Module 6. Working capital management

Lesson 34

34.1 Introduction

It has already been stated that the working capital is the difference between current assets and the current liabilities. In order to estimate the requirements of working capital one has to forecast the amount of current assets and the current liabilities. However, in case of certain current assets the cash costs involved are much less than the value of the current assets. For example, if the sundry debtors are estimated at Rs. 1, 00,000 and the cost of production of the goods with them is only Rs. 75,000, the amount of funds blocked with them is only Rs. 75,000 and not Rs. 1, 00,000. Moreover, if the cost of production includes a sum of Rs.5.000 as depreciation the amount of actual funds blocked with them is only Rs. 70,000. This is equally true of the cost of finished goods and work-in-progress which may include the amount of depreciation. Many experts, therefore, calculate the working capital requirements by taking into account only the cash cost blocked in sundry debtors stock of work- in-progress and finished goods. According to this approach the debtors are computed not as a percentage of sales but as a percentage of cash costs. Similarly the finished goods and work-in-progress are valued according to cash cost. Planning is the essence of business management. It is only by planning that management can realistically view future problems, analyze them, study their Impact on the activities of business and decide on the policy to be followed for achieving the objective of making profits.

Profit planning is necessarily a part of operations planning. It is the basis of planning cash, capital expenditure and pricing. It involves the prediction of most aspects of a firm's operations. While enterprises usually plan its sales, activities and costs and then calculates the profit it hopes to make, in the case of profit planning. However, a target of profit is laid down in advance and then decision is taken regarding sales, activities and costs required to achieve the targets. Thus, "Profit planning is the planning of future operations to attain maximum profit or to maintain a specified level of profit".

34.2 Sources of Short Term Finance

· Acruals

· Trade Credit

· Working Capital advance by commercial banks

· Regulation of bank finance

· Public deposits

· Inter – corporate deposits

· Short – Term loans from financial institutions

· Right debentures for working capital

· Commercial paper

· Factoring


The major accrual items are wages and taxes. These are simply what the firm owes to its employees and to the government. Wages are usually paid on a weekly, fortnightly, or monthly basis – between payments, the amounts owed but not yet paid are shown as accrued wages on the balance sheet. Income tax is payable quarterly and other taxes may be payable half – yearly or annually. In the interim, taxes owed but not paid may be shown as accrued taxes on the balance sheet.

Accruals vary with the level of activity of the firm. When the activity level expands, accruals increase and when the activity level contracts accruals decrease. As they respond more or less automatically to changes in the level of activity, accruals are treated as part of spontaneous financing.

Trade credit

Trade credit represents the credit extended by the suppliers of goods and services. It is a spontaneous source of finance in the sense that it arises in the normal transactions of the firm without specific negotiations, provided the firm is considered credit worthy by its suppliers. It is an important source of finance representing 25 percent to 50 percent of short – term financing.

Working capital advance by commercial banks

Working capital advance by commercial banks represents the most important source for financing current assets. This section discusses the following aspects of this source of finance: (i) application and processing, (ii) sanction and terms of condition, (iii) forms of bank finance, (iv) nature of security and (v) margin amount.

Forms of Bank Finance

Working capital advance is provided by commercial banks in three primary ways: (i) cash credits/overdrafts, (ii) loans, and (iii) purchase / discount of bills. In addition to these forms of direct finance, commercials banks help their customers in obtaining credit from other sources through the letter of credit arrangement.

Cash Credits/ Overdrafts

Under a cash credit or overdraft arrangement, a pre – determined limit for borrowing is specified by the bank. The borrower can draw as often as required provided the outstandings do not exceed the cash credit / overdraft limit. The borrower also enjoys the facility of repaying the amount, partially or fully, as and when he desired interest is charged only on the running balance, not on the limit sanctioned. A minimum charge may be payable, irrespective of the level of borrowing, for availing this facility. This form of advance is highly attractive from the borrower's point of view because while the borrower has the freedom of drawing the amount in installments as and when required, interest is payable only on the amount actually outstanding.


These are advances of fixed amounts which are credited to the current account of the borrower or released to him in cash. The borrower is charged with interest on the entire loan amount, irrespective of how much he draws. In this respect this system differs markedly from the overdraft or cash credit arrangement wherein interest is payable only on the amount actually utilized. Loans are payable either on demand or in periodical installments. When payable on demand, loans are supported by a demand promissory note executed by the borrower. There is often a possibility of renewing the loan.

