Financial Management

Unit-IV
Subject Faculty: Mr. Anmol Panvanda (Department of Management)

DIVIDEND DECISIONS
Dividend:

A dividend is a payment made by a corporation to its shareholders, usually as a distribution

of profits. When a corporation earns a profit or surplus, it can either re-invest it in the
business (called retained earnings), or it can distribute it to shareholders. A corporation may
retain a portion of its earnings and pay the remainder as a dividend. Distribution to
shareholders can be in cash (usually a deposit into a bank account) or, if the corporation has
a dividend reinvestment plan, the amount can be paid by the issue of further shares or share
repurchase.

A dividend is allocated as a fixed amount per share, with shareholders receiving a dividend in
proportion to their shareholding. For the joint stock company, paying dividends is not
an expense; rather, it is the division of after tax profits among shareholders. Retained
earnings (profits that have not been distributed as dividends) are shown in the shareholder
equity section in the company's balance sheet - the same as its issued share capital. Public
companies usually pay dividends on a fixed schedule, but may declare a dividend at any
time, sometimes called a special dividend to distinguish it from the fixed schedule
dividends. Cooperatives, on the other hand, allocate dividends according to members'
activity, so their dividends are often considered to be a pre-tax expense.

The word "dividend" comes from the Latin word "dividendum" ("thing to be divided").

Forms of Payment

Cash dividends are the most common form of payment and are paid out in currency, usually
via electronic funds transfer or a printed paper check. Such dividends are a form of
investment income and are usually taxable to the recipient in the year they are paid. This is
the most common method of sharing corporate profits with the shareholders of the company.
For each share owned, a declared amount of money is distributed. Thus, if a person owns 100
shares and the cash dividend is 50 pence per share, the holder of the stock will be paid GBP
Rs.50. Dividends paid are not classified as an expense, but rather a deduction of retained
earnings. Dividends paid does not show up on an income statement but does appear on
the balance sheet.

Stock or scrip dividends are those paid out in the form of additional stock shares of the
issuing corporation, or another corporation (such as its subsidiary corporation). They are
usually issued in proportion to shares owned (for example, for every 100 shares of stock
owned, a 5% stock dividend will yield 5 extra shares).

Nothing tangible will be gained if the stock is split because the total number of shares
increases, lowering the price of each share, without changing the market capitalization, or
total value, of the shares held.

Stock dividend distributions are issues of new shares made to limited partners by a
partnership in the form of additional shares. Nothing is split, these shares increase the market
capitalization and total value of the company at the same time reducing the original cost basis
per share.

Stock dividends are not includable in the gross income of the shareholder for US income tax
purposes. Because the shares are issued for proceeds equal to the pre-existing market price of
the shares; there is no negative dilution in the amount recoverable.

Property dividends or dividends in specie (Latin for "in kind") are those paid out in the
form of assets from the issuing corporation or another corporation, such as a subsidiary
corporation. They are relatively rare and most frequently are securities of other companies
owned by the issuer, however they can take other forms, such as products and services.

Interim dividends are dividend payments made before a company's Annual General
Meeting (AGM) and final financial statements. This declared dividend usually accompanies
the company's interim financial statements.

Other dividends can be used in structured finance. Financial assets with a known market
value can be distributed as dividends; warrants are sometimes distributed in this way. For
large companies with subsidiaries, dividends can take the form of shares in a subsidiary
company. A common technique for "spinning off" a company from its parent is to distribute
shares in the new company to the old company's shareholders. The new shares can then be
traded independently.
Basic Factors Affecting Dividend Decision
Theoretically, over the past number of years, it has been believed by the academicians that
the dividend decision is influenced by number of factors. Some of the factors that affect the
dividend decision of a firm are listed as follows:

• Legal Provisions: Indian Companies Act, 1956 has given the guidelines regarding legal
provisions as to dividends. Such guidelines are required to be followed by the companies
whenever the dividend policy is to be formulated. As per the guidelines, a company is
required to transfer a certain percentage of profits to reserves in case the dividend to be paid
is more than 10 percent. Further, a company is also required to pay dividend only in cash but
only with the exception of bonus shares.
• Magnitude of Earnings: Another important aspect of dividend policy is the extent of
company’s earnings. It serves as the introductory point for framing the dividend policy. This
is so because a company can pay dividends either from the current year’s profit or the past
year’s profit. So, if the profits of a company increase, it will directly influence the dividend
declaration as the latter may also increase. Thus, the dividend is directly linked with the
availability of the earnings with the company.
• Desire of Shareholders: The decision to declare the dividends is taken by Board of
Directors but they are also required to consider the desire of the shareholders, which depend
on the latter’s economic condition. The shareholders, who are economically weak, prefer
regular dividend policy while the rich shareholders may prefer capital gains as compared to
dividends. However, it is very difficult for the board to reconcile the conflicting interests of
different shareholders yet the dividend policy has to be framed keeping in view the interest of
all the interested parties.
• Nature of Industry: The nature of industry in which a company is operating, influences the
dividend decision. Like the industries with stable demand throughout the year are in a
position to have stable earnings, thus, should have the stable dividend policy and vice-versa.
• Age of the Company: A company’s age also determine the quantum of profits to be
declared as dividends. A new company should restrict itself to lower dividend payment due
to saving funds for the expansion and growth as compared to the already existing companies
who can pay more dividends. Grullon et al. (2002) suggested that as firms mature, they

experience a contraction in their growth which results in a decline in their capital

