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 .
b) The net working capital can be defined in two ways :
1. The most common definition of net working capital ( NWC ) is the difference
between 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 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 can
be 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

The basic components of working capital are ,

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:
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 can be earned will
naturally depend , among other things , upon the magnitude of sales . A successful sales
program is , in other words , necessary for earning profits by any business enterprise .
However , sales do not convert into cash instantly ; there is invariably a time lag between
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 can be said to be 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 would be no need
for current assets (working capital) . But since it is not possible , the firm is forced to
have current assets . Since the cash inflows and outflows do not match , firms have to
necessarily keep cash or invest in short term liquid securities so that they will be in
position to meet obligations when they become due . Similarly , firms must have
adequate inventory to guard against the possibility of not being able to meet demand for
their products . Adequate inventory , therefore, provides a cushion against being out of
stock . If firms have to be 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 sales activity
which , in turn , enhances the owner’s wealth .

4. Characteristics Of Current Assets

In management of working capital two characteristics of current assets must be borne in
mind : a) short life span and b) swift transformation into other assets forms .
Current assets may have a short life. Cash balance 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 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 ,
i) Decisions relating to working capital management are repetitive and frequent
ii) The difference between profit and present value is insignificant
iii) The close interaction among working capital components implies that efficient
management of one component cannot be undertaken without simultaneous
consideration of other components .

5. Factors Affecting Working Capital

The working capital needs of a firm are influenced by numerous factors . The important
ones are
i) Nature of business : The working capital requirement of a firm is closely
related to the nature of business . A service firm , like electricity undertaking
or a transport corporation which has a short operating cycle and which sells
predominantly on cash basis , has a modest working capital requirement . On
 the other hand , 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 .
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 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 marked by 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 peak business season . Such 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 not be inclined to
wait because other manufacturers are ready to meet their needs . Further
generous credit terms may have to be offered to attract customers in highly
competitive market . Thus , working capital needs tend to be high because of
greater investment in finished goods inventory and accounts receivable .
If the market is strong and competition is weak , a firm can manage with
smaller inventory of finished goods because customers can be 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 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 to be 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 firm begins with the acquisition of raw materials and ends
with the collection of receivables . It may be divided into four 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 each of these stages less the credit period allowed by the suppliers to the
firms . It can be 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 may be calculated as follows ;

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 = Average books debts

Average credit sales pert day

C = Average trade creditors

Average credit purchase per day

7. Computation of Working capital

The two components of working capital (WC) are current assets (CA) and current
liabilities (CL) . They have a bearing on the cash operating cycle . In order to calculate
working capital needs, what is required is the holding period of various types of
inventories , the credit collection period and the credit payment period . Working capital
also depends on the budgeted level of activity in terms of productivity / sales . The
calculation of WC is based on the assumption that the productivity is carried on evenly
throughout the year and all costs accrue similarly . As the working capital requirements
are related to the cost excluding depreciation and not to the sale price , WC is computed
with reference to cash cost . The cash cost approach is comprehensive and superior to
the operating cycle approach based on holding period of debtors and inventories and
payment period of creditors .
Estimation of Current Assets –

Raw Material Inventory : The investment in raw materials inventory is estimated on the
basis of ,

Raw material inventory = Budgeted Cost of raw Average inventory

Production X material(s) X holding period
( in units ) per unit ( months/days )
12 months / 365 days

Work-in-Progress (WIP) Inventory : The relevant costs to determine WIP inventory

are the proportionate share of cost of raw materials and conversion costs ( labour and
manufacturing overhead costs excluding depreciation ). In case of full unit of raw
material is required in the beginning the unit cost of WIP would be higher , i.e. , cost of
full unit + 50% of conversion cost , compared to the raw material requirement throughout
the production cycle ; WIP is normally equivalent to 50% of total cost of production.
Symbolically ,
Budgeted Estimated Average time span
Production X WIP cost X of WIP inventory
( in units ) per unit ( months / days )
12 months / 365 days

Finished Goods Inventory : Working capital required to finance the finished goods
inventory is given by factor as below

Budgeted Cost of goods produced Finished goods

Production X per unit ( excluding X holding period
( in units ) depreciation ) ( months / days )
12 months / 365 days
Debtors : The WC tied up in debtors should be estimated in relation to total cost price
(excluding depreciation) , symbolically

Budgeted Cost of sales per Average debt

Credit sale X unit excluding X collection period
( in units ) depreciation ( months / days )
12 months / 365 days

Cash and Bank Balances : Apart from WC needs for financing inventories and debtors
, firms also find it useful to have some minimum cash balances with them . It is difficult to
lay down the exact procedure of determining such an amount . This would primarily
based on the motives for holding cash balances of the business firm , attitude of
management toward risk , the access to the borrowing sources in times of need and past
experience , and so on .

Estimation of Current Liabilities –

The working capital needs of business firms are lower to that extent such needs are met
through the current liabilities ( other than bank credits ) arising in the ordinary course of
business . The important current liabilities ( CL ) , in this context are , trade creditors ,
wages and overheads :

Trade Creditors :
Budgeted yearly Raw material Credit period
Production X requirement X allowed by creditors
( in units ) per unit ( months / days )
12 months / 365 days
Note : proportional adjustment should be made to cash purchase of raw materials.
Direct Wages :
Budgeted yearly Direct Labour Average time-lag in
Production X cost per unit X payment of wages
( in units ) ( months / days )
12 months / 365 days

The average credit period for the payment of wages approximates to a half-a-month in
the case of monthly wage payment: The first days’ wages are , again , paid on the 30 th
day of the month , extending credit for 28 days and so in . Average credit period
approximates to half-a-month .

Overheads ( Other Than Depreciation and Amortisation )

Budgeted yearly Overhead Average time lag in

Production X cost per unit X payment of overheads
( in units ) ( months / days )
12 months / 365 days

The amount of overheads may be separately calculated for different types of overheads .
In case of selling overheads , the relevant item would be sales volume instead of
production volume .

8. Trade-Off Between Profitability and Risk

In evaluating firm’s net working capital position an important consideration is the trade-
off between profitability and risk . In other words , the level of NWC has a bearing on
profitability as well as risk . The term profitability used in this context is measured by
profit after expenses . The term risk is defined as the profitability that a firm will become
technically insolvent so that it will not be able to meet its obligations when they become
due for payment .
The risk of becoming technically insolvent is measured using NWC . It is assumed that
the greater the amount of NWC , the less risk prone the firm is . Or , the greater the
NWC , the more liquid is the firm and , therefore , the less likely it is to become
technically insolvent . Conversely , lower level of NWC and liquidity are associated with
increasing level of risk . The relationship between liquidity , NWC and risk is such that if
either NWC or liquidity increases , the firms risk decreases .

Nature of Trade-Off :
If a firm wants to increase its profitability , it must also increase its risk . If it is to
decrease risk , it must decrease profitability . The trade-off between these variables is
that regardless of how the firm increases profitability through the manipulation of WC ,
the consequence is a corresponding increase in risk as measured by the level of NWC .
In evaluating the profitability-risk trade-off related to the level of NWC , three basic
assumptions which are generally true , are a) that we are dealing with a manufacturing
firm , b) that current assets are less profitable than fixed assets and c) the short term
funds are less expensive than long term funds .

Effect of the Level of Current Assets on the Profitability-Risk Trade-Off :

The effect of the level of current assets on profitability-risk and trade-off can be shown
using the ratio of current assets to total assets . This ratio indicates the percentage of
total assets that are in the form of current assets . A change in the ratio will reflect a
change in the current assets . It may either increase or decrease .

Effect of Increase / Higher Ratio

An increase in the ratio of current assets to total assets will lead to a decline in
profitability because current assets are assumed to be less profitable than fixed assets .
A second effect of the increase in the ratio will be that the risk to technical insolvency
would also decrease because the increase in current assets , assuming no change in
current liabilities, will increase NWC .

Effect of Decrease / Lower Ratio

A decrease in the ratio of current assets to total assets will result in an increase in
profitability as well as risk . The increase in profitability will primarily be due to the
corresponding increase in fixed assets which are likely to generate higher returns. Since
the current assets decrease without a corresponding reduction in current liabilities, the
amount of NWC will decrease, thereby increasing risk.
Effect of Change in Current Liabilities on Profitability-Risk Trade-off :
As in the case of current assets, the effect of change in current liabilities can also be
demonstrated by using the ratio of current liabilities to total assets. This ratio will indicate
the percentage of total assets financed by current liabilities.
The effect of change in level of current liabilities would be that the current liabilities-total
assets ratio will either a) increase or b) decrease .

Effect of an Increase in the Ratio

One effect of the increase in the ratio of current liabilities to total assets would be that
profitability will increase. The reason for the increased profitability lies in the fact that
current liabilities, which are a short term sources of finance will be reduced. As short
term sources of finance are less expensive than long-run sources, increase in ratio will,
in effect, means substituting less expensive sources for more expensive sources of
financing. There will, therefore, be a decline in cost and a corresponding rise in
profitability.
The increased ratio will also increase the risk. Any increase in the current liabilities,
assuming no change in current assets, would adversely affect the NWC. A decrease in
NWC leads to an increase in risk. Thus, as the current liabilities-total assets ratio
increases, profitability increases, but so does risk.

