unit-1 conceptual framework

7/31/2019 UNIT-1 Conceptual Framework

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UNIT 1 CONCEPTUAL FRAMEWORK

Objectives

The objectives of this unit are to:

Explain the various types of working capital and their behaviour. Examine the cyclical flow and characteristics of working capital.

Discuss the significance and tools of planning for working capital.

Find out the impact of inflation on working capital and finally.

Analyse the trends in working capital in Indian companies.

Structure1.1 Introduction1.2 Definition of Working Capital

1.3 Constituents of Working Capital

1.4 Types of Working Capital

1.5 Cyclical Flow and Characteristics of Working Capital1.6 Planning for Working Capital

1.7 Working Capital and Inflation

1.8 Trends in Working Capital

1.9 Summary1.10 Key Words

1.11 Self Assessment Questions

1.12 Further Readings

1.1 INTRODUCTION

Financial management can be divided into two broad areas of responsibility as themanagement of long-term capital and the management of short-term funds orworking capital. The management of working capital which constitutes a majorarea of decision-making for financial managers is a continuous function whichinvolves the control of the every ebb and flow of financial resources circulatingin the enterprise in one form or another. It also refers to the management of current assets and current liabilities. Efficient management of working capital isan essential prerequisite for the successful operation of a business enterpriseand improving its rate of return on the capital invested in short-term assets.

Virtually every business enterprise requires working capital to pay-off its short-term obligations. Moreover, every firm needs working capital because its notpossible that production, sales, cash receipts and payments are all instantaneousand synchronised. There elapses certain time for converting raw materials intofinished goods: finished goods into sales and finally realisation of sale proceeds.Hence, funds are required to support all such activities in the firm. A number of terms like working funds, circulating capital, temporary funds are usedsynonymously for working capital. However, the expression, Working Capital, is


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on Like, most other financial terms the concept of working capital is used indifferent connotations by different writers. Thus, there emerged the following twoconcepts of working capital.

i) Gross concept of working capital

ii) Net concept of working capital

Gross concept:

No special distinction is made between the terms total current assets and workingcapital by authors like Mehta, Archer, Bogen, Mead and Baker. According tothem working capital is nothing but the total of current assets for the followingreasons:

i) Profits are earned with the help of the assets which are partly fixed and

partly current. To a certain degree, similarity can be observed in fixed andcurrent assets in that both are partly borrowed and yield profit over andabove the interest costs. Logic then demands that current assets should betaken to mean the working capital of the corporation.

ii) With every increase in funds, the gross working capital will increase whileaccording to the net concept of working capital there will be no change inthe funds available for the operating manager.

iii) The management is more concerned with the total current assets as theyconstitute the total funds available for operating purposes than with thesources from which the funds came, and that

iv) The net concept of working capital had relevance when the form of organisation was single entrepreneurship or partnership. In other words aclose contact was involved between the ownership, management and control

of the enterprise and consequently the ownership of current and fixed assetsis not given so much importance as in the past.

Net concept:

Contrary to the aforesaid point of view, writers like Smith, Guthmann andDongall. Howard and Gross, consider working capital as the mere differencebetween current assets and current liabilities. According to Keith. V. Smith, abroader view of working capital would also include current liabilities such asaccounts payable, notes payable and other accruals. In his opinion, workingcapital management involves the managing of individual current liabilities and themanaging of all inter-relationships that link current assets with current liabilitiesand other balance sheet accounts. The net concept is advocated for the followingreasons:

i) in the long-run what matters is the surplus of current assets over currentliabilities.

ii) it is this concept which helps creditors and investors to judge the financialsoundness of the enterprise.

iii) what can always be relied upon to meet the contingencies is the excess of current assets over current liabilities, since it is not to be returned; and


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Theories and Approachesand liabilities. On the contrary, the net concept is said to be the point of view of an accountant. In this sense, working capital is viewed as a liquidation concept.

Therefore, The solvency of the firm is seen from the point of view of thisdifference Generally, lenders and creditors view this as the most pertinentapproach to the problem of working capital.

1.3 CONSTITUENTS OF WORKING CAPITAL

No matter how, we define working capital, we should know what constitutescurrent assets and current liabilities. Let us refer to the Balance Sheet of LupinLaboratories Ltd. for this purpose.

Current Assets: The following are listed by the Company as current assets:1) Inventories:

a) Raw materials and packing materials

b) Work-in-progress

c) Finished/Traded goods

d) Stores, Spares and fuel

2) Sundry Debtors:

a) Debts outstanding for a period exceeding six months

b) Other debts3 ) Cash and Bank balances:

a) With Scheduled Banks

i) in Current accounts

ii) in Deposit accounts

b) With others

i) in Current accounts

4) Loans and advances:

a) Secured Advancesb) Unsecured (considered good)

i) Advances recoverable in cash or kind for value to bereceived

ii) Deposits

iii) Balances with customs and excise authorities

Current liabilities: The following items are included under this category.

