Executive Summary

Working capital is a subject which involves detailed knowle

The working capital ratio is a key figure in financial management. It
characterizes how much financial funds are required by short term,
operating activities. The calculation of working capital functions are as so
Inventory + Trade Receivables Trade Liabilities. The core objective is
maintaining the lowest working capital as possible in order to reduce
financial responsibility, without endangering the ability to operate the
business. Further more the reduced working capital forces efficiency of
invested capital, releases cash from balance sheets and improves
balance sheet structures.
The working capital goal for each subsidiary which it is obliged to follow.
The ratio must be not more than 12.5 % of annual turnover. However, to
achieve the goal an active working capital management is required.
Therefore an organisation to control should be drawn up and controlling
measures to improve the figure must be defined and carried out.
Setting up an organisation for the working capital management is the
precondition to control working capital effectively and sustainably. Firstly,
it is essential to define who is responsible for the controlling process.
The figure must be calculated, planned and improved. Therefore further
key ratios must be defined and targets set. In addition, continual targetperformance comparisons must be conducted as well as defining
measures for improvement. These measures advance the effectiveness
of the working capital key processes; the forecast to fulfill process, the
order-to-cash process and the purchase-to-pay process.
The concept includes the necessary steps for implementing the
organisation for the working capital management and measures for the
continuous improvement of the working capital.

INTRODUCTION
Working Capital Management involves managing the balance between firms
short-term assets and its short-term liabilities. The goal of working capital management is
to ensure that the firm is able to continue its operations and that it has sufficient cash
flow to satisfy both maturing short-term debt and upcoming operational expenses. The
interaction between current assets and current liabilities is, therefore, the main
theme of the theory of working capital management.
There are many aspects of working capital management which makes it important
function of financial management.
Time: Working capital management requires much of the finance managers time.
Investment: Working capital represents a large portion of the total investment in assets.
Credibility: Working capital management has great significance for all firms but it is
very critical for small firms.
Growth: The need for working capital is directly related to the firms growth.

Working capital
Working capital is the capital available for conducting the day-to-day operations of the
business and consists of current assets and current liabilities.
Current Assets

Current Liabilities

Inventories

Trade Payables

Trade Receivables

Bank Overdrafts

Cash
Short Term Investment

Working capital can be viewed as a whole but interest is usually focussed on the
individual components such as inventories or trade receivables. Working capital is
effectively the net current assets of a business.
Working capital can either be:
Positive

Current assets are greater than Current Liabilities

Negative

Current assets are less than Current Liabilities

Working capital management

Working capital management is the administration of current assets and current liabilities.
Effective management of working capital ensures that the organisation is maximising
the benefits from net current assets by having an optimum level to meet working capital
demands.
It is difficult trying to achieve and maintain an optimum level of working capital for
the organisation. For example having a large volume of inventories will have two effects,
firstly there will never be stock outs, so therefore the customers are always satisfied, but
secondly it means that money has been spent on acquiring the inventories, which is not
generating any returns (i.e.inventories is a non productive asset), there are also additional
costs of holding the inventories (i.e. warehouse space, insurance etc).
The important aspect of working capital is to keep the levels of inventories, trade
receivables, cash etc at a level which ensures customer goodwill but also keeps
costs to the minimum.
With trade payables, the longer the period of credit the better as this is a form of
free credit, but again the goodwill with the supplier may suffer.

Assessment of working capital

A unit needs finance not only for acquisition of fixed assets but also for its day-to-day
operations. A manufacturing concern has to obtain raw material for processing, pay wage
bills and other manufacturing expenses, store finished goods for marketing and grant credit to
its customers. It may have to pass through the following stages to complete its operating
cycle.
1. Conversion of cash into raw materials raw materials may be procured either on
payment of cash or on credit. Even if procured on credit, cash may have to be paid.
2. Conversion of raw materials into stock- in- process and finished goods.
3. Conversion of finished goods into receivables / Debtors or cash.
4. Conversion of receivables / Debtors into cash.
Working capital cycle (operating/trading/cash cycle)
The working capital cycle measures the time between paying for goods supplied to you
and the final receipt of cash to you from their sale. It is desirable to keep the cycle as
short as possible as it increases the effectiveness of working capital. The diagram below
shows how the cycle works.

The table below shows how the activities of a business have an impact on the cash flow.

TRADE PROCESS

EFFECTS ON CASH

Inventories are purchased on credit which Inventories bought on credit temporarily help
creates trade payables.
with cash flow as there is no immediate pay
for these inventories.
The sale of inventories is made on credit This means that there is no cash inflow even
which creates trade receivables.
though inventory had been sold. The cash for
the sold inventory will be received later.
Trade payables need to be paid, and the cash The cash has to be collected from the trade
is collected from the trade receivables.
receivables and then paid to the trade
payables otherwise there is cash flow
problem.
The control of working capital is ensuring that the company has enough cash
in its bank.
This will save on bank interest and charges on overdrafts. The company also needs to ensure
that the levels of inventories and trade receivables is not too great, as this means funds are
tied up in assets with no returns (known as the opportunity cost).
The working capital cycle therefore should be kept to a minimum to ensure efficient and cost
effective management.
Differences in working capital for different industries

Inventories

Trade receivables

Trade payables

Manufacturing
High volume of WIP
and Finished goods.
High level of trade
receivables, as they
tend be dependent on
a few customers.
Low to medium
levels of trade
payables.

Retail
Goods for re-sale
only and usually low
volume.
Very low levels as
most goods are
bought in cash.

Service
None or very little
inventories.

Very high levels of

trade payables due to
huge purchase of
inventory.

Low levels of
payables.

Usually low levels as

services are paid for
immediately.

Operating Cycle of a Manufacturing Unit

A non-manufacturing trading concern may not require funds for purchase of raw material
and their processing , but it also needs finance for storing goods and providing credit to its
customers .
Similarly, concern engaged in providing services may not have to keep high inventories, but
it may have to provide credit facility to its customers. Thus, all enterprises engaged in
manufacturing or trading or providing services require finance for their day-to- day
operations. The amount required to finance day-to-day operations is called working capital
and the assets and liabilities created during the operating cycle are called current assets and
current liabilities.
It may observed from the above that working capital finance is essential to carry on day-today operations and to maintain the operating cycle of an enterprise.fixed assets cannot
generate income unless they are used with the help of working capital. Therefore ,working
capital is considered as lifeblood of an enterprise.
1. Assessment of working capital requirement
It is necessary to make a proper assessment of total requirement of the working capital which
depends on the nature of the activities of an enterprise and the duration of it s cycle .it has to
be ensure that the unit will have regular supply of raw materials to facilitate uninterrupted
production . The unit should also be maintain adequate stock of finished goods for smooth
sales operations . the requirement of trade credit facilities to be given by the unit to its
customers should also be assessed on the basis of the practice prevailing in the particular
industry / trade . While assessing the above requirements ,it should also be ensured that
carrying costs for inventories and duration of credit to customers are minimised.

With a view to have proper assessment of working capital requirements , the concept of
Maximum Permissible Bank Finance (MPBF) was introduced in November ,1975 as part of
implementation of the recommendations of the Study Group to frame guidelines for followup of bank credit (Tandon Study Group). Over the years ,varous improvements had been
brought about in the system on the basis of experience gained and suggestion received.
Consistent with the policy of liberalisation ,great operational freedom has been provided to
banks in dispensation of credit. Reserve bank has decided in April, 1997 to withdraw the
prescription in regard to assessment of working capital needs based on the concept of MPBF
enunciated by Tandon Study Group . Accordingly, an appropriate system may be evolved by
banks for assessing the working capital credit needs of borrowers.
As bank have been given freedom to adopt any method for assessing the working capital
requirements, they have several options before them. Banks may provide working capital
according to their perception of the borrower and the credit needs. Banks should lay down, to
their Boards , Transparent policy and guidelines for credit dispensation , in respect of each
broad category of economic activity.
If desired , banks may follow turnover methods for large borrowers also after suitable
modifications . At a present , turnover method is used for borrowers requiring credit limits
upto Rss.5 crores and its details are given in this Project .since major corporates have adopted
cash budgeting as a tool of funds management, banks may consider adopting cash budget
system for assessing the working capital finance in respect of large borrowers. Cash budget
method is more suitable for seasonal industries like sugar, tea, etc. Reserve bank has no
objection to the individual banks retaining the present concept of MPBF with necessary
modifications or any other system . A few banks have evolved Projected Balance Sheet
(PBS) method by making certain modification in the MPBF method . Under PBS method, the
limit of Bank finance is decided keeping in view the Extent of Financial support required by
a borrower and the acceptability of the borrowers overall financial position . under PBS
method also , a borrowers total business operations , financial position , profitability
estimates and fund flow statements are studied on the lines of MPBP method . However, rigid
norms of current ratio or minimum level of liquidity are not insisted under the PBS method .
A borrower is provided working capital finance as per the Requirement shown in projected
balancesheet under PBS method . The projected bank borrowings are termed as Assessed
Bank Finance(ABF).
It may clarified that although banks have been given freedom to adopt any suitable method
for assessment of working capital requirements, they should continue to follow the exposure
norms relating to single/group borrowers and prudential norms. Further, the Reserve Banks
instructions relating to directed credit (such as to priority sector, export, etc.), quantitative
limits on lending (such as bridge finance in certain cases, rediscounting of bills earlier
discounted by non-banking finance companies,etc.,) shall continue to apply.
Although Reserve Bank has given necessary freedom to banks for adopting any suitable
method desired by them for assessment of working capitals requirement , most of the banks

are still following the Maximum Permissible Bank Finance method and Turnover Method
which are discussed below.
2. Maximum Permissible Bank Finance (MPBF) method for assessment of working
capital requirement
Following
method:

steps should be taken to assess working capital requirement under MPBF

a) Estimate the reasonable level of current assets (Inventory, Receivables
etc.) Required.
b) Estimate the level of current liabilities other than bank borrowings.
c) Work out the working capital gap i.e, total current assets les current
liabilities other than bank borrowings.
d) Under first method of lending, banks can finance up to 75 per cent of
working capital gap and balance should come from long term fund i.e,
owned funds and term borrowings.
e) Under second method of lending, borrower should provide 25% of total
current asset out of long term funds, i.e., owned funds and term
borrowings. Banks will provide balance amount after deducting credit
available for purchases and other current liabilities.

