20-06-2014, 04:47 PM
Working capital management
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Introduction
Working capital or Short term finance: refers to current assets and current liabilities
There are two concepts of working capital:
Gross working capital i.e. current assets
Net working capital i.e. current assets – current liabilities
Working capital management : it is a continuous process of making decisions relating to short term financing it deals with current assets and current liabilities.
Management of working capital refers to the management of current assets as well as current liabilities
Determination of level of current assets
An important working capital decision is concerned with determining the level of investment in current assets.
There are two types of working capital policies
Flexible policy (conservative)
Restrictive policy (aggressive)
Flexible policy: under this policy the investment in current asset is high. This means that a firm has huge balance of cash and marketable securities, large amount of inventories, and high level of debtors.
Restrictive policy: under this policy the investment in current asset is low. This means that firm has small balance of cash and marketable securities, small amount of inventories, and low level of debtors.
Determining the optimal level of current assets involves a tradeoff between costs that rise with current assets (carrying costs) and costs that fall with current assets (shortage costs)
Carrying costs: are mainly in nature of the cost of financing a higher level of current assets.
Shortage costs: are mainly in the form of disruption in production schedule, loss of sale, and loss of customer goodwill
Sources of financing working capital
Accruals
Trade credits
Working capital advanced by commercial banks
Public deposits
Inter corporate deposits
Short term loans from financial institutions
Rights debenture for working capital
Commercial papers
Factoring
Accruals
Expenses incurred but not paid. The major accruals items are wages and taxes. Since no interest is paid by the firms on its accruals they are often regarded as free source of finance they are a good source of finance but they are not under the control of management
Trade credit
Refers to the credit that a customer gets from suppliers of goods in the normal course of business. In practice the buying firm do not have to pay cash immediately for the purchases made. This delay of payment is a short term financing called trade credits it contributes to about one third of the short term financing .
Requirements for Obtaining Trade Credit
Earnings record over a period of time
Liquidity position
Record of payment
Cultivating good supplier relationship
Benefits
Easy availability
Flexibility
Informality
Working capital advance by commercial bank
Bank finance are the main institutional sources of working capital finance in India.
Bank considers firms sales and production plans and the desirable level of current assets in determining the working capital requirements. The amount approved is called credit limit.
In practice banks do not lend 100% of the credit limit they deduct margin money. Margin requirement is meant to ensure security
Forms of bank finance
Cash credits or overdrafts
Loans
Purchasing or discounting of bill
Letter of credit
Public deposits
Many firms have solicited unsecured deposits from the public in recent years, mainly to finance their working capital requirements.
Advantages
To the company
The procedure for obtaining public deposits is fairly simple
No restrictive covenant (agreement or contract) are involved
No security is offered against public deposit
The post-tax cost is fairly reasonable
To the public
Rate of interest is higher than other alternatives
The maturity period is fairly short- one to three years
Disadvantages
To the company
The quantum of funds that can be raised by way of public deposit is limited.
The maturity period is relatively short
To the public
No security offered by the company
Interest on public deposits is not exempt from taxation
Inter corporate deposits
A deposit made by one company with another, normally for a period up to six months, is referred to as inter corporate deposit.
These are of three types
Call deposits: in theory, a call deposit is withdrawable by the lender on a giving a day’s notice. In practice, however, the lender has to wait for at least three days. The interest rate on these deposits may be around 10% per annum
Three months deposit : most popular in practice the interest rate on such deposits is around 12% per annum
Six month deposit : normally lending companies do not exceed deposits beyond this time they carry interest rate of around 15% per annum.
Features
Lack of regulation
Secrecy
Importance of personal contact
Rights debenture for working capital
Public limited companies can issue rights debentures to their shareholders with the object of augmenting the long term resources of the company for working capital requirements.