1 ) Current Liabilities:

a) Sundry creditorsb) Unclaimed dividend warrants

c) Unclaimed debenture interest warrants

2) Short term credit:

a) Short term loans

b) Cash credit from banks

c) Other short term payables


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Concepts and Determinationof Working Capital

3) Provisions:

a) For Taxationb) Proposed Dividend

i) on preference shares

ii) on equity shares

Besides, items like prepaid expenses, certain advance payments are also includedin the list of current assets. Similarly, bills payable, income received in advancefor the services to be rendered are treated as current liabilities. Nevertheless,there is difference of opinion as to what is current. In the strict sense of theterm, it is related to the, operating cycle, of the firm and current assets aretreated as those that can be converted into cash within the operating cycle. Theperiod of the operating cycle may be more or less compared to the accountingperiod of the firm. In case of some firms the operating cycle period may besmall and in an accounting period there can be more than one cycle. In order toavoid this confusion, a more general treatment is given to the, currentness, of assets and liabilities and the accounting period (generally one-year) is taken asthe basis for distinguishing current and non-current assets.

1.4 TYPES OF WORKING CAPITAL

Sometimes, working capital is divided into two varieties as:

i) Permanent working capitalii) Variable working capital

Permanent Working Capital: Though working capital has a limited life andusually not exceeding a year, in actual practice some part of the investment inthat is always permanent. Since firms have relatively longer life and productiondoes not stop at the end of a particular accounting period some investment isalways locked up in the form of raw materials, work-in-progress, finished stocks,book debts and cash. The investment in these components of working capital issimply carried forward to the next year. This minimum level of investment incurrent assets that is required to continue the business without interruption isreferred to as permanent working capital. While suggesting a methodology forfinancing working capital requirements by commercial banks, the Tandoncommittee has also recognised the need to maintain a minimum level of investment in current assets. It referred them as, hard core current assets. TheCommittee wanted the borrowers to meet this portion of investment out of theirown sources and not to depend on commercial banks.

Variable Working Capital: This is also known as the circulating or transitoryworking capital. This is the amount of investment required to take care of thefluctuations in the business activity. While permanent working capital is meant totake care of the minimum investment in various current assets, variable workingcapital is expected to care for the peaks in the business activity. Whileinvestment in permanent portion can be predicted with some probability,investment in variable portion of working capital cannot be predicted easily assudden changes in the business activity causes variations in this portion of working capital.

1.4.1 Working Capital Behaviour

One of the implications of the division of working capital into two types is tounderstand its behaviour over a period of time. Investment in working capital isrelated to sales volume. A variation in sales volume over time would consequently


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Theories and Approachesbring about a change in the investment of working capital. This is said to varydepending upon the type of working capital. These variations with respect todifferent types of firms are presumed to vary as indicated in Fig. 1.1

Figure 1.1 exemplifies the behaviour of different types of working capital indiverse firms affected by seasonal and cyclical variations in production or sales.In case of non-growth non-seasonal and non-cyclical firms, all the working capitalcan be considered permanent as shown in (A). Similarly, growing firms requiremore working capital over a period of time, but fluctuations are not assumed tooccur. As such, in this case also, no variable portion of working capital ispresent. In the third case (growing seasonal and non-cyclical firms), there aretwo types of working capital. On the contrary, in case of growing, seasonal andcyclical firms, all the working capital is assumed to be of varying type.

Fig. 1.1: Behaviour of Working Capital

(A) Non-growth, non-seasonal (B) Growing, non-seasonalnon-cyclical firms and non-cyclical firms

PermanentW.C

(C) Growing, seasonal and (D) Growing, seasonal andnon-cyclical firms cyclical firms

VariableW.C.

Variable W.C.

Activity 1.1

Mention the points of differentiation betweeni) Gross concept and Net concept

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P e r m

a n e n t w

o r k i n g

C a p i t

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P e r m a n e n t W.

C

W o r

k i n g

C a p

i t a l ( R s . )

Time (years)


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ii) Permanent working capital & Variable working capital

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1.5 CYCLICAL FLOW AND CHARACTERISTICS OFWORKING CAPITAL

For every business enterprise there will be a natural cycle of activity. Due to theinteraction of the various forces affecting the working capital, it transforms andmoves from one to the other. The role of the financial manager then, is to ensurethat the flow proceeds through different working capital stages at an effectiverate and at the appropriate time. However, the successive movements in thiscycle will be different from one enterprise to another, based on the nature of theenterprises. For example:

i) If the enterprise is a manufacturing concern, the cycle will run somethinglike: Cash (buying) Raw Materials (production) Finished Goods (saleson credit) Accounts Receivable (Collections) Cash.

ii) If the enterprise is purely a Retailing Company and one, which has no

manufacturing problem the cycle is shortened as:Cash (buying) Merchandise (Sales) AccountsReceivables (Collections) Cash.

iii) If the enterprise is a purely financing enterprise, the cycle is still shorter andit can be shown as:

Cash (sanction of loans) Debtors (collections) Cash.