Purchase/ Discount of Bills

A bill arises out of a trade transaction. The seller of goods draws the bill on the purchaser. The bill may be either clean or documentary (a documentary bill is supported by a document of title to goods like a railway receipt or a bill of lading) and may be payable on demand or after a usance period which does not exceed 90 days. On acceptance of the bill by the purchaser, the seller offers it to the bank for discount / purchase. When the bank discount / purchases the bill it releases the funds to the seller. The bank presents the bill to the purchaser (the acceptor of the bill) on the due date and gets its payment.

The Reserve Bank of India launched the new bill market scheme in 1970 to encourage the use of bill as an instrument of credit. The objective was to reduce the reliance on the case credit arrangement because of its amenability to abuse. The new bill market scheme sought to promote an active market for bills as a negotiable instrument so that the lending activities of a bank could be shared by other banks. It was envisaged that a bank, when Likewise a bank which has surplus funds would invest in bills. Obviously for such a system to work, there has to be a lender of last resort which can come to the succor of the banking system as a whole. This role naturally has been assumed by the Reserve Bank of India which rediscounts bills of commercial banks up to a certain limit. Despite the blessings and support of the Reserve Bank of India, the new bill market scheme has not functioned very successfully in practice.

Letter of Credit

A letter of credit is an arrangement whereby a bank helps its customers to obtain credit from its (customer's) suppliers. When a bank opens a letter of credit in favour of its customers for some specific purchases, the bank undertakes the responsibility to honour the obligation of its customer, should the customer fail to do so. To illustrate suppose a bank opens a letter of credit in favour of A for some purchases that A plants to make from B. If A does not make payment to B within the credit period offered by B, the bank assume the liability of A for the purchases covered by the letter or credit arrangement. Naturally, B would hardly have any hesitation to extend credit to A when a bank opens a letter of credit arrangement the credit is provided by the supplier but the risk is assumed by the bank which opens the letter of credit. Hence, this is an indirect form of financing as against overdraft, cash credit, loans, and bill purchasing / discounting which are direct forms of financing. Note that in direct financing the bank assumes risk as well as provides financing.

34.3 Inter-Corporate Deposits

A deposit made by one company with another, normally for a period up to six months, is referred to as an inter – corporate deposit. Such deposits are usually of three types:

Call Deposits In theory, a call deposit is withdrawable by the lender on giving a day's notice. In practice, however, the lender has to wait for at least three days. The interest rate on such deposits may be around 12 percent annum.

Three-Months Deposits More popular in practice, these deposits are taken by borrows to tide over a short – term cash inadequacy that may be caused by one or more of the following factors : disruption in production, excessive imports of raw material, tax payment, delay in collection, dividend payment, and unplanned capital expenditure. The interest rate on such deposits is around 15 percent annum.

Six-Months Deposits Normally lending companies do not extend deposits beyond this time frame. Such deposits, usually made with first – class borrowers, carry an interest rate of around 18 percent per annum.

Characteristics of the Inter – Corporate Deposits Market

It may be of interest to note the following characteristics of the inter – corporate deposit market.

Lack of Regulation The lack of legal hassles and bureaucratic red tape makes an inter - corporate deposit transaction very convenient. In a business environment otherwise characterized by a plethora of rules and regulations, the evaluation of the inter – corporate deposit market is an example of the ability of the corporate sector to organize itself in a reasonably orderly manner.

Secrecy The inter – corporate deposit market is shrouded in secrecy. Brokers regard their lists of borrowers and lenders as guarded secrets. Tightlipped and circumspect, they are somewhat reluctant to talk about their business. Such desclosures, they apprehend, would result in unwelcome competition and undercutting of rates.

Importance of Personal Contacts Brokers and lenders argue that they are guided by a reasonably objective analysis of the financial situation of the borrowers. However, the truth is that lending decisions in the inter-corporate deposit markets are based on personal contacts and market information which may lack reliability. Given the secrecy that shrouds this operation and the non – availability of hard data, can it be otherwise?

Last modified: Friday, 5 October 2012, 10:37 AM