working capital management

WORKING CAPITAL MANAGEMENT

CHAPTER – 1

INTRODUCTION OF WORKING CAPITAL

Working capital is the employment of current assets and current liabilities in

such a way as to increase short-term liquidity. Working capital management is a

significant fact of financial management due to the fact that it plays a crucial role in

keeping the wheels of business enterprise running. Working capital management is

concerned with the short-term financial decisions, which have been comparatively

neglected in the literature of finance. Shortage of funds for working capital has

caused many businesses to fail. Lack of efficient and effective utilization of working

capital leads to low rate of returns on capital employed or even compels to sustain

loses. The need for skilled working capital has become greater in recent years.

A firm usually invests a part of its permanent capital in fixed assets and keeps

a part of it for working capital, for example meeting day-to-day requirements. The

requirement of working capital varies from firm to firm, depending on the nature of

business, production policy, market conditions, seasonality of operation, condition of

supply etc. Working capital to a company is like a blood of human body. It is the

most vital ingredient of business. Working capital if carried out effectively and

efficiently and consistently, will assure the health of an organization.

Every organization has to arrange for adequate funds for meeting day-to-day

expenditure, apart from investment from fixed assets. Working capital is the flow of

ready funds necessary for the working of the enterprise. It consists of funds invested

in current asset of that asset, which in the ordinary course of business, can be turned

into cash within a brief period without undergoing reduction in value and without

disruption of organization. Current liabilities are those indented to be paid in ordinary

course of business within a short period of time. Working capital serves the fallowing

purposes: -

1. To meet the cost of inventories, raw materials purchases, work in progress,

finished goods etc.

2. To pay wages and salaries.

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3. To meet overhead cost, factory cost, office and administration cost, taxes,

selling distribution expense, packing, advertisements etc.

FIG 1.1 CIRCULATION OF CURRENT ASSET

CHAPTER – 2

DEFINITION OF WORKING CAPITAL

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INVENTORIES

CASH

RECEIVABLES


In case of gross working capital, it is the concept that focus attention of two

aspects of current asset management:

1. Optimum investment in current asset.

2. Financing of current assets.

Following definitions of working capital place emphasis on gross working

capital.

1. According to Mead, Mallot & Field. “Working capital means current assets”.

2. According to Bonneville. “Working capital is any acquisition of funds which

increase the current asset, increases working capital, for they are one and the

same.”

3. According to J.S Mills. “The sum of current asset is the working capital of

the firm”.

Now let us look at the definitions of net working capital. It reflects the modern

concept of working capital, which is also most commonly used. According to the new

concept of working capital it refers to the difference between current asset and

current liability. It is the excess of current asset over current liability. Current liabilities

refer to the claims of outsiders, which are expected to mature for payment within an

accounting year. It includes creditors for goods, bills payable, bank overdraft etc. The

concept may be better understood in the fallowing equation: -

WORKING CAPITAL = CURRENT ASSET – CURRENT LIABILITY.

The net working capital (a) indicate the liquidity position of the firm and (b)

suggest the extend to which working capital needs to be financed by permanent

sources of fund. Both the net and gross concept of working capital is the two facets

of working capital management.

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Net working capital may be of the fallowing type:

Positive and quantitive net working capital: - It arises when current asset

exceeds current liability.

Negative or quantities net working capital: - It occurs when current

liabilities are in excess of current asset.

CHAPTER – 3

CLASSIFICATION OF WORKING CAPITAL

Working capital may be classified on the fallowing basis:

1. On the basis of concept:

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I. Gross working capital (represented by the total current asset).

II. Net working capital (excess of current asset over current liabilities).

2. On the basis of periodicity of requirements:

I. Fixed or permanent working capital: It represents that part of capital

permanently locked up in the current asset to carry out the business smoothly.

This investment in current asset increase as the size of business expands.

Examples of such investment are those required to maintain the minimum stock

of raw material, work in progress, finished products, loose tools and

equipments. This arrangement requires minimum cash balance to be kept in

reserve for payment of wages salaries and all other current expenditure

throughout the year. The permanent fixed working capital may again be

subdivided into fallowing:

(A) Regular working capital: It is the minimum amount of liquid capital

required to keep up the circulation of the capital from cash to inventories; to

receivables and again to cash. This includes sufficient minimum cash balance

to discount all bills and to maintain adequate supply of raw material etc.

(B) Reserve margin or cushion working capital: It is the excess capital over

the needs of regular working capital, that should be kept in reserve for

contingencies, that may arise at any time. These contingencies include rising

price, strikes, business decompressions, special operation such as

experiment with new product etc.

II. Variable working capital: Variable working capital changes with the increase or

decrease in the volume of business. It may be subdivided into fallowing: -

{A} Seasonal variable working capital: The working capital required to meet

the seasonal liquidity of business is seasonal variable working capital.

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{B} Special variable working capital: It is that part of variable working capital,

which is required for financing special operation such as extensive marketing

campaigns, experiment with product or methods of production, carrying of

special jobs etc.

CHAPTER – 4

ADEQUACY OF WORKING CAPITAL

Working capital or investment in current asset is a must for meeting the day-

to-day expenditure on salaries, wages rent, advertising etc and for maintaining the

fixed asset. Large-scale capital in fixed asset is often determined by relatively small

amount of current asset. The heart of industry, working capital, if weak the business

cannot prosper and survive, although there may be a large investment of fixed

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assets. Inadequate as well as superfluous working capital is dangerous for the health

of the industry.”Inedequate working capital is disastrous, whereas superfluous

working capital is a criminal waste”. Both situations are unwarranted in a sound

business organization. Adequacy of working capital is the lifeblood and controlling

nerve center of a business.

Some of the uses of adequate working capital are:

1) CASH DISCOUNT: By adequate working capital the business can avail the

advantage of cash discount by paying cash for the purpose of raw material

and merchandise. If proper cash balance is maintained, this will reduce the

cost of production.

2) SENSE OF SECURITY AND CONFIDENCE: Adequate working capital create

a sense of security, confidence and loyalty throughout the business and also

among its consumers, creditors and business associates .The proprietor,

official or manager of a concern are carefree, if they have proper capital

arrangements because they need not worry for the payment of business

expenditure or creditors.

3) SOLVENCY AND CONTINUOUS PRODUCTION: In order to maintain the

solvency of business, it is essential that sufficient amount of funds are

available to make all the payments in time as and when they are due. In the

absence of working capital, production will suffer in the era of cutthroat

competition and business can never flourish in the absence of adequate

working capital.

4) SOUND GOODWILL AND INCREASED DEBT CAPACITY: Promptness of

payment in business creates goodwill and increases the debt capacity of the

firm. If the investors and borrowers are confident that they will get their due

interest and payment of principle in time, a firm can raise funds from market,

purchase goods on credit and borrow short term loans from bank etc.

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5) EASY LOANS FROM THE BANK: An adequate working capital helps the

company to borrow unsecured loans from the bank, because the excess

provides a good security to the unsecured loans. If the business has a good

credit standing and trade reputation, bank favors in granting seasonal loans.

6) DISTRIBUTION OF DIVIDEND: Short of working capital, a company cannot

distribute dividend to its shareholders in spite of sufficient profits. To make up

for the deficiency of working capital, profits are to be retained in business. On

the other hand ample dividend can be declared and distributed to the market

value of share and increase by sufficient working capital.

7) EXPLOITATION OF GOOD OPPORTUNITIES: Good opportunity can be

exploited through adequacy of capital in a concern. For example – A company

may make off seasons purchase, resulting in substantial saving or it can fetch

big supply orders resulting in good profits.

8) MEETING UNSEEN CONTINGENCY: As stock piling of finished goods

becomes necessary, depression shoots up the working demand of capital. If a

company maintain adequate working capital, unseen contingencies such as

financial crisis due to heavy loses, business oscillation etc can easily be

overcome.

9) INCREASE IN EFFICIENCY OF FIXED ASSETS: Proper maintainces and

adequate working capital increase the efficiency of fixed asset of business. It

has been rightly said,” the fate of large scale investment in fixed capital is

often determined by a relatively small amount of current asset.”

10)HIGH MORALE: The provision of adequate working capital improves the

morale of the executive as they get an environment of security, certainty and

confidence, which is a great psychological factor in improving the overall

efficiency of business and of the person who is at the helm of affair in the

company.

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11)INCREASE PRODUCTION EFFICIENCY: A continuous supply of raw

material, research programs, innovation and technical development and

expansion programs are successfully carried out if adequate capital is

maintained in the business. It increases production capacity, which increase

the efficiency and morale of the employees.

CHAPTER – 5

EVILS OF INADEQUATE WORKING CAPITAL

Some of the evils of not having adequate working capital in a business firm or

a company are as fallows:

1) LOSS OF CREDIT WORTHINESS AND GOODWILL: A firm losses its credit

worthiness and goodwill if it fails to honors its current liability. It finds it difficult

to procure the required funds for its business operation on easy terms. This

leads to reduced profitability and production interruption.

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2) NO BENEFIT FROM FAVORABLE OPPORTUNITY: With inadequate working

capital a firm fails to undertake profitable projects. It prevents the firm from

availing the benefit of available opportunity and stagnate its growth.

3) FAILURE TO AVAIL CREDIT OPPORTUNITY: Due to inadequate working

capital a firm fail to avail attractive credit opportunities.

4) OPERATING INEFFICIENCIES: Inadequate working capital leads to

operating inefficiencies, as day-to-day commitment cannot be met.

5) LOW RATE OF RETURN ON FIXED ASSET: Inadequate working capital

leads to a lowering down of rate of returns of fixed asset, as it cannot be

efficiently utilized or maintained due to inadequacy of working capital.

6) INCREASE IN BUSINESS RISKS: Inadequate working capital increases the

business risk of the firm. Unable to discharge its current liability it is liable to

be declared as insolvent. Thus inadequate working capital posses a serious

threat to the working and survival of the firm.

7) CANNOT ACHIEVE PROFIT TARGET: Due to inadequate working capital the

firm cannot achieve its profit target, as it cannot put into operation, its

operating plans due to shortage of working capital.