The above two methods of lending may be illustrated by taking the following example of a
borrowers financial position projected as at the end of next year.
Xxxxxxxxxxxxx
If may be observed from the above that in the First Method, the borrower has to provide a
minimum of 25 per cent of working capital gap from long-term funds (owned funds and term
borrowings) and it gives a minimum current ratio 1:1. In the Second Method, the borrower
has to provide a minimum of 25 per cent of total current assets from long-term funds (owned
funds and term borrowings) and it gives a minimum current ratio of 1.33:1. The minimum
contribution of long term funds is called minimum stipulated Net Working Capital (NWC)
which comes from owned funds and term borrowings.
In the past, the Reserve Bank used to prescribe norms for raw material, goods -in-process,
finished goods and debtors for several industries. Theses norms used to be revised from time
to time depending on the position of the industry. This practice was discontinued in April,
1997 when the Reserve Bank decided to withdraw the compulsion of MPBF method and
given freedom to banks to follow any method desired by them. Now many banks at their
ownfollow MPBF method. They can decide the reasonable level of current assets according
to their judgement in consultation with the borrower.
While estimating the total requirement of long-term funds for new projects, financial
institutions/banks should calculate margin for working capital by applying the Second
Method of lending. A project may suffer from shortage of working capital funds if sufficient

margin for working capital is not provided as per the Second Method of lending while
estimating long-term requirements of funds.

3. Classification of Current Assets and Current Liabilities

In order to calculate maximum permissible bank finance, it is necessary to have proper
classification of various items of current assets and current liabilities. An illustrative list of
current assets and current liabilities for the purpose of assessment of working capital is
furnished below :
I.
i.
ii.

iii.
iv.
v.
vi.
vii.
viii.
ix.
x.
xi.
xii.
II.
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.

ix.

Current Assets
Cash and bank balances
Investments
a) Government and other Trustee Securities (other than for long-term purposes, e.g.,
Sinking Fund, Gratuity Fund etc.)
b) Fixed deposits with banks
Receivables arising out of sales other than deferred receivables (including bills
purchased and discounted by banks)
Instalments of deferred receivables due within one year
Raw material and components used in the process of manufacture including those in
transit
Stocks-in-process including semi-finished goods
Finished goods including goods-in-transit
Other consumable spares
Advance payment of Tax
Pre-paid expenses
Advances for purchase of raw-material, components and consumable stores
Payment to be received from contracted sale of fixed assets during the next 12
months.
Current Liabilities
Short-term borrowings (including bills purchased and discounted) from
a) Banks, and b) others
Unsecured loans
Public deposits maturing within one year
Sundry creditors (trade) for raw materials and consumable stores and spares
Interest and other charges accrued but not due for payment
Advances/progress payments from customers
Deposits from dealers, selling agents, etc.
Statutory Liabilities
a) Provident Fund dues
b) Provisions for taxation
c) Sales-tax, excise duty, etc.
d) Obligations towards workers considered as statutory
e) Others (to be specified)
Miscellaneous Current Liabilities
a) Dividends

b)
c)
d)
e)
III.

Liabilities for expenses

Gratuity payable within one year
Other Provisions
Any other payments due within one year

Notes on Classification of Current Assets And Current Liabilities

1) Investments in shares, debentures, etc., and advances to other firms/companies, not
connected with the business of the borrowing firm, should be excluded from current
assets. Similarly , investments made in units of Unit Trust of India and other mutual
funds and in associate companies/subsidiaries, as well as investments made and/or
loans extended as intercorporate deposits should not be included in the build-up of
current assets while assessing maximum permissible bank finance. However,
temporary investments in money market instruments like Money Market Mutual
Funds, Commercial Paper, Certificate of Deposits, etc., which are for the purpose of
parking short term surplus, should be classified as current assets.
2) The borrowers are not expected to make the required contribution of 25 per cent from
long term sources in respect of export receivables. Therefore, export receivables may
be included in the total current assets for arriving at the maximum permissible bank
finance but the minimum stipulated net working capital (i.e. 25 per cent of working
capital gap under the First Method of lending and 25 per cent of total current assets
under the Second Method of lending) may be reckoned after excluding the quantum
of export receivables from the total assets.
3) Dead inventory i.e., slow-moving or obsolete items should not be classified as
current assets.
4) Security deposits/Tender deposits given by borrower should be classified as noncurrent assets irrespective of whether they mature within the normal operating cycle
of one year or not.
5) Advances/Progress payments from customers should be classified as current
liabilities. However, where a part of the advances received (as in the case of booking
for automobiles/two wheelers) is required by Government regulations to be invested
in certain approved securities, the benefit of netting may be allowed to the extent of
such investment and the balance may be classified as a current liability.
6) Deposits from dealers, selling agents, etc., received by the borrower may be treated
as term liabilities irrespective of their tenure if such deposits are accepted to be
repayable only when the dealership/agency is terminated. The deposits which do not
fulfil the above condition should be classified as current liabilities.
7) Disputed liabilities in respect of income-tax, excise duty, customs duty and electricity
charges need not be treated as current liabilities except to the extent provided for in
the books of the borrower. Where such disputed liabilities are treated as contingent
liabilities for period beyond one year, the borrower should be advised to make
adequate provisions so that he may be in a position to meet the liabilities as and when
they accrue.
8) If disputed excise liability has been shown as a contingent liability or by way of notes
to the balance sheet, it need not be treated as current liability for calculating the

permissible bank finance unless it has been collected or provided for in the accounts
of borrowers. A certificate from the statutory auditors of the borrowers may be
obtained regarding the amount collected from the customers in respect of disputed
excise liability or provisions made in the borrowers accounts. The amount of excise
duty payable should be treated as current liability for the purpose of working out the
permissible limit of bank finance strictly on the basis of the certificate from the
borrowers statutory auditors. The same principle may also be applied for disputed
sales tax dues.
9) In case of other statutory dues, dividends, etc., estimated amounts payable within one
year should be shown as current liabilities even if specific provisions have not been
made for their payment.
10) As per the instructions issued by the Reserve Bank in October, 1993, the entire term
loan instalments falling due for payment in the next twelve months need not be
treated as an item of current liabilities for the purpose of arriving at MPBF. However,
the entire amount of term loan instalments due within next twelve months should
continue to be treated as current liability for the purpose of calculating the current
ratio.
11) Many times borrowers have to provide margin money to banks for obtaining Letter of
Credit/Bank Guarantee. Margin money deposited for LCs and guarantees relating to
current operations of the unit should be included in current assets
12) Automatic plastic injection moulds are used by manufacturers of writing instruments.
Banks may, at the time of commencement of operations of a unit, treat these
automatic plastic injection moulds as fixed assets to be funded out of project finance
made available by a financial institution and /or a bank. Subsequently, during the
operating cycle of a unit, if these moulds are required to be replaced, the cost of
replacement may be supported by way of working capital credit by treating them as
part of current assets.
13) Receivables comprising of bills negotiated under demand/usance LCs and Bank
borrowings under LCs will not form part of current assets and current liabilities
respectively.
4. Information / Data required for Assessment of Working Capital
In order to assess the requirements of working capital on the basis of production needs, it is
necessary to get the data from the borrowers regarding their past/projected production, sales,
cost of production, cost of sales, operating profit, etc. In order to ascertain the financial
position of the borrowers and the amount of working capital needs to be financed by banks, it
is necessary to call for the data from the borrowers regarding their net worth, long-term
liabilities, current liabilities, fixed assets, current assets, etc. The Reserve Bank prescribed the
forms in 1975 to submit the necessary details regarding the assessment of the working capital
requirements under its Credit Authorisation Scheme. The Scheme of Credit Authorisation was
changed into Credit Monitoring Arrangement in 1988. The forms used under Credit
Authorisation Scheme for submitting necessary information have also been simplified in
1991 for reporting the credit sanctioned by banks above the cut off point to Reserve Bank
under its Scheme of Credit Monitoring Arrangement has also been discontinued, the banks

are using these forms for calculating working capital requirement under MPBF method.
Following six forms are used for submitting information to banks.
I)

