Nature, Scope and Definition of Working Capital
Nature, Scope and Definition of Working Capital
Nature, Scope and Definition of Working Capital
Working Capital
In an ordinary sense, working capital denotes the amount of funds needed for meeting day-to-day
operations of a concern.
This is related to short-term assets and short-term sources of financing. Hence it deals with both,
assets and liabilities—in the sense of managing working capital it is the excess of current assets
over current liabilities. In this article we will discuss about the various aspects of working
capital.
The sum total of all current assets of a business concern is termed as gross working capital. So,
Gross working capital = Stock + Debtors + Receivables + Cash.
The difference between current assets and current liabilities of a business concern is termed as
the Net working capital.
Hence,
Working capital plays a vital role in business. This capital remains blocked in raw materials,
work in progress, finished products and with customers.
1. Adequate working capital is needed to maintain a regular supply of raw materials, which in turn
facilitates smoother running of production process.
2. Working capital ensures the regular and timely payment of wages and salaries, thereby
improving the morale and efficiency of employees.
3. Working capital is needed for the efficient use of fixed assets.
4. In order to enhance goodwill a healthy level of working capital is needed. It is necessary to build
a good reputation and to make payments to creditors in time.
5. Working capital helps avoid the possibility of under-capitalization.
6. It is needed to pick up stock of raw materials even during economic depression.
vii. Working capital is needed in order to pay fair rate of dividend and interest in time, which
increases the confidence of the investors in the firm.
1. It helps measure profitability of an enterprise. In its absence, there would be neither production
nor profit.
2. Without adequate working capital an entity cannot meet its short-term liabilities in time.
3. A firm having a healthy working capital position can get loans easily from the market due to its
high reputation or goodwill.
4. Sufficient working capital helps maintain an uninterrupted flow of production by supplying raw
materials and payment of wages.
5. Sound working capital helps maintain optimum level of investment in current assets.
6. It enhances liquidity, solvency, credit worthiness and reputation of enterprise.
vii. It provides necessary funds to meet unforeseen contingencies and thus helps the enterprise
run successfully during periods of crisis.
Gross working capital refers to the amount of funds invested in various components of current
assets. It consists of raw materials, work in progress, debtors, finished goods, etc.
The excess of current assets over current liabilities is known as Net working capital. The
principal objective here is to learn the composition and magnitude of current assets required to
meet current liabilities.
Negative working capital refers to the excess of current liabilities over current assets.
The minimum amount of working capital which even required during the dullest season of the
year is known as Permanent working capital.
It represents the additional current assets required at different times during the operating year to
meet additional inventory, extra cash, etc.
It can be said that Permanent working capital represents minimum amount of the current assets
required throughout the year for normal production whereas Temporary working capital is the
additional capital required at different time of the year to finance the fluctuations in production
due to seasonal change. A firm having constant annual production will also have constant
Permanent working capital and only Variable working capital changes due to change in
production caused by seasonal changes. (See Figure 7.1.)
Similarly, a growth firm is the firm having unutilized capacity, however, production and
operation continues to grow naturally. As its volume of production rises with the passage of time
so also does the quantum of the Permanent working capital. (See Figure 7.2.)
(d) Pre-payments
Current liabilities are those which are generally paid in the ordinary course of business within a
short period of time, i.e. one year.
The other key objective is profitability. Funds tied up in working capital tend to earn little, or no,
return. Hence, a company with a high level of working capital may fail to achieve the return on
capital employed (Operating profit ÷ (Total equity and long-term liabilities)) expected by its
investors.
Therefore, when determining the appropriate level of working capital there is a trade-off between
liquidity and profitability:
The trade-off is perhaps most obvious with regards to the holding of cash. Although cash
obviously provides liquidity it generates little return, even if held in the form of cash equivalents
such as treasury bills. This is particularly true in an era of low interest rates (for example, in
November 2016 the annualised yield on three-month US dollar treasury bills was approximately
0.4%).
Although an optimal level of working capital may exist it may not be achievable due to factors
beyond management’s control, such as an unreliable supply chain influencing inventory levels.
However businesses must at least avoid the extremes:
Overtrading: insufficient working capital to support the level of business activities. This can
also be described as under-capitalisation and is characterised by a high and rising proportion of
short-term finance to long-term finance
Over-capitalisation: an excessive level of working capital, leading to inefficiency.
The cash account, like all asset accounts, is a debit account. This means that debit or left entry in
the cash account would increase the cash account. A credit entry would do the opposite.
Accounting Example
Cash is recorded as a current asset on the balance sheet. Even though cash can be saved for
future periods, it is still considered a current asset because it can because it can be used in one
period. Long-term assets like vehicles cannot be completely used during one accounting period.
Since balance sheets display current and long-term assets in order of liquidity, cash is always the
first item on a balance sheet. Many times companies combine cash and cash equivalents on the
balance sheet. Since cash equivalents are closely related to cash, the true meaning of the cash
account is not distorted on the balance sheet.
If a company overdrafts its checking account, it technically has no cash and actually owes the
bank money. In this case, a negative cash balance is usually not displayed as a current asset.
Instead a cash overdraft is presented as a current liability.
