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Understanding Working Capital

Subject: UNDERSTANDING WORKING CAPITAL Credit: 4

SYLLABUS

Concepts and Determination of Working Capital Conceptual Framework, Operating Environment of Working Capital, Determination of Working Capital,

Theories and Approaches

Management of Current Assets Management of Receivables, Management of Cash, Management of Marketable Securities, Management of

Inventory

Financing of Working Capital Needs Bank Credit: Principles and Practices, Bank Credit: Methods of Assessment and Appraisal, Other Sources of

Short Term Finance

Working Capital Control and Banking Policy Capital control, Banking System Reformation, Tasks of the monetary policy, the banking system reform,

Perfection of banking legislation, Banking Reform in India

Working Capital Management: An Integrated View Liquidity vs. Profitability, Payables Management Planning for Working Capital Investment Factors Influencing

Working Capital Performance, Corporate working capital management

Money Market in India India Money Market, India Market Size, Global Integration of India’s Money Market, Model and Estimation

Suggested Readings:

1. V.K. Bhalla Working capital management

2. Hirishikes Bhattacharya Working capital management

3. F.C. Schers Modern Working capital management.

4. Indian Financial System by Machiraju, Vikas Publishing house

5. Indian Financial System by Pathak, Bharati V, Pearson education.

CHAPTER 1

CONCEPTS AND DETERMINATION OF WORKING CAPITAL

CONCEPTUAL FRAMEWORK

Definition of Working Capital

Working capital may be defined in two ways, either as the total of current assets or as the variation

flanked by the total of current assets and total of current liabilities. Like mainly other financial

conditions the concept of working capital is used in dissimilar connotations through dissimilar writers.

Therefore, there appeared the following two concepts of working capital.

Gross concept of working capital

Net concept of working capital

Gross Concept

No special distinction is made flanked by the conditions total current assets and working capital through

authors like Mehta, Archer, Bogen, Mead, and Baker. Just as to them working capital is nothing but the

total of current assets for the following causes:

Profits are earned with the help of the assets which are partly fixed and partly current. To a sure degree,

parallel can be observed in fixed and current assets in that both are partly borrowed and yield profit in

excess of and above the interest costs. Logic then demands that current assets should be taken to mean

the working capital of the corporation.

With every augment in funds, the gross working capital will augment while just as to the net concept of

working capital there will be no transform in the funds accessible for the operating manager.

The management is more concerned with the total current assets as they constitute the total funds

accessible for operating purposes than with the sources from which the funds came, and that

The net concept of working capital had relevance when the shape of organisation was single

entrepreneurship or partnership. In other languages a secure get in touch with was involved flanked by

the ownership, management and manage of the enterprise and consequently the ownership of current

and fixed assets is not given so much importance as in the past.

Net Concept

Contrary to the aforesaid point of view, writers like Smith, Guthmann, and Dongall. Howard and Gross

believe working capital as the mere variation flanked by current assets and current liabilities. A broader

view of working capital would also contain current liabilities such as explanations payable, notes

payable and other accruals. In his opinion, working capital management involves the managing of

individual current liabilities and the managing of all inter-relationships that link current assets with

current liabilities and other balance sheet explanations. The net concept is advocated for the following

causes:

In the extensive-run what matters is the surplus of current assets in excess of current liabilities.

It is this concept which helps creditors and investors to judge the financial soundness of the enterprise.

what can always be relied upon to meet the contingencies is the excess of current assets in excess of

current liabilities, as it is not to be returned; and

This definition helps to discover out the correct financial location of companies having the similar

amount of current assets.

In common, the gross concept is referred to as the Economics concept, as assets are employed to

derive a rate of return. What rate of return is generated through dissimilar assets is more

significant than the analyzed variation flanked by assets and liabilities. On the contrary, the net

concept is said to be the point of view of an accountant. In this sense, working capital is viewed as a

liquidation concept. So, the solvency of the firm is seen from the point of view of this variation usually,

lenders and creditors view this as the mainly pertinent approach to the problem of working capital.

Constituents of Working Capital

No matter how, we describe working capital, we should know what constitutes current assets and current

liabilities. Let us refer to the Balance Sheet of Lupin Laboratories Ltd. for this purpose.

Current Assets

The following are listed through the Company as current assets:

Inventories:

Raw materials and packing materials

Work-in-progress

Finished/Traded goods

Stores, Spares and fuel

Sundry Debtors:

Debts outstanding for a era exceeding six months

Other debts

Cash and Bank balances:

With Scheduled Banks

In Current explanations

In Deposit explanations

With others

in Current explanations

Loans and advances:

Secured Advances

Unsecured (measured good)

Advances recoverable in cash or type for value to be received

Deposits

Balances with customs and excise authorities

Current Liabilities

Current Liabilities:

Sundry creditors

Unclaimed dividend warrants

Unclaimed debenture interest warrants

Short term credit:

Short term loans

Cash credit from banks

Other short term payables

Provisions:

For Taxation

Proposed Dividend

On preference shares

On equity shares

Besides, things like prepaid expenses, sure advance payments are also incorporated in the list of current

assets. Likewise, bills payable, income received in advance for the services to be rendered are treated as

current liabilities. Nevertheless, there is variation of opinion as to what is current. In the strict sense of

the term, it is related to the, operating cycle, of the firm and current assets are treated as those that can be

converted into cash within the operating cycle. The era of the operating cycle may be more or less

compared to the accounting era of the firm. In case of some firms the operating cycle era may be little

and in an accounting era there can be more than one cycle. In order to avoid this confusion, a more

common treatment is given to the, currentness, of assets and liabilities and the accounting era (usually

one-year) is taken as the foundation for distinguishing current and non-current assets.

Kinds of Working Capital

Sometimes, working capital is divided into two diversities as:

Permanent working capital

Variable working capital

Permanent Working Capital

However working capital has a limited life and generally not exceeding a year, in actual practice some

section of the investment in that is always permanent. As firms have relatively longer life and

manufacture does not stop at the end of a scrupulous accounting era some investment is always locked

up in the shape of raw materials, work-in-progress, finished stocks, book debts and cash. The investment

in these components of working capital is basically accepted forward to the after that year. This

minimum stage of investment in current assets that is required to continue the business without

interruption is referred to as permanent working capital. While suggesting a methodology for financing

working capital necessities through commercial banks, the Tandon committee has also recognized the

require to uphold a minimum stage of investment in current assets. It referred them as, difficult core

current assets. The Committee wanted the borrowers to meet this portion of investment out of their own

sources and not to depend on commercial banks.

Variable Working Capital

This is also recognized as the circulating or transitory working capital. This is the amount of investment

required to take care of the fluctuations in the business action. While permanent working capital is

meant to take care of the minimum investment in several current assets, variable working capital is

expected to care for the peaks in the business action. While investment in permanent portion can be

predicted with some probability, investment in variable portion of working capital cannot be predicted

easily as sudden changes in the business action reasons variations in this portion of working capital.

Working Capital Behaviour

One of the implications of the division of working capital into two kinds is to understand its behaviour

in excess of an era of time. Investment in working capital is related to sales volume. A difference in

sales volume in excess of time would consequently bring in relation to the transform in the investment

of working capital. This is said to modify depending upon the kind of working capital. These variations

with respect to dissimilar kinds of firms are presumed to modify as indicated in Fig. 1.1. Figure 1.1

exemplifies the behaviour of dissimilar kinds of working capital in diverse firms affected through

seasonal and cyclical variations in manufacture or sales.

In case of non-growth non-seasonal and non-cyclical firms, all the working capital can be measured

permanent as shown in (A). Likewise, rising firms need more working capital in excess of an era of

time, but fluctuations are not assumed to happen. As such, in this case also, no variable portion of

working capital is present. In the third case (rising seasonal and non-cyclical firms), there are two kinds

of working capital. On the contrary, in case of rising, seasonal and cyclical firms, all the working capital

are assumed to be of varying kind.

Fig. 1.1 Behavior of Working Capital

Cyclical Flow and Aspects of Working Capital

For every business enterprise there will be a natural cycle of action. Due to the interaction of the several

forces affecting the working capital, it transforms and moves from one to the other. The role of the

financial manager then, is to ensure that the flow proceeds by dissimilar working capital levels at an

effective rate and at the appropriate time. Though, the successive movements in this cycle will be

dissimilar from one enterprise to another, based on the nature of the enterprises. For instance:

If the enterprise is a manufacturing concern, the cycle will run something like:

Cash(buying)Raw Materials(manufacture)Finished Goods(sales on credit) Explanations

Receivable (Collections)Cash.

If the enterprise is purely a Retailing Company and one, which has no manufacturing problem the cycle

is shortened as:

Cash (buying)Merchandise (Sales)Explanations Receivables (Collections) Cash.

If the enterprise is a purely financing enterprise, the cycle is still shorter and it can be shown as:

Cash (sanction of loans)Debtors (collections)Cash.

But in real business situations, the cyclical flow of working capital is not easy and smooth going, as one

may be tempted to conclude from these easy flows. This cyclical procedure is repeated again and again

and so do the values stay on changing as they move by the cash to cash path. In other languages the cash

flows arising from cash sales and collections from debtors will either exceed or be lower than cash

outflows represented through the amounts spent on materials, labour, and other expenses. An excess

cash outflow in excess of cash inflow is a clear indication of the enterprise having suffered a loss.

Therefore it is evident, that the amount of working capital required and its stage at any scrupulous time

will be governed directly through the frequency with which this cash cycle can be continued and

repeated. The faster the cycle the lesser will be the investment needed in working capital. Shape the

aforesaid discussion, one can easily identify three significant aspects of working capital, namely, short

life span, swift transformation and inter–related asset shapes and synchronization of action stages.

Short-life Span

Components of working capital are short-existed. Typically their life span does not exceed one year. In

practice, though, some assets that violate this criterion are still classified as current assets.

Swift Transformation and Inter-related Asset Shapes

In addition to their short span of life, each component of the current assets is swiftly transformed into

the other asset. Therefore cash is utilized to replenish inventories. Inventories are diminished when

sales increase explanations receivable and collection of explanations receivable increases cash balances.

Therefore a natural corollary of this quick transformation is the frequent and repetitive decisions that

affect the stage of working capital and the secure interaction that exists in the middle of the members of

the family of working capital. The latter entails the assumption that efficient management of one asset

cannot be undertaken without simultaneous consideration of other assets.

Assets Shapes and Synchronization of Action Stages

A third characteristic of working capital components is that their life span depends upon the extent to

which the vital behaviors like manufacture, sharing, and collection are non-instantaneous and

unsynchronized. If these three behaviors are only instantaneous and synchronized, the management of

working capital would obviously be a trivial problem. If manufacture and sales are synchronized there

would be no require to have inventories. Likewise, when all customers pay cash, management of

explanations receivable would become unnecessary.

Scheduling for Working Capital

Scheduling gives a logical starting point for several of the decisions. It is extremely much true for

working capital decision also. Unless, we plan for procurement and effective exploit as suggested, not be

in a location to get best out of working capital. In a method, effective scheduling leads to appropriate

allocation of the money in the middle of dissimilar components of working capital. Drawing a

distinction of the type of Peter F. Drucker, flanked by efficiency (doing items right) and effectiveness

(throughout right items). Scheduling clearly embraces the latter. It is for this cause scheduling for

working capital is measured highly appropriate and inclusive of the present discussion on conceptual

framework.

While scheduling should logically begin at the top of the organizational hierarchy, responsibility for

scheduling exists at all stages within the organisation. While working capital scheduling is a section of

financial scheduling the responsibility permeats in the middle of dissimilar managers within the

organisation responsible for managing dissimilar components of working capital. At the stage of

scheduling for individual components of working capital persons like materials manager, credit manager

and cash manager are involved. Though, the overall responsibility for coordinating the scheduling of

working capital typically rests with the top management.

Apparatus of Scheduling for Working Capital

It should be motivating to know how to identify the relevant apparatus for completing the scheduling

exercise. We can note down the following apparatus of analysis with respect to time- frame.

Short term scheduling – Cash Budgeting

Medium term scheduling – Determination of appropriate stages of working capital things

Extensive term scheduling –Projected pay outs and returns to shareholders in conditions of CVP and

funds flow analysis.

Cash Budget

In the short term cash budgeting is measured a handy device for scheduling working capital. The exploit

of cash budget technique as a means of determining the size of the cash flows is measured larger to the

exploit of proforma balance sheets or judging through the past experience. A cash budget is a

comparison of estimated cash inflows and outflows for a scrupulous era such as a day, a week, a month,

a quarter, or year. Typically Cash budget is intended to cover one–year era and the era sheltered is sub-

divided into intervals. It can be prepared in several ways like the one based on cash receipts and

disbursements method, or the adjusted net income method, or the working capital differential method.

The budgeting procedure begins with the beginning balance to which are added expected receipts. This

amount is reached through multiplying expected cash receipts through the probability sharing that the

management budgetary will prevail throughout the budgetary era. If outlays exceed the beginning

balance plus anticipated receipts the variation necessity is financed from external sources. If an excess

exist, management necessity create a decision concerning its disposal either in conditions of investing in

short-term securities, repaying the existing debts, or returning the funds to the share-holders.

The preparation of the cash budget helps management in several ways. Management will be able to ward

off the disadvantages of excessive liquidity, as there will be fact on how and when such cash results in.

Likewise it will be able to get in touch with dissimilar sources of fund to tide in excess of a situation of

cash shortage and can avoid rushing to obtain fund at whatever cost. It allows the management to relate

the maturity of the loan to require and determine the best source of funds, as the fact furnished through

the budget reflects the amounts and time for which funds are needed. Further, cash Budget establishes a

sound foundation for controlling the cash location.

Of the many methods of preparing the cash budget, Receipts and Payments method is popular in the

middle of several undertakings. Moreso the preparation of cash budgets in the organisations was an

integral section of the budgetary procedure, as the entire of the budgetary building was divided into

revenue budgets, expenditure budgets and cash budgets. Cash budget was prepared through the

organisations through borrowing figures from several other budgets which they prepared such as the:

Manufacture budgets.

Sales budget.

Cost of manufacture estimates with its necessary subdivisions for instance.

Materials purchase estimates:

Labour and personnel estimates:

Plant maintenance estimates: etc.

Man authority budget.

Community and welfare estimates

Profit and loss estimates.

Capital expenditure budget.

Therefore , cash budget is prepared as a means of identifying the past cash flows and determine the

future course of activity. Cash budgets, usually are prepared through all enterprises on yearly foundation

having monthly break–ups.

Medium Term Scheduling

In the medium term determining appropriate stage of working capital is measured a focal point. We have

discussed in detail the following three approaches to determine optimum investment in working capital.

Industry Norm Approach

Economic Modeling Approach

Strategic Choice Approach

CVP Analysis

As a measure of extensive term scheduling, macro- stage techniques like C-V-P and funds flow are

measured helpful in creation an effective scheduling. These are helpful not only for working capital

scheduling but also for the whole financial scheduling. At the stage of working capital scheduling, we

are required to set up relationships flanked by costs, volume, and profits. However the regular break-

even point is used to determine that stage of sales or manufacture which equals total costs, in the region

of working capital, we can be careful in relation to the costs and revenues akin to working capital things

such as inventory, receivables, and cash. Firms often face a dilemma of whether to lay an order to stay a

scrupulous stage of inventory or not and whether a customer be provided credit or not. These matters

can be effectively dealt with orientation towards the C-V-P relationships.

In this context, a distinction may be made flanked by cash break even point and profit break-even point,

which symbolizes liquidity and profitability respectively. Cash break-even point, which is defined as

that stage of sales per era for which sales revenue presently equals the cash outlays associated with the

product or business. This type of an analysis helps in focusing on the regions of cash deficit and cash

surplus leading to bigger liquidity management. When we appreciate the information that working

capital is a liquidation concept, the utility of CVP concept in creation bigger exercise in scheduling for

working capital requires no special emphasis.

Funds Flow

Funds flow is yet another tool used in the extensive run to examine the financial location of a company.

However the term funds can be understood to contain all financial possessions, preparation of funds

flow statements on working capital foundation are more general in fund. The preparation of such flow

statements provides a thought as to the movement of funds in the organisation. The particulars relating

to the funds generated from operations and changes in net working capital location are highly relevant in

this analysis. A firm‘s capability to pay off its current debts depends largely on its skill to close funds

from operations. The prime objective of funds flow report (prepared on the foundation of working

capital movements) is to illustrate the ebb and flow of funds by working capital and to shed light on

factors contributing to the movements. As a matter of information the internal movement of wealth (to a

big extent) generally takes lay in the middle of working capital things. An analysis of these movements

so would give an understanding of the efficiency of working capital management.

For that matter, one has to ascertain changes in current assets and current liabilities throughout the two

balance sheet dates and record variations in working capital. This would help in identifying the net

changes. i.e., increases and decreases in working capital location.

Working Capital and Inflation

Inflation, which is commonly indicated through the rise in prices of goods and services, is so rampant in

the world that no economy is distant off from its deleterious effects. Inflation has been experienced

through approximately all the countries in the world irrespective of their political system and the level of

industrialization. The information is that, in excess of the last two decades, annual rates of inflation in

excess of two to three percent have become general all in excess of the world.

In India, the rate of inflation was more than in several other countries, and the wholesale prices rose

through approximately 32 percent throughout 1956-61, through slightly less than 30 percent throughout

1961-66, and 25 percent throughout the Annual Plan eras (1966-69). Besides fluctuations the annual rate

of rise in the wholesale price was exceptionally high and in 1974-75, approximately alarming. Inflation

rate based on Wholesale Price Index (WPI) averaged approximately 9 per cent throughout 1970-71 to

1990-91. Again it touched the highest stage of the decade in 1991-92 at 16.7 percent, when the

economic action was at its lowest ebb. Consequent upon the reforms, there has been some recovery in

the economy and the rate of inflation has approach down to even 2 percent throughout 1998-99,

threatening the regime of deflation. Nevertheless, there is no consistency in the performance of the

economy. Again the rate of inflation is moving towards a standard of 4-5 percent. Alongside these

indices there are some hidden inflationary potentials which are not evident. Prominent in the middle of

these are generous subsidies, changing international prices of crude oil and petroleum products and the

administered prices for sure other products. The combined impact of these factors is definitely seen on

the inflation.

Size of Working Capital

Inflation reasons a spurt in the prices of input factories like raw materials, labour, fuel and authority,

even however there is no augment in the quantum of such input factors used. Secondly inflationary

circumstances through providing motivation for higher profits induce the manufacturers to augment their

volume of operations. High profits and high prices make further demand therefore , leading to further

investments in inventories, receivables, and cash. The cycle, therefore continues for an extensive time,

entailing on the fund manager to arrange for superior working funds after each successive augment in

the volume of operations. Thirdly, companies also tend to accumulate inventories throughout inflation to

reap the speculative profits. This type of blocking up of funds, in turn necessitates enterprise to uphold

superior working capital funds. Finally the existing financial reporting practices of firms on the

foundation of historical costs as per the companies Act and Income Tax Act are also responsible, for the

reduction in the size of working capital fund. Throughout the era of inflation, as historical costs set

against the current prices and inventories are valued at current prices, higher profits would be accounted.

The reporting of inflated profits makes two aberrations. The company has to pay higher taxes on the

inflated profit figure however much of it is unrealized and if the company also declares the remaining

profits as dividends, it leads to sharing of dividends out of capital and eventually reduces the funds

accessible to the company for operations in inflationary years owing to escalation in cost of inputs,

augment in the volume of operations, accumulation of speculative inventory and the adoption of

historical cost accounting system.

Availability of Working Capital

Besides the problem of increased demand for funds there would be a reduction in the availability of such

funds associated with higher costs throughout inflation. There would be no problem if the working

capital funds were accessible to an unlimited extent at a reasonable cost, regardless of the economic

condition prevailing in the economy. In reality, the situation is totally the opposite as both internal and

external sources of funds for financing working capital become scarce.

As pointed out earlier, throughout inflation the availability of internal sources gets reduced because of

the maintenance of records on historical cost foundation. On the other hand, the location with regard to

external sources of funds is equally disheartening. The rapid augment in inflation has given rise to the

formulation of tight money policy through the Reserve Bank of India with a view to restricting the flow

of credit in the economy. Consequently, the extension of credit facilities from banks has become very

limited.

Till recently, companies depended heavily on public deposits for meeting their working capital

necessities. Their availability though was reduced due to the restrictions imposed through the RBI on the

companies for the mobilization of deposits from public, particularly as 1978. Further the advent of

Government companies into the capital market for accepting public deposits made it harder to draw

funds from the public.

Coming to the deal credit, one necessity note that it may not be accessible for extensive eras, and the

suppliers of goods tighten the credit facilities throughout inflationary era. The issue of extensive term

loans may also be slackened, as the investors would be less attracted through investments offering a

fixed return like debentures and preference shares. This is so because in conditions of purchasing

authority the principal amount of investment as well as the interest would dwindle. Therefore , these

restrictions and limitations on the availability of working capital from internal and external sources

create it hard for the fund manager to raise funds throughout inflation.

Components of Working Capital

It may be motivating at this level of the analysis to believe the impact of inflation on the components of

working capital, namely, inventory receivables and cash.

Inventory

Not several understand fully the impact of inflation on the management of inventory. Inflation affects

the decisions in respect of inventory in several ways, namely;

It leads to in excess of-investment in inventory.

It results in shortages.

It affects valuation of inventories; and

It renders the traditional inventory manage techniques ineffective.

Throughout the eras of inflation when the prices rise rapidly, companies will have an incentive to invest

more heavily in inventory than is indicated through the minimum cost calculation. If the management

believes the price of an thing will augment through 10 per cent in the after that month, considerably

more of that thing may be ordered than normal, of course, due to augment in inventory the company

may get speculative gain, but this speculative gain may be off-set through the augment in taxes due to

higher profit figures, accounted in times of inflation and higher carrying costs.

Another difficulty that the company is required to face is the material shortages in the eras of inflation. It

is not recognized whether inflationary escalations result in shortages or shortages happen because of

instability caused through inflation. Whatever be the real source of the problem, companies should be

conscious of the price trends and accordingly re-evaluate their internal purchasing and organizational

systems.

Extremely few firms realize the impact of inflation on the valuation of inventory and the extent to which

it contributes to unrealized profits. In other languages, inflation affects the valuation of inventories,

affecting thereby the amount of profits accounted in the financial statements.

Not only inflation affects the inventory, but inflation itself is also increased due to the inefficient

management of inventory. Delivering the keynote address at a National Convention on the subject of,

‗Curbing Inflation by Effective Materials Management‘, Shri P.J.Fernandes put forward the following

five propositions to illustrate the impact of inflation on the materials management.

The stocks which are held through the enterprises have a direct and immediate connection to common

price stages.

The price stage in any country is to a great extent determined through the cost of manufacture. The cost

of manufacture is to a great extent determined through the cost of inputs. Hence, if the cost of inputs

goes up, the cost of manufacture as well as the price stage also goes up.

An effective system of materials management necessity necessarily results in an augment in

manufacture.

The materials manager can have a total and absolute impact on manufacture outside his element, and

It is the materials management, which can reduce the crushing burden of credit expansion, and the

money supply, which again will have a direct and absolute impact on inflationary tendency.

Finally, it may be measured with the help of the following illustration how inflation renders the

traditional inventory manage techniques ineffective. Based on the EOQ formula, if one spaces orders as

shown in the instance, the total material cost comes to Rs. 1,27,656.25 (i.e., Material Cost + Ordering

Costs + Inventory Carrying Costs). In contrast, If the firm in question does not apply the EOQ technique

and basically resorts to buying at the single stretch or lot buying, the total material cost would be only

Rs. 1,12,520/- as worked out below:

Quantity needed for the year = Rs. 1,00,000

No of orders = 1(one lot)

Ordering Costs = 1 × 20 = Rs. 20

Carrying Costs = 1,00,000/2 × 25/100 = 12,500

Material Cost = Rs. 1,00,000

Total Cost = 1,00,000 + 20 + 12,500 = Rs.1,12,520

Therefore , it would seem that the conventional inventory manage technique of EOQ is not really valid

under the assumed circumstances.

Receivables

The effect of inflation on the receivables is felt by the size of investment in receivables. The amount of

investment in receivables varies depending upon the credit and collection policies of the organisation.

Evidently, throughout the eras of inflation the higher the amount involved in the receivables the greater

would be the loss to the company, as the debtor would be paying cheaper rupees.

Similarly, the length of the time too creates the firm lose much in the transaction. For example, if the

firm in the beginning made a credit sale of in relation to the Rs. 1,00,000 with an allowed credit era of

three months, assuming a 20 percent inflation in the economy, the amount the company receives in real

conditions after the allowed credit era becomes only Rs. 95,000. Here, even considering the similar time

lag flanked by delivery and realization, as flanked by debtors and creditors, sundry debtors would make

better problem than the sundry creditors, because the declining value of sundry debtors would affect

adversely the anticipated profitability of the enterprise. Therefore , the effect of inflation varies in

accordance with the quantum of receivables and the time allowed repaying them.

Cash

Management of cash takes on an added importance throughout the eras of inflation. With money losing

value in real conditions approximately daily, idle cash depreciates rapidly. A company that holds Rs.1,

00,000 in cash throughout 20 percent annual rate of inflation discovers that the money‘s real value is

only Rs. 80,000 in conditions of current purchasing authority. Even more significant, idle cash is not

earning any return. Throughout inflationary eras, it is significant that cash is treated as an asset required

to earn a reasonable return. The loss on the excess cash may be off-set or partly mitigated, if it is

invested to produce an income in the shape of interest earned. Obviously, if the rate of interest exceeds

the rise in the price stage, the firm realizes a gain equivalent to the excess, or sustains a loss if it is vice

versa. Further, the loss of the purchasing authority of excess cash is of scrupulous concern, if the

company sells debts or fixed income securities with the intention of subsequently investing the proceeds

in fixed assets.

Trends in Working Capital

In order that we gain a bigger thought of the working capital, it is also necessary to go into the working

capital in Indian companies, besides having a thought of the conceptual framework. For the purpose of

analyzing trends in working capital, data is culled from the publications of RBI on ―Finances of public

limited companies‖. The data of RBI covers roughly in relation to the one-third of the nongovernment,

non-financial companies in conditions of paid-up capital. Table 1.1 depicts the era sheltered from 1992-

93 to 2001-02. The trends are analyzed for this era of nine years with a gap of one year (98-99). In view

of the variations in the example number of companies throughout the era under consideration, trends are

analyzed to a great extent in conditions of percentages than in absolutes.

Size of Working Capital

Working capital, if taken, as the total of current assets increased from Rs. 67,558 crores in 1992-93 to

Rs. 1,96,426 crores in 2001-02. In conditions of percentages, working capital worked out to in relation

to the53 percent of the total net assets of the Indian companies. Nevertheless, there is a decline in the

percentage to 43 percent in 2001-02 approximately 10 percentage points. The implication of the revise

of size is that the ratio of current assets to total assets gives a measure of comparative liquidity of the

firm‘s asset building. The higher the ratio the lower would be the profitability and risk. In the sense that

higher investment in current assets not only locks up the funds that can be gainfully employed

elsewhere, but also necessitates the firm to incur additional costs in the maintenance of such high

volume of current assets.

An effort is made to capture the location in the middle of diverse industries. An examination of this

location has revealed that current assets as per cent of total net assets stood high in the industries such as

trading, construction, tobacco, sugar, cotton, textiles, engineering and rubber (See Table-1.1) It seems

that all traditional industries had higher amounts invested in working capital. A welcome characteristic

of these trends is that diversified companies (with a wide diversity of product clusters) had investment in

working capital up to approximately 42.6 percent only. Further, the relation flanked by current assets

and current liabilities (as depicted by current ratio) is sending a signal of poor liquidity. Accepting that a

2:1 relation flanked by current assets and current liabilities as comfortable in exhibiting adequate

liquidity, the public limited companies have never been closer to this average . It was varying flanked by

the lowest of 1.23:1 and the highest of 1.52:1 throughout the era, 1992-98. In case of individual

industries too none of them could achieve this spot except for shipping industry.

Constituents of Working Capital

In order to know the significance of each of the things of working capital, it is bigger to decompose the

total. Such an effort is made both for current assets and current liabilities. In the middle of the current

assets, loans and advances dominated the total location. Approximately half of the current assets are in

the shape of debtors and advances. It is heartening to note that the dominant location of inventories once

has approach down significantly from approximately 60 percent to only presently 32 percent now.

Receivables always blamed more than half of the current assets. Debtors can be measured more liquid

than inventories. In that sense this development can be measured a healthy characteristic of the Indian

corporate sector.

In the middle of the current liabilities sundry creditors and other current liabilities have engaged a prime

lay, constituting approximately 60 percent. Bank borrowings for working capital purposes have

approach down following the credit discipline exercised through the Reserve Bank, throughout nineties,

but showing up throughout 2001-02. These trends provide a thought of the behaviour of working capital

in Indian companies.

OPERATING ENVIRONMENT OF WORKING CAPITAL

Monetary and Credit Policies

Throughout seventies after the economies have started experiencing high inflation and low growth (a

phenomenon described ‗stagflation‘) economists have turned their attention to the potentiality of the

monetary policy in the economic policy creation . The comparative importance of growth and price

continuity as the objectives of monetary policy became the focus of attention in both urbanized and

developing economies. In a method, the objectives of monetary policy can be no dissimilar from the

overall objectives of economic policy. While some central banks believe monetary targeting as

operationally meaningful, some others focus on interest rates. Whatever be the method, growth with

continuity is attempted as the objective of monetary and economic policy of India. In the conduct of

monetary policy, the following characteristics become pertinent:

Money Supply

Bank Rate

CRR & SLR

Interest Rates

Selective Credit Controls

Flow of Credit

Money Supply

As a section of the policy exercise, monetary growth is targeted every year. Policy events are

pronounced, so as to take care of this targeting exercise. This is expected to uphold real growth and

include inflation. In this context, the Central Bank identifies the order of expansion in broad money

(recognized popularly as M3 and includes of currency with the public demand and time deposits with

commercial banks, and other deposits with RBI) that would be used as an intermediate target to realize

the ultimate objective of the policy. In the case of India, both output expansion and price continuity is

significant objectives; but depending on the specific conditions of the year, emphasis is placed on either

of the two. Increasingly, it is being recognized that central banks would have to target price continuity as

real growth itself would be in jeopardy, if inflation rates go beyond the periphery of tolerance. On a

historical foundation, the standard inflation rate‘ in India (―which had declined from 9.0 percent in

1970s to 8.0 percent in 1980s) went up markedly to a double-digit stage of 10.7 per cent throughout the

first half of 1990s. The focus of monetary policy in recent years has, so, been to bring down the inflation

rate to a modest stage. Monetary growth is being moderated in such a method that the credit necessities

for productive behaviors are adequately met.

For example, the monetary growth target, for 1996-97 was set at approximately the similar stage as in

the previous year (15.5 percent). The monetary policy for 1996- 97 sought to consolidate the gains on

the inflation front. It underscored the imperative require to sustain the lower and stable stage of inflation,

while ensuring the availability of adequate bank credit to support the growth of real sector of the

economy. Broad money growth was projected at 15.5 percent to 16 percent, assuming a 6 percent

growth in real GDP. The credit policy for the year has also been tailored to achieve the above objective.

Basing on the past, the monetary and credit policy for 1997-98 sought to target broad money growth in

the range of 15.0 - 15.5 percent, on the foundation of a projected real GDP growth rate of in relation to

the6 percent and an assumed inflation rate of the similar order. To compare the actual attainments, the

broad money growth of 17.0 percent throughout 1997-98 was higher than that in the previous financial

year (16.0 percent). The lower order of augment in the monetary base in 1996-97 necessity is viewed in

the context of the important cut in Cash Reserve Ratio (CRR) from 14 to 10 per cent of the net demand

and Time liabilities. The resulting increases in lend able possessions of the banks (to the tune of Rs.17,

850 crore) meant decrease in the ratio of reserves to deposits. This was reflected in the augment in broad

money multiplier from 3.1 to 3.5 as on March 31, 1997.

For the year 2002-03, the mid-term Review of Monetary and Credit Policy released on October 29, 2002

had projected the GDP growth in the range of 5.0 to 5.5 percent taking into explanation accessible data

on the performance of the South-West monsoon. The advance estimates for 2002-03 released through

the CSO in January 2003 has placed GDP growth at 4.4 percent, which reflects an estimated decline in

the output from agriculture and allied behaviors through as much as 3.1 percent. The earlier projection in

the Reserve Bank's mid-term Review of October 2002 was based on a much lower decline of 1.5 percent

in agricultural output. The overall growth performance of the industrial sector, as per CSO advance

estimates, at 5.8 percent is, though, much higher than that of 3.2 percent in the previous year. The

services sector is estimated to grow through 7.1 percent as against 6.5 percent in the earlier year, largely

on explanation of higher growth in construction, domestic deal, and transport sectors. The CSO has also

placed the growth of financing, real estate and business services sector at 6.5 percent for 2002-03 as

compared with 4.5 percent in 2001-02.

The annual rate of inflation in 2002-03 as considered through the augment in WPI, on an standard

foundation, for the year as a entire was, however, lower than that in the previous year 3.3 percent as

against 3.8 percent a year ago. Monetary and credit aggregates for the year 2002-03 reflected the impact

of mergers that took lay in the banking industry. Throughout 2002-03, the growth in money supply, was

15.0 percent as against 14.2 percent which was well within the projected trajectory. In the middle of the

components, growth in aggregate deposits of scheduled commercial banks (SCBs) at 12.2 percent net of

mergers (16.1 percent with mergers), was lower than that of 14.6 percent in the previous year. The

expansion in currency with the public was lower at 12.5 percent as against 15.2 percent in the previous

year.

Bank Rate

The Bank Rate has been defined in Part 49 of the Reserve Bank of India Act, 1934 as the average rate at

which the bank is prepared to buy or rediscount bills of swap or other commercial papers eligible for

purchase under the Act. The significance of bank rate is that it designates the rate at which the public

should be able to obtain accommodation on the specified kinds of paper from the commercial banks as

well as the Central Bank. This is expected to curb the tendency towards relatively high interest rates and

ensure satisfactory banking services and reasonable rates to the people. Secondly, bank rate symbolizes

the foundation of the rates at which people can obtain credit. Thirdly, bank rate also has a significant

psychological value as an instrument of credit manages. In effect, a transform in the bank rate is to

create the cost of securing funds from the Central Bank cheaper or more expensive, bring in relation to

the changes in the building of market interest rates and serve as a signal to the money market, business

society and the public of the relaxation or restrain in credit policy. Nevertheless, the success of bank rate

policy depends on the following:

That the bank rate of the Central bank should have a prompt and decisive power on money rates and

credit circumstances within its region of operation;

That there should be a substantial measure of elasticity on the economic building, in order that prices,

wages, rents, manufacture and deal might respond to changes in money rates and credit circumstances;

and

That the international flow of capital should not be hampered through any arbitrary restrictions and

artificial obstacles.

As distant as India is concerned, the exploit of bank rate as an instrument of credit manage is less

frequent. Throughout 1951- 74, Bank rate was changed only nine times; but was revised only thrice

throughout 1975-96. More so, in majority of the cases, bank rate has been used in conjunction with other

instruments of credit manage to realize the needed effectiveness in the manage exercise. It is, of late, the

RBI is taking events to reactivate the Bank Rate and link it to the interest rates of significance, so as to

facilitate its emergence as the ‗reference rate‘ for the whole financial system. With effect from the

secure of business on April 15, 1997, the Bank Rate was reduced from12 percent to 11 percent and

further to 10 percent w.e.f. June 25, 1997. This reduction in the Bank Rate signaled the beginning of a

low interest rate regime, as these downward movements resulted in same reductions in lending and

deposit rates in the financial markets. Growths in the external habitation leading to speculative action in

the Swap market resulted in a transform in the direction of interest rate policy. RBI subsequently

reviewed this policy and reduced the rate to 6 percent w.e.f. April 29, 2003.

CRR and SLR

Variations in the reserve necessities is yet another credit manage technique used through a Central Bank.

The Central Bank through this technique can transform the amount of cash reserves of banks and affect

their credit creating capability. It may be applied on the aggregate outstanding deposits or on the

increments after a base date or even on sure specific categories of deposits. This has a certain and

identifiable impact as compared to Bank Rate changes or open market operations. The two instruments

under this category are:

Cash Reserve Ratio (CRR)

Statutory Liquidity Ratio (SLR)

Under part 42(1) of the RBI Act, scheduled commercial banks were required to uphold with the RBI at

the secure of business on any day, a minimum cash reserve on their demand and time liabilities.

Likewise, banks were required under part 24(2A) to uphold a minimum amount of liquid assets equal to

but not less than sure percentage of demand and time liabilities. However the RBI did not exploit CRR

and SLR as important instruments of credit manage throughout the entire of the sixties, it started varying

the ratios as then actively. The implication of these variations is that when the ratio is brought down it

would release the funds that would have otherwise been locked up for investment through the

commercial banks. Of late, the RBI has removed the reserve necessities on inter bank liabilities w.e.f.

April 26, 1997. This single measure released Rs.950 crore for investment in deal and industry. Likewise,

as a section of monetary and credit policy for the second half of 1997-98, RBI reduced CRR through

two percentage points from 10.0 percent in eight stages of 0.25 each. The total addition to liquidity from

this was estimated at in relation to the Rs. 9,600 crore.

Even however the obligation of banks is to uphold their liquid assets at a minimum of 25 percent, in the

light of the require to restrain the pace of expansion of bank credit, the RBI has imposed a much higher

percentage of minimum liquid assets and in some cases to the extent of even 35 percent. These events

have started impounding huge amount of possessions of the banks and encouraging governments

[Central and State] to have a simple access to bank credit. It also led to the shrinkage of possessions

accessible for genuine credit purposes. In view of the strong opposition from the banks and basing on

the recommendations of the committee on ―Financial Sector Reforms‖, RBI reduced the ceiling to its

original stage of 25 percent of the net demand and time liabilities (NDTL). The banking system already

holds government securities of in relation to the39 percent of its net demand and time liabilities (NDTL)

as against the statutory minimum requirement of 25 percent.

The cash reserve ratio (CRR) leftovers a significant instrument for modulating liquidity circumstances.

The medium-term objective is, though, to reduce CRR to the statutory minimum stage of 3.0 percent. On

a review of growths in the international and domestic financial markets, a 75 foundation point reduction

in the CRR throughout June to November, 2002 was followed through a further 25 foundation points cut

from June 14, 2003 taking the stage of the CRR down to 4.5 percent. The minimum daily maintenance

of CRR was raised to 80 percent of the standard daily requirement for all the days of the reporting for

night with effect from the fortnight beginning November 16, 2002. This was subsequently lowered to 70

percent with effect from the fortnight beginning December 28, 2002. The payment of interest on eligible

CRR balances maintained through banks was changed from quarterly foundation to monthly foundation

from April 2003. The CRR has been approximately halved as April 2000 resulting in cumulative release

of first round possessions of in excess of Rs.33,500 crore (Table 1.1)

Table 1.1 Cash Reserve Ratio

The statutory liquidity ratio (SLR) to be maintained through all scheduled commercial banks leftovers

unchanged at a minimum of 25 percent of net demand and time liabilities (NDTL) as October 1997. As

a prudential measure to strengthen the urban co-operative banks (UCBs), the proportion of SLR holding

in the shape of government and other approved securities to NDTL has been increased in a phased

manner. From April 1, 2003, all scheduled UCBs have to uphold the whole SLR holding of 25 percent

of NDTL in government and other approved securities only. Likewise, local rural banks (RRBs) were

required to uphold their whole SLR holding in government and other approved securities through March

31, 2003 with SLR holdings of RRBs in the shape of deposits with sponsor banks maturing beyond

March 31, 2003 being reckoned for the SLR till maturity. The maturity proceeds of such deposits would

have to be converted into government securities for RRBs not reaching the 25 percent minimum stage of

SLR in Government securities through that time..

Interest Rates

Realizing the information that Bank Rate is not functioning as an effective tool of credit manage, RBI

started influencing the cost of credit, by the changes in interest rates. The RBI derived the power to

regulate the interest rates of banks under parts 21 and 35a of the Banking Regulation Act, 1949. This

authority covers both the advances and deposit rates. The rates on loans and advances are controlled

largely in order to power the demand for credit and to introduce a unit of discipline in the exploit of

credit. This is usually done through stipulating minimum rates of interest for extending credit against

commodities sheltered under selective credit manage. Also, concessive or ceiling rates of interest are

made applicable to advances for sure purposes or to sure sectors to reduce the interest burden and

therefore facilitate their development. Further, the objectives behind fixing the rates on deposits are to

avoid unhealthy competition amongst the banks for deposits, stay the stage of deposit rates in alignment

with the lending rates of banks, and aid in deposit mobilization.

In addition to RBI, sure other agencies also have the power to fix rates of interest for dissimilar kinds of

financial behaviors. For example, the controller of capital issues (now abolished) used to fix the ceiling

on coupon rates on industrial debentures and preference shares. The Indian Banks Association (IBA)

had been fixing the ceiling on call rates as 1973, until 1988, when call rates were freed from the ceiling.

The Government of India fixes the rate on treasury bills and extensive-term government securities. The

Government has important power in the fixation of interest rates on extensive-term loans of

Development Fund Organizations [DFIs]. This is how the rates of interest are administered in India,

leading to a big diversity of multiple and intricate interest rates.

Realizing the deficiencies of this administered system of rates of interest and following the

recommendations of the committee to Review the working of Monetary System (under the

Chairmanship of Chakravarty), RBI has started rationalizing the interest rate building as 1991. One of

the objectives of the present policy seems to be to reduce the multiplicity of interest rates and to bring in

relation to the simplification in their building. Efforts are being made to eliminate all criteria, other than

the size of loan, while deciding the credit policy. Recent policy changes in this regard contain:

Interest rate on domestic term deposits with maturity of 30 days to one year was connected to the Bank

Rate; through stipulating interest rate on these deposits as ‗not exceeding Bank Rate minus 2 percentage

points per annum‘ from April 16. 1997;

Bringing under the similar ceiling the Non-Resident (External) (NRE) Rupee term deposits with that of

domestic term deposits;

Allowing banks to announce a distinct Prime Term Lending Rate (PTLR) for term loans of three years

and above;

Creation the banks to announce the maximum spread in excess of the PLR for all advance other than

consumer credit.

Permitting banks to prescribe distinct Prime Lending Rates (PLRs) for loan and cash credit components

and also distinct spreads for both the components.

Permitting banks to give foreign currency denominated loans to their customers for meeting either their

foreign currency or rupee necessities;

Freedom for banks to decide the rate of interest on post-shipment export credit on medium and

extensive-term foundation.

In recent years, there has been a persistent downward trend in the interest rate structure reflecting

moderation of inflationary expectations and comfortable liquidity situation. Changes in policy rates

reflected the overall softening of interest rates as the Bank Rate has been reduced in levels from 8.0

percent in July 2000 to 6.25 percent through October 2002, which is the lowest rate as May 1973.

Selective Credit Controls

Central banks, usually, have a policy to exploit qualitative techniques in addition to quantitative

techniques of credit manage. The mainly widely used of the qualitative techniques are selective credit

manage and moral suasion. While the common credit controls operate on the cost and total volume of

credit, selective credit controls relate to apparatus accessible with the monetary power for regulating the

sharing or direction of bank possessions to scrupulous sectors of the economy in accordance with the

broad national priorities measured necessary for achieving the set, developmental goals. These manage

techniques have special relevance to developing countries owing to the meager supply of credit and the

chance of credit being mis-utilised for unproductive and speculative purposes. In exercise of the

authority conferred on to it, the RBI may provide directions of the following type to the banks usually or

to any bank or a cluster of banks in scrupulous.

The purposes for which advances may or may not be made;

The margins to be maintained in respect of secured advances;

The maximum amount of advances; and

The rate of interest and other conditions and circumstances subject to which advances may be granted or

guarantees may be given.

Approximately as the transitional of 1956, RBI has started exercising authority vested in it. A number of

commodities and products have been sheltered at one time or the other. Some of the commodities, which

had been under frequent controls, are food grains, cotton, raw jute, oil seeds, vegetable oils, sugar,

cotton yarn and textiles. Though, the situation has changed recently. After the implementation of new

economic policy in 1991, there has been a phasing out of the selective credit controls. Through the end

of 1996, approximately all the controls were virtually eliminated. The only exception being the advances

against buffer stock of sugar and unreleased stock of sugar-to-sugar mills. Though, in order to counter

temporary deterioration in price-supply situation, selective credit controls were re-imposed only for a era

of three months (from April to July 7, 1997) on bank advances against stocks of wheat. Further,

effective from October 22, 1997, differential minimum margins of 10 percent and 15 percent were

stipulated for advances against levy and free sale sugar respectively; leaving advances against buffer

stock free from periphery.

Flow of Credit

A favorable development throughout 2002-03 has been a continued augment in credit flow to the

commercial sector reflecting industrial recovery. Throughout 2002-03, nonfood credit of scheduled

commercial banks (SCBs) registered a high growth of 26.2 percent (Rs.1,40,144 crore) and, net of

mergers, it rose through 17.8 percent (Rs.95,599 crore), as against an augment of 13.6 percent

(Rs.64,302 crore) in the previous year. The incremental non-food credit-deposit ratio throughout 2002-

03 at 79 percent is the highest recorded in excess of the last five years. This is indicative of the

information that a substantial section of lend able possessions of banks has been deployed for productive

purposes. This is also borne out through the strong growth of 10.3 percent in demand deposits in 2002-

03, which is largely used for working capital necessities. The augment in total flow of funds from SCBs

to the commercial sector throughout 2002-03, Including banks' Investments in bonds/debentures/shares

of public sector undertakings and private corporate sector, commercial paper (CP) etc, was also higher at

24.5 percent (Rs.1,51,569 crore) as against 12.7 percent (Rs.69,483 crores) in the previous year. The

total flow of possessions to the commercial sector, including capital issues, global depository receipts

(GDRs) and borrowings from financial organizations was at Rs 1,88,262 crore as compared with Rs

1,42,082 crore in the previous year.

In order to introduce a unit of discipline in the utilization of bank credit, especially through big

borrowers, the loan component was raised progressively from 75 percent in April 1995 to 80 percent in

April 1997. Further, the instructions relating to the computation of Maximum Permissible Bank Fund

(MPBF) for working capital necessities have been withdrawn. Banks were permitted to evolve their own

methods for assessing working capital necessities of borrowers. In a biggest departure from the past,

banks were permitted to frame their own ground rules for consortium arrangements. In order to

introduce further flexibility in the credit delivery system, banks were given freedom to shape or not to

shape a consortium, even if the credit limit of the borrower exceeds Rs. 50 crores.

Keeping in view of require supporting the efforts to revive the capital market, banks were allowed to

extend loans to corporate against shares held through them to enable such corporate to meet the

promoters‘ contribution. The periphery and the era of repayment of such loans would be determined

through banks. Banks were also permitted to sanction bridge loans to companies against expected equity

flows for an era not exceeding one year, subject to the guidelines approved through their respective

boards. Taking into explanation the changing scenario, banks were asked to review the existing

arrangements for financing deal and services. The RBI directed banks to evolve an appropriate method

of assessing loan necessities of borrowers in the service sector and statement the arrangements made in

this regard. It is clear from the foregoing discussion that the changes in the monetary and credit policies

power working capital decisions in conditions of the availability of credit and cost of credit directly and

by the ‗balancing of the economy‘ indirectly.

Financial Markets

The role of financial markets is paramount, in the mobilization and allocation of savings in the economy.

They are the agencies that give necessary funds for all productive purposes. In addition, the role of

financial markets is increasingly becoming critical in transmitting signals for policy and in facilitating

liquidity management. They are regarded as an essential adjunct to economic growth. The real economy

can be sound and productive only when financial markets operate on prudent rows. The largest

organized financial markets in India are:

The credit market, which is dominated through commercial banks;

The money market with call money segment forming a sizeable proportion;

Equity and term lending market consisting of primary, secondary and term lending segments;

Corporate debt market comprising PSU bonds and corporate debentures;

Gilt-edged market for Government securities;

Housing fund market;

Hire purchase and leasing fund market, wherein the non-bank financial companies (NBFCs)

predominate;

Insurance market; and

Foreign swap market.

In addition, there is an unorganized and informal fund market comprising of money lenders in villages

and indigenous bankers in towns/municipalities. All the agencies constitute the financial sector of India.

In the recent past (as 1991) government has embarked upon effecting biggest changes in the regions of

industrial deal and swap rate policies. These changes are intended to correct the macro-economic

imbalances and effect structural adjustments with the objective of bringing in relation to the more

competitive system and promoting efficiency in the real sectors of the economy. Economic reforms in

the real sectors of the economy will not produce desired results, unless the former are supplemented

through appropriate and effective financial sector reforms. With this end in view, the Government of

India has appointed a committee on the working of financial system of the country in August 1991 under

the chairmanship of M.Narasimham.

The committee was asked, inter alia, to look at the existing building of the financial system and its

several components and to create recommendations for improving the efficiency and effectiveness of the

system with scrupulous reference to the economy of operations, accountability, and profitability of the

commercial banks and financial organizations. The committee has submitted its statement in November

1991. As the submission of the statement, the Government has taken many steps on dissimilar

characteristics of the recommendations. The important steps that were taken are:

A strict criterion was evolved for companies that access securities markets. The issuers of securities are

required to meet sure standards like the payment of dividend, minimum share-holding requirement, etc.

The Securities and Swap Board of India (SEBI) took many steps for widening and deepening dissimilar

segments of the market for promoting investor defense and market development;

The safety and integrity of the securities market were strengthened by the organization of risk

management events, which incorporated a comprehensive system of margins, intra-day trading and

exposure limits, capital adequacy norms for brokers and setting up of deal/resolution guarantee funds.

Reforms in the secondary market focused on improving market transparency, integrity, and

infrastructure.

FIIs were permitted to invest up to 10 per cent in equity of any company, to invest in unlisted companies

and to invest in debt securities without any requirement for investment in equity. They were also

permitted to invest in dated government securities within the framework of guidelines on FII investment

in debt instruments.

Government has also initiated events to deepen and broaden the government securities market and

augment its liquidity.

The earlier restriction that debt instruments of a corporate could be listed only after its equity had been

listed on any swap was removed.

Investment guidelines concerning the utilization of funds of LIC were revised.

The Mutual Finance Regulations issued through SEBI in 1993 were further revised on the foundation of

a special revise commissioned through it.

Economic Liberalisation and Industry

The economic liberalisation programmed initiated through the Government in the early nineties has

changed the face of industry, more particularly the dynamics of financial habitation. There has been a

sea transform in the organizational building and operations of the players in money and capital markets.

The distinction flanked by extensive term financing and short term financing is gradually on the wane.

Development Banks are now converting themselves into ordinary commercial banks. Deregulation of

interest rates, emergence of a liberalized capital market and rising participation of bank in conditions of

financing have significantly convinced the operations of development banks. With their fray into the

realm of working capital loans; the traditional divide into the operational domain of development banks

and commercial banks is receiving blurred. One of the implications of this development is that the

hitherto privileged access to assured sources of low cost funds will disappear. There has already been an

effort to align all the forces to market create the latter decide the equilibrium flanked by supply of and

demand for funds.

The monetary policy framework has undergone changes in excess of the recent era in response to

reforms in the financial sector and the rising external orientation of the economy. The endeavor of the

policy has been to enhance the allocative efficiency of the financial sector, preserve financial continuity,

and improve the transmission mechanism of monetary policy through moving from direct to indirect

instruments. The stance of the monetary policy has been to ensure provision of adequate liquidity to

meet credit growth and suggest investment demand in the economy, while continuing a vigil on the

movements in the price stage and to continue with the present policy of interest rate building in the

medium term. On the fiscal front, the government expenditure has been cut in real conditions. The burnt

has been borne through cuts in investments and expenditure on social sector.

There were big slippages in the fiscal correction. The growing deficits on the revenue explanation are

often cited as the largest reason for the observed phenomenon. Behind these lie the erosion of excise tax

base, mounting interest burden on public debt, rising subsidies and the growing cost of wages and

salaries. On the external front, following the liberalisation, India devalued its currency leaving an impact

on the exports and imports. With an unsuccessful interlude with exam scripts and dual swap rate system;

India went in for a unified market determined swap rate system. Correcting the swap rate valuation of

the past was a biggest event on the reform procedure. The lower swap rate enhances the profitability of

existing exports, more importantly, it broadens the range of eligible exports. It creates imports more

costly and gives scope for import substitution, therefore narrowing the range of potential imports. The

rupee is now convertible on current explanation, subject to swap rate risk. Some of the significant

components of capital explanation are substantially liberalized.

Another dimension of the liberalisation on the external front is that the gates for foreign investment were

wide open. foreign deal and foreign investment seem to be mutually influential. Portfolio investments

have become extremely important in many developing countries, including India. Just as to a revise

mannered through Business Row (dated 28-03-04) foreign investors manage 30 percent of India‘s top

companies. In conditions of wealth, foreigners now manage a third of the market capitalization of the

Nifty Companies ( 50 in number). A further analysis of the share-holding patterns suggests that there is

an augment in the holding in such sectors as oil, gas, petro-chemical, authority, and automobiles. One

might wonder, if East India Company Syndrome – a sort of creeping acquisition of effective manage and

wealth – is under method.

These growths produce some direct and some indirect effects on the growth and development of Indian

industry in the years to approach . More specifically, growths in the financial sector pose serious

concerns for the effective exploit of working capital through the industry.

DETERMINATION OF WORKING CAPITAL

Determination of Working Capital Requires : Dissimilar Approaches

The question that what is the adequate amount of working capital required to run a business, is

attempted to be answered in many ways. Theoreticians, through their natural inclination to construct

models, have based their analogy on sure foundations and constructed models to estimate the optimum

investment in working capital. Whereas, lenders such as banks, financial organizations have based their

decisions on manufacture schedules and industry practices. In flanked by, a new point of view was

urbanized calling for the adoption of a strategic approach to the decision-creation . Let us now talk about

these theoretical issues to further our understanding of the subject matter.

Industry Norm Approach

This approach is based on the premise that every company is guided through the industry practice. If a

majority of the elements constituting a scrupulous industry adopt a kind of practice, other elements may

also follow suit. This may finally, turn out to be an industry practice. This practice decides the normal

stage of investment in dissimilar current asset things. As a matter of information, optimum stage of

investment in receivables is to a great extent convinced through the industry practices. If majority of the

firms of a scrupulous industry have been granting say three months credit to a customer, others will have

no other method except for to follow the majority; due to the fear of losing customers. However there is

no foundation for such a kind of fear in fixing norms for other things of current assets, elements usually

prefers to follow majority.

Though, the troubles in following this kind of an approach are obvious: The classification of elements

into a scrupulous industry is not that simple. Firms may not be susceptible for such a neat classification;

when the elements are multi-product firms.

Deciding a standard to symbolize a scrupulous industry is highly hard. The norms, therefore , urbanized

can be less of a reality and more of a myth.

Averages have no meaning to several firms, as the nature of firms differs.

Industry norm approach may result in imitative behaviour resulting in damage to innovation.

This approach may also promote ‗difficult mentality‘, therefore limiting the scope for quality. For

instance, if X element is able to uphold its manufacture schedule with only one month requirement of

raw material, while the industry norm being 2 months, there is no wisdom as to why X should also stay

2 months.

Industry norm approach is not suggested through several as a benchmark for creation investment in

current assets. Nevertheless, this has been a practice followed through several as a custom, even the

Tandon Committee has urbanized norms for maintenance of current assets on industry foundation.

Economic Modeling Approach

Model structure, of late, has become a crucial exercise in several disciplines. Theoreticians are creation

efforts to be as much precise as possible. Widespread exploit of quantitative techniques has helped

theoreticians to develop a framework to test their hypotheses. Models effort to suggest an optimum

solution to a given problem. As in the case of several disciplines, in the region of fund also model

structure has been attempted. As distant as working capital is concerned, optimum investment in

inventory is sought to be decided with the help of EOQ model. This has turned out to be a significant

concept in the purchase of raw materials and in the storage of finished goods and in-transit inventories.

