CHAPTER 1

WORKING CAPITAL –A THEORITICAL BACKDROP

1.1 Introduction

The value of an enterprise as measured with the help ofBalance-Sheet is considered as sufficient reflection of its assets.

“Although the term ‘asset’ denotes wealth, an entrepreneur may notlike to hold many assets. He prefers to hold fixed assets like plant &machinery, land & building etc. as these assets generate goods and services.But he would hate to hold current assets like debtors, stock or even cash.He would like to imagine himself in a situation where his productionprocess takes very little time to convert the input into finished goods whichgets sold immediately in cash the moment it rolls out of production process.But an entrepreneur’s dream is hardly realized. He finds instead that hisproduction process takes quite some time and quantity of finished goodsremains in stores. Moreover the sales are not always in cash - some amountof credit he has to give. Input market is so uncertain that he has to keepcertain amount of safety stock all the time. So whether an entrepreneurlikes it or not this entire process generates certain assets which are calledas ‘current assets”.(1) And the portion of capital invested in such currentassets to carry on day to day business operations is known as ‘WorkingCapital’.

(1) Hrishikesh Bhattacharya, Working Capital Management Strategies and Techniques,Prentice Hall Of India, New Delhi ,2005; Page No 1 and 2.

CHAPTER 1

WORKING CAPITAL – A THEORITICAL BACKDROP

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“The term ‘working capital’ is so much in use in common parlanceand is so much misunderstood”. (2)

There is no uniformity as regards to this concept amongst the users.The resulting confusion is probably intensified by the fact that the term‘working capital’ does not appear as such in the Balance-Sheet.

“However irrespective of this the fact remains that working capitalrepresents 65% of total assets of major companies around the world, makingit the largest component of capital employed.” (3)

Working capital is regarded as lifeblood of modern business. Themanagement of working capital plays an important role in maintaining thefinancial health of a business firm during the normal course of business. Itseffective provision can do much to ensure the success of a business unit.Effective working capital management helps in balancing the two sides ofBalance-Sheet in such a way that the net worth of business increases withoutincreasing the riskiness of business. However, efficient management ofworking capital is possible only if the user fully understands the meaningof the term working capital. The researcher therefore felt the need to elucidatethe meaning and definitions of working capital given by expert personalitiesand institutions.

1.2 Meaning and Definitions of Working Capital

Working capital is the amount of capital readily available to anorganization. It refers to an amount that is essential for day to day operations(2) Hrishikesh Bhattacharya, Working Capital Management Strategies and Techniques,

Prentice Hall Of India, New Delhi, 2005, Page No. xiii.(3) REL Consultancy for Finance, www.relcount.com

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of a business unit. Working capital is the amount of capital with thehelp of which every firm tries to maintain the flow of revenues fromoperations.

“The concept of working capital was perhaps first evolved by KarlMarx though in a different form when he introduced the concept of ‘variablecapital”. (4)

Guthmann and Dougall, corporate finance experts have definedworking capital as “excess of current assets over current liabilities.” Thisview was elaborated by Dr. Kolin Park and Professor J. W. Gladson whenthey defined working capital as “excess of current assets of business (cash,accounts receivables, inventories, for example) over current items owed toemployees and others (such as salaries and wages payable, accountspayable etc.)”

According to Keynes, “working capital is the aggregate ofgoods-in-production, including such minimum stocks, whether of rawmaterial or of finished products as are required to avoid risks or interruptionof process or to tide over seasonal irregularities.”(5)

Annual survey of industries defines working capital as “Stocks, work-in-progress, cash in hand and at bank and the net balance receivable overamounts payable at the end of accounting year.” (6)

(4) Hrishikesh Bhattacharya, Working Capital Management Strategies and Techniques,Prentice Hall Of India, New Delhi ,2005, Page No 2.

(5) Hrishikesh Bhattacharya, Working Capital Management Strategies and Techniques,Prentice Hall Of India, New Delhi ,2005, Page No 2.

