Unit 3

3.1
Working capital management or current assets management is one of the vital parts of
financial management. Working capital is concerned with short term finance or finance
required for routine activities or operations. Effective and efficient management of working
capital ensures the success of a business. The inefficiency of management may lead to loss,
which in turn leads to shut down of business operations. Hence, study of working capital
management is not only limited to financial management but also to the overall management
of the organization.

Working capital management involves deciding upon the amount and composition of current
assets and the manner in which it is financed. The finance manager must take utmost care
in determining the appropriate level of working capital.

Fixed Capital

Fixed capital means that capital which is used in the business for long term investment like
purchase of fixed assets such as plant and machinery, land, building, furniture etc.
Investment of funds in these assets would block the firm's capital on a permanent or fixed
basis. Hence, it is termed as fixed capital. a

Working Capital

Fixed capital is meant for long term investment; whereas working capital is for short term
investment wherein organization invests these funds in day to day operations of business.
For example working capital deals with activities like purchase of raw materials, payment of
labor charges, payment of bills etc. Hence these funds or capital are termed as working
capital or short term capital. It is also known as circulating capital because the funds
invested in current assets keep revolving fast and constantly converted into cash and this
cash flows out again in exchange for other current assets.

Definitions of Working Capital

Working capital refers to a firm's Investment in short term assets such as cash accounts
receivables, Inventories etc.- Weston & Brigham

The sum of the current assets is the working capital of the business. - J. S. Mill Working

capital is the amount of funds necessary to cover the cost of operating the enterprise. -
Shubin

1. Principle of Risk Variation

Risk arises in business when it is unable to meet its obligations or make payments when it is
due. Huge investment made in current assets with less dependence on short term
borrowings, increases liquidity and reduces risk but decreases the profitability. On the
contrary, less investment in current assets and greater dependence on short term
borrowings increase risk, reduces liquidity and increases profitability.

Therefore, depending upon risk and profitability, the management has to change the size of
their investment in working capital.

2. Principle of Cost of Capital

Cost of capital refers to the rate of return on investment. For raising working capital finance,
various sources are employed wherein each source has a different cost of capital and
disparity in the degree of risk. Normally, higher the risk, lower the cost and lower the risk
higher the cost. Therefore, the management should always try to achieve a proper balance
between these two i.e., cost and risk.

3. Principle of Equity Position

According to this principle, the firm's equity position should be justified with the amount of
working capital invested in each component. Every rupee invested in the current assets
should contribute to the net worth of the firm. The level of current assets can be measured
with the help of two ratios: i) Current asset as a percentage of total assets.

ii) Current asset as a percentage of total sales.

Thus a finance manager while deciding the composition of current assets ,must consider the
appropriate industrial averages.

4. Principle of Maturity of Payment

According to this principle, efforts should be made by the firm to relate maturities of payment
to its flow of internally generated funds. Maturity of payment should not have greater
disparity as it would lead to greater risk. Generally shorter the maturity schedule of current
liabilities in relation to expected cash inflow, greater the inability to meet its obligations in
time. However a margin of safety should be provided for short term debt payments.

Thus this principle states that the working capital should be raised from different sources so
that the firm is able to repay them on maturity out of its inflow of funds.

3.2
SIGNIFICANCE OF ADEQUATE WORKING CAPITAL
The following are some of the reasons for maintaining adequate amount of working capital:

1. Adequate working capital can provide uninterrupted flow of production which strengthens
the solvency of a business.

2. Sufficient working capital can help the business to pay all its current abilities and operating
expenses in time which will enhance, create and maintain goodwill 3. The adequate reserve
of working capital ensures a steady flow of raw materials to production process leading to
continuous production.

4. The adequate stock of working capital makes it possible for a company to purchase the
trading goods in cash and cash purchase always carries the benefit of getting cash discount.

5. An organization can make regular payment of salaries, wages and other day-to-day
commitments only when it has sufficient working capital.

6: A company can avail the opportunities of price fluctuations if it has adequate working
capital in business.

7. It creates ability in the business to face emergencies such as strikes, flood, fire etc.,

8. It can also attract more number of investors into its business by making regular payment
of dividends. This gains the confidence of investors which creates a favorable market to
raise additional funds in the future.

9. It enables a business to withstand periods of depression smoothly,

10. If the company's credit standing solvency is high, it can arrange loans from banks and
others on easy and favorable terms.

Hence, adequate working capital can help to operate the business smoothly without any
financial problems and also improves the efficiency of business by reducing wastages,
enhancing production, increasing the morale of employees, and creating an environment of
security.

FACTORS DETERMINING WORKING CAPITAL

The amount of working capital required varies from one business to another. The
requirement for fixed and working capital increases with the growth and expansion of
business. Additional funds are required for upgrading the technology or to meet current
debts or expand the business etc. Therefore it becomes important to evaluate the various
factors that determines the need for working capital.

Some of the major factors are:

1. Nature of business
The requirement of working capital largely depends upon the nature or character of its
business. Public utility companies like railways, transport etc. employs less amount of
working capital because no funds are tied up in inventories and receivables. While the
trading company requires large amount of working capital as they have to invest in current
asset like inventories, cash, receivables etc. whereas manufacturing undertakings require
sizeable working capital between these two extremes.

2. Size of business

The composition of assets in the business depends upon the size of a busines and the scale
in which it is operating. Small companies require smaller proportions working capital than
large companies. But in some cases, even smaller concern may need more working capital
due to high overhead charges, inefficient use of availab resources etc.

3. Cash requirements

Cash is one of the essential components for successful operation of the production maintain
good credit relations. But, it would be expensive to hold excessive cast Hence, cash is one
of the important factors to determine working capital.

4. Volume of sales

This is an important factor which affects the size and components of working capital. A firm
maintains current assets as they are needed to support the operation activities which results
in sales. As the volume of sales increases, there is an increase in the investment of working
capital and vice versa. Hence the volume of sales determines the ame working capital.

5. Terms of Purchases and Sales

If the credit terms of purchases are more favorable and those of sales are less liberal, less
cash will be invested in inventory. A firm gets more time for payment to creditors or suppliers.
Hence, if the business has favorable terms and conditions of credit, it can reduce working
capital. On the other hand if the terms are unfavorable, it Increases the requirement of
working capital.

6. Price level changes

The requirement of working capital is also affected by the changes in price levels. The rise in
prices will require the organization to maintain larger amount of working capital as they have
to meet the needs of business operations.

7. Inventory turnover

If the inventory turnover is high, the working capital requirement will be low. Thus the finance
manager should determine the minimum level of stock to be maintained throughout the
period of operations.
8. Receivables turnover

A prompt collection of receivables and good facilities for setting payables results in low
working capital requirements. Hence, it is necessary to have an effective control of
receivables.

9. Production schedule

The availability of working capital ensures the continuity of production schedule. Delay in
production slows down the operations of business. So an organization should have a
systematic planning and smooth flow of production from raw materials stage to the end of
production.

10. Business cycle

The requirements of working capital depend upon the stage of business cycle. During the
period of prosperity, the requirement of working capital will be more since the business
expands and less during the period of depression. In the growth stage of business, there is a
need for large amount of capital to cover the needs of business cycle whereas in decline
stage, there may be a brief period when business faces difficulties in collection and sales.
Thus, depending on the phase, the organization should make the availability of funds.

11. Production cycle

Production cycle refers to the period taken to convert raw materials into finished goods. The
longer the production cycle the greater is the requirement of working capital. To minimize the
requirement, the production cycle should be shortened without affecting the manufacturing
process.

