types of working capital

8/6/2019 Types of Working Capital

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Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the

management of working capital.[16]

These policies aim at managing the current

assets(generally cash and cash equivalents, inventories and debtors) and the short term financing, suchthat cash flows and returns are acceptable.

Cash management. Identify the cash balance which allows for the business to meet day to day

expenses, but reduces cash holding costs.

Inventory management. Identify the level of inventory which allows for uninterrupted production but

reduces the investment in raw materials and minimizes reordering costs and hence increases

cash flow; see Supply chain management; Just In Time (JIT); Economic order

quantity (EOQ); Economic production quantity (EPQ).

Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract

customers, such that any impact on cash flows and the cash conversion cycle will be offset by

increased revenue and hence Return on Capital (orvice versa); see Discounts and allowances.

Short term financing. Identify the appropriate source of financing, given the cash conversion cycle:

the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to

utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".


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WORKING CAPITAL

1. Concept And Definition Of Working Capital

There are two concept of Working Capital : gross and

net .

a)The term gross working capital , also referred to as

working capital , means the total current assets .


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b)The net working capital canbe defined in two ways

:

1. The most common definition of net working capital

( NWC ) is the differencebetween current assets and

current liabilities ; and

2. Alternate definition of NWC is that portion of

current assets which is financed with long term funds .

The task of financing manager in managing working

capital efficiently is to ensure sufficient liquidity in the

operations of the enterprise . Net working capital , as a

measure of liquidity is not very useful for comparing

the performance of different firms , but it is quite


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useful for internal control . The NWC helps in

comparing the liquidity of the same firm over time . For

the purpose of working capital management , therefore

, NWC canbe said to measure the liquidity of the firm .

In the other words , the goal of working capital

management is to manage the current assets and

liabilities in such a way that an acceptable level of

NWC is maintained .

2. Components Of Working Capital

Thebasic components of working capital are ,


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Current Assets :

a)Inventories

i) Raw Materials and Components

ii) Work in Progress

iii) Finished Goods

iv) Others

b)Trade Debtors

c)Loans And Advances

d)Investments

e)Cash And Bank Balance

Current Liabilities:


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a)Sundry Creditors

b)Trade Advances

c)Borrowings

d)Commercial Banks

e)Provisions

3. Need For Working Capital

Given the objective of financial decision making to

maximise the shareholders wealth , it is necessary to

generate sufficient profits . The extent to which profits


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canbe earned will naturally depend , among other

things , upon the magnitude of sales . A successful sales

program is , in other words , necessary for earning

profitsby anybusiness enterprise . However , sales do

not convert into cash instantly ; there is invariably a

time lagbetween sale of goods and the receipt of cash .

There is therefore , a need for working capital in the

form of current assets to deal with the problem arising

out of the lack of immediate realisation of cash against

goods sold . Therefore sufficient working capital is

necessary to sustain sales activity . Technically this is

referred to s operating cycle . The operating cycle canbe


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said tobe at the heart of the need for the working

capital . In other words the operating cycle refers to the

length of time necessary to complete the following cycle

of events :

a)Conversion of cash into raw materials;

b)Conversion of raw materials to inventory ;

c)Conversion of inventory into receivables ;

d)Conversion of receivables into cash .

If it were possible to complete the sequences

instantaneously , there wouldbe no need for current

assets (working capital) . But since it is not possible ,

the firm is forced to have current assets . Since the cash


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inflows and outflows do not match , firms have to

necessarily keep cash or invest in short term liquid

securities so that they willbe in position to meet

obligations when theybecome due . Similarly , firms

must have adequate inventory to guard against the

possibility of notbeing able to meet demand for their

products . Adequate inventory , therefore, provides a

cushion againstbeing out of stock . If firms have tobe

competitive , they must sell goods to their customer on

credit which necessitates the holding of accounts

receivables . It is in these ways that an adequate level

of working capital is absolutely necessary for smooth


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sales activity which , in turn , enhances the owners

wealth .

4. Characteristics Of Current Assets

In management of working capital two characteristics

of current assets mustbeborne in mind : a) short life

span andb) swift transformation into other assets

forms .

Current assets may have a short life. Cashbalance may

be held idle for a week or two, account receivables may

have a life span of 30 to 60 days , and inventories may

be held for 30 days to 100 days . The life span of


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current assets depend on the time required in the

activities of procurement , production , sales and

collection and the degree of synchronisation among

them .

Each current asset is swiftly transformed into other

assets forms : cash is used for acquiring raw materials ,

raw materials are transformed into finished goods ( this

transform may involve several stages of work in

progress ) ; finished goods , generally sold on credit , are

converted into accounts receivable , and finally account

receivables on reliasation , generate cash .