(6) http://mospi.nic.in

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Having reviewed the meaning and definitions of working capital,the researcher found it relevant to highlight the important concepts anddeterminants of working capital.

l Gross Working Capital

It refers to the firm’s total investment in current assets. Currentassets are the assets which can be converted into cash within anaccounting year and includes cash, short term securities, debtors(accounts receivables), bills receivables and stock. According to thisconcept, working capital is the aggregate of current assets.

l Net Working Capital

It refers to the excess of current assets over current liabilities. Currentliabilities are those claims of outsiders which are expected to maturefor payment within an accounting year and include creditors (accountpayables), bills payable and outstanding expenses. Net working capitalis a qualitative concept which indicates the liquidity position offunds and the extent to which working capital needs may be financedby permanent sources of funds. It can be positive or negative. Apositive net working capital arises when current assets are greaterthan current liabilities. And a negative working capital occurs whencurrent liabilities are greater than current assets.

The gross and net working capitals are calculated as follows :

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Current Assets :Raw material inventory

(+) work-in progress(+) finished goods stock(+) debtors(+) Pre-paid expenses(+) bills receivables(+) short-term investments(+) cash and bank balances

= Gross Working CapitalLESS -Current Liabilities

Creditors for material(+) creditors for expenses(+) bills payable(+) tax liability(+) short term loans

= Net Working Capital

l Operating Cycle Concept- Working capital circulates in the businessand current assets change their form from one form to another. Thiscirculation of working capital is known as ‘working capital cycle’ or‘operating cycle’. The concept of operating cycle suggests that workingcapital can be determined by the length of cycle of operation. Thelength is measured by number of days required at each stage beginningfrom acquisition of raw material, its storage, conversion into finishedproducts, storage of finished goods, realization of money from debtors

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and credit period allowed by suppliers of goods and services. Thelength of operating cycle is calculated by aggregating all these periodsand adjusting for credit period allowed by creditors. Thus an operatingcycle is the time duration required to convert inventories into finishedgoods, finished goods into sales and sales into cash.The operating cycle of a manufacturing company involves threephases (7) :

1. Acquisition of resources such as raw material, labour, powerand fuel etc.

2. Manufacture of the product which includes conversion of rawmaterial into work-in-progress and work-in-progress intofinished goods.

3. Sale of product either for cash or on credit. Credit sales createaccounts receivable for collection

Calculation of Operating CycleOperating cycle = R+WIP+FG+D-C whereR= number of days raw material remains in store.This is calculated as follows :R= I/MI= average inventory (opening inventory + closing inventory)/2M= average daily material consumption (material consumed in ayear / 365days)

(7) Annual survey of Industries, Central Statistics Organization, Government ofIndia.

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WIP = number of days the materials are under production process.It is computed as follows :WIP= W/CW= average work in progressC= average daily cost of finished goods produced. (Annual cost of production/365 days)FG = number of days finished goods are in store.This is computed as follows:FG = G/FG = average finished goods in store. (Opening stock offinished goods + closing stock of finished goods) / 2F = average daily cost of finished goods sold.(Cost of finished goods sold annually / 365 days)D = credit period allowed to debtors.This is calculated as follows:D= Dr/SDr = average debtors (Opening debtors + closing debtors) / 2S = average daily credit sales during the year(Annual net credit sales / 365 days)C = credit period allowed by creditors.This is computed as follows:C = Cr / PCr = average creditors (Opening creditors + closing creditors) / 2P = average daily credit purchases during the year(Annual net credit purchases / 365 days)Hence operating cycle = I / M + W/C + G/F + Dr/S – Cr/P

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Diagram Showing Working Capital Cycle

Source: http://www.leadership-tools.com

l Fixed Working Capital -

The need for the current assets arises because of the operating cycle.Operating cycle is a continuous process, so need for current assetsis felt constantly. The need for investment in current assets mayincrease or decrease over a period of time according to changes inthe level of production. But there is a need for minimum amount ofworking capital, which is essential to carry business operations,irrespective of changes in the level of sales or production. Suchminimum level of working capital is known as ‘permanent workingcapital’ or ‘fixed working capital’.

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l Fluctuating Working Capital -

Depending upon the changes in the production and sales, the needfor working capital, over and above fixed working capital also changes.This extra capital needed to support the changing levels of activitiesof business over and above its fixed working capital is called as‘fluctuating working capital’ or ‘temporary working capital’.