12. Seasonal fluctuations

The organizations which produce seasonal products require adequate working capital during
one period and less in the other period. In some cases the raw material may not be available
throughout the year. Hence huge amount of inventory has to be purchased during such
seasons which give rise to more working capital requirements.

13. Repayment ability

An organization's ability will determine the level of working capital it employs. Based on
repayment plans, it prepares cash flow projections to fix working capital accordingly.

14. Changes in technology

Technological developments related to production can have an impact on the need

for working capital.

15. Firm's policies

There are various firms' policies like credit policy, production policy etc which will
affect the size of working capital.

3.3 types of working capital

1. Permanent Working capital

It refers to the minimum level of current assets which is continuously required by

the enterprise to carry on its regular business operations. For instance, every
organization has to maintain a minimum stock of raw material, finished goods cash
balance etc. for smooth functioning of their production. Since working capital invested
These current assets is permanently blocked, hence it is also known as fixed working
capital. The need for permanent working capital will fluctuate depending upon the
growth of the business. The permanent working capital can be further classified into regular
working capital and reserve working capital. Regular working capital assists in circulation of
current assets from cash to

(1) Regular working capital

inventories, from Inventories to receivables and from receivables to cash and so on.

(ii) Reserve working capital

Reserve working capital is the excess amount over the requirement for regular
working capital which may be provided for contingencies that may arise at unstated periods
such as strikes, rise in prices, depression etc. It is the additional working capital needed to
support the changing production and sales in the business. In other words, it represents
additional current assets required at different times during the operating year. For example,
extra inventory has to be

2. Temporary or variable working capital:

maintained to support sales during peak period, Investment in inventories, receivables,
etc., will decrease in periods of depression. As the amount of working capital keeps on
fluctuating from time to time on the basis of business activities, it is termed as temporary
working capital. Variable working capital can be further classified as seasonal
working capital and special working capital.

(1) Seasonal working capital:

The capital required to meet the seasonal needs of the enterprise is called seasonal working
capital. During the season time, firm require to source its needs to meet the seasonal
demand. The working capital which required meeting the seasonal needs of the enterprise is
called seasonal working capital.

(II) Special working capital:

The capital which is required to meet the special exigencies such as launching extensive
marketing campaigns for conducting research, extra production, extra purchase etc is
referred as special working capital.
 3.4 OPERATING CYCLE:
The operating cycle is the time gap between the sales and their actual realization in the form
of cash. In simple terms, the duration of time required to complete the various stages of
business activity is called the operating cycle.

Generally in a manufacturing process, the operating cycle involves the following events
which is shown below:

Conversion of cash into raw materials

Conversion of raw materials to work in progress

Conversion of work in progress to finished goods

Conversion of finished goods into accounts receivables

Conversion of accounts receivables into cash

Due to the circulating nature of current assets it is known as circulating or revolving capital.

In case of trading business, the operating cycle will include the length of time taken for
conversion of cash into debtors and conversion of debtors to cash.

DETERMINATION OF OPERATING CYCLE

The following formula can be used to compute operating cycle:

Raw material and storage = Average stock of raw material/Average raw material
consumption per day
Work in a progress =

Average work in progress inventory/Total cost of production per day

Finished goods conversion period =

Average stock of finished goods/Total cost of sales per day

Receivables conversion period = Average accounts receivables/Net credit sales per day

Payables deferral period =

Average purchases/Net credit purchases per day

CASH CONVERSION CYCLE

Cash conversion cycle is a cycle which consists of 3 periods, which equals the
length of time between the firm's actual cash expenditures to pay for productive resources
and its own cash receipts from the sale of products/services (that is the length of time
between paying for labor and materials and collecting on receivables). Thus cash conversion
cycle equals the average length of me money is tied in current assets.

Cash conversion cycle can be expressed by the mathematical equation given below:

Inventory conversion period = inventory/sales per day

Receivables collection period = receivables/average sales of the year

Payables deferral period = payables/purchases per day

CALCULATION OF DURATION OF TIME OR OPERATING

CYCLE:
The duration of the operating cycle for the purpose of determining working capital
requirements is equivalent to the sum of the durations of each of the stages less the credit
period allowed by the creditors of the firm.

Symbolically the duration of the working capital cycle can be stated as follows:
O-R+W+F+D-C where,

0 - Duration of the operating cycle

R Raw materials and stores storage periodi

W Work-in-progress period

F Finished stock storage period

D Debtors collection period

C Creditor's payments period.

Each of the components of the operating cycle can be calculated as follows:

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

W = Average work in progress inventory/Average cost of production per day

F = Average finished stock inventory/Average cost of goods sold per day

D = Average book debts/Average credit purchases per day

C = Average trade creditors/Average credit purchases per day

3.6 SOURCES OF WORKING CAPITAL

The working capital required in business can be raised through various sources These
sources can be classified into long term and short term sources which is explain
below:

Long term Sources of Working Capital

Long term sources are sources through which funds are raised for a longer period of time. In
order to ensure appropriate liquidity for the enterprise, it would be wise to meet the
permanent or core part of working capital through long term sources. This would also make it
possible to reduce the overall cost since cost of long term funds is often lower than short
term funds.

Some of the main long term sources that may be tapped for working capital are:

1. Issue of Shares
Issue of shares is the most important sources of raising the long term capital. company can
issue various types of shares such as equity, deferred share etc.

2. Floating of Debentures:
A debenture is an instrument issued by a company acknowledging debt to its
holders. The firm issuing debentures enjoys a number of benefits such as trading on
equity, retention of control of tax benefits etc.

3. Accepting Public deposit;

Public deposits are the fixed deposits accepted by a business enterprise directly from the
public. Tapping public deposit is directly related to the image of the company.

4. Raising Funds by Internal financing:

It means the reinvestment made by a company of its surplus earnings in its business. It is
the internal source of finance which can be funded for raising permanent working capital
requirements.

Short term Sources of Working Capital

This provides financial assistance for a shorter period of time 1.e. less than one
year. The firm must arrange these sources in advance to meet day-to-day operational
expenses.

1. Trade credit:
Trade credit refers to the credit that a customer avalls from the supplier of goods in the
normal course of business. In short, the buying firms (customer) do not have to pay cash
immediately for the purchases made. This deferral payment is nothing but short term
financing which is a major source of short term finance to firms.

2. Accrued expenses and deferred incomes:

a) Accrued expenses represent a liability that a firm has to pay for the services which it
has already received. Some of the accrual includes wages, salaries, taxes, interest etc.
which has to be paid after some fixed interval of time. Thus, they represent Interest free
sources of financing.
b) Deferred income represents funds received by the firm for goods and services which It
has agreed to supply in future. These receipts increase the firm's liquidity in the form of cash.
So, they constitute an important source of short term finance. Advance payments made by
customers comprise the main form of deferred income.

3.Bank finance:

Banks are the main source of working capital finance. A firm can withdraw from a bank
within the maximum credit limit approved. It can withdraw funds from the following forms
listed below:

I.Overdraft:
Under this facility, the borrower is allowed to withdraw funds in excess of the balance in his
current account up to a certain limit during stipulated period. It is a very flexible agreement
as the borrower can withdraw and repay funds whenever he desires. Interest is charged on a
daily balance on the amount actually withdrawn subject to some minimum charges. Under
this the borrower operates the accounts through cheques.