1. Transaction Motive:
The transaction motive refers to the cash required by a firm to meet the day to day needs of its
business operations. In an ordinary course of business, the firm requires cash to make the
payments in the form of salaries, wages, interests, dividends, goods purchased, etc.
Likewise, it also receives cash from its sales, debtors, investments. Often the firm’s cash inflows
and outflows do not match, and hence, the cash is held up to meet its routine commitments.
2. Precautionary Motive:
The precautionary motive refers to the tendency of a firm to hold cash, to meet the contingencies
or unforeseen circumstances arising in the course of business.Since the future is uncertain, a firm
may have to face contingencies such as an increase in the price of raw materials, labor strike,
lockouts, change in the demand, etc. Thus, in order to meet with these uncertainties, the cash is
held by the firms to have an uninterrupted business operations.
3. Speculative Motive:
The firms hold cash for the speculative purposes to avail the benefit of bargain purchases that
may arise in the future. For example, if the firm feels the prices of raw material are likely to fall
in the future, it will hold cash and wait till the prices actually fall.
Thus, a firm holds cash to exploit the possible opportunities that are out of the normal course of
business. These opportunities could be in the form of the low-interest rate charged on the
borrowed funds, expected fall in the raw material prices or favorable change in the government
policies.
Thus, the cash is the most significant and liquid asset that the firm holds. It is significant as it is
used to pay off the firm’s obligations and helps in the expansion of business operations.
Cash planning is a technique to plan and control the use of cash. A projected cash flow statement
may be prepared, based on the present business operations and anticipated future activities. The
cash inflows from various sources may be anticipated and cash outflows will determine the
possible uses of cash.
A cash budget is the most important device for the control of receipts and payments of cash. A
cash budget is an estimate of cash receipts and disbursements during a future period of time. It is
an analysis of flow of cash in a business over a future, short or long period of time. It is a
forecast of expected cash intake and outlay.
The short-term forecasts can be made with the help of cash flow projections. The finance
manager will make estimates of likely receipts in the near future and the expected disbursements
in that period. Though it is not possible to make exact forecasts even then estimates of cash flows
will enable the planners to make arrangement for cash needs.
It may so happen that expected cash receipts may fall short or payments may exceed estimates. A
financial manager should keep in mind the sources from where he will meet short-term needs. He
should also plan for productive use of surplus cash for short periods.
The long-term cash forecasts are also essential for proper cash planning. These estimates may be
for three, four, five or more years. Long-term forecasts indicate company’s future financial needs
for working capital, capital projects, etc.
Both short-term and long-term cash forecasts may be made with the help of following
methods:
In this method the receipts and payments of cash are estimated. The cash receipts may be from
cash sales, collections from debtors, sale of fixed assets, receipts of dividend or other incomes of
all the items; it is difficult to forecast sales. The sales may be on cash as well as credit basis.
Cash sales will bring receipts at the time of sale while credit sales will bring cash later on.
The collections from debtors (credit sales) will depend upon the credit policy of the firm. Any
fluctuation in sales will disturb the receipts of cash. Payments may be made for cash purchases,
to creditors for goods, purchase of fixed assets, for meeting operating expenses such as wage bill,
rent, rates, taxes or other usual expenses, dividend to shareholders etc.
The receipts and disbursements are to be equaled over a short as well as long periods. Any
shortfall in receipts will have to be met from banks or other sources. Similarly, surplus cash may
be invested in risk free marketable securities.
It may be easy to make estimates for payments but cash receipts may not be accurately made.
The payments are to be made by outsiders, so there may be some problem in finding out the
exact receipts at a particular period. Because of uncertainty, the reliability of this method may be
reduced.
This method may also be known as sources and uses approach. It generally has three sections:
sources of cash, uses of cash and adjusted cash balance. The adjusted net income method helps in
projecting the company’s need for cash at some future date and to see whether the company will
be able to generate sufficient cash.
If not, then it will have to decide about borrowing or issuing shares, etc. In preparing its
statement the items like net income, depreciation, dividends, taxes, etc. can easily be determined
from company’s annual operating budget.
The estimation of working capital movement becomes difficult because items like receivables
and inventories are influenced by factors such as fluctuations in raw material costs, changing
demand for company’s products and likely delays in collections. This method helps in keeping a
control on working capital and anticipating financial requirements.
Below are some of the best methods we’ve found to effectively manage your cash flow.
Keep track of it
First and foremost, you have to know the status of your cash flow in order to be able to manage
it. This means keeping a close eye on every area of the business where money is involved, and
regularly checking how much is being spent versus received.
Once you have a good idea of the business’s general cash flow health, you can begin to plan
ways to improve it. If you find any problems, such as a few large expenses that mean more
money is going out than coming in, then look for and apply a fix early on.
It could also include selling assets which are outdated or no longer needed, as this can provide
you with capital to finance more jobs or reinvest in the business.
This in turn will ease cash flow problems and make them far easier to manage, which is a great
help when it comes to running a business.
Such investments can help build up an emergency fund for cash flow problems. This could prove
to be a life saver and a worthy investment further down the line, as it will prevent cash running
out – which would grind your business to a halt.
