Capital is the total investment of the company and budgeting is the art of building budgets.

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1 WHAT IS CAPITAL BUDGETING? Capital budgeting is a company s formal process used for evaluating potential expenditures or investments that are significant in amount. It involves the decision to invest the current funds for addition, disposition, modification or replacement of fixed assets. The large expenditures include the purchase of fixed assets like land and building, new equipments, rebuilding or replacing existing equipments, research and development, etc. The large amounts spent for these types of projects are known as capital expenditures. Capital Budgeting is a tool for maximizing a company s future profits since most companies are able to manage only a limited number of large projects at any one time. Capital budgeting usually involves calculation of each project s future accounting profit by period, the cash flow by period, the present value of cash flows after considering time value of money, the number of years it takes for a project s cash flow to pay back the initial cash investment, an assessment of risk, and various other factors. Capital is the total investment of the company and budgeting is the art of building budgets. FEATURES OF CAPITAL BUDGETING 1) It involves high risk 2) Large profits are estimated 3) Long time period between the initial investments and estimated returns CAPITAL BUDGETING PROCESS: A) Project identification and generation: The first step towards capital budgeting is to generate a proposal for investments. There could be various reasons for taking up investments in a business. It could be addition of a new product line or expanding the existing one. It could be a proposal to either increase the production or reduce the costs of outputs. B) Project Screening and Evaluation: This step mainly involves selecting all correct criteria s to judge the desirability of a proposal. This has to match the objective of the firm to maximize its market value. The tool of time value of money comes handy in this step. Also the estimation of the benefits and the costs needs to be done. The total cash inflow and outflow along with the uncertainties and risks associated with the proposal has to be analyzed thoroughly and appropriate provisioning has to be done for the same.

2 C) Project Selection: There is no such defined method for the selection of a proposal for investments as different businesses have different requirements. That is why, the approval of an investment proposal is done based on the selection criteria and screening process which is defined for every firm keeping in mind the objectives of the investment being undertaken. Once the proposal has been finalized, the different alternatives for raising or acquiring funds have to be explored by the finance team. This is called preparing the capital budget. The average cost of funds has to be reduced. A detailed procedure for periodical reports and tracking the project for the lifetime needs to be streamlined in the initial phase itself. The final approvals are based on profitability, Economic constituents, viability and market conditions. Need Guidance? Ask from Experts! D) Implementation: Money is spent and thus proposal is implemented. The different responsibilities like implementing the proposals, completion of the project within the requisite time period and reduction of cost are allotted. The management then takes up the task of monitoring and containing the implementation of the proposals. E) Performance review: The final stage of capital budgeting involves comparison of actual results with the standard ones. The unfavorable results are identified and removing the various difficulties of the projects helps for future selection and execution of the proposals.

3 FACTORS AFFECTING CAPITAL BUDGETING: Availability of Funds Structure of Capital Management decisions Accounting methods Taxation policy Working Capital Capital Return Need of the project Government policy Earnings Lending terms of financial institutionseconomic value of the project CAPITAL BUDGETING DECISIONS: The crux of capital budgeting is profit maximization. There are two ways to it; either increase the revenues or reduce the costs. The increase in revenues can be achieved by expansion of operations by adding a new product line. Reducing costs means representing obsolete return on assets. Accept / Reject decision If a proposal is accepted, the firm invests in it and if rejected the firm does not invest. Generally, proposals that yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the others are rejected. All independent projects are accepted. Independent projects are projects that do not compete with one another in such a way that acceptance gives a fair possibility of acceptance of another. Mutually exclusive project decision Mutually exclusive projects compete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects. Only one may be chosen. Mutually exclusive investment decisions gain importance when more than one proposal is acceptable under the accept / reject decision. The acceptance of the best alternative eliminates the other alternatives. Capital rationing decision In a situation where the firm has unlimited funds, capital budgeting becomes a very simple process. In that, independent investment proposals yielding a return greater than some predetermined level are accepted. But actual business has a different picture. They have fixed capital budget with large number of investment proposals competing for it. Capital rationing refers to the situation where the firm has more acceptable investments requiring a greater amount of finance than that is available with the firm. Ranking of the investment project is employed on the basis of some predetermined criterion such as the rate of return.

4 Capital Budgeting Capital budgeting (or investment appraisal) is the process of determining the viability to long-term investments on purchase or replacement of property plant and equipment, new product line or other projects. Capital budgeting consists of various techniques used by managers such as: 1. Payback Period 2. Discounted Payback Period 3. Net Present Value 4. Accounting Rate of Return 5. Internal Rate of Return 6. Profitability Index All of the above techniques are based on the comparison of cash inflows and outflow of a project however they are substantially different in their approach. A brief introduction to the above methods is given below: Payback Period measures the time in which the initial cash flow is returned by the project. Cash flows are not discounted. Lower payback period is preferred. Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash inflows. Higher NPV is preferred and an investment is only viable if its NPV is positive. Accounting Rate of Return (ARR) is the profitability of the project calculated as projected total net income divided by initial or average investment. Net income is not discounted. Internal Rate of Return (IRR) is the discount rate at which net present value of the project becomes zero. Higher IRR should be preferred. Profitability Index (PI) is the ratio of present value of future cash flows of a project to initial investment required for the project.