But in real business situations, the cyclical flow of working capital is not simpleand smooth going, as one may be tempted to conclude from these simple flows.This cyclical process is repeated again and again and so do the values keep onchanging as they move through the cash to cash path. In other words the cash

flows arising from cash sales and collections from debtors will either exceed orbe lower than cash outflows represented by the amounts spent on materials,labour and other expenses. An excess cash outflow over cash inflow is a clearindication of the enterprise having suffered a loss. Thus it is apparent, that theamount of working capital required and its level at any particular time will begoverned directly by the frequency with which this cash cycle can be sustainedand repeated. The faster the cycle the lesser will be the investment needed inworking capital.

Form the aforesaid discussion, one can easily identify three importantcharacteristics of working capital, namely, short life span, swift transformation andinterrelated asset forms and synchronization of activity levels.

1. Short-life Span

Components of working capital are short-lived. Typically their life span does notexceed one year. In practice, however, some assets that violate this criterion arestill classified as current assets.

2. Swift Transformation and Inter-related Asset Forms

In addition to their short span of life, each component of the current assets isswiftly transformed into the other asset. Thus cash is utilised to replenish


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Theories and Approachesinventories. Inventories are diminished when sales occur that augment accountsreceivable and collection of accounts receivable increases cash balances. Thus anatural corollary of this quick transformation is the frequent and repetitivedecisions that affect the level of working capital and the close interaction thatexists among the members of the family of working capital. The latter entails theassumption that efficient management of one asset cannot be undertaken withoutsimultaneous consideration of other assets.

3. Assets Forms and Synchronization of Activity Levels

A third characteristic of working capital components is that their life spandepends upon the extent to which the basic activities like production, distributionand collection are non-instantaneous and unsynchronized. If these three activities

are only instantaneous and synchronized, the management of working capitalwould obviously be a trivial problem. If production and sales are synchronizedthere would be no need to have inventories. Similarly, when all customers paycash, management of accounts receivable would become unnecessary.

1.6 PLANNING FOR WORKING CAPITAL

Planning provides a logical starting point for many of the decisions. It is verymuch true for working capital decision also. Unless, we plan for procurement andeffective use we will not be in a position to get best out of working capital. In away, effective planning leads to appropriate allocation of the money amongdifferent components of working capital. Drawing a distinction of the kind of Peter F. Drucker, between efficiency (doing things right) and effectiveness(during right things). Planning clearly embraces the latter. It is for this reasonplanning for working capital is considered highly appropriate and inclusive of thepresent discussion on conceptual framework.

While planning should logically begin at the top of the organisational hierarchy,responsibility for planning exists at all levels within the organisation. Whileworking capital planning is a part of financial planning the responsibility permeatsamong different managers within the organisation responsible for managingdifferent components of working capital. At the level of planning for individualcomponents of working capital persons like materials manager, credit manager

and cash manager are involved. However, the overall responsibility for co-ordinating the planning of working capital typically rests with the topmanagement.

1.6.1 Tools of Planning for Working Capital

It should be interesting to know how to identify the relevant tools for completingthe planning exercise. Treating the planning for working capital as part of financial planning. We can note down the following tools of analysis with respectto time- frame.

a) Short term planning Cash Budgeting

b) Medium term planning Determination of appropriate levels of workingcapital items

c) Long term planning Projected pay outs and returns to shareholders interms of CVP and funds flow analysis.

Cash budget: In the short term cash budgeting is considered a handy device forplanning working capital. The use of cash budget technique as a means of determining the size of the cash flows is considered superior to the use of proforma balance sheets or judging by the past experience. A cash budget is a


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comparision of estimated cash inflows and outflows for a particular period suchas a day, a week, a month, a quarter or year. Typically Cash budget is designedto cover oneyear period and the period covered is sub-divided into intervals. Itcan be prepared in various ways like the one based on cash receipts anddisbursements method, or the adjusted net income method, or the working capitaldifferential method.

The budgeting process begins with the beginning balance to which are addedexpected receipts. This amount is reached by multiplying expected cash receiptsby the probability distribution that the management budgetary will prevail duringthe budgetary period. If outlays exceed the beginning balance plus anticipatedreceipts the difference must be financed from external sources. If an excessexist, management must make a decision regarding its disposal either in terms of

investing in short-term securities, repaying the existing debts or returning thefunds to the share-holders.