expenditures. Consequently, these firms have more free cash flow to pay as dividends.
Similarly, Brav et al. (2005) suggested that more mature firms are more likely to pay
dividends. In contrast, younger firms need to build up reserves to finance the future growth
opportunities, thus, making them to retain the earnings.
• Taxation Policy: The tax policy of a country also influences the dividend policy of a
company. The rate of tax directly influences the amount of profits available to the company
for declaring dividends.
• Control Factor: Yet another factor determining dividend policy is the threat to loose
control. If a company declares high rate of dividend, then there is the possibility that a
company may face liquidity crunch for which it has to issue new shares, resulting in dilution
of control. Keeping this threat in view, a company may go for lower level of dividend
payments and more ploughing back of profits in order to avoid any such threat.
• Liquidity Position: A company’s liquidity position also determines the level of dividend. If
a company does not have sufficient cash resources to make dividend payment, then it may go
for issue of bonus shares.
• Future Requirements: A company while faming dividend policy should also consider its
future plans. If it foresees some profitable investment opportunities in near future then it may
go for lower dividend and vice-versa.
• Agency Costs: The separation of ownership and control results in agency problems.
Agency costs can be reduced by distributing dividends (Rozeff, 1982, Easterbrook, 1984,
Jensen et al., 1992). In this stratum, dividends are paid out to stockholders in order to prevent
managers from building unnecessary empires to be used in their own interest. In addition,
dividends reduce the size of internally generated funds available to managers, forcing them to
go to the capital market to obtain external funds (Easterbrook, 1984). As explained in Rozeff
(1982), firms with a larger percentage of outside equity holdings are subject to higher agency
costs. The more widely spread is the ownership structure, the more acute the free rider
problem and the greater the need for outside monitoring. Hence, these firms should pay more
dividends to control the impact of widespread ownership.
• Business Risk: Business risk is a potential factor that may affect dividend policy. High
 levels of business risk make the relationship between current and expected future profitability

less certain. Consequently, it is expected that firms with higher levels of business risk will
have lower dividend payments. Many researchers argued that the uncertainty of a firm’s
earnings may lead it to pay lower dividends because volatile earnings materially increase the
risk of default. In addition, field studies using survey data (e.g., Lintner, 1956) reported
compelling evidence that risk can affect dividend policy. In these surveys, managers
explicitly cited risk as a factor that influences their dividend choice.

DIVIDEND POLICY

A dividend policy dictates how much cash is returned to shareholders. When deciding what
dividend to pay, if any, a company must look at the profits it has made and weigh up how much
should be retained in the business to fund future growth and how much should be returned to
investors. If it has had a bad year and it doesn’t have enough profit to cover its investment needs
and the dividend, but expects the poor performance to be a one-off, then it may still make a
payout to investors by either dipping into any surplus cash it has or using debt. The dividend
policy dictates how the value of the dividend is calculated and when it is paid. It also clarifies
who gets what if a business has multiple share classes. For example, preference shares are usually
entitled to dividends before common shareholders while American depositary receipts (ADRs)
often earn a different dividend to other investors. Some share classes may not be entitled to
dividends at all. Some companies also choose to add what is known as a ‘scrip alternative’
dividend programme, which allows shareholders to receive the value of their dividends in new
shares in the business rather than cash. Dividend policies may also include clauses that detail
how bonus payments may work, such as special dividends or share buybacks.

Types of dividend policies

There is no definitive way of forming a dividend policy but there are four main types that are
used by most publicly-listed businesses. However, there are additional ways to return cash to
shareholders too.

1. Residual dividend policy

2. Stable dividend policy
3. Progressive dividend policy
4. Regular dividend policy
5. Irregular dividend policy (special dividends)
6. Share buybacks
7. Scrip dividends

FACTORS DETERMINING DIVIDEND POLICY

Profitable Position of the Firm
Dividend decision depends on the profitable position of the business concern. When the firm
earns more profit, they can distribute more dividends to the shareholders.

Uncertainty of Future Income

Future income is a very important factor, which affects the dividend policy. When the
shareholder needs regular income, the firm should maintain regular dividend policy.
Legal Constrains
The Companies Act 1956 has put several restrictions regarding payments and declaration of
dividends. Similarly, Income Tax Act, 1961 also lays down certain restrictions on payment of
dividends.

Liquidity Position
Liquidity position of the firms leads to easy payments of dividend. If the firms have high
liquidity, the firms can provide cash dividend otherwise, they have to pay stock dividend.

Sources of Finance
If the firm has finance sources, it will be easy to mobilise large finance. The firm shall not go for
retained earnings.

Growth Rate of the Firm

High growth rate implies that the firm can distribute more dividend to its shareholders.

Tax Policy
Tax policy of the government also affects the dividend policy of the firm. When the government
gives tax incentives, the company pays more dividend.

Capital Market Conditions

Due to the capital market conditions, dividend policy may be affected. If the capital market is
prefect, it leads to improve the higher dividend.

Walter’s Model
Prof. James E. Walter argues that the dividend policy almost always affects the value of the
firm.
Walter model is based in the relationship between the following important factors:
• Rate of return I
• Cost of capital (k)
According to the Walter’s model, if r > k, the firm is able to earn more than what the
shareholders could by reinvesting, if the earnings are paid to them. The implication of r > k is
that the shareholders can earn a higher return by investing elsewhere.
If the firm has r = k, it is a matter of indifferent whether earnings are retained or distributed.
Assumptions
Walters model is based on the following important assumptions:
1. The firm uses only internal finance.
2. The firm does not use debt or equity finance.
3. The firm has constant return and cost of capital.
4. The firm has 100 recent payout.
5. The firm has constant EPS and dividend.
6. The firm has a very long life.
Walter has evolved a mathematical formula for determining the value of market share.

Where,
P = Market price of an equity share D =
Dividend per share
r = Internal rate of return E =
Earning per share
Ke = Cost of equity capital

Example:
From the following information supplied to you, ascertain whether the firm is following an
optional dividend policy as per Walter’s Model?
Total Earnings Rs. 2,00,000
No. of equity shares (of Rs. 100 each 20,000) Dividend
paid Rs. 1,00,000
P/E Ratio 10
Return Investment 15%
The firm is expected to maintain its rate on return on fresh investments. Also find out what
should be the E/P ratio at which the dividend policy will have no effect on the value of the share?
Will your decision change if the P/E ratio is 7.25 and interest of 10 %?
Solution:
Criticism of Walter’s Model
The following are some of the important criticisms against Walter model:
Walter model assumes that there is no extracted finance used by the firm. It is not practically
applicable.
There is no possibility of constant return. Return may increase or decrease, depending upon the
business situation. Hence, it is applicable.
According to Walter model, it is based on constant cost of capital. But it is not applicable in the
real life of the business.
WORKING CAPITAL

