MANAGEMENT OF

WORKING CAPITAL

© The Institute of Chartered Accountants of India

This chapter is Divided into Six Units:

UNIT I: Introduction to Working Capital Management

UNIT II: Treasury and Cash Management
UNIT III: Management of Inventory
UNIT IV: Management of Receivables
UNIT V: Management of Payables
UNIT VI: Financing of Working Capital
 MANAGEMENT OF WORKING CAPITAL 10.3

INTRODUCTION TO WORKING CAPITAL

MEANING AND CONCEPT OF WORKING

CAPITAL
 In accounting term working capital is defined
as the difference between current assets and
current liabilities. If we break down the

Working Capital = Current Assets – Current Liabilities

components of working capital we will find

working capital as follows:

 Working capital means the funds (i.e.; capital) available and

used for day to day operations (i.e.; working) of an enterprise.

 It consists broadly of that portion of assets of a business which are

used in or related to its current operations. It refers to funds which
are used during an accounting period to generate a current
income of a type which is consistent with major purpose of a firm
existence.
 FINANCIAL MANAGEMENT

CLASSIFICATION OF WORKING CAPITAL

WORKING CAPITAL

On The Basis of Concepts On The Basis of Time

Gross Working Net Working Permanent / Fixed Temporary /

Capital Capital Working Capital Fluctuating
Working Capital

Initial Working Regular Working

Capital Capital

Seasonal Working Special Working

Capital Capital
I. On The Basis of Concepts
1) Gross Working Capital
 Gross working capital is the amount of funds invested
in various components of current assets.
 Current assets are those assets which are easily /
immediately converted into cash within a short period
of time say, an accounting year.
 Current assets includes Cash in hand and cash at
bank, Inventories, Bills receivables, Sundry debtors,
short term loans and advances.

2) Net Working Capital

 Net working capital is the excess of current assets over
current liability, or, say:
 NET WORKING CAPITAL = CURRENT ASSETS – CURRENT
LIABILITIES.
 Net working capital can be positive or negative.
 When the current assets exceeds the current
liabilities are more than the current assets.
 Current liabilities are those liabilities, which are
intended to be paid in the ordinary course of business
within a short period of normally one accounting year
out of the current assts or the income business.

CONSTITUENTS OF CURRENT ASSETS

1) Cash in hand and cash at bank
2) Bills receivables
3) Sundry debtors
4) Short term loans and advances
5) Inventories of stock as:
i) Raw material
 ii) Work in process
iii)Stores and spares
iv) Finished goods
6. Temporary investment of surplus funds.
7. Prepaid expenses
8. Accrued incomes.
9. Marketable securities.

CONSTITUENTS OF CURRENT LIABILITIES

1. Accrued or outstanding expenses.
2. Short term loans, advances and deposits.
3. Dividends payable.
4. Bank overdraft.
5. Provision for taxation, if it does not amt. to app. of profit.
7. Sundry creditors
II On The Basis of Concepts
1) Permanent / Fixed Working Capital
 Permanent or fixed working capital is minimum amount which
is required to ensure effective utilization of fixed facilities and
for maintaining the circulation of current assets.
 Every firm has to maintain a minimum level of raw material,
work- in-process, finished goods and cash balance, as this part
of working is permanently blocked in current assets.
 As the business grow the requirements of working capital also
increases due to increase in current assets.
a) Initial working capital
 At its inception and during the formative period of its
operations a company must have enough cash fund to
meet its obligations.
 The need for initial working capital is for every company
to consolidate its position.
b) Regular working capital
 Regular working capital refers to the minimum amount of liquid
capital required to keep up the circulation of the capital from the
cash inventories to accounts receivable and from account
receivables to back again cash.
 It consists of adequate cash balance on hand and at bank, adequate
stock of raw materials and finished goods and amount of
receivables.