These two characteristics has certain implications ,


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i) Decisions relating to working capital

management are repetitive and frequent

ii) The differencebetween profit and present value

is insignificant

iii) The close interaction among working capital

components implies that efficient management of

one component cannotbe undertaken without

simultaneous consideration of other components .

5. Factors Affecting Working Capital


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The working capital needs of a firm are influencedby

numerous factors . The important ones are

i) Nature ofbusiness : The working capital

requirement of a firm is closely related to the

nature ofbusiness . A service firm , like

electricity undertaking or a transport corporation

which has a short operating cycle and which sells

predominantly on cashbasis , has a modest

working capital requirement . On the other hand

, manufacturing concern like a machine tools

unit , which has a long operating cycle and


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which sells largely on credit has a very

substantial working capital requirement .

ii) Seasonality of Operation : Firms which have

marked seasonality in there operations usually

have highly fluctuating working capital

requirement . For example , consider a firm

manufacturing air conditioners . The sale of air

conditioners reaches the peak during summer

months and drops sharply during winter season .

The working capital need of such a firm is likely

to increase considerably in summer months and

decrease significantly during winter period . On


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the other hand , a firm manufacturing consumer

goods like soaps , oil , tooth pastes etc. which

have fairly even sale round the year , tends to

have a stable working capital need .

iii) Production Policy : A firm markedby

pronounced seasonal fluctuation in its sale may

pursue a production policy which may reduce the

sharp variations in working capital requirements

. For example a manufacturer of air conditioners

may maintain steady production through out the

year rather than intensify the production

activity during the peakbusiness season . Such


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decision may dampen the fluctuations in

working capital requirements .

iv) Market Conditions : When competition is keen ,

larger inventory of finished goods is required to

promptly serve the customers who may notbe

inclined to waitbecause other manufacturers are

ready to meet their needs . Further generous

credit terms may have tobe offered to attract

customers in highly competitive market . Thus ,

working capital needs tend tobe highbecause of

greater investment in finished goods inventory

and accounts receivable .


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If the market is strong and competition is weak , a firm

can manage with smaller inventory of finished goods

because customers canbe served with delay . Further in

such situation the firm can insist on cash payment and

avoid lock up of funds in accounts receivables it can

even ask for advance payment , partial or total .

v) Conditions of Supply : The inventory of raw

material , spares and stores depends on the

conditions of supply . If supply is prompt and

adequate , the firm can manage with small

inventories . However if the supply is

unpredictable and scant then the firm , to ensure


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continuity of production , would have to acquire

stocks as and when they are available and carry

large inventories on an average . A similar policy

may have tobe followed when the raw material

is available only seasonally and production

operations are carried out round the year .

6. Operating Cycle Analysis

The Operating cycle of the firmbegins with the

acquisition of raw materials and ends with the

collection of receivables . It maybe divided into four


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stages a) raw material and stores storage stage , b)

work-in-progress stage , c) finished goods inventory

stage and d) debtors collection stage .

Duration of operating cycle : The duration of

operating cycle is equal to the sum of the duration of


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each of these stages less the credit period allowedby the

suppliers to the firms . It canbe given as

O = R + W + F + D C

Where O = Duration of operating cycle

R = Raw material and stores storage period

W = Work-in-progress period

F = Finished goods storage period

D = debtors collection period

C = Creditors payment period

The components of Operating cycle maybe calculated

as follows ;


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R = Average stock of raw materials and stores

Average raw material and stores consumption

per day

W = Average Work-in-progress inventory

Average cost of production per day

F = Average Finished Goods Inventory

Average cost of goods sold per day

D = Averagebooks debts


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Average credit sales pert day

C = Average trade creditors

Average credit purchase

Types of working capital

The type, kinds of a thing are depending upon the different utilization of working capital.

It prominently works in the direction of performing different functions in different situation and

in the context of divergent variables. So following are some important types of working capital.

.

Net Working

Capital Gross Working

Capital

Permanent

Working capital

Temporary

Working Capital

Types of

Working Capital

Balance Sheet

Working Capital

Cash WorkingCapital

Negative

Working Capital


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1) Net Working Capital:

Term Net working capital can be define in two way

i) It is the difference between current assets and current liabilities.

ii) Amount left for operational requirement.

2) Gross Working Capital:

Gross working capital means the total current assets.

3) Permanent Working Capital:

It is the minimum amount of the current assets, which are needs to conduct the business

even during the dullest season of the year. This amount varies from year to year depending

upon the growth of a company and stage of the business cycle in which it operates. It is the

amount of funds required to produce the goods and services, which are necessary to satisfy

demand at a particular point.