Concepts of Working Capital

Working capital or circulating capital indicates circular flow of funds in the day-to-day or
routine activities of business. However, this term is used in two ways; in the gross and in the
net concept. In the broad sense, the term ’working capital is used to denote the ’total current
assets’. The following are some definitions of this group.
"Working Capital means current assets". -Mead, Baker, Malott.
"The sum of the current assets is working capital of a business". -J.S. Mill.
"Any acquisition of funds which increases the current assets increases working capital also,
for they are one and the same". - Bonneville
"Working capital refers to a firm’s investment in short-term assets-cash, marketable
securities, accounts receivable and inventories". - Weston & Brigham
Types of Working Capital
Working capital can be classified either on the basis of its concept or on the basis of
periodicity of its requirements.
(a) On the Basis of Balancesheet Concept. On the basis of its concept, it may be either gross
working capital or net working capital. Gross working capital is represented by the total
current assets. The net working capital is the excess of current assets over current
liabilities.
(i) Gross Working Capital = Total Current Assets
(ii) Net Working Capital = CA-CL (Current Assets-Current Liabilities)

(b) On the Basis of Requirements. According to Gerstenbergh, the working capital can be
classified into two categories on the basis of time and requirement:
(i) Permanent Working Capital. It refers to the minimum amount of investment
which should be there in the fixed or minimum current assets like inventory,
accounts receivable, or cash balance etc., in order to carry out business smoothly.
This investment is of a regular or permanent type and as the size of the firm
expands, the requirement of permanent working capital also increases. Tandon
 Committee has referred to this type of working capital as "hard core working
capital".

(ii) Variable Working Capital. The excess of working capital over permanent
working capital is known as variable working capital. The amount of (144) such
working capital keeps on fluctuating from time to time on the basis of business
activities. It may again be sub-divided into seasonal and special working capital.
Seasonal Working Capital is required to meet the seasonal demands of busy
periods occuring at stated intervals. On the other hand, special working capital is
required to meet extra-ordinary needs for contingencies. Events like strike, fire,
unexpected competition, rising price tendencies or initiating a big advertisement
campaign require such capital. The following diagram illustrates the difference
between permanent and variable working capital.

Operating Cycle Concept

Every business undertaking requires funds for two prupose-investments in fixed assets and
investment in current assets. Funds required investing in inventories; debtors and other current
assets keep on changing shape and volume. For example, a company has some cash in the
beginning. This cash may be paid to the suppliers of raw-materials, to meet labour costs and
other overheads. These three combined would generate work-in-progress which will be
converted into finished goods on the completion of the production process. On sale, these
finished goods get converted into debtors and when debtors pay, This cash will again be used for
financing raw materials, work-in-progress, finished goods and debtors etc. So the cycle is
completed on the conversion of these currents assets into cash. This time period is simply known
as the working capital cycle of the firm. In other words, Working Capital Cycle indicates the
length of time between a firm’s paying for materials entering into stock and receiving the cash
from the sale of finished goods. In a manufacturing firm, the duration of time required to
complete the sequence of events is called operating cycle. In case of a manufacturing company,
the operating cycle is the length of time necessary to complete the following cycle of events :- (i)
Conversion of cash into raw materials. (ii) Conversion of raw materials into work-in-progress;
(iii) Conversion of work-in-progress into finished goods; (iv) Conversion of finished goods in
accounts receivable, and (v) Conversion of accounts receivable into cash. This cycle is repeated
again and again. This operating cycle is clear from the following chart :

MEANING OF WORKING CAPITAL

Working capital is the amount of funds needed by an enterprise to
finance its day to day operation. It is the part of capital employed in short-
term operation such as raw materials, semi finished products, sundry debtors.
Because of its variable nature, the working capital is also referred to as
circulating capital. It may be pointed
out that the total working capital is composed of two parts.
• Regular Capital
• Variable Capital

ADEQUATE WORKING CAPITAL:

The firm should maintain a sound working capital
position. It should have adequate working capital to run its business operations. Both
excessive as well as inadequate working capital positions are dangerous from firm's point of
view. Excessive working capital means holding costs and idle funds which earn no profit for
the firm. Paucity of working capital not only impairs the firm's profitability but also results in
production interruptions and inefficiencies and sales disruption

Importance/Need/Advantage of Adequate Working Capital:

• Availability of Raw Materials Regularly:-
Adequacy of working capital makes it possible for a firm to pay the suppliers of
raw materials on time. As a result it will
continue to receive regular supplies of raw materials and thus there will be no
disruption in production process.
• Full Utilization of Fixed Assets:-
Adequacy of working capital makes it possible for a firm to utilize its fixed assets fully and
continuously. For example, if there is inadequate stock of raw material, the machines will not
be utilized in full and their productivity will be reduced.
• Cash Discount:-
A firm having the adequate working capital can avail the cash discount by purchasing
the goods for cash or by making the payment before the due date.
• Increase in Credit Rating:-
Paying its short-term obligations in time leads to a strong credit rating which enables the firm
to purchase goods on credit on favorable terms and to maintain its line of credit with banks
etc. it facilities the taking of loan in case of need.
• Exploitation of Favorable Market conditions:-
Whenever there are
chances of increase in prices of raw materials, the firm can purchase sufficient
quantity if it has adequate of working capital. Similarly, if a firm receives a bulk order for
the supply of goods it can take advantage of such opportunity if it has sufficient
working capital.

• Facility in Obtaining Bank Loans:-

Banks do not hesitate to advance even the unsecured loan to a firm which has the sufficient
working capital. This is because the excess of current assets over current liabilities itself is a
good security.
• Increase in Efficiency of Management:-
Adequacy of working capital has a favorable psychological effect on the managers. This is
because no obstacle arises in the day-to-day business operations. Creditors, wages and all
other expenses are paid on time and hence it keeps the morale of manager’s high
• Ability to face crisis:-
Adequate working capital enables a concern to face business crisis in emergencies such as
depression, because during such periods, generally, there is much pressure on working
capital.
• Solvency of the business:-
Adequate working capital helps in maintaining solvency of the business by providing
uninterrupted flow of production.
• Good will
Sufficient working capital enables a business concern to male prompt payments and hence
helps in creating and maintaining good will.

DETERMINANTS OF WORKING CAPITAL:

A firm should have neither too much nor too little working capital. A large number of
factors, each has a different importance, influencing working capital needs of firms. The
importance of factors also changes for a firm over time.

