Planning & Financing of Working Capital

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1 Planning & Financing of Working Capital Objectives of Working Capital Elements of Working Capital Sources of Working Capital Working Capital Control and Banking Policy Tondon Committees Recommendations Illustration Chore Committee Report

2 Objectives of Working Capital Procurement of required amount of working capital and its effect utilization is the important function of working capital management. While preparing the working capital financial plan, the financial manager should be kept in mind following objectives. 1.Availability of adequate funds 2.Minimum cost 3.Matching between profitability and liquidity 4.Flexibility 5.Optimum use of funds

3 Objectives of Working Capital Let us see them in brief. 1. Availability of adequate funds: A sound working capital financial plan must ensure the supply of adequate amount of working capital needed by the business enterprises, for current & future needs. 2. Minimum cost: Fund required by the firm should be made available at the lowest cost. This is made possible through planning-considering in advance various cost factors and trends of capital market an suggesting the best course of action.

4 Objectives of Working Capital 3. Matching between profitability and liquidity: Profitability & liquidity are inversely related. A judicious balance between them is one of the fundamental principles of successful finance planning. 4. Flexibility: The working capital financial plan should provide sufficient scope for change and readjustment in the financial structure. 5. Optimum use of funds: All possible efforts should be made that funds do not remain idle.

5 Elements of Working Capital Working Capital Management refers to the administration of all aspects of current assets and current liabilities. The financial manager must determine the levels and composition of current assets. The following are the important elements of working capital. 1.Inventories 2.Accounts Receivables 3.Marketable Investment 4.Cash 5.Creditors

6 Elements of Working Capital 1. Inventories: Inventories constitute an important part of the current assets. It include all requirements in raw materials, spare parts and finished goods. There are many aspects of inventory management which should be taken into consideration such as: Fixing of level of inventories Determining economic ordering quantity Deciding the issue price policy Ensure proper storage facility Ensure cost control

7 Elements of Working Capital 2. Accounts Receivables: Most of the organisations use the credit sales method. The credit sales recorded in the book debts in accounting language. Regarding accounts receivables in working capital management, the finance manager must be taken into consideration such as: Ensure liberal credit policies Cost of recovering debts Interest charges Risk associated with advance credit Impact on promotion of sales Setting up the procedure for the creation of bills

8 Elements of Working Capital 3. Marketable Investments: Firm hold temporary investments for surplus cash flows arising either during seasonal operations or out of sale of long term securities. If the firm need to maintain sound working capital position, it should be taken into consideration such as: Determining the size of temporary investments Cash forecast Ensure the cash liquidity position Shortage of bank credit facilities Period of short-term investments Interest earned on investment

9 Elements of Working Capital 4. Cash: Cash is the significant portion of the working capital. There must be adequate cash to meet the requirement of all the segments of the organisation. The major source of cash is the amount of profit earned during the year from its business operations. It is necessary that every segment of the organization must consider the: Sources of cash inflows Application or uses of cash outflows Cash expenses Position of excess cash or less cash Cash forecast

10 Elements of Working Capital 5. Creditors: Creditors is one of the important elements of working capital. If the payment of creditor is delayed there is a possibility of saving of some interest but it can be very costly because it will spoil the goodwill of the concern in the market. If try to get liberal credit loans the payment may be made at the stipulated time.

11 Sources of Working Capital The financial manager is always interested in obtaining the WC; at right time, at right reasonable rate and at the best possible favorable terms. The long term WC can be conveniently financed by (a) Owner s Equity (b) Genders Equity and (c) Reduction of Fixed Assets. The short term WC fund can be obtained for financing day to day business requirements through; 1. Trade credit 2. Bank credit 3. Discounting Bills

12 Sources of Working Capital Sources of Working Capital Long Term Medium & Short Term Issue of Shares Internal External Floating of Debentures Depreciation Bank Credit Long Term Loan Taxation Provision Trade Credit Private Loans Accrued Expenses Discounting Bills, Notes, Hundies Public Deposits Private Loans A/c s Rec. Financing Lease Reserves & Provisions Government Assistance Sale of Unwanted Assets Customer s Credit Loans from directors Hire Purchase & Sale

13 Working Capital Control and Banking Policy The important sources of working capital finance are, 1. Trade credit and 2. Bank credit. The guidelines for effective working capital finance are formulated on the basis of the report submitted by the Tandon committee (1975) and Chore committee (1980) respectively. let s look both of the committees recommendations in brief.

14 Tandon Committees Recommendations The Tandon committee submitted its report in August most of its recommendations were accepted and implemented by Reserve Bank of India. The major recommendations are as below; 1. Norms for Inventory 2. Norms for Lending (a) Method - I (b) Method II (c) Method III The above methods are explain in illustration.

15 Illustration Current Liabilities Rs. Current Assets Rs. Bank Borrowings 1,000 Raw Material 800 Sundry Creditors 800 Work-in-progress 500 Other Current Liabilities 200 Finished Goods 360 Sundry Debtors 500 Other Current Assets 100 2,000 2,260 Thus, Current Assets = Rs. 2,260 Current Liabilities other than Bank Borrowings = Rs. 2,000 1,000 = 1,000

16 Method - I Solution 1] Total Current Assets 2,260 2] Less: Other Current Liabilities 1,000 3] Working Capital Gap (1 2) 1,260 4] Less: 25% margin on Working Capital Gap (to be funded from long-term sources) 314 5] Maximum Permissible Bank Finance(3 4) 946 6] Excess Borrowing (Bank Borrowing 1, ) 54

17 Method - II Solution 1] Total Current Assets 2,260 Less: 25% margin on (1) (to be funded from long-term sources) 556 1,694 2] Less: Other Current Liabilities 1,000 3] Maximum Permissible Bank Finance 694 4] Excess Borrowing (Bank Borrowing 1, ) 306

18 Method - III Solution 1] Total Current Assets 2,260 2] Less: Permissible core current assets (to be funded from long-term sources) 500 3] Effective Current Assets for this Purpose 1,760 4] Less: 25% of (3) 440 5] Less: Other Current Liabilities 1, ] Maximum Permissible Bank Finance 1,000 7] Excess Borrowing (Bank Borrowing 1, ) 680

19 Chore Committee Recommendations In 1979, R.B.I. appointed a committee to review the system of cash credit under chairmanship of Shri Chore. The major recommendations from the committee were accepted by R.B.I. Some of them are as below; 1. Borrower limits exceeds by Rs. 50 lakhs, will have to submit their quarterly working capital statement. 2. Commercial banks should not encourage frequent sanctions of temporary limits even for short period. 3. The over dependence on bank credit by medium or large borrowers must be reduced. 4. Commercial banks should encourage the bill system of finance.

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