Particulars of the existing/proposed limits from the banking system (From I)

Particulars of the existing credit from the entire banking system as also the term loan
facilities availed of from the term lending institution / banks are furnished in this form.
Maximum and minimum utilisation of the limits during the last 12 months and outstanding
balance as on a recent date are also given so that a comparison can be made with the limits
now requested for and the limits actually utilised during the last 12 months.
II)

Operating Statement (From II)

The data relating to gross sales, net sales, cost of raw materials, power and fuel, direct labour,
depreciation, selling, general and administrative expenses, interest, etc., are furnished in this
form. It also covers information on operating profit and net profit after deducting total
expenditure from total sale proceeds.
III)

Analysis of Balance Sheet (Form III)

A complete analysis of various items of last years balance sheet, current years estimates
and following years projections are given in this form. The details of current liabilities, term
liabilities, net worth, current assets, fixed assets, other non-current assets, etc., are given in
this form as per the classification accepted by the banks.
IV)

Comparative Statement of Current Assets and Current Liabilities (Form IV)

This form gives the details of various items of current assets and current liabilities as per the
classification accepted by the banks. The figures given in this form should tally with the
figures given in the Form III where details of all the liabilities and assets are given. This form
used to indicate all the current assets and current liabilities at one place. In case of inventory
(raw materials, consumable spares, stock-in-process and finished goods), receivables and
sundry creditors, the holding level are given not only in absolute amounts but also in terms of
number of months so that a comparative study may be done with the past trends. They are
indicated in terms of number of months in brackets below their amounts.
V)

Computation of Maximum Permissible Bank Finance (Form V)

On the basis of the details of the current assets and current liabilities given in Form IV,
Maximum Permissible Bank Finance is calculated in this form to find out the credit limits to
be allowed to the borrowers.

VI)

Funds Flow Statement (Form VI)

In this form, funds flow of long term sources and uses is given to indicate whether long-term
funds are sufficient for meeting the long-term requirements. In addition to long-term sources
and uses, increase/decrease in current assets is also indicated in this form.

5. Check-list for verification of the information/data

Banks should verify not only the arithmetical accuracy of the data furnished by the borrowers
but also the logic behind various assumptions based on which the projections have been
made. For this purpose, bank official should hold discussions with borrowers on projected
sales, level of operations, level of inventory, receivables, etc. It necessary, a visit to the
factory may also be made to have a clear idea of the products and processes.
An illustrative check-list is given below to indicate the various points to be examined by
banks while financing the credit requirements of the borrowers.
I)

Utilisation of Existing Limits

i)
It may examined whether the limits have been adequately utilised during
the last 12 months. If not, the justification for further enhancement may be
ascertained. It may so happen that the past profits which were employed in
working capital might be intended to be withdrawn for investment in fixed
assets on account of modernisation, expansion, diversification, etc.,
thereby creating need for recouping working capital funds. In such cases,
additional limit might be sought although the existing limits were not
utilised adequately during the last year. The sanction of additional limits in
such cases may lead to a slip-back in the current ratio, but slip-back should
not be allowed to a level below 1.33.
ii)
If the limits have been overdrawn, its reasons may be ascertained. If the
financial position of the unit is weak, steps for its improvement may be
decided.

II)

Operating Statement
i)
As the entire working capital assessment is directly linked to sales figure,
it may be ensured that the annual projection of sales is reasonable in
relation to the installed/licensed capacity, availability of inputs,
environmental conditions, marketing prospects, etc.
ii)
In the case of existing units, projected sales should be in accordance with
the past trend. If the projected sales are not in true with past trend and
appear to be over ambitious, the reasons should be ascertained to ensure
that the sales projections are realistic.
iii)
If the unit is likely to implement a modernisation/expansion/diversification
project, its impact on sales may be assessed.
iv)
It may be ascertained whether the previous years projection of sales, on
the basis of which limits were fixed last year, has been realised. If not, the
reasons for the short-fall may be examined. If a borrower approaches for
additional limits on the basis of the projection of higher sales than that

v)
vi)
vii)

viii)

ix)
x)

xi)

xii)

xiii)

III)

given in the previous year which was not realised the matter should be
carefully examined.
If there is a declining trend in net sales, reasons thereof may be studied. A
detailed study be done if an increase in limits is sought in such cases.
The valuation of sales projections should be based on the current ruling
prices.
Similarly, the valuation of various inputs constituting cost of sales in the
projections should also be based on current prices. It should be ensured
that price escalations are not built into to the projections of sales as well as
cost of various inputs.
It may be ascertained whatever the raw materials consumption as a
percentage of cost of production is in keeping with the past trend. If it
shows any undue increase, the reasons for it may be examined
It may be ensured that consumable stores and other items used in the
process of manufacture are included in raw materials.
It may be ascertained whether adequate depreciation has been provided. If
the method of providing depreciation is changed, its impact on cost of
production may be analysed.
It may be ascertained whether selling, general and administrative expenses
are in keeping with the past trend. If they show an increase in terms of the
percentage to sales, the reasons thereof may be examined.
It may be examined whether the operating profit/profit before tax is
increasing in line with the sales. If not, its reasons may be ascertained and
analysed.
In the case of new units, the estimated production may be assumed at 40 to
80 per cent of the installed capacity in the first year depending on the
nature of products, availability of inputs, marketing prospects, etc. The
utilisation of the capacity may gradually increase in subsequent years. In
the case of new units. Financed by term lending institutions, projections
accepted by them regarding sales, requirement of raw materials, cost of
production etc., may be taken as the basis for providing working capital.
Banks and term lending institution should have joint/simultaneous
appraisal of the projects.

Analysis of Balance Sheet

i)
The classification of current assets and current liabilities should be made
as per the usual accepted approach of banks.
ii)
It may be ascertained whether the level of raw materials, stock-in-process,
finished goods and receivables are in conformity with the stipulated
norms, if any, prescribed by the bank. It may be mentioned that the
Reserve Bank has discontinued the practice of prescribe norms. Banks
may prescribe their own norms. If no norms are prescribed, the level of
inventory and receivables should be in tune with the past trends. If the
levels of inventories and receivables are above the norms, if any, or past
trends, an analysis may be done to find out the reasons.

iii)

iv)

v)

vi)

vii)
viii)

ix)

x)
xi)
xii)
xiii)

xiv)

IV)

The level of the stock of spares may be estimated on the basis of the past
experience. The projected stock of spares not exceeding 12 month
consumption for imported items and 9 months consumption for
indigenous items may be treated as current assets. Spares held beyond
these levels may be treated as non-current assets.
Some of the borrowers may have the tendency to show the requirements of
imported raw materials at an inflated level. The higher build-up of
imported raw materials should be justified on the basis of economic
quantity for placing purchase order, lead time in getting replenishment, etc.
If the level of inventories is very high, the details of the age of inventory
may be obtained to find out whether some of the items have become
obsolete.
If the level of receivables is very high, the names of main buyers and the
period of credit offered may be ascertained. It may be examined whether a
portion of the receivables is likely to be irrecoverable and if so, sufficient
provision should be made for bad debts.
The details of inter-corporate investments and advances should be obtained
and the reasons for not liquidating them may be examined.
Some of the borrowers may have a tendency show the sundry creditors and
other current liabilities in the projected figures at a reduced level. Although
no norms have been fixed for sundry creditors, it is expected that the level
of sundry creditors should be in accordance with the past trend and trade
practices. Sundry creditors in terms of months purchases may be verified
with the past trends. If a sudden decline in the creditors for purchases is
observed, reasons for it may be ascertained.
The borrowers should make adequate provision for taxes, dividends,
statutory liabilities, etc., and if this has not been done, the extent of
liabilities under these heads which have to be met within one year, should
be classified as current liabilities.
It may be ensured that intangible assets like patents, goodwill, etc., are
written off over a period of years.
It may be ascertained whether the net worth shows an increasing trend. If
the trend shows a decline in net worth, its reasons may be ascertained
Net working capital should show an increasing trend from year to year. If
not, reasons thereof should be ascertained.
If the date of balance sheet has been changed, the reasons for it should be
ascertained to find out whether it has been done only for the purpose of
showing a rosy picture.
Information may be obtained about contingent liabilities to know their
impact on the working of the unit.

Computation of Maximum Permissible Bank Finance

i)
Generally, Maximum Permissible Bank Finance (MPBF) should be
calculated on the basis of the Second Method of lending. If the Second

ii)

iii)

iv)

V)

Method of lending has not been followed, reasons for it may be

ascertained.
If export bills limit is to be allowed over and above the permissible bank
finance, the export bills should be excluded from the total sales and export
receivables should also be excluded from the build-up of current assets.
Separate limits may be given for export receivables even without keeping
the 25 per cent margin from long term sources.
The third party outstation cheques/drafts purchase limits should be within
the MPBF. However, at the request of the borrowers, such limits may be
allowed to a small extent over and above the MPBF.
It may be ascertained whether there is any co-relation between projected
increase in production/sales and increase in limits, if not, the reasons for it
may be studied.