The preparation of the cash budget helps management in many ways.Management will be able to ward off the disadvantages of excessive liquidity,since there will be information on how and when such cash results in. Similarly itwill be able to contact different sources of finance to tide over a situation of cash shortage and can avoid rushing to obtain finance at whatever cost. It allowsthe management to relate the maturity of the loan to the need and determine thebest source of funds, since the information furnished by the budget reflects theamounts and time for which funds are needed. Further, cash Budget establishes asound basis for controlling the cash position.

Of the several methods of preparing the cash budget, Receipts and Paymentsmethod is popular among many undertakings. Moreso the preparation of cashbudgets in the organisations was an integral part of the budgetary process, sincethe whole of the budgetary structure was divided into revenue budgets,expenditure budgets and cash budgets. Cash budget was prepared by theorganisations by borrowing figures from various other budgets which theyprepared such as the:

i) Production budgets.

ii) Sales budget.

iii) Cost of production estimates with its necessary subdivisions for example.a) materials purchase estimates:

b) labour and personnel estimates:

c) plant maintenance estimates: etc.

iv) Manpower budget.

v) Township and welfare estimates

vi) Profit and loss estimates.

vii) Capital expenditure budget.

Thus, cash budget is prepared as a means of identifying the past cash flows anddetermine the future course of action. Cash budgets, generally are prepared byall enterprises on yearly basis having monthly breakups.

Medium term planning : In the medium term determining appropriate level of working capital is considered a focal point. In unit 3 of this course onDetermination of working Capital, we have discussed in detail the followingthree approaches to determine optimum investment in working capital.

1) Industry Norm Approach


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In India, the rate of inflation was more grievous than in many other countries,and the wholesale prices rose by almost 32 percent during 1956-61, by slightlyless than 30 percent during 1961-66, and 25 percent during the Annual Planperiods (1966-69). Besides fluctuations the annual rate of rise in the wholesaleprice was exceptionally high and in 1974-75, almost alarming. Inflation rate basedon Wholesale Price Index (WPI) averaged around 9 per cent during 1970-71 to1990-91. Again it touched the highest level of the decade in 1991-92 at 16.7percent, when the economic activity was at its lowest ebb. Consequent upon thereforms, there has been some recovery in the economy and the rate of inflationhas come down to even 2 percent during 1998-99, threatening the regime of deflation. Nevertheless, there is no consistency in the performance of theeconomy. Again the rate of inflation is moving towards an average of 4-5percent. Alongside these indices there are some hidden inflationary potentials

which are not apparent. Prominent among these are generous subsidies, changinginternational prices of crude oil and petroleum products and the administeredprices for certain other products. The combined impact of these factors isdefinitely seen on the inflation. The impact of inflation on working capital beunderstood in the following manner.

1.7.1 Size of Working Capital

Inflation causes a spurt in the prices of input factories like raw materials, labour,fuel and power, even though there is no increase in the quantum of such inputfactors used. Secondly inflationary conditions by providing motivation for higherprofits induce the manufacturers to increase their volume of operations. Highprofits and high prices create further demand thus, leading to further investmentsin inventories, receivables and cash. The cycle, thus continues for a long time,entailing on the finance manager to arrange for larger working funds after eachsuccessive increase in the volume of operations. Thirdly, companies also tend toaccumulate inventories during inflation to reap the speculative profits. This kind of blocking up of funds, in turn necessitates enterprise to maintain larger workingcapital funds. Finally the existing financial reporting practices of firms on thebasis of historical costs as per the companies Act and Income Tax Act are alsoresponsible, for the reduction in the size of working capital finance. During theperiod of inflation, since historical costs set against the current prices andinventories are valued at current prices, higher profits would be reported. The

reporting of inflated profits creates two aberrations. The company has to payhigher taxes on the inflated profit figure though much of it is unrealised and if the company also declares the remaining profits as dividends, it leads todistribution of dividends out of capital and eventually reduces the funds availableto the company for operations in inflationary years owing to escalation in cost of inputs, increase in the volume of operations, accumulation of speculative inventoryand the adoption of historical cost accounting system.

1.7.2 Availability of Working Capital

Besides the problem of increased demand for funds there would be a reductionin the availability of such funds associated with higher costs during inflation.

There would be no problem if the working capital funds were available to anunlimited extent at a reasonable cost, regardless of the economic conditionprevailing in the economy. In reality, the situation is completely the opposite asboth internal and external sources of funds for financing working capital becomescarce.