5 CAPITAL BUDGETING TECHNIQUES / METHODS There are different methods adopted for capital budgeting. The traditional methods or non discount methods include: Payback period and Accounting rate of return method. The discounted cash flow method includes the NPV method, profitability index method and IRR. Payback period method: As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project. With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved. However, as the method is based on thumb rule, it does not consider the importance of time value of money and so the relevant dimensions of profitability. Payback period = Cash outlay (investment) / Annual cash inflow Example Project A Project B Cost 1,, 1,, Expected future cash flow Year 1 5, 1,, Year 2 5, 5, Year 3 1,1, 5, Year 4 None None TOTAL 2,1, 1,1, Payback 2 years 1 year Payback period of project B is shorter than A, but project A provides higher returns. Hence, project A is superior to B. Need Guidance? Ask from Experts! Accounting rate of return method (ARR): This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the

6 criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected. This method takes into account the entire economic life of a project providing a better means of comparison. It also ensures compensation of expected profitability of projects through the concept of net earnings. However, this method also ignores time value of money and doesn t consider the length of life of the projects. Also it is not consistent with the firm s objective of maximizing the market value of shares. ARR= Average income/average Investment Discounted cash flow method: The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows are then compared. This technique takes into account the interest factor and the return after the payback period. Net present Value (NPV) Method: This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. However, understanding the concept of cost of capital is not an easy task. The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be: Where A1, A2. represent cash inflows, K is the firm s cost of capital, C is the cost of the investment proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present, value cannot be known. NPV = PVB PVC where,

7 PVB = Present value of benefits PVC = Present value of Costs Internal Rate of Return (IRR): This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash inflows. However, computation of IRR is a tedious task. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment. It can be determined by solving the following equation: If IRR > WACC then the project is profitable. If IRR > k = accept If IR < k = reject Profitability Index (PI): It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows. PI = PV cash inflows/initial cash outlay A, PI = NPV (benefits) / NPV (Costs) All projects with PI > 1. is accepted. IMPORTANCE OF CAPITAL BUDGETING 1) Long term investments involve risks: Capital expenditures are long term investments which involve more financial risks. That is why proper planning through capital budgeting is needed.

8 2) Huge investments and irreversible ones: As the investments are huge but the funds are limited, proper planning through capital expenditure is a pre-requisite. Also, the capital investment decisions are irreversible in nature, i.e. once a permanent asset is purchased its disposal shall incur losses. 3) Long run in the business: Capital budgeting reduces the costs as well as brings changes in the profitability of the company. It helps avoid over or under investments. Proper planning and analysis of the projects helps in the long run. SIGNIFICANCE OF CAPITAL BUDGETING Capital budgeting is an essential tool in financial management Capital budgeting provides a wide scope for financial managers to evaluate different projects in terms of their viability to be taken up for investments It helps in exposing the risk and uncertainty of different projects It helps in keeping a check on over or under investments The management is provided with an effective control on cost of capital expenditure projects Ultimately the fate of a business is decided on how optimally the available resources are used Example of Capital Budgeting: Capital budgeting for a small scale expansion involves three steps: recording the investment s cost, projecting the investment s cash flows and comparing the projected earnings with inflation rates and the time value of the investment. For example, equipment that costs $15, and generates a $5, annual return would appear to "pay back" on the investment in 3 years. However, if economists expect inflation to rise 3 percent annually, then the estimated return value at the end of the first year ($2,) is actually worth $15,385 when you account for inflation ($2, divided by 1.3 equals $15,385). The investment generates only $385 in real value after the first year. Conclusion: According to the definition of Charles T. Hrongreen, Capital Budgeting is a long-term planning for making and financing proposed capital outlays. One can conclude that capital budgeting is the attempt to determine the future.

9 Two Methods of capital budgeting In earlier articles, we have discussed the capital budgeting and its types. Today we will discuss the methods of capital budgeting: (I)Traditional methods i) Pay back period method: this method means the period in which the total investment in the permanent assets pays back itself. This method is based upon the concept that every capital expenditure pays itself back within a certain period of time. Thus, this method measures the period of time means the time taken where the cost of project is recovered from the earning of the project itself. Decision rule: the investment with a shorter pay back period is accepted and the one which has a longer pay back period is rejected. Pay back period= original cost of asset/ cash inflow Advantages of Pay back period method: 1. it is easy to calculate, simple to understand. 2. it saves cost. 3. a firm having less funds can select the shorter time period for pay back Disadvantages of Pay back period method: 1. it fails to take in account cash inflow earned after pay back period. 2. it does not take into account salvage value of asset. ii) Improvement to traditional approach to pay back method: a) Post pay back profitability method: the main disadvantage of pay back method is that it fails to take in account cash inflow earned after pay back period so true profitability of the project can not be ascertained. An improvement to this method can be done only by taking into account the return received after the pay back period. Post pay back profitability= post pay back profit *1/inveastment b) Pay back reciprocal method: this method is used to find out the internal rate of return generated by a project. It is used when equal cash inflow is generated every year. Pay back reciprocal = annual cash inflow*1/ total investment c) Post pay back period method: the limitation of the pay back method was that it ignores the life of the project beyond the pay back period. But this method takes into account the life of the project beyond the pay back period. Hence the project which gives the greatest post pay back period is accepted.

10 d) Discounted pay back method: the pay back method ignores the time value of money. Discounted pay back method is an improvement over this method. Under this method the present value of all cash inflow and cash outflow is calculated at an appropriate discount rate. Discounted pay back period is the period at which the present value of cash inflow = present value of cash outflow. The project with the shorter time period is accepted. iii) Rate of return method or accounting method: this method takes into account the earning expected from the investment over their whole life. This is called accounting method as it used the accounting concept of profit after tax and depreciation. Decision rule: the project with higher rate of return is accepted and the project with the lower rate of return is rejected. a) Average rate of return method: under this method average profit after tax and depreciation is calculated and then it is divided by total investment. Average rate of return= average annual profit after tax and depreciation*1/net investment b) Return per unit of investment method: it is slightly different from the above method. under this method total profit after tax and depreciation is divided by total investment. Return per unit of investment = total profit after tax and depreciation *1/net investment c) Average return on average investment: it is a good method of finding out rate of return on investment. Average return on average investment = average annual profit after tax and depreciation*1/aveage investment Advantages of rate of return method: 1. It is easy to calculate, simple to understand. 2. It gives better view of profitability. 3. It is based upon the accounting concept. Disadvantages of rate of return method: 1. It fails to take in account cash flow. 2. It does not take into time value of money.