Speed up payments
One of the most effective cash flow management techniques is speeding up payments. This
means encouraging the customer to part with their money before the end of the invoicing period.
It could include asking for an upfront payment before work has started or is completed, or
offering incentives for early payment, such as a discount.
Getting paid upfront means you’ll have access to more cash for helping with things like business
operations, paying employees, investing in growth and more.
Managing your cash flow doesn’t need to be an overly complicated process, provided you have
the systems in place to effectively control it.
The amount that the company is owed is recorded in its general ledger account entitled Accounts
Receivable. The unpaid balance in this account is reported as part of the current assets listed on
the company’s balance sheet.
When goods are sold on credit, the seller is likely to be an unsecured creditor of its customer.
Therefore, the seller should be cautious when selling goods on credit.
Good accounting requires that an estimate should be made for any amount in Accounts
Receivable that is unlikely to be collected. The estimated amount is reported as a credit balance
in a contra-receivable account such as Allowance for Doubtful Accounts. This credit balance will
cause the amount of accounts receivable reported on the balance sheet to be reduced. Any
adjustment to the Allowance account will also affect Uncollectible Accounts Expense, which is
reported on the income statement.
Here,
Where, FC = Fixed Cost, VC = Variable Cost and DSO = Days sales outstanding.
3. Collection Expenses
This is the cost incurred for operating and managing the collection and credit department of a
firm. This includes the administrative cost of credit department, salary and commission paid to
collection staff, cost paid for telephone and communication and so on.
4. Cash Discount
It is the cost incurred to induce the customer for early payments of their accounts. A firm can
offer cash discount to its customers to reduce the average collection period, bad debt losses, and
the cost of investment in receivables. The discount cost is calculated as cash discount percentage
multiplied by sales to discount customers as given below:
Discount Cost = Annual credit sales X Percentage discount customer X Percentage cash discount
Where as credit and advances made by banks are their financial Assets. But banks’ credit has to
be productive and must contribute to the generation of the borrower’s income and also towards
increasing the rate of growth of the economy as a whole.
Banks mobilize deposits to contribute to gross national product through their different kind of
deposit schemes. About 60% of these funds are deployed as bank credit in various sectors of
economy.
Thus deposit mobilisation and credit dispensation are the two most important functions of
commercial banks. In a way, these banks are the trustees of the savings and idle funds of the
society. How efficiently they are able to discharge this responsibility depends largely upon the
quality of their credit portfolio.
Deposits:
1. Current Deposits,
2. Saving Deposits,
3. Fixed Deposits, and
4. Certificate of deposits.
Borrowed Funds:
Owned Funds:
1. Paid-up Capital.
2. Reserve funds.
3. Balance of Profit and Loss Account.
These functions are co-related with the credit policies of banks which are subject to a great
extend, by the national policies. Keeping in view of the security of depositors (whose funds are
used by banks for lending) certain restriction on lending functions are imposed by the
regulations. Also the lending operations of banks are subject to restrictions imposed by the
Reserve Bank of India from time to time in the interest of monetary stability.
Indian banks operate under several restrictions of credit policy like social lending, DRI lending,
SSI lending, Priority sector lending, agriculture sector lending, Micro and SME lending etc. and
in addition to all the reserve requirements and socio-economic objectives. In fact a sizable
portion of banks resources is virtually taken out of bank’s discretion by pre-emption of funds
reserve requirements and other Government sponsored schemes.
Banks in India cannot give out their entire deposit amount in loans. The regulatory authorities
issue necessary guideline in this regard based on the monitory and financial policy of the
government. The banks in India chalk out their own credit policies in view of the guide lines
issued by the regulatory authorities.
In broad prospective banks deploy their funds into three main uses Cash, Investments, Loan and
advances. But the cash and investments are determined largely by the RBI according the which it
is mandatory for banks to maintain liquidity level to protect the banks and customers by way of
Cash Reserve Ratio and Statutory Liquidity Ratio at present the cash reserve ratio is 6% (with
effect from 24.4.2010) of total time and demand liabilities. This ratio is subject to changes
depending upon the monetary policy.
All the above combined together take out sizable portion of bank resources and for the purpose
of lending bank has to depend what is left out after meeting these constraints.
For each bank efficient management of credit portfolio is of utmost importance as it has
tremendous impact on the banks’ profitability. The ongoing financial reforms have no doubt
provided various opportunities to the banks for growth, but have exposed them to various risk,
which need to be effectively managed.
With financial reforms and liberlisation policies of the government such new venues have come
where credit exposure of banks has increased with the inherent risks. The situation became
aggressive with increase of sick loan accounts. In order to arrest the situations RBI made credit
norms more strict.
In the wake of continued tightening of norms of income recognition, asset classification and
provisioning, increased competition and emergence of new types of risk in the financial sector, it
has become imperative that the credit functions are strengthened by each bank.
Loan Products:
Banks in ordinary course of business extend loan facilities by way of fund based facilities and/or
non-fund based facilities. The fund based facilities are usually allowed by way of term loans,
cash credit, bills discounted/purchased, demand loans, overdrafts etc.