8) LOW MORALE OF BUSINESS EXECUTIVES: Inadequate working capital

adversely lowers the morale of the firm’s executive, as they do not have an

environment of certainty safety and confidence, which is necessary

psychological factor in improving the overall efficiency of a business firm.

9) WEAKENING OF FINANCIAL CAPACITY: Inadequate working capital

weakens the shock absorbing capacity of the firm, as it cannot meet the

contingencies arising from business fluctuation, financial loses etc.

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CHAPTER – 6

EVILS OF EXCESSIVE WORKING CAPITAL

Now let us look at some of the evils of having excessive or redundant working

capital:

1. IDLE FUNDS: Excessive and redundant working capital implies the presence

of idle funds, which earn no profits for the firm. A firm with excessive working

capital cannot earn proper rate of return on its total investments, as profits are

distributed on the whole of its capital. This brings down the rate of return to

the shareholders. Lower dividend reduce the market value of shares and

causes capital losses to the shareholders.

2. DECLINE IN OPERATING EFFICIENCY: Companies often adopt some

objectionable devices to inflate profits to maintain or increase the rate of

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dividend. Sometimes unearned dividends are paid out of company’s capital to

keep the show of prosperity by window dressing of accounts. In order to make

up the deficiency of reduced earnings, certain provision, such as the provision

for depreciation, repairs and renewals are not made. This leads to decline in

operating efficiency and fall in profits.

3. LOSS OF CONFIDENCE AND GOODWILL: Excessive working capital leads

to lower rate of returns on company’s total investments. Lower dividend leads

to reduction of market value of companies share much less than the book

value. The shareholders losses confidence in the company and the goodwill

or the credit of the company suffers a serious setback. Thus the financial

stability of the company is jeopoderzied.

4. MISAPPLICATION OF FUNDS: Companies with excessive working capital do

not utilize the resources prudently. The company purchases excessive

inventories and fixed assets, which do not add to the profitability and increase

its maintaince cost and losses due to theft, waste and mishandling.

5. EVILS OF OVERCAPITALIZATION: Excessive working capital leads to over

capitalization, which is disastrous to the smooth working and survival of the

company and effect the interest of those associated with the company.

6. INEFFICIENT MANAGEMENT: Excessive working capital indicates that the

management is not interested in expanding the business; otherwise the

excessive capital might have been utilized for this purpose.

7. DESTRUCTION IN TURNOVER RATIO: Superfluous working capital destroys

the control of turnover ratio, which is commonly used in conduct of an efficient

business. It eradicates all other guide and signpost commonly used and

employed in conducting and operating a business.

Thus a company must have working capital adequate to its requirements. It

must neither be excessive or inadequate. While inadequate working capital

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adversely affects the business operation and profitability, excessive working capital

keep it idle and earn no profits.

CHAPTER – 7


Working capital is the money used to make goods and attract sales. The less

working capital is used to attract sale, the higher is it likely to be the return of

investment. Working capital management is about the commercial and financial

aspect of inventory, credit, marketing, royalty and investment policy. The higher the

profit margin, lower is it likely to be the level of working capital tied up in creating and

selling titles. The faster that we create and sell the books the higher is it likely to be

the return on investment.

Now let us look at some of the definitions of working capital management:

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PROF K V SMITH: “Working capital management is concerned with problems

that arise in attempting to manage the current asset, the current liability and

the interrelation that exist between them”.

WESTON AND BRIGHAM: “Working capital management refer to all aspect

of administration of both current asset and current liability”.

JAMES C VAN HORNE: “Current asset, by definition are asset normally

converted into cash within one year. Working capital management is

concerned with the administration of these asset-namely cash and marketable

securities”.

Now let us look at some of the main and important objective of working capital

management:

1. To decide upon the optimum level of investment in various current asset I.e.

determining the size of working capital.

2. By optimizing the investment in current asset and by reducing the level of

current liability, the company can reduce the locking up of funds in working

capital and thereby it can improve the return on capital employed in the

business.

3. To decide upon the optimum mix of short-term funds in relation to long-term

capital.

4. The company should always be in a position to meet its current obligation,

which should be properly supported by current assets available with the firm.

Maintaining excess fund in working capital means locking of funds without any

returns.

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5. To locate appropriate source of short term financing.

6. Maintaining working capital at appropriate levels.

7. Availability of sufficient funds at time of need.

8. The Firm should manage its current asset in such a way that marginal returns

on investment in current asset is not less than the cost of capital employed to

finance the current assets.

CHAPTER – 8

IMPORTANCE OF WORKING CAPITAL MANAGEMENT

According to Husband and Hockery,”the prime object of management is to

make a profit, either or not this is accomplished, depend on the manner in which

working capital is accomplished”. The primary object of working capital is

management is to manage the firm’s current asset and current liability in such a

manner that a satisfactory level of working capital is maintained. The firm may

become insolvent if it cannot maintain a satisfactory level of working capital. Working

capital assist in increasing the profitability of the concern. The working capital

position decide the various policies in the business with receipt to general operation

viz importance of working capital.

Positive correlation between sale and current assets: There is a positive

correlation between the sale of the product of the firm and its current assets.

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Increase in the sale of the product requires a corresponding increase in current

assets. Therefore, the current asset must be managed properly.

Investment in current asset: Generally more than half of the total capacity of

the firm is invested in current assets. Thus less than half of the capital is blocked in

fixed asset. Therefore management of working capital attracts the attention of the

management.

No alternative for current asset: While fixed capital can be acquired on

lease in emergency, there is no alternative for current asset. Investment in current

asset cannot be avoided without substantial losses.

Important for small unit: The management of working capital is more

important for small unit because they do not relay on long term capital market and

have easy access to short term finance source such as trade credit, short term bank

loans etc.

CHAPTER – 9

FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

Now let us look at the various factors determining the working capital

requirement in a business firm:

(A) Nature of businesses: The amount of working capital is related to the nature of

business. It concerns, where the cost of raw material used in manufacture of a

product is very large in production to its total cost of manufacture, the requirement of

working capital will be very large. For instance a cotton or sugar mills require a large

amount of working capital. On the other hand firms requiring large amount of

investment in fixed asset require less working capital. Public utility concern like

Indian Railways, require a lesser amount of working capital as compared to trading

or manufacturing concern, partly because of cash nature of their business and partly

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because, they are selling service instead of a commodity and there is no need of

maintaining inventories.

(B) Size of business unit: The general principle in this regard is that the bigger the

size of business, the larger will be the amount of working capital required, because

the larger business unit are required to maintain big inventories for the flow of the

business and to spend more in carrying out the business operation smoothly.

(C) Seasonal variation: Strong seasonal variation create special problem of working

capital in controlling the internal financial swings in many companies such as sugar

mills, oil mills, woolen mills etc. These require larger amount of working capital in the

season to purchase the raw material in large quantity and utilize them throughout the

year. They adjust their production schedule and maintain a steady rate of production

in off seasons. Thus they require larger amount of working capital during season.

(D) Time consumed in manufacture: The average time taken in the process of

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

The larger the period of manufacture the larger will be the working capital required.

Capital goods industries managed to minimize their investment in working capital by

asking advances from consumers as work proceeds in their orders.

(E) Turnover of circulating capital: Turnover means ratio of annual gross sales to

average working asset. It means the speed with which circulating capital complete its

round, or number of times the amount invested in working asset has been converted

into cash by sale of finished goods and reinvested in working asset during the year.

The faster the sales the larger the turnover. Conversely greater the turnover, larger

the volume of business to be done with given working capital. It require lesser

amount of working capital in spite of larger sale because of great turnover.

(F) Labor intensive versus capital intensive industries: In labor intensive

industries, larger working capital is required because of regular payment of heavy

wage bills and more time taken in completing the manufacturing process. On the

other hand the capital intensive industry requires require lesser amount of working

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capital because of heavy investment in fixed asset and shorter period in many

acquiring processes.

(G) Need to stockpile raw material and finished goods: The industry, where it is

necessary to stockpile the raw material and finished goods increase the amount of

working capital, which is tied up in stock and stores. In some line of business where

the materials are bulky and best purchased in large quantity such as cements,

stockpiling of raw material is very usual and used. In companies where labor strike is

very frequent like public utility concern, stockpiling of raw material is advisable. In

certain industries which are seasonal in nature, finished goods stock have to be in

large quantity which require large working capital.

(H) Terms of purchase and sale: Cash or credit terms of purchase and sale also

affect the amount of working capital .If a company purchase all goods in cash and

sells its finished product on credit, it will require a large amount of working

capital .On the other hand a concern having credit facility and allows no credit to its

customers will require less amount of working capital. Terms and conditions of

purchase and sale are generally governed by prevailing trade practice and by

changing economic conditions.

(I) Conversion of current asset into cash: The need of having cash in hand to

meet the day to day requirement like payment of wage and salary, rent etc has an

important bearing in deciding the adequate amount of working capital. The greater

the cash requirement, higher will be the need of working capital. A company has

ample stock of liquid current asset will require lesser amount of working capital

because it can encash its assets immediately in open market.

(J) Growth and extension of business: Growing concern requires more working

capital than that which is static. It is logical to except larger amount of working capital

in a going concern to meet its growing need of funds and for its expansion programs

through it varies with economic condition and corporate practice.

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(K) Business cycle fluctuation: Business cycle affect the requirement of working

capital At times, when the prices are going up and boom condition prevail, the

management seek to pile up big stock of raw material to have an advantage of lower

price and maintain a big stock of finished goods with an expectation to earn more

profit by selling it at higher price in future. The expansion of business unit caused by

the inflationary condition creates demand for more and more working capital.

Depression involves the locking up of big amount in working capital as the

inventories remain unsolved and book debts uncollected. The reduction in the

volume of business may result in increasing the cash position because of reduction

in inventories and receivable that usually accompanies decline in sale and

shortening in capital expenditure. In such case shortage of working capital develops.