11 (II)Time adjusted or discounted method: The main drawback of the traditional method is that it gives equal value to the present and future flow of incomes and do not take into consideration the time value of money. A rupee earned today has more value than the rupee earned after five years. This method is also called modern method of capital budgeting. i) Net present value method: this method takes into account the time value of money which means the return on investment is calculated by introducing the time element. This method realizes the concept that a rupee earned today has more value than the rupee earned after five years. To calculate net present value the following steps are used: a) First of all determine the appropriate rate of interest selected as minimum rate of return or discount rate. b) Compute the present value of cash outflow at determined discount rate. c) Compute the present value of cash outflow at determined discount rate. d) Calculate the net present value of each project by subtracting the present value of cash inflow from the present value of cash outflow. Decision rule: if the net present value is positive or zero or than project is accepted otherwise rejected. NPV is + accepted NPV is zero accepted NPV is rejected

12 The project having maximum positive value is accepted among various proposals. Present value = 1/ (1+r) n Advantages of net present value method: 1. It takes into account maximum profitability. 2. It gives better view of profitability. 3. It recognizes the time value of money. Disadvantages of net present value method: 1. It is difficult to understand. 2. It is difficult to determine the discount rate. ii) Internal rate of return method: this method is also known as time adjusted rate of return, discounted rate of return, yield method, discounted cash flow, and trial and error method. Under this method cash flow of a project is discounted at a suitable rate by hit and trial method. It is the rate where present value of cash inflow= present value of cash outflow. To calculate internal rate of return the following steps are used: a) Determine the future net cash flow. b) Determine the discount rate at which cash inflow = cash outflow. Decision rule: IRR > minimum required rate of return than accept the proposal IRR < minimum required rate of return than reject the proposal IRR = minimum required rate of return than indifferent Advantages of internal rate of return method: 1. It takes into account maximum profitability. 2. It gives better view of profitability. 3. It recognizes the time value of money. Disadvantages of internal rate of return method: 1. It is difficult to understand. 2. The result of NPV and IRR differs.

13 iii) Profitability index or benefit cost ratio: it is the relationship between present value of cash inflow and present value of cash outflow. Profitability index = present value of cash inflow/ present value of cash outflow Or Profitability index = net present value/ initial cash outlay Net profitability index = profitability index 1 Decision rule: if PI > 1 accepts the project if PI < 1 reject the project if PI = 1 indifferent. Advantages of profitability index method 1. This method takes into consideration all the requirements of sound investment decisions. 2. It recognizes the time value of money. Disadvantages of profitability index method 1. It is difficult to understand. 2. This method does not take into account size of investment.

14 CHAPTER OBJECTIVES Meaning and Concept of Working Capital Classification or Kinds of Working Capital Importance or Advantages of Adequate Working Capital Excess or Inadequate Working Capital Need or Objects of Working Capital Factors determining Working Capital Requirements Management of Working Capital Principles Determining Working Capital Financing Mix Lets Sum Up Questions Meaning of Working Capital Capital required for a business can be classified under two main categories viz. (i) (ii) Fixed capital Working capital. Every business needs funds for two purposes for its establishment and to carry out its day-to-day operations. Long-term funds are required to create production facilities through purchase of fixed assets such as plant and machinery, land, Building etc. Investments in these assets represent that part of firm s capital which is blocked on permanent basis and is called fixed capital. Funds are also needed for short-term purposes for purchase of raw materials, payment of wages and other day-to-day expenses etc. These funds are known as working capital which is also known as Revolving or circulating capital or short term capital. According to Shubin, Working capital is amount of funds necessary to cover the cost of operating the enterprise.

15 Concept of Working Capital There are two concepts of working capital: (i) (ii) Gross working capital Net working capital. Gross working capital is the capital invested in total current assets of the enterprise. Examples of current assets are : cash in hand and bank balances, Bills Receivable, Short term loans and advances, prepaid expenses, Accrued Incomes etc. The gross working capital is financial or going concern concept. Net working capital is excess of Current Assets over Current liabilities. Net Working Capital = Current Assets Current Liabilities When current assets exceed the current liabilities the working capital is positive and negative working capital results when current liabilities are more than current assets. Examples of current liabilities are Bills Payable, Sunday debtors, accrued expenses, Bank Overdraft, Provision for taxation etc. Net working capital is an accounting concept of working capital. Classification or Kinds of Working Capital Working capital may be classified in two ways: (a) On the basis of concept (b) On the basis of time On the basis of concept working capital is classified as gross working capital and net working capital. On the basis of time working capital may be classifies as Permanent or fixed working capital and Temporary or variable working capital.

16 Permanent or Fixed working capital It is the minimum amount which is required to ensure effective utilisation of fixed facilities and for maintaining the circulation of current assets. There is always a minimum level of current assets which its continuously required by enterprise to carry out its normal business operations. As the business grows, the requirements of permanent working capital also increase due to increase in current assets. The permanent working capital can further be classified as regular working capital and reserve working capital required to ensure circulation of current assets from cash to inventories, from inventories to receivables and from receivables to cash and so on. Reserve working capital is the excess mount over the requirement for regular working capital which may be provided for contingencies that may arise at unstated periods such as strikes, rise in prices, depression etc.

