BBA IV Sem

Sub: Financial Management - II

Chapter 2
Working Capital Mgt.
SSBES ITM Nanded
Dr. Mohamed Ahmed A.R.

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 Meaning of Working Capital

Working Capital is another part of the capital which is needed

for meeting day to day requirement of the business concern.
For example, payment to creditors, salary paid to workers,
purchase of raw materials etc., normally it consists of recurring in
nature.
It can be easily converted into cash. Hence, it is also known as
short-term capital.
working capital is also called circulating capital or revolving
capital or floating capital or liquid capital.
It is also known as operating capital.

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 Definitions of Working Capital

According to the definition of Mead, Baker and

Malott, “Working Capital means Current Assets”.

According to the definition of J.S.Mill, “The sum of

the current asset is the working capital of a
business”.

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 Nature of Working Capital

1. Working capital is that part of total capital which is

required for the day to day working of an enterprise.
2. Working capital is the amount invested in current assets.
Current assets are short lived.
3. The level of investment in each of the current assets
varies from day to day. Therefore managing current
assets require more attention than managing fixed
assets.
4. The level of working capital in a firm determines its
liquidity position. However, the working capital should
be neither too large nor too less.
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 Nature of Working Capital

5. Generally, the working capital requirements are

financed through short term sources However, a part of
it may be financed through long term sources
6. Working capital management involves cash
management, receivables management payables
management, and inventory management.
7. Current assets are inter-related to each other. That is,
the decision related to one current asset will also affect
other current assets.

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 Components of Working Capital

Current assets: Current assets are those assets which can

be converted into cash in the Normal course of activity
of a firm usually one year.
Examples of current assets include cash, short term
investment, bank balance B/R. stock of raw material,
stock of work-in-progress, stock of finished goods, sundry
debtors, prepaid expenses, advance payment of tax
etc.

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 Components of Working Capital

Current liabilities: Current liabilities are those liabilities

which are payable during short period usually within a
year. Examples of current liabilities include short term
borrowings, sundry creditors, B/P, advance payments
from customers, outstanding expenses, provision for
taxation, dividends payable etc.

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 Components of Working Capital

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 Concepts of Working Capital

Gross Concept:
According to gross concept working capital refers to the
amount of funds invested in current assets. Thus working
capital is equal to total current assets.
The working capital as per gross concept is called gross
working capital. This concept is used by the management to
evaluate the current working capital position and to ensure
the optimum investment in individual current assets.
Gross concept is a quantitative concept.

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 Concepts of Working Capital

Net Concept:
According to net concept, working capital refers to excess of
current assets over current liabilities. To be more clearly,
working capital is equal to total current assets minus total
current liabilities.
Thus working capital refers to net current asset. The working
capital as per net concept is called net working capital. The
net concept is a qualitative concept because it establishes a
relationship between current assets and current liabilities.

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 Dangers of inadequate Working Capital

1. Lack of Solvency
 Inadequate working capital creates problem for making payment of salary,
wages and short-term liabilities of a firm. It weakens the solvency position of the
company.
2. Liquidity Problem
 A firm cannot maintain proper liquidity because of the shortage of working
capital.
3. Opportunity Loss
 A business firm may lose new opportunities due to insufficient amount of working
capital. Business expansion is also impossible.
4. Damage Goodwill
 A firm fails to meet its financial obligations due to inadequate working capital. It
affects or damages the goodwill of the firm.
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 Dangers of inadequate Working Capital

5. Inefficiency
 A firm cannot utilize its fixed assets and other production facilities effectively because
of the shortage of fund. So, production process will be disturbed and leads to
inefficiency.
6. No Discount
 It is impossible to purchase raw materials and other requirements in bulk quantity
because of poor liquidity. So, opportunity of trade discount and cash discount cannot
be availed.
7. No Attraction of Investors
 A firm cannot attract investors and lenders due to poor liquidity and solvency position.
8. Low Rate of Return
 Due to inadequate amount of working capital, a firm cannot function properly. It
leads to low rate of return on investment.

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 Dangers of Excessive Working Capital

1. Excessive working capital means idle funds which gives no

profit. Thus the rate of return falls.
2. The value of shares may fall due to lower rate of return on
investment.
3. Efficiency of management may deteriorate.
4. It may encourage speculation.
5. Liberal dividend policy may be encouraged
6. Inefficiency may be encouraged. There may be increased
waste and loss due to bad debts.

