WORKING CAPITAL

MANAGEMENT
A Curtain Raiser

--------------------------------
Duke Ghosh, Ph.D
 CASH IS KING (OR QUEEN)!
• Profit = Revenue – Expenses
• Profit = a leftover after deducting all admissible expenses
• Revenues can be: (a) booked & collected, (b) booked but not collected
• Receivables cannot be converted into “payroll” instataneously!
• Expenses can be: (a) paid, (b) yet to be paid
• What is the difference?
• Which is more important – PAT or Cash Profit?
• Cash = What is “literally” available in the bank (or in the cash-box) of the company
• It is a LIQUID Asset! (What is Liquidity?)
• Cash may not always be in the form of “Cash” – liquid investments are like cash
• Cash keeps the “Door Open” – Avoids “Lock In”
• Difference between a Company’s success and failure is Cash, Cash and only Cash!

• Firms with high level of liquid assets generally exhibit (a) high growth opportunities, (b) low
access to capital markets, (c) small in size (Opler, et al., 1999)
 CASH FLOW
• NCF = CIF – COF
• Non Cash Assets may lock in Cash
• Profit, Liabilities and Non Cash Expenses generate Cash
• When NCF<0, the firm has to borrow to make the NCF ≥ 0 or CLOSE DOWN!
• Whether NCF > = < 0 depends on:
• Operating Activities (Sales, Purchase, Other Payments, etc.)
• Investing Activities (Purchase or Sale of Assets, Loans made to suppliers
and/or advances received from Customers, etc.)
• Financing Activities (Changes in Capital Structure, Payment of Dividends,
Interest, etc.)
• Is a Positive Cash Flow always a Good Indicator for the Health of a
Firm?
 A FEW ISSUES FOR ANALYSIS!
• What if the PBT is declining?
• What if the Receivables are Ageing?
• What is the Quality of Debtors?
• Is the growth rate in Cash driven by a growth of Non-Operating Activities?
• What if the Creditors are showing abnormal increase?
• What if the Debt is increasing substantially?
• What are the interest rates and loan covenants? Are the Debts secured or unsecured?
• What is the nature of advances/loans given to the suppliers?
• What if the Assets are dwindling – what type of Assets?
• Is the Net Worth growing? What are the components of growth of the Networh?
• Is there a seasonality in cashflow?

• Dispassionate Look at the Cash Flow

• Venture “BEYOND CASH FLOW”
• Historical Performance is Important
• Industry Benchmarks
• Cash Flow Statement (actually, all financial statements) can tell us a STORY!
 WORKING CAPITAL MANAGEMENT
• WCM is the management of the Current Assets and the Current Liabilities
• The TENOR in consideration is less than 12 Months [Short Term]
• The CL is the Source of Short Term Funds
• The CA is the Application of Short Term Funds

- Perfect World is a UTOPIA [Perfect World implies: No Uncertainty, No

Information Asymmetry, No Information Search Costs, No Production &
Technology Constraints]
- Reality is there exists uncertainty (demand/price/quality/availability),
information asymmetry & capacity constraints
- In reality, there also exists SPREADS between borrowing and lending rates

Absence of a sound WCM strategy will mean some unproductive assets or

costly source of funds
 WORKING CAPITAL ACCOUNTS
Current Liabilities
• Creditors Current Assets
• Accruals & Provisions • Cash
• Current Long-Term • Marketable Securities
Debt • Debtors
• Short-term Debts • Pre-paid Expenses
• Other Current Liabilities • Other Current Assets

LTL + NW
LTA

Key Questions in WCM:

(a) How Should the Firm Manage its Cash?
(b) To Whom Should the Firm Grant Credit and how much?
(c) How Much Inventory Should the Firm Hold?
(d) How should it raise short term debt?
 SEMANTICS
1. Asset = Liability + Net Worth
2. CA + NCA = LTL + CL + Net Worth
3. CA – CL = (LTL + Net Worth) – NCA
4. Net Working Capital = CA – CL = (LTL + Net Worth) – NCA
• What is the Significance of NWC?

1. (Cash + Non Cash CA) + NCA = LTL + (CLOSTB + STB) + Net Worth
2. Cash = LTL + Net Worth + CLOSTB + STB – Non Cash CA – NCA

• How can cash be increased?

 HOW CA IS FUNDED

NWC
Short Term
Borrowings
TCA
AP +
Provisions+
OCL

• Note: NWC+STB constitutes the portion of the TCA not funded by the Current Liabilities

• What is a Good Strategy?

•Increase NWC?
•Increase STB?
•Increase CL other than STB?
 CYCLES (OF CONCERN)!
Collection of
Order for Payment to Sale of FG Cash from
RM Placed Creditors on Credit Receivables

Arrival
of RM

Time
O A B C D

• Cash flows are not always synchronized – some unwanted cashflows precede
the wanted cashflows
• Cash can also be uncertain – timing and amount is not known in advance

• What is the Problem in the cycle ?

• How to handle the mismatch?
 OPERATING CYCLE
• Operating Cycle = The time period between the acquisition of
inventory and the collection of Cash from the Receivables
OC has two components:
(a) Inventory Period = Time period between acquisition and sale of inventory
(b) AR Period = Time period between Sale of Inventory and Collection of
Receivables

RM Inv WIP Inv FG Inv AR Cash

OC Describes how a product moves through different stages of the CA

Accounts
Note:
(1) At each step, the asset is moving closer to CASH
(2) Some prefer to define operating cycle from the point of time when the order
is placed for RM
 CASH CYCLE
• AP Cycle = Time between receipt of inventory and payment for it
• What is the Significance of the AP Cycle?

• Cash Cycle = Time Period between Cash Disbursement (payment to the

creditors) and Cash Collection (from the receivables)
• Cash Cycle = Operating Cycle – Accounts Payable Cycle
• What is the Significance of the Cash Cycle?
• As a Prudent Manager, what should be your action plan?
• Need for short term financial decision arises as the length of the cash
cycle increases. The gap can be filled up by:
• Borrowing
• Holding adequate stock of marketable securities
• Note: ALL CYCLES ARE MEASURED IN AN APPROPRIATE UNIT OF
TIME (Days/Months/Years)
 RAW MATERIAL CYCLE

Average Stock of RM
Raw Material Cycle = -------------------------------------------
Avg. Daily RM Consumption

(Opening Stock + Closing Stock)/2

= --------------------------------------------
(Annual RM Consumption)/360

Note:
Closing Stock = Opening Stock+ Purchase-Consumption(Issue)
Hence, Consumption = Opening Stock + Purchase - Closing Stock

• RM Cycle is expressed in the Days (or Months) of Consumption

• Opening & Closing Stock are BS Items

• Consumption is P&L Item
 WIP CYCLE
Average Stock of WIP
WIP Cycle = ------------------------------------------------
Avg. Cost of Production per Day

(Opening Stock + Closing Stock)/2

= --------------------------------------------
(Annual Cost of Production)/360

Note:
1. COP = RM Consumed + Stores Consumed + Purchase of Trading Goods + Power &
Fuel + Direct Labour + OME + Depreciation + (Opening Stock of WIP – Closing
Stock of WIP)
2. Closing Stock of WIP = Opening Stock of WIP + Manufacture of WIP – Issue of
WIP
OSWIP – CSWIP = Issue – Manufacture
OSWIP – CSWIP >=<0, according as Issue – Manufacture >=< 0

WIP Cycle is expressed as No. of Days (or Months) of the COP

 FG CYCLE

Average Stock of FG
FG Cycle = ------------------------------------------------
Avg. Cost of Sales per Day

(Opening Stock of FG+Closing Stock of FG)/2

= -------------------------------------------------------
(Annual Cost of Sales)/360
Note:
COS = RM Consumed + Stores Consumed + Purchase of Trading Goods + Power
& Fuel + Direct Labour + OME + Depreciation+(Opening Stock of WIP –
Closing Stock of WIP) + (Opening Stock of FG – Closing Stock of FG)

FG Cycle is expressed as No. of Days (or Months) of the COS

 CREDITORS’ CYCLE

Average Level of Creditors

Creditors’ Cycle = ------------------------------------------------
Avg. Credit Purchase per Day

(Opening Creditors+Closing Creditors)/2

= -------------------------------------------------------
(Annual Credit Purchase)/360
Note:
In the absence of Data on Credit Purchase, the Total Annual Purchase is used in
the Denominator

Creditors’ Cycle is expressed as No. of Days (or Months) of the Credit Purchase
(or Purchase)
 DEBTORS’ CYCLE

Average Level of Debtors

Debtors’ Cycle = ------------------------------------------------
Avg. Credit Sales per Day

(Opening Debtors + Closing Debtors)/2

= -------------------------------------------------------
(Annual Credit Sales)/360
Note:
In the absence of Data on Credit Sales, the Total Annual Sales is used in
the Denominator

Debtors’ Cycle is expressed as No. of Days (or Months) of the Credit Sales
(or Sales)
 SHORT TERM FINANCIAL POLICY
• Flexible Short Term Financial Policy
• Large balances of Cash and/or MS
• Large Investment in Inventories
• Liberal credit decisions – high level of receivables

• Restrictive Short Term Financial Policy

• Low balances in Cash and/or MS
• Low investments in inventory
• Low account receivables

• Dimensions of the Short Term Financial Policy

• What should be the size of the firm’s investment in CA?
• Flexible (or Accommodative) policy aims at maintaining a high ratio of CA : Sales
• Restrictive Policy implies a low ratio

• What should be the Pattern of Financing of CA

• Flexible policy implies a low ratio of STD/LTD
• Restrictive policy implies a high ratio of STD/LTD
 FLEXIBLE STFP – WHAT IT ALL MEAN?
• CA holding level is the highest in the Flexible Policy
• Is the firm risk-averse?
• Is the business model (product – market – technology) require such policy?
• Is this an industry norm?
• Does the firm want to maximize Customer Service Outputs?
• Flexible policies are costly – WHY?
• Cost of liabilities
• Inventory carrying costs
• Rate of return of short term assets < Rate of return on long term assets
• Cost of LTD > Cost of STD
• Tradeoff between short term assets and long term assets
• Transaction costs are low
• Shortage (stock out) costs are low

• Reverse is true true for the Restrictive Policies

THANK YOU!
WORKING CAPITAL
MANAGEMENT
A Curtain Raiser

--------------------------------
Duke Ghosh, Ph.D
 CASH IS KING (OR QUEEN)!
• Profit = Revenue – Expenses
• Profit = a leftover after deducting all admissible expenses
• Revenues can be: (a) booked & collected, (b) booked but not collected
• Receivables cannot be converted into “payroll” instataneously!
• Expenses can be: (a) paid, (b) yet to be paid
• What is the difference?
• Which is more important – PAT or Cash Profit?
• Cash = What is “literally” available in the bank (or in the cash-box) of the company
• It is a LIQUID Asset! (What is Liquidity?)
• Cash may not always be in the form of “Cash” – liquid investments are like cash
• Cash keeps the “Door Open” – Avoids “Lock In”
• Difference between a Company’s success and failure is Cash, Cash and only Cash!