17 Temporary or Variable working capital It is the amount of working capital which is required to meet the seasonal demands and some special exigencies. Variable working capital is further classified as seasonal working capital and special working capital. The capital required to meet seasonal needs of the enterprise is called seasonal working capital. Special working capital is that part of working capital which is required to meet special exigencies such as launching of extensive marketing campaigns for conducting research etc. Importance or Advantages of Adequate Working Capital : Working capital is the life blood and nerve centre of a business. Hence, it is very essential to maintain smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages of maintaining adequate amount of working capital are as follows: 1. Solvency of the Business: Adequate working capital helps in maintaining solvency of business by providing uninterrupted flow of production. 2. Goodwill: Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. 3. Easy Loans: A concern having adequate working capital, high solvency and good credit standing can arrange loans from banks and others on easy and favourable terms. 4. Cash Discounts: Adequate working capital also enables a concern to avail cash discounts on purchases and hence it reduces cost. 5. Regular Supply of Raw Material: Sufficient working capital ensure regular supply of raw materials and continuous production. 6. Regular payment of salaries, wages and other day to day commitments: A company which has ample working capital can make regular payment of salaries, wages and other day to day commitments which raises morale of its employees, increases their efficiency, reduces costs and wastages. 7. Ability to face crisis: Adequate working capital enables a concern to face business crisis in emergencies such as depression. 8. Quick and regular return on investments: Every investor wants a quick and regular return on his

18 investments. Sufficiency of working capital enables a concern to pay quick and regular dividends to is investor as there may not be much pressure to plough back profits which gains the confidence of investors and creates a favourable market to raise additional funds in future. 9. Exploitation of Favourable market conditions: Only concerns with adequate working capital can exploit favourable market conditions such as purchasing its requirements in bulk when the prices are lower and by holding its inventories for higher prices. 1. High Morale: Adequacy of working capital creates an environment of security, confidence, high morale and creates overall efficiency in a business. Excess or Inadequate Working Capital Every business concern should have adequate working capital to run its business operations. It should have neither excess working capital nor inadequate working capital. Both excess as well as short working capital positions are bad for any business. Disadvantages of Excessive Working Capital 1. Excessive working capital means idle funds which earn no profits for business and hence business cannot earn a proper rate of return. 2. When there is a redundant working capital it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses. 3. It may result into overall inefficiency in organization. 4. Due to low rate of return on investments, the value of shares may also fall. 5. The redundant working capital gives rise to speculative transaction. 6. When there is excessive working capital, relations with banks and other financial institutions may not be maintained. Disadvantages of Inadequate working capital 1. A concern which has inadequate working capital cannot pay its short-term liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities. 2. It cannot buy its requirements in bulk and cannot avail of discounts. 3. It becomes difficult for firm to exploit favourable market conditions and undertake profitable projects due to lack of working capital.

19 4. The rate of return on investments also falls with shortage of working capital. 5. The firm cannot pay day-to-day expenses of its operations and it created inefficiencies, increases costs and reduces the profits of business. The Need or Objects or Working Capital The need for working capital arises due to time gap between production and realisation of cash from sales. There is an operating cycle involved in sales and realisation of cash. There are time gaps in purchase of raw materials and production, production and sales, and sales and realisation of cash. Thus, working capital is needed for following purposes. 1. For purchase of raw materials, components and spares. 2. To pay wages and salaries. 3. To incur day-to-day expenses and overhead costs such as fuel, power etc. 4. To meet selling costs as packing, advertisement 5. To provide credit facilities to customers. 6. To maintain inventories of raw materials, work in progress, stores and spares and finished stock. Greater size of business unit large will be requirements of working capital. The amount of working capital needed goes on increasing with growth and expansion of business till it attains maturity. At maturity the amount of working capital needed is called normal working capital. Factors Determing the Working Capital Requirements The following are important factors which influence working capital requirements: 1. Nature or Character of Business: The working capital requirements of firm depend upon nature of its business. Public utility undertakings like electricity, water supply need very limited working capital because they offer cash sales only and supply services, not products, and such no funds are tied up in inventories and receivables whereas trading and financial firms require less investment in fixed assets but have to invest large amounts in current assets and as such they need large amount of working capital. Manufacturing undertaking require sizeable working capital between these two.

20 2. Size of Business/Scale of Operations: Greater the size of a business unit, larger will be requirement of working capital and vice-versa. 3. Production Policy: The requirements of working capital depend upon production policy. If the policy is to keep production steady by accumulating inventories it will require higher working capital. The production could be kept either steady by accumulating inventories during slack periods with view to meet high demand during peak season or production could be curtailed during slack season and increased during peak season. 4. Manufacturing process / Length of Production cycle: Longer the process period of manufacture, larger is the amount of working capital required. The longer the manufacturing time, the raw materials and other supplies have to be carried for longer period in the process with progressive increment of labour and service costs before finished product is finally obtained. Therefore, if there are alternative processes of production, the process with the shortest production period should be chosen. 5. Credit Policy: A concern that purchases its requirements on credit and sell its products/services on cash requires lesser amount of working capital. On other hand a concern buying its requirements for cash and allowing credit to its customers, shall need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors or bills receivables. 6. Business Cycles: In period of boom i.e. when business is prosperous, there is need for larger amount of working capital due to increase in sales, rise in prices etc. On contrary in times of depression the business contracts, sales decline, difficulties are faced in collections from debtors and firms may have large amount of working capital lying idle. 7. Rate of Growth of Business: The working capital requirements of a concern increase with growth and expansion of its business activities. In fast growing concerns large amount of working capital is required whereas in normal rate of expansion in the volume of business the firm may have retained profits to provide for more working capital. 8. Earning Capacity and Dividend Policy. The firms with high earning capacity generate cash profits from operations and contribute to working capital. The dividend policy of concern