William J. Baumol has attempted to apply this inventory model to the determination of optimum cash

balances that can be held through an enterprise. The transactions demand for money is sought to be

analyzed from this point of view. As per the model, the optimum stage of cash is decided through the

carrying cost of holding cash and the cost of transferring marketable securities to cash and vice versa.

Likewise, the decision to sell to a scrupulous explanation should be based objectively upon the

application of profit maximizing model. In this regard, Robert M. Soldofsky urbanized a model for

Explanations receivable management. He has laid down the following formula for creation a credit

decision, leading to optimum investment in receivables.

However models are accessible to decide optimum investment in case of some significant components

of working capital, for several other things, no such modeling is attempted; nor is there an effort at the

aggregate stage. Moreover, these models are subject to sure assumptions and circumstances. Their utility

comes under scrutiny for want of these assumptions turning out to be distant from reality. For this and

many other causes, economic modeling is not much popular with Indian companies.

Strategic Choice Approach

Unlike industry norm approach and economic modeling approach, this is not an average method which

suggests sure benchmarks to work with. The earlier methods suggest the exploit of sure yardsticks or

guidelines, irrespective of the differences in size of the business elements, nature of industry, business

building, or competition. For instance, optimum investment in inventory can be had through applying

the equation and it is approximately universal for every business element. Likewise, industry norm

approach suggests the similar yardstick for every element constituting that industry, in spite of variations

in the size, nature of business, conditions of sale and purchase, and competition.

In contrast, the strategic choice approach recognizes the variations in business practice and advocates

the exploit of ‗strategy‘ in taking working capital decisions. The spirit behind this approach is to prepare

the element to face challenges of competition and take a strategic location in the market lay. The

emphasis is on the strategic behaviour of the business element. The firm is self-governing in choosing its

own course of activity; not necessarily guided through the rules of the industry. This creates it obligatory

on the section of the firm to set its own targets for attainment in the region of working capital. For

example, if the firm has set an objective like rising market share from the present stage of 20 percent to

40 percent, it can think of devising an appropriate credit policy. Such a policy may involve variations in

the conditions followed at present such as extending the credit era, enhancing the credit limit or rising

the percentage of cash discount, etc.

Therefore , the strategic choice approach presupposes a highly competitive habitation and the

willingness of the management to take risks. The success of the approach also depends on the skill of the

management to set realistic goals and prepare appropriate strategy to achieve them. Any wrong

scheduling will lead the firm into trouble; much worse than what it was when either of the earlier

methods were being followed.

Factors Influencing Determination

The working capital necessities of a firm depend on a number of factors. It is a general proposition that

the size of working capital is a function of sales. Sales alone will not determine the size of the working

capital, but instead it is constantly affected through the criss-crossing economic currents flowing in a

business. The nature of the firm‘s behaviors, the industrial health of the country, the availability of

materials, the ease or tightness of the money market, are all sections of these shifting forces. Of them,

the power of operating cycle is measured paramount.

Operating Cycle

As working capital is represented through the sum of current assets, the investment in the similar is

determined through the stage of each current asset thing. To a big extent, the investment in current asset

things is decided through the ‗Operating Cycle‘ (OC) of the enterprise. The concept of operating cycle is

extremely important for computation of working capital necessities. The size of investment in each

component of working capital is decided through the length of O.C. The term operating cycle can be

understood to symbolize the length of time required for the completion of each of the levels of operation

involved in respect of working capital things. This helps portray dissimilar levels of manufacturing

action in its several manifestations, such as peaks and troughs, beside with the required supporting stage

of investment at each level in working capital. The sum of these level-wise investments is the total

amount of working capital required to support the manufacturing action at dissimilar levels of the cycle.

The four significant levels of that can be recognized as:

Raw materials and stores inventory level

Work-in-progress level

Finished goods inventory level

Book Debts level

The following is the formula used to arrive at the OC era in an enterprise.

‗t‘ = (r–c) + w + f + b, where

‗t‘ = stands for the total era of the operating cycle in number of days;

‗r‘ = the number of days of raw materials and stores consumption necessities held in raw materials and

stores inventory;

‗c‘ = the number of days purchases, incorporated in deal creditors;

‗w‘ = the number of days of cost of manufacture held in work-in-progress;

‗f‘ = the number of days cost of sales incorporated in finished goods; and

‗b‘ = the number of days sales in book debts.

The computations involved are:

The standard inventory or book debts stage can be arrived at through finding the mean flanked by the

relevant opening and closing balances for the year. The standard consumption or output or cost of sales

or sales per day can be obtained through dividing the respective annual figures through 365.

The first comprehensive and coherent exposition of the OC concept looks to be that of Park and

Gladson. They attempted to set up how current assets and liabilities were — the two determinants of

working capital. This search led them to the conclusion that the prevailing one-year temporal average

applied in classifying assets or liabilities as current‘ was not universally valid. What was current or non

current depended on the nature of the core business action. Therefore , for a fruit processing business

two to three months would be the correct criterion of currentness. For alumbering or wine-creation

business, though, an era of longer than one year would be the average . Flanked by such extremes, the

currentness of era for each business would be a function of the nature of its vital action as dictated

through the technical necessities and trading conventions.

Instead they used the term ‗natural business year‘ within which an action cycle is completed. Later, the

accounting principles board of the American Institute of the Certified Public Accountants while defining

working capital used this concept. In addition to the power of operating cycle, there is a diversity of

factors that power the determination of working capital. A brief account of the similar is provided

hereunder.

Nature of Business

A company‘s working capital necessities are directly related to the kind of business operations. In some

industries like public utility services the consumers are usually asked to create payments in advance and

the money therefore received is used for meeting the necessities of current assets. Such industries can

carry on their business with comparatively less working capital. On the contrary, industries like cotton,

jute etc. may have to purchase raw materials for the entire of the year only throughout the harvesting

season, which obviously increases the working capital requires in that era.

Management’s Attitude Towards Risk

Management‘s attitude towards risk also powers the size of working capital in an undertaking. It is, of

course, hard to provide a extremely precise and determinable meaning to the management‘s attitude

towards risk, but as suggested through Walker, the following principles involving risk may serve as the

foundation of policy formulation:

If working capital is varied comparative to sales the amount of risk that firm assumes also varies and the

opportunity for gain or loss is increased;

Capital should be invested in each component of working capital as extensive as the equity location of

the firm increases;

The kind of capital used to fund working capital directly affects the amount of risk that a firm assumes

as well as the opportunity for gain or loss and cost of capital; and

The greater the disparity flanked by the maturities of a firm‘s short-term debt instruments and flow of

internally generated funds, the greater the risk and vice-versa.

Briefly, these principles imply that the policies governing the size of the working capital are determined

through the amount of risk, which the management is prepared to undertake.

Growth and Expansion of Business

It is logical to anticipate that superior amounts of working capital are needed to support the rising

operations of a business concern. But, there is no easy formula to set up the link flanked by growth in

the company‘s volume of business and the growth of working capital. The critical information is that

require for increased working capital funds does not follow the growth in business action but precedes it.

Citerus paribus, growth industries need more working capital than those that are static.

Product Policies

Depending upon the type of things manufactured through adjusting its manufacture schedules a

company may be able to off-set the effects of seasonal fluctuations upon working capital. The choice

rests flanked by varying output in order to adjust inventories to seasonal necessities and maintaining a

steady rate of manufacture and permitting stocks of inventories to build up throughout off-season era. In

the first example, inventories are kept to minimum stages; in the second, the uniform manufacturing rate

avoids high fluctuations of manufacture schedules but enlarged inventory stocks make special risks and

costs.

Location of the Business Cycle

Besides the nature of business, manufacturing procedure and manufacture policies, cyclical and seasonal

changes also power the size and behaviour of working capital. Throughout the upswing of the cycle and

the busy season of the enterprise, there will be require for a superior amount of working capital to cover

the lag flanked by increased require and the receipts. The cyclical and seasonal changes largely power

the size of the working capital by the inventory stock. As regards the behaviour of inventory throughout

the business cycles, there is no unanimity of opinion in the middle of economists. A few say that

inventory moves in conventionality with business action. While others hold the view that business action

depends upon the behaviour of the inventory of finished goods which is determined through the credit

mechanism and short-term rate of interest. Whatever are the view points, the information leftovers that

the cyclical changes do power the size of the working capital.

Conditions of Purchase and Sale

The magnitude of the working capital of a business is also affected through the conditions of purchase

and sale. If, for example, an undertaking purchases its materials on credit foundation and sells its

finished goods on cash foundation, it needs less working capital in excess of an undertaking which is

following the other method of purchasing on cash foundation, and selling on credit foundation. It all

depends on the management‘s discretion to set credit conditions in consideration with the prevailing

market circumstances and industry practices.

Miscellaneous

Separately from the factors some others like the operating efficiency, profit stages, management‘s

policies towards dividends, depreciation and other reserves, price stage changes, shifts in demand for

products competitive circumstances, vagaries in supply of raw materials, import policy of the

government, hazards and contingencies in the nature of business, etc., also determine the amount of

working capital required through an undertaking.

Tandon Committee Norms

As mid-sixties, the issue of financing working capital has been engaging the attention of industry and

the policy makers. The events taken through the Reserve Bank of India incorporated the introduction of

Credit Authorization Scheme in November 1965, Constitution of the Dahejia Committee in October

1968, Tandon Committee in July 1974, and the Chore Committee in March 1979. In excess of the years,

effort has been made to streamline the flow of credit from the banking sector to the industry. The link

flanked by financing of working capital and the recommendations of several committees is that the latter

tried to create out a case for fixing norms for the maintenance of several current assets; therefore

leading to the determination of optimum working capital.

In this regard, Tandon Committee, for the first time, made an effort to prescribe norms for holding

diverse current asset things. The committee wanted the commercial banks to quantify the desirable stage

of net working capital and the maximum permissible lending through the banks. In its approach to the

methods of lending, the Committee sought to identify the ‗Reasonable stage of current assets‘ as the

foundation of its calculation of dissimilar methods. In other languages, the total of current assets is based

on the norms suggested through them rather than the actual current assets held through the undertakings.

For this purpose, the Committee suggested norms for carrying raw materials, work-in-progress, finished

goods, and receivables in respect of 15 biggest industries. The norms for the four types of assets are

related in the following manner:

Kind of Asset Relation to

1. Raw Materials Month‘s consumption of raw materials

2. Work-in-progress Month‘s cost of manufacture

3. Finished goods Month‘s cost of sales

4. Receivables Month‘s sales

The norms symbolize the maximum stages of inventories and receivables in each kind of industry. It is

further laid down that, if the holding of any type of asset is higher than the stage fixed through the

comparative norms, the surplus would be treated ‗excess‘ holding to be shed off, failing which an

amount equal to the value thereof would be treated as excess borrowing and a levy of penal rate of

interest is suggested on such excess borrowing. Again, it is not permitted to set off such excess against

any shortfall in the holding of other current assets, as the norms symbolize the maximum permissible

stages of holdings. The list of fifteen industries incorporated cotton textiles, synthetic textiles, jute,

pharmaceuticals, rubber, fertilizers, vanaspati, paper and engineering. This system of lending sustained

with small variations approximately up to the beginning of the present decade. But there is no transform

in the vital philosophy as to the assessment of working capital norms, based on the industry norm

approach.

Present Policy of Banks

After the implementation of a phased liberation programme as 1991, the RBI decided to allow full

operational freedom to the banks in assessing the working capital necessities of the borrowers. All the

instructions relating to Maximum Permissible Bank Fund (MPBF) have been withdrawn. As an

alternative, a revised system of assessing working capital limits has been evolved. Accordingly, one of

the following three methods has been suggested for adoption through the commercial banks.

Turnover method

Eligible working capital limit method

Cash-flow method

Under the ‗Turnover method‘, working capital necessities of all the borrowers enjoying aggregate

finance based working capital limits up to Rs.2 crore from the banking system are being assessed on the

foundation of a minimum of 25% of their projected annual turnover. Of this, 5% of the annual turnover

should be brought through method of promoter‘s contribution. Therefore , the remaining 20 % is only

financed through the banks.

As is apparent, this call for a transform in the approach of the RBI in assessing working capital requires

of the industrial elements. The industry norm approach followed so distant yields a lay to the easy

turnover method and norms have no role to play. Higher the turnover, higher would be the credit facility

accessible. In the earlier system, (industry norm approach), maintenance of a high stage of current assets

or any other assets has no significance to the computation of working capital requires, excepting the

industry norms fixed on some practical foundation. On the contrary, elements having higher turnover are

permitted to hold higher current assets, however as per norms it is excess. Moreover, this kind of a

practice encourages firms to stock materials and finished goods with lax inventory manage. Little firms

lag in competition to big firms, as there is an inherent advantage to the latter.

Alternatively banks may also follow ‗Cash-flow method‘ to fund the working capital requires of the

industrial elements. Under this method, banks will meet the deficit if any due to payments being higher

than the receipts in that month. For this purpose, borrowers are instructed to prepare monthly cash flow

statements and impose sure manage events to ensure smooth operation of the system. This method too

abandons the industry norm approach in assessing working capital requires. This method takes into

explanation only the variation flanked by receipts and payments. This variation may arise for many

causes and may not be entirely due to changes in working capital things. However care is expected to be

taken through the industrial elements in preparing cash flow statements, implementation of the method

in practice will only highlight its suitability.

THEORIES AND APPROACHES

Making of Value by Working Capital Management

Making of value has been said to be the objective of a company. In the realm of fund it turns out to be

the function of firm‘s investment, financing and dividend decisions. In addition to extensive term

investment decisions, companies face several decisions involving investment in current assets. Quite

often, maximization of profits is regarded as the proper objective of the firm. but it is not as inclusive as

that of maximizing shareholders‘ value. A right type of approach to decisions of investment and

financing of working capital can contribute to the attainment of the objective function.

Value maximization is measured constant with the interests of several clusters that interact with the

business. Take for example shareholders; businesses can often do what individuals cannot do on their

own. Business homes pool up possessions and engage in mass manufacture, which is beyond the

capability of an individual as shareholder. Perpetual succession ensures sufficient confidence to a

creditor. The point of view of community is well taken care of, as there is a realization on the company

that it cannot pursue profit maximization as a goal. A framework is therefore created for analyzing the

financial decisions from the standpoint of maximizing value.

Be that as it may, how should one proceed to make value by working capital management. The answer

is: invest in an asset, if its net present value is positive. The information is that the vital principles of

extensive term asset investment decisions should apply equally well to short term asset investment

decisions. So, it is useful to look at this criterion more closely in conditions of current asset investment

decisions. The common formula for finding net present value of a project is:

Where A1 to A symbolize annual cash inflows on an after tax foundation. ‗K‘ is the discount factor,

which is usually taken as the cost of capital. ‗C‘ symbolizes the initial outflow.

This equation can be used to decide the choice of investment in current assets taking into explanation

their shorter life span. Accepting one year life as average to categories assets into fixed and current,

NPV has to be calculated for each year. For this purpose, the equation can be customized as follows to

elicit NPV.

Like the decisions in capital budgeting, the problem leftovers as that of determination of risk and

therefore the appropriate discount rate to apply. Sometimes, practitioners tend to exploit net profit

criterion to decide the investment in current assets; which they believe is an easy modification of the

concept of NPV as shown below:

Approaches to Working Capital Investment

Every business enterprise requires paying scrupulous attention towards the scheduling and managing of

working capital. Dissimilar approaches have been suggested for this purpose. Of them, let us focus our

attention on the following two approaches:

Walker‘s approach

Deal off approach

Walker’s Approach

Early in 1964 Ernest W. Walker has urbanized a four-section theory of working capital. He has lain

down that a firm‘s profitability is determined in section through the method its working capital is

supervised. When the working capital is varied comparative to sales without a corresponding transform

in manufacture, the profit location is affected. If the flow of funds created through the movement of

working capital is interrupted, the turnover of working capital is decreased, as is the rate of return on

investment. In this regard. Walker has laid down the following four principles with respect to working

capital investment.

First Principle

This is concerned with the relation flanked by the stages of working capital and sales. His principle is

that: if working capital is varied comparative to sales, the amount of risk that a firm assumes is also

varied and the opportunity for gain or loss is increased. This implies that a definite relation exists

flanked by the degree of risk that management assumes and the rate of return. The more the risk that a

firm assumes, the greater is the opportunity for gain or loss. Believe the following Table 1.2:

Table 1.2 XYZ Manufacturing Company

It can be seen from the data that the return on investment has increased from 7.6 percent to 16.6 per cent

when working capital fell from Rs. 1,20,000 to Rs.50,000. Moreover, it is whispered that while the

potential gain resulting from each decrease in working capital is greater in the beginning than potential

loss, exactly opposite occurs, if the management continues to decrease working capital (see-Figure 1.2).

Fig. 1.2 Working Capital Relative to Sales

It is also presumed that through analyzing correctly the factors determining the amount of the several

components of working capital as well as predictions of the state of the economy, management can

determine the ideal stage of working capital that will equilibrate its rate of return with its skill to assume

risk. Though, as mainly managers do not know what the future holds, they tend to uphold an investment

in working capital that exceeds the ideal stage. It is this excess that concerns us, as the size of the

investment determines a firm‘s rate of return on investment.

Second Principle

Capital should be invested in each component of working capital as extensive as the equity location of

the firm increases. This principle is based on the concept that each rupee invested in fixed or working

capital should contribute to the net worth of the firm.

Third Principle

The kind of capital used to fund working capital directly affects the amount of risk that a firm assumes

as well as the opportunity for gain or loss and cost of capital. It is indisputable that dissimilar kinds of

capital possess varying degrees of risk. Investors relate the price for which they are willing to sell their

capital to this risk. They may charge less for debt than equity, as debt capital possesses less risk.

Therefore risk is related to the return. Higher risk may imply a higher return too. Unlike rate of return,

cost of capital moves inversely with risk. As additional risk capital is employed through management,

cost of capital declines. This connection prevails until the firm‘s optimum capital building is achieved.

Fourth Principle

The greater the disparity flanked by the maturities of a firm‘s short-term debt instruments and its flow of

internally generated funds, the greater the risk and vice-versa. This principle is based on the analogy that

the exploit of debt is recommended and the amount to be used is determined through the stage of risk,

management wishes to assume. It should be noted that risk is not only associated with the amount of

debt used comparative to equity, it is also related to the nature of the contracts negotiated through the

borrower. Some of the more significant aspects of debt contracts directly affecting a firm‘s operation are

restrictive clauses of the contracts and dates of maturity.

Lenders of short-term funds are particularly conscious of this problem, and in an attempt to protect them

selves through reducing the risk associated with improper maturity dates, they are requiring firms to

produce documents depicting cash flows. These documents when properly prepared, not only illustrate

the stage of loans necessary to support sales but also indicate when the loans can be repaid. In other

languages, lenders realize that a firm‘s skill to repay short-term loans is directly related to cash flow and

not to earnings, and so, a firm should create every attempt to the maturities to its flow of internally

generated funds.

Deal off Approach

It is apparent from the revise of Walker‘s principles that working capital decisions involve a deal-off

flanked by risk and return. All decisions of the financial manager are assumed to be geared to

maximization of shareholders wealth, and working capital decisions are no exception. Accordingly. risk-

return deal-off characterizes each of the working capital decision. There are two kinds of risks inherent

in working capital management, namely, liquidity risk and opportunity loss risk. Liquidity risk is the

non-availability of cash to pay a liability that falls due. Even however it may occur only on sure days, it

can reason, not only a loss of reputation but also create the work condition unfavorable for receiving the

best conditions on transaction with the deal creditors. The other risk involved in working capital

management is the risk of opportunity loss i.e. risk of having too small inventory to uphold manufacture

and sales, or the risk of not granting adequate credit for realizing the achievable stage of sales. In other

languages, it is the risk of not being able to produce more or sell more or both, and so, not being able to

earn the potential profit, because there are not sufficient funds to support higher inventory and book

debts. Therefore , it would not be out of lay to mention that it is only theoretical that the current assets

could all take zero values. Indeed, it is neither practicable nor advisable. In practice, all current assets

take positive values, because firms seek to reduce working capital risks.

The risk-return deal-off involved in managing the firm‘s liquidity via investing in marketable securities

is illustrated in the following instance. Firms A and B are identical in every respect but one. Firm B has

invested Rs.5,000 in marketable securities which has been financed with equity. That is, the firm sold

equity shares and raised Rs.5,000.00. The balance sheets and net incomes of the two firms are shown in

Table 1.3. Note that Firm A has a current ratio of 2.5 (reflecting net working capital of Rs. 15,000) and

earns a 10 percent return on its total assets. Firm B, with its superior investment in marketable securities

has a current ratio of 3 and has net working capital of Rs.20,000. As the marketable securities earn a

return of only 9 percent before taxes (4.5 percent after taxes with a 50 percent tax rate). Firm B earns

only 9.7 percent on its total investment. Therefore , investing in current assets and in scrupulous in

marketable securities, does have a favorable effect on firm‘s liquidity but it also has an unfavorable

effect on the firm's rate of return earned on invested funds. The risk-return deal-off involved in holding

more cash and marketable securities, so, is one of added liquidity versus reduced profitability.

Table 1.3 The Effects of Investing in Current Assets on Liquidity and Profitability

Approach to Financing Working Capital

Financing the firm‘s working capital necessities has been shown to involve simultaneous and inter-

related decisions concerning the firm‘s investment in current assets. Fortunately, there exists a principle,

which can be used as a guide to firm‘s working capital financing decisions. This is the hedging principle

or matching principle. Basically speaking, the hedging principle involves matching the cash flow

generating aspects of an asset with the maturity of the source of financing used to fund its acquisition.

For instance, a seasonal expansion in inventories, just as to the hedging principle, should be financed

with a short-term loan or current liability. The rationale underlying the rule is straightforward. Funds are

needed for a limited era of time, and when that time has passed, the cash needed to repay the loan will

be generated through the sale of the extra inventory things. Obtaining the needed funds from an

extensive-term source (longer than one year) would mean that the firm would still have the funds after

the inventories (they helped fund) have been sold. In this case the firm would have ―excess‖ liquidity,

which they either hold in cash or invest in low yielding marketable securities until the seasonal augment

in inventories occurs again and the funds are needed. This would result in an in excess of-all lowering of

firm profits.

Let us take another instance in which a firm purchases a new packing machine, which is expected to

produce cash saving to the firm through eliminating require for two laborers and, consequently their

salaries. This amounts to an annual savings of Rs.20,000. while the new machine costs Rs. 1,00,000 to

install and will last 10 years. If the firm chooses to fund this asset with a one-year loan, then it will not

be able to repay the loan from the cash flow generated through the asset. Hence, in accordance with the

hedging principle, the firm should fund the asset with a source of financing that more almost matches

the expected life and cash flow generating aspects of the asset. In this case a 7 to 10-year loan would be

more appropriate than a one-year loan. To put it extremely succinctly the hedging principle states that

the firm‘s assets not financed through spontaneous sources should be financed in accordance with the

rule: permanent assets (including permanent working capital requires) financed with long-term sources

and temporary assets (viz. fluctuating working capital require) with short-term sources of fund towards

the liquidity risk. We may graphically show the hedging principle as depicted in Figure 1.3A

Fig. 1.3A Hedging Financing Strategy

Note that permanent asset requires are matched exactly with spontaneous plus extensive-term sources of

financing while temporary current assets are financed with short-term sources of financing. This may be

termed as hedging financing strategy. In practice we may approach crossways sure modifications of this

strict hedging strategy. Figure 1.3B and 1.3C depict two modifications.

Fig. 1.3B Conservative Financing Strategy: Long-term Financing Exceeds Permanent Assests

Shaded region symbolizes the firm‘s exploit of extensive-term plus spontaneous financing in excess of

the firm‘s permanent asset financing requires.

Fig. 1.3C Aggressive Financing Strategy: Permanent Reliance on Short-term Financing

Shaded region reflects the firm‘s continuous exploit of short-term financing to support its permanent

asset requires. The firm follows a more careful plan, whereby extensive-term sources of financing

exceed permanent assets in trough era such that excess cash is accessible (which necessity is invested in

marketable securities). Note that the firm actually has excess liquidity throughout the low ebb of its asset

cycle and therefore faces a lower risk of being caught short of cash than a firm that follows the pure

hedging approach. Though, the firm also increases its investment in relatively low-yielding assets such

that its return on investment is diminished.

In contrast, Figure 1.3C depicts a firm that continually finances a section of its permanent asset requires

with short term funds and therefore follows a more aggressive strategy in managing its working capital.

It can be seen that even when its investment in asset requires is lowest the firm necessity still rely on

short-term financing. Such a firm would be subjected to increased risks of cash shortfall, in that it

necessity depend on a continual rollover or replacement of its short-term debt with more short-term debt.

The benefit derived from following such a policy relates to the possible savings resulting from the

exploit of lower-cost short-term debt as opposed to extensive-term debt. Mainly firms will not

exclusively follow any one of the three strategies in determining their reliance on short-term credit.

Instead, a firm will at times discover itself overly reliant on extensive term financing and therefore

holding excess cash and at other times it may have to rely on short-term financing during a whole

operating cycle. The hedging principle does, though; give a significant guide concerning the appropriate

exploit of short-term credit for working capital financing.

Effect of Choice of Financing on ROI

It would be now pertinent to look at the impact of the choice of financing on, return on investment.

Believe the following Data in Table-1. 4.

Table 1.4 Effect of Choice of Financing on ROI

It is apparent from the data contained in Table 1.4 that the Firm (X) by extensive term debt has a current

ratio of 4 times and Rs.30,000 in net working capital, whereas Firm Y‘s current ratio is only 1 time,

which symbolizes zero net working capital. Because of lower interest rates on short-term debt (bank

credit in this case) Firm ‗Y‘ was able to earn a ROI of 38.6 percent compared to that of ‗X‘, which could

earn only 37.5 percent. Therefore a firm can reduce its risk of illiquidity by the exploit of extensive

term debt at the expense of a reduction of its return on investment funds. Once again we see that the

risk-return deal-off involves an increased risk of illiquidity versus increased profitability.

REVIEW QUESTIONS

Distinguish between gross working capital and net working capital?

Discuss the various types of working capital and trace out the behaviour of working capital with respect

to time?

How do you plan for the working capital of an organisation? Choose your own company as an example?

What is the Role of Central Bank in designing and implementing monetary and credit policy?

Money Supply is the key factor that reflects the volume of trade in any country, Discuss.

What are the various factors influencing the determination of working capital?

Distinguish between turnover method and cash budget method which of them do you suggest to a

banker?

Distinguish between Fixed asset management and current asset management.

How is value created through working capital management?

CHAPTER 2

Management of Current Assets

Management of Receivables Credit Policy

Designing credit policy is the first step in receivables management. In designing credit policy, the

management can follow two broad approaches. Firstly, the policy can be intended under the assumption

of unlimited manufacture/sales and funds accessible for investment in receivables. If credit policy is

intended under this assumption and subsequently some constraints are experienced on sales or funds

accessible for receivables, then managers have to restrict the credit at the time of implementing the

credit policy. But this may reason sure difficulties to customers because of deviation from the

announced credit policy. For instance, if a company announces that credit will be unlimited to sure

categories of customers based on unlimited funds assumption and subsequently refuse to grant credit due

to limited funds accessible for investment in receivables, it will make hardship to the customer. Under

the second approach, the credit policy could be intended keeping in mind the limitations on

manufacture/sales volume and funds accessible for investment in receivables. This is aimed to achieve

optimum utilization of manufacture capability and funds accessible for receivables. It also ensures

consistency of credit policy. The credit policy consists of the following components:

Credit Era

Discount

Credit Eligibility

Credit Limit

Credit Era

Decision on credit era is determined through many factors. It is significant to check the credit era given

through other firms in the industry. It would be hard to sustain through adopting a totally dissimilar

credit policy as compared to that of industry. For instance, if the industry practice is 30 days of credit

era, a firm which offers 120 days credit would certainly draw more business but the cost associated with

managing longer credit era also increases simultaneously. On the other hand, if the firm reduces the

credit era to 10 days, it would certainly reduce the cost of carrying receivables but volume would also

decline because several customers would prefer other firms, which offer 30 days credit. In other

languages, granting deal credit is an aspect of price.

The time that the buyer gets before payment is due, is one of the dimensions of the product (like

excellence, service, etc.) which determine the attractiveness of the product. Like other characteristics of

price, the firm‘s conditions of credit affect its volume. All other items being equal, longer credit era and

more liberal credit-granting policies augment sales, while shorter credit era and more stringent credit

granting policies decrease sales. These policies also affect the stage and timing of sure costs. Evaluation

of credit policy changes necessity compare with the changes in sales and additional revenues generated

through the sales as a result of this policy transform and costs effects. While additional volume and

revenue associated with such additional volume are clear and measurable, the cost effects need further

analysis.

Cost of Extending Credit Era

Lengthening credit era delays the cash inflows. For instance, suppose a firm increases the credit era from

30 days to 90 days. Customers, old as well as new, will now pay at the end of 90 days and the cash

inflows from these sales would happen further into the future. That means, the firm has to delay in

settling its dues to others or resort to short-term borrowing if the payments cannot be delayed. The

interest cost of short-term borrowing arises largely on explanation of extending the credit era.

Discount

When a firm pursues aggressive credit policy, it affects cash flows in the shape of delayed collection and

bad debts. Discounts are offered to the customers, who purchased the goods on credit, as an incentive to

provide up the credit era and pay much earlier. For instance, suppose the conditions of credit is ―3/10 net

60‖. It means if the customer, who gets 60 days credit era can pay within 10 days from the date of

purchase and get a discount of 3% on the value of order. As the customer uses the opportunity cost of

funds and availability of cash in taking decision, the cash discount should be set attractive. The discount

quantum should be greater than interest rate of short-term borrowings.

Credit Eligibility

Having intended credit era and discount rate, the after that logical step is to describe the customers, who

are eligible for the credit conditions. The credit-granting decision is critical for the seller as credit-

granting has economic value to buyers and buyer‘s decision on purchase is directly affected through this

policy. For example, if the credit eligibility conditions reject a scrupulous customer and needs the

customer to create cash purchase, the customer may not buy the product from the company and may

seem forward to someone who is agreeable to grant credit. Nevertheless, it may not be desirable to grant

credit to all customers. It may instead examine each potential buyer before deciding whether to grant

credit or not based on the attributes of that scrupulous buyer. While the earlier two conditions of credit

policy viz. credit era and discount rate are not changed regularly in order to uphold consistency in the

policy, credit eligibility is periodically reviewed. For example, an entry of new customer would warrant

a review of credit eligibility of existing customers.

The decision whether a scrupulous customer is eligible for credit conditions usually involves a detailed

analysis of some of the attributes of the customer. Credit analysts normally cluster the attributes in order

to assess the credit worthiness of customers. One traditional method of organizing the fact is through

characterizing the applicant beside five dimensions namely, Capital, Character, Collateral, Capability

and Circumstances. These five dimensions are also popularly described Five Cs of credit analysis.

Capital

The term capital here refers to financial location of the applicant firm. It needs an analysis of financial

strength and weakness of the firm in relation to other firms in the industry to assess the credit worthiness

of the firm. Financial fact is normally derived from the financial statements of the firm and analyzed by

ratio analysis. The liquidity ratios like current ratio, debt service coverage ratio, etc. are often used to get

a preliminary thought on the financial strength of the firm. Further analysis contains trend analysis and

comparison with the other industry norm or other firms in the industry.

Character

A prospective customer may have high liquidity but delay payment to their suppliers. The character

therefore relates to willingness to pay the debts. Some relevant questions relating to character are:

What is the applicant‘s history of payments to the deal?

Has the firm defaulted to other deal suppliers?

Does the applicant‘s management create a good-faith attempt to honor debts as they become due?

Fact on these regions is useful to assess the applicant‘s character.

Collateral

If a debt is supported through collateral, then the debt enjoys lower risk because in the event of default,

the debt holder can liquidate the collateral to recover the dues. The collateral reasons hardship to other

debt holders. Therefore , the analysts should seem into both the availability of collateral for the debt and

the amount of collateral the firm has given to others. In computing the liquidity of the firm, the analysts

should remove the assets used for collateral and take into explanation only the free assets. The credit

worthiness improves if the customer is willing to offer collateral assets or the value of collateral asset

backed loan is low.

Capability

The capability has two dimensions - management‘s capability to run the business and applicant firm‘s

plant capability. The future of the firm depends on the management‘s skill to meet the challenges.

Likewise, the facility should exist to use the opportunity. As the assessment of capability is a judgment

on the section of analysts, a lot of care should be taken in assessing this characteristic.

Circumstances

These are the economic circumstances in the applicant‘s industry and in the economy in common. Scope

for failure and default is high when the industry and economy are in contraction stage. Credit policy is

required to be customized when the circumstances are not favorable. The policy changes contain liberal

discount for payment within a stipulated era and imposing lower credit limit. The fact composed under

five Cs can be analyzed in common to decide whether the customer is eligible for credit or fit into a

statistical model to get an unbiased credit rating of the customer.

Credit Limit

If a customer falls within the desired limit of credit worthiness, the after that issue is fixing the credit

amount. This is some item same to banks fixing overdraft limit for the explanation holders. If a customer

is new, normally the credit limit is fixed at the lowest stage initially and expanded in excess of the era

based on the performance of the customer in meeting the liability. Credit limit may undergo a transform

depending on the changes in the credit worthiness of the customer and changes in the performance of

customer‘s industry.

Credit Evaluation Models

How the credit analysts collect the fact required for processing credit application under five Cs was

discussed. Credit evaluation models are useful for the analysts to procedure the fact to decide credit

worthiness of the customer. It is possible to building credit evaluation model in dissimilar ways. An

experienced credit analyst can evaluate the credit worthiness through basically scanning the fact

received or composed for the credit proposal. When the credit transactions augment or number of

customer increases, it may be hard to apply this methodology. It will also reason delay in processing

credit proposals and lead to inconsistent decision. Therefore , it is always useful to make a credit

evaluation system and standardize the appraisal. Decision-tree model and multivariate statistical model

are usually used to make credit evaluation system

Decision Tree Model

Under decision-tree model, credit applications are rated under dissimilar parameters. For example, if a

company uses five Cs factors, the analysts rate the credit applicant under each of the five Cs. Decision-

tree is initially created for all possible routes and decisions at the end of each circuit are indicated.

Figure 21 illustrates decision-tree model by three credit fact namely capital, character and collateral. If a

character, capital and collateral are strong, then the applicant firm is granted big amount of credit. On

the other hand, if the first two are strong but the collateral is weak, a limited credit could be granted.

Fig. 2.1 Decision Tree Credit Evolution Model

If character is weak but capital and collateral are strong, then credit is limited to collateral value. On the

other hand, if all the three are weak, it is a dangerous credit proposal and hence to be rejected. In Figure

2. 1, we have taken two broad ratings, which can be further divided into three or five level rating.

Raising the credit variable and rating level will lead to more branches and credit limit can be prescribed

for each branch apart. It is also possible to exploit the above decision-tree to decide whether a detailed

credit evaluation has to be mannered. For instance, if character, capability and circumstances are good

but capability and collateral are weak, it may need a detailed credit evaluation. That means, the fact

composed is inadequate and an intensive analysis is required.

Multivariate Statistical Model

Several firms have started by sophisticated statistical techniques in conducting their credit analysis.

Multiple Discriminate Analysis (MDA) employs a series of variables to categories people or objects into

two or more separate clusters. A credit scoring system utilizes multiple discriminate analysis to

categories potential credit customers into two clusters: good credit risk and bad credit risk. An

significant advantage of credit scoring system is that all of the variables are measured simultaneously,

rather than individually as in the decision tree analysis. The model is capable of handling both numerical

events such as debt-equity ratio, current ratio, profit periphery, etc., as well as non-numerical events like

character of the customer as good, bad, standard. When a credit scoring model is constructed with

historical data of a few customers, the model would produce a equation as given below:

The model produces the coefficient values and when a new application is received for credit scoring, the

values of Xs are to be considered and substituted in the model equation to get the discriminate score.

The discriminate is then compared with the point of isolation to lay the applicant in one of the two

clusters. For instance, if the point of isolation is 3.80, when the applicant‘s score is above 3.80, then the

applicant is placed in fair or excellent risk cluster. If the score is below 3.80, then it is risky proposal.

Therefore , it is possible to evaluate where a scrupulous customer stands in conditions of credit

worthiness. No difficulty is felt when the scores are much above or below the isolation point but credit

worthiness of customers, whose scores are secure to isolation point, are hard to assess. In such cases,

further analysis is made to understand the credit worthiness of the customers. It is also possible to

outsource credit rating evaluation from specialized credit rating agencies.

Credit scoring models are periodically updated to take into explanation changes in the habitation and

also reassess the credit worthiness of the customers. An outdated model may wrongly classify the

customers and lead to heavy losses. Further, while developing the system, it is necessary to ensure good

example for developing the model. It is equally significant that the model is validated before employing

it. Several foreign banks and credit card agencies extensively exploit credit rating schemes and establish

them useful in taking credit decision.

Rating Methodologies of Credit Rating Organizations

Credit rating has become one of the professionalized services in the recent past. However rating is more

general with dissimilar securities offered through industrial elements, there is also focus on the rating of

individuals and organizations as credit applicants. For example, CRISIL's rating methodology contains

the following key factors for deciding the credit worthiness of a borrowing company.

Business Analysis

Industry Risk (nature and foundation of competition, key success factors, demand supply location,

building of industry, cyclical/seasonal factors. Government policies etc.)

Market location of the company within the industry (market share, competitive advantages, selling and

sharing arrangements product and customer variety, etc.).

Operating efficiency of the company (vocational advantages, labor relationships, cost building, technical

advantages and manufacturing efficiency as compared to those of competitors etc.)

Legal location (conditions of prospectus, trustees and their responsibilities: systems for timely payment

and for defense against forgery/fraud; etc.)

Financial Analysis

Accounting excellence (overstatement/understatement of profits; auditors qualifications; method of

income recognition; inventory valuation and depreciation policies; off balance sheet liabilities; etc.)

Earnings defense (sources of future earnings growth; profitability ratios; earnings in relation to fixed

income charges; etc.)

Adequacy of cash flows (in relation to debt and fixed and working capital requires; sustainability of cash

flow; capital spending flexibility; working capital management etc.)

Financial flexibility (alternative financing plans in times of stress; skill to raise funds; asset

redeployment potential; etc.)

Management Evaluation

Track record of the management; scheduling and manage systems; depth of managerial talent;

succession plans.

Evaluation of capability to overcome adverse situations

Goals, philosophy and strategies

The factors are measured for companies with manufacturing behaviors. The assessment of fund

companies lays emphasis on the following factors in addition to the financial analysis and management

evaluation.

Regulatory and Competitive Habitation

Building and regulatory framework of the financial system

Trends in regulation/deregulation and their impact on the company.

Fundamental Analysis

Capital Adequacy (assessment of true net worth of the company, its adequacy in relation to the volume

of business and the risk profile of the assets.)

Asset Excellence (excellence of the company's credit-risk management systems for monitoring credit;

sector risk; exposure to individual borrowers; management of problem credits; etc.)

Liquidity Management (capital building; term matching of assets and liabilities; policy on liquid assets

in relation to financing commitments and maturing deposits.)

Profitability and Financial Location (historic profits; spreads on finance deployment; revenues on non-

finance based services; accretion to reserves; etc.)

Interest and Tax Sensitivity (exposure to interest rate changes; tax law changes and hedge against

interest rate; etc.)

Individual Credit Rating

As indicated earlier, credit rating has become more popular now, with financial instruments than

individuals. Nevertheless, there are now costing organizations like the Onida Individual credit Rating

Agency (ONICRA), developing specific methodology to help in rating individuals as consumers. The

ONICRA model considers the following three parametres as significant:

I. Individual Thoughts

Personal strengths

Qualification Job.

Continuity

Occupation Tenure

Duration of keep in personal lay of residence

Capacity –

Income

Future Occupation Prospects

Strengths

Financial characteristics

Discipline

Willingness to pay

II. Transaction Thoughts

Risk

Security

Ownership of the asset

Manage in excess of end exploit of the product collateral

Exposure

Modalities of payment

Direct deduction from salary

Advance post dated cheques

Automated debiting of bank explanation

Payment on due date

Payment on demand

III. Environmental Thoughts- Economy

Monitoring Receivables

Managing receivables does not end with granting of credit as dictated through the credit policy. It is

necessary to ensure that customers create payment as per the credit term and in the event of any

deviation, corrective actions are required. Therefore , monitoring the payment behaviour of the

customers assumes importance. There are many possible causes for customers to deviate from the

payment conditions.

Changing Customer Business Aspects

The customers, who have earlier agreed to create payment within a sure era of time, may deviate from

their acceptance and delay the payment. For instance, economic slow down or slow down in the industry

of the customers business may force the customers to delay the payment. In information, the bills

payable become discretionary cash outflow thing in economic recession. Therefore , a secure watch on

the performance of customer‘s industry is required.

Inaccurate Policy Forecasts

A wide deviation from the credit conditions and actual flow of cash flows illustrate inaccurate forecast

and defective credit policy. It is quiet possible that a firm uses defective credit rating model or wrongly

assesses the credit variable. For instance, it is quiet possible to overestimate the collateral value and then

lend more credit. If this is the cause for wide deviation, it needs updating the model or training the

employees.

Improper Policy Implementation

Often wide deviation is noticed in practice while implementing credit policy. This may not be

intentional but regularly in the shape of accommodating special requests of the customers. For instance,

a customer may not be eligible for credit or higher credit as per the model in force. The customer may

personally see the concerned manager and request her/him to relax the credit restriction. If there is no

policy in lay to trade with these kinds of request and ad hoc decisions are made, then wide deviation is

possible. Often these deviations become costly for the firm. Intervention of top officials and ad hoc

decisions are cited as biggest causes for widespread defaults in several public financial organizations.

Therefore , it is necessary to ensure that policies are implemented in letter and spirit.

Monitoring gives signals of deviation from expectations. There are many monitoring techniques

accessible to the credit managers. The monitoring system begins with aggregate analysis and then move

down to explanation-specific analysis.

Investments in Receivables

The decision to supply on credit foundation leads to investments in receivables. Credit policy is intended

in such a method that investment requires of receivables are optimized i.e. return is greater than cost

associated with investments. Credit monitoring starts with an assessment of investment in receivables as

a percentage of total assets. The investments in receivables are then compared with the budget. Any

deviation from budgeted value shows delay in collection or managers deviating shape the credit policy.

For instance, if a firm based on credit policy worked out that investments in receivables is 12%, the

actual value for the last three months is approximately 18%, there are two possible causes. Firstly, some

of the customers are not paying and therefore , the receivables value has gone up. Secondly, the

managers would be giving more credit than the prescribed limit or extend the credit era. In either case, it

needs an investigation and account from managers for the increased investment in receivables.

Collection Era

Receivables can be related to sales in dissimilar ways. The simplest shape of analysis is comparing sales

and receivables for dissimilar eras to know the trend. While this analysis provides a reasonable

understanding on how the receivables have moved in excess of the era, it fails to provide an implication

of the changes in the trend. For instance, if sales and receivables of two eras are Rs. 90 lakhs, 120 lakhs

and Rs.120 lakhs, Rs.140 lakhs respectively, the figures illustrate (i) the sales value has gone up

throughout the era, and (ii) receivables have also gone up beside with sales. A shaper focus on changes

in the trend can be obtained through computing the collection era of the two eras. The collection era is

computed as follows:

Credit sales per day are computed through dividing the total credit sale of the era through the number of

days of the era. If the sales value are related to quarterly sales value, then sales per day for the two

quarters are Rs. 1 lakh (Rs.90 lakhs/90 days) and Rs. 1.33 lakh (Rs.120 lakhs/90 days) respectively. The

collection era for the two quarters is:

Collecting Receivables

The analysis explained earlier are useful to know the trend of collection and identify customers, who are

not paying on due dates. This should enable the management to take appropriate activity to collect the

dues, which is the largest objective of receivables management. Collecting receivables begins with

timely mailing of invoices. There are many processes accessible to credit managers, who necessity

judiciously decide when, where and to what extent pressure should be applied to delinquent customers.

Management of collection action should be based on cautious comparison of likely benefits and costs.

Inexpensive processes contain periodical mailing of duplicate bills reminding the customers that the

explanation is not settled or sending a formal letter informing nonpayment of bill and requesting the

customer to pay immediately. Written follow-up on an overdue explanation is referred to as dunning. If

a customer fails to respond to these reminders, then expensive processes are initiated. Personal telephone

calls and reminder by registered post are initially tried. Even if these steps fail to deliver the desired

results, a personal visit through the credit manager or representative to sort out the issue would be

useful. If the credit manager realizes that the customer is willfully defaulting or is in deep trouble and

hence unlikely to pay the dues, a formal legal activity is initiated either to recover the dues or file a

liquidation petition before the court to recover the dues. It is hard to prescribe exactly as to which and

when these collection processes should be adopted. If collection policy is strict, then it would reduce the

outstanding receivables but at the similar time frightened several potential customers from doing

business. On the other hand, a liberal collection policy would invite several willful defaulters to do

business with the company.

The assumes that the firm takes the responsibility of collection. Two alternatives are accessible to firms

in collecting the receivables. The first one described factoring enables the firm to transfer the receivables

to factoring agent, who takes the responsibility of collection. Some factoring mediators takes the credit

risk (i.e. the factoring mediators bear the loss on explanation of bad debts) and others accept factoring

without credit risk. In India, we have factoring subsidiaries of Canara Bank, SBI, etc. and Exim Bank

does the factoring service relating to export bills. The second one is described receivables securitization.

Securitization is somewhat same to factoring but here the securitizing agent sells the elements of

receivables to investors in the market. However the concept of securitization is popular in fund related

receivables like housing loans, credit cards receivables, lease rentals, etc., the concept is gradually

spreading to other kinds of receivables. A few securitization trades have already been completed in India

and the market will witness more such transactions in the close to future.

Strategic Issues in Receivables Management

Business management today involves continuous formulation of strategies and also, to develop and carry

out tactics to implement the strategies to gain competitive advantage. The discussion on receivables

management so distant focused on operational issues such as how changes in credit policy affects

investments in receivables, how to monitor collection pattern, what are the options accessible in dealing

with delinquent customers, etc. Receivables management, though, can support the strategies being

pursued through the organisation to gain sure competitive strength.

Firms pursuing strategies to acquire cost leadership require a appropriate credit policy to support their

strategies. For example, if a firm is trying to achieve cost leadership by economies of level of

manufacture, then it has to generate a big volume of sales. As credit term is an economic variable in

buying decision, the credit conditions should be supportive to sell big volume. That means, the firm may

have to offer more days of credit particularly for those who buy in big quantity. Of course, the cost of

investment in receivables will go up initially but without a liberal credit policy, the assets created to

achieve economics of sale will be idle. In information, the additional cost of investments in receivables

requires to be measured while computing the benefit arising out of economies of level.

projects. Such type of supplier‘s credit may also be feasible when the interest cost of a domestic firm is

much higher than the interest cost of supplier firm situated in a dissimilar country.

A firm dealing with a big number of customers may discover it hard to control the receivables within the

existing organizational set up. If a few other cluster companies also face same troubles, it may start a

distinct subsidiary to control the receivables of all cluster companies. Several companies have started

their subsidiary to control share transfer occupations of cluster companies. It is also equally possible to

centralize the credit rating service of the customers by subsidiaries. Instead of starting their own

subsidiaries, it is also possible to go in for factoring services and credit rating agencies to outsource

these services. Several foreign banks outsource the services not directly related to their core behaviors in

order to stay the organisation lean. It is a method to convert several of the fixed costs into variable costs.

All these decisions have strategic implications and therefore , it is hard to visualize the receivables

management as a operational issues of management in the contemporary business habitation.

MANAGEMENT OF CASH

Motives of Holding Cash

Fixed assets are used to convert the raw materials into finished goods. Investments in current assets

cannot be avoided due to constraints in technology, manufacturing procedure and customers behaviour

of challenging dissimilar models at a point secure to her/his home and at the point of consumption.

Inventory and bills receivables have become essential to continue business operations more fruitfully.

Emphasis is always given to reduce the investments in these assets and therefore reduce the working

capital cycle. Investment in cash and marketable securities are the least productive assets. Often, firm is

not dependent on this asset in the manufacturing procedure nor is required for creating inventory or

selling. Therefore , the vital question is why firms hold cash and marketable securities?

Transaction Motive

Money is required to settle customers‘ bills, pay salary and wages to workers, pay duties and taxes, etc.

Some cash balance is to be maintained to complete these transactions. The amount to be maintained for

the transaction motive depends on the cash inflows and outflows. Often, firms prepare a cash budget

through incorporating the estimates of inflows and outflows to know whether the cash balance would be

adequate to meet the transactions.

Precautionary or Hedging Motive

The transaction motive takes into explanation the routine cash requires of the firm. It is also based on the

assumption that inflows are as per estimation. Though, the future cash requires for transaction purposes

are uncertain. The uncertainty arises on explanation of sudden augment in expenditure or delay in cash

collection or inability to source the materials and other supplies on credit foundation. The firm has to

protect itself from such contingencies through holding additional cash. This is described as

precautionary motive of holding cash balance. Precautionary cash balance is also maintained to meet the

non-routine requires. Usually, cash required for precautionary motive is held in the shape of short-term

securities with the objective to earn at least some positive return. The securities are sold and cash is

realized as and when such emergency demand for cash arises.

Speculative Motive

If the firm intends to use the opportunities that may arise in the future suddenly, it has to stay some cash

balance. The term ―speculative motive‖ to some extent is a misnomer as cash is not kept to conduct any

speculation but merely to use opportunity. This is particularly relevant in commodity sector, where the

prices of material fluctuate widely in dissimilar eras and the firm's business success depends on it‘s the

skill to source the material at the right time. Some of the materials, whose prices illustrate important

volatility, are cotton, aluminum, steel, chemicals, etc. Surplus cash is also used for taking in excess of

other firms. Firms that intend to take advantage on the above counts stay big cash balances with them,

however the similar are not required either for transactions or as a precaution.

Managing Uneven Supply and Demand for Cash

Firms usually experience some seasonality in sales, which leads to excess cash flows in sure era of the

year. This is not permanent surplus and cash is required at dissimilar points of time. One possible

solution to address this mismatch of cash flows is to pay off bank loans whenever there is excess cash

and negotiate fresh loan to meet the subsequent demands. As firms are discovered to some amount of

uncertainty in receiving the loan proposal sanctioned in time, the surplus cash is retained and invested in

short-term securities. In a competitive habitation, firms also felt the desire of holding cash to get

flexibility in meeting competition. For example, when a competitor suddenly resorts to huge

advertisement and other product promotion, it forces other firms to augment advertisement cost or some

other sales promotion such as ―free gift‖ for every purchase or lottery scheme, etc. Amount held in the

shape of cash and marketable securities of twenty manufacturing companies of BSE-30 Index (Sensex)

firms has increased from Rs. 20827.76 cr. in 1999 to Rs. 20094.91 in 2003 (Table 2.1).

Table 2.1 Investment in Cash and Marketable Securities of Manufacturing Companies in Sensex.

Determinants of Cash Flows

Investments in cash and marketable securities depend on the cash flow of the firm. Firms, which

primarily sell the product against cash (e.g. petroleum products, gold, etc.) may not need much cash

balance to be maintained as there is always cash inflows to the firm. Banks and insurance companies,

which receive cash on regular intervals, can work with smaller cash balance at branch stage. On the

other hand, firms in a competitive industry which have to extend credit to the customers require

upholding big amount of cash to meet dissimilar motives of holding cash. Cash flows are also affected

through many other factors, which can be broadly classified into internal and external factors.

Internal Factors

Internal factors relate to policies of management relating to working capital components and future

growth plan. These factors are determined through the firm and arising out of management decisions.

Manufacture-related Policies

Manufacture-related policies determine manufacture plan, which in turn affect, purchase of material and

other components and stage of finished goods. For instance, firms that follow manufacture policy of

manufacturing for inventory and then selling the product in the market will normally carry high volume

of material and other inventory in order to ensure smooth manufacture procedure. The augment in

purchase action will demand more cash compared to other firms, which follow order-based manufacture

policy. Likewise, if manufacture procedure is automated, then the demand for cash to pay wages to

workers will approach down significantly. Firms following JIT, MRP, FMS, etc., could reduce the

common stage of inventory and they also favorably contribute to the demand for cash.

Policies on Discretionary Expenses

Expenses not directly linked to the manufacturing procedure, which have some amount of flexibility in

timing the expenditure are described discretionary expenses. Examples of discretionary expenses are

Research & Development cost, advertisement, replacement of a machine before its life, etc. Some of the

discretionary expenditure is intended in advance whereas in other cases, the require arises suddenly. The

management policy on sanctioning discretionary expenses has a bearing on the cash flow. If

management follows a flexible policy and allows the expenses after seeing the current cash location, the

pressure on cash will approach down significantly.

Policies on Receivables

The policies on deal receivable, which is last level of operating cycle, affect the cash flow. The credit

era and cash discount jointly determine the flow of cash. While liberal credit policy delays cash flow,

attractive discount policy speeds up the collection procedure.

Financial Policies

Firms, which pursue active capital expenditure programme in the shape of new projects or expansion,

require cash. While section of possessions is raised externally in the shape of fresh debt or equity, the

balance is expected from the internal surplus. The financing policy of the firm determines the cash flow.

Internal funding is also expected to meet any delay in raising external sources. These firms may need

more cash to meet such eventuality. Likewise, the dividend policy of the firm affects the cash flow.

Firms, which follow liberal dividend policy, will put pressure on internal cash flows.

Payment Polices

The skill to get credit conditions for purchases of materials and other products and services also affects

the cash flow. If the firm maintains creditworthiness, it could always discover it simple to source

material and other things on credit foundation. On the other hand, if materials and other things are to be

bought on cash foundation or only limited credit era is accessible, the demand for cash increases.

External Factors

External factors can be broadly classified into monetary and fiscal factors and industry-related factors.

Monetary and Fiscal Factors

The central bank (Reserve Bank of India) periodically spells out monetary policies and by which powers

the availability of money. The monetary policy in turn is affected through the fiscal factors of the

country. In a liberal monetary policy regime, it will not be hard to get credit from banks as well as from

suppliers of material and services. Therefore , the require for holding cash is therefore limited to

transaction motive. Cash required for precautionary and speculative motives can be easily raised.

Element-2 on 'Operating Habitation of Working Capital' includes more discussion on monetary policy

issues.

Industry-related Factors

Industry-related factors affect the cash flow in the shape of practices followed through other firms in the

industry on conditions of sale and nature of material and services required. Cash flow will be positive in

retail industry. Cash flow will be cyclical for industries such as plantation and agro based products. Cash

flow is volatile in sure industries like entertainment and hospitality industry. Cash flow is usually

negative for manufacturing industries. Depending on the nature of cash flow relating to the industry, the

demand for holding cash is determined.

Cash Forecasting

An understanding of determinants of cash inflows and outflows alone is not adequate in managing cash.

It is necessary to forecast cash flows by our understanding on the determinants of cash flows of the firm.

Cash forecasting is the core of cash management. A firm, which is not forecasting the cash flows as a

section of managing the cash flows, will face unanticipated cash shortage. In order to mitigate the

unanticipated cash shortage, typically the firm will either delay the payment procedure or resort to

emergency borrowing. Delay in payments to suppliers will affect the price or delay in supply, causing

increased cost or expensive manufacture delays. Emergency borrowing will also augment the cost of

borrowings. A firm with surplus cash flow will also discover it hard to control the cash without a

forecast. As the fact on how extensive the surplus cash will remain is not recognized, there is no method

for the firm to effectively exploit the cash. If short-term surplus cash is invested for extensive-term, it

will make unanticipated cash shortage. Surplus cash lying within the firm will also encourage operating

managers to pile up the inventory and resort to several unproductive investments. Therefore , cash

forecast is inevitable in managing the cash.

A biggest problem in forecasting of cash flows is that it cannot be done independently. The determinants

are several as seen in the previous part and also highly inter-related with other budgets. Cash

forecast/budget integrates many other forecasts.