It represents the current assets, which are required on a continuing basis over the year. It is

maintain as the medium to carry on operation at any time. Permanent working capital has

following features:

i) It is classified on the basis of the time factor.

ii) Its size increase with the growth of the business.

iii) It constantly shifted from one assets o another and continues to remain in the

business process.

4) Temporary Working Capital:

It represents the additional assets, which are required at different times during the

operating year. Seasonal working capital is the additional amount of current assets

particularly cash, receivables, and inventory which is required during the more active


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business seasons of the year. It is the temporary investment in the current assets and

possesses he following features:

a) It is not always gainfully employed, though is May also shift from one

asset to another as permanent working capital does.

b) It is particularly suited to business of seasonal on cyclical nature.

5) Balance Sheet Working Capital:

The balance sheet working capital is one, which is calculated from the items appearing in

the balance sheet. Gross working capital, which is represented by the excess of current assets

over current liabilities, is example of the balance sheet working capital.

6) Cash Working Capital:

It is one, which is calculated from the items appearing in he Profit and Loss Account. It

shows the real flow of money or value at a particular time and considered to be most realistic

approach in working capital management. It is the basic of he operation cycle concept, which

has assumed a great importance in financial management in recent year. The reason is that

the cash working capital indicates he adequacy of he cash flow which is an essential pre

requisite of a business.

7) Negative Working Capital:

It emerges when current liabilities exceeds current assets, such a situation is absolutely

theoretical and occurs when a firm is nearing a crisis of some magnitude.


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Principles of Working Capital Management:

There are some principles of sound working capital management policy. They are as

follows:

1) Principle of Risk Variation:

Risk here refers to inability of a firm to meet its obligation when they become due for

payment. Large investment in current assets with less dependence on a short term borrowing

increase liquidity, reduces dependence on short term borrowing increases liquidity, reduces risk.

On the other hand less investment in current assets and greater dependence on debt

increase the risk, reduces liquidity and increases profitability. In other word these is a definite

inverse relationship between he degree of risk and profitability.

A conservative management prefers to minimize risk by maintaining a higher level of current

assets or working capital while a liberal management should be to establish a suitable trade off

between profitability and risk.

2) Principle of Cost of Capital:

The various sources of rising of working capital finance have different cost of capital and

the degree of risk involved. Generally higher the risk lower is the cost and lower the risk higher

is the cost. A sound working capital management should always try to achieve a proper balance

between these two.

3) Principle of Equity position:

According this principle, the amount of working capital invested in each component

should be adequately justified by a firms equity position. Every rupee invested in the current

assets should contribute to he net worth of he firm.

4) Principle of Maturity of Payment:


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This principle is concerned with planning he sources of finance for working capital.

According to this principle, a firm should make every efforts o related maturity of payment to its

flow of internally generated funds. Maturity pattern of various current obligations is an impotent

factor in risk assumptions and risk assessment.

Factors determining working capital

1) Nature or character of Business:

The working capital requirement of a firm basically depends upon he nature of its

business. Public utility undertaking like Electricity, Water Supply, and Railways need very

limited working capital because they offer cash sales only and supply services, not products and

as such no funds are tied up in inventories and receivables.

On the other hand trading and financial firms require less investment in fixed assets but they

have to invest large amount in current assets like inventories, receivables and cash. So they need

large amount of working capital.

2) Production cycle:

Another factor, which has a bearing on the quantum of working capital, is the production

cycle. The term production or manufacturing cycle refers to the time involved in the

manufacturing of goods. It covers the time span between the procurement of raw material and the

completion of the manufacturing process leading to the production of finished goods.

In other words, there is sometime gap before raw material becomes finished goods. To

sustain such activities that need for working capital is obvious. The longer time span (production

cycle) the large will be the tied up funds and therefore, larger is working capital need and vise

versa.


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3) Production Policy:

In certain industry the demand is subject to wide fluctuations due to seasonal variations.

The requirement of working capital in such case, depend upon the production policy. The

production can be either kept steady by accumulating inventories during slack period with a view

to meet high demand during peak season of the production could be curtailed during the slack

season and increased during the peak season. If policy is to keep production steady by

accumulating inventories it will require higher working capital.

4) Credit Policy:

The credit terms granted to customers have a bearing in the magnitude of working capital

by determining the level of book debts. The credit sales result in higher book debs. Higher book

debts mean more working capital. On the other hand, if liberal credit terms are available from the

supplies of goods trade needs less working capital.

The working capital requirement of a business are thus, affected by term of purchase and

sale, and the ole given to credit by a company in its dealing with creditors and debtors.