Diagram Showing Concepts of Permanent andFluctuating Working Capital

Source: http://tutor2u.net

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1.3 Determinants of Working Capital -

Source: http://www.svtuition.org

There are no set rules or formulae to determine the working capitalrequirements of a firm. Following are the factors which generally influencethe working capital requirements of the firm (8) :

l Nature of Business –

Manufacturing and trading firms need more amount of working capitalthan service industries as their investment in stock (inventory andfinished goods) is more than service industries.

l Market and Demand Conditions –

The working capital needs of the firm are related to its sales. Growingfirms need working capital continuously to support enlarged scale ofoperations.

(8) Pande I. M., Financial Management, Tenth Edition, Vikas Publishing HousePvt. Ltd., New Delhi, 2010, Page Nos. 654 -656

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l Technology and Manufacturing Policy –

The manufacturing cycle (or the inventory conversion cycle) comprisesthe purchase and use of raw materials and production of finished goods.Longer the manufacturing cycle, larger will be the firm’s working capitalrequirements.

l Credit Policy –

The credit policy of the firm affects the working capital by influencingthe level of debtors.

l Credit From Suppliers –

The working capital requirements of the firm are also affected by creditterms granted by its suppliers. A firm will need less working capital ifliberal terms are available to it from the suppliers.

l Operating Efficiency –

The operating efficiency of the firm relates to the optimum utilizationof its resources at minimum cost. The use of working capital is improvedand pace of cash conversion cycle is accelerated with operating efficiency.

l Price Level Changes –

Generally, rising price levels requires a firm to maintain higher amountof working capital.

Thus there are many factors that influence the working capital needs ofa business firm. The importance of these determinants changes for a business

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firm over a period of time. The finance manager of the firm has to analyzerelevant determinants in order to decide the appropriate investment in theworking capital.

1.4 Management of Working Capital -

Working capital is the vital input of a business unit irrespective of itssize and nature. It is just like a nerve centre of human body. Unless the financialresources are free to flow into various activities of business, it cannot reap thereturns properly. So adequacy of working capital is a pre-requisite of anybusiness concern. “Management of working capital implies management indetermining the required amount, economical procurement and efficiency inutilization of the current assets” (9)

It refers to the administration of all components of working capital - cash,debtors, stock and payables. The financial performance of a business unit dependsultimately the way in which the working capital is mobilized and employed. Ascurrent funds are scarce and involve cost they have to be employed carefully,efficiently and effectively. Therefore it is essential to have a prudent managementof working capital. Effective provision and management of working capital cando much to ensure the success of business unit.

The working capital position of an organization is often considered asan index of state of health of a company. A comfortable working capital positiongenerally indicates good health, while stringent working capital indicatessymptoms of strain for a business unit.

(9) Dr. Ghosh Arindam “Working Capital Management Practices in some SelectedIndustries in India”, The Management Accountant, Vol. 42 January 2007,

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So efficient handling of current assets as well as current liabilities isabsolutely essential to maintain optimum level of working capital funds.

Inadequate or excessive working capital is very detrimental to the healthof a business unit. In fact it is challenging task for any business organization tomaintain equilibrium between profitability and liquidity, which are the mostvital determinants of the success of the business firm. Therefore efficientmanagement of working capital has become an important consideration inrunning business undertakings.

Following are the two important aspects of working capitalmanagement :

1. Short life span of each component of working capital.

2. Swift transformation into other forms of assets.

These aspects have following implications :

1. Decisions relating to working capital management are repetitiveand frequent.

2. The close interaction among working capital components impliesthat efficient management of one component cannot beundertaken without simultaneous consideration of othercomponents.

Thus a financial manager has to see that right resources are tapped tofinance current assets and current liabilities are paid in time.

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There are many aspects of working capital management which makeit important function of the financial manager (10) :

1. Time -

Working capital management requires much of financial manager’stime. Empirical observations show that the financial managers haveto spend much of their time to the daily internal operations, relatingto current assets and current liabilities of the firm.

2. Investment -

Working capital represents a large portion of the total investment incurrent assets. So a financial manger has to pay special attention tothe management of current assets on a continuing basis.

3. Criticality -

Working capital management has a great significance for all firmsbut it is very critical for small firms.

4. Growth -

The need for working capital is directly related to the firm’s growth.As sales grow, the firms need to invest more in inventories anddebtors. These needs become frequent and fast when the sales growcontinuously.

(10) I. M. Pande, Financial Management, Tenth Edition,Vikas Publishing HousePvt. Ltd., New Delhi, 2010, Page Nos. 656 -657

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Thus all precautions should be taken for the effective and efficientmanagement of working capital. The finance manager should payparticular attention to the levels of current assets and the financing ofthe current assets.