Therefore, an analysis of relevant factors should be made in order to determine total

investment in working capital. The following is the description of factors which generally
influence the working capital requirements. The working capital requirement is determined
by a large number of factors
but, in general, the following factors influence the working capital needs of an
enterprise:
• Nature of Business :-
Working capital requirements of an enterprise are largely influenced by the nature of its
business. For instance, public utilities such as railways, transport, water, electricity etc. have
a very limited need for working capital because they have invested fairly large amounts in
fixed assets. Their working capital need is minimal because they get immediate payment
for their services and do not have to
maintain big inventories. On the other extreme are the trading and financial enterprises
which have to invest fewer amounts in fixed assets and a large amount in working capital.
This is so because the nature of their business is such that they have to maintain a sufficient
amount of cash, inventories and debtors. Working capital needs of most of the manufacturing
enterprises fall between these two extremes, that is, between public utilities and trading concerns.
• Size of Business:-
Larger the size of the business enterprise, greater would be the need for working capital. The
size of a business may be measured in terms of scale of its business operations.
• Growth and Expansion:-
As a business enterprise grows, it is logical to expect that a larger amount
of working capital will be required. Growing industries require more working capital
than those that are static.
• Production cycle:-
Production cycle means the time-span between the purchase of raw materials and its
conversion into finished goods. The longer the production cycle, the larger will be the need
for working capital because the funds will be tied up for a longer period in work in process.
If the production cycle is small, the need for working capital will also be small.
• Business Fluctuations:-
Business fluctuations may be in the direction of boom and depression. During boom period
the firm will have to operate at full capacity to meet the increased demand which in turn,
leads to increase in the level of inventories and
book debts. Hence, the need for working capital in boom conditions is bound to
increase. The depression phase of business fluctuations has exactly an opposite effect
on the level of working capital requirement.
• Production Policy:-
The need for working capital is also determined by production policy. The demand for
certain products (such as woolen garments) is seasonal. Two types of production policies
may be adopted for such products. Firstly, the goods may be produced in the months
of demand and secondly, the goods may be produces throughout the year. If the second
alternative is adopted, the stock of finished goods
will accumulate progressively upto the season of demand which requires an increasing
amount of working capital that remains tied up in the stock of finished goods for some
months.

• Credit Policy Relating to Sales:-

If a firm adopts liberal credit policy in respect of sales, the amount tied up in debtors will
also be higher. Obviously, higher book debts mean more working capital. On the other hand,
if the firm follows tight credit policy, the magnitude of working capital will decrease
• Credit Policy Relating to Purchase:-
If a firm purchases more goods on credit, the requirement for working capital will be less. In
other words, if liberal credit terms are
available from the suppliers of goods (i.e., creditors), the requirement for working
capital will be reduced and vice versa.
• Availability of Raw Material:-
If the raw material required by the firm is available easily on a continuous basis, there
will be no need to keep a large inventory of such materials and hence the requirement of
working capital will be less. On the other hand, if the supply of raw material is irregular, the
firm will be compelled to keep an excessive inventory of such raw materials which will result
in high level of working capital. Also, some raw materials are available only during a
particular season such as oil seeds, cotton, etc. They would have to be necessarily purchased
in that season and have to be kept in stock for a period when supplies are lean. This will
require more working capital.
• Availability of Credit from Banks:-
If a firm can get easy bank facility in case of need,
it will operate with less working capital. On the other hand, if such facility is not
available, it will have to keep large amount of working capital.
• Volume of Profit:-
The net profit is a source of working capital to the extent it has been
earned in cash. Higher net profit would generate more internal funds thereby
contributing the working capital pool.
• Level of Taxes:-
Full amount of cash profit is not available for working capital purpose. Taxes have to be paid
out of profits. Higher the amount of taxes less will be the profits for working capital.
• Dividend Policy:-
Dividend policy is a significant element in determining the level of working capital in an
enterprise. The payment of dividend reduces the cash and thereby, affects the working capital
to that extent. On the contrary, if the company does not pay dividend but retains the profits,
more would be the contribution of profits towards capital pool.
• Depreciation Policy:-
Although depreciation does not result in outflow of cash, it affects the working capital
indirectly. In the first place, since depreciation is allowable expenditure in calculating net
profits, it affects the tax liability. In the second place, higher depreciation also means
lower disposable profits and, in turn, a lower dividend payment. Thus, outgo of cash is
restricted to that extent.
• Price Level Changes:-
Changes in price level also affect the working capital requirements. If the price level is
rising, more funds will be required to maintain the
existing level of production. Same level of current assets will need increased
investment when prices are increasing. However, companies that can immediately their
product prices with rising price levels will not face a severe working capital problem. Thus, it
is possible that some companies may not be affected by rising prices while others may be
badly hit.
• Efficiency of Management:-
Efficiency of management is also a significant factor to determine the level of working
capital. Management can reduce the need for working capital by the efficient utilization of
resources. It can accelerate the pace of cash cycle and thereby use the same amount working
capital again and again very quickly

Significance of Working Capital

• Conversion of cash into inventory.
• Conversion of inventory into receivable.
• Conversion of receivable into cash.
These events constitute
operating cycle of business. If all these events could happen simultaneously, there
would not arise any need for working capital. Since cash inflows and cash outflows do not m
atch, an
organization need necessary cash and liquidity tobe able to meet its obligations. Thus adequat
e capital is required for smooth operation of any business concern.
Sound working capital management results in maximization
of productivity and Profits. It requires the
maintenance of proper balance between working and fixed capital, so as to
maintain both profitability and
solvency. Proper management synchronizes cash receipts and cash outlays.
For small concerns, efficient working capital management is still more essential to ensure pur
chase of inputs
at competitive prices and timely payment to factors of production. It may be noted that shorte
r the gap
between spending of money on production of goods and the recovery of money through rapid
sales turnover, the better shall be the quality of working capital management.

Factors Affecting Working Capital Requirements

In case of a small enterprise, the various factors affecting its working capital requirements.
• Size of Business.
Size of unit and the volume of business.
• Nature of Process.
Nature of production process i.e. lengthier the duration of production, higher shall be
the working capital needs and vice-versa.
• Proportion of Raw Materials and Total Cost.
Proportion of raw material to total cost must be decided.
• Terms of Sale & Purchase.
Terms of sale and purchase e.g. sales are on cash terms, lesser working capital will be
sufficient.
• Turnover of Inventories.
If inventories are large and their turnover is slow, larger working capital would be needed.
• Labour Vs. Capital Intensive.
Labour vs. capital intensive, the former requiring higher amounts of working capital.
• Cash Requirements.
Cash requirements will have direct impact on working capital quantum.
• Banking Facilities.
Availability of goods and dependable banking facilities reduces working capital needed.
• Seasonal Requirements.
Seasonal requirements may push up the amount of working capital needed.
• Contingencies.
If the demand and prices for small concerns products are subject to
wide fluctuation, contingency provision will have to
be made for arranging higher amounts of working capital

Determination of Working Capital Needs

Working capital requirements of small enterprise varies from unit to unit and in accordance
with the difference on the nature of the enterprise. Broadly speaking, working capital should
be adequate to meetoperating expenses like raw materials, labour, factory and other overhead
s etc. Operating expenses can beascertained from the final accounts ofthe firm. But the worki
ng capital requirements needs not be equal to the level of expenses. Operating cycle is of
primary significance in every case.

