paying for goods supplied to you and the final receipt of cash to you from their sale. It is desirable to keep the cycle as short as possible as it increases the effectiveness of working capital. The diagram below shows how the cycle works.

The table below shows how the activities of a business have an impact on the cash flow.

TRADE PROCESS EFFECTS ON CASH

Inventories are purchased on credit which creates trade payables.

Inventories bought on credit temporarily help with cash flow as there is no immediate pay for these inventories.

The sale of inventories is made on credit which creates trade receivables.

This means that there is no cash inflow even though inventory had been sold. The cash for the sold inventory will be received later.

Trade payables need to be paid, and the cash is collected from the trade receivables.

The cash has to be collected from the trade receivables and then paid to the trade payables otherwise there is cash flow problem.

The control of working capital is ensuring that the company has enough cash in its bank.This will save on bank interest and charges on overdrafts. The company also needs to ensure that the levels of inventories and trade receivables is not too great, as this means funds are tied up in assets with no returns (known as the opportunity cost).The working capital cycle therefore should be kept to a minimum to ensure efficient and cost effective management.

Differences in working capital for different industries

Manufacturing Retail ServiceInventories High volume of WIP

and Finished goods.Goods for re-sale only and usually low volume.

None or very little inventories.

Trade receivables High level of trade receivables, as they tend be dependent on a few customers.

Very low levels as most goods are bought in cash.

Usually low levels as services are paid for immediately.

Trade payables Low to medium levels of trade payables.

Very high levels of trade payables due to huge purchase of inventory.

Low levels of payables.

Operating Cycle of a Manufacturing Unit

A non-manufacturing trading concern may not require funds for purchase of raw material and their processing , but it also needs finance for storing goods and providing credit to its customers .

Similarly, concern engaged in providing services may not have to keep high 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 operations is called working capital and the assets and liabilities created during the operating cycle are called current assets and current liabilities.

It may observed from the above that working capital finance is essential to carry on day-to-day operations and to maintain the operating cycle of an enterprise.fixed assets cannot generate income unless they are used with the help of working capital. Therefore ,working capital is considered as lifeblood of an enterprise.

1. Assessment of working capital requirement

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 and the duration of it s cycle .it has to be ensure that the unit will have regular supply of raw materials to facilitate uninterrupted production . The unit should also be maintain adequate stock of finished goods for smooth sales operations . the requirement of trade credit facilities to be given by the unit to its customers should also be assessed on the basis of the practice prevailing in the particular industry / trade . While assessing the above requirements ,it should also be ensured that carrying costs for inventories and duration of credit to customers are minimised.

With a view to have proper assessment of working capital requirements , the concept of Maximum Permissible Bank Finance (MPBF) was introduced in November ,1975 as part of

implementation of the recommendations of the Study Group to frame guidelines for follow-up of bank credit (Tandon Study Group). Over the years ,varous improvements had been brought about in the system on the basis of experience gained and suggestion received. Consistent with the policy of liberalisation ,great operational freedom has been provided to banks in dispensation of credit. Reserve bank has decided in April, 1997 to withdraw the prescription in regard to assessment of working capital needs based on the concept of MPBF enunciated by Tandon Study Group . Accordingly, an appropriate system may be evolved by banks for assessing the working capital credit needs of borrowers.

As bank have been given freedom to adopt any method for assessing the working capital requirements, they have several options before them. Banks may provide working capital according to their perception of the borrower and the credit needs. Banks should lay down, to their Boards , Transparent policy and guidelines for credit dispensation , in respect of each broad category of economic activity.

If desired , banks may follow turnover methods for large borrowers also after suitable modifications . At a present , turnover method is used for borrowers requiring credit limits upto Rss.5 crores and its details are given in this Project .since major corporates have adopted cash budgeting as a tool of funds management, banks may consider adopting cash budget system for assessing the working capital finance in respect of large borrowers. Cash budget method is more suitable for seasonal industries like sugar, tea, etc. Reserve bank has no objection to the individual banks retaining the present concept of MPBF with necessary modifications or any other system . A few banks have evolved Projected Balance Sheet (PBS) method by making certain modification in the MPBF method . Under PBS method, the limit of Bank finance is decided keeping in view the Extent of Financial support required by a borrower and the acceptability of the borrower’s overall financial position . under PBS method also , a borrowers total business operations , financial position , profitability estimates and fund flow statements are studied on the lines of MPBP method . However, rigid norms of current ratio or minimum level of liquidity are not insisted under the PBS method . A borrower is provided working capital finance as per the Requirement shown in projected balancesheet under PBS method . The projected bank borrowings are termed as Assessed Bank Finance(ABF).

It may clarified that although banks have been given freedom to adopt any suitable method for assessment of working capital requirements, they should continue to follow the exposure norms relating to single/group borrowers and prudential norms. Further, the Reserve Bank’s instructions relating to directed credit (such as to priority sector, export, etc.), quantitative limits on lending (such as bridge finance in certain cases, rediscounting of bills earlier discounted by non-banking finance companies,etc.,) shall continue to apply.

Although Reserve Bank has given necessary freedom to banks for adopting any suitable method desired by them for assessment of working capitals requirement , most of the banks are still following the Maximum Permissible Bank Finance method and Turnover Method which are discussed below.

2. Maximum Permissible Bank Finance (MPBF) method for assessment of working capital requirement

Following steps should be taken to assess working capital requirement under MPBF method:

a) Estimate the reasonable level of current assets (Inventory, Receivables etc.) Required.

b) Estimate the level of current liabilities other than bank borrowings.c) Work out the working capital gap i.e, total current assets les current

liabilities other than bank borrowings.d) Under first method of lending, banks can finance up to 75 per cent of

working capital gap and balance should come from long term fund i.e, owned funds and term borrowings.

e) Under second method of lending, borrower should provide 25% of total current asset out of long term funds, i.e., owned funds and term borrowings. Banks will provide balance amount after deducting credit available for purchases and other current liabilities.

The above two methods of lending may be illustrated by taking the following example of a borrower’s financial position projected as at the end of next year.

Xxxxxxxxxxxxx

If may be observed from the above that in the First Method, the borrower has to provide a minimum of 25 per cent of working capital gap from long-term funds (owned funds and term borrowings) and it gives a minimum current ratio 1:1. In the Second Method, the borrower has to provide a minimum of 25 per cent of total current assets from long-term funds (owned funds and term borrowings) and it gives a minimum current ratio of 1.33:1. The minimum contribution of long term funds is called minimum stipulated Net Working Capital (NWC) which comes from owned funds and term borrowings.

In the past, the Reserve Bank used to prescribe norms for raw material, goods -in-process, finished goods and debtors for several industries. Theses norms used to be revised from time to time depending on the position of the industry. This practice was discontinued in April, 1997 when the Reserve Bank decided to withdraw the compulsion of MPBF method and given freedom to banks to follow any method desired by them. Now many banks at their ownfollow MPBF method. They can decide the reasonable level of current assets according to their judgement in consultation with the borrower.

While estimating the total requirement of long-term funds for new projects, financial institutions/banks should calculate margin for working capital by applying the Second Method of lending. A project may suffer from shortage of working capital funds if sufficient margin for working capital is not provided as per the Second Method of lending while estimating long-term requirements of funds.

3. Classification of Current Assets and Current Liabilities

In order to calculate maximum permissible bank finance, it is necessary to have proper classification of various items of current assets and current liabilities. An illustrative list of current assets and current liabilities for the purpose of assessment of working capital is furnished below :

I. Current Assetsi. Cash and bank balances

ii. Investments a) Government and other Trustee Securities (other than for long-term purposes, e.g.,

Sinking Fund, Gratuity Fund etc.)b) Fixed deposits with banks

iii. Receivables arising out of sales other than deferred receivables (including bills purchased and discounted by banks)

iv. Instalments of deferred receivables due within one yearv. Raw material and components used in the process of manufacture including those in

transit vi. Stocks-in-process including semi-finished goods

vii. Finished goods including goods-in-transitviii. Other consumable spares

ix. Advance payment of Tax x. Pre-paid expenses

xi. Advances for purchase of raw-material, components and consumable storesxii. Payment to be received from contracted sale of fixed assets during the next 12

months.