Kinds of Cash Forecast

The cash forecasts generated through the firms can be broadly differentiated under two dimensions: the

length of eras incorporated within the cash forecast and the approaches to cash flows used in the cash

forecast. Cash forecasts are normally prepared for one-year era but the forecast is broken down to many

smaller eras like, quarterly, monthly or weekly cash forecasts. The choice of scrupulous periodicity

depends on the volume of cash flows, nature of cash flows and the desirability of the management.

Firms broadly follow two approaches in the preparation of cash forecast. Under the direct approach,

firms forecast several receipts and payments things for dissimilar eras and consolidate the forecasts into

cash budget. Under indirect approach, firms start with forecast of earnings and then add back all non-

cash expenses and deduct all non-cash revenues, to get cash forecast. This is same to preparation of

funds flow/cash flow report, which is normally prepared by historical accounting fact as a section of

financial report analysis.

The format of monthly cash budget is illustrated in Table 2.2. It lists out biggest cash inflow and outflow

that arise in the normal operation of business. The instance also shows how the cash deficit and cash

surplus are dealt with to uphold the minimum balance.

Table 2.2 Monthly Cash Budget

Methods of Cash Flow Forecasting

The above Table provides the output as a result of forecasting exercise. Though, each thing in the above

Table needs many computations and assumptions. While a few cash flow things are self-governing,

many others are dependent on several other variables. Forecasting method depends on the nature of cash

flows. Some of the general methods of forecasting are explained below:

Self-governing Cash Flow Things: These cash flow things are self-governing of other factors or

predetermined. Lease rent for office structure, property tax, insurance premium, etc., are few things

which are determined independently.

Dependent Cash Flow Things: Several cash flow things are dependent on other financial variables. For

example, cash collection from sundry debtors depends on sales of the previous months, credit conditions

and collection pattern. An understanding of the connection flanked by the cash flow variables is

significant in forecasting the cash flows. If only one variable is associated with cash flow things, then

estimation is not hard. On the other hand, if many variables are associated with a cash flow thing,

econometric models are used to get the value. For example, if customers take more than two months

credit era to pay the amount, it is possible to regression model to measure the proportion of amount

composed from several months‘ sales. The model uses cash collection of the month as dependent

variable and previous month‘s sales values as self-governing variables.

Growth in Cash Flow Things: As business grows, the cash flow things also see a positive growth.

Suppose the total sales grow at five percent every quarter and credit (60 days) sales is eighty percent of

the sales. If forty percent of the customers pay at the end of two months in time, another 40 percent pays

at the end of three months and the balance 20 percent pays at the end of fourth month the amount

composed from the customers is also expected to illustrate an uptrend due to growth in sales.

The mainly usual approach to cash forecasting is the Receipts and Payments methods as carried in

Table-6.3. After the firm has determined what kinds of receipts and payments are significant in its

overall cash flow, an significant question is how to forecast the future stage of inflows and outflows.

There are four general techniques of forecasting these things of receipt and payment.

Direct Method: In by this technique, it is assumed that the variable to be forecast is self-governing of all

other variables, or alternatively, is predetermined. The variables (e.g. lease rental) are forecast through

by its expected or predetermined stage.

Proportion of Another Explanation: This technique is used to project financial variables that are

expected to modify directly with the stage of another variable. For instance, if sales volume increases, it

is natural that more elements will have to be produced to replenish inventory. It is then reasonable to

project sure direct costs of manufacture, such as direct materials, as a per cent of sales.

Compounded Growth: This method is used when a scrupulous financial variable is expected to grow at

a steady growth rate in excess of time. The formula used is:

Yt = (1 + g) Y t-1

Where Yt-1 is the prior era‘s stage of y and g is the growth rate

Multiple Dependencies : Under this technique the variable is measured to be convinced through more

than one factor. The statistical technique of linear regression is often employed with historical data to

determine which explanatory variables are important in explaining the dependent variable. As suggested,

see the application of regression technique after a while.

As cash forecasts trade mostly with the close to future, several of the things on the cash forecast are

generally estimated through some difference of the mark method. The bases of these mark estimates are

generally the firm‘s other financial plans. Remaining estimates are mostly on a proportion of another

explanation‘ foundation, the another explanation often being a scrupulous era‘s sales. The other two

methods are employed less regularly. It is a general experience that forecast of disbursements is much

easier than receipts, because the cash manager can rely on internal fact and knowledge of payment

policy in order to determine what requires to be paid and when. Besides, he has the knowledge of firm‘s

other plans (or budgets) and can create exploit of the forecasting techniques. Though, a biggest

challenge for him comes in estimating the receipts from the collection of the firm‘s receivables. In this

regard, an useful forecasting method is to examine the historical payment patterns to determine the

proportion of credit sales that are composed at several times after the date of sale, and then to exploit

this fact (beside with the estimates of future sales) to project future receipts. We may, though, adopt a

bigger and a more sophisticated approach. In this all collection rates are estimated simultaneously

through regressing past sales figures against past collections. The estimated coefficients of the sales

figures in the regression can be interpreted as the collection proportions, and the average errors of the

estimated regression coefficients as the uncertainty inherent in the estimation of these collection

proportions.

Let us take an instance. Suppose that a firm has regressed its monthly collections for past months against

the appropriate past monthly sales figures and has obtained the following results:

The figures in parentheses below the estimated collection rates are the average errors of these collection

rates. In this equation, Ct is the collection from receivable in era t, St – 1 is the sales in era t –1 (say,

previous month), and St – 2 is the sales in era t-2 (say, two months previously). Assume also that these

were the only statistically important explanatory variables (the variables like St – 3, St – 4, etc. and

dummy variables to assess seasonality, were not important), and that the overall estimated equation was

highly important. We may now interpret the regression results in the following method. The estimated

collection rates are 75.4 per cent (regression coefficient on St – 1) of the previous month‘s sales and

24.1 per cent (regression coefficient on St – 2) of the sales from two months previously. The implied bad

debt rate is 0.5 per cent, equal to one minus the sum of the collection rates. The average error figures

are used to test the statistical significance of the estimated regression coefficients.

Simulation Approach

Simulation analysis permits the financial manager to incorporate in his forecasting both mainly likely

value of ending cash balances (surplus/deficits) for each of the forecast eras (say, for each month in

excess of the after that quarter) and the periphery of error associated with this estimate. It involves the

following steps: First, probability distributions for each of the biggest uncertain variables are urbanized.

The variables would usually contain sales, selling price, proportion of cash and credit sales, collection

rates, manufacture costs, and capital expenditures. Some of these variables have the greatest power upon

cash balances. Clearly, more time and attempt should be spent in obtaining probability distributions of

these variables. Second, values are drawn at random for the variables from their respective probability

distributions, and by these values each balances are estimated. Third, the procedure is repeated many

times (say, 100 times). Needless to say, such tedious and cumbersome computations are done on

computer. From the trial results, fact of the type as shown in table 2.3 would be generated.

Table 2.3 Hypothetical Simulation Results

How can the fund manager exploit the results of the simulation. The usefulness of the results as shown

in Table 2.3 lies in the information that summary statistics (i.e. standard cash balances and average

deviation) can be used to determine upper/lower estimates of cash surplus or deficit for each month,

with a probability of say 95 per cent that cash balance will remain within the estimated range. Assuming

that the sharing of month-ending cash balances is normal, we can obtain the upper/lower estimates

through applying the following formula.

With the fact of this kind in hand, fund manager can now address the formulation of appropriate

investment and financing strategies. Let us now proceed with some examples to show the point. Believe

our hypothetical simulation results and assume that the costs of having insufficient cash and the costs of

hedges (i.e. financial arrangement to fall back upon in case of shortage of cash) are such that the firm

desires to incur, at maximum, a 5 per cent chance of having insufficient cash to cover expenses. What is

the maximum amount for which the firm should close a row of credit? The maximum expected deficit is

in the month of June, with a mean of Rs. 12,21,000 and a average deviation of Rs. 3,53,000. The Z

statistic for 95 per cent confidence interval is 1.645; and 1.645 times of Rs. 3,53,000 is Rs.5,80,685. The

maximum amount that the firm should arrange to borrow is Rs. 12,21,000 plus. Rs. 5,80,685 or Rs.

18,01,685. There is a 5 per cent chance that the actual borrowing requires in June will be greater than

this and a 95 per cent chance that the necessities will be less than this.

Let us now believe that the firm is contemplating how much of the estimated surplus in September to

invest in a 60-day investment. How much can the firm invest and have only 10 per cent chance of

having to resell the investment in September? Z statistic for 90 per cent confidence interval is 1.28;

times of Rs. 4,21,000 is Rs.5,38,880; Rs. 5,91,000 less Rs. 5,38,880 is Rs.52,120. There is 10 per cent

chance that cash surplus in September will be less than Rs. 52,120. So, the firm can invest the amount in

the 60-days investment and have a 10 per cent chance that they will have to liquidate the investment

prior to maturity. The examples are designed to show the mechanics of manipulating means, average

deviations, and probabilities of cash balances rather than to present realistic hedging strategies. In

practice, the array of possible hedging strategies is quite a bit more complicated. One is required to

believe several alternatives and the associated costs and risk in hedging strategies.

Managing Uncertainty in Cash Flow Forecast

Cash flow forecast is crucial in cash management. Therefore , the efficiency of cash management is

directly related to the skill to accurately forecast cash flows. Unluckily, two significant cash flow

variables namely sales and collection carry a lot of uncertainty and therefore affects the cash flow

forecast. It is also hard to adjust the manufacture and purchasing action immediately in reaction to the

lower sales and there is always some time lag flanked by decline in sales and actual adjustment in

manufacturing behaviors. Sales and collection pattern are affected through many variables and mainly of

them are external factors such as competition from internal and external market, seasonality, changes in

consumers‘ taste, recession in the market, government policy, etc. Firms have small manage on these

variables. Recognizing and managing cash flow difference is therefore another significant issue in cash

management. There are many methods by which firms recognize and control the uncertainty associated

with cash flow difference.

Sensitivity Analysis

The impact of changes in cash flow variables on cash balance is examined by sensitivity analysis. The

objective of the analysis is to determine the mainly sensitive cash flow variables that will lay the cash

management in a hard location. This fact is useful to evaluate the possibility of cash flow variable

affected to that extent, plan to ensure that the cash flow variable is within the normal limit and prepare a

contingency plan.

Scenario Analysis

Here cash flows are forecasted under dissimilar assumptions and cash requirement under dissimilar

scenarios is worked out. Depending on the stage of risk taking capacity, firm selects a scenario and uses

it for cash management

Simulation Analysis

It is an extension of scenario analysis. In scenario analysis, the user defines possible scenarios and the

computer generates the cash forecast. In simulation, the computer is allowed to generate several

scenarios based on random numbers. As a big number of scenarios are generated, it is possible to

describe the sharing of cash flow forecast and uncertainty associated with he forecast.

Holding a Stock of Extra Cash or Close to-Cash Asset

This is the simplest solution to control the uncertainty associated with the forecasting of cash flow. This

is relied upon when the stage of uncertainty is high.

Extra Borrowing Capability

If the uncertainty analysis model helps to figure out the era in which the firm is likely to face serious

problem of cash management, then it is worth to negotiate with bankers or other financing agencies well

in advance for additional temporary credit. It is possible to have a standby arrangement with the bank or

financial intermediaries.

By Interest-Rate Derivatives

If uncertainty in cash flows is on explanation of expected changes in the interest rate affecting the

interest income or interest payments, the interest-rate derivatives such as interest rates futures and

interest rate options are useful to control this section of risk.

Managing Surplus Cash

Profit creation firms have to generate surplus cash at the end of operating cycle as the cash composed

from debtors is greater than cash invested initially. Though, in reality, several profit creation firms see

the pressure of negative flow of cash. There are many causes for this situation. The mismatch of inflows

and outflows and diversion of short-term funds for extensive-term requires are two biggest causes for

this condition. However it is not desirable to divert the short-term funds for extensive-term requires,

often firms resort to this diversion if there is some delay in receiving extensive-term funds. The situation

is set right once the firm receives the extensive-term funds. In other languages, profit-creation firms

periodically generate cash surplus even however they face pressure on cash flows in other times. The

issue is how to trade with such surplus cash. Excess cash balance is the least productive asset of the firm

and therefore should be minimized.

Firms normally resort to investing short-term surplus cash in short-term liquid securities to earn some

return. The firm has to decide on two issues at this juncture. First, it should decide on investment

avenues and products. The amount to be invested is the after that significant decision.

The investment product is typically short-term, highly liquid government securities. The Indian money

market is not fully urbanized and usually restricted to banks and other institutional investors. The

investment widely used through the Indian corporate sector to lay short-term capital in Element-64

scheme of Element Trust of India. Earlier, investment in Element-64 enjoyed sure tax benefit also for

the corporate sector. As several private sector mutual funds have floated open-ended debt-based

schemes, the demand for this source of investment has increased in recent times. Certificate of deposits,

commercial paper and inter-corporate deposits are other popular schemes in which short-term funds are

placed. After liberalization of the economy, money and capital markets have become active and the

volume and diversity in the instruments traded has increased. The advent of money market mutual funds

has broaden the scope for surplus cash investment.

The amount to be invested depends on transaction cost associated with investment and era for which the

amount is accessible for investment. As the return on short-term securities is usually low, frequent

investment and divestment increases the transaction cost and therefore affect the overall return.

Investment optimization models like Baumol, Miller-Orr and Stone are accessible to guide firms to

decide on how much to be invested.

Managing Cash-In-Transit

The discussion sheltered so distant usually relates to forecasting of future cash flows and managing the

surplus or deficit cash flows. A related issue of cash management is improving collection efficiency,

particularly speeding up the conversion of cash-in-transit to cash. The concept is explained with easy

instance. Suppose a firm in New Delhi sold Rs.10 lakhs worth of goods to another firm situated in town

close to Madurai. At the end of credit era, when the selling firm made an enquiry in excess of phone in

relation to the payment, the customer informed that they have posted the cheque on that day and gave

the payment details. The postal department will take in relation to the four to five days to deliver the

post to the seller firm. The seller firm may take in relation to the day or two to procedure the receipt and

the cheque will be deposited on sixth or seventh day in the bank explanation. As it is outstation cheque,

the bank will take in relation to the another one to two weeks to collect the money as the collection bank

again has to send the cheque through post to issuer‘s bank and get the collection details through post. In

other languages, it will take in relation to the two to three weeks to complete the entire exercise. The

buyer in this procedure enjoyed another two-three week credit, which is described ''Float'. On a Rs. 10

lakhs, the interest cost for three weeks is approximately Rs. 10000 (1%). The electronic clearing system

that reduces the collection time at the bank end is not accessible at all spaces. The issue is how the

selling firm speeds up the collection procedure. However a easy solution is to request the customer to

pay by demand draft and send the draft through speed-post or courier after deducting the cost of DD and

courier charges, customers may not agree to the proposal as they loose the float Therefore , we require to

seem into our collection system for improvement.

Selection of Banks with Accelerated Clearing Facilities

An analysis of the time delay in the collection procedure, particularly collection of outstation cheques,

shows that a important section of delay is at banks end. If a firm is having customers by out the country,

then it is necessary to select a bank, which provides accelerated clearing facilities. Banks may be at least

insisted to procedure the clearing by speed post to cut down the delay arising on explanation of postal

transaction.

Maintaining Explanations in Many Branches

To cut down the time delay in clearing outstation cheques, the firm can open explanations in significant

municipalities, where the number of clients are more and deposit the cheque in the branches to get

regional clearing facility. Funds composed may be electronically transferred to the head office.

Acceleration of Cheque Processing at the Firm

This is within the manage of the firm. Often, the sales person, who collects the cheque from the

customer will first illustrate the collection to his/her boss before sending the cheque to explanations

department. If the boss is not accessible or in a meeting, the cheque will be in his table for a day or two

before it moves to explanations department. The person, who receives the cheque in the explanations

department, will first identify the relevant bill. If there is any shortfall in the value, this will be discussed

with the sales department. After reconciling the cheque amount with the bill, the explanations

department prepares receipt and creates an entry in the cash-book. The cheque now moves to the person

who is preparing challan for depositing into the bank.

If the cheque is deposited beyond sure hours, this will not be taken up for the day‘s clearing and the

cheque has to wait for one more day for collection. All these behaviors can be done after noting down

the relevant cheque details and directly handing in excess of the cheque to the employee who is looking

after the bank transaction. It needs simplification of process involved in processing of collection.

Exploit of Lockboxes

The lockbox is a post office box number to which some or all the customers would be requested to mail

their cheques. The lockbox will be opened in many municipalities and the regional branches of the bank

are authorized to open the box and clear the cheques. The amount composed under lockbox is

transferred to the notified explanation. This concept is popular in the US and other urbanized countries

but not prevalent in India.

Electronic Funds Transfer and Anywhere banking

The advent of banking technology and the spread of internet facilities has changed the face of corporate

cash management. The more towards paperless economy reduces several of the difficulties in dealing

with cheques/drafts. It should be clear from the prior discussion that the time necessary for transmittal of

cash from one firm to another revolves mainly approximately the passing from one hand to another of a

piece of paper, i.e., the cheque. if we can eliminate this paper there will be a biggest saving in the time

and cost.

The system of electronic remittances introduced through several foreign and Indian banks has

approximately achieved the objective of cheque-less payment mechanism. Added to this, the concept of

'Anywhere Banking' practiced through several banks also is helping speedy flow of remittances. with

these growths, it should not be hard for the firms to eliminates the 'Float. unluckily, several corporate in

India are not much in favor of the' Electronic Funds Transfer System' largely because of their habit of

delaying the payments. It may though, be hoped, that the collection procedure in the close to future will

be fully automatic, as distant as the banking operations are concerned.

Mis-In-Cash Management

The preparation of cash budget based on forecast of cash flows is only the starting point of cash

management. It is the scheduling section of cash management. The forecast of cash flows and budget

exercises help the management to locate cash deficient and surplus eras. Managers decide on dealing

with the deficit and surplus, which is decision-creation section of cash management. The exercise is

completed, if the manage unit is also brought into the cash management system. The manage unit is

required as the operations of the business enterprise may often deviate from the plan. It is extremely

general that wide deviation arises flanked by intended and actual cash flows, which keeps the financial

managers always under severe pressure. Often, attention of the managers is drawn after the problem

urbanized to a full stage. Therefore , the crucial issue in cash management is continuous fact on actual

cash flows and reporting of deviation. Minor deviation can be tackled through postponing sure

discretionary payments or speedy collection of book debts through offering cash discounts. If the

deviation is expanding, it needs biggest corrections in the shape of negotiating fresh loan with bankers

and improving the collection mechanism. Such corrective actions are possible through developing a

good reporting system that highlights such deviations without loss of time. The daily cash statement is

the best vehicle for obtaining a running comparison flanked by the forecast and actual cash flows. Daily

cash reporting is useful even if cash budget and forecast are not accessible on daily foundation. It helps

the managers to understand the flow of cash on daily foundation and a comparison of cumulative figures

with the budget designates the target still to be achieved to stay the budget in force. In addition, the

reporting on daily foundation to top management forces the operating people to work efficiently. This is

extremely useful as accounting profit cannot be computed on daily foundation and accessible only at the

end of quarter.

Meaningful analysis can be done through consolidating cash flows on daily foundation into two

documents namely Cash Flow Budget-Actual Variance Analysis and Cumulative Cash Flow Report for

the year to date. The formats for the two reporting documents are given below (See tables 2.4 and 2.5).

Table 2.4 Cash Flow Budget-Actual Variance Analysis from…….to………..

Table 2.5 : Cumulative Cash Flow Report For the Year-to -Date

A diversity of cash reports intended for specific requires of individual companies are in vogue for

checking cash flows and ensuring consistent availability of adequate cash. For instance, if the firm has

only a few big customers, the top management would like to have customer-wise cash collection

reporting to speed up the procedure of collection at the highest stage. The fact composed from these

statements is useful to fix responsible centers for variance and initiate corrective steps, which are

essential steps in manage exercise. The corrective steps contain short-term efforts such as speeding up

the collections through chasing a few big customers and extensive-term policy changes such as revising

credit era or credit-granting decision.

MANAGEMENT OF MARKETABLE SECURITIES

Require for Investment in Securities

Marketable securities result from investment decisions that really are not the largest section of the firm‘s

business. But marketable securities cannot be ignored, as they constitute a section of the value of the

firm that is entrusted to management. For some firms, investments in marketable securities extend to

lakhs or even crores of rupees. Table 2.6, provides the investments in marketable securities of few well

recognized companies in India. The firms were chosen because of their familiarity and also because of

the differences flanked by them. Investments in marketable securities of these ten example firms

illustrate not only a wide difference in the middle of them but also wide difference flanked by the two

points of time. Reliance Industries maintained the top location in both years. Marketable securities share

in the current assets has also gone up from 29.6% to 41.8% whereas on the total assets, the percentage

shows a marginal transform. A same transform is also seen in the case of Bajaj Auto and Hindalco

Industries. In case of HPCL and Tata Iron & Steel Industries, the Investments in marketable securities as

a percentage of current assets remained stable. The share of Wipro and Grasim industries, which was

extremely low in 1998-99 has gone up steeply through 2002 - 2003. In Tata Authority the trend was

reverse in excess of the five year era.

Table 2.6 Holding in Marketable Securities of Select India Companies

There are many causes for such variation in the investments in marketable securities flanked by the

firms and flanked by the years. For example, companies like Lakshmi Machine Works Ltd. (LMW) and

NEPC Micon, leading manufacturers of textile machinery and windmill authority equipments, used to

have an order booking for one to three years. Companies, which lay the order with LMW and NEPC pay

advances beside with the order. Mainly companies in the auto-cars segment like Maruti Udyog Ltd

(MUL) and Telco that entered the little car segment collects advances when they launch new models.

Though they cannot exploit these short-term surplus cash flows for any extensive-term purposes.

Surplus cash is therefore invested in marketable securities primarily to earn an income, which

otherwise leftovers idle within the firm. Companies may not always have an opportunity to demand

advances from the customers. For example, the recession in textile industry and common economic

recession has affected the order flow of LMW and NEPC. Rigorous competition flanked by the car

manufacturers forces several of them to sell the cars without challenging any initial amount from the

customers. Therefore , companies, which were flushed with money at one point of time and investing

heavily in marketable securities, may issue short-term securities to others and borrow money at another

point of time.

Another prominent cause for holding marketable securities is on explanation of mismatch flanked by the

borrowing and investment programme. Companies like Reliance Industries, which are just executing

many projects, are consistent borrowers of money in both domestic and international markets. These

projects are executed in excess of a era of time. It is often hard to borrow money exactly for the

requirement of the year or month as the cost of borrowing, sentiment of the market and regulatory

necessities are to be taken into explanation in deciding the amount to be borrowed. Companies therefore

borrow more than their current requirement. It not only applies to borrowing but also applies to equity

financing. Money raised in the shape of debt or equity has a cost and it cannot be immediately put into

exploit for any extensive-term purpose. They are invested in short-term securities with an intention to

recover at least a section of the cost of borrowing.

Several companies, which adopted the profit centre concepts, have made the fund department as one of

the profit centers. It means the fund department has to add revenue to the firm. Top management wants

financial department to illustrate how they helped the company to improve the bottom-line. Through

dealing with marketable securities in the shape of securities and foreign swap derivatives, financial

managers‘ ought to demonstrate their skill to cut down the cost or augment the benefit. Investments in

marketable securities also depend on the aggressiveness of the financial managers’ in dealing with such

assets.

Several companies today have a distinct treasury division that operates in marketable securities and

other financial products. But aggressive relations in marketable securities will augment the risk of

financial operations. For example, Procter and Gamble (US), which bought leveraged interest rate swaps

for $ 200 million from Bankers Trust in 1994, to cut down the interest cost of their commercial paper

borrowing, had finally incurred a loss of $100 million. The task of financial managers, who become

involved with marketable securities either full-time or section-time, consists of three issues. First,

manager‘s necessity understands the detailed aspects of dissimilar short-term investment opportunities.

Second, manager‘s necessity understands the markets in which those investment opportunities are

bought and sold. Third, managers necessity develop a strategy for deciding when to buy and sell

marketable securities, which securities to hold, and how much to buy or sell in each transaction.

Kinds of Marketable Securities

Marketable securities accessible for investments can be grouped under many ways. They can be

classified under three broad heads namely debt securities, equity securities and contingent claim

securities, which in turn can be grouped under many heads.

Debt Securities

All debt securities symbolize a promise to pay a specific amount of money (the principal amount) to the

holder of the security on a specific date (the maturity date). In swap for investing in security, the

investor or holder of the security, receives interest. This interest may be paid upon maturity of the

security (as with mainly short term debt instruments) or in periodic installments (as with mainly

extensive term debt instruments).

Money Market Instruments

The market for debt securities of relatively short maturity (usually one year or less) is described money

market. The money market provides a considerable amount of liquidity to all participants in financial

market. Companies and government entities that discover themselves temporarily short of cash can raise

funds quickly through issuing money market instruments. Investors who have cash to invest for short

eras of time can invest in money market instruments that will give them with a return while not

committing their funds for extensive eras.

Call Money

The demand and time liabilities (DTL) of a bank are evaluated every fortnight on a Friday described the

‗Reporting Friday‘. Throughout the first fortnight following the Reporting Friday, the bank is expected

to uphold daily 15 % of its DTLs (as on the Reporting Friday) in cash with RBI. This is recognized as

cash reserve ratio CRR. The banks are expected to uphold this balance in such a method that the

standard daily balances are within the stipulated requirement. The market that arises as a result of

borrowing and lending through banks in order to uphold their CRR is recognized as the call market.

Theoretically call money is money that is literally on call, i.e., it can be described back at short notice. In

the case of inter bank market, the notice era can be as short as one day.

Certificates of Deposit

A certificate of deposit (CD) is an instrument issued through a bank or other depository organization on

behalf of funds placed on deposit at the bank for a sure era of time. They are described negotiable

certificates of deposit. Negotiable CDs are usually not redeemable before maturity, but an investor who

purchases, for instance, a six-month CD may sell it to another investor one month later rather than wait

until the CD matures. The interest on CDs is calculated on the face amount of the CD. It is a non-

discount instrument and pays the face amount plus accrued interest at maturity. The rates accessible to

investors in CDs are typically somewhat higher (averaging in relation to the1 percent higher) than those

on T-bills of equal maturity. This yield differential can be attributed to many factors: a) the somewhat

thinner market for CDs, b) the tax differential, c) the risk factor of the issuing financial organization.

Commercial Paper

Commercial paper (CP) is the term, for the short-term promissory notes issued through big corporations

with high credit ratings. Commercial paper generally carries no stated interest rate and sells at a discount

from its face value as T-bills. The objective of the RBI introducing CP as an instrument to fund working

capital requires was to reduce the dependence of corporate on banks. Also, through pricing the CP at

market rates, the financial efficiency of corporate was coveted to augment. Also, this instrument

securities the working capital limits. The companies can now issue CP for a maturity era ranging from 3

months to less than a year. Minimum net worth of issuer is also reduced from Rs. 5 crores to Rs.4 crores

and the minimum working capital (finance-based) limit is also being reduced from Rs. 5 crores to Rs. 4

crores.

Bankers Acceptances

Bankers‘ Acceptances are time drafts drawn on a commercial bank for which the bank guarantees

payment of the face value upon maturity. They are commonly used to fund international transactions for

the short term. For e.g., a jewellery retailer in India might purchase watches from a manufacturer in

Switzerland, paying for the goods through sending a time draft (a draft payable at some future date)

drawn upon the jeweller‘s bank. When the bank accepts the draft, it stamps ―carried‖ on the reverse face

of the draft, meaning that the bank guarantees payment of the draft upon maturity. In effect, the bank is

guaranteeing the credit of the jeweller. As the credit behind the draft is now on the bank, the draft can be

traded in the money market beside with other short-term debt instruments. Although bankers‘

acceptances are accessible to individual investors, they are typically mainly popular with commercial

banks and foreign investors.

Government Securities or Securities Guaranteed through the Government

Government securities are public debt instruments issued through the Government of India, State

Governments or Financial Organizations, Electricity boards, Municipal Corporation etc. guaranteed

through the governments to fund their projects. The default risk of these securities is perceived to be

lower than that of corporate bonds or equity shares as they are issued on explanation of Sovereign risk.

These securities are so termed as Giltedged securities. Government securities traded in the money

markets fall within 5 separate categories.

Treasury Bills

Central Loans

State Loans

Central Guaranteed loans

State Guaranteed loans

The order of these securities ranges from mainly liquid to less liquid and also safest to less safe. All

these securities are of dissimilar maturities and coupon rates. Currently, the highest coupon rate of a

government security is 13.40 % (in State loan 13.50 %). The longest maturity accessible is 21 years.

You may refer money market page of economic dailies such as The Economic Times or The Hindu

Business Row, where you get indicative rates for several of these securities for dissimilar maturity eras.

Exhibit-7.1 shows some of the inputs, which you normally see in a money market page of economic

dailies.

Treasury bills have of late started attracting good response, especially as the introduction of 364 days T

Bill in April 1992. Just, there are 2 maturities - 91 days and 364 days. A third category of T-Bills that

was for 182 days has been withdrawn as April 1993. Government securities are one of the lowest

yielding securities that one can invest in. Mainly investments in these securities are made due to

regulatory causes. Throughout the second fortnight following the Reporting Friday, the banks have to

uphold 34.5 % of DTL up to 17/09/93 and 25 % on incremental DTL as that date, in Government

securities. This is recognized as Statutory Liquidity Ratio (SLR).

Capital Market Debt Instruments

The capital market supplies extensive-term funds to corporations, government entities and other users of

capital. The common kind of debt instrument of the capital market is the bond. Bonds generally pay

interest to the holder once every six months (semi-annually) and pay the principal or face amount upon

maturity. Although the face amounts of bonds do modify, the typical bond has a face value of Rs. 1000.

The market value of the bond, the price for which it deals in the market, can be greater or less than par

depending on interest rates and other market factors.

Treasury Notes and Treasury Bonds

The extensive-term bond issues of the treasury that are accessible to investors are the Treasury notes and

the Treasury bonds. Treasury notes have original fixed maturities of not less than one and not more than

ten years from the date of issue. They are accessible in denominations as little as $ 1000, except for that

the T.notes of less than four years is generally not issued for less than $ 5000. Treasury bonds are like

notes in every respect in that their original maturities are from more than ten years to approach as

extensive as thirty years.

Municipal Bonds

Municipal bond, in spite of the word municipal, contains all bond issues of states, countries,

municipalities, and other political subdivisions of the United States. An significant distinguishing

characteristic of municipal bonds is that all interest payments are exempt from U.S. income taxes. They

are also exempt from any state or municipality income taxes within the issuing city. However couple of

corporations in the states of Gujarat and Maharashtra, have issued bonds of this type, this market is less

active in India.

Public Sector Undertaking (PSU) Bonds

PSU bonds are issued to fund projects of several public sector undertakings like NTPC (National

Thermal Authority Corporation), IRFC (Indian Railways Fund Corporation), etc. There are two types of

bonds Tax free with a coupon of 9 % or 10 % or 10.5 %, and taxable with a coupon of 13 % to 18 %. As

1985-86, the public sector undertakings have been raising possessions from the capital markets, by the

issue of bonds, termed as PSU bonds. With presently Rs. 354 crores in 1985-86, the amount of bonds

issued has increased to Rs. 4,625 crores in 1991-92. This was inevitable, as the gilt-edged market could

not be enlarged further, without putting up the SLR ratio. Also, the dependence of the PSUs on central

and state budgets could be progressively reduced. With the divestiture programme somewhat going

slow, the reliance of PSUs on bond segment will augment.

Corporate Bonds

Debt securities of corporations with maturity of longer than one year are corporate bonds. The usual par

value of a corporate bond is Rs. 100 and sometimes Rs. 10,000, and maturities range from in relation to

the two to as several as thirty years. In recent years, though, corporate bond issues have been of shorter

maturities as inflation and economic uncertainties have caused investors to be less willing to commit

their funds for longer eras of time.

Equity Investments

Equity securities symbolize the residual ownership of the firm. Residual ownership means that the debt

holder‘s necessity first is paid off, before the company belongs totally to the equity holders. The two

kinds of equity securities are general stock and preferred stock.

General Stock

The general stockholders are the risk takers; they own a portion of the firm that is not guaranteed, and

they are last in row with claims on the company‘s assets in the event of a bankruptcy. In return for

taking this risk, they share in the growth of the firm because the growth in the value of the company

accrues to the general shareholders. The company may create a periodic cash payment described a cash

dividend to the general stockholders. Cash dividends are commonly paid to shareholders on a quarterly

foundation, but they may be paid annually, irregularly, or even not at all. The general shareholder has no

guarantee of getting a dividend payment. General stockholders generally have voting rights that allow

them to vote on the corporation‘s board of directors. As the board of directors hires the top management

of the company, the stockholders indirectly determine the company‘s management.

Preferred Stock

Preferred stock is technically an equity interest in the company, but its aspects are more like those of

bonds. Preferred means that this kind of stock has a stated par value that symbolizes a claim against

corporate assets that supersedes the claims of the general stockholders, but is subordinate to the claims

of bondholders. Preferred stock also carries a fixed cash dividend to the general shareholders. Like debt,

preferred stock is often systematically retired by a sinking finance. It also does not symbolize true

residual ownership because preferred shareholders generally do not participate in earnings growth

through getting higher dividends, as general shareholders do.

Contingent Claim Securities

Contingent claim securities are securities that provide the holder a claim upon another asset, contingent

upon the holder‘s meeting sure contract circumstances. Although there are several kinds of contingent

claim securities, the three mainly popular types of investments today are options, warrants, and

convertible securities.

Options

An option is a contract giving its holder the right to buy or sell an asset or security at a fixed price. All

options are valid only for a specified time era, after which they expire. A call option provides its holder

the right to buy the underlying asset and thereby guarantees the purchase price of the asset for the

duration of the option. A put option carries the right to sell and guarantees the selling price of the

underlying security.

Warrants

Warrants are like call options that are issued through the corporation. They provide their holders the

right to purchase the general stock from the corporation at a fixed price. Warrants generally have longer

life than options (typically five to seven years), although a few perpetual warrants do exist. Corporations

generally issue warrants in conjunction with another issue of securities and offer a ―package trade.‖ For

instance, the purchase of one share of preferred stock might entitle the investor to receive one warrant to

purchase general stock of the company. Companies offer such packages to sweeten the trade and create

the other security easier to sell.

Convertible Securities

Convertible securities are securities that may be converted into general stock. A convertible bond is a

bond that the holder may swap for general stock of the corporation. The other general kind of

convertible security is the convertible preferred stock, which is basically a preferred stock that the

holder can swap for a sure number of shares of general stock of the corporation.

Futures Contracts

A contract that arranges for delivery and payment of an asset at a future date is a futures contract.

Futures contracts are traded publicly on the futures exchanges, and these exchanges have urbanized

contracts on a number of assets, such as corn, wheat, soybeans, and frozen pork bellies. These contracts,

often described commodity futures because of the nature of the underlying asset, allow producers and

consumers of the commodities to plan their manufacture and sales in advance as well as allow

speculators to enter the market. A second cluster of futures, on such assets as U.S. Treasury bills,

negotiable CDs, and stock markets indexes, is described financial futures. These futures allow investors

in such securities to spread some of the risk to speculators and aid in the investment procedure.

Market for Securities

Securities market can be broadly classified into short-term securities market (also described money

market) and extensive-term securities market. These markets beside with banking and financial

organizations are described capital markets, where dissimilar requires for money are exchanged.

Financial managers, however interested in investing their surplus assets for a short era, are not bound to

restrict their investments in short-term securities. What is significant is liquidity of investments. It is

quiet possible to invest in extensive-term securities such as 20-year government bond and sell it after a

week, which is essentially a short-term investment in a extensive-term bond. Likewise investment can be

made for a short era in equity or derivative securities. An understanding of dissimilar markets is

significant for the financial managers in this context. As suggested, talk about some of the biggest

aspects of the market under three broad heads namely money market, market for extensive-term capital

and market for derivative securities.

Money Market

Money market is a lay where borrower meets the lender to deal in money and other liquid assets that are

secure substitutes for money. A urbanized money market will have big number of instruments, both in

conditions of diversity and volume, attendance of big number of traders and subsistence of requisite

infrastructure to facilitate efficient resolution of transactions. Till 1991, money market in India was in a

dormant state. It was operating in a closely regulated habitation, where interest rates are fixed and

regulated. The operations were also restricted in a few securities involving commercial banks. The

circumstances of the money market improved after the Reserve Bank of India initiated several changes

on the foundation of the recommendation of the Vaghul Committee, which recommended deregulation

of interest rates, introduction of new instruments and augment in the number of participants. As a result,

India now has fairly urbanized money market with a number of instruments and active trading. The

establishment of organizations likes, Discount and Fund Home of India Ltd. (DFHL), SBI Guilt, etc.,

and arrival of many entire sale dealers has provided liquidity to the market. Mutual funds have also

started actively investing in short- term securities beside with banks and other institutional investors

Investing short-term surplus in short-term securities has an advantage in excess of other securities

because short-term securities will reflect the interest accrued on a day to day foundation. For example, if

a company has Rs. 50 lakhs surplus money for a short era, it can invest in a commercial paper or

treasury bill or a extensive-term government bond. If the prices of all the three instruments are observed

at the end of the week, the first two securities will reflect the interest earned and therefore move upward

whereas there is no guarantee that the prices of extensive-term securities reflect the interest earned

section for such little interval. Also, the short-term securities are less affected through the interest rate

changes (described interest rate risk). For instance, if the central bank increases the interest rate

throughout the week, the prices of extensive-term bond will decline more than short-term bonds. Before

investing in money market securities, it is bigger to seem into yield curve of securities traded in the

market. A yield curve is the one, which shows the return accessible for securities having dissimilar

maturities. This curve is useful to managers to deal-off flanked by return and interest rate risk. Further,

the yield curve will illustrate the expectation of the market on the future interest rate scenario, which is

a basic input for any treasury managers. Interest rate is the one which affects approximately every aspect

of the economy like business performance, stock market, money market, foreign swap market and

derivatives market.

Market for Extensive-term Securities

Market for extensive-term securities is a lay where the borrowers raise capital for longer term. Due to

active secondary market for several of the extensive-term securities, there is no require that only

investors having extensive-term surplus alone enter into the market. For example, a important

percentage of volume of trading (more than 75%) in stocks, which are extensive-term instruments, are

settled within a trading cycle of five days. Now ‗T + 2‘ trading is going on in the market. Extensive-term

securities - debt, equity and other kinds of securities - are actively traded in the stock exchanges like

National Stock Swap, Mumbai Stock Swap. These exchanges trade in corporate securities, government

securities PSU securities and elements of mutual funds,. Stock exchanges are more organized than the

money market, which primarily operates in excess of phones. Now trading is mostly on-row.

The objective of investing in marketable securities require not always be for short-term purpose. If the

surplus money is accessible for fairly longer era, investment in extensive-term securities can be

measured because the return will be more. Due to active secondary market, there is no liquidity risk in

the event of sudden require of funds. Of course, investment in equity oriented securities has some

amount of investment risk. Investing in portfolio of stocks or investing by mutual funds can reduce a

section of investment risk.

Market for Derivative Securities

Market for derivative securities is less urbanized in India. A few commodity futures exchanges like

Pepper and Coffee exchanges have been recognized. Banks are allowed to offer foreign swap related

derivative products. Derivative trading is taking lay now on Indian stock exchanges in a limited method.

As all derivatives are also marketable securities, traded actively in the secondary market, they qualify

for investing surplus cash. Derivatives are accessible for dissimilar stages of risk takers. It is possible

through entering into two transactions - one in the normal market and the other in derivative market, it is

possible to make a low risk investment. As derivative transactions need only periphery, which is

normally 5% to 20% depending on the nature of underlying assets, it is possible to make a leverage

(borrowing by the market) and effort to maximize the return provided the company is willing to assume

the additional risk.

Optimization Models

At the beginning of this element, we have observed that holding cash in excess of immediate

requirement means missing out an opportunity to earn an income. Though, it is necessary to discover the

cost associated with investing action before taking investment decision. For instance, if Rs. 5,00,000 is

surplus accessible for one-week and it can earn an interest income of Rs. 750 for one week, the interest

income is to be compared with cost associated with buying and selling of securities. Suppose, the

security dealer charges 0.1% commission. The firm will incur Rs. 500 when it buys the security and

another Rs.500 when it sells the security. The total cost of Rs. 1000 is greater than Rs. 750 and therefore

, the net effect of the investment is loss. The investment decision is feasible, if the surplus money is

accessible for two weeks or more. Therefore , the decision on investing surplus money requires a

cautious analysis of cost and benefit.

Bierman - McAdams Model

This model is dissimilar from other models because it assumes that the investment in marketable

securities is on explanation of raising excess funds from extensive-term sources. The cause for raising

excess capital from extensive-term sources is due to high cost of raising capital from the extensive-term

sources and therefore , the cost is to be optimized. An instance will be useful to understand the concept.

Suppose a firm needs Rs. 10,00,000 every year from extensive-term possessions for after that four years

for sure capital expenditure. The interest cost prevailing for extensive-term funds is 14% and flotation

cost (cost of brokerage or processing and legal fee paid to bankers or financial organizations, stamp

duty, etc.) is Rs. 50000. The flotation cost is one time cost and not always proportional to amount raised.

It is a fixed cost at least for a range of capital raised from the market. Assume if the firm raises more

than Rs. 10 lakhs, the excess amount can be invested at 11.5% in marketable securities. With this set of

fact, assess the impact of the following two alternatives.

Rs. 10 lakhs every year and;

Rs. 20.00 lakhs in the first year and another Rs. 20 lakhs in the third year.

In the Table 2..7 given below, the yearly cash outflow under the two circumstances is given.

Table 2..7 The Yearly Cash Outflow under the Two Circumstances is given below:

The net interest outflow in Option 2 is lower than the interest outflow of Option 1. Therefore , the firm

benefits through raising Rs. 20 lakhs at the beginning of year 1 (Year 0 in the Table), spends Rs. 10

lakhs and invests the balance in marketable securities at 11.5% for a year. The marketable securities are

sold at the end of year 1 and the value is used for capital expenditure of year 2. There is no require to

raise fresh funds in year 2 because the required amount is already raised. The procedure is repeated

again in year 3. This strategy leads to reduction of overall cost of funds because the total amount spent

on flotation is only Rs. 1,00,000 against Rs. 2,00,000 under Option 1. What in relation to the other

options like raising Rs. 30 lakhs in year 1 and Rs. 10 lakhs in Year 4 or Rs. 40 lakhs in year 1? None of

these options provide you a lower cost than raising Rs. 20 lakhs in year 1 and Rs. 20 lakhs in year 3.

Bierman and McAdams showed the method to get the optimal financing by the following equation.

Substituting the value of funds required (Rs. 10 lakhs), flotation cost of Rs. 50000, interest rate of 14%

on new financing and 11.5% interest income on marketable securities in the equation, we get the

following:

The model simply optimize the flotation cost with the variation flanked by interest outflow and interest

income on marketable securities. This model helps the financial managers to decide on how much to be

raised from the market given the requirement of funds and how much to be invested in marketable

securities. On the other hand, the remaining four models guide the fund managers on how to switch

funds from marketable securities to cash and vice versa.

Baumol Model

This model assumes that the demand for cash is continuous and frequent withdrawal of cash from

investment will cost more. Therefore , the model provides an approach to discover the optimal

withdrawal of cash from investments. An instance will be useful to understand the concept. Colleges or

Universities like IGNOU collect fee from the students at the beginning of the year or term.

Assume the receipt for the year is Rs. 12 lakhs. There is no biggest cash inflow throughout the year or

term. Though, the organization needs cash continuously to meet several operational expenses throughout

the year or term. Assume the total demand for the cash throughout the year is Rs. 10 lakhs. Suppose the

initial receipt of Rs. 12,00,000 is invested in marketable securities. The issue before us is how much

worth of marketable securities is to be sold and cash be realized. If there is no transaction cost of selling

securities, the amount could be as low as possible. If the cost of each transaction is Rs. 575, how much

money is to be withdrawn every time. The cost affects our decision because if we withdraw too several

times, it will cost more. At the similar time if we withdraw a big amount, then the cash is idle and we

lose an opportunity to earn a return. Baumol resolves the problem by the following equation, which

provides an optimal withdrawal quantity.

Substituting the value of funds required (Rs.10 lakhs), transaction cost (Rs.575) and interest on

marketable securities (11.5%) in the equation, we get the following:

The organization has to sell securities worth of Rs. 1,00,000 every time to optimize the transaction cost

and interest income on marketable securities. That means, the sale will be effected at the end of every

fifth week.

Beranek Model

Beranek‘s model is same to Baumol‘s model but the assumption here is dissimilar. Beranek‘s model

assume that the firm‘s disbursement takes lay periodically whereas the inflows are continuous. As

buying of the securities has also costs the firm, it is not desirable to invest on daily foundation. The

inflows are accumulated to a stage and then invested with an objective of minimizing the cost of buying

of the securities. As any delay in investment will affect the opportunity income, the two are to be

balanced. As suggested, provide a dissimilar instance to show this model. Suppose a supermarket needs

cash at the end of every month to pay salaries, rent and settle the dues of suppliers. The firm on the other

hand receives the cash of Rs. 1 lakh daily from the sale of provision and other things and the total

amount composed throughout the month is Rs. 30 lakhs. Assume the whole collection is required at the

end of month. That means whatever purchases has been made throughout the month in marketable

securities, they have to be liquidated at the end of the month. The interest on marketable securities per

month and transaction cost of purchasing securities are 0.95833% (11.5% per year) and Rs. 255

respectively. The issue before the fund manager of the super market is whether the investment is to be

done on daily foundation or the receipts are accumulated up to a point before investment. Substituting

the values in the Baumol‘s equation, we get the optimal investment as almost Rs. 4.00 lakhs. That

means, funds are to be accumulated for four days before buying marketable securities and optimal

ordering lot is Rs. 4.00 lakhs.

Miller and Orr Model

The earlier two models assume that one of the two cash flow variables namely cash inflow or cash

outflow is consistent and therefore approach out with a solution on optimal withdrawal value or

investment value. In a situation where both inflow and outflow are not consistent, Miller and Orr model

is useful. The model is based on manage-limit approach. Just as to the approach, the optimum stage is

first derived based on sure assumptions and this optimum stage requires to disturbed only when the

assumptions are violated. Miller and Orr model by the interest rate on marketable securities, transaction

cost and minimum desired stage of cash, derive the optimal cash holding for the firm with the exploit of

following equation

By the minimum desirable cash limit described Lower Limit (L), Miller and Orr model provides the

Upper Limit of cash holding (H), which is equal to:

As extensive as cash is within upper limit (H) and lower limit (L), no activity is required. The moment

the cash balance breached one of these two limits, an activity is required. If the cash balance touched the

upper limit (H), then all the excess cash above the optimal holding (Z) is invested in marketable

securities. Likewise, if the cash balance touched the lower limit (L), the firm sells marketable securities

to an extent that brings the cash balance back to optimal cash holding (Z). The following instance shows

how the three values given in the Miller and Orr model are derived.

The Treasurer of Blue Diamond Hotel wants to develop a cash management model for investing surplus

cash in marketable securities. As the cash flows illustrate a volatile behaviour, the Treasurer feels the

Miller and Orr model is the mainly appropriate for the situation. An analysis of last three-year daily cash

flows shows a average deviation of Rs. 12,200. Investment in marketable securities currently offers a

return of 12% per annum. The transaction cost per transaction is Rs.300. The Treasurer believes the

hotel should have minimum cash balance of Rs. 20,000. What is the optimal cash holding? When an

investment or disinvestment activity is to be taken? Substituting the above values in the Miller and Orr

model, we get the following:

Therefore , the cash management policy is when the cash balance goes below Rs. 20,000, marketable

securities are sold and cash balance is brought back to Rs.46702. If the cash balance exceeds Rs.

100107, the cash value above Rs. 46702 is invested in marketable securities. The cash balance is

allowed to move flanked by Rs. 20000 and Rs.100107 and occasionally brought down to the optimum

stage.

Stone Model

Bernell Stone suggested that instead of mechanically taking activity on the foundation of Miller and Orr

model whenever the cash balance is breached the upper or lower limit, the treasurer can forecast the

behaviour of future cash flows of two or more days and exploit this fact in taking investment decision.

Under this model, the firm sets out two inner limits. For example in the instance, if the firm sets an inner

limit for minimum balance at Rs. 30,000 and another inner limit for maximum balance at Rs. 90,000, the

treasurer evaluates the cash flows for the after that two days whenever the cash balance hits the

previously defined Miller and Orr model. Assume the cash balance touched Rs. 20000. The firm

evaluates whether the after that two days inflows will bring back the cash location at Rs. 30000 or more.

If the forecast fails to illustrate such an improvement, the securities are sold and cash balance is brought

towards the optimum stage. On the other hand, if the cash balance is likely to move above Rs. 30000, no

activity is required at this level. Investment in marketable securities will also be taken on the similar

row. The two inner limits are provided largely to avoid unwanted transaction.

Strategies for Managing Securities

As indicated at the beginning of this element, the financial managers require to have an understanding

on dissimilar kinds of securities and the markets in which the securities are traded before venturing into

investments in securities. In addition to giving a fair amount of overview on the above two, we have also

discussed dissimilar models useful in taking decision on investments in marketable securities. By this set

of fact and knowledge, the financial manager has to design a strategy in managing securities. In

developing a strategy, the first and foremost issue is an understanding of the firm‘s cash flow behaviour.

This is essential because the model, which is useful for managing the securities, depends on the cash

flow behaviour. An analysis of historical cash flows and volatility events such as variance or cash out

locations will be useful to set manage limits. In other languages, the first set of actions in developing a

strategy is to approach out with a reasonable cash management model for the firm.

The second step in the procedure of designing the strategy is the extent to which the firm should take

risk while investing in securities. In other languages, in level one, we have recognized the amount

accessible for investments but we haven‘t specified the nature of investments. A set of guidelines

requires to be urbanized that will direct the operational managers while taking investment decisions. For

example, several banks have a clearly defined investment policy that lists the type of securities where

the surplus cash can be invested. It is advisable to prescribe the proportion of investments in dissimilar

securities like government securities 60%, corporate securities 20%, etc. The firm should have a clear

mechanism to get the risk of the portfolio and this fact should be made accessible to chief of treasury

operations. If the stage of operation is extremely high, it is worth to implement the concepts like Value-

at-Risk (VAR) to avoid biggest losses on such transactions.

The last step is to develop systems in continuous monitoring of this action and improving the reporting

system. Several companies throughout the securities scam era have suffered because of lack of

monitoring and faulty system.

MANAGEMENT OF INVENTORY

In any business or institutions, all functions are interlinked and linked to each other and are often

overlapping. Some key characteristics like supply chain management, logistics and inventory shape the

backbone of the business delivery function. So these functions are very significant to marketing

managers as well as fund controllers.

Inventory management is a extremely significant function that determines the health of the supply chain

as well as the impacts the financial health of the balance sheet. Every institutions constantly strives to

uphold optimum inventory to be able to meet its necessities and avoid in excess of or under inventory

that can impact the financial figures.

Inventory is always dynamic. Inventory management needs consistent and cautious evaluation of

external and internal factors and manage by scheduling and review. Mainly of the institutions have a

distinct department or occupation function described inventory planners who continuously monitor,

manage and review inventory and interface with manufacture, procurement and fund departments.

Defining Inventory

Inventory is an idle stock of physical goods that include economic value, and are held in several shapes

through an institutions in its custody awaiting packing, processing, transformation, exploit or sale in a

future point of time.

Any institutions which is into manufacture, trading, sale and service of a product will necessarily hold

stock of several physical possessions to aid in future consumption and sale. While inventory is a

necessary evil of any such business, it may be noted that the institutions hold inventories for several

causes, which contain speculative purposes, functional purposes, physical necessities etc.

From the definition the following points stand out with reference to inventory:

All institutions occupied in manufacture or sale of products hold inventory in one shape or other.

Inventory can be in complete state or partial state.

Inventory is held to facilitate future consumption, sale or further processing/value addition.

All inventoried possessions have economic value and can be measured as assets of the institutions.

Dissimilar Kinds of Inventory

Inventory of materials occurs at several levels and departments of an institutions. A manufacturing

institutions holds inventory of raw materials and consumables required for manufacture. It also holds

inventory of semi-finished goods at several levels in the plant with several departments. Finished goods

inventory is held at plant, FG Stores, sharing centers etc. Further both raw materials and finished goods

those that are in transit at several sites also shape a section of inventory depending upon who owns the

inventory at the scrupulous juncture. Finished goods inventory is held through the institutions at several

stocking points or with dealers and stockiest until it reaches the market and end customers.

Besides Raw materials and finished goods, institutions also hold inventories of spare sections to service

the products. Defective products, defective sections and scrap also shapes a section of inventory as

extensive as these things are inventoried in the books of the company and have economic value.

Kinds of Inventory through Function

Table 2.8 Types of Inventory by Function

Inventory Management Concepts

Inventory management and supply chain management are the backbone of any business operations. With

the development of technology and availability of procedure driven software applications, inventory

management has undergone revolutionary changes. In the last decade or so we have seen version of

enhanced customer service concept on the section of the manufacturers agreeing to control and hold

inventories at their customers end and thereby effect Presently In Time deliveries. However this concept

is the similar in essence dissimilar industries have named the models differently. Manufacturing

companies like computer manufacturing or mobile phone manufacturers call the model through name

VMI - Vendor Supervised Industry while Automobile industry uses the term JIT - Presently In Time

where as apparel industry calls such a model through name - ECR - Efficient consumer response. The

vital underlying model of inventory management leftovers the similar.

Let us take the instance of DELL, which has manufacturing facilities all in excess of the world. They

follow a concept of Build to Order where in the manufacturing or assembly of laptop is done only when

the customer spaces a firm order on the

web and confirms payment. Dell buys sections and accessories from several vendors. DELL has taken

the initiative to work with third party service providers to set up warehouses nearest to their plants and

control the inventories on behalf of DELL‘s suppliers. The 3PL - third party service provider receives

the consignments and holds inventory of sections on behalf of Dell‘s suppliers. The 3PL warehouse

homes inventories of all of DELL‘s suppliers, which might number to more than two hundred suppliers.

When DELL receives a confirmed order for a Laptop, the system generates a Bill of material, which is

downloaded at the 3PL, processed and materials are arranged in the cage as per assembly procedure and

delivered to the manufacturing floor directly. At this point of transfer, the recognition of sale happens

from the Vendor to Dell. Until then the supplier himself at his expense holds the inventory.

Let us seem at the benefits of this model for both Dell as well as Its Suppliers:

With VMI model, Dell has reduced it‘s in bound supply chain and thereby gets to reduce its logistics

and inventory management costs substantially.

DELL gets to postpone owning inventory until at the time of actual consumption. Thereby with no

inventories DELL has no require for working capital to be invested into holding inventories.

DELL does not have to set up inventory operations and employ teams for operations as well as

management of inventory functions.

Supplier Benefits:

Supplier gets to set up bigger connection and collaboration with DELL with extensive-term business

prospect.

Through agreeing to hold inventories and effect JIT supplies at the door to DELL, supplier will be in a

bigger location to bargain and get more business from DELL.

With VMI model, supplier gets an opportunity to engage in bigger value proposition with his customer

DELL.

Supplier gets confirmed forecast for the whole year with commitments from DELL for the quantity off

take.

VMI supervised is supervised through 3PL and supplier does not have to engage himself in having to set

up and control inventory operations at DELL‘s premise.

3PL Supervised VMI holds inventories of all suppliers thereby charges each supplier on per pallet

foundation or per sq.ft foundation. Supplier thereby gets to pay on transaction foundation without having

to marry fixed costs of inventory operations.

Today mainly of the Multi National companies have successfully supervised to get their suppliers and

3PL service providers to setup VMI by out their plants all in excess of the world and this model has

become the order of the day.