Working Capital Requirement Formula =

Operating Exp in Previous Year/Number of operating Cycles in Year

Working Capital Sources:

Every concern has to finance its Working Capital out of various sources. Fixed Working
Capital of the business is financed out of the long-term capital employed in the business,
whereas temporary Working Capital of the business is arranged out of short-term capital
employed in the business. Different sources of permanent and temporary Working Capital
are written as follows:
Sources of Permanent Working Capital

External sources:
• Issue of shares
• Issue of debentures; and
• Raising of long-term loans.

Internal sources:

Ploughing back of profit or reinvestment of profit.

Sources of Temporary Working Capital

External sources:
• Trade creditors;
• Advance from customers;
• Short-term borrowings;
• Bank overdraft;
• Outstanding wages and expenses; and
• Short-term public deposits.

Sources
Long-Term Loans
A loan is the amount of money that is given to an individual or a company on the agreement
they will repay the amount borrowed in a period that exceeds 12 months and at
predetermined interest rates. Long-term loans are usually secured against certain assets and
are offered by commercial banks, the government and financial institutions. This type of loan
provides the long-term working capital for the business.

Short-Term Loans
Short-term loans are loans that are to be repaid within a year from the time they are
borrowed. Savings banks, cooperatives and the government through the Small Business
Administration are some of the institutions that offer these loans. Bank overdraft is one such
 source of business finance. A bank overdraft is a withdrawal made by a business that exceeds
the amount of balance in its bank account, although the amount of money does not exceed a
set limit.

Line of Credit
This is a form of a loan agreement between the bank and the borrower that enables the
borrower to acquire some amount of the funds on demand, but the borrower does not have to
take the loan. A business may secure working capital through this service if it has recurring
expenses at regular intervals.

Trade Credit
This credit service offered by suppliers allows businesses to get goods and pay for them later.
This is a source of working capital that may be acquired from all suppliers depending on the
business arrangements, the type of business you conduct and the worth of the credit to be
offered.

Asset-Based Financing
A business may use its assets to secure working capital from financial institutions that offer
asset based loans. The asset includes machinery, vehicle or accounts receivable. Accounts
receivable are financial documents of people or companies that owe money to the business
and they may be traded in to finance working capital at discounting companies.

Inventory Financing
These loans are secured with the business` inventory acting as the security. Finance for
working capital may be acquired through its inventory although the business cannot sell it
until the loan is repaid because the lender has the right to the inventory until the loan has
been repaid.

COMPONENTS OF WORKINC CAPITAL MANAGEMENT

Often the interrelationships among the working capital components create real challenges for the
financial managers. Inventory is purchased from suppliers, sale of which generates accounts
receivable and collected in cash from customers to pay off those suppliers. Working capital has
to be managed because the firm cannot always control how quickly the customers will buy, and
once they have made purchases, exactly when they will pay. That is why; controlling the “cash-
to-cash” cycle is paramount.

The different components of working capital management of any organization are:

• Inventory (Inventory Management)

• Debtors / accounts receivables (Receivables Management)

• Cash and Cash equivalents. (Cash and Credit Management)

INVENTORY MANAGEMENT

Effective inventory management is all about knowing what is on hand, where it is in

use, and how much finished product results.

Inventory management is the process of efficiently overseeing the constant flow of units into
and out of an existing inventory. This process usually involves controlling the transfer in of
units in order to prevent the inventory from becoming too high, or dwindling to levels that
could put the operation of the company into jeopardy. Competent inventory management also
seeks to control the costs associated with the inventory, both from the perspective of the total
value of the goods included and the tax burden generated by the cumulative value of the
inventory.

Balancing the various tasks of inventory management means paying attention to three key
aspects of any inventory. The first aspect has to do with time. In terms of materials acquired
for inclusion in the total inventory, this means understanding how long it takes for a supplier
to process an order and execute a delivery. Inventory management also demands that a solid
understanding of how long it will take for those materials to transfer out of the inventory be
established. Knowing these two important lead times makes it possible to know when to
place an order and how many units must be ordered to keep production running smoothly.
Calculating what is known as buffer stock is also key to effective inventory management.
Essentially, buffer stock is additional units above and beyond the minimum number required
to maintain production levels. For example, the manager may determine that it would be a
good idea to keep one or two extra units of a given machine part on hand, just in case an
emergency situation arises or one of the units proves to be defective once installed. Creating
this cushion or buffer helps to minimize the chance for production to be interrupted due to a
lack of essential parts in the operation supply inventory.

Inventory management is not limited to documenting the delivery of raw materials and the
movement of those materials into operational process. The movement of those materials as
they go through the various stages of the operation is also important. Typically known as a
goods or work in progress inventory, tracking materials as they are used to create finished
goods also helps to identify the need to adjust ordering amounts before the raw materials
inventory gets dangerously low or is inflated to an unfavorable level.

Finally, inventory management has to do with keeping accurate records of finished goods
that are ready for shipment. This often means posting the production of newly completed
goods to the inventory totals as well as subtracting the most recent shipments of finished
goods to buyers. When the company has a return policy in place, there is usually a sub-
category contained in the finished goods inventory to account for any returned goods that are
reclassified as refurbished or second grade quality. Accurately maintaining figures on the
finished goods inventory makes it possible to quickly convey information to sales personnel
as to what is available and ready for shipment at any given time.

In addition to maintaining control of the volume and movement of various inventories,

inventory management also makes it possible to prepare accurate records that are used for
accessing any taxes due on each inventory type. Without precise data regarding unit volumes
within each phase of the overall operation, the company cannot accurately calculate the tax
amounts. This could lead to underpaying the taxes due and possibly incurring stiff penalties
in the event of an independent audit.