As pointed out earlier, during inflation the availability of internal sources getsreduced because of the maintenance of records on historical cost basis. On theother hand, the position with regard to external sources of funds is equally


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Theories and Approachesdisheartening. The rapid increase in inflation has given rise to the formulation of tight money policy by the Reserve Bank of India with a view to restricting theflow of credit in the economy. Consequently, the extension of credit facilitiesfrom banks have become extremely limited. Further, the diversion of bank fundsto priority sectors, after nationalisation has made it more difficult to raise fundsfrom banks.

Till recently, companies depended heavily on public deposits for meeting theirworking capital requirements. Their availability however was reduced due to therestrictions imposed by the RBI on the companies for the mobilisation of depositsfrom public, particularly since 1978. Further the advent of Government companiesinto the capital market for accepting public deposits made it more difficult toattract funds from the public.

Coming to the trade credit, one must note that it may not be available for longperiods, and the suppliers of goods tighten the credit facilities during inflationaryperiod. The issue of long term loans may also be slackened, as the investorswould be less attracted by investments offering a fixed return like debentures andpreference shares. This is so because in terms of purchasing power the principalamount of investment as well as the interest would dwindle. Thus, theserestrictions and limitations on the availability of working capital from internal andexternal sources makes it difficult for the finance manager to raise funds duringinflation.

1.7.3 Components of Working Capital

It may be interesting at this stage of the analysis to consider the impact of inflation on the components of working capital, namely, inventory receivables andcash.

Inventory

Not many understand fully the impact of inflation on the management of inventory. Inflation affects the decisions in respect of inventory in many ways,namely;

i) It leads to over-investment in inventory.

ii) It results in shortages.

iii) It affects valuation of inventories; and

iv) It renders the traditional inventory control techniques ineffective.

During the periods of inflation when the prices rise rapidly, companies will havean incentive to invest more heavily in inventory than is indicated by the minimumcost calculation. If the management believes the price of an item will increase by10 per cent in the next month, substantially more of that item may be orderedthan normal, of course, due to increase in inventory the company may getspeculative gain, but this speculative gain may be off-set by the increase in taxes

due to higher profit figures, reported in times of inflation and higher carryingcosts.

Another difficulty that the company is required to face is the material shortagesin the periods of inflation. It is not known whether inflationary escalations resultin shortages or shortages occur because of instability caused by inflation.Whatever be the real source of the problem, companies should be conscious of the price trends and accordingly re-evaluate their internal purchasing andorganisational systems.


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Very few firms realise the impact of inflation on the valuation of inventory andthe extent to which it contributes to unrealised profits. In other words, inflationaffects the valuation of inventories, affecting thereby the amount of profitsreported in the financial statements.

Not only inflation affects the inventory, but inflation itself is also increased due tothe inefficient management of inventory. Delivering the keynote address at aNational Convention on the subject of, Curbing Inflation through EffectiveMaterials Management, Shri P.J.Fernandes put forward the following fivepropositions to show the impact of inflation on the materials management.

a) The stocks which are held by the enterprises have a direct and immediaterelationship to general price levels.

b) The price level in any country is to a great extent determined by the cost of production. The cost of production is to a great extent determined by thecost of inputs. Hence, if the cost of inputs goes up, the cost of production aswell as the price level also goes up.

c) An effective system of materials management must necessarily result in anincrease in production.

d) The materials manager can have a total and absolute impact on productionoutside his unit, and

e) It is the materials management, which can reduce the crushing burden of

credit expansion, and the money supply, which again will have a direct andabsolute impact on inflationary tendency.

Finally, it may be considered with the help of the following illustration howinflation renders the traditional inventory control techniques ineffective.

Assumptions

1) Annual consumption Rs. 1,00,000

2) Economic Ordering Quantity Rs. 3,125

3) No of orders per year 32

4) Ordering cost Rs. 20 per order

5) Carrying cost Rs. 25 per cent

6) Lead time constant

7) Price rise 5 per cent permonth.

The ordering and carrying costs would be as follows:

a) Ordering costs = 32 20 = Rs 640

3125 25b) Carrying costs = = Rs 390.632 100

c) Total costs = Rs. 640 + 390.63 = Rs 1030.63

If 32 orders are placed in a year, the distribution of the same in each month andthe material cost month-wise would be as given below.