Effect of a Decrease in the Ratio

The consequences of a decrease in the ratio are exactly opposite to the results of an
increase. That is, it will lead to a decrease in profitability as well as risk. The use of more
long term funds which, by definition, are more expensive will increase the cost; by
implication profits will also decline. Similarly, risk will decrease because of the lower
level of current liabilities on the assumption that current assets remains unchanged.

Combined Effect of Changes in Current Assets and Current Liabilities on

Profitability-Risk Trade-off:
The combined effects of changes in current assets and current liabilities can be
measured by considering them simultaneously. We have seen the effect of decrease in
the current assets-total assets ratio and effect of an increase in the current liabilities-total
assets ratio. These changes, when considered independently, lead to an increased
profitability coupled with a corresponding increase in risk. The combined effect of these
changes should, logically, be to increase over all profitability as also risk and at the same
time decrease NWC.

FINANCING WORKING CAPITAL

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.
Advantages
i) It is easily, almost automatically available.
ii) It is flexible and spontaneous source of finance.
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 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.
 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 of Credit : 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 form of 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 of Security

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 ‘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:
• 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.
• 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.
• A charge need not be made in writing but a mortgage deed must be
attested.
• 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 of India 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 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 month’s 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 of Credit : 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,
• 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.
• 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.
• Half-yearly Operating Statement : Form III. The actual operating
performance for the half-year ended against the estimates are given in
this.
• 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) Framework of 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.
• CP’s can be issued for periods ranging between 15 days and one year. Renewal
of CP’s is treated as fresh issue.
• The minimum size of an issue is Rs.25 lakh and the minimum unit of subscription
is Rs.5 lakh.
• The maximum amount that a company can raise by way of CPs is 100% of the
working capital limit.
• 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.
• 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% ).
• The participants/investors in CPs can be corporate bodies, banks, mutual funds,
UTI, LIC, GIC, NRI’s on non-repatriation basis. The Discount and Finance House
of India ( DFHI ) also participates by quoting its bid and offer prices.
• 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.
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 seller’s 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
factor’s 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 :
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 of Services :
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.

MANAGING WORKING CAPITAL

1. Cash Management

A) Objectives:

The basic objective of cash management are two fold: a) to meet the cash disbursement
needs and b) to minimise funds committed to cash balances. These are conflicting and
mutually contradictory and the task of the cash management is to reconcile them.

Meeting Payment Schedule

In normal course of business, firms have to make payments of cash on a continuous and
regular basis to suppliers of goods, employees and so on. At the same time, there is a
constant inflow of cash through collections from debtors. A basic objective of cash
management is to meet the payment schedule, that is, to have sufficient cash to meet
the cash disbursement needs of a firm.
The advantages of adequate cash are : (i) it prevents or bankruptcy , (ii) the relationship
with banks is not strained, (iii) it helps in fostering good relations with trade creditors and
suppliers of raw materials, as prompt payment may help their own cash management,
(iv) a cash discount can be availed of if payment is made within the due date, (v) it leads
to a strong credit rating , (vi) to take advantage of favorable business opportunities that
may be available periodically, and finally (vii) the firm can meet unanticipated cash
expenditure with a minimum of strain during emergencies, such as strikes, fires, or a
new marketing campaign by competitors. Keeping large cash balances, however,
implies a high cost.

Minimising Funds Committed to Cash Balances

The second objective of Cash Management is to minimise cash balances. In minimizing
the cash balances, two conflicting aspects have to be reconciled. A high level of cash
balances will, as mentioned above, ensure prompt payment together with all the
advantages. But it also implies that large funds will remain idle, as cash is a non earning
asset and the firm will have to forgo profits. A low level cash balances, on the other
hand, may mean failure to meet the payment schedule. The aim of cash management,
therefore, should be to have optimal amount of cash balances.

Factors Determining Cash Needs

i) Synchonisation of cash flows : The proper synchronization between the
outflows and inflows should be followed . This is possible by adopting cash
budget technique. The properly prepared budget will pinpoint the
months/periods when the firm will have an excess or a shortage of cash.
ii) Short Costs : The cash budgets reveals the periods of shortage of cash, but,
in addition, there may be some unexpected shortfalls. The expenses incurred
as a result of shortfalls is called as Short Costs.
iii) Excess Cash Balance Costs: The cost of having excessively large cash
balances is known as the excess cash balance cost. If large funds are idle,
the implication is that the firm has missed opportunities to invest those funds
and has thereby lost interest which it would otherwise have earned. This loss
of interest is primarily the excess cost.
iv) Procurement and Management : These are the costs associated with
establishing and operating cash management staff and activities. They are
generally fixed and are mainly accounted for by salary, storage, handling of
securities and so on.
v) Uncertainty and Cash management : Finally, the impact on cash
management strategy is also relevant as cash flows cannot be predicted with
complete accuracy.

Cash Budget : Management Tool

Cash Budget is the most important tool in cash management. It is the statement showing
the estimated cash inflows and cash outflows over the planning horizon.
The various purposes of cash budgets are : (i) to co-ordinate the timings of cash needs,
(ii) it pinpoints the period when there is likely to be excess cash, (iii) it assists
management in taking cash discounts on its account payables, (iv) it helps to arrange
needed funds on the most favorable terms and prevents accumulation of excess funds.
Preparation of Cash Budget
The principle aim of the cash budget, as a tool is to predict cash flows over a given
period of time, and to ascertain whether at any point of time there is likely to be excess
or shortage of cash.
The first element of cash budget is the selection of the period of time to be covered by
the budget. It s referred to as the planning horizon over which the cash flows are to be
projected. There is no fixed rule , it varies from firm to firm. The period selected should
be neither too long nor too short. If it is too long, it is likely that the estimates will be
inaccurate. If, on the other hand, the time span is too small many important events which
lie just beyond the period cannot be accounted for and the work associated with the
preparation of the budget becomes excessive. If the flows are expected to be stable and
dependable, such a firm may prepare a cash budget covering a long period, say, a year
and divide it into quarterly intervals. In the case of firms whose flows are uncertain, a
quarterly budget, divided into monthly intervals, may be appropriate. If the flows are
subjected to extreme fluctuations, even a daily budget may be called for. The idea
behind subdividing the budget period into smaller intervals is to highlight the movement
of cash from one subperiod to another.
The second element of the cash budget is the selection of the factors that have a
bearing on cash flow. Items included in cash budget are only cash items; non-cash items
like depreciation and amortisation are excluded. The cash budgets are broadly divided
into two broad categories: (a)operating and (b) financial. The former includes cash
generated by the operations of the firms and are known as operating cash flows, the
later consists of financial cash flows.

Operating Cash Flow

Operating Cash Flow Items
Inflows / Cash Receipts Outflows / Disbursements
1. Cash Sales 1. Accounts payable / Payable payments
2. Collection of Accounts Receivables 2. Purchase of raw materials
3. Disposals of Fixed Assets 3. Wages and Salaries
4. Factory Expenses
5. Administrative and selling expenses
6. Maintenance Expenses
7. Purchase of Fixed Assets
Among the operating factors affecting cash flows, are the collection of accounts ( inflows
) and accounts payable ( outflows ). The terms of credit and the speed with which the
customer pay would determine the lag between the creation of accounts receivable and
their collection. Also, discounts and allowances for early payments, returns from
customers and bad debts affect cash inflows. Similarly in case of accounts payable
relating to credit purchase, cash outflows are affected by the purchase terms.

Financial Cash Flows

Financial Cash Flow Items

Cash Inflows / Receipts Cash Outflows / Payments
1. Loans / Borrowings 1. Income-tax / Tax payment
2. Sales of Securities 2. Redemption of loan
3. Interest received 3. Repurchase of shares
4. Dividend received 4. Interest paid
5. Rent received 5. Dividend paid
6. Refund of tax
7. Issue of new shares and securities

Preparation of Cash Budget

After the time span of the cash budget decided and the pertinent operating and financial
factors have been identified, the final step is the construction of the cash budget. Thus
the total cash inflows, cash outflows and the net receipt or payment is worked out.

C) Cash Management : Basic Strategies

The cash budget, as a management tool, would throw light on the net cash position of
the firm. After knowing the cash position, the management should workout the basic
strategies to be employed to manage its cash.
The broad cash management strategies are essentially related to the cash turnover
process, that is, the cash cycle together with the cash turnover. The cash cycle refers to
the process by which the cash is used to purchase materials from which are produced
goods, which are then sold to customers, who later pay the bills. The firm receives cash
from customers and the cycle repeats itself. The cash turnover means the number of
times the cash is used during each year. The cash cycle involves several steps along
the way as fund flows from the firms accounts.