2) Temporary / Fluctuating Working Capital

 Temporary / Fluctuating working capital is the working capital
needed to meet seasonal as well as unforeseen requirements. It may
be divided into two types.
a) Seasonal Working Capital
 There are many lines of business where the volume of operations are
different and hence the amount of working capital vary with the
seasons.
 The capital required to meet the seasonal needs of the enterprise is
known as seasonal Working capital.
 b) Special Working Capital

The Capital required to meet any special operations such as experiments with new
products or new techniques of production and making interior advertising campaign
etc.

The following diagrams shows Permanent and

Temporary or Fluctuating or variable working capital:

Both kinds of working capital i.e. permanent and

fluctuating (temporary) are necessary to facilitate
production and sales through the operating cycle.
 SIGNIFICANCE OF WORKING CAPITAL

Importance of Adequate Working Capital

1. Solvency of the business: Adequate working capital helps in

maintaining the solvency of the business by providing

uninterrupted of production.

2. Goodwill : Sufficient amount of working capital enables a firm

to make prompt payments and makes and maintain the

goodwill.

3. Easy loans: Adequate working capital leads to high solvency

and credit standing can arrange loans from banks and other on

easy and favorable terms.

4. Cash discounts: Adequate working capital also enables a

concern to avail cash discounts on the purchases and hence

reduces cost.

5. Regular Supply of Raw Material: Sufficient working capital

ensures regular supply of raw material and continuous

production.
6. Regular payment of salaries, wages and other day to day

commitments: It leads to the satisfaction of the employees and

raises the morale of its employees, increases their efficiency,

reduces wastage and costs and enhances production and profits.

7. Exploitation of favorable market  conditions: If a firm is

having adequate working capital then it can exploit the

favorable market conditions such as purchasing its requirements

in bulk when the prices are lower and holdings its inventories

for higher prices.

8. Ability to Face Crises: A concern can face the situation during

the depression.

9. Quick and regular return on investments: Sufficient

working capital enables a concern to pay quick and regular of

dividends to its investors and gains confidence of the investors

and can raise more funds in future.

10.High morale: Adequate working capital brings an environment

of securities, confidence, high morale which results in overall

efficiency in a business.
DETERMINANTS OF WORKING CAPITAL

Cash

Price Level
Changes Inventory

Operating Factors to be
Efficiency Receivables
considered while
planning for
Working Capital
requirement
Technology
Short-term
and Financing
Manufac
tur Options
ing Policies
Market
andNature of
DemandBusiness Conditions

Some of the factors which need to be considered while planning for working capital
requirement are:

1. Cash – Identify the cash balance which allows for the business to meet day-
to-day expenses, but reduces cash holding costs (example - loss of interest
on long term investment had the surplus cash invested therein).
2. Inventory – Identify the level of inventory which allows for uninterrupted
production but reduces the investment in raw materials and hence increases
cash flow. The techniques like Just in Time (JIT) and Economic order quantity
(EOQ) are used for this.
3. Receivables – Identify the appropriate credit policy, i.e., credit terms which
will attract customers, such that any impact on cash flows and the cash
conversion cycle will be offset by increased revenue.

4. Short-term Financing Options – Inventory is ideally financed by credit

granted by the supplier. However, depending on the cash conversion cycle, it
may be necessary to utilize a bank loan (or overdraft), or to “convert debtors
to cash” through “factoring” in order to finance working capital requirements.
5. Nature of Business - For e.g. in a business of restaurant, most of the sales
are in Cash. Therefore, need for working capital is very less. On the other
hand, there would be a higher inventory in case of a pharmacy or a bookstore.
6. Market and Demand Conditions - For e.g. if an item’s demand far exceeds its
production, the working capital requirement would be less as investment in
finished goods inventory would be very less with continuous sales.
7. Technology and Manufacturing Policies - For e.g. in some businesses the
demand for goods is seasonal, in that case a business may follow a policy
for steady production throughout the whole year or rather may choose a
policy of production only during the demand season.
8. Operating Efficiency – A company can reduce the working capital
requirement by eliminating waste, improving coordination, process
improvements etc.
9. Price Level Changes & Exchange Rate Fluctuations – For e.g. rising prices
necessitate the use of more funds for maintaining an existing level of activity.
For the same level of current assets, higher cash outlays are required.
Therefore, the effect of rising prices is that a higher amount of working capital
is required. Another example would be unfavorable exchange rate movement
in case of imported raw materials would warrant additional cost of same.
 MANAGEMENT OF WORKING CAPITAL
 The working capital needs adequate attention and efficient management.
When we talk about the management, it involves 3 Es i.e. Economy,
Efficiency and Effectiveness and all these three are required for the working
capital management.