II. Current Liabilitiesi. Short-term borrowings (including bills purchased and discounted) from

a) Banks, and b) others ii. Unsecured loans

iii. Public deposits maturing within one yeariv. Sundry creditors (trade) for raw materials and consumable stores and sparesv. Interest and other charges accrued but not due for payment

vi. Advances/progress payments from customers vii. Deposits from dealers, selling agents, etc.

viii. Statutory Liabilitiesa) Provident Fund duesb) Provisions for taxation c) Sales-tax, excise duty, etc. d) Obligations towards workers considered as statutorye) Others (to be specified)

ix. Miscellaneous Current Liabilitiesa) Dividends

b) Liabilities for expensesc) Gratuity payable within one yeard) Other Provisionse) Any other payments due within one year

III. Notes on Classification of Current Assets And Current Liabilities1) Investments in shares, debentures, etc., and advances to other firms/companies, not

connected with the business of the borrowing firm, should be excluded from current assets. Similarly , investments made in units of Unit Trust of India and other mutual funds and in associate companies/subsidiaries, as well as investments made and/or loans extended as intercorporate deposits should not be included in the build-up of current assets while assessing maximum permissible bank finance. However, temporary investments in money market instruments like Money Market Mutual Funds, Commercial Paper, Certificate of Deposits, etc., which are for the purpose of parking short term surplus, should be classified as current assets.

2) The borrowers are not expected to make the required contribution of 25 per cent from long term sources in respect of export receivables. Therefore, export receivables may be included in the total current assets for arriving at the maximum permissible bank finance but the minimum stipulated net working capital (i.e. 25 per cent of working capital gap under the First Method of lending and 25 per cent of total current assets under the Second Method of lending) may be reckoned after excluding the quantum of export receivables from the total assets.

3) Dead inventory i.e., slow-moving or obsolete items should not be classified as current assets.

4) Security deposits/Tender deposits given by borrower should be classified as non-current assets irrespective of whether they mature within the normal operating cycle of one year or not.

5) Advances/Progress payments from customers should be classified as current liabilities. However, where a part of the advances received (as in the case of booking for automobiles/two wheelers) is required by Government regulations to be invested in certain approved securities, the benefit of netting may be allowed to the extent of such investment and the balance may be classified as a current liability.

6) Deposits from dealers, selling agents, etc., received by the borrower may be treated as term liabilities irrespective of their tenure if such deposits are accepted to be repayable only when the dealership/agency is terminated. The deposits which do not fulfil the above condition should be classified as current liabilities.

7) Disputed liabilities in respect of income-tax, excise duty, customs duty and electricity charges need not be treated as current liabilities except to the extent provided for in the books of the borrower. Where such disputed liabilities are treated as contingent liabilities for period beyond one year, the borrower should be advised to make adequate provisions so that he may be in a position to meet the liabilities as and when they accrue.

8) If disputed excise liability has been shown as a contingent liability or by way of notes to the balance sheet, it need not be treated as current liability for calculating the permissible bank finance unless it has been collected or provided for in the accounts of borrowers. A certificate from the statutory auditors of the borrowers may be obtained regarding the amount collected from the customers in respect of disputed excise liability or provisions made in the borrower’s accounts. The amount of excise duty payable should be treated as current liability for the purpose of working out the permissible limit of bank finance strictly on the basis of the certificate from the borrowers’ statutory auditors. The same principle may also be applied for disputed sales tax dues.

9) In case of other statutory dues, dividends, etc., estimated amounts payable within one year should be shown as current liabilities even if specific provisions have not been made for their payment.

10) As per the instructions issued by the Reserve Bank in October, 1993, the entire term loan instalments falling due for payment in the next twelve months need not be treated as an item of current liabilities for the purpose of arriving at MPBF. However, the entire amount of term loan instalments due within next twelve months should continue to be treated as current liability for the purpose of calculating the current ratio.

11) Many times borrowers have to provide margin money to banks for obtaining Letter of Credit/Bank Guarantee. Margin money deposited for LCs and guarantees relating to current operations of the unit should be included in current assets’

12) Automatic plastic injection moulds are used by manufacturers of writing instruments. Banks may, at the time of commencement of operations of a unit, treat these automatic plastic injection moulds as fixed assets to be funded out of project finance made available by a financial institution and /or a bank. Subsequently, during the operating cycle of a unit, if these moulds are required to be replaced, the cost of replacement may be supported by way of working capital credit by treating them as part of current assets.

13) Receivables comprising of bills negotiated under demand/usance LCs and Bank borrowings under LCs will not form part of current assets and current liabilities respectively.

4. 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 and 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 the working capital requirements under its Credit Authorisation Scheme. The Scheme of Credit Authorisation was changed into Credit Monitoring Arrangement in 1988. The forms used under Credit

Authorisation 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 has also been discontinued, the banks are using these forms for calculating working capital requirement under MPBF method. Following six forms are used for submitting information to banks.

I) Particulars of the existing/proposed limits from the banking system (From I)

Particulars of the existing credit from the entire banking system as also the term loan facilities availed of from the term lending institution / banks are furnished in this form. Maximum and minimum utilisation of the limits during the last 12 months and outstanding balance as on a recent date are also given so that a comparison can be made with the limits now requested for and the limits actually utilised during the last 12 months.

II) Operating Statement (From II)

The data relating to gross sales, net sales, cost of raw materials, power and fuel, direct labour, depreciation, selling, general and administrative expenses, interest, etc., are furnished in this form. It also covers information on operating profit and net profit after deducting total expenditure from total sale proceeds.

III) Analysis of Balance Sheet (Form III)

A complete analysis of various items of last year’s balance sheet, current year’s estimates and following year’s projections are given in this form. The details of current liabilities, term liabilities, net worth, current assets, fixed assets, other non-current assets, etc., are given in this form as per the classification accepted by the banks.

IV) Comparative Statement of Current Assets and Current Liabilities (Form IV)

This form gives the details of various items of current assets and current liabilities as per the classification accepted by the banks. The figures given in this form should tally with the figures given in the Form III where details of all the liabilities and assets are given. This form used to indicate all the current assets and current liabilities at one place. In case of inventory (raw materials, consumable spares, stock-in-process and finished goods), receivables and sundry creditors, the holding level are given not only in absolute amounts but also in terms of number of months so that a comparative study may be done with the past trends. They are indicated in terms of number of months in brackets below their amounts.

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

On the basis of the details of the current assets and current liabilities given in Form IV, Maximum Permissible Bank Finance is calculated in this form to find out the credit limits to be allowed to the borrowers.

VI) Funds Flow Statement (Form VI)

In this form, funds flow of long term sources and 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.

5. Check-list for verification of the information/data

Banks 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 official should hold discussions with borrowers on projected sales, level of operations, level of inventory, receivables, etc. It necessary, a visit to the factory may also be made to have a clear idea of the products and processes.

An illustrative check-list is given below to indicate the various points to be examined by banks while financing the credit requirements of the borrowers.

I) Utilisation of Existing Limitsi) It may examined whether the limits have been adequately utilised during

the last 12 months. If not, the justification for further enhancement may be ascertained. It may so happen that the past profits which were employed in working capital might be intended to be withdrawn for investment in fixed assets on account of modernisation, expansion, diversification, etc., thereby creating need for recouping working capital funds. In such cases, additional limit might be sought although the existing limits were not utilised adequately during the last year. The sanction of additional limits in such cases may lead to a slip-back in the current ratio, but slip-back should not be allowed to a level below 1.33.

ii) If the limits have been overdrawn, its reasons may be ascertained. If the financial position of the unit is weak, steps for its improvement may be decided.

II) Operating Statementi) As the entire working capital assessment is directly linked to sales figure,

it may be ensured that the annual projection of sales is reasonable in relation to the installed/licensed capacity, availability of inputs, environmental conditions, marketing prospects, etc.

ii) In the case of existing units, projected sales should be in accordance with the past trend. If the projected sales are not in true with past trend and appear to be over ambitious, the reasons should be ascertained to ensure that the sales projections are realistic.

iii) If the unit is likely to implement a modernisation/expansion/diversification project, its impact on sales may be assessed.

iv) It may be ascertained whether the previous year’s projection of sales, on the basis of which limits were fixed last year, has been realised. If not, the reasons for the short-fall may be examined. If a borrower approaches for additional limits on the basis of the projection of higher sales than that given in the previous year which was not realised the matter should be carefully examined.

v) If there is a declining trend in net sales, reasons thereof may be studied. A detailed study be done if an increase in limits is sought in such cases.

vi) The valuation of sales projections should be based on the current ruling prices.

vii) Similarly, the valuation of various inputs constituting cost of sales in the projections should also be based on current prices. It should be ensured that price escalations are not built into to the projections of sales as well as cost of various inputs.

viii) It may be ascertained whatever the raw material’s consumption as a percentage of cost of production is in keeping with the past trend. If it shows any undue increase, the reasons for it may be examined

ix) It may be ensured that consumable stores and other items used in the process of manufacture are included in raw materials.

x) It may be ascertained whether adequate depreciation has been provided. If the method of providing depreciation is changed, its impact on cost of production may be analysed.

xi) It may be ascertained whether selling, general and administrative expenses are in keeping with the past trend. If they show an increase in terms of the percentage to sales, the reasons thereof may be examined.

xii) It may be examined whether the operating profit/profit before tax is increasing in line with the sales. If not, its reasons may be ascertained and analysed.

xiii) In the case of new units, the estimated production may be assumed at 40 to 80 per cent of the installed capacity in the first year depending on the nature of products, availability of inputs, marketing prospects, etc. The utilisation of the capacity may gradually increase in subsequent years. In the case of new units. Financed by term lending institutions, projections accepted by them regarding sales, requirement of raw materials, cost of production etc., may be taken as the basis for providing working capital. Banks and term lending institution should have joint/simultaneous appraisal of the projects.