Minimum Operating Cash

The higher the cash turnover, the less is the cash a firm requires. A firm should,
therefore, try to maximize the cash turnover. But it must maintain a minimum amount of
operating cash balance so that it does not run out of cash. The basic strategies that can
be employed to do the needful are as follows:
i) Stretching accounts payable : In other words, a firm should pay its
accounts payable as late as possible without damaging its credit standing. It
should, however take advantage of the cash discount available on prompt
payment.
ii) Efficient Inventory-Production Management : Increase inventory turnover,
avoiding stock-outs, that is, shortage of stocks. This can be done in following
ways:
a) Increasing the raw materials turnover by using more efficient inventory
control techniques.
b) Decreasing the production cycle through better production planning,
scheduling and control techniques, it will lead to an increase in WIP
inventory turnover.
c) Increasing the finished goods turnover through better forecasting of
demand and a better planning of production.
iii) Speeding Collection of Accounts Receivable : Another strategy for
efficient cash management is to collect account receivable as quickly as
possible without losing future sales because of high-pressure collection
techniques. The average collection period of the receivables can be reduced
by changes in (a) credit terms, (b) credit standards, and (c) collection policies.
iv) Combined Cash Management Strategies : We have seen strategies related
to (i) accounts receivables, (ii) inventory, and (iii) accounts receivables but
there are certain problems for management . First, if the accounts payable
are postponed too long, the credit standing of the firm may be adversely
affected. Secondly, a low level of inventory may lead to a stoppage of
production as sufficient raw materials may not be available for uninterrupted
production, or the firm may be short of enough stock to meet the demand for
 its product, that is, ‘stock-out’. Finally, restrictive credit standards, credit terms
and collection policies may jeopardize sales. These implications should be
constantly kept in view while working out cash management strategies.

2. Receivables Management

A) Objectives

The term receivables is defined as debt owed to the firm by the customers arising from
sale of goods or services in the ordinary course of business. When a firm makes an
ordinary sale of goods or services and does not receive payment, the firm grants trade
credit and creates accounts receivables which could be collected in the future.
Receivables management is also called trade credit management. Thus accounts
receivable represent an extension of credit to customers, allowing them a reasonable
period of time in which to pay for the goods received.
The sale of goods on credit is an essential part of the modern competitive economic
systems. In fact, the credit sale and, therefore, the receivables, are treated as a
marketing tool to aid the sale of goods. As a marketing tool, they are intended to
promote sales and obligations through a financial instrument. Management should weigh
the benefits as well as cost to determine the goal of receivables management. The
objective of receivable management is to promote sales and profits until that point is
reached where the return on investment in further funding receivables is less than the
cost of funds raised to finance that additional credit. The specific costs and benefits
which are relevant to the determination of the objectives of receivables management are
examined below.
a) Costs : The major categories of costs associated with the extension of credit and
accounts receivable are
(i) Collection Cost : Collection costs are administrative costs
incurred in collecting the receivables from the customers to
whom credit sales have been made.
(ii) Capital Cost : The increased level of accounts receivable is
an investment in assets. They have to be financed thereby
involving a cost. It includes the additional funds required to
 meet its own obligation while waiting for payment from its
customer and also the cost on the use of additional capital to
support credit sales, which alternatively could be profitably
employed elsewhere.
(iii) Delinquency Cost : This cost arises out of the failure of the
customers to meet their obligations where payment on credit
sales become due after the expiry of the credit period. Such
costs are called delinquency costs.
(iv) Default Costs : Finally, the firm may not be able to recover
the overdues because of the inability of the customers. Such
debts are treated as bad debts and have to be written off as
they cannot be realized. Such costs are treated as default
costs associated with credit sales and accounts receivables.

b) Benefits : Apart from the costs, another factor that has a bearing on accounts
receivable management is the benefit emanating from credit sales. The benefits
are the increased sales and anticipated profits because of the more liberal policy.
The impact of the liberal trade credit policy is likely to take two forms. Firstly, it is
oriented to sales expansion. Secondly, the firm may extend credit to protect its
current sales against emerging competition. Here, the motive is sales-retention.
From the above discussion, it is clear that investments in receivables involve
both benefits and costs. The extension of trade credit has a major impact on
sales, cost and profitability. Therefore account receivable management should
aim at a trade off between profit (benefits) and risk (cost).
While it is true that general economic conditions and industry practices have a
strong impact on the level of receivables, a firms investment in this type of
current assets is also greatly affected by its internal policy. A firm has little or no
control over environmental factors, such as economic conditions and industry
practices. But it can improves its profitability through a properly conceived trade
credit policy or receivables management.

B) Credit Policies
In the preceding discussion it has been clearly shown that the firms objective with
respect to receivables management is not merely to collect receivables quickly but
attention should also be given to the benefit-cost trade-off involved in the various areas
of accounts receivable management. The first decision area is Credit Policies.
The credit policy of the firm provides the framework to determine (a) whether or not to
extend credit to a customer and (b) how much credit to extend. The credit policy decision
of firm has two broad dimensions:
(i) Credit Standards : The term credit standards represents the basic criteria for
the extension of credit to customers. The quantitative basis of establishing
credit standards are factors such as credit ratings, credit references, average
payment period and certain financial ratios. Since we are interested in
illustrating the trade-off between benefit and cost to the firm as a whole, we
do not consider here these individual components of credit standards. To
illustrate the effect, we have divided the overall standards into (a) tight or
restrictive, and (b) liberal or non-restrictive. The trade-off with reference to
credit standards covers
(a) Collection Costs : The implications of the relaxed credit standards are (i)
more credit, (b) a large credit department to service accounts receivable
and related matters, (iii) increase in collection costs. The effect of
tightening of credit standards will be exactly the opposite. These costs
are likely to be semi-variable.
(b) Investments in Receivables or the Average Collection Period : The
investment in accounts receivable involves a capital cost as funds have to
be arranged by the firm to finance them till customer makes payment.
Moreover higher the average accounts receivables, the higher is the
capital or carrying cost. A change in credit standards-relaxation or
tightening-leads to a change in the level of accounts receivable either (i)
through a change in sales, or (ii) through a change in collections.
A relaxation in credit standards, as already stated, implies an increase in
sales which, in turn, would lead to higher average accounts receivable.
Further relaxed standards would mean that credit is extended liberally so
that it is available to even less credit-worthy customers who will take a
longer period to pay overdues. In contrast, a tightening of credit standards
would signify (i) a decrease in sales and lower average accounts
 receivables, and (ii) an extension of credit limited to more credit-worthy
customers who can promptly pay their bills and, thus, a lower average
level of accounts receivable.
(c) Bad Debt Expenses : Another factor which is expected to
be affected by changes in credit standards is bad debt
expenses. They can be expected to increase with
relaxation in credit standards and decrease if credit
standards become more restrictive.
(d) Sales Volume : Changing credit standards can also be
expected to change the volume of sales. As standards are
relaxed, sales are expected to increase; conversely, a
tightening is expected to cause a decline in sales.

B) Credit Analysis

Besides establishing credit standards, a firm should develop procedures for evaluating
credit applicants. The second aspect of credit policies of a firm is credit analysis and
investigation. Two basic steps are involved in the credit investigation process :
(a) Obtaining Credit information : The first step in credit analysis is obtaining
credit information on which to base the evaluation of a customer. The sources of
information, broadly speaking, are
(i) Internal : Usually, firms require their customers to fill various forms and
documents giving details about financial operations. They are also
required to furnish trade references with whom the firms can have
contacts to judge the suitability of the customer for credit. This type of
information is obtained from internal sources of credit information.
Another internal source of credit information is derived from the records of
the firms contemplating an extension of credit.
(ii) External : The availability of information from external sources to assess
the credit-worthiness of customers depends upon the development of
institutional facilities and industry practices. In India, the external sources
of credit information are not as developed as in the industrially advanced
countries of the world. Depending upon the availability, the following
external sources may be employed o collect information.
 - Financial Statements : One external source of credit information is
the published financial statements, that is, the balance sheet and the
profit and loss account. They contain very useful information such as
applicants financial viability, liquidity, profitability, and debt capacity.
They are very helpful in assessing the overall financial position of a
firm, which significantly determines its credit standing.
- Bank References : Another useful source of credit information is the
bank of the firm which is contemplating the extension of credit. The
modus operandi here is that the firm’s banker collects the necessary
information from the applicants bank. Alternatively, the applicant may
be required to ask his banker to provide the necessary information
either directly to the firm or to its bank.
- Trade References : These refer to the collection of information from
firms with whom the applicant has dealings and who on the basis of
their experience would vouch for the applicant.
- Credit Bureau Report : Finally, specialist credit bureau reports from
organizations specializing in supplying credit information can also be
utilized.

(b) Analysis of Credit Information : Once the credit information has been
collected from different sources, it should be analysed to determine the credit-
worthiness of the applicant. The analysis should cover two aspects:
(i) Quantitative : The assessment of the quantitative aspects is based on
the factual information available from the financial statements, the past
records of the firm, and so on. The first step involved in this type of
assessment is to prepare an Aging Schedule of the accounts payable of
the applicant as well as calculate the average age of accounts payable.
This exercise will give an insight into the past payment pattern of the
customer. Another step in analyzing the credit information is through a
ratio analysis of the liquidity, profitability and debt capacity of the
applicant. These ratios should be compared with the industry average.
Morever, trend analysis over a period of time would reveal the financial
strength of the customer.
 (ii) Qualitative : The quantitative assessment should be supplemented by a
qualitative/subjective interpretation of the applicants credit-worthiness.
The subjective judgement would cover aspects relating to the quality of
management. Here, the reference from other suppliers, bank references
and specialist bureau reports would form the basis for the conclusion to
be drawn. In the ultimate analysis, therefore, the decision whether to
extend credit to the applicant and what amount to extend will depend
upon the subjective interpretation of his credit standing.