In case of non-fund based facilities by way of issuance of inland and foreign letters of credit,
issuance of bank guarantees, deferred payment guarantees, bills acceptance facilities etc. All
these are usual type of loan facilities provided by banks. There are several other fields for which
banks provide financial assistance.
All overdrafts accounts are treated like current accounts where a cheque book is issued to the
borrowers to withdraw the loan amount as per requirement. Normally overdrafts are allowed
against the Bank’s own deposits, Government securities, approved shares and debentures of
companies, life insurance policies, government supply bills, cash incentives and duty drawbacks,
personal security etc.
2. Demand Loans:
A demand loan account is an advance for a fixed amount and no debits are made subsequent to
the initial advance except for interest, insurance premia other sundry charges. Loan is secured by
way of a promissory note and therefore subsequent drawing are not allowed. In fact it has the
effect of permanently reducing the original advance.
Normally demand loans are allowed against bank’s own deposits, government securities,
approved shares/debentures of companies, life insurance policies, pledge of gold/silver,
mortgage of immoveable property, etc.
3. Term Loans:
Term loans are sanctioned normally for acquisition of fixed assets like land, building,
plant/machinery, office equipments, furniture-fixture etc. for purchase of transport vehicles and
other vehicles, agricultural equipments etc.
Term loans are granted for different periods, short term, medium term and long term and the
duration varies normally 3-7 years but in exceptional cases banks do extend this period from case
to case. Term loans for infrastructure Projects can be allowed even with longer repayment period
which depends on the type of projects’ completion and commencement of the purpose be may
production, service or any other field.
A limit of particular amount depending on the need of the borrower and the securities available is
fixed and the borrower can draw on account within the prescribed limit. Drawing more than
fixed limit makes it an irregular account.
5. Bill Finance:
Advances against Indian bills are sanctioned in the form of limits (the amount fixed) for
purchase of bills or discount of bills or bills sent for collection. Such limits are fixed for genuine
trade transactions only. Bill are either payable on demand or at sight. In case of Usance bills
which are payable on maturity after certain period of time nature of account mostly differs than
that of bills payable on sight.
6. Packing Credit:
Packing credit is an advance given to an exporter who holds a Code Number assigned to him by
the Directorate General of Foreign Trade, for financing the, purchase, processing, packing of
goods against an export letter of credit or a firm export order, or evidence of an export order.
Letter of credit is issued by the bank at the request of its customer in favour of a third party
informing him that the bank undertakes to accept the bills drawn on its customers up to the
amount stated in the letter of credit subject to the fulfillment of the conditions stipulated therein.
This way, when a bank issues LC, it assumes responsibility to pay its beneficiary on production
of bills drawn in accordance with the terms and conditions of the LC.
It is also known as “Documentary Credit” and is most popular method of payment/receipt in the
international as well as domestic trade. Under documentary credit, the buyer’s promise to pay the
seller on presentation of the documents, is Substituted by Banks’ undertaking to pay, on seller
fulfilling the prescribed terms and conditions. Therefore the buyer’s liability to pay is to the
credit issuing bank rather than to the seller.
There are several definitions of documentary credit but following definition appears to be more
accurate.
1. The Buyer:
2. Issuing Bank:
Issuing Bank is the Bank which issues or opens a letter of credit on the request of the buyer (in
practice this bank is also the banker of the buyer).
3. The Seller:
The Seller is the one in whose favour the L/C is opened and to whom the L/C is addressed. He is
also known as Beneficiary of L/C entitled to obtain payment under L/C.
4. Advising Bank:
Advising Bank is the intermediary bank which advises the L/C to the beneficiary. By advising it
undertakes the responsibility of authenticity of the L/C.
5. Confirming Bank:
Confirming Bank is a bank who may be requested by the issuing bank to add its confirmation. If
agreed to, the bank becomes a party to the L/C and undertakes the responsibility to honour the
bills. In practice Advising bank is asked to add confirmation.
6. Negotiating Bank:
Negotiating Bank is bank to whom the seller is supposed to submit the documents for negotiation
and get the payment as per the drawn bill.
7. Reimbursing Bank:
Reimbursing Bank is bank who is authorized by issuing bank to reimburse the paying or
negotiating bank.
(ii) Guarantees:
Guarantee is a contract to perform the promise, or discharge the liability of a third person in case
of his default. In the ordinary course of business, banks often issue guarantees on behalf of their
customers in favour of third parties. When bank issues such a guarantee, it assumes a
responsibility to pay the beneficiary, in the event of a default made by the customer.
Definition:
“Section 126 of Indian Contract Act defines guarantee as contract to perform the promise
or discharge the liability of a third person in case of default, Guarantee is also known as
LG.”
Contract of Indemnity:
As per section 124 of the Indian Contract Act an indemnity is defined as a contract by which one
party promises to save the other from loss caused to him by the conduct of the promiser himself
or by conduct of any other person.
Types of Guarantees:
1. Financial Guarantee:
In Financial guarantees, the guarantor is undertaking to pay damages in monetary terms on the
happening of some default as specified in the Letter of Guarantee.