Fund Flow Statement

i)
The long term sources should be adequate to cover the ling-term uses and
leave a reasonable surplus for being employed as working capital. If longterm sources are less than the long-term uses, it may be inferred that short
term funds are being diverted for purpose other than working capital
needs. Such cases should be properly examined.
ii)
Increase in various items of inventory which is disproportionate to
percentage rise in sales should be examined in detail.
iii)
The increase in short-term bank borrowings should be in line with the
additional limits sought by the company over the previous years level of
availment.
iv)
The increase in short-term bank borrowings should be matched suitably by
the increase in current assets, particularly inventory and receivables. If it is
not so, short-term funds might be utilised for repayment of other current
liabilities or be diverted for fixed assets or for inter-corporate
investment/advances. Such matters should be examined in detail.
It may be noted that the above check-list is not an end in itself. It only indicates
broad aspects to be examined by banks and helps in analysis and interpretation of
the data furnished by the borrowers for taking judicious decisions.

6. Turnover Method for assessment of working capital requirements

With the object of simplifying the procedure for assessment of working capital requirements
for small and medium units, the instructions relating to the First and Second Method of
lending and the norms for inventories and receivables have been replaced by simplified
formula. As per the guidelines issued by Reserve Bank, such units may be provided working
capital limits by banks on the basis of a minimum 20 per cent of their projected annual
turnover for new as well as existing units. Borrowers would be required to bring in 5 per cent

of their annual turn-over as margin money. In other words, 25 per cent of the output value
should be computed as working capital requirement of which at least 4/5 th (20 per cent of
projected turnover) should be provided by banks and the balance 1/5 th (5 per cent of
projected turnover) should be contributed by the borrowers from long term sources towards
margin for the working capital. It can be examined by the following illustration :
1. Projected turnover
2. Working capital requirement
(25per cent of projected turnover)
3. Bank finance for working capital
(20 per cent of projected turn over or
4/5th of working capital requirement)
4. Margin money for working capital from long
Term sources (5 per cent of projected turnover
or 1/5th of working capital requirement)

300 lakh
300*25/100=75 lakh

300*20/100=60 lakh

75*4/5=60lakh
300*5/100=15 lakh
75*1/5=15lakh

As the assessment of working capital depends on the projected turnover/output, banks

should satisfy themselves about the reasonableness of the projected annual turnover of the
Applicants on the basis of the annual statement of accounts or any other documents such as
return filed with sales tax/revenue authorities and also ensure that the estimated increase
during the year is realistic . It may be further clarified that projected turnover/output means
projected gross sales which may include excise duty also.
The above guidelines have been framed assuming an average production/processing cycle
of three months (i.e., working capital is likely to be turned over four times in a year).
However, certain industries may have a production cycle shorter or longer than three months.
Therefore, the assessment of working capital requirement may be done both ways i.e., as per
projected turnover basis and also traditional method based on a borrowers overall production
cycle. If the credit requirement based on production/processing cycle is higher than the one
assessed on projected turnover basis, the higher limit may be sanctioned as the guidelines
stipulate to provide credit limits at the minimum of 20 per cent of the projected turnover. In
other words, more than 20 per cent of the projected turnover may be sanctioned in such cases.
If the higher limit (more than 20 per cent of the projected turnover) is sanctioned, the
borrower should also bring in proportionately higher amount in relation to his requirement of
bank finance. As per the norms, atleast 1/5th of the total working capital requirement should
be brought in by way of long term sources, by the borrowers and the bank finance may be
provided for 4/5 of the total working capital requirement.
If the assessed credit requirement on traditional method based on borrowers overall
production cycle is lower than the one assessed on projected turnover basis, the credit limit
can be sanctioned at 20 per cent of the projected turnover. However, actual drawals may be
allowed on the basis of drawing power to be determined by banks after excluding unpaid
stocks.
In case of traders also, credit limit may be assessed at 20 per cent of the projected
turnover. However, many traders may have high turnover or they may avail of credit facility

from the market. Therefore, actual drawals should be allowed by on the basis of drawing
power to be determined by banks after excluding unpaid stocks.
In case of traders also, credit limit may be assessed at 20 per cent of the projected
turnover. However, many traders may have high turnover or they may avail of credit facility
from the market. Therefore, actual drawals should be allowed by banks on the basis of
drawing power to be determined after ensuring that unpaid stocks are excluded. In the case of
commodities covered under selective credit control, directives issued by RBI from time to
time should be scrupulously followed.
As per the guidelines issued by RBI in march,1991, banks should adopt the simplified
procedure of sanctioning working capital limits on the basis of 20 per cent of the projected
annual turnover to all units(new as well as existing) requiring aggregate fund Based working
capital limits up to Rs.5 crore from the banking system.

7. Fixation of Fund-based and Non-Fund-based Limits

After arriving at the total amount of working capital requirements, banks may decide
about the various fund-based and non-fund based limits and sub-limits. The bulk of the
inventory limit is generally released by way of open cash credit based on the projected level
of the borrowers operations. The receivables limit may be either by way of cash credit or
overdraft against book debts or by way of bills limit. Within the sanctioned limits, drawing
power may be allowed on the basis of statements received under the quarterly/monthly
information system depending on the regularity and reliability of the information or on the
basis of monthly stock statements ensuring that there is no double financing involved.
Many borrowers do not utilise to a great extent the credit limits sanctioned to them. Such
large unutilised credit limits may create several problems in efficient management of funds
and also implementing macro-credit policy. With a view to improve discipline in the
availment of bank finance by borrowers and to facilitate better funds management, it was
decided to levy a commitment fee on the unutilised portion of the working capital limits with
effect from January 1, 1991. In the case of borrowers with working capital limits of Rs. 1
crore and above, scheduled commercial banks were required to levy a minimum commitment
charge of 1 per cent per annum. On the unutilised portion of the quarterly operating limit
subject to a toleration level of 15 per cent of the Quarterly operating limit.
With effect from july1,1996, the levy of commitment charge has been left to the discretion
of the financing bank/consortium/syndicate and will not be mandatory for banks. Therefore,
banks may evolve their own guidelines in regard to commitment charge for ensuring credit
discipline.
In addition to the fund based limits, non-fund-Based limits like inland letter of credit
/Foreign letter of credit , guarantees and acceptances are given keeping in view the genuine
needs and the capacity of the borrowers. While considering foreign letter of credit , the
requirement of imports , quantum of import license on hand/expected , sources of funds to

retire the imports bills when received, availability of funds to pay import duty, etc., should be
kept in view. In the case of financial/performance guarantees, it may be ensured that the
borrower has the necessary experience, capacity and means to perform the required
obligations under the contract without any default and that he will be in a position to
reimburse the bank if default occurs due to unforeseen and the bank is required to make the
payment under the guarantee.
Banks should not issue guarantees favouring financial institution for the term loans
extended by them, as the institution are expected to appraise each proposal and bear the risk
themselves. Similarly, banks should not issue guarantee/co-acceptances favouring financial
institution (including Power Finance Corporation Ltd.) for the assistance provided by them
under Buyers Line of Credit Scheme (BLCS). Under the BLCS, financial institutions assume
the role of a primary lender by directly providing credit to the buyer to facilitate purchase of
machinery, equipment, etc., covered by the transaction. As the primary lender is required to
make proper assessment of the proposal and secure a charge by hypothecation of the assets
financed, it would not be in order for the financial institution to shift the risk of repayment by
obtaining a bank guarantee. It may be clarified that BLCS is different from the Bills
Rediscounting Scheme operated by financial institution (including Power Finance
Corporation Ltd) for sale of machinery, where the primary credit is provided by the sellers
bank to the seller through bills drawn on the buyer and co-accepted by the buyers bank. As
the seller bank has no access to the security covered by the transaction which remains with
the buyer, the buyers bank can give co-acceptance in such cases. Similarly, buyers bank can
give co-acceptance/guarantee for differed payment offered after proper appraisal of the
proposal.
8. Fixation of drawing power against working capital limits
Credit limits are fixed at the time of annual/quarterly review on the basis of projected
assets and liabilities. However, it is necessary to regulate the borrowings on the basis of
actual build-up of current assets rather than the projected ones. Therefore, monthly stock
statement indicating the actual levels of inventories is obtained every month and drawing
power is calculated after deducting the necessary margin. If the overdraft / cash credit limit
has been sanctioned against book debts also, it is necessary to obtain the monthly statement
of book debts to work out the drawing power against them. The drawing power fixed on the
actual build-up of the current assets should be within the sanctioned credit limits. It can be
said that while statement of stocks and debtor take care of the security available to a bank,
quarterly / annual review takes care of the need based requirements and finds out the long
term funds available to finance a part of the current assets.
The borrowers should be asked to value the stocks shown in the stock statement in the
manner as for the purpose of annual accounts. The value of the closing stocks disclosed in the
monthly stock statement on the date of the year end should tally with the stock shown in the
balance sheet.