Require for Inventory Management

Inventory is a necessary evil that every institutions would have to uphold for several purposes. Optimum

inventory management is the goal of every inventory planner. In excess of inventory or under inventory

both reason financial impact and health of the business as well as effect business opportunities.

Inventory holding is resorted to through institutions as hedge against several external and internal

factors, as precaution, as opportunity, as a require and for speculative purposes.

Causes why Institutions Uphold Raw Material Inventory

Mainly of the institutions have raw material inventory warehouses attached to the manufacture facilities

where raw materials, consumables and packing materials are stored and issue for manufacture on JIT

foundation. The causes for holding inventories can modify from case to case foundation.

Meet difference in Manufacture Demand

Manufacture plan changes in response to the sales, estimates, orders and stocking patterns. Accordingly

the demand for raw material supply for manufacture varies with the product plan in conditions of

specific SKU as well as batch quantities. Holding inventories at a surrounding warehouse helps issue the

required quantity and thing to manufacture presently in time.

Cater to Cyclical and Seasonal Demand

Market demand and supplies are seasonal depending upon several factors like seasons; festivals etc and

past sales data help companies to expect a vast surge of demand in the market well in advance.

Accordingly they stock up raw materials and hold inventories to be able to augment manufacture and

rush supplies to the market to meet the increased demand.

Economies of Level in Procurement

Buying raw materials in superior lot and holding inventory is establish to be cheaper for the company

than buying frequent little lots. In such cases one buys in bulk and holds inventories at the plant

warehouse.

Take Advantage of Price Augment and Quantity Discounts

If there is a price augment expected few months down the row due to changes in demand and supply in

the national or international market, impact of taxes and budgets etc, the company‘s tend to buy raw

materials in advance and hold stocks as a hedge against increased costs.

Companies resort to buying in bulk and holding raw material inventories to take advantage of the

quantity discounts offered through the supplier. In such cases the savings on explanation of the discount

enjoyed would be considerably higher that of inventory carrying cost.

Reduce Transit Cost and Transit Times

In case of raw materials being imported from a foreign country or from a distant absent vendor within

the country, one can save a lot in conditions of transportation cost buy buying in bulk and transporting

as a container load or a full truck load. Section shipments can be costlier.

In conditions of transit time too, transit time for full container shipment or a full truck load is direct and

faster unlike section shipment load where the freight forwarder waits for other loads to fill the container

which can take many weeks. There could be a lot of factors resulting in shipping delays and

transportation too, which can hamper the supply chain forcing companies to hold safety stock of raw

material inventories.

Extensive Lead and High Demand Things Require to be Held in Inventory

Often raw material supplies from vendors have extensive lead running into many months. Coupled with

this if the scrupulous thing is in high demand and short supply one can anticipate disruption of supplies.

In such cases it is safer to hold inventories and have manage.

Finished Goods Inventory

All Manufacturing and Marketing Companies hold Finished Goods inventories in several sites and all by

FG Supply Chain. While finished Goods move by the supply chain from the point of manufacturing

until it reaches the end customer, depending upon the sales and delivery model, the inventories may be

owned and held through the company or through intermediaries associated with the sales channels such

as traders, trading partners, stockiest, distributors and dealers, C & F Mediators etc. Why and when do

Institutions hold Finished Goods Inventories:

Markets and Supply Chain Design: Institutions carry out detailed analysis of the markets both at

national as well as international / global stages and work out the Supply Chain strategy with the help of

SCM strategists as to the ideal site for setting up manufacture facilities, the network of and number of

warehouses required to reach products to the markets within and outside the country as well as the mode

or transportation, inventory holding plan, transit times and order management lead times etc, keeping in

mind the mainly significant parameter being, to achieve Customer Satisfaction and Demand Fulfillment.

Manufacture Strategy necessitates Inventory holding: The blue print of the whole Manufacture

strategy is dependant upon the marketing strategy. Accordingly institutions produce based on marketing

orders. The manufacture is intended based on Build to stock or Build to Order strategies. While Build to

Order strategy is manufactured against specific orders and does not warrant holding of stocks other than

in transit stocking, Build to Stock manufacture gets inventoried at several central and forward sites to be

able to cater to the market demands.

Market penetration: Marketing departments of companies regularly run branding and sales promotion

campaigns to augment brand awareness and demand generation. Aggressive market penetration strategy

depends upon ready availability of inventory of all products at adjacent warehousing site so that product

can be made accessible at short notice - in conditions of number of hours lead time, at all sales sites by

out the state and municipality. Any non-availability of stock at the point of sale counter will lead to dip

in market demand and sales. Hence holding inventories becomes a must.

Market Size, site and supply design: Supply chain design takes into explanation the site of market,

market size, demand pattern and the transit lead time required to reach stocks to the market and

determine optimum inventory holding sites and network to be able to hold inventories at national, local

and regional stages and achieve two biggest objectives. The first objective would be to ensure correct

product stock is accessible to service the market. Secondly stocks are held in spaces where it is required

and avoid unwanted stock build up.

Transportation and Physical Barriers: Market site and the physical terrain of the market coupled with

the regional trucking and transportation network often demand inventory holding at adjacent sites. Hilly

areas for instance may need longer lead-time to service. All types of vehicles may not be accessible and

one may have to hire specialized containerized vehicles of vast capacities. In such cases the will have to

have an inventory holding plan for such markets. Distant absent market sites means longer lead times

and transportation delays. Inventory holding policy will take into explanation these factors to work out

the plan.

Regional tax and other Govt. Rules: In several countries where GST is not implemented, local state tax

rules apply and modify from state to state. Accordingly while one state may offer a tax rebate for a

scrupulous set of product category, another state may charge higher regional taxes and lower inter state

taxes. In such cases the demand for product from the neighboring state may augment than from the

regional state. Accordingly inventory holding would have to be intended to cater to the market

fluctuation. While in case of exports from the country of origin into another market located in another

country, one requires to take into explanation the rules concerning import and customs duties to decide

optimum inventories to be held en circuit or at destination.

Manufacture lead times: FG inventory holding becomes necessary in cases where the lead-time for

manufacture is extensive. Sudden market demand or opportunities in such cases need FG inventories to

be built up and supplies to be effected.

Speculative gain: Companies always stay a watch on the economy, annual state budget, financial

habitation and international habitation and are able to foresee and estimate situations, which can have an

impact on their business and sales. In cases where they are able to estimate a augment in industry prices,

taxes or other levies which will result in an overall price augment, they tend to buy and hold vast stocks

of raw materials at current prices. They also hold up finished stock in warehouses in anticipation of a

impending sale price augment. All such moves reason companies to hold inventories at several levels.

Avoid Sure Costs: Finally institutions hold FG inventories to satisfy customer demand, to reduce sales

management and ordering costs, stock out costs and reduce transportation costs and lead times.

Kinds of Inventories - Self-governing and Dependant Demand Inventories

Inventory Management trades essentially with balancing the inventory stages. Inventory is categorized

into two kinds based on the demand pattern, which makes the require for inventory. The two kinds of

demand are Self-governing Demand and Dependant Demand for inventories.

Self-governing Demand:

An inventory of an thing is said to be falling into the category of self-governing demand when the

demand for such an thing is not dependant upon the demand for another thing.

Finished goods Things, which are ordered through External Customers or manufactured for stock and

sale, are described self-governing demand things.

Self-governing demands for inventories are based on confirmed Customer orders, forecasts, estimates

and past historical data.

Dependant Demand:

If the demand for inventory of an thing is dependant upon another thing, such demands are categorized

as dependant demand.

Raw materials and component inventories are dependant upon the demand for Finished Goods and

hence can be described as Dependant demand inventories.

Take the instance of a Car. The car as finished goods is an held produced and held in inventory as self-

governing demand thing, while the raw materials and components used in the production of the Finished

Goods - Car derives its demand from the demand for the Car and hence is characterized as dependant

demand inventory.

This differentiation is necessary because the inventory management systems and procedure are

dissimilar for both categories.

While Finished Goods inventories which is characterized through Self-governing demand, are

supervised with sales order procedure and supply chain management procedures and are based on sales

forecasts, the dependant demand for raw materials and components to production the finished goods is

supervised by MRP -Material Possessions Scheduling or ERP -Enterprise Resource Scheduling by

models such as Presently In Time, Kanban and other concepts. MRP as well as ERP scheduling depends

upon the sales forecast released for finished goods as the starting point for further activity.

Managing Raw Material Inventories is distant more complicated than managing Finished Goods

Inventory. This involves analyzing and co-coordinating delivery capability, lead times and delivery

schedules of all raw material suppliers, coupled with the logistical procedures and transit timelines

involved in transportation and warehousing of raw materials before they are ready to be supplied to the

manufacture shop floor. Raw material management also involves periodic review of the inventory

holding, inventory counting and audits, followed through detailed analysis of the reports leading to

financial and management decisions. Inventory planners who are responsible for scheduling, managing

and controlling Raw Material inventories have to answer two fundamental questions, which can also be

termed as two vital inventory decisions.

Inventory planners require to decide how much of Quantity of each Thing is to be ordered from Raw

Material Suppliers or from other Manufacture Departments within the Institutions.

When should the orders be placed ?

Answering the two questions will call for a lot of back end work and analysis involving inventory

classifications and EOQ determination coupled with Cost analysis. These decisions are always taken in

co ordination with procurement, logistics and fund departments.

Inventory Costs

Inventory procurement, storage and management is associated with vast costs associated with each these

functions. Inventory costs are simply categorized into three headings:

Ordering Cost

Carrying Cost

Shortage or stock out Cost & Cost of Replenishment

Cost of Loss, pilferage, shrinkage and obsolescence etc.

Cost of Logistics

Sales Discounts, Volume discounts and other related costs.

Inventory Classification - ABC Classification, Advantages & Disadvantages

Inventory is a necessary evil in any institutions occupied in manufacture, sale or trading of products.

Inventory is held in several shapes including Raw Materials, Semi Finished Goods, Finished Goods and

Spares. Every element of inventory has an economic value and is measured an asset of the institutions

irrespective of where the inventory is situated or in which shape it is accessible. Even scrap has residual

economic value attached to it.

Depending upon the nature of business, the inventory holding patterns may modify. While in some cases

the inventory may be extremely high in value, in some other cases inventory may be extremely high in

volumes and number of SKU. Inventory may be help physically at the manufacturing sites or in a third

party warehouse site.

Inventory Controllers are occupied in managing Inventory. Inventory management involves many

critical regions. Primary focus of inventory controllers is to uphold

optimum inventory stages and determine order/replenishment schedules and quantities. They attempt to

balance inventory all the time and uphold optimum stages to avoid excess inventory or lower inventory,

which can reason damage to the business.

ABC Classification

Inventory in any institutions can run in thousands of section numbers or classifications and millions of

section numbers in quantity. So inventory is required to be classified with some logic to be able to

control the similar. In mainly of the institutions inventory is categorized just as to ABC Classification

Method, which is based on pareto principle. Here the inventory is classified based on the value of the

elements. The principle applied here is based on 80/20 principles. Accordingly the classification can be

as under:

A Category Things Comprise 20% of SKU & Contribute to 80% of $ spend.

B Category Things Comprise 30% of SKU & Contribute to 15% of $ spend.

C Category Things Comprise 50% of SKU & Contribute to 5% of $ spend.

The above is only an illustration and the actual numbers as well as percentages can modify.

Table 2.8 Inventory Listing through Dollar Usage Percentage.

Advantages of ABC Classification

This type of categorization of inventory helps one control the whole volume and assign comparative

priority to the right category. For Instance A Class things are the high value things. Hence one is able to

monitor the inventory of this category closely to ensure the inventory stage is maintained at optimum

stages for any excess inventory can have vast adverse impact in conditions of overall value.

A Category Things: Helps one identify these stocks as high value things and ensure tight manage in

conditions of procedure manage, physical security as well as audit frequency.

It helps the managers and inventory planners to uphold accurate records and attract management‘s

attention to the issue on hand to facilitate instant decision-creation .

B Category Things: These can be given second priority with lesser frequency of review and less tightly

controls with adequate documentation, audit controls in lay.

C Category Things: Can be supervised with vital and easy records. Inventory quantities can be superior

with extremely few periodic reviews.

Table. 2.9 Take the case of a Computer Manufacturing Plant; the several things of inventory can be

broadly classified as under:

Disadvantages

Inventory Classification does not reflect the frequency of movement of SKU and hence can mislead

controllers.

B & C Categories can often get neglected and pile in vast stocks or susceptible to loss, pilferage,

slackness in record manage etc.

Inventory Manage - Inventory Audits and Cycle Counts

Any inventory of Raw materials, finished goods as well as Intermediate in procedure inventory has an

economic value and is measured an asset in the books of the company. Accordingly any asset requires to

be supervised to ensure it is maintained properly and is stored in close habitation to avoid pilferage, loss

or thefts etc. Inventory manage assumes significance on explanation of several factors.

First of all inventory of raw materials as well as finished goods can run in thousands of SKU diversities .

Secondly inventory can be in one site or spread in excess of several sites. Thirdly inventory may be with

the company or may be under the custody of a third party logistics provider. These factors necessitate

inventory maintenance mechanisms to be devised to ensure inventory manage.

Inventory manage is also required as an operational procedure requirement. Inventory is has two

dissimilar dimensions to it. On one stage it is physical and

involves physical transactions and movement of inventory. While on the other hand, inventory is

recognizable through the book stock and the system stocks maintained. This necessitates inventory

manage mechanism to be implemented to ensure the book stocks and the physical stocks match at all

times.

Thirdly the inventory always moves by supply chain and goes by several transactions at several spaces.

The number of transactions and handling that it goes by from the point of origin to the point of

destination is numerous. So it becomes essential to manage inventory and have visibility by the pipeline

including transit inventory. Inventory manage is exercised by inventory audits and cycle counts. An

inventory audit essentially includes of auditing the books stocks and transactions and matching physical

stocks with the book stock.

Cycle counts: Cycle count refers to the procedure of counting inventory things accessible in physical

sites. Depending upon the nature of inventory, number of transactions and the value of things, cycle

count can be accepted on periodically or perpetually.

Daily Cycle Count: Normally where the number of SKUs is extremely high coupled with high n umber

of transactions and by put, daily cycle count is initiated, where in a sure percentage of sites or SKUs are

counted on daily foundation and physical stock is compared with system stock. Through the end of the

month all of the stocks would have been sheltered once in cycle count.

Inventory system throws up a count list based on an analysis of the movements of fast moving SKUs

beside with other attributes like value etc. In some of the system, inventory controllers can set up the

attributes for each cycle count.

Quarterly & Half Yearly Cycle Counts: End of the sales quarter or end of half yearly sales, finished

goods and spare sections are normally sheltered under inventory audit and a 100% cycle count is

accepted out.

Wall to Wall Cycle Count: End of financial year and closing of books entails doing wall to wall cycle

count of all stocks lying in all sites and tallying with books of explanation. This is a mandatory audit

requirement and until stock figures are reconciled, certified through auditors and published, New Year

books of explanations cannot be started a fresh.

How the Audit Procedure Works ?

Except for daily cycle counts, all other cycle counts entail counting hundred percent of all the stocks

through stopping all transactions throughout the counting era. System transactions are also frozen until

the count is completed. Inventory system throws up count list with SKU number, account and site

number. The operator goes to the site, checks the SKU, counts the qty accessible and updates the list,

which is then fed into the system. The system reconciles the physical quantity with system quantity and

throws up discrepancy statement, which is further worked upon to tally and adjust inventory.

Operational Challenges in Inventory Management

The latest trend in all industries has been to outsource inventory management functions to Third Party

Service providers. Companies outsource both Raw Material Inventory as well as Finished Goods to the

Service Provider.

In case of finished goods inventory, depending upon the supply chain design, there may be multiple

stocking points at national, local and state stages. In such an event each of the warehouse a dissimilar

service provider may control operations, as one may not be able to discover a supplier having operations

all in excess of the country.

So the inventory in such a situation will be supervised in the Company‘s system as well as in the Service

provider‘s system. Inventory management and manage becomes a critical function especially in such

situations where multi sites and multiple service providers are involved.

To ensure Inventory manage is maintained crossways all sites, following critical points if focused upon

will help:

Set up and outline Operations Procedure for Service Providers: Attract up SOP - Average Operating

process detailing warehouse operations procedure, warehouse inventory system procedure as well as

documentation procedure.

Especially in a 3rd Party Service Provider‘s facility, it is significant to have procedure adherence as well

as defined management, authorization and escalation building for operations failing which inventory

operations will not be under manage.

Set up inventory visibility at each of the site by MIS Reports: Attract up list of reports and MIS data for

all sites and ensure they are mailed to a central desk in the inventory team for daily review. The

inventory team leader should examine daily reports of all sites and highlight any non-conventionality

and resolve them as well as update the management.

Initiate Daily Stock count process to be accepted out at all of the sites and accounted back to the

inventory desk.

Daily stock count should be able to reflect site accuracy, stock accuracy as well as transaction summary

for the day.

Monthly audits and inventory count should be implemented at all sites without fail and insist on one

hundred percent adherence.

Quarterly inventory - wall-to-wall count or half yearly and annual wall-to-wall count should be

implemented depending upon the volume of transactions as well as value of transactions at each site.

Central Inventory team to be responsible for ensuring review of all reports and controlling inventories at

all sites.

Inventory reconciliation - involves reconciling physical inventory at location with the system inventory

at 3PL Location and then reconciling 3PL System stocks with company‘s system stock.

Visiting biggest locations and being present throughout physical stock audits on quarterly or half yearly

foundation is extremely significant.

Lastly stay reviewing procedures and ensure training and re training is accepted out frequently and at all

times at location so that a procedure oriented civilization is imbibed and all operating staff understand

the importance of maintaining procedures as well as inventory health.

Inventory is nothing but money to the company. If 3PL vendor is managing the inventory, needless to

say you should have your procedures in lay to be able to manage and uphold inventory health.

REVIEW QUESTIONS

Explain important components of receivables management system?

Why do we need a credit policy? How do you evaluate credit policy?

How do you assess the credit worthiness of customers?

Explain the objective of cash management system. How do you deal with the conflicting nature of the

objectives?

What are the principal motives of holding cash in a business despite its unproductive nature?

Discuss internal and external determinants that affect the flow of cash.

What is the primary cause of interest rate risk?

Discuss the important features of the Miller-Orr model.

What are bond call provision and why are they used?

Why do firms hold inventory? Illustrate with Examples.

Explain different components of an inventory system?

What are different costs associated with holing inventory? How are they related?

CHAPTER 3

Financing of Working Capital Needs

BANK CREDIT - PRINCIPLES AND PRACTICES

Principles of Bank Lending

While granting loans and advances commercial banks follow the three cardinal principles of lending.

These are the principles of safety, liquidity, and profitability, which have been explained below:

Principle of Safety: The mainly significant principle of lending is to ensure the safety of the funds lent.

It means that the borrower repays the amount of the loan with interest as per the loan contract. The skill

to repay the loan depends upon the borrower‘s capability to pay as well as his willingness to repay. To

ensure the former, the banker depends upon his tangible assets and the viability of his business to earn

profits. Borrower‘s willingness depends upon his honesty and character. Banker, so, takes into

explanation both the characteristics to determine the credit - worthiness of the borrower and to ensure

safety of the funds lent.

Principle of Liquidity: Banks rally funds by deposits which are repayable on demand or in excess of

short to medium eras. The banker so lends his funds for short era and for Working Capital purposes.

These loans are mainly repayable on demand and are granted on the foundation of securities which are

easily marketable so that he may realize his dues through selling the securities.

Principle of Profitability: Banks are profit earning organizations. They lend their funds to earn income

out of which they pay interest to depositors, incur operational expenses, and earn profit for sharing to

owners. They charge dissimilar rates of interest just as to the risk involved in lending funds to several

borrowers. Though, they do not have to sacrifice safety or liquidity for the sake of higher profitability.

Following the principles banks pursue the practice of diversifying risk through spreading advances in

excess of a reasonably wide region, distributed amongst a good number of customers belonging to

dissimilar deals and industries. Loans are not granted for speculative and unproductive purposes

Approach of Credit

Commercial banks give fund for working capital purposes by a diversity of methods. The largest

systems or approach of credit, prevalent in India are depicted in the following diagram.

The conditions and circumstances, the rights and privileges of the borrower and the banker differ in each

case. We shall talk about below these methods of granting bank credit.

Overdrafts

This facility is allowed to the current explanation holders for a short era. Under this facility, the current

explanation holder is permitted through the banker to attract from his explanation more than what stands

to his credit. The excess amount drawn through him is deemed as an advance taken from the bank.

Interest on the exact amount overdrawn through the explanation-holder is charged for the era of actual

utilisation. The banker may grant such an advance either on the foundation of collateral security or on

the personal security of the borrower. Overdraft facility is granted through a bank on an application

made through the borrower. He is also required to sign a promissory note. So, the customer is allowed

the amount, up to the sanctioned limit of overdraft as and when he requires it. He is permitted to repay

the loan as per his convenience and skill to do so.

Cash Credit System

The salient characteristics of this system are as follows:

Under this system, the banker prescribes a limit, described the Cash Credit limit, up to which the

customer- borrower is permitted to borrow against the security of tangible assets or guarantees.

The banker fixes the Cash Credit limit after considering several characteristics of the working of the

borrowing concern i.e., manufacture, sales, inventory stages, past utilization of such limit, etc.

The borrower is permitted to withdraw from his Cash Credit explanation, amount as and when he

requires them. Surplus funds with him are allowed to be deposited with the banker any time. The Cash

Credit explanation is therefore a running explanation, wherein withdrawals and deposits may be made

regularly any number of times.

As the borrower withdraws from Cash Credit explanation he is required to give security of tangible

assets. A charge is created on the movable assets of the borrower in favour of the banker.

When the borrower repays the borrowed amount in full or in section, security is released to him in the

similar proportion in which the amount is refunded.

The banker charges interest on the actual amount utilised through him and for the actual era of

utilization.

However the advance made under Cash Credit System is repayable on demand and there is no specific

date of repayment, in practice the advance is rolled in excess of a era of time i.e. the debit balance is

hardly fully wiped out and the loan continues from one era to another.

Under this system, the banker keeps adequate cash balance to meet the demand of his customers as and

when it arises, but interest is charged on the actual amount of loan availed of. Therefore, to neutralize

the loss caused to the banker, the latter imposes a commitment charge at a normal rate of 1% or so, on

the unutilized portion of the cash credit limit.

Merits of Cash Credit System

The Cash Credit System has the following merits:

The borrower requires not stay surplus funds idle with him. He can deposit the surplus funds with the

banker, reduce his debit balance, and therefore minimize the interest burden. On the other hand he can

withdraw funds at any time to meet his requires.

Banks uphold one explanation for all transactions of a customer. As documents are required only once in

a year the costs of repetitive documentation is avoided.

Demerits of Cash Credit System

The Cash Credit System, on the other hand, suffers from the following demerits:

Cash Credit limits are prescribed only once in a year and hence they are fixed keeping in view the

maximum amount that can be required within a year. Consequently, portion leftovers unutilized for

section of the year throughout which bank funds remain unemployed.

The banker leftovers unable to verify the end exploit of funds borrowed through the customer. Such

funds may be diverted to unapproved purposes.

The banker leftovers unable to plan the utilization of his funds as the stage of advances depend upon the

borrower‘s decision to borrow at any time.

As the volume of cash transactions increases significantly under the cash credit system as against the

loan system, the cost of handling cash, honoring cheques, taking and giving delivery of securities

increases the transactions cost of banks.

As there is only commitment charge of 1% or less, there will be a tendency on the section of companies

to negotiate for a higher limit.

Loan System

Under the loan system, a definite amount is lent at a time for a specific era and a definite purpose. It is

withdrawn through the borrower once and interest is payable for the whole era for which it is granted. It

may be repayable in installments or in lump sum. If the borrower requires funds again, or wants to

renew an existing loan, a fresh proposal is placed before the banker. The banker will create a fresh

decision depending upon the availability of cash possessions. Even if the full loan amount is not utilized

the borrower has to pay the full interest.

Advantages of the Loan System

The loan system has the following advantages in excess of the Cash Credit System:

This system imposes greater financial discipline on the borrowers, as they are bound to repay the whole

loan or its installments on the due date/ dates fixed in advance.

At the time of granting a new loan or renewing an existing loan, the banker reviews the loan

explanation. Therefore unsatisfactory loan explanations may be discontinued at his discretion.

As the banker is entitled to charge interest on the whole amount of loan, his income from interest is

higher and his profitability also increases because of lower transaction cost.

Short Term Loans

Short term loans are granted through banks to meet the Working Capital necessities of the borrowers.

Such loans are generally granted for an era up to one year and are secured through the tangible movable

assets of the borrowers like goods and commodities, shares, debentures etc. Such goods and securities

are pledged or hypothecated with the banker. Reserve Bank of India has exercised compulsion on banks

as 1995 to grant 80% of the bank credit permissible to borrowers with credit of Rs 10 crore or more in

the shape of short term loans which may be for several maturities. Reserve Bank has also permitted the

banks to roll in excess of such loans i.e. to renew the loan for another era at the expiry of the era of the

first loan.

Medium and Extensive Term Loans

Such loans are usually described ‗Term Loans‘ and are granted through banks with All India Financial

organizations like Industrial Development Bank of India, Industrial Fund Corporation of India,

Industrial Credit and Investment Corporation of India Ltd. Term loans are granted for medium and

extensive conditions, usually above 3 years and are meant for purchase of capital assets for the

establishment of new elements and for expansion or diversification of an existing element. At the time

of setting up of a new industrial element, term loans constitute a section of the project fund which the

entrepreneurs are required to raise from dissimilar sources. These loans are generally secured through

the tangible assets like land, structure, plant, and machinery etc. In October 1997 Reserve Bank of India

permitted the banks to announce distinct prime lending rate for term loans of 3 years and above.

In April 1999 Reserve bank of India also permitted the banks to offer fixed rate loans for project

financing. Reserve Bank of India has encouraged the banks to lend for project fund as well. In

September, 1997 ceiling on the quantum of the term loans granted through banks individually or in

consortia/syndicate for a single project was abolished. Banks now have the discretion to sanction term

loans to all projects within the overall ceiling of the prudential exposure norms prescribed through

Reserve bank. The era of term loans will also be decided through banks themselves. However term loans

are meant for meeting the project cost but as project cost contains periphery for Working Capital , a

section of term loans essentially goes to meet the requires of Working Capital.

Bridge Loans

Bridge loans are in information short term loans which are granted to industrial undertakings to enable

them to meet their urgent and essential requires. Such loans are granted under the following conditions:

When a term loan has been sanctioned through banks and/ or financial organizations, but its actual

disbursement will take time as necessary formalities are yet to be completed.

When the company is taking necessary steps to raise the funds from the Capital market through issue of

equities/debt instruments.

Bridge loans are provided through banks or through the financial organizations which have granted term

loans. Such loans are automatically repaid out of the amount of term loan when it is disbursed or out of

the funds raised from the Capital Market. Reserve Bank of India has allowed the banks to grant such

loans within the ceiling of 5% of incremental deposits of the previous year prescribed for individual

banks‘ investment in Shares/ Convertible debentures. Bridge loans may be granted for a maximum era

of one year.

Composite Loans

Composite loans are those loans which are granted for both, investment in capital assets as well as for

working capital purposes. Such loans are generally granted to little borrowers, such as artisans, farmers,

little industries etc. Under the composite loan scheme, both term loans and Working Capital are

provided by a single window. The limit for composite loans has recently (in Feb., 2000) been increased

from Rs. 5 lakhs to Rs.10 lakhs for little borrowers.

Personal Loans

These loans are granted through banks to individuals specially the salary-earners and others with regular

income, to purchase consumer durable goods like refrigerators, T.Vs., cars etc. Personal loans are also

granted for purchase/construction of homes. Usually the amount of loans is fixed as a multiple of the

borrower‘s income and a repayment schedule is prepared as per his capability to save.

Classification of Advances Just as to Security

Banks attach great importance to the safety of the funds, lent as loans and advances. For this purpose,

they inquire the borrowers to make a charge on their tangible assets in their favour. In some cases, the

banks close their interest through asking for a guarantee given through a third party. Besides the tangible

assets or a guarantee, banks rely upon the personal security of the borrower and grant loans which are

described unsecured advances‘ or ‗clean loans‘. In the balance sheet, banks classify advances as follows:

Secured Advances

Just as to Banking Regulation Act 1949, a secured loan or advance means ―a loan or advance made on

the security of assets, the market value of which is not at any time less than the amount of such loan or

advances‖. An unsecured loan or advance means a loan or advance not so secured. The largest

characteristics of a secured loan are:

The advance is made on the foundation of security of tangible assets like goods and commodities, life

insurance policies, corporate and government securities etc.

A charge is created on such security in favor of the banker.

The market value of such security is not less than the amount of loan. If the former is less than the latter,

it becomes a partly secured loan.

Unsecured Advances

Unsecured advances are granted without asking the borrower to make a charge on his assets in favour of

the banker. In such cases the security happens to be the personal obligation of the borrower concerning

repayment of the loan. Such loans are granted to parties enjoying high reputation and sound financial

location. The legal status of the banker in case of a secured advance is that of a secured creditor. He

possesses absolute right to recover his dues from the borrower out of the sale proceeds of the assets in

excess of which a charge is created in his favour. In case of an unsecured advance, a banker leftovers an

unsecured creditor and stand at par with other unsecured creditors of the borrower, if the latter defaults.

Guaranteed Advances

The banker often safeguards his interest through asking the borrower to give a guarantee through a third

party may be an individual, a bank or Government. Just as to the Indian Contract Act, 1872, a contract

of guarantee is defined as ―a contract to perform the promise or discharge the liability of third person is

case of his default”. The person who undertakes this obligation to discharge the liability of another

person is described the guarantor or the surety. Therefore a guaranteed advance is, in information, also

an unsecured advance i.e. without any specific charge being created on any asset, in favour of the

banker. A guarantee carries a personal security of two persons i.e. the principal debtor and the surety to

perform the promise of the principal debtor. If the latter fails to fulfill his promise, liability of the surety

arises immediately and automatically. The surety so, necessity be a reliable person measured well for the

amount for which he has stood as surety. The guarantee given through banks, financial organizations

and the government are so measured precious.

Manners of Creating Charge in Excess of Assets

In case of secured advance, a charge is created in excess of an asset of the borrower in favour of the

lender. Through making of charge it is meant that the banker gets sure rights in the tangible assets of the

borrower. The borrower still leftovers the owner of the asset, but the banker gets the right of realizing

his dues out of the sale proceeds of the asset. Therefore banker‘s interest is safeguarded. There are many

methods of creating charge in excess of the borrower‘s assets as shown below:

Pledge

Pledge is the mainly popular method of creating charge in excess of the movable assets. Indian Contract

Act, 1872, defines pledge as ‘bailment of goods as security of payment of a debt or performance of a

promise”. The person who offers the security is described the pledger and the person to whom the goods

are entrusted is described the ‗pledgee‘. Therefore bailment of goods is the essence of a pledge. Indian

Contract Act defines bailment as ―delivery of goods from one person to another for some purpose upon

the contract that the goods are returned back when the purpose is accomplished or otherwise disposed of

just as to the instructions of the bailor‖. Therefore when the borrower pledges his goods with the banker,

he delivers the goods to the banker to be retained through him as security for the amount of the loan.

Delivery of goods may be either (i) physical delivery or (ii) constructive or symbolic delivery. The latter

does not involve physical delivery of the goods. The handing in excess of the keys of the go down

storing the goods, or even handing in excess of the documents of the title to goods like warehouse

receipts, duly endorsed in favour of the banker amounts to constructive delivery.

It is also essential that the banker necessity return the similar goods to the borrower after he repays the

amount of loan beside with interest and other charges. The pledgee (banker) is entitled to sure rights,

which are conferred upon him through the Indian Contract Act. The foremost right is that he can retain

the goods pledged for the payment of debt and interest and other charges payable through the borrower.

In case the pledger defaults, the pledgee has the right to sell the goods after giving pledger reasonable

notice of sale or to file a suit for the amount due from him.

Hypothecation

Hypothecation is another method of creating charge in excess of the movable assets of the borrower. It is

preferred in conditions in which transfer of possession in excess of such assets is either inconvenient or

is impracticable. For instance, if the borrower wants to borrow on the security of raw materials or goods

in procedure, which are to be converted into finished products, transfer of possession is not

possible/practicable because his business will be impeded in case of such transfer. Likewise a

transporter requires the vehicle for plying on the road and hence cannot provide its possession to the

banker for taking a loan. In such conditions a charge is created through method of hypothecation.

Under hypothecation, neither ownership nor possession in excess of the asset is transferred to the

creditor. Only an equitable charge is created in favour of the banker. The asset leftovers in the

possession of the borrower who promises to provide possession thereof to the banker, whenever the

latter needs him to do so. The charge of hypothecation is therefore converted into that of a pledge. The

banker enjoys the rights and authorities of a pledgee. The borrower uses the asset in any manner he

likes; via he may take out the stock, sell it, and replenish it through a new one. Therefore a charge is

created on the movable asset of the borrower. The borrower is deemed to hold possession in excess of

the goods as an agent of the creditor. To enforce the security, the banker should take possession of the

hypothecated asset on his own or by the court.

Mortgage

A charge on immovable property like land & structure is created through means of a mortgage. Transfer

of Property Act 1882 defines mortgage as‖ the transfer of an interest in specific immovable property for

the purpose of securing the payment of money, advanced or to be advanced through method of loan, an

existing or future debt or the performance of an engagement which provide rise to a pecuniary

liability”. The transferor is described the ‗mortgagor‘ and the transferee ‗mortgagee‘. The owner

transfers some of the rights of ownership to the mortgagee and retains the remaining with him. The

substance of transfer of interest in the property necessity is to close a loan or to ensure the performance

of an engagement which results in monetary obligation. It is not necessary that actual possession of the

property be passed on to the mortgagee. The mortgagee, though, gets the right to recover the amount of

the loan out of the sale proceeds of the mortgaged property. The mortgagor gets back the interest in the

mortgaged property on repayment of the amount of the loan beside with interest and other charges.

Types of Mortgages

However Transfer of Property Act identifies seven types of mortgages, but from the point of view of

transfer of title to the mortgaged property, mortgages are divided in to

Legal mortgages and

Equitable mortgages

In case of Legal Mortgage, the mortgagor transfers legal title to the property in favour of the mortgagee

through executing the Mortgage deed. When the mortgage money is repaid, the legal title to the

mortgaged property is re-transferred to the mortgagor. Therefore in this kind of mortgage expenses are

incurred in the shape of stamp duty and registration charges. In case of an equitable mortgage the

mortgagor hands in excess of the documents of title to the property to the mortgagee and therefore

makes an equitable interest of the mortgagee in the mortgaged property. The legal title to the property is

not passed on to the mortgagee but the mortgagor undertakes by a Memorandum of Deposit to execute a

legal mortgage in case he fails to pay the mortgaged money. In such situation the mortgagee is

emauthorityed to apply to the court to convert the equitable mortgage into legal mortgage.

Equitable Mortgage has many advantages in excess of Legal Mortgage. It is not necessary to register the

Memorandum of Deposit or the covering letter sent beside with the Documents of title. Actual handing

in excess of through a borrower to the lender of documents of title to immovable property with the

intention to constitute them as security is enough. As registration is not mandatory, fact concerning

mortgage leftovers confidential and the mortgagor‘s reputation is not affected. When the debt is repaid

documents are returned back to the borrower, who may re-deposit the similar for taking another loan

against the similar documents. But the banker should be extremely cautious in retaining the documents

in his possession, because if the equitable mortgagee is negligent or mis-symbolizes to another person,

who advances money on the security of the mortgaged property, the right of the latter will have first

priority.

Assignment

The borrower may give security to the banker through assigning any of his rights, properties, or debts to

the banker. The transferor is described the ‗assignor‘ and the transferee the ‗assignee‘. The borrowers

usually assign the actionable claims to the banker under part 130 of the Transfer of Property Act 1882.

Actionable claim is defined as a claim to any debt, other than a debt secured through mortgage of

immovable property or through hypothecation or pledge of movable property or to any beneficial

interest in movable property not in the possession of the claimant. A borrower may assign to the banker:

The book debts,

Money due from a government department or semi-government organisation and

Life insurance policies.

Assignment may be either a legal assignment or an equitable assignment. In case of legal assignment,

there is absolute transfer of actionable claim which necessity is in writing. The debtor of the assignor is

informed in relation to the assignment. In the absence of the above the assignment is described equitable

assignment.

Lien

The Indian Contract Act confers upon the banker the right of common lien. The banker is emauthorityed

to retain all securities of the customer, in respect of the common balance due from him. The banker gets

the right to retain the securities handed in excess of to him in his capability as a banker till his dues are

paid through the borrower. It is deemed as implied pledge.

Secured Advances

Secured advances explanation for important portion of total advances granted through banks. As we

have seen, in case of secured advances, a charge is created on the assets of the borrowers in favour of the

banker, which enables him to realize his dues out of the sale proceeds of the assets. Let us first revise the

common principle of secured advances:

Marketability of Securities: The banker grants advances on the foundation of those securities which are

easily marketable without loss of time and money, because in case of non-payment through the

borrower, the banker shall have to dispose off the security to realize his dues.

Adequacy of Periphery: Banker also maintains a variation flanked by the value of the security and the

amount lent. This is described ‗periphery‘. Suppose a banker grants a loan of Rs. 100 /- on the security

valued at Rs. 200/- the variation flanked by the two (i.e. Rs. 200 - Rs. 100 = Rs. 100) is described

periphery. Periphery is necessary to safeguard the interest of the banker as the market value of the

security may fall in future and /or interest and other charges become payable through the borrower,

therefore raising the liability of the borrower towards the banker. Dissimilar margins are prescribed in

case of dissimilar securities.

Documentation: Banker also needs the borrower to execute the necessary documents e.g. Agreement of

pledge, Mortgage Deed, Promissory notes etc. to safeguard his interest.

Goods and Commodities

Bulk of the advances granted through banks is secured through goods and commodities, raw material

and finished goods etc., which constitute the stock-in-deal of business homes. Though, agricultural

commodities are likely to deteriorate in excellence in excess of an era of time. Hence banks grant short

term loans only against such commodities. The problem of valuation of stock pledged with the bank is

not a hard one, as daily quotations are easily accessible. Banker generally prefers those commodities

which have steady demand and a wider market. Such goods are required to be insured against fire and

other risks. Such goods either pledged or hypothecated to the banker are released to the borrower in

proportion to the amount of loan repaid.

Agro-based commodities such as food grains, sugar, pulses, oilseeds, cotton are sensitive to the market

forces of demand and supply and prices. As our country has faced seasonal shortages in many of these

commodities, the reserve bank of India under the power vested in it through the Banking Regulation

Act, issues directives recognized as Selective Credit Manage (SCC) to scheduled commercial banks

throughout the commencement of each busy season which is, in practical conditions, the commencement

of the Kharif or the Rabi season each year. In order to ensure that speculation in these sensitive

commodities does not take lay, the Reserve Bank of India in its busy season policy issues direction to

manage the credit for commodities through:

Fixing an overall ceiling for credit to sensitive commodities for each bank as entire. For instance, total

credit against these commodities in a scrupulous year may be restricted to 80% of the previous year‘s

stage;

Fixing margins and rates of interest that can be levied through banks in their credit against the selected

commodities; and

Banning the flow of bank credit towards financing one or more of these selected commodities.

Each bank takes into consideration the RBI‘s policy on selective credit manage while determining its

own credit policy. The Head Offices of banks advise their branches on the conditions and circumstances

applicable to SCC commodities.

Documents of Title to Goods

These documents symbolize actual goods in the possession of some other person. Hence they are

evidence of possession or manage in excess of the goods. For instance, warehouse receipts, railway

receipts, Bill of lading etc. are documents of title to goods. When the owner of goods represented

through these documents wants to take a loan from the banker, he endorses such documents in favour of

the banker and delivers them to him. The banker is therefore entitled to receive the delivery of such

goods, if the advance is not repaid.

Stock Swap Securities

Stock Swap Securities comprise of the securities issued through the Central and State governments,

semi-govt., organizations, like Port Trust & Improvement Trust, Shares and Debentures of companies

and Elements of the Mutual Funds listed on the Stock Exchanges. The Govt. securities are carried

through banks because of their simple liquidity, continuity in prices, regular accrual of income and

simple transferability. In case of corporate securities banks prefer debentures of companies vis-à-vis

shares because the debenture holder usually happens to be secured creditor and there is a contractual

obligation on the company to pay interest thereon frequently. Amongst the shares, banks prefer

preference shares, because of the preferential rights enjoyed through the preference shareholders in

excess of equity shareholders. Banks accept equity shares of those companies which they approve after

thorough screening and examination of all characteristics of their working. A charge in excess of such

securities is created in favour of the banker.

Reserve Bank of India has permitted the banks to grant advances against shares to individuals up to Rs.

20 lakhs w.e.f. April 29, 1998 if the advances are secured through dematerialized Securities. The

minimum periphery against such dematerialized shares was also reduced to 25%. Advances can also be

granted to investment companies, shares, & stock brokers, after creation a cautious assessment of their

necessities.

Life Insurance Policies

A life insurance policy is measured an appropriate security through a banker as repayment of loan is

ensured to the banker either at the time policy matures or at the time of death of the insured. Moreover,

the policy has a surrender value which is paid through the insurance company, if the policy is

discontinued after a minimum era has lapsed. The policy can be legally assigned to the banker and the

assignment may be registered in the books of the insurance company. Banks prefer endowment policies

as compared to the entire life policies and insist that the premium is paid frequently through the insured.

Fixed Deposit Receipts

A Fixed Deposit Receipt issued through the similar bank is the safest security for granting an advance

because the receipt symbolizes a debt due from the banker to the customer. At the time of taking a loan

against fixed deposit receipt the depositor hands in excess of the receipt to the banker duly discharged,

beside with a memorandum of pledge. The banker is therefore authorized through the depositor to

appropriate the amount of the FDR towards the repayment of loan taken from the banker.

Real Estate

Real Estate i.e. immovable property like land and structure are usually not regarded appropriate security

for granting loans for working capital. It is hard to ascertain that the legal title of the owner is free from

any encumbrance. Moreover, their valuation is a hard task and they are not readily realizable assets.

Preparation of mortgage deed and its registration takes time and is expensive also. Real Estates are, so,

taken as security for term loans only.

Book Debts

Sometimes the debts which the borrower has to realize from his debtors are assigned to the banker in

order to close a loan taken from the banker. Such debts have either become due or will accrue due in the

close to future. The assignor necessity executes an instrument in writing for this purpose, clearly

expressing his intention to pass on his interest in the debt to the assigner (banker). He may also pass an

order to his debtor to pay the assigned debt to the banker.

Supply Bills

Banks also grant advance on the security of supply bills. These bills are offered as security through

persons who supply goods, articles, or materials to several Govt. departments, semi-govt. bodies and

companies, and through the contractors who undertake govt. contract work. After the goods are supplied

through the suppliers to the govt. department and he obtains an inspection note or Receipted Challan

from the Deptt., he prepares a bill for the goods supplied and provides it to the bank for collection and

seeks an advance against such supply bills. Such bills are paid through the purchaser at the expiry of the

stipulated era.

Security for bank credit could be in the shape of a direct security or an indirect security. Direct security

contains the stocks and receivables of the customers on which a charge is created through the bank by

several security documents. If in the view of the bank, the primary or direct security is not measured

adequate or is risk prone, that is, subject to heavy fluctuations in prices, excellence etc., the bank may

need additional security either from the customer or from a third party on behalf of the customer. The

additional security so obtained is recognized as Indirect or ―Collateral Security‖. The term collateral

means running parallel or jointly and collateral security is an additional and distinct security for

repayment of money borrowed.

In case the customer is unable to give additional security when required through the bank, he may be

required to give collateral security from a third party. The general shape of the third party collateral

security is a guarantee given through a person on behalf of the customer to the bank. The third party

collateral security in turn may be unsecured or secured. For instance, where the guarantor has executed a

guarantee agreement only, the collateral security is unsecured. Though, if he lodges beside with the

guarantee agreement, security such as title deeds to his property creating mortgage through deposit of

title deeds with the bank, a secured collateral security is created.

Purchase and Discounting of Bills

Purchase and discounting of bills of swap is another method banks give credit to business entities. Bills

of swap and promissory notes are negotiable instruments which arise out of commercial transactions

both in inland deal and foreign deal and enable the debtors to discharge their obligations towards their

creditors. On the foundation of maturity era , bills are classified into:

Demand bills and

Usance bills.

When a bill is payable ‗at sight‘ ‗on demand‘ or on presentment, it is described a demand bill. If it

matures for payment after a sure era of time say 30,60,90 days , after date or sight, it is described a

usance bill. No stamp duty is required in case of demand bills and on usance bills, if they (i) arise out of

the bona fide commercial transactions , (ii) are payable not more than 3 months after date or sight and

(iii) are drawn on or made through or in favour of a commercial or cooperative bank. When the drawer

of a bill encloses with the bill documents of title to goods, such as the railway receipt or motor transport

receipt, to be delivered to the drawee , such bills are described documentary bills. When no such

documents are attached the bill is described a clean bill. In case of documentary bills, the documents

may be delivered on accepting the bill or on creation its payment. In the former case it is described

Documents against Acceptance (D/A) foundation, and in the latter case Documents against Payment

(D/P) foundation. In case of a clean bill, the relevant documents of title to goods are sent directly to the

drawee.

Process for Discounting of Bills

When the seller of the goods draws a bill of swap on the buyer (debtor), he has two options to trade with

the bill.

To send the bill to a bank for collection, or

To sell it to, or discount it with, a bank

When the bill is sent to the bank for collection the banker acts as the agent of the drawer and creates its

payment to him only on the realisation of the bill from the drawee. The banker sends it to its branch at

the drawee‘s lay, which presents it before the drawee, collects the amount, and remits it to the collecting

banker, who credits the similar to the drawer‘s explanation. In case of collection of bills, the bank acts as

an agent of the drawer of the bill and does not lend his funds through giving credit before actual

realisation of the bill. The business of purchasing and discounting of bills differs from that of collection

of bills. In case of purchase/discounting of bills, the bank credits the amount of the bill to the drawer‘s

explanation before its actual realisation from the drawee. The banker therefore lends his own funds to

the drawer of the bill. Bills purchased or discounted are so, shown under the head ‗ Loans and

Advances‘ in the Balance Sheet of a bank.

The practice adopted in case of demand bills is recognized as purchase of bills. As demand bills are

payable on demand, and there is no maturity, the banker is entitled to demand its payment immediately

on its presentation before the drawee. Therefore the money credited to the drawer‘s explanation, after

deducting charges/discount, is realized through the banker within a few days. In case of a usance bill

maturing after a era of time usually 30,60,or 90 days, so, banker discounts the bill i.e. credits the amount

of the bill, less the amount of discount, to the drawer‘s explanation. Thereafter, the bill is sent to the

bank‘s branch at the drawee‘s lay which presents it to the drawee for acceptance. Documents of title to

goods, if enclosed with the bills, are released to him on accepting the bill. The bill is thereafter retained

through the banker till maturity, when it is presented to the acceptor of the bill for payment.

Advantages of Discounting of Bills

A banker derives the following advantages through discounting the bills of swap:

Safety of funds lent: However the banker does not get charge in excess of any tangible asset of the

borrower in case of discounting of bills, his interest is safeguarded through the information that the bills

of swap includes signatures of two parties—the drawer and the drawee (acceptor)— who are responsible

to create payment of the bill. If the acceptor fails to create payment of the bill the banker can claim the

entire amount from his customer, the drawer of the bill. The banker can debit the customer‘s explanation

and recover the money on the due date. The banker is able to recover the amount as he discounts the

bills drawn through parties of standing and good reputation.

Certainty of payment: Every usance bill matures on a sure date. Three days of grace are allowed to the

acceptor to create payment. Therefore , the amount lent to the customer through discounting the bills is

definitely recovered through the banker on its due date. The banker knows the date of payment of the

bills and hence can plan the utilization of his funds well in advance and with profit.

Facility of re-discounting of bills: The banker can increase his funds, if require arises, through re-

discounting the bills, already discounted through him, with the Reserve Bank of India, other banks and

financial organizations and the Discount and Fund Home of India Ltd. Reserve Bank of India can also

grant loans to the banks on the foundation of the bills held through them.

Continuity in the value of bills: The values of the bills leftovers fixed and unchanged while the value of

all other goods, commodities and securities fluctuate in excess of era of time.

Profitability: In case of discounting of bills, the amount of interest (described discount) is deducted in

advance from the amount of the bill. Hence the effective yield is higher than loans and advances where

interest is payable quarterly/half yearly.

Derivative Usance Promissory Notes

Banks may re-discount the discounted bills of swap with other banks and financial organizations. For

this purpose, under the normal process, the bills are endorsed in favour of the re-discounting bank

/organization and delivered to it. At the time of maturity reverse procedure is required. To simplify the

process of re-discounting, Reserve Bank of India has dispensed with the must of physical lodgment of

the discounted bills. Instead, banks are permitted, on the foundation of such discounted bills, to prepare

derivative usance promissory notes for appropriate amounts like Rs. 5 lakh or Rs. 10 lakh and for

appropriate maturities like 60 days or 90 days. These derivative usance promissory notes are

rediscounted with the re-discounting bank or organization. The essential condition is that the derivative

promissory note should be backed through unencumbered bills of swap of at least equal value till the

date of maturity. In the meanwhile, any maturing bill may be replaced through another bill for equal

amount. No stamp duty is required on such derivative usuance promissory notes.

Compulsion on the Exploit of Bills

To encourage the exploit of bills of swap through corporate borrowers, the Reserve Bank of India had

directed the commercial banks to advice their corporate borrowers to fund their domestic credit

purchases from little level industrial elements as well as from others at least to the extent of 25 percent

through method of acceptance of bills drawn upon them through their suppliers. This was to be

stipulated as a condition for sanctioning working capital credit limits. Banks were also authorized to

charge an additional interest from those borrowers who did not comply with these necessities in any

quarter. In October 1999 Reserve bank of India permitted the banks to charge interest rate on

discounting of bills without reference to Prime Lending Rate. They are now free to offer competitive

rate of interest on the bill discounting facility. The compulsion was also withdrawn. Revised Guidelines

of RBI on Discounting of Bills

Banks may sanction working capital limits as also bills limits to borrowers after proper appraisal of their

credit requires and in accordance with the loan policy as approved through their Board of Directors.

Banks are required to open letters of credit (LCs) and purchase /discount/ negotiate bills under LCs only

in respect of genuine commercial and deal transactions of their borrower constituents who have been

sanctioned regular credit facilities through them.

For the purpose of credit exposure, bills purchased discounted/negotiated under LCs or otherwise would

be reckoned as exposure on the bank‘s borrower constituent. Accordingly, the exposure should draw a

risk-weight appropriate to the borrower constituent (viz.,100 per cent for firms, individuals, corporate)

for capital adequacy purposes.

Banks have been permitted to exercise their commercial judgment in discounting of bills of services

sector. Banks would require ensuring that actual services are rendered and accommodation bills are not

discounted. Services sector bills should not be eligible for rediscounting.

Bank Credit by Debt Instruments

Throughout recent years, banks have resorted to granting big credit to the corporate sector and the public

sector undertakings through investing in their debt instruments like bonds, debentures, and commercial

paper. Banks discover excess liquidity with them in the midst of low off take of credit, through the

corporate sector. Taking advantage of such a situation, companies prefer to raise funds through method

of private placement of their bonds, debentures, and commercial paper. Throughout 1998-99 roughly Rs.

35, 000 crore was raised from debt instruments only by private placements. Mainly of this was

subscribed through the banks. Their outstanding investment in debt paper was Rs. 41,458 crore as at the

end March, 1999 as against Rs. 28,378 crore a year earlier. Investment in C.P.s stood at Rs. 4,033 crore

at the end of March 1999. Therefore corporate have been able to raise funds from the investors

(including banks) at rates lower than the prime lending rates of banks.

Moreover, investment in debt instruments is not reckoned as bank credit and hence does not entail

bank‘s obligation to grant advances to priority sectors based thereon. Further, the relaxation granted

through Reserve Bank of India in April 1997 to the banks to invest in the bonds and debentures of

private corporate sector without any limit, has also contributed to the greater flow of bank credit by debt

instruments.

Non Finance Based Facilities

The credit facilities explained are finance based facilities wherein funds are provided to the borrower for

meeting their working capital requires. Banks also give non-finance based facilities to the customers.

Such facilities contain:

Letters of credit and

Bank guarantees.

Under these facilities, banks do not immediately give credit to the customers, but take upon themselves

the liability to create payment in case the borrower defaults in creation payment or performing the

promise undertaken through him.

Letter of Credit

A letter of Credit(L/C) is a written undertaking given through a bank on behalf of its customer, who is a

buyer , to the seller of goods, promising to pay a sure sum of money provided the seller complies with

the conditions and circumstances given in the L/C. A Letter of Credit is usually required when the seller

of goods and services trades with strange parties or otherwise feels the must to safeguard his interest.

Under such conditions, he asks the buyer to arrange a letter of credit from his banker. The banker issuing

the L/C commits to create payment of the amount mentioned therein to the seller of the goods, provided

the latter supplies the specified goods within the specified era, and comply with other conditions and

circumstances. Therefore through issuing Letter of Credit on behalf of their customers, banks help them

in buying goods on credit from sellers who are quite strange to them. The banker issuing L/C undertakes

an unconditional obligation upon himself, and charge a fee for the similar. L/Cs may be revocable or

irrevocable. In the latter case, the undertaking given through the banker cannot be revoked or

withdrawn.

Bank Guarantee

Banks issue guarantees to third parties on behalf of their customers. These guarantees are classified into

(i) Financial guarantee, and (ii) Performance guarantee. In case of the financial guarantees, the banker

guarantees the repayment of money on default through the customer or the payment of money when the

customer purchases the capital goods on deferred payment foundation. A bank guarantee which

guarantees the satisfactory performance of an act, say completion of a construction work undertaken

through the customer, failing which the bank will create good the loss suffered through the beneficiary is

recognized as a performance guarantee.

Credit Worthiness of Borrowers

The business of granting advances is a risky one. It is more risky especially in case of unsecured

advances. The safety of the advance depends upon the honesty and integrity of the borrower, separately

from the worth of his tangible assets. The banker has, so, to investigate into the borrower‘s skill to pay

as well as his willingness to pay the debt taken. Such an exercise is described credit investigation. Its

aim is to determine the amount for which a person is measured creditworthy. Credit worthiness is judged

through a banker on the foundation of borrower‘s ( i ) character, (ii) capability and (iii) capital.

Character: Character contains a number of personal aspects of a person e.g. his honesty, integrity,

promptness in fulfilling his promises and repaying the dues, sense of responsibility, reputation, and

goodwill enjoyed through him. A person having all these qualities, without any doubt in the minds of

others , possesses, an excellent character and hence his creditworthiness is measured high.

Capability: If the borrower possesses necessary technological ability, managerial skill and experience to

run a scrupulous business or industry, success of such an enterprise is taken for granted except for in

some unforeseen conditions, such a person is measured creditworthy through the banker.

Capital: The borrower is also expected to have financial stake in the business, because in case the

business fails, the banker will be able to realize his money out of the capital put in through the borrower.

It is a sound principle of fund that debt necessity be supported through enough equity.

The comparative importance of the factors differs from banker to banker and from borrower to

borrower. Banks are granting advances to technically qualified and experienced entrepreneurs but they

are required to put in a little amount as their own capital. Reserve Bank of India has recently directed the

banks to dispense with the collateral requirement for loans up to Rs. 1 lakh. This limit has recently been

further increased to Rs. 5 lakh for the tiny sector. Determination of credit worthiness of a borrower has

become now a more scientific exercise. Special organizations like rating companies such as CRISIL,

ICRA, CARE, have approach on to the field and each of them has urbanized a methodology of its own.