III) Analysis of Balance Sheeti) The classification of current assets and current liabilities should be made

as per the usual accepted approach of banks.ii) It may be ascertained whether the level of raw materials, stock-in-process,

finished goods and receivables are in conformity with the stipulated norms, if any, prescribed by the bank. It may be mentioned that the

Reserve Bank has discontinued the practice of prescribe norms. Banks may prescribe their own norms. If no norms are prescribed, the level of inventory and receivables should be in tune with the past trends. If the levels of inventories and receivables are above the norms, if any, or past trends, an analysis may be done to find out the reasons.

iii) The level of the stock of spares may be estimated on the basis of the past experience. The projected stock of spares not exceeding 12 month’ consumption for imported items and 9 months’ consumption for indigenous items may be treated as current assets. Spares held beyond these levels may be treated as non-current assets.

iv) Some of the borrowers may have the tendency to show the requirements of imported raw materials at an inflated level. The higher build-up of imported raw materials should be justified on the basis of economic quantity for placing purchase order, lead time in getting replenishment, etc.

v) If the level of inventories is very high, the details of the age of inventory may be obtained to find out whether some of the items have become obsolete.

vi) If the level of receivables is very high, the names of main buyers and the period of credit offered may be ascertained. It may be examined whether a portion of the receivables is likely to be irrecoverable and if so, sufficient provision should be made for bad debts.

vii) The details of inter-corporate investments and advances should be obtained and the reasons for not liquidating them may be examined.

viii) Some of the borrowers may have a tendency show the sundry creditors and other current liabilities in the projected figures at a reduced level. Although no norms have been fixed for sundry creditors, it is expected that the level of sundry creditors should be in accordance with the past trend and trade practices. Sundry creditors in terms of months purchases may be verified with the past trends. If a sudden decline in the creditors for purchases is observed, reasons for it may be ascertained.

ix) The borrowers should make adequate provision for taxes, dividends, statutory liabilities, etc., and if this has not been done, the extent of liabilities under these heads which have to be met within one year, should be classified as current liabilities.

x) It may be ensured that intangible assets like patents, goodwill, etc., are written off over a period of years.

xi) It may be ascertained whether the net worth shows an increasing trend. If the trend shows a decline in net worth, its reasons may be ascertained

xii) Net working capital should show an increasing trend from year to year. If not, reasons thereof should be ascertained.

xiii) If the date of balance sheet has been changed, the reasons for it should be ascertained to find out whether it has been done only for the purpose of showing a rosy picture.

xiv) Information may be obtained about contingent liabilities to know their impact on the working of the unit.

IV) Computation of Maximum Permissible Bank Financei) Generally, Maximum Permissible Bank Finance (MPBF) should be

calculated on the basis of the Second Method of lending. If the Second Method of lending has not been followed, reasons for it may be ascertained.

ii) If export bills limit is to be allowed over and above the permissible bank finance, the export bills should be excluded from the total sales and export receivables should also be excluded from the build-up of current assets. Separate limits may be given for export receivables even without keeping the 25 per cent margin from long term sources.

iii) The third party outstation cheques/drafts purchase limits should be within the MPBF. However, at the request of the borrowers, such limits may be allowed to a small extent over and above the MPBF.

iv) It may be ascertained whether there is any co-relation between projected increase in production/sales and increase in limits, if not, the reasons for it may be studied.

V) Fund Flow Statementi) The long term sources should be adequate to cover the ling-term uses and

leave a reasonable surplus for being employed as working capital. If long-term sources are less than the long-term uses, it may be inferred that short term funds are being diverted for purpose other than working capital needs. Such cases should be properly examined.

ii) Increase in various items of inventory which is disproportionate to percentage rise in sales should be examined in detail.

iii) The increase in short-term bank borrowings should be in line with the additional limits sought by the company over the previous year’s level of availment.

iv) The increase in short-term bank borrowings should be matched suitably by the increase in current assets, particularly inventory and receivables. If it is not so, short-term funds might be utilised for repayment of other current liabilities or be diverted for fixed assets or for inter-corporate investment/advances. Such matters should be examined in detail.

It may be noted that the above check-list is not an end in itself. It only indicates broad aspects to be examined by banks and helps in analysis and interpretation of the data furnished by the borrowers for taking judicious decisions.

6. Turnover Method for assessment of working capital requirements

With the object of simplifying the procedure for assessment of working capital requirements for small and medium units, the instructions relating to the First and Second Method of lending and the norms for inventories and receivables have been replaced by simplified formula. As per the guidelines issued by Reserve Bank, such units may be provided working capital limits by banks on the basis of a minimum 20 per cent of their projected annual turnover for new as well as existing units. Borrowers would be required to bring in 5 per cent of their annual turn-over as margin money. In other words, 25 per cent of the output value should be computed as working capital requirement of which at least 4/5 th (20 per cent of projected turnover) should be provided by banks and the balance 1/5 th (5 per cent of projected turnover) should be contributed by the borrowers from long term sources towards margin for the working capital. It can be examined by the following illustration :

1. Projected turnover - 300 lakh2. Working capital requirement - 300*25/100=75 lakh

(25per cent of projected turnover)3. Bank finance for working capital - 300*20/100=60 lakh

(20 per cent of projected turn over or4/5th of working capital requirement) - 75*4/5=60lakh

4. Margin money for working capital from long 300*5/100=15 lakhTerm sources (5 per cent of projected turnover 75*1/5=15lakhor 1/5th of working capital requirement)

As the assessment of working capital depends on the projected turnover/output, banks should satisfy themselves about the reasonableness of the projected annual turnover of the Applicants on the basis of the annual statement of accounts or any other documents such as return filed with sales tax/revenue authorities and also ensure that the estimated increase during the year is realistic . It may be further clarified that projected turnover/output means projected ‘gross sales’ which may include excise duty also.

The above guidelines have been framed assuming an average production/processing cycle of three months (i.e., working capital is likely to be turned over four times in a year). However, certain industries may have a production cycle shorter or longer than three months. Therefore, the assessment of working capital requirement may be done both ways i.e., as per projected turnover basis and also traditional method based on a borrower’s overall production cycle. If the credit requirement based on production/processing cycle is higher than the one assessed on projected turnover basis, the higher limit may be sanctioned as the guidelines stipulate to provide credit limits at the minimum of 20 per cent of the projected turnover. In other words, more than 20 per cent of the projected turnover may be sanctioned in such cases. If the higher limit (more than 20 per cent of the projected turnover) is sanctioned, the borrower should also bring in proportionately higher amount in relation to his requirement of bank finance. As per the norms, atleast 1/5th of the total working capital requirement should

be brought in by way of long term sources, by the borrowers and the bank finance may be provided for 4/5 of the total working capital requirement.

If the assessed credit requirement on traditional method based on borrower’s overall production cycle is lower than the one assessed on projected turnover basis, the credit limit can be sanctioned at 20 per cent of the projected turnover. However, actual drawals may be allowed on the basis of drawing power to be determined by banks after excluding unpaid stocks.

In case of traders also, credit limit may be assessed at 20 per cent of the projected turnover. However, many traders may have high turnover or they may avail of credit facility from the market. Therefore, actual drawals should be allowed by on the basis of drawing power to be determined by banks after excluding unpaid stocks.

In case of traders also, credit limit may be assessed at 20 per cent of the projected turnover. However, many traders may have high turnover or they may avail of credit facility from the market. Therefore, actual drawals should be allowed by banks on the basis of drawing power to be determined after ensuring that unpaid stocks are excluded. In the case of commodities covered under selective credit control, directives issued by RBI from time to time should be scrupulously followed.