The scope of working capital management can be grouped into two broad areas (i)
Profitability and Liquidity and (ii) Investment and Financing Decision.

Scope of Working Capital Management

Liquidity and Profitability Investment and Financing

Liquidity and Profitability

 For uninterrupted and smooth functioning of the day to day business of
an entity it is important to maintain liquidity of funds evenly. As we have
already learnt in previous chapters that each rupee of capital bears some cost.
 So, while maintaining liquidity the cost aspect needs to be borne in mind.
Also, a higher working capital may be intended to increase the revenue &
hence profitability, but at the same time unnecessary tying up of funds in
idle assets not only reduces the liquidity but also reduces the opportunity to
earn better return from a productive asset.
 Hence, a trade-off is required between the liquidity and profitability which
increases the profitability without disturbing the day to day functioning. This
requires 3Es as discussed above i.e. economy in financing, efficiency in
utilisation and effectiveness in achieving the intended objectives.
The trade-off between the components of working capital can be summarised as
follows:

Component Advantages of Trade-off Advantages of

of Working higher side (between lower side
Capital (Profitability) Profitability and (Liquidity)
Liquidity)
Inventory Fewer stock-outs Use techniques Lower inventory
increase the like EOQ, JIT etc. requires less capital
profitability. to carry optimum but endangered
level of inventory. stock-out and loss of
goodwill.
Receivables Higher Credit Evaluate the Cash sales provide
period attract credit policy; use liquidity but fails to
customers and the boost sales and
increase revenue revenue (due to lower
services of credit period)
debt management
(factoring)
agencies.
Pre- payment Reduces uncertainty Cost-benefit Improves or
of expenses and analysis required maintains liquidity.

profitable in
inflationary
environment.
Cash and Payables are Cash budgets and Cash can be invested
Cash honoured in time, other in some other
equivalents improves the investment avenues
goodwill and cash management
helpful in getting techniques can be
future discounts. used
Payables and Capital can be used in Evaluate the Payables are
Expenses some other credit policy and honoured in time,
investment avenues related cost. improves the
goodwill and helpful
in getting future
discounts.
 Approaches of working capital investment
Based on the organisational policy and risk-return trade off, working capital
investment decisions are categorised into three approaches i.e. aggressive,
conservative and moderate.

Approaches of Working Capital Investment

Agrressive Moderate Conservative

(a) Aggressive:
 Here investment in working capital is kept at minimal investment in current
assets which means the entity does hold lower level of inventory, follow strict
credit policy, keeps less cash balance etc.
 The advantage of this approach is that lower level of fund is tied in the
working capital which results in lower financial costs but the flip side could be
risk of stock-outs & that the organisation could not grow which leads to
lower utilisation of fixed assets and long-term debts. In the long run firm may
stay behind the competitors.
(b) Conservative:
 In this approach, organisation choose to invest high capital in current assets.
Organisations use to keep inventory level higher, follows liberal credit
policies, and cash balance as high as to meet any current liabilities
immediately.
 The advantages of this approach are higher sales volume, increased demand
due to liberal credit policy and increase goodwill among the suppliers due
to payment in short time. The disadvantages are increase cost of capital,
inventory obsolescence, higher risk of bad debts, shortage of liquidity in
long run due to longer operating cycles.
(c) Moderate:
This approach is in between the above two approaches. Under this approach a
balance between the risk and return is maintained to gain more by using the funds in
very efficient manner.
ESTIMATING WORKING CAPITAL NEEDS
Operating cycle is one of the most reliable methods of Computation of Working
Capital.
However, other methods like ratio of sales and ratio of fixed investment may also
be used to determine the Working Capital requirements. These methods are briefly
explained as follows:
(i) Current Assets Holding Period: To estimate working capital needs based
on the average holding period of current assets and relating them to costs
based on the company’s experience in the previous year. This method is
essentially based on the Operating Cycle Concept.
(ii) Ratio of Sales: To estimate working capital needs as a ratio of sales on the
assumption that current assets change with changes in sales.