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Theories and Approaches

Total Material Cost

No. of months No. of orders Material cost

1st.Month 2 3125 2 1.00 = 6,250.00

2nd Month 3 3125 3 1.05 = 9,843.75

3rd Month 3 3125 3 1.10 = 10,312.50

4 th Month 2 3125 2 1.15 = 7,187.50

5 th Month 3 3125 3 1.20 = 11,250.00

6 th Month 3 3125 3 1.25 = 11,718.75

7 th Month 3 3125 3 1.30 = 12,187.50

8 th Month 2 3125 2 1.35 = 8,437.50

9 th Month 3 3125 3 1.40 = 13,125.00

10 th Month 3 3125 3 1.45 = 13,593.75

11 th Month 3 3125 3 1.50 = 14,062.50

12 th Month 2 3125 2 1.55 = 9,687.50

32 1,27,656.25

Based on the EOQ formula, if one places orders as shown in the example, thetotal material cost comes to Rs. 1,27,656.25 (i.e., Material Cost + Ordering Costs+ Inventory Carrying Costs). In contrast, If the firm in question does not applythe EOQ technique and simply resorts to buying at the single stretch or lotbuying, the total material cost would be only Rs. 1,12,520/- as worked out below:

1) Quantity needed for the year = Rs. 1,00,000

2) No of orders = 1(one lot)

3) Ordering Costs = 1 20 = Rs. 20

4) Carrying Costs = 1,00,000/2 25/100 = 12,500

5) Material Cost = Rs. 1,00,000

6) Total Cost = 1,00,000 + 20 + 12,500 = Rs.1,12,520

Thus, it would appear that the conventional inventory control technique of EOQ isnot really valid under the assumed conditions.

Receivables

The effect of inflation on the receivables is felt through the size of investment inreceivables. The amount of investment in receivables varies depending upon thecredit and collection policies of the organisation. Evidently, during the periods of inflation the higher the amount involved in the receivables the greater would be

the loss to the company, since the debtor would be paying cheaper rupees.Likewise, the length of the time too makes the firm lose much in the transaction.For instance, if the firm in the beginning made a credit sale of about Rs. 1,00,000with an allowed credit period of three months, assuming a 20 percent inflation inthe economy, the amount the company receives in real terms after the allowedcredit period becomes only Rs. 95,000. Here, even considering the same time lagbetween delivery and realisation, as between debtors and creditors, sundrydebtors would create bigger problem than the sundry creditors, because thedeclining value of sundry debtors would affect adversely the anticipated


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profitability of the enterprise. Thus, the effect of inflation varies in accordancewith the quantum of receivables and the time allowed to repay them.

Cash

Management of cash takes on an added importance during the periods of inflation. With money losing value in real terms almost daily, idle cash depreciatesrapidly. A company that holds Rs.1, 00,000 in cash during 20 percent annual rateof inflation finds that the moneys real value is only Rs. 80,000 in terms of current purchasing power. Even more important, idle cash is not earning anyreturn. During inflationary periods, it is important that cash is treated as an assetrequired to earn a reasonable return. The loss on the excess cash may be off-setor partly mitigated, if it is invested to produce an income in the form of interest

earned. Obviously, if the rate of interest exceeds the rise in the price level, thefirm realises a gain equivalent to the excess, or sustains a loss if it is vice versa.Further, the loss of the purchasing power of excess cash is of particular concern,if the company sells debts or fixed income securities with the intention of subsequently investing the proceeds in fixed assets.

1.8 TRENDS IN WORKING CAPITAL

In order that we gain a better idea of the working capital, it is also necessary togo into the working capital in Indian companies, besides having an idea of theconceptual framework. For the purpose of analysing trends in working capital,data is culled from the publications of RBI on Finances of public limitedcompanies. The data of RBI covers roughly about one-third of the non-government, non-financial companies in terms of paid-up capital. Table 1.1 depictsthe period covered from 1992-93 to 2001-02. The trends are analysed for thisperiod of nine years with a gap of one year (98-99). In view of the variations inthe sample number of companies during the period under consideration, trends areanalysed to a great extent in terms of percentages than in absolutes.

1.8.1 Size of Working Capital

Working capital, if taken, as the total of current assets increased from Rs. 67,558crores in 1992-93 to Rs. 1,96,426 crores in 2001-02. (as worked out in table 1.3).In terms of percentages, working capital worked out to about 53 percent of thetotal net assets of the Indian companies. Nevertheless, there is a decline in thepercentage to 43 percent in 2001-02 almost 10 percentage points.

The implication of the study of size is that the ratio of current assets to totalassets provides a measure of relative liquidity of the firms asset structure. Thehigher the ratio the lower would be the profitability and risk. In the sense thathigher investment in current assets not only locks up the funds that can begainfully employed elsewhere, but also necessitates the firm to incur additionalcosts in the maintenance of such high volume of current assets.

An attempt is made to capture the position among diverse industries. Anexamination of this position has revealed that current assets as per cent of totalnet assets stood high in the industries such as trading, construction, tobacco,sugar, cotton, textiles, engineering and rubber (See Table-1.1) It appears that alltraditional industries had higher amounts invested in working capital. A welcomefeature of these trends is that diversified companies (with a wide variety of product groups) had investment in working capital upto around 42.6 percent only.