(L) Profit margin and profit appropriation: Some firms enjoy a leading position in

the market due to quality product and good marketing management or monopoly

power in the market and thereby earn huge profits. It contributes towards working

capital, provided it is earned in cash. Cash profit can be found by adjusting the non-

cash item like depreciation, outstanding expense, accumulated losses and expense

written off in net profit. But in practice the whole cash inflows are not considered as

cash available for use as cash is used up to increase the other asset like, book

debts and fixed asset stock etc. In a growing concern working capital requirement

will be estimated on how the cash available is rightfully used. Even if the net profit is

earned in cash, whole of it is not available for working capital purpose. The

contribution towards working capital is effected by the way in which profit are

appropriated and affected by tax action, dividend, depreciation and reserve policy.

(M) Price level changes: The financial manager should predict the effect of price

level changes on working capital requirement of the firm. Rising price level will

require a higher level of working capital to maintain the same level of current asset,

as it will require higher investments. However if companies reverse their product

prices, they will not face a severe working capital problem. Thus the effect of rising

price will be different for different firm depending upon their price policy and its

nature.

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(N) Dividend policies: There is a well-established relationship between dividend

and working capital in companies where successive dividend policy is followed. The

changes in working capital position bring about an adjustment in dividend policy. In

order to maintain an established dividend policy, the management gives due

consideration to its effect on cash requirements. Storage of cash may induce the

management to reduce cash dividend. Strong cash position may justify the cash

dividend, even if earnings are not sufficient to cover the payments. Shortage of cash

is one of the reasons for issue of stock dividend. On the other hand if the company

follow the policy of retention of profit in business, the working capital position will be

quite adequate, alternatively, if the whole of the profit are distributed among the

shareholders, companies working capital position will suffer.

(O) Close coordination between production and distribution policy: This will

reduce the demand of working capital.

(P) An absence of specialization in the distribution of products: This will require

more working capital as such concerns will have to maintain its own marketing

organization.

(Q) If the means of transporting and communication are less developed: More

working capital is required in such areas to store the material and finished goods.

(R) Hazards in a particular business also decide the magnitude of working

capital required.

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CHAPTER – 10

WORKING CAPITAL FINANCING

The main source of working capital financing, namely, trade credit, bank

credit, RBI framework/regulation of bank credit/finance/advances, factoring and

commercial papers will be discussed in this chapter.

1. TRADE CREDIT: Trade credit refers to the credit extended by the suppliers of

goods and service in normal course of transaction/business/sale of the firm.

According to trade practice, cash is not paid immediately for purchase but

after an agreed period of time. There is however, no formal/specific

negotiation of trade credit It is an informal arrangement between buyer and

seller. There is no legal instrument of acknowledgement of debt, which is

granted on an open account basis.

(a) ADVANTAGES: - Trade credit as a source of short-term working

capital finance has certain advantages. It is easily available. Moreover

it is flexible and spontaneous source of finance. The availability and

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magnitude of trade credits is related to the size of operation of a firm in

relation to sales/purchase. If the credit purchase of goods decline,

availability of credit will also decline. Trade credit is also an informal,

spoteganous source of finance. Not requiring negotiation and formal

agreement, trade credit is free from the restriction associated with

formal/negotiated source of finance/credit.

(b) COST: Trade credit does not involve any explicit interest charged.

However there is an implicit cost of trade credit. It depends on trade

credit offered by suppliers of goods. The smaller the difference

between the payment day and the end of the discount period, the

larger is the annual interest/cost of trade credit.

2. BANK CREDITS: It is the primary institutional source of working capital

finance in India. In fact it represent the most important source of financing of

credit asset. It can be provided by banks in five ways

(a) Cash/credit overdrafts: Under cash credits, the bank specifies a

predetermined borrowing/credit limit. The borrowers can draw/borrow

up to the stipulated credit/overdraft limit. Similarly repayment can be

made wherever desired during the period. The interest is determined

on the basis of the running balance/amount actually utilized by

borrower and not on the sanctioned amount.

(b) Loans: Under the arrangement the entire amount of borrowing is

credited to the current account of the borrower .The borrower has to

pay interest on the total amount.

(c) Bills purchased/discounted: -The amount made available under this

arrangement is covered by the cash credit and the overdraft limit.

Before discounting the bill the bank satisfies itself with the credit

worthiness of the drawer and the genuineness of the bill. To

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popularize the scheme, the discounting banker asks the drawer of the

bill (i.e. the seller of the goods) to have his bills accepted by the

drawee bank.

(d) Term loans for working capital: Under this arrangement, banks

advance loans for three to seven years repayable in yearly and half

yearly installments.

(e) Letter of credit: While the other forms of bank credit are direct forms

of financing in which banks provide funds as well as bears risk, letter

of credit is an indirect form of working capital financing and bank

assume only the risk, the credit being provided by the supplier.

MODES OF SECURITY

Banks provide credit on the fallowing modes of security:

1. Hypothecation: Under this mode of security the bank provide credit to

borrowers against the security of movable property, usually inventory of

goods.

2. Pledge: Pledge, as a mode of security is different from hypocatation in

that in the former unlike the later goods, which are offered as security

is transferred to the physical possession of the lender.

3. Lien: The term lien refers to the right of the party to retain goods

belonging to other party until a debt due to him is paid.

4. Mortgage: It is the transfer of legal stock equitable interest in specific

immovable property for securing the payment of debt.

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CHAPTER – 11

RESERVE BANK OF INDIA FRAMEWORK FOR REGULATION OF BANK

CREDIT

Till the mid sixties, the notable feature of bank financing of working capital of

corporate industrial borrowers were (a) easy access/over-reliance, i.e. in excess of

legimate requirement and (b) pre ponderance of cash credit arrangement/device

through which his finance was provided. In order to secure arrangement of a bank

credit with planning priorities and ensures equitable distribution to various sectors of

Indian economy, the RBI initiated several policy measures measure to direct bank

credit to priority sectors and enforce a measure of financial discipline among

industrial borrowers. However the basic character of bank financing and industry

namely, over borrowing and domination of cash credit system did not materially alter.

To reorient bank lending to industry to the two emerging reality of the Indian

economy in terms of the crucial factors of regulating controlling it, the RBI constitute

from time to time a number of expert groups to examine the various aspect of

banking policy relating to industrial financing, the notable being Dehejia committee of

1969,Marathe committee of 1974,Chore committee of 1980 and Marathe committee

of 1984.The recommendation of these groups ( refer to annexure) shaped the

framework/regulation of industrial finance by banks after mid 1970s.After mid 1990

24


the framework have been relaxed permitting banks greater flexibility in tune with the

emergence of new banking in the country, focusing on viability and profitability in

contrast with earlier trust on social/development banking .The main element of the

framework and the subsequent relaxation are discussed.

CHAPTER – 12

FIXATION OF NORMS

A notable feature of the framework /regulation to the fixation of norms for bank

lending to industry fall under two category:

1. Inventory and receivable norms: The norms refer to the maximum level

for holding inventory and receivable in each industry. Initially, the

inventory and receivable norms were applied in respect to 15 major

industries accounting for about one half of the industrial advance of the

bank. The norms pertained to (a) raw material including stores and

other item used in the process of manufacture: (b) stocks in process (c)

finished goods and receivables and bills purchased and discounted.

The norms were based on time elements

2. Lending norms: The lending norms are the basic element of the

framework of bank lending to have far-reaching implications. According

to lending norms a part of the current asset should be financed by

trade credit and other current liabilities. The remaining part of the

current asset, termed, as working capital gap should be partly financed

by owner’s funds and long-term borrowing and partly by short-term

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credit. There are three alternative methods for working out the

maximum permissible level of bank borrowing/finance, each

successive method reducing the involvement of short-term bank credit

to support current assets.

CHAPTER –13

HOW “PUBLISHERS” CAN MAKING MORE EFFICIENT USE OF WORKING

CAPITAL

The table below lists items, which influence working capital levels favorably

and adversely for Publishers

Items that reduce working capital

levels

Items that increase working capital levels

-- Customers who pay promptly

-- Advance payment by customers

-- Long print runs expect where all the books are required on publication e.g. schools and university textbooks.

-- Increased profit margins -- Lower profit margins

-- Inventory which is sold and paid

for quickly by customers and

publication

-- Lower inventory level by reducing

print quantities and working with

printers who will delivery quickly and

produce low print runs economically

-- Slow authors whom deliver late

and whose manuscript require

substantial editing.

-- Holding paper stock unless

market condition demand and the

saving are large

-- Slow schedules for development of new titles

26


-- Successful promotion that speed

up the rate of sale.

-- Licensing

-- Paying suppliers on completion

with credit

-- Making advance payment to printers-- Seasonal sales except where the publishers print only for the season

CHAPTER – 14

ASSESSMENT OF WORKING CAPITAL REQUIREMENT IN SEASONAL

INDUSTRY

In the seasonal industries the level of working capital requirement will not be

similar all the year. In times of off-season, the working capital requirements and

therefore, the level of investment in current asset and liability are very low. But

during seasons, the firm requirement of working capital is at peak level. Now let us

look at the sugar industry. The crushing season in the year will remain for five to six

month’s time. During the season the plant is expected to work at full capacity, with

triple shift working and the requirement of stock is very high resulting in increased

sugar stock. The requirement for payment of labor, expense and maintenance is also

very high. There will not be immediate sale of sugar and finished stock inventory will

be much higher.

After the completion of crushing season the plants will stop and only upkeep

and maintenance of plant will be incurred and the level of current asset and the

current liabilities will come down and the working capital requirement will be very

low. For efficient management of working capital the finance manager should be able

to properly estimate the season and off season requirement of working capital. For

this the fallowing precaution are taken:

27


1. Preparation of projected cash flow statement showing the cash flow for peak

season, normal season and off-season requirement.

2. Make proper arrangement with the banks and other source of finance to meet

the short-term need of season

3. Make proper arrangement for meeting contingencies of higher-level

requirements than the projected level of requirement.

4. Proper and careful assessment of working capital requirement for the season

and off-season requirement.

5. Care to be taken to reduce the level of investment in current asset after the

season is completed.

CHAPTER – 15

METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENT

Now let us look at some of the ways used by a business firm in estimating the

working capital requirement:

Operating cycle method: Operating cycle is a period that a business enterprise

takes in converting cash back into cash. It has the fallowing four stages.

(a) The raw material and stores inventory stage.

(b) The semi finished goods or work in progress stage

(c) The finished goods inventory stage.