(iii) Ratio of Fixed Investments: To estimate Working Capital requirements as a

percentage of fixed investments.
OPERATING OR WORKING CAPITAL CYCLE
A useful tool for managing working capital is the operating cycle.
The operating cycle analyses the accounts receivable, inventory and accounts
payable cycles in terms of number of days. For example:
 Accounts receivables are analyzed by the average number of days it takes
to collect an account.
 Inventory is analyzed by the average number of days it takes to turn over
the sale of a product (from the point it comes in the store to the point it
is converted to cash or an account receivable).
 Accounts payables are analyzed by the average number of days it takes to
pay a supplier invoice.
Operating/Working Capital Cycle Definition
 Working Capital cycle indicates the length of time between a company’s
paying for materials, entering into stock and receiving the cash from sales
of finished goods.
 It can be determined by adding the number of days required for each stage in
the cycle. For example, a company holds raw materials on an average for
60 days, it gets credit from the supplier for 15 days, production process
needs 15 days, finished goods are held for 30 days and 30 days credit is
extended to debtors. The total of all these, 120 days, i.e., 60 – 15 + 15 + 30 +
30 days is the total working capital cycle.

Working Capital Cycle

Cash

Receivables Raw Material Labour

Overhead

Stock WIP
 If you……………… Then ………………….

Collect receivables (debtors) faster You release cash from the cycle

Collect receivables (debtors) slower Your receivables soak up cash.

Get better credit (in terms of duration or You increase your cash resources.
amount) from suppliers.
Shift inventory (stocks) faster You free up cash.

Move inventory (stocks) slower. You consume more cash.

The duration of working capital cycle may vary depending on the nature of the
business.
In the form of an equation, the operating cycle process can be expressed as follows:
Operating Cycle = R + W + F + D – C
Where,
R = Raw material storage period
W = Work-in-progress holding period
F = Finished goods storage period
D = Receivables (Debtors) collection period.
C = Credit period allowed by suppliers (Creditors).

The various components of Operating Cycle may be calculated as shown

below:

(1) Raw Material Average stock of raw material


Storage Period Average Cost of Raw Material Consumption per day
(2) Work-in-Progress Average Work - in- progress inventory
holding period = Average Cost of Production per day

(3) Finished Goods Average stock of finished goods

storage period = Average Cost of Goods Sold per day

(4) Receivables Average Receivables

(Debtors) collection = Average Credit Sales per
day
period
(5) Credit period Average Payables
allowed by suppliers = Average Credit Purchases per day
(Creditors)
 Estimation of amount of Different Components of Current
Assets and Current Liabilities
 The various constituents of current assets and current liabilities have a
direct bearing on the computation of working capital and the operating cycle.
The holding period of various constituents of Current Assets and Current
Liabilities cycle may either contract or expand the net operating cycle period.
 Shorter the operating cycle period, lower will be the requirement of working
capital and vice-versa.

Estimation of Current Assets

(i) Raw Materials Inventory: The funds to be invested in raw materials

inventory may be estimated on the basis of production budget, the estimated cost
per unit and average holding period of raw material inventory by using the
following formula:

Estimated Production (units) x Estimated cost per unit x Average raw material storage period
12months / 365days *

(ii) Work-in-Progress Inventory: The funds to be invested in work-in-progress can

be estimated by the following formula:
Estimated Production (units) x Estimated WIP cost per unit x Average WIP holding period
12months / 365days *

(iii) Finished Goods: The funds to be invested in finished goods inventory can be
estimated with the help of following formula:

Estimated Production (units)

12M/365 Days x Estimated cost of product on per unit x Average finished goods storage period
(iv) Receivables (Debtors): Funds to be invested in trade receivables (debtors) may
be estimated with the help of following formula:
Estimated Credit sales (units)

12months / 365days * x Estimated cost of sales (Excl. Dep.) per unit x Average receivable collection period

(v) Cash and Cash equivalents: Minimum desired Cash and Bank balance to be
maintained by the firm has to be added in the current assets for the computation
of working capital.