BANK CREDIT - METHODS OF ASSESSMENT AND APPRAISAL

Brief Historical Backdrop

In India, traditionally the Cash Credit System has been in vogue for an extremely extensive time and to a

superior extent. There are two largest defects in this system. First, the stage of advances in a bank is

determined not through how much a banker can lend at a scrupulous point of time but through the

borrower‘s decision to borrow at that time. Secondly, the Cash Credit advances, however repayable on

demand through the banker, are usually rolled in excess of and therefore never fall below a sure stage

throughout the course of a year. Therefore the business concerns employ bank funds on a quasi-

permanent foundation. Realizing these drawbacks in the Cash Credit System, Reserve Bank of India

appointed a revise cluster, under the chairmanship of Shri P.L. Tandon to frame guidelines for the

follow up of bank credit. Accepting the recommendations of Tandon Revise Cluster, Reserve Bank of

India advised the banks in 1975 to follow a reformed system of Cash Credit, which is recognized as ‗

Maximum Permissible Bank Fund System‘. In 1980, necessary modifications were made in the above in

the light of the recommendations of another working cluster recognized as ‗Chore Committee‘.

The Maximum Permissible Bank Fund System (MPBF) was considerably liberalized in 1993.

Ultimately, in April 1997, the MPBF System was made optional to the banks. Reserve Bank of India has

permitted the banks to follow any of the following methods for assessing the working capital necessities

of the borrower:

The Turnover Method for little borrowers, already enforced, may be sustained for this category of

borrowers,

The Cash Budget System may be followed through banks for big borrowers who prepare Cash Budget,

The existing Maximum Permissible Bank Fund System, may be retained , if necessary, with

modifications.

Any other system.

Therefore enough operational flexibility has been given to the banks in their efforts to assess working

capital requires. But, on the other hand, compulsion has been enforced on banks to introduce a

compulsory loan component in bank credit and exposure norms have been prescribed. In case of big

borrowers flexibility is allowed to shape consortium or to go for syndication.

Maximum Permissible Bank Fund System

The Maximum Permissible Bank Fund System was introduced in India in 1975. Initially, it was made

obligatory for all borrowers with credit limits of Rs. 10 lakh and above. The Tandon Committee, while

suggesting this system, made an important effort towards modernizing the methodology of credit

appraisal. The Chore Committee, strengthened the System further. In the wake of liberalisation policy,

the MPBF System was considerably liberalized in the year 1993. In April 1997, it ceased to be

mandatory and banks were permitted to adopt this system with modification, if any, or to adopt any

other system of credit appraisal. As the MPBF System is still relevant in India, we shall revise its salient

characteristics as customized /amended in 1993.

Norms for Inventories and Receivables

The largest thrust of this system is on assessing the credit requires of a borrower on the foundation of

holding of current assets, as per the prescribed norms. Initially, the Committee suggested norms for

holding several current assets for 15 industries. Later on, approximately all industries were sheltered.

The norms were prescribed for several current assets as follows:

For raw materials expressed as so several months‘ consumption. Raw materials contain store and other

things used in the procedure of production.

For stock in procedure, expressed as so several months‘ cost of manufacture

For finished goods, expressed as so several months‘ cost of sales,

For receivables, expressed as so several months‘ sales.

These norms were to be treated as the maximum quantity of current assets to be held through a

borrower. If a borrower had supervised with less quantity in the past, he should continue to do so. The

norms were for the standard stage of holding of a scrupulous current asset and not for a scrupulous thing

of a current asset. For mainly of the industries a combined norm was prescribed for finished goods and

receivables. The objective of laying down the norms of inventories was to ensure that banks assess the

credit requires of a borrower on the foundation of reasonable stage of inventories held as per the norms.

Therefore the credit granted was designed to be requiring- based. Though, the Reserve Bank permitted

the banks to deviate from the norms in specified conditions.

In 1993, Reserve bank of India provided more flexibility to the banks in this regard. Banks were

permitted to create their own assessment of credit necessities of borrowers based on their own revise of

the borrowers‘ business operations i.e. taking into explanation the manufacture/processing cycle of the

industry as well as the financial and other relevant parameters of the borrowers. Banks are now allowed

to decide the stages of holding of each thing of inventory and receivables, which in their view would

symbolize a reasonable build up of current assets for being supported through bank fund. Reserve Bank

of India now does not prescribe norms for each thing of inventory and receivables. Its role is now

confined to advising the overall stages of inventories and receivables of dissimilar industries for the

guidance of the banks. The guidelines were made applicable to all borrowers enjoying aggregate

finance-based working capital limit of Rs. 2 crore and above from the banking system. (Instead of Rs. 10

lakhs earlier) All borrowers enjoying aggregate finance based credit limits of up to Rs. 2 crore from the

banking system were exempted from the above guidelines. Their working capital requires are now

assessed on the foundation of projected Turnover Method which was earlier applicable to village and

tiny industries and other little level industries enjoying fund based working capital limits up to Rs. 50

lakhs.

Methods of Lending

The MPBF system permits the banks to fund only a portion of the borrowers‘ working capital necessities

from bank credit. The borrower is expected to depend less and less on banks to fund his working capital

requires. The Tandon Committee suggested the following three methods of lending for determining the

permissible stage of bank borrowing. It is to be noted that each successive method is designed to

augment progressively the involvement of extensive term funds comprising borrower‘s owned funds and

term borrowings to support current assets. The three methods of lending are as follows:

First Method of Lending: Under this method, banks have to work out the working capital gap through

deducting current liabilities other than bank borrowings from the current assets. Bank can give a

maximum credit up to 75 percent of working capital gap. The balance is to be met through the own

funds of the borrower and term loans.

Second Method of Lending: Under this method, the borrower has to give for a minimum of 25 percent

of the total current assets out of extensive term funds i.e. own funds plus term borrowings. After

deducting current liabilities other than bank borrowings from the rest of the current assets, the balance of

current assets are to be financed by bank borrowings. Therefore the total current liabilities inclusive of

bank borrowing will not exceed 75 percent of current assets.

Third method of Lending: This is the similar as the second method except for one variation. The core

current assets, i.e. the permanent current assets which should be financed from extensive term funds are

deducted from the total current assets. Of the balance of current assets, 25% are financed from extensive

term sources and the rest out of current liabilities including bank borrowings.

Approach of Credit

On the recommendation of the Tandon Committee, the Reserve Bank of India prescribed at the time of

introduction of MPBF System that banks should bifurcate accommodation into (1) loan comprising the

minimum stage of borrowing which the borrower expects to exploit during the year and (2) a demand

cash credit to meet the fluctuating necessities of credit. A slightly higher rate of interest on demand

Cash Credit component than for loan component was also suggested. Reserve Bank of India directed the

banks that the interest rate on demand Cash Credit should be higher through one percent in excess of the

rate of interest on the loan component. The above directive was withdrawn through Reserve Bank of

India in 1980. Subsequently in 1995 Reserve Bank of India introduced a compulsory loan component in

the delivery of bank credit.

Peak Stage and Non Peak Stage Limits

The Chore Committee suggested important modification in the MPBF System, which were enforced

through the Reserve Bank of India in December 1980. Hitherto credit limits were sanctioned on the

foundation of peak stage necessities of the borrowers, but a portion of the similar remained unutilized

throughout the non-peak season. The MPBF System was, so, customized so as to need the banks to fix

credit limits for the normal peak stage and non-peak stage necessities of the borrower apart. These limits

are to be fixed on the foundation of the utilization of such limits in the past. The era throughout which

they have to be utilized is also required to be specified. Seasonal limits are required to be fixed in case

of all agro-based industries and consumer goods industries having seasonal demand. For other industries

only one limit is to be fixed.

Withdrawal of Funds

After the peak stage and non- peak stage credit limits are sanctioned through the banks, the borrower is

required to indicate, before the commencement of each quarter, his expected necessities of funds in that

quarter. Such necessities are described the ‗operating limits‘. Borrower is expected to withdraw funds

from the banks as per his necessities within the operating limit in that quarter subject to a tolerance of

10% either method. Banks also need the borrower to submit monthly stock statements to determine his

drawing authority within the operating limit. Hence the actual amount availed of as bank credit will be

the operating limit or the drawing authority, whichever is lower. If a borrower draws more than or less

than these tolerance limits, it necessity be measured as an irregularity in the explanation. In such

situation banks should take necessary corrective steps to avoid the repetition of such irregularity in

future.

Submission of Quarterly Statements

Each borrower enjoying finance-based working capital limit of Rs. 2 crore or more is required to submit

to the banker the following two quarterly statements:

Report giving estimates of manufacture, sales, stock location, and current liabilities. (This report is to be

submitted in the week preceding the commencement of the quarter to which it relates).

Report showing actual performance in the quarter. This report is to be submitted within six weeks from

the end of the quarter. In addition to these, the borrowers are also required to submit half yearly

operating report and funds flow report, beside with a half yearly balance sheet within 2 months from the

secure of the half year.

Reserve Bank of India has also prescribed penalties for non-submission of the above statements within

the prescribed era as follows:

Banks are permitted to invariably charge penal interest of at least 1 percent per annum for an era of one

quarter on the outstanding under several working capital limits sanctioned to a borrower.

If the default is of a serious nature or persists for two consecutive quarters, banks may believe charging

a rate of interest higher than the normal lending rate determined for a borrower on his whole

outstanding, under the working capital limits sanctioned, until such time as the location relating to

timely submission of several statements is regularized.

In case of continuous/persisting defaults, banks may further believe freezing the operations in the

explanation after giving due notice to the borrower.

Sick elements which remain closed, and borrowers affected through political disturbances, riots, natural

calamities are excluded from the necessities of submission of statements.

Commitment Charge

Banks are permitted to levy a minimum commitment charge of 1 percent per annum on the unutilized

portion of the working capital limits, subject to tolerance stage of 15 percent of such limits. This is

applicable incase of borrowing elements with aggregate finance-based working capital credit limits of

Rs. 1 crore and above from the banking system. The commitment charge will be exclusive of overall

ceiling of 2 percent of penal additional interest, as stipulated through the Reserve Bank of India. The

commitment charge will not apply to:

Drawing in excess of the operating limit

Working Capital limits sanctioned to sick/weak elements

Limits sanctioned for export credit as well as against export incentives

Inland Bill limit

Credit limit granted to commercial banks, financial organizations, and cooperative banks.

Ad-hoc Credit Limits

As 1993 banks are permitted to decide the quantum as also era of any ad-hoc credit facilities based on

their commercial judgment and merits of individual cases. Banks will also have the discretion to decide

in relation to the charging of interest for sanctioning ad-hoc credit limits.

The Turnover Method

The Turnover Method of assessing working capital requires was introduced through Reserve Bank of

India in 1991 in case of village and tiny industries and other little level industries having aggregate

finance-based working capital credit limits up to Rs. 50 lakh from the banking system. In 1993 it was

extended to non-little level industries borrowers also, having aggregate credit limit up to Rs. 1 crore.

Later, banks were advised to follow this method for little borrowers with credit limit up to Rs. 4 crore in

case of little industries and up to Rs. 2 corer in case of other borrowers. In the budget of 1999-2000 this

limit has been raised to Rs. 5 crore in case of little level industries.

The turnover method ensures adequate and timely flow of credit to the borrowers. Under this method,

norms of inventory and receivables and the first method of lending are not applicable to the borrower.

On the other hand, credit requires of the borrower are assessed on the foundation of their projected

annual turnover(PAR), which means projected gross levels inclusive of the excise duty. The following

are the steps to be followed under this method:

First, the projected sales of the borrower for the entire year are assessed. The projection should be

justified, reasonable, achievable, and falling in row with the past trend in the industry concerned. It can

be ascertained through scrutinizing annual report of explanations, several returns filed, and orders on

hand and the installed capability of the element, etc.

Banks should work out working capital necessities at a minimum stage of 25% of the carried turnover,

assuming a standard manufacture/processing cycle of 3 months.

Borrower should contribute 5% of the turnover as his periphery or as Net Working Capital

The remaining 20% of the turnover should be measured as the working capital credit limits through the

bank. If the borrower is having periphery, greater than 5% of the turnover, the similar is to be measured

for arriving at the credit limits, which can be scaled down below 20% of the turnover. Hence the word

‗minimum‘ is designed for the working capital gap and not for the limits to be sanctioned. The facilities

designed under this method should be require-based and not based on eligibility.

The Cash Budget Method

As already noted, the Reserve Bank of India has permitted the banks to choose Cash Budget Method, as

one of the alternatives to MPBF method, in case of big borrowers. This method endeavors to assess the

credit necessities of a borrower on the foundation of his projected cash inflows and outflows throughout

a specific era of time. One of the significant drawbacks of MPBF method is that the working capital

limit is limited to the carried stage of current assets, and not much significance is attached to the cash

flows of the borrowers. Sometimes the receivables remain unrealized for longer era of time or

inventories are accumulated for a longer era due to peculiar nature of demand. Therefore the borrowers

face the liquidity problem which is turn affects their manufacture as require-based working capital limits

taking into explanation their cash flows, are not made accessible to them.

Under the Cash Budget Method, the whole funds necessities of a borrower are taken into explanation.

Payments which are not inevitable and which may be incurred upon the availability of funds are not

incorporated. For instance, payment of dividends, unrelated investments, diversion for making of fixed

assets for forward/backward integration is excluded from the total outflows. The Cash budget method

therefore helps in arriving at require-based working capital limits. Therefore this method avoids

accumulation of superior current assets than actual necessities, diversion of funds because of availability

of surplus funds and also prevents sickness of the business elements due to inadequate working capital

funds. As the current assets are taken as prime security for working capital limits, banks can restrict their

exposure to the extent of availability of the security.

On the foundation of the Cash Projections, quarterly Working Capital limits may be fixed. For

monitoring of the utilization of credit limits, the bank may call for data periodically i.e. monthly,

quarterly or half yearly, in addition to the balance sheet. If in a quarter excess fund has been availed of,

account may be described from the borrower, and a penal interest may be charged on the excess amount

for the whole previous quarter to enforce financial discipline.

Compulsory Loan Component in Bank Credit

In April 1995, Reserve Bank of India introduced a reform of distant reaching significance in the delivery

system of bank credit. Reserve Bank introduced a compulsory loan component in the credit granted

through banks to big borrowers and issued guidelines to the banks in this regard . The salient

characteristics of these guidelines as amended up to date are as follows:

Initially in April 1995, the loan component was made compulsory in case of borrowers with maximum

permissible bank fund of Rs. 20 crore and above. In April 1996 it was extended to all borrowers with

MPBF of Rs. 10 crore and above. As October 1997 the loan component for all borrowers having MPBF

of Rs. 10 crore and above has been consistently prescribed at 80 percent of MPBF. The cash credit

portion has consequently been reduced to 20 percent. It is mandatory for banks/ consortia/syndicate to

restrict the cash credit component as specified above.

For borrowers with working capital credit limits of less than Rs. 10 crore, the Reserve Bank of India has

permitted the banks to settle with their customers the stages of loan and cash credit components. Such

borrowers may like to avail of bank credit in the shape of loans because of lower rate of interest

applicable on loan component.

Reserve Bank has also permitted the banks to identify the business behaviors which may be exempted

from the loan system of delivery of bank credit on the ground that such business behaviors are cyclical

and seasonal in nature or have inherent volatility and hence application of loan component may make

difficulties.

The minimum era of the loan for working capital purposes is to be fixed through banks in consultation

with the borrowers. Banks are also permitted to split the loan component just as to require of the

borrowers with dissimilar maturities for each segments and allow roll in excess of loans.

Banks are permitted to fix their prime lending rate and spread in excess of the prime lending rate apart

for loan component and cash credit component.

Reserve Bank of India has permitted that a borrower can avail of the loan component for working capital

purpose , at more than the specified stage of 80% of MPBF. In such cases the cash credit component

shall stand reduced. A borrower can also attract the loan component first.

An ad hoc limit may be sanctioned only after the borrower has fully utilized the cash credit and the loan

components.

In case of consortium/syndicate, member banks should share the cash credit component and the loan

component on a pro rata foundation depending upon their individual share in MPBF.

Bill limit for inland bills should be carved out of the loan component.

The Reserve Bank has allowed the banks to permit the borrowers to invest their short term/temporary

surplus in short term money market instruments like commercial paper, certificate of deposits and in

term deposits with banks.

Export credit limit (both post-shipment and pre-shipment) are to be excluded from MPBF for the

purpose of bifurcation of credit limits into loan and cash credit components.

The loan component would be applicable to borrowal explanations classified as average and sub-

average .

The vital objective behind the bifurcation of credit limits into loan component and Cash Credit

component is to bring in relation to the discipline in the utilization of bank credit and to gain bigger

manage in excess of the flow of credit. As you already know, there is no financial discipline on the

borrower in case of cash credit system —he may borrow any amount within the operating limit at any

time and may repay the similar as per his choice and convenience. The banker, so, leftovers unable to

plan the utilization of his possessions in advance and his earnings are affected, as he earns interest on the

actual amount utilized through the borrower. Through introducing a compulsory loan component which

now explanations for the biggest section of bank credit, banks can ensure that their possessions are

utilized for the full era of the loan and therefore their earnings are enhanced. Such a system will also

compel the borrowers to resort to scheduling in utilizing the funds.

Interest Rates on Bank Advances

Interest rates charged through banks on their advances were, to a great extent regulated through the

Reserve Bank of India for in excess of two decades (1971-1991). The Narasimham Committee 1991

recommended deregulation of interest rates on advances in a phased manner. Accepting its

recommendation, Reserve Bank of India abolished the minimum lending rate on advances of Rs. 2 lakh

in October 1994 and asked the banks to fix their own prime lending rate which will be their minimum

lending rate. Concessional interest rate of 12% was prescribed for advances up to Rs. 25,000 and a

higher rate of 13.5% was prescribed for advances in excess of Rs. 25,000 and up to Rs. 2 lakh. In

October 1996, Reserve Bank of India asked the banks to announce the maximum spread in excess of the

Prime Lending rate for all advances other than the consumer credit. Banks have also been permitted to

prescribe dissimilar Prime Lending Rates for the loan component and the cash credit component in order

to encourage the borrowers to prefer the loan component because of lower spread. Banks were allowed

to fix their Prime Lending Rates and spread after taking into consideration their cost of funds,

transaction cost, and minimum spread.

In April 1998, Reserve Bank further extended the procedure of deregulation through permitting the

banks to charge interest on advances below Rs. 2 lakh at a rate not exceeding their Prime Lending Rate,

which is accessible to the best borrowers of the bank concerned. However the Reserve bank has granted

freedom to the commercial banks to prescribe their own Prime Leading Rates, the changes in the Bank

Rate announced through the Reserve Bank of India from time to time do exert their power on the bank‘s

decisions on their Prime Lending Rates. For example, the reduction of Bank Rate through Reserve Bank

of India through one percentage point from 9% to 8% effective March 1, 1999 was immediately

followed through same reduction in the Prime Lending Rate of State bank of India and all other

commercial banks. The Reserve Bank of India has therefore made the bank rate a reference rate for

other interest rates.

Tax on Bank Interest

The Government of India re-introduced interest tax on income from interest accruing to the financial

organizations with effect from October 1, 1991 and has withdrawn it in the budget for 2000-2001.

Interest Tax was payable on gross interest income of banks and credit organizations like cooperative

communities occupied in the business of banking (excluding cooperative communities providing credit

facilities to farmers and village artisans), public financial organizations, state financial corporations, and

fund companies.

Interest Tax was charged @ 2% on the gross amount of interest earned through banks, including the

commitment charges and discount on promissory notes and bills of swap. Interest earned on Cash

Reserves maintained with Reserve Bank of India, discount on Treasury bills and interest on loans to

other credit organizations was not incorporated in the income from interest for this purpose. Banks were

permitted to reimburse themselves through creation necessary adjustments in the interest charges.

Hence the real burden of this tax was borne through the borrowers themselves as credit became costlier

to them through the amount of interest tax.

Prudential Norms for Exposure Limits

Credit necessities of big business homes are invariably big. Banks follow the policy of diversifying their

risks through spreading their lending in excess of dissimilar borrowers who are occupied in dissimilar

kinds of deals and industries, in order to minimize their risks. They do not commit big possessions to a

single borrower or a cluster of borrowers for bigger risk management. Reserve Bank of India has laid

down prudential norms for banks, for exposure to a single borrower or cluster of borrowers as follows:

The overall exposure to a single borrower shall not exceed 20% of the net worth of the bank. The

exposure ceiling has been reduced from 25% to 20% effective April 1,2000. In case it exceeds 20% of

capital funds as on October 31, 1999, banks are expected to reduce it to 20% through end of October

2001, and

The overall exposure to a cluster of borrowers shall not exceed 50% of the net worth of the bank.

For determining exposure to a single borrower/ cluster, credit facilities will contain the following:

Advances through method of loans, cash credit, overdrafts

Bill purchased/discounted

Investment in debentures,

Guarantees, letters of credit, co-acceptances, underwriting etc.

Investment in Commercial Paper

The non-finance based facilities shall be counted @ 50% of sanctioned limit and added to total finance

based limits. While the Reserve Bank of India has granted flexibility to the banks to assess the credit

necessities of the borrowers as already noted, the above prudential norms are to be invariably complied

through the banks.

Consortium Advances

Credit requires of big borrowers may be met through banks in any of the following ways:

Through sole bank

Through multiple banks

On consortium foundation

On syndication foundation

Sole banking i.e. lending through a single bank to a big borrower, subject to the possessions accessible

with it and limited to the exposure limits imposed through the Reserve Bank of India. When the credit

necessities of a borrower are beyond the capability of a single bank, the borrower may resort to multiple

banking i.e. borrowing from a number of banks simultaneously and self-governing of each other, under

distinct loan agreements with each of them. Securities are charged to them apart.

Consortium lending, also described joint financing, or participation financing, is also undertaken

through a number of banks but against a general security which leftovers charged to all the banks for the

total advance. Generally, in case of consortium lending one of the banks acts as a consortium leader and

takes a leading section in the processing of the loan proposal, its documentation, recovery etc. The

participating banks enter into an agreement setting out the conditions and circumstances of such

participation arrangement.

Reserve Bank Directives

Consortium lending through banks in India commenced in 1974 when Reserve Bank of India issued

guidelines to the banks in this regard. In 1978 formation of consortium was made obligatory where the

aggregate credit limits sanctioned to a single borrower amounted to Rs. 5 crore or more. In October

1993, this threshold limit for formation of consortium was raised to Rs. 50 crore and the guidelines was

also suitably revised.

Following the policy of liberalisation and deregulation in the financial sector, the Reserve Bank of India

decided in October 1996, that whenever a consortium is shaped either on a voluntary foundation or on

obligatory foundation, the ground rules of the consortium arrangement would be framed through the

participating banks in the consortium. These rules may relate to the following:

Number of participating banks

Minimum share of each bank

Sanction of additional/ad hoc limit in emergency situation/contingencies through lead bank/other banks

The fee to be charged through the lead bank for the services rendered through it

Grant of any facility to the borrower through a non-member bank

Deciding time frame for sanctions/ renewals.

In April 1997, Reserve Bank of India withdrew the mandatory necessities on formation of consortium

for working capital necessities under multiple banking arrangements. Reserve bank has advised the

banks to evolve an appropriate mechanism for adoption of a sole bank/multiple bank/consortium or

syndication approach through framing necessary ground rules on operational foundation. While the

aforesaid flexibility has been granted to the banks, they are required not to exceed the single

borrower/cluster exposure limits laid down through the Reserve Bank. Banks have been advised to

ensure to have an effective system for appraisal, flow of fact on the borrower in the middle of the

participating banks, commonality in approach and distribution of lending possessions, under the single

window concept. Banks have also been permitted to adopt the syndication circuit, if the arrangement

suits the borrower and the financing banks.

Syndication of Credit

Reserve Bank of India has permitted the banks to adopt syndication circuit to give credit in lieu of

consortium advance. A syndicated credit differs from consortium advance in sure characteristics. The

salient characteristics of a syndicated credit are as follows:

It is an agreement flanked by two or more banks to give a borrower a credit facility by general loan

documentation.

The prospective borrower provides a mandate to a bank, commonly referred to a ‗Lead Manager, to

arrange credit on his behalf. The mandate provides the commercial conditions of the credit and the

prerogatives of the mandated bank in resolving contentious issues in the course of the transaction.

The mandated bank prepares a Fact Memorandum in relation to the borrower in consultation with the

latter and distributes the similar amongst the prospective lenders, inviting them to participate in the

credit.

On the foundation of the Fact Memorandum each bank creates its own self-governing economic and

financial evaluation of the borrower. It may collect additional fact from other sources also.

Thereafter, a meeting of the participating banks is convened through the mandated bank to talk about the

syndication strategy relating to coordination, communication and manages within the syndication

procedure and to finalize the trade timings, charges for management, cost of credit, share of each

participating bank in the credit etc.

A loan agreement is signed through all the participating banks

The borrower is required to provide prior notice to the Lead Manager or his agent for drawing the loan

amount so that the latter may tie up disbursement with the other lending banks.

Under the system, the borrower has the freedom in conditions of competitive pricing.

OTHER SOURCES OF SHORT TERM FINANCE

Public Deposits

Public deposits are unsecured deposits carried through companies for specific eras and at specific rates

of interest. These deposits have acquired prominence as a source of fund for the companies, as it is more

convenient and cheaper to mobilize short term fund by such deposits. Public deposits give a fine

instance of disintermediation, as the borrower directly accepts the deposits from the lenders, of course

with the help of brokers. In India, acceptance of deposits from the public is regulated through parts 58A

and 58B of the Companies Act 1956, and the Companies (Acceptance of Deposits) Rules, 1975. The

above parts were inserted in the Companies Act in 1974 with the objective to safeguard the interests of

the depositors. The regulatory framework in this regard is contained in the Companies Act and the

Rules. Their significant provisions are stated below:

Parts 58A (1) the Central Government, in consultation with the Reserve Bank of India , to prescribe the

limits up to which, the manner in which and the circumstances subject to which deposits may be invited

or carried through a company either from the public or from its members. Such deposits are to be invited

in accordance with the rules made under this part and after insertion of an advertisement issued through

the company.

Part 58 (2) (c) which was inserted with effect from March 1, 1997 prohibits a company which is in

default in the repayment of any deposit or section thereof or any interest thereupon, from accepting any

further deposit.

Categories of Deposits and Statutory limits

Rule 3 lays down that the era for which such deposits may be carried through a company should not be

less than 3 months and not more than 36 months from the date of acceptance or renewal of deposit.

Companies are not permitted to accept deposits repayable on demand or on notice. Deposits carried

through companies are divided into the following two categories and distinct limits have been prescribed

for each of them:

Deposits received from specified sources:

Deposits against unsecured debentures

Deposits from shareholders

Deposits guaranteed through directors

The maximum limit up to which such deposits are allowed is 10% of the aggregate paid up share capital

and free reserves.

Deposit received from the common public: This category of deposits may be carried to the extent of

25% of the aggregate paid up capital and free reserves of the company.

For government companies, there is only one single limit of 35% of paid up capital and free reserves for

all such deposits. Companies are, though, permitted to accept or renew deposit from depositors falling in

category (i) above for eras below 6 months but not less than 3 months for the purpose of meeting any

short term necessities of funds provided such deposits do not exceed 10% of the aggregate of paid up

share capital and free reserves of the company.

Maintenance of Liquid Assets

Every company accepting public deposit is required to deposit or invest before 30th April of each year,

an amount which shall not be less than 15% of the amount of its deposits which will mature throughout

the after that financial year ending 31st March in any one or more of the following:

In a current or other deposit explanation with any scheduled bank, free from charge or lien,

In unencumbered securities of the central or state governments,

In unencumbered securities in which Trust funds may be invested under the Indian Trust Act, 1882; or

In unencumbered bonds issued through Housing Development Fund Corporation Ltd.

The securities referred to in clauses (b) or (c) shall be reckoned at their market value. The amount

deposited or invested as aforesaid shall not be utilized for any other purpose than the repayment of

deposits maturing throughout the year.

Rates of Interest and Brokerage

The Rules prescribe the maximum rate of interest payable on such deposits. At present companies are

allowed to pay interest not exceeding 15% per annum at rates which shall not be shorter than monthly

rests. Companies are permitted to pay brokerage to any broker at the rate of 1% of the deposits for an era

of up to 1 year, 1½ % for an era more than 1 year but up to 2 years and 2% for an era exceeding 2 years.

Such payment shall be on one time foundation.

Advertisement

Every company intending to invite or accept deposits from the public necessity issue an advertisement

for that purpose in a leading English newspaper and in one vernacular newspaper circulating in the state

in which the registered office of the company is located. The advertisement necessity is issued on the

power and in the name of the Board of Directors of the company. The advertisement necessity includes

the circumstances subject to which deposits shall be carried through the company and the date on which

the Board of Directors has approved the text of the advertisement. In addition, the advertisement

necessity includes the following fact, namely:

Name of the company,

The date of incorporation of the company,

The business accepted on through the company and its subsidiaries with the details of branches of

elements, if any,

Brief particulars of the management of the company

Names, addresses and jobs of the directors,

Profits of the company, before and after creation provision for tax, for the three financial years

immediately preceding the date of advertisement,

Dividends declared through the company in respect of the said years.

A summarized financial location of the company as in the two audited balance sheets immediately

preceding the date of advertisement in the prescribed shape.

A report to the effect that on the day of the advertisement, the company has no overdue deposits, other

than the unclaimed deposits, or a report showing the amount of such overdue deposits, as the case may

be, and

A declaration as prescribed under the Rules.

The advertisement shall be valid until the expiry of six months from the date of closure of the financial

year in which it is issued or until the date on which the balance sheet is laid before the company at its

common meeting, or where Annual Common Meeting for any year has not been held, the latest day on

which that meeting should have been held as per the Companies Act, whichever is earlier. A fresh

advertisement is required to be made in each succeeding financial year. Before issuing an advertisement,

a copy of such advertisement shall have to be delivered to the Registrar for registration. Such

advertisement should be signed through the majority of the Directors of the company or their duly

authorized mediators. The above provision concerning mandatory publication of an advertisement is

necessary in case the company invites public deposits. But if the company intends to accept deposits

without inviting the similar, it is not required to issue an advertisement but a report in lieu of such

advertisement shall have to be delivered to the Registrar for registration, before accepting deposits. The

contents of the report and its validity era shall be the similar as in the case of an advertisement.

Process for Accepting Deposits

Every company intending to accept public deposits is required to supply to the investors shapes, which

shall be accompanied through a report through the company containing all the particulars specified for

advertisements. The application necessity also include a declaration through the depositor stating that

the amount is not being deposited out of the funds acquired through him through borrowing or accepting

deposits from any other person. On accepting a deposit or renewing an existing deposit, every company

shall furnish to the depositor or his agent a receipt for the amount received through the company within

an era of eight weeks from the date of receipt of money or realisation of cheques. The receipt necessity

is signed through an officer of the company duly authorized through it. The company shall not have the

right to alter to the disadvantage of the depositor, the conditions, and circumstances of the deposit after

it is carried.

Register of Deposits

Every company accepting deposits is required to stay as its registered office one or more registers in

which the following particulars in relation to the each depositor are to be entered:

Name and address of the depositors,

Date and amount of each deposit

Duration of the deposit and the date on which each deposit is repayable

Rate of interest

Date or dates on which payment of interest will be made.

Any other particulars relating to the deposit.

These registers shall be preserved through the company in good order for an era of not less than eight

years from the end of the financial year in which the latest entry is made in the Register.

Repayment of Deposits

Deposits are carried through companies for specified era say 12 months, 18 months, 24 months, etc.

Companies prescribe dissimilar rates of interest for deposits for dissimilar eras. Other conditions and

circumstances are also prescribed through the companies and interest is paid at the stipulated rate at the

time of maturity of the deposit. But, if a depositor desires repayment of the deposit, before the era

stipulated in the Receipt, companies are permitted to do so, but interest is to be paid at a lower rate.

Rules prescribe that if a company creates repayment of a deposit after the expiry of a era of six months

from the date of such deposit, but before the expiry of the era for which such deposit was carried

through the company, the rate of interest payable through the company shall be determined through

reducing one percent from the rate which the company would have paid had the deposit been carried for

the era for which the deposit had run.

The rules also give that if a company permits a depositor to renew the deposit, before the expiry of the

era for which such deposit was carried through the company, for availing of benefit of higher rate of

interest, the company shall pay interest to such depositor at higher rate, if

Such deposit is renewed for a era longer than the unexpired era of the deposit, and

The rate of interest as stipulated at the time of acceptance or renewal of a deposit is reduced through one

percent for the expired era of the deposit and is paid or adjusted or recovered.

The Rules also stipulate that if the era for which the deposit had run includes any section of a year, then

if such section is less than six months, it shall be excluded and if section is six months or more, it shall

be reckoned as one year.

Return of Deposits

Every company accepting deposits is required to file with the Registrar every year before 30th June, a

return in the prescribed shape and giving fact as on 31st March of the year. It should be duly certified

through the auditor of the company. A copy of the similar shall also be filed with the Reserve Bank of

India.

Penalties

Sub-part 9 and 10 of part 58 A, which were inserted with effect from 1st September 1989, give

machinery for repayment of deposits on maturity, and also prescribes penalties for defaulting

companies. Just as to sub-part (9), if a company fails to repay any deposit or section thereof in

accordance with the conditions and circumstances of such deposit, the Company Law Board may, if it is

satisfied, direct the company to create repayment of such deposit forthwith or within such time or

subject to such circumstances as may be specified in its order. The Company Law Board may issue such

order on its own or on the application of the depositor and shall provide a reasonable opportunity of

being heard to the company and to other concerned persons.

Sub-part 10 prescribes penalty for non-compliance with the above order of the Board. Whoever fails to

comply with its order shall be punishable with imprisonment which may extend to 3 years and shall also

be liable to a fine of not less than Rs. 50 for every day throughout which such non-compliance

continues. Part 58 A (6) stipulates penalties for accepting deposits in excess of the specified limits.

Where a company accepts deposits in excess of the limits prescribed or in contravention of the manner

or condition prescribed, the company shall be punishable:

Where such contravention relates to the acceptance of any deposit, with fine which shall not be less than

an amount equal to the amount of the deposit carried,

Where such contravention relates to the invitation of any deposit, with fine which may extend to Rs. 1

lakh, but not less than Rs. 5000.

Every officer of the company who is in default shall be punishable with imprisonment for a term which

may extend to 5 years and shall also be liable to fine.

Deduction of Tax At Source

Just as to part 194 A of the Income Tax Act, 1961, the companies accepting public deposits are required

to deduct income tax at source at the prescribed rates if the aggregate interest paid or credited

throughout a financial year exceeds Rs. 5000. This limit has been recently (May 2000) rose from Rs.

2500 to Rs. 5000.

Public Deposits with Companies in India

Public Deposits constitute a significant source of working capital for corporate in India. Just as to the

data published through the Reserve Bank of India, the total amount of Public deposits with the

companies as at the end of March 1997 was Rs. 357, 153 crores, out of which 62.7% was held through

the Non-fund companies and the rest through fund companies and other Non-banking Companies.

Companies draw deposits because of higher rates of interest vis-à-vis the banks. Moreover, mainly of

the companies give incentive ranging from 0.25 to 1% to the depositors. For the guidance of the

depositors the fixed deposits of the companies are rated also through the Credit Rating agencies and the

credit ratings are published through the companies to solicit deposits. The rate of interest varies with the

credit rating assigned to it. Higher credit rating carries lower rate of interest and vice-versa.

Public deposits with the companies are unsecured deposits and do not carry the cover of deposit

insurance while bank deposits are insured through Deposit Insurance and Credit Guarantee Corporation

of India to the extent of Rs. 1 lakh in each explanation. Several companies default in the repayment of

the deposits beside with interest. In several cases, the District Consumers Disputes Redressal Fora have

penalized the companies for not paying their depositors‘ money. The Fora have held the companies

guilty for deficiency of service and maintained that a depositor was a consumer within the meaning of

the Consumer Defense Act., 1986 Nevertheless, reputed companies do draw deposits from the public,

because of their sound financial location and reputation.

Commercial Paper

Commercial paper (C.P) is another source of raising short term funds through highly rated corporate

borrowers for working capital purposes. A commercial paper at the similar time gives an opportunity to

cash rich investors to park their short term funds. The Reserve Bank of India permitted companies to

issue Commercial paper in 1989 and issued guidelines entitled ―Non banking Companies (Acceptance of

Deposits by Commercial Paper) Directions 1989,‖ to regulate the issuance of C.Ps. The guidelines have

been significantly relaxed and customized from time to time. The salient characteristics of these

guidelines (as amended to date) are as follows:

Eligibility to Issue CPs

Companies (except for the banking companies) which fulfill the following necessities are permitted to

issue CPs in the money market:

The minimum tangible net worth of the company is Rs. 4 crore as per the latest audited balance sheet.

The company has finance-based working capital limits of not less than Rs. 4 crore.

The shares of the company are listed at one or more stock exchanges. Closely held companies whose

shares are not listed on any stock swap are also permitted to issue CPs provided all other circumstances

are fulfilled.

The company has obtained minimum credit rating from a Credit rating agency i.e. CP2 from Credit

Rating Fact Services of India Ltd., A2 from Investment Fact & Credit Rating Agency or PR2 from

Credit Analysis and Research.

Conditions of Commercial Paper

The Commercial paper may be issued through the companies on the following conditions and

circumstances:

The minimum era of maturity should be 15 days (It was reduced from 30 days effective May 25, 1998)

and the maximum era less than one year.

The minimum amount for which a CP is to be issued to a single investor in the primary market should be

Rs. 25 lakh and thereafter in multiple of Rs. 5 lakh

CPs is to be issued at a discount to face value. The rate of discount is freely determined through the

issuing company and the investors.

The issuing company shall bear the dealers fee, rating agencies fee, and other charges. Stamp duty shall

also be applicable on CPs.

CPs may be issued to any person, corporate body included in India, or even unincorporated bodies. CPs

may be issued to Non-resident Indians only on no repatriation foundation and such CPs shall not be

transferable.

The issue of CP will not be underwritten or co-carried through any individual or organization.

There will be no grace era for payment. The holder of the CP shall present the instrument for payment to

the issuing company.

Ceiling on the Amount of Issue of Commercial Paper

The amount for which the companies issue Commercial Paper is to be carved out of the finance based

working capital limit enjoyed through the company with its banker. The maximum amount that can be

raised by issue of commercial paper is equal to 100 percent of the finance based working capital limit.

The latter is reduced protanto on the issuance of CP through the company. Effective October 19, 1996

the amount of CP is permitted to be adjusted out of the loans or cash credit or both as per the

arrangement flanked by the issuer of the CP and the concerned bank.

Standby Facility Withdrawn

The amount of CP is carved out of the borrower‘s working capital limit. Till October 1994 commercial

banks were permitted to give standby facility to the issuers of CPs. It ensured the borrowers to attract on

their cash credit limit in case there was no roll-in excess of CP. Therefore the repayment of the CP was

ensured automatically. In October 1994 Reserve bank of India prohibited the banks to grant such stand-

by facility. Accordingly, banks reduce the cash credit limit when CP is issued. If subsequently, the issuer

needs a higher cash credit limit, he shall have to approach the bank for a fresh assessment of his

requirement for the enhancement of credit limit. Banks do not automatically restore the limit and believe

the sanction of higher limit afresh. In November 1997, Reserve Bank of India permitted the banks to

decide the manner in which restoration of working capital limit is to be done on repayment of the CP if

the corporate requests for restoration of such limit.

Process for Issuing Commercial Paper

The company which intends to issue CP should submit an application in the prescribed shape to its

bankers or leader of the consortium of banks, jointly with a certificate from an approved credit rating

agency. The rating should not be more than 2 months old.

The banker will scrutinize the proposal and if it discovers the proposal satisfying all eligibility criteria

and circumstances, shall take the proposal on record.

Thereafter, the company will create arrangement for privately placing the issue within an era of 2 weeks.

Within 3 days of the completion of the issue, the company shall advice the Reserve Bank by its bankers

the amount actually raised by CP.

The investors shall pay the discounted value of the CP by a cheque to the explanation of the issuing

company with the banker.

Thereafter, the finance-based working capital limit of the company will be reduced correspondingly.

Commercial Paper in India

The Vagul Committee suggested the introduction of commercial paper in India to enable the high worth

corporate to raise short term funds cheaper as compared to bank credit. On the other hand, the investors

in CPs were expected to earn a bigger return because of the absence of intermediaries flanked by them

and the borrowers. As the issuer bears the cost of issuing the CPs, his total cost is higher through 1%

point or so in excess of the discount rate on the CPs issued through him. Commercial paper is being

issued through corporate in India for in relation to the decade now. Throughout this era the quantum of

outstanding CPs has slowly increased. Till May 1997 the outstanding amount of CPs remained below

the stage of Rs. 1000 crore and the rate of discount ranged above 11%. But as May 1997 the outstanding

amount has slowly increased and the discount rate remained much below 10%. Throughout the year

1998, Rs. 5249 crore were raised throughout the first fortnight of January 1998 and again in the second

fortnight of August 1998 when discount rate ranged flanked by 8.5 and 11%. As May 1998, the stage of

outstanding CPs has slowly risen and has touched the spot of Rs. 11153 crore in December 1998.

Discount rate touched the low range of 8.5 to 9% throughout this era. Through the end of July 31, 2003,

the outstanding CPs stood at Rs.7,557 crore and the typical effective rates of discount varied flanked by

4.99% to 8.25%. Therefore the corporate discover the CP circuit distant cheaper than normal bank

credit.

Banks continue to be the biggest investors in CPs as they discover CPs of top-rated companies

extremely attractive, because of the excess liquidity situation they are just placed in. Outstanding

investments in CPs steadily increased to Rs. 7658 crore as on September 30.1999 due to simple

liquidity. The Reserve Bank of India has issued revised draft guidelines on July 6,2000 for the issuance

of commercial paper. The significant changes proposed were:

Corporate are permitted to issue CP up to 50% of their working capital (fund based) under the automatic

circuit, i.e. without prior clearance from the banks.

CPs can be issued for wide range of maturities from 15 days to 1 year and can be in denominations of

Rs. 5 lakh or multiple there of.

Financial Organizations may also issue CPs.

Foreign instructional investors may invest in CPs. Within 30% limit set for their investments in debt

instruments

Credit rating again will decide the era of validity of the issue.

Inter-Corporate Loans

Short term fund for working capital necessities of a company may be raised by accepting inter-corporate

loans or deposits. On the other hand, some other companies face financial stringency and require cash

possessions to meet their immediate liquidity requires. The former lend their surplus possessions to the

latter by brokers, who charge for their services. Intercorporate loans facilitate such lending and

borrowings for short eras of time. The prevailing market circumstances do exert their power on the

determination of interest rates.

Statutory Provisions Prior to January 1999

The Inter-corporate loans were, till recently, governed through the provisions of part 370 of the

Companies Act, 1956 and the Rules framed hereunder. This part provided that no company shall (a)

create any loan to or (b) provide any guarantee or give any security in relationship with a loan given to

any body corporate unless such loan or guarantee has been previously authorized through a special

settlement of the lending company. But such special settlement was not required in case of loans made

to other bodies corporate not under the similar management as the lending company where the aggregate

of such loans did not exceed thirty percent of the aggregate of the subscribed capital of the lending

company and its free reserves.‘ Further the aggregate of the loans made through the lending company to

all other bodies corporate shall not, except for with the prior approval of the Central Government,

exceed.

Thirty percent of the aggregate of the subscribed capital of the lending company and its free reserves,

where all such other bodies are not under the similar management as the lending company.

Thirty percent of the aggregate of the subscribed capital of the lending company and its free reserves,

where all such corporate are under the similar management as the lending company.

Part 372 of the Companies Act laid down the limits for investment through a company in the shares of

another body corporate. Rules framed there under lay down that the Board of Directors of a company

shall be entitled to invest in the shares of any other body corporate up to thirty percent of the subscribed

equity share capital or the aggregate of the paid up equity and preference share capital of such other

body corporate whichever is less. Permission of the Central Government was also required in case the

investment made through the Board of Directors in all other bodies corporate exceed thirty percent of

the aggregate of the subscribed capital and reserves of the investing company.

Present Statutory Provisions

After the promulgation of Companies (Amendment) Ordinance 1999 in January 1999 the provisions of

parts 370 and 372 were made ineffective and instead a new part 372A was inserted to govern both inter-

corporate loans and investments. Just as to the new part 372 A, a company shall, directly or indirectly.

Create any loan to any other body corporate,

Provide any guarantee, or give security in relationship with a loan made through any other person to any

body corporate, and

Acquire, through method of subscription, purchase or otherwise, the securities of any other body

corporate up to 60% of its paid up capital and free reserves or 100% of the free reserves, whichever is

more.

The loan, investment, guarantee or security can be given to any company irrespective of whether it is

subsidiary company or otherwise. If the aggregate of all such loans and investments exceed the above

limit the company would have to close the permission of shareholders by a special settlement which

should specify the particulars of the company in which investment is to be made or loan, security, or

guarantee is proposed to be given. It should also specify the purpose of the investment, loan, security, or

guarantee and the specific sources of funding. The settlement should be passed at the meeting of the

Board with the consent of all directors present at the meeting and the prior approval of the public

financial organizations where any term loan is subsisting, is obtained. But no prior approval of the

public financial organization is necessary , if there is no default in payment of loan installment or

repayment of interest thereon as per the conditions and circumstances of the loan. The above provisions

of Part 372 A will not apply to any loan made through a Holding company to its wholly owned

subsidiary or any guarantee given through the former in respect of loan made to the latter or acquisition

of securities of the subsidiary through the holding company. Part 372 A Shall not apply to any loan,

guarantee or investment made through a banking company, an insurance company or a housing fund

company or a company whose principal business is the acquisition of shares, stocks, debentures etc or

which has the substance of financing industrial enterprises or of providing infra structural facilities.

The loan to any body corporate shall be made at a rate of interest not lower than the Bank rate. A

company which has defaulted in complying with the provisions of the part 58A of the Companies Act,

1956 shall not be permitted to create interoperate loans and investment till such default continues.

Company‘s creation inters- corporate loans/ investment are required to stay a Register showing the

prescribed details of such loans/investments/guarantees. Such Register shall be open for inspection and

extracts may be taken there from. The provision of the new part are not applicable to loans made

through banking, insurance/housing fund/investment company and a private company, unless it is

subsidiary of a public company. If a default is made in complying with the provisions of part 372A, the

company and every officer of the company who is in default shall be punishable with improvement up to

2 years or with fine up to Rs. 50,000/-.

Bonds and Debentures

Bonds and debentures are another shape of raising debt for augmenting funds for extensive term

purposes as well as for working capital. It has gained popularity throughout recent years because of the

depressed circumstances in the new equities market and the permission given to the banks to invest their

funds in such bonds and debentures. These debentures may be fully convertible, partly convertible, or

non-convertible into equity shares. The salient points of the Guidelines issued through Securities and

Swap Board of India (SEBI) in this regard are as follows:

Issue of fully convertible debentures having a conversion era more than 36 months will not be

permissible unless conversion is made optional with ―put‖ and ―call‖ options.

Compulsory credit rating is required, if conversion of fully convertible debentures is made after 18

months.

Premium amount on conversion, and time of conversion in levels, if any, shall be predetermined and

stated in the prospectus. The rate of interest shall be freely determined through the issuer.

Companies issuing debentures with maturity up to 18 months are not required to appoint Debentures

Trustees or to make Debentures Redemption Reserves. In other cases the names of debentures trustee

necessity are stated in the prospectus. The trust deed necessity is executed within 6 months of the

closure of the issue.

Any conversion in section or entire of the debentures will be optional at the hands of the debenture

holders, if the conversion takes spaces at or after 18 months from the date of allotment but before 36

months.

In case of Non-Convertible Debentures and Partly convertible debentures, credit rating is compulsory if

maturity exceeds 18 months.

Premium amount at the time of conversion of Partly convertible debentures shall be pre-determined and

stated in the Prospectus. It necessity also state the redemption amount, era of maturity, yield on

redemption for Non-convertible/ Partly Convertible Debentures.

The discount on the non-convertible portion of the Partly convertible debentures, in case they are traded

and process for their purchase on mark trading foundation, necessity be disclosed in the prospectus.

In case, the non-convertible portions of partly Convertible Debentures or Non- Convertible Debentures

are to be rolled in excess of without transform in the interest rate, a compulsory option should be given

to those debenture holders who want to withdraw and encase their debentures. Positive consent of the

debenture holder‘s necessity is obtained for all-in excess of.

Before the rollover, fresh credit rating shall be obtained within an era of six months prior to the due date

of redemption and necessity be communicated to the debenture holders before the rollover. Fresh Trust

Deed necessity is made in case of rollover.

The letter of fact concerning rollover shall be vetted through SEBI.

The disclosure relating to raising of debenture will include amongst other items

The existing and future equity and extensive term debt ratio,

Servicing behaviour of existing debentures,

Payment of interest due on due dates on term loans and debentures

Certificate from a financial organization or bankers in relation to the no objection for a second or pari

passu charge being created in favour of the trustees to the proposed debenture issue.

Companies which issue debt instruments by an offer document can issue the similar without submitting

the prospectus or letter of offer for vetting to SEBI or obtaining an acknowledgement card from SEBI in

respect of the said issue, provided the:

Company‘s securities are already listed on any stock swap

Company has obtained at least an ‗adequately safe‘ credit rating for its issue of debt instrument from a

credit rating agency.

The debt instrument is not convertible, is not issued beside with any other security or, without any

warrant with an option to convert into equity shares.

In such cases a category I Merchant bank shall be appointed to control the issue and to submit the offer

document to SEBI. The Merchant banker acting as Lead Manager should ensure that the document for

the issue of debt instrument includes the required disclosure and provides a true, correct, and fair view

of the state of affairs of the company. The merchant banker will also submit a due diligence certificate to

SEBI.

The debentures of a company can be listed at a Stock Swap, even if its equity shares are not listed.

The trustees to the Debenture issue shall have the authority to protect the interest of debenture holders.

They can appoint a nominee director on the Board of the company in consultation with institutional

debenture holders.

The lead bank will monitor the utilization of funds raised by debentures for working capital purposes. In

case the debentures are issued for capital investment purpose, this task of monitoring will be performed

through lead Organization/ Investment Organization.

In case of debentures for working capital, institutional debenture holders and trustees should obtain a

certificate from the company‘s auditors concerning utilization of funds at the end of each accounting

year.

Company should not issue debentures for acquisition of shares or for providing loans to any company

belonging to the similar cluster. This restriction does not apply to the issue of fully convertible

debentures provided conversion is allowed within an era of 18 months.

Companies are required to file with SEBI certificate from their bankers that the assets on which security

is to be created are free from any encumbrances and necessary permission to mortgage the assets have

been obtained or a No objection from the financial organizations/ banks for a second or pari passu

charge has been obtained, where the assets are encumbered.

Factoring of Receivables

Factoring of receivables is another source of raising working capital through a business entity. Factoring

is an agreement under which the receivables arising out of the sale of goods/services are sold through a

firm(described the client) to the factor (a financial intermediary). The factor thereafter becomes

responsible for the collection of the receivables. In case of credit sale, the purchaser promises to pay the

sale proceeds after an era of time. The seller has to wait for that era for realizing his claims from the

buyer. His cash cycle is therefore prolonged and he requires superior working capital. Factoring is of

recent origin in India.

Government of India notified factoring as a permissible action for the banks in July 1990. They have

been permitted to set up distinct subsidiaries for this purpose or invest in the factoring companies

together with other banks. Two factoring companies have been set up through banks together with Little

Industries Development Bank of India. SBI Factors and Commercial Services Ltd., has been promoted

through State Bank of India, Union, Bank of India and the Little Industries Development Bank of India.

Canbank Factors Ltd. is another factoring company promoted together through Canara Bank, Andhra

Bank and SIDBI. The Foremost Factors Ltd. is the first private sector company which has commenced

its operations in 1997.

With Recourse and Without Recourse Factoring

Factoring business may be undertaken on ‗with recourse‘ or ‗without recourse‘ foundation. Under with

recourse factoring, the factor has recourse to the client if the receivable purchased turn out to be

irrecoverable. In other languages, the credit risk is borne through the client and not the factor. The factor

is entitled to recover the amount from the client the amount paid in advance, interest for the era and any

other expenses incurred through him. In case of, without recourse factoring, the factor does not possess

the above right of recourse. He has to bear the loss arising out of non-payment of dues through the

buyer.

Mechanism of Factoring

An agreement is entered into flanked by the seller and the factor for rendering factoring services.

After selling the goods to the buyer, the seller sends copy of invoice, delivery challen, instructions to

create payment to the factor, to the buyer and also to the factor.

The factor creates payment of 80% or more of the amount of receivable to the seller.

The seller should also execute a deed of assignment in favour of the factor to enable him to recover

amount from the buyer.

The seller should also obtain a letter of waiver from the banker in favour of the factor, if the bank has

charge in excess of the asset sold to the buyer.

The seller should provide a letter of confirmation that all circumstances of the sale transactions have

been completed.

The seller should also confirm in writing that all payments receivable from the debtor are free from any

encumbrances, charge, and right of set off or counter claim from another person, etc.

The facility of factoring in India is accessible to all shapes of business organisations in manufacturing,

service and trading. Sole proprietary concerns, partnership firms and companies can avail of the services

of factors, but a ceiling on the credit which they can avail of in conditions of the value of the invoice to

be purchased is usually fixed for each client in medium and little level sectors. Usually the era for which

receivables are factored ranges flanked by 30 and 90 days.

The factor evaluates the client on the foundation of several criteria e.g. stage of receivables turnover, the

excellence of receivables, growth in sales, etc. The factor charges a service fee and a discount. The

service fee is charged in advance and depends upon the invoice value for dissimilar categories of clients.

It ranges flanked by 0.5-.2% of the invoice value.

REVIEW QUESTIONS

Why does a bank as a general rule not lend on long term basis ?

What are the common securities against which a bank may lend for working capital purposes ? Can a

bank extend an unsecured loan or advance ?

Discuss the different ways by which banks provide credit to business entities?

State the two broad categories of deposits which non-banking companies can accept to meet their

working capital needs.

Describe five important terms and conditions for issuing Commercial Paper.

Why are banks major investors in Commercial Paper?

Describe the eligibility conditions prescribed for issuing the Commercial Paper.

Describe five important terms and conditions for issuing Commercial Paper.

Why are banks major investors in Commercial Paper?

CHAPTER 4

Working Capital Control and Banking Policy

CAPITAL CONTROL

In economics, capital manage is the monetary policy device that a country‘s government (i.e., sovereign

authority) uses to regulate the flows into and out of a country‘s capital explanation, i.e., the flows of

investment-oriented money into and out of a country or currency. The decade as the Asian Currency

Crisis in 1997-1998 has rekindled debate in excess of the wisdom of developing markets having capital

controls. As globalization advanced with the formalization of the World Deal Institutions and Uruguay

Round of Common Agreement on Tariffs and Deal (GATT), developing countries were urged through

the International Monetary Finance and others to liberalize their capital controlled environments.

As it became clear that countries doing this, including Malaysia, Thailand and Mexico, essentially ceded

manage of their economies to external forces, namely international capital movements, hot money and

capital flight; and countries that did not, like China and India, retained manage and were not almost as

vulnerable to the volatility of international capital movement, some argued that capital controls were

advisable for smaller economies to exploit, and to transition absent from them only in excess of

extensive, common evolutionary timelines. Malaysia is an instance of a country that switched regimes,

from open in the late 1990s, to close.

Economists supporting capital controls in sure cases were not only from the left, but also liberal

economists like Jagdish Bhagwati and news publications like The Economist.

Banking Policy and Trends Policy Events

These contain freedom for banks to lend at interest rates below their respective PLRs to exporters and

other creditworthy borrowers (including public enterprises), permission to formulate fixed deposit plans

offering higher and fixed interest rates to senior citizens, flexibility in the composition of working

capital as flanked by cash credit and loan components, reduction in exposure limits for borrowers,

revised guidelines for exposure of banks to capital market, and guidelines for investment in non-SLR

securities by the private placement circuit.