21 also influences the requirements of its working capital. A firm that maintains a steady high rate of cash dividend irrespective of its generation of profits need more working capital than firm that retains larger part of its profits and does not pay so high rate of cash dividend. 9. Price Level Changes: Changes in price level affect the working capital requirements. Generally, the rising prices will require the firm to maintain large amount of working capital as more funds will be required to maintain the same current assets. The effect of rising prices may be different for different firms. 1. Working Capital Cycle: In a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with realisation of cash from the sale of finished products. This cycle involves purchase of raw materials and stores, its conversion into stocks of finished goods through work in progress with progressive increment of labour and service costs, conversion of finished stock into sales, debtors and receivables and ultimately realisation of cash and this cycle again from cash to purchase of raw material and so on. The speed with which the working capital completes one cycle determines the requirements of working capital longer the period of cycle larger is requirement of working capital. Managemant of Working Capital Working capital refers to excess of current assets over current liabilities. Management of working capital therefore is concerned with the problems that arise in attempting to manage current assets, current liabilities and inter relationship that exists between them. The basic goal of working capital management is to manage the current assets and current of a firm in such a way that satisfactory level of working capital is maintained i.e. it is neither inadequate nor excessive. This is so because both inadequate as well as excessive working capital positions are bad for any business. Inadequacy of working capital may lead the firm to insolvency and excessive working capital implies idle funds which earns no profits for the business. Working capital Management policies of a firm have a great effect on its profitability, liquidity and structural health of organization. In this context, evolving capital management is three dimensional in nature. 1. Dimension I is concerned with formulation of policies with regard to profitability, risk and liquidity. 2. Dimension II is concerned with decisions about composition and level of current assets.

22 3. Dimension III is concerned with decisions about composition and level of current liabilities. Principles of Working Capital Management Principles of Working Capital Management Principle of Risk Principle of Principle of Principle of Variation Cost of Capital Equity position Maturity of Payment 1. Principle of Risk Variation: Risk refers to inability of firm to meet its obligation as and when they become due for payment. Larger investment in current assets with less dependence on short-term borrowings increases liquidity, reduces risk and thereby decreases opportunity for gain or loss. On other hand less investment in current assets with greater dependence on short-term borrowings increases risk, reduces liquidity and increases profitability.

23 There is definite direct relationship between degree of risk and profitability. A conservative management prefers to minimize risk by maintaining higher level of current assets while liberal management assumes greater risk by reducing working capital. However, the goal of management should be to establish suitable trade off between profitability and risk. The various working capital policies indicating relationship between current assets and sales are depicted below:- 2. Principle of Cost of Capital: The various sources of raising working capital finance have different cost of capital and degree of risk involved. Generally, higher the risk lower is cost and lower the risk higher is the cost. A sound working capital management should always try to achieve proper balance between these two. 3. Principle of Equity Position: This principle is concerned with planning the total investment in current assets. According to this principle, the amount of working capital invested in each component should be adequately justified by firm s equity position. Every rupee invested in current assets should contribute to the net worth of firm. The level of current assets may be measured with help of two ratios. (i) Current assets as a percentage of total assets and (ii) Current assets as a percentage of total sales. 4. Principle of Maturity of Payment: This principle is concerned with planning the sources of finance for working capital. According to this principle, a firm should make every effort to relate maturities of payment to its flow of internally generated funds. Generally, shorter the maturity schedule of current liabilities in relation to expected cash inflows, the greater inability to meet its obligations in time.

24 (1) The Hedging or Matching Approach: The term hedging refers to two off-selling transactions of a simultaneous but opposite nature which counterbalance effect of each other. With reference to financing mix, the term hedging refers to process of matching of maturities of debt with maturities of financial needs. According to this approach the maturity of sources of funds should match the nature of assets to be financed. This approach is also known as matching approach which classifies the requirements of total working capital into permanent and temporary working capital. The hedging approach suggests that permanent working capital requirements should be financed with funds from long-term sources while temporary working capital requirements should be financed with short-term funds.

25 (2) The Conservative Approach: This approach suggests that the entire estimated investments in current assets should be financed from longterm sources and short-term sources should be used only for emergency requirements. The distinct features of this approach are: (ii) (iii) (iv) Liquidity is greater Risk is minimised The cost of financing is relatively more as interest has to be paid even on seasonal requirements for entire period. Trade off Between the Hedging and Conservative Approaches The hedging approach implies low cost, high profit and high risk while the conservative approach leads to high cost, low profits and low risk. Both the approaches are the two extremes and neither of them serves the purpose of efficient working capital management. A trade off between the two will then be an acceptable approach. The level of trade off may differ from case to case depending upon the perception of risk by the persons involved in financial decision making. However, one way of determining the trade off is by finding the average of maximum and the minimum requirements of current assets. The average requirements so calculated may be financed out of long-term funds and excess over the average from short-term funds. (3). Aggressive Approach: The aggressive approach suggests that entire estimated requirements of current asset should be financed from short-term sources