As per the guidelines issued by RBI in march,1991, banks should adopt the simplified procedure of sanctioning working capital limits on the basis of 20 per cent of the projected annual turnover to all units(new as well as existing) requiring aggregate fund Based working capital limits up to Rs.5 crore from the banking system.

7. Fixation of Fund-based and Non-Fund-based Limits

After arriving at the total amount of working capital requirements, banks may decide about the various fund-based and non-fund based limits and sub-limits. The bulk of the inventory limit is generally released by way of open cash credit based on the projected level of the borrower’s operations. The receivables limit may be either by way of cash credit or overdraft against book debts or by way of bills limit. Within the sanctioned limits, drawing power may be allowed on the basis of statements received under the quarterly/monthly information system depending on the regularity and reliability of the information or on the basis of monthly stock statements ensuring that there is no double financing involved.

Many borrowers do not utilise to a great extent the credit limits sanctioned to them. Such large unutilised credit limits may create several problems in efficient management of funds and also implementing macro-credit policy. With a view to improve discipline in the availment of bank finance by borrowers and to facilitate better funds management, it was decided to levy a commitment fee on the unutilised portion of the working capital limits with effect from January 1, 1991. In the case of borrowers with working capital limits of Rs. 1 crore and above, scheduled commercial banks were required to levy a minimum commitment

charge of 1 per cent per annum. On the unutilised portion of the quarterly operating limit subject to a toleration level of 15 per cent of the Quarterly operating limit.

With effect from july1,1996, the levy of commitment charge has been left to the discretion of the financing bank/consortium/syndicate and will not be mandatory for banks. Therefore, banks may evolve their own guidelines in regard to commitment charge for ensuring credit discipline.

In addition to the fund based limits, non-fund-Based limits like inland letter of credit /Foreign letter of credit , guarantees and acceptances are given keeping in view the genuine needs and the capacity of the borrowers. While considering foreign letter of credit , the requirement of imports , quantum of import license on hand/expected , sources of funds to retire the imports bills when received, availability of funds to pay import duty, etc., should be kept in view. In the case of financial/performance guarantees, it may be ensured that the borrower has the necessary experience, capacity and means to perform the required obligations under the contract without any default and that he will be in a position to reimburse the bank if default occurs due to unforeseen and the bank is required to make the payment under the guarantee.

Banks should not issue guarantees favouring financial institution for the term loans extended by them, as the institution are expected to appraise each proposal and bear the risk themselves. Similarly, banks should not issue guarantee/co-acceptances favouring financial institution (including Power Finance Corporation Ltd.) for the assistance provided by them under Buyers’ Line of Credit Scheme (BLCS). Under the BLCS, financial institutions assume the role of a primary lender by directly providing credit to the buyer to facilitate purchase of machinery, equipment, etc., covered by the transaction. As the primary lender is required to make proper assessment of the proposal and secure a charge by hypothecation of the assets financed, it would not be in order for the financial institution to shift the risk of repayment by obtaining a bank guarantee. It may be clarified that BLCS is different from the Bills Rediscounting Scheme operated by financial institution (including Power Finance Corporation Ltd) for sale of machinery, where the primary credit is provided by the seller’s bank to the seller through bills drawn on the buyer and co-accepted by the buyer’s bank. As the seller’ bank has no access to the security covered by the transaction which remains with the buyer, the buyer’s bank can give co-acceptance in such cases. Similarly, buyer’s bank can give co-acceptance/guarantee for differed payment offered after proper appraisal of the proposal.

8. Fixation of drawing power against working capital limits

Credit limits are fixed at the time of annual/quarterly review on the basis of projected assets and liabilities. However, it is necessary to regulate the borrowings on the basis of actual build-up of current assets rather than the projected ones. Therefore, monthly stock statement indicating the actual levels of inventories is obtained every month and drawing power is calculated after deducting the necessary margin. If the overdraft / cash credit limit has been sanctioned against book debts also, it is necessary to obtain the monthly statement

of book debts to work out the drawing power against them. The drawing power fixed on the actual build-up of the current assets should be within the sanctioned credit limits. It can be said that while statement of stocks and debtor take care of the security available to a bank, quarterly / annual review takes care of the need based requirements and finds out the long term funds available to finance a part of the current assets.

The borrowers should be asked to value the stocks shown in the stock statement in the manner as for the purpose of annual accounts. The value of the closing stocks disclosed in the monthly stock statement on the date of the year end should tally with the stock shown in the balance sheet.

9. Stock inspection/verification of statement of book debts

In orders to verify the information given by the borrower in the stock market statement, sometimes stock inspection may also be done. The periodicity of the inspection depends on the health of the account. Inspection of the stock of an irregular account may be done more frequently than the stock of a satisfactory account. At the time of inspection, efforts should be made to find out the turnover in the stocks with the help of stock register and invoice for purchase and sales. It may indicate the quantum of slow moving or non-moving or non saleable redundant stocks. In such cases, a discussion should be held with the management to find out the corrective measures. It may also be ascertained during the inspection that the valuation methods followed for valuation of stocks shown in stock statement is as per method followed for the preparation of annual balance sheet and quarterly/half-yearly statements.

If the stock inspection reveals a serious shortfall in stocks, a detailed stock verification may be carried out. If necessary, assistance of outside experts may be taken for verification of stocks in such cases. During the course of the factory visit / stock inspection, the banks official should have a discussion with the top management about the working of the unit. Discussion with the management may be very useful to identify the problems, if any, faced by the unit and also to find out the corrective steps to solve them.

If the overdraft/ cash credit limits have been sanctioned against book debts, the statement of book debts should be examine to find the trend of book debts. If book debts are showing sharp increase without corresponding increase of sales, the age of book debts should be studied to find out the position of doubtful debts. Comparative study of ratios of inventories to sales and book debts to sales may indicate the position of slow moving inventories and doubtful debt respectively.

10. Sanction of Ad-Hoc Limits

Banks may sanction ad-hoc limits to the borrowers for their genuine requirements. The quantum and the period of ad-hoc limits may be decided by banks on the basis of their commercial judgement and merit of each case.

Sometimes, exporters may receive certain export orders which were not taken into account earlier while fixing maximum permissible bank finance. Additional credit may be provided to exporters for executing export orders even if sanction of such additional credit exceeds maximum permissible bank finance sanctioned to a unit. It should be ensured that exporters with confirmed letters of credit/firm export orders are not denied bank credit just because of the ceiling of existing sanctioned limits.

Many banks have framed special schemes to provide additional working capital finance against the security of fixed assets/collateral security.

Banks can provide additional facilities keeping in view the security available, working results and financial position of the unit.

11. Conclusion- Freedom of banks from MPBF method

As mentioned earlier, banks have been given freedom to evaluate their own system for assessing the working capital requirement and it is not obligatory for them to follow MPBF method. They can follow MPBF method, turnover method, projected balance sheet methods, cash budget method or any other method approved by the boards for assessment of working capital requirements. Whatever method may be followed by banks , they should keep a watch on current ratio and repaying capacity of borrowers. Check lists given in this project to verify the data given by the borrower will be useful under any method of lending followed by the banks. The information given in the operating statement and balance sheet should be analysed keeping in view the checklists given in this project. Long term resources should be more than fixed assets leaving a surplus to provide margin for working capital.

Liabilities Assets

Equity Fixed Assets

Long term debt

Current Assets

Current liabilities

Equity and long term debts should be more than fixed assets to provide margin to the bank for financing current assets. The items included in equity, long term debt, current liabilities,

fixed assets and current assets are given in the project on Ratio Analysis of this project. if current liabilities are more than current assets, the borrower should be asked to bring in long term resources to improve the current ratio.

As RBI does not stipulate norms for inventory and receivables for various industries, banks have to decide about reasonable level of inventory and receivables to be financed by them. Proper management of inventories and receivables is necessary to have maximum advantage of funds utilised in them. It is essential to keep sufficient level of inventories and receivables to ensure smooth flow of production and sales. At the same time, excess inventories and receivables should be avoided to minimise the cost.

Types of working capital policy

Within a business, funds are required to finance both non-current and current assets.The level of current assets fluctuates, although there tends to be an underlying level required for current assets.

Assets m

100 Temporary fluctuating current assets

80

Per m anent cur r ent as s et s (Core level of inventories, trade receivables etc)

50

0 Time

Non cur r ent a ss ets

A company must decide on a policy on how to finance its long and short-term assets. There are 3 types of policies that exist:

Conservative policy Moderate policy Aggressive policy

All the non current assets, permanent assets and some temporary current assets are

financed by long- term finance.

All the non current assets, permanent assets are

financed by long-term finance. The temporary

fluctuating assets financed by short- term finance.