5) Growth and Expansion:

The working capital requirement of concern increase with the growth and expansion of

its business activities. Although, It is difficult to determine the relationship between the growth

in the volume of business and the growth in the working capital of a business, yet it may be

concluded that for normal rate of expansion in the volume of business. We may have retained

profits to provide for me working capital but in fast growing concern, we shall require lager

amount of working capital.

6) Seasonal Variation:


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In certain industry raw material is no available throughout the year. They have to buy raw

material in bulk during the season to ensure uninterrupted flow and process them during the

entire year. So a huge amount is blocked in form of row material during the peak season, which

gives more requirements for working capital and less requirement during the slack season.

7) Earning Capacity:

Some firm have more earning capacity than others due to quality of the products,

monopoly condition etc. Such firms with high earning capacity may generate cash profits from

operations and contribute to their working capital.

8) Dividend Policy:

The dividend policy of a concern influence on the requirement of the working capital. A

firm that maintains a steady high rate of cash dividend irrespective of its profits level needs more

working capital than the firm that retains large part of its profits and does not pay at high rate of

cash dividend.

9) Other Factors:

Certain other factors such as operating efficiency, management ability, irregularities in

supply, import policy, assets structure, importance of labour, banking facilities etc, also influence

the requirement of working capital.

Sources of Working Capital

Mainly there are two sources of working capital:

i. Permanent or Fixed working capital

ii. Temporary or variables working capital


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In any concern, a part of the working capital investments are as investment in fixed

assets. This is so because there is always a minimum level of current assets, which are copiously

required by the enterprise to carry out its day-to-day business operation and this minimum,

cannot be expected to reduce at any time. This minimum level of current assets need long term

working capital, which is permanently blocked.

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 gives rise to short term working

capital which is required for day to day transaction also.

The fixed proportion of working capital should be generally financed from the fixed capital

sources while the temporary or variable working capital equipment may be met from the short

term sources of capital.

Methods of Calculation of Required Working Capital

The methods of calculation of required working capital are as follows:

Sources of Working Capital

Long term Sources

1) Shares

2) Debentures

3) Public Deposits

4) Ploughing back of Profits

5) Loans from Financial

institution

Short Term sources

1) Commercial Banks

2) Indigenous Banks

3) Trade Creditors

4) Installment Credit

5) Advances

6) Account receivable

7) Credit

8) Accrued Expenses

9) Differed Income

10 Commercial Pa er


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Working Capital Cycle:

The working capital cycle is also known as operating cycle. It refers to the duration

between the firms payment of cash for raw material, entering into production and inflow of

cash from debtors and realization of receivables. Simply speaking, operating cycle is the

duration between the outflow of cash and inflow of cash and this may be evidenced from the

following working capital cycle.

The above and network diagram may offer a clear picture of a complete working capital

i.e. it is a cash phenomenon. In the diagram, raw material, stock refers to material only. In work

in process, components involve are raw material, wages, and overhead more specifically

manufacturing overheads. Finished stock consists components of material, wages and overheads

inclusive of factory, office and administration and selling and distribution. Debtors include

material, wages, overheads and profits. Credit involves for the components of raw material, etc.

something a contingency margin is also given while estimating the working capital requirement.

The operating cycle consists of him following events, which continues throughout his life

of a firm remaining engaged in commercial activities.

Receivables

Finished Goods

Raw Material Work In Process

Cash


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Avg. Stock of Raw Material

1) Raw Material Holding Period =Avg. Cost of Consumption per day

Avg. Stock of Work in Process2) Work in Process Holding Period =Avg. Cost of Production per day

Avg. Stock of Finished Goods

3) Finished Goods Holding Period =Avg. Cost of Goods Sold per day

Avg. Book Debt

4) Receivables Collection Period =Avg. Credit Sales per day

Avg. Trade Creditors

5) Creditors Collection Period =Avg. Credit Purchased per day

In the form of a simple equation working capital cycle or operating cycle can be

represented as bellow:

O = R+W+F+D-C

Where, O = Operating Cycle (In Days)

R = Raw Materials Holding PeriodW = Work in Process Holding Period

F = Finished Goods Holding PeriodD = Receivables Collection Period

C = Creditors Collection Period.