26 even a part of fixed assets investments be financed from short-term sources. This approach makes the finance mix more risky, less costly and more profitable. Hedging Vs Conservative Approach Hedging Approach 1. The cost of financing is reduced. 2. The investment in net working capital is nil. 3. Frequent efforts are required to arrange funds. Conservative Approach 1. The cost of financing is higher 2. Large Investment is blocked in temporary working capital. 3. The firm does not face frequent financing problems. 4. The risk is increased as firm is vulnerable to sudden shocks. 4. It is less risky and firm is able to absorb shocks. Lets Sum Up The term working capital may be used to denote either the gross working capital which refers to total current assets or net working capital which refers to excess of current asset over current liabilities. The working capital requirement for a firm depends upon several factors such as Nature or Character of Business, Credit Policy, Price level changes, business cycles, manufacturing process, production policy. The working capital need of the firm may be bifurcated into permanent and temporary working capital. The Hedging Approach says that permanent requirement should be financed by long term sources while the temporary requirement should be financed by shortterm sources of finance. The Conservative approach on the other hand says that the working capital requirement be financed from long-term sources. The Aggressive approach says that even a part of permanent requirement may be financed out of short-term funds. Every firm must monitor the working capital position and for this purpose certain accounting ratios may be calculated.

27 Working Capital: 8 Sources of Working Capital Finance Explained! The two segments of working capital viz., regular or fixed or permanent and variable are financed by the long-term and the short-term sources of funds respectively. The main sources of long-term funds are shares, debentures, termloans, retained earnings etc. The sources of short-term funds used for financing variable part of working capital mainly include the following: 1. Loans from commercial banks 2. Public deposits 3. Trade credit 4. Factoring 5. Discounting bills of exchange 6. Bank overdraft and cash credit 7. Advances from customers 8. Accrual accounts These are discussed in turn. 1. Loans from Commercial Banks: Small-scale enterprises can raise loans from the commercial banks with or without security. This method of financing does not require any legal formality except that of creating a mortgage on the assets. Loan can be paid in lump sum or in parts. The short-term loans can also be obtained from banks on the personal security of the directors of a country. Such loans are known as clean advances. Bank finance is made available to small- scale enterprises at concessional rate of interest. Hence, it is generally a cheaper source of financing working capital requirements of enterprise. However, this method of raising funds for working capital is a time-consuming process. 2. Public Deposits: Often companies find it easy and convenient to raise short- term funds by inviting shareholders, employees and the general public to deposit their savings with the company. It is a simple method of raising funds from public for which the company has only to advertise and inform the public that it is authorised by the Companies Act 1956, to accept public deposits. Public deposits can be invited by offering a higher rate of interest than the interest allowed on bank deposits. However, the companies can raise funds through public deposits subject to a maximum of 25% of their paid up capital and free reserves.

28 But, the small-scale enterprises are exempted from the restrictions of the maximum limit of public deposits if they satisfy the following conditions: The amount of deposit does not exceed Rs. 8 lakhs or the amount of paid up capital whichever is less. (i) The paid up capital does not exceed Rs. 12 lakhs. (ii) The number of depositors is not more than 5%. (iii) There is no invitation to the public for deposits. The main merit of this source of raising funds is that it is simple as well as cheaper. But, the biggest disadvantage associated with this source is that it is not available to the entrepreneurs during depression and financial stringency. 3. Trade Credit: Just as the companies sell goods on credit, they also buy raw materials, components and other goods on credit from their suppliers. Thus, outstanding amounts payable to the suppliers i.e., trade creditors for credit purchases are regarded as sources of finance. Generally, suppliers grant credit to their clients for a period of 3 to 6 months. Thus, they provide, in a way, short- term finance to the purchasing company. As a matter of fact, availability of this type of finance largely depends upon the volume of business. More the volume of business more will be the availability of this type of finance and vice versa. Yes, the volume of trade credit available also depends upon the reputation of the buyer company, its financial position, degree of competition in the market, etc. However, availing of trade credit involves loss of cash discount which could be earned if payments were made within 7 to 1 days from the date of purchase of goods. This loss of cash discount is regarded as implicit cost of trade credit. 4. Factoring: Factoring is a financial service designed to help firms in managing their book debts and receivables in a better manner. The book debts and receivables are assigned to a bank called the 'factor' and cash is realised in advance from the bank. For rendering these services, the fee or commission charged is usually a percentage of the value of the book debts/receivables factored. This is a method of raising short-term capital and known as 'factoring'. On the one hand, it helps the supplier companies to secure finance against their book debts and receivables, and on the other, it also helps in saving the effort of collecting the book debts. The disadvantage of factoring is that customers who are really in genuine difficulty do not get the opportunity of delaying payment which they might have otherwise got from the supplier company. In the present context where industrial sickness is spreading like an epidemic, the reason for which particularly in SSI sector being delayed payments from their suppliers; there is a clear-cut rationale for introduction of factoring system. There has been some progress also on this front. The recommendations of the Study Group (RBI 1996) to examine the feasibility of setting up of factoring organisations in the country, under the Chairmanship of Shri C. S. Kalyanasundaram have been accepted by the Government of India. The Group is of the view that factoring for SSI units could prove to be mutually beneficial to both Factors and SSI units and Factors should make every effort to orient their strategy to crystallize the potential demand from the sector.