Estimation of Current Liabilities

Current liabilities are deducted from the current assets to get working capital.
Hence, the amount of working capital is lowered to the extent of current liabilities
(other than bank credit) arising in the normal course of business. The important
current liabilities like trade payables, wages and overheads can be estimated as
follows:
(i) Trade Payables: Trade payable can be estimated on the basis of material
purchase budget and the credit purchase.
Estimated credit purchase × Credit period allowed by suppliers
12months / 365days *

(ii) Direct Wages: It is estimated with the help of direct wages budget.
Estimated labour hours× wages rate per hour × Average time lag in payment of wages
12months / 365days *

(iii) Overheads (other than depreciation and amortization):

Estimated Overheads × Average time lag in payment of overheads
12months / 360 days *

*Number of days in a year may be taken as 365 or 360 days.

Estimation of Working Capital Requirements

Amount Amount Amount

I. Current Assets:
Inventories:
-Raw Materials ---
-Work-in-process ---
-Finished goods --- ---
Receivables:
-Trade debtors ---
-Bills --- ---
Minimum Cash Balance ---
Gross Working Capital --- ---
II. Current Liabilities:
Trade Payables ---
Bills Payables ---
Wages Payables ---
Payables for overheads --- ---
III. Excess of Current Assets over ---
Current Liabilities [I – II]
IV. Add: Safety Margin ---
V. Net Working Capital [III + IV] ---
Working Capital Requirement Estimation based on Cash Cost
This approach is based on the fact that in the case of
current assets, like sundry debtors and finished goods,
etc., the exact amount of funds blocked is less than
the amount of such current assets. For example:
 If we have sundry debtors worth ` 1 lakh and our cost of
production is ` 75,000, the actual amount of funds blocked in
sundry debtors is ` 75,000 the cost of sundry debtors, the rest (`
25,000) is profit.
 Again some of the cost items also are non-cash costs;
depreciation is a non-cash cost item. Suppose out
of ` 75,000, ` 5,000 is depreciation; then it is
obvious that the actual funds blocked in terms of
sundry debtors totaling ` 1 lakh is only ` 70,000.
In other words, ` 70,000 is the amount of funds
required to finance sundry debtors worth ` 1 lakh.
 Similarly, in the case of finished goods which are
valued at cost, non-cash costs may be excluded to
work out the amount of funds blocked.
 therefore, calculate the working capital requirements
by working out the cash costs of finished goods and
sundry debtors. Under this approach, the debtors
are calculated not as a percentage of sales value
but as a percentage of cash costs. Similarly, finished
goods are valued according to cash costs.
COMPONENTS OF WORKING CAPITAL

The components of working capital are:

 CASH MANAGEMENT

 RECEIVABLES MANAGEMENT
 INVENTORY MANAGEMENT

 PAYABLE MANAGMENT
 TREASURY AND CASH MANAGEMENT

CASH BUDGETING

 Cash budgeting is an important tool for controlling the cash.

It is prepared for future period to know the estimated amount
of cash that may be required.

 Cash budget is a statement of estimated cash inflows and

outflows relating to a future period. It gives information about
the amount of cash expected to be received and the amount of
cash expected to be paid out by a firm for a given period.