1. i) LG for payment of determined liabilities towards tax, excise, duties, custom duties, octroi etc.
2. ii) LG issued towards disputed liabilities.
3. Performance Guarantee:
Under such LGs the letter of Guarantees are issued mostly to secure performance, of the
contracts, the need to pay the LG amount will arise only in the event of non-performance of the
contractual obligation.
It is popularly known as (DPG) The necessity to issue DPG arises in case of purchase of Capital
goods like machinery. In such guarantees the banks are undertaking to pay the installments due
under the deferred payment schedule. Unlike all other LGs here the payment will have to be
made by the banks on the accepted due dates and thereafter the installment is recovered from the
party.
Although there is very large list of directions issued by the RBI in this regard and also it is
an ongoing process as these directions are issued frequently but gist if provided below:
1. Reserve Bank of India has prescribed norms for bank lending to non-bank financial companies
and financing of public sector disinvestments.
2. Banks are now free to determine their own lending rates but each bank needs to declare its Prime
Lending Rate popularly known as PLR as approved by its board of directors. Each bank should
also indicate the maximum spread over the PLR for all credit exposures other than retail loans.
Banks are also given freedom to lend at a rate below the PLR in respect of creditworthy
borrowers. However credit rates for certain categories of advances are regulated by the RBI.
(NOTE: The Prime lending rate is the minimum rate at which banks sanction loans. In most
cases or say in majority of cases the bank charges higher than the PLR and in rare of rarest case
interest rate is charged below PLR. The PLR system was recently changed and a new system
know as BPLR (Basic Prime Lending Rate) was introduced. Lately this system has also been
changed with BASE rate with provision not to lend blew Base rate.)
1. The banks are prohibited to grant any loan or make any commitment of granting loans or
advances to or on behalf of any of its Directors, or any firm in which any of its Director is having
any interest as a partner, manager, employee, or guarantor or any company.
The Reserve Bank of India has issued specific directions prescribing exposure limits for banks
and long-term lending institutions in respect of their lending to individual borrowers and to all
companies in a single group.
1. Exposure ceiling for a single borrower is 15% of capital funds effective from March 2002. Group
exposure limit is 40% of capital funds effective from March, 2002. In case of financing for
Infrastructure Projects, the single borrower exposure limit is extendable by another 5% i.e., up to
20% of capital funds and the group exposure limit is extendable by another 10% (i.e. up to 50 %
of capital funds). Capital fund is the total capital as defined under capital adequacy norms (Tier I
and Tier II capital).
2. Non-fund bases exposures are calculated at 100 % and in addition, banks include forward
contracts in foreign exchange and other derivative products, like currency swap and options, at
their positive market value (including potential future exposure) in determining individual or
group borrower exposure ceilings, effective from April 1, 2003.
iii) Facilities extended by way of equipment leasing, hire-purchase finance and factoring
services.
1. iv) Advances against shares, debentures, bonds, and units of mutual funds to stock brokers and
market makers.
2. v) Bank loan for financing promoters’ contributions.
3. vi) Bridge loan against equity flows/issues.
In order to ensure that exposures are evenly distributed the Reserve Bank of India requires banks
to fix internal limits of exposure to specific sectors. These limits are subject to periodical review
by the banks.
In order to achieve the targets of monetary, economic and financial policies the government of
India decides to elevate certain sections for extended bank facilities. Under such policies it
remains the main objective to spread the economic growth even to lowest level of the society. As
such different sectors are selected for such purposes which are given priority over other schemes
of lending by banks.
In view of above the RBI requires commercial banks to lend a certain percentage of their net
bank credit to specific sectors known as Priority Sector. Total priority sector advances should be
40% of net bank credit with agricultural advances required to be 18% of net bank credit and
advances to the weaker sections required to be 10 % of net bank credit and 1% of the previous
year’s net bank credit required to be lent under the Differential Rate of Interest scheme popularly
known as DRI scheme.
While Priority sector has not been defined either by government or by RBI but categories
of PS are set forth as follows:
Direct finance to agriculture shall include short, medium and long term loans given for
agriculture and allied activities (dairy, fishery, piggery, poultry, beekeeping etc.) directly to
individual farmers, Self Help Group (SHGs) or joint liability groups (JLGs) of individual farmers
without limit and to others (such as corporate, partnership firms and institutions) up to the limits
prescribed for taking up agricultural/allied activities. Direct and indirect agriculture finance is
defined in detail by the RBI.
Direct finance to small enterprises shall include all loans given to micro and small
(manufacturing) enterprises engaged in manufacturing/production, processing or preservation of
goods, and micro and small (service) enterprises engaged in providing or rendering of services,
and whose investment in plant and machinery and equipments respectively does not exceed the
amounts of Rs. 5 crores.
3. Retail Trade:
Retail trade shall include traders/private retail traders dealing in essential commodities (fair price
shops) and consumer co-operative stores with credit limits not exceeding Rs. 20 lacs.
4. Micro Credit:
Provision of credit and other financial services and products of very small amounts not
exceeding Rs. 50000/- per borrower, either directly or indirectly through a SHG/JLG mechanism
or to NBFC/MFI for on-lending up to Rs. 50000/- per borrower, will constitute micro credit.