• Firms with high level of liquid assets generally exhibit (a) high growth opportunities, (b) low
access to capital markets, (c) small in size (Opler, et al., 1999)
 CASH FLOW
• NCF = CIF – COF
• Non Cash Assets may lock in Cash
• Profit, Liabilities and Non Cash Expenses generate Cash
• When NCF<0, the firm has to borrow to make the NCF ≥ 0 or CLOSE DOWN!
• Whether NCF > = < 0 depends on:
• Operating Activities (Sales, Purchase, Other Payments, etc.)
• Investing Activities (Purchase or Sale of Assets, Loans made to suppliers
and/or advances received from Customers, etc.)
• Financing Activities (Changes in Capital Structure, Payment of Dividends,
Interest, etc.)
• Is a Positive Cash Flow always a Good Indicator for the Health of a
Firm?
 A FEW ISSUES FOR ANALYSIS!
• What if the PBT is declining?
• What if the Receivables are Ageing?
• What is the Quality of Debtors?
• Is the growth rate in Cash driven by a growth of Non-Operating Activities?
• What if the Creditors are showing abnormal increase?
• What if the Debt is increasing substantially?
• What are the interest rates and loan covenants? Are the Debts secured or unsecured?
• What is the nature of advances/loans given to the suppliers?
• What if the Assets are dwindling – what type of Assets?
• Is the Net Worth growing? What are the components of growth of the Networh?
• Is there a seasonality in cashflow?

• Dispassionate Look at the Cash Flow

• Venture “BEYOND CASH FLOW”
• Historical Performance is Important
• Industry Benchmarks
• Cash Flow Statement (actually, all financial statements) can tell us a STORY!
 WORKING CAPITAL MANAGEMENT
• WCM is the management of the Current Assets and the Current Liabilities
• The TENOR in consideration is less than 12 Months [Short Term]
• The CL is the Source of Short Term Funds
• The CA is the Application of Short Term Funds

- Perfect World is a UTOPIA [Perfect World implies: No Uncertainty, No

Information Asymmetry, No Information Search Costs, No Production &
Technology Constraints]
- Reality is there exists uncertainty (demand/price/quality/availability),
information asymmetry & capacity constraints
- In reality, there also exists SPREADS between borrowing and lending rates

Absence of a sound WCM strategy will mean some unproductive assets or

costly source of funds
 WORKING CAPITAL ACCOUNTS
Current Liabilities
• Creditors Current Assets
• Accruals & Provisions • Cash
• Current Long-Term • Marketable Securities
Debt • Debtors
• Short-term Debts • Pre-paid Expenses
• Other Current Liabilities • Other Current Assets

LTL + NW
LTA

Key Questions in WCM:

(a) How Should the Firm Manage its Cash?
(b) To Whom Should the Firm Grant Credit and how much?
(c) How Much Inventory Should the Firm Hold?
(d) How should it raise short term debt?
 SEMANTICS
1. Asset = Liability + Net Worth
2. CA + NCA = LTL + CL + Net Worth
3. CA – CL = (LTL + Net Worth) – NCA
4. Net Working Capital = CA – CL = (LTL + Net Worth) – NCA
• What is the Significance of NWC?

1. (Cash + Non Cash CA) + NCA = LTL + (CLOSTB + STB) + Net Worth
2. Cash = LTL + Net Worth + CLOSTB + STB – Non Cash CA – NCA

• How can cash be increased?

 HOW CA IS FUNDED

NWC
Short Term
Borrowings
TCA
AP +
Provisions+
OCL

• Note: NWC+STB constitutes the portion of the TCA not funded by the Current Liabilities

• What is a Good Strategy?

•Increase NWC?
•Increase STB?
•Increase CL other than STB?
 CYCLES (OF CONCERN)!
Collection of
Order for Payment to Sale of FG Cash from
RM Placed Creditors on Credit Receivables

Arrival
of RM

Time
O A B C D

• Cash flows are not always synchronized – some unwanted cashflows precede
the wanted cashflows
• Cash can also be uncertain – timing and amount is not known in advance

• What is the Problem in the cycle ?

• How to handle the mismatch?
 OPERATING CYCLE
• Operating Cycle = The time period between the acquisition of
inventory and the collection of Cash from the Receivables
OC has two components:
(a) Inventory Period = Time period between acquisition and sale of inventory
(b) AR Period = Time period between Sale of Inventory and Collection of
Receivables

RM Inv WIP Inv FG Inv AR Cash

OC Describes how a product moves through different stages of the CA

Accounts
Note:
(1) At each step, the asset is moving closer to CASH
(2) Some prefer to define operating cycle from the point of time when the order
is placed for RM
 CASH CYCLE
• AP Cycle = Time between receipt of inventory and payment for it
• What is the Significance of the AP Cycle?

• Cash Cycle = Time Period between Cash Disbursement (payment to the

creditors) and Cash Collection (from the receivables)
• Cash Cycle = Operating Cycle – Accounts Payable Cycle
• What is the Significance of the Cash Cycle?
• As a Prudent Manager, what should be your action plan?
• Need for short term financial decision arises as the length of the cash
cycle increases. The gap can be filled up by:
• Borrowing
• Holding adequate stock of marketable securities
• Note: ALL CYCLES ARE MEASURED IN AN APPROPRIATE UNIT OF
TIME (Days/Months/Years)
 RAW MATERIAL CYCLE

Average Stock of RM
Raw Material Cycle = -------------------------------------------
Avg. Daily RM Consumption

(Opening Stock + Closing Stock)/2

= --------------------------------------------
(Annual RM Consumption)/360

Note:
Closing Stock = Opening Stock+ Purchase-Consumption(Issue)
Hence, Consumption = Opening Stock + Purchase - Closing Stock

• RM Cycle is expressed in the Days (or Months) of Consumption

• Opening & Closing Stock are BS Items

• Consumption is P&L Item
 WIP CYCLE
Average Stock of WIP
WIP Cycle = ------------------------------------------------
Avg. Cost of Production per Day

(Opening Stock + Closing Stock)/2

= --------------------------------------------
(Annual Cost of Production)/360

Note:
1. COP = RM Consumed + Stores Consumed + Purchase of Trading Goods + Power &
Fuel + Direct Labour + OME + Depreciation + (Opening Stock of WIP – Closing
Stock of WIP)
2. Closing Stock of WIP = Opening Stock of WIP + Manufacture of WIP – Issue of
WIP
OSWIP – CSWIP = Issue – Manufacture
OSWIP – CSWIP >=<0, according as Issue – Manufacture >=< 0

WIP Cycle is expressed as No. of Days (or Months) of the COP

 FG CYCLE

Average Stock of FG
FG Cycle = ------------------------------------------------
Avg. Cost of Sales per Day

(Opening Stock of FG+Closing Stock of FG)/2

= -------------------------------------------------------
(Annual Cost of Sales)/360
Note:
COS = RM Consumed + Stores Consumed + Purchase of Trading Goods + Power
& Fuel + Direct Labour + OME + Depreciation+(Opening Stock of WIP –
Closing Stock of WIP) + (Opening Stock of FG – Closing Stock of FG)

FG Cycle is expressed as No. of Days (or Months) of the COS

 CREDITORS’ CYCLE

Average Level of Creditors

Creditors’ Cycle = ------------------------------------------------
Avg. Credit Purchase per Day

(Opening Creditors+Closing Creditors)/2

= -------------------------------------------------------
(Annual Credit Purchase)/360
Note:
In the absence of Data on Credit Purchase, the Total Annual Purchase is used in
the Denominator

Creditors’ Cycle is expressed as No. of Days (or Months) of the Credit Purchase
(or Purchase)
 DEBTORS’ CYCLE

Average Level of Debtors

Debtors’ Cycle = ------------------------------------------------
Avg. Credit Sales per Day

(Opening Debtors + Closing Debtors)/2

= -------------------------------------------------------
(Annual Credit Sales)/360
Note:
In the absence of Data on Credit Sales, the Total Annual Sales is used in
the Denominator

Debtors’ Cycle is expressed as No. of Days (or Months) of the Credit Sales
(or Sales)
 SHORT TERM FINANCIAL POLICY
• Flexible Short Term Financial Policy
• Large balances of Cash and/or MS
• Large Investment in Inventories
• Liberal credit decisions – high level of receivables

• Restrictive Short Term Financial Policy

• Low balances in Cash and/or MS
• Low investments in inventory
• Low account receivables

• Dimensions of the Short Term Financial Policy

• What should be the size of the firm’s investment in CA?
• Flexible (or Accommodative) policy aims at maintaining a high ratio of CA : Sales
• Restrictive Policy implies a low ratio

• What should be the Pattern of Financing of CA

• Flexible policy implies a low ratio of STD/LTD
• Restrictive policy implies a high ratio of STD/LTD
 FLEXIBLE STFP – WHAT IT ALL MEAN?
• CA holding level is the highest in the Flexible Policy
• Is the firm risk-averse?
• Is the business model (product – market – technology) require such policy?
• Is this an industry norm?
• Does the firm want to maximize Customer Service Outputs?
• Flexible policies are costly – WHY?
• Cost of liabilities
• Inventory carrying costs
• Rate of return of short term assets < Rate of return on long term assets
• Cost of LTD > Cost of STD
• Tradeoff between short term assets and long term assets
• Transaction costs are low
• Shortage (stock out) costs are low

• Reverse is true true for the Restrictive Policies

THANK YOU!
MANAGING CASH

Presentation 2
------------------------------------------
Duke Ghosh, Ph.D.
 WHY HOLD CASH?
• Transaction Purpose: For Purchasing different factors of production

• Precautionary Purpose: To meet any unforeseen adversity

• Speculative Purpose: To register some windfall gains [Take advantage of

attractive interest rates, capital gains and FOREX Rate fluctuations]

These 3 motives were first pointed out by John Maynard Keynes in 1936 (The
General Theory of Employment, Interest and Money).
Md = kPY + L(r), k>0, L’(r) <0

James Tobin’s Portfolio Balance Approach deals in more detail about these
aspects
 PRINCIPLES OF CASH MANAGEMENT
• Generate Liquidity – Prudent Mix of Cash & Marketable Securities
• What are marketable securities?

• Optimize Cash Holding so that

(a) Efficiency of Operations is not violated
(b) No Excess Cash is held and Returns foregone

• Optimal choice of Marketable Securities – MS should earn optimal return and,

at the same time, should be MARKETABLE

• Contingency Planning
• Why? How?
 COSTS ASSOCIATED WITH HOLDING CASH
• A firm opting for holding a small Cash Balance will have to sell Marketable
Securities very frequently; On the contrary, a firm holding a large Cash
Balance, will sell marketable Securities less frequently
• Why?

• Converting Marketable Security involves Transaction Cost

• What are transaction costs? Examples?