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 The Operating Cycle Concept

According to Hunt, William and Donaldson, "The working

capital is required because of the time gap between the sale
and their actual realisation in cash.
This time gap is technically termed as "Operating Cycle' of the
business".
The operating cycle is the length of time between the
company's outlay on raw materials, wages and other
expenses and inflow of cash from sale of goods.
Operating cycle is an important concept in management of
cash and management of working capital

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 The Operating Cycle Concept

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 Need of Working Capital

1. Purchase of raw materials and spares: The basic part of

manufacturing process is, raw materials. It should purchase
frequently according to the needs of the business concern.
Hence, every business concern maintains certain amount as
Working Capital to purchase raw materials, components,
spares, etc.
2. Payment of wages and salary: The next part of Working
Capital is payment of wages and salaries to labour and
employees. Periodical payment facilities make employees
perfect in their work. So a business concern maintains
adequate the amount of working capital to make the payment
of wages and salaries
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 Need of Working Capital

3. Day-to-day expenses: A business concern has

to meet various expenditures regarding the
operations at daily basis like fuel, power, office
expenses, etc.
4. Provide credit obligations: A business concern
responsible to provide credit facilities to the
customer and meet the short-term obligation. So
the concern must provide adequate Working
Capital.
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Entrance
 FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

1. Nature of business: Working Capital of the business concerns largely

depend upon the nature of the business. If the business concerns follow
rigid credit policy and sell goods only for cash, they can maintain lesser
amount of Working Capital. A transport company maintains lesser
amount of Working Capital while a construction company maintains
larger amount of Working Capital.
2. Production cycle: Amount of Working Capital depends upon the
length of the production cycle. If the production cycle length is small,
they need to maintain lesser amount of Working Capital. If it is not, they
have to maintain large amount of Working Capital.
3. Business cycle: Business fluctuations lead to cyclical and seasonal
changes in the business condition and it will affect the requirements of
the Working Capital. In the booming conditions, the Working Capital
requirement is larger and in the depression condition, requirement of
Working Capital will reduce. Better business results lead to increase the
Working Capital requirements
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 FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

4. Production policy: It is also one of the factors which affects the Working Capital
requirement of the business concern. If the company maintains the continues
production policy, there is a need of regular Working Capital. If the production
policy of the company depends upon the situation or conditions, Working Capital
requirement will depend upon the conditions laid down by the company.
5. Credit policy: Credit policy of sales and purchase also affect the Working
Capital requirements of the business concern. If the company maintains liberal
credit policy to collect the payments from its customers, they have to maintain
more Working Capital. If the company pays the dues on the last date it will
create the cash maintenance in hand and bank.
6. Growth and expansion: During the growth and expansion of the business
concern, Working Capital requirements are higher, because it needs some
additional Working Capital and incurs some extra expenses at the initial stages

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 FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

7. Availability of raw materials: Major part of the Working

Capital requirements are largely depend on the availability of
raw materials. Raw materials are the basic components of the
production process. If the raw material is not readily available, it
leads to production stoppage. So, the concern must maintain
adequate raw material; for that purpose, they have to spend
some amount of Working Capital.
8. Earning capacity: If the business concern consists of high level
of earning capacity, they can generate more Working Capital,
with the help of cash from operation. Earning capacity is also
one of the factors which determines the Working Capital
requirements of the business concern
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 Maximum Permissible Bank Finance (MPBF)

Maximum Working capital a bank can provide as a loan to the business is

called MPBF.
There are various committees who recommended different methods of tit,
two of them are Tandon Committee and Chore Committee
Tandon Committee
RBI appointed study group under the chairmanship of Shri P.L. Tandon in
July, 1974.
Tandon committee made certain recommendations inter alia comprising
of recommendations on norms for inventory and receivables for 15 major
industries, new approach to bank lending, style of lending credit,
information system and follow up, supervision and control and norms of
capital structure.

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 Maximum Permissible Bank Finance (MPBF)

1. Norms for inventory and receivables

 Recommended by Tandon Committee for 15 major industries, cover
about 50 per cent of industrial advances of banks.
These norms were arrived at after examining the trends reflected in the
company finance studies conducted by the Reserve Bank of India and
detailed discussion with representatives and experts of the industries
concerned.
2. Bank lending: The Committee introduced the concept of working
capital gap. This gap arised due to the non-coverage of the current assets
by the current liabilities other than bank borrowings. A certain portion of
this gap will be filled up by the borrower’s own funds and long-term
borrowings.

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 Maximum Permissible Bank Finance (MPBF)

The Committee developed three alternatives for working out

the maximum permissible level of bank borrowings:
1. 75% of the working capital gap will be financed by the bank
i.e.
Total Current assets
Less: Current Liabilities other than Bank Borrowings
= Working Capital Gap.
Less: 25% of Working Capital gap from long-term sources.

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 Maximum Permissible Bank Finance (MPBF)

2. Alternatively, the borrower has to provide for a minimum of

25% of the total current assets out of long-term funds and the
bank will provide the balance.
The total current liabilities inclusive of bank borrowings will not
exceed 75% of the current assets:
Total Current Assets
Less: 25% of current assets from long-term sources.
Less: Current liabilities other than Bank borrowings
= Maximum Bank Borrowing permissible.