9. Stock inspection/verification of statement of book debts

In orders to verify the information given by the borrower in the stock market statement,
sometimes stock inspection may also be done. The periodicity of the inspection depends on
the health of the account. Inspection of the stock of an irregular account may be done more
frequently than the stock of a satisfactory account. At the time of inspection, efforts should be
made to find out the turnover in the stocks with the help of stock register and invoice for
purchase and sales. It may indicate the quantum of slow moving or non-moving or non
saleable redundant stocks. In such cases, a discussion should be held with the management to
find out the corrective measures. It may also be ascertained during the inspection that the
valuation methods followed for valuation of stocks shown in stock statement is as per method
followed for the preparation of annual balance sheet and quarterly/half-yearly statements.
If the stock inspection reveals a serious shortfall in stocks, a detailed stock verification
may be carried out. If necessary, assistance of outside experts may be taken for verification of
stocks in such cases. During the course of the factory visit / stock inspection, the banks
official should have a discussion with the top management about the working of the unit.
Discussion with the management may be very useful to identify the problems, if any, faced
by the unit and also to find out the corrective steps to solve them.
If the overdraft/ cash credit limits have been sanctioned against book debts, the statement
of book debts should be examine to find the trend of book debts. If book debts are showing
sharp increase without corresponding increase of sales, the age of book debts should be
studied to find out the position of doubtful debts. Comparative study of ratios of inventories
to sales and book debts to sales may indicate the position of slow moving inventories and
doubtful debt respectively.
10. Sanction of Ad-Hoc Limits
Banks may sanction ad-hoc limits to the borrowers for their genuine requirements. The
quantum and the period of ad-hoc limits may be decided by banks on the basis of their
commercial judgement and merit of each case.
Sometimes, exporters may receive certain export orders which were not taken into account
earlier while fixing maximum permissible bank finance. Additional credit may be provided to
exporters for executing export orders even if sanction of such additional credit exceeds
maximum permissible bank finance sanctioned to a unit. It should be ensured that exporters
with confirmed letters of credit/firm export orders are not denied bank credit just because of
the ceiling of existing sanctioned limits.
Many banks have framed special schemes to provide additional working capital finance
against the security of fixed assets/collateral security.
Banks can provide additional facilities keeping in view the security available, working
results and financial position of the unit.

11. Conclusion- Freedom of banks from MPBF method

As mentioned earlier, banks have been given freedom to evaluate their own system for
assessing the working capital requirement and it is not obligatory for them to follow MPBF
method. They can follow MPBF method, turnover method, projected balance sheet methods,
cash budget method or any other method approved by the boards for assessment of working
capital requirements. Whatever method may be followed by banks , they should keep a watch
on current ratio and repaying capacity of borrowers. Check lists given in this project to verify
the data given by the borrower will be useful under any method of lending followed by the
banks. The information given in the operating statement and balance sheet should be analysed
keeping in view the checklists given in this project. Long term resources should be more than
fixed assets leaving a surplus to provide margin for working capital.

Liabilities
Equity

Assets
Fixed Assets

Long term debt

Current Assets
Current liabilities

Equity and long term debts should be more than fixed assets to provide margin to the bank
for financing current assets. The items included in equity, long term debt, current liabilities,
fixed assets and current assets are given in the project on Ratio Analysis of this project. if
current liabilities are more than current assets, the borrower should be asked to bring in long
term resources to improve the current ratio.
As RBI does not stipulate norms for inventory and receivables for various industries,
banks have to decide about reasonable level of inventory and receivables to be financed by
them. Proper management of inventories and receivables is necessary to have maximum
advantage of funds utilised in them. It is essential to keep sufficient level of inventories and
receivables to ensure smooth flow of production and sales. At the same time, excess
inventories and receivables should be avoided to minimise the cost.

Types of working capital policy

Within a business, funds are required to finance both non-current and current assets.The
level of current assets fluctuates, although there tends to be an underlying level required for
current assets.
Assets
m
100
Temporary fluctuating current assets

80
Permanent current assets
(Core level of inventories, trade receivables etc)
50

Non current assets

0
Time

A company must decide on a policy on how to finance its long and short-term assets.
There are 3 types of policies that exist:
Conservative policy

Moderate policy

Aggressive policy

All the non current assets,

permanent assets and some
temporary current assets are
financed by long- term
finance.

All the non current assets,

permanent assets are
financed by long-term
finance. The temporary
fluctuating assets financed
by short- term finance.

All the non current assets,

permanent assets are
financed by long- term.
Remaining permanent assets
all temporary fluctuating
assets by short- term.

90m long term debts and

equity.
10m short term overdrafts
and bank loans.

80m long term debts and

equity.
20m short term overdrafts
and bank loans.

65 long term debts and

equity.
35m short term overdrafts
and bank loans.

Summary of the three policies:

Long Term
Finance
Short Term
Finance

Conservative policy
Non current assets
Permanent assets
Temporary current
assets
Temporary current
assets

Moderate policy
Non current assets
Permanent assets

Aggressive policy
Non current assets
Permanent assets

Temporary current
assets

Permanent assets
Temporary current
assets

With an aggressive working capital policy, a company will hold minimal levels of inventories
in order to minimise costs. With a conservative working capital policy the company will hold
large levels of inventories. The moderate policy is somewhere in between the conservative
and aggressive.
EXAMPLE
An entitys working capital financing policy is to finance working capital using short-term
financing to fund all the fluctuating current assets as well as some of the permanent part of
the current assets.

Importance of Working Capital Management

For smooth running an enterprise, adequate amount of working capital is very

essential. Efficiency in this area can help, to utilize fixed assets gainfully, to assure
the firms long-term success and to achieve the overall goal of maximization of the
shareholders, fund. Shortage or bad management of cash may result in loss of cash
discount and loss of reputation due to non-payment of obligation on due dates.
Insufficient inventories may be the main cause of production held up and it may compel
the enterprises to purchase raw materials at unfavourable rates.

Like-wise facility of credit sale is also very essential for sales promotions. It is
rightly observed that many a times business failure takes place due to lack of
working capital. Adequate working capital provides a cushion for bad days, as a
concern can pass its period of depression without much difficulty. O Donnel et
al. correctly explained the significance ofadequate working capital and mentioned
that to avoid interruption in the production schedule and maintain sales, a concern
requires funds to finance inventories and receivables.
The adequacy of cash and current assets together with their efficient handling
virtually determines the survival or demise of a concern. An enterprise should
maintain adequate working capital for its smooth functioning. Both, excessive
working capital and inadequate working capital will impair the profitability and general
health of a concern.
The danger of excessive working capital are as follows:
Heavy investment in fixed assets A concern may invest heavily in its fixed assets which is not justified by actual sales.
This may create situation of over capitalisation.
Reckless purchase of materials Inventory is purchased recklessly which results in dormant slow moving and obsolete
inventory. At the same time it may increase the cost due to mishandling, waste,
theft, etc.
Speculative tendencies Speculative tendencies may increase and if profit is increased dividend distribution
will also increase. This will hamper the image of a concern in future when speculative loss
may start.

Liberal credit Due to liberal credit, size of accounts receivables will also increase. Liberal credit
facility can increase bad debts and wrong practices will start, regarding delay in
payments.
Carelessness
Excessive working capital will lead
adversely affect the profitability.
Paucity of working capital

to carelessness

about

costs

which

is also bad and has the following dangers:

will

1. Implementation of operating plans becomes difficult and a concern may not achieve
its profit target.
2. It is difficult to pay dividend due to lack of funds.
3. Bargaining capacity is reduced in credit purchases and cash discount could not be
availed.
4. An enterprise looses its reputation when it becomes difficult even to meet day-today commitments.
5. Operating inefficiencies may creep in when a concern cannot meet it financial
promises.
6. Stagnates growth as the funds are not available for new projects.
7. A concern will have to borrow funds at an exorbitant rate of interest in case of need.
8. Sometimes, a concern may be bound to sale its product at a very reduced rates to
collect funds which may harm its image.

Factors Influencing Working Capital Requirement

Numerous factors can influence the size and need of working capital in a concern.
So no set rule or formula can be framed. It is rightly observed that, There is no
precise way to determine the exact amount of gross or net working capital for every
enterprise. The data and problem of each company should be analysed to
determine the amount of working capital.
Briefly, the optimum level of current assets depends upon following determinants.
Nature of business-

Trading and industrial concerns require more funds for working capital. Concerns
engaged in public utility services need less working capital. For example, if a concern is
engaged in electric supply, it will need less current assets, firstly due to cash nature
of the transactions and secondly due to sale of services. However, it will invest more in
fixed assets.
In addition to it, the investment varies concern to concern, depending upon the
size of business, the nature of the product, and the production technique.
Conditions of supplyIf the supply of inventory is prompt and adequate, less funds will be needed. But,
if the supply is seasonal or unpredictable, more funds will be invested in
inventory. Investment in working capital will fluctuate in case of seasonal nature of
supply of raw materials, spare parts and stores.
Production policyIn case of seasonal fluctuations in sales, production will fluctuate accordingly
and ultimately requirement of working capital will also fluctuate. However, sales
department may follow a policy of off-season discount, so that sales and production
can be distributed smoothly throughout the year and sharp, variations in working
capital requirement are avoided.
Seasonal OperationsIt is not always possible to shift the burden of production and sale to slack period. For
example, in case of sugar mill more working capital will be needed at the time of crop and
manufacturing.
Credit AvailabilityIf credit facility is available from banks and suppliers on favourable terms and
conditions, less working capital will be needed. If such facilities are not
available more working capital will be needed to avoid risk.
Credit policy of enterprisesIn some enterprises most of the sale is at cash and even it is received in advance while, in
other sales is at credit and payments are received only after a month or two. In
former case less working capital is needed than the later. The credit terms depend
largely on norms of industry but enterprise some flexibility and discretion. In order to
ensure that unnecessary funds are not tied up in book debts, the enterprise should follow
a rationalized credit policy based on the credit standing of the customers and other
relevant factors.