(d) The accounts receivable and book debt stage.

Each of he above stage is expressed in terms of days of relevant activity.

Each requires a level of investment to support it. The sum of these stage wise

investments will be total amount of working capital of the firm. The fallowing formulae

can be used to express the framework of the operating cycle.

T = (S * C) + W + F + B

Where

T Stands for the total period of operating cycle in number of days

R Stands for the number of days of raw material and stores

28


Consumption requirement held in raw material and store

Inventory

C The number of days of purchase in trade creditors

W The number of days of cost of production held in W.I.P

F The number of days of cost of sales held in finished goods

B The number of days of sale in book debt

The consumption may be made as under:

Average inventory of raw material and stores

R = Average per day of consumption of raw materials and stores

Average trade creditors

C = Average credit purchase per day

Average work in progress

W = Average cost of production per day

Average inventory of finished goods

F = Average cost of sale per day

Average book debts

B = Average sales per day

The average inventory, trade creditors, working progress, finished goods and

book debts can be computed by adding the opening and closing balance at the end

of the year in the respective accounts and dividing the concerned annual figures by

365 or the number of days in a given period.

The operational cycle method of determining working capital requirements

gives only an average figure. In this method the fluctuations in the intervening period

due to seasonal and other factors and their impact on working capital cannot be

judged. Continuous short run detailed forecasting and budgeting exercise are

necessary to identify these impacts.

29


The new concept that is gaining more and more importance in recent years is

this style of working capital method. The operating cycle refer to the average time

elapsed between the acquisition of raw material and the final cash realization.

Cash is used to buy the raw materials and other stores, so cash is converted

into raw materials and stores inventories. Then the raw materials and stores are

issued to the production department. Wages are paid and other expense are

incurred in the process and work in progress comes into existence. Work in progress

becomes finished goods. Finished goods are sold to costumers on credit. In the

course of time these costumers pay cash for the goods purchased by them. Cash is

retrieved and cycle is completed.

The operating cycle of working capital is shown below:

CASH

ACCOUNTS RECEIVABLE

PURCHASE OF RAW MATERIAL

INVENTORY FINISHED GOODS

W.I.P

FIG 15.1 OPERATING CYCLE OF WORKING CAPITAL

Percent of sales method: It assumes that certain balance sheet items vary directly

with sales. Thus the ratio of the given balance sheet item to sales remains constant.

The firms need in terms of percentage of annual sales envisaged in each individual

balance sheet items are expressed in the following three ways:

As number of days of sale

As turnover

As percent of sales

30


Regression analysis method: This is a very useful statical technique of working

capital forecasting which helps in making projection after establishing the

relationship in the past years between sales and working capital and its various

components. This analysis may be carried out through the graphic portrayals or

through mathematical formulae. The relationship between the sales and working

capital of various components may be simple and direct indicating linearly between

the two. It may be complex involving simpler linear regression or simple curvilinear

regression and multiple regression situations. This method is particularly suitable for

long term forecasting.

CHAPTER – 16

WORKING CAPITAL REPORT

A sensible finance manager is always vigilant for avoiding the financial

embarrassment likely to be caused to the firm due to inadequacy of working capital.

He always takes utmost care so as to keep himself well informed of the working

capital position, its present aspect and its future prospects. Working capital report

varies according to the requirement of individual firms and circumstances.

Some of the types of working capital report are:

Inventory report: It gives in detail a comparative analysis of composition of closing

stock of raw material and finished products. It may be prepared weekly, monthly or

quarterly. It brings into light the fact whether working capital is unnecessarily blocked

up in the inventory. Fallowing is an example of monthly inventory report.

Sr no Ite

m

Cod

e no

Max

Stoc

k

Limit

Min

Stoc

k

Limit

Orde

r size

Op

Bal

Receive

d During

The

Month

Issue

d

durin

g the

Month

Balanc

e

1 001 *** *** *** *** *** *** *** ***

31


2 002 *** *** *** *** *** *** *** ***

3 003 *** *** *** *** *** *** *** ***

4 004 *** *** *** *** *** *** *** ***

5 005 *** *** *** *** *** *** *** ***

6 006 *** *** *** *** *** *** *** ***

7 007 *** *** *** *** *** *** *** ***

Cash report: It reflects the net liquidity position of the concern. It is prepared on daily

basis. It shows the summary of daily cash receipt, cash disbursements and the cash balance.

Fallowing is the Performa of a cash report.

Particular

s

Current

a/c

Letter of

credit

a/c

Fixed

deposit

a/c

Cash in

chest

Total Previous

week

A

REVENUE

X *** *** *** *** *** ***

Y *** *** *** *** *** ***

Z *** *** *** *** *** ***

B

CAPITAL

X *** *** *** *** *** ***

Y *** *** *** *** *** ***

Z *** *** *** *** *** ***

TOTAL ****** ****** ****** ****** ****** ******

Receivables report: These help in studying up the efficiency of the collection

policies and the desirability of credit policies. Detailed report may be made to depict

32


the reserve for bad and doubtful debts position. Some companies prepare aging

report in respect of debtors and receivables. A Performa of receivable report is given

below

BALANCE AT THE BEGINNING

SUPPLIES MADE DURING THE MONTH

REALIZATION MADE DURING THE MONTH

BACK

RECO

VERY

BAL

ANC

E

SR NO PART

Y

MORE

THAN

1

YEAR

6

MO

NT

HS

LESS THAN 6 MONTHS

BILLS

REALI

ZED

BILLS

NOT

REALI

ZED

MORE

THAN

1

YEAR

MOR

E

THA

N 6

MON

THS

BEL

OW

6

MTH

S

33


CHAPTER - 17

RECEIVABLES MANAGEMENT

The receivables represent an important component of current asset of a firm.

The purpose of this chapter is to analyze the importance of efficient management of

receivables, within the framework of a firm’s objective of value maximizing. The first

section of this chapter discusses the objective of receivables management. This is

followed by an indebt analysis of three crucial aspect of management of receivables.

Before understanding the objectives of receivables management let us first

understand the two concepts, which forms an important part in receivables

management, namely debtors and creditors.

34


Debtors: Debtors (Accounts Receivable) are customers who have not yet made

payment for goods or services, which the firm has provided. The objective of debtor

management is to minimize the time-lapse between completion of sales and receipt

of payment. The costs of having debtors are:

1. Opportunity costs (cash is not available for other purposes);

2. Bad debts.

Debtor management includes both pre-sale and debt collection strategies.

Pre-sale strategies include:

1. Offering cash discounts for early payment and/or imposing penalties for late

payment;

2. Agreeing payment terms in advance;

3. Requiring cash before delivery;

4. Setting credit limits;

5. Setting criteria for obtaining credit;

6. Billing as early as possible;

7. Requiring deposits and/or progress payments.

Post-sale strategies include:

1. Placing the responsibility for collecting the debt upon the center that made

the sale;

2. Identifying long overdue balances and doubtful debts by regular analytical

reviews;

3. Having an established procedure for late collections, such as

- A reminder;

- a letter;

- cancellation of further credit;

- telephone calls;

35


- use of a collection agency;

- legal action.

Creditors; Creditors (Accounts Payable) are suppliers whose invoices for goods or

services have been processed but who have not yet been paid. Organizations often

regard the amount owing to creditors as a source of free credit. However, creditor

administration systems are expensive and time-consuming to run. The over-riding

concern in this area should be to minimize costs with simple procedures.

While it is unnecessary to pay accounts before they fall due, it is usually not

worthwhile to delay all payments until the latest possible date. Regular weekly or

fortnightly payment of all due accounts is the simplest technique for creditor

management.

Electronic payments (direct credits) are cheaper than cheque payments,

considering that transaction fees and overheads more than balance the advantage of

delayed presentation. Some suppliers are unenthusiastic to receive payments by this

method, but in view of the significant cost advantage (and the advantages to the

suppliers themselves) departments may wish to encourage suppliers to accept this

option. However, electronic payments are likely to be used in combination with,

rather than as a replacement for, cheque payments.

Objectives of receivables management:

The term receivables are defined as debts owed to the firm by customers

arising from sale of goods or service in the ordinary course of business. When a firm

makes an ordinary sale of goods or service and does not receive payment the firm

grant credit and credits account receivable. Receivables management is also known

as trade credit management and thus, account receivables represent an extension of

credits to customers, allowing them a reasonable period of time in which to pay the

goods received.

36


The sale of goods on credit is an essential part of modern competitive

economic systems. Infact, credit sales and therefore receivables are treated as

marketing tools to aid the sale of goods. The objective of receivable management is

to promote the sale and profits until that point is reached where the return on

investment in further funding receivable is less than the cost of funds raised to

finance that additional credit (i.e.) cost of capital.

Now let us see some costs in receivable management:

1. Collection cost: Collection costs are administrative costs incurred in collecting

the receivables from the customers to whom credit sale have been made.

2. Capital cost: The increased level of account receivable is an investment in

asset. They have to be financed thereby incurring a cost. The cost on the use

of additional capital, to support the credit sale, which alternatively, profitably

employed is therefore a part of the cost of receivables.

3. Delinquency cost: These cost arise out of the failure of customers to meet

their obligation when payment on credit sale becomes dew after the expiry of

credit period. Such cost is called delinquency cost.

4. Default cost: Finally the firm may not be able to recover the overdue because

the inability of the customers to pay. Such that are treated as bad debts and

have to be written off, as they cannot be realized is called default cost.

Benefits:

The benefits are increased sales and anticipated profits because of a more

liberal policy. When firms extend trade credits, that is, invest in receivables; they

intend to increase the sales. The impact of liberal trade credit policy is likely two

take two forms. First it is oriented to sales expansion. In other words a firm may

grant trade credit to increase sale to existing customers. Secondly the firm gives

trade credit to protect its current sales against competitions.