Total Operating Cost

Working Capital Required =Number of Operating Cycle


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Components of Working Capital:

CurrentAssets:

i) Stock of Raw Material (formonth consumption)

ii) Work In Process (forMonth)a) Raw Materials

b) Direct Labourc) Overheads

iii) Stock of Finished Goods (formonth sales)

iv) Sundry Debtors or Receivables (formonth sales)

v) Payments in Advance (if any)

vi) Balance of Cash (required to meet day-to-day Expenses)

vii) Any Other (if any)

Less: CurrentLiabilities:

i) Creditors (formonth purchase of raw materials)

ii) Outstanding Expenses (for month)

iii) Others (if any)

Working Capital (CA CL)

Add: Provision/ Margin for contingencies

Net Working Capital Required

Amount

------

------

------

------

------

------

------

------

------

------

---------

------

----------


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Management of working capital:

Working capital, in general practice, refers to him excess of current assets over current

liabilities. Management of working capital therefore, is concerned with problems that arise in

attempting to mange him current assets, current liabilities, and interrelationship that exists

between them. In other word it refers to all aspects of administration of both current assets and

current liabilities.

The basic goal of working capital management is to manage the current assets and current

liabilities of a firm in such way that a satisfactory level of working capital is maintained, i.e.

neither inadequate nor excessive. This is so because both inadequate as well as excessive

working capital position is bad for the business. Inadequacy of working capital, may lead the

firm insolvency and excessive working capital implies idle funds, which earn no profit for the

business. Working capital management policies of the firm have a great effect on its profitability,

liquidity and structural health of the organization. In this context, working capital management is

three-dimensional nature:

1) Dimension I is concerned with the formulation of he policy with regard to

Profitability, risk and liquidity.

2) Dimension II is concerned with the decision about his composition and level of current

assets.


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3) Dimension III is concerned with the decision about his composition and level of current

liabilities.

This dimension aspect of his working capital has been more clearly and precisely

Explains by the following diagram.

Profitability, Risk & Liquidity

Dimension I

Dimension III Dimension

II

Composition& Level of current assets

Composition & levelOf current Liabilities

Evaluation of working capital


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The working capital management needs attention of all the finance head/ working capital

management is important for avoiding unnecessary blockage of fund. Like that liquidity is

important at it refer to the short-term financial strength of company.

It is very important to have proper balance in regard to the liquidity of the firm.

FFFIIINNNAAANNNCCCIIINNNGGGWWWOOORRRKKKIIINNNGGGCCCAAAPPPIIITTTAAALLL

After determining the level of Working Capital, the firm has to decide how it is to be financed. The

need for finance arises mainly because the investment in working capital/current assets, that is,

raw material, work-in-progress, finished goods and receivables typically fluctuates during the year.

Although long-term funds partly finance current assets and provide the margin money for working

capital, such working capitals are virtually exclusively supported by short term sources. The main

sources of working capital financing are namely, Trade credits, Bank credits and commercial

bankers.

1. Trade Credit

Trade credit refers to the credit extended by the supplier of goods and services in the normal

course of business of the firm. According to trade practices, cash is not paid immediately for

purchases but after an agreed period of time. Thus, trade credit represents a source of finance for

credit purchases.

There is no formal/specific negotiation for trade credit. It is an informal agreement between the

buyer and the seller. Such credit appears in the books of buyer as sundry creditors/accounts

payable. The most of the trade credit is on open account as accounts payable, the supplier of

goods does not extend credits indiscriminately. Their decision as well as the quantum is based

on a consideration of factors such as earnings record over a period of time, liquidity position of

the firm and past record of payment.

AAddvvaannttaaggeess

i) It is easily, almost automatically available.

ii) It is flexible and spontaneous source of finance.


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iii) The availability and the magnitude of trade credit is related to the size of operation of

the firm in terms of sales/purchases.

iv) It is also an informal, spontaneous source of finance.

v) Trade credit is free from restrictions associated with formal/negotiated source of

finance/credit.

2. Bank Credit

Bank credit is primarily institutional source of working capital finance in India. In fact, it

represents the most important source for financing of current assets. Working Capital finance is

provided by banks in five ways :

(a) Cash Credit / Overdrafts : Under cash credit/ overdraft agreement of bank

finance, the bank specifies a predetermine borrowing/credit limit. The burrower

can burrow upto the stipulated credit. Within the specified limit, any number of

drawings are possible to the extent of his requirements periodically. Similarly,

repayment can be made whenever desired during the period. The interest is

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

burrower and not on the sanctioned limit. However, a minimum charge may be

payable on the unutilized balance irrespective of the level of borrowing for availing

of the facility. This type of financing is highly attractive to the burrowers because,

firstly, it is flexible in that although borrowed funds are repayable on demand, and,

secondly, the burrower has the freedom to draw the amount in advance as an

when required while the interest liability is only on the amount actually

outstanding. However, cash credit/overdraft is inconvenient to the banks and

hampers credit planning. It was the most popular method of bank financing of

working capital in India till the early nineties. With the emergence of the new

banking since mid-nineties, cash credit cannot at present exceed 20% of the

maximum permissible bank finance (MPBF)/credit limit to any borrower.