 Format of Cash Budget

__________Co.
Ltd.
Cash
Budget
Period____
__________
 Month 1 Month 2 Month 3 Month 12
Receipts:
1. Opening balance
2. Collection from
debtors

3. Cash sales
4. Loans from banks
5. Share capital
6. Miscellaneous
receipts
7. Other items
Total
Payments:
1. Payments to creditors
2. Wages
3. Overheads
(a)
(b)
(c)
4. Interest
5. Dividend
6. Corporate tax
7. Capital expenditure
8. Other items
Total
Closing balance
[Surplus (+)/Shortfall (-)]
William J. Baumol’s Economic Order Quantity Model,
(1952)

 According to this model, optimum cash level is that level of

cash where the carrying costs and transactions costs are the
minimum.

 The optimum cash balance according to this model will be that

C 2UP
S

point where these two costs are minimum. The formula for
determining optimum cash balance is:
Where, C = Optimum cash balance
U = Annual (or monthly) cash
disbursement

P = Fixed cost per transaction.

S = Opportunity cost of one rupee p.a.
(or p.m.)
 MANAGEMENT OF
INVENTORY

 This refers to the optimal ordering quantity that will incur the
minimum total cost (order cost and carrying cost) for an item of
inventory.

 With the increase in the order size, the ordering cost decreases but
the carrying cost increases and the optimal order, quantity is
determined where these two costs are equal. The company is always
tried to keep an eye on the level of safety stock and the lead-time
associated with the orders made.

2 AO
EOQ= √
c

A= Annual consumption. O= Ordering cost per order. C= Carrying cost per unit.
 MANAGEMENT OF
RECEIVABLES

APPROACHES TO EVALUATION OF CREDIT

POLICIES
 There are basically two methods of evaluating the credit
policies to be adopted by a Company – Total Approach and
Incremental Approach. The formats for the two approaches
are given as under:
Particulars Present Proposed Proposed Proposed
Policy Policy I Policy II Policy III
` ` ` `
A. Expected Profit:
(a) Credit Sales ………. …………. ……….. ……….
(b) Total Cost other than Bad
Debts
(i)Variable Costs ……… ………… ………. ……….
(ii) Fixed Costs ……… ………… ………. ……….
……… ………. ………. ……..
(c) Bad Debts ……… ………… ……… ……….
(d) Cash discount
(e) Expected Net Profit before .…….. ……….. ……… ……….
Tax (a-b-c-d)
(f) Less: Tax ……... ……….. ………. ………
(g) Expected Profit after Tax ..……. ……… ……… ………
B. Opportunity Cost of ..…… ……… ………. ………
Investments in Receivables
locked up in Collection
Period
Net Benefits (A – B) ……… ……… ……… ……….