(ii) Cash credit

Under this facility, the borrower is allowed to withdraw funds from the bank upto an approved
credit limit. Borrower can draw money periodically to the extent of his requirements and
repay it by depositing surplus funds in his cash credit account wherein there is no
commission charged. Therefore, interest is payable on the amount actually utilized by the
borrower. It is approved against the security of current assets.

(iii) Bills purchasing and discounting

Under this facility, a borrower obtains credit from a bank against the bills . The bank
purchases or discounts the borrower's bills.

3.7 MANAGEMENT OF INVENTORY

INTRODUCTION:

Inventories constitute a major element of working capital. It is therefore important that

investment in inventory is properly controlled. The inventory management has to take care of
deciding minimum and maximum level, issues, receipts and inspection of inventory,
determining EOQ, proper storage facility, keeping check over obsolescence and ensuring
control over movement of inventories.

INVENTORY:

Inventory means stock of goods meant for sale. The term inventory consists of:
● Raw materials
● Work-in-progress
● Finished goods
● Spares
● Consumables-e.g.: cotton waste, oil soaps etc.

INVENTORY MANAGEMENT

Inventory management is concerned with the activities employed in maintaining the optimum
number or amount of each inventory item. The objective of Inventory management is to
provide uninterrupted production, sales, and/or customer-service levels at the minimum cost.

OBJECTIVES OF INVENTORY CONTROL/MANAGEMENT

The Inventory management aims at achieving the following objectives:

(1) To keep the investment on inventories to the minimum.

(II) To minimize ordering and carrying cost.

(ii) To improve quality of products.

(iv) To ensure uninterrupted supply of raw materials to production dept.

(v) To maintain sufficient finished goods to ensure smooth sales operations and efficient
customer service.

INVENTORY MANAGEMENT MOTIVES

1. Transaction Motive: It includes production of goods and sale of goods. And facilitates
uninterrupted production and delivery of order at a given time.
2. Precautionary Motive: Precautionary motive ensures holding of inventory unexpected
changes in demand and supply factors.
3. Speculative Motive: Speculative motive compels to hold some inventories to take
advantage of changes in prices and getting quantity discounts.

IMPORTANCE OF INVENTORY CONTROL MANAGEMENT

The significance of inventory management is:

1 To have the stocks available when they are required.

2. To manage the space availability by preventing stock level going beyond the fored level.

3. To facilitate purchasing economies.

4.To eliminate duplication in ordering or in replenishing stocks by centralizing the stores from
which purchase requisition arise.

5. To maintain adequate accountability of inventory assets.

6. To keep down investment in inventories, inventory carrying costs and obsolescence

losses to the minimum.

7. To serve as a means for the location and disposition of inactive and obsolete items
of stores.

8. To decide which item to stock and which items to procure on demand.

COST OF HOLDING INVENTORY

There are three types of costs involved in holding and managing inventory. They are:
1. Ordering Costs, 2. Carrying Costs and 3. Stock-out Costs.
1. Ordering Costs

Ordering costs pertain to placing an order for the purchase of raw materials. This includes
cost of requisition, cost of preparation of purchase order, cost of sending reminders, cost of
transportation of goods and cost of receiving of goods and cost of unloading the items of
goods. Ordering cost remains fixed irrespective of the size of the order. Therefore ordering
cost per units will be lower for large orders.

2. Carrying Costs

It consists of cost of carrying or holding stocks. They are:

(i) Cost of storage such as rent of the godown, salary of the warehouse
(ii) Insurance premium for the goods in stores and warehouse.
(iii) Risk of obsolescence and deterioration.
(iv) Risk of theft, damage, pilferage and fire.
(v) Interest on the funds locked up in Inventories.
(vi) Fall in prices of materials or finished goods.

Carrying costs are directly proportionate to the size of the inventories held. Hence, carrying
costs favour minimum inventories.

3. Stock-out Costs

They refer to the costs that may arise due to stoppage of production or business due to
shortage of inventories, shortage of inventories may arise on account of power failure,
machine breakdown, strike, lockout, civil disturbances and the like. Stock-out favour the
holding of large inventories.

TECHNIQUES OF INVENTORY CONTROL/MANAGEMENT

To exercise control over inventory, following techniques are followed:

1. ABC analysis (Always Better Control)

2. VED Analysis (Vital, Essential, Desirable)
3. FSN analysis(Fast- Moving, Slow-Moving, Non -Moving)
4.HML (high, Medium, Low)
5. SDE (Scarcely, Difficulty, Easily)
6. JIT (Just-In- Time)
7. EOQ (Economic Order Quantity)
8. Determination of stock levels
9. Determination of safety stock
10. Inventory turnover ratios
11. Perpetual inventory system
12. Two bin technique
13. Order cycling system
1. ABC analysis (Always Better Control)

Under this technique materials are classified into three categories viz A category, B category
and C category. Materials of high value and less in number are included in Category A. They
are subject to strict control since it involves huge investment. Materials of moderate value
and moderate in number are included in Category B. They are subject to moderate control.
Materials of low value and large in number are included in Category C. They are subject to
least control since it involves minimal investment. It is depicted in the following table:

II. VED Analysis

This technique is used for the classification of spare parts. The demand for spares depends
upon the performance of the plant and machinery. The spare parts are classified into Vital,
Essential and Desirable.

V-Vital spare parts: They are must for running the business and should be stored
adequately. Non availability of such materials causes havoc in the business,

E-Essential spare parts: They are necessary but can be stocked in less quantity Items
whose non availability can be tolerated for 2-3 days

D-Desirable spare parts: Items whose non availability can be tolerated for a long period.
Stocking may be avoided at times especially when the lead time is less.

The classification of spares under three categories is an important decision. A wrong

classification of spares will create difficulties for production department. The classification of
spare parts should be left to the technical staff because they know the need, urgency and
use of these spares.

III. FSN analysis

F-S-N analysis is based on the consumption pattern of the items. The items under this
analysis are classified into three groups: F (fast moving), S (slow moving) and N
(non-moving).

a) Fast Moving Items: The demand for fast moving items is generally high. Thus,
special care should be taken in respect of these items; otherwise the production may be
interrupted due to shortage of such materials. These items are required to be reviewed
regularly.

b) Slow Moving Items: Inventories which have a low turnover are brought under the category
of slow-moving items. These items are not issued at frequent intervals.

c) Non-Moving Items: The items with almost nil consumption are brought under the category
of no-moving items. All obsolete Inventories constitute this category.

IV. HML (High, Medium, Low):

This is similar to ABC analysis except that, in this analysis, the items are classified
on the basis of unit cost rather than their usage value. The items are classified accordingly

● H: High Unit value> 1000 (Sanctioned by higher officials)

● M: Medium -Unit value 100 to 1000
● L: Low- Unit value < 100

V. SDE

This technique uses the criterion of the availability of items. In this analysis:
S stands for scarcely available items which are short in supply and they have to be stocked
adequately.
D refers to the difficult items in medium quantity. i.e. difficulty to obtain and it can be stocked
in E represents easily available items from the local market and need not be stocked

VI. JIT Just In Time

IT was first introduced by Toyota in Japan. It helps to produce the needed quantity at the
needed time. It involves purchase of materials in such a way that delivery of purchased
materials is assured just before their use or consumption/ demand

Objectives/benefits/advantages of JIT

● It reduces wastage.
● Enhances productivity.
● Continuous flow of production.
● Ensures timely delivery.
● Reduction in carrying cost.
● Reduction in the cost of inspection, cost of early delivery and delayed delivery.