All the non current assets, permanent assets are

financed by long- term. Remaining permanent assets

all temporary fluctuating assets by short- term.

90m long term debts and equity.

10m short term overdrafts and bank loans.

80m long term debts and equity.

20m short term overdrafts and bank loans.

65 long term debts and equity.

35m short term overdrafts and bank loans.

Summary of the three policies:

Conservative policy Moderate policy Aggressive policyLong Term Finance

Non current assetsPermanent assetsTemporary current assets

Non current assetsPermanent assets

Non current assetsPermanent assets

Short Term Finance

Temporary current assets

Temporary current assets

Permanent assetsTemporary current assets

With an aggressive working capital policy, a company will hold minimal levels of inventories in order to minimise costs. With a conservative working capital policy the company will hold large levels of inventories. The moderate policy is somewhere in between the conservative and aggressive.

EXAMPLE

An entity’s working capital financing policy is to finance working capital using short-term financing to fund all the fluctuating current assets as well as some of the permanent part of the current assets.

Importance of Working Capital Management

For smooth running an enterprise, adequate amount of working capital is very

essential. Efficiency in this area can help, to utilize fixed assets gainfully, to assure

the firm’s long-term success and to achieve the overall goal of maximization of the

shareholders, fund. Shortage or bad management of cash may result in loss of cash

discount and loss of reputation due to non-payment of obligation on due dates.

Insufficient inventories may be the main cause of production held up and it may compel

the enterprises to purchase raw materials at unfavourable rates.

Like-wise facility of credit sale is also very essential for sales promotions. It is

rightly observed that “many a times business failure takes place due to lack of

working capital.” Adequate working capital provides a cushion for bad days, as a

concern can pass its period of depression without much difficulty. O’ Donnel et

al. correctly explained the significance ofadequate working capital and mentioned

that “to avoid interruption in the production schedule and maintain sales, a concern

requires funds to finance inventories and receivables.”

The adequacy of cash and current assets together with their efficient handling

virtually determines the survival or demise of a concern. An enterprise should

maintain adequate working capital for its smooth functioning. Both, excessive

working capital and inadequate working capital will impair the profitability and general

health of a concern.

The danger of excessive working capital are as follows:

Heavy investment in fixed assets -

A concern may invest heavily in its fixed assets which is not justified by actual sales.

This may create situation of over capitalisation.

Reckless purchase of materials -

Inventory is purchased recklessly which results in dormant slow moving and obsolete

inventory. At the same time it may increase the cost due to mishandling, waste,

theft, etc.

Speculative tendencies -

Speculative tendencies may increase and if profit is increased dividend distribution

will also increase. This will hamper the image of a concern in future when speculative loss

may start.

Liberal credit -

Due to liberal credit, size of accounts receivables will also increase. Liberal credit

facility can increase bad debts and wrong practices will start, regarding delay in

payments.

Carelessness –

Excessive working capital will lead to carelessness about costs which will

adversely affect the profitability.

Paucity of working capital is also bad and has the following dangers:

1. Implementation of operating plans becomes difficult and a concern may not achieve

its profit target.

2. It is difficult to pay dividend due to lack of funds.

3. Bargaining capacity is reduced in credit purchases and cash discount could not be

availed.

4. An enterprise looses its reputation when it becomes difficult even to meet day-to-

day commitments.

5. Operating inefficiencies may creep in when a concern cannot meet it financial

promises.

6. Stagnates growth as the funds are not available for new projects.

7. A concern will have to borrow funds at an exorbitant rate of interest in case of need.

8. Sometimes, a concern may be bound to sale its product at a very reduced rates to

collect funds which may harm its image.

Factors Influencing Working Capital Requirement

Numerous factors can influence the size and need of working capital in a concern.

So no set rule or formula can be framed. It is rightly observed that, “There is no

precise way to determine the exact amount of gross or net working capital for every

enterprise. The data and problem of each company should be analysed to

determine the amount of working capital.

Briefly, the optimum level of current assets depends upon following determinants.

Nature of business-

Trading and industrial concerns require more funds for working capital. Concerns

engaged in public utility services need less working capital. For example, if a concern is

engaged in electric supply, it will need less current assets, firstly due to cash nature

of the transactions and secondly due to sale of services. However, it will invest more in

fixed assets.

In addition to it, the investment varies concern to concern, depending upon the

size of business, the nature of the product, and the production technique.

Conditions of supply-

If the supply of inventory is prompt and adequate, less funds will be needed. But,

if the supply is seasonal or unpredictable, more funds will be invested in

inventory. Investment in working capital will fluctuate in case of seasonal nature of

supply of raw materials, spare parts and stores.

Production policy-

In case of seasonal fluctuations in sales, production will fluctuate accordingly

and ultimately requirement of working capital will also fluctuate. However, sales

department may follow a policy of off-season discount, so that sales and production

can be distributed smoothly throughout the year and sharp, variations in working

capital requirement are avoided.

Seasonal Operations-

It is not always possible to shift the burden of production and sale to slack period. For

example, in case of sugar mill more working capital will be needed at the time of crop and

manufacturing.

Credit Availability-

If credit facility is available from banks and suppliers on favourable terms and

conditions, less working capital will be needed. If such facilities are not

available more working capital will be needed to avoid risk.

Credit policy of enterprises-

In some enterprises most of the sale is at cash and even it is received in advance while, in

other sales is at credit and payments are received only after a month or two. In

former case less working capital is needed than the later. The credit terms depend

largely on norms of industry but enterprise some flexibility and discretion. In order to

ensure that unnecessary funds are not tied up in book debts, the enterprise should follow

a rationalized credit policy based on the credit standing of the customers and other

relevant factors.

Growth and expansion-

The need of working capital is increasing with the growth and expansion of an

enterprise. It is difficult to precisely determine the relationship between volume

of sales and the working capital needs. The critical fact, however, is that the need for

increased working capital funds does not follow growth in business activities but

precedes it. It is clear that advance planning is essential for a growing concern.

Price level change-

With the increase in price level more and more working capital will be needed

for the same magnitude of current assets. The effect of rising prices will be different

for different enterprises.

Circulation of working capital-

Less working capital will be needed with the increase in circulation of working

capital and vice-versa. Circulation means time required to complete one cycle i.e.

from cash to material, from material to work-in-progress, form work-in-progress to

finished goods, from finished goods to accounts receivable and from accounts

receivable to cash.

Volume of sale-

This is directly indicated with working capital requirement, with the increase in sales

more working capital is needed for finished goods and debtors, its vice versa is also true.

Liquidity and profitability-

There is a negative relationship between liquidity and profitability. When working

capital in relation to sales is increased it will reduce risk and

Growth and expansion-

The need of working capital is increasing with the growth and expansion of an

enterprise. It is difficult to precisely determine the relationship between volume

of sales and the working capital needs. The critical fact, however, is that the need for

increased working capital funds does not follow growth in business activities but

precedes it. It is clear that advance planning is essential for a growing concern.

Circulation of working capital-

Less working capital will be needed with the increase in circulation of working

capital and vice-versa. Circulation means time required to complete one cycle i.e.

from cash to material, from material to work-in-progress, form work-in-progress to

finished goods, from finished goods to accounts receivable and from accounts

receivable to cash.

Volume of sale-

This is directly indicated with working capital requirement, with the increase in sales

more working capital is needed for finished goods and debtors, its vice versa is also true.

Liquidity and profitability-

There is a negative relationship between liquidity and profitability. When working

capital in relation to sales is increased it will reduce risk and profitability on one side

and will increase liquidity on the other side.

Management ability-

Proper co-ordination in production and distribution of goods may reduce

the requirement of working capital, as minimum funds will be invested in absolute

inventory, non-recoverable debts, etc.

External Environment-

With development of financial institutions, means of communication, transport

facility, etc., needs of working capital is reduced because it can be available as and when

needed.

Determinants of Working Capital

There are no set rules or formulas to determine the working capital requirement

of a firm. A number of factors influence the need and quantum of the working

capital of a firm. These are discussed below:

Nature of industry -

The composition of an asset is related to the size of a business and the industry

to which it belongs. Small companies have smaller proportion of cash, requirements

and inventory than large corporations. Need of working capital is thus determined

by the nature of an enterprise.

Demand of creditors -

Creditors are interested in the security of loans. They want their advances to be

sufficiently covered. They want the amount of security in assets which are greater than

liabilities.

Cash requirements -

Cash is one of the current assets which are essential for the successful

operations of the production cycle. Cash should be adequate and properly

utilized. A minimum level of cash is always needed to keep the operations going.