(b) Loans : under this arrangement, the entire amount of borrowing is credited to the

current account of the borrower or released in cash. The borrower has to pay

interest on the total amount. The loans are repayable on demand or in periodic

installments. They can also be renewed from time to time. As a form of financing,

loans imply a financial discipline on the part of the borrowers. From a modest


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beginning in the early nineties, at least 80% of MPBF must be in form of loans in

India.

(c) Bills Purchased/Discounted : This arrangement is of relatively recent origin in

India. With introduction of the New Bill Market Scheme in 1970 by RBI, bank credit

is being made available through discounting of usance bills by banks. The RBI

envisaged the progressive use of bills as an instrument of credit as against the

prevailing practice of using the widely-prevalent cash credit arrangement for

financing working capital. The cash credit arrangement gave rise to unhealthy

practices. As the availability of bank credit was unrelated to production needs,

borrower enjoyed facilities in excess of their legitimate needs. Moreover, it led to

double financing. This was possible because credit was taken form different

agencies for financing the same activity. This was done, for example, by buying

goods on credit from suppliers and raising cash credit b hypothecating the same

goods. The bill financing is intended to link credit with sale and purchase of goods

and, thus eliminate the scope for misuse or diversion of credit to other

purposes.Before discounting he bill, the bank satisfies itself about the credit

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

scheme, the discount rates are fixed at lower rates than those of cash credit. The

discounting banker asks the drawer of the bill to have his bill accepted by the

drawee bank before discounting it. The later grants acceptance against the cash

credit limit, earlier fixed by it, on the basis of the borrowing value of stocks.

Therefore, the buyer who buys goods on credit cannot use the same goods as a

source of obtaining additional bank credit.


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The modus operandi of bill finance as a source of working capital financing is that a

bill that arises out of a trade sale-purchase transaction on credit. The seller of goods

draws the bill on the purchaser of goods, payable on demand or after a usance period

not exceeding 90 days. On acceptance of the bill by the purchaser, the seller offers it to

the bank for discount/purchase. On discounting the bill, the bank releases the funds to

the seller. The bill is presented by the bank to the purchaser/acceptor of the bill on

due date for payment. The bills can be rediscounted with the other banks/RBI.

However, this form of financing is not popular in the country.

d) Term Loans for Working Capital : Under this arrangement, banks advance loans for 3-

7 years payable in yearly or half-yearly installments.

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

in which banks provide funds as well as bear risk, letter of credit is an indirect formof working capital financing and banks assume only the risk, the credit being

provided by the suppliers himself.

The purchaser of goods on credit obtains a letter of credit from a bank. The bank

undertakes the responsibility to make payment to the supplier in case the buyer

fails to meet his obligations. Thus , the modus operandi of letter of credit is that the

supplier sells goods on credit/extends credit to the purchaser, the bank gives a

guarantee and bears risk only in case of default by the purchaser.

3. Mode ofSecurity

a) Hypothecation : Under this mode of security, the banks provide credit to borrowers

against the security of movable property, usually inventory of goods. The goods

hypothecated, however, continue to be in the possession of the owner of these goods

(i.e. the borrower ). The rights of the lending bank (hypothecate) depend upon the terms

of the contract between the borrower and the lender. Although the bank does not have

physical possession of the goods, it has the legal right to sell the goods to realize the

outstanding loan. Hypothecation facility is normally is not available to new borrowers.

b) Pledge : Pledge, as a mode of security, is different from hypothecation in that in the

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

physical possession of the lender. An, essential perquisite of pledge, therefore, is that

the goods are in the custody of the bank. The borrower who offer the security is, called a


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pawnor (pledgor), while the bank is called the pawnee (pledgee). The lodging of goods

by the pledgor to the pledgee is a kind of bailment. Therefore, pledge creates some

liabilities for the bank. It must take reasonable care of goods pledged with it. In case of

non-payment of the loans, the bank enjoys the right to sell the goods.

c) Lien : The term lien refers to the right of a part to retain goods belonging to another

party until a debt due to him is paid. Lien can be of two types: (i) particular lien, and (ii)

general lien. Particular lien is a right to retain goods until a claim pertaining to theses

goods is fully paid. On the other hand, general lien can be applied till all dues of the

claimant are paid. Banks usually enjoy general lien.

d) Mortgage : It is the transfer of a legal/equitable interest in specific immovable property

for securing the payment of debt. The person who parts with the interest in the property

is called mortgagor and the bank in whose favour the transfer takes place is the

mortagagee. The instrument of transfer is called the mortgage deed. Mortgage is, thus,

conveyance of interest in the mortgaged property. The mortgage interest in the property

is terminated as soon as the debt is paid. Mortgage are taken as an additional security

for working capital credit b banks.

