Project objectives:
To learn the effective management of working capital.
The Birth
Registered on 16th Sept 1935 with an authorized capital of Rs 10.00 lakh and
commenced business on 8th Feb 1936.
The Childhood
Known as a common man's bank since inception, its initial help to small units
has given birth to many of today's industrial houses. After nationalization in
1969, the bank expanded rapidly. It now has 1276 branches (as of 31st March
2004) all over India. The Bank has the largest network of branches by any
Public sector bank in the state of Maharashtra.
The Adult
The bank has fine tuned its services to cater to the needs of the common man
and incorporated the latest technology in banking offering a variety of
services.
Banks Philosophy
• Mobilisation of Money
• Modernisation of Methods and
• Motivation of Staff.
Banks Aims
The bank wishes to cater to all types of needs of the entire family, in the
whole country. Its dream is "One Family, One Bank, Maharashtra Bank".
The Autonomy
The Bank attained autonomous status in 1998. It helps in giving more and
more services with simplified procedures without intervention of Government.
OPERATING CYCLE:-
Accounts
Cash
Finished goods
Raw Work-in-
Tandon committee has referred to this type of working capital as “core current
assets”.
Temporary
Capital (Rs.)
Time
Temporary
Time
While lower levels of working capital increase the risk but have the
potentiality of increasing the profitability also.
In the absence of such situation, the financial position in respect of the firm’s
liquidity may not be satisfactory in spite of satisfactory liquidity ratio.
In order to achieve this objective the finance manager has to perform basically
following two functions: -
1) Estimating the amount of working capital.
2) Sources from which these funds have to be raised.
Symbolically the duration of the working capital cycle can be put as follows: -
O=R+W+F+D-C
Where,
O=Duration of operating cycle;
R=Raw materials and stores storage period;
W=Work-in-progress period;
F=Finished stock storage period;
D=Debtors collection period;
C=Creditors payment period.
After computing the period of one operating cycle, the total number of
operating cycles that can be computed during a year can be computed by
dividing 365 days with number of operating days in a cycle. The total
expenditure in the year when year when divided by the number of operating
cycles in a year will give the average amount of the working capital
requirement.
There are three basic approaches for determining the working capital
financing mix.
Meaning of cash
The term “cash” with reference to cash management is used in two
senses. In a narrower sense it includes coins, currency notes, cheques, bank
drafts held by a firm with it and the demand deposits held by it in banks.
In a broader sense it also includes “near-cash assets” such as, marketable
securities and time deposits with banks. Such securities or deposits can
immediately be sold or converted into cash if the circumstances require. The
term cash management is generally used for management of both cash and
near-cash assets.
1. Transaction motive
A firm enters into a variety of business transactions resulting in both
inflows and outflows. In order to meet the business obligation in such a
situation, it is necessary to maintain adequate cash balance. Thus, cash
balance is kept by the firms with the motive of meeting routine business
payments.
2.Precautionary motive
A firm keeps cash balance to meet unexpected cash needs arising out of
unexpected contingencies such as floods, strikes, presentment of bills for
payment earlier than the expected date, unexpected slowing down of
collection of accounts receivable, sharp increase in prices of raw materials,
Downloaded from a2zmba.blogspot.com
etc. The more is the possibility of such contingencies more is the cash
kept by the firm for meeting them.
3.Speculative motive
A firm also keeps cash balance to take advantage of unexpected
opportunities, typically outside the normal course of the business. Such
motive is, therefore, of purely a speculative nature.
For example,
A firm may like to take advantage of an opportunity of purchasing raw
materials at the reduced price on payment of immediate cash or delay
purchase of raw materials in anticipation of decline in prices.
4.Compensation motive
Banks provide certain services to their clients free of charge. They,
therefore, usually require clients to keep a minimum cash balance with them,
which help them to earn interest and thus compensate them for the free
services so provided.
Business firms normally do not enter into speculative activities and,
therefore, out of the four motives of holding cash balances, the two most
important motives are the compensation motive.
In both the cases, he has to decide about the following two basic factors:
(i) Security:
This can be ensured by investing money in securities whose price
remain more or less stable.
(ii) Liquidity:
(iii) Yield:
Most corporate managers give less emphasis to yield as compared to
security and liquidity of investment. They, therefore, prefer short-term
government securities for investing surplus cash. However, some corporate
managers follow aggressive investment policies, which maximize the yield on
their investments.
(iv) Maturity:
Surplus cash is available not for an indefinite period. Hence, it will be
advisable to select securities according to their maturities keeping in view the
period for which surplus cash is available. If such selection is done carefully,
the finance manager can maximize the yield as well as maintain the liquidity
of investments.