General nature of business -

The general nature of a business is an important determinant of the level of

the working capital. Working capital requirements depends upon the general nature and

its activity on work. They are relatively low in public utility concerns in which

inventories and receivables are rapidly converted into cash. Manufacturing

organisations, however, face problems of slow turn-over of inventories and

receivables, and invest large amount in working capital.

Time –

The level of working capital depends upon the time required to manufacture goods.

If the time is longer, the amount of working capital required is greater and vice-

versa. Moreover, the amount of working capital depends upon inventory turnover

and the unit cost of goods that are sold. The greater this cost, the larger is the amount of

working capital.

Volume of sales -

This is the most important factor affecting the size and component of working

capital. A firm maintains current assets because they are needed to support the

operational activities which results in sales. The volume of sales and the size of the

working capital are directly related to each other. As the volume of sales

increases, there is an increase in the investment of working capital in the cost of

operations, in inventories and in receivables.

Terms of purchases and sales -

If the credit terms of purchases are more favourable and those of sales less liberal,

less cash will be invested in inventory. With more favourable credit terms, working

capital requirements can be reduced as a firm gets time for payment to creditors or

suppliers.

Inventory turnover -

If the inventory turnover is high, the working capital requirements will be low. With

good and efficient inventory control, a firm is able to reduce its working capital

requirements.

Receivables turnover -

It is necessary to have effective control over receivables. Prompt collection of

receivables and good facilities for setting payables result into low working capital

requirements.

Business cycle -

Business expands during periods of prosperity and decline during a period

of depression. Consequently, more working capital is required during periods of

prosperity and less during the periods of depression.

Variation in sales -

A seasonal business requires the maximum amount of working capital for a

relatively short period of time.

Production cycle -

The time taken to convert raw material into finished products is referred to as the

production cycle or operating cycle. The longer the duration of production cycle, the

greater is the requirement of working capital. Utmost care should be taken to shorten the

period of the production cycle in order to minimize working capital requirements.

Liquidity and profitability -

If a firm desires to take a greater risk for bigger gains or losses, it reduces the size of

its working capital in relation to its sales. If it is interested in improving its

liquidity, it increases the level of its working capital. However, this policy is likely

to result in a reduction of sales volume and, therefore, of profitability. A firm,

therefore, should choose between liquidity and profitability and decide about its

working capital requirements accordingly.

Profit planning and control -

The level of working capital is decided by management in accordance with its policy

of profit planning and control. Adequate profit assists in the generation of cash. It

makes it possible for management to plough back a part of earnings into the

business and substantially build up internal financial resources.

Activities of the firm -

A firm’s stocking of heavy inventory or selling on easy credit term calls for a

higher level of working capital than a firm selling services or making cash sales.

1. RATIO ANALYSIS

Working capital ratios

Ratios are way of comparing financial values and quantities to improve our understanding. In particular they are used to assess the performance of a company. When analysing performance through the use of ratios it is important to use comparisons as a single ratio is meaningless. A ratio is a simple arithmetical expression 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 can be calculated for these purposes turnover.

The use of ratios

To compare results over a period of time To measure performance against other organisations To compare results with a target To compare against industry averages

We shall now look at some of the working ratios in detail and explain how they can be interpreted.

1. Current ratio.

2. Quick ratio

3.  Absolute liquid ratio

4.  Inventory turnover ratio.

5.  Receivables turnover.

6.  Payable turnover ratio.

7.  Working capital

8.  Working capital leverage

9.  Ratio of current liabilities to tangible net worth.

2.    FUND FLOW ANALYSIS

Fund flow analysis is a technical device designated to the study the source from which additional funds were derived and the use to which these sources were put. The fund flow analysis consists of:

 

a.      Preparing schedule of changes of working capital

b.     Statement of sources and application of funds.

It is an effective management tool to study the changes in financial position (working capital) business enterprise between beginning and ending of the financial dates.

 

3.    WORKING CAPITAL BUDGET

A budget is a financial and / or quantitative expression of business plans and polices to be pursued in the future period time. Working capital budget as a part of the total budge ting process of a business is prepared estimating future long term and short term working capital needs and sources to finance them, and then comparing the budgeted figures with actual performance for calculating the variances, if any, so that corrective actions may be taken in future. He objective working capital budget is to ensure availability of funds as and needed, and to ensure effective utilization of these resources. The successful implementation of working capital budget involves the preparing of separate budget for each element of working capital, such as, cash, inventories and receivables etc.  

 

ANALYSIS OF SHORT – TERM FINANCIAL POSITION OR TEST OF LIQUIDITY

The short –term creditors of a company such as suppliers of goods of credit and commercial banks short-term loans are primarily interested to know the ability of a firm to meet its obligations in time. The short term obligations of a firm can be met in time only when it is having sufficient liquid assets. So to with the confidence of investors, creditors, the smooth functioning of the firm and the efficient use of fixed assets the liquid position of the firm must be strong. But a very high degree of liquidity of the firm being tied – up in current assets. Therefore, it is important proper balance in regard to the liquidity of the firm. Two types of ratios can be calculated for measuring short-term financial position or short-term solvency position of the firm.

1.     Liquidity ratios.

2.     Current assets movements ‘ratios.

 

A)   LIQUIDITY RATIOS

Liquidity refers to the ability of a firm to meet its current obligations as and when these become due. The short-term obligations are met by realizing amounts from current, floating or circulating assts. The current assets should either be liquid or near about liquidity. These should be convertible in cash for paying obligations of short-term nature. The sufficiency or insufficiency of current assets should be assessed by comparing them with short-term liabilities. If current assets can pay off the current liabilities then the liquidity position is satisfactory. On the other hand, if the current liabilities cannot be met out of the current assets then the liquidity position is bad. To measure the liquidity of a firm, the following ratios can be calculated:

1.     CURRENT RATIO

2.     QUICK RATIO

3.     ABSOLUTE LIQUID RATIO

4. DEBT EQUITY RATIO

1.   CURRENT RATIO

Current Ratio, also known as working capital ratio is a measure of general liquidity and its most widely used to make the analysis of short-term financial position or liquidity of a firm. It is defined as the relation between current assets and current liabilities. Thus,

CA = Current assets (times)Current liabilities

The two components of this ratio are:

1)     CURRENT ASSETS

2)     CURRENT LIABILITES

Current assets include cash, marketable securities, bill receivables, sundry debtors, inventories and work-in-progresses. Current liabilities include outstanding expenses, bill payable, dividend payable etc.

A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current obligations in time. On the hand a low current ratio represents that the liquidity position of the firm is not good and the firm shall not be able to pay its current liabilities in time. A ratio equal or near to the rule of thumb of 2:1 i.e. current assets double the current liabilities is considered to be satisfactory.

 CALCULATION OF CURRENT RATIO

e.g. ( Rupees in crore)

Year 2011 2012 2013

Current Assets 81.29 83.12 13,6.57

Current Liabilities 27.42 20.58 33.48

Current Ratio 2.96:1 4.03:1 4.08:1

Interpretation:-

As we know that ideal current ratio for any firm is 2:1. If we see the current ratio of the company for last three years it has increased from 2011 to 2013. The current ratio of company is more than the ideal ratio. This depicts that company’s liquidity position is sound. Its current assets are more than its current liabilities.

2. QUICK RATIO AND ACID TEST RATIO

Quick ratio is a more rigorous test of liquidity than current ratio. Quick ratio may be defined as the relationship between quick/liquid assets and current or liquid liabilities. An asset is said to be liquid if it can be converted into cash with a short period without loss of value. It measures the firms’ capacity to pay off current obligations immediately.

Quick ratio = Current assets (times) Current liabilities

Where Quick Assets are:

1)           Marketable Securities

2)           Cash in hand and Cash at bank.

3)           Debtors.

A high ratio is an indication that the firm is liquid and has the ability to meet its current liabilities in time and on the other hand a low quick ratio represents that the firms’ liquidity position is not good.

As a rule of thumb ratio of 1:1 is considered satisfactory. It is generally thought that if quick assets are equal to the current liabilities then the concern may be able to meet its short-term obligations. However, a firm having high quick ratio may not have a satisfactory liquidity position if it has slow paying debtors. On the other hand, a firm having a low liquidity position if it has fast moving inventories.

CALCULATION OF QUICK RATIO

e.g.                                                              (Rupees in Crore)

Year 2011 2012 2013

Quick Assets 44.14 47.43 61.55

Current Liabilities 27.42 20.58 33.48

Quick Ratio 1.6 : 1 2.3 : 1 1.8 : 1

Interpretation :

A quick ratio is an indication that the firm is liquid and has the ability to meet its current liabilities in time. The ideal quick ratio is   1:1. Company’s quick ratio is more than ideal ratio. This shows company has no liquidity problem.