 Statement showing the Evaluation of Credit Policies

(based on Total Approach)
Advise: The Policy……. should be adopted since the net benefits
under this policy are higher as compared to other policies.
Here
(i) Total Fixed Cost = [Average Cost per unit – Variable Cost per
unit] × No. of
units sold on credit under Present Policy
(ii) Opportunity Cost = Total Cost of Credit Sales ×
Collection period (Days)
Required Rate of Return 365
×
(or 360) 100
Statement showing the Evaluation of Credit Policies (based on
Incremental Approach)
Particulars Present Proposed Proposed Proposed
Policy Policy I Policy II Policy III
days days days days
` ` ` `
A. Incremental Expected Profit:
Credit Sales ………. …………. ……….. ……….
(a) Incremental Credit Sales ………. …………. ……….. ……….
(b) Less: Incremental Costs of
Credit Sales
(i) Variable Costs ………. …………. ……….. ……….
(ii) Fixed Costs ………. …………. ……….. ……….
(c) Incremental Bad Debt Losses ………. …………. ……….. ……….
(d) Incremental Cash Discount ………. …………. ……….. ……….
(e) Incremental Expected Profit ………. …………. ……….. ……….
(a-b-c-d)
(f) Less: Tax ………. …………. ……….. ……….
(g) Incremental Expected Profit ………. …………. ……….. ……….
after Tax
………. …………. ……….. ……….
B. Required Return on
Incremental Investments:
(a) Cost of Credit Sales ………. …………. ……….. ……….
(b) Collection Period (in days) ………. …………. ……….. ……….
(c) Investment in Receivable (a × ………. …………. ……….. ……….
b/365 or 360)
(d) Incremental Investment in ………. …………. ……….. ……….
Receivables
(e) Required Rate of Return (in %) ………. …………. ……….. ……….
(f) Required Return on ………. …………. ……….. ……….
Incremental Investments (d ×
e)
Incremental Net Benefits (A – B) ………. …………. ……….. ……….
Advise: The Policy ……should be adopted since net benefits under
this policy are higher as compared to other policies.
Here:
(i) Total Fixed Cost = [Average Cost per unit – Variable Cost per
unit] × No. of
units sold on credit under Present Policy
(ii) Opportunity Cost = Total Cost of Credit Sales ×
Collection period (Days)
Required Rate of Return 365
×
(or 360) 100
Statement showing the Evaluation of Factoring Proposal
Particulars `
A. Annual Savings (Benefit) on taking Factoring Service
Cost of credit administration saved ………...
Bad debts avoided …………
Interest saved due to reduction in average collection …………
period (Wherever applicable)
[Cost of Annual Credit Sales × Rate of Interest × (Present
Collection Period – New Collection Period)/360* days]
Total ………..
B. Annual Cost of Factoring to the Firm:
Factoring Commission [Annual credit Sales × % of ………..
Commission (or calculated annually)]
Interest Charged by Factor on advance (or calculated ………...
annually )
[Amount available for advance or (Annual Credit Sales –
Factoring Commission – Factoring Reserve)] ×
Collection Period (days)
[ ×Rate of Interest]
360 *
Total ………..
C. Net Annual Benefits/Cost of Factoring to the Firm: A-B
Rate of Effective Cost of Factoring to the Firm
= Net Annual cost of Factoring ×100 or
Amount available for advance
Net annual Cost of Factoring×100 Advances to be paid
Advances to be paid = (Amount available for advance
– Interest deducted by factor)
*1 Year is taken as 360 days
Advise:

1. The company should avail Factoring services if rate of effective

Cost of Factoring to the firm is less than the existing cost of
borrowing or if availing services of factoring results in to
positive Net Annual Benefits.
2. The company should not avail Factoring services if the Rate of
Effective Cost of Factoring to the Firm is more than the
existing cost of borrowing.
 MANAGEMENT OF PAYABLES (CREDITORS)

COMPUTATION OF COST OF PAYABLES

 By using the trade credit judiciously, a firm can reduce the
effect of growth or burden on investments in Working Capital.
 Now question arises how to calculate the cost of not taking
the discount.
 The following equation can be used to calculate nominal
cost, on an annual basis of not taking the discount:
d 365days
100  d t

However, the above formula does not take into account the
compounding effect and therefore, the cost of credit shall be even

365
 100  t 1
 100  d 


higher. The cost of lost cash discount can be estimated by the
formula:
Where,
d = Size of discount i.e. for 6% discount, d = 6
t = The reduction in the payment period in days, necessary
to obtain the early discount or Days Credit Outstanding – Discount
Period.
 FINANCING OF WORKING CAPITAL

MAXIMUM PERMISSIBLE BANK FINANCE (MPBF)-

TANDON COMMITTEE
1st Method
Total current assets required xxx
Less: Current Liabilities xxx
Working Capital Gap xxx
Less: 25% from Long-term sources xxx
Maximum permissible bank borrowings xxx
nd
2 Method
Current assets required xxx
Less: 25% to be provided term long-term funds xxx
xxx
Less: Current Liabilities xxx
Maximum permissible bank borrowings Xxx
rd
3 Method
Current assets Xxx
Less: Core Current assets Xxx
Xxx
Less: 25% to be provided from long-term funds Xxx
Xxx
Less: Current Liabilities Xxx
Maximum permissible bank borrowings Xxx
The Reserve Bank of India set up in 1974 a study group under the chairmanship of
Mr. P.L. Tandon, popularly referred to as The Tandon Committee.