CORPORATE FINANCE

II Unit
Short term working capital

Estimating working capital requirements Approach adopted by Commercial banks,
Commercial paper- Public deposits and inter corporate investments.
WORKING CAPITAL MANAGEMENT
INTRODUCTION

The term working capital is commonly used for the capital required for day-to-day
working in a business concern, such as for purchasing raw material, for meeting day-to-
day expenditure on salaries, wages, rents rates, advertising etc. But there are much
disagreement among various financial authorities (Financiers, accountants, businessmen
and economists) as to the exact meaning of the term working capital.

Working capital refers to the capital required for day-to-day operations of a business
enterprise. There are two concepts of Working Capital Gross Working capital and Net
Working capital.

1. Gross Working Capital
Gross Working capital refers to the firms Securities, Debtors, Bills Receivable
and Inventory). Current assets are those assets, which can be converted into cash within a
period of one year.

2. Net Working Capital
Net Working capital refers to the difference between current assets and current liabilities.
It may be positive or negative.

TYPES OF WORKING CAPITAL

Working capital can be divided into two categories on the basis of time. They are
Permanent Working Capital and Temporary or Variable Working capital.

Permanent Working Capital refers to that minimum amount of investment in current
assets, which is required at all times to carry on minimum level of business activities. It
represents the current assets required on a continuing basis over the entire year, and
hence should be financed out of long term funds.

Temporary Working capital represents the additional current assets required at
different times during the operating year.

Need for Working Capital

Working capital is needed till a firm gets cash on sale of finished products. It depends on
two factors:

i. Manufacturing cycle i.e. time required for converting the raw material into finished
product; and

ii. Credit policy i.e. credit period given to Customers and credit period allowed by
creditors.

Thus, the sum total of these times is called an Operating and it consists cycle of the
following six steps:

Conversion of cash into raw materials.
Conversion of raw materials into work-in-process.
Conversion of work-in-process into finished products.
Time for sale of finished goodscash sales and credit sales.
Time for realization from debtors and Bills receivables into cash.
Credit period allowed by creditors for credit purchase of raw materials, inventory
and creditors for wages and overheads.






Importance or Advantages of Adequate Working Capital

Working capital is the life blood and nerve centre of a business. Just as circulation of
blood is essential in the human body for maintaining life, working capital is very
essential to maintain the 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
the 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 other on easy and favourable terms.

4. Cash Discounts: Adequate working capital also enables a concern to avail cash
discounts on the purchases and hence it reduces costs.

5. Regular supply of raw materials: Sufficient working capital ensures 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 the morale of its employees,
increases their efficiency, reduces wastages and costs and enhances production and
profits.


7. Exploitation of favorable market conditions: Only concerns with adequate working
capital can exploit favorable market conditions such as purchasing its requirements in
bulk when the prices are lower and by holding its inventories for higher prices.

8. Ability to face Crisis: Adequate working capital enables a concern to face business
crisis in emergencies such as depression because during such periods, generally, there is
much pressure on working capital.

9. Quick and Regular return on Investments: Every Investor wants a quick and regular
return on his investments. Sufficiency of working capital enables a concern to pay quick
and regular dividends to its investors as there may not be much pressure to plough back
profits. This gains the confidence of its investors and creates a favourable market to raise
additional funds i.e., the future.

10. High morale: Adequacy of working capital creates an environment of security,
confidence, and 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 either redundant or excess working neither capital nor
inadequate or shortage of working capital. Both excess as well as short working capital
positions are bad for any business. However, out of the two, it is the inadequacy of
working capital which is more dangerous from the point of view of the firm.

Disadvantages of Redundant or Excessive Working Capital

1. Excessive Working Capital means ideal funds which earn no profits for the
business and hence the business cannot earn a proper rate of return on its
investments.

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. Excessive working capital implies excessive debtors and defective credit policy
which may cause higher incidence of bad debts.