C) Credit Terms

The second decision area in accounts receivables management is the credit terms. After
the credit standards have been established and the credit-worthiness of the customer
has been assessed, the management of a firm must determine the terms and conditions
on which the trade credit will be made available. The stipulations under which goods are
sold on credit are referred to as credit terms. The credit terms specifies the repayment
terms of receivables.
The credit terms have three components : (i) credit period, in terms of duration of time
for which trade credit is extended-during this period the overdue amount must be paid by
the customer; (ii) cash discount, if any, which the customer can take advantage of,
that is, the overdue amount will be reduced by this amount; and (iii) cash discount
period, which refers to the duration during which the discount can be availed of.
The credit terms, like the credit standards, affect the profitability as well as the cost of a
firm. A firm should determine the credit terms on the basis of cost-benefit trade-off. The
components of credit are here below:
(a) Cash Discount : The cash discount has implications for the sales volume, average
collection period/average investment receivables, bad debt expenses and profit per unit.
In taking a decision regarding the grant of cash discount the management has to se
what happens to these factors if it initiates increase, or decrease in the discount rate.
The changes in the discount rate would have both positive and negative effects. The
implications of increasing or initiating cash discount are as follows:
i. The sales volume will increase. The grant of
discount implies reduced prices. If the demand for the products is elastic,
reduction in prices will result in higher sales volume.
 ii. Since the customers, to take advantage of the discount, would
like to pay within the discount period, the average collection period would be
reduced. The reduction in the collection period would lead to a reduction in the
investment in receivables as also the cost. The decrease in the average
collection period would also cause a fall in bad debt expenses. As a result,
profits would increase.
iii. The discount would have a negative effect on the profits. This is
because the decrease in prices would affect the profit margins per unit of sale.
D) Collection Policies

The third area involved in accounts receivable management is collection policies. Thy
refer to the procedures followed to collect the accounts receivable when, after the expiry
o the credit period, they become due. These policies cover two aspects:
(i) Degree of Collection Effort : To illustrate the effect of the collection effort, the credit
policies of a firm may be categorised into (i) strict / light, and (ii) lenient. The collection
policy would be tight if very rigorous procedures are followed. A tight collection policy
has implications which involve benefits as well as costs. The management has to
consider a trade-off between them. Likewise, a lenient collection effort also affects the
cost-benifit trade-off. The effect of tightening the collection is discussed below :
- Bad debt expenses would decline.
- The average collection period will be reduced.
- As a result profit will increase.
- Increased collection costs.
- Decline in sales volume.

The effect of lenient policy will just be the opposite.

(ii) Type of Collection Efforts : The second aspect of collection policies relates to the
steps that should be taken to collect overdues from the customers. A well established
collection policy should have clear-cut guidelines as to the sequence of collection efforts.
After the credit period is over and payment remains due, the firm should initiate
measures to collect them. The effort should in the beginning be polite, but, with the
passage of time, it should gradually become strict. The steps usually taken are (i) letters,
including reminders, to expedite payment; (ii) telephone calls for personal contact; (iii)
personal visits; (iv) help of collection agencies; and finally,(v) legal action. The firm
should take recourse to very stringent measures, like legal actions, only after all other
avenues have been fully exhausted. They not only involve cost but also affect the
relationship with the customers. The aim should be to collect as early as possible;
genuine difficulties of the customers should be given due consideration.
3. Marketable Securities

A) Meaning And Characteristics

Once the optimal level of cash balance of a firm has been determined, the residual of its
liquid assets is invested in marketable securities. Such securities are short term
investment instruments to obtain a return on temporarily idle funds. In other words, they
are securities which can be converted into cash in a short period of time, typically a few
days. To be liquid, a security must have two basic characteristics: a ready market and
safety of principal. Ready marketability minimizes the amount of time required to convert
a security into cash. A second determinant of liquidity is that there should be little or no
loss in the value of a marketable security over time. Only those securities that can be
easily converted into cash without any reduction in the principal amount qualify for short
term investments. A firm would be better off leaving the balances in cash if the
alternative were to risk a significant reduction in principle.

B) Selection Criterion

A major decision confronting the financial managers involves the determination of the
mix of cash and marketable securities. In general, the choice of the mix is based on a
trade-off between the opportunity to earn a return on idle funds during the holding
period, and the brokerage costs associated with the purchase and sale of marketable
securities.
There are three motives for maintaining liquidity and therefore for holding marketable
securities: transaction motive, safety motive and speculative motive. Each motive is
based on the premise that a firm should attempt to earn a return on temporarily idle
funds. An assessment of certain criteria can provide the financial manager with a useful
framework for selecting a proper marketable securities mix. These considerations
include evaluation of :
 (i) Financial Risk : It refers to the uncertainty of expected returns from a
security attributable to possible changes in the financial capacity of the
security issuer to make future payments to the security owner. If the
chances of default on the terms of the investment is high, then the
financial risk is said to be high and vise versa .
(v) Interest Rate Risks : The uncertainty associated with the expected
returns from a financial instrument attributable to changes in interest
rates is known as interest rate risk. If prevailing interest rates rise
compared with the date of purchase, the market price of the securities
will fall to bring their yield to maturity in line with what financial
managers could obtain by buying a new issue of a given instrument, for
instance, treasury bills. The longer the maturity of the instrument, the
larger will be the fall in prices. To hedge against the price volatility
caused by interest rate risk, the market securities portfolio will tend to
be composed of instruments that mature over short period.
(vi) Taxability : Another factor affecting observed difference in market yields
is the differential impact of taxes. A differential impact on yields arises
because interest income is taxed at the ordinary tax rate while capital
gains are taxed at a lower rate.
(vii) Liquidity : With reference to marketable securities portfolio, liquidity
refers to the ability to transform a security into cash. The financial
manager will want the cash quickly and will not want to accept a large
price reduction in order to convert the securities.
(viii) Yield : The final selection criterion is the yields that are available on the
different financial assets suitable for inclusion in the marketable
portfolio. All the four factors listed above, influence the available yields
on financial instruments. The finance manager must focus on the risk-
return trade-offs associated with the four factors on yield through his
analysis.

Marketable Security Alternatives

i) Treasury Bills : There are obligations of the government. They are sold on a
discount basis. The investor does not receive an actual interest
 payment. The return is the difference between the purchase price and
the face value of the bill. The treasury bills are issued only in bearer
form. They are purchased, therefore, without the investors name on
them. As the bills have the full financial backing of the government, they
are, for all practical purposes, risk-free.
ii) Negotiable Certificates of Deposits : These are marketable receipts for
funds that have been deposited in a bank for a fixed period of time. The
deposit funds earn a fixed rate of interest. The CD’s are offered by
banks on a basis different from treasury bills, that is, they are not sold at
discount. When the certificate mature, the owner receives the full
amount deposited plus the earned interest.
iii) Commercial Paper : It refers to short-term unsecured promissory note sold
by large business firms to raise cash. As they are unsecured, the
issuing side of the market is dominated by large companies which
typically maintain sound credit rating. Commercial paper can be sold
either directly or through dealers. Companies with high credit ratings
can sell directly to the investors. They can even be purchased with
varying maturities. For all practical purposes, there is no active trading
in secondary market for commercial papers although direct sellers of
CPs often repurchase it on request.
iv) Bankers’ Acceptances : These are draft (order to pay) drawn on a specific
bank by an exporter in order to obtain payment for goods he has
shipped to a customer who maintains an account with that specific
bank. They can also be used in financing domestic trade. The draft
guarantees payment by the accepting bank at a specific point of time.
The seller who holds such acceptance may sell it at a discount to get
immediate funds. They serve the wide range of maturities and are sold
on a discount basis, payable to the bearer.
v) Repurchase Agreements : These are legal contracts that involves the actual
sale of securities by a borrower to the lender with a commitment on the
part of the former to repurchase the securities at the current price plus a
stated interest charge. The securities involved are government
securities and other money market instruments. The borrower is either a
financial institution or a security dealer.
 vi) Units : The units of Unit Trust of India (UTI) offers a reasonably convenient
alternative avenue for investing surplus liquidity as (i) there is a very
active secondary market for them, (ii) the income for units is tax-exempt
up to a specified amount and, (iii) the units appreciate in a fairly
predictable manner.
vii) Intercorporate Deposits : Intercorporate deposits, that is, short-term
deposits with other companies is a fairly attractive form of investment of
short-term funds in terms of rate of return which currently ranges
between 12 and 15 per cent. However, apart from the fact that one
month’s time is required to convert them into cash, intercorporate
deposits suffers from high degree of risk.
viii) Bill Discounting : Surplus funds may be developed to purchase/discount
bills. Bills of exchange are drawn by seller on the buyer for the value of
goods delivered to him. If the seller is in need of funds, he may get the
bills discounted. Bill discounting is superior to intercorporate deposits
for investing surplus funds.
ix) Call market : It deals with funds borrowed/lent overnight/one-day (call)
money and notice money for periods up to 14 days. It enables
corporates to utilize their float money gainfully. However the returns are
highly volatile. The stipulations pertaining to the maintenance of cash
reserve ratio (CRR) by banks is the major determinant of the demand of
funds and is responsible for volatility in call rates. Large borrowings by
them to fulfill their CRR requirements pushes up the rates and a sharp
decline takes place once these funds are met.