1.5 Working Capital Financing Approaches

There are four basic approaches for determining an appropriateworking capital financing mix.

Chart Showing Working Capital Financing Approaches

l The Hedging or Matching Approach -

According to this approach the firm adopts a financial planwhich matches the expected life of an asset with expected life ofsource of funds raised to finance asset. Matching approach providesan offset for each asset in a balance-sheet with a financial instrumentof same maturity. Thus, a five year loan may be raised to financemachinery with an expected life of five years and stock of goods tobe sold in a month may be financed with a bank loan of one month.When this approach is followed long term financing is used to financefixed and permanent current assets and short term financing is usedto finance temporary or variable current assets. The working capitalfinancing strategy as per this approach is as follows :

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Long Term Funds = Fixed assets +Total permanent current assets

Short Term Funds = Total temporary current assets

But the application of this approach is not as simple as itappears because in practice the uncertainty associated with the livesof individual assets makes the matching approach difficult toimplement.

l The Aggressive Approach -

As per this approach the entire estimated requirements ofcurrent assets are financed through short term sources of finance.This is non-conservative approach which makes the finance morerisky. This approach suggests that current assets are maintained justto meet the current liabilities without keeping any margin forvariations in working capital needs. The working capital financingstrategy as per this approach is as follows :-

Long Term Funds = Fixed assets+ Part of permanent current assets

Short Term Funds = Part of permanent current assets+ Total temporary current Assets

But the firm that uses this approach has to refund the debtmore frequently, and this increases the risk that it will be unable toobtain new financing as needed. In addition to this the greaterpossibility of interest rate fluctuations associated with this financingadds to the firm’s risk.

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l The Conservative Approach -

This approach suggests that the entire estimated investmentin current assets should be financed through long term sources offinance and short term sources should be used only for emergencyrequirements. This approach suggests that risk should not be takenin working capital management and business firm should carry highlevels of current assets in relation to sales. This approach believesthat surplus current assets enable the firm to absorb sudden variationsin levels of pre-determined business operations. The working capitalfinancing strategy as per this approach is as follows:-Long Term Funds = Fixed assets

+ Total permanent current assets+ part of temporary current assets.

Short Term Funds = Part of temporary current assets.

This approach reduces the risk associated with interest ratefluctuations.

l Zero Working Capital Approach -

This is one of the latest trends in working capital management.This approach suggests that at all times the current assets should beequal to current liabilities of the business organization. Excessiveinvestment in current assets is avoided and firm meets its currentliabilities out of the matching current assets. This approach helpsbusiness firm to have self-imposed financial discipline which resultsin smooth and uninterrupted working capital cycle. The workingcapital financing strategy as per this approach is as follows :-

Total Current Assets = Total Current Liabilities

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Thus, there is a conflict between different working capitalfinancing approaches. The choice between short and long termfinancing involves a trade-off between risk and return. The financemanager has to strike a right balance which is crucial to the workingcapital management.

Diagram showing Working Capital Financing Approaches

Continued on next page

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Diagram showing Working Capital Financing Approaches (continued)

Source: http://mupfc.marshall.edu

1.6 Current System of Working Capital Finance

Working capital management is a process of planning and controllingthe level and the mix of current assets of company as well as financingthese assets. (11)

The investment in raw materials, stock-in-progress, finished goods,and receivables (principal constituents of current assets) often varies a greatdeal during the course of the year. Hence, the financial manager generallyspends a good chunk of his time in finding money to finance current assets.Thus two major issues that are involved in managing firm’s use of shortterm financing are:1. How much short term financing should the firm use?2. What specific sources of short term financing should be selected?(11) Bhalla.V.K., Working Capital Management Text and Cases, Anmol Publications

Pvt. Ltd., New Delhi, 1998, Page No 1.

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Generally the following two basic factors are considered while selectingthe short term finance :

1. Effective cost of credit

2. Availability of credit considering amount needed and the periodof time when the finance is required

Most business organizations depend upon banks and financialinstitutions for financing their working capital needs.

The nature of credit provided for working capital needs of businessorganizations is both secured and unsecured.