The initiatives specially aimed at strengthening the operational efficiency of banks relate to the

Voluntary Retirement Plan, the Banking Service Recruitment Boards, Credit Fact Bureau, and

enlargement of the reach and scope of the electronic funds transfer facility.

Voluntary Retirement Plan (VRS)

VRS was implemented through 26 out of 27 public sector banks in 2000-2001. Indian Banks.

Association (IBA), the total staff strength in public sector banks at the end of March 2000 was 8, 63,188

out of whom 1, 26,714 or 14.7 per cent applied for VRS. In relation to the80 per cent of the number of

applications were carried, and the staff relieved under VRS until December 31, 2001 were 1, 01,300.

This constituted 11.7 per cent of the total staff strength at the end of March 2000. Banks were advised

through the Reserve Bank to treat the ex-gratia payment as deferred revenue expenditure (DRE), which

would not be reduced from Tier I capital. The location will be regularized through the end of the

accounting year in which the DRE gets completely wiped out. The maximum era of deferment has been

fixed at five years, including the year of acceptance of VRS applications through the banks.

Banking Service Recruitment Boards

In pursuance of the announcement made through the Fund Minister in his Budget speech, the Banking

Service Recruitment Boards (BSRBs) have been abolished. Accordingly, banks have been advised to

frame their own recruitment strategies, with the approval of the respective Boards, to meet future

necessities.

While framing such strategies, banks are required to ensure, inter alia, that the recruitment policy is

transparent and fair, with due symbols of the members of SC/ST and minority societies in selection

committees. Banks have also been advised to ensure that reservations in posts and related

concessions/relaxations in fees and spots, as laid down through the Government of India, are strictly

followed.

Electronic Funds Transfer (EFT)

EFT facilitates transfer of funds electronically within and crossways municipalities and flanked by

branches of a bank and crossways banks. EFT is operated through RBI, and is accessible for funds

transferred crossways 13 biggest municipalities in the country as on January 11, 2002. With effect from

October 1, 2001, big value transactions upto Rs. 2 crore have been permitted under EFT. Transfer of

funds on a ―similar-day‖ foundation was implemented effective from January 2, 2002 at the four metro

centers with three settlements per day.

Little and Medium Enterprises (SMEs)

Troubles Facing the SSI Sector

The SSI sector confronts many troubles despite its strategic importance in any industrialization strategy

and its immense potential for employment generation. The problem which continues to be a large hurdle

for the development of the sector is lack of access to timely and adequate credit. The Abid Hussain

Committee on SSIs (1997) examined the troubles of the SSI sector and recommended a package of

policies to restructure the industry in the context of current global economic changes.

The Expert Committee was of the view that the existing institutional building for delivering credit to

SSEs requires a thorough overhaul. It endorsed the recommendations of the Nayak Committee and

urged the RBI to implement the similar. The Committee recommended restructuring of financial support

by SFCs and SIDCs, tapping of other sources of funding for SSEs, extending credit rating services to

little elements, and addressing the credit requires of tiny elements to ensure that they are not bypassed

through the commercial banking system. The overall credit availability for SSIs throughout 1991-1996

amounts to only 13% of the value of manufacture. The Nayak Committee had recommended a desirable

norm of 20% of the value of manufacture to be made accessible through method of working capital by

term-lending organizations and commercial banks A norm of 75% was set for fixed capital assets

whereas actual availability is only 55%.

Lack of fund has been one of the biggest reasons of sickness in the SSI sector, blocking access to

technical modernization and other growth possibilities. There is an urgent require to enlarge flow of

credit to the SSI sector from institutional sources. The making of a facilitating habitation for SSIs will

centre on access to credit. The Ninth Five Year Plan estimates additional working capital funds at Rs.

1420 to 1460 billion for the little sector. Lowering interest-rates, specifying a time-frame to clear loan

applications and adherence to norms set down through the Nayak Committee are some of the minimum

events that require to be taken. Legislative events have a role to play with regard to funding and

financing of little level elements. There are events which can simply ensure that impediments to credit

availability are removed. These events contain:

Right to reasonable credit from commercial banks as per RBI guidelines framed after consultation with

representative Board

Defense against non-normative demands for security

Appeal and enforcement through Ombudsman/Board

Access to public funds through method of debentures, deposits, securities

Government guarantee for loans from banks

The events to support Marketing and Competitiveness are as follows:

State to exempt from contract security

Prompt return of contract securities in case of others

Prompt payment events

Defense against undue bundling of contracts through the state

Defense against restrictive and monopolistic deal practices

Ombudsman/arbitral services for enforcement

Impact of WTO

The emerging challenges to the little-level sector are to approach from the impact of the Agreements

under WTO to which India is a signatory beside with 134 member countries. The setting up of the WTO

in 1995 has altered the framework of international deal towards non-decorative, market-oriented

policies. This is in keeping with the policy shift that occurred worldwide as the early 1980s in favour of

free market forces and a tilt absent from State regulation/intervention in economic action.

This is expected to lead to an expansion in the volume of international deal and changes in the pattern of

commodity flows. The largest outcomes of WTO-stipulated necessities will be brought in relation to the

through reduction in export subsidies, greater market access, removal of non-tariff barriers and reduction

in tariffs. There will also be tighter patent laws by regulation of intellectual property rights under the

TRIPS Agreement which lays down what is to be patented (both products and procedures), for what

duration (20 years instead of the present 7 years under India‘s 1970 Patent Law), and on what

conditions.

The responses through trading countries and the reframing of domestic economic policies which will

result from the impact of WTO and the repercussions on the global economy of all these changes are

highly uncertain as they involve many unforeseeable factors. Though, there are sure indications of the

form of future deal patterns. Increased market access to imports (of approximately 3% of domestic

manufacture to be raised to 5%) will mean opening up the domestic market to big flows of imports. The

removal of quantitative restrictions (QRs) on imports has been speeded up to 2001.

At present 714 things are in the restricted category but imports of these things will soon be freed from

all restrictions as announced in the recent EXIM policy. Increased market access under WTO necessities

will also mean that our industries can compete for export markets in both urbanized and developing

countries. But the expected surge in our exports can approach in relation to the only if the SSI sector is

restructured to meet the demands of global competitiveness which is the key to the future of little

industries in the present context.

BANKING SYSTEM REFORMATION

Situation Appraisal

Monetary policy of the Belarusian authorities is distinguished through its unique character in the middle

of the post-socialist countries of Central and Eastern Europe. By, in contravention of the current

legislation, ―a printing press‖ as a source of covering low-effective public expenditure and levying

therefore enormous inflation tax on the population, the Government and the National Bank have

achieved dubious economic growth and retained unproductive employment. As a result the country‘s

economy has turned up in the financial and technical deadlock.

The following can be furnished to dramatize this thesis. Within the last six years net domestic ruble

credit of the National Bank increased in relation to the120 times, ruble money mass - almost 210 times,

official swap rate of the Belarusian ruble decreased 111 times while consumer prices went up 161 times.

These figures are undoubtedly indicative of the information that ―soft‖ monetary policy advocated

through the present-day economic ideologists as presuming point-like public support to some branches

at the expense of credit emission through the principle ―emission to fund manufacture of the goods does

not lead to inflation‖ has emerged invalid.

Unique character of the monetary policy in Belarus is stipulated through the following reasons. First,

this is incredible economic incompetence of the Belarusian ruling elite as well as its total dependence

upon the Head of the State. For some years the Government and the National Bank took and

implemented decisions in the monetary sphere that were distant absent not only from the usually carried

practice in the civilized countries but also general sense. That concerns first of all the policy of covering

public expenditure through credit emission of the National Bank, actual refusal of positive real interest

rate, and attempts of administrative regulation of inflation and swap rate.

Instead of real evaluation of financial possibilities of the country and exploit of budget possessions, the

authorities occupied in developing numerous programs without effective facilities of implementation.

Second, this is deep-rooted disrespect of own country that turned into chronic inferiority intricate not

allowing the majority of political elite representatives to get rid of the ―provisional men‖ feeling. Out of

ten years of its subsistence the Belarusian monetary system had perspectives of self-governing

development for in relation to throne and half years (end of 1994 - beginning of 1996). All other years

passed under the sign of either a portion of the Russian money system (91-93) or pending fast

―unification‖ (ruble zone of ―new kind‖, attempts to eliminate the Belarusian ruble in April of 1994,

preparation, and signing of the agreement on union state in 1996, etc.).

As a consequence extensive-term goals and benchmarks were away in the monetary policy, facilities of

its implementation were weak, qualified specialists left for commercial buildings, and dealings with the

international financial institutions were actually broken. Third, this is absence of the market reforms in

the real sector of economy that would have forced the political authority to pursue common economic

and monetary policy facilitating the development of private business.

Specifics of slow reformation of the real sector shown through the absence of systematic approaches and

integrity in the introduced economic transformations have resulted in the information that private sector

has not received adequate development, and consequently transitional class capable of sounding its

economic interests has not been shaped.

Shadow and semi-criminal business took the advantages of the effected economic policy. Economy of

the country turned up eventually dependent on economic location of the public sector enterprises. In this

situation all attempts, initiated through the specialists, to suggest and accomplish market plans of the

monetary sphere were doomed to fail. Fourth, this is typical of the former USSR republics and very die-

difficult relapse of socialist attitude to legality when the laws are applied commensurate with their

usefulness for a scrupulous office holder.

In case of the monetary system this principle can be emphasized through the following instance. The

Law on The National Bank in effect from 1991 to 2000 stipulated that the latter could grant credits to

the Government ―for a term, as a rule, up to 6 months‖. Nevertheless, accretion of extensive-term credit

amounts made up 122.6 billion rubles in 2000 alone (credits to cover budget deficit would be referred

afterwards to the augment of domestic national debt). The Law on Banks explicitly barred the

Government to interfere into action of the banks. But that did not inhibit the Government to force the

banks to give credits to the Agro-Industrial Intricate.

Such a queer method to interpret the laws has led to the information that the enterprises and banks acted,

as distant as they could, in the similar manner and avoided transparency of their operations at the money

market. As a result steady and negative attitude was shaped to the policy of the monetary authorities,

and this is inadmissible in the pursuit of stabilization of the national monetary element. Fifth, this is

voluntarism in the formation of priority tasks of the economic policy and their misbalance. The State

existed beyond its income. Target parameters of volume indices (volume of housing construction,

volumes of industrial output through the branches, etc.) passed in excess of to the row ministries and

departments were recognized arbitrary without taking accessible financial recourses of the State into

explanation. Economic policy turned into a hostage of the populist political goals such as achievement

of the GDP physical volume of 1990 in 2000.

Economic policy aimed at the growth of manufacture at any expense through monetary expansion has

brought in relation to the higher rates of inflation. As 1997 the parameters of credit emission through the

National Bank and growth of money mass in national currency invariably exceeded the target figures

approved every year in the Biggest Directions of the Monetary Policy.

The situation was aggravated through directive maintenance of the Belarusian ruble swap rate at the

overestimated stage with introduction of mandatory surrender of the foreign currency receipts. That

resulted in the appearance of multiple swap rates and shadow foreign swap market, more numerous

barter trades, foreign currency deficit to pay for critical import, and a number of other adverse

consequences. For example, share of housing construction in the total amount of credit emission of the

National Bank made up 59% in 1999 and 38% in 2000 whereas this share is to total 90% as indicated in

the forecast of the social and economic development for 2001.

The housing construction credits were extended at a reduced interest rate of 5% per year (while standard

monthly inflation, for instance, in 1999 was as high as 11%) and for extensive conditions (up to 40

years). A narrow circle of people who got the opportunity to build dwellings under such circumstances,

was indirectly subsidized at the expense of other people who accepted the burden of inflation tax. Weak

and shadowed to a big extent economy could not generate a strong and civilized banking system.

The state of the Belarusian banking system within last five years can be characterized in the mainly

common method through the following characteristics. First, this is its chronic financial weakness.

Assets of the Belarusian banks do not demonstrate noticeable tendencies to augment, and are in the state

of deep stagnation. Throughout the five-year era they decreased in currency calculation through 6%. The

residue of credits on 01.01.2001 amounted to in relation to the95% as compared with analogous index

on 01.01.1996. Percent of doubtful loans was on steady up rise - 17.9% of the balance of credit arrears

on 01.01.2001 in comparison with 13.2% five years earlier.

Second, this is differentiation of the commercial banks through biggest indices. A privileged location

and demonstrate unconditional support of the public sector of economy. Their share of possessions

amounts to 80-90% through largest articles of the aggregated balance of assets and liabilities of the

banking system. The share of Joint Stock Saving Bank ―Belarusbank‖ exceeds in some cases the official

index of monopolization - in excess of 35%.

From the economic point of view this means that the mainly effective private business is limited in

credit support through the banking system while the authorized banks being actually public, cannot

anticipate important preferences from external financial markets. As a result the banks and real sector

are not able to feed each other, and are doomed to financial weakness.

Third, this is formality in observing the regulations of safe banking action. The National Bank

performed insurance of the deposits of the population only in the authorized banks. Up to 2000 the

regulations of obligatory reserve formation were always lowered in practice - amount of reserves made

up regularly only 5-6% with the official reserve norm of 16-18%.

Fourth, this is insufficient transparency of the banks. In excess of last nine years no trustworthy bank

was set up in the country, and the fact on financial location of the banks is accidental and published as a

rule in non-public editions with little circulation. So confidence of the enterprises and population to the

banking system that is needed to accumulate free financial possessions under the circumstances of

reliability and return is at the very low stage in the present situation. It is no wonder that economic

mediators prefer to exploit any opportunity to export capital out of the country.

The troubles of the Belarusian banking system jointly with the current monetary policy create any

perspectives of its development indefinite. As a consequence that leads to financial separation of a rather

numerous cluster of the banks within the little and poor state and inevitable liquidation of the majority of

them. The Belarusian authorities will have to face a new problem in 2001 - inconsistency flanked by the

declared rigid monetary policy and financial necessities of the unreformed real sector.

Some indications were felt in 2000 when the National Bank merely tried to limit the rate of credit

emission. With the statistical GDP growth of 5.8% the investments dropped through 3.4%, income on

the sale of products - through 14.9%, profitability reduced through 2.3%, specific weight of loss-creation

enterprises increased through 6.4 percent points to 23.5% of all enterprises. More rigid monetary policy

will bring in relation to the bankruptcy of several enterprises and associated banks. That occurred at the

level of financial stabilization in practically all post-soviet republics.

Common Circumstances

Largest directions and events of the monetary policy for a transitional-term era were suggested

proceeding from the following conditions:

Beginning from February 2000 the Government and the National Bank pursue more weighted and

measured monetary policy that contains limitation of credit emission through the National Bank to cover

budget deficit, transfer to positive real interest rates, cancellation of the majority of currency market

limits, and abolition of multiple currency swap rates.

Signature of the agreement with the Russian Federation on the transfer to general money element in

2005 and monitoring programme with the IMF for a era of April-September 2001 (provided the

agreement has been realized) forces the President Management and the Government to take a number of

sure events towards reformation of the real sector of economy (liberalization of pricing, privatization of

public sector, bankruptcy of loss-creation enterprises, lift of the barriers for the development of little

and medium business).

Nevertheless, despite definite successes in the monetary sphere achieved in 2000, growth rates of prices

are still at the inadmissibly high stage.

The first objective source of inflation in the Belarusian economy has not been removed - high stage of

money mass growth. Failure to pay and deficiency of working capital of the enterprises in the real sector

of economy caused through low economic efficiency generate consistent demand for financial

possessions. In order to avoid bankruptcies of the loss-creation enterprises and reduction of

employment the Government, in the absence of other sources (foreign credits and private investments),

meets the necessities predominantly at the expense of emission crediting.

The National Bank has to carry on emission financing of current cash gaps and deficit of the republican

budget on the entire. Besides, methods of extra-economic character are used to force the commercial

banks to continue crediting of the public programs in the field of the Agro-Industrial Intricate at their

own possessions. The current macroeconomic policy necessity is based on the following principles:

Systematic approach - mutual consistency of the events and parameters of monetary, fiscal, foreign

economic, structural, and institutional policy. The policy of financial stabilization should be

accompanied with active privatization, and should produce circumstances for restructuring of the real

sector of economy, for making of stimulating institutional habitation to develop private business and

draw foreign investments;

Balanced targets of macroeconomic policy - radical inventory and review of the volume targets in the

public programs (housing construction, Agro-Industrial Intricate, etc.) in order to create them constant

with the financial possibilities of the State.

TASKS OF THE MONETARY POLICY

Principle objective of the monetary policy is to shape confidence on the section of business and

households in the national money element in the close to future. To attain this objective the following

tasks have to be solved:

To reduce the rate of inflation to 25% in the first year, 15% in the second, 5-10% in the third, and stay it

afterwards at a stage not exceeding 5% per year;

To uphold positive real interest rate of all financial instruments denominated in the national currency.

Attractive deposit policy will create it possible to augment specific weight of time ruble deposits in the

money mass, which are the largest source of credit possessions for the requires of the real sector of

economy. Owing to higher confidence in the national currency dollar-filling of the economy will be

reduced, buildings of the broad money mass will be improved through higher specific weight of the

national currency in its total volume, monetization coefficient will be increased;

To introduce the regime of floating swap rate and close convertibility of the Belarusian ruble in current

operations. Behaviors of the National Bank should be limited through ironing out regional, market

fluctuations of the swap rate and speculative misbalances in the currency demand and supply.

Expediency of this swap rate regime is determined through the information that it corresponds to a great

extent to the interests of little countries with middle economy having export-oriented building as the

stage of business action and load of the accessible producing capacities directly depend on the demand

for domestic products in the world market. This regime will create it possible to ensure competitiveness

of the domestic goods due to the tendency of real swap rate to reach an effective stage. Taking moderate

inflation within the era of stabilization into explanation (unlike the regimes with fixed swap rate)

burdensome currency interventions may be avoided.

To set up a regulative base for the system of non-public financial organizations capable of servicing

internal and external payment transactions as well as insuring safety of the money accumulations of the

enterprises and savings of the households;

To bring expenditure and revenue of the republican budget into balance.

Directions of Implementation

Consecutive reduction of the accretion of net crediting of the budget deficit through the National Bank

and its complete discontinuation through the third year of reforms. Positive effect consists in eliminating

the biggest inner source of inflation and lowering the national currency swap rate. Besides, the

Government will be described ―to live within its means‖.

Reduction of the growth rate of net internal ruble credit of the National Bank to standard 2-3% per

month at the beginning of reforms and afterwards to 15-20% per year. That will generate rigid budgetary

restrictions for all economic entities.

Regulation of the growth rate of aggregate internal credit (ruble and foreign currency) in order to

support the medium-term economic programme of the Government in proportion to expected growth of

GDP.

Securance of steady annual growth of net foreign assets of the National Bank to reach complete

coverage of the national currency money base at the current swap rate. In the given case the requirement

for annual growth of foreign currency reserves has primarily psychological character that increases

confidence in the current monetary policy.

Preparation of the circumstances (accumulation of net foreign assets and permanent manage in excess of

the growth of ruble money mass) to tie up the Belarusian ruble to Euro with subsequent integration of

the country into European Economic Society. The Authorities will have to demonstrate adherence of the

country to the European vector of development and to accept economic rules of the civilized market

behaviour.

Limitation of the growth rate of broad ruble money mass to standard 2-3% per month in the first year of

reforms and subsequently to 3.5-5% per year. As the rate of inflation goes down preconditions will seem

to augment the coefficient of monetization of GDP.

Successive reduction of the norm of obligatory reserves to 5-10% with total abolition of all privileges to

the commercial banks. That will allow, first, to decrease the cost of ruble and foreign currency credits

for the real sector of economy, and, second, give the banks with the possibility to uphold sufficiently

attractive interest rate on time deposits.

Elimination of all restrictions in the domestic currency market to reach internal convertibility of the

national money element with subsequent transfer of the Belarusian ruble to convertibility on current

operations.

Regulative promotion of settlements in the Belarusian ruble within CIS and secure neighbors - Poland,

Baltic countries, Russia - to free the possessions of convertible currencies for investment projects.

Maintenance of the refinancing and interest rates in the money market at the stage exceeding current

stage of inflation to stimulate saving and to promote investment procedure.

The events necessity is executed in package. They will create it possible to increase confidence in the

national money element, to slowly edge out dollar as means of saving and circulation, to substantially

augment foreign currency reserves of the National Bank. Furthermore, the suggested monetary policy is

a prerequisite of integration of Belarus into the European Society.

THE BANKING SYSTEM REFORM

Principle purpose of reformation and restructuring of the banking system is to shape a society of credit

and financial organizations that are able to accumulate free internal and external financial possessions

with their profitable disposition, and to render all banking services to domestic and foreign customers.

Largest troubles of the Belarusian banking system consist in its common financial weakness (as against

01.04.2001 it had assets totaling only 2 billion dollars out of which own possessions were less than 17%,

44% - possessions of the customers, and 10% - those of the National Bank). In relation to the half of all

assets of the banking system are disposed as credits to the legal entities, majority of which are low-

efficient and loss-creation enterprises of the public sector. Total amount of doubtful, overdue and

prolonged credits create up 19.2% out of the loans provided.

In relation to the8.7% of the assets are disposed in the low-profit public securities. Deductions to

obligatory reserves create up 4.7%. The banking system of Belarus does not practically possess financial

instruments that are able to ensure accumulation of money possessions in real calculation. Concentration

of almost 78% of all assets in six authorized semi-public banks that have to service public programs

associated with crediting of the low-efficient Agro-Industrial Intricate and housing construction,

produces a rather negative effect on the financial location of the banking system. The privileges on

obligatory reserves and interest rates granted in return, do not permit to effectively regulate the money

market through the market instruments and bring in relation to the certain distortions in its work.

Financial rehabilitation of the banking system necessity contains two directions:

Arrears of the real sector enterprises to the banks should be restructured;

Recapitalization of the banks should be performed by attraction of additional financial possessions to the

banking system.

Restructuring of doubtful to redeem arrears of the enterprises to the banks can be implemented through

two means: through conciliation processes and through compulsory events. In case the enterprise refuses

to strike a conciliation agreement, the bank will have a right to initiate the process of bankruptcy

irrespective of the shape of property of the given enterprise in accordance with the current legislation

(the Law on bankruptcy). Recapitalization of the banks throughout the era of general recovery of the

economy may contain the following events:

For the purpose of operational safety of the attracted possessions extraordinary provisional events are to

be taken in all commercial banks to restore common liquidity of the banking system.

Aggregate own capital of the Belarusian banks is to be significantly enlarged within first two years after

beginning of the radical reforms.

Spectrum of crediting and financial organizations is to be widened through setting up dedicated non-

banking organizations (investment, mortgage, leasing companies, communities of mutual crediting, etc.)

assuming that some banks that do not have possibilities to enlarge their own capital, will be transformed

into such organizations.

A cluster of leading Belarusian banks is to be encouraged to get acknowledgement at the international

financial markets including corresponding credit rating.

International rules of accounting are to be used through the Belarusian banks. Largest statistics on the

commercial banks are to be passed in excess of to self-governing analytical centers for systematic

processing and publication of domestic bank rating.

Transactions in the active explanations of the banks that fail to shape reserves on doubtful credits are to

be restricted (as against 01.04.2001 a sum of doubtful credits amounting to 153 billion rubles was

sheltered through reserves only through 84% without prolonged and overdue credits, if such credits are

taken into consideration - 57%).

All banks with overdue arrears on extended credits in excess of 5% out of all granted credits, are to work

out a plan of own rehabilitation including a schedule of expected conciliation agreements with the

borrowers and initiation of the process of bankruptcy.

The banks should be encouraged to develop a set of events aimed at own financial rehabilitation:

To adopt within 2-3 years a practice of preservation of the common licenses only for the banks having

international rating;

To work out a facility of coercive sale of the controlling block of stock of those banks that frequently

fail to observe prudential norms and jeopardize the safety of the whole banking system. This right

should be entrusted a banking supervision department or bank restructuring agency;

To set up ultimate specific weight of the enterprise shares in the bank assets so that to encourage the

banks to restore liquidity as fast as possible.

The Government and the National Bank should undertake in short order the following actions:

Legal and actual restoration of sovereignty of the National Bank from the executive authority as

essential must of developing a contemporary banking system responsible before creditors and

depositors.

Withdraw the possessions of the State and the National Bank from the equity capital of the commercial

banks, primarily from Belarusbank and Belagroprom bank, with their subsequent sale at free auctions.

This is required, first, to create the circumstances equal for all banks, and, second, to exclude possibility

of non-market pressure of the Authorities and the National Bank on the money market by self-governing

of them banks.

Restoration of the dedicated Saving Bank servicing exclusively the households and working in the

money market. That will allow to raise the safety of household savings and to strengthen the market of

extensive-term money possessions.

Reorganization of Belagroprombank through means of its division into six (through number of areas)

regional land banks with transfer of the controlling block of shares to regional authorities. That will

allow development of local financial markets approximately regional land banks in the future.

Making of the third stage of crediting and financial organizations - dedicated non-bank crediting and

financial organizations with limited license commissions and without the right to uphold resolution

explanations of the legal entities and physical persons (investment, trust, mortgage and other companies,

communities of mutual crediting, credit unions, etc.). As a result additional possessions will be attracted

to the money market including the ones from the ―gray‖ economy. Specialization and bigger-excellence

crediting and financial services will be ensured, too.

Setting of a special non-public finance as stock company to insure deposits of the households and time

deposits of the legal entities. The finance will be replenished through proportional unrequited

contributions of the banks and non-bank crediting and financial organizations. That will augment

confidence in the banks and therefore enlarge their resource base.

Restriction of operations in the active explanations of the banks that fail to shape reserves for doubtful

credits.

Development of a facility of accelerated lawsuits against enterprises-borrowers who are not able to

redeem extended bank credits, their bankruptcy and property transfer for provisional management

through recommendation of the bank-creditors.

Development and adoption of a facility of coercive sale of the controlling block of stock of those banks

that frequently fails to observe prudential norms and jeopardize the safety of the whole banking system.

That will allow speeding up the process of owner transform in the inefficient banks without their

bankruptcy and public commotion, to draw more professional management, and to reduce a share of

problem banks in the banking system.

Making of the Union of commercial banks is to be initiated. The Union will assume together and

severally responsibility for the financial location of the member-banks, up to setting up a special non-

public company insuring deposit risks of the depositors and creditors of the ―union banks‖ on one face,

and providing recommendations to the agency supervising the banks on coercive sale of the controlling

block of shares of the banks suffering financial troubles, on the other face. That should prevent

unexpected bank bankruptcies.

The service in charge of surveillance in excess of the commercial banks should be removed from the

National Bank. A self-governing agency is to be set up on its base. That will allow to split the functions

of licensing, regulation and supervision of the banking system, and to augment its transparency.

Calculation of all prudential regulations proceeding from own capital of the banks and not from their

equity capital. That will allow to abandon artificial attraction of new shareholders and to enlarge

capitalization of already issued shares and their market value.

Branches of reliable foreign banks are to be attracted to the country; their participation in the capital of

already operating Belarusian banks will be encouraged, for instance, by issue of American and European

depositary receipts. That will allow to draw additional possessions to the banking system and to

intensify competition flanked by commercial banks.

Transfer to the international standards of financial reporting of the Belarusian banks for the purpose of

their prompt version to the world financial markets and procreation of appropriate bank ratings.

Development of necessary actions aimed at receiving credit rating for Belarus and appropriate bank

rating for the commercial banks. The banks that do not possess commonly carried international rating,

will have limited foreign currency licenses. Furthermore, the banks that do not possess internal national

rating, will have limited domestic license to service the households.

Review of all current banking legislation of the country in the following directions:

Separate differentiation of authorities flanked by monetary entities;

Competition flanked by monetary entities;

Supremacy of law in regulation of monetary dealings;

Consideration of disputable issues through courts;

Material, administrative and other responsibility of any entity, including state authorities, for the damage

inflicted through wrongful actions;

Transparency in dealings flanked by entities;

Provision of fact to the public on the National Bank policy and location of the monetary organizations.

The events suggested are aimed at financial strengthening of the Belarusian banking system, creation it

dynamic, transparent, including entry to the world financial markets as a full member. Unlike the block

of monetary policy, their implementation does not need comprehensive approaches and may be executed

any time as economic and political circumstances get ready.

PERFECTION OF BANKING LEGISLATION

Appraisal of the Situation

Analysis of the monetary policy pursued in 1995-2000 has displayed that within the frames of the

present institutional arrangement of the monetary sphere no regulating efforts on the section of the

monetary authorities are able to radically improve its location, and comparative stabilization of the

money market is of short-term character.

The legislation administering banking behaviors in Belarus proceeded from market principles on some

locations. In the second half of the 90-ies when backtrack from the economic reforms began, bank

regulating acts emerged unprotected from the edicts and decrees, equated to laws, of the President. Legal

field of action of the National Bank and commercial crediting and financial organizations was

substantially deformed.

Suffice to note, that through the Presidential Decree of March 21, 1998 the National Bank, contrary to

the Constitution, was subordinated in operative conditions to the Government and remained in this

location till June of 2000. The only method out is to develop and to introduce promptly the legislative

base needed to implement market reforms in the monetary and banking system, and coordinated with the

legislation in the real sector of economy. Adopted in the fall of 2000 a variant of the Banking Code of

the Republic of Belarus does not meet the given necessities as it has retained to a great extent the

drawbacks of the preceding legislation and in some locations deterioration has taken lay.

Biggest Directions Banking Legislation Perfection

Market principles applied in the majority of dynamically developing countries will be laid down in the

foundation of legislation regulating the banking action.

Transition to the monetary system of open kind and market-based determination of the national currency

official swap rate should be sounded through legislation.

Introduce historic name of the national currency - taler. That will emphasize final selection of the

country development as a sovereign state.

To set up the substance of money regulation - amount and building of money base, and total money

mass in circulation as well.

To determine largest instruments and methods of money regulation, principles of arranging money

turnover, and order of cash money circulation.

To set a rigid ban on by monetary emission to fund budget deficit and any public or other projects as

well as banks for an era of in excess of one year.

To introduce limitations for participation of the emission bank in economic action including

participation in the capital of commercial banks.

To close exclusive responsibility of the National Bank for the development and execution of the

monetary policy in the Republic of Belarus.

Maximum transparency and openness of the National Bank should be recognized through legislation.

The norms linked with central bank status should be significantly changed.

The mainly significant legislative provision ensuring independence of the National Bank should be its

accountability before the Parliament. Principle objectives and tasks of the National Bank are suggested

to be defined in a legislative method: maintenance of price continuity, securance of steady purchasing

authority of the national currency and its swap rate with foreign currencies.

Independence of the National Bank of the executive authority should be based on three chief principles:

institutional, financial, and personal. Financial independence presumes own budget of the National

Bank. That contains also establishment of the stage and shapes of labour compensation of its employees.

Personal independence of the National Bank management is arranged through strictly regulated order of

appointment and dismission of its highest officials through the Parliament. The provision that stipulates

the status of the Chairman of the Board of Directors of the National Bank as member of the Government

should be cancelled. Through virtue of the suggested autonomy of the National Bank the norms should

be provided for regulation of interrelations flanked by dissimilar stages of its management - Board and

Council of Directors, through removing them from the internal statute of the central bank.

The law should legally arrange dealings of the central bank with the government (prohibition of direct

centralized crediting of budget deficit, commitments to close liquidity of public short-term liabilities),

mutual responsibility for pursued general monetary policy, and division of surveillance functions in

excess of crediting and financial organizations. A significant section of the law is legal arrangement of

the limits of licensing and surveillance authorities of the National Bank, rules of their application, as

well as the order of presentation of surveillance fact on the action of the banks and non-bank crediting

and financial organizations to other agencies of state management and mass media. A new approach is

needed to perform surveillance of the commercial banks and non-bank crediting and financial

organizations.

State registration, licensing and cancellation of licenses of the commercial banks, establishment of

largest norms associated with regulation of the money market in the country should be left with the

National Bank. Surveillance of the banks and non-bank organizations should be passed in excess of to a

special committee on surveillance of the action of the crediting and financial organizations, rights and

obligations of which will be defined in a special law. Licensing and regulation of the action of the non-

bank crediting and financial organizations should be entrusted with the Ministry of Fund.

Furthermore, all prudential supervision (manage of liquidity, solvency, big risks, etc.) of the action of all

crediting and financial organizations will be given to a special supervising committee. Practice of the

recent years has shown inefficiency of concentration of all functions in the National Bank. To temporary

suspension of any license issued through the National Bank or Ministry of Fund. The supreme governing

body of the committee is to be set up on a parity foundation out of the representatives of the National

Bank, Ministry of Fund, and members of the committee itself.

The following provisions should be specified in the law on the non-bank crediting and financial

organizations:

Non-bank organizations necessity not perform exclusively banking functions - attraction of deposits,

extension of credits on their own behalf, and explanation keeping;

Non-bank organizations necessity not have correspondent explanations in the single payment system;

Specialization of the non-bank organizations should be maintained through issuing a limited number of

licenses (not more than three);

Relatively low start-up equity capital;

Licensing of the non-bank crediting and financial organizations through the Ministry of Fund that

suggests participation of the latter in pursuing of the financial policy coordinated with the National

Bank.

New Banking Code will be structurally collected of a package of self-governing laws - on monetary

system, on central bank, on banking universal and dedicated crediting and financial organizations, on

active, passive and intermediary banking operations, on non-bank crediting and financial organizations,

on banking trust, on foreign currency operations and foreign swap manage, on mutual crediting of little

business entities, on surveillance of the action of the crediting and financial organizations (banking

supervision) and some other legislative acts.

Each of them regulates in a legislative manner a distinct sphere of monetary behaviors and defines

responsibilities of distinct legal entities and corresponding public authorities. Advantages of the

suggested building consist in the following: some component sections of the common code may be

adopted and refined not as an entire but successively as corresponding economic circumstances

transform, and as public authorities are ready to guarantee their observation and economic entities - their

implementation.

BANKING REFORM IN INDIA

Considered through share of deposits, 83 percent of the banking business in India is in the hands of state

or nationalized banks, which are banks that are owned through the government, in some, increasingly

less clear-cut method. Moreover, even the non-nationalized banks are subject to long regulations on who

they can lend to, in addition to the more average prudential regulations.

Government manage in excess of banks has always had its fans, ranging from Lenin to Gerschenkron.

While there are those who have accentuated the political importance of public manage in excess of

banking, mainly arguments for nationalizing banks are based on the premise that profit maximizing

lenders do not necessarily deliver credit where the social returns are the highest. The Indian government,

when nationalizing all the superior Indian banks in 1969, argued that banking was ―inspired through a

superior social purpose‖ and necessity ―sub serve national priorities and objectives such as rapid growth

in agriculture, little industry and exports.‖

There is now a body of direct and indirect proof showing that credit markets in developing countries

often fail to deliver credit where its social product might be the highest, and both

We thank the Reserve Bank of India, in scrupulous Y.V. Reddy, R.B. Barman, and Abhiman Das, for

generous assistance with technological and substantative issues. We also thank Abhiman Das for

performing calculations which involved proprietary RBI data, as well as Saibal Ghosh and Petia

Topalova for helpful comments. We are grateful to the staff of the public sector bank we revise for

allowing us access to their data. We gratefully acknowledge financial support from the Alfred P. Sloan

Basis.

If nationalization succeeds in pushing credit into these sectors, as the Indian government claimed it

would, it could indeed raise both equity and efficiency. The cross-country proof on the impact of bank

nationalization is not extremely encouraging. For instance, discover in a cross-country setting that

government ownership of banks is negatively correlated with both financial development and economic

growth.

They interpret this as support for their view, which holds that the potential benefits of public ownership

of banks, and public manage in excess of banks more usually, are swamped through the costs that

approach from the agency troubles it makes: cronyism, leading to the deliberate misallocation of

capital, bureaucratic lethargy, leading to less deliberate, but possibly equally costly errors in the

allocation of capital, as well as inefficiency in the procedure of mobilizing savings and transforming

them into credit. Unluckily the interpretation of this kind of cross-country analysis is never simple, and

never more so than the case of something like bank nationalization, which typically occurs as section of

a package of other policies. For instance, Bertrand et. al., revise a 1985 banking deregulation in France,

which gave banks much greater freedom to compete for clients.

They discover that deregulated banks respond more to profitability when creation lending decisions.

After the reform, firms that suffer a negative shock are much more likely to undertake restructuring

events, and there is more entry and exit in bank-dependent industries. Micro studies of the effect of bank

nationalization are unusual: a significant exception is Mian who examines the privatization of a big

public bank in Pakistan in 1991.

He discovers that the privatized bank does a bigger occupation both at choosing profitable clients and

monitoring existing clients, than the commercial banks that remained public. Micro data from a

nationalized bank to evaluate the effectiveness of the Indian banking system in delivering credit.

The Indian financial system is characterized through under-lending in the sense that there are several

firms that could earn big profits if they were given access to credit at the current market prices.

The work with the aim of by that proof and proof from other research through ourselves and others, to

approach to an assessment of the appropriate role of the Indian government vis-à-vis the banking sector.

We first give an extremely brief history of banking in India.

We begin through presenting proof that there is substantial under-lending in India. To understand what

role public ownership of banks may play in under lending, we identify differences flanked by public and

private banks in the sect oral allocation of credit flanked by public and private banks. In scrupulous, we

focus on the question of whether being nationalized has made these banks more responsive to what the

Indian government wants them to do. We statement results, based on work through Cole showing that on

several of the declared objectives of ―social banking,‖ the private banks were no less responsive than the

comparable nationalized banks, with the exception of agricultural lending.

Finally, the last sub-part compares the performance of public and private banks as financial

intermediaries and concludes that the public banks have been less aggressive than private banks in

lending, in attracting deposits and in setting up branches, at least as 1990. We discover that official

lending policy is extremely rigid. Moreover, loan administrators do not seem to exploit what small

flexibility they have. We argue that the proof suggests that bankers in the public sector have a

preference for what we may call passive lending.

To understand why this is the case, we look at the incentives and constraints faced through public loan

administrators. We focus on whether vigilance action impedes lending, and whether public sector banks

prefer to lend to the government, rather than private firms. The penultimate section compares the

performance of public and private banking in two other regions. First, we look at how nationalization of

banks has affected the availability of bank branches in rural regions, and discover that, if anything,

nationalization seems to have inhibited the growth of rural branches. Second, we attempt to say

something in relation to the sensitive issue of NPAs and bailouts.

While the dataset we have now is rather sparse, it seems that the bailouts of the public banks have

proved more expensive for the government, but once we manage for differences in size flanked by the

public and private banks, it is less clear-cut. We conclude in a short discussion of the implications of

these results for the future of banking reform. Backdrop India has an extensive history of both public

and private banking. Contemporary banking in India began in the 18th century, with the founding of the

English Agency Home in Calcutta and Bombay. In the first half of the 19th century, three Presidency

banks were founded. After the 1860 introduction of limited liability, private banks began to seem, and

foreign banks entered the market.

The beginning of the 20th century saw the introduction of joint stock banks. In 1935, the presidency

banks were merged jointly to shape the Imperial Bank of India, which was subsequently renamed the

State Bank of India. Also that year, India‘s central bank, the Reserve Bank of India (RBI), began

operation. Following independence, the RBI was given broad regulatory power in excess of commercial

banks in India. In 1959, the State Bank of India acquired the state-owned banks of eight former princely

states. Therefore , through July 1969, almost 31 percent of scheduled bank branches during India were

government controlled, as section of the State Bank of India. The post-war development strategy was in

several ways a socialist one, and the Indian government felt that banks in private hands did not lend

sufficient to those who needed it mainly.

In July 1969, the government nationalized all banks whose nationwide deposits were greater than Rs.500

million, resulting in the nationalization of 54 percent more of the branches in India, and bringing the

total number of branches under government manage to 84 percent. Prakesh Tandon, a former chairman

of the Punjab National Bank (nationalized in 1969) describes the rationale for nationalization as follows:

Several bank failures and crises in excess of two centuries, and the damage they did under ‗laissez faire‘

circumstances; the requires of intended growth and equitable sharing of credit, which in privately owned

banks was concentrated largely on the controlling industrial homes and influential borrowers; the

requires of rising little level industry and farming concerning fund, equipment and inputs; from all these

there appeared an inexorable demand for banking legislation, some government manage and a central

banking power, adding up, in the final analysis, to social manage and nationalization.

After nationalization, the breadth and scope of the Indian banking sector expanded at a rate possibly

unmatched through any other country. Indian banking has been extraordinarily successful at achieving

mass participation. Flanked by the time of the 1969 nationalizations and the present, in excess of 58,000

bank branches were opened in India; these new branches, as of March 2003, had mobilized in excess of

9 trillion Rupees in deposits, which symbolize the overwhelming majority of deposits in Indian banks.

This rapid expansion is attributable to a policy which required banks to open four branches in unbanked

sites for every branch opened in banked sites. Flanked by 1969 and 1980, the number of private

branches grew more quickly than public banks, and on April 1, 1980, they reported for almost 17.5

percent of bank branches in India.

In April of 1980, the government undertook a second round of nationalization, placing under

government manage the six private banks whose nationwide deposits were above Rs. 2 billion, or a

further 8 percent of bank branches, leaving almost 10 percent of bank branches in private hands. The

share of private bank branches stayed fairly consistent flanked by 1980 to 2000. Nationalized banks

remained corporate entities, retaining mainly of their staff, with the exception of the board of directors,

who were replaced through appointees of the central government.

The political appointments incorporated representatives from the government, industry, agriculture, as

well as the public. (Equity holders in the national bank were reimbursed at almost par). As 1980, has

been no further nationalization, and indeed the trend seems to be reversing itself, as nationalized banks

are issuing shares to the public, in what amounts to a step towards privatization. The considerable

accomplishments of the Indian banking sector notwithstanding, advocates for privatization argue that

privatization will lead to many substantial improvements.

Recently, the Indian banking sector has witnessed the introduction of many ―new private banks,‖ either

newly founded, or created through previously extant financial organizations. The new private banks

have grown quickly in the past few years, and one has grown to be the second main bank in India. India

has also seen the entry of in excess of two dozen foreign banks as the commencement of financial

reforms. While we consider both of these kinds of banks deserve revise, our focus here is on the older

private sector, and nationalized banks, as they symbolize the overwhelming majority of banking action

in India.

The Indian banking sector has historically suffered from high intermediation costs, due in no little

section to the staffing at public sector banks: as of March 2002, there were 1.17 crores of deposits per

employee in nationalized banks, compared to 2.05 crores per employee in private sector banks. As with

other government-run enterprises, corruption is a problem for public sector banks: in 1999, there were

1,916 cases which attracted attention from the Central Vigilance Commission.

While not all of these symbolize crimes, the investigations themselves may have a harmful effect, if

bank administrators fear that approving any risky loan will inevitably lead to scrutiny. Advocates for

privatization also criticize public sector banking as unresponsive to credit requires. We exploit recent

proof on banking in India to shed light on the comparative costs and benefits of nationalized banks.

During this exercise, it is significant to bear in mind that the Indian banking sector is going by

something like a transformation. Therefore , it is potentially a dangerous time to evaluate its

performance by historical data.

Under-lending so is a characteristic of the whole financial system: the firm has not been able to raise

sufficient capital from the market as an entire. In other languages, while as suggested, focus on the

clients of a public sector bank, if these firms are receiving too small credit from that bank, they should in

theory have the option of going elsewhere for more credit. If they do not or cannot exercise this option,

the market cannot be doing what, in its idealized shape, we would have expected it to do. Though, we

know that the Indian financial system does not function as the ideal credit market might.

Mainly little or medium firms have a connection with one bank, which they have built up in excess of

some time–they cannot anticipate to walk into another bank and get as much credit as they want. For

that cause, their skill to fund investments they require to create does depend on the willingness of that

one bank to fund them. In this sense the results we statement might extremely well reflect the

specificities of the public sector banks, or even the one bank that was type sufficient to share its data

with us, however given that it is seen as one of the best public sector banks, it looks unlikely that we

would discover much bigger results in other banks in its category.

On the other hand we do not have comparable data from any private bank and so cannot tell whether

under-lending is as much of a problem for private banks. As suggested,, though, later statement some

results on the comparative performance of public and private banks in conditions of overall credit

delivery Our identification of credit constrained firms is based on the following easy observation: if a

firm that is not credit constrained is offered some extra credit at a rate below what it is paying on the

market, then the best method to create exploit of the new loan necessity be to pay down the firm‘s

current market borrowing, rather than to invest more.

This is because, through the definition of not being credit constrained, any additional investment will

drive the marginal product of capital below what the firm is paying on its market borrowing. It follows

that a firm that is not facing any credit constraint will expand its investment in response to additional

subsidized credit becoming accessible, only if it has no more market borrowing. Through contrast, a

firm that is credit constrained will always expand its investment to some extent.

A corollary to this prediction is that for unconstrained firms, growth in revenue should be slower than

the growth in subsidized credit. This is a direct consequence of the information that firms are

substituting subsidized credit for market borrowing. So, if we do not see a gap in these growth rates, the

firm necessity is credit constrained. Of course, revenue could augment slower than credit even for non-

constrained firms, if the technology has declining marginal return to capital. These predictions are more

robust than the traditional method of measuring credit constraints as the excess sensitivity of investment

to cash flow.

Our approach inscribes itself in a literature that tries to identify specific shocks to wealth in order to

identify credit constraints. In Banerjee and Duflo we test these predictions through taking advantage of a

recent transform in the so-described ―priority sector‖ rules in India: all banks in India are required to

lend at least 40 percent of their net credit to the priority sector, which contains little level industry (SSI),

at an interest rate that is required to be no more than 4 percentage points their prime lending rate. If

banks do not satisfy the priority sector target, they are required to lend money to specific government

agencies at low rates of interest. In January, 1998, the limit on total investment in plants and machinery

for a firm to be eligible for inclusion in the little level industry category was raised from Rs. 6.5 million

to Rs. 30 million.

Our empirical strategy focuses on the firms that became newly eligible for credit in this era, and uses

firms that were always eligible for priority sector credit as a manage. The proof for under-lending Data:

The data we exploit were obtained from one of the bigger-performing Indian public sector banks. We

exploit data from the loan folders maintained through the bank on profit, sales, credit rows and

utilization, and interest rates.

The loan folders also statement all numbers that the banker was required to calculate (e.g. his projection

of the bank‘s future turnover, his calculation of the bank‘s credit requires, etc.) in order to determine the

amount to be lent.

We have data on 253 firms (including 93 newly eligible firms). The data is accessible for the whole

1997 to 1999 era for 175 of these firms. We are in effect comparing how the outcomes transform for the

large firms after 1998, with how they transform for the little firms.

As y is always a growth rate, this is, in effect, a triple variation–we can allow little firms and large firms

to have dissimilar rates of growth, and the rate of growth to differ from year to year, but we assume that

there would have been no differential changes in the rate of growth of little and big firms in 1998, away

the transform in the priority sector regulation.

By, respectively, the log of the credit limit and the log of after that year‘s sales (or profit) in lay of y in

equation 1, we obtain the first level and the reduced shape of a regression of sales on credit, by the

interaction LARGE POST as an instrument for credit. As suggested, present the corresponding

instrumental variable regressions. Results: The transform in the regulation certainly had an impact on

who got priority sector credit. The credit limit granted to firms below Rs. 6.5 million in plant and

machinery (henceforth, little firms) grew through 11.1 percent throughout 1997, while that granted to

firms flanked by Rs.6.5 million and Rs. 30 million (henceforth, large firms), grew through 5.4 percent.

In 1998, after the transform in rules, little firms had 7.6 percent growth while the large firms had 11.3

percent growth. In 1999, both large and little firms had in relation to the similar growth, suggesting they

had reached the new status quo.

This is confirmed when we estimate equation 1 by bank credit as the outcome. The coefficient of the

interaction term LARGE POST is 0.95, with a average error of 0.033. Estimates the probability that a

firm‘s credit limit was changed: the coefficient on LARGE POST is secure to zero and insignificant,

suggesting that the reform did not affect which firm‘s limits was changed. This corresponds to the

common observations that whether or not a firm‘s file is brought out for a transform in limit has nothing

to do with the requires of the firm, but respond to internal dynamics of the bank. As suggested, create

exploit of this information to partition the example into two clusters on the foundation of whether there

was a transform in the credit limit or not: the example where there was no transform in limit can be used

as a ―placebo‖ cluster, where we can test our identification assumption.

Finally, the estimated impact of the reform on loan size for firms whose limit was changed: the

coefficient of the interaction LARGE POST is 0.27, with a average error of 0.10. This augment in credit

was not accompanied through a transform in the rate of interest. It did not lead to reduction in the rate of

utilization of the limits through the large firms: the ratio of total turnover (the sum of all debts incurred

throughout the year) to credit limit is not associated with the interaction LARGE POST. The additional

credit limit therefore resulted in an augment in bank credit utilization through the firms.

The coefficient of the interaction LARGE‖POST in the sales equation, in the example where the limit

was increased, is 0.19, with a average error of 0.11. Through contrast, in the example where there was

no augment in limit, the interaction LARGE POST is secure to zero (0.007) and insignificant, which

suggests that the sales result is not driven through a failure of the identification assumption. The

coefficient of the interaction LARGE POST is 0.27 in the credit regression, and 0.19 in the sales

regression: therefore , sales increased approximately as fast as loans in response to the reform. This is an

indication that there was small or no substitution of bank credit for non-bank credit as a result of the

reform, and that firms are credit constrained.

We restrict the example to firms which have a positive amount of borrowing from the market both

before and after the reform, and therefore have not totally substituted bank borrowing for market

borrowing. In this example as well, we obtain a positive and important effect of the interact ion LARGE

POST, indicating that these firms necessity be credit constrained. We present the effect of the reform on

profit. Because our dependent variable is the logarithm of profit, we can only estimate the impact on

firms whose profits were positive. The effect is even better than that of sales: 0.54, with a average error

of 0.28.

Here again, we see no effect of the interaction LARGE POST in the example without a transform in

limit (row 2), which lends support to our identification assumption. The big effect on profit is not

enough to set up the attendance of credit constraints: even unconstrained firms should see profits

augment when they gain access to subsidized credit, because they would substitute cheaper capital for

more expensive capital. Though, if firms were not expanding, we should not anticipate seeing sales or

costs (not accounted) expand as well.

Note that the coefficient is a lower bound of the effect of working capital on sales, because the reform

should have led to some substitution of bank credit for market credit. The IV coefficient is 0.75, with a

average error of 0.37. The effect of working capital on sales is extremely secure to 1, a result which

would imply that there cannot be equilibrium without credit constraint. The IV estimate of the impact of

bank credit on profit is 1.79, however again the example is limited to firms with positive profits. This is

considerably greater than, which suggests that the technology has a strong fixed cost component.

Though, these coefficients also allow us to estimate the effect of credit expansion on profits. We can

exploit this estimate to get a sense of the standard augment in profit caused through every rupee in loan.

The standard loan is Rs 8, 6800. So, and augment of Rs. 1,000 in the loan corresponds to a 1.15%

augment in loans. Taking 1.79 as the estimate of the effect of the log augment in loan on log augment in

profit, an augment of Rs. 1,000 in lending reasons a 2% augment in profit. At the mean profit (which is

Rs. 36,700, this would correspond to an augment in profit of Rs. 756.13 A last piece of significant proof

is whether large firms become more likely to default than little firms after the reform: the augment in

profits (and sales) may otherwise reflect more risky strategies pursued through the big firms. In order to

answer this question, we composed additional data on the firms based in the Mumbai area (138 firms, a

bit in excess of half the example). In scrupulous, we composed data on whether any of these firm‘s loan

had become non-performing assets (NPA) in 1999, 2000 or 2001, or were NPA before 1999.

The number of NPAs is disturbingly big (constant with the high rate of NPAs in Indian banks), but big

and little firms are equally likely to have a non-performing loan: 7.7% of the large firms and 7.29% of

the little firms (who were not already NPA), default on their loan in 2000 or 2001. In the middle of the

firms in Mumbai, 2.5% of the big firms, and 5.96% of the little firms had defaulted flanked by 1996 and

1998. The fraction of firms that had defaulted therefore increased a small bit more for big firms, but the

variation is little, and not important. The augment in credit did not reason an unusually big number of

large firms to default. Default rate, and the higher cost of lending to the firms in the priority sector, is

not enough to narrow significantly the gap flanked by our estimate of the rate of returns to capital and

the interest rate.

By these estimates and our previous estimates of the cost of lending to little firms, we compute that the

interest rate banks should charge to these firms is secure to 22% (rather than the 16% they are charging

on standard). This means that the gap flanked by the social marginal product of capital is at least 66%.

These results give clear proof of extremely substantial under-lending: some firms clearly can absorb

much more capital at high rates of return. Moreover the firms in our example are through Indian

standards quite substantial: these are not the extremely little firms at the margins of the economy, where,

even if the marginal product is high, the scope for expansion may be quite limited. These data do not tell

us anything directly in relation to the efficiency of allocation of capital crossways firms.

Though, the IV estimate of the effect of loans on profit is strongly positive, while the OLS estimate is

not dissimilar from zero. In other languages, firms that have higher growth in loans do not generate

faster growth in profits, suggesting that normally banks do not target loans enhancements to the mainly

profitable firms. This is constant with proof accounted in Dasgupta15, that the interest rate paid through

firms and through implication the marginal product of capital varies enormously within the similar sub-

economy. It is also constant with the more direct proof in Banerjee and Munshi showing that there is

extremely substantial difference in the productivity of capital in the knitted garment industry in Tirupur.

Furthermore, while we have no direct data on this point, banker‘s lore suggests that the firms that have

relatively simple access to credit tend to be the better and longer recognized firms. The under provision

of credit to little-level industry was one of the key causes cited for nationalization in 1969: therefore , it

might in information be the case that while the public sector banks give relatively small credit to SSI

firms, private banks are even worse. Bank Ownership and Sectoral Allocation of Credit An significant

rationale for the Indian bank nationalizations was to direct credit towards sectors the government idea

were underserved, including little level industry, as well as agriculture and backward regions.

Ownership was not the only means of directing credit: the Reserve Bank of India issued guidelines in

1974, indicating that both public and private sector banks necessity give at least one-third of their

aggregate advances to the priority sector through March 1979. In 1980, it was announced that this quota

would be increased to 40 percent through March 1985. Sub-targets were also specified for lending to

agriculture and weaker sectors within the priority sector. As public and private banks faced the similar

regulation, in this section we focus on how ownership affected credit allocation. The comparison of

nationalized and private banks is never simple: banks that fail are often merged with healthy

nationalized banks, which creates the comparison of nationalized banks and non-nationalized banks

secure to meaningless.

The Indian nationalization experience of 1980 symbolizes a unique chance to learn in relation to the

connection flanked by bank ownership and bank lending behaviour. The 1980 nationalization took lay

just as to a strict policy rule: all private banks whose deposits were a sure cutoff were nationalized. After

1980, the nationalized banks remained corporate entities, retaining mainly of their staff, however the

board of directors was replaced through nominees of the Government of India. Both the banks that got

nationalized under this rule and the banks that missed being nationalized, sustained to operate in the

similar habitation, and face the similar regulations and so ought to be directly comparable.

Even this comparison flanked by banks presently nationalized and presently not nationalized may be

invalid, because policy rule means that banks nationalized in 1980 are superior to the banks that

remained private. If size powers bank behaviour, it would be incorrect to attribute all differences flanked

by nationalized and private sector banks to nationalization. In this section, based on Cole, we adopt an

approach in the spirit of regression discontinuity design, and compare banks that were presently above

the 1980 cutoff to those that were presently below the 1980 cutoff, while manage- ling for bank size in

1980. The thought behind this comparison is that the connection flanked by size and behaviour should

not transform dramatically approximately the cutoff, unless nationalization itself reasons changes in

bank behaviour.