Growth and expansionThe need of working capital is increasing with the growth and expansion of an
enterprise. It is difficult to precisely determine the relationship between volume
of sales and the working capital needs. The critical fact, however, is that the need for
increased working capital funds does not follow growth in business activities but
precedes it. It is clear that advance planning is essential for a growing concern.
Price level changeWith the increase in price level more and more working capital will be needed
for the same magnitude of current assets. The effect of rising prices will be different
for different enterprises.
Circulation of working capitalLess working capital will be needed with the increase in circulation of working
capital and vice-versa. Circulation means time required to complete one cycle
i.e. from cash to material, from material to work-in-progress, form work-in-progress
to finished goods, from finished goods to accounts receivable and from accounts
receivable to cash.
Volume of saleThis is directly indicated with working capital requirement, with the increase in sales
more working capital is needed for finished goods and debtors, its vice versa is also true.
Liquidity

and

profitability-

There is a negative relationship between liquidity and profitability. When working

capital in relation to sales is increased it will reduce risk and
Growth and expansionThe need of working capital is increasing with the growth and expansion of an
enterprise. It is difficult to precisely determine the relationship between volume
of sales and the working capital needs. The critical fact, however, is that the need for
increased working capital funds does not follow growth in business activities but
precedes it. It is clear that advance planning is essential for a growing concern.
Circulation of working capitalLess working capital will be needed with the increase in circulation of working
capital and vice-versa. Circulation means time required to complete one cycle i.e.
from cash to material, from material to work-in-progress, form work-in-progress to
finished goods, from finished goods to accounts receivable and from accounts
receivable to cash.

Volume of saleThis is directly indicated with working capital requirement, with the increase in sales
more working capital is needed for finished goods and debtors, its vice versa is also true.
Liquidity

and

profitability-

There is a negative relationship between liquidity and profitability. When working

capital in relation to sales is increased it will reduce risk and profitability on one side
and will increase liquidity on the other side.
Management

ability-

Proper co-ordination in production and distribution of goods may reduce

the requirement of working capital, as minimum funds will be invested in absolute
inventory, non-recoverable debts, etc.
External

Environment-

With development of financial institutions, means of communication, transport

facility, etc., needs of working capital is reduced because it can be available as and when
needed.

Determinants of Working Capital

There are no set rules or formulas to determine the working capital requirement
of a firm. A number of factors influence the need and quantum of the working
capital of a firm. These are discussed below:
Nature of industry The composition of an asset is related to the size of a business and the industry
to which it belongs. Small companies have smaller proportion of cash, requirements
and inventory than large corporations. Need of working capital is thus determined

by the nature of an enterprise.

Demand of creditors Creditors are interested in the security of loans. They want their advances to be
sufficiently covered. They want the amount of security in assets which are greater than
liabilities.
Cash requirements Cash is one of the current assets which are essential for the successful
operations of the production cycle. Cash should be adequate and properly
utilized. A minimum level of cash is always needed to keep the operations going.
General nature of business The general nature of a business is an important determinant of the level of
the working capital. Working capital requirements depends upon the general nature and
its activity on work. They are relatively low in public utility concerns in which
inventories and receivables are rapidly converted into cash. Manufacturing
organisations, however, face problems of slow turn-over of inventories and
receivables, and invest large amount in working capital.
Time
The level of working capital depends upon the time required to manufacture goods.
If the time is longer, the amount of working capital required is greater and viceversa. Moreover, the amount of working capital depends upon inventory turnover
and the unit cost of goods that are sold. The greater this cost, the larger is the amount of
working capital.

Volume of sales This is the most important factor affecting the size and component of working
capital. A firm maintains current assets because they are needed to support the
operational activities which results in sales. The volume of sales and the size of the
working capital are directly related to each other. As the volume of sales
increases, there is an increase in the investment of working capital in the cost of
operations, in inventories and in receivables.
Terms of purchases and sales If the credit terms of purchases are more favourable and those of sales less liberal,

less cash will be invested in inventory. With more favourable credit terms, working
capital requirements can be reduced as a firm gets time for payment to creditors or
suppliers.
Inventory turnover If the inventory turnover is high, the working capital requirements will be low. With
good and efficient inventory control, a firm is able to reduce its working capital
requirements.
Receivables turnover It is necessary to have effective control over receivables. Prompt collection of
receivables and good facilities for setting payables result into low working capital
requirements.
Business cycle Business expands during periods of prosperity and decline during a period
of depression. Consequently, more working capital is required during periods of
prosperity and less during the periods of depression.
Variation in sales A seasonal business requires
relatively short period of time.

the maximum amount of working capital for a

Production cycle The time taken to convert raw material into finished products is referred to as the
production cycle or operating cycle. The longer the duration of production cycle, the
greater is the requirement of working capital. Utmost care should be taken to shorten the
period of the production cycle in order to minimize working capital requirements.

Liquidity and profitability If a firm desires to take a greater risk for bigger gains or losses, it reduces the size of
its working capital in relation to its sales. If it is interested in improving its
liquidity, it increases the level of its working capital. However, this policy is likely to
result in a reduction of sales volume and, therefore, of profitability. A firm, therefore,
should choose between liquidity and profitability and decide about its working capital
requirements accordingly.
Profit planning and control The level of working capital is decided by management in accordance with its policy

of profit planning and control. Adequate profit assists in the generation of cash. It
makes it possible for management to plough back a part of earnings into the
business and substantially build up internal financial resources.
Activities of the firm A firms stocking of heavy inventory or selling on easy credit term calls for a
higher level of working capital than a firm selling services or making cash sales.

1. RATIO ANALYSIS
Working capital ratios
Ratios are way of comparing financial values and quantities to improve our understanding.
In particular they are used to assess the performance of a company. When analysing
performance through the use of ratios it is important to use comparisons as a single ratio is
meaningless.
A ratio is a simple arithmetical expression one number to another. The technique of ratio
analysis can be employed for measuring short-term liquidity or working capital position of a
firm. The following ratios can be calculated for these purposes turnover.

The use of ratios

To compare results over a period of time

To measure performance against other organisations
To compare results with a target
To compare against industry averages

We shall now look at some of the working ratios in detail and explain how they can be
interpreted.
1. Current ratio.
2. Quick ratio
3. Absolute liquid ratio
4. Inventory turnover ratio.
5. Receivables turnover.
6. Payable turnover ratio.
7. Working capital
8. Working capital leverage
9. Ratio of current liabilities to tangible net worth.

2.

FUND FLOW ANALYSIS

Fund flow analysis is a technical device designated to the study the source from which
additional funds were derived and the use to which these sources were put. The fund
flow analysis consists of:

a.

Preparing schedule of changes of working capital

b.

Statement of sources and application of funds.

It is an effective management tool to study the changes in financial position (working

capital) business enterprise between beginning and ending of the financial dates.

3.

WORKING CAPITAL BUDGET

A budget is a financial and / or quantitative expression of business plans and polices

to be pursued in the future period time. Working capital budget as a part of the total
budge ting process of a business is prepared estimating future long term and short
term working capital needs and sources to finance them, and then comparing the
budgeted figures with actual performance for calculating the variances, if any, so that
corrective actions may be taken in future. He objective working capital budget is to
ensure availability of funds as and needed, and to ensure effective utilization of these
resources. The successful implementation of working capital budget involves the
preparing of separate budget for each element of working capital, such as, cash,
inventories and receivables etc.

ANALYSIS OF SHORT TERM FINANCIAL POSITION OR TEST OF

LIQUIDITY
The short term creditors of a company such as suppliers of goods of credit and
commercial banks short-term loans are primarily interested to know the ability of a
firm to meet its obligations in time. The short term obligations of a firm can be met
in time only when it is having sufficient liquid assets. So to with the confidence of
investors, creditors, the smooth functioning of the firm and the efficient use of fixed
assets the liquid position of the firm must be strong. But a very high degree of
liquidity of the firm being tied up in current assets. Therefore, it is important
proper balance in regard to the liquidity of the firm. Two types of ratios can be
calculated for measuring short-term financial position or short-term solvency
position of the firm.

1.

Liquidity ratios.

2.

Current assets movements ratios.

A) LIQUIDITY RATIOS
Liquidity refers to the ability of a firm to meet its current obligations as and when these
become due. The short-term obligations are met by realizing amounts from current, floating

or circulating assts. The current assets should either be liquid or near about liquidity. These
should be convertible in cash for paying obligations of short-term nature. The sufficiency or
insufficiency of current assets should be assessed by comparing them with short-term
liabilities. If current assets can pay off the current liabilities then the liquidity position is
satisfactory. On the other hand, if the current liabilities cannot be met out of the current assets
then the liquidity position is bad. To measure the liquidity of a firm, the following ratios can
be calculated:
1.