• Total Transaction Costs are generally directly proportional to how frequently

the firm converts Marketable Securities to Cash
• What are the ways to minimize transaction costs?

• Therefore, the Transaction Costs are INVERSELY Proportional to the Cash

Balance that the firm holds

• On the other hand the Opportunity Cost (interest loss) is directly proportional
to the level of Cash Balance that the firm
• Can you explain why?
COST OF HOLDING CASH
Opportunity Cost
The loss of Interest (which could have been earned by holding marketable
securities)
Let, r = the rate of interest on Marketable Securities
Let, ch = Level of Cash Holding
Opportunity Cost of Holding ch = Interest Income Foregone = r*ch

OC

r*ch

ch
 COST OF HOLDING CASH
Transaction Cost
Bank Charges and other incidental charges for converting Marketable
Securities into Cash
Let,
a = Cost of each transaction when marketable securities are converted into cash and
vice versa. Note that a = fixed and is decided by the Bank
Let, n= no. of such transactions
n a (1/ch), where ch is the Cash Holding implying, More the level of Cash Holding, less
is the no. of transactions required
\n = k/ch, where, k is a constant
Total Transaction Cost, T = n*a = (k/ch)*a
Or, T*ch = k*a = l , where, l = k*a = constant
This is the equation of a Rectangular Hyperbola
Therefore, Total Cost of Holding Cash = OC+TC
 OPTIMAL CASH BALANCE

Total Cost

Costs Opportunity Cost

Transaction Costs

Cash Balance

The optimal Cash Balance is the Ordinate at the Point where the Total Cost of
Holding Cash is Minimum
 BAUMOL MODEL
Baumol, W.J. (1952), The Transaction Demand for Cash: An Inventory Theoretic
Approach, The Quarterly Journal of Economics, Vol. 66, No. 4

Answers the following questions:

(a) How much is the optimal cash holding?

(b) What is the optimal investment strategy?

Assumptions:

(a) Cash Flows are known with certainty

(b) Cash is received periodically
(c) Cash Payment is continuous at a Steady Rate
(d) Investments in Marketable Securities yield a rate of return per period of
transaction – rate of return is determined by the FI’s
(e) Transaction Cost of converting Marketable Securities into Cash is constant

When the cash is received, the cash is kept in an account.

The expenses are incurred by drawing down the balance from the same account
 BAUMOL MODEL…CONTD.

Y/2 Y/2

Cash Investment
Balance Balance

t/2 t/2 t/2

Time Time

Here the firm takes 2 Transaction Strategy:

(a) Receives the Cash (Y) and converts Y/2 as Marketable Securities
(b) For the first half of the Time period, Cash Balance Y/2 takes care of the
immediate requirements
(c) When the Cash Balance, Y/2 is depleted, it converts its Investment
Balance, Y/2 into cash and this cash takes care of the remaining part of
the period
 BAUMOL MODEL…CONTD.

2Y/3

Cash Y/3 Investment Y/3

Balance Balance

t/3 t/3 t/3 t/3 t/3

Time Time

Here the firm takes 3 Transaction Strategy:

(a) Receives the Cash (Y) and converts 2Y/3 as Marketable Securities
(b) For the first 1/3 of the Time period, Cash Balance Y/3 takes care of the
immediate requirements
(c) When the Cash Balance, Y/3 is depleted, it converts ½ its Investment
Balance for taking care of the cash requirement for 1/3 of the time
period
(d) Finally, it liquidates the remaining investment balance, Y/3 and converts
into Cash
 BAUMOL MODEL…CONTD.
𝑌 = 𝐶𝑎𝑠ℎ 𝑅𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑎𝑡 𝑡𝑖𝑚𝑒 0
𝑎 = 𝑇𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡 𝐶𝑎𝑠ℎ 𝑡𝑜 𝑀𝑆 𝑎𝑛𝑑 𝑉𝑖𝑐𝑒 𝑉𝑒𝑟𝑠𝑎
𝑖 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑓𝑜𝑟 𝑃𝑒𝑟𝑖𝑜𝑑 𝑡

For 2 Transactions Strategy:

𝑌
𝑎 𝑖𝑠 ℎ𝑒𝑙𝑑 𝑎𝑠 𝐶𝑎𝑠ℎ
2
𝑌 𝑡
𝑏 𝑖𝑠 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑖𝑛 𝑀𝑆 𝑓𝑜𝑟 𝑝𝑒𝑟𝑖𝑜𝑑
2 2
𝑡 𝑌
𝑐 𝐴𝑡 𝑡ℎ 𝑝𝑒𝑟𝑖𝑜𝑑, 𝑀𝑆 𝑖𝑠 𝑙𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑒𝑑 𝑎𝑛𝑑 𝑖𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑎𝑔𝑎𝑖𝑛 𝑎𝑠 𝐶𝑎𝑠ℎ
2 2
𝐿𝑒𝑡, 𝜋 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑡ℎ𝑖𝑠 𝑆𝑡𝑟𝑎𝑡𝑒𝑔𝑦
𝑖 𝑌 𝑖𝑌
𝜋= ∗ − 2𝑎 = − 2𝑎
2 2 4
For 3 Transactions Strategy:
𝑖 2𝑌 𝑖 𝑌 𝑖𝑌
𝜋= ∗ + ∗ − 3𝑎 = − 3𝑎
3 3 3 3 3
 BAUMOL MODEL…CONTD.
For n transactions
𝑖 𝑛−1 𝑌 𝑖 𝑛−2 𝑌 𝑖 𝑌
𝜋= + + ⋯……+ − 𝑛𝑎
𝑛 𝑛 𝑛 𝑛 𝑛 𝑛
𝑖𝑌
𝜋= ! 𝑛 − 1 + 𝑛 − 2 + ⋯ . +2 + 1 − 𝑛𝑎
𝑛
𝑖𝑌 𝑛 − 1 .𝑛
𝜋= ! − 𝑛𝑎
𝑛 2
𝑛−1
𝜋 = 𝑖𝑌 − 𝑛𝑎
2𝑛
𝑑𝜋 2𝑛 − 2 𝑛 − 1
= 0 → 𝑖𝑌 −𝑎 =0
𝑑𝑛 4𝑛!
#"
𝑖𝑌 !
𝑂𝑟, 𝑛 =
2𝑎
Check if SOC is satisfied at this n.
 BAUMOL MODEL…CONTD.
Results:

(a) The firm will make 1 Deposit in the Investment account and (n*-1)
withdrawals from the Investment Account

(b) Amount of the initial deposit in the Investment A/c is [(n*-1)/n*].Y

(c) Amount of withdrawal in each installment is (1/n*).Y

[Prove all these results by yourself]!!!!!

 BAUMOL MODEL…CONTD.
Results:

(a) The firm will make 1 Deposit in the Investment account and (n*-1)
withdrawals from the Investment Account

(b) Amount of the initial deposit in the Investment A/c is [(n*-1)/n*].Y

(c) Amount of withdrawal in each installment is (1/n*).Y

[Prove all these results by yourself]!!!!!

 BERANEK MODEL
Assumptions:

(a) Unlike Baumol Model, the Cash Receipt is continuous and at a Steady Rate
(b) Unlike Baumol Model, Cash Payments are Periodic

(c) All the other assumptions of Baumol Model hold

Here, n* = (I.Y/2a)1/2
The firm will make (n*-1) deposits and 1 withdrawal
Amount f periodic investment is (Y/n*)
Amount of the final withdrawal is [(n*-1)/n*].Y
 MILLER & ORR MODEL

Cash
Balance
Time

• Baumol Model and Beranek Model assumes that the cashflows are certain

• Miller & Orr assumes that Cash Flows (and hence Cash Balances) over a
given period are actually Random

The big question is “What is the optimal level of Cash Holding under such a
random situation?”
 MILLER & ORR MODEL…CONTD.
Assumptions:

(a) Net Cashflows ~ N(0,σ2)

(b) σ2 is constant over time
(c) Net Cash Flows are uncorrelated over time
(d) Investments yield a fixed rate of return per period of transaction (say, i)
(e) Transaction Cost (a) is constant over time
(f) Investment/Disinvestments are spontaneous
(g) The firm attempts to maximize profit from investments

Under these assumptions, M&O define a variable R, with:

R = (3a σ2/4i)1/3
 MILLER & ORR MODEL…CONTD.
M&O argues that:

(a) L is the Lower Control Limit fixed by the management

(b) C* = R+L is the Optimal Return Point or the Targeted Cash Level

(c) U = 3C* - 2L is the Optimal Upper Control Limit

(d) Upward movement of Cash Balance is allowed till it reaches U. The

moment it reaches U, the Cash Balance must be Returned to C*

(e) Downward movement f Cash Balance is allowed till it reaches L,soon after
the cash balance must be returned to C*

(f) Average Cash Balance is (4C* - L)/3

 MILLER & ORR MODEL…CONTD.

Cash
Balance
R

Time
 FLOAT
LUMAX AIR LTD. NATIONAL BEARINGS
• Supplies Liquid Oxygen to • Banks with HSBC,
NATIONAL Kolkata
• Banks with SBI, Burdwan
• Makes payment to
• Makes a supply to LUMAX by Cheque
NATIONAL; Invoice Value is
Rs. 1.00 Lacs

• Collects the cheque from

NATIONAL and deposits with
SBI
 FLOAT…CONTD.
Day 1: NATIONAL Issues the Cheque

Day 2: LUMAX collects the Cheque

Day 3: LUMAX deposits the Cheque with SBI

Day 4: SBI lodges the cheque for clearing

Day 5: Clearing
Day 6: Clearing

Day 7: LUMAX : Rs. 1.00 Lacs (Cr)

NATIONAL: Rs. 1.00 Lacs (Dr.)

0
 FLOAT…CONTD.
Further Assumption:
(a) Day 0: Credit Balance in National’s A/c was Rs. 100.00 Lacs. Book Balance &
Bank Balance were Reconciled

(a) Day 1: Credit Balance in Lumax A/c was Rs. 75.00 Lacs. Book Balance &
Bank Balance Reconciled

(b) No other cheques were received or issued

 FLOAT…CONTD.
LUMAX AIR LTD. NATIONAL BEARINGS
• Day 2, 3, 4, 5, 6 • Day 1, 2, 3, 4, 5, 6

Book Bal = Rs. 76.00 Lacs Book Balance: Rs. 99.00 Lacs
Bank Bal = Rs. 75.00 Lacs Bank Balance: Rs. 100.00 Lacs

Bank Bal < Book Bal Bank Bal > Book Bal

• Day 7
• Day 7
Book Bal = Bank Bal = 99.00 Lacs
Book Bal = Bank Bal = 76.00
 DISBURSEMENT FLOAT
For the period Day 0 – Day 6, NATIONAL can utilize EXTRA Balance of Rs. 1.00
Lacs

The company can withdraw Rs. 1.00 Lacs, invest in shares, sell them on Day 6,
earn capital gains and replenish the Bank account.