Secured Sources of Working Capital Finance -

Secured sources of working capital finance involve a pledge of specificassets given as a collateral in case the borrower defaults in payment ofprinciple or interest. Secured borrowings give the lender a claim on a specificset of assets in case of default. Hence secured credit arrangement offers anadded margin of safety to the lender. These sources include both pre-saleand post-sale finance.

Pre-sale Working Capital Finance –

This source includes finance against raw material or finished goods.The assets like inventories are used as collateral for short term loans. Theamounts of loan that can be obtained depend on both the marketabilityand perishability of inventory. Raw material may have commodity value.

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Finished goods inventory may be converted to cash at a reasonable value.And work-in-progress has very little value. So generally raw material servesas an excellent source of collateral, since it can be easily liquidated.

Post Sale Working Capital Finance -

This source includes finance against book debts, bill purchasing anddiscounting and invoice discounting. From lender’s standpoint, accountsreceivable represent a desirable form of collateral as they are relativelyliquid and their value is relatively easy to recover if the borrower becomesinsolvent. Many companies use accounts receivable as collateral for shortterm financing by either pledging their receivables or factoring them.Generally borrower firm gets full credit for bill amount in case of billdiscounting or purchasing. Whereas when finance is provided againsthypothecation of outstanding book debts an appropriate margin is retainedby banks or financial institutions. Finance is also provided against thesupply bills which are supported by invoice and delivery challans aftermaintaining an appropriate margin.

Unsecured Sources of Working Capital Finance -

These sources include all those sources that have lender’s faith inability of borrower to repay the funds when due as security.

The unsecured sources of working capital finance include bothnegotiated and spontaneous finance.

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Spontaneous finance -

The finance which naturally arises in the course of business is calledas spontaneous finance. This source includes trade credit. Trade credit isone of the most flexible sources of working capital finance available to abusiness firm. The dependence on this source is higher due to negligiblecost of finance as compared to negotiated finance. Particularly, small firmsare heavily dependent on trade credit as a source of short term financesince they find it difficult to raise funds from banks or other sources.Trade credit is a facility whereby business firm is allowed by supplier todefer the immediate payment to a definite future period. If a buyer firmis able to get credit without any legal evidence or instrument, it is termedas ‘open account trade credit’ and appears as ‘sundry creditors’ in theBalance-Sheet of buyer firm. Whereas when the credit is provided againsta legal instrument, notably negotiable instrument in acknowledgement ofdebt, the same appears as ‘bills payable’ in the Balance-Sheet of buyerfirm. The main advantages of spontaneous credit are easy availability,flexibility and informality. Even though the spontaneous credit appearsto be cost-free since it does not involve explicit interest charges, it doesinvolve implicit cost. The cost of credit may be transferred to the buyervia the increased cost of goods supplied by the seller.

Negotiated finance -

Finance which has to be negotiated with lender, say, bank orfinancial institution is called as ‘negotiated finance’. Such working capitalfinance is self-liquidating in nature. Borrowing occurs when business firm

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has high financial needs and the credit is liquidated as the requirementsdecrease.

1.7 Bank Finance for Working Capital

Most business organizations depend upon banks for financing theirworking capital requirements. Banks in India today constitute as majorsuppliers of working capital credit to any business activity and areconsidered as main institutional source of working capital finance.

Bank finance for working capital consists of several types of creditarrangements. The actual type of working capital financing by banks changesfrom case to case, depending upon the convenience and requirements ofborrower. Each type has a unique combination of maturity, interest rate,fees, collateral required and the conditions under which the credit can becalled or revoked.

But generally banks provide working capital using one or more ofthe following modes:

l Overdraft

Under this facility, the borrower is allowed to withdraw funds inexcess of the balance in his current account, up to a certain specifiedlimit, during a stipulated period of time. Though overdrawn amountis repayable on demand, it generally continues for a long period byannual renewals of the limits. It is a very flexible mode of workingcapital finance as the borrower can repay the amount, partially orfully, as and when he desires. The interest is charged only on runningbalance and not on the limit sanctioned.