5. Education Loan:
Education loans include loans and advances granted to only individuals for educational purposes
up to Rs. 10 lacs for studies in India and Rs. 20 lacs for studies abroad, and do not include those
granted to institutions.
6. Housing Loan:
(iv) To tiding over the demand fluctuations by maintaining reasonable safety stock;
(vi) To maintain necessary records for protecting against thefts, wastes leakages of inventories
and to decide timely replenishment of stocks.
1. It improves the liquidity position of the firm by reducing unnecessary tying up of capital in
excess inventories.
2. It ensures smooth production operations by maintaining reasonable stocks of materials.
3. It facilitates regular and timely supply to customers through adequate stocks of finished products.
4. It protects the firm against variations in raw materials delivery time.
5. It facilitates production scheduling, avoids shortage of materials and duplicate ordering.
6. It helps to minimise loss by obsolescence, deterioration, damage, etc.
7. It enables the firms to take advantage of price fluctuations through economic lot buying when
prices are low.
(ii) The objectives of better sales through improved service to customer; reduction in inventories
to reduce size of investment and reducing cost of production by smoother production operations
are conflicting with each other.
(iii) The control of inventories is complex because of the many functions it performs. It should
be viewed as shared responsibilities.
This length is called “economic order quantity” and an economic order quantity is one which
permits lowest cost per unit and is most advantages.
Q = √2AS/I
I stand for inventory carrying cost per unit per year in rupees.
2. Inventory Models
Inventory models determine when and how inventory to carry.
(ii) Lowest-cost decision rules for inventory management pertain to either buying products from
outside or producing then within the company.
(iii) Single inventory models assume no delivery delay and that demand is known.
3. ABC Analysis
In order to exercise effective control over materials, A.B.C. (Always Better Control) method is
of immense use. Under this method materials are classified into three categories in accordance
with their respective values. Group ‘A’ constitutes costly items which may be only 10 to 20% of
the total items but account for about 50% of the total value of the stores.
A greater degree of control is exercised to preserve these items. Group ‘B’ consists of items
which constitutes 20 to 30% of the store items and represent about 30% of the total value of
stores.
A reasonable degree of care may be taken in order to control these items. In the last category i.e.
group ‘Q’ about 70 to 80% of the items is covered costing about 20% of the total value. This can
be referred to as residuary category. A routine type of care may be taken in the case of third
category.
This method is also known as ‘stock control according to value method’, ‘selective value
approach’ and ‘proportional parts value approach’.
If this method is applied with care, it ensures considerable reduction in the storage expenses and
it is also greatly helpful in preserving costly items.
5. VED Analysis
Vital essential and desirable analysis is used primarily for the control of spare parts. The spare
parts can be divided into three categories:
(i) Vital
(ii) Essential
(iii) Desirable
(i) Vital: The spares the stock out of which even for a short time will stop production for quite
some time and future the cost of stock out is very high are known as vital spares.
(ii) Essential: The spare stock out of which even for a few hours of days and cost of lost
production is high is called essential.
(iii) Desirable: Spares are those which are needed but their absence for even a week or so will
not lead to stoppage of production.
Need and Objectives of Financing of
Working Capital, Short Term Credit
The primary objective of working capital management is to ensure smooth operating cycle of
the business. Secondary objectives are to optimize the level of working capital and minimize the
cost of such funds.
The superior objective of financial management is wealth maximization and that can be gained
by profit maximization accompanied with sustainable growth and development. For sustainable
growth and development, the objectives of all the stakeholders including customers, suppliers,
employees, etc should be aligned to the growth of the organization.
This implies that the operating cycle i.e. the cycle starting from the acquisition of raw material to
its conversion to cash should be smooth. It is Objectives of Working Capital Management not
easy; it is as good as circulating 5 balls with two hands without dropping a single one. If
following 6 points can be managed, this operating cycle can be management well.
It means raw material should be present on the requirement and it should not be a cause to
stoppages of production.
All other requirements of production should be in place before time.
The finished goods should be sold as early as possible once they are produced and inventoried.
The accounts receivable should be collected on time.
Accounts payable should be paid when due without any delay.
Cash should be available as and when required along with some cushion.
Working capital here refers to the current assets less current liabilities (net working capital). It
should be optimized because higher working capital means higher interest cost and lower
working capital means a risk of disturbance of operating cycle.
The cost of capital utilized on working capital should be minimized so as to achieve higher
profitability. If the investment in working capital involves bank finance, interest rates should be
negotiated with the bank.
Cost can be minimized by utilizing long-term funds but in a proper mix. While deciding the mix
of working capital, the fundamental principle of financial management should be kept in mind
that fixed assets and permanent assets should be financed by long term sources of finance of
approximately same maturity and short-term or temporary assets should be financed by short-
term sources of finance.
OPTIMAL RETURN ON CURRENT ASSET INVESTMENT
The return on the investment made in current assets should be more than the weighted average
cost of capital so as to ensure wealth maximization of the owners. In other words, the rate of
return earned due to investment in current assets should be more than the rate of interest or cost
of capital used for financing the current assets.