VII. EOQ

Economic order quantity is the quantity of materials which can be purchased at minimum
cost. It aims at minimizing ordering cost and carrying cost.
Assumptions of EOQ Model:

(i) Demand for the product is constant and uniform throughout the period.
(ii) Lead time is constant.
(iii) Price per unit of the product is constant.
(iv) Inventory holding cost is based on average Inventory.
(v) Ordering costs are constant.
(vi) All demands of the product will be satisfied.

VIII. Determination of Stock Levels:

An efficient inventory management requires that a firm should maintain an optimum level of
inventory where inventory costs are the minimum and at the same time there is no stock-out
which may result in loss of sale or stoppage of production. Various stock levels are
discussed as follows:

A. Maximum stock level

B. Minimum stock level
C. Reorder level
D. Danger level

a) Maximum Level: It is quantity of materials beyond which a firm should not exceed its
stocks. If the quantity exceeds the maximum level limit then it will be overstocking. A firm
should avoid overstocking because it will result in high material costs.

b) Minimum Level: This represents the quantity which must be maintained in hand all times.
If stock is less than the minimum level then the work will stop due to shortage of materials.

c) Re-ordering Level: When the quantity of materials reaches at a certain figure than
a fresh order is sent to get materials again. The order is sent before the materials reach
minimum stock level.

d) Danger Level: It is the level beyond which materials should not fall in any case. If danger
level arises then immediate steps should be taken to replenish the stocks even if more cost
is incurred in arranging the materials. If materials are not arranged immediately there is a
possibility of stoppage of work.

IX. Determination of safety stock

Safety stock is a buffer stock to meet some unanticipated increase in usage. The stock out
may prove costly by affecting the smooth working of the concern.

X. Inventory turnover ratios

These ratios are calculated to find out whether the inventory is properly utilized or not

Inventory turnover ratio = COGS/Average inventory

Conversion period = No. of days in a year/ ITR

Where,

COGS = cost of goods sold

ITR = Inventory Turnover Ratio

XI. Perpetual inventory system

Normally, stocktaking is done at the end of the year. In a perpetual system, the stock taking
may be done either regularly or continuously. The procedure is as under

a) Stock taking team selects the store room, where stock is to be done, on a random
basis.
b.)All the bins in that storeroom are checked.
c.)The physical balance in the bin is counted or measured, dependent on the type of
the material.
d.)The actual stock is recorded in the sheets provided for this purposes.
e.)There is no prior intimation to the stores department to maintain surprise element.
f.)All the stores are checked, at least three or four times in a year, on a rotation basis.
g.)There is a surprise element to the stores personnel so that shortages cannot be
accommodated from other sources as intimation is given on the day of checking only.
h.)If there is discrepancy between stock ledgers, bin card with physical stocks, they are
investigated, immediately, as there could be posting mistakes in stores ledger
i.)Only after verification and obtaining proper approval, shortages and excess, if any
are recorded in the bin cards and stores ledger, as physical stocks rule the actual
position.

XII. Two bin technique

It is the oldest technique of inventory control. This technique is used to control C Category
Inventory. Under this technique inventory is separated into two bins or groups. First bin
contains the stock just enough to last from the date a new order is placed until it is received
for Inventory. The second bin contains the stock which is enough to meet the current
demands.

XIII. Order cycling system

In this system periodic reviews are made of each item of inventory and orders are placed to
restore the stock to a prescribed supply level. What is the frequency of review? Frequency of
review depends on the criticality of the inventory item. At each review date the required
number of items are ordered to bring the inventory to the predetermined supply level.
 3.8 Management Of Cash

INTRODUCTION:

Cash is one of the current assets of the company. Cash is crucial for any business. It is
needed to keep the business moving on. Shortage of cash leads to stoppage of production
and loss of profits. Cash itself does not produce goods and services. It is used as a medium
to acquire other assets.

CASH

In a narrow sense cash includes currency notes, coins, cheques, demand drafts and bank
demand deposits. But in a broad sense it includes not only the above stated items but also
bank time deposits and marketable securities. Cash is one the current assets of a company.
Cash means liquid assets that a business owns.

MOTIVES OF HOLDING CASH

A firm holds cash for the following purposes:

1. Transaction motive: Under this motive cash is held for paying the day today operating
expenses. For example: Purchase of raw materials, payment of business expenses,
payment of tax, payment of dividends. The need to hold cash would not arise if there is
perfect synchronization between the cash receipts and cash payments.

2. Precautionary motive: Under this motive cash is held by a business concern to meet
various contingencies. Contingencies could be floods, strikes and failure of important
customers, slow down in collection of accounts receivables, sharp increase in the cost of raw
materials etc. It provides a cushion or buffer to withstand some unexpected emergency.

3. Speculative motive: This motive comes from a desire of holding cash to gain in
speculative transactions such as purchase of raw materials at reduced prices on payment of
immediate cash, dealing in commodities in bulk purchasing and selling when rates are
considered favourable.

CASH MANAGEMENT

Cash management means efficient collection and disbursement of cash and any temporary
investment of cash. Maintaining optimum level of cash in an organization is called cash
management. It means forecasting, collecting, disbursing, investing and planning for the
cash a company needs to operate smoothly.

OBJECTIVES/GOALS OF CASH MANAGEMENT

Cash management aims to achieve the following objectives:
1. To maintain a minimum cash reserve.
2. To meet cash disbursement as per Payment schedule.
3. To meet cash collection as per repayment schedule.
4. To minimize funds locked up as cash balance by maintaining optimum cash balance.
5. To seize potential opportunities for profitable long term investments.
6. To minimize the operating cost of cash management.
7. To earn a cash balance.
8. To build the image of creditworthiness.
9. To meet requirements of bank relationships.
10. To satisfy day-today business requirements,

IMPORTANCE OF CASH MANAGEMENT

Cash management has assumed importance because of the following points

1.Cash forecasting: Cash inflow and outflows should be planned to project cash
surplus or deficit for each period of planning. Cash budget should be prepared for
this purpose. Cash Budget means estimation of cash receipt and cash disbursement
during a future period of time. Cash budget is a forecast of future cash receipts and cash
disbursement over various intervals of time.

2. Managing the Cash Flows: The inflow and outflow of cash should be properly managed.
The inflows of cash should be accelerated while the outflow of cash should be decelerated
as far as possible.

3. Optimum Cash Level: The firm should decide on the appropriate level of cash balances.
The cost of excess cash and the danger of cash deficiency should be matched to determine
the optimum level of cash balances.

4. Investing Idle Cash: The idle cash or precautionary cash balance should be property
invested to earn profit. The firm should decide on the division of such cash balance between
bank deposits and marketable securities.

5. Cash Planning: Cash Inflows and outflows are inseparable parts of the business
operations of all firms. The firm needs cash to invest in inventories, receivables and fixed
assets and to make payments for operating expenses in order to maintain growth in sales
and earnings. It is possible that a firm may be making adequate profits but may suffer from
the shortage of cash as its growing needs may be consuming cash very fast. Thus cash
planning is essential.

FUNCTIONS OF CASH MANAGEMENT

The finance manager has to ensure that investment in cash is efficiently utilized.