e) Charge : Where immovable property of one person is, by the act of parties or by the

operation of law, made security for the payment of money to another and the transaction

does not amount to mortgage, the latter person is said to have a charge on the property

and all the provisions of simple mortgage will apply to such a charge. The provision are

as follows:

y A charge is not the transfer of interest in the property though it is security for

payment. But mortgage is a transfer of interest in the property.

y A charge may be created by the act of parties or by the operation of law. But a

mortgage can be created only by the act of parties.

y A charge need not be made in writing but a mortgage deed must be attested.

y Generally, a charge cannot be enforced against the transferee for

consideration without notice. In a mortgage, the transferee of the mortgage

property can acquire the remaining interest in the property, if any is left.

4. Reserve Bank ofIndia Framework for Regulation of Bank Credit

After mid-nineties, the framework for regulation of bank credits has been relaxed

permitting banks greater flexibility in tune with the emergence of new banking in the


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country, focusing on viability and profitability in contrast to the earlier thrust on

social/development banking. The notable features of the framework/regulation related to

fixation of norms for bank lending to industry. The norms are:

a) Inventory and Receivable Norms : The norms refer to the maximum level for holding

inventories and receivables in each industry. Raw materials were expressed as so many

months consumptions; WIP as so many months cost of production; finished goods and

receivables as so many months of cost of sales and sales respectively. These norms

represent the maximum levels of holding inventory and receivables in each industry.

Borrowers were not expected to hold more than that level. The fixation of these norms

was, thus, intended to reduce the dependency of industry on bank credit.

b) Lending Norms/Approach to Lending/MPBF : According to the lending norms, a part

of the current assets should be financed by the trade credit and other current liabilities.

The remaining part of the current assets, termed as working capital gap, should be partly

financed by the owners funds and long term borrowings and partly by short term bank

credit. The approach to lending is vitally significant. It takes into account all the current

assets requirements of borrowers total operational needs and not merely inventories or

receivables; it also takes into account all the other sources of finance at his command.

Another merit of the approach is that it invariably ensures a positive current ratio and,

thus, keeps under check any tendency to overtrade with borrowed funds.

c) Forms of Financing/Style ofCredit : In 1995, a mandatory limit on cash credit and a

loan system of delivery of bank credit was introduced. The cash-credit limit was initially

limited to 60% of the MPBF. The balance 40% could be availed of as short term loans.

The cash credit limit sanctions are currently 20% and loan component 80%.

d) Information and Reporting System : The main components of the information and

reporting system are four, namely,

y Quarterly Information System : Form I. Its contents are (i) production and

sales estimates for the current and the next quarter, and (ii) current assets and

current liabilities estimates for the next quarter.

y Quarterly Information System : Form II. It contains (i) actual production and

sales during the current year and for the latest completed year, and (ii) actual

current assets and current liabilities for the latest completed quarter.

y Half-yearly Operating Statement : Form III. The actual operating performance

for the half-year ended against the estimates are given in this.


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y Half-yearly Operating Statement : Form IIIB. The estimates as well as the

actual sources and uses of funds for the half-year ended are given.

5. Commercial Papers

Commercial Paper (CP) is a short term unsecured negotiable instrument, consisting of usance

promissory notes with a fixed maturity. It is issued on a discount on a face value basis but it can

also be issued in interest bearing form. A CP when issued by a company directly to the investor

is called a direct paper. The companies announce current rates of CPs of various maturities,

and investors can select those maturities which closely approximate their holding period. When

CPs are issued by security dealer on behalf of their corporate customers, they are called dealer

paper. They buy at a price less than the commission and sell at the highest possible level. The

maturities of CPs can be tailored within the range to specific investments.

a)Advantages

- CP is a simple instrument and hardly involves any documentation.

- It is flexible in terms of maturities which can be tailored to match the cash flow of

the issuer.

- A well rated company can diversify its sort-term sources of finance from banks to

money market at cheaper cost.

- The investors can get higher returns than what they can get from the banking

system.

- Companies which are able to raise funds through CPs have better financial

standing.

- The CPs are unsecured and there are no limitations on the end-use of funds

raised through them.

- As negotiable/transferable instruments, they are highly liquid.

b) Frameworkof Indian CP Market

The CPs emerged as sources of short-term financing in the early nineties. They are regulated

by RBI. The main element of present framework are given below.

y CPs can be issued for periods ranging between 15 days and one year. Renewal of CPs

is treated as fresh issue.

y The minimum size of an issue is Rs.25 lakh and the minimum unit of subscription is Rs.5

lakh.