The purposes of inventories are:

 • To maintain independence of operations
• To meet variation in product demand
• To allow flexibility in production scheduling
• To provide a safeguard for variation in raw material delivery time
• To take advantage of economic purchase order size

INVENTORY COSTS
Five types of costs need to be considered when analyzing inventory decisions:
• Holding (or carrying) costs: storage facilities, handling, insurance, pilferage, breakage,
obsolescence, depreciation, taxes, and the opportunity cost of capital.
• Setup (or production change) costs: line conversion, equipment change-over, report
preparation, etc.
• Ordering costs: typing, calling, transportation, receiving, etc. This cost does not depend
or vary on the number ordered.
• Shortage costs (stockout costs): the loss due to losing a specific sale, customers’
goodwill, or future business.
• Cost of the item

INDEPENDENT VERSUS DEPENDENT DEMAND

Independent demand (i.e., the demand by consumers) is influenced by market conditions
outside the control of operations. Independent demand calls for a replenishment philosophy.
Orders are made to replenish inventory.
Dependent (or derived) demand is related to the demand for another item. For example, parts,
intermediate goods, and raw materials face a demand dependent on the demand for the final
goods. Dependent demand calls for a requirements philosophy. Orders are made if there is a
demand or requirement for the final product.

INVENTORY CONTROL TECHNIQUES

Inventory Control Techniques:

It refers to the techniques for efficiently maintaining the flow of materials.
The following are the important inventory control techniques:
a) Economic order quantity b) Fixation of stock levels c) ABC Analysis d) Just in Time (JIT)

Economic Order Quantity (EOQ):

The economic order quantity or EOQ is the certain amount to be ordered at specific intervals.
It gives the perfect sawtooth pattern in a graph of inventory versus time.
EOQ is simple to understand and use but it has several restrictive assumptions which are also
disadvantages in practice. Even with these weaknesses, EOQ is a good place to start to
understand inventory systems. EOQ assumes:

• Demand rate is constant, uniform, recurring, and known.

• Lead time is constant and known.
• Price per unit of product is constant; no discounts are given for large orders.
• Inventory holding cost is based on average inventory.
• Ordering or setup costs are constant.
• All demands will be satisfied; no stockouts are allowed.

D = demand rate, units per year

S = cost per order placed, or setup cost, dollars per order
C = unit cost, dollars per unit
i = holding or carrying rate, percent of dollar value per year
Q = lot size, units
TC = total or ordering cost plus carrying cost, dollars per year
Annual purchase cost = DC
Annual ordering cost = (D/Q)S
Annual holding cost per year = HQ/2 = iCQ/2
TC = total annual cost = DC + (D/Q)S + iCQ/2
 OPERATING CYCLE

Example:
The estimated annual production is 2, 00,000 units. The set-up cost per production run is Rs 200

and carrying cost per unit per year is Rs 5. Calculate the optimum production size by applying
EOQ formula.
Stock Levels:
Efficient inventory management requires an effective stock control system. One of the important

aspects of inventory control is stock level. Level of stock has a significant bearing on the

profitability. Over-stocking requires large capital investments whereas under-stocking affects

flow of the production process. The following are the levels of stock fixed for efficient

management of inventory.

Re-order Level:
It is the level which indicates when to place an order for purchase of raw materials. This is also
termed as the ordering level. Following formula is used for calculating Re-order level:

Reorder Level = Lead time x Average usage

Or = Minimum stock level + (Average consumption x normal delivery period)

Or = Safety stock + Lead time consumption

= Maximum consumption x Maximum reorder period

Minimum Stock Level:

It indicates the minimum level of stock below which the quantity of an item should not be

allowed to fall. This level is also called safety stock or buffer stock level. It is calculated by using
following formula:

Minimum Stock Level = Re-order Level – [Normal consumption x Normal re-order period]
Maximum Stock Level:
The maximum stock level indicates the maximum level of inventory beyond which the quantity
of any item is not allowed to increase in order to ensure that unnecessary working capital is not
blocked.

It is calculated by using following formula:

Maximum Stock Level = Reorder level + Reorder quantity – (Minimum consumption X
Minimum reorder period)

Or = Economic Order Quantity + Safety Stock

Average Stock Level:

Average stock level is fixed by taking the average of maximum stock level and minimum stock
level.

Average Stock Level = 1/2 (Maximum Stock Level + Minimum Stock Level)

Example:

The following information is available in respect of a particular material:

Reorder Quantity: 3,600 units Maximum Consumption: 900 units per week Minimum

Consumption: 300 units per week Normal Consumption: 600 units per week Re-order period: 3
to 5 weeks Calculate (i) Re-order level (ii) Maximum stock level (iii) Minimum stock level (iv)
Average stock level
ABC Analysis:
ABC Analysis is one of the important inventory control techniques. In a big manufacturing

concern it is not always possible to pay equal attention to each and every raw material. In such

cases raw materials are classified according to their value so that proper control may be

exercised on materials having high value. ABC Analysis is an analytical technique that tries to

group materials into three categories on the basis of cost involved.

The categories are:

A – High value materials

B – Medium value materials

C – Low value materials

Items that are high value and less than 10% of the total consumption of inventory are grouped
under Category A. This category requires most attention. Category C consists of low cost items
but having large number of units. Category B lies between Category A and Category C. ABC
analysis can be represented as:

The following steps are to be adopted for computation of ABC analysis:

i. Compute the consumption value of each item of material.

ii. Rank them as per their consumption values.

iii. Classify them in A. B and C categories as per their consumption values.

Example 8.6:

From the information given below, prepare an ABC Analysis chart:

i. Just in Time:
Just in time (JIT) inventory control system was developed by Taiichi Okno of Japan and was first

introduced in Toyata Manufacturing Company of Japan. So it is also known as Toyata

Production Method. The basic idea behind this system is that a firm should keep minimum level

of inventory on the assumption that suppliers will deliver the raw materials as and when

required. This system tries to make inventory carrying cost as zero.

Three important elements of JIT are Just in time purchasing, just in time production and just in
time supply. Just in time purchasing, just in time production and just in time delivery can be
effectively applied through adoption of advanced manufacturing technology.

RECEIVABLES MANAGEMENT

Management of trade credit is commonly known as Management of Receivables.