Or

The company can withdraw cash, purchase some trading goods, sell them on day
6, earn profit and replenish the Bank account

This extra cash (Bank Balance – Book Balance) available to the company is called
Disbursement Float

Disbursement Float (DF) is beneficial to the company, provided the company

can profitably use this DF

Positive DF implies that Bank Balance > Book Balance

 COLLECTION FLOAT
During the period Day 1 - Day 6, LUMAX can never utilize the amount of Rs. 1.00
Lacs BECAUSE Cash is not available to it, inspite of the fact that it has received
payment.

For LUMAX this Rs. 1.00 Lacs is called the Collection Float

Collection Float is Disadvantageous to the Firm

Positive CF implies that Book Balance > Bank Balance

Cost of Collection Float: Opportunity cost associated with not being able to
use the cash i.e. the loss of interest, which, otherwise the firm could have earned
by parking the cash meaningfully.
 NET FLOAT
A Firm is both a Supplier and a Customer

It issues Cheques and Receives Cheques

At any point in time, it has both Disbursement Float and Collection Float

Net Float = Disbursement Float - Collection Float

NF>0 implies that Bank Balance > Book Balance

NF<0 implies that Book Balance > Bank Balance

NF>0 is favourable
NF<0 is unfavourable
 FLOAT MANAGEMENT
Philosophy of Float Management:
Efforts to make NF>0 and as large as possible

Corollary
Increase Disbursement Float
Reduce Collection Float

Cost of Float (Cost of Collection Float): The opportunity cost (the interest
loss) of not availing the cash

Float Management also tries to minimize this Cost

• Try to Accelerate conversion of Collected Cheques to Cash (Reduce Collection

Float)
• Try to Slow Down conversion of issued cheques to cash (Increase Disbursement
Float)
 CASH COLLECTION PROCESS
Company
Customer Company Deposits
Mails Receives Cheque to Cash
Cheque Cheque the Bank Available

Mailing Delay Processing Delay Clearing Delay

Collection Time

Clearing Delay: The firm has no control

Mailing Delay: Reduce for lowering Collection Float

Processing Delay: Reduce for lowering Collection Float

Mailing Delay: Increase for Increasing Disbursement Float

 CASH CONCENTRATION
• Normally a company has customers spread across the country
• It receives cheques at all locations
• The cheques are sent to the Central Office
• The cheques are encashed at a Central Location

The above procedure is generally preferred on account of:

(a) Better Control over Cash
(b) Better Cash Management
(c) Ease of Budgeting

The system is called Cash Concentration

However, note that, Cash Concentration has the following demerits:

(a) Mailing Delay Increases
(b) Clearing Delay Increases (for clearing of outstation cheques)
(c) Additional Cost incurred for settlement of outstation cheques
 CONCENTRATION BANKING
• Open Account with a Bank having branch at each location where cheques are
collected
• Cheques are Collected by the Company
• Cheques are deposited at the respective Branches
• Cheques are cleared through Local Clearing
• Funds are Transferred to a Central Account (under control of HO)

This system of Banking is called Concentration Banking

The Bank with which the Central Account is maintained is called the
Concentration Bank

In case, the Concentration Bank does not have accounts at all locations it enter
into an arrangement with some other Bank (Corresponding Bank)

Concentration Banking helps to minimize:

(a) Mailing Delay
(b) Clearing Delay
(c) Costs associated with Outstation Clearing
 CASH MANAGEMENT SYSTEM
Most Banks are offering the CMS Service as a Corporate Banking Solution

CMS is a Concentration Banking System with the following add-on facilities:

(a) Cheque Pick-up Facility
(b) Same Day Credit (even for Non-High Value Cheques), pending clearing
[High Value Clearing > Rs. 1.00 Lacs] for local cheques
(c) Instant Fund Transfer to the Central Account or any Account as specified by
the Client
(d) In case of outstation cheques, the Cash is available within 2 days from the
date of collection of the Cheque

The Banks offer the service at a Fee

CMS was first started in India by Corporation Bank and then followed
by the Citi Bank.
 CONTROLLING DISBURSEMENT FLOAT
• Disbursement Float is advantageous for the Company.

• Tactics for increasing the Disbursement Float are questionable from both
ethical, operational and economic viewpoint

• Maximizing Disbursement Float may actually prove costly to the firm

• A popular mechanisms for increasing Disbursement Float are:

Zero Balance Accounts: The company maintains a master account (with

positive Cash Balance) together with a set of sub-accounts with Zero
Balance. When cheques are drawn on the zero balance accounts, funds are
transferred from the Master Account. This makes a little more time available
to the firm
 REFERENCE
•Modern Working Capital Management: Text & Cases
Frederick C. Scherr, (Prentice Hall)

•Fundamentals of Corporate Finance

Brealey & Myers (Tata McGraw Hill)

•Financial Management: Theory & Practice

Prasanna Chandra (Tata McGraw Hill)

•Banking Strategy, Credit Appraisals and Lending Decisions: A Risk Return

Framework
H. Bhattacharya (Oxford University Press)
MANAGING CASH

Presentation 2
------------------------------------------
Duke Ghosh, Ph.D.
 WHY HOLD CASH?
• Transaction Purpose: For Purchasing different factors of production

• Precautionary Purpose: To meet any unforeseen adversity

• Speculative Purpose: To register some windfall gains [Take advantage of

attractive interest rates, capital gains and FOREX Rate fluctuations]

These 3 motives were first pointed out by John Maynard Keynes in 1936 (The
General Theory of Employment, Interest and Money).
Md = kPY + L(r), k>0, L’(r) <0

James Tobin’s Portfolio Balance Approach deals in more detail about these
aspects
 PRINCIPLES OF CASH MANAGEMENT
• Generate Liquidity – Prudent Mix of Cash & Marketable Securities
• What are marketable securities?

• Optimize Cash Holding so that

(a) Efficiency of Operations is not violated
(b) No Excess Cash is held and Returns foregone

• Optimal choice of Marketable Securities – MS should earn optimal return and,

at the same time, should be MARKETABLE

• Contingency Planning
• Why? How?
 COSTS ASSOCIATED WITH HOLDING CASH
• A firm opting for holding a small Cash Balance will have to sell Marketable
Securities very frequently; On the contrary, a firm holding a large Cash
Balance, will sell marketable Securities less frequently
• Why?

• Converting Marketable Security involves Transaction Cost

• What are transaction costs? Examples?

• Total Transaction Costs are generally directly proportional to how frequently

the firm converts Marketable Securities to Cash
• What are the ways to minimize transaction costs?

• Therefore, the Transaction Costs are INVERSELY Proportional to the Cash

Balance that the firm holds

• On the other hand the Opportunity Cost (interest loss) is directly proportional
to the level of Cash Balance that the firm
• Can you explain why?
COST OF HOLDING CASH
Opportunity Cost
The loss of Interest (which could have been earned by holding marketable
securities)
Let, r = the rate of interest on Marketable Securities
Let, ch = Level of Cash Holding
Opportunity Cost of Holding ch = Interest Income Foregone = r*ch

OC

r*ch

ch
 COST OF HOLDING CASH
Transaction Cost
Bank Charges and other incidental charges for converting Marketable
Securities into Cash
Let,
a = Cost of each transaction when marketable securities are converted into cash and
vice versa. Note that a = fixed and is decided by the Bank
Let, n= no. of such transactions
n a (1/ch), where ch is the Cash Holding implying, More the level of Cash Holding, less
is the no. of transactions required
\n = k/ch, where, k is a constant
Total Transaction Cost, T = n*a = (k/ch)*a
Or, T*ch = k*a = l , where, l = k*a = constant
This is the equation of a Rectangular Hyperbola
Therefore, Total Cost of Holding Cash = OC+TC
 OPTIMAL CASH BALANCE

Total Cost

Costs Opportunity Cost

Transaction Costs

Cash Balance

The optimal Cash Balance is the Ordinate at the Point where the Total Cost of
Holding Cash is Minimum
 BAUMOL MODEL
Baumol, W.J. (1952), The Transaction Demand for Cash: An Inventory Theoretic
Approach, The Quarterly Journal of Economics, Vol. 66, No. 4

Answers the following questions:

(a) How much is the optimal cash holding?

(b) What is the optimal investment strategy?

Assumptions:

(a) Cash Flows are known with certainty

(b) Cash is received periodically
(c) Cash Payment is continuous at a Steady Rate
(d) Investments in Marketable Securities yield a rate of return per period of
transaction – rate of return is determined by the FI’s
(e) Transaction Cost of converting Marketable Securities into Cash is constant

When the cash is received, the cash is kept in an account.

The expenses are incurred by drawing down the balance from the same account
 BAUMOL MODEL…CONTD.

Y/2 Y/2

Cash Investment
Balance Balance

t/2 t/2 t/2

Time Time

Here the firm takes 2 Transaction Strategy:

(a) Receives the Cash (Y) and converts Y/2 as Marketable Securities
(b) For the first half of the Time period, Cash Balance Y/2 takes care of the
immediate requirements
(c) When the Cash Balance, Y/2 is depleted, it converts its Investment
Balance, Y/2 into cash and this cash takes care of the remaining part of
the period
 BAUMOL MODEL…CONTD.

2Y/3

Cash Y/3 Investment Y/3

Balance Balance

t/3 t/3 t/3 t/3 t/3

Time Time

Here the firm takes 3 Transaction Strategy:

(a) Receives the Cash (Y) and converts 2Y/3 as Marketable Securities
(b) For the first 1/3 of the Time period, Cash Balance Y/3 takes care of the
immediate requirements
(c) When the Cash Balance, Y/3 is depleted, it converts ½ its Investment
Balance for taking care of the cash requirement for 1/3 of the time
period
(d) Finally, it liquidates the remaining investment balance, Y/3 and converts
into Cash
 BAUMOL MODEL…CONTD.
𝑌 = 𝐶𝑎𝑠ℎ 𝑅𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑎𝑡 𝑡𝑖𝑚𝑒 0
𝑎 = 𝑇𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡 𝐶𝑎𝑠ℎ 𝑡𝑜 𝑀𝑆 𝑎𝑛𝑑 𝑉𝑖𝑐𝑒 𝑉𝑒𝑟𝑠𝑎
𝑖 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑓𝑜𝑟 𝑃𝑒𝑟𝑖𝑜𝑑 𝑡

For 2 Transactions Strategy:

𝑌
𝑎 𝑖𝑠 ℎ𝑒𝑙𝑑 𝑎𝑠 𝐶𝑎𝑠ℎ
2
𝑌 𝑡
𝑏 𝑖𝑠 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑖𝑛 𝑀𝑆 𝑓𝑜𝑟 𝑝𝑒𝑟𝑖𝑜𝑑
2 2
𝑡 𝑌
𝑐 𝐴𝑡 𝑡ℎ 𝑝𝑒𝑟𝑖𝑜𝑑, 𝑀𝑆 𝑖𝑠 𝑙𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑒𝑑 𝑎𝑛𝑑 𝑖𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑎𝑔𝑎𝑖𝑛 𝑎𝑠 𝐶𝑎𝑠ℎ
2 2
𝐿𝑒𝑡, 𝜋 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑡ℎ𝑖𝑠 𝑆𝑡𝑟𝑎𝑡𝑒𝑔𝑦
𝑖 𝑌 𝑖𝑌
𝜋= ∗ − 2𝑎 = − 2𝑎
2 2 4
For 3 Transactions Strategy:
𝑖 2𝑌 𝑖 𝑌 𝑖𝑌
𝜋= ∗ + ∗ − 3𝑎 = − 3𝑎
3 3 3 3 3
 BAUMOL MODEL…CONTD.
For n transactions
𝑖 𝑛−1 𝑌 𝑖 𝑛−2 𝑌 𝑖 𝑌
𝜋= + + ⋯……+ − 𝑛𝑎
𝑛 𝑛 𝑛 𝑛 𝑛 𝑛
𝑖𝑌
𝜋= ! 𝑛 − 1 + 𝑛 − 2 + ⋯ . +2 + 1 − 𝑛𝑎
𝑛
𝑖𝑌 𝑛 − 1 .𝑛
𝜋= ! − 𝑛𝑎
𝑛 2
𝑛−1
𝜋 = 𝑖𝑌 − 𝑛𝑎
2𝑛
𝑑𝜋 2𝑛 − 2 𝑛 − 1
= 0 → 𝑖𝑌 −𝑎 =0
𝑑𝑛 4𝑛!
#"
𝑖𝑌 !
𝑂𝑟, 𝑛 =
2𝑎
Check if SOC is satisfied at this n.
 BAUMOL MODEL…CONTD.
Results:

(a) The firm will make 1 Deposit in the Investment account and (n*-1)
withdrawals from the Investment Account

(b) Amount of the initial deposit in the Investment A/c is [(n*-1)/n*].Y

(c) Amount of withdrawal in each installment is (1/n*).Y

[Prove all these results by yourself]!!!!!

 BAUMOL MODEL…CONTD.
Results:

(a) The firm will make 1 Deposit in the Investment account and (n*-1)
withdrawals from the Investment Account

(b) Amount of the initial deposit in the Investment A/c is [(n*-1)/n*].Y

(c) Amount of withdrawal in each installment is (1/n*).Y

[Prove all these results by yourself]!!!!!

 BERANEK MODEL
Assumptions:

(a) Unlike Baumol Model, the Cash Receipt is continuous and at a Steady Rate
(b) Unlike Baumol Model, Cash Payments are Periodic

(c) All the other assumptions of Baumol Model hold

Here, n* = (I.Y/2a)1/2
The firm will make (n*-1) deposits and 1 withdrawal
Amount f periodic investment is (Y/n*)
Amount of the final withdrawal is [(n*-1)/n*].Y
 MILLER & ORR MODEL

Cash
Balance
Time

• Baumol Model and Beranek Model assumes that the cashflows are certain

• Miller & Orr assumes that Cash Flows (and hence Cash Balances) over a
given period are actually Random

The big question is “What is the optimal level of Cash Holding under such a
random situation?”
 MILLER & ORR MODEL…CONTD.
Assumptions:

(a) Net Cashflows ~ N(0,σ2)

(b) σ2 is constant over time
(c) Net Cash Flows are uncorrelated over time
(d) Investments yield a fixed rate of return per period of transaction (say, i)
(e) Transaction Cost (a) is constant over time
(f) Investment/Disinvestments are spontaneous
(g) The firm attempts to maximize profit from investments

Under these assumptions, M&O define a variable R, with:

R = (3a σ2/4i)1/3
 MILLER & ORR MODEL…CONTD.
M&O argues that:

(a) L is the Lower Control Limit fixed by the management

(b) C* = R+L is the Optimal Return Point or the Targeted Cash Level

(c) U = 3C* - 2L is the Optimal Upper Control Limit

(d) Upward movement of Cash Balance is allowed till it reaches U. The

moment it reaches U, the Cash Balance must be Returned to C*

(e) Downward movement f Cash Balance is allowed till it reaches L,soon after
the cash balance must be returned to C*

(f) Average Cash Balance is (4C* - L)/3

 MILLER & ORR MODEL…CONTD.

Cash
Balance
R

Time
 FLOAT
LUMAX AIR LTD. NATIONAL BEARINGS
• Supplies Liquid Oxygen to • Banks with HSBC,
NATIONAL Kolkata
• Banks with SBI, Burdwan
• Makes payment to
• Makes a supply to LUMAX by Cheque
NATIONAL; Invoice Value is
Rs. 1.00 Lacs

• Collects the cheque from

NATIONAL and deposits with
SBI
 FLOAT…CONTD.
Day 1: NATIONAL Issues the Cheque

Day 2: LUMAX collects the Cheque

Day 3: LUMAX deposits the Cheque with SBI

Day 4: SBI lodges the cheque for clearing

Day 5: Clearing
Day 6: Clearing

Day 7: LUMAX : Rs. 1.00 Lacs (Cr)

NATIONAL: Rs. 1.00 Lacs (Dr.)

0
 FLOAT…CONTD.
Further Assumption:
(a) Day 0: Credit Balance in National’s A/c was Rs. 100.00 Lacs. Book Balance &
Bank Balance were Reconciled

(a) Day 1: Credit Balance in Lumax A/c was Rs. 75.00 Lacs. Book Balance &
Bank Balance Reconciled

(b) No other cheques were received or issued

 FLOAT…CONTD.
LUMAX AIR LTD. NATIONAL BEARINGS
• Day 2, 3, 4, 5, 6 • Day 1, 2, 3, 4, 5, 6

Book Bal = Rs. 76.00 Lacs Book Balance: Rs. 99.00 Lacs
Bank Bal = Rs. 75.00 Lacs Bank Balance: Rs. 100.00 Lacs

Bank Bal < Book Bal Bank Bal > Book Bal

• Day 7
• Day 7
Book Bal = Bank Bal = 99.00 Lacs
Book Bal = Bank Bal = 76.00
 DISBURSEMENT FLOAT
For the period Day 0 – Day 6, NATIONAL can utilize EXTRA Balance of Rs. 1.00
Lacs

The company can withdraw Rs. 1.00 Lacs, invest in shares, sell them on Day 6,
earn capital gains and replenish the Bank account.

Or

The company can withdraw cash, purchase some trading goods, sell them on day
6, earn profit and replenish the Bank account

This extra cash (Bank Balance – Book Balance) available to the company is called
Disbursement Float

Disbursement Float (DF) is beneficial to the company, provided the company

can profitably use this DF

Positive DF implies that Bank Balance > Book Balance

 COLLECTION FLOAT
During the period Day 1 - Day 6, LUMAX can never utilize the amount of Rs. 1.00
Lacs BECAUSE Cash is not available to it, inspite of the fact that it has received
payment.

For LUMAX this Rs. 1.00 Lacs is called the Collection Float

Collection Float is Disadvantageous to the Firm

Positive CF implies that Book Balance > Bank Balance

Cost of Collection Float: Opportunity cost associated with not being able to
use the cash i.e. the loss of interest, which, otherwise the firm could have earned
by parking the cash meaningfully.
 NET FLOAT
A Firm is both a Supplier and a Customer

It issues Cheques and Receives Cheques

At any point in time, it has both Disbursement Float and Collection Float

Net Float = Disbursement Float - Collection Float

NF>0 implies that Bank Balance > Book Balance

NF<0 implies that Book Balance > Bank Balance

NF>0 is favourable
NF<0 is unfavourable
 FLOAT MANAGEMENT
Philosophy of Float Management:
Efforts to make NF>0 and as large as possible

Corollary
Increase Disbursement Float
Reduce Collection Float

Cost of Float (Cost of Collection Float): The opportunity cost (the interest
loss) of not availing the cash

Float Management also tries to minimize this Cost

• Try to Accelerate conversion of Collected Cheques to Cash (Reduce Collection

Float)
• Try to Slow Down conversion of issued cheques to cash (Increase Disbursement
Float)
 CASH COLLECTION PROCESS
Company
Customer Company Deposits
Mails Receives Cheque to Cash
Cheque Cheque the Bank Available

Mailing Delay Processing Delay Clearing Delay

Collection Time

Clearing Delay: The firm has no control

Mailing Delay: Reduce for lowering Collection Float

Processing Delay: Reduce for lowering Collection Float

Mailing Delay: Increase for Increasing Disbursement Float

 CASH CONCENTRATION
• Normally a company has customers spread across the country
• It receives cheques at all locations
• The cheques are sent to the Central Office
• The cheques are encashed at a Central Location

The above procedure is generally preferred on account of:

(a) Better Control over Cash
(b) Better Cash Management
(c) Ease of Budgeting

The system is called Cash Concentration

However, note that, Cash Concentration has the following demerits:

(a) Mailing Delay Increases
(b) Clearing Delay Increases (for clearing of outstation cheques)
(c) Additional Cost incurred for settlement of outstation cheques
 CONCENTRATION BANKING
• Open Account with a Bank having branch at each location where cheques are
collected
• Cheques are Collected by the Company
• Cheques are deposited at the respective Branches
• Cheques are cleared through Local Clearing
• Funds are Transferred to a Central Account (under control of HO)

This system of Banking is called Concentration Banking

The Bank with which the Central Account is maintained is called the
Concentration Bank

In case, the Concentration Bank does not have accounts at all locations it enter
into an arrangement with some other Bank (Corresponding Bank)

Concentration Banking helps to minimize:

(a) Mailing Delay
(b) Clearing Delay
(c) Costs associated with Outstation Clearing
 CASH MANAGEMENT SYSTEM
Most Banks are offering the CMS Service as a Corporate Banking Solution

CMS is a Concentration Banking System with the following add-on facilities:

(a) Cheque Pick-up Facility
(b) Same Day Credit (even for Non-High Value Cheques), pending clearing
[High Value Clearing > Rs. 1.00 Lacs] for local cheques
(c) Instant Fund Transfer to the Central Account or any Account as specified by
the Client
(d) In case of outstation cheques, the Cash is available within 2 days from the
date of collection of the Cheque

The Banks offer the service at a Fee

CMS was first started in India by Corporation Bank and then followed
by the Citi Bank.
 CONTROLLING DISBURSEMENT FLOAT
• Disbursement Float is advantageous for the Company.

• Tactics for increasing the Disbursement Float are questionable from both
ethical, operational and economic viewpoint

• Maximizing Disbursement Float may actually prove costly to the firm

• A popular mechanisms for increasing Disbursement Float are:

Zero Balance Accounts: The company maintains a master account (with

positive Cash Balance) together with a set of sub-accounts with Zero
Balance. When cheques are drawn on the zero balance accounts, funds are
transferred from the Master Account. This makes a little more time available
to the firm
 REFERENCE
•Modern Working Capital Management: Text & Cases
Frederick C. Scherr, (Prentice Hall)

•Fundamentals of Corporate Finance

Brealey & Myers (Tata McGraw Hill)

•Financial Management: Theory & Practice

Prasanna Chandra (Tata McGraw Hill)

•Banking Strategy, Credit Appraisals and Lending Decisions: A Risk Return

Framework
H. Bhattacharya (Oxford University Press)
MANAGING INVENTORY

Duke Ghosh, Ph.D.