What differentiates such a loan from the other conventional ones in the market is the ease of
availing one. However, there are many short terms loan in India offering you the funds you need
to meet any short-term financial need. Here, we try to cover the ins and outs of the 5 most
popular sources of short-term loans, to help you make an informed decision when it comes to
availing short-term finance.
1. Trade Credit
Possibly one of the most affordable sources of obtaining interest-free funds, you can avail a trade
credit where the lender would give you the time to pay for a purchase without incurring any
additional cost. A trade credit is usually extended for a period of 30 days.
However, you can consider asking for a longer tenor that would easily fit into your plan.
A flexible repayment tenor will allow you to leverage the additional time and funds to finance
other initiatives.
2. Bridge Loans
A bridge loan will help to tide you over till the time you get another loan, usually of a bigger
value, approved. In India, such a loan assumes importance in case of transactions relating to
property. For example, if you want to buy a new house but don’t have sufficient funds because
the old one hasn’t been sold off yet. You might want to wait for the funds to come through once
you get a potential buyer for the old property, but this will have its own downsides, including the
price of the new property shooting up.
It is during this waiting time that you can avail a bridge loan, that offers two-pronged benefits- it
helps you with the funds to buy the property while giving you ample time to wait and get a good
deal on the old one.
3. Demand Loans
A demand loan can help you meet any urgent financial obligation. You can pledge your
insurance policies and other savings instruments such as NSCs in lieu of the loan. A certain
percentage of the maturity value on such savings instruments will determine the extent to which
you will be eligible to borrow as the loan amount.
4. Bank overdraft
This is a facility that you can avail on your current account. With an overdraft facility at your
disposal, you will be able to withdraw money despite your account not having sufficient cash to
cover such withdrawals. Essentially, it helps you to borrow money within a sanctioned overdraft
limit.
Much like any other loan, an interest rate (often lower than that on credit cards) is levied on the
outstanding overdraft balance. Having said that be wary of certain additional costs that might be
attached with such a facility, including fees per withdrawal.
5. Personal loans
You can avail a personal loan to meet a variety of needs like home renovation, wedding, higher
education or travel costs. You could also use a personal loan to meet a medical emergency or
consolidate all your existing into one.
Many lenders offer a personal loan on the basis of your income level, employment and credit
history, and perceived capacity to repay. Unlike a home or car loan, a personal loan isn’t a
secured one. This simply means that the lender will not have anything to auction in case you
default on repaying the loan amount. What differentiates a personal loan from all the above loans
is that it gives you a substantial loan amount with flexible tenor to facilitate repayment.
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For example, Mr. Smith is paid $20 per hour. He is paid through the 25th day of the month, and has
worked an additional 32 hours during the 26th through 30th days of the month. This unpaid amount
is $640, which the employer should record as accrued wages as of month-end. This accrual may be
accompanied by an additional entry to accrue for any related payroll taxes.
The accrued wages entry is a debit to the wages expense account, and a credit to the accrued
wages account. The entry should be reversed at the beginning of the following reporting period.
Accounts Payable
The accounts payable process or function is immensely important since it involves nearly all of a
company’s payments outside of payroll. The accounts payable process might be carried out by an
accounts payable department in a large corporation, by a small staff in a medium -sized company, or
by a bookkeeper or perhaps the owner in a small business.
Regardless of the company’s size, the mission of accounts payable is to pay only the company’s
bills and invoices that are legitimate and accurate. This means that before a vendor’s invoice is
entered into the accounting records and scheduled for payment, the invoice must reflect:
To safeguard a company’s cash and other assets, the accounts payable process should
have internal controls. A few reasons for internal controls are to:
prevent paying a fraudulent invoice
prevent paying an inaccurate invoice
prevent paying a vendor invoice twice
be certain that all vendor invoices are accounted for
Periodically companies should seek professional assistance to improve its internal controls.
The accounts payable process must also be efficient and accurate in order for the company’s
financial statements to be accurate and complete. Because of double-entry accounting an omission
of a vendor invoice will actually cause two accounts to report incorrect amounts. For example, if a
repair expense is not recorded in a timely manner:
If the vendor invoice for a repair is recorded twice, there will be two problems as well:
In other words, without the accounts payable process being up-to-date and well run, the company’s
management and other users of the financial statements will be receiving inaccurate feedback on
the company’s performance and financial position.
A poorly run accounts payable process can also mean missing a discount for paying some bills
early. If vendor invoices are not paid when they become due, supplier relationships could be
strained. This may lead to some vendors demanding cash on delivery. If that were to occur it could
have extreme consequences for a cash-strapped company.
Just as delays in paying bills can cause problems, so could paying bills too soon. If vendor invoices
are paid earlier than necessary, there may not be cash available to pay some other bills by their due
dates.
Trade Credit
Trade credit is an important external source of working capital financing. It is a short-term credit
extended by suppliers of goods and services in the normal course of business, to a buyer in order to
enhance sales. Trade credit arises when a supplier of goods or services allows customers to pay for
goods and services at a later date. Cash is not immediately paid and deferral of payment represents
a source of finance.