3. ABSOLUTE LIQUID RATIO

Although receivables, debtors and bills receivable are generally more liquid than inventories, yet there may be doubts regarding their realization into cash immediately or in time. So absolute liquid ratio should be calculated together with current ratio and acid test ratio so as to exclude even receivables from the current assets and find out the absolute liquid assets. Absolute Liquid Assets includes :

Absolute Liquid Ratio =      Absolute Liquid Assets

                                                  Current Liabilities

Absolute Liquid Assets = Cash & Bank Balances.

CALCULATION OF ABSOLUTE LIQUID RATIO

Year 2011 2012 2013

Absolute Liquid Assets 4.69 1.79 5.06

Current Liabilities 27.42 20.58 33.48

Absolute Liquid Ratio .17 : 1 .09 : 1 .15 : 1

Interpretation :

These ratio shows that company carries a small amount of cash. But there is nothing to be worried about the lack of cash because company has reserve, borrowing power & long term investment. In India, firms have credit limits sanctioned from banks and can easily draw cash.

4. DEBT EQUITY RATIO

The debt to equity ratio measures how much a company should safely be able to borrow over long periods of time. It does this by comparing the company’s total debt (including short term and long term obligations) and individual it by the amount of owner’s equity. For now, you only need to know that number can be found at the bottom of the balance sheet. Actually calculate debt to equity ratio in segment two when we look at real balance sheet.

Debt Equity Ratio = Debt

Equity

5. RETURN ON CAPITAL EMPLOYED

A return on capital employed, also called earning power is a measure of a business performance which is not affected by interest charges and tax- burden. It abstracts away the effect of capital structure and tax factor and focuses on operating performance. Hence it is eminently suited for inter-firm, so internally consistent.

Return on Capital Employed = Profit Before Tax

Total Assets

6. EARNING PER SHARES

It is states a corporation’s profits on a per share basis.it can be a helpful in further comparison to the market price of the stock. It is index of profitability from shareholder’s point of view. The higher the earning per share, the more attractive will be the investment plan.

Earning Per Shares = Profit After Tax

Numbers Of Equity Shares

B) CURRENT ASSETS MOVEMENT RATIOS

Funds are invested in various assets in business to make sales and earn profits. The efficiency with which assets are managed directly affects the volume of sales. The better the management of assets, large is the amount of sales and profits. Current assets movement ratios measure the efficiency with which a firm manages its resources. These ratios are called turnover ratios because they indicate the speed with which assets are converted or turned over into sales. Depending upon the purpose, a number of turnover ratios can be calculated. These are :

1.  Inventory Turnover Ratio

2.  Debtors Turnover Ratio

3.  Creditors Turnover Ratio

4.  Working Capital Turnover Ratio

The current ratio and quick ratio give misleading results if current assets include high amount of debtors due to slow credit collections and moreover if the assets include high amount of slow moving inventories. As both the ratios ignore the movement of current assets, it is important to calculate the turnover ratio.

1. INVENTORY TURNOVER OR STOCK TURNOVER RATIO :

Every firm has to maintain a certain amount of inventory of finished goods so as to meet the requirements of the business. But the level of inventory should neither be too high nor too low. Because it is harmful to hold more inventory as some amount of capital is blocked in it and some cost is involved in it. It will therefore be advisable to dispose the inventory as soon as possible.

Inventory Turnover Ratio =      Cost of Goods Sold

                                                   Average Inventory

Inventory turnover ratio measures the speed with which the stock is converted into sales. Usually a high inventory ratio indicates an efficient management of inventory because more frequently the stocks are sold; the lesser amount of money is required to finance the inventory. Whereas low inventory turnover ratio indicates the inefficient management of inventory. A low inventory turnover implies over investment in inventories, dull business,

poor quality of goods, stock accumulations and slow moving goods and low profits as compared to total investment.

Average Stock   =   Opening Stock + Closing Stock  

2

   CALCULATION OF INVENTORY TURNOVER RATIO

e.g                                                       (Rupees in Crore)

Year 2011 2012 2013

Cost of Goods sold 110.6 103.2 96.8

Average Stock 73.59 36.42 55.35

Inventory Turnover Ratio 1.5 times 2.8 times 1.75 times

Interpretation :

These ratio shows how rapidly the inventory is turning into receivable through sales. In 2012 the company has high inventory turnover ratio but in 2013 it has reduced to 1.75 times. This shows that the company’s inventory management technique is less efficient as compare to last year.

2.                 INVENTORY CONVERSION PERIOD:

Inventory Conversion Period =   365 (Net Working Days)

                                                 Inventory Turnover Ratio

CALCULATION OF INVENTORY CONVERSION PERIOD

e.g.

Year 2011 2012 2013

Days 365 365 365

Inventory Turnover Ratio 1.5 2.8 1.8

Inventory Conversion Period 243 days 130 days 202 days

Interpretation:

Inventory conversion period shows that how many days inventories takes to convert from raw material to finished goods. In the company inventory conversion period is decreasing. This shows the efficiency of management to convert the inventory into cash.

3.                 DEBTORS TURNOVER RATIO :

A concern may sell its goods on cash as well as on credit to increase its sales and a liberal credit policy may result in tying up substantial funds of a firm in the form of trade debtors. Trade debtors are expected to be converted into cash within a short period and are included in current assets. So liquidity position of a concern also depends upon the quality of trade debtors. Two types of ratio can be calculated to evaluate the quality of debtors.

a)       Debtors Turnover Ratio

b)      Average Collection Period

Debtors Turnover Ratio =  Total Sales (Credit)

                                                    Average Debtors

Debtor’s velocity indicates the number of times the debtors are turned over during a year. Generally higher the value of debtor’s turnover ratio the more efficient is the management of debtors/sales or more liquid are the debtors. Whereas a low debtors turnover ratio indicates poor management of debtors/sales and less liquid debtors. This ratio should be compared with ratios of other firms doing the same business and a trend may be found to make a better interpretation of the ratio.

Average Debtors = Opening Debtor + Closing Debtor

                                                        2

CALCULATION OF DEBTORS TURNOVER RATIO

e.g.

Year 2011 2012 2013

Sales 166.0 151.5 169.5

Average Debtors 17.33 18.19 22.50

Debtor Turnover Ratio 9.6 times 8.3 times 7.5 times

Interpretation :

This ratio indicates the speed with which debtors are being converted or turnover into sales. The higher the values or turnover into sales. The higher the values of debtors turnover, the more efficient is the management of credit. But in the company the debtor turnover ratio is decreasing year to year. This shows that company is not utilizing its debtors efficiency. Now their credit policy become liberal as compare to previous year.

4.                 AVERAGE COLLECTION PERIOD :

Average Collection Period =    No. of Working Days

                                             Debtors Turnover Ratio

The average collection period ratio represents the average number of days for which a firm has to wait before its receivables are converted into cash. It measures the quality of debtors. Generally, shorter the average collection period the better is the quality of debtors as a short collection period implies quick payment by debtors and vice-versa.

Average Collection Period =      365 (Net Working Days)  

                                             Debtors Turnover Ratio

CALCULATION OF AVERAGE COLLECTION PERIOD

Year 2011 2012 2013

Days 365 365 365

Debtor Turnover Ratio 9.6 8.3 7.5

Average Collection Period 38 days 44 days 49 days

Interpretation :

The average collection period measures the quality of debtors and it helps in analyzing the efficiency of collection efforts. It also helps to analysis the credit policy adopted by company. In the firm average collection period increasing year to year. It shows that the firm has Liberal Credit policy. These changes in policy are due to competitor’s credit policy.

5.                 WORKING CAPITAL TURNOVER RATIO :

Working capital turnover ratio indicates the velocity of utilization of net working capital. This ratio indicates the number of times the working capital is turned over in the course of the year. This ratio measures the efficiency with which the working capital is used by the firm. A higher ratio indicates efficient utilization of working capital and a low ratio indicates otherwise. But a very high working capital turnover is not a good situation for any firm.

Working Capital Turnover Ratio =       Cost of Sales

                                                        Net Working Capital

 

Working Capital Turnover       =                             Sales                

                                                        Networking Capital

 

CALCULATION OF WORKING CAPITAL TURNOVER RATIO

e.g.

Year 2011 2012 2013

Sales 166.0 151.5 169.5

Networking Capital 53.87 62.52 103.09

Working Capital Turnover 3.08 2.4 1.64

Interpretation :

This ratio indicates low much net working capital requires for sales. In 2013, the reciprocal of this ratio (1/1.64 = .609) shows that for sales of Rs. 1 the company requires 60 paisa as working capital. Thus this ratio is helpful to forecast the working capital requirement on the basis of sale.