37


Credit policies:

The credit policy of the firm provides a framework to determine (a) whether or

not to extend credit to a costumer (b) how much credit to extend. The credit

policy decision of a firm has two broad dimensions

1. Credit standards

2. Credit analysis

CHAPTER – 18

WORKING CAPITAL RATIO

Working capital ratios indicate the ability of a business concern in meeting its

current obligation as well as its efficiency in managing the current asset in the

generation of sales. These ratios are applied to evaluate the efficiency with which the

firm manages and make use of its current assets. The fallowing three categories of

ratio are used for efficient management of working capital (a) efficiency ratios (b)

Liquidity ratios (c) Structural health ratios.

Efficiency ratio: This ratio is computed by dividing the working capital by

sale. This ratio helps to measure the efficiency of utilization of networking capital. It

signifies for an amount of sale a relative amount of working capital is needed. If any

38


increase in sale is contemplated, working capital should be adequate and thus this

ratio is useful for maintaining adequate level of working capital.

Inventory turnover ratio: This ratio indicate the effectiveness and efficiency

of the inventory management .The formulae is as fallows

INVENTORY TURNOVER RATIO = SALES / CURRENT ASSET

This ratio shows how speedily the inventory is turned into accounts receivable

through sales. The lower the inventory of sales ratio, the more efficiently the

inventory is said to manage and vice versa.

Current assets turnover ratio: This ratio formula is:

CURRENT ASSET TURNOVER RATIO = SALES / CURRENT ASSETS

This ratio indicates the efficiency with which the current asset turn into sales.

The lower the current asset to sales ratio, it implies a more efficient use of funds.

Thus, a high turnover rate indicates reduced lock up of funds in current assets. An

analysis of this ratio over a period of time reflects working capital management of a

firm.

Liquidity ratio: This ratio indicate the extend of soundness of the current

financial position of an undertaking and the degree of safety provided to the

creditors. The higher the current ratio, the larger amount of rupee available, per

rupee for current liability, the more the firms ability to meet current obligation and the

greater safety of funds of short term creditors. The liquidity ratio formulae is

LIQUIDITY RATIO = CURRENT ASSET, LOANS, ADVANCES/ CURRENT

LIABILITY

Current assets are those assets, which can be converted into cash within an

accounting year. Current liability and provisions are those liability that are payable

within a year. A current ratio of 2: 1 indicates a highly solvent position. Banks

consider a current ratio of 1: 3: 1 as minimum acceptable level for providing working

capital finance. The constituents of the current asset are as important as current

asset themselves for evaluation of companies solvency position.

39


Quick ratio: This ratio is a more refined tool to measure the liquidity of an

organization. It is a better test of financial strength than the current ratio, because it

excludes very slow moving inventories and the item of current asset, which cannot

be converted into cash easily. This ratio shows the extend of cushion of protection

provided from the quick assets to the current creditors. A quick ratio of 1: 1 is usually

considered satisfactorily through it is again a rule of the thumb only.

Structural health ratio: This ratio explains the relationship between current

asset and total investment in current asset. A business enterprise should use its

current asset effectively and economically because it is out of the management of

these assets that profits accrue. A business will end up in losses if there is any

lacuna in managing assets to the advantage of business. Investment in fixed assets

being inelastic in nature there is no elbowroom to make an amendment in this

sphere and its impact on profitability remains minimal. This structural ratio can be

indicated as

S.H.R = NET ASSETS / CURRENT ASSET

An analysis of current assets composition enable one to examine in which

components the working capital funds are locked up. Large tie up of funds in

inventories effect profitability of the business adversely owing to carry over cost .in

addition losses are likely to occur by the way of depreciation, decay, obsolesce,

evaporation and so on. Receivable constitute another component of current assets If

the major portion of current assets are made of cash alone the profitability will be

decreased because cash is a non earning asset. If the portion of cash balance is

excessive then it can be said that management is not efficient to employ surplus

cash.

Debtor turnover ratio: This ratio shows the extend of trade credit granted

and the efficiency in the collection of debts and thus it is an indicative of trade credit

management. The lower the debtor to sale ratio the better the trade credit

management and better the quality of debtors. The lower debtor means prompt

payment by customers. An excessive long collection period on the other hand

indicates a very liberal ineffective inefficient credit and collection policy.

DEBTOR TURNOVER RATIO = SALES / DEBTORS

40


Average collection period measures how long it takes to collect amounts from

debtors. The actual collection period can be compared with the stated credit terms of

the company. If it is longer than those terms, this indicate some insufficiency in the

procedure of collecting debts

Bad debts to sale ratio: This ratio indicates the efficiency of the controlled

procedure of the company. The actual ratio is compared with the target of norms to

decide whether or not it is acceptable.

Creditor turnover period: The measurement of creditor turnover period

shows the average time taken to pay for goods and service by the company. In

general the longer the credit period achieved the better, because delay in payments

means that the operation of the company is financed interest free by suppliers funds.

But there will be point beyond which if they are operating in a sellers market, may

harm the company. If too long a period is taken to pay creditors, the credit rating of

the company may suffer, thereby making it more difficult to obtain supplier in future.

CREDIT TURNOVER PERIOD = CREDITORS * 365 / PURCHASES

CHAPTER – 19

WORKING CAPITAL LEVERAGES

One of the important objectives of working capital management is by

maintaining the optimum level of investment in current asset and by reducing the

current liability .The company can minimize the investment in working capital and

thereby improve the return of capital employed. The term working capital leverages

refer to the impact of level of working capital on company’s profitability. The working

capital management should improve the productivity of investment and current asset

and ultimately it will increase the return on capital employed. Higher level of

investment in current asset than is required means increase in the cost of interest

charged on short term loans and working capital finance raised from banks and will

resulting the lover return on capital employed and vice versa. Working capital

leverages measures the responsiveness of ROCE for changes in current asset. It is

measured by applying the fallowing formulae

41


Working capital leverages = C.A / T.A - ּטC.A

Where:

C.A = CURRENT ASSET

T.A = TOTAL ASSETS (net fixed asset = current asset )

C.A = CHANGE IN CURRENT ASSETּט

IMPACT OF INFLATION ON WORKING CAPITAL REQUIREMENT

When the inflation rate is high, it will have a direct impact on the requirement

of working capital as explained below

1. Inflation will cause the slow turnover figure at higher level even if there is no

increase in the quantity of sale. The higher the sale means the higher level of

balance in receivables.

2. Inflation will result in the increase of raw material price and hike in the

payment for expenses and as a result increase in balance of trade creditors

and creditors for expense.

3. Increase in the valuation of closing stock will result in showing higher profits

but without its realization into cash cause the firm to pay higher tax dividend

and bonus. This will lead the firm in serious problem in fund shortage and the

firm may enable to meet its short term and long-term obligation.

4. Increase in investment in current asset means the increase in the requirement

of working capital without corresponding increase in sale or profitability of a

firm.

Keeping in view of the above stated points the finance manager should be

very careful about the impact of inflation in assessment of working capital

requirement and its management.

42


IMPACT OF DOUBLE SHIFT WORKING ON WORKING CAPITAL REQUIREMENT

If the firm, which is presently running in single shift, plans to go for working in

double shift, the fallowing factors should be considered in assessing the working

capital requirement of the firm.

1. Working in double shift means requirement of raw materials will be doubled

and another variable expense will also increase drastically.

2. With the increase in the raw material requirement and expenses, the raw

material inventory and work in progress will increase simutanunsly. The

creditors for goods and creditors for expense balance will also increase.

3. Increase in production to meet the increased demand, which will also increase

the stock of finished goods. The increase in sales means increase in debtor

balance.

4. Increased in production will result in increased requirement of working capital

5. The fixed expense will increase with the working on double shift basis.

The finance manager should reassess the working capital requirement if the

change is contemplated from single shift operation to double shift operation.

43


CHAPTER – 20

ZERO WORKING CAPITAL

This is one of the newest trends in working capital management. The idea is

to have zero working capital .For e.g. at all times the current asset shall be equal to

current liability. Excess investment in current asset is avoided and firms meet its

current liability out of the matching current asset.

As current ratio is 1 and quick ratio below 1,there may be appreansation

about the liquidity, but if all current assets are performing and are accounted at their

realizable values, these fears are misplaced. The firm saves opportunity cost on

excess investments in current assets and as bank cash credit limit are limits are

linked to inventory levels, interest cost is also sold. There would be a self-imposed

financial disciple on the firm to manage their activity within their current liability and

current asset and there may not be attendance to over borrow or divert funds.

44


Zero working capital also ensures a smooth and uninterrupted working capital

cycle, and it will pressurize the financial manager to improve the quality of current

asset at all times, to keep them 100 percent realizable. There will also be a constant

displacement in current liability and the possibility of having overdue may diminish.

The tendency to postpone current liability payment has to be curbed and working

capital always maintained at zero. Zero working capital will also call for a fine

balancing act in financial management, and the success in this endeavor would get

reflected in healthier bottom lines.

CHAPTER – 21

OVERTRADING

Overtrading arises when a business expands beyond the level of funds

available. Overtrading an attempt to finance a certain volume of production and sales

with inadequate working capital .If the company does not have enough funds of its

own to finance stock and debtors it is forced, if it wish to expand, to borrow from

creditors and from banks on overdraft sooner or later and such expansion financed

completely by funds of others, will lead to a chronic imbalance in the working capital

ratio.

Expansion is advantageous so long as the business has funds available to

finance stock and debtors involved. Overtrading begins at a point where the

business relies on extra trade credit and increased turnover are financed by taking

longer period of credit from suppliers and/or negotiating an extension of overdraft

limits with the banks.

45


Over dependence on outside finance is a sign of weakness, unless the

expansion is curtailed, suppliers may refuse credit beyond certain limit, and the

banks may call for the reduction in overdrafts. If this happens the business may be

insolvent in that it does not have sufficient liquid resource to pay for current operation

or to repay current liability until customers pay for sale made on credit terms, or

unless the stock is sold for a loss for immediate cash payments.

Using the fallowing ratios it will be possible to analyze the situation properly

1. Working capital = current asset: current liability

2. Acid test = quick asset: current liability

3. Stock turnover = stock: cost of sale

4. Debtor’s turnover = debtors: credit purchases

The object of using these ratios is to detect a disorientation of liquidity position

of a firm and increase reliance upon trade creditors and overdraft facilities.