Receivables are one of the three primary components of working capital, the other being
inventory and cash, the other being inventory and cash. Receivables occupy second important
place after inventories and thereby constitute a substantial portion of current assets in several
firms. The capital invested in receivables is almost of the same amount as that invested in
cash and inventories. Receivables thus, form about one third of current assets in India.
Trade credit is an important market tool as it acts like a bridge for mobilization of goods
from production to distribution stages in the field of marketing. Receivables provide
protection to sales from competitions. It acts no less than a magnet in attracting potential
customers to buy the product at terms and conditions favourable to them as well as to the
firm. Receivables management demands due consideration not financial executive not only
because cost and risk are associated with this investment but also for the reason that each
rupee can contribute to firm's net worth.

MEANING AND DEFINITION: When goods and services are sold under an agreement
permitting the customer to pay for them at a later date, the amount due from the customer is
recorded as accounts receivables; So, receivables are assets accounts representing amounts
owed to the firm as a result of the credit sale of goods and services in the ordinary course of
business. The value of these claims is carried on to the assets side of the balance sheet under
titles such as accounts receivable, trade receivables or customer receivables.
This term can be defined as "debt owed to the firm by customers arising from sale of goods
or services in ordinary course of business."
According to Robert N. Anthony, "Accounts receivables are amounts owed to the business
enterprise, usually by its customers. Sometimes it is broken down into trade accounts
receivables; the former refers to amounts owed by customers, and the latter refers to amounts
owed by employees and others".

Generally, when a concern does not receive cash payment in respect of ordinary sale of its
products or services immediately in order to allow them a reasonable period of time to pay
for the goods they have received. The firm is said to have granted trade credit. Trade credit
thus, gives rise to certain receivables or book debts expected to be collected by the firm in the
near future. In other words, sale of goods on credit converts finished goods of a selling firm
into receivables or book debts, on their maturity these receivables are realized and cash is
generated.
According to prasanna Chandra, "The balance in the receivables accounts would be; average
daily credit sales x average collection period." 3 The book debts or receivable arising out of
credit has three dimensions:
• It involves an element of risk, which should be carefully assessed. Unlike cash sales
credit sales are not risk less as the cash payment remains unreceived.
• It is based on economics value. The economic value in goods and services passes to the
buyer immediately when the sale is made in return for an equivalent economic value
expected by the seller from him to be received later on.
• It implies futurity, as the payment for the goods and services received by the buyer is
made by him to the firm on a future date.
The customer who represent the firm's claim or assets, from whom receivables or book-debts
are to be collected in the near future, are known as debtors or trade debtors. A receivable
originally comes into existence at the very instance when the sale is affected. But the funds
generated as a result of these ales can be of no use until the receivables are actually collected
in the normal course of the business.
Receivables may be represented by acceptance; bills or notes and the like due from others at
an assignable date in the due course of the business. As sale of goods is a contract,
receivables too get affected in accordance with the law of contract e.g. Both the parties
(buyer and seller) must have the capacity to contract, proper consideration and mutual assent
must be present to pass the title of goods and above all contract of sale to be enforceable
must be in writing. Moreover, extensive care is needed to be exercised for differentiating true
sales form what may appear to be as sales like bailment, sales contracts, consignments etc.
Receivables, as are forms of investment in any enterprise manufacturing and selling goods on
credit basis, large sums of funds are tied up in trade debtors. Hence, a great deal of careful
analysis and proper management is exercised for effective and efficient management of
Receivables to ensure a positive contribution towards increase in turnover and profits.

Instruments Indicating Receivables

Harry Gross has suggested three general instruments in a concern that provide proof of
receivables relationship. They are briefly discussed below: -
Open Book Account This is an entry in the ledger of a creditor, which indicates a credit
transaction. It is no evidence of the existences of a debt under the Sales of Goods.
Negotiable Promissory Note It is an unconditional written promise signed by the maker to
pay a definite sum of money to the bearer, or to order at a fixed or determinable time.
Promissory notes are used while granting an extension of time for collection of receivables,
and debtors are unlikely to dishonor its terms.
Increase in Profit As receivables will increase the sales, the sales expansion would favorably
raise the marginal contribution proportionately more than the additional costs associated with
such an increase. This in turn would ultimately enhance the level of profit of the concern.
Meeting Competition A concern offering sale of goods on credit basis always falls in the top
priority list of people willing to buy those goods. Therefore, a firm may resort granting of
credit facility to its customers in order to protect sales from losing it to competitors.
Receivables acts as an attracting potential customers and retaining the older ones at the same
time by weaning them away firm the competitors.
Augment Customer's Resources Receivables are valuable to the customers on the ground that
it augments their resources. It is favoured particularly by those customers, who find it
expensive and cumbersome to borrow from other resources. Thus, not only the present
customers but also the Potential creditors are attracted to buy the firm's product at terms and
conditions favourable to them. Speedy Distribution
Receivables play a very important role in accelerating the velocity of distributions, As a
middleman would act quickly enough in mobilizing his quota of goods from the productions
place for distribution without any hassle of immediate cash payment. As, he can pay the full
amount after affecting his sales. Similarly, the customers would hurry for purchasing their
needful even if they are not in a position to pay cash instantly. It is for these receivables are
regarded as a bridge for the movement of goods form production to distributions among the
ultimate consumer.

Cost of Maintaining Receivables: Receivables are a type of investment made by a firm.

Like other investments, receivables too feature a drawback, which are required to be
maintained for long that it known as credit sanction. Credit sanction means tie up of funds
with no purpose to solve yet costing certain amount to the firm. Such costs associated with
maintaining receivables are detailed below: -

Administrative Cost: If a firm liberalizes its credit policy for the good reasons of either
maximizing sales or minimizing erosion of sales, it incurs two types of costs:
Credit Investigation and Supervision Cost: As a result of lenient credit policy, there
happens to be a substantial increase in the number of debtors. As a result the firm is required
to analysis and supervises a large volume of accounts at the cost of expenses related with
acquiring credit information either through outside specialist agencies or form its own staff.

Collection Cost: A firm will have to intensify its collection efforts so as to collect the
outstanding bills especially in case of customers who are financially less sound. It includes
additional expenses of credit department incurred on the creation and maintenance of staff,
accounting records, stationary, postage and other related items.