 INVENTORY MAY RESIDE OUTSIDE THE
FACTORY!

RM WIP FG

• RM = Materials, Consumables and Spares required for manufacturing.

Available at the stores, in-transit and at the premises of the vendors carrying
out the job-works
• WIP = Goods in the intermediate stages of production. Available at the
Shop-floor and at the premises of the vendors carrying out the job works
• FG = Goods that are ready for sale. Available at the Despatch Bay, in-Transit
and at the stocking points

For the trading firms, FG constitutes almost 100% of the inventory

 WHY INVENTORY?
• Demand is Stochastic
• Machine Breakdowns are Stochastic
• Lead Time is Stochastic
• Supplier Performance is Stochastic
• External Shocks are Stochastic

• In this world of uncertainty, Inventory acts as a Comfort and a Buffer

• Managers may tend to hold inventory more than what is actually required
• Is it desired?
• Is it advisable?
• What should be the Correct strategy?
 INVENTORY HELPS!
• Required for widening the latitude in planning and scheduling successive
operations
• RM inventory helps a firm to DECOUPLE the purchasing and production
activities
• RM Inventory also helps the firm to take advantage of the right opportune
moment for buying
• WIP helps in optimizing the capacity utilization at each stage of production
and the overall capacity usage
• WIP also helps in reducing the delay and idle time at each shop
• FG helps the firm to decouple the production and marketing activities
• FG helps to maximize the Customer Service Outputs (CSO)
• FG Inventory reduces the probability of losing market to the competitors
 INVENTORY COSTS!
• Opportunity Cost of the Funds Blocked in Inventory
• Transportation, Storage and Warehousing Costs
• Insurance Costs
• Order Processing Costs [Costs Associated with each ISSUE and RECEIPT]
• Costs due to Physical Loss of Items Stored [Damage/Pilferage]
• Costs associated with the Loss of Shelf Life in case of Perishable Goods
• Costs associated with Loss of Market at a Specific Location
• Inter-Depot Transportation Costs
 OBJECTIVES OF INVENTORY MANAGEMENT
(a) Minimization of Costs associated with Inventory

(a) Optimize Inventory so that:

(I) No Disruption in Operations occur
(II) Probability of Market Loss is minimized
(III) Customer Satisfaction is Maintained

(c) There are two basic questions of the Inventory Management:

(I) What should be the size of the order?
(II) At what level should the order be placed? – Reorder Level
 PRICING OF MATERIALS FOR VALUATION
(1) First In First Out (FIFO)
• Assumes that the order in which the materials are received in the
stores is the order in which they are issued from the stores.
• Material which is issued first is priced on the basis of the cost of the
material received earliest
• Closing Stock is valued at the “oldest” price!

(2) Last In First Out (LIFO)

• Assumes that the material which is purchased last is issued first.
• Material issues are priced on the basis of the cost of the most recent
purchases
• Closing stock is valued at the “newest” price!

(3) Weighted Average Cost Method: Material issues are priced at the
weighted average cost of materials in stock

• Try to explain it yourself!

• Which Method is Better?

 ABC ANALYSIS
(1) Fewer Percentage of Items accounts for higher proportion of Annual Usage
Value

(2) ABC Analysis concentrates on the control of inventory accounting for the bulk
of the usage value

(3) Category A = Most Important Items, consisting of 15-25% of the inventory

items and accounting for 60-75% of the usage value

(4) Category B = Consists of 20-30% of the inventory items and accounts for 20-
30% of the usage value

(5) Category C = Consists of 40-60% of the Inventory Items and accounts for
10-15% of the usage value

Note: The cut-off levels are arbitrary and may differ across companies and
management
 ABC ANALYSIS…CONTD.
(1) Find out the Consumption Value against each items [Price x Quantity]

(2) Assign a rank [I,2,….,n] against each item, based on the Consumption value

(3) Arrange the Items in descending order according to the Rank

(4) Record the Running Cumulative Total of the Consumption

(5) Express the Cumulative Consumptions as a percentage of the Total

Consumption

(6) Express each number, 1,2,……,n as a percentage of n

(7) Look at the percentages of Consumption Value against the cumulative

percentages of numbers and classify Items in classes A, B, C
 CLASSIFICATION BASED ON THE MOVEMENT
(1) Fast Moving: The materials which have greater demand and moves out fast.
Here usage per period of time is high.

(2) Slow Moving: The materials with less demand and usage per period of time
is low

(3) Dead Stock: The materials with no demand and the usage per period of time
is almost zero

• It is advisable to keep a high level of Safety Stock in case of Fast Moving

Items, especially when the lead time is high

• Care must be taken to ensure that one can cope up with the sudden spurts
in demand in case of the slow moving stocks.

• Focus must be given on disposing the Dead Stock

• JIT can be an effective strategy in case of Slow Moving Stocks

 JUST-IN-TIME
(1) Developed by Taichi Okno

(2) Principle followed by Toyota and many World Leaders in Manufacturing

(3) Very difficult to follow in case the Customer wants to look at a wide spectrum
of products before making a purchasing decision

(4) What JIT means is NOT ZERO Inventory but MINIMAL INVENTORY

(5) Criteria for successful implementation of JIT:

• Strong and dependable relation with the suppliers
• Suppliers not geographically emote vis-à-vis the customer
• Reliable transportation system
• An efficient within the shop-floor logistics system
• Easy flow of accurate information
• An ATTITUDE
 INDICES OF EFFECTIVENESS
Cost of Goods sold
Overall Inventory Turnover Ratio = -------------------------------------------
Average Total Inventory

Annual Consumption of RM
RM Inventory Turnover Ratio = ----------------------------------------------
Average RM Inventory

Cost of Production
WIP Inventory Turnover Ratio = ----------------------------------------
Average WIP Inventory

Cost of Goods Sold

FG Inventory Turnover Ratio = ----------------------------------------
Average Inventory of FG

RM Cycle [Discussed Earlier]

WIP Cycle [Discussed Earlier]
FG Cycle [Discussed Earlier]
 INDICES OF EFFECTIVENESS
Number of Times Out of Stock
Out of Stock Index = -----------------------------------------------
Number of Times Requisitioned

Value of Spare Parts Inventory

Spare Parts Index = ----------------------------------------------
Value of Capital Equipment

• The ratios need to be compared with Industry Average and Best Practices

• One should carefully look at the ratios with a careful idea of the Business
Model and Business Process

• Monitoring the ratios is a REGULAR Exercise

THANK YOU.
MANAGEMENT OF RECEIVABLES

1 Duke Ghosh, Ph.D.

 WHY ALLOW CREDIT ON SALES?
Buyers’ Imperfect Knowledge
(a) Buyer may have imperfect knowledge about the Quality and Quantity of
goods supplied
(b) Buyer buys time before making the final payment for the goods supplied [Or
be sure about the quantity supplied]
(c) This is mostly the case when the Buyer has a strong bargaining power vis-à-
vis the Supplier

Generate Demand
Sellers use Attractive Credit Terms to generate additional demand for the
Commodities

2
 WHY ALLOW CREDIT ON SALES?
Financial Arbitrage for The Seller
(a) Suppose the bargaining power of the Seller Firm is strong with respect to the
Banking System
(b) Also the Bargaining Power of the Seller Firm > Bargaining Power of the
Buyer Firm
(c) Because of (a), the Seller Firm can extract credit from the Banking System
[@ an ROI of 12-14%]
(d) While selling the goods to the Buyer, it negotiates a Credit Term [This is
advantageous for the buyer, as it will not have to pay immediately!!!]
(e) While pricing the goods, the Seller charges a premium [Rate of Interest for
Credit offered to the Buyer]. Normally, the ROI used is 24% p.a.
(f) Because of the availability of Credit Facility from the Bank, the Cash Flows
are not affected
(g) In the process, the Seller has an Arbitrage Opportunity of 10%-12% p.a. 3
 RECEIVABLES & FLOAT
Seller
Credit Sale Customer Deposits
is Made Issues Cheque to Seller’s
Cheque the Bank Account is
Credited

Collection Float

Accounts Receivable

• Collection Float is a Sub-set of Accounts Receivables

• Managing Collection Float is an Essential Part of the Receivables Management

4
 TERMS OF SALE
TOS consists of 3 Distinct Components
(a) Period for which the Credit is Granted [called Credit Period] – What is the
Reference Date? – Date of Order? Date of Invoice?.....what?

(b) Cash Discount Available [in Case the Buyer wishes to pay Earlier] and the
Discount Period

(c) Type of Credit Instrument

5
 TERMS OF SALE: SEMANTICS
2/10 Net 60 Days
It means:
(a) The buyer has to pay the amount specified in the invoice within 60 days from
the date of the Invoice
(b) If the payment is made within 10 days [from the date of the invoice] the
buyer will get a Cash Discount of 2%
(c) Note: If the buyer pays within 10 days, the sale is treated as Cash Sales

The General Form is: x/y Net z Days

In case the TOS is just Net z Days, it means that there is No Cash Discount
Applicable for Early Payment
6
 EVALUATING CREDIT WORTHINESS
• Offering Credit is Contingent on the Evaluation of Credit-worthiness of the
Customer
• 3 C’s of Credit Worthiness: Capacity, Character, Collateral
• Ability to Pay + Willingness to Pay
• Ability to Pay (Capacity): Analysis of Financial Statements, Bank Statements,
Quality of the Debtors of the Customer, Cash Flow Projections, Analysis of
Economy-Industry-Company, External Credit Ratings
• Willingness to Pay (Character): Past Payment Performance, History &
Background, Market Feedback, Feedback through Informal Channels
• Collateral: Bank Guarantee, Personal Guarantee, Other Collaterals

7
 CREDIT PERIOD
• In the earlier example:
(a) 60 (z) Days is the Credit Period: The length of the time within which the
customer has to pay
(b) 10 (y) Days is the Discount Period: The length of the period during which the
customer is eligible for Cash Discount