29 5. Discounting Bills of Exchange: When goods are sold on credit, bills of exchange are generally drawn for acceptance by the buyers of goods. The bills are generally drawn for a period of 3 to 6 months. In practice, the writer of the bill, instead of holding the bill till the date of maturity, prefers to discount them with commercial banks on payment of a charge known as discount. The term 'discounting of bills' is used in case of time bills whereas the term, 'purchasing of bills' is used in respect of demand bills. The rate of discount to be charged by the bank is prescribed by the Reserve Bank of India (RBI) from time to time. It generally amounts to the interest for the period from the date of discounting to the date of maturity of bills. If a bill is dishonoured on maturity, the bank returns the dishonoured bill to the company who then becomes liable to pay the amount to the bank. The cost of raising finance by this method is the amount of discount charged by the bank. This method is widely used by companies for raising short-term finance. 6. Bank Overdraft and Cash Credit: Overdraft is a facility extended by the banks to their current account holders for a short-period generally a week. A current account holder is allowed to withdraw from its current deposit account upto a certain limit over the balance with the bank. The interest is charged only on the amount actually overdrawn. The overdraft facility is also granted against securities. Cash credit is an arrangement whereby the commercial banks allow borrowing money up to a specified-limit known as 'cash credit limit.' The cash credit facility is allowed against the security. The cash credit limit can be revised from time to time according to the value of securities. The money so drawn can be repaid as and when possible. The interest is charged on the actual amount drawn during the period rather on limit sanctioned. The rate of interest charged on both overdraft and cash credit is relatively higher than the rate of interest given on bank deposits. Arranging overdraft and cash credit with the commercial banks has become a common method adopted by companies for meeting their short- term financial, or say, working capital requirements. 7. Advances from Customers: One way of raising funds for short-term requirement is to demand for advance from one's own customers. Examples of advances from the customers are advance paid at the time of booking a car, a telephone connection, a flat, etc. This has become an increasingly popular source of short-term finance among the small business enterprises mainly due to two reasons. First, the enterprises do not pay any interest on advances from their customers. Second, if any company pays interest on advances, that too at a nominal rate. Thus, advances from customers become one of the cheapest sources of raising funds for meeting working capital requirements of companies. 8. Accrual Accounts: Generally, there is a certain amount of time gap between incomes is earned and is actually received or expenditure becomes due and is actually paid. Salaries, wages and taxes, for example, become due at the end of the month but are usually paid in the first week of the next month. Thus, the outstanding salaries and wages as expenses for a week help the enterprise in meeting their working capital requirements. This source of raising funds does not involve any cost.

30 A constant flow of working capital is an intrinsic component of a successful business. This is especially true considering the outflow that is a part and parcel of every cycle: salaries and wages need to be paid; raw materials need to be purchased and equipment need to be serviced; funds are needed for marketing, advertising, and other general overhead costs; reserves are required till the customers make their payment. Working capital is truly the lifeline for any company. The question arises as to how does a business acquire funds for working capital. There are two types of financing: short term and long term. Short Term Financing Banks can be an invaluable source of short term working capital finance. 1. Overdraft Agreement: By entering into an overdraft agreement with the bank, the bank will allow the business to borrow up to a certain limit without the need for further discussion. The bank might ask for security in the form of collateral and they might charge daily interest at a variable rate on the outstanding debt. However, if the business is confident of making the repayments quickly, then an overdraft agreement is a valuable source of financing, and one that many companies resort to. 2. Accounts Receivable Financing: Many banks and non-banking financial institutions provide invoice discounting facilities. The company takes the commercial bills to the bank which makes the payment minus a small fee. Then, on the due date the bank collects the money from the customer. This is another popular method of financing especially among small traders. Businesses that offer large terms of credit can carry on their operations without having to wait for the customers to settle their bills. 3. Customer Advances: There are many companies that insist on the customer making an advance payment before selling them goods or providing a service. This is especially true while dealing with large orders that take a long time to fulfill. This method also ensures that the company has some funds to channelize into its operations for fulfilling those orders. 4. Selling Goods on Installment: Many companies, especially those that sell television sets, fans, radios, refrigerators, vehicles and so on, allow customers to make their payments in installments. Since many of these items have become modern day essentials, their customers might not come from well-to-do backgrounds or the cost of the product might be too prohibitive for immediate payment. In such a case, instead of waiting for a large payment at the end, they allow the customers to make regular monthly payments. This ensures that there is a constant flow of funds coming into the business that does not choke up the accounts receivable numbers. Long-Term Financing

31 Relying purely on short-term funds to meet working capital needs is not always prudent, especially for industries where the manufacture of the product itself takes a long time: automobiles, aircraft, refrigerators, and computers. Such companies need their working capital to last for a long time, and hence they have to think about long term financing. 1. Long-Term Loan from a Bank: Many companies opt for a full-fledged long term loan from a bank that allows them to meet all their working capital needs for two, three or more years. 2. Retain Profits: Rather than making dividend payments to shareholders or investing in new ventures, many businesses retain a portion of their profits so that they may use it for working capital. This way they do not have to take loans, pay interest, incur losses on discounted bills, and they can be selfsufficient in their financing. 3. Issue Equities and Debentures: In extreme cases when the business is really short of funds, or when the company is investing in a large-scale venture, they might decide to issue debentures or bonds to the general public or in some cases even equity stock. Of course, this will be done only by conglomerates and only in cases when there is a need for a huge quantum of funds. Companies cannot rely only on limited sources for their working capital needs. They need to tap multiple avenues. They also need to constantly evaluate what their needs are, through analysis of financial statements and financial ratios, and choose their working capital channels judiciously. This is an ongoing process, and different routes are appropriate at different points in time. The trick is to choose the right alternative as per the situation. Top 1 Sources of Working Capital Finance Business Article shared by : <="" div="" style="margin: px; padding: px; border: px; outline: px; font-size: 16px; vertical-align: bottom; max-width: 1%; background: transparent;"> The following points highlight the top ten sources of working capital finance. The sources are: 1. Intercorporate Loans and Deposits 2. Commercial Paper (CP) 3. Funds Generated from Operations 4. Retained Profit 5. Depreciation Provision 6.