Further, the relation between current assets and current liabilities (as depictedthrough current ratio) is sending a signal of poor liquidity. Accepting that a 2:1relation between current assets and current liabilities as comfortable in exhibitingadequate liquidity, the public limited companies have never been closer to this


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Theories and Approachesstandard. It was varying between the lowest of 1.23:1 and the highest of 1.52:1during the period, 1992-98. In case of individual industries too none of them couldachieve this mark except shipping industry. (See Table 1.2).

1.8.2 Constituents of Working Capital

In order to know the significance of each of the items of working capital, it isbetter to decompose the total. Such an attempt is made both for current assetsand current liabilities. Among the current assets, loans and advances dominatedthe total position. Almost half of the current assets are in the form of debtorsand advances (see Table-1.3). It is heartening to note that the dominant positionof inventories once has come down significantly from around 60 percent to only

just 32 percent now. Receivables always blamed more than half of the currentassets. Debtors can be considered more liquid than inventories. In that sense thisdevelopment can be considered a healthy feature of the Indian corporate sector.

Among the current liabilities sundry creditors and other current liabilities haveoccupied a prime place (see Table- 1.4), constituting around almost 60 percent.Bank borrowings for working capital purposes have come down following thecredit discipline exercised by the Reserve Bank, during nineties, but showing upduring 2001-02. These trends give an idea of the behaviour of working capital inIndian companies.

1.9 SUMMARY

This unit has aimed at providing a conceptual understanding of the issues involvedin working capital. Thus, it started with the discussion on definition and endedwith the trends in working capital in Indian companies. There is a cleardifference in the understanding of the concept of working capital amongaccountants and economists. This unit has attempted to highlight this aspect.Similarly, what constitutes working capital is discussed to enhance theunderstanding of the readers. Though there is a broad consensus, there are afew differences in identifying the constituents, particularly in the area of investments and advance payments. Attempt has also been made to highlight thesignificant characteristics of working capital. Working capital planning isconsidered yet another issue, which engages the attention of corporate managers.The discussion is further strengthened to incorporate matters on inflation and

trends. At the end, a synoptic view is presented of the working capital trends, ascompiled from the data of RBI.

1.10 KEY WORDS

Working capital: Working capital is defined as the total of current assets or asthe difference between current assets and current liabilities.

Current assets: The total of inventories, debtors, loans and advanced, cash andmarketable securities.

Current liabilities: The sum of sundry creditors, unclaimed dividends short termloans, bank credit and various types of provisions.

Permanent working capital: Minimum level of investment in current assetsrequired for production.

Variable working capital: Working capital which takes care of the fluctuationsin business activity.

Cash budget: A projection of estimated cash inflows and outflows.

CVP analysis: A measure of long term planning to study the relationship amongcost, volume and profit.


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Funds flow : A tool to underline changes in the movement of funds.

Inflation: A phenomenon of rising prices.

1.11 SELF ASSESSMENT QUESTIONS

1) Distinguish between gross working capital and net working capital?

2) Why is working capital considered a liquidation concept?

3) Discuss the various types of working capital and trace out the behaviour of working capital with respect to time?

4) What is the impact of inflation on working capital?

5) How do you plan for the working capital of an organisation? Choose yourown company as an example?

6) Refer to the balance sheets of a company for a few years and analyse thetrends is working capital. What do they mean to the enterprise studied?

Table 1.1 : Current Assets as percentage of total net assets among different industrygroups in public limited companies in India

S l. Industry 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01 01-02

1) Tea 38.1 34.6 41.2 38.8 36.2 39.5 38.6 36.5 35.6

2) Sugar 62.6 58.9 60.4 56.3 56.2 54.8 55.4 56.8 57.6

3) Tobacco 68.5 66.3 66.7 67.6 61.8 60.0 - - -

4) Cotton Textiles 51.7 53.5 53.5 53.2 51.8 50.7 42.1 41.6 41.85) Silk Rayon 50.1 48.4 49.3 35.9 30.8 28.9 - - -

Textiles

6) Engineering 62.2 58.3 58.4 57.3 52.5 49.2 - - -

7) Chemicals 45.0 44.3 42.8 41.5 37.3 36.1 45.5 45.4 46.1

8) Rubber 57.3 56.5 55.6 60.0 58.0 56.8 46.8 47.9 46.3

9) Paper 47.3 43.8 44.7 43.4 34.5 37.6 34.3 35.3 32.7

10) Construction 74.5 71.6 71.7 50.9 66.5 37.1 66.3 64.5 65.5

11) Electricity 23.6 16.1 19.6 23.8 29.4 23.9 61.5 58.7 57.4

12) Trading 79.2 77.7 79.5 80.9 79.1 80.1 82.5 83.5 81.6

13) Shipping 28.6 30.6 38.8 36.9 37.0 36.6 50.4 47.3 45.4

14) Diversified Co. 47.5 45.0 44.3 48.9 43.7 40.8 36.8 43.1 42.6Source: RBI Bulletins, October 1997, October 1999 and October 2003.