4. Inventory Management

A) Objectives
The basic responsibility of the financial manager is to make sure the firms cash flows are
managed efficiently. Efficient management of inventory should ultimately result in the
maximization of the owner’s wealth. As we know that in order to minimise cash
requirements, inventory should be turned over as quickly as possible, avoiding stock-
outs that might result in closing down the production line or lead to a loss of sales. It
implies that while the management should try to pursue the financial objective of turning
inventory as quickly as possible, it should at the same time ensure sufficient inventories
to satisfy production and sales demands. The objective of inventory management
consists of two counterbalancing parts: (i) to minimise investment in inventory, and (ii)
meet a demand for the product by efficiently organizing the production and sales
operations. These two conflicting objectives of inventory management can also be
expressed in terms of cost and benefit associated with inventory. That the firm should
minimise investment in inventory implies that maintaining inventory involves costs, such
that the smaller the inventory, the lower is the cost to the firm. But inventories also
provide benefits to the extent that they facilitate the smooth functioning of the firm: the
larger the inventory, the better it is from the viewpoint. Obviously, the financial managers
should aim at a level of inventory which will reconcile these conflicting elements. That is
to say, an optimum level of inventory should be determined on the basis of the trade-off
between costs and benefits associated with the levels of inventory.

B) Costs of Holding Inventory

One operating objective of inventory management is to minimise cost. Excluding the cost
of merchandise, the cost associated with inventory fall into two basic categories:
(i) Ordering or Acquisition or Set-up costs : This category of cost is associated
with the acquisition or ordering of inventory. Firms have to place orders with
suppliers to replenish inventory of raw materials. The expense involved are
referred to as ordering costs. The ordering costs consist of (a) preparing the
purchase order or requisition form and (b) receiving, inspection, and recording
the goods received to ensure both quantity and quality. The cost of acquiring
materials consists of clerical costs and costs of stationery. It is therefore, called,
a set-up cost. They are generally fixed per order placed, irrespective of the
amount of the order. The acquisition costs are inversely related to the size of
inventory: they decline with the inventory. Thus, such costs can be minimised
 by placing fewer orders for a large amount. But acquisition of a large quantity
would increase the cost associated with the maintenance of inventory, that is,
carrying cost.

(ii) Carrying costs : The second broad category of costs associated with inventory
are the carrying costs. They are involved in maintaining or carrying inventory.
The cost of holding inventory may be divided into two categories:
(a) Those that arise due to the storing of inventory : The main
components of this category of carrying costs are (1). Storage
costs, that is, tax, depreciation, insurance, maintenance of the
building, utilities and janitorial services; (2). insurance of
inventory against fire and theft; (3). Deterioration in inventory
because of pilferage, fire, technical obsolescence, style
obsolescence and price decline; (4). Serving costs, such as,
labour for handling inventory, clerical and accounting costs.
(b) The opportunity cost of funds : This consists of expenses in
raising funds (interest on capital) to finance the acquisition of
inventory. If funds are not locked in inventory, they would have
earned a return. This is the opportunity cost of funds or
financial cost component of the cost.
The carrying costs and the inventory size are positively related
and move in the same direction. If the level of inventory
increases, the carrying costs also increase and vice versa.
The sum of the order and carrying costs represents the total
cost of inventory. This is compared with the benefits arising out
of inventory to determine the optimum level of inventory.

C) Benefits of Holding Inventory

The second element in the optimum inventory decision deals with the benefits
associated with holding inventory. The three types of inventory, raw materials, work-in-
progress and finished goods, perform certain useful functions. The rigid tying (coupling)
of purchase and production to sales schedules is undesirable in the short run as it will
deprive the firms certain benefits. The effect of uncoupling (maintaining inventory) are as
follows
(i) Benefits in Purchasing : If the purchasing of raw materials and other goods
is not tied to production/sales, that is, a firm can purchase independently to
ensure the most efficient purchase, several advantages would become
available. In the first place, a firm can purchase larger quantities than is
warranted by usage in production or the sales level. This will enable it to avail
of discounts that are available on bulk purchases. Moreover, it will lower the
ordering cost as fewer acquisitions would be made. There will, thus, be a
significant saving in the costs. Secondly, firms can purchase goods before
anticipated or announced price increases. This will lead to a decline in the
cost of production. Inventory, thus, serves as a hedge against price increases
as well as shortages of raw materials. This is highly desirable inventory
strategy.
(ii) Benefits in Production : Finished goods inventory serves to uncouple
production and sale. This enables production at rate different from that of
sales. That is, production can be carried on at a rate higher or lower than the
sales rate. This would be a special advantage to firms with seasonal sales
pattern. In their case, the sales rate will be higher than the production rate
during the part of the year (peak season) and lower during the off season.
The choice before the firm is either to produce at a level to meet the actual
demand, that is, higher production during peak season and lower (or nil)
production during off-season, or, produce continuously throughout the year
and build up inventory which will be sold during the period of seasonal
demand. The former involves discontinuity in the production schedule while
the later ensures level production. The level production is more economical
as it allows the firm to reduce the cost of discontinuities in the production
process. This is possible because excess production is kept as inventory to
meet future demands. Thus, inventory helps a firm to coordinate its
production scheduling so as to avoid disruption and the accompanying
expenses. In brief, since inventory permits least cost production scheduling,
production can be carried on more efficiently.
(iii) Benefits in Work-in-Progress : The inventory in Work-in-Progress performs
two functions. In the first place, it is necessary because production processes
 are not instantaneous. The amount of such inventory depends upon
technology and efficiency of production. The larger the steps involved in the
production process, the larger the WIP and vice versa. By shortening the
production time, efficiency of the production process can be improved and the
size of this type of inventory reduced. In a multi-stage production process, the
WIP serves a second purpose also. It uncouples the various stages of
production so that all of them do not have to be performed at the same time
rate. The stages involving higher set-up costs may be most efficiently
performed in batches with WIP inventory accumulated during a production
run.
(iv) Benefits in Sales : The maintenance in inventory also helps a firm to
enhance its sales efforts. For on thing, if there are no inventories of finished
goods, the level of sales will depend upon the level of current production. A
firm will not be able to meet demand instantaneously. The inventory serves to
bridge the gap between current production and actual sales. A basic
requirement in a firms competitive position is its ability vis-à-vis its competitor
to supply goods rapidly. If it is not able to do so, the customer are likely to
switch to suppliers who can supply goods at short notice. Moreover, in the
case of firm having a seasonal pattern of sales, there should be a substantial
finished goods inventory prior to the peak sales season. Failure to do so may
mean loss of sales during the peak season.

To summarise the preceding discussion relating to objective of inventory management,

the two main aspects pertain to the minimisation of investment in inventory, on the one
hand, and the need to ensure that there is enough inventory to meet demand such that
production and sales operations are smooth. By holding less inventory, the cost can be
minimized, but there is a risk that the operations will be disturbed as the emerging
demands cannot be met. On the other hand, by holding a large inventory, the chances of
disruption of operations are reduced, but, the cost will increase. The appropriate level of
inventory should be determined in terms of a trade-off between the benefits and cost
associated with maintaining inventory.

D) Techniques
There are many sophisticated mathematical techniques available to handle inventory
management problems. We will discuss some of the simple production-oriented methods
of inventory control to indicate a broad framework for managing inventories efficiently in
conformity with the goal of wealth maximization. The major problem – areas that
comprise the heart of inventory control are

(i) Classification Problem : A B C System

The A B C System is a widely used classification technique to classify different types
of inventories and to determine the type and degree of control required for each.
This technique is based on the assumption that a firm should not exercise the same
degree of control on all items of inventory. It should rather keep a more rigorous
control on items that are (a) the most costly, and/or (b) the slowest-turning, while
items that are less expensive should be given less control effort.
On the basis of the cost involved, the various inventory items are classified into three
classes A, B and C. The items included in group A involves largest investment.
Inventory control for such items must be most rigorous and intensive and most
sophisticated inventory control techniques should be applied to these items. The C
group item consists of items of inventory which involve relatively small investments
although the number of items is fairly large. These items deserve minimum attention.
The B group stands midway. It deserves less attention than A but more than C. It can
be controlled by less sophisticated technique.

(ii) Order Quantity Problem : Economic Order Quantity ( EOQ ) Model

After determining the type of controls for each categories of items ( A B and C ),
question arises regarding the appropriate quantity to be purchased in each lot to
replenish the stock. Buying a large quantity implies a higher average inventory level
which will assure (a) smooth production/sales operations, and (b) lower ordering or
setup costs. But it will involve higher carrying costs. On the other hand, if the order
quantity is small then the carrying cost is reduced but it will increase the ordering
costs. On the basis of the trade-off between the both the optimum level of order to
be placed should be determined. The optimum level of inventory is called as
economic order quantity (EOQ). The economic order quantity can be defined as that
level of inventory order that minimises the total cost associated with inventory
management.
Assumptions : EOQ model is based on following assumptions:
- the firm knows with certainty the annual consumption of a particular
item of inventory.
- The rate at which the firm uses inventory is steady over time.
- The order placed to replenish inventory stocks are received at exactly
that point in time when inventories reach zero.
- There are two distinguishable costs associated with inventories: cost
of ordering and cost o carrying.
- Cost of order is constant regardless of the size of the order.
- The cost of carrying is fixed percentage of the average value of
inventory.