Capital Cost There is no denying that maintenance of receivables by a firm leads to

blockage of its financial resources due to the tie log that exists between the date of sale of
goods to the customer and the date of payment made by the customer. But the bitter fact
remains that the firm has to make several payments to the employees, suppliers of raw
materials and the like even during the period of time lag. As a consequence, a firm is liable to
make arrangements for meeting such additional obligations from sources other than sales.
Thus, a firm in the course of expanding sales through receivables makes way for additional
capital costs.

Production and Selling Cost: These costs are directly proportionate to the increase in sales
volume. In other words, production and selling cost increase with the very expansion in the
quantum of sales. In this respect, a firm confronts two situations; firstly when the sales
expansion takes place within the range of existing production capacity, in that case only
variable costs relating to the production and sale would increase. Secondly, when the
production capacity is added due to expansion of sales in excess of existing production
capacity. In such a case incremental production and selling costs would increase both
variable and fixed costs.

Delinquency Cost: This type of cost arises on account of delay in payment on customer's
part or the failure of the customers to make payments of the receivables as and when they fall
 due after the expiry of the credit period. Such debts are treated as doubtful debts. They
involve: -
• Blocking of firm's funds for an extended period of time,

• Costs associated with the collection of overheads, remainders legal expenses and on
initiating other collection efforts.

Default Cost Similar to delinquency cost is default cost. Delinquency cost arises as a result
of customers delay in payments of cash or his inability to make the full payment from the
firm of the receivables due to him. Default cost emerges a result of complete failure of a
defaulter (customer) to pay anything to the firm in return of the goods purchased by him on
credit. When despite of all the efforts, the firm fails to realize the amount due to its debtors
because of him complete inability to pay for the same. The firm treats such debts as bad
debts, which are to be written off, as cannot be recovers in any case.

CASH MANAGEMENT

Cash is one of the important components of current assets. It is needed for performing all the
activities of a firm, i.e. from acquisition of raw materials to marketing of finished goods.

Therefore it is essential for a firm to maintain an adequate cash balance. One of the important
functions of a finance manager is to match the inflows and outflows of cash so as to maintain
adequate cash.

i. Meaning of Cash:
With reference to cash management cash has two meanings—ready cash and near cash. Currency
notes, coins, bank balances are the examples of ready cash where as marketable securities,
treasury bills, etc. are the examples of near cash. Management of cash means management of
both ready cash as well as near cash.

ii. Reasons for Holding Cash:

John Maynard Keynes identified the following three reasons for holding cash:

Transaction Motive:
This refers to holding of cash to meet routine payments such as purchases, wages, operating
expenses, etc.

Precautionary Motive:
This refers to holding of cash to meet unexpected demands for cash such as to meet the extra
cash payment for purchase of raw materials due to increase in cost of raw materials.

Speculative Motive:
This refers to holding of cash to take advantage of favorable market conditions such as to
purchase excess quantity of raw materials for getting a handsome discount.

iii. Models of Cash Management:

A fund manager is responsible for maintaining adequate cash balances so that the liquidity

position of the firm remains strong. It is necessary for him/her to know what should be the

optimum cash balance and in what quantity marketable securities should be purchased or sold.
There are several models of cash management to determine the optimum level of cash balances.

These are described below:

i. Baumol Model:
This Model, also known as Inventory Model was developed by William J. Baumol, and is based

on the combination of Inventory Theory and Monetary Theory. According to this model, the

optimum level of cash is that level of cash where the cost of carrying and transaction cost are

minimum. Here, carrying cost means the interest foregone on marketable securities and
transaction cost refers to cost of liquidating marketable securities.

The optimum cash balance according to this model is:

Where, C = Optimum cash balance,

D = Annual cash disbursement,

F = Fixed cost per transaction, and

O = Opportunity cost of one rupee per annum.

Example:
A firm maintains a separate account for cash disbursement. Total disbursements are Rs 2,

10,000. Administration and transaction cost of transferring cash to disbursement account is Rs 25

per transfer Marketable securities’ yield is 5% p.a. Determine the optimum cash balance as per

the Baumol Model.

i. Miller-Orr Cash Management Model:

This model sets two levels for cash—an upper limit h and a lower limit z. Upper limit is three
times the lower limit. As per this model, if the cash balance reaches the upper limit, excess cash
balance, i.e. h-z should be invested in marketable securities and in the reverse case, marketable
securities should be liquidated.

The lower limit of cash balance, i.e. z is calculated by using the following formula:
Where, z is the lower limit,

b is the fixed cost per order,

σ2 is the variance of daily changes in expected cash balance,

LL is the lower control limit, and i is the interest rate per day

Cash Budget an important technique of managing Cash:

A cash budget itemizes the projected sources and uses of cash in a future period. This
budget is used to ascertain whether company operations and other activities will provide a
sufficient amount of cash to meet projected cash requirements. If not, management must
find additional funding sources.
The inputs to the cash budget come from several other budgets. The results of the cash
budget are used in the financing budget, which itemizes investments, debt, and both interest
income and interest expense.
The cash budget is comprised of two main areas, which are Sources of Cash and Uses of
Cash. The Sources of Cash section contains the beginning cash balance, as well as cash
receipts from cash sales, accounts receivable collections, and the sale of assets. The Uses of
Cash section contains all planned cash expenditures, which comes from the direct materials
budget, direct labor budget, manufacturing overhead budget, and selling and administrative
expense budget. It may also contain line items for fixed asset purchases and dividends to
shareholders.
If there are any unusually large cash balances indicated in the cash budget, these balances
are dealt with in the financing budget, where suitable investments are indicated for them.
Similarly, if there are any negative balances in the cash budget, the financing budget
indicates the timing and amount of any debt or equity needed to offset these balances.
Example:
From the following forecast of income and expenditure, prepare a cash budget for the
months January to April, 2020.
Additional information is as follows:
1. The customers are allowed a credit period of 2 months.
2. A dividend of Rs 10,000 is payable in April.
3. Capital expenditure to be incurred: Plant purchased on 15th January for 15,000; a Building has
been purchased on 1st March and the payments are to be made in monthly installments of Rs
2,000 each.
4. The creditors are allowing a credit of 2 months.
5. Wages are paid on the 1st of the next month.
6. Lag in payment of other expenses is one month.
7. Balance of cash in hand on 1st January, 2020 is Rs 15,000.