CURRENT RATIO

2.

QUICK RATIO

3.

ABSOLUTE LIQUID RATIO

4.

DEBT EQUITY RATIO

1. CURRENT RATIO

Current Ratio, also known as working capital ratio is a measure of general liquidity and its
most widely used to make the analysis of short-term financial position or liquidity of a firm.
It is defined as the relation between current assets and current liabilities. Thus,
CA

Current assets
Current liabilities

(times)

The two components of this ratio are:

1)

CURRENT ASSETS

2)

CURRENT LIABILITES

Current assets include cash, marketable securities, bill receivables, sundry debtors,
inventories and work-in-progresses. Current liabilities include outstanding expenses, bill
payable, dividend payable etc.
A relatively high current ratio is an indication that the firm is liquid and has the ability to pay
its current obligations in time. On the hand a low current ratio represents that the liquidity
position of the firm is not good and the firm shall not be able to pay its current liabilities in
time. A ratio equal or near to the rule of thumb of 2:1 i.e. current assets double the current
liabilities is considered to be satisfactory.
CALCULATION OF CURRENT RATIO
e.g.

( Rupees in crore)

Year

2011

2012

2013

Current Assets

81.29

83.12

13,6.57

Current Liabilities

27.42

20.58

33.48

Current Ratio

2.96:1

4.03:1

4.08:1

Interpretation:As we know that ideal current ratio for any firm is 2:1. If we see the current ratio of the
company for last three years it has increased from 2011 to 2013. The current ratio of
company is more than the ideal ratio. This depicts that companys liquidity position is sound.
Its current assets are more than its current liabilities.
2. QUICK RATIO AND ACID TEST RATIO
Quick ratio is a more rigorous test of liquidity than current ratio. Quick ratio may be defined
as the relationship between quick/liquid assets and current or liquid liabilities. An asset is said
to be liquid if it can be converted into cash with a short period without loss of value. It
measures the firms capacity to pay off current obligations immediately.
Quick ratio

Current assets
Current liabilities

(times)

Where Quick Assets are:

1)

Marketable Securities

2)

Cash in hand and Cash at bank.

3)

Debtors.

A high ratio is an indication that the firm is liquid and has the ability to meet its current
liabilities in time and on the other hand a low quick ratio represents that the firms liquidity
position is not good.
As a rule of thumb ratio of 1:1 is considered satisfactory. It is generally thought that if quick
assets are equal to the current liabilities then the concern may be able to meet its short-term

obligations. However, a firm having high quick ratio may not have a satisfactory liquidity
position if it has slow paying debtors. On the other hand, a firm having a low liquidity
position if it has fast moving inventories.

CALCULATION OF QUICK RATIO

e.g.

(Rupees in Crore)

Year

2011

2012

2013

Quick Assets

44.14

47.43

61.55

Current Liabilities

27.42

20.58

33.48

Quick Ratio

1.6 : 1

2.3 : 1

1.8 : 1

Interpretation :
A quick ratio is an indication that the firm is liquid and has the ability to meet its current
liabilities in time. The ideal quick ratio is 1:1. Companys quick ratio is more than ideal
ratio. This shows company has no liquidity problem.

3. ABSOLUTE LIQUID RATIO

Although receivables, debtors and bills receivable are generally more liquid than inventories,
yet there may be doubts regarding their realization into cash immediately or in time. So
absolute liquid ratio should be calculated together with current ratio and acid test ratio so as
to exclude even receivables from the current assets and find out the absolute liquid assets.
Absolute Liquid Assets includes :
Absolute Liquid Ratio =

Absolute Liquid Assets

Current Liabilities

Absolute Liquid Assets = Cash & Bank Balances.

CALCULATION OF ABSOLUTE LIQUID RATIO

Year

2011

2012

2013

Absolute Liquid Assets

4.69

1.79

5.06

Current Liabilities

27.42

20.58

33.48

Absolute Liquid Ratio

.17 : 1

.09 : 1

.15 : 1

Interpretation :
These ratio shows that company carries a small amount of cash. But there is nothing to be
worried about the lack of cash because company has reserve, borrowing power & long term
investment. In India, firms have credit limits sanctioned from banks and can easily draw cash.
4.

DEBT EQUITY RATIO

The debt to equity ratio measures how much a company should safely be able to borrow over
long periods of time. It does this by comparing the companys total debt (including short term
and long term obligations) and individual it by the amount of owners equity. For now, you
only need to know that number can be found at the bottom of the balance sheet. Actually
calculate debt to equity ratio in segment two when we look at real balance sheet.
Debt Equity Ratio =

Debt
Equity

5. RETURN ON CAPITAL EMPLOYED

A return on capital employed, also called earning power is a measure of a business
performance which is not affected by interest charges and tax- burden. It abstracts away the

effect of capital structure and tax factor and focuses on operating performance. Hence it is
eminently suited for inter-firm, so internally consistent.
Return on Capital Employed =

Profit Before Tax

Total Assets

6. EARNING PER SHARES

It is states a corporations profits on a per share basis.it can be a helpful in further comparison
to the market price of the stock. It is index of profitability from shareholders point of view.
The higher the earning per share, the more attractive will be the investment plan.
Earning Per Shares =

Profit After Tax

Numbers Of Equity Shares

B) CURRENT ASSETS MOVEMENT RATIOS

Funds are invested in various assets in business to make sales and earn profits. The efficiency
with which assets are managed directly affects the volume of sales. The better the
management of assets, large is the amount of sales and profits. Current assets movement
ratios measure the efficiency with which a firm manages its resources. These ratios are called
turnover ratios because they indicate the speed with which assets are converted or turned over
into sales. Depending upon the purpose, a number of turnover ratios can be calculated. These
are :
1. Inventory Turnover Ratio
2. Debtors Turnover Ratio
3. Creditors Turnover Ratio
4. Working Capital Turnover Ratio
The current ratio and quick ratio give misleading results if current assets include high amount
of debtors due to slow credit collections and moreover if the assets include high amount of
slow moving inventories. As both the ratios ignore the movement of current assets, it is
important to calculate the turnover ratio.

1. INVENTORY TURNOVER OR STOCK TURNOVER RATIO :

Every firm has to maintain a certain amount of inventory of finished goods so as to meet the
requirements of the business. But the level of inventory should neither be too high nor too
low. Because it is harmful to hold more inventory as some amount of capital is blocked in it
and some cost is involved in it. It will therefore be advisable to dispose the inventory as soon
as possible.
Inventory Turnover Ratio =

Cost of Goods Sold

Average Inventory

Inventory turnover ratio measures the speed with which the stock is converted into sales.
Usually a high inventory ratio indicates an efficient management of inventory because more
frequently the stocks are sold; the lesser amount of money is required to finance the
inventory. Whereas low inventory turnover ratio indicates the inefficient management of
inventory. A low inventory turnover implies over investment in inventories, dull business,
poor quality of goods, stock accumulations and slow moving goods and low profits as
compared to total investment.
Average Stock = Opening Stock + Closing Stock
2
CALCULATION OF INVENTORY TURNOVER RATIO
e.g

(Rupees in Crore)

Year

2011

2012

2013

Cost of Goods sold

110.6

103.2

96.8

Average Stock

73.59

36.42

55.35

1.5 times

2.8 times

1.75 times

Inventory Turnover Ratio

Interpretation :
These ratio shows how rapidly the inventory is turning into receivable through sales. In 2012
the company has high inventory turnover ratio but in 2013 it has reduced to 1.75 times. This

shows that the companys inventory management technique is less efficient as compare to last
year.

2.

INVENTORY CONVERSION PERIOD:

Inventory Conversion Period = 365 (Net Working Days)

Inventory Turnover Ratio
CALCULATION OF INVENTORY CONVERSION PERIOD
e.g.

Year

2011

2012

2013

Days

365

365

365

Inventory Turnover Ratio

1.5

2.8

1.8

243 days

130 days

202 days

Inventory Conversion Period

Interpretation:
Inventory conversion period shows that how many days inventories takes to convert from
raw material to finished goods. In the company inventory conversion period is decreasing.
This shows the efficiency of management to convert the inventory into cash.
3.

DEBTORS TURNOVER RATIO :

A concern may sell its goods on cash as well as on credit to increase its sales and a liberal
credit policy may result in tying up substantial funds of a firm in the form of trade debtors.
Trade debtors are expected to be converted into cash within a short period and are included in
current assets. So liquidity position of a concern also depends upon the quality of trade
debtors. Two types of ratio can be calculated to evaluate the quality of debtors.

a)

Debtors Turnover Ratio

b)

Average Collection Period

Debtors Turnover Ratio =

Total Sales (Credit)

Average Debtors

Debtors velocity indicates the number of times the debtors are turned over during a year.
Generally higher the value of debtors turnover ratio the more efficient is the management of
debtors/sales or more liquid are the debtors. Whereas a low debtors turnover ratio indicates
poor management of debtors/sales and less liquid debtors. This ratio should be compared with
ratios of other firms doing the same business and a trend may be found to make a better
interpretation of the ratio.
Average Debtors = Opening Debtor + Closing Debtor
2

CALCULATION OF DEBTORS TURNOVER RATIO

e.g.