EOQ Formula :

EOQ = I 2FU
   PC

where
U = annual sales
F = fixed cost per order
P = purchase price per unit
C = Carrying cost

Limitations :
- The assumption of constant consumption and the instantaneous
replenishment of inventories are of doubtful validity. It is possible that
deliveries from suppliers may be slower than expected for reasons
beyond control. It is also possible that there may be an unusual and
unexpected demand for stocks. To meet such contingencies
additional stock called as safety stock is kept.
 - Another weakness of EOQ model is that the assumption of a known
annual demand for inventories is open to question. There is likelihood
of discrepancy between the actual and the expected demand, leading
to a wrong estimate of the economic ordering quantity.
- In addition, there are some computation problems involved. A more
difficult situation may occur when the number of orders to be placed
may turn out to be a fraction.

A Case Study On SIEMENS LTD :

The present study seeks to analyse the working capital management with a case study
of a noted company in the capital goods industry, viz. Siemens Ltd. The case study
aims at examining in the context of the published figures of the accounting
statements how far the management of WC has been successful in case of
Siemens during period 1997 to 2001.

Siemens Ltd. is a leading electrical and electronics engineering company in India.

Established in 1922, it was incorporated as a company in 1957 and in 1962 was
converted into a public limited company with 51% of its equity held by Siemens AG
and the remaining 49% held by Indian shareholders. It operates in the energy,
industry, health care, transportation, information, communications and components
business segments It also operates joint ventures in the fields of
telecommunications and information technology.

In addition, Siemens Group in India has presence in the field of Power Design,
Renovation & Modernisation of existing power plant, Lighting, and Household
goods. The Siemens Group in India has a widespread marketing and distribution
network in addition to multiple manufacturing facilities in India. It also has a well
organised up-market value addition in Engineering, Software, System Integration,
Erection, Commissioning and Customer Services

General Performance Review

The first recession of the new millennium has set in. Most indicators suggest that the
Indian economy is running out of steam. The uncertainty of its revival has cast a shadow
on the prospects of a 6.5% GDP growth rate for the current fiscal. Consequently, the
Central Statistical Organization has scaled down GDP growth for 2000-01 to 5.2% This
makes it the third worst growth rate since 1991-92.

In the Infrastructure area, the Power Generation sector continued to experience a

sluggish growth for the 6th consecutive year, with a meager 4,000 MW being added to
the installed capacity last year. The issue of payment security as offered by the State
Electricity Boards has put investors on high caution. As part of power sector reforms, the
Government’s focus on the Power Transmission and Distribution (T&D) sector,
generated a higher demand in the High Voltage and Metering businesses. Reduced
budgetary support to Railways put new projects on hold, with emphasis shifting to areas
such as safety. Siemens too experienced similar trends, with Power Generation’s order
inflow contracting, although the Power Plant Automation and High Voltage business
witnessed higher growth than other segments. Transportation Systems business volume
too remained steady. Despite the difficult environment, these businesses have posted
satisfactory results.

The Industrial segment continued to remain stagnant due to the lack of fresh
investments. In the first four months of 2001-02 (April – July 2001), industrial production
grew by only 2.3% as compared to 5.9% during the same period of the previous year.
Overall, the market characteristics changed to smaller sized orders, while the industry
continued to experience price cut-backs due to competitive forces. In order to combat
the pressures, several key players in this segment were engaged in restructuring their
businesses in order to optimize capacities and reduce costs. Besides, as a consequence
of lower demand, new projects suffered. Yet, in this lackluster market, Siemens
succeeded in gaining market shares in most areas, while improving its overall
profitability position through the launch of innovative products, systems, solutions and
services, as well as an improved cost structure. One area that remains of high concern
is the Low Voltage Distribution Systems, which is saddled with excess capacity.

Siemens’ overall market and customer focus approach saw it launch numerous
innovative products, systems, solutions and service. This enabled it to attain an
increased market share. At the same time, improved productivity and effective asset
management, gave the Company a better cost structure, which boosted its bottom-line.
While the top-line has remained steady, the Company substantially improved the quality
of its results, bringing it further to a healthier and more stable position.

Energy

Power Generation

In the last year, Power Generation in India continued to experience sluggish growth,
which saw a meager 4,000 MW being added to the installed capacity. In the wake of the
continued slow pace of reforms, no major projects took off the ground, considerably
affecting the new order inflow position. Issues surrounding the payment security as
offered by the State Electricity Boards (SEBs) have additionally acted as deterrents
putting investors on high caution.

The Power Generation Division’s business was therefore impacted due to the declining
market conditions. While New Order intake and turnover overall declined by 23% and
28% respectively as compared to the previous year, the Division’s export business
volume witnessed a two-fold increase. The Division posted a healthy margin, with the
Automation group being a major contributor to the profitability, which also gained
substantial market share.

In the last year, the Division signed an agreement with Instrumentation Ltd., Kota, a
public sector enterprise, to address the power plant automation needs of SEBs and
Central Power Sector Utilities. In keeping with its policy to continually provide enhanced
value, the Division launched new automation solutions that have met with considerable
success. The introduction of new technologies and innovative customer-centric
strategies supported its increased market penetration. In the area of service, the Division
has launched new initiatives, which included a Call Center concept to ensure round-the-
clock connectivity with customers. It also received its first comprehensive C&I
maintenance contract worth Rs. 8 million from DVC Mejia.

Some of the other important orders received last year include those bagged by the
Division’s Automation Group for the Renovation & Modernisation of WBSEB Santaldih
valued at Rs 45 million and captive power plant units of Hindalco, Renusagar (2x84 MW)
valued at Rs. 71 million. In addition the Service Groups too, received significant orders
from Paguthan (655 MW CCPP) and Reliance for a 25 MW Replacement Turbine at
Patalganga.

Outlook: In the backdrop of the continued slow pace of reforms and the long gestation
period for the benefits to be realized, this sector is expected to remain “stagnant” for the
current year. The scaling down of the power capacity addition from 40,000 MW to
20,000 MW in the Ninth Five-Year Plan period (1997-2001) is a further dampener to the
much-needed progress. While the Union Budget 2001 has not provided any major relief
to the IPPs, it is expected that captive power generation and co-generation will see
some growth.

The Power Generation Division’s focus will continue to be the same as in the last year
with added thrust on providing newer technologies to various areas, like steam
generation for thermal power plants. It intends to step up providing comprehensive
services by enhancing its all-India network and providing maximum benefits to its
customers

Energy

Power Transmission and Distribution Division

The Transmission and Distribution (T&D) sector emanated mixed signals last year.
Identification of T&D as a priority sector, with the Government’s plans to invest Rs 400
million over three years, is a positive sign. On the other hand, the poor financial state of
the State Electricity Boards (SEBs), continues to hinder growth. Overall, the T&D market
has a CAGR of 5%, with below average growth in the medium voltage and transformer
segments, and above average growth in the high voltage and automation segments.

During the last fiscal, the Division introduced new products such as the 36kV Air
Insulated metal-clad Switchgear as well as the low-cost numerical relays targeted at the
Industry and Utilities segment. It also ventured into a new business area, that of
protection systems for high-capacity generators. In a significant development, the
Division was awarded market development responsibilities in eight more Asian and
African countries by Siemens AG. It also signed a Technical Collaboration agreement
with a Switchboard manufacturer abroad to promote exports..

Some major orders bagged by the Division in the last year include those from Karnataka
Power Transmission Corporation Ltd (KPTCL) and Haryana Vidyut Prasarak Nigam Ltd
(HVPNL) for HV Switchgear worth Rs 392 million and Rs 287 million respectively. It also
procured an order worth Rs 80 million from MSEB for Energy Management systems.
The Division has successfully executed orders from KPTCL and Gridco notched in the
previous fiscal.

Outlook: With T&D emerging as a priority sector, increase in demand for substations,
transmission lines and metering equipment is expected to provide greater business
opportunities in which the Division looks forward to being a key participant. While
enhancing its dominance as a major T&D player in India, it has in the offing new
initiatives in the area of Energy Management Systems. The Division will increase its
presence in the overseas market through a higher thrust in export business. In order to
stem losses and return back to profitability, the Division will undertake restructuring
measures entailing resource adjustments across all processes, particularly in the
manufacturing area.

Industry

Automation & Drives

The Industry segment, as a whole, witnessed a downward trend during the last fiscal,
mainly due to the substantial drop in new investments. A major portion of the Standard
Products Division’s (A&D) business is triggered as a result of such investments, as well
as from the maintenance sector, both of which have remained sluggish during the last
fiscal. To remain afloat in the difficult competitive environment, several leading
companies in this segment to which A&D caters, focused attention on restructuring,
rather than enhancing business.

Outlook: The market in which A&D operates is expected to remain stagnant in the year
ahead. In order to strengthen it’s position in this situation, the Division is working on
strategies for increasing sales through an increased presence in unserved market and
will introduce new offerings in Motors, Generators and Drives. It is investing in improving
service levels and will review processes so as to reduce cycle time, and costs.

Industrial Solutions & Services Division

Recessionary trends in the Indian economy dampened business sentiment in the

investment dependent industrial sector. During the last fiscal, the capital goods sector of
the industry continued its downward slide due to paucity of new investments and in the
first four months of 2001-02 (Apr – July 2001), it shrunk by 6.1%, compared to a growth
of 4.5% during the corresponding period of the previous year.

Outlook: With the decline in new investments in the industrial sector and sections of
industry shifting focus on restructuring operations, the market sentiments are expected
to remain dampened. Under the circumstances, the Division foresees a challenging year
ahead, specially since realizations from industrial projects usually have long gestation
periods.