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l Cash credit

It is facility similar to overdraft arrangement. Under this facility,borrower is allowed to withdraw funds from the bank up to a certainsanctioned credit limit. These limits are sanctioned against the securityof current assets. The borrower can draw as often as required providedthe outstanding do not exceed the cash credit limit. There are nocommitment charges so the interest is charged on the funds actuallyutilized by the borrower.

l Working capital Loans

These are advances of fixed amounts which are credited to the currentaccount of the borrower or released to him in cash. The borrower ischarged with interest on the entire amount of loan, irrespective ofhow much he draws. Generally these loans are availed by borrowerto meet unforeseen contingencies. The borrower is required to payhigher rate of interest above the normal rate on such credits.

l Purchase/discount of bills

Under the purchase or discounting of bills, borrower can obtain creditfrom a bank against its bills. When the banks discounts/purchasesthe bill of exchange it releases the funds to the seller. The bankpresents the bill to the purchaser on the due date and gets its payment.The amount provided under this facility is covered within the overallcash credit or overdraft limit. Reserve Bank Of India has issuedguidelines from time to time to encourage bill financing.

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l Line of credit

It is generally an informal agreement or understanding between theborrower and the bank. Under this type of agreement there is nolegal commitment on part of bank to provide the stated credit. Itgenerally covers the period of one year corresponding to theborrower’s fiscal year and represents an ongoing relationship withthe bank. It may be renewed as per the needs of the borrower. Lineof credit generally requires the borrower to maintain a minimumbalance in the bank throughout the loan period. This minimum balancewhich is normally stated as a percent of the line of credit increasesthe effective cost of credit.

l Transaction loan

Under this arrangement the loan is made available for specific purpose.The loan is obtained by signing a demand promissory note, usuallybacked by third party guarantee, agreement of hypothecation of stockheld / acquired with the loan amount, and agreement for non-diversion of sale proceeds. For a transaction loan no tangible securityis provided by borrower to the bank.

l Letter of credit (L/C)

Letter of credit is a guarantee from a bank stating that a loan will bemade to the client if specified conditions are met. It commonly usedin international trade. Under this arrangement the supplier insiststhat the buyer should ensure that his bank will make payment if hefails to meet his financial obligations. A bank opens a L/C in favor

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of the customer to facilitate his purchase of goods. Thus the risk ispassed on to the bank. Bank charges the customer for opening theL/C.

Thus banks are playing an important role in working capitalfinancing. They are providing the infrastructure on which the growthof business and industry depends as far as their financial needs areconcerned. So banking industry has to respond to the changes in thefield of trade and business by introducing integrated package ofdiverse financial services.

1.8 Working capital control and banking policy

The purpose of bank lending in India has traditionally been seen asthe provision of short term finance for business. Banks have been providingthe working capital finance to meet short term financial needs of Indiancorporate sector and they are following certain norms while granting theworking capital finance. To ensure smooth flow of credit from banks toindustries, Reserve Bank of India has constituted various committees toreview prevailing norms pertaining to flow of credit from banking sectorto industries from time to time.

The following is the review of some prominent committees alongwith their recommendations:-

Till mid-1970s the principal of bank lending in India waspredominantly security oriented. It was more or less net worth based,collaterised financing. In 1969 major banks were nationalized and with thatthe approach to lending was also changed.

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In 1974, a study group under the chairmanship of P.L. Tandon wasformed to examine the existing methods of lending and suggest the guidelinesfor the rational allocation and optimum use of bank credit. The groupsubmitted its report in August 1975, popularly known as ‘Tandon CommitteeReport’. This report is considered as landmark in the history of bank lendingin India. The committee pointed out that the misuse of funds and doublefinancing was easily possible under the existing system of bank financebased on cash credit system. Breaking away from traditional methods ofsecurity oriented lending, the committee pointed out that the best securityfor bank loan is a well-functioning business enterprise and not collaterals.Committee suggested three ways to determine the maximum permissiblelevel of bank borrowings. It also suggested that the borrower be allowedto retain only the reasonable level of current assets, particularly inventoryand receivables. The committee gave the norms for inventory and receivablesin different industries.

In 1979, Reserve Bank of India constituted another working groupunder the chairmanship of K. B. Chore. The group submitted its report inAugust 1979. The group worked within the framework of lending systemproposed by Tandon Committee. The committee was set up to review theoperation of the cash credit system with reference to the gap betweensanctioned credit limits and the extent of their utilization. The committeesuggested that the borrowers should contribute more funds to financeworking capital and reduce dependence on bank credit, banks shouldappraise and fix separate limits for the ‘peak level’ and ‘normal-non-peaklevel’ and the existing system of three types of lending : cash credit, loansand bills should continue.