CHAPTER – 22

OVERCAPITALIZATION AND UNDER CAPITALIZATION OF WORKING

CAPITAL

If there are excessive stock, debtors and cash and very few creditors, there

will be an over investment in current asset. The inefficiency of managing working

capital will cause this excessive working capital resulting in lower returns in working

capital employed. and long-term funds will be unnecessarily tied up when they could

be invested to earn profit. This situation is known as overcapitalization of working

capital.

Under capitalization is a situation where a company does not have funds

sufficient to run the normal operation smoothly. This may happen, due to inefficient

working capital or diversion of working capital funds to finance capital items. If the

company faces the situation of undrecapitalization, then it will face difficulty in

meeting current obligation, procurement of raw material, meeting day-to-day running

expense etc. The result will ultimately be reduced profitability, and reduced turnover.

The finance manager must take immediate and proper step to overcome the

46


situation by making arrangements for sufficient working capital. For this purpose he

should prepare the realistic cash flow and fund flow statement of the company.

Some of the symptoms of poor working capital management are:

1. Excessive carriage of inventory over the normal levels required for

business will result in more balance in trade creditors account. More

creditors balance will cause strain on the management in management

of cash.

2. Working capital problem will arise when there is a show down in

collection of debtors.

3. Sometimes capital goods will be purchased from the funds available for

working capital. This will result in the working capital and its impact on

the operation of the company.

4. Unplanned production schedule will cause excessive stock of finished

goods or failure in meeting dispatch shedadule. More funds kept in the

form of cash will not generate any profit for the business.

5. Inefficiency in using potential trade credit require more funds for

financing working capital.

6. Overtrading will cause shortage of working capital and its ultimate

effect is on the operation of the company.

7. Dependence in short term source of finance for financing permanent

working capital causes less profitability and will increase strain on

management in managing working capital.

8. Inefficiency in cash management will cause embezzlement of cash.

47


CHAPTER – 23

INVENTORY MANAGEMENT

Inventories symbolize the second largest asset categories for manufacturing

companies, next only to plant and equipments. The proportion of inventories to total

asset varies between fifteen to thirty percent. Inventories are stocks of the product a

company is manufacturing for sale and component that make up the product. There

are three types of inventories: raw materials, work in progress and finished goods.

Raw materials are materials and components that are inputs in making the final

product. The work in progress, also called stock in progress, refer to goods in

intermediate stage of production. Finished goods consist of the final products that

are ready for sale. While manufacturing firms generally hold all three types of

inventories, distribution firms hold mostly finished goods. As inventory management

has important financial implication, the financial manager has the responsibility to

ensure that the inventory properly monitored and controlled.

The three general motives for holding the inventories are:

1. The transaction motives that emphasis the need to maintain inventories

to facilitate smooth production and sales operation.

48


2. The precautionary motive that necessitates holding of inventories to

guard against the risk of unpredictable change in demand and supply

force and other factors.

3. The speculative motive which influence the decision to increase and

reduce the inventory level to take advantage of price fluctuations.

The objectives of holding inventory are:

1. To maintain a large size of inventory for efficient and smooth

production and sales operation.

2. To maintain a minimum investment in inventories to maximize

profitability.

The objective of inventory management should be to determine and maintain

optimum level of inventory investment. The firm should always avoid a situation of

over investment or under investment in inventories. If there is over investment in

investment then it would result in unnecessary tie up of firm’s funds, loss of profit,

excessive carrying cost and risk of liquidity. Maintaining an inadequate level of

inventories is also dangerous. The consequence of under investment in inventories

will lead to production hold up and failure to meet delivery commitments. The aim of

inventory management thus should be to avoid excessive and inadequate level of

inventories and to maintain sufficient inventories for smooth production and sales

operation. Efforts should be made to place an order at the right time and with the

right source to acquire the right quantity at he right place and quality. An effective

inventory management should:

1. Ensure a continuous supply of materials to facilitate uninterrupted production.

2. Maintain sufficient stock of raw material in periods of short supply and

anticipate price change.

3. Maintain sufficient finished goods inventory for smooth sales operation, and

efficient customer service.

4. Minimize the carrying cost and time.

5. Control investment in inventories and keep it at an optimal level.

ECONOMIC ORDER QUANTITY:

49


There are two basic questions that should be considered in inventory

management namely (a) What should be the size of order? (b) At what level should

the order be placed?

This includes three types of cost:

1. Ordering cost: It relates to purchased items that include expense on

fallowing: requisitioning, preparation of purchase order, expediting,

transport and receiving and placing in storage.

2. Carrying cost: It includes expenses on interest on capital locked up in

inventory, storage, and insurance, obsolesce and taxes. Carrying cost

generally are 25% of the value of inventory held.

3. Storage cost: It arises when inventories are short of requirement for

meeting the need of production or demand of customers. Inventory

shortage may result in high cost, less efficient and uneconomic

production schedules, customer dissatisfaction and loss of sale.

Thus when a firm order in large quantities, in a bid to reduce the total

ordering cost, the average inventory, other things being equal, tends to be high

thereby increasing the carrying costs. In view of such relationship, minimization of

overall inventory management would require a consideration of trade off among

these costs.

For determining Economic Order Quantity formula the fallowing symbols

are used:

U Annual usage/demand

Q Quantity ordered

F Cost per order

C Percent carrying cost

P Price per unit

TC Total cost of ordering and carrying

T.C = U * F * Q * P * C

50


The total cost of ordering and carrying cost is minimized when

Q = √ 2 FU / PC

CHAPTER – 24

MONITORING AND CONTROLLING OF INVENTORIES

This includes the tools of ABC (Always Better Control) analysis, the

various measures for judging the effectiveness of inventories, the concept of just

in time inventory control and the steps that may be taken to maintain control over

inventories.

ABC analysis: In most inventories a small proportion of items account for a

very substantial usage (in terms of monetary value of annual consumption) and a

very large proportion of items account for a very small usage (in terms of

monetary value of annual usage). ABC analysis, based on this empirical reality,

advocates in essence, a selective approach to inventory control, which calls for

greater concentration of efforts on inventory items accounting for the bulk usage

value. This approaches calls for classifying inventories into three broad

categories namely A, B and C categories. Category A represent the most

important items, which generally consist of 15 to 25 % of inventory items and

constitute for 60 –70 % of annual usage value. Category B, represent items of

moderate importance, generally consist of 20 to 30 % of inventory items and

account for 20 to 30 % of annual usage value. Category C represent items of

least importance, generally consisting of forty to sixty percent of inventory items

and accounts for 10 to 15 % of annual usage value.

51


To illustrate the use of ABC analysis, let the information on usage and

price of 20 items used by Control System Limited be

CLASS NUMBER OF

ITEMS

% OF ITEMS % OF

USAGE

VALUES

A 5 25 68.3

B 5 25 21.4

C 10 50 10.2

The procedure for numerical calculation of ABC analysis will be (1) Rank

the items of inventory on the basis of usage value (2) Record the cumulative

usage in value (3) Show the cumulative percent of the usage item. Now a days

many large manufacturers operate on just in time basis whereby all the

components to be assembled on a particular day arrive at the factory early that

morning, no earlier-no later. This helps to minimize manufacturing costs as JIT

stock take up a little space, minimize stock holding and virtually eliminate the risk

of obsolete and damaged stock. Because JIT manufacturers hold stock for a

short time, they are able to conserve substantial cash. IT is a good model to

strive for, as it embraces all the principle of sensible stock management.

The key issue for a business is to identify the fast and slow stock movers

with the objective of establishing optimum stock level for each category and

thereby minimize the cash tied up in stock. Factors to be considered when

determining optimum stock level include (a) what are the projected sales of each

product? (b) How widely available are the raw materials, components etc? (c)

How long does it take for delivery by suppliers? (d) Can you remove slow movers

from your product range without compromising best sellers?

Remember that stock sitting on shelves for long period of time ties up

money that is not working for you. For better stock control a firm should try the

fallowing (a) Review the effectiveness of existing purchases and inventory

52


system? (b) Know the stock turn for all major item of inventory (c) apply tight

control to significant few items and simplify controls for trivial many. (d) Sell off

outdated or slow moving merchandise—It gets more difficult to sell the longer you

keep it. (e) Consider having part of your product outsourced to another

manufacturer rather than making it yourself (f) Review your security procedure to

ensure that no stock “is going out the back door”! Higher than necessary stock

levels tie up cash and cost more in insurance, accommodation costs and interest

charges.

CHAPTER – 25

STRATEGIES IN WORKING CAPITAL MANAGEMENT

At present more finance option are available to the finance manager to see

the operation of his firm go smoothly. Depending on the risks of business

strategies is evolved to manage the working capital.

Conservative working capital strategy: A conservative strategy

suggests carrying high levels of current asset in relation to sales. Surplus current

asset enable the firm to absorb sudden variation in sales, production plans, and

procurement time without destructing production plans. Additionally the higher

liquidity level reduces the risk of insolvency. But lower risk translates into lower

returns. Large investment in current asset lead to higher interest and carrying

cost and encouragement for efficiency. But conservative policy will enable the

firm to absorb day o day risk. It assures continuous flow of operation and

illuminates worry about recurring obligation. Under this strategy, long term

financing covers more than the total requirement of capital. The excess cash is

invested in short-term marketable securities and in need these securities are sold

off in the market to meet the urgent requirement of working capital.

Aggressive working capital strategy: Under this approach current asset

are maintained just to meet the current liability without keeping cushions for the

variation in working capital needs. The companies working capital is financed by

53


long-term source of capital and seasonal variation are met through short-term

borrowing. Adoption of this strategy will minimize the investment in net working

capital and ultimately it lowers the cost financing working capital needs. The main

drawback of this strategy is that it necessitates frequent financing and also

increase, as the firm is variable to sudden shocks.

A conservative current asset financing strategy would go for more long-

term finance, which reduces the risk of uncertainty associated with frequent

refinancing. The price of this strategy is higher financing cost since long-term

rates will normally exceed short-term rates. But when aggressive strategy is

adopted, some time the firm runs into mismatches and defaults. It is a cardinal

principle of corporate finance that long term source and short-term assets should

finance long term asset by a mix of long and short-term source.