Low Voltage Distribution Systems

At present, the low voltage distribution industry in India suffers from excessive
manufacturing capacity due to the presence of a large number of players and dwindling
demand as a result of the depressed market conditions.

In its endeavor to make operations viable, the Division has proposed to introduce
several measures. This includes an offer of alternative jobs to its workers at Siemens
Metering, a plant in the neighborhood. This process of implementation has seen some
delays resulting in the unit making even more production losses, thus affecting the
overall result.

Outlook: The market conditions are expected to remain depressed, with the prices
witnessing a further drop due to competitive forces. Under the present circumstances,
the Division’s business outlook is not very encouraging and it will have to undertake
some major actions to make the operations viable. Therefore, the Division‘s major
objective during the new fiscal is to bring the business back into the black with a new
approach.

Healthcare

Medical Solutions Division

The Indian healthcare market grew at about 15% with cardiology, oncology and high-end
diagnostics being the key growth areas in the metro centers and routine imaging and
critical care equipment in the non-metros. The entry of private healthcare service
providers had a catalytic influence in offering world-class medical diagnostic and
treatment facilities. These positive trends fueled business opportunities for the Medical
Solutions Division.

Outlook: The outlook for the Healthcare sector in India looks highly positive. Sizable
investments are expected to be made by private players for setting up corporate
hospitals and diagnostic centers

Transportation

Transportation Solutions Division

In the face of the severe resource crunch over the last two years, the Indian Railways
have put new investment programs on hold. Barring wagons, procurement of all rolling
stock items such as EMUs, Metro Coaches, Diesel & Electric Locomotives have been
curtailed and there are no fresh projects in the pipeline.

Outlook: Indian Railways' emphasis on safety improvements will see higher investments
in this segment in the future with a projected 11% growth in Signalling and 18% growth
in miscellaneous electricals. To retain it’s leadership position, the Division will seek out
opportunities that may so arise and will also venture into newer segments such as rolling
stock upgradation, multiple units etc.

Information & Communication

Enterprise Networks
The Information & Communication – Enterprise Networks (ICN EN) Division, after a slow
start during the first quarter, had a successful fiscal year registering a 15% growth in line
units versus the previous fiscal year. It made a substantial recovery from the second half
onwards with a strong sales momentum that resulted in a modest increase in revenues
by 6% over the previous year.

. Outlook: The Indian enterprise telecommunication market is poised to grow at 18 -

20% in the current year. The migration to Voice over IP (VOIP) technology, drop in tariffs
for long distance calls, availability of leased lines at competitive rates, growth in the
service industry with attendant boost in the call center market, are some key factors that
are expected to drive growth in the data, voice and video usage.

Information & Communication

Mobile Phones

The Information and Communication – Mobile Phones Division (ICM MP), has achieved
a commendable 147% growth in sales units during the last fiscal. Correspondingly,
revenues surged by 89% as a result of the Division’s aggressive sales and marketing
efforts.

Demand for mobile phones in India is being increasingly fueled by preference for
lifestyle-oriented brands, rather than technology and features. In keeping with this trend,
in the last year, ICM launched two new models, the A35 at the lower end and the SL 45
at the higher end. SL45, a technological revolution with a built-in MP3 player and a 32-bit
multimedia card, enables the user to listen to high-quality music. It is positioned as a
lifestyle accessory for the status-conscious. The A35, being one of the smallest and
lightest phones, is particularly attractive for the youth segment.

Outlook: In the current fiscal, the mobile phones market is expected to grow by nearly
70%. To meet the increased demand, ICM will increase retail visibility, strengthen
distribution network and further intensify its dealer development program to increase
sales at point-of-sale in major cities in India. It would also concentrate on continued
brand building efforts through the “Siemens Inspired Dealers” program and Siemens
“Shop-in-Shop” program.

Information & Communication

Siemens Information Systems Limited

The Indian software sector, which saw a phase of rapid growth in the last decade, has
begun to experience the effects of the global economic slowdown. Globally and in India,
the industry has witnessed a downward trend that began in the last quarter of FY 2000,
and in 2001, experienced its full impact.

Outlook: The current fiscal would continue to be tough for the software development
sector. In partnership with Siemens Business Systems, SISL expects to grow in the
Europe & Asia–Pacific regions. The company also plans to improve its EVA through
better payment collection.

Outlook for Siemens Ltd.

In the backdrop of continued economic slowdown, the infrastructure and industry sectors
in India are expected to remain “stagnant”. Even if there is a pick-up, it’s effects will be
evident anywhere between six months to one year in time lag. While the scaling down of
the power capacity addition from 40,000 MW to 20,000 MW in the 9th five year plan
period (1997-2001) has retarded growth in this sector, it is expected that captive power
generation and co-generation will pickup, providing opportunities for Siemens.

Power Transmission & Distribution is emerging as a priority sector in India and if the
issues surrounding payments and financing are resolved, this segment is expected to
see an increased demand for substations, transmission lines and metering equipment. If
this happens, Siemens expects to garner business opportunities as a key participant in
the development of this sector.

The low voltage distribution industry in India is suffering from over capacity and so is the
Siemens manufacturing unit at Joka, Kolkata. In order to make the operations of this unit
viable, the Company plans to initiate further actions to streamline and optimize
resources

The telecommunications sector, in particular for Enterprise Networks, is on the upswing.

New business opportunities continue to emerge in this sector, with the hospitality and
corporate sector showing stronger growth. Siemens plans to strengthen sales channels
to take advantage of this growth potential. In the fast growing mobile phones business,
Siemens plans to focus on increased retail visibility through special programs,
strengthen the distribution network and further intensify its channel sales to boost point-
of-sale volumes in major Indian cities.

The entry of corporate healthcare service providers and opening up of the healthcare
insurance sector to private players will make access to healthcare services easier and
provide the much-needed fillip to this sector. Here, Siemens is strongly poised to
leverage these emerging opportunities and plans to launch top-of-line products and
services, as called for by the market.

Audited Balance Sheet Of Siemens LTD

Table 1

S.R. No. Particulars

Year Year Year Year Year
ended ended ended ended ended
30.9.01 30.09.00 30.09.99 30.09.98 30.09.97
(12 mts) ( 12 mts ) ( 12 mts ) ( 12 mts ) ( 18 mts )

Net Sales & Services (excluding

1 11572.8 10832.75 10505.88 9959.3 17514.1
Excise Duty)

2 Lease and Other Income 778.74 896.39 715.06 525.2 461.9

3 Total Expenditure 10962 10573.94 10235.21 9680.67 16807.7

Operating Profit before Interest &

4 1389.3 1155.2 985.73 803.83 1168.3
Depreciation

5 Interest 17.12 48.85 278.2 466.02 1243.1

Gross Profit/Loss(-) after Interest but

6 1372.18 1106.35 707.53 337.81 -74.8
before Depreciation

7 Depreciation 294.58 315.01 358.08 472.76 724.4

 Profit / Loss(-) before Exceptional
8 1077.6 791.34 349.45 -134.95 -799.2
items and Tax Adjustment

9 Exceptional items -113.37 154.86 31.55 -331.87 -924.6

10 Tax Adjustment -236.43 106.16 29.8 -93.41 -37.5

11 NetProfit/Loss(-) 687.21 840.04 351.2 -560.23 -1556.3

12 Paid up Equity Share Capital 336.27 354.94 283.97 283.97 284

Reserves excluding revaluation

13 2873.69 2480.82 591.13 1173.77 1188.9
reserves
2. Objectives of the Study

The objective of the study is to make a comprehensive analysis of Working Capital Management of
the company . Specifically the objectives are :

i) To find out the size of Working Capital ( WC ) and to measure its liquidity and the operational
efficiency by using ratio analysis .
ii) To ascertain the estimated WC needs by fitting linear regression line , to find out the degree
of association between the estimated and the actual WC by competing simple correlation
coefficient and to test the significance of such coefficient .
iii) To make element-wise analysis of WC and to identify the elements / components responsible
for variation in WC .

3. Methodology of Study

The methods or the techniques which have been used for collection and analysis of data in this
study are as follows :
(i) Collection of Data : The data of SL for the period 1997 to 2001 used in this study has
been collected from the Annul Reports for the years 1997 to 2001.
(ii) Analysis of Data : For analysing the data the technique of ratio analysis , simple
mathematical tools like percentages and averages etc. and simple statistical technique
like Simple Correlation Technique have been used .

Findings of the study with detailed discussion

The observations on the findings of the study are as follows :

A. The size of WC and some liquidity and efficiency ratios of Siemens for the period of study have
been depicted in Table2 and 3. For this purpose , “ Gross Working Capital ( GWC ) Concept “ is
followed . The amount of GWC decreased from 729.6 crores in 1998 to 472.86 crores in 2000
showing a decrease of 35.2 %t . This quantitative comparison is not sufficient to judge the
efficiency of the WCM . For this reason , liquidity analysis and analysis of operational efficiency
have been done to assess the quantitative efficiency of the WCM of the company by computing
the following ratios .