Efficient cash management functions calls for cash planning, evaluation of benefits and
costs of policies, procedures and practices and synchronisation of cash inflows and outflows.
 1. It forecasts the cash inflows and cash outflows.
2. It determines the safety level of the cash balance.
3. It monitors the safety level of cash balance.
4. It regulates the cash inflows.
5. It regulates the cash outflows.
6. It undertakes aggressive search for relatively more productive uses for surplus
funds.
7. Plans the investment avenues for excess cash balance.
8. It avails the banking facilities and maintains good relationship with bankers.
9. It protects the organization from cash embezzlement through strict supervision.
10. It ensures the liquidity position of the organization.

BENEFITS OF CASH MANAGEMENT

● Increase the amount and speed of cash flowing into the company.
● Reduces the amount and speed of cash flowing out.
● Makes the most efficient use of available cash.
● Takes advantage of money-saving opportunities such as cash discounts.
● Develops a sound borrowing and repayment program.
● Impresses lenders and investors.
● Reduces borrowing costs by borrowing only when necessary.
● Provides funds for expansion.
● Plans for investing surplus cash..
● Finances seasonal business needs.

TOOLS/TECHNIQUES OF CASH MANAGEMENT

The following are some of the techniques which ensure speedy collection of ca

slowing disbursements:

1. Cash management planning:

Cash planning is a technique to plan and control the use of cash. It protects the financial
condition of the firm by developing a projected cash statement from a foreca of expected
cash inflows and outflows for a given period. The forecast may be based on the present
operations or the anticipated future operations. Cash plans are very crucial in developing the
overall operating plans of the firm.

Cash planning may be done on a daily, weekly or monthly basis. The period and frequency
of cash planning generally depends upon the size of the firms and philosophy of the
management. Large firms prepare daily and weekly forecasts Medium-size firms usually
prepare weekly and monthly forecasts. Small firms may not prepare formal cash forecasts
because of the non-availability of information and information and small-scale operations. As
a firm grows and business operations become complex, cash planning becomes inevitable
for its continuing success. In order to take care of all these considerations, the firm should
prepare a cash budget.

Cash Budget means estimation of Cash Receipt and Cash Disbursement during a future
period of Time. Cash Budget is a forecast of future Cash Receipts and Cash Disbursement
over various intervals of Time.

According to Guthmen and Dougal, "Cash budget is an estimate of and disbursements for a
future period of time".

Characteristics of Cash Budget:

1. Cash budget is a statement of anticipated cash receipts and payments.
2. Cash budget is related to predetermining future period.Working Capital.
3. Cash budget is expressed in terms of monetary values.
4. Cash budget is forecast of financial aspirations of the enterprise.
5. Cash budget is an outline of future policies and actions of the management.

Importance/Benefits of Cash Budget

Following are the benefits of preparing the cash budget:

● Cash budget is helpful in planning.

● It helps in forecasting the future needs of funds.
● It helps in maintenance of optimum cash balance.
● It aids in controlling cash expenditure.
● It facilitates evaluation of performance.
● It helps in the formulation of a sound dividend Policy.
● It is a basis of long term planning and coordination.
● Testing the influence of proposed expansion.

2. Cash management control:

This technique involves:

1. Accelerating cash inflows

2. Slowing down cash outflows

Accelerating cash inflows:

Cash management is successful only when collections are accelerated and cash
disbursement, as far as possible delayed. The following methods of cash management will
help to accelerate cash inflows

● Prompt payment by customers

● Quick conversion of payment into cash
 ● Decentralized collection
● Lock box system

Prompt Payment by Customers

Following are the ways through which a firm can prompt payment from customers:

● In order to accelerate cash inflows the collections from customers should be prompt.
This will be possible by prompt billing. The customers should be promptly informed
about the amount payable and the time by which it should be paid. It will be better if a
self addressed envelope is sent along with the bill and quick reply is requested.
● Another method for prompting customers to pay earlier is to allow them a cash
discount. The availability of discount is a good saving for the customers and in an
anxiety to earn it they make quick payments. Cash discount is an allowance given to
the customers to enable them to make the payment promptly.
● Cash inflows can be accelerated by improving the cash collecting process. Once the
customer writes the cheque in favour of the concern the collection can be quickened
by its early collection.

Quick conversion of payment into Cash:

This is another method of accelerating cash inflows. It includes the following:

● Managing time, time taken by the post office for transferring the cheque from
customer to the firm. It is referred to as a postal float.
● Time taken in processing the cheque within the organization and sending it to the
bank for collection is called lethargy.
● Collection time within the bank i.e time taken by the bank in collecting the payment
from the customer's bank, it is called bank float.
● The postal float, lethargy and bank float are collectively referred to as deposit float.
● The term deposit float refers to the cheques written by the customers but the amount
not yet usable by the firm. An efficient cash management will be possible only if the
time taken in deposit float is reduced and make the money available for use. This can
be done by decentralizing collections.

Decentralized Collection:

This is also one of the techniques of accelerating cash inflows. A big firm operating over a
wide geographical area can accelerate collections by using the system of decentralized
collections. Under this method a number of collection centres are opened in different areas
instead of collecting receipts at one place. The idea of opening different collecting centres is
to reduce the mailing time from customer's despatch of cheque and its receipt in the firm and
then reducing the time in these cheques. On the receipt of the cheque it is immediately sent
for collection. Since the party may have issued the cheque on a local bank, it will not take
much time in collecting it. The amount so collected is sent to the central office at the earliest.
Decentralized collection system saves mailing and processing time.
Lock Box System:

Under this system the firm selects some collecting centres at different places. The places
are selected on the basis of the number of customers and the remittances to be received
from a particular place. The firm hires a post box in a post office and the parties are asked to
send the cheques on that post box number. A local bank is authorized to operate the post
box. The bank will collect the post a number of times in a day and start the collection
process of cheques. The amount collected is credited to the firm's account. The bank will
prepare a detailed account of cheques received which will be used by the firm for processing
purposes. This system reduces the delays due to mailing and processing time.

B. Deaccelerating /Slowing Cash Outflows

Following are the methods of deaccelerating cash outflows/cash payments:

● Paying on last day

● Adjusting payroll
● Centralization of payments
● Making use of float

Paying on Last Date:

The disbursements can be delayed on making payments on the last date only. If the credit is
for 10 days then payment should be made on 10 day only. It can help in using the money for
short periods.

Adjusting payroll:

Economy can be exercised on payroll funds also. It can be done by reducing the frequency
of payments. If the payments are made weekly then this period can be extended to a month.
Secondly the finance manager can plan the issuing of salary cheques and their
disbursements. If the cheques are issued on Saturday then only a w cheques may be
presented for payment, even on Monday all cheques may not be presented. On the basis of
his past experience, a finance manager can deposit the money in a bank because it may be
clear to him about the average time taken by employees in encashing their pay cheques.

Centralization of Payments:

The payments should be centralized and payments should be made through drafts and
cheques. When cheques are issued from the main office then it will take time for the
cheques to be cleared through post. The benefit of cheque collecting time is availed.

Making use of Float:

There is a time lag between the issue of a cheque by the firm and its presentation bits bank
by the customer's bank for payment. The implication is that although the deque has been
issued, cash would be required later when the cheque is presented trencashment. Therefore
a firm can send remittances although it does not have cash its bank at the time of issuance
of the cheque. Meanwhile funds can be arranged to make payment when the cheque is
presented for collection after a few days. Float used in this sense is called cheque kiting.

3.Determining the Optimum Cash Balance:

One of the primary responsibilities of the financial manager is to maintain a sound liquidity
position of the firm so that the dues are settled in time. The firm needs cash to One of the
primary responsibilities of the financial manager is to maintain a sound Purchase raw
materials and pay wages and other expenses as well as for paying dividend, Interest and
taxes. The test of liquidity is the availability of cash to meet the fm's obligations when they
become due.