Efficient working capital management techniques are those that

compressed operating cycle. The length of operating cycle is equal to the sum of

the length of the inventory period and the receivable period. Just in time inventory

management techniques reduce carrying cost by slashing the time that goods are

parked as inventories. To shorten the receivables period without necessary

reducing the credit period, corporate can offer trade discount for prompt payment.

Rs

SECULAR GROWTH

LONG TERM FINANCING

SEASONAL INVESTMENT IN VARIATION MARKETABLE SECURITY

54


Time

FIG 25.1 CONSERVATION WORKING CAPITAL STRATEGY

Rs Seasonal variation

Short term financing

Secular growth Long term financing

Time

FIG 25.2 AGGRESSIVE WORKING CAPITAL STRATEGY

55


CHAPTER – 26

ROLE OF CASH AND BANK IN WORKING CAPITAL MANAGEMENT

Good cash management can have a major impact on overall working capital

management. The key elements of cash management are:

1. Cash forecasting;

2. Balance management;

3. Administration;

4. Internal control.

Cash Forecasting. Good cash management requires regular forecasts. In

order for these to be essentially accurate, they must be based on information

provided by those managers responsible for the amounts and timing of expenditure.

Capital expenditure and operating expenditure must be taken into account. It is also

necessary to collect information about impending cash transactions from other

financial systems, such as creditors and payroll.

Balance Management. Those responsible for balance management must

make decisions about how much cash should at any time be on call in the Bank

Account and how much should be on term deposit at the various terms available.

There are various types of mathematical model that can be used. One type is

analogous to the ERQ inventory model. Linear programming models have been

56


developed for cash management, subject to certain constraints. There are also more

complicated techniques.

Administration. Cash receipts should be processed and banked as quickly

as possible because:

1. They cannot earn interest or reduce overdraft until they are banked;

2. Information about the existence and amounts of cash receipts is

usually not available until they are processed.

Where possible, cash floats (mainly petty cash and advances) should be avoided. If,

on review, the only reason that can be put forward for their existence is that "we've

always had them", they should be discontinued. There may be situations where they

are useful, however. For example, it may be desirable for minor parts of departments

to meet urgent local needs from cash floats rather than local bank accounts.

Internal Control. Cash and cash management is part of a department's

overall internal control system. The main internal cash control is invariably the bank

reconciliation. This provides assurance that the cash balances recorded in the

accounting systems are consistent with the actual bank balances. It requires regular

clearing of reconciling items.

57


CHAPTER – 27

CONCLUSIONS

In conclusion, good management of working capital is part of good financial

management. Effective use of working capital will add to the operational efficiency of

a department; optimal use will help to generate maximum returns.

Ratio analysis discussed in the beginning, can be used to identify working

capital areas, which require closer management. Various techniques and strategies,

discussed above are available for managing specific working capital items.

Debtors, creditors, cash and in some cases inventories are the areas most

likely to be relevant to a firm.

58


CHAPTER –28

ANALYSES 1

GUJARAT AMBUJA CEMENTS L.T.D

Gujarat Ambuja cements was set up in 1986.In the last decade the company

has grown tenfold. With the commencement of commercial production of its 2 mn

tones plant in Chandrapur, Maharashtra, Ambuja will become India’s third largest

cement company with a capacity of 12.5 mn tones and revenue in excess of 2500

crores. Its plants are one of the most efficient in the world with environment

protection measures that are on par with the finest in the developed world.

Ambuja fallows a unique home grown philosophy of giving people the

authority to set their own targets, and the freedom to achieve their goals. This simple

vision has created an environment where there are no limits to excellence, no limits

to efficiency and has proved to be a powerful engine of growth for the company.

Ambuja, believes that an asset is worth only as much as the people who use it. The

people’s efforts to constantly raise efficiency have not only raised the bar at Ambuja,

but across the industry as well. Thus their people continue to achieve ever-high

efficiency and productivity at all their plants.

59


Over 40 % of the production cost of cement is power. Ambuja realized that to

run a profitable company, they need to keep power cost to minimum. So they set up

a captive power plant at a substantially lower cost than the national grid. They

sourced a cheaper and a higher quality coal from South Africa. They also brought

better furnace oil from the Middle East. The result is that today hey are in a position

to sell their excess power to the local government.

Their sea borne bulk cement transportation facility has brought many costal

markets within easy reach. It also made Ambuja India’s largest exporter of cement

consistently for the last five years. As a result Ambuja is the most profitable cement

company in India, and the lowest cost producer of cement in the world. Ambuja has

received the highest quality award – The national quality award and the only current

company to do so. It was also the first to receive ISO 9002 quality certification.

Performance highlights of Gujarat Ambuja cements Ltd for the years 2001 – 2002 and 2002 – 2003

PARTICULARS2002 – 2003

(Rs in cores)

2001 -2002

(Rs in cores)

Sales 1592 1474

(-) Expenditure 1126 1010

PBDIT 466 464

(-) Depreciation & Amortization 138 129

PBIT/Operating profit 328 335

(-) Interest/Financial charges 97 134

PBT 231 201

(-) Provision for tax 45 14

PAT 186 187

60


STATEMENT SHOWING WORKING CAPITAL OF GUJAART AMBUJA

CEMENT LTD

Particulars 2002 – 2003

Rs in lacks

2001 – 2002

Rs in lacks

CURRENT ASSETS:

Inventories 20837 16143

Sundry debtors 3901 3344

Cash and Bank balance 5072 2861

Other current asset 2371 2435

Loans and advances 15055 15278

TOTAL CURRENT ASSET (A) 47236 40061

CURRENT LIABILITY

Current liability 18821 22060

Provisions 3430 8313

TOTAL CURRENT LIABILITY

(B)

22251 30373

61


NET WORKING CAPITAL (A-B) 24985 9668

Statement indicating short-term ratio:

1. Liquid ratios:

RATIO FORMULAE 2002 - 2003 2001 - 2002

A) Current ratio Current

asset/current

liability

47236 / 22251

=2.12

40061 / 30373 =

1.32

B) Quick ratio (Current asset –

inventories) /

current liability

26399 / 22251 =

1.86

23918 / 30373 =

0.79

C) Cash ratio Cash + marketable

securities / current

liability

5072 / 22251 =

0.23

2861 / 30373 =

0.09

2. Turnover ratios:

RATIO FORMULAE 2002 - 2003 2001 - 2002

A) Debtor turnover

ratio

Net credit sales /

Closing debtors

1592 / 39.01 = 1474 / 33 =

Debtor collection

period

365 days / DTR 365 / 40.81 = 9 365 / 44 =14

62


B) Stock in trade

ratio

Cost of goods sold

/ Closing stock in

trade

964.5 / 64.30 = 15 898 / 63 =8

Stock holding

period

365 days STR 365 / 15 = 24 365 / 14 =26

C) Stores and

consumables

turnover ratio

Cost of goods sold

/ Closing

consumables

433.99 / 143.98 =

3.01 days

406.90 / 97.93 =

4.16 days

Stores and

consumables

holding period

365 / SCTR 365 / 3.01 = 121

days

365 / 4.16 = 87

days

D) Creditor

turnover ratio

Net credit

purchases /

Closing Creditors

464.34 / 112.27 =

4.14 days

461.40 / 167.32 =

2.76 days

Creditors payment

period

365 / CTR 365 / 4.1 = 88

days

365 / 2.76 = 132

days

3. Effect of turn over ratio on working capital:

RATIO 2002 –

2003 (IN

DAYS)

2001 –

2002 (IN

DAYS)

Stock holding period 24 26

(ADD) Stores and consumables holding period 121 87

63


(ADD) Debtors collection period 9 8

(LESS) Creditors payment period 88 132

Total 66 (11)

4. Profitability ratio:

RATIO FORMULAE 2002 - 2003 2001 - 2002

Gross profit margin

ratio

Gross profit / net

sales

328 / 1592 = 0.21

=21%

335 / 1474 = 0.23

= 23%

ANALYSIS:

WORKING CAPITAL OUTLAY:

In the cement business where the production and marketing cycle can be

long, working capital funds a number of activity: the purchase of raw materials,

making advances, availing cash discount on the total billing, maintaining an inventory

on production spares, sustaining the production cycle without interruption and

sustaining all the usual function within the organization.

Working capital accounted for 7.8 percent of the companies total capital

employed in 2002 – 2003.The total quantum of working capital was rs 24985 lac in

2002-2003 compared to 9688 lacks in 2001-2002,a 157.9% increase. The

company’s turnover to working capital ratio increased from 6.6 times in 2001-2002 to

15.7 times in 2002-2003.

LIQUIDITY RATIOS:

It implies the firm’s ability to pay its debts in a short run. It involves the

relationship between the current asset and current liability. In case of Gujarat

Ambuja Cements, the net working capital was Rs 9688 lacks in 2001-2002 has

64


increased to Rs 24985 lacks in the year 2002-2003.It means that the liquidity

position of the firm has increased. This is mainly due to increase in inventory holding

and cash balances.

The current ratio implies the firm’s ability to meet its current obligation. In

2001-2002 the current ratio was 1.32,which is now increased to 2.12 in 2002-

2003,which means that the company has current asset, which are 2.12 times the

current liability. This shows that the overall liquidity position of the company has seen

an improvement over the previous year. The increase in current ratio in over the

earlier period can be attributed towards an increase in inventory holdings and also a

noticeable rise in cash holdings over the earlier period. This if further affraimed by

quick ratio, which has shown a significant rise from 0.79 in 2001-2002 to 1.86 in

2002-2003.In fact the quick ratio has more than doubled over the previous year.

Thus, the company has managed to generate adequate cash surplus to meet its

growing business needs. Besides they have also built up good stock levels of coal

and other packing materials, probably to take advantage of low price prevailing in the

market.

SUNDRY DEBTORS:

Sundry debtors stood at 3901 lacks in 2002-2003,compared with Rs 3344

lacks in 2001-2002,a 16.66 percent increase. Sales have increased by 9.34 percent

in 2002-2003,and average collection period has more or less remained steady from

8 days in 2002 to nine days in 2003.This indicates that the company has succeeded

in achieving growth in sales and at the same time, efficiently collected its receivables

from the marketplace, as in the previous year. Credit worthiness was appraised on a

periodic basis.