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I. Liquidity Analysis :

Liquidity ratio

Table 2
S.R.No Particulars 1998 1999 2000 2001
1 Quick Ratio 0.40 0.35 0.42 0.63
2 Current ratio 0.85 0.93 0.90 1.01
3 Debt equity Ratio 1.99 1.25 0.51 0.15
4 PBDIT / Interest 0.47 0.37 1.52 8.18
5 Interest Incidence 31.84 17.85 17.38 12.54

(i) Current Ratio ( CR ) : This ratio is a basic measure of judging the ability of the company to
pay off its current obligations out of its short-term resources . The higher the CR, the larger is
the amount available per rupee of short term obligations and accordingly , the greater is the
feeling of security . Although sometimes it is said that a CR of 2 : 1 is ideal , but there is no
rigidity about it . Each firm has to develop its own standards or ideal ratio from past
experience and this only can be taken as a norm . It is observed from Table 1 from year 1998
the ratio was 0.85 : 1 . In the year 2001 the CR was 1.01 which is far below the conventional
standard of 2 : 1 which implies that liquidity position of the company was not satisfactory .

(ii) Quick Ratio ( QR ) : This ratio is a stricter test of liquidity than the CR as it gives no
consideration to inventory which may be slow moving . QR places more emphasis on
immediate conversion of assets into cash than does the CR. Rule of thumb is 1 : 1 for the QR
. Judged from the traditional norms, liquidity position of SL as weak as its QR fluctuated
between 0.40 in 1998 to 0.63 in 2001. On an average , this ratio was 0.5 . However, there
was a slight improvement in the QR during the last 3 years of the study period. Although it is
clear that in all the years under study liquid assets of the company were not adequate to
meet very short term debt, it is a fact that many well managed private sector enterprises in
India are successfully operating with a QR of just 0.5.
(iii) Debt Equity Ratio : The debt equity ratio has shown a downward trend in the recent years
and has also been in good . In the year 1998 the D/E ratio was 1.99 while in 2001 the same
is 0.15
(iv) Interest Coverage Ratio : This ratio measures the firms capacity to service the fixed interest
on term loan It is determined by dividing the operating profits or earnings before interest and

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 tax by the fixed assets interest charges on loans . It has been observed that SL has
continuously been increasing the service coverage ratio from 1998 to 2001. In the year 1998
the ratio was 0.47 and the same today in the year 2001 is 8.18

II. Operational Efficiency Analysis :

Inventory Turn Over Ratio

Table 3
S.R.No Particulars 1998 1999 2000 2001
1. Average days of raw material in Stores 100 127 79 52
2. Average Days of Production 30 27 22 17
3. Average days of finished goods 20 24 19 12
4. Average days of Debtors 87 135 113 103
5. Gross working Capital Cycle 236 313 233 185
6. Average days of Creditors 118 203 196 181
7. Net working capital cycle 119 111 36 4

(i) Inventory Turnover Ratio ( ITR ) : This ratio is a valuable measure of the efficiency of
inventory management . Generally speaking, the higher the ITR the shorter the average
time between investment in inventory and its conversion into sales and thus the greater
the efficiency of inventory management. The ITR of the company was higher in all the
years under when compared to ‘Indian Manufacturing industry’ average of 2.12. It
indicates that the company had cared or been able to manage its inventory very
impressively. In 1998 the cost of goods sold was Rs 824.94( crores )where as the
inventory was Rs 150.71 ( crores ) the calculated Inventory turn over ratio is 5.47. While
in 2001 the same was 11.81.Hence we also see an increase in the Inventory turnover
ratio which shows a positive trend during the period under study reflecting the substantial
improvement in the efficiency of inventory management of the company.

(ii) Debtor Turnover Ratio ( DTR ) : This ratio shows the efficiency achieved in using the
funds invested in debtors. This ratio can be given as Total Sales to debtor ( Sundry
Debtors and Advances recoverable in Cash ). The higher DTR implies quicker collection
of debtors and also enables the company to transact a larger volume of business without
corresponding increase in investment in debtors.

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B. To estimate the required amount of WC of SL assuming a linear dependency of WC on Sales,
the regression equation of WC on Sales y = a + bx has been considered where y = WC , x =
Sales b = regression coefficient of y on x and a = intercept . Refer Table 4 . Further , the
deviation between WC (y) and the estimated WC (y’) and co-efficient of correlation between
them have been found out .
Table 4

Sr. Year X Y X^2 XY Y^2

No. Sales GWC

Rs.'00 Rs.'00
Crores Crores
1 1997 1777.3 961.84 3158937.5 1709516.7 925136
2 1998 1042.1 729.06 1085930.7 759738.84 531528
3 1999 1099.4 552.48 1208570.4 607368.89 305234
4 2000 1142.8 472.86 1306014.7 540389.14 223597

Summ 5061.6 2716 6759453 3617014 1985495

MEAN 1265.4 679.1 1689863.3 904253.4 496373.8

From Table 4 we can say

Mean x = 1265.25
Mean y = 679.05

Syx = Summation(yx) – (Summation(x).summation(y))/n

( Where n = number of years )

Syx = 179330

Sxx = Summation(x^2)-((Summation(x))^2)/n

Sxx = 354553

Syy = Summation(y^2)-((Summation(y))^2)/n

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Syy = 141058

Co-efficient of Correlation r = Syx / Sqrt.(SxxxSyy)

= 0.80

b = Sxy/Sxx = 0.80

therefore a = 337.10 using the equation Y=a+bX where Y and X are the mean values )

The value of co-efficient of correlation signifies that there is a direct relation between WC and sales .
Using these values we can arrive to the equation as

Y = 337.10 + 0.80X

C. Operating Cycle
For the year 1999 the operating cycle can be calculated as

O=R+W+F+D–C

R = Raw Material storage period = Average stock of raw materials and stores
Average raw material & stores consumption per day

W = WIP Storage period = Average WIP Inventory

Average cost of production per day

F = Finished Goods Storage Period = Average Finished Goods Inventory

Average cost of goods sold per day

D = Debtors Collection Period = Average Book Debts

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 Average credit Sales/day

C = Creditors Payment Period = Average Trade Credit

Average Credit Purchase/day

Particulars Year Sep 97 Year Sep 98 Year Sep 99 Year Sep 00

18 mts 12 mts 12 mts 12 mts

Inventory management ( times )

Raw Material 3.6 2.94 4.82 6.89
Stores Turn over 7.18 1.32 0.86 0.72
Semi Finished goods turn over 12.19 13.55 16.93 21.65
Finished goods turn over 18.68 15.1 19.43 29.65

Debtors TurnOver 4.21 2.7 3.24 3.53

Creditors Turnover 3.1 1.8 1.86 2.02

Stock accumulation rate (%) -31.36 -26.25 -13.01 -46.29

Inventories / Current assets ( % ) 24.04 21.77 18.78 11.21
Inventories / working Capital( % ) -136.45 -269.61 -171.49 825.82

Working Capital Cycle

Average Daily ( Rs cr )
Purchase of raw material 0.8 0.47 0.51 0.51
Cost of sales 4.07 2.33 2.38 2.56
Sales 4.87 2.85 3.01 3.13

Holding period ( Nos of days )

Raw material and spares 100 127 79 52
Production 30 27 22 17
Finished goods 20 24 19 12
Debtors 87 135 113 103

Gross working capital cycle 236 313 233 185

Credit availed from creditors 118 203 196 181
Net working capital cycle 119 111 36 4

Gross working Capital reqd . ( Cr ) 961.84 729.06 552.48 472.86

Net working capital cycle ( Cr ) 482.62 257.51 86.27 9.94

Raw Material productivity ( Times )

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VOP/ Raw material 2.44 2.23 3.98 4.96
Gross Value added / raw material cost 1.18 1.1 1.12 1.39

Management of Sundary debtors

Incremantal Sales 702.64 -735.29 57.3 43.46
Incremental Contribution 101.01 -178.36 31.32 -27.44
Incremental Bad Debts 40.3 -50.58 0 0
Net Contribution 60.71 -127.78 31.32 -27.44

Incremental Debtors -12.21 -58.27 -35.55 3.28

Incremental Debtors at cost -10.2 -47.49 -28.04 2.68
Opportunity cost of debtors -3.66 -10.97 -7.96 0.57
Surplus 64.37 -116.81 39.28 -28.01

Credit Period ( Nos of days ) 87 135 113 103

4. Observations

The general performance regarding the Working Capital Management in SL was very much
encouraging during the period under study .
The Plus Points are :
• The company is in right direction of reducing the inventory , it is reduced from 72% in 1988 to
41.8% in 1994 and then it is nearly constant there after with 43.5% in 1999 of the GWC.
• Debtors have shown an increasing trend say from 87 days in 1998 to 103 days in 2001this is
also keeping in mind the recession shown by the market

• Through regression analysis we also have realized that the estimated working capital and the
actual can be analysed give the standard deviation between them . The fluctuation between
them is also minimum to operate at a better margins there by increasing over all profitability
of the business Hence the company would not face the risk of maximum over or under
utilization of WC funds which is also an indicator of better efficiency in managing WC on the
part of the company.
• Operating Cycle has reduced from 119 days in 1998 to just 4 days in the year 2001
• . Profit can be increased by controlling (a) bad debts , (b) control over Debtors and (c) also
by controlling inventory.

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 BIBLIOGRAPHY

1. Finance India Magazine

2. Annual Report ( 1997 – 2001 )

3. Web Site – Indiaifoline.com

4. Confideration for Monitoring Indian Economy ( Software Prowess)

5. Financial Management – Khan & Jain

7. Financial Management – Prasannachandra

8. Cash Management and working Capital Management – S Srinivasan

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