Liquid balance must be maintained at the optimum level. It is the level which
gives the minimum cost of holding the liquid balance. Determination of such a level is
very important for efficient cash management. If the liquid balance exceeds the
required balance, it remains idle and, therefore, it involves opportunity costs in the sense
that the amount could have been put to more effective use. Now the liquidity position of the
enterprise becomes more sound. On the other hand, if liquid balance is short of the
requirements, the firm may have to incur storage costs.

Thus, if a firm maintains less cash balance, then its liquidity position will be weak.If higher
cash balance is maintained, then there will be wastage. Thus a firm should maintain an
optimum cash balance, neither a small nor a larger cash balance

4. Investing Surplus Cash:

Cash not required for temporary periods of short durations can be invested in near-cash
assets, i.e. marketable securities which are readily convertible into cash. Even though the
cash is temporarily idle, it should not be kept so because if the firm has an opportunity to
earn interest through investing it in marketable securities, why should it not avail of the
same.

3.9 MANAGEMENT OF ACCOUNT RECEIVABLES:

INTRODUCTION

A concern is required to allow credit sales in order to expand its sales volume. It is
not always possible to sell goods on a cash basis only. Sometimes, firms might have
established a practice of selling foods on credit basis. Under these circumstances, it is not
possible to avoid credit sales. The increase in sales is also essential to increase profitability.
Thus receivables constitute a significant portion of current assets of a firm.

Meaning of Receivables:

Receivables represent amounts owed to the firm as a result of sale of goods or services in
the ordinary course of business. These are claims of the firm against its customers and form
part of its current assets. Receivables are also known as accounts receivables, trade
receivables, customer receivables or book debts.

COST OF MAINTAINING RECEIVABLES:

The allowing of credit to customers means giving of funds for the customer's use The
concern incurs the following costs on maintaining receivables:

1. Cost of Financing Receivables: When goods and services are provided on credit then
concern's capital is allowed to be used by the customers. The receivables are financed from
the funds supplied by shareholders for long term financing and through retained earnings.
The concerns incur some cost for collecting funds which finance receivables. In other words
it is capital blocked in bills receivables or credit sales.

2. Cost of Collection: A proper collection of receivables is essential for receivables

management. The customers who do not pay the money during a stipulated credit period are
sent reminders for early payments. Some persons may have to be sent for collecting these
amounts. All these costs are known as collection costs which a concern is generally required
to incur.

3. Bad debts: Sometimes customers may fail to pay the amounts due towards them. The
amounts which the customers fail to pay are known as bad debts.

Characteristics of Receivables

The Receivables have the following characteristics:

● Receivables involve the risk of bad debts.

● Implies futurity i.e., buyers make the payment in future.
● It is based on economic value.

RECEIVABLES MANAGEMENT

Receivables management is the process of making decisions relating to investment in trade

debtors. Certain investment in receivables is necessary to increase the sales and profits of a
firm. But at the same time investment in this asset involves cost consideration also. Further
there is a risk of bad debts too.

Importance of Receivables Management

The main purposes of accounts receivables arising out of credit sales from the
view points of manufacturers, wholesalers and other sellers of goods and services are:

(1) To increase the sales volume by selling large quantity to customers without demanding
immediate payment.
(2) To increase profitability of the firm. Increase in sales volume on credit basis.increases
profit. Besides, firms enjoy the advantages of higher margin in credit sales.
(3) To meet the competition and to retain market shares, a firm resorts to credit sales in
order to follow similar practices of the competitors.
(4) To avoid diminishing sales turnover.
(5) To avoid sadling a company with unnecessary long-term debt.
(6) To establish a continuous source of liquid working capital.
(7) To increase working capital turnover.
(8) To Improve return on invested capital.
(9) To protect and improve credit ratings.
(10) To take advantage of profitable opportunities requiring additional cash.

Objectives Receivables Management

The basic objectives of Accounts Receivables are as follows:

(1) To maximize firm's value.
(ii) To ensure optimum investment in sundry debtors.
(iii) To control the cost of credit.

Benefits of Receivables Management

(1) It results in increase in sales.

(ii) It leads to increase in profits.
(iii) It results in increase in market share.

FACTORS INFLUENCING THE SIZE OF RECEIVABLES

The amount to be blocked in receivables depends upon the following factors:

1.Size of Credit Sales: The volume of credit sales is the first factor which increases or
decreases the size of receivables. If a concern sells only on cash basis, as in the case of
Bata Shoes Company, then there will be no receivables. The higher the part of credit sales
out of total sales, figures of receivables will also be more or vice versa.

2. Credit Policies: A firm with conservative credit policy will have a low size of
receivable while a firm with liberal credit policy will be increasing this figure. The vigour with
which the concern collects the receivables also effects its receivables.

3. Terms of Trade: The size of receivables also depends upon the terms of trade. The period
of credit allowed and rates of discount given are linked with receivables. If credit period
allowed is more, then receivables will also be more. Sometimes trade policies of competitors
have to be followed otherwise it becomes difficult to expand the sales.

4. Expansion Plan: When a concern wants to expand its activities, it will have to enter new
markets. To attract customers, it will give Incentives in the form of credit facilities. The
periods of credit can be reduced when the firm is able to get permanent customers. In the
early stages of expansion more credit becomes

essential and size of receivables will be more. Credit Collection Efforts: The collection of
credit should be streamlined. The customers should be sent periodical reminders if they fail
to pay in time. On the other hand, if adequate attention is not paid towards credit collection
then the

5.concern can land itself in a serious financial problem. An efficient credit collection
machinery will reduce the size of receivables.

6. Habits of Customer: The paying habits of customers also have a bearing on the size of
receivables. The customers may be in the habit of delaying payments even though they are
financially sound. The concern should remain in touch with such customers and should
make them realize the urgency of their needs.

MONITORING ACCOUNTS RECEIVABLES/TECHNIQUES

OF RECEIVABLES MANAGEMENT

There are traditional techniques for monitoring accounts receivables. They are -

(a) Receivables turnover

(b) Average collection period
(c) Aging schedule and
(d) Collection matrix

a. Receivables turnover provides relationship between credit sales and debtors of a

firm. It indicates how quickly receivables or debtors are converted into cash.
Ramamurthy observes "collection of debtors is the concluding stage for process of
sales transaction".

Debtors Receivables Turnover ratio = Credit Sales /Average Debtors or or

receivables.
b. Average Collection Period (ACP) It tells how long a firm takes to convert
the help of the following formula
ACP = 365/ Debtors or receivables

FINANCING OF WORKING CAPITAL

The working capital requirements of a concern can be classified as:

(a) Permanent or Fixed working capital requirements.

(b) Temporary or Variable working capital requirements.