1.Baumol model: -
This model was suggested by William J Baumol. It is similar to one
used for determination of economic order quantity.
According to this model, optimum cash level is that level of cash where the
carrying costs and transactions costs are the minimum.
Carrying costs
This refers to the cost of holding cash, namely, the interest foregone on
marketable securities. They may also be termed as opportunity cost of keeping
cash balance.
Transaction costs
Downloaded from a2zmba.blogspot.com
This refers to the cost involved in getting the marketable securities
converted into cash. This happens when the firm falls short of cash and to
sell the securities resulting in clerical, brokerage, registration and other costs.
There is an inverse relationship between the two costs. When one
increases, the other decreases, the other decreases. Hence, optimum cash level
will be at that point where these two costs are equal.
C= 2U x P
S
Where,
C = Optimum cash balance
U = Annual (or monthly) cash disbursements
P = Fixed costs per transaction
S = Opportunity cost of one rupee p.a. (p.m)
2. Miller-Orr Model
Baumol model is not suitable in those circumstances when the
demand for cash is not steady and cannot be known in advance.
Miller-Orr model helps in determining the optimum level of
cash in such circumstances. It deals with cash management problem
under the assumption of stochastic or random cash flows by laying
down control limits for cash balances. These limits consist of an
upper limit (h), lower limit (o) and return point (z). When cash
balance reaches the upper limit, a transfer of cash equal to “h-z” is
effected to marketable securities. When it touches the lower limit, a
transfer equal to “z-o” from marketable securities to cash is made.
No transaction between cash to marketable securities and
marketable securities to cash is made during the period when the
cash balance stays between the high and low limits.
Downloaded from a2zmba.blogspot.com
The model is illustrated in the form of the following chart:
Cash balance
z Return point
The above chart shows that when cash balances reaches the upper limit,
an account equal to “h-z” is invested in the marketable securities and cash
balance comes down to “z” level. When cash balance touches the lower limit
marketable securities of the value of “z-o” are sold and the cash balance again
goes up to ‘z’ level.
The upper limit and lower limit are set on the basis of opportunity cost
of holding cash; degree of likely fluctuation in cash balances and the fixed
costs associated with securities transactions.
Kinds of inventories
Inventories can be classified into three categories.
(ii) Work-in-progress:
This includes those materials, which have been committed to
production process but have not yet been completed.
The levels of the above three kinds of inventories differ depending upon the
nature of the business.
(iii) Obsolescence
Downloaded from a2zmba.blogspot.com
This may be due to change in customers taste, new production
technique, improvements in the product design, specifications, etc.
Management of inventory
Inventories often constitute a major element of the total working capital
and hence it has been correctly observed, “good inventory management is
good financial management”.
Inventory management covers a large number of issues including
fixation of minimum and maximum levels; determining the size of the
inventory to be carried ; deciding about the issue price policy; setting up
receipt and inspection procedure; determining the economic order quantity;
providing proper storage facilities, keeping check on obsolescence and setting
up effective information system with regard to the inventories.
The former cost may be referred as the “cost of acquiring” while the
latter as the “ cost of holding” inventory. The cost of acquiring decreases
while the cost of holding increases with every increase in the quantity of
purchase lot. A balance is, therefore, struck between the two opposing factors
and the economic ordering quantity is determined at a level for which
aggregate of two costs is the minimum.
Formula:
Q= 2U x P
S
Where,
Q = Economic Ordering Quantity
U = Quantity (units) purchased in a year (month)
P = Cost of placing an order
S = Annual (monthly) cost of storage of one unit.
The set up cost is of the nature of fixed cost and is to be incurred at the
time of commencement of each production run. Larger the size of the
production run, lower will be the set-up cost per unit.
However, the carrying cost will increase with increase in the size of the
production run.
Thus, there is an inverse relationship between the set-up cost and
inventory carrying cost. The optimum production size is at that level where
the total of the set-up cost and the inventory carrying cost is the minimum.
In other words, at this level the two costs will be equal.
The formula for EOQ can also be used for determining the optimum
production quantity as given below:
E= 2U x P
Where
E = Optimum production quantity
U = Annual (monthly) output
P = Set-up cost for each production run
S = Cost of carrying inventory per annum (per month)
Meaning of receivables
Receivables are assets accounts representing amounts owed to the firm
as a result of sale of goods / services in the ordinary course of business.