• It is a Matter of Convention that Credit Period starts from the Date of Invoice
[This is NOT A RULE]. Other forms of Credit Period are:
(a) From the Date of Receipt of Goods
(b) From the Date of Acceptance of Goods [from the Date of GRN]
(c) From the Date of Submission of Invoice to the Buyer
(d) From the Date of Purchase Order
8
 LENGTH OF THE CREDIT PERIOD
Length of the Credit Period is Determined by the Following Factors:
• Operating Cycle of the Buyer/Seller
• Inventory Cycle of the Buyer/Seller
• In case the Credit Period > Inventory Cycle of the Buyer, it means that the
Seller is Financing the Inventory
• In case, Credit Period > Operating Cycle of the Buyer, it implies that the
Seller is Financing the Inventory and Receivable
(c) Perishability of Goods: High Perishability implies Low Collateral Value. In
such cases, the Credit Period is Shorter
(d) Demand: High Demand implies fast turnover and higher bargaining power of
the Seller. Higher demand leads to Shorter Credit Period
(e) Credit Risk: Higher Credit Risk implies Shorter Credit Period
(f) Importance of the Buyer
9
(g) Competition
 AVERAGE COLLECTION PERIOD
ACP = Average Account Receivables/ Average Daily Sales
= [(Op. Debtors + Closing Debtors)/2]/ [Net Sales/360]
It implies that:
(a) If ACP is y Days
(b) And if the daily Sales is Rs. X
(c) The Average Account Receivables is Rs. Xy
I.e. Account Receivables = Average Daily Sales x ACP
(d) Cash Discounts encourage the Customers to Pay Early and help the Seller in
reducing the Investment in Receivables

10
 COLLECTION EFFORT
• Amount (yet to be paid by the Customers) within the Credit Period as per the
TOS is called Receivables Outstanding
• Amount (yet to be paid by the Customers) beyond the Credit Period (as per
the TOS) is called Receivables Overdue
• Collection Effort consists of the following steps:
(a) Preparing an Age Analysis of Receivables
(b) Monitoring the State of Receivables
(c) Reminders/Reports to Customers regarding Due Dates
(d) Reminders/ Requests to Customers for Overdue
(e) Threat of Legal Actions
(f) Initiation of Legal Procedures

• Collection Effort is Costly; Sometimes firms employ external agencies to 11

follow-up with the customers
 MONITORING RECEIVABLES
• Calculate ACP [On the basis of the past data – say, for 5 years]
• This will give an an idea about the Trend of ACP
• Compare this ACP with the Industry Bench-mark and Best Practices
• Monitor the ACP continuously over time [every month/quarter]
• In case the demand of the goods is seasonal, there may be fluctuation of
ACP
• Compare Monthly/Quarterly ACPs YOY
• Compare ACPs for Customer Segments, Product Groups, Geographical
Markets, etc
• In case there is a sudden increase in ACP, immediate attention is needed
• Analyse the causes of sudden increase and try to design corrective
mechanisms
• Revisit the Collection Strategies
12
 AGING SCHEDULES
(1) Aging Analysis is the Basic Tool for Monitoring Receivables
(2) Aging Schedule looks like:

(3) Concentrate on the Ages which are higher than the ACP
(4) Revisit the Collection Strategies for the Overdue Accounts
13
COLLECTION MATRIX

Percentage of Receivables Collected in Different Months

Apr May June Jul Aug Sept

Month of Sale 30.00 20.00 10.00 15.00 25.00 37.00

First Following Month 10.00 17.00 15.00 16.00 22.00 32.00

Second Following Month 20.00 15.00 12.00 32.00 14.00 15.00

Third Following Month 5.00 10.00 9.00 15.00 18.00 16.00

Fourth Following Month 20.00 20.00 25.00 20.00 6.00 0.00

Fifth Following Month 10.00 10.00 15.00 2.00 10.00 0.00

Sixth Following Month 5.00 8.00 14.00 0.00 5.00 0.00

Total 100.00 100.00 100.00 100.00 100.00 100.0014

 SECURING RECEIVABLES - INSTRUMENTS
• Cash/Cheque on Delivery [COD] Consignments: Transporter/Logistics
Provider collects the payment (on behalf of the seller) at the time of delivery.
The service is provided by the transporter at a fee
• Godown Delivery Consignments: The consignment is kept at the
Transporter’s Godown and is to be delivered against the Consignee Copy of
the Consignment Note. The consignor retains the Consignee Copy and hands
it over to the Consignee only on the receipt of payment
• Through Bank Consignments: Invoice + Consignee Copy of the
Consignment Note is presented to the Seller’s Bank who in-turn presents it to
the Customer’s Bank. The Customer’s A/c is debited and the Seller’s A/c is
credited with the Bill Amount. On the Seller’s A/c being Credited, the Seller’s
Bank Endorses the Invoice and Consignment Note. The Consignee takes
delivery [from the Transporter’s Godown] on the basis of these Endorsed
Documents. [Note: The Transporter has to be an IBA Approved Transporter]
• Letter of Credits
• Bills of Exchange[BOE]: A Negotiable Instrument drawn by the Customer
15
in favour of the Seller, acknowledging the payment obligation
16
17
18
 CHANNEL FINANCING

Vendors Firm Dealers

• Vendor Financing = Financing the Backward Channel

• Dealer/Distributor Financing = Financing the Forward Channel

• A Banking Product which has become immensely popular with most Blue-chip
companies

• Very popular in case of Automobile, FMCG, Petroleum, etc.

19
 CHANNEL FINANCING…CONTD.
Mechanism of Channel Financing (Forward Channel)
• Principal Company negotiates with a Bank and arranges for individual Credit
Limit (from Bank) for the Dealers
• After sales, the receipted copy of the invoice is sent to the Bank
• Bank pays the principal company the Invoice Amount
• The corresponding amount is treated as Credit given to a particular dealer
• The Dealer has to pay the Bank the amount along with the Interest
• The arrangement improves the Cashflow position of the Principal
• Because the Principal negotiates with the Bank on behalf of a large number
of dealers, the arrangement enables the Dealers to get better Deal (Limit &
Interest Rate) that what each could have managed in case it negotiated
individually

20
 CHANNEL FINANCING…CONTD.
• Channel Financing is of two types:
(a) Without Recourse: In case of default by the Dealer, the Bank takes up the
case with the dealer
(b) With Recourse: Should there be a defaulting dealer, the Principal stands as
the guarantor with a commitment to pay back to the bank

• Typically, Interest Rates for Channel Financing Without Recourse is higher

than that for Channel Financing with Recourse

21
 THANK YOU
22
WORKING CAPITAL FINANCE

1 Duke Ghosh, Ph.D.

 FINANCIAL INTERMEDIATION
• Financial Intermediaries [FI] are the institutions that acts as a Liaison
between the Individual Investors and the Entities seeking Investments
• FI reduces the problem of “Double Coincidence of Wants”
• India: Banks are the main sources for Financial Intermediation
• Why are Banks interested in financing Working Capital?
(a) Certain Deposits accepted by Banks are of Shorter Maturity
(b) Such funds need to be invested in Projects with Shorter Maturity
(c) Otherwise, there may be Asset-Liability Mismatch [ALM]

2
 WHAT DO BANK’S ASSESS?
• Should credit be granted? – Go, No-Go: An early decision
• Is the borrower Creditworthy? – Detailed & Educated Decision
• What are the Risks? How Risks can be mitigated?
• What kind of Facility? – Purpose of loan
• What Amount?
• At what Price? At what Fee?
• What should be the repayment mechanism? – Tenor/Moratorium
• What Security – Primary & Collateral
• What Guarantees to be taken?
• Under what Terms & Conditions? - Covenants
• Credit, if granted, for what period? – Tenor
• How to Disburse? – Ensuring End-use of Funds
• Bundle it with Other Wholesale Banking Products? 3

• What should be Frequency of Monitoring?

 ASSESSING – PROMOTER/GROUP
• RBI Defaulters’ List
• CIBIL
• What other Business do the Promoters have?
• Are these business related/unrelated?
• Is there a Synergy between these businesses?
• Financials of Associate Concerns
• Market Reputation – Vendors, Customers, ….
• Family History

4
 ASSESSING – INDUSTRY
• Domestic Outlook of the business
• Global outlook
• Extent of competition
• Growth Drivers – How is the organization handling these?
• Cost Drivers – How is the organization handling these?
• What are the most important bottlenecks? – Are they being taken care of?
• Who are the major competitors? What is there condition?
• How can the firm have Competitive Advantage?

5
 ASSESSING – CHANGES IN CIRCUMSTANCES
• Statutory Changes expected
• Fiscal changes expected
• Political changes expected
• Changes in EXIM rules
• Dumping by Other countries
• Changes in Technology expected

Are these expected changes Opportunities OR Threats to the Firm?

6
 ASSESSING – STATUTORY RESTRICTIONS & COMPLIANCE
• Pollution Control Certificate
• Child Labour
• Emission Norms
• Ozone Depleting Chemicals
• License
• Registration
• Restriction/Ban

- Pollution Control Boards are POWERFUL

- Many banks have lost money, because, companies have been forced to close
down
- Case: Sponge Iron Industry (Sambalpur, Orissa)

7
 ASSESSING – EXIM POTENTIAL
• IEC Code? – DGFT
• Special Status? – SEZ/STP?
• Is the firm complying norms of SEZ/STP?
• Country Risks/FOREX Risks – Is the firm hedging such risks?
• Single Customer? Single Market? – Concentration Risks

Those companies which depended only on the US market are bleeding!

No one is sure for how long these firms will continue to suffer!

8
 ASSESSING – BUSINESS
• Single Product?/ Single Market? – Concentration Risk
• Green Field/ Brownfield?
• New Product/Concept? – Marketing Potential?
• What is the USP?
• Core Competency
• Experienced? Expertise? – Sources of Expertise?
• Bottlenecks? Are they been removed?
• Past Financial Performance?
• Scope for the future?

TELERAMA/BUSH were leading TV manufacturers in the early 80s.

Where are they now?
9
 ASSESSING – EXPOSURE NORMS
• Industry Ceiling (Internal)
• RBI Prudential Norms – Single Borrower, Group Exposure, etc.
• Rating-wise Internal Ceiling
• Bank’s Exposure Level in the Company – Check the ceilings
• Bank’s Exposure in the Group – check the ceilings

RBI Master Circulars – Important

Bank’s Credit Policy - Important

10
 ASSESSING – TAKEOVER LOANS
• Is the firm a “Bank-hopper”? If yes, why?
• Repayment Record
• Utilization of Limit
• Routing of funds?
• NOC form other Banks – Consortium/ Multiple Banking
• Consortium Minutes – check minutely
• Confidential Opinion Report from Banks – written & verbal
• Dilution of Security – Permissible?
• Sharing of Charge between banks – Is it acceptable?
• Comparative Share among Banks
• NO DUES & Release of Charge

11
 RECAPITULATION
Total Assets = Total Liabilities
LTA+CA = LTL + CL [Other than Bank Borrowings]+Bank Borrowings
CA = (LTL-LTA) + CL [Other than Bank Borrowings] + Bank Borrowings
CA = NWC + CLOBB + BB

• NWC can be assumed to be a Contribution from the Promoters

• CLOBB is that part of the Current Assets financed by Sundry Creditors, etc.

12
 HOW CA IS FUNDED

NWC
Bank
Borrowings
TCA
AP+Provisions
+OCL

• Note: NWC+BB constitutes the portion of the TCA not funded by the Current
Liabilities

13
CORPORATE BANKING PRODUCTS

CPB

Balance Sheet Items Off-Balance Sheet Items

Term Loans [TL] Working Capital Facilities LC BG

Cash Credit Export Finance Bil Discounting Channel Financing Inland LC Foreign LC Performance Guarantee Financial Guarantee

Export Packing Credit Post-Shipment Credit 14

 CPB…CONTD.
Balance Sheet Items: Assistance by the Banks, which are Fund-based and appear
on the Assets side of the Bank. Also called the Fund Based Facilities.