In any concern, a part of the working capital investments are as permanent investments in
fixed assets. This is so because there is always a minimum level of current assets which are
continuously required by the enterprise to carry out its day-to-day business operations and
this minimum cannot be expected to reduce at any time. This minimum level of current
assets gives rise to permanent or fixed working capital as this part of working capital
is permanently blocked in current assets.
 Similarly, some amount of working capital may be
required to meet the seasonal demands and some special exigencies such as rise in prices,
strikes, etc. this proportion of working capital gives rise to temporary on variable working
capital which cannot be permanently employed gainfully in business.
The fixed proportion of
working capital should be generally financed from the fixed capital sources while the
temporary or variable working capital requirements of a concern may be met from the short
term sources of capital.
The various sources for the financing of working capital are as
follows:

FINANCING OF PERMANENT/FIXED OR LONG-TERM WORKING

CAPITAL:

Permanent working capital should be financed in such a manner that the enterprise may
have its interrupted use for a sufficiently long period. There are five important sources of
permanent or long-term

1. Shares. Issue of shares is the most important source for raising the permanent or
long-term capital. A company can issue various types of shares as equity shares, preference
shares and deferred shares. According to the Companies Act, 1956, however, a public
company cannot issue deferred shares. Preference shares carry preferential rights in
respect of dividend at a fixed rate and in regard to the repayment of capital at the time of
winding up the company. Equity shares do not have any fixed commitment charge and the
dividend on these shares is to be paid subject to the availability of sufficient profits. As far as
possible, a company should raise the maximum amount of permanent capital by the issue of
shares.
2. Debentures. A debenture is an instrument issued by the company acknowledging its debt
to its holder. It is also an important method of raising long-term or permanent working capital.
The debenture-holders are the creditors of the company. A fixed rate of interest is paid on
debentures. The interest on debentures is a charge against a profit and loss account. The
debentures are generally given floating charge on the assets of the company. When the
debentures are secured they are paid on priority to other creditors. The debentures may be
of various kinds such as simple, naked or unsecured debentures, secured or mortgaged
debentures, redeemable debentures. irredeemable debentures, convertible debentures and
non-convertible debentures. The debentures as a source of finance have a number of
advantages both to the investors and the company. Since interest on debentures have to be
paid on certain predetermined intervals at a fixed rate and also debentures get priority on
repayment at the time of liquidation, they are very well suited to cautious investors. The firm
issuing debentures also enjoys a number of benefits such as trading on equity, retention of
control, tax benefits, etc.

3. Public Deposits. Public deposits are the fixed deposits accepted by a business enterprise
directly from the public. This source of raising short term and medium-term finance was very
popular in the absence of baking facilities. In the past, generally, public deposits were
accepted by textile industries in Ahmedabad and bay for periods of 6 months to 1 year. But
now-a-days even long-term deposits for 5 to 7 years are accepted by the business houses.
Public deposits as a source of finance have a large number of advantages such as a very
simple and convenient source of finance, taxation benefits, trading on equity, no need for
securities and an inexpensive source of finance. But it is not free from certain dangers such
as, it is an uncertain, unreliable, unsound and inelastic source of finance. The Reserve Bank
of India has also laid down certain limits on public Non-banking reserves. deposits. concerns
cannot borrow by way of public deposits more than 25% of its paid-up capital and free

4.Ploughing Back of Profits. Ploughing back of profits means reinvesting earnings in its
business. It is an internal source of finance and is not suitable for an established firm for
expansion, modernisation and replacement etc. This method of finance has a number of
advantages as it is the cheapest rather cost-free source of finance; there is no need to keep
securities; there is no dilution of control ; it ensures stable dividend policy and gains
confidence of the public. But excessive resort to ploughing back of profits may lead to
monopolies, misuse of funds, over capitalisation and speculation, etc.

5. Loans from Financial Institutions. Financial institutions such as Commercial Banks, Life
Insurance Corporation, Industrial Finance Corporation of India, State Financial Corporations,
State Industrial Development Corporations, Industrial Development Bank of India, etc. also
provide short-term, medium-term and long-term loans. This source of finance is more
suitable to meet the medium-term demands of working capital. Interest is charged on such
loans at a fixed rate and the amount of the loan is to be repaid by way of instalments in a
number of years.
FINANCING OF TEMPORARY, VARIABLE OR SHORT-TERM WORKING
CAPITAL The main source of short-term working capital are as follows:

1. Indigenous Bankers

2. Trade Credit

3. Instalment Credit

4. Advances

5. Accounts Receivable Credit or Factoring

6. Accrued Expenses

7. Deferred Incomes

8. Commercial Paper 9. Commercial Banks

1. Indigenous Bankers:

Private money-lenders and other country bankers used to be the only source of finance prior
to the establishment of commercial banks. They used to charge very high rates of interest
and exploited the customers to the largest extent possible. Now-a-days with the
development of commercial banks they have lost their monopoly. But even today some
business houses have to depend upon indigenous bankers for obtaining loans to meet their
working capital requirements.

2. Trade Credit:

Trade credit refers to the credit extended by the suppliers of goods in the normal course of
business. As present day commerce is built upon credit, the trade credit arrangement of a
firm with its suppliers is an important source of short-term finance. The credit-worthiness of a
firm and the confidence of its suppliers are the main basis of securing trade credit. It is
mostly granted on an open account basis whereby supplier sends goods to the buyer for the
payment to be received in future as per terms of the sales invoice. It may also take the form
of bills payable whereby the buyer signs a bill of exchange payable on a specified future
date.

When a firm delays the payment beyond the due date as per the terms of sales invoice, it is
called stretching accounts payable. A firm may generate additional short-term finances by
stretching accounts payable, but it may have to pay penal interest charges as well as to
forgo cash discount. If a firm delays the payment frequently, it adversely affects the credit
worthiness of the firm and it may not be allowed such credit facilities in future.

The main advantages of trade credit as a source of short-term finance include:

(i) It is an easy and convenient method of finance.
(ii) It is flexible as the credit increases with the growth of the firm.
(iii) It is an informal and spontaneous source of finance.

However, the biggest disadvantage of this method of finance is charging higher prices by the
suppliers and loss of cash discount.

3.Instalment Credit:

This is another method by which the assets are purchased and the possession of goods is
taken immediately but the payment is made in instalments over a predetermined period of
time. Generally, interest charged on the unpaid price or it may be adjusted in the price. But,
in any case, it provides funds for sometime and is used as a source of short-term working
capital by many business houses which have difficult fund positions.

4. Advances:

Some business houses get advances from their customers and agents against orders and
this source is a short-term source of finance for them. It is a cheap source of finance and in
order to minimise their investment in working capital, some firms having long production
cycles, specially the firms manufacturing industrial products prefer to take advances from
their customers.

5.Factoring or Accounts Receivable Credit:

Another method of raising short term finance is through accounts receivable credit offered by
commercial banks and factors. A commercial bank may provide finance by discounting the
bills or invoices of its customers. Thus, a firm gets immediate payment for sales made on
credit. A factor is a financial institution which offers services relating to management and
financing of debts arising out of credit sales. Factoring is becoming popular all over the world
on account of various services offered by the institutions engaged in it. Factors render
services varying from bill discounting facilities offered by commercial banks to a total take
over of administration of credit sales including maintenance of sales ledger, collection of
accounts receivables, credit control and protection from bad debts, provision of finance and
rendering of advisory services to their clients. Factoring may be on a recourse basis, where
the risk of bad debts is borne by the client, or on a non-recourse basis, where the risk of
credit is borne by the factor. At present, factoring in India is rendered by only a few financial
institutions on a recourse basis However, the Report of the Working Group on Money Market
(Vaghul Committee) constituted by the Reserve Bank of India has recommended that banks
should be encouraged to set up factoring divisions to provide speedy finance to the
corporate entities.