They, therefore, represent the claims of a firm against its customers and
are carried to the “assets side” of the balance sheet under titles such as
accounts receivables, customer receivables or book debts. They are, as stated
Purpose of receivables
Accounts receivables are created because of credited sales. Hence the
purpose of receivables is directly connected with the objectives of making
credited sales.
1. Capital costs:
Maintenance of accounts receivables results in blocking of the firm’s
financial resources in them. This is because there is a time lag between the
2. Administrative costs:
The firm has to incur additional administrative costs for maintaining
accounts receivable in the form of salaries to the staff kept for maintaining
accounting records relating to customers, cost of conducting investigation
regarding potential credit customers to determine their creditworthiness, etc.
3. Collection costs:
The firm has to incur costs for collecting the payments from its credit
customers. Sometimes, additional steps may have to be taken to recover
money from defaulting customers.
4. Defaulting costs:
Sometimes after making all serious efforts to collect money from
defaulting customers, the firm may not be able to recover the overdues
because of the of the inability of the customers. Such debts are treated as bad
debts and have to be written off since they cannot be realized.
For example,
If a firm’s credit terms are “net 15”, it means the customers are
expected to pay within 15 days from the date of credit sale.
OVERTRADING:
Overtrading means an attempt to maintain or expand scale of operations
of the business with insufficient cash resources. Normally, concerns having
overtrading have a high turnover ratio and a low current ratio. In a situation
like this, the company is not in a position to maintain proper stocks of
materials, finished goods, etc., and has to depend on the mercy of the
suppliers to supply them goods at the right time. It may also not be able to
extend credit to its customers, besides making delay in payment to the
creditors. Overtrading has been amply described as “overblowing the
balloon”. This may, therefore, prove to be dangerous to the business since
disproportionate increase in the operations of the business without adequate
resources may bring its sudden collapse.
Causes of overtrading
The following may be the causes of over-trading:
(iii) Over-expansion:
In national emergencies like war, natural calamities, etc., a firm may be
required to produce goods on a larger scale. Government may pressurize the
manufacturers to increase the volume of production without providing for
adequate finances. Such pressure results in over-expansion of the business
ignoring the elementary rules of sound finance.
Consequences of overtrading
The consequences of over-trading can be summarized as follows:
UNDERTRADING:
It is the reverse of overtrading. It means improper and underutilization
of funds lying at the disposal of the undertaking. In such a situation the level
of trading is low as compared to the capital employed in the business. It
results in increase in the size of inventories, book debts and cash balances.
Undertrading is a matter of fact an aspect of overcapitalization. The basic
cause of undertrading is, therefore, underutilization of the firm’s resources.
Such underutilization may be due any one or more of the following causes:
Quick Ratio (Total Current =x Similar to the Current Ratio but takes
Assets - times account of the fact that it may take time
Inventory)/ to convert inventory into cash
Total Current
Liabilities
Nature of business
The working capital requirement of a firm is closely related to the
nature of its business. A service firm, like an electricity undertaking which has
a short operating cycle, which sells predominantly on cash basis, has a modest
working capital requirement. On the other hand, a manufacturing concern like
a machine tools unit, which has a long operating cycle and which sells largely
on credit, has a very substantial working capital requirement.
Seasonality of operations
Firms which have marked seasonality in their operations usually have
highly fluctuating working capital requirements. To illustrate, consider a firm
manufacturing ceiling fans. The sale of ceiling fans reaches a peak during the
summer months and drops sharply during the winter period.
Downloaded from a2zmba.blogspot.com
Production policy
A firm marked by pronounced seasonal fluctuation in its sales pursue a
production policy, which may reduce the sharp variations in working capital
requirements.
Market conditions
The degree of competition prevailing in the market place has an
important bearing on working capital needs. When competition is keen, a
larger inventory of finished goods is required to promptly serve customers
who may not be inclined to wait because other manufacturers are ready to
meet there needs.
Conditions of supply
The inventory of raw materials, spares, and stores depends on the
conditions of supply. If the supply is prompt and adequate, the firm can
manage with small inventory.
2INDIGENOUS
RAW MATERIALS
______ DAYS
4FINISHED GOODS
_______ DAYS
5SUNDRY DEBTORS
______ DAYS
6MONTHLY EXPENSES
FOR ONE MONTH
TOTAL (A)
d Minimum stipulated
Net working capital 11.41 13.93 11.32 12.5
(25% of total current assets
Excluding expected receivables.)
BIBLIOGRAPHY
1. Author: Dr. S N Maheshwari
Name of the book: Financial Management
Edition 2004
Publisher name: SULTAN CHAND &SONS
Pages no.: D.290 onwards