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In 1982, it was felt that an independent review of Credit AuthorizationScheme, which had been in operation for several years, would be usefuland accordingly Reserve Bank of India appointed a committee in November1982 to review the working of Credit Authorization Scheme (CAS). Thecommittee which came to be referred as ‘Marathe Committee’ submitted itsreport in July 1983. The major recommendations of this committee were inthe area of providing incentive for borrowers to comply with all therequirements of the scheme and for the banks to improve the quality ofcredit appraisal. The committee stressed that the CAS (Credit AuthorizationScheme) should not be looked upon as a mere regulatory measure andbanks be allowed discretion to deploy credit in CAS cases. The committeepointed out that the basic purpose of CAS is to ensure orderly creditmanagement and improve quality of bank lending so that all borrowings,whether large or small, are in conformity with the policies and prioritieslaid down by the Central Banking Authority.

In 1993, a study group was instituted by Reserve Bank of Indiaunder the chairmanship of Mr. Vaz. The group recommended that the banksshould device their own methods and tools for undertaking the risk analysisand pricing of loans to be sanctioned to the units.

With a view to free the banks from rigidities of Tandon Committeerecommendations in the area of working capital finance and consideringthe ongoing liberalizations in financial sector, Indian Banking Associationconstituted a committee on ‘working capital finance’ including ‘assessmentof maximum permissible bank finance’, headed by Mr. K. Kannan. Thecommittee submitted its report to IBA (Indian Banking Association) on 25 thFebruary 1997. The committee examined all aspects of working capital

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finance and came up with far reaching recommendations on modalities ofassessment of working capital finance. The committee felt that line of creditsystem should replace the existing system of assessment / fixation of sub-limits within total capital requirement.

A line of credit is not a credit facility per se, it is an outer limit fortotal working capital finance and within this outer limit various types ofworking capital fund based as well as non-fund based credit facilities withappropriate limit should be made available to borrower (12). The committeepointed out that in view of current deregulations and liberalizations, thebanks should handle their credit administration considering their riskperceptions, risk analysis and risk forecasting. The committee suggestedthat the existing system of assessment of working capital finance may bereplaced by a new system of assessment of working capital finance.

Today the working capital finance available to industry and businessis subject to following guidelines issued by Reserve Bank of India.(13) .

l Reserve Bank Of India has withdrawn the concept of maximumpermissible bank finance in April 1997.

l Banks are now free to evolve their own method for assessing workingcapital requirements of borrowers, within the prudential guidelinesand exposure norms prescribed by Reserve Bank of India.

l Banks have to formulate lending basis considering the Reserve BankOf India instructions relating to:-

(12) Bhalla V. K., Working capital management text and cases, Anmol PublicationsPvt Ltd., New Delhi, 1998, Page No 629.

(13) Ravi Kishore, Financial Management, Tan Prints (India) Pvt. Ltd., 2007,Page No. 354

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l Direct credit such as priority lending, export etc.

l Quantitative limit on such financing against shares, financing forconsumer durables etc.

l Prohibition of credit such as bridge finance, rediscounting of billsearlier discounted by Non-banking Financial Institutions etc.

l In respect of borrowers enjoying fund based working capital limit ofRs. 5 crore and above banks are required to finance minimum of25% of credit sales by way of bills discounting/purchasing.

l Banks may while sanctioning / renewing credit limits to large corporateborrowers who are enjoying working capital limit of Rs. 10 croreand above, fix separate sub-limit within overall limit, specially formeeting payment obligations in respect of purchases from small scaleindustries either on cash or on bill basis.

l Loan system is applicable to borrowers enjoying working capitallimit of Rs. 10 crore and above. Banks will have to fix a minimumlevel of loan component at 80%. Banks are given freedom to changethe composition of working capital finance by increasing the cashcomponent beyond 20% or increasing loan component beyond 80%.

Thus the norms or guidelines that are followed by the banks whileproviding working capital finance have been greatly influenced by therecommendations of these committees.

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1.9 Supply chain and working capital financing

Today’s business is witnessing a swift expansion in trade. Dynamic,collaborative and trusting alliance relationships and networks are keys tothe survival and success in 21st century. Today many firms are making aconscious decision to par down the organization and to focus more oncore capabilities while trying to create alliance or strategic partnershipswith suppliers, transport and warehousing companies and distributors whoare good at what they do. This team approach of making and distributingproducts and services is becoming most effective and efficient way of doingbusiness to stay successful.