Year

2011

2012

2013

Sales

166.0

151.5

169.5

Average Debtors

17.33

18.19

22.50

9.6 times

8.3 times

7.5 times

Debtor Turnover Ratio

Interpretation :

This ratio indicates the speed with which debtors are being converted or turnover into sales.
The higher the values or turnover into sales. The higher the values of debtors turnover, the
more efficient is the management of credit. But in the company the debtor turnover ratio is
decreasing year to year. This shows that company is not utilizing its debtors efficiency. Now
their credit policy become liberal as compare to previous year.
4.

AVERAGE COLLECTION PERIOD :

Average Collection Period =

No. of Working Days

Debtors Turnover Ratio

The average collection period ratio represents the average number of days for which a firm
has to wait before its receivables are converted into cash. It measures the quality of debtors.
Generally, shorter the average collection period the better is the quality of debtors as a short
collection period implies quick payment by debtors and vice-versa.
Average Collection Period =

365 (Net Working Days)

Debtors Turnover Ratio

CALCULATION OF AVERAGE COLLECTION PERIOD

Year

2011

2012

2013

Days

365

365

365

Debtor Turnover Ratio

9.6

8.3

7.5

38 days

44 days

49 days

Average Collection Period

Interpretation :
The average collection period measures the quality of debtors and it helps in analyzing the
efficiency of collection efforts. It also helps to analysis the credit policy adopted by company.
In the firm average collection period increasing year to year. It shows that the firm has
Liberal Credit policy. These changes in policy are due to competitors credit policy.
5.

WORKING CAPITAL TURNOVER RATIO :

Working capital turnover ratio indicates the velocity of utilization of net working capital. This
ratio indicates the number of times the working capital is turned over in the course of the
year. This ratio measures the efficiency with which the working capital is used by the firm. A
higher ratio indicates efficient utilization of working capital and a low ratio indicates
otherwise. But a very high working capital turnover is not a good situation for any firm.

Working Capital Turnover Ratio =

Cost of Sales
Net Working Capital

Working Capital Turnover

Sales
Networking Capital

CALCULATION OF WORKING CAPITAL TURNOVER RATIO

e.g.

Year

2011

2012

2013

Sales

166.0

151.5

169.5

Networking Capital

53.87

62.52

103.09

Working Capital Turnover

3.08

2.4

1.64

Interpretation :
This ratio indicates low much net working capital requires for sales. In 2013, the reciprocal of
this ratio (1/1.64 = .609) shows that for sales of Rs. 1 the company requires 60 paisa as

working capital. Thus this ratio is helpful to forecast the working capital requirement on the
basis of sale.
INVENTORIES
(Rs. in Crores)

Year

2010-2011

2011-2012

2012-2013

Inventories

37.15

35.69

75.01

Interpretation :
Inventories is a major part of current assets. If any company wants to manage its working
capital efficiency, it has to manage its inventories efficiently. The graph shows that inventory
in 2010-2011 is 45%, in 2011-2012 is 43% and in 2012-2013 is 54% of their current assets.
The company should try to reduce the inventory upto 10% or 20% of current assets.

CASH BANK BALANCE :

(Rs. in Crores)

Year

Cash Bank Balance

2010-2011

2011-2012

2012-2013

4.69

1.79

5.05

Interpretation :
Cash is basic input or component of working capital. Cash is needed to keep the business
running on a continuous basis. So the organization should have sufficient cash to meet
various requirements. The above graph is indicate that in 2011 the cash is 4.69 crores but in
2012 it has decrease to 1.79. The result of that it disturb the firms manufacturing operations.
In 2013, it is increased upto approx. 5.1% cash balance. So in 2013, the company has no
problem for meeting its requirement as compare to 2012.
DEBTORS :

(Rs. in Crores)

Year

Debtors

2010-2011

2011-2012

2012-2013

17.33

19.05

25.94

Interpretation :
Debtors constitute a substantial portion of total current assets. In India it constitute one third
of current assets. The above graph is depict that there is increase in debtors. It represents an
extension of credit to customers. The reason for increasing credit is competition and company
liberal credit policy

CURRENT ASSETS :
(Rs. in Crores)

Year

Current Assets

2010-2011

2011-2012

2012-2013

81.29

83.15

136.57

Interpretation :
This graph shows that there is 64% increase in current assets in 2013. This increase is arise
because there is approx. 50% increase in inventories. Increase in current assets shows the
liquidity soundness of company.
CURRENT LIABILITY :
(Rs. in Crores)

Year

2010-2011

2011-2012

2012-2013

Current Liability

27.42

20.58

33.48

Interpretation :
Current liabilities shows company short term debts pay to outsiders. In 2013 the current
liabilities of the company increased. But still increase in current assets are more than its
current liabilities.

NET WOKRING CAPITAL :

(Rs. in Crores)

Year

2010-2011

2011-2012

2012-2013

Net Working Capital

53.87

62.53

103.09

Interpretation :
Working capital is required to finance day to day operations of a firm. There should be an
optimum level of working capital. It should not be too less or not too excess. In the company
there is increase in working capital. The increase in working capital arises because the
company has expanded its business.

FINANCIAL RATIO
Financial Ratio Kirloskar
Pneumatic Company
----- in Rs. Cr -------

Investment
Valuation
Ratios
Face Value
Dividend Per Share
Operating
Profit
Per
Share (Rs)
Net Operating Profit Per
Share (Rs)
Free Reserves Per Share
(Rs)
Bonus in Equity Capital
Profitability Ratios
Operating
Profit
Margin(%)
Profit Before Interest And
Tax Margin(%)
Gross Profit Margin(%)

Mar
'14

Mar
'13

Mar
'12

Mar
'11

10
-43.6
8
376.
67
--

10
-54.
49
427
.28
--

10
-68.
63
518
.99
--

10
-53.9
6
382.
84
--

11.6
4

11.
64

11.
64

11.6
4

11.5
9
8.59

12.
75
10.
41
10.
65
10.
29
10.
29
8.6
6
8.6
6
26.
3
17.
94
17.
08
211
.21
211
.21
26.
3

13.
22
11.
18
11.
41
10.
87
10.
87
9.1

14.0
9
11.4
7
11.7

9.1

8.75

37.
99
26.
94
26.
94
178
.86
178
.86
37.
99

33.8
1
23.5
1
23.5
1
145.
4
145.
4
33.8
1

8.86

Cash Profit Margin(%)

9.7

Adjusted Cash Margin(%)

9.7

Net Profit Margin(%)

7.31

Adjusted
Net
Profit
Margin(%)
Return
On
Capital
Employed(%)
Return On Net Worth(%)

7.31

Adjusted Return on Net

Worth(%)
Return
on
Assets
Excluding Revaluations
Return
on
Assets
Including Revaluations
Return on Long Term
Funds(%)
Liquidity And Solvency

19.8
7
12.4
7
12.0
2
227.
94
227.
94
19.8
7

11.0
9
11.0
9
8.75

Ratios
Current Ratio

1.1

Quick Ratio

0.87

Debt Equity Ratio

--

1.1
9
0.8
6
--

Long Term Debt Equity

Ratio
Debt Coverage Ratios
Interest Cover

--

--

167.
07
--

54.
3
--

205.
01
143.
78

11.5
7
4

Total Debt to Owners

Fund
Financial
Charges
Coverage Ratio
Financial
Charges
Coverage Ratio Post Tax
Management
Efficiency
Ratios
Inventory Turnover Ratio

1.1
6
0.8
3
0.0
3
0.0
3

1.19

35.5
2
0.07

63.
05
46.
8

75.
05
0.0
3
85.
14
62.
91

8.1
1
4.7
8
8.1
1
4.2
5
2.9
8
3.0
6
--

5.97

0.87
0.07
0.07

41.7
2
30.3
7

Investments
Turnover
Ratio
Fixed
Assets Turnover
Ratio
Total
Assets
Turnover
Ratio
Asset Turnover Ratio

11.5
7
2.42

Average
Raw
Material
Holding
Average Finished Goods
Held
Number
of
Days
In
Working Capital
Profit & Loss Account
Ratios
Material
Cost
Composition
Imported Composition of
Raw Materials Consumed
Selling Distribution Cost
Composition
Expenses as Composition
of Total Sales
Cash
Flow
Indicator

--

7.5
8
4.1
1
8.2
2
3.0
9
2.1
2
2.1
6
--

--

--

--

--

3.91

27.
41

4.6
7

19.9
7

52.7
4
12.8
1
--

56.
11
19.
31
--

57.
52
20.
98
--

58.7
4
19.7
5
--

5.07

4.7
8

2.63

Debtors Turnover Ratio

1.73
1.72

-5.97
3.23
2.63
---

Ratios
Dividend Payout Ratio
Net Profit
Dividend Payout Ratio
Cash Profit
Earning Retention Ratio
Cash Earning Retention
Ratio
AdjustedCash Flow Times

41.1
4
30.2
1
57.3
3
68.9
8
--

37.
03
29.
96
61.
11
68.
83
--

28.
93
24.
21
71.
07
75.
79
0.0
8

40.7
9
32.1
8
59.2
1
67.8
2
0.22