In Spite of many services offered by factoring, it suffers from certain limitations. The most
critical fall outs of factoring include;

(i) the high cost of factoring as compared to other sources of short-term finance,
(ii) the preception of financial weakness about the firm availing factoring services, and
(iii) adverse impact of tough stance taken by factor, against a defaulting buyer, upon the
borrower resulting into reduced future

6. Accrued Expenses:

Accrued expenses are the expenses which have been incurred but not yet due and hence
not yet paid also. These simply represent a liability that a firm has to pay for the services
already received by it. The most important items of accruals are wages and salaries,
interest, and taxes. Wages and salaries are usually paid on monthly, fortnightly or weekly
basis for the services already rendered by employees. The longer the payment-period, the
greater is the amount of liability towards employees or the funds provided by them. In the
same manner, accrued interest and taxes also constitute a short-term source of finance.
Taxes are paid after collection and in the intervening period serve as a good source of
finance. Even income-tax is paid periodically much after the profits have been earned. Like
taxes, interest is also paid periodically while the funds are used tinuously by a firm. Thus, all
accrued expenses can be used as a source of finance.

The amount of accruals varies with the change in the level of activity of a firm. When the
activity level expands, accruals also increase and hence they provide a spontaneous source
of finance. Further, as no interest is payable on accrued expenses, they represent a free
source of financing. However, it must be noted that it may not be desirable or even possible
to postpone these expenses for a long period. The payment period of wages and salaries is
determined by provisions of law and practice in industry. Similarly, the payment dates of
taxes are governed by law and delays may attract penalities. Thus, we may conclude that
frequency and magnitude of accruals is beyond the control of managements. Even then,
they serve as a spontaneous, interest free, limited source of short-term financing.

7. Deferred Incomes:

Deferred incomes are incomes received in advance before supplying goods or services.
They represen funds received by a firm for which it has to supply goods or services in future.
These funds increase the liquida of a firm and constitute an important source of short-term
finance. However, firms having great demand for its products and services, and those having
good reputation in the market can demand deferred incomes

8. Commercial Paper:

Commercial paper represents unsecured promisory notes issued by firms to raise short-term
funds. Its an important money market instrument in advanced countries like U.S.A. In India,
the Reserve Bank of Inda introduced commercial paper in the Indian money market on the
recommendations of the Working Group Money Market (Vaghul Committee). But only large
companies enjoying high credit rating and sound financial health can issue commercial
paper to raise short-term funds. The Reserve Bank of India has laid down a number of
conditions to determine eligibility of a company for the issue of commercial paper. Only a
company which is listed on the stock exchange, has a net worth of at least Rs. 10 crores and
a maximum permissible bank finance of Rs. 25 cr res can issue commercial paper not
exceeding 30 percent of its working capital limit
The maturity period of commercial paper, in India, mostly ranges from 91 to 180 days. It is
sold at discount from its face value and redeemed at face value on its maturity. Hence, the
cost of raising funds, through this source, is action of the amount of discount and the period
of maturity and no interest rate is provided by the Reserve ink of India for this purpose.
Commercial paper is usually bought by investors including banks, insurance companies, unit
trusts and firms to invest surplus funds for a short-period. A credit rating agency, called
CRISIL, has been set up in India by ICICI and UTI to rate commercial papers. Commercial
paper is a cheaper source of raising short-term finance as compared to the bank credit and
proves to be effective even during periods of tight bank credit. However, it can be used as a
source of finance only by large companies enjoying high credit ratings and sound financial
health. Another disadvantage of commercial paper is that it cannot be redeemed before the
maturity date even if the issuing firm has surplus funds to pay back.

9. Working Capital Finance By Commercial Banks:

Commercial banks are the most important source of short-term capital. The major portion of
working capital loans are provided by commercial banks. They provide a wide variety of
loans tailored to meet the specific requirements of a concern. The different forms in which
the banks normally provide loans and advances are as follows:

(a) Loans

(b) Cash Credits

(c) Overdrafts

(d) Purchasing and Discounting of bills.

(a) Loans. When a bank makes an advance in lump-sum against some security it is called a
loan. In case of a loan, a specified amount is sanctioned by the bank to the customer. The
entire loan amount is paid to the borrower either in cash or by credit to his account. The
borrower is required to pay interest on the entire amount of the loan from the date of the
sanction. A loan may be repayable in lump sum or instalments. Interest on loans is
calculated at quarterly rests and where repayments are stipulated in instalments, the interest
is calculated at quarterly rests on the reduced balances. Commercial banks generally
provide short-term loans up to one year for meeting working capital requirements. But
now-a-days term loans exceed the one year break provided by banks. The term loans may
be either medium-term or long-term loans.

(b) Cash Credits. A cash credit is an arrangement by which a bank allows his customer to
borrow money upto a certain limit against some tangible securities or guarantees. The
customer can withdraw from his c credit limit according to his needs and he can also deposit
any surplus amount with him. The interest in cash cash credit is charged on the daily
balance and not on the entire amount of the account. For these reasons, its most favourite
mode of borrowing by industrial and commercial concerns. The Reserve Bank of India issue
directive to all scheduled commercial banks on 28th March 1970, prescribing a commitment
charge banks should levy on the unutilised portion of the credit limits.
(c) Overdrafts. Overdraft means an agreement with a bank by which a current
account-holder is allowed to withdraw more than the balance to his credit upto a certain limit.
There are no restrictions for operation of overdraft limits. The interest is charged on daily
overdrawn balances. The main difference etween cash credit and overdraft is that overdraft
is allowed for a short period and is a temporary accomodation whereas the cash credit is
allowed for a longer period. Overdraft accounts can either be clean overdrafts, partly
secured or fully secured.

(d) Purchasing and Discounting of Bills. Purchasing and discounting of bills is the most
important form in which a bank lends without any collateral security. Present day commerce
is built upon credit. The eller draws a bill of exchange on the buyer of goods on credit. Such
a bill may be either a clean bill or a documentary bill which is accompanied by documents of
title to goods such as a railway receipt. The bank discount. At the maturity of the bills, the
bank presents the bill to its acceptor for payment. In case the bill discounted is dishonoured
by non-payment, the bank recovers the full amount of the bill from the customer along with
expenses in that connection.

In addition to the above mentioned forms of direct finance, commercial banks help their
customers in obtaining credit from their suppliers through the letter of credit arrangement.

Letter of Credit:

A letter of credit popularly known as L/c is an undertaking by a bank to honour the

obligations of its customer upto a specified amount, should the customer fail to do so. It
helps its customers to obtain credit from suppliers because it ensures that there is no risk of
non-payment. L/c is simply a guarantee by the bank to the suppliers that their bills upto a
specified amount would be honoured. In case the customer fails to pay the amount, on the
due date, to its suppliers, the bank assumes the liability of its customer for the hases made
under the letter of credit arrangement.

A letter of credit may be of many types, such as:

(i) Clean Letter of Credit. It is a guarantee for the acceptance and payment of bills without
any conditions.

(ii) Documentary Letter of Credit. It requires that the exporter's bill of exchange be
accompanied by certain documents evidencing title to the goods.
(iii) Revocable Letter of Credit. It is one which can be withdrawn by the issuing bank without
the prior consent of the exporter.
(iv) Irrevocable Letter of Credit. It cannot be withdrawn without the consent of the
beneficiary.
(v) Revolving Letter of Credit. In such a type of letter of credit the amount of credit is
automatically reversed to the original amount after such an amount has once been paid as
per defined conditions of the business transaction. There is no deed for further application
for another letter of credit to be issued provided the conditions specified in the first credit are
fulfilled.
(vi) Fixed Letter of Credit. It fixes the amount of financial obligation of the issuing bank either
in one bill or in several bills put together. curity Required in Bank Finance