Many companies now work in seamless end-to-end networks frombuying raw material to selling finished products to end consumers,integrating and sharing information with suppliers and distributors. Thishas given them a great improvement in efficiency, margins, cost and qualitycontrol. Companies today may trade with dozens or even hundreds ofsuppliers and customers located in different places.

So along with information technology, engineering, marketing andoperations, finance has to play a critical enabling role in this quest forvalue added relationship. Channel partners of large business corporations(suppliers, dealers, distributors, transporters, warehousing companies andafter sales service providers) have realized that unless they manage theirfinances smartly, sustaining high growth will be tough. To maintain thepace of growth, channel partners need substantial amount of working capital.Non availability of working capital finance could seriously hamper theirgrowth and in turn, that of industry. The banks/financial institutions are

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generally not concerned as to how the other channel partners are financingtheir activity.

Dr. Venkatramani in her publication entitled “Facility of factoringservices” has mentioned certain limitations of bank financing identified bythe study group appointed by Reserve Bank of India headed by C.S.Kalyanasundaram. (14) For a supplier, there is a tremendous pressure onworking capital. Most suppliers especially from ‘small industries sector’cannot afford separate staff for credit sales administration and collection.Consequently they have to utilize the important man hours in this exercisewhich could have otherwise been utilized for increasing production andsales development. Amongst the members of supply chain, the OriginalEquipment Manufacturers are dominant purchasers and in many cases thepayment schedule and fancies of Original Equipment Manufacturersdominate the entire process of supply chain. The slackness in the paymentsystem is widespread and has a spin-off effect because poor collectionfrom debtors results in poor payments to creditors”.

Thus as a supply chain grows, it needs a financial solution to supportit. In recent past, there has been a quiet revolution in the way companiesmanage and optimize their physical supply chain using the trade financeproducts alongside.

After this elaboration, the researcher narrows down to ChannelFinancing – a facility of working capital finance for detailed study.

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(14) Dr. Venkataramani, Facility of Factoring Services, A Guna Gaurav NyasPublication – Think Line, Nashik, publication no. 32, 2004

BOOKS :-

1. Hrishikesh Bhattacharya, Working Capital Management Strategiesand Techniques, Prentice Hall Of India, New Delhi ,2005

2. V. K. Bhalla, Working Capital Management Text and Cases, AnmolPublications Pvt. Ltd., New Delhi, 1998

3. H.P.S. Pahwa, Bank Finance to Business and Industry, Vinod LawPublications, Lucknow, 1998

4. Krish Rangarajan and Anil Misra, Working Capital Management,Excel Books, New Delhi, 2005

5. Prasanna Chandra, financial Management Theory and Practice, TataMcGraw-Hill Publishing Company limited, New Delhi, 2003

6. Dr. K. J. Reddy and Dr. D. Himachalam, Working Capital Managementin Consumer Co-operatives, The associated Publishers, AmbalaCantt., 2006

7. I.M. Pande, Financial Management, Tenth Edition,Vikas PublishingHouse Pvt. Ltd., New Delhi, 2010,

8. Ravi Kishore, Financial management, Tan Prints(India) Pvt. Ltd.,2007

9. Dr. Venkataramani, Facility of Factoring services, A Guna GauravNyas Publication – Think Line, Nashik, publication no. 32, 2004

REFERENCES

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ARTICLES :-

1. The management Accountant, vol.42 January 2007, Dr. Arindam Ghosh,“Working capital management practices in some selected industriesin India”

2. Annual Survey Of Industries, Central Statistical organization, Govt.Of India, pg.1

3. Financing of working capital in textile industry in India, Nand KishorSharma, Finance and Accounting issues and perspectives for 21stcentury,

4. Working capital leverage management: case analysis, R. L. Hyderabad,Contemporary issues in Accounting, RBSA publishers, Jaipur, 2003.

WEB SITES :-

1. REL Consultancy for finance, www.relcount.com

2. http://www.leadership-tools.com

3. http://tutor2u.net

4. http://mospi.nic.in

5. http://www.svtuition.org

6. http://mupfc.marshall.edu

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