Like other sources of finance, trade credit is also associated with certain disadvantages,
which are as follows:
1. Trade credit is available only to those companies that have a good track record of repayment in the
past.
2. For a new business, it is very difficult to finance working capital through trade credit.
3. It is very expensive, if payment is not made on the due date.
Bank Loans
Working capital loans are as good as term loan for a short period. These loans may be repaid in
installments or a lump sum at the end. The borrower should take such loans for financing permanent
working capital needs. The cost of interest would not allow using such loans for temporary working
capital.
Overdrafts
Cash credit or bank overdraft is the most useful and appropriate type of working capital financing
extensively used by all small and big businesses. It is a facility offered by commercial banks
whereby the borrower is sanctioned a particular amount which can be utilized for making his
business payments. The borrower has to make sure that he does not cross the sanctioned limit. The
best part is that the interest is charged to the extent the money is used and not on the sanctioned
amount which motivates him to keep depositing the amount as soon as possible to save on interest
cost. Without a doubt, this is a cost-effective working capital financing.
Bill Discounting
Invoice discounting can be technically defined as the selling of bill to invoice discounting company
before the due date of payment at a value which is less than the invoice amount. The difference
between the bill amount and the amount paid is the fee of the invoice discounting to the company.
The fee will depend on the period left before payment date, amount and the perceived risk.
The bills or invoices under bill discounting are legally the ‘bill of exchange’. A bill of exchange is a
negotiable instrument which is negotiable mere by endorsing the name. For example our currency is
an example of bill of exchange. Currency provides value written over it to the bearer of the
instrument. In the case of bill discounting, such bills can be either payable to the bearer or payable
to order. Therefore, after discounting a bill, a bank can further get the bill discounted from other
banks in case of cash flow requirement.
Commercial Papers
Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically for
the financing of accounts receivable, inventories and meeting short-term liabilities. Commercial
paper is usually issued at a discount from face value and reflects prevailing market interest rates.
Commercial paper is an unsecured and discounted promissory note issued to finance the short-term
credit needs of large institutional buyers.
1. The maturity period of commercial paper lies between 15 days to less than 1 year.
2. It is sold at a discount but redeemed at its par value.
3. There is no well-developed secondary market for commercial paper; rather they are placed with
existing investors who intend to hold it till it gets matured.
Commercial Papers have a variety of benefits to both, the issuer as well as the investor.
There are a few important things to note about Commercial Papers, such as their rules, conditions
and requirements.
Certificates Of Deposit
Certificate of Deposit (CD) implies an unsecured, money market negotiable instrument, issued by
the commercial bank or financial institution, either in demat form or as a usance promissory note, at
a discount to face value at market rates, against the amount deposited by an individual, for a
stipulated time.
In finer terms, certificate of deposit is a fixed interest bearing term deposit, which has a fixed
maturity. It limits the access to the funds, until the lock-in period of the investment, i.e. the depositor
cannot withdraw funds, on demand.
Eligibility: All scheduled commercial bank, not including regional rural bank and cooperative bank,
are eligible to issue the certificate of deposit. It can be issued by the bank to individuals, companies,
trust, funds, associations, etc. On the non-repatriable basis, it can be issued to Non-Resident
Indians (NRIs) also.
Maturity period: The CDs are issued by the bank at a discount to face value, at market-related
rates, ranging from 3 months to one year. When a financial institution issues CD, the minimum term
is one year and maximum three years. In addition to this, no grace period is allowed for the
repayment of CD.
Denomination: The minimum issue size of a certificate of deposit is Rs. 5,00,000 to a single
investor. Moreover, when the certificate of deposit exceeds Rs. 5,00,000, it should be in multiples of
Rs. 1,00,000. Add to that; there is no ceiling on the total amount of funds raised through it.
Transferability: Certificate of deposit existing in physical form can be freely transferred by way of
endorsement and delivery. CDs in dematerialised form can be transferred, as per the process of
other dematerialised securities.
Reserve requirement: Banks are required to keep CRR and SLR on the issue price of the
certificate of deposit.
Format: Banks and financial institutions can issue CD in dematerialised form only. Although the
investor, at their discretion, can seek a certificate in traditional form. Moreover, it attracts stamp duty.
Discount: Certificate of Deposit is issued at a discount to face value, determined by the market,
which can be front end or rear end discount. The effective rate of discount is greater than the quoted
rate in case of front end discount. On the contrary, in rear end discount, the CDs yield the quoted
rate on the expiry of the specified term.
Banks issue certificate of deposit when the deposit growth is comparatively slow, and credit demand
is high, and there is a tightening trend in the call rate. These are high-cost liabilities, and banks take
recourse of CD’s only when there exist stiff liquidity conditions in the market.
Factoring
Factoring is an arrangement whereby a business sells all or selected accounts payables to a third
party at a price lower than the realizable value of those accounts. The third party here is known as
the ‘factor’ who provides factoring services to business. The factor would not only provide financing
by purchasing the accounts but also collects the amount from the debtors. Factoring is of two types
– with recourse and without recourse. The credit risk of nonpayment by the debtor is borne by the
business in case of with recourse and it is borne by the factor in the case of without recourse.