INVENTORIES:

Inventories increased from Rs 16143 lacks in 2001-2002 to Rs 20837 lacks in

2002-2003,a 29% increase over the previous year primarily due to the increase in

stock of coal and packing material. Goods and consumables holding period

65


increased from 87 days to 121 days As a result the total inventory-holding period

also increased from days in 2001 –2002 to 145 days in 2002-2003.

SUNDRY CREDITORS:

The sundry creditors decreased from 16732 lacks in 2001-2002 to Rs 11226

lacks in 2002-2003,a 32.9% decrease’s a result creditors payment period decreased

from 132 days in 2001-2002 to 88 days in 2002-2003.It seemed that the company

has pushed hard its cost cutting drive, and effectively negotiated with its major

suppliers to reduce the price of the supplies and compensated the suppliers to a

certain extend by accepting a lower credit period. Also, the company seems to have

generated enough cash from its operation to pay off the suppliers on a timely basis.

The company has strived hard to reduce its liabilities by paying off the creditors,

which shows that they have efficiently planned their finance.

To summarize one can say that, Gujarat Ambuja Cement has utilized its

working capital efficiently. It has been able to process at lower prices by

compromising on credit period from its creditors up to 88 days and has efficiently

collected from debtors in nine days. But the inventory seem to be slightly on the

higher side as compared to the previous year, which may me due to the company

availing the benefits of low price of material in the market.

PROFITABILITY RATIO:

This is the ratio that measures the firm’s activity and the ability to generate profits.

The gross profit margin ratio of Gujarat Ambuja Cement has decreased from 23% in

01-02 to 21% in 02-03.On an average it shows that company has made good profit

as compared to the earlier year.

66


CHAPTER – 29

ANALYSES 2

SHREE CEMENTS LTD

SHREE cements is one of the major energy efficient and productive cement

manufacturing in the world. SHREE cements is engaged in manufacture of cement

through the dry process route in north India. The company process two plants in

Bewar and Rajastan.Shree cements manufacture cements of two varieties – Gray

cement and Clinker cement. Its competitive advantage lays in its ability to

constituently generate a production in excess of its installed capacity.

In 2002 – 2003,Shree Company recorded a turnover of Rs 399.27 crore as

against Rs 554.60 crore in 2001 - 2002.This was because 2002 - 2003 comprised 9

working months as compared to 12 working months the previous year. In 2002 -

2003 SHREE cements posted a 28% increase in its cash profits i.e. 49.84 crore as

compared to the previous year.

The vision of SHREE cement is to register a strong consumer surplus through

a superior cement quality at affordable prices. And their mission is to strengthen

realization through intelligent brand building and to increase he awareness of

superior products through a realistic and convincing communication process with

consumers.

The company is looking forward to make financial accounting module

available online for the authorized users. It also plans to get input from Weigh Bridge

online to exercise better control on inbound and out bound logistics. In coming days

67


IT is expected to play an even more important role in terms of integrating various

activities of business, maintaining Data and providing information.

PERFORMANCE HIGHLIGHTS OF SHREE CEMENTS LTD FOR THE YEAR 2001-2002 & 2002-

2003

PARTICULARS2002-2003

(NINE MONTHS)

Rs in crores

2001-2002

(TWELVE MONTHS)

Rs in crores

Sales 397.21 554.60

Other income 0.30 0.28

Increase/Decrease in stock 6.01 (13.31)

(-) Expenditure 326.75 445.80

PBDIT 76.77 95.77

(-) Interest and financial charges 26.93 44

Gross profit 49.84 51.77

(-) Depreciation and a moralization 43.12 25.64

PBT 6.72 26.13

(-) Provision for tax 3.10 -

68


(-) Provision for deferred tax 2.14 -

PAT 1.48 26.13

Statement showing working capital of shree cements ltd

PARTICULARS2002-2003

All rs in crores

2001-2002

All rs in crores

Current assets:

Inventories 4103 3472

Sundry debtors 3003 4082

Cash and bank balance 553 1891

Loan and advance 6423 6584

Total current assets (A) 14082 16029

Current liabilities

Current liability 5840 5488

Provisions 446 599

Total current liability (B) 6286 6087

Net working capital (A-B) 7796 9942

Statement indicating Short term ratios

69


Liquidity ratio:

RATIO FORMULAE 2002-2003 2001-2002

A) CURRENT RATIO CURRENT ASSETS /

CURRENT LIABILITY

14082/6286

= 2.24

16029/6087 =

2.63

B) QUICK RATIO CURRENT ASSETS –

INVENTORY /CURRENT

LIABILITY

9979/6286 =

1.59

12557/607 =

2.06

C) CASH RATIO CASH + MARKETABLE

SECURITIES/CURRENT

LIABILITY

553/6286 =

0.08

1891/6087 =

0.31

Turnover ratio:

RATIO FORMULAE 2002-2003 2001-2002

A) Inventory turnover

ratio

Goods sold/closing stock 39722/4103

= 9.68

55460/3472 =

16

Inventory holding period 365 days/ITR 274/9.68 =

28 days

365/16 = 23

days

B) Debtor turnover ratio Net credit sales/Closing

debtors

39722/3003

= 13

55460/4082 =

14

Debtor collection period 365 days/DTR 274/13 = 21

days

365/14 = 27

days

C) Creditor turnover

period

Net credit

purchases/Closing

14829/3754 20823/3405 =

70


creditors =3.95 6.11

Creditor payment period 365/CTR 274/3.96 =

69 days

365/6.11 = 60

days

EFFECT OF THE TURNOVER RATIO ON WORKING CAPITAL

RATIO 2002-2003 2001-2002

Inventory holding period 28 DAYS 23 DAYS

ADD Debtor collection period 21 DAYS 27 DAYS

LESS Creditor payment period 69 DAYS 60 DAYS

TOTAL (20) (10)

PROFITABILITY RATIO

RATIO FORMULAE 2002-2003 2001-2002

Gross profit margin

ratio

Gross profit/Net

sales

4984/39722 = 0.13

= 13%

5176/55461 = .09 =

9%

ANALYSIS:

WORKING CAPITAL OUTLAY:

In the cement business where the production and marketing cycle can be

long, working capital funds a number of activity: the purchase of raw materials,

making advances, availing cash discount on the total billing, maintaining an inventory

on production spares, sustaining the production cycle without interruption and

sustaining all the usual function within the organization.

71


Working capital accounted for 12 percent of the companies total capital

employed in 2002 – 2003.The total quantum of working capital was rs 77crore in

2002-2003 compared to 99.42 crore in 2001-2002,a 21.58% decrease.

LIQUIDITY RATIOS: It implies the firms ability to pay its debtors I the short run. It

involves the relationship between the current asset and the current liability. In the

case of SHREE cements, the net working capital was rs 99.42 crores in 2001-2002

and reduced to RS 77.96 cr in 2002-2003.It means that the liquidity position of the

company has decreased.

The current ratio implies the firm’s ability to meet its current obligation. In 01-

02 the current ratio was 2.63,which has now come down to 2.24, which means that

the company has current asset, which are 2.24 times the current liability. Thus the

liquidity position of the company has reduced. The quick ratio implies the firms ability

to pay off its liabilities without relaying on the sale of the inventory or its recovery.

The quick ratio is reduced from 2.06 in 01-02 to 1.59 in 02-03.,which means the

inventories are reduced over a period of time and that liquidity position is good

although the current ratio gives a different picture.

SUNDRY DEBTORS: Retail sale increased by ten percent in 2002-2003 and sundry

debtors decreased by Rs 10.79 crore. This indicates that the companies collets its

outstanding faster from the marketplace. Sundry debtors stood at 30.03 crore in

2002-2003 compared with 40.82 crore in 2001-2002, a 26.43% decrease. Debtor’s

day decreased from 27 days in 2001-2002 to 21 days in 2002-2003,reflecting

prudent debtor management. Credit worthiness was appraised on a periodic basis.

Attractive financial incentive scheme were instituted to ensure a quick settlement of

outstanding.

INVENTORY :Inventories increased from 34.05 crore in 2001-2002 to 37.54 crore in

2002-2003 which is a 10.24% increase. Creditor payment period increased from

sixty days in 2001-2002 to sixty nine days in 2002-2003, which shows a prudent

credit management. The company has strived hard to push their creditors, which

shows they have efficiently planed things.

72


PROFITABILITY RATIO: This is the ratio that measures the firm’s activity and its

ability to generate profit. The gross profit margin of SHREE CEMENTS has

decreased from thirteen percent to nine percent but on average it shows that the

companies has made good profit as compared to the earlier year.

CHAPTER –30

CONCLUSIONS – COMPARISONS OF THE TWO CEMENT

INDUSTRIES

In the cement industry, where the production cycle and the marketing cycle

may be long, working capital is required for various reason like purchase of raw

material, making advances, availing cash discounts on the total billings, maintaining

an inventory of production spares, sustaining the production cycle without

interruption, payment of wages and salaries and sustaining all the useful function

within the companies.

Gujarat Ambuja Cement working capital accounted for 7.8% of the total

capital employed for the year 2003,indicating 157.9% increase as compared to the

previous year where as that of SHREE cement accounted for 12% indicating 21.58%

decrease of the capital employed.

In general comparing the two cement industries, the inventory management of

SHREE cements ltd is very good as it holds inventory for only 28 days in comparison

Gujarat Ambuja who hold it for 121 days.

AS far as the debtor management is concerned, It is Gujarat Ambuja cements

that manage its debtors efficiently as it receives from the debtors on an average

period of nine days. SHREE CEMENTS, in 21 days.

Gujarat Ambujas payable period has reduced from 132 days in 2001 - 2002 to

88 days in 2002 – 2003. Thus Ambuja has supplemented its cost cutting effort by

accepting lower credit period from suppliers from lower price. On the other hand

payable period of SHREE cements has increased from 60 days in 2001 - 2002 to 69

73


days in 2002 - 2003, indicating that they has negotiated a better credit period with its

suppliers at the same price.

On an average one can say that both the cement industries are managing

their working capital in such a way as to increase their profitability in the market.

74