Off-Balance Sheet Items: Facilities like LC/BG which are Non-Fund Based facilities
and appear as Contingent Liabilities

LC immediately after Negotiation becomes a FB Facility

BG, immediately after Encashment becomes a FB Facility

15
 BANKING ARRANGEMENT FOR WC FINANCE
(a) Sole Banking: WCF is availed from a Single Bank
(b) Consortium Banking: A Consortium of Banks [led by a Lead Bank] provides
the Working Capital to the Firm.
The Assessment of Working Capital is done by the Lead Bank and all the
other Member Banks have to accept the Assessment.
Participating Banks are bound by the Inter-se Agreement
(c) Multiple Banking: A group of Banks provides the WC to the firm
Every Member Bank individually assesses the Requirement
No Inter-se Agreement exists

• Banks are immaterial, Banking System is Important

• A Firm should not be Over-financed or Under-financed by the Banking
System 16
 MPBF
• MPBF = Maximum Permissible Bank Finance for Working Capital
• MPBF from the entire Banking System is Important
• As per Extant Guidelines by RBI, the MPBF can be assessed by any of the
following Methods:
(a) MPBF – Method I
(b) MPBF – Method II [Most Popular]
(c) Turnover Method [Appropriate for Traders]
(d) Cash Budget Method [Appropriate for Seasonal Industries]
• MPBF is always Assessed for the Future [Next 1 or 2 Years]
• Sum Total of WCF from all the Banks <= Assessed MPBF [A MUST]

17
 MPBF [METHOD I]

As on As on As on
31.3.2021 (Rs. 31.3.2022 (Rs. 31.3.2023 (Rs.
Crores) Crores) Crores)
Srl No Computation of MPBF [Actual] [Estimated] [Projected]
1 Current Assets 17.88 26.95 27.14
2 Current Liabilities Other Than Bank Borrowings 9.09 13.78 12.78
3 Working Capital Gap ( 1- 2 ) 8.79 13.17 14.36
4 Minimum Stipulated NWC ( 25 % OF 3 ) 2.20 3.29 3.59
5 Actual/Projected NWC 4.65 5.82 7.01
6 Item 3 - Item 4 6.59 9.88 10.77
7 Item 3 - Item 5 4.14 7.35 7.35
8 M.P.B.F( lower of 6 and 7 ) 4.14 7.35 7.35

18
 MPBF [METHOD II]

As on As on As on
31.3.2021 (Rs. 31.3.2022 (Rs. 31.3.2023 (Rs.
Crores) Crores) Crores)
Srl No Computation of MPBF [Actual] [Estimated] [Projected]
1 Current Assets 17.88 26.95 27.14
2 Current Liabilities Other Than Bank Borrowings 9.09 13.78 12.78
3 Working Capital Gap ( 1- 2 ) 8.79 13.17 14.36
4 Minimum Stipulated NWC ( 25 % OF 1 ) 4.47 6.74 6.79
5 Actual/Projected NWC 4.65 5.82 7.01
6 Item 3 - Item 4 4.32 6.43 7.58
7 Item 3 - Item 5 4.14 7.35 7.35
8 M.P.B.F( lower of 6 and 7 ) 4.14 6.43 7.35

19
 MPBF: METHOD I VS. METHOD II
• Minimum Stipulated NWC in Method I is 25% of WCG
• Minimum Stipulated NWC in Method II is 25% of CA
• Since, in many cases, CA>WCG,
Min. Stipulated NWC in Method II > Min Stipulated NWC in Method I

• There is every possibility that MPBF assessed by Method I>MPBF assessed

by Method II
• In other words, Method II specifies more Margin Requirement
• A Conservative Banker always prefers Method II to Method I
• MPBF [Method II] is widely used by the Bankers in case of Manufacturing,
Service Industries and Large Trading Houses
• Bankers are Comfortable with MPBF Methodology

20
 TURNOVER METHOD
2021-22 (Rs. Lacs) 2022-23 (Rs. Lacs)
Sl No Parameter [Estimated] [Projected]
1 Actual/Projected Net Sales 3883.0 5375.00
2 Accepted Net Sales 3883.0 5375.00
3 25% of 2 970.75 1343.75
4 Margin: 5% of 2 194.15 268.75
5 Actual/Projected NWC 246.34 370.99
6 Sl No. 3 - Sl. No. 4 776.60 1075.00
7 Sl No. 3 - Sl. No. 5 724.41 972.76
8 MPBF [Minimum of 6 & 7] 724.41 972.76

21
 CASH BUDGET METHOD
• WC Facility is the used to bridge the Time Difference the Expenses incurred
for producing the goods and Money Realized by selling the Goods
• Expenses = Outflow of Cash
• Sales Realized = Inflow of Cash
• Long Term Surplus [LTL-LTA] determines the components of NWC of the
Company
• Cash Budget Method analyses the Cash Flow statement for the next 12
Months and arrives at the MPBF
• Cash Inflow in the Revenue Account = Cash Sales+Realization of
Receivables+Other Income ……..(A)
• Cash Outflow from the Revenue Account= Cash Purchase of RM+Cash
Purchase of Power & Fuel+Payment of Wages & Salaries+Payment of Other
Manufacturing Expenses+Payment of Other Establishment Costs+Payment of
S&D Expenses+Payment of Interest+Payment of Taxes+Payment of
Dividends+Payment to Creditors …………….(B)
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• A-B = Surplus/Deficit in the Revenue Account
 CASH BUDGET …CONTD.
• Cash Inflow in the Capital Account = Induction of Equity Capital+Inflow from
Fresh Term Loan+Inflow from Fresh Debenture+Inflow from Fresh
Unsecured Loan ………………..(C)
• Cash Outflow from the Capital Account = Purchase of Fixed
Assets+Repayment of Term Loan+Increase in Investment+Repayment of
Unsecured Loan………………..(D)
• C-D = Surplus/Deficit in the Capital Account
• (A-B) + (C-D) = Overall Surplus/Deficit
• (A-B) + (C-D) – Opening Cash Balance = Net Surplus/Deficit
• Banks finance the Net Deficit
• Since the Cashflows are drawn for each of the Next 12 Months, the Peak
Deficit becomes the MPBF

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 WC FACILITY: SEMANTICS
• Limit = Assessed MPBF or Amount Sanctioned (on the basis of Application),
whichever is lower
• Drawing Power (DP): Maximum Amount that the Firm can borrow during a
particular Month. This is assessed Monthly on the basis of the estimated
statement of CA, CL and NWC submitted by the Firm
• Margin = Promoters’ Contribution [Generally Calculated as a Fixed % of the
CA or WCG]
• Primary Security = Banks have a Charge on the Assets created out of the
Finance availed. Bank has a Hypothecation Charge on the Current Assets in
case of Working Capital Finance
• Collateral Security = Any security, other than the Primary Security, offered to
the Bank for securing the WC Facility
Eg: Hypothecation Charge on the Fixed Assets, Mortgage of Properties,
Pledge of Goods at the Warehouse, Lien on a Deposit Account
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CHARGE ON SECURITIES

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 FUND BASED WC FACILITIES
• Overdraft [OD]
(a) The amount of WC Facility is directly related to the amount of Security
[Generally Fixed Deposits].
(b) Interest Rate applicable is 1% over and above the ROI on FD
• Cash Credit (CC):
(a) Most popular WC Product available from Banks
(b) Account Operates like a Typical Current Account – Withdrawals (Dr) are
loans and Deposits (Cr) are Repayments.
(c) Amount of DP is calculated every month on the basis of the Stock and
Book Debt Statements
(d) Dr Balance in the account cannot exceed the DP
(e) Interest is charged on the daily product basis at Monthly Rests Maximum

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 FUND BASED WC FACILITIES…CONTD.
• WCDL
(a) It is like a Short Term Loan for meeting Working Capital Finance
(b) The tenor of the Loan cannot exceed 1 year and the Minimum Tenor is 7
Days
(c) The Repayment Period must be indicated – either in the form of Bullet
Payment or in the form of Installments
(d) WCDL helps the Bank to reduce the Opportunity Cost on Idle Fund in
case of CC
(e) As per RBI guidelines, upto 80% of a CC Limit can be disbursed through
WCDL
(f) WCDL is beneficial for the Bank but disadvantageous for the Borrower
[Why????]

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 FUND BASED WC FACILITIES…CONTD.
• Bill Discounting

(a) Drawer = Seller, Drawee = Purchaser, Payee = Bank from whom the Seller
gets Credit under Bill Discounting Scheme
(b) Under BD scheme, the seller presents the Bill to the Bank, along with the
Invoice immediately after despatching the goods.
(c) Bank sends it to the Drawee for acceptance
(d) Once the Drawee accepts, the Bill, the Bank pays the Drawer, after
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discounting
(e) On the due date, the Bank collects the sum from the Drawee
 FUND BASED WC FACILITIES…CONTD.
• FCNR(B) Loans
(a) Foreign Currency Non Resident (Bank) is the name of a Deposit Schemes
operated by Indian Banks to collect Deposits from Non Resident Indians and
Overseas Corporate Bodies (OCB)
(b) The deposits are collected in USD, GBP, Euro, JPY, Canadian Dollar &
Australian Dollar
(c) Tenor of these deposits = 12 months to 36 Months
(d) Principal & Interest are to be paid in Foreign Currencies
(e) Deposits received in FCNR(B) Accounts are made lent to the Corporates –
these loans are called FCNR(B) Loans
(f) Amount disbursed is in the Foreign Currency
(g) Borrower must repay the loan and the Interest in Foreign Currency
(h) Banks Hedge the Foreign Exchange Risk
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(i) Borrowers get a lower rate of Interest [LIBOR+x00 bps]
 OTHER AVENUES OF WC FINANCE
• Commercial Paper [CP]
(a) Unsecured Loans from Investors
(b) These are Short Term Loans mostly for meeting WC Requirements
(c) Who can issue CP?? – Reputed Corporates,
(d) Qualifications for raising CP:
• Permission from RBI
• TNW [as per the latest Audited Balance Sheet] > Rs. 4.00 Crores
• Company must have a sanctioned WC facility from a Bank
• The account is a Standard Asset in the Bank
(e) Rating of the CP to be issued must be done by an authorised Rating Agency
(f) Minimum Maturity of CP = 7 Days, Maximum Maturity = 1 Year. Under no
Circumstances the maturity date should exceed the date till which the rating is valid
(g) CP can be issued in denominations of Rs. 5.00 Lacs or Multiples thereof
(h) Limit of CP = As Approved by the Board of Directors or the Amount Indicated by the
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Rating Agency, whichever is lower
THANK YOU

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