32 Amortisation Provisions 7. Deferred Tax Payments 8. Accrued Expenses 9. Deposits and Advances 1. Public Deposits. Source # 1. Intercorporate Loans and Deposits: In present corporate world, it is a common practice that the company with surplus cash will lend other companies for short period normally ranging from 6 days to 18 days. The rate of interest will be higher than the bank rate of interest and depending on the financial soundness of the borrower company. This source of finance reduce intermediation of banks in financing. Source # 2. Commercial Paper (CP): ADVERTISEMENTS: CP is a debt instrument for short-term borrowing, that enables highly-rated corporate borrowers to diversify their sources of short-term borrowings, and provides an additional financial instrument to investors with a freely negotiable interest rate. The maturity period ranges from three months to less than 1 year. Since it is a short-term debt, the issuing company is required to meet dealers fees, rating agency fees and any other relevant charges. Commercial paper is short-term unsecured promissory note issued by corporation with high credit ratings. Source # 3. Funds Generated from Operations: Funds generated from operations, during an accounting period, increase working capital by an equivalent amount. The two main components of funds generated from operations are retained profit and depreciation. Working capital will increase by the extent of funds generated from operations. Source # 4. Retained Profit: Profit is the accretion of fund which is available for finance internally, to the extent it is retained in the organization. Retained profits are an important source of working capital finance. Source # 5. Depreciation Provision: Since there is no cash outflow to the extent of depreciation provided in the accounting, it is used for financing the internal operations of a firm. The amount

33 deducted towards depreciation on fixed assets is not immediately used in acquisition of fixed assets and such amount is retained in business for same time. This is used as a temporary source of working capital so long as the capital expenditure is postponed. Source # 6. Amortisation Provisions: Any provisions made for meeting the future payments or expenses such as provision for dividend, provision for taxation, provision for gratuity etc. provide a source of finance so long as they are kept in the business. Source # 7. Deferred Tax Payments: ADVERTISEMENTS: Another source of short-term funds similar in character to trade credit is the credit supplied by the tax authorities. This is created by the interval that elapses between the earning of the profits by the company and the payment of the taxes due on them. Deferred payment of taxes is also used as a temporary source of working capital so long as the amount is deposited with the tax authorities. The taxes deducted at sources, collection of sales tax and excise duty, retirement benefits deducted from salaries of staff etc. also retained in business for some time and used as a source of working capital. Source # 8. Accrued Expenses: Another source of spontaneous short-term financing is the accrued expenses that arise from the normal conduct of business. An accrued expense is an expense that has been incurred, but has not yet been paid. For most firms, one of the largest accrued expenses is likely to be employees accrued wages. For large firms, the accrued wages held by the firm constitute an important source of financing. Usually, accrued expenses are not subject to much managerial manipulation. Source # 9. Deposits and Advances: ADVERTISEMENTS:

34 The deposits collected from dealers and advances received from customers will also constitute a source of finance. Source # 1. Public Deposits: Deposits from the public is one of the important source of finance particularly for well established big companies with huge capital base. The period of public deposits is restricted to a maximum 5 years at a time and hence, this source can provide finance only for short-term to medium-term, which could be more useful for meeting working capital needs of the company. It is advisable to use the amounts of public deposits for acquiring assets of long-term nature unless its pay back is very short.

35 Cash Management Definition: The Cash Management is concerned with the collection, disbursement and the management of cash in such a way that firm s liquidity is maintained. In other words, it is concerned with managing the cash flows within and outside the firm and making decisions with respect to the investment of surplus cash or raising the cash from outside for financing the deficit. The objective of cash management is to have adequate control over the cash position, so as to avoid the risk of insolvency and use the excessive cash in some profitable way. The cash is the most significant and highly liquid asset the firm holds. It is significant as it is used to pay the firm s obligations and helps in the expansion of business operations. The concept of cash management can be further understood in terms of the cash management cycle. The sales generate cash, and this has to be disbursed out. The firm invests the surplus cash or borrows cash in case of deficit. Thus, it tries to achieve this cycle at a minimum cost along with the liquidity and control. An optimum cash management system is one that not only prevents the insolvency but also reduces the days in account receivables, increases the collection rates, chooses the suitable investment vehicles that improves the overall financial position of the firm. The importance of the cash management can be understood in terms of the uncertainty involved in the cash flows. Sometimes the cash inflows are more than the outflows, or sometimes the cash outflows are more. Thus, a firm has to manage cash affairs in a way, such that the cash balance is maintained at its minimum level while the surplus cash is invested in the profitable opportunities.

36 Motives for Holding Cash Definition: The Motives for Holding Cash is simple, the cash inflows and outflows are not well synchronized, i.e. sometimes the cash inflows are more than the cash outflows while at other times the cash outflows could be more. Hence, the cash is held by the firms to meet the certain as well as uncertain situations. Motives for Holding Cash Majorly there are three motives for which the firm holds cash. 1. Transaction Motive: The transaction motive refers to the cash required by a firm to meet the day to day needs of its business operations. In an ordinary course of business, the firm requires cash to make the payments in the form of salaries, wages, interests, dividends, goods purchased, etc. Likewise, it also receives cash from its sales, debtors, investments. Often the firm s cash inflows and outflows do not match, and hence, the cash is held up to meet its routine commitments. 2. Precautionary Motive: The precautionary motive refers to the tendency of a firm to hold cash, to meet the contingencies or unforeseen circumstances arising in the course of business. Since the future is uncertain, a firm may have to face contingencies such as an increase in the price of raw materials, labor strike, lockouts, change in the demand, etc. Thus, in order to meet with these uncertainties, the cash is held by the firms to have an uninterrupted business operations.