INVENTORIES

(Rs. in Crores)

Year 2010-2011 2011-2012 2012-2013

Inventories 37.15 35.69 75.01

Interpretation :

Inventories is a major part of current assets. If any company wants to manage its working capital efficiency, it has to manage its inventories efficiently. The graph shows that inventory in 2010-2011 is 45%, in 2011-2012 is 43% and in 2012-2013 is 54% of their current assets. The company should try to reduce the inventory upto 10% or 20% of current assets.

CASH BANK BALANCE :

(Rs. in Crores)

Year 2010-2011 2011-2012 2012-2013

Cash Bank Balance 4.69 1.79 5.05

Interpretation :

Cash is basic input or component of working capital. Cash is needed to keep the business running on a continuous basis. So the organization should have sufficient cash to meet various requirements. The above graph is indicate that in 2011 the cash is 4.69 crores but in 2012 it has decrease to 1.79. The result of that it disturb the firms manufacturing operations. In 2013, it is increased upto approx. 5.1% cash balance. So in 2013, the company has no problem for meeting its requirement as compare to 2012.

DEBTORS :

(Rs. in Crores)

Year 2010-2011 2011-2012 2012-2013

Debtors 17.33 19.05 25.94

Interpretation :

Debtors constitute a substantial portion of total current assets. In India it constitute one third of current assets. The above graph is depict that there is increase in debtors. It represents an extension of credit to customers. The reason for increasing credit is competition and company liberal credit policy

CURRENT ASSETS :

(Rs. in Crores)

Year 2010-2011 2011-2012 2012-2013

Current Assets 81.29 83.15 136.57

Interpretation :

This graph shows that there is 64% increase in current assets in 2013. This increase is arise because there is approx. 50% increase in inventories. Increase in current assets shows the liquidity soundness of company.

CURRENT LIABILITY :

(Rs. in Crores)

Year 2010-2011 2011-2012 2012-2013

Current Liability 27.42 20.58 33.48

Interpretation :

Current liabilities shows company short term debts pay to outsiders. In 2013 the current liabilities of the company increased. But still increase in current assets are more than its current liabilities.

 

NET WOKRING CAPITAL :

(Rs. in Crores)

Year 2010-2011 2011-2012 2012-2013

Net Working Capital 53.87 62.53 103.09

Interpretation :

Working capital is required to finance day to day operations of a firm. There should be an optimum level of working capital. It should not be too less or not too excess. In the company there is increase in working capital. The increase in working capital arises because the company has expanded its business.

Kirloskar Pneumatic Company Profit & Loss account ------------------- in Rs. Cr. ------------------- Mar '14 Mar '13 Mar '12 Mar '11 Mar '10

12 mths 12 mths 12 mths 12 mths 12 mths

IncomeSales Turnover 509.93 548.81 711.61 527.47 474.24Excise Duty 0 0 45.46 36.27 21.33Net Sales 509.93 548.81 666.15 491.2 452.91Other Income 16.05 13.59 11.37 8.51 8.93Stock Adjustments -18.95 12.13 -20.27 6.24 -16.82Total Income 507.03 574.53 657.25 505.95 445.02ExpenditureRaw Materials 255.16 307.95 383.5 288.65 248.66Power & Fuel Cost 7.17 8.16 7.48 5.6 4.85Employee Cost 80.88 80.28 72.95 62.34 54.24Other Manufacturing Expenses 0 0 24.39 16.73 13.03Selling and Admin Expenses 0 0 43.35 34.41 29.25Miscellaneous Expenses 88.79 94.56 23.03 15.79 13.97Preoperative Exp Capitalised 0 0 0 0 0Total Expenses 432 490.95 554.7 423.52 364 Mar '14 Mar '13 Mar '12 Mar '11 Mar '10

12 mths 12 mths 12 mths 12 mths 12 mths

Operating Profit 58.98 69.99 91.18 73.92 72.09PBDIT 75.03 83.58 102.55 82.43 81.02Interest 0.35 1.31 3.51 6.04 5.41PBDT 74.68 82.27 99.04 76.39 75.61Depreciation 13.21 11.49 12.06 11.33 7.35Other Written Off 0 0 0 0 0Profit Before Tax 61.47 70.78 86.98 65.06 68.26Extra-ordinary items 0 0 1.48 0.86 0.7PBT (Post Extra-ord Items) 61.47 70.78 88.46 65.92 68.96Tax 22.64 23.68 26.56 21.59 20.66Reported Net Profit 38.83 47.1 61.91 43.5 47.57Total Value Addition 176.84 183 171.19 134.87 115.33Preference Dividend 0 0 0 0 0Equity Dividend 12.84 15.41 15.41 15.41 15.41Corporate Dividend Tax 2.18 2.62 2.5 2.5 2.62Per share data (annualised)Shares in issue (lakhs) 128.44 128.44 128.44 128.44 128.44Earning Per Share (Rs) 30.23 36.67 48.2 33.87 37.04Equity Dividend (%) 100 120 120 120 120Book Value (Rs) 220.03 201.5 178.87 144.61 124.37

FINANCIAL RATIO

Financial Ratio Kirloskar Pneumatic Company ----- in Rs. Cr -------

Mar '14

Mar '13

Mar '12

Mar '11

Investment Valuation RatiosFace Value 10 10 10 10Dividend Per Share -- -- -- --Operating Profit Per Share (Rs) 43.68 54.49 68.63 53.96Net Operating Profit Per Share (Rs) 376.67 427.2

8518.99

382.84

Free Reserves Per Share (Rs) -- -- -- --Bonus in Equity Capital 11.64 11.64 11.64 11.64Profitability RatiosOperating Profit Margin(%) 11.59 12.75 13.22 14.09Profit Before Interest And Tax Margin(%)

8.59 10.41 11.18 11.47

Gross Profit Margin(%) 8.86 10.65 11.41 11.7Cash Profit Margin(%) 9.7 10.29 10.87 11.09Adjusted Cash Margin(%) 9.7 10.29 10.87 11.09Net Profit Margin(%) 7.31 8.66 9.1 8.75Adjusted Net Profit Margin(%) 7.31 8.66 9.1 8.75Return On Capital Employed(%) 19.87 26.3 37.99 33.81Return On Net Worth(%) 12.47 17.94 26.94 23.51Adjusted Return on Net Worth(%) 12.02 17.08 26.94 23.51Return on Assets Excluding Revaluations

227.94 211.21

178.86

145.4

Return on Assets Including Revaluations

227.94 211.21

178.86

145.4

Return on Long Term Funds(%) 19.87 26.3 37.99 33.81Liquidity And Solvency RatiosCurrent Ratio 1.1 1.19 1.16 1.19Quick Ratio 0.87 0.86 0.83 0.87Debt Equity Ratio -- -- 0.03 0.07Long Term Debt Equity Ratio -- -- 0.03 0.07Debt Coverage RatiosInterest Cover 167.07 54.3 75.05 35.52Total Debt to Owners Fund -- -- 0.03 0.07Financial Charges Coverage Ratio 205.01 63.05 85.14 41.72Financial Charges Coverage Ratio Post Tax

143.78 46.8 62.91 30.37

Management Efficiency RatiosInventory Turnover Ratio 11.57 7.58 8.11 5.97Debtors Turnover Ratio 4 4.11 4.78 --Investments Turnover Ratio 11.57 8.22 8.11 5.97

Fixed Assets Turnover Ratio 2.42 3.09 4.25 3.23Total Assets Turnover Ratio 1.73 2.12 2.98 2.63Asset Turnover Ratio 1.72 2.16 3.06 --Average Raw Material Holding -- -- -- --Average Finished Goods Held -- -- -- --Number of Days In Working Capital -3.91 27.41 4.67 19.97Profit & Loss Account RatiosMaterial Cost Composition 52.74 56.11 57.52 58.74Imported Composition of Raw Materials Consumed

12.81 19.31 20.98 19.75

Selling Distribution Cost Composition

-- -- -- --

Expenses as Composition of Total Sales

5.07 3 4.78 2.63

Cash Flow Indicator RatiosDividend Payout Ratio Net Profit 41.14 37.03 28.93 40.79Dividend Payout Ratio Cash Profit 30.21 29.96 24.21 32.18Earning Retention Ratio 57.33 61.11 71.07 59.21Cash Earning Retention Ratio 68.98 68.83 75.79 67.82AdjustedCash Flow Times -- -- 0.08 0.22