Table 1.2 : Current ratio among different industry groups in public limited companies in India

S l. Industry 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01 01-02

1) Tea 1.56 1.60 1.96 1.5 1.4 1.7 1.6 1.4 1.4

2) Sugar 1.16 1.32 1.35 1.2 1.1 1.1 1.2 1.1 1.0

3) Tobacco 1.22 1.34 1.30 1.3 1.3 1.3 - - -

4) Cotton Textiles 1.26 1.33 1.35 1.4 1.4 1.3 1.2 1.2 1.0

5) Silk Rayon 1.43 1.64 1.72 1.6 1.0 0.8 - - -

Textiles

6) Engineering 1.35 1.36 1.44 1.3 1.3 1.2 - - -7) Chemicals 1.41 1.43 1.54 1.5 1.5 1.3 1.3 1.3 1.2

8) Rubber 1.36 1.38 1.54 1.6 1.4 1.4 1.3 1.3 1.2

9) Paper 1.17 1.34 1.52 1.3 1.3 1.2 1.1 1.1 0.8

10) Construction 1.09 1.04 1.09 1.1 1.5 0.9 1.3 1.3 1.1

11) Electricity 1.00 0.98 1.18 1.3 1.1 1.4 1.4 1.3 1.3

12) Trading 1.21 1.29 1.28 1.4 1.5 1.4 1.4 1.4 1.4

13) Shipping 1.28 1.64 2.29 2.1 2.1 1.9 1.4 1.2 1.2

14) Diversified 1.84 1.73 1.82 1.4 1.3 1.2 1.0 1.1 1.2


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Theories and ApproachesCompanies

Source: RBI Bulletins, October,1997; October 1999 and October 2003.

Tabla-1.3 : Constituents of current Assets (in percent )in public limited companies.

S l . Particulars 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01 01-02

1. Inventories 39.8 33.3 32.5 34.5 32.2 32.0 33.8 33.7 31.8

2. Receivables 50.9 47.5 52.9 53.2 56.3 55.2 53.4 53.7 54.3

3. Quoted Investments 2.6 11.8 7.4 4.9 4.8 3.5 4.9 5.5 5.5

4. Advance of 0.1 0.1 0.2 0.1 0.1 0.1 0.4 0.4 -Income tax

5. Cash & Bank 6.6 7.3 6.9 7.3 6.6 9.2 7.5 6.7 8.4Balances

Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00

Current Assets (67558) (82134) (115541) (136469) (148353) (155716)(179159) (189080) (196426)

Source: RBI Bulletins, October, 1997, October 1999 & October 2003.

Note: Figurers in the brackets indicate absolute amounts in crores.

Table 1.4 : Constituents of current liabilities (in per cent) in public limited companies

Part iculars 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01 01-02

A. Short term 33.2 28.3 29.5 29.7 29.8 29.3 32.0 37.5 40.0borrowingsfrom Banks

B. Unsecured loans 6.5 8.4 9.4 8.9 13.4 15.6 - - -from Companiesand others

C. Trade dues and 59.7 62.7 60.6 60.7 55.9 54.0 63.1 55.2 53.2other Currentliabilities

1.Sundry creditors 38.5 39.2 34.2 37.6 35.2 20.2 37.5 33.8 31.7

2.Others 21.2 23.5 26.4 23.1 20.7 31.8 25.6 21.4 21.5

D. Provisions 0.6 0.6 0.5 0.7 1.0 1.0 4.9 5.4 9.8

Total Current Liabilities 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0( 48 08 9) ( 54 30 7) ( 67 61 8) ( 96 64 6) ( 1116 53 ) ( 12 65 55 ) ( 13 30 05 )( 164 27 3) (1 80 16 5)

Source: RBI Bulletins, October 1997; October.1999 and October 2003.Note: Figures in the brackets indicate absolute amounts in crore.

1.12 FURTHER READINGS

1) V.K. Bhalla, 2003, Working Capital Management , Amol Publications Pvt.Ltd., New Delhi-110002.

2) Rao, K.V., 1990, Management of Working Capital , Deep & Deep,New Delhi.

3) Ramamoorthy, V.E., 1976, Working Capital Management ,. IFMR, Madras.4) Dileep R. Mehta., 1974, Working Capital Management , Englewood Cliffs,

Prentice Hall.

5) Park and Gladson, 1963, Working Capital, Macmillan, New York.

unit-1 conceptual framework

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