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y The maximum amount that a company can raise by way of CPs is 100% of the working

capital limit.

y A company can issue CPs only if it has a minimum tangible net worth of Rs.4 crore, a

fund-based working limit of Rs.4 crore or more, at least a credit rating of P2 (Crisil ), A2 (

Icra ), PR-2 ( Care ) and D-2 ( Duff & Phelps ) and its borrowal account is classified as

standard asset.

y The CPs should be issued in the form of usance promissory notes, negotiable by

endorsement and deliver at a discount rate freely determined by the issuer. The rate of

discount also includes the cost of stamp duty ( 0.25 to 0.5% ), rating charges (0.1 to

0.2%), dealing bank fee ( 0.25% ) and stand by facility ( 0.25% ).

y The participants/investors in CPs can be corporate bodies, banks, mutual funds, UTI,

LIC, GIC, NRIs on non-repatriation basis. The Discount and Finance House of India (

DFHI ) also participates by quoting its bid and offer prices.

y The holder of CPs would present them for payment to the issuer on maturity.

c) Effective Cost/Interest Yield

As the CPs are issued at discount and redeemed at it face value, their effective pre-tax

cost/interest yield

= { (Face Value Net amount realised) / (Net amount realised) }x{(360) / (Maturity period) }

where net amount realised = Face value discount issuing and paying agent (IPA) charges

that is, stamp duty, rating charges, dealing bank fee and fee for stand by facility.

6. Factoring

Factoring provides resources to finance receivables as well as facilitates the collection of

receivables. Although such services constitute a critical segment of the financial services

scenario in the developed countries, they appeared in the Indian financial scene only in the

early nineties as a result of RBI initiatives. There are two bank sponsored organisations which

provide such services: (i) SBI Factors and Commercial Services Ltd., and (ii) Canbank Factors

Ltd. The first private sector factoring company, Foremost Factors Ltd. Started operations since

the beginning of 1997.


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a) Definition : Factoring can broadly be defined as an agreement in which receivables

arising out of sales or goods/services are sold by a firm ( client ) to the factor ( a

financial intermediary ) as a result of which the title of the goods/services represented by

the said receivables passes on to the factor. Henceforth, the factor becomes responsible

for all credit control, sales accounting and debt collection from the buyer. In a full service

factoring concept ( without resource facility ), if any of the debtor fails to pay the dues as

a result of his financial inability/insolvency/bankruptcy, the factor has to absorb the

losses.

b) Mechanism : Credit sales generate the factoring business in the ordinary course of

business dealings. Realisation of credit sales is the main function of factoring services.

Once a sale transaction is completed, the factor steps in to realise the sales. Thus the

factor works between the seller and the buyer and sometimes with the sellers bank

together.

c) Functions of a Factor: Depending on the type/form of factoring, the main functions of a

factor, in general terms, can be classified into five categories:

i) Financing facility/trade debts :

The unique feature of factoring is that a factor purchases the book debts of his

client at a price and the debts are assigned in favour of the factor who is usually

willing to grant advances to extent of, say, 80% of the assigned debts. Where the

debts are factored with recourse, the finance provided would become refundable

by the client in case of non-payment of the buyer. However, where the debts are

factored without recourse, the factors obligation to the seller becomes absolute

on the due date of the invoice whether or not the buyer makes the payment.

ii) Maintenance/administration of sales ledger :

The factor maintains the clients sales ledger. In addition, the factor also

maintains a customer-wise record of payments spread over a period of time so

that any change in the payment pattern can be easily identified.

iii) Collection facility of accounts receivable :

The factor undertakes to collect the receivables on the behalf of the client

relieving him of the problems involved in collection, and enables him to

concentrate on other important functional areas of the business. This also

enables the client to reduce the cost of collection by way of savings in

manpower, time and efforts.

iv) Credit Control and Credit Restriction :


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The factor in consultation with the client fixes credit limits for approved

customers. Within these limits, the factor undertakes to purchase all trade debts

of the customer without resource. In other words, the factor assumes the risk of

default in payment by the customer. Operationally, the line of credit/credit limit up

to which the client can sell to the customer depends on his financial position, his

past payment record and value of goods sold by the client to the customer.

v) Advisory Services :

These services are a spin-off of the close relationship between a factor and a

client. By virtue of their specialised knowledge and experience in finance and

credit dealings and access to extensive credit information, factors can provide a

variety of incidental advisory services to their clients.

vi) Cost ofServices :

The factors provide various services at a charge. The charge for collection and

sales ledger administration is in the form of a commission expressed as a value

of debt purchased. It is collected in advance. The commission for short term

financing as advance part-payment is in the form of interest charge for the period

between the date of advance payment and the date of collection date. It is also

known as discount charge.

types of working capital

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