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 Maximum Permissible Bank Finance (MPBF)

3. The third alternative is also the same as the second one

noted above except that it excludes the permanent portion of
current assets from the total current assets to be financed out of
the long-term funds, viz.
Total Current assets
Less: Permanent portion of current assets Real Current Assets
Less: 25% of Real Current Assets
Less: Current liabilities other than Bank Borrowings
= Maximum Bank Borrowing permissible.

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 Maximum Permissible Bank Finance (MPBF)

Thus, by following the above measures, the excessive

borrowings from banks will be gradually eliminated and the
funds could be put to more productive purposes.
The above methods may be reduced to equation as under:
1st Method : PBC = 75/100 x WCG
2nd Method : PBC = TCA – [(25/100 x TCA) + OCL]
3rd Method : PBC = TCA – [CRA + 25/100 (TCA – CRA) + OCL]

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 Maximum Permissible Bank Finance (MPBF)

Where,
PBC stands for Permissible Bank Credit
WCG stands for Working Capital Gap
TCA stands for Total Current Assets
OCL stands for Other Current Liabilities
(i.e. Current Liabilities other than Bank Borrowings)
CRA stands for Amount required to finance Core Assets.

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 Maximum Permissible Bank Finance (MPBF)

3. Style of credit:
A change in the style of lending has also been suggested by the
Committee so as to bifurcate the cash credit into a loan account
and demand cash credit instead of treating the entire credit limit
as cash credit for a year.
This will make the credit less expensive to borrowers. The demand
cash credit will meet the seasonal requirements of industry and will
be wiped out automatically at the end of the business cycle.
This will introduce a better financial discipline in the credit system
and will generate better financing system in the banking economy
with numerous advantages

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 Maximum Permissible Bank Finance (MPBF)

4. Information system: To monitor better credit information system in the

banking industry, the committee suggested for the borrower to submit
quarterly statements in the prescribed format about its operations, current
assets and current liabilities and funds flow statements with monthly stock
statements and projected balance sheets and profit and loss account at
the end of financial year.
5. Follow up: The Committee also suggested a close follow up for
supervision and control of the use of credit by the banks and change in
attitude of the banks from security-oriented lending to production oriented
lendings/ credit.
6. Norms of Capital Structure: For examining the capital structure of the
company the norms have also been suggested by the committee for
monitoring a better equity : debt relationship
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 Maximum Permissible Bank Finance (MPBF)

Chore Committee
Reserve Bank of India accepted the above
recommendations of the Tandon Committee but found that
the gap between sanctioned cash credit limit and its
utilisation has remained unanswered.
In this context, RBI appointed in April 1979 a working group
under the Chairmanship of Mr. K.B. Chore to look into this gap
between the sanctioned limits and their utilisation.

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 Maximum Permissible Bank Finance (MPBF)

The Chore Committee has, inter alia, recommended as follows:

(1) emphasised need for reducing the dependance of large
and medium scale units on bank finance for working capital;
(2) to supplant the cash credit system by loans and bills
wherever possible; and
(3) to follow simplified information system but with penalties
when such information is not forthcoming within the specified
limit

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 Maximum Permissible Bank Finance (MPBF)

Chore Committee also suggested that the banks should adopt

henceforth Method II of the lending recommended by the Tandon
Committee so as to enhance the borrowers’ contribution towards
working capital.
The observance of these guidelines will ensure a minimum current ratio
of 1.33 : 1. Where the borrowers are not in a position to comply with this,
excess borrowings on account of adoption of Method II should be
segregated and converted into a working capital term loan (WCTL).
This loan should be made repayable in half-yearly instalments over a
period not exceeding five years. WCTL may carry a rate of interest
higher than the rate applicable on the relative cash credit limit, not
exceeding the ceiling with a view to encouraging an early liquidation of
WCTL.
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 Maximum Permissible Bank Finance (MPBF)

It was also suggested that banks should fix separate limits where feasible
for peak level and non-peak level requirements with periods where there
is a pronounced seasonal trend.
This will not apply to agro-based industries but also to certain consumer
industries like fans, refrigerators, etc.
The borrower should be discouraged from approaching banks
frequently for ad hoc limits in excess of the sanctioned limits excepting
those special circumstances when such requests be considered for short
duration with 1 per cent additional interest over normal rate which could
be waived in general cases on merits.

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 Maximum Permissible Bank Finance (MPBF)

Sick units may be allowed general exemptions from the above

requirements.
The Committee also favoured encouragement be given to bill
finance i.e. bill acceptance and bill discounting practices involving
banks, buyers and sellers.
The Committee suggested some modifications and improvements
in the system earlier recommended by the Tandon Committee.
The modified system includes that banks should submit half-yearly
statements to RBI above credit limits of borrowers with aggregate
working capital of Rs. 50 lakhs and above from the banking system.

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