Key guidelines applicable to such debentures
The amount of debenture issue should not exceed (a) 20 percent of the gross current assets , loans and advances minus the long term funds presently available for financing working capital, or (b) 20 percent of the paid up share capital, including preference capital and free reserves, whichever is lower of the two
The debt : equity ratio , including the proposed debenture issue, should not exceed 1:1
The debenture shall first be offered to the existing Indian resident shareholders of the company on a pro rata basis
Commercial paper
Commercial paper represents short-term unsecured promissory notes issued by the firms which enjoy a fairly high credit rating. Generally, large firms with considerable financial strength are able to issue commercial paper.
Features
The maturity period of commercial paper usually range from 90 days to 360 days.
Commercial paper is sold at a discount from its face value and redeemed at its face value. Hence the implicit interest rate is a function of the size of discount and the period of maturity.
Commercial paper is either directly placed with investors who intend holdings it till its maturity hence there is no well developed secondary market for commercial paper
Factoring
A factor is a financial institution which offers services relating to management and financing of debts arising from credit sales.
While factoring is well established in developed countries like USA and UK. It has extended to number of other countries in recent past including India. Subsidiaries of four Indian banks provide factoring services.
Factoring is a unique financial innovation. It is both a financial as well as management support to a client.
It is a method of converting a non productive, inactive asset(receivables) into a productive asset (cash) by selling receivables to a company that specializes in their collection and administration
Features
The factor selects the account of the client that would be handled by it and establishes, along with the client, the credit limits applicable to the selected accounts.
The factor assumes responsibility for collecting the debt of accounts handled by it. For each account, the factor pays to the client at the end of the credit period or when the amount is received whichever is earlier.
The factor advances money to the client against not yet collected or not yet due debts. Typically the amount advanced may be 70 to 80% of the face value of the debt
It carries an interest rate which may be equal to or marginally higher then the lending rate of commercial banks.
Factoring may be on a recourse basis (that means the credit risk is borne by the client ) or on a non recourse basis ( means credit risk is borne by the factor)
Besides the interest on advances against debt the factor charges a commission which may be 1 to 2 percent of the face value of the debt factored
Norms for inventory and receivables
In the mid 1970’s the RBI accepted the norms for raw materials , stock-in-progress, finished goods, and receivables that were suggested by Tondon committee for fifteen major industries.
These norms were based on companies finance studies made by RBI.
These norms represent the maximum level for holding inventory and receivables in each period
Lending Norms
Maximum Permissible Bank Finance (MPBF)
In view of the above approach to bank lending, the committee suggested the following three methods of determining permissible level of bank borrowing:
First Method
In the first method, the borrower will contribute 25 percent of the working capital gap; the remaining 75 percent can be financed from bank borrowings. This method will give a minimum current ratio of 1:1
MPBF = 0.75 (CA-CL)
CA = current assets as per the norms
CL = non bank current liabilities like trade credit and provisions
Second Method
In the second method, the borrower contribute 25 percent of the total current assets. The remaining of the working capital gap (i.e. the working capital gap less the borrower’s contribution) can be bridged from the bank borrowings. This method will give a current ratio of 1.3:1
MPBF= 0.75(CA)-CL
Working capital financing
Long term financing: the sources of long term financing include ordinary shares capital, preference share capital, debentures, long term borrowings and reserves and surplus.
Short term financing: short term financing is obtained for a period less then 1 year. It includes loans from banks, public deposits, commercial papers, factoring of receivables etc.
Approach
Matching
Conservative
Aggressive
Working capital leverage
The term working capital leverage, refers to the impact of level of working capital on company’s profitability.
Higher level of investment in current assets than is actually required means increase in the cost of interest charges on the short term loans and working capital finance raised from banks etc. and will result in lower return on capital employed and vice versa. Working capital leverage measures the Responsiveness of ROCE ( return on capital employed) for changes in current assets.
It is calculated by using the following formula:
Working capital leverage = C.A
T.A – D.C.A
Factors affecting working capital
Nature of business
Seasonality of operations
Production policy
Market conditions
Conditions of supply