This will allow for credible causal inference on the role of bank ownership on bank behaviour. In order

to get a sense of the magnitude of lending differences in the middle of bank kinds, we first divide the

banks into five clusters, based on their size in 1980: State Bank of India and its affiliates, big

nationalized banks (nationalized in 1969), ―marginal‖ nationalized banks (nationalized in 1980),

―marginal‖ private banks (relatively big, but presently too little to be nationalized in 1980), and little

private banks. Because the geographic districts in which banks are situated modify (soil excellence, rural

population, etc.), and face dissimilar economic shocks, we focus here on comparing differential bank

behaviour within each district. Our outcomes of interest contain standard loan size, residual interest rate,

20 and share of bank lending to the following regions: agriculture, rural credit, little level industry,

government credit, and ―deal, transport and fund.‖

To estimate bank-cluster effects, we credit outcome variables for each bank cluster g in district d on D

district dummy variables, and BG1,..., BGG bank cluster dummy variables. The estimated bank cluster

effects provide the standard share each bank provides to each sector, after controlling for differences

crossways districts. For instance, the estimated ˆã for the standard loan size from banks in the State Bank

of India cluster is Rs. 56,190. Compared to the standard loan size of the State Bank of India,

nationalized banks gave slightly smaller loans (an standard of 6,430 Rs. lower), while marginal

nationalized banks gave slightly superior loans (the standard was 8,350 Rs. greater), marginal private

banks gave much superior loans (35,310 Rs. more), and little private banks gave loans much superior on

standard (58,500 Rs. more).

These results seem to confirm conventional wisdom that nationalized and public banks provide smaller

loans than private banks. The mainly informative comparison is flanked by what we described the

―marginal‖ nationalized and the ―marginal‖ private bank, which were same in size, but the former were

nationalized while the latter weren‘t. Several of the differences flanked by the marginal nationalized and

the marginal private banks are big: the marginal private banks gave 5 percentage points less credit to

agriculture than the marginal nationalized banks: given that the all-India share of credit to agriculture is

11 percent, this variation is substantial.

The results also suggest that nationalization led to more credit to little level industry (an augment of 2

percentage points comparative to the private banks; India-wide little level industry receives 9 percent of

total credit), four percentage points more credit to rural regions (compared to a national standard of 12

percent), and slightly more to government enterprises. These increases approach at the expense of credit

deal, transport, and fund (nationalized banks gave 6 percent points less, compared to the national

standard share of 21 percent).

The rural and government lending differences are important at the 5 percent stage, while all others are

important at the one percent stage. While this is suggestive that private and public banks behave

differently, the values in the table modify not only flanked by marginal private and marginal

nationalized banks, but crossways other bank clusters as well. Therefore , from this data alone, we

cannot rule out the possibility that the variation in lending behaviour is attributable to bank size, rather

than ownership.

To obtain an accurate measure of the impact of nationalization, we look at lending behaviour at the

individual bank stage, adopting a full-fledged regression-discontinuity approach. We first estimate bank

effects analogous to the cluster effects estimated in equation (2), through replacing the Bank Cluster

dummy indicators with individual bank dummy indicators, to obtain coefficients 1,... B.

These coefficients tell us to what extent bank b behaves differently from other banks, after controlling

for the aspects of the districts in which each bank operates. We then regress the individual indicators on

log deposits of the bank in 1980 (sizeb), an indicator variable (Natb),which takes the value of one when

the size was superior than the cutoff and the bank so nationalized, and an interaction term.

Banks are ordered through the size of their deposits in 1980, so that banks below the cutoff of 14.5 are

private, while banks above were nationalized in 1980.21 Contrary to the results obtained through easy

comparison of means, there does not seem to be any important variation in lending to little-level

industry flanked by public and private banks that are of same size. That is, we cannot reject the

hypothesis that nationalization had no effect on credit to little-level industry. On the other hand,

nationalization seems to have had the effect of lowering the amount of credit banks give to deal,

transport, and fund. Nationalization seems to have had a big effect on credit to agriculture.

There is a connection flanked by size in 1980 and lending to agriculture in 1992: superior banks lend

more to agriculture. Though, there is a visible break in the connection at the nationalization cut-off:

banks presently above the cutoff lend considerably more to agriculture than banks, even after accounting

for the effect of size. For instance, for agriculture in 1992, the estimated break is.084, with a average

error of.029: the variation flanked by nationalized and private banks is quite important, both

economically and statistically. The point estimates of the structural break confirm some of the

differences, but suggest that others are merely functions of bank size. In scrupulous, as considered

through credit in 1992, nationalization had a causal effect on agricultural credit and rural credit, raising

each through in relation to the8 percentage points.

These numbers are big, given that the set of all banks lent only 11 percent of credit to agriculture and 12

percent to rural regions. These results are important at the 1 percent stage. Nationalization seems to have

had no effect on the amount of credit banks lend to little level industry, but caused a nine percentage

point decrease in the credit banks issued to deal, transport and fund. Not surprisingly, we see that

nationalized banks lend more to government-owned enterprises; the two-percentage point variation is

particularly big in light of the information credit to government borrowers symbolizes only two percent

of bank credit. Public sector banks seem to lend at slightly lower interest rates, however the point

estimate, seventy foundation points, is not statistically important. We also attempted to measure whether

public sector banks gave more credit to industries that had been recognized for support in several five-

year plans after 1980, but establish no proof that these industries were favored.

The differences flanked by the nationalized and private banks look to have decreased in excess of time:

in the 2000 data, the point estimate on agricultural lending beads from 8 to 5 points, on rural lending

from 7 to 3 points, and on deal and transport and fund from -11 to -6 percentage points. In sum, bank

ownership does look to have had a limited impact on the government‘s skill to direct credit to specific

sectors. By the early 1990s, the credit habitation in India was extremely tightly regulated.

The government set interest rates, required both public and private banks to issue 40 percent of credit to

the priority sector, and to meet specific sub-targets within the priority sector.

Nevertheless, banks controlled through the government provided considerably more credit to

agriculture, rural regions, and the government, at the expense of credit to deal, transport, and fund.

However, surprisingly, there was no effect on credit to little level industry. Lending differences shrunk

in excess of the 1990s, and in 2000 were in relation to the half of what they were in the early 1990s.

This might reflect the rising dynamism of the private sector banks in the liberalized habitation of the

1990s or the loosening grip of the government on the nationalized banks. To determine whether public

ownership of banks inhibits financial intermediation, we again compare banks presently above and

presently below the 1980 nationalization cut-off, by data from the Reserve Bank of India, for the era

1969 to 2000. We contain the six, which were nationalized, which were not.

As we have data from both the pre and post era, we adopt a variation-in-differences approach.

Specifically, we the annual transform in bank deposits, credit, and number of bank branches on a

dummy for post nationalization, and a dummy for post-nationalization in a liberalized habitation. We

break the post-nationalization analysis up into two eras because the former era was characterized

through sustained financial repression, while substantial liberalization events were implemented in the

beginning of the 1990s. Public and private banks could well behave differently before and after

liberalization. Because superior banks may grow at dissimilar rates than little banks, we contain bank

fixed effects (i).

The parameters of interest are 1 and 2, which capture the differential behaviour of nationalized

banks after the nationalization. Average errors are adjusted for auto-correlation within each bank. The

results suggest that while the overall rate of growth in deposits and credit slowed considerably in the era

1980-1990 comparative to the 1969-1979 era, there was no differential effect for nationalized and

private banks. In the nineties, deposit and credit growth slowed further still. In this liberalized

habitation, deposits and credit of the nationalized banks slowed down more than the private banks:

deposits grew 7.3 percent slower, while credit grew 8.8 percent less quickly. These results are important

at the ten and five percent stage, respectively.

The growth rate in bank branches usually tracked credit and deposits, however the decline after 1980

was more severe. While the growth rates for nationalized banks were slightly lower in both eras, the

differences are not statistically important. To answer the question of whether there was a important

variation flanked by public and private banks prior to nationalization, were estimate equation, replacing

the bank fixed effects with a nationalization dummy, and a manage function (Kb, 80) = 1Kb,80

+2K2 b,80, which controls for the effect of 1980 log deposits of each bank in 1980 (denoted Kb,80).

(These results are not accounted, but are accessible from the authors).

The manage function allows bank growth to depend on bank size, while the nationalization dummy will

pick up any differences flanked by the nationalized and non-nationalized banks that are not related to

size. The estimates suggests that credit, deposit and number of branches grew at the similar speed

flanked by 1969 and 1979 for banks that were going to be nationalized in 1980 and those that were not.

The coefficients on the interaction conditions remain negative, and are virtually unchanged from the

specification. Therefore , it is only after the 1980 nationalization that banks nationalized in 1980 started

to grow more gradually.

These results give some proof that nationalization hindered the spread of intermediation in the 1990s,

but not earlier. We seem for characteristics of public banks, examining both official lending policies,

and other incentives faced through employees of public sector banks. Official Lending Policies While

public sector banks in India are nominally self-governing entities, they are subject to intense regulation

through the Reserve Bank of India (RBI). This contains rules in relation to the how much a bank should

lend to individual borrowers–the so-described ―maximum permissible bank fund.‖

Until 1997, the rule was based on the working capital gap, defined as the variation flanked by the current

assets of the firm and its total current liabilities excluding bank fund (other current liabilities). The

presumption is that the current assets are illiquid in the extremely short run and so the firm requires

funding them. Deal credit is one source of fund, and what the firm cannot fund in this method constitutes

the working capital gap. Firms were supposed to cover a section of this financing require, corresponding

to no less than 25 percent of the current assets, from equity.

The sum of all loans from the banking system was supposed not to exceed this amount. This definition

of the maximum permissible bank fund applied to loans above Rs. 20 million. For loans below Rs.20

million, banks were supposed to calculate the limit based on the projected turnover of the firm. Projected

turnover was to be determined through a loan officer in consultation with the client. The firm‘s

financing require was estimated to be 25 percent of the projected turnover and the bank was allowed to

fund up to 80 percent of what the firm requires, i.e. up to 20 percent of the firm‘s projected turnover.

The rest, amounting to at least 5 percent of the projected turnover has again to be financed through

extensive term possessions accessible to the firm. In the transitional of 1997, following the

recommendation of the committee on financing of the little level industries (the Nayak committee), the

RBI decided to provide each bank the flexibility to evolve its own lending policy, under the condition

that it be made explicit.

Moreover the Nayak committee recommended that the turnover rule be used to calculate the lending

limit for all loans under Rs. 40 millions. Given the freedom to choose the rule, dissimilar banks went for

slightly dissimilar strategies. The bank we studied adopted a policy which was, in effect, a mix flanked

by the now recommended turnover-based rule and the older rule based on the firm‘s asset location. First

the limit on turnover foundation was calculated as: min (0.20 Projected turnover, 0.25 Projected

turnover ― accessible periphery). The accessible periphery here is the financing accessible to the firm

from extensive term sources (such as equity), and is calculated as Current Assets ― Current Liabilities

from the current balance sheet. In other languages the presumption is that the firm has somehow

supervised to fund this gap in the current era and so should be able to do so in the future.

So the bank only requires funding the remaining amount. Note that if the firm had previously supervised

to get the bank to follow the turnover based rule exactly, its accessible periphery would be precisely 5

percent of turnover and the two amounts in 6 would be equal. The rule did not stop here. For all loans

below Rs.40 million, the loan officer was supposed to exploit both equation 6 and the older rule

represented through 5. The main permissible limit on the loan was the maximum of these two numbers.

Two comments in relation to the nature of this rule are in order. First, this turnover based approach to

working capital fund is relatively average even in the USA.

Though the view in the USA is that working capital fund is essentially financing inventories and is so

backed through the value of the inventories. In India, the inventories do not look to give adequate

security, as evidenced through the high rates of default. In such cases it may be much more significant to

pay attention to profitability, as profitable companies are less likely default. Second, in the USA the role

of finding promising firms and promoting them is accepted out, to a important extent, through venture

capitalists. In India the venture capital industry is still nascent and it will be a while before it can play

the role that we anticipate of its US equivalent.

So banks may have to be more pro-active in promoting promising firms. Following a rule that does not

put any weight on profits may not be the method to favour the mainly promising firms: while the

projected turnover calculation does favour faster rising firms, the loan officer is not allowed to project a

growth rate greater than 15 percent. This may be sufficient to meet the requires of a mature firm, but a

little firm that is rising fast clearly requires much more than 15 percent. It is significant that the rules

encourage the loan administrators to lend more to companies on the foundation of promise.

Actual Lending Policy

The lending policy statements provide us the outside limits on what the banks can lend. There is nothing

in the policies that stops them from lending less, however bankers are always enjoined to lend as much

as possible in official documents. It is also possible, given that it is not clear how these rules are

enforced, that the banks sometimes exceed the limits–it is, for instance, often alleged that loan

administrators in public sector banks provide out irresponsibly big loans to their friends and business

associates. It is not even clear how one would necessarily know that banker had lent too much given that

he is given the task of estimating expected turnover. Based on work through Banerjee and Duflo, we so

seem at the actual practice of lending in our example of loans.

We exploit the similar data source that was used in previous work through Banerjee and Duflo to seem

at what bankers actually do. As we have data on current assets and other current liabilities, it is trivial to

calculate the limit just as to the traditional, working capital gap-based method of lending (henceforth

LWC). We can also calculate the limit on turnover foundation (henceforth LTB). The maximum of LTB

and LWC is, just as to the rules, the real limit on how much the banker can lend to the firm. Inertia and

the fear of prosecution As public sector banks are owned through the government, employees of the

bank are treated through law as public servants, and therefore subject to government anti-corruption

legislation.

There is an impression in the middle of bankers that it is extremely simple to be charged with

corruption, and that the law states that if any government functionary takes a decision which results in

direct financial gain to a third party, the individual is prima facie guilty of corruption, and necessity

prove her or his innocence. The executive director of a big public sector bank was quoted saying ―Fear

of prosecution for corruption hangs in excess of every loan officer‘s head like the sword of Damocles.‖

The Economic Times of India has attributed slowdowns in lending directly to vigilance action. A

working cluster on banking policy set up through the Reserve Bank of India, and chaired through M.S.

Verma, noted: The [working cluster] observed that it has received symbols from the managements and

the unions of the banks complaining in relation to the diffidence in taking credit decisions with which

the banks are beset at present. This is due to investigations through outside agencies on the

accountability of staff in respect of some of the Non Performing Assets. The cluster also noticed a

marked reluctance at several stage to take any credit decision.‖

In response to criticism from bankers, economists, and others, the Central Vigilance Commission

(henceforth CVC), which is the body entrusted to investigate potential cases of fraud in the public

sector, introduced in 1999 a special chapter of the vigilance manual, on vigilance in public sector banks.

The language would almost certainly not reassure anyone with experience working in a western bank.

The manual reads, for instance, that ―every loss caused to the institutions, either in pecuniary or non-

pecuniary conditions, require not necessarily become the subject matter of a vigilance inquiry... once a

vigilance angle is apparent, it becomes necessary to determine by an impartial investigation as to what

went wrong and who is accountable for the similar.‖

Interviews with public sector bankers revealed widespread concern: the legal proceedings nearby

charges of corruption can drag on for years, leaving individuals charged with corruption in an uncertain

state. Even if an individual is exonerated, she may have been relieved of her duties, transferred, or

passed in excess of for promotion throughout the time of investigation. In theory (as well as practice),

even one loan gone bad may be enough to start vigilance proceedings.

The possible penalties stand in stark contrast to rewards. While banks are constantly urged through the

Reserve Bank of India to lend as much as possible, there are no explicit incentives for creation good

loans, or ways to penalize administrators who create conservative decisions.

In effect, bankers are accountable to more than one power –the loan officer‘s boss is one of them but

central vigilance may be another, and the press may be yet another. In such conditions, it may be

extremely hard to give effective incentives.

If this were the case, loan administrators would prefer not to take new decisions. Basically renewing the

loan without changing the amount is one simple method to avoid responsibility, especially if the original

decision was someone else‘s (loan administrators are regularly transferred). And when they do take a

decision, creation certain that they did not deviate enormously from the precedent, is a method of

covering themselves against charges of wrong-doing or worse.

Not surprisingly, the Central Vigilance Commission disputes the claim that there is a ―fear psychosis,‖

and, to bolster their location, released in 2000 a ―critical analysis‖ of vigilance action in public sector

banks in 1999. The analysis reveals that in 1999, the Central Vigilance Commission received 1916

references, 72 per cent of which were credit-related, recommending punishment in the majority of cases.

Their 2000 statement states ―out of every 100 cases coming before it, the Commission would advice

biggest penalty proceedings in 28 cases, minor penalty proceedings in 32 cases, and administrative

warning/exoneration in 40 cases.‖

The author of the statement, a CVC official, argued that this stage of action should not be sufficient to

reason ―fear psychoses‖: ―These figures reveal that a person is not damned the moment his case is

referred to the Commission... These statistics seem to indicate a extremely fair and objective approach

on the section of the Commission to the cases that were referred to it.‖ Based on work through Cole

seems at whether there is any proof for the so-described fear psychosis. The vital thought is easy: we

inquire whether bankers who are ―secure to‖ bankers who have been subject to CVC activity, slow down

lending in the aftermath of that scrupulous CVC activity.

Monthly credit data, through bank, were provided through the RBI. Data on frauds are naturally

extremely hard to approach through. It is also the policy of the government of India to stay the data on

vigilance action confidential: while some aggregated statistics are published, they are too aggregated to

be useful for econometric analysis.

Though, in 1998, in an attempt augment the penalty for fraud by stigma, the government authorized the

CVC to publish the name, location, employing bank, and punishment of individual administrators of

government agencies charged with biggest frauds.

This list consists of eighty-seven officials in public sector banks flanked by the years 1992 and 2001.

While nature of the fraud with which they are charged is not recognized, we do know that almost 72 per

cent of frauds relate to illegal extension of credit, while the balance is classified as kite-flying or ―other.‖

As our hypothesis is that vigilance results in a decrease in lending action, the inclusion of spurious non-

credit related vigilance action should bias coefficients towards zero.

The first approach is to exploit bank stage monthly lending data to estimate the effect of vigilance action

on lending, by the following equation, where it is log credit extended through bank i in month is a bank

fixed-effect, at is a month fixed effect, and an indicator variable for whether vigilance action was

accounted through the CVC for bank i in month t-k. Average errors accounted are adjusted for serial

correlation and heteroscedasticity. The vital thought is to compare the bank that was affected through

the vigilance action with other public sector banks, before and after the vigilance event.

Which event window to exploit is not immediately clear: the appropriate start date would mainly likely

be the month in which it became recognized that vigilance proceedings were under method, or possibly

the date bankers learned of the judgment. The data published through the CVC provide only the date at

which the CVC provided advice on the case, and the date on which activity was taken. Nor is it clear

how extensive it should take before an effect seems, or for how extensive one would accept this effect to

last. We so let the data decide, through estimating models which allow effects ranging from one month

to four years.

REVIEW QUESTIONS

What is capital control?

Explain the banking system reformation.

What is monetary policy? And explain the tasks of the monetary policy.

Explain the concept of perfection of banking legislation

Discuss the banking reform in India

CHAPTER 5

Working Capital Management: An Integrated View

LIQUIDITY VS PROFITABILITY

Concept of Liquidity

Through the term ‗liquidity‘ it is meant the debt-repaying capability of an undertaking. It refers to the

firm‘s skill to meet the claims of suppliers of goods, services and capital. Just as to Archer and

D‘Ambrosio, liquidity means cash and cash availability, and it is from current operations and previous

accumulations that cash is accessible, to take care of the claims of both the short-term suppliers of

capital and the extensive-term ones. It has two dimensions; the short-term and the extensive-term

liquidity. Short-term liquidity implies the capability of the undertaking, to repay the short-term debt,

which means the similar as the skill of the firm in meeting the currently maturing obligations shape out

of the current assets. The purpose of the short-term analysis is to derive a picture of the capability of the

firm to meet its short-term obligations out of its short-term possessions, that is, to estimate the risk of

supplying short-term capital to the firm.

Analysis of the firm‘s extensive-term location has for its rationale, the delineation of the skill of a firm

to meet its extensive-term financial obligations such as interest and dividend payment and repayment of

principal. Extensive-term liquidity refers to the skill of the firm to retire extensive-term debt and interest

and other extensive-run obligations. When relationships are recognized beside these rows, it is assumed

that in the extensive-run assets could be liquidated to meet the financial claims of the firm. Quite often

the expression ‗liquidity‘ is used to mean short-term liquidity of the companies. In the present revise,

liquidity is taken to mean the short-term liquidity which refers to the skill of the undertakings to pay of

current liabilities. This is chosen because the revise is related to the management of short-term assets

and liabilities. Further, the concept of short-term liquidity is more suited to enterprises that have a

remote possibility of becoming insolvent. In other languages, the extensive-run success of an

undertaking lies in its skill to survive in the immediate future.

Further, a company may have tremendous potential for profitability in the extensive-run, but may

languish due to inadequate liquidity. It is, so, short-term liquidity that has been measured crucial to the

extremely subsistence of an enterprise.

Measurement of Liquidity

Liquidity of an enterprise can be studied in two ways, namely (i) Technological liquidity, and (ii)

operational liquidity. The variation flanked by the two methods of liquidity measurement depends upon

whether one assumes the ‗liquidation concept‘ of business as in case of the technological liquidity or the

‗going concern concept‘ of business as in the case of the operational liquidity.

The first method of computation of liquidity is based on the assumption that the firm might become

insolvent at any time and whether, in such an event, the current assets held through the undertakings

would be enough to pay-off the current liabilities. On the other hand, the computation of ‗operational

liquidity‘ attempts the measurement of the firm‘s potential to meet the current obligations on the

foundation of net cash flows originating from out of its own operations; with the view that a

manufacturing enterprise cannot pay off current liabilities from it current assets when it is in the run. It

is assumed under this approach the firms are going firms and hence the liabilities are met by the net cash

flows arising out of their operations.

Technological Liquidity: Technological liquidity is normally evaluated on the foundation of the

following ratios in a business enterprise.

Current Ratio

Current ratio expresses the precise relation flanked by current assets and current liabilities. It is

calculated through dividing current assets with current liabilities.

Current Ratio = Current assets/Current liabilities.

It designates the availability of current assets in rupees for every one rupee of current liabilities. A high

ratio means that the firm has more investment in current assets. While a low ratio designates that the

firm in question is unable to retire its current liabilities, In information, a satisfactory current ratio for

any given firm is hard to judge. For mainly manufacturing undertakings, a ratio of 2:1 is traditionally

measured a bench-spot of adequate liquidity. Though, in some of the undertakings like public utilities

and service firms, this average ratio is not particularly useful as they carry no inventories for sale.

Current ratio is equally useful to both the outsiders and the management. To an outsider, it is a measure

of the firm‘s skill to meet its short-term claims. As distant as the management is concerned, the ratio

discloses the magnitude of the current assets that the firm carries in relation to its current liabilities. As

regards the outsider, the superior the ratio, the more liquid is the firm. But, from the management point

of view, a superior ratio designates excess investment in less profit-generating assets. On the contrary, a

low current ratio or downward trend in the ratio designates the inefficient management of working

capital. Nevertheless, the current ratio is a crude and quick measure of the firm‘s liquidity as it is only a

test of the quantity and not the excellence. The limitation of this ratio as an indicator of liquidity lies in

the size of the inventory of the enterprise. If inventory shapes a high proportion of current assets, the 2:1

ratio might not be adequate, as a meaningful measure of liquidity.

Quick or Acid-test Ratio

Recognizing that inventory might not be extremely liquid or slow moving, this ratio takes the quickly

realizable assets and events them against current liabilities. This is a more refined of somewhat

conservative estimate of the firm‘s liquidity, as it establishes a relation flanked by quick or liquid assets

and current liabilities. To be precise, a quick asset is one that can be converted into cash immediately or

reasonably soon without loss of value, for example, cash is the mainly liquid of all assets. The other

assets which are measured to be relatively liquid and incorporated in the quick category are explanations

and bills receivable and marketable securities. Inventory and era expenses are measured to be less liquid.

Inventories normally need some time for realizing into cash. The quick ratio is, then, expressed as a

relation flanked by quick assets and current liabilities, as:

Conventionally, a quick ratio of 1 : 1 is measured to be a more satisfactory measure of liquidity location

of an enterprise. In information, this ratio does not entirely supplant the current ratio; rather, it partially

supplements current ratio and when used in conjunction with it, tends to provide a bigger picture of the

firm‘s skill to meet its claims out of short-term assets.

Absolute Liquidity Ratio

Absolute liquidity ratio is the refinement of the concept of eliminating inventory as liquid asset in the

acid-test ratio, because of their uncertain value at the time of liquidation. Although receivables are

usually much more liquid in nature than inventories, some doubt may exist regarding their liquidity as

well. So, through eliminating receivables and inventories from the current assets, another measure of

liquidity is derived through relating the sum of cash and marketable securities to the current liabilities.

Usually, an absolute liquidity ratio of 0.5 : 1 is measured appropriate in evaluating liquidity.

Operational Liquidity

Operational liquidity which is based on the going concern concept of business, is determined through

expressing cash flows as a percentage of current liabilities. It is verified here whether the enterprises

incorporated in the revise would be able to discharge its current liabilities from the cash flows generated

from the operations.

Determinants of Liquidity

The measurement of liquidity was accomplished through comparing current assets with current

liabilities. But, focus has not been thrown on the factors that determine liquidity. Many factors power

the liquidity location of an undertaking. Important in the middle of them are:

The nature and volume of business;

The size and composition of current assets and current liabilities:

The method of financing current assets;

The stage of investment in fixed assets in relation to the total extensive-term funds; and

The manage in excess of current assets and current liabilities.

Firstly, the nature and volume of business power the liquidity of an enterprise. Depending upon the

nature of the elements, some firms need more of working capital than others. For some of the concerns

like public utilities, less proportion of working capital is needed, vis-à-vis, manufacturing institutions.

Besides, an rising volume of business also enhances the funds needed to fund current assets. In these

situations, if the firm does not divert some funds shape the extensive-term sources, the liquidity ratios

would be adversely affected.

Secondly, the size and the composition of current assets and current liabilities were the vital factors that

determine the liquidity of an enterprise. If a higher investment is made in the current assets in relation to

current liabilities, there would be a corresponding rise in the current ratio. While quickly and other ratios

depend on the composition of current assets.

Thirdly, the method of financing current assets reasons changes in the liquidity ratios. If greater section

of the current assets is financed shape extensive-term sources, greater also would be the current ratio. On

the other hand, if the concern depends much on the outside sources for financing current assets, the ratio

would fall.

Fourthly, the absorption of funds through fixed assets is one of the biggest reasons of low liquidity. As

more and more of the firm‘s total funds are absorbed in this procedure, there will be small left to fund

short-term requires and so liquidity ratios fall. Hence, the degree of liquidity is determined through the

attitude of the management in the allocation of permanent funds flanked by fixed and current assets.

Finally, stringent manage in excess of the current things reasons fluctuations in the liquidity ratios. If

investment in current assets is not taken care of properly, the firm may accumulate excess liquidity,

which may adversely affect the profitability. On the contrary, unduly strict manage of the investment in

all kinds of current assets may eventually endanger the subsistence of the firm; owing to noncompliance

of claims because of the shortage of funds. Likewise, manage in excess of current liabilities also plays

an significant role in determining liquidity of an enterprise through requiring the firm to contribute

necessary funds from extensive-term sources to stay up the liquidity location.

Effects of Liquidity

Liquidity of a business is one of the key factors determining its propensity to succeed or fail. Both

excess and shortage of liquidity affect the interests of the firm. Through excess liquidity in a business

enterprise, it is meant that it is carrying higher current assets than are warranted through the necessities

of manufacture. Hence, it designates the blocking up of funds in current assets without any return.

Besides, the firm has to incur costs to carry them overtime. Further, the value of such assets would

depreciate in times of inflation, if they are left idle. Owing to the cornering of capital, the firm may have

to resort to additional borrowing even at a fancy price. On the other hand, the impact of inadequate

liquidity is more severe. The losses due to insufficient liquidity would be several. Manufacture may

have to be curtailed or stopped for want of necessary funds.

As the firm will not be in a location to pay off the debts, the credit worthiness of the firm is badly

affected. In common, the smaller the amount of default, the higher would be the damage done to the

image of the element. In addition, the firm will not be able to close funds from outside sources, and the

existing creditors may even force the firm into bankruptcy. Further, insufficient funds will not allow the

concern to launch any profitable project or earn attractive rates of return on the existing investment.

Flanked by the excess and inadequate liquidity, the latter is measured to be more detrimental, as the lack

of liquidity may endanger the extremely subsistence of the business enterprise.

Besides, both the excess and inadequate liquidity adversely affect the profitability. If the firm is earning

extremely low rates of return or incurring losses, there would be no funds generated through the

operations of the company, which are essential to retire the debts. In information, there is a tangle

flanked by liquidity and profitability, which eventually determines the optimum stage of investment in

current assets. Of the liquidity and profitability, the former assumes further importance as profits could

be earned with ease in subsequent eras, once the image of the element is maintained. But, if the firm

losses its face in the market for wants of liquidity, it needs Qerculean efforts to restore its location.

Instances are not lacking of great industrial giants, with comfortable book profits coming to grief for

want of liquidity.

Concept of Profit

Profits are essential for the working of a private free-enterprise economy. Unluckily, there is no

common agreement in relation to the meaning of the term ‗corporate profits‘, and this has led to variety

of opinions on the subject of profits. The controversy looks to be prevailing in respect of what

constitutes ‗profit‘; how profit should be considered and how profit contributes towards a healthy and

vigorous economy. As such it is not surprising to discover people coming up with dissimilar

interpretations of profits while analyzing the similar set of financial data. These differences may arise

basically because people apply dissimilar values to the data or bring dissimilar insights into their

interpretations. One of the examples of this problem is the variation in the concept of the profits as per

economists and accountants.

The differences get manifested in their concern for future and the past while viewing the profits. Like

wise, the business manager and the deal union leader quite obviously emphasize interpretations of

profits that symbolize their best interests. Academicians differ in the middle of themselves in relation to

the theoretical concepts of profits and the procedure of decision-creation . The term ‗profits‘ can also be

used through any of these people with respect to a single firm and to the aggregate of several firms. The

meaning attributed to the word ‗profit‘ ranges shape the view point that it is the whole return received

through the business to the view that ‗pure‘ profit is residual in nature as it is arrived at after deductions

are made shape total income for wages, interest and rent. Clark argued that profit results exclusively

from dynamic transform e.g., inventions, which yield temporary profit to entrepreneurs. Hawley holds

that risk bearing is the essential function of the entrepreneur and is the foundation for profit.

While differing in their views in relation to the reasons of profits, proponents of both these views regard

profit as residual. It is to be recalled that profit has been linked through F.H. Knight with uncertainty,

through Schumpeter with innovations, through Hawley with risk bearing, and through Mrs. Robinson,

Chamberlin and Kalecki with the degree of monopoly authority.

The connection flanked by business, profit and economic growth is simply extremely easy. Profit

determines investment and investment is essential to growth. Therefore , a steep and continuing decline

in profit is likely to mean a serious drop in the investment stances, higher profit would mean higher

investment and faster growth.

Further, it is through no accident that business profits, business investment, and unemployment shape

three significant economic indicators that depict the stage of economic action. More business investment

is needed to give more occupations for the rapidly rising labour force and one of the extremely

dependable ways to get more investment is to plough back adequately from the profits.

The decline in profits throughout the postwar era has in information been accompanied through a short

decline in the business investment in several countries in the world. The thought that profit is good‘ is

unacceptable to several people. The thought that higher profits are even bigger is still unpalatable. What

the critics of profit erroneously perceive is that businessmen aim not at developing economic behaviors

but on profiteering and fleecing the consumers.

Almost certainly their intention tells them that one man‘s profit is another man‘s loss and, as such the

obvious conclusion is that profit means use. But experience is a bigger guide than instinct and

experience teaches that in a competitive economy business profit necessity accrue to those ventures that

best serve the common economic welfare. The targets of private business are private profits. The great

virtue of a free and competitive economy is that it stabilizes organic link flanked by profits and

economic welfare and so undermining one results in the undermining of both.

Profits may be increased through reducing corporate taxes. But tax cut is not a panacea and does not

guarantee that profit will rise or the investment will continue to rise, Its benefits could be lost if growing

business costs lead either to inflation or to the reduction of profits or both. Conversly, the benefit of tax

reduction can be greatly enhanced if business costs can be reduced. The responsibility for controlling the

augment in the business costs rests on several agencies. It rests in section with the business

management; in section with government, state and regional; in section with employees and their unions

and in section with the public.

Therefore it necessity certainly be established that the profits are one of the principal engines of

economic growth, and it necessity be seen that the prospect for profits is bright sufficient in this country

to assure sustained economic expansion.

The profitability of an industry has obviously a direct bearing on its growth. This is principally due to

the psychological incentives and the financial possessions that the profitability gives. High profitability

creates possible to plough back substantial possessions, helps to raise equity capital in the investment

market; and create it possible to raise loans. Therefore , it is business confidence in the stage of

profitability which is the primary determinant of the decision to invest. Despite the vilification of profit

through forces on the extreme left, a mixed economy will not undertake productive investment in plant

and machinery unless management in reasonably assured of earning a rate of return at least

commensurate with the risks involved.

Measurement of Profitability

Profit is measured an indicator of operational efficiency of the firm. Profitability of a firm is considered

on the following two bases:

Based on Sales

Based on Investment

Basing on sales, the following three ratios can be measured significant in judging the profitability of an

enterprise.

Gross profit ratio

Operating profit ratio

Net profit ratio

Gross Profit Ratio

This is calculated through comparing the Gross profit (sales - cost of goods sold) with the Net Sales of a

firm

This ratio designates the profit generated through a firm for every one rupee of sale made. For instance,

a Gross profit ratio of 25 per cent designates that for every one rupee sales, the firm creates a profit of 25

paise. Gross profit ratio depends upon the connection flanked by the selling price and the cost of

manufacture including direct expenses. The gross profit ratio reflects the efficiency with which the firm

produces/purchases the goods. Given the consistent stage of selling price, cost price and raw material

consumption per element, the gross profit ratio would also remain similar from one year to another. If

there is a transform in the gross profit ratio from one year to another then causes necessity be looked for.

If the efficiency of the firm is similar then the transform in gross profit ratio may result because of

transform in selling price or cost price or raw material consumption per element.

The gross profit ratio should be analyzed and studied as a time series. For a single year, the gross profit

ratio may not indicate much in relation to the efficiency stage of the firm. Though, when studied as a

time series, it may provide the rising or decreasing trend and hence an thought of the stage of operating

efficiency of the firm. A high gross profit ratio or a low gross profit ratio for a scrupulous era does not

have any meaning unless compared with some other firm operating in the similar industry or compared

with the industry standard.

Operating Profit Ratio (OP Ratio)

The operating profit refers to the pure operating profit of the firm i.e. the profit generated through the

operation of the firm and hence is calculated before considering any financial charge (such as interest

payment), non-operating income/loss and tax liability, etc. The operating profit is also termed as the

Earnings Before Interest and Taxes (EBIT). The OP ratio may be calculated as follows:

The OP ratio shows the percentage of pure profit earned on every 1 rupee of sales made. The OP ratio

will be less than the GP ratio as the indirect expenses such as common and administrative expenses,

selling expenses and depreciation charge, etc. are deducted from the gross profit to arrive at the

operating profits i.e. EBIT. Therefore the OP ratio events the efficiency with which the firm not only

manufactures/ purchases the goods but also sells the goods. The OP ratio in conjunction with the GP

ratio can depict whether changes in the profitability of the firm are caused through transform in

manufacturing efficiency or administrative efficiency. It can help to identify the corrective events to

improve the profitability.

Net Profit Ratio (NP Ratio)

The NP ratio establishes the connection flanked by the net profit (after tax) of the firm and the net sales

and may be calculated as follows:

The NP ratio events the efficiency of the management in generating additional revenue in excess of and

above the total cost of operations. The NP ratio shows the overall efficiency in manufacturing,

management, selling and sharing of the product. This ratio also shows the net contributions made

through every 1 rupee of sales to the owner‘s funds. The NP ratio designates the proportion of sales

revenue accessible to the owners of the firm and the extent to which the sales revenue can decrease or

the cost can augment without inflicting a loss on the owners. So, the NP ratio shows the firm‘s capability

to face the adverse economic situations.

The NP ratio can be meaningfully employed to revise the profitability of the firm when this ratio is used

jointly with the GP ratio and the OP ratio. A time series analysis of the GP ratio, OP ratio and the NP

ratio can help to identify the causes for variations in the profitability. As the variation flanked by the

operating profit and the net profit arises only because of financial charges and the taxes, an insight into

their comparison may illustrate as to how efficiently the firm is financed and how well the fund

manager is able to hold down taxes. Basing on Investment, the following TWO ratios may be measured

important.

Return on Assets

Return on Capital Employed

Return on Assets (ROA)

This ratio events the profitability of the firm in conditions of assets employed in the firm. The ROA is

calculated through establishing the connection flanked by the profits and the assets employed to earn

that profit. Generally the profit of the firm is considered in conditions of the net profit after tax and the

assets are considered in term of total assets or total tangible assets or total fixed assets. Conceptually, the

ROA is considered as follows:

There are several other adaptations of the ROA to how much is the profit earned through the firm per

rupee of assets used. Sometimes, the amount of financial charges (interest, etc.) is added back to the net

profit figure to relate the net operating profit with the operating assets of the firm. Through separating

the financing effect shape the operating effect, the ROA gives a cleaner measure of the profitability of

these assets. In such a case, the ROA can be calculated as follows:

Therefore , the ROA events the overall efficiency of the management in generating profits for a given

stage of assets. The ROA essentially relates the profits to the size of the firm (which is considered in

conditions of the assets). If a firm increases its size but is unable to augment its profits proportionately,

then the ROA will decrease. In such a case raising the size of the assets i.e. the size of the firm will not

through itself advance the financial welfare of the owners. The ROA of a scrupulous firm should be

compared with the industry standard as the amount of assets required depends upon the nature and

aspects of the industry.

Return on Capital Employed (RCE)

The profitability of the firm can also be analyzed from the point of view of the total funds employed in

the firm. The term funds employed or the capital employed refers to the total extensive term sources of

funds. It means that the capital employed includes of shareholders funds plus extensive term debts.

Alternatively, it can also be defined as fixed assets plus net working capital. This ratio may be calculated

as shown below:

Profitability and Working Capital

There has been an effort made to highlight the nexus flanked by liquidity, profitability and working

capital. A further examination can be idea of with the following indicators.

Net Working Capital: As a common rule, current obligations or current liabilities are paid off through

reducing current assets, which are assets that can be converted into cash on short notice. The arithmetic

variation flanked by current assets and current liabilities is described net working capital and it

symbolizes a cushion for creditors. Although this measure is not a ratio, it is commonly incorporated in

the liquidity ratios while analyzing companies. It is widely used through creditors and credit rating

agencies as a measure of liquidity. More working capital is preferred to less. In other languages,

creditors like a ‗large‘ cushion to protect their interest. Though, too much working capital can act to the

detriment of the company because they may not be utilizing the funds effectively. It has been establish

that in some cases, the net working capital turned out to be negative in some years. This implies the

mobilization of more current liabilities compared to current assets. Judged from this point of view, the

liquidity location and the consequent efficiency can be stated to be extremely low.

Working Capital Turnover: The turnover of working capital, which designates the frequency at which

they were rotating is another measure of the efficiency of working capital management. Like any other

turnover or action ratio, a low ratio reflects a slow movement of the current assets, thereby implying a

suboptimum utilization of working capital.

Rate of Return on Current Assets: The return on current assets is yet another useful economic indicator

of the profitability of the enterprises and therefore designates the efficiency or otherwise with which the

current assets are put to exploit. The rate of net profit to current assets is calculated to under row the

efficiency. In case where current assets shape more than half, this ratio becomes important.

PAT as Percentage of Sales: One of the significant profitability ratios calculated for the purpose of

measuring management‘s efficiency is the profits after tax as percentage of sales. This is the overall

measure of firm‘s skill to turn each rupee of sales into profit. If the net periphery is inadequate, the firm

will fail to achieve satisfactory return on owner‘s equity. This ratio also designates the firm‘s capability

to withstand adverse economic circumstances. A firm with a high net periphery ratio would be in an

advantageous location to survive in the face of falling sales, prices, growing cost of manufacture, or

declining demand for the product. It would really be hard for a low net periphery firm to withstand these

adversities. Likewise, a firm with high net profit periphery can create bigger exploit of favorable

circumstances, such as growing sales prices, falling costs of manufacture, or rising demand for the

product. Such a firm will be able to accelerate its profits at a faster rate than a firm with low net profit

periphery.

Assets Turnover: Generally the turnover ratios are employed to determine the efficiency with which a

scrupulous asset is supervised and also to believe the connection flanked by sales and several things of

assets for this purpose. These ratios which are described action ratios, indicate the speed with which the

investment in the assets is receiving rotated or converted into sales. A proper balance flanked by sales

and assets usually reflects that assets are supervised well. Although fixed assets may not uphold secure

relation with sales, they are taken as significant because of their contribution to manufacture. Hence

total assets turnover is taken as an indicator to measure the extent of sales generated for one rupee

investment in assets.

Collection Era: Another indicator which is measured to be significant in judging the working capital

efficiency is the collection era. This ratio designates the total number of days that was taken through the

firms in collecting their debts. A comparison of the norms fixed with the results obtained would

illustrate the positive or negative tendencies.

Interest as Percentage of Profits before Interest and Tax: One of the ratios that are used to determine

the debt capability of a firm is this coverage ratio. This ratio reveals the skill of the company in servicing

the debt undertaken. A high ratio speaks in relation to the interest burden of the company and

consequently the adverse impact of the similar on profitability. In the similar method, a high ratio

enhances the financial risk of the firm.

Liquidity vs. Profitability in Working Capital Decisions

All decisions of the financial manager are assumed to be geared to maximization of shareholders wealth,

and working capital decisions are no exception. Accordingly, risk-return deal-off characterizes each of

the working capital decision. There are two kinds of risks inherent in working capital management,

namely, liquidity risk and opportunity loss risk. Liquidity risk is the non-availability of cash to pay a

liability that falls due. It may occur only on sure days. Even so, it can reason not only a loss of

reputation but also create the work condition unfavorable for receiving the best conditions on transaction

with the deal creditors. The other risk involved in working capital management is the risk of opportunity

loss i.e. risk of having too small inventory to uphold manufacture and sales, or the risk of not granting

adequate credit for realizing the achievable stage of sales. In other languages, it is the risk of not being

able to produce more or sell more or both, and, so, not being able to earn the potential profit, because

there were not sufficient funds to support higher inventory and book debts.

Therefore , it would not be out of lay to mention that it is only theoretical that the current assets could all

take zero values. Indeed, it is neither practicable nor advisable. In practice, all current assets take

positive values because firms seek to reduce working capital risks. Though, if more funds are deployed

in current assets, the higher would be the cost of funds employed, and so, lesser the profit. If liquidity

goes up, profitability goes down. The risk-return deal-off involved in managing the firm‘s liquidity via

investing in marketable securities is illustrated in the following instance. Firms A and B are identical in

every respect but one Firm B has invested Rs. 5,000 in marketable securities, which has been financed

with equity. That is, the firm sold equity shares and raised Rs.5,000. The balance sheets and net incomes

of the two firms are shown in Table 5.1. Note that Firm A has a current ratio of 2.5 (reflecting net

working capital of Rs. 15.000) and earns a 10 per cent return on its total assets. Firm B, with its superior

investment in marketable securities has a current ratio of 3 and has net working capital of Rs. 20,000. As

the marketable securities earn a return of only 9 per cent before taxes (4.5 per cent after taxes with a 50

per cent tax rate), Firm B earns only 9.7 per cent on its total investment.

Therefore , investing in current assets and in scrupulous in marketable securities, does have a favorable

effect on firm‘s liquidity but it also has an unfavorable effect on the firm‘s rate of return earned on

invested funds. The risk return deal-off involved in holding more cash and marketable securities, so, is

one of added liquidity versus reduced profitability.

In the exploit of current versus extensive-term debt for financing working capital requires also the firm

faces a risk-return deal-off. Other items remaining the similar, the greater its reliance upon short-term

debt or current liabilities in financing its current asset investments, the lower will be its liquidity. On the

other hand, the exploit of current liabilities offers some extremely real advantages to the user in that they

can be less costly than extensive-term financing as they give the firm with a flexible means of financing

its fluctuating requires for current assets.

Table 5.1 The Effects of Investing in Current Assets on Liquidity and Profitability

If for instance, a firm requires funds for a three-month era throughout each year to finance a seasonal

expansion in inventories, then a three-month loan can give substantial cost saving in excess of a

extensive-term loan (even if the interest rate on short-term financing should be higher). This results from

the information that the exploit of extensive term debt in this situation involves borrowing for the whole

year rather than for the three month era when the funds are needed; this increases the interest cost for the

firm. There exists a possibility for further saving because in common, interest rates on short-term debt

are lower than on extensive-term debt for a given borrower. We may demonstrate the risk-return deal-off

associated with the exploit of current versus extensive term liabilities with the help of an instance given

below:

Believe the risk-return aspects of Firm X and Firm Y, whose balance sheets and income statements are

given in Table 5.1. Both firms had the similar seasonal requires for financing during the past year. In

December, they each required Rs.20,000 to fund a seasonal expansion in explanations receivable. In

addition, throughout the four-month era beginning with August and extending by November both firms

needed Rs. 10,000 to support a seasonal buildup in inventories. Firm X financed its seasonal financing

necessities by Rs. 20,000 in extensive-term debt carrying an annual interest rate of 10 per cent. Firm Y,

on the other hand, satisfied its seasonal financing requires by short-term borrowing on which it paid 9

per cent interest. As Firm Y borrowed only when it needed the funds and did so at the lower rate of

interest on short-term debt, its interest expense for the year was only Rs.450, whereas Firm X incurred

Rs. 2,000 as annual interest expense.

The end result of the two firms financing policies is evidenced in their current ratio, net working capital,

and return on total assets which seem at the bottom of Table 5.1. Firm X by extensive-term rather than

short-term debt, has a current ratio of 3 times and Rs.20,000 in net working capital. Whereas Firm Y‘s

current ratio is only 1, which symbolizes zero net working capital. Though, owing to its lower interest

expense, Firm Y was able to earn 10.8 per cent on its invested funds, whereas Firm X produced a 10 per

cent return. Therefore , a firm can reduce its risk of illiquidity by the exploit of extensive-term debt at

the expense of a reduction of its return on invested funds. Once again we see that the risk-return deal-off

involves an increased risk of illiquidity versus increased profitability.

PAYABLES MANAGEMENT

Payables: Their Significance

Payables constitute a current or short term liability on behalf of the buyer‘s obligation to pay a sure

amount on a date in the close to future for value of goods or services received. They are short term

deferments of cash payments that the buyer of goods and services is allowed through the seller. Deal

credit is extended in relationship with goods purchased for resale or for processing and resale, and hence

excludes consumer credit provided to individuals for purchasing goods for ultimate exploit and

installment credit provided for purchase of equipment for manufacture purposes. Deal credits or

payables serve as non-interest bearing source of funds in mainly cases. They give a spontaneous source

of capital that flows in naturally in the course of business in keeping with recognized commercial

practices or formal understandings.

Kinds of Deal Credit

Deal Credits or Payables could be of three kinds: Open Explanations, Promissory Notes and Bills

Payable. Open Explanation or open credit operates as an informal arrangement wherein the supplier,

after satisfying himself in relation to the credit-worthiness of the buyer, dispatches the goods as required

through the buyer and sends the invoice with particulars of quantity dispatched, the rate and total price

payable and the payment conditions. The buyer records his liability to the supplier in his books of

explanations and this is shown as payables on open explanation. The buyer is then expected to meet his

obligation on the due date. The Promissory note is a formal document signed through the buyer

promising to pay the amount to the seller at a fixed or determinable future time. Where the client fails to

meet his obligation as per open credit on the due date, the supplier may need a formal acknowledgement

of debt and a commitment of payment through a fixed date. The promissory note is therefore an

instrument of acknowledgement of debt and a promise to pay. The supplier may even stipulate an

interest payment for the delay involved in payment.

Bills Payable or Commercial Drafts are instruments drawn through the seller and carried through the

buyer for payment on the expiry of the specified duration. The bill or draft will indicate the banker to

whom the amount is to be paid on the due date, and the goods will be delivered to the buyer against

acceptance of the bill. The seller may either retain the bill or present it for payment on the due date or

may raise funds immediately thereon through discounting it with the banker. The buyer will then pay the

amount of the bill to the banker on the due date.

Determinants of Deal Credit

Size of the Firm

Smaller firms have rising dependence on deal credit as they discover it hard to obtain alternative sources

of fund as easily as medium or big sized firms. At the similar time, superior firms that are less

vulnerable to adverse turns in business can command prompt credit facility from the supplier, while

smaller firms may discover it hard to sustain credit worthiness throughout eras of financial strain and

may have reduced access to credit due to weak financial location.

Industrial Categories

Dissimilar categories of industries or Commercial enterprises illustrate varying degrees of dependence

on deal credit. In sure rows of business the prevailing commercial practices may stipulate purchases

against payment in mainly cases. Monopoly firms may insist upon Cash on delivery. There could be

instances where the firm‘s inventory, turns in excess of every fortnight but the firm enjoys thirty days

credit from suppliers, whereby the deal credit not only finances the firm‘s inventory but also gives

section of the operating funds or additional working capital.

Nature of Product

Products that sell faster or which have higher turnover may require shorter term credit. Products with

slower turnover take longer to generate cash flows and will require extended credit conditions.

Financial Location of Seller

The financial location of the seller will power the quantities and era of credit he wishes to extend.

Financially weak suppliers will have to be strict and operate on higher credit conditions to buyers.

Financially stronger suppliers, on the other hand, can dictate stringent credit conditions but may prefer

to extend liberal credit as extensive as the transactions give benefits in excess of the costs of extending

credit. They can afford to extend credits to smaller firms and assume higher risks. Suppliers with

working capital crunch will be willing to offer higher cash discounts to encourage early payments.

Financial Location of the Buyer

Buyer‘s creditworthiness is an significant factor in determining the credit quantum and era. It may be

logical to anticipate big buyers not to insist on extended credit conditions from little suppliers with weak

bargaining authority. Where goods are supplied on a consignment foundation, the supplier gives extra

fund for the merchandise and pays commission to the consignee for the goods sold. Little retailers are

therefore enabled to carry much superior stages of stocks than they will be able to fund through

themselves. Slow paying or delinquent explanations may be compelled to accept stricter credit

conditions or higher prices for products, to cover risk.

Conditions of Sale

The magnitude of deal credit is convinced through the conditions of sale. When a product is sold, the

seller sends the buyer an invoice that identifies the goods or services, the price, the total amount due and

the conditions of the sale. These conditions fall into many broad categories just as to the net era within

which payment is expected. When the conditions of sale are only on cash foundation, there can be two

situations, viz., Cash On Delivery (COD) and Cash Before Delivery (CBD). Under these two situations,

the seller does not extend any credit.

Cash Discount

Cash discount powers the effective length of credit. Failure to take advantage of the cash discount could

result in the buyer by the funds at an effective rate of interest higher than that of alternative sources of

fund accessible. Through providing cash discounts and inducing good credit risks to pay within the

discount era, the supplier will also save on the costs of management linked with keeping records of dues

and collecting overdue explanations.

Degree of Risk

Estimate of credit risk associated with the buyer will indicate what credit policy is to be adopted. The

risk may be with reference to buyer‘s financial standing or with reference to the nature of the business

the buyer is in.

Nature and Extent of Competition

Monopoly status facilitates imposition of tight credit term whereas intense competition will promote the

tendency to liberalize credit. Newly recognized companies in competitive meadows may more readily

resort to liberal deal credit for promoting sales than recognized firms which are more formal in deciding

on credit policies.

Datings

In seasonable industries, sellers regularly exploit datings to encourage customers to lay their orders

before a heavy selling era. For several consumer durables, the demand will be of this kind. The require

for an air-conditioner is felt in the summer, leading to heavy ordering at a scrupulous point of time. This

has double advantages. For manufacturer, he can schedule manufacture more conveniently and reduce

the inventory stages. Whereas, the buyer has the advantage of not having to pay for the goods until the

peak, of the selling era. Under this arrangement, credit is extended for a longer era than normal.

Cost of Credit

Billing methods can modify. The payment of invoices may be stipulated as a number of days after the

date of the invoice or after the receipt of the goods. In instances of seasonal business, when the supplier

wishes to induce customers to acquire and hold inventories in advance of the peak sales era, he may

resort to dating. The supplier, under this arrangement, extends longer duration credit to the buyer and

allows him to pay for the goods when the peak era sales pick up. In some cases, a series of dispatches

affected throughout a era, say, a month, are bunched jointly for invoicing and the credit term is reckoned

from the invoice date. When the credit does not cover cash discount for early payment, the deal credit is

measured to be a cost free source of financing for the buyer. It is not uncommon for some of the buyers

to delay payments beyond the due date, therefore extending the era of exploit of costless deal credit.

Deal credit is a built-in source of financing that is normally connected to the manufacture cycle of the

purchasing firm. If payments are made strictly in accordance with credit conditions, deal credit can be

regarded as a cost free, non-discretionary source of financing. But where the buyer takes the privilege of

delaying payment beyond the due date, it assumes the shape of discretionary financing and if this

becomes a regular characteristic resulting in delinquency, deal credit will cease to be cost free. The

supplier may stop credit or may charge a higher price for the product, to cover the risk. The supplier

may offer cash discount for payment within a specified number of days after the invoice or after the

receipt of goods. Usually such concessions for expedited resolution are given to select customers on

informal foundation. Where the aim is to induce earlier payment wherever possible, cash discounts are

provided for in the credit conditions. The quantum of discount offered will modify for dissimilar

categories of business and clients. Cash discount is to be distinguished from the other categories of

discount that may be offered through the seller, namely, the deal discount and the quantity discount. The

deal discount is a reduction from the invoice or list price offered to the dealer or trader in the channel of

sharing. Quantity discounts are given when purchases are made in sizeable lots.

When the cash discount is allowed for payment within a specified era, we can compute the cost of credit.

For example, if 30 days‘ credit is offered with the stipulation of a 2 per cent cash discount for payment

made 20 days earlier than the due date, 2 per cent of the amount due can be saved, which amounts to an

attractive annual saving rate of 36 per cent. If cash discount is not availed, the effective rate of interest

of the funds held will work out to 36.7 per cent. The interest is Rs. 2 on Rs. 98 for a era of 20 days, and

the rate of interest will be:

2/98 × 360/20 = 36.7 per cent.

If 60 days‘ credit is extended, with a cash discount of 2 per cent for payment within 10 days, there is a

saving of Rs. 2 for paying 50 days ahead. The effective rate of interest is 2/98 × 360/50 = 14.7 per cent.

For 90 days‘ credit, with 2 per cent cash discount for payment within 10 days, the effective interest

works out to 9.2 per cent. Therefore the more liberal the credit conditions, the saving from cash

discount declines and so does the effective rate of interest for by the funds till the due date. If, though,

the discounts are not taken and the resolution is made earlier than the due date, the effective rate of

interest will modify. For a firm that resists from taking the cash discount, its cost of deal credit declines

the longer it is able to delay payment.

The rationale for availing deal credit should be its savings in cost in excess of the shapes of short term

financing, its flexibility and convenience. Stretching deal credit or explanations payable results in two

kinds of costs to the buyer. One is the cost of cash discount foregone and the other is the consequence of

a poor credit rating. The contention that there is no explicit cost to deal credit if the payment is made

throughout the discount era or if the payment is made on the due date when no cash discount is offered,

is not completely tenable. The supplier who is denied the exploit of funds throughout the credit era may

bear the cost fully or pass on section of it to the buyer by higher prices. This will depend on the nature of

demand for the product. If the demand is elastic, the supplier may opt to bear the cost himself and

refrain from charging higher prices to recover section of it. The buyer should satisfy himself that the

burden of deal credit is not unduly loaded on him by disguised price revisions. Repeated delinquency

and deterioration in credit reputation do involve an opportunity cost however it is hard to measure. Some

suppliers may be more tolerant to delayed payments at some times than on other occasions.