4. It may result into overall inefficiency in the organization.

5. When there is excessive working capital, relations with banks and other financial
institutions may not be maintained.
6. Due to low rate of return on investments, the value of shares may also fall.

7. The redundant working capital gives rise to speculative transactions.

FACTORS EFFECTING WORKING CAPITAL NEEDS OF FIRMS

1. Nature of business:

In the case of public utility concern like railways, electricity etc most of the transactions
are on cash basis. Further they do not require large inventories. Hence working capital
requirements are low. On the hand, manufacturing and trading concerns require more
working capital since they have to invest heavily in inventories and debtors. Example
cotton or sugar mil

2. Size of business

Generally large business concerns are required to maintain huge inventories are required.
Hence bigger the size, the large will be the working capital requirements.



3. Time consumed in manufacture

To run a long production process more inventories is required. Hence the longer the
period of manufacture, the higher will the requirements of working capital and vice-
versa.

4. Seasonal fluctuations

A number of industries manufacture and sell goods only during certain seasons. For
example the sugar industry produces practically all sugar between December and April.
Their working capital requirements will be higher during this session. It is reduced as the
sales are made and cash is realized.

5. Fluctuations in supply

If the supply of raw materials is irregular companies, are forced to maintain huge stocks
to avoid stoppage of production. In such case, working capital requirement will be high.

6. Speed of turnover

A concern say hotel which effects sales quickly needs comparatively low working
capital. This is because of the quick conversion of stock into cash. But if the sales are
slow, more working capital will be required.

7. Terms of sales

Liberal credit sales will result in locking up of funds in sundry debtors. Hence a
company, which allows liberal credit, will need more working capital than companies,
which observe strict credit norms.


8. Terms of purchase

Working capital requirements are also affected by the credit facilities enjoyed by the
company. A company enjoying liberal credit facilities from its suppliers will need lower
amount working capital. (For example book shops). But a company that has to purchase
only for cash will need more working capital.

9. Labour intensive Vs. Capital intensive industries

In labour intensive industries, large working capital is required because of heavy wage
bill and more time taken for production. But the capital intensive industries require lesser
amount of working capital because of has investment in fixed assets and shorter time
taken for production.

10. Growth and expansion of business

A growing concern needs more working capital to finance its increasing activities and
expansion. But working capital requirements are low in the case static concerns.

11. Price level changes

Changes in price level also affect the working capital requirements. Generally the rising
prices will require the firm to maintain large amount of working capital. This is because
more funds will be required to maintain the same amount of working capital to maintain
the same level of activity.






Working capital advance by commercial banks

Working capital advance by commercial banks represents the most important source for
financing current assets.

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

i. Cash Credit / Overdrafts: Under a cash credit or overdraft arrangement, a pre-
determined limit for borrowing is specified by the bank. The borrower can draw as often
as required provided the out standings do not exceed the cash credit / overdraft limit.

ii. Loans: These are advances of fixed amounts which are credited to the current account
of the borrower or released to him in cash. The borrower is charged with interest on the
entire loan amount, irrespective of how much he draws.

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

iv. Letter of Credit: A letter of credit is an arrangement whereby a bank helps its
customer to obtain credit from its (customer credit in favor of its customer for some
specific purchases, the bank undertakes the responsibility to honour the obligation of its
customer, should the customer fail to do so.

Commercial Paper

Commercial paper can be defined as a short term, unsecured promissory notes which are
issued at discount to face value by well known companies that are financially strong and
enjoy a high credit rating. Here are some of the features of commercial paper

1. They are negotiable by endorsement and delivery and hence they are flexible as well as
liquid instruments. Commercial paper can be issued with varying maturities as required
by the issuing company.

2. They are unsecured instruments as they are not backed by any assets of the company
which is issuing the commercial paper.

3. They can be sold either directly by the issuing company to the investors or else issuer
can sell it to the dealer who in turn will sell it into the market.

4. It helps the highly rated company in the sense they can get cheaper funds from
commercial paper rather than borrowing from the banks.