A policy of delayed payments is bad business practice and in the extensive run can prove extremely

expensive or may even lead to freezing of credit source. Credit reputation is a valuable asset that

requires to be preserved with utmost care. The extensive run policy should be to avail discounts, if

offered, utilize credit eras to the full and discharge obligations on schedule. The following formula can

be used for determining the effective rate of return:

R = C (360)/D (100-C), where

R = Annual interest rate for the exploit of funds

C = Cash discount

D = Number of extra days the customer has the exploit of supplier‘s funds.

Stretching Explanations Payable

It is normally assumed that the payment to the supplier is made at the end of due date. Though, a firm

may postpone payment beyond this era. This kind of postponement is described stretching or Leaning on

the deal. The cost of stretching explanations payable is two fold : the cost of cash discount foregone and

the possible deterioration in the credit rating. If a firm stretches its payables excessively, so that its

payables are significantly delinquent, its credit rating will suffer. Suppliers will view the firm with

apprehension and may insist on rather strict conditions of sale. Although it is hard to measure, there is

certainly an opportunity cost to a deterioration in the firm‘s excellence of payment.

Advantages of Payables

Simple to obtain

Payable or Deal Credit is readily obtainable, in mainly cases, without extended procedural formalities.

Throughout eras of credit crunch or paucity of working capital, deal credit from big suppliers can be a

boon to little buyers.

Suppliers Assume the Risk

Where the suppliers have the advantage of high gross margins on their products, they would be able to

assume greater risks and extend more liberal credit.

Informality

In deal credit, there is no rigidity in the matter of repayment on scheduled dates, occasional delays are

not frowned upon. It serves as an extendable, convenient source of unsecured credit.

Continuous Financing

Even as the current dues are paid, fresh credit flows in, as further purchases are made. It is a continuous

source of fund. With a steady credit term and the expectation of continuous circulation of deal credit-

backing up repeat purchases, deal credit does in effect, operate as extensive term source.

Effective Management of Payables

The salient points to be noted on effective management of payables are:

Negotiate and obtain the mainly favorable credit conditions constant with the prevailing commercial

practice pertaining to the concerned product row.

Where cash discount is offered for prompt payment, take advantage of the offer and derive the savings

there from.

Where cash discount is not provided, settle the payable on its date of maturity and not earlier. It pays to

avail the full credit term.

Do not stretch payables beyond due date, except for in inescapable situations, as such delays in meeting

obligations have adverse effects on buyer‘s credibility and may result in more stringent credit

conditions, denial of credit or higher prices on goods and services procured.

Sustain healthy financial status and a good track record of past relations with the supplier so that it

would uphold his confidence. The quantum and the conditions of credit are largely convinced through

suppliers‘ assessment of buyer‘s financial health and skill to meet maturing obligations promptly.

In highly competitive situations, suppliers may be willing to stretch credit limits and era. Assess your

bargaining strength and get the best possible trade.

Avoid the tendency to divert payables. Uphold the self liquidating character of payables and do not

exploit the funds obtained there from for acquiring fixed assets. Payables are meant to flow by current

assets and speedily get converted into cash by sales for meeting maturing short term obligations.

Give full fact to suppliers and concerned credit agencies to facilitate a frank and fair assessment of

financial status and associated troubles. With fuller appreciation of client‘s initiatives to honor his

obligations and the occasional financial strains which he might be subjected to for a diversity of causes,

the supplier will be more considerate and flexible in the matter of credit extension.

Stay a consistent check on incidence of delinquency. Delays in resolution of payables with references to

due dates can be classified into age clusters to identify delays exceeding one month, two months, three

months, etc. Once overdue payables are given priority of attention for payment, the delinquency rate can

be minimized or eliminated altogether.

REVIEW QUESTIONS

Bring out the effects of liquidity on the survival of a firm

Explain the concepts of Liquidity and Profitability

Illustrate with examples the trade off between liquidity and profitability

Is profit equivalent to exploitation? Argue

Profitability and working capital are related in many ways; what are they?

CHAPTER 6

Planning for Working Capital Investment

FACTORS INFLUENCING WORKING CAPITAL PERFORMANCE

In practice, however, working capital management has become the Achilles‘ heel of scores of fund

institutions, with several CFOs struggling to identify core working capital drivers and the appropriate

stage of working capital. From the perspective of the Chief Financial Officer, the concept of working

capital management is relatively straightforward: to ensure that the institutions are able to finance the

variation flanked by short-term assets and short-term liabilities.

As a result, companies can be limited in their skill to weather unforeseen or adverse measures and

ensure that cash is readily accessible where it is needed, regardless of the conditions. Through

understanding the role and drivers of working capital management and taking steps to reach the ―right‖

stages of working capital, companies can minimize risk, effectively prepare for uncertainty and improve

overall performance.

For mainly CFOs, the greatest challenge with respect to working capital management is the require to

understand and power factors that are out of their direct manage, in order to obtain a complete picture of

the company‘s requires. The CFO‘s span of manage can be limited in conditions of functional silos,

however corporate fund may well have some authorities of power in excess of operating elements.

While institutions usually concentrate on the right procedures, such as cash, payables and their supply

chain, they are less likely to take into explanation several internal and external constraints that can

dictate how effectively those procedures are executed.

For instance, the legal and business environments can have a important impact on performance.

Likewise, internal thoughts—such as organizational building, shared systems, autonomous business

elements, multinational operations and even fact technology—can impact working capital, creating

barriers that can hinder a CFO‘s skill to truly understand, and so control, the company‘s requires. The

human factor is another significant consideration.

If management is focused purely on top-row growth, insufficient attention may be applied to cash flow

management and forecasting. A difficult-row focus on year-end or quarter-end results can produce a

flattering, but inaccurate, picture of working capital performance and lead to counter-productive

behaviour. Believe the impact on working capital of a year-end sales push, where manufacture has been

structure up inventory (which may not be the appropriate inventory) to meet this artificial demand, and

the excellence of receivables deteriorates throughout the early section of the following year. While there

is no magical solution for effecting robust working capital management, there are a number of

prerequisites for gaining manage of the intricate procedure.

Cash Flow Forecasting

Proper cash flow forecasting is essential to successful working capital management. To do this

effectively, institutions necessity take into explanation internal and external working capital drivers and

believe the sensitivity of those drivers to changes in the business or market. Several questions require to

be asked: How will unforeseen measures impact working capital necessities? What if a sudden market

downturn or upturn occurs? What if the company loses a biggest customer? What happens if a biggest

competitor takes a important activity to improve its market location? As each of these could have a

sizable impact on the business, institutions necessity assumes that the only certainty will be uncertainty,

and prepare accordingly.

In addition to assessing the cash flow impact of potential measures, companies should believe the

possibility of having to create additional working capital investments. That‘s because measures could

affect non-operational cash necessities such as investments, credit ratings and the skill to service debt, as

well as inventory, payables and receivables. Company‘s necessity implements contingency plans that

take a holistic view of the institutions in the context of a diversity of dissimilar demanding situations.

This will help minimize the adverse effects of unforeseen measures and give financial flexibility in

uncertain times through having working capital as a ready source of cash. How can you control

uncertainty? The three fundamental approaches are: manage it, predict it, react to it. The mainly

successful approaches are based approximately one approach, but include units of all three. Market-

leading companies, possibly not surprisingly, are in the best location to control uncertainty, often

enjoying the skill to manage supply, minimize inventory and apply payment pressure on customers.

Companies with less power, though, necessity rely more heavily on a strategy of prediction. To properly

prepare for measures and improve or uphold performance throughout times of uncertainty, institutions

necessity develops an objective, business-driven view of the role of working capital. Without real insight

into true working capital drivers, a company may be able to produce a reasonably good consolidated

forecast, but discover that accuracy beads substantially when it comes to producing divisional, operating

element or even a product-row forecast.

Beyond Balance Sheets

The mainly effective programs for both improving working capital performance and forecasting are

those that seem beyond the regional institutions and believe the broader corporate habitation. Corporate

investment and financing arrangements, for instance, may give for cash to be delivered through one site,

but utilized at others.

Restrictions on the repatriation of cash, internal inefficiencies in moving cash, delays driven through

banks and sometimes-inadequate access to fact can create the procedure problematic. Cash generated in

another. As a result, companies necessity plan global working capital improvement initiatives in the

context of the ultimate exploit for the cash, rather than basically managing regional balance sheets.

Improving Working Capital Management

Successfully improving working capital management needs a multi-pronged approach. Company‘s

necessity seeks granular detail to identify the underlying drivers of working capital. This needs

separating perception from reality and pinpointing impediments to efficient cash flow, such as poor links

flanked by manufacture and billing or clumsy treasury operations. Company‘s necessity also adopts an

entrepreneurial mindset. They necessity performance quickly to drive transform through combining

operational and financial skills, and expand their thinking beyond the fund institutions to gain a more

complete view of overall operations.

Rather than wait for the perfect solution, they necessity identify and implement strategies that result in

quick wins, generating short-term cash to finance longer-term projects. Having the right people in lay

can also create or break the attempt. Companies require identifying individuals who can be responsible

for setting targets and performance stages and be held accountable for delivering. These professionals

should be encouraged to challenge the status quo and drive transform, by cross-functional teams.

Considered Approach

Finally—and this is where several projects fail—companies necessity remove emotion from the analysis

procedure. All initiatives necessity is business-case driven, and projects without measurable results or

those not contributing to overall goals should be abandoned. Companies necessity agrees on success

criteria, prioritize based on contributions to these criteria and continuously measure performance.

While working capital forecasting is critical to a company‘s skill to create informed strategic business

decisions, several CFOs thrash about with the procedure because of a lack of manage and real insight

into the underlying drivers of their working capital requires. Through empowering the whole institutions

to understand the company‘s true working capital requires, companies can successfully reduce their

financial risk, prepare for uncertainty and make a ready cash reserve that will give flexibility and

security throughout hard times.

CORPORATE WORKING CAPITAL MANAGEMENT

Many recent business studies suggest that corporations, on standard, in excess of-invest in working

capital. For instance, REL Consultancy Cluster has for years mannered an annual survey of corporate

working capital management practices for CFO Magazine, which CFO Magazine then reports. The REL

2005 Working Capital Survey concludes that U.S. corporations had roughly $460 billion unnecessarily

tied up in working capital. Likewise, the results of a revise arguing that poor working capital

management practices cost IT companies billions of dollars annually. Do US corporations in excess of-

invest in working capital? If so, to what extent is this due to agency troubles? We address both of these

questions in this revise. To see how significant the efficiency of a corporation‘s working capital

management can be, we exploit an instance given in Shin and Soenen (1998).

Shin and Soenen (1998) point out that Wal-Mart and Kmart had same capital buildings in 1994, but

because Kmart had a cash conversion cycle of roughly 61 days while Wal-Mart had a cash conversion

cycle of 40 days, that Kmart likely faced an additional $198.3 million per year in financing expenses.

Such proof demonstrates that Kmart‘s poor management of its working capital contributed to its going

bankrupt. As their 2005 U.S. survey statement points out, there is a high positive correlation flanked by

the efficiency of a corporation‘s working capital policies and its return on invested capital.

By data on a panel of U.S. corporations from 1990 by 2004, we discover proof of a significantly

negative connection flanked by firm value and investment in working capital that is constant with in

excess of-investment in working capital. An additional $1 million investment in working capital is

associated with a roughly 119 to 129 thousand dollar reduction in firm value. To put this in perspective,

a firm that under-utilizes debt through $1 million, can augment firm value through roughly $140

thousand at current rates through rising its interest tax shield. Consequently, it is clear that working

capital management decisions have corporation valuation effects of the similar magnitude of corporate

capital building decisions – and so almost certainly warrant presently as much attention.

Turning to what powers a firm‘s management of working capital, we discover that a firm‘s working

capital policy is convinced through its industry‘s working capital policies, its size, its expected sales

growth, the proportion of outside directors on its board, the current compensation of its CEO, and its

CEO‘s share ownership. Consequently, managerial incentives and the monitoring of management are

important powers on a firm‘s working capital management performance.

Shin and Soenen point out that a corporation‘s working capital is the result of the time lag flanked by the

expenditure for the purchase of raw materials and the collection from the sale of finished goods. As

such, it involves several dissimilar characteristics of corporate operational management: management of

receivables, management of inventories, exploit of deal credit, etc. Consequently, there are streams of

research on individual characteristics of working capital management (cash and marketable securities,

e.g. Mauer, Sherman and Kim, deal credit, e.g. Rajan and Peterson etc.).

Though, Schiff and Lieber, Sartoris and Hill, and Kim and Chung all emphasize the require to believe

the joint effects of these individual policies, particularly with respect to inventory and credit decisions.

For this cause, we only talk about the prior literature that focuses on overall working capital

management. With respect to the effect of working capital management on firm value, we discover no

direct proof . While Schiff and Lieber, Sartoris and Hill, and Kim and Chung model the effects of

working capital management practices on firm value, they do not give proof on whether firms actually

do maximize their value through their working capital management choices.

The revise that comes adjacent to addressing this issue is the revise through Shin and Soenen, which

examines the relation flanked by dissimilar accounting profitability events and net deal cycles, a

summary efficiency measure of a firm‘s working capital management. Shin and Soenen‘s revise implies,

without providing direct proof , that firms that control their working capital more efficiently (i.e., shorter

net deal cycle) experience higher operating cash flow and are potentially more precious.

Though, this last implication does not necessary follow because firms that have longer net deal cycles

are also investing in short-term assets which may pay off in subsequent eras. Further, their proof does

not speak to whether the market sees firms as in excess of-investing in net working capital. So the

question as to whether firms in excess of-invest in net working capital on standard is unanswered

through prior research.

As for the determinants of working capital practices, we discover even less prior proof on which to

attract. Nunn uses the PIMS database to look at why some product rows have low working capital

necessities, while other product rows have high working capital necessities. In addition, Nunn is

interested in ―permanent‖ rather than temporary working capital investment as he uses data averaged in

excess of four years. By factor analysis, he specifies factors associated with the manufacture, sales,

competitive location, and industry. Reinforcing the role of industry practices on firm practices,

Hawawini, Viallet, and Vora look at the power of a firm‘s industry on its working capital management.

By data on 1,181 U.S. firms in excess of the era 1960 to 1979, they conclude that there is a substantial

industry effect on firm working capital management practices that is stable in excess of time. From these

studies, we conclude that sales growth and industry practices are significant factors influencing a firm‘s

investment in working capital. There are models to define how working capital management practices

power firm value, there is practically no proof that firms control their working capital so as to maximize

their value. Further, there is small proof on what factors power a firm‘s management of working capital,

particularly whether agency cost issues are concerns.

Example and Example Data

To address these questions, we look at samples of U.S. public corporations from 1990 by 2004. We

begin through identifying all U.S. corporations with Compustat and CRSP data in excess of this time

era. After that, we exclude all firms in financial service industries as working capital has a extremely

dissimilar meaning in these industries. This example is what we look at when we revise the effect of

investment in net working capital on firm value. To revise what powers working capital management

performance; we add data from a number of dissimilar data sources, which reduces our example in

dissimilar analyses. First, we exploit the Investor Responsibility Research Centre (IRRC) Governance

database to obtain data on sure corporate governance characteristics in excess of the 1990 by 2004 time

era.

The availability of these data underlies our choice of time era to revise. Specifically, IRRC collects data

on governance provisions in effect for at least 3,155 biggest US corporations consisting of the S&P 1500

firms and other companies selected ―primarily on the foundation of market capitalization and high

institutional ownership stages‖ in excess of the years 1990 to 2004. As the original IRRC data is biennial

and sometimes triennial, we exploit the filling method adopted through Gompers Ishii and Metrick

(2003) and lately followed through Bebchuk Cohen and Ferrell (2004) in structure our example for all

the years in excess of the example era.

We say the maximum number because the number of firms with IRRC data is superior than the number

of firms with S&P Execucomp data and the number of firms with IRRC‘s Directors data. We exploit the

IRRC‘s Directors database to collect fact on the board of directors of example firms. We exploit S&P

Execucomp database to collect fact on CEO compensation and share ownership. The exploit of these

data further in our analysis of what factors power a firm‘s working capital performance

Capital Cash Flow Analysis

While earlier examples focused on the costs associated with investment in working capital, they do not

address the potential benefits. Clearly a company has to have stock on hand in order to create some

sales. Further, competition flanked by firms may need them to give customers with interim financing in

the shape of deal credit – which becomes a receivable to the supplier. Therefore , the net effect of

investment in working capital is not as straightforward as earlier examples suggest. To discern if firms

in excess of-invest in working capital, we exploit the capital cash flow valuation model used in Kaplan

and Ruback (1995) as our guide.

Like Kaplan and Ruback, we add the firm‘s current cash balances and exploit a net working capital

definition that excludes investment in cash balances. This approach is particularly precious in our

context as it allows us to distinct out cash management issues, which have been the focus of a distinct

literature and Pinkowitz and Williamson, from working capital management issues. Based upon this

DCF valuation model, we develop two regression models to ascertain the connection flanked by firm

investment in net working capital and its market value. Therefore we are able to address the question of

whether or not the market sees firms as in excess of-investing in net working capital.

Regression Model 2

Our first regression model follows the DCF valuation approach taken in Kaplan and Ruback (1995).

Though, the analysis ignores incremental investment in cash and marketable securities. Whether such

incremental investment should be incorporated or excluded is unclear because some formulations of the

DCF valuation framework exploit definitions of working capital that contains cash and marketable

securities and some do not. To estimate these two regression models, we exploit Compustat data. The

first variable, MVF(t), symbolizes the market value of the firm computed as in Fama and 8 French

(2002). Specifically, we start with total assets, subtract the book value of equity and add back the market

value of equity as of the end of fiscal year.

To estimate, CASH(t), we exploit the cash and marketable securities balance of the firm at the similar

point in time as we measure its market value. We do this to be constant with the method that Kaplan and

Stein considered cash balances in their valuation model. To estimate OCF(t+1), we exploit the two

approaches called in Kaplan and Stein (1995), and like their paper, we only statement the results based

on the second approach as the results are same. Specifically, we start with net income; add back

depreciation and amortization expense, interest expense, and the proceeds from the sale of fixed assets.

To estimate INVL(t+1), we exploit the firm‘s investment in extensive-term assets (PPE) from its cash

flow report. By changes in PPE as an alternative measure does not transform our ceases and so we only

statement results by this measure.

To estimate INVS(t+1), we exploit a definition of net working capital that is constant with the one in

Kaplan and Stein‘s paper. Specifically, we exploit current assets minus cash and marketable securities,

minus explanations payable, and minus accrued expenses. There are two significant points to note in

relation to the this definition. First, we are separating out investment in cash and marketable securities.

Second, we are focused on the investment in current assets that necessity be financed with non-

spontaneous or outside sources of financing. This definition is constant with our valuation model. To

estimate INVC(t+1), we compute the transform in the balance of cash and marketable securities flanked

by fiscal years. It is significant to note that we estimate for the fiscal year subsequent to the date on

which we measure the value of a firm and its cash balances.

We do this to be constant with our valuation model. The after that issue that we have to confront is how

to specify the data generating procedure for our regression models. It should be fairly obvious that

MVF(t) is a nonnegative random variable. While some researchers have scaled MVF(t) through the

book value of assets to make an estimate of Tobin‘s q. We do not take this approach, however as

suggested, see that it does not later, as it introduces additional troubles when there is more difference in

book values of assets than in any of the explanatory variables. One 9 alternative is to take the logarithm

of the dependent variable and exploit OLS to estimate a linear regression on it. Unluckily, as Manning

(1997) explains, this is not always appropriate, and can lead to biased estimates of the marginal effects

of the explanatory variables.

Consequently, we follow the recommendation of Hardin and Hilbe and exploit a generalized linear

model approach with a log link assumption.

Specifically, we adopt a common estimating equation approach (a GMM approach) by the logarithm

link function, ln(E(y|x)), and estimate the average errors by the Rogers/Huber/White estimators adjusted

for clustering at the firm stage. Both models provide fairly same results. Current cash balances,

operating cash flow, and investment in fixed assets are all positively priced. The last inference suggests

that additional investment in fixed assets for mainly firms increases their value.

Interestingly, all these inferences are constant with those that would be derived from estimates

accounted in either Faulkender or Wang (2005) or Pinkowitz and Williamson (2005). More importantly,

for our revise, we discover that the coefficient on the investment in working capital variable is

significantly negative.

Following the interpretation of equation (4), this result implies that at the periphery, firms tend to in

excess of-invest in working capital on standard. As well as several annual REL Working Capital

Surveys. Apparently, the market recognizes this in excess of-investment and discounts firms for it.

Evaluated at the mean values of the explanatory variables, an additional $1 million investment in

working capital is associated with a roughly $129 thousand reduction in firm value.

To put this in perspective, a firm that under-utilizes debt through $1 million, can augment firm value

through roughly $140 thousand at current rates through rising its interest tax shield.11 Consequently, it

is clear that working 9 capital management decisions have corporation valuation effects of the similar

magnitude of corporate capital building decisions – and so almost certainly warrant presently as much

attention.

The analysis gives proof that on the periphery, firms seem to in excess of invest in net working capital

on standard. It is significant to note that this result does not suggest that the value of net working capital

is negative, but rather the incremental value of working capital is negative as we only look at investment

at the periphery. As our valuation model is not typically that used in empirical corporate fund, we

exploit the valuation framework proposed in Pinkowitz and Williamson (2005), which is an extension of

the valuation framework proposed in Fama and French (1998), to explore the robustness of our results.

To implement this approach we exploit Compustat data for the example firms in our prior valuation

analysis to compute the following variables taken from Pinkowitz and Williamson (2005). M is the

market value of equity following Fama and French‘s (1998) definition. E is earnings before

extraordinary conditions, plus interest, deferred tax credits and investment tax credits. NA is assets

minus cash. NNA is NA minus explanations receivable and inventory. RD is research and development

expense. I is interest expense. DIV is general cash dividends. C is cash and marketable securities. NWC

is explanation receivable plus inventory minus explanations payable. Following Pinkowitz and

Williamson, we divide each of these variables through total assets for the era, so that X(t) is the stage of

variable X in year t divided through the stage of assets in year t. In addition, we compute dX(t) as the

transform in the stage of X from year t-2 to year t divided through total assets in year t.

And finally, we compute dX(t+2) as the transform in the stage of X from year t to year t+2 divided

through total assets in year t. Pinkowitz and Williamson argue that if the firm is not at some optimum,

then changes are significant to contain to capture movements toward or absent from the optimum. While

we are dubious of this interpretation, we follow their instance. While Pinkowitz and Williamson uses the

methodology of Fama and MacBeth (1973) to estimate their regression models, we exploit the panel

data approach advocated in Peterson (2005) as it seems larger to the Fama and MacBeth methodology.

Therefore all our average errors are estimated by Roger estimators adjusted for clustering on the firm

stage.

Our results for their base specification are somewhat dissimilar than theirs as our estimated coefficient

on the stage of cash variable is 0.701, rather than 0.97 as in their revise. This variation may be due to the

variation in time era studied: their regression covers 1950 to 1999, while ours covers 1990 by 2004.

Other than differences in numerical values, our estimates share the similar signs as their estimates.

Structure on this base specification, we after that estimate a regression model with net assets reduced

through investment in explanations receivable and inventory and then add a variable for investment in

net working capital, defined through explanations receivable plus inventory minus explanations payable

as this mimics our prior definition of net working capital.

The negative and important coefficient on the stage of net working capital investment is constant with

our prior estimated valuation model result in that it suggests that firms on standard in excess of-invest in

net working capital. Before reaching a cease on how much, we after that estimate a specification that

contains prior and future changes in net working capital investment and statement. The accounted results

suggest that prior and future investment in net working capital augment firm value. Such estimated

coefficients suggest that Pinkowitz and Williamson interpretation of their transform variables is

somewhat questionable as we should not observe a negative sign on the coefficient associated with the

current stage of investment in net working capital if their interpretation was correct.

Nevertheless, we can estimate the total effect of investment in net working capital on firm value through

evaluating its effect by current, past and future investment in net working capital. Evaluated at our

example averages, the total effect is that an additional $1 million investment in net working capital

overall reduces firm value through roughly $119,326. What is striking in relation to the this estimate is

that it is secure to the $129,000 estimate that we derive from our prior valuation analysis. Given this

consistency, we conclude 12 that our valuation analysis suggests that the market views firms as in

excess of-investing in net working capital on standard.

That corporations in excess of-invest in net working capital, the after that question is why. One obvious

possibility is that managers do not expend the attempt necessary to minimize net working capital

because of incentive compatibility troubles, or agency troubles. Prior literature suggests that there are

three likely sources of misalignment: (1) CEO incentives, (2) board incentives, and (3) the building of

corporate governance. As suggested, explore each of these possibilities, but before we do we necessity

first develop a vital model to identify potential manage variables. Therefore , we conduct this analysis in

a series of steps.

We first develop a core model, and then we explore the power of board aspects, CEO compensation and

ownership, and finally corporate charter provisions on a corporation‘s efficiency in managing its

working capital. As our dependent variable in these regressions, we exploit a firm‘s cash conversion

cycle (i.e., the inventory conversion era plus the receivables collection era minus the payables deferral

era by Compustat data) as our measure of the efficiency of its working capital management. While there

are alternatives, such as Shin and Soenen‘s NTC measure, the cash conversion cycle measure (CCC) is

average in several corporate fund textbooks and is used in the REL Working Capital Surveys as a

summary measure.

Consequently, we follow industry and textbook practice and exploit this measure for the efficiency of a

firm‘s overall working capital management. Note that we winsorize this and all of our accounting and

compensation variables at the 1% stage to avoid distortions due to outliers. For our core model, we

conjecture that the following factors are important powers on a firm‘s working capital management.

First, prior research such as Hawawini, Viallet, and Vora (1986) suggests that industry practices are

important determinants of a firm‘s working capital management practices. The working capital 13

policies of say a software company are going to be quite dissimilar from those of a retail shoe company.

Consequently, it is significant to manage for the power of industry practices on a firm‘s working capital

practices.

To do this, we exploit the median cash conversion cycle of firms within a firm‘s industry, CCCM, to

proxy for the typical working capital practices within such industry. For our identification of a firm‘s

industry we exploit the Fama and French (1997) 48 industry delineations. Second, firm size may power

the efficiency of a firm‘s working capital management. Superior firms may need superior investments in

working capital because of their superior sales stages. Or, alternatively, superior firms may be able to

exploit their size to forge relationships with suppliers that are necessary for reductions in investments in

working capital.

Current supply chain management practices need a lot of coordination flanked by companies and are

typically easier for a superior firm to implement than for a smaller firm to implement. Therefore , firm

size is likely to power the efficiency of a firm‘s working capital management, however the direction of

the effect is an open question. We exploit a firm‘s total assets, TA, as our proxy for its size. Third, the

proportion of a firm‘s assets reported for through fixed assets might exercise an power on a firm‘s

working capital performance. For instance, the inventory troubles of an automobile sections

manufacturer are likely to be quite dissimilar from that of a software manufacturer. Further, the

receivables troubles of these kinds of companies are also likely to be dissimilar. To measure this

variable, we take the ratio of a firm‘s property, plant and equipment to its total assets, and name it PTA.

Fourth, based upon Nunn‘s (1981) proof , we anticipate firm sales to power a firm‘s working capital

management. In this relationship, and constant with our earlier regression results, we anticipate a firm‘s

expected future sales to power its working capital investment, and so its cash conversion cycle. For

instance, a firm might build up inventories in anticipation of future sales growth, and as a result, may

also augment its exploit of deal credit. To proxy for such growth, we exploit the firm‘s percentage sales

growth in excess of the future two years and name this variable, FSG. Finally, some might argue that

firms with some degree of market authority are able to work trades with suppliers and customers that

provide them an advantage in excess of competitors. To capture this possibility, we compute the

Herfindahl-Hirschman index by sales data for each firm‘s industry, again by Fama and French‘s (1997)

48 industry delineations.

The more concentrated the industry the more likely this will power the cash conversion cycles of firms

within it. We denote this variable as HHI. To determine the relevance of the above core factors to the

efficiency of a firm‘s working capital management, we regress the firm‘s cash conversion cycle, CCC,

on these above factors. Before conducting this analysis, we necessity address the specification of the

data generating procedure as CCC is a non-negative random variable. While we would prefer to exploit

the similar data generating procedure specification used in our valuation analysis, it does not seem

appropriate for these data. A Hausman kind test designates that a random effects model is inappropriate

in this case, and so we exploit a fixed effect model on a logarithmic transformed dependent variable and

estimate Rogers/Huber/White average errors adjusted for firm stage clustering.

These results suggest that firms do not exploit their size or market authority to reduce their cash

conversion cycle. If anything, they exploit their location to relax their efforts. Of the factors examined,

industry practices are the largest determinant of a firm‘s working capital practices. In addition, positive

future sales growth is associated with increased investment in net working capital. And finally, firms

with more tangible extensive-term assets reduce their investment in net working capital. These results,

we now add the board aspects of a firm to our core regression model to extend it. We exploit two aspects

to capture the essential characteristics of a corporation‘s board: its size considered through the number

of directors (DIR), and its proportion of outsiders on the board (POD).

Prior literature leads us to anticipate that superior boards might be lax in monitoring management and so

be associated with longer cash conversion cycles than other firms in their industry. Conversely, prior

literature suggests that more outsiders on the board lead to greater monitoring of management, which we

anticipate will result in shorter cash conversion cycles for these firms. These results suggest that board

size is not a important power, but that board composition is. The greater the proportion of outsiders on

the board, the bigger the performance of the firm‘s working capital management. This result is constant

with the monitoring role of outsider directors.

Continuing this row of inquiry, we now contain the compensation and share ownership of the CEO in

our expanded regression model. The more the CEO is paid, the more likely they will have incentives to

reduce a firm‘s cash conversion cycle. Consequently, we anticipate the firm‘s cash conversion cycle to

be negatively correlated with the CEO‘s total current compensation. We measure such compensation

that includes of CEO‘s salary and bonus by the Execucomp database and denote it as TCCOMP. Note

that we exclude their current era stock option grants from this measure and only focus on their current

non-stock compensation.

We exclude their current stock option grants because we instead focus on their total unexercised stock

option holdings. Stock options granted in the past might be presently as significant an power as current

stock option grants in our effort to capture managerial incentive alignment with shareholder interests.

Consequently, it might be bigger to recognize a CEO‘s total unexercised stock option location. To

estimate this quantity, we exploit the Execucomp database to estimate the dollar value of the CEO‘s

unexercised stock options and denote this variable as TUO.

Finally, we can anticipate the CEO‘s current shareholdings to power the management of the firm‘s cash

conversion cycle. For this cause, we construct the proportion of stocks held through the CEO and call it

CEOPS. Unluckily, the effect of this variable is less clear as it could either make incentives for the

manager to tightly manage this cycle, or if it could make incentives for managers to expend less attempt

on this action if they have the authority to avoid the expenditure of such attempt.

While both CEO compensation components have a negative power on their firm‘s cash conversion

cycle, only the total current compensation component has a statistically important effect. In some ways

this is constant with our earlier expectation that a firm‘s investment in working capital primarily powers

its performance in the current and close to future eras. Consequently, we should anticipate current CEO

compensation to have a greater power on the firm‘s cash conversion cycle, while we might anticipate

their unexercised stock options to power their extensive-term investment decisions. Interestingly, the

CEO share ownership is significantly positively related to their firm‘s cash conversion cycle. So, the

incentive effect of stock ownership seems to be dominated through other effects of CEO stock

ownership.

Expanding our regression model further, we now contain a consideration of the firm‘s corporate charter

provisions. Such provisions have figured prominently in recent literature on cash management as result

of Gompers, Ishii, and Metrick‘s (2003) proof on the connection flanked by these corporate aspects and

equity returns. To begin this analysis, we follow Harford, Mansi, and Maxwell and basically contain

Gompers, Ishii and Metrick‘s governance index, GINDEX. The accounted proof does not suggest that

these firm aspects are important powers on a corporation‘s working capital performance.

Whether this cease is correct is somewhat unclear as the GINDEX assumes that all of charter provisions

have the similar power on a firm‘s cash conversion cycle and that assumption has been subject to

criticism in recent governance literature. For instance, executive severance agreements such as golden

parachutes can provide management an incentive to agree to a takeover, while poison pills ostensibly are

designed to deter takeovers. More importantly, some provisions (e.g., advance notice necessities) are

designed to primarily power internal changes in corporate governance, while other provisions (e.g.,

supermajority necessities for a merger) are designed to solely deter external changes in corporate

manage without any impact on internal governance.

Consequently, we make many indices which cluster governance characteristics through designed

purpose. Our component indices are: internal provisions, external provisions, compensation and liability

provisions, minority voting provisions, and state laws. The rationale for each is as follows. Primarily

powers its performance in the current and close to future eras. Consequently, we should anticipate

current CEO compensation to have a greater power on the firm‘s cash conversion cycle, while we might

anticipate their unexercised stock options to power their extensive-term investment decisions.

Interestingly, the CEO share ownership is significantly positively related to their firm‘s cash conversion

cycle. So, the incentive effect of stock ownership seems to be dominated through other effects of CEO

stock ownership. Expanding our regression model further, we now contain a consideration of the firm‘s

corporate charter provisions. Such provisions have figured prominently in recent literature on cash

management as result of Gompers, Ishii, and Metrick‘s (2003) proof on the connection flanked by these

corporate aspects and equity returns. To begin this analysis, we follow Harford, Mansi, and Maxwell

and basically contain Gompers, Ishii and Metrick‘s governance index, GINDEX.

The accounted proof does not suggest that these firm aspects are important powers on a corporation‘s

working capital performance. Whether this cease is correct is somewhat unclear as the GINDEX

assumes that all of charter provisions have the similar power on a firm‘s cash conversion cycle and that

assumption has been subject to criticism in recent governance literature. For instance, executive

severance agreements such as golden parachutes can provide management an incentive to agree to a

takeover, while poison pills ostensibly are designed to deter takeovers.

More importantly, some provisions (e.g., advance notice necessities) are designed to primarily power

internal changes in corporate governance, while other provisions (e.g., supermajority necessities for a

merger) are designed to solely deter external changes in corporate manage without any impact on

internal governance. Consequently, we make many indices which cluster governance characteristics

through designed purpose. Our component indices are: internal provisions, external provisions,

compensation and liability provisions, minority voting provisions, and state laws.

The rationale for each is as follows. The internal provisions index, INTERNAL, contains provisions that

limit the constitutional rights of shareholders, like staggered boards, limitations on shareholder rights to

amend charter and bylaws, and advance notice necessities. So, the internal provisions index focuses on

provisions that primarily power internal governance or changes in the internal manage of a firm. The

external provisions index, EXTERNAL, which is constituted of provisions like poison pills,

supermajority necessities to approve mergers, fair price, and anti-greenmail, focuses on provisions that

are primarily used to thwart external manage contests (i.e., takeover bids).

The compensation and liability provisions index, C&L, focuses on provisions that primarily power

directors‘ legal liability costs, or compensation received through administrators and directors in the

event of a manage transform. The minority voting provisions index, MVP, focuses on shareholder voting

rules, largely cumulative and confidential voting rules. The state laws index, SLAWS, focuses on anti

takeover provisions endorsed state law. Because these anti takeover statutes are often implemented

through default in all firms included in a scrupulous state, and are sometimes redundant with the

attendance of firm stage anti-takeover defenses, it is not clear that they add much.

The regression results from substituting these component indices for the GINDEX. While the negative

sign on both the internal provisions index and the compensation and liabilities index are constant with

the arguments in Baranchuk, Kieschnick, and Moussawi (2005) in that such provisions help managers to

maximize the value of potential growth options in their establishments, neither coefficient is statistically

important.

Further, none of the coefficients of the dissimilar corporate charter indices are statistically important and

so we conclude that the corporate charter aspects of a corporation do not significantly power its working

capital management performance. Overall, our proof for the compensation and governance variables

suggest that monitoring of management and managerial compensation are more significant powers on a

firm‘s management of its working capital.

Many recent business studies suggest that US corporations, on standard, in excess of invest in working

capital. If correct, and if established through the market, then one should observe a negative relation

flanked by investment in working capital and firm value. We address this issue through examining data

on samples of U.S. corporations from 1990 by 2004. We discover that on standard firms have in excess

of-invested in their working capital in the sense that additional investment in working capital is

associated with a reduction in firm value. Such a cease seems constant with the several annual surveys

through REL Consultancy for the CFO Magazine on corporate working capital performance.

Apparently the market recognizes this in excess of-investment and discounts firms for it. Though, one

can also view the flip face of this proof and explain why firms like Wal-Mart suggest that their working

capital management practices are a source of their value. Given this proof , we then turn to the question

of what factors power the efficiency of a corporation‘s working capital management. We discover that

the inefficiency of a firm‘s working capital management is positively correlated with firm size and

uncorrelated with its industry‘s concentration. We interpret these results as suggesting that firms are not

by their market authority at the periphery to improve the efficiency of their working capital management

practices.

Instead, they tend to follow the practices of their industry. Further, they tend to invest in working capital

in anticipation of future sales growth. Expanding this analysis to contain dissimilar firm governance

characteristics, we discover proof that the superior the proportion of outsiders on a firm‘s board, the

bigger its working capital management performance. Such proof is constant with the monitoring of

management role of outside directors. Taking the CEO‘s compensation and stock ownership also proves

significant. The superior the CEO‘s current compensation the bigger the firm‘s working capital

management performance.

Though, the superior the CEO‘s share of the firm‘s stock, the contrary behaviour is shown. Finally,

taking corporate charter characteristics in explanation, we discover no proof that any such

characteristics are important powers on a corporation‘s working capital management practices.

Consequently our proof seems to emphasize the role of board monitoring of management and

management‘s compensation in it‘s manage of the firm‘s working capital. One question that is raise

through our revise is what determines industry practices, as it is clear from our firm stage analyses that

industry practices are a critical determinant of firm practices. We defer this issue to future research.

REVIEW QUESTION

Explain the factors influencing working capital performance

What is cash flow forecasting?

Discuss the concept of corporate working capital management.

What is regression model 2

CHAPTER 7

Money Markets in India

INDIA MONEY MARKET

The money market is a mechanism that trades with the lending and borrowing of short term funds. The

India Money Market has approach of age in the past two decades. In order to revise the money market

of India in detail, we at first require to understand the parameters approximately which the money

market in India revolves. The performance of the Indian Money Market is heavily dependent on real

interest rate that is the interest rate that is inflation adjusted.

However the money market is free from interest rate ceilings, structural barriers and other institutional

factors can be held responsible for creating distortions in India Money Market. Separately from the call

market rates, the other interest rates in the Indian Money Market generally do not transform in the short

run. It is due to this disparity flanked by the opposite forces that is prevalent in the money market in

India that a well defined income path cannot be traced. Owing to the deregulation of the interest rate in

the early nineties following the economic reforms laid down through the then fund minister Dr.

Manmohan Singh, studies regarding the behaviour of interest rate were restricted. Though the liquidity

of the market creates it‘s a good subject for empirical research.

The Indian Money Market involves a wide range of instruments. Here, maturities range from one day to

a year, issued through banks and corporate of several sizes. The money market is also closely connected

with the Foreign Swap Market by the procedure of sheltered interest arbitrage in which the forward

premium acts as a bridge flanked by domestic and foreign interest rates.

To examine the interest rates that characterize the Indian Money Market, the following units require

being sheltered:

The term building of interest rate.

The variation flanked by domestic and international interest rates

The market building differences flanked by the auction markets that clear continuously and the customer

markets.

The credit speed flanked by instruments involving same maturity but diverse risk factor.

Such is the distortion in the Indian Money Market.

INDIA MARKET SIZE

In order to estimate the size of the Indian Market, we require understanding the scope of the Indian

Market. India Market Size is vast almost certainly better in comparison to its geographical extent. The

Size of the Indian Market owes much of its credit to the information that it is the second mainly

populated country in the world. The Indian Market can be classified in a number of ways. Some of them

are discussed below. The Indian Market can be broadly classified under the following heads:

Commodity Market

Money Market

Labour Market

Capital Market

The commodity market in India trades with the swap of goods, the cost of which is estimated in

conditions of domestic currency. It can be subdivided into the following two categories:

Wholesale Market

Retail Market

The money market of India involves all monetary transactions. It be further divided under the following

two categories.

Currency Market

Bond Market

The labour market as the name suggests, consists of the whole working population of the nation. It

involves the services provided through the people of India in the primary, secondary and tertiary sectors.

The services of the individuals are assessed in conditions of the wages they get for their services. The

Capital Market trades with all those assets which are responsible for manufacture both directly and

indirectly. Let us now take a seem at what the present scenario of each of the above markets is like. The

traditional wholesale market in India dealt with entire sellers who bought goods from the farmers and

manufacturers and then sold them to the retailers after creation a profit in the procedure. It was the

retailers who finally sold the goods to the consumers. With the passage of time the importance of entire

sellers began to fade out for the following causes:

The entire sellers in mainly situations, acted as mere parasites that did not add any value to the product

but raised its price which was eventually faced through the consumers.

The improvement in transport facilities made the retailers directly interact with the producers and hence

the require for entire sellers was not felt.

In recent years, the extent of the retail market (both organized and unorganized) has evolved in leaps and

bounds. Considering the present growth rate, the total valuation of the Indian Retail Market is estimated

to cross Rs. 10,000 billion through the year 2010. Same scenario can be observed in other markets as

well. Demand for commodities is likely to become four times through 2010 than what it just is. The

money market is also expected to experience a same augment with the encouragement of Foreign Direct

Investment (FDI) through the central government. Therefore the ever rising extent of the Indian Market

is complementing the growth of the economy in a large method.

GLOBAL INTEGRATION OF INDIA’S MONEY MARKET

Financial openness exists when residents of one country are able to deal assets with residents of another

country, i.e. when financial assets are traded goods. A weak definition of complete financial openness,

which one might refer to as financial integration, can be given as a situation in which the law of one

price holds for financial assets- i.e. domestic and foreign residents deal identical assets at the similar

price. A strong definition would add to this the restriction that identically defined assets e.g. a six-month

Treasury bill, issued in dissimilar political jurisdictions and denominated in dissimilar currencies are

perfect substitutes in all private portfolios.

The degree of financial integration has significant macroeconomic implications in conditions of the

effectiveness of fiscal and monetary policy in influencing aggregate demand as well as the scope for

promoting investment in an economy. The free and unrestricted flow of capital in and out of countries

and the ever rising integration of world capital markets can be attributed to the procedure of

Globalization.

The benefits of such integration are liquidity enhancement on one hand and risk diversification on the

other, both of which are instrumental in creation markets more efficient and also facilitate smooth

transfers of funds flanked by lenders and borrowers. India began a extremely gradual and selective

opening of the domestic capital markets to foreign residents, including non-resident Indians (NRIs), in

the eighties.

The capital market opening picked up pace throughout the nineties. In this paper we attempt and

estimate the degree of financial integration flanked by India and the rest of the World, through focusing

on the degree of integration of the Indian money market with global markets.

Frenkel (1992) in his review of Capital Mobility measurement outlined four dissimilar definitions of

perfect capital mobility that are in widespread exploit, of which three are of relevance to the current

paper.

These are real interest parity, uncovered interest parity and sheltered interest parity.

Real interest parity hypothesis states that international capital flows equalize real interest rates

crossways countries.

Uncovered interest parity states that capital flows equalize expected rates of return on countries‘ bonds

regardless of exposure to swap risk.

Sheltered interest parity states that capital flows equalize interest rates crossways countries when

contracted in the similar currency. Frenkel (1992) shows that these three definitions are in ascending

order of specificity in the following sense. Only definition

That the sheltered interest differential is zero is an unalloyed criterion for ―capital mobility‖ in the sense

of the degree of financial market integration crossways national boundaries. Condition

That the uncovered interest differential is zero needs that

Hold and that there be zero swap risk premium. Condition.

That the real interest differential be zero needs condition

And in addition that expected real depreciation is zero.

The uncovered interest parity (UIP) theory states that differences flanked by interest rates crossways

countries can be explained through expected changes in currencies. Empirically, the UIP theory is

generally rejected assuming rational expectations, and accounts for this rejection contain that

expectations are irrational, or that time-varying risk premia are present respectively. In a survey of 75

published estimates, Froot and Thaler (1990) statement few cases where the sign of the coefficient on

interest rate differentials in swap rate prediction equations is constant with the unbiasedness hypothesis

and not a single case where it exceeds the theoretical value of unity.

This resounding unanimity on the failure of the predictive authority of interest differentials is virtually

unique in the empirical literature in economics. A third account was provided through McCallum

(1994a), who observes that regressing the transform in mark swap rates on the forward premium, one

typically discovers a negative regression parameter of -4 to -3 contrary to the expected parameter of +1.

McCallum argues, though, that this finding may be constant with the UIP theory, if one introduces

policy behaviour.

Assuming policymakers adjust interest rates in order to stay swap rates stable, and that they are

interested in smoothing interest rate movements, McCallum derives a reduced shape equation for the

mark swap rate under rational expectations. In information, this results in a negative theoretical

connection flanked by the transform in the mark swap rate and the forward premium constant with his

empirical findings. Christensen, M. (2000) extend the data set used through McCallum to contain the

recent 8 years and discover that $/DM, $/£ and $/Yen for the era 1978.01m to 1999.03m behave

amazingly well just as to the customized UIP theory urbanized through McCallum.

Though, when he estimates the policy reaction function, its structural parameters are inconsistent with

the UIP relationships estimated. Nevertheless, there seems to be overwhelming empirical proof against

UIRP, at least at frequencies less than one year. Fama (1984) focuses on statistical properties of this

relation. He discovers that from the end of August 1973 to the end of 1982, the variance of the swap risk

premium has been big, exceeding the variance of expected future mark rates changes of the dollar

against each of ten other biggest currencies (in excess of monthly intervals).

On the other hand Frankel and Froot (1987), in the middle of others, propose an account of UIP

deviations based on the subsistence of asymmetries flanked by currencies. By survey data to

approximate the swap rates‘ behaviour, they illustrate that mediators were expecting a 10% depreciation

of the Dollar against the Spot in excess of 1981-85 whereas the differential in corresponding interest

rates was only approximately 4%. Given that this empirical proof has not stopped theorists from relying

on UIRP, it is fortunate that recent proof is more favorable.

Bekaert and Hodrick (2001) and Baillie and Bollerslev (2000) argue that doubtful statistical inference

may have contributed to the strong rejections of UIRP at higher frequencies. Chinn and Meredith (2001)

marshal proof that UIRP holds much bigger at extensive horizons. They test this hypothesis by interest

rates on longer-maturity bonds for the U.S., Germany, Japan and Canada. The results of these extensive

horizon regressions are much more positive — the coefficients on interest differentials are of the correct

sign, and mainly are closer to the predicted value of unity than to zero.

Ravi Bansal and Magnus Dahlquist (2000) conclude that the often establish negative correlation flanked

by the expected currency depreciation and interest rate differential is, contrary to popular belief, not a

pervasive phenomenon. It is confined to urbanized economies, and here only to states where the U.S.

interest rate exceeds foreign interest rates.

The sheltered interest parity (CIP) postulates that interest rates denominated in dissimilar currencies are

equal once you cover yourself against foreign swap risk. Unlike the UIP, there is empirical proof

supporting CIP hypothesis. Empirical studies such as Frenkel and Levich, Frankel (1989), in the middle

of others, discover that the CIP holds in mainly cases on the Eurocurrency market (where remunerated

assets have same default and political risk aspects) as the collapse of the Bretton Woods regime in early

1970‘s.

Lewis shows that risk premia do not modify significantly and often switch sign, contrary to what the

observed continuity of the countries‘ global creditor or debtor status would predict. Though she explains

that not only the conditional variance of swap rate is not important sufficient to explanation for risk

premia movements, but also that risk premia examined in the short run should concern capital flows and

investors with same temporal horizons, such as currency traders, hedge funds and mutual funds

managers. Frankel (1991) reports mean sheltered interest differentials (CIDs) for the era 1982 to 1987

for a selection of urbanized and developing economies by monthly observations of the 3-month regional

money market rate against the equivalent Eurodollar rate.

Focusing on the East Asian economies in the example – Japan, Hong Kong, Malaysia and Singapore –

the null of a zero differential is rejected for the first three economies, however only marginally in that

the CIDs are extremely low. Chinn and Frankel (1992) establish that the CIDs were little for Japan,

Hong Kong and Singapore, but big for Malaysia. In the Indian context, Varma (1997) has undertaken an

analysis of the sheltered interest parity. His posits a structural break in the money market in India in

September 1995, with CIP become effective from that point on for the first time in the Indian money

market.

The structural break itself is attributed to interplay flanked by the money market and the foreign swap

market. The era after 1995 is though witness to many deviations from the CIP. Varma has used rates on

Treasury bills, certificates of deposit and commercial paper and call money rate to examine the Indian

money market. For the foreign rate he has calculated an implicit euro-rupee rate for six, three and

overnight maturity.

Therefore he uses a mix of actual and constructed rates of dissimilar maturity. A intensive test needs

exploit of interest rates on identical instruments (e.g. maturity, risk) and a constant forward rate (era of

forwards should be identical to that of instruments). This is possibly the first time that such a test is

being accepted out for India.

MODEL AND ESTIMATION

Estimating Equations

One of the key implications of international financial integration is on the degree of movement/co-

movement of interest rates in countries in excess of time and their comparison in conditions of

convergence or having a general trend. The connection flanked by two countries‘ interest rates is termed

as interest rate parity.

The interest rate theory proposes that given perfect capital mobility, perfect capital market and fixed

swap rates the interest on identical assets (identical in conditions of maturity etc) would be equal

crossways countries. Though, in the real world 5 with capital controls, flexible swap rates and imperfect

capital markets divergence flanked by interest rate is regularly observed and persist in excess of

extensive eras.

Given the reality of non-frictionless capital markets and flexible swap rates the recent adaptations of the

interest parity theorem attribute this divergence to the expectation in relation to the exchange rate

movements.

Based on the preference individuals have for risk there are two adaptations of this vital relation: a)

Uncovered Interest Rate Parity- Assume that individuals are risk neutral. With no capital controls and

perfect capital markets the interest differential flanked by two countries is equal to transform in swap

rate: it – it* = St+1-St where it is domestic interest rate it*/ is foreign interest rate on same asset

(identical in all compliments except for yield and currency denomination) St is the mark swap rate.

A risk neutral person would replace St+1 through his expectation in relation to the future swap rate. So

we get it – it* = E (St+1) – St Any deviation from UIP can be attributed to currency associated risks in

the absence of hedging agreements- namely currency premium and expectation bias. b) Sheltered

Interest Parity- Assume that individuals are risk averse. Such an individual would like to cover himself

for any unexpected currency fluctuation throughout the tenure of the trade. Given the forward contract

market, he would purchase a forward contract and exploit the swap rate mentioned in the contract. Then

any variation in interest rate should be equated to forward premium.

This is described CIP: it – it* = Ft- St or it – it* = ft where Ft is forward rate and ft is forward premium.

Any deviation from CIP would suggest that the markets are inefficient, regulations like capital controls

exist and costs like sovereign risk, individual borrowing constraints are not reported for.

Econometrics

The problem with by Ordinary Least Square as an estimation technique relates to the issue of non-

stationary of the time series involved in the above equation. In case of non-stationary times series the

estimate would be spurious and biased. Though if we can illustrate that the two variables in question are

co integrated than the OLS estimates are super constant and would converge to their true value faster.

Therefore before drawing inferences based on the results of ordinary least squares it is imperative to

check the variables namely F (3-month forward premium) and IDIFF (3-month TB auction rate

differential flanked by India and U.S). In case the two series are integrated of the similar order we can

then test for counteraction flanked by the two non-stationary variables. Under the null hypothesis the

above statistic follows a t-sharing with n-2 degrees of freedom.

Stationarity and Co-Integration

As we are by high frequency time series data it is necessary to test for stationarity of the variables

involved in above regressions. In case of non-stationarity, we require to illustrate that the variables of

similar order of integration are co integrated.

The after that step is to test for Co-integration flanked by IDIFF and F by Johansen‘s processes. Both the

maximum and trace Eigen value statistics strongly reject the null hypothesis that there is no co

integration flanked by the variables (i.e. r = 0), but do not reject the hypothesis that there is one co

integrating relation flanked by the variables (i.e. r = 1). Hence by least squares would yield super-

constant estimators. Note that DCALL is stationary and therefore can be incorporated as an exogenous

policy variable in the interest parity equation.

The calculated absolute value of t for the hypothesis test is 1.09, which is less than the critical value 2.

So we can accept the Ho at 5% stage of significance and conclude that CIP holds for the era under

consideration. This shows that short-term money markets (3-month) in India are receiving integrated

with global (US) money markets even however the integration is distant from perfect. We would have

liked to test the hypothesis for 1-month, 6-month and 1 year treasury bills, but a totally constant data set

is not accessible. In our view hybrid data sets do not give a intensive test (e.g. by 6 month forwards to

test integration flanked by one year securities).

Un-sheltered Interest Parity

The interest rate parity hypothesis postulates that with flexible swap rates and non-frictionless capital

markets the variation flanked by the yield on identical assets in two countries could be explained

through expected transform in the swap rate. Assuming perfect foresight we can test for uncovered

interest rate parity through regressing transform in mark swap rate on interest rate differential and

testing for the coefficient of interest rate differential being equal to 1.

Given that CIP has been shown to hold throughout the similar time era, this implies that the swap risk

premium for the Indian rupee is not zero (i.e. it is positive). There have been a number of recognized

external shocks throughout the nineties, such as the Mexican crisis and the Asian crises that lead to

heightened external uncertainty and increased foreign swap risk perception. These were also situations

in which the Central bank (RBI) intervened in the financial markets.

Swap Risk and RBI Intervention

As per the declared policy of the Reserve Bank of India (RBI), RBI intervenes to smooth out short term

fluctuations in demand-supply balances arising from lumpy demand for foreign swap (e.g. big

repayment of debt) that it thinks will lead to excessive volatility given the thinness of the market.

This intervention is commonly done by sale/purchase of foreign swap. If the behaviour of the RBI is

totally symmetric with zero sterilization, we would anticipate symmetric effects on call markets

(increased/reduced liquidity) and on forward rates (higher/lower reserves). The higher the degree of

sterilization the less the effect of foreign inflow on liquidity and more asymmetric the connection

flanked by call rates and forward rates (i.e. growing call rates have superior co-efficient than falling

ones). The RBI also intervenes to counter sharp adverse changes in expectations, like those arising from

domestic and global political growths (e.g. post Pokharan sanctions, Kargil war) and external crisis such

as the Mexican and Asian crisis. This intervention is commonly done by short-term instruments

(overnight and 7-day repos, bank rate/moral suasion of banks), and translates into sharp upward

movement in the inter-bank call money market rates. These in turn are reflected in a rise in foreign swap

forward rates. It is only at the time of the after that auction, though, that these growths get reflected in

the T-bill auction rates. Such tightening is usually followed in due course through a loosening to the

starting location, but forwards may not revert to the original stage given the residual uncertainty.

The estimated coefficient of the interest differential has now fallen from 0.65 to 0.58. Though, to see

whether it is statistically dissimilar from 1 we would perform the t- test for the restriction again. External

shocks and RBI swap market stabilization efforts by the short-term money market look to loosen the link

flanked by the domestic and foreign money markets.

The paper shows that the short-term (up to 3 month) money markets in India are receiving progressively

integrated with those in the USA even however the degree of integration is distant from perfect.

Sheltered interest parity is established to hold for while uncovered interest parity fails to hold. The

variation flanked by the two can be attributed to the subsistence of an swap risk premium in excess of

and above the expected depreciation of the currency. Analysis of RBI interventions in response to

foreign swap shocks suggests that these may play a role in the deviations from interest parity. Further

work requires to be done though on this as well as on instruments of other maturity such as 1 month and

6 month (for which constant data was not accessible).

REVIEW QUESTIONS

Explain the money market of India.

Discuss the Indian market size.

What are the effects and impacts of global integration of India‘s money market?

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