However use of commercial paper is limited to only blue chip companies and from the
point of view of investors though commercial paper provides higher returns for him they
are unsecured and hence investor should invest in commercial paper according to his risk
-return profile.

Eligibility for issuance of CP

Presently, companies, which satisfy the following requirements, shall be eligible
to issue commercial paper:

The tangible net worth of the company is not less than Rupees four crore

Working capital (fund-based) limit of the company is not less than four crore

The minimum credit rating of the company shall be P-2 from CRISIL or
equivalent from other Rating agencies

The borrowed account of the company is classified as a Standard Asset.

Besides companies, Primary Dealers (PDs) and Satellite Dealers are also
permitted to issue CP.

Public Deposits

Many firms, large and small, have solicited unsecured deposits from the public in recent
years, mainly to finance their working capital requirements.

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

a. Call Deposits: In theory, a call deposit is withdra notice. In practice, however, the
lender has to wait for at least three days. The interest rate on such deposits may be around
10 percent per annum.

b. Three-months Deposits: More popular in practice, these deposits are taken by
borrowers to tide over a short-term cash inadequacy that may be caused by one or more
of the following factors: disruption in production, excessive imports of raw material, tax
payment, and delay in collection, dividend payment, and unplanned capital expenditure.
The interest rate on such deposits is around 12 percent per annum.

c. Six-months Deposits: Normally, lending companies do not extend deposits beyond
this time frame. Such deposits usually made with first-class borrowers, carry and interest
rate of around 15 percent per annum.
The various advantages of public deposits enjoyed by the companies are:

1.
There is no involvement of restrictive agreement


2.
The process involved in gaining public deposit is simple and easy


3.
The cost incurred after tax is reasonable


4.
Since there is no need to pledge security for public deposits, the assets of firm that
can be mortgaged can be preserved


The disadvantages of public deposits from the company's point of view are:

1.
The maturity period is short enough


2.
Limited fund can be obtained from the public deposits


Who accepts public Deposits?

Public and private limited non banking non financial companies of varying sizes.
Public and private limited non banking financial companies
Government companies since 1980.
Branches of foreign companies.
Partnership terms.
Proprietary concerns.

Inter corporate investments

Inter corporate investment occurs when one corporation purchases the shares of another.
There are four types of long term inter corporate investments: portfolio, significant
influence, controlling and joint controlling.

Portfolio investments

Portfolio investments are long-term investments whereby the investor is unable to
exercise significant influence or control o and investing policies. This is presumed to be
the case when the investor owns less than 20% share ownership. However, this
presumption may be overturned by evidence to the contrary. Portfolio investments are
accounted for using the cost method.

Significant influence investments
Significant influence investments are long-term investments whereby the investor is able
to exercise significant influence over the investing policies, but does not unilaterally
control the investee. Significant influence is presumed to be the case when the investor
owns between 20% 49% of the shares of the investee. Again, this presumption may be
overturned by evidence to the contrary. For example, the presence of a controlling
investor with a large equity interest might preclude any other investors from exercising
significant influence. Evidence that an investor exercises significant influence includes
representation on the board of directors, dictating the terms of related party transactions,
interchange of management personnel, etc. Significant influence investments are
accounted for using the equity method.

Difference between cost and equity method

The cost and equity method differ in terms of how they record the change in the value of
the investment over time. Because investors with significant influence are able to
determine the investee's policies, the income earned by the investee is treated as if it was
earned by the investor itself. As a result, in the equity method, the investor accrues the
income earned by the investee. Inter company profits are eliminated because the investor
and investee are considered to be part of the same economic entity. Also, significant
influence investors control the dividend policy of the investee, so dividends are treated as
a liquidation of the investment rather than income.

In terms of a portfolio investment, the investor cannot impact the management policies of
the investee and so, does not accrue income. Also, the investor does determine the
dividend policy, so dividends are recognized as income. Inter company profits are
recognized because the investor and investee are considered separate economic entities.
The change in the value of the